Mortgage Banking, Comptroller's Handbook

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Comptroller’s HandbookA-MBSafety and nt(M)Earnings(E)Liquidity(L)Sensitivity toMarket Risk(S)OtherActivities(O)Mortgage BankingVersion 1.0, February 2014Office of theComptroller of the CurrencyWashington, DC 20219

Version 1.0ContentsIntroduction .1Background . 1Primary and Secondary Mortgage Markets . 2Fundamentals of Mortgage Banking. 3Common Mortgage Banking Structures . 4Mortgage Banking Profitability . 4Statutory and Regulatory Authority . 9Preemption and Visitorial Powers . 10Capital Requirements . 11Risks Associated With Mortgage Banking . 12Credit Risk . 12Interest Rate Risk . 13Liquidity Risk . 13Price Risk . 14Operational Risk . 14Compliance Risk . 16Strategic Risk . 18Reputation Risk. 19Risk Management . 20Management and Supervision . 20Internal and External Audits . 21Information Technology . 22Mortgage Banking Functional Areas . 22Loan Production . 23Secondary Marketing . 38Servicing . 50Mortgage Servicing Assets . 67Examination Procedures .75Scope . 75Management and Supervision . 80Internal and External Audits . 85Information Technology . 89Loan Production . 92Secondary Marketing . 109Servicing . 121Mortgage Servicing Assets . 133Conclusions . 138Internal Control Questionnaire . 140Verification Procedures . 149Comptroller’s HandbookiMortgage Banking

Version 1.2ContentsAppendixes.152Appendix A: Sample Request Letter . 152Appendix B: Hedging . 159Appendix C: Mortgage Banking Accounting . 175Appendix D: Common Mortgage Banking Structures . 194Appendix E: Standards for Handling Files With Imminent Foreclosure Sale . 203Appendix F: Risk Assessment Factors . 206Appendix G: Glossary. 212Appendix H: Abbreviations . 226References .228Comptroller’s HandbookiiMortgage Banking

Version 1.0Introduction BackgroundIntroductionThe Office of the Comptroller of the Currency’s (OCC) Comptroller’s Handbook booklet,“Mortgage Banking,” provides guidance for bank examiners and bankers on variousmortgage banking activities, such as the purchase or sale of mortgages in the secondarymortgage market. Throughout this booklet, national banks and federal savings associations(FSA) are referred to collectively as banks, except when it is necessary to distinguishbetween the two.BackgroundMortgage banking generally involves loan originations as well as purchases and sales ofloans through the secondary mortgage market. A bank engaged in mortgage banking mayretain or sell loans it originates or purchases from affiliates, brokers, or correspondents. Thebank may also retain or sell the servicing on the loans. Through mortgage banking, banks canparticipate in any combination of these activities.Banks have traditionally originated residential mortgage loans to hold in their loan portfolios.Examiners should refer to the “Retail Lending Examination Procedures” and the to-bepublished “Residential Real Estate Lending” booklets of the Comptroller’s Handbook forguidance on banks that primarily originate mortgage loans to be retained in their loanportfolios. More expansive mortgage banking activities are a natural extension of thetraditional origination process. This booklet and the examination procedures it outlines areintended for banks that engage in purchases or sales of mortgages in the secondary market.Mortgage banking is affected by changing economic conditions and new legislation,regulations, accounting principles, regulatory guidance, examination efforts, and legalactions. Numerous changes have addressed systemic issues revealed in the recent financialcrisis, including deficiencies related to the origination and servicing of residential mortgageloans.In 2010, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act(Dodd–Frank), which included a number of changes to consumer protection laws and createdthe Consumer Financial Protection Bureau (CFPB). The CFPB has undertaken variousrulemakings to implement Dodd–Frank changes, including amending Regulation Z toimplement changes to the Truth in Lending Act (TILA) and Regulation X to implementchanges to the Real Estate Settlement Procedures Act (RESPA). For instance, in January2013, the CFPB issued final rules amending Regulation X and Regulation Z to introduce newservicing-related standards and requirements. Other final rules further amend Regulation Z,including to require that creditors make a reasonable, good faith determination of aconsumer’s ability to repay any consumer credit transaction secured by a dwelling, toestablish certain protections from liability for “qualified mortgages,” and to implementComptroller’s Handbook1Mortgage Banking

Version 1.0Introduction Backgroundchanges to the requirements for certain home-secured loans. Many of these rules are expectedto become effective in January 2014. 1The CFPB’s rulemaking efforts, however, are ongoing. Bankers and examiners should ensurethat the standards they follow are current. Examiners should contact the OCC’s Credit andMarket Risk Division to obtain information on recent developments that are not reflected inthis booklet. In particular, the booklet does not attempt to address the specific requirementsof the various rules issued by the CFPB implementing requirements of Dodd–Frank,including amendments to Regulation Z (implementing TILA), Regulation X (implementingRESPA), and servicing standards, which are effective January 2014. The safety andsoundness principals discussed in this booklet are consistent with those rules. Compliancewith these and other finalized rules, such as the Qualified Residential Mortgage Rule, is abasic tenet of a safe and sound mortgage operation.The mortgage banking industry is highly competitive and involves many types of firms,including brokers, correspondents, mortgage banks, commercial banks, investment banks,and savings associations. Some of these firms are small and local, while others are large andnational. Banks and their subsidiaries and affiliates make up a large and growing proportionof the mortgage banking industry. Banks that originate or purchase residential loans need tohave sound third-party risk management practices.Mortgage banking activities generate fee income and may provide cross-selling opportunitiesthat can enhance a bank’s retail banking franchise. The expansion of traditional lending toencompass other mortgage banking activities has taken place in the context of a general shiftby commercial banks from activities that produce interest income to ones that producenoninterest income and fees.Information technology (IT), including business processes, has evolved into an increasinglyimportant support function that facilitates mortgage banking operations. Sophisticatedorigination and servicing systems, Web-based applications, the use of third parties to performbusiness processes, and complex valuation models are notable examples. The increasedreliance on technology and its dependency on data and telecommunication infrastructureshave led to an increased number of risks that must be managed appropriately.Primary and Secondary Mortgage MarketsA mortgage lender’s key function is to provide funds for the purchase or refinancing ofresidential properties. This function is carried out in the primary mortgage market, in whichlenders originate mortgages by lending to homeowners and purchasers. In the secondarymortgage market, lenders and investors buy and sell loans that were originated in the primarymortgage market. Lenders and investors also buy and sell securities in the secondary marketthat are collateralized by pooled mortgage loans.1More comprehensive information regarding Regulation X and Regulation Z, including recent amendments tothose rules, is provided in other Comptroller’s Handbook booklets, including “Truth in Lending Act” and “RealEstate Settlement Procedures Act” in the Consumer Compliance series.Comptroller’s Handbook2Mortgage Banking

Version 1.0Introduction BackgroundBanks participate in the secondary market to gain flexibility in managing their long-terminterest rate exposures, to increase liquidity, manage credit risk, and expand opportunities toearn fee income.The secondary mortgage market is a result of various public policy measures and programs topromote homeownership that date back to the 1930s. Several government agencies andgovernment-sponsored enterprises (GSE) have played important parts in fosteringhomeownership. The Federal Housing Administration (FHA), for example, encouragesprivate mortgage lending by providing insurance against default. The Federal NationalMortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (FreddieMac), and the Federal Housing Agency provide market liquidity for conventional, FHA, andU.S. Department of Veterans Affairs (VA) mortgages by operating programs to purchaseloans and convert them into securities to sell to investors. In addition, beginning in 1997,several Federal Home Loan Banks (FHLB) entered the mortgage loan purchase business.Banks can sell loans directly to GSEs and private investors or they can convert loans intomortgage-backed securities (MBS). MBSs include pass-through securities, an arrangement inwhich undivided interests or participations in the pool are sold and the security holdersreceive pro rata shares of the resultant cash flows. Collateralized mortgage obligations(CMO) are another form of MBS. CMOs stratify credit and prepayment risk into trancheswith various levels of risk and return for investors.The mortgage industry continues to evolve, with new mortgage products being developed inboth the conforming (eligible for sale to the GSEs) and nonconforming markets.Fundamentals of Mortgage BankingWhen a bank originates a mortgage loan, it creates two commodities: a loan and the right toservice the loan. Banks can sell loans in the secondary market with servicing retained orreleased. Servicing is inherent in most lending assets; it becomes a distinct asset or liabilityonly when contractually separated from the underlying lending assets or loans. A mortgagebank can separate servicing from a loan in two ways: (1) by selling a loan and retaining theservicing or (2) by separately purchasing or assuming the servicing of a loan from a thirdparty.Successful mortgage banking operations require effective management information systems(MIS) to accurately identify the value created and costs incurred to produce and servicedifferent mortgage products. The largest mortgage servicing firms invest heavily intechnology to manage and process large volumes of individual mortgage loans with a varietyof payment structures, escrow requirements, and investor disbursement schedules. Thesefirms also operate sophisticated call centers to handle customer service, collections, defaultmanagement, and foreclosure referrals. A highly developed technology infrastructure is arequisite for banks to effectively handle large and rapidly growing portfolios.The benefits of economies of scale in loan production and servicing activities have led togreater industry consolidation. Given the cyclical nature of mortgage banking activities andComptroller’s Handbook3Mortgage Banking

Version 1.0Introduction Backgroundindustry consolidation trends, banks need to maximize efficiencies to compete effectively.Well-defined business processes combined with continuous improvements enablemanagement to enhance operational effectiveness.Common Mortgage Banking StructuresWhile a mortgage banking business is rather simple in theory, the combination of differenttypes of operations and the various levels of risk make the review of each bank unique.Management can structure a bank to participate in one or several parts of the mortgagebanking process. Examiners should expect management to have appropriately evaluated thebank’s operation and risk profile to determine the relevant measurement criteria for itsincome and expenses.Banks with similar operational profiles may have different goals. In all cases, managementand the board should outline the strategies and goals of their mortgage banking operation. Atthe outset of a review, examiners should determine the type of mortgage banking operation inplace and obtain management reports for monitoring mortgage banking activities.Management’s strategic planning process and business plan should address the activity, risk,and goals of the bank’s operation. Management and the board should set reasonable limits,guidelines, and measurement standards for the bank’s operation. This planning also shouldaddress strategies to deal with changes as the mortgage banking operation goes throughbusiness cycles. See appendix D for more details on mortgage banking structures.Mortgage Banking ProfitabilityOverviewMortgage banking is a cyclical business, and earnings can be volatile. Without propermanagement, a profitable mortgage banking operation can quickly generate substantiallosses. Consistent profitability in mortgage banking requires a significant level of oversightby the board and senior management, and careful management of all mortgage bankingactivities. This section provides guidance for reviewing the earnings of a mortgage bankingoperation, and offers an overview of the components of mortgage banking profitability andhow each component relates to the value of mortgage servicing rights (MSR). 2Mortgage Banking EarningsMortgage banking earnings can be volatile, and management must closely monitor theoperation’s performance. Unlike the revenue from many banks’ operations, mortgagebanking revenue consists primarily of gain on sale and mortgage servicing revenue.2As defined in the “Glossary,” mortgage servicing right (MSR) and mortgage servicing asset (MSA) are oftenused interchangeably. For purposes of this booklet, the tern MSR is used in the context of trading, profitability,hedging, and other general matters. MSA is applied to those discussions associated with the functionaloverview, examination procedures, and accounting practices.Comptroller’s Handbook4Mortgage Banking

Version 1.0Introduction BackgroundA mortgage banking operation’s income and expense components can change at significantlydifferent rates and in different directions over time, resulting in substantial shifts inprofitability. Each segment of a mortgage banking operation (originations, sales, andservicing) contributes to the operation’s net earnings.The potential for rapid changes in interest rates and mortgage volume creates a need forflexible, cost-efficient funding arrangements. The financing structure is largely dependent onthe nature of the mortgage banking operation, typically balancing the need for flexibility withprotection against interest rate changes. A bank can pay off short-term funding as originationvolumes decline but remains highly susceptible to interest rate changes. Conversely, longerterm funding arrangements offer a fixed interest rate but create costs if volumes decline.A bank’s interest income and interest expense generally move in the same direction as rateschange over time, depending on the repricing characteristics of the bank’s assets andliabilities. By contrast, a mortgage bank’s noninterest income and expense components canchange at significantly different rates and directions. As a result, substantial shifts inprofitability can occur very quickly.The success of a mortgage banker’s operations often depends on how effective the banker isat creating or acquiring the MSR and how the bank disposes of it (through sale or theoperation of a servicing department). If the MSR is sold, the value is reflected in the gain onsale. If retained, the benefit to

operation, and offers an overview of the components of mortgage banking profitability and how each component relates to the value of mortgage servicing rights 2(MSR). Mortgage Banking Earnings . Mortgage banking earnings can be volatile, and management must closely monitor the operation’s performance.