When the FRB released the U.S. Basel rules yesterday, it tried to reassure worry-warts that the new standards, while stringent, wouldn’t ruffle financial-market feathers. Maybe so under the macroeconomic analysis used to see what will happen by 2019. But, on a line-of-business basis starting right about now, the Basel proposals redefine key banking activities and, with them, the future of banks engaged in them. We’ve seen this before – financial markets go quickly to the least-capitalized provider or, if shadow firms can’t fill a particular role, the business goes bye-bye. Thus, history suggests – I would say dispositively demonstrates – that these rules will re-engineer U.S. banking and, in some key areas like residential mortgages, not in any way regulators will like.
It’s important first to state that I am no defender of current risk-based capital rules in this product area. As early as 2003, I testified to Congress not just about risks looming at Fannie Mae and Freddie Mac, but also those brewing in the broader mortgage market. Structured products like piggyback mortgages were, I warned, classic capital-arbitrage plays because banks were allowed to engineer high loan-to-value (LTV) loans, keep the riskiest bit on balance sheet and hold the same amount of capital required of high-quality corporate obligations. Some fun, or it was while it lasted.
So, the old rules were wrong. But, does this make the new ones right? Not so much. In the “silo” of prudential regulatory capital, they may look right, but, when the rules in this silo are aimed at another major policy consideration – revitalized private capital in mortgage finance – a huge explosion of conflicting ideals occurs.
The current risk-based capital rules in the U.S. simply differentiate residential mortgages into two categories under the simple approach used by all but the very biggest banks. Residential mortgages are weighted either fifty percent or 100 percent based on LTV and whether or not there is private mortgage insurance (MI). The advance internal ratings-based approach is more complex, setting capital by probability-of-default and loss-given-default calculations buttressed by some model constraints. The new approach totally turns the screws on these standards, based, of course, on the hard lessons regulators learned about mortgage risk. In the “standardized” option banks between $500 million and $250 billion in assets can use, risk weightings would range from 35 percent to 200 percent based not just on LTV (with no offset for MI), but also on product type. The advanced approaches are a lot more complex, but now must be benchmarked to these standards to prevent too much fun with models.
This might sound like long-overdue discipline except for one more thing. The standardized option keeps the zero weighting for U.S. Government-guaranteed MBS (Ginnies) and a twenty percent weighting for those backed by the GSEs. So, as has been longstanding practice, banks can book anything they want with no fear of punitive risk weightings if they can pop the loan off to FHA, Fannie or Freddie.
What, you say? The risk-retention rules will put a stop to that? Not as proposed, since all of these originations and securitizations would be exempt. Thus, as before, the U.S. taxpayer – directly through Ginnie and indirectly through the struggling GSEs – will be the do-not-pass-go place for banks to send almost all of their mortgage obligations. The only difference Basel III will make is a new capital incentive for banks to hold very high-quality mortgages themselves, essentially cherry-picking their originations so that the GSEs and Ginnie get just the junk.
I’m not at all sure what this does for systemic risk reduction or even for prudential management at the banks under Basel’s thumb. But, I do know that it’s a death-knell to one cherished policy objective the industry shares with the FRB and Treasury: a return of private capital to mortgage securitization. As I read this proposal, it creates a giant capital-driven sucking sound that pulls all but the highest-quality mortgages from bank originators to federal coffers. I hear you saying, “The qualified-mortgage rules will fix this because only good loans will be originated going forward.” Maybe, but that of course is unknown until the QM is complete. More importantly, though, the QM doesn’t really matter here because the capital incentives trump these prudential ones.
Under the new rules, capital that counts is capital that costs – that is, a limited class of tangible instruments that now must be held in considerably higher amount. Thus, any product with a high risk weighting is a dubious, if not doomed proposition. Even loans that can and should be QMs and those that should still be made to qualified borrowers outside the QM framework will be very expensive propositions for banks to make and, then, hold in portfolio. If all but the most gold-plated mortgages can’t be held, they will have to be securitized. And, if they are securitized to private issuers, the resulting RMBS come back with their own punitive capital charge. So, the choice is USG or GSE – some return to private capital.