GDP per-worker vs. GDP per-capita

Published by the R Street Institute.

We have previously compared the growth in real per-capita gross domestic product between the United States and Japan and among the 10 largest advanced economies. Growth in GDP per-capita measures the increase in the average economic well-being in the country, and adjusts gross GDP growth for whether the population is increasing, stable or declining.

We now shift to comparisons of growth in GDP per-worker (more precisely, per employed person). This addresses productivity, rather than overall economic well-being, and adjusts for shifts in the composition of the population among those who are employed. Those are who not employed include, for example, children, full-time students, retired people, those unemployed and looking for work, those unemployed and not looking for work, and those (especially mothers) who do plenty of work in the home, but not as paid employees.

If the overall population is growing, it’s possible for GDP to grow while GDP per-capita does not. Similarly, if there is a shift within the population toward greater workforce participation, GDP per-capita might grow, while GDP per-worker does not. More generally, the growth rates of these measures of economic performance may be quite different.

Table 1 compares the striking slowdown in economic growth between the last half of the 20th century and the first 15 years of the 21st in the growth of real GDP, both per-capita and per-worker. However, the 21st century slowdown, while marked, is less extreme when measured per-worker (1.82 percent to 1.11 percent) than when measured per-capita (2.25 percent to 0.90 percent). In other words, the productivity slowdown is less than the overall economic welfare deceleration. This reflects demographic changes: from 1959 to 2000, the number of workers grew faster than the population as a whole. In the 21st century, it’s grown more slowly.

How does the United States compare to Japan, when measured in growth in real GDP per-worker?  Here our data makes us shift to 1960 to 2014, still a more than 50-year run. The relative growth performance of the two countries flips dramatically between the 20th and 21st centuries, although both are significantly slower, as shown in Table 2. Japan will continue to be an interesting case of a very technically advanced, but rapidly aging economy with falling employment and a falling population going forward.

Seemingly small differences in compound growth rates make for big differences if they continue over time. Table 3 shows the multiple of real GDP per-worker over 50 years in the actual second half of the 20th century, compared to a projection for 50 years of the 21st century if the century’s current trends continue. The result is a drop from an aggregate improvement of 2.5 times, to 1.7 times.

Can the growth in real GDP per-worker reaccelerate or not?  That is indeed the question.

Letter to Oversight Board of Puerto Rico

Published by the R Street Institute.

In response to your request for public comments on the draft Puerto Rico fiscal plan, I respectfully submit the following thoughts.

An old friend of mine who ran a publishing company was famous for returning manuscripts to hopeful authors with this note written at the top: “OK to revise.”  This is my summary view of the draft plan for three reasons:

1. The recent elections in both Puerto Rico and the United States resulted in changing both administrations. Presumably a new governor and new members of the U.S. Treasury Department will have different or additional positions to explore.

2. The draft plan entirely sidestepped the critical question of how to approach the debt restructuring obviously required.

3. The draft plan likewise sidestepped the essential questions about how to address the insolvent public-pension plans of Puerto Rico.

However, parts of the draft plan should, in my opinion, enter into final form and implementation as rapidly as practicable. These are the programs to improve budget controls, financial reporting, rationalization of expenditures, effectiveness of tax collections and, in general, all programs to promote stronger financial management and financial integrity.  It seem to me that these should be put into a separate plan document for individual and expedited consideration.

To these essential programs should, in my opinion, be added the creation of a chief financial officer for Puerto Rico, closely modeled on the very successful Office of the Chief Financial Officer of Washington, D.C., which was one of the key reforms under its Financial Control Board in the 1990s.

It would be a pleasure to provide any other information which might be useful.

Yours respectfully,

Alex J. Pollock

Growth in per-capita GDP: How does the United States rank?

Published by the R Street Institute.

Growth in gross domestic product after adjustment for inflation (real GDP) is the most frequently reported and discussed economic measure. More important, however, is how people on average are doing from an economic standpoint. This means measuring output per person, or real per-capita GDP, and its growth rate.

How does the United States rank among other countries on this growth measure?

In “Japan vs. the U.S. in Per Capita GDP,” we observed that, for the 15 completed years of the 21st century, there is not much difference between average growth in real per-capita GDP between the United States and Japan—the latter often described as suffering from economic stagnation.

Now we expand our comparison to the 10 largest advanced economies in the world. Here they are, ranked by the average growth rate in real per-capita GDP in this century so far:

Note that the United States and Japan are together right in the middle of the pack, fifth and sixth, respectively, bracketed by Canada and the Netherlands.  Three other countries achieved substantially higher real growth rates when measured per person, and three were substantially lower, including Italy, whose growth rate was negative. Among the 10 countries, the average growth rate was 0.73 percent per year, in between the United States and Japan.

The table also shows how much aggregate difference there is as the growth rate compounds for 15 years. At Australia’s leading 1.44 percent average growth rate, aggregate product per person increased by 24 percent in 15 years. The comparable number for the United States is 14 percent. France and Spain are half that at 7 percent and Italy is a 7 percent decrease.

The effects of differences in compound growth rates are always impressive if they continue over a long time.

We calculate what the aggregate increase in average economic well-being would be if the growth rate in real per-capita GDP could be sustained for a lifetime of 80 years. Australians would become, on average, three times better off during their lives; Canadians, Americans and Japanese about twice as well off.  Spaniards would be 40 percent better off. In the long view of the millennia of human history, this is very impressive.

Of course, if the growth rate in real per-capita GDP could be 2 percent, these numbers would be much more impressive yet. Then, in an 80-year lifetime, the average economic standard of living would quintuple.

Homeownership Rates: It depends on whether you are married

Published by the R Street Institute.

The attached piece originally appeared in the Autumn 2016 edition of Housing Finance International.

American political rhetoric endlessly repeats that homeownership is part of the “American Dream.” So it is for most people, especially if you are married, as we will see.

As part of promoting this “dream,” the U.S. government has for many years created large subsidies for mortgage borrowing and huge government-sponsored financial institutions to expand mortgage lending. Most notable among these are Fannie Mae and Freddie Mac, which notoriously went broke in 2008 while following the government’s orders to make more so-called “affordable” loans, and survived only thanks to a $189 billion taxpayer bailout.

Fannie and Freddie are still massive operations, featuring a combined $5 trillion in assets (that’s trillion with a “T”), equity capital that is basically zero and utter dependence on the credit of the U.S. Treasury.

Given these massive and extremely expensive efforts, how has the American homeownership rate fared? Let us look back 30 years to 1985, and compare it to 2015. Thus we can go past the housing bubble and collapse of the 2000s, as well as past the financial collapse of the savings and loans in the late 1980s, and observe what has happened over a generation.

Read the rest.

‘Fin’ versus ‘tech’ in fintech

Published by the R Street Institute.

Financial technology – or “fintech,” in the modern parlance – may be seen as trendy, but computing technology has strongly influenced banking and finance for decades. Its effects include the creation of general-use credit and debit cards, going back to the 1950s, which we now take for granted worldwide; ATMs available any time and almost anywhere, going back to the 1970s; and the data capabilities that make structured mortgage-backed securities possible, going back to the 1980s.

Visa and MasterCard are considered leading fintech companies, which they are. Former Federal Reserve Chairman Paul Volcker once cynically remarked that ATMs were the only real financial innovation of recent times. Meanwhile, MBS vividly display the double potential of innovation, first for growth and then for disaster.

Investment banker J. Christopher Flowers has expressed the view that the current fintech boom will “leave a trail of failed companies in its wake.” Of course it will, just like the hundreds of automobile companies that sprang up a century ago or the myriad dot-com companies that mushroomed in the 1990s. The automobile and the internet were both society-changing innovations and the hundreds of failures are how we discover which are the truly valuable ideas and which aren’t. To paraphrase Friedrich Hayek’s memorable essay, competition is a discovery procedure.

Over time we will find out which innovations are real and which are mere fads. A key distinction in fintech, as in the financial world in general, is between those changes that make transactions faster, cheaper, more mobile and less bothersome (the “tech”), on the one hand; and those that make it easier to make loans and take credit risk (the “fin”), on the other. The former are likely to yield some truly useful innovations; the latter, which require lending people money that you hope they will pay back on time and with interest, is an old and tricky art. It is much easier to fool yourself about whether you are actually improving lending, as compared to technology.

Consider the idea of “lending money over the internet.” The “internet” part may invent something faster, cheaper and easier—just like the ATMs Volcker touts. The “lending money” part may be simply a new name for making bad loans, just as the dark side of MBS turned out to be.

So on one hand, we may have real innovation and progress, and on the other, merely endless cyclical repetition of costly credit mistakes. For example, the fintech firms LendingClub and OnDeck Capital presently find their stock prices about 80 percent down from their highs of less than two years ago, as they learn painful lessons about the “fin” part of fintech.

Nor is this distinction new. As James Grant, the acerbic and colorful chronicler of the foibles of financial markets, wrote in 1992:

In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history.

So they did, and more than 2,800 U.S. financial institutions, their growing computer power notwithstanding, failed between 1982 and 1992.

Bankers in the 21st century – avidly using vastly greater technological prowess, supplied with reams of data, running complex computer models to measure and manage (or so they thought) their credit risks – made even more egregious mistakes. As we all know, they created an amazing credit bubble and came close to tanking the entire financial system. Did the technology help them or seduce them?

Mathematicians and physicists – the “rocket scientists,” as they were called – had brought their impressive computer skills to Wall Street to help apply technology to mortgage finance. In the memorable summary of George Mason University’s Tony Sanders, “The rocket scientists built a missile which landed on themselves.” The mistakes were in the “fin” part of this effort, not the “tech” part.

In every financially trendy boom, we hear a lot about “creative” new financial products. A painful example was the homeownership strategy announced with fanfare by the Clinton administration in the 1990s. It called for “creative” mortgages, which turned out to mean mortgages likely to default.

Such products, no matter how much innovative computer technology surrounds and helps deliver them, are not real financial innovations. They are merely new ways to lower credit standards, run up leverage and increase old risks by new names. They are thus illusory financial innovations. As also pointed out by James Grant, science is progressive, but credit is cyclical.

Real innovations turn ideas into institutions which endure over time, various mistakes notwithstanding, as credit cards, ATMs and MBS have. Illusory innovations cyclically blossom and disappear. Both produce uncertainty, and uncertainty means we cannot know the future, period. We will continue to be surprised, positively and negatively, by the effects of financial innovation.

In short, financial markets are always in transition to some new state, but only some of this is progress. The rest is merely cyclical repetition. What is fintech?  Doubtless, it is some of both.

Happy birthday, TARP!

Published by the R Street Institute.

Today, Oct. 3, is the eighth anniversary of congressional passage of the act that created the famous or notorious $700 billion bank bailout program in the midst of financial panic of late 2008. In case you have forgotten, TARP stood for the Troubled Asset Relief Program, and the authorizing legislation was the Emergency Economic Stabilization Act of 2008. An emergency it was, with one failure following fast on another.

Eight years on, when we know that the panic passed, when house prices are booming again, when the stock market is high and life has gone on, it’s hard to recreate psychologically the uncertainty and fear of that period. Memories naturally lose their vividness and then fade altogether, making the next cyclical bust more likely.

The design of TARP originally was to quell the crisis by having the U.S. Treasury buy depreciated mortgage-backed securities from banks, removing these “troubled assets” from private balance sheets and thus giving them “relief.” When this was proposed, it was already clear that it was not going to work. The crisis had created insolvencies, with deficit equity capital. By buying assets from banks so they realized big losses, you were not going to fix their capital. Neither would lending them more money from the Federal Reserve fix their capital:  if you are broke, no matter how much more you borrow, you are still broke.

By September 2008, the British government already had decided it had to make equity investments in insolvent banks. This replicated the U.S. experience of the 1930s, when the Reconstruction Finance Corp., originally set up to make loans to troubled banks, realized it had to make equity investments instead, in the form of preferred stock. It also replicated the experience of Japan in the 1990s. As TARP was being debated, it seemed to me that the equity investment model was better than the proposed TARP design, and so it proved to be. The RFC overall made a profit on its bank investments, and so, as it turned out, did TARP.

But what Treasury Secretary Henry Paulson had told Congress in getting the legislation passed was that they were approving a program for buying mortgage securities. However, as Paulson revealed in educational crisis memoir “On the Brink,” even as these arguments were being made:

Ben Bernanke had told me that he thought that solving the crisis would demand more than the illiquid asset purchases we had asked for. In his view, we would have to inject equity capital into financial institutions.

Bernanke was right about that, but Paulson thought “we would sabotage our efforts with Congress if we raised our hands midstream and said we might need to inject equity.” Well, you can’t tell the elected representatives of the people what is really going on. When the act did get passed and signed into law Oct. 3, says Paulson: “I made sure to tell…the team: ‘Figure out a way we can put equity in these companies.’” And so they did.

Shortly thereafter, Paulson reflects, “I began seriously to doubt that our asset-buying program could work. This pained me, as I had sincerely promoted the purchases to Congress and the public as the best solution” and “dropping the asset-buying plan would undermine our credibility.” Instead, TARP proceeded by making equity investments in preferred stock.

By now, the TARP investments in banks are almost entirely liquidated at a profit to the Treasury. The program went on to make losing investments in the bailouts of automobile companies (which equally were bailouts of the United Automobile Workers union) and to spend money not authorized by statute on programs for defaulted mortgages. All in all, Oct. 3 launched a most eventful history.

“I had expected [TARP] to be politically unpopular, but the intensity of the backlash astonished me,” wrote Paulson.

Its birthday is a good time to reflect on TARP and try to decide what you would have done in Secretary Paulson’s place, had you been handed that overwhelming responsibility.

Economic reform for Puerto Rico

Published by the R Street Institute.

The attached letter was submitted to the Bipartisan Congressional Task Force on Economic Growth in Puerto Rico.

Among the most fundamental of Puerto Rico’s many economic problems is that it is “stuck in a monetary union with the United States” (as Desmond Lachman of the American Enterprise Institute has correctly characterized it).  In this situation of being forced to use the U.S. dollar, the Puerto Rican economy is simply uncompetitive, but the use of exchange rate policies to improve competitiveness or cushion budget tightening’s impact on domestic demand is precluded.

This is the same massive problem that Greece had and still has from being stuck in the monetary union of the euro.  With any external currency adjustment forbidden, all the adjustment falls on internal reduction of costs.  As Greece demonstrates, this continues to be very difficult and daunting, both economically and politically.  This is true even after its creditors have taken huge haircuts. Puerto Rico’s creditors will take big haircuts, too, but that won’t solve its ongoing lack of competitiveness or the impact of the required budget tightening.

The European Union leadership feared that Greece’s exit from the euro might set off the unraveling of their whole common currency project.  In contrast, there is not the slightest possibility that whatever happens in Puerto Rico will affect the stability or dominant role of the U.S. dollar.  Even in the Greek case, European policy makers did seriously consider a back-up plan for a paper currency to be issued by Greek banks which would certainly have depreciated against the euro.

Dr. Lachman argues that Puerto Rico “needs the boldest of economic programs.”  My suggestion is that the Task Force should consider “thinking about the unthinkable,” and include in its work a study of the “outside the box” possibility of currency reform for Puerto Rico. This would involve creating a new Puerto Rican currency which would be considerably devalued with respect to the U.S. dollar, thus allowing external, not only wrenching internal, adjustment of Puerto Rico’s uncompetitive cost structures. There is plenty of precedent for such currency reform, although this case is certainly complicated by the status of Puerto Rico as a territory.  Could a U.S. territory have its own currency?  Why not?

In such a study, one would have to consider the balance sheets of all the Puerto Rican depositories and how they would be affected in detail by denomination in a new currency, how various contracts would be affected, how exchange between the new currency and other currencies would be introduced, whether a new Puerto Rican central bank would be established, and many other problems of transition and functioning, of course.  Existing Puerto Rican government debt in U.S. dollars would not be subject to redenomination, but this debt, a growing amount of it in default, is going to have to be significantly written down in any case.

Does the current monetary union pose deep problems for Puerto Rico?  Undoubtedly.  Would it make sense to release Puerto Rico from being stuck in a monetary union in which it cannot compete?  Possibly.  Would this be better than the Greek model of forcing internal cost deflation while providing big external subsidies?  Probably.   It does seem sensible to take a serious look at the possibility of currency reform.

Thank you for the chance to comment on this critical issue.  It would be a pleasure to provide any further information which might be helpful.

Japan versus the United States in per-capita GDP

Published by the R Street Institute.

We often see and hear in the media about the “stagnation” of economic growth in Japan. Let’s look at the numbers and see how Japan has done compared to the United States in the 15 years of the 21st century so far.

If we measure by growth in real gross domestic product (GDP), without considering changes in population, Japan’s economic growth is far behind that of the United States. From 2000 to 2015, its real GDP grew an average of 0.72 percent per year, while U.S. real GDP grew an average of 1.77 percent.

In average growth rates, more than 1 percent per year is a big difference, indeed, as it compounds over time. Over 15 years, this annual growth rate difference would add up to U.S. GDP being 30 percent larger, compared to 11 percent larger for Japan, a difference of 19 percentage points.

However, economic well-being is not measured by aggregate GDP, but by GDP per capita. The question is how much production there is per person. In this case, measuring per-capita growth gives us a very different outcome.

In 2015, Japan’s population was essentially the same as it was in 2000, with an average annual growth rate of 0.01 percent. The corresponding annual growth rate of the U.S. population was 0.87 percent. So the U.S. added 39 million more people over the period to provide for.

Thus real GDP growth per capita in Japan was 0.71 percent per year. In the United States, it was 0.89 percent – a much more similar number. The growth rate advantage over Japan, measured per capita, is reduced to a modest 0.18 percent.

If 0.71 percent growth is “stagnant,” what is 0.89 percent?

OFR points to low interest rates without mentioning the Fed

Published by the R Street Institute.

In the July 2016 edition of its Financial Stability Monitor, the U.S. Treasury Department’s Office of Financial Research (OFR) points out multiple times that exceptionally low interest rates are exacerbating systemic risks. But OFR somehow never mentions the Federal Reserve as the cause the low interest rates and, therefore, the risks.

The OFR was set up to analyze and report on systemic financial risk. Governments and central banks are among the most important causes of this risk. But can one part of the government ever say that another part is generating systemic risk, even when it manifestly is?  Apparently not.

Thus, we discover in the OFR report that:

U.S. interest rates have declined to ultra-low level levels, which can motivate excessive risk-taking and borrowing.

Note the passive voice: “have declined.” The relevant actor, the Fed, is not cited.

Key market risks stem from persistently low U.S. interest rates.

And who is setting these rates?

The report points to the “situation exacerbated by the U.K. vote.” So we can mention Brexit, but not the Fed.

Low U.S. long-term interest rates underpin excesses in investor risk-taking, as well as high U.S. equity prices and commercial real estate prices…these excesses…could compound other threats, including credit risk.

Somehow no mention of the Fed’s strategy to create “wealth effects” by promoting investor risk-taking.

Low interest rates have prompted investors to take risks to get better returns.

Who did the prompting?

Commercial real estate prices climbed rapidly…generally attributed to low interest rates and low vacancy rates. However, such large and rapid price increases can make an asset market more susceptible to large price declines.

Yup, the danger of central banks promoting wealth effects.

Is the OFR able to say what it really thinks?  If not, it needs to be replaced as soon as possible by somebody who can.

Negative real interest rates are politics

Published by the R Street Institute.

In a recent Wall Street Journal piece, Jason Zweig cites Harvard’s Carmen Reinhart as rightly pointing out that “low interest rates will keep transferring massive amounts of wealth from savers to borrowers.” In fact, short-term interest rates are not merely “low,” but in real, inflation-adjusted terms, they are negative.

The negative real interest rates imposed by the Federal Reserve for more than seven years now have, indeed, expropriated savings and subsidized borrowings. In particular, they have subsidized leveraged speculation, providing essentially free margin loans to the speculators at the expense of the savers. As a temporary crisis measure in a financial panic, one can defend this. But not for more than seven years.

A cynical description of politics is taking money from the public and giving it to your friends. In simple fact, when you use the power of the government to take money from some people and give it to others, that is absolutely politics, no matter what else it might also be called. For example, it might also be called “monetary policy.” By imposing negative real interest rates, the Fed is without question engaging in political decisions and political actions.

The average real yield on six-month Treasury bills since the end of 2008 has been negative 1.3 percent. The 50-year historical average is about positive 1.6 percent. The difference goes right out of the pockets of the savers and into the pockets of borrowers. Of course, the biggest borrower of all, which gets by far the biggest transfer of money, is the federal government itself. In this sense, negative interest rates are another way of imposing a tax. Imposing a tax is obviously a political act.

Where does the Fed get the legitimacy to impose taxes and to take some people’s money and give it to others, for years after the crisis has ended?  How and to whom is it accountable for these political acts?

Where, how and to whom, indeed?

Housing Finance: Two strikes, and now?

Published in the Urban Institute.

Memories fade. So while trying to draw conclusions about going forward, we should also do our best to remember our past expensive lessons in politicized housing finance.

It should be most sobering to Americans engaged in mortgage lending that the U.S. housing-finance sector collapsed twice in three decades—a pretty dismal record. There was first the collapse of the savings and loan-based system in the 1980s, then again that of the Fannie Mae and Freddie Mac-based system in the 2000s. The first also caused the failure of the government’s Federal Savings and Loan Insurance Corp.; the second forced the government to admit that the U.S. Treasury really was on the hook for the massive debt of Fannie and Freddie, frequent protestations to the contrary notwithstanding. The first generated a taxpayer bailout of $150 billion; the second, a taxpayer bailout of $187 billion. That’s two strikes. Are we naturally incompetent at housing finance?

In both cases, the principal housing-finance actors had tight political ties to the government, which allowed them to run up risk while claiming a sacred housing mission. The old U.S. League for Savings, the trade association for savings and loans, was in its day a serious political force and closely linked with the Federal Home Loan Bank Board. In their glory days, in turn, Fannie and Freddie bestrode the Washington and housing worlds like a hyper-leveraged colossus. In retrospect, these were warning signs.

The savings and loans did what the regulators told them to do: make long-term, fixed-rate mortgage loans financed short. Fannie and Freddie were viewed as a solution to this interest-rate-risk problem, then had a credit-risk disaster instead. They, too, did what the regulators told them to do: acquire a lot of lower-credit-quality loans. Thinking that regulators know what risks will come home to roost in the future is another warning sign.

We need to eschew all politicized schemes and move to something more like a real housing-finance market, if we want to avoid strike three.

Seven steps to housing-finance reform

Published by the R Street Institute.

The attached policy brief appeared in the Housing Finance Reform Incubator report published in July 2016 by the Urban Institute.

The giant American housing finance sector is as important politically as it is financially, which makes it hard to reform. From the 1980s on, it was unique in the world for its overreliance on the “government-sponsored enterprises” (GSEs), Fannie Mae and Freddie Mac—privately owned, but privileged and with “implicit” government guarantees. According to Fannie and Freddie, their lobbyists and members of Congress reading scripts from Fannie in its former days of power and glory, this made American housing finance “the envy of the world.”

In fact, it didn’t, and the rest of the world did not experience such envy. But Fannie and Freddie did attract investment from the rest of the world, which correctly saw them as U.S. government credit with a higher yield: this channeled the savings of thrifty Chinese and others into helping inflate American house prices into their historic bubble. Fannie and Freddie were a highly concentrated point of systemic vulnerability.

Needless to say, Fannie and Freddie, and American housing finance in general, then became “the scandal of the world” as they went broke. What schadenfreude my German housing-finance colleagues enjoyed after years of being lectured by the GSEs on the superiority of the American system. Official bodies in the rest of the world pressured the U.S. Treasury to protect their investments in the insolvent Fannie and Freddie, which of course it did and does. The Treasury is also protecting the Federal Reserve, which in the meantime became the world’s biggest investor in Fannie and Freddie securities.

More than seven years later, America is still unique in the world for centering its housing-finance sector on Fannie and Freddie, even though they have equity capital that rounds to zero. Now they are primarily government-owned and entirely government-controlled housing-finance operations, completely dependent on the taxpayers. Nobody likes this situation, but it has already outlasted numerous reform proposals.

Is there a way out that looks more like a market and less like a statist scheme? A way that reduces the distortions of excessive credit that inflates house prices, runs up leverage and sets up both borrowers and lenders for failure? In other words, can we reduce of the chance of repeating the mistakes of 1980 to 2006? I suggest seven steps to reform American housing finance:

1. Turn Fannie and Freddie into SIFIs at the “10 percent moment”

2. Enforce the law on Fannie and Freddie’s guarantee fees

3. Encourage skin in the game from mortgage originators

4. Form a new joint FHLB mortgage subsidiary

5. Create countercyclical LTVs

6. Reconsider local mutual self-help mortgage lenders

7. Liquidate the Fed’s MBS portfolio

Turn Fannie and Freddie into SIFIs at the ’10 percent moment’

The original bailout deal for Fannie and Freddie created a senior preferred stock with a 10 percent dividend. As everybody knows, the amended deal makes all their net profit a dividend, which means there will never be any reduction of the principal, no matter how much cash Fannie and Freddie send the Treasury. It is easy, however, to calculate the cash-on-cash internal rate of return (IRR) to the Treasury on its $189.5 billion of senior preferred stock. So far, this is about 7 percent – positive, but short of the required 10 percent. But as Fannie and Freddie keep sending cash to the Treasury, the IRR will rise and will reach a point when total cash paid is equivalent to a 10 percent compound return, plus repayment of the entire principal. That is what I call the “10 percent moment.” It provides a uniquely logical point for reform, and it is not far off, perhaps late 2017 or early 2018.

At the 10 percent moment, whenever it arrives, Congress should declare the senior preferred stock fully repaid and retired, as in financial substance it will have been. Simultaneously, Congress should formally designate Fannie and Freddie as Systemically Important Financial Institutions (SIFIs). That they are indeed SIFIs – able to put not only the entire financial system but also the finances of the U.S. government at risk – is beyond the slightest doubt.

As soon as Fannie and Freddie are officially, as well as in economic fact, SIFIs, they will get the same minimum capital requirement as bank SIFIs: 5 percent of total assets. At their current size, this would require about $250 billion in equity. This is a long trip from zero, but they could start building capital, while of course being regulated as undercapitalized until they aren’t. Among other things, this means no dividends on any class of stock until the capital requirement is met.

As SIFIs, Fannie and Freddie will get the Fed as their systemic risk regulator. In general, they should be treated just like big bank SIFIs. Just as national banks have the Fed, as well as the Comptroller of the Currency, they will have the Fed, as well as the Federal Housing Finance Agency.

Since it is impossible to take away Fannie and Freddie’s too-big-to-fail status, they should pay the government for its ongoing credit guaranty, just as banks pay for theirs. I recommend a fee of 0.15 percent of total liabilities per year.

Fannie and Freddie will be able to compete in mortgage finance on a level basis with other SIFIs, and swim or sink according to their competence.

Enforce the law on Fannie and Freddie’s guarantee fees

In the Temporary Payroll Tax Cut Continuation Act of 2011, Title IV, Section 401, “Guarantee Fees,” Congress has already decided how Fannie and Freddie’s guarantee fees (g-fees) must be set. Remarkably, the law is not being obeyed by their conservator, the Federal Housing Finance Agency.

The text of the statute says the guarantee fees must “appropriately reflect the risk of loss, as well the cost of capital allocated to similar assets held by other fully private regulated financial institutions.”

This is unambiguous. The simple instruction is that Fannie and Freddie’s g-fees must be set to reflect the capital that private banks would have to hold against the same risk, and also the return private banks would have to earn on that capital. The economic logic is clear: to get private capital into the secondary mortgage market, make Fannie and Freddie price to where private financial institutions can fairly compete.

This is, in fact, a “private sector adjustment factor,” just as the Fed must use for its priced services. The difference is that the Fed obeys the law and the FHFA doesn’t.

Of course, the FHFA finds this legislative instruction highly inconvenient politically, so ignores it or dances around it. But Congress didn’t write the act to ask the FHFA what it liked, but to tell it what to do. The FHFA needs to do it.

Encourage skin in the game for mortgage originators

A universally agreed-upon lesson from the American housing bubble was the need for more “skin in the game” of credit risk by those involved in mortgage securitization. But lost in most of the discussion was the optimal point at which to apply credit-risk skin in the game. This point is the originator of the mortgage loan, which should have a junior credit risk position for the life of the loan. The entity making the original mortgage is in the best position to know the most about the borrower and the credit risk of the borrower. It is the most important point at which to align incentives for creating sound credits.

The Mortgage Partnership Finance (MPF) program of the Federal Home Loan Banks was and is based on this principle. (I had the pleasure of leading the creation of this program.) The result was excellent credit performance of the MPF mortgage loans, including through the crisis. The principle is so obvious, isn’t it?

I do not suggest making this a requirement for all originators, but to design rules and structures in mortgage finance to encourage this optimal credit strategy.

Form a new joint FHLB mortgage subsidiary

Freddie Mac was originally a wholly owned, joint subsidiary of the 12 Federal Home Loan Banks (FHLBs). Things might have turned out better if it had remained that way.

FHLBs (there are now 11 of them) are admirably placed to operate secondary markets with the thousands of smaller banks, thrifts and credit unions—and perhaps others—that originate mortgages in their local markets. As lenders to these institutions, FHLBs know and have strong ability to enforce the obligations of the originators, both as credit enhancers and as servicers. But to be competitive, and for geographic diversification, they need a nationwide scope.

The precedent for the FHLBs to form a nationally operating mortgage subsidiary is plain. They should do it again.

Create countercyclical LTVs

As the famous investor Benjamin Graham pointed out long ago, price and value are not the same: “Price is what you pay, and value is what you get.”

Likewise, in mortgage finance, the price of the house being financed is not the same as its value, and in bubbles, prices greatly exceed the sustainable value of the house. Whenever house prices are in a boom, the ratio of the loan to the sound lendable value becomes something much bigger than the ratio of the loan to the inflated current price.

As the price of any asset, including houses, goes rapidly higher and further over its trend line, the riskiness of the future price behavior becomes greater—the probability that the price will fall a lot keeps increasing. Just when lenders and borrowers are feeling more confident because of high collateral “values” (really, prices), their danger is, in fact, growing. Just when they are most tempted to lend and borrow more against the price of the asset, they should be lending and borrowing less.

A countercyclical LTV (loan-to-value ratio) regime would reduce the maximum loan size relative to current prices, in order to keep the maximum ratio of loan size to underlying lendable value more stable. The boom would thus induce smaller LTPs (loan-to-price ratios); steadier LTVs; and greater down payments in bubbly markets—thus providing an automatic dampening of price inflation and a financial stabilizer.

Often discussed are countercyclical capital requirements for financial institutions, which reduce the leverage of those lending against riskier prices. The same logic applies to reducing the leverage of those who are borrowing against risky prices. We should do both.

Canada provides an interesting example of where countercyclical LTVs have actually been used.

Reconsider local mutual self-help mortgage lenders

In the long-forgotten history of mortgage lending, an important source of mortgage loans were small, mutual associations owned by their depositors and operating with an ethic that stressed saving, self-discipline, self-help, mutual support and homeownership. Demonstrated savings behavior and character were key qualifications for borrowing. The idea of a mortgage was to pay it off.

In the Chicago of 1933, for example, the names of such associations included: Amerikan, Archer Avenue, Copernicus, First Croatian, Good Shepherd, Jugoslav, Kalifornie, Kosciuszko, Narodi, Novy Krok, Polonia, St. Paul, St. Wenceslaus, Slovak and Zlata Hora…you get the idea.

In my opinion, the ideals of these mutual associations are worth remembering and reconsidering; they might be encouraged (not required) again. We would have to make sure that current loads of regulatory compliance costs are not allowed to smother any such efforts at birth.

Liquidate the Fed’s MBS portfolio

What is the Fed, a central bank, doing holding $1.7 trillion of mortgage-backed securities (MBS)? The founders of the Fed and generations of Fed officers since would have found that impossible to imagine. The MBS portfolio exists because the Fed was actively engaged in pushing up house prices, as part of its general scheme to create “wealth effects,” by allocating credit to the housing sector using its own balance sheet. It succeeded— house prices have not only risen rapidly, but are back over their trend line on a national average basis.

Why is the Fed still holding all these mortgages? For one thing, it doesn’t want to recognize losses when selling its vastly outsized position would drive the market against it. Some economists argue that even big losses do not matter if you are a fiat currency central bank. Perhaps not, but they would be embarrassing and unseemly.

Whatever justification there may have been in the wake of the collapsed housing bubble, the Fed should now get out of the business of manipulating the mortgage market. It can avoid recognizing any losses by simply letting its mortgage portfolio steadily run off to zero over time through maturities and prepayments. It should do so, and cease acting as the world’s biggest savings and loan.

Especially with the reforms to Fannie and Freddie discussed above, we would get closer to having a market price of mortgage credit. Imagine that!

Envoi

Will these seven steps solve all the problems of American mortgage finance and ensure that we will never have another crisis? Of course not. But they will set us on a more promising road than sitting unhappily where we are at present.

Why can’t the US reform its housing-finance sector?

Published by the R Street Institute.

The attached policy brief appeared in the Summer 2016 edition of Housing Finance International, the quarterly journal of the International Union for Housing Finance (IUHF).

It is sobering to Americans that the U.S. housing finance collapsed twice in three decades: in the 1980s and again in the 2000s. This is certainly an embarrassing record.

The giant American housing finance sector, with $10 trillion in mortgage loans, is as important politically as it is financially. Many interest groups want to receive government subsidies through the housing finance system. This makes it very hard to reform.

From the 1980s to today, U.S. housing finance has been unique in the world for its overreliance on the so-called “government-sponsored enterprises,” Fannie Mae and Freddie Mac. Fannie and Freddie get government guarantees for free, which are said to be only “implicit,” but are utterly real. According to Fannie and Freddie in their former days of power and glory, this made American housing finance “the envy of the world.” In fact, the rest of the world did not feel such envy. But Fannie and Freddie did attract investment from the rest of the world, which correctly saw their issues as U.S. government credit with a higher yield. In the 2000s, this channeled the savings of thrifty Chinese and others into helping inflate American house prices into their amazing bubble. Fannie and Freddie became a key point of concentrated systemic vulnerability.

In 2008, Fannie and Freddie went broke. What schadenfreude my German housing finance colleagues enjoyed after years of being lectured on the superiority of the American system!  Official bodies in the rest of the world pressured the U.S. Treasury to protect their investments in the obligations of the insolvent Fannie and Freddie, which the Treasury did and continues to do. The Federal Reserve, in the meantime, has become the world’s biggest investor in Fannie and Freddie securities.

Almost eight years after the financial collapse, America is still unique in the world for centering its housing finance sector on Fannie and Freddie, even though they have equity capital that rounds to zero. They are primarily government-owned and entirely government-controlled housing finance operations, completely dependent on the taxpayers. Nobody likes this situation, but it has outlasted numerous reform efforts.

Is there a way out of this statist scheme—can we move American housing finance toward something more like a market?  Is there a way to reduce the distortions caused by Fannie and Freddie, to control the hyper-leverage that inflates house prices and the excessive credit that sets up both borrowers and lenders for failure?  Can we reduce the chance of repeating the mistakes of 1980 to 2007?  Here are some ideas.

Restructure Fannie and Freddie

The original government bailout of Fannie and Freddie created senior preferred stock with a 10 percent dividend, which the U.S. Treasury bought on behalf of the taxpayers. This was later amended to make the dividend be all their net profit. That meant there would never be any reduction of the principal, and the GSEs will be permanent wards of the state.

It is easy, however, to calculate the cash-on-cash internal rate of return (IRR) to the Treasury on its $189.5 billion investment in senior preferred stock, given the dividend payments so far of $245 billion. This represents a return of about 7 percent – positive, but short of the required 10 percent. As Fannie and Freddie keep sending cash to the Treasury, the IRR will rise, and will reach a point when total cash paid is equivalent to a 10 percent compound return, plus repayment of the entire principal. That is what I call the “10 Percent Moment.” It provides a uniquely logical point for reform, and it is not far off, perhaps in early 2018.

At the 10 Percent Moment, whenever it arrives, Congress should declare the senior preferred stock fully repaid and retired, as in financial substance, it will have been. Simultaneously, Congress should formally designate Fannie and Freddie as systemically important financial institutions (SIFIs). They are unquestionably SIFIs – indeed, they are Global SIFIs – able to put not only the entire financial system, but also the finances of the U.S. government at risk. This is beyond the slightest doubt.

As soon as Fannie and Freddie are designated officially – as well as in economic fact – as SIFIs, they will get the same minimum equity capital requirement as bank SIFIs: 5 percent of total assets. At their current size, this would require about $250 billion in equity. They must, of course, be regulated as undercapitalized until they aren’t. Among other things, this means no dividends on any class of stock until the capital requirement is met.

As SIFIs, Fannie and Freddie will and should get the Federal Reserve as their systemic risk regulator, in addition to their housing finance regulator.

It is impossible to take away Fannie and Freddie’s too-big-to-fail status, no matter what any government official says or does. Therefore they should pay the government for its ongoing credit guaranty, on the same basis as banks have to pay for deposit insurance. I recommend a fee of 0.15 percent of total liabilities per year.

Then Fannie and Freddie will be able to compete in mortgage finance on a level basis with other SIFIs, and swim or sink according to their competence.

Promote skin in the game for mortgage originators

A universally recognized lesson from the American housing bubble was the need for more “skin in the game” of credit risk by those involved in mortgage securitization. Lost in the discussion is the optimal point at which to apply credit risk skin in the game. This optimal point is originator of mortgage loans, which should have a junior credit risk position for the life of the loan. The entity making the original mortgage is in the best position to know the most about the borrower and the credit risk of the borrower. It is the most important point at which to align incentives for creating sound credits.

The Mortgage Partnership Finance (MPF) program of the Federal Home Loan Banks was and is based on this principle (I had the pleasure of leading the creation of this program). It finances interest-rate risk in the bond market but keeps the junior credit risk with the original lender. The result was excellent credit performance of the MPF mortgage loans, including through the 2000s crisis.

I believe this credit-risk principle is obvious to most of the world. Why not to the United States?

Create countercyclical LTVs

As the famous investor Benjamin Graham pointed out long ago, price and value are not the same:  “Price is what you pay, and value is what you get.” Likewise, in mortgage finance, the price of the house being financed is not the same as its value: in bubbles, prices greatly exceed the sustainable value of houses. Whenever house prices are in a boom, the ratio of the loan to the sound lendable value becomes something much bigger than the ratio of the loan to the inflated current price.

As the price of any asset (including houses) goes rapidly higher and further over its trend line, the riskiness of the future price behavior becomes greater—the probability that the price will fall continues to increase. Just when lenders and borrowers feel most confident because of high collateral “values” (which really are prices), their danger is in fact growing. Just when they are most tempted to lend and borrow more against the price of the asset, they should be lending and borrowing less.

A countercyclical LTV (loan-to-value ratio) regime reduces the maximum loan size relative to current prices, in order to keep the maximum ratio of loan size to underlying lendable value more stable. The boom would thus induce smaller LTVs, and greater down payments, in bubbly markets—thus providing a financial stabilizer and an automatic dampening of price inflation.

Countercyclical capital requirements for financial institutions reduce the leverage of those lending against riskier prices. The same logic applies to reducing the leverage of those who are borrowing against risky prices. We should do both.

Canada provides an interesting example of where countercyclical LTVs have actually been used; Germany uses sustainable lendable value as the same basic idea. The United States needs to import this approach.

Liquidate the Fed’s mortgage portfolio

What is the Federal Reserve doing holding $1.7 trillion of mortgage-backed securities (MBS)? The authors of the Federal Reserve Act and generations of Fed chairmen since would have found that impossible even to imagine. This massive MBS portfolio means the Fed allocates credit to housing through its own balance sheet. Its goal was to push up house prices, as part of its general scheme to create “wealth effects.” It succeeded— house prices have not only risen rapidly, but are back over their trend line on a national average basis. This means, by definition, that the Fed also has made houses less affordable for new buyers.

Why in 2016 is the Fed still holding all these mortgages?  For one thing, it doesn’t want to recognize losses when selling its vastly outsized position would drive the market against it. Some economists argue that losses of many times your capital do not matter if you are a fiat currency central bank. Perhaps or perhaps not, but they would be embarrassing and cut off the profits the Fed sends the Treasury to reduce the deficit.

Whatever justification there might have been in the wake of the collapsed housing bubble, the Fed should now get out of the business of manipulating the mortgage-securities market. If it is unwilling to sell, it can simply let its mortgage portfolio run off to zero over time through maturities and prepayments. It should do so, and cease acting as the world’s biggest savings and loan.

The collapses of the 1980s and 2000s should have taught the American government a lesson about the effects of subsidized, overleveraged mortgage markets. It didn’t. The reform of the Fannie and Freddie-centric U.S. housing finance sector has not arrived, nor is there any sign of its approach. But we need to keep working on it.

The Senate needs to pass the House’s Puerto Rico bill

Published by the R Street Institute.

The government of Puerto Rico is broke. It now has multiple defaults on its record, most recently for $367 million in May. More and bigger defaults are on the way, probably beginning July 1. It’s already June 22.

The U.S. Senate should pass the U.S. House’s Puerto Rico bill now.

The House approved the bill by a wide margin, after a long and thorough bipartisan discussions that included sensible compromises and ultimate agreement between the administration and the legislators. The bill gets all the essential points right. These are:

• The creation of an emergency financial control board, or “Oversight Board,” to get under control and straighten out the financial management and fiscal balance of the Puerto Rican government.

• An orderly and equitable process overseen by the board to address restructuring the government’s unpayable debts.

• Beginning a long-term project to move Puerto Rico toward a successful market economy and away from its failed government-centric one.

Of course, any complex set of legislative provisions can give rise to arguments and possibly endless debates about details. That would be a big mistake.

It’s time to enact the bill and get the essentials in place as soon as possible.

R Street and Americans for Tax Reform urge the Senate to pass H.R. 5278 (PROMESA)

Published by the R Street Institute.

June 21, 2016

Dear Senator,

On behalf of the undersigned free market organizations, we urge you to vote “Yes” on the House-passed H.R. 5278, the Puerto Rico Oversight, Management, and Economic Stability Act of 2016 (PROMESA). Puerto Rico faces many challenges, and unfortunately the territory’s fiscal challenges cannot be fixed overnight. However, by putting strong, independent oversight in place, requiring fiscal reforms, and creating a path for addressing financial debt, PROMESA lays the foundation for prudent fiscal management that will lead to future solvency.

The Puerto Rican crisis is the result of many years of fiscal and economic mismanagement, and both the island’s own government and the federal government are complicit. While untangling the web of failed policy will take time, the fact remains: Puerto Rico is broke. The Puerto Rican government is already failing to meet its debt obligations, and with every day that passes, the probability of a crisis increases.

With defaults, combined unfunded pension and debt obligations over $115 billion, and the Puerto Rican government’s failure to produce audited financial statements for several fiscal years, it is imperative to establish financial oversight, get an accurate understanding of the situation, and create an appropriately calibrated fiscal plan to restore growth. The Oversight Board set out in PROMESA is empowered to do exactly this. The Oversight Board will exercise its authority to acquire accurate financial information, establish fiscal plans, create budgets, negotiate with creditors, and ensure enforcement of the deals and plans created under its authority.

While this oversight control is the required first step toward abating Puerto Rico’s crisis, PROMESA also enacts several immediate pro-growth reforms, including altering the island’s unemployment generating minimum wage requirements and overtime regulations, and putting a plan in place for infrastructure improvements. These changes are an important part of altering the island’s path, and we urge the congressional task force created by the bill to search for further opportunities to reform policies currently limiting Puerto Rico’s growth and promote a market economy.

PROMESA lays out a process to ensure the island’s creditors are treated justly during any future debt restructuring. It encourages voluntary restructuring, requires the Oversight Board to ‘respect the relative lawful priorities’ of the various debt classes, and distinguishes between debt obligations and pensions.

We applaud the House for its leadership on this issue. The bill has been strengthened, and currently represents Puerto Rico’s best chance to return solid fiscal footing. It is now the Senate’s turn. By voting for passage, Senators will fulfill their obligation under the Constitution to ‘make all the needful rules’ regarding the territories. We urge you therefore to vote yes.

Sincerely,

R Street Institute

Americans for Tax Reform

Does the Federal Reserve know what it’s doing?

Published by the R Street Institute.

The attached policy study was published in Cato Journal,  Vol. 36, No. 2.

The Federal Reserve is the most financially dangerous institution in the world. It represents tremendous systemic risk—more systemic financial and economic risk than anybody else. Fed actions designed to manipulate the world’s dominant fiat currency, based on the debatable theories and guesses of a committee of economists, can create runaway consumer price and asset inflation, force negative real returns on people’s savings, reduce real wages, stoke disastrous financial bubbles that lead to financial collapses, distort markets and resource allocation, and in general create financial instability. The Fed has done or is doing all of these things—ironically enough—in the name of pursuing stability. But whatever its intentions, does the Fed actually know what it is doing? Clearly, it hasn’t in the past, and it is exceptionally dubious in principle that it ever can. Since that is true, how can anybody think the Fed should be an independent power?

Time for Congress to vote in the new Puerto Rico bill

Published by the R Street Institute.

A revised bill to address the intertwined debt, fiscal and economic crises of Puerto Rico has just been introduced in the U.S. House. H.R. 5278 proposes “to establish an Oversight Board, to assist the Government of Puerto Rico…in managing its public finances.”

This “assistance” (read, “supervision”) is needed intensely. If all goes well, the House Natural Resources Committee will report the bill out promptly and it will proceed to enactment.

As is well-known, the government of Puerto Rico is broke and defaulting on its debt. At $118 billion, by the committee’s reckoning (which rightly includes unfunded government pensions), that debt is six times the total debt and unfunded pensions of the City of Detroit as it entered bankruptcy. This is a truly big insolvency, which reflects long years of constant fiscal deficits filled in by excess borrowing. Moreover, as the committee points out, Puerto Rico’s “state-run economy is hopelessly inefficient.”

There are three fundamental tasks involved in the complex and massive problems, and the bill addresses all three. These are:

1. To establish an emergency financial control board to determine the extent of the insolvency, develop fiscal and operational reforms and put the government of Puerto Rico on a sound financial basis. The bill uses the more politic title of “Oversight Board,” but the tasks are the same. They will not be easy and are sure to be contentious, but are necessary.

1. To restructure the unpayable debt and settle how the inevitable losses to creditors are shared among the parties. The bill gives the Oversight Board the authority, if necessary, to put forth a plan of debt reorganization and the legal framework to reach settlement.

1. To move Puerto Rico toward economic success – that, is toward a market economy and away from its failed government-centric economy – and thus to give it the potential for future growth. These reforms will not be easy, either, but the bill sets out a process to start the required evolution.

The discussion of the necessary steps has been long and full. Now it’s time for Congress to vote in the new bill.

Puerto Rico: Time for Congress to act

Published by the R Street Institute.

The finances of Puerto Rico’s government are unraveling rapidly. With the commonwealth government broke and scrambling, its Legislative Assembly already has empowered Gov. Alejandro García Padilla to declare a moratorium on all debt payments.

In a report that was kept secret, the Government Development Bank, which is at the center of complex intragovernmental finances, was found last year to be insolvent. Adding together the explicit government debt and the liabilities of its 95 percent unfunded government pension plan, the total problem adds up to about $115 billion.

There is no pleasant outcome possible here. The first alternative available is to deal with many hard decisions and many necessary reforms in a controlled fashion. The second is to have an uncontrolled crisis of cascading defaults in a territory of the United States.

Congress needs to choose the controlled outcome by creating a strong emergency financial control board for Puerto Rico—and to do it now. This is the oversight board provided for in the bill currently before the House Natural Resources Committee. The bill further defines a process to restructure the Puerto Rican government’s massive debts, which undoubtedly will be required.

Some opponents of the bill, in a blatant misrepresentation, have been calling it a “bailout” to generate popular opposition. To paraphrase Patrick Henry, these people may cry: Bailout! Bailout!…but there is no bailout.

Enacting this bill is the first step to get under control a vast financial mess, the result of many years of overborrowing, overlending and financial and fiscal mismanagement.

Again to cite Patrick Henry, “Why stand we here idle?”

Puerto Rico bill proceeds with oversight board and no bailout

Published by the R Street Institute.

The House Natural Resources Committee is taking testimony today on its bill to address the Puerto Rico debt crisis, and could send a finished bill to the full U.S. House as early as tomorrow. As the Puerto Rican government’s finances continue to unravel rapidly, it is decidedly time for Congress to act.

The bill gets two fundamental issues right. It takes the essential first step: creating a strong emergency financial control board to oversee and reform the Puerto Rican government’s abject financial situation and operations. The oversight board the bill provides should be put in place as soon as possible. (See “Puerto Rico needs a financial control board.”)

Second, it provides no bailout for the bondholders. Should U.S. taxpayers provide a bailout to those who unwisely lent money to the Puerto Rican government? Clearly not. When governments spend and borrow themselves into insolvency, those who provide the debt should bear the risk on their own. Since the citizens of Puerto Rico themselves pay no federal income taxes, this imperative is even stronger.

Objections are raised that these losing investments were made while relying on the Puerto Rican government’s inability to enter bankruptcy proceedings. But the fact that you cannot enter bankruptcy does not stop you from going broke. When you are broke, and the cash is gone, and the lenders won’t lend to you any more, the question becomes how big a loss the various parties will take. Nobody knows the right answer at this point: that’s one of the reasons we need the oversight board.

The Puerto Rican government has now made settlement offers for outstanding debt which would pay, on average, about 66 cents to 75 cents on the dollar. For the debt held by its own residents, it offers a special deal: you could be paid at par, starting 49 years from now, and get an interest rate of 2 percent. Discounted at 5 percent, this implies a value of about 45 cents on the dollar. Presumably, this would be a way to avoid recognizing losses for Puerto Rican credit unions which would not mark to market.

There are three contenders for the vanishing cash of the Puerto Rican government: the creditors, the ongoing operations of the government and the beneficiaries of the large and virtually unfunded government pension plan. How to share the losses among the claimants is the fight at the center of all insolvencies and will be so in this one, too.

There is no pleasant way out of the current situation. We won’t even know how deep the component insolvencies are until the oversight board gets in there and figures it out. In the meantime, we also should wrestle with the third fundamental issue: how to create a successful market economy to replace Puerto Rico’s current failed government-centric one.

Update on U.S. property prices in the Fed’s brave new world

The attached policy short was published in the Spring 2016 edition of Housing Finance International, the quarterly journal of the International Union for Housing Finance.

Readers of my last update in Housing Finance International may recall this principle: The collateral for a home mortgage loan is not the house, but the price of the house. Likewise, the collateral for a commercial real estate loan is not the property, but the price of the property.

A key question always accompanies this principle: How much can asset prices change? The answer is always: More than you think. Prices can go up more than you expected, and they can go down a lot more than you thought possible; a lot more than your “worst case scenario” projected. The more prices have gone up in the boom, and the more leverage has been induced by their rise, the more likely are their subsequent fall and the bust.

From this, we can see how dangerous a game the Federal Reserve and other major central banks have played by promoting asset price inflation through their monetary manipulations of the last several years. Unavoidably, among the asset prices affected are those of residential and commercial real estate.

The Fed has tried asset price inflation before. In the wake of the collapse of the tech stock bubble in 2000, under then-Chairman Alan Greenspan, the Fed set out to promote a housing boom in order to create a “wealth effect” that would offset the recessionary effects of the previous bubble’s excesses. I call this the Greenspan Gamble. As we know, the boom got away into a new and far more damaging bubble. It was in fact a simultaneous double bubble in housing and in commercial properties. This is made apparent in Graph 1, showing the decade from 2000-2010. These events stripped Greenspan of his former masterful aura and of his former media title, “The Maestro.”

The economically sluggish aftermath of the twin bubbles brought us, under Greenspan’s successor, Ben Bernanke, the Bernanke Gamble. The Fed once again set about promoting asset price inflation and “wealth effects” to offset the financial and economic drag of the previous excesses. The brave new world of the Bernanke Gamble includes exceptionally low interest rates, years of negative real short-term interest rates, and the effective expropriation of savers, while making the Fed into the biggest investor in mortgage assets in the world. Of course this has inflated real estate prices.

Graph 2 shows U.S national average house prices from 1987 to 2015 and their trend line. The bubble’s extreme departure from the trend is obvious. It is essential to observe that the six years of price deflation, from the peak in 2006 to 2012, while a 27 percent aggregate fall, brought house prices only back to their trend line – there was very little downside overshoot. Since 2012, prices have risen by 31 percent in less than four years, and are now 12 percent over their trend line. This rate of increase is unsustainable. On top of that, the U.S. government is once again, as it did the last time around, pushing mortgage loans with small down payments and greater credit risk. Some politicians have apparently learned nothing and forgotten everything.

The price behavior of commercial real estate has been even more extreme. As shown in Graph 3, while commercial real estate prices peaked in 2008 at a level similar to that of housing in 2006, their fall was much steeper, dropping 40 percent, or about half again as much as house prices. The difference presumably reflects the large government efforts to prop up the prices of houses.

From the 2010 bottom in commercial real estate prices, they have now almost doubled, and the current index is 17 percent above the prices at the peak of the bubble. Cranes are busy, and this so far makes the Fed happy, since it means strong construction spending. But what comes next?

Asset prices need to be understood on an inflation-adjusted basis. Over long periods of time, the inflation-adjusted increase in U.S. house prices is very modest – only about 0.6 percent per year, on average. This means home ownership is a good long-term hedge against the central bank’s endemic inflation, but on average, not a great investment. Graph 4 shows real house price movements over 40 years, from 1975 to 2015, stated in constant 2000 dollars, and the modestly increasing long-term trend line. As of the end of 2015, average house prices are 19 percent above the inflation-adjusted trend – not yet a bubble, but distinctly a renewed boom.

Rapid increases in house and commercial real estate prices is what in the past has induced extrapolations of further price increases, looser credit standards, increasing leverage, and overconfidence among lenders and borrowers. We can only hope that this time they remember that it is the price, not the property, which is being leveraged.

Will the Bernanke Gamble end in similar fashion to the Greenspan Gamble? Will the historical average of a financial crisis about every 10 years continue? We will find out.