Slick accounting at the Federal Reserve could prove disastrous

Published in The Hill.

“Mr. Chairman, on exhibit two, panel four, ‘deferred asset.’ This is kind of a nice term, ‘deferred asset.’ As far as I know, the committee has never used the deferred asset. It strikes me as a possible political firefight to bring that into play. All of the scenarios here, other than option one, if I’m reading this correctly, would bring the deferred asset into play, with possible repercussions, I think, for the Federal Reserve.”

This was James Bullard, president of the Federal Reserve Bank of St. Louis, speaking at the September 2012 meeting of the Federal Open Market Committee, according to the minutes. Said a staff member in reply, “It has never been the case that we have had, for the Federal Reserve System as a whole, a deferred asset.” But they knew that they might have one going forward. Earlier in the meeting, the staff had reported that all the options considered to reduce the Fed’s bond portfolio would cause the “creation of a deferred asset,” perhaps even a “substantial deferred asset.”

What in the world were they talking about? In this context, what did this, as Bullard ironically said, “nice” term mean? In fact, they were discussing how, if they ever tried to reduce their huge portfolio of long-term Treasuries and mortgage-backed securities, they were liable to take big losses. They were pondering the effect which the losses arising from any attempt to normalize their balance sheet would have on their financial condition.

What the Fed meant by “deferred asset” in clear language is the “net losses we would take.” What would be deferred is the recognition of the losses in retained earnings. The losses under consideration might occur by selling some of the Fed’s vast investment in long-term securities for less than it paid for them. Could this happen? Of course. Buy at the top for $100 and sell later for $95 means a loss of $5 for anybody.

Already in 2012, the Federal Open Market Committee was struggling with the clear possibility that such losses could be very large, indeed much larger than the Fed’s net worth. Thus, such losses had the potential to render the central bank insolvent on a balance sheet basis, as well as making it it so that the Fed would be sending no money to the Treasury to reduce the budget deficit, perhaps for several years.

In one scenario presented to the Federal Open Market Committee at that 2012 meeting, the “deferred asset” would get to about $175 billion. At the time of the meeting, the Fed’s net worth was only $55 billion, so its leaders were contemplating the possibility of losing up to three times its capital. This was happening while running a long-term securities portfolio of $2.6 trillion.

If negative net worth did arrive, the Fed could still print any money needed to pay its bills, but the balance sheet wouldn’t look so good. And might not publishing a balance sheet with negative net worth mean a “possible political firefight” in Bullard’s phrase? What might Congress say or do? The Fed didn’t want to find out. So it invented having a “deferred asset,” if necessary, rather than reporting a negative net worth.

In short, this “deferred asset” would be an imaginary asset. It would be booked in this fashion to avoid recognizing the effect of net losses on capital. In accounting terms, it would be a big debit looking for someplace to go. The proper destination of the debit for everybody in the world, including the Fed, is to retained earnings, where it would reduce capital, or even make it negative. But the Fed does not choose to allow this, and the central bank defines its own accounting rules.

So the Fed would send the debit to an accounting “deferred asset” instead, which hides the loss and overstates capital. Harshly described, for ordinary banks, this would be called accounting fraud. So more than five years ago, the Fed understood very well the big losses that might result from its massive “quantitative easing” investments, and how such losses might dwarf the Fed’s capital. It knew it could prevent showing a negative net worth by a slick accounting move. Hence the extensive discussion of the “deferred asset,” which does indeed sound a lot better in the minutes than “negative capital.”

Since then, the Fed’s portfolio is much bigger, up to $4.2 trillion, so the potential losses are much bigger now, while the Fed’s capital is much smaller, down to $39 billion because the Congress expropriated a lot of its retained earnings. Interest rates have gone up. Selling down the Fed’s portfolio could now cause an even bigger negative net worth, or “deferred asset.” As we know, the Fed has concluded not to make any sales, only move extremely slowly toward balance sheet normalization by holding all its long-term portfolio to maturity.

Should the Federal Reserve, in the circumstances of 2012 or now, reveal the projected losses from any portfolio sales and resulting “deferred asset” to the public? Should it discuss candidly with its boss, the Congress, how big the losses and negative net worth might turn out to be? Or should it just prepare the accounting gimmick for use, if necessary, worry in private, put on a good face in public, and hope for the best? What would you do, thoughtful reader, in their place?

Federal Reserve will be judged by future on these years of low rates

Published in The Hill.

The government’s official interest rate price-fixing committee, otherwise known as the Federal Reserve, has just raised its target fed funds rate by a quarter-point. This surprised no one, as the Fed intended, since it works hard to manage expectations.

What would the rate be if it were set in private markets instead of by a government committee? No one knows, but presumably it would be higher.

The Fed’s latest move still leaves interest rates at remarkably low levels. In the 1980s and 1990s, most people would have considered it impossible for the fed funds rate to be under 2 percent. Now we have the Fed’s current target range of 1.5 to 1.75 percent—to make it easy, let’s just call it 1.75 percent. Not only is this rate low, but in real inflation-adjusted terms, it is negative. In February, the Consumer Price Index went up 2.2 percent year-over-year, so the new fed funds target in real terms is 1.75 percent minus 2.2 percent  =  negative 0.45 percent.

It looks like it will take one more increase, at least, to get the real fed funds rate up to around zero and numerous increases after that to approach a normal level. Needless to say, normal real interest rates are positive, not negative.

What might a normal level be? We can make a fair guess by looking at long-term averages. Graph 1 shows nominal fed funds rates and inflation rates from mid-1954 to year-end 2017.

Over this long term, the fed funds rate averaged 4.86 percent. The annual rate of inflation averaged 3.56 percent. So the long-term average real fed funds rate was 1.3 percent.

If inflation going forward runs at the Fed’s target inflation rate of 2 percent, it would suggest a normalized fed funds rate of 3.3 percent. To get there would take six more quarter-point increases. On similar logic, the normalized yield on the 10-year Treasury note would be 4.5 percent, instead of the current 2.8 percent, and the rate on a 30-year mortgage loan would be 6.2 percent, up from the current 4.4 percent level. Of course, if inflation turns out to move higher than 2 percent, the normalized fed funds rate, and also the other rates, will be correspondingly higher.

Graph 2 shows the real fed funds rates over the same years.

As is apparent from this graph, we have lived through and remain in an exceptionally long period of negative real fed funds rates. It is by far the longest stretch of such negative real rates in our six decades of data. While normal real fed funds rates are positive, it is not unusual for them to be negative for some periods, such as when the Fed is facing a recession, or a financial crisis, or both, or has a desire to inflate asset prices. Extended negative real interest rates are good at inducing asset-price booms.

Since the 1950s, there were negative real fed funds rates during the following times:

• Six quarters during 1956-1958;

• Two quarters during 1970-1971;

• 15 quarters during 1974-1977;

• Five quarters during 1979-1980;

• Three quarters at about zero in 1992-1993;

• 11 quarters during 2002-2005;

• Three quarters in 2008.

And then the all-time champion run of negative real fed funds rates:

• 30 quarters, equivalent to 7.5 years, during 2009 to now.

It is hardly surprising that this period has been accompanied by booms in equity, bond and house prices. Was the Fed’s strategy during these years wise? The future will judge that, looking back.

For now, we can say, in sum, that the Fed’s target fed funds rate remains remarkably low, is still negative in real terms, and has a long way to go to get back to normal.

Economic crises are invariably failures of the imagination

Published in Real Clear Markets.

A fundamental issue in all risk management is oversight vs. seeing.  You can be doing plenty of oversight, analysis, regulation and compliance, with much diligence and having checkers check on checkers, but is the whole process able to envision the deep and surprising risks that are the true fault lines under your feet?  Or are you only analyzing, regulating, writing up and color coding dozens of factors which while important, are not the big risk which is going to take you and perhaps the system of which you are a part, down?  For example, in the midst of your risk management oversight efforts, whether as a company or as the government, could you see in 2005 or 2006, or at the latest by 2007, that U.S. average house prices across the whole country, were likely to drop like a stone?  And see what would happen then?

Most people, including the most intelligent, experienced and informed, could not.

Former Treasury Secretary Timothy Geithner, in his memoir of the 2007-2009 financial crisis, Stress Test (2014), draws this essential conclusion: “Our crisis, after all, was largely a failure of imagination. Every crisis is.” If you can’t imagine it, if you consider that the deep risk event is unimaginable or impossible, your oversight will not see the risk. “For all our concern about ‘froth’,” Geithner continues, “we didn’t foresee how a nationwide decline in home prices could induce panic in the financial system.”

This is a profoundly important insight.  Geithner expands on it: “Our failures of foresight were primarily failures of imagination, like the failure to foresee terrorists flying planes into buildings before September 11.  But severe financial crises had happened for centuries in multiple countries, in many shapes and forms, always with pretty bad outcomes.  For all my talk about tail risk, negative extremes, and stress scenarios, our visions of darkness still weren’t dark enough.”

That was not for lack of effort, but for lack of seeing.  “The actual main failing was over-reliance on formal econometric models,” banking scholar Charles Goodhart suggests in his acute essay, “Central bank evolution: lessons learnt from the sub-prime crisis” (2016).  He points out that as the housing bubble was inflating, there was copious housing finance data which could be and was analyzed:

“There were excellent monthly data on virtually all aspects of mortgage finance in the USA starting from the 1950s.  By the 2000s such data provided over 50 years of all aspects of US mortgage finance.  During this period, there had only been a very few months in which the value of houses, and the mortgages related to them, of a regionally diversified portfolio of housing assets over the US as a whole had faced a loss, and then only a very small one.

“While there had been sharp declines in housing valuations in certain specific regions, i.e. the North East in 1991-2, the oil producing states in the mid-1980s, etc., a regionally diversified portfolio virtually never showed a loss, and then only a minor one, over these 50 years.”  The conclusion seemed clear enough at the time: house prices did not, so would not, fall on a national average basis.  A portfolio of mortgages diversified across regions would be protected.  “Virtually everyone was sucked into the general conventional wisdom that housing prices”—on average—“were almost sure to continue trending generally upwards.”

This clear, though in retrospect completely wrong, conclusion could be professionally quantified: “Put those data into a regression analysis, and then what you will get out is an estimate that any loss of value in a regionally diversified portfolio of greater than about three or four percent would be…highly improbable.”  But as the bubble got maximally inflated, its shriveling became highly probable instead of improbable.  As we know, average U.S, house prices went down by 27% and fell not for a few months, but for six years, in spite of all kinds of government interventions.  The housing market went down for longer than a great many people could stay solvent.

“Of course,” Goodhart reminds us, “econometric regressions are based on the implicit assumption that the future will be like the past.” The less of the past we know, the worse an assumption this is. In this case, fifty years and one country, even a very big country, were not enough.

To expand how much of the past we have studied, both in terms of more time and more places, is perhaps one way to improve our ability to see risks, imagine otherwise unimaginable outcomes, and thus improve our risk oversight.  Perhaps.  There are no guarantees of success.

House prices: What the Fed hath wrought

Published in The Hill.

After the peak of the housing bubble in 2006, U.S. house prices fell for six years, until 2012. Are these memories getting a little hazy?

The Federal Reserve, through forcing years of negative real short-term interest rates, suppressing long-term rates, and financing Fannie Mae and Freddie Mac to the tune of $1.8 trillion on its own vastly expanded balance sheet, set out to make house prices go back up.  It succeeded.  Indeed it has overachieved.  Average house prices are now significantly higher than they were at the top of the bubble.  This is shown in the following 20-year history of the familiar S&P Case-Shiller national house price index.

Read the full article here.

Banks need more skin in the housing finance game

Published by American Banker.

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

But the concentration is still there, a decade later.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Confiscation of gold by the federal government: A lesson

Published in Real Clear Markets.

Historically as well as now, people in America tried to protect themselves against the government’s devaluation of their dollars by holding gold; and formerly, by buying Treasury bonds which promised to pay in gold.  The fundamental thought was and is the same that many holders of Bitcoin and other “cryptocurrencies” have now: hold something that the government cannot devalue the way it can its official currency.

Unfortunately for such an otherwise logical strategy, governments, even democratic governments, when pushing comes to shoving, may use force to control and even take away what you thought you had.  The year 1933 and the new Franklin Roosevelt presidency provide vividly memorable, though little remembered, examples.  First the U.S. Treasury defaulted on its promises to pay gold bonds in gold; then under notable executive orders, the U.S. government confiscated the gold of American citizens and threatened them with prison if they didn’t turn it in.  It moreover prohibited the future holding of any gold by Americans, an outrageous prohibition which lasted four decades, until 1974.

All this may seem unimaginable to many people today, perhaps including Bitcoin enthusiasts, but in fact happened.  Said Roosevelt in explanation, “The issuance and control of the medium of exchange which we call ‘money’ is a high prerogative of government.”

President Hoover had warned in 1932 that the U.S. was close to having to go off the gold standard.  Running for President, Roosevelt called this “a libel on the credit of the United States.”  He furthermore pronounced that “no responsible government would have sold to the country securities payable in gold if it knew that the promise—yes, the covenant—embodied in those securities was…dubious.”  The next year, during Roosevelt’s own administration, this “covenant” was tossed overboard.  Congress and the President “abrogated”—i.e. repudiated—the obligation of the government to pay as promised.  One can argue that this was required by the desperate economic and financial times, but about the fact of the default there can be no argument.

Roosevelt’s Executive Order 6102, “Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government,” of April 5, 1933 marks an instructive moment in both American monetary and political history.  To modern eyes, it looks autocratic, or perhaps could fairly be described as despotic.

The order begins, “By virtue of the authority vested in me by Section 5(b) of the Act of October 6, 1917,” without naming what act that is.  Why not?  Well, that was the Trading with the Enemy Act which was used to confiscate German property during the First World War.

The order states:

-“All persons are hereby required to deliver on or before May 1, 1933…all gold coin, gold bullion and gold certificates now owned by them or coming into their ownership.”

-“Until otherwise ordered any person becoming the owner of any gold coin, gold bullion or gold certificates shall, within three days after receipt thereof, deliver the same.”

-“The Federal Reserve Bank or member bank will pay therefore an equivalent amount of any other form of coin or currency”—in other words, we will give you some nice paper money in exchange.

Lastly, the threat:

-“Whoever willfully violates any provision of this Executive Order or of these regulations or of any rule, regulation or license issued hereunder may be fined not more than $10,000, or, if a natural person, may be imprisoned for not more than ten years, or both.”

Ten thousand 1933 dollars was a punitive fine—equivalent to about $190,000 today.  But the real punishment for trying to protect your assets was “We’ll put you in jail for ten years!”

A few months later the order was revised and tightened up by Roosevelt’s Executive Order 6260, “On Hoarding and Exporting Gold” of August 28, 1933.  It specifies that “no person shall hold in his possession or retain any interest, legal or equitable, in any gold,” and adds a reporting requirement: “Every person in possession of and every person owning gold…shall make under oath and file…a return to the Secretary of the Treasury containing true and complete information” about any gold holdings, “to be filed with the Collector of Internal Revenue.”  So the IRS was brought in as an enforcer, too.  The threat of fines and prison continued as before.

It’s a prudent idea to protect yourself against the government’s perpetual urge to depreciate its currency. But if pushing comes to shoving, how do you protect yourself against the government’s confiscating the assets you so prudently acquired—and its being willing to put you in prison if you try to keep them?  What governments, even democratic ones, are willing to do when under sufficient pressure, is a lesson Bitcoin holders and everybody else can usefully consider.

Who is this ‘we’ that should manage the economy?

Published in Law & Liberty.

Adair Turner, the former Chairman of the British Financial Services Authority, has written a book about the risks and unpredictability of financial markets which has many provocative insights. It also has a frustrating blind spot about how government actions can and do contribute to financial crises.

Turner clearly addresses the failure of governments to understand what was going on as the crises of the 2000’s approached, including his notable mea culpa discussed below. But there is no discussion anywhere of the culpability of government actions which greatly contributed to inflating the bubble of housing debt and pumping up leverage on the road to the U.S. housing finance collapse.

The fateful history of Fannie Mae and Freddie Mac is not discussed, even though Turner rightly emphasizes how dangerous leveraged real estate is as a key source of financial fragility. Fannie and Freddie, with $5 trillion in real estate risk, do not rate an entry in the index.

The problems of student debt make it into a footnote in chapter six, where its rapid growth in the United States is observed, along with the judgment that “much of it will prove unpayable,” but it is not mentioned that this is another government loan program.

The role of government deposit insurance in distorting credit markets, so notable in the U.S. savings and loan collapse of the 1980s, is not considered. That instructive collapse gets one passing sentence.

The Federal Reserve, along with other central banks, created the Great Inflation of the 1970s that led to the disastrous financial crises of the 1980’s. Seeking a house price boom and a “wealth effect” in the 2000’s, the Federal Reserve promoted what turned out to be a house price bubble. Turner provides no proposals about how to control the obvious dangers of central banks, although he does point out their mistake in thinking that they had created a so-called “Great Moderation.” That turned out to have been instead a Great Overleveraging.

There can be no doubt of Turner’s high intelligence, as his double first in history and economics at Cambridge and his stellar career, leading to his becoming Lord Turner, attest. But as an old banking boss of mine memorably observed, “it is easier to be brilliant than right.”

This universal principle applies as well to leading central bankers, regulators, and government officials of all kinds as it does to private actors. The bankers “that made big mistakes,” Turner correctly says, “did not consciously seek to take risks, get paid, and get out: they honestly but wrongly believed that they were serving their shareholders’ interests.”  So also for the authors of mistaken government actions: they didn’t intend to make mistakes, but wrongly believed they were serving the public interest.

When former Congressman Barney Frank, for example, the “Frank” of the bureaucracy-loving Dodd-Frank Act, said before the crisis said that he wanted to “load the dice” with Fannie and Freddie, he never intended for the dice to come up snake eyes, but they did. Throughout the book, Turner displays the tendency to assume the consequences of government action to be knowable and benign, rather than unknowable and often perverse.

Debt and the Devil opens with the remarkable confession of government ignorance shown in the following excerpts.  As he became Chairman of the Financial Services Authority in 2008, Turner relates:

“I had no idea we were on the verge of disaster.”

“Nor did almost everyone in the central banks, regulators, or finance ministries, nor in financial markets or major economics departments.”

“Neither official commentators nor financial markets anticipated how deep and long lasting would be the post-crisis recession.”

“Almost nobody foresaw that interest rates in major advanced countries would stay close to zero for at least 6 [now it’s 8] years.”

“Almost no one predicted that the Eurozone would suffer a severe crisis.”  (That crisis featured defaults on government debt.)

“I held no official policy role before the crisis.  But if I had, I would have made the same errors.”

If governments, their regulators, and their central banks cannot understand what is happening and the real risks are, then it is easy to see why their actions may be unsuccessful and indeed generate perverse results.  So we have to amend some of Turner’s conclusions, to make his partial insights more complete.

“Central banks and regulators alone cannot make the financial system and economies stable,” he says.  True, but we must add:  but they can make financial systems and economies unstable by monetary and credit distortions.

We are “faced with a free market bias toward real estate lending” needs additionally: and an even bigger government bias and government promotion of real estate lending.

Turner quotes Charles Kindleberger approvingly: “The central question is whether central banks can contain the instability of credit and slow speculation.” This needs a matching observation:  The central question is whether central banks can hype the instability of credit and accelerate speculation. They can.

“Banking systems left to themselves are bound to create too much of the wrong sort of debt” needs amendment:  Banking systems pushed by governments to expand risky loans to favored political constituencies are bound to create too much of the wrong sort of debt, which will lead to large losses.  This will be cheered by the government until it is condemned.

“At the core of financial instability in advanced economies lies the interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate.” Insightful, but incomplete.  Here is the complete thought: At the core of financial instability lies the interaction between the potentially limitless supply of the punchbowl of central bank credit, bank credit, government guarantees of real estate credit, and the inelastic supply of real estate.

“Private credit creation is inherently unstable.” Here the full thought needs to be: Private and government credit creation is inherently unstable. Indeed, Turner supplies a good example of the latter: Japanese government debt has become so large relative to the Japanese economy that it “will simply not be repaid in the normal sense of the word.”

According to Turner, what is to be done?  He supplies a deus ex machina: “We.” So he asserts that “We need to manage the quantity and influence the allocation of credit,” and “We must influence the allocation of credit among alternate uses,” and “We must therefore deliberately manage and constrain lending against real estate assets.” Who is this “We”?  Lord Turner and his friends?  There is no “We” who know how credit should be allocated.

In an overall view, Turner concludes that “All complex systems are potentially unstable,” and that is true. But it must be understood that the complex system of finance includes inside itself all the governments, central banks, regulators and politicians, as well as all the private financial actors. Everybody is inside the system; nobody is outside the system, let alone above the system, looking down with ethereal perspective and the ability to manage everything. In particular, there is no “We” outside the complex system.  “We,” whoever they may be, are inside the complex system with its inherent uncertainty and instability, along with everybody else.

Time to reform Fannie and Freddie is now

Published in American Banker.

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

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

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

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

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

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

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

This I call the “10 Percent Moment.”

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

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

That will make 2018 an opportune time for fundamental reform.

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

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

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

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

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

FHFA’s g-fee calculation ignores the law

Published in American Banker.

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

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

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

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

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

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

Why has the agency failed to fulfill its legal obligation?

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

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

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

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

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

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

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

Giant ‘QE’ gamble: How will it end?

Published in the Library Of Law And Liberty.

The Federal Reserve made a colossal gamble with its so-called “Quantitative Easing” or “QE,” which is simply a euphemism for its $4.4 trillion binge of buying long-term bonds and mortgages. Its big bid for long bonds, along with parallel programs undertaken by other members of the international fraternity of central banks, has artificially suppressed long-term interest rates, and has deliberately fostered asset-price inflations in bonds, stocks and houses.

Will this gamble pan out?

The Fed now intends to reduce its buying and slowly shrink its portfolio by letting bond maturities and mortgage prepayments exceed new purchases. As its big bid is reduced, will the asset-price inflations it fostered end well in some kind of soft landing, or will they end badly in an asset-price deflation? Will the Fed be able to take its stake off the table and go away a winner—or will it ultimately lose?

Nobody knows, including the Fed itself. The officials who run the institution are guessing, like everybody else—and hoping.

In particular, they are hoping that by making the unwinding of the gamble very slow, with emphatic announcements well in advance, they will mitigate the potential negative price reactions in bond, stock and housing markets. Well, maybe this strategy will work—or maybe not. The behavior of complex financial systems is fundamentally uncertain. As Nobel laurate economist Robert Shiller said in a recent interview with Barron’s, “We don’t know what will happen in this unwinding.”

Shiller is right. But who are the “we” who don’t know? In addition to himself, “we” includes Nobel laureates, all other economists, financial market actors, regulators, the Federal Reserve, all the other central banks, and you, honored reader and me.

With its buying in the trillions, the Fed made asset prices go up and long-term interest rates go down, as intended. Simply reversing its manipulation by selling in the trillions, turning its big bid in the market into a big offer, would surely make asset prices go down and interest rates go up, perhaps by a lot. This outcome the Fed wants at all costs to avoid. So it is not selling any of its bonds or mortgages. The plan is to stop buying as much, a little at a time, while continuing the steady stream of rhetorical assurances. We don’t know, and Fed officials don’t know, if this will work as hoped.

The Fed did not strive to inflate asset prices as an end in itself, of course. The theory was that this would result in a “wealth effect,” which would in turn accelerate economic growth. Did it? Would economic growth have been worse or better without QE? Were the risks entailed in the inflation of asset prices worth whatever additional growth it may or may not have induced? In fact, U.S. real gross domestic product growth over the many years of QE has been generally unimpressive.

“Evaluating the effects of monetary policy is difficult,” as Stephen D. Williamson, an economist with the Federal Reserve Bank of St. Louis, writes in a new article in The Regional Economist, and “with unconventional monetary policy, the difficulty is magnified.” Williamson adds that “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case the QE is actually detrimental.” He points out that Canada without QE had better growth than the United States with it. As usual in macroeconomics, you can’t prove it one way or the other.

The Fed’s effect on asset prices seems clear, however. As one senior investment manager recently said about the price of the U.S. Treasury 10-year note, “What it tells you is the amount of distortion that quantitative easing is creating.” How much of that distortion is going to reverse itself?

With QE, the Fed has been practicing “asset transformation,” according to Williamson. That is economics-speak for borrowing short and lending long. The Fed is funding its long-term bonds and very long-term mortgage securities with short-term, floating-rate deposits. This is one of the most classic of all financial speculative gambles. In other words, the Fed has created a balance sheet for itself that looks just like a 1980s savings and loan, and has become, in effect, the biggest savings and loan in history.

Williamson reasonably asks if the Fed has any competitive advantage at holding such a speculative position, and doubts that it does. However, I believe the Fed does have two unique advantages in this respect: control of its own accounting, and lack of penalties for insolvency. The Fed uniquely sets its own accounting standards for itself, and Fed officials have decided never to mark its securities portfolio to market. More remarkably, even if it should realize losses on the actual sale of securities, officials have decided not to let such losses reduce its reported capital, but to carry the required debits to a hokey intangible asset account. No one else would be allowed to get away with that.

Suppose hypothetically that realized losses on the Fed’s giant portfolio come to exceed its small capital (less than 1 percent of the portfolio). Even then, it is not clear whether that would affect the Fed. Many economists argue that insolvency doesn’t matter if you can print the money to pay your obligations. Nonetheless, it would be embarrassing to the Fed to be technically insolvent, and its QE-unwind program is designed to avoid any realized losses while not disclosing any mark-to-market losses.

Although the GDP growth effects of the QE gamble are uncertain, it certainly has succeeded in two other ways besides inducing asset-price inflation: in robbing savers, and in allocating credit. By forcing real interest rates on conservative savings to be negative, the Fed has transferred billions of dollars of wealth from savers to borrowers—especially to the government, the biggest borrower of all, and to leveraged speculators. It has meanwhile assured the aggrieved savers that they are really better off being sacrificed for the greater good.

QE also means the Fed allocated trillions in credit to its favored sectors: housing and the government. In housing, this resulted in national average house prices inflating back up to their bubble levels, obviously making them less affordable. For the government, the Fed made financing its deficits cheaper and easier, and demonstrated once again that the real first mandate of any central bank is financing, as needed, the government of which it is a part.

As the Fed moves to unwind its big QE gamble, what will happen? It, and we, will find out by experience.

Taxpayers shouldn’t be asked to pay for Fannie and Freddie’s risk exposure

Published in The Hill.

As the old Washington saying goes, “When all is said and done, more is said than done.” This certainly applies to the years of congressional debates about how to reform Fannie Mae and Freddie Mac. They are dominant forces in the huge American mortgage market, operating effectively as arms of the U.S. Treasury.

Can you ever protect the taxpayers against the risk of Fannie and Freddie? In their current form, with virtually zero capital — and soon literally zero capital — they are and will continue to be utterly dependent on the taxpayers’ credit card for their entire existence. Every penny of their income depends on the credit support of the taxpayers.

Since 2008, Fannie and Freddie have been a $5 trillion risk turkey, roosting in the dome of the Capitol. The members of Congress are unhappy and greatly irritated by its presence, but didn’t know how to get rid of this embarrassment their predecessors created.

Of course, even before their humiliating government conservatorship, Fannie and Freddie traded every minute on the credit of the U.S. Treasury and were always were a risk to the taxpayers. Although in those days they had some positive capital of their own, it was not very much capital relative to their risks. Without their free use of the taxpayers’ credit card, they would have been much smaller, much less leveraged, much less profitable and much less risky.

Once the Congress had set up Fannie and Freddie as government-sponsored risk takers, was there any way to remove the taxpayers’ risk exposure? The historical record offers little hope. No matter what any Treasury secretary or any other politician says, or even what any legislation provides, the global debt markets will simply not believe that two institutions representing half of all U.S. mortgage credit and sponsored by the U.S. government will not be bailed out by the Treasury. And the debt markets will be right.

In 1992, while revising the legislation that governs Fannie and Freddie, Congress solemnly tried to wiggle out of the problem. It added to the statutes of the United States a provision entitled, “Protection of Taxpayers Against Liability” for Fannie and Freddie’s debts. This “protection” is still on the books, although it did not provide any protection to the taxpayers.

Title XIII, “Government-Sponsored Enterprises,” of the Housing and Community Development Act of 1992, Section 1304, pronounced:

This title may not be construed as obligating the Federal Government, either directly or indirectly, to provide any funds to the Federal Home Loan Mortgage Corporation [Freddie], the Federal National Mortgage Association [Fannie], or the Federal Home Loan Banks, or to honor, reimburse or otherwise guarantee any obligation…

But naturally, when push came to shove in the housing-finance crisis, the federal government, directly and indirectly, did fully honor, entirely reimburse and effectively guarantee all the obligations of Fannie and Freddie anyway.

The statute went on to say:

This title may not be construed as implying that any such enterprise or bank, or any obligations or securities of such enterprise or bank, are backed by the full faith and credit of the United States.

Nice try, but no cigar. All the bond markets in the world knew that this fine language notwithstanding, all Fannie and Freddie’s obligations were in fact backed by the credit of the United States, as they still are and will continue to be.

What do you suppose the members of Congress who wrote and voted for those provisions were really thinking? Did they foolishly imagine that Fannie and Freddie could never actually get in financial trouble? Were they simply cynical, knowing that their provisions would not in fact protect the taxpayers? Or did at least some members of Congress truly believe they were doing something meaningful? One wonders.

The “protection of taxpayers” included in the 1992 act obviously failed. Can Congress avoid taxpayer risk from Fannie and Freddie next time? It seems unlikely in the extreme. But you might take a number of steps to reduce the inevitable taxpayer risk, including much higher capital requirements for Fannie and Freddie than heretofore, and charging a meaningful fee for the use of the taxpayers’ credit card, which will cause them to use it less.

There is one additional key lesson: government-sponsored enterprises, if they are created, should never, never be given perpetual charters like those given to Fannie and Freddie. If they were instead given limited life charters, say for 20 years (like First and Second Banks of the United States), Congress could at least periodically consider whether it would like to end the taxpayer risk game by not renewing the charter.

Treasury should not bail out Fannie and Freddie’s subordinated debt

Published in Economics 21.

When the U.S. Treasury bailed out Fannie Mae and Freddie Mac in 2008, holders of $13.5 billion in Fannie’s and Freddie’s subordinated debt—debt paid off after senior debt is repaid—were completely protected. Instead of experiencing losses to which subordinated lenders can be exposed when the borrower fails, they got every penny of scheduled payments on time.

The structural reasons for the unusual occurrence should be carefully examined by the Treasury to avoid its repetition.

This outcome was the exact opposite of the academic theories that had for years pushed subordinated debt as the way to create market discipline for financial firms that benefit from government guarantees on their senior obligations. In the event, Fannie’s and Freddie’s subordinated debt produced, and its holders experienced, zero market discipline. So much for the academic theories, at least as applied to government-sponsored enterprises.

“Perhaps surprisingly,” a Federal Reserve 2015 post-mortem study of the bailout says, “the two firms maintained their payments on the relatively small amount of subordinated debt they had.”

In terms of the theory that subordinated debt will be fully at risk, this is very surprising. As economist Douglas Elmendorf, former director of the Congressional Budget Office, wrote in criticism of this bailout detail, “The crucial role of subordinated debt for any company is to create a group of investors who know they will lose if the company fails.” But the Fannie and Freddie bailout was structured so that it didn’t happen.

The $13.5 billion is certainly a material number. While small relative to Fannie’s and Freddie’s immense liabilities, it was a significant part of their overall capital structure. In June 2008, Fannie and Freddie combined reported common equity of $18.3 billion and preferred stock of $35.8 billion, giving them, with the subordinated debt, total capital of $67.6 billion. The subordinated debt was thus 20 percent of reported total capital at that point, but it did not carry out its function as capital.

“In fact, subordinated debt is part of regulatory capital since the Basel I Accord (1988) and was always meant to absorb losses,” says a 2016 study for the European Parliament. Fannie and Freddie were not subject to the Basel Accord, but this nicely states the general theory.

“Market discipline is best provided by subordinated creditors,” wrote banking expert Paul Horvitz in 1983. A Federal Reserve study group produced the report “Using subordinated debt as an instrument of market discipline” in 1999. In 2000, Fed economists considered “a number of regulatory reform proposals aimed at capturing the benefits of subordinated debt” and concluded that it would indeed provide market discipline. “Ways to enhance market discipline… focused in large part on subordinated debt,” as a study by Fannie and Freddie’s regulator observed. Consistent with these theories, in October 2000, Fannie and Freddie committed to begin issuing publicly traded subordinated debt, and did. But bailout practice turned out to be inconsistent with the theory.

The Treasury knew precisely what it was doing for the subordinated debt holders. “These agreements support market stability,” said then-Treasury Secretary Henry Paulson’s Sept. 7, 2008 statement about the bailout, “by providing additional security and clarity to GSE debt holders—senior and subordinated—and support mortgage availability by providing additional confidence to investors…etc.” Treasury slipped that “and subordinated” in there in the middle of the paragraph, without any further comment or explanation.

“Under the terms of the agreement,” Paulson continued, “common and preferred shareholders bear losses ahead of the new government senior preferred shares.” But the government’s new senior preferred shares would by definition bear losses ahead of the subordinated debt. Why have the taxpayers be junior to the subordinated debt?

It appears that the Treasury was trapped as an unintended result of the Fannie and Freddie reform legislation of earlier in that bailout year, the Housing and Economic Recovery Act of 2008. A major battle in the creation of that act was to include the potential for receivership for Fannie and Freddie in the event of their failure—so, in theory, the creditors would have to consider the possibility of loss. Overachieving, Congress in HERA Section 1145 made receivership not just possible, but mandatory, in the event that Fannie and Freddie’s liabilities exceeded their assets and the regulator confessed it.

But in the midst of the financial crisis, the last thing Treasury wanted was a receivership, because the last thing they it wanted was to panic the creditors around the world by the prospect that they would be taking losses on Fannie’s and Freddie’s trillions of dollars of senior debt and MBS. Instead, they wanted to convince these creditors that there would be no losses. Treasury theoretically could have arranged to guarantee all the senior debt and MBS formally, but that would have forced the U.S. government to admit on its official books that it had an additional $5 trillion of debt. That would have been honest bookkeeping, but was an obvious nonstarter politically.

Once having decided against receivership, Treasury had to put the taxpayers’ money in as equity. Officials calculated that if Fannie and Freddie’s net worth were zero, their liabilities would not exceed their assets, so kept putting in enough new equity to bring the equity capital to zero. But once they had done that, there was no way to give the subordinated debt a haircut.

“We have been directed by FHFA to continue paying principal and interest on our outstanding subordinated debt,” Fannie reported. The covenants of the subordinated debt provided that if it were not being paid currently, no dividends could be paid by Fannie and Freddie—that would have included dividends on the Treasury’s senior preferred stock.

One reform idea, the mandatory receivership, had knocked out the previous reform idea that subordinated debt must take losses, and neither happened.

So financial theory notwithstanding, Fannie and Freddie’s subordinated debt achieved nothing. Its holders got a premium yield but were fully protected by the U.S. Treasury. The purchasers had made a very good bet on the financial behavior of governments when confronted with the failings of government-sponsored enterprises.

The 10th year since the bailout of Fannie and Freddie, and of their subordinated debt, will begin in September. Will Treasury now begin to address the structural issues?

Fannie and Freddie face the moment of truth on their taxpayer bailouts

Published in The Hill.

Almost nine years ago, in September 2008, Fannie Mae and Freddie Mac were broke and put into government conservatorship by the Federal Housing Finance Agency. Less than two months before, the regulator had pronounced them “adequately capitalized.” As everybody knows, the U.S. Treasury arranged to bail them out with a ton of taxpayer money, ultimately totaling $187.5 billion, in order to get their net worth up to zero.

The original form of the bailout was senior preferred stock with a 10 percent dividend. By agreement between two parts of the government, the FHFA as conservator and the Treasury, the dividend was changed starting in 2013 from the original 10 percent to essentially 100 percent of the net profit of the two companies, whatever that turned out to be, in this notorious “profit sweep.”

By now, under the revised formula, Fannie and Freddie have paid in dividends to the Treasury $276 billion in total. That sounds like a lot more than $187.5 billion, a point endlessly repeated by the speculators in Fannie and Freddie’s still-existing common and junior preferred stock. Does this mean that Fannie and Freddie have economically, if not legally, paid off the Treasury’s investment? Nope. Not yet. But almost.

Let us suppose—which I believe to be the case—that the original 10 percent is a reasonable rate of return on the preferred stock for the taxpayers, who in addition got warrants for 79.9 percent of Fannie and Freddie’s common stock with an exercise price that rounds to zero. The 10 percent compares to the interest rate of 2 percent or so on 10-year Treasury notes and is greater than the average return on equity of 8 percent to 9 percent for banks in recent years.

The question is: When would all the payments by Fannie and Freddie to the Treasury constitute first a 10 percent annual yield on the preferred stock and then have been sufficient to retire all its par value with the cash that was left over?

This is easy to calculate. We lay out all the cash flows, all the investment that went into Fannie and Freddie from the Treasury, and all the dividends they paid to the Treasury, and calculate the cash-on-cash internal rate of return. When the internal rate of return gets to 10 percent, the economic payoff will have been achieved. I call this the “10 percent moment.”

As of the second quarter of 2017, the internal rate of return is 9.68 percent, so the 10 percent moment is close. If Fannie and Freddie pay the third quarter dividends they have projected, on a combined basis, the 10 percent moment will arrive in the third quarter of this year. The internal rate of return will have reached 10.02 percent.

However, viewing Fannie and Freddie separately, it is slightly more complex. Fannie is at 9.36 percent and should get to 10 percent by the fourth quarter of this year. Freddie has already made it, with an internal rate of return of 10.11 percent as of the second quarter of 2017.

At the 10 percent moment, let’s say the end of 2017, the Treasury could very reasonably and fairly consider its senior preferred stock as fully retired and agree to amend the agreements accordingly. Treasury should then also exercise all its warrants, to assure its 79.9 percent ownership of any future retained earnings and of whatever value the common stock may develop, guaranteeing the taxpayers the equity upside which was part of the original deal, and also assuring its voting control.

At that point, should it develop, the capital of Fannie and Freddie would still be zero. In this woefully undercapitalized state, they would still be regulated accordingly, and still be utterly dependent on the Treasury. They should begin immediately to pay a fee to the Treasury for its effective guaranty of their obligations. This fee should be charged on their total liabilities and be equivalent to what the Federal Deposit Insurance Corp. would charge a large bank with their level of capital for deposit insurance — for starters, a bank with zero capital.

There are a few other requirements for this new deal for Fannie and Freddie. They should immediately be designated as the large and “systemically important financial institutions” they so obviously are by the Financial Stability Oversight Board. The massive systemic risk they represent should be supervised by the Federal Reserve, and their minimum capital requirement should be set at a 5 percent leverage capital ratio.

They must immediately start complying with the law that sets their guarantee fees at the level which a private financial institution would have to charge to cover its cost of capital. This requirement for guarantee fees is clearly established in the Temporary Payroll Tax Cut Continuation Act of 2011. Finally, they should pay the relevant state and local corporate income taxes, like everybody else.

Under these conditions, with the profit sweep and the senior preferred stock gone, but also with most of their economic rents and special government favors removed, Fannie and Freddie would have a reasonable chance to see if they could become successful competitors. They would still be too big to fail, of course, but they would be paying a fair price for the privilege.

The Fed: Can the world’s biggest S&L get back to normal?

Published in the Library Of Law And Liberty

The balance sheet of today’s Federal Reserve makes it the largest 1980s-model savings and loan in the world, with a giant portfolio of long-term, fixed-rate mortgage securities combined with floating-rate deposits. This would certainly have astonished the legislative fathers of the Federal Reserve Act, like congressman and later Sen. Carter Glass, who strongly held that the Fed should primarily be about discounting short-term commercial notes.

It would equally have amazed the Fed’s past leaders, like its longest-serving chairman, William McChesney Martin, who presided over the Fed under five U.S. Presidents, from 1951 to 1969.  Martin thought the Fed should confine its open-market activities to short-term Treasury bills and instituted the “bills only doctrine” in 1953. He would have been most surprised and we can imagine displeased at the amount of Treasury bills now included in the Fed’s bloated $4.5 trillion of assets.  As of June 7, 2017, the Treasury bills held by the Fed are exactly zero. This is as radical on one end of the maturity spectrum as the long-term mortgages are on the other.

As part of its so-called “quantitative easing” program—a more respectable-sounding name for buying lots of bonds—the Fed reports its mortgage securities portfolio as $1.77 trillion as of June 7.  Its investment is actually somewhat larger than that, since the Fed separately reports $152 billion of unamortized premiums net of discounts it has paid. If we guess half of those premiums are attributable to the MBS, the total becomes $1.85 trillion. The Fed owns 18 percent of all the first mortgages in the country, which total $10 trillion. It owns nearly 30 percent of all the Fannie Mae, Freddie Mac and Ginnie Mae MBS that are outstanding. It is big, a market-moving position, and that was indeed the idea: to move the market for MBS up, mortgage interest rates down and house prices up.

The Fed has in its portfolio $2.46 trillion of long-term Treasury notes and bonds. Adding in the other half of the unamortized premiums brings its investment to $2.54 trillion. The Fed owns 24 percent of all the Treasury notes and bonds that are in the hands of the public. Again, a remarkably large, market-moving position.

The Fed’s problem is now simple and obvious: once you have gotten into positions so big relative to the market and moved the market up, how do you get out without sending the market down?  The Fed is expending a lot of rhetorical energy on this problem.

As Federal Reserve chairman half a century ago, Martin was rightly skeptical of the advice of academic economists, but the control of the Fed is now dominated by academic economists. The former gold standard, whose last vestige disappeared when the United States reneged on its Bretton Woods commitments in 1971, has been replaced by what James Grant aptly calls “the Ph.D. standard.”

The Ph.D. standard is accompanied by the strident insistence that the Fed must be entirely and unconstitutionally independent, so that it can carry out whatever monetary experiments the debatable theories of its committee of economists lead to. Since 2008, nine years ago, these theories have concluded that the Fed should create “wealth effects,” which means manipulating upward the prices of houses, bonds and equities by buying a lot of long-term securities. In promoting asset-price inflation, the Fed, in company with the other major central banks, has greatly succeeded. Is that good?

It is one thing to try this in the midst of a crisis and a deep recession. But the last recession ended in mid-2009, eight years ago. The stock market has been rising for eight years, since the first quarter of 2009, passed its 2007 high in 2013 and has been dramatically booming since. House prices bottomed in 2012, have been rising much faster than incomes for five years and are, amazingly, back over their 2006 bubble peak.

So why is the Fed still buying long-term mortgages and bonds? It is definitely still a big bid in both markets, because it is continuing to buy in order to replace all the maturities and prepayments in its huge portfolio. Why doesn’t it just stop buying, instead of endlessly talking about the possibility of stopping, eight years after the end of crisis? Well, the Fed’s leaders want to manage your expectations, so you won’t think it’s a big deal–they hope–when it finally does really stop buying.

That time has still not come, the Fed just announced June 14. Perhaps later this year, although even this timing was hedged, it expects to allow a slight bit of runoff—but not now! The Fed would then still be buying, but a little less.  This “very gradual and predictable plan” would start with reducing securities purchases by $10 billion a month. Annualizing that rate, in a year, the portfolio would go from $4.4 trillion to $4.3 trillion.

The Fed will continue its status as the world’s biggest S&L.

The major central banks form a tight fraternity. They have all been engaged in long-term securities-buying programs, the ultimate effects of which are subject to high uncertainty. Predictable human behavior, when subject to high uncertainty, is to herd together, to have the comfort of having the colleagues you respect all doing the same thing you are doing. This includes all thinking the same way and making the same arguments, that is, cognitive herding. Central banks are clearly not exempt from this basic human trait.

To paraphrase a famous line of John Maynard Keynes, “a prudent banker is one who goes broke when everybody else goes broke.” A central banking variation might be, “a prudent central banker is one who makes mistakes when everybody else is making the same mistakes.” Will this turn out to be the case with the matching “quantitative easing” purchases they did together?

Here are the long-term securities portfolios of the elite of the central bank fraternity:

The European Central Bank has a slightly bigger bond portfolio than even the Fed does, but one significantly larger relative to the size of the economy. All these “quantitative easing” programs are definitely huge relative to the respective GDPs, the champion being the Swiss central bank with the remarkable size of 149 percent of gross domestic product. For better or worse, they are all in it together.

As a result of this massive central bank intervention, it is reasonably argued that there are no real market prices for bonds now—only central bank-manipulated prices. “Yields are too low in the U.S.,” as Abby Joseph Cohen of Goldman Sachs recently told Barron’s, and “there is no major economy with yields where they should be.”

What would happen to the Fed’s savings and loan-style balance sheet if interest rates did go back to normal?  We know what happened to the savings and loan industry when interest rates went sharply up: they became insolvent. Could that happen to the Federal Reserve? Indeed. Let’s do the simple bond math.

What is the average duration of all the Fed’s long-term mortgages and bonds?  A reasonable guess might be five years–if anything, this guess is easy on the Fed, and the duration of its mortgages will extend if rates rise. But let’s say five years. That means if long-term interest rates would rise by only 1 percent–not much—the market value of the Fed’s portfolio will fall by 1 percent x 5 = 5 percent.  A 5 percent market loss on $4.4 trillion is $220 billion. Let’s compare that to the Federal Reserve System’s total capital, which is $40.8 billion. The Fed’s loss of market value on a 1 percent rise in long-term interest rates would be more than five times its capital.

Of course, interest rates might go up by more. A 2 percent rise would mean a market value loss of $440 billion, or more than 10 times the Fed’s capital. No wonder the Fed adamantly refuses to mark its securities portfolio to market!

Most economists confidently assert that no one would care at all if a fiat currency issuing central bank like the Fed became deeply insolvent on a mark-to-market basis. They may well be right. But in that case, why hide the reality of the market values?

The Swiss National Bank is required by its governing law to mark its securities portfolio to market and reflect that in its published financial statements.  Why does the Federal Reserve lag behind the Swiss in disclosure and financial transparency?

Glass-Steagall never saved our financial system, so why revive it?

Published in The Hill.

The Banking Act of 1933 was passed in an environment of crisis. In March of that year, all of the nation’s financial institutions were closed in the so-called “bank holiday,” which followed widespread bank runs over the prior months.

Sen. Carter Glass, D-Va., a chief author of the bill and senior member of the Committee on Banking and Currency, was determined not to “let a good crisis go to waste.” Though he did not like the proposals from Chairman Henry Steagall, D-Ala., for federal deposit insurance, he agreed to support it on the condition that the legislation include Glass’ own pet idea that commercial banking be separated from much of the securities business.

It was poor policy from the start, but it took more than six decades to get rid of it. Now some political voices want to revive it. Financial ideas — like financial markets — have a cycle. Reviving Glass-Steagall would be an action with substantial costs, but no benefits. Its primary appeal seems to be as a political slogan.

Not having Glass-Steagall had nothing to do with the housing bubble or the resulting financial crisis of 2007 to 2009, except that being able to sell failing investment banks to big commercial banks was a major advantage for the regulators. And not having the law, in fact, had nothing to do with the crises of Glass’ own time, including the banking panic of 1932 to 1933 and the Great Depression.

Meanwhile, having Glass-Steagall in force did not prevent the huge, multiple financial busts of 1982 to 1992, which caused more than 2,800 U.S. financial institution failures, or the series of international financial crises of the 1990s.

While Glass-Steagall was in place, it required commercial banks to act, under Federal Reserve direction, as “the Fed’s assistant lenders of last resort,” whenever the Fed wanted to support floundering securities firms. This happened in the 1970 collapse of the commercial paper market, which followed the bankruptcy of the giant Penn Central Railroad, and in the “Black Monday” collapse of the stock market in 1987.

The fundamental problem of banking is always, in the memorable phrase of great banking theorist Walter Bagehot, “smallness of capital.” Or, to put the same concept in other words, the problem is “bigness of leverage.” So-called “traditional” commercial banking is, in fact, a very risky business, because making loans on a highly leveraged basis is very risky, especially real estate loans. All of financial history is witness to this.

Moreover, making investments in securities — that is, buying securities, as opposed to being in the securities business — has always been a part of traditional commercial banking. Indeed, it needs to be, for a highly leveraged balance sheet with all loans and no securities would be extremely risky and entirely unacceptable to any prudent banker or regulator.

You can make bad loans and you can buy bad investments, as many subprime mortgage-backed securities turned out to be. As a traditional commercial bank, you could make bad investments in the preferred stock of Fannie Mae and Freddie Mac, which created large losses for numerous banks and sank some of them.

Our neighbors to the north in Canada have a banking system that is generally viewed as one of the most stable, if not the most stable, in the world. The Canadian banking system certainly has a far better historical record than does that of the United States.

There is no Glass-Steagall in Canada: all the large Canadian banks combine commercial banking and investment banking, as well as other financial businesses, and the Canadian banking system has done very well. Canada thus represents a great counterexample for Glass-Steagall enthusiasts to ponder.

In Canada, there is now a serious question of a housing bubble. If this does give the Canadian banks problems, it will be entirely because of their “traditional” banking business of making mortgage loans — the vast majority of mortgages in Canada are kept on banks’ own balance sheets. If the bubble bursts, they will be glad of the diversification provided by their investment banking operations.

To really make banks safer, far more pertinent than reinstating Glass-Steagall, would be to limit real estate lending. Real estate credit flowing into real estate speculation is the biggest cause of most banking disasters and financial crises. Those longing to bring back their grandfather’s Glass-Steagall should contemplate instead the original National Banking Act, which prohibited real estate loans altogether for “traditional” banking.

Among his other ideas, Glass was a strong proponent of the “real bills” doctrine, which held that commercial banks should focus on short-term, self-liquidating loans to finance commercial trade. His views were reflected in the Federal Reserve Act, which, as Allan Meltzer has described it, had “injunctions against the use of credit for speculation” and an “emphasis on discounting real bills.” This approach which does not leave a lot of room for real estate lending.

If today’s lawmakers want to be true to Sen. Glass, they could more strictly limit the risks real estate loans create, especially in a boom, and logically call that “a 21st century Glass-Steagall.”

Detroit and Puerto Rico: Which is the worse insolvency?

Published in Real Clear Markets.

Over four decades beginning in the 1970s, the U.S. financial system had one big municipal debt crisis per decade.  These were New York City in the 1970s, the Washington Public Power Supply System (“Whoops!”) in the 1980s, Orange County, California in the 1990s, and Jefferson County, Alabama in the 2000s.

But our current decade, not yet over, has already set two consecutive all-time records for the largest municipal insolvencies in history: first the City of Detroit, which entered bankruptcy in 2013, and then Puerto Rico, which is now in an equivalent of bankruptcy especially created for it by Congress (under Title III of the PROMESA Act of 2016).

Between bonds, unfunded pensions, and other claims, Detroit’s record-setting debt upon bankruptcy was $18.8 billion.  Puerto Rico has far surpassed that.  Its comparable debt is $122 billion, or 6.5 times that of Detroit, with $74 billion in bonds and $48 billion in unfunded pensions.

On the other hand, Puerto Rico is five times bigger than Detroit, with a population of 3.4 million, compared to 687,000.  We need to look at the problems on a per capita basis.

The result is not optimistic for the creditors of Puerto Rico.  As shown below, Puerto Rico’s debt per capita is much bigger—33% higher– than Detroit’s was in 2013: about $35,800 versus $26,900.

Total debt      Population   Debt per capita

Puerto Rico         $122 billion       3,411,000           $35,800

Detroit                $ 18.8 billion        687,000           $27,400

On top of more debt, Puerto Rico has much less income per capita—23% less—than Detroit did.  So as it arrives in court for a reorganization of its debts, its ratio of debt per capita to income per capita is 3.1 times, compared to 1.8 times for Detroit.  As shown below, this is 70% greater relative debt—or alternately stated, Puerto Rico’s per capita income to debt ratio is only 59% of Detroit’s.

Puerto Rico          Detroit           PR/ Detroit      Detroit/ PR

Total debt per capita                   $35,800              $27,400              131%                   77%

Income per capita                       $11,400              $14,900              77%                     131%

Per capita debt / income             3.14x                   1.84x                  170%                   59%

Puerto Rico’s unemployment rate is very high at over 12%.  This not as huge as Detroit’s 22%, but Puerto Rico’s abysmal labor participation rate of 40%, compared to Detroit’s already low 53%, offsets this difference.  This leaves Puerto Rico with proportionally even fewer earners with lower incomes to pay the taxes to pay the much higher debt.

On a macro basis, then, it appears that the creditors of Puerto Rico can expect to do even more poorly than those of Detroit.  How poorly was that?

At its exit from a year and a half of bankruptcy, Detroit’s total debt had been reduced to $10.1 billion.  Overall, this was 53 cents on the dollar, or a loss of 47% from face value, on average.  However, various classes of creditors came out very differently.  Owners of revenue bonds on self-supporting essential services came out whole on their $6.4 billion in debt.  If we exclude this $6.4 billion, leaving $12.4 billion in claims by everybody else, the others all together got $3.7 billion, or a recovery of 30 cents on the dollar, or a loss of 70%, on average.

Recoveries in this group ranged from 82 cents on the dollar for public employee pensions, to 74 cents for the most senior general obligation bonds, to 44 cents on more junior bonds, to 25 cents for settling swap liabilities, to 13 cents on certificates of participation, to 10 cents on non-pension post-retirement benefits and other liabilities.  It is noteworthy that the public employee pensions did take a meaningful haircut, although they came out far better than most others.  The pension settlement also included special funds contributed by the State of Michigan and special funds contributed by charitable foundations to protect the art collection of the Detroit Institute of Arts.  These latter factors will not be present in the Puerto Rico settlement.

As a macro estimate, if we take as a baseline Detroit’s average settlement of 53 cents on the dollar and multiply it by Puerto Rico’s 59% of Detroit’s ratio of per capita income to debt, we get a guess of 31 cents on average for all the creditors.  This is not extremely different from the official fiscal plan approved by the Puerto Rico Oversight Board, which estimates cash available for debt service of about 24% of the contractual debt service over the next ten years.

What will happen in the debt reorganization bargains, what role pension debt will play, how various classes of creditors will fare with respect to each other, what political actions there may be—all is up in the air as the court begins its work.

The lenders and borrowers responsible for the huge financial mistakes which led to deep insolvency need to seriously think through, as in every debt disaster, “How did we get ourselves into this mess?!”  They are a long way from getting out of it.

The Fed must be held accountable and the CHOICE Act will make it so

Published in The Hill.

This week, the House Financial Services Committee passed Chairman Jeb Hensarling’s Financial CHOICE Act. Most of the public discussion of this bill is about its changes in banking regulations, but from a constitutional point of view, even more important are the sections that deal with the accountability of regulatory agencies and the governance of the administrative state.

Accountability is a central concept in every part of the government. To whom are regulatory agencies accountable? Who is or should be their boss? To whom is the Federal Reserve, a special kind of agency, accountable? Who is or should be its boss? To whom should the Consumer Financial Protection Bureau (CFPB) be accountable? Who should be its boss?

The correct answer to these questions, and the answer given by the CHOICE Act, is the Congress. Upon reflection, we should all agree on that. All these agencies of government, populated by unelected employees with their own ideologies, agendas, and will to power — as vividly demonstrated by the CFPB — must be accountable to the elected representatives of the people, who created them, can dissolve them, and have to govern them in the meantime. All have to be part of the separation of powers and the system of checks and balances that is at the heart of our constitutional order.

But accountability does not happen automatically: Congress has to assert itself to carry out its own duty for governance of the many agencies it has created and its obligation to ensure that checks and balances actually operate.

The theme of the Dodd-Frank Act was the opposite: to expand and set loose regulatory bureaucracy in every way its drafters could think of. It should be called the Faith in Bureaucracy Act.

In the CHOICE Act, Congress is asserting itself at last to clarify that regulatory agencies are derivative bodies accountable to the Congress, that they cannot be sovereign fiefdoms — not even the Dictatorship of the CFPB, and not even the money-printing activities of the Federal Reserve.

The most classic and still most important power of the legislature is the power of the purse. The CHOICE Act accordingly puts all the regulatory agencies, including the regulatory part of the Federal Reserve, under the democratic discipline of Congressional appropriations.

This notably would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB — which was designed precisely to evade the democratic power of the purse. It is sometimes objected that appropriations “inject politics” into these decisions. Well, of course! Democracy is political. Expansions of regulatory power are political, all pretense of technocracy notwithstanding.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. It provides that actions whose costs exceed their benefits should not be undertaken without special justification. That’s pretty logical and hard to argue with. Naturally, assessing the future costs and benefits of any action is subject to uncertainties — perhaps very large uncertainties. But this is no reason to avoid the analysis — indeed, forthrightly confronting the uncertainties is essential.

The CHOICE Act also requires an analysis after five years of how regulations actually turned out in terms of costs and benefits. This would reasonably lead — we should all hope it will — to scrapping the ones that didn’t work.

Further Congressional governance of regulatory agencies is provided by the requirement that Congress approve major regulatory rules — those having an economic effect of $100 million or more. Congress would further have the authority to disapprove minor rules if it chooses by joint resolution. This is a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

On the Federal Reserve in particular, the CHOICE Act devotes a title to “Fed Oversight Reform and Modernization,” which includes improving its accountability.

“Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to,” once succinctly testified a president of the New York Fed. Under the CHOICE Act, such reviews would happen at least quarterly.

In these reviews, I recommend that the Federal Reserve should in addition be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers.

The CHOICE Act requires of new regulatory rules that they provide “an assessment of how the burden imposed … will be distributed among market participants.” This good idea should by analogy be applied to burdens imposed on savers by monetary actions.

By my estimate, the Federal Reserve has taken since 2008 over $2 trillion from savers and given it to borrowers. The Federal Reserve may want to defend its sacrifice of the savers as a necessary evil — but it ought to openly and clearly quantify the effects and discuss the economic and social implications with the Congress.

In sum, the CHOICE Act represents major improvements in the accountability of government agencies to the Congress and ultimately to the people. These are very significant steps forward in the governance of the administrative state to bring it under better constitutional control.

Data transparency and multiple perspectives

Published in Data Coalition.

One question underlying the very interesting data project and proposed legislation we are considering today is the relationship of data transparency to multiple perspectives on financial reality. In a minute, we will take up the question: Of all the possible views of a statue, which is the true view?

But first, let me say what a pleasure it is to participate in these discussions of financial transparency; the new Financial Transparency Act, a bill introduced in Congress last night; data standardization; and of course, greater efficiency— we are all for making reporting and compliance less costly.

Let me add to this list the separation of data and analysis, or what we may call the multiplication of perspectives on the financial object. The potential separation of data and analysis may allow a richer and more varied analysis and deeper understanding, in addition to greater efficiency, in both government and business.

As the new white paper “Standard Business Reporting,” by the Data Foundation and PricewaterhouseCoopers, says: “By eliminating documents and PDFs from their intake, and replacing document-based reporting with open data…agencies…gained the ability to deploy analytics without any translation.” Further, that standardized data “will allow individuals to focus on analytics and spend time understanding the data.”

In historical contrast to these ideas, it is easy for me to remember when we couldn’t do anything like that. When I was a young international banking officer working in Germany, one day—4,000 miles to the west, back in the Chicago headquarters—the head of the international banking department had lunch with the chairman of the board. Picture the chairman’s elegant private dining room, with china, silver and obsequious service. In the course of the lunch, the chairman asked: “For our large customers, can we see in one place all the credit exposure we have to them in different places around the world?” Said the executive vice president of international banking: “Of course we can!”

The next day, all over the world, junior people like me were busy with yellow pads and calculators, wildly working to add up all the credit exposure grouped into corporate families, so those papers could be sent to somebody else to aggregate further until ultimately they all were added up for the chairman.

That was definitely not data independent of documents. Imagine the high probability, or rather the certainty, of error in all those manually prepared pages.

A classic problem in the philosophical theory of knowledge turns out to be highly relevant to the issues of data transparency. It is the difference between the real object, the “thing in itself,” and any particular representation or perspective on it. In philosophical terms, the object is different from any particular perspective on it, but we can only perceive it or think about it or analyze it from particular perspectives.

Likewise, a reporting document is a composite of the data—the thing—and some theory or perspective on the data which form the questions the report is designed to pursue and answer.

Let’s consider a famous type of report: GAAP financial statements.

Somewhere far underneath all the high-level abstractions, reflecting many accounting theories, are the debits and credits, myriad of them doing a complex dance.

I think of my old, practical-minded instructor in Accounting 101. This essential subject I studied in night school when I was a trainee in the bank. I would ride the Chicago “L” train to my class, my feet freezing from the cold draft blowing under the doors. But this lesson got burned into my mind: “If you don’t know what to debit and what to credit,” he said, “then you don’t understand the transaction from an accounting point of view.” This has always seemed to me exactly right.

Later on, in this spirit, I used to enjoy saying to accountants advising me on some accounting theory: “Just tell me what you are going to debit and what you are going to credit.” This usually surprised them!

I wonder how many of us here could even begin to pass my old accounting instructor’s test when considering, say, the consolidated financial statements of JPMorgan. What would you debit and credit to produce those?  Of course we don’t know.

For JPMorgan, and everybody else, the debits and credits are turned into financial statements by a very large set of elaborate theories and imposed perspectives. These are mandated by thousands of pages of Financial Accounting Standards pronounced by the Financial Accounting Standards Board. Many of these binding interpretations are highly debatable and subject to strongly held, inconsistent views among equally knowledgeable experts.

Any large regulatory report has the same character: it is a compound of data and theory.

An articulate recent letter to the editor of the Wall Street Journal argues that: “The CPA profession has made the accounting rules so convoluted that GAAP financials no longer tell you whether the company actually made money.” This, the letter continues, is “why companies are increasingly reporting non-GAAP. Investors are demanding this information. …Why should public companies not supply shareholders with the same metrics that the management uses?” Why not, indeed?

In other words, why not have multiple interpretative perspectives on the same data, instead of only one?  This is a fine example of the difference between one perspective—GAAP—and other possibly insightful perspectives on the same financial object. Why not have as many perspectives readily available as prove to be useful?

We are meeting today in Washington, D.C., a city full of equestrian statues of winning Civil War generals. (The losing side is naturally not represented.)  Think, for example, of the statues of General Grant or Sheridan or Sherman or Logan—all astride their steeds. Perhaps you can picture these heroic statues in imagination.

I like to ask people to consider this question:  What is the true view of a statue?  Is it the one from the front, the top, the side (which side?), or what?  Every view is a true view, but each is partial. Even the view of such an equestrian statue directly from behind—featuring the horse’s derriere—is one true view among others. It is not the most attractive one, perhaps, but it may make you think of some people you know.

Likewise, what is the true view of a company, a bank, a government agency, a regulated activity or a customer relationship?  Every document is one view.

Pondering this brings back a memory of my professor of 19th century German philosophy. “The object,” he proposed, “is the sum of all possible perspectives on it.”

Similarly, we may say that a financial structure or a policy problem or an entity or an activity is the sum of many perspectives on it. The ideal of open data available for multiple reports, analyses and purposes is a practical application of this metaphysical idea.

The ideal is not new. In 1975, I went to London to work on a project to define all the elements—what were supposed to become the standardized data—for characterizing all the bank’s corporate customer relationships. The computing technology expert leading the project convincingly explained how these data elements could then be combined and reordered into all the reports and analyses we would desire.

Then, as now, it was a great idea—but then it never actually happened. It was before its time in technical demands. But now I suspect the time has really come. Fortunately, since then, we have had four decades of Moore’s Law operating, so that our information capacities are more than astronomically expanded.

So:

• By freeing transparent, open data from being held captive in the dictated perspectives of thousands of reporting documents;

• By saving data from being lost in the muddle of mutually inconsistent documents;

• Can we provide transparent data, consistently defined, which will promote a wide variety of multiple perspectives to enrich our analysis and create new insights;

• Not to mention making the process a lot cheaper?

This would be a great outcome of the project under consideration in our discussions today.

FSOC is too political to be taken seriously

Published in American Banker.

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

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

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

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

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

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

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

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

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

U.S. banks’ real estate boom could be signaling next crisis

Published in Inside Sources.

Excessive real estate credit is the most common cause of banking booms, busts and collapses, throughout history, right up through the most recent financial crisis and around the world.

The U.S. commercial banking system has gotten much bigger relative to the U.S. economy than it used to be, although there are many fewer banks. The principal source of this growth is that banks have vastly increased their real estate exposure relative to the U.S. economy as a whole. This acceleration in real estate risk has fundamentally changed the nature of the banking system and its systemic risk.

Looking back to 1960, there were in the United States: 13,126 commercial banks and 18,962 depository institutions. By the end of 2016, depositories totaled only 5,913, of which 5,113 were commercial banks. That’s a 69 percent reduction in the number of depository institutions, and a 61 percent reduction in commercial banks.

On the other hand, in 1960, the total assets of the commercial banking system were only $256 billion. Though hard to believe, the entire banking system had total assets of only about one-tenth of today’s JPMorgan-Chase, and only 1.6 percent of today’s banking assets of $15.6 trillion. Citibank — which wasn’t Citibank then, but the dignified First National City Bank of New York — had less than $9 billion in assets. To our minds, now muddled by decades of constant inflation — including a central bank that has formally committed itself to creating perpetual inflation — these all seem like very small numbers.

Instead of measuring in nominal dollars, to see through the fog of long years of inflation, we can measure banking assets consistently relative to the size of the economy, as a percent of annual gross domestic product. The $256 billion of commercial banking assets in 1960 was 47 percent of the $541 billion in GDP.

The increase is striking: by 2016, banking assets had gone from 47 percent to 83 percent of GDP. That is more than a 75 percent increase in the banking system’s size relative to the economy, at the same time the number of banks fell by more than 60 percent. At present, this ratio is close to its all-time bubble peak.

What is driving this growth? It’s not commercial and industrial loans. On the trend, their percent of GDP is flat at 8 percent to 10 percent since 1960. On average, the commercial and industrial loans of the banking system have kept up with the growth of the economy, but not more.

The real driving factor is real estate credit. The commercial banking system’s real estate loans rose relentlessly from 5 percent of GDP in 1960, to more than 26 percent at their bubble peak, and are now at 22.5 percent.

Nor is this the whole real estate story. With the popularization of mortgage securitization, the banking system’s securities portfolio, not only its loan portfolio, shifted to real estate risk. Going back to 1992, the sum of banks’ real estate loans and mortgage-backed securities as a percent of GDP has risen to 32 percent — six times the 1960 level.

In short, the vast bulk of the dramatic increase in the size of the banking system relative to the economy comes from the acceleration of real estate exposure — a rising trend for more than six decades. How can the banks keep doing this? Well, it helps to have your liabilities guaranteed by the government, both explicitly through deposit insurance and implicitly through bailouts and central banking.

Should the banking system keep getting bigger relative to the economy, and should this increase continue overwhelmingly to reflect real estate risk? That is a dubious proposition. As Columbia University’s Charles Calomiris has written (in a not-yet-published paper): “The unprecedented pandemic of financial system collapses over the last four decades around the world is largely a story of real estate booms and busts. Real estate is central to systemic risk.”

Very true. But as Calomiris notes, the Financial Stability Oversight Board, set up as part of the Dodd-Frank Act to oversee the U.S. financial system, “seems to be uninterested.”

The Bank Holding Company Act of 1956 defined a bank as an institution that accepts demand deposits and makes commercial loans. Neither part of this old definition still touches on the main point. A bank now is for the most part an institution that makes real estate loans and funds them with government-guaranteed liabilities.

This banking evolution poses a huge systemic question: How do you deal with a banking system whose risks are concentrated in real estate prices and leverage? To this question we are, as yet, without an answer. Do the supposed systemic thinkers at the Financial Stability Oversight Council even understand the magnitude of the historic shift in risk? Maybe a future FSOC with new members will do better.