The US housing market in the past 10 years has been characterized by unusually long-lasting low interest rates and robust government-backed mortgage programs. These market conditions have allowed nonbank lenders to boom in the last decade. In 2018 there are several proposals brought forth by regulators looking to agree on a final housing finance reform solution – the single largest piece of unfinished business 10 years after the housing crisis. The problem with these proposals is that they put too much emphasis on traditional lenders such as banks and depository institutions, and not enough on the new risk-takers of the U.S. economy: non-bank lenders.
In the aftermath of the 2008 crisis, regulators and lawmakers implemented a myriad of regulations on banks’ lending practices, in an effort to prevent toxic mortgages. As a result, over the past decade most banks decided to either completely exit the mortgage lending business, or severely limit their mortgage lending to only the worthiest borrowers with stellar credit. This created a very large gap in the lending market. Enter the nonbank lenders.
These nonbanks are usually private institutions that offer limited transparency into their lending activities, and don’t fall under the same regulations as banks. Nonbanks are regulated by state financials regulators such as the Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators. However, these organizations have not yet established uniform data and reporting standards – it is very much a work in progress. Thus, for the time being, nonbanks have the liberty to provide mortgages to less financially-qualified borrowers without much oversight.
As a result, in 2016, these nonbank lenders originated over half (53%) of all mortgages in the US. However, that 53% is mostly made-up of mortgage borrowers with lower credit scores. Most non-bank borrowers have less income/wealth, are less likely to have college degrees and are more likely to be minorities. They include 85% of all FHA borrowers, 64% of all black and Hispanic borrowers, and 58% of all low-to-moderate income borrowers. These groups tend to require loans with smaller down payments and have less inherited wealth to depend on in case of an economic downturn. The risk of defaulting on their payments is considerably higher.
While these nonbank lenders are filling in the funding gap and provide financing to a very large demographic that is not being serviced by the traditional lenders, they are exposing themselves and the lending industry to huge risks.
Unlike traditional banks, which handled all three main mortgage functions (origination, servicing and funding), nonbanks only handle the origination and servicing part, while using borrowed funds from banks. Nonbank mortgage lenders depend on credit to finance their origination costs and costs of mortgages in default. Most nonbanks are required to continue making payments to investors, insurers and tax authorities even when their borrowers skip or default on their payments. Also, nonbanks’ creditors – the warehouse lenders – can decide to pull or renegotiate their lines of credit, leaving nonbanks illiquid. Declines in house prices, a rise in mortgage defaults, or sustained rises in long-term interest rates, could each prove fatal to the nonbank lending companies. These multiple points of failure make it a very risky business.
While taking most of the risk, unlike banks, non-bank lenders have extremely limited resources available to survive an economic downturn. Only six percent of their assets are cash, while seventy percent of the nonbanks’ assets are mortgages held for sale. This means that they are used as collateral for their lines of credit and cannot be used by the company to cover any losses. To make matters worse, as of end of 2017, eighty-three percent of nonbanks’ debt was in lines of credit with maturities of less than a year. When that year is over, there is a high risk the interest rates will increase. Without the resources available to banks, such as the Federal Reserve and the Federal Home Loan Banks, nonbanks have no liquidity backstop – absolutely no safety net – in the event of an economic downturn. This could prove catastrophic to the U.S. economy.
The Housing Reform Act is currently underway but most of the rules and regulations proposed are focused on the traditional bank lenders and GSEs, while all but ignoring the rapid rise of nonbank lending and the risks that come with it. If nonbanks were to fail, the U.S. government (taxpayers) would still have to financially cover the losses through FHA, VA, GSEs or Ginnie Mae. From our perspective as taxpayers, it would be a similar situation as the 2008 crisis, but instead of bailing out banks, we would have to bail out nonbanks. We cannot let this happen.
The regulators must take a more active role to address the regulations of the nonbank lending sector, similar to the traditional banking regulatory framework. Regulators must find a way to either limit the nonbank’s sector exposure to risk, or ensure nonbanks secure the resources necessary to sustain themselves in an economic downturn, or a combination of both. Regulators must finalize the state prudential minimums for nonbanks. In addition to net worth, capital and liquidity requirements, this new regulation must consider all factors that determine the nonbanks’ risk, such as maturity and capacity of their debt facilities, business model, and their hedging strategies. To do so, regulators must immediately address and correct the lack of access to data (nonbanks are mostly private) and the lack of staff and resources dedicated to the regulation of nonbanks. They pose an enormous risk on the U.S. economy – comparable to that of the 2008 mortgage crisis – and thus, must be treated accordingly.
Brookings Institute: Mapping the Boom in the Nonbank Mortgage Lending