Ginnie Mae’s recent announcement of its financial eligibility requirements for single-family applicants and issuers represents a major step forward in reducing potential systemic risk to the housing finance system.
Since the financial crisis of 2008, a significant structural change has occurred which, over time, threatens the long-term stability of housing finance. The growth in the number of non-bank financial institutions that originate and service mortgage loans and the concentration of their industry is an unintended consequence of the decline in mortgage activity by depository corporations and has for some time been a gaping hole in the systemic risk management for the sector.
Non-banks, for example, account for more than 87% of all Ginnie Mae creations and more than two-thirds of GSE creations. The presence of non-banks has allowed the housing finance system to heal from the crisis without further disrupting markets, however, these companies generally present significantly higher counterparty risk for Ginnie Mae.
Ginnie Mae is exposed to counterparty risk in several ways. In the event of an issuer default, Ginnie Mae is responsible for transmitting payments to Ginnie MBS investors. In the event of a repairer failure, Ginnie Mae could experience service transfer issues as well as a host of other operational challenges.
For years, Ginnie Mae has been sorely under-resourced, making the agency extremely vulnerable to the failure of a major issuer or servicer. If that happened, the repercussions on the market would be immense.
Non-banks specializing in mortgages are collectively at risk due to a number of factors; a monoline business model that generates greater overall mortgage cycle earnings volatility than more diversified custodians, greater reliance on less stable sources of liquidity, larger investments in mortgage servicing rights (MSR) assets ) riskier and a lack of federal regulatory oversight for safety and soundness.
Federal safety and soundness regulatory requirements for custodians, including risk-based capital and liquidity ratios, are important for the banking industry in general and even more so for larger banks. As a result, these institutions are subject to scrutiny of their risk management practices, governance and culture, which, as we learned during the last crisis, were key ingredients in taking excessive risks.
In the aftermath of the crisis, banks were forced to raise considerable capital, revamp their risk management functions, and significantly improve their mortgage underwriting and servicing practices and infrastructure. To be fair, this level of regulatory oversight was necessary due to banks’ criticality to the financial system and their potential exposure. FDIC a through federal deposit insurance. However, the exposure to non-bank counterparty risk for Ginnie Mae is very real and critical to contain.
To shed light on some of this non-bank counterparty risk, consider these statistics. The top 10 MSR holders represent 62% of the total MSR for loans guaranteed by Ginnie MBS. Only two of these 10 are custodians. And the top 30 companies account for 83% of those MSRs.
MSRs are notoriously difficult to value and are treated as a mark-to-model Level 3 asset. Estimation of value is highly dependent on a multitude of assumptions such as the discount rate to be used as well as models for projecting interest rates and estimating voluntary and involuntary prepayment rates over time. In a market where interest rates can sometimes move rapidly, MSRs lead to significantly higher balance sheet volatility and are even more of a concern when they represent a significant portion of a company’s asset base, such as is the case for several large non-banks.
It should come as no surprise, then, that Basel capital requirements impose a 250% risk weighting on bank MSRs not deducted from Common Equity Tier 1 (CET1) capital.
It is well established that the credit profile of Ginnie Mae borrowers is riskier than for GSE loans. On two important dimensions of credit, the median FICOs and debt-to-income ratios (DTIs) of loans originated by nonbanks were worse than custodians.
Additionally, in an empirical study of bank and non-bank mortgage risks, I found that controlling for all other factors used to underwrite a borrower, loans originated between 1999 and 2015 by non-banks were 1.5 to 2.2 times more likely to be 90 days late or worse. than the other initiators. While no specific factor can be attributed to this result, it may reflect issues with a lack of federal safety and soundness oversight that may manifest in loan manufacturing quality issues over time. .
We saw this with several large non-bank institutions during the 2008 crisis. The combination of a higher overall credit risk profile for Ginnie Mae borrowers than GSEs and higher credit risk attributes for borrowers with loans originated by non-banks, further highlights the need to ensure strong net worth, liquidity and risk-based capital requirements for these businesses.
Ginnie Mae’s revised financial eligibility requirements provide a sensible way to manage their counterparty risk in a consistent way that creates a more level playing field for all market participants.
Some will no doubt argue that tighter liquidity, net worth and capital requirements will reduce the size of the market and thereby impose unnecessary hardship on potential borrowers. Achieving a balance between fair access to the mortgage market and prudent risk management practices is always an issue when developing new industry rules.
When the GSEs and FHFA announced years ago that they would impose risk-based capital requirements on private mortgage insurers, similar concerns have been raised, but over time these requirements have proven beneficial for GSEs, mortgage insurance companies and the market as a whole to strengthen a critical segment of the housing finance system.
Non-banks served the housing finance system well in the years following the 2008 financial crisis and their importance in originating and servicing mortgages is recognized. Their monumental success in this area, however, poses a considerable risk to Ginnie Mae and the housing finance system in general.
By tightening their new financial eligibility requirements, Ginnie Mae has taken a step in the right direction to reduce their exposure to counterparty risk as well as systemic risk to the housing finance system.
Clifford Rossi is a professor of practice and executive-in-residence at the Robert H. Smith School of Business at the University of Maryland. He has 23 years of industry experience, having held several senior risk management positions with some of the largest financial institutions.
This column does not necessarily reflect the opinion of the editorial staff of HousingWire and its owners.
To contact the author of this story:
Clifford Rossi at [email protected]
To contact the editor responsible for this story:
Sarah Wheeler at [email protected]