The Silent Crisis in Housing Finance
It's shaping up to be a solid year in the U.S. housing sector. New mortgage originations are up over last year's total of $1.6 trillion in new credit. Some analysts are even predicting that new mortgage volumes could get close to $2 trillion in 2016 due to a modest surge in mortgage refinancing. Furthermore, default rates are continuing to fall on one- to four-family mortgages, mirroring the generally benign credit environment across the banking industry's $9 trillion in total loans.
But beneath this calm surface, the U.S. mortgage industry is facing a crisis. Kroll Bond Rating Agency outlined some of the issues regarding liquidity and profitability in a report last month. The basic problem, however, comes down to over-regulation.
In the wake of the 2008 financial crisis and the passage of the Dodd-Frank law two years later, the composition of the market for making and servicing residential mortgage loans has changed dramatically: the costs for servicers are rising and smaller nonbanks are replacing a dwindling population of bank lenders.
With the creation of the Consumer Financial Protection Bureau, the cost of servicing mortgage loans in the U.S. has dramatically risen. Prior to the crisis, servicing a defaulted mortgage cost less than $500 annually. Today, under the harsh regulatory regime put in place by the CFPB, the cost is closer to $2,500 — and that estimate does not include the extensive delays in foreclosure timelines now built into current state and federal laws. Sure, servicing performing loans is less costly; however, profit margins have also been squeezed so that investors in these businesses are lucky to see single-digit equity returns.
Adding to the mortgage market's predicament is the exit of banks from the single-family mortgage business in favor of multifamily and commercial assets that are not subject to the CFPB mortgage rules. The reasons for the steady exodus of banks from the residential mortgage space are many, but Basel III and U.S. prudential regulations are chief among them. U.S. regulation today is antithetical to mortgage finance generally and imposes restrictions and penalties on this important asset that go against the traditional American view of home ownership as a societal benefit.
As commercial banks migrate away from mortgage lending, the nonbanks that are taking their place have smaller balance sheets and lack an ability to retain the cash balances that once made mortgage servicing an attractive business for bank lenders. Indeed, nonbanks miss roughly half of the potential revenue from a residential mortgage loan because they cannot retain the cash balances. The nonbank must give this cash business to a depository and then borrow the money back with a haircut. This makes it extremely tough to achieve profitability overall.
Officials responsible for oversight of the agency mortgage market are openly concerned about the lack of profitability in the market for mortgage servicing, including both the financial results for servicers and the falling valuations for mortgage servicing rights (MSRs). Many publicly traded mortgage firms are not particularly profitable, and as a result, trade at deep discounts to book value, effectively cutting them off from equity market funding.
Continued writedowns of MSRs, in part due to the application of fair value accounting, have significantly diminished investor confidence in mortgage investments and have limited capital market access for a number of nonbank mortgage companies. The same factors have pushed up the cost of debt financing for short-term needs such as warehouse lines and default advances (provided by banks, of course), and have made it impractical for nonbanks to raise term debt financing even in the high-yield market.
Given the sharp increase in the cost of making and servicing residential mortgage loans, the top four U.S. banks are slowly exiting the government and conforming loan markets. Instead, they are making jumbo loans to more affluent borrowers who have little likelihood of default. Jumbo originations make up more than half of the mortgage loans made by the largest banks. Indeed, there are only three depositories left in the market for the Federal Housing Administration or VA loans and that number is likely to fall further in the next several years.
The U.S. faces the prospect of having the market for government-guaranteed and conforming loans largely in the hands of smaller, less-capitalized nonbanks at a time when depositories are restricting lending to making loans to good customers that are retained on their balance sheets. Indeed, contrary to expectations about growing mortgage lending volumes, current industry trends suggest a gradual reduction in capacity for both lending and servicing that should alarm regulators and policymakers alike.
In the near term, we face the risk of a substantial number of smaller nonbank mortgage lenders and servicers exiting the housing market, either voluntarily or via bankruptcy. In the event of a default of a nonbank mortgage servicer, it seems pretty clear that it will be very difficult to find buyers for these businesses — much less raise new capital and provide the indemnification required to operate in the agency markets. Secured bank lenders will liquidate the collateral held against credit lines. The unsecured creditors may simply walk away, leaving the CFPB and other regulators to figure out who will service these unprofitable loan portfolios.
In the medium term, it is pretty clear that mortgage servicing fees are going to need to rise by about 100% in order to help mortgage servicers make up some of the profitability lost since 2010.
If we, as Americans, want a healthy mortgage industry that is compliant with the law and able to meet the needs of consumers, then we must adjust the economics of this heavily regulated business to allow investors to meet their cost of capital. Otherwise, nobody will want to be in this business. And as mortgage servicing fees rise — and they will — it will be the consumer who must pay the freight for the various benefits of regulation under Dodd-Frank.
Christopher Whalen is senior managing director and head of research at Kroll Bond Rating Agency. He can be reached @rcwhalen.