Alert September 25, 2012

Basel III Implications for Residential Mortgage Lending

The proposed Basel III Standardized Approach (the “Standardized Approach”) for calculating risk-weighted assets (which governs the denominator of the calculation of risk-based capital ratios), significantly modifies the capital treatment of residential mortgages which may result in certain types of mortgage products becoming economically unviable.  The Standardized Approach applies to all depository institutions, top tier bank holding companies with $500 million or greater in consolidated assets, and all top tier savings and loan holding companies.  Please see the June 12, 2012 Financial Services Alert for prior coverage of the proposed Basel III standards.

Under the Standardized Approach, residential mortgages are divided into two categories for purposes of risk-weighting.  Category 1 mortgages consist of traditional mortgages not to exceed 30 years in maturity, that have regular periodic payments, are subject to certain underwriting standards and for which the interest rate may not increase beyond certain limits.  A junior-lien mortgage held by the same banking organization may be treated as a Category 1 mortgage if there are no intervening liens and the junior lien meets all of the required criteria of a Category 1 mortgage.  All other mortgages, including all other junior-lien mortgages and nontraditional mortgage products that do not conform to the prescribed terms and standards of Category 1, are classified as Category 2 mortgages.  The risk weights for Category 1 mortgages range from 35% to 100%, depending on the loan-to-value (“LTV”) ratio of the loan at the time of the origination or restructuring of the loan.  The risk weights for Category 2 mortgages range from 100% to 200% depending on the LTV ratio of the loan at the time of the origination or restructuring of the loan.  For purposes of determining the LTV ratio and risk weight of a loan, a banking organization that holds both a first and junior lien on the same property must combine the exposures to such property.  Currently, under the general risk-based capital rules residential mortgages are subject to a 50% or 100% risk weight and under the Basel II standardized approach residential mortgages that meet certain prudential criteria are subject to a 35% risk weight.

The proposed definition of Category 1 mortgages under the Standardized Approach is similar in nature to, but neither identical to nor harmonized with, the proposed definitions of “qualified mortgages” and “qualified residential mortgages” under the Dodd-Frank Act, which relate to legal liability under the ability-to-pay underwriting standards and the retention of risk in mortgage securitizations, respectively.  Please see the July 24, 2012 Consumer Financial Services Alert for prior coverage of the qualified mortgage standard and the April 19, 2011 Financial Services Alert for prior coverage of the qualified residential mortgage standard.

Further, under the Standardized Approach if a banking organization provides a credit enhancing representation or warranty on assets it sold or otherwise transferred to third parties, the banking organization would be required to treat such arrangement as an off-balance sheet guarantee under Section 33 of the Standardized Approach and apply a 100% credit conversion factor to the exposure amount.  This would include loan and other asset sales in which the sale agreement provides for (i) early default clauses, (ii)  premium refund clauses for assets guaranteed by the U.S. government, a U.S. government or a U.S. government-sponsored entity (i.e., Fannie Mae or Freddie Mac); or (iii) the return of assets in instances of fraud, misrepresentation or incomplete documentation.  The 100% credit conversion factor would need to be applied for the duration of such credit enhancing representation or warranty.

The effect of these changes on the capital treatment of residential mortgages will increase the amount of capital that must be held against the exposure to many types of residential mortgage loans.  For example, a loan with an 85% LTV ratio that is currently subject to a 50% risk weight would be subject to a 75% risk weight if classified as a Category 1 loan and a 150% risk weight if classified as a Category 2 loan.  Further, the confluence of the capital treatment under the Standardized Approach and the requirements of the qualified mortgage and qualified residential mortgage rules is expected to effectively create a small range of “plain vanilla” mortgage products that will not be subject to high capital risk weights, risk retention requirements and heightened legal liability under the prescribed underwriting standards.

The credit rating agency Fitch Ratings Ltd. recently stated that, due to the effects of the Standardized Approach, it believes that banks will continue to meet the demand for traditional loan products while passing along the additional cost of capital to borrowers, but that it also believes that “it is unlikely that banks will continue to originate or sell significant volumes of nontraditional mortgage products, thereby reducing [the] availability of credit to many borrowers.