To the Point With Bob: Proposed Capital Requirements on Big Banks Would Mean Fewer Choices and Higher Mortgage Costs

(To the Point with Bob is a periodic blog by MBA President & CEO Bob Broeksmit, CMB. You can view this and past blogs here.)

Mortgage interest rates are higher than they have been in 20 years. The supply of affordable housing for purchase or rent is inadequate. These factors are making it harder to address racial disparities in homeownership and wealth. Given the inextricable link between mortgage lending, the American Dream, and the overall health of the economy, banking regulators should be doing whatever they can to support real estate markets and the broader economy. Unfortunately, the opposite is happening.

In July, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) unveiled a proposal to increase capital requirements for banks with $100 billion or more in assets by about 15 to 20%. The rules had been in the works as a fine-tuning of current capital standards, but the size of the proposed capital increase appears to have been an overreaction to the high-profile bank failures earlier this year. In short, the proposed rule is the wrong medicine for the wrong patient at the wrong time.

The proposed rule, known as the “Basel III endgame,” refers to a panel convened by the Bank for International Settlements (BIS) in Basel, Switzerland, that establishes an international framework for bank supervision. This latest iteration of standards and mandates proposed by U.S. regulators to implement the endgame framework would directly affect every bank with assets of more than $100 billion–institutions that play significant roles as mortgage lenders, servicers, aggregators, and in warehouse lending and mortgage servicing rights financing. Consequently, the rule will impact banks and nonbanks alike, small and large institutions, and every delivery channel for real estate finance.

The diversity of business models and delivery channels is a core strength of our housing finance system. The Basel III proposal threatens to disrupt business models and ripple through the housing finance ecosystem in harmful ways, raising costs and limiting choices for mortgage seekers, all without a compelling justification.

The proposed rule would increase the risk weights for single-family mortgages by 20 percentage points above the levels recommended in the Basel Committee framework. Such a hike when banks are adhering to pristine mortgage underwriting practices and single-family mortgage delinquencies are at an all-time low makes no sense. Ultimately, the proposed rule would make it harder for borrowers with smaller downpayments–often first-time buyers, low- and moderate-income families, and minorities–to secure mortgages. To be clear, more capital required on a given asset class will mean higher costs, less lending, or a combination of both.

The rule also disregards the vital role private mortgage insurance plays in reducing risk for lenders and opening a path to homeownership for people who cannot come up with a 20% downpayment. For a mortgage loan with a loan-to-value (LTV) ratio higher than 80%, the rule would subject banks to at least 60% risk weight to cover possible credit losses–even if they are already insured against credit losses. Banks typically require borrowers on high LTV loans to carry mortgage insurance to mitigate risk and make the loans eligible for sale on the secondary market. Because the rule ignores the benefits of reduced credit risk exposure, borrowers would be burdened by the insurance premiums as well as higher capital costs that banks would pass onto them.

The proposed rule would also increase capital charges for warehouse lending facilities, putting pressure on depository institutions to pull back on lending to independent mortgage bankers that provide more than 60% of single-family mortgage lending and 80-90% of government-insured loans that serve first-time, low- and moderate-income, veteran, and minority homebuyers. Warehouse lending is critical to ensuring there is enough liquidity in the mortgage marketplace to meet the needs of borrowers. It would be counterproductive to handicap lenders and borrowers already struggling with interest rate hikes over the last year.

The Basel III proposal also takes an illogical approach to mortgage servicing rights (MSR). MSRs are created whenever an institution originates a loan for sale into the secondary market. The MSR is an asset that represents the income stream received for collecting payments, passing them through to the investor, and setting aside taxes and insurance premiums in escrow accounts. However, mainly due to the punitive treatment of MSRs imposed by the current capital rules, many banks have exited this market segment.

The proposed rule further increases capital requirements on MSR assets for large regional banks, driving banks further away from the mortgage market. This will further suppress bank demand for MSRs. With less demand for MSRs, they become a less valuable asset for banks and IMBs. The result is less liquidity in the housing finance system, banks pulling back even further from making and servicing loans, and reduced opportunities and choices for mortgage borrowers. This regulatory excess is a dagger at the heart of the housing market.

Given the potential harm to lenders, consumers, and the broader economy, the Basel III proposal should have been backed up by a robust economic impact analysis. Instead, a scant 15 pages of impact assessment was included in the more than 1000-page document. The analytical shortcomings might partially explain the lack of unanimity in the vote to issue the proposed rule. 

Banking agency regulators stress that they provided an extended comment period and a three-year implementation period. A phased-in approach would not make up for the proposal’s negative impact. It would be better if regulators withdrew this ill-advised proposal and took some time to conduct a much-needed impact analysis.

The Endgame revisions to Basel III were supposed to be a fine-tuning of the framework, but the proposal from U.S. regulators is a major departure that would have significant consequences. The banking agencies’ proposed rule would weaken the agility and diversity of the mortgage banking sector and put upward pressure on already-high interest rates. That is the last thing aspiring homebuyers need, especially those with modest incomes or in minority communities – constituencies the Biden Administration regularly champions.

It is critical to get regulatory policy right, and MBA will not relent in pressing its case.