The significant turmoil in the mortgage markets is causing many in the industry to re-evaluate how to best engage in the lending business. Stand alone mortgage lenders are finding it increasingly difficult to fulfill their important role of making home ownership a possibility for many Americans. A primary source of this difficulty is the need for funding, as liquidity, namely loan sales, wholesale lines, and structured finance arrangements, have become extremely scarce.
As with all crises, these sources of funding will likely return, to a substantial extent, as the markets stabilize. Nonetheless, certain mortgage lenders have expressed a desire to evaluate alternatives that could provide them with greater stability through the inevitable housing cycles. In some cases, mortgage lenders have decided that affiliation with a bank or thrift institution, or conversion to a bank or thrift charter, may provide that stability. In addition, banking organizations and financial services firms with special or limited purpose bank or thrift charters may be considering acquiring mortgage companies to obtain the relationships developed by the lenders and thereby increase their customer base.
A number of Wall Street investment banks have acquired stand-alone mortgage origination platforms in the last few years, and Merrill Lynch, in 2006, obtained Office of Thrift Supervision approval to shift its mortgage business into an expanded, full service thrift institution. This Alert article discusses some of the reasons behind these developments, including the greater access to liquidity sources that banking organizations enjoy and, for federally chartered institutions, the benefit of federal preemption of state laws.
To be clear, even though there are significant benefits to conducting a mortgage lending business through a bank or thrift charter that are discussed below, doing so is by no means a way to avoid regulation. The banking industry is among the most highly regulated industries in the United States, and operating through a depository institution charter involves oversight from federal and, possibly, state banking regulators, depending on the charter type. Banking organizations must also follow guidance from federal banking regulators that discourages origination of sub-prime loans and encourages thorough documentation and underwriting of prospective borrowers, and they need to support on-balance-sheet assets with appropriate levels of capital as well as to fulfill their obligations under the Community Reinvestment Act, among other requirements. In addition, as a result of the sub-prime crisis and the effect of declining home values and broader economic uncertainty on foreclosure rates, Congress and federal and state regulators are very focused on the lending practices of all segments of the mortgage industry, including the banking organizations. Furthermore, as recent earnings reports show, the banking industry is certainly not immune to broader economic turmoil.
Despite the highly regulated environment in which banking organizations operate, however, there are valid reasons for certain mortgage lenders to consider affiliation with a bank or thrift. Conducting a mortgage business within a bank or thrift charter provides important advantages over a non-bank mortgage company platform, including, as described below, stability of funding and access to additional liquidity sources, the ability to offer customers a wider variety of products and services, and, for federally chartered entities, federal preemption of state laws. Indeed, the following discussion is also relevant to a bank or thrift that is considering the acquisition of a mortgage company, as it highlights the benefits a depository institution can provide to the operations of such an institution.
Access to Funding. With respect to funding, non-bank lenders rely chiefly on selling and securitizing loans and warehouse lines of credit to support originations, and those that hold loans or mortgage-backed securities for their portfolio also may turn to the asset-backed commercial paper markets as well as using reverse repurchase agreements to obtain funding. Banks and thrifts also access these funding sources. In addition, however, banks and thrifts can access funds through the ability to take insured deposits and obtain advances from the Federal Home Loan Bank System, the Fed Funds market and other sources. For example, a bank or thrift can raise funds through issuing brokered certificates of deposit or through participating in a sweep program in which customers of an affiliated or even a nonaffiliated brokerage firm can sweep available cash balances in their brokerage accounts into insured deposits at the bank or thrift. A depository institution that holds servicing rights could even potentially access cash by self depositing escrows for taxes and insurance payments. And banks or thrifts that are members of the Federal Home Loan Bank System can pledge mortgage loans and mortgage-backed securities as collateral for funding advances. Generally, it is not possible for a bank or thrift to transfer its access to additional liquidity to an affiliated mortgage lender due to affiliate transactions restrictions that apply to insured depository institutions. However, conducting a mortgage business within the depository institution or an operating subsidiary of the institution avoids these limitations.
Access to Enhanced Customer Relationships. Because it is possible to offer deposit and lending products and even fiduciary and asset management services within a bank or thrift charter, conducting a mortgage lending business through a banking organization or affiliation with a banking organization also provides an opportunity to offer customers a significantly wider range of products and services over time and to obtain a wider share of customers’ wallets and a more diverse revenue base to more easily weather downturns in the mortgage industry. At the same time, mortgage lenders continue to be of interest to banks, because of the “stickiness” of their products as an opportunity to cross-sell a wide range of products and services to borrowers and prospective borrowers.
Affiliation Considerations. For mortgage lenders and banks considering possible affiliation, the nature of the affiliation depends in part upon the scale of the mortgage business. The March 5, 2002 Alert discussed the relative advantages and disadvantages of various charter types. However, a more local mortgage company with a focus on a single market or a regional market that spans a few states might consider a state bank, where it is possible to develop a close relationship with a local regulator and where the advantages of federal preemption of state law are not as compelling.
On the other hand, lenders with a larger network covering many states or the entire country would benefit from affiliation with a federally chartered entity because federal preemption of state law, which the Supreme Court most recently reaffirmed in the context of operating subsidiaries of national banks in its Watters vs. Wachovia Bank decision last spring, makes it possible to operate on a uniform basis in all markets. In addition, a thrift charter is often an ideal vehicle through which to conduct a lending business focused on residential mortgage lending because thrifts have historically focused on mortgage lending and are able to operate branches nationwide with relatively few limitations. As noted above, banks are themselves highly regulated and many industry observers expect that Congress and state legislatures will likely enact tougher limitations an all segments of mortgage lenders. However, even if federal and state laws impose additional consumer protection requirements on the industry, it is likely that federally chartered entities will still have the benefit of operating under a single set of rules that applies nationwide.
Conclusion. In sum, operating a mortgage origination business through a bank or thrift charter is an alternative worth considering for those mortgage lenders who are evaluating their options for weathering the current storm in the mortgage industry. Affiliation with a bank or thrift charter is certainly not a practical or desirable option for lenders who focus on sub-prime lending and it may not be desirable for many mortgage lenders who are content to wait for the markets to return to normalcy. However, conducting business through a depository institution charter may enable a mortgage lender to stabilize its operations and to focus more on the important business of home lending, and acquiring a mortgage platform may permit a depository institution to expand its reach to customers and provide additional opportunities to cross sell a wide range of products and services.Goodwin Procter has assisted many nonbank financial services firms, including lenders, to evaluate whether a bank/thrift charter would be beneficial to their operations, and has assisted banks/thrifts to acquire nonbank operating companies.