• Key insight: As written, new capital standards for U.S. banks fail to account for the additional risk posed by many home loan clients who obtain second mortgages. Fixing the problem will significantly reduce the rule's benefit to banks.
• What's at stake: The new capital standards create incentives to move second liens off bank balance sheets and into fragmented credit arrangements that serve little purpose other than reducing regulatory capital requirements.
• Forward look: A national mortgage registry would provide, for the first time, a comprehensive picture of leverage across the mortgage finance system and serve as an early-warning tool for market participants, regulators and policymakers.

Federal banking regulatorshave proposed anew capital rule that determineshow much capital banks must hold against potential losses on home mortgage loans. The proposal bases mortgage capital requirements on a borrower's equity in the home.

This general approach is sensible. However, the proposal contains a significant structural flaw that weakens the accuracy of its risk-based capital framework and creates an unlevel playing field by treating economically similar levels of borrower leverage. In the case of borrowers who take out second mortgages, the proposal treats risk differently depending on where the second lien is held.

Specifically, the proposal bases capital on the borrower's combined loan-to-value ratio when both liens are held by the same bank. Because higher leverage increases credit risk, the bank is required to hold more capital. This is the economically correct result.

The flaw appears when the second mortgage is held at a different institution rather than by the first-lien bank. The borrower carries the same combined debt against the same home, the equity cushion is the same, and the likelihood of default is the same. Even though the first-lien bank benefits from the loss-absorbing protection provided by the second lien, the borrower's higher combined leverage still creates more risk than a standalone first lien.

Yet, the capital rule treats the first-lien bank as if the second mortgage did not exist. The bank holds capital based only on its original loan, as if the borrower's leverage had never changed. The combined leverage effectively vanishes from the capital framework.

As a result, two banks facing borrowers with identical leverage can end up with materially different capital requirements based solely on whether the second lien is retained on the same balance sheet or held at another institution.

The rule therefore creates incentives to move second liens off bank balance sheets and into fragmented credit arrangements that serve little purpose other than reducing regulatory capital requirements.

A common example arises after origination. Many bank-held first liens were originated before 2022 at 3% to 4% interest rates, leaving borrowers locked in and unable to refinance economically at current rates. When these borrowers need cash, they often obtain a second mortgage rather than refinance the low-rate first lien into today's higher-rate environment. If a borrower obtains a sufficiently large second lien from the same bank that holds the first lien, the borrower's combined leverage increases and the bank's regulatory capital requirement rises by 30% to 50%, depending on the resulting combined loan-to-value ratio.

However, if the same second lien is obtained from another institution, the capital requirement for the first-lien bank remains unchanged. The same increase in borrower leverage that triggers a substantially higher capital requirement when both liens are held by one bank is ignored when the second lien is held elsewhere.

Why does this matter? Available industry data suggest that more than half of second liens are held at institutions other than the first-lien lender. The share of second liens among borrowers locked into low-rate first mortgages will likely continue to grow under current market conditions, particularly as nonbank institutions expand their second-lien lending activities.

The problem is straightforward: The rule stops recognizing combined leverage once the second mortgage leaves the balance sheet. The location of the second lien changes, but the borrower's leverage does not.

The fix is also straightforward. The capital charge on a first-lien mortgage should account for the increased risk associated with the borrower's combined leverage when the second lien is held by another institution. A practical solution is to base the capital requirement on a blend of the requirement for the first lien alone and the requirement that would apply if both liens were held by the same institution.

My analysis of the proposal indicates that recognizing the risk created by second liens held at other institutions would increase capital requirements for first-lien banks by approximately $2 to $3 billion — about 12% to 17% of the approximately $17 billion in capital relief the banking rule provides. Banks with a larger concentration of first liens whose related seconds are held elsewhere could experience materially larger increases in their capital requirements.

The proposed capital framework cannot function effectively unless banks have reliable information about second liens held at other institutions. Today, that information generally does not exist. Second liens held at other institutions are often invisible to first-lien banks, regulators and other market participants.

To close this gap, the federal government should establish a national mortgage registry and require second liens to be reported. Without a federal reporting mandate, combined leverage will remain largely invisible whenever liens are split across institutions.

A national subordinate-lien registry would also benefit the government sponsored enterprises in the mortgage market, the Federal Housing Administration, credit risk transfer investors, and other market participants by providing more accurate information for risk measurement, pricing, and risk management.

One lesson of the 2008 housing crisis was that lenders, investors, the GSEs, FHA, and regulators lacked a complete picture of borrower leverage as second liens and other forms of subordinate financing accumulated across the mortgage system. A national mortgage registry would provide, for the first time, a comprehensive picture of leverage across the mortgage finance system and serve as an early-warning tool for market participants, regulators and policymakers.

The March 19th proposal recognizes that leverage matters. But leverage that cannot be measured cannot be regulated.