Those are the implications of recent reports whose authors seem to be yelling “Fire!” in a crowded room, but no one moves.
Here’s their main message:
Regulations imposed on banks after the financial crisis make banks safer, in part by making it harder and more expensive for them to borrow and lend as risk rises. So non-banks have moved into that vacated space.
“We find that non-bank funding, from balance sheet data, has risen by about 50 percent since the crisis in the U.S.,” write Manmohan Singh and Zohair Alam in “Leverage – A Broader View,” an International Monetary Fund Working Paper published March 19. Meawhile, credit supplied by banks hasn’t grown much since the 2008 collapse, the authors say.
From another study: “Non-bank mortgage originators … represented almost half of mortgage originations in 2016, up sharply from around 20% in 2007,” write five analysts from the Federal Reserve Board and the University of California, Berkeley, in “Liquidity Crises in the Mortgage Market” published February 27.
Non-banks can include money market funds, mortgage companies, hedge funds, insurance companies, pension plans, foundations. endowments, government and corporate treasurers, real estate investment trusts, corporate credit unions, other asset managers and households.
Non-bank financing can create problems, the writers explain.
For one thing, regulators don’t track or oversee non-banks the way they do banks. Therefore, non-banks can more easily overreach and regulators may not know when financial markets are getting overextended.
Then, when there’s a run on the non-banks because their funders see problems and withdraw their money, non-banks will not have the resources or government support to keep credit flowing to the broader economy during the crisis, the way banks do. The economy will strangle.
And there’s more.
As risk moves out of banks and into non-banks, it often returns to banks through the back door, the writers show. That’s because non-banks do a lot of their borrowing and lending with banks, usually using repos and securities loans. This creates an unseen interconnectedness that threatens regulators’ efforts to protect the banks.
Write Singh and Alam:
There are many avenues where banks interact with non-banks.
Banks lend to non-banks: Non-banks often get the money to make long-term loans by first getting short-term repo and securities loans from banks. This is possible because bank regulators view short-term collateralized loans as pretty safe. After all, the bank can demand repayment in the blink of an eye.
In one example, since 2008 banks have cut back on making home loans and instead banks are lending to non-banks – like mortgage companies – which in turn use that money to make the home loans, according to the Fed and UC Berkelely analysts.
In another example, when regulators warned banks against leveraged lending in 2013, non-banks started doing more of the leveraged lending and increased their borrowing from banks, according to a New York Fed staff report in May 2017.
Write the five Fed and UC analysts:
In total, we estimate that large banks extended $47 billion in credit to non-banks in 2016:Q4. A bit more than 60% of these credit facilities were identified by the banks as being for (mortgage) purposes, with another 13% for working capital, 5% for general corporate purposes, and 20% for other reasons.
Banks borrow from non-banks: Banks can borrow securities from non-banks by putting up other securities as collateral, for example in a repo or securities loan transaction. Since no cash changed hands, regulators don’t require banks to report this transaction on their books, even though the banks are using the securities like cash.
Then when the banks turn around and use these borrowed securities to benefit a client, this transaction may not be on the books either, explain Singh and Alam. The authors estimate up to half of bank transactions that use collateral may fall into this unseen category. They write:
Although non-bank funding has been recognized as large and increasing, their off-balance sheet funding to banks “falls through the cracks.”
Here’s an example from Singh and Alam:
if Walmart wants to expand in Texas and needs funding from its relationship bank, Citi, the treasurer of Citi can choose to fund its client from deposits or wholesale funding (which are both on balance sheet), or from pledging collateral it has received off-balance sheet to another bank (e.g., Barclays). For the treasurer, deposits, or wholesale funding, or pledged collateral (after a few steps), are all fungible resources that can be mobilized to fund a client.
The off-the-books transactions mean banks have about a third more leverage – that is, business done with debt – than regulators can see, estimate Singh and Alam. This matters because regulators require banks to use more of their own money, instead of borrowed money, when regulators see bank leverage going up, to make sure the bank has more capacity to absorb losses. But hidden leverage doesn’t get that cushion, of course.
“Wow. A third,” was how consultant Jonathan Cooper reacted to the Singh-Alam estimate in an April 17 article for Securities Finance Monitor. Cooper described the Singh-Alam paper this way:
Manmohan Singh, an economist known in the securities financing world for his work on collateral velocity and market plumbing, and Alam are raising the alarm bell over risks hidden inside off-balance sheet leverage. These transactions are often with non-banks – hedge funds, insurance companies and money market funds are just some examples. The trades involve pledged assets and repo and securities lending are ground zero.
Because most non-banks are not publicly traded, it’s hard for analysts to assess their condition and their potential impact on the financial markets. This differs from banks, which are required by regulators to make detailed financial reports.
“A fundamental difficulty in trying to understand the role of non-banks in the U.S. mortgage market is the very limited data available,” write You Suk Kim, Steven M. Laufer and Karen Pence with the Federal Reserve Board and Richard Stanton and Nancy Wallace with UC Berkeley, in their “liquidity crises” paper.
“Researchers—as well as many mortgage-market monitors and regulators—do not have the information needed to assess the risks of this sector,” they write.
Said Cooper in Securities Finance Monitor, “The non-bank sector, especially in the US, is large in comparison to banks. Not including them in a way that allows us to examine the leverage they receive and provide to banks creates a huge gap in our understanding of the systemic riskiness of the financial sector.”
The mortgage market can be an especially dangerous place for non-banks, as Americans saw in the financial crisis.
The main vulnerability of non-banks in the mortgage market is their reliance on warehouse lines of credit from banks, which are structured as short-tern repo transactions in which non-banks put up mortgages as collateral, explain the Fed and UC Berkeley analysts.
In a crisis, banks can quickly stop rolling over those lines of credit and immediately seize their repo collateral to sell it, thanks to a 2005 bankruptcy law that said repo lenders can seize their mortgage collateral without waiting for resolution in bankruptcy court. These fire sales help drive down the value of all mortgage collateral, anywhere, and can lead to a cascade of non-bank failures and a recession.
Wrote the Bloomberg editorial board on April 30:
In recent years, highly regulated institutions such as Bank of America — burned by billions of dollars in fines — have shied away from the mortgage business. Instead, they provide short-term credit to non-banks such as Quicken Loans and PennyMac, which do the actual lending. Non-banks now originate some 60 percent of new mortgages.
In one way, this shift from banks to non-banks is beneficial: It supplies mortgage credit that might otherwise have disappeared. But it’s also dangerous, because the non-banks are both lightly regulated and fragile. …. In a crisis, banks might pull the lenders’ credit lines, crippling them at precisely the wrong time for the broader economy….
Americans have seen this movie before.
For example, in 2006 and 2007 banks cancelled billions of dollars of lines of credit to mortgage lenders, which led to their “immediate demise,” the five Fed and UC analysts write.
Origination volumes by the non-banks, which hovered around $800–900 billion a year from 2003 to 2006, plummeted to $280 billion in 2008. Many of these firms experienced bankruptcies and closures … the total number of mortgage companies (both independent and affiliated with banks) fell in half—a drop of nearly 1,000 companies—between 2006 and 2012.
Imagine the destruction if non-banks had represented 50 or 60 percent of the mortgage market then, as they do today, instead of their 20 percent share in 2007.
The five Fed and UC analysts conclude:
A collapse of the non-bank mortgage sector has the potential to result in substantial costs and harm to consumers and the U.S. government.
Ted Tozer, former president of Ginnie Mae, a government agency that guarantees mortgage securities for investors, made these comments at a Ginnie Mae Summit in 2015:
Today almost two thirds of Ginnie Mae guaranteed securities are issued by independent mortgage banks. And independent mortgage bankers are using some of the most sophisticated financial engineering that this industry has ever seen. We are also seeing greater dependence on credit lines, securitization involving multiple players, and more frequent trading of servicing rights . . . In other words, the risk is a lot higher … and these risks are amplified many times over. . . . we have depended on sheer luck. Luck that the economy does not fall into recession and increase mortgage delinquencies. Luck that our independent mortgage bankers remain able to access their lines of credit. And luck that nothing critical falls through the cracks. . .
To some observers, letting the repurchase market underpin so many financial market transactions makes no sense.
Repo is now “the globe’s most monolithic pot of dollars. Moreover, by all accounts, repo is the primary source of funding for the growing, non-bank source of lending funds,” said Kurt Dew, visiting lecturer, Northeastern University, in an April 11 Seeking Alpha blog. This is in spite of the fact that in 2007-2008 “repo funding drove the entire American financial system into the foster care of the federal government.”
The Office of Financial Research, created by the Dodd-Frank Act to help prevent another financial crisis, warned in its 2017 Financial Stability Report of three ways repos pose risks to the financial markets:
(1) The giant global banks have increased their reliance on “runnable liabilities,” led by repos, from 37 percent in 2009 to 53 percent in 2016.
(2) U.S. triparty repo will only have one clearing bank soon, creating “a key vulnerability” as J.P, Morgan withdraws and leaves only Bank of New York Mellon to do the job.
(3) Non-bank broker-dealers, whose regulation has changed little since the crisis, are increasingly active in the triparty repo market.
The Office of Financial Research is the only agency trying to track the repurchase market, but it faces budget cuts and layoffs because in other projects it has disappointed observers on all sides of the political spectrum.
Argued the Bloomberg editorial board on March 13.:
This is shortsighted. Regulators can’t do their jobs if they don’t know what’s going on. The OFR should be revived, not dismantled,.
It’s not rocket science
The solutions to non-bank risk “aren’t rocket science,” say the Bloomberg editorial board:
Regulators should put banks and non-banks on a more equal footing. This requires clearer rules on the legal responsibility for bad loans, and higher capital and liquidity requirements for non-banks. Big institutional investors, such as endowments and pension funds, ought to insist on more standardization and better governance in the securities they buy — including deal agents and mechanisms to ensure that servicers act to maximize loan values. If they won’t insist, regulators might have to consider setting standards…..
No two financial crises are ever quite the same. The next one won’t be like the last. But history teaches lessons, and there’s no excuse for ignoring them.
Write Singh and Alam:
A more systematic collection of information on non-bank funding would help improve our understanding of global leverage and allow researchers and policy makers to observe the development of related risks in a much more accurate and timely manner.
The New York Fed analysts conclude:
The easiness with which risk migrates in and out of the banking sector, highlighted in our findings, suggests that it is critical to consider the stability of the entire financial system, and not just that of the banking system.