Wells Fargo’s Home Loan Machine Powers Through Basel III Cap

Most big lenders are proceeding as if new capital rules will inevitably force them to shrink their mortgage servicing rights, with a notable exception: Wells Fargo (WFC).

The nation’s largest home lender has been widening its lead over the other giant originators, keeping it flush with assets that represent the income stream for handling remittances from homeowners. Such claims equaled about 14% of the Tier 1 common equity Wells estimated it had under the Basel III rules as of the fourth quarter. That would run afoul of the 10% cap that would be phased in under the international capital accord.

By contrast, Bank of America (BAC) has been choking off production, and reported selling nearly $1 billion of mortgage servicing rights last year, citing Basel III as one reason. The company’s ratio of MSRs to Tier 1 common equity under the current rules fell by about 6 percentage points from the prior year to 6% in the fourth quarter, according to data in Securities and Exchange Commission filings. (B of A does not provide estimates for capital levels under the Basel III proposal.)

Similarly, Ally Financial has been cutting back on lending in part to prepare for the new capital standards, though its MSRs still measured about a fifth of Tier 1 common equity at yearend.

Overall — including at Wells — the value of servicing rights has tumbled in recent periods because of low interest rates, which spur borrowers to refinance and therefore terminate the flow of fees from outstanding loans, and high levels of delinquent mortgages, which are costly to service and eat into net revenues.

Volatility is one reason to create some clearance under the Basel III ceiling, however: with such assets priced at less than 1% of associated unpaid principal loan balances at most large servicers, a slowdown in prepayments or an improvement in delinquencies could quickly push mortgage servicing rights on a $1.5 trillion pool of loans far above a 10% cap.

Reducing the capital burden posed by MSRs is a key consideration in the Federal Housing Finance Agency’s project to overhaul servicer compensation. Servicing fees — currently set at an annual rate of 25 basis points of balances for loans guaranteed by Fannie Mae and Freddie Mac — generally exceed servicing costs, and cutting the fees would shrink the net present value of the earnings stream that MSRs reflect. (One rationale for the gap is that the servicing rights serve as a form of collateral Fannie and Freddie could transfer to a different company if a servicer fails to meet performance standards.)

Moreover, the Basel III rules are designed to be phased in gradually, giving servicers time to change course, depending on the terms U.S. regulators ultimately adopt.

In Senate testimony Thursday, however, Federal Reserve Gov. Daniel Tarullo made an argument in favor of limiting MSRs’ contribution to capital, questioning banks’ ability to sell such assets to absorb losses in an emergency. “By and large a firm cannot treat a receivable as if it’s part of capital,” he said. “When you get the money then it can be treated as capital.”

With Wells Fargo’s mortgage business steaming full speed ahead, something has to give.