Current Levels of Agency MBS Liquidity Likely to Stay Put

money-fourAlthough agency mortgage-backed securities liquidity has declined recently, it remains mostly where it was prior to the housing bubble; the current levels of agency MBS liquidity are likely to be in place for a while, since the factors driving the decline are unlikely to slow down in the foreseeable future, according to an analysis from the Urban Institute released Monday.

In a white paper titled “Declining Agency MBS Liquidity Is Not All about Financial Regulation,” Karan Kaul and Laurie Goodman of the Urban Institute contend that tighter financial regulation and higher capital requirements are not the only reasons behind the recent decline in agency MBS liquidity.

With approximately $5.7 trillion in securities outstanding as of the end of Q2 2015, according to data from Securities Industry and Financial Markets Association, making it one of the most liquid fixed-income markets in the world (behind only the U.S. Treasury market), according to the Urban Institute. The majority of these agency mortgage-backed securities are issued by Fannie Mae, Freddie Mac, Ginnie Mae, or another government agency. The market has “historically been very liquid because participants have been able to trade large volumes of securities relatively easily and quickly,” according to the authors.

The average daily trading volume of agency RMBS is down substantially from the bubble period of 2008, when it was $350 million; even though it has fallen since the crisis, the average daily trading volume has still been about $190 million since the beginning of 2014. That number is close to the 2003-2004 pre-bubble average, according to the authors.

Whether or not the trading volume is simply reverting to more sustainable levels or is a sign of a more serious problem has yet to be determined, according to the authors. Existing research and many reports in the press have asserted that more stringent regulation put in place post-crisis is responsible for the declining fixed-income liquidity.

“The new regulatory safeguards have had their intended effect of reducing the amount of risk taken by financial firms. But to expect a reduction in risk without causing some impact on liquidity is trying to have it both ways.”

Karan Kaul and Laurie Goodman

“Specifically, higher capital requirements, conservative leverage ratios and curbs on proprietary trading under the Dodd-Frank Act have made it more expensive for large financial services institutions to take risks,” the authors wrote. “While that is certainly true, our view is there is more to declining agency MBS liquidity than just regulation.”

Two high-level trends are in play as far as reasons for declining agency MBS liquidity beyond regulation: investor heterogeneity has been reduced by a major shift in MBS ownership from active traders to “buy and hold” investors, and with it, the “ability of markets to self-correct temporary price dislocations, resulting in more pronounced episodes of volatility”; and mortgage refinance volume has dropped steeply without an increase in purchase originations, which has resulted in a drop in agency MBS issuances, which has in turn led to a decline in trading volume, according to the authors.

After-effects of the crisis are driving these trends, which leads the authors to the conclusion that the levels of agency RMBS liquidity are here to stay. First, the Fed’s ownership of outstanding agency RMBS is not likely to change until the Fed changes course, and no one knows when that will be (the Fed and commercial banks now own more than half of outstanding agency RMBS); second, it is  “virtually certain that the GSEs won’t be allowed to run investment portfolios in any meaningful way, form, or scale moving forward”; and third, there is no concrete reason to believe that stringent regulations put in place after the crisis will ease up.

“If excessive risk-taking led to an increase in liquidity previously, then it should be no surprise that a reduction in risk will cause liquidity to decline,” the authors wrote. “Part of this reduction in risk and liquidity is no doubt driven by tighter regulation, but it is also driven by an extraordinary shift in MBS ownership pattern as well as weak mortgage originations and issuance activity. The new regulatory safeguards have had their intended effect of reducing the amount of risk taken by financial firms. But to expect a reduction in risk without causing some impact on liquidity is trying to have it both ways.”


House Postpones Vote on Proposal to Cap Salaries of Fannie Mae, Freddie Mac CEOs

Fannie-Freddie-logos-twoThe U.S. House of Representatives has postponed voting on a bill that will limit the salaries of Fannie Mae and Freddie Mac CEOs due to a hefty lineup of other legislation.

The vote was originally scheduled to take place last week.

The vote on the GSEs’ CEO pay limits was delayed last week due to a number of bills that came across the House’s desk, including a vote to elect Rep. Paul Ryan, R-Wisconsin as the new Speaker of House.

H.R. 2243, also known as the Equity in Government Compensation Act of 2015, was introduced by U.S. Congressman Ed Royce (R-California) in May in response to a proposal by Mel Watt, Director of the FHFA (the GSEs’ conservator), for new executive compensation plans for Fannie Mae CEO Timothy Mayopoulos and Freddie Mac CEO Donald Layton that could raise their pay as high as the 25th percentile of the market, which computes to about $7.26 million per year.  The SEC outlined that Fannie Mae and Freddie Mac CEOs’ direct compensation will consist of an annual base salary of $750,000, fixed deferred salary at an annual rate of $2.05 million, and at-risk deferred salary with an annual target amount of $1.2 million, totaling $4 million.

Watt said in a statement in July that the purpose of the pay raises was to “promote CEO retention, allow reliable succession planning, and ensure the continuity, efficiency and stability” at Fannie Mae and Freddie Mac. Watt’s predecessor, Ed DeMarco, capped the GSE CEO pay at $600,000 a year more than three years ago after four years of conservatorship.

Ed Delgado, president and CEO of the Five Star Institute, stands against the bill and believes that “Fannie Mae and Freddie Mac could stand to benefit institutionally from pay raises. The GSEs carry the weight of the mortgage industry and competitive compensation plans will enable them to be aggressive in terms of retaining intellectual capital.”

Royce’s bill would suspend Watt’s proposed compensation packages for Fannie Mae and Freddie Mac executives and would limit the salaries to the highest level paid at the FHFA, which the Congressional Budget Office estimated in 2011 to be $255,000 per year. It would also place non-executive GSE employees on the General Schedule (GS) pay scale, where the most they could earn annually would be $132,122.

The bill passed in the House Financial Services Committee by a vote of 57-1 on July 29 with enormous bipartisan support.

“I think it is entirely legitimate for the executives at those institutions to be subject to compensation limits.”

—White House Secretary Josh Earnest

Royce said in a statement on his website that it is “unconscionable” that Freddie Mac would elevate the pay of its CEO to that level while taxpayers are still on the hook. The fact that the GSEs are still under conservatorship of the FHFA, where they have been since September 2008, is still a contentious topic among politicians and stakeholders in the housing market.

“At a time when American families are still struggling to find their footing financially, it is absolutely unconscionable that regulators would allow the taxpayer-bailed out Freddie Mac to pay its CEO over $7 million dollars a year,” Royce said. “Just last week a stress test of the GSEs showed the possibility of a future taxpayer bailout to the tune of $150 billion, yet FHFA appears to be pursuing the pre-crisis model of private gains and public losses. We can’t simply put the blinders on and say the GSEs are just like other companies. We need to move towards a model that allows the private sector to compete on a level-playing field, not one where Fannie and Freddie act like the private corporations with taxpayers on the hook for losses. In the interim, I will be introducing legislation to block this potential hike in CEO pay.”

The Senate version of the bill, or S.236, co-sponsored by Sen. David Vitter (R-Louisiana) and Sen. Elizabeth Warren (D-Massachusetts) and was passed unanimously in September.

“Near universal support in both the House and Senate for capping GSE CEO pay is proof positive that multi-million dollar raises at taxpayer bailed-out and backed organizations are unconscionable,” Royce said. “I applaud Senator Vitter for his quick work in getting this bill through the Senate and will work to replicate his success in the House.”

The Department of Treasury highly opposes the FHFA’s approach to the GSEs’ CEO compensation and “urged the agency to reject any increase. Treasury has consistently recommended that existing limits on compensation continue.”

The White House is also for the pay limits on Fannie Mae and Freddie Mac CEO’s salaries. “I think it is entirely legitimate for the executives at those institutions to be subject to compensation limits,” stated White House Press Secretary Josh Earnest.

The bill is due to be voted on later in November.

Will Weakening the FSOC Put the Country at Risk of Another Financial Crisis?

TreasuryThe Financial Stability Oversight Council (FSOC) was created out of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in order to bring the financial regulatory community together to respond to risks to the financial system in order to prevent another financial crisis.

Attempts are being made by financial industry advocates to weaken the FSOC. Those advocates are accusing the Council of being overzealous in protecting the financial industry. Weakening the FSOC would only prevent the Council from identifying risks to the financial system, therefore putting the country at risk of another devastating financial crisis, according to an op/ed piece by Deputy Assistant Secretary for the FSOC at the U.S. Department of the Treasury Patrick Pinschmidt on MSNBC on Monday.

“Unfortunately, there is legislation pending in both houses of Congress that would heavily tip the scales back in Wall Street’s favor and leave our country vulnerable to another crisis,” Pinschmidt said. “These changes would take the council’s methodical process and mire it in a series of protracted, bureaucratic steps that would require the council to spend as many as four years studying a company before it could take any action. Some of these proposals would also raise the standard for action by the council to a dangerously high threshold, all but ensuring inaction despite the risk to financial stability.”

Proponents of these proposals contend that if passed, these proposals would make the FSOC more effective; however, Pinschmidt argues that they would have the opposite effect, impeding the Council’s ability to identify risks to the financial system.

The FSOC has broken down barriers between agencies created a culture of regulatory cooperation and interagency information sharing in the five years since its creation, which has served to make the financial system safer and more resilient, according to Pinschmidt. The Council has also responded to potential weaknesses in the financial system and helped regulators focus on critical issues that include cybersecurity vulnerabilities and structural weaknesses in short-term funding markets.

“We need a body with a single-minded focus on protecting U.S. financial stability and identifying new threats on the horizon—and that’s exactly what the council is doing.”

—Patrick Pinschmidt

One of the major reasons why the financial crisis occurred back in 2008 is that the country was ill-equipped to address risks to the financial system; the regulatory structure could not keep up with the changing U.S. financial marketplace and the country lacked single entity that was accountable for protecting the stability of the entire financial system, Pinschmidt said. Not only that, but certain large nonbank financial companies such as AIG were not subject to adequate oversight. One of the FSOC’s main responsibilities is to provide such oversight for these nonbank financial firms by addressing risk these companies face that could put the entire financial system at risk.

“This isn’t a judgment that a company is on the verge of failure,” Pinschmidt said. “Rather, it is a recognition that if one of these designated companies were to experience distress, there could be significant consequences for the broader financial system and economy. This was a clear lesson from the financial crisis.”

Those opposing the FSOC say that the Council’s designation of certain firms as “systemically important financial institutions” (SIFIs), or in other words, designating them as posing a threat to the stability of the country’s entire financial system if they were to fail, equates to naming institutions as “Too Big to Fail,” thus perpetuating what Dodd-Frank was meant to end. One such institution is MetLife, the insurance provider designated as a nonbank SIFI in December 2014 by the FSOC. In January, MetLife sued the FSOC a month later in an attempt to have the SIFI tag removed. MetLife claims that as a nonbank SIFI, it is subject to heightened regulation which the company says will increase compliance costs, hence increasing costs to consumers without any added safety benefit for the financial system. The case is still pending.

Pinschmidt said in order to prevent another crisis, it is important to remember what caused the last one and how the country reached that point.

“We must remain vigilant,” he said. “We need a body with a single-minded focus on protecting U.S. financial stability and identifying new threats on the horizon—and that’s exactly what the council is doing.”

Banks Need to Take Precautions With Credit Risk to Avoid Repeat of Financial Crisis

seal-on-moneyBanks need to take steps now to avoid emerging credit risk in today’s financial system in order to prevent another financial meltdown, according to Comptroller of the Currency Thomas Curry in a public address on Monday.

In a speech at the RMA Annual Risk Management Conference in Boston, Curry stated that the topic of credit risk was muted as recently as 2012 because banks were still in a post-crisis state of recovery and were being extremely cautious with lending—some believe too cautious. Three years ago, however, the need to discuss credit risk was minimal because loan demand was soft, consumer confidence was down, and businesses were reluctant to make loans to only the most creditworthy borrowers.

In the last 18 months, however, banks have generally become profitable as economic conditions have improved, unemployment is down, and loan demand has increased, leading Curry to ask: “Where do we go from here? What will it take to ensure that banks remain solvent, stable, and secure in their role in the payments and credit system?”

Curry pointed out that the increased regulation of today is designed to prevent another financial crisis similar to the one in 2008; however, he said, things do not need to get to that point if the right decisions are made today in the financial system, particularly in the area of credit risk by banks.

While banks are prospering, however, they have created some credit risk concern by loaning to customers who almost certainly would not have qualified four or five years ago because of the risk they pose, Curry said.

“Many banks have made a conscious decision to increase their risk appetite and take on additional credit risk,” Curry said. “They are doing this in part because in times of economic growth banks feel confident that they can. But they are also targeting less creditworthy customers and offering easier terms and conditions because they feel that they must, in order to hold their own against the competition for loan growth, market share, and revenue.”

“We can ensure a safe and sound banking system and avoid crises if we take sensible and toughminded steps now to address the emerging risks I’ve discussed today.”—Thomas Curry

Credit risk is showing up now in banks in two classic forms, according to Curry: that of relaxed underwriting and increased loan concentrations. While banks with increased loan concentrations and eased underwriting standards always prosper for a time, there will eventually be a “day of reckoning,” Curry said. As a regulator, Curry said, his job is to raise awareness of the credit risk these conditions pose before things reach that point.

“At present, these concentrations flash yellow lights rather than red ones, and, as I’ve noted, credit quality has not suffered significantly as a result,” Curry said. “Our job as supervisors is to ensure that things stay that way.”

Curry said he would like to see banks take the initiative to address concentration risk on their own, without supervisory action, and stated that the OCC has provided tools to help them do so. He urged risk managers to carefully examine their respective banks’ loan loss allowance to see if it is appropriate for the level of risk their bank is taking on.

“We’ve been through a long period in which banks have been steadily reducing reserves,” Curry said. “Just over the last two years, the key ratio of the loan loss allowance to total loans dipped by more than 40 percent. Although banks have argued, with some justice—and please note the qualification—that improvements in loan quality justified those reserve releases, drawdowns of that magnitude are clearly disproportionate.”

Curry stated it was clear to him that the reserves needed to be raised in order to account for the increasing credit risk in the financial system today

“We can ensure a safe and sound banking system and avoid crises if we take sensible and toughminded steps now to address the emerging risks I’ve discussed today,” Curry said.

Bank of America Agrees to $335 Million Settlement Involving RMBS

money-fiveBank of America’s troubles with residential mortgage-backed securities are not over yet. According to the bank’s quarterly filing with the Securities and Exchange Commission, the bank has agreed to pay $335 million to settle a federal lawsuit that claims the bank misled shareholders as to the quality of certain mortgage-backed securities sold to investors immediately following the crisis.

Shareholders of the Pennsylvania Public School Employees’ Retirement System (PSERS) claimed in the suit that Bank of America misled them into buying stock in 2009 and 2010, some of which the bank sold to repay a $45 billion bailout. The plaintiffs also claimed that the bank knew it could not raise enough capital to buy back billions of dollars worth of securities backed by risky residential mortgage loans. Many of the risky loans were issued by Countrywide, one of the nation’s largest subprime lenders which Bank of America acquired in 2008.

The plaintiffs also claimed that Bank of America knew that recordkeeping in MERSCORP’s private Mortgage Electronic Registration System (MERS), which is a national electronic database that tracks changes in mortgage servicing and beneficial ownership interests in residential mortgage loans on behalf of its members, prevented the bank from legally foreclosing on thousands of mortgages that were delinquent.

The complaint alleges that MERS, which was created in 1995, operated seamlessly until 2008, when the housing crisis began and the country saw a major increase in mortgage defaults. The complaint states that “a number of courts made clear that it would be nearly impossible for mortgage holders or servicers to foreclose on loans processed or transferred via MERS. To foreclose on a mortgage, a party must have title to it. Courts reasoned that because MERS listed itself as the mortgagee, mortgage holders and servicers did not have standing to foreclose. Some of these suits involved BoA and Countrywide in their capacities as a mortgage holder or servicer.”

A spokesperson for the PSERS confirmed to DS News via email that a proposed settlement has been reached with Bank of America in a class action pending in the U.S. District Court for the Southern District of New York, saying “We are pleased to have served as lead  plaintiff for this case and to have achieved this proposed settlement on behalf of PSERS’ members and fellow class members. The proposed settlement is pending approval by Honorable William H. Pauley, III.”

When contacted for comment, a Bank of America spokesman directed DS News to the bank’s SEC filing, which can be accessed by clicking here. In the filing, the bank stated that “[t]he parties in Pennsylvania Public School Employees‘ Retirement System v. Bank of America, et al. agreed to settle the claims for $335 million, an amount that was fully accrued as of June 30, 2015. The agreement is subject to final documentation and court approval.”

MERSCORP issued the following statement regarding the Pennsylvania Public School Employees’ Retirement System v. Bank of America case: “Neither MERSCORP Holdings, Inc. nor its subsidiary, Mortgage Electronic Registration Systems, Inc. (MERS) was a party to the lawsuit or the settlement. The courts have consistently found MERS’ role to be valid and we continue to operate in all 50 states. Today, MERS is named as mortgagee on more than two-thirds of new mortgage originations. In the 2012 order denying Bank of America’s motion to dismiss, the judge stated ‘Indeed, the plaintiff’s counsel conceded at oral argument that there is ‘nothing wrong’ with MERS if it is used correctly.’”

Bank of America has spent more than $70 billion on legal settlements and regulatory claims since the financial crisis, a large portion of which has stemmed from its July 2008 acquisition of Countrywide and the subsequent acquisition of Merrill Lynch six months later. This amount includes a then-record $16.65 billion settlement with the government in August 2014 over the misrepresentation of the quality of mortgage-backed securities sold to investors.