It’s not easy to be a home buyer these days. With home prices rising around 6% annually, owning a home has become less affordable. As you might expect, it’s also been difficult for lenders in the mortgage business whose firms provide the financing for the millions of Americans wanting to buy their own residence. With loan origination and volume decreasing, and after executives reduce their company’s costs, they are faced with the decision of whether to lower margins or credit standards.
Such a “race to the bottom,” which partly caused the 2008 U.S. economic meltdown, isn’t the only thing that could precipitate the next housing crisis.
I’m referring to what’s known in the financial industry as “liquidity risk.” In basic terms, this is the ability for a firm to meet short-term financial obligations such as compensating employees. Liquidity risk is particularly acute within the housing sector because non-bank lenders originate more than 50% of home loans, up from just 9% in 2009.
Non-banks also make up more than 45% of total “servicing,” by which I mean performing functions such as collecting monthly mortgage payments, accounting for taxes, and so forth. Indeed, non-banks filled the void after several banks cut back their mortgage practices after the 2008 financial crisis. But these two entities, banks and non-banks, are interdependent. Typically, banks such as Wells Fargo WFC, -1.51% and Citigroup C, -1.32% provide lines of credit to non-bank lenders so these entities can originate and service mortgages.
Unlike banks which can rely on short-term deposits as a source of capital, non-banks don’t have a captive deposit base. Here is how the financing works: non-banks originate loans and then sell them to other entities such as Freddie Mac and Fannie Mae, which pay nonbanks an ongoing fee to service the loan. The lifetime value of this fee is an asset known as a mortgage servicing right or MSR. Non-banks use MSRs as collateral, so that they can borrow money from banks to use as working capital.
But MSRs are extremely sensitive to interest rate moves. If rates fall, several smaller and thinly capitalized non-bank lenders may find it difficult to access funds needed to service loans. In addition, non-banks hedge the value of mortgages on their books to guard against moves in rates, and this requires the posting of collateral with counterparties. If the value of this collateral drops, it will also be difficult for the underperforming non-banks to obtain financing.
Some 40% of non-banks didn’t turn a profit in 2018, according to Richey May & Co, and these institutions are likely to be in a tough situation if liquidity dries up. Well-run non-banks should perform an analysis of their liquidity situations and identify risk factors. They also ought to shore up capital, in anticipation of a market event.
What’s concerning is that an external event could generate liquidity risk in the housing market. For example, when the threat of “Grexit” rattled the markets in 2016, 10-year Treasury TMUBMUSD10Y, -0.39% yields fell to 1%. This decline meant that MSRs weren’t worth as much. Therefore, banks could seek margin calls and demand more collateral from non-banks.
Indeed, the value of MSRs are also volatile because there isn’t a penalty for paying off a mortgage early, so banks charge a higher premium to lend against this asset. Translation: it’s expensive for non-banks to borrow money, especially when they most need it.
A recent Brookings Institution study contends that the housing sector “appears to have minimal resources to bring to bear in a stress scenario.” The authors posit that the failure of a non-bank could lead to deleterious consequences for the broader U.S. economy. Several small non-banks may not know what to do during such a crisis. Therefore, executives at these firms should focus as much on liquidity as they do on market share, and arguably even more.
Let’s not wait for liquidity risk to fell the housing system. These structural solutions can mitigate and perhaps prevent what could be a systemic threat:
1. Rely on the private sector: Non-banks should be able to borrow from the public markets or directly from banks. The problem is that this solution is countercyclical: when non-banks most need capital, it will be difficult to obtain it. Perhaps large institutions can provide committed capital at a reasonable price, so that non-banks can weather a liquidity crisis. If non-banks suffer losses on their hedges but make money on their MSRs, they should be able to access the value of these outperforming assets. So, one avenue to explore is to structure securities that address these liquidity needs.
2. Emergency funding from the Federal Home Loan Banks (FHLBs): FHLBs, backed by the U.S. government, provide liquidity to institutions like other banks, credit unions, and insurance companies. FHLBs should adopt a special provision so that non-banks can access stable and countercyclical sources of funding when capital is difficult to obtain elsewhere.
3. Lending from GSEs: Government Sponsored Enterprises (GSEs) such as Freddie Mac and Fannie Mae could provide direct loans to non-banks to help these firms meet their short-term commitments. There will be a concern that taxpayers would be on the hook. But there needs to be a lender of last resort, and government assistance must be weighed against the consequences of a systemic failure within the housing crisis, like we experienced in 2008.
Non-banks have indeed served as a key source of liquidity in the housing market, providing more reasonably priced options for those shopping for a mortgage. But when the markets turn, we non-bankers will need what we usually provide others — access to affordable capital.