Why nonbanks are booming, and what kind of risk they bring

The nonbank market share of agency purchase mortgage originations is growing at an astronomical pace, moving from 27% in mid-2012 to 48% in late 2014, according to a new study by a senior fellow and a researcher at the Mossavar-Rahmani Center for Business and Government at Harvard’s Kennedy School.

Harvard’s Kennedy School is not the only place reporting these numbers. The American Enterprise Institute’s International Center on Housing Risk also recently put out a study citing the seismic shift in home purchase loan originations away from large banks to nonbanks.

AEI attributed the shift to the fact that compared to large banks, nonbanks are more thinly capitalized and more lightly regulated, generally face less reputational and litigation risk and tend to have a shorter-term outlook.

Here’s Harvard’s Kennedy School’s list of five factors contributing to the non-bank boom in mortgage origination and servicing:

1. Regulation of mortgages has been tightened and broadened and unlike the pre-crisis era, federal oversight now covers both banks and non-banks and state regulation has also been tightened.
2. Non-bank technological innovation is improving customer experience and non-bank market share.
3. Depository institutions have either retreated from the mortgage origination market, or grown more selective, as they’ve been hit with waves of new regulations and legal actions targeting them.
4. Non-banks are disproportionately engaged in FHA-insured lending to higher-risk borrowers.
5. Basel III and other regulatory actions have driven depository institutions out of mortgage servicing.

While the study notes that surges have caused alarm with politicians and policymakers, nonbanks are emerging to meet a need in the market.

The median FICO score of an FHA-insured non-bank borrower is 667, versus 682 for banks, and at several large nonbank originators it is below 660. 

The Harvard study states three major sources of concerns to reduce the risks of today’s nonbanks:

1. Non-banks’ reliance on FHA-insured loans is increasing their riskiness and recently lowered FHA insurance premiums may accelerate this trend.
2. Some nonbanks could pose a counterparty risk to Fannie Mae and Freddie Mac in the event of a downturn, but new bank-like Fannie Mae and Freddie Mac non-bank standards may hamper positive non-bank growth.
3. Rather than writing nonbanks off as bad, the report urges policymakers to adapt to balance concerns over systemic stability, consumer protection and market fairness.

These are the four areas that policymakers need to be aware of, according to Harvard's Kennedy School:

1. Address the largest source of nonbank mortgage origination risk: inappropriately priced FHA insurance, which can be addressed through residual income testing and other reforms.
2. Be wary when applying bank-like regulation to nonbanks given their distinct structure, and that some new bank-like standards will be disproportionately burdensome to smaller market participants.
3. Reform Fannie Mae and Freddie Mac; their poor fiscal condition causes, and recently lowered down payments intensifies, the risk that nonbank originators and servicers pose as counterparties.
4. Apply OIRA-review to FHFA and other federal financial regulators to streamline regulatory approaches and mitigate unintended consequences – like Basel III capital rules driving banks out of mortgage servicing