Testimony to the House Committee on Natural Resources at Hearing on “The Status of the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA): Lessons Learned Three Years Later”

Published by the R Street Institute.

Six Lessons

Mr. Chairman, Ranking Member Bishop, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views.  I have spent almost five decades working in and on the banking and financial system, including studying the recurring insolvencies of municipal and sovereign governments.  I have personally experienced and studied numerous financial crises and their political aftermaths, and have authored many articles, presentations, testimony and two books on related subjects.  Prior to R Street, I was a resident fellow at the American Enterprise Institute 2004-2016, and President and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

In my view, there are six key lessons about PROMESA, the massive insolvency of the government of Puerto Rico, and the role of the Oversight Board we should consider.  These are:

1. The fundamental bargain of PROMESA was sound. But it could be improved.

2. In such situations, a lot of conflict and controversy is unavoidable and certain.

3. The Oversight Board should have more power: in particular, it should have the same Chief Financial Officer provisions as were so successfully used in the Washington DC reforms.

4. Oversight boards are likely to last more than three years. In Puerto Rico, all the problems were of course made more difficult by the destructive hurricanes, and the flow of federal emergency funds into the Puerto Rican economy now makes the financial problems more complex.

5. Large unfunded pensions are a central element in these situations and set up an inescapable conflict between the claims of bondholders and pensioners.

6. Progress must operate on three levels of increasing difficulty:

7. Equitable reorganization of the debt (including pension debt)

8. Reform for efficiency and reliability in the fiscal and financial functioning of the government

9. Reforms which allow a growing, enterprising successful market economy to emerge from the historic government-centric economy.

1. The fundamental bargain of PROMESA was sound. But it could be improved.

As it considered PROMESA, the Congress was faced with a municipal insolvency of unprecedented size.  As one analyst correctly wrote, “There is no municipal borrower remotely as insolvent as Puerto Rico.”  Indeed, adding together its $70 billion in bond debt and $50 or $60 billion in unfunded pension debt, the government of Puerto Rico has debt of more than six times that of the City of Detroit, the previous all-time record holder, as it entered bankruptcy.

The fundamental bargain Congress constructed in PROMESA to cope with Puerto Rico’s financial crisis made and makes good sense.  It may be described as follows:

     -To the Puerto Rican government:  We will provide reduction and restructuring of your unpayable debts, but only if it is accompanied by fundamental financial and government reform.

     -To the creditors:  You will get an appointed board to oversee and reform Puerto Rico’s finances, but only if it also has debt reduction powers.

This is a sound bargain.  The resulting Oversight Board created by the act was and is, in my judgment, absolutely necessary.  But its members, serving without pay, were as we all know, given an extremely difficult responsibility.  So far, significant progress has been made, but much remains to do.  Let us hope the Senate promptly confirms the existing members of the Board, so that its work may continue uninterrupted.

In the negotiations leading to PROMESA, it was decided to create an Oversight Board, less powerful than a control board.  I thought at the time, and it seems clear in retrospect, that it would have been better—and would still be better–for it to have more of the powers of a financial control board, as discussed further under Lesson 3.

Two well-known cases of very large municipal insolvencies in which financial control boards were successfully used were those of New York City and Washington DC.  In 1975, New York City was unable to pay its bills or keep its books straight, having relied on, as one history says, “deceptive accounting, borrowing excessively, and refusing to plan.”  In 1995, Washington was similarly unable to pay its vendors or provide basic services, being mired in deficits, debt and financial incompetence. 

Today, New York City has S&P/Moody’s bonds ratings of AA/Aa1, and Washington DC of AA+/Aaa.  We should hope for similar success with the financial recovery of Puerto Rico.

• In such situations, a lot of conflict and controversy is unavoidable and certain.

Nothing is less surprising than that the actions and decisions of the Oversight Board have created controversy and criticism, or that “the board has spent years at odds with unhappy creditors in the mainland and elected officials on the island.”

As one Oversight Board member, David Skeel, has written, the Board “had been sharply criticized by nearly everyone.  Many Puerto Ricans and economists…argued that our economic projections were far too optimistic….  Creditors…insisted that the economic assumptions in the fiscal plan were unduly pessimistic and…provided too little money for repayment.”

The settlement of defaults, reorganization of debt and creation of fiscal discipline is of necessity passing out losses and pain, accompanied by intense negotiations.  Of course, everyone would like someone else to bear more of the loss and themselves less.  It is utterly natural in the “equitable reorganization of debt” for insolvent debtors and the creditors holding defaulted debt to have differing views of what is “equitable.”

If only one side were critical of the Oversight Board, it would not be doing its job.  If it is operating as it should, both sides will complain, as will both ends of the political spectrum.  In this, I believe we must judge the Oversight Board successful.

The financial control boards of New York City and Washington DC are now rightly considered as a matter of history to have been very successful and to have made essential contributions to the recovery of their cities.  But both generated plenty of complaints, controversy, protests and criticism in their time.

In Washington, for example, “city workers protested by blocking the Control Board’s office with garbage trucks during the morning rush hour.”  In the board’s first meeting, “protesters shouted ‘Free D.C.’ throughout the meeting, which was brought to an end by a bomb threat.”  Later, “in one of its most controversial actions, the Board fired the public school superintendent, revoked most of the school board’s powers, and appointed its own superintendent to lead the system.”

In New York, the board “made numerous painful, controversial decisions that the administration of Mayor Abraham D. Beame was unwilling or unable to make.  It ordered hundreds of millions of dollars in budget cuts above those proposed by the administration and demanded the layoffs of thousands of additional city workers.  It rejected a contract negotiated by the city’s Board of Education…it also rejected a transit workers’ contract.”

What did this look like at the time?  “In the eyes of many people in the city, it was most distasteful,” said Hugh Carey, then Governor of New York State.  “They saw the control board as the end of home rule, as the end of self-government.”  Another view: “The city of New York was like an indentured servant.”

In restructurings of debt and fiscal operations, it has been well observed that a “key factor is making sure that the sacrifice is distributed fairly.”  But what is fair is necessarily subject to judgment and inevitably subject to dispute.

• The Oversight Board should have more power: in particular it should have the same Chief Financial Officer provisions as were so successfully used in the Washington DC financial reforms.

As PROMESA came into effect, as has been observed, “The most obvious obstacle…was that no one really knew what Puerto Rico’s revenues and expenditures were.” This financial control mess, stressed by expert consultants at the time, highlights the central role in both creating and fixing the debt crisis, of financial management, reporting and controls.  Progress had been made here with efforts of both the Oversight Board and Puerto Rico, as the certified fiscal plan has been developed.  But the government of Puerto Rico still has not completed its audited financial statements for 2016 or 2017, let alone 2018.

Of the historical instances of financial control boards in municipal insolvencies, there is a key parallel between Puerto Rico and Washington DC:  in both cases, there is no intervening state. The key role played by New York State, or by Michigan in the Detroit bankruptcy, for example, is missing. The reform and restructuring relationship is directly between the U.S. Congress and the local government.

The most striking difference between the Washington DC board and the Oversight Board is the greater power of the former.  This was true in the initial design in 1995, but when Congress revised the structure in 1997 legislation, the Washington board was made even stronger.  Most notably, the Washington design included the statutory Office of the Chief Financial Officer, which answered primarily to the control board and was independent of the mayor.  Puerto Rico has created its own Chief Financial Officer, as good idea as far as it goes, but it lacks the reporting relationship to the Oversight Board and the independence which were fundamental to the Washington reforms. 

Today, long after Washington’s financial recovery, the independence remains.  As explained by the current Office of the Chief Financial Officer (OCFO) itself:

“In 1995, President Clinton signed the law creating a presidentially appointed District of Columbia Financial Control Board…. The same legislation…also created the position of Chief Financial Officer, which had direct control over day-to-day financial operations of each District agency and independence from the Mayor’s office.  In this regard, the CFO is nominated by the Mayor and approved by the DC Council, after which the nomination is transmitted to the U.S. Congress for a thirty-day review period.

“The 2005 District of Columbia Omnibus Authorization Act…reasserted the independence and authority of the OCFO after the Control Board had become a dormant administrative agency on September 30, 2001, following four consecutive years of balanced budgets and clean audits.”

If PROMESA were ever to be revised, for example trading additional financial support for additional reform and financial controls, as happened in the Washington DC case in 1997, I believe the revision should include structuring an Office of the Chief Financial Officer for Puerto Rico on the Washington DC model.

• Oversight boards are likely to last more than three years. In Puerto Rico, all the problems were of course made more difficult by the hurricanes, and the flow of emergency funds into the Puerto Rican economy now makes the financial problems more complex.

As we come up on the third anniversaries of PROMESA and the Oversight Board, we can reflect on how long it may take to complete the Oversight Board’s responsibilities of debt reorganization and financial and fiscal reform.  More than three years.

The New York City control board functioned from 1975 to 1986, or eleven years.  There was a milestone in 1982, which was the resumption of bank purchases of its municipal bonds. That took seven years.

The Washington DC control board operated from 1995 to 2001, or six years.  (Both boards still remain in the wings, capable of resuming activity, should the respective cities backslide in their financial disciplines.)

Everything in the Puerto Rico financial crisis was made more uncertain and difficult by the destruction from the disastrous hurricanes of 2017.  Now, as in response, large amounts of federal disaster aid are flowing into the Puerto Rican economy. 

How much this aid should be is of course a hotly debated political issue.  But whatever it turns out to be, this external flow makes the formation of the long-term fiscal plan more complex.  Whether the total disaster relief is the $82 billion was estimated by the Oversight Board, the $41 billion calculated as so far approved, or some other number, it is economically a large intermediate-term stimulus relative to the Puerto Rican economy, with its GDP of approximately $100 billion.

There are significant issues of how effectively and efficiently such sums will be spent, what the economic boost will be as they generate spending, employment and government revenues, whether they can result in sustainable growth or only a temporary effect, and therefore how they will affect the long-term solvency and debt-repayment capacity of the government of Puerto Rico.  Even if none of these funds go to direct debt payment, their secondary effects on government revenues may.  How to think through all this is not clear (at least to me), but a conservative approach to making long-term commitments based on short-term emergency flows does seem advisable.

The Oversight Board will have to come up with some defined approach to both long and short-term outlooks, as it continues its double project of debt reorganization and fiscal reform.  That is yet another difficult assignment for them, requiring time and generating controversy.

• Large unfunded pensions are a central element in these situations and set up an inescapable conflict between the claims of bondholders and pensioners.

Puerto Rican government pension plans are not only underfunded, they are basically unfunded.  At the time a PROMESA, a generally used estimate of the pension debt was $50 billion, which added to the $70 billion in bond debt made $120 billion in all.  It appears that there is in addition $10 billion in unfunded liabilities of government corporations and municipalities, making the pension debt $60 billion, and thus the total debt, before reorganization haircuts, $130 billion.  As I learned from an old banker long ago, in bankruptcy, assets shrink and liabilities expand.

How are the competing claims of bondholders and pensioners equitably to be settled?  This is an ever-growing issue in municipal and state finances—very notably in Illinois and Chicago, for example, as well as plainly in Puerto Rico.  The bankruptcy settlement of the City of Detroit did give haircuts to pensions—a very important precedent, in which the state constitution of Michigan was trumped by federal bankruptcy law.  But the pensions turned out in Detroit, as elsewhere, to be de facto senior to all unsecured bond debt. This reflects the political force of the pensioners’ claims and needs.

On April 30, the Oversight Board demanded that the government of Puerto Rico act to enforce required contributions to pension funds from several public entities and municipalities.  It is “unacceptable to withhold retirement contributions from an employee and not immediately transfer that money into the individual retirement account where it belongs,” wrote our colleague on the panel, Natalie Jaresco.  She is right, of course.  Except that it is worse than “unacceptable”—it is theft.

Pensions as a huge component of municipal insolvencies will continue to be a tough issue for the Oversight Board, as well as for a lot of other people.

• Progress must operate on three levels of increasing difficulty:

• Equitable reorganization of the debt (including pension debt)

• Reform for efficiency and reliability in the fiscal and financial functioning of the government

• Reforms which allow a growing, enterprising successful market economy to emerge from the historic government-centric economy.

Three years into the process, the first of these requirements is difficult and controversial, but well under way.

The second is harder, because it is challenging government structures, embedded practices, power, and local politics.  Relative to addressing insolvency, the most important areas for reform are of course the financial and fiscal functions.  Reform would be advanced by the creation of an Office of the Chief Financial Officer on the Washington DC model.

The third problem is by far the most difficult.  Solving the first two will help make solving the third possible, but the question of how to do this is not yet answered, subject to competing theories, and major uncertainty.  We all must hope for the people of Puerto Rico that it will nonetheless happen.

Thank you again for the chance to share these views.

Testimony on The Bipartisan Housing Finance Reform Act of 2018

Published by the R Street Institute.

KEY POINTS

1. We should be heading for a reform which transforms the system into one which is 80% private and only 20% government.

2. The best place for mortgage credit risk to reside is with the lender who makes the loan in the first place, who should retain significant credit risk "skin in the game" for the life of the loan.

3. The best we can do to dampen price distortions is to move toward the goal of making the housing finance system 80% private.

4. Guarantee fees for the GSEs must be calculated to include the cost of capital that would be required for a regulated private financial institution to bear the same credit risk.

5. Congress should remove Fannie and Freddie's special government privileges and make them pay for their formerly free Treasury guarantee, turning them from GSEs into normal competitors, and creating a competitive, instead of duopolistic, mortgage securitization market.

6. The FHLBs should be authorized to form, own and manage a joint subsidiary dedicated to mortgage finance, including securitization and also advancing structures with lender skin in the game, on a national basis.

The bipartisan discussion draft advances the development of fundamental housing finance reform. As it proposes, we need to move toward a system with greater private capital at risk, more competition, and more robust risk distribution to achieve sustainable home finance for the American people.

Digital Money: More competition? Even more central bank monopoly?

Published by the R Street Institute.

Mr. Chairman, Ranking Member Moore and Members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. As part of my many years of work in banking and on financial policy issues, I have studied the history and various concepts of money, including the development of central banks and banking systems, and authored many articles, presentations and testimony on related subjects. Before joining R Street, I was a resident fellow at the American Enterprise Institute 2004-2015, and president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

Central Bank Monopoly or Privately Issued Money?

As we think about the future of money, which grows ever more digital in its transactions and records, it helps to consider the varieties of money displayed by the past. Today, we are accustomed to the Federal Reserve and other central banks having a monopoly on the issuance of each national money. A senior officer of the Bank of England has summed up the prevailing view:

The distinctive feature of a central bank derives from its role as the monopoly supplier of outside money, [that is] notes and coin and commercial bank reserve deposits. These constitute the ultimate settlement asset for an economy and mean that the central bank has a unique ability to create or destroy liquidity.

But do you have to have a central bank as the monopoly supplier of money? Historically, clearly not. For one thing, there have not always been central banks. The Bank of Canada, for example, dates only from 1934 and there was obviously money in Canada before that, as there was in the United States before the Federal Reserve was chartered in 1913 and subsequently developed its currency-issuing monopoly. Even with the Fed, there were other forms of U.S. currency existing until the 1960s—namely, silver certificates and United States notes. National banks issued their own currency until the 1930s, as authorized under the National Bank Act of 1863-64.

One of the intriguing questions posed by bitcoin and other “cryptocurrencies” (hereafter “bitcoin” for short) is whether today there can be a successful privately issued currency that is widely accepted and constantly used in settlement of purchases and sales, and thus actually serves as money. This would be a money which is not issued by the government or its central bank, and is not backed by the force and power of compulsion of the federal government.

There have been numerous historical examples of private currencies, but to my knowledge there has never been a private fiat currency. They all were claims on some kind of assets, which bitcoin and its siblings are explicitly not.

Consider a classic form of money: gold and silver coins. As the interesting book Money and the Nation State tells us, “Nothing about operating a mint requires the state rather than private enterprise to perform that function. … Private mints operated in the United States until they were prohibited during the Civil War.” Such coins, unlike all currency today, were intrinsically valuable, whether minted privately or by governments.

A common form of private money in the American 19th century were the circulating notes of state-chartered banks. So you might have carried in your wallet a $5 bill issued by something like the Third State Bank of Skunk Creek or hundreds of others. I had an acquaintance who had a huge collection of such banknotes—he gave me a copy of a $3 bill issued by the Wisconsin Marine and Fire Insurance Co., a predecessor of one of my former employers, now a tiny part of today’s JPMorgan Chase. All such notes were backed by the loans, investments and capital of the issuing bank—they were not fiat money, as bitcoin wishes it might become.

The “free banking” theory maintains that a monetary system is better when composed of competing currency issued by private banks, instead of a monopoly currency of the central bank. This is far from the dominant view, however.

Most money used in transactions today is in the form of deposits, already a kind of digital money, operated for the most part and settled electronically, in this country denominated in U.S. dollars. Deposits are also backed by the assets and capital of the issuing bank, as well as the guaranty of the federal government, which if its deposit insurance fund fails, can tax some people to make good the deposits of others. Deposits are thus a mix of private and government money.

Troubled financial times have given rise to experiments with currency. “In America’s first depression, 1819-1821,” we learn from economist Murray Rothbard, “four Western states (Tennessee, Kentucky, Illinois and Missouri) established [their own] state-owned banks, issuing fiat paper.” Unfortunately, this did not end well, as “the new paper depreciated rapidly.” In contrast, the strategy of the Federal Reserve today is to have its paper depreciate slowly and steadily.

During the Great Depression of the 1930s, many municipalities, including the financially desperate City of Detroit, issued their own currency, or “scrip,” to make payrolls. They were out of U.S. dollars and could not borrow any more. The scrip could be used to pay property and other local taxes, which gave it some currency. It often traded at discounts to regular dollars, but still could be used to buy things locally. Says one history of this emergency experiment:

Some sort of scrip was issued by several hundred municipalities, business associations, companies, banking organizations, barter and self-help cooperatives. … Cash-strapped counties and cities across the country paid their employees with scrip issued against prospective tax receipts and good for current taxes and other public fees. In the early 1930s, 25 states revised their laws to authorize the issue of scrip.

These were interesting, but temporary expedients. They do not provide much support for the monetary hopes of bitcoin enthusiasts.

Turning to theory as opposed to history, the great economist, Friedrich Hayek, in his essay, “Choice in Currency,” provided a theory congenial to the libertarian strain of bitcoin backers. Said Hayek:

Why should we not let people choose freely what money they want to use? … I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful. … I hope it will not be too long before complete freedom to deal in any money one likes will be regarded as the essential mark of a free country.

I sympathize with these ideas, but I think that Hayek’s hope, expressed in 1975, will continue to be disappointed.

Heading Toward an Even Greater Monopoly?

Will the new and ubiquitous computing power of our time reverse the historical trend toward central bank monopoly of money and create more competition in currency? Bitcoin theorists imagine that it will, but it is easier to imagine digital currency moving us in exactly the opposite direction: toward even greater monopolization of money by the central bank.

Many central banks are interested in the idea of having their own digital currency. That means letting the general public, not only banks, have deposit accounts directly with the central bank, in addition to carrying around its paper currency. The appeal of this idea to central banks is natural: it would vastly increase their size, power and role in the economy.

In a digital age, it would clearly be possible for a central bank, in our case the Federal Reserve, to have tens of millions of accounts directly with individuals, businesses, associations, municipal governments and anybody else, which would be all-electronic. In terms of pure financial technique, there is nothing standing in the way. But would this be a good idea? Should Congress ever consider it?

In a recent article, “The Bank of Our Dreams,” Matthew Klein suggests that it would be a wonderful idea. “It is time for the largest U.S. bank to open its doors to the public,” he says. Citing the proposal of three law school professors, “A Public Option for Bank Accounts (Or Central Banking for All),” he summarizes:

Their ‘public option for bank accounts’ would offer every American household and business a checking account [though presumably there would be no paper checks] at the Fed.’ This would ‘create a frictionless system, like email.’

The Federal Reserve would be in direct competition with all private banks in such a scheme. It would certainly be a highly advantaged government competitor. It could offer “risk-free” accounts and pay a higher interest rate, if it liked, cross-subsidizing this business with the profits from its currency-issuing monopoly. It would be regulating its competitors while shot through with conflicts of interest. It would put the evolution of central banks a hundred years into reverse.

There are in the American banking system about $12 trillion in domestic deposits. Could the Federal Reserve grab half of them? Why not? That would be $6 trillion, which would expand its balance sheet to $10 trillion. A pretty interesting and unattractive vision of enhanced monopoly.

Says Klein:  “Offering Federal Reserve accounts to the general public would also reduce the taxpayer subsidy for bank risk-taking.” Actually, it would do the opposite: vastly increase taxpayer risk by putting the risk into the Federal Reserve itself.

For the Federal Reserve would have to do something with mountain of deposits—namely make loans and make investments. It would automatically become the overwhelming credit allocator of the financial system. Its credit allocation would unavoidably be highly politicized. It would become merely a government commercial bank, with the taxpayers on the hook for its credit losses. The world’s experience with such politicized lenders makes a sad history.

In short, to have a central bank create digital currency is a terrible idea—one of the worst financial ideas of recent times.

The Future of Money

There is no doubt that the digitalization of financial transactions, records, access to information and communication will continue to increase, and that the electronic networks underlying the activity continue to grow more intense and omnipresent. But the fundamental nature of money, it seems to me, will not change. It will either be:

• The monopoly issuance of a fiat currency by the central bank as part of the government, backed by the power of the government. That the whole world operates on such currencies is a remarkable—and dangerous—invention of the 20th century.

• Or if private currencies do again develop, they will, as in the past, have to be based on a credible claim to reliable assets. With Hayek, we could hope (without much hope) that this might bring competition for government fiat money.

It is clear that having a fiat currency is far too precious and profitable for governments for them ever to go back to a government currency backed and convertible into actual assets, whether gold coins or otherwise.

Government fiat currencies will operate in increasingly digitalized forms. Still, paper money will retain its advantages of secure privacy, immediate settlement without intermediaries and the ability to function when the electricity is shut down. Recently, I was amazed to find that my younger son, an up-and-coming banking officer, was walking around with the total of $1 in his wallet, but of course with a well-used debit card. As this generational difference indicates, doubtless our ideas of money will grow ever more dependent on having the electricity on at all times and everywhere.

Attempts at private fiat currencies, with no claim to any underlying assets, in my view have a very low probability of ever achieving widespread acceptance and functioning as money.

An increase of the monopoly power of central banks, of which we already have too much, should be avoided.

Thank you again for the chance to share these views.

Testimony of Alex J. Pollock: Federal Reserve accountability and structure

Published by the R Street Institute.

Testimony of

Alex J. Pollock

Distinguished Senior Fellow

R Street Institute

Washington, DC

To the Subcommittee on Monetary Policy and Trade

Of the Committee on Financial Services

United States House of Representatives

Hearing on “A Further Examination of Federal Reserve Proposals”

January 10, 2018

Federal Reserve Accountability and Structure

Mr. Chairman, Ranking Member Moore, and Members of the Subcommittee, thank you for the opportunity to be here today.  I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views.  As part of my many years of work in banking and on financial policy issues, I have studied the role and history of central banks, including authoring numerous articles, presentations and testimony regarding the Federal Reserve.  Before joining R Street, I was a resident fellow at the American Enterprise Institute 2004-2015, and the president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

The proposals under consideration today are all parts of a timely and fundamental review of America’s central bank.  As Congressman Huizenga has rightly said, “With the Federal Reserve having more power and responsibility than ever before, it is imperative the Fed…become more transparent and accountable.”

From James Madison, who wanted to protect the new United States from “a rage for paper money,” to now, money has always been and is an inherently political issue, involving many questions which are not amenable to technocratic solutions, but require judgments about the general welfare. For example, Congress instructed the Federal Reserve in statute to pursue “stable prices.”  But the Federal Reserve decided on its own that the term “stable prices” means perpetual inflation–at the rate of 2% a year.  This reasonably could be viewed as a contradiction in terms, but certainly raises the question: Who should have the power to make such judgments?  The Fed by itself?

Under the current monetary regime, with the Fed as the creator of the world’s dominant fiat currency, busy manipulating money, credit, and interest rates, we have experienced the great inflation of the 1970s, the financial crises of the 1980s, and the bubbles and financial crises of the 1990s and 2000s.  (The outcome of the bubbles of the 2010s is not yet known.)

The problems are not due to bad intentions or lack of intelligence, but to the unavoidable uncertainty of the economic and financial future.  Since this future is unknown and unknowable, the Fed is incapable of knowing what the results of its own actions will be. It will inevitably be faced with “conundrums” and “mysteries.”   Monetary manipulation always involves judgments, which can also be called guesses and gambles.  How should the Fed be accountable for its various judgments, guesses and gambles, and to whom?  And at the same time, how should it be accountable for how it spends the taxpayers’ money and how it makes decisions?

I believe there are four general categories which should organize our consideration of today’s draft bills.  These are, along with the related drafts:

1. Accountability of the Federal Reserve

-Bring the Fed into the appropriations process

-Define the blackout period

1. Checks and balances appropriate to the Fed

-Vice Chairman for Supervision’s reports to Congress

-Disclosures of highly paid employees and financial interests

1. Centralized vs. federal elements in the Fed’s structure

-Revise the membership of the Federal Open Market Committee

-FOMC to establish interest rates on deposits with the Fed

-Modify appointment process for presidents of Federal Reserve Banks

1. Dealing with uncertainty

-Staff for each Fed governor

Accountability 

The power to define and manage money is granted by the Constitution to the Congress.  There can be no doubt that the Federal Reserve is a creature of the Congress, which can instruct, alter or even abolish it at any time.   Marriner Eccles, the Chairman of the Fed after whom its main building is named, rightly described the Federal Reserve Board as “an agency of Congress.”  As the then-president of the New York Federal Reserve Bank testified in the 1960s, “Obviously, the Congress which has set us up has the authority and should review our actions at any time they want to, and in any way they want to.”  He was right, and that is the true spirit of “audit the Fed.”

To whom is the Federal Reserve accountable?  To the Congress, the elected representatives of the People, for whom the nature and potential abuse of their money is always a fundamental issue.

It is often objected that such accountability would interfere with the Fed’s “independence.”  In my opinion, accountability is an essential feature of every part of the government, which should never be compromised.  If accountability interferes with independence, so much the worse for independence.

In any case, the primary central bank independence problem is independence from the executive, not from the Congress.  The executive naturally wants its programs and especially its wars financed by the central bank as needed.  This natural tendency goes far back in history.  The deal which created the Bank of England was its promise to lend money for King William’s wars on the continent.  Napoleon set up the Bank of France because “he felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes.”

The Federal Reserve first made itself important by helping finance the First World War.  To finance the Second, as a loyal servant of the Treasury, the Fed bought all the bonds the Treasury needed at the constant rate of 2 ½%.  The Fed’s desire to end this deal with the Treasury in 1951, six years after the world war ended, gave rise to a sharp dispute with the Truman administration.  That administration was by then having to finance the Korean War, a war that wasn’t going so well.  For his role in making the Fed more independent of the Treasury, Fed Chairman William McChesney Martin was considered by Truman as a “traitor.”  Two decades later, Fed Chairman Arthur Burns was famously pressured by President Nixon to match monetary actions to the coming election.  Burns was marvelously quoted as saying that if the Fed doesn’t do what the President wants, “the central bank would lose its independence.”

The Federal Reserve Reform Act of 1977 and the Humphrey-Hawkins Act of 1978 were attempts under Democratic Party leadership to make the Fed more accountable to Congress.  I think it is fair to say these attempts were not successful, but instead led principally to scripted theater.

The most fundamental power of the legislature is the power of the purse.  If Congress wants to get serious about Federal Reserve accountability, it could make use this essential power.  Every dollar of Fed expense is taxpayer money, which would go to the Treasury’s general fund if not spent by the Fed on itself.  Since it is taxpayer money, the proposal of one draft bill to subject it to appropriations like other expenditures of taxpayer funds makes sense.  The draft limits the expenditures so subject to those for non-monetary policy related costs.  In fact, I think it would be fine to subject all Fed expenses to appropriations.

A second draft bill defines blackout periods for communications from the Fed, including communications to Congress, around Federal Open Market Committee meetings.  The draft would precisely set the blackout period as a week before and a day after the relevant meeting.  This certainly seems a reasonable definition.

Checks and Balances

Checks and balances are essential to our Constitutional government, and no part of the government, including the Federal Reserve, should be exempt from them.  But how should the Fed, so often claiming to be “independent,” fit into the system of checks and balances?

The required appropriation of some or all of the Fed’s expenses would be one way.  Another way is additional required reporting regarding its regulatory plans and rules, since the Fed has amassed huge regulatory power.  It tends to get more regulatory power after a crisis, no matter how great its mistakes and failings were beforehand, as it did after the last crisis, including getting a Vice Chairman for Supervision.

One draft bill requires that this Vice Chairman for Supervision, or others if the position is vacant, regularly report to Congress in writing and in person on “the status of all pending and anticipated rulemakings.”  Given the increase of the Fed’s regulatory power, especially its powerful role as the dominant regulator of “systemic risk,” this seems appropriate.

Another draft bill would require disclosures regarding highly paid Federal Reserve Board employees (those making more than a GS-15). The draft also would require disclosures of financial interests.  Federal Reserve actions and announcements are market moving events.  Addressing potential conflicts of interest is a standard policy.

Centralized vs. Federal Elements of the Fed’s Structure

The original Federal Reserve Act of 1913 tried to balance regional and central power.  Hence the name, “Federal Reserve System,” as opposed to a single “Bank of the United States.”  Carter Glass, one of the legislative fathers of the 1913 Act, it is said, liked to ask witnesses in subsequent Congressional hearings: Does the United States have a central bank?  The answer he wanted was “No, it has a federal system of reserve banks.”

This theory lost out in the Banking Act of 1935, when power in the Fed was centralized in Washington, as promoted by Marriner Eccles (who still knew, as noted above, that the Federal Reserve Board is “an agency of Congress”).

Centralization in the Fed reached its zenith with the elevation of the Fed Chairman to media rock star status, as in the title, “The Maestro.”  Some adjustment back to more dispersed power within the Fed arguably would make sense.  Three of the draft bills move in this direction.

The first would expand the membership of the Federal Open Market Committee to include the presidents of all the Federal Reserve Banks, instead of five of them at a time.  Since all the presidents already attend and participate in the discussions of the committee, the old voting rule does seem pretty artificial, especially since the Committee by and large operates on a consensus basis.  If some proposal of the Chairman and the Board of the Fed were so controversial that it was opposed by a super-majority of the presidents, such a proposal surely would deserve additional consideration rather than implementation under the old voting rules.

A second draft bill would make the FOMC responsible for the setting the interest rate on deposits with Federal Reserve Banks.  Since this interest rate has now become a key element of monetary policy, placing it with related monetary decisions is quite appropriate.

A third draft in this area would return the election of Federal Reserve Band presidents to the whole Board of Directors of the bank in question.  This reflects the principle that in every board of directors, all directors, however elected or appointed, have the same fiduciary responsibilities.  The Board of Governors will continue to appoint one-third of the directors of each Federal Reserve Bank.

Dealing with Uncertainty

I have asserted the essential uncertainty characterizing Federal Reserve decisions.  One approach to uncertainty is to promote intellectual diversification within the organization rather than a party line.

The staff of a body like the Fed naturally tends to be focused on serving a successful, powerful and dominant chairman.  This risks promoting group-think.  A well-known problem for the other Fed governors is lack of staff support for other directions they may want to investigate or pursue.

A good provision of the draft bills is “Office staff for Each Member of the Board of Governors,” which would provide each non-chairman governor at least two staff assistants.  It seems to me this might provide these other governors greater ability to pursue their own ideas, theories and research, and thus allow them to be more effective members of the Board and potentially provide greater intellectual diversification to the Fed’s thinking.

In sum, the Federal Reserve without question needs to be accountable to the Congress, be subject to appropriate check and balances, and be understood in the context of inherent financial and economic uncertainty.  It would benefit from rebalancing of centralized vs. federal elements in its internal structures.

Thank you again for the chance share these views.

The Fed should be required to provide Congress a regular savers’ impact analysis

Published by the R Street Institute.

Mr. Chairman, Ranking Member Moore and Members of the Committee,

Thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I have spent more than four decades working in and on the banking system, including studying the role of central banks in both normal times and crises. I was president and CEO of the Federal Home Loan Bank of Chicago for 12 years, then worked on financial policy issues at the American Enterprise Institute, and moved to R Street last year.

I believe this hearing is examining a critical issue:  What is the Federal Reserve doing to savers, notably including retirees?

To begin with my conclusion: Congress should require a savers’ impact analysis from the Federal Reserve at each discussion of the Fed’s policies and plans with the committees of jurisdiction. Under the CHOICE Act, this would be quarterly. This analysis should quantify, discuss and project for the future the effects of the Fed’s policies on savings and savers, so these effects can be explicitly considered along with other relevant factors.

Savings are essential to aggregate long-term economic progress and to personal and family financial well-being and responsibility. However, the American government’s policies, including those of the Federal Reserve, have subsidized and overemphasized the expansion of debt and have forgotten savings. The old theorists of savings and loans, to their credit, were clear that “savings” came first, and made possible the “loans.” Our current national policy could be described, instead of “savings and loans,” as “loans and loans.”

There is no doubt that among the very important effects of Federal Reserve actions from 2008 to now have been the expropriation of American savers, which has been especially painful for many retirees. This has been done through the imposition of negative real interest rates on savings during the remarkably long period of nine years, from 2008 to now. Negative real interest rates would be expected from the central bank in crisis mode, but it is a long time since that was over. The financial crisis ended in spring 2009, and the accompanying recession ended in June 2009, eight years ago. House prices bottomed in 2012—five years ago—and have reinflated rapidly. As we speak, they are back up over their bubble peak. The stock market has been on a bull run since 2009 and is at all-time highs. A logical question is: what is the Fed doing, still forcing negative real interest rates on savers at this point?  The Fed should be required to explain to Congress, with quantitative specifics, what it has done, what it thinks it is doing and what it plans to do, in this respect.

Consumer price inflation year-over-year in May 2017 was 1.9 percent. The Federal Reserve endlessly announces to the world its intention to create perpetual inflation of 2 percent, which is equivalent to a plan to depreciate savings at the rate of 2 percent per year.

Against that plan, what yield are savers getting?  The June 2017 Federal Deposit Insurance Corp. national interest rate report shows that the average interest rate on savings accounts is 0.06 percent. The national average money market deposit account rate is 0.12 percent, according to Bankrate, and the average three-month jumbo certificate of deposit 0.11 percent. Savers can do better than the averages by moving their money to the higher-yielding banks and instruments, but in no case can they get their yield up to anywhere near the inflation rate or the Fed’s annual inflation target. In the wholesale secondary market, for example, 90-day Treasury bills are yielding about 1 percent. And savers have to pay income taxes even on these paltry yields, making the negative real return worse.

Thrift, prudence and self-reliance, which should be encouraged, are instead being discouraged.

The CHOICE Act would require in general that the Federal Reserve be made more accountable, as it should be. No government entity, including the Fed, should be exempt from the constitutional design of checks and balances. To whom is the Fed accountable?  To the Congress, of course, which created it, can abolish or redesign it and must oversee its tremendously powerful and potentially dangerous activities in the meantime. The savers’ impact analysis is fully consistent with the provisions of the bill.

The CHOICE Act would also require that new regulations provide “an assessment of how the burden imposed…will be distributed among market participants.” This excellent principle should also be applied to the Fed’s reports to Congress of what they are doing. In particular, the Fed has been taking money away from savers in order to give it to borrowers. This benefits borrowers in general, but notably benefits highly leveraged speculators in financial markets and real estate, since it has made financing their leverage close to free. Even more importantly, it benefits the biggest borrower of all by far—the government itself. Expropriating savers through the Federal Reserve is a way of achieving unlegislated taxation.

By my estimate, the Federal Reserve has taken since 2008 about $2.4 trillion from savers. The specific calculation is shown in the table at the end of this testimony. The table assumes savers could invest in six-month Treasury bills, then subtracts from the average interest rate on them the inflation rate, giving the real interest rate, which on average is -1.32 percent. This rate is then compared to the normal real interest rate, based on the 50-year average, giving us the gap the Fed has created between the actual real rates to savers and the historically normal real rates. This gap, which has averaged 2.97 percent, is multiplied by the total household savings. This gives us, by arithmetic, the total gap in dollars.

Let me repeat the answer: $2.4 trillion.

The Federal Reserve, I imagine, wishes to defend its sacrifice of the savers as a necessary evil, “collateral damage” in the course of pursuing the greater good. But there can be no doubt that taking $2.4 trillion from some people and giving it to others is a political decision and a political act. As a clearly political act, it should be openly and clearly discussed with the Congress, quantifying the effects on various sections of savers, borrowers and investors, and analyzing the economic and social implications.

The effects of the creation and manipulation of money pervade society, transfer wealth among various groups of people and can cause inflations, asset-price inflations and disastrous bubbles, which turn into busts. The money question is inherently political—it is political economics and political finance we are considering. Therefore, in developing and applying the theories and guesses with which it answers the money question, the Federal Reserve needs to be accountable to the Congress.

If you believed that the Federal Reserve had superior knowledge and insight into the economic and financial future, you could plausibly conclude that it should act as a group of philosopher-kings and enjoy independent power over the country. But no one should believe this. It is obvious that the Fed is just as bad at economic and financial forecasting as everybody else is. It is unable to predict the results of its own actions consistently. There is no evidence that it has any special insight. This is in spite of (or perhaps because of) the fact that it employs hundreds of Ph.D. economists, can have all the computers it wants (having no budget constraint) and can run models as complicated as it chooses.

Moreover, the notion of philosopher-kings is distinctly contradictory to the genius of the American constitutional design.

Seen in a broader perspective, the Federal Reserve is an ongoing attempt at price fixing and central planning by committee. Like all such efforts, naturally, it is doomed to recurring failure. It cannot know what the right interest rate is, and it cannot know how much of the losses of the bubble it is right to extract from savers.

Since the Fed cannot operate on knowledge of the future, it must rely on academic theories, in addition to flying by the seat of its pants. Its theories and accompanying rhetoric change over time and with changing personalities. Grown-up, substantive discussions with the Congress about which theories it is applying, what the alternatives are, who the winners and losers may be and what the implications are for political economy and political finance—just as the CHOICE Act suggests—would be a big step forward in accountability. Of course, we need to add a formal savers’ impact analysis.

The table calculating the cost imposed on savers by the Fed’s nine years of negative real interest rates is on the next page.

Thank you again for the chance to share these views.

Pollock before Oversight Subcommittee

Here’s more from R Street Distinguished Senior Fellow Alex Pollock’s testimony before the House Committee on Financial Services on the arbitrary and inconsistent non-bank SIFI designation process.

Pollock testifies on CHOICE Act before House Financial Services

Published by the R Street Institute.

R Street Distinguished Senior Fellow Alex J. Pollock testified July 12, 2016 before the House Financial Services Committee about the CHOICE Act, legislation that proposes to loosen regulatory controls on banks that choose to hold sufficient capital to offset their risk to the financial system. Video of Alex’s testimony, as well as Q&A about the Volcker Rules and other reforms to the Dodd-Frank Act, is embedded below.

Testimony to House Financial Services Committee on the CHOICE Act

Published by the R Street Institute.

Mr. Chairman, Ranking Member Waters and members of the committee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I spent 35 years in banking, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago and then 11 years as a fellow of the American Enterprise Institute, before joining R Street earlier this year. I have both experienced and studied many financial cycles, including the political contributions and reactions to them, and my work includes the issues of banking systems, central banking, risk and uncertainty in finance, housing finance and government-sponsored enterprises and the study of financial history.

“Detailed intrusive regulation is doomed to fail.” This is the considered and, in my view, correct conclusion of a prominent expert in bank regulation, Sir Howard Davies, former chairman of the U.K. Financial Services Authority and former director of the London School of Economics. Detailed, intrusive regulation is what we’ve got, and under the Dodd-Frank Act, ever more of it. “Financial markets cannot be directly ‘controlled’ by public authorities except at unsustainable cost,” Davies adds. Surely there is a better way to proceed than promoting unfettered bureaucratic agencies trying through onerous regulation to do something at which they are doomed to fail.

I believe the CHOICE Act offers the opportunity of a better way, precisely by offering banks a fundamental choice.

The lack of sufficient capital in banks is a permanent and irresistible temptation to governments to pursue intrusive microregulation, which becomes micromanagement. This has an underlying logic to it. In a world in which governments explicitly and implicitly guarantee bank creditors, the government in effect is supplying risk capital to the banks which do not have enough of their own. Suppose the real requirement in a true market would be for an equity capital ratio of 8 percent of assets, but the bank has only 4 percent. The government implicitly provides the other 4 percent – or half the required capital. We should not be surprised when the, in effect, 50 percent shareholder demands a significant say about how the bank is run, even if the resulting detailed regulations will not be successful.

However, the greater the equity capital is, the less rationale there is for the detailed regulation. In our example, if the bank’s own capital were 8 percent, the government’s effective equity stake would be down to zero. This suggests a fundamental and sensible trade-off: more capital, reduced intrusive regulation. But want to run with less capital?  You get the intrusive regulation.

In other words, the CHOICE Act says to U.S. banks:  “You don’t like the endless additional regulation imposed on you by the bloated Dodd-Frank Act. Well, get your equity capital up high enough and you can purge yourself of a lot of the regulatory burden, deadweight cost and bureaucrats’ power grabs which were all called forth by Dodd-Frank.”

CHOICE does not set up higher capital as a mandate or an order to increase the bank’s capital. Rather it offers a very logical decision to make between two options. These are:

1. Option One: Put enough of your equity investors’ own money in between your creditors and the risk that other people will have to bail the creditors out if you make mistakes. Mistakes are inevitable when dealing with the future, by bankers, regulators, central bankers and everybody else. The defense is equity capital; have enough so that the government cannot claim you are living on the taxpayers’ credit, and therefore cannot justify its inherent urge to micromanage.

2. Option Two: Don’t get your equity capital up high enough and instead live with the luxuriant regulation of Dodd-Frank. This regulation is the imposed cost of, in effect, using the taxpayers’ capital instead of your own to support your risks.

I believe the choice thus offered in the proposed act is a truly good idea. To my surprise, The Washington Post editorial board agrees. They write:

More promising, and more creative, is Mr. Hensarling’s plan to offer relief from some of Dodd-Frank’s more onerous oversight provisions to banks that hold at least 10 percent capital as a buffer against losses…such a [capital] cushion can offer as much—or more—protection against financial instability as intrusive regulations do, and do so more simply.

Very true and very well-stated.

Making the choice, banks would have to consider their cost of capital versus the explicit costs and opportunity costs of the regulatory burden. Some might conclude that Option Two would yield higher returns on equity than Option One; some will conclude that Option One is the road to success. I imagine some banks would choose one option, while some would choose the other.

Different choices would create a healthy diversification in the banking sector. They would also create, over time, a highly useful learning experience for both bankers and governments. One group would prove to be sounder and to make greater contributions to economic growth and innovation. One group would, in time, prosper more than the other. The other group will end up less sound and less successful. Which would be which?  I think the group with more capital, operating in relatively freer markets with greater market discipline, would prove more successful. But we would find out. Future think-tank fellows could write highly instructive papers on the contrast.

Of course, to establish the proposed choice, we have to answer the question: how much capital makes is high enough? For a bank to make the deal proposed in the CHOICE Act, it would have to have a tangible leverage capital ratio of at least 10 percent. That is a lot more than current requirements, but is it enough?

Consider the matter first in principle: without doubt there is some level of equity capital at which this trade-off makes sense—some level of capital at which everyone, even habitual lovers of bureaucracy, would agree that the Dodd-Frank burdens become superfluous or, at least, cause costs far in excess of their benefits.

What capital ratio is exactly right can be, and is, disputed. Because government guarantees, subsidies, mandates and interventions are so intertwined with today’s banks, there is simply no market answer available. Moreover, we are not looking for a capital level which would remove all regulation—only the notorious overreaction and overreach of Dodd-Frank. For example, the CHOICE Act requires to qualify for Option One that, in addition to 10 percent tangible capital, a bank must have one of the best two CAMELS ratings by the regulator—”CAMELS” being assessments of capital, asset quality, management, earnings, liquidity and sensitivity to market risk.

Numerous proposals for the right capital levels have been made. However, the fact that no one knows the exact answer should not stop us from moving in the right direction.

Among various theories and studies, the International Monetary Fund concluded that “bank [risk-based] capital in the 15-23 percent range would have avoided creditor losses in the vast majority of past banking crises,” and that this range is consistent with “9.5 percent of total leverage exposure.” Obviously, a 10 percent level is somewhat more conservative than that.

Economist William Cline recently concluded that “the optimal ratio for tangible common equity is about 6.6 percent of total assets and a conservative estimate…is about 7.9 percent.”

Paul Krugman proposed a maximum assets-to-capital ratio of 15:1, which is equivalent to a leverage capital ratio of 6.7 percent. Anat Admati and Martin Hellwig came in much higher, arguing for a leverage capital requirement of 20 percent to 30 percent – however, with no empirical analysis. Economists David Miles, Jing Yang and Gilberto Marcheggiano estimated optimal bank capital at about 20 percent of risk-weighted assets, which in their view means a 7 percent to 10 percent leverage capital ratio.

In a letter to the Financial Times, a group of academics asserted a requirement for 15 percent leverage capital, but a study by economists Anil Kashyap, Samuel Hanson and Jeremy Stein proposed risk-based capital of 12 percent to 15 percent, which means a leverage capital ratio of 6 percent to 8 percent. Banking expert Charles Calomiris proposed 10 percent leverage capital.

All in all, it seems to me that the 10 percent tangible leverage capital proposed in the CHOICE Act to qualify for Option One is a fair level. It subtracts all intangible assets and deferred-tax assets from the numerator of the ratio, and adds the balance sheet equivalents of off-balance sheet items to the total assets in the denominator. Thus, it is a conservatively structured measure.

In 2012, Robert Jenkins, then a member of the Bank of England’s Financial Policy Committee, gave a speech to the Worshipful Company of Actuaries entitled “Let’s Make a Deal,” which put forward the same fundamental idea as does the CHOICE Act. The proposed deal was a “rollback of the rule book” in exchange for banks raising “their tangible equity capital to 20 percent of assets.” He explained the logic as follows:

• “We all agree that too many bankers got it wrong.”

• “We acknowledge that too many regulators got it wrong.”

• So, the best solution is to increase the tangible equity and “in return we can pare back the rule book—drastically.”

Under the CHOICE Act, in exchange for 10 percent tangible leverage capital, along with a high CAMELS rating, the deal is, to repeat, not to eliminate all regulation, but to exit from the excesses of Dodd-Frank. We should view Dodd-Frank in its historical context, as an expected political overreaction to the then-recent crisis. Now, for banks taking Option One, there would still be plenty of regulation, but not the notoriously onerous entanglements of Dodd-Frank. In exchange for Jenkins’ suggested move to 20 percent leverage capital, one would rationally eliminate a lot more regulation and bureaucratic power—to pare it back, as he says, “drastically.” The proposed act is more moderate.

The CHOICE Act uses the simple and direct measure of tangible leverage capital. This is, in my judgment, superior to the complex and sometimes opaque measures of risk-adjusted assets and risk-based capital. Although, in theory, risk-based capital might have been attractive, in fact, its manifestations have been inadequate, to say the least. Risk adjustments assume a knowledge in regulatory bureaucracies about what is more or less risky that does not exist—because risk is in the future. They are subject to manipulations and mistakes and, more importantly, to political factors. Thus, for example, Greek sovereign debt was given a zero risk weighting and ended up paying lenders 25 cents on the dollar. The risk weightings of subprime MBS are notorious. Fannie Mae and Freddie Mac debt and preferred stock were given preferential risk weightings, which helped inflate the housing bubble—a heavily political decision and a blunder.

The deepest problem with risk weightings is that they are bureaucratic, while risk is dynamic and changing. Designating an asset as low risk is likely to induce flows of increased credit, which end up making it high risk. What was once a good idea becomes a “crowded trade.” What was once a tail risk becomes instead a highly probable unhappy outcome.

Of course, no single measure tells us all the answers. Of course, managing a bank or supervising a bank entails understanding multiple interacting factors. But for purposes of setting up the choice for banks in the proposed act, I believe the simplicity of tangible leverage capital is the right answer.

In my judgment, the proposed choice between Option One and Option Two makes perfect sense. It takes us in the right direction and ought to be enacted.

Thank you again for the chance to share these views.

An Emergency Financial Control Board for Puerto Rico

 Testimony of 

Alex J. Pollock

Resident Fellow

American Enterprise Institute 

To the Committee on the Judiciary

United States Senate 

Hearing on Puerto Rico’s Fiscal Problems

December 1, 2015

An Emergency Financial Control Board for Puerto Rico

Mr. Chairman, Ranking Member Leahy, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Immediately before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on financial systems and credit crises, including municipal debt crises.

The government of Puerto Rico, having run a long series of constant budget deficits, has accumulated a very large debt which according to its own statements, it cannot pay. It is cut off from all normal municipal bond market financing and is running out of cash. The credit ratings of its many debt issuing entities are at the bottom of the scale, with a preponderance of CC ratings from S&P and Fitch and Ca ratings from Moody’s, with additional defaults on or restructurings of government debt expected.  With its current budget operations, financial control systems and government structure, it cannot produce clear, audited financial statements.  The study performed by former IMF officers earlier this year concluded that “the overall deficit is larger than recognized, its true size obscured by incomplete accounting” and cited “weak budget execution and opaque data.”  In addition, public pension obligations, which in insolvency pit pensioners against creditors, are virtually unfunded and an estimated $44 billion pension liability must be added to the $71 billion in debt. 

It is my recommendation that the Congress should promptly create an Emergency Financial Control Board to assume oversight and control of the financial operations of the government of Puerto Rico, as Congress successfully did in 1995 with Washington, DC; as New York State, with federal encouragement, successfully did with the insolvent and defaulting New York City in 1975; and as the State of Michigan did with the appointment of an Emergency Manager for the insolvent City of Detroit in 2013.  Such Boards have also been used in Cleveland (1980), Philadelphia (1991), and Springfield, Massachusetts (2004).  There is plenty of precedent. 

Under the United States Constitution, Congress has sovereignty over territories and the clear authority to create such a Control Board.  In my opinion, with Puerto Rico’s severe and longstanding financial problems, Congress also has the responsibility to do so.

This should be the first step, prior to other possible legislative actions.  I believe that the initial requirement is to establish independent, credible authority over all books, records and other relevant information; to analyze what the true overall financial deficit is; to determine which Puerto Rican government bodies are insolvent, in particular understanding the financial condition of the Government Development Bank which lends to the others; to consider fiscal, accounting and structural reforms which will lead to future balanced budgets and control of debt levels; and to consider in the light of all of these, how the current excessive levels of debt should be addressed.  The Control Board should analyze and report to Congress on whether creating a bankruptcy regime for Puerto Rico is warranted as a subsequent legislative action.

The Administration’s statement on “Puerto Rico’s Economic and Fiscal Crisis” includes this proposal: “Enact strong fiscal oversight and help strengthen Puerto Rico’s fiscal governance…Congress should provide independent fiscal oversight.”  This goes in the right direction, but is vague.  I believe it needs to be something more specific, thus more likely to work: a Control Board.  The Administration says financial oversight should “respect Puerto Rico’s autonomy,” but in fact Congress has unquestioned jurisdiction here.  As one harsh, but accurate, assessment has it: if you are a subsidiary government and “you screw up your finances bad enough,” you are going to get control and direction from somebody else.

The details of the Puerto Rican government’s financial situation are complex, but the fundamentals are simple and make a familiar pattern. The government of Puerto Rico is broke.  In the current century, it has run a budget deficit every single year-- 15 years in a row.  Operating deficits have been financed by borrowing.  As debts multiplied, debt service was met by additional borrowing.  As one municipal bond expert wrote, “The Commonwealth [was] utilizing debt issuance to pay interest on existing indebtedness.” This is the definition of a Ponzi scheme.   

Such debt escalations always end painfully when the lenders stop lending, as has now occurred.  What must inevitably follow is reform of fiscal operations, default on or restructuring of debt, bailout funding, or permutations and combinations of these.  What in particular must be done, and what the complete financial condition is, the proposed Emergency Financial Control Board must take up.

As the government of Puerto Rico recently disclosed:

     -“On October 30, 2015 the Commonwealth filed a notice that the Commonwealth would not file its audited financial statements for fiscal year 2014 by October 31, 2015.” 

     -“The Commonwealth cannot provide an estimate at this time of when it will be able to complete and file its audited financial accounts.”

A municipal bond analyst from UBS opined that the “inability to produce an audited financial statement for a fiscal year that ended almost sixteen months ago is inexplicable.”  On the contrary, it is all too explicable, given a financially stressed, insolvent borrower. 

Among the “Risk Factors” for investors in its debt, the government currently cites the following:

     -“The Commonwealth faces an immediate liquidity crisis.” 

     -“The Commonwealth does not have sufficient resources to pay its debt obligations in accordance with their terms.”

     -“The budget deficit of the Commonwealth’s central government during recent years may be larger than the historical deficits of the General Fund because they do not include the deficits of various governmental funds, enterprise funds, and Commonwealth instrumentalities.”

     -“The Puerto Rico Planning Board recently acknowledged the existence of certain significant deficiencies in the calculation of its macroeconomic data.”

     -“The assets of the Commonwealth’s retirement system will be completely depleted within the next few years unless the Commonwealth makes significant additional contributions…the Retirement Systems will continue to have large unfunded actuarial accrued liability and a low funding ratio for several decades.” 

     -“Each fiscal year, the Commonwealth receives a significant amount of grant funding from the U.S. government.  A significant portion of these funds is utilized to cover operating costs.”

     -“The Commonwealth’s accounting, payroll and fiscal oversight systems have deficiencies due to obsolescence and compatibility issues…this has affected the Commonwealth’s ability to control and forecast expenses.” 

     -“The Commonwealth has frequently failed to meet its revenue projections.”

     -“The Government Development Bank’s financial condition has materially deteriorated and it could become unable to honor all its obligations.”

     -The Government Development Bank has historically served as the principal source of short-term liquidity for the Commonwealth and its instrumentalities,” but faces “the inability of the Commonwealth and its instrumentalities to repay their loans.”

     -“The Commonwealth has failed to file its financial statements before the 305-day deadline in ten of the past thirteen years, including the most recent fiscal years (2012, 2013 and 2014).”

They themselves have said it.  All indications are of a government much in need of emergency, authoritative management help which is not dependent on short-term local politics. 

In addition, one Puerto Rican expert testified to the Senate Finance Committee that “Puerto Rico has an excessively bureaucratic and inefficient central government…when it comes to fiscal policy, budgeting, financial recordkeeping, tax collection, business permitting, professional contracting, use of modern technology and overall performance….Anyone who has dealt with the Puerto Rican government knows how opaque and difficult to navigate it can be.” Another expert has described “significant government corruption and predatory rent-seeking behavior,” along with “substantial tax evasion.”  Are these assertions true?  A Control Board will need to make judgments and then decisions accordingly.

I previously mentioned the robust precedents for Emergency Financial Control Boards.  As one analyst correctly observed, “The fundamentals of Puerto Rico resemble those of New York City in the mid-1970s and of other municipalities on which a Financial Control Board has been imposed.” 

The closest legal parallel is Washington DC, which had become a financial quagmire by the mid-1990s. Like Puerto Rico, Washington DC, not being a state, is Constitutionally subject to the direct jurisdiction of Congress. Congress responded with the District of Columbia Financial Responsibility and Management Assistance Act of 1995, which created the District of Columbia Financial Responsibility and Management Assistance Authority.  (A good political title, which might be adapted for use in Puerto Rico.)  

The Act was developed, approved and implemented as a successful bipartisan effort and the Board was given broad powers and authority.  These included approving or disapproving financial plans and budgets, implementing recommendations on financial stability and management, approving the appointment of the Inspector General of the District government, having total access to official reports and data, holding hearings, issuing subpoenas, and requiring District officers and employees to carry out its orders.

A very important power, worthy of note, was to approve the appointment of an independent District Chief Financial Officer—an office which continues today.

Two years later, Congress followed up with the National Capital Revitalization and Self-Government Improvement Act of 1997, which set tighter controls.  The purposes included: “to improve the ability of the District of Columbia government to match its resources with its responsibilities”—in other words, to run a balanced budget.  Another explicit goal of this act is very relevant to Puerto Rico: improvement in tax collection.

Although there were disputes and difficulties along the way, the Washington DC Control Board achieved clear success in financial management and controls, efficiency, and indeed reaching balanced budgets.  It adjourned in 2001, after Washington DC achieved its fourth consecutive balanced budget. The city’s bond ratings greatly improved; they have now reached AA/Aa.  However, the Board remains in the wings, authorized for a possible return, should Washington DC’s budget discipline ever again slide into aggregate deficits.

Another strong precedent is New York City. Like Puerto Rico, it had run a long series of budget deficits, financed them with ever more debt, and finally needed new loans to service the old ones.  In the spring of 1975, the market for the city’s debt closed.  By that fall, the city government was out of money and was, with the support of many of its prominent citizens, lobbying desperately for a federal bailout.  President Ford wisely turned this down.

Instead a deal was worked out among the federal, state and city governments, resulting in the establishment by New York State of the New York City Emergency Financial Control Board.  Other elements of the deal were the default, called a “moratorium,” on the city’s short-term notes; later Congressionally-approved provision of seasonal emergency financing for three years by the U.S. Treasury; and restructuring of debt through bonds issued by the Municipal Assistance Corporation, also established by New York State.  The necessity of the Control Board was primary.  

Intensely needed reforms of New York City’s spending, management, budget discipline, financial reporting and financial controls were achieved. New York City by now has also improved its bond ratings to AA/Aa.  Here is another success story for Control Boards and their ability to bring outside authority and resulting action.  As then-Treasury Secretary William Simon later wrote, “The city and state were required to make decisions of a type they had heretofore refused to make.” 

The State of Michigan, facing several municipalities in serious financial difficulty, adopted the Local Government and School District Accountability Act in 2011, authorizing the appointment of Emergency Managers, individuals rather than a board, with very broad financial and operating powers.  The best known was Kevyn Orr in the City of Detroit, appointed in 2013, but four other Michigan cities have had similar appointments. (It seems to me that the more common practice of appointing a board, with the balance of multiple perspectives and expertise, is a preferred structure.) 

In Detroit, the first step was the Emergency Manager.  Having analyzed the massive problems and the debt, he concluded that the city’s deep insolvency required a municipal bankruptcy.  This largest municipal bankruptcy ever was concluded in 20­­14, with major losses to creditors, including smaller but significant losses to pension claims.  Following the settlement of the bankruptcy, the Emergency Manager has been succeeded by the Detroit Financial Review Commission, which will continue to oversee the city’s budgets and financial management.

Should Puerto follow Washington DC and New York City, working its way through its management and debt problems without a bankruptcy proceeding? --or should it follow Detroit, with a bankruptcy included along with reforms?  I believe Congress should first appoint the Control Board for Puerto Rico, and charge it with getting on top of the financial situation, pursuing management reforms, considering the debt servicing issues, and then recommending to Congress whether or not a bankruptcy, which would involve new bankruptcy legislation, is required.

Let’s compare the debt burdens of three of the cases. The government of Puerto Rico’s $71 billion in total debt is 15% greater than the $62 billion, when re-stated to 2015 dollars, of New York City during its 1975 debt crisis.  Detroit’s debt, in 2015 dollars, was $19 billion.  Since the populations of the three are very different--Puerto Rico, 3.6 million; New York City 7.9 million; City of Detroit, 700 thousand-- we need to view the per capita local government debt.  These were, at the time of each crisis, expressed in 2015 dollars:

                               Puerto Rico             $20 thousand     

                              New York City          $ 8 thousand

                              City of Detroit          $27 thousand 

Puerto Rico is much more heavily indebted per capita than New York City was, but less so than Detroit.

One of the most distressing economic statistics of Puerto Rico is its labor participation rate of less than 40%.  There is additional work in the “informal” sector, but that does not generate taxes to pay the government’s debt.  So let’s look at local government debt per officially employed person in 2015 dollars:

                              Puerto Rico            $71 thousand 

                              New York City         $19 thousand

                              City of Detroit          $90 thousand 

Again, the Puerto Rican debt level per employee is much worse than New York City, but 20% less bad than Detroit.  Maybe in Puerto Rico the Emergency Financial Control Board will be sufficient to work through the reforms while debts are restructured outside of bankruptcy. I do not think it is possible to say at this point.

In any case, the financial and managerial problems are severe, cash is running out, and time is wasting.  In my judgment, Congress should establish the Emergency Financial Control Board for Puerto Rico as a high priority.

Thank you again for the opportunity to share these thoughts.

How Many Mandates Does the Fed Have? How Many Can It Achieve?

 Written Testimony of 

Alex J. Pollock

Resident Fellow

American Enterprise Institute 

To the Committee on Financial Services

U.S. House of Representatives

Hearing on “The Many Mandates of the Fed”

December 12, 2013 

How Many Mandates Does the Fed Have?  How Many Can It Achieve?

Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to submit this written testimony.  I am Alex Pollock, a resident fellow at the American Enterprise Institute where I focus on financial policy issues, and these are my personal views.  Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general.

My discussion has two main themes: 

1. Discretionary fiat-currency central banking is subject to high uncertainty.  Therefore the attempts of central banks to “manage” financial and economic stability are inevitably subject to mistakes, and recurring big mistakes.  The naive belief that any central bank, or anybody, could actually know enough about the future, and in particular about the future of complex, recursive globalized economies and financial markets, to be an economic “Maestro”, is a fundamental error.

2. While the Federal Reserve is often said to have a “dual mandate,” which would be difficult enough, it fact it has six mandates.  The combination of these mandates has created in the Fed a remarkable concentration of power.  But the Fed does not, and because the future is unknowable, cannot, succeed at all its mandates.   

Uncertainty and the Lack of Knowledge

In the early 21st century, the Fed and other central bankers gave themselves great credit for having engineered what they thought they observed: the so-called “Great Moderation.”  But the Great Moderation turned out to be the Era of Great Bubbles.  The U.S., in successive decades, had the Tech Stock Bubble and then the disastrous Housing Bubble.  In addition, other countries had destructive real estate and government debt bubbles. 

Presiding over the Era of Great Bubbles as Chairman of the world’s principal central bank from 1987 to 2006, was Alan Greenspan, a man of high intelligence and wide economic knowledge, with scores of subordinate Ph.D. economists to build models for him.  He was then world famous as “The Maestro,” for supposedly being able to always orchestrate the macro economy to happy outcomes.  In reality, the idea that anyone, no matter how talented, could be such a Maestro is absurd, but it was widely believed nonetheless, just as the idea that national house prices could not fall was widely believed.

In his new book, Chairman Greenspan relates, with admirable candor, that at the outset of the financial crisis in August, 2007, “I was stunned.”  He goes on to discuss the failure of the Fed to anticipate the crisis.  For example: “The model constructed by the Federal Reserve staff combining the elements of Keynesianism, monetarism and other more recent contributions to economic theory, seemed particularly impressive,” but “the Federal Reserve’s highly sophisticated forecasting system did not foresee a recession until the crisis hit.  Nor did the model developed by the prestigious International Monetary Fund. 

Even extremely complex models are abstract simplifications of reality and they do not do well with discontinuities like the panicked collapse of bubbles, so it is not surprising that “leading up to the almost universally unanticipated crisis of September, 2008, macromodeling unequivocally failed when it was needed most, much to the chagrin of the economics profession,” as Greenspan writes.

Central banking is not and cannot be a science, cannot operate with determinative mathematical laws, cannot make reliable predictions of an ineluctably uncertain and unknowable future.  We should have no illusions about the probability of success of such a difficult attempt as central banks’ “managing” economic and financial stability, no matter how intellectually impressive its practitioners may be.  “We did not anticipate that the decline in house prices would have such a broad-based effect on the stability of the financial system,” as another impressive intellect, Fed Chairman Ben Bernanke, has admitted.

Before the Era of Great Bubbles, a vast Federal Reserve mistake was the Great Inflation of the 1970s, under the Fed chairmanship of distinguished economist Arthur Burns, when annual inflation rates in the U.S. got to double digit levels.  In the aftermath of this decade of inflation was a series of financial crises of the 1980s, involving among other things, the failure of 2,237 U.S. financial institutions between 1983 and 1992, and the international sovereign debt crisis of the 1980s.  The Great Inflation was created by the Fed itself and its money printing exertions of those days.

In the next decade, the 1980s, with some success and by imposing a lot of pain, the Fed undertook “fighting inflation”—the inflation it had itself caused.  In the 2000s, it performed a variation on this pattern: the Fed first stoked the asset price inflation of the colossal Housing Bubble, then worked hard to bail out the Bubble’s inevitable collapse.

The Fed and other fiat-currency central banks are in the money illusion business, trying to affect the costs of real resources by depreciating the currency they issue at more or less rapid rates, by money creation and financial market manipulations.  The business of money illusion often turns into the business of wealth illusion, since central banks can and do fuel asset price inflations.  Asset inflations of bubble proportions create “wealth” that will evaporate.

Asset price inflation can be intentional on the part of the Fed when it is trying to bring about ”wealth effects,” as it did with the housing boom in 2001-2004 and is now doing again with so-called “quantitative easing,” including its unprecedented $1.5 trillion mortgage market manipulation.

Future financial histories will reflect something their authors will know, but we cannot: what the outcome of the Bernanke Fed’s massive interventions in the long-term government debt and mortgage markets will have been.  About this at present we, and the Federal Reserve itself, can only guess.  In the 1920s, the then-dominant personality in the Fed, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.”  The current Fed has given the bond and mortgage markets a barrel of whiskey, in a way which would have astonished previous generations of Fed governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

The final outcome of this intervention will probably render the Bernanke Fed in future histories as either a great hero or else as a great bum.  The probability distribution appears to me as bimodal, with nothing in between.  It represents a remarkable central banking gamble—one which without doubt has greatly increased the interest rate risk of the entire financial system, as well as of the Fed’s own balance sheet.  It reflects the ultimate in discretionary central banking with multiple mandates. 

How Many Mandates?

We constantly hear, not least from the Fed itself, about how it has a “dual mandate” of price stability and maximizing employment.  Experts have debated whether the Fed or any central bank can achieve balancing these two mandates successfully.  This question much oversimplifies the problem, for the Fed has not two mandates, but six.

To begin with, the provision of the Federal Reserve Reform Act of 1977 that gives rise to all the talk of a dual mandate actually assigns the Fed three mandates.  It provides that the Fed shall: “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  Obviously, that is three goals—a triple mandate, not a dual mandate.  However, the “moderate long-term interest rates” idea, perhaps because it is impractical, usually gets conveniently left out.

In addition, the Fed has three more mandates.  Two are from the original 1913 Act: to provide an elastic currency, and to regulate and promote financial stability.  The final mandate is the real essence of central banking: to finance the government as needed.

That makes six mandates.  How is the Fed doing on each?  Can it ever be expected to achieve them all? 

Let us start with “stable prices.”  This mandate in its literal sense was dropped by the Fed long ago and is now a dead letter.  The Fed’s frequently announced goal is not stable prices, but a relatively stable rate of increase in prices, with a target of 2% inflation a year, continuing indefinitely.  Bluntly put, the Fed is committed to perpetual inflation (although I cannot recall seeing it use this honest term) at a rate which will cause average prices to quintuple in the course of an average lifetime. With a straight face, the Fed and other central bankers call this “price stability”—a remarkable example of Orwellian newspeak.  While it is confused on the actual legal mandate, a recent article discussing the Fed in Barron’s correctly describes the current practice: “Half of its dual mandate, inflation.”  

A classic rationale for inflation is that real wages can be reduced without reducing nominal wages, and that real debts can be reduced without (as much) default on nominal debts.  Nonetheless, it is my opinion that the current commitment of the Fed and other fiat-currency central banks to perpetual inflation will be judged in the long run as inconsistent with financial stability, and instead part of the decades of financial instability which began in the 1970s.  However that may be, price stability is what we intentionally don’t have.

When the goal of “maximum employment” was added to the governing statute in 1977, many people, including the Democratic sponsors of the bill, believed there was a simple-minded trade-off between inflation and employment.  Shortly after enactment of this mistaken idea, the stagflation of the late 1970s demonstrated its error.  No one believes it now, but its presence in statute gives the Fed much increased power to exercise inherently uncertain discretionary central banking.

Within a few years of enactment of the “moderate long-term interest rates” mandate, the Fed was pushing interest rates to all-time highs, with the 10-year Treasury interest rate reaching 15% in the early 1980s.  This was hardly a “moderate” rate, to be sure. 

The history of the Fed and manipulation of long-term rates is instructive.  During the 1940s, the Fed was a big buyer of long-term government bonds to finance World War II and to suppress the cost of borrowing for the U.S. Treasury.  This was a major precedent considered by Chairman Bernanke for “quantitative easing.”  After the war, the Fed continued to hold down interest rates; at length it was debated whether it should.  President Truman and his Treasury Secretary thought it should, but in the 1951 “Accord,” the Treasury and the Fed agreed the purchases would end.  In the ensuing three decades, interest rates kept rising, making a 30-year bear bond market, until their 1980s peak.

Now we have had an equivalent three-decade long bull bond market and the Fed, of course, is again a big buyer of bonds.  It has again been a success at manipulating long-term interest rates downward, to near zero or even negative real rates.  That is also not a “moderate” interest rate.

Of far greater seniority and standing is the fourth mandate of the Fed, which stood very first in the Federal Reserve Act in 1913.  The legislative fathers of the Fed told us clearly what they wanted to achieve.  The original Act begins:

     “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”

In 1913, an elastic currency meant the ability to make loans from the Federal Reserve Banks to expand credit and print money to match the economic exigencies of the moment, whether reflecting the agricultural seasons, the business cycle or a financial panic.  In the background was the experience of the Panic of 1907.  One hundred years after that, in the Panic of 2007 to 2009, elastic currency was furnished with great energy by the Fed.  Although the panic is over, the elastic currency is still very expanded, now called “quantitative easing.”

As intended by the original Federal Reserve Act, an elastic currency is most certainly what we have got, not only in the U.S., but given the global role of the dollar, in the world.  That is one mandate fully achieved.  It is, as designed, very helpful in panics, but it also fits well with the more recent goal of perpetual inflation.

The fifth mandate is expressed in the beginning of the Federal Reserve Act as “to establish a more effective supervision of banking in the United States,” now also thought of as ensuring financial stability.  Although it was hoped at the creation of the Fed that it would make financial crises “mathematically impossible,” in fact in the one hundred years since then there have been plenty of crises, right up to the most recent one.  The Fed has full command of a very elastic currency, but the crises keep happening.  “Financial crises will always be with us,” as Bernanke has written, “That is probably unavoidable.”  I believe that is correct, optimistic hopes about the most recent expansion of the Fed’s supervisory power notwithstanding.

If only the governors, officers and staff of the Fed could know the future!  Then they could doubtless avoid the crises.  Since they do not and cannot know the future, it is plausibly argued that instead they help cause the crises by discretionary money creation and financial interventions which induce debt, leverage, asset inflation and illusory “wealth,” with recurring unhappy endings. 

The sixth and most basic central bank mandate of all is financing the government when needed.  In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the Treasury’s interest cost.  At three years old, it had lent its full efforts to finance the government during the First World War.  It is monetizing Treasury bonds as we discuss it.  So convenient a thing it is for a government to have a central bank that almost every government has one. 

This fundamental relationship is exemplified in the deal which formed the quintessential central bank, the Bank of England, in 1694.  The deal was that the Bank would lend money to the government, in exchange it got a monopoly in the issuance of currency.  This is still the basic structure of the Fed’s balance sheet.  Equally instructive is the founding of the Bank of France in 1800: “Bonaparte…felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes”—a natural political desire.   

Hence the ambivalence of Federal Reserve “independence.”  As William McChesney Martin, Fed Chairman in the 1950s and 1960s, said, the Fed is independent “within the government.”

Yet it is true that “the Fed has also become a colossus,” as the provocative historian of the Fed, Bernard Shull, has written.  The combined six mandates, whether or not successfully achieved, make what Shull calls “an enormous concentration of power in a single Federal agency that is more autonomous than any other and one in which a single individual, the Chairman, has assumed an increasingly important role.”

The accumulated power of the Fed gives it the greatest potential to create systemic financial risk of any institution in the world, while it is claiming and trying to reduce systemic risk.  This fact alone warrants the review of the Federal Reserve and its many mandates which the Committee has wisely undertaken.

Thank you very much for the opportunity to share these views.

The Fed Is as Poor at Knowing the Future as Everybody Else

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Monetary Policy and Trade

Of the Committee on Financial Services

U.S. House of Representatives

Hearing on “The Fed Turns 100: Lessons Learned from a Century of Central Banking”

September 11, 2013 

The Fed Is as Poor at Knowing the Future as Everybody Else

Mr. Chairman, Ranking Member Clay, and Members of the Subcommittee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general. 

A striking lesson of the 100-year history of the Federal Reserve is how it has been able from its beginning to now to inspire entirely unjustified optimism about what it can know and what it can accomplish. 

Upon the occasion of the Federal Reserve Act in 1913, an American Banker writer opined, “The financial disorders which have marked the history of the past generation will pass away forever.”  Needless to say, the Fed has not made financial disorders disappear, and not for lack of trying, while it has often enough contributed to them.  

In 1914, the then-Comptroller of the Currency expressed the view that with the creation of the Fed, “financial and commercial crises, or panics…seem to be mathematically impossible.”  They weren’t.

The unrealistic hopes continued.  As a forthcoming history says, “The bankers at the Federal Reserve kept the money flowing in to the American economy at a pitch that held interest rates low and kept expanding business and consumer credit… [but] there was no rise in prices.  The business cycle…had finally been tamed—or so it seemed.  Economists around the world praised the Federal Reserve.  Some even predicted that a ‘new era’ in economics had begun.”  This passage sounds like it is describing the central bank optimism of the early 2000s with the so-called “Great Moderation,” but in fact it is describing the 1920s.  We know what came next, and the Fed is widely blamed for its deflationary blunders in the crisis of the early 1930s, and again in 1937.

In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the interest rates on government debt, thus doing in great scale exactly what the fathers of the Federal Reserve Act had tried to prevent: monetizing government debt.  (The Fed had also lent its full efforts to finance the government during the American participation in the First World War.)

After enjoying the American global economic hegemony of the 1950s, the 1960s brought a new high point in optimism about what discretionary manipulation of interest rates and financial markets could achieve.  Otherwise intelligent and certainly well-educated economists actually came to believe in what they called “fine tuning”: that the Fed and government policy “could keep the economy more or less perfectly on course,” as discussed by Fed Chairman Bernanke in his new book, The Federal Reserve and the Financial Crisis.  Some economists even held a conference in 1967 to discuss “Is the Business Cycle Obsolete?”  It wasn’t. 

The fine tuning notion “turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s,” Bernanke writes, “so one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.”  Very true.

Indeed, the performance of the Federal Reserve at economic and financial forecasting in the last decade, including missing the extent of the Housing Bubble, missing the huge impact of its collapse, and failing to foresee the ensuing sharp recession, certainly strengthens the case for humility on the Fed’s part, especially when it attempts to forecast financial market dynamics.  The poor record of economic forecasting is notorious, and the Fed is no exception to the rule.

If only the Chairman, the Governors, the Presidents and the scores of economists of the Federal Reserve could really know the future!  Then they could carry out their discretionary actions without the many mistakes, both deflationary and inflationary, which have marked the history of the Fed.  These mistakes should not surprise us.  As Arthur Burns, Fed Chairman in the 1970s and architect of the utterly disastrous Great Inflation of that decade, said: “In a rapidly changing world, the opportunities for making mistakes are legion.”

In a 1996 speech otherwise famous for raising the issue of “irrational exuberance,” then-Fed Chairman Alan Greenspan sensibly discussed the limits of the Fed’s knowledge.  “There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment and inflation,” he said.  (Since it is effectively the world’s central bank embedded in globalized financial markets, the Fed would need not merely a model of the American economy, but one of the world economy.) 

“In principle,” Chairman Greenspan continued,” there may be some unbelievably complex set of equations that does that.  But we [the Fed] have not been able to find them, and do not believe anyone else has either.”  They certainly have not, as subsequent history has amply demonstrated.  Moreover, in my view, not even in principle can any model successfully predict the complex, recursive financial and economic future—so the Fed cannot know with certainty what the results of its own actions will be. 

Nonetheless, the 21st century Federal Reserve and its economists again became optimistic, and perhaps hubristic, about the central bank’s abilities when Chairman Greenspan had been dubbed “The Maestro” by the media and knighted by the Queen of England.  It is now hard to remember the faith he and the Fed then inspired and the confidence financial markets had in the support of what was called the “Greenspan put.”

Queen Elizabeth would later quite reasonably ask why the economists and central banks failed to see the crisis coming.  One lesson we can draw from this failure is that a group of limited human beings, none of whom is blessed with knowledge of the future, with all the estimates, guesses, and fundamental uncertainty involved, by being formed into a committee, cannot rationally be expected to fulfill the mystical notion that they can guarantee financial and economic stability.

In the early 2000s, of particular pride to the Fed was that the central bankers thought they were observing a durable “Great Moderation” of macro-economic behavior, a promising “new era,” and gave their own monetary policies an important share of the credit.  With an eye on a hoped-for “wealth effect” from rising house prices, the Fed pushed interest rates exceptionally low as the housing bubble was rapidly inflating, which many observers, including me, view as a critical mistake.  Chairman Bernanke has since insisted that the Great Moderation was “very real and striking.”  Yet, since it is apparent that the Great Moderation led to the Great Bubble and then to the Great Collapse, how could it have been so real?

Economic historian Bernard Shull has explored the paradox that throughout its 100 years, no matter how many mistakes the Fed makes, or how big such mistakes are, it nonetheless keeps gaining more power and prestige.  In 2005, he made the following insightful prediction:  “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”  Indeed, in the wake of the bubble and collapse, the political and regulatory overreaction came, as it always does each cycle.  The Dodd-Frank Act gave the Fed much expanded regulatory authority over financial firms deemed “systemically important financial institutions” or “SIFIs,” and a prime role in trying to control “systemic risk.”

But the lessons of history make it readily apparent that the greatest SIFI of them all is the Federal Reserve itself.  It is unsurpassed in its ability to create systemic risk for everybody else through its unlimited command of the principal global fiat money, the paper dollar.  As former-Senator Bunning reportedly asked Chairman Bernanke, “How can you regulate systemic risk when you are the systemic risk?”  A good question!  Who will guard these guardians?

A memorable example of systemic risk is how the Fed’s Great Inflation of the 1970s destroyed most of the savings and loan industry by driving interest rates to levels previously thought impossible.  In the 1980s, the Fed under then-Chairman Paul  Volcker, set out to “fight inflation”--—the inflation the Fed had itself created.  In this it was successful, but the high interest rates, deep recession and sky-high dollar exchange rate which resulted, then created often-fatal systemic risk for heartland industries and led to a new popular term, “the rust belt.”  A truly painful outcome of some kind was unavoidable, given the earlier inflationary blunders.

A half-century before that, in 1927, the then-dominant personality in the Federal Reserve, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.”  In our times, the Fed has decided to give the bond market and the mortgage market a barrel or so of whiskey in the form of so-called “quantitative easing.”  This would undoubtedly have astonished previous generations of Federal Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

How will this massive manipulation of the government debt and mortgage markets turn out?  Will it make the current Fed into a great success or become another historic blunder?  In my opinion, neither the Fed nor anybody else knows—about this all of us can only guess.  It is a huge and fascinating gamble, which has without doubt induced a lot of new systemic interest rate risk into the economy and remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.

In the psychology of risky situations, actions seem less risky if other people are doing the same thing.  That is why, to paraphrase a celebrated line of John Maynard Keynes, a “prudent banker” is one who goes broke when everybody else goes broke.  That other central banks are also practicing versions of “quantitative easing” may induce the same subjective comfort.  A decade ago, bankers felt a similar effect when they all were expanding mortgage debt together.

Robert Solow recently claimed that “Central banking is not rocket science.”  Indeed, it isn’t: discretionary central banking is a lot harder than rocket science.  This is because it is not and cannot be a science at all, because it cannot operate with determinative mathematical laws, because it cannot make reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future.  We should have no illusions, in sharp contrast to the 100 years of illusions we have entertained, about the probability of success of such a difficult attempt, no matter how intellectually brilliant and personally impressive its practitioners may be.

It is often debated whether the Fed can successfully achieve two objectives, the so-called “dual mandate,” rather than one.  It does seem doubtful that it can, but the question oversimplifies the problem, for the Fed has not two mandates, but six.

The precise provision of the Federal Reserve Reform Act of 1977, which gives rise to the discussion of the “dual mandate,” is almost always mischaracterized, for that provision assigns the Fed three mandates, not two.  The Fed shall, it says, “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  This is a “triple mandate,” at least.  The third statutorily assigned goal is almost always forgotten.  It is doubtful indeed that the Fed can simultaneously do all three. 

But in addition to these, the Fed has three more mandates.  These are: to furnish an elastic currency, the historically first mandate and the principal reason for the existence of the Fed in the first place; to act as the manager of the risks and profits of the banking club, now expanded to include other “SIFIs”; and finally, to provide ready financing for the deficits of the government of which it is a part, as needed.

Let us do a quick review of how the Fed is doing at each of its six mandates.

To begin with “stable prices”:  this goal was in fact dropped long ago.  The Fed’s goal is not and has not been for decades stable prices, but instead permanent inflation—with a relatively stable rate of increase in prices.  In other words, the Fed’s express intention is a steady depreciation of the currency it issues, another idea which would have greatly surprised the authors of the Federal Reserve Act.  At its “target” of 2% inflation a year, average prices will quintuple in a normal lifetime.  Economists can debate whether a stable rate of price increases rather than a stable price level is a good idea, but you cannot term perpetual inflation “price stability” with a straight face.

Turning to “maximum employment”:  Nobody believes any more, as many people believed when this goal was added to the governing statute in 1977, that there is a simple trade-off between inflation and sustained employment.  It was still believed when the Humphrey-Hawkins Act of 1978 was passed, although it was already being falsified by the great stagflation of the late 1970s.  Humphrey-Hawkins added a wordy provision requiring the Fed to report to and discuss with Congress its plans and progress on the triple mandate.  Did these sessions succeed?  They obviously did not avoid the financial disasters of the 1980s and 2000s, or the inflation of giant bubbles in tech stocks and housing.

On “moderate long-term interest rates”:  As the Treasury’s servant in the 1940s, the Fed kept the yield on long-term government bonds at 2 ½%.  After this practice was ended by the “Treasury-Fed Accord” of 1951, a 30-year bear bond market ensued, which ultimately took long-term interest rates to 15% in the early 1980s—this was not a “moderate” interest rate, to be sure.  With the Fed’s current massive bond buying, rates on long-term government bonds got to 1½%-2%, which was zero or negative in real terms—also not a “moderate” interest rate.

The fourth mandate stood right at the beginning of the original Federal Reserve Act in 1913.  The authors of the Act told us clearly what they wanted to achieve:

     “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”

An elastic currency is most definitely what we have got, not only in the U.S., but given the global role of the dollar, in the world.  Indeed, we have one much more elastic than originally intended.  This is very handy during financial panics when the Fed is acting as the lender of last resort.  The unanswered question is:  given a pure paper currency (not originally intended, of course) with unlimited elastic powers, what limits should there be other than the demonstrably fallible beliefs and judgments of the members of the Federal Reserve?  

Charles Goodhart’s monograph, The Evolution of Central Banks, makes a strong argument that it helps to understand central banks, including the Fed, by thinking of them as the manager of the banking club, which tries to preserve and protect the banking industry.  This becomes most evident in banking crises.  It was explicitly expressed in an early Fed plaque:  “The foundation of the Federal Reserve System is the co-operation and community of interest of the nation’s banks.”  Such candor is not currently in fashion—the fifth mandate is now called “financial stability.”  As discussed, this mandate has been expanded by Dodd-Frank beyond banks to make the Fed the head of an even bigger financial club. 

Sixth is the most basic central bank function, and Fed mandate, of all: financing the government, a core role of central banks for over three centuries.   As economist Elga Bartsch has correctly written, “The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank.”  Thus for governments that wish to finance long-term deficits with debt, like the United States, central banks are exceptionally useful, which is one reason virtually all governments have one-- no matter how disappointing the central bank’s performance at stable prices, maximum employment, moderate long-term interest rates, and financial stability may be.  Needless to say, the power of financing the government is also dangerous. 

Allan Meltzer, an eminent scholar of the Federal Reserve and our colleague on this panel, near the end of his magisterial A History of the Federal Reserve, quotes the classic wisdom of monetary thinker Henry Thornton from 1802-- 211 years ago, who proposed:

     “to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction: in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself….  To suffer the solicitations of the merchants, or the wishes of the government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.”

These are sensible guidelines, as my friend Allan suggests.  But another lesson of 100 years of Federal Reserve history is that we have still not figured out how to implement them.

Thank you again for the opportunity to share these views.

We Don’t Need GSEs

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Financial Services

U.S. House of Representatives

Hearing on Learning from Mortgage Finance Systems of Other Countries

June 12, 2013

We Don’t Need GSEs 

Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  From 1999 to 2001, I also served as President of the International Union for Housing Finance (IUHF), a trade association devoted to the international exchange of housing finance ideas and information. In fact, I have just returned to the U.S. from an IUHF conference at which representatives of 42 countries met to share issues and experiences in this sector, which is economically and politically important to all countries. 

The American housing finance sector has collapsed twice in the last three decades, once as a government promoted savings and loan-based system, and once as a government promoted GSE-centric system.  We should never assume that the particular, highly unusual,  historical development of U.S. housing finance should define the limits of our considerations.  There is no doubt that there is much to learn of much practical import from examining U.S. housing finance in international perspective, including how experts from other countries view our system from outside.

Comparing our housing finance sector to other countries, the one thing most unusual about it was and is the dominant and disproportionate role played by Fannie Mae and Freddie Mac, as government-sponsored enterprises or GSEs.  Fannie and Freddie’s role and was and is unique among housing finance systems.  The GSEs themselves used to claim that this made U.S. housing finance “the envy of the world,” a view not shared by the world.  When Fannie and Freddie were the darlings of Washington and the stars of Wall Street, they would come to IUHF meetings and boastfully promote their GSE model.  But mortgage professionals from other countries were not convinced. 

Let us begin by asking and answering five essential questions from an international perspective:

1.      Are GSEs like Fannie and Freddie necessary for effective housing finance?

                       No.  This is obvious from the many countries which achieve similar or higher  home ownership than the U.S. without them. 

2.     Did GSEs get for the U.S. an internationally high home ownership rate?

                      No.

3.     Well, did GSEs get for the U.S. an above-average home ownership rate?

                      No.

4.     Are GSEs necessary to have long-term, fixed rate mortgages?

                      No.

5.     Even if they had a disastrous actual outcome, are GSEs the best model in theory?

                      No. 

Along with incorrectly saying that GSEs made U.S. housing finance “the envy of the world,” it was often additionally claimed (without supporting data) that the U.S. had the highest home ownership rate in the world.  This seemed plausible to Americans, but was wrong.  Interestingly, people in England also claimed that they had the highest home ownership.  In fact, England, with a completely different housing finance system and no GSEs, has been and is effectively tied with the U.S. in home ownership rate—both now at 65%, and both in the bottom half, as you will see in the ranking below.

Based on the free use of the U.S. Treasury’s credit, through the so-called “implicit” but very real (as events  made clear) guaranty, massive amounts of Fannie and Freddie’s debt securities were sold around the world.  The GSEs ran up the leverage of the housing finance sector.  As a market distortion which pushed credit at housing, they inflated house prices and escalated systemic risk.  Foreign investors helped pump up the housing bubble through the GSEs while being fully protected from the risk, and then were bailed out by the taxes of ordinary Americans.  Of course, other countries also made housing finance mistakes, but nobody else made this particular, giant mistake.

The political interest in housing finance begins with what I think is a valid proposition: that in a democracy it is advantageous to have widespread property ownership among the citizens.  The experiences of other countries make it obvious that high home ownership levels can be attained without GSEs—and moreover without tax deductions for mortgage interest; without our very unusual practice of making mortgage loans into non-recourse debt; without government orders to make “creative”—that is riskier—mortgage loans, which were part of being a GSE; and with prepayment fees. 

The following table, “Comparative Home Ownership Rates,” is an update with the most recent available data of a comparison I presented to the Congress in 2010.  It displays home ownership in 28 economically advanced countries.  The U.S. ranks 20th, just behind England.  The median home ownership rate among these countries is 68%, compared to our 65%. 

Comparative Home Ownership Rates

Source:  AEI research

How do financial professionals in other countries view the U.S. housing finance sector?

More than a decade ago, when Fannie and Freddie were still riding high, and Fannie in particular was a greatly feared bully boy whom both Washington politicians and Wall Street bankers were afraid to cross or offend, I presented the GSE-centric U.S. housing finance system to the Association of Danish Mortgage Banks in Copenhagen.  When I was done, the CEO of one of their principal mortgage lenders memorably summed things up: 

          “In Denmark we always say that we are the socialists and America is the land of free enterprise.  Now I see that when it comes to mortgage finance, it is the opposite!”

He was so right.  But now, with Fannie and Freddie continuing to be guaranteed by the U.S. Treasury, able to run with zero capital and infinite leverage, being granted huge loopholes by the Consumer Financial Protection Bureau, and being heavily subsidized by the Federal Reserve’s buying up their MBS, they have a bigger market share and more monopoly power than before.  The American housing finance sector is more socialized than ever. 

Here’s a view from Britain, where a senior financial official said recently: 

          “We don’t want a government guaranteed housing finance market like the United States have.”

They don’t want what we have—and we don’t want it either.  How do we conceptualize the range of alternate possibilities?

Every housing finance system in the world must address two fundamental questions.  The first is how to match the nature of the mortgage loan with an appropriate funding source, so you are not lending long and borrowing short.  Different approaches distribute the interest rate risk among the parties involved—lenders, investors, borrowers, governments, taxpayers--in various ways. 

Basic sustainable variations observed in different countries include variable rate mortgages funded with short-term deposits; medium term fixed-rate mortgages funded with medium-term fixed rate deposits or bonds; long-term fixed rate mortgages funded with long-term fixed rate bonds or covered bonds. In general, to soundly fund long-term fixed-rate mortgages, you have to have access to the bond market.  In an advanced financial system, it does not require a GSE to do this.  

The classic example of not achieving the needed interest rate match was the collapse of the American savings and loan industry in the 1980s.  What broke the savings and loans was the combination of their interest rate mismatch with the soaring interest rates of the great inflation created by the Federal Reserve in the 1970s.  While the lenders were crushed, borrowers who had old 30-year fixed rate mortgages in this period of rising interest rates and inflating house prices did very well. 

In contrast, the 30-year fixed rate mortgage was terrible for great numbers of borrowers in the U.S. crisis of the 2000s.  With the floating rate mortgage system of England, the rapid fall of interest rates in the housing crisis was automatically passed on to the borrowers in the form of lower payments, which helped contain the crisis.  American borrowers faced with falling interest rates and house price deflation, on the other hand, were often locked in to high payments and punished by their 30-year fixed rate mortgages, which thereby made the housing bust worse in this country.   

The second fundamental question of housing finance systems is who will bear the credit risk.  In most countries, the lender retains the credit risk, which is undoubtedly the superior alignment of incentives.  With covered bonds, which are used in many countries, you can simultaneously achieve fixed-rate funding while keeping the lender fully on the hook for the credit performance of the mortgage loans being funded. 

The American GSE approach (and also that of private MBS) systematically separates the credit risk from the lender-- so you divest the credit risk of the loans you make to your own customers.  This was and is a distinct outlier among countries.  It had disastrous results, needless to say.

The most perfect conceptual solution to the two fundamental questions of housing finance, which functions very well in practice in its national setting, is the housing finance system of Denmark.  This system has been justifiably admired by many observers.  It operates in a small country, but represents big basic ideas.

The Danish mortgage approach to interest rate risk in its funding market is explicitly governed by what it calls the “matching principle.”  This means that the interest rate and prepayment characteristics of the mortgage loans being funded are passed on entirely to the investor in Danish mortgage covered bonds.  This allows long-term fixed rate mortgages, as well as variable rate mortgages. 

At the same time, the entire credit risk is retained by the mortgage bank lenders.  They have 100% “skin in the game” for credit risk, in exchange for an annual fee, thus insuring alignment of incentives for credit performance.  Deficiency judgments, if foreclosure on a house does not cover the mortgage debt, are actively pursued.  In other words, mortgage loans are always made with recourse to the borrower’s other income and assets.  This is true in most countries.  The U.S. state laws or practices of non-recourse mortgage lending are again a distinct outlier. 

The fundamentals of the Danish mortgage system go back over 200 years, to the 1790s.  There are no GSEs.  The Danish system can deliver long-term fixed rate loans of up to 30 years with a prepayment option.  This is a private housing finance system build on quite robust principles, which claims that no mortgage bond holder has suffered a credit loss in over two centuries. Denmark can and in the last decade did have a housing price bubble and bust, but the housing finance sector performed much better through it than did ours, and its covered bonds were sold throughout 2007-09.   We should note that the Danish system generates a home ownership rate of 54%, on the low side.

Another interesting case of the splitting of bond market funding and credit risk is that of Cagamas, or the National Mortgage Company of Malaysia.  Cagamas buys mortgage loans from lenders, and then issues bonds to finance them, but the mortgage purchases are with full recourse to the lender, so the lender retains 100% of the credit risk and the alignment of incentives.  

Cagamas is 80% owned by the banks and 20% by the Malaysian central bank, so it is a GSE, but not a Fannie and Freddie-style GSE.  Instead it functionally resembles the Federal Home Loan Banks (FHLBs).  FHLBs provide bond market funding for mortgages through advances to banks, but the banks retain all the credit risk.  FHLBs also buy mortgages, but only when the bank credit enhances the mortgages it has made.  (It may be of interest that of all sizeable American GSEs, considering Fannie, Freddie and the Farm Credit Banks, the FHLBs are the only ones which have never gone broke.) 

A very stable, sound, and very conservative housing finance market is that of Germany.  Some of its banks got into trouble in this cycle by buying U.S. mortgage securities, but their domestic mortgage market did not experience either a housing price boom-bust or a mortgage credit crisis.  The problem is that the German system generates a very low home ownership rate, only 43%--as well as a relatively late age at which people are on average able to buy houses.  I imagine that neither of these would be politically acceptable in the U.S.

Nevertheless, there are two German ideas worthy of study.  One is the German version of mortgage covered bonds (“Pfandbriefe”).  With a statutory basis more than one hundred years old (and, it is claimed, a history going back to Frederick the Great in the 18th century), these covered bonds form and large and relatively stable source of bond-based mortgage funding with no GSE.  The issuing bank retains all the credit risk of the mortgage loans. Mortgage loans funded with these covered bonds have a maximum LTV of 60%.

Many people have proposed, and I agree, that the U.S. should introduce covered bonds without a government guaranty as a mortgage funding alternative, as part of escaping from the mortgage market’s subservience to GSEs.

A second German housing finance idea worth considering is their emphasizing the role of savings as an essential part of sound housing finance.  The German building and savings banks (“Bausparkassen”) continue to practice the savings contract, which was once also common in this country.  By such a contract, the borrower commits to regular savings as part of qualifying for a mortgage loan.  This is, in my opinion, a very old-fashioned, very good idea.

Canada makes a pertinent comparison for the U.S., both countries being advanced, stable, financially sophisticated and North American. The Canadian housing finance system, like most in the world, has no GSEs.  It is primarily funded on the balance sheets of banks, although Canadian banks are also becoming issuers of covered bonds under new legislation, and it came through the crisis of 2007-09 in much better shape than did we did.  Mortgage lending is more conservative and creditor-friendly, and the Canadian system currently produces a higher home ownership rate of 67%.

Although it has no GSEs, Canada does have a very important government body to promote housing finance, which plays a substantial role in the mortgage sector.  This is the Canada Mortgage and Housing Corporation (CMHC).  Its principal activity is insuring (i.e. guaranteeing) mortgage loans—and it guarantees approximately half of all Canadian mortgages.  This is about the same proportion as the combined Fannie and Freddie have of outstanding the U.S. mortgage credit exposure.

But in contrast to the game the U.S. played of pretending that Fannie and Freddie were “private,” and that the government exposure was not really there (it was only “implicit”), CMHC’s status is refreshingly clear and honest.  It is a 100% government-owned and controlled corporation.  It has an explicit guaranty from the government.  It also provides housing subsidies which are on budget and must be appropriated by Parliament.  So Canada, while having this large government intervention in the mortgage market, is definitely superior to us in candor and clarity about it.

This exemplifies what I believe to be a core principle:  You can be a private company.  Or you can be part of the government.  But you should never be allowed to pretend you are both.  In other words, Fannie and Freddie should cease to be GSEs.  Considering the international anomaly and the disastrous government experiment they represent, we should all be able to agree on this.

Thank you again for the opportunity to share these views.

The Subprime Bust and the One-Page Mortgage Disclosure

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

Washington, DC 

To the Senate Banking and Financial Institutions Committee

State of Michigan

The Subprime Bust and the One-Page Mortgage Disclosure 

November 28, 2007

Mr. Chairman, Vice Chairmen Sanborn and Hunter, and members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I spent 35 years in banking, including 12 years as President and CEO of the Federal Home Loan Bank of Chicago, and am a Past President of the International Union for Housing Finance.  I have both experienced and studied many credit cycles, of which the housing and subprime mortgage boom and bust is the latest example.  Before all that, I grew up in Michigan, in the City of Detroit, graduating from Redford High School.

The deflation of the housing bubble and the subprime mortgage bust is, as everyone now knows, the biggest financial issue of the year, and nowhere more so than in Michigan.  I will address two aspects of this issue: understanding the fundamental pattern in which we are caught; and making sure future borrowers are better equipped to protect themselves than those of today.

The severe problems of all the industries involved in housing and mortgage finance, as well as of a great many mortgage borrowers, can best be understood as the deflation of a classic asset bubble.  The boom is always marked by rapid and unsustainable asset price increases, inducing and fueled by a credit overexpansion marked by unwise optimism, which leads to unwise credit decisions on the part of both lenders and borrowers.  The inevitable bust follows with defaults, losses and a credit contraction.  We are in the midst, and by no means near the end, of the contraction.

American residential mortgages represent the largest credit market in the world, and residential real estate is a huge asset class and component of household wealth. The negative effects of the deflating bubble on macroeconomic growth are sizeable and significant—some forecasters believe negative enough to cause a recession, which will in turn worsen the mortgage credit problems.

Among possible political responses are temporary programs to bridge and partially offset the impact of the bust, and to reduce the risk of a housing sector debt deflation or self-reinforcing downward spiral.

We can also take long term steps to fundamentally improve the functioning of the mortgage market.  Today I will focus on a very simple but powerful proposal, which has been introduced into both houses of the U.S. Congress, passed as a local ordinance in by the Washington, DC Council, and could be used at a state level: a one-page mortgage disclosure which tells borrowers what they really need to know about their mortgage loan in a clear and straightforward way.  This would both better equip borrowers to protect themselves and make the mortgage market more efficient.

1. Understanding the Fundamental Pattern

Needless to say, the unsustainable expansion of subprime mortgage credit and the great American house price inflation of the new 21st century are both over.  Former enthusiasm at rising home ownership rates and financial innovation (now a little hard to remember) have been replaced by an international credit market panic, layoffs, closing or bankruptcy of more than a hundred subprime lenders, still accelerating delinquencies and foreclosures, a deep recession in the homebuilding industry, tens of billions of dollars of announced losses by financial firms, tightening or disappearing liquidity, increasingly pessimistic forecasts, and of course, recriminations.

A few months ago, typical estimates of the credit losses involved were about $100 billion.  Then they grew to $150 billion, a number Federal Reserve Chairman Bernanke recently cited, and which I believe to be a reasonable estimate.  Other forecasts have the total losses at $250 billion, $300 billion, and even $400 billion—well, uncertainty is high.  Those are the losses for the lenders; for the borrowers, as you all know only too well, rising foreclosures are an obvious social and political issue.  

All these elements display the classic patterns of recurring credit overexpansions and their aftermath, as colorfully discussed by students of financial cycles like Charles Kindleberger, Walter Bagehot and Hyman Minsky.  Such expansions are always based on optimism and the euphoric belief in the ever-rising price of some asset class—in this case, houses and condominiums.  This appears to offer a surefire way for lenders, investors, borrowers and speculators to make money, and indeed they do, for a while.  As long as prices always rise, everyone can be a winner.

A good example of such thinking was the 2005 book by an expert housing economist entitled, Are You Missing the Real Estate Boom? Why the Boom Will Not Bust and Why Property Values Will Continue to Climb Through the Rest of the Decade. 

This time, we had several years of remarkably rising house prices—the greatest U.S. house price inflation ever, according to Professor Robert Shiller of Yale University.  The total value of residential real estate about doubled between 1999 and 2006, increasing by $10 trillion.  The great price inflation stimulated the lenders, the investors, the borrowers and the speculators.   If the price of an asset is always rising, the risk of loans seems less and less, even as the risk is in fact increasing, and more leverage always seems better.

A key point is that in the boom, many people experience financial success.  This so-far successful speculation is extrapolated.  Subprime borrowers could get loans to buy houses they would otherwise be unable to and benefit from subsequent price appreciation.  A borrower who took out a very risky 100% LTV, adjustable rate mortgage with a teaser rate to buy a house which subsequently appreciated 30% or 40% now had substantial equity and a successful outcome as a result of taking risk.

Should people be able to take such risks if they want to?  Yes, but they should have a clear idea of what they’re doing.

Of course, we know what always happens sooner or later: the increased risk comes home to roost, prices fall, and there is a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of fraud and swindles, and the search for the guilty.  You would think we would learn, but we don’t.  Then come late-cycle political reactions.

With regard to the last point, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, the Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988.  (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.)  Kindleberger estimated that over the centuries, financial crises recur about once a decade on average, and so apparently do emergency housing acts.  It seems probable to me that, given the current problems, this fall or winter will bring an emergency housing act of 2007 or 2008. Indeed, the “Emergency Home Ownership and Mortgage Equity Protection Act of 2007” has been introduced in to the Congress.

A year ago, it was common to say that while house prices would periodically fall on a regional basis, they could not on a national basis, because that had not happened in the large U.S. market since the Great Depression.  Well, now house prices are falling on a national basis, as measured by the S&P/Case-Shiller national index. 

House sales have dropped steeply, and for-sale inventories of new and existing houses and condominiums are high.  At the same time, rising mortgage delinquencies and defaults, along with the collapse of funding through securitization, have caused lenders to drop subprime products or exit the business altogether and generally raise credit standards. The Chairman of Countrywide Credit has announced, “We are out of the subprime business.”  Sharply reduced mortgage credit availability reduces housing demand.

With excess supply and falling demand, it is not difficult to arrive at a forecast of further drops in house prices.  The recent Goldman Sachs housing forecast, pointing out “substantial excess supply” and that “credit is being rationed,” projects that average house prices will fall 7% a year through 2008.  This is along with projected falling home sales and housing starts.

Professor Shiller has suggested that this cycle could see “more than a 15% real drop in national home price indicies.”  Certainly a return to long term trends in house values would imply a significant adjustment.

The Bank of America’s current forecast has nominal house prices falling 15% (real prices over 30%) over four years, having started this year and not bottoming until 2011. 

Thus the “HPA” or house price appreciation of credit models has now become “HPD”—house price depreciation.

The June 30, 2007 National Delinquency Survey of the Mortgage Bankers Association reports a total of 1,090,300 seriously delinquent mortgages.  Serious delinquency means loans 90 days or more past due plus loans in foreclosure.  Of the total, 575,200 are subprime loans.  Thus subprime mortgages, which represent about 14% of mortgage loans, are 53% of serious delinquencies. 

The survey reports 618,900 loans in foreclosure, of which 342,500 or 55% are subprime.

The ratio of subprime loans in foreclosure peaked in 2002 at about 9%, compared to its June 30 level of 5.5%.  Seriously delinquent subprime loans peaked during 2002 at 11.9%, compared to 9.3%. These second-quarter ratios are not as bad as five years ago, but they are still rising. 

A systematic regularity of mortgage finance is that adjustable rate loans have higher defaults and losses than fixed rate loans within each quality class.  Thus we may array the June 30, 2007 serious delinquency ratios as follows:

                  Prime fixed              0.67%              Prime ARMs             2.02%

                  FHA fixed                4.76%              FHA ARMs               6.95%

                  Subprime fixed        5.84%              Subprime ARMs     12.40%

The particular problem of subprime ARMs leaps out of the numbers. The total range is remarkable: the subprime ARM serious delinquency ratio is over 18 times that of prime fixed rate loans. 

Mortgage finance has some reliable systematic risk factors.  The mortgage boom had all the systemic risk factors operating together:

-Subprime loans have higher defaults and losses than prime loans.

-Adjustable rate loans of all kinds have higher defaults and losses than fixed rate loans.

-High loan-to-value (LTV) loans have higher defaults and losses than low LTV loans.

-Low documentation loans have higher defaults and losses than standard documentation loans. 

-Loans for investment properties have higher defaults than loans for owner-occupied houses.

The subprime mortgage lenders knew all these statements were true, but the risk acceleration of the boom outstripped the expectations of their models.  As Moore’s Law of Finance states, “The model works until it doesn’t.” 

A central problem is that during the boom the subprime market got very much larger than it used to be.  In the years of credit overexpansion, it grew to $1.3 trillion in outstanding loans, up over 8 times from its $150 billion in 2000.  So the financial and political impact of the subprime level of delinquency and foreclosure is much greater than in earlier years. 

But for Michigan, it is not only a subprime problem.  Michigan’s serious delinquency rate for all mortgage loans is 4.61%, almost twice the national average of 2.47%.  This reflects the employment problems of the domestic auto industry, on top of the housing deflation, as is also the case for the neighboring high-delinquency states of Ohio and Indiana.

Michigan’s serious delinquency rates are more or less double the national average in all mortgage loan categories, with the June 30 comparisons as follows: 

                                                        Michigan               U.S.                 Michigan/U.S.

Subprime ARMs                               21.08%              12.40%                    1.7X 

FHA ARMs                                       13.78%                6.95%                    2X

FHA fixed rate                                   10.75%                4.76%                    2.3X 

Subprime fixed rate                             9.47%                5.84%                    1.6X 

Prime ARMs                                        4.65%                2.02%                    2.3X

Prime fixed rate                                   1.34%                 0.67%                    2X

For the country as a whole, fixed rate FHA loans have a serious delinquency rate similar to that for fixed rate subprime loans.  This is also true for Michigan, which also has the highest FHA serious delinquency rate of any state.

The American residential mortgage market has about $10 trillion in outstanding loans.  Residential real estate is a huge asset class, with an aggregate value of about $21 trillion, and is of course the single largest component of the wealth of most households. 

A 15% average house price decline would mean a more than $3 trillion loss of wealth for U.S. households, which would be especially painful for those who are highly leveraged.  It would certainly put a crimp in getting cash to spend through cash-out refinancing and home equity loans.

The deflation of a bubble centered on such large stocks of debt and assets always causes serious macroeconomic drag.  Housing busts have typically translated into recessions.  It goes without saying that the current bust has already been and will continue to be a significant negative for economic growth.  Moody’s recently forecast that the “unexpectedly steep and persistent downturn” in the mortgage and housing sector would last until 2009. 

At an AEI conference last March, my colleague Desmond Lachman predicted that the economic impact of the housing problems would be much worse than was generally being said at the time, including what he considered the overoptimistic view of the Federal Reserve, and that they would become a major political issue.  These were certainly good calls. 

Large losses from the deflating housing and mortgage bubble have already happened and must unavoidably work their way through the financial and economic system.  Reductions in household wealth and tighter credit constraints on consumers might be enough to turn consumption growth negative and cause a recession.

This would be, my colleague John Makin has suggested, “the price we pay” for the housing bubble.

2. A Simple Proposal for Fundamental Improvement: The One-Page Form

The mortgage market, like all financial markets, is constantly experimenting with how much risk there should be. The subprime mortgage boom obviously overshot on risk creation; lenders, borrowers and the economy are now paying the price.  “Risk,” as an old boss of mine used to say, “is the price you never thought you’d have to pay.”

Should ordinary people be free to take a risk in order to own a home, if they want to?  Yes, provided they understand what they are getting into.  (This is a pretty modest risk, to say the least, compared to those our immigrant and pioneer ancestors took, such as my great-grandfather, heading out to his homesteaded farm in Michigan.)   

Should lenders be able to make risky loans to people with poor credit records, if they want to?  Yes, provided they tell borrowers the truth about what the loan obligation involves in a straightforward, clear way. 

A market economy based on voluntary exchange and contracts requires that the parties understand the contracts they are entering into.  A good mortgage finance system requires that the borrowers understand how the loan will work and how much of their income it will demand.

Nothing is more clear than that the current American mortgage system does not achieve this.  Rather it provides an intimidating experience of being overwhelmed and befuddled by a huge stack of documents in confusing language and small type presented to us for signature at a mortgage closing.  This complexity results from legal and compliance requirements; ironically, past regulatory attempts to insure full disclosure have made the problem worse.  This is because they attempt full, rather than relevant, disclosure. 

Trying to describe 100% of the details in legalese and bureaucratese results in essentially zero actual information transfer to the borrower.  The FTC recently completed a very instructive study of standard mortgage loan disclosure documents, concluding that “both prime and subprime borrowers failed to understand key loan terms.” 

Among the remarkable specifics, they found that:

          “About a third could not identify the interest rate” 

          “Half could not correctly identify the loan amount” 

          “Two-thirds did not recognize that they would be charged a prepayment penalty” and 

          “Nearly nine-tenths could not identify the total amount of up-front charges.”

As the events of the current bust have demonstrated, this problem is especially important in, though by no means limited to, the subprime mortgage market.

To help address these shortcomings of the mortgage market which are evident, I believe a new, superior disclosure approach is needed.  The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal.  Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments. 

The superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower well before closing.

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties.  The total monthly obligation needs to be put clearly in the context of the borrower’s income.

To have informed borrowers who can better protect themselves, the key information must be simply stated and clear, in regular-sized type, and presented from the perspective of what commitments the borrower is making and what that means relative to household income.  The borrowers can then “underwrite themselves” for the loan.  They have a natural incentive to do so—and can if they have the relevant intelligible, practical information. 

The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as principal loan terms.  The “housing expense ratio” means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income.  This should be shown for both the initial interest rate and the fully-indexed interest rate.  In typical types of subprime loans, as has become so painfully obvious, the fully-indexed expense ratio can be a remarkably larger burden than the initial or “teaser” rate suggests.

I have called the one-page form, “Basic Facts About Your Mortgage Loan.”  With it are brief explanations of the mortgage vocabulary and some avuncular advice for borrowers. Borrowers should receive it from the lender in time to ensure understanding and the ability to make a decision to seek alternatives.  A copy of the proposed form accompanies this testimony, as well as a copy of a Washington Post editorial recommending it. 

I believe mandatory use of this form would help achieve the required clarity, make borrowers better able to protect themselves by understanding what the mortgage really means to them, and at the same time would promote a more efficient mortgage finance system.  This seems to me a completely bipartisan idea, which should be implemented as a fundamental reform, whatever else is done or not done.

Thank you again for the opportunity to share these views.

Attachments:  

     The One-Page Form (“Basic Facts About Your Mortgage Loan”)

     Washington Post editorial (“The Next Financial Crisis—How to Avoid It”)

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Hearing on Systemic Risk and Regulation

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Financial Services

United States House of Representatives

Hearing on Systemic Risk and Regulation 

October 2, 2007

Mr. Chairman, Ranking Member Bachus and members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I spent 35 years in banking, including twelve years as President and CEO of the Federal Home Loan Bank of Chicago.  I am a Past President of the International Union for Housing Finance and a director of three companies in financial businesses. 

My career has included many credit cycles which involved issues of systemic risk, from the credit crunch of 1969, the commercial paper panic of 1970, and the real estate investment trust collapse of 1975 (in which the entire commercial banking system was thought by some to be insolvent) to the current example of the credit panic triggered by the ongoing subprime mortgage and housing bust, and a number of others in between.  Moreover, I have studied the long history of such financial events and their recurring patterns. 

Booms and Busts in Context

To begin with, let me try to put the issues of financial booms and busts and the related question of systemic risk in context.

The fundamental principle is that long term growth and the greatest economic well being for ordinary people can only be created by market innovation and experimentation.  Markets for goods and services must be accompanied by markets in financial instruments, which by definition place a current price on future, thus inherently uncertain, events.  This much is obvious but easy to forget when addressing the results of a bust with the benefit of hindsight, when it seems like you would have to stupid to make the mistakes that smart people actually made.

Dealing with putting prices on the inherently uncertain future, all financial markets are constantly experimenting with how much risk there should be, how risks are distributed, what the price of risk-bearing should be, and how risk trades off with financial success or failure.  Should individuals and institutions be free to take financial risks if they want to?  Yes, they should.

In the boom, many people succeed, just as many people succeeded for a long time in the subprime mortgage and housing boom.  This success gets extrapolated, supports optimism and makes lenders and investors, including private pools of capital, confident.  Lender and investor confidence tends to the underestimation of risks, in particular, the risk that the price of the asset in favor, most recently houses, could fall or fall very much; and underestimation of the risk that if prices fall, especially in a leveraged sector, asset and credit markets could become illiquid.

In my opinion, the principles stated by the President’s Working Group for private pools of capital are professional and sensible.  But even if everybody followed them, we would not avoid the inevitable times of financial turbulence.

We know for certain that markets will create long term growth and also cyclical booms and busts, but just what or when the outcome of a particular innovation will be cannot be known in advance.  It can only be discovered by running the market experiment, as so brilliantly discussed in Friedrich Hayek’s “Competition as a Discovery Procedure.”

How hard it is to outguess this discovery procedure is shown by the fact that a mere three months ago, the financial and economic world was constantly treated to statements by very intelligent and well-informed people that there was “abundant liquidity” or even a “flood of liquidity,” which would guarantee a firm market bid for risky assets and narrow spreads.  Then we were suddenly confronted with a lack of bids, nonfunctioning markets and the “evaporation of liquidity.”

Likewise, some very intelligent and well-informed people said, up until August, that the subprime mortgage bust would be “contained” and not cause wider financial or economic problems.  Now we have had a subprime-induced credit panic and an ongoing credit crunch, with falling house prices, but the stock market has gone back up to near its high.  How do we interpret that?  

A fundamental point is that markets are recursive.  Whatever opinions influence buying and selling and hedging, whatever models of financial behavior are relied on, whatever is done to regulate them, are all fed back into the system of interactions and change behavior in unpredictable ways.  Thus models of financial behavior, themselves changing the market, tend to become less effective or obsolete, as did subprime credit models. 

Regulations likewise change financial behavior, are arbitraged, and may end up producing the opposite of their intent.  This is why regardless of what any regulator or legislator may do, markets will always create however much risk they want.  Then when the bust has begun, regulatory actions to reduce or control risk may turn out to be procyclical, reinforcing the downward momentum.

Models  

To successfully avoid booms and busts, regulatory operations or market actors would have to know the future.  They often attempt to do so through creating models.

Of course, there is always a difference between financial models, however mathematically refined, and financial reality.  This is so whether the models are those of Wall Street “rocket scientists” structuring securities, credit rating agencies, hedge funds or other private pools of capital, sophisticated institutions, the Federal Reserve or other regulators, or investment analysts.  Finance cannot in principle be turned into physics. 

John Maynard Keynes memorably observed that a prudent banker is one who goes broke when everybody else goes broke.  One way to do this is to use models with the same assumptions that everybody else has.  Then you can be confident when everybody else is confident and afraid when everybody else is afraid. (We can be skeptical of the models approach of Basel II in this respect.)

Once a Decade, On Average

The classic patterns of booms based on credit overexpansions and their following busts are colorfully discussed by such students of financial cycles as Charles Kindleberger, Walter Bagehot and Hyman Minsky. 

Kindleberger, surveying several centuries of financial history, observed that financial crises and scandals occur, on average, about once every ten years.  This matches my own experience.  Every bust is followed by reforms, but the next bust arrives nonetheless.  Still the trend of market innovation and long term growth continues.

The increased risk accumulated in credit overexpansions ultimately comes home to roost and prices of the favored asset fall.  There is a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of frauds and swindles (always), and then the search for the guilty.  There is a sharp restriction of credit.  For example, the chief executive of Countrywide recently announced, “We are out of the subprime business.” 

There is a generalized retreat from risky assets, and a new danger arises: fire sales of assets turning into a debt deflation and the ruin of the financial system—systemic risk has arrived.  Our students of financial cycles all support government intervention to stabilize the downward momentum.  This is the correct answer as long as it is temporary.

To come to the current situation, it is evident that the present combination of the excess inventory of houses and condominiums, with the rapid restriction of mortgage credit—in other words, increased supply plus falling demand, equals a trend of falling house prices.  The models used to analyze, rate and price subprime securitizations include as a key factor house price appreciation (“HPA” in the trade jargon).  Now that we have house price depreciation, what will happen if prices fall much more and much more broadly than the models, the investors, the lenders and the regulators thought they could?

Unfortunately, a vicious cycle of falling house prices, more defaults, further credit tightening, less demand, further falls in prices, more defaults, and so on, is possible for a while, though of course not forever.  Financial market result: Fear. 

The fear is increased by great uncertainty about the value of subprime securities if no one wants to buy them anymore.  What are they worth as assets to an investor, notably a leveraged investor?  What are they worth as collateral to a lender—especially a very risk-averse repo dealer or commercial paper buyer?

Greater disclosure and transparency are reasonably suggested, although financial accounting, at least, is never truly “transparent.”

For example, what does “value” even mean when there are few or no buyers?  How can assets be marked to market if there is no active market?  Should everybody’s portfolio be marked to fire sale prices, or instead to some estimate of intrinsic value?  Who is actually broke and who isn’t?  The answers to these classic questions of the bust are never clear, except in retrospect.

Liquidity

As Bagehot wrote, “Every great crisis reveals the excessive speculations of many houses which no one before suspected.”  So has our current bust, and these unpleasant surprises reinforce the uncertainty make about who is broke and who isn’t (perhaps including yourself).  With this uncertainty and personal as well as institutional risk, everyone becomes conservative at once.  When all investors and lenders, institutionally and personally, try quite logically to protect themselves by avoiding risk, the result is to make liquidity disappear and to put the whole at risk. Note that possibility of regulatory or political punishment arising from the search for the guilty will increase the risk aversion.

In other words, it is belated risk aversion which creates systemic risk. To understand why this can happen, we have to see that “liquidity” is not a substance which can “flow,” be a “flood,” “slosh around,” or be “pumped” somewhere, to use a number of misleading expressions.

In fact, liquidity is a figure of speech.  It is verbal shorthand for the following situation:  

     -A is ready and able to buy an asset from B on short notice

     -At a price B considers reasonable

     -Which usually means  C has to be willing to lend money to A

     -And if C is a dealer, both A and C have to believe the asset could readily be sold to D

     -Which means A and C believe there is an E willing to lend money to D.

Good times, a long period of profits, and an expansionary economy induce financial actors and observers to take this situation, “liquidity,” too much for granted, so liquidity comes to be thought of as how much you can borrow.  When the crisis comes, it is found to be about what happens when you can’t borrow, except from some government instrumentality.

At this point we have arrived at why central banks exist.  The power of the government, with its ability to compel, borrow, tax, print money, and credibly guarantee the payment of claims, can intervene to break the everybody-stops-taking-risk-at-once psychology of systemic risk.

The key is to assure that this intervention is temporary, as are credit panics by nature.  As historically recent examples of government interventions in housing busts, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, the Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988.  (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.)  This is in line with Kindleberger’s estimate of about once a decade on average, and an emergency housing act of 2007 would fit the pattern.

The liquidity crunch won’t last forever.  Large losses will be taken,  the market get used to the idea, who is broke and who isn’t sorted out, failures reorganized, risks reassessed, models rewritten, and revised clearing prices discovered.  A, B, C, D and E will get back into business trading and lending to each other again. 

Liquidity will return reasonably quickly for markets in prime instruments.  One long time observer of finance, whose insights I value, has predicted that “the panic about credit markets will be a memory by Thanksgiving.”

I believe this is probably right; however, the severe problems with subprime mortgages and securities made out of them, related defaults and foreclosures, and falling house prices will continue long past then.  They will continue to cause macroeconomic drag and financial difficulties, but the moment of systemic panic will have passed. 

The “Cincinnatian Doctrine”

In conclusion, my view is that it is not possible to design society, no matter what regulatory systems may be implemented, to avoid financial booms and busts and their resulting risk of systemic panics.  We do need temporary interventions of the government periodically, when the financial system is threatened by a downward spiraling debt deflation.  In other words, booms and busts are endemic to market economies with financial markets in which people are free to take risks and engage in borrowing against the uncertain future.  They are a price well worth paying in return for the innovation and growth only such markets can create.

In normal times, that is, about 90% of the time, we predominately want the economic efficiency, innovation, productivity and the resulting well-being for ordinary people produced by competitive markets.  But when the financial system hits its inevitable periodic crises, about 10% of the time, the intervention of the government is often necessary.  This intervention should be temporary.  If prolonged, it will tend to cartels, bureaucracy, less innovation, and less growth.  In the extreme, of course, it becomes socialist stagnation. 

Thus I suggest a 90%-10% policy mix.  I have elsewhere explored this idea as the “Cincinnatian Doctrine.”

In the wake of every bust, various plans are put in place to prevent all future ones, but the next bust arrives in about ten years anyway. Such plans suffer from the assumption that financial group behavior is mechanistic and can be addressed by designing mechanisms.  In fact, it is organic, creative, recursive and emergent. That is the source of its strength in creating wealth, also of its weakness in getting periodically carried away.  I do not believe any regulatory structures can alter these fundamental characteristics.

Thank you again for the opportunity to share these views.

Hearing on Bank Mergers and Subprime Mortgage Credit Problems

From Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Domestic Policy Committee on Oversight and Government Reform

United States House of Representatives

Hearing on Bank Mergers and Subprime Mortgage Credit Problems

Cleveland, Ohio May 21, 2007

***

The One-Page Mortgage Disclosure Proposal

When considering borrowers in financial trouble, whether from unwise borrowing, not having understood the loan, or even induced into loans by misrepresentation, there is a natural political reaction to try to protect them through credit regulation.

I believe a superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income. The borrowers can then “underwrite themselves.” They have the natural incentive to do so—we need to add intelligible, practical information.

To help address the shortcomings of the subprime market which have become evident, I believe a new, superior disclosure approach is needed, whether or not we do anything else. The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal. Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower three days before closing. 2

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties. The total monthly obligation needs to be put clearly in the context of the borrower’s income.

Current American mortgage loan documents certainly do not achieve this. Most of us have had the experience of being overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to us for signature at a mortgage closing. The complexity results from legal and compliance requirements. Ironically, past regulatory attempts to insure full disclosure have made the problem worse. That is because they attempt full, rather than relevant, disclosure.

To achieve an informed borrower, the key information must be simply stated and clear, in regular-sized type: 90% of the relevant information which is clear and understandable is far better than 100% of the details which are complex and hard to read. Trying to describe the details in specific legal and bureaucratic terms results in essentially zero information transfer to the borrower.

The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as principal loan terms. The “housing expense ratio” means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income. This should be shown for both the initial interest rate and the fully-indexed interest rate. In typical types of subprime loans, the fully-indexed expense ratio can be a remarkably larger burden than the initial or “teaser” rate suggests.

The proposed one-page “Basic Facts About Your Mortgage Loan” form, with accompanying common sense explanations and avuncular advice, is Attachment 1.

One of the deans of mortgage journalists has written of how the one-page proposal is distinct from previous regulations and simplification attempts. His article is also attached.

Whatever else is done or not done, I believe the one-page disclosure would be an important step forward for America’s and Ohio’s mortgage borrowers and housing finance system.

How to Improve the Credit Rating Agency Sector

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Banking, Housing and Urban Affairs

United States Senate 

Hearing on Assessing the Current Oversight and Operations of Credit Rating Agencies

March 7, 2006

How to Improve the Credit Rating Agency Sector

Good morning, Mr. Chairman, Ranking Member Sarbanes and members of the Committee.  Thank you for the opportunity to testify today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views on the need to reform the credit rating agency sector.

It is important and timely for Congress to address this issue.  There is no doubt that the existing SEC regulation and practice represents a significant anti-competitive barrier to entry in the credit rating business, although this was not intended when the regulation was introduced 30 years ago.  Nonetheless, the actual result of the SEC’s actions, and in recent years, inaction, has been to create what is in effect a government-sponsored cartel.

A few weeks ago Barron’s magazine had this to say about the two leading rating agencies:

     “Moody’s and Standard and Poor’s are among the world’s great businesses.  The firms amount to a duopoly and they have enjoyed huge growth in revenue and profits in the past decade.”

Barron’s continues:

     “Moody’s has a lush operating profit margin of 55%...S&P’s [is] 42%.”

An equity analyst’s investment recommendation from last year explains the reason for this exceptional and enviable profit performance: 

     “Companies are not unlike medieval castles.  The most successful are that boast some sort of economic moat that makes it difficult, if not impossible, for competitors to attack or emulate.  Thanks to the fact that the credit ratings market is heavily regulated by the federal government, rating agencies enjoy a wide economic moat.”  (emphasis added)

This is an accurate assessment. 

I recommend that Congress remove such government-created protection or “economic moat,” and promote instead a truly competitive rating agency sector, with all the advantages to customers that competition will bring, including better prices, more customer choice, more innovation, greater efficiency, and reduced potential conflicts of interest. 

I believe that the time has come for legislation to achieve this. 

Instead of allowing the SEC to protect the dominant firms (in fact, if not on purpose), in my view Congress should mandate an approach which is pro-competitive and pro-market discipline.  Last year the AEI  published an article of mine (attached for the record) entitled, “End the Government-Sponsored Cartel in Credit Ratings”:  I respectfully hope Congress will do so this year. 

The “NRSRO” Issue

In the best theoretical case, not only the designation by the SEC of favored rating agencies, but also the regulatory term “NRSRO” would be eliminated.  The term has produced unintended effects never imagined when it was introduced in 1975, and in theory it is unquestionably time for it to retire.

In its place, the responsibility to choose among rating agencies and their services should belong to investors, financial firms, issuers, creditors and other users of ratings—in short, to the market.  A competitive market test, not a bureaucratic process, will then determine which rating agencies turn out to be “widely accepted by the predominant users of ratings,” and competition will provide its normal benefits.

This is altogether different from the approach taken in proposals by the SEC staff, which in my opinion, are entirely unsatisfactory.

Very much in the right direction is the bill introduced in the House by Congressman Michael Fitzpatrick, HR 2990. 

This bill directly addresses the fact that a major practical obstacle to reform is that the SEC’s “NRSRO” designation has over three decades become enshrined in a very large and complex web of interlocking regulations and statutes affecting thousands of financial actors.  The combined effect is to spread the anti-competitive force of the SEC’s regulation throughout the financial system, with too few customer alternatives, too little price and service competition, and the extremely high profits for the favored firms, as we have already noted.  But how can we untangle this regulatory web?

As you know, HR 2990 does so in what I think is an elegant fashion by keeping the abbreviation “NRSRO,” but completely changing its meaning.  By changing the first “R” from “Recognized” to “Registered,” it moves from a restrictive designation regime, to a pro-competitive disclosure regime.  This change, in my view, is in the best tradition of American financial market theory and practice: competition based on disclosure, with informed investors making their own choices. 

Voluntary Registration 

Becoming an “NRSRO” is now, and would be under a registration approach, an entry into the regulated use of your ratings by regulated financial entities.  Therefore I believe that registration in a new system should be entirely voluntary.  If any rating agency wants to continue as simply a private provider of ratings to customers who make such use of them as they desire, other than regulatory use, it should continue as it is, with no requirement to register.  But if it wants to be an “NRSRO,” the way is plain and open.

I think this voluntary approach entirely removes the First Amendment arguments which have been made against HR 2990. 

Rating Agency Pricing Models

An extremely important advantage of a voluntary registration, as opposed to an SEC designation, regime is that it would allow multiple rating agency pricing models to compete for customer favor.  The model of the dominant agencies is that securities issuers pay for credit ratings.  Some critics argue that this creates a conflict of interest.

The alternative of having investors purchase the credit ratings arguably creates a superior incentive structure.  This was the original historical model for the first 50 years of the rating agency business.  If investors pay, it obviously removes the potential conflict of interest and any tendency toward a “race to the bottom” in ratings quality.

In my view, there should be no regulatory or legal prescription of one model or the other:  the market should use whichever credit rating providers best serve the various needs, including the regulatory needs, of those who use the ratings. 

Transition to a New Regime

The decentralization of decisions entailed by a competitive, disclosure-based regime is wholly positive.  Investors and creditors, as well as multiple regulatory agencies, should have to think about how credit ratings should be used and what related policies they wish to adopt.  They should be expected to make informed judgments, rather than merely following an SEC staff decision about whether somebody is “recognized.”

The worst outcome, to be avoided in any case, would be regulation of actual credit ratings by the SEC, or (what would come to be equivalent) regulation of the process of forming credit ratings.  This would be a worse regime than we have now.

Of course, a fully competitive rating agency market will not happen all at once.  There are significant natural (as well as the SEC’s artificial) barriers to entry in this sector, including the need to establish reputation, reliability, and integrity; the prestige factor involved in the purchase of opinions and judgments; and the inherent conservatism of institutional risk management policies.  Nevertheless, in time, innovation and better products can surmount such barriers, when not prevented by regulation.

Because the desirable transition to a competitive rating agency sector would be evolutionary, I believe any concern about disrupting the fixed income markets is misplaced. 

It is important to remember that no matter what the rating agency regime may be, we simply cannot hope for 100% success in predicting future credit performance.  There will never be a world in which there are no ratings mistakes, any more than in any other endeavor which makes judgments about future risks and uncertainties.  But this fact only emphasizes the importance of a vibrant marketplace of ratings opinions, analysis, ideas, forecasts, and risk assessments. 

On timing, the “NRSRO” issue has been a regulatory issue and discussion for a decade, in what seems to me a dilatory fashion.  My recommendation is that Congress should now settle the issue of competition vs. cartel in this key financial sector, moving to create the best American model of competition and disclosure, rather than prescription and government sponsorship. 

This will bring in time better customer service, more innovation, more customer alternatives, greater price competition, and reduced duopoly profits, and indeed better credit ratings will emerge.

Thank you again for the chance to be here today.