Commercial banks unlikely to return to residential mortgages

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Over the past decade since the 2008 financial crisis, the commercial banking industry has slowly withdrawn from the most risky portion of the U.S. residential mortgage market and reduced the overall exposure to the entire asset class. Some hopeful souls in Washington believe this trend will soon reverse, but I'm sad to say that is increasingly unlikely. Outside of some specialist banks that are equipped to deal with the financial and regulatory challenges of residential lending and servicing, the industry is migrating away from mortgage lending.

The industry can be divided into three segments based upon the borrower credit score. Banks have largely abandoned the bottom third of the market and even some of the middle segment as well. Loans with credit scores below a 700 FICO are essentially unattractive to commercial banks, either to sell or to hold in portfolio. The reasons for this trend are complex, but the net effect is that banks have largely abandoned the market for low-FICO, high loan-to-value mortgages guaranteed by the Federal Housing Administration.

The financial and reputational risks associated with making and servicing distressed mortgages have convinced many lenders to downsize or even eliminate originating residential mortgages for all but the most affluent customers. As a result, banks focus on originating and/or acquiring larger jumbo mortgages and multifamily loans, which tend to have superior credit characteristics and also higher servicing income. And there is no sign that this trend is changing.

One indication of the exodus by commercial banks from mortgage lending and loan servicing is the fact that noninterest income for banks is essentially flat going back a decade. There are two measures of noninterest income that historically were very important to bank earnings, but today less so — loan servicing and asset sales.

Over the past five years, one-to-four family loans serviced by banks for others have fallen from $4.2 trillion to just $3.8 trillion at the end of the third quarter of 2018. As of Sept. 30, 2018, the national banks regulated by the Office of the Comptroller of the Currency serviced approximately 17.2 million first-lien mortgage loans with $3.26 trillion in unpaid principal balances. This $3.26 trillion represents 32% all residential mortgage debt outstanding in the United States.

The other key measure of the decline in mortgage lending activity by U.S. banks is asset securitizations and sales, an activity that once generated billions of dollars in noninterest income annually for the industry, but which continues to shrink even as bank balance sheets have grown. Quarterly sales of one-to-four family mortgages by all banks have fallen from over $1 trillion in 2007 to $700 billion at the start of 2016 and $540 billion at the end of the third quarter of 2018.

In addition, the portion of bank balance sheets allocated to one-to-four family mortgage loans held for investment has also declined even as the industry has grown. At the start of 2000, one-to-four family mortgages held in portfolio accounted for just shy of 20% of the $7 trillion in total bank assets held by U.S. banks. At the end of the third quarter of 2018, the $2.1 trillion in bank-owned one-to-four family mortgages accounted for just 11% of $17 trillion in total industry assets. So since 2000, bank balance sheets have more than doubled, but the portion allocated to one-to-four family mortgages has fallen.

Another way to observe the decline of bank market share in the world of residential lending and servicing is the fair value of mortgage servicing rights reported by U.S. banks. Since 2008, U.S. banks have reported a sharp decline in the value of MSRs held on balance sheets, even as the valuations for mortgage servicing assets have soared. From a peak valuation of $75 billion at the end of 2009, bank owned MSRs have fallen dramatically to just $46 billion in the third quarter of 2018. And MSR valuation multiples have doubled over the past decade.

This decline in bank ownership of MSRs is primarily due to transfers of distressed and performing loans to nonbank servicers, REITs, and buy-side investors. Fear of reputational risk arising from distressed loan servicing and also punitive capital rules for MSRs make these assets prohibitively expensive for banks to hold. No surprise, the nonbank share of mortgage originations has increased dramatically, with 78% of the Government National Mortgage Association loans now being originated by nonbanks.

Nonbank investors who have been buying MSRs at premium multiples over the past three years should be mindful that servicing residential mortgages can be a highly variable business. In particular, periods of high credit losses tend to drive net servicing fees into the red as capital and financing costs associated with servicing distressed mortgages overwhelm the periodic income that makes loan servicing an attractive business in periods of low defaults. The fact that many nonbanks have participated away future "excess" servicing income makes the nonbanks even more fragile in a rising default environment.

The good news is that U.S. banks have largely downsized their mortgage lending and servicing operations, making the financial system better able to absorb future shocks when the mortgage market starts returns to normal after years of manipulation by the Federal Open Market Committee. The major banks have greatly reduced exposure to lending and servicing, resulting in a clear shrinkage in the relative importance of what were once a key business lines.

The bad news is that the home price inflation engineered by the FOMC under Chairs Ben Bernanke and Janet Yellen creates a trap that may eventually destroy a number of nonbank lenders and servicers. When default rates do start to rise on residential mortgages, the brunt of the impact will be felt by nonbank firms that lack the capital and liquidity to navigate through the credit cycle. So ask not whether the U.S. banking industry will return to mortgage lending. Ask instead how nonbank mortgage firms, which are funded by secured commercial bank credit, will survive the next several years.

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Underwriting Commercial banking Originations Servicing Nonbank MSR Credit scores FHA OCC