Nonbanks and The Next Crisis

 

 

Researchers at the Fed and UC Berkeley have posted Liquidity Crises in the Mortgage Markets. The authors conclusions are particularly troubling:

The nonbank mortgage sector has boomed in recent years. The combination of low interest rates, well-functioning GSE and Ginnie Mae securitization markets, and streamlined FHA and VA programs have created ample opportunities for nonbanks to generate revenue by refinancing mortgages. Commercial banks have been happy to supply warehouse lines of credit to nonbanks at favorable rates. Delinquency rates have been low, and so nonbanks have not needed to finance servicing advances.

In this paper, we ask “What happens next?” What happens if interest rates rise and nonbank revenue drops? What happens if commercial banks or other financial institutions lose their taste for extending credit to nonbanks? What happens if delinquency rates rise and servicers have to advance payments to investors—advances that, in the case of Ginnie Mae pools, the servicer cannot finance, and on which they might take a sizable capital loss?

We cannot provide reassuring answers to any of these questions. The typical nonbank has few resources with which to weather these shocks. Nonbanks with servicing portfolios concentrated in Ginnie Mae pools are exposed to a higher risk of borrower default and higher potential losses in the event of such a default, and yet, as far as we can tell from our limited data, have even less liquidity on hand than other nonbanks. Failure of these nonbanks in particular would have a disproportionate effect on lower-income and minority borrowers.

In the event of the failure of a nonbank, the government (through Ginnie Mae and the GSEs) will probably bear the majority of the increased credit and operational losses that will follow. In the aftermath of the financial crisis, the government shared some mortgage credit losses with the banking system through putbacks and False Claims Act prosecutions. Now, however, the banks have largely retreated from lending to borrowers with lower credit scores and instead lend to nonbanks through warehouse lines of credit, which provide banks with numerous protections in the event of nonbank failure.

Although the monitoring of nonbanks on the part of the GSEs, Ginnie Mae, and the state regulators has increased substantially over the past few years, the prudential regulatory minimums, available data, and staff resources still seem somewhat lacking relative to the risks. Meanwhile, researchers and analysts without access to regulatory data have almost no way to assess the risks. In addition, although various regulators are engaged in micro-prudential supervision of individual nonbanks, less thought is being given, in the housing finance reform discussions and elsewhere, to the question of whether it is wise to concentrate so much risk in a sector with such little capacity to bear it, and a history, at least during the financial crisis, of going out of business. We write this paper with the hope of elevating this question in the national mortgage debate. (52-53)

As with last week’s paper on Mortgage Insurers and The Next Housing Crisis, this paper is a wake-up call to mortgage-market policymakers to pay attention to where the seeds of the next mortgage crisis may be hibernating, awaiting just the right conditions to sprout up.

Mortgage Insurers and The Next Housing Crisis

photo by Jeff Turner

The Inspector General of the Federal Housing Finance Agency has released a white paper on Enterprise Counterparties: Mortgage Insurers. The Executive Summary reads,

Fannie Mae and Freddie Mac (the Enterprises) operate under congressional charters to provide liquidity, stability, and affordability to the mortgage market. Those charters, which have been amended from time to time, authorize the Enterprises to purchase residential mortgages and codify an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families. Pursuant to their charters, the Enterprises may purchase single-family residential mortgages with loan-to-value (LTV) ratios above 80%, provided that these mortgages are supported by one of several credit enhancements identified in their charters. A credit enhancement is a method or tool to reduce the risk of extending credit to a borrower; mortgage insurance is one such method. Since 1957, private mortgage insurers have assumed an ever-increasing role in providing credit enhancements and they now insure “the vast majority of loans over 80% LTV purchased by the” Enterprises. In congressional testimony in 2015, Director Watt emphasized that mortgage insurance is critical to the Enterprises’ efforts to provide increased housing access for lower-wealth borrowers through 97% LTV loans.

During the financial crisis, some mortgage insurers faced severe financial difficulties due to the precipitous drop in housing prices and increased defaults that required the insurers to pay more claims. State regulators placed three mortgage insurers into “run-off,” prohibiting them from writing new insurance, but allowing them to continue collecting renewal premiums and processing claims on existing business. Some mortgage insurers rescinded coverage on more loans, canceling the policies and returning the premiums.  Currently, the mortgage insurance industry consists of six private mortgage insurers.

In our 2017 Audit and Evaluation Plan, we identified the four areas that we believe pose the most significant risks to FHFA and the entities it supervises. One of those four areas is counterparty risk – the risk created by persons or entities that provide services to Fannie Mae or Freddie Mac. According to FHFA, mortgage insurers represent the largest counterparty exposure for the Enterprises. The Enterprises acknowledge that, although the financial condition of their mortgage insurer counterparties approved to write new business has improved in recent years, the risk remains that some of them may fail to fully meet their obligations. While recent financial and operational requirements may enhance the resiliency of mortgage insurers, other industry features and emerging trends point to continuing risk.

We undertook this white paper to understand and explain the current and emerging risks associated with private mortgage insurers that insure loan payments on single-family mortgages with LTVs greater than 80% purchased by the Enterprises. (2)

It is a truism that the next crisis won’t look like the last one. It is worth heeding the Inspector General’s warning about the

risks from private mortgage insurance as a credit enhancement, including increasing volume, high concentrations, an inability by the Enterprises to manage concentration risk, mortgage insurers with credit ratings below the Enterprises’ historic requirements and investment grade, the challenges inherent in a monoline business and the cyclic housing market, and remaining unpaid mortgage insurer deferred obligations. (13)

One could easily imagine a taxpayer bailout of Fannie and Freddie driven by the insolvency of the some or all of the six private mortgage insurers that do business with them. Let’s hope that the FHFA addresses that risk now, while the mortgage market is still healthy.

What To Do With MERS?

Albert_V_Bryan_Federal_District_Courthouse_-_Alexandria_Va

Bloomberg BNA quoted me in More Policy Queries As MERS Racks Up Court Wins (behind a paywall). The article further discusses the case I had blogged about earlier this week.  It reads, in part,

Mortgage Electronic Registration Systems, Inc. (MERS), the keeper of a major piece of the U.S. housing market’s infrastructure, has beaten back the latest court challenge to its national tracking system, even as criticism of the company keeps coming (Montgomery County v. MERSCORP, Inc., 2015 BL 247363, 3d Cir., No. 14-cv-04315, 8/3/15). In an Aug. 3 decision, the U.S. Court of Appeals for the Third Circuit reversed a lower court ruling in favor of Nancy J. Becker, the recorder of deeds for Montgomery County, Pa., whose lawsuit claimed MERS illegally sidestepped millions of dollars in recording fees.

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MERS has faced an array of critics, including those who say its tracking system is cloaked in secrecy. MERS disagrees, and provides a web portal for homeowners seeking information.

A host of friend-of-the-court briefs filed in the Third Circuit blasted the company, including one filed in March by law school professors who said the MERS system “has introduced unprecedented opacity and incompleteness to the record of interests in real estate.”

One of those, Brooklyn Law School Professor David Reiss, Aug. 6 raised the question whether MERS, though not a servicer, might be the subject of increased oversight.

“The problems consumers faced during the foreclosure crisis were compounded by MERS,” Reiss told Bloomberg BNA. “Those issues have not been resolved by the MERS litigation, and it would be interesting to see if the Consumer Financial Protection Bureau will seek to regulate MERS as an important player in the servicing industry. It would also be interesting to see whether state regulators will pick the ball in this area by further regulating MERS to increase transparency and procedural fairness for homeowners,” he said.