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Impact of Bank Capital

Proposals on the Residential

Mortgage Markets

August 2012

Kenneth E. Kohler

Anna T. Pinedo

Morrison & Foerster LLP

This is MoFo. 2

Introduction

On June 12, 2012, the Federal banking agencies (the OCC, Federal Reserve Board and FDIC) (the “Agencies”) formally proposed three sets of significant changes to the U.S. regulatory capital framework:

The Basel III Proposal, which applies the Basel III capital framework to almost all U.S. banking organizations

The Standardized Approach Proposal, which applies certain elements of the Basel II standardized approach for credit risk weightings to almost all U.S. banking organizations

The Advanced Approaches Proposal, which applies changes made to Basel II and Basel III in the past few years to large U.S. banking organizations subject to the advanced Basel II capital framework

The original deadline for comments on all three proposals was Sept. 7, 2012. In early August, the Agencies extended the comment deadline to October 22, 2012

This presentation examines the likely impacts of the bank capital proposals on U.S. residential mortgage markets

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Impacted Aspects of Mortgage Business

The proposals address regulatory capital treatment of: Single-family (1-4 unit) mortgage loans

Residential construction loans

Multi-family mortgage loans

Mortgage-backed securities (MBS)

Mortgage servicing rights (MSRs)

Gain on sale of mortgage loans and MBS

The proposals principally affect mortgage-related assets held in bank portfolios – not mere origination

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Summary of Likely Impacts

The proposals encourage conservatively underwritten, traditional

mortgage loans

The proposals provide incentives for banks to hold conservatively underwritten,

plain vanilla product – and penalize banks for holding mortgage loans deemed by

the regulators to be more risky

The proposals do not address origination, so banks desiring to offer a broader

range of products to borrowers who need more flexible payment options or lower

downpayments, for example, can still make such loans, but are pushed to sell them

in the secondary market shortly following origination

Even so, banks constitute a substantial portion of the secondary market, so non-

traditional products will have fewer purchasers – likely affecting price and liquidity

of non-traditional products

This is MoFo. 5

Summary of Likely Impacts (cont’d)

Banks with excess capital (regardless of size) will have more flexibility to offer non-

traditional loan products if they choose to do so

The few large, multinational banks subject to the Advanced Approaches may have

more flexibility than the vast majority of banks subject to the Standardized Approach

with regard to holding non-traditional loan products

Advanced Approaches banks must adopt the most restrictive of the Standardized Approach

and Advanced Approaches methodologies

Advanced Approaches banks may still have room to apply internal analyses that non-traditional

products do not require the draconian capital haircuts that Standardized Approach banks must

apply

At a minimum, the large multinational banks will likely have a competitive advantage in the loan

products they can offer, if they choose to do so

The restrictive treatment of MSRs will discourage banks from selling loans

with servicing retained, and will lead many banks to try to sell MSRs The new rules will encourage whole loan sales with servicing released

To the extent there is not a robust secondary market for both loans and servicing, banks will

have little incentive to lend beyond the level of loans they can comfortably hold in portfolio

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Summary of Likely Impacts (cont’d)

The proposals do nothing to encourage securitization as a take-out for loans originated by banks While the changes from the current rules for securitizations are not as substantial

as the changes for whole loans, at the margin they are more restrictive than current rules

Regulatory and accounting changes implemented since the financial crisis – together with the continued weak housing market – have virtually shut down the new issue RMBS market

All things being equal, the proposals suggest additional opportunities for non-bank lenders, securitizers and servicers to assume a larger role in the residential mortgage markets. Examples: PHH Mortgage and Quicken Loans (originators)

Nationstar and Ocwen (servicers)

Redwood Trust and Pennymac (mortgage REITs)

The proposals will likely have a substantial negative impact on the mortgage insurance industry.

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Summary of Likely Impacts (cont’d)

Policy Implications

Availability of credit

First-time buyers

Non-traditional or credit-challenged borrowers who require flexible terms

Fair lending

Recycling of mortgage funds for lending

Proposals provide little or no incentive for banks to originate beyond their ability

to hold loans in portfolio

When the restrictive and capital treatment of residential lending is added to

other restrictive developments such as credit risk retention and FAS 166/167,

unclear whether many banks will even consider residential mortgage lending to

be a profitable activity worth pursuing

Further negative effect on the thrift/savings and loan industry

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Summary of Likely Impacts (cont’d)

Relationship to Other Regulatory Initiatives and Industry

Developments

Credit risk retention

“Qualified mortgage” definition

FDIC Safe Harbor

Servicing reform

Accounting rules

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Applicability

Basel III Proposal

All U.S. banks that are subject to minimum capital requirements, including Federal

and state savings banks.

Bank and savings and loan holding companies other than “small bank holding

companies” (generally bank holding companies with consolidated assets of less

than $500 million).

Top-tier domestic bank and savings and loan holding companies of foreign banking

organizations.

Does not apply to foreign banking organizations, but does apply (with

a few exceptions) to U.S. bank subsidiaries, and top-tier U.S. bank

holding company subsidiaries, of foreign banking organizations.

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Applicability (cont’d)

Standardized Approach Proposal

Generally the same as for Basel III Proposal, except does not apply to Advanced

Approaches banks

Advanced Approaches Proposal

Covers banking organizations currently subject to “advanced approaches” rules or

market risk rules under Basel II

Consolidated assets ≥ $250 billion, or

Total consolidated on-balance sheet foreign exposures ≥ $10 billion, or

Aggregate trading assets and trading liabilities equal to 10% or more of

total assets or at least $1 billion

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Basel III

Effective Dates/Transitional Periods

Minimum Tier 1 capital ratios – 2013-2015

Regulatory capital adjustments and deductions – 2013-2018

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Mortgage Risk Weights The most direct impact is from the changes to risk-weighting for

residential mortgage assets under the Standardized Approach

These changes will apply to the vast majority of U.S. banks

Even Advanced Approaches banks must apply a “minimum common denominator”

test—they must calculate capital requirements under both approaches and adopt

the most restrictive

The Standardized Approach will be effective Jan. 1, 2015, with banks

permitted to opt in earlier

No change to risk-weighting for government-supported loans

Loans unconditionally guaranteed by U.S. government or agencies – 0% risk

weight

Loans conditionally guaranteed by U.S. government or agencies – 20% risk weight

Loans guaranteed by Fannie Mae or Freddie Mac – 20% risk weight

However, major changes to risk-weighting for non-governmental

single-family first lien mortgage loans, currently risk-weighted at 50%

(with limited exceptions)

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Mortgage Risk Weights (cont’d)

Proposal includes a matrix under which the risk-weighting of a

residential first mortgage loan depends principally on two variables:

Loan terms and underwriting: Category 1 (traditional) vs. Category 2 (non-

traditional)

Term

Payment schedule

Documentation

Loan-to-value (LTV) ratio

Eight sets of risk weights—generally higher than current rules

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Mortgage Risk Weights (cont’d)

LTV Ratio (%) Category 1 Risk Weight Category 2 Risk Weight

<60 35% 75%

>60, <80 50% 100%

>80, <90 75% 150%

>90 100% 200%

Residential mortgage risk weight chart

(Applies to single-family mortgage loans not guaranteed by U.S. government, agency or GSE)

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Risk-Weights: LTV Rules

The “loan” component of LTV ratio (numerator) determined using

maximum loan amount

HELOCs – use total credit line

Closed-end mortgages – use fully funded outstanding principal amount

Junior liens -- include total funded and unfunded commitments on senior loans in

addition to junior loan amount

The “value” component of LTV (denominator) is the lesser of (i)

acquisition cost or (ii) appraised value of property at origination (or

estimated value if an appraisal is not required)

Private mortgage insurance (PMI) not taken into account in

determining LTV ratio

LTV ratio to be updated when a loan is modified or restructured

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Risk-Weight Categories Two categories – “Category 1” and “Category 2,” with Category 2 loans

carrying at least twice the risk-weighting of a Category 1 loan with the same

LTV

Category 1 loans are narrowly defined as extremely conservatively

underwritten, “plain vanilla” traditional loans

first liens only

maximum 30-yr. term

no principal deferral, negative amortization or balloon payments

No “low-doc” or “no-doc” loans

Any loan not satisfying Category 1 tests is a Category 2 loan

Federal regulators are authorized to re-assign a Category 1 loan as a

Category 2 loan if they conclude loan is not prudently underwritten; but no

authority to upgrade a loan’s category from Category 2 to Category 1

Category 1 definition is very close to the definition of “qualified mortgage,” or

“QM,” currently under discussion in proposed credit risk retention regulations

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Risk-Weight Categories (cont’d) A Category 1 loan must satisfy the following criteria:

the term of the loan may not exceed 30 years

the mortgage loan must provide for regular periodic principal payments but may not

provide for negative amortization, deferral of payments of principal or balloon

payments

the annual rate of interest on the loan may increase no more than two percentage

points in any 12-month period and no more than six percentage points over the

term of the loan in the case of an adjustable rate loan

the standards used to underwrite the loan must: (i) take into account all of the

borrower’s obligations; and (ii) result in a conclusion that the borrower is able to

repay the loan using: (A) the maximum interest rate that may apply during the first

five years after the closing date of the loan; and (B) the maximum possible

principal amount over the life of the loan

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Risk-Weight Categories (cont’d)

the determination of the borrower’s ability to repay the loan must be based on

documented, verified income

for a first-lien HELOC, the borrower must qualify using principal and interest

payments based on the maximum contractual exposure under the terms of the

HELOC

the loan may not be 90 days or more past due or on non-accrual status

the mortgage loan may not be a junior lien loan except where the same institution

holds both the first lien loan and the junior lien loan, with no intervening liens (in

which case the junior loan may be treated as a Category 1 loan if each loan has

the characteristics of a Category 1 loan)

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Loans Sold with Recourse

Under current rules, mortgage loans sold with recourse are

converted to an on-balance sheet credit equivalent amount 120 days

after sale.

The Standardized Approach Proposals eliminates the 120-day

“grace period.”

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Restructured and Modified Loans

Current Capital Treatment

Restructured or modified mortgage loans risk-weighted at 50% or 100%

Loans modified under HAMP retain original risk weight classification

Proposed Capital Treatment (Standardized Approach)

Restructured or modified loans are classified based on terms of the new loan

Category 1—100% risk weight

Category 2—200% risk weight

If LTV is updated, loan can be classified as if it were a newly originated loan

Loans modified solely under HAMP retain their original risk weight classification

This is MoFo. 21

Multifamily Mortgage Loans

Current Capital Treatment

Multifamily loans are risk-weighted at 100% for the first year. Thereafter, their risk

weight drops to 50% if certain conditions are met:

All P&I payments must have been timely made for the first year

The loan must amortize over a period of 30 years or less, and the term of the

loan cannot be less than 7 years

Annual NOI must exceed annual debt service by 20% for a fixed rate loan or

15% for an adjustable rate loan

Proposed Capital Treatment (Standardized Approach)

Same treatment as under current rule (100% first year, 50% if conditions are met),

plus an additional condition:

The LTV ratio does not exceed 80% for a fixed rate loan or 75% for an

adjustable rate loan

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Residential Construction Loans

Current Capital Treatment

Construction loans for one-to-four family residential pre-sold properties generally

risk-weighted at 50% if certain conditions are met

Proposed Capital Treatment (Standardized Approach)

Current treatment continues with additional conditions, including:

Builder must incur at least the first 10% of direct costs of construction (including

land) before the builder may draw on the loan

Construction loan amount may not exceed 80% of the sales price of the pre-

sold residence

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Risk-Weighting Under Advanced

Approaches

Unlike Standard Approach, very little change to current risk-

weighting for residential mortgage loans under Advanced

Approaches

Advanced Approaches still rely on determination of probability of default and

probable loss if a default, based on the bank’s internal ratings-based system

probability of default based on estimated long-term average one-year default

rate for similar loans

floor of 10% on probable loss of a default for loans not guaranteed by a

government or agency

The proposal would remove a requirement under current advanced

approach that probability of default be adjusted upward to account

for effects of seasoning

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Securitization Exposures

Standardized Approach Operational requirements

Due diligence

Calculation of exposures

Off-balance sheet

Repo-style transactions

On-balance sheet

Risk-weighting alternatives

SSFA Approach

20% floor

Gross-Up Approach

Other

Treatment of gain-on-sale

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Securitization Exposures (cont’d)

Advanced Approaches Changes to Securitization Exposures:

New definition of resecuritization exposures

Broadening of the definition of securitization exposures, while excluding certain traditional investment firms from definition

Removal of ratings-based and internal assessment approaches for securitization exposures; new hierarchy for exposure treatment

General use of supervisory formula approach (“SFA”) or its simplified version of SFA (“SSFA”) in calculating capital requirements for securitization exposures, as well as guarantees and credit derivatives referencing such exposures

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Securitization Exposures (cont’d)

Revised Capital Treatment of Certain Exposures

Exposures affected: certain securitization exposures (CEIOs, high-risk

exposures, low-rated exposures); eligible credit reserves shortfall; certain failed

capital markets transactions

New treatment – assigned a general 1,250 percent risk-weighting instead of

deduction from capital (dollar-for-dollar capital)

Market Risk Capital Rule: Federal and state savings banks and their holding companies that meet the

market risk capital rule threshold criteria would become subject to the market

risk capital rule

This is MoFo. 27

Capital Treatment of MSRs

The proposals substantially change the capital treatment of MSRs for

the worse, and are likely to cause banks to shun the retention of

MSRs in future loan sales and securitizations

Current treatment

Intangible assets, including MSRs, limited to 100% of tier 1 capital

MSRs valued at lesser of 90% of FMV and 100% of unamortized BV

Non-deducted MSRs assigned a 100% risk weighting

Proposed treatment

MSRs capped at 10% of common equity tier 1 capital, with any excess deducted

from common equity tier 1 capital

MSRs, deferred tax assets and investments in common stock of other financial

institutions subject to an aggregate cap of 15% of common equity tier 1 capital

To the extent not deducted from common equity tier 1 capital, MSRs assigned a

250% risk-weighting

MSRs valued at 90% of FMV, marked-to-market quarterly

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Capital Treatment of Gain-on-Sale

The Basel III proposal penalizes the use of gain-on-sale

accounting by requiring gain-on-sale associated with a

securitization exposure to be deducted from common

equity tier 1 capital This rule reflects the continuing view that the “origination for sale” model was a

major factor leading to the Financial Crisis

The restriction applies only to an increase in the equity capital of a banking

organization resulting from the consummation or issuance of a securitization (other

than an increase resulting from the receipt of cash)

The limitation does not apply to gain-on-sale from the sale of whole loans

Origination-for-sale has fallen into disfavor in any event, in part because of more

restrictive accounting rules

This provision limits the incentive for banks to sell loans to recycle funds for

mortgage lending by restricting one of the most common forms of “recycling”

This is MoFo. 29

Conclusion

Thank you!

August 2012

1 NY2-706484

Proposed Capital Rules – Mortgage-Related Issues

I. Basel II – Capital Components and Deductions Current Rules Proposal Components Tier 1 capital Tier 1

• Common stock • Shareholders equity • Perpetual preferred

Tier 1 common equity capital • Common • Retained earnings • AOCI Additional Tier 1 capital • Noncumulative perpetual

preferred Tier 2 capital • Subordinated debt • Cumulative perpetual preferred

• Subordinated debt Deductions After-tax gain-on-sale associated with securitizations

• No deduction or adjustment • Deduct from common equity Tier 1 capital

Credit-enhancing interest-only strips reflecting after-tax gain-on-sale

• Excess of amounts over 25% of Tier 1 capital deducted

• Deduct from common equity Tier

Mortgage servicing assets Greater of deduction representing: • Excess of sum of MSA, non-

mortgage service assets, and purchased credit card relationships over 100% of Tier 1 capital

• 10% of fair market value MSAs

Three stages • Amount that exceeds 10% of

common equity Tier 1 capital must be deducted from CET1 • Sum of remaining amount

of MSAs and DTAs and (after their own 10% deductions) that exceeds 17.65% of adjusted CET1 must be deducted from CET1

• At a minimum, 10% of fair market value of MSAs must be deducted from CET1

II. Risk Weights for Mortgage Loans Current Rules Proposal First-lien mortgages • Amount to be risk-weighted is

unpaid principal balance • First-lien residential mortgage

“made in accordance with prudent underwriting standards:” 50%

• All other residential mortgages: 100%.

• No change in risk weight for modified or restructured loans

• Amount to be risk-weighted is unpaid principal balance

Risk weights depend on two sets of factors: category and loan-to-value ratio. • Category 1

- 30-year maturity or less - Regular periodic payments

August 2012

2 NY2-706484

Current Rules Proposal • Past-due loans: 100% - Underwriting takes into

account all of borrower’s obligations

- Conclusion that borrower able to repay based on (i) maximum interest rate in first five years and (ii) original loan amount is maximum balance over the life of the loan

- Interest rate may adjust no more than 2% in twelve-month period and no more than 6% over life of the loan

- Borrower’s income documented and verified

- Loan is not more than 90 days past due or on non-accrual status

- Not a junior-lien loan. • Category 2:

- Fails to meet any Category 1 condition

- All principal payment optional loans

- All loans with balloon payments

- All “low-doc” and “no-doc” loans

LTVs – four tiers:

LTV Cat. 1 Cat. 2 <60% 35% 100% 60-80% 50% 100% 80-90% 75% 150% >90% 100% 200%

• Value is the lesser of the actual

acquisition cost or appraised value at origination or restructuring

HELOCs • 100% • May be treated as Category 1 if

underwriting is based on maximum principal and interest rate payments.

Junior-lien mortgages

• 100% • Category 2, but - Holder of both first- and

junior-lien mortgages, with no intervening mortgagee, may treat both loans as Category 1, if terms meet

August 2012

3 NY2-706484

Current Rules Proposal Category 1 requirements

- Loan amount for determining LTV ratio is outstanding balance plus maximum contractual principal amounts of more senior-lien mortgage loans, as of date junior-lien mortgage was originated

Restructured or modified mortgages

• Original risk weight: 50% or 100%

• Loan modified under HAMP

retains original risk weight

• Assigned to Category 1 or 2 based on new terms and conditions

• If new appraisal is performed, mortgage is risk-weighted by LTV ratio.

• If no new appraisal: - Category 1: 100% - Category 2: 200%

• Loan modified solely under

HAMP retains original risk weight

FHA and VA loans • 0% • 0%

Mortgage loans sold with recourse

• After 120 days, converted to on-balance sheet assets at 100%

• Immediately converted to on-balance sheet assets at 100%

• No 120-day grace period

Pre-sold residential construction loans

• 50%, if - Firm contracts - Purchaser has obtained

commitment for permanent financing

- Purchaser has made substantial earnest money deposit

- Underwriting requirements

• 50% under largely the same conditions as current rule, but specifically: - Prudent underwriting - Purchaser is an individual

intending to occupy as a residence

- Legally binding written sales contract

- Firm written commitment for permanent financing

- Earnest money must be at least 3%

- Earnest money deposit held in escrow

- Builder must incur at least first 10% of direct costs

- Loan may not exceed 80% of sales price

- Loan not more than 90 days past due or on non-accrual status

• If purchase contract is

August 2012

4 NY2-706484

Current Rules Proposal cancelled, 100% risk weight

Past-due mortgages

• 100% • Loan becomes a Category 2 loan and is risk-weighted by LTV tier

Multifamily mortgages

• 100% in first year • 50%, if

- All principal and interest payments on time in preceding year

- Amortization not to exceed 30 years

- Original maturity not less than seven years

- NOI in previous fiscal year not less than 120% of annual debt service (115% in case of adjustable rate loan

• 100% in first year • 50%, if

- Same conditions as current rule, plus

- Original LTV on loan may not exceed 80% for fixed-rate loan or 75% for adjustable rate loan

Mortgage servicing assets • Together with other servicing assets and purchased credit card relationships, capped at 100% of Tier 1 capital. Excess to be deducted.

• Non-deducted amount risk-weighted at 100%.

• On stand-alone basis, capped at 10% of bank’s adjusted common equity tier 1 capital. Excess to be deducted from common equity

• Non-deducted amount risk-weighted at 250%.

III. Securitization Exposures Current Rules Proposal Qualitative Requirements

• Implicit—as necessary for accounting purposes and legal opinions

• Operational requirements - Due diligence - Traditional securitizations - Synthetic securitizations - Clean-up calls

Exposure amounts

• Face amount • Off-balance sheet - Notional amount - Special calculation for

eligible ABCP liquidity facility, depending on whether SSFA applies

• Repo-style transactions - OTC derivative weights - Collateralized transaction

weights • On-balance sheet - Carrying value

August 2012

5 NY2-706484

Current Rules Proposal Risk-weighting options • No explicit floor

• Rating agency classifications • Gross-up approach

• 20% floor • Simplified supervisory formula

approach • Gross-up approach • Alternatives

Mortgage servicing assets • 100% on amount not deducted

from Tier 1 capital • 250% on amount not deducted

from common equity Tier 1 capital

Interest-only strips

• Non-credit enhancing I/O strip - If two or more external

ratings, weighted according to lower rating

- Otherwise, 100% • Dollar-for-dollar on amount of

credit-enhancing I/O strip not deducted from Tier 1 capital

• Interest-only MBS: 100% • 1,,250% (dollar-for-dollar) on

credit-enhancing interest-only strip that does not constitute an after-tax gain-on-sale

Credit-risk mitigants • Collateral • Credit derivatives • Guarantees

• Same set of mitigants, but substantially new definitions and requirements

• Collateral - Simple approach - Haircut

• Credit derivative - Eight conditions

• Guarantees - Eligible guarantors

expanded to include Contacts Anna T. Pinedo New York 212-468-8179 apinedo@mofo.com

Dwight Smith Washington, D.C. 202-887-1562 dsmith@mofo.com

Kenneth E. Kohler Los Angeles 213-892-5815 kkohler@mofo.com