Government lenders await ‘McCargo rule’

In our last column, we happily announced the prospect of a common and uniform rule on the eligibility of GNMA and Federal Housing Finance Agency issuers. And that’s mostly what we got. The only negative in the otherwise positive event was the retention of venture capital [RBC] proposal that was included in last year’s aborted proposal for GNMA issuer eligibility.

At first, many issuers were surprised that Ginnie Mae not only accepted RBC’s proposal, but made no changes to it. The agency appears to have ignored the many public comments from issuers or the tremendous work done by the Mortgage Bankers Association, the Housing Policy Council and other trades to provide background information on the requirements of capital.

Some broadcasters initially took umbrage at the apparent rejection of their significant contribution to Ginnie Mae and newly installed chairwoman Alanna McCargo. But when it became apparent after the Aug. 17, 2022, joint announcement with the FHFA that new Ginnie officials were in no rush to discuss the new rule, issuers took a second look.

In summary, venture capital [RBC] rule, alias the “McCargo rule” imposes different capital requirements on the assets of independent mortgage banks [IMBs]. Most notable are the 250% capital requirements for mortgage servicing rights [MSRs]which reflects the Basel IV capital weighting for MSRs held by banks above a certain percentage of authorized capital.

Importantly, the joint FHFA-Ginnie Mae rule also excludes “excess MSRs” from the net worth calculation. In a sense, the RBC rule itself is less of an issue for IMBs than the fact that Ginnie Mae excludes excess management assets and term debt from the definition of net worth. Why this was done is a question for historians. This was a significant omission, but one that can easily be corrected.

It’s unclear exactly how Ginnie Mae will actually enforce her RBC rule, but one thing most issuers in the industry agree on is that the current rule would force many government lenders out of business. By excluding excess MSRs, which are the most valuable asset held by a mortgage bank, Ginnie Mae has constructed a perfectly countercyclical capital regime that would crush the government loan market if left unmodified.

Suppose an issuer has an MSR valued at 140 basis points, or about a multiple of 3.5 times annual cash flow. In this example, approximately 80 basis points are counted as “net worth” and 60 basis points are defined as “excess” and excluded under Ginnie Mae’s rule. But here’s the thing: if the valuation of the MSR is 120 basis points, then the “net worth” drops to 60 basis points; at 100 basis points, net worth drops to around 50 basis points.

As the MSR value decreases, the adjusted net worth decreases disproportionately, with the difference going to unauthorized “excess service”. In a declining interest rate environment, when loan volumes increase, most large IMBs would fail under the McCargo Rule due to the large swing in “net worth” as defined by Ginnie Mae. Failure to follow the Ginnie Mae rules, keep in mind, is considered an event of default by lenders.

The fundamental problem with Ginnie Mae RBC’s proposal is that it treats IMBs as federally insured banks rather than finance companies. Banks have permanent and segregated capital and considerable government subsidies that enable depositories to transcend economic and interest rate cycles. Banks are tasked with maintaining the profits and capital needed to absorb loan losses during a recession.

IMBs, on the other hand, have working capital for short-term cash needs, including loans and servicing in case of default, and long-term capital in the form of cash investments. in MSRs and unsecured debt to finance purchases of services. The MSR value is a function of the cash flows received each month and, in a cycle of falling interest rates, the value of the option to refinance a loan in your management portfolio. Most lenders will finance 50% of a Ginnie Mae MSR with a bank.

While banks can transform interest rate maturities, IMBs are completely and 100% correlated to movements in short-term interest rates. While a bank may borrow short-term and lend long-term, IMBs run their business with few long-term assets other than MSRs and loans held for investment. IMBs do not have the inherent ability to absorb credit losses and often operate with negative working capital, especially during a period of high loan arrears.

For Ginnie Mae, the answer to the question of how to manage IMB risk is to think like a lender, not a regulator. Luckily, the answer is detailed in the MBA’s response last year to Ginnie Mae’s acting director Michael Drrayne and an Urban Institute article that was published at the same time. Laurie Goodman, Ted Tozer and Karan Kaul stated the obvious:

“Forcing the banking framework on non-banks is inappropriate, as the fundamental risk is very different…. The current proposal – by pricing risk-based capital up to the amount of MSR equal to adjusted net worth, non-banks being required to hold capital equal to the value of the excess MSRs – is extremely punitive, as it assumes that the excess MSRs are valued at zero (a full write-down).This assumption does not meet the concept of liquidity-based insolvency.

Not only does Ginnie Mae RBC’s proposal not address liquidity risk, it makes the situation worse than for commercial banks. By imposing punitive capital weightings on MSRs and providing no credit for term and subordinated unsecured debt, Ginnie treats mortgage banks like second-class citizens. Cash investments in MSRs and term debt are perhaps the most important foundations of IMB capital structure.

It was more than a little ironic to see Wells Fargo & Co, the last major commercial bank to own Ginnie Mae’s services, recently announce its exit from the government loan market, including matching loans. Yet despite this latest setback, Ginnie Mae has a great opportunity to redesign its issuer eligibility proposal in a way that takes into account liquidity risk and will gain strong support from the mortgage industry.

If we are going to use the Basel framework to guide our actions, we need to focus on liquidity risk handled by cash rather than credit risk mitigated by static measures of capital. The simplest and most direct way to do this is to expand the definition of eligible assets to meet Ginnie Mae’s definition of net worth, as shown below:

Tier 1 capital: cash and cash equivalents, T&I, P&I advances

Tier 2 capital: Excess MSR (50%), term debt greater than 1 year

This framework aligns the Ginnie Mae issuer rules on how banking regulators manage capital and also aligns with GAAP and lender haircuts for MSRs, which is the most relevant concept for this discussion. More importantly, this revised rule would be easy for issuers to understand and manage, as it encourages investment in MSRs and also increases term debt for permanent capital.

Most issuers would be happy to require a higher net worth in exchange for some flexibility in net worth definitions. Ginnie Mae may issue guidelines on the amount of Tier 2 capital allowed, depending on the individual issuer, delinquency levels and their loss mitigation proficiency. It is the operational risk of defaulting on loans and mitigating losses, after all, that is the real risk for Ginnie Mae. Let’s focus on risk.

If President McCargo wants to settle the question of issuer eligibility this year and prepare for the real battle, namely rising delinquency levels, better think more like a lender and less like a banking regulator.

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