Yesterday marked an important turning point for housing finance. The Federal Reserve voted on a final Basel III rule that is significantly friendlier to residential housing finance than the earlier proposal. While the FDIC and OCC must still vote on it, the finalization of this rule is important as it opens the door for completion of the qualified residential mortgage rule. The completion of this set of rules will in turn provide clarity to the banking and capital markets, allowing them to pursue expanded mortgage lending as interest rates and profitability rise with the improving economy.
The initial proposal for Basel III would have created a new structure of risk weights on residential mortgages, creating variation in how much capital, a cushion against losses, banks must hold against mortgages based on the size of downpayments. Mortgage insurance could not be used as a compensating factor for low downpayment loans. Thus, banks would have to hold additional capital against loans with downpayments less than 20% as compared to earlier standards. This extra regulatory capital creates a cost for banks as the return is less than would be achieved if it were invested. Banks would pass this cost onto the consumers in the form of higher mortgage rates. One estimate put the cost at an additional 80 to 85 basis points on top of the retail rate for a prime mortgage with 5% downpayment (e.g. if today’s rate on a 30-year FRM with 5% down is 4.5%, then the rate under Basel III would be 5.3%). An increase of that size would have a significant impact on affordability; an impact that would increase over the decade as we move into an environment of higher mortgage rates. Under the finalized rule, there is no change to the capital requirements for mortgages; an important change for the housing industry!
Another important change from the proposed rule is how Basel III will impact smaller banks and community lenders. These entities will be largely exempt from the more onerous regulations imposed on larger and systemically important banks.
However, there remain issues that might affect residential mortgages. Banks will be limited in the amount of mortgage servicing rights that they can hold, reducing its value to banks. Servicing mortgages, collecting payments and passing them onto investors, can be a lucrative business for banks. This change will likely shift much of the servicing to non-bank financial companies and to smaller banks, thus reducing the high concentration of mortgage servicing among the largest banks and enhancing competition and thereby lowering the price of servicing which should result in lower mortgage rates. However, this change could raise the cost in the short term if the non-bank sector cannot expand to match the supply during the transition. The Fed extended the phase-in period for smaller banks, which should help to ameliorate this impact.
In addition, the largest banks which are deemed systemically important financial institutions (SIFI) will still be subject to enhanced accounting and capital requirements. Thus, this change may cause them to shy away from holding assets such as higher LTV mortgages. This could reduce demand for these assets in the near term putting upward pressure on mortgage rates, but shift them to smaller banks in the long term. This change could raise the cost marginally as smaller banks will need to improve oversight to monitor these loans in accordance with Basel III and many have a higher cost of capital than the large banks. However, it might also sync well with efforts to improve and expand the number of securitizers. One academic study found that mortgages which were originated and securitized by the same institutions had lower delinquency rates during the subprime crisis. The authors of the study suggested that the closeness in the production chain allowed for soft information about the borrower or the loan to be passed onto the securitizer, which enabled more accurate pricing and a better ability to manage default risks. Thus, expanding the number of small banks that originate and securitize loans following the FHA-Ginnie Mae model could improve the performance of securitized mortgages without the need for risk retention as suggested in the QRM rule. This model would dovetail with some suggestions for reform of the GSEs.
Finally, the regulators indicated that one reason for not adopting the new risk weighting scheme is the other forthcoming regulations that will impact the housing finance industry. This reference is to the qualified mortgage (QM), which is largely complete, and the qualified residential mortgage (QRM) rules which define the underwriting and origination of loans and the securitization of mortgages, respectively. The QM rule significantly improves underwriting of mortgages and bars several risky product features such as interest only, negative amortization loans, and amortizations longer than 30 years. However, the yet to be decided QRM rule would require a 20% downpament requirement for mortgages that are securitized, which would have a large impact on the home purchase market as 85% of first time buyers who finance their purchase put down less than 20% for downpayment. A Basel III rule with risk weights would effectively have the same impact on low downpayment loans, forcing the QRM rule to do the same or create distortions in the market. Since the Federal Reserve is one of the regulators involved in deciding the QRM regulation, this change to Basel III suggests that regulators may be coming around to recognition of the dangers of a system that requires high downpayments in lieu of stronger underwriting and product controls. Comments by Fed staff suggested that they are leaving this open until after the QM and QRM are decided.
Yesterday’s vote on a final Basel III rule by the Federal Reserve is a second important step in conjunction with the QM rule to bringing clarity to housing finance. The final Basel III rule as voted on by the Fed avoids raising the cost of low downpayment mortgage, though it could modestly raise some rates. Still the change is a boost to the housing industry and bodes well for the final major regulatory hurdle, the QRM rule.