Potential Impact of the Revised Capital Rule on Nonbanks

This section describes how the mortgage servicing market might change if the revised capital rule were also applied to nonbank firms. The analysis is a hypothetical exercise based on estimates from public filings. The federal banking agencies only have the authority to set capital requirements for nonbanks that are subject to the supervision of one of the agencies, such as nonbank financial companies that the FSOC has determined shall be supervised by the Board.¹⁰³ Other agencies have some ability to set financial requirements for nonbank servicers. Under its conservatorship authority, FHFA has the ability to set financial strength requirements for the GSEs' servicer counterparties. Ginnie Mae can also set criteria for its servicer counterparties. Ginnie Mae and FHFA recently enacted increases in these requirements, which took effect January 1, 2015, ¹⁰⁴ and December 31, 2015, ¹⁰⁵ respectively. State regulators have also proposed prudential standards that would apply to nonbank servicers.¹⁰⁶

Capital requirements for insured depository institutions must be strong enough to limit the moral hazard associated with government-provided deposit insurance, which also tends to reduce the incentive for private market participants to monitor the risk-taking behavior of regulated banks. However, nonbank firms, including nonbank servicers, do not have access to deposit insurance and thus are more closely monitored by a range of counterparties and stakeholders. This difference implies that the capital requirements that apply to banking institutions would not necessarily be appropriate for nonbank servicers.

If the revised capital rule were applied to nonbank firms, the MSA treatment would likely affect nonbank activity in the mortgage servicing market. However, the deduction of MSAs from regulatory capital would prove far more consequential for nonbank servicers than the 250 percent risk weight for MSAs that are not deducted. The discussion in this section, therefore, focuses on the potential effect of the MSA deduction approach.

The effect of this approach on nonbank servicers depends on the structure of the nonbank servicer's balance sheet, which in turn depends on the servicer's corporate structure and business model. Broadly speaking, nonbank servicers fall into three groups, although most servicers are some combination of these models. The first group consists of servicers that have a REIT structure. The portfolios of REITs, in order to meet REIT tax requirements, are heavily weighted towards passive real-estate investments such as MBS and whole loans held for investment. The second group consists of firms that primarily specialize in servicing and that grow their portfolios by purchasing MSAs in bulk. These firms have balance sheets weighted heavily towards servicing advances and MSAs. The third group consists of firms that primarily originate mortgages, sell them into the secondary market, and retain the servicing rights. These firms typically have portfolios of loans held for sale in addition to MSAs and servicing advances.

Currently, aggregate holdings of MSAs by REITs are small. REITs serviced 6 percent, measured by the UPB, of mortgages serviced by nonbanks in 2015.¹⁰⁷ However, direct REIT investments in MSAs increased significantly in the wake of the 2013 IRS PLR referenced earlier in this report. In particular, REIT holdings of MSAs increased from $5 million in 2012 to nearly $1 billion in 2015, while total assets of these REITs contracted over this period from $48 billion to $37 billion.¹⁰⁸

The effect of REITs on nonbank servicers, though, is larger than this tabulation suggests. Many nonbank servicers have a relationship or affiliation with a REIT. Such nonbank servicers typically finance part of their balance sheet by selling their excess servicing as an interest-only strip associated with the MSAs to a third-party REIT. Nonbanks have been increasing their use of this financing structure. Two REITs that buy these excess servicing strips, for example, increased their holdings of these assets from $250 million in 2012 to $2.5 billion in 2015, at a time when their overall assets increased from $48 billion to $52 billion.¹⁰⁹ REITs have also provided nonbank servicers with funding for servicing advances.

Table 4 shows selected components of the balance sheets of nine large publicly traded nonbank servicers.¹¹⁰ This balance sheet information was used to estimate a proxy of each firm's ratio of MSAs to CET1 capital.¹¹¹ The analysis focuses only on publicly traded firms--which hold about 60 percent of the UPB of loans serviced for others by nonbanks--because data are not available on privately held firms.¹¹² The analysis does not include several large privately held nonbank servicers, including Quicken Loans Inc. (Quicken), Caliber Home Loans, Inc., Lakeview Loan Servicing, LLC, and Freedom Mortgage Corporation, and may overweigh firms that elect REIT tax treatment because these firms are more likely to be publicly traded.

Table 4. Balance sheet components and selected capital ratios for selected large nonbank mortgage servicers
Thousands of dollars, except as noted

Entity	MSAs, fair value	Servicing advances	Residential mortgages	Real estate securities	Total assets	CET1 proxy	MSAs at FV/total assets	MSAs at FV/CET1 proxy
Two Harbors	493,688	37,499	3,985,158	7,825,320	14,575,772	3,576,561	3%	14%
Hatteras	269,926	0	361,307	14,302,230	16,137,526	1,865,105	2%	14%
Redwood Trust	191,976	1,000	3,928,803	1,233,256	6,231,027	1,146,265	3%	17%
PHH	880,000	691,000	743,000	0	3,652,000	1,318,000	24%	67%
Stonegate Mortgage	199,637	19,374	645,696	0	1,280,626	261,628	16%	76%
Ocwen	1,222,745	2,151,066	2,902,299	7,985	7,404,809	851,562	17%	144%
Nationstar Mortgage	3,358,327	2,223,083	9,117,664	0	16,654,070	1,758,114	20%	191%
Walter Investment	1,810,416	1,595,911	13,214,845	0	18,591,501	804,676	10%	225%
PennyMac	1,426,592	299,354	1,101,204	0	3,505,294	270,826	41%	527%

Source: Staff calculations based on SEC Form 10-K data.

As suggested by the discussion above, servicers that are REITs can have large portfolios of mortgages and MBS relative to their holdings of MSAs. As a result, the ratios of MSAs to a CET1 capital proxy would be relatively low for this subset of nonbank servicers (Two Harbors, Hatteras, and Redwood Trust)--around 14 to 17 percent. Although complying with the revised capital rule would increase some of these firms' incentives to increase capital and might induce them to shed some servicing rights or otherwise rebalance their portfolios, their fundamental business model likely would remain viable.

Because MSAs constitute a larger share of the total assets of other nonbank servicers compared with those structured as REITs, such nonbank servicers could incur substantial capital deductions, unless they substantially increased their capital levels. Two such nonbank servicers--PHH Corporation and Stonegate Mortgage Corporation--would have MSAs to CET1 capital proxy ratios in the range of 65 to 75 percent. Three of the nonbank servicers--Ocwen, Nationstar, and Walter--would have MSAs to CET1 capital proxy ratios around 150 to 225 percent and PennyMac, as a result of its corporate structure, could potentially have an MSAs to CET1 capital proxy ratio of around 525 percent. Thus, nonbank servicers without a REIT structure would face pressures to increase their capital levels or change their business models significantly, or both, if they were subject to the revised capital rule.

In the event that these nonbank servicers--other than the three publicly traded REITs--left the mortgage servicing business, the concentration of the servicing industry, based on the HHI, would double, from roughly 850 for the mortgage servicing industry in 2015 to around 1,600.¹¹³ The analysis assumes, for purposes of this exercise, that no new servicers enter the market, and the portfolios of the nonbanks that exit the market are spread across the remaining servicers in proportion to their current servicing share. Although the increase in concentration is significant under this scenario, it is generally consistent with the HHI values in 2009 and 2010--the last time period when nonbank servicers significantly reduced their market share. Importantly, this higher value does not appear to be problematic from a competition perspective, as DOJ guidelines consider markets with HHIs between 1,500 and 2,500 to be moderately concentrated. Under these conditions, mortgage servicers would likely still have limited market power.

The assumptions underlying this exercise may not be true in practice. For example, banking institution servicers may be reluctant to increase their market share. In some cases, this reluctance may stem from concerns about breaching the 10 percent deduction threshold, particularly in a scenario where a banking institution is considering acquiring the servicing portfolio of a large nonbank. For example, as of the fourth quarter of 2015, four banking institution servicers that had a significant presence in the servicing market would have been able to take on the entire servicing portfolio of the two biggest nonbank servicers (Nationstar and Walter) without the acquiring banking institution breaching the deduction threshold in the revised capital rule; six banking institution servicers would have been able to take on the entire servicing portfolio of any of the five largest nonbank servicers (Nationstar, Walter, PennyMac, Quicken, and Ocwen) without breaching the threshold.¹¹⁴ In other cases, a banking institution's reluctance to increase its servicing portfolio might stem from the higher costs of servicing loans and the banking institution's experiences with nonperforming loans during and after the crisis. Offsetting this consideration to some extent is the fact that the compensation for servicing loans might increase after the nonbank firms left the market. This increased compensation might offset any increases in capital costs and might also induce new servicers to enter the market.

References

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