The implementation of new rules and regulations affecting the housing sector has been underway for several years, driven by Basel III, the Dodd-Frank Act and revisions to existing law. How this tangle of conflicting limitations and incentives is affecting the housing sector is something laymen only partially understand. Although the brave new supervisory regime pretends to protect consumers, in fact the net effect of the thousands of pages of new rules and regulations is to limit access to credit while leaving public policy concerns like “too big to fail” unresolved.
First and foremost, the capital adequacy regulations contained in the “final” draft Basel III proposal just promulgated by the Federal Reserve and other agencies is openly hostile to housing: this even though the agreement was modified significantly to address concerns raised by the industry. The final rule rejected the draconian Category 1/Category 2 approach for residential mortgages and the proposed risk-weight, which ranged from 35%-200% based upon loan-tovalue, or LTV.
Instead, the rule retains “the treatment for residential mortgage exposures that is currently set forth in the general risk-based capital rules.” Exposures secured by a first lien on a single-family home that are prudently underwritten and performing receive a 50% risk-weight; all other loans receive a 100% risk-weight. “Prudently underwritten” is not necessarily going to be synched with a Qualified Mortgage or QM, though could plausibly be interpreted more broadly. This is positive for the industry, notes veteran industry watcher Rob Chrisman, “but the risk-weight for FHA and VA loans would increase from zero percent to 20 percent, which is the same for MBS issued by Fannie Mae and Freddie Mac.”
Not only does Basel III make it more expensive for banks to hold Federal Housing Administration and Veterans Affairs loans that are explicitly guaranteed by the U.S. government, but the rule also states that residential mortgages are excluded from the definition of financial collateral. Home loans are not thought to be appropriate because they exhibit “increased variation and credit risk” and are relatively more speculative than the recognized forms of financial collateral under the proposal.
The Mortgage Bankers Association notes that the present definition of financial collateral for banks includes residential mortgages in the financial collateral definition, generally allowing warehouse lines of credit to be risk-weighted at 50% (the risk-weight of the underlying collateral). Second liens, seriously delinquent loans and loans underwritten with extremely high LTVs are assigned a 100% risk weight. However, the Basel rule states “if a banking organization holds the first and junior lien(s) on a residential property and no other party holds an intervening lien, the banking organization must treat the combined exposure as a single loan secured by a first lien for purposes of assigning a risk weight…”
So if a nonagency 1-4 family loan has a 100% risk-weight for Basel III, this means that the bank puts up 8% capital behind the asset. A QM loan would likely be 50% risk weight or 4% capital allocation in the example above. Community banks won some key concessions in this regard. “Numerous changes have been made to the proposal to reduce its complexity and to minimize the potential burden that would be placed on smaller and community banking organizations,” said Fed Gov. Elizabeth Duke when the proposal was released in July.
The capital treatment for mortgage servicing rights or MSRs was not changed in the final Basel III proposal. Banks must subtract the fair value of the MSRs above 10% of tangible common equity from risk-based capital for regulatory calculations, making it an expensive asset in terms of capital allocation. An MSR above 10% of TCE has a 250% risk-weight, meaning banks have to put up 20% capital vs. the FV of the MSR asset. Capital treatment for nonperforming loans was also changed to 150% of the exposure vs. 100% under the current rule. All of these rules make it more costly for banks to hold mortgage assets.
Under the new rule, all banks would have to treat warehouse lines as commercial loans with a risk-weight of 100%. This means that when a large bank provides warehouse funding to smaller banks or nonbank firms like Carrington, the haircut on the collateral backing the warehouse facility is larger, reducing the total funding available for mortgages.
As with the approach to MSRs, overall the Basel III rule is harshly antagonistic to real estate as an asset class. The Basel III capital rule reflects a European view of consumer credit that is antithetical to America’s free market system where fair access to credit is the legal standard.
On top of the new capital rules, the federal bank regulators are preparing to propose standards for a Qualified Residential Mortgage or QRM that will provide guidance for minimum downpayments and guidelines for issuers of mortgage securities in terms of how much of a retained interest the sponsor must keep. The section of Dodd-Frank that requires “skin in the game” is one of the most poorly considered parts of this extremely broad law and effectively works as a tax on private mortgage securities.
Combined with Basel III, the Dodd-Frank law reinforces the de-facto monopoly of the U.S. government in the mortgage market while crippling the ability of private investors to provide meaningful capital to support housing.
I wrote a long and fairly technical comment on Section 941 of the Dodd-Frank law on the financial blog site Zero Hedge titled “Dodd-Frank, True Sale & Skin in the Game (Update 1).” For those of you who live outside the world of finance, what you need to know is that Dodd-Frank is hurting the housing market by imposing unreasonable economic limits on the world of private mortgage securities.
Section 941 of Dodd-Frank is essentially a tax on issuers of private mortgage bonds, an economic penalty on private issuers of securities to support housing finance. The rule was put in place because nobody in Washington has the guts to enforce the securities laws or go after blatant acts of securities fraud against investors committed by banks during the 2000s. The Dodd-Frank law requires the Fed and other regulators to set rules for QRMs that don’t require risk retention, essentially the part of the market that already is dominated by the U.S. government housing agencies.
Net-net, Section 941 of Dodd-Frank kills the market for private mortgage securities. Most issuers of mortgage bonds already have significant exposure to these transactions. Dodd-Frank puts in place a requirement for additional risk retention by issuers of mortgage securities that reduces the proceeds from the sale and thereby limits the amount of financing for the housing industry.
The sad part is that former members of Congress like Barney Frank and Christopher Dodd don’t understand the mortgage market well enough to realize the harm done by many of the provisions of the law named for them.
One former staffer who worked on Section 941 opines: “[The Qualified Residential Mortgage rule] is likely the most mindless part of Dodd-Frank. In all the time I worked on the bill, I never heard a sound reason for ‘skin in the game’ — just simplistic platitudes from proponents who had no background in the area. It was clear it could never be effectively implemented.”
As I noted in some detail in Zero Hedge, the risk retention rules of Dodd-Frank reduce the amount of credit available to the housing sector by making it difficult for private investors to “sell” mortgage bond loans privately in the secondary markets. In effect, all mortgage securities become “covered bonds” that add no incremental leverage to the economy.
As I wrote on Zero Hedge: “Why is this important? When a U.S. government agency purchases a loan from a bank, they are increasing the leverage to the economy. How? By giving the bank back its money so that another loan can be made. With the skin-in-the-game provisions of Dodd-Frank, however, it is virtually impossible for issuers of private mortgage securities to add any leverage to the U.S. economy.”
The good news is that representatives of the banking and housing industry are engaged with regulators and members of Congress to fix some of the most egregious excesses of Dodd-Frank and Basel III. The changes to the Basel III mortgage rule dropping the harsh capital risk weights for 1-4 family mortgages was a partial victory.
But the rest of the changes discussed above and elsewhere in the new regulatory world facing the housing sector are negative. Modifying these rules so that we can protect consumers and maintain reasonable availability of housing finance will take a lot of time and hard work.
