In the continuing aftermath of the financial crisis, the nation’s biggest banks are hemorrhaging income from their mortgage divisions. Whether it’s due to massive settlements stemming from fraudulent pre-crisis lending practices, like the one that Bank of America announced on Tuesday, or due to shrinking mortgage originations, like JPMorgan Chase announced on Wednesday, the big banks are hurting in the mortgage business.
Their losses have turned into huge growth for nonbank and smaller lenders. According to a report from the Federal Housing Finance Agency’s Office of the Inspector General, the amount of loans that Fannie Mae and Freddie Mac have purchased from nonbank and smaller lenders has exploded in the last few years.
And that may be cause for some concern among the government-sponsored enterprises, the FHFA’s watchdog says.
“According to Fannie Mae documents, 46.6% of its mortgages were purchased from nonbank mortgage companies in the first three quarters of 2013, which was up from 33.2% in 2011,” the FHFA-OIG report states. “Freddie Mac data shows that its share of mortgage purchases from nonbank mortgage companies more than doubled from 8.4% to 20.5% over that same period, but its share remains significantly lower than Fannie Mae’s share.”
The FHFA-OIG cites two nonbanks as examples of the growth it has seen in its examination of Fannie and Freddie.
Mortgage sales from Nationstar Mortgage and its parent company, Fortress Investment Group, grew from $441.7 million in the first quarter of 2011 to $7.7 billion in the third quarter of 2013. Fortress Investment Group was the sixth largest seller to Fannie Mae in the third quarter of 2013, and Nationstar Mortgage was the ninth largest seller to Freddie Mac that quarter.
Walter Investment Management Corporation, the parent company of specialty servicer Green Tree Servicing, initiated mortgage sales to Fannie Mae in the fourth quarter of 2012. Its mortgage sales to Fannie Mae grew from just $15.4 million in the fourth quarter of 2012 to $6.3 billion in the third quarter of 2013, making the firm Fannie Mae’s fifth largest seller that quarter.
The increase of nonbank and smaller lender has its positives and negatives, according to the FHFA-OIG. “For example, the shift in market share among the Enterprises’ sellers reduces the Enterprises’ highly concentrated financial exposure to their largest counterparties,” the FHFA-OIG report states. “However, the shift may also increase their exposure to certain risks and raises their costs for counterparty risk management.”
The FHFA-OIG identified three specific risks that the nonbanks pose for the GSEs:
Elevated counterparty credit risks - The Enterprises’ increase in mortgage purchases from smaller lenders and nonbank mortgage sellers may elevate their exposure to counterparty credit risk—the risk that a counterparty will default on financial obligations to the Enterprises, e.g., their representation and warranty obligations.
Elevated operational risks – According to the FHFA-OIG report, one Enterprise official told the FHFA-OIG that, relative to large commercial banks, the operations of some smaller lenders may lack sophistication, resulting in potential quality control and fraud management problems. For example, small lenders may lack access to experts in increasingly complex subject areas, such as regulatory compliance.
Elevated reputational risks - According to the FHFA, Enterprise officials, and the documents that the FHFA-OIG obtained, buying loans from some nonbanks could damage the Enterprises’ reputations. This could occur if, for example, an Enterprise bought loans from a lender that harmed consumers by engaging in fraud or other misconduct. Moreover, the Enterprises’ reputations could be damaged if several of these entities failed while the Enterprises had financial exposure to them, as could occur under adverse market conditions.
The OIG says that the counterparty credit risk is increased because the GSEs traditional top sellers are “generally well-capitalized financial firms that benefit from broad access to funding and maintain diversified business lines.”
The OIG says that it is concerned about the “relatively limited financial capacity” of some of the smaller and nonbank lenders.
“According to FHFA officials and records, some of the Enterprises’ emerging sellers may not have the financial capacity necessary to honor their representation and warranty commitments on the mortgages they sell to the Enterprises,” the OIG report says. “Consequently, the Enterprises could incur financial losses on mortgages purchased from such lenders if they do not comply with established underwriting guidelines.”
The OIG says that the elevated operation risk is due in part to the incredible growth seen by some of the nonbank and smaller lenders.
“FHFA officials said that the increased pace of the specialty servicers’ business could cause them to stretch their operational capacity or overrun their quality control procedures,” the OIG report states.
“We observe that this, in turn, could increase the potential for representation and warranty claims and credit losses on the mortgages they sell to the Enterprises. We have reported on problems that the Enterprises discovered in the servicing operations of a specialty servicer and the need for increased oversight.”
Additionally, the OIG cites the potential reputational damage that could come from being associated with certain nonbanks.
“This could occur if, for example, an Enterprise bought loans from a lender that harmed consumers by engaging in fraud or other misconduct,” the OIG states. “Moreover, the Enterprises’ reputations could be damaged if several of these entities failed while the Enterprises had financial exposure to them, as could occur under adverse market conditions.”
In the course of the OIG’s investigation, the FHFA identified a nonbank lender that “exemplifies” the reputational risks. The report does not identify the nonbank lender by name.
“This particular lender became a top 20 seller to one Enterprise during the refinance boom of 2012 to 2013. In 2013, one of the lender’s businesses engaged in abusive lending practices causing it to be subjected to regulatory and enforcement actions by several state authorities,” the OIG report states.
“Representatives of the affected Enterprise told us that it assessed the lender’s mortgage- lending operations during the period of its rapid growth,” the report continues. “In the third quarter of 2013, the Enterprise became increasingly concerned with the heightened reputational risk caused by the regulatory enforcement actions and civil litigation that had been filed against the lender and accepted the lender’s voluntary suspension from doing further business with the Enterprise.”
During the FHFA OIG’s investigation, it also determined that in 2013, the FHFA did not specifically test and validate the Enterprises’ controls over the risks associated with the recent shift in direct mortgage sales by smaller and nonbank lenders. “For example, the examiners did not validate the effectiveness of the Enterprises’ operational reviews of new and current mortgage sellers,” the report states.
The Enterprises have reportedly taken a number of steps recently to mitigate these risks, according to the OIG report.
“However, due to other examination priorities, FHFA did not specifically test and validate their effectiveness during its 2013 examination activities,” the report states.
“The Agency has scheduled a number of relevant examination activities during its 2014 examination cycle, and it plans to issue related guidance on risk management practices. We will continue monitoring the effectiveness of the Agency’s efforts to oversee this critical issue.”