UPDATE 1-U.S. risk council warns about asset managers, mortgage servicers

Wed May 7, 2014 6:09pm EDT

(Adds a comment from SEC Chair Mary Jo White, more details about the report and reactions)

By Emily Stephenson and Sarah N. Lynch

WASHINGTON May 7 (Reuters) - The U.S. financial risk council on Wednesday raised red flags about new, potentially risky practices by asset managers and nonbank mortgage servicers, which they said are not regulated as carefully as banks.

The sectors were highlighted by the Financial Stability Oversight Council in a report published on Wednesday.

The council is a group of financial regulators established by the 2010 Dodd-Frank law. The group watches out for market risks and imposes additional regulation on large "systemic" firms whose collapse could harm the financial system.

The group issues a report every year that explores the landscape of financial activity and warns about new risks.

Previous reports have mentioned activities by nonbank mortgage servicers and asset managers, but did not detail all of the risks included this year.

Regulators said they are concerned that some traditional bank activities are moving to nonbank firms that are not subject to capital and liquidity requirements.

The focus on asset management activity will likely frustrate the industry, which fears the FSOC might designate large firms such as BlackRock or Fidelity as "systemic."

A U.S. Treasury study last fall found that certain activities by asset managers could pose systemic risks. Funds say the study is flawed.

The FSOC's new report questions an activity by asset managers that was mentioned only briefly in the Treasury report.

At issue are indemnifications that asset managers offer some clients involved in securities lending activities to guard against the risk of borrower defaults.

Although asset managers do receive collateral in exchange for the securities they lend, the report raises concerns that indemnifications could still leave asset managers at risk because they are not required to set aside capital.

"The indemnification that asset managers provide may be a source of stress on their own balance sheets, while at the same time resulting in lower protection for the lenders relative to the indemnities provided by banks," the report says.

The report does not name firms, but BlackRock, for example, disclosed in November 2013 that it had indemnified $115 billion worth of securities-lending loan balances for clients and that it held $121 billion in cash and securities as collateral against it.

The issue of indemnification could come up on May 19, when the FSOC hosts a public meeting on potential risks posed by asset managers.

SEC Chair Mary Jo White, an FSOC member who voted to release the report, would not comment after the meeting on whether her agency would look into new rules around indemnification or securities lending.

"In terms of all of our registrants we regulate, we are obviously looking across issues ...compliance issues as well as systemic risk issues," White said.

MORTGAGE SERVICERS

Wednesday's report also raises concerns about a shift in mortgage servicing activity to nonbanks.

Mortgage servicers handle borrowers' accounts, processing payments and handling foreclosure proceedings. Some banks have sold their servicing businesses in recent years to nonbank firms such as Ocwen Financial Corp and Nationstar Mortgage Holdings Inc.

The report says nonbank servicers do not have the same capital, liquidity or risk oversight as banks. As a result, it said the failure of a nonbank servicer could hurt investors in mortgage-backed securities.

A person familiar with the matter said the mention of specific industries in the report did not mean firms were headed toward systemic designation. But outside observers warned that could be the result.

"We believe this was an intentional effort to signal nonbank servicers that they are at risk of a ... designation if they get too big or too dominant," Jaret Seiberg of Guggenheim Securities said in a research note. (Reporting by Emily Stephenson and Sarah N. Lynch; Additional reporting by Ashley Lau in New York; Editing by Karey Van Hall and Sandra Maler)

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