Proposed updates to the Basel accord would force U.S. banks with large mortgage servicing portfolios to take a multibillion-dollar regulatory capital hit.
If there's consolation to be had, it's that the sting could have been much worse.
Under the capital and liquidity reform package issued in July by the Basel Committee on Banking Supervision, mortgage servicing assets would be counted as 10% of Tier 1 capital at most — and even less if the bank has large holdings of deferred tax assets or other intangible assets.
Though more favorable to U.S. banks than an earlier version that would have entirely excluded mortgage servicing rights from regulatory safety measures, the proposal is still far more stringent than the U.S.'s current 50% cap. If implemented, it would harm the capital ratios of mortgage-heavy institutions from specialized community banks to giants like Wells Fargo. And industry lobbyists warn the rule will make a revival of the private-label securitization market increasingly unlikely.
"This is going to change the servicing business," said David Stephens, chief financial officer and chief operating officer at United Capital Markets, a firm that provides MSR hedging services. "The majority of the little guys don't even know about it."
Like most everything related to Basel III, the adoption of the rule by international and U.S. regulators remains uncertain — and its implementation date years off. But some industry observers said that it could rob a servicing-heavy business model of some of its allure and harm specialized players in the market. And because the value of MSRs is closely tied to changes in interest rates, the proposed rule's impact would almost certainly grow if interest rates rise.
In a conversation with American Banker, a representative of the Office of the Comptroller of the Currency (OCC) described the 10% cap as a compromise with European regulators who viewed them as intangible assets akin to goodwill that are unsuited to be included in regulatory capital at all. (As a byproduct of securitization and secondary marketing, servicing rights are largely a concern of U.S. institutions.)
"It's a compromise that tries to balance the need for conservatism in our capital rules with the desire to recognize the relative value of assets like MSRs," said the official, who declined to speak for attribution. "It makes no sense to treat MSRs like goodwill."
Alex Pollock, a fellow at the American Enterprise Institute, said he believes the 10% cap could well contribute to stability in the banking sector. Assuming that MSRs appreciate when interest rates are rising — which usually happens when the economy is growing — and fall in value after the economy peaks and rates drop, the limit could insulate banks' capital positions from cyclical changes, Pollock said. When there's only so much capital you can gain on the way up, there's only so much you can lose on the way down.
But industry advocates argued that limiting the contribution of MSRs to Tier 1 capital would cause problems on a grander scale than individual bank balance sheets.
Jim Gross, vice president of accounting, tax and bank regulation for the Mortgage Bankers Association, said the proposed cap would inhibit a return to a healthy originate-to-distribute mortgage model.
"When you've got a lot of banks on the sidelines for private-label stuff, these things are nails in the coffin for a viable business model," he said. The rebound of the secondary market has already been challenged by changes in the last two years that have brought special-purpose vehicles onto the balance sheet and called into question the protection that mortgage-backed securities holders would receive if a bank with securitized loans fails.
Given their current portfolios, both Bank of America Corp. and JPMorgan Chase could take a small hit to their capital positions. But the bank likely to see the biggest effect from the change in dollar terms is Wells Fargo, which has $99 billion of Tier 1 capital and $17 billion of servicing rights.
Even at the bank's conservative MSR valuations, which are far below those of its competitors, the new Basel limit would strip Wells of $4 billion, or 4%, of its Tier 1 equity position when risk weightings are taken into account.
In a comment letter to the Basel Committee, Wells vigorously protested the December Basel MSR proposal, calling its assertion that MSRs were unreliable "simply incorrect" and arguing that servicing rights are an "inherent part of our housing finance market."
Wells would not discuss the updated proposal for this story.
But some observers argued that a 10% Tier 1 capital limit could give the largest servicers a competitive advantage. For smaller institutions that have a heavily concentrated position in mortgage servicing — first-quarter call report data shows that there are at least 10 banks whose MSR portfolios account for half their common equity — the rule could force a rethinking of capital.
Ed Meekins, executive vice president of Central of Kansas — a privately held, $812 million-asset bank holding company with $11.2 million of servicing assets — said the change could alter his bank's approach to servicing. Though the company's $84 million in Tier 1 equity gives it a healthy capital ratio, a 10% cap "would cause us to rethink how much MSRs we would be willing to hold," Meekins said. "We're a nonpublicly traded, closely held corporation, so we have limited access to capital."
Bigger, more diversified, publicly traded institutions would likely be in a position to take up the slack if smaller institutions decided the regulatory capital limits made specializing in servicing inviable, Stephens said.
"It will play into the aggregators' hands," Stephens said. "If a little guy wants to be significant in mortgage banking, and doesn't want to sell his best customers to Wells, he's going to be constrained by this."
Gross noted that U.S. regulators have taken a pass on implementing some elements of previous Basel agreements, and said the MBA will try to persuade them to do the same with the 10% cap.
"The best way to go is to address head on with the regulators: what is it about servicing rights that you deem so risky?" he said.
Should Basel receive international approval, the MBA and other industry groups will have a chance to say their piece, the OCC official said. But the U.S. would not deviate from the accord lightly.
"There's every expectation that whatever agreement is finalized in Basel will be reflected in our rules," the OCC official said. "With that said, once Basel's finalized, we'll go forward with a notice of proposed rulemaking. In a lot of ways, the process is just beginning."