Return of banks to government loan market still doubtful
At the end of October last year, the Department of Housing and Urban Development and the Department of Justice set forth a memorandum of understanding to further the effective and efficient enforcement of the False Claims Act, with respect to participants in all Federal Housing Administration single-family mortgage insurance programs.
The objective of the MOU was to reduce uncertainty among mortgage lenders, banks and nonbanks alike, with respect to when the DOJ would bring FCA actions arise from alleged fraud with respect to government guaranteed loans.
"As part of a broad initiative to ensure that the severity of certain violations is matched with the appropriate remedy, HUD has worked to provide clarity and certainty to program participants concerning FHA's requirements," noted the joint HUD/DOJ statement. Specifically, HUD has considered how the False Claims Act fits within the spectrum of remedies that may be utilized to address violations of program requirements.
The mortgage industry received this news very positively, particularly since FCA actions by the Department of Justice has been blamed for the exodus of commercial banks from the FHA/USDA/VA loan market. A recent report by the Financial Stability Oversight Council notes that nonbanks now account for over three quarters of all Ginnie Mae issuance and service the vast majority of government loans.
In fact, small nonbanks originate the vast majority of all mortgage loans made in the United States, but then sell the loans into the secondary market. Banks then count these purchases as "originations." For some reason the agencies represented in the FSOC don't seem to understand this little nuance.
Despite the hard work by HUD Secretary Ben Carson and FHA Commissioner Brian Montgomery in crafting the MOU, banks are unlikely to return to the government loan market. The two largest banks that remain as significant Ginnie Mae issuers — Wells Fargo and Flagstar Bank — are among the few banks that have the operational skills to actually service government loans. Indeed, one of the inaner aspects of the FSOC report on the "systemic risks" presented by nonbank mortgage companies is that it fails to state that most commercial banks simply cannot operate profitably in the government loan market.
First and foremost, the challenges banks face when originating government loans and issuing Ginnie Mae securities makes this one of the worst performing asset classes that a bank can hold on its balance sheet. Between the relatively low mortgage coupons, the small size of government loans, and the still very real perils of facing consumers in any transaction makes the risk-adjusted return on capital of government loans negative. While larger banks may be able to justify holding such assets based upon scale, specifically in the case of Wells Fargo, smaller, privately owned banks simply have no reason to take this risk.
Second is the question of servicing. In order for a bank or nonbank to service loans in the government market, the operations must be essentially error free. This is a very high standard of operational excellence and, again, begs the question as to why HUD and the agencies represented within the FSOC would even think it prudent to encourage depositories to engage in an activity that they cannot do profitably.
Since the 2008 mortgage crisis, it was the specialized, high-touch nonbanks that resolved the massive backlog of defaulted residential mortgages in the government, agency and private label markets. Most large commercial banks such as JPMorgan Chase, Bank of America and Citigroup sold their distressed government portfolios to nonbanks at the behest of prudential regulators. Now that the nonbanks have done the hard work of cleaning up the mess in the government market created by big banks, however, these same agencies now want the banks to return to government lending?
A third factor that is important to consider is that government mortgages tend to be small, on average well below $300,000 in unpaid principal balance. While the servicing fees for government-insured mortgages at 32 basis points on UPB annually are higher than the 25 bps paid on agency loans, the cost of servicing is also far higher. Indeed, even though commercial banks benefit from retaining the escrow balances associated with Ginnie Mae securities, many banks are still unable to function in the government market on a consistently profitable basis.
Commercial banks would much rather originate larger agency loans or private label mortgages, which carry the same or higher servicing fees on a much larger UPB. Apparently the folks at the FSOC have never asked the key question: Would you as a commercial bank rather earn 25 basis points a year on a $5 million UPB private mortgage with a low loan-to-value ratio and a high FICO borrower with little or no probability of default? Or would you prefer to originate (or worse, purchase in the secondary market) a smaller government loan with a lower coupon, higher servicing costs and greater chance of litigation or penalty from HUD and/or the DOJ?
Finally, it is important to consider that the banking industry has been slowing migrating away from single-family as well as multifamily mortgages for more than a decade. The passage of the 2010 Dodd-Frank Act and other laws and settlement have made the American consumer toxic from a risk perspective, particularly for federally insured depositories. Looking at the data collected by the FDIC, it is clear that the portion of bank balance sheets allocated to single-family mortgages of all descriptions has been shrinking as a percentage of total bank assets since the 1990s and that the portion attributable to one-to-four family and multifamily mortgages has been relatively flat.
Today the portion of bank balance sheets allocated to one-to-four family residential mortgages is just 14% of industry assets. More important, the size and quality of the average bank-owned one-to-four has grown significantly since the 2008 mortgage crisis. Bank originations and, more important, purchases and sales of one-to-four family loans into securitizations has also fallen dramatically since 2008, from almost $1 trillion per quarter a decade ago to less than $450 billion in the third quarter of 2019.
The moral of the story is that commercial banks prefer larger, higher quality mortgages, both to retain on balance sheet and for securitizations into the agency and private label market. The latter have higher coupons and servicing income. The fact that the more operationally skilled nonbanks have come to specialize in government mortgages is hardly surprising if you assess the cost to originate and service these loans. Yet for some reason, when it comes to perceived "problems" such as the market share of nonbank lenders in government lending and servicing, HUD and the agencies represented by the FSOC refuse to focus on the public data to inform their policy deliberations.