Stanley C. Middleman: Are Non-banks Really a Systemic Risk?
Stanley C. Middleman is chairman and CEO of Freedom Mortgage, Mount Laurel Township, N.J., one of the nation’s largest full-service mortgage bankers and a leader in government-insured lending. He serves on the Board of Directors of the Mortgage Bankers Association and the MBA Residential Board of Governors (RESBOG) and is also a member of the Housing Policy Executive Council.
The Financial Stability Oversight Council issued its annual report in December where it identified the growth of nonbank mortgage origination and servicing as a risk to the U.S. financial system. But is this really correct?
Since the 2008 financial crisis and the passage of the Dodd-Frank legislation in 2010, state and federal regulators have focused on the alleged risks from non-bank financial companies. The collapse of such high-profile firms as Lehman Brothers, Bear Stearns and AIG caused regulators considerable concern, leading them to suggest everything from capital requirements for non-banks to identifying large insurance companies such as MetLife and Prudential as “systemically significant” financial institutions.
However, most of these concerns are not applicable to non-bank mortgage lenders and miss some important realities in the marketplace. First and foremost, firms such as Lehman and Bear Stearns were highly leveraged, with little capital or liquidity to absorb market shocks. Further, they engaged in fraud, specifically making bad loans and selling even more toxic securities to unknowing investors.
In the mortgage market of 2019, non-bank lenders finance their operations via various forms of market and secured bank borrowing, which provides funding diversity and stability. While few non-bank mortgage firms access the capital markets, securitization or sale of whole loans provides another means of liquidity. In fact, there have been relatively few defaults among non-bank mortgage firms. When failures have occurred, such as the bankruptcies of GMAC/Rescap, Taylor Beane and Stearns Lending, normal bankruptcy procedures were used, while other troubled firms have simply been acquired by others. No government bailouts were involved in any of these cases.
Another misconception among bank-centered regulators is that non-banks are somehow less regulated and poorly suited to conduct financial services—mortgage lending in particular. In fact, non-bank mortgage lenders are subject to significant oversight from the Consumer Financial Protection Bureau as well as regulators in all 50 states, and they must follow rigid government lending program rules. Most mortgages are actually originated by non-banks, and many non-banks have acquired or retained the servicing rights to continue assisting borrowers that banks simply aren’t interested in having as customers. Non-banks even cleaned up the mess after the 2008 financial crisis, but as an industry, we get little thanks for that remarkable fact.
One of the more bizarre aspects of the FSOC deliberations and recent academic commentary is the idea that a loan servicer, which is in fact an asset manager, is somehow a systemic risk. In many ways, the handwringing and concern from regulators about mortgage servicing mirrors some of the dialog involving MetLife, which had to exit the mortgage market because of unwarranted concerns about a large insurer that serviced mortgages.
In fact, both insurance companies and loan servicers are essentially asset managers. When they need funding to fix a troubled loan or make a payment, they typically cover the cash need either internally or via fully secured bank lines. Indeed, loan servicers and insurers share a common feature in that they tend to generate vast amounts of free cash flow and liquidity.
When it comes to loan servicers, the FSOC and regulators have spent years fretting about supposed hazards that do not really exist. But let me suggest an idea.
The most important element in reducing risk is ensuring ample liquidity to deal with adverse events that inevitably come to pass. Rather than focusing on non-banks as a source of risk, it would be great if regulators would focus instead on increasing the liquidity available to non-bank financial firms. After all, when you are talking about promoting economic growth, the non-bank financial sector is far more important than government-regulated banks. Without non-bank mortgage firms, volumes in the U.S. mortgage industry would be at least cut in half—a very bad result for the American consumer and prospective homeowner.
For example, FHFA could instruct the Federal Home Loan Banks to open membership to any financial institution that can meet the financial requirements and has eligible mortgage loans. FHLB advances are fully secured, self-liquidating loans, like bank financing. Instead of giving the large commercial banks a monopoly on wholesale funding for the housing market, why not expand the universe of liquidity to non-banks?
We all recognize that non-banks sometime get in trouble and even fail, which is why successful businesses in the industry focus first and foremost on operational excellence and maintaining ample liquidity. The larger non-bank mortgage firms as a group are quite robust and have more than sufficient liquidity and capital to weather any likely economic storm. Indeed, when the economy slows and defaulted mortgages start to once again grow in number, it will be the non-banks that will be on the front lines to address the problem.
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