Earlier this week, global regulators ventured back into the shadows, outlining new rules they hope will prevent another systemic-risk cataclysm.  Nice thought but, as they talk, the shadows creep across the banking garden.  Case in point:   the move of mortgage servicing from big banks to private-equity firms.  Does this migration mean more risk and also make it harder to transition back to private capital in mortgage finance?  We think so, but doubt much will be done to stop it.

Last week, a major private-equity (PE) firm, Fortress, took its mortgage servicer public, the second public offering for a mortgage servicer in a month.  Why the gold rush?  The $10 trillion servicing market (notional value) has been dominated by banks, especially in recent years when nonbank entrants bit the dust.  But, market indications are that $4 trillion of this $10 trillion is on the block. Nonbanks already hold about $1 trillion in servicing rights, a share that will go up significantly if Fortress takes on Ally’s book, as some market rumors say is in the offing.

Banks want out for two reasons.  First and foremost, the capital model for holding mortgage servicing rights (MSRs) has changed.  Banks held MSRs in part because capital rules counted them as a form of Tier 1 capital, making these assets particularly attractive and fueling consolidation in them by big banks that could house the complex operational capabilities necessary for servicing.  Now, Basel III takes most MSRs out of the Tier 1 capital equation, sharply reducing their value to big banks.  Since this regulatory change comes in tandem with other policy actions – most notably all the legal and reputational risk resulting from slipshod servicing and pending FHFA rules to change how servicers are paid – some big banks want to drop their servicing holdings and, we think, to exit the business in its entirety as soon as possible.

From a purely market perspective, there’s no problem if banks lose and PEs win and, given the poor performance of MSRs from a financial perspective and the awful revelations of servicing standards, it’s hard to contest that mortgage servicing needs a makeover. But, what happens if it moves from regulated institutions to the shadows?  Bank rules for mortgage servicing were bad, but they are being fixed.  Even if the fix isn’t perfect, some rules still beat none.

To be sure, the CFPB may help to prevent one adverse consequence of servicing outside the banks:  consumer-protection problems.  In the past, big nonbank servicers were even worse at what they did than big banks.  In fact, one reason big banks are getting so much blame now is that they took over nonbank servicing operations without fully understanding what empty boxes they bought.  Part of the reason for this lay in the wholly unregulated nature of mortgage servicing before the crisis; now, with the CFPB, a single agency has the power to issue consumer-protection standards across the servicing spectrum, with the Bureau’s director saying again today that he plans shortly to start to do just that.

So, if consumer protection is provided, what else could be problematic if nonbank servicers move from the shadowy realm of specialty operations into the big time?  Servicing is critical to securitization, since someone must handle payments from borrowers and, then, get them to investors.  If borrower payments stop, then the servicer also has to intervene to foreclose or modify the loan, because any secondary market that forces investors not just to open envelopes, but also to nail doors shut is dysfunctional on day one.

Investors can only count on servicers if servicers have two key attributes:  risk management to support obligations in the new, far more demanding environment and – critical – capital to ensure payments can be advanced and put-back requests can be honored.  So far, the only equity the nonbank servicers has comes from their IPO – understandable since the firms aren’t under any prudential capital standards and have followed the usual leverage-loan model to get this far.  Over time, they may well build capital to meet investor demands, but how much and how robust will it be?  And, importantly, for how long are these PEs committed to this business?  Typically, PEs come and go – again, understandable since this is the fundamental rationale of private-equity firms.  But, if banks don’t want servicing and PEs aren’t in it for the long run, can liquid secondary mortgage market survive?

The shift of servicing to the shadows isn’t, of course, the only question darkening the prospects for mortgage securitization.  Larger doubt is cast by the uncertain future of the GSEs, the parlous condition of the FHA, the uncertain state of the risk-retention rules and a host of other pending policy matters.  It’s for this reason that several big banks have become increasingly enamored with covered bonds.  Now, they’ve persuaded Congress to love them too, with the Senate earlier this week starting work on a covered-bond bill with a very good shot at enactment.  One key point:  covered bonds don’t need servicing because mortgages stay on a bank’s portfolio even when investors buy bonds backed by them.  PEs start your disposition engines.