Sam Vallandingham won't say how he is restructuring his bank. That is a trade secret.

But he will say that he spent a lot of time and money coming up with the plan to spare his Barboursville, W.Va.-based First State Bank from the consequences of the Federal Reserve's capital rules.

First State Bank, headquartered near where West Virginia abuts Ohio and Kentucky, is not the kind of bank that the government blamed for causing the financial crisis. It's a small community bank, one that boasts that it kept low delinquency rates on its home loans throughout the crisis.

Nevertheless, Vallandingham, the bank's president and CEO, has had to map out an overhaul of the bank's business structure in order to keep it doing what he views as its core competency: Making and servicing home loans.

The change was forced, Vallandingham says, by the raft of new rules that the federal government imposed on home loans and servicing those loans, a response to the abuses of the subprime crisis. Those rules, meant to protect borrowers and prevent another crisis, are now playing out on the ground, and hitting some of the community banks that the government meant to protect.

"It wasn't one rule; it was the combination of all of them that crushed us," Vallandingham said.

In fact, it's not just the numerous rules that federal regulators have imposed on home loans that has made lending difficult for banks, according to bank analysts. Rather, it's a confluence of factors, including the fear of litigation.

"Rezzy is becoming a non-bank business," said Christopher Whalen, chairman of Whalen Global Advisors LLC, referring to residential mortgage lending. "You can't look at the numbers and make a really good case for getting into rezzy."

An outgrowth of 2008

The situation facing banks today is one of the many far-reaching repercussions of the 2008 financial crisis, which the government's investigators concluded was in part kicked off by a decline in lending standards.

As the housing bubble inflated, mortgage lenders increasingly made loans without ascertaining borrowers' income, or that included terms making it impossible for the loan to be repaid. After the bubble burst, a foreclosure crisis ensued, complete with widespread problems with paperwork and procedure that led to a 50-state investigation and ultimately a high-profile settlement involving the five biggest banks.

That experience, plus the government's regulatory response, made it clear to banks that, on the margins, servicing loans was no longer a great idea.

"The banks were pretty much overwhelmed" by delinquencies during the crisis, said Thomas Crowe, a senior director in Fitch Ratings' U.S. residential mortgage-backed securities group.

Fitch noted in a January report that the number of non-bank mortgage servicing is rising relative to banks in the post-crisis years.

In 2008, banks serviced 90 percent of home loans, but that number had fallen to 67 percent by 2016, according to the Mortgage Bankers Association.

In 2013 alone, big banks such as Bank of America and Ally Financial sold off the servicing rights for $500 billion worth of mortgages.

A large chunk of that shift came from big banks selling off their servicing businesses. In 2013 alone, big banks such as Bank of America and Ally Financial sold off the servicing rights for $500 billion worth of mortgages.

That was also the year that the Consumer Financial Protection Bureau finished writing major new rules on mortgages, and the Federal Reserve finalized new capital rules for banks that disfavored mortgage servicing.

Vallandingham's bank hasn't stopped servicing home loans, because doing so is a core business. But the capital rules have created pressure for him to drop the servicing business, forcing him to plan a restructuring of the bank's corporate structure in order to maintain it.

Capital on hand

Requirements to maintain a higher level of capital in banks are the single most important change regulators have made in the wake of the crisis. Regulators sought them because of the fatal indebtedness of many banks before the crisis. Higher capital effectively means less indebtedness.

The 2010 Dodd-Frank law, the major financial reform passed by the Democratic Congress under President Barack Obama, including rules mandating that lenders vary loan applicants ability to repay.

Mandating a minimum of 10 percent capital relative to assets, for example, means that if the bank is lending out $100 worth of loans — which are assets, from the bank's perspective — it can have at most $90 of its own debt to creditors. In other words, 10 percent of its funding must come from ownership stakes rather than borrowing.

The rationale is that losses to bondholders cause crises, because they cause panics. Losses to shareholders do not. Higher capital ratios mean that shareholders have more to lose before bondholders are threatened.

Calculating that capital ratio, though, is extremely complicated, because regulators require that individual assets are "weighted" for riskiness. For instance, a Treasury security has a zero risk weight because it is perceived as riskless because the U.S. government is never expected to miss a payment. Accordingly, the bank doesn't have to have capital for that asset. A home loan, however, is risk-weighted at 100 percent, meaning that if the bank has a 10 percent capital minimum, it must maintain 10 cents of capital for every dollar in home loans.

First State Bank's bottom line has taken a hit thanks to the capital rules' treatment of mortgage servicing rights, which are assets that are related to, but distinct from, the bread-and-butter bank asset of the home loan. It is the right to be paid for servicing a home loan that another entity owns.

For example, a bank might extend a home loan to a borrower in its community and then sell the loan to Fannie Mae, the government-sponsored enterprise that buys mortgages from all over the country and packages them into securities to sell to investors all over. In that case, the community bank might retain the right to continue to send out bills and collect the payments on that loan for Fannie Mae, in exchange for fees. That income stream creates an asset.

As it happens, the rights to service mortgages are weighted punitively, in mortgage bankers' eyes. A bank must have 2.5 times the capital for each dollar in mortgage servicing assets that they would for each dollar in, for instance, home loans.

In First State Bank's case, that's a major hit. The bank has just under $200 million in assets, making it on the small end of banks. But it services a book of $700 million worth of loans in 20 states, according to Vallandingham. When the new capital rules were put in place, it decreased the bank's regulatory capital by $2 million, he says, limiting the bank's ability to offer new loans without falling afoul of capital ratio minimums.

Will it change?

Bank lobbyists in Washington have been trying to get the capital rules revised. But bankers trying to keep their businesses afloat now cannot count on the rules being changed.

"Ultimately, you either have to sell or find another way around it," Vallandingham said of the bank's mortgage servicing business, noting that many of his peers have sold off their mortgage servicing rights. His plan is to restructure his company in such a way that it can continue servicing mortgages through a separate entity without incurring the capital charges.

It's hard to fathom that regulators intended to force community bankers out of servicing. In fact, the opposite is more likely. Community bankers pride themselves on relationship banking, meaning that they live in the area that they serve, and are more likely to understand customers' unique circumstances and to develop a relationship with them. In the case of a borrower trying to work out a problem paying their mortgage, corresponding with a small servicer might mean talking to the same person in multiple calls, rather than being shunted off to a different person each time at a big company.

Of course, there's a reason that regulators wanted banks with mortgage servicing assets to maintain higher capital. Interest rate movements can cause the value of mortgage servicing assets to fluctuate wildly, placing the bank in danger of misjudging just how much risk it has taken on. "The dollar value of that income stream can change quite dramatically," said Roelof Slump, a managing director in Fitch Rating's RMBS group.

JPMorgan Chase head Jamie Dimon said he thought that overly burdensome regulations have slowed mortgage originations by $300 billion a year.

At the same time, however, a 2016 Fed study concluded that, out of the 518 banks that failed between 2007 and 2015, mortgage servicing assets played a leading role in the failure of only one.

Now, regulatory and market pressures are combining to move mortgage servicing out of banks and into less-regulated non-bank servicers such as Ocwen and Nationstar. That's not necessarily a bad thing, said Slump, but "I'm not certain that that move from bank to non-bank was an objective of regulators."

Meanwhile, banks must grapple with the combined effect of mortgage rules.

Larry Winum, president and CEO of Glenwood State Bank in Glenwood, Iowa, says that, unlike many of his banker friends, he has no choice but to stay in the mortgage business. Glenwood is a bedroom community for Omaha, Nebraska, and providing mortgages for those communities is key to what the bank does.

While the capital rules aren't binding for Winum's bank, because it easily clears the minimum capital ratios, the other new rules have led his bank to steer customers toward non-mortgage options, he says.

In one recent case, he says, a customer came in asking about a home equity loan to purchase a truck. His staff tried to steer the customer instead to a car loan. While it would come with a higher rate, there would be far less paperwork and no mandatory waiting period. When the customer said he wanted the truck immediately, the bank offered him a 10-day consumer loan so he could purchase it while the home equity loan was being prepared.

Winum asked himself if that consumer was better protected from abusive credit products, as was the purpose of the Consumer Financial Protection's rules. "No, not at all ... that's the type of stuff we have to do to get by all the regulations," Winum said.

What regulations? The 2010 Dodd-Frank law, the major financial reform passed by the Democratic Congress under President Barack Obama, including rules mandating that lenders vary loan applicants' ability to repay. Now, lenders must consider and document eight factors demonstrating ability to repay, including income, assets, employment, credit and more. Those rules are in addition to newly-updated disclosure requirements.

Winum insists that the paperwork doesn't help his customers. His business depends on honest dealing, he says. A ripped-off customer would spread bad reviews around the local coffee shops, ruining the bank.

And customers tend not to pay attention to the paperwork themselves. "They always say: We trust you, we trust you and we trust you," he said. "They're not going to sit there and read the whole thing."

Meanwhile, the bank has paid around $10,000 to update its software to manage the new paperwork and dedicated more staff to the job.

The cost of servicing a loan for which the borrower is making payments on time has nearly tripled since 2008, according to the Mortgage Bankers Association.

And bankers believe that the inflexible rules mean that many creditworthy borrowers are not able to get loans, especially people whose income is not easily documented, such as contractors.

What that means in terms of bank profitability is not easy to suss out, and is the subject of controversy.

In all, banking industry profits hit a record $171.3 billion in 2016, suggesting that business is good.

But bankers maintain that the mortgage business could be even better, to the tune of hundreds of billions of dollars of loans, without risking another financial crisis, if some of the recent rules were corrected.

One figure cited by bankers is an estimate from the Urban Institute, a Washington think tank, that overly tight credit standards prevented 1.1 million home loans from being made in 2015. In an April letter to shareholders, JPMorgan Chase head Jamie Dimon said he thought that overly burdensome regulations have slowed mortgage originations by $300 billion a year.

In January, Citigroup announced that it would be selling off servicing rights on $97 billion of mortgages to New Residential Investment for $950 million, a reflection of the new rules disfavoring bank ownership of servicing rights.

One indication of the specific impact of the mortgage rules is the stock prices of big banks such as Citigroup. In January, the bank announced that it would be selling off servicing rights on $97 billion of mortgages to New Residential Investment for $950 million, a reflection of the new rules disfavoring bank ownership of servicing rights. The company's stock price dropped 1 percent the morning of the announcement.

Of course, community banks face different circumstances than megabanks. Banks such as Vallandingham's cannot easily drop the home loan business in favor of other business lines, as big banks with many subsidiaries can do.

Bankers want relief from Congress, and community bankers have allies on both sides of the aisle. Community banks would get a significant reduction in mortgage rules from the Financial CHOICE Act, a measure that passed the House in June. That bill, though, can't pass the Senate thanks to the threat of a filibuster from Democrats who allege that some of its measures would be giveaways to Wall Street banks.

While the community banking sector has also improved in profitability in recent years, it has a stronger case to get out from some of the new rules. Over the past several decades, they have faced pressures to merge or sell out. Over the past few years, with the new rules in place, only a handful of new banks have been opened.

"It's just become more difficult to be a banker," Winum said.