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A regulatory loophole on mortgage servicing should be a no-no. Basel III should, once fully implemented, prevent any one U.S. bank from being too dominant at managing the nuts and bolts of home loans. It will impose a punitive charge if more than 10 per cent of a bank's capital is dedicated to supporting the business. But there's a way for lenders to get mortgage servicing rights off the balance sheet yet keep the income. That risks adding more confusion to a complex part of the market.
MSRs are a quirk of U.S. mortgage finance. They're an estimate of a bank's future revenue from processing payments of home loans. They can also be a handy fillip to a bank's earnings as they're worth more when rates rise, offsetting a potential drop in mortgage lending. But the crisis laid bare conflicts of interest and poor business practices. The top five players recently paid a $25-billion (U.S.) fine.
Bank of America, Citi and JPMorgan have been reducing their market share in the MSR market. Wells Fargo, though, has held steady. As of the end of 2012 its MSRs were already running up against the Basel III capital cap. Breaching the limit would mean having to hold capital of 1,250 per cent against the excess.
That's why its executives have flirted with the idea of selling some MSRs and then leasing back the day-to-day business. It has been done before by servicing specialist Ocwen Financial , which is not subject to bank capital rules. Wells' finance chief Tim Sloan recently said the bank is in no hurry to do anything. But it would not necessarily just have to win more business to tip over the limit: an increase in interest rates would push up the MSR value and the amount of capital needed.
The problem with such transactions is that they push the owners of the MSRs one step further away from borrowers. That can create even more confusion about who is legally and financially responsible for the assets, which would make any future large-scale mortgage defaults even harder to resolve. Moreover, buyers may be non-banks, which would push the assets into the less regulated shadow banking system.
It may be that Wells and whoever might buy the MSRs could devise enough checks and balances to make it work. But if there's no clear benefit to borrowers, regulators should find a way to stop it.