Basel III      
As we start of the New Year, I think it is a good idea to assess Basel III’s impact on banks.  We have just finished year one of the five year phase in of Basel III. As many of you are well aware, when the Federal Reserve Board approved the Basel III Regulatory Capital and Market Risk Final Rule (“Basel III Rule”) on July 2, 2013, mortgage servicing assets (MSAs) were not given favorable treatment. MSAs are contractual rights owned by a bank to service mortgage loans owned by others for a fee.  In particular, the Basel III Rule does not allow banks to apply the full value of their MSAs to their Tier 1 Capital; banks will only be able to count a portion of the value of their MSAs as Tier 1 Capital. Under the Basel III Rules:

  • MSAs are individually limited to 10% of a bank’s common equity Tier 1 capital. MSAs in excess of the 10% threshold must be deducted from common equity;
  • The combined balance of MSAs, deferred tax assets, and investments in the common stock of unconsolidated financial institutions is limited to 15% of a bank’s common equity Tier 1 capital. If these combined assets exceed the 15% threshold, they must be deducted from common equity;
  • Any portion of a bank’s MSAs that are not deducted from the calculation of common equity Tier 1 will be subject to a 100% risk weight that will increase to 250% in 2018.      

Significant Impact on Regional and Community Banks
Financial institutions of all sizes sell mortgage loans that they originate to third parties like Freddie Mac and Fannie Mae. Many regional and community banks had a strategy to originate and sell mortgage loans to an investor in the secondary market but retain the right to service the mortgage loan. This was a way for regional and community banks to manage their interest rate risk by selling long-term credit assets while simultaneously maintaining valuable customer relationships. By retaining the servicing rights, the banks were also able to collect a stable source of fee income, which is a valuable asset in the current market. 

By making it very expensive for banks to hold MSAs in excess of the Basel III thresholds, (as well as increasing the regulatory risk associated with mortgage servicing as described in previous blog posts), there is a large disincentive for regional and community banks to service the mortgage loans that they make to their customers. Regional and community banks are faced with the choice of either selling their mortgage loans into the secondary market servicing-released and jeopardize their customer relationships or reducing their secondary market sales altogether, thereby reducing their fee income, which is also less than optimal. Selling mortgage loans servicing released also doesn’t make sense in the current low interest rate market. MSAs have historically risen in value as interest rates climb, largely because borrowers do not refinance and fewer loans are paid off. As such, banks can use MSAs to offset lower origination income that banks may suffer when interest rates rise. 

Banks Continue to Sell Mortgage Servicing Portfolios to Nonbank Servicers
In 2014, Ocwen Financial Corp. (Ocwen) and Nationstar Mortgage both doubled the size of their servicing portfolios, according to industry newsletter Inside Mortgage Finance. At the end of the 3rd quarter of 2014, four of the top five mortgage servicers are banks but Nationstar is the 4th largest servicer, with a $378 billion portfolio that is approximately 53% the size of the third largest bank mortgage servicer, Bank of America, which has a $722 billion portfolio. Basel III applies to almost all banks and bank holding companies but does not apply to non-bank mortgage servicers. According to the Financial Stability Oversight Council’s 2013 Annual Report, mortgage servicing rights at US commercial banks and thrifts have declined by more than half since their peak in mid-2008. The volume of mortgage servicing portfolio sales has even caught the attention of regulators, who are starting to be concerned with the growth of the “shadow banking” sector. The Financial Stability Oversight Counsel, which is a federal agency responsible for monitoring risks in the financial system, has cited the growth of nonbank mortgage servicers as an emerging threat to the financial system. Notwithstanding increased regulatory scrutiny, including New York Department of Financial Institution’s intervention in the sale of MSAs to Ocwen in 2014, the American Bankers Association expects that banks will sell an additional $1 trillion in MSAs in the next two to three years. 

Practical Implications
Overall, consumers will likely lose because Basel III impacts service, credit availability and pricing of residential mortgage loans.   Banks will need to curtail lending in order to shrink the balance sheet.  Many banks will have to get out of the mortgage servicing business which translates into less variety of community and regional bank relationships with consumers.  Since banks generally price mortgage loans based upon their use capital, the Basel III Rules have and will increase the cost of funding for banks, which will ultimately result in higher prices for consumers attempting to get mortgage loans. When you layer the new regulatory rules (e.g. Qualified Mortgages, new Servicing Standards, Regulation AB, and other consumer regulations) on top of Basel III, regulators have created a potent New Year cocktail that many regional and community banks cannot afford to drink.