Regulation is the Issue in Housing Finance
Below are some thoughts for the discussion at Cato Institute in Washington, D.C., today, “Financial Crisis and Reform: Have We Done Enough to Fix the Government-Sponsored Enterprises?”
The title for today’s discussion is a question “Have We Done Enough to Fix the Government-Sponsored Enterprises?” The short answer is “Yes.”
A decade and a half before the US government took over the GSEs in 2008, Harold Ramis came out with a film called “Groundhog Day” starring Bill Murray, Andie MacDowell, and Chris Elliott.
Murray’s character, an arrogant TV newsman from Pittsburgh named Phil Connors, is caught in a time loop, repeating the same day over and over again. Talking about GSE reform has taken on a similar quality.
There is a crisis in the world of mortgage finance, but it has nothing to do with the debate of government-sponsored enterprises such as Fannie Mae and Freddie Mac. The situation with the GSEs is a Washington story that deals mostly with issues of equity and public policy, but gets virtually all of the attention from the financial media.
To the bond market, though, the only validation needed to support the “AAA” rating of the GSEs is the credit support of the United States, period. The “sale” of the GSEs 50 years ago was a financial fraud perpetrated by members of Congress and a number of Presidents going back to Lyndon Johnson.
The US government never “loosed dominion” over the GSEs, to paraphrase Supreme Court Justice Louis Brandeis, who ruled in 1925 that an incomplete sale “imputes fraud conclusively.” The erstwhile shareholders of the GSEs, seen through that prism, are really creditors rather than owners.
Meanwhile, the business of making and servicing loans is being slowly decimated by over-regulation, soaring operating costs and uneven interest rate markets. Over-regulation of the mortgage industry hurts banks and non-bank financial institutions, and their customers and shareholders. More the any other change to the Dodd-Frank law, the standard for regulation of lenders needs to be revisited.
A bizarre line of thinking prevalent in the academic world says that increased regulation of commercial banks since 2008 has somehow made non-banks more competitive that depositories, which are after all GSEs just like Fannie Mae and Freddie Mac. Banks have access to the Discount Window, federal deposit insurance and other subsidies, and are protected from hostile takeovers by the Fed. But of course, we all know that Feinberg’s First Law states that no private entity can compete with a GSE.
In fact, the increased regulation of home mortgage finance has made it virtually impossible for many smaller non-bank firms and community banks to operate profitably in the residential mortgage market. There is a steady exodus of both banks and non-banks out of residential lending and servicing, particularly from the government guaranteed market overseen by the Federal Housing Administration (FHA).
The growing dominance of the remaining non-banks in the FHA market raises both liquidity and credit concerns. Non-banks have the least ability to fund FHA lending, servicing and loss mitigation tasks, yet they are now well more than half of the total market. And the FHA is taking share away overall from the GSEs through insuring below-prime loans, paper the commercial banks won’t touch.
In 2014, JPMorgan (NYSE:JPM) Chairman Jamie Dimon very publicly moved his bank out of the FHA market, a trend that has been followed by many other commercial banks. Dimon is especially critical of the FHA’s use of the False Claims Act, Civil War era legislation that was intended to protect the government from fraud by suppliers. Many industry participants say that the False Claims Act has been used abusively by the Department of Justice to extort fines and settlements from banks and non-banks alike.
Many of the supposed “violations” of law alleged by the DOJ did not happen at all, but the mere threat of criminal prosecution of a bank’s officers and directors has been enough to compel most private lenders to settle and pay. Not only have these unwarranted fines been costly for shareholders, but the withdrawal of banks from the FHA market has, according to Dimon, reduced mortgage lending by banks to the tune of about $300 billion annually.
Likewise, the undefined “abusive practices” standard contained in the Dodd-Frank law has been used to extract billions in fines from banks as well as non-banks. Only in rare instances such as Quicken’s litigation with the DOJ and PHH Corp’s (NYSE:PHH) now famous Constitutional challenge of the Consumer Finance Protection Bureau (CFPB) have private lenders been willing to fight back against this abuse of power by the CFPB and DOJ.
Most of us are familiar with the travails of Ocwen Financial (NYSE:OCN), but literally dozens of other non-bank mortgage firms have been unjustly penalized by the CFPB and state agencies. Most recently, the CFPB issued a sensational statement, saying it was fining Fay Servicing, a high-touch distressed mortgage servicer in Chicago, more than $1 million for “illegal foreclosure practices.” According to the CFPB, an “investigation” found that Fay Servicing was “keeping borrowers in the dark” about their foreclosure prevention options.
Like many mortgages firms that have settled with the agency, Fay founder and CEO Ed Fay took issue with the characterizations in the CFPB’s remarkable press release. He notes that his firm was not asked to pay a fine, otherwise known as a civil penalty payment. Rather, Fay was asked to pay $1.15 million in redress to borrowers; to offer borrowers opportunities to pursue foreclosure relief; and comply with mortgage servicing rules.
This action against Fay, PHH, Ocwen and many, many other firms follows the familiar pattern of the National Mortgage Settlement and the CFPB’s rule making authority, both of which essentially allow aspiring politicians to tax private mortgage firms for “abusive practices” or “violations of law” without any due process or transparency. And at the top of the political food chain, the US Attorney and the CFPB act as judge and jury in a modern day Star Chamber in issuing enforcement actions and fines.
The cost of regulation is seen in the expense required to make or service a home loan. According to the Mortgage Bankers Association, the average cost of servicing a performing loan rose to $181 in 2015, three times higher than in 2008 when the cost per loan was $59.
The average cost of servicing a non-performing loan grew to $2,386 in 2015, almost five times higher than in 2008 when the cost per loan was $482. This increase in cost was driven by one public policy priority enshrined in Dodd-Frank, namely protecting American consumers from abuse of process when they failed to repay their home mortgages. Defaulting on your mortgage has become a new American entitlement.
With the election of Donald Trump, both banks and non-banks believed that salvation was at hand. Stock prices soared on the promise of deregulation of the financial services industry, both via reform legislation and more simply by putting agencies such as the DOJ and CFPB back into business friendly hands after eight years of bleeding under the Obama Administration.
The Trump Administration has proposed that the CFPB be substantially stripped of its powers, but events in the bond market have created even bigger headaches. Yet despite a lot of positive talk coming from Washington, the situation facing the mortgage industry is dire as Q2 2017 comes to an end.
First and foremost, the talk early on regarding infrastructure spending and lowering taxes took Treasury bond yields up half a percentage point in the three months after the election. The sharp rise in rates right after November 2016 put the kibosh on mortgage refinancing, driving industry volumes down sharply. As shown in the chart below, the Mortgage Bankers Association (MBA) has future refi volumes flat lined at $100 billion per quarter into 2019 vs $250 billion per quarter in Q2-Q4 2016.
Because of the upward move in interest rates in the three months following the election of Donald Trump, today the mortgage industry is running light on home lending volumes to the tune of $300-400 billion this year. When you hear us suggest that the Federal Open Market Committee could easily sell $50-100 billion per month in mortgage bonds from its hoard, this decline in agency issuance is partly the reason. The chart below shows the 10-year Treasury bond and 30-year mortgage rate.
If you understand the concept of option adjusted duration, then you’ll perceive that by maintaining a position of over $2.2 trillion in mortgage securities, the Federal Open Market Committee has created a downward bias on long-term interest rates. The resulting compression in bond yields (and credit spreads) now visible in the mortgage and forward rate/TBA markets is in direct opposition to the policy objectives of the FOMC, of note. This is why we believe that Chair Yellen and the FOMC err in putting increases in benchmark rates ahead of portfolio sales.
The operating results for the industry reflect the political and financial confusion that the two above charts illustrate. MBA Vice President of Industry Analysis Marina Walsh and her colleagues have dutifully assembled statistics for the US mortgage industry in Q1 2017 and the results are truly dreadful.
"The drop in overall production volume in the first quarter of 2017 resulted in the highest per-loan production expenses reported since inception of our study in the third quarter of 2008," said Walsh. "While higher production revenues mitigated a portion of the cost increase, production profitability nonetheless declined by more than half the previous quarter. For those mortgage bankers holding mortgage servicing rights, an increase in mortgage interest rates resulted in MSR valuation gains and helped overall profitability."
Other key MBA findings:
Average production volume fell to $455 million per company in the first quarter, down from $690 million per company in the fourth quarter. Volume by count per company averaged 1,944 loans in the first quarter, down from 2,811 loans in the fourth quarter.
Average pre-tax production profit fell to 10 basis points in the first quarter, down from an average net production profit of 24 bps in the fourth quarter. Since inception of the Performance Report in third quarter 2008, net production income has averaged 51 bps.
Purchase share of total originations, by dollar volume, rose to 68 percent in the first quarter, compared to 58 percent in the fourth quarter. For the mortgage industry as a whole, MBA estimated purchase share at 59 percent in the first quarter.
When our friends in the regulatory community ask us why the mortgage industry does not make more investments in expensive new technology to improve the servicing process, we gently remind them that half of the industry is not profitable. Most of the rest have equity returns in mid-single digits at best, paltry results that consign these businesses to mostly debt financing, with full collateral of course.
A cynic might say that no sane investor would allocate capital to this business -- unless there is serious scale involved, say at least $100 billion in unpaid principal balance (UPB) of loans serviced. Go big a la Nationstar (NYSE:NSM), Quicken, Flagstar (NYSE:FBC) or Lonestar’s Caliber, or go home. Since for most non-bank mortgage firms the intangible MSR is the only real capital asset, innovative financing for loan servicing assets is currently the holy grail.
For regulators and researchers to compare non-banks with heavily subsidized and regulated banks is fanciful, but it also reflects an indifference on the part of the policy community regarding the real world impact of regulation on people and markets. The changes in regulatory incentives in the banking world since 2008 have made residential loans among the least attractive loan types for any financial institution.
Regulators have actively discouraged banks from engaging in either lending or servicing below-prime loans. With some notable exceptions, most banks have decided to avoid residential lending. Why? Because the risk-adjusted returns are relatively low once high operating expenses and regulatory/reputation risk is factored into the equation.
The goal of any regulatory change in the mortgage world should be to preserve the protections for consumers that were codified in the National Mortgage Settlement and also contained in Dodd-Frank, but make the regulatory process less adversarial and, frankly, more fair. The current regulatory environment for consumer lending in the US is entirely counter-productive for both consumers and investors.
Former Solicitor General Ted Olson said of the Dodd-Frank consumer agency in arguments for PHH: “The CFPB’s structure is the product of aggregating some of the most democratically unaccountable and power-centralizing features of the federal government’s administrative state.” Nothing better proves Olson's point than the treatment of the mortgage industry by the CFPB over the past five years.
The employees, customers and investors of mortgage companies enjoy the same Constitutional protections as all Americans. They should be treated with respect and fairness, rather than disdain and indifference. No other industry in America faces the level of punitive hostility that the mortgage community endures at the hands of the CFPB and other agencies. If regulators work with the industry to balance fairness with regulation, mortgage industry profitability will improve and with it the possibility of operational improvements that best serve consumers and investors as well.