An increasing number of community bankers are asking themselves whether its worth the hassle – and the risk – to originate mortgages, particularly after the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the subsequent promulgation of the qualified mortgage and ability-to-repay rules. These regulations, if not followed correctly, could increase banks’ liability.
We would argue, however, that mortgage origination can still be profitable and represents a good source for steady, recurring income. Moreover, it may enable banks to cross sell more products and services to appreciative customers, as homeownership remains the bedrock of the American Dream.
Qualified Mortgage Restrictions
Under the new regulatory rules, a qualified mortgage is one in which the lender has analyzed the borrower’s ability to repay based on income, assets and debts. The borrower cannot take on monthly debt payments in excess of 43% of pre-tax income and the lender cannot charge more than three percent in points and origination fees, unless the loan amount is for less than $100,000.
Moreover, a qualified mortgage cannot be deemed risky or overpriced by having negative-amortization, balloon, 40-year or interest-only terms. Under qualified mortgage rules, safe harbor provisions protect lenders against lawsuits by distressed borrowers who claim the lender gave them a mortgage that the lender knew they could not repay. Lenders can resell qualified mortgages in the secondary market to Fannie Mae and Freddie Mac and other entities.
Small lenders, lenders who hold mortgages in their portfolios instead of selling them into the secondary mortgage market and rural lenders face fewer lending restrictions than larger lenders. Of course, banks can make other types of mortgages that aren’t qualified mortgages, but sales of such mortgages in the secondary market are limited and provide fewer legal protections for lenders.
Many bankers fear such liability and are deciding to exit the business line altogether. Yet, according to the Mortgage Bankers Association’s latest Quarterly Mortgage Bankers Performance Report, independent mortgage banks and mortgage subsidiaries of chartered banks reported a profit of $744 per-loan in the fourth quarter. Punk Ziegel analyst Richard Bove contended in the Economist that banks should stay in the business because mortgages typically provide steady recurring income streams. Making mortgages can also lead to cross-selling opportunities. Wells Fargo Bank, for example, one of the country’s top mortgage originators, is also known for having some of the best cross-sell ratios in the industry.
But for mortgages to be a viable line of business for community banks, particularly in the new regulatory era, banks must define and refine their strategy, commit to it and build the infrastructure. If they choose to build a mortgage operation in-house, for example, banks need to hire not only experienced mortgage bankers, but also underwriting and compliance professionals with the right expertise. On the technology side, they can invest in mortgage origination software or use vendors’ cloud platforms.
Smaller banks with few branches may opt to open mortgage loan production offices in contiguous markets that make sense for them, using a centralized back-office for underwriting. In order to make these in-house investments work, however, a bank has to be committed to doing substantial origination volume.
That doesn’t mean that banks must have all of the processes in-house if they truly can’t afford it, or prefer to focus on other lines of business. Institutions can choose a number of different models, including outsourcing some or even all of the operations. If banks outsource back-office operations but keep the front-end in-house, they have to make sure they perform enough due diligence to adequately determine whether prospective homeowners really do have the ability to repay their mortgages.
The mortgage business cannot continue to be an afterthought; there’s just too much risk for the little revenue that would be generated. Banks need to commit to the business and invest in the necessary compliance structure, or else they’ll find themselves in trouble. If a bank doesn’t have the expertise to underwrite mortgages, particularly under the new Qualified Mortgage rules, they should strongly consider outsourcing that process. While the outsourcer would be generating the required disclosure documents, banks still must have someone with expertise embedded in the front-end process to correct any errors. They need a dedicated compliance person, focused solely on mortgages, not a sales-focused production person, to avoid conflicts of interest.
Additionally, if banks sell their loans to another servicer, they must be careful not to sell to a larger institution that would be stuffing the monthly mortgage payment notices with offers for their own products. Rather, banks should consider selling to investors who do not go after the bank’s customers and the servicing agreement should include provisions to that effect.
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