What’s systemic in the secondary mortgage market? Don't ask FSOC.

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When Financial Stability Oversight Council announced last week that it is studying the secondary mortgage market’s systemic risks, it reopened questions many thought the Trump administration buried: who or what is systemic and what then is to be done about it?

The FSOC was as transparent as always — not — and provided absolutely no information about which activities are on the griddle or whether individual firms — most notably Fannie Mae and Freddie Mac — are in the dock for potential designation as a systemically important financial institution.

However, it’s clear that a new regulatory construct for residential-mortgage finance will be wrought before the government-sponsored enterprises are allowed to leave conservatorship. What’s in store will determine the next generation of mortgage-market winners and losers, making it important at the outset to ensure that the FSOC’s conclusions are founded on a sound understanding of what constitutes systemic risk and then how best to mitigate it.

Since the question of what’s systemic burst into consciousness in 2008, academic and regulatory thinking has come up with an array of systemic-risk signifiers.

As a 2018 meta-analysis of systemic-risk research describes, model-builders have had a field day with various network-effect and value-at-risk models with scant application to real-world finance on a forward-looking basis. However, regulators have heeded at least some of this advice, using proxies for 2008-style contagion risk to craft a set of systemic-risk indicators.

In its own stab at defining systemic risk for the GSEs, the Federal Housing Finance Agency proposes a systemic surcharge based on a market-share indicator. In contrast, the global systemically important bank (G-SIB) indicators are multifaceted, with size — a sort of market-share proxy — buttressed by considerations such as the indispensable nature of a financial entity or infrastructure, complexity and cross-border scope.

The problem with each of these size, structural and network-effect approaches is that they are endogenous. That is, inward-focused. They focus on factors about one institution that purport to represent its impact on the financial system as a whole, but in fact only measure an entity in relation to the other entities being measured.

Thus, academic research measures network effects only within the financial system. The FHFA’s mortgage-debt measure of market share may well miss other systemic signifiers — perhaps GSEs are systemic not because they are large, but because they are indispensable or, less flattering, ill-capitalized and illiquid.

The conservatorship was called in 2008 not because Fannie and Freddie were big, but because they couldn’t handle all the mortgages they purchased when the secondary market suddenly shut down.

The G-SIBs may or may not be systemic in their own right. What’s known is how they stack up against other banks because they are designated in comparison to a constant list of big banks with no attention to systemically important entities outside the scope of the analysis.

The activity-and-practice construct the FSOC prefers to SIFI designation is a major advance over the approach taken in the past to banks and once-designated nonbank SIFIs. It attempts to identify business lines or financial products that pose systemic risk regardless of who offers them, turning not to a simple remedy such as a capital surcharge, but instead to a more structural risk-mitigation strategy to contain systemic risk.

However, the FSOC’s methodology could still be unduly endogenous, looking at interconnections among financial institutions as sources of systemic risk unless it accounts for exogenous shocks. Exogenous systemic risk that arrives not from within the complex network effects academics love to model and regulators expect, but from outside the financial system.

For example, the coronavirus pandemic is an exogenous shock to the financial system, one that makes painfully clear how the macroeconomy instantly affects financial stability. Up until now, virtually all thinking about systemic risk assumes that it’s financial-market instability that causes macroeconomic risk, not the other way around.

Exceptions to the belly-button model of systemic-risk analytics are the Fed’s stress tests and the resolution plans large banks must live by. The total loss-absorbing capacity (TLAC) standard also figures here in that it requires banks to hold buffers at all times above and beyond those meant to be drawn down under stress, although these buffers are also systemic-shock absorbers as learned of late.

All of these requirements assume exogenous shocks to a bank’s balance sheet and require advance insulation against it. It is this insulation that made banks so resilient even as nonbanks crumpled until the Fed stepped in to backstop them with the trillions deployed beginning in mid-March.

Importantly, all banks under most of these rules proved resilient, not just the G-SIBs subject to the toughest standards. It’s thus resilience and resolvability — not designation — that makes the difference.

Extrapolating these lessons to the secondary mortgage market, it’s clear that naming names is far less meaningful than ensuring resilience under stress. Stress must be judged not just from within the financial system, but also from beyond due to operational, geopolitical and of course macroeconomic risk.

As noted in 2012, resolvability — not size, complexity and other indicators — is the best indicator of systemic risk. If a financial institution can absorb stress without resort to its federally insured depository or the central bank, it is likely to be a bulwark against systemic risk, not a cause thereof.

Resolvability also provides an initial buffer against systemic activities and practices. If the entity can absorb stress without transmitting it to innocent bystanders, then activities offered by providers are likely to prove both robust under financial-market stress and as safeguards in macroeconomic debacles.

Using the resolvability and resilience criterion, it’s clear that credit-enhancement counterparties that can pay claims under even acute stress do not pose systemic risk; those that can’t, do.

Similarly, originators and servicers that can sustain demand and handle delinquencies do not pose systemic risk; those that can’t, do. It doesn’t matter what undermines the provider’s ability to meet its obligations so much as its ability to carry on under acute strain.

The activity-and-practice framework also captures products that transmit resilience and resolvability risk. For example, products that put borrowers at risk because loan terms are manageable under only the best of circumstances pose systemic risk if the number of affected borrowers is large enough to threaten macroeconomic or financial-market stability.

On whom or what the systemic label is affixed will befall significant new strategic challenges. There is an array of methodological and analytical ways to judge resolvability and resilience on both an institutional and product basis.

Hopefully the FSOC will use them and not tired, inward-looking criteria to make its determinations. Hard lessons from the past have shown that rearing financial entities only for financial-system instability leaves not just them, but the broader economy at acute risk. A system independent of federal guarantees and bailouts requires a systemic construct recognizing the world as it is, not was.

Editor's note: This article originally appeared, in slightly different form, in an email to Federal Financial Analytics’ clients.

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Secondary market Mortgages Mortgage defaults GSIBs SIFIs FHFA Fannie Mae GSEs Freddie Mac