U.S. financial regulators led by the Treasury’s Steven Mnuchin and the Federal Reserve’s Jerome Powell have been put on notice about the risk of an economically damaging cash crunch in the $11 trillion home mortgage market.

Behind the concern aired recently at the Financial Stability Oversight Council headed by Secretary Mnuchin: The rapid growth of so-called shadow banks in the origination and servicing of home loans, especially riskier ones.

“There is a real weakness here,” said University of California, Berkeley professor Nancy Wallace, who co-authored a 2018 paper entitled ‘Liquidity Crises in the Mortgage Market’ with a fellow academic and three Fed economists. “Many of these firms are financially fragile.”

That’s because they’re dependent on short-term bank credit lines that could be pulled at times of financial stress. The worry is that could end up hurting the housing market and the economy as the financiers are forced to cut back or curtail their mortgage business.

FSOC, the umbrella group of regulators established after the financial crisis which includes Fed Chairman Powell and Securities and Exchange Commission chief Jay Clayton, discussed the home loan market in September.

Staff from the Fed, the Federal Housing Finance Agency and the Conference of State Bank Supervisors gave a presentation on the “growth of nonbank mortgage origination and servicing and potential related risks,” the council said in a little-publicized readout of the meeting.

The presentation focused on the industry’s reliance on short-run financing, including the possibility of liquidity drying up -- a concern highlighted in the paper Wallace wrote with Fed Deputy Associate Director Karen Pence.

Mortgage Originations
It’s unclear how the regulators reacted to the presentation, but the fact that the issue came up at all underscores that the risk is on the radar screen. There’s no indication though that the council is considering singling out the business as a risk to financial stability. In fact, mortgage originations surged in the second quarter as lower interest rates enticed home owners to refinance their loans.

A Treasury Department spokesman declined to comment.

As conventional banks pulled back from the mortgage market due to limited profit opportunities and increased regulation after the financial crisis, the independent mortgage companies flooded in.

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