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Systemic Risk, Real or Imagined

Washington | Last week, we released a paper rebutting the 2019 report by the Financial Stability Oversight Council (FSOC), which claims rather incredibly that nonbank mortgage servicing companies could pose a “systemic risk” to the markets and the US economy. The FSOC report singles out potential risks arising from nonbanks servicing defaulted mortgages and also risk to banks providing loans to finance these activities.


Do Nonbank Mortgage Companies

Pose Systemic Risk to the US Economy?

[https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3519454]


The notion that cash generating asset managers like mortgage loan servicers could cause a systemic risk event is pretty laughable. Read the FSOC paper and references if you want details, but the agency seems to be again ignoring market basics as well as the public record in formulating its dire pronouncements. We said as much in an interview in Real Vision, released yesterday.



The Dodd-Frank agency FSOC asserts with respect to nonbank mortgage servicers that "if delinquency rates rise or nonbanks otherwise experience solvency or liquidity strains, their distress could transmit risk to the financial system." The FSOC report provides no analytical backing for this sweeping statement and ignores the highly detailed public record with respect to the insolvency of nonbank mortgage companies that goes back decades.


The FSOC report states: "Widespread defaults or financial difficulties among nonbank mortgage companies could result in a decline in mortgage credit availability among these borrowers." Again, the FSOC offers no analytical backing for this statement and ignores the public record of defaults by nonbank finance companies. We’ve written several papers on the topic of muneris interruptio since our days at Kroll Bond Rating Agency.


As with the unfortunate case of MetLife (NYSE:MET), the FSOC report is based on “implausible, contrived scenarios” rather than “substantial evidence in the record” and “logical inferences from the record.” We don’t think that the FSOC articulates a credible scenario for the systemic failure of a nonbank residential loan servicer. Simply stated, the scenario advanced by staff from the Federal Reserve Board and the Conference of State Bank Supervisors seems disconnected from current commercial practice in the market for secured financing.


Former New York Fed Chief Gerald Corrigan defined a systemic risk as when markets are surprised. The shock in 2008 caused such dismay among investors – and eliminated market liquidity in mortgage backed securities -- that Lehman Brothers, Bear Stearns, American International Group (NYSE:AIG) and Citigroup (NYSE:C) all failed as a result.


Surprise in the financial markets stems from an asymmetry between information and risk. When the imbalance is repaired, money moves – sometimes violently -- to restore the balance between perception and actual risk. Banks such as Citi and Deutsche Bank (NYSE:DB), which have in past hidden risk from investors, have suffered severe consequences and, in one case, failed and caused a systemic shock. Nonbank companies, by comparison, tend to die quietly in the hands of a US Bankruptcy Trustee.


Concealing material information with respect to a security is still fraud in the US, thus the cause of a systemic risk event would seem likely to involve fraud. The tough part for the FSOC, of course, is identifying the particular information asymmetry and related mispricing of securities such that a systemic risk event might occur.


Sadly, the mission of the FSOC strikes us as a fool’s errand. No agency is likely to predict the next market break. As we noted in our conversation with RealVision, the FSOC agencies will be the last to know about future market contagion. Because predicting a systemic market break is essentially impossible, the FSOC instead has decided to focus on companies or even whole industries that might be catalysts for market breaks.


The 2019 FSOC report mischaracterizes the risk from nonbank mortgage companies and also does a disservice to the commercial banks operating in this sector as lenders. If a “systemic event” did not occur in 2018, when much of the mortgage lending industry was losing money, then it is not likely to occur dear colleagues.


The FSOC report illustrates the intellectual bias against nonbank companies that exists in much of the regulatory community, both in the US and around the globe. The term “shadow banks” is pejorative and demeaning to private sector firms, but is frequently used by regulators and researchers when discussing nonbank financial firms. Nonbank companies represent the private sector, while commercial banks are government sponsored entities (GSEs) that enjoy enormous subsidies such as federal deposit insurance, access to the Fed’s discount window and the Federal Home Loan Banks.


Commercial banks operate with leverage ratios of 15:1 or higher, when off-balance sheet exposures and derivatives are considered. Even with these advantages, however, commercial banks are far less efficient than their nonbank peers when operating in the mortgage market. As a result, some regulators view nonbanks as a threat to commercial banks.


We can think of lots of areas in the market today that warrant concern when it comes to systemic risk, but nonbank loan servicing is definitely not one of them. We work in the sector as advisors to a number of players in the world of mortgage finance, so call us biased. But the FSOC’s report is a bad piece of work and an embarrassment to Treasury Secretary Stephen Mnuchin.


If we were talking about lenders or issuers of securities, for example, there might be a basis for an interesting conversation. But to focus the FSOC’s attention on mortgage servicing suggests a misunderstanding of the world of secured financing and the multi-trillion dollar “too be announced” or TBA market for mortgage agency collateral.


Looking at the world of finance, the chief risk to the system is the growing atrophy of banks in the EU and Asia, particularly Japan, and related extensions of risk to compensate. Thus, came the world of transformation repo. Off-balance sheet dollar financing. And before that, off-balance sheet finance by US banks. All of these concessions to the zombie banks create systemic risk by the bucketload.


When we asked Paul Volcker in 2017 about allowing banks into off-balance sheet finance, this after the Third World debt defaults of the 1970-80s, he answered: “They were broke. What else could we do?”


At the end of the day, for all of us it’s all about hiding the risk, maximizing the rating and minimizing the spread over funding -- for the entire world. Thus we think that the next systemic risk event could very well originate outside of the regulated US market. So much for our Platonic guardians.




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