August 2012
Kenneth E. Kohler
Anna T. Pinedo
Morrison & Foerster LLP
© 2012 Morrison & Foerster LLP | All Rights Reserved | mofo.com
Impact of Bank Capital
Proposals on the Residential
Mortgage Markets
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
This is MoFo.
2
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
This is MoFo.
3
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 nontraditional products will have fewer purchasers – likely affecting price and liquidity
of non-traditional products
This is MoFo.
4
Summary of Likely Impacts (cont’d)
 Banks with excess capital (regardless of size) will have more flexibility to offer nontraditional 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
This is MoFo.
5
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.
This is MoFo.
6
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
This is MoFo.
7
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
This is MoFo.
8
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.
This is MoFo.
9
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
This is MoFo.
10
Basel III
 Effective Dates/Transitional Periods
 Minimum Tier 1 capital ratios – 2013-2015
 Regulatory capital adjustments and deductions – 2013-2018
This is MoFo.
11
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)
This is MoFo.
12
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 (nontraditional)
 Term
 Payment schedule
 Documentation
 Loan-to-value (LTV) ratio
 Eight sets of risk weights—generally higher than current rules
This is MoFo.
13
Mortgage Risk Weights (cont’d)
Residential mortgage risk weight chart
(Applies to single-family mortgage loans not guaranteed by U.S. government, agency or GSE)
LTV Ratio (%)
Category 1 Risk Weight
Category 2 Risk Weight
<60
35%
75%
>60, <80
50%
100%
>80, <90
75%
150%
>90
100%
200%
This is MoFo.
14
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
This is MoFo.
15
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
This is MoFo.
16
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
This is MoFo.
17
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)
This is MoFo.
18
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.”
This is MoFo.
19
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
This is MoFo.
20
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
This is MoFo.
21
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 presold residence
This is MoFo.
22
Risk-Weighting Under Advanced
Approaches
 Unlike Standard Approach, very little change to current riskweighting 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
This is MoFo.
23
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
This is MoFo.
24
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
This is MoFo.
25
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
This is MoFo.
26
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
This is MoFo.
27
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”
This is MoFo.
28
Conclusion
Thank you!
This is MoFo.
29
August 2012
Proposed Capital Rules – Mortgage-Related Issues
I. Basel II – Capital Components and Deductions
Components
Tier 1 capital
Tier 2 capital
Deductions
After-tax gain-on-sale associated
with securitizations
Current Rules
Proposal
Tier 1
• Common stock
• Shareholders equity
• Perpetual preferred
Tier 1 common equity capital
• Common
• Retained earnings
• AOCI
• Subordinated debt
Additional Tier 1 capital
• Noncumulative perpetual
preferred
• Cumulative perpetual preferred
• Subordinated debt
• No deduction or adjustment
• Deduct from common equity Tier
1 capital
Credit-enhancing interest-only
strips reflecting after-tax gain-onsale
• 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, nonmortgage 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
First-lien mortgages
Current Rules
• 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
1
NY2-706484
Proposal
• 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
Current Rules
• Past-due loans: 100%
Proposal
- 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
<60%
60-80%
80-90%
>90%
Cat. 1
35%
50%
75%
100%
Cat. 2
100%
100%
150%
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
2
NY2-706484
August 2012
Restructured or modified
mortgages
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
• Original risk weight: 50% or
100%
• 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 under HAMP
retains original risk weight
• 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 onbalance sheet assets at 100%
• Immediately converted to onbalance 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
3
NY2-706484
August 2012
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
•
•
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 riskweighted 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 riskweighted at 250%.
100% in first year
50%, if
- Same conditions as current
rule, plus
- Original LTV on loan may
not exceed 80% for fixedrate loan or 75% for
adjustable rate loan
III. Securitization Exposures
Qualitative Requirements
Exposure amounts
Current Rules
• Implicit—as necessary for
accounting purposes and legal
opinions
Proposal
• Operational requirements
- Due diligence
- Traditional securitizations
- Synthetic securitizations
- Clean-up calls
• 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
4
NY2-706484
August 2012
Current Rules
• No explicit floor
• Rating agency classifications
• Gross-up approach
Proposal
• 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
Risk-weighting options
Contacts
Anna T. Pinedo
New York
212-468-8179
[email protected]
Dwight Smith
Washington, D.C.
202-887-1562
[email protected]
5
NY2-706484
Kenneth E. Kohler
Los Angeles
213-892-5815
[email protected]