REQUIRED READING: Community banks represent approximately 20% of the mortgage market – but, more importantly, much of this mortgage lending is concentrated in the small towns and rural areas of our country, which are not effectively served by large banks. We cannot rely on the mega-banks to serve these small communities.
Any mortgage reforms or any rules or regulations that make mortgage lending impractical for community banks will seriously harm small towns and rural communities. It is critical that the housing finance system preserves the important role of community banks.
Community bank mortgages are of the highest quality. Community banks seek to ensure that mortgages are affordable for their customers. Loans are underwritten based on personal knowledge of the borrower and his or her circumstances – not based on statistical modeling done in another part of the country or based solely on others' automated underwriting engines.
Community banks generally did not market subprime loans with the characteristics that have led to recent problems, such as ‘teaser’ rates and lack of appropriate documentation. As responsible community-based lenders, community banks require appropriate documentation of borrower income and do not make loans that compel borrowers to refinance or sell in order to remain solvent.
Community banks may sell residential mortgages directly to Fannie Mae, Freddie Mac or the Federal Home Loan Banks (FHLBanks), to an intermediary, or hold them in portfolio until they mature. When community banks sell their well-underwritten loans into the secondary market, they help to stabilize and support that market.
Community bank loans sold to the government-sponsored enterprises (GSEs) or other investors are underwritten as though they were to be held in portfolio. Community banks often go beyond the ratios and statistics used by the GSE automated programs and underwrite based on direct and personal knowledge of the community and the financial situation of the borrower.
This relationship-based underwriting makes a striking impact on the performance data. In a typical year, before the GSEs accelerated their purchases of riskier loans, community bank-originated loans became ‘seriously delinquent’ (i.e., more than three months delinquent) at about one-third the rate of all GSE loans. In the most frenzied, exuberant years of mortgage lending, 2005 through 2007, the general pool of GSE loans was seriously delinquent at a rate four or five times higher than loans originated by community banks and sold to GSEs.
In the wake of the financial crisis, with the general tightening in underwriting standards, community bank loans have continued to perform better – with a delinquency rate one third to one half that of other loans. Community bank loans perform better in all market conditions and contribute to the safety and soundness of the secondary market. Community banks are also portfolio lenders.
The quality of community bank underwriting is complemented by more personalized servicing, which is also strengthened by close ties to customers and communities and has proved more effective at keeping mortgages out of default.
A servicer based 1,000 miles away won't have such knowledge. Smaller servicing portfolios and better control of mortgage documents also provide an advantage over the large servicers. For these reasons, community banks have generally been able to identify repayment problems at the first signs of distress and work out mutually agreeable solutions with struggling borrowers. Many times, the single point of contact is the branch manager or loan officer that made the loan, so the borrower knows who to go to when a problem arises.
As steps are taken to address the abusive servicing standards of some large lenders, it must be recognized that community banks have fundamentally different standards, practices and risks. Overly prescriptive servicing requirements that require costly technology upgrades, applied across the board, will cause many community banks to exit the mortgage servicing business, which will accelerate consolidation of the servicing industry, leaving it to the largest too-big-to-fail lenders.
Secondary market access
Secondary market access is vitally important to community bank mortgage lenders, and the critical questions of corporate structure, governance and mission will determine whether, and to what extent, they are able to participate. If the terms are not right, the secondary market could be an impractical or unattractive option for community banks.
For decades, the housing GSEs worked well and supported high-quality mortgage lending by banks of all sizes. However, conflicting demands of investor expectations and arbitrary affordable housing goals, combined with weak oversight and inadequate risk management, sent the GSEs off track, ending a long and successful run. These conflicts must be remedied going forward.
Here are some of the key features community banks seek in a first-rate secondary market:
Equal access. To be sustainable and robust, the secondary market must be impartial and provide equitable access and pricing to all lenders regardless of their size, location, or lending volume. Without the appropriate structure, a secondary market entity will have a strong incentive to offer favorable terms to only the largest lenders. Such an outcome would drive further industry consolidation, increase systemic risk and disadvantage the millions of customers served by small lenders.
Financial strength and reliability. The secondary market must be financially strong and reliable enough to effectively serve mortgage originators and their customers, even in challenging economic circumstances. Strong regulatory oversight is needed to ensure the secondary market operates in a safe and sound manner.
No appropriation of customer data for cross selling of financial products. When a community bank sells a mortgage to a secondary market entity, it transfers proprietary consumer data that would be highly valuable for the purposes of cross selling financial products. Without large advertising budgets to draw in new customers, community banks seek to deepen and extend their relationships with their current customer base.
Secondary market entities must not be allowed to use or sell this data. Community banks must be able to preserve their customer relationships and franchises after transferring loans.
The option to retain servicing. Originators must have the option to retain servicing after the sale of a loan. In today's market, the large aggregators insist the lender release servicing rights along with the loan. Transfer of servicing entails transfer of data for cross-selling, the concern identified earlier.
While servicing is a low-margin business – in fact, community banks would make more money by releasing servicing rights – it is a crucial aspect of my relationship-lending business model, giving me the opportunity to meet the additional banking needs of my customers.
Limited purpose and activities. The resources of any secondary market entities must be focused on supporting residential and multifamily housing. They must not be allowed to compete with originators at the retail level, where they would enjoy an unfair advantage.
Private capital that protects taxpayers. Securities issued by the secondary market entities must be backed by private capital and third-party guarantors. Government catastrophic loss protection must be fully and explicitly priced into the guarantee fee and the loan-level price. This guarantee would not only provide credit assurances to investors, but would also sustain robust liquidity, even during periods of market stress.
The worst outcome in GSE reform would be to allow a small number of mega-firms or Wall Street firms to mimic the size and scale of Fannie and Freddie under the pretense of creating a private sector solution strong enough to assure the markets in all economic conditions. This would create a new moral hazard, just as pernicious as the one it replaced, driving mass consolidation of the mortgage market. Any solution that fuels this consolidation is only setting up the financial system for an even bigger collapse than the one we've just been through.
One way to achieve secondary mortgage market reform that would satisfy the above criteria, and which should be considered, is replacement of Fannie Mae and Freddie Mac with cooperatives that are privately capitalized and owned by the industry and that have an appropriate level of government support and oversight to ensure stability and market liquidity.
The FHLBanks are a critical resource to community banks. The vast majority are FHLBank members and are active advance users; they look to the FHLBanks as a primary source of liquidity when needed. FHLBank advances play a significant role in supporting community bank mortgage, small business and agricultural lending, and they help community banks manage the interest rate risk in their portfolios.
The largest financial institutions in the country can easily tap the international financial markets for funds; community banks can only do that through their partnership with their local FHLBank. Also, through the Affordable Housing Program, which includes grants and special programs for first-time home buyers, FHLBanks partner with their members to support affordable housing and economic development in communities across the country.
During the darkest days of the financial crisis, the FHLBanks continued to lend to their members without interruption. Advances expanded dramatically during the financial crisis as many parts of the credit markets shut down. This is exactly how the model was designed to work in a crisis – scalable and are able to expand and contract with the demand for credit. The financial crisis would no doubt have been worse without the existence of the FHLBank system, which provided one of the few lifelines available.
Most FHLBanks also offer a residential mortgage secondary market option for their members through the Mortgage Partnership Finance and similar programs. Through these programs, members sell mortgages to their FHLBank but are also obligated to provide a credit enhancement, or "skin in the game." The FHLBank manages the interest rate risk inherent in the long-term mortgages that it purchases.
Without this option, many community banks would not be able to make the long-term fixed-rate loans their customers expect and would not be able to compete with large banks. As Fannie Mae and Freddie Mac have imposed new restrictions and unfavorable pricing, community banks are now selling more of their loans to the FHLBank programs.
In the future housing finance system, the FHLBanks must be kept distinct from Fannie Mae and Freddie Mac or their successors. Proposals to merge the FHLBank system with Fannie Mae and Freddie Mac are not the right solution to address the future of the two housing GSEs. While community banks have benefited from the existing FHLBank secondary market programs, advances must remain the primary business of the FHLBanks.
Terry Jorde is senior executive vice president and chief of staff for the Independent Community Bankers of America, based in Washington, D.C. She can be reached at (800) 422-8439. This article is adapted and edited from a speech delivered before a meeting of the Bipartisan Policy Center Housing Commission and the Jack Kemp Foundation.