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News — Recent SVB and Signature Bank failures notwithstanding, the financial industry’s stability for surviving a major downturn could depend on large, nonbank mortgage players. These entities are thinly capitalized, have high leverage, are subject to no federal safety and soundness oversight and sit on top of large exposures to highly volatile assets. They’re prone to excessive risk taking.

During the 2008 financial crisis, hundreds of nonbank mortgage lenders and servicers went bankrupt. Since, they have enjoyed a renaissance of sorts. This rise filled a void left behind by depositories reeling over mounting credit losses, intense regulatory scrutiny, litigation and reputation damage. However, while market conditions in recent years remained strong, nonbanks have posed significant risk to the stability of the mortgage market when another major downturn inevitably occurs.

Today, the corporate structure and weak regulatory oversight of nonbanks prioritizes short鈥恡erm business objectives over long鈥恡erm viability. These factors, moreover, invite weak risk management governance and practices, which at some point will manifest into poor loan鈥恗anufacturing quality, resulting in extraordinary losses for the mortgage industry and another industry shakeout.

Nonbank Business Model Naturally Promotes Risk鈥�Taking

According to , between 2007 and 2016 the share of nonbank origination volume rose from 20% to about 50%. These same lenders today represent three quarters of loans sold to Ginnie Mae. What's more, since the crisis, the share of nonbank mortgage servicing.

Given the magnitude of the 2008 crisis and regulatory response, the retreat by traditional banks from the mortgage market and subsequent move by nonbanks to take up market slack wasn't surprising. The timing of this market turnover, with one of the tightest credit environments for mortgage lending in decades, spurred on nonbank participation, as it masked underlying conditions that in the presence of market stress places these firms in greater jeopardy than depositories generally.

Hedge funds and private equity firms maintain significant ownership stakes in some of the larger nonbank mortgage companies today. However, while such activity permits private capital to flow into the mortgage market, the nature of nonbank regulation - coupled with this type of ownership structure - promotes greater risk鈥恡aking by these firms over time relative to depositories. 

Another risk nonbanks face is from large positions in a highly volatile asset class called mortgage servicing rights or MSRs.  The value of these assets is based on a strip of interest earned on each mortgage that is serviced, and so the valuations can fluctuate dramatically depending on the direction and level of mortgage rates. This, coupled with their relatively thin liquidity poses significant risk at times.

Nonbank regulatory oversight for the most part occurs at the state level, which translates into significant variability in the quality and consistency of oversight of these firms compared to bank safety and soundness regulation. This in turn provides a perfect environment for nonbanks to take on greater risk.

Hedge fund and private equity investors have limited experience with risk governance practices that traditional banks have spent the last decade building, thanks in part to regulatory mandates. This blind spot for risk management, given the acute return-focused nature of nonbank investors, promotes underinvestment in risk management capabilities that lie dormant during benign economic periods, only to emerge when markets unravel.

Loan Manufacturing, Mortgage Cycle and Risk

The risk infrastructure used by mortgage originators and servicers tends to expand and contract in concert with the mortgage cycle. Boom periods stretch underwriting resources to the limit while default and collections resources slacken. During these periods, greater loan volume — combined with credit risk expansion — puts enormous pressure on the mortgage production risk infrastructure.

Without robust risk controls, processes and governance in place, these systems can fail under the weight of excessive risk鈥恡aking. For example, a found that lenders with relatively high repurchase rates from Fannie Mae or Freddie Mac (an indication of defective loan manufacturing process) tended to experience credit losses that were 1.5-2.5 times higher than other firms for the 2003-2008 origination years, controlling for other borrower, loan and property risk factors.

Building on this analysis, I developed a similar statistical model (predicting the probability a loan would become 90 days past due or worse) to examine the relative risk of depositories and nonbanks. From a random sample of 180,000 mortgages originated between 1999-2016 and sold to one of the GSEs, a model incorporating similar variables as those used in the earlier study was estimated. An indicator variable for whether the firm was a depository or not was included and interacted with origination underwriting periods denoted as pre鈥恇oom (prior to 2004); boom (2004-2007) and crisis; and aftermath (2008-2016).

Loans originated by nonbank firms during the boom period were 20% riskier than loans originated by depositories. However, the risk of nonbanks is statistically no different from that of depositories since the crisis. These results support the point that the risk of nonbanks is masked during times when credit standards are tighter.

Under such circumstances, strong borrower and collateral requirements can cover up deficient operational risks in the underwriting and origination process that become more apparent as credit standards relax and production accelerates.

Implications and Parting Thoughts

Weak regulatory oversight of nonbank mortgage companies requires mortgage securitizers to redouble their efforts to manage counterparty risk exposure to these firms. Nonbanks have three strikes against them in their business model that increase market volatility during stress periods: they tend to be thinly capitalized, their funding sources pose liquidity risk and their risk management processes tend to be underdeveloped.

During the 2008 crisis, warehouse lines, asset鈥恇acked commercial paper and tri鈥恜arty repurchase agreements — major sources of mortgage financing of nonbanks — dried up and helped put many nonbank mortgage companies out of business. The good news is that in the years since the crisis, strong net worth and liquidity requirements have been established by the GSEs and Ginnie Mae. For example, the GSEs took steps to impose a set of rigorous (bank鈥恖ike) risk鈥恇ased capital standards on private mortgage insurance companies and Ginnie has done the same for their counterparties including nonbanks as well as added liquidity buffers.

However, given the increasing importance of nonbanks to the mortgage industry, their oversight needs to continue to evolve. In addition to strong liquidity and capital standards, the largest nonbanks should be subject to a form of heightened expectations for risk management that is compatible with their corporate structure and governance. Doing so will ensure alignment of risk鈥恡aking between nonbanks and depositories, mitigating another race to the bottom in mortgage underwriting.

(Derived from published by the Global Association of Risk Professionals)

Clifford Rossi (PhD) is a professor of the practice and executive鈥�in鈥�residence at the Robert H. Smith School of Business, University of Maryland, and a Principal of Chesapeake Risk Advisors, LLC. He has nearly 25 years of experience in financial risk management, having held a number of C鈥�level positions at major banking institutions. Prior to his current posts, he was the chief risk officer for Citigroup's North America Consumer Lending Division.