The Big Picture – March 23rd, 2023

Published Mar 23, 2023

The focus lately has been on banks, and the massive amount of liquidity they have drawn from the Fed’s discount window is seen as cause for alarm (see chart below). I think there’s another less worrisome explanation and that is that after 2008, banks learned that it’s best to borrow excess liquidity from the Fed before it’s needed than to be forced to accept the Treasury Department as your partner later.

But regulated banks represent only about half of the world’s financial intermediation (see next chart) and while the job of converting short term deposits into longer term loans makes banks more vulnerable in the early stages of a confidence crisis, non-bank financial intermediaries (NBFIs) are not immune to second and third order effects.

Source: Financial Stability Board

We are very familiar with non-banks playing a large role in the mortgage business, but other NBFIs include hedge funds, money managers, and insurance companies. While they don’t rely on deposits for funding, they do rely on loans from other institutions as well as the debt markets, neither of which are immune to fear. 2008 proved that even money market funds invested in ‘safe’ assets can be subject to the same problem banks face as withdrawals force asset sales which produce losses which cause more withdrawals. Although NBFIs might take less duration risk than banks, it is necessary to take other forms of risk to produce returns for their shareholders and these risks often involve assets with “spread” risk such as bonds with embedded optionality (MBS and callable debt) and securities with credit exposure (lower rated corporate bonds, riskier sovereign debt, etc.). And big things are happening in both volatility and credit.

For 1,289 trading days leading up to this month, only 30 days saw moves in the 2-year Treasury yield greater than 10 bps (roughly 2.5% of the outcomes). Since March 1, we’ve seen 10 days with moves greater than 10 bps or roughly 66% of the outcomes! Anyone entering this month short options in any form (MBS or MSRs for example) is getting shellacked. It’s one thing to have a day or two of elevated volatility, but as the chart below shows, implied volatility has been at early pandemic levels for a while. How are things in credit markets? High-yield bond spreads indicate these investors are getting very worried but remember, we haven’t yet seen real recession symptoms so these spreads could widen even further.

I’m not trying to alarm anyone. On the contrary, if/when you start to hear news about NBFIs, I don’t want you to be caught off-guard. Stresses in the NBFI world are not inevitable, but they would be normal under the circumstances. And there are steps that could be taken to stabilize systemically important NBFIs such as allowing access to the Fed’s discount window. But here we would be entering a world of politics and moral dilemmas and even if these measures were allowed, it’s not clear that NBFIs would be willing to accept the oversight quid pro quo that comes with government support; NBFIs choose to be non-banks for a reason.   

The bright star in all of this? Thanks to the hard work and dedication of people at Fannie, Freddie, FHA, VA, and GNMA, our resilient housing finance system chugs along unfazed providing trillions of dollars in liquidity so that we can continue to serve homebuyers.

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