The big shift: over the last few years, the contours of the mortgage industry have been reshaped as non-banks tripled their share of originations while the largest banks scaled back.

Author:England, Robert Stowe

The tectonic plates beneath the mortgage business landscape have been steadily shifting for years, reconfiguring and reordering the lineup of players and delivering a seismic shift for the entire industry. Just as large banks have scaled back their outsized role as paramount providers of mortgage credit, non-bank mortgage banking companies have been moving to fill the void. [paragraph] As a result, the non-bank share of all origination volume has tripled, from 13.8 percent in 2012 to 43.3 percent in the first quarter of 2015, according to Inside Mortgage Finance. [paragraph] This recent restructuring of the market follows years (2009 to 2012) when a handful of large banks dominated the mortgage industry. That dominance resulted in large part because several prior non-bank mortgage players went under during the housing bust.

Long after the mortgage meltdown of 2007 and the financial crisis of 2008, the top banks in the mortgage business are still dealing with problem loans made during the housing bubble and the resulting defaults, foreclosures, buybacks and settlements with government agencies and investors.

There continues to be, for the largest banks in particular, a fair amount of headline and reputational concern that has led them to reduce their exposure to the mortgage business, according to industry observers. "They have reduced their servicing exposure, particularly their exposure to higher-cost servicing and borrowers with lower cross-sell potential," says Stanford Kurland, chief executive officer of PennyMac Loan Services LLC, Moorpark, California.

PennyMac, founded in 2008, is the eighth-largest mortgage originator, producing $8.82 billion in volume in the first quarter of 2015, according to Inside Mortgage Finance. Last year the company ranked 14th with $28.8 billion in originations.

Lawsuits, higher capital standards and other regulatory changes are part of "the big squeeze" that is reducing the share of mortgage business originated by big banks, according to Bob Walters, chief economist at Quicken Loans Inc., Detroit.

Due to the "pounding" big banks have endured from lawsuits and fines and penalties, "they have been chastened and are pulling back and being very careful about the lending they are doing," says Walters.

A more risk-averse approach to the business has dried up the pipeline of originations coming from mortgage brokers, according to Walters.

"Prior to the financial crash of 2007 and 2008, about 30 [percent] to 35 percent of mortgage origination were done by mortgage brokers," says Walters. These were small shops of two to 10 loan officers, but together they made up a vast army of originators.

"Tens of thousands of brokers would originate loans and they would end up being brokered to Bank of America, Wells Fargo, GMAC, Citi and Chase--all the large entities," says Walters. "These brokers made the big banks the dominant part of the market," he adds.

Now mortgage brokers represent only 8 percent to 10 percent of originations, Walters says. This is mostly as a result of regulation, especially the Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act), which required brokers and all originators to be licensed. In addition, the big banks have largely stopped doing business with brokers.

"Wells Fargo got out. Bank of America got out. Chase got out," says Walters. "That share of the market has been picked up by other entities."

Penalty juggernaut

One of the reasons big banks have been reducing exposure is because they have been penalized severely for how they have handled bad loans during foreclosures and for investor losses on loans and related securities issued before 2008. Federal and state governments have forced huge settlements after bringing a raft of lawsuits. The toll in settlement costs is staggering.

According to New York-based Keefe, Bruyette and Woods Inc. (KBW), banks had paid $187 billion in settlements and fines between 2009 and March 2015, mostly to the Department of Justice (DOJ) and state attorneys general.

Bank of America has taken the biggest hit, with a total payout of $76.6 billion or an astonishing 41 percent of the overall legal costs for all banks. Three more of the largest U.S. banks have also been hit hard. JPMorgan Chase has shelled out settlements and fines of $38 billion; Citigroup, $16 billion; and Wells Fargo, $10 billion.

To some, the penalties seem draconian and perhaps not entirely justified, given they are based on loans made and securities issued by companies that were acquired during the financial crisis at the urging of federal authorities.

For Bank of America, for the most part the penalties are for the misconduct at two companies that occurred before the bank acquired them: former market leader Countrywide Home Loans and Merrill Lynch. According to the Department of Justice, the settlement included a statement of facts in which the bank has acknowledged that it sold billions of dollars of residential mortgage-backed securities (RMBS) without disclosing to investors key facts about the quality of the securitized loans. DOJ also claimed the bank conceded that it originated risky mortgage loans and made misrepresentations about the quality of those loans to Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA).

For JPMorgan Chase, the greatest share of the penalties has been paid for misconduct at Bear Stearns and Washington Mutual before the bank acquired them. While the Department of Justice claimed at the time of the settlement in December 2013 that JPMorgan had admitted making "serious misrepresentations" to investors in mortgage-backed securities, bank executives have insisted they had not admitted to any specific violations of the law.

The severity of punishment has left an indelible mark. "It has had a very chilling effect on the banking industry," says John Robbins, CMB, founder and board member of The Mortgage Collaborative, a San Diego-based independent lending cooperative serving small and midsized mortgage lenders.

The enforcement response has forced a rethinking that has led to a de-emphasis of the mortgage business. That reorientation has been made not only because of the losses the banks incurred from bad loans and securities, but also from the troubled foreclosure process that followed.

Big banks have scaled back mortgage exposure in varying degrees across the mortgage business, from origination to servicing. "Legacy portfolios and mortgage servicing rights [MSR] have been sold and larger banks, to one degree or another, have narrowed their channels for originations by ending correspondent lending and restricting retail lending to the bank's own customers," says PennyMac's Kurland.

Fallout from Basel III

New capital rules that apply to banks and not their non-bank competitors are another engine driving the shift in lending from banks to non-banks. Chief among these rules is the Basel III rule that limits servicing rights to 10 percent of Tier 1 common equity. The rule is often cited as prompting an onslaught of MSR transfers from banks to non-banks beginning in 2010 and accelerating after 2012.

The Basel III challenge for large banks is that the mortgage servicing assets they already had on their...

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