The combination of historically low mortgage rates and the prospect of surging inflation is causing a growing number of local banks to begin selling their residential mortgage loans in the secondary market.
The trend marks a departure from tradition for some Connecticut banks, which have tended to hold mortgage loans they originate within their own portfolios.
“It has not been a business strategy in the past,” said Chris Buchholz, executive vice president at Rockville Bank, which has assets of $1.5 billion and 21 offices. “But [mortgage] rates have been low and inflation will be kicking up. Margins on the loans are going to get squeezed.”
The change will likely mean that prospective homebuyers will face tighter lending standards. As banks begin to sell their loans to Fannie Mae and Freddie Mac, the government-backed entities that finance most of the secondary market for mortgages, they will have to conform to Fannie and Freddie lending standards, which have tightened as the two mortgage giants deal with billions of dollars in bad loans.
“If we want to sell the loan to Freddie or Fannie now or in the future, we have to cater to their rules,” said Martin Geitz, president and CEO of Simsbury Bank, which for the first time plans to sell its mortgages into the secondary market. Simsbury Bank has $223 million assets and five branches.
In explaining the strategy, Geitz noted that about 80 to 85 percent of a community bank’s operating revenue typically comes from its net interest margin, which is the difference between the money a bank gains from interest on loans and the money it pays out as interest on deposits.
Historically, community banks have kept mortgage loans they originate on their balance sheets because they have proven to be a steady and reliable source of fee and interest income.
However, this month interest rates on 30-year fixed-rate mortgages fell below 5 percent, the lowest they have been since April 1971, when Freddie Mac started tracking the data.
At the same time, local bankers are concerned that enormous federal government spending to boost the ailing economy will lead to inflation, causing “interest rates to go up drastically in the next two or three years,” Geitz said.
In a rising rate environment, a bank’s cost of funds — basically, the rates paid to attract deposits — goes up as the interest income on their portfolio of fixed-rate mortgages remains flat.
“That margin is what allows us to keep the lights on,” Geitz said. “As [deposit] rates go up, we could be paying 5 percent for CDs and have 5 percent mortgages on the books. We wouldn’t be making any money, if that were the case.”
By selling mortgages to the secondary market, banks can replenish their coffers, giving them new funds to offer more mortgages to new borrowers. It also ensures that they are not left with a balance sheet full of unprofitable loans.
Over the years, Rockville Bank has done little business in the secondary market, but it is preparing to get more active in it now, Buchholz said.
High demand for mortgage refinancing is adding to the need to turn to the secondary market as a precaution.
Farmington Savings Bank, with $1.1 billion in assets and 16 offices, is experiencing a similar trend with refinancings.
Gerald Noonan, president of the Connecticut Bankers Association, said the move to sell mortgages to the secondary market will likely last for the next six months to a year.
“Banks that have portfolio loans have to be prudent, and I think they will continue to put them in the secondary market,” Noonan said. “Spreads are so narrow that banks really have no choice.”
Bert Ely, a banking industry consultant in Virginia, said Connecticut bankers are right to be concerned about the potential impact of soaring interest rates.
He said they are taking steps to avoid being caught in the trap that ruined hundreds of savings and loans in the 1980s.
During that period, when S&Ls were holding large portfolios of fixed-rate mortgages, the market rates for deposits shot up — even higher than the returns they were earning on the mortgages.
From 1989 to 1992, Connecticut experienced 37 banks failures.
“When you get into a low-rate environment, it certainly makes sense to sell long-term fixed-rate mortgages,” Ely said. “Most banks have been doing that anyway since the S&L crisis.”
But by turning to the secondary market, community banks risk losing a bit of their local feel. When mortgages are sold to Fannie Mae and Freddie Mac, the loan originator usually disappears from the process, forcing borrowers to deal with faceless institutions from outside the state.
But, several local bankers plan to address that threat by continuing to service the loans.
“That’s important for us so that customers know who they are dealing with,” Buchholz said. “That’s part of the identity of being a community bank.”
