In our paper this week on the high-risk consequences of well-intentioned regulation, one of our seven resulting fears is the sharp hike in taxpayer risk. The American Banker picked this up, citing the growing reliance of mortgage markets on government-backed entities because private capital from regulated institutions is hide-bound by new requirements. Though many of these are warranted in the wake of the mortgage debacle, rules have costs and those subject to them must adapt. Big banks are thus reducing their mortgage operations and non-banks free of most costly rules have run to take their place. The announcement that one big servicer – Ocwen – may now face “going-concern” risks makes it all too clear that unregulated firms fly high due to arbitrage benefits, but all too often come crashing down. When they do so in mortgage servicing, taxpayer risk will rise still higher because the big counterparties of these non-banks are – guess who – you and me.
Big banks were indeed bad mortgage originators, servicers, and securitizers in the few disastrous years before 2008. However, a fair amount of the pain and suffering they caused came from functionally-unregulated entities they picked up at the start of the crisis. This in my opinion doesn’t absolve the acquirers of responsibility – big banks should know by now that bargains aren’t always cheap. But the majority of the worst practices were spawned in companies like Fremont, New Century, Countrywide, Bear Stearns, Merrill Lynch, Morgan Stanley, and so many others.
All of them were more than enabled by two other private companies largely operating outside the law, Fannie Mae and Freddie Mac. Big banks on their own – Wachovia is a case in point – matched non-banks subprime loan for subprime loan, but it’s far from clear that they would have succumbed to temptation had not so many unregulated companies been free to do so and had the GSEs not offered a free pass to rid the banks of high-risk loans.
Because of the combination of collapse and consolidation during the crisis, 2009 dawned with a mortgage-finance system dominated in the U.S. by GSEs in conservatorship, FHA, VA, and a few very, very big banks. Under heavy regulatory guns, big banks largely originated for the government entities, sharply reducing their portfolios and thus shifting what had been their risk back to Uncle Sam. However, the combination of legal risk and the regulatory burden now applicable even to government-backed activities has forced many of these banks to cede ground to the non-banks that have sprung back to life with astonishing agility.
According to another American Banker article, the share of non-bank servicing of FHA loans since 2011 has exploded to 62% while large banks now do only 30% of FHA’s servicing. As I said, big banks were bad before the crisis and one might thus say it’s just as well that they aren’t the majority of the mortgage market anymore. But, there’s one critical difference between banks and non-banks: capital.
Capital means that banks can pay servicer advances to investors, including the taxpayer when we own the mortgage credit risk by way of the GSEs, FHA, and VA. Capital means that, if called to account for abusive loans sold through their securitization channels, banks can pay up – not happily or fast, but still to the tune of tens of billions of dollars that at least go some way to reimbursing homeowners and taxpayers. Capital also is there to reimburse the government when a guaranteed loan goes bad – a critical cushion when an originator can act with impunity because the FHA has provided it with 100% government insurance unless or until it can make it pay up. VA loans have only a partial guarantee, which also leaves Ginnie holding the bag if it can’t find the lender.
Finally, capital means that, under proper controls, profit is constrained by prudence because a company is in business for the long haul, not just a quick buck. Banks of course lost sight of this before the crisis, in part because their capital constraints were lax. But, compare the costs they have shouldered to that of all the non-banks that lit the fuse on the mortgage crisis – companies like Fremont, New Century, American Home, and so many others either sold out to big banks or, if they were smaller, simply saw their CEOs hop in their BMWs to find a whole new gig before someone came asking for their money back.
As the mortgage market restructures and risks fly who knows where, regulators are rightly frightened – Ginnie Mae has asked Congress to fund personnel to track its counterparties, FHFA is drafting counterparty credit-risk standards, and there is growing thought of meaningful capital for non-bank FHA and VA originators.
Sadly, these changes – should they come – may well be too late. Rules drive competitiveness no matter how right a rule may be from a policy perspective. Taxpayers are thus already on the hook for billions of dollars of high-risk mortgages originated or serviced by non-banks since the crisis began. Under regulatory stress, some will exit the market, leaving what they wrought in the government’s hands. Others, like Ocwen, may come apart before management is ready to dismantle them. Either way, it’s an ugly omen of a costly new mortgage crisis only seven years after the last, disastrous one.