How much capital does an independent mortgage bank need

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Back in 2016, this writer wrote a series research papers and reports which examined the differences between depositories and financial companies in terms of sources and uses of capital. These efforts were in response to a dangerous trend in government policy debates regarding independent mortgage banks, which focused on concepts and criteria more appropriate for commercial banks.

After all, financial companies are part of the private sector, and banks are government-sponsored organizations that enjoy numerous government subsidies and monopoly protection from the Federal Reserve Board over the US payment system. If you are not an insured depositary, then you are a client of the bank.

Non-banking organizations depends on banks for funding. This group includes all IMBs and, notably, Fannie Mae and Freddie Mac. The fundamental economic difference between banks and non-banks colors the conversation, which is rooted in the question: how much capital does a non-bank mortgage company need?

Banks hold capital as a source of strength, if only for one reason or another other than to reduce the cost of resolution for the FDIC bank insurance fund. Banks have capital to cover credit losses. On the other hand, non-bank financial companies have working capital levels that correlate with changes in interest rates. The Mortgage Bankers Association chart below shows pre-tax operating income divided by the amount of the loan, in basis points.

IMB is unable to cover significant losses. Properly understood, IMBs are retail chains that often buy rather than lend and then sell those loans to investors. IMB enables an ecosystem of correspondents and wholesale brokers with a single purpose to make loans and sell them on the secondary market as quickly as possible. Banks are concerned with maintaining capital, but non-banks are keen to maximize asset turnover.

It is no coincidence that commercial banks such as Western Alliance Bancorp (NYSE: WAL), which acquired super efficient aggregator AmeriHome, or American Express (NYSE: AXP), trades on the equity markets at a premium over other banks. Why? Because the DNA of a financial company runs in their veins. These banks maximize asset turnover and hence capital utilization, generating prohibitive returns on equity.

On the other hand, most commercial banks are deliberately deprived of functionality through regulation to avoid risk, and especially the risk of direct collision with consumers. Commercial banks have escaped from direct exposure to the FHA, Veterans Affairs, and USDA markets over the past decade, but at the same time they have increased IMB’s wholesale availability through warehouses and advance lines.

Bank lines of credit for IMB are fully backed by government-insured, conventional or private loans, but insulate the bank from consumers who are rightly considered toxic in terms of reputational risk. Commercial lending is the best business for banks and this fact was confirmed by prudential regulators after the 2008 financial crisis.

IMB, for its part, is much more operationally efficient than banks and better able to service one to four family loans without conflicting with state or federal regulators. Ten years after the 2008 crisis, the partnership between commercial banks and IMB appears to be balanced. Banks provide financing to the wholesale mortgage lending business, while IMB issues and services loans. Indeed, IMB often sells loans to commercial banks.

Over the past few years, first the Financial Stability Supervisory Board, then the Federal Housing Finance Agency, and then the Conference of State Banks Supervisors have threatened IMB with ill-informed capital rules for banks. These rules, including for the GSE themselves, ignore the basic economic and financial differences between a bank and a financial company.

A tip to all of the above agencies: if regulation doesn’t work economically, then it probably won’t work as government policy either.

More recently, Ginny Mae threatened IMB with new qualifications that would drastically reduce leverage and profitability in the government loan market. This change will lead to a drop in government lenders and significantly reduce the cost of mortgage servicing assets. I reviewed this suggestion in a recent blog post at the Institute for Risk Analytics.

The question raised by the Ginny Mae Rule, as well as the Potential Capital Rule for Regular Issuers emanating from the FHFA, is this: How much capital does a mortgage bank really need?

Most IMBs actually operate with net negative working capital, especially stores with high asset turnover. Banks provide this capital in the form of secured and unsecured debt. Since IMB’s goal is to provide and sell loans, including loans that fall out of their service book, IMB does not want or need to build up excess capital. And the stock markets are not interested in providing IMB or even GSE with a level of capital similar to that of a bank.

IMB has some long-term obligations, but the operational ability to make and service loans at a profit and the financial ability to retain mortgage servicing rights are two key attributes of a successful mortgage bank.

As IMB’s service portfolio grows, more and more businesses can be created within the company, which significantly increases the return on equity of the issuer and the stability of the business. A large service book is good for IMB.

For regulators, the key assessment of IMB in terms of liquidity should be a simple NPV test that is closer to that used by the SEC and FINRA for broker-dealers than for commercial banks. IMB must have sufficient net worth to support its loan portfolio and MSR, including financing timely interest payments bondholders. Warehouse lines and especially urgent debts should be considered when meeting liquidity needs.

One of the key aspects of this analysis for both Ginny Mae and the FHFA should be how much of the service rights IMB retains. Serving an active loan costs a few basis points, but troubled loan service can cost more than the service charge and can take months. Ensuring that IMB maintains a sufficient portion of its service bandwidth to cover operating or lending costs incurred in reducing losses is critical.

Rather than trying to impose bank capital rules on financial companies, regulators at FHFA and Ginnie Mae should instead take steps to maintain minimum liquidity. Back in November 2018, prior to the sudden departure of Ginny Mae President Michael Bright, the agency issued a new member rule (APM 18-07) requiring IMBs to inform investors about the sale of shares or whole MSRs

“To ensure stability and liquidity in the secondary market, Ginnie Mae is implementing a series of updates to its counterparty risk management system to improve the financial strength of issuers,” said Ginnie Mae. The program has not been publicly announced since then, but it remains an important template for Ginny Mae and the FHFA to consider expanding.

Both the FHFA and Ginny Mae would benefit from abandoning the draconian rules of bank capital and instead focusing on a simple capital and liquidity regime that allows IMB to make and sell loans. Here’s another hint for regulators: as profitability declines, IMB’s capital will also diminish, making access to the bank loan and debt markets a decisive factor. Do not set static capital levels for IMBs when you know the tide is going away. Call Federal Reserve Chairman Jay Powell for any questions.

By focusing on important things, such as maximizing operational efficiency and profitability, and monitoring sales of service revenue to investors, regulators can ensure a robust non-bank lending and services market, as well as protect the commercial banks that support the mortgage finance market. But don’t try to pretend that IMB or even GSE are commercial banks. This is a stupid business that will end in tears.





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