On July 27, the nation’s primary federal banking regulators—the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency—released a proposed capital framework (PDF) for banks with more than $100 billion in assets.

Though the proposal intends to reduce risk in the US financial system, its narrow focus on banks may actually increase risk in the mortgage market. By making it less economical for large banks to support the mortgage market, the proposal would shift mortgage lending from depositories to independent mortgage banks (IMBs), yet make it more difficult for the IMBs to handle the role asked of them.

Implications of the newly proposed banking regulations

Most controversially (PDF), the proposal would increase the amount of capital that large banks must hold against mortgages held in portfolio. Where today, the risk weight for all mortgages is 50 percent, bank regulators have proposed risk weights from 40 to 90 percent, depending on the mortgage’s loan-to-value ratio. This would take the capital that large banks are required to hold against these mortgages well beyond what is needed to cover the risk, reinforcing the decade-long retreat of banks from the mortgage market (PDF).

This regulatory nudge of the mortgage market from banks to IMBs might not be a problem were it not that the proposal also makes it more difficult for IMBs to support the mortgage market.

For most IMBs, mortgage servicing rights (MSRs) are the dominant asset and warehouse lending is the dominant source of liquidity. When an IMB steps in to maintain the payments owed to mortgage-backed securities investors as borrowers fall behind—a role critical to the functioning of the mortgage market—they look to warehouse lenders for the needed short-term funding, putting up their MSRs as collateral. Warehouse lending is also important to IMBs’ mortgage lending, providing them the funding to cover the period between a loan’s origination and its securitization.

The proposal would strain the economics of the IMBs’ MSRs and their warehouse lending, making it more challenging for many IMBs to operate.

By increasing the credit conversion factor used to calculate the capital that must be held against funding commitments of a year or less that are not unconditionally cancellable, regulators would double the capital required for most warehouse lines. Though this increase would be offset by a decrease in the risk weight applied to the few publicly traded, investment-grade IMBs, it would meaningfully increase the cost of short-term funding for all but these few IMBs.

The proposal would also reduce the share of a large lender’s Tier 1 capital (the form of capital that receives the most favorable treatment) that can come in the form of MSRs. Currently, MSRs can make up 25 percent of a large lender’s Tier 1 capital, with every dollar of MSRs above that threshold requiring a lender to hold another dollar of capital, rendering it uneconomical. Under the proposal, that limit will fall to 10 percent.

A few larger banks already exceed this lower limit and several more are close, which means that they would go from being buyers of MSRs to sellers, driving down the value of the asset. This downward pressure on the value of most IMBs’ primary asset will force them to put up more of it to secure short-term funding with warehouse lenders, which will already be looking to tighten the terms of their lines.

These two changes together could squeeze many IMBs, particularly in times of stress. As borrowers begin to struggle to make their payments and both the importance and liquidity needs of IMBs rise, the proposal will make it more difficult for many IMBs to come up with the funding needed to keep the market functioning.

With the capital treatment of mortgage lending pushing banks further out of the mortgage market, no one should expect them to come to the rescue.

Broadening the view of mortgage risk would better protect the financial system

In their overly narrow focus on the risk to banks, bank regulators appear to be missing the bigger picture, at least in the mortgage market. Opening their aperture a little and adopting a more moderate approach to the risk that large banks take in supporting the mortgage market would ultimately put the financial system as a whole, including the larger banks, on more stable ground.