Proposed Basel III capital rules for mortgage servicing rights could sharply curtail servicing assets held by large banks and radically reshape the mortgage industry.
Mortgage Banking
February 2013
By Robert Stowe England
United States banking regulators are expected soon to issue final rules for banks to comply with the Basel III international accord on bank capital standards.
The proposed capital rules, issued in June 2012, had a suggested date for the final rule of Jan. 1, 2013. However, on Nov. 9, the banking regulators announced the final rule would be delayed--but did not give a new suggested completion date.
Leaders in the mortgage industry have called for modifications of the proposed rule in face-to-face meetings with the regulators at the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC).
The biggest worry centers on rules governing the capital banks will have to set aside for mortgage servicing rights (MSRs) and the exorbitant penalties that could impair bank capital if such assets exceed a 10 percent cap.
Under existing U.S. banking rules, 10 percent of the fair market value of MSRs is deducted from tier 1 or core capital. Under the Basel III proposal, however, banks would additionally have to deduct any MSRs above 10 percent from the common equity component of tier 1 capital.
Current banking rules limit the value of intangible assets, including MSRs, to 100 percent of tier 1 capital--with no separate sub-limit on MSRs.
Under the proposed Basel III rule, MSRs not deducted from common equity tier 1 capital would have a very high risk-weighting of 250 percent--that is, 2.5 times their value. Valuations would be set quarterly at 90 percent of their fair market value.
“The increased capital required on servicing makes it in essence a toxic asset. You really can’t go over the 10 percent because the capital requirement is so extreme,” says Tom Healy, chief executive officer of Level 1 Loans, Fort Lauderdale, Florida, a subsidiary of Sextant Group Inc., Pittsburgh.
What is Basel III?
The proposed 96-page Basel III rule in the United States was proposed by American banking regulators to bring the United States into compliance with the 69-page 2010 Basel Accord reached by the Basel Committee on Banking Supervision, a Basel, Switzerland-based organization representing central bankers from 27 countries.
What is the thinking behind the design of the new rules? “The Basel limits on servicing are, to a certain extent, nonsensical because they are equating MSRs with goodwill--and goodwill is an intangible,” says Healy.
“I’m not sure the international community really understands what is fairly unique to the U.S., the servicing industry,” explains Healy.
“Like a loan, servicing rights are dictated by a contract, and that contract stipulates the kind of cash flows you are going to receive,” he says. “Clearly, [servicing] cash flows are a little bit more uncertain than on a loan, but they are not goodwill.”
The Mortgage Bankers Association (MBA) filed an 84-page letter on Oct. 17 expressing concerns about the proposed rules. The group is calling for regulators to increase the allowable ratio of MSRs to tier 1 capital from 10 percent to 25 percent for commercial banks and to 50 percent for savings-and-loan associations.
“The Basel III proposed rule creates the potential for the greatest systemic shift in mortgage finance that most anybody can remember,” says David Stevens, MBA’s president and chief executive officer.
“Today banks, especially community banks, can leverage up to 100 percent of the tier 1 capital against servicing rights. That’s going to drop to 10 percent,” explains Stevens. “You know, we’re talking about not just a minor contraction. We’re talking a potentially massive contraction in the institutional capacity to hold servicing rights.”
The mortgage industry is also facing a raft of rules from the Consumer Financial Protection Bureau (CFPB) governing loan compensation, servicing operations and impediments to innovations in mortgage products--all springing from the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
“The ultimate realization of all this rulemaking is [that mortgage] rates go up,” says Stevens. “If they go up in a managed, proportional way to the real risk, that’s one thing. If they go up in an arbitrary way, simply due to an over-correction in the market due to extraordinary rules that create massive systemic change in the industry, that’s another. And I think that’s the risk we’re running here.”
Critics in high places
Rising alarms from banks and the mortgage banking industry gained more traction after then-FDIC director and current FDIC vice chairman Thomas Hoenig called for scrapping the proposed Basel III rules entirely in a speech at SourceMedia’s American Banker Regulatory Symposium last September.
The proposed rules are unnecessarily complex and “rely on a set of subjective, simplifying assumptions to align a firm’s capital and risk profiles,” Hoenig said at the American Banker symposium.
He recommended that regulators “go back to the basics” and start over in a new effort to devise a simpler approach.
Hoenig charged that U.S. regulators fail to understand the interplay between regulations and the markets. “Whereas the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and can never catch up,” he said.
Hoenig predicted, “[the] most brazen and most connected banks with the smartest experts will game the system,” while the rules would put smaller banks with fewer resources at a competitive disadvantage.
Explaining the proposed capital rules
Basel III--aimed at improving safety, soundness and liquidity in banks around the world--boosts the amount of equity that is required. It also aims to improve the quality of capital by introducing the concept of a common equity to the overall tier 1 capital, eliminating some assets from being included in tier 1 and raising the overall capital banks are required to hold.
U.S. regulators, like their overseas counterparts, typically divide bank capital into tier 1 (or core capital) and tier 2 capital. The tier 1 minimum is raised in the Basel III proposal from the current 4 percent to a proposed 6 percent.
Also, banks must have a minimum 4.5 percent ratio of common equity to risk-weighted assets. The requirement that banks have an overall minimum of total capital at 8 percent remains unchanged.
The U.S. Basel III rule also calls for an additional 2.5 percent capital conservation buffer, plus another 2.5 percent countercyclical capital buffer.
Banks are likely to add more capital than the proposed rule requires, according to commentary issued by the Financial Regulatory Reform Working Group, a multidisciplinary collection of lawyers organized by Weil, Gotshal & Manges LLP, New York, to provide commentary on the Dodd-Frank Act and related matters.
It is not just the capital requirements in Basel III that will increase bank capital. Higher capital requirements can also be found in Dodd-Frank.
“What you’re really hearing is the sound of the barn door slamming shut,” says Donald Lamson, partner and head of the Financial Institutions Advisory & Financial Regulatory Group in the Washington, D.C, office of Shearman & Sterling LLP.
“Regulators wished that banks had much larger capital accounts during the crisis than they actually had,” he explains. “If you look at Dodd-Frank, the general approach is when in doubt, require additional capital--and if that doesn’t work, require some more.”
On Jan. 7, the Basel Committee on Banking Supervision announced it was delaying until 2019 the requirement that banks complete their phase-in to one part of its Basel III accord--the liquidity coverage ratio. This rule requires banks to hold enough cash, government bonds and other liquid investments to be able to withstand an intense 30-day liquidity crisis similar to the one that froze up the international banking system in September and October of 2008.
Who will be buying MSRs?
The proposed Basel III rules on MSRs “will certainly reshape who owns the MSRs--and, as such, will change the landscape a little bit within the mortgage business,” says Greg Tornquist, president and chief executive officer of Cenlar FSB, based in Ewing, New Jersey, a subsidiary of Cenlar Capital Corporation. Cenlar FSB is a third-party residential loan servicer.
Tornquist agrees that banks will pare back their market share of MSRs and that the new rules will reduce the value and pricing of MSRs. “Some of that is already happening, although I suspect more items are in play,” he says.
The big question, Tornquist says, is who is going to hold MSRs.
Any firms contemplating entering the servicing business will need to have capital to back the MSRs and be able to deal with the interest-rate risk that goes with owning these assets. The company also would have to be able to service the loans, which can be done under a sub-servicing arrangement with an existing servicer, and satisfy regulatory compliance matters.
Tornquist identifies certain companies he thinks could step up to the plate as buyers of MSRs because they have the expertise to manage the assets: real estate investment trusts (REITS), private equity and mortgage bankers who could raise capital to buy the MSRs.
“I think it’s probably going to be a combination of all those things that ultimately absorbs those MSRs,” he says.
Tornquist also believes that there are banks, credit unions and other financial institutions that were not able to compete for MSRs in the past that might now want to buy them and keep their holdings below 10 percent.
Other mortgage industry observers are less confident that there will be enough capacity from those who want to hold servicing to meet the needs of the mortgage market.
“It will probably migrate over to nonfinancial institutions,” says Jim Gross, vice president of financial accounting and public policy at MBA.
“The unfortunate thing is that there are not many large nonbank financial institutions that own servicing rights. There’s been a major consolidation over the last 15 years and most of the ones consolidating have been the largest banks,” Gross says.
“So, once you get away from the large banks, the size of the servicing portfolios drops significantly. There’s no ready home for servicing,” he says.
MBA’s Gross, who was among the mortgage industry representatives meeting with regulators late last fall, says that regulators were receptive to industry concerns about MSRs. “Clearly in the case of one or two regulators, they were looking for alternatives to minimize the impact,” he adds.
Gross thinks that having a huge slice of MSRs migrate away from large banks should worry regulators and the banking industry.
“The thing that concerns us is that having the bank as a servicer is a natural thing. The two major banking consumer relationships are mortgages and deposit accounts. If the bank has to sell servicing to a non-financial institution, they no longer have an ongoing contact with the customer,” he says.
Servicing values have declined
In the last four years MSR values have steadily declined and the proposed Basel III rule has played a role, according to Healy.
“Overall, Basel hurts value. That’s the bad news. The good news is that it’s pretty much already built into the prices we are developing,” Healy says.
Healy thinks Basel III is probably hurting demand for servicing. “There are probably 1,250 banks and thrifts that have servicing. Only about 60 or so have MSRs in excess of 10 percent of equity,” he says. Those 60 banks and thrifts have an estimated $2.5 trillion to $3 trillion in servicing in an overall MSR market of $8 trillion to $9 trillion, according to Healy.
“Can these [60] entities buy more? I think the answer is an unequivocal ‘no,’” says Healy. “But on the supply side, will they be forced to liquidate? I also think the answer is ‘no’ there,” he adds.
“Given the transition periods being discussed and given the markdowns we’ve seen in servicing over the last two years, I think it’s reasonable to expect that just through amortization, prepays and the actual write-down of values, the industry can correct itself without dumping trillions of dollars worth of servicing [now] on the books,” Healy states on a hopeful note.
“So, supply probably won’t be affected too much, but demand will be affected,” Healy says.
Level 1 Loans keeps track of the value of servicing from banks’ 10-Q filings with the Securities and Exchange Commission (SEC). Those filings reveal that the value of servicing, which was 109 basis points in December 2009, fell to 99 basis points in 2010, to 68 in 2011 and to 61 at the end of September 2012.
“That’s a 44 percent decline in value. That’s one of the reasons I’m arguing it’s already built into the prices,” says Healy.
Is Basel responsible for this steep decline in MSR values? “It’s kind of hard to tell,” says Healy.
“Basel is just one of an enormous amount of problems . . . , on both the origination and servicing side, [that our industry] is encountering right now,” he explains. “It’s like one additional tornado in a hurricane. Is it all that big a deal? Well, a tornado is a big deal--but in the grand scheme of a hurricane, what’s one more?” Healy asks. “Basel’s kind of that way.”
He adds, “We’ve got QE [quantitative easing by the Fed], the attorneys general [foreclosure] settlement, repurchase risks, and unemployment and flat demographics, and QRM and Dodd-Frank--all these things, especially the uncertainty surrounding them, its killing prices and it’s killing value. Is Basel impacting value? Without a doubt. Certainly. But so are a lot of other things. They are all pushing it down, too.”
Regulators don’t understand servicing
The regulators, Healy contends, fail to understand that servicing is a high-transaction value, low-profit business. “I’m think Washington views it as somewhat akin to Wall Street. Well, it’s not,” he says.
The typical profit per loan per year in servicing was only $78 in 2011, Healy notes. “It doesn’t take too much in additional costs to reduce that to zero,” he adds. “In fact, it was a negative $20 in 2008 due to all the incremental costs we weren’t prepared to address--loss mitigation, repurchase risks, impairment losses.”
While MSR prices are low, their intrinsic economic value is high, giving MSRs a “tremendous upside” in pricing, according to Healy.
“Brand-new servicing in my mind is gold. It’s very plain vanilla. It’s well underwritten, incredibly low coupon--[Federal Reserve Chairman Ben] Bernanke is making sure of that,” he says.
“We should have fewer foreclosures in the future. In addition, real estate seems to be stabilizing. So, we should have less credit losses in the future. We should have fewer prepayments in the future. The duration of this asset should be longer. The volatility should be diminished,” he explains.
MSR values are so low that if the regulators “limited somewhat the 10 percent cap [on MSRs], it would help the industry,” Healy says. “We’d probably see more of the banks retain more servicing.”
Sandler O’Neill’s comment letter
Sandler O’Neill & Partners LP, a New York-based investment banking firm, filed a 33-page comment letter with the regulators on Sept. 20. The firm took issue with, among other things, Basel III’s proposed 10 percent cap on MSRs.
Sandler O’Neill, too, is worried about the regulatory excess in Washington. Three of the mortgage provisions in Basel III, combined with Dodd-Frank’s requirement of a 5 percent retained interest in the securitization of non-qualified mortgage assets, “could materially impair the business model for creating residential mortgage credit in the United States, resulting in increased cost to consumers and/or limited access to funding,” Sandler O’Neill stated in its comment letter.
Sandler O’Neill cited Basel III’s treatment of MSRs plus the higher risk-weighting for higher LTV loans in its comment letter. The investment banker also took issue with the banking regulators’ capital treatment of representations and warranties provided on assets sold to Fannie Mae, Freddie Mac or backed by Ginnie Mae.
Basel III requires that such reps and warrants be treated by banks as off-balance-sheet guarantees with a 100-percent credit-conversion factor applied to the exposure when calculating how much capital the bank would have to hold. This rule alone could require $7 billion in additional capital, according to Sandler O’Neill.
The harmful effects of Basel III’s residential mortgage provisions, especially the deduction of MSRs above threshold levels from regulatory capital, combined with the 5 percent risk retention for securitizations in Dodd-Frank, creates a toxic brew, according to Sandler O’Neill.
“If you put these factors together, they could fundamentally alter the profitability of the mortgage banking model and cumulatively, that could make it less attractive for banks to participate in mortgage lending,” says Tom Killian, principal with Sandler O’Neill.
“And if there are fewer people who are providing this [type of credit], or if they would have to charge more to participate in this activity, it lessens the availability of mortgage credit, and the pricing of credit is higher,” says Killian.
Killian is cautiously optimistic. “It would not surprise me if the regulators come out with interim final rules, with substantively all the changes they anticipate--with some wiggle room to make some modifications,” he says.
Given the gap between the views expressed in comment letters and the language of the proposed rule, the regulators would have to go a long way to even begin to address the concerns of the mortgage industry. MB
Robert Stowe England is a freelance writer based in Arlington, Virginia, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at
Copyright © 2013 by Mortgage Banking Magazine
Reprinted with Permission
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