Megan Brooks
Banks play a crucial role in the mortgage market, and it is common for individuals to associate mortgage lenders with traditional banks or savings institutions. While banks do provide mortgages, the landscape of mortgage lending is far more complex and involves various players beyond traditional banks. In recent years, the market share of traditional banks in mortgage originations has decreased, with a growing presence of shadow banks or independent mortgage companies. This shift highlights the importance of understanding whether banks hold the mortgages they make and the underlying dynamics influencing this decision.
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What You'll Learn
- Banks sell mortgages to free up capital and reduce risk
- Traditional banks face competition from shadow banks
- Banks are more likely to hold mortgages on their balance sheets if they are well-capitalised
- Banks can sell the mortgage debt and retain the servicing rights
- Banks are important to the housing market
Banks sell mortgages to free up capital and reduce risk
Banks have a choice when it comes to mortgages: they can either hold them on their balance sheets or sell them. When banks sell mortgages, they can free up their capital and reduce risk.
Banks are required to keep a certain amount of cash on hand to meet federally mandated cash reserve requirements and to have funds available for account holders and customers. By selling mortgages, banks can ensure they have enough cash to handle withdrawals and continue lending. Selling mortgages converts longer-term, less liquid assets on the balance sheet to cash, the most liquid asset. This helps banks maintain sufficient liquidity to meet their obligations.
Selling mortgages also reduces risk for banks. When a bank issues a mortgage, it takes on the risk of the borrower defaulting. By selling the mortgage, the bank transfers this risk to the buyer. This can be particularly important during economic downturns or periods of financial instability when the risk of default may be higher.
Additionally, selling mortgages can be more profitable for banks in certain situations. While banks can make money by collecting interest on mortgages over time, selling mortgages provides an opportunity to generate immediate income. Banks can earn commissions on the loans they sell and use the proceeds to invest in other profitable ventures.
The decision to sell mortgages is often influenced by a bank's financial position and risk appetite. Well-capitalized banks with strong balance sheets may be more inclined to hold mortgages, while less capitalized banks may opt to sell them to free up capital and reduce their exposure to potential losses.
It's worth noting that banks may sell the mortgage debt itself, keep the servicing rights, or sell both the debt and the servicing rights. The dynamics of the mortgage market, including the presence of shadow banks and regulatory factors, also play a role in banks' decisions to sell mortgages.
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Traditional banks face competition from shadow banks
Traditional banks take deposits and use those funds to make loans, including mortgages. They are heavily regulated and subject to strict requirements to hold capital against the loans they keep on their balance sheets. Banks have a choice to either sell mortgages or hold mortgages on their balance sheets and collect interest and principal until the loans are paid off.
Shadow banks, on the other hand, do not take deposits and are lightly regulated. They generally do not have the balance sheet capacity to keep the mortgages they originate. Shadow banks raise short-term funds in the money markets and use those funds to buy assets with longer-term maturities. They are not subject to traditional bank regulation and cannot borrow in an emergency from the Federal Reserve. Shadow banks provide credit and generally increase the liquidity of the financial sector. They can sometimes provide credit more cost-efficiently than traditional banks.
The stricter capital requirements and heavier regulatory burden traditional banks face put them at a competitive disadvantage in the conforming loan market. Between 2008 and 2017, shadow banks grew their share of conforming mortgage originations from around 25% to almost 60%. The balance sheet capacity to hold mortgages is an important factor explaining market segmentation because of differences among banks themselves. Well-capitalized banks are more likely to keep mortgages, while poorly capitalized banks are more likely to behave like shadow banks and sell mortgages on the secondary market.
The shadow banking system includes entities such as hedge funds, money market funds, structured investment vehicles (SIVs), credit investment funds, exchange-traded funds, credit hedge funds, private equity funds, securities broker-dealers, credit insurance providers, securitization and finance companies, and mortgage lenders. The system has grown in importance to rival traditional depository banking and played a role in the subprime mortgage crisis of 2007-2008 and the global recession that followed.
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Banks are more likely to hold mortgages on their balance sheets if they are well-capitalised
Banks play a crucial role in the mortgage market by providing loans to individuals and holding mortgages on their balance sheets. However, not all banks hold the mortgages they make, and there are various factors that influence their decision to retain or sell mortgages. One significant factor is the bank's capitalisation.
Well-capitalised banks are more likely to keep mortgages on their balance sheets, while poorly capitalised banks tend to sell them on the secondary market. This behaviour is similar to that of shadow banks, which don't take deposits and are lightly regulated. Shadow banks generally don't have the balance sheet capacity to retain mortgages. Traditional banks, on the other hand, take deposits and use them to fund mortgage loans. They are subject to strict regulatory requirements, including holding capital against the loans they keep on their balance sheets.
The ability to hold mortgages on their balance sheets gives traditional banks an advantage in the jumbo mortgage market, where it is challenging to sell loans. In contrast, shadow banks have an advantage in the conforming mortgage market due to their lighter regulatory burden. The balance sheet capacity to hold mortgages is a critical factor in market segmentation, with well-capitalised banks more inclined to retain mortgages and poorly capitalised banks more likely to sell them.
The decision to hold or sell mortgages has implications for the banking system's stability and the availability of mortgages. Policies that increase the supply of jumbo loans tend to benefit high-income borrowers, potentially raising inequality levels. Conversely, policies boosting the supply of conforming loans benefit less affluent borrowers and reduce inequality. Additionally, the proposed Basel rules, which include higher capital requirements for mortgages held on bank balance sheets, may further influence banks' decisions to retain or sell mortgages. These rules could lead to higher interest rates on bank-originated mortgages and a shift in market share towards non-banks.
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Banks can sell the mortgage debt and retain the servicing rights
Banks can choose to sell mortgages to government-sponsored enterprises (GSEs), collecting an origination fee and, in some cases, a fee for servicing the mortgages. Alternatively, they can hold mortgages on their balance sheets, collecting interest and principal until the loans are paid off, but taking on the risk of borrowers defaulting. Well-capitalized banks are more likely to keep mortgages, while poorly capitalized banks are more likely to sell them on the secondary market.
Mortgages are financial instruments that can be bought and sold between investors. This debt may be sold multiple times without the homeowner's knowledge. Mortgage-backed securities (MBS) are created when mortgages are packaged together and sold on the secondary mortgage market. This market exists to ensure a continuous flow of funds in the housing and financing markets. MBS investors receive income from mortgage payments, and mortgage lenders receive cash to extend loans to new borrowers.
Mortgage servicing rights (MSR) come into play when the original mortgage lender sells the rights to service a mortgage to another party, typically a mortgage servicing company. The third party then takes on the responsibility for day-to-day tasks such as sending monthly payment statements, collecting payments, managing insurance fees, and maintaining records. Lenders often sell MSRs to free up lines of credit and lend money to additional borrowers.
Banks can sell mortgage servicing rights while retaining the rights to service the mortgage. This allows them to free up capital to originate more loans while maintaining the relationship with the borrower. The borrower's experience remains largely unchanged, except that payments are directed to the mortgage servicing company.
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Banks are important to the housing market
Banks are integral to the housing market, and this has been the case for a long time. Banks provide the funding for mortgage companies, and they also hold deposits and have stable funding sources, which gives them the flexibility to keep mortgages on their balance sheets. Banks are also heavily regulated, which means they must keep cash reserves to meet withdrawals and handle loans.
Mortgage companies, on the other hand, do not hold deposits and are not as heavily regulated as banks. They rely on lines of credit to fund mortgages, which they quickly sell. They are also more likely to sell mortgages to free up capital and manage interest rate risk. This is an important factor in the housing market as it affects the availability of mortgages and the stability of the banking system.
While the traditional view of a banker as a mortgage lender persists, the reality is that banks now represent a smaller part of the mortgage market. This is due to the rise of shadow banks, which are independent mortgage companies that don't take deposits and are lightly regulated. Shadow banks have gained market share, particularly in the conforming mortgage market, due to the stricter capital requirements that traditional banks face.
Despite this, banks remain important to the housing market. They provide funding for mortgage companies, and their interconnectedness with these companies means they are key to Americans achieving homeownership. Banks also have the capacity to hold mortgages on their balance sheets, which gives them an advantage in the jumbo market. Well-capitalized banks are more likely to keep mortgages, while poorly capitalized banks may behave more like shadow banks and sell mortgages on the secondary market.
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Frequently asked questions
Banks have the option to hold the mortgages they make, but they often sell them.
Banks sell mortgages to free up their capital, ensuring they can handle withdrawals and make loans to other applicants. Selling mortgages also get debt and default risk off their books.
The bank sells the mortgage debt and sometimes the mortgage servicing rights, which means they transfer the responsibility of receiving the borrower's repayments to another institution.
After a bank sells a mortgage, investors buy them for the steady monthly income generated by the loan interest.
Traditional banks represent only a small part of the mortgage market. Shadow banks, independent mortgage companies that don't take deposits, are another option.
