Nonbanks

FSOC Issues Report on Nonbank Mortgage Servicing Highlighting Strengths, Vulnerabilities and Recommendations

June 5, 2024 By Nanci Weissgold

What Happened?

In May 2024, the Financial Stability Oversight Council (FSOC or Council) issued a Report on Nonbank Mortgage Servicing (the Report). The Report recognizes the strengths of nonbank mortgage companies (NMCs) and the important role they serve. However, the Council warns that the vulnerabilities of NMCs are more acute due, in part, to the mortgage market shift from banks to NMCs, the increasing federal government exposure to NMCs, financial strain of nonbank originators following the end of the refinance boom, and considerable liquidity risk from NMCs funding sources. The Council warns that it will continue to monitor such risks and take or recommend additional actions in accordance with its Analytic Framework (the 2023 Analytic Framework) and Nonbank Designation Guidance (the 2023 Nonbank Designation Guidance), which we discussed in a prior blog post. The Council also makes several recommendations, including asking Congress to establish a fund financed by the nonbank mortgage sector and administered by an existing federal agency to ensure there are no taxpayer-funded bailouts should a nonbank mortgage servicer fail.

Why Does it Matter?

Background

The Dodd-Frank Act empowers FSOC to designate a nonbank financial company subject to enhanced prudential standards and supervision by the Federal Reserve’s Board of Governors by a two-thirds vote of the Council. The Council is comprised of 10 voting members consisting of the U.S. prudential regulators, the Director of the Consumer Financial Protection Bureau (CFPB), the Director of the Federal Housing Finance Agency, the Chair of the Securities and Exchange Commission, the Chairman of the Commodity Futures Trading Commission, an independent member having insurance expertise, and five non-voting members with the Secretary of the Treasury serving as Chairperson of the Council.

This designation can be made upon the Council’s finding that:

Material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or
The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability in the United States.

The Council’s 2023 Analytic Framework provides a non-exhaustive list of eight potential risk factors and the indicators that FSOC intends to monitor that include: (i) leverage, (ii) liquidity risks and maturity mismatches, (iii) interconnections, (iv) operational risk, (v) complexity of opacity, (vi) inadequate risk management, (vii) concentration, and (viii) destabilizing activities. Additionally, FSOC will assess the transmission of those risks by evaluating: (i) exposure, (ii) asset liquidation, (iii) critical function or service, and (iv) contagion. The 2023 Nonbank Designation Guidance, procedural in nature, defines a two-stage process the Council will use to make a firm-specific “nonbank financial company determination” pursuant to FSOC’s Analytic Framework. The Council also has the authority to make recommendations to regulators and Congress and engage in interagency coordination.

The 2024 Report on Nonbank Mortgage Servicing

At the outset, the Council recognizes that the NMC market share has increased significantly. Based on HMDA data, NMCs originate around two-thirds of mortgages in the United States and owned the servicing rights on 54 percent of mortgage balances in 2022 as compared to 2008 when NMCs originated only 39 percent of mortgages and owned the servicing rights on only four percent of mortgage balances. Moreover, in the 10-year period between 2014 and 2024, the share of Agency (i.e., Fannie Mae, Freddie Mac, and Ginnie Mae) servicing handled by NMCs increased from 35 percent 66 percent.

In 2023, NMCs serviced around $6 trillion for the Agencies and approximately 70 percent of the total Agency market.

FSOC recognizes that NMCs filled a void following the 2007-2009 crisis when banks exited the market due to several factors (such as the revised capital rules on banks, making MSRs less attractive, as well as perceived increased costs of default servicing resulting from the National Mortgage Settlement, the Independent Foreclosure Review, prosecutions under the False Claims Act, and private litigation.) According to FSOC, NMCs developed substantial operational capacity and embraced technology. The Council also recognizes NMCs’ strength in servicing historically underserved borrowers. In 2022, NMCs originated greater than 70 percent of mortgages extended to Black and Hispanic borrowers and more than 60 percent of low- and moderate-income borrowers.

While recognizing the strengths of NMCs, the Report also highlights several vulnerabilities. Of the eight risk factors identified in the 2023 Analytic Framework, FSOC focuses its concerns on the following four vulnerabilities:

Liquidity Risks & Maturity Mismatches: As provided in the 2023 Analytic Framework, a shortfall of sufficient liquidity to cover short-term needs, or reliance on short-term liabilities to finance longer-term assets, can lead to rollover or refinance risk. FSOC may measure this risk by looking at the ratios of short-term debt to unencumbered liquid assets and the amount of additional funding available to meet unexpected reductions in available short-term funds. FSOC reports “considerable” liquidity concerns from NMCs’ funding sources and servicing contracts. First, NMCs’ reliance on warehouse lines of credit can result in (i) margin calls, (ii) repricing or restructuring lines by raising interest rates, changing the types of acceptable collateral, or canceling lines, (iii) exercising cross default provisions, and (iv) the risk of multiple warehouse lenders enforcing covenants or imposing higher margin requirements at the same time. Second, NMCs face liquidity risk from margin calls on the hedges in place to protect interest rate movements while mortgages are on a warehouse line. Third, NMCs face liquidity risks from their lines of credit that are collateralized by mortgage servicing rights (MSRs), that can also result in margin calls. Finally, requirements to advance funds on behalf of the investor (particularly Ginnie Mae) or repurchase mortgages from securitization pools may result in liquidity strains.
Leverage: As provided in the 2023 Analytic Framework, leverage is assessed by levels of debt and other off-balance sheet obligations that may create instability in the face of sudden liquidity restraints, within a market or at a limited number of firms in a market. To assess leverage, the Council may look at quantitative metrics such as ratios of assets, risk-weighted assets, debts, derivatives liabilities or exposures, and off-balance sheet obligations to equity. The Report cites to data from Moody’s Ratings which requires an NMC to have a ratio of secured debt to gross tangible assets of less than 30 percent for its long-term debt rating to be investment grade. In the third quarter of 2023, 37% of NMCs met this standard and 35% of NMCs had ratios in excess of 60 percent which is considered a high credit risk. According to FSOC, equity funding by NMCs add to leverage vulnerability.
Operational Risk: As provided in the 2023 Analytic Framework, operational risk arises for the “impairment or failure of financial market infrastructures, processes or systems, including due to cybersecurity vulnerabilities.” The Report highlights that for NMCs operational risks include continuity of operations, threats from cyber events, third-party risk management, quality control, governance, compliance, and processes for servicing delinquent loans.
Interconnections: As provided in 2023 Analytic Framework, direct or indirect financial interconnections include exposures of creditors, counterparties, investors, and borrowers that can increase the potential negative effect measured by the extent of exposure to certain derivatives, potential requirement to post margin or collateral, and overall health of the balance sheet. Through warehouse lenders, other financing sources, servicing and subservicing relationships, NMCs are connected to each other. Because of such linkages, the Council is concerned that financial difficulties at one core lender could affect many NMCs.

Because of these NMC vulnerabilities, FSOC is concerned that NMCs could transmit the negative effects of such shocks to the mortgage market and broader financial system through the following channels discussed in the 2023 Analytic Framework:

Critical Functions and Services: As provided in 2023 Analytic Framework, a risk to financial stability can arise if there could be a disruption of critical functions or services that are relied upon by market participants for which there is no substitute. FSOC is concerned that if an NMC is under financial strain, it would not have the resources to carry out its core responsibilities, which could result in bankruptcy, borrower harm, operational harm, or servicing transfers mandated by state regulators.
Exposures: This refers to the level of direct and indirect exposure of creditors, investors, counterparties, and others to particular instruments or asset classes. Again, if an NMC faced financial strain that impacted the ability of the NMS to execute its functions, other counterparties could be harmed, including investors and credit guarantors. The Agencies could also experience high costs and credit losses and may have challenges in transferring servicing to a more stable servicer. The Report notes that “servicing assumption risk may be slightly less acute (though not less costly) for the enterprises, which have more preemptive tools available to them to assist a servicer in distress than Ginnie Mae does.”
Contagion and Asset Liquidation: While these are two separate risks, the Council grouped them together. As defined in the 2023 Analytic Framework, contagion is the potential for financial contagion arising from public perceptions of vulnerability and loss of confidence in widely held financial instruments. Asset liquidation is rapid asset liquidation and the snowball effect of a widespread asset selloff across sectors. The Council is concerned that because MSRs are a large share of NMCs’ assets, “changes in macroeconomic conditions or funder risk appetite” could depress MSR valuations resulting in rapid liquidation and have a material impact on NMC solvency and access to credit.

Because of the federal government’s financial support to Fannie Mae and Freddie Mac, and the direct responsibility for Ginnie Mae’s guarantee to bond investors, the federal government has an interest in addressing servicing risks. FSOC does not believe such risks, as identified above, are sufficiently addressed by the states or existing federal authority. First, “[n]o federal regulator has direct prudential authorities over nonbank mortgage servicers.” Second, the state regulators have prudential authority, however, only nine states (as of April 2024) have adopted prudential financial and corporate governance standards. To that end, the Council recommends:

State regulators adopt enhanced prudential requirements, further coordinate supervision of nonbank mortgage servicers, and require recovery and resolution planning for large nonbank mortgage servicers.
Federal and state regulators should continue to monitor the nonbank mortgage sector and develop tabletop exercises to prepare for the failure of nonbank mortgage servicers.
Congress should provide the Federal Housing Finance Agency and Ginnie Mae with additional authority to establish safety and soundness standards and directly examine nonbank mortgage servicer counterparties for compliance with such standards. Congress should also authorize Ginnie Mae and encourage state regulators to share information with each other and Council members.
Congress should consider legislation to provide more protections for borrowers to keep their homes.
Congress should consider providing Ginnie Mae with authority to expand its Pass-Through Assistance Program (PTAP) to include tax and insurance payments, foreclosure costs and or advances during periods of severe market stress.
Congress should through legislation establish a fund (financed by the nonbank mortgage servicing sector) to facilitate operational continuity of servicing for servicers in bankruptcy or failure to ensure the servicing obligations can be transferred, or the company is recapitalized or sold. The Council recommends that Congress provide “sufficient authority to an existing federal agency to implement and maintain the fund, assess appropriate fees, set criteria for making disbursements, and mitigate risks associated with the implementation of the fund.”

What Do I Need to Do?

Well, shortly after the Report was issued, CFPB Director Chopra issued a statement, indicating that: “The Report is silent on what, if any, tools the FSOC itself should use to address these risks. That must be the next phase of our work. In line with the 2023 Analytic Framework and Nonbank Designation Guidance, we should carefully consider whether any large nonbank mortgage companies meet the statutory threshold for enhanced supervision and regulation by the Federal Reserve Board.”

Given that warning, NMCs should pay careful attention to the statutory threshold for enhanced supervision and work on mitigating their liquidity and other risks. The Report points out that the CSBS enhanced prudential standards are enforceable by the states that have adopted such standards “including through multistate examinations that include at least one state that has adopted the standards or through referrals to states that have adopted these standards.” Thus, servicers should anticipate more state or multistate probes concerning liquidity and corporate governance. And, while stating the obvious, now is the time to double down on managing operational risks, including but not limited to continuity of operations, threats from cyber events, third-party risk management, quality control, governance, compliance, and processes for servicing delinquent loans.

FSOC Approves Analytic Framework for Financial Stability Risks and Guidance on Nonbank Financial Company Designations

November 14, 2023 By Nanci Weissgold, Anoush Garakani, Aileen Ng

A&B Abstract:

On November 3, 2023 the Financial Stability Oversight Council (hereinafter “FSOC” or “Council”) unanimously approved final versions of: (1) the new Analytic Framework for Financial Stability Risk Identification, Assessment, and Response (“Analytic Framework”); and (2) the updated Guidance for Nonbank Financial Company Determinations (“Nonbank Designations Guidance”). The Analytic Framework was published today in the Federal Register and is effective immediately, and the Nonbank Designations Guidance will be effective 60 days after publication in the Federal Register.

Given the recent bank failures, it should come as no surprise that federal regulators are focusing on financial risks to U.S. stability across various sectors, including nonbank mortgage lenders and servicers.

Background

Following the 2007-2009 financial crisis, the Dodd-Frank Act created FSOC, an interagency panel of top U.S. financial regulators, to monitor excessive risks to U.S. financial stability and facilitate intergovernmental cooperation to effectively address those risks. Chaired by the Treasury Secretary and consisting of 10 voting members (comprised of the U.S. prudential regulators including, among others, the Consumer Financial Protection Bureau (“CFPB”)) and 5 nonvoting members, one of the Council’s statutory purposes is to specifically oversee large, interconnected bank holding companies or nonbank financial companies that pose potential risks to U.S. financial stability and, given the broad statutory mandate, the Council’s monitoring may cover an expansive range of asset classes, institutions, and activities, such as:

Markets for debt, loans, and other institutional and consumer financial products and services;
Central counterparties and payment, clearing, and settlement activities;
Financial entities, including banking organizations, broker-dealers, mortgage originators and services;
New or evolving financial products and practices; and
Developments affecting the resiliency of the financial system, such as cybersecurity and climate-related financial risks.

The Dodd-Frank Act empowers the Council to designate a nonbank financial company subject to certain prudential standards and supervision by the Federal Reserve’s Board of Governors. The Dodd-Frank Act lists 10 factors that Council must consider before making such designation. To date, the Council has used this authority sparingly. According to Treasury Secretary Janet Yellen, the Council’s updated Nonbank Designations Guidance will make it easier to use its nonbank designation authority, eliminating “several prerequisites to designation … that were not contemplated by the Dodd-Frank Act and that are based on a flawed view of how financial risks develop and spread” that exist under the previous guidance issued in 2019.

As the country experienced a regional bank crisis earlier this year, it would not be unreasonable to conclude that the Council may use its authorities less sparingly than in the past. The Council’s annual reports specifically address the potential risks of nonbank companies, support the updated requirements issued by the Federal Housing Finance Authority, Ginnie Mae and the CSBS Model State Regulatory Prudential Standards for Nonbank Mortgage Servicers, and recommend that relevant federal and state regulators continue to enhance or establish information sharing in responding to distress at a mortgage servicer. Indeed, in June 2022, FSOC restarted its Nonbank Mortgage Servicing Task Force, an interagency group to facilitate coordination and additional market monitoring of nonbank servicers.

The Finalized Analytic Framework

The finalized Analytic Framework, which is not a formal rule, broadly describes the approach FSOC expects to take in “identifying, assessing, and responding to certain potential risks to U.S. financial stability,” and interprets “financial stability” to mean the “financial system being resilient to events or conditions that could impair its ability to support economic activity, such as by intermediating financial transactions, facilitating payments, allocating resources, and managing risks.” The Council’s statutory mandate includes the duty to monitor a wide class of assets, such as new or evolving financial products and practices, and nonbank financial companies, such as mortgage originators and servicers, at several key pressure points.

Following consideration of public comments on the proposed Analytic Framework, which we previously discussed, the finalized Analytic Framework reflects several key changes from the proposed Analytic Framework, which include:

A description of the term “threat to financial stability” that builds on the proposed interpretation, specifically, to mean events or conditions that could “substantially impair” the financial system’s ability to support economic activity;
Additional examples of the types of quantitative metrics FSOC will consider to assess vulnerabilities that contribute to risks to financial stability;
Clarification on the relationship between the vulnerabilities and the four transmission channels (discussed below) by highlighting vulnerabilities that may be particularly relevant to a channel; and
An emphasis on the importance of FSOC’s engagement with state and federal financial regulatory agencies as it assesses potential risks and the extent to which existing regulation may mitigate those risks.

Under the finalized Analytic Framework, a non-exhaustive list of potential risk factors and the indicators that FSOC intends to monitor includes:

Leverage, assessed by levels of debt and other off-balance sheet obligations that may create instability in the face of sudden liquidity restraints.
Liquidity Risks & Maturity Mismatches, measured by the ratios of short-term debt to unencumbered liquid assets and the amount of additional funding available to meet unexpected reductions in available short-term funds.
Interconnections, measured by the extent of exposure to certain derivatives, potential requirements to post margin or collateral, and overall health of the balance sheet.
Operational Risks, measured by the failure to implement proper controls related to financial market infrastructures and the vulnerability of cybersecurity incidents.
Complexity or Opacity, such as the extent to which transactions occur outside of regulated sectors, in a grey area of overlapping or indefinite jurisdiction, or are structured in such a way that cannot be readily observed due to complexity or lack of disclosure.
Inadequate Risk Management, such as the failure to maintain adequate controls and policies or the absence of existing regulatory oversight.
Concentration, measured by the market share for the provision of important services within segments of applicable financial markets and the risk associated with high concentration in a small number of firms.
Destabilizing Activities, such as trading practices that substantially increase volatility in a particular market, especially when a moral hazard is present.

Just as FSOC will consider all the factors listed above as sources of potential financial risk contagion, it will also assess the transmission of those risks to broader market sectors and other specific entities based on certain metrics. This non-exhaustive list of transmission risk factors includes:

Exposures: The level of direct and indirect exposure of creditors, investors, counterparties, and others to particular instruments or asset classes.
Asset liquidation: Rapid asset liquidation and the snowball effect of a widespread asset sell off across sectors.
Critical function or service: The potential consequences of interruption to critical functions or services that are relied upon by market participants for which there is no substitute.
Contagion: The potential for financial contagion arising from public perceptions of vulnerability and loss of confidence in widely held financial instruments.

Despite receiving comments recommending that the Analytic Framework specifically address climate-related risk, FSOC declined to do so, explaining that it believes potential risks related to climate change may be assessed under other factors such as through the “interconnections” vulnerability factor and the “exposures” transmission channel. Similarly, FSOC declined to specifically discuss risks to the financial needs of underserved families and communities because it expects that such risks would be considered under the “critical function or service” transmission channel.

Once a financial risk has been identified, FSOC may use various tools to mitigate such risk depending on the circumstances. For instance, FSOC may work with the relevant federal or state regulator to seek to address the risk. Where a regulator can sufficiently address such risk in a timely manner, FSOC will encourage regulators to do so. Through formal channels, the Council can make a public recommendation to Congress or regulatory agencies to apply new standards or heightened scrutiny to a known risk within their jurisdiction. Where no clear-cut regulatory oversight exists, the Council may make legislative recommendations to Congress to address the risk. These formal recommendations to agencies or Congress, made pursuant to section 120 of the Dodd-Frank Act, are also subject public notice and comment.

In addition to making nonbinding recommendations for action to the appropriate financial regulatory authorities, FSOC is empowered to make a “nonbank financial company determination,” by a two-thirds vote, that a specific company shall be supervised by the Federal Reserve Board of Governors and subject to enhanced prudential standards. This designation can be made upon FSOC’s finding that:

Material financial distress at the nonbank financial company could pose a threat to the financial stability of the United States; or
The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability in the United States.

Nonbank Financial Company Designation Final Interpretative Guidance

The finalized Nonbank Designations Guidance is procedural in nature relating to nonbank financial company designation. It defines a two-stage process FSOC will use to make a firm-specific “nonbank financial company determination” discussed in FSOC’s Analytic Framework. In the proposed interpretive guidance issued for public comment in April 2023, the Council recognized that in the past, it “has used this authority sparingly, but to mitigate the risks of future financial crises, the Council must be able to use each of its statutory authorities as appropriate to address potential threats to U.S. financial stability.” The Nonbank Designations Guidance will change the 2019 guidance in the following three ways:

First, under the current guidance, FSOC is committed to relying on federal and state regulators to address problematic nonbank financial company activity before considering whether a designation is appropriate. The new guidance removes this prioritization and allows FSOC to consider an entity for a designation proactively, without first relying on regulators to act before FSOC begins deliberating.
Second, FSOC has finalized the Analytic Framework discussed above to revise its process for monitoring risks to U.S. financial stability. This comprehensive new framework replaces that found in Section III of the 2019 interpretive guidance. Because the new guidance is focused on the procedural process for making nonbank financial company designations, the substantive analytic factors applied by FSOC in its assessments will be contained in the separate Analytic Framework document.
Third, FSOC has reversed course and is eliminating its current practice of conducting a cost-benefit analysis and an assessment of the likelihood of material financial distress prior to making its determination. FSOC has concluded that these processes are not required by Section 113 of the Dodd-Frank Act. FSOC defines “material financial distress” as a nonbank financial company “being in imminent danger of insolvency or defaulting on its financial obligations.” In eliminating the “likelihood” assessment required by the 2019 guidance, the Council will now presuppose a company’s material financial distress and then evaluate what consequences could follow for U.S. financial stability.

With respect to the formal process for nonbank financial company determinations, the finalized Nonbank Designations Guidance describes a two-stage process that FSOC will use once they decide to review a company for a potential designation.

Stage One: FSOC will conduct a preliminary analysis of a company that has been identified for review based on quantitative and qualitative information available publicly and regulatory sources. FSOC will notify the company no later than 60 days before a vote is held to evaluate the company for Stage Two. A company under review may submit information for FSOC’s review and may request to meet with FSOC staff and members agencies responsible for the analysis. When evaluating a company in Stage One, the Council’s Nonbank Designations Committee may decide whether to analyze the risk profile of the company as a whole or to consider the risk posed by its subsidiaries as separate entities, depending on which entity the Council believes poses a threat to financial stability. At Stage One, FSOC is statutorily obligated to collect information from any relevant, existing regulators that oversee the company’s activities concerning the specific risks the Council has identified.

Stage Two: Any nonbank financial company selected for additional review will receive notice that the company is being considered for supervision by the Federal Reserve and enhanced prudential standards. The Nonbank Designations Guidance says that “[t]he review will focus on whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the company, could pose a threat to U.S. financial stability.” At this point, if a company is under consideration for a Proposed Determination it will receive a formal Notice of Consideration from the Council.

The Council will begin its Stage Two review by consulting with the U.S. Treasury Department’s Office of Financial Research (OFR) and relevant financial regulators to ascertain the risk profile of the company. This information would remain confidential throughout the process, and, once interagency coordination has produced all available information, the company will be invited to submit any relevant information to the Council. These submissions may include “details regarding the company’s financial activities, legal structure, liabilities, counterparty exposures, resolvability, and existing regulatory oversight. . . . Information relevant to the Council’s analysis may include confidential business information such as detailed information regarding financial assets, terms of funding arrangements, counterparty exposure or position data, strategic plans, and interaffiliate transactions.” Council staff from the FSOC Deputies Committee will be available to meet with representatives of the company and will disclose the specific focus of the Council’s analysis, although the areas of analytic focus may change based on the ongoing analysis.

Finally, if FSOC preliminarily designates the company for supervision by the Federal Reserve and subjects it to enhanced prudential standards, the company will be able to request a nonpublic hearing after which FSOC may vote to make a final designation. FSOC will conduct an annual review for any company designated by the Council to determine whether continued Federal Reserve supervision and enhanced prudential standards are still appropriate. This annual review period will afford the company the opportunity to meet with Council representatives and present information or make a written submission to the Council about its efforts to mitigate risk. If the Council decides to sustain the designation, it will present the company with a written explanation for its decision.

Takeaway

Given the 2023 regional banking crisis, it is no surprise that federal regulators are focusing on potential risks to financial stability. In FSOC’s 2021 and 2022 annual reports, nonbank mortgage companies have been identified as a potential risk. The Federal Housing Finance Agency and Ginnie Mae have both updated their minimum financial eligibility requirements for seller/servicers and issuers with such requirements taking effect with varying effective dates later in 2023 and 2024. States also have started to adopt prudential regulatory standards for nonbank mortgage servicers. By voting through the Analytic Framework and Nonbank Designations Guidance, the Council signals that it remains vigilant to weaknesses in the financial system and will utilize a variety of tools and approaches to strengthen its supervision over companies if existing protections do not adequately mitigate financial stability risks. Indeed, CFPB Director and voting member of the Council, Rohit Chopra, has expressed strong support for the actions taken and points out that the Council currently has “a total of zero shadow banks” designated as systemically important and that could pose a threat to financial stability which, according to Director Chopra, will most likely change once the Council implements the new guidance and conducts evaluations to identify shadow banks that meet the statutory threshold for enhanced oversight.