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Basel's Treatment of GSE Securities Threatens Housing Recovery

U.S. housing markets have recently shown signs of improvement, but the Basel Committee on Banking Supervision's treatment of Fannie Mae and Freddie Mac securities in its new liquidity coverage ratio calculation could significantly slow or even halt a sustainable recovery.

Restricting the use of government-sponsored enterprise mortgage securities toward the amount of high-quality liquid assets used in computing the LCR may impede further progress by raising mortgage costs and negatively affecting banks' ability to manage liquidity risk.

The Basel Committee has mandated two new bank liquidity ratios for banks in an effort to address liquidity risk problems that arose during the financial crisis. One of these new ratios, the LCR, requires banks to maintain a level of highly liquid assets of at least 100% of cash outflows over a stressed 30-day period. The Basel Committee introduced a tiered structure for the types of liquid assets that may be counted toward satisfying the LCR. Assets of the highest quality (referred to as Level 1), such as cash and securities issued by sovereigns, may be included in unlimited amounts while those in Level 2a and Level 2b are subject to haircuts and a cap on the percentage of total high-quality liquid assets that contribute to the LCR. And it is in this differential treatment of liquid assets where the problem for agency securities arises.

Today, GSE securities account for approximately 40% of bank liquidity portfolios, according to Morgan Stanley data. Under the Basel LCR framework, GSE securities would be classified as Level 2a assets subject to a 15% haircut and, a 40% cap net of haircuts of total liquid assets used in computing the LCR. As a result, banks might need to cut back on their use of GSE securities in their liquidity portfolios, forcing them to use lower-yielding securities like Treasuries, which will adversely impact banks' ability to manage risk.

The basis for this treatment lies in the requirement that GSE securities carry a 20% risk weight for computing risk-based capital. Rather than focus on the risk weight of the asset, Basel should determine the asset's liquidity classification based on factors indicative of the asset's liquidity quality. GSE securities are one of the most liquid fixed-income markets in the world, with nearly $4 trillion outstanding and an average trading volume of $250 billion daily, according to dealer estimates and the Securities Industry and Financial Markets Association. It is also worth noting the Basel LCR treatment of GSE securities could be at odds with the Dodd-Frank Act's Section 165 requirements for liquidity management where GSE securities are recognized as high-quality liquid assets.

For agency securities, a strong case can be made for these assets to be reclassified as Level 1 assets. First, coupons of agency securities have been almost perfectly correlated with yields on U.S. Treasury securities over time. The low price volatility of agency mortgage-backed securities is another hallmark of their deep liquidity. And the fact that these securities are actively traded across a number of exchanges on a daily basis allows for transparency and price discovery that further underscores their exceptional liquidity.

Ironically, GSE MBS have been the workhorse of the Federal Reserve's Quantitative Easing program, with the Fed purchasing about $70 billion of these securities monthly ($40 billion as part of its current monetary policy, plus an additional $30 billion due to reinvestment of paydowns) and having $1 trillion of GSE securities on its balance sheet today.

When the Fed one day unwinds its QE program, the Basel LCR treatment of GSE MBS as Level 2a assets could adversely affect housing markets should banks not be able to take up the Fed's purchases. This could put upward pressure on GSE MBS yields, further boosting mortgage rates over time. And, this could lead to nonbank firms exerting greater influence over mortgage rates than banks should the latter reduce the purchases of GSE securities. For this reason, the Fed needs to act strongly and support a reclassification of GSE securities to Level 1 for LCR calculations.

It could be relatively straightforward for U.S. regulators to classify agency securities as Level 1. The Basel Committee Standardized Approach includes a provision that provides some latitude for countries to treat claims on certain public entities, such as Fannie and Freddie, as claims on the U.S, government, given their conservatorship status, which would permit classifying them as Level 1 assets.

Basel's treatment of GSE securities in the LCR, if left unchanged, poses risk to the fragile housing recovery. The current classification is inconsistent with the liquidity characteristics of these assets and illustrates how simple categorizations by asset risk-weighting can lead to unintended consequences for markets.

Clifford V. Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland. 


(5) Comments



Comments (5)
Cliff, great work again. I enjoy your writing. Keep up the good work.
To GMahler and Parkerco, good observations on the sovereigns but you forget two important points. First, by definition Uncle Sam is all wise. Therefore we need no budget and all investments must be sterling. Second is a new BIS proposal titled "Second Consultative Document Margin requirements for non-centrally cleared derivatives". There is a neat little passage that says;
"Similarly, the BCBS and IOSCO support not applying the margin requirements in a way that would require sovereigns, central banks, multilateral development banks, or the Bank for International Settlements, to either collect or post margin."
In addition to being all valuable and acceptable for level 1, sovereigns would seem to be immune from margin requirements. What say we find a state to secede from the union. We could call it the nation of Flim-Flam. The primary export would be sugar coated paper; always level 1, of course!
Tim Alexander
Posted by Heytimbo | Friday, March 29 2013 at 9:19AM ET
Thanks for soundly increasing the awareness of LCR. Level 1 for sovereign debt is one of the rules that created the EU banking crisis. Obviously all government debt is not the same. In the future GSE MBS will not have the backing of the full faith & credit of the US and the Fed will not be buying the market, so Level 2a may be appropriate for those securities, but obviously not for the MBS with full US backing.
Posted by parkerco | Wednesday, March 27 2013 at 5:02PM ET
Good article. Thanks.

BTW, is it only me, or does anyone else find it astonishing, pathetic, hilarious, frightening [fill in the word of your choice] that "securities issued by sovereigns" are Level 1 assets?
Posted by GMahler | Wednesday, March 27 2013 at 4:11PM ET
GSE securities aren't liquid, just marketable. From Fed FoF data, about a quarter of depository institution assets - about $3 trillion - are in securities, mostly long term and mostly GSE, in search of yield. The stated strategy is to sell them quickly when rates start to rise and prices fall (they have to mark to market). That's also Bernanke's strategy for an even larger Fed portfolio.
Note that while there are now hundreds of economists at the Treasury/Fed chaired FSOC doing stress tests, they are forbidden from testing: "what happens if interest rates rise" on the stated premise that the Fed can prevent that.
Posted by kvillani | Wednesday, March 27 2013 at 4:00PM ET
Housing uber alles. "...forcing them[banks] to use lower-yielding securities like Treasuries, which will adversely impact banks' ability to most effectively manage risk." It will also adversely impact their ability to extract this particular kind of subsidy from the safety net.
Posted by Edward Kane | Wednesday, March 27 2013 at 2:40PM ET
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