BWFT MSR Market Strategies – Regulatory Brief:
Reviewing the FDIC’s “CBLR” Proposal / Impact to MSR Market
Summary:
- We review key elements of the FDIC proposal and its impact to the market for MSRs.
- We present highlighted statistics that would point to a swift repricing and demand for MSR.
- These new proposed rules would be a significant departure from the Basel III rules which appear in comparison to be demonstrably punitive and to have had a dramatically negative impact on MSR demand, valuations and community bank involvement in mortgage banking in general (see below).
- Based on the same body of research presented below, these rules purport a number of new bank entrants to mortgage banking, increased bank activity to purchase (or, on the margin, to not sell) MSR, and a likely bias to be less conservative in capitalization of MSR resulting in higher valuations.
- MSR related hedging programs open a potential avenue for regulators to provide additional regulatory relief for banks that that manage day to day market risks of their business activities and for our part we believe should be included in the final rule.
- We reiterate our call for a potentially meaningful spread tightening in conventional and government MSR to be upwards of 50 OAS bps / 0.25 multiple with the latter investor having better upside as these rules come to fruition. Since we last wrote, we already have seen tightening of co-issue to bulk spreads with co-issue outperforming and we expect this trend to continue.
- Taken in total, we believe these changes to be a very business friendly start but would like to see incentives for those that hedge MSR as an add-on above the 25% CBLR capital limit.
Key Points about the FDIC CBLR Proposal
- Voted by the FDIC board to go for comment with a 60-day comment period.
- Would Replace existing Basel 3 rules with a simplified Community Bank Leverage ratio (CBLR) for Banks that meet the 9% threshold and meet other key balance sheet hurdles.
- In its current state the FDIC proposal would greatly simplify compliance for owners for MSR.
- Places a 25% cap on MSR Assets as a percentage of CBLR tangible equity in order to be CBLR eligible. In a related vein interested readers will note an additional 25% cap on deferred tax liability as a percentage of CBLR tangible equity to be CBLR eligible.
- Creates potential for commentary on an ‘alternative approach’ but weighs simplicity as a chief concern in implementation. We believe these changes to be a very business friendly start but would like to see additional incentives above the 25% capital limit for those that hedge.
- Participants who meet the requirement would be considered ‘well-capitalized’. A review and included in the proposal document states that of 5408 depository institutions under $10 billion in total consolidated assets, as many as 4469 or ~82.6% would be considered well capitalized.
- Since it has been put forth as a proposal, we believe there to be additional possibility for further loosening of the rule. Taken in total, we believe these changes to be a very business friendly start but would like to see incentives for those that hedge MSR as an add-on above the 25% CBLR capital limit.
What is New the CBLR Proposal?
If enacted, eligible Community Banking Organizations would be able to elect the community bank leverage ratio (CBLR) framework. To be eligible Community Banking Organizations would need to have less than $10 billion in total consolidated assets, have an eligible balance sheet mix and a computed “CBLR” greater than 9 percent. Gone would be the requirement to compute and adhere to other risk-based and leverage-based capital requirements. Participants that meet the 9% threshold would be considered ‘well capitalized’. Tangentially, if enacted we believe this could be a meaningful event for the mortgage industry given the potential impact to MSR prices (higher in our opinion). In our previous update, BWFT cited the extensive work completed by the MBA on this issue which for brevity we will reference very briefly. Interested readers can go here[1] to get the details. These new proposed rules would be a significant departure from the Basel III rules which appear in comparison to be demonstrably punitive and to have had a dramatically negative impact on MSR demand, valuations and community bank involvement in mortgage banking in general.
How Capital Rules Impact Bank Involvement in Mortgage Banking, MSR Demand, and Valuation
Capital rules ultimately drive bank appetite to create, retain or sell, and buy mortgage servicing rights given the role that leverage plays in facilitating banking activity and its centrality to how banks seek to optimize within regulatorily capital restrictions. An increase in regulatory capital for MSR will ultimately cause banks to disfavor MSR whereas loosening of capital requirements likely facilitates greater activity whether it be purchase, originate or retain. In what follows we reference work completed to provide a statistical framework to infer bank demand for MSR, where we would expect valuations to migrate, and ultimately what timing we could expect.
An interesting working paper that discusses Basel III, Regulatory Uncertainty and associated Bank behavior as it relates to MSR can be found here[2]. In this paper, Hendricks, et al. identify historical trends and statistical analysis reviewing Community Banker responses in terms of demand, valuation, and timing.
In their working paper focused on regulatory uncertainty and bank behavior as a result of Basel III, Hendricks, et al. compared banks below the Basel III cut off (banks on the cusp) with those that exceeded the threshold (control). The statistics presented suggested a strong behavioral bias between the two groups. In fact, cuspy banks originated fewer mortgages (by as much as 11.5%), reduced their overall MSR on balance sheet (by as much as 0.74%) and had significantly lower MSR valuations (9.8% lower) than banks in the control group over the study period. The authors suggested that for cuspy banks, the market value of MSR on balance sheet purportedly impacted the associated capital charge and risk weighting and therefore created an incentive to take a conservative view on internal MSR values. With these statistics, the authors suggested a relationship between tighter rules and an impetus for less mortgage related activity, lower demand for MSR on balance sheet and for suppression of MSR values. As a likely extension, with the newly proposed FDIC rules (as drafted), we expect to see a number of new bank entrants to mortgage banking, increased activity to purchase (or, on the margin, to not sell) MSR, and a likely bias to be less conservative in capitalization of MSR resulting in higher valuations.
Timing is Everything…
For MSR market participants, the FDIC proposal represents a significant catalyst, but timing, as in most things, is everything. What will the market response to this proposal be, and when will it transpire? To that end, we would be remiss if we did not point out that one of the key elements of the Hendricks, et al. paper was in timing the behavioral response by banks to perceived changes in regulation. They were able to demonstrate that not only was there statistical evidence to suggest a change in behavior was associated with regulation but also that the change of behavior occurred well in advance of regulatory implementation (namely, immediately following an announcement) of any regulation. For MSR market participants this research implies that as result of the proposal’s circulation, and its likely quick ratification, a meaningful change to MSR demand, valuation, and pricing is likely to ensue and rather quickly.
It’s not what you do, it’s the way you do it: No Credit for Those that Hedge
What is missing from the 25 percent threshold postulated by the FDIC proposal is a path forward for those who meet the CBLR 9% threshold but are seeking to grow their MSR risk upwards of the 25% threshold. As has been offered in conjunction with other Level 3 assets on bank balance sheets (for example: counterparty valuation adjustment or CVA), the FDIC proposal omits a key feature: netting. The concept of netting gives banks the ability to seek and obtain regulatory relief should they be able to show that they have risk mitigating mechanisms in place to prevent unwanted profit and loss volatility. The application and usage by banks of MSR related hedging programs opens a potential avenue for regulators to provide additional regulatory relief for banks that manage the day to day market risks of their business activities.
Above 25%, Credit to those who Hedge
We believe for bank owners of MSR the FDIC falls short in incentivizing community banks to hedge their portfolios which is by definition a risk reducing activity. By providing capital relief incentives above the 25% threshold the FDIC could incentivize banks to take less risk, provide greater board and investor transparency and potentially earn additional income. Indeed, for those community banks that seek to have a larger MSR asset profile as a share of tangible equity (say above the 25% threshold), an opportunity to reduce risk while potentially earning additional income and achieving capital relief would be irresistible. One path the regulators could take is tangible equity charge based off change in fair value net-of-hedge rate shocks (say +25 or +50 bps) to the combined hedged MSR-hedge portfolio. Eligible hedges would be exempted from the counting in the CBRL off-balance sheet computation.
Summary and Final Thoughts
We reiterate our belief that MSR prices are set to go higher on the back of higher demand, a highly constructive regulatory environment and far less bulk MSR available in the market. Community banking capital relief is now entrenched as a catalyst on the horizon and we expect to see tighter spreads/higher multiples, better pricing and even better warehouse liquidity.
Once again, we reiterate our call to see Bank demand for Mortgage Servicing rise dramatically and as an indirect result, a much stronger bank ‘bid’ for mortgage servicing.
Based off many recent conversations through our franchise, the interest to hold and hedge the MSR asset by various market participants has been high. The proposed changes add additional support to the asset class and we expect to see a degree of meaningful price appreciation.
We estimate spread tightening potential in conventional and government MSR to be upwards of 50 OAS bps (~0.25x multiple) with the latter investor having better upside. Further we expect co-issue to bulk spreads to tighten dramatically given heavy bank demand and participation in electronic platforms. Since we last wrote, we already have seen tightening of co-issue to bulk spreads with co-issue outperforming.
Have Questions? Contact us at inquires@bluewater-fintech.com
Al Qureshi
Managing Partner
aqureshi@bluewater-fintech.com Direct: (917) 744-2391 Toll free: (866) 217-0246 |
Jason E. Sweeney
Executive Director, Business Development jsweeney@bluewater-fintech.com Direct: (443) 909-8758 Toll free: (866) 217-0246 |
[1] “Basel III Implementation”, May 2018, https://www.mba.org/issues/commercial-issues/basel-iii-implementation (Accessed November 23, 2018).
[2] Hendricks, Et Al. “Responding to Regulatory Uncertainty: Evidence from Basel III”, March 2016, https://deepblue.lib.umich.edu/bitstream/handle/2027.42/110908/1213_Shakespeare_March2016.pdf (Accessed November 23, 2018).