Fitch Says New Capital Requirements Could Increase Costs for 'Plain Vanilla" Mortgages

September 20, 2012

Proposed U.S. regulations outlining Basel III-driven capital requirements for residential mortgage lending could increase borrowing costs for "plain vanilla" mortgage products, which are classified as Category 1 loans, Fitch Ratings said in a Sept. 19 release.

Additionally, nontraditional mortgages, viewed as high risk by regulators, may be effectively eliminated from broad availability at regulated banks.

U.S. regulators' "notice of proposed rulemaking" (NPR) addressing capital requirements and risk-weighted asset (RWA) calculation criteria would, if adopted, ultimately push banks away from all but the most conventional and low risk forms of mortgage lending, according to Fitch.

Nontraditional products such as loans amortizing over more than 30 years, negative amortization mortgages, and loans lacking verification of a borrower's ability to repay would all be assigned Category 2 risk status under the NPR, forcing banks to hold two to three times more capital than presently required. For example, current capital rules place a 50% risk weighting on mortgages with an 85% loan to value. However, under the NPR, the same loan could generate a 150% risk weighting if classified as a Category 2 loan.

The definition of a Category 2 loan, while not identical, is similar to the idea of a qualified mortgage and a qualified residential mortgage pursuant to the Dodd-Frank Act. The Dodd-Frank Act enhances regulatory burden via credit risk retention for loan securitizations and compliance requirements. Together, the Dodd-Frank Act and the NPR are expected to sharply curtail the ability and willingness of banks to underwrite or purchase loans that regulators view as high risk.

Furthermore, Fitch said the NPR heightens risk sensitivity by imposing risk weights against credit-enhancing representations and warranties for both Category 1 and 2 loans that are sold. Under current regulations, risk-based capital charges are not applied to mortgages that are sold, even when the seller provides representations and warranties to take back loans that experience early payment defaults (within 120 days of sale). The NPR, in contrast, would require lenders to hold capital for the duration of the credit-enhancing reps and warranties, including early default and premium refund clauses that regulators regard as off-balance sheet guarantees.

As a result of the proposed capital changes, Fitch Ratings believes that banks will continue to meet demand for traditional loan products and pass along the additional cost of capital to borrowers. However, given the stricter treatment of Category 2 loans in the NPR and Dodd-Frank Act, it is unlikely that banks will continue to originate or sell significant volumes of nontraditional mortgage products, thereby reducing availability of credit to many borrowers.

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