Impact of Bank Capital Proposals on the Residential Mortgage Markets

Transcription

1 2012 Morrison & Foerster LLP All Rights Reserved mofo.com Impact of Bank Capital Proposals on the Residential Mortgage Markets August 2012 Kenneth E. Kohler Anna T. Pinedo Morrison & Foerster LLP

2 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, 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

3 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

4 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

5 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

6 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

7 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

8 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

9 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

10 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

11 Basel III Effective Dates/Transitional Periods Minimum Tier 1 capital ratios Regulatory capital adjustments and deductions This is MoFo. 11

12 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

13 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

14 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

15 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

16 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

17 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

18 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

19 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

20 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

21 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

22 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

23 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

24 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

25 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

26 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

27 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

28 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

29 Conclusion Thank you! This is MoFo. 29

30 August 2012 Proposed Capital Rules Mortgage-Related Issues I. Basel II Capital Components and Deductions Current Rules Components Tier 1 capital Tier 1 Common stock Shareholders equity Perpetual preferred Proposal Tier 1 common equity capital Common Retained earnings AOCI Additional Tier 1 capital Noncumulative perpetual preferred Tier 2 capital Subordinated debt Cumulative perpetual preferred Subordinated debt Deductions After-tax gain-on-sale associated with securitizations No deduction or adjustment Deduct from common equity Tier 1 capital Credit-enhancing interest-only strips reflecting after-tax gain-onsale Mortgage servicing assets Excess of amounts over 25% of Tier 1 capital deducted 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 Deduct from common equity Tier 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 NY 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 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

31 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 Cat. 1 Cat. 2 <60% 35% 100% 60-80% 50% 100% 80-90% 75% 150% >90% 100% 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 NY

32 August 2012 Restructured or modified mortgages Current Rules Original risk weight: 50% or 100% Loan modified under HAMP retains original risk weight 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 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 solely under HAMP retains original risk weight FHA and VA loans 0% 0% Mortgage loans sold with recourse Pre-sold residential construction loans NY After 120 days, converted to onbalance sheet assets at 100% 50%, if - Firm contracts - Purchaser has obtained commitment for permanent financing - Purchaser has made substantial earnest money deposit - Underwriting requirements 3 Immediately converted to onbalance sheet assets at 100% No 120-day grace period 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

33 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 Mortgage servicing assets 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 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%. 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 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%. III. Securitization Exposures Qualitative Requirements Current Rules Implicit as necessary for accounting purposes and legal opinions Proposal Operational requirements - Due diligence - Traditional securitizations - Synthetic securitizations - Clean-up calls Exposure amounts 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 NY

34 Risk-weighting options Mortgage servicing assets Interest-only strips Credit-risk mitigants Current Rules No explicit floor Rating agency classifications Gross-up approach 100% on amount not deducted from Tier 1 capital 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 Collateral Credit derivatives Guarantees August 2012 Proposal 20% floor Simplified supervisory formula approach Gross-up approach Alternatives 250% on amount not deducted from common equity 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 Same set of mitigants, but substantially new definitions and requirements Collateral - Simple approach - Haircut Credit derivative - Eight conditions Guarantees - Eligible guarantors expanded to include Contacts Anna T. Pinedo New York apinedo@mofo.com Dwight Smith Washington, D.C dsmith@mofo.com Kenneth E. Kohler Los Angeles kkohler@mofo.com NY