To understand the context, U.S. agencies decided to review banks’ capital framework in response to the financial crisis, consistent with the standards issued by the Basel Committee on Banking Supervision in 2010 (Basel III). U.S. regulators increased the overall quality and quantity of banks’ capital and improved leverage ratios for the largest banks. 

In 2017, the Basel Committee issued a second set of revisions to Basel III, called the Basel Endgame, to address the calculation of risk-weighted assets and limit banks’ internal models to estimate risk. U.S. regulators have been working on these rules for years but have prioritized them since the recent bank failures of Silicon Valley Bank and Signature Bank. 

Initially, regulators signaled that big Wall Street banks might face a 15% to 20% average increase in overall capital requirements. The current rule for mortgages was expected to remain unchanged: first-lien whole loans prudently underwritten and performing to their original terms receive a 50% risk weight, while other loans receive a 100% risk weight. 

However, this week, Bloomberg reported that under the latest draft proposal, 40% to 90% risk weights would be assigned for large banks issuing residential mortgages, depending on the loan-to-value ratio. That’s 20 basis points higher than the international standard. Residential mortgage-backed securities guaranteed by government-sponsored enterprises (GSEs) wouldn’t be affected. 

More pain for the jumbo market 

“Our initial thought is that the impact would not be huge, just because the GSEs are the main source of mortgages and banks are not holding loans that have high loan-to-value that are conforming – they probably get they done through the FHA or the GSEs to be securitized,” Bose George, managing director at Keefe, Bruyette & Woods (KBW), said. 

According to George, the rule would impact only the jumbo market, a very high credit quality market. So, even there, George’s team assumes only a few loans would fall into this category of high LTV, ultimately having higher capital requirements. 

“We are assuming that the impact in the jumbo space is probably going to be slightly higher mortgage rates, as opposed to volume significantly shifting to the nonbanks,” George said in an interview with HousingWire. “Right now, there’s a gap between where banks offer rates on jumbo and where the securitization market needs to be. So, if we have rates go up by 5 or 10 basis points, it’s not going to move that away from the banks on the jumbo side.”

However, the regulatory proposal comes amid a shrinking jumbo market. The product has been a bank offering since the financial crisis due to these institutions’ need for deposits, but it suffered from recent bank failures. At HousingWire’s Mortgage Rates Center, data from Optimal Blue shows 30-year fixed rates for jumbos at 6.99% on Wednesday, compared to 6.74% for conforming loans.  

Inside Mortgage Finance (IMF) estimates lenders originated $37 billion in jumbo loans from January to March 2023, down from $58 billion in the previous quarter and $133 billion in the same period last year. First Republic Bank, rescued by JPMorgan Chase in May, Wells Fargo and JPMorgan were the top three jumbo producers in the period. 

Same market, different players 

Following the financial crisis of 2008, depositary lenders retreated from the residential mortgage markets due to higher capital costs and reduced profitability. Consequently, independent mortgage banks, which have less stringent regulatory requirements, now have nearly two-thirds of the mortgage pie.  

“We would expect banks affected by these proposals to lobby for a more even playing field vs. nonbank lenders,” Mario Ichaso, senior residential mortgage backed-securities strategist at Wells Fargo, said in a trading desk commentary on Tuesday night. “We would not be surprised to see changes to these proposals down the road, but participants should continue to monitor these developments for any spillover effects to the MBS market.” 

Big bank executives have started to publicly criticize the proposal to increase capital requirements on their mortgage loans. 

“I think there’s been a desire to finish up Basel III,” Brian Moynihan, chair and CEO of Bank of America, said in an earnings call with analysts on Tuesday. “They’ve [regulators] got to think through the downside of some of these rules, and that they could push stuff outside the industry to nonbanks (…) and the resilience of those institutions, is interesting to watch through cycles.”

Moynihan estimates that a 10% increase in BofA’s capital levels would prevent the bank from making about $150 billion of loans at the margin. 

JPMorgan Chase Chief Financial Officer Jeremy Barnum said, “All else [being] equal, higher capital requirements definitely are going to increase the cost of credit, which is bad for the economy.” And, in the mortgage space, JPMorgan might pull back even further if new rules are applied. 

“When you increase the capital requirements, it makes it even harder. So, that just becomes one of the areas where you’re in that tension between remixing versus pricing power that we talked about a second ago. And it might, in fact, mean that we do less credit available for homeowners and more regulatory risk as the activity moves outside the perimeter,” Barnum told analysts last week. 

On July 10, Federal Reserve Vice Chair for Supervision Michael Barr said the proposal’s more accurate risk measures would be equivalent to requiring the largest banks to hold “an additional $2 of capital for every $100 of risk-weighted assets.”

“For the banks that would need to build capital to meet the requirements, assuming that they continue to earn money at the same rate as in recent years, we estimate that banks would be able to build the requisite capital through retained earnings in less than two years, even while maintaining their dividends,” Barr said. 

Barr also signaled that capital requirements would affect banks with assets over $100 billion. It was undoubtedly influenced by the recent experience with institutions with assets between $100 billion and $200 billion collapsing. Several sources said it’s unusual for regulators to adopt risk weightings by bank sizes when the risk weighting traditionally applies to the asset. 

“I think that’s where the regional banks will likely be the hardest hit. And theoretically, it will drive some consolidation, which I think is odd given that they [regulators] have made bank mergers more difficult,” Pete Mills, senior vice president of residential policy at the Mortgage Bankers Association (MBA), said. 

Mills added: “There are a lot of conflicting regulatory pressures in the market. Regulators are worried about the growth of the IMBs market share, but they’re doing things that would appear to exacerbate it. IMBs are a very robust business model if there’s warehouse credit available. And we’ve got several public companies now. One of the strengths of our housing finance system is the diversity of business models – banks, nonbanks, REITs as holders of mortgage assets, credit unions, and community banks. Maintaining that balance is important.” 

Taylor Stork, Community Home Lenders of America (CHLA) president and Chief Operating Officer at Developer’s Mortgage Company, said that the new capital requirements proposed for the large banks, combined with the heightened interest rate risk of portfolio lending as rates have skyrocketed, would only likely to heighten the trend towards IMB mortgage dominance.

“Mortgage lending by Wall Street banks has plummeted since the 2008 housing crisis, as independent mortgage banks now originate two-thirds of all loans and decisively outperform banks in loans to minorities and other underserved borrowers,” Stork said in a statement. 

The secondary market is not immune 

If the new rule changes the mortgage origination dynamics due to higher capital requirements for these assets, it will be reflected in the secondary market. 

“The impact may be more profound at the regional bank level, which tends to have higher exposures to the whole loan residential market relative to those institutions with more than $700 billion in assets. This could result in more securitization activity from regional banks into the private label market as they look to shed some of their residential exposures,” Ichaso said. 

Mills particularly worries about the impacts on the MSR market and warehouse lending. 

“Banks could stop accumulating MSRs and sell servicing. And, if they sell servicing to improve their capital ratios, who will buy the servicing if other banks are facing the same punitive capital standards?” Mills said. “Banks are a critical source of liquidity for the market by providing warehouse lines to IMBs. We’re again concerned that a large increase in capital of 15% to 20% would discourage banks from participating in the warehouse lending business.”

A recent BTIG report from analysts Eric Hagen and Jake Katsikas also stated that the Basel III Endgame would incentivize banks to shred their MSR portfolios. 

“Broadly speaking, we expect banks could continue shedding MSRs if new capital requirements end up more restrictive than the 250% risk weight already in place through Basel. 

According to the BTIG report, the top three banks in agency servicing – Wells Fargo, JPMorgan and U.S. Bank – control upwards of $1.5 trillion in unpaid principal balance. 

“Beneath them, but still in the top 50, are dozens of community banks and thrifts with less than $10 billion of servicing, which we see as a potentially ripe source of supply for nonbank lenders and servicers to encroach on over time. It goes in-hand with long-duration MSRs also looking more challenging from an asset-liability management standpoint for franchises with shorter-term or more sensitive deposits, which could induce incremental selling activity.” 

Is the Basel Endgame coming soon?

The Federal Reserve, Federal Depository Insurance Corporation and the Office of the Comptroller of the Currency, which together regulate banks, are expected to unveil the Basel Endgame proposed changes on July 27, Bloomberg reported. 

Mills speculated that bank failures and rescues amplified the regulators’ desire to implement the Basel Endgame “more quickly than they would have otherwise.”

“It appears they’re going directly to a notice of proposed rulemaking. So, they’re skipping the advance notice process. Our other concern is, typically, when you have a significant change in capital regulations, they will do what’s called a quantitative impact study, a QIS. At least we haven’t heard anything to suggest that they are going to do that this time around,” he said. 

Overall, industry experts said higher capital requirements for mortgages wouldn’t be the remedy for problems like the recent bank failures. 

“The problems that the industry had with mortgages, in fact, a few months ago, had nothing to do with credit risk. It had to do with the interest-rate risk or that the assets on banks’ balance sheets had long-duration mortgages,” George said. “The new changes would address a problem or issue that came up much earlier when Basel III was being sort of implemented. From that standpoint, it seems like it’s solving a problem that isn’t currently a problem.” 

Michael Bright, CEO of Structured Finance Association, said, “I would like to know what problem would be solved because the market is pretty regulated right now. LTVs are still quite low. Home prices are quite high. The delinquencies are very low. The underwriting process has gone through a sea change over the last 10 years.”

Bright added: “Silicon Valley did fail, but it was very unique in a lot of ways, and to recapitalize the entire system focusing on non-agency mortgages just because of that, to me, seems like an overreaction.”