The financial press provides daily reports on the meltdown of the subprime mortgage industry. On any given day, one can read stories about the demise of another mortgage lender, the layoff of additional mortgage professionals, or the catastrophic impact of the meltdown on families or communities. To be sure, the subprime industry meltdown is one of the dominant financial stories of 2007.
No senior officer of a financial institution should wait for history to be written before anticipating the effects of the subprime meltdown on his institution. Bank regulators are already responding to the subprime meltdown by looking into real estate practices that have not received much scrutiny in recent years. Here is where we have seen the focus.
It Isn’t Gone Just Because It Has Been Sold
It has become commonplace for a bank to originate mortgage loans with the intent of selling the loans into the secondary market. A community bank may originate a large number of mortgage loans and sell those loans to a larger institution, with those mortgage loans ultimately become securitized. The arrangement under which the community bank originates and sells the mortgage loans to the larger institution is usually the subject of a lengthy contract, supplemented by an even lengthier set of guidelines. Together, the contract and guidelines set forth detailed rules governing the origination of the mortgage loans. Just as importantly, these documents specify the circumstances under which the originating lender must buy back the loans.
Here is where the uniform regulatory capital guidelines enter the story. A few years ago, the guidelines were amended to take into account “residual liability.” These amendments were designed to address the capital support needed when a bank sells an asset, yet retains some interest in that asset. Even if the asset is sold, and might be treated as a sale for accounting purposes, the regulators ruled that the retention of residual liability in that asset requires continued capital support for that asset.
The bank regulators then applied this concept to the sale of mortgage loans. Normal representations and warranties regarding a sold mortgage were not a problem. The lender originating the mortgage could represent to the purchaser of the mortgage that the underlying obligor’s signature was valid and that the appraisal of the property conformed to industry standards. If these representations were later found to be untrue, the originating bank could agree to buy the loans back without giving rise to residual liability for regulatory purposes. This was because representations and warranties of this type were reasonably within the control of the originating lender at the time the loan was originated.
On the contrary, the regulators found any representation or warranty by the seller that was beyond the control of the seller to constitute a creditenhancing representation or warranty. As such, these kinds of representations and warranties would give rise to residual liability. A bank that made such credit enhancing representations and warranties would still be required to support the loan so sold with the appropriate amount of capital required under the capital adequacy guidelines. In other words, for capital adequacy purposes, a loan with a creditenhancing representation or warranty would be treated as if the loan were never sold.
In recent months, bank regulators have rediscovered residual liability as it applies to mortgage loans sold by community banks to larger fi nancial institutions. Regulators have focused on three types of warranties sometimes seen in an agreement between a community bank and a larger institution:
Early default clauses. Generally, the originator of a 1-4 residential mortgage may buy it back if there is a default due to nonpayment within 120 days of the sale. If the originator agrees to buy the loan back after 120 days of the sale, due to nonpayment, the warranty is regarded as credit enhancing and gives rise to residual liability.
Guarantee of value of collateral. Any warranty by the seller of the loan that the property securing the loan has a particular value is viewed as credit enhancing, and therefore subject to residual liability.
Premium repurchase. Any warranty by the seller of the mortgage loan to repurchase the loan for an amount at a premium to that amount then owed on the loan, even if the repurchase would otherwise be permissible u n d e r t h e guidelines, will be viewed as credit enhancing, and therefore give rise to residual liability.
Many banks have entered into mortgage sale agreements without ever having given much thought to residual liability. Especially since the regulators have rediscovered the impact of residual liability rules, it is an appropriate time to review these agreements. Our experience is that the content of these agreements varies greatly, depending upon the purchaser of the mortgage loans. In many instances, we have found that the selling bank must still support the “sold” loans with capital, at least for some additional time after the sale.
Real Estate Lending Guidelines
Bank regulators are also demonstrating a newfound interest in the real estate lending guidelines. In particular, regulators have been reviewing exceptions to the real estate lending guidelines and determining whether the bank is in compliance with the aggregate capital and individual category limits. Under the guidelines, all loans in excess of the supervisory limits should not exceed 100% of total capital. Within that total, no category of exception (development, construction, improved property, etc.) is supposed to exceed 30% of total capital. Moreover, if the bank still has residual liability of any sold loans, those loans will be treated as if they had never been sold, not only for capital adequacy purposes as discussed above, but also for purposes of determining compliance with the limits of the real estate guidelines. The subprime meltdown is causing bank regulators to look more closely at real estate lending practices. Examiners are performing real estate examination programs that they have not run in years. Senior bank executives should not wait for their bank’s next examination to see if there are issues that need to be addressed. If an issue is found, it is better to spot the issues independently of the examiners. Corrective measures and adjustments to policies are best developed away from the spotlight of an examination.