Risk doesn’t stand still

Published in Library Of Law And Liberty.

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe explores the movement and transformation of risks in adapting, self-referencing systems, of which financial systems are a notable example. In this provocative new book, the Wall Street Journal’s chief economics commentator Greg Ip contemplates how actions to reduce and control risk are often discovered to have increased it in some other way, and thus, “how safety can be dangerous.”

This is an eclectic exploration of the theme, ranging over financial markets, forest fires, airline and automobile safety, bacterial adaptation to antibiotics, flood control, monetary policy and financial regulation. In every area, Ip shows the limits of human minds trying to anticipate the long-term consequences of decisions whose effects are entangled in complex systems.

In the early 2000s, the central bankers of the world congratulated themselves on their insight and talent for having achieved, as they thought, the Great Moderation. It turned out they didn’t know what they had really been doing, which was to preside over the Great Leveraging. Consequently, and much to their surprise, they found themselves in the Great Collapse of 2007 to 2009, and then, with no respite, in the European debt crisis of 2010 to 2012.

Ip begins his book two decades before that, in 1989, at a high-level conference on the topic of financial crises. (Personally I have been going to conferences on financial crises for 30 years.) He cites Hyman Minsky, who “for decades had flogged an iconoclastic theory of business cycles that fellow scholars had largely ignored.” Minsky’s theory is often summarized as “Stability creates instability”—that is, periods of safety induce the complacency and the mistakes that lead to the crisis. He was right, of course. Minsky (who was a good friend of mine) added something else essential: the rise of financial instability is endogenous, arising from within the financial system, not from some outside “shock.”

At the same conference, the famous former Federal Reserve Chairman Paul Volcker raised “the disturbing question” of whether governments and central banks “end up reinforcing the behavior patterns that aggravate the risk.” Foolproof shows that the answer is yes, they do.

Besides financial implosions, Ip reflects on a number of natural and engineering disasters, including flooding rivers, hurricane damage, nuclear reactor meltdowns, and forest fires, and concludes that in all of these situations, as well, measures were taken that made people feel safe, “and the feeling of safety allowed danger to re-emerge, often hidden from view.”

The natural and the man-made, the “forests, bacteria and economies” are all “irrepressibly adaptable,” he writes. “Every step we take to suppress the risks . . . will provoke some other, offsetting step.” So “neither the economy nor the natural world turned out to be as amenable to human management” as was believed.

As Velleius Paterculus observed in the history of Rome that he wrote circa 30 AD, “The most common beginning of disaster was a sense of security.”

Why are we like this? Ip demonstrates, for one thing, how quickly memories fade as new and unscarred generations arrive to create their own disasters. Nor is he himself immune to this trait, writing: “The years from 1982 to 2007 were uncommonly tranquil.”

Well, no.

In fact, the years between 1982 and 1992 brought one financial disaster after another. In that time more than 2,800 U.S. financial institutions failed, or on average more than 250 a year. It was a decade that saw a sovereign debt crisis; an oil bubble implosion; a farm credit crisis; the collapse of the savings and loan industry; the insolvency of the government deposit insurer of the savings and loans; and, to top it off, a huge commercial real estate bust. Not exactly “tranquil.” (As I wrote last year, “Don’t Forget the 1980s.”)

“Make the most of memory,” Ip advises. After the Exxon Valdez oil spill disaster, he says, the oil company “used the disaster to institute a culture of safety . . . designed to maintain the culture of safety and risk management even as memories of Valdez fade.”

We often do try to ensure that “this can never happen again.” After the 1980s, many intelligent and well-intentioned government officials went to work to enact regulatory safeguards. They didn’t work. As Arnold Kling pointed out in an insightful paper, “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008,” some of the biggest reforms from the earlier time became central causes of the next crisis—a notable example of Ip’s conclusions.

We are forced to realize that the U.S. housing finance sector collapsed twice in three decades. We may ask ourselves, are we that incompetent?

Consider a financial system. The “system” is not just all the private financial actors—bankers, brokers, investors, borrowers, savers, traders, speculators, hucksters, rating agencies, entrepreneurs, principals and agents—but equally all the government actors—multiple legislatures and central banks, the treasuries and finance ministries who must constantly borrow, politicians with competing ambitions, all varieties of regulatory agencies and bureaucrats, government credit and subsidy programs, multilateral bodies. All are intertwined and all interacting with each other, all forming expectations of the others’ likely actions, all strategizing.

No one is outside the system; all are inside the system. Its complexity leaves the many and varied participants inescapably uncertain of the outcomes of their interactions.

Within the interacting system, a fundamental strategy, as Ip says, is “to do something risky, then transfer some of the risk to someone else.” This seems perfectly sensible—say, getting subsidized flood insurance for your house built too near the river, or selling your risky loans to somebody else. But “the belief that they are now safer encourages them to take more risk, and so the aggregate level of risk in the system goes up.”

“Or,” he continues, “it might cause the risky activity to migrate elsewhere.” Where will the risk migrate to? According to Stanton’s Law, which seems right to me, “Risk migrates to the hands least competent to manage it.” Risk “finds the vulnerabilities we missed,” Ip writes. This means we are always confronted with uncertainty about what unforeseen vulnerabilities the risk will find.

Finally, the author puts all of this in a wider perspective. “My story, however, is not about human failure,” he writes, “it is about human success.” There can be no economic growth without risk and uncertainty. The cycles and crises will continue, so what we should look for is not utter stability but “the right trade-off between risk and stability.” The cycles and crises are “the price we pay for an economic system that encourages and rewards risk.” This seems to me profoundly correct.

Where is OCC in court battle over state usury limits?

Published in American Banker with William M. Isaac.

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

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

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

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

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

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

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

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

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

In the meantime, what happens?

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

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

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

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

Your retirement dream may require working much longer

Published in Real Clear Markets.

A recent Citigroup monograph, “The Coming Pensions Crisis,” begins with some questions very much in the spirit of our time:  “What’s your dream for retirement?  Is it living on the beach, traveling on cruise ships…relaxing and enjoying the good life”?

Personally speaking, my dream for retirement is not to retire—at least, not now. I think if Warren Buffett can keep running the world’s greatest investment company at 85, and Alan Greenspan could run the world’s most powerful central bank until 79 before going on to lecture and write books, and Maurice R. “Hank” Greenberg can be battling the goliath of the government at 90, why would I stop at 73?  How much sitting on the beach, going on cruises and relaxing can you stand?

What, after all, is “the good life”?

As used by Citigroup, “the good life” means consuming without producing. The words of an old hymn admonish us to “work, for the night is coming.” Here the suggestion is instead: “play, for the night is coming.”

I understand that tastes differ, so may you may prefer the latter. But no one can escape the accompanying question: how many years can you afford to play without working, to consume without producing? If you retire at 63 and live to 85, you will have been retired for a quarter of your life. Should you live to 95 instead, you will have been retired for a third of your life. On average, such an arrangement cannot work financially.

As average lives grow longer, “the reality for many of us,” Citigroup rightly says, “is that there isn’t enough in the piggy bank to last throughout their retired life.” The same problem confronts many pension funds, both private and public, upon which workers rely. They don’t have nearly enough money in the piggy bank, either—not by a long shot.

This daunting problem – in total, an $18 trillion shortfall, by Citigroup’s estimate – is staring us in the face. There are only two answers. Put more money in the piggy bank while you are working—and as retirements grow longer, this means a lot more. Or make the retired years fewer by working longer. Or both. The math of the matter all comes down to this.

An essential element in the math is what I call the “W:R Ratio,” which measures how many years you work compared to how many years you will be retired. All the money spent in retirement is the result of what is saved, in one fashion or another, during one’s working years. This may be what you personally saved and invested, or what your employer subtracted from your compensation and invested, or the money the government took from your compensation and spent, but promised to pay back later.

The surest way to finance your retirement is to keep your W:R ratio up by not retiring too soon.

In 1950, the average age of retirement in the United States was 67. Average life expectancy at birth was 68. Average life expectancy for those who reaches age 65 was 79. Suppose you started work at 20 and retired at 67—working 47 years and ultimately living to age 79. Your W:R ratio was 47 working years divided by 12 retired years, or 3.9. You worked and could contribute to savings for about four years for every year of retirement.

Contrast the current situation. The average retirement age is much lower, at 63. Average life expectancy once you get to 65 is up to 86. Retirement has gotten longer from both ends. Also, many more people have post-secondary education and begin work later. Suppose you work from 22 to 63-years-old and live to age 86. Your W:R ratio is 41 divided by 23, or only 1.8. You have worked less than two years for each year of retirement. Can that work financially? No.

So the crux of the W:R relationship is: how many years do you have to work in order to save enough to pay your expenses for one year of retirement?  What is your guess?  One year of work for one year of retirement—say retiring after 30 years at 55 and living to 85?  No way. Two years?  That would take a heroic and implausible savings rate.

Calculations show that with retirement savings of about 10 percent of income, and historically average real returns of 4 percent a year on the invested savings, the W:R ratio needs to be 3:1. That means if you start working at 22 and live to 86, the financeable retirement age is 70. Or if you start work at 25, the financeable retirement age is 71. All of this is speaking of averages, of course, not necessarily in any individual case.

If the savings are lower, the rate of return is lower or both, the W:R ratio and the age of retirement must rise even more. The Federal Reserve is now making the problem much worse for retirement savings with low, zero or negative real interest rates. We have to hope this expropriation of savers by the Fed is temporary, historically speaking.

What certainly proved to be temporary was the idea that those still in good health and capable in many cases of productive work in a service economy should instead expect to be paid comfortably for long years of play. When combined with greatly extended longevity, this 1950s dream was simply unrealistic; indeed, it was impossible. Today’s savings and pension fund shortfalls bear witness to this financial reality. We must adjust our expectations and plans back to higher average W:R ratios and later retirements than in recent times.

Puerto Rico needs a financial control board

Published in Real Clear Markets.

The government of Puerto Rico is broke. Having run a long series of constant budget deficits, financed by escalating borrowing, it has accumulated about $71 billion in debt which cannot be paid as agreed. To this must be added an estimated $44 billion of virtually unfunded public-employee pension liability, giving a total debt problem of at least $115 billion. This dwarfs in size the bankruptcy of the City of Detroit, the former municipal insolvency record holder.

What to do? The situation is complex and what all the needed reforms are is not yet clear, but the first required step is very clear: Congress should promptly create an emergency financial control board to assume oversight and control of the financial operations of the government of Puerto Rico.

This is just as Congress successfully did in 1995 with the insolvent Washington, D.C.; as New York State, with federal encouragement, successfully did with the insolvent New York City in 1975; and as the State of Michigan did with the appointment of an emergency manager for the insolvent City of Detroit in 2013. Such action has also been taken with numerous other municipal debtors.

Under the U.S. Constitution, Congress has complete sovereignty over territories like Puerto Rico and the clear authority to create a financial control board. Given the Puerto Rican government’s severe and longstanding financial mismanagement, Congress also has the responsibility to do so.

This should be the first step, before other possible actions. The sine qua non for financial reform is to establish independent, credible authority over all books, records and other relevant information; to determine what the true overall deficit is; to determine which Puerto Rican government bodies are insolvent, in particular to understand the financial condition of the Government Development Bank, which lends to the others; and to develop fiscal, accounting and structural reforms which will lead to future balanced budgets and control of debt levels. Of course, it must also consider how to address the current excessive and unpayable debt.

Should Puerto Rico follow Washington and New York, working its way through its management, bureaucratic and debt problems without a bankruptcy proceeding? Or should it follow Detroit, with a bankruptcy included along with reforms? The financial control board should be charged with recommending to Congress whether a municipal bankruptcy regime for Puerto Rico should be created.

Does all this take responsibility and power away from the current Puerto Rican government? Of course it does. As one harsh, but accurate, assessment put it: if you are a subsidiary government and “you screw up your finances bad enough,” you are going to get control and direction from somebody else. This is as it is, and as it should be.

In the current century, the government of Puerto Rico has run a budget deficit every single year: 15 years in a row. As debts multiplied, debt service was met by additional borrowing and new debt issued to pay the interest on the existing debt. This is the definition of a Ponzi scheme.

Such debt escalations always end painfully when the lenders belatedly stop lending, as has now occurred in Puerto Rico. What must inevitably follow is reform of fiscal operations, default on or restructuring of debt in bankruptcy or otherwise, bailout funding or combinations of these. What in particular must be done is what the financial control board should take up, preferably sooner rather than later.

As the government of Puerto Rico (“the Commonwealth”) has disclosed:

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

• “The Commonwealth faces an immediate liquidity crisis.”

• “The budget deficit of the Commonwealth’s central government during recent years may be larger than the historical deficits of the General Fund.”

• “The assets of the Commonwealth’s retirement system will be completely depleted within the next few years.”

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

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

• “The Government Development Bank’s financial condition has materially deteriorated… [it faces] the inability of the Commonwealth and its instrumentalities to repay their loans.”

• “The Commonwealth has failed to file its financial statements before the 305-day deadline in ten of the past thirteen years.”

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

They themselves have said it. It is high time for an emergency financial control board. The board may be given a politically friendlier name, but its formidable task will be the same.