Non-banks in the Mortgage Market
It's hardly an overstatement to say that the institutional type of mortgage originators and servicers is playing a crucial role in the post-crisis U.S. mortgage market landscape. At the most aggregated level, there are essentially two types of entities inhabiting this landscape - banks and non-banks. Banks are highly regulated depository institutions that usually handle the three key mortgage functions of origination, funding and servicing by themselves. Non-banks represent the complement of this set of institutions and usually focus on either mortgage origination or servicing.
There have been several distinct phases in the evolution of non-bank lending but we'll restrict ourselves to the past twenty years. Over this period, the mortgage market presence of non-bank institutions has gone through three distinct phases. Pre-financial crisis, the non-bank share of mortgage originations averaged 30-35%, the share fell to 10-20% in the financial crisis, and post-crisis has rebounded sharply to more than 50%. But, this averaged number conceals the importance of non-banks to the Ginnie Mae sector where the share of originations is now at a staggering 85-90%.
This institutional diversity has important implications for Agency MBS investors from the vantage point of both voluntary and involuntary prepayments. For example, non-bank lenders have more readily embraced fintech and therefore usually offer a much more efficient path towards refinancing than banks. On the other hand, the COVID-19 pandemic exposed the fact that non-bank lenders have much less access to stable forms of short-term liquidity and are not well-positioned to handle servicing advances in a climate of a national surge in delinquency rates coupled with the widespread availability of forbearance plans. Of course, in the current economic climate, there are also broader concerns from the vantage point of systemic risk given the crucial role non-banks are playing in the U.S. housing finance sector but we will not address these issues here.
Institutional Structures for Mortgage Lending
It is insightful to look at the business model of both banks and non-banks because in a crucial sense it encodes the types of environments they are able flourish in, and in which they are challenged.
Tautologically, all financial institutions differ in the composition of their assets and liabilities but there's one crucial liability that differentiates the banks from non-banks: the presence of deposits. Deposits generally imply a relatively stable funding base for an institution but also subject it to greater regulation. The other distinguishing factor for depository institutions is that they typically don't unbundle the three crucial mortgage lending-related functions of origination, funding and servicing.
Within the overall category of depository institutions, there are essentially three different types:
Commercial banks: These range from small community to large multinational banks and participate in a number of businesses including residential and commercial mortgage lending, mutual funds, investment banking etc.
Credit unions: Not-for-profit organizations funded by member deposits and principally focused on consumer lending.
Thrifts: Institutionally similar to commercial banks but almost entirely focused on residential lending.
Non-depository institutions focused on one or more of the functions of mortgage lending are often referred to as mortgage banks or, to be more precise, independent mortgage banks (and sometimes, pejoratively, as shadow banks), in order to differentiate them from affiliates of commercial banks that also specialize in mortgage lending. Generally:
Independent mortgage banks almost by definition are much less diversified with respect to business lines than commercial banks since they focus on a specific facet of mortgage finance;
Rely heavily on short-term funding such as warehouse lines of credit;
Are typically capitalized to a lesser extent than large commercial banks; and,
Are subject to a different and less onerous regulatory framework relative to depository institutions. Non-banks are subject to state supervision in every state in which they operate. At the federal level, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the Consumer Financial Protection Bureau (CFPB) and authorized it to supervise and ensure compliance with consumer protection laws by mortgage lenders, consumer and student loan providers, and certain larger nonbank market participants. However, the CFPB does not conduct financial safety and soundness examinations of these companies.
The Post-Crisis Increase in Non-bank Share
Non-bank participation in the mortgage market can be scrutinized from two different vantage points: origination and servicing. In both cases, although the trend is less pronounced in servicing, there has been a dramatic shift in market share from banks to non-banks in the post-crisis (i.e., 2010 onwards) era.
Pre-crisis, the non-bank model was largely focused on underwriting and servicing borrowers that didn't fit into standard GSE underwriting guidelines and had a significant presence in the Alt-A and Subprime markets. Almost all such firms either went bankrupt during the Financial Crisis (e.g., New Century) or were acquired by a commercial bank (e.g., Countrywide).
The post-crisis rebound of non-banks has therefore been an instance of the phoenix rising from the ashes with several contributing factors. A significant one has been the regulatory challenges faced by banks post-crisis which have weakened their competitive presence. The Dodd-Frank act imposed minimum risk-based capital requirements which generally increased average Tier 1 risk-based capital ratios. At a more targeted level, the new Basel III capital treatment of mortgage servicing assets resulted in a number of banks reducing their exposure to this sector. On a separate regulatory front, in the aftermath of the Financial Crisis, significant settlements were extracted from a number of banks for underwriting practices related to their correspondent originations. New non-banks that entered the market post-crisis did not have this legacy exposure to worry about.
Several non-bank lenders have embraced technology to offer what is effectively an online mortgage origination process. While the rates offered by these so-called fintech lenders are not necessarily lower than those offered by other institutions, the streamlined process is a strong draw for mortgage borrowers. For example, Quicken, which is probably the canonical fintech lender, has processing lags that are as much as two to three weeks faster than the average lender.
Crucially, a highly supportive post-crisis macro environment of steady/declining mortgage rates and decreasing credit risk has provided an ideal environment for the expansion of non-bank lending. However, we expect this lending model to start showing signs of stress in 2020 and beyond as the environment for mortgage credit risk is much less benign because of the staggering increase in unemployment spawned by the COVID-19 pandemic.
Identifying Non-Banks in Loan-level MBS Data
Seller and Servicer names are available in Agency MBS data in non-normalized form (i.e., the same entity may be identified by different strings) and a first step is to map all the different variations of an entity name to a standard name. In the second step, MachineSP's classification strategy uses the HMDA Lender file to determine the entity type. This file contains this information for all lenders who have ever filed a HMDA report by filing year thus allowing us to backfill this data across time. Currently, the different categories supported in the MachineSP database are Bank, Non-Bank, Credit Union and HFA (Housing Finance Association).
The Impact of Non-Bank on Prepayments
The loan-level Agency MBS data set offers the ability to precisely quantify what the impact of entity type on prepayments is, once the originator has been appropriately classified as above. In the analysis below, the category "Bank" encompasses all depository institutions including credit unions. The data set focuses on 30-year FHA loans where it is possible to decompose prepayments into voluntary payoffs resulting from turnover or refinancing, and involuntary payoffs resulting from the buyout of delinquent loans.
The figure below highlights the noticeable impact of being a non-Bank on voluntary prepayment speeds. We choose to highlight the 2019 vintage here but similar trends are visible across different loan vintages. As discussed above, loans serviced by non-banks are expected to refinance faster because borrowers face a far more streamlined process.
On the other hand, as the next figure demonstrates, when it comes to involuntary prepayments, buyout rates on non-bank loans have much slower in the current environment as these institutions have to carefully manage their liquidity. This trend may reverse if non-banks are successful in raising external capital for the repurchase of delinquent loans.