In September, the nation’s banking regulators released a proposal to increase the capital required of banks with more than $100 billion in assets. The effort was intended to decrease systemic risk, but by focusing narrowly on the risk posed by banks, it would likely increase risk in the mortgage market.

The proposal would make it more expensive for large banks to hold, sell or service mortgages, reinforcing their now decade-long retreat from mortgage lending.

And yet, it would also undermine the institutions that will need to fill the vacuum, independent mortgage banks, by making it more expensive for banks to provide them financing or a market for their primary asset, mortgage-servicing rights.

There is a lot here to unpack, so we’ll take it piece by piece.

First, the proposal would apply new risk-weights, operational risk requirements and stress testing to mortgages held on portfolio that would more than double the capital that large lenders must hold against loans with high loan-to-value ratios. This is much higher than what is required to cover the risk, and would disproportionately impact lower-income borrowers and borrowers of color.

Banks would be unable to improve the economics of mortgage lending by transferring the risk to a third party, a common practice in the mortgage industry. The GSEs are given significant capital relief when they transfer this risk to private mortgage insurers or through capital market or reinsurance structures, which makes sense given the significant reduction in cost associated with that risk.

By contrast, the proposal provides banks with minimal capital relief for transferring this risk through capital market structures, with no credit at all provided for mortgage insurance or reinsurance.

Nor would banks be able to improve their economics by distributing their mortgages into the mortgage-backed securities market. They would still have to meet the capital requirements that apply to portfolio lending for the period between origination and sale and then cover a meaningful new capital charge on the fee income from the sale.

In short, the proposal would make it increasingly uneconomic for large banks to originate mortgages no matter how they manage the risk.

Leaving the field to independent mortgage banks may not in itself pose a problem — to date, they have been up to the task of their ever-increasing role in the market — but the proposal also undermines IMBs in two critical ways. 

The largest asset for most IMBs is their mortgage-servicing rights (MSRs), which generates a revenue stream critical to many of them. One of the major sources of demand for this asset is large banks, yet the proposal would reduce dramatically the amount of MSRs that a large lender can hold economically.

Currently, all but the largest banks can hold MSRs equal to up 25% of its combined shareholder equity and retained earnings, with every dollar of MSRs above that threshold, requiring a bank to hold another dollar of equity or earnings, rendering it uneconomical. Under the proposal, that limit will fall to 10% of equity and earnings, a limit a few large lenders already exceed and several more are fast approaching.

This means that a number of institutions would go from being buyers of MSRs to sellers, driving down the value of the primary asset of most IMBs’, an effect that would be compounded as income from MSRs is also subject to the new capital charge on fee income.

Large banks are also the primary source of liquidity for most IMBs. IMBs rely on lines of credit to large banks to “warehouse” loans until they can be securitized, finance their MSRs and cover the cost of advancing payments to investors when borrowers default on their obligations.

The proposal would double the capital that banks must hold against most of these lines for all but a few publicly traded IMBs. This would lead banks to tighten or reprice their lines, constraining liquidity for IMBs through the cycle, particularly in times of stress when they need it most. 

In short, then, the proposal would also undermine the economics of the very lenders needed to fill the vacuum left by the retreat of the banks. 

Judging by the public comments of some of the regulators since the proposal’s release,these impacts on the mortgage market appear to be unintended.

The regulators do not appear to have set out to address systemic risk in the mortgage market and simply have gotten it wrong. They focused so narrowly on the risk posed to and by banks that they missed the degree to which addressing those risks would increase risk in the system more broadly.

Whatever the reasons, their proposal would increase risk in the mortgage market, pushing banks out of the market and making it increasingly inhospitable for the independent mortgage banks left to carry the load.

The financial system would be better served if regulators were more sensitive to these dynamics in the mortgage market, adjusting the final capital rules to ensure that banks are able to continue to provide the mortgage market with the stability it needs.

Laurie Goodman is an Institute fellow and the founder of the Housing Finance Policy Center at the Urban Institute. Jim Parrott is a nonresident fellow at the Urban Institute and owner of Parrott Ryan Advisors.

This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.

To contact the authors of this story:

Laurie Goodman at [email protected] or Jim Parrott at [email protected]

To contact the editor responsible for this story:
Deborah Kearns at [email protected]