Banking presents opportunities for non-depository mortgage companies seeking to boost competitiveness and expand market share. By acquiring or establishing a bank, a mortgage company can enjoy advantages over nonbank lenders, including access to cheap and reliable funding through FDIC-insured deposits, the ability to export interest rates, exemptions from state licensing, and—with a federal charter—preemption of many state mortgage lending laws.
Banking products and services offer new revenue streams, and can help a mortgage company reduce concentrations, diversify risk and minimize uneven business cycles. But regulatory hurdles have become so difficult that unless the mindset changes, it is unlikely that a mortgage company can acquire or establish a bank.
This is unfortunate, because adding mortgage origination capacity can significantly boost bank profitability. Federal Reserve Board Gov. Elizabeth Duke has noted that "only a small fraction of community banks engage in the origination of mortgages for sale, securitization, or mortgage servicing," however, "since the financial crisis…measures of profitability at banks with such activities have significantly exceeded those at community banks not engaged in these business lines."
Very recently, Complete Financial Solutions, a mortgage company, announced its agreement to acquire American Patriot Bank, a Tennessee-based commercial bank. The transaction is subject to bank regulatory approvals. The application may become a litmus test to whether the regulatory hostility to mortgage company acquisitions of banks has thawed.
The OCC handbook's chapter on mortgage banking says "mortgage banking activities generate fee income and may provide cross-selling opportunities that can enhance a bank's retail banking franchise."
Of course, entering the banking business isn't easy for any applicant—it requires time, effort and expense, and involves substantial regulatory obstacles, especially if the applicant is seeking to charter a bank de novo. The regulatory barriers to entry, however, are much higher for mortgage companies, which are held to a different standard than other applicants.
While banking regulators have historically looked on mortgage companies with disfavor, this attitude seems accentuated by the recent financial crisis. Today, almost by default, regulators reject attempts by mortgage companies to acquire existing banks or charter new ones. Most of the time, the negativism expressed at a prefiling meeting with the regulators is enough to dissuade even the most intrepid of mortgage companies.
Regulators seem to believe that mortgage companies that acquire banks or obtain bank charters threaten the federal safety net provided by deposit insurance and access to the Federal Reserve's discount window and payment system. Extending the benefits of the federal safety net to such companies would create a moral hazard and result in excessive risk-taking, they say.
Some of these concerns are justified. Since 2007, many nonbank mortgage lenders have gone out of business. According to popular belief, such lenders were among the chief culprits of the financial crisis, a sentiment shared by banking supervisors. But even if the lending practices of some nonbank mortgage companies contributed to the financial crisis, not all mortgage companies should be placed in the penalty box.
While monoline lenders may be more susceptible to certain risks than companies with more diversified business models, they may also be adept at managing those risks. But concerns about monolines may be misguided, as most mortgage companies do not offer one type of loan product to one type of borrower; a mortgage business typically various offerings and serves different types of customers. And by entering the banking business, a mortgage company could further diversify its products and services and lose the "monoline" label.
Instead of a one-size-fits-all approach to mortgage company/bank combinations, banking supervisors should evaluate proposed transactions on their own terms. Supervisors should assess an applicant's ability to manage and contain the risks involved in operating a mortgage business.
Even if the resulting bank will be a mortgage business with a bank charter, this should not jeopardize an application if the bank will implement an effective risk management program, geared towards the specific risks posed by its business model.
Banking regulators need not develop new standards for evaluating an applicant's mortgage risk management program; these already exist in numerous guidance documents and regulations and include:
• Proper corporate governance, including an appropriate organizational structure, communication, reporting and segregation of duties.
• Competent management, and sound management processes that include planning, policy making, personnel administration, control systems, and comprehensive management information systems.
• Effective policies and procedures, and strong internal controls governing each functional area.
• Well-defined business strategies, permissible activities, lines of authority, operational responsibilities, and acceptable risk levels.
• A strategic plan based on current and prospective market conditions and industry competition, including sufficient long-term resource commitment to endure cyclical downturns, and for niche lenders, a clearly delineated targeted market segment and appropriate business strategies.
• A business plan describing strategies for acquiring, selling, and servicing mortgage banking assets, and providing for adequate resources to support the bank's activities.
• An ongoing, comprehensive audit program that includes both internal and external audits of all aspects of the bank's mortgage lending operations with findings, including control weaknesses, reported to the board of directors or its audit committee.
• A strong IT culture.
• Strong risk management standards for nontraditional or subprime mortgage products.
• Risk-management controls for the valuation, accounting and hedging of mortgage-servicing assets.
• Effective processes for managing risks posed by the bank's third-party service provider relationships.
Regulators should apply these standards when evaluating the prospects of a proposed bank-mortgage company combination. Mortgage banking can be risky, but its risks are not inherently greater than those faced by banks. Notwithstanding recent events, mortgage banking should not automatically raise a regulatory red flag.
The mortgage industry is not monolithic; there are good and bad actors. With proper management and controls, the risks that keep regulators up at night can be mitigated and contained.
David Baris is a partner of BuckleySandler LLP and also executive director of the American Association of Bank Directors.
Peter Olszewski, counsel of BuckleySandler, contributed to this article.