Having a conversation with a client
this past weekend, I realized how important is to understand the process of
Buying a home when acquiring a mortgage, this particular individual was
frustrated since the Bank is not giving him a mortgage even though his down payment
is over 60% of the house value, and the problem is his income, Why if i am
risking more on this transaction, i cannot get a mortgage?.
Depository institutions have
traditionally originated residential mortgage loans to hold in their loan
portfolios, and mortgage banking is a natural extension of this
traditional origination process. Although it can include loan origination,
mortgage banking goes beyond this basic activity.
On this article i will try to explain how the bank analyzes a Mortgage, why
they choose carefully which loans are profitable and which ones are not (from
the bank perspective) and make understandable the real business behind a loan:
Mortgage banking generally involves
loan originations, purchases, and sales through the secondary mortgage market.
A mortgage bank can retain or sell
loans it originates and retain or sell the servicing on those loans. Through
mortgage banking, national banks can and do participate in any or a combination
of these activities. Banks can also participate in mortgage banking activities
by purchasing rather than originating loans.
The mortgage banking industry is
highly competitive and involves many firms and intense competition. Firms
engaged in mortgage banking vary in size from very small, local firms to
exceptionally large, nationwide operations. Commercial
banks and their subsidiaries and
affiliates make up a large and growing proportion of the mortgage banking
Mortgage banking activities generate
fee income and provide cross-selling opportunities that enhance a bankâ€™s retail
banking franchise. The general shift from traditional lending to mortgage
banking activities has taken place in the context of a more recent general
shift by commercial banks from interest income activities to non-interest, fee
The key economic function of a
mortgage lender is to provide funds for the purchase or refinancing of
residential properties. This function takes place in the primary mortgage
market where mortgage lenders originate mortgages by lending funds directly to homeowners.
This market contrasts with the secondary mortgage market. In the secondary mortgage
market, lenders and investors buy and sell loans that were originated directly
by lenders in the primary mortgage market. Lenders and investors
also sell and purchase securities in the secondary market that are collateralized
by groups of pooled mortgage loans.
Banks that use the secondary market to
sell loans they originate do so to gain flexibility in managing their long-term
interest rate exposures. They also use it to increase their liquidity and
expand their opportunities to earn fee-generated income.
The secondary mortgage market came
about largely because of various public policy measures and programs aimed at
promoting more widespread home ownership. Those efforts go as far back as the
1930s. Several government-run and government-sponsored programs have
played an important part in fostering home ownership, and are still important in
the market today. The Federal Housing Administration (FHA), for example,
encourages private mortgage lending by providing insurance against default. The
Federal National Mortgage Association (FNMA or Fannie Mae) supports conventional,
FHA and Veteranâ€™s Administration (VA) mortgages by operating programs to
purchase loans and turn them into securities to sell to investors.
When a bank originates a mortgage
loan, it is creating two commodities, a loan and the right to service the loan.
The secondary market values and trades each of these commodities daily.
Mortgage bankers create economic value by producing these assets at a cost that is less than their
Risks Associated with Mortgage Banking
For purposes of the OCCâ€™s discussion of risk, examiners assess banking risk
relative to its impact on capital and earnings. From a supervisory
perspective, risk is the potential that events, expected or unanticipated, may
have an adverse impact on the bankâ€™s capital or earnings. The OCC has defined
nine categories of risk for bank supervision purposes. These risks are: Credit,
Interest Rate, Liquidity, Price, Foreign Exchange, Transaction, Compliance, Strategic,
and Reputation. These categories are not mutually exclusive; any product or
service may expose the bank to multiple risks. For analysis and
discussion purposes, however, the OCC identifies and assesses the risks separately.
The applicable risks associated with mortgage
banking are: credit risk, interest rate risk, price risk, transaction risk,
liquidity risk, compliance risk, strategic risk, and reputation risk. These are
discussed more fully in the following paragraphs.
Credit risk is the risk to earnings or
capital arising from an obligorâ€™s failure to meet the terms of any contract
with the bank or to otherwise fail to perform as agreed. Credit risk is found
in all activities where success depends on counterparty, issuers, or borrower
performance. It arises any time bank funds are extended, committed, invested,
or otherwise exposed through actual or implied contractual agreements, whether
reflected on or off the balance sheet.
In mortgage banking, credit risk
arises in a number of ways. For example, if the quality of loans produced or
serviced deteriorates, the bank will not be able to sell the loans at
prevailing market prices. Purchasers of these assets will discount their bid prices or avoid
acquisition if credit problems exist. Poor credit quality can also result in
the loss of favorable terms or the possible cancellation of contracts with
secondary market agencies.
Â Interest Rate Risk
Interest rate risk is the risk to
earnings or capital arising from movements in interest rates. The economic
perspective focuses on the value of the bank in todayâ€™s interest rate
environment and the sensitivity of that value to changes in interest rates.
Interest rate risk arises from differences between the timing of rate changes
and the timing of cash flows (repricing risk); from changing rate relationships
among different yield curves affecting bank activities (basis risk); from
changing rate relationships across the spectrum
of maturities (yield curve risk); and from interest-related options embedded in
bank products (options risk). The evaluation of interest rate risk must
consider the impact of complex, illiquid hedging strategies or products, and also the
potential impact on fee income which is sensitive to changes in interest rates.
In those situations where trading is separately managed this refers to
structural positions and not trading positions.
Higher interest rates can reduce
homebuyersâ€™ willingness or ability to finance a real estate loan and, thereby,
can adversely affect a bank that needs a minimum level of loan originations to
remain profitable. Rising interest rates, however, can increase the cash flows
expected from the servicing rights portfolio and, thus, increase both projected
income and the value of the servicing rights. Falling interest rates normally
result in faster loan prepayments, which can reduce cash flows expected from the rights and the value of the bank's servicing portfolio.
Price risk is the risk to earnings or
capital arising from changes in the value of portfolios of financial
instruments. This risk arises from market-making, dealing, and position-taking
activities in interest rate, foreign exchange, equity, and commodities markets.
Falling interest rates may cause
borrowers to seek more favorable terms and withdraw loan applications before
the loans close. If customers withdraw their applications, a bank may be unable
to originate enough loans to meet its forward sales commitments. Because of
this kind of â€œfallout,â€ a bank may have to purchase additional loans in the secondary
market at prices higher than anticipated. Alternatively, a bank may choose to
liquidate its commitment to sell and deliver mortgages by paying a fee to the counterparty, commonly called a pair-off arrangement.Â
Transaction risk is the risk to
earnings or capital arising from problems with service or product delivery.
This risk is a function of internal controls, information systems, employee
integrity, and operating processes. Transaction risk exists in all products and services.
To be successful, a mortgage banking
operation must be able to originate, sell, and service large volumes of loans efficiently.
Transaction risks that are not controlled can cause the company substantial
To manage transaction risk, a mortgage
banking operation should employ competent management and staff, maintain effective
internal controls, and use comprehensive management information systems. To
limit transaction risk, a bankâ€™s information and recordkeeping systems must be
able to accurately and efficiently process large volumes of data.
Because of the large number of
documents involved and the high volume of transactions, detailed subsidiary
ledgers must support all general ledger accounts. Similarly, accounts should be
reconciled at least monthly and be supported by effective supervisory controls.
Excessive levels of missing collateral
documents are another source of transaction risk. If the bank has a large
number of undocumented loans in its servicing portfolio, purchasers will not be
willing to pay as high a price for the portfolio. To limit this risk,
management should establish and maintain control systems that properly identify
and manage this exposure.
Â Liquidity Risk
Â Liquidity risk is the risk to earnings
or capital arising from a bankâ€™s inability to meet its obligations when they
come due, without incurring unacceptable losses.
Liquidity risk includes the inability to manage unplanned decreases or changes
in funding sources. Liquidity risk also arises from the bankâ€™s failure to
recognize or address changes in market conditions that affect the ability to
liquidate assets quickly and with minimal loss in value.
In mortgage banking, credit and
transaction risk weaknesses can cause liquidity problems if the bank fails to
underwrite or service loans in a manner that meets investorsâ€™ requirements. As
a result, the bank may not be able to sell mortgage inventory or servicing rights to
generate funds. Additionally, investors may require the bank to repurchase
loans sold to the investor which the bank inappropriately underwrote or
Â Compliance risk is the risk to
earnings or capital arising from violations of, or non-conformance with, laws,
rules, regulations, prescribed practices, or ethical standards. Compliance risk
also arises in situations where the laws or rules governing certain bank products or
activities of the bankâ€™s clients may be ambiguous or untested. Compliance risk exposes
the institution to fines, civil money penalties, payment of damages, and the
voiding of contracts. Compliance risk can lead to a diminished
reputation, reduced franchise value, limited business opportunities, lessened
expansion potential, and lack of contract enforceability.
Strategic risk is the risk to earnings
or capital arising from adverse business decisions or improper implementation
of those decisions. This risk is a function of the compatibility of an
organizationâ€™s strategic goals, the business strategies developed to achieve those goals, the
resources deployed against those goals, and the quality of implementation. The resources
needed to carry out business strategies are both tangible and intangible. They
include communication channels, operating systems, delivery networks, and
managerial capacities and capabilities.
Reputation risk is the risk to
earnings or capital arising from negative public opinion. This affects the
institutionâ€™s ability to establish new relationships or services, or continue
servicing existing relationships. This risk can expose the institution to
litigation, financial loss, or damage to its reputation. Reputation risk
exposure is present throughout the organization and is why banks have the
responsibility to exercise an abundance of caution in dealing with its
customers and community. This risk is present in activities such as asset
management and agency transactions.