As 2017 winds down and American households seek to figure out optimal withholding strategies under the new tax law, we've been contemplating which 2017 trends are likely to persist into 2018 and what looks to be new on the horizon. Here are few of them.
The end of DFAST as we know it?
The proposed "Economic Growth, Regulatory Relief, and Consumer Protection Act" was introduced by a bi-partisan group of senators last month. The bill would potentially reduce to fewer than ten 1) the number of banks designated as systemically important financial institutions (SIFIs) and subjected to “enhanced prudential standards” (currently numbering 34) and 2) the number of banks subjected to DFAST (currently numbering about 125).
The first impact is the one generating headlines in the popular press. The bill would phase in an increase of the SIFI threshold from $50 billion to $250 billion, ultimately subjecting only the ten biggest banks in America to the “enhanced prudential standards” currently required under the Dodd-Frank Act. Shrinking the SIFI designation is an interesting development that bears watching, but let’s face it, there were never really that many $50 billion banks to begin with. Out of nearly 5,000 U.S. commercial banks as of 9/30/2017, just 34 had to submit CCAR capital plans (required of all banks with at least $50 billion in assets) to the Federal Reserve in 2017.
It’s the proposed change to the DFAST requirement that really has our attention, however. As of 9/30/2017, more than 125 banks reported over $10 billion in assets, thus requiring them to perform DFAST stress testing—along with all the modeling and model validation that accompanies it. In addition, most of the 30 or so banks with between $8 billion and $10 billion in total assets certainly have DFAST on their radar and had begun investing in the systems and modelers necessary to comply. If the Senate bill passes and DFAST is scrapped for all banks below $250 billion, the number of banks with DFAST concerns (either currently or on the near-term horizon) will plunge from more than 150 to fewer than ten.
It will be interesting to watch how these other 140 banks (and their regulators) respond to the proposed legislation as it works through the Congress in early 2018. Will it pass quickly enough for the smaller banks to pull the plug entirely on their 2018 DFAST processes? Will their regulators let them?
U.S. institutions get serious about CECL
The year 2021 may still feel like the distant future for non-SEC filers who have until then to adopt the Current Expected Credit Losses (CECL) standard, but by mid-2018, most 2020 CECL adopters will have made critical commitments. Chief among these is the selection of a CECL solution (execution platform) in time to allow for implementation plus a full year of a parallel runs.
Participants in RiskSpan’s recent CECL webinars have identified and discussed the universal need for a fully integrated, end-to-end CECL product that integrates data management, modeling expertise and reporting into a streamlined solution that meets the standard and saves time and money. We expect interest in solutions that meet these criteria to spike during 2018.
SEC filers (who must adopt the standard in 2020) that have not yet selected a system will find themselves at a significant disadvantage as they will not have time to compare a full year of allowance estimates in parallel between the new CECL standard and the existing incurred-loss standard.
Changes to housing and mortgage markets—and to the securitization industry that supports them
Among the new tax law’s most widely discussed (and debated) provisions are 1) the dampening impact a higher standard deduction will have on the benefit of the mortgage interest deduction and 2) the $10,000 deduction cap on state, local, and property taxes.
The new law will either eliminate or significantly reduce the tax benefits of homeownership for a significant number of households. The removal of these incentives will be felt throughout the mortgage industry—from those who buy and sell homes, to those who finance the transactions directly and via securitization vehicles.
It’s hard to see home prices going anywhere but down in the short term. The tax benefits that will disappear in 2018 are implicitly baked into almost every real estate transaction—particularly those involving financing. Removing them makes the transaction less valuable. We leave it to others to predict the magnitude of the drop, but qualitatively speaking, falling home prices pose interesting questions to firms (like ours) that model voluntary and involuntary prepayment activity. We would reasonably expect both to increase marginally as borrowers with the means to prepay their mortgages do so and perhaps a modest uptick in “strategic defaults” among borrowers at the margin who find themselves underwater.
Neither of these changes is likely to be dramatic—particularly if rates remain at their current historic lows. Low rates dampen both the benefit of the interest deduction and the incentive to prepay. And strategically defaulting will likely turn out to be an over-reaction to what may turn out to be a short-term price correction in real estate values.
Calculations underpinning these predictions will change if interest rates rise, and analysts anticipate as many as three Fed rate hikes during 2018. Prevailing interest rates will also have a say in the extent to which the private-label MBS market makes any kind of resurgence in 2018. Unless steps are taken to reduce the regulatory and other costs of securitization, current rates just don’t have enough juice to make private-label securitizations profitable for many market participants.
Distributed ledger technology (i.e., blockchain) makes its presence felt in the capital markets
For nearly a decade, we (and others) have speculated about whether “this is the year” when the private-label MBS market will begin mounting its comeback. We don’t know whether this will be the year for that, but 2018 is certainly shaping up to be one in which blockchain begins to transform capital markets and paves the way for PLS’s long-awaited return.
As we discussed in our recent post on the topic, many of the obstacles standing between us and a flourishing PLS market relate to mistrust resulting from information asymmetries among the various PLS parties. We predict that blockchain and related technologies around smart contracts will play a dramatically increased role in addressing these issues during 2018.
Fintech firms will continue to lay the groundwork for incorporating blockchain solutions that will automate cash flow modeling and reconciliation, dynamically share all relevant loan-level data among transaction parties, and ultimately disrupt and revolutionize the due diligence process as we know it.
The observation, “Prediction is difficult, especially about the future,” has been attributed to Niels Bohr, Yogi Berra, Mark Twain, Albert Einstein, and approximately 100 million other people. We don’t claim any particular clairvoyance, but we feel reasonably confident in our assertion that these trends will continue to march ahead in 2018. We look forward to helping to drive several of them forward and wish you the best in the New Year.