Mortgage Lending Compliance Structure Pertaining to Dodd-Frank and the Availability of Credit for Rural Housing

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1 Mortgage Lending Compliance Structure Pertaining to Dodd-Frank and the Availability of Credit for Rural Housing Report, Findings and Conclusions Gregory McKee North Dakota State University Albert Kagan Concordia College September 2014 Statements and opinions expressed in this report are solely those of the authors and do not necessarily reflect the opinions and recommendations of either North Dakota State University or Concordia College.

2 Executive Summary The Dodd Frank Wall Street Reform and Consumer Protection Act (Pub. L , H.R. 4173) was signed into law on July 21, The intent of the legislation is: To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end too big to fail, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices (enrolled final version). Dodd- Frank imposed new duties and obligations on loan originators. Among the new residential mortgage loan origination standards are that originators must be qualified and licensed as described by applicable law. Rural home financing is authorized under the Farm Credit Act of 1971 Part 613, Subpart A, Specific requirements pertaining to rural home mortgages are described in the Act as well as Agricultural Credit Associations participation. The supply of affordable housing is constrained differently in rural, as compared with non rural, areas. Relatively lower income, on average; reduced access to affordable credit; illiquidity and absence of equity are features of the US rural housing sector. Within the Uniform Call Report (UCR) the reporting item pertaining to rural home mortgages was implemented in Approximately $2.5 billion was reported as rural home mortgages in 2005 across the Farm Credit System. This value increased to over $4.2 billion in 2013, comprising 3.0% percent of all Agricultural Credit Associations loans. Total loans for the Farm Credit System are $148.2 billion at year end 2013 as reported by the UCR. The UCR is the data source for all Farm Credit System financial data used in this report. Rural residential loans are highly concentrated within the Farm Credit System. The ten largest associations offered 89 percent of all rural residential loans in These 10 associations also held 51 percent of all Farm Credit System loans in 2013 as well. This group of rural residential loan participants was seven of the ten largest lenders in the entire Farm Credit System in All are among the 25 largest FCS lenders. Seven of the associations have assets of $5 billion or more; while three other associations report assets between $1.3 and $1.6 billion. A Farm Credit Association s participation in the rural residential loan sectors requires Dodd- Frank compliance proficiency. Expertise in completing rural mortgage loan applications, acquiring the necessary technology for loan processing, and develop sufficient resources to be functional with continuing compliance and regulatory change. A combination of operational, market, and regulatory conditions make the Dodd-Frank regulations appear to be a barrier to entry for farm credit associations not currently dedicating resources to developing compliance with these regulations. Credit unions and community banks have substantially larger outstanding real estate loan volumes than Agricultural Credit Associations. Both credit unions and community banks are less concentrated in terms of number of institutions offering real estate mortgages than Agricultural Credit Associations. i

3 Agricultural Credit Associations that have a substantive presence in the rural residential real estate market indicate that this market segment is mission driven by both the FCA and the local board of directors. The ACAs that participated in this study indicate that they will continue to pursue this type of loan and are committed to staying current with proper training and technological investments. ii

4 Mortgage Lending Compliance Structure Pertaining to Dodd-Frank and the Availability of Credit for Rural Housing Summary of Mortgage Lending Requirement Changes The Dodd-Frank Act was passed in This bill was intended to facilitate transparency in financial transactions. Among the features of this bill was the Mortgage Reform Act. The intent of the legislation was to provide incentives for the market to offer loans with a relatively higher probability of repayment and to develop sustainable lending practices. Dodd-Frank affects the application of the Truth in Lending Act (TILA), enacted in 1968; regulations implementing the Act are Regulation Z. A key concept in Dodd-Frank is the definition of a qualified mortgage. This is a set of legal requirements that provide compensation incentives to originators for making safer loans. Ideally, the combination of requirements provides incentives for originators to make secure loans regardless of whether the loan is originated with the intent to sell the loan to another party. In summary, a qualified mortgage is described as one that, in general, (1) has no negative amortization or deferred principal payment, (2) no balloon payment, (3) has verified and documented sources for repayment ability, (4) a fully amortized loan payment schedule for fixed rate loans, (5) underwriting at the maximum rate for the first five years of an adjustable rate loan during the first five years, (6) complies with debt-to-income regulatory guidelines, (7) meets certain definitions of points and fees, and (8) has a maximum 30 year term. Qualified residential mortgages extend these qualifications by having the additional condition of the loan secured by a dwelling, although it need not be the consumer s principal dwelling. Dodd-Frank imposed new duties and obligations on loan originators. Among the new residential mortgage loan origination standards are the following. Originators must be licensed as described by applicable law. Dodd-Frank attempts to eliminate originators from having borrowers pursue unsustainable loans that are sold to the secondary market. Originators are prohibited from receiving compensation that varies based on any component of the loan or from the amount of principal. Originators cannot receive compensation from the consumer and a third party. Dodd- Frank prohibits originators from steering consumers towards residential mortgage loans that the borrower lacks the ability to repay as well as not allowing originators to direct the consumer toward loans that strip equity. Dodd-Frank reduces excessive fees during the loan ordination process, does not allow for loan conditions that are abusive to the consumer, steer consumers to non-qualified mortgages and away from a qualified mortgage, mischaracterize a consumer s credit history. Another aspect of the Dodd Frank legislation prevents originators from discouraging consumers from looking for a cheaper loan with another lender. This Act also requires the originator to provide a copy of the appraisal of the property, which also affects the implementation of the Equal Credit Opportunity Act (Regulation B). Such appraisals are required to be done by individuals or an organization that is independent of the originator. The Act eliminates prepayment penalties on non-qualified mortgages, and phases out prepayment penalties on qualified mortgages. The Mortgage Reform Act requires a variety of disclosures of resources, policies, payment schedules, applicable charges; rate reset schedules, monthly statement formats, and escrow payments. The Mortgage Reform Act also affected the disclosures for high-cost loans, as described in the Home Ownership and Equity Protection Act 1

5 (HOEPA) of The 2013 HOEPA Rule reduced the annual percentage rate threshold; modified the definition of points and fees, including an exclusion for bona fide discount points and private mortgage insurance premiums; added a new threshold for high-cost loans, and added a cure provision for high cost mortgage loan compliance violations. Mortgage originators are now liable for damages beyond the actual harm incurred by the consumer upon violation of these provisions. Regulations associated with the Mortgage Reform Act have been and continue to be developed and refined. Many provisions of regulations associated with the Act were to be developed by early Each potential originator in the qualified mortgage market makes decisions about optimal dedication of resources to awareness of these regulations as well as efforts to comply. Rationale of Farm Credit System Affordable housing supply has a different set of constraints in rural, as compared with non rural, areas. Relatively lower income, on average; reduced access to affordable credit; illiquidity and absence of equity (Drabenstott and Meeker, 1997; Kroszner, 2008) are features of the US rural economy. In addition, changes in the structure of rural banking often lead to only local banks maintaining interest in serving local business needs. Acquired banks by larger financial institutions oftentimes were no longer interested in serving small local businesses (Drabenstott and Meeker, 1997; De Young et al 2012). Notably, limited or no secondary market exists for certain rural home loans. Farm Credit System institutions are designed to be prominent participants in financing eligible agricultural producers. Agricultural Credit Associations (ACAs) provide credit and closely related financial services through favorable and unfavorable economic times (Barry, Brake and Banner, 1993). Ambrose and Buttimer (2005) indicate the presence of the Farm Credit System likely improves credit access that is limited to rural conforming mortgage borrowers. Local ACAs participate in relationship lending. Association branches are available at several locations in the chartered territory, providing access to information about borrower conditions and offering increased diversity of banking options. In addition, local associations may have a web-based lending and/or informational presence. Overview of Farm Credit System in Lending A number of associations within the Farm Credit System offer rural residential real estate loans. Association representatives view offering rural residential loans as consistent with the Farm Credit System mission to provide dependable credit in rural areas. Availability of these loans is subject to Farm Credit System-specific regulations. ACAs are authorized to finance moderately priced, single-family residences in rural areas with populations of 2,500 or less, with loans covering up to 85 percent of the appraised value of the residence securing the loan (Collender et al. 1997; FCA Regulation, 2014). Interviews with representatives of ACAs indicate the customary definition of moderately priced is a dwelling equal to a maximum $269,807. Another determination of a moderately priced dwelling is found in 12 C.F.R (a)(4)(ii). This second method authorizes FCS banks and associations to determine whether housing in a particular rural area is "moderately priced" by documenting data from a credible, independent, and recognized national or regional source. Housing values at or below the 75th percentile are deemed to be moderately priced (Jacob, 2007). Home loans are limited to 15 percent of all 2

6 outstanding loans held by a particular association by FCA regulation. Potential borrowers may also have to meet Farm Credit System-specific requirements in the event that the loan is nonconforming or the parcel exceeds secondary market allowances with respect to acreage size. In this circumstance borrowers must possess the potential to generate income from agricultural related activities to qualify for a loan that is for agricultural purposes that would not be a conforming loan under 12 C.F.R Given the cooperative business nature of agricultural credit associations, borrowers must invest in stock in the association. In this case, ACAs that participated in this study typically charge $1000 per rural residential home loan. In the majority of discussions the $1,000 is included as a closing cost item, in other situations this amount becomes part of the loan principal. Rural home mortgage borrowers, in turn, may or may not be eligible for patronage dividends from the association (if available) and are typically ineligible for voting privileges by virtue of a rural residential loan. Therefore this cooperative ownership / non-voting class of members obtain what is termed a participation certificate. Effect of Dodd-Frank on the Farm Credit System Any potential effect of the Dodd-Frank Act on rural residential real estate lending can be discerned from the effects of the Act on community banks. Approximately 6,000 community banks provide financial services across the country. In 2013, 3,000 community banks were headquartered in non-msa areas. Specialized knowledge of local financial/business conditions and of borrower characteristics promotes relationship lending. As a result, nationwide, community banks provide 15.7 percent of residential mortgage lending and 43.8 percent of farmland loans (Marsh and Norman, 2013). USDA reports (USDA/ERS, 2014) that community banks provide 34.5 percent of farmland loans, this discrepancy is based on the reporting sources. Marsh and Norman (2013) contend that Dodd-Frank encourages financial product standardization as a response to compliance, thereby undermining the ability of intermediaries to customize lending/mortgage products to borrower needs and reducing the competitive availability funds or increasing the cost of credit. Marsh (2013) indicates Dodd-Frank will fail to achieve its goals of providing incentives for banks to operate robustly at moderate scales of business and to strengthen consumer protection. Marsh reasons that compliance costs will displace community banks relative to larger banks, this action may force community banks to consolidate in an attempt to mitigate regulatory compliance expenses, hire and retain experienced employees while increasing training costs for existing employees. McTaggart and Callaghan (2011) believe community banks may lose access to interchange fee income and be subject to more stringent financial regulations, thereby reducing revenues and increasing costs simultaneously. Seide (2012) reasons other weaknesses exist in the legislation which will lead to continued wrongful foreclosures which may indirectly provide additional bailouts to financial institutions. Farm real estate loans have been historically provided by agricultural credit associations. As mentioned, however, some ACAs also provide loans for residential home financing. As an originator of residential real estate loans, ACAs must expend resources to interpret and implement both compensation and documentation regulations generated in response to modifications of Regulation Z as a result of the Dodd-Frank Act. These changes do not apply to traditional loans for farm land or farm operations. Instead, these changes apply to qualified residential loans (as defined by the Farm Credit Administration) that associations classify as 3

7 qualified mortgages that are subsequently subject to the additional restrictions imposed by Farm Credit regulations (population, farm income, moderate price, loan concentration limit). To observe the potential effects of the Dodd-Frank Act on Agricultural Credit Association rural residential real estate loans, two sources of data were collected. First, Farm Credit System financial data are compiled for each farm credit association from the Uniform Call Report (UCR) available at the Farm Credit Administration website. Data are used from the fourth quarter of each year beginning in 2005 through 2013 when the TYPRURRE field began to be populated in the UCR. The TYPRURRE variable is the reporting category for a rural residential mortgage within an ACA. The UCR contains annual statements of rural residential loan balances for each association and other loan types, as well as quarterly updates of other information, including assets. Secondly a comparison of loan distributions among real estate loans reported by ACAs with active mortgage loans and other types of loans was made with credit unions and community banks operating within the same or adjacent geographical areas. Credit union financial data are compiled from the 5300 Call Reports available at the National Credit Union Administration (NCUA) website. Call Reports contain year-to-date financial statement and operational data from each credit union. Quarterly data are available from Q through Q Community bank financial information is obtained from Statistics on Depository Institution available at the Federal Deposit Insurance Corporation website. Quarterly data are used between Q and Q Upon examination of the Uniform Call Report rural residential real estate loan field, TYPRURRE, eight agricultural credit associations and one farm credit bank were selected for interviews regarding their approach and experience with offering rural residential real estate loans. Each selected organization agreed to schedule a phone conference to discuss the Dodd- Frank implementation upon rural residential real estate loans. Representatives of the following associations and correspondent bank were from the following: AgCountry, ACA; Ag Credit, ACA; AgStar, ACA; Farm Credit East, ACA; Farm Credit Mid-America, ACA; Farm Credit Services of America, ACA; Greenstone, ACA; Northwest Farm Credit Services, ACA; and AgFirst, FCB. In each case, representatives were asked about the particular organizations reasons for providing rural residential real estate loans, specific methods for identifying and implementing Dodd-Frank related regulations, methods for forming and delivering rural real estate loan products within the association s trade area (chartered territory) and details about the association s product offerings. All interviews were conducted by phone in August and September 2014 by the authors. All subsequent references to information from interviewees are intended to convey a consensus of understanding by all interviewees on a given topic, unless otherwise noted. Scale of Farm Credit System To begin the assessment of the effect of the Dodd-Frank Act on rural residential real estate loans, an examination of the scope of the Farm Credit System was undertaken. 97 ACAs were operating in 2005 along with 5 Farm Credit Banks. The 97 associations had $88,653,438,000 in assets, and $84,349,193,000 in outstanding loans. The associations had $1,356,829,000 in interest income. In ACSs were operational along with 4 Farm Credit Banks. The 82 associations had $157,149,257,000 in assets and $148,202,518,000 in outstanding loans 4

8 (Uniform Call Report Q4 2013). The agricultural credit associations earned $1,543,079,000 in interest income. These categories grew 77% (assets), 76% (outstanding loans), and 14% (interest income) between year-end 2005 and year-end Production agriculture real estate is the most common type of loan, followed by agriculture production and intermediate term loans, across all associations. Rural residential real estate loans were the fifth largest category in 2005, on average; rural residential real estate loans increased to become the fourth largest category in System wide rural residential real estate loans have historically been at or less than 3 percent of all loans (since reporting of this category was part of the UCR in 2005), well below the regulatory maximum of 15 percent. Tables 1 and 2 shows the distribution of major loan types in ACAs and the annual value of outstanding loans for the five loan types with the largest balances. Of the five largest categories of loans, since 2009, production real estate and rural residential real estate loans have had the largest annual growth rates in outstanding balances, of 7 percent and 5 percent respectively; production loans have grown at an average of 3 each year. Alternatively, rural residential real estate loans had the third largest percentage growth between 2005 and 2013, with processing and marketing loans increasing from $3.1 billion to $8.8 billion (184% growth), agricultural real estate increasing from $50.7 billion to $87.6 billion (72% growth) and rural residential real estate loans increasing from $2.5 billion to $4.2 billion (69% growth). These loan categories grew at an average annual rate of 11 percent between 2006 and 2008 across the Farm Credit System; between 2009 and 2013 the average annual rate was 5 percent. Rural Residential Real Estate Loans in Agricultural Credit Associations Rural residential real estate loans concentration is examined within the Farm Credit System. There are magnitudes of difference in the volume of rural residential loans offered by the FCS. In 2005, 7 (of 97) associations had no loan volume for this category, 24 associations had less than one million in outstanding loans (not including the 7 associations with $0), 27 ACSs had $10 million or more, and 4 of these associations had over $100 million in rural real estate loans. In 2013, 8 (of 82) associations had no reported loan activity for this type, 19 associations had less than one million in outstanding loans (not including the 8 associations with $0), 26 associations had $10 million or more and while of these 7 organizations reported over $100 million within this category of loans. In other words, it is typical for a third of the associations to have between $0 and $1 million in rural residential loans while another third have $10 million or more. The largest associations in 2005 and 2013 have approximately $1 billion and $2 billion respectively in rural mortgage real estate loans (Table 3). Residential loan products also differ by size of the ACAs providing these loan types. The median rural residential loan volume in 2005 across all ACAs was $3.6 million, but the average was $26 million. The average asset size was determined for the five associations smaller or larger than the median or mean. In other words, the average assets of the ten associations with loan volumes greater or less than the median or mean were calculated. The average assets of five associations with rural residential loan volumes greater than or less than the median are $371 million. The average assets of the five associations with rural residential loan volumes greater than or less than the average are is $876 million. In 2013 the median had increased to $4.7 million while the average had risen to $51.8 million. The average assets of the 5 associations above and five below the median loan volume was $811 million. The average assets of the five associations above and 5

9 five below the average loan volume was $3.3 billion. Therefore, as indicated, a few, larger, associations offer much greater loan volumes than most associations. In 2005 and 2013, ACAs with approximately average rural residential real estate loan volumes are approximately three times the size of associations with the median loan volume, on average. States with numerous associations holding $1 million or less in rural residential real estate loans in 2013 include California (5 associations), Kansas (3 associations), North Dakota (3 associations), and Oklahoma (4 associations). None of the 21 associations headquartered in these four states had outstanding rural residential real estate loans of more than $10 million and 3 had balances between $1 and $10 million; 9 associations had balances of less than $1 million. Rural Residential Real Estate Loan Portfolio of Largest Lending Associations This study evaluated the ten associations with the largest outstanding rural residential real estate loan amounts. The composition of this group had little change between 2005 and The ten largest rural residential real estate lenders are headquartered in states in the eastern half of the country, with the exception of Farm Credit Services of America, ACA (NE) and Northwest Farm Credit Services, ACA (WA). In 2005 and 2013, these ten associations offered 79 and 89 percent of all rural residential loans within the Farm Credit System, respectively. These 10 associations also held 43 and 51 percent of all Farm Credit System assets between 2005 and 2013, respectively. These associations were seven of the ten largest lenders in the entire Farm Credit System in 2013, based on total outstanding loan volumes. All are among the 25 largest FCS lenders. Seven of the associations have assets of $5 billion or more; while three other associations report assets between $1.3 and $1.6 billion. Table 4 shows the distribution of outstanding loans, of ACAs within the five largest categories, by year; Table 5 shows the aggregate amount of the loan categories. These results indicate that, even among the ten largest rural residential real estate lenders, production agriculture real estate is the largest type of loan by outstanding assets, followed by agricultural production and intermediate term loans. Rural residential real estate loans are often the fourth and sometimes third largest category over time. This relatively high importance of rural real estate loans suggests these ten associations consider rural residential real estate loans differently in their portfolio than the typical association. Between 2005 and 2013, rural residential real estate loans have been about 4.7 percent of the association s portfolio, on average, as compared with 2 percent across the Farm Credit System. This set of observations implies that rural residential real estate loans are highly concentrated within the Farm Credit System. This loan category is not approaching the regulatory limit of 15 percent for these associations as a group. Overall the rural real estate loan sector is 1.5 percent of all System loans in Interviewees were asked about the role of rural residential real estate loans in the strategic plans of the top seven associations offering rural residential real estate loans. Results indicate these associations, as does the Farm Credit System, has room within the regulatory cap to increase rural residential real estate loans. Only one association had reached the 15 percent limit, in The other associations had 8, 6, 4, 3, 2, and 1 percent of their outstanding loans as rural residential real estate loans. Interviewees indicated their respective boards of directors have passed policies that either deliberately requested acquisition of resources to commence offering rural residential real estate loans, or were supportive of the management team developing this 6

10 capacity. It appears that the associations offering the largest amounts of rural real estate loans intend to continue to operate within this market segment. Nevertheless, the rate of growth of outstanding rural residential real estate loans in the portfolio of the top ten lending associations has generally slowed. This pattern is consistent with the other types of financial institutions that have been participating in rural real estate loan programs (see Figure 1). Real Estate Loan Comparisons with Credit Unions and Community Banks A comparison of the volume and distribution of real estate loans in the portfolios of agricultural credit associations with those of community banks and credit unions was undertaken. For purposes of this study all credit unions whose headquarters were located outside a metropolitan statistical area were included in this comparison. At year-end ,870 credit unions met this criterion. These credit unions offered nearly $203 billion in primary (first) home mortgages, held collective assets of $808 billion, and generated net interest income of $65 million. The average share of loans within the credit unions portfolio that were primary mortgage loans was determined. In 2013, 22 percent of loans were for primary mortgages while an additional eight percent were reported as real estate lending of some other type. First mortgage loans grew at an average annual rate of 12 percent between 2005 and 2008 across credit unions within this cohort; these mortgage loans grew at an average annual rate of 6 percent between 2009 and Hence, credit unions have a substantially larger outstanding real estate loan volume than agricultural credit associations. Since nearly 4,900 credit unions offer these loans, the credit union sector is less concentrated in terms of number of institutions offering real estate mortgages or in terms of location as to loan closings. As described above, rural residential loans grew at an average annual rate of 11 percent between 2006 and 2008 across the Farm Credit System; between 2009 and 2013 the average annual rate was 5 percent. Hence, total first mortgage loan volume grew about one percent more slowly in the Farm Credit System during 2005 to 2008 and between 2009 and 2013 than in credit unions (see Tables 6 and 7). For purposes of this study all community banks whose headquarters were located outside a metropolitan statistical area were observed. In 2013, 3,024 banks met this criterion. These banks offered $141 billion in single family home mortgages, had assets of $773 billion, and reported net interest income of $29 billion (Table 7). The average share of loans that were single family mortgage loans was determined. In 2013, 35 percent of all loans were primary mortgages (Table 6) while an additional 1.1 percent was multiple family residential mortgages. First mortgage loans grew at an average annual rate of 3.1 percent between 2005 and 2008 across all community banks headquartered in a non-msa area. Residential mortgage loans declined at slightly less than one-half percent annually from 2009 through Community banks have a larger outstanding mortgage loan volume. Community banks are considerably less concentrated in terms of number of institutions offering residential mortgages or in terms of geography as too where these loans are available. Total single family mortgage loan volume grew more slowly than across the Farm Credit System between 2005 and Table 6 shows the annual loan distribution of mortgages in non metro community banks. Table 7 shows the associated loan volume. Table 8 indicates the fraction of assets as real estate loans. Concentration of loans within credit unions and community banks headquartered in non-msa areas, compared with ACAs are shown in Table 9. 7

11 The community bank data also include an indicator for the county in which the bank was headquartered. Counties served by seven of the ten largest rural residential real estate lending ACAs were identified. Real estate loan data was collected for community banks in these same counties. Table 10 shows a comparison of loan distribution for community banks and ACAs for select years between 2005 and 2013 when the same geographic area is considered, provides a more realistic assessment of agricultural credit association loan distribution. In most cases the fraction of loans as real estate loans diverge significantly between agricultural credit associations and community banks. For example, 185 community banks served the same chartered counties as Agstar in percent of all loans in these community banks, on average, were single family home loans. At the same time, 1.5 percent of AgStar loans were rural residential real estate. In 2013 these percentages were 30.5 and 1.6 respectively for community banks in the same territory as that served by AgStar. The smallest geographic region served by one of the ten largest rural residential lenders is that of Ag Credit (Fostoria, Ohio), which is served by 31 community banks. In 2005 and 2013, 45 percent and 44 percent of all community bank loans were single home mortgages. Rural residential real estate loans were 8 and 15 percent of Ag Credit loans. The association territory with the greatest number of community banks, Farm Credit Services of America (Omaha, NE), had community banks with 16 and 15 percent of loans as single home mortgages in 2005 and 2013, respectively. These percentages were 3 and 6 for the Association. FCA regulations regarding community size, moderately priced real estate affect the available market for loans accessible to ACAs differently from community banks. Loan Characteristics Interviewed participants were asked about the characteristics of the rural residential real estate loans offered. A variety of loan products were discussed, including fixed and variable rate loans. These loans were available for a variety of terms. Fixed rate loans included 10/15/20/25 and 30 year terms. Adjustable rate mortgages with fixed terms of 5/6 years and total terms of 24/30 years were mentioned. There was some discussion that these associations were able to provide fixed rate products that were typically unavailable at competing financial institutions in the same geographic market based upon characteristics of the loan within the context of risk determination. Interest rates for individual loans were not available for this study. Interviewees were mindful of relative spreads between rural residential real estate loans and other products offered within the association. Rural residential real estate loans were generally smaller than other loan products due to FCA regulations and in certain circumstances competitive market conditions. Interviewees also noted the relative competitive disadvantage that the membership requirement of $1,000 created for their products. Some associations included this as part of the principal, but most appear to include this fee as a closing cost item. Some associations offer patronage with the participation membership but most do not. Participation certificate members do not have voting rights associated with these loans. In some associations the $1,000 was returned to the borrower when the loan was completed (paid). Loans offered by the interviewed agricultural credit associations were overwhelmingly described as conforming loans or qualified mortgages, according to the new Dodd-Frank regulations. Since associations are able to make loans to parcels with non-conforming characteristics, this is also a possible market for loans. Interviewees described loans with non-conforming characteristics as 8

12 pertaining to the agriculture real estate category of loans. Hence, the rural residential real estate loan category is generally reserved for conforming loans to consumers with a potential for agricultural income. Some discussion was centered on whether to classify the loan as rural residential real estate or agricultural real estate. Two mechanisms pertaining to this issue were mentioned. In the first option, the collateralization source was a determinant. The other approach is the intent of use; if the property was to be used for agricultural production, despite a primary residence present, the loan was classified as agricultural real estate. The selection of loan type has tax implications, oftentimes associations compete with other financial institutions based on their ability to offer relatively lower tax consequence loan as part of the loan package. Farmland is taxed at a different, typically lower, rate than residential land. At least one interviewee described a practice of some non-agricultural credit association lenders advising customers to pursue a residential mortgage, instead of an agricultural real estate loan. The possible tax consequences may be a result of the financial institution not being comfortable collateralizing the loan as agricultural land. This circumstance is not common given the reticence of banks or credit unions to extend funds for agricultural land purchases. A likely outcome may be to have the parcel divided into a residential portion and the remainder as agricultural land. An ACA is able to isolate a portion of the customer s parcel, based on the presence or absence of a residence, and offer loans based on the different land use type in a more streamlined fashion than other financial institutions. The interviewee described the competitive advantage associations offered customers by being able to offer both residential and agricultural real estate loans. Interviewees indicated that since many of the mortgage loans are conforming, they are eligible for sale on the secondary market. A range of interactions with the secondary market were discussed with the interview participants. Typically the overwhelming majority of rural real estate mortgages are retained in the association s portfolio. One association indicated that the organization had formed a secondary market relationship with Fannie Mae and another had pooled loans to Farmer Mac at times. One Farm Credit Bank purchased mortgage loans from member associations within the trade area. There was some discussion of mortgage loans being sold to a commercial bank, as well as purchases of loans by a Farm Credit Bank from commercial banks, but these formed a negligible percentage of the portfolio. As noted one Farm Credit Bank has been an active correspondent participant with numerous ACAs within and sometimes across its chartered territory. This bank had over $2.3 billion in rural residential loans during This was an increase from $0.4 billion in To place this loan value in context the entire Farm Credit System, including agricultural credit associations and a Farm Credit Bank, had $6.6 billion in the segment in The reason described by the Farm Credit Bank as to why they are involved in this sector is that this is part of the mission for the Farm Credit System, providing financing to rural America. Secondarily this category of loans is profitable and the bank provides a service as a secondary market intermediary for ACAs that do not have the compliance expertise or are looking for an outlet for commitments that will not be held in portfolio. 9

13 Operational Responses to Dodd Frank A series of questions were asked of association representatives about the resources the associations used to acquire compliance expertise. The associations interviewed had made deliberate decisions to develop employees and employee teams with Dodd-Frank compliance expertise. Interviewees indicated that many associations had offered rural residential real estate loans, in some cases, for several years. The accumulation of experience by these employees had enabled them to understand the changes associated with the new regulations. In other cases, interviewees indicated that employees had professional expertise with conforming real estate loans prior to their employment with the association. Interviewees also indicated that ACAs have made investments in employees learning about real estate regulation changes and assessing their ability to comply. Association representatives also described specialized investments in information technology to generate forms that enable loan officers to document required disclosures. Certain associations have developed specialized mortgage expertise within branch officers across locations. Not all association offices have rural residential real estate expertise. Instead, potential customers would interact with a local loan officer, who would refer the borrower to a mortgage specialist if available, or the application would be transferred to a centralized underwriting group within the association for further processing. Decisions to develop these resources were described as being based on expected rates of return from rural residential real estate loans that were consistent with other loan categories offered by the association. Board support in offering rural residential real estate loans was necessary but not sufficient to develop these resources. In fact, interviewees described a range of board support for offering this product from either initiating the idea to becoming persuaded over time about the viability of the rural mortgage loan product. Institutional Innovations Data in Tables 1, 2, 5 and 9 indicate outstanding rural residential real estate loans are concentrated within a limited number of associations and perhaps some regions of the country. Interviewees were asked about the absence of loan volume in California. Their opinion was that farm consolidation led to an insufficient number of borrowers to make offering this type of loan viable for an association. Another aspect of the absence of rural housing loans by California ACAs may be related to the definition of rural area and the moderately priced guideline. The parameters simply rule out this type of loan category and/or make it too complicated to implement. When speaking with at least one other association about why it did not offer rural mortgage loans a similar reply was provided, low customer volume, in this circumstance despite having assets greater than some of the largest rural residential real estate lenders. As a result, many associations have not invested resources to assure compliance with Dodd-Frank regulations, to develop expertise in completing rural mortgage loan applications, to acquire the necessary technology for loan processing, or to develop sufficient resources to be functional with continuing compliance and regulatory change. An analysis of demand conditions for rural residential lending is outside the scope of this study. However, the number of cities and towns with populations of 2,500 or less, consistent with lending guidelines, can be observed in each state. Table 11 displays the number and average population of incorporated locations eligible for rural residential lending (U.S. Census Bureau 10

14 2013). Those with populations of 2,500 or less are considered eligible for rural residential lending under the guidelines. These data provide information about demand conditions local ACA management considers when deciding whether to provide rural residential real estate loans. In California, approximately 35 incorporated communities had populations of 2,500 or less in 2013; there were 439 such hamlets in North Dakota in In both cases, no ACA headquartered in the state provides rural mortgage loans directly to its current or potential members. Clearly the decision to provide rural residential real estate loans is not simply a numerical relationship of the population within a service territory. The USDA National Agricultural Statistics Service provides data on the number of farm operators in each state. In 2007, there were 131,000 operators in California and 45,000 in North Dakota. Although these data do not reveal how many operators live within an area eligible for rural residential lending, it is clear, again, that no simple numerical relationship exists between the numbers of potential borrowers in any given ACA to spread rural real estate lending compliance costs over its portfolio. The authors were unable to identify average real estate price data for all counties served by ACAs. A question was asked as to whether current or potential members of these associations could have access to rural residential real estate loans in any other pathway. Interviewees indicated representatives of associations in these areas could either (1) refer current or potential members to other associations that offered rural residential real estate loans or (2) representatives of associations offering these loans could solicit loans of customers in the service territory of other associations provided these were granted permission (territorial concurrence). In either case, associations exchanged concurrence, a formal recognition of the charter of the association not offering the loan. Use of the concurrence mechanism is in deliberate response to the choice made by some associations to not include rural residential loan activities as a feature of the association s strategic plan. The use of the concurrence mechanism also suggests that associations could plan, strategically, to develop expertise in Dodd-Frank regulation compliance for rural residential real estate loans. Given the operational responses for information technology and personnel described above, some associations may choose to forgo dedicating resources to develop expertise in complying with Dodd-Frank regulations since the income associated with expected loan volume is less than the cost of these resources. Interviewees were asked whether their respective associations intend to share their expertise in Dodd-Frank compliance with other associations. Most, but not all, indicated they are willing to or are considering sharing their expertise. There was some interest in the possibility of developing System wide expertise or regionally-based expertise in Dodd- Frank compliance. Dodd-Frank Compliance as a Barrier to Entry A combination of operational, market, and regulatory conditions make the Dodd-Frank regulations appear to be a barrier to entry for agricultural credit associations not currently dedicating resources to developing compliance with these regulations. As mentioned, some associations rely on the concurrence mechanism to refer rural residential real estate loans requests from current or potential members within their territory to other associations active in making these loans. Changes in population, either through declining rural population and/or farm consolidation has resulted in fewer opportunities to generate loan applications. Indeed at least 11

15 one interviewee indicated the population in their trade territory was too low to justify the investment in compliance expertise. Furthermore, regulations continue to be developed and released by the Consumer Financial Protection Bureau, requiring modification of existing operations and development of new expertise, incurring significant personnel expenditures to train and maintain proficiency in this topic. Farm Credit-specific rules on the authority of associations to offer rural residential loans, when combined with Dodd-Frank regulations, further constrained the ability of associations to solicit loans. Interviewees indicated that the reasonably priced guideline sets $269,807 as the maximum appraised price of a property considered for a loan. Associations with territory near urban areas often observed appraised property values in excess of this value. Interviewees described a process whereby they could assemble data about the current level and trend of prices in the region and submit a request to the Farm Credit Administration to increase this maximum price to a greater value. Interviewees described this as a time consuming and otherwise costly process. Furthermore, this limit differential applied only to select areas of the association s territory, perhaps a specific county or similarly sized region. Other interviewees indicated they had deliberately forgone this process or had chosen to avoid offering rural residential real estate loans in areas near urban regions of their trade territory. In some circumstances the maximum appraised price was described as being substantially less than $269,807. There is not data to explain the range in observed limits on maximum appraised values. An inability of a given association to offer rural residential real estate loans has implications for the volume of business with any particular customer. Given the importance of relationship lending within the association, loan officers seek to inform current and existing customers about the variety of loan products offered for the diverse financing needs of customers. Interviewees indicated rural residential loans form one component of a suite of products loan officers recommend to customers. If an association is unable to make the residential loan product available this may affect the viability of the lender-customer relationship. Alternatively, associations using the concurrence mechanism forgo the possibility of forming multi-product relationships with customers since the limit of the lending relationship is restricted to the real estate loan itself. Therefore, the association that engages in mortgage lending creates a public good for other associations which desire an expanded lending relationship. Traditional microeconomic theory indicates agents tend to underinvest in public goods relative to the socially desirable outcome. Agricultural credit associations are aware of their role in offering rural residential real estate loans and thereby facilitate entry into this product market. Interviewees mentioned that in some instances there are few alternatives to the Farm Credit System for access to credit. Interviewees mentioned that certain community banks or other financial organizations simply do not offer home finance products in rural locations. Certain agricultural credit associations discussed the issue of micro markets within the chartered territory. The micro market was mentioned earlier in this report when moderately priced residential homes may have higher market values due to proximity to urban areas or resort related communities. Each association has the option to seek a variance to the lending cap if market conditions are attractive. From discussions with the association representatives in this 12

16 study there was no clear pattern or mechanism to address this market segment. Some associations have gone through the market adjustment process as needed while other associations enforce the moderately priced ceiling. When an association chooses not to address the moderately priced maximum the implication is that customers will seek alternative financing from a different type of market participant. A secondary component of the moderately priced property with regard to a market adjustment determination does not alter the 85 percent loan to value capitalization maximum for rural home loans as described by several ACA representatives that participated in this study. Summary and Conclusions Rural residential real estate loans are 2.9 percent of the total Farm Credit System loans in This percentage has been consistently in the 3 percent range since 2005 when this category became a reported item in the Uniform Call Report. This loan category is the fourth largest loan type within the FCS; however the percentage has been unchanged since This may indicate that rural residential real estate loans are not viewed as a risk diversion item across the System. The degree of concentration of this loan type further supports the assumption that many ACAs do not pursue these loans as a risk mitigation product. Study participants from the Agricultural Credit Associations that agreed to be interviewed for this project expressed three consistent views with respect to rural residential real estate loans. The first view is that the infrastructure needed by an association to enter this market is expensive and requires to be continually updated. This includes registration and training of loan originators, specialized software and an institutional commitment to building an expertise in this segment. The second consistent observation was that this market segment has certain competitive dynamics that are not present within other components of an ACA s portfolio. For example the spreads attained within this segment oftentimes is not as robust as other loan opportunities. This was mentioned when rural real estate loans occur in geographical areas where other types of financial institutions have market presence. The third view mentioned by the ACA participants was the limited market segment (FCA definition of potential loan borrowers), the investment in an associations stock and oftentimes the constraint of the moderately priced valuation. As mentioned the relative lack of ACA participation in California due to the rural community definition, the consolidation of farming operations and the moderately priced regulation. There appears to be limited interest in the many ACAs to enter this market given the prior noted concerns. Agricultural Credit Associations that have a substantive presence in the rural residential real estate market indicate that this market segment is mission driven by both the FCA and the local board of directors. The ACAs that participated in this study indicate that they will continue to pursue this type of loan and are committed to staying current with proper training and technological investments. These organizations also stated that other ACAs would not enter this market due to the limited demand in certain locations, the elevated front end start-up expenses within this loan type, the continuing cost of compliance maintenance and the limited loan size within many markets. There was some degree of discussion with the study participants about sharing their expertise within the rural residential real estate segment. For the most part these individuals did were not 13

17 averse to working with other associations across the System in an effort to expand and enhance loan opportunities in this category. Limited discussion addressed implementation strategies pertaining to this extension of expertise of cost and scale efficiencies. 14

18 References Ambrose, Brent W., and Richard J. Buttimer Jr. "GSE impact on rural mortgage markets." Regional Science and Urban Economics 35.4 (2005): Barry, Peter J., John R. Brake, and Delmar K. Banner. "Agency relationships in the farm credit system: The role of the farm credit banks." Agribusiness 9.3 (1993): Collender, Robert, Patrick Sullivan. Credit in rural America. United States Department of Agriculture, Economic Research Service. Agricultural Economic Report 749 (1997). Accessed September 18, DeYoung, Robert, et al. "Small business lending and social capital: are rural relationships different?." University of Kansas Center for Banking Excellence Research paper 1 (2012). Drabenstott, Mark, and Larry Meeker. "Financing rural America: A conference summary." Economic Review 82.2 (1997): 89. FCA Regulation--PART ELIGIBILITY AND SCOPE OF FINANCING. Modified September 30, FCA%20Regulation/ docx. Accessed November 2, Jacob, A. Farm Credit Administration Informational Memorandum-- Clarification of 12 C.F.R Rural Home Financing April 10, cation_of_rural_home_financing_reg.pdf. Accessed November 2, Kroszner, Randall S. "The Community Reinvestment Act and the recent mortgage crisis." Board of Governors of the Federal Reserve System (2008). h. Accessed Sep. 18, 2014 Marsh, Tanya D. Regulatory Burdens : The Impact of Dodd Frank on Community Banking. Statement before the House Committee on Oversight and Government Reform. (2013). Accessed September 18, Marsh, Tanya D., and Joseph W. Norman. "The impact of Dodd-Frank on community banks." American Enterprise Institute May 7 (2013). McTaggart, T., and M. Callaghan. "Challenges currently facing community banks, including requirements of the Dodd-Frank Act." Financial Services Alert 22 (2011). 15

19 Seide, Christopher K. "Consumer Financial Protection Post Dodd-Frank: Solutions to Protect Consumers Against Wrongful Foreclosure Practices and Predatory Subprime Auto Lending." University of Puerto Rico Business Law Journal 3 (2012): US Census Bureau American Factfinder. USDA/Economic Research Service U.S. Farm Sector Financial Indicators, F. Accessed November 23,

20 Appendix Table 1. Distribution of Outstanding Loans, Within the FCS for the Top Five Categories, Production & Processing and Farm Related Farm Real Estate Year Intermediate Term Marketing Business % 28.5% 3.7% 2.0% 3.0% % 28.6% 5.4% 2.1% 2.9% % 27.8% 7.0% 2.1% 2.9% % 29.7% 8.1% 2.0% 3.0% % 30.2% 6.9% 1.5% 2.9% % 29.5% 6.5% 1.6% 2.9% % 28.4% 5.6% 1.6% 3.0% % 27.1% 5.6% 1.6% 2.9% % 26.0% 6.0% 1.6% 2.9% Rural Residential Real Estate Table 2. Value of Outstanding Loans, Within the FCS for the Top Five Categories, ($1,000). Year Farm Real Estate Production & Intermediate Term Processing and Marketing Farm Related Business Rural Residential Real Estate ,784,760 24,072,392 3,103,259 1,709,807 2,517, ,196,231 27,129,844 5,164,814 1,955,534 2,778, ,375,272 29,804,537 7,530,643 2,271,280 3,072, ,320,845 33,827,296 9,292,940 2,304,924 3,393, ,018,999 36,155,333 8,292,428 1,804,559 3,419, ,953,481 37,022,233 8,186,779 1,965,350 3,630, ,309,091 36,131,691 7,196,072 2,042,258 3,771, ,200,746 37,843,181 7,776,598 2,283,368 4,026, ,561,481 38,493,580 8,818,941 2,369,173 4,245,306 Table 3. Number of Agricultural Credit Associations with Selected Values of Outstanding Rural Residential Loans, 2005 and Number of Associations Year Value of Outstanding Loans 2005 $0 7 $1 to $999, $1,000,000 to $9,999, $10,000,000 to $99,999, $100,000,000 or more $0 8 $1 to $999, $1,000,000 to $9,999, $10,000,000 to $99,999, $100,000,000 or more 7 17