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Basel III’s Impact On Residential Mortgages

The comment period for the Basel III proposals has passed, and the banking community now awaits the final rules. Basel III proposes some fundamental changes to the calculation of a bank’s capital, and many of these changes are quite complex—threatening a potential compliance burden for many institutions. Among other things, the proposals would revamp the risk weighting of many asset classes for purposes of your bank’s capital calculation.

The proposed changes to the risk weighting of one to four family residential loans could have a particularly widespread impact. Current rules weight mortgage loans at either 50% or 100% depending upon a certain factors. The proposed rules would assign one of seven risk weightings ranging from 35% to 200% for each mortgage loan depending upon several factors, most notably the loan to value ratio.

As proposed, Basel III would separate mortgage loans into two groups: Category One and Category Two. To qualify as a Category One loan, the mortgage loan must meet each of the following criteria:

  • The term must not exceed 30 years;
  • The loan must be secured by a first lien on real property;
  • The terms must require regular payments that do not: increase the loan’s principal balance, allow the borrower to defer repayment of principal, or result in a balloon payment;
  • The loan’s underwriting must have taken into account all of the borrower’s obligations (e.g., taxes, insurance, etc.) and the borrower’s ability to repay assuming the loan’s maximum contractual interest rate;
  • The interest rate cannot increase more than 200 basis points in any 12 month period or more than 600 basis points over the loan’s life;
  • The borrower’s ability to repay must be based upon documented, verified income; and
  • The loan must not be more than 90 days past due or on non-accrual.

One to four family mortgage loans without a government guarantee that do not qualify as a Category One loan would be considered Category Two loans, including any balloon loan.

After a loan is assigned a category, its risk weight depends upon its loan to value ratio. To calculate this ratio, the amount of the loan for a first lien residential mortgage whose principal amount cannot increase is the current loan balance. For first lien residential mortgages whose principal balances can increase, the loan is the maximum contractual principal amount of the loan, regardless of whether the loan has been fully funded. For junior lien residential mortgages, the loan amount is determined to be the maximum contractual amount of the junior loan plus the maximum contractual amount of all senior loans outstanding at the time the junior loan was originated.

The value portion of the loan to value calculation is the lesser of (1) the acquisition cost if the loan is made in a purchase transaction and (2) the property value based upon an appraisal or evaluation at the time of origination or restructuring.

Based upon a loan’s category assignment and loan to value ratio, each loan would be assigned a risk weight pursuant to the following table:

Loan to Value Ratio Risk Weight for Category 1 Loans Risk Weight for Category 2 Loans
60% or less 35% 100%
Greater than 60% and less than or equal to 80% 50% 100%
Greater than 80% and less than or equal to 90% 75% 100%
Greater than 90% 100% 200%

While the final rules may deviate from these proposals, the proposals could significantly impact some banks’ capital positions by changing the risk weighting of assets. Banks should carefully consider the final rules to determine their impact on their institution, and banks whose capital positions may be negatively impacted by these proposed rules should consider whether to take proactive steps to soften Basel III’s blow to their capital account.