While they may score poorly on financial literacy tests, many Americans do have key events in their financial lives seared in memory. Maybe it was getting their first credit card or paycheck. Very likely, homeowners won’t forget bearing the financial details of their life to a lender, especially if the banker smoothed their jitters and helped them through the complex mortgage process.

Providing personalized service that carries a memorable, even emotional, component, is integral to community banking. But their mortgage participation has declined overall, dropping from a 21.2 percent share of the volume of single-family loan originations in 2008 to 12.4 in 2024, according to the Mortgage Bankers Association.

Unnerved by the foreclosure crisis circa 2008-09, regulators imposed stricter standards, including tightening capital requirements for mortgages that banks hold in portfolio and for mortgage servicing rights.

Now, amid a nationwide housing affordability pinch, lawmakers and regulators in Washington, D.C., are revising mortgage-related banking rules and housing policies—possibly encouraging community banks to return to the business of mortgage lending.

Mission central

While mortgage activity is down, community banks are definitely not out of that arena. “Most community banks offer mortgages in some capacity,” says Tim Roy, vice president of housing finance policy for the Independent Community Bankers of America. And in rural areas, community banks are still a significant source, since Roy explains that they often fund rural homes that don’t fit the secondary market standards other lenders favor.

As a result, community banks don’t often sell off all the loans on the secondary market, but “portfolio” or keep some of them, enabling them to serve borrowers “who might not fit the generic boxes of [the agencies, like Fannie Mae, that buy mortgages],” explains Dave Mason, senior vice president, director of mortgages at First International Bank & Trust, a $6 billion Watford City, N.D.-based institution. “Just because you don’t fit the boxes doesn’t mean you don’t deserve the loan,” Mason explains. “There’s no substitute for playing in your own sandbox,” he adds, meaning that local banks often have intimate knowledge of customers’ income prospects and other factors relating to loan eligibility.

Even when FIB&T sells mortgages it originates, “We want to retain as much servicing on the loans as possible,” Mason adds. “The borrower would prefer interaction with us.” Indeed, not only do borrowers like the ability to handle payment issues with a local banker, but Federal Reserve vice chair for supervision Michelle Bowman recently observed that during the pandemic, more borrowers experiencing financial distress were more likely to receive forbearance from banks than from nonbank servicers.

At Southern Bancorp, a $5 billion, Arkadelphia, Ark.-based community development financial institution, Jeremy Ray Davis, president of mortgage, who also serves as co-chair of the Mortgage Bankers Association’s Community Bank Network, underscores the importance of recent policy and regulatory initiatives: “I hear a consistent theme from my peers across the country: Community banks still believe mortgage lending is core to relationship banking.” While lending volumes were dented, “the commitment hasn’t gone away. It’s been squeezed by economics, not abandoned by choice.”

Bank enticements

In March, several proposals were unveiled that “should eliminate some of the pain points for community banks in making mortgages,” Roy says.

For instance, President Trump signed an executive order on March 13 directing federal agencies to prepare rules for a menu of mortgage-related changes. One element in that executive order, notes Roy, directs the Federal Home Loan Banks to offer longer-term funding options “so that community bankers can better manage their portfolio of mortgages, particularly their longer-term loans.” Community banks, Roy adds, typically are members of their regional federal home loan bank, and consider FHLB funding an important tool to keep mortgage dollars available.

Modernizing home appraisal rules, which might mean simplifying the requirements to qualify as an approved appraiser, or aligning appraisal requirements between VA and FHA, is another directive in the executive order. However, “all the details of the executive order are left to the agencies,” and the process could take months before being finalized, Roy says.

New capital requirements

While many policies will not be immediately implemented, proposed rules on capital requirements for mortgages in portfolio and for mortgages servicing rights (MSRs) were also announced, and are expected to be initiated in the near term, Roy says.

For one, stricter rules imposed after the foreclosure crisis placed a 50 percent risk weighting on mortgages in portfolio, but now regulators are “taking a more holistic look” at the characteristics of those mortgages, explains Roy. The 50 percent weighting still holds, but “could go lower for low LTV loans.” The added nuance reflects how borrowers holding more equity present a lower risk.

“If capital gets more risk-sensitive ... it could be a net positive for us because the majority of our production is high quality, lower LTV, well-documented loans,” observes Amanda Morris-Feldman, executive vice president, treasurer and CFO, at the $693 million First Federal Savings Bank, in Rochester, Ind. Lower requirements related to risk “make it easier to justify holding some mortgages in portfolio when it fits our balance sheet strategy,” she adds. “The trade-off is that high LTV or higher-risk layering would carry higher capital, so we’d either price that in, tighten guidelines, or lean even more on selling those loans rather than holding them.”

The other important revision drops the previous requirement that banks deduct a portion of mortgage servicing assets [known as the 25 percent cap]. Mortgage servicing assets will simply be assigned a 250 percent risk weighting, notes Roy.

“Certainly, anything that relieves capital requirements gives us more leeway,” says Pat Schlimmer, executive vice president and director of home loans, at the $1.2 billion nbkc bank, based in Overland Park, Kan. The change could mean that nbkc increases its servicing, he adds. An added attraction is that “servicing income is a nice natural hedge to fluctuating interest rates,” Schlimmer notes.

“We would try to retain even more servicing rights with lower capital constraints,” Mason observes. And because servicing is “more profitable at scale,” there’s incentive to build that business, Roy adds.

But even with less stringent capital rules, the mortgage servicing business still carries the same “day-to-day considerations,” notes Morris-Feldman. “MSR values can still swing with rates and prepayments, and servicing still comes with heavy operational and compliance expectations. So we’d view it as incremental balance-sheet and capital flexibility, while keeping the same internal limits, stress testing, and governance around the servicing book.”

Cyclical challenges

Mortgage interest charges move up and down, not only with market conditions, but as Morris-Feldman noted above, with rate adjustments based on risk factors like the amount of down payment. Borrowers’ appetites for refinancing directly rise and fall with rate pricing. Home purchase activity is also influenced by rate levels, as well as other drivers like overall economic conditions.

The fluctuations inherent in the mortgage business presents challenges. One is holding a typical 30-year mortgage in a portfolio when rates could move significantly from that level over time. “Once you keep mortgages on the balance sheet, you’re really signing up to manage a few things at the same time: You use up balance-sheet capacity and capital, you add meaningful interest-rate risk because prepayments speed up when rates fall, and the loans extend when rates rise, and you need stable long-term funding,” observes Morris-Feldman.

At nbkc bank, “We have five-one ARM products for people who just missed the conforming rules of Freddie or Fannie. We portfolio the five-one ARMs for these people [to later refinance into a conforming 30-year loan] when they qualify,” he explains.

Staffing for both busy and more quiet periods is another concern tied to mortgage cycles, especially since “community banks tend not to hire a lot during a boom, and then lay off workers,” says Roy.

“It is my philosophy and the bank’s philosophy that we don’t want to be that company that ramps up during busy times and then lets people go,” Schlimmer agrees. Besides, compliance concerns require loan officers who are familiar with procedures, Roy notes.

At nbkc, the solution is to take a “conservative approach” to hiring. “We might miss some opportunities,” Schlimmer relates. The bank invests in technology like tools for validating borrowers’ income and assets, and it helps boost productivity during busy periods.

“The banks that manage staffing best build their pipelines around purchased business and sustained community relationships rather than refinance volume. That foundation holds up better when rate environments shift,” adds Davis.

Measured expansion

Whether community banks return to previous mortgage participation levels will depend on housing market conditions, notes Roy. But even if home affordability comes roaring back soon, bankers will probably build the business slowly, he adds.

Taking deliberate, thoughtful steps is how nbkc has built a sizable mortgage operation that now employs about 85 loan officers in its home loan division, which does a large volume of both conventional and VA lending...

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