The Fed wants to let a dangerous asset loose on bank balance sheets

The Fed's recent announcement about changing capital rules on mortgages and mortgage servicing rights (MSR) assets on bank balance sheets is a mixed bag from a risk management perspective. My American Banker article posted this morning provides more insight on this topic. Revisiting a more refined approach consistent with Basel on layering in loan-to-value ratios in setting risk weights is a sensible approach to an otherwise sledgehammer approach to risk-based capital for whole mortgages. So is their reconsideration of the 250% risk weight on MSRs, vis a vis other risk assets. 

However, removing the deduction of MSRs over 10% of a bank's common equity Tier 1 (CET1) capital is a bridge too far for this asset that has shown to be excessively volatile and difficult to value as a Level 3 asset. MSR values are highly dependent on getting interest rates, discount rates and prepayments accurately measured and that is a very tricky business for even the most analytically sophisticated banks. I was at two very large banks that experienced large mishaps in valuing and hedging their MSRs. I understand and appreciate the intent to reduce systemic risk in mortgage origination and servicing that has become dominated by large nonbank financial institutions post-2008 that have no federal safety and soundness oversight. Reducing the potential systemic risk from nonbanks in mortgage banking by eliminating the MSR cap on bank capital is certainly laudable, but not at the expense of incenting the buildup of one of the riskier assets known on bank balance sheets. A potential solution lies in maintaining a cap on MSRs at a level between that set currently and by Ginnie Mae, permitting some offset for hedging and aligning that regulatory treatment between banks and nonbanks to maintain a level playing field in mortgage banking.