Will FHFA create a level playing field for nonbanks?
Federal Housing Finance Agency Director Mark Calabria promised to change his agency. So far he is not disappointing.
In addition to pushing to move Fannie Mae and Freddie Mac out of federal conservatorship, he is also making some changes to how all four government-sponsored enterprises — the others being Ginnie Mae and the Federal Home Loan Banks — operate and are regulated. The mixture so far is a combination of positives and negatives, but the long-suffering independent mortgage banks — also known as nonbanks — may yet get some respect.
Last year, Calabria was responsible for raising the question of nonbank risk with the Financial Stability Oversight Council. This writer released a paper rebutting the 2019 FSOC report, which claims rather incredibly that nonbank mortgage servicing companies could pose a “systemic risk” to the markets and the U.S. economy. The FSOC report singles out potential liquidity risks arising from nonbanks servicing defaulted mortgages and also risk to banks that finance these activities. Yet today, commercial banks still have 80% market share in mortgage servicing, as shown below.
More than anything else, the FSOC's accusations against nonbanks reflect a very poor understanding of the world of secured finance. The first big question for Calabria and his colleagues at the FHFA is whether or not they understand that the attitude of the FSOC and bank regulators behind it is antithetical to the mortgage industry. Prudential regulators hate small residential mortgages of the type seen in the government market and Ginnie Mae securities, and especially dislike nonbanks.
Prudential regulators hate nonbanks, first and foremost, because they're not banks. Nonbanks are far more efficient than commercial banks. Nonbanks actually make most of the mortgage loans in the U.S. each year. Fed researchers refer pejoratively to nonbank finance companies as "shadow banks."
But to paint nonbanks as a source of systemic risk, particularly given the track record of commercial banks in causing the 2008 subprime mortgage fiasco, seems absurd. But let's go down memory lane for just a moment.
In the early 1980s, just before the nonbanks known as savings and loans were tossed into the wood chipper, Citibank introduced a new global product called "Mortgage Power." This no-doc, no-income verification product was designed for the self-employed.
The first truly subprime mortgage loan product offered by a large U.S. bank, Mortgage Power was an unmitigated disaster. By the early 1990s, Citi's credit losses in mortgages were in double digits and Mortgage Power was shuttered.
By 2000, however, Citi was ready to dive back into the subprime mosh pit. It acquired Associates First Capital, the largest consumer finance company, in September 2000. This acquisition set the stage for the bank's collapse in 2008. Citi, in particular, was responsible for socializing the no-doc, no-income verification subprime toxic loan that was the dominion of finance companies for the world of federally insured banks. Countrywide, WaMu, Lehman Brothers and Bear Stearns merely followed Citi’s pioneering lead.
Today, as in 2008, nonbanks are the customers of banks. The risk, the collateral and the capital of the nonbanks is held by a bank that finances the mortgage business. The world of mortgage finance is fully collateralized in terms of credit, self-liquidating in terms of legal resolution and fully hedged in the to-be-announced markets in terms of liquidity (i.e., collateral) risk. Commercial bank lenders oversee and supervise this risk taking and post 100% capital against mortgage lines as per Basel III.
Simply stated, the world of mortgage finance is the least risky part of the U.S. fixed-income markets. Yet the FHFA just issued a new proposal for capital rules for GSE seller/servicers that reflect the anti-nonbank mentality that seems to pervade much of the world of Washington. FHFA's rule would set higher capital requirements for seller/servicers operating in the government-insured market of the Federal Housing Administration/U.S. Department of Agriculture/Veterans Affairs loans and Ginnie Mae securities, companies that are predominantly nonbanks.
The fact is that, with notable exceptions such as Flagstar and Cenlar, nonbanks are the only lenders and servicers that are able to operate in the government loan market profitably. But the FHFA seems intent upon penalizing the nonbank issuers operating in the government market, without any recognition of the superior operating records and financial performance nonbanks have achieved. Dollar-for-dollar of capital employed, nonbanks generate more revenue and create far less net risk in the markets that do commercial banks.
The growth in the Ginnie Mae market since 2008, from low single digits to more that 20% of total issuance, was created by nonbanks. If Calabria really wants to address risk in the mortgage market, why doesn't FHFA try to be helpful to nonbanks for a change? Specifically, the FHFA should help increase nonbank liquidity by allowing nonbanks to be full members of the Federal Home Loan Banks.
The Wall Street Journal reports that the FHFA may soon allow nonbanks to become members of the FHLBs, an important change that would diversify sources of liquidity for nonbanks and provide a countercyclical buffer for the housing sector. Few people remember that in the dark days immediately following 2008, the FHLBs provided enormous liquidity to the banking system that helped to avoid dozens more failures of community banks.
Just as small banks have few sources of liquidity — and fewer friends in Washington than do the biggest banks — nonbanks have only a couple of choices when it comes to financing loan production and fixing defaulted loans, cash on hand or a bank credit line. Some of the more sophisticated nonbank lenders also access the short-term repo markets to finance dry government and agency mortgage notes. But providing nonbanks access to the FHLBs would provide an important liquidity backstop for all independent mortgage bankers.
For years, recalcitrant elements within the FHLBs have resisted the idea of allowing "unregulated" nonbanks back into the system either directly or via captive insurance companies. After all, the first members of the FHLB System were insurance companies. But captive insurance subsidiaries of mortgage banks and REITs have been wrongly criticized by bankers, who treat the FHLBs as their private funding vehicle. But why should JPMorgan and Wells Fargo get subsidized access to the FHLBs, but not independent mortgage bankers and REITs?
While he is imposing new capital requirements on nonbanks, Calabria might consider being helpful as well. Open FHLB membership to any entity that supports mortgage finance, either as a lender or investor, and has eligible collateral to access credit from the system.
Any nonbank that can meet the FHLB rules and has collateral should be allowed to access the credit available to JPMorgan and Wells Fargo. And when the bank lobbyists and regulators start to whine about the risk from nonbanks, Mark, just remember two words: Mortgage Power.