Three of the Federal Home Loan banks are about to kick off a second alternative secondary-market program.
The Home Loan banks of Indianapolis, Cincinnati, and Seattle have jointly developed their own loan-purchasing program, which they plan to test in the third quarter. The program will have a regional focus and a unique risk-sharing plan, which will distinguish it from the well-known Mortgage Partnership Finance program, a three-year-old nationwide program run by the Chicago bank.
Though the three banks have not yet decided on a permanent name for their new program, for now they are calling it the Mortgage Purchase Program.
Buying loans is a relatively new business for the Federal Home Loan banks. Bruce Morrison, chairman of the Federal Housing Finance Board, the agency that regulates the 12 federally chartered banks, has been encouraging the banks since 1996 to develop pilot programs to compete against Fannie Mae and Freddie Mac.
The Home Loan banks long have lent money to banks in their regions to finance mortgage loans, invested in mortgage-backed securities, and provided correspondent banking services such as wire transfers to their members.
But the Home Loan banks knew they needed to diversify if they wanted their business to grow, said Beth C. Nellist, manager of finance communications at the Indianapolis bank. Fannie and Freddie were making good profits by holding loans in their portfolios, so it seemed natural for the banks to do the same, she said.
The Chicago bank led the way in 1997 by starting the Mortgage Partnership Finance program, which splits the risk on loans between the seller, the member bank, and the buyer, the Home Loan bank.
The Home Loan bank takes on the interest rate risk, and the seller retains the credit risk by providing credit enhancement and gets paid by the buyer for doing so. In contrast, Fannie and Freddie take on all the risk of a loan and therefore reap all the rewards. Hence, for some loans, the Mortgage Partnership Finance program has been able to offer sellers prices that represent better value over the life of the loan than Fannie or Freddie do.
Though eight of the 12 Home Loan banks now participate in the Mortgage Partnership Finance program, the banks in Indianapolis, Seattle, and Cincinnati opted out, because their member-lenders wanted local control for the program and also wanted price-setting to be done by their regional bank, Ms. Nellist said. (The San Francisco Home Loan bank is applying to join the Mortgage Partnership Finance program.)
Under Mortgage Partnership Finance, while regional Home Loan banks do the buying, the Chicago Home Loan bank sets loan prices and also runs back-office operations for the other participating Home Loan banks.
Last year, Ms. Nellist said, the Indianapolis, Seattle, and Cincinnati banks came up with an alternative risk-sharing structure. Under the Mortgage Purchase Program, instead of paying the seller a fee for providing credit enhancement, the Home Loan bank will create a credit reserve.
Ms. Nellist said the Home Loan banks participating in the new program will buy loans at prices comparable to what Fannie and Freddie would offer but will include incentives that Fannie and Freddie do not provide, including a four-layer credit-protection structure that rewards sellers for making good loans.
The first layer, worth roughly 20% of the value of a loan, will consist of either the owner's equity or private mortgage insurance. If the loan goes bad, the purchasing Home Loan bank, like a typical mortgage bank, would sell the house and recoup the first layer of credit.
The key to the program is the second layer of credit protection. After it buys a loan, a Home Loan bank would take 50 basis points and put it in a lender risk account. If losses on the loan exceed the first layer of credit protection, the Home Loan bank would start dipping into the account. If the loan performs well, the seller would gradually earn back the 50 basis points after the first three years of the loan. Thus, lenders have an added incentive to make good loans.
The lender risk account would also give sellers an accounting bonus, Ms. Nellist said. Sellers would be able to book the value of the lender risk account as income at the time of sale.
The third layer of the protection structure will be supplemental mortgage insurance. The first three layers together account for up to 40% of the loan's value. The remaining 60% of the loan value will be covered by the Home Loan banks themselves. This plan will benefit the Home Loan banks in that they would lose money only if they failed to get 60% of the value on the house.
The Mortgage Purchase Program will have a different name at each of the Home Loan banks, and back-office operations will be run separately.
The success of the nationwide Mortgage Partnership Finance program has made the Indianapolis bank's members eager to get the new regional program up and running. "Our marketing people say that some of the members get a little impatient," Ms. Nellist said.
There has been so much demand from "a small set of our members" for an outlet for FHA loans that the Indianapolis bank recently applied for Finance Board approval to participate in the Mortgage Partnership Finance program, she said.
Ms. Nellist added that although participation in the nationwide program "is likely, it's not a done deal." If it happens, it would be within a few months, she said.