Abstract: A growing number of community banks are originating mortgage loans for sale to the secondary market. Although this can be an effective strategy for boosting fee income, it’s critical for management and the board of directors to understand the inherent risks.
Why the Increase?
Traditionally, community banks that participated in the secondary market were brokers, originating mortgages closed on behalf of larger financial institutions. In 2013, the Consumer Financial Protection Bureau (CFPB) finalized new loan originator compensation rules, which substantially limited the fees a broker could earn.
Since then, many community banks, in an effort to enhance noninterest income, have begun originating mortgages on their own behalf and then selling them to secondary market investors.
What are the Risks?
Community banks that move away from the broker role and originate their own loans increase their risk exposure. For one thing, they become subject to CFPB rules, including the Ability-to-Repay (ATR) and Qualified Mortgage (QM) rules. Even after selling a loan to the secondary market, a bank remains liable under these rules and may be required to buy back the loan years later if it’s determined that it failed to properly evaluate the borrower’s ability to repay or to meet qualified mortgage standards.
To mitigate these risks, it’s important for banks to develop or update underwriting policies, procedures and internal controls to ensure compliance with the ATR and QM rules. It’s also critical for banks to have loan officers and other personnel in place with the skill and training necessary to implement the rules.
There’s also a risk that contracts to sell mortgages to the secondary market will have a negative effect on a bank’s regulatory capital. Often, these contracts contain credit-enhancing representations and warranties (CERWs), under which the seller assumes some of the risk of default or nonperformance. Generally, these exposures must be reported and risk-weighted (using one of several approaches) on a bank’s call reports, which can increase the amount of capital or reserves the bank is required to maintain.
Is there a Safe Harbor?
The Basel III capital rules provide a safe harbor that exempts certain representations and warranties from the risk-based capital rules. For example, CERWs don’t include:
- Early default clauses and similar warranties in connection with qualifying one- to four-family residential first mortgages that permit a buyer to return a loan (or obtain a premium refund) in the event of default for a period not to exceed 120 days from the original sale,
- Premium refund clauses in connection with certain government-guaranteed loans, and
- Warranties that permit a buyer to return a loan in cases of misrepresentation, fraud or incomplete documentation.
If, however, a loan sale agreement contains an early default period that exceeds 120 days, the bank must risk-weight the warranty until it expires.
Read the Fine Print
Community banks weighing a move from broker to originator of secondary market mortgages must consider the risks involved before entering the arena. In addition to taking steps to manage compliance risks, banks should review loan sale agreements carefully — particularly representations and warranties — and evaluate their potential impact on regulatory capital.