Christopher Whalen is a senior managing director at Kroll Bond Rating Agency.
Christopher Whalen is a senior managing director at Kroll Bond Rating Agency. Bloomberg

Over the next several years, Kroll Bond Rating Agency expects that the top four commercial banks will downsize or exit entirely from the business of originating and servicing residential mortgages. Whereas prior to the 2008 financial crisis the business of home lending was dominated by the top four banks, today a growing collection of specialty bank and nonbank firms are entering the mortgage lending and servicing fields. Quicken Loans, for example, is the second largest residential mortgage lender and servicer after Wells Fargo. The $11 billion total asset Flagstar Bank is the 10th largest U.S. mortgage lender and has a large, performing, servicing portfolio. Today, more home loans are made by nonbanks than banks. And notably, credit unions are the fastest growing category of mortgage lenders and servicers, but this is not an easy business.

The largest banks, in particular, have been receiving a continuous battering by regulators and prosecutors reinforcing the message that banks need to avoid financial and reputational hazards, particularly in areas such as residential mortgage loans. For example, regulators have told several banks Kroll Bond Rating Agency has rated in the past year to discontinue the servicing of distressed loans, this apparently based on the belief that such activities generate excessive risk. Not surprisingly, the market share of commercial banks in residential mortgage origination and servicing is falling. As the veteran chief executive officer of one century-old mortgage lender told us last year, "the consumer has become toxic." Not surprisingly, that banker has made growing commercial lending his new priority.

Banks have been forced to rationalize their residential mortgage lending and securities operations. Unlike the heady days of 2004 and 2005, when large banks originated and sold low-quality nonconforming mortgages into a robust private market, today the U.S. mortgage market is almost exclusively a government-run affair dominated by three housing agencies. The new Dodd-Frank rules for a "qualified mortgage" or QM serve as a demarcation line of risk for banks, which will not underwrite a conforming loan that cannot be sold to a government-sponsored enterprise. The market for jumbo prime mortgages for affluent Americans has grown significantly since the crisis, but the rules for loan documentation and pricing mandated by Dodd-Frank effectively exclude roughly a third of all Americans from obtaining mortgage credit.

Commercial banks have sharply curtailed their volumes for "non-QM" mortgages and are even shrinking production of qualified mortgages to focus only on the highest-quality borrowers. Stated simply, the big banks are not interested in making a mortgage loan that has any likelihood of default. Indeed, the only new non-QM mortgages being originated by U.S. banks tend to be jumbo prime mortgages that are too large for the conforming loan market. Part of the reason that the market has not come back for non-QM, private-label mortgage loans made to borrowers with relatively low FICO scores, is that the returns on such loans are simply too low. Even ignoring the loan price cap in the new Dodd-Frank regulations, the mid-single digit spreads on non-QM loans are simply not sufficient to entice most private investors.

The cost of servicing mortgage loans has also risen several-fold since 2008. The combination of rising mortgage origination and servicing costs, and falling lending volumes, translates into modest risk-adjusted returns, a fact which is convincing many banks large and small to exit the residential mortgage market entirely. This emigration of banks from the residential loan sector is partly offset by the growth of nonbanks, but over the past five years the U.S. mortgage market has seen a significant decrease in capacity. With the end of the distressed mortgage trade, the entire mortgage industry is in the process of rationalizing both human and financial capital to fit a financing market half the size of the market which existed before the crisis.

The evolution from depositories to nonbanks as providers of mortgage credit is in some ways back to the future, specifically the 1980s, when nonbanks called thrifts provided most housing loans. The reemergence of nonbanks as the primary providers of mortgage credit has caused great consternation among regulators and three federal housing agencies. But these changes are largely a result of regulation.

The fact is that the cost of capital and compliance has convinced many bankers that making home loans to American families is not worth the risk. New lending volumes at roughly $1.5 trillion in 2015 are less than half of the peak volumes seen a decade ago and are just barely sufficient to prevent the body of mortgage credit supporting the U.S. housing sector from shrinking.

Over the past three decades, a number of obstacles have also been placed in the path of nonbanks in terms of how they fund their operations. In the early 1990s, nonbanks could issue short-term debt for purchase by money market funds, creating the environment for that era of robust economic growth.

The 1998 changes to Securities and Exchange Commission Rule 2a-7 gave commercial banks a monopoly on creating assets for the money markets and thus a corner on providing short-term funding for most nonbanks. In the future, we will see a number of nonbank models emerge with ample equity capital and term debt as the primary sources of capital. If the SEC could craft a prudent means for nonbanks to again access the short-term credit markets by amending Rule 2a-7, that change could provide a powerful mechanism for encouraging credit creation and job growth — as was the case in the 1990s.

As the commercial banks retreat from many markets that banks entered in the 1990s and 2000s, nonbanks are going to take up the slack and grow into many areas of consumer finance. We hope that policymakers will focus some attention on the question of how to restore and strengthen the markets for nonbank financial companies, which necessarily operate at lower levels of leverage than publicly supported banks and, for example, don't benefit from subsidized deposits. More than half of the profit a bank or credit union earns from servicing a mortgage comes from the float on payments of interest, taxes and insurance. Nonbanks operating in the mortgage sector don't have access to that revenue stream to help finance their businesses.

Another important area of expansion for nonbanks is non-mortgage consumer lending, including the so-called marketplace lenders. These marketplace lenders are comprised of a variety of platforms and business models that, in some cases, allow retail investors the opportunity to purchase fractional interests in unsecured loans. Seen in the context of the SEC's changes to Rule 2a-7, the fact that nonbank marketing and securities operations such as Lending Club are in 2016 placing consumer loans directly with investors is a thought-provoking development.

As we move through 2016 and beyond, the scope of the changes now underway in the banking sector are going to become more and more apparent to consumers and policy makers. The enormous number of legal and regulatory changes put in place since 2008 have set in motion many different types of business model modifications, many of which are still in process and will be for years to come. When people talk of the Dodd-Frank adoption process being "done," it is well to recall that these legal rules and prohibitions will change the business of banking and finance in profound ways and over years and decades. It is very possible, however, that some of the Dodd-Frank law will eventually be modified when demands for economic growth again outweigh the voices of caution.

Christopher Whalen is a senior managing director at Kroll Bond Rating Agency.