Industry Overview—Mortgage Companies
4.01 As a result of the relative imbalance between the supply and demand for residential mortgage funds, mortgage banking entities play an integral role in providing mortgage capital based on housing finance demands of the general public in various geographic locations. The market where mortgage banking entities originate loans to borrowers is referred to as the primary market. The market where originated loans and mortgage-backed securities (MBS) trade is referred to as the secondary market.
4.02 The principal participants in the secondary market for residential financing are government sponsored entities (GSEs), such as the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Also active in the secondary market are federal agencies such as the Government National Mortgage Association (Ginnie Mae), the U.S. Department of Veterans Affairs (VA), and the Federal Housing Administration (FHA). These entities participate in the secondary market as issuers, investors, or guarantors of asset-backed securities (ABSs) such as MBSs, real estate mortgage investment conduits, and collateralized mortgage obligations. Private entities have also been active in the secondary market as issuers, investors, and guarantors, though the extent of their participation has varied significantly in response to market conditions. (Chapter 7, “Investments in Debt and Equity Securities,” of this guide describes ABS transactions and considerations for investors in ABSs.)
4.03 Freddie Mac and Fannie Mae primarily purchase conventional fixed and variable rate residential mortgage loans, originated by private entities, and Ginnie Mae generally purchases pools of government insured residential mortgage loans. These secondary market participants typically buy and sell originated loans, securitize them into MBSs, and sell the securities to investors.
4.04 MBSs became more prominent with the creation of Ginnie Mae in 1968 and the subsequent issuance of the first Ginnie Mae pass-through securities. Nontraditional mortgage investors were more inclined to invest in Ginnie Mae pass-through securities as a result of government guarantees on both the underlying mortgage collateral and on the securities themselves. During this same time period, Freddie Mac began selling pass-through securities backed by conventional residential mortgages. By the mid-1970s, the investment community accepted MBSs as viable securities collateralized by residential mortgages.
4.05 Beginning in the early 1970s, secondary market activities for all mortgage lenders increased substantially as a result of the establishment of Freddie Mac and the new involvement of Fannie Mae and Freddie Mac with the conventional secondary market. Prior to that time, Fannie Mae was one of the few national secondary mortgage market participants through its whole loan purchase and sale programs related to government loans.
4.06 In 2008, Fannie Mae and Freddie Mac experienced dramatic repercussions as a result of the financial crisis and were placed into conservatorship of the Federal Housing Finance Agency (FHFA). In September 2008, the U.S. Treasury Department acquired $1 billion of preferred shares in each GSE and has since provided additional capital as necessary. The future state of the GSEs is uncertain and has been the subject of legislative focus since they were placed into conservatorship.
4.07 The securities markets play a significant role in the execution and pricing of residential MBSs. In addition, the markets handle a significant volume of residential mortgage backed transactions. As a result, securities markets influence mortgage pricing on a national scale and also influence the design of various mortgage products.
4.08 With the dominant role of the mortgage securities markets and economic changes throughout the mortgage lending industry, nontraditional participants in the secondary market (as opposed to the traditional bank and thrift portfolio lenders) continue to evolve. Securities underwriters, commercial banks, financial guaranty companies, insurance companies, and real estate investment trusts play various roles in the mortgage banking industry. In addition, mortgage lending entities have securitized other types of loan products, such as commercial mortgage loans, subprime residential mortgage loans, and home equity loans (junior lien mortgages).
4.09 The Mortgage Partnership Finance (MPF) Program, which is available through most Federal Home Loan Banks (FHLBs), provides FHLB member institutions an alternative method for funding home mortgages for their customers. Under the MPF Program, the lender originates loans for, or sells loans to, the respective FHLB. The lender retains some or all of the credit risk and customer relationship (through servicing) inherent in the loan, and shifts the interest rate risk and prepayment risk to the FHLB. The lender receives a credit enhancement fee from the FHLB in exchange for managing the credit risk of the loan. Effectively, the FHLBs offer an alternative funding strategy to the traditional secondary mortgage market, particularly for smaller entities that do not have the desire or ability to hedge the associated interest rate risk and prepayment risk. The Mortgage Purchase Program (MPP) was introduced in 2000 to further support the FHLBs’ mission of expanding housing finance opportunities in the several districts for members that originate and hold mortgages on their books. The MPP, similar to the MPF program shifts the interest rate risk and prepayment risk to the FHLB while the member retains the customer relationship and credit risk of the loan.
4.10 Many mortgage banking entities are subsidiaries of banks or bank holding companies. Mortgage banking is generally compatible with a bank’s financing operations, and the bank is an obvious resource for the mortgage banking entity’s financing requirements. A mortgage banker typically draws upon its warehouse line of credit, whereby mortgage loans are funded by advances from the credit line, and are “warehoused” in the portfolio as security for the credit line until the credit line is paid down through the subsequent sale of the mortgage loans into the secondary market. The interest margin between the rate a mortgage bank can fund its operations and the rate at which it can extend mortgage financing is critical to the financial success of the entity.
4.11 In turn, access to the secondary mortgage market is an important source of liquidity for banks and savings institutions. Many institutions have deposit bases that are keyed to variable rates and, therefore, are particularly sensitive to interest rate risk. A variable rate deposit base cannot fund long term, fixed rate assets without creating significant loss exposure in rising interest rate environments. Therefore, sales of mortgage loans in the secondary market are an important source of liquidity and income. In addition, income streams created from servicing and other ancillary fees are an important source of funds to many institutions. Access to the secondary market also provides opportunities to restructure existing long-term loan portfolios, in order to meet asset/liability objectives or capital requirements.
4.12 Mortgage banking activities primarily consist of two separate but interrelated activities, namely, (a) the origination or acquisition of mortgage loans for the purpose of selling those loans to permanent investors in the secondary market, and (b) the subsequent servicing of those loans. Mortgage loans are acquired for sale to permanent investors from a variety of sources, including in-house origination and purchases from third-party correspondents.
4.13 Residential mortgage loans may be sold to investors with or without the right to service such loans (that is, sold servicing released or servicing retained, respectively). Fannie Mae, Freddie Mac, Ginnie Mae, and securitization vehicles do not have their own servicing functions, so mortgage companies that sell loans to those entities in the secondary market typically sell the loans servicing retained or sell the servicing to another party. Servicing rights offer the servicer additional and potentially significant sources of income in the form of servicing fees, late fees, float earnings, and other ancillary fees. Servicing fees are typically expressed as a percentage of a loan’s unpaid principal balance, such as 0.25 percent or 25 basis points per year, which is deducted from the amounts due to the investor (that is, the servicing fee is a “strip” of the loan’s stated coupon interest). Servicing also provides intangible benefits such as customer relationships, which may yield future sources of revenue such as refinancing fees.
4.14 The servicing function includes collecting payments from borrowers, transmitting insurance and tax payments to the related recipients, remitting payments to investors, performing the collection and loss mitigation functions for delinquent loans, and handling all phases of foreclosure proceedings. The precise nature of the servicing function is dependent on the specific requirements of the investor and the pooling and servicing agreement or similar agreement.
4.15 The servicing rights attributable to a mortgage portfolio are generally viewed as a primary asset of a mortgage banking entity. The value of the servicing asset is a function of the anticipated life of the servicing right (how long the loan is expected to be outstanding and serviced) and the estimated net servicing revenues attributable to the servicing function as compared to the adequate servicing compensation that another substitute servicer would demand in the market. The market for purchases and sales of loan servicing rights is limited; thus, there is a limited degree of liquidity and observable market prices for servicing rights. Even when there is a price discovery for servicing rights, an entity needs to consider the relevance of observable prices because the transactions may involve unique terms or may reflect features that are not an attribute of the unit of account being measured (for example, intangible assets). Furthermore, servicing portfolios are subject to significant volatility in valuation as unanticipated periods of rapid prepayments, increases in loan losses, increases in market servicing costs, and changes in the discount rates can cause substantial declines in the value of the servicing asset. Accordingly, the assumptions upon which the value of servicing transactions is based are critical to the reported financial results of the servicing entity. Refer to FASB Accounting Standards Codification (ASC) 860, Transfers and Servicing, for accounting requirements relating to servicing rights. See paragraphs 4.21–.32 for regulatory guidance about servicing assets.
4.16 FASB ASC 948, Financial Services—Mortgage Banking, establishes accounting and reporting standards for mortgage banking entities and entities that engage in certain mortgage banking activities. Some of the items subject to the guidance in FASB ASC 948 are financial instruments. In addition, FASB ASC 820, Fair Value Measurement, provides guidance that may be applied to certain mortgage related items such as derivative loan commitments, derivative sales contracts, loans held for sale, and servicing rights. FASB ASC 825, Financial Instruments, allows entities to choose, at specified election dates, to measure eligible items at fair value (the fair value option) with gains and losses recorded in earnings at each subsequent reporting date. Additionally, FASB ASC 860-50-30-1 requires an entity at initial recognition to measure a servicing asset or servicing liability that qualifies for separate recognition regardless of whether explicit consideration was exchanged at fair value.1 In accordance with FASB ASC 860-50-35-1, an entity should subsequently measure each class of servicing asset and servicing liability using either the amortization method or the fair value measurement method. Paragraphs 2 and 4 of FASB ASC 860-50-35 state that the election should be made separately for each class of servicing assets and servicing liabilities and the entity should apply the same subsequent measurement method to each servicing asset and servicing liability in a class. A detailed discussion on the accounting for servicing assets and servicing liabilities can be found in chapter 10, “Transfers and Servicing and Variable Interest Entities,” of this guide.
4.17 Some mortgage banking entities elect to account for loans held for sale at fair value under the fair value option in accordance with FASB ASC 825. Because derivative instruments are often used to mitigate the risks of subsequent changes in fair value of the loans between the commitment date and the sale, applying the fair value election eliminates the operational burden of achieving fair value hedge accounting in accordance with the requirements of FASB ASC 815, Derivatives and Hedging, because both the loans and the derivative instruments used to hedge the risks of changes in fair value are recorded at fair value through earnings.
4.18 The magnitude of interest rate movements and the speed with which they can occur make risk management in a mortgage banking entity complex and difficult because they influence the demand for loans, the qualification of borrowers for loans, prices of loans, and how long the loans will be outstanding before they are repaid (for example, prepayment risk). Risk mitigation strategies and operating plans, as well as sophisticated reporting systems that provide the information needed to carry out the plans and strategies, are used to monitor and control the interest risk exposure of mortgage banking operations.
4.19 In addition to the interest rate risk inherent in the mortgage loan pipeline (the inventory of loan commitments in various stages of process) and prepayment risk inherent in the servicing asset, an entity that sells loans it originated or purchased also is subject to recourse or repurchase risk under specific provisions or representations and warranties in the sale agreement. Recourse risk is the risk that an investor may either reject a loan or mandate the mortgage lender to repurchase the loan or reimburse the investor for credit-related losses if there is a defect related to the underwriting or documentation of the loan that contributes to a subsequent loss or if the loan becomes delinquent within a specified amount of time after purchase. This risk varies based on the source and underwriting procedures of the loan, terms of the sale, and servicing agreement with each investor. An entity will establish a liability measured at fair value at the date of transfer related to these various representations and warranties that reflect management’s estimate of losses for loans for which it has repurchase or make-whole obligations and will adjust that contingent liability subsequently based on actual claims activity and changes in expectations. Many investors have filed lawsuits against private issuers of MBSs over defects in the underwriting process and inadequate disclosures over credit risks inherent in the underlying loans.
4.20 Mortgage banking is a complex financial services business requiring advanced analytical skills, financial modeling, and forecasting abilities. The necessary level of computer systems support for mortgage banking operations is significant. Access to large volumes of accurate data that is instantly available is paramount in managing the risks of mortgage banking. The resources necessary to compete effectively have made it difficult for the small, independent firm to survive, and the medium to large size mortgage banking operations are often subsidiaries of larger institutions, both financial and nonfinancial.
4.21 Publicly held mortgage companies are generally subject to requirements of federal securities laws, including the Securities Act of 1933, the Securities Exchange Act of 1934 (the 1934 Act), and the Sarbanes-Oxley Act of 2002. Companies whose securities are registered under the 1934 Act must comply with its reporting requirements through periodic filings with the SEC.
4.22 Virtually all states have enacted laws governing the conduct of mortgage lenders and mortgage servicers, and have created regulatory bodies to oversee the industry. The majority of all jurisdictions have licensing requirements for mortgage brokering, lending, and servicing. The scope of these requirements can vary significantly. Certain states simply require that an entity register with a state before participating in a certain mortgage related activity. Other regulations require compliance with strict regulations concerning recordkeeping, office location, accounting, and origination and servicing procedures.
4.23 The mortgage lending process is regulated by both state and federal law. Regulations are generally designed to protect the consumer from unfair lending practices, and noncompliance with the regulations may result in financial liability, including the imposition of civil money penalties and reimbursements to borrowers, where applicable. Certain of the more significant regulations are discussed in chapter 8, “Loans,” and chapter 9, “Credit Losses,” of this guide. On February 25, 2003, the Office of the Comptroller of the Currency (OCC); the FDIC; the Board of Governors of the Federal Reserve System (Federal Reserve) (collectively, the federal banking agencies); and the Office of Thrift Supervision (OTS), prior to its transfer of powers to the OCC, the FDIC, and the Federal Reserve,2 issued Interagency Advisory on Mortgage Banking. This important document discusses examination concerns about the valuation and modeling of servicing assets and discusses the need to determine if an impaired servicing asset should be written off. In May 2005, the federal banking agencies, along with the OTS, and National Credit Union Administration (NCUA) issued Interagency Advisory on Accounting and Reporting for Commitments to Originate and Sell Mortgage Loans. This advisory provides guidance related to the origination of mortgage loans that will be held for resale, and the sale of mortgage loans under mandatory delivery and best efforts contracts.
4.24 On October 4, 2006, the federal banking agencies, along with the OTS, and the NCUA jointly issued Interagency Guidance on Nontraditional Mortgage Product Risks. The guidance discusses how institutions can offer nontraditional mortgage products in a safe and sound manner and in a way that clearly discloses the benefits and risks to borrowers. On June 8, 2007, the federal banking agencies, along with the OTS, and the NCUA jointly published guidance entitled Illustrations of Consumer Information for Nontraditional Mortgage Products. The illustrations are intended to assist institutions in implementing the consumer protection portion of the Interagency Guidance on Nontraditional Mortgage Product Risks (interagency guidance).
4.25 On May 29, 2008, the federal banking agencies, along with the OTS, and the NCUA published Illustrations of Consumer Information for Hybrid Adjustable Rate Mortgage Products. The illustrations are intended to assist institutions in implementing the consumer protection portion of the Interagency Statement on Subprime Mortgage Lending adopted on July 10, 2007, and to provide information to consumers on hybrid adjustable rate mortgage products as recommended by that interagency statement. The illustrations are not model forms and institutions may choose not to use them.
4.26 In March 2009, the Treasury Department announced guidelines under the Home Affordable Mortgage Program to promote sustainable loan modifications for homeowners at risk of losing their homes due to foreclosure. Modifications come in the form of lower monthly payments and principal reductions. Also in March 2009, the FHFA, which regulates Fannie Mae and Freddie Mac, created the Home Affordable Refinance Program (HARP). HARP incentivizes mortgage servicers to modify loans to give healthy borrowers access to market interest rates in instances in which the loan collateral is worth less than the balance on the mortgage. The FHA and VA also have comparable loan modification programs. These modification programs were introduced as temporary responses to the financial crisis and, as such, had expiration dates in the short term; however, the programs have been extended past those dates and continue to be available to borrowers at risk of foreclosure.
4.27 In February 2014, the OCC issued an updated “Mortgage Banking” booklet of the Comptroller’s Handbook. The booklet provides updated guidance to examiners and bankers on assessing the quantity of risk associated with mortgage banking and the quality of mortgage banking risk management. It also addresses changes to the functional area of production, secondary marketing, servicing, and mortgage servicing rights to incorporate regulatory changes. Furthermore, it addresses, among other statutory and regulatory changes, amendments to Regulation X and Regulation Z (such as, new servicing-related standards and requirements and ability-to-repay requirements) issued by the Consumer Financial Protection Bureau. The booklet applies to all banks engaged in mortgage banking activities. Readers are encouraged to view this publication under the “Publications—Comptroller Handbook” page at www.occ.gov.
4.28 In addition, in connection with various lending programs that a mortgage lender may be involved in, specific program requirements may be applicable. Certain common requirements are discussed in the following paragraphs.
4.29 The U.S. Department of Housing and Urban Development (HUD) sponsors a broad range of programs designed to revitalize urban neighborhoods, stimulate housing construction, encourage home ownership opportunities, and provide safe and affordable housing. The programs are carried out through various forms of federal financial assistance, including direct loans and mortgage insurance. The FHA was established by Congress in 1934 and is part of HUD. The FHA was created to encourage lenders to make residential mortgage loans by providing mortgage insurance. To participate in the FHA mortgage insurance program, a mortgage lender must obtain HUD approval by meeting various requirements prescribed by HUD, including maintaining minimum net worth requirements. Net worth requirements vary depending on the program.
4.30 To obtain approval to sell and service mortgage loans for Fannie Mae or Freddie Mac, or both, a mortgage lender must meet various requirements including maintaining an acceptable net worth. Upon approval, a mortgage lender enters into a selling and servicing contract and must comply with the terms of the respective selling and servicing guides, which set forth detailed requirements regarding underwriting, mortgage delivery, and servicing.
4.31 Ginnie Mae was created by Congress as part of HUD. Ginnie Mae’s primary role is to guarantee MBSs issued by Ginnie Mae approved lenders and backed principally by FHA insured and VA-guaranteed loans. To obtain Ginnie Mae approval, a mortgage lender must meet various eligibility requirements as prescribed in chapter 2, “Eligibility Requirements—Approval as a Ginnie Mae Issuer,” of the Ginnie Mae MBS Guide. Among the requirements, an issuer must be an approved FHA mortgagee in good standing and maintain specific net worth, liquidity, institution-wide capital, and insurance requirements.
4.32 Mortgage lenders may also enter into agreements with private investors to sell and service mortgage loans. Such agreements set forth various standards applicable to the transaction and may include minimum financial or net worth requirements.
4.33 Institutions may incur losses as a result of uncollectible receivables from other government programs such as the FHA or Ginnie Mae, from other investors such as Freddie Mac and Fannie Mae, or from insolvent private mortgage insurers.
4.34 The VA Home Loan Guaranty Program helps VA loan participants to compete for better loan terms in the housing market. The loan guaranty program can be used by any veteran who served after September 16, 1940, as well as men and women on active duty, surviving spouses and reservists. Historically, the VA paid lenders 100 percent of the outstanding debt on defaulted loans that the VA guaranteed. In return, the lenders turned the borrowers' residential properties over to the VA, which would dispose of them. The VA had the option of guaranteeing the lesser of 60 percent of a loan's original balance or $27,500, leaving the property with the lender if that is less costly for the agency. Called a no-bid option, this practice was seldom used, especially because inflation pushed up housing prices during the late 1970s and early 1980s. However, as inflation began to slow and the costs of carrying foreclosed houses began to rise, the VA began to invoke the no-bid option.
4.35 On October 1, 2008, the VA issued Circular 26-08-19, Implementation of Loan Guarantee Provisions of Public Law 110-389. Section 501 of Public Law 110-389 provides a temporary increase in the maximum guaranty amount for loans closed January 1, 2009, through December 31, 2011. During this period, the “maximum guaranty amount” set forth in this circular should be substituted for the maximum guaranty amount specified at Veterans' Benefits, U.S. Code Title 38, Section 3703(a)(1)(C), Code of Federal Regulations (CFR), Loan Guaranty, Title 38, Sections 36.4302(a)(4) and 36.4802(a)(4), and in the VA Lender’s Handbook. The guaranty amount for loans remains unchanged for situations in which the original principal loan amount is $417,000 or less. If the original principal loan amount is greater than $417,000, the VA will guarantee 25 percent of the original principal loan amount, up to the maximum guaranty amount. The maximum guaranty amount varies depending upon the location of the property. In February 2009, the VA issued changes to Circular 26-08-19 to clarify entitlement calculations for certain veterans with previously used, unrestored entitlement. Readers are encouraged to refer to the VA website for details regarding the maximum guarantee calculation.
4.36 In an environment with increased risk of foreclosure losses (including unrecoverable servicer advances; foreclosure costs such as attorneys' fees, inspections, and so forth; and the implicit cost to carry the asset until ultimate sale), the evaluation of loss allowances on VA and privately insured mortgage loans becomes increasingly difficult. Chapter 11, “Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets,” of this guide provides guidance on the valuation of foreclosed real estate, and chapter 9 of this guide, provides guidance on the evaluation of the collectability of real estate loans.
4.37 To participate in HUD programs, a nonsupervised mortgagee (a lender other than a financial institution that is a member of the Federal Reserve or whose accounts are insured by the FDIC or the NCUA) and a supervised mortgagee must comply with the requirements of the Consolidated Audit Guide for Audits of HUD Programs, issued by the HUD Office of the Inspector General. The guide requires that the engagement be performed in accordance with Government Auditing Standards and contains (a) suggested procedures for testing an entity’s compliance with laws and regulations affecting HUD-assisted programs, (b) a requirement to test internal control over compliance in all HUD-related audits, (c) the basic financial statements and types of supplementary information presented with an entity’s basic financial statements, and (d) an auditor’s reporting responsibilities and illustrative reports on the basic financial statements and supplementary information, internal control, and compliance with laws and regulations.
4.38 In August 2002, HUD released the Final Uniform Financial Reporting Standards Rule (CFR, General HUD Program Requirements; Waivers, Title 24, Part 5) requiring electronic submission of the financial statement package required for annual mortgagee recertification. In order to ensure the integrity of this audited financial information, mortgagees’ auditors are required to attest to the data electronically. The required information and associated attestation were historically performed on the Lender Assessment Subsystem (LASS). In 2014, LASS was replaced by the Lender Electronic Assessment Portal.
4.39 HUD releases Mortgagee Letters to notify lenders about amendments to FHA operations, policies, and procedures. Readers are encouraged to visit the “Mortgagee Letters” page at www.hud.gov to assess the applicability of the releases and how the releases might impact accounting and financial reporting matters, as well as audit requirements.
Asset Servicing for Investors
4.40 Lenders that service residential mortgage loans for investors may be required to engage an auditor to provide assurance relating to management’s written assertions about compliance with the SEC Regulation AB or the minimum servicing standards set forth in the Uniform Single Attestation Program for Mortgage Bankers (USAP), or both. The USAP examination engagement is performed in accordance with AT-C section 315, Compliance Attestation (AICPA, Professional Standards). USAP was developed by the Mortgage Bankers Association and is intended to provide the minimum servicing standards with which an investor should expect a servicing entity to comply.
4.41 Regulation AB3 codifies requirements for registration, disclosure, and reporting for all publicly registered ABS, including MBS. Regulation AB requires the issuance of an attestation report on assessment of compliance with servicing criteria for ABSs, establishes the required disclosures associated with the securities registration process, establishes the reporting requirements for ABSs, and necessitates an annual servicing assertion.