New regulation meant to ensure banks have enough easy-to-sell assets to survive a crisis is creating doubt over whether $1.1 trillion of mortgage debt qualifies, potentially hurting demand in a key cog of the U.S. home-finance system.
Left unclear was whether some or all of a type of bonds known as agency collateralized mortgage obligations can count toward the liquidity coverage ratio approved this week by U.S. banking regulators, according to analysts at JPMorgan Chase & Co., Credit Suisse Group AG and Citigroup Inc.
The government-backed debt, which isn't explicitly mentioned in the rule, represents a big part of bank holdings. Wall Street banks create the investments by bundling existing bonds into notes with varying risks, meaning they help support the broader mortgage-backed securities market that funds and sets interest rates on about 80 percent of new home loans.
"It appears that there is no blanket treatment of CMOs in the final rule," JPMorgan analysts led by Matt Jozoff said in a Sept. 3 report. "Thus, while the final rule does not exclude" the debt, "the need to prove that securities meet the requirements could deter some banks from owning them."
National banks and thrifts held $443 billion of agency CMOs on June 30, according to Federal Deposit Insurance Corp. data, compared with $274 billion of Treasuries and $950 billion of less complex government-backed mortgage notes. Banks hold the debt in part because the techniques used to create CMOs can transform simpler mortgage bonds into new securities that offer more protection against rising rates.
While analysts at Credit Suisse said they're interpreting the rules to mean the debt can be counted, the ambiguity might push some banks to "conservatively avoid classifying them" as among their liquid assets, the analysts, led by Mahesh Swaminathan in New York, wrote in a report.
"The people who wrote the rules are giving the regulators on the ground some leeway to interpret it," Walt Schmidt, a Chicago-based strategist at FTN Financial, said in a telephone interview. "The working assumption is going to be that CMOs will count" in the same way as the underlying securities "but there is some uncertainty about whether that will be true. It's something to watch for those who have very large CMO books."
Simpler mortgage bonds known as agency pass-through securities, guaranteed by taxpayer-backed Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae, are permitted to be either fully or partially counted as liquid assets under the regulation.
There are some caveats that can apply to CMOs backed by that debt, which are created by slicing the securities into a series of new notes that can pay off at different times or pay out in varying ways depending on the pace at which underlying loans get repaid.
Bank regulators said that to count as liquid under the new rule, assets can't be "unique, bespoke, or complex structures which are difficult to value on a routine basis," and must be "liquid and readily marketable."
That's likely to rule out "some more exotic structures" in the CMO market, while allowing others, Citigroup analysts including Ankur Mehta wrote in a report.
"We think this interpretation is in line with market expectations since banks have been adding simple" Ginnie Mae "CMO structures to meet their LCR requirement since last October," the analysts said.
By not making their inclusion explicit, the rule may at least make it tougher for banks to count CMOs, potentially curbing demand.
With certain types, the limiting language could "potentially require additional evidence to justify its ready marketability," the Credit Suisse analysts said.
While the liquidity rules don't apply to smaller banks, their examiners are likely to look at them as a set of "best practices," and those lenders have little choice but to comply with their suggestions, according to Camden Fine, president of the Independent Community Bankers of America.
"They hold your charter and your livelihood in their hands," he said yesterday in an interview.