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Basel III redux: the new international capital standards for banks known as Basel III need to be rethought when it comes to mortgage servicing rights. Otherwise, there will be a dramatic migration of servicing assets to non-depository institutions.

Mortgage lending today operates in an artificial environment. More than 90 percent of all mortgages originated are Fannie Mae, Freddie Mac and Ginnie Mae product--and a large share of the resultant securities are purchased by the Federal Reserve. There is essentially no private mortgage market. [paragraph] This situation cannot go on indefinitely. At some point we need to reintroduce private capital into the equation. [paragraph] Additionally, because bureaucrats are not necessarily skilled at identifying consumer needs and ways to profitably satisfy them, entrepreneurs need to be incented to re-enter the market and create products that economically satisfy these evolving needs. [paragraph] Current regulations will either impede this transition or drive it into the hands of non-regulated enterprises. [paragraph] The Dodd-Frank Wall Street Reform and Consumer Protection Act, the Consumer Financial Protection Bureau (CFPB), National Mortgage Settlement, artificially low interest rates, Home Affordable Modification Program (HAMP), Home Affordable Refinance Program (HARP) and other government programs are all distorting the market. They are layering on often-conflicting requirements, impeding the growth of the private sector and creating regulation arbitrage opportunities.

Most of these programs just mentioned directly affect the operational side of the mortgage industry with a strong secondary impact on mortgage banking financial returns. Basel III, on the other hand, has little operational impact but directly affects the financial returns of this industry.


Basel is an international committee that was established in 1974 with the goal of improving, and making more consistent, the supervisory guidelines that each country imposes on their banks. The Basel Committee on Banking Supervision has no enforcement capabilities but is well respected and, thus, is a strong force in defining banking regulations worldwide.

The 1988 Basel Accord (Basel I) was the first attempt at defining uniform capital requirements across country lines. It was based on five classes of assets grouped by credit risk.

While overall capital required was defined as 8 percent, each of the five classes carried risk weightings that were a percentage of that 8 percent, ranging from zero percent (e.g., U.S. Treasuries) up to 100 percent (e.g., commercial loans) for bank assets of good credit quality.

Basel II, introduced in 2004, added a three-pillar concept. These pillars included:

* Establishing minimum capital required based on not only Basel I's five credit risk levels, but also a bank's operational and market risks;

* Requiring bank supervisors to perform reviews of their banks to assess the efficacy of each bank's own Pillar 1 conclusions; and

* Adding additional disclosures in banks' regulatory filings that address each bank's capital position and risks. This was intended to allow for better market understanding and, thus, enforce market discipline.

Implementation of Basel II was slow due to the political and economic environment during those boom days. The economic bust of 2007, however, resulted in a recognition by the Basel Committee that further work needed to be done to further strengthen global capital requirements.

What is Basel III?

Basel III was first introduced in 2010/2011, modified in January 2013 and finalized in July 2013. It has not yet been implemented.

Basel III calls for banks to hold additional minimum capital and addresses liquidity concerns as well. There are myriad changes within Basel III that affect most aspects of banks' balance sheets.

From the perspective of bank-owned mortgage bankers, however, the final outcome was a partial "win" for mortgage lenders and a "lose" for mortgage servicers.

Mortgage lenders were initially faced with the prospect of holding increasing capital on existing mortgages based on each loan's mortgage category as well as the borrower's loan-to-value ratio (LTV). These seven categories were defined similarly, but not identically, to current Qualified Mortgage (QM) definitions.

The capital required on these categories ranged from a low of 35 percent risk weighting on plain-vanilla loans under 60 percent LTV to 200 percent for non-qualified, high-LTV mortgages.

Capital requirements on the industry's $2.4 trillion of residential mortgages would have increased materially and possibly duplicate the loan-loss reserves.

Fortunately, this proposal was rescinded because it was deemed to be redundant with the upcoming QM standard under the Dodd-Frank Act. While the Basel III proposal was rescinded, the QM rule, which prohibits risky products such as interest-only loans and negative-amortization loans, is scheduled to go into effect on Jan. 10, 2014.

The impact on servicers

Mortgage servicers did not fare as well. Banks and savings-and-loans (S&Ls) that have mortgage servicing assets (MSAs) on their balance sheet will have to hold substantially more capital against this asset than they did prior to the Basel III implementation.

While not well understood by people outside of industry practitioners, servicing is the backbone of the real estate finance industry. Originators lend the money; servicers get it back.

It is a high-transaction-volume/low-profit-margin business that is currently stressed by high operational and compliance costs. The 2012 MBA Cost Study showed that average annual net income on loans serviced plummeted to 66 cents per loan. This was driven by increased costs as well as accelerated amortization of the MSA. Basel III will further stress returns relative to capital required.

Current capital requirements call for a "haircut" of 10 percent of the MSA; this 10 percent is in essence a direct deduction to equity. Additionally, the remaining 90 percent of the MSA is considered a 100 percent risk-weighted asset and is assigned an 8 percent capital requirement.

As seen in the "Today" column of Figure 1, this converts to a blended average capital required of 17.2 percent. I have assumed adequate earnings from the MSA and other assets to yield a return on this total required equity of 15 percent.



                           Today    >Basel III

Cash                      15,000        15,000

Loans                    122,500       122,500

MSAs at 25% of Equity      2,500         2,500

TOTAL ASSETS             140,000       140,000

EQUITY                    10,000        10,000

Capital Required:

-Existing 10% Haircut       10%      15%

-Base                       90%      85%

Base Risk Weighting        100%     250%

Capital Required:

-Haircut                   100%     100%

-Base Required               8%      20%

Total Capital Required    17.2%      32%

RO(R)E                      15%     8.1%

SOURCE: Level1Analytics LLC

Basel III is consistent with this approach, with two major exceptions.

* First, it increases the risk weighting on the MSA from 100 percent to 250 percent (that is, that capital required increases from 8 percent to 20 percent); and

* Second, it replaces the existing 10 percent across-the-board haircut with a haircut equal to the excess of MSAs on the balance sheet over 10 percent of Tier 1 capital.

Accordingly, as illustrated in the "Basel III" column of Figure 1, MSAs that aggregate 25 percent of equity would go from a 17.2 percent capital required today to 32 percent under Basel III.

The 17.2 percent is a result of today's 100 percent capital required on 10 percent of the asset (the haircut) and 8 percent held on the remainder. The 32 percent results from the 100 percent capital required on the excess MSA over the 10 percent threshold (15 percent) and 20 percent capital required on the rest.

As the percentage of MSA/equity increases, so does this capital required. Absent an improvement in earnings (which is unlikely), return on required equity would fall.

Assuming the exact same earnings that returned 15 percent in the "Today" scenario discussed earlier, return on required equity (RoRE) would drop to 8.1 percent under Basel III at this 25 percent MSA/capital ratio. Naturally, as this percentage increases, returns continue to drop.

Servicing rights in excess of the 10 percent capital limit become, in essence, a toxic asset.

What happens next?

Banks that are currently in excess of this 10 percent limit must act. Accordingly, the transition period for implementing Basel III is critically important. The final regulations include a phased implementation.

The phase-in period for smaller, less-complex banking organizations will begin in January 2015, while the phase-in period for larger institutions begins in January 2014.

The phase-in is to be completed by 2019. This should allow time for an orderly amortization of this asset down to acceptable levels. The average life of a portfolio at a 12 percent annual prepay speed is only seven years.

The alternative is to sell servicing to bring this asset down to the statutory 10-percent-of-equity level or, at a minimum, to stop or slow down the banks' acquisition appetite. Either way, this may materially disrupt the supply/demand dynamics for mortgage servicing rights. This dynamic is not trivial.

As of Dec. 31, 2012, there were 7,092 banks (down 17 percent from year-end 2007). Of those banks, 1,210 had mortgage servicing assets on their books and 59 of these already have MSAs in excess of 10 percent of their equity.

Additionally, while Basel III limits the ratio of MSAs to equity, it also has a cap of 15 percent of all intangibles as a percentage of equity (i.e., Tier 1 capital). There are an additional 147 banks with MSAs that had total intangibles in excess of this 15 percent cap. Accordingly, there are a total of 206 banks that need to either diminish their intangibles or increase capital.

Assuming that this entire adjustment was accomplished by the disposition of MSAs, the amount of servicing that would have to be disposed of today equals approximately $800 billion.

This assumes that servicing values overall approximate the 73 basis points (73 basis points is the average reported values on $4.5 trillion of the largest banks' servicing assets from their year-end 10Qs). As mentioned earlier, however, it appears that this disposition can come from sales or amortization. In either case, it is quite probable that the appetite for additional servicing from these 206 institutions may be somewhat muted.

Basel III will have a negative impact on the financial dynamics of mortgage servicing rights. As demonstrated here, the capital required can easily reach or exceed 30 percent versus 8 percent for most loans.

The ostensible reason for this is that MSAs are "intangible assets." This classification needs to be rethought.

The case for changing Basel's treatment of servicing

Servicing rights, like their underlying loans, represent a contractually determined (investor agreement) set of future cash flows with the borrower having certain payment responsibilities and an option to prepay at will. The only difference between an MSA and a mortgage loan is in the yield or strip allocated to the owner of each. In addition, the holder of the servicing strip usually does not have the same risk of principal loss as the holder of the underlying loan.

This asset should not be in the same category as goodwill (another intangible asset). Interestingly, non-credit-enhancing Fannie Mae interest-only strips, which have very similar financial dynamics to mortgage servicing rights, have a risk weighting of only 100 percent.

As is well known, the real estate finance industry is huge and critically important to a robust U.S. economy. And it is understandable that we should all take the steps necessary to prevent the kind of meltdown we had in 2007. However, these steps must not be conflicting across the regulatory landscape and they should reflect economic reality.

When I was in college, I recall having to solve linear programming problems where we were presented with a set of simultaneous equations that imposed a series of constraint lines on the problem at hand. The solution, as illustrated in Figure 2, is represented by the intersection of these constraint lines.

We are in a similar situation in the banking industry today. Disparate rulemakers are imposing the constraints within which we must work. For example, we must satisfy the credit needs of our communities but cannot make loans outside of the intersection of a very narrow set of Qualified Mortgages.

We must operate our institutions in a safe and sound manner, but if we charge more for higher-risk loans, we may be subject to disparate impact suits.

We have an imperative to properly service these loans but are being economically forced to sell the servicing to non-regulated institutions. The "feasible solution" box keeps shrinking.

Accordingly, we are creating a "regulatory arbitrage" opportunity where the artificially prescribed yields of these assets in the hands of depositories are less than the economic yield as perceived by the markets. This will result in a migration of these assets to non-regulated entities that are not subject to Basel.

The private market does not believe that mortgage servicing rights require a 30 percent capital cushion. Accordingly, MSAs will migrate to these non-depositories.

Banks cannot thrive if they do not take on any risk. There is a risk in avoiding all risks. Neither can they develop the credit products that their communities demand if they do not take on any risk.

Banks are sitting on $11 trillion of deposits as of year-end 2012. This is larger than the entire amount of mortgage loans outstanding today. To create disincentives for banks to invest these deposits in the residential real estate business does our economy a tremendous disservice.

The implementation of Basel III in the United States needs to properly reflect the idiosyncrasies of the U.S. real estate finance industry and allow for a relationship between risk and return that is consistent with market perceptions of the economic dynamics of our industry.

Thomas J. Healy, CMB, is president of Level1Analytics LLC, Fort Lauderdale, Florida. He can be reached at
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Title Annotation:SERVICING
Comment:Basel III redux: the new international capital standards for banks known as Basel III need to be rethought when it comes to mortgage servicing rights.
Author:Healy, Thomas J.
Publication:Mortgage Banking
Date:Sep 1, 2013
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