Is the FSOC underestimating risks to US financial stability?

What is happening?

During a congressional hearing on financial stability, Steven Mnuchin, secretary of the US Treasury, spoke about the rapid increase in non-bank mortgage origination as one of his top concerns for financial stability.

On December 5, Mr Mnuchin was questioned for nearly three hours by the congressional members of the House Financial Services Committee in a hearing about financial stability. The hearing also coincided with the Financial Stability Oversight Council’s (FSOC’s) annual report and this formed the basis of most of the questions from the committee. The FSOC is chaired by Mr Mnuchin and was set up under Dodd-Frank to promote market discipline and to respond to emerging financial stability threats. 

FSOC reeled off a long list of potential threats to the US financial system such as a global economic slowdown, a disorderly Brexit, cyber attacks, the transition to new interest rate benchmarks, the growth in corporate debt and mortgage origination by shadow banks. But overall it rated the risks to the US financial system as 'moderate'.

During the hearings, Mr Mnuchin talked extensively about the risks emanating from the growth of non-bank mortgage originators, which now appear to be responsible for nearly half of all new mortgages in the US, from about 10% a decade ago. He said these largely monoline financial firms have less liquidity than banks, but he rebuffed suggestions that they are less well regulated than banks. 

In turn, these mortgages have become a major source of product for the securitisations underwritten by government-sponsored enterprises (GSEs), such as Fannie Mae, which has implications for taxpayers if they go wrong. Mr Mnuchin acknowledged that these mortgages tend to be lower quality than those originated by banks, but that this did not mean the GSEs are necessarily securitising poor-quality mortgages. Indeed, he saw the role of the GSEs as a good way of keeping tabs on the activities of these non-banks.  

However, Mr Mnuchin said there is some evidence that the underwriting standards of non-banks is slipping. One area that has caused concern among commentators and Congress is the growth of collateralised loan obligations (CLOs), which have become a major source of demand for corporate bonds, absorbing 62% of new issuance in 2018.

However, Mr Mnuchin seemed far from worried as these corporate loans (which are also seeing falling origination standards) are mainly ending up outside the banking system and in CLO vehicles backed by long-term capital. In 2018, only 8% of these loans were bought by banks   

Why is it happening? 

These hearings are routine and are an important means for Congress to hold the administration to account for its actions. Since the last presidential elections, the Democrats now dominate the House of Representatives and chair the House Financial Services Committee. Since then, they have become much more probing into the administration’s actions, particularly under the chairmanship of Democrat Maxine Waters.  

What do the bankers say? 

The banks currently have an administration that is much more friendly towards them than the previous one. Mr Mnuchin’s remarks are unlikely to give them much cause for concern and he did little to contradict the current focus on simplifying regulations or deregulation as the Democrats would see it. 

Mr Mnuchin’s most common response to the threats identified by the FSOC is to monitor them through an activities-based approach to regulation. 

Will it provide the incentives?  

If anything, Mr Mnuchin seems a little too relaxed about the potential threats to the US financial system, even if the FSOC does rate them as moderate and even though banks are much better capitalised. That could change very quickly in the event of a ‘black swan’ event, such as a major cyber or terror attack – or even just a rapid descent into recession caused by a trade war, for example. 

Also, it looks like a lot of risk has slipped into the shadow banking sector, where there is evidence of falling underwriting standards combined with rising leverage. This is a classic combination for a bust, which would definitely hit the banks as it would hurt the economy and could create indirect impacts possibly from hedge funds buying these assets on credit. 

And though Mr Mnuchin talked of focusing on non-bank mortgage firms lacking liquidity, working with the FSOC and others to pursue housing reform, he gave little in the way of concrete action over how these risks should be curbed. 

With the current economic growth cycle potentially much nearer to its end than its beginning, now is the time for supervisors to be more vigilant in neutralising potential threats.