A US Bitcoin reserve would do much for Bitcoin and little for taxpayers

Published in The Hill with Paul H. Kupiec. Also Published in Real Clear Markets.

Speaking at the Nashville Bitcoin 2024 conference, Sen. Cynthia Lummis (R-Wyo.) floated a “revolutionary proposal” to make the federal government a Bitcoin investor. It is hard to imagine how this might benefit U.S. taxpayers or support the dollar’s value, but it certainly would raise the dollar price of Bitcoin.

While it is unsurprising that a plan to use taxpayer dollars to benefit foreign and domestic Bitcoin owners would have the Nashville audience cheering, it is impossible to justify. Neither the Federal Reserve nor the U.S. Treasury would want to or should be permitted to support Bitcoin’s price.

According to the accompanying statement issued by Lummis’s office, this proposal would create “a strategic Bitcoin reserve” of 1 million Bitcoins that the government would “would be required to hold … for 20 years.” We couldn’t have the government selling its Bitcoin and driving down the cryptocurrency’s price, now could we? 

This plan is as quintessentially American as a Louis L’Amour novel about mining the Comstock Lode. In 1878, owners of silver mines in places like Virginia City, Nev., succeeded in lobbying Congress to pass the Bland-Allison Act which required the government to support the price of silver by buying and stockpiling large amounts. 

Few ideas are new in politics or finance. Although a plan to force the federal government to buy something to support its price is hardly new, the proposed source of funds for these purchases is especially problematic.

In her Nashville remarks, Lummis said, “We will convert excess reserves at our 12 Federal Reserve banks into Bitcoin over five years. We have the money now!” 

 If by “excess reserves” Lummis means the “paid-in capital and surplus” of Federal Reserve district banks, as we have explained elsewhere, measured by generally accepted accounting standards, the Fed’s total paid-in capital and surplus account balance is negative $145 billion. Since September 2022, the Fed has had to borrow $145 billion just to fund its own expenses.

If the Fed is going to invest in Bitcoin, it would have to borrow even more money. Or it could sell some of its deeply underwater investments and book a big loss. Neither alternative makes sense. 

Even if the Fed did have positive paid-in capital and surplus funds available to invest, there is a more fundamental problem. The Federal Reserve Act, as a bedrock principle, restricts the Fed’s open market investments to U.S. government obligations or instruments guaranteed by the federal government or its agencies. This law would have to be amended to allow the Fed to purchase Bitcoin. 

If Congress did consider changing the act, other crypto coins and special interest assets would assuredly lobby Congress to be included as Fed-eligible investments. Such legislation would create enormous pressure to use the Fed’s monetary powers to purchase these assets, allocate credit and extend implicit subsidies. 

Additionally, holding Bitcoin would create a large operating loss for the Fed. Bitcoin pays no interest, but the Fed has to pay interest on the money it borrows to finance its investments. At current rates, every dollar borrowed to hold Bitcoin would cost the Fed 5.4 percent in annual interest. 

Suppose the Fed bought half a million Bitcoins at today’s price of about $60,000 each. At an interest cost of 5.4 percent, the Fed would incur operating cash losses of $1.6 billion a year on its Bitcoin investment. Over 20 years, the operating losses would total $32 billion, or more than 100 percent of the investment.

According to a report by CoinDesk, Lummis’s proposed Bitcoin Act of 2024 would also require the Treasury to revalue its gold stock and use the resulting capital gains to buy Bitcoin. We explained the mechanics of such a transaction in an article addressing the 2023 federal debt ceiling debate.

The current market price of gold is about $2,500 per ounce. The Treasury owns about 261.5 million ounces of gold. The Gold Reserve Act, amended in 1973, requires the Treasury to value its gold at $42.22 per ounce. At current market prices, the Treasury owns about $640 billion in gold but values it at a little over $11 billion. 

If the law were changed to force the Treasury to revalue its gold, it could issue $629 billion in new gold certificates to the Fed in return for dollars. This accounting transaction would create $629 billion in newly-printed dollars for the Treasury to spend. Using an accounting adjustment to create $629 billion for the Treasury to spend on Bitcoin is inflationary and does nothing to enhance the value of the U.S. dollar.

From a risk exposure perspective, any federal government investment in Bitcoin would be leveraged speculation on the price of a notoriously volatile intangible asset. 

Bitcoin enthusiasts and promoters have long claimed that Bitcoin will be an alternative to replace the dollar, allowing cryptocurrency users to escape the Fed, the Treasury and the U.S. government. Strategically, it’s extremely unlikely that the Fed and the Treasury will embrace this proposal as a cause to subsidize and promote.

The Treasury, in particular, reaps great advantages from the worldwide, massive holdings of U.S. dollar securities and currency — this is the famous “exorbitant privilege” of issuing the global reserve currency. It is central to financing the American government and American geopolitical power.  

It is pretty hard to imagine the Treasury wanting to invest in an alternative asset that seeks to weaken or even end its crucial advantages.

The Bitcoin proposal claims it would “bolster” and “fortify” the U.S. dollar, but truth be told, it is a plan to bolster the value of Bitcoin that provides no benefit for the the dollar. Once the facts are understood, no U.S. taxpayer without Bitcoins would support a proposal to use their tax dollars to bolster its price. 

A government Bitcoin reserve is just a bad idea.

The Fed Has No Earnings to Send to the CFPB

Published by the Federalist Society and RealClear Markets:

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

“Earnings” means net profit:

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

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

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

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

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

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

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

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

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

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

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

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

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

A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

The Fed's Capital Is Rapidly Heading to Zero, and Below

Published in RealClear Markets.

Since September 2022, the Federal Reserve has lost about $36 billion.  A big number!—and notably big compared to the Fed’s stated capital of $42 billion. Thus the Fed has already run through about 85% of its capital and has only $6.6 billion (0.07 % of its total assets) left as of February 22. How long will it take to burn through that?  Less than three weeks.

So the Fed’s real capital will hit zero in mid-March. By April Fools’ Day, it will be proceeding into ever more negative territory.

What does negative capital mean for the world’s top central bank?  As for any entity, it means that its liabilities exceed its assets, and that it is technically insolvent.

Here we are dealing with the Fed’s real capital, in contrast to the stated capital its financial statements report.  For every organization, everywhere and necessarily, losses reduce retained earnings and thus total capital.  Nothing could be more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses of $36 billion. But the Fed wishes to exempt itself from this law of accounting, by treating its losses as an asset, which they aren’t.  It wishes us to believe that if it loses $100 billion, as it probably will in 2023, or $200 billion, or even $1 trillion, that its capital would always be the same.  “LOL,” as people text these days. The situation may make you think of the cynically realistic remark of Jean-Claude Juncker, when he was the head of the European finance ministers: “When it becomes serious, you have to lie.”

The Fed itself and most economists claim about the losses and the looming negative capital that “It doesn’t matter and no one cares.” They point out that the Fed can continue to print up more money to pay its obligations, no matter how much it has lost or how much less its assets are than its liabilities.  

Nonetheless, it is surely embarrassing to have lost all your capital, let alone twice or three times your capital, as the Fed will have done by the end of this year.  Whether it did this intentionally or unintentionally, it raises pointed questions about whether the Fed correctly anticipated such huge losses and how negative its capital would become, and, if it did, whether it informed Congress of what was coming.

A second argument the Fed and its supporters make is that “Central banks are not supposed to make profits.”  This is not correct.  All central banks, including the Fed, are designed precisely to make profits for the government through their currency monopoly.  They issue non-interest bearing currency, and make interest bearing investments.  This makes profits automatically and thereby reduces the Treasury’s deficit.  But no more.  The easy profits have been wiped out by the losses on the Fed’s $5 trillion risk position of investing long and borrowing short, now upside down.  The Fed has trillions of long-term “Quantitative Easing” investments it bought to yield 2% or 3 %, but the cost of funding them is now over 4 1/2%-- a guaranteed way to lose money.  And the Fed’s borrowing costs are likely headed still higher, making its losses still bigger. 

Thus the losses are the actualization of the immense financial risk the Fed knowingly took, while not knowing how bad the outcome would be.  The Fed’s losses now make its capital negative, increase the federal deficit and are a fiscal burden on the Treasury.

The Fed is not alone in this problem, since many central banks together set themselves up for losses. “Euro Area Braces for Era of Central-Bank Losses After QE Binge,” in the words of a recent Bloomberg headline. In Great Britain, His Majesty’s Treasury has committed to pay for losses of the Bank of England, and the Canadian Finance Ministry has entered into a contract with the Bank of Canada to offset any realized losses on the Bank’s QE bonds.  

Should the U.S. Treasury recapitalize the Fed by buying stock in the Federal Reserve Banks?  Unlike in most other countries, the U.S. government does not own the stock of its central bank— private banks do.  The Fed does have a formal call on the private banks to require them to buy more stock-- the half of their stock subscription they have not paid in.  This would raise about $36 billion in new capital.

But the Fed certainly does not want to be seen as needing to call this additional capital-- or needing to skip its dividend, as both the European Central Bank and the Swiss central bank have done this year.

Nor does the Fed wish its balance sheet to show its real capital.  But if, as the Fed argues, it doesn’t matter and no one cares, why go through the charade?  Why not simply report the true number?

Profligacy in Lockstep

Published in Law & Liberty and re-published in RealClear Markets with Paul Kupiec:

The Swiss National Bank’s (SNB) financial statements for the nine months ending September 30, 2022, show a bottom-line loss of US$150 billion.* A number to get your attention!

Under the strong financial discipline of its charter act, the SNB must mark its investments to market, and reflect any market value loss or profit in its income statement and capital account. From having capital of $221 billion at the end of 2021, the SNB’s capital has been reduced by 73% to $59 billion on September 30 due to falling market prices. Still, the SNB has a capital ratio—a bank’s equity to its total assets—over 6%.

In contrast, the Federal Reserve’s reported capital ratio, which does not reflect the Fed’s massive mark-to-market losses, is 0.5%. The Federal Reserve Bank of New York, by far the largest of the Federal Reserve Banks, has a reported capital ratio of 0.3%—again not counting its market value losses. “It helps the credibility of the central bank to be well capitalized,” said the Vice Chairman of the SNB in October 2022. Presumably, the Fed does not agree.

With Swiss candor, the Chairman of the SNB observed, also in October 2022, that many central banks “brought down longer-term interest rates by buying government and corporate bonds. This increased central banks’ balance sheets and the risks they bear.” (italics added) They certainly did run up their risk, all together, and now the big risks they assumed are turning into losses all around the central bank club.

The Reserve Bank of Australia announced in September that losses on its investments caused its capital to drop to a negative $8 billion on June 30. Its Deputy Governor admitted that “If any commercial entity had negative equity… [it] would not be a going concern,” but maintained, “there are no going concern issues with a central bank in a country like Australia.” Nonetheless, it’s pretty embarrassing to have lost more than all of your capital.

The Bank of England joined “the club of major central banks showing negative net worth” if its investments are marked-to-market, Grant’s Interest Rate Observer reported. Thus far, the Bank has lost $230 billion on its bond investments, 33 times the Bank’s capital of $7 billion as of February 2022, its fiscal year-end. Fortunately for the Bank, it has an indemnity from His Majesty’s Treasury—that is, the taxpayers—to cover the losses. “I am happy to reaffirm…that any future losses incurred by the Asset Purchase Fund will be met in full by the Government,” wrote a Chancellor of the Exchequer. In July 2022 the Financial Times summed it up: “With an indemnity provided by HM Treasury the Bank of England need not fret.” But should the taxpayers who bear the loss fret?

The Bank of Canada carries most of its investments at market value, and its financial statements reflect market value losses of $26 billion as of November 2022. These mark-to-market losses would render the bank’s capital negative were it not for a formal indemnity agreement it has with the Government of Canada. The Canadian government has contractually agreed to make up any realized losses on the Bank’s bond purchase programs. That’s a good thing for the Canadian central bank, since its capital ratio is only 0.1%.

While the Bank of Canada’s financial statements do show that its investment losses put the taxpayers at risk, you have to read the financial statement footnotes carefully to understand what the accounting means. The Bank carries an asset called “Derivatives: Indemnity agreements with the Government of Canada.” This asset is the amount that the government is on the hook for—in other words, it equals $26 billion in mark-to-market losses. Since the Bank’s total reported capital is only about $0.5 billion, the real capital of the Bank is its claim on Canadian taxpayers to reimburse its losses.

Now having created the same risks together, the world’s central banks are suffering big losses together.

The European Central Bank (ECB) has assets of over $9 trillion and a capital ratio of 1.3%. How do its mark-to-market losses compare to its $119 billion in capital? It’s hard to tell, but a German banking colleague wrote us, “ECB is not really transparent, [but] you can guess… Expect price losses in its portfolio of about $800 billion.” If his informed guess is accurate, the ECB has negative capital of about $680 billion on a mark-to-market basis. As our colleague also pointed out, many of the ECB’s investments are low-quality sovereign bonds. It will be interesting indeed to see how these ECB problems play out.

In September, the Governor of the Dutch central bank, De Nederlandsche Bank (DNB), formally wrote to the Ministry of Finance to discuss the Bank’s looming losses, and how “a situation may arise in which the DNB is faced with negative capital.” This is without considering the mark-to-market of its bond portfolio, because the DNB uses accounting conventions, like the Federal Reserve, that do not recognize mark-to-market losses on its QE investments.

“In an extreme case,” the letter continued, “a capital contribution from the shareholder may be necessary.” The sole shareholder is the Dutch government, so once again the cost would be transferred to the taxpayers.

In this unattractive situation the DNB has plenty of company: “All central banks implementing purchase programs, both in the euro area and beyond, are facing these negative consequences,” the Governor observed, adding that these included the Federal Reserve, the Swedish Riksbank, and the Bank of England.

Then, in an October television interview, the Governor brought up the old-fashioned idea of gold. The DNB’s negative capital problem could be ameliorated or avoided he said, by counting as capital the large unrealized profit on its gold. The Bank does mark its 19.7 million ounces of gold to market but keeps the appreciation in a separate $33 billion accounting “reserve,” which is not included in its capital account.

Although it is against the current rules of the Euro system, it would make perfect sense to include the market value of the gold when calculating the DNB’s capital, as the Swiss National Bank does. (This idea would not help the Federal Reserve, because it owns no gold.) It is no small irony that, to bolster their capital, modern fiat currency central banks would consider turning to the value of the “barbarous relic” of gold, against which their own currencies have over time so greatly depreciated.

Coming to the world’s leading central bank, the mark-to-market loss on the Federal Reserve’s investments, as we have previously written, is huge—estimated at a remarkable $1.3 trillion loss as of October 2022. This is 30 times the Fed’s total capital of $42 billion. More immediately pressing, the Fed is now running operating losses that it does recognize in its profit and loss statement of $1 billion or more a week, or annualized losses of $50 to $60 billion. Not counting the mark-to-market losses on its investments, the Fed’s operating losses at this rate will exceed its capital in less than a year.

Complicating the problem, the shares of the Federal Reserve Banks are owned not by the government, but by Fed member commercial banks. Under the Federal Reserve Act, the Fed’s shareholders are required to be assessed for a portion of any losses, but the Fed has thus far seemed to ignore the law and is sharing its operating losses with the taxpayers instead.

“Major central banks tend to move together,” as economist Gary Shilling pointed out recently. We believe this is because the major central banks are a coordinating elite club. They do not and cannot know the financial and economic future, and they must act based on highly unreliable forecasts. They face, and know they face, deep and fundamental uncertainty. Under these circumstances, intellectual and behavioral herding is natural and to be expected. Now having created the same risks together, they are suffering big losses together. In many cases, the accumulating losses will exceed central bank capital and be borne by the taxpayers.

*All currencies have been translated to US dollars at mid-November exchange rates.

Who owns the Fed’s massive losses?

Published in The Hill and RealClear Markets.

By Paul H. Kupiec and Alex J. Pollock

We estimate that at the end of May, the Federal Reserve had an unrecognized mark-to-market loss of about $540 billion on its $8.8 trillion portfolio of Treasury bonds and mortgage securities. This loss, which will only get larger as interest rates increase, is more than 13 times the Federal Reserve System’s consolidated capital of $41 billion.

Unlike regulated financial institutions, no matter how big the losses it may face, the Federal Reserve will not fail. It can continue to print money even if it is deeply insolvent. But, according to the Federal Reserve Act, Fed losses should impact its shareholders, who are the commercial bank members of the 12 district Federal Reserve banks.

Among Federal Reserve officials and many economists, it is fashionable to argue that any losses the Federal Reserve should suffer, no matter how large, will have no operational consequence. Now that the Fed has already experienced mark-to-market losses of epic proportions and will soon face large operating losses, something it has never seen in its 108-year history, we are about to see if this is true.

Member banks must purchase shares issued by their Federal Reserve district bank. Member banks only pay for half the par value of their required share purchases “while the remaining half of the subscription is subject to call by the Board.”

In addition to potential calls to buy more Federal Reserve bank stock, under the Federal Reserve Act member banks are also required to contribute funds to cover any district reserve bank’s annual operating losses in an amount not to exceed twice the par value of their district bank stock subscription. Note especially the use of the term “shall” and not “may” in the Federal Reserve Act:

“The  shareholders  of every  Federal  reserve  bank shall  be  held  individually responsible,  equally  and  ratably,  and  not  one  for  another,  for  all  contracts, debts,  and  engagements  of  such  bank  to  the  extent  of  the  amount subscriptions  to  such  stock  at  the  par  value  thereof  in  addition  to  the  amount subscribed.” (bold italics added).

Despite congressional revisions to the Federal Reserve Act over more than a century, the current Act still contains this exact passage.

By the Federal Open Market Committee’s own estimates, short-term policy rates will approach 3.5 percent by year-end 2022. Many think policy rates will go higher, maybe much higher, before the Fed successfully contains surging inflation. Our estimates suggest that the Federal Reserve will begin reporting net operating losses once short-term interest rates reach 2.7 percent. This estimate assumes the Fed has no realized losses from selling securities. If short-term rates reach 4 percent, we estimate an annualized operating loss of $62 billion, or a loss of 150 percent of the Fed’s total capital.

This unenviable financial situation — huge mark-to-market investment losses and looming negative operating income — is the predictable consequence of the balance sheet the Fed has created. The Fed is paying rising rates of interest on bank reserves and reverse repurchase transactions while its balance sheet is stuffed with low-yielding long-term fixed rate securities. In short, the Fed’s income dynamics resemble those of a typical 1980s savings and loan.

In 2011, the Federal Reserve announced its official position regarding realized losses on its investment portfolio and system operating losses:

“In the unlikely scenario in which realized losses were sufficiently large enough to result in an overall net income loss for the Reserve Banks, the Federal Reserve would still meet its financial obligations to cover operating expenses. In that case, remittances to the Treasury would be suspended and a deferred asset would be recorded on the Federal Reserve’s balance sheet.”

Under this unique accounting policy, operating losses do not reduce the Federal Reserve’s reported capital and surplus. A positive reserve bank surplus account is ensured by increasing an imaginary “deferred asset” account district reserve banks will book to offset an operating loss, no matter how large the loss. Among other things, this accounting “innovation” ensures that the Fed can keep paying dividends on its stock. Similar creative “regulatory accounting” has not been utilized since the 1980s when it was used to prop up failing savings institutions.

The Fed’s stated intention is to monetize operating losses and back any newly created currency with an imaginary “deferred asset.” It is impossible to imagine that the authors of the Federal Reserve Act would have approved of allowing the Fed to create an imaginary “deferred asset” as a mechanism to hide the fact that the Fed is depleting its cushion of loss-absorbing assets while paying banks dividends and interest on their reserve balances, when the act itself makes member banks as stockholders liable for Federal Reserve district bank operating losses.

Clearly, if the Fed is required to comply with the language in the Federal Reserve Act and assess member banks for its operating losses it could impact monetary policy. The prospect of passing Fed operating losses on to member banks could create pressure to avoid losses by limiting the interest rate paid to member banks or discouraging asset sales needed to shrink the Fed’s bloated balance sheet. Moreover, if the Fed’s losses were passed on, some member banks may face potential capital issues themselves.  

Will the Fed ignore the law, monetize its losses, and create a new source of inflationary pressure? Or will it pass its losses on to its shareholders? Stay tuned.

The INDEX Act Is a Major Step Forward In Corporate Governance

Published in RealClear Markets. Also published in the Federalist Society.

An unsolved problem in American corporate governance is that a few big asset management firms have through their index funds grabbed dominating voting power in hundreds of corporations by voting shares which represent not a penny of their own money at risk. They have in effect said to the real investors whose own money is at risk, “I’ll just vote your shares.  I’ll vote them according to my agenda.  I don’t want to bother with what you think.”

This obviously opens the door for the exercise of hubris, as has perhaps notably been the case with BlackRock, but more importantly, it violates the essential principle that the principals, not the agents, should govern corporations. This principle is well-established and unquestioned when it comes to broker-dealers voting shares held in street name. The brokers can vote on significant matters only with instructions from the economic owners of the shares. Exactly the same clear logic and rule should apply to the managers of the passive funds which have grown so influential using other people’s money.

Now Senators Pat Toomey (R-PA), the Ranking Member of the Senate Banking Committee, and Dan Sullivan (R-Alaska), with eleven co-sponsors, have addressed the problem directly by introducing an excellent bill: The INDEX (Investor Democracy Is Expected) Act. This bill would apply the longstanding logic for broker-dealer voting to passive fund asset manager voting, which makes perfect sense. As Senator Toomey said in announcing the bill, “The INDEX Act returns voting power to the real shareholders…diminishing the consolidation of corporate voting power.” You couldn’t have a goal more basic than that.

This bill ought to be approved by overwhelming bipartisan majorities. To oppose it, any legislator would have to sign up to the following pledge: “I believe Wall Street titans should be able to vote other people’s shares without getting instructions from the real owners.” That does not sound like a political winner.

The asset management firms themselves seem to be feeling the force of the INDEX Act logic. BlackRock said it looks forward “to working with members of Congress and others on ways to help every investor—including individual investors—participate in proxy voting.” Vanguard said it “believes it is important to give investors more of a voice in how their proxies are voted.”

If enacted, as it should be, the INDEX Act will require these nice words to be put into action.

Federal Housing Regulators Have Learned and Forgotten Everything

Published in Law & Liberty and in Real Clear Markets.

Should the government subsidize buying houses that cost $1.2 million? The answer is obviously no. But the government is going to do it anyway through Fannie Mae and Freddie Mac. The Federal Housing Finance Authority (FHFA) has just increased the size of mortgage loans Fannie and Freddie can buy (the “conforming loan limit”) to $970,080 in “high cost areas.” With a 20% down payment, that means loans for the purchase of houses with a price up to $1,212,600.

Similarly, the Federal Housing Administration (FHA) will be subsidizing houses costing up to $1,011,250. That’s the house price with a FHA mortgage at its increased “high cost” limit of $970,800 and a 4% down payment.

The regular Fannie and Freddie loan limit will become $647,200, which with a 20% down payment means a house costing $809,000. The median U.S. price sold in June 2021 was $310,000. A house selling for $809,000 is in the top 7% in the country. One selling for $1,212,600 is in the top 3%. To take North Carolina for example, where house prices are less exaggerated, an $809,000 house is in the top 2%. For FHA loans, the regular limit will become $420,680, or a house costing over $438,000 with a 4% down payment—41% above the national median sales price.

Average citizens who own ordinary houses may think it makes no sense for the government to support people who buy, lenders that lend on, and builders that build such high-priced houses, not to mention the Wall Street firms that deal in the resulting government-backed mortgage securities. They’re right.

Fannie and Freddie, which continue to enjoy an effective guarantee from the U.S. Treasury, will now be putting the taxpayers on the hook for the risks of financing these houses. Through clever financial lawyering, it’s not legally a guarantee, but everyone involved knows it really is a guarantee, and the taxpayers really are on the hook for Fannie and Freddie, whose massive $7 trillion in assets have only 1% capital to back them. FHA, which is fully guaranteed by the Treasury, has in addition well over a trillion dollars in loans it has insured.

By pushing more government-sponsored loans, Fannie, Freddie, its government conservator, the FHFA, and sister agency, the FHA, are feeding the already runaway house price inflation. House prices are now 48% over their 2006 Housing Bubble peak. In October, they were up 15.8% from the year before. As the government helps push house prices up, houses grow less and less affordable for new families, and low-income families in particular, who are trying to climb onto the rungs of the homeownership ladder.

As distinguished housing economist Ernest Fisher pointed out in 1975:

[T]he tendency for costs and prices to absorb the amounts made available to prospective purchasers or renters has plagued government programs since…1934. Close examination of these tendencies indicates that promises of extending the loan-to-value ratio of the mortgage and extending its term so as to make home purchase ‘possible for lower income prospective purchasers’ may bring greater profits and wages to builders, building suppliers, and building labor rather than assisting lower-income households.

The reason the FHFA is raising the Fannie and Freddie loan-size limits by 18%, is that its House Price Index is up 18% over the last year. FHA’s limit automatically goes up in lock step with these changes. These increases are procyclical acts. They feed the house price increases, rather than acting to moderate them, as a countercyclical policy would do. Procyclical government policies by definition make financial cycles worse and hurt low-income families, the originally intended beneficiaries.

The contrasting countercyclical objective was memorably expressed by William McChesney Martin, the longest-serving Chairman of the Federal Reserve Board. In office from 1951 to 1970, under five U.S. presidents, Martin gave us the most famous of all central banking metaphors. The Federal Reserve, he said in 1955, “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Long after the current housing price party has gotten not only warmed up, but positively tipsy, the Federal Reserve of 2021 has, instead of removing the punch bowl, been spiking the punch. It has done this by, in addition to keeping short term rates at historically low levels, buying hundreds of billions of dollars of mortgage securities, thus keeping mortgage rates abnormally low, and continuing to heat up the party further.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more.

In fact, the government has been spiking the housing party punch in three ways. First is the Federal Reserve’s purchases of mortgage securities, which have bloated its mortgage portfolio to a massive $2.6 trillion, or about 24% of all U.S. residential mortgages outstanding.

Second, the government through Fannie and Freddie runs up the leverage in the housing finance system, making it riskier. This is true of both leverage of income and leverage of the asset price. It is also true of FHA lending. Graph 1 shows how Fannie and Freddie’s large loans have a much higher proportion of high debt-to-income (DTI) ratios than large private sector loans do. In other words, Fannie and Freddie tend to lend more against income, a key risk factor.

Graph 1: Percent of loans over 43% DTI ratio

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Fannie and Freddie also make a greater proportion of large loans with low down payments, or high loan-to-value (LTV) ratios, than do corresponding private markets. Graph 2 shows the percent of their large loans with LTVs of 90% or more—that is, with down payments of 10% or less—another key risk factor.

Graph 2:  Share of loans with LTV ratios over 90%

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Now—on top of all that– the FHFA, by upping the loan sizes for Fannie and Freddie, is bringing to the party a bigger punch bowl. That the size limit for Fannie and Freddie is very important in mortgage loan behavior, we can see from how their large loans bunch right at the limit, as shown by Graph 3.

The third spiking of the house price punch bowl consists of the government’s huge payments and subsidies in reaction to the pandemic. A portion of this poorly targeted deficit spending money made its way into housing markets to bid up prices.

A key housing finance issue is the differential impact of house price inflation on lower-income households. AEI Housing Center research has demonstrated how the spiked punch bowl has inflated the cost of lower-priced houses more than others. This research shows that rapid price increases crowd out low-income potential home buyers in housing markets. Thus, as Ernest Fisher observed nearly 50 years ago, government policies that make for rapid house price inflation constrain the ability to become homeowners of the very group the government professes to help.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more. The question of upping the size of Fannie and Freddie loans, and correspondingly those of the FHA, is part of a larger picture of what the overall policy for them should be. Should we favor making their subsidized, market distorting, taxpayer guaranteed activities even bigger than the combined $8 trillion they are already?  Should they become even more dominant than they are now?  Or should the government’s dominance of the sector and its risk be systematically reduced?  That would be a movement toward a mortgage sector that is more like a market and less like a political machine.

In short, what about the future of the government mortgage complex, especially Fannie and Freddie: Should they be even bigger or smaller?  We vote for smaller.

How might this be done? As a good example, Senator Patrick Toomey, the Ranking Member of the Senate Banking Committee, has introduced a bill that would eliminate Fannie and Freddie’s ability to subsidize loans on investment properties, a very apt proposal. It will not advance with the current configuration of the Congress, but it’s the right idea. Similarly, it would make sense to stop Fannie and Freddie from subsidizing cash-out refis, mortgages that increase the debt on the house. Another basic idea, often proposed historically, but of course never implemented, would be to reduce, not increase, the maximum size of the loans Fannie and Freddie can buy, and by extension, FHA can insure.

In the meantime, the house price party rolls on. How will it end after all the spiked punch?  Doubtless with a hangover.

Alex J. Pollock is a senior fellow at the Mises Institute and the author of Finance and Philosophy: Why We're Always Surprised. His five decades of financial experience include being the Principal Deputy Director of the U.S. Treasury’s Office of Financial Research and the president and CEO of the Federal Home Loan Bank of Chicago.

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Edward J. Pinto is an American Enterprise Institute (AEI) senior fellow and director of AEI’s Housing Center. The Center monitors the US markets using a unique set of Housing Market Indicators. Active in housing finance for over 40 years, he was an executive vice president and chief credit officer for Fannie Mae until the late 1980s.

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An Incredibly Misguided Nomination for Comptroller of the Currency

Published in Real Clear Markets:

The Biden administration has certainly made the most misguided nomination for Comptroller of the Currency in history with its nominee, Saule Omarova. Professor Omarova has published proposals displaying deep ideological commitments which make her obviously unacceptable for this key responsibility in the banking system. Even after this has become apparent, the Biden administration has very surprisingly not withdrawn her name and a Senate Banking Committee hearing on the nomination has been scheduled for this week, November 18.

Concerning this hearing, every Democratic senator on the Banking Committee should be asked in public:

- Do you subscribe to the proposals published by Professor Omarova?  

- Do you support taking all deposits away from private banks?   

- Do you support making the Federal Reserve in charge of "economy-wide credit allocation"? 

- Do you support making the Federal Reserve a deposit monopoly?  

- Do you support having the New York Federal Reserve Bank short investments it [somehow] decides are too expensive and buy to boost the price of investments it [somehow] decides are too cheap?  

- Do you support giving the government seats on privately owned companies' boards of directors, with the government having "disproportionate voting power"?  

All these remarkably unwise and naive proposals are explicitly made in her published articles.

Honorable Senators:  If you support these proposals, you should stand up and say so out loud, so everybody can hear you.  If you don't support them, you should obviously vote No on this nomination.

No More Debt Ceiling Increases: Let the Federal Government Default

Published in Real Clear Markets:

In the meantime, the Democratic Party and the media will predictably continue to scream, “The United States has never defaulted on its debt!” As ‘The Hill’ recently pointed out, this isn’t true, but nonetheless we’ll be told that if Congress doesn’t raise the debt ceiling the world will end.

Why a Fed Digital Dollar is a Bad Idea

Published in Real Clear Markets with co-author Howard Adler.

On July 19, the top-level President’s Working Group on Financial Markets met to address “the need to act quickly to ensure there is an appropriate U.S. regulatory framework in place” for stablecoins,  a form of cryptocurrency backed by assets, often denominated in dollars. The meeting cited “the risks to end-users, the financial system and national security.”  This is a pretty clear message from a group composed of the Secretary of the Treasury, the Chairs of the Federal Reserve, SEC, CFTC, and FDIC and the Comptroller of the Currency.

Another element of federal policy on this issue was telegraphed by Fed Chair Jerome Powell when he recently discussed the Federal Reserve’s research on issuing its own digital dollar stablecoin.  “You wouldn’t need stablecoins, you wouldn’t need cryptocurrencies if you had a digital U.S. currency– I think that’s one of the stronger arguments in its favor,” he said.  The impetus towards such central bank digital currencies (CBDCs) in many other countries, coupled with the thought that this might weaken the dollar’s global role, added to regulatory concerns about private stablecoins, appear to be pushing the Fed towards the issuance of its own CBDC.  The motivation is understandable, but we still think it would be a bad idea.

There are now a number of private stablecoins circulating that are backed in some fashion by U.S. dollar-denominated assets, such as Tether and USD coin.  Facebook has announced its intention to launch its own U.S. dollar-backed stablecoin, the “diem,” later this year.  If used by a meaningful proportion of Facebook’s several billion subscribers, this could enormously increase the stablecoin universe.  Government officials, unsurprisingly, are focusing on the lack of any regime for their regulation and the need for one.

At the same time, central banks worldwide are considering their own CBDCs.  As of April 2021, more than 60 countries were in some stage of exploring an official digital currency, including many highly developed countries. But it is China’s digital yuan, now being tested in a dozen Chinese cities, that causes the most concern.

China seems to have two goals in establishing a CBDC. The first is more control over its citizens. If the digital yuan became ubiquitous, the Chinese government would have instant knowledge and control over its citizens’ money, potentially allowing it, for example, to confiscate the funds of political dissidents or block their payments and receipts.

The second goal is to challenge the dominance of the U.S. dollar in international transactions. The dollar is the currency used in 88 percent of foreign exchange transactions, while the renminbi was used in only four percent, according to the Bank for International Settlements. Who, located outside of China, would choose to give the Chinese Communist Party control over their money? The answer is those potentially subject to U.S. sanctions. As the issuer of dollars that the world’s banks need to transact business, the United States government has long demanded and received access from banks to information related to international transactions, which it has used to impose sanctions on hostile states and those it considers terrorists and criminals. Some countries (perhaps Iran, Cuba and Venezuela) may choose to use the digital yuan to avoid U.S. sanctions, as may countries participating in China’s Belt and Road program whose large debts to China may provide the Chinese with leverage over their choices.

If the digital yuan and other CBDCs are widely implemented, as seems almost inevitable, proponents of the Fed digital dollar may argue that there would be erosion in the dominance of the U.S. dollar in international trade and less demand for U.S. dollar-denominated assets including U.S. Treasury securities, pushing interest rates on Treasuries up, making it more costly for the United States to fund its historic deficits. The Federal Reserve might also believe it is in the public interest to issue its own stablecoin because it would be safer and less prone to fraud than private cryptocurrencies.  In order to preserve the dollar’s dominance and to constrain the use of private cryptocurrencies, it appears likely that the Federal Reserve will decide this fall, when it is scheduled to report on its consideration of a digital dollar, to move forward with its own CBDC.  Is this desirable?

Regulation of private stablecoins is on the way in any case, regardless of whether the Fed issues a stablecoin.  More importantly, a digital dollar would further centralize and provide vastly more authority to the already powerful Federal Reserve.  The negative impact of a Fed CBDC, both on citizens’ privacy rights and by shifting the power to allocate credit from the private sector to the government, would be enormous.

A Fed CBDC would make it hard for private citizens to avoid financial snooping by the government in every aspect of their financial lives. Moreover, suppose, as one would expect, that that the Fed’s CBDC siphoned large deposit volumes from private banks. The Fed would have to invest in financial assets to match these deposit liabilities, which would centralize credit allocation in the Federal Reserve, politicizing credit decisions and turning the Fed into a government lending bank. The global record of government banks with politicized lending has been dismal. A digital dollar could therefore undo more than a century of central bank evolution, which has usefully divided the issuer of money from private credit decisions. In the process, a digital dollar would subject private banks to vastly unequal and inevitably losing competition with the government’s central bank.  Finally, a CBDC would make it easier for the central bank to expropriate the people’s savings through negative interest rates.  For these reasons, a CBDC may fit an authoritarian country like China, but not the United States.

The delicious irony in the CBDC saga is that cryptocurrency was created because people were afraid of government control and wished to insulate their financial lives from monetary manipulation by central banks. With CBDCs, their ideas would be used to increase exactly the type of government interference and control that the crypto-creators sought to escape.

At AEI, a Monetary Panel Expressed Pessimism About Inflation

Published in Real Clear Markets.

“While their conjectures are as speculative as any vulnerability identified in an official financial stability report, unlike official financial stability reports, they have the freedom to identify government policies and regulatory shortcomings as vulnerabilities,” Kupiec said.

The first panelist to speak was Alex Pollock, distinguished senior fellow at R Street Institute, a free market think tank in Washington, DC. Pollock mentioned several possible causes of the next financial crisis, including errors in judgment by the world’s central banks, a housing-market collapse, a future pandemic, or war. He cautioned that a crisis could be caused by a factor that “nobody sees coming,” which would inevitably hamper state response.

“If the next crisis is again triggered by what we don’t see, the government reaction will again be flying by the seat of their pants, making it up as they go along,” Pollock said.

Read the rest here.

Pity FOMC Members Trying to Divine a Future They Can’t Know

Published in Real Clear Markets.

Pity the poor members of the Federal Open Market Committee! These Federal Reserve Board Governors and Federal Reserve Bank Presidents all know in their hearts, for sure, each one, that they do not and cannot know the financial and economic future—that they do not and cannot know, among other things, how bad the current hot inflation is going to get, or how long it will last.

Yet they are forced to make forecasts and statements published all over the world about things they cannot know.  Their statements move markets and influence behavior, so they have to guess and worry about not only about what will happen, but about what others will do based on what they say.  They cannot know for sure what the results of their own actions will be, or what actions others will take, no matter how sincerely they try to make their best guesses.  And of course, they have to worry about what the politicians will say or demand.

How seriously should we take the Fed’s forecasts?  Last December, they projected inflation for 2021 at 1.8%.  Half way through the year, this looks to have been wildly wrong.  The rapid inflation of 2021, with the Consumer Price Index increasing year to date at well over 6% annualized, clearly surprised them. I am speaking of the inflation as experienced only in 2021, with no comparison to the crisis time of 2020 or “base effect.”  You might say this was a blind side hit on the FOMC quarterbacks.

On June 16, FOMC members upped their guess for this year’s inflation to 3.4%–an 89% increase in their expected inflation rate, best thought of as the rate of depreciation in the dollar’s purchasing power, of your wages and of your savings.  This revised expectation came with an essential hedge: “Inflation could turn out to be higher and more persistent than we expect”– a sensible and true statement by Fed Chairman Powell.

Powell also made this sound observation: “We have to be humble about our ability to understand the data.”  Just like the rest of us!  But the rest of us are not assigned a part in the public drama of the FMOC.  “All the world’s a stage,” but the FMOC is an especially challenging stage.  The Fed is no better at economic and financial forecasting than anybody else, but the show must go on.

The FMOC continues to characterize the current high inflation as mostly “transitory.”  Well, paraphrasing J.M. Keynes, we may observe that in the long run, everything is transitory.  In the process of transitioning, a lot can happen.  FMOC members are now hoping and making estimates for inflation to fall back to around 2% by the end of 2022—a long forecasting way away.  There is a self-referential problem here: what inflation does depends on what the FOMC does. So the poor FOMC members must forecast their own behavior under future, unknown circumstances.

In particular, future inflation depends on whether the Fed keeps up its historic, giant monetization of government debt and mortgages, and on how big it bloats its own balance sheet, already over $8 trillion as of this week.  At its June meeting, the FMOC gave instructions to keep up the big buying, including buying more mortgages at the rate of $480 billion a year.

Consider that the housing market is in the midst of a runaway price inflation.  By March, using the Case-Shiller Index, house prices were up by 13% year over year.  The most current data indicates, according to the AEI Housing Center, house price inflation now running at over 15%.  Yet the Fed continues to stimulate and subsidize a market which is already red hot.  One is hard pressed to imagine any remotely plausible excuse for that.

We have to wonder what the poor FOMC members must feel in their own hearts about this issue.  Do they really believe in some rationale?  Is it a case of “We easily believe that which we wish to believe,” as Julius Caesar said?  Or in their private hearts, are the FOMC members only voting “yes” for monetizing more billions of mortgages with serious mental reservations and doubts?  I have to believe the latter is the case, but suppose we won’t know until their memoirs are published.

Meanwhile, the members of the FOMC are like the airmen in the old World War II song, “Comin’ in on a wing and a prayer!”  They have no alternative to that, so we must all wish them good luck.

The Oversight Board Keeps Working On Puerto Rico’s Record Insolvency

Published in Real Clear Markets.

The government of Puerto Rico continues to hold the all-time record for a municipal insolvency, having gone broke with over $120 billion in total debt, six times as much as the second-place holder, the City of Detroit.

Faced with this huge, complex, and highly politicized financial mess, and with normal Chapter 9 municipal bankruptcy legally not available, the Congress wisely enacted a special law to govern the reorganization of Puerto Rico’s debts. “PROMESA,” or the Puerto Rico Oversight, Management, and Economic Stability Act, provided for a formal process supervised by the federal courts, in effect a bankruptcy proceeding.  It also created an Oversight Board (formally, the Financial Oversight and Management Board for Puerto Rico) to coordinate, propose and develop debt settlements and financial reform.  These two legislative actions were correct and essential. However, the Oversight Board was given less power than had been given to other such organizations.  The relevant models are notably the financial control boards of Washington DC and New York City and the Emergency Manager of Detroit, all successfully called in to address historic municipal insolvencies and deep financial management problems.

It was clear from the outset that the work of the Puerto Rico Oversight Board was bound to be highly contentious, full of complicated negotiations, long debates about who should suffer how much loss, political and personal attacks on the Board and its members, and heated, politicized rhetoric.  And so it proved to be.  Since the members of the Oversight Board are uncompensated, carrying out this demanding responsibility requires of them a lot of public spirit.

An inevitable complaint about all such organizations, and for the Puerto Rico Oversight Board once again, is that they are undemocratic.  Well, of course they are, of necessity, for a time. The democratically elected politicians who borrowed beyond their government’s means, spent the money, broke their promises, and steered the financial ship of state on the rocks should not remain in financial control.  After the required period of straightening out the mess and re-launching a financial ship that will float, normal democracy returns.

It is now almost five years since PROMESA became law in June, 2016.   It has been, as it was clear it would be, a difficult slog, but substantial progress has been made.  On February 23, the Oversight Board announced a tentative agreement to settle Puerto Rico’s general obligation bonds, in principle the highest ranking unsecured debt, for on average 73 cents on the dollar.  This is interestingly close to the 74 cents on the dollar which Detroit’s general obligation bonds paid in its bankruptcy settlement.   If unpaid interest on these bonds is taken into account, this settlement results in an average of 63 cents on the dollar.  In addition, the bondholders would get a “contingent value” claim, dependent on Puerto Rico’s future economic success—this can be considered equivalent to bondholders getting equity in a corporate reorganization–very logical.

The Oversight Board has just filed (March 8) its formal plan of adjustment.  It is thought that an overall debt reorganization plan might be approved by the end of this year and that the government of Puerto Rico could emerge from its bankrupt state.  Let us hope this happens.  If it does, or whenever it ultimately does, Puerto Rico will owe a debt of gratitude to the Oversight Board.

We can draw two key lessons.  First, the Oversight Board was a really good and a necessary idea.  Second, it should have been made stronger, on the model of previous successes.  In particular, and for all future such occasions, the legislation should have provided for an Office of the Chief Financial Officer independent of the debtor government, as was the case with the Washington DC reform.  This was highly controversial, but effective. Any such board needs the numbers on a thorough and precise basis.  Puerto Rico still is unable to get its audited annual reports done on time.

A very large and unresolved element of the insolvency of the Puerto Rican government remains subject to a debate which is important to the entire municipal bond market.  This is whether the final debt adjustments should include some reduction in the almost completely unfunded government pension plans.  Puerto Rico has government pension plans with about $50 billion in debt and a mere $1 billion or so in assets.

There is a natural conflict between bondholders and unfunded pension claims in all municipal finance, since not funding pensions is a back door deficit financing scheme.  General obligation bonds are theoretically the highest ranking unsecured credit claims, and senior to unfunded pensions.  But the reality is different.  De facto, reflecting powerful political forces, pensions are the senior claim.  Pensions did take a haircut in the Detroit bankruptcy, but a significantly smaller one than did the most senior bonds.  In other municipal bankruptcies, unfunded pensions have come through intact.

What should happen in Puerto Rico?  The Oversight Board has recommended modest reductions in larger pensions, reflecting the utter insolvency of the pension plans.  Puerto Rican politicians have opposed any adjustment at all.  Bondholders of Illinois: take note of this debate.

I suggest a final lesson:  the triple-tax exemption of interest on Puerto Rican bonds importantly contributed to its ability to run up excess and unpayable debts.  Maybe there was a rationale for this exemption a hundred years ago.  Now Puerto Rico’s bonds should be put on the same tax basis as all other municipal bonds.

Congress Must Take Control of Money Back From the Fed

Published in Real Clear Markets.

The question of Money is always political.  What is the definition of “money,” what is its nature, how is it created, and how are debts settled—these are questions that have been much debated over time, sometimes very hotly.  Recall, for example, William Jennings Bryan’s famous, burning rhetoric of 1896:

“You shall not press down upon the brow of labor this crown of thorns—you shall not crucify mankind upon a cross of gold”!

He was addressing the definition of money.

What the U.S. Constitution says about the definition of money is succinct.  Article I, Section 8 gives Congress the express power:

“To coin money [and] to regulate the value thereof.”

As writers on the subject have pointed out innumerable times, to “coin” is obviously not the same as to “print.”

How then does it come about that the American government issues irredeemable, fiat, paper money, and this is the only kind of money we have today?

The Constitution expressly prohibits the states from issuing such paper money, but is silent about the national government on this point.

Considering original intent through the Constitutional debates, the founding fathers were nearly unanimous in their strong opposition to paper money, as the Notes of the Debates in the Federal Convention make completely clear.  In general, they shared the view later expressed by James Madison about:

“The rage for paper money…or any other improper or wicked project.”

Although this was the dominant opinion of the members of the convention, and although they debated an express prohibition of national paper money, they decided not to include it.  Of course, neither was there an authorization.

In the discussion, George Mason explained:

“Though he had a mortal hatred to paper money, yet…he could not foresee all the emergencies” of the future and was “unwilling to tie the hands of the legislature.”

Paper money in this view is a matter only for emergencies.

The Constitutional result was the express power “to coin” and silence on “to print.”  Should one conclude that there is an implied power for the government to print pure paper money?  Further, is there an implied power to make it a legal tender in payment of debts, even if those debts had been previously contracted for and explicitly required payment in gold coin?

A lot of supreme judicial ink would later be devoted to debating and ultimately deciding this question.
In the Constitutional Convention debates, Gouverneur Morris:

“Recited the history of paper emissions and the perseverance of the legislative assemblies in repeating them, with all the distressing effects.”

He further predicted:

“If a war was now to break out, this ruinous expedient would again be resorted to.”

This prediction was proved right when the Civil War did break out, and the Lincoln administration soon turned to paper money to pay the costs of the Union Army.

In 1861, faced with the staggering expenses of the war, Congress authorized the issuance of paper money, or “greenbacks,” as they were called.  In 1862, it made them a legal tender.  Predictably, the greenbacks went to a large discount against gold—their value fluctuated with the military fortunes of the ultimately victorious Union.

As another war measure, national bank notes were created by the National Currency Acts of 1863 and 1864, which we now know as the National Bank Act.  The main point was to use the new national banks to monetize the Treasury’s debt.  Governments always like the power to monetize their deficits.

After the Civil War, the expedient of paper money as legal tender resulted in a series of Supreme Court cases in which:

First, making paper money a legal tender for debts previously contracted in gold was found unconstitutional in a 4-3 decision.

Then, soon afterwards, the Court reversed itself 5-4, after the addition of two new justices, finding that it was constitutional, after all.  The new majority stressed the sovereign right of a government to do what was necessary to preserve itself.

About the legal tender cases it has been said:

“Measured by the intensity of the public debate at the time, it was one of the leading constitutional controversies in American history.”

Yet they are now largely forgotten.

In one of the series of legal tender decisions, one later overruled, the Court wrote:

“Express contracts to pay in coined dollars can only be satisfied by the payment of coined dollars…not by tender of United States notes.”

That this decision did not stand was handy for the United States government later—in 1933, when it defaulted on its express promise to pay Treasury gold bonds in gold.  Instead it paid in paper money.

This action the Supreme Court upheld in 1935 by 5-4, although no one doubted the clarity of the promise to pay that was broken.  Among the majority’s arguments were the sovereign right of the government to default if it wanted to and the sovereign right of the national government to regulate money.

Coming to today: We have a pure fiat money system of the paper Federal Reserve notes in your wallet and bookkeeping entries on the books of the Fed.

This paper currency, the Federal Reserve on its own has committed to depreciate by 2% per year forever, in spite of the fact that the Federal Reserve Act instructs it to pursue “stable prices.”

By promising perpetual 2% inflation, the Fed keeps promising to make average prices quintuple in a normal lifetime.  (That is simply the math of compound interest.)

The Fed made this momentous, inherently political, decision on its own, without the approval of the Congress.  It did not ask Congress for legislative approval and no hearings on this debatable proposal about the nature of money were held.

Where, under the Constitution, did the Fed get this right to proceed without Congress?  That the Fed presumed to do this on its own authority was a highly questionable action of the administrative state.

I believe one could correctly argue that this was an unconstitutional violation of Article I, Section 8. Unfortunately, we have no lawsuit about it, so we can only observe it.

One scholar of the legal tender cases concluded:

“There remains the intriguing question of the Constitutional basis for today’s legal tender paper… today’s fiat money.”

Indeed there does.  But the political basis rules and life goes on.

Eliminating Fannie & Freddie’s Competitive Advantages by Administrative Action

Published in Real Clear Markets.

Among the strategic goals for reform of Fannie Mae and Freddie Mac specified by Treasury Secretary Steven Mnuchin in Congressional testimony on October 22 was: “Legislation could achieve lasting structural reform that…eliminates the GSEs’ competitive advantages over private-sector entities.” A good idea, except legislation won’t happen.

As the Secretary suggests, replacing the current government-dominated, duopolistic secondary housing finance sector with a truly competitive one is an excellent goal. But fortunately, it does not take legislation. It can be achieved with purely administrative actions—three of them, to be exact. These administrative actions are:

1. Set Fannie and Freddie’s capital requirements equal to those of private financial institutions for the same risks.

2. Have Fannie and Freddie pay the same fee to the government for its credit support that other Too Big To Fail financial institutions have to pay.

3. Set Fannie and Freddie’s g-fees at the level that includes the cost of capital required for private financial institutions to take the same risk.

The Same Capital Requirement

The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator, has full authority to set their capital requirements. FHFA simply has to set them in a systemically rational way: namely, so that the same risk requires the same capital across the system: the same for Fannie and Freddie as for private financial institutions.

Running at hyper-leverage was a principal cause of Fannie and Freddie’s failure and bailout. It naturally induced market actors to perform capital arbitrage and send credit exposure to where the capital was least—that is, into Fannie and Freddie—thereby sticking the taxpayers with the risk.

The capital for mortgage credit risk is still the least at Fannie and Freddie and the risk is still sent every day to the taxpayers by way of them. Even with the revised agreement between the FHFA and the Treasury announced on September 30, Fannie and Freddie will be able to in time increase their capital only to $45 billion combined. This is exceptionally small compared to their risk of $5.5 trillion: it would represent a capital ratio of less than 1%, still hyper-leverage.

Something like a 4% capital requirement would be more like the equilibrium standard required to eliminate the capital arbitrage, which would imply a total capital for the two government-backed entities of about $220 billion. I do not insist on the exact numbers, only that the FHFA should implement the right principle: same risk, same capital.

The Same Fee for Government Support

Fannie and Freddie are Too Big To Fail (TBTF). No one doubts or can doubt this. Their business and indeed their existence utterly rely on the certainty of government support. This means their creditors have immense moral hazard: they don’t have to worry about the credit risk of the trillions of Fannie and Freddie fixed income securities they hold. History has proved that the creditors are right to rely on government support—when Fannie and Freddie were deeply insolvent, the bailout assured that the creditors nonetheless received every penny of interest and principal on time.

What is this government support worth? A huge amount. There is widespread agreement that Fannie and Freddie should pay an explicit fee for it, but how much? The right answer is to remove their unfair competitive advantage by having them pay at the same rate as any other Too Big To Fail institution with the same leverage and the same risk to the government.

In other words, have the FDIC determine what the deposit insurance rate for a TBTF bank with Fannie and Freddie’s leverage and risk would be, and require them to pay that to the Treasury. Then they would be on the same competitive basis as private financial institutions.

Setting the right fee in exchange for the ongoing government support is within the power of the FHFA as Conservator and the Treasury, by the two of them amending their Fannie and Freddie Senior Preferred Stock Purchase Agreements accordingly.

The Same Guaranty-Fee Logic

The key action here, which the FHFA is already not only empowered but directed by Congress to take, is already in law—to be specific, in the Temporary Tax Cut Continuation Act of 2011. This statute requires the setting of Fannie and Freddie’s g-fees to include not only the risk of credit losses, but also “the cost of capital allocated to similar assets by other fully private regulated financial institutions.” The FHFA Director is instructed to make this calculation and increase the g-fees accordingly. The FHFA has egregiously not carried out this unambiguous instruction. It should do so now, thereby removing the third distorting competitive advantage which historically allowed Fannie and Freddie to drive out private capital.

Each of these administrative actions by itself would create a serious advance toward the stated goal. To take all three of them would settle the matter: game, set, match. No legislation needed.

Unfunded Pensions: Watch out, bondholders!

Published in Real Clear Markets.

A reorganization plan for the debt of the government of Puerto Rico was submitted to the court Sept. 27 by the Puerto Rico Oversight Board. It covers $35 billion of general obligation and other bonds, which it would reduce to $12 billion.

On average, that is about a 66 percent haircut for the creditors, who thus get 34 cents on the dollar, compared to par. Pretty steep losses for the bondholders, but steep losses were inevitable given the over-borrowing of the Puerto Rican government and the previous over-optimism of the lenders. Proposed haircuts vary by class of bonds, but run up to 87 percent, or a payment of 13 cents on the dollar, for the hapless bondholders of the Puerto Rican Employee Retirement System.

In addition to its defaulted bonds, the Puerto Rican government has about $50 billion in unfunded pension obligations, which are equivalent to unsecured debt. But the pensioners do much better than the bondholders. Larger pensions are subject to a maximum reduction of 8.5 percent, while 74 percent of current and future retirees will have no reduction. Those with a reduction have the chance, if the Puerto Rican government does better than its plan over any of the next 15 years, to have the cuts restored.

The Oversight Board’s statement does not make apparent what the overall haircut to pensions is, but it is obviously far less than for the bondholders. “The result is that retirees get a better deal than almost any other creditor group,” as The New York Times accurately put it. This may be considered good and equitable, or unfair and political, depending on who you are, but it is certainly notable. The Times adds: “Legal challenges await the plan from bondholders who believe the board was far too generous to Puerto Rico’s retired government workers.”

The Puerto Rican debt reorganization plan demonstrates once again, in municipal insolvencies and bankruptcies, unfunded pension obligations are de facto a senior claim compared to any other unsecured debt, including general obligation bonds that pledge the full resources and taxing power of the issuing government. This is not because they are legally senior, but because they are politically senior.

By running up their unfunded pensions, municipalities have not only stressed their own finances, but have effectively subordinated the bondholders. When it comes to unfunded pensions, the Puerto Rico outcome, like that of Detroit and others, announces: Bondholders, Watch Out!

Have Fannie and Freddie Paid the Taxpayers Back Yet?

Published in the Real Clear Markets.

The distinguished judges of the U.S. Court of Appeals for the Fifth Circuit have considered how much Fannie Mae and Freddie Mac have paid the Treasury Department to compensate the taxpayers for the giant bailout which kept Fannie and Freddie in existence and business.  The court observed in its September 6 judgment:

“The net worth sweep transferred a fortune from Fannie and Freddie to Treasury.”  Specifically, “Treasury had disbursed $187 billion and recouped $250 billion.”

The “net worth sweep” is the dividend on the senior preferred stock in Fannie and Freddie acquired by the Treasury in the bailout.  Originally set at 10% per year in 2008, the dividend was changed in August 2012—in the “Third Amendment” to the governing agreement—to essentially, “just send in all your profit” each quarter, hence a “sweep.”  The Treasury then owned $187 billion of senior preferred stock acquired for cash, as the court suggested, and another $2 billion in exchange for the original credit support agreement, for a total of $189 billion.  (Now it owns $199 billion.)

Fannie and Freddie should, said the court, “of course…pay back Treasury for [their] draws on the funding commitment.” And “Treasury was also entitled to compensation for the cost of financing.”  No one could disagree.  “But the net worth sweep continues transferring [Fannie and Freddie’s] net worth indefinitely, well after Treasury has been repaid,” it critically points out.  This must make us ask: Have Treasury and the taxpayers been repaid at this point?  The answer is not obvious, as sometimes has been asserted, and requires a little arithmetic.

In short, does having been paid $250 billion vs. a $189 billion principal amount automatically mean full repayment?  As every banker knows, it doesn’t.

Consider a simple analogy.  Suppose you borrowed $1,000 at an interest rate of 10%, under a $5,000 commitment with a commitment fee of 1% per year.  Suppose you pay only the interest and the commitment fee, but never a penny of principal.  After ten years, you will have paid $1,500.   You could truly observe that “You lent me $1,000 and I have paid you $1,500.”  But how much principal do you still owe?  You still owe all $1,000, without a doubt.

We can apply the same logic to Fannie and Freddie and see what happens.

Let us go back to August 2012, and suppose that the Third Amendment and the “net worth sweep” had never happened.  There is outstanding $189 billion of senior preferred stock.  The dividend remains the original 10%.  That is a dividend of $18.9 billion a year.  In addition to the dividend, as the court rightly noted, the original deal provides for Treasury also to charge an ongoing commitment fee. This was to compensate the taxpayers for their continuing credit support, which backed up and continues to back up all Fannie and Freddie’s liabilities.  Nine Fifth Circuit judges in an accompanying opinion call this support “a virtually unlimited line of credit from the Treasury.”  It effectively guarantees liabilities totaling $5.5 trillion—you don’t get that for free.  With vast liabilities and effectively zero capital, Fannie and Freddie could not function for even a minute without taxpayer support.  The Housing Reform Plan just published by the Treasury clearly provides for Fannie and Freddie to pay a commitment fee—and they undoubtedly should.

What would be a fair price for the taxpayers’ credit commitment?  Based on what the FDIC would charge a severely undercapitalized bank for the credit guarantee which is called deposit insurance, I believe 0.18% of total liabilities per year is a good guess.  This credit support fee on $5.5 trillion in liabilities gives an annual fee of $9.9 billion.

Thus, going back to our hypothetical 2012 with no profit sweep, Fannie and Freddie should have been paying Treasury $18.9 billion plus $9.9 billion or a total of $28.8 billion a year.  That was seven years ago.  Had Fannie and Freddie been paying that instead of the profit sweep for seven years the aggregate payment for dividends and commitment fee only, would have been $202 billion.  That payment would provide no reduction of the $189 billion of principal.

But Fannie and Freddie paid $250 billion.  That is $42 billion more than $202 billion, which might fairly be used to retire some of the $189 billion principal.  If we credit Fannie and Freddie with the going rate of interest, say 2%, on this amount, we might make that $45 billion.  That gives us $189 billion less $45 billion, leaving $144 billion of principal still to be repaid.

Suppose you think my suggested commitment fee is too high.  Let us cut it in half, to 0.09 %.  Then by analogous math, Fannie and Freddie’s required payment of 10% dividends plus commitment fees would be $23.9 billion a year, or $167 billion in total for seven years.  That would leave $83 billion, or $88 billion with interest, for principal reduction.  Result: they would have $101 billion still to pay.

Even when we remove by hypothesis Treasury’s claim on the perpetual net worth sweep criticized by the court, it is far from the case that Treasury has been repaid.

These considerations must be taken into account as Treasury and the Federal Housing Finance Agency (as conservator for Fannie and Freddie) revise the Preferred Stock Purchase Agreement as part of the administration’s housing finance reform plan.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Published in Real Clear Markets.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Members of Congress whose financial markets credo begins with “I believe in the Dodd-Frank Act,” experience severe cognitive dissonance when faced with the systemic financial risk created by Fannie Mae and Freddie Mac. Of course, this applies principally to Congressional Democrats. Here is the logic of their problem:

If you believe in the Dodd-Frank Act, you must believe in the concept of SIFIs (Systemically Important Financial Institutions).

If you believe in the Dodd-Frank Act, you must believe that SIFIs should be regulated by the Federal Reserve in addition to any other regulator, and that the Fed must be able to set “more stringent” regulations to reduce systemic risk.

If you believe in the concept of SIFIs, you cannot escape the obvious fact that Fannie and Freddie are SIFIs.

So if you believe in the Dodd-Frank Act, you must believe that Fannie and Freddie should be regulated by the Fed to address systemic risk.

But many politicians who wish to believe in the Dodd-Frank Act also wish to escape this inescapable conclusion. “Wait!” they say, “If the Fed regulates Fannie and Freddie, maybe that will hurt housing, so don’t do it!” There is the cognitive dissonance. Stating it in more candid terms, they fear that regulating the systemic risk of Fannie and Freddie in accordance with the Dodd-Frank Act would limit political schemes to run up mortgage risk, and likewise limit the ability to push all that risk onto the Treasury and the taxpayers. Indeed it would, especially recalling that Dodd-Frank authorizes “more stringent” regulations for SIFIs. Presumably, for starters, Fannie and Freddie would no longer be able to run at hyper-leverage.

The Dodd-Frank faithful cannot have it both ways. They cannot both believe in the Dodd-Frank Act and oppose the Fed as systemic risk regulator of Fannie and Freddie. It’s one or the other, not both.

Others do not have this logical problem. For example, my good friend, Peter Wallison of the American Enterprise Institute, opposes recognizing that Fannie and Freddie are SIFIs (thereby disagreeing with me), because he does not want to give the Fed any more power than it already has. Peter can do this with intellectual consistency because he doesn’t believe in the Dodd-Frank Act in the first place.

Another approach to opposing the Fed as systemic risk regulator of Fannie and Freddie would be to deny its supposed ability to regulate any systemic risk at all. This approach would observe the deep uncertainty of the financial future, which is constantly displayed, and argue that neither the Fed nor anybody else can have the knowledge to be a successful systemic risk regulator. But if you think this, you obviously do not believe in the Dodd-Frank Act.

Neither these nor any other arguments against making the Fed a Fannie and Freddie regulator are available to those who recite the Dodd-Frank creed. They must agree with the accuracy of this syllogism:

1. SIFIs must be regulated by the Fed.
2. Fannie and Freddie are obviously SIFIs.
3. Therefore, Fannie and Freddie must be regulated by the Fed.

If you believe in the Dodd-Frank Act, it is simply “Q.E.D.”

Congress Moves to Put Pension Benefit Guaranty Corporation On Taxpayer Dole

Published by Real Clear Markets.

The Ways and Means Committee of the House just approved a bill for a big taxpayer bailout of private multi-employer/union-sponsored pension plans.  Many of these plans are hopelessly insolvent.  In other words, they have committed to pay employee pensions far greater than they have any hope of actually paying. In the aggregate, the assets of multi-employer plans are hundreds of billions of dollars less than what they have solemnly promised to pay.

There is an inescapable deficit resulting from past failures to fund the obligations of these plans. This means somebody is going to lose; somebody is going to pay the price of the deficit.  Who?  Those who created the deficits? Or instead: How about the taxpayers? The latter is the view of the Democratic majority which passed the bill out of committee in a 25-17 straight partyline vote on July 10.

“Wait a minute!” every taxpayer should demand, “aren’t all these pension plans already guaranteed by an arm of the U.S. government?”  Yes, they are–by the government’s Pension Benefit Guaranty Corporation (PBGC). But there is a slight problem:  the PBGC’s multi-employer guarantee program is itself broke.  It is financially unable to make good on its own guarantees. The proposed taxpayer bailout is also a bailout ofthis deeply insolvent government program.

This was not supposed to be able to happen.  In creating the PBGC, the Employee Retirement Income Security Act (ERISA) required, and has continued to require up to now, that the PBGC be self-financing.  But it isn’t–not by a long shot. Its multi-employer program shows a deficit net worth of $54 billion.  The PBGC was not supposed ever to need any funds from the U.S. Treasury.  But it is now proposed to give it tens of billions of dollars from the Treasury, and the bill does not have any limiting number.

“ERISA provides that the U.S. government is not liable for any obligation or liability incurred by the PBGC,” says the PBGC’s annual report every year.  But here we have another of the notorious “implicit guarantees,” which pretend they are not guarantees until it turns out that they really are.  Consider that if the PBGC’s multi-employer program were a private company, any insurance commissioner would have closed it down long ago.  No rational customer would pay any premiums to an insurer which is demonstrably unable to pay its committed benefits in return.  Only the guarantee of the Treasury, “implicit” but real, keeps the game going.

Bailing out guarantees which were claimed not to put the taxpayers on the hook, but in fact did, is the familiar pattern of “implicit” guarantees.  They are originally done to keep the liability for the guarantees off the government’s books, an egregious accounting pretense, because everybody knows that when pushing comes to shoving, the taxpayers will be on the hook, after all.

In such “self-financing,” off-balance sheet entities, the government generally does not charge the fees which their risk economically requires. This is true even if their chartering acts theoretically require it.  Undercharging for the risk, politically supported by the constituencies who benefit from the cheap guarantees, allows the risk to keep increasing.  So in time, the day of the taxpayer bailout comes.

Notable examples of this are the bailouts of the Farm Credit System, the Federal Savings and Loan Insurance Corporation (FSLIC), Fannie Mae, and Freddie Mac.  However, the bailout of Farm Credit included serious reforms to the System, and the bailout of FSLIC, serious reforms to the savings and loan industry.  The bailouts of Fannie and Freddie were combined with putting them in conservatorship under the complete control of the Federal Housing Finance Agency, where they remain today.

Now for the PBGC, when we read all the way to the very last paragraph on the last page of the bill, page 40, we find that the PBGC’s multi-employer program, which was supposed never to need any appropriated funds, is to get generous taxpayer funds forever.  “There is appropriated to the Director of the Pension Benefit Guarantee Corporation,” says this paragraph, “such sums as may be necessary for each fiscal year.”  The multi-employer pensions would thus become an entitlement, on the taxpayer dole.  There is no limiting number or time.  Nor in the previous 39 pages is there any reform of the governance, operations, or ability of these pension plans to finance themselves on a sustainable basis.

In short, the bill passed by the Ways and Means Committee is a bailout with no reform.  But the governing principle for all financial bailouts should be instead: If no reform, then no bailout.