Federal Reserve Board Vice Chairman for Supervision Michelle Bowman gave
Bowman's proposal would
When you see warehouse lender banks compelling customers to place assets inside special purpose vehicles to reduce the risk weight on fully collateralized warehouse loans, the need for change is apparent.
Basel III is nonsense when it comes to residential mortgages. We discuss the background of the Basel III risk weights for residential mortgage assets in
There are two key parts to Bowman's proposal. First, the proposals would remove the requirement to deduct excess mortgage servicing assets from regulatory capital while maintaining the 250% risk weight assigned to these assets.
When Basel lll was finalized in 2012, EU regulators prevailed by imposing extraordinary risk weights on servicing assets and loans. MSRs do have market and operational risks, but zero credit risk.
Bowman also says regulators will seek public comment on the appropriate risk weight for servicing assets. The Basel III rules assigned a punitive capital risk weight to MSRs, yet there was no public explanation from regulators for the current 250% risk weight for MSRs. Secured loans likewise have de minimus net loss rates.
If and when the Fed issues a rule proposal on changes to the Basel III regulations, the central bank should first document where the MSR risk weighting came from in the first place. And who devised the 50-100% risk weight for secured residential mortgage loans?
When an agency or government mortgage loan is endorsed, it essentially becomes a T-bill and can be financed in the repo markets at par. Bowman would increase the risk sensitivity of capital requirements for mortgage loans held on bank books. One approach uses loan-to-value ratios to determine the applicable risk weight for residential real estate loans rather than a static standard.
Loan-to-value ratios are a critical criterion for residential mortgage-backed securities ratings, especially with private and jumbo loans. Rating agencies all employ LTV as a primary quantitative factor to determine both probability of default and potential loss severity on mortgages within an MBS or in a portfolio.
During her speech, Bowman said that "holding MSRs is not the right choice for every bank. Successfully managing the volatility in MSR valuations as interest rates change requires sophisticated hedging capabilities or an effective borrower retention strategy." Fair enough.
Some of Bowman's criticisms threw a little too much shade on IMBs and were probably inaccurate for banks as well. Since MSRs are negative-duration assets with cash flow, they provide enormous, counter-cyclical liquidity support for the institution during recessions and also serve as a natural hedge for the loan portfolio. Only public mortgage firms need hedge the intangible MSR.
In addition, most banks prefer to retain mortgage servicing in-house to ensure positive customer experiences. Servicing creates customer loyalty when done well but creates significant frustration when done poorly, as large banks proved after 2008. Nonbanks are far better at servicing loans, one reason why the changes proposed by Bowman are unlikely to see depositories return.
Mortgage servicing, like most financial processing functions, has become a huge scale game. The investment in technology to effectively compete is becoming more and more costly for smaller portfolio companies, driving industry consolidation. If you don't have at least half a trillion in servicing assets, then sell and become a broker. Banks control just one quarter of the lending market today.
Although Bowman is right that servicing can create problems for providers "when done poorly," problems occurred more frequently at banks than at non-banks, one reason besides Basel III that banks exited servicing. Remember Bank of America Countrywide? The large nonbank servicers have made huge investments to improve internal processes and controls, investments that most banks cannot make.
Indeed, among the top bank lenders, JPMorgan Chase is one of the few depositories to service its own mortgage and consumer loans in-house. While the bank handles the primary relationship, they may
The changes proposed by Vice Chairman Bowman may make it easier and more attractive for banks to hold MSRs as assets, a very important change that will make banks more stable financially and broaden their revenue. This is especially important for regional and community banks that were forced out of mortgage lending by the 250% risk weight in the Basel III rules.
This change alone would make the Fed's efforts worthwhile, but the larger question is whether an even lower capital cost for MSRs would encourage banks to get back into purchasing loans from third parties, mostly nonbanks and brokers. Unless the bank is active in the third-party origination channel, getting back into loan servicing does not make a lot of sense.
JPMorgan has $1 trillion in unpaid principal balance of servicing and holds $10 billion in MSRs, a result of its active purchase of prime jumbo loans in the TPO channel. JPMorgan is also the largest secured warehouse lender in the industry.
Yet even if the Fed lowers the capital requirement for MSRs, it seems unlikely that depositories are suddenly going to develop an appetite for mortgage lending and servicing.
First, the 250% capital charge is still way too high for banks to allocate significant capital and few banks have any share. Inside Mortgage Finance reports that Chase is the only bank in the top ten agency lenders.
"The TPO space is also a non starter for banks," one leading bank executive tells NMN. "MSRs are still 250% risk weighted. There is too much counter-party risk and thin margins hurting returns."
"Banks can deploy capital more efficiently and with less risk in other assets." he continues. "It's going to take more than regulatory change for banks to get back into mortgages in a big way and start competing for agency loans again."
Risk is the second reason that lower capital rules for MSRs and loans will not really change much. Banks happily ceded ground to the nonbanks around agency and GNMA production.
Being wholesale lenders to nonbanks is a much better business that making $200,000 loans to FHA borrowers, who have 100 times greater propensity to default or prepay vs prime borrowers pursued by a JPMorgan.
After all, more than Basel III it was reputation risk, litigation and progressive politics ℅ the likes of Senator Elizabeth Warren that originally convinced big banks to exit the Ginnie Mae market and much of conventionals. Vice Chairman Bowman needs to lower the risk weight for MSRs a lot – say 100% – to restart that conversation.
