Government lenders await the ‘McCargo Rule’

In our last column, we joyfully heralded the prospect of a uniform, joint rule on issuer eligibility from GNMA and the Federal Housing Finance Agency. And that is mostly what we got. The one negative in the otherwise positive event was the retention of the risk-based capital [RBC] proposal that was contained in last year’s abortive proposal for issuer eligibility from GNMA.

At first, many issuers were taken aback by the fact that Ginnie Mae not only retained the RBC proposal, but made no changes. The agency seemed to have taken no notice of the extensive public comment from issuers or the huge amount of work done by the Mortgage Bankers Association, Housing Policy Council and other trades to provide substantive feedback on the capital requirements.

Some issuers initially took umbrage at the apparent dismissal of their extensive input to Ginnie Mae and the newly installed President, Alanna McCargo. But when it became apparent after the August 17, 2022 joint announcement with FHFA that Ginnie’s new officials were in no hurry to discuss the new rule, issuers took a second look.

To summarize, the risk based capital [RBC] rule, a.k.a. the “McCargo Rule” places different capital requirements on the assets of independent mortgage banks [IMBs]. Most notable are the 250% capital requirements for mortgage servicing rights [MSRs], which mirrors the Basel IV capital weight for MSRs held by banks above a certain allowed percentage of capital. 

Importantly, the joint FHFA-Ginnie Mae rule also excludes “excess MSRs” from the calculation of net worth. In a sense, the RBC rule itself is less the issue for IMBs than the fact that Ginnie Mae excludes excess servicing assets and term debt from the definition of net worth. Why this was done is a question for the historians. It was a significant omission, but one that can be corrected easily.

It is not entirely clear how Ginnie Mae will actually implement its RBC rule, but the one thing that most issuers in the industry agree upon is that the present rule would force many government lenders out of business. By excluding excess MSRs, which is the most valuable capital asset owned by a mortgage bank, Ginnie Mae has constructed a perfectly counter-cyclical capital regime that would crush the government loan market if left unaltered.

Let’s say that an issuer had an MSR valued at 140bp or roughly a multiple of 3.5x annual cash flow.  In this example, about 80bp is counted as “net worth” and 60bp is defined as “excess” and excluded under the Ginnie Mae rule. But .’s the problem: if the MSR valuation is 120bp, then “net worth” falls to 60bp; at 100bp, net worth falls to about 50bp. 

As MSR value falls, adjusted net worth declines disproportionately, with the difference going to disallowed “excess servicing.” In a falling interest rate environment, when loan volumes are rising, most large IMBs would fail under the McCargo Rule due to the large swing in “net worth” as defined by Ginnie Mae. Non-compliance with Ginnie Mae rules, keep in mind, is considered an event of default by lenders.

The basic problem with the Ginnie Mae RBC proposal is that it looks at IMBs as federally-insured banks rather than finance companies. Banks have permanent, separate capital and considerable public subsidies that allows depositories to transcend economic and interest rate cycles. Banks are about maintaining profits and capital necessary to absorb credit losses during a recession.

IMBs, on the other hand, have working capital for short-term cash needs, including lending and default servicing, and long-term capital in the form of cash investment in MSRs and unsecured debt to finance purchases of servicing. The MSR value is a function of the cash flows received each month and, in a falling interest rate cycle, the value of the option to refinance a loan in your servicing portfolio. Most lenders will finance 50% of a Ginnie Mae MSR with a bank.

While banks can transform interest rate maturities, IMBs are completely and 100% correlated to movements in short-term interest rates. a bank can borrow short and lend long, IMBs run their business with few long-term assets other than MSRs and loans held for investment.  IMBs have no in.nt ability to absorb credit losses and often operate with negative working capital, especially during a period of high loan delinquency.

For Ginnie Mae, the answer to the question of how to manage the risk from IMBs is to think like a lender, not a regulator. By good fortune, the answer is detailed in the MBA’s response last year to Acting Ginnie Mae head Michael Drayne and a paper by Urban Institute that was released at the same time. Laurie Goodman, Ted Tozer and Karan Kaul stated the obvious:

“Imposing the bank framework on nonbanks is inappropriate, as the fundamental risk is very different…. The current proposal — by assessing the risk-based capital up to the amount of MSR equal to the adjusted net worth, with nonbanks required to hold capital equal to the value of the excess MSRs — is extremely punitive, as it assumes excess MSRs are valued at zero (a complete write-down). This assumption does not address the concept of a liquidity-based insolvency.”

Not only does the Ginnie Mae RBC proposal not address liquidity risk, but it makes the situation worse than for commercial banks. By imposing punitive capital weights on MSRs and giving zero credit for unsecured term and subordinated debt, Ginnie treats mortgage banks as second class citizens. Cash investments in MSRs and term debt are perhaps the most important foundations for the capital structure of IMBs. 

It was more than a little ironic to see Wells Fargo & Co, the last major commercial bank to own Ginnie Mae servicing, recently announce its departure from government loan market, including correspondent lending. Yet despite this latest setback, Ginnie Mae has a great opportunity to refashion its issuer eligibility proposal in a way that addresses liquidity risk and will get the strong support from the mortgage industry.

If we are going to use the Basel framework to guide our actions, we must focus on liquidity risk addressed by cash rather than credit risk mitigated by static measures of capital. The most simple and straight-forward way to do this is to expand the definition of assets eligible for meeting the Ginnie Mae definition of net worth, as shown below:

Tier 1 Capital: Cash & Equivalent, T&I, P&I Advances
Tier 2 Capital: Excess MSR (50%), Term debt beyond 1 year

This framework aligns the Ginnie Mae issuer rules with how bank regulators manage capital and also aligns with GAAP and lender haircuts for MSRs, which is the more relevant concept for this discussion. Most important, this revised rule would be easy for issuers to understand and manage because it encourages investment in MSRs and also raising term debt for permanent capital. 

Most issuers would be glad to have higher net worth required in return for flexibility on the definitions of net worth.  Ginnie Mae could publish guidelines for the amount of Tier 2 capital allowed, depending upon the individual issuer, levels of delinquency and their proficiency at loss mitigation. It is operational risk from loan delinquency and loss mitigation, after all, that is the true risk to Ginnie Mae. Let’s focus on the risk.

If President McCargo wants to put the issuer eligibility question to bed this year and prepare for the real battle, namely mounting levels of loan delinquency, best to think more like a lender and less like a bank regulator.