The Death of Mortgage Banking and the Shadow Banking System

The Los Angeles Times’ “Bill would fundamentally reform home mortgage industry” reports that House Financial Services Committee Chairman Barney Frank and friends introduced the Mortgage Reform and Anti-Predatory Lending Act of 2009 (H.R. 1728) on March 26. The most chilling provision of the bill for the shadow banking system is the extension of liability for underwriting violations to third party securitizers. Together with the 5% capital requirement for originators of all production except 30-year fixed rate loans, this will lead to the end of most mortgage bankers.

My understanding of the players is mortgage brokers originate loans for commercial, savings and mortgage banks as correspondents or independent agents. They do not warehouse or maintain their own capital for production. Mortgage bankers both originate and warehouse loans prior to sale or securitization and are therefore dependent on the almost nonexistent warehouse financing. Even loans originated for sale to Fannie Mae and Freddie Mac must be financed for a short period of time.

Banks no longer trust mortgage brokers and are now relying on their own retail networks for originations. And if mortgage bankers cannot even get adequate warehouse financing, where are they going to come up with the 5% capital requirement for ARMs and other exotics? This will limit the few surviving mortgage brokers and bankers to only writing the safest 30-year fixed rate production.

Consumer protections include: forbidding payments to loan originators based on interest rate and type of loan, minimum mortgage quality standards, loan officer “duty of care” related to home buyers’ income and ability to pay, and the “net tangible benefit” test for refinancing.

Mortgage originators are so scared that The Dallas Morning News’ “Mortgage rates are great – if you can qualify” reports that they are being even more strict than Fannie (FNM) and Freddie (FRE) require to insure their loans get purchased.

Mortgage banks are not depository institutions, so beyond the 5% of ARMs and exotics they do not have capital requirements to be impaired by maintaining liability on securitizations. The GSEs do require a minimum of capital, but the capital requirement is not based on production. The real issue in the new liability is whether mortgage bankers will be reliable counterparties for investors in their whole loans and securitization.

Banks on the other hand have little to gain capital wise in securitizations if they cannot remove the risk from their balance sheet. This will seal the fate of the 20-year old shadow banking system that Bernanke and Geithner are desperately trying to resuscitate. It does not matter that investors and the actual trusts are excluded from liability; capital relief was the primary motivation of banks feeding the shadow banking system.

Eventually the government will realize that promoting basic savings through a basic banking system is the route to long term financial recovery. The Federal Reserve should be charged with balancing interest rates paid on savings with interest rates charged on lending. The needs of savers for income should not be sacrificed for the needs of borrowers. Increased incentives to savers will make more money available to lend, thus promoting long-term economic growth and eliminating any need for a shadow banking system.

Monopolizing the banking system and creating disincentives for savings provides only short term economic relief. Having the FDIC penalize banks for offering higher savings rates is just one example. The shadow banking system was a black swan in the history of banking and should never be resurrected.

Disclosure: Author is long FNM and FRE.

Comments

[Alan Young:]

"And if mortgage bankers cannot even get adequate warehouse financing, where are they going to come up with the 5% capital requirement for ARMs and other exotics? "
Well, isn't that the point? Make sure the loan is going to be worth something before you write it and sell it to an investor. That's how the mortgage business always worked, before Wall Street high-flyers got creative with it.
This is a feature, not a bug.

Apr 07 04:52 PM

[CautiousInv...:]

Thanks to the author for the reporting and keeping us abreast of unfolding events.

When you consider that everyone is screaming at the banks to increase lending and Bernanke has, more or less, submitted the Fed to membership in the shadow banking system by agreeing to lend against certain classes of securitized assets, this is really dismaying.

If the proposed legislation passes....in it shining brilliance...in one fell swoop they will probably reduce the size of the shadow banking system and will certainly choke off lending to prospective home buyers.

It's all the more amazing when you consider that it was not that long ago that Barney and Chriss Dodd were leaning on the GSE's to relax lending standards and expand their portfolio of loans to include riskier assets.

Apr 07 04:58 PM

[Gary A:]

The shadow banking system was a scam that came out of Basel 2, 1998. Until the framers of this scam are prosecuted it is business as usual once people forget.

Apr 07 06:22 PM

[Yohei:]

Savings have to increase. Therefore the retail saver has to get a return of, say, 3% net of inflation.

A casual examination of the facts shows that the CPI-U understates inflation by at least several points. Using the pre-Clinton CPI calculation (much less the pre-Johnson more valid calculation) current inflation is 3.5%.

Therefore large FDIC insured Certificates of Deposit need to return about 6.5% at this time. The problem is regulatory, naturally.

Apr 07 07:03 PM

[Ishortyou:]

those bolcheviks are realizing that the 'affordable housing sponsorship' through Fannie and Freddie was a fiasco that almost lead us to the stone age, now they realize if you dont have the money to pay dont buy it!

Apr 07 07:31 PM

[prudentinve...:]

This sounds like a reasonable set of rules to reduce liklihood of another bubble and more egregious losses being passed on to the overburdened public treasury. Too bad there isn't a minimum downpayment requirement, just like there used to be until the 1990's. My understanding is that in Canada, buyers still must put 20% down, but if this appears onerous, perhaps we should start with 10% then increase it to 20% after a few years, after the market has stabilized.

As head of the house banking committe, Rep. Frank bears much responsibility for the current mess. Had he exercised sound judgment and proposed such legislation a few years ago we would never have gotten to this sorry state of affairs.

Apr 07 08:26 PM

[Dirk McCoy:]

I'm not sure you have it right on mortgage brokers. I have a couple friends who are mortgage brokers who are very busy right now with refinancings using banks that send them their rate sheets daily and integrate them somewhat with their systems, but are independent- just like insurance brokers. Perhaps it's because these guys are very trustworthy and have been in this business a long time that they are busy right now.

As for mortgage bankers, I suppose having capital to loan is part what makes them "bankers", and if they're going to collect fees to do underwriting then requiring them to keep some skin in the game for non-traditional products seems reasonable- though I'm not sure why 15 year loans wouldn't qualify moreso than 30.

Apr 07 11:36 PM

[ArkansasAngie:]

When this bill comes up to a vote let's all hope that our representatives actually read the bill.

Apr 08 07:27 AM

[pacman1947:]

Michael,
I agree with your conclusion, "The shadow banking system was a black swan in the history of banking and should never be resurrected."

We need to find a means to control the back room banking, and illuminate the opaque deals made that caused this disaster. Banking should have never been a Black Op.

Apr 08 08:39 AM

[Augustus:]

No. That is not how the mortgage business always worked. The Mortgage Banker originated the loan for sale, generally understanding the guidelines of the loan purchasers. When the loan was sold as a whole loan, the entire loan with any loss responsibility went to that purchaser in total. The warehouse line was cleared and more loans originated for sale. The Mortgage Bankers existed to offer the borrower lower rates than the local institution may have available.

The ultimate control on the Mortgage Banker was that no investor / purchaser would buy their loans if they did not properly underwrite the loans. that does not mean that there would not be any foreclosures, just that there would not be any mortgage fraud. The Mortgage Banker would lose the ability to originate and sell, probably losing the servicing business as well.


On Apr 07 04:52 PM Alan Young wrote:

> "And if mortgage bankers cannot even get adequate warehouse financing,
> where are they going to come up with the 5% capital requirement for
> ARMs and other exotics? "
> Well, isn't that the point? Make sure the loan is going to be worth
> something before you write it and sell it to an investor. That's
> how the mortgage business always worked, before Wall Street high-flyers
> got creative with it.
> This is a feature, not a bug.

Apr 08 09:24 AM

[Chris Cook:]

I suspect that the deficit-based system of mortgage-backed credit is beyond redemption.

I think that there is an "asset-based" solution available through a new take on equity,and a vriation onREITs, however.

seekingalpha.com/artic...

Apr 08 09:38 AM

[kingaj12:]

Retail banking is not going to make a come-back. All us folks are not likely to take our money out of mutual funds and put it into a bank account paying 2%. That is what happened to the old banking system and what initiated the SL crisis in 1980's.

Having Congress dictate lending practices is foolish beyond words.

Apr 08 09:58 AM

[eieinli:]

Right! We already forgot the outrageous BONUSES that "stunned" Herr OBAMA!


On Apr 07 06:22 PM Gary A wrote:

> The shadow banking system was a scam that came out of Basel 2, 1998.
> Until the framers of this scam are prosecuted it is business as usual
> once people forget.

Apr 08 12:19 PM

[PainfullyAware:]

The Shadow Banking Interests Still Have Great Power. (We Just Gave Them A Stupid Amount Of Money And Told Them They Could Value Their Assets At "What Ever You Think They Are Worth.)

I will be surprised if, through the process of Congress, the intent of this proposed bill is not bastardized and rendered inert. It is well evident that our "Representatives" listen to K-Street Lobbyists with greater reverence than the populous. Que Bono - Follow The Money.

Complexity Favors The Sinister.

Reality Will Be Reality Whether Believed In Or Not.

At Least The Root Cause Of This Calamity Is Gaining Some Attention - A Glimmer Of Hope.

"Having Congress dictate lending practices is foolish beyond words." - kingaj

Very Wise Statement kingaj - That is not the proper role of the Federal Government.

"When this bill comes up to a vote let's all hope that our representatives actually read the bill." - ArkansasAngie

Alas, The Irony Of Your Statement Illicits A Bitter Chuckle.


We will eventually set in place legislation meant to keep this event from happening again. After about 40 years they will begin to argue that things have changed and that those laws are "Old And Restrictive".

Humanity Is Constant In Behavior; Only The Tools And Environment Change. This is why the Constitution is TIMELESS; It Addresses Human Behavior.

To Assume Benevolence IS Foolish.

Apr 08 01:22 PM

[User 357469:]

Hey pacman1947...

Was getting in the top 20 important enough to you that you needed to use several of your own accounts to boost your own ratings?

On Apr 08 08:39 AM pacman1947 wrote:

> Michael,
> I agree with your conclusion, "The shadow banking system was a black
> swan in the history of banking and should never be resurrected."
>
>
> We need to find a means to control the back room banking, and illuminate
> the opaque deals made that caused this disaster. Banking should have
> never been a Black Op.
>

Apr 08 05:37 PM

[dw57:]

considering that the main cause of todays debacle is that mortgage brokers and banks wrote contracts they knew had no chance of being repaid. how are these changes bad? they are not subject to CRA or almost any federal regulations, they only cared that the borrower could breath (and there have been many reports of that). and they would even go back and refinance to even worse loans all to do one thing. make the loan to get a commission. since they weren't responsible for the loan after the fact, they didn't care that if that loan were to go bad. Fannie and Freddie were at most collaborators. they should never have reduced their standards. and the rating agencies were a major factor. they were rating junk as AAA+ and knew it.

Apr 09 11:50 AM

[p.e:]

"Eventually the government will realize that promoting basic savings..."
eventually.. may be...
Now interest is taxed, mortg. is tax deductible. Inflation punishes saver, rewarding borrower and inflation seems to be the goal. All efforts are directed towards reducing borrowing costs, with obvious consequences.
Savings are vulnerable, anything from counter party risks to civil litigation (divorce, accidents, liabilities of all kinds). One is much more likely to be in litigation if known to have substantial savings.
People are mortal and may die before using their savings.
There are reasons why people do not save.
Saving is unlikely to be promoted any time soon as, in the short term, it will only make economic situation more difficult. And who is thinking about long term?

Apr 10 10:08 PM

[Gary A:]

I don't think it was a black swan. I think the whole mortgage toxic loan apparatus was planned and was a scam against the middle classes of the world, mainly the US. hubpages.com/hub/We-Al...

Apr 15 11:17 PM