mortgage markets m - morrison & foerster
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012 M
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Impact of Bank Capital
Proposals on the Residential
Mortgage Markets
August 2012
Kenneth E. Kohler
Anna T. Pinedo
Morrison & Foerster LLP
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Introduction
On June 12, 2012, the Federal banking agencies (the OCC, Federal Reserve Board and FDIC) (the “Agencies”) formally proposed three sets of significant changes to the U.S. regulatory capital framework:
The Basel III Proposal, which applies the Basel III capital framework to almost all U.S. banking organizations
The Standardized Approach Proposal, which applies certain elements of the Basel II standardized approach for credit risk weightings to almost all U.S. banking organizations
The Advanced Approaches Proposal, which applies changes made to Basel II and Basel III in the past few years to large U.S. banking organizations subject to the advanced Basel II capital framework
The original deadline for comments on all three proposals was Sept. 7, 2012. In early August, the Agencies extended the comment deadline to October 22, 2012
This presentation examines the likely impacts of the bank capital proposals on U.S. residential mortgage markets
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Impacted Aspects of Mortgage Business
The proposals address regulatory capital treatment of: Single-family (1-4 unit) mortgage loans
Residential construction loans
Multi-family mortgage loans
Mortgage-backed securities (MBS)
Mortgage servicing rights (MSRs)
Gain on sale of mortgage loans and MBS
The proposals principally affect mortgage-related assets held in bank portfolios – not mere origination
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Summary of Likely Impacts
The proposals encourage conservatively underwritten, traditional
mortgage loans
The proposals provide incentives for banks to hold conservatively underwritten,
plain vanilla product – and penalize banks for holding mortgage loans deemed by
the regulators to be more risky
The proposals do not address origination, so banks desiring to offer a broader
range of products to borrowers who need more flexible payment options or lower
downpayments, for example, can still make such loans, but are pushed to sell them
in the secondary market shortly following origination
Even so, banks constitute a substantial portion of the secondary market, so non-
traditional products will have fewer purchasers – likely affecting price and liquidity
of non-traditional products
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Summary of Likely Impacts (cont’d)
Banks with excess capital (regardless of size) will have more flexibility to offer non-
traditional loan products if they choose to do so
The few large, multinational banks subject to the Advanced Approaches may have
more flexibility than the vast majority of banks subject to the Standardized Approach
with regard to holding non-traditional loan products
Advanced Approaches banks must adopt the most restrictive of the Standardized Approach
and Advanced Approaches methodologies
Advanced Approaches banks may still have room to apply internal analyses that non-traditional
products do not require the draconian capital haircuts that Standardized Approach banks must
apply
At a minimum, the large multinational banks will likely have a competitive advantage in the loan
products they can offer, if they choose to do so
The restrictive treatment of MSRs will discourage banks from selling loans
with servicing retained, and will lead many banks to try to sell MSRs The new rules will encourage whole loan sales with servicing released
To the extent there is not a robust secondary market for both loans and servicing, banks will
have little incentive to lend beyond the level of loans they can comfortably hold in portfolio
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Summary of Likely Impacts (cont’d)
The proposals do nothing to encourage securitization as a take-out for loans originated by banks While the changes from the current rules for securitizations are not as substantial
as the changes for whole loans, at the margin they are more restrictive than current rules
Regulatory and accounting changes implemented since the financial crisis – together with the continued weak housing market – have virtually shut down the new issue RMBS market
All things being equal, the proposals suggest additional opportunities for non-bank lenders, securitizers and servicers to assume a larger role in the residential mortgage markets. Examples: PHH Mortgage and Quicken Loans (originators)
Nationstar and Ocwen (servicers)
Redwood Trust and Pennymac (mortgage REITs)
The proposals will likely have a substantial negative impact on the mortgage insurance industry.
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Summary of Likely Impacts (cont’d)
Policy Implications
Availability of credit
First-time buyers
Non-traditional or credit-challenged borrowers who require flexible terms
Fair lending
Recycling of mortgage funds for lending
Proposals provide little or no incentive for banks to originate beyond their ability
to hold loans in portfolio
When the restrictive and capital treatment of residential lending is added to
other restrictive developments such as credit risk retention and FAS 166/167,
unclear whether many banks will even consider residential mortgage lending to
be a profitable activity worth pursuing
Further negative effect on the thrift/savings and loan industry
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Summary of Likely Impacts (cont’d)
Relationship to Other Regulatory Initiatives and Industry
Developments
Credit risk retention
“Qualified mortgage” definition
FDIC Safe Harbor
Servicing reform
Accounting rules
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Applicability
Basel III Proposal
All U.S. banks that are subject to minimum capital requirements, including Federal
and state savings banks.
Bank and savings and loan holding companies other than “small bank holding
companies” (generally bank holding companies with consolidated assets of less
than $500 million).
Top-tier domestic bank and savings and loan holding companies of foreign banking
organizations.
Does not apply to foreign banking organizations, but does apply (with
a few exceptions) to U.S. bank subsidiaries, and top-tier U.S. bank
holding company subsidiaries, of foreign banking organizations.
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Applicability (cont’d)
Standardized Approach Proposal
Generally the same as for Basel III Proposal, except does not apply to Advanced
Approaches banks
Advanced Approaches Proposal
Covers banking organizations currently subject to “advanced approaches” rules or
market risk rules under Basel II
Consolidated assets ≥ $250 billion, or
Total consolidated on-balance sheet foreign exposures ≥ $10 billion, or
Aggregate trading assets and trading liabilities equal to 10% or more of
total assets or at least $1 billion
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Basel III
Effective Dates/Transitional Periods
Minimum Tier 1 capital ratios – 2013-2015
Regulatory capital adjustments and deductions – 2013-2018
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Mortgage Risk Weights The most direct impact is from the changes to risk-weighting for
residential mortgage assets under the Standardized Approach
These changes will apply to the vast majority of U.S. banks
Even Advanced Approaches banks must apply a “minimum common denominator”
test—they must calculate capital requirements under both approaches and adopt
the most restrictive
The Standardized Approach will be effective Jan. 1, 2015, with banks
permitted to opt in earlier
No change to risk-weighting for government-supported loans
Loans unconditionally guaranteed by U.S. government or agencies – 0% risk
weight
Loans conditionally guaranteed by U.S. government or agencies – 20% risk weight
Loans guaranteed by Fannie Mae or Freddie Mac – 20% risk weight
However, major changes to risk-weighting for non-governmental
single-family first lien mortgage loans, currently risk-weighted at 50%
(with limited exceptions)
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Mortgage Risk Weights (cont’d)
Proposal includes a matrix under which the risk-weighting of a
residential first mortgage loan depends principally on two variables:
Loan terms and underwriting: Category 1 (traditional) vs. Category 2 (non-
traditional)
Term
Payment schedule
Documentation
Loan-to-value (LTV) ratio
Eight sets of risk weights—generally higher than current rules
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Mortgage Risk Weights (cont’d)
LTV Ratio (%) Category 1 Risk Weight Category 2 Risk Weight
<60 35% 75%
>60, <80 50% 100%
>80, <90 75% 150%
>90 100% 200%
Residential mortgage risk weight chart
(Applies to single-family mortgage loans not guaranteed by U.S. government, agency or GSE)
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Risk-Weights: LTV Rules
The “loan” component of LTV ratio (numerator) determined using
maximum loan amount
HELOCs – use total credit line
Closed-end mortgages – use fully funded outstanding principal amount
Junior liens -- include total funded and unfunded commitments on senior loans in
addition to junior loan amount
The “value” component of LTV (denominator) is the lesser of (i)
acquisition cost or (ii) appraised value of property at origination (or
estimated value if an appraisal is not required)
Private mortgage insurance (PMI) not taken into account in
determining LTV ratio
LTV ratio to be updated when a loan is modified or restructured
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Risk-Weight Categories Two categories – “Category 1” and “Category 2,” with Category 2 loans
carrying at least twice the risk-weighting of a Category 1 loan with the same
LTV
Category 1 loans are narrowly defined as extremely conservatively
underwritten, “plain vanilla” traditional loans
first liens only
maximum 30-yr. term
no principal deferral, negative amortization or balloon payments
No “low-doc” or “no-doc” loans
Any loan not satisfying Category 1 tests is a Category 2 loan
Federal regulators are authorized to re-assign a Category 1 loan as a
Category 2 loan if they conclude loan is not prudently underwritten; but no
authority to upgrade a loan’s category from Category 2 to Category 1
Category 1 definition is very close to the definition of “qualified mortgage,” or
“QM,” currently under discussion in proposed credit risk retention regulations
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Risk-Weight Categories (cont’d) A Category 1 loan must satisfy the following criteria:
the term of the loan may not exceed 30 years
the mortgage loan must provide for regular periodic principal payments but may not
provide for negative amortization, deferral of payments of principal or balloon
payments
the annual rate of interest on the loan may increase no more than two percentage
points in any 12-month period and no more than six percentage points over the
term of the loan in the case of an adjustable rate loan
the standards used to underwrite the loan must: (i) take into account all of the
borrower’s obligations; and (ii) result in a conclusion that the borrower is able to
repay the loan using: (A) the maximum interest rate that may apply during the first
five years after the closing date of the loan; and (B) the maximum possible
principal amount over the life of the loan
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Risk-Weight Categories (cont’d)
the determination of the borrower’s ability to repay the loan must be based on
documented, verified income
for a first-lien HELOC, the borrower must qualify using principal and interest
payments based on the maximum contractual exposure under the terms of the
HELOC
the loan may not be 90 days or more past due or on non-accrual status
the mortgage loan may not be a junior lien loan except where the same institution
holds both the first lien loan and the junior lien loan, with no intervening liens (in
which case the junior loan may be treated as a Category 1 loan if each loan has
the characteristics of a Category 1 loan)
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Loans Sold with Recourse
Under current rules, mortgage loans sold with recourse are
converted to an on-balance sheet credit equivalent amount 120 days
after sale.
The Standardized Approach Proposals eliminates the 120-day
“grace period.”
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Restructured and Modified Loans
Current Capital Treatment
Restructured or modified mortgage loans risk-weighted at 50% or 100%
Loans modified under HAMP retain original risk weight classification
Proposed Capital Treatment (Standardized Approach)
Restructured or modified loans are classified based on terms of the new loan
Category 1—100% risk weight
Category 2—200% risk weight
If LTV is updated, loan can be classified as if it were a newly originated loan
Loans modified solely under HAMP retain their original risk weight classification
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Multifamily Mortgage Loans
Current Capital Treatment
Multifamily loans are risk-weighted at 100% for the first year. Thereafter, their risk
weight drops to 50% if certain conditions are met:
All P&I payments must have been timely made for the first year
The loan must amortize over a period of 30 years or less, and the term of the
loan cannot be less than 7 years
Annual NOI must exceed annual debt service by 20% for a fixed rate loan or
15% for an adjustable rate loan
Proposed Capital Treatment (Standardized Approach)
Same treatment as under current rule (100% first year, 50% if conditions are met),
plus an additional condition:
The LTV ratio does not exceed 80% for a fixed rate loan or 75% for an
adjustable rate loan
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Residential Construction Loans
Current Capital Treatment
Construction loans for one-to-four family residential pre-sold properties generally
risk-weighted at 50% if certain conditions are met
Proposed Capital Treatment (Standardized Approach)
Current treatment continues with additional conditions, including:
Builder must incur at least the first 10% of direct costs of construction (including
land) before the builder may draw on the loan
Construction loan amount may not exceed 80% of the sales price of the pre-
sold residence
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Risk-Weighting Under Advanced
Approaches
Unlike Standard Approach, very little change to current risk-
weighting for residential mortgage loans under Advanced
Approaches
Advanced Approaches still rely on determination of probability of default and
probable loss if a default, based on the bank’s internal ratings-based system
probability of default based on estimated long-term average one-year default
rate for similar loans
floor of 10% on probable loss of a default for loans not guaranteed by a
government or agency
The proposal would remove a requirement under current advanced
approach that probability of default be adjusted upward to account
for effects of seasoning
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Securitization Exposures
Standardized Approach Operational requirements
Due diligence
Calculation of exposures
Off-balance sheet
Repo-style transactions
On-balance sheet
Risk-weighting alternatives
SSFA Approach
20% floor
Gross-Up Approach
Other
Treatment of gain-on-sale
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Securitization Exposures (cont’d)
Advanced Approaches Changes to Securitization Exposures:
New definition of resecuritization exposures
Broadening of the definition of securitization exposures, while excluding certain traditional investment firms from definition
Removal of ratings-based and internal assessment approaches for securitization exposures; new hierarchy for exposure treatment
General use of supervisory formula approach (“SFA”) or its simplified version of SFA (“SSFA”) in calculating capital requirements for securitization exposures, as well as guarantees and credit derivatives referencing such exposures
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Securitization Exposures (cont’d)
Revised Capital Treatment of Certain Exposures
Exposures affected: certain securitization exposures (CEIOs, high-risk
exposures, low-rated exposures); eligible credit reserves shortfall; certain failed
capital markets transactions
New treatment – assigned a general 1,250 percent risk-weighting instead of
deduction from capital (dollar-for-dollar capital)
Market Risk Capital Rule: Federal and state savings banks and their holding companies that meet the
market risk capital rule threshold criteria would become subject to the market
risk capital rule
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Capital Treatment of MSRs
The proposals substantially change the capital treatment of MSRs for
the worse, and are likely to cause banks to shun the retention of
MSRs in future loan sales and securitizations
Current treatment
Intangible assets, including MSRs, limited to 100% of tier 1 capital
MSRs valued at lesser of 90% of FMV and 100% of unamortized BV
Non-deducted MSRs assigned a 100% risk weighting
Proposed treatment
MSRs capped at 10% of common equity tier 1 capital, with any excess deducted
from common equity tier 1 capital
MSRs, deferred tax assets and investments in common stock of other financial
institutions subject to an aggregate cap of 15% of common equity tier 1 capital
To the extent not deducted from common equity tier 1 capital, MSRs assigned a
250% risk-weighting
MSRs valued at 90% of FMV, marked-to-market quarterly
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Capital Treatment of Gain-on-Sale
The Basel III proposal penalizes the use of gain-on-sale
accounting by requiring gain-on-sale associated with a
securitization exposure to be deducted from common
equity tier 1 capital This rule reflects the continuing view that the “origination for sale” model was a
major factor leading to the Financial Crisis
The restriction applies only to an increase in the equity capital of a banking
organization resulting from the consummation or issuance of a securitization (other
than an increase resulting from the receipt of cash)
The limitation does not apply to gain-on-sale from the sale of whole loans
Origination-for-sale has fallen into disfavor in any event, in part because of more
restrictive accounting rules
This provision limits the incentive for banks to sell loans to recycle funds for
mortgage lending by restricting one of the most common forms of “recycling”
August 2012
1 NY2-706484
Proposed Capital Rules – Mortgage-Related Issues
I. Basel II – Capital Components and Deductions Current Rules Proposal Components Tier 1 capital Tier 1
• Common stock • Shareholders equity • Perpetual preferred
Tier 1 common equity capital • Common • Retained earnings • AOCI Additional Tier 1 capital • Noncumulative perpetual
preferred Tier 2 capital • Subordinated debt • Cumulative perpetual preferred
• Subordinated debt Deductions After-tax gain-on-sale associated with securitizations
• No deduction or adjustment • Deduct from common equity Tier 1 capital
Credit-enhancing interest-only strips reflecting after-tax gain-on-sale
• Excess of amounts over 25% of Tier 1 capital deducted
• Deduct from common equity Tier
Mortgage servicing assets Greater of deduction representing: • Excess of sum of MSA, non-
mortgage service assets, and purchased credit card relationships over 100% of Tier 1 capital
• 10% of fair market value MSAs
Three stages • Amount that exceeds 10% of
common equity Tier 1 capital must be deducted from CET1 • Sum of remaining amount
of MSAs and DTAs and (after their own 10% deductions) that exceeds 17.65% of adjusted CET1 must be deducted from CET1
• At a minimum, 10% of fair market value of MSAs must be deducted from CET1
II. Risk Weights for Mortgage Loans Current Rules Proposal First-lien mortgages • Amount to be risk-weighted is
unpaid principal balance • First-lien residential mortgage
“made in accordance with prudent underwriting standards:” 50%
• All other residential mortgages: 100%.
• No change in risk weight for modified or restructured loans
• Amount to be risk-weighted is unpaid principal balance
Risk weights depend on two sets of factors: category and loan-to-value ratio. • Category 1
- 30-year maturity or less - Regular periodic payments
August 2012
2 NY2-706484
Current Rules Proposal • Past-due loans: 100% - Underwriting takes into
account all of borrower’s obligations
- Conclusion that borrower able to repay based on (i) maximum interest rate in first five years and (ii) original loan amount is maximum balance over the life of the loan
- Interest rate may adjust no more than 2% in twelve-month period and no more than 6% over life of the loan
- Borrower’s income documented and verified
- Loan is not more than 90 days past due or on non-accrual status
- Not a junior-lien loan. • Category 2:
- Fails to meet any Category 1 condition
- All principal payment optional loans
- All loans with balloon payments
- All “low-doc” and “no-doc” loans
LTVs – four tiers:
LTV Cat. 1 Cat. 2 <60% 35% 100% 60-80% 50% 100% 80-90% 75% 150% >90% 100% 200%
• Value is the lesser of the actual
acquisition cost or appraised value at origination or restructuring
HELOCs • 100% • May be treated as Category 1 if
underwriting is based on maximum principal and interest rate payments.
Junior-lien mortgages
• 100% • Category 2, but - Holder of both first- and
junior-lien mortgages, with no intervening mortgagee, may treat both loans as Category 1, if terms meet
August 2012
3 NY2-706484
Current Rules Proposal Category 1 requirements
- Loan amount for determining LTV ratio is outstanding balance plus maximum contractual principal amounts of more senior-lien mortgage loans, as of date junior-lien mortgage was originated
Restructured or modified mortgages
• Original risk weight: 50% or 100%
• Loan modified under HAMP
retains original risk weight
• Assigned to Category 1 or 2 based on new terms and conditions
• If new appraisal is performed, mortgage is risk-weighted by LTV ratio.
• If no new appraisal: - Category 1: 100% - Category 2: 200%
• Loan modified solely under
HAMP retains original risk weight
FHA and VA loans • 0% • 0%
Mortgage loans sold with recourse
• After 120 days, converted to on-balance sheet assets at 100%
• Immediately converted to on-balance sheet assets at 100%
• No 120-day grace period
Pre-sold residential construction loans
• 50%, if - Firm contracts - Purchaser has obtained
commitment for permanent financing
- Purchaser has made substantial earnest money deposit
- Underwriting requirements
• 50% under largely the same conditions as current rule, but specifically: - Prudent underwriting - Purchaser is an individual
intending to occupy as a residence
- Legally binding written sales contract
- Firm written commitment for permanent financing
- Earnest money must be at least 3%
- Earnest money deposit held in escrow
- Builder must incur at least first 10% of direct costs
- Loan may not exceed 80% of sales price
- Loan not more than 90 days past due or on non-accrual status
• If purchase contract is
August 2012
4 NY2-706484
Current Rules Proposal cancelled, 100% risk weight
Past-due mortgages
• 100% • Loan becomes a Category 2 loan and is risk-weighted by LTV tier
Multifamily mortgages
• 100% in first year • 50%, if
- All principal and interest payments on time in preceding year
- Amortization not to exceed 30 years
- Original maturity not less than seven years
- NOI in previous fiscal year not less than 120% of annual debt service (115% in case of adjustable rate loan
• 100% in first year • 50%, if
- Same conditions as current rule, plus
- Original LTV on loan may not exceed 80% for fixed-rate loan or 75% for adjustable rate loan
Mortgage servicing assets • Together with other servicing assets and purchased credit card relationships, capped at 100% of Tier 1 capital. Excess to be deducted.
• Non-deducted amount risk-weighted at 100%.
• On stand-alone basis, capped at 10% of bank’s adjusted common equity tier 1 capital. Excess to be deducted from common equity
• Non-deducted amount risk-weighted at 250%.
III. Securitization Exposures Current Rules Proposal Qualitative Requirements
• Implicit—as necessary for accounting purposes and legal opinions
• Operational requirements - Due diligence - Traditional securitizations - Synthetic securitizations - Clean-up calls
Exposure amounts
• Face amount • Off-balance sheet - Notional amount - Special calculation for
eligible ABCP liquidity facility, depending on whether SSFA applies
• Repo-style transactions - OTC derivative weights - Collateralized transaction
weights • On-balance sheet - Carrying value
August 2012
5 NY2-706484
Current Rules Proposal Risk-weighting options • No explicit floor
• Rating agency classifications • Gross-up approach
• 20% floor • Simplified supervisory formula
approach • Gross-up approach • Alternatives
Mortgage servicing assets • 100% on amount not deducted
from Tier 1 capital • 250% on amount not deducted
from common equity Tier 1 capital
Interest-only strips
• Non-credit enhancing I/O strip - If two or more external
ratings, weighted according to lower rating
- Otherwise, 100% • Dollar-for-dollar on amount of
credit-enhancing I/O strip not deducted from Tier 1 capital
• Interest-only MBS: 100% • 1,,250% (dollar-for-dollar) on
credit-enhancing interest-only strip that does not constitute an after-tax gain-on-sale
Credit-risk mitigants • Collateral • Credit derivatives • Guarantees
• Same set of mitigants, but substantially new definitions and requirements
• Collateral - Simple approach - Haircut
• Credit derivative - Eight conditions
• Guarantees - Eligible guarantors
expanded to include Contacts Anna T. Pinedo New York 212-468-8179 [email protected]
Dwight Smith Washington, D.C. 202-887-1562 [email protected]
Kenneth E. Kohler Los Angeles 213-892-5815 [email protected]