The Future of Mortgage Finance:QM, QRM and Basel III

Jay Brinkmann*Chief Economist and

SVP, Research & Education

*Comments and opinions are solely those of the presenter and do not necessarily represent official positions of the MBA or its members.

2

Components of Mortgage Finance Industry

• Borrowers• Originators/Loan Officers• Institutions, charter-type and size• Secondary market execution versus portfolio• Servicing

Each is being impacted in a major way, but by far more than just QM, QRM and Basel III .

3

Borrowers

• Credit tightened because big increases in loss severity make any defaults very expensive.

• Current and future drivers of severity• Liability under ability to repay provisions of QM for non-

safe harbor loans. Legal costs plus potential legal damages.

• Defaulted loan servicing costs under new guidelines.• Greatly increased foreclosure timelines in some states.• Pattern of buy-back demands from GSEs and other

investors.

Due to 150 bp over APR limit on risk-based pricing, few high risk loans will be made to avoid going above the QM safe harbor trigger.

4

Credit Scores on Completed Transactions Still Well Above Normal

January

-07

April-07

July-07

October-

07

January

-08

April-08

July-08

October-

08

January

-09

April-09

July-09

October-

09

January

-10

April-10

July-10

October-

10

January

-11

April-11

July-11

October-

11

January

-12

April-12

July-12

October-

12620

630

640

650

660

670

680

690

700

710

720

Average FICO score – FHA endorsements

Purchase Average FICO Score (Oct) Refi Average FICO Score (Jan)

In addition:

• Fannie Mae Weighted Average FICO on Acquisitions (Q3 2012): 761

• Freddie Mac Weighted Average FICO on Acquisitions (Q3 2012): 762

• Last Sequoia Deal: 771

Sources: FHA Monthly, Fannie Mae and Freddie Mac Credit Supplements, S&P

5

Credit Pricing vs. Underwriting

Source: Fannie Mae LLPA Matrix

6

Homebuyers Predominantly Served by Government Housing Programs

7

2011 HMDA Data – Purchase Originations

Source: FFIEC, MBA NOTE: Retail/Broker Originations for Home Purchase and Refinance – Secured by A First Lien Only, No Multifamily,

8

Challenges for Institutions

• Higher operating costs driving out smaller lenders and reducing economies of scale for larger lenders

• Effectiveness of different business models in a market dominated by purchase mortgages

• Regulatory and liability risks to bank business caused by mortgage business

• Reputation risks from disparate impact claims and other discrimination allegations

• Basel III

9

10

Retail Apps per Underwriter per Month

188

152

134

165

126

103

124 113

75

60

193

120

102

124

99

112

82 94

72

57

0

50

100

150

200

250

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Large Lenders Small Lenders

Source: MBA/STRATMOR Peer Group Survey

11

2011Data Show Net Exit from Business

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 20116,500

7,000

7,500

8,000

8,500

9,000

9,500

Number of Institutions Reporting HMDA Data

Source: FFIEC

12

Basel III Overview

Main Issues

• Increased capital requirements• Increased risk weights• Treatment of MI• Treatment of mortgage servicing rights

13

Basel III Risk Weights for Residential Mortgages

LTV Category 1 Category 2(QM?) (non-QM?)

60 % or less 35% 100%

80% to 60% 50% 100%

80% to 80% 75% 150%

Greater than 90% 100% 200%

14

Basel III Impact on Mortgages Held in PortfolioFunding examples for 95 LTV mortgage with MI:

Category 1 Mortgage Category 2 Mortgage

Mortgage 100$ Mortgage 100$

Funded with Cost Funded with CostDeposits 96$ 2% Deposits 96$ 2%Equity 4$ 15% Equity 4$ 15%

Total cost 2.52% Total cost 2.52%

Under Basel III: Under Basel III:

Funded with Cost Funded with CostDeposits 92$ 2% Deposits 84$ 2%Equity 8$ 15% Equity 16$ 15%

Total cost 3.04% Total cost 4.08%

Increase: 0.52% Increase: 1.56%

15

Impact of Basel III on Mortgage Servicing RightsBasel III will make it very expensive for banks to hold mortgage servicing rights:

• MSRs more than 10% of Tier 1 capital must be deducted from equity. Given fluctuations in MSR values due to interest rates, the size of this deduction is unknown from quarter to quarter.

• Remaining MSRs carry a 250% risk weight.• MSRs plus most deferred tax items are limited to 15% of

Tier 1 capital.

16

Impact of Basel III on Banks with MSRs

AssetsRisk

Weights Deductions from Equity

Risk Weights

Cash 15,000$ 0% 15,000$ 0%Residential mortgages 200,000$ 50% 200,000$ 100%Consumer loans 50,000$ 100% 50,000$ 100%Commercial loans 100,000$ 100% 100,000$ 100%Mortgage servicing rights 15,000$ 100% (11,000)$ 4,000$ 250%Other assets 10,000$ 100% 10,000$ 100%

Total assets 390,000$ 379,000$

LiabilitiesDeposits 345,000$ 345,000$ Other Liabilities 5,000$ 5,000$

Equity 40,000$ (11,000)$ 29,000$

Tier 1 capital: 40,000$ Tier 1 capital: 29,000$ Risk-weighted assets: 275,000$ Risk-weighted assets: 370,000$

Risk-based capital ratio: 14.5% Risk-based capital ratio: 7.8%

Under Basel IIIUnder Current Rules

17

QRM/Risk Retention

• QM is designed to protect borrowers, QRM is designed to protect investors.

• The retained risk requirements are still to be determined but will be based on the investors (Fannie, Freddie and FHA loans are exempt) and the credit risk of the loans.

• Strong industry push to make QM and QRM guidelines the same.

• The big problem with QRM is that investors set the credit criteria and originators will have to hold capital against risk models and risk appetites they do not control.

• The result will be a further narrowing of credit and significant impediment to the resumption of a private label market for mortgage-backed securities.

18

Conclusions

• Increasing operational and compliance complexity favor big banks, BUT

• Smaller independents have been better at originating purchase mortgages, BUT

• The regulatory complexities and potential QM liabilities and increased GSE &FHA fees point toward putting more loans into portfolio, BUT

• The increased Basel III capital requirements (and interest rate risk of long-term, fixed rate mortgages) make that expensive, BUT

• Basel III requirements on MSRs and potential QRM retained risk requirements make securitization a problem, BUT

• The Justice Department and HUD will sue you if you don’t make the loan.