BankThink The CFPB is funded by the Fed's profits. Trouble is, there are none

Read the article in American Banker here.

JPMorgan Chase, FDIC put an end to First Republic's slow bleed

Published in the American Banker:

"There's a lesson in that for all finance that what seems like a darling and a wonderful winner at one moment seems like the opposite only a little while later," said Alex Pollock, a former Treasury Department official.

…

"Obviously there's a very generalized problem of people making the most classic financial mistake, which is investing in long-term fixed-rate assets and funding them with floating-rate money," Pollock said. "They were lulled into it by the actions of the central banks — by keeping interest rates both long and short-term very low for very long periods of time, and convincing people that it was going to continue."

Give Fannie, Freddie the same capital standards as everybody else

Published in American Banker.

Taking up a key issue in housing finance reform, one within his control as the new director of the Federal Housing Finance Agency, Mark Calabria told a conference recently that Fannie Mae and Freddie Mac must in the future have a strong capital position.

He’s absolutely right. And this would be in vivid contrast to the 0.2% capital ratio they have now.

Calabria stated that “all large, systemically important financial institutions should be well capitalized,” specifically including Fannie and Freddie. “That would seem non-debatable at this point.”

Indeed it does. No one can plausibly disagree.

But what is the number? What is the explicit capital ratio which would implement Calabria’s excellent principle?

I believe his remarks in effect gave us the answer by asking the question in this pertinent way: “How do we level the playing field to where all large financial institutions have similar capital” so that Fannie and Freddie do not have “lower standards than everybody else?”

The answer to this well-framed question is obvious: Give the government-sponsored enterprises the same capital requirement for mortgage risk that everybody else has. In short, the answer is 4%. This is the internationally recognized standard for mortgage risk, which represents virtually all of Fannie and Freddie’s assets. The FHFA should, in my view, immediately establish a minimum capital requirement for Fannie and Freddie of tangible equity equal to 4% of total assets.

Considering them on a combined basis, 4% of Fannie and Freddie’s assets of $5.5 trillion results in a required capital of $220 billion between the two of them. That is 22 times their current capital and $210 billion more capital than they’ve got right now.

Naturally, Fannie and Freddie cannot retain or raise any more capital while subject to the “profit sweep” to the Treasury, but let us suppose the senior preferred stock purchase agreements between the Treasury and the FHFA as conservator could be renegotiated. This outcome would not be unreasonable, since the Treasury now has an internal rate of return on its preferred stock investment of about 12% — which is pretty good — and much better than the original 10% agreement. On top of that, Treasury still has warrants to acquire 79.9% of Fannie and Freddie’s common stock at an exercise price of virtually zero (0.001 cents per share). That could be a nice pop for the taxpayers on top of the 12% average annual return.

As President Trump’s March 27 memorandum on housing finance reform makes clear, as part of any renegotiation, Fannie and Freddie will need to pay the Treasury for its ongoing credit support, implicit or otherwise. This should absolutely be required.

How much in fees should they pay? That is debatable, to be sure, but definitely not nothing. We might consider that the lowest rated banks on the FDIC’s deposit insurance fee table pay a range of 16 to 30 basis points of total liabilities per year for their government guarantee. Let’s give the critically undercapitalized Fannie and Freddie the benefit of the doubt and assume the lowest end of that range: a fee to the Treasury of 16 basis points.

What kind of return on equity could a Fannie and Freddie capitalized at 4% then expect? Here’s one estimate. Fannie and Freddie’s combined net profits for the first quarter of 2019 were $3.8 billion. That annualized is $15.2 billion — let’s call it $16 billion. Subtract from that the 16 basis point fee to the Treasury assessed on liabilities, which after tax would be $7 billion. Add the fact that they would have $210 billion more cash worth 2.5%, or approximately $4 billion, after tax. In sum, that gives $13 billion in net profit pro forma, or an ROE of about 6%. If the fee to Treasury were dropped to 10 basis points, the pro forma ROE would rise to a little over 7%.

That seems like a reasonable starting range. It compares to the 5-year average ROE of U.S. banks of 9.6%. From the 6% to 7% range, there are lots of actions in pricing, greater efficiency and improved methods for management to pursue. But running at hyper-leverage as in the old days and in the conservatorship days would not be possible. That would move the mortgage market toward the more competitive state that Calabria correctly envisions.

What should happen next? The FHFA should set a 4% capital standard for Fannie and Freddie. The Financial Stability Oversight Council should designate Fannie and Freddie as the “systemically important financial institutions” they so obviously are, treating them the same as others of their size. The Treasury should exercise as a gain for the taxpayers its warrants for their common stock, removing any uncertainty about the warrants.

When capital has become sufficient, the FHFA should end the conservatorships and implement regulation which ensures that Fannie and Freddie’s credit risk stays controlled and tracks how the more competitive, less GSE-centric mortgage system evolves.

Congress does not have to do anything in this scenario. That is good, because it is highly unlikely that it will do anything.

The unstable stability council

From American Banker’s Bankshot Podcast:

R Street’s Alex Pollock appears on the most recent Bankshot Podcast. At first the Financial Stability Oversight Council wanted to target individual nonbanks that pose a risk to the economy. Now it wants to target activities rather than firms. Is that a good idea or a political ploy? 

Click here to listen to the pull podcast.

Is Dodd-Frank council evolving, or throwing in the towel?

Published in the American Banker.

“In my judgment at the time” the FSOC was established was that “it was not well constructed,” said Alex Pollock, a senior fellow at the R Street Institute. “It’s set up to be naturally a logrolling operation among bureaucratic agencies. It’s a very hard kind of structure to get to work well, because everybody wants to defend his own territory from encroachment by somebody else.” 

Pollock said the council’s ability to prevent crises should not be the sole criteria for judging the shift toward an activities-based approach, because the alternative of designating firms one by one might not succeed, either. “I think it’s worth a try.”

Fed ‘independence’ is a slippery slope

Published in American Banker, The Federalist Society, The American Conservative, and Live Trendy News.

Many observers, like Captain Renault in Casablanca, were “shocked, shocked!” at President Trump’s sharp criticism of the Federal Reserve and his attempt to influence it against raising interest rates, inquiring whether the president can fire the Fed chairman.

Yet many presidents and their administrations have pressured the Fed, going back to its earliest days, when the Woodrow Wilson administration urged it to finance bonds for the American participation in the First World War. The Fed compliantly did so, proving itself very useful to the U.S. Treasury.

That was not surprising, since the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board, and the board met in the Treasury Department.

In the decades since then, lots of presidents have worked to influence the Fed’s actions. Their purpose was usually to prevent the Fed from raising interest rates, exactly like Trump. It was also often to cause the Fed to finance the U.S. Treasury and to keep down the cost of government debt, just as “quantitative easing” does now.
But has a president ever fired a Federal Reserve Board chairman?

Yes, in fact. President Truman effectively fired Fed Chairman Thomas McCabe in 1951. “McCabe was informed that his services were no longer satisfactory, and he quit,” Truman said. Being informed by the president that your performance is not satisfactory is being fired, I’d say. One might argue that McCabe didn’t have to resign, but he did.

The background to McCabe’s departure was a heated and very public dispute between the Truman administration, including Truman personally, and the Fed about interest rates and financing the Korean War. Truman had even summoned the entire Federal Reserve Open Market Committee to the White House, where he made plain what he wanted, which was straightforward. Since the Second World War, the Fed, as the servant of the Treasury, bought however many Treasury bonds it took to keep their interest rate steady at 2.5% — this was the “peg.” In the middle of the Korean War, Truman understandably wanted to continue it.

The Fed, on the other hand, was understandably worried about building inflation, and wanted to raise interest rates. As the two sides debated in January 1951, American military forces were going backwards down the Korean peninsula, in agonizing retreat before the onslaught of the Chinese army. Although financial historians always tell this story favoring the Fed, I have a lot of sympathy for Truman.

By now we have been endlessly instructed, especially by the Fed itself, that the Fed is and must be “independent,” and this has become an article of faith, especially for many economists. However, the opposite opinion has often been prominent, including when the Fed and the Treasury completely coordinated their actions during the financial crisis of 2007-2009 — as they should have.

What exactly does Fed “independence” mean? Allan Sproul, a long-time and influential president of the Federal Reserve Bank of New York, maintained that the Fed “is independent within the government.” That is masterfully ambiguous. It expresses a tension between the executive branch, Congress and the Fed, searching for an undefined political balance.

When McCabe resigned, Truman appointed, he thought, his own man, William McChesney Martin from the Treasury Department. Martin is often viewed as the hero of establishing Fed independence — correspondingly, Truman later considered him a “traitor.” But Martin’s understanding of what Fed “independence” means was complex: He “was always careful to frame his arguments in terms of independence from the executive branch, not from Congress,” a history of Fed leadership says.

“It is clear to me that it was intended the Federal Reserve should be independent and not responsible to the executive branch of the Government, but should be accountable to Congress,” Martin testified in 1951. “I like to think of a trustee relationship to see that the Treasury does not engage in the natural temptation to depreciate the currency.”

Seven decades later, how accountability to Congress should work is still not clear, and Martin would certainly be surprised that the current Fed has formally committed itself to the perpetual depreciation of the currency at 2% per year.

Martin stayed as Fed chairman until 1970, which allowed him to experience pressure from five different administrations. The most memorable instance was the personal pressure applied by President Johnson. In late 1965, the Fed raised interest rates with the war in Vietnam, domestic spending and government deficits expanding.

“Johnson summoned the Fed Chairman to his Texas ranch and physically shoved him around his living room, yelling in his face, ‘Boys are dying in Vietnam and Bill Martin doesn’t care!’” one history relates.

That’s quite a scene to imagine.

One may wonder whether Fed independence is a technical or a political question. It is political. The nature and behavior of money is always political, no matter how much technical effort at measuring and modeling economic factors there may be.

For example, the Fed over the last decade systematically took money away from savers and gave it to leveraged speculators by enforcing negative real interest rates. Taking money from some people to give it to others is a political act. That is why the Fed, like every other part of the government, should exist in a network of checks and balances and accountability.

There is also a fundamental problem of knowledge involved in the idea of independence. How much faith should one put in the judgments of the Fed, which are actually guesses? The answer is very little — about as much faith as in any other bunch of economic forecasts, given that the Fed’s record is as poor as everybody else’s. The Fed’s judgments are guesses by sophisticated, intelligent and serious people, but nonetheless guesses about an unknowable future.

Arthur Burns, the Fed chairman from 1970 to 1978, observed that among the reasons for “The Anguish of Central Banking” is that “in a rapidly changing world the opportunities for making mistakes are legion. Even facts about current conditions are often subject to misinterpretation.”

Very true — and moreover, the world is always changing.

In the light of the political reality of Federal Reserve history, a completely independent Fed looks impossible. In the light of the unknowable future, it looks undesirable.

Changes to capital rules should be part of GSE overhaul

Published in American Banker.

Changes to capital rules should be part of GSE overhaul

Acting Federal Housing Finance Agency Director Joseph Otting has certainly gotten the mortgage market’s attention.

To the great interest of all concerned, but especially to the joy of the speculators in Fannie and Freddie’s shares, he recently told agency staff that the FHFA and the Treasury would be working on a plan to soon take Fannie and Freddie out of their 10 years of government conservatorship. Their share prices jumped.

The joy — and the share prices — have since moderated, after more careful comments from the White House. Still, it appears that any near-term change would have to be done by administrative action, since there is zero chance that the divided Congress is going to do so by legislation.

The FHFA and Treasury can do it on their own. They put Fannie and Freddie into conservatorship and constructed the conservatorship’s financial regime. They can take them out and implement a new regime.

But should they? Only if, as part of the project, they remove the Fannie and Freddie capital arbitrage which leads to the hyper-leverage of the mortgage system.

Running up that leverage is the snake in the financial Garden of Eden. As everybody who has been in the banking business for at least two cycles knows, succumbing to this temptation increases profits in the short term but leads to the recurring financial fall.

Leverage is run up by arbitraging regulatory capital requirements in order to cut the capital backing mortgages. Before their failure, when they had at least had some capital, Fannie and Freddie still served to double the leverage of mortgage risk by creating mortgage-backed securities.

Here’s the basic math. The standard risk-based capital requirement for banks to own residential mortgage loans is 4% — in other words, leverage of 25 to 1. Yet if banks sold the loans to Fannie or Freddie, then bought them back in the form of mortgage-backed securities, Fannie and Freddie would have capital of only 0.45% and the banks only 1.6%, for a total of 2.05%, due to lower capital requirements for the government-sponsored enterprises. Voila! The systemic leverage of the same risk jumped to 49 from 25. This reflected the politicians’ chronic urge to pursue expansionary housing finance. Now that Fannie and Freddie have virtually no capital, even the 0.45% isn’t there.

The risks of the assets are the same no matter who holds them, and the same capital should protect the system no matter how the risks are moved around among institutions — from a bank to Fannie or Freddie, for example. If the risk is divided into parts, say the credit risk for Fannie or Freddie and the funding risk for the bank, the sum of the capital for the parts should be the same as for the asset as a whole.

But the existing system abysmally fails this test.

If 4% is the right risk-based capital for mortgages, then the system as a whole should always have to have at least 4%. If the banks need 1.6% capital to hold Fannie and Freddie mortgage-backed securities, then Fannie and Freddie must have 2.4% capital to support their guarantee, or about 5 times as much as their previous requirement. If Fannie and Freddie hold the mortgages in portfolio and thus all the risks, they should have a 4% capital requirement, 60% more than their former requirement.

The FHFA is working on capital requirements and has the power to make the required fix.

Bank regulation also needs to correct a related mistake. Fortunately, Mr. Otting is also Comptroller of the Currency. Banks were encouraged by regulation to invest in the equity of Fannie and Freddie on a super-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a risible 1.6%, since changed to a still risible 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (Your broker’s margin desk wouldn’t let you do that!)

In short, the banking system was used to double leverage Fannie and Freddie. To fix that, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so it really would be equity from a consolidated system point of view.

All in all, if Treasury and the FHFA decide to end the conservatorships, that would be fine. That is, provided they simultaneously stop the systemic capital arbitrage and add the two highly-related reforms.

Fannie and Freddie will continue to be too big to fail, even without the capital arbitrage, and will continue to be dependent on and benefit enormously from the Treasury’s effective guarantee. They need to pay an explicit fee for the value of this taxpayer support. The fee should be built in to any revision of the existing senior preferred stock purchase agreements between them and the Treasury.

Finally, Fannie and Freddie are without question systemically important financial institutions. To address their systemic risk, Treasury and the FHFA should get them formally designated as the SIFIs they so obviously are.

The Fed is technically insolvent. Should anybody care?

Published in American Banker.

As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?

The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.

If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.

The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.

And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?

All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.

Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.

People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.

About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?

Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.

When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.

It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.

It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?

Minneapolis Fed’s TBTF plan has some GSE-sized holes

Published in American Banker.

The Federal Reserve Bank of Minneapolis this winter finalized its “Minneapolis Plan to End Too Big to Fail” — that is, a plan intended to end the problem of “too big to fail” financial institutions, including both banks and nonbank financial companies.

But here is something remarkable: Fannie Mae and Freddie Mac, among the most egregious cases of “too big to fail,” appear nowhere at all in the plan.

Have the Federal Reserve Bank of Minneapolis authors forgotten how Fannie and Freddie blew masses of hot air into the housing bubble, then crashed, then got a $187 billion bailout from the U.S. Treasury? Have they not noticed that Fannie and Freddie remain utterly dependent on the credit guaranty of the Treasury, remaining TBTF to the core?

Since the plan focuses on excessive leverage as the fundamental cause of “too big to fail” risk, have they not considered that Fannie and Freddie each had capital of less than zero at the end of last year, so they had infinite leverage along with their $5.4 trillion in liabilities?

Defenders of Fannie and Freddie will cry that they can’t build capital when the Treasury takes all their profits every quarter. But whoever may be to blame does not change the overwhelming fact: the government-sponsored enterprises are “too big to fail.”

The Minneapolis plan notes that, under the current regime, firms “can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely.” This is true — and it is especially true of Fannie and Freddie. So the plan should say instead: “Under the current regime, banks and nonbank financial firms, including notably Fannie Mae and Freddie Mac with their $5 trillion in risk exposure, can continue as TBTF institutions potentially indefinitely.”

What should be done about the TBTF nonbank companies? According to the Minneapolis Fed, the answer is for the Congress to impose a “tax on leverage” that offsets the advantages of running at high leverage and low capital. This tax on leverage will apply to any company with more than $50 billion in total assets. Since Fannie has over $3 trillion of assets and Freddie over $2 trillion, it is safe to say they would qualify.

If the secretary of the Treasury certifies that the company in question does not pose systemic risk, the tax would be 1.2 percent of liabilities under the plan. It is certainly hard or impossible to imagine that any Treasury secretary could certify that Fannie and Freddie pose no systemic risk. So in their case the tax on leverage would be 2.2 percent of total liabilities — 2.2 percent of “anything other than high quality common equity.”

Among the types of firms that the plan would consider for the leverage tax are “funding corporations, real estate investment trusts, trust companies, money market mutual funds, finance companies, structured finance vehicles, broker/dealers, investment funds and hedge funds.” Again, and amazingly, Fannie and Freddie are not on the list.

But if this proposal applies to any these entities, or indeed to anybody at all, it certainly applies to Fannie and Freddie. That is especially true since the market arbitrages across capital requirements of different financial institutions. It sends mortgages to Fannie and Freddie, not because they are most skilled at managing risk, but rather because they have the highest leverage. This was true even before they crashed, since Fannie and Freddie had charters granting them far greater leverage than any other financial institutions.

We’ve calculated how much the proposed Minneapolis tax on leverage would cost these financial behemoths. For Fannie, total liabilities are $ 3.35 trillion, so the annual tax would be 2.2 percent times that, or $74 billion. Fannie’s profit before tax for the year 2017 was $18.4 billion, so the tax in the size proposed by the Minneapolis Plan would be four times Fannie’s total pretax profit.

For Freddie, the corresponding numbers are liabilities of $2.05 trillion and a leverage tax of $45 billion, which would be 2.7 times its 2017 pretax profit.

In short, instead of paying about 100 percent of their profits to the Treasury, Fannie and Freddie together would pay Treasury well over 300 percent of their profits. This would obviously cause them to operate at a huge pro forma loss.

As a first step, we make the much more modest proposal that Fannie and Freddie should be required to pay the Treasury for its credit support, which makes their existence possible, an annual fee of 0.15 percent to 0.20 percent. Such a fee would be consistent with what undercapitalized banks must pay for a government guarantee from the Federal Deposit Insurance Corp., which is also assessed on their total liabilities. Fannie and Freddie’s effective, though not explicit, guarantee from the Treasury is extremely valuable and should be paid for, without question. As is the intent of the Minneapolis plan, charging a fair price for it would significantly reduce the capital arbitrage the GSEs exploit, reduce the distortions and vulnerabilities they introduce into the mortgage market and reduce the massive taxpayer subsidies they have heretofore enjoyed.

As the foremost “too big to fail” institutions in the country — indeed, in the world — Fannie and Freddie must be included in any TBTF reform plan that is to be taken seriously.

A better way to assess disparate impact

Published in American Banker.

The Department of Housing and Urban Development is currently reviewing its disparate impact regulation, and it’s possible the courts, including the Supreme Court, could take the issue up once again.

Here’s the key issue: What if a lender applies the same credit underwriting standards to all credit applicants, but this results in different demographic groups having different credit approval-credit decline ratios? Is that necessarily a problem?

One position is that applying the same credit standards to everybody, regardless of demographic group, is exactly what every lender should be doing. Yet supporters of “disparate impact” argue that if there are different ratios for loan approvals versus loan declines among groups, it must mean there is some kind of hidden, even if entirely unintended, bias in the process.

Which side is right? There is a straightforward, data-based way to tell. It is simply to add to the report the default rates on the loans in question and compare them to the approval ratios by group.

Suppose, for example, that demographic Group A has a lower loan approval rate and therefore a higher decline rate than Group B. We must also compare their default rates. There are three possibilities: Group A either has the same, a lower or a higher default rate than Group B.

If Group A has the same default rate as Group B, then the underwriting procedure and the different approval-decline ratios were fair and appropriate, since they resulted in the same default outcome. Predicting and controlling defaults is the whole point of doing the credit analysis.

If the default rate of Group A is lower than Group B, however, that shows that it is experiencing a different credit standard, which may be a higher standard, or may be one biased one against Group A, even if it is not intended.

In the third possibility, if the default rate for Group A is higher than Group B, that shows that in spite of the fact Group A had a lower approval and higher decline ratio, it was nonetheless being given easier credit standards, or that the process was biased in its favor, even if not intended.

We need the facts of default rates to objectively and calmly address this issue. Why not simply provide them as part of the regular Home Mortgage Disclosure Act reports?

Some previous discussions of this issue have analyzed the different groups by factors such as household income or standard credit ratios. But such factors are merely attempted predictions of future default rates, not the reality of the actual default rates. It is much better to use the direct reality of defaults, since controlling defaults is the whole point of credit underwriting.

As HUD addresses the issue, a resolution based on fact should be adopted: Report the default rates on relevant loans and compare them to approval-decline rates, and then draw the logically necessary conclusions. If the question gets to the courts, judges should insist on the same fundamental logic being applied.

Banks need more skin in the housing finance game

Published by American Banker.

We all know it was a really bad idea in the last cycle to concentrate so much of the credit risk of the huge American mortgage loan market on the banks of the Potomac River — in Fannie Mae and Freddie Mac.

But the concentration is still there, a decade later.

The Fannie and Freddie-centric U.S. housing finance system removes credit risk from the original lenders, taking away their credit skin in the game. It puts the risk instead on the government and the taxpayers.

Many realized in the wake of the crisis that this was a big mistake (although a mistake made by a lot of smart people) in the basic design of the inherently risk-creating activity of lending money. Many realized after the fact that the American housing finance system needed more credit skin in the game.

Skin-in-the-game requirements were legislated for private mortgage securitizations by the Dodd-Frank Act, but do not apply to lenders putting risk into Fannie and Freddie. Regulatory pressure subsequently caused Fannie and Freddie to transfer some of their acquired credit risk to investors — but this is yet another step farther away from those who originated the risk in the first place.

That isn’t where the skin in the game is best placed. The best place, which provides the maximum alignment of incentives, and the maximum use of direct knowledge of the borrowing customer, is for the creator of the mortgage loan to retain significant credit risk. No one else is as well placed.

The single most important reform of American housing finance would be to encourage more retention of credit skin in the game by those making the original credit decision.

In this country, we unfortunately cannot achieve the excellent structure of the Danish mortgage bond system, where 100% of the credit risk is retained by the lenders, and 100 percent of the interest rate risk is passed on to the bond market. The Danish mortgage bank which makes the loan stays on the hook for the default risk and receives corresponding fee income. The loans are pooled into mortgage bonds, which convey all the interest rate and prepayment risk to bond investors. This system has been working well for over 200 years.

There are clearly many American mortgage banks which do not have the capital to keep credit skin in the game in the Danish fashion. But there are thousands of American banks, savings banks and credit unions which do have the capital and can use to it back up their credit judgments. The mix of the housing finance system could definitely be shifted in this direction.

If you are a bank, your fundamental skill and your reason for being in business is credit judgment and the managing of credit risk. Residential mortgage loans are essential to your customers and are the biggest loan market in the country (and the world). Why do you want to divest the credit risk of the loans you have made to your own customers, and pay a big fee to do so, instead of managing the credit yourself for a profit? There is no good answer to this question, unless you think your own mortgage loans are of poor credit quality. For any bankers who may be reading this: Do you think that?

But, it will be objected: The regulators force me to sell my fixed-rate mortgage loans because of the interest rate risk, which results from funding 30-year fixed-rate loans with short-term deposits. True, but as in Denmark, the interest rate risk can be divested while credit risk is maintained. For example, the original 1970 congressional charter of Freddie provided lenders the option of selling Freddie high loan-to-value ratio loans by maintaining a 10% participation in the loan or by effectively guaranteeing them, not only by getting somebody else to insure them.

Treasury Secretary Steven Mnuchin recently told Congress that private capital must be put in front of any government guarantee of mortgages. That’s absolutely right — but whose capital? The best solution would be to include the capital of the lenders themselves.

In sharp contrast to American mortgage-backed securities in this respect are their international competitors, covered bonds. These are bonds banks can issue, collateralized by a “cover pool” of mortgage loans which remain assets of the bank. Thus covered bonds allow a long-term bond market financing, but all the credit risk stays on the bank’s balance sheet, with its capital fully at risk.

American regulators and bankers need to shake off their assumption, conditioned by years of Fannie and Freddie’s government-promoted dominance, that the “natural” state of things is for mortgage lenders to divest the credit risk of their own customers. The true natural state for banks is the opposite: to be in the business of credit risk. What could be more obvious than that?

The housing finance system should promote, not discourage, mortgage lenders staying in the credit business. Regulators, legislators, accountants and financial actors should undertake to reform regulatory, accounting and legal obstacles to the right alignment of incentives and risks. The Federal Housing Finance Agency should be pushing Fannie and Freddie to structure their deals to encourage originator retention of credit risk.

The result will be to correct, at least in part, a fundamental misalignment that the Fannie and Freddie model foisted on American housing finance.

Time to reform Fannie and Freddie is now

Published in American Banker.

The Treasury Department and the Federal Housing Finance Agency struck a deal last week amending how Fannie Mae and Freddie Mac’s profits are sent to Treasury as dividends on their senior preferred stock.

But no one pretends this is anything other than a patch on the surface of the Fannie and Freddie problem.

The government-sponsored enterprises will now be allowed to keep $3 billion of retained earnings each, instead of having their capital go to zero, as it would have done in 2018 under the former deal. That will mean $6 billion in equity for the two combined, against $5 trillion of assets — for a capital ratio of 0.1 percent. Their capital will continue to round to zero, instead of being precisely zero.

Here we are in the tenth year since Fannie and Freddie’s creditors were bailed out by Treasury. Recall the original deal: Treasury would get dividends at a 10 percent annual rate, plus — not to be forgotten — warrants to acquire 79.9 percent of both companies’ common stock for an exercise price of one-thousandth of one cent per share. In exchange, Treasury would effectively guarantee all of Fannie and Freddie’s obligations, existing and newly issued.

The reason for the structure of the bailout deal, including limiting the warrants to 79.9 percent ownership, was so the Treasury could keep asserting that the debt of Fannie and Freddie was not officially the debt of the United States, although de facto it was, is, and will continue to be.

Of course, in 2012 the government changed the deal, turning the 10 percent preferred dividend to a payment to the Treasury of essentially all Fannie and Freddie’s net profit instead. To compare that to the original deal, one must ask when the revised payments would become equivalent to Treasury’s receiving a full 10 percent yield, plus enough cash to retire all the senior preferred stock at par.

The answer is easily determined. Take all the cash flows between Fannie and Freddie and the Treasury, and calculate the Treasury’s internal rate of return on its investment. When the IRR reaches 10 percent, Fannie and Freddie have sent in cash economically equivalent to paying the 10 percent dividend plus retiring 100 percent of the principal.

This I call the “10 Percent Moment.”

Freddie reached its 10 percent Moment in the second quarter of 2017. With the $3 billion dividend Fannie was previously planning to pay on December 31, the Treasury’s IRR on Fannie would have reached 10.06 percent.

The new Treasury-FHFA deal will postpone Fannie’s 10 percent Moment a bit, but it will come. As it approaches, Treasury should exercise its warrants and become the actual owner of the shares to which it and the taxpayers are entitled. When added to that, Fannie reaches its 10 percent Moment, then payment in full of the original bailout deal will have been achieved, economically speaking.

That will make 2018 an opportune time for fundamental reform.

Any real reform must address two essential factors. First, Fannie and Freddie are and will continue to be absolutely dependent on the de facto guarantee of their obligations by the U.S. Treasury, thus the taxpayers. They could not function even for a minute without that. The guarantee needs to be fairly paid for, as nothing is more distortive than a free government guarantee. A good way to set the necessary fee would be to mirror what the Federal Deposit Insurance Corp. would charge for deposit insurance of a huge bank with 0.1 percent capital and a 100 percent concentration in real estate risk. Treasury and Congress should ask the FDIC what this price would be.

Second, Fannie and Freddie have demonstrated their ability to put the entire financial system at risk. They are with no doubt whatsoever systemically important financial institutions. Indeed, if anyone at all is a SIFI, then it is the GSEs. If Fannie and Freddie are not SIFIs, then no one is a SIFI. They should be formally designated as such in the first quarter of 2018, by the Financial Stability Oversight Council —and that FSOC has not already so designated them is an egregious and arguably reckless failure.

When Fannie and Freddie are making a fair payment for their de facto government guarantee, have become formally designated and regulated as SIFIs, and have reached the 10 percent Moment, Treasury should agree that its senior preferred stock has been fully retired.

Then Fannie and Freddie would begin to accumulate additional retained earnings in a sound framework. Of course, 79.9 percent of those would belong to the Treasury as 79.9 percent owner of their common stock. Fannie and Freddie would still be woefully undercapitalized, but progress toward building the capital appropriate for a SIFI would begin. As capital increased, the fair price for the taxpayers’ guarantee would decrease.

The New Year provides the occasion for fundamental reform of the GSEs in a straightforward way.

FHFA’s g-fee calculation ignores the law

Published in American Banker.

In a recent report to Congress, the Federal Housing Finance Agency once again failed to satisfy a fundamental legal requirement. This is a requirement that the FHFA keeps ignoring, apparently perhaps because it doesn’t like it. But to state the obvious, the preferences of a regulatory agency do not excuse it from complying with the law.

The law requires that when the FHFA sets guarantee fees for Fannie Mae and Freddie Mac, the fees must be high enough to cover not only the risk of credit losses, but also the cost of capital that private-sector banks would have to hold against the same risk. This is explicitly not the amount of capital that Fannie and Freddie or the FHFA might think would be right for themselves, but the cost of the capital requirement for regulated private banks.

This requirement, created by the Temporary Payroll Tax Cut Continuation Act of 2011, was clear and unambiguous. The law mandated a radical new approach to setting, increasing and analyzing Fannie and Freddie’s g-fees, based on a reference to the private market. In setting “the amount of the increase,” the law said, the FHFA director should consider what will “appropriately reflect the risk of loss, as well as the cost of capital allocated to similar assets held by other fully private regulated financial institutions.”

In other words, the director of the FHFA is instructed to calculate how much capital fully private regulated financial institutions have to hold against mortgage credit risk, the required return on that capital for such private banks and therefore the cost of capital for private banks engaging in the same risk as Fannie and Freddie. This includes the credit losses from taking this risk and operating costs, both of which must be added the private cost of capital. The net sum is the level of Fannie and Freddie’s guarantee fees that the FHFA is required to establish.

The law also further requires the FHFA to report to Congress on how Fannie and Freddie’s g-fees “met the requirements” of the statute – that is, how they included the cost of capital of regulated private banks.

However, if you read the FHFA’s October 2017 report on guarantee fees, nowhere in it will you find any discussion — not a single word — about private banks’ cost of capital for mortgage credit risk. There is the same amount of discussion — zero — about how that private cost of capital enters the analysis and calculation of Fannie and Freddie’s required g-fees. Yet this is the information and annual analysis that Congress demanded of the FHFA.

Why has the agency failed to fulfill its legal obligation?

A reasonable hypothesis is that the FHFA doesn’t like the answer that results when this analysis and calculation are performed, so it is tap-dancing instead of answering the question and implementing the answer. In short, the calculation required by the law results in much a higher level of g-fees than at present. This reflects the whole point of the statutory provision — to make the private sector competitive and to take away Fannie and Freddie’s subsidized cost of capital and the distortions it creates.

The FHFA certainly understands the importance of this issue. Its report clearly sets out the components of the calculation of g-fees, saying, “Of these components, the cost of holding capital is by far the most significant.” That would be the perfect section to add the required analysis of the cost of capital for regulated private financial institutions and to use that to calculate the legally required g-fees.

But instead, the report treats us to a discussion of how “each [government-sponsored enterprise] uses a proprietary model to estimate … the amount of capital it needs.” The mortgage companies use “models to estimate the amount of capital and … [subject] that estimate to a target rate of return” to “calculate a model guarantee fee.”

That’s nice, but here are the two questions that must be answered:

• What is the cost of capital for a private regulated financial institution to bear the same credit risk as Fannie and Freddie?

• What is the g-fee calculation based on that cost of capital for private institutions?

The FHFA has not answered these questions. Instead, the agency said it had “found no compelling economic reason to change the overall level of fees.” How about complying with the law?

FSOC is too political to be taken seriously

Published in American Banker.

The Financial Stability Oversight Council is a political body masquerading as an analytical one. A dubious creation of the Dodd-Frank Act, it reflects that law’s urge to expand the power of bureaucrats, in turn reflecting the implausible credo that they can control “systemic risk” because they know the financial future better than other people. They don’t.

The expected result of a committee of heads of federal agencies chaired by the Treasury secretary is a politicized process. This was undoubtedly the case with the council’s attempt to designate MetLife as a “systemically important financial institution.” It should not be surprising that a U.S. District Court judge threw out the designation, ruling that it was “arbitrary and capricious,” and “hardly adhered to any standard when it came to assessing MetLife’s threat to financial stability.” In dissenting from the council’s action on MetLife, S. Roy Woodall — the FSOC’s statutorily required independent member with insurance expertise — said the designation relied on “implausible, contrived scenarios.”

Decisions concerning “systemic risk,” an unclear term in any case, cannot be purely analytical and objective. They involve generalized and debatable theories. They are, to a significant extent, inherently judgmental, subjective and political. The FSOC effectively sits as a miniature, unelected legislature. That is a bad idea.

The fundamental problem is the structure of the FSOC as designed by Dodd-Frank. To begin with, it is chaired by the Treasury secretary, a senior Cabinet member who always has major partisan interests at stake. No company can be considered for SIFI status without the Treasury secretary’s approval. This means that, by definition, the FSOC’s work is not a disinterested, analytical process. An administration is positioned to pick winners and losers. Under the Obama administration, MetLife was in the crosshairs, but Fannie Mae, Freddie Mac and Berkshire Hathaway were off-limits.

Meanwhile, most other FSOC members are heads of independent regulatory agencies, strongly motivated by bureaucratic self-interest to defend their jurisdictional turf from intrusions by the others, and to defend their regulatory records from criticism.

This conflicts with the ostensible purpose of the FSOC: to provide the combined substantive deliberation and development of insights into evolving risks from a diverse group of officials. The expectation that that purpose could be achieved was naive. When I asked one former senior FSOC official from the Obama administration if the meetings of the FSOC members had ever provided a new insight, he gave me a candid answer: No. One can hypothesize that the authors of Dodd-Frank were in fact not naive — that they welcomed another way to expand the reach of the administrative state.

The FSOC’s decision-making authority grants significant regulatory power to Treasury, as well as to members who help decide which firms are SIFIs and which are not. But that’s only the beginning, since the designation process also grants enormous power to the Federal Reserve. If an insurance company becomes designated by the FSOC, it falls under the Fed’s supervisory authority, even though the Fed has little or no experience in insurance regulation. Every head of the central bank who participates in FSOC designations is an interested and conflicted party in discussions that result in expanding the Fed’s authority. The politicization also leads the FSOC to ignore companies that more objectively deserve the SIFI label. The most egregious case of this, of course, is the council’s utter failure to address Fannie Mae and Freddie Mac, which are without question very systemically risky. On top of being huge, they are incarnations of these systemic risk factors: highly leveraged real estate and the moral hazard created by government guarantees.

Dodd-Frank assigns the FSOC the task of “eliminating expectations on the part of shareholders, creditors and counterparties that the Government will shield them from losses.” But Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses. But the staff of the FSOC was ordered not to study them—a bankruptcy of the FSOC’s intellectual credibility.

It appears that the FSOC has so much baggage that the best approach is simply to scrap it. If a truly independent, analytical systemic risk regulator is desired, it should be created outside of the Treasury’s political control.

‘Commercial’ bank is misnomer. ‘Real estate’ bank is more apt

Published in American Banker.

Comparing banking in the 1950s to today, we find giant changes that surely would have astonished the bankers of that earlier time. What’s the biggest and most important one?

You might nominate the shrinkage in the total number of U.S. banks from over 13,200 in 1955 to only about 5,300 now — a 60 percent reduction. Or you might say the rise of interstate banking, or digital technology going from zero to ubiquitous, or the growth of financial derivatives into hundreds of trillions of dollars, or even air conditioning making banking facilities a lot more pleasant.

You might point out that the whole banking industry’s total assets were only $209 billion in 1955, less than one-tenth the assets of today’s JPMorgan Chase, compared with $15 trillion now. Or that total banking system equity was $15 billion, less than 1 percent of the $1.7 trillion it is now. Of course, there have been six decades of inflation and economic growth. The nominal gross domestic product of the United States was $426 billion in 1955, compared with $17.9 trillion in 2015. So banking assets were 49 percent of GDP in 1955, compared with 83 percent of GDP now.

But I propose that the biggest banking change during the last 60 years is none of these. It is instead the dramatic shift to real estate finance and thus real estate risk, as the dominant factor in the balance sheet of the entire banking system. It is the evolution of the banking system from being principally business banks to being principally real estate banks.

In 1955, commercial and industrial loans were 40 percent of total banking loans and real estate loans only 25 percent. The great banking transition set in after 1984. The share of C&I loans kept falling, down to about 20 percent of total loans, while real estate loans rose to about 50 percent, with a bubble-induced peak of 60 percent in 2009. In this remarkable long-term shift, the share of real estate loans doubled, while the share of commercial and industrial loans dropped in half. The lines crossed in 1987, three decades ago and never met again, despite the real estate lending busts of the early 1990s and of 2007-9.

The long-term transition to concentration in real estate would have greatly surprised the authors of the original National Banking Act of 1864, which prohibited national banks from making any real estate loans at all. This was loosened slightly 1913 by the Federal Reserve Act and significantly in 1927 by the McFadden Act — in time for the ill-fated real estate boom of the late 1920s.

The real estate concentration is even more pronounced for smaller banks. For the 4,700 banks with assets of less than $1 billion, real estate loans are 75 percent of all loans, about the same as their bubble-era peak of 76 percent.

Moreover, in another dramatic change from the 1950s, the securities portfolio of the banking system has also become heavily concentrated in real estate risk. Real estate securities reached 74 percent of total banking system securities at the height of the housing bubble. They have since moderated, to 60 percent, but that is still high.

In terms of both their lending and securities portfolios, we find that commercial banks have become basically real estate banks.

Needless to say, this matters a lot for understanding the riskiness of the banking system. The assets underlying real estate loans and securities are by definition illiquid. The prices of these assets are volatile and subject to enthusiastic run-ups and panicked, unexpected drops. When highly leveraged on bank balance sheets, real estate over banking’s long history has been the most reliable and recurring source of busts and panics.

A good example is the frequency of commercial bank failures in 2007-12 relative to their increasing ratio of real estate loans to total loans at the outset of the crisis in December 2007. From the first quartile, in which real estate loans are less than 57 percent of loans, to the third quartile, in which they are over 72 percent, the frequency of failure triples, and failures are nine times as great for the highest ratio quartile as for the lowest. In the fourth quartile, real estate loans exceeded 83 percent of loans, and the failure rate is over 13 percent, which represents 60 percent of all the failures in the aftermath of the bubble. The 50 percent of banks with the highest real estate loan ratios accounted for 82 percent of the failures.

Central to the riskiness of leveraged real estate is the risk of real estate prices falling rapidly from high levels — and right now those prices are again very high. The Comptroller of the Currency’s current “Risk Perspective” cites rapid growth in commercial real estate loans, “accompanied by weaker underwriting standards” and “concentration risk.”

The predominance of real estate finance in banking’s aggregate banking balance sheet makes that risk far more important to the stability of the banking system than the bankers of the 1950s could ever have imagined.

The perfect antidote to Dodd-Frank

Published in American Banker.

To overhaul the Dodd-Frank Act, here is a radical and really good idea from House Financial Services Committee Chairman Jeb Hensarling, R-Texas.

The Financial CHOICE Act, Hensarling’s bill, says to U.S. banks: “Don’t like the endless additional regulation imposed on you by the bloated Dodd-Frank Act? 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 – all of which Dodd-Frank called forth.”

This Choice bill, which stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs, is not an order to increase your capital. Rather, it’s offering a logical choice.

Option 1: Put enough of your equity investors’ own money in between your creditors and the risk that other people will have to bail them out if you make big mistakes. And you may. Then, the government can’t claim you live on the taxpayers’ credit, and therefore, can’t justify its inherent urge to micromanage.

Option 2: Don’t get your equity capital up high enough and live with the luxuriant regulation instead. Think of this scenario as the imposed cost of using the taxpayers’ capital instead of your own to support your risks.

Depending on how large the explicit costs and the opportunity costs of the regulation are, you might think that the second option will yield higher returns on equity than option one or you might not. Some banks would choose one option, while some would choose the other.

Different choices would create diversification in the banking sector. They would also create highly useful learning over time. One group would end up sounder and make greater contributions to economic growth and innovation. One group would, over time, prosper more than the other.

Of course, we have to answer: how high is high enough? The 10 percent tangible leverage capital required to get the deal in the proposed legislation is a lot more than now, but is it even enough?

To consider the matter first in principle: surely, there is some level of equity capital at which this trade-off makes sense, some level at which everyone — even habitual lovers of bureaucracy — would agree that the Dodd-Frank burdens would be 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, mandates and interventions are so intertwined with today’s banks, there is simply no market answer available. Numerous proposals, based on more or less no data, have been made. The fact that no one knows the exact answer should not, however, stop us from moving in the right direction.

Among various theories, economist and New York Times columnist Paul Krugman proposed a maximum assets-to-capital ratio of 15:1, which means a minimum leverage capital ratio of 6.7 percent. Anat Admati, a Stanford finance professor, and Martin Hellwig, an economics professor at the University of Bonn, argued for a 20 percent to 30 percent leverage capital requirement with no empirical analysis. Economists David Miles, Jing Yang and Gilberto Marcheggiano estimated that the optimal bank capital is about 20 percent of risk-weighted assets, which in their view means 7 percent to 10 percent leverage capital, in a white paper. A group of 20 academics from finance and banking specializations suggested in a letter to the Financial Times a 15 percent leverage capital requirement. Economists Anil Kashyap, Samuel Hanson and Jeremy Stein proposed 12 percent to 15 percent risk-weighted, which means about 6 percent to 8 percent leverage capital. Professor Charles Calomiris suggested 10 percent leverage capital. Economist William Cline estimated the optimal leverage capital ratio at 6.6 percent to 7.9 percent. Robert Jenkins, a member of the financial policy committee at the Bank of England, gave a speech to the Worshipful Company of Actuaries entitled “Let’s Make a Deal,” where the deal was the “rollback of the rule book” in exchange for raising “equity capital to 20 percent of assets.” In my opinion, the 10 percent tangible leverage capital ratio in Hensarling’s bill is a fair stab at it.

In exchange for 10 percent leverage capital, it is essential to understand that the deal is not to eliminate all regulation. Indeed, there would still be plenty of regulation for banks taking the deal. However, option one is a distinctly better choice than the notorious overreaction and overreach of Dodd-Frank. In exchange for a further move to 20 percent leverage capital, one would rationally eliminate a lot more regulation and bureaucratic power.

It’s also essential to understand that the proposed capital ratio as specified in the Hensarling bill subtracts all intangible assets and deferred-tax assets from the allowable capital and adds the balance sheet equivalents of off-balance sheet items to total assets. Thus, it is conservative in both the numerator and denominator of the ratio.

In my judgment, the choice offered to banks by Chairman Hensarling’s proposal makes perfect sense. It goes in the right direction and ought to be enacted. Even the Washington Post editorial board agrees with this. In an op-ed, the editorial board writes:

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 cash cushion can offer as much—or more—protection against financial instability as intrusive regulations do, and do so more simply.

Very true!

Where is OCC in court battle over state usury limits?

Published in American Banker with William M. Isaac.

A surprising decision of the Second Circuit Court of Appeals in the case of Midland Funding v. Madden threatens the functioning of the national markets in loans and loan-backed securities. The ruling, if it stands, would overturn the more than 150-year-old guiding principle of “valid when made.”

The effects of the decision could be wide-ranging, affecting loans beyond the type at issue in the case. It is in the banking industry’s interest for the Supreme Court, at the very least, to limit its applicability. And since the Madden case could deal a blow to preemption under the National Bank Act, it is time for the Office of the Comptroller of the Currency to voice an opinion.

Under the valid-when-made principle, if the interest rate on a loan is legal and valid when the loan is originated, it remains so for any party to which the loan is sold or assigned. In other words, the question of who subsequently owns the financial instrument does not change its legal standing. But the appeals court found that a debt buyer does not have the same legal authority as the originating bank to collect the stated interest.

In the words of the amicus brief filed before the U.S. Supreme Court on behalf of several trade associations:

Since the first half of the nineteenth century, this Court has recognized the ‘cardinal rule’ that a loan that is not usurious in its inception cannot be rendered usurious subsequently. ” U.S. credit markets have functioned on the understanding that a loan originated by a national bank under the National Banking Act is subject to the usury law applicable at its origination, regardless of whether and to whom it is subsequently sold or assigned.

This, the argument continues, “is critically important to the functioning of the multitrillion-dollar U.S. credit markets.” So it is. And such markets are undeniably big, with hundreds of billions of dollars in consumer credit asset-backed securities, and more than $8 trillion in residential mortgage-backed securities, plus all whole loan sales.

Marketplace lenders and investors have already raised intense concerns about the decision, but the impact could go further. The validity of numerous types of loan-backed securities packaged and sold on the secondary market could suddenly be called into question. Packages of whole loans, as well as securitizations, include the diversified debt of multiple borrowers from different states with different usury limits, and then sold to investors. But the Madden decision suggests those structures are at risk of violating state usury laws.

A possible interpretation to narrow the impact of the case would be for future court decisions to find that the Madden outcome only applies to the specific situation of this case, namely to defaulted and charged-off loans sold by a national bank to an entity that is not a national bank. Thus, only the buyers of such defaulted debt would be bound by state usury limits in their collection efforts, and the impact will largely be limited to diminishing the value of such loans in the event of default.

The Second Circuit decision might not, based on this hypothesis, apply to performing loans or to the loan markets in general. However, as pointed out in a commentaryby Mayer Brown: “it will take years for the Second Circuit to distinguish Madden in enough decisions that the financial industry can get comfortable that Madden is an anomaly.” The law firm’s commentary presented many potential outcomes, including that the Madden case could be “technically overturned” but without the high court providing explicit support for the “valid-when-made” principle. That “would be a specter haunting the financial industry,” according to the firm’s analysis.

In the meantime, what happens?

It would be much better for the Supreme Court to reaffirm the valid-when-made principle as a “cardinal rule” governing markets in loans, and the Supreme Court is being petitioned to accept the case for review.

But at this point, one would also expect the OCC, the traditional defender of the powers of national banks and the preemption of state constraints on national bank lending, to be weighing in strongly. The comptroller of the currency should protect the ability of national banks to originate and sell loans guided by the valid-when-made principle. But the OCC seems not to be weighing in at all and is strangely absent from this issue.

Everyone agrees that national banks can make loans under federal preemption of state statutes, subject to national bank rules and regulations. Everyone agrees, as far as we know, that the valid-when-made principle is required for loans to move efficiently among lenders and investors in interstate and national markets, whether as whole loans or securities.

In our view, the OCC ought to be taking a clear and forceful public position to support the ability of national banks to originate loans which will be sold into national markets.