Conservatives set the stage for another CFPB funding fight

Published in The Hill.

Alex Pollock, a senior fellow at the right-leaning Mises Institute, suggested that the Dodd-Frank Act blocked a future Congress from “disciplining” the agency with “the power of the purse” by granting it a share of the Fed’s earnings. 

“With inescapable logic, however, that depends on there being some earnings to share in,” Pollock wrote in a post on the blog run by the Federalist Society, a conservative legal group. 

Podcast: Consumer Financial Protection Bureau Wins in Supreme Court But Can the Fed Continue to Fund the CFPB Without Earnings?

Published by Ballard Spahr. Also in JD SUPRA,

Special guest Alex J. Pollock, Senior Fellow with the Mises Institute and former Principal Deputy Director of the Office of Financial Research in the U.S. Treasury Department, joins us to discuss his recent blog post published on The Federalist Society website in which he urges Congress to look into the question of whether the Federal Reserve can lawfully continue to fund the CFPB if (as now) the Fed has no earnings. We begin with a review of the Supreme Court’s recent decision in CFSA v. CFPB which held that the CFPB’s funding mechanism does not violate the Appropriations Clause of the U.S. Constitution. Alex follows with an explanation of the CFPB’s statutory funding mechanism as established by the Dodd-Frank Act, which provides that the CFPB is to be funded from the Federal Reserve System’s earnings. Then Alex discusses the Fed’s recent financial statements and their use of non-standard accounting, the source of the Fed’s losses, whether Congress when writing Dodd-Frank considered the impact of Fed losses on the CFPB’s funding, and how the Fed can return to profitability. We conclude the episode by responding to arguments made by observers as to why the Fed’s current losses do not prevent its continued funding of the CFPB, potential remedies if the CFPB has been unlawfully funded by the Fed, and the bill introduced in Congress to clarify the statutory language regarding the CFPB’s funding.

Alan Kaplinsky, Senior Counsel in Ballard Spahr’s Consumer Financial Services Group, hosts the conversation.

Alex’s blog post, "The Fed Has No Earnings to Send to the CFPB," can be found here.

Who’s got the mortgage credit risk?

Published in Housing Finance International Journal:

The government-centric U.S. system

I have long thought that for any housing finance system which decides to make 30-year fixed rate loans, the Danish mortgage system has created the best division of the main component risks: credit risk and interest rate risk (which includes prepayment risk). The Danish system has a far better division of risk bearing than the government-dominated, taxpayers-at-risk U.S. system.

This was made strikingly clear to me in the year 2000, when thanks to the International Union for Housing Finance (of which I was then the President), I participated in a meeting in Copenhagen in which the Danish mortgage banks presented their covered bond system, and I presented the Fannie Mae and Freddie Mac-based American mortgagebacked securities (MBS) system. I explained how these so-called “GSEs” or “government-sponsored enterprises” worked, how they were the dominant powers in the huge U.S. mortgage market, and how they protected their government-granted financial power with impressive political clout.

At the conclusion of our discussion, the CEO of one of the large Danish mortgage lenders made this unforgettable observation:

“You know, we always say that here in Denmark we are the socialists, and that America is the land of free markets. But now I see that in mortgages, it is exactly the opposite!”

He was so right, especially with respect to American mortgage credit risk, which had become, and still is, heavily concentrated in Fannie and Freddie and thus in Washington DC.

A fundamental characteristic of the American MBS system is that the bank or other lender that makes a mortgage loan quickly sells it to Fannie or Freddie and divests the credit risk generated by its own customer, its own credit judgment, and its own loan. The loan with all its credit risk moves to Fannie or Freddie, totally away from the actual lender which dealt with the borrower. To compensate Fannie and Freddie for taking over the credit risk, the lender must pay them a monthly fee for the life of the loan, which for a prudent and skillful lender, is many times the expected loss rate on the mortgage credit.

Why would the actual lender do this, especially if it believes in its own credit judgment? In America, it does so because it wishes to get the loan financed in the bond market, so it can escape the interest rate risk of a 30-year fixed rate, prepayable, loan.

But the two risks do not necessarily need to be kept together – to divest the interest rate risk you do not in principle need to divest the credit risk, too. The brilliance of the Danish housing finance system is that it gets 100% of the of the interest rate risk of the 30-year fixed rate, prepayable loan financed in the bond market, but the original mortgage lender retains 100% of the credit risk for the life of the loan and gets a fee for doing so. The interest rate risk is divested to bond investors; the credit risk and related income stays with the original private lender. This division of risks, in my judgment, is clearly superior to that of the American system, and results in a far better alignment of incentives to make good loans in the first place

After our most interesting symposium in Denmark, how did the MBS system of the U.S. work out? The risk chickens come home to roost in the US. Treasury. In 2008, both Fannie and Freddie failed from billions in bad loans. They both were bailed out by the Treasury, as being far “too big to fail.” All their creditors, including subordinated debt holders, were fully protected by the bailout, although the stockholders lost 99% from the share price top to the bottom. Fannie and Freddie were both forced into a government conservatorship, which means a government agency is both regulator and exercises all the authority of the board of directors. They became owned principally by the government through the Treasury’s purchase of $190 billion in preferred stock. In addition, the Treasury obtained an option to acquire 79.9% of their common stock for a tiny fraction of one cent per share.

In short, from government-sponsored enterprises, Fannie and Freddie were made into government-owned and government-controlled enterprises (so I call them “GOGCEs”). So they remain in 2024. The government likes having total control of them in political hands, the Treasury likes the profits it currently receives as the majority owner, and no change is anywhere in sight.

While having become part of the government, Fannie and Freddie have maintained their central and dominant role in the U.S. housing finance system. The actual lenders are still divesting the credit risk of their own loans to the GOGCEs. Mortgage credit risk is still concentrated in Washington DC. My mortgage market contacts tell me that Fannie and Freddie’s old arrogance has returned. The two at the end of 2023 represented the remarkable sum of $6.9 trillion of residential mortgage credit risk.

To this huge number, to see the full extent of the U.S. government’s domination of mortgage credit risk, we have to add in Ginnie Mae. Ginnie is a 100% governmentowned corporation, which guarantees MBS formed from the loans of the U.S. government’s official subprime lender, the Federal Housing Administration, and of the Veterans Administration. It guarantees $2.5 trillion in mortgage loans.

Thus, in total, Fannie, Freddie and Ginnie represent about $9.4 trillion or 67% of the $14 trillion total U.S. residential mortgages outstanding. Two-thirds of the mortgage credit risk is ultimately a risk for the taxpayers. In Denmark, in notable contrast, all the credit risk of the mortgage bond market is held by the private mortgage banks.

Can it make any sense to have two-thirds of the entire mortgage credit risk of the country guaranteed by the government and the taxpayers? No, it can’t. The GOGCE-based MBS system can only result in political pressures to weaken credit standards and in excess house price inflation. This is not the system or the risk distribution the U.S. should have, but it is politically hard to get out of it.

The current U.S. MBS system is, I believe, the path-dependent result of the anomalous evolution of American housing finance in the wake of the 1980s collapse of the old savings and loans, combined with the lobbying force of the complex of housingrelated industries. Danish housing finance has superior risk principles, but we in America are unfortunately stuck with our government-centric system.

Event: Mises Supporters Summit 2024

Hosted by the Mises Institute.

Get ready for an extraordinary experience at the 2024 Supporters Summit featuring Lew Rockwell, Tom DiLorenzo, and special guest Tom Luongo. The Summit will take place October 10–12, 2024, at the lovely Omni Hilton Head Oceanfront Resort on the stunning Hilton Head Island.

The theme of this year’s Supporters Summit is “Our Enemy, the State.” Perhaps no institution dominates modern life more than the state, which for centuries has tolerated no competition, whether from families, churches, or local communities. Rather, the state demands total obedience and monopolistic power. Few other institutions have so thoroughly succeeded in achieving this in all of human history.

Mises Institute faculty and scholars will explore the nature, history, and consequences of the state, and how the state has sought to control every aspect of daily life through control of money, education, markets, and more. 

Event Highlights:

• Thursday, October 10: Kick off with a welcoming reception and registration.

• Friday, October 11: Engage in speaker and scholar presentations, enjoy a catered lunch, and wrap up the day with a low country boil dinner and social hour, featuring the debut of our new documentary about the Federal Reserve.

• Saturday, October 12: Gather for more presentations with our speakers and scholars, culminating in a dinner and keynote lecture from Tom Luongo.

Featured Guests:

Lew Rockwell, Tom DiLorenzo, Tom Luongo, Joe Salerno, Guido Hülsmann, Tom Woods, Bob Murphy, Jeff Herbener, Peter Klein, Alex Pollock, Timothy Terrell, Per Bylund, Patrick Newman, Mark Thornton, Shawn Ritenour, Jonathan Newman, Wanjiru Njoya, William Poole, and more.

Register here.

Causes of the Great Depression

Published in Law & Liberty.

About every ten years or so, financial crises spoil economic hopes and many best-laid plans. As scary as they are while happening, like everything else, in time, they tend to fade from memory. For example, can you recall the remarkable number of US depository institutions that failed in the crisis of the 1980s? (The correct answer: More than 2,800!)

The weakness of financial memory is one reason for recurring over-optimism, financial fragility, and new crises. But the Great Depression of the 1930s is an exception. It was such a searing experience that it retains its hold on economic thought almost a century after it began and more than 90 years after its US trough in 1933. That year featured the temporary shutdown of the entire US banking system and an unemployment rate as high as 24.9 percent. More than 9,000 US banks failed from 1929–33. Huge numbers of home and farm mortgages were in default, and 37 cities and three states defaulted on their debt. How could all this happen? That is still an essential question, with competing answers.

This collection of Ben Bernanke’s scholarly articles on the economics of the Depression was originally published in 2000. That was two years before he became a Governor on the Federal Reserve Board, and seven years before, as Federal Reserve Chairman, he played a starring world role in the Great (or Global) Financial Crisis of 2007–09 and its aftermath, always cited as “the worst financial crisis since the Great Depression.”

Bernanke’s Essays on the Great Depression has now been republished, with the addition of his Lecture, “Banking, Credit and Economic Fluctuations,” delivered upon winning the Nobel Prize in Economics in 2022. They make an interesting, if dense and academic, read.

“To understand the Great Depression is the Holy Grail of macroeconomics,” is the first line of the first article of this collection. “Not only did the Depression give birth to macroeconomics as a distinct field of study, but … the worldwide economic collapse of the 1930s remains a fascinating intellectual challenge.” Indeed it does.

Bernanke points out that “no account of the Great Depression would be complete without an explanation of the worldwide nature of the event.” As one example of this, we may note that Germany was then the second largest economy in the world, and “the collapse of the biggest German banks in July 1931 represents an essential element in the history,” as a study of that year relates. Germany was at the center of ongoing disputes about the attempted financial settlements of the Great War (or as we say, World War I). Widespread defaults on the intergovernmental debts resulting from the war also marked the early 1930s.

“What produced the world depression of 1929 and why was it so widespread, so deep, so long?” similarly asked the eminent financial historian, Charles Kindleberger. “Was it caused by real or monetary factors?” Was it “a consequence of deliberate and misguided monetary policy on the part of the US Federal Reserve Board, or were its origins complex and international, involving both financial and real factors?”

“Explaining the depth, persistence, and global scope of the Great Depression,” Bernanke reflects in his 2022 Lecture, “continues to challenge macroeconomists.” Although he concludes that “much progress has been made,” still, after nearly a century, things remain debatable. This calls into question how much science there is in economics looking backward, just as the poor record of economic forecasting questions whether there is much science in its attempts to look forward.

In economics, it seems, we can’t know the future, we are confused by the present, and we can’t agree on the past. Those living during the Depression were confused by their situation, just as we are now by ours. As Bernanke writes, “The evidence overall supports the view that the deflation was largely unanticipated, and indeed that forecasters and businesspeople in the early 1930s remained optimistic that recovery and the end of deflation were imminent.”

In Lessons from the Great Depression, a 1989 book that Bernanke often references, Peter Temin provides this wise perspective: “We therefore should be humble in our approach to macroeconomic policy. The economic authorities of the late 1920s had no doubt that their model of the economy was correct”—as they headed into deep disaster. “It is not given to us to know how future generations will understand the economic relations that govern how we live. We should strive to be open to alternative interpretations.”

Bernanke considers at length two alternative causes of the Depression and through his work adds a third.

The first is the famous Monetarist explanation of Federal Reserve culpability, referred to by Kindleberger, derived from the celebrated Monetary History of the United States by Milton Friedman and Anna Schwartz. Friedman and Schwartz, writes Bernanke, “saw the response of the Federal Reserve as perverse, or at least inadequate. In their view, the Fed could have ameliorated the deflationary pressures of the early 1930s through sustained monetary expansion but chose not to.” About this theory, Bernanke says, “I find it persuasive in many respects.” However, “it is difficult to defend the strict monetarist view that declines in the money stock were the only reason for the Depression, although … monetary forces were a contributing factor.” It seems eminently reasonable that multiple causes were at work to cause such a stupendously disastrous outcome.

“The Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

A second approach takes as central to the depth of the Depression the effects of governments’ clinging too long to the Gold Exchange Standard. That was the revised version of the gold standard that was put together in the 1920s as the world tried to return to something like the pre-Great War monetary system, which previously had accompanied such impressive advances in economic growth and prosperity. The Classic Gold Standard was destroyed by the Great War, as governments bankrupted themselves, then printed the money to spend on the war’s vast destruction and set off the rampant inflations and hyper-inflations that followed.

After the inflations, there was no simple going back to the monetary status quo ante bellum. However, “the gold standard [was] laboriously reconstructed after the war,” Bernanke relates, referring to the Gold Exchange Standard. “By 1929 the gold standard was virtually universal among market economies. … The reconstruction of the gold standard was hailed as a major diplomatic achievement, an essential step toward restoring monetary and financial conditions—which were turbulent during the 1920s—to … relative tranquility.”

Financial history is full of ironies. Here we had a “major diplomatic achievement” in global finance by intelligent and well-intentioned experts. But “instead of a new era of tranquility,” Bernanke tells us, “by 1931 financial panics and exchange rate crises were rampant, and a majority of countries left gold in that year. A complete collapse of the system occurred in 1936.” The United States left the gold standard in 1933.

Bernanke highlights the comparative studies of countries during the 1930s which found a notable pattern of “clear divergence”: “the gold standard countries suffered substantially more severe contractions,” and “countries leaving gold recovered substantially more rapidly and vigorously than those who did not,” and “the defense of gold standard parities added to the deflationary pressure.” Thus, he concludes, “the evidence that monetary shocks played a major role in the Great Contraction, and that these shocks were transmitted around the world primarily through the working of the gold standard, is quite compelling.” 

So far, we have an explanatory mix of the behavior of central banks faced with huge shocks in the context of the revised Gold Exchange Standard in the aftermath of the runaway inflations stemming from the Great War.

In addition, Bernanke’s own work emphasizes the role of credit contractions, not just monetary contractions, with a focus on “the disruptive effect of deflation on the financial system”—or in macroeconomic terms, “an important role for financial crises—particularly banking panics—in explaining the link between falling prices and falling output.” Bernanke provides a depressing list of banking crises around the world from 1921 to 1936. This list is nearly four pages long.

Bernanke concludes that “banking panics had an independent macroeconomic effect” and that “stressed credit markets helped drive declines in output and employment during the Depression.” This seems easily believable.

Bernanke’s articles also address employment during the Depression. Although economic conditions significantly improved after 1933, unemployment remained remarkably, perhaps amazingly, high. Continuing through all of the 1930s, it was far worse than in any of the US financial and economic crises since. At the end of 1939, US unemployment was 17.2 percent. At the end of 1940, after two full presidential terms for Franklin Roosevelt and the New Deal, unemployment was still 14.6 percent. Very high unemployment lasted a very long time.

The Depression-era interventions of both the Hoover and the Roosevelt administrations focused on maintaining high real wages. As Bernanke writes, “The New Deal era was a period of general economic growth, set back only by the 1937–38 recession. This economic growth occurred simultaneously with a real wage “push” engineered in part by the government and the unions.” But “how can these two developments be consistent?” Well, economic growth from a low level with a government push for high real wages was accompanied by high and continued unemployment. That doesn’t seem like a surprise.

The New Deal real wage push continued what had begun with President Hoover. The Austrian School economist, Murray Rothbard, says of Hoover in the early Depression years, “No one could accuse him of being slack in inaugurating the vast interventionist program.” He quotes Hoover’s statement in 1932 that wage rates “were maintained until the cost of living had decreased and profits had practically vanished. They are now the highest real wages in the world.” Rothbard rhetorically asks, as we might ask of the 1930s in general, “But was there any causal link between this fact and the highest unemployment rate in American history?” As Temin observes about the 1930s, “the Germans kept wages low and reached full employment quickly; the Americans raised wages and had to cope with continued unemployment.”

Turning to a more general perspective on the source of the Depression, Rothbard observes that “many writers have seen the roots of the Great Depression in the inflation of World War I and of the postwar years.”

Yet more broadly, it has long seemed to me that in addition to the interconnected monetary and credit problems carefully explored in Bernanke’s book, the most fundamental source of the Depression was the Great War itself, and the immense shocks of all kinds created by the destruction it wreaked—destruction of life, of wealth, in economics, in finance, of the Classic Gold Standard, of currencies, in the creation of immense and unpayable debts, and the destruction of political and social structures, of morale, of pre-1914 European civilization.

As Temin asks and answers, “What was the shock that set the system in motion? The shock, I want to argue, was the First World War.”

And giving Bernanke’s Nobel Prize Lecture the last word, “In the case of the Depression, the ultimate source of the losses was the economic and financial damage caused by World War I.” 

Can the Fed Fund the CFPB?

Published with Paul Kupiec in Law & Liberty also published in AEI.

The Consumer Financial Protection Bureau (CFPB) has been a source of controversy since its creation. Critics of the agency have long argued that its independent status is unconstitutional. In a recent decision, however, the Supreme Court affirmed the constitutionality of the CFPB’s funding scheme, even though it circumvents the normal Congressional appropriation process by “allowing the Bureau to draw money from the earnings of the Federal Reserve System.”

This decision belies the Fed’s current financial condition and conflicts with provisions in the Federal Reserve Act. The fact of the matter is that the Fed no longer has any earnings. It currently has huge cash operating losses and must borrow to fund both the Fed’s and the CFPB’s operations. When it is not literally printing dollars to pay these bills, the Fed is borrowing on behalf of the system’s 12 privately owned Federal Reserve district banks—not the federal government. These borrowings are not federally guaranteed. More problematic still is that nine of the 12 Federal Reserve district banks (FRBs) are technically insolvent, as is the Fed System as a whole.

The CFPB’s unique funding structure comes from provisions in the 2010 Dodd-Frank Act. Essentially, it requires that the Fed transfers funds to the CFPB without oversight from the congressional Appropriations Committees. In its 7-2 decision, the Supreme Court upheld these provisions and found that the funding apparatus “constitutes an ‘Appropriatio[n] made by Law’” because it is “drawn from the Treasury.”

One unfortunate bug in the Court’s opinion is that, since the Federal Reserve is currently making losses, there are no Federal Reserve System earnings for the CFPB to draw upon. The system has lost a staggering sum of $170 billion since September 2022, and continues to accumulate more than $1 billion in operating losses each week. Under standard accounting rules, it has negative capital and is technically insolvent. The Fed stopped sending distributions of its earnings to the US Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments to the CFPB at the same time for the same reason.

The second problem with the Court’s decision is that, unless the CFPB draws all its expenses from the Federal Reserve in the form of Federal Reserve Notes, the transferred monies are neither “public money” nor “drawn from the Treasury.” This is the law of the land as codified in the Federal Reserve Act.

When the Federal Reserve posts an operating loss, it must rebalance its accounts. It can do this by (1) selling assets or using the proceeds from maturing assets to cover the loss; (2) reducing its retained earnings, or if there are no retained earnings, reducing its paid in equity capital; or (3) issuing new liabilities. Regardless of how it chooses to rebalance its books, each new dollar of Fed operating loss or dollar spent funding the CFPB causes the Fed’s liabilities to increase relative to its assets, and, under standard accounting rules, the Fed’s liabilities are already greater than its assets.

Because of interest rate increases, the true market value of the Fed’s assets is far less than their book value—a shortfall of about $1 trillion. The Fed has stated that it will hold these assets to maturity to avoid realizing these mark-value losses. Meanwhile, the Fed’s $170 billion in accumulated cash operating losses have already fully exhausted the Fed’s retained earnings and paid in equity capital, so now the Fed must borrow to balance its accounts.

The Fed has three ways it can borrow to pay for the CFPB or new Fed operating losses. It can: (1) issue new Federal Reserve Notes; (2) borrow by increasing deposits at Federal Reserve district banks; or, (3) borrow from financial markets using reverse repurchase agreements. Of these three ways the Fed borrows, only Federal Reserve Notes are explicitly guaranteed by the full faith and credit of the US government and can be considered “public money drawn from the Treasury.” 

According to the Federal Reserve system’s 2023 audited financial statements:

Federal Reserve notes are the circulating currency of the United States. These notes, which are identified as issued to a specific Reserve Bank, must be fully collateralized. …The Board of Governors may, at any time, call upon a Reserve Bank for additional security to adequately collateralize outstanding Federal Reserve notes. … In the event that this collateral is insufficient, the FRA provides that Federal Reserve notes become a first and paramount lien on all the assets of the Reserve Banks. Finally, Federal Reserve notes are obligations of the United States government.

The Federal Reserve Act does not grant the Fed unlimited authority to print new paper currency to cover its losses or fund CFPB operations. As of May 22, the Fed’s H.4.1 report shows that it owned less than $7.3 trillion in assets but had more than $7.4 trillion in liabilities issued to external creditors, including $2.3 trillion in Federal Reserve Notes. After collateralizing its outstanding currency, the system has $5 trillion in remaining assets, but more than $5.1 trillion in outstanding liabilities other than Federal Reserve Notes. The system as a whole has more than $127 billion in external liabilities that cannot be legally turned into Federal Reserve Notes.

To the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes, the CFPB is not being funded by “public money drawn from the Treasury.”

Under the Federal Reserve Act, about $5 trillion of Federal Reserve System’s current external liabilities are not backed by the federal government but only by the creditworthiness of the 12 FRBs. But nine, including all of the largest FRBs, have negative capital when measured using generally accepted accounting standards. With about $1 trillion in unrecognized market value losses on their securities, the true financial condition of the 12 FRBs is far weaker than their accounting capital suggests. And to make matters worse, only three of the 12 FRBs have enough collateral to redeem all of their external liabilities by printing new paper currency, which is the only federally guaranteed liability FRBs issue.

In addition, the largest funding source for the Fed, deposits in FRBs, are not explicitly collateralized or guaranteed by the federal government. FRB deposits are only protected by the value of FRB assets that are not otherwise pledged. Although the Fed’s depositors may believe they have an “implicit Treasury guarantee” in the same way that Freddie Mac and Fannie Mae bondholders believed that their bonds were guaranteed by the US Treasury, the Federal Reserve Act does not include a federal government guarantee for FRB deposits.

Fed deposits are meant to be protected by FRB paid-in capital and surplus, but that has been fully consumed by the operating losses in nine of 12 FRBs; and also protected in law (but not in practice) by a callable capital commitment and a “double liability” call on member bank resources that is an explicit FRB shareholder responsibility under the Federal Reserve Act. In other words, member banks as FRB shareholders, are legally responsible for some part of any loss incurred by the FRB’s unsecured liability holders, most importantly FRB depositors.

But notwithstanding large operating losses that have completely consumed the capital of most FRBs, the Federal Reserve Board has never utilized its powers under the Federal Reserve Act to increase the capital contributions of member banks or invoke member bank loss-sharing obligations. Indeed, all FRBs, even the most technically insolvent FRB, New York, continue to pay member banks dividends on their FRB shares, as well as make payments to the CFPB from nonexistent earnings. 

If, in the highly unlikely event that FRB member banks were called upon to inject additional capital into their FRB to cover Fed operating losses and CFPB expenses, these monies would clearly not be public monies drawn from the Treasury. Yet, under the Supreme Court’s ruling, the cash proceeds of the call on FRB member banks would be shipped over to pay the expenses of the CFPB. This fact alone seems to contradict the logic of the Supreme Court’s majority decision.

In sum, the Supreme Court’s recent ruling notwithstanding, the CFPB’s funding mechanism currently conflicts with the clear language of both the Dodd-Frank Act and Federal Reserve Act. As long as the Fed continues to suffer operating losses, the CFPB is not being funded with Federal Reserve earnings, and to the extent that the CFPB is not being fully funded with newly issued Federal Reserve Notes—and it is not—the CFPB is not being funded by “public money drawn from the Treasury.”

Fed Losses May Sour CFPB’s Supreme Court Win

Published in Inside Mortgage Finance:

“Because of the losses, the Fed stopped sending its surplus to the Treasury Department, and it should have done the same for the CFPB, Alex Pollock…”

It’s the Fed That’s a Risk to Financial Stability

Published in The New York Sun and The Mises Institute.

Central bankers whistle ‘Dixie’ as mark-to-market losses dramatically shrink the banking system’s economic capital.

Whistling a happy tune, the Federal Reserve vice chairman for supervision, Michael Barr, recently testified to Congress that “overall, the banking system remains sound and resilient.” A more candid view of the risks would be less sanguine.  

Mr. Barr reported that banking “capital ratios increased throughout 2023.” He failed, though, to discuss the mark-to-market losses that have dramatically shrunk the banking system’s economic capital and capital ratios.

A recent study of American banks, including analyses of both their securities and fixed rate loans, estimates that the banking system has at least a $1 trillion mark-to-market loss resulting from the move to normalized interest rates.

Since that loss is equal to half of the banks’ approximately $2 trillion in book value of tangible equity, their aggregate real capital has dropped by about 50 percent. This is just in time for them to be confronted with large potential losses from that classic source of banking busts, commercial real estate, as the prices of many buildings are falling vertiginously.

Given his current position, Mr. Barr could not be expected to mention another particularly large and inescapable threat to financial stability, that from the Federal Reserve itself.  As central bank not only to the United States, but to the dollar-using world, the Fed combines great power with an inevitable lack of knowledge, and its actions are a fundamental source of financial instability.

When the Federal Reserve was created, the secretary of the treasury at the time, William Gibbs McAdoo, proclaimed that the Fed would “give such stability to the banking business that extreme fluctuations in interest rates and available credits… will be destroyed permanently.” A remarkably bad prediction.

Instead, throughout the life of the Fed, the financial system has suffered recurring financial crises and Fed mistakes. Mistakes by the Fed are inevitable because the Fed is always faced with an unknowable economic and financial future.  This explains its poor record at economic forecasting, including inflation and interest rates.

No matter how intelligent its leaders, how many Ph.D.s it hires, how many computers it buys, how complex it make its models, or how many conferences it holds at posh resorts, the Fed cannot reliably predict the future results of its own actions, let alone the unimaginably complex global interactions that create the economy. 

The Fed held both short-term and long-term interest rates abnormally low for more than a decade.  It manipulated long term rates lower by the purchase of $8 trillion of mostly fixed rate Treasury bonds and mortgage securities, mostly funded by floating rate deposits, making its own balance sheet exceptionally risky.  It decided to manage the expectations of the market, and frequently assured one and all that interest rates would be “lower for longer” (until, of course, they were higher for longer).

Observe the result:  Gigantic interest rate risk built up in the banking system. A notable case was Silicon Valley Bank, which made itself into a 21st century version of a 1980s savings and loan, investing heavily in 30-year fixed rate mortgage-backed securities and funding them with short-short term deposits, while its chief executive served on the Board of the Federal Reserve Bank of San Francisco.

SVB was doing basically the same thing with its balance sheet that the Fed was.  In the SVB case, it became the one of the largest bank failures in American history; in the Fed’s case, it has suffered its own mark to market loss of more than $1 trillion, in addition to operating cash losses of $172 billion so far. Adding the mark-to-market losses of the Fed and the banking system together, we have a total loss of $2 trillion. We are talking about real money.

The Fed was the Pied Piper of interest rate risk and consequent losses. 
Jim Bunning was the only man ever to be both a Hall of Fame baseball player and a U.S. Senator. He pitched a perfect game in the major leagues, and he delivered a perfect strike in the Senate when Chairman Ben Bernanke was testifying on how the Fed was going to regulate systemic financial risk. In paraphrase, Senator Bunning asked, “How can you regulate systemic risk when you are the systemic risk?” There is no answer to this superb question.

Challenging the CFPB After CFPB v. CFSA

Published in Ballard Spahr L.L.P.:

On May 20, Professor Emeritus Hal Scott from Harvard Law School, wrote an op-ed in the Wall Street Journal entitled: “The CFPB’s Pyrrhic Victory in the Supreme Court” and on May 21, Alex J Pollock wrote an article which was published on The Federalist Society website entitled: “The Fed has no earnings to send to the CFPB,” Professor Scott and Mr. Pollock stated that Federal Reserve System started incurring losses in September, 2022, that such losses continue to the present day and that the Fed is projected to incur losses until 2027.

The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

The relevant text of the Dodd-Frank Act is clear: “Each year (or quarter of such year) . . . the Board of Governors shall transfer to the [Consumer Financial Protection] Bureau from the combined earnings of the Federal Reserve System, the amount determined by the Director to be reasonably necessary . . . ” (emphasis added).

“Earnings” means net profit:

“EARNINGS: Profits; net income.” (Encyclopedia of Banking and Finance)

“Earnings: Net income for the company during a period.” (Nasdaq financial terms guide)

“A company’s earnings are its after-tax net income.” (Investopedia)

“Earnings are the amount of money a company has left after subtracting business expenses from revenue. Earnings are also known as net income or net profit.” (Google “AI Overview”)

“Earnings: The balance of revenue for a specific period that remains after deducting related costs and expenses.” (Webster’s Third New International Dictionary)

The Democratic majority which passed the Dodd-Frank Act on a party line vote in 2010—knowing that it was likely to lose the next election (as it did)—cleverly blocked a future Congress from disciplining the new creation through the power of the purse by granting the CFPB a share of the Fed’s earnings every quarter. With inescapable logic, however, that depends on there being some earnings to share in.

Naturally the congressional majority assumed (probably without ever thinking about it) that the Fed would always be profitable. It always had been. But that turned out to be a wildly wrong assumption.

The Supreme Court has ruled that the CFPB funding scheme is constitutional. The opinion by Justice Thomas finds that nothing in the text of the Constitution prevents such a scheme, despite, as pointed out in Justice Alito’s dissent, the way it thwarts the framers’ separation of powers design.

However, no one seems to have pointed out to the Court that the Federal Reserve System now has no earnings for the CFPB to share in. Instead, the Fed is running giant losses: it has lost the staggering sum of $169 billion since September 2022, and it continues to lose money at the rate of more than $1 billion a week. Under standard accounting, it would have to report negative capital and technical insolvency.

The Fed stopped sending distributions of its earnings to the U.S. Treasury in September 2022 because there were no earnings to distribute. It should have stopped sending payments from its earnings to the CFPB at the same time for the same reason. This seems to be required by the statute.

It is sometimes said that the payment to the CFPB is based on the Fed’s expenses, not its earnings, because the statute also provides that “the amount that shall be transferred to the Bureau in each fiscal year shall not exceed a fixed percentage of the total operating expenses of the Federal Reserve.” But this “shall not exceed” provision is merely setting a maximum or cap relative to expenses, not a minimum, to the transfer from earnings. The minimum could be and is now zero—unless you think with negative Fed earnings the CFPB should be sending the Fed money to help offset its losses.

Although the situation seems clear, it is contentious. Congress should firmly settle the matter by rapidly enacting the Federal Reserve Loss Transparency Act (H.R. 5993) introduced by Congressman French Hill. This bill provides, with great common sense and financial logic: “No transfer may be made to the Bureau if the Federal reserve banks, in the aggregate, incurred an operating loss in the most recently completed calendar quarter until the loss is offset with subsequent earnings.”

The Fed’s losses continue. Its accumulated losses will not be offset for a long time. Congress should be thinking about whether it wishes to appropriate funds to the CFPB to tide it over.

Macro or Micro, Blinder Can’t Sell Bidenomics

Published in The Wall Street Journal.

Mr. Blinder wants to compare Mr. Biden to former President Franklin Roosevelt, but the current president doesn’t display the supreme deviousness and talent for manipulation, wrapped in rhetorical brilliance, of Roosevelt. There is, however, an important parallel.

In 1944, the Democratic Party bosses knew that whoever got nominated for vice president had a high probability of becoming the president, as indeed happened when Roosevelt died three months into his new term. They forced sitting Vice President Henry Wallace to be replaced on the new ticket by Harry Truman, luckily for the country and the world. Are the current Democratic bosses as smart and as responsible as the old pols of 1944?

Chairman Powell and The Fed’s Limits

Published in American Institute for Economic Research, RealClear Policy, and the Federalist Society.

Federal Reserve Chairman Jerome Powell has realistically assessed the limits of the Fed’s knowledge, models, and legislative mandate.  Bravo!  His candor is far superior to any “pretense of knowledge” displayed by central banks and is a sound warning of the mission creep to which their regulatory activities are tempted. 

Speaking at the Stanford Business School in early April, Powell observed that “Of course, the outlook is still quite uncertain.”  Indeed, inflation is looking worse than the Fed had hoped, long-term interest rates have backed up, and short-term rates may not fall from here, or may rise. No one knows, including the Fed. The financial and economic future is fundamentally and inherently uncertain. A better statement would have been, “Of course, the outlook is ALWAYS uncertain.”  

The dismal record of central banks’ economic forecasts confirms that they not only do not, but cannot, know the financial future, or what the results of their own actions will be, or what future actions they may take.  Powell, trained in law and on Wall Street instead of academic economics, seems admirably aware of this truth, a truth uncomfortable for those who wish to put their faith in central banks.  

Powell has previously pointed out that the celebrated “r star” (r*) — the “neutral interest rate” — is a theoretical idea which can never be directly observed.  Economic models depending on it must produce uncertain results.  In trying to be guided by such an idea, Powell wittily suggested, “We are navigating by the stars under cloudy skies.”  That is a really good line and deserves to go down with former Fed Chairman William McChesney Martin’s famous “take away the punchbowl” in central banking lore. 

Central banks’ poor forecasting record reflects both the limitations of human minds, no matter how brilliant, educated, and informed, and also the interactive, recursive, complex, expectational, reflexive, non-predictable nature of financial reality itself, so very different from Newtonian physical systems. Economic and financial systems are not composed of mechanisms (although that is a favorite metaphor in economics) but have among their core dynamics competing minds. 

From this recognition, we see why “the macro-economic discipline can be thought more-or-less as an evaluation of a constant stream of surprises,” as an acute financial observer recently wrote.  Economists, he continued, of course including those employed by central banks, tend to build “models of how the world should work, rather than how it does.  It is not surprising that macro-economic forecasts based on these models fail.”  We may conclude, as Powell seems to suggest, that we should not be surprised by the continuing surprises. 

It is essential not to attribute the forecasting failures of central banks to any lack of intelligence, educational credentials, good intentions, or computer power.  These failures of the highly competent arise because of the fundamentally odd kind of reality created by the economic and financial interactions they are trying to forecast and manipulate. 

Especially difficult is that all economics is political economics, all finance is political finance, and all central banking is political central banking.  Politics is always stirring and dumping spices, and sometimes poison, into the economic stew, especially by starting and prolonging wars, which are the single most important financial events.  Just now we have plenty of war to contend with.   

What are the central bankers to do?  A good place to start is intellectual realism about how genuinely cloudy the economic future is.  As an ancient Roman concluded, “Res hominum tanta caligine volvi.” (“Human affairs are surrounded by so much fog!”) 

Sticking to the Assigned Mission 

Also in his Stanford speech, Chairman Powell cited two well-known goals assigned by Congress to the Fed: maximum employment and stable prices. Note that the second, as written in the Federal Reserve Act, is exactly as Powell stated: “stable prices” — not “stable inflation,” “low inflation,” “perpetual inflation at 2 percent,” or any other price target except “stable prices.”  Obviously, the Fed has not achieved stable prices.  Should it nevertheless take on additional issues not assigned by Congress? 

Powell answered soundly: No. “We need to continually earn [our] grant of independence,” he said, “by sticking to our knitting.” 

He continued in a paragraph well worth quoting at length: 

        To maintain the public’s trust, we also need to avoid ‘mission creep.’  Our nation faces many challenges, some of which directly or indirectly involve the economy.  Fed policymakers are often pressed to take a position on issues that are arguably relevant to the economy but not within our mandate, such as particular tax and spending policies, immigration policy, and trade policy.  Climate change is another current example.  Policies to address climate change are the business of elected officials and those agencies they have charged with this responsibility.  The Fed has received no such charge. 

Very true, it hasn’t. 

Thus, he said, “We are not, nor do we seek to be, climate policymakers.”  Nor is the Fed, nor should it seek to be, a policymaker for illegal immigration, law enforcement, failing public schools, the bankrupt student loan fiasco, insolvent Social Security and Medicaid programs, or scores of other issues.   

Powell’s general conclusion is excellent: “In short, doing our job well requires that we respect the limits of our mandate.” This is consistent with his sensible 2024 Senate testimony that the Fed cannot create a US central bank digital currency without Congressional authorization. 

But when it comes to controlling Fed mission creep regarding climate change, Powell did leave himself a significant hedge that Congress should think about.  This was: “We do, however, have a narrow role that relates to our responsibilities as a bank supervisor.  The public will expect that the institutions we regulate and supervise will understand and be able to manage the material risks they face, which, over time, are likely to include climate-related risks.” 

How narrow is “narrow”?  Will Fed actions in this respect be mandate-disciplined?  Or under a different Fed leadership, might they swell and create a gap in limits big enough to drive a (presumably electric) truck through?  We know that out-of-control financial regulators can decide to act as legislatures on their own, such as in the notorious Operation Choke Point scandal.  Political actors who cannot get the Congress to approve their notions have discovered that the banking system is indeed a choke point for anybody needing to make financial transactions — that is, everybody.  The most dangerous thing about a central bank digital currency is that the Fed itself could become a monopoly choke point operator, the dark possibilities of which have already been demonstrated in China and Canada. 

Congress should applaud Chairman Powell’s candor on uncertainty and strongly support his principle of operating the Fed within the limits of its mandate.  But as Fed leadership and presidential administrations come and go, Congress should itself define, not leave up to the Fed, what “narrow” expansions of the Fed’s role are authorized, and what is beyond the limits. 

Federal Reserve’s Capital Has Now Plummeted to Negative $121 Billion, and Congress Needs To Act

Published in The New York Sun.

Meantime the central bank seeks to palm off on the public the idea that its staggering negative capital is a ‘deferred asset.’

Hold up your hand if you think that the aggregate losses of an organization are an asset of that organization. No hands at all? Absolutely right. Losses are not an asset. That’s accounting 101. Yet the greatest central bank in the world, the Federal Reserve, insists on claiming that its continuing losses, which have accumulated to the staggering sum of $164 billion, are an accounting asset.

The Fed seeks to palm off this accounting entry as a “Deferred Asset.” Why does the Fed do this, which perhaps makes it look tricky instead of majestic? Because it does not want to report that it has lost all its $43 billion in capital and now has negative capital. The inevitable arithmetic is plain: start with the Fed’s $43 billion in capital, lose $164 billion, and the capital has inescapably become negative $121 billion. 

The Fed is not pleased with this answer. In addition to its “Deferred Asset” gambit, it frequently and publicly asserts that negative capital does not matter if you are a money-printing central bank. The idea seems to be that a central bank can always print up more money. The Fed further declares that it is not in business to maximize profits. Even were all this true, it fails to change the correct capital number: negative $121 billion.

If it really doesn’t matter that the Fed has negative capital, why does it not just publish the true number? If the Fed is right, no one will care at all. The Bank of Canada does it right. Its September 30, 2023 balance sheet clearly reports its capital of negative $4.5 billion in Canadian currency. The Bank of Canada also has an agreement with the Ministry of Finance so that any realized losses it takes on its “QE” bond investments “are indemnified by the Government of Canada.” * 

The Fed has no such contract with America’s Treasury. The Fed presumably has an “implied guaranty” from the Treasury, just like Fannie Mae and Freddie Mac did, but there is nothing formal. It seems certain that Congress never dreamed that the Fed could experience the losses and the negative capital that are now reality.

The Fed ran an exceptionally risky balance sheet with little capital. The key vulnerability was and is interest rate risk, the same risk that caused the failure of the savings and loans in the 1980s. The Fed’s capital was a mere 0.5 percent of its total assets. When the Fed incurred big interest rate risk losses starting in 2022, it rapidly lost all its capital because it had so little capital to begin with.

Whose fault was that? 

The reason the Fed had so little capital was the Congress. Anxious to take the profits of the Fed to spend, the Congress limited by law the retained earnings the Fed could build to a mere $6.8 billion, or less than 0.1 percent of the Fed’s assets. Moreover, as the Fed made itself ever riskier, Congress did nothing to either limit the risk, or to increase the capital to reflect the risk.

Did Congress understand the Fed’s balance sheet? If not, Congress is also at fault for that failure. Congress has provided in the Federal Reserve Act, from the original act to today, that the Federal Reserve Banks have a legal call on their commercial bank stockholders to double their paid-in capital. Thus the Fed has the statutory right to raise $36 billion in additional capital.

That would not bring its capital up to zero. It would, though, be a lot better than nothing. Yet the proud Fed has not chosen to issue the capital call that Congress designed, and Congress has not suggested that the Fed do so. Is Congress paying attention to the Fed’s financial condition? 

The Bank of England, which has a formal support agreement from His Majesty’s Treasury, studied the need for central bank capital in a recent working paper.* * It observed that “Financial strength can support central bank independence and credibility.”

“When capital is low,” the Bank of England concluded, “central banks should be able to retain their profits to help strengthen their capital position.” Congress prohibited the Fed from doing this, even as its capital relative to risk got miniscule. 

Congress needs to fix the Federal Reserve Act to allow capital to be built up corresponding to the risks undertaken. Of course, that means Congress has to understand the risks. As for the Fed’s capital at this point, negative $121 billion certainly qualifies as “low.”

________

*  Bank of Canada, Quarterly Financial Report, Third Quarter 2023.

* * Bank of England, ‘Central bank profit distribution and recapitalization,’ Staff working paper no. 1,069, April 2024.

Why Is the Fed Losing Money When It Does Such a Handsome Business With Irredeemable Paper Money Abroad?

At some point a leader will step forward prepared to call the central bank out on its losses.

Published in The New York Sun.

The Federal Reserve issues the most successful irredeemable, pure fiat circulating paper currency in world history, in other words, dollar bills.  These printed pieces of paper are formally titled “Federal Reserve Notes,” but they are not really notes, because a note is a promise to pay, and Federal Reserve Notes don’t promise to pay anything at all. 

Under the original Federal Reserve Act of 1913, Federal Reserve Notes really were notes. Against them the Federal Reserve promised to pay — and did indeed pay for its first 20 years — gold coin to redeem them.  The Federal Reserve Banks were required to hold gold in reserve to make these promises credible.  No more, of course.  

The Federal Reserve, unlike many other contemporary central banks, now owns zero gold.  The only promise the current Fed makes is that it will depreciate the purchasing power of its dollars forever, trying for a depreciation rate of 2 percent per year. In other words, it aims for an 80 percent depreciation over an average human lifetime. 

There is a lot of the Fed’s paper currency in circulation — in total value about $2.3 trillion.  This compares to $492 billion 25 years ago.  Meaning, in one generation, the Fed’s paper money in circulation has increased to 4.7 times its 1998 amount, far faster than nominal GDP, which has grown to 3.0 times its 1998 level.  

In 1998, Federal Reserve Notes in circulation were equal to 5.4 percent of GDP.  This ratio soared to 8.4 percent in 2023, for an increase of 56 percent relative to GDP. How can this have happened when all those years were marked by constant discussions of how we were moving to a cashless society? 

And how can it have happened when everybody can observe the increasing use of credit cards or electronic payments instead of currency?   I keep being surprised by how my own grown children are content to go around with hardly any cash, and how many people pay with cards for trivially small purchases. 

So why has the Fed’s paper currency outstanding increased so much? An instructive contrast is with Canada, a neighboring economy with a sophisticated financial system. The Bank of Canada had C$118 billion in its fiat paper currency in circulation as of September 30, 2023 — 4.1 percent of the Canadian GDP.  

Thus, relative to GDP, the Fed has more than twice the amount of paper currency circulating as does the Bank of Canada. Why? The reason is that the Bank of Canada is only the central bank of Canada, while the Fed is in important respects the central bank of the world.

That means that America’s paper currency, in spite of the Fed’s constant depreciation of its purchasing power, is widely used in numerous other countries, as superior to whatever money is printed up locally. The Fed has estimated that as of 2021, “foreigners held $950 billion in U.S. banknotes.” 

That comes to “about 45% of all Federal Reserve Notes outstanding, including two-thirds of all $100 bills.”  Updating to 2023, we can guess that foreigners hold approximately $1 trillion in American dollar bills. This constitutes a handsome and profitable international business for the Fed.

Its paper currency, with little cost to produce, provides zero-interest funding, which the Fed invests in interest-bearing securities.  This makes profit as easily as falling off a log.  With market interest rates at 5 percent, those $1 trillion in dollar bills are worth about $50 billion a year in net interest income for the Fed.

Thank you, foreign dollar bill holders.  The remaining $1.3 trillion of domestically held currency is worth a net interest income of $65 billion a year, for a combined total of about $115 billion a year.  This is why the Fed should always be profitable.  And yet — what do you know? — it has become the opposite.

In 2023, the Fed racked up a net loss of the truly remarkable sum of $114 billion.  In other words, it ran through its whole margin on currency issuance plus another $114 billion, and its losses continue in 2024 at about $28 billion for the first quarter. Just to mark the point, these losses are highly newsworthy.

The losses result from the Fed’s $6.3 trillion of investments in long-term Treasury bonds and mortgage securities yielding on average a mere 2 percent or so, while the Fed now must pay more than 5 percent on its own deposits and borrowings, putting it financially upside down.

In short, despite its profitable international business of currency printing, the Fed is suffering giant net losses in the same fashion as typical 1980s savings and loans did. This scandal has yet come into focus for the American public, but it’s a fair bet that it will do so — if the right leader steps forward.

Surprise, the Only Constant

Published in the Federalist Society.

A review of Alex Pollock & Howard Adler, Surprised Again! The COVID Crisis and the New Market Bubble (2022)

I approach phenomena that I don’t understand with good cheer and don’t give in to them. I’m above them. Man should be aware that he is above lions, tigers, stars, above everything in nature, even above what is incomprehensible and seems miraculous, otherwise he’s not a man but a mouse afraid of everything.

The House with the Mezzanine: An Artist’s Story, Anton Chekhov

In the late 1980s, the United States experienced what was called the “Savings and Loan Crisis.” Savings and loan associations (S&Ls), firms much like banks, had committed the financial sin of borrowing short and lending long: they borrowed by taking deposits repayable in the near term to finance their making of longer-term thirty-year residential and other real estate loans at fixed interest rates. As interest rates eventually rose, the S&Ls and investment firms found themselves having to pay higher and higher amounts of interest to cover the low fixed amounts of interest they were receiving from their borrowers. That is a financial practice in which one can engage, albeit not indefinitely. Regulators and investors nonetheless were surprised when many S&Ls failed, costing the federal government billions of dollars.

Even after that, in the late 1990s and early 2000s, the government and financial markets incented banks and investment firms to lend to higher-risk low-income borrowers to purchase homes. Policymakers thought sincerely that relaxed lending standards would enable lower-income persons to more quickly and easily realize the American dream of home ownership, which would in turn enable them to build up equity in their newly purchased homes as home values rose. That equity could be used to start a small business or send children to college. Unfortunately, home prices did not continue to rise relentlessly and eventually dropped, leaving lenders with inadequate collateral. As these borrowers eventually were unable to repay their loans, the lenders found themselves holding loans of dubious and uncertain value, and investors were surprised. This all came to a head in 2008 with what is now called the “Great Financial Crisis.” Regulators charged with protecting our financial system were surprised again.

Read the rest here.

Letter: FDIC Swiss stance — case of pot calling kettle black

Published in the Financial Times:

One may doubt the diplomatic wisdom of the decision of the chair of the US Federal Deposit Insurance Corporation to criticise the Swiss government’s handling of the Credit Suisse failure (Report, April 11), but one cannot fail to be amused by the FDIC pot calling the Swiss kettle black.

Far from using “standard bank closure powers”, the FDIC and other US regulators in 2023 gave assurances all was in good shape, in an attempt to avoid widespread panic in the banking system, and then took the extraordinary action of guaranteeing all the uninsured deposits of collapsing banks. This cost the FDIC $16bn it could not afford; it took these billions from other banks to save wealthy venture capitalists and crypto barons from taking a moderate and well-deserved haircut on the uninsured deposits they so imprudently held in sometimes extravagant amounts. The Swiss are probably too polite to point out to the FDIC chair that this was certainly an unfortunate precedent.

Alex J Pollock Senior Fellow, Mises Institute, Lake Forest, IL, US

House prices are falling in Canada, rising in the U.S. — why the difference?

Published in Housing Finance International.

Canada and the United States both span the North American continent, sharing a 3,900- mile border running between the Atlantic and Pacific Oceans. In GDP, the U.S. is more than twelve times as big, but they are both rich, economically advanced countries, with sophisticated financial systems and active housing finance markets, and similar home ownership ratios of about 66%.

The central banks of both countries practiced extreme “quantitative easing” to suppress interest rates and expand credit; both the Federal Reserve and the Bank of Canada multiplied their total assets to nine times in 2021 what they were in 2008; both central banks reduced short term interest rates to nearly zero in response to the Covid crisis. Both countries experienced a massive house price bubble, which took average house prices by 2022 to far above the former housing bubble peaks of 2006 (U.S.) and 2008 (Canada).

With both countries suffering runaway inflation in 2022, both central banks rapidly pushed short-term interest rates up to about 5% and started “quantitative tightening,” letting their balance sheets shrink. The mortgage interest rates in both countries more than doubled, the standard Canadian five-year mortgage rate jumping from 2.4% to 5.5%, and the standard U.S. 30-year mortgage rate from a low of 2.7% to over 7%. (But note the difference between a very low interest rate fixed for five years and one fixed for 30 years, as discussed further below.)

In both countries, the house buyers’ monthly interest payments for a new mortgage loan of the same size has more than doubled. A normal expectation is that this should be making house prices fall. In Canada, they have indeed fallen, but in the U.S., average house prices have been rising.

As of January 2024, average Canadian house prices have dropped more than 18% from their peak of March 2022, although they of course vary by region. In greater Toronto, Canada’s largest city, for example, house prices are 20% down from their peak; in the Hamilton-Burlington area, down 25%. On the other hand, in the oil and gas capital of Calgary, in western Canada, house prices have reached a new all-time high. On average, across the country, house prices are down significantly from their peak, but the peak was steep, and house prices are still historically high. It would not be surprising for them to continue their decline.

In contrast, U.S. average house prices, after dipping about 5% after their June 2022 peak, are back over it. The S&P Case Shiller national house price index was 308.3 at that peak, in December 2023 it was 310.7, in spite of the greatly increased mortgage interest rates. According to the AEI Housing Center (AEI), year-over-year U.S. average house price appreciation,1 measured monthly, has always been positive from 2022 to early 2024, and in January 2024 the year-over-year house price increase was 6.4%. AEI predicts a 5% average U.S. house price increase for the full year 2024.2

Of course, there is regional variation. Along the Pacific coast, San Francisco prices are down 13% from their 2022 peak, Seattle down over 12%, and Portland down about 8%. On the other side of the country, Miami and New York City have made new highs.

An interesting surprise is that the fastest house price appreciation is now in the mid-sized, Midwestern cities of Indianapolis, Indiana; Grand Rapids, Michigan; and Milwaukee, Wisconsin; all far from the Sun Belt and where they have a real winter. House prices are up over the last year by 13% in Indianapolis, 12% in Grand Rapids and about 11% in Milwaukee.

Overall, the U.S. looks not only different from Canada, but an exception to what the Financial Times described as “the widespread drop in global house prices that hit advanced economies” and “the deepest property downturn in a decade.”3

The U.S. house price behavior is even more notable when combined with its dramatic shrinkage of the volumes of house purchases and of mortgage originations. The volume of mortgages for house purchases in early February 2024 was 35% less than it was in 2019, before the Covid crisis. It was 10% below the already weak same period in 2023. Refinance mortgages with cash taken out were down 60% from 2019, and refinance mortgages with no cash out were down 75%.

With these drops in business volumes, U.S. mortgage banks, which rely on an originate-tosell business model, are in their own recession. United Wholesale Mortgage, the top mortgage originator in 2023 with $108 billion in mortgage loans, was second in 2022 with $127 billion. Its volume was thus down 15% and it posted a loss of $70 million for 2023. Rocket Mortgage, the top originator in 2022 with $133 billion in loans originated, was second in 2023 with $79 billion, or down 41% in volume. It made a 2023 annual loss of $390 million. “One of the worst quarters for mortgage origination in recent history,” said its chief financial officer about the end of 2023.4

How can prices still be rising when volumes are so reduced, and interest rates are so much higher? The most common explanation is that the supply of houses for sale also remains low. Among many others, AEI observes the “historically tight supply.”5

Contributing to the tight supply is that people with 3% or less 30-year mortgages are less inclined to sell and give up the striking financial advantage of the cheap mortgage, which is locked in for a very long time, as long as they stay in the house. There is no way to monetize the large value of that existing mortgage to the borrower except by staying put.

A key difference between the Canadian and U.S. mortgage markets, which presumably affects the house price behavior, is the contrast between a typical five-year mortgage and a typical 30-year mortgage, respectively. With low- rate mortgages from three years ago, for example, the Canadian homeowners have only two years left of value from the cheap financing. The new, higher rates work their way into the household finances much more quickly. After the same three years, the American homeowners have 27 years of a large, valuable liability left—a new, higher rate is very far off indeed, if they keep the house. But if they sell it, the mortgage is due on sale, and they will face the new, more than doubled interest rate right away.

The unique American political and financial commitment to the 30-year fixed rate mortgage is now suppressing the supply of houses for sale and helping hold up house prices, postponing the correction of the 21st century’s second house price bubble, and making American houses less affordable for new buyers. This is certainly an unintended consequence of U.S. national housing finance policy.

The provocative financial writer, Wolf Richter, suggests that the causality runs not only from low supply of houses for sale to higher prices, but also the other way around. “Now the hope for lower mortgage rates is holding back potential buyers and potential sellers alike,” he writes. “The housing market remains frozen because prices are still too high.”6 On a historical basis, it appears that both Canadian and U.S. house prices are still too high. The difference between their principal mortgage instruments is one factor explaining why prices have been falling in one and rising in the other, as we continue to live through the distortions of and adjustments to the Covid crisis.

It might be argued that the U.S. housing finance system would be improved by less subsidy for and less political devotion to the 30-year mortgage. There could be more emphasis on 15-year mortgages instead, which have less interest rate risk and create a faster build-up of housing equity for the borrower. A gradual transition by changing the rules applied to the government mortgage promoters, Fannie Mae, Freddie Mac and the Federal Housing Administration, could be imagined. However, the political probability of such a change is zero.

__________________

1 A better name for this measure would be “house price change,” since there of course can be “depreciation” as well as “appreciation.” But we seem to be stuck with the “HPA” term. “Appreciation,” it is true, has prevailed on average over time, especially in nominal, as opposed to inflation-adjusted terms. Inflation-adjusted U.S. year-over-year house prices were falling from November 2022 to June 2023, but remained positive in nominal terms, as reported by AEI.

2 “Home Price Appreciation (HPA) Index—January 2024,” AEI Housing Center.

3 “Global house price downturn shows signs of reversal as rate-cut hopes rise,” Financial Times, February 26, 2024.

4 “Rocket posts $233 million net loss in 4Q,” National Mortgage News, February 22, 2024.

5 “Housing Finance Watch, 2024 Week 6,” AEI Housing Center.

6 “Mortgage Rates Rise Back to 7%, Housing Market Re-Freezes, Buyers’ Strike Continues. Prices Are Just Too High,” Wolf Street, February 21, 2024.

May 22 AEI Event: The Federal Reserve and Financial Stability Risk

A video livestream will be made available on May 22. Please scroll down to view.

Register here

Contact Information

Event: Beatrice Lee | Beatrice.Lee@aei.org
Media: MediaServices@aei.org | 202.862.5829

One year after the Silicon Valley Bank failure required a Federal Reserve and Federal Deposit Insurance Corporation bailout, the US banking system is being challenged by large interest rate–related mark-to-market losses on its bond portfolio and a looming commercial property–sector crisis. What was the Fed’s role in these developments, and what should it do now?

Join as AEI scholars and experts discuss the seriousness of these challenges for the banking system and their implications for Federal Reserve policy.

Submit questions to Beatrice.Lee@aei.org or on Twitter with #AskAEIEcon.

Agenda

1:00 p.m.
Introduction:
Desmond Lachman, Senior Fellow, American Enterprise Institute

1:05 p.m.
Panel Discussion

Panelists:
Jan Hatzius, Chief Economist, Goldman Sachs
Desmond Lachman, Senior Fellow, American Enterprise Institute
Bill Nelson, Executive Vice President, Bank Policy Institute
Kevin Warsh, Shepard Family Distinguished Visiting Fellow in Economics, Hoover Institution

Moderator:
Alex J. Pollock, Senior Fellow, Mises Institute

2:30 p.m.
Q&A

3:00 p.m.
Adjournment

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Register here

Fixing A Big Mistake in Risk-Based Capital Rules

Published in AIER:

We are observing a great debate between the US banking regulators who wish to impose new, so-called “Basel III Endgame” rules to significantly increase bank capital, on one side, and the banks who argue they already have more than enough capital, joined by various borrowing groups who fear loans to them may be made more expensive or less available, on the other. It has been described as “the biggest fight between banks and regulators in the US in years.”

Said the president of the Financial Services Forum, “Additional significant capital increases, such as those of the Basel III Endgame proposal, are not justified and would harm American households, businesses and the broader economy.”

The Acting Comptroller of the Currency “pushed back at banks’ claims…saying the lenders could always cut dividends and buybacks instead.”

The debate generated similar disagreements among members of the Senate Banking Committee in a December 2023 hearing and is ongoing.

Leaving aside the fact there never can be an end to the endless and heavily political arguments about bank capital, what is most remarkable in this debate is what is not discussed. Not discussed is that the Basel risk-based capital requirements completely leave out interest rate risk. In its most common form that is the risk created by lending long at fixed interest rates while borrowing short at floating rates, which can be dangerous, even fatal, to the bank.

Excessive interest rate risk was a principal cause of the large bank failures of 2023, three of the largest failures in US history — Silicon Valley Bank, Signature Bank, and First Republic Bank. Widespread vulnerability due to interest rate risk among banks was, at that crisis point, the reason the American financial regulators declared that there was “systemic risk” to financial stability, so they could make exceptions to the normal rules. These involved promising to pay off uninsured depositors in failed banks with money taken from other banks; having the Federal Reserve offer loans to banks without sufficient collateral, so they would not have to sell their underwater investments; and as in every crisis, offering words of assurance from government and central bank officials that really banks were secure — although this does seem inconsistent with declaring a systemic-risk emergency.

Banking expert Paul Kupiec, in an extensive bottom-up analysis of US banks, concludes that the interest rate risk on their fixed rate securities and loans has resulted in an aggregate mark to market, unrealized but economically real, loss of about $1.5 trillion — a staggering number. The tangible capital of the entire banking system is about $1.8 trillion. The market-value losses on interest rate risk would thus have consumed approximately 80 percent of the banking system’s total tangible capital. If that is right, the banks on a mark-to-market basis would have only about 20 percent of the capital they appear to have. A less pessimistic, but still very pessimistic, analysis suggests that the fair value losses on securities and loans of banks with $1 to $100 billion in assets have in effect reduced regulatory capital ratios by about 45 percent. Applying this to the whole system would suggest a mark-to-market loss from interest rate risk of about $1 trillion. The banking system thus displays a dramatically diminished margin for error, just as it faces the looming losses from the imploding sectors of commercial real estate, a common villain in financial busts.

That interest-rate risk is fundamental is obvious, basic Banking 101. But it is a risk nonetheless very tempting when the central bank has artificially suppressed interest rates for long periods, as it did for more than a decade. Lots of banks succumbed as the Fed, playing the Pied Piper, led them into the current problems. Recent press reports tell us: “Rising Rates Hit Regional Lenders”; “US banking sector earnings tumble 45%” as “the swift rise in interest rates…continues to weigh on lenders”; “Truist Financial swung to a loss”; “Citigroup …reported a net loss for the fourth quarter 2023 of $1.8 billion”; “Higher-for-longer interest rates remain the key risk for real estate assets globally”; and “Bank losses worldwide reignite fears over US commercial property sector”.

The Federal Reserve itself is suffering mightily from the interest rate risk it induced. Its operating losses now exceed $150 billion, and its mark to market loss is approximately $1 trillion. If the aggregate market value loss of the banks is $1 trillion to $1.5 trillion, when we consider the greater banking system to include both the banks and the Fed, its total loss due to interest rate risk is about $2 trillion to $2.5 trillion. The Fed is belatedly introducing into its stress test ideas “exploratory scenarios,” to test the effects of rising interest rates. But “the results will not be used to calculate [required] capital.”

Interest-rate risk was at the heart of the notorious collapse of the savings and loan industry in the 1980s, the hopeless insolvency of its government deposit insurer, and the ensuing taxpayer bailout. People thought the lesson had been learned, and probably it had, but it seems it was forgotten. 

Interest-rate risk remains particularly relevant to mortgage finance, mortgages being the largest credit market in the world after government debt, because of the unique devotion of American financial and regulatory politics to 30-year fixed rate mortgages, which are notably dangerous. So are very long-term fixed-rate Treasury bonds, but bank regulation always promotes buying Treasury bonds to help out the government. Both long Treasuries and 30-year mortgages in the form of the mortgage-backed securities guaranteed by government agencies are in current regulation included as “High Quality Liquid Assets.” The agency MBS are given very low risk-based capital requirements. Treasuries are always described as “risk-free assets” and given zero risk-based capital requirements. But of course they both can and have created plenty of interest rate risk.

However the in-process “Basel III Endgame” debate turns out, Basel international risk-based capital requirements will still fail to address interest rate risk. They will still promote investing in 30-year agency MBS and long Treasuries, in spite of their riskiness. This serves the political purpose of favoring and promoting housing and government finance, but not the soundness of the banking system. 

A complete process of including interest rate risk by measuring the dynamic net exposure to interest rate changes of the total on- and off-balance sheet assets, liabilities and derivatives of a bank, and appropriately capitalizing it, would doubtless be a task of daunting complexity for risk-based capital calculations under the Basel agreements, as evidenced by the Basel Committee’s “Standards — Interest rate risk in the banking book.” But an extremely simple fix to address very large amounts of interest rate risk is readily available.

This is simply to correct the woefully low risk-based capital required for 30-year agency MBS and for very long Treasury debt. These miniscule capital requirements get rationalized by very low credit risk, but they utterly fail to reflect very high interest rate risk.

The risk-based capital required for Treasuries, to repeat, is zero. The risk-based capital for 30-year fixed rate mortgages in the form of agency MBS merely 1.6 percent (a risk weighting of 20 percent multiplied by the base of 8 percent). Contrast this zero or minimal capital to the market value losses now being actually experienced. Using as a benchmark the losses the Federal Reserve had on its investments as of September 30, 2023:

          Treasuries    A loss of 15 percent

          Agency MBS  A loss of 20 percent
 

That more capital than provided under the Basel rules is needed to address the interest rate risk of these long term, fixed-rate exposures appears entirely obvious.

I suggest the risk weights of these investments, so potentially dangerous to banks (not to mention to central banks), should be increased to 50 percent for 30-year agency MBS and 20 percent for long Treasuries, thus giving us risk-based capital requirements of 4 percent (instead of 1.6 percent) for long agency MBS and 1.6 percent (instead of zero) for long Treasuries.

These are guesses and approximations, of course. While simple, they come much closer to addressing the real risk than does the current system. It is time to learn and apply the expensive lessons of interest rate risk once again.

Two sets of objections will vociferously be made. The housing complex will complain that this will make mortgages more expensive. The Treasury (and all finance ministries) will complain that this will make ballooning government deficits more expensive to finance. What do we want? To match the capital to the real risks, or to manipulate the capital regulations to subsidize politically favored borrowers?

I am for the former. Lots of people, alas, are for the latter. This is a perpetual problem of political finance.

The Fed Doesn’t Know the Natural Rate of Interest

Published in The Wall Street Journal.

Mr. Levy describes the Fed’s permanent problem: It doesn’t and can’t know what the natural rate of interest is. Everyone should pity the members of the Federal Open Market Committee, who must inwardly confess that they can’t know the answers, yet have to play their parts in the Fed melodrama nonetheless.

Alex J. Pollock

Senior fellow, Mises Institute

Lake Forest, Ill.

Appeared in the March 14, 2024, print edition as 'Fed Doesn’t Know the Natural Rate of Interest'.