Trump’s nominee for Treasury Secretary, Steve Mnuchin, was questioned last week by Members of the Senate Finance Committee on how he will serve as Secretary of the Treasury if confirmed. (The Finance Committee, not the Banking Committee, will vote on the nomination). Below is CREFC’s analysis of how Mnuchin, if confirmed, will treat issues affecting commercial real estate (CRE) finance. We base our analysis on both Mnuchin’s testimony and written responses.
Volcker Rule 2.0: CREFC’s policy staff is inclined to believe, under a Mnuchin regime, that the Volcker Rule will be administratively softened in the years ahead. During testimony, Mnuchin said: “As Chair of FSOC I would plan to address the issue of the definition of the Volcker Rule to make sure that banks can provide the necessary liquidity for customer markets and address the issues in the Fed report.” Administrative reforms will probably mean a retool of the rule to more clearly define “prop trading” and facilitate greater liquidity as dealer inventories grow. This “bright line” referred to by Mnuchin could entail establishing metrics that would seek to delineate proprietary trading from market making.
Stepping Back from the RNC’s Position on Glass-Steagall: During his testimony Mnuchin repeated his willingness to consider a reprisal of Glass-Steagall. While a “Glass-Steagall 2.0” has no apparent pathway to becoming law, as Congressional republicans have so far been adamantly against such a reform, we would caution the market that any future headline risk from the financial services industry could change opinions in Washington.. On the campaign trail, then-candidate Trump seemed warm to the idea of a “21st Century Glass-Steagall”, but the issue has not received much attention from his advisors since. Breaking up the banks à la Glass-Steagall appears to run counter in philosophy to relaxation of the Volcker rule.
Like-Kind Exchanges and Tax Reform: In his written responses to questions from Committee Members, Mnuchin offered definitive, but targeted, support for certain like-kind exchanges: “I agree that farmers, ranchers, and small business should be able to use like-kind exchanges for real and personal property in order to operate efficiently, create jobs, and strengthen the US economy.” To be fair, the wording of his answer was mostly parroting the question’s language. Given this exchange and hearing from the chief tax writer in the House, we believe current odds favor little disruption of current like-kind exchange provisions (also referred to as 1031 exchanges) during the upcoming tax reform debate. Please see Tax section later in this bulletin.
Fannie and Freddie. The Government-Sponsored Enterprises (GSEs) – Fannie Mae and Freddie Mac – were discussed as part of three separate Q&A segments, including both of Sen. Warner’s (D-VA) rounds. In aggregate, Mr. Mnuchin made three broad points. First, he distanced himself from calls to “recap and release” the GSEs and stated his hope for a bipartisan solution. Second, he described the GSEs as “very important entities” and touched on their role in ensuring secondary-market liquidity. Third, in the context of GSE reform efforts, Mr. Mnuchin repeatedly stated his goals were to protect taxpayers, ensure access to housing-related capital, and work in a bipartisan manner. Our view is that Mr. Mnuchin’s comments left just enough for everyone in the housing policy conversation to find something they can praise and something they can condemn, but we do not believe the broader mortgage finance policy conversation has been meaningfully altered. It is clear that Mr. Mnuchin is likely to bring a renewed sense of urgency to the issue, but other issues will be prioritized in the near-term (e.g., tax reform). Accordingly, our view remains that comprehensive mortgage finance reform legislation meaning a bill that alters either the GSEs’charters or conservatorship -- only has ~30% likelihood of enactment in this Congress. We maintain, however, that the declining GSE capital buffers, the potential impact of tax reform on Fannie Mae’s and Freddie Mac’s deferred tax assets, and the upcoming change in personnel could compel targeted administrative policy shifts. Furthermore, Senator Crapo has kept GSE reform a priority. So regardless of whether a bill can be passed this year, we believe that Senate Banking is highly likely to take up the debate this Congress.
On Tuesday, January 24th, the Senate Banking Committee overwhelmingly approved Dr. Ben Carson for the post of Housing Secretary, clearing him by voice vote. No date has been set for the full Senate to give Carson an up or down vote, but CREFC expects an easy path to confirmation barring any late-breaking developments.
While Mr. Carson’s testimony primarily concentrated on single-family housing, he did state, in line with President Trump, that “Overly burdensome housing regulations are bad for everyone and are increasing income inequality. Research by Harvard professors found that by reducing the ability of people to move around within an economy and between different economies, strict land use regulations are reversing 100 years of income convergence across U.S. states.” We believe this deregulatory theme will also apply to multifamily housing as well, though no details have been provided as such by Mr. Carson.
Forbes-Tate Partners is CREFC’s outside counsel for monitoring legislation outside of and intersecting with CRE, Congressional Leadership, and the White House.
As you know, comprehensive tax reform is at the top of the agenda for the Trump Administration and Congressional Republicans. Specifically, enacting comprehensive tax reform has long been a priority for House Speaker Paul Ryan; we fully expect him to expend significant political capital in order to get a bill passed out of the House of Representatives prior to the August recess. In preparation for a push to overhaul the tax code, House Republicans under Ways and Means Committee Chairman Kevin Brady (R-TX) last June released a blueprint that outlines their overarching vision for reform. This document was meant to provide a framework for House Republicans to run on during their re-election campaigns and to subsequently provide a path forward for the Trump Administration.
Currently, the Administration and Congress are working to add further details to the blueprint and to craft legislative language codifying the principles contained in the document. The timing for the release of a more concrete plan remains uncertain, but we expect to see a discussion draft or legislative language in the later 1st or early 2nd quarter. As expected, the process is fluid, with much of today’s corporate tax debate focused on new policies, including border adjustability (the so-called “BAT”), interest deductibility, and proportional expensing.
House Republicans are further along than their Senate counterparts, but we fully expect the Senate to turn its focus to tax reform following the completion of work on items including confirmation of Administration nominees, efforts to overturn Obama-era regulations through the Congressional Review Act, and legislation to repeal and replace the Affordable Care Act. We will continue to provide you with updates as the process progresses. Please see the next story to understand the implications for commercial real estate as it relates to tax reform.
As described above, comprehensive tax reform is at the top of the agenda for the Trump Administration and Congressional Republicans. House Republicans, under Ways and Means Committee Chairman Kevin Brady (R-TX), last June released a blueprint that outlines their overarching vision for reform. The plan is certainly unconventional – it takes a holistic view of revenue capture and gores many sacred cows in the process. The Senate has not developed a bill, as tax reform legislation must begin in the House.
The blueprint proposes significant changes for commercial real estate. Below are high-level descriptions of the reforms being considered:
Reductions in Marginal Rates: The plan would reduce the corporate tax rate to 20% and reduce the top rate on pass-throughs, such as partnerships and LLCs, to 25%. In addition, the blueprint would lower the top individual rate to 33% and allow individuals to exclude 50% of qualified investment income. Accordingly, long-term capital gains and dividend income would be subject to a top rate of 16.5%. To provide for these massive rate reductions, the Chairman proposes deemed repatriation of foreign earnings and a border adjustment tax (BAT) regime (see below) that together have the potential to raise over $1 trillion.
International Tax: In the international tax area, the blueprint proposes a destination-based system under which income earned outside the United States would generally not be subject to US tax. As a transition (i.e., a one-time “revenue raiser”), previously accumulated foreign earnings (currently estimated at over $2 trillion) would be subject to tax (in other words, deemed to be repatriated) at a lower tax rate.
The blueprint establishes the above-mentioned BAT, under which exports from the United States would not be subject to US tax – regardless of where products and services are produced, and conversely, products and services that are imported into the United States are subject to US tax. Proponents assert that this proposal could remove incentives to transfer businesses outside the United States as well as attract foreign investment into the United States. Brady has been quoted as saying, “This is a very simple policy. Is your product or service consumed in the U.S.? ... Once businesses understand it's not a VAT, and you don't have to track it transaction by transaction ... At the end of the year, a business adds up its export sales and doesn't count it as income. At the end of the year, it adds up its import costs and doesn't count them as expenses. That's the border adjustable tax. It is that simple.”
Full Immediate Expensing: The blueprint would allow an immediate deduction for 100% of the investment in all property except land, which would eliminate the current depreciation regime. For the purchase of a building, for example, the buyer could immediately write-off the full expense in the first year instead of taking depreciation over several years. If the full expensing creates a net operating loss (NOL), the NOLs can be carried forward indefinitely, though the deduction is limited to 90% of net taxable income.
Interest Income Deduction: Another feature that may be of significant concern to the commercial real estate industry is the interest limitation proposal. The blueprint would limit interest deductions to the amount of interest income, which could be detrimental to industries like real estate that rely heavily on leverage. In most cases, without significant interest income, the provision would essentially result in a denial of the interest deduction.
Currently, the blueprint provides little detail on how it would treat existing debt, however the blueprint notes generally that there will need to be transition rules.
Other Real Estate-Related Issues Not Specified in the Blueprint
Like-Kind Exchanges: Section 1031 allows the tax-free exchange of similar assets, such as real estate, and is commonly used in the commercial real estate industry. While the blueprint does not mention repeal of or modification to section 1031 specifically, like the mortgage interest deduction, it is frequently cited as another provision that might be eliminated or modified to raise revenue for other changes. For example, former House Ways & Means Chairman Camp proposed to eliminate the provision, while President Obama’s budget proposed certain limitations. It is possible that Ways and Means will consider section 1031 as a “special-interest” provision that should be eliminated or modified. Thus, the treatment of like-kind exchanges should also be watched closely. Note that Treasury Secretary Nominee Mnuchin expressed support for such exchanges during his confirmation hearing (see the above story).
REITs and MLPs: Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) are also not mentioned in the blueprint, and thus, the tax-preferred status of these entities is uncertain. Other features of the blueprint might have an impact on these structures, such as the immediate deduction for investments in all property except land, which would be a tremendous benefit for real estate, including that held through REITs and MLPs.
REMICs: Real Estate Mortgage Investment Conduits (REMICs) are a critical tax structure for Commercial Mortgage-Backed Securities (CMBS). They are similarly not mentioned in the blueprint, and there has been little to no discussion about any proposed changes to their status or structure.
Carried Interest: Taxing carried interest at ordinary income rates is another proposal that, while not specifically mentioned in the blueprint, is raised frequently as a potential revenue source. Changes to the carried interest rules have been proposed on Capitol Hill and the Administration, and during the campaign; both Hillary Clinton and Donald Trump supported changes. Real estate partnerships frequently utilize carried interest structures (generally called a “promote” in the real estate context) and even though the political rhetoric is generally targeted at private equity and hedge fund managers, the high-profile debate over this provision makes it likely that it will be raised in future tax reform discussions, with potential impact on real estate.
In one of the Trump
Administration’s first official acts on January 20, executive departments and
agencies were asked to freeze review and final publication of pending
regulations. You can see the memo here. While the move is headline-grabbing, it
should not be viewed as controversial; the Obama Administration issued a
similar freeze request in 2009, available here.
move essentially asks that President Trump’s appointees be given the
opportunity to review any regulations in the pipeline, which the new leadership
could subsequently withdraw, revise, or implement without change. In
effect, this a temporary measure to pause regulations while the new
administration is setting up shop.
action is limited in scope primarily because it does not apply to the
regulators that oversee commercial real estate finance. Specifically, Trump’s
recent freeze does not apply to ‘independent agencies’, which include
the FDIC, Fed, OCC, SEC, CFTC, and CFPB. Independent agencies generally
differ from executive or cabinet agencies (like Treasury, Homeland Security,
Labor, etc.) in that their leadership cannot be fired “at will” by the President.
Some independent agencies are also insulated from annual congressional
they have the ability to self-fund through means such as assessments on
industry or transactional fee structures.
agencies may choose to put some regulations on hold, but they would not face
any formal repercussions if they chose to move forward with rulemakings.
For a deeper background on the applicability of the memo to independent
agencies, see Executive Order 12866, which is referenced in the
White House memo.
Pathway to Regulatory Reform
most of the relevant CRE finance rules are promulgated by the above-listed independent
agencies, CREFC staff do not expect this action alone to divert rulemaking
around any of the major items in the regulatory pipeline, such as the
risk-based capital changes awaiting adoption in March by the Basel Committee on
Banking Supervision and the Net Stable Funding Ratio, scheduled to be adopted
by the FDIC, Fed and OCC in 1H 2017.
pending leadership changes at many of the agencies could lead to delays
or withdrawal of pending rules. In limited cases, leadership change
at an agency could also result in revisions to standing rules. As of this
writing, there is little known about pending leadership changes or any specific
information to suggest that the pending rules will not be adopted.
narrow area of CRE finance applicability relates to some foreign capital
inflows. The regulatory freeze does apply to a proposed rule relating to the EB-5 visa program,
which grants foreign investors eligibility for permanent residence status if
they make a qualifying investment in a commercial enterprise in the U.S.
current rules, the EB-5 visas are available to immigrants who invest $1 million
in a commercial project that will create or preserve at least 10 jobs in the
U.S. The threshold amount is reduced to $500,000 if the applicants choose to
invest in a high-unemployment area. An investment can be made directly
into the business or through an approved “regional center”, which is a
third-party vehicle that handles the job creation aspects.
January 13, the Department of Homeland Security proposed a new rule that would dramatically increase required
EB-5 investment thresholds. Under the proposed rule (covered by the Trump
freeze memo) the standard investment thresholds would rise to $1.8 million
generally and $1.35 million in high unemployment areas. The thresholds in
the proposed rule are higher than levels Congress currently is contemplating as
it works to reauthorize a portion of the program, which lapses on April 28,
the regulatory freeze, the Trump administration and new Homeland Security
Secretary John Kelly will now take the lead in determining the fate of the
rule, but the industry likely will have options to provide feedback. The
proposal currently is open for comment until April 11, 2017. Moreover,
Congress’s reauthorization efforts will provide a forum to examine parameters
of the EB-5 program.
More to Come
In 2015, the CREFC team published a study with Dr. Sam
Chandan, Associate Dean of the Schack Institute of Real Estate at NYU School of
Professional Studies, that summarized our and others’ regulatory impact on
multifamily and commercial real estate lending analyses. That model, which
estimated the inflection point at which borrowing costs become disruptive, can
be used for all types of rate shocks. Based on CMBS loan data, we estimated
that a 100-basis-point movement in rates was the point at which borrowers might
conclude that funding costs did not tie out with deal economics. Many variables
affect the analysis, but this past week’s second rate hike in the U.S since
2008 suggests it is time to revisit the estimated headroom in the CRE market,
or stated another way, the marginal borrowing cost increases borrowers are
willing to absorb before such increases trigger a dislocation in the market
such that borrowers are unable to refinance maturing loans.
Taken together, the December 14,
2016 25-basis point rate hike and the approximately 25-basis points of
regulatory-driven increase since the CREFC study leave about 50 basis points of
headroom. Admittedly, this is a blunt model in that it assumes that the rate
increases affect all loans equally and that all other factors remain
When you consider the costs of the capital and liquidity
regulations that are coming into place in 2018 (Net stable Funding Ratio (NSFR),
Fundamental Review of the Trading Book (FRTB), and others), in addition to the
potential for further rate increases, it may seem tight. Together, we estimate that the NSFR and the
FRTB will add roughly 10 basis points of costs to high-quality loans and bonds.
The NSFR is often referred to as a new “binding constraint” (the regulatory requirement that is most
onerous), alongside risk-based capital, the leverage ratio and stress tests. As
to the FRTB, the trade associations (GFMA, IIF and ISDA) that led the industry
comment letters submitted throughout the several year consultation cycle (but
most recently on January
14, 2016), estimated that the FRTB would require banks to hold an average
of 2.2 times the amount of capital currently being held against all
securitization asset classes. A senior tranche with a 15% risk weight today
could have a 33% risk weight in 2018. The FRTB and other new requirements will reduce total headroom to approximately 40 basis
points, which allows for less than two rate hikes of 25-basis points.
Considering that the normalized benchmark Fed Funds rate is
considered to be 3.00%, according to certain analyses, our headroom appears to
be relatively low. Jeffrey Lacker, President of the Federal Reserve Bank of
Richmond, speculated last week that there might be three or more rate hikes in
2017. (Lacker will be a voting member of the FOMC next year, but he will be an
alternate.) At the same time, we know that rate increases have been largely
offset by inflows of capital into the U.S., and that at least some of that
capital is put to work in the commercial real estate markets.
If foreign capital is one of the biggest offsetting factors
to potential borrowing cost shocks, it would be wise to monitor risk factors to
those flows. While this is not a sufficient forum to review all the drivers of
fund flows, it is critical to note that the same monetary policy moves that
make USD-denominated assets more attractive, can also make foreign currencies
While the U.S. CRE markets have a lot going for them and
they are clearly able to absorb more disruption, there is both a theoretical
and an actual limit to the shocks that can be adjusted to in a relatively
seamless manner. In 2017, the CREFC team will be working to minimize further
regulatory impact, and we welcome your input and support. For engagement,
please contact me, David McCarthy or Marty Schuh.
The Systemically Important Financial Institutions (SIFIs) designation has long been a target for reform, and recent congressional action may provide hope for supporters of a more analytical method of designation. On December 5, the House passed the Systemic Risk Designation Improvement Act (H.R. 6392) by 254 to 161, with all present Republicans and 20 Democrats voting for passage.
SIFI Designation Background: The SIFI designation automatically includes bank holding companies with more than $50 billion in assets and applies a host of requirements, known as Enhanced Prudential Standards, that seek to prevent or mitigate “too big to fail” scenarios. The requirements include stress testing, living wills (requiring regulator blessing), as well as more stringent capital and liquidity requirements. While banks are subject to the automatic asset threshold, non-bank companies also may be designated SIFIs by the Financial Stability Oversight Council (FSOC), a group chaired by the Treasury Secretary and comprised of voting representatives from nine U.S. regulators and a non-voting seat for the Federal Insurance Office. Instead of the automatic $50 billion threshold for banks, H.R. 6392 would require the FSOC to apply an indicator-based approach to screening for nonbank SIFI candidates and to determine whether an entity should be put through the multi-stage SIFI designation process required for insurance companies, financial utilities, and other potential SIFIs.
Criticisms of the Designation Process: Critics of the SIFI designation have found fault on two major fronts. The automatic $50 billion asset threshold for banks is too blunt to actually measure systemic risk. A broad set of stakeholders also have expressed concerns about the opaqueness of FSOC’s process for designating non-banks as SIFIs. The U.S. regulators have indicated a willingness to entertain raising the SIFI threshold for banks, but they have not supported changes to the non-bank process.
The bill would dump the $50 billion threshold and instead require FSOC to use the indicator-based measurement approach, established by the Basel Committee on Banking Supervision (BCBS). And like the one used for non-banks, FSOC would use the indicators to determine whether the material financial distress of the bank holding company could pose a threat to the financial stability of the United States. The considerations used by the Basel measurements are: size, interconnectedness, extent of readily available substitutes or financial institution infrastructure for services, global cross-jurisdictional activity, and complexity. Additionally, the bill would require that each SIFI designation would be subject to a two-thirds majority vote of FSOC and allow designated banks to petition FSOC for review before final determination (the same process nonbanks currently are afforded).
The methodology used in the bill also would align with the approach used by the Financial Stability Board and the BCBS, which designates Global Systemically Important Banks (G-SIBs). Currently, the U.S. is home to 8 G-SIBs, while Europe has 15 and Asia has 7.
Alternate Approaches to Bank Relief: The SIFI threshold has been a congressional target before, and even some regulators have hinted at moving the dial. In 2015, the now-outgoing Senate Banking Committee Chairman Sen. Richard Shelby (R-AL) proposed a $500 billion threshold as part of broader financial services reform package. Senate Democrats balked at the level, and the Senate never voted on the measure. Regulators and some Democrats have conceded that $50 billion may be too low: the Fed’s Dan Tarullo previously suggested a $100 billion threshold could be palatable; and Fed Chair Janet Yellen also has remarked that a modest increase in the threshold may be necessary.
Probability for Enactment in 2016: The broad bipartisan support is an encouraging sign for reformers as it heads to the Senate for consideration. Additionally, the bill’s reliance on the Basel methodology could be more palatable to those wary of rollbacks while still granting relief to smaller and less complex banks. Even with the current bipartisan support, President Obama’s signature would still be needed to enact this as law. The margin in the House’s vote would not be strong enough to override a veto (two-thirds of the House and Senate would be needed to override a veto). Nevertheless, H.R. 6392 could serve as a blueprint for SIFI reform for the incoming Trump Administration and the 115th Congress.
What Would Success of the Bill Mean for the CRE Sector?
If the bill is enacted, it will likely lead to a reduction in the number of banks that must adhere to SIFI standards. Ultimately, the primary benefit would be a reduction in costs, both in capital and compliance efforts. For the CRE sector, this could mean regional and small banks would have less capital tied up for regulatory purposes. Stress tests and resolution plans are lengthy and costly endeavors that put additional pressure on banks’ profitability and influence reallocation of resources. Even with a change in the letter of the law, regulators could still have supervisory expectation that, in effect, would maintain many of the enhanced standards and requirements. Additionally, Basel III and the expected Basel IV requirements wouldn’t live or die by the change in designation approach.
Any changes to SIFI designations likely will invite criticism that deregulation will lead to another “too big to fail.” Although the proposed analytical method may reduce the number of SIFIs, the approach is not without controversy as evidenced by the criticism of the non-bank designation process.
While opposition is growing among banks against asset levels as a measure of systemic risk, regulators may not be ready to dump asset thresholds. For example in May 2016, six financial services regulators re-proposed an Incentive Compensation rule that relied on tiered asset levels to subject institutions to varying compliance requirements, with more stringent requirements kicking in at $50 billion and $250 billion. The proposed incentive compensation rule is still outstanding, but it could be a harbinger for the staying power of asset thresholds, among other things.
Please contact David McCarthy for more information.
The House Financial Services Committee has taken the first step toward reauthorizing The National Flood Insurance Program (NFIP), set to expire next year on September 30th. The program remains essential to CRE due to certain commercial assets relying on the government plans as opposed to private policies.
Subcommittee Chairman Blaine Luetkemeyer (R-MO), who chairs the housing and insurance subcommittee, is circulating among Republican members for discussion this week a set of long-awaited principles he hopes will guide the debate to shore up the government insurance arm while simultaneously bolstering the private flood insurance market. Luetkemeyer recommends that NFIP align its practices with the private sector when it comes to calculating premiums. Also up for debate is the level to which private insurance policies will be permitted in lieu of government policies when gauging loan compliance.
Thanks to a politically-driven actuarially imbalance, the NFIP, which insures homes and some commercial properties against flood risk, is $23 billion in debt. Luetkemeyer has for months hinted at areas of focus to shore up the NFIP's fiscal footing, expand consumer options, provide more transparency around how flood insurance rates are set, improve flood mapping and add more flexibility in flood mitigation.
Highlights of proposed changes include requiring the government to rely on reinsurance or "capital markets alternatives" as a means to protect taxpayers; phasing out coverage for certain residential and commercial structures; eliminating non-compete restrictions for insurers participating in the NFIP's "Write Your Own" program, and repealing mandatory coverage requirements for commercial properties.
Luetkemeyer also recommends enacting a House-passed bill by Reps. Dennis Ross and Patrick Murphy that aims to make it easier for homeowners to use private flood insurance to satisfy requirements for government-backed mortgages. The Ross-Murphy bill (H.R. 2901) passed the House by voice vote 419-0 back in April.
The Financial Services Committee under Chairman Jeb Hensarling (R-TX) is said to want to get a head start on what could be a contentious debate around what to do with the program. Potentially complicating matters, however, is a shuffling soon of committee chairs in light of a retirement on a ranking subcommittee. If and when this happens, the Luetkemeyer document could be rendered obsolete before it becomes a draft.
The Senate Banking Committee, slated to be chaired by Idaho Republican Senator Mike Crapo, has not yet shown its outline for reauthorization, or a schedule for hearings or formal committee consideration.
As one Hill newspaper succinctly noted: “When it comes to flood insurance, political divisions tend to be more geographic than partisan. And the lobbying effort cuts across industries and special interests, including insurance, banking, real estate, environmental advocacy focused on climate change and fiscal conservatives.”
CREFC will continue to engage on this issue and welcomes your input for recommendations to the new Chairman in support of CRE provisions within the broader flood insurance reauthorization. While the “principles document” is just the beginning, we will bring the issue before the relevant forums and policy committee before our advocacy campaign begins in earnest.
Please contact Marty Schuh for more information.
A dissection of liquidity conditions meandered throughout 2016 with much debate between the officials and the industry over the nature of market health and with little agreed upon by the two sides. In 2017, several new rules and supervisory tools are expected to crystallize, and these will be some of the more impactful measures the regulators have taken to date. Below is a summary of some of the analyses published this year and how regulation may have affected four broad dimensions of liquidity in the U.S. There are numerous articles, papers and presentations worth reading on the subject, some of them published by our member firms; for a more complete reading list, please contact Christina Zausner.
· Dimension 1: Liquidity of Benchmark Bonds and Currency
Experts from the official sector and some from industry often agree that the U.S. Treasury market is generally healthy at this time, and that it should remain so unless the FOMC were to take the unexpected step of selling down its Quantitative Easing portfolio. They look at the 2013 “taper tantrum” and conclude that the market healed itself quickly and without major disruptions. For a 2016 update on the Joint Staff Report that discusses the 2013 event and the structure of the Treasury market, see this link to the Treasury Notes Blog.
Others point out that on-the-run (OTR) and off-the-run (OFTR) Treasury securities trade very differently, and that transaction costs for OFTR Treasuries have increased considerably. For a Bloomberg article that elaborates on the contrarian view, see this link.
Going forward, the new risk-based capital requirements being considered by the Basel Committee on Banking Supervision (BCBS), which include the Fundamental Review of the Trading Book (FRTB), may further disrupt the functioning of the Treasury market. The FRTB covers and adds costs to all traded products, including Treasures.
· Dimension 2: Liquidity of FX Markets and a Potential New Super-Cycle Story
The aspect of the currency markets that the authorities and the industry seem to agree on is the foreign exchange (FX) swaps and forward markets, where trading patterns have been subverting norms for some time now, and even raising concerns of a super cycle taking hold.
The head economist of the Bank of International Settlements, Claudio Borio, and a team of his colleagues highlighted a troubling and persistent anomaly in these markets recently. The Borio team published a paper that analyzed the “covered interest parity” (CIP), the normative condition when the relationship between interest rates and the spot and forward currencies are in equilibrium. For those of you who remember the LIBOR Overnight Interest Swap (OIS) spread going wild and kicking off the worst of the downturn, this isn’t that.
The OIS series that showed us the dislocation in the overnight USD borrowing market was largely driven by fears about the counterparties, the banks themselves. Now the problem is that because of structural changes to the financial systems broadly, it can be cheaper to borrow dollars in one market than in another. In other words, the central rules of currency trading have broken down (seemingly), arbitrage opportunities have opened up and hedging activity is now subject to higher transaction costs and volatility.
The authors of this paper assert that the core problem today is no longer the credit rating of the bank but the cost of the credit (and liquidity) that a bank offers. In short, balance- sheet usage has become too costly, dollars and dollar collateral are harder to come by. In particular, repo funding, which is popular for trading and hedging activities, has become even more expensive.
At CREFC, we are watching the progress of the Net Stable Funding Ratio (NSFR), which is expected to be finalized in the 1H 2017. The NSFR will add costs to CMBS activities on two levels: 1) it will place more pressure on traded markets generally, by adding costs to repo funding; and 2) by assessing trading exposures, such as CMBS, with new costs too. Because the NSFR was aligned with the Liquidity Coverage Ratio (LCR), which was the first of two liquidity ratios mandated under Basel III, CMBS are granted no compensation for costs, as other asset classes are. As a result, the NSFR further increases CMBS’ cost basis versus other traded securities.
· Dimension 3: Liquidity of the Money Markets and Cash-Management Products
The US Chamber of Commerce and The Clearing House have both produced insightful research (do we have links?) on the current state of the money markets, which are important in their own rights as financial products, but also critical to cash-management operations at financial institutions and corporations. The combination of the SEC’s floating Net Asset Value (NAV) rule, the Leverage Ratio and the LCR have caused money-market premiums to increase seemingly permanently. More importantly, product availability has diminished for treasurers and monetary policy could be limited too in this new market structure.
· Dimension 4: Liquidity in Non-Sovereign Credit Market
One of the most daring statements made about secondary-market liquidity was expressed by Joseph Tracy, Senior Advisor to the President of the Federal Reserve Bank of New York. At a Brookings Institution event, he mentioned that the regulators might be missing some things. Specifically, Mr. Tracy spoke about the difficulties in tracking the number of deals the contraction in liquidity had prevented. At the time, the senior Fed official was discussing the corporate bond market, but theoretically, the statement could apply to other asset classes, including CMBS.
While Mr. Tracy did not go so far as to suggest that regulation caused some market weaknesses, he opened the door to the possibility. All the same, the FRTB and the NSFR are expected to go into effect in 2018 and 2019, and that secondary-market liquidity will diminish even further.
For recent letters to the regulators and to members of Congress on these subjects, please see CREFC’s Government Relations site. For our latest letter, which CREFC signed with other trade associations and sent to the U.S. banking agencies on 12/02/2016 regarding Basel IV, please see this link. For questions and comments, please contact Christina Zausner.
separate and diametrically opposed camps have galvanized in recent weeks. There
are those who are pro-capital requirements and who are motivated by the need to
further insulate the global financial system from perceived excess and another
government bailout. There are also those who are more liquidity-driven, who
believe that too much regulation is dampening the pace of economic growth.
Camp 1, the capital requirements band, are promoting various policy solutions,
including: 1) Basel IV, a collection of new requirements awaiting a vote in the
Basel Committee on Banking Supervision (BCBS) and that would increase
risk-based capital requirements; 2) a reinstatement of the Glass Steagall Act;
and 3) other Too-Big-to-Fail (TBTF) measures, such as the one proposed by President of the Minneapolis
Kashkari, on November 16. Amongst other things, proposes to take the punchbowl
away from banks and nonbanks by raising capital requirements for large banks to
heights not contemplated in polite society before now and also applying a tax
on shadow banks.
Camp 2, the pro-capital availability group is contemplating some impactful
measures too, including: 1) a repeal-and-replace package for the Dodd-Frank
Act; and 2) blocking Basel IV and other internationally-driven requirements in
the U.S. (To access a letter sent to the US banking agencies on November 18,
please go to this link.)
the prevailing zeitgeist at home and abroad is starting to favor the latter
camp, they will be less successful, unless they coordinate with the other side
to form a coalition. Early indications suggest that the repeal (and
replacement) of the Affordable Care Act (ACA) and any major tax reform package are
the incoming Administration’s priorities. We not only expect them to put these
initiatives forward first but that the Senate will also seek to establish a straight
majority, 51-vote requirement for the upcoming budget acts, as well.
both the 2017 (as of October 2016) and 2018 (as of March 2017) budgets will be
in play soon after the 115th Congress takes their seats in January,
theoretically there are two bites at the apple for major changes soon out of
the gate. If reconciliation rules agreed to in the 2017 and 2018 budgets follow
the recent pattern, they will limit Congress to one major legislative package
per annual spending bill.
is quite possible that the ACA and tax reform will be put through the system
with a 51-person vote, while the Dodd-Frank Act will be dealt with separately. If this scenario proves itself out, then any
changes to the Dodd-Frank Act will be subject to the higher vote threshold (all
major legislative packages are subject to 60 votes). Our lobbyist and prognosticator,
Marty Schuh, thinks there is reason to believe that deals can be made with certain
Democrat Senators who will be up for election in 2018 and who are in states
that have recently or traditionally shown a strong “R”-leaning.
contact Christina Zausner and Marty Schuh for more information.