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Secondary market.


The debate over the regulatory capital treatment of purchased mortgage servicing rights (PMSR) is threatening to throw a monkey wrench into the secondary market's efficient mortgage delivery system. The regulatory action in question is the FDIC's proposal to limit to 25 percent of core capital the amount of PMSR included in the regulatory capital of state non-member banks. The Federal Institutions Reform, Recovery and Enforcement Act (FIRREA) requires that the Office of Thrift Supervision (OTS) pick up this FDIC standard and apply it to the S&Ls and savings banks it regulates. In formulating the standard, FIRREA requires the FDIC to adopt a rule no less stringent than the treatment provided by the Office of the Comptroller of the Currency (OCC) for national banks. The OCC limits identifiable intangibles, (e.g., PMSR to 25 percent of tier 1 capital). The debate, therefore, boils down to the following: (1) Will the FDIC, and consequently, the OTS, adopt an across-the-board 25 percent of core capital limitation on PMSR? (2) Alternatively, will the FDIC yield to the demands of MBA and others and adopt a case-by-case approach? (3) Will the OCC relax its 25 percent limitation and thereby force the FDIC to move in the same direction? (4) If a restrictive across-the-board limitation is adopted, how seriously will it damage the mortgage delivery system?

When the comment period ended last month the FDIC had received almost 100 comments from the industry. The overwhelming sentiment of these letters and of statements made in hearings before the House financial institutions subcommittee was that the proposed 25 percent is unnecessary and will result in devaluation of the servicing right commodity.

For several reasons MBA is more hopeful than before that the 25 percent limitation may not come into being. First, it's questionable whether or not the current four FDIC board members will vote to adopt the FDIC proposal. Second, the FDIC would face considerable political pressure from Congress if it finalized the rule. Congress appears ready to take some action on the grounds that the FDIC's action could have a detrimental effect on homebuyers, thrifts and the cost of the thrift bailout. With respect to the latter, the Resolution Trust Corporation is having a difficult time disposing of more than $100 billion in servicing portfolios acquired from insolvent thrifts.

The most promising breakthrough on the purchased servicing issue is the recent announcement that the OCC will be soliciting comment on the PMSR issue in a notice of rulemaking. The notice will request comment from the industry on a wide range of questions relating to this issue. The OCC has not been pressured into doing this. The OCC is taking another look at its own 25 percent limitation based on all of the concerns generated by the FDIC's proposal. The OCC's solicitation of comment is the first step leading to an OCC proposed rule on the capital treatment of PMSR expected later this summer. We do not believe the OCC would be engaging in this process if it intended to tighten the capital treatment even further. A more likely scenario would be an easing of the requirement especially because banks are beginning to come close to their PMSR capital limit. In any case because both the FDIC and OCC are committed to having a single capital standard for PMSR, the OCC action will effectively postpone any final FDIC decision until the OCC regulatory process has run its course.

The ability of financial institutions to buy mortgage servicing is an essential part of an efficient mortgage delivery system, (i.e., the secondary mortgage market). The evolution and operation of the secondary mortgage market has helped provide consumers with lower cost home financing and has allowed depository institutions a vehicle for counterbalancing interest rate risk.

It should be made clear that much of the purchased mortgage servicing added to the books of financial institutions each year comes from current production. In effect, the financial institution (or its mortgage banking affiliate) acts as a wholesaler by purchasing loans from mortgage originators (correspondents). When the correspondents sell the loans, they also sell the rights to service the loans (i.e., "sale of loans servicing released"). The loan purchaser (financial institution or its affiliate) pays a release fee premium for these rights. The originator in turn, is able to factor this premium into the rates offered borrowers. From a public policy perspective this scenario is an optimal way to create and service mortgages. The originators, acting as specialists, are able to produce mortgages at a lower cost than if a wholesaler had originated them directly. The wholesalers/purchasers, acting as servicing specialists, are able to service the loans at a lower cost than if the originator had to service the loans. The process also makes it possible for many more originators to exist because the wholesaler acts as a permanent investor for loans created by originators, and capital requirements to become an originator are relatively low. The large number of originators and the servicing release premiums paid by wholesalers serve to increase competition at the retail level and force originators to offer the best terms to homebuyers.

An arbitrary 25 percent limitation on the amount of servicing a wholesaler can count as capital will disrupt this efficient process. Sooner or later institutions not already at the limit will reach their capacity to purchase from correspondents. Faced with no outlets to sell their loans and the servicing that goes with them, what will originator-only firms do? The possible outcomes are that originators lose their ability to specialize as the low-cost producer of mortgage loans or they will cease to exist as originators. In the end, the consumers will pay the price in terms of less competition and higher mortgage rates.

Alternatively, a decline in servicing prices (caused by an arbitrary limitation on servicing) may force loan originators to recapture any lost income at the time of origination rather than through the servicing of the mortgages (or through the sale of servicing). This will translate into higher financing costs for consumers because few mortgage lenders, which are already operating on narrow profit margins, will be capable of absorbing these losses without damaging their ongoing viability.

The excess supply of servicing, stimulated primarily by the proposed capital rule, has already started to have an effect on the mortgage delivery system. We are not only seeing a significant drop in the prices paid for seasoned portfolios sold in bulk, but there have also been significant reductions in the servicing release premiums wholesalers offer to correspondents. Today's market is a buyer's market. Many sellers of servicing are having difficulty finding investors.

In sum, the outcome of this capital issue could have a tremendous impact on the way mortgages are originated and sold in the secondary market through correspondent networks. A limitation on PMSR will have the indirect effect of increasing mortgage interest rates for consumers. The limitation will impede the ability of large thrift/bank affiliated mortgage servicers to purchase loans/servicing rights from low-cost origination specialists. The origination specialist will no longer be able to reduce the interest rate charged to borrowers as a result of the servicing release premium paid by the loan purchaser.

Finally, a 25 percent limitation will force many quality servicers to withdraw from the servicing business to be replaced potentially by less experienced thrifts and banks that will have to generate capital in order to make a long-term business commitment to provide quality servicing. While financial institutions in the past have successfully raised capital though stock issuances, this option may be a costly alternative under current market conditions where financial institutions' stock prices are at their lowest.

For these reasons, MBA will continue to vigorously represent the interests of our members before the banking and thrift regulators in an effort to persuade them to make the right decision on this important issue.
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Title Annotation:mortgages
Author:Taliefero, Michael
Publication:Mortgage Banking
Date:May 1, 1990
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