In an increasingly volatile marketplace, community banks need to be resourceful to take advantage of strategies that can help them maintain profitability and stability over time. Selling mortgage loans that your bank originated to secondary market investors can create a much-needed influx of cash, but it’s important to understand and mitigate the risks.
How did we get here?
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, which were revised in April 2021 with a mandatory compliance date of October 1, 2022. Even after selling a loan to the secondary market, a bank remains liable under these rules. A bank might even 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 revised 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.
Moreover, there’s 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, 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. In turn, this can increase the amount of capital or reserves the bank is required to maintain.
Will updated Basel III rules add risk?
In addition, the Basel III capital rules are currently being updated to reduce operational risk in banks. The update was made in response, in part, to several 2023 regional bank failures largely caused by inadequate levels of capital. Known as the Basel III endgame, the update is somewhat controversial because some see its requirements as excessively stringent. Currently, the Basel III endgame is scheduled to take effect July 1, 2025, and will phase in the capital ratio impact over three years.
Among other things, the updated rules would reduce banks’ ability to use their own models for calculating capital requirements for loans. Banks would instead be required to use standardized measures and models to evaluate loan risks.
Stay vigilant.
Community banks have much to gain by selling their mortgage loans to the secondary market, but only if they fully understand and take steps to mitigate the potential problems. Staying on top of the latest regulatory updates and developing proper procedures and internal controls will help ensure the rewards outweighs the risks.
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