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How Community Banks Can Come Back Strong in the Mortgage Business

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Community banks remain the financial backbone for a large swath of the United States, despite ongoing consolidation and competitive pressure from large ubiquitous banking institutions.

Unlike their large bank competitors, community banks rely on old-fashioned but largely reliable methods of underwriting loans built more on knowing the customer than on scale-driven automated underwriting processes that contributed to excessive risk-taking and the mortgage crisis. Banking is a scale business and community banks feel the effects of this structural headwind in various forms, such as increased regulatory burden that severely stretches legal and regulatory staff or higher transactions costs in selling assets such as mortgages to the secondary market. Pursuing policy solutions that minimize market distortions is critical to efforts that assure community banks maintain their presence in local mortgage markets.

The decline of Fannie Mae and Freddie Mac could usher in a sort of mortgage renaissance for community banks, facilitated by their natural partner, the Federal Home Loan Bank System. A glimpse into this future was offered recently in testimony by Federal Housing Finance Agency Deputy Director Sandra Thompson to the Senate Banking Committee. Noting the importance of community banks in rural and underserved markets, Thompson highlighted the hurdles confronted by these firms in selling mortgages that are not good balance sheet products from an interest rate risk management perspective. The government-sponsored enterprises for years charged smaller banks higher guarantee fees for selling conventional conforming mortgages than they charged the large seller-servicers. Community banks encountered similar terms through large correspondent lenders that acted as intermediaries between these banks and the GSEs. This made sense because like banking, mortgage securitization is a volume-driven business. When small lenders want to originate fixed-rate mortgages, their outlets are limited to the GSEs; a large aggregator that in turn sells up to the GSE or retains for its own investment or sale; or keeping the loans on the small firm's own balance sheet. However, long-term fixed-rate mortgages are poorly matched against typically shorter-term funding used by community banks and this mismatch in the duration of the asset and liability creates interest rate risk for the banks. As a result, selling fixed-rate loans and holding adjustable-rate mortgages in the portfolio is the traditional strategy for such lenders. But these lenders find themselves at the mercy of large lenders and GSEs in selling their product.

Recognizing some of the secondary market difficulties faced by community banks, the FHFA has stepped in to require the GSEs to better align loan sale execution strategies between those that have traditionally favored large lenders (swapping loans for mortgage-backed securities) and those preferred by smaller lenders (exchanging loans for cash). Beyond these and some other steps taken by the FHFA, unleashing the potential for Federal Home Loan banks to enhance community bank mortgage activity is critical to a stable and robust housing finance system.

In their mission to provide liquidity to member institutions, many of which are community banks and credit unions, each Federal Home Loan bank is focused on serving the needs of its members, most notably in the form of FHLB advances to fund mortgages, or in other ways such as acting as aggregator of loans from members that can be sold directly to Fannie Mae for securitization. In a post-GSE world, the Federal Home Loan banks could expand their current aggregation activities across all Qualified Mortgage products directly with private investors.

Another innovation that directly serves the needs of its community bank members is the risk-sharing arrangements the FHLBs establish through their Mortgage Partnership Finance programs. Under these structures, member institutions sell their mortgages to an FHLB and retain a portion of the credit risk while shedding interest rate risk from the balance sheet. These programs could evolve over time to provide community banks and credit union members more flexible structures for participating directly in credit risk-sharing arrangements that can be lucrative for the investor (in this case a community bank) and have largely been the domain of larger, more sophisticated investors. Working alongside an FHLB, smaller institutions could expand their investment opportunities while effectively managing their risks. Little would need to be done formally to the structure of the FHLB system for this to occur, although from an operational efficiency perspective, some sort of shared services risk-sharing model among the FHLBs along the lines of the FHLB aggregation facility might be appropriate.

A more expansive role for the FHLBs is for them to become the issuer of choice for community banks should the GSEs go away. Community banks' traditional underwriting model might prove valuable, to the extent that the loans they produce outperform the one-size-fits-all production mill of their much larger banking cousins and this gets reflected in better securities pricing.

The FHFA is on the right track in calling out the potential of the FHLBs to support community bank mortgage activities. They should be an integral part of housing finance reform.

Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.

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