Banks currently apply a 250% risk weight to MSRs, while loans held on balance sheets typically receive a 50% risk weight.
Although regulators intended these requirements to limit the bank’s excessive concentration in volatile, high-risk MSRs and less liquid MSRs, they also contributed to reducing the bank’s participation in the space. The bank’s shares of mortgage and MSR ownership declined from about 60% and 95%, respectively, in 2008 to about 35% and 45% in 2023.
Mario Ichaso, Wells FargoA security strategist based in the residential housing center, said that the decrease in the bank’s participation in residential properties (one to four units) “may be driven less by financial management and more by the reduction of interest in real estate.”
“Great competition from non-banking operators – many of whom continue to expand their technical advantages – have materially depressed returns,” Ichaso said.
Moving forward from Basel III
In 2023, the Fed proposed a Basel III “Endgame,” which was abandoned. The proposal would not have reduced the MSR deduction limit for common equity tier 1 (CET1) capital from 25% to 10% for banks with at least $100 billion in assets. Currently, banks under the advanced channels face a limit of 10%, while those of small regional institutions remain at 25%.
For loans held on balance sheets, it also sought to introduce graduated risk weights based on loan-to-value (LTV) ratios, aligning the US closer to global standards. But the proposal was heavily criticized for adding an additional 20% risk weight.
In his speech, Bowman outlined two upcoming proposals. One can eliminate 250% of the MSR risk weight while seeking to comment on the appropriate level. One would introduce greater risk sensitivity to residential mortgage exposures, potentially binding LTV capital requirements instead of using a uniform standard. Bowman did not provide additional details.
“These potential changes will address legitimate concerns about the structure of the mortgage market while maintaining appropriate safeguards,” Bowman said. “I look forward to receiving feedback from the industry and other stakeholders as we consider these changes.”
Anticipating the effects
KBW analysts said the most significant impact could be on MSRs, where banks can generate stronger returns on equity than non-banks, given similar servicing costs. This is due to their ability to use escrow funds. Non-banks, in contrast, have more limited access to profitability.
Regarding origination, analysts noted that the revised capital rules could provide favorable treatment for low LTV loans (less than 50%).
“It is possible that banks can offer better rates on LTV adjustable-rate mortgages (ARM) than they can hold on the balance sheet,” KBW analysts wrote. “Prior to the GFC, there were many banks/thrifts that focused on ARM mortgages, and a favorable monetary regime could help revive some of this activity.”
Ichaso added that other institutions may be more willing to compete for market share in an environment where non-banks dominate the origination but do not have the large sums available in the banking system.
Such changes may also affect the secondary market, as the large holding of mortgaged assets by banks may reduce the purchase price of assets. It will lead to the complete elimination of conventional MBS.
“At the end, agency MBS pools may shift to higher LTVs as lower LTV loans are retained by banks,” Ichaso said. “A more pronounced impact could occur in the non-agency market, where prime jumbo issuance has been more active. Depending on the re-rating, high-balance, low-LTV loans could see balance sheet consolidation, potentially reducing the supply of non-agency MBS.”
