Mortgage-Related Assets: Capital Requirements Vary Depending on Type of Asset
Published: 2016-12-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: During the 2007–2009 financial crisis, many banking organizations lacked capital of sufficient quality and quantity to absorb substantial losses on mortgages and mortgage-related assets, revealing these assets to be riskier than previously thought. In response to the crisis, banking regulators around the world moved to strengthen requirements for capital adequacy. In the United States, the Dodd-Frank Wall Street Reform and Consumer Protection Act introduced, among other things, new capital requirements for bank holding companies and savings and loan holding companies. Internationally, in December 2010 the Basel Committee on Banking Supervision (which had issued the Basel I and Basel II frameworks) issued the Basel III framework—a comprehensive set of reforms to strengthen global capital and liquidity standards—with the goal of promoting a more resilient banking sector. Under this framework, banks apply risk weights to different assets to determine the amount of capital they need to meet regulatory requirements.
GAO was asked to explain how capital requirements for a mortgage depend upon how it is financed and how the requirements have changed since the crisis. This report examines the risk weights for residential mortgages and certain other mortgage-related assets under the U.S. Basel III-based rule and how they compare to those in effect under prior capital regimes and for nonbank entities. GAO examined information on capital requirements from current and past rules.
GAO received technical comments from the banking regulators, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: Rules for capital adequacy require banks to hold a percentage of their assets as capital to act as a financial cushion to absorb unexpected losses. Under current rules, banks must hold capital equal to at least 8 percent of risk-weighted assets. Since the early 1990s, U.S. federal banking regulators have used a risk-weighting system under which banks multiply asset amounts by factors, known as risk weights, to calculate risk-weighted assets. Different types of assets have different risk weights that attempt to capture the assets' relative risk. The Basel III-based final rule adopted in 2013 by the U.S. federal banking regulators incorporates higher risk weights for certain mortgage-related assets while leaving others unchanged from prior capital regimes (Basel I and Basel II). Most banks use the standardized approach for calculating risk-weighted assets, but large internationally active banks use an advanced approach that relies on formulas established by the regulators and inputs from their internal systems.
Under the standardized approach, the risk weights for single-family residential mortgages are largely unchanged by the final rule. Similarly, the risk weights under this approach for residential mortgage-backed securities (MBS) guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac have not changed since Basel I.
Under the advanced approach, large internationally active banks use a formula defined in regulation to determine the capital requirements for residential mortgage exposures, which include whole loans as well as MBS guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac. This formula has not changed since it went into effect in 2008 under the Basel II-based rule.
For both approaches, the ways for determining risk weights for securitization exposures and mortgage servicing assets have changed under the final rule, which may increase these risk weights. As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, the final rule eliminates the use of credit ratings for determining risk weights for securitization exposures, instead relying on regulator-established formulas. Also, the final rule reduces the cap on mortgage servicing assets that can be included in capital calculations and will raise the risk weight from 100 percent to 250 percent.
The Basel III-based final rule largely left in place the historically lower risk weights of MBS guaranteed by Fannie Mae and Freddie Mac vis-à-vis other mortgage-related assets, which can influence the demand for these securities relative to whole loans and privately issued MBS. However, the full impact of changes in risk weights for holdings of mortgage-related assets remains uncertain because insufficient time has passed since these changes took effect, and for some assets the changes have not yet been fully phased in. GAO's recent work suggested that many lenders generally appeared to be participating in residential mortgage lending much as they had before capital requirements changed. Also, data on mortgage debt outstanding and on banks' holdings of different assets indicate that trends in holdings of mortgage debt and mortgage-related assets that predate the changes in risk weights have continued. But increased risk weights for some mortgage-related assets may lead to changes in banks' decisions about securitizing and servicing mortgages.

section_title: Letter
paragraphs: During the 2007–2009 financial crisis, many banking organizations lacked  capital of sufficient quality and quantity to absorb substantial losses,  specifically on mortgages and mortgage-related assets, revealing these  assets to be riskier than previously thought. In response to the crisis,  banking regulators around the world moved to strengthen requirements  for capital adequacy. In the United States, the 2010 Dodd-Frank Wall  Street Reform and Consumer Protection Act (Dodd-Frank Act) required,  among other things, that the U.S. federal banking regulators develop new  capital requirements for bank holding companies, savings and loan  holding companies, and banks. At about the same time, at the  international level, in December 2010 the Basel Committee on Banking  Supervision (Basel Committee) issued the Basel III framework—a  comprehensive set of reforms to strengthen global capital and liquidity  standards—with the goal of promoting a more resilient banking sector. In  2013 and 2014, the U.S. federal banking regulators adopted rules to  implement many aspects of the Basel III capital framework that apply to  banks, savings associations, and top-tier U.S. bank and savings and loan  holding companies (with certain exceptions). These rules, commonly  referred to as the Basel III capital requirements, are generally being  phased in by 2019.
You asked us to explain how the capital requirements for a typical  mortgage depend upon how the loan is financed (i.e., whole loan, lender  recourse, single-class MBS, credit risk transfer, PLS, FHA, REMIC, etc.)  and compare these capital requirements to those in place before the  financial crisis. This report examines the risk weights—that is, the weights  (or factors) used to calculate the amount of capital needed to meet  regulatory requirements—for mortgages and other mortgage-related  assets under the U.S. Basel III capital requirements and how they  compare to those in effect under prior capital regimes and for nonbank  entities holding mortgage-related assets.
To address this objective, we reviewed and analyzed the banking  agencies’ final rules implementing various regulatory capital regimes and  relevant literature on bank capital regulation, including academic studies  and research by industry organizations, federal agencies, and others with  a focus on bank regulatory capital and the assignment of risk weights to  mortgages and mortgage-related exposures. Additionally, we analyzed  sections of the Dodd-Frank Act that restricted the use of external credit  ratings in setting regulatory capital in the United States. We also reviewed  financial accounting standards to understand impacts of capital  requirements on banks’ willingness to engage in securitization of  mortgage assets. Furthermore, we reviewed our prior reports and reports  by the Basel Committee and the Congressional Research Service on  capital requirements, including those for the housing government- sponsored enterprises Fannie Mae and Freddie Mac (the enterprises)  and nonbank financial institutions, to better understand differences in  capital requirements that may affect institutions’ decisions related to  mortgage-related assets. We also reviewed data from the Board of  Governors of the Federal Reserve System (Federal Reserve) on  mortgage debt outstanding and from SNL Financial, which provides  comprehensive regulatory financial data on financial institutions, on  banks’ holdings of mortgage-related assets to observe trends in holdings  of mortgage-related assets. We assessed the reliability of both data  sources by reviewing information about the data and systems that  produced them, comparing the data to other published sources, and by  reviewing assessments we did for previous studies. We determined that  the data we used remains sufficiently reliable for the purposes of our  reporting objectives. Finally, we interviewed market participants, including  officials at the Mortgage Bankers Association, to obtain additional insights  into changes in capital requirements.
We conducted this performance audit from May 2016 to December 2016  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Bank capital performs several important functions. Among other things,  capital acts as a financial cushion to absorb unexpected losses, promotes  public confidence in the solvency of the institution and the stability of the  banking sector, and provides protection to depositors and deposit  insurance funds. Because of capital’s role in absorbing losses, promoting  confidence, and protecting depositors, federal banking regulations require  banking organizations to maintain adequate capital, and regulators set  minimum capital levels to help ensure that institutions do so, including a  target total minimum risk-based capital ratio—that is, the ratio of capital to  risk-weighted assets. Federal law authorizes banking regulators to take a  variety of actions to ensure capital adequacy, including informal and  formal enforcement actions. Federal banking regulators generally expect  institutions to hold capital at levels higher than regulatory minimums.
Capital rules in the United States generally follow a framework of  measures adopted by the Basel Committee. U.S. federal banking  regulators have adopted various risk-based capital regimes over the past  decades. Under these frameworks, assets and off-balance-sheet  exposures are assigned to one of several broad risk categories according  to the obligor (for example, the person or legal entity contractually  obligated on an exposure), or if relevant, the guarantor or the nature of  the collateral. Banking organizations multiply the aggregate dollar  amount or exposure amount in each risk category by the risk weight  associated with that category. The resulting risk-weighted amounts from  each of the risk categories are added together, and generally this sum is  the banking organization’s total risk-weighted assets, which comprises  the denominator of the risk-based capital ratio. For example, a $1,000 on- balance-sheet asset at a 20 percent risk weight would equal $200 in risk- weighted assets. An additional $1,000 on-balance-sheet asset at a 50  percent risk weight would equal $500 in risk-weighted assets, for a total of  $700 in risk-weighted assets (compared to the $2,000 in total assets).  The risk weights enable one to calculate the amount of capital a banking  organization would need to hold for a given asset—its “capital charge”—in  order to meet the minimum risk-based capital ratio requirements. To meet  an 8 percent minimum total capital ratio requirement, the organization  with the $700 in risk-weighted assets in the previous example would need  to hold $56 in capital ($700×0.08). The minimum total capital charge for  the $1,000 on-balance-sheet asset that was risk-weighted at 20 percent  would be $16 ($1,000×0.2×0.08), while the minimum capital charge for  the $1,000 on-balance-sheet asset that was risk-weighted at 50 percent  would be $40 ($1,000×0.5×0.08).
Risk weights for mortgages and other mortgage-related assets have been  included in a number of these regulatory capital frameworks over the  years, including the following:
The Basel Capital Accord (Basel I), which was adopted in 1988 and  implemented in the United States in the early 1990s, established a  system of generally applicable risk weights for specific assets  (including mortgage-related assets) to calculate total risk-weighted  assets and defined a minimum total risk-based capital ratio (the ratio  of regulatory capital to risk-weighted assets) of 8 percent with limited  exceptions. Under this system, all assets of a certain category—for  example, commercial loans—were assigned a flat risk weight without  regard for differences in credit quality among the assets in that  category (simple risk-bucket approach). Asset categories were  classified into one of four risk-weight buckets—0 percent, 20 percent,  50 percent, or 100 percent.
Amendments to the U.S. federal banking regulators’ rules adopted in  2001 implemented a multilevel, ratings-based approach to assess  capital requirements on asset securitizations— including mortgage- backed securities (MBS)—based on their relative exposure to credit  risk. The approach used credit ratings from nationally recognized  statistical rating organizations (NRSRO) to measure relative exposure  to credit risk and determine the associated risk-based capital  requirement.
In 2007, U.S. federal banking regulators adopted capital rules for  large internationally active banking organizations that were based on  a revised framework published by the Basel Committee in 2006  (Basel II). Only large, internationally active banks—banks with  consolidated total assets (excluding assets held by an insurance  underwriting subsidiary of a bank holding company) of $250 billion or  more or with consolidated total on-balance-sheet foreign exposure of  $10 billion or more—were required to adopt the advanced approaches  for measuring risk (including mortgage-related credit risk) established  in the Basel II-based rules. Under these rules, the advanced internal  ratings-based approach used risk parameters determined by a bank’s  internal systems as inputs into a formula developed by supervisors for  calculating minimum regulatory capital and expanded the use of credit  ratings to measure credit risk.
U.S. federal banking regulators promulgated a final rule in 2013 to  incorporate many of the changes included in the Basel III  framework. Among other changes, the final rule includes a new  standardized approach for credit risk to replace the Basel I generally  applicable risk-based capital rule. The final rule also removed  references to credit ratings that were in the Basel I generally  applicable rule and the advanced internal ratings-based approach,  consistent with requirements in Section 939A of the Dodd-Frank Act.
Other entities that hold mortgages and mortgage-related assets have  different capital requirements. For example, in 1992 the Office of Federal  Housing Enterprise Oversight, which at the time was the regulator for the  enterprises, adopted minimum capital requirements based on the  enterprises’ on-balance-sheet assets and off-balance-sheet obligations.  Nonbank financial institutions that service mortgages for the enterprises  and Ginnie Mae must comply with minimum capital and net worth  requirements those entities have issued.
section_title: The Basel III-Based Final Rule Changes the Risk Weights for Some Mortgage- Related Assets
paragraphs: The Basel III final rule adopted in 2013 by the U.S. federal banking  regulators and generally effective as of January 2015 incorporates higher  risk weights for certain mortgage-related exposures while leaving others  unchanged (see table 1). For example, the risk weights for most single- family residential mortgages are largely unchanged by the final rule.  However, the final rule changed the risk weights for some mortgage- related securitization exposures and for mortgage servicing assets.
subsections: section_title: Overall Risk Weights for Mortgages Remain Largely Unchanged
paragraphs: Risk weights for residential first-lien mortgages on one-to-four family  properties that are held in banks’ portfolios have remained largely  unchanged since the adoption of the Basel I-based rules. Under the  standardized approach outlined in the Basel III-based final rule, the  portions of mortgages that are conditionally guaranteed by U.S.  government agencies, such as the Federal Housing Administration or the  Department of Veterans Affairs, are assigned 20 percent risk weights  under the standardized approach—essentially unchanged since Basel I.  Other mortgages—and the portions of mortgages not guaranteed by U.S.  government agencies—secured by one-to-four family residential  properties are assigned a 50 percent risk weight, provided that such loans  are:  secured by a property that is either owner-occupied or rented; made in accordance with prudent underwriting standards, including  standards relating to the loan amount as a percentage of the  appraised value of the property; not 90 days or more past due or carried in nonaccrual status; and not restructured or modified (other than through the Department of the  Treasury’s Home Affordable Modification Program).
Also, if a banking organization holds the first-lien and junior-lien  residential mortgage exposures, and no other party holds an intervening  lien, the institution must combine the exposures and treat them as a  single loan secured by a first lien to determine the loan-to-value ratio and  assign a risk weight. Banking organizations are required to assign a 100  percent risk weight to a first-lien residential mortgage exposure that does  not meet the criteria previously listed and to junior-lien residential  mortgage exposures if the banking organization does not hold the first  lien on the property.
The advanced internal ratings-based approach requires banking  organizations to use a formula defined in regulation to determine the  capital requirements for residential mortgage exposures, which are  grouped into segments that have similar (homogeneous) risk  characteristics. The formula for the capital charge for nondefaulted  residential mortgage exposures uses values for the probability of default  and loss given default that each bank derives from its internal systems  (see app. I). For example, applying a probability of default of 3 percent  and losses given default of 20 percent to a segment of nondefaulted  residential mortgages would result in a risk weight of about 50 percent  using this formula. This formula is unchanged since it went into effect in  2008.
Under this advanced approach, defaulted residential mortgage exposures  that are covered by an eligible U.S. government guarantee have a capital  charge of 1.6 percent for the portion that is covered by the guarantee—an  implicit 20 percent risk weight (0.016 ÷ 0.08 = 0.2). The previous rules  did not include a separate provision for defaulted residential mortgage  exposures covered by a government guarantee. Defaulted residential  mortgage exposures not covered by an eligible U.S. government  guarantee have a capital charge of 8 percent, which implies a risk weight  of 100 percent.
The standardized approach and the advanced approach both assign a  risk weight of 50 percent to pre-sold construction loans with a legally  binding sales contract unless the purchase contract is cancelled, in which  case a banking organization must assign a 100 percent risk weight.
section_title: Some Risk Weights for Mortgage-Related Securitization Exposures Changed under the Final Rule
paragraphs: The Basel III-based final rule keeps the risk weights for government- and  enterprise-guaranteed MBS outlined under the previous rules but  changes how the risk weights for private-label securities are calculated.  Under the standardized approach, residential MBS guaranteed by Ginnie  Mae have a risk weight of 0 percent, while residential MBS issued and  guaranteed by Fannie Mae and Freddie Mac have a risk weight of 20  percent—unchanged since Basel I. As shown previously in table 1, risk  weights for other MBS that qualify as securitization exposures can range  from 20 percent to 1,250 percent under either the standardized or the  advanced approaches. Previously, risk weights for securitization  exposures could be as low as 7 percent under the advanced approach.  Under the current rules, banks using the advanced internal-ratings based  approach must also apply the standardized approach. If banks are unable  to use the formulas and approaches defined in the final rule for the  standardized and advanced approaches—for example, because they do  not have data to calculate all the inputs—they must apply the 1,250  percent risk weight to their securitization exposures.
subsections: section_title: Securitization Exposure Calculations under the Standardized Approach
paragraphs: The Basel III final rule establishes two methods for calculating risk  weights for securitization exposures under the standardized approach:
The simplified supervisory formula approach relies on objective inputs  to calculate risk weights for securitization exposures using a formula.  To use this approach, a bank needs to know the performance of the  underlying assets.
The “gross-up” approach involves calculating an amount of capital for  the bank’s exposure as well as for the portion of more senior  exposures (that is, the least risky tranches, which are given priority for  repayment), if any, for which the bank’s exposure provides support. If  a bank does not have access to the inputs required to calculate the  simplified supervisory formula approach, or prefers a simpler  approach, the gross-up approach can be applied.
Banks that are subject to another rule, the market risk rule, must use the  simplified supervisory formula approach. Banks that are not subject to  this other rule may choose to use either method but must use the same  method across all exposures.
The simplified supervisory formula approach takes into account the  weighted average capital charge for the underlying exposures,  delinquency level of the underlying collateral, and the relative size and  seniority of the security in the securitization structure (see app. II for the  details of the formula). The current balances of all the underlying  exposures in the securitization structure are used to calculate the  attachment and detachment points for each level, or tranche, of the  structure. Losses are first borne by the lowest tranches. Once a tranche  experiences a total loss, the next tranche immediately senior to it begins  to bear any additional losses.
The following hypothetical securitization structure illustrates the simplified  supervisory formula approach for a securitization backed by a pool of  residential mortgages that would be risk-weighted at 50 percent. For such  a securitization, the typical capital charge of the underlying mortgage pool  is 4 percent (50 percent risk weight multiplied by 8 percent minimum risk- based capital ratio). Assuming that 5 percent of the mortgages in the pool  are delinquent and have a risk weight of 100 percent (for an 8 percent  capital charge), the weighted average capital charge of the mortgage pool  would be 4.2 percent. The risk weights for each of the tranches can be  calculated using the formula outlined in the final rule and described in  appendix II. The risk-weight results for a pool that does not involve  resecuritizations are shown in table 2. If 10 percent of the underlying  mortgage pool is delinquent, the weighted average capital charge would  be 4.4 percent, and the tranche risk weights for the lower (more risky)  tranches would increase, reflecting the increased likelihood of losses on  these tranches. In both scenarios, the most senior tranches would have  risk weights of 20 percent.
Risk weights for other securitization exposures, such as real estate  mortgage investment conduits, can also be calculated using the simplified  supervisory formula approach. Similarly, the credit risk transfer  transactions the enterprises have engaged in with various investors would  be treated as securitization exposures for banks that hold these notes. In  most cases, these notes would have risk weights at or near 1,250 percent  due to the holders of the notes being in or near the first-loss position.
Previously, under the Basel I-based rules that most banks were subject to  through 2014, some private-label securitization exposures were assigned  general risk weights while others were given risk weights based on credit  ratings. For example, privately issued MBS backed by mortgages that  would qualify for the 50 percent risk weight would receive a 50 percent  risk weight, subject to certain conditions. Mortgage securitization  exposures—including direct credit substitutes, recourse, and residual  interests—that were externally rated were assigned risk weights between  20 percent (for long-term credit ratings of AAA or AA) and 200 percent  (for BB ratings, which indicate higher risk).
The gross-up approach in the Basel III-based rule is the same as an  approach that was available under the previous rules. To calculate risk- weighted assets under the gross-up approach, a banking organization  determines three inputs along with the exposure amount: the pro rata  share, the enhanced amount, and the applicable risk weight.
The pro rata share is the par value of the banking organization’s  exposure as a percentage of the par value of the tranche in which the  securitization exposure resides—for example, a $5,000 exposure in a  $10,000 junior tranche of one-to-four family residential mortgages  would be a 50 percent pro rata share.
The enhanced amount is the par value of all tranches that are more  senior to the tranche in which the exposure resides. These more  senior tranches are “enhanced”—that is, their credit profiles are  improved by—the subordinated tranches. If the total securitization in  the previous example is $100,000, the par value of all tranches that  are more senior to the tranche in which the bank has an interest is  $90,000.
The applicable risk weight is the weighted-average risk weight of the  underlying exposures in the securitization as calculated under the  standardized approach. For mortgages not guaranteed by the federal  government (as in the previous example), the underlying exposures  can have risk weights of either 50 percent or 100 percent. The  weighted-average risk weight would be 75 percent if half of the total  amount of underlying mortgages had a risk weight of 50 percent and  the remaining underlying exposures had a risk weight of 100 percent.
For the previous example, assume the weighted-average risk weight of  the underlying exposures is 50 percent (that is, all the mortgages meet all  of the requirements discussed previously, such as not 90 days past due  and not restructured or modified). The risk weight would then be applied  to the bank’s interest—$5,000—plus the pro rata share of the more senior  tranches—50 percent of $90,000. In other words, $50,000 ($5,000 plus  $45,000) would be multiplied by the 50 percent risk weight. The result,  $25,000, is equivalent to a 500 percent risk weight on the bank’s $5,000  exposure. The bank would then multiply the $25,000 by the minimum  capital requirement of 8 percent to determine that the capital requirement  for the $5,000 exposure is $2,000.
section_title: Securitization Calculations under the Advanced Internal Ratings-Based Approach
paragraphs: For the advanced internal ratings-based approach, the Basel III-based  final rule eliminates the credit ratings-based approach that had been the  primary method for determining risk weights for securitization exposures  under the previous rules. The credit ratings-based approach assigned risk  weights to securitization exposures based on their seniority in the  securitization structure and the effective number of exposures (as  determined by a formula), as well as their external ratings from one or  more NRSROs or inferred ratings. These risk weights ranged from 7–20  percent for the highest investment grade (long-term) securitization  exposures (e.g., AAA) to 35–100 percent for the lowest investment grade  exposures (e.g., BBB+, BBB, BBB-) to 250–650 percent for exposures  one category below investment grade (e.g., BB+, BB, BB-).
The primary method for banks using the advanced internal ratings-based  approach to calculate capital requirements for securitization exposures is  the supervisory formula approach. The supervisory formula approach was  an alternative method banks could use under the Basel II-based rules for  securitization exposures for which there was no applicable external or  inferred credit rating. It has remained largely unchanged from the Basel II- based rules with one significant exception: a 20 percent risk-weight floor,  rather than a 7 percent risk-weight floor, now applies to all securitization  exposures. The supervisory formula approach requires banks to calculate  several input parameters on an ongoing basis. These include  the exposure’s credit enhancement level and thickness;  the exposure-weighted average loss given default for the underlying  exposures to the securitization transaction and the effective number of  underlying exposures (both determined by formulas specified in the  final rule); and  the capital requirements for the underlying exposures, such as those  for residential mortgage exposures described earlier.
If banks using the advanced internal ratings-based approach are unable  to calculate the inputs for the supervisory formula approach, they may  use the simplified supervisory formula approach described earlier.
section_title: Risk Weights for Mortgage Servicing Assets Will Increase
paragraphs: The Basel III-based final rule changes the treatment of mortgage  servicing assets by (1) lowering the cap on the amount of mortgage  servicing assets that can be included in capital calculations, which  reflects, in part, the uncertainty regarding the ability of banking institutions  to realize value from these assets, especially under adverse financial  conditions, and (2) increasing the risk weights. Mortgage servicing assets  are the contractual rights owned by a banking organization to service (for  a fee) mortgage loans that are owned by others. Under previous rules,  banks included up to 90 percent of fair value or 100 percent of book value  of mortgage servicing assets in their capital calculations, whichever was  lower, and mortgage servicing assets were subject to 100 percent risk  weight. In contrast, the final rule caps the recognition of mortgage  servicing assets at 10 percent of the common equity component of tier 1  capital. Mortgage servicing assets exceeding the 10 percent threshold  must be deducted from common equity. Deductions from common equity  reduce the numerator in banks’ calculations of their risk-based capital  ratios. Mortgage servicing asset amounts that are not deducted from  common equity are currently subject to a 100 percent risk weight, and  that risk weight will increase to 250 percent beginning January 1, 2018,  when the phase-in period ends. The future increase in the risk weight  will increase risk-weighted assets, the denominator for banks’ risk-based  capital ratios. As a result, both the stricter cap and higher risk weight on  mortgage servicing assets will reduce banks’ risk-based capital ratios,  making the required minimum level more difficult to maintain.
section_title: The Enterprises and Nonbank Financial Institutions Are Not Subject to the Final Rule or Capital Requirements That Involve Risk Weights
paragraphs: The final rule does not apply to the enterprises or nonbank financial  institutions. The enterprises’ previous regulator, the Office of Federal  Housing Enterprise Oversight, established risk-based capital  requirements that were defined by stress test scenarios rather than fixed  risk weights. A simulated stress test was used to project the enterprises’  financial performance over a 10 year period and measure capital  adequacy, or the amount of capital required to survive a prolonged period  of economic stress without new business or active risk management  action. When the enterprises were placed in conservatorship in 2008,  their new regulator, the Federal Housing Finance Agency, suspended the  enterprises’ capital requirements.
Nonbank financial institutions such as nonbank mortgage servicers follow  capital requirements established by Ginnie Mae and the enterprises in  order to service loans these entities guaranteed, but these requirements  do not involve risk weights. The minimum capital requirements that are  currently in place or that have been proposed are shown in table 3.
section_title: Effects of Changes to Capital Requirements on Holdings of Mortgage- Related Assets Are Uncertain
paragraphs: The full impact of the changes to capital requirements for holdings of  mortgage-related assets remains uncertain because insufficient time has  passed since these changes took effect for both banks and nonbank  mortgage servicers, and for some assets the changes have not yet been  fully phased in. However, our past work suggested that—based on  analysis of data included in banks’ Consolidated Reports of Condition and  Income (commonly referred to as Call Reports) and Credit Union 5300  Call Reports—many lenders generally appeared to be participating in  residential mortgage lending much as they had in the past. In addition,  data on mortgage debt outstanding published by the Federal Reserve  indicate that holdings of mortgage debt for one-to-four family properties  have remained consistent with trends that predate the 2014–2015  changes in risk weights (see fig. 1): (1) mortgage debt held or guaranteed  by the enterprises holding steady, (2) mortgage debt held by depository  institutions also holding steady, (3) mortgage debt held or guaranteed by  Ginnie Mae continuing to increase slightly, and (4) mortgage debt backing  private-label securities continuing its steady decline.
But increased risk weights for some mortgage-related assets, among  other factors, can have potential implications for banks’ decisions about  securitizing and servicing mortgages and investing in MBS. Securitizing  mortgages creates exposures that may carry increased risk weights for  banks. These exposures can include mortgage servicing assets, recourse  obligations, and residual interests.
As discussed previously, the cap on the amount of mortgage servicing  assets that can be included in capital calculations is now lower than it  previously was—10 percent of common equity rather than either 90  percent of fair value or 100 percent of book value. Banks that exceed  the cap may need to hold more capital for these assets. In addition,  mortgage servicing assets will have a higher risk weight under the  final rule beginning in 2018, which will also increase the capital  required for these assets. Fewer banks may want to retain these  servicing rights and instead may seek to sell them to nonbank  financial institutions that are not subject to the final rule. The total  amount of mortgage servicing assets held by banks peaked in 2009  and generally has been decreasing in subsequent years, according to  data compiled by SNL Financial. In 2016 reports on mortgage  servicing and nonbank servicers, we found that the share of U.S.  residential mortgages serviced by nonbank servicers increased from  approximately 6.8 percent in the first quarter of 2012 to approximately  24.2 percent in the second quarter of 2015, while the share serviced  by the largest nationwide, regional, and other banks decreased from  about 75.4 percent to about 58.6 percent over the same period.
Banking organizations may face recourse obligations (for example, to  repurchase mortgages they have sold to others) when loans default  within a certain period after the sale. Banks reported a decreasing  amount of residential mortgages serviced for others with recourse,  according to data compiled by SNL Financial, but this trend predates  the Basel III-based final rule.
Under current credit risk retention rules, banks must retain an interest  equal to at least 5 percent of the credit risk for mortgage-backed  securities they sponsor unless the security qualifies for an applicable  exemption, including being exclusively backed by mortgages that  meet the definition of a “qualified mortgage.” These residual  interests are included in risk-weighted assets and may carry higher  risk weights under the Basel III-based rules than under the previous  rules, depending on how they are structured. Residual interests that  are structured as a vertical slice of the securitization structure  (meaning the sponsor retains a 5 percent interest in each tranche)  would have a lower risk weight than residual interests that are  structured as a horizontal slice of the securitization (meaning the  sponsor retains the most junior 5 percent interest in the securitization  structure). Few transactions involving the securitization of mortgages  that do not meet the qualified mortgage definition have been  completed since the rule went into effect. Instead, banks may be  electing to hold these mortgages in their portfolios or to originate  loans that meet the qualified mortgage definition, including those that  can be sold to the enterprises. The increase in banks’ holdings of  securities backed by the enterprises could be evidence of this latter  scenario, as banks often deliver loans to the enterprises in exchange  for enterprise MBS. Holdings of enterprise MBS would have lower risk  weights than holding whole loans in portfolio (whether or not they  meet the qualified mortgage definition).
Finally, the Basel III-based final rule largely left unchanged the historically  lower risk weights of MBS guaranteed by the enterprises vis-à-vis other  mortgage-related assets, which can influence the demand for these  securities relative to whole loans and privately issued MBS. While  holdings of MBS guaranteed by Ginnie Mae retain a 0 percent risk weight  and holdings of MBS guaranteed by the enterprises retain a 20 percent  risk weight under the standardized approach (and their treatment under  the advanced approach has not changed), holdings of privately issued  MBS may face higher risk weights than under the prior rules. For privately  issued MBS that have an external credit rating, the minimum weight  increased from 7 percent to 20 percent for banks subject to the advanced  approach, and the junior tranches of these MBS are likely subject to  higher risk weights in part because credit ratings can no longer be used to  calculate risk weights. According to data compiled by SNL Financial,  banks’ holdings of MBS guaranteed by Ginnie Mae and the enterprises  have been increasing while their holdings of other residential MBS have  been decreasing, but these trends predate the changes to risk weights for  privately issued MBS.
section_title: Agency Comments
paragraphs: We sought and received technical comments on a draft of this report from  the Board of Governors of the Federal Reserve System, Office of the  Comptroller of the Currency, and Federal Deposit Insurance Corporation  and incorporated their comments and feedback into the final report.
We are sending copies of this report to the appropriate congressional  committees and other interested parties. In addition, the report is  available at no charge on the GAO website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices  of Congressional Relations and Public Affairs may be found on the last  page of this report. GAO staff who made major contributions to this report  are listed in appendix III.
section_title: Appendix I: Calculation of Risk-Weighted Assets for Retail Exposures under the Advanced Internal Ratings-Based Approach
paragraphs: Under the advanced internal ratings-based approach, residential  mortgages are included in retail exposures. Generally, a banking  organization must calculate retail risk-weighted asset amounts in four  distinct phases:  1.  Phase 1 – Categorization of exposures  During this phase, the banking organization determines which of its  exposures are wholesale exposures, retail exposures, securitization  exposures, or equity exposures. Retail exposures are further categorized  as residential mortgage exposures, qualifying revolving exposures, or  other retail exposures.  2.  Phase 2 – Segmentation of retail exposures  During the second phase, a banking organization must group the retail  exposures in each retail subcategory into segments that have  homogeneous risk characteristics. A banking organization must also  segment defaulted retail exposures separately from nondefaulted retail  exposures.  3.  Phase 3 – Assignment of risk parameters to segments of retail  exposures  During phase 3, the banking organization must associate a probability of  default (PD), a loss given default (LGD), and an exposure at default  (EAD) to each segment of retail exposures such as residential mortgages.
𝐾𝐾=𝐿𝐿𝐿𝐿𝐿𝐿 ×𝑁𝑁�𝑁𝑁−1(𝑃𝑃𝐿𝐿)+√R×𝑁𝑁−1(0.999) �−(𝐿𝐿𝐿𝐿𝐿𝐿×𝑃𝑃𝐿𝐿) where K represents the capital charge; N(.) means the cumulative  distribution function for a standard normal random variable; N-1(.) means  the inverse cumulative distribution function for a standard normal random  variable; and R is the non-defaulted exposures correlation factor. For  residential mortgage exposures, R is set equal to 0.15 in the Basel III- based final rule.
𝐾𝐾=0.2 ×𝑁𝑁�𝑁𝑁−1(0.03)+√0.15×𝑁𝑁−1(0.999) √0.85 𝑁𝑁−1(0.03)=−1.88079  𝑁𝑁−1(0.999)=3.09023  𝐾𝐾=0.2 ×𝑁𝑁�−1.88079+0.3873×3.09023 0.92195 𝐾𝐾=0.2 ×𝑁𝑁(−0.74185)−(0.006)  𝑁𝑁(−0.74185)=0.22909  𝐾𝐾=0.2 ×0.22909−(0.006)  𝐾𝐾=.03982,or approximately 4%  �−(0.2×0.03) �−(0.006)
The capital charge, K, reflects the risk weight multiplied by the minimum  capital requirement. Therefore, dividing the capital charge of  approximately 4 percent by the minimum capital requirement of 8 percent  produces a risk weight of about 50 percent.
section_title: Appendix II: Specification of the Simplified Supervisory Formula Approach
paragraphs: −22.3214(0.0604−0.0104) −22.3214(0.0304−0)
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Karen Tremba (Assistant  Director), Don Brown (Analyst-in-Charge), M’Baye Diagne, Rachel  DeMarcus, Marc Molino, Jennifer Schwartz, and Tyler Spunaugle made  significant contributions to this report.