Most voters aren’t going to get hot under the collar about battles in Washington, DC, over bank capital requirements, but they definitely relate to stories about home loans becoming more expensive or less available. That doesn’t mean debate is straightforward, especially once each side starts throwing numbers around.
It’s no surprise that mortgages quickly became a flashpoint in the Federal Reserve’s proposal to overhaul regulation. The immediate fight is over the tougher treatment of loans with smaller down payments, which could make life much harder for low-income and first-time homebuyers. However, there’s another side to this scrap, which exposes both the scale of changes in how risk is measured under the Fed’s proposal and how easy it is to misinterpret what those changes mean.
I need to take you on a brief, slightly geeky trip into the weeds of how banks work out their capital needs, but it’s worth a look because the same story is likely to crop up in credit card debt or auto loans, too. Essentially, the new rules appear to mean that banks have to hold far more capital when they create a mortgage and sell it to federal funding agencies like Fannie Mae or Freddie Mac than if they keep it on their own balance sheet. That would throw a huge spanner in the works of US banking. The two government-sponsored enterprises are cornerstones of the market: Fannie and Freddie hold nearly 50% of outstanding loans for one- to four-family residences.
The problem comes from the risk weighting of banks’ assets and activities: That is the balance sheet measure used to say how much capital a bank needs. Currently, under the Fed’s standardized approach, a mortgage with a down payment of 10% to 20% of the home’s value attracts a risk-weighting of 50% on the loan, plus a 20% addition derived from the Fed’s stress tests on average. So a total of 70%.
That means every $100 of mortgages gets measured as $70 of risk-weighted assets. A bank with a minimum capital requirement of 10% must have at least $7 of equity to back those loans, while they are on its balance sheet.
But things aren’t so simple under the new rules, according to a recent analysis by the Bank Policy Institute, a lobby group. First, that initial 50% risk-weighting gets bumped up to 60%, but on top of that banks also have to add extra protection against operational risks, which are the losses they could suffer from IT failures or having to cough up lawsuit settlements and fines.
This is where things start to look weird. The operational risk add-on for banks keeping mortgages on their books is expected to be about 5%, according to the BPI, which comes on top of the increased credit risk charge and the same addition from stress tests. The all-in risk weighting in this case increases to 85% from 70%.
But if a bank is selling those mortgages, it has to calculate operational risk weights on the fees it generates from that distribution business, too. The BPI calculates the typical operational risk charge could be 60%, which would make the all-in charge 140% — double what it is today and much more than the 85% charge for keeping the debt.
Why would the Fed want to discourage banks from offloading mortgages to Fannie and Freddie — or from using securitization to offload risks in general? The answer is that it doesn’t. Looking at the risk weightings in isolation gives a misleading picture of what’s going on here.
To see why, work through how these charges look in dollars. The BPI example assumes a bank originates and sells $30 billion of mortgages every three months, or $120 billion each year, and that the loans are on its balance sheet for 45 days at a time on average. In other words, the bank typically has $15 billion of mortgages on its balance sheet at any given time. Applying the credit risk and stress test charges to that balance gives a risk weighting of $12 billion.
Now we have to add those operational risk charges, which are calculated from the interest the bank earns on the mortgages while it owns them, plus the fee income from selling them on, multiplied by some constants used in the rules for scaling. The formula gives an answer of $9 billion of operational risk charges to give total risk-weighted assets of $21 billion — or a capital requirement of $2.1 billion.
And if the bank just writes $120 billion of mortgages and keeps them? The all-in 85% risk weighting would mean it has $102 billion of risk-weighted assets at the end of the year, or capital needs of $10 billion. In other words, much more.
Risk weightings tell one story, but the numbers in dollars tell a different one entirely. Furthermore, the revenue would be much higher in the distribution business per dollar of capital needed than in the retention business, so selling to Fannie and Freddie ought to be more profitable, too. Bottom line: The Fed isn't trying to hobble mortgages or put Fannie, Freddie or any securitization market on a sudden diet of deals.
Regulators have set out to increase capital requirements, especially for the biggest banks, and there is much that will come under intense pressure to be changed: Operational risk gets double counted in the new rules and the stress, for example. But it’s also very easy to give people the wrong idea about what any of these changes mean — especially when it comes to influencing non-specialist politicians and voters.
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