The Cincinnatian Doctrine revisited

Published by the R Street Institute.

The attached policy study originally appeared in the Winter 2016 edition of Housing Finance International.

Ten years ago, in September 2006, just before the great housing bubble’s disastrous collapse, the World Congress of the International Union for Housing Finance, meeting in Vancouver, Canada, devoted its opening plenary session to the topic of “Housing Bubbles and Bubble Markets.” That was certainly timely!

Naturally, knowing what would come next is easier for us in retrospect than it was for those of us then present in prospect. One keynote speaker, Robert Shiller, famous for studies of irrational financial expectations and later a winner of a Nobel Prize in economics, hedged his position about any predictions of what would come next in housing finance. Six months later, the U.S. housing collapse was underway. The second keynote speaker argued, with many graphs and charts, that the Irish housing boom was solid. Of course, it soon turned into a colossal bust. As the saying goes, “Predicting is hard, especially the future.”

Some IUHF members, in the ensuing discussion, expressed the correct view that something very bad was going to result from the excess leverage and risky financial behavior of the time. None of us, however, foresaw how very severe the crisis in both the United States and Europe would turn out to be, and the huge extent of the interventions by numerous governments it would involve.

Later in the program, also very timely as it turned out, was a session on the “Role of Government” in housing finance. On that panel, I proposed what I called “The Cincinnatian Doctrine.” Looking back a decade later, it seems to me that that this idea proved sound and is highly relevant to our situation now. I am therefore reviewing the argument with observations on the accompanying “Cincinnatian Dilemma” as 2016 draws to a close.

The two dominant theories of the proper role for government in the financial system, including housing finance, are respectively derived from two of the greatest political economists, Adam Smith and John Maynard Keynes.

Smith’s classic work, “The Wealth of Nations,” published in the famous year 1776, set the enduring intellectual framework for understanding the amazing productive power of competitive private markets, which have since then utterly transformed human life. In this view, government intervention into markets is particularly prone to creating monopolies and special privileges for politically favored groups, which constrains competition, generates monopoly profits or economic rents, reduces productivity and growth, and transfers money from consumers to the recipients of government favors. It thus results in less wealth being created for the society and ordinary people are made worse off.

Keynes, writing amid the world economic collapse of the 1930s, came to the opposite view: that government intervention was both necessary and beneficial to address problems that private markets could not solve on their own. When the behavior underlying financial markets becomes dominated by fear and panic, when uncertainty is extreme, then only the compact power of the state, with its sovereign authority to compel and tax, and its sovereign credit to borrow against, is available to stabilize the situation and move things back to going forward.

Which of these two is right? Considering this ongoing debate between fundamental ideas and prescriptions for political economy, the eminent financial historian, Charles Kindleberger, asked, “So should we follow Smith or Keynes?” He concluded that the only possible rational answer is: “Both, depending on the circumstances.” In other words, the answer is different at different times.

Kindleberger was the author (among many other works) of “Manias, Panics and Crashes,” a wide-ranging history of the financial busts which follow enthusiastic booms. First published in 1978, the book was prescient about the financial crises that would follow in subsequent decades, and has become a modern financial classic. A sixth edition of this book, updated by Robert Z. Aliber in 2011, brought the history up through the 21st century’s international housing bubbles, the shrivels of these bubbles that inevitably followed and the crisis bailouts performed by the involved governments. Throughout all the history Kindleberger and Aliber recount, the same fundamental patterns continue to recur.

Surveying several centuries of financial history, Kindleberger concluded that financial crises and their accompanying scandals occur, on average, about once every 10 years. In the same vein, former Federal Reserve Chairman Paul Volcker wittily remarked, “About every 10 years, we have the biggest crisis in 50 years.” This matches my own experience in banking, which began with the “credit crunch” of 1969 and has featured many memorable busts since, not less than one a decade. Unfortunately, financial group memory is short, and it seems to take financial actors less than a decade to lose track of the lessons previously so painfully (it was thought) learned.

Note that with the peak of the last crisis being in 2008, on the historical average, another crisis might be due in 2018 or so. About how severe it might be we have no more insight than those of us present at the 2006 World Congress did.

The historical pattern gives rise to my proposal for balancing Smith and Keynes, building on Kindleberger’s great insight of “Both, depending on the circumstances.” I quantify how much we should have of each. Since crises occur about 10 percent of the time, the right mix is:

• Adam Smith, 90 percent, for normal times

• J.M. Keynes, 10 percent, for times of crisis.

In normal times, we want the economic effi­ciency, innovation, risk-taking, productivity and the resulting economic well-being of ordinary people that only competitive private markets can create. But when the financial system hits its periodic crisis and panic, we want the interven­tion and coordination of the government. The intervention should, however, be temporary. This is an essential point. If prolonged, it will tend to monopoly, more bureaucracy, less innovation, less risk-taking and less growth and less eco­nomic well-being. In the extreme, it will become socialist stagnation.

To get the 90 percent Smith, 10 percent Keynes mix, the state interventions and bailouts must be with­drawn after the crisis is over.

This is the Cincinnatian Doctrine, named after the Roman hero Cincinnatus, who flourished in the fifth century B.C. Cincinnatus became the dictator of Rome, being “called from the plough to save the state.” In the old Roman Republic, the dictatorship was a temporary office, from which the holder had to resign after the crisis was over. Cincinnatus did—and went back to his farm.

Cincinnatus was a model for the American founding fathers, and for George Washington in particular. Washington became the “modern Cincinnatus” for saving his country twice, once as general and once as president, and returning to his farm each time.

But those who attain political, economic and bureaucratic power do not often have the virtue of Cincinnatus or Washington. When the crisis is over, they want to hang around and keep wielding the power which has come to them in the crisis. The Cincinnatian Dilemma is how to get the government interventions withdrawn once the crisis is past. In other words, how to bring the Keynesian 10 percent crisis period to end, and the normal Smith 90 percent to resume its natural creation of growth and wealth.

The financial panic ended in the United States in 2009 and in Europe in 2012. But the interventions have not been withdrawn. The central banks of the United States and Europe are still running hugely distorting negative real interest rate experiments years after the respective crises ended. Fannie Mae and Freddie Mac, effectively nationalized in the midst of the crisis in 2008, have not been reformed and are still operating as arms of the U.S. Treasury. The Dodd-Frank extreme regula­tory overreaction, obviously a child of the heat of its political moment, has not yet been reformed.

The Cincinnatian Doctrine cannot work to its optimum unless we can figure out how to solve the Cincinnatian Dilemma.

Designation of Fannie Mae and Freddie Mac as SIFIs

Published by the R Street Institute.

Dear Secretary Mnuchin:

The Treasury Department has just issued a new review of “Financial Stability Oversight Designations,”[1] and we are writing to you in your capacity as Chairman of the Financial Stability Oversight Council (FSOC) that is responsible for implementing financial stability oversight designations. In the context of FSOC’s responsibility to address systemic financial risk, we would like to address a major omission in its past work, and make three fundamental points:

1. Fannie Mae and Freddie Mac are two of the largest and most highly leveraged financial institutions in the world. Fannie Mae is larger than JPMorgan or Bank of America; Freddie Mac is larger than Wells Fargo or Citigroup. They fund trillions of dollars of mortgages and sell trillions of dollars of mortgage-backed securities and debt throughout the financial system and around the world. The U.S. and the global economy have already experienced the reality of the systemic risk of Fannie Mae and Freddie Mac. When their flawed fundamental structure, compounded by mismanagement, caused them both to fail in September 2008, there can be no doubt that without a bailout, default on their obligations would have greatly exacerbated the financial crisis on a global basis.

2. We respectfully urge that Fannie Mae and Freddie Mac be designated as Systemically Important Financial Institutions (SIFIs) so that the protective capital and regulatory standards applicable to SIFIs under the law can also be applied to them. These two giant mortgage credit institutions clearly meet all of the criteria specified by the Dodd-Frank Act and implementing regulations[2] for designation as a SIFI. They also meet the international criteria of the Financial Stability Board for designation as a Global SIFI (G-SIFI).

3. Fannie Mae and Freddie Mac continue to operate in “conservatorship” and now have an even greater market share than before, based on an effective guarantee of all their obligations and mortgage-backed securities by the U.S. Treasury. Conservatorship status obligates the federal government, absent a change in the law, to return them to shareholder control after they have been stabilized financially. The Congress has, with much accompanying debate but no action so far, considered a variety of legislative reform measures with respect to the two companies. Whether or not Congress changes the law, we believe it is essential for Fannie Mae and Freddie Mac to be designated as SIFIs.

Puerto Rico: Storms and savings

Published by the R Street Institute.

Puerto Rico has a long history of many disastrous hurricanes, as once again this year with the devastating Hurricane Maria. These disasters recur frequently, historically speaking, in an island located “in the heart of hurricane territory.” Some notable examples follow, along with descriptions excerpted from various accounts of them.

• In 1867, “Hurricane San Narciso devastated the island.” (Before reaching Puerto Rico, it caused “600 deaths by drowning and 50 ships sunk” in St. Thomas.)

• In 1899, Hurricane San Ciriaco “leveled the island” and killed 3,369 people, including 1,294 drowned.

• In 1928, “Hurricane San Felipe…devastated the island”…“the loss caused by the San Filipe hurricane was incredible. Hundreds of thousands of homes were destroyed. Towns near the eye of the storm were leveled,” with “catastrophic destruction all around Puerto Rico.”

• In 1932, Hurricane San Ciprian “caused the death of hundreds of people”…“damage was extensive all across the island” and “many of the deaths were caused by the collapse of buildings or flying debris.”

• In 1970, Tropical Depression Fifteen dumped an amazing 41.7 inches of rain on Puerto Rico, setting the record for the wettest tropical cyclone in its history.

• In 1989, Hurricane Hugo caused “terrible damage. Banana and coffee crops were obliterated and tens of thousands of homes were destroyed.”

• In 1998 came Hurricane Georges, “its path across the entirety of the island and its torrential rainfall made it one of the worst natural disasters in Puerto Rico’s history”…“Three-quarters of the island lost potable water”…“Nearly the entire electric grid failed”…“28,005 houses were completely destroyed.”

• In 2004, Hurricane Jeanne caused “severe flooding along many rivers,” “produced mudslides and landslides,” “fallen trees, landslides and debris closed 302 roads” and “left most of the island without power or water.”

• And in 2017, as we know, there was Hurricane Maria (closely following Hurricane Irma), with huge destruction in its wake.

These are some of the worst cases. On this list, there are nine over 150 years. That is, on average, one every 17 years or so.

All in all, if we look at the 150-year record from 1867 to now, Puerto Rico has experienced 42 officially defined “major hurricanes”—those of Category 3 or worse. Category 3 means “devastating damage will occur.” Category 4 means “catastrophic damage will occur.” And Category 5’s catastrophic damage further entails “A high percentage of framed homes will be destroyed…Power outages will last for weeks to possibly months. Most of the area will be uninhabitable for weeks or months.”

Of the 42 major hurricanes since 1867 in Puerto Rico, 16 were Category 3, 17 were Category 4 and 9 were Category 5, according to the official Atlantic hurricane database.

Doing the arithmetic (150 years divided by 42), we see that there is on average a major hurricane on Puerto Rico about every 3.5 years.

There is a Category 4 or 5 hurricane every 5.8 years, on average.

And Category 5 hurricanes occur on average about every 17 years.

There are multiple challenging dimensions to these dismaying frequencies–humanitarian, political, engineering, financial. To conclude with the financial question:

How can the repetitive rebuilding of such frequent destruction be financed?  Thinking about it in the most abstract way, somewhere savings have to be built up. This may be either by self-insurance or by the accumulation of sufficiently large premiums paid for insurance bought from somebody else. Self-insurance can include the cost of superior, storm-resistant construction. Or funds could be borrowed for reconstruction, but have to be quite rapidly amortized before the next hurricane arrives. Or somebody else’s savings have to be taken in size to subsidize the recoveries from the recurring disasters.

Is it possible for Puerto Rico to have a long-term strategy for financing the recurring costs of predictably being in the way of frequent hurricanes, other than using somebody else’s savings?

Was the Bank of England right to lie for its country in 1914?

Published by the R Street Institute.

Jean-Claude Juncker, now the president of the European Commission and then head of the European finance ministers, sardonically observed about government officials trying to cope with financial crises:  “When it becomes serious, you have to lie.” The underlying rationale is presumably that the officials think stating the truth might make the crisis worse.

No one would be surprised by politicians lying, but Juncker’s dictum is the opposite of the classic theory of the Roman statesman Cicero, who taught that “What is morally wrong can never be expedient.” Probably few practicing politicians in their hearts agree with Cicero about this. But how about central bankers, for whom public credibility is of the essence?  Should they lie if things are too bad to admit?

An instructive moment of things getting seriously bad enough to lie came for the Bank of England at the beginning of the crisis of the First World War in 1914. At the time, the bank was far and away the top central bank in the world, and London was the unquestioned center of global finance. One might reasonably have assumed the Bank of England to be highly credible.

A fascinating article, “Your country needs funds: The extraordinary story of Britain’s early efforts to finance the First World War” in Bank Underground, a blog for Bank of England staffers, has revealed the less-than-admirable behavior of their predecessors at the bank a century before. Or alternately, do you, thoughtful reader, conclude that it was admirable to serve the patriotic cause by dishonesty?

Fraud is a crime, and the Bank of England engaged in fraud to deceive the British public about the failed attempts of the first big government-war-bond issue. This issue raised less than a third of its target, but the real result was kept hidden. Addressing “this failure and it subsequent cover-up,” authors Michael Anson, et al., reveal that “the shortfall was secretly plugged by the Bank, with funds registered individually under the names of the Chief Cashier and his deputy to hide their true origin.” In other words, the Bank of England bought and monetized the new government debt and lied about it to the public to support the war effort.

The lie passed into the Financial Times under the headline, “OVER-SUBSCRIBED WAR LOAN”—an odd description, to say the least, of an issue that in fact was undersubscribed by two-thirds. Imagine what the Securities and Exchange Commission would do to some corporate financial officer who did the same thing.

But it was thought by the responsible officers of the British government and the Bank of England that speaking the truth would have been a disaster. Say the authors, “Revealing the truth would doubtless have led to the collapse of all outstanding War Loan prices, endangering any future capital raising. Apart from the need to plug the funding shortfall, any failure would have been a propaganda coup for Germany.” Which do you choose: truth or a preventing a German propaganda coup?

We learn from the article that the famous economist, John Maynard Keynes, wrote a secret memo to His Majesty’s Treasury, in which he described the Bank of England’s actions as “compelled by circumstances” and that they had been “concealed from the public by a masterful manipulation.” A politic and memorable euphemism.

Is it right to lie to your fellow citizens for your country? Was it right for the world’s greatest central bank to commit fraud for its country?  The Bank of England thought so in 1914. What do central banks think now?

And what do you think, honored reader?  Suppose you were a senior British official not in on the deception in 1914, but you found out about it with your country enmeshed in the expanding world war. Would you choose the theory of Juncker or Cicero?

Why is Richard Cordray voting on FSOC?

Published by the R Street Institute.

The Financial Stability Oversight Council (FSOC) just made the good decision to remove the designation of the insurance company American International Group as a “SIFI” or “systemically important financial institution.” This was a good idea, because the notion that regulators meeting as a committee should have the discretion to expand their own power and jurisdiction was a bad idea in the first place – one of the numerous bad ideas in the Dodd-Frank Act. The new administration is moving in a sensible direction here.

The FSOC’s vote was 6-3. All three opposed votes were from holdovers from the previous Obama administration. No surprise.

One of these opposed votes was from Richard Cordray, the director of the Consumer Financial Protection Bureau (CFPB). Wait a minute! What is Richard Cordray doing voting on a matter of assessing systemic financial risk? Neither he nor the agency he heads has any expertise or any responsibility or any authority at all on this issue. Why is he even there?

Of course, Dodd-Frank, trying to make the CFPB important as well as outside of budgetary control, made him a member of FSOC. But with what defensible rationale? Suppose it be argued that the CFPB should be able to learn from the discussions at FSOC. If so, its director should be listening and by no means voting.

Mr. Cordray, and any future director of the CFPB attending an FSOC meeting, should have the good grace to abstain from votes while there.

And when in the course of Washington events, the Congress gets around to reforming Dodd-Frank, it should remove the director of the CFPB from FSOC, assuming both continue to exist, and from the board of the Federal Deposit Insurance Corp. while it is at it, on the same logic.

Has Canada’s housing bubble finally reached bursting point?

Published by the R Street Institute.

The attached policy brief originally appeared in the Autumn 2017 issue of Housing Finance International, the quarterly journal of the International Union for Housing Finance.

Both Canadian and foreign observers have watched with wonder as Canadian house prices have continued up and up, waiting for the inevitable correction and fall. Average Canadian house prices are more than three times as high as they were in 2000. They already looked very high in 2012, five years ago, but have risen rapidly, by another 43 percent, since then. They have inflated measured household net worth, inflated household debt and debt-to-income ratios with rapidly expanding mortgages, caused the number of realtors in Toronto to expand by 77 percent in the last decade and they display “an element of speculation,” in the careful words of the governor of the Bank of Canada, Stephen Poloz.

The national Housing Market Assessment of the Canada Mortgage and Housing Corp. “continues to detect strong overall evidence of problematic conditions … due to overvaluation and acceleration in house prices.” This is pretty clear language for a government agency that is itself heavily at risk in the mortgage sector.

“The longer it goes, the bigger it gets, the more you start to be concerned,” said Gov. Poloz in June of this year.

It has gone on very long and gotten very big. Although Canada has a sophisticated and advanced financial system; although the central bank and financial regulators have, a number of times, tightened lending rules to try to moderate the house price inflation; and although the cities of Vancouver and Toronto have put on fees to slow down foreign house buying, the boom has continued. On the other hand, this is not surprising, since the Bank of Canada, like its U.S. counterpart, has run negative real interest rates for most of the last eight years. These reliably induce asset-price inflations and promote bubbles.

As shown in Graph 1, the Canadian house price inflation dwarfs the infamous U.S. housing bubble, which imploded starting in 2007, as well as the U.S. price run-up of the last five years.

To add some perspective to the comparison, total residential mortgages in Canada are C$1.5 trillion, or $1.2 trillion in U.S. dollars. This is equal to about 11 percent of the U.S. outstanding mortgages of $10.3 trillion. In contrast, Canadian 2016 GDP of C$2.0 trillion, or US$1.6 trillion, is 8.7 percent of the U.S. GDP of $18.6 trillion. Thus, mortgage debt in Canada is much higher relative to GDP than in the United States: 73 percent compared to 55 percent.

Notably, 73 percent is about the same ratio as the United States had at the peak in house prices in mid-2006.

Home ownership ratios in the two countries have been similar over time, but Canada’s last census (2011) shows 69 percent home ownership, compared with the recent 63.4 percent in the United States. As shown in Graph 2, this reflects the pumping up of the U.S. home ownership rate during the housing bubble, and then a more than 5 percentage point fall in the wake of its collapse. Whether Canada will experience a similar fall in its home ownership rate with a deflation of its housing bubble is yet to be seen.

Canada’s house prices certainly look toppy to many people: “There’s no question house prices can’t continue at this level” is the conclusion of senior Canadian bank economist Jean-Francois Perrault. “Signs are looking increasingly negative for [the] Canadian housing bubble …The party is increasingly over,” says a Seeking Alpha investment commentary. But calling the timing of the top of a bubble is always tricky. It may make us think of how then-Federal Reserve Chairman Alan Greenspan suggested in 1996 that U.S. stock prices were excessive and were displaying “irrational exuberance.” After his speech, stock prices continued to go up for three more years. In the event, they crashed in 2000, so Greenspan turned out to be right in the long term – but he missed the timing by an embarrassingly long way, and failed to reissue his warning in 1999 when the irrational exuberance was at its maximum.

Has the Canadian housing bubble reached bursting point at last? Has it possibly seen a “canary in the coal mine”? One house price index for metropolitan Toronto, Canada’s largest city and financial capital, fell 4.6 percent from June to July. Although prices are still up strongly from a year earlier, the number of house sales was down 40 percent from the previous year. At the same time, there was “a surge in new listings as homeowners saw a downturn looming and rushed to list their houses before prices fell…adding a flood of new inventory to the market,” reported Toronto’s Globe and Mail.

Was that a summer blip or a changed trend? The Toronto realtors’ association suggested that it “had more to do with psychology.” Yes, booms and busts in house prices always have a lot to do with psychology and sharp swings between greed and fear in beliefs about the future. There are, the realtors’ association said, “would-be home buyers on the sidelines waiting to see how market conditions evolve” – waiting for lower prices, that is. The problem is that if enough people wait for lower prices, the prices will get lower.

“Everyone agrees it’s a bubble; now the question is, how it ends,” says another Canadian economist, David Madani, who predicts it will be a hard landing with house prices falling 20 percent to 40 percent. But whether Canada’s long-running house price boom will end with a bang or a whimper, a hard or soft landing, a difficult time or a disaster, is just what no one knows. If house prices fall significantly, a lot of unrealized, paper “wealth” will disappear (it was not really there in the first place), mortgage defaults will increase, credit will become tighter, politicians will overreact and real estate brokers will grow fewer instead of multiplying. But Canada will not necessarily follow the housing bubble deflation patterns of the United States, or of any other country – the United Kingdom, Ireland or Spain, for example.

Comparing Canada and the United States, two key institutional differences are apparent. One is that Canadian residential mortgages have full recourse to the borrower, in case the price of the house is insufficient to cover the mortgage debt. This case becomes more likely after a bubble, especially for those who bought near the top. In contrast, in the United States, either by law or practice, most mortgages are nonrecourse, and can effectively be settled by “jingle mail” – moving out and sending the keys to the lender.

A second key difference is that the overwhelming majority, 87 percent of residential mortgages in Canada, are held on the balance sheets of depository institutions. C$1.1 trillion of the mortgages are on the books of the chartered banks, and C$191 billion of the credit unions, for a combined C$1.3 trillion out of total mortgages of C$ 1.5 trillion. In contrast, U.S. depositories hold $ 2.4 trillion in whole mortgage loans and $ 1.8 trillion in residential mortgage-backed securities, which combined make $ 4.2 trillion; so only 41 percent of the total mortgages are on the books of the banks. This gives Canadian mortgage finance an entirely different institutional structure. In the U.S. case, most mortgages were and are held by investors in mortgage securities, who have no direct relationship with the borrowing customer and no role in making the loan in the first place. While at one time promoted as a more advanced system, this made managing the deflation of the U.S. housing bubble much more difficult.

On the other hand, there is an important similarity between the Canadian and U.S. cases: major government guarantees of mortgages, thus government promotion of mortgage debt and exposure to mortgage credit risk. In the United States, this happens through the guarantees of mortgage credit risk by Fannie Mae, Freddie Mac and Ginnie Mae, which now add up to $6.1 trillion or 59 percent of the total residential mortgages. The Canada Mortgage and Housing Corp. (CMHC), itself explicitly guaranteed by the government, insures C$502 billion of mortgage loans, or 35 percent of the total market. In addition, it guarantees C$ 457 billion of mortgage-backed securities – but the securities largely contain government-insured loans, so this is a double guaranty of the same underlying credit risk.

How would CMHC fare if the Canadian bubble turns into a serious house price deflation? We may find out.

How does the United States rank in homeownership?

Published by the R Street Institute.

There are a lot of different housing-finance systems in the world, but the U.S. system is unique in being centered on government-sponsored enterprises. These GSEs—Fannie Mae and Freddie Mac—still dominate the system even though they went broke and were bailed out when the great housing bubble they helped inflate then deflated.

They have since 2008 been effectively, though not formally, just part of the government. Adding together Fannie, Freddie and Ginnie Mae, which is explicitly part of the government, the government guarantees $6.1 trillion of mortgage loans, or ­­59 percent of the national total of $10.3 trillion.

On top of Fannie-Freddie-Ginnie, the U.S. government has big credit exposure to mortgages through the Federal Housing Administration, the Federal Home Loan Banks and the Department of Veterans Affairs. All this adds up to a massive commitment of financing, risk and subsidies to promote the goal of homeownership.

But how does the United States fare on an international basis, as measured by rate of homeownership?  Before you look at the next paragraph, interested reader, what would you guess our international ranking on home ownership is?

The answer is that, among 27 advanced economies, the United States ranks No. 21. This may seem like a disappointing result, in exchange for so much government effort.

Here is the most recent comparative data, updated mostly to 2015 and 2016:

 Sources: Government statistics by country

It looks like U.S. housing finance needs some new ideas other than providing government guarantees.

How big a bank is too big to fail?

Published by the R Street Institute.

The notion of “too big to fail”—an idea that would play a starring role in banking debates from then to now—was introduced by then-Comptroller of the Currency Todd Conover in testimony before Congress in 1984. Conover was defending the bailout of Continental Illinois National Bank. Actually, since the stockholders lost all their money, the top management was replaced and most of the board was forced out, it was more precisely a bailout of the bank’s creditors.

Continental was the largest crisis at an individual bank in U.S. history up to that time. It has since been surpassed, of course.

Conover told the House Banking Committee that “the federal government won’t currently allow any of the nation’s 11 largest banks to fail,” as reported by The Wall Street Journal. Continental was No. 7, with total assets of $41 billion. The reason for protecting the creditors from losses, Conover said, was that if Continental had “been treated in a way in which depositors and creditors were not made whole, we could very well have seen a national, if not an international crisis the dimensions of which were difficult to imagine.” This is the possibility that no one in authority ever wants to risk have happen on their watch; therefore, it triggers bailouts.

Rep. Stewart McKinney, R-Conn., responded during the hearing that Conover had created a new kind of bank, one “too big to fail,” and the phrase thus entered the lexicon of banking politics.

It is still not clear why Conover picked the largest 11, as opposed to some other number, although he presumably because he needed to make Continental appear somewhere toward the middle of the pack. In any case, here were the 11 banks said to be too big to fail in 1984, with their year-end 1983 total assets – which to current banking eyes, look medium-sized:

If you are young enough, you may not remember some of the names of these once prominent banks that were pronounced too big to fail. Only two of the 11 still exist as independent companies: Chemical Bank (which changed its name to Chase in 1996 and then merged with J.P. Morgan & Co. in 2000 to become JPMorgan Chase) and Citibank (now Citigroup), which has since been bailed out, as well. All the others have disappeared into mergers, although the acquiring bank adopted the name of the acquired bank in the cases of Bank of America, Morgan and Wells Fargo.

The Dodd-Frank Act is claimed by some to have ended too big to fail, but the relevant Dodd-Frank provisions are actually about how to bail out creditors, just as was the goal with Continental. Thus in the opposing view, it has simply reinforced too big to fail. I believe this latter view is correct, and the question of who is too big to fail is very much alive, controversial, relevant and unclear.

Just how big is too big to fail?

Would Continental’s $41 billion make the cut today? That size now would make it the 46th biggest bank.

If we correct Continental’s size for more than three decades of constant inflation, and express it in 2016 dollars, it would have $97 billion in inflation-adjusted total assets, ranking it 36th as of the end of 2016. Is 36th biggest big enough to be too big to fail, assuming its failure would still, as in 1984, have imposed losses on hundreds of smaller banks and large amounts of uninsured deposits?

If a bank is a “systemically important financial institution” at $50 billion in assets, as Dodd-Frank stipulates, does that mean it is too big to fail?  Is it logically possible to be one and not the other?

Let us shift to Conover’s original cutoff, the 11th biggest bank. In 2016, that was Bank of New York Mellon, with assets of $333 billion. Conover would without question have considered that—could he have imagined it in 1984—too big to fail. But now, is the test still the top 11?  Is it some other number?

Is $100 billion in assets a reasonable round number to serve as a cutoff? That would give us 35 too big to fail banks. At $250 billion, it would be 12. That’s close to 11. At $500 billion, it would be six. We should throw in Fannie Mae and Freddie Mac, which have been demonstrated beyond doubt to be too big to fail, and call it eight.

A venerable theory of central banking is always to maintain ambiguity. A more recent theory is to have clear communication of plans. Which approach is right when it comes to too big to fail?

My guess is that regulators and central bankers would oppose anything that offers as bright a line as “the 11 biggest”; claim to reject too big to fail as a doctrine; strive to continue ambiguity; and all the while be ready to bail out whichever banks turn out to be perceived as too big to fail whenever the next crisis comes.

Virgin Islands follow Puerto Rico into the debt day of reckoning

Published by the R Street Institute.

What do Puerto Rico and the U.S. Virgin Islands have in common?  They are both islands in the Caribbean, they are both territories of the United States and they are both broke.

Moreover, they both benefited (or so it seemed in the past) from a credit subsidy unwisely granted by the U.S. Congress: having their municipal bonds be triple-tax exempt everywhere in the country, something U.S. states and their component municipalities never get. This tax subsidy helped induce investors and savers imprudently to overlend to both territorial governments, to finance their ongoing annual deficits and thus to create the present and future financial pain of both.

Puerto Rico, said a Forbes article from earlier this year—as could be equally said of the Virgin Islands—“could still be merrily chugging along if investors hadn’t lost confidence and finally stopped lending.” Well, of course:  as long as the lenders foolishly keep making you new loans to pay the interest and the principal of the old ones, the day of reckoning does not yet arrive.

In other words, both of these insolvent territories experienced the Financial Law of Lending. This, as an old banker explained to me in the international lending crisis of the 1980s, is that there is no crisis as long as the lenders are merrily lending. The crisis arrives when they stop lending, as they inevitably do when the insolvency becomes glaring. Then everybody says how dumb they are for not having stopped sooner.

Adjusted for population size, the Virgin Islands’ debt burden is of the same scale as that of Puerto Rico. The Virgin Islands, according to Moody’s, has public debt of $2 billion, plus unfunded government pension liabilities of $2.6 billion, for a total $4.6 billion. The corresponding numbers for Puerto Rico are $74 billion and $48 billion, respectively, for a total $122 billion.

The population of the Virgin Islands is 106,000, while Puerto Rico’s is 3.4 million, or 32 times bigger. So we multiply the Virgin Islands obligations by 32 to see how they compare. This gives us a population-adjusted comparison of $64 billion in public debt, and unfunded pensions of $83 billion, for a total $147 billion. They are in the same league of disastrous debt burden.

What comes next?  The Virgin Islands will follow along Puerto Rico’s path of insolvency, financial crisis, ultimate reorganization of debt, required government budgetary reform and hoped for economic improvements.

A final similarity: The Virgin Islands’ economy, like that of Puerto Rico, is locked into a currency union with the United States from which, in my opinion, it should be allowed to escape. This would add external to the imperative internal adjustment, as the debt day of reckoning arrives.

Presentation to IUHF World Congress

This presentation on the topic of federal government intervention in the U.S. housing market was delivered by R Street Distinguished Senior Fellow Alex Pollock at the 30th International Union for Housing Finance World Congress in Washington, D.C.

Even without Durbin Amendment repeal, Congress should pass the CHOICE Act

Published by the R Street Institute with Clark Packard.

House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has done the yeoman’s work of putting together a host of fundamantal conservative reforms in the CHOICE Act. Although repeal of the Durbin amendment would have been a positive, pro-market reform, Congress should pass the bill even if this repeal is not included.

The most important provision of the bill allows banks the very sensible choice of maintaining substantial equity capital in exchange for a reduction in onerous and intrusive regulation. This provision puts before banks a reasonable and fundamental trade-off: more capital, less intrusive regulation. This is reason enough to support the CHOICE Act. Its numerous other reforms also include improved constitutional governance of administrative agencies, which are also a key reason to support the bill.

Accountability of banks

The 10 percent tangible leverage capital ratio, conservatively calculated, as proposed in the CHOICE Act, is a fair and workable level.

A key lesson of the housing bubble was that mortgage loans made with 0 percent skin in the game are much more likely to cause trouble. To be fully accountable for the credit risk of its loans, a bank can keep them on its own balance sheet. This is 100 percent skin in the game. The CHOICE Act rightly gives relief to banks holding mortgage loans in portfolio from regulations that try to address problems of a zero skin in the game model – problems irrelevant to the incentives of the portfolio lender.

Accountability of regulatory agencies

The CHOICE Act is Congress asserting itself to clarify that regulatory agencies are derivative bodies accountable to the legislative branch. They cannot be sovereign fiefdoms, not even the dictatorship of the Consumer Financial Protection Bureau. The most classic and still most important power of the legislature is the power of the purse.  The CHOICE Act accordingly puts all the financial regulatory agencies under the democratic discipline of congressional appropriations. This notably would end the anti-constitutional direct grab from public funds that was granted to the CFPB precisely to evade the democratic power of the purse.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. Overall, this represents very significant progress in the governance of the administrative state and brings it under better constitutional control.

Accountability of the Federal Reserve

The CHOICE Act includes the text of The Fed Oversight Reform and Modernization Act, which improves governance of the Federal Reserve by Congress. As a former president of the New York Federal Reserve Bank once testified to the House Committee on Banking and Currency: “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.” That is entirely correct. Under the CHOICE Act, such reviews would happen at least quarterly. These reviews should include having the Fed quantify and discuss the effects of its monetary policies on savings and savers.

Reform for community banks

A good summary of the results of the Dodd-Frank Act is supplied by the Independent Community Bankers of America’s “Community Bank Agenda for Economic Growth.” “Community banks,” it states, “need relief from suffocating regulatory mandates. The exponential growth of these mandates affects nearly every aspect of community banking. The very nature of the industry is shifting away from community investment and community building to paperwork, compliance and examination,” and “the new Congress has a unique opportunity to simplify, streamline and restructure.”

So it does. The House of Representatives should pass the CHOICE Act.

Puerto Rico’s inevitable debt restructuring arrives

Published by the R Street Institute.

“Debt that cannot be repaid will not be repaid” is Pollock’s Law of Finance. It applies in spades to the debt of the government of Puerto Rico, which is dead broke.

Puerto Rico is the biggest municipal market insolvency and, now, court-supervised debt restructuring in history. Its bond debt, in a complex mix of multiple governmental issuers, totals $74 billion. On top of this, there are $48 billion in unfunded public-pension liabilities, for a grand total of $122 billion. This is more than six times the $18.5 billion with which the City of Detroit, the former municipal insolvency record holder, entered bankruptcy.

The Commonwealth of Puerto Rico will not enter technical bankruptcy under the general bankruptcy code, which does not apply to Puerto Rico. But today, sponsored by the congressionally created Financial Oversight and Management Board of Puerto Rico, it petitioned the federal court to enter a similar debtor protection and debt-settlement proceeding. This framework was especially designed by Congress for Puerto Rico under Title III of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) of 2016. It was modeled largely on Chapter 9 municipal bankruptcy and will operate in similar fashion.

This moment was inevitable, and Congress was right to provide for it. It is a necessary part of the recovery of Puerto Rico from its hopeless financial situation, fiscal crisis and economic malaise. But it will make neither the creditors, nor the debtor government, nor the citizens of Puerto Rico happy, for all have now reached the hard part of an insolvency: sharing out the losses. Who gets which losses and how much the various interested parties lose is what the forthcoming proceeding is all about.

The proceedings will be contentious, as is natural when people are losing money or payments or public services, and the Oversight Board will get criticized from all sides. But it is responsibly carrying out its duty in a situation that is difficult, to say the least.

There are three major problems to resolve to end the Puerto Rican financial and economic crisis:

• First, reorganization of the government of Puerto Rico’s massive debt: this began today and will take some time. In Detroit, the bankruptcy lasted about a year and a half.

• Second, major reforms of the Puerto Rican government’s fiscal and financial management, systems and controls. Overseeing the development and implementation of these is a key responsibility of the Oversight Board.

• Third—and by far the most difficult step and the most subject to uncertainty—is that Puerto Rico needs to move from a failed dependency economy to a successful market economy. Economic progress from internally generated enterprise, employment and growth is the necessary long-term requirement. Here there are a lot of historical and political obstacles to be overcome. Not least, as some of us think, is that Puerto Rico is trapped in the dollar zone so it cannot have external adjustment by devaluing its currency.

The first and second problems can be settled in a relatively short time; the big long-term challenge, needing the most thought, is the third problem.

The story of the Puerto Rican financial and economic crisis just entered a new chapter, but it is a long way from over.

CHOICE Act would be major progress for financial system

Published by the R Street Institute.

Mr. Chairman, Ranking Member Waters and members of the committee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I have spent more than four decades working in and on banking and housing finance, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago and 11 years focused on financial policy issues at the American Enterprise Institute, before joining R Street last year. I have experienced and studied many financial crises and their political aftermaths, starting when the Federal Reserve caused the Credit Crunch of 1969 when I was a bank trainee.

My discussion will focus on three key areas of the proposed CHOICE Act. All deal with essential issues and, in all three, the CHOICE Act would create major progress for the financial system, for constitutional government and for financing economic growth. These areas are accountability, capital and congressional governance of the administrative state.

The CHOICE Act is long and complex, but there are a very large number of things to fix—like the Volcker Rule, among many others– in the even longer Dodd-Frank Act.

A good summary of the real-world results of Dodd-Frank is supplied by the “Community Bank Agenda for Economic Growth” of the Independent Community Bankers of America. “Community banks,” it states, “need relief from suffocating regulatory mandates. The exponential growth of these mandates affects nearly every aspect of community banking. The very nature of the industry is shifting away from community investment and community building to paperwork, compliance and examination.” I think this observation is fair.

The Community Bankers continue: “The new Congress has a unique opportunity to simplify, streamline and restructure.” So it does, and I am glad this committee is seizing the opportunity.

In November 2016, Alan Greenspan remarked, “Dodd-Frank has been a—I wanted to say ‘catastrophe,’ but I’m looking for a stronger word.” Although the financial crisis and the accompanying recession had been over for a year when Dodd-Frank was enacted, in the wake of the crisis, as always, there was pressure to “do something” and the tendency to overreact was strong. Dodd-Frank’s something-to-do was to expand regulatory bureaucracy in every way its drafters could think of—it should be known as the Faith in Bureaucracy Act. This was in spite of the remarkably poor record of the government agencies, since they were important causes of, let alone having failed to avoid, the housing bubble and the bust. Naïve faith that government bureaucracies have superior knowledge of the financial future is a faith I do not share.

Accountability of the Administrative State

Accountability is a, perhaps the, 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 be accountable? Who should be its boss?

The answer to all these questions is of course: the Congress. We should all agree on that. All these agencies of government, populated by unelected employees, 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 which is at the heart of our constitutional order. This also applies to the Federal Reserve. In spite of its endlessly repeated slogan that it must be “independent,” the Federal Reserve must equally be accountable.

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 for its obligation to ensure that checks and balances actually operate.

The CHOICE Act is an excellent example of the Congress 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—and 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. Regulatory expansions 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 not to do the analysis—indeed, forthrightly to confront 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—I hope it will—to scrapping the ones that didn’t work.

To enhance and provide an overview of the regulatory agencies’ cost-benefit analyses, the CHOICE Act requires the formation of a Chief Economists Council, comprising the chief economist of each agency. This appeals to me, because it might help the views of the economists, who tend to care a lot about benefits versus costs, balance those of their lawyer colleagues, who may not.

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 strikes me as a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

Taken together, these provisions are major increases in the accountability of regulatory agencies to the Congress and ultimately to the people. They are very significant steps forward in the governance of the administrative state and bringing it under better constitutional control.

Accountability of the Federal Reserve

A word more on the Federal Reserve in particular, since the CHOICE Act devotes a title to “Fed Oversight Reform and Modernization” (FORM), which includes improving its governance by Congress. In a 1964 report, “The Federal Reserve after Fifty Years,” the Domestic Finance Subcommittee of the ancestor of this committee, then called the House Committee on Banking and Currency, disapprovingly reviewed the idea that the Federal Reserve should be “independent.” This was in a House and committee controlled by the Democratic Party. The report has this to say:

• “An independent central bank is essentially undemocratic.”

• “Americans have been against ideas and institutions which smack of government by philosopher kings.”

• “To the extent that the [Federal Reserve] Board operates autonomously, it would seem to run counter to another principle of our constitutional order—that of the accountability of power.”

In my view, all these points are correct.

The president of the New York Federal Reserve Bank testified to the 1964 committee: “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.” That is entirely correct, too.

Under the CHOICE Act, such reviews would happen at least quarterly. I would like to suggest an additional requirement for these reviews. I believe that the Federal Reserve should 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 more than $2 trillion from savers and given it to borrowers. The Federal Reserve may 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.

Accountability of Banks

Let me turn to accountability in banking, under two themes: providing sufficient equity to capitalize your own risks; and bearing the risk you create—otherwise known as “skin in the game.”

The best-known provision of the CHOICE Act is to allow banks the very sensible choice of having substantial equity capital—to be specific, a 10 percent or more tangible leverage capital ratio—in exchange for reduction in onerous and intrusive regulation. Such regulation becomes less and less justifiable as the capital rises. As I testified last July, this is a rational and fundamental trade-off: More capital, less intrusive regulation. Want to run with less capital and thus push more of your risk onto the government? You get more regulation.

It is impossible to argue against the principle that there is some level of equity capital at which this trade-off makes sense for everybody—some level of capital at which everyone, even habitual lovers of bureaucracy, would agree that the Dodd-Frank burdens are superfluous, with costs higher than their benefits.

But exactly what that level is, can be and is, disputed. Because banking markets are so shot through with government guarantees and distortions, there is no clear market test. All answers are to some degree theoretical, and the estimates vary—some think the number is less than 10 percent leverage capital—for example, economist William Cline finds that optimal bank leverage capital is 7 percent—or 8 percent to be conservative. Some think it is more—15 percent has been suggested more than once. The International Monetary Fund came up with a desired risk-based capital range which they concluded was “consistent with 9.5 percent” leverage capital—that’s pretty close to 10 percent. Distinguished banking scholar Charles Calomiris suggested “roughly 10 percent.” My opinion is that the fact that no one knows the exactly right answer should not stop us from moving in the right direction.

All in all, it seems to me that the 10 percent tangible leverage capital ratio, conservatively calculated, as proposed in the CHOICE Act is a fair and workable level to attain “qualifying banking organization” status, in other words, the more capital-less onerous regulation trade-off. The ratio must be maintained over time, with a one-year remediation period if a bank falls short, and with immediate termination of the qualifying status if its leverage capital ratio ever falls below 6 percent—a ratio sometimes considered very good. All this seems quite reasonable to me.

The CHOICE Act mandates a study of the possible regulatory use of the “non-performing asset coverage ratio,” which is similar to the “Texas ratio” from the 1980s. The point is to compare the level of delinquent and nonaccrual assets to the available loan loss reserves and capital, as a way of estimating how real the book equity is. This study is a good idea.

To be fully accountable for the credit risk of your loans, you can keep them on your own balance sheet. This is 100 percent skin in the game. One of the true (not new, but true) lessons of the housing bubble was that loans made with 0 percent skin in the game are much more likely to cause trouble. So Dodd-Frank made up a bunch of rules to control the origination of mortgages which feed into a zero skin in the game system. These rules are irrelevant to banks that keep their own loans.

The CHOICE Act therefore gives relief to banks holding mortgage loans in portfolio from regulations which arose from problems of subprime securitization, problems alien to the risk structure and incentives of the portfolio lender.

Accountability for Deals with Foreign Regulators

A challenging issue in the governance of the administrative state are deals that the Treasury and the Federal Reserve are alleged to have made with foreign regulators and central bankers, is in the context of their participation in the international Financial Stability Board (FSB). These deals have been made, the suggestion is, outside of the American legal process, and then imported to the United States.

Were there any such deals, or were there merely discussions?

We know that the FSB has publicly stated that it will review countries for “the implementation and effectiveness of regulatory, supervisory or other financial sector standard and policies as agreed by the FSB.” As agreed by the FSB?  Does that mean a country, specifically the United States, is supposed to be bound by deals made in this committee?  Did the American participants in these meetings feel personally committed to implement some agreements?

We also know that there is a letter that would shine light on this question: a September 2014 letter from Mark Carney, the governor of the Bank of England and chairman of the FSB, to then-Treasury Secretary Lew. This letter allegedly reveals the international discussions about American companies, including it is said, whether Berkshire Hathaway should be designated a systemically important insurer (an idea not politically popular with the Obama administration). A Freedom of Information Act request for the letter has previously been denied by the Treasury, which admits, however, that it exists.

I believe that Congress should immediately request a copy of this letter as part of its consideration of the “International Processes” subtitle of the CHOICE Act. While at it, Congress should request any other correspondence regarding possible agreements within the FSB.

The international subtitle rightly requires regulatory agencies and the Treasury to tell the Congress what subjects they are addressing in such meetings and whether any agreements have been made.

Accountability for Emerging Financial System Risks

The CHOICE Act makes a number of positive changes to the structure and functions of the Financial Stability Oversight Council (FSOC). Here I would like to suggest a possible addition.

I believe the responsibility for reporting to Congress on identified emerging financial system risks should be clearly assigned to the secretary of the Treasury. As the Chairman of FSOC, the secretary is in charge of whatever discussions are required with regulatory agencies, the Federal Reserve or foreign governments.

Forecasts of the unknowable financial future are hard to get right, needless to say, but I believe a unified, single assignment of responsibility for communications with Congress of the best available risk assessments would be a good idea.

Thank you again for the chance to share these views.

What’s next for U.S. housing finance?

Published by the R Street Institute.

The attached policy study originally was published in the Spring 2017 edition of Housing Finance International.

With the new administration of President Donald Trump, and simultaneous Republican majorities in both houses of the Congress, can the United States look forward to meaningful reform of Fannie Mae, Freddie Mac and American housing finance?

My view is that it is highly unlikely. The interested parties and the policy ideas are simply too fragmented for a politically energetic solution to emerge and be enacted. Many powerful interest groups are fond of the subsidies that Fannie and Freddie pass on to them from the taxpayers. At the same time, a dissonant chorus of well-intentioned theoreticians promote mutually inconsistent proposals.

The topic of the debates—the American housing finance sector—is genuinely huge, with $10.2 trillion in outstanding mortgage loans. That is a number about equal to the combined gross domestic products of Germany, France, the United Kingdom and Canada.

U.S. housing finance also has a troubled history. It collapsed in the 1980s, when based on the savings and loan model, and required a $150 billion taxpayer bailout. The bonds sold to finance that bailout won’t be paid in full for another 13 years from now – until 2030. The 1980s U.S. housing finance scandal led to abolition of the government’s housing finance promoter and regulator of the time, the Federal Home Loan Bank Board, in 1989. One of the lessons drawn by American financial regulators at that point was that housing finance needed to focus on the securitization of mortgages, a less-than-perfect conclusion.

So, the United States tried again, this time with a model that featured at its core securitization and the “government-sponsored enterprises” Fannie Mae and Freddie Mac. Fannie and Freddie rapidly expanded mortgage credit by issuing trillions of dollars in mortgage-backed securities and debt in highly leveraged balance sheets, which always depended on the so-called “implicit” guarantee of the U.S. government. That was a mistake, but they and the politicians who promoted them foolishly claimed that this model was “the envy of the world.” Both government-sponsored and private mortgage securitization inflated. The increase in outstanding mortgage loans was remarkable, as shown in Graph 1, and was accompanied by political cheering.

Total American mortgage loans reached $2 trillion in 1988. By 2006, during the golden years of Fannie and Freddie, they had quintupled to $10 trillion. Nominal GDP increased by 2.6 times during this period, so mortgage debt was growing far faster the economy for years, a clear danger sign in retrospect. There was an acceleration after 1998, when mortgages crossed $4 trillion. Today, after the fall, total mortgage loans are at about the same level as in 2006, having gone basically sideways for a decade. Graph 2 shifts to the long-term growth of total U.S. mortgage loans relative to the size of the economy, measured as a percent of GDP – and displays an instructive history.

In this graph, we see first the post-World War II U.S. mortgage credit boom, which ran until 1964. Then mortgages as a percent of GDP were flat at about 30 percent for 20 years. They rose to 45 percent in the 1980s-1990s, then took off with the great mortgage bubble, reaching 77 percent in 2007 as disaster loomed.

At that point, as we know, the American housing finance sector, with its post-1980s “improvements,” had an even bigger collapse than before, including the failure of Fannie and Freddie. Among the bailouts of the time was a $189 billion crisis equity infusion in the deeply insolvent Fannie and Freddie by the taxpayers. Fannie and Freddie thus became subsidiaries of the U.S. government. They remain so to this day, almost nine years after their humiliating failure.

Since the top of the bubble, total U.S. mortgages as a percent of GDP have fallen to 55 percent. This is sharply corrected from the peak, but is still a high level, historically speaking – equal to the proportion in 2002 and close to twice the level of 1964 or 1980.

Because of their government support, Fannie and Freddie remain powers in the American mortgage system. They guarantee or own $4.9 trillion of mortgage loans – or 48 percent of all the mortgage loans in the United States. They have combined $5.3 trillion in total assets and $5.3 trillion in liabilities. You will readily see by arithmetic that they have no net worth to speak of.

The Treasury Department controls 79.9 percent of the common stock of Fannie and Freddie. Why not 80 percent or 100 percent? Because that would have forced the government to put Fannie and Freddie’s $5 trillion of debt on the government’s books – an outcome the government was and is desperate to avoid. Honest accounting is not going to happen, and the Treasury will continue whatever gyrations it takes to keep its Fannie and Freddie exposure as an off-balance-sheet liability.

The Treasury Department also owns $189 billion of senior preferred stock in Fannie and Freddie, the bailout investment. This was the amount required to bring their net worth up to zero, where it remains. Although Fannie and Freddie are now reporting profits – a combined $20.1 billion for 2016 – virtually all of this is paid to the Treasury as dividends on the senior preferred stock, so there is no increase in their capital. The profits made by the government, at least for now, from owning these biggest companies in the mortgage business, and from absorbing half the country’s mortgage credit risk, thus go to help reduce the annual government deficit.

At Dec. 31, 2016, Fannie and Freddie’s combined net worth was about $11 billion, compared to their assets of $5.3 trillion. This gives them a risible capital ratio of 0.2 percent – so close to zero that the difference doesn’t matter.

Fannie and Freddie’s principal business is guaranteeing mortgages. So here is an essential question: What is the value of $5 trillion in guarantees from guarantors with zero capital? Clearly the answer is that such guarantees by themselves have no value. Every bit of the value and all ability of Fannie and Freddie to report a profit comes not from themselves, but from the fact that the government truly (though not formally) guarantees their $5.3 trillion in liabilities. In this sense, it certainly seems fair that the Treasury continue to take all the profits which its guarantee creates.

The government is also involved in directly financing Fannie and Freddie’s debt, for the U.S. central bank has in its investment portfolio the remarkable amount of $1.7 trillion of Fannie and Freddie’s mortgage-backed securities. Thus, the Federal Reserve owns and has monetized one-third of Fannie and Freddie’s liabilities and one-sixth of all the mortgages in the country. This is unorthodox central banking, to say the least. The Fed is still buying Fannie and Freddie’s MBS, eight years after the 2009 end of the crisis, as they make new investments to replace any maturity or prepayment of principal. The Fed’s interest-rate risk position is exactly like that of a 1980s savings and loan institution: long-term, fixed rate mortgages funded short. How will that turn out? One must wonder.

In the meantime, the Fed is reporting billions of dollars of short-term profits from investing in long-term fixed-rate mortgages and funding them with floating rate deposits. The bulk of this profit it then pays to the U.S. Treasury. The scheme reduces the government deficit in the short run by speculating in the interest rate risk of mortgages guaranteed by Fannie and Freddie and in turn guaranteed by the Treasury. The financial relationships of the Federal Reserve, the Treasury Department and Fannie and Freddie make an intriguing tangle. One plausible argument is that we should view them all together as one financial entity, the intertwined Treasury-Fed-Fannie-Freddie financial combine.

Viewed from the rest of the world, the American housing finance system is not only impressively big, but odd and indeed unique. The thing that makes it most odd continues to be the role and financial structure of Fannie and Freddie. In addition to their function of guaranteeing and massively concentrating mortgage credit risk, it is clear that they are entirely wards of the state and intertwined in a very complex fashion in the government’s finances.

What’s next for U.S. housing finance? Will Fannie and Freddie just continue forever as subsidiaries of the government? Nobody admits to liking the status quo very much. But the status quo has tremendous inertia and has proved highly resistant to change over the last eight years.

Do Fannie and Freddie as government subsidiaries represent a good model for American housing finance? For those (like me) who believe in competitive, private markets as the superior form of allocating resources and risk, the answer is obviously “no.” In particular, people like me think that reinstating anything like the former disastrous Fannie and Freddie “GSE” structure would be a monumental mistake. Many people do not want to see another government bailout of a Fannie and Freddie that have eternally zero capital. Many others correctly think that private capital should bear the principal credit risk in the mortgage market. Speculators who have bought the 20.1 percent of Fannie and Freddie’s common stock that the government does not control, or who own the old, junior preferred stock whose noncumulative dividends have not been paid for years, hope for some political event that will generate windfall gains for them.

All these people would like change, but there is no consensus proposal. Moreover, many other interests wouldn’t mind seeing the old Fannie and Freddie come back, or even the current Fannie and Freddie continue.

For example, homebuilders like having the government guarantee mortgages so it’s easier to sell houses, including bigger and more expensive houses. Realtors like anything that helps sell houses faster and increases their commissions. Investment banks find it easier and more profitable to sell mortgage-backed securities around the world when they are guaranteed by the U.S. government. Then they can be marketed as so-called “rate products,” where the investors don’t have to worry about credit risk. In addition, these firms can then more make money selling swaps and options to hedge the interest rate risk of Fannie and Freddie MBS. Affordable housing groups like the subsidies that Fannie and Freddie used to pass out so freely, as do left-leaning politicians looking for ways to get money for their constituents without facing a vote in Congress.

For several years after the most recent housing crisis, it seemed that Fannie and Freddie’s egregious failure, and their embarrassing bailout, would surely trigger some kind of fundamental reform. But it didn’t. Bills were introduced in Congress, but didn’t pass. Many plans for how to reform American housing finance in general and Fannie and Freddie in particular were published, and some of them widely circulated and debated, but years went by and nothing happened.

The Trump administration would clearly have different ideas for housing finance reform than its predecessor, but in its early months, it has not so far articulated any specific recommendations. The new secretary of the Treasury, Steven Mnuchin, has previously said that continuing government ownership of Fannie and Freddie is unacceptable, but has not yet provided any proposed path to change it.

In my opinion, no legislative reform proposals, whether from the new administration or elsewhere, have a high probability of success in any near term. But there is one possibility we should consider as the one that makes the most sense.

This requires admitting that we cannot get rid of Fannie and Freddie, and that we cannot stop the government from making them “too big to fail” whenever they next get themselves in trouble. However, we should in the meantime take away all the special government favors and sponsorship that allowed Fannie and Freddie to so distort the gigantic American housing finance market.

I propose that Fannie and Freddie should be treated in exactly the same way as every other trillion-dollar bank—that is, exactly the same as Citigroup, JPMorgan Chase, Bank of America, Well Fargo and the like. They should have the same capital requirements—with a minimum of 5 percent equity capital to total assets. They should make equivalent payments to the government for their taxpayer credit support, just as the banks do for deposit insurance. They should lose their indefensible exemption from state and local corporate income taxes. They should be clearly designated as the “systemically important” institutions they so obviously are and be regulated just like the other big banks under the forceful hand of the Federal Reserve.

Life under these terms would be harder for Fannie and Freddie than just living on the free guarantee from the taxpayers as a subsidiary of the government. But the American housing finance sector would be healthier, more based on private capital and less prone to entering yet another collapse.

Is this scenario possible? Yes. Is it likely? No.

Murphy’s Law and a banking career

Published by the R Street Institute.

Murphy’s law is well-known in the form: “Whatever can go wrong, will go wrong” and similar variations on the theme. But the intellectually interesting substance of Murphy’s law is:  “Whatever can go wrong, will go wrong, given enough time.”

When a financial calamity has a very small probability of occurring—let’s say a 1 percent chance that it will and 99 percent that it won’t in any given year—we tend not, as a practical matter, to worry about it much. In most years, nothing will happen, and when it hasn’t happened for a long time, we may even start to treat the risk as essentially zero. Professors Jack Guttentag and Richard Herring authored a classic paper that gave this tendency the provocative name “disaster myopia.”

Banking and finance are full of events with a very small expected probability, but which are very costly when they do happen – e.g., a financial crisis.

Suppose the chance of a financial crisis is 1 percent annually. Suppose you optimistically start your banking career at the age of 23 and work to age 68, by which time you will be seasoned and cynical. That will be 45 years. Because you have given it enough time, the probability that you will experience at least one crisis during your career grows from that 1 percent in your trainee year to a pretty big number: 36 percent.

We observe in the real world that financial crises occur pretty frequently—every decade or two—and that there are a lot of different countries where a financial crisis can start. We also observe that virtually no one—not central bankers, regulators, bankers, economists, stock brokers or anybody else—is good at predicting the financial future successfully. Do we really believe the risk management and credit screens of banks, regulators and central banks are as efficient enough to screen down to a 1 percent probability?  I don’t.

Suppose instead that the probability of the banking crisis is 2 percent, with 98 percent probability that it won’t happen in a given year. Are banks even that good?  How about 5 percent, with a 95 percent probability of not happening?  That would still feel pretty safe. One more dubious of the risk-management skills of bankers, regulators and the rest might guess the probability, in reality, is more like 10 percent, rather than 1 percent. Even then, in most years, nothing will happen.

How does our banker fare over 45 years with these alternate probabilities?  At 2 percent chance per-year, over 45 years, there is a 60 percent probability he will experience at least one crisis. At 5 percent, the probability becomes 90 percent of at least one crisis, with a 67 percent chance to see two or more. If it’s 10 percent, then over 45 years, the probability of experiencing at least one crisis is 99 percent, and the probability of experiencing at least two is 95 percent. Since we learn from troubles and failures, banking looks like it furnishes the probability of an educational career.

In the last 45 years, there have been financial crises in the 1970s, 1980s, 1990s and 2000s. In the 2010s, we have so far had a big sovereign default in Greece, set the record for a municipal insolvency with the City of Detroit, and then broke that record with the insolvency of Puerto Rico. And the decade is not over. All of these crises by decade have been included in my own career around banking systems, of now close to 48 often-eventful years. The first one—the Penn Central Railroad bankruptcy and the ensuing panic in the commercial paper market—occurred when I was a trainee.

Since 1982, on average, a little less than 1 percent of U.S. financial institutions failed per year, but in the aggregate, there were 3,464 failures. Failures are lumped together in crisis periods, while some periods are calm. There were zero failures in the years 2005-2006, just as the housing bubble was at its peak and the risks were at their maximum, and very few failures in 2003-2004, as the bubble dangerously inflated. Of course, every failure in any period was a crisis from the point of view of the careers of then-active managers and employees.

A further consideration is that the probability of a crisis does not stay the same over long periods—especially if there has not been a crisis for some time. As Guttentag and Herring pointed out, risks may come to be treated as if they were zero, which makes them increase a lot. The behavior induced by the years in which nothing happens makes the chance that something bad will happen go up. In a more complex calculation than ours, the probability of the event would rise over each period it doesn’t occur, thanks to human behavior.

But we don’t need that further complexity to see that, even with quite small and unchanging odds of crises, given enough time across a career, the probability that our banker will have one or more intense learning experiences is very high, just as Mr. Murphy suggests.

A flawed process generated by a flawed structure

Published by the R Street Institute.

Testimony to the Subcommittee on Oversight and Investigations
U.S. House Committee on Financial Services

Madam Chairman, Ranking Member Green and members of the Subcommittee, thank you for the opportunity to be here today. I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views. I spent 35 years in banking, including 12 years as president and CEO of the Federal Home Loan Bank of Chicago, and then 11 years as a fellow of the American Enterprise Institute, before joining R Street last year. I have both experienced and studied numerous financial crises and financial cycles, including the political contributions to their creation and the political reactions afterward, and my work includes the issues of banking systems, central banking, risk and uncertainty in finance, housing finance and government-sponsored credit, and extensive study of financial history.

To begin, let me compliment the committee staff for their detailed, specific paper on the FSOC’s non-bank designation process. The paper embodies a very good analytical idea: it “compares the FSOC’s evaluation memoranda [of various companies] against one another to measure the consistency of the FSOC’s analysis.” This comparison, as documented in the paper, results in the conclusions that the treatment of different companies is not consistent, that FSOC did not follow its own formal guidance, and in summary, that the evaluations upon which companies either were or were not designated as systemically risky (as “SIFIs”) “have been characterized by multiple inconsistencies and anomalies on key issues.”

The paper says that “These examples cast doubt on the fairness of the FSOC’s designation process.” They do, but in my opinion, the more important point than fairness, is that the observations cast doubt on the objectivity of the FSOC’s work. Were these evaluations impartial analyses looking for disinterested conclusions, or were they rationalizations for conclusions already reached in political fashion?

As we all know, U.S. District Judge Rosemary Collyer, in her decision on the lawsuit MetLife brought against FSOC, found for MetLife and ruled that FSOC’s action was “arbitrary and capricious.” I want to focus on one of the reasons stressed by the judge: the assumptions FSOC made to arrive at its proposed designation.

Considering hypothetical losses resulting from MetLife, Judge Collyer’s Opinion pointedly observes that: “FSOC assumed that any such losses would affect the market in a manner that ‘would be sufficiently severe to inflict significant damage on the broader economy.’ …These kinds of assumptions pervade the analysis; every possible effect of MetLife’s imminent insolvency was summarily deemed grave enough to damage the economy.” [italics mine]

But the judge continued: “FSOC never projected what the losses would be, which financial institutions would have to actively manage their balance sheets, or how the market would destabilize as a result.” [original italics]

Further, “FSOC was content…to stop short of projecting what could actually happen if MetLife were to suffer material financial distress.” FSOC’s work appears pretty pathetic in this light, doesn’t it?  FSOC “hardly adhered to any standard when it came to assessing MetLife’s threat to U.S. financial stability,” the judge found.

This sound and sensible judicial decision was appealed by the previous administration. I believe the current Treasury Department should immediately request the Department of Justice to withdraw the appeal, and that Justice should do so as soon as possible.

Recall that the point of designation of insurance companies as SIFIs is to give significant regulatory jurisdiction over them to the Federal Reserve Board, an institution with little or no experience in insurance regulation and which certainly cannot be considered expert in it. The Independent Member of FSOC Having Insurance Expertise, Roy Woodall, who indubitably is a true expert in the insurance business and its regulation, voted against the SIFI designation of MetLife. Coming again to FSOC’s assumptions, he objected:  “The analysis relies on implausible, contrived scenarios” [my italics], which moreover, include “failures to appreciate fundamental aspects of insurance and annuity products.”

Mr. Woodall continued that “the central foundation for this designation” is the assumption of “a sudden and unforeseen insolvency of unprecedented scale [and] of unexplained causation.” He reasonably added, “I simply cannot agree with such a premise.” Can anybody?

Voting against the earlier designation of Prudential Financial as a SIFI, Mr. Woodall similarly pointed out that “Key aspects of [FSOC’s] analysis are not supported by the record or actual experience,”  that it presumes “an unfathomable and inexplicable simultaneous insolvency and liquidation of all insurance companies” among its “misplaced assumptions.”

Ed DeMarco, a distinguished financial regulator who was at the time the acting director of the Federal Housing Finance Agency and thus the conservator of Fannie Mae and Freddie Mac, joined the dissent on Prudential and also observed the lack of evidence presented in the FSOC’s evaluation. FSOC proceeded “despite the acknowledgment that no institution has as disproportionally large exposure to Prudential”; it “does not fully take account of the stability of Prudential’s liabilities”; it assumes that “withdrawals at Prudential could lead to runs at other insurance companies without providing supporting evidence.” Once again, FSOC was operating on assumptions.

Of course, Messrs. Woodall and DeMarco were in the minority. But did the majority address their serious and substantial objections?  Was there a meaningful, substantive exchange among FSOC members about the conceptual issues and the relevant evidence, as would be appropriate, before voting the proposal in?  I am told that there was not.

Why not?  The whole point of the existence of FSOC is supposed to be the combined substantive deliberation and development of insights by this committee of the heads of financial regulatory agencies. But it doesn’t seem to happen. So the designation process does not work well not only at the staff level, but also at the level of the FSOC as a corporate body.

I directly asked one former senior FSOC insider from the previous administration if the meetings of FSOC members had ever provided a new insight into financial issues. After thinking a moment, he gave me a candid answer: “No.”

Why is this?  The Milken Institute, in a recent paper, proposed idealistically that although FSOC is currently nothing like this, “policy makers should convert the FSOC into a truly cooperative working group of regulators focused on risks.” To anyone familiar with the ways of Washington, this will seem an unlikely outcome.

The underlying problem, it seems to me, is the structure of FSOC itself. The shortcomings of the designation process reflect the underlying problems with the fundamental design. To begin with, FSOC is primarily a group of individuals each representing a regulatory agency, with turf to protect from intrusions by the others, and a regulatory record to defend from criticism, as principal bureaucratic concerns.

It is a big group, with 15 official members, but in addition, they all bring along helpers and allies. At the FSOC meeting of Dec. 18, 2014—which approved the MetLife SIFI designation—there were, according to its minutes, 46 people present. It’s pretty hard, indeed impossible, to imagine a real, open, give-and-take and “truly cooperative” discussion with 46 people.

Moreover, FSOC is chaired by the secretary of the Treasury, a necessarily very political, powerful senior government actor with major partisan and institutional interests always in play. No company can be taken up for systemic risk study by the SIFI staff without the approval of the secretary. Does this suggest a disinterested analytical process?

The Federal Reserve is a special case in the structural design of FSOC, because it stands to expand its power every time FSOC makes a SIFI designation. Does the Federal Reserve like power?  Would it like to acquire a big new jurisdiction?  Of course, and it is a party at interest in every SIFI discussion. I think it is not unreasonable to suggest that, given the Fed’s major conflict of interest, it should recuse itself from any SIFI votes.

With this context, it is easier to see why the FSOC’s SIFI evaluations had to rely on big assumptions and tended to make inconsistent analyses of different companies. It was because the decisions being made were inherently judgmental, with inherently subjective elements, made amid competing interests—that is to say, unavoidably political.

The shortcomings of the FSOC evaluations appear at least consistent with the theory that the evaluations were meant to rationalize decisions already made. Where might the pressure for such decisions have come from?

One publicly debated possibility is that commitments were already made in the setting of the international Financial Stability Board, in which two of the FSOC members, it is sometimes suspected, made deals with foreign central bankers and regulators about which companies were “global systemically important insurers.” There is dispute about whether the FSB discussions were really agreements, and whether they were thought to be binding. But there is no dispute that the international discussions and the naming of “Global SIIs” preceded the Prudential and MetLife designations of the FSOC. Roy Woodall reflected: “While the FSB’s action should have no influence, I have come to be concerned that the international and domestic processes may not be entirely separate.” A related question is whether the Treasury and Federal Reserve FSOC members felt personally committed by their international discussions. If they did, it seems that they should have disclosed that and recused themselves from the FSOC decisions. Did they feel committed to follow the FSB?  Only they know.

During their research for the study of the FSOC designations process, the committee staff asked the FSOC’s executive director, Patrick Pinschmidt, what “significant damage on the broader economy” meant, in their assessments. Mr. Pinschmidt replied: “It’s up to each voting member of the council to decide for him or herself what constitutes a significant threshold.” That sounds like depending on subjective judgments to me.

I agree that it is a naturally good idea for financial regulatory agencies to get together and share information, ideas and experiences (to the extent that they will really share). But what is a committee of heads of regulatory agencies, who are acting as individuals and not even on behalf of the relevant boards or commissions, doing making political decisions?  If Congress wants to have the Federal Reserve Board regulate big insurance companies, it can make it so in statute, using whatever subjective judgments it wants. In my view, FSOC is a distinctly inappropriate body to act as a little legislature.

The staff paper of FSOC’s evaluations of possible SIFIs, those recommended for designation and those not, details the inconsistencies in treatment. But these differences pale beside the huge discrepancy of those companies chosen for evaluation and those companies not evaluated at all, because the previous Treasury Secretary did not approve their being studied. The FSOC staff did not even analyze them, because of some higher, prior, political judgment. I think this could fairly be characterized as desperately wanting to “see no evil” when it comes to the systemic financial risk of some entities.

The most egregious cases are Fannie Mae and Freddie Mac, which are obviously systemically important and without question systemically very risky. To document that is simple, starting with their combined $5 trillion in credit risk, virtually zero capital and ubiquitous interconnectedness throughout the country and world. Two of the biggest causes of systemic risk are leveraged real estate and the moral hazard created by the government—Fannie and Freddie are both of these combined and to the max.

The Dodd-Frank Act gives a key assignment to FSOC:  “To promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties that the Government will shield them from losses in the event of failure.” Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses, not only as a hypothetical, but as a vast fact. They operate entirely on the government’s credit. They represent the very essence of the problem that FSOC was supposedly created to address. But FSOC doesn’t even study them—instead, the staff was ordered not to study them.

That is an inconsistency raised to the nth power – in my view, a bankruptcy of FSOC’s intellectual credibility as run by the previous administration.

A recent article claims that “the next financial crisis that rocks America…will be driven by pension funds that cannot pay what they promised.” Whether or not it triggers the next crisis, there is no doubt that this is a looming huge risk.

In the very center of this risk is an insurance company absent from FSOC’s evaluation as a SIFI: the Pension Benefit Guaranty Corp. The PBGC is not only on the hook as guarantor of unpayable pensions nationwide, but is already insolvent itself with, according to its own books, a deficit net worth of $76 billion. Might PBGC represent a systemic risk?  Yes. Do the creditors of the PBGC think “the Government will shield them from losses”?  Yes. Does the FSOC staff evaluate the PBGC?  Nope.

In sum, it appears that the flawed process of FSOC’s SIFI designations is generated by the flawed structure of FSOC itself.

In my opinion, structural reform of FSOC is needed as part of larger the Dodd-Frank reform legislation. But here are a few recommendations for improvements which could be implemented by the new administration in the short run:

• FSOC should have regular meetings of principals only with substantive discussions of major issues and explorations of disagreements. No helpers, no staff.

• The secretary of the Treasury should immediately instruct the FSOC staff to undertake systemic risk evaluations of Fannie Mae and Freddie Mac.

• The secretary of the Treasury should immediately instruct the FSOC staff to undertake a systemic risk evaluation of the Pension Benefit Guarantee Corporation.

• The Treasury Department should immediately request the Department of Justice to withdraw the government’s appeal in the MetLife v. FSOC suit and the Department of Justice should immediately do so.

• FSOC staff should be encouraged to come up with new ideas on evolving risks for discussion among the FSOC principals.

• Any SIFI evaluation should strictly follow the rules and guidance approved by FSOC, with analysis performed in a strictly consistent manner.

• Assumptions about macro reactions and assumptions of implausible and contrived scenarios should be clearly identified as judgments and guesses.

• International discussions and actual decisions of FSOC should be kept strictly separate. Any international agreements, even if informal, made by FSOC members, should be fully disclosed.

Again, my appreciation to the committee staff for their productive study of the inconsistent FSOC designation process and the very important issues it raises.

And thank you very much for the chance to share these views.

George Kaufman: 57 years of banking changes and ideas

Published by the R Street Institute.

57 Years of Banking Changes and Ideas

Remarks at the Dinner in Honor of Professor George Kaufman’s Retirement

Nov. 17, 2016

It is a great pleasure to be able to add these reflections to our proceedings in honor of George Kaufman upon his retirement.

We begin a quick trip through American financial history during George’s career with this quotation:

The past 100 years of American banking have been characterized by periods of remarkably rapid change.

This observation is from 56 years ago, from the 1960 Report of the Federal Deposit Insurance Corp. It was true then, and is true now.

The year before that, in 1959, the young George Kaufman walked into the Federal Reserve Bank of Chicago to begin his career. Needless to say, the “periods of remarkably rapid change” in American banking continued as his career progressed.

In 1960, there were in the United States: 13,126 commercial banks, 5,320 savings and loans, and 516 mutual savings banks. Those institutional differences then seemed much more important than they do now—these groups all had their own trade associations, for example. Together they made in 1960 a total of 18,962 depository institutions. As we all know, this number is now just over 6,000 and continues to fall. But that is still a lot of banks!

Two questions which would occur to the participants in this dinner, although doubtless never to ordinary citizens, are: When did the United States have its maximum number of banks?  And how many banks was that?  (I will not call on Charlie Calomiris here, because he might know.[1])  The answers are the year 1921 and it was 31,076 commercial banks. In addition, there were more than 8,000 savings and loans.

Coming back to 1960, the total assets of the aggregate commercial banking system were $256 billion—about one-tenth of the assets of today’s JPMorgan-Chase. That was 48 percent of the 1960 gross domestic product of $535 billion. The total assets of the prestigious 1959 Citibank—which wasn’t “Citibank” in those days, but the First National City Bank of New York—were $8.3 billion, or about 0.3 percent of the current JPMorgan.

Closer to home, I found the 1958 numbers for the Continental Illinois National Bank and Trust Co. of Chicago. That then-very-conservative balance sheet had total assets of $2.9 billion—today’s size of a large community bank.

A truly striking statistic is that in 1960, non-interest-bearing demand deposits at national banks were equal to about 60 percent of their total banking assets—something unimaginable now.

Also in 1960, there were still outstanding $55 million of national bank notes—currency issued by individual banks. The Federal Reserve had on its balance sheet $279 million of silver certificates. These were the paper money, as you will recall, which the U.S. Treasury promised to redeem for a silver dollar—something quite different from the fiat currency we have come to know so well. Well, perhaps not so different after all, because in the first decade of George’s career, the government decided it would renege on its commitment to pay in silver.

A roomful of economists will not have failed to notice that in all the numbers I have cited, I have used nominal dollars. There are two reasons for this:

1. Rhetorical fun

2. To remind us that George’s long career has involved unceasing, endemic inflation.

Indeed, this has progressed to the point where the Federal Reserve has formally committed itself to perpetual inflation. Such a development in Federal Reserve ideology would have greatly shocked and surprised the chairman of the Federal Reserve for the first decade of George’s career, William McChesney Martin, who called inflation “a thief in the night.”

Speaking of the Fed, George’s first career decade also included the Credit Crunch of 1966 and his second began with the Credit Crunch of 1969. Those were the days of the notorious “Reg Q,” under which the Fed set maximum interest rates on deposits and, in so doing, caused the painful crunches.

Did the Fed know what the right interest rate was in 1966 or 1969?

Nope.

Does the Fed know what the right interest rate is now?

Nope.

We move into the 1970s. They started with a world historical event, at least as far as finance goes: the default by the United States on its Bretton Woods commitment to redeem dollars held by foreign governments for gold. Announcing this decision in August 1971, President Richard Nixon blamed the problem on “international money speculators.” The real proximate cause was French President Charles de Gaulle’s financial good sense of preferring gold to overvalued dollars.

In the wake of the end of Bretton Woods, the 1970s brought us the worldwide system of fiat currencies and floating exchange rates. This system has experienced a remarkable series of debt and currency crises in the ensuing years.

Speaking of debt crises, the default by Puerto Rico was discussed this afternoon. On Page 15 of George’s 38-page curriculum vitae, we find that in 1975, George was involved in the government finances of Puerto Rico and was a consultant to Puerto Rico’s Government Development Bank. This bank is now utterly insolvent, as is the whole government of Puerto Rico. However, I do not think it would be fair to attribute this to George’s 1975 advice!

In 1976, George was working in the U.S. Treasury Department. Here were the 10 largest banks in the United States, in order, in 1976:

1. Bank of America (that is, the one is San Francisco)

2. Citibank

3. Chase Manhattan

4. Manufacturers Hanover

5. Morgan Guaranty

6. Continental Illinois

7. Chemical Bank

8. Bankers Trust

9. First National Bank of Chicago

10. Security Pacific

Of these 10, only two still exist as independent companies. They are Chemical Bank, which became JPMorgan-Chase, and Citibank, which has in the meantime been bailed out three times.

In the next decade, in 1981, George became the John F. Smith Professor of Finance and Economics here at Loyola University of Chicago, the chair he has held ever since, also serving as the director of the Center for Financial and Policy Studies.

Soon after George got his chair, the financial disasters of the 1980s came raining down. I assert, however, that this is correlation, not causation.

On a Friday in August 1982, then-Fed Chairman Paul Volcker called his counterpart at the Bank of Japan and announced that “The American banking system might not last until Monday!” Over the years 1982-1992, the notable total of 2,808 U.S. financial institutions failed. That is an average of 255 failures per year over those 11 years, or five failures a week. As many of us remember, the decade included the crisis of huge defaults on LDC—or “less developed country,” as we then said—debts; the collapse of the savings and loan industry; the bursting of the oil price bubble, which among other things, took down every big bank in Texas; the collapse of a bubble in farmland, which broke the Farm Credit System; and finally, a massive commercial real estate bust.

These 1980s disasters, which George studied and wrote about with much insight, call to mind James Grant’s vivid comment about the time: “Progress is cumulative in science and engineering but cyclical in finance. … In technology, banking has almost never looked back, [but] this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in financial history.”

The 1980s included, of course, the 1984 collapse of Continental Illinois Bank. Defending the ensuing bailout, then-Comptroller of the Currency Todd Conover introduced the memorable term “too big to fail.” The problem of “too big to fail” became an important theme in George’s work.

In the midst of these 1980s financial debacles, in 1986, George led the creation of the Shadow Financial Regulatory Committee. In its operation through 2015, the committee published 362 mostly trenchant and provocative policy statements. No. 362 was still dealing with “too big to fail.”

For the year 1987, George published a summary of this “dramatic year in U.S. banking and finance,” which included these observations: that “rates on long-term Treasury bonds stood at 9 ½%”; that “some 185 commercial banks failed during the year”; that “the drain on the Federal Savings and Loan Insurance Corporation was so great that the corporation ran out of reserves and had to be recapitalized by Congress”; and that “Alan Greenspan replaced Paul Volcker as chairman of the Federal Reserve,” while “M. Danny Wall [became] chairman of the Federal Home Loan Bank Board.”

Remember the Federal Home Loan Bank Board?  Those of us here may, but hardly anybody else does. For Danny Wall, being made head of it in 1987 was like being made captain of the Titanic after it had already hit the iceberg. In contrast, Alan Greenspan rose to worldwide stardom and became “The Maestro”—until he wasn’t.

In the 1990s, George and the Shadow Committee were very influential in shaping FDICIA—the Federal Deposit Insurance Corporation Improvement Act of 1991, which put into statute the theory of prompt corrective action. The decade later brought a series of international financial crises, starting with the frantic bailout of Mexico in 1994.

In the next decade, the fifth of George’s career, came—as we all know too well—the massive housing and housing-finance bubble, bust and shrivel of the 2000s. Reflecting on prompt corrective action in light of those experiences, my conclusion is that it’s a pretty good theory, but financial exuberance makes it hard to practice.

The exuberance of the 2000s was defended as rational by many ex ante, then denounced as irrational ex post. In the aftermath of the 2007-09 crisis, I chaired panel of which George was a member. He gave this wonderful concluding comment:

Everybody knows Santayana’s saying that those who fail to study the past are condemned to repeat it. In finance, those who do study the past are condemned to recognize the patterns they see developing, and then repeat them anyway!

Now here we are, near the end of 2016. I believe we are probably closer to the next crisis than to the last one. It seems to me we need a Shadow Financial Regulatory Committee Roman Numeral II to get to work on it.

Ladies and Gentlemen:

Let us raise our glasses to George Kaufman and 57 years of achievement, acute insights, scholarly contributions, policy guidance and professional leadership, all accompanied by a lively wit.

To George!

[1] The next morning, Charlie told me that he did know

What Dow 20,000 looks like in inflation-adjusted terms

Published by the R Street Institute.

The Dow Jones industrial average closing Jan. 25 at more than 20,000 inspired big, top of the fold front-page headlines in both the Wall Street Journal and the Financial Times (although the story was on Page 14 of The Washington Post). The Journal and FT both ran long-term graphs of the DJIA, but both were in nominal dollars. In nominal dollars, the 100-year history looks like Graph 1—the DJIA is 211 times its Dec. 31, 1916, level.

This history includes two world wars, a Great Depression, several other wars, the great inflation of the 1970s, numerous financial crises, both domestic and international, booms and recessions, amazing innovations, unending political debating and 18 U.S. presidents (10 Republicans and eight Democrats). Through all this, there has been, up until yesterday, an average annual nominal price increase of 5.5 percent in the DJIA.

Using nominal dollars makes the graphs rhetorically more impressive, but ignores that, for much of that long history, the Federal Reserve and the government have been busily depreciating the dollar. A dollar now is worth 4.8 percent of what it was 100 years ago, or about 5 cents in end-of-1916 dollars. To rightly understand the returns, we have to adjust for a lot of inflation when we look at history.

Graph 2 shows 100 years of the DJIA in inflation-adjusted terms, stated in end-of-1916 dollars:

Average annual inflation over these 100 years is 3.1 percent. Adjusting for this, and measuring in constant end-of-1916 dollars, 20,069 on the DJIA becomes 964. Compared to a level of 95 as of Dec. 31, 1916, the DJIA in real terms has increased about 10 times. Still very impressive, but quite different from the nominal picture. The average annual real price increase of the DJIA is 2.3 percent for the 100 years up to yesterday.

Growth rates of 2 percent, let alone 3 percent, extended over a century do remarkable things.

The housing bubble renewed?

Published by the R Street Institute.

Average U.S. house prices are back over their 2006 bubble top, as measured by the Case-Shiller Home Price Indices. “Home Prices Recover Ground Lost During Bust” read the Wall Street Journal headline.

But these prices are in nominal dollars, not inflation-adjusted dollars. While the Federal Reserve assures us that inflation is “low,” it tirelessly works to depreciate the dollar. Over the decade since the housing bubble peak, aggregate inflation has been 19 percent, so 2016 dollars are worth 84 cents compared to 2006 dollars.

House prices since 1987 in nominal terms look like this:

In inflation-adjusted terms, the chart is different. Average house prices in real terms are indeed very high, but still 16 percent below their bubble top. They have reached the level of March 2004, when the bubble was well advanced into exuberance, but not yet at its maximum. It had made about 54 percent of its 1999-2006 run.

From 1999 to 2004, real house prices increased at an average rate of 7.2 percent per year. In our renewed house price boom from 2012 to now, real prices have increased at 6.6 percent per year—pretty similar.

All this is depicted in Chart 2:

The Federal Reserve had reduced short-term interest rates to very low levels in 2001 to 2004, which fed the bubble. In 2004, it started to raise them. The house price run up since 2012 has also been fed by extremely low interest rates. Now the Fed must raise rates again and is getting ready to do so. Long-term mortgage interest rates have already increased sharply.

Should being back to 2004 in real terms worry us?  Yes.

Household incomes can fall even when everyone’s getting richer

Published by the R Street Institute.

One of the politically hottest statistics right now is median household income, especially its slow growth. But there is a big problem with understanding what this statistic means, since it mixes up two different things: the changing composition of households and changes in incomes. If the makeup of households is altering dramatically, as it has in recent decades, median household income may be a quite misleading number.

For example, it is mathematically possible for everyone’s income to be rising, while the median household income is falling. How is that possible?  The paradox is caused by counting by households, when the relationship between individuals and households keeps shifting.

To take the simplest possible case: Consider a population of one household, a married couple, each of whom has an income of $50,000. The median household income is $100,000. Their incomes each rise by 10 percent to $55,000—but they get divorced. Now there are two households. The median household income has become $55,000. The median household income has gone down by 45 percent!  Obviously, we have a demographic event, not an income event.

Suppose our married couple stays married with their new household income of $110,000. An immigrant joins the population, making $20,000, which is three or four times his previous income. In this case, the median household income has become $65,000, falling 35 percent!  But everybody is better off than they were before.

In what is naturally a more complicated way, just these sorts of major changes have been going on inside the statistics that count income by household. If the composition of households were unchanged, the statistics would be more straightforward. But this is obviously not the case. Until the demographic changes are untangled from the results, it’s not clear what the changes in median household income tell us.