The Fed’s ‘temporary’ mortgage-backed security experiment will last decades

Published in The Hill with Paul Kupiec. Also published in RealClear Markets.

It has been nearly 14 years since Federal Reserve Chairman Ben Bernanke told Congress that the Fed’s emergency quantitative-easing policy, of which the most radical part was buying mortgage-backed securities, was “temporary” and would be “reversed.”  

The Fed made huge mortgage-backed securities purchases. The purchases pushed mortgage interest rates to artificially low levels, stoked the second great house price bubble of the 21st century and made houses unaffordable for many. 

In addition, these mortgage-backed securities investments unintentionally caused massive Fed losses. They are costing the Fed and taxpayers billions of dollars a month and will for years to come, as there is no practical way for the Fed to reverse its very large, deeply underwater mortgage-backed securities investment. 

The Fed created a giant, loss-making mortgage-backed securities portfolio. It currently owns $2.3 trillion in mortgage-backed securities mostly bought at the top of the market when mortgage yields were artificially low. 

Today, these mortgage-backed securities are worth far less than the Fed paid for them. The June 30 Fed financial statement shows an unrealized market value loss of $423 billion on the Fed’s mortgage-backed securities investments. This loss is nearly 10 times the Fed’s financial statement reported capital of $43 billion. 

We say “reported capital” because the Fed has suffered $207 billion in realized cash operating losses that it has amazingly not deducted from its reported capital. Using standard accounting rules, per our estimate, the Fed’s actual capital as of Oct. 30, is $43 billion minus its accumulated cash operating loss of $207 billion; or negative $164 billion.  

In addition, the Fed has $423 billion in unrealized mortgage-backed securities market value losses because interest rates today are much higher than the rates the Fed earns on its mortgage-backed securities. 

The Fed invested in 30-year fixed-rate mortgage-backed securities, almost all of which have remaining maturities of more than 10 years. It earns about 2.2 percent interest on its mortgage-backed securities but pays a 4.9 percent interest rate to fund them. 

The Fed has a negative 2.7 percent spread on these mortgage-backed securities meaning that it costs the Fed an annualized $62 billion to own these securities. Remarkable asset-liability management!  

The Fed’s cash losses are also losses to the U.S. Treasury. So without any congressional approval, the Fed’s very large, very underwater mortgage-backed securities investment is imposing tens of billions of dollars of costs annually on taxpayers.   

According to a congressional testimony about the Fed’s emergency investments by Chairman Bernanke on June 12, 2014: 

“What we are doing here is a temporary measure which will be reversed so that at the end of the process, the money supply will be normalized, the Fed’s balance sheet will be normalized, and there will be no permanent increase … in the Fed’s balance sheet.”

It is now 2024. How long is “temporary”? Why doesn’t the Fed just sell its mortgage-backed securities and put the problem behind it?   

It is not practical for the Fed to sell all its mortgage-backed securities. If it sold them, the Fed would, under the unrealistic assumption that it could sell its mortgage-backed securities at their current estimated market value, realize $423 billion in new cash losses. We estimate that would make the Fed’s capital, measured using standard accounting rules, negative $587 billion. 

While the Fed would, we expect, continue to claim that it had $43 billion in capital, the $423 billion in market value losses would become actual cash losses and have to be reported in the Fed’s profit and loss statement. Reporting such a huge cash loss would not only be an embarrassment but could trigger congressional investigations and unwanted oversight. 

More realistically, the Fed would simply not be able to sell its mortgage-backed securities for its current fair value estimate. The Fed’s $2.3 trillion investment is a massive position. It is so big that in reality it can’t be sold. There are about $9.4 trillion in total mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae of which, the Fed owns almost 25 percent. 

If the Fed tried to quickly sell its portfolio, the sale would crash the mortgage-backed securities market and result in a cash loss much larger than $423 billion. It could reduce the inevitable negative market price impact by liquidating its mortgage-backed securities gradually over time, but the mere announcement that the Fed planned to sell would lower prices in the mortgage-backed securities market. 

Moreover, either approach would push up mortgage interest rates — hardly a welcome political outcome. 

It seems likely the mortgage-backed securities will be on the Fed’s balance sheet until they finally mature. In the meantime, they will continue racking up billions of dollars in cash losses each month. 

It looks like the Fed is stuck with very large, losing “temporary” mortgage-backed securities investments for a long time to come. 

Alex J. Pollock is a senior fellow at the Mises Institute. Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

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.

Without Chevron, the Fed has crucial questions to address

Published with Paul H. Kupiec in The Hill.

On June 28, the Supreme Court overturned the Chevron Doctrine, which previously allowed unelected government bureaucracies to interpret their governing statutes to stretch and expand their agencies’ powers.

Now, unless regulatory powers are explicit in law, federal agencies’ interpretations of their authority will no longer be given deference by the courts when challenged. Congress should remove legislative ambiguities or risk the uncertainty of potential judicial challenges to Federal Reserve powers.

The Federal Reserve is the most powerful unelected body in the country. What could the demise of the Chevron Doctrine mean for the Fed?

When Sen. Jack Reed (D-R.I.) posed this question during the Fed’s recent semiannual congressional testimony, Chairman Jerome Powell said the Fed was “very focused on reading the actual letter and intent of the law and following it very carefully,” calling the practice “a strong intuitional value that we have.”

“Those are brand-new decisions that just came down, and we are in the process of studying them,” Powell said.

Considering the Fed’s history of expanding its powers using creative interpretations of its authorizing legislation, Powell’s answer made us chuckle. The demise of the Chevron Doctrine gives the Fed’s legal eagles lots to ponder.

First, consider the all-important issue of preserving the value of the dollar. In the Federal Reserve Act, Congress instructed the Fed to pursue “stable prices” — a self-evidently clear direction. The Fed, with no congressional debate or approval, reinterpreted its congressional assignment as a duty to promote inflation at the rate of 2 percent per year forever.

Thus, the Fed, without any change in its congressional remit, construed “stable prices” to mean quintupling prices — reducing the dollar’s purchasing power by 80 percent — over an 80-year lifetime.

Stable prices? George Orwell may still be alive, well and working at the Federal Reserve Board.

While obfuscation of the term “stable prices” may be the most consequential example of the Fed’s failure to abide by the letter of the authorizing legislation, it is by no means unique. Consider the Federal Reserve Board’s decision to design its own disingenuous accounting standards to hide the fact that the combined Fed system losses — $183 billion since September 2022 — have consumed all of the system’s capital, and then some.

The Federal Reserve Act also requires the Fed to publish informative financial statements of the Federal Reserve Banks. While the Fed reports losses, it does not subtract losses from its retained earnings, as any bank it regulates must and as standard accounting rules require.

Instead, astonishingly, the Fed classifies its losses as an asset. It books its losses as the opaquely titled “Deferred asset — remittances to the Treasury.” This dubious accounting allows the Fed to report its capital as positive $43 billion when using standard accounting rules, its capital is negative $140 billion. We have been unable to find the law that authorizes the Fed to create a new accounting standard.

Next, consider the Federal Reserve Board’s decision to continue paying the expenses of the Consumer Financial Protection Bureau (CFPB) notwithstanding the fact that the Fed’s payments to the CFPB have been violating the funding provision of the Dodd-Frank Act since September 2022.

The Dodd-Frank Act created the CFPB and provides for its funding. The act does not classify the CFPB’s funding as a Federal Reserve Board expense, but instead, directs that the CFPB be funded out of the Federal Reserve system’s earnings.

The Dodd-Frank Act requires the board of governors to “transfer to the bureau from the combined earnings of the Federal Reserve System, the amount determined by the director to be reasonably necessary.”

Congress could have made CFPB expenses an explicit expense of the Federal Reserve Board and instructed the Fed to pay the CFPB’s expenses using Federal Reserve Act authority whether the Fed had any earnings or not. But it didn’t.

In May, the Supreme Court affirmed the constitutionality of using Fed earnings that otherwise would have been transferred to the Treasury to pay the CFPB’s expenses. This decision did not consider whether it was legal for the Fed to transfer money to fund the CFPB when the Fed has had no combined earnings.

Under a clear reading of the Dodd-Frank Act and the Supreme Court’s recent decision, when the Fed has no earnings, it has no earnings to transfer to the CFPB, just as it has no earnings to send to the Treasury.

The Fed has not offered any legal defense for continuing to pay the CFPB’s expenses. It owes one to Congress and the public.

Other policy questions arise in the post-Chevron world. These include the authority to take on massive balance sheet risk without approval from Congress — a risk that has generated more than a trillion dollars of unrealized market value Fed losses, engineering international agreements governing domestic bank capital and credit regulations that are, in all but name, treaties that should require Senate approval and actively embracing executive branch climate change policies without explicit congressional authority.

The demise of the Chevron Doctrine creates new uncertainty regarding Federal Reserve powers not clearly enumerated in current law. Unless Congress preemptively addresses legislative ambiguities, the economy will face the risks associated with the uncertain outcomes of potential judicial challenges to Federal Reserve powers.

It’s time for universities to share the burden of student loan defaults

Published with Arthur Herman in The Hill.

While the nation is rightly worried about the proliferation of antisemitism on its college campuses, another higher education abuse also needs prompt attention.

On Dec. 6 – St. Nicholas Day – President Biden handed student loan defaulters another $5 billion gift in debt forgiveness. The administration’s eagerness to win the votes of student loan borrowers by shifting the cost of student debt from borrowers to taxpayers now adds up to $132 billion of student loans those borrowers will not have to pay — even though the Supreme Court ruled a related scheme unconstitutional last June.

But if borrowers don’t pay the debts they incurred and default on their debts, someone else has to pay. Right now, that someone else is American taxpayers. Now it’s time that the cost of nonpayment of student loans be shared by those who have benefitted the most directly from federal student loans: namely, the colleges and universities themselves.

By inducing their students to borrow from the government, higher education institutions collect vastly inflated tuition and fees, which they then spend without worrying about whether the loans will ever be repaid. This in turn incentivizes them to push the tuition and fees, and room and board, ever higher — by an average of 169 percent since 1980, according to a Georgetown University study.

In short, in the current system the colleges get and spend billions in borrowed money and put all the loan risk on somebody else — including those student borrowers who responsibly pay off their own debt and those who never borrowed in the first place, not to mention taxpayers, whether they attended a college or not.

This perverse pattern of incentives and rewards must stop. A more equitable model would insist that colleges have serious “skin in the game.” It would insist that they participate to some degree in the losses from defaulted and forgiven loans to their own students.

This idea has been thoughtfully discussed and proposed in Congress before, but now is the time to implement a model that realigns incentives and rewards in our national student loan system and distributes the burden of risk more equitably.

The first principle should be that the more affluent the college is, the higher its participation in the losses should be. The wealthiest colleges with massive endowments should be covering 100 percent of any losses on federal loans to their students, which they can easily afford. Others can cover a lower, but still significant, percentage, but every college that finances itself with federal student loans should assume some real cost when its students default on their loans. Four million student loans enter default each year, not counting the Biden scheme for student loan “forgiveness,” which creates even more losses.

Specifically, we propose the following “skin in the game” requirements for colleges on losses from federal student loans to their students, based on their endowment size:

Endowment Size     Cumulative Rank in Endowments   Coverage of Losses

Over $10 billion                           Top 0.6%                                          100%

$5 billion to $10 billion                Top 1.1%                                            80%

$3 billion to $5 billion                  Top 1.7%                                            60%     

$2 billion to $3 billion                  Top 2.6%                                            40%

All others                                         100%                                            20%

Any fair observer would have to conclude that this represents a rational and efficient matching of benefits and costs.

Moreover, we propose that the most affluent colleges that participate in federal student loans, such as Harvard, Yale and Stanford, should contribute to a “Trust to Offset Losses from Federal Student Loans” through an excise tax on their endowments — some of which are larger than the GDP of sovereign countries. 

This tax would apply to only about the top 1 percent or 2 percent of college endowments. The trust would then be used to offset some of the remaining losses the less affluent colleges cannot pay, thus sharing the wealth of the top 1 percent or 2 percent to help others in need.

For the excise tax to fund the Trust to Offset Losses, we propose:

Endowment Size           Cumulative Rank In Endowments          Tax Rate                     

Over $5 billion                             Top 1.1%                               1% per annum

$2.5 to $5 billion                          Top 2%                                   0.5% per annum

It seems only fair that the wealthiest colleges be asked to contribute to cover the student loan losses the Biden administration is sticking taxpayers with. After all, they benefited the most from the Great Tuition Bubble since the 1980s, just as subprime mortgage brokers benefited in the Great Housing Bubble in the early 2000s.

Since Biden’s St Nicholas Day gift to student borrowers simultaneously gave a large lump of coal to the taxpaying public, not to mention to those borrowers who made every sacrifice to meet their loan obligations, it’s high time to give the rest of us a Christmas present of a new model for government student loans. The proper model should be one that will keep on giving as colleges and universities take on the responsibility and accountability they have shirked until now.

The Fed’s losses have passed $100 Billion: What’s next?

Published in The Hill and RealClear Markets.

There has just been a landmark event at the Federal Reserve: Its accumulated operating losses have passed $100 billion. This startling number, which would previously been thought impossible, was reported on Sept. 14, 2023, in the Fed’s H.4.1 Release.

It is essential to understand that these are not mark-to-market paper losses; they are real cash losses resulting from the Fed’s expenses being to this remarkable extent greater than all its revenue. These are equally losses to the U.S. Treasury and thus costs to the taxpayers; nonetheless the Fed keeps officially insisting that its losses don’t matter. (Meanwhile the Fed’s mark-to-market losses are more than $ 1 trillion in the most recent public report.)

The Fed started posting operating losses in September 2022, so it has taken only 12 months to produce this ocean of red ink. Looking forward, annualizing the year-to-date results suggests the Fed’s net loss for calendar year 2023 will be about $117 billion. 

We must add the $17 billion it lost in the last four months of 2022, so at the end of 2023, the accumulated losses of the Fed may be about $134 billion. That means the losses will have run through the Fed’s entire capital of $43 billion, plus another $91 billion, for losses of more than three times its capital. What comes next?

The losses will continue into 2024. As long as short-term interest rates stay at their current historically normal levels of around 5 percent (that is, if we have “normal for longer”), what the Fed has to pay on its deposits and borrowings will create a punishing negative spread against the Fed’s trillions of very long-term, low yielding investments. 

Since the Fed bought heavily at the top of the market and the bottom in yields, these investments yield on average only about 2 percent. It doesn’t take a Ph.D. in finance to see that lending at 2 percent while borrowing at 5 percent will not be a winner.

The Fed owns $5 trillion of Treasury securities, of which $4 trillion have more than one year left to run, $2.3 trillion more than five years and $1.5 trillion more than 10 years.  (One of its investments is in the Treasury 1.25 percent of 2050, for example.)  

The average yield on these Treasury securities is 1.96 percent, according to the most recent Fed Quarterly Financial Report. The Fed also owns $2.5 trillion of 30-year mortgage-backed securities (MBS), of which $2.4 trillion have remaining maturities of more than 10 years. 

The MBS have an average yield of 2.20 percent. Combined, that suggests an overall yield of 2.04 percent, which compares to a current funding cost of deposits and repurchase agreements of about 5.37 percent. Voila the Fed’s problem: A negative spread of more than 3 percent on investments with very low yields locked in for years to come. In short, the Fed made itself into a gigantic version of a 1980s savings & loan.

An estimate of the Fed’s running rate of losses in very rounded numbers is as follows.  It has $7.5 trillion of investments yielding 2 percent. Of this, $2.3 trillion are financed at zero interest cost by circulating dollar bills, so the Fed is making about $46 billion a year from its government-granted monopoly of currency issuance. There are about $5.2 trillion of remaining investments financed at a -3 percent spread for an annual loss of $156 billion. There are $9 billion in overhead expenses. The approximate annualized running rate is thus:

                           Profit from currency monopoly                        $46 billion

                           Loss on leveraged investments                        ($156 billion)

                           Operating expenses                                           (9 billion)

                           Net (Loss)                                                            ($119 billion)

By mid-2022, the Fed knew it had serious operating losses looming and published a projection of them. Its base case projection was for a peak cumulative loss of $60 billion — the reported $100 billion loss is already a lot more than that, let alone the $134 billion loss likely by the end of 2023. And the ultimate peak losses will be far greater still — if 2024 is anywhere near as bad as 2023, that alone takes it far over $200 billion. (The Fed also considered a remote, “tail risk event” of its mark to market losses reaching $1.1 trillion. With its current mark to market loss, the “tail risk event” has already happened.)

The Fed should regularly provide Congress updated calculations of the possible path of its future losses. From what has been reported so far, we know that to struggle back to break even, the Fed will have to wait what looks like years for its underwater investments to roll off, or short-term rates would have to fall a lot, or some combination of these. 

We might guess that, for example, it will take a runoff of $3 trillion of its long-term investments with a drop in short-term interest rates to 4 percent to get close to break even.

Failing that, and in the meantime, the Fed itself, the Treasury and the taxpayers will be suffering continuing huge losses. We will simultaneously be running an interesting test of the Fed’s claim that these losses don’t matter.

Will the Fed take the medicine one of its presidents prescribes for other banks?

Published in The Hill.

The president of the Federal Reserve Bank of Minneapolis, Neel Kashkari, like an old doctor for ailing banks, recently prescribed a stern regimen for those in weakened conditions from big mark-to-market losses on their long-term investments and loans. Speaking at a National Bureau of Economic Research panel this month, Kashkari pointedly asked: 

“What can a bank do that is already facing large mark-to-market losses?” 

An excellent and hard question, for the losses have already happened, economically speaking. Of course, these banks can passively hold on and hope that interest rates will go back down to their historic lows, and hope that depositors will stop demanding higher yields or departing elsewhere. 

Besides hoping, what can they do?

Doctor Kashkari unsympathetically reviewed the possible medicines, all bitter. These, he said, were three: 

1. Try to raise more equity. 

2. Sell the underwater assets. 

3. Cut dividends. 

Considering these options, Kashkari observed that raising equity may not be so easy or attractive, since investors may not be inclined to invest in funding losses. Divesting the underwater assets by definition means selling at a loss, so the unrealized losses become realized losses on the accounting books.  This perhaps would render the bank formally undercapitalized or worse and may frighten large depositors — will they run?

The third option of cutting dividends then appears as the most practical way to conserve some capital, but as Kashkari asked rhetorically, how many bank CEOs are likely to want to cut their dividends? So he proposed new stress tests with high-interest rates, which would lead to restricting the dividends by regulatory order.

Physician, Heal Thyself! 

Kashkari did not mention that the biggest bank in the country, the one he works for, is facing particularly large mark-to-market losses. The $8 trillion Federal Reserve has net mark-to-market loss of $911 billion as of its last report on March 31. This mark-to-market loss is a remarkable 21 times its total capital of $42 billion. Moreover, according to my calculations, the Fed appears to be heading for an operating loss of about $110 billion for the year 2023. 

So it is timely and appropriate to apply “Doctor” Kashkari’s three possible medicines to the Federal Reserve itself.  

1. The Fed is clearly in a position to raise more equity in the face of its losses if it chooses to. All the commercial bank members of the Federal Reserve are required to subscribe to stock in the Federal Reserve according to a formula based on their own capital, but they all have bought only half of their required subscriptions. The Fed has the right to call for the purchase of the other half at its discretion. It could issue that call right now, and double its paid-in capital. But will it?   

1. The Fed could obviously sell some of its underwater investments. But just as for other banks, that would turn unrealized losses into realized losses and make the Fed’s existing accounting losses even bigger. As the leading investor in mortgage-backed and long-term Treasury securities, large sales by the Fed could move market prices downward, increasing its mark-to-market losses on the remaining investments. Although it has produced projections of realizing losses by sales of underwater investments, the Fed, like the banks Kashkari discussed, chooses not to sell. 

1. How about dividends then? The Fed is paying rich dividends of 6 percent to small banks and the 10-year Treasury yield to large banks while it is running an estimated annual loss of about $110 billion, has a $911 billion mark to market loss, and properly accounted for per my calculations, has negative capital of $38 billion, which is getting more negative each week. It is borrowing money to pay its dividends. And what would a high interest rate stress test applied to the Fed’s massive interest rate risk show? Should the Fed take Kashkari’s dividend medicine and restrict or skip its dividends in light of its huge losses? Revising Kashkari’s rhetorical question, how many Federal Reserve presidents and governors want to do that, including the president of the Federal Reserve Bank of Minneapolis? 

As that president explained, when you already have large economic losses, none of the options are appetizing. 

The debt ceiling debates are tainted by these common fallacies

Published in The Hill with Paul H. Kupiec.

After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

The media is full of stories and opinion pieces about the debt ceiling, many of them repeating administration officials’ and their surrogates’ claims that: It is unconstitutional for the U.S. to default on its debt, the U.S. has never defaulted on its debt and there are no other measures to prevent default, so the only solution to averting an imminent debt crisis is to raise the debt ceiling without reducing deficits. 

These claims are misleading, if not demonstrably false.

The 14th Amendment to the Constitution, ratified in 1868, included language that asserted the validity of war debt incurred by the Union while forbidding repayment of any debts incurred by the states of the Confederacy. The amendment states in part:

“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned” and “Neither the United States nor any state shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States.”

The Civil War context is clear.

In the midst of the 1995-1996 debt ceiling negotiations, President Bill Clinton said, if need be, he would use the 14th Amendment as justification for ignoring the debt ceiling “and force the courts to stop me.” In contrast, during the 2011 debt ceiling negotiations, the Treasury general counsel wrote that “the Constitution explicitly places the borrowing authority with Congress, not the President.” The latter is correct legal thought, the former mere political bravado. 

The 14th Amendment argument especially fails because it is obvious that the U.S. could easily pay all its debt by not making other expenditures, and moreover, because the United States has in fact defaulted on its debt multiple times since the amendment’s adoption, once explicitly upheld by the Supreme Court.

The U.S. government refused to redeem Treasury gold bonds for gold in 1933 as the bonds had unambiguously promised. In 1968, it refused to redeem its silver certificates for silver notwithstanding its explicit promise to pay “one silver dollar, payable to the bearer on demand.” In 1971, the U.S. government refused to redeem the dollar claims of foreign governments for gold, as promised in the Bretton Woods Agreement, approved by Congress in 1945. Reneging on its Bretton Woods commitments by the U.S. government in 1971 fundamentally changed the global monetary system, putting the whole world onto a pure fiat currency system — a significant default event by any measure.

The 1933 gold bond default is instructive since the government’s refusal to make the gold payments it had unquestionably promised was upheld by the Supreme Court in a 5-4 decision in 1935. The majority opinion found, “Contracts, however express, cannot fetter the constitutional authority of the Congress.” A concurring opinion wrote, “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion announced for the Court.”

Also, contrary to assertions by the secretary of the Treasury and the chairman of the Federal Reserve, there is a proven legal measure that could be used to materially postpone the day the U.S. Treasury runs out of cash without increasing the debt limit.

The Treasury owns 261.5 million ounces, or 8,000 tons, of gold that have a current market value of over $500 billion at the market price of just under $2,000 per ounce. However, for government accounting purposes, the value of the Treasury’s gold is set by the Par Value Modification Act of 1973, which “directed the Secretary of the Treasury … to establish a new par value of the dollar … of forty-two and two-ninths dollars per fine troy ounce of gold.“

Congress could allow the Treasury to raise cash and avoid a default by amending this law to value gold at or near its current market price. Such a revaluation would be consistent with the guidance in the Federal Accounting Standards Advisory Board’s Technical Bulletin 2011-1. This change would allow the Treasury to monetize more than $500 billion in new gold certificates with no additional Treasury debt issuance.

Updating the value of gold certificates to avoid default is not a hypothetical idea — it has been done before. In 1953, when the Eisenhower administration faced a debt ceiling standoff and needed more time to negotiate, it issued $500 million in new gold certificates to the Fed to raise cash and avoid a government default. The transaction worked as intended, as it would again.   

In contrast to what is often claimed in the current debt ceiling debate: The 14th Amendment does not allow an administration to ignore a congressional debt ceiling, the U.S. government has defaulted on its obligations multiple times and Congress and Treasury have a proven option they could use to produce large amounts of additional cash without raising the debt ceiling.

Paul H. Kupiec is a senior fellow at the American Enterprise Institute. Alex J. Pollock is a senior fellow at the Mises Institute and co-author of “Surprised Again!—The Covid Crisis and the New Market Bubble” (2022). After weeks of heated debate, the White House and GOP leadership have reportedly reached a deal to suspend the debt ceiling; the House Rules Committee is considering the deal this afternoon. 

Hemorrhaging losses, the Fed’s problems are now the taxpayer’s

Published in The Hill with Paul H. Kupiec.

When liabilities exceed assets, equity capital is negative and an entity is technically insolvent. Few institutions in that condition can continue operating at a loss indefinitely, and those that can usually benefit from an explicit government guarantee. Past special cases have included government-backed agencies like the U.S. housing GSEs. 

From mid-March 2023, there will be a new addition to the list of institutions that, while losing billions of dollars a month and technically insolvent, with the benefit of taxpayer support will still be able to issue billions in new interest-bearing liabilities. That institution is the Federal Reserve.

With large projected operating losses and liabilities already in excess of assets, existing creditors are unlikely to be repaid, let alone new creditors. No sensible fiduciary would lend under these conditions unless newly injected funds have seniority in bankruptcy or carry an explicit government guarantee.

Since mid-September, the Federal Reserve has lost about $36 billion and will continue to post billions of dollars a month in losses for many months if not years to come. Fed losses have already consumed about 85 percent of its stated capital of $42 billion. It will take less than 3 weeks for the Fed to burn through the $6.6 billion of its remaining capital. 

The Fed routinely creates new money by purchasing interest-bearing U.S. Treasury securities in exchange for newly created Federal Reserve notes or interest-bearing bank reserves. From mid-March on, the Fed will, for the first time in its history, pay for its accumulating losses by issuing new liabilities without acquiring any new interest-bearing assets. The Fed will pay its bills by printing new money — not just Federal Reserve Notes that pay no interest, but by issuing new reserve balances that pay banks an interest rate higher than can be earned in a savings account.

When the housing GSEs were insolvent and losing money hand-over-fist, the U.S. Treasury used congressional powers in the Housing and Economic Recovery Act of 2008 to inject enough new capital to save the GSEs from defaulting so they could continue to borrow and operate. How can a technically insolvent and loss-hemorrhaging Federal Reserve continue to operate without a similar congressionally-approved bail-out?  Do other central banks have the Fed’s seemingly magical power to continue operations while technically insolvent, and yet still issue billions in new interest-bearing liabilities to cover losses?

The “magic” begins with the fact that, regardless of the size of its accumulated losses, the Fed will always report positive equity capital. By any sensible accounting standard, losses reduce retained earnings and capital. Nothing is more basic. The Fed’s real capital is its stated capital of $42 billion minus its accumulated losses. The Fed magically suspends this law of accounting by booking its accumulated losses as an asset. If Fed losses accumulate to $100 billion, as they probably will in 2023, or to $200 billion or more by 2024, the Fed will report that it still has $42 billion in equity capital. Magic.

The Fed and many economists believe that the Fed’s losses and its looming negative capital position are inconsequential. While other central banks shrug-off losses, they are not so cavalier with their accounting treatment of losses, nor do they contend that their capital position is of no consequence.

In reporting its recent losses, the European Central Bank canceled paying dividends and was careful to state that its losses were well covered by its reserves and so had no impact on its capital. The Swiss National Bank’s $143 billion loss in 2022 caused it to cancel its dividend payments and reduce its retained earnings. It still remains well-capitalized by central bank standards. In Great Britain, His Majesty’s Treasury explicitly agreed to offset losses of the Bank of England, and the Canadian Finance Ministry has a contract with the Bank of Canada to offset any realized losses on its QE bonds. Meanwhile, the Dutch central bank alerted its country’s Treasury of the possibility that the bank might need to be recapitalized. For all of these central banks, their equity capital position apparently does matter.

With negative real capital and massive losses accruing, how will the Fed still pay member banks a dividend, interest on their reserves balances, conduct monetary policy and pay its bills? With the benefit of an implicit government guarantee — a guarantee that has so far avoided any mention in congressional hearings.

On a consolidated government basis, the Fed’s accounting treatment — paying for accumulating losses by creating new interest-bearing liabilities — is equivalent to the U.S. Treasury selling new interest-bearing debt and remitting the proceeds to the Fed to cover its losses. If Fed losses were paid and accounted for in this way, the Fed’s losses would count against the Federal budget deficit and the new Treasury debt issued would add to the Federal government’s outstanding debt.

With the Fed counting its accumulating losses as a deferred asset, the losses do not reduce the Fed’s reported equity capital or increase the federal budget deficit. Moreover, the new interest-bearing liabilities the Fed issues to pay bank dividends, interest on bank reserves and to cover other Fed operating costs do not count as part of the U.S. Treasury’s outstanding debt.

The Fed’s accounting trickery allows the Fed to borrow taxpayer money to cover its losses without the borrowing or the losses appearing on the Federal government’s ledgers. The Fed itself decides how much to borrow from taxpayers without any explicit congressional authorization. The current arrangement inadvertently allows the Fed to appropriate, borrow and spend taxpayer dollars on its own authority — an issue that should be addressed in the Fed’s next semi-annual congressional appearance.

How to pay all of the Treasury’s bills without raising the debt limit

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The news is filled with dire warnings of what will happen if Congress does not lift the debt ceiling and the U.S. Treasury defaults on its debt. 

Conservative House Republicans in the new Congress have promised to block any increase in the debt ceiling without an agreement to make cuts in the government’s massive deficit spending. President Biden has vowed not to negotiate and says Congress must pass a clean bill that only increases the debt ceiling. 

Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”Unless Congress raises the debt limit, Treasury Secretary Janet Yellen estimates that the Treasury will run out of cash and be unable to pay all its bills sometime in June, triggering a default on the U.S. Treasury’s outstanding debt.

It would be ridiculous, wouldn’t it, for the Treasury to default on its debt when it owns more than half a trillion dollars worth of the most classic monetary asset there is: gold. If there is a way to convert the gold into cash in the Treasury’s bank account, then the government can pay its bills through the end of the fiscal year 2023 without an increase in the debt limit. There is a way, and it has been done multiple times in the past. All that is required is the passage of a bill that changes a few words in existing legislation — a bill that both Republicans and Democrats should support.

The Treasury owns a lot of gold: 261.5 million ounces of it, or more than 8,170 tons. The market price of gold is about $1,940 per ounce, so the Treasury’s gold is actually worth about $507 billion. Because of a law passed in 1973, the Gold Reserve Act requires the Treasury to value its gold at $42.22 per ounce — a number 50 years out of date and with no connection to reality. Gold is in fact a giant undervalued monetary asset of the Treasury. Unlike the phony idea of the Treasury issuing a trillion-dollar platinum coin, the gold owned by the U.S. Treasury is real; because of an outdated law, the Treasury just values it at an absurdly low price.

With the proposed change, the Treasury can simply issue gold certificates against the market value of its gold and deposit these certificates into its account with the Federal Reserve. The Fed will credit the Treasury’s account with an equivalent value in dollars, and the Treasury can spend the money as needed. The Treasury already has $11 billion in gold certificates deposited with the Fed. If the Treasury revalues its gold holding to current prices, we calculate that it can deposit $494 billion in new gold certificates at the Fed — creating $494 billion in spendable dollars without creating a penny of additional Treasury debt.

The Gold Reserve Act, as amended in 1973, provides that: “The Secretary [of the Treasury] may issue gold certificates against other gold held in the Treasury. The Secretary may prescribe the form and denominations of the certificates.” So the authorization to create gold certificates could not be clearer.

Then comes the words needing legislative change: “The amount of outstanding certificates may be not more than the value (for the purpose of issuing those certificates, of 42 and two-ninths dollars a fine troy ounce) of the gold held against the gold certificates.” New legislation is required to modify the Gold Reserve Act and strike “42 and two-ninths dollars” and replace it with “the current market value (as determined by the Secretary at the time of issuance).”

Voila! The Treasury has $494 billion more in cash with no additional debt. The president’s budget proposed a deficit of $1.2 trillion for fiscal 2023, so the additional funds should carry the Treasury from the current June deadline to easily past the end of fiscal 2023, giving the new Republican House majority, and the Democratic Senate majority, time to negotiate, in regular order, and pass a 2024 fiscal year budget with spending cuts as well as pass a new appropriately-sized debt ceiling to facilitate government funding in fiscal 2024 and beyond.

By merely recognizing the true market value of the Treasury’s gold holdings, the intense embarrassment to the administration and Congress of a looming default by the Treasury can be completely avoided. It is indeed ironic that in a world of inflated fiat currency and massive deficit finance, simply recognizing the true value of the government’s gold holdings can keep the government solvent. There are no budgetary tricks involved. It’s been done before and can work again.

Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again!—The Covid Crisis and the New Market Bubble. ” Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The Fed’s quantitative easing gamble costs taxpayers billions

Published in The Hill with Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

The year 2023 is shaping up to be a challenging one for the Federal Reserve System. 

The Fed is on track to post its first annual operating loss since 1915. Per our estimates, the loss will be large, perhaps $100 billion or more, and this cash loss does not count the unrealized mark-to-market losses on the Fed’s massive securities portfolio. An operating loss of $100 billion would, if properly accounted for, leave the Fed with negative capital of $58 billion at year-end 2023. 

At current interest rates, the Fed’s operating losses will impact the federal budget for years, requiring new tax revenues to offset the continuing loss of billions of dollars in the Fed’s former remittances to the U.S. Treasury.

The Federal Reserve has already confirmed a substantial operating loss for the fourth quarter of 2022. Audited figures must wait for the Fed’s annual financial statements, but a preliminary Fed report for 2022 shows a fourth-quarter operating loss of over $18 billion. The weekly Fed H.4.1 reports suggest that after December’s 50 basis point rate hike, the Fed is losing at a rate of about $2 billion a week. This weekly loss rate when annualized totals a $100 billion or more loss in 2023. If short-term interest rates increase further, operating losses will increase. Again, these are cash losses and do not include the Fed’s unrealized, mark-to-market loss, which it reported as $1.1 trillion on Sept. 30. 

The Fed obviously understood its risk of loss when it financed about $5 trillion in long-term, fixed-rate, low-yielding mortgage and Treasury securities with floating-rate liabilities. These are the net investments of non-interest-bearing liabilities — currency in circulation and Treasury deposits — thus investments financed by floating rate liabilities.

These quantitative easing purchases were a Fed gamble. With interest rates suppressed to historically minimal levels, the short-funded investments made the Fed a profit. But these investments, so funded, created a massive Fed interest rate risk exposure that could generate mind-boggling losses if interest rates rose — as they now have.

The return of high inflation required the Fed to increase short-term interest rates, which pushed the cost of the Fed’s floating-rate liabilities much higher than the yield the Fed earns on its fixed-rate investments. Given the Fed’s 200-to-1 leverage ratio, higher short-term rates quickly turned the Fed’s previous profits into very large losses. The financial dynamics are exactly those of a giant 1980s savings and loan.

To cover its current operating losses, the Fed prints new dollars as needed. In the longer run, the Fed plans to recover its accumulated operating losses by retaining its seigniorage profits (the dollars the Fed earns managing the money supply) in the future once its massive interest rate mismatch has rolled off. This may take a while since the Fed reports $4 trillion in assets with more than 10 years to maturity. During this time, future seigniorage earnings that otherwise would have been remitted to the U.S. Treasury, reducing the need for Federal tax revenues, will not be remitted. 

While not widely discussed at the time, the Fed’s quantitative easing gamble put taxpayers at risk should interest rates rise from historic lows. The gamble has now turned into a buy-now-pay-later policy — costing taxpayers billions in 2023, 2024 and perhaps additional years as new tax revenues will be required to replace the revenue losses generated by quantitative easing purchases. 

The Fed’s 2023 messaging problem is to justify spending tens of billions of taxpayer dollars without getting congressional pre-approval for the costly gamble. Did Congress understand the risk of the gamble? The Fed tries to downplay this embarrassing predicament by arguing that it can use non-standard accounting to call its growing losses something else: a “deferred asset.” The accumulated losses are assuredly not an asset but properly considered are a reduction in capital. The political fallout from these losses will be magnified by the fact that most of the Fed’s exploding interest expense is paid to banks and other regulated financial institutions.

When Congress passed legislation in 2006 authorizing the Fed to pay interest on bank reserve balances, Congress was under the impression that the Fed would pay interest on required reserves, and a much lower rate of interest — if anything at all — on bank excess reserve balances. Besides, at the time, excess reserve balances were very small, so if Fed did pay interest on excess reserves, the expense would have been negligible.  

Surprise! Since 2008, in response to events unanticipated by Congress and the Fed, the Fed vastly expanded its balance sheet, funding Treasury and mortgage securities purchases using bank reserves and reverse repurchase agreements. The Fed now pays interest on $3.1 trillion in bank reserves and interest on $2.5 trillion in repo borrowings, both of which are paid at interest rates that now far exceed the yields the Fed earns on its fixed-rate securities holdings. The Fed’s interest payments accrue to banks, primary dealers, mutual funds and other financial institutions while a significant share of the resulting losses will now be paid by current and future taxpayers.

It was long assumed that the Fed would always make profits and contribute to Federal revenues. In 2023 and going forward, the Fed will negatively impact fiscal policy — something Congress never intended. Once Congress understands the current and potential future negative fiscal impact of the Fed’s monetary policy gamble, will it agree that the looming Fed losses are no big deal? 

Alex J. Pollock is a senior fellow at the Mises Institute and the co-author of the new book, “Surprised Again! — The Covid Crisis and the New Market Bubble.” Paul H. Kupiec is a senior fellow at the American Enterprise Institute.

Among six proposals to regulate cryptocurrency, one is superior

Published in The Hill with Howard B. Adler:

In the wake of billions in losses suffered by investors from the failure of cryptocurrency exchange FTX and other crypto collapses, how to regulate cryptocurrencies is a hot topic the new Congress must address. Competing proposals for it to consider range from banning cryptocurrencies outright, to giving them government backing, to stifling them with regulatory bureaucracy, to letting them fail or succeed entirely on their own. 

Some urge that cryptocurrencies simply be banned. This is the approach taken by China in 2021 when it banned all private cryptocurrency transactions and imposed an official “digital yuan” to monitor its citizens even more. The Chinese approach reflects the belief that currency must be a state monopoly and the official currency must have no private competitors. After FTX, some commentators have asked whether cryptocurrency should be banned in the United States. While banning cryptocurrency may be a characteristic response by an absolutist state like China, we do not believe it is appropriate for the United States. 

A second approach, unsurprisingly advocated by Securities and Exchange Commission Chairman Gary Gensler, is to have the SEC take over cryptocurrency regulation primarily by using its existing powers to regulate securities. Gensler believes that “the vast majority” of crypto tokens are securities already within the SEC’s jurisdiction. Of course, the SEC failed to head off the FTX collapse or any of the other cryptocurrency debacles. A glaring problem with this approach is that it requires the SEC to first assert that a particular form of crypto is a security and then for this issue to be litigated — a slow, expensive and inefficient process. A former SEC chair conceded that Bitcoin, the archetypal and largest cryptocurrency by market cap, is not a security and many cryptocurrencies are structured similarly to Bitcoin. 

The Commodity Futures Trading Commission has proposed that it should be the principal cryptocurrency regulator. This is called for in the Digital Commodities Consumer Protection Act, a bill reportedly pushed by former FTX CEO Sam Bankman-Fried and other members of the cryptocurrency industry. The crypto industry is said to regard the CFTC as a less stringent regulator than the SEC. One proposal is for each cryptocurrency firm to get to choose either the SEC or the CFTC as its regulator.  

From a different perspective, a group of top U.S. financial regulators has put forward a banking-based regulatory approach. This would be applied to stablecoins, a type of cryptocurrency backed by or redeemable at par in dollars (or other government currencies), and intended to maintain a stable value with respect to the dollar. This approach, advanced by the Treasury and the President’s Working Group on Financial Markets, would require that stablecoin issuers be chartered as regulated, FDIC-insured banks. The rationale for this approach is that stablecoin issuers are functionally taking deposits, which is by definition a banking function.  

Regulation as a bank is the most invasive form of financial regulation and imposes very high compliance costs.  For the business models of many cryptocurrency issuers, this may be the functional equivalent of banning cryptocurrency.  (Perhaps this is the outcome actually intended.)  More importantly, the only good thing that can be said about FTX’s and other cryptocurrency failures is that they did not damage the wider financial system or result in taxpayer bailouts.  Requiring cryptocurrency issuers to be FDIC-insured puts them in the federal safety net and puts taxpayers on the hook for future losses.  In our view, creating taxpayer support is going in exactly the wrong direction. 

A fifth approach, in a bill introduced by Sen. Pat Toomey (R-Pa.), would authorize a new type of license from the Office of the Comptroller of the Currency for stablecoin issuers, presumably less onerous than a full banking license and not requiring FDIC insurance. Issuers would be subject to examination and required to disclose their assets and redemption policies. Most importantly, they would be required to provide quarterly “attestations” from a registered public accounting firm. 

As a further step, we believe that disclosure of full, audited financial statements is critical. Right now, most cryptocurrencies are not subject to any kind of accounting disclosure. But no one should ever invest money in an entity that does not provide audited financial statements without recognizing that their funds are at extreme risk. If a federal regulatory system for cryptocurrency is to emerge, financial statement requirements are essential. 

Sixth and finally, it has been proposed that cryptocurrency not be specially regulated at all. Instead, it should be treated like a “minefield,” with appropriate warnings that investors face danger and invest entirely at their own risk. Investors would be able to rely on the protections of general commercial law and existing anti-fraud and criminal laws, but if cryptocurrency ventures crash, they crash, and their debts are reorganized in bankruptcy with losses to the investors and creditors, but not to taxpayers.  

Since cryptocurrency originated as a libertarian revolt against the government monopoly on money, this approach is consistent with its founding ideas. If people want to risk their money, they ought to be allowed to do so. However, they must be able to understand what they are doing. All parties should clearly understand that Big Brother is not protecting them when they hold or speculate in cryptocurrency. 

We believe that this sixth approach is superior in philosophy, but that it needs to be combined with required full, audited financial statements and disclosures about risks and important matters such as assets and redemption policies. Such a combination is the most promising path forward for cryptocurrency regulation. 

Howard B. Adler is an attorney and a former deputy assistant secretary of the Treasury for the Financial Stability Oversight Council. Alex J. Pollock is a senior fellow of the Mises Insitute and former Principal Deputy Director of the Treasury’s Office of Financial Research. They are the coauthors of the newly released book,” Surprised Again! The COVID Crisis and the New Market Bubble.” 

The Fed is in the red: Should it still pay CFPB’s bills?

Published in The Hill with Paul Kupiec.

The Fifth Circuit Court of Appeals just ruled that the Dodd-Frank Act’s requirement that the Federal Reserve pays the expenses of the Consumer Financial Protection Bureau is unconstitutional. This important ruling adds to another problematic aspect of the CFPB’s funding scheme — the Federal Reserve no longer has enough earnings to cover the $692 million in checks the CFBP writes each year.

The CFPB’s 2022 “Budget Overview” states that “The CFPB’s operations are funded principally by transfers … from the combined earnings of the Federal Reserve.” But in the fall of 2022, this is not true. There are no such earnings, the Fed is losing money. Making the Fed pay the CFPB’s expenses simply makes those losses larger. It also keeps the CFPB’s expenses out of the federal budget deficit where the court ruling says they rightly belong.

Former Fed Chairman Ben Bernanke has just been awarded the Nobel Prize in economics, but the policy of quantitative easing he championed has left the Fed with market value losses of monumental proportions. We estimate that the Fed’s balance sheet as of mid-October suffers from a $1.3 trillion mark-to-market loss. That is 30 times the Fed’s total capital of $42 billion. To put the size of this loss in perspective, it is nearly equal to Spain’s GDP and larger than the GDP of Indonesia.

The Fed says these mark-to-market losses are not an issue, they are “merely” unrealized losses. It does not include them in the asset valuations or the capital it reports on its financial statements. Since the Fed does not intend to sell any of its underwater investments, it says there is no danger it will experience a cash loss. While the Fed can feign indifference to a $1.3 trillion market value loss on its investment portfolio, imagine your reaction if you opened your 401(k) statement and saw a very large unrealized loss. 

As short-term interest rates increase, the Fed is experiencing both unrealized mark-to-market losses and cash operating losses. Both will continue because of the Fed’s massive interest rate mismatch. The Fed’s investment portfolio has a net position of about $5 trillion of long-term fixed-rate investments, much of them with remaining maturities of more than 10 years. These investments are funded with floating rate liabilities. The Fed is the financial equivalent of a $5 trillion 1980s-vintage savings and loan. When short-term interest rates rise, its profits naturally shrink and then turn into losses.

We estimate that, in round numbers, for each 1 percent that short-term interest rates increase, the Fed’s annual net income falls by $50 billion. Since the interest rate on the Fed’s floating rate liabilities has increased by 3 percent (so far) in 2022, the Fed is now posting substantial losses and will continue to post losses going forward.

In May, we estimated that the Fed would begin losing money when short-term rates exceed 2.7 percent. With the last FOMC rate increase, the Fed is now paying about 3.1 percent on bank reserve balances so the Fed’s operating profits should already be in the red. A comparison of the Fed’s Oct. 19, H.4.1 Report with its report from mid-September shows that, over the past month, the Fed has accumulated an operating loss of about $5 billion. The loss appears in Table 6 in the account, “Earnings remittances due to the U.S. Treasury.” On Oct. 19, the account is negative, which means the Fed is now losing money.

A loss of $5 billion in a month annualizes to a loss of $60 billion. At current short-term interest rates, not only are there no Fed profits to cover the checks CFPB will be writing, but the Fed’s annual operating loss is on a path that will soon exceed the Fed’s total capital. If these operating losses were booked into retained earnings, as required by Generally Accepted Accounting Principles, within a year, the Fed would report negative capital. In other words, using normal accounting standards, the Fed will soon be technically insolvent.

But unlike the banks it regulates, the Fed will not report negative capital and it won’t go out of business as its losses continue to accumulate. In its accounting statements, the Fed will offset operating losses dollar-for-dollar by debiting an intangible (better said, an imaginary) asset account called a “deferred asset.” As long as the Fed has a deferred asset balance, which may be for years, it will make no payments to the Treasury. In the meantime, the Fed will print money to pay its bills, further contributing to inflation.

If interest rates continue to increase, as nearly everyone expects, Fed losses will grow. The Fed’s total cash losses could easily grow to $100 billion or more over time — maybe a lot more — before rates decline. Ironically, the more the Fed fights inflation by increasing short-term interest rates, the bigger its own loss becomes.

From its inception in 1913, the Fed has been structured to make profits from its money printing monopoly and required to send most of its profits to the Treasury to reduce the federal deficit. But today the Fed’s short-funded quantitative easing investments have resulted in losses that exceed its seigniorage profits.

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Accounted for properly, Fed losses increase the federal deficit that ultimately must be paid by future taxes — but Fed losses are currently not counted in federal deficit estimates. As the next Congress considers Fed reforms, it should also require that Fed operating losses also be included in the federal budget deficit.

While the CFPB’s expenses are clearly federal government expenditures, they are currently not counted in the federal budget and have hitherto been set by an unelected CFPB director and evaded congressional appropriations by making the Fed pay the CFPB’s bills. If the Fifth Circuit’s ruling prevails, these expenditures could be put into a normal democratic process, set by the elected representatives of the people in a constitutional fashion, and no longer be increasing the Federal Reserve’s already embarrassingly large losses.

Alex J. Pollock is the co-author of the newly published “Surprised Again!—The Covid Crisis and the New Market Bubble,” and a senior fellow at the Mises Institute.  Paul Kupiec is a senior fellow at the American Enterprise Institute.

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.

Biden’s Appointments Speak to an Extremist Agenda

Published in TownHall.

Perhaps the most outrageous example of the president’s extremist appointments was his nomination of Saule Omarova to head the Office of the Comptroller of the Currency. A graduate of Moscow State University on the Lenin Personal Academic Scholarship, Omarova tweeted in 2019, “Until I came to the US, I couldn’t imagine that things like gender pay gap still existed in today’s world. Say what you will about old USSR, there was no gender pay gap there. Market doesn’t always 'know best.'” In an academic paper Omarova’s advocated that “central bank accounts fully replace — rather than compete with — private bank accounts.” It’s disturbing that a person who spent much of her academic career deriding capitalist institutions and advocating for unprecedented government management of the economy, was nominated for such a critical economic position. At least the nation can be thankful that Omarova withdrew her nomination in December – as many moderate Democrats made clear they could not support her nomination.

Read the rest here.

Biden's radical Treasury nominee in her own words

Published in The Hill.

In an incomprehensible act, President Biden has nominated as comptroller of the currency Saule Omarova — a law school professor who thinks that banks should have their deposit business taken away and transferred to the government, the Federal Reserve should be the monopoly provider of retail and commercial deposits, the Fed should perform national credit allocation, the Federal Reserve Bank of New York should intervene in investment markets whenever it thinks prices are too high or too low (shorting or buying a wide range of investments accordingly), the government should sit on boards of directors of private banks with special powers and disproportionate voting power, new federal bureaucracies should be set up to regulate financial regulators and carry out national investment policy and in general, it seems, has never thought of a vast government bureaucracy or a statist power that she doesn’t like.

What follows is a collection of such particularly unwise proposals in Professor Omarova’s own words, which might be appropriately called “Omarova’s Little Book.” 

“On the liability side” of the banking system, Professor Omarova “envisions the ultimate ‘end-state’ whereby central bank accounts fully replace — rather than compete with — private bank accounts,” according to her 2020 paper, “The People’s Ledger: How to Democratize Money and Finance the Economy.”

“On the asset side,” she “lays out a proposal for restructuring the Fed’s investment portfolio and redirecting its credit-allocation power…leaving the asset side free to serve as the tool of the economy-wide credit allocation.”

In short, “the key is…eliminating private banks’ deposit-taking function and giving the Fed new asset-side tools of shaping economy-wide credit flows,” the proposed regulator of national banks writes.

At this point, it is already unnecessary to proceed any further, but we will.

In the paper, “The ‘Too Big To Fail’ Problem,” Omarova suggests “an expansion of the Federal Reserve’s so-called ‘open market operations’…to encompass trading in a wide range of financial assets. … If, for example,  a particular asset class — such as mortgage-backed securities or technology stocks — rises in market value at rates suggestive of a bubble trend, the FRBNY trading desk would short these securities.” 

“The FRBNY trading desk would go long on particular asset classes when they appear to be artificially undervalued.” 

Also, a “National Investment Authority” would be “charged with developing and implementing a comprehensive strategy of national economic development.” 

In “The Climate Case for a National Investment Authority,“ she said "The NIA will act directly within markets as a lender, guarantor, market-maker, venture capital investor and asset manager. … It will use these modalities of finance in a far more assertive and creative manner.”

These ideas will perhaps strike you, as they do me, as exceptionally naïve.

Meanwhile, in “Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation,” Omarova proposes creating a “Public Interest Council,” which “would have a special status … outside of the legislative and executive branches." The Council "would comprise…primarily academic experts [!]" and "it would have broad statutory authority to collect any information it deems necessary from any government agency or private market participant and to conduct targeted investigations.”

On top of that, in “Bank, Governance and Systemic Stability: The ‘Golden Share’ Approach,” she recommends a “new golden share mechanism” which would give “the government special, exclusive and nontransferable corporate-governance rights in privately owned enterprises.”

“As a holder of the golden share, the government could have disproportionate voting power with respect to the election of the company’s directors and various strategic decisions,” reads the paper.

“This ability to affect directly a private firm’s substantive business decisions — without holding a controlling economic equity stake — is a particularly promising feature of the golden share,” Omarova thinks. Do you?

While considering this quite remarkable nomination, any member of the Senate Banking Committee who personally supports these proposals of Omarova should boldly hold up their hand and then speak in their defense. It seems hard to believe there would be many hands.

The US has never defaulted on its debt — except the four times it did

Published in The Hill.

Every time the U.S. government’s debt gets close to the debt ceiling, and people start worrying about a possible default, the Treasury Department, under either party, says the same thing: “The U.S. government has never defaulted on its debt!” Every time, this claim is false.

Now Treasury Secretary Yellen has joined the unfailing chorus, writing that “The U.S. has always paid its bills on time” and “The U.S. has never defaulted. Not once,” and telling the Senate Banking Committee that if Congress does not raise the debt ceiling, “America would default for the first time in history.”  

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This is all simply wrong. If the United States government did default now, it would be the fifth time, not the first. There have been four explicit defaults on its debt before. These were:

1. The default on the U.S. government’s demand notes in early 1862, caused by the Treasury’s financial difficulties trying to pay for the Civil War. In response, the U. S. government took to printing pure paper money, or “greenbacks,” which during the war fell to significant discounts against gold, depending particularly on the military fortunes of the Union armies.

2. The overt default by the U.S. government on its gold bonds in 1933. The United States had in clear and entirely unambiguous terms promised the bondholders to redeem these bonds in gold coin. Then it refused to do so, offering depreciated paper currency instead. The case went ultimately to the Supreme Court, which on a 5-4 vote, upheld the sovereign power of the government to default if it chose to. “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States,” wrote Justice Harlan Stone, a member of the majority, “the government, through exercise of its sovereign power…has rendered itself immune from liability,” demonstrating the classic risk of lending to a sovereign. In “American Default,” his highly interesting political history of this event, Sebastian Edwards concludes that it was an “excusable default,” but clearly a default.

3. Then the U.S. government defaulted in 1968 by refusing to honor its explicit promise to redeem its silver certificate paper dollars for silver dollars. The silver certificates stated and still state on their face in language no one could misunderstand, “This certifies that there has been deposited in the Treasury of the United States of America one silver dollar, payable to the bearer on demand.” It would be hard to have a clearer promise than that. But when an embarrassingly large number of bearers of these certificates demanded the promised silver dollars, the U.S. government simply decided not to pay. For those who believed the certification which was and is printed on the face of the silver certificates: Tough luck.

4. The fourth default was the 1971 breaking of the U.S. government’s commitment to redeem dollars held by foreign governments for gold under the Bretton Woods Agreement. Since that commitment was the lynchpin of the entire Bretton Woods system, reneging on it was the end of the system. President Nixon announced this act as temporary: “I have directed [Treasury] Secretary Connally to suspend temporarily the convertibility of the dollar into gold.” The suspension of course became permanent, allowing the unlimited printing of dollars by the Federal Reserve today. Connally notoriously told his upset international counterparts, “The dollar is our currency but it’s your problem.”

To paraphrase Daniel Patrick Moynihan, you are entitled to your own opinion about the debt ceiling, but not to your own facts about the history of U.S. government defaults.

Will the Federal Reserve have a monopoly in digital currencies?

Published in The Hill.

Cryptocurrencies started out with a libertarian desire to give people an alternative to national money, thereby escaping government power to depreciate their fiat currencies through inflation. Many governments, including the United States, have gone so far as to promise perpetual inflation, a key function of which is to help governments depreciate their own debt. Governments can also completely destroy the value of their currency through hyperinflation, as has happened throughout history.

To create a meaningful alternative to this government money monopoly was a noble intent, consistent with the classic proposal by Friederich Hayek in “Choice in Currency.” He asked, “Why should we not let people choose freely what money they want to use?” He argued, “Practically all governments of history have used their exclusive power to issue money to defraud and plunder the people.” Cryptocurrency enthusiasts agreed. They were, however, too optimistic about how forcefully governments could react, first by imposing regulation and then by realizing that governments themselves could issue digital currency to the public.

The great irony here is that the idea of a digital alternative to national money can morph into an idea to expand and solidify the government money monopoly. According to a survey by the Committee on Payments and Market Infrastructure of the Bank for International Settlements, more than 60 central banks, representing 80 percent of the world population, are researching central bank digital currencies. More than half of them have moved on to actual experiments or more “hands on” activities.

The broadest form of government digital currency would be the central bank offering deposit accounts to the public at large, so individuals, businesses, corporations, nonprofit organizations, and municipal entities could have deposit accounts at the Federal Reserve instead of with a private bank. Then their financial transactions in the digital currency with each other would be settled directly by the accounting entries on the electronic books of the Federal Reserve. Efficient and risk reducing!

Such a centralization has happened before. Paper currency became monopolized by the Federal Reserve in the form of government notes in the early 20th century. Until then, private banks issued their own paper currency. I have a copy of a $3 bill issued in the 1840s by a previous banking employer. Needless to say, no such currency is used today.

Could money in the form of deposits, such as money in the form of paper currency, be monopolized by the central bank, given current technology? In principle that could be the case. Direct deposits at the Federal Reserve would be close to being default and liquidity risk free. No need to worry about whether your bank might fail, whether it might become illiquid or insolvent, or whether your deposit was over the insurance limit. You would have no need to withdraw cash if you were worried about banks in a crisis because you would be holding a direct Federal Reserve obligation. That would no doubt appeal to many holders of money and, in our electronic world, it is quite easy to imagine such a central bank digital currency.

Do we like the idea, however, that deposits would be concentrated in the government instead of spread among 5,000 private banks? How much of the deposit market the central bank could take over depends on whether it would pay interest on the deposits. If it paid zero interest, its market share would be much less. But the Federal Reserve can and does pay interest on deposits. There are $14 trillion in total deposits in the banking system. Suppose 50 percent of them moved to digital deposits with the Federal Reserve compared to the 100 percent market share the Federal Reserve has in paper currency. That would be a towering $7 trillion. The government money monopoly would become bigger and more powerful.

What would the Federal Reserve do with its new $7 trillion? It would have to invest it. It would become an even bigger allocator of credit. It might allocate a lot more credit to the government itself and its favored housing sector. Or it might get into corporate credit, displacing private investors and becoming a state commercial bank. The history of such banks has been generally pathetic because their credit decisions inevitably become politicized. The Federal Reserve could also more readily impose negative interest rates directly on the people, thereby expropriating their savings.

On top of all that, the government would also have financial Big Data extraordinaire. It would know almost everything about our financial lives. Digital currency would then have traveled from libertarian choice to Big Brother. If not strictly limited and controlled, central bank digital currency could turn out to be one of the worst financial ideas of the 21st century.

Colleges need to have skin in the game to tackle student loan debt

Published in The Hill.

Republican Senator Lamar Alexander of Tennessee rightly wants to make colleges more accountable for the results of student loans. With these federal loans, the government lends with no credit underwriting, the students get in debt, but who gets all the money? The colleges. If the students fail to repay the loans, who takes the hit? The taxpayers. This is a perverse incentive structure. It leads to, as his committee report found, “nearly half of all borrowers not making payments on their student loans.”

Alexander proposes a “new accountability system for colleges based upon whether borrowers are actually repaying their student loans.” Great idea! In a similar vein, the annual White House budget correctly observes a “better system would require postsecondary institutions that accept taxpayer funds to share in the financial responsibility associated with student loans.” Indeed, each college should share the risk of whether its students repay the money they borrowed and the college spent. Nothing improves your behavior like having to share in the risk you are creating. In his book “Skin in the Game,” Nassim Nicholas Taleb wrote, “If you inflict risk on others, and they are harmed, you need to pay some price for it.”

In student loans, with their abysmal repayment rate, colleges play the same role as subprime mortgage brokers did in the infamous housing finance bubble. They promote the loans without regard to how they might be repaid, they make money from the loans, and they pass all the risk on to somebody else. In the housing finance case, the risk went ultimately to the taxpayers. In the student loan case, it goes directly to the taxpayers. Just as the flow of easy mortgage credit induces higher house prices then takes even more debt to pay the higher price, the flow of easy student credit induces higher college prices then takes even more debt to pay the higher tuition. It is a sweet deal for colleges that create the risk, keep all the money, and stick the taxpayers with all the losses.

A Brookings Institution research paper points out that with low repayment rates, the federal student loan program represents a “sizeable taxpayer funded transfer” to the colleges. It rightly asks how much of the taxpayer losses the college should have to pay back. It proposes that each cohort of college borrowers be measured at the end of five years of required payments, and each college has to pay at least 25 percent of the amount by which the actual principal reduction has fallen short of 20 percent of the total of the original loans after five years. The 20 percent principal reduction results from what would happen with a 15 year amortization of the loan pool as the standard used. That seems perfectly reasonable.

This proposal is a good stab at it, but I would say do not wait for five years to address the problem. Do it every year. Take the total loan pool of each borrower cohort of the college. Establish a 15 year amortization schedule for the principal of the pool. Measure every year how much principal has actually been paid in the pool as a whole. Each year the college should pay to the Treasury, I suggest 20 percent of any repayment shortfall against the standard. That would be a steady financial feedback loop.

After 15 years, the college will have reimbursed taxpayers for 20 percent of whatever loan principal was not paid. Of course, taxpayers would still be paying for 80 percent of the losses. The 20 percent loss participation would be enough to give the college the right incentives to improve its repayment performance and control instead of constantly bloating the debt of its students. Student loan borrowers, like mortgage borrowers, are hurt being saddled with thousands of dollars in debt they cannot pay.

Colleges should have maximum flexibility for how to work on this. They could increase efficiency, reduce their costs and their prices, or shorten the time to graduation to scale back the need for borrowing. They should make sure the students understand what loans mean and how they are expected to repay, consider their ability to pay, guide the students to programs with the most promising job prospects for them, and adjust their mix of programs. They can do all of the above plus other ideas and managing the tradeoffs involved. Colleges should no longer play the role of subprime mortgage brokers. They need some skin in the game now.

President makes the smart call for reforming housing finance system

Published in The Hill.

In a recent White House memorandum, President Trump said, “It is time for the United States to reform its housing finance system.” He is right about that. He is also right about principal elements of reform, as listed in the memorandum, notably reducing taxpayer risks, expanding the role of the private sector, establishing “appropriate” capital requirements for Fannie Mae and Freddie Mac, providing that the government is properly paid for its credit support of Fannie and Freddie, facilitating competition, addressing the systemic risk of Fannie and Freddie, defining what role they should have in multifamily mortgage finance, and terminating their conservatorships only when the other reforms are put in place.

In all this, the Treasury is instructed to distinguish between what can be done by administrative action and what would require legislation. This seems to set the stage for carrying out the former, even if Congress cannot agree on the latter, which it probably cannot. The memorandum provides that for “each administrative reform,” the Treasury housing reform plan will include a “timeline for implementation.” This timetable instruction represents a pretty clear declaration of intent to proceed.

Needless to say, the general directions can only be implemented after being turned into specifics. While that seems impossible for Congress to agree on, the executive branch can define the specific administrative actions it wishes to take. As the administration comes to decisions about the details, is there an appropriate model to consider for Fannie and Freddie? Is there some way to simplify thinking about the issues they present, which entails swarms of lobbying interests?

I think there is. The model should be too big to fail and systemically important financial institutions. Fannie is bigger than JPMorgan Chase. Freddie is bigger than Citigroup. There is no doubt Fannie and Freddie remain too big to fail. They are an essential point of vulnerability of American residential mortgage finance, the biggest credit market in the world except for Treasury debt. Should they implode, the government will again rush to the rescue of their global and domestic creditors.

Vast intellectual and political efforts have gone into lowering the odds that too big to fail banks will need bailouts or generate systemic crisis. We need to apply the results of that effort to Fannie and Freddie, which now run with virtually no capital. But before the crisis, they already ran at extreme leverage. Indeed, they leveraged up the whole housing finance system, making the system, as well as themselves, much riskier.

What about their capital requirements? Following our model, simply apply the risk based capital standards of systemically important banks to Fannie and Freddie. The same risks need the same capital, no matter who holds them. Fannie or Morgan? Freddie or Citi? The same risk and the same risk based capital. This would result in a required capital for the two on the order of $200 billion, or about $190 billion more than they have.

How much should they pay the government for its credit support? The same as the too big to fail banks pay. For them, this is called a deposit insurance premium. For Fannie and Freddie, you could call it a credit support fee, which would replace the profit sweep in their deal with the Treasury. Deposit insurance fees are assessed on total bank liabilities. Apply the same to Fannie and Freddie credit support fee and at the same level as would be required for a giant bank of equivalent riskiness.

I estimate this would be about 0.18 percent per year, but recommend the administration ask the Federal Deposit Insurance Corporation to run its big bank model on Fannie and Freddie and report on what level of fee results. Note that the Treasury stands behind the Federal Deposit Insurance Corporation, just as it stands behind Fannie and Freddie.

With such a serious amount of capital, Fannie and Freddie would need to charge guarantee fees that would allow greater competition in the private sector. This would be consistent with the law, which requires that their guarantee fees be set at levels that would cover the cost of capital of private regulated financial institutions. If they have the same risk based capital requirement, then that should follow for Fannie and Freddie.

With $200 billion in capital and a credit support fee of 0.18 percent, I estimate that Fannie and Freddie could sustain a return on total capital of 8 percent or so, which is quite satisfactory. The Treasury should exercise its warrants for about 80 percent of their common stock to share in this return until Treasury sells the stock, which will generate a large gain for the taxpayers. It seems to me that virtually all of this might be done by administrative action. Let us hope the administration will proceed apace.

It’s time for the Fed to be made accountable for its actions

Published in The Hill.

The U.S. Constitution assigns responsibility for the nature of money to the Congress. As Article I, Section 8 famously says, “Congress shall have Power…To coin Money [and] regulate the Value thereof.”

How can this be consistent with the idea that the Federal Reserve should be “independent,” as it is so often proclaimed, especially by the Fed itself? The answer is that it is not consistent.

Last week, the House Financial Services Committee approved the Federal Reserve Reform Act of 2018, H.R. 6741, which was sponsored by Rep. Andy Barr (R-Ky.), the chairman of the Subcommittee on Monetary Policy and Trade. The full committee passed the bill 30-21, with the vote along party lines.

This is an important effort to move toward the proper constitutional ordering of authority over money and regulating the value thereof, which we now call “monetary policy,” whatever the future of the bill may be.

Who should be in charge of money and its value? The Fed all by itself or the Fed as accountable to Congress? Almost all of the very many economists I know think that the Fed, a very large employer of economists, should be independent.

But that cannot be the right answer in a government whose essential character requires robust checks and balances.

I believe proponents of Fed independence tend to view it as a committee of economic philosopher-kings. But this fits neither its existence as part of a democratic government, nor the inherent uncertainties and limitations of its knowledge of the economic present, let alone the future.

Section 2 of the bill, Monetary Policy Transparency and Accountability, requires the Fed to discuss with Congress what the Fed is trying to do, in some specificity and in plain English, as distinct from “Fedspeak.”

The Fed would be required to discuss what its monetary strategy for each coming year is, how it plans to use the various instruments at its disposal, what monetary policy rules it has adopted and how these might change.

After the fact, it must discuss how the monetary strategy did change, if it did. This seems a pretty reasonable discussion for the Fed to have with the elected representatives of the people, who have the constitutional responsibility for the value of money.

Section 11 C (b) contains a nice definition of what money should mean in the pure fiat currency system we now have:

A generally acceptable medium of exchange that supports the productive employment of economic resources by reliably serving as both a unit of account and store of value.

This is what the bill instructs the Fed to produce. It is in notable contrast to the endemic inflation the Fed has presided over for the last several decades, which has resulted in a dollar today being worth what a dime was in 1950.

In the bill as originally proposed, a Section 12 would have changed the Fed’s so-called “dual mandate” of “maximum employment [and] stable prices” to simply “stable prices.” This vividly contrasts with the current Fed’s formal commitment to perpetual inflation. This provision did not make it into the committee’s approval, but is such an important idea that it deserves discussion.

The “dual mandate” was enacted in the 1970s, when people believed in the Phillips Curve theory that you would increase employment by running up inflation.

If it were up to me, on the next opportunity, I would write this new mandate somewhat differently, along these lines: “All Federal Reserve strategies are to be consistent with stable prices on average over the long run.”

This is because in an innovative, free-market economy with sound money, prices will rise sometimes and sometimes fall, but have a basically flat trend over the long run. It must not be forgotten that the Fed’s original 1913 mandate, “to furnish an elastic currency” to finance crises, is still there.

Section 3 (a) of the bill, “Returning to a Monetary Policy Balance Sheet,” would require the Fed’s investment portfolio to be essentially held in Treasury securities (with a few exceptions for gold certificates, foreign central bank obligations or the International Monetary Fund).

The real point is to take the Fed out of being a massive investor in real estate mortgage securities, thus out of being a promoter of house price inflation and out of effectively being a giant savings and loan vehicle. The Fed would have to give all non-qualifying investments to the U.S. Treasury in exchange for Treasury securities.

This is not as strict as the “Bills Only” policy adopted by the Fed under Chairman William McChesney Martin in the 1950s, but reflects similar ideas. Martin’s policy required that all Fed investments be in short-term Treasury bills.

To show how much things can change, the Fed for the last several years owned zero Treasury bills, and today, bills represent about 2 percent of its assets.

The Federal Reserve has grown over time to be an institution that combines immense power with a yearning for “independence.” Rep. Barr is right that, faced with this behemoth, the Congress should be improving its oversight and exercising its duty to define money and regulate its value.