Mortgage market participants have very little to cheer in the recent proposal from U.S. bank regulators detailing bank short-term liquidity requirements.

The Liquidity Coverage Ratio diminishes the attractiveness of holding government-sponsored enterprise mortgage-backed securities, high quality non-GSE mortgage-backed securities and lines of credit from Federal Home Loan banks. It simultaneously penalizes standard practices of using derivatives to hedge mortgage pipeline interest rate risk and commitments to finance residential mortgages during a stress period on liquidity. The stakes are high for the mortgage industry as to where the final liquidity rules will fall as treatment of MBS as high-quality liquid assets has significant implications for ones issued in a post-GSE environment.

From a risk management and regulatory perspective, the motivation behind implementation of the LCR is sound. In a speech on liquidity regulation, Federal Reserve Gov. Jeremy C. Stein highlighted the trade-offs between after-the-fact liquidity risk interventions by regulators (who effectively become lenders of last resort) versus establishing liquidity requirements before the fact. The last crisis clearly demonstrated the need for stronger short-term liquidity requirements. The fragility of liquidity provisions in financial markets imposes systemic risk due to externalities not appropriately accounted for by banks, such as the social costs associated with market failures.

As with most public policy, the difference between good and bad regulation is in the details. Using just the mortgage market as an example, the execution of otherwise well ntended and sound financial regulation, such as LCR, will create a drag on financing one of the most important segments of the U.S. economy. At the most basic level, the LCR attempts to ensure that large banks (generally over $50 billion in assets) have sufficient liquid assets to weather a severe liquidity crunch over a 30-day period. In doing so, these banks would need to maintain a level of HQLA that represents at least 100% of net cash outflows over the 30-day stress period. The issue lies in defining what constitutes HQLAs and cash outflows for mortgage-backed securities, derivatives hedging instruments and mortgage commitments.

Under the LCR, the banking agencies reverted to differences in Basel risk-based capital treatment of mortgage securities guaranteed by the U.S. (i.e., Ginnie Mae MBS and those guaranteed by Fannie Mae and Freddie Mac). Ginnie Mae MBS receive more favorable treatment under the Basel standards in recognition of the federal guarantee versus the theoretical implicit U.S. guarantee of GSE securities.

The LCR has three categories – Level 1, 2A and 2B – that define what assets may be included as HQLA. GSE securities fall in Level 2A, which are discounted by 15%, and combined with level 2B assets, cannot exceed 40% of HQLA. As a result, GSE securities are placed at a disadvantage to Ginnie Mae securities in terms of banks' regulatory liquidity preference.

In addition, the LCR excludes from the HQLA definition high-quality, private-label residential MBS. With estimates by the Federal Reserve that banks will have to raise liquidity buffers by $200 billion to be in compliance, GSE and private label securities may take a valuation hit over the transition period to the 2015 implementation date. Moreover, with momentum building in Congress for a much smaller role for government in mortgage securitization, this second class treatment of GSE securities and the entire exclusion of private MBS from HQLA suggests more headwinds are in store for a private mortgage market.

The Fed's argument for placing GSE MBS into Level 2A is curious given they are still snapping up these bonds under their quantitative easing program. The Fed argued that since GSE securities do not enjoy a full guarantee from the federal government, they should be treated differently than Ginnie Mae MBS. Tell that to taxpayers that footed the bill for both agencies after they entered conservatorship in 2008. Presumably this LCR treatment of GSE securities could also dampen interest in FHLB-issuance of MBS on behalf of community banks, an option under the Corker-Warner Senate GSE reform plan. And excluding FHLB lines of credit creates a further drag on mortgage financing as banks seek more regulatory-favored sources of liquidity.

Beyond the HQLA definitions, the LCR creates a potential drag on mortgage financing activities by including derivatives used to hedge mortgage pipeline interest rate risk and mortgage commitments in defining cash outflows. By doing so, the LCR incents banks to reduce their focus on mortgage financing in order to maintain regulatory compliance.

Without question, implementation of short-term liquidity requirements in the banking sector should mitigate the kind of liquidity crisis experienced during 2008. However, the banking agencies should be mindful that proposed treatment of mortgage securities and associated mortgage financing activities will constrain this sector while handicapping efforts to bring private capital back to the secondary market.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland.