When regulators create new risk

As 2021 begins, there are many perspectives on risks and rewards independent mortgage banks face in the New Year. One of the biggest risks — and among the least remarked by the mainstream media narrative — is the tendency of regulators to act illegally and beyond the scope of the authority granted by Congress or the states. This arbitrary action tends to make the system more, not less, risky.

A reader recently commented to housing market maven Rob Chrisman: “The U.S. Constitution lays out three branches of government, yet it appears that we now have four branches as the powerless Congress and the inattentive White House now have to bow down to the newly appointed fourth branch: Regulators. Wasn’t there something in U.S. history about a revolution because of taxation without representation?” Yup.

In fact, public agencies led by the Federal Reserve often stretch the definition of “necessary and proper” to the breaking point when seeking to fulfill public mandates. The Fed’s aggressive open market operations to support employment is a case in point. But the desire to serve as aggressive advocates of the public interest does not endow these public agents with legislative powers.

Consider a couple of examples very germane to the world of mortgage finance. First is the obsession of the Fed and their counterparts at the Bank of England to eliminate Libor, aka the “London interbank offered rate.” The entire $12 trillion mortgage market is financed using the Libor market, along with much of the rest of finance globally.

The Fed and BOE fixed Libor a decade ago. Yet now these agencies want banks to stop using the deep, liquid Libor market. Instead, they ordered counterparties to use the nonsensical economist invention known as “SOFR” as a replacement. Since SOFR is an artificial overnight rate and does not yet have a market, including a term structure out even 30 days, warehouse lenders and other providers of cash to the markets are not moving. Some banks have even challenged the Fed privately to explain why using SOFR is not “unsafe and unsound.”

In December, the Fed and BOE were forced to relent and delay the death of LIBOR, a revealing retreat by our regulators since they don’t actually possess the legal power to enforce this change. In the case of the Federal Reserve, for example, no notice for public comment was ever issued regarding the LIBOR termination. Very simply, the Fed does not have the power to enforce this edict in court or to compel banks or IMBs to comply via regulation. Market structure is a matter for the Securities and Exchange Commission, if anywhere.

Frankly, there is no reason for banks and other counterparties to accept the diktats of the Federal Reserve Board regarding Libor. If the Fed has the legal power to enforce the prohibition on the use of Libor in the United States, then the failure to seek public comment is a blatant violation of the Administrative Procedures Act.

We suspect that the true explanation is that the Fed knows it has no legal authority to enforce this change and is hoping to merely bully market participants into compliance. Obviously, the Fed should leave the choice of markets to investors.

And Fed Chairman Jerome Powell should quietly drop the effort to kill Libor.

Another example of regulators run amok may be found with the Conference of State Bank Supervisors regarding its proposal for a broader prudential framework for IMB servicers. The CSBS requested public comment on this supposedly national framework, but never actually cites the legal authority for the rule or why the CSBS thinks that it may take the time and resources of IMBs to support this ersatz rule making process.

Emboldened by Federal Housing Finance Agency Director Mark Calabria’s statements to the Financial Stability Oversight Council regarding the systemic “risk” posed by residential mortgage servicers, the CSBS proposes to impose bank-like liquidity restrictions nationally on IMBs. This is a radical and wholly unwarranted change that promises to further reduce liquidity and volumes in conventional and government mortgages. These markets comprise 80% of all residential loans today and are crucial for helping the U.S. overcome COVID-19 economically.

In the request for comment by the CSBS, they state with respect to loan servicers that IMBs have “an obligation to both parties of the transaction, making servicers simultaneously responsible for efficiently servicing the market and protecting consumers.” The CSBS does not cite a statutory reference for this statement or many other assertions of authority in the proposal.

While loan servicers have a contractual duty to note holders and other parties and a duty of care to consumers via the National Mortgage Settlement and the Dodd-Frank legislation, the CSBS legal construction regarding safety and soundness is tenuous at best and deserves a legal challenge from IMBs and the trades.

With the exception of the State of New York, most other states represented by the CSBS do not have any legal authority to impose bank-like safety and soundness rules on IMBs. The CSBS may think that having such power would be preferable, but such legal powers do not yet exist. To work around this lack of legal authority, the CSBS apparently proposes to export New York State law on a national basis and rely upon the New York Department of Financial Services for enforcement.

Supported by the actions of Director Calabria at FHFA, the CSBS is essentially attempting to impose a national standard upon IMBs via an illegal regulatory action that encroaches upon the power of the federal government, and without specific legal authority from each CSBS member state to support and enforce such rules. The CSBS proposal could actually hurt liquidity for IMBs.

“[P]rudential regulation alone, while desirable, will not mitigate the unique liquidity risks the sector faces, and unless it is done right, regulation might even cause unintended consequences,” write Karan Kaul and Laurie Goodman of Urban Institute. “We conclude that prudential regulation and a permanent solution to the liquidity risk must go hand in hand.”

They continue: “[I]t seems obvious that nonbank prudential regulation is best accomplished via a single federal regulator that supersedes state regulators. This will be more effective and more efficient. Given that the FHFA already has significant experience overseeing the mortgage market through its regulation of Fannie Mae, Freddie Mac and the Federal Home Loan Banks, it would be the natural regulator for nonbank servicers.”

Will the Mortgage Bankers Association take the example of Met Life’s battle with the FSOC a decade ago and block the aggressive power grab by the CSBS? After all, the CSBS is basically a trade association that lacks the legal authority to act as a national regulator. More important, will the Biden White House join the MBA in challenging the CSBS? This is a fundamental question of federal supremacy that the incoming Biden Administration must quickly decide.

It is perhaps interesting for Senate Republicans led by Pat Toomey, R-Pa., to consider that 31 states represented by the CSBS are now controlled by Republicans. Congress needs to hold hearings on the recent actions of the CSBS to better define where state authority ends and federal supremacy in terms of national housing policy begins.