Comment Letter To OCC, Board of Governors of the Federal Reserve System, and FDIC

Published by the R Street Institute.

Via e-mail to:

Office of the Comptroller of the Currency

Board of Governors of the Federal Reserve System

Federal Deposit Insurance Corporation

         Re.: Comments on the Proposed Joint Rule on “Regulatory Capital Treatment for Investments in  Certain Unsecured Debt Instruments of Global Systemically Important U.S. Bank Holding Companies, Certain Intermediate Holding Companies, and Global Systemically Important Foreign Banking Organizations”

              OCC: Docket ID OCC-2018-0019; RIN 1557-AE38

              Board: Docket No. R-1655; RIN 7100-AF43

              FDIC: RIN 3064-AE79

Dear Sirs and Mesdames:

Thank you for the opportunity to comment on this proposed joint rule.

In my view, the logic of the proposal is impeccable.  Because it is, it should be applied to another, parallel situation, as discussed below.  The proposal’s objective, “to reduce interconnectedness and contagion risk among banks by discouraging banking organizations from investing in the regulatory capital of another financial institution,” makes sense, but might be improved by adding, “or if such investments are made, to ensure that they are adequately capitalized.”

I believe another rule with exactly the same logic and exactly the same objective is required to address a key vulnerability of the U.S. banking system.  That is to apply the logic of the proposed rule to any investments made by U.S. banks in the equity securities of Fannie Mae and Freddie Mac, two of the very largest and most systemically risky of American financial institutions.  As you know, hundreds of American banks took steep losses on their investments in the preferred stock of Fannie and Freddie when those institutions collapsed, and such investments caused a number of banks to fail.  That banks were able to make these investments on a highly leveraged basis was, in my judgment, a serious regulatory, as well as management, mistake.  On top of this, U.S. regulations allowed banks to own Fannie and Freddie securities without limit.

Banks were thus encouraged by regulation to invest in the equity of Fannie and Freddie on a hyper-leveraged basis, using insured deposits to fund the equity securities.  Hundreds of banks owned about $8 billion of Fannie and Freddie’s preferred stock.  For this disastrous investment, national banks had a risk-based capital requirement of a mere 1.6%, since changed to a still inadequate 8%.  In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (With due respect, your broker’s margin desk wouldn’t letyou do that.)

In short, the banking system was used to double leverage Fannie and Freddie, just as the investments in TLAC debt addressed by the proposal would otherwise double-leverage big banks.  To analogously correct the systemic risk, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so that it really would be equity from a consolidated system point of view.

I respectfully recommend, true to the principle and the logic of the proposed joint rule, that any investments by a bank in the preferred or common stock of Fannie and Freddie should be deducted from its Tier 1 regulatory capital.  I believe this should apply to banks of all sizes.

These are my personal views.  It would be a pleasure to provide any further information or comments which might be helpful.

Thank you for your consideration.

                                                                                    Respectfully,

                                                                                    Alex J. Pollock

Financial Goblins

Published by the R Street Institute.

Just in time for Halloween last week, three financial goblins appeared in the Financial Times in the same October 31 issue:

-China Minsheng Investment Group, “the country’s largest private investment company,” with “crushing debt problems,” reportedly is cutting senior and mid-tier salaries by 53% “in a bold decision to save itself.”

-WeWork, the struggling former financial darling, drew a forecast from hedge fund manager Bill Ackman that it has “a high probability of being a zero for the equity as well as for the debt.”

-“South Korea’s biggest hedge fund, Lime Asset Management” is “swamped by investors’ demands to get their money back,” is “forced to sell hard-to-trade assets…at fire-sale prices,” and has “suspended withdrawals.”

The next day, the Wall Street Journal added:

“Depositors swarmed a rural bank here…rushing to pull money out.”

Perhaps these four goblins represent various leaks springing in the global “Everything Bubble” the central banks have inflated?

Do you believe central bank assurances?

Published by the R Street Institute.

To reassure savers worried about the safety of their deposits, the Reserve Bank of India (India’s central bank) recently announced it “would like to assure the general public that Indian banking is safe and stable and there is no need to panic.”

The problem is that when government officials issue such assurances, do you believe them?

Governments confronted by the risk of a banking crisis have to say the same thing regardless how severe the risk really is. They must say that the system is safe and you should not panic, because they are afraid that, by sharing any doubts, they would themselves set off the panic they fear. Therefore, their statements of assurance have no informational substance.

“When it becomes serious, you have to lie,” Jean-Claude Juncker, then head of the eurozone finance ministers, with admirable candor said of the European financial crisis of the 2000s.

“We have no plans to insert money into either of those two institutions,” Treasury Secretary Henry Paulson said of Fannie Mae and Freddie Mac in the summer of 2008. One month later, he began inserting into both of them what became $187 billion of bailout money.

Governments and banks in stressed situations are up against Walter Bagehot’s insight into the fragility of credit. “Every banker knows that if he has to prove he is worthy of credit,” Bagehot wrote in 1873, “in fact his credit is gone.” I imagine that will always be true.

The term “credit” comes from credo = “I believe.” In a threatened crisis, you suddenly realize that you have not much ground, if any, for believing in a bank’s soundness or believing the government’s assurances that things are fine.

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Published by the R Street Institute.

EDWARD J. PINTO and TOBIAS J. PETER                       ALEX J. POLLOCK

AEI Housing Center                                         R Street Institute

September 26, 2019

Department of Housing and Urban Development

Regulations Division

Office of the General Counsel

451 7th Street SW

Washington, DC 20410

Submission via www.regulations.gov

Dear Sir/Madam:

Re.: Docket No. FR-6111-P-02; RIN: 2529-AA98

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Thank you for the opportunity to comment on this proposed rule on the Disparate Impact Standard. The authors of the comment have many years of experience in housing finance, as operating executives, analysts, and students of housing finance systems and their policy issues.  We believe this rulemaking has the potential to significantly improve the existing standard.

Our fundamental recommendation is that the consideration of disparate impact issues must be able to include credit outcomes, i.e. default rates, not only credit underwriting inputs.  Specifically:

1. Mortgage lenders, including smaller lenders, should have the option to use a credit outcomes-based statistical approach, as defined below, which qualifies as a valid defense under the Disparate Impact rule. This would improve the fairness, operation, and statistical basis of the rule.

2. HUD should develop a credit outcomes-based statistical screening approach that allows it to assess with a high degree of confidence, whether differences in mortgage lending results raise disparate impact questions for further review.

In both cases, the ability to use credit outcomes would enhance clarity and reduce uncertainty.

Problems with the Pure Input Approach

Applying its credit standards in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing.  Typically, the question of whether this is being carried out has been approached by looking only at inputs to a lending decision.  This results in a focus on differing credit approval/credit decline rates between protected and non-protected classes.  The argument is then made that the existence of differing credit approval/credit decline rates between classes is evidence of discrimination even if a lender applies exactly the same set of credit underwriting standards to all credit applicants.[1]

Read in full here.

Key points in the Treasury’s paper on Fannie/Freddie reform

Published by the R Street Institute.

The important parts of the Treasury’s new paper on Fannie Mae and Freddie Mac reform are not the legislative recommendations, since legislation is not going to happen. They are the administrative steps that can be taken now, with political will. Of these, the key ones are:

• Increased capital requirements for Fannie and Freddie, under which the same risks, whether taken by private institutions or by Fannie and Freddie, have the same capital protection;

• Removing regulations which especially favor Fannie and Freddie over other competitors;

• An ongoing fee from Fannie and Freddie to the Treasury to pay for the taxpayer credit support, without which Fannie and Freddie could not exist;

• Rewarding the taxpayers for their bailout of Fannie and Freddie by having Treasury exercise its warrants for 79.9 percent of Fannie and Freddie’s common stock. Since the exercise price is one-thousandth of a cent per share, this will be a nice and well-deserved profit for the taxpayers.

The Treasury’s articulated direction of a more competitive mortgage market with less taxpayer risk is certainly correct.

Who should pick credit-risk-scoring models?

Published by the R Street Institute.

American residential mortgage finance is the second-largest credit market in the world, behind only U.S. Treasury debt. Its immense size, at $10.4 trillion in outstanding loans, perhaps alone justifies the endless debates about how to reform it and improve its risk structures. In addition, the subject of mortgages is always political, being central to homeownership and to large housing-related industries and constituencies.

One relevant issue in the inside baseball of mortgage finance is the question of credit-scoring models. Credit scores and the models that calculate them are deeply imbedded in the credit decisions about mortgages. The purpose of the scores is to contribute to the credit consideration statistical estimates of the probability of default. Since credit underwriting is all about predicting and controlling the frequency and patterns of defaults, and therefore the credit losses experienced by the risk-taking lenders, this is a key idea.

Because Fannie Mae and Freddie Mac dominate the great middle of the mortgage market, the “conforming loan” sector, how they use credit scores has become a subject of congressional action, regulatory rulemaking and ongoing discussion. I just got a question on this issue when testifying to the Senate Banking Committee this week. In particular, the issue concerns Fannie and Freddie’s use of the FICO score, the incumbent mortgage-finance leader, or the challenger VantageScore. But it applies in principle to any other credit score that may be developed.

How to decide among competing scores is a highly technical matter. The more pertinent question from the political and economic perspective is who should decide. The answer to who is clear and definitive: whoever is taking the credit risk should decide how to use credit scores and which to use. That is the party that will bear the losses resulting from credit decisions, the one with skin in the game. Those without credit skin in the game should not get to choose which credit scores to use.

In short, the right principle is: the risk-taker decides. If Fannie and Freddie are taking the credit risk, they should decide which credit scores to use and how to use them, based on the most analytical, most objective criteria they can discover. And the same for any other risk-taker.

Should there be competition among credit scores?  Of course, competition is essential in this market, as anywhere. The right locus for competition is for the producers of credit scores to make the best cases they can to the risk-takers about the performance of their scores. May the most predictive, highest-performing score win.

Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?

Published by the R Street Institute.

Testimony of

Alex J. Pollock

Distinguished Senior Fellow

R Street Institute

Washington, DC

To the Committee on Banking, Housing, and Urban Affairs

United States Senate

           Hearing on “Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?”

June 25, 2019

Fannie and Freddie Are Obviously SIFIs

Mr. Chairman, Ranking Member Brown, 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 housing finance system.  This included serving as President and CEO of the Federal Home Loan Bank of Chicago 1991-2004, and as a resident fellow of the American Enterprise Institute 2004-2015.  I have personally experienced and studied numerous financial cycles, crises and their political aftermaths, and have authored many articles, presentations, testimony and two books on related subjects, including the nature of systemic financial risk.

To begin with the essence of today’s question: Are Fannie Mae and Freddie Mac, which guarantee half the credit risk of the massive U.S. housing finance sector, and which have combined assets of $5.5 trillion, systemically important?  Obviously, they are.  Are they financial companies?  Of course.  So they are systemically important financial institutions as a simple fact.

This is true if you consider them as two of the largest and most highly leveraged financial institutions in the world, but it is equally true if you consider them as an activity that generates systemic risk.  Guaranteeing half the credit risk of the biggest credit market in the world (except for U.S. Treasury securities) is a systemically important and systemically risky activity.  Leveraged real estate is, and has been throughout financial history, a key source of credit collapses and crises, as it was yet once again in 2007-2009.  The activity of Fannie and Freddie is 100% about leveraging real estate.  Moreover, they have been historically, and are today, themselves hyper-leveraged.

To use the words of the Dodd-Frank Act, could Fannie and Freddie “pose a threat to the financial stability of the United States”?  They have already demonstrated that they can.

The Financial Stability Board has stated this fundamental SIFI characteristic: “the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie and Freddie displayed at the time of their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability.  As we all know, in 2008, U.S. public authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out, with ultimately $190 billion of public funds.  In addition, they pledged the credit support from the U.S. Treasury which protected and still protects Fannie and Freddie’s  global creditors.

Fannie and Freddie continue to represent giant moral hazard, as they always have.  Since they now have virtually zero capital, they are even more dependent on the Treasury’s credit support and its implicit guarantee than they were before.

That Fannie and Freddie are SIFIs in financial reality no reasonable person would dispute.

Yet so far, the Financial Stability Oversight Council (FSOC) has not designated Fannie and Freddie as official SIFIs. To a non-political observer, judging purely on the merits of the case, this would be highly surprising. FSOC’s historical inaction in this instance has certainly not added to its intellectual credibility. To Washington observers, naturally, it just seems like ordinary politics.

This hearing requires us to consider how FSOC should deal with the fact of Fannie and Freddie’s systemic importance.  Should FSOC recognize the reality by formally designating Fannie and Freddie as the SIFIs they so obviously are?  Or should FSOC keep ignoring the issue?

I believe FSOC should formally designate Fannie and Freddie as SIFIs and strongly recommend that action.  That would be consistent with the clear provisions of the Dodd-Frank Act.  In my opinion, the country needs Fannie and Freddie to be integrated into the efforts to understand and deal with systemic risk.  Without including Fannie and Freddie, these efforts are woefully incomplete.

Let us consider the SIFI factors of size, interconnectedness, substitutability, leverage, maturity mismatch and liquidity risk, and existing regulation.

Size

In total assets, Fannie is far larger than even the biggest SIFI banks.  The following table ranks by size the ten largest existing SIFIs plus Fannie and Freddie.  As it shows, Fannie is bigger in assets than JPMorgan Chase and Bank of America, and Freddie is bigger than Citigroup and Wells Fargo.  On this combined table of twelve huge financial institutions, Fannie is #1 and Freddie is #4.

Size of Fannie, Freddie and the Largest Ten Existing Official SIFIs

Total AssetsFannie Mae$ 3.42 trillionJPMorgan Chase 2.74Bank of America 2.38Freddie Mac 2.09Citigroup 1.96Wells Fargo 1.89Goldman Sachs 0.93Morgan Stanley 0.88U.S. Bancorp 0.48PNC Financial Services 0.39TD Group US 0.38Capital One Financial 0.37

Sources: S&P Global Market Intelligence; Fannie Mae, 1st Quarter 10-Q 2019; Freddie Mac, 1st Quarter 10-Q 2019

Interconnectedness

The obligations of Fannie Mae and Freddie Mac are widely held throughout the U.S. financial system and around the world.  U.S. depository institutions hold well over $1 trillion of their securities.  The Federal Reserve itself holds $1.6 trillion in MBS, mostly those of Fannie and Freddie.  Could Fannie and Freddie be allowed to fail and impose credit losses on the Fed? Presumably not.  Preferential banking regulations promote Fannie and Freddie, including low risk-based capital requirements for their MBS and debt, creating an incentive for depository institutions to hold large exposures to those securities. These low risk-based capital requirements for depository institutions compound the hyper-leverage of Fannie and Freddie themselves, and amplify their systemic risk.

Moreover, U.S. banks are allowed to buy the equity, preferred stock and subordinated debt of Fannie and Freddie, and fund these investments with government-insured deposits.  This combination results in systemic double leverage.

The interconnectedness of Fannie and Freddie’s mortgage-backed securities and debt with the global financial system became vivid in 2008. As then-Secretary of the Treasury Henry Paulson correctly judged, a default on Fannie and Freddie’s obligations would have dramatically exacerbated the financial crisis on a global basis.

As Paulson recounted in his memoir of the crisis, On the Brink:

“From the moment the GSEs’ problems hit the news, Treasury had been getting nervous calls from officials of foreign countries that were invested heavily with Fannie and Freddie.  These calls ratcheted up after the [2008 HERA] legislation.  Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee”—and also “what this would imply for other U.S. obligations, such as Treasury bonds.”

As Fannie and Freddie reported large losses, Paulson relates that he instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.”  In an even more revealing comment, Paulson added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the overwhelming global systemic risk of not bailing them out, Paulson’s assurance turned out to be true for all of Fannie and Freddie’s debt and MBS holders.  Even those who had bought subordinated debt, thereby intentionally taking more risk, were protected.

Substitutability

Fannie and Freddie’s systemic role is critical and cannot be replaced in the short or medium term—there are no substitutes.  They play a unique, systemically central role and remain the dominant force in the funding of U.S. mortgages.   There are no meaningful competitors because of their huge, ongoing risk subsidies from the government.  In 2018, they guaranteed $917 billion in MBS.  In the first quarter, 2019 they had a 63% market share of MBS issuance (including Ginnie Mae, the government has a 94% market share.) Their balance sheets represent about half of total U.S. mortgage loans outstanding.  Thousands of mortgage originators, servicers, domestic and international investors and derivatives counterparties depend on their continued functioning and government-dependent solvency.    This is one reason that the U.S. Congress has been unable to pass any legislation to end their conservatorship.

Leverage

In addition to their massive size, Fannie and Freddie have historically displayed extreme leverage and continue to do so.  As of March 31, 2019, their balance sheets show a combined capital ratio of a risible less than 0.2% and they are hyper-leveraged at over 500 to 1.  Of course, under the bailout agreement, the government will not let them build retained earnings, but the fact of the hyper-leverage remains.

Maturity Mismatch and Liquidity Risk

The American 30-year fixed-rate, freely prepayable mortgage loan is one of the most complex financial instruments in the world to finance and hedge. Unlike the fixed-rate mortgages of most other countries, the prepayment risk of these mortgages is not offset by prepayment fees. This necessitates a complex derivatives market which trades in the risks of prepayment behavior.  Fannie and Freddie together own about $400 billion of mortgages in their own portfolios, on an extremely leveraged basis.  They are major counterparties in interest rate derivatives and options markets.  Their MBS spread the complex interest rate risks of American 30-year fixed rate mortgages, while concentrating the credit risk of U.S. house prices, now again at an all-time high.  The liquidity of Fannie and Freddie’s securities and of Fannie and Freddie themselves completely depends on the implicit guarantee of the U.S. Treasury.

Existing Regulation

Fannie and Freddie of course have an existing regulator, the Federal Housing Finance Agency (FHFA).  But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system.

U.S. residential mortgages constitute the largest loan market in the world, with $10.4 trillion in outstanding loans.  The risks of this huge market include the holdings by banks of the MBS and debt of Fannie and Freddie.  There are no limits on the amount of Fannie and Freddie obligations which can be owned by banks.

As discussed above, the risks of Fannie and Freddie also flow into the banking system because banks are allowed to invest in Fannie and Freddie’s equity on a highly-leveraged basis, which creates systemic double leverage.  In the financial crisis of 2007-2009, many banks took large losses and a number failed because of their exposure to Fannie and Freddie’s preferred stock, an exposure which was encouraged by regulation.  This is an issue the Federal Reserve, as a systemic risk regulator, would want to consider.

A major systemic risk is that Fannie and Freddie are by definition 100% concentrated in the risks of leveraged real estate.  Indeed, they are by far the largest concentration of mortgage credit risk in the world. Leveraged real estate, needless to say, has a long and painful record of being at the center of banking collapses and financial crises.

Fannie and Freddie’s primary regulator is likewise devoted only to housing finance. Such a regulator always faces the temptation to become a cheerleader and promoter of housing and housing finance.  This brought down the old Federal Home Loan Bank Board, abolished in 1989, and arguably also the Office of Thrift Supervision, abolished in 2010.

In sum, Fannie and Freddie are huge in size, huge in risk, close to zero in capital, tightly interconnected to thousands of counterparties, and force risk on the U.S. Treasury. They meet the criteria specified by the Dodd-Frank Act and its implementing regulations for designation as a SIFI, both as institutions and considered as a systemically risky activity.  They also meet the international criteria of the Financial Stability Board for designation as a Global SIFI.

If Fannie and Freddie are not SIFIs, then nobody in the world is a SIFI, and if any institution is a SIFI, then so are Fannie and Freddie.  Addressing their systemic risk through designation as a SIFI would logically match their systemically important role and riskiness.

Conservatorship

In September 2008, as we know, the Federal Housing Finance Agency determined that Fannie and Freddie each were “in an unsafe or unsound condition to transact business,” and “likely to be unable to pay its obligations or meet the demands of its creditors in the normal course of business.” The government placed them into conservatorship, and thus assumed “all rights, titles, powers, and privileges of the regulated entity, and of any stockholder, officer, or director of such regulated entity with respect to the regulated entity and the assets of the regulated entity.”

Conservatorship was never intended to be a perpetual status for Fannie and Freddie, but it continues in its 11th year, an outcome altogether unintended and undesired.

Should designating Fannie and Freddie as SIFIs be delayed because they are in conservatorship?  The answer, it seems to me, is clearly No.  They are just as systemically important and systemically risky in conservatorship as out of it. They create just as much or more moral hazard.  The Conservator cannot manage their systemic risk.  Indeed, because of the “net worth sweep” deal between the Treasury and the FHFA as Conservator, Fannie and Freddie are even more highly leveraged than before.  Meanwhile, under the Conservator, they continue to expand mortgages with high debt service to income ratios, another form of increased leverage.

The Federal Reserve as Additional Regulator

If—I hope it is when—Fannie and Freddie are formally designated as the SIFIs they economically are, the Federal Reserve will become an additional, systemic risk regulator for them.  This seems to me a good idea, since the Fed is the best placed of all existing regulatory agencies to consider the risks Fannie and Freddie pose from the view of the financial system as a whole.  Of course, the statute assigns this responsibility to the Fed for all SIFIs.  If you don’t like this outcome of SIFI designation, should you therefore claim that Fannie and Freddie are not SIFIs?

Suppose we grant that the Fed, like everybody else, has numerous shortcomings.  That does not mean that Fannie and Freddie are not SIFIs. Let us concede that the Fed, like everybody else, is far from perfect.  It should still take on, as the only available authorized actor, the essential task of understanding and addressing what Fannie and Freddie are doing to systemic risk.

Of course, Fannie and Freddie already have a primary regulator, but so do all other SIFIs.  That the FHFA regulates Fannie and Freddie is no more an argument against their being SIFIs than the fact that the Comptroller of the Currency regulates national banks would prevent banks from being SIFIs.

The Fed should be able to consider, and should consider, for such “large, interconnected financial institutions,” in the words of the Dodd-Frank Act, “establishment and refinement of prudential standards and reporting and disclosure requirements…taking into consideration their capital structure, riskiness, complexity, financial activities…size, and any other risk-related factors.”

For example, the Fed might usefully consider with respect to Fannie and Freddie such questions as:

-Whether their capital requirements and their leverage cause capital arbitrage and thereby increased risk in the financial system as a whole.

-Whether the same risks should be capitalized in the same way between private financial institutions and Fannie and Freddie.

-How Fannie and Freddie’s concentration in leveraged real estate risk affects the risk of the financial system.

-How or whether Fannie and Freddie’s activities contribute to house price inflation and thereby reduce housing affordability.

-Whether their heavy concentration in California mortgages amplifies earthquake risk.

-How much banking regulations which favor Fannie and Freddie increase the riskiness of banks.

-Whether the double leverage in the financial system created by allowing banks to invest in Fannie and Freddie’s equity makes sense.

-Whether Fannie and Freddie’s market dominance decreases or increases systemic risk.

-How much risk is being pushed on the Treasury and the taxpayers by Fannie and Freddie, at what economic cost.

I believe is that the Fed as systemic risk regulator of Fannie and Freddie would be a force for sound and well-capitalized housing finance, which would be better understood in the context of its interaction with the rest of the banking and financial system.  That should be everybody’s goal.

Concluding Questions and Answers

Are Fannie and Freddie SIFIs?  Yes, without a doubt.

Do Fannie and Freddie cause systemic financial risk?  Yes.

Is the Federal Reserve a reasonable place to try to understand and address the systemic risks?  Yes.

Should FSOC recognize these facts by formally designating Fannie and Freddie as SIFIs?  Yes.

When?  The sooner, the better.

Thank you again for the chance to share these views.

Why did economists think negative interest rates were impossible?

Published by the R Street Institute.

“Many things that had once been unimaginable nevertheless came to pass.” So it is with negative interest rates, a very good case of this insightful saying of physicist Freeman Dyson.

Many economists once confidently discussed how there was a “zero bound,” so interest rates could not go below zero in nominal terms. They had a nice theoretical argument, which seemed logical, and which they repeated over the years, for why this had to be so.

The world has a lot of negative interest rates anyway. Last week, the global total of bonds with negative interest rates reached $12.5 trillion, with a “T.”

So much for the zero bound and so much for the argument. Why did the economists believe what is manifestly not the case—with the proof of the opposite case now in trillions?

The argument was that as long as paper currency was available, which is always worth par and has an interest rate of zero, nobody would ever choose to hold a note, or deposit or bond with a negative interest rate. They would always pick a zero return over less than zero. This sounds OK. Why isn’t it true in real life?

The problem is that it applies for relatively small amounts on a personal basis, but not for huge amounts on an institutional basis. It is easy to imagine keeping $5,000 or $10,000 in currency instead of in a deposit account or money-market investment or paying $500 in cash to your plumber. You could readily have a wallet, or a box or a safety deposit box full of paper currency.

But suppose you are an institution with hundreds of billions of dollars to invest—that would be a lot of $100 bills. Or try to imagine the astronomical daily trading of financial markets trying to settle in paper currency. Or a corporation with 100,000 employees deciding it would go back to payrolls made in envelopes of currency and coins. Currency is simply not a substitute for the accounting money of banks and central banks at institutional size. Q.E.D.

There is a further intriguing issue. How negative can interest rates get? Negative 1 percent? Negative 2 percent? More? When would something blow up? Nobody knows.

A final speculation: I believe that a free financial market would never on its own create negative interest rates, which is the inherently silly idea that the lenders should pay the borrowers for the privilege of lending them money. Only in a world of the manipulations of fiat currency central banks, I believe, can negative interest rates happen. But that, of course, is the world we have.

Letter to Financial Stability Board on SIFI Oversight

Published by the R Street Institute.

Alex J. Pollock and Thomas H. Stanton

Washington DC.

                                                                                         June 11, 2019

Secretariat

Financial Stability Board

c/o Bank for International Settlements

CH-4002

Basel, Switzerland

By E-Mail: fsb@fsb.org

Dear Sirs, Mesdames:

Re.: A Large Gap in Global TBTF Reforms

We write in reference to the announcement of the “Evaluation of too-big-to-fail reforms” in your memorandum of May 23, 2019. We respectfully point out that, while the 3 July 2017 Framework refers broadly to evaluating “G20 Financial Regulatory Reforms,” and the May 23 Summary Terms of Reference refer to SIFIs broadly, the May 23 press release calls for evaluation only of Systemically Important Banks.

We urge that FSB solicitations with respect to evaluating TBTF reforms must address SIFIs that are not Banks. It could be that, without saying so, that is the intention of the FSB, and we are submitting this comment letter just to be sure. Specifically, we recommend that this Evaluation must include the obviously TBTF firms, Fannie Mae and Freddie Mac.

As is well known, these two grossly undercapitalized firms failed and were bailed out in the financial crisis of 2008, having become one of the most vulnerable points in the financial system.

Fannie Mae and Freddie Mac today have $5.5 trillion in combined assets, representing half the credit risk of the massive U.S. mortgage market. They are unquestionably systemically important, but they have not been designated as SIFIs by the U.S. Financial Stability Oversight Council. On the merits, this seems highly surprising. We believe it represents a major gap in the global response to implementing global systemic risk and TBTF reforms, which the Evaluation should address.

We suggest the following points from your terms of reference are particularly relevant:

1. “The TBTF problem arises when the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie Mae and Freddie Mac displayed at the time of their failure and display now the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability. As demonstrated by the history of the financial crisis, public authorities not only felt overwhelming pressure but did in fact bail them out with $190 billion of public funds.

1. “G20 leaders endorsed the FSB framework for Reducing the moral hazard posed by SIFIs.”

Fannie Mae and Freddie Mac continue to represent enormous moral hazard. Since they are now even more dependent on the U.S. Treasury’s implicit guarantee than before, the moral hazard they represent is even greater than in 2008.

1. “The evaluation will focus on…requirements for additional loss absorbency through higher capital buffers.”

Fannie Mae and Freddie Mac are much more highly leveraged than TBTF banks were in 2008, and now have far less capital than before their collapse. In fact, their equity capital is virtually zero. As of March 31, 2019, their combined capital ratio is a risible 0.2% and they are hyper-leveraged at 500 to 1.

1. “The evaluation will cover…cross-border and cross-sectional effects.”

Fannie Mae and Freddie Mac’s $5.5 trillion in mortgage-backed securities and debt are sold and traded in global capital markets.

1. “The FSB will engage with relevant stakeholders (market participants, academics, civil society, etc.).”

It would be a pleasure to provide any further information which would be helpful in adding Fannie Mae and Freddie Mac to the scope of the Evaluation.

With sincere thanks for your consideration,

Respectfully submitted,

Alex J. Pollock                                                   Thomas H. Stanton

Distinguished Senior Fellow                              Fellow

R Street Institute                                             Johns Hopkins University

Washington, DC                                          Washington, DC

Attachment: Brief bios of the authors

Cc: Financial Stability Oversight Council

Attachment

Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, DC. Previously, he was a resident fellow at the American Enterprise Institute from 2004 to 2015, and President and Chief Executive Officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He is the author of Boom and Bust (2011) and Finance and Philosophy (2018), as well as numerous articles and Congressional testimony. His work focuses on financial policy issues, financial cycles, risk and uncertainty, housing finance and banking systems, and the interactions of these with politics. Mr. Pollock is a director of CME Group; Ascendium Education Group; and the Great Books Foundation; and a past-president of the International Union for Housing Finance. He is a graduate of Williams College, the University of Chicago, and Princeton University.

Thomas H. Stanton served as President of the Association for Federal Enterprise Risk Management, a member of the federal Senior Executive Service, a board member of the National Academy of Public Administration (NAPA), and as Chair of the NAPA Standing Panel on Executive Organization and Management. In 2017 NAPA honored him with the George Graham Award for Exceptional Service to the Academy. In 2018 he received the Enterprise Risk Management Hall of Fame award. Mr. Stanton teaches as an adjunct faculty member at the Center for Advanced Governmental Studies at Johns Hopkins University. He is the author of A State of Risk: Will Government Sponsored Enterprises be the Next Financial Crisis? (HarperCollins, 1991), which presented the idea of contingent capital that is now being applied to reduce vulnerability of financial institutions globally, and of Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012). Mr. Stanton’s degrees are from the University of California at Davis, Yale University, and the Harvard Law School. Many of his publications can be found at www.thomas-stanton.com.

Is the monetary universe Newtonian or Einsteinian?

Published by the R Street Institute.

Is there an absolute standard of monetary or economic value? Nope. The monetary universe is not Newtonian, with a fixed frame of reference, but Einsteinian, with frames of reference moving with respect to each other. Prices are exchange rates with no substantive existence.

As the monetary economist Hans F. Sennholz instructively wrote:

There is no absolute monetary stability, never has been, never can be. Economic life is a process of perpetual change. People continually choose between alternatives, attaching ever-changing values to economic goods… [T]he exchange ratios of their goods are forever adjusting…nothing is fixed.

Money…is subject to man’s valuations and actions in the same way that all other economic goods are. Its subjective, as well as objective, exchange values continually fluctuate. … There is no true stability of money, whether it is fiat or commodity money. There is no fixed point or relationship in economic exchange…[in] this inherent instability of economic value.

– Hans F. Sennholz, Money and Freedom (1985), p 37.

As part of all this, governments and central banks can depreciate the currencies they control, run down the purchasing power of wages and savings and, in extreme but repeated cases, create hyperinflations.

There can be better or worse, but no perfect monetary system. All of them—whether the gold standard, gold and silver, a gold exchange system, the Bretton-Woods system, pure fiat currencies, independent or dependent central banks, inflation targets or not, fixed or managed or floating exchange rates—have various combinations of problems and advantages, and chances of breaking down.

Reality is so difficult.

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.

Over a century, which years were inflation-control champions and which booby-prize winners?

Published by the R Street Institute.

How much can the rate of inflation move around? A lot.

The Consumer Price Index (CPI) began in 1913, the same year the Federal Reserve was created. The CPI’s path over the 106 years since then displays notable variations in inflation — or alternately stated, in the rate of depreciation of the purchasing power of the U.S. dollar. In this post, I consider the average inflation rates during successive 10-year and five-year periods, starting in 1913. (The very last period, 2013-2018, includes six years.) I also note the context of historical events. Wars, especially, induce accelerated government money-printing, but the history displays constant inflation since 1933, sometimes slower, sometimes much faster.

Which decades and half-decades are the inflation-control champions, meaning the lowest average inflation rate without descending into serious deflation?  The decade champion is that of Presidents Eisenhower and Kennedy, 1953-1962. Its average inflation rate was 1.31 percent.

The booby prize goes to 1973-1982, when inflation averaged the awful rate of 8.67 percent per year. No wonder Arthur Burns, who was chairman of the Federal Reserve from 1970 to 1978, afterward gave a speech entitled “The Anguish of Central Banking.” In second place for the booby prize is 1913-1922, with an average inflation rate of 5.60 percent. That was the result of the first World War. The decade included, first, double-digit inflation then a short, very sharp depression in 1921-1922, but high inflation overall.

The inflation-control champion among half-decades is 1923-27, during the boom of the “Coolidge Prosperity,” when inflation averaged only 0.47 percent. In second place is 1953-57 at 1.24 percent. At that time, William McChesney Martin, who considered inflation “a thief in the night,” was chairman of the Fed.

Table 1 shows the record by 10-year periods in chronological order. It also shows what $1 at the beginning of each period was worth in purchasing power at the end of each 10 years. The last column shows what $1 in 1913 was worth in purchasing power, as it depreciated over the entire 106 years.

Table 2 shows the five-years periods, this time in order of lowest average inflation to highest, with historical notes on the context. It contrasts the lowest third of the observations with the highest third.

The average annual inflation over the 106 years was 3.11 percent. That reduced the $1 of 1913 to about 4 cents by the end of 2018, as shown in Graph 1. Note that, because of the scale of the graph, the change looks smaller in recent decades, but it isn’t. For example, the drop in purchasing power from 1983 to 2013 is the same as that from 1943 to 1973—about 60 percent in 30 years in each case.

Many central banks, including the Federal Reserve, now believe in perpetual inflation of 2 percent. Had that inflation rate been maintained since 1913, instead of the actual 3.11 percent, the dollar’s purchasing power from then to now would have followed the dashed line on the graph and fallen to 12 cents, instead of 4 cents.

We know from history that big wars will always be financed, in part, by depreciation of the currency of the winners, while the losers’ currencies will often be wiped out. There were several wars in addition to the two world wars in the 106 years under consideration, but was the constant inflation since 1933 necessary? Perhaps there was no other way for the government to deal with the debt automatically produced when taxes are forever less than government expenditures, war or no war, and the Federal Reserve is always there to help the Treasury out by monetizing its debt.

Thanks to Daniel Semelsberger for research assistance.

Comments/ RIN 2590-AA98: Validation and Approval of Credit Score Models by Fannie Mae and Freddie Mac

Published by the R Street Institute.

On behalf of National Taxpayers Union, R Street Institute, Citizens Against Government Waste, Institute for Liberty and Taxpayers Protection Alliance (“the undersigned”), we respectfully submit these comments to the Federal Housing Finance Agency (FHFA) concerning its Notice of Proposed Rulemaking for the validation and approval of credit score models. The undersigned are pleased to comment in favor of the proposed rule, which we believe represents a fair and reasonable interpretation of section 310 of the “Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.” Our organizations have long been involved in financial services issues and are prominent voices on housing finance matters. Importantly, we all follow the same housing policy fundamentals: a system that promotes broad access to credit for qualified borrowers, a significant private capital buffer, and administrative actions that promote competitive markets and protect taxpayers.

Since Fannie Mae and Freddie Mac (the GSEs) were placed into conservatorship more than a decade ago, our organizations have called for Congressional and administrative actions to mitigate taxpayer exposure to risky activity. Taxpayers have expressed concern about greatly expanded GSEs activities in the private market while enjoying the unique competitive advantages of government backing. With the GSEs having more than $5 trillion of mortgage risk on their extremely leveraged balance sheets, which are by extension underwritten by taxpayers, the federal government holds a considerable level of risk.

Economists widely agree that the significant increase in housing foreclosures that fueled the 2008 financial crisis and subsequent recession was a result of a weakening of GSE mortgage standards through affordable housing goals. These goals required the GSEs meet annual quotas of low- and moderate-income mortgages. As time went on and the number of prime borrowers dried up, the GSEs had to expand operations in the subprime market in order to meet their annual quotas. As the market shrank, the GSEs found it harder and harder to find creditworthy borrowers causing them to lower their standards to meet their affordable housing goals. This involved either reducing the accepted credit score, lowering the required down payment, raising the debt-to-income ratio, or accepting low or no documentation.

Accepting lower credit standards certainly expanded the number of people who were eligible for a mortgage, but it allowed a greater number of under-qualified borrowers to obtain a loan who would have otherwise been denied such a large line of credit. Once defaults skyrocketed and the housing bubble burst, the GSEs were wired more than $190 billion from taxpayers to keep them afloat and were placed into conservatorship where they remain to this day.

If there is one lesson from the 2008 housing crisis that should have been learned, it is that overly ambitious affordable housing goals and the rush to qualify numerous borrowers by any means can put the economy, and taxpayers, at great risk. GSEs utilize credit scores in several ways including benchmarks for risk fees, loan eligibility guidelines, and (for Freddie Mac) one of many attributes in making a credit assessment. They are also used internally to balance counterparty risk, an often-overlooked but very important role. Thus, allowing new credit score models into the GSE framework could have major consequences for their operations, their risk, and in turn taxpayer liabilities.

Such consequences would also reverberate throughout the private sector, as lenders, loan servicers, mortgage insurers, and other parts of the industry would face all manner compliance and implementation costs. New credit scoring methods in the GSEs could also eventually spill over into taxpayer-backed lending programs at the Federal Housing Administration, the Small Business Administration, and other agencies. In an environment where GSEs and FHA appear to be more heavily weighting their portfolios with higher-risk loans, the introduction of new credit scores could even affect the overall systemic risk calculation at an especially delicate point in financial markets. These factors are discussed in greater detail in a Policy Paper that National Taxpayers Union filed separately with FHFA.

It is of particular concern to free market, limited government groups to see how the “Credit Score Competition Act,” included as Section 310 of S. 2155, “the Economic Growth, Regulatory Relief, and Consumer Protection Act” that passed in 2018, will be implemented. Section 310 directs FHFA to create a process for evaluating new credit scoring models for use by the GSEs but does not mandate they accept more just one type of credit score. We believe FHFA interpreted the legislative text in a careful and thoughtful manner that complies with legislative intent. The proposed rule issues standards for compliance, which sets forth several factors that must be considered in the validation and approval process, including the credit score model’s integrity, reliability, and accuracy, its historical record of predicting borrower and credit behaviors, and consistency of any model with GSE safety and soundness.

Further, FHFA rightly notes in the proposed rule that alternative scores may immediately gain a competitive advantage in the market. As such, the rule specifically “prohibits an Enterprise from approving any credit score model developed by a company that is related to a consumer data provider through any common ownership or control, of any type or amount.” In addition, the proposed rule not only calls for sound cost-benefit analysis in evaluating new models, it also builds in conflict-of-interest guardrails (which are standard in other regulatory spheres) to ensure that those models compete on a level playing field. This holds promise for creating a true market-driven competitive environment with an opportunity for innovation.

Additionally, we are supportive of the straightforward, four-step process which the Enterprises evaluate and implement alternative credit-scoring models. The process is summarized below:

1. Solicitation of applications from credit score model developers; Proposes that solicitation for new applications occur at least every seven years, or as determined necessary by FHFA.

2. Initial review of submitted applications;
   ● Each GSE would obtain the data from the data provider on behalf of the applicant.

3. Credit score assessment;
   ● During this assessment phase, each credit score model would be assessed for accuracy, reliability, and integrity.
   ● Approaches for assessing accuracy include: 1) Comparison-based. This approach will not require the applicant’s credit score to be more accurate than the existing credit score in use by the GSEs. This approach would be more subjective and indicate reasonableness of the credit score’s accuracy. 2) Champion-Challenger. The applicant’s credit score must be more accurate than the existing credit score in use by the GSEs. This would be a bright line test.

4. Enterprise business assessment;
   ● During this phase, a GSE would assess the credit score model in conjunction with the GSEs business systems and processes.
   ● In addition, the GSE must consider impacts on the mortgage finance industry, assess competitive effects, conduct a third-party vendor review, and any other evaluations established by the GSE.

The validation and approval process, which produces the resulting approved credit score model, must meet these five statutory requirements:

(i) satisfy minimum requirements of integrity, reliability, and accuracy; (ii) have a historical record of measuring and predicting default rates and other credit behaviors; (iii) be consistent with the safe and sound operation of the corporation; (iv) comply with any standards and criteria established by the Director of the Federal Housing Finance Agency under section 1328(1) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992; and (v) satisfy any other requirements, as determined by the corporation.

Taxpayers have a significant stake in the housing finance market and FHFA must do everything in its power to ensure that taxpayer risk is mitigated to its fullest extent. The proposed rule will undoubtedly help to protect from a potential “race to the bottom” effect to qualify as many possible borrowers as possible through political manipulation of tools that are supposed to be reliable predictors of risk. Significant innovation in the credit scoring space is already occurring through the advent of refinements and expansions to existing standard tools, which themselves are being subjected to rigorous testing. We believe these modernizations can be balanced with the benefits of a stable, predictable system of lending and finance that measures and protects against risk, not only to borrowers and lenders, but also to taxpayers.

Thank you for the opportunity to offer our views on this proposed rule. We urge FHFA to adopt the rule as is and implement it in a timely manner.

Pete Sepp, President
National Taxpayers Union

Alex J. Pollock, Distinguished Senior Fellow
R Street Institute

Tom Schatz, President
Citizens Against Government Waste

David Williams, President
Taxpayers Protection Alliance

Andrew Langer, President
Institute for Liberty

Re: Comments/ RIN 2590-AA98: Validation and Approval of Credit Score Models by Fannie Mae and Freddie Mac

Published by the R Street Institute.

Dear Mr. Pollard:
Thank you for the opportunity to submit these comments on the Proposed Rule on Credit Score Models:

1. In my opinion, the Proposed Rule overall is sensible and well-considered, and consistent with sound housing finance.

2. Since credit scores are part of the analysis and management of credit risk, the principal decisions about their use should rest with those who take the credit risk—in this case, with Fannie Mae and Freddie Mac. The process as defined by the Proposed Rule thus puts the primary responsibility for analysis and decisions in the right place, with Fannie and Freddie, with review by the FHFA as regulator.

3. It certainly makes sense for Fannie and Freddie to consider various available alternative credit score models, as provided in the Proposed Rule, but the primary decision criterion should always be each model’s contribution to accurately predicting future loan credit performance. The Proposed Rule reasonably suggests consideration of each model’s accuracy and reliability on its own, as well as when used within Fannie and Freddie’s credit management systems, but the latter is clearly the more important question.

4. As the Proposed Rule importantly observes, “Credit scores are only one factor considered by [Fannie and Freddie] in determining whether to purchase a loan.”

5. It is essential, as reflected in the Proposed Rule, for considerations of credit score models to take into account the time, effort, complexity, uncertainty, and costs (direct and indirect) to the mortgage industry of alternative decisions. In particular, the effects on smaller mortgage lenders should be addressed.

6. It is a good idea to have the possibility of small-scale experiments or “pilot programs,” if appropriate, as the Proposed Rule provides.

7. The Proposed Rule suggests using the standard definition of default with a time horizon of two years from loan origination. Consistent with the very long term of mortgage loans, I believe longer time horizons should also be tested for the extent of continuing predictive power of credit score models.

These are my personal views. It would be a pleasure to discuss any of them further.

Respectfully submitted,

Alex J. Pollock

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.

Predicting is hard…

Published by the R Street Institute.

From Reuters, on June 27, 2017:

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe there will be another financial crisis for at least as long as she lives.

From CNBC, on Dec. 11, 2018:

There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.

The financial future is murky, but one of these predictions will be right.

Hume’s Timely Political Advice from 1741

Published by the R Street Institute.

I am neither surprised nor upset by the divisive partisanship of current times. Emotional partisanship is nothing new in the world. But we certainly must condemn the bad manners it now engenders.

David Hume, the great philosopher, economist and historian, reflected calmly on partisan passions in 1741, in his Essays Moral and Political. Here are some relevant excerpts (with ellipses deleted):

“There are enow of zealots on both sides who kindle up the passions of their partisans, and under pretense of public good, pursue the interests and ends of their particular faction.

“Those who either attack or defend a minister in such a government as ours, where the utmost liberty is allowed, always carry matters to an extreme, and exaggerate his merit or demerit. His enemies are sure to charge him with the greatest enormities, both in domestic and foreign management, and there is no meanness or crime, of which in their account, he is not capable. On the other hand, the partizans of the minister make his panegyric run as high as the accusations.

“When this accusation and panegyric are received by the partizans of each party, no wonder they beget an extraordinary ferment on both sides, and fill the nation with violent animosities.”

Hume included this excellent and timely advice for us, reading it 277 years later:

“For my part, I shall always be more fond of promoting moderation than zeal. Let us therefore try, if it be possible to draw a lesson of moderation with regard to the parties into which our country is at present divided.”

Good manners should control our behavior, whatever our feelings may be inside, and moderation frees the mind to think. Like Hume, let us be fond of promoting it.

Government Debt: A Quiz

Published by the R Street Institute.

Government debt is a favored investment class all over the world, but it has a colorful history full of financial adventures. Often enough, historically speaking, it has resulted in investors gazing sadly on unpaid sovereign promises to pay, to paraphrase Max Winkler’s “Foreign Bonds: An Autopsy,” his chronicle of the long list of government defaults up to his day in the 1930s. The list has grown much longer since.

Here are six sets of years.  What do they represent?

1. 1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014

2. 1828, 1898, 1902, 1914, 1931, 1937, 1961, 1964, 1983, 1986, 1990

3. 1826, 1843, 1860, 1894, 1932, 2012

4. 1876, 1915, 1931, 1940, 1959, 1965, 1978, 1982

5. 1826, 1848, 1860, 1865, 1892, 1898, 1982, 1990, 1995, 1998, 2004, 2017

6. 1862, 1933, 1968, 1971

All these are years of defaults by a sample of governments. For the first five of them, see Carmen Reinhart’s “This Time Is Different Chartbook: Country Histories.” They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

And No. 6 is the United States.

In the case of the United States, the defaults were: The refusal to redeem greenbacks for gold or silver, as promised, in 1862. The refusal to redeem gold bonds for gold, as promised, in 1933. The refusal to redeem silver certificates for silver, as promised, in 1968. The refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.

The U.S. government has since stopped promising to redeem money for anything else, making it a pure fiat currency, and stopped promising to redeem its bonds for anything except its own currency.  This prevents future defaults, but not future depreciation of both the currency and government debt.

Winkler related a great story to give us an archetype of government debt from ancient Greek times.  Dionysius, the tyrant of Syracuse, was hard up and couldn’t pay his debt to his subjects, the tale goes.  So he issued a decree requiring that all silver coins had to be turned in to the government, on pain of death. When he had the coins, he had them reminted, “stamping at two drachmae each one-drachma coin.” Brilliant!  With these, he paid off his debt, becoming, Winkler says, “the Father of Currency Devaluation.”

Observe that Dionysius’s stratagem was in essence the same as that of the United States in its defaults of 1862, 1933, 1968 and 1971.

So advantageous it is to be a sovereign when you are making promises.

Better late than never

Published by the R Street Institute.

September brought endless discussions of the 10th anniversary of the bankruptcy of Lehman Brothers and the failures of Fannie Mae and Freddie Mac. Tomorrow, Oct. 3, brings the 10th anniversary of congressional authorization of the Troubled Asset Relief Program (TARP) bailouts created by the Emergency Economic Stability Act.

After all this time, we still await reform of American housing finance – the giant sector that produced the bubble, its deflation, the panic and the bust.

During the panic in fall 2008, in the fog of crisis, “We had no choice but to fly by the seat of our pants, making it up as we went along,” Treasury Secretary Henry Paulson has written of the time. That is no longer the problem.

In retrospect, it is clear that the panic was the climax of a decadelong buildup of leverage and risk, much of which had been promoted by the U.S. government. This long escalation of risk was thought at the time to be the “Great Moderation,” although it was in fact the “Great Leveraging.”

The U.S. government promoted and still promotes housing debt. The “National Home Ownership Strategy” of the Clinton administration—which praised “innovative,” which is to say poor-credit-quality, mortgage loans—is notorious, but both political parties were responsible. The government today continues to promote excess housing debt and leverage though Fannie and Freddie. It has never corrected its debt-promotion strategies.

A profound question is why the regulators of the 2000s failed to foresee the crisis. It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is the mismatch between prevailing ideas and the emergent, surprising reality when the risks turn out to be much greater and more costly than previously imagined.

There is a related problem: regulators are employees of the government and feel reluctant to address risky activities the government is intent to promote.

At this point, a decade later, reform of the big housing finance picture is still elusive. But there is one positive, concrete step which could be taken now without any further congressional action. The Financial Stability Oversight Council (FSOC), created in 2010, was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions (SIFIs) for increased oversight of their systemic risk. In general, I believe this was a bad idea, but it exists, and it might be used to good effect in one critical case to help control the overexpansion of government-promoted housing finance debt.

FSOC has failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important and systemically risky. This failure to act may reflect a political judgment, but it is intellectually vacuous.

Fannie and Freddie should be forthwith designated as the SIFIs they so unquestionably are. Better eight years late than never.

Federal Reserve brings the real Fed Funds Rate up to about zero

Published by the R Street Institute.

As everybody knew it would, the Federal Reserve Board announced today it is bringing its target federal funds rate up to a range of 2 percent to 2.25 percent—in shorter form, to about 2.25 percent. That is still a very low rate, especially translated, as is economically required, to a real interest rate—that is, one adjusted for inflation. The new Federal Reserve target rate, in real terms, is more or less zero.

To adjust for inflation, you have to choose a measure of inflation. The Consumer Price Index over the 12 months through August 2018 rose 2.7 percent. Thus, using the CPI, the new inflation-adjusted Fed Funds target is 2.25 percent minus 2.7 percent, or a real rate of -0.45 percent.

Suppose as an inflation measure you like the Personal Consumption Expenditures Index (PCE) instead. Over the 12 months ended in July 2018, it went up 2.3 percent, so 2.25 percent is still a slightly negative real interest rate.

But the Fed likes to use the “core” PCE, which excludes food and energy prices. This is especially good for people don’t have to buy things to eat or gas for their car. Core PCE rose 2 percent for the same period. That would result in a slightly positive real interest rate of 2.25 percent, minus 2 percent, or 0.25 percent.

Averaging these three estimates together gives a real fed funds target rate of negative 0.08 percent—close enough to zero for monetary policy work, given its vast uncertainties.

Zero is a remarkably low real fed funds rate nine years after the end of the last recession, nine years after the end of the 2007-2009 financial crisis, in a time of strong economic growth and, more to the point, in the midst of a remarkable asset price inflation in houses, commercial real estate and securities.

Nobody, including the Federal Reserve, knows what real interest rates should be, but there is little doubt that a free market, without central bank manipulation, would by now have set them higher.

When and how will the current asset price inflation end?  Nobody, including the Fed, knows that either.