As nonbank lenders continue to grow their stake in the mortgage industry, researchers from the Harvard Kennedy School argue that regulatory reforms should come to lower the risk associated with these institutions.
Between 2012 and 2014, nonbank lending institutions magnified their market share to 48% from 27%, according to a study by Marshall Lux, a senior fellow at Kennedy's Mossavar-Rahmani Center for Business and Government and senior advisor at The Boston Consulting Group, and Robert Greene, a research assistant at the Mossavar-Rahmani Center. At the same time, these institutions' risk profile stands much higher than that of banks, in part because of nonbank lenders' reliance on Federal Housing Administration-insured loans.
The median FICO score for an FHA-insured nonbank borrower is 667, while it rests at 682 for banks. Lux and Greene note that the Cleveland Fed views this as subprime. While FHA-insured lending has given nonbank institutions much of a leg to stand on — albeit a shaky one — the researchers noted other trends that have led to their surge in the mortgage industry.
For starters, nonbank lenders have led the charge in technological innovation, which helps to improve customer experiences. But it's the expanded regulation, the study's authors argued, that caused much of the situation seen today.
Regulations broadly have tightened the purse strings of bank and nonbank lenders alike. Nonetheless, Basel III and other regulation have resulted in many depository institutions leaving the mortgage servicing industry. Many of these same institutions have also exited mortgage origination, and those that have stayed have become more selective.
All of this has left a void that nonbank lenders eagerly filled. But these lenders pose more of a risk to the industry than growing market share, or even the riskiness of their dependence on FHA-insured loans.
"Nonbank originators and servicers may pose a counterparty risk to the [government-sponsored enterprises] in a market downturn," the researchers wrote.
To prevent against this, Lux and Greene proposed certain fixes for the industry and regulators. To start, they suggest applying residual income testing and other reforms to improve inappropriately priced FHA insurance and combat this major source of nonbank mortgage risk.
They also advised reforming Freddie Mac and Fannie Mae to improve their fiscal condition, so that nonbank institutions pose less of a hazard.
Finally, they cautioned regulators to approach standards with caution. While it may be appropriate to change nonbank standards, as Fannie Mae and Freddie Mac did May 20, Lux and Greene said that given their different structure, these reforms can burden smaller market participants and may be ill-suited to a nonbank framework. Still some regulation is needed the authors contended, especially where new technologies are concerned, to avoid potential industrywide negative effects of these disruptors.
Similarly, the researchers noted that the Federal Housing Finance Agency and other regulators should review their approaches to avoid unintended effects, such as the Basel III rules pushing banks out of mortgage servicing.
"Policymakers are right to be concerned about growing risk in U.S. mortgage origination and servicing markets, and to pay close scrutiny to the increased market share of nonbank mortgage originators and servicers," the authors wrote in the conclusion to their study. "However, as our research suggests, the marketwide trends of and systemwide risks posed by today's nonbanks are different than those of precrisis subprime-originating nonbanks."
