Capital rule's impact on mortgage risk offsets worries industry

One driver of fears housing finance stakeholders have had about the bank capital proposal's potential for pushing affected depositories out further out of home lending is its disregard for certain accepted forms of risk management broadly used in the mortgage industry.

That theme is evident in several Basel III endgame comment-period reactions specific to first-lien single-family loans.

The most commonly-cited example is private mortgage insurance, which capital rules for prominent government-related home loan agencies and current bank regs generally account for, but new rules for depositories essentially wouldn't. 

"This proposal fails to recognize MI," said Seth Appleton, president of U.S. Mortgage Insurers.

To be sure, bank regulators have a reason for not adjusting for MI in their proposal that's tied to some failures during the financial crisis.

But there is consensus among some mortgage groups submitting comment letters that treating MI like it poses the same concerns it did during the Great Recession discounts the impact of broad reforms responding to it, including stronger capital standards insurers have.

"The industry holds 169% of the capital required by PMIERs," Appleton said, referring to the private mortgage insurer eligibility requirements that key secondary mortgage-market players set. All MIs have kept capital levels above minimum requirements since their inception in 2015.

Disregard for MI's benefit is part of a core concern a broad swath of industry and consumer advocacy groups have had with the rule related to ascending risk weights for mortgages with high loan-to-value ratios, indicating they have lower down payments crucial to affordability.

Current rules include private mortgage insurance in the a category of loans that get a break on their risk weight, so the Mortgage Bankers Association is calling for a revision to proposed regulation that continues to account for MI's use.

The group in its comment letter is calling on regulators to simply "give credit to mortgage insurance for those higher LTV loans by going one LTV bucket lower," said Pete Mills, the association's senior vice president of residential policy and member engagement.

Use of private mortgage insurance is most common in the United States and its omission in the proposed U.S. version of global bank rules is one of the reasons there's been concern in housing finance about how they compare or interact with other industry capital regs.

"I think some of the concern is around what the justification is for making these sweeping determinations around the risk in the mortgage markets without really considering a lot of the work that's already been done and aligning with other requirements post financial crisis," said Chuck Cross, senior advisor at the Conference of State Bank Supervisors, commenting on how the bank capital proposal compares to other rules in the U.S. housing finance market.

The bank proposal's disregard of private MI is at odds with its treatment in the enterprise regulatory capital framework that governs Fannie Mae and Freddie Mac, which government-related entities nonbanks are more reliant on as loan outlets. Fannie and Freddie's regulator recently finalized some tweaks to the ERCF but plans to revisit it again.

"Fannie and Freddie get credit for mortgage insurance," noted Ed DeMarco, president of the Housing Policy Council, and a former regulator of the two enterprises, which have been in a government conservatorship that the ERCF was designed to help them exit.

"In doing so FHFA considered several things," he added. "One, they considered the overhaul of the master agreements between mortgage insurance companies and lenders so that Fannie and Freddie have much less rescission risk than they did going into the Great Financial Crisis. 

"The second thing is FHFA has done multiple rounds of setting prudential management, capital and liquidity requirements for mortgage insurance companies, and that is now overseen by the GSEs."

The FHFA, Fannie and Freddie had not responded to requests for comment at deadline

But FHFA Director Sandra Thompson has shown frustration with lack of recognition for mortgage insurance in another context: opposition to an update of the enterprises' pricing grids that included new breaks for low down-payment loans and raised fees slightly for others.

Fannie and Freddie loans with a lower ratio still typically have fees lower than HLTV products and the borrowers with the latter type of loan also must pay for mortgage insurance, she noted at a recent National Housing Conference event.

"I don't think people took into consideration the cost of mortgage insurance," Thompson said.

MI helps cover default risk that rises significantly at LTVs above 80% and the enterprises can't buy loans with ratios at that level without it.

Meanwhile, within the context of the bank proposal, the concern is not limited to private MI, but also potentially other common risk-management instruments used by the two agencies and depositories.

"Banks continue to evolve in terms of their role in our financial system and one of those roles is they no longer are simply buyers and holders of credit risk on loans they make. Just like Fannie and Freddie, they are no longer just buyers and holders of credit risk," DeMarco said

"Banks should be encouraged to be able to distribute some portion of that risk and they should be able to do it or mortgage insurance. They should be able to do it through traditional reinsurance and they should be able to do it using credit-linked notes and other structured finance vehicles in which they lay off that risk," he added.

Entities that regulate depository institutions should be establishing standards  "whereby banks get appropriate capital relief for doing that," DeMarco said.

"It's a very punitive structure under current law. This proposal makes it even worse," Mills said, commenting on the existing and proposed bank capital rules around mortgage servicing rights.

Again, bank regulators (and Ginnie Mae, which does have somewhat aligned nondepository rules pending) have their reasons: MSR valuations can be volatile. But MSRs also are a natural hedge for interest rate risks when financing costs are rising as they did in 2023's banking crisis.

"For a mortgage servicing asset, when rates go up, the value of that asset goes up. Whereas if you're financing a mortgage, it's going down. So this becomes a hedge against movement in interest rates and we've seen that very thing play out the last 18-24 months," DeMarco noted.

A third major mortgage risk-management the bank capital proposal presents is in terms of the more onerous rules it imposes on unused portions of corporate credit or warehouse lines nonbank lenders use to fund their loan pipelines, Mills noted.

Higher rates recently have already boosted warehouse lending costs for nonbanks, and if their providers also have to contend with a higher capital charge it could further impede mortgage sector liquidity.

"It takes some elasticity out of the warehouse space because undrawn portions are now very expensive," Mills said.

The CSBS has shown concern about the proposal's impact on warehouse financing in addition to how it could impede access to affordable financing for consumers or nonbank servicers' ability to obtain liquidity using their servicing rights, in addition to its disconnect with other industry rules.

The proposed rules could lead to "a reduction of liquidity in the nonbank sector on the warehouse lending side, to the extent that banks reduce their exposure," said Kevin Byers, senior director, consumer protection and nondepository supervision at CSBS.

The big question for the mortgage industry as a whole now is how receptive federal bank regulators will be to changing any of this.

With the broader housing finance industry voicing concerns — including some of the consumer advocacy groups the Biden administration may look to — and a general lack of consensus on the rule, change appears possible.

A coalition of 27 organizations that included NHC, the National Urban League, NAACP, UnidosUS, and the MBA signed a comment letter, noting concerns it "will lead to reduced credit availability for all types of real estate buyers and undermine economic growth."

Not only is there some consensus among consumer and business contingents in housing that the proposal needs changes, but some governmental entities (including at least one Fed governor) also have been in agreement that the rule should be rethought.

"I'm hopeful that they've heard that message because it's come from a broad spectrum of groups and officials," Appleton said.