Office of Financial Research 2013 Annual Report Released December - PDF document

Office of Financial Research 2013 Annual Report Released December 17, 2013 Available at http://www.treasury.gov/initiatives/ofr/about/Documents/OFR_AnnualReport2013_FINAL_12- 17-2013_Accessible.pdf Chapter 5.5, Preliminary Research Based on Recent Data Collections

adverse scenarios and evaluate how well a nonbank rates, MBS yields, haircuts, and funding runs could help servicer is prepared to weather an economic downturn. evaluate mortgage REIT performance through a variety of adverse scenarios. The Offjce is exploring avenues for These data gaps could have implications for policy gaining a better understanding of this market. proposals. A mortgage fjnance reform bill proposed in the U.S. House of Representatives in July 2013 includes 5.5 Preliminary Research Based on language to address confmicts of interest by preventing Recent Data Collections loan servicers that hold a junior lien on a property from servicing other loans on the same property (see H.R. 2767, 2013). But because regulators do not currently Ongoing data collection and sharing initiatives broaden the collect comprehensive mortgage servicing information, Offjce’s access to valuable information concerning fjnancial evaluating the effects of such a policy on fjnancial stabil- stability. However, there is no perfect real-world dataset. ity is not possible because we cannot accurately deter- Part of the research process is learning what can be done mine how often this confmict occurs across the United with available data. How reliably do the data refmect the States. An expanded collection of mortgage servicing quantities that they are supposed to measure? How noisy are data from banks and nonbank servicers identifjed con- the data? What questions can be readily answered? What sistently over time as mortgages were transferred and questions can be addressed only indirectly? sold could address this data gap. This section summarizes the beginnings of research programs that use three newly available datasets. Two Mortgage Real Estate Investment Trusts. As noted of the datasets contain information about money-fund in Chapter 2, mortgage real estate investment trusts asset holdings and credit default swap transactions (REITs) are leveraged investment vehicles with large that is high-quality, comprehensive, and separated holdings of agency mortgage-backed securities (MBS). into components, or disaggregated. The other dataset The sector depends heavily on the repo market and contains information about hedge funds and is more is highly concentrated, with two fjrms accounting for limited. In our analysis, we discuss what we can learn about 60 percent of sector assets. In May and June 2013, and cannot learn from these data. Each of the follow- mortgage REITs shed roughly $45 billion of MBS as ing sections begins by posing the main question our interest rates rose, due to their exposure to duration risk research attempts to answer. and basis risk. These sales likely contributed to rapid increases in yields and volatility in the MBS market. Active Management of Money Market Funds Sparse data are available to evaluate the risks posed by mortgage REITs. Although most mortgage REITs are How do managers of money market funds adjust the com- publicly listed companies, the depth of data presented position of fund assets at times of fjnancial market stress? in public fjlings varies widely across fjrms, and on Money market funds play a signifjcant role in the fjnan- the whole the data are inadequate to assess the risks cial system. The soundness of the funds and investor they pose to fjnancial stability. Mortgage REITs are confjdence in their soundness are important to fjnan- generally excluded from reporting requirements of cial stability. The strategies funds use to manage their the Investment Company Act of 1940. Although the risks affect other asset markets. For example, a sudden Dodd-Frank Act increased the reporting requirements shift by money market funds out of a particular asset of hedge funds and private equity funds, the require- class can disrupt other markets. ments on mortgage REITs remain unchanged. In 2010, the SEC required money market funds to fjle More data are needed to understand the risks posed by a monthly report on portfolio holdings as of the last mortgage REITs. Information describing the distribu- business day of the previous month on its new Form tion of their portfolio holdings, borrowings, and deriv- N-MFP (see Rule 30b1-7 under the 1940 Act). Form ative positions across tenors, rates, haircuts, and other N-MFP reports help regulators understand risks faced instrument-specifjc parameters would contribute to a by money market funds and the Offjce actively moni- greater understanding of the vulnerabilities of mort- tors the fjlings. But gaps remain. gage REITs. Stress tests against shocks to borrowing 86 86 2013 OFR Annual Report 2013 OFR Annual Report

If there were no gaps in available data, regulators Figure 52. Five-Year Credit Default Swaps Spreads for could monitor the price volatilities of all assets held in Select Eurozone Countries (basis points) fund portfolios on a real-time basis. In practice, regu- lators face a time lag when monitoring asset holdings. 1,400 Although asset holdings are available from the SEC 1,200 through Form N-MFP, the Offjce has limited informa- tion on the secondary-market trading of money market 1,000 fund assets because some market data are available only to registered traders. 800 We use information from other sources to draw 600 inferences about the risks embedded in money fund 400 assets and the asset-allocation strategies funds used to control these risks. In particular, we closely watch 200 developments in the eurozone and the potential effects on money fund risks and possible spillovers to 0 Nov May Nov May Nov May U.S. fjnancial markets. 6 One barometer of risk in the 2010 2011 2011 2012 2012 2013 eurozone is the market for credit default swaps (CDS or swaps), fjnancial instruments that insure against a Austria Belgium France Germany government defaulting on its debt. Investors can buy Ireland Italy sovereign default CDS to hedge against risk, or to bet Netherlands Spain on a country’s future. Source: Markit Group, Ltd The Offjce used money fund data from Form N-MFP to examine how the eurozone sovereign debt crisis eurozone CDS spreads, including those of Germany spilled into prime money funds. Prime money funds and France, began to rise in mid-2011. are required to invest in high-quality, short-term debt securities, and typically do not hold eurozone Data collected on Form N-MFP indicate that prime sovereign debt. However, the funds have an indirect money market funds reduced their holdings of debt exposure to eurozone sovereign debt because they issued by eurozone fjnancial institutions while euro- may invest in some short-term corporate debt issued by zone CDS spreads were rising. Figure 53 shows that European banks and fjnancial fjrms. That corporate from late 2010 through the middle of 2011, prime debt is sensitive to the risk of sovereign debt default money funds held about $500 billion in debt issued because the issuing fjrms are based in the region or by banks and fjnancial institutions in eurozone coun- invest in the foreign debt. tries, or 30 percent of total prime fund assets. By the end of 2011, prime fund exposure to these institutions Figure 52 displays the costs of insuring against the dropped by half. failure of sovereign debt, as measured by CDS spreads for eurozone countries. Spreads for Ireland, Italy, and Was this decline the result of investors running from Spain were high and rising throughout 2010. Prime particular funds? In other words, did investors sell money funds were largely unaffected by this trend their holdings of prime money market funds with because their eurozone exposures were concentrated heavy eurozone investments and increase their hold- primarily among entities based in Germany and ings of prime funds with low eurozone investments? Or France. Spreads for these countries were low and stable was the change the result of individual fund managers through the end of October 2010, averaging about 38 shifting the composition of their portfolios away from basis points for Germany and 65 for France. These eurozone investments? The fjnancial stability implica- spreads rose slightly in early 2011, but then returned tions of events such as the sovereign debt crisis heavily to spreads of about 40 and 75 basis points respectively, depend on the reason for the decline in the overall by mid-2011. However, spreads increased through eurozone exposure of prime fund assets. the remainder of 2011. The fjgure shows that several 87 87 Addressing Data Gaps