Federal Reserve brings the real Fed Funds Rate up to about zero

Published by the R Street Institute.

As everybody knew it would, the Federal Reserve Board announced today it is bringing its target federal funds rate up to a range of 2 percent to 2.25 percent—in shorter form, to about 2.25 percent. That is still a very low rate, especially translated, as is economically required, to a real interest rate—that is, one adjusted for inflation. The new Federal Reserve target rate, in real terms, is more or less zero.

To adjust for inflation, you have to choose a measure of inflation. The Consumer Price Index over the 12 months through August 2018 rose 2.7 percent. Thus, using the CPI, the new inflation-adjusted Fed Funds target is 2.25 percent minus 2.7 percent, or a real rate of -0.45 percent.

Suppose as an inflation measure you like the Personal Consumption Expenditures Index (PCE) instead. Over the 12 months ended in July 2018, it went up 2.3 percent, so 2.25 percent is still a slightly negative real interest rate.

But the Fed likes to use the “core” PCE, which excludes food and energy prices. This is especially good for people don’t have to buy things to eat or gas for their car. Core PCE rose 2 percent for the same period. That would result in a slightly positive real interest rate of 2.25 percent, minus 2 percent, or 0.25 percent.

Averaging these three estimates together gives a real fed funds target rate of negative 0.08 percent—close enough to zero for monetary policy work, given its vast uncertainties.

Zero is a remarkably low real fed funds rate nine years after the end of the last recession, nine years after the end of the 2007-2009 financial crisis, in a time of strong economic growth and, more to the point, in the midst of a remarkable asset price inflation in houses, commercial real estate and securities.

Nobody, including the Federal Reserve, knows what real interest rates should be, but there is little doubt that a free market, without central bank manipulation, would by now have set them higher.

When and how will the current asset price inflation end?  Nobody, including the Fed, knows that either.

Ten Years After the 2008 Crisis: The Downside of the 30-year Fixed-Rate Mortgage

Published by the R Street Institute.

Here’s a lesson on the 10th anniversary of the 2008 financial crisis that almost nobody seems to have noticed:  the serious downside of the standard U.S. 30-year fixed rate mortgage, as displayed during the collapse of the housing bubble.

To hear politicians, promoters of government mortgage guarantees, proponents of Fannie Mae and Freddie Mac, and typical American housing-finance commentators at all times loudly singing the praises of the 30-year fixed-rate mortgage, you would think it has no downside at all. But of course, like everything else, it does.

Glenn Hubbard, former chairman of the Council of Economic Advisers, wrote recently of the crisis: “Millions of homeowners who were current on their mortgage payments were unable to refinance to lower rates because they were underwater” — in other words, the price of their house had fallen below what they owed on the mortgage. But that is only half of the explanation; the other half is that these homeowners could not get a lower interest rate because they had a fixed-rate mortgage. Therefore, they were stuck with what had become a burdensome interest rate relative to the market.

In contrast, the interest rate on floating-rate mortgages automatically goes down, even if the falling price of the house has put the loan underwater. This automatically reduces the mortgage payments due, reduces the financial pressure on the borrowers, and improves their cash position. Mortgage borrowers in many countries benefited from this reality during the financial crisis, but not the unlucky Americans who had a 30-year fixed-rate mortgage combined with a sinking house price.

Floating-rate mortgages naturally do become more expensive if interest rates rise, but are less expensive when interest rates fall — as they did dramatically during the crisis. Conversely, our 30-year fixed-rate mortgages are fine if house prices inflate upward forever, but in a housing deflation with falling interest rates, they are terrible for the borrowers. As the housing bubble shriveled, they turned out not to be a “free lunch” of a continuous option to refinance, but a very expensive lunch for, as professor Hubbard says, “millions of homeowners.” The more highly leveraged the mortgages were, the more expensive it was.

There is no doubt that the prevalence of the 30-year fixed-rate mortgage made the American housing finance crisis worse. Few people understand this.

Remarks at AEI’s ‘Conference on the 10th anniversary of the financial crisis’

Published by the R Street Institute.

Thanks, Peter. It’s a pleasure to be in a panel with such distinguished colleagues.

I’d like to begin by pointing out that, in addition to being the instructive 10th anniversary we have been discussing, today is also a notable 11th anniversary: On Sept. 14, 2007, Northern Rock bank, a major British mortgage lender, could no longer fund itself in wholesale markets, and an emergency lender-of-last-resort facility from the Bank of England was announced. That day, long lines of depositors began to form outside branches of Northern Rock, its website collapsed and its phone lines were jammed.

The first bank run in England since the days of Queen Victoria was underway. So was the first bailout of the 2007-2009 financial crisis. The crisis reached its peak panic just one year later, as Lehman Brothers went down.

Let’s review a few of the events as the ultimate panic approached.

In June 2008, Larry Lindsay wrote an article for AEI entitled, “It’s Only Going to Get Worse.” He was so right.

In July, Congress passed the law authorizing the Treasury to put money into Fannie and Freddie. Secretary Paulson said he wouldn’t need to. “Nervous calls” from officials of foreign countries to the U.S. Treasury were urging that their large investments in the securities of the tottering Fannie Mae and Freddie Mac be protected by the U.S. government.

On Sept. 7, Fannie and Freddie were put into conservatorship along with their Treasury bailout. Fannie’s common stock had closed at $7 a share Friday, Sept. 5. On Monday, Sept. 8, it was 73 cents.

A week later, Friday, Sept. 12, Lehman’s common stock closed at $3.65 a share. By Monday, Sept. 15, it was 21 cents.

On Sept. 16, losses on Lehman commercial paper forced the Reserve Primary money market fund to “break the buck”; also the Federal Reserve loaned AIG $85 billion.

On Sept. 20, the Bush administration submitted TARP legislation to Congress.

The times were frightening, to be sure and obscured by the “fog of crisis.” As Secretary Paulson later wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.”

Imagine you are a Treasury secretary, finance minister or head of a central bank. You are in the fog of crisis, but you can see that you and your colleagues are standing on the edge of a cliff, staring down into the abyss of potential debt deflation. Will you choose to risk the eternal obloquy of being the one who did nothing?  Of course not. You will intervene and keep intervening with whatever bailouts seem necessary. Your only objective will be to survive the crisis. That’s what you would do, if you were in office, and so would everybody else, just as is always done.

Only, of course, in 2008, they didn’t bail out Lehman. Would you have done so, under the circumstances of the time?

But more fundamentally, the panic was the climax of more than a decade of a long buildup of leverage and risk, and much of this, as has been rightly said, was promoted by the U.S. government. How had the long increase in risk seemed at the time?

Well, the central bankers believed they had created the “Great Moderation,” which turned out to be the “Great Leveraging.” Tim Geithner, then-president of the Federal Reserve Bank of New York, thought in 2006 that “[f]inancial institutions are able to measure and manage risk more effectively,” a belief common at the time.

But: “The reality is that we didn’t understand the economy as well as we thought we did,” as Fed Vice Chairman Don Kohn candidly reflected. “Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis.”

That is reasonably close to a mea culpa, although he sweeps in a lot of other people in his confession. Does the Fed understand the economy any better today than it did in the 2000s?  Is it ever, as Peter Fisher has asked, “candid about the uncertainty” it always faces?

The government promoted housing debt. Most notoriously, the “National Home Ownership Strategy” of the Clinton administration pushed for “innovative” – that is, poor credit quality – mortgage loans. It goes without saying that the government promoted excess housing debt and leverage though Fannie and Freddie, as it continues to do today. These debt-promotion strategies never have been rejected by the U.S. government.

The crisis ended in the spring of 2009, after the Fed had the very good sense to replace mark-to-market tests with “stress tests.” That was an ingenious way out of a problem. Whether by cause or coincidence, the stock market started back up on its long bull run. The S&P Bank Index, which had been at 281 on Sept. 12, 2008, bottomed at 77 on March 5, 2009, after a loss of more than 70 percent. It has since then gotten up over 500.

In the boom, it seems like the boom will last forever. In the bust, it seems like the bust will last forever. Of course, neither is the case, but it feels that way.

By midyear 2009, it was clear we had survived the crisis. Now, it was time for the inevitable political reaction to it, as happens in every financial cycle. Now was the hour for the politicians, including those who had pushed the policies that made things worse, to show how they could fix the problems.

Imagine you are a politician. What would you do in the wake of a huge crisis and bust?

First of all, you certainly have to Do Something!  You can’t just stand there, any more than the central bankers and regulators could during the panic.

Some of us, including Peter Wallison, Ed Pinto, Chairman Jeb Hensarling and me, thought it was a great opportunity to restructure U.S. housing finance into a primarily private, market system, with private capital bearing the risk of its actions.

In 2010, I proposed, in a piece called “After the Bubble,” a list of reform actions which included these:

-Create a private secondary market for prime, middle-class mortgages;

-Design a transition to having no government-sponsored enterprises;

-Stop using the banking system to double-leverage the GSEs, should they survive;

-Facilitate credit-risk retention by mortgage originators;

-Develop countercyclical loan-to-value discipline;

-Create bigger loss reserves in good times;

-Use a one-page key mortgage information form focused on whether the borrower can afford the loan;

-Address the banking system’s overconcentration in real estate risk; and

-Rediscover savings as an explicit goal of housing finance.

It still seems like a good list to me, but needless to say, this wasn’t the direction taken.

A different path was chosen, one always available to the legislature: to expand regulations and the regulatory bureaucracy, with orders that they are not to allow such problems again. This was in spite of the fact that “[n]o regulator had the foresight to predict the financial crisis,” as Andrew Haldane of the Bank of England said, adding, “although some have since exhibited supernatural powers of hindsight.”

But the most interesting question is why did regulators fail to foresee the crisis?  It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is one of knowledge of the future, not of effort. The problem is the inherent uncertainty, the ineluctable lack of knowledge of the future—the mismatch between prevailing ideas and the emergent, surprising reality.

There is another problem: regulators are employees of the government and cannot be expected to stop activities the government is intent on promoting, or act against the interests of their employers. As Bill Poole so convincingly wrote in his paper for this conference:

“An obvious first observation is that the affordable housing policy and mortgage goals given to the GSEs were policies of the Congress, President Clinton and President Bush.” He asks rhetorically, “Should the Fed somehow have undercut the stated policies of the president and the Congress?” The same question applies to all the other regulators.

In spite of these problems, the politicians did what they usually do in the wake of the bust: expand the regulatory bureaucracies and give them more power, renewing Woodrow Wilson’s faith in “expert” bureaucracy. The resulting many thousands of pages of new rules protect the politicians who had to Do Something from the charge of not doing anything or of not doing enough. There is no doubt that the thousands of man-years that went into negotiating and writing the new rules were spent by intelligent, informed, well-intentioned people intent on making the financial system into a mechanism with less chance of failure, although we all know the chance of failure never becomes zero. This is a fine goal, but suffers because financial markets are not a mechanism. (Of course, the bureaucratic excesses of Dodd-Frank were enabled by the temporarily overwhelming congressional majorities of the Democratic Party, which only lasted until they were lost in 2010.)

In the wake of the crisis, the power of the Federal Reserve was also greatly expanded, its role in feeding the bubble and its complete failure to anticipate the collapse notwithstanding. This is the latest of numerous examples in history of Shull’s Paradox, which is that the Fed always gets more powerful, no matter what blunders it makes.

Another action always available to politicians is to set up a committee and give them a big, great-sounding assignment. In this case, the committee was FSOC (the Financial Stability Oversight Council) and its assignment was to figure out, address and avoid systemic risk. There is no evidence that FSOC has the ability to do this, but creating it was a perfectly sensible action from the politicians’ point of view. No one can accuse them of ignoring systemic risk!

FSOC was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions, or SIFIs. FSOC has designated a few firms, then de-designated most of them, but it has utterly failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important. This may be politically prudent on its part, but is intellectually vacuous. I believe Fannie and Freddie should be designated as the SIFIs they so obviously are immediately. Better late than never.

The Fannie and Freddie problem displays the more general fatal flaw in FSOC. It cannot control or even point out the systemic risk created by the government itself. Its members cannot criticize their employer.

The last point I will mention here is a key one: the post-crisis political reaction insisted that there had to be more equity capital in the financial system. This was a good idea, agreed upon by almost everybody. But note that the banks’ capital was able to get so small in the first place, only because the government was correctly believed to be guaranteeing the depositors. Fannie and Freddie’s capital was able to get even smaller because of the correct belief that the government was guaranteeing their creditors.

In the wake of the bust, the Federal Reserve set out to create a “wealth effect” by pushing back up the prices of houses and the prices of financial assets, in order in theory to stimulate economic growth. As we all know too well, it pursued this by massive purchases of long-term Treasury bonds (while reducing its portfolio of short-term Treasury bills to zero) and of very long-term mortgage-backed securities, increasing the Fed’s own balance sheet, as is well-known, up to $4.5 trillion. The Fed also kept real short-term interest rates negative for the better part of seven years.

Whatever the arguments for doing these things as short-term measures, the Fed has kept them as long-term, unquestionably distortionary programs, even now reducing its balance sheet only slightly and getting real short-term interest rates up to approximately zero. The result has been a massive asset price inflation in real estate, financial assets and other assets.

The Fed got its renewed house price boom, all right. Nominal house prices are now well over their bubble peak.

The Fed also instituted the payment of interest on excess reserves held with it by banks. This allowed it to suppress the credit expansion that would have occurred in classic banking theory, and to itself allocate credit instead. To what did it allocate credit?  To housing and to the government deficit.

Where and how will the Fed-induced remarkable asset price inflation end?  I don’t know. The Fed doesn’t know. The financial regulators don’t know. That is hidden in the uncertainty of the economic future. It may be the Fed’s hoped-for soft landing, but then, it might not be.

Finally, here is a reminder of some essential things not done by the politicians or the regulators or the central bank in the wake of the crisis, among others:

• They did not create a primarily private secondary market for prime mortgages.

• They did not design a transition to having no GSEs.

• They did not develop countercyclical LTV discipline.

• They did not address the overconcentration of the banking system in real estate risk.

• They did not rediscover savings as an explicit goal of housing finance.

They did get equity ratios increased, which was good.

They did preside over an efflorescence of bureaucracy and a giant asset price inflation.

What next?  This is a period of uncertainty, just like every other period.

FR-6111-A-01 Reconsideration of HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Published by the R Street Institute.

Department of Housing and Urban Development

Regulations Division

Office of the General Counsel

Washington, DC 20410

www.regulations.gov

Dear Sir/Madam:

Re.: FR-6111-A-01   Reconsideration of HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Thank you for the opportunity to comment on this advanced notice of proposed rulemaking, which we believe has the potential to significantly improve the existing standard.  The authors of this comment each have many years of experience in housing finance, both as operating executives and as students of housing finance systems and their policy issues.

Our comments are in particular directed to your Question #6: “Are there revisions to the Disparate Impact Rule that could add to the clarity, reduce uncertainty, decrease regulatory burden, or otherwise assist regulated entities and other members of the public in determining what is lawful?”

The short answer to this question is Yes.  We recommend one major, fundamental change which would great enhance clarity and understanding, while greatly reducing uncertainty, in the concepts and operation of the rule: This is to add to the analysis of HMDA data the default rates on mortgages, organized by the same demographic categories as used in HMDA reporting.

Discussion

Applying one’s credit standards in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing.  Is it evidence of discrimination if a lender applies exactly the same set of credit underwriting standards to all credit applicants, but this results in different demographic groups having different credit approval-credit decline ratios?  And is this result evidence of discrimination?

There is a straightforward, data-based way to tell.  It is to add the default rates on the mortgages for each group, and compare them to the approval-decline ratios by group, adjusting for ex ante credit risk factors.

If a demographic group A has a lower credit approval rate and therefore a higher credit decline rate than another group B, the revised rule should require comparing their default rates.

There are three possible outcomes:

1. If group A has the same default rate as group B, then the underwriting procedure was effective and the different approval-decline ratios were appropriate and fair, since they resulted in the same default outcome. Controlling and predicting defaults is the whole point of credit underwriting. Here there is no evidence of disparate impact.

2. If the default rate for group A is higher than for group B, that shows that in spite of the fact that group A had lower credit approval and higher decline rates, it was nonetheless being given easier credit standards. The process was evidently biased in its favor, not against it, even if this was not intended. Again, there is no evidence of disparate impact.

3. If on the other hand, group A’s default rate is lower than that of group B, that shows that group A is experiencing a higher credit standard, even if this is not intended. This may be evidence of disparate impact.

As Nobel laureate in economics Gary Becker wrote, “The theory of discrimination contains the paradox that the rate of default on loans approved for blacks and Hispanics by discriminatory banks should be lower, not higher, than those on mortgage loans to whites.”

In short, if the default rate of group A is equivalent or higher than that of group B, then the claim of disparate impact disappears.

Some discussions of the disparate impact issue have analyzed different demographic groups by household income or other credit factors, but while these factors may be indicators of future default rates, they are not the experienced reality.  Any sufficient analysis must add the reality of the actual default rates.

In sum, we need the facts of default rates to address this issue objectively.  We recommend that HUD’s revised rule should require them to be provided as an essential part of the analysis of any possible disparate impact issue.

The default data by HMDA category is not now readily available from typical mortgage servicing records, but research at the AEI Center on Housing Markets and Finance has shown that the required matching of HMDA to relevant risk and performance data is practicable, as well as theoretically required in order to, as a factual matter, determine any disparate impact.

For example, the experience of FHA loans for the years 2013 to 2017, comparing credit approval ratios to default rates by demographic group is shown in Attachment A.  In all cases, although the credit approval ratios for minorities are lower, their default rates are higher, as are their risk-adjusted default rates, indicating no disparate impact in the aggregate.

We look forward to sharing with you with the further data the Center is developing to help advance the appropriate policy considerations.

It would be a pleasure to discuss this recommendation further with you at your convenience, should you so desire.

Thank you again for the chance to participate in this timely reconsideration.

Yours respectfully,

Alex J. Pollock                                                       Edward J. Pinto

Distinguished Senior Fellow                                 Co-director

R Street Institute                                                  AEI Center on Housing Markets and Finance

Is inflation “quite good” or “a thief in the night”?

Published by the R Street Institute.

“Consumer Price Inflation Hits Six-Year High,” is the headline of a July 12 economic report.  The Bureau of Labor Statistics has just reported that as of June, the Consumer Price Index was up 2.9% over a year ago, its biggest increase since 2012. Without food and energy prices, which the Federal Reserve likes to exclude, consumer prices were up 2.3% over the twelve months.  Earlier this week, financial commentator Wolf Richter helpfully reminded us of the obvious: “Consumer price inflation whittles down the purchasing power of labor.”

How should we think about that?  Let us contrast the views of high officers of the Federal Reserve at different times.

William McChesney Martin was the all-time longest serving Chairman of the Federal Reserve Board, from 1951 to 1970, spanning five different U.S. presidents.  A Federal Reserve building in Washington is named after him.

Charles Evans is the current President of the Federal Reserve Bank of Chicago.  He has held this position for more than a decade, since 2007.

Dr. Evans recently told the Wall Street Journal that he thinks the current inflation “looks quite good,” adding, “I’d like to see inflation expectations a little bit higher.”

Such language would presumably have surprised Chairman Martin, who memorably described inflation as “a thief in the night.”  A scholar of the Fed as an institution, Peter Conti-Brown, interprets Martin’s vision of the central bank accordingly: “The keeper of the currency is the one that one that has to enforce the commitment not to steal money through inflation.”

So does inflation “look quite good” or is it “a thief in the night”?

Fashions in central bank ideas change over time: Which view do you prefer?

North America update: A bubble and a boom both nearing their ends?

Published by the R Street Institute.

North America certainly presents an interesting housing-finance picture, with big house-price inflation in both Canada and the United States.

Canada’s house price inflation is bigger. Indeed, Canadian house prices surely qualify as a bubble. They have ascended to levels far higher than those at the very top of the U.S. bubble. The increases have been remarkable, and the many years of their run, with hardly a pause, has kept surprising observers (like me) who thought it would have to end before now. Canadian government officials have been worried about it for some time and have tried to slow it down by tightening mortgage credit standards and putting special taxes on foreign house buyers in Toronto and Vancouver. Meanwhile, in the United States, house prices since 2012 – for about six years, have again been booming, fueled by the cheap mortgage credit manufactured by the Federal Reserve. Average U.S. house prices are now over their bubble peak of 2006. However, they are nowhere near the records set in Canada.

Graph 1 shows the paths of average Canadian versus U.S. house prices in the 21st century, with the price indexes set to the year 2000 = 100.

Read the rest here.

Have financial follies changed since Walter Bagehot’s day?

Published by the R Street Institute.

Among everything you might read in the realm of finance, there is nothing more enjoyable than reading Jim Grant, with his sparkling mixture of ideas, research and wit—except perhaps reading the great Walter Bagehot himself, with his wonderful Victorian rhetoric. Now we have Jim Grant writing on Walter Bagehot—a terrific combination. I have had the pleasure of reading several chapters from this new book in process.

Of course, Jim finds striking quotations from Bagehot, sometimes from surprising sources. For example, in a letter to his fiancée, Eliza Wilson, written during the financial panic of 1857, Jim has found what Bagehot observed about the “nature of financial faith.”

All banking rests on credit and credit is rather a superstition. At any rate it is adopted not from distinct evidence but from habit, usage and local custom.

That is why it is true that, as Bagehot later wrote in Lombard Street, “(e)very banker knows that if he has to prove he is worthy of credit … in fact his credit is gone.”

When the 1857 panic was over, Bagehot wrote Eliza from London:

The last few times I have been here everybody was on their knees asking for money, now you have to go on your knees to ask people to take it.

“Few better observations of the cycles of bankerly feast and famine have ever been written,” says Jim, continuing: “Historians of economic thought may make of it what they will that the passages formed part of Bagehot’s love letters” to Eliza!

I’m not sure what to make of that, either.

Credit expansion replaced panic, and proceeding to the 1860s, Jim relates, “Financiers reconsidered the field of opportunity. They found it to be bigger and more alluring than before,” just as their successors did in the 1970s, 1980s, 1990s, 2000s and 2010s. Continuing Jim’s text:

The British government borrowed at 3% with the assurance of absolute safety. The Turkish government, with no such assurance, willingly paid 12% to 15%; the Egyptian government, 8% to 9%; the government of the Confederate States of America [this is in the 1860s, remember] 7% along with an option on the price of cotton.

This international credit expansion, like others, led ultimately to defaults and losses. Need we add that today we are once again experiencing stresses in emerging market debts?

The mention of the bonds of the Confederate States of America should remind us of Pollock’s Law of War Finance, which is: Do not lend to the side that is going to lose. By 1865, it was clear that the holders of Confederate bonds were out of luck. The next year, 1866, brought the infamous collapse of the previously prestigious and unquestioned financial firm of Overend, Gurney & Co. in London. As Overend was going down, we learn from Jim’s text:

Their only recourse was to the Bank of England. Would the Old Lady Bank extend a helping hand? The Bank dispatched a three-man team to inspect the supplicant’s books. The verdict was negative—[Overend] was insolvent—and the Bank declined to assist. The heretofore unimaginable occurred. Overend, Gurney closed its doors. The ensuing panic exhausted the descriptive powers of the financial press.

The formerly famous insolvent bank as supplicant to the central bank; this may sound too familiar.

“In the aftermath of the failure of Overend, Gurney,” Jim writes, “investors in foreign bonds arrived in force … In the dull, post-panic British economy, savers strained to earn more than the 3 ¼% available on British government bonds. Risky borrowers, arm-in-arm with their opportunistic bankers, stepped forward to fill the void.” But “Bagehot anticipated the consequences of the coming overseas bond bubble.”

In the 1870s, Jim continues:

Egypt, then a semi-autonomous province of the Turkish, or Ottoman, Empire, was one such seeker of funds. In the case of Egypt, not even the Egyptian government had the [financial] figures.

We may instructively note, much more recently, that neither did, nor does, the government of Puerto Rico, the largest municipal insolvency in history, have its financial figures straight. Nor did the biggest municipal insolvency of its time, the government of New York City, a generation ago and a century after Bagehot was writing on Egypt. But in none of these cases did it stop the investors from sending in their money on faith.

So Bagehot acutely described the financial adventures, mistakes, and foibles of his day, which were a lot like those of our day. Jim draws a further key conclusion about his subject’s character:

Bagehot stood up for the ideal of personal responsibility in financial dealings.

May we all.

We are certainly looking forward to reading the whole of Jim’s new book on Bagehot’s life, ideas, controversies and times.

Fed continues negative real interest rates

Published by the R Street Institute.

The Federal Reserve yesterday raised its target fed funds rate to a range of between 1.75 percent and 2 percent; let’s just call it 2 percent. That feels a lot higher than the nearly 0 percent it was from the end of 2008 to 2015, but it is still very low and still less than the current rate of inflation. The Consumer Price Index rose over the last 12 months by 2.8 percent, so to do the simple arithmetic:

New Federal Reserve target interest rate: 2%

Less: Inflation rate: 2.8%

Equals: Real short-term interest rate: (0.8%)

In short, nine years after the end of the last recession, nine years into the bull stock market and six years after house prices bottomed and began a new ascent, the Fed is still forcing negative real short-term interest rates on the economy, the financial system and savers.

No wonder that it continues to preside over a massive asset price inflation.

Gold: An especially bad prediction

Published by the R Street Institute.

The history of finance and economics is full of utterly wrong predictions. This should, but doesn’t, teach us intellectual humility when it comes to pontificating about the future. Here is a memorable one, worthy of special mention in the all-time worst financial predictions list:

When the U.S. government stops wasting our resources by trying to maintain the price of gold, its price will sink…to $6 an ounce rather than the current $35 an ounce.

–Henry Ruess, chairman of the Joint Economic Committee of the U.S. Congress, 1967*

In the 1960s, pace Chairman Ruess, the U.S. government was not trying to hold up the price of gold, but to hold up the price of its dollar; that is, to hold down the price of gold. In this effort, it admitted complete defeat in 1971 by reneging on its Bretton-Woods commitments.

The price of gold today is $1,291 an ounce. It is equally true to say that the price of the dollar is 1/1,291 of an ounce of gold, as compared to the official price in Ruess’ day of 1/35 of an ounce.

__________________

*Thanks to investor-philosopher David Kotok of Cumberland Advisors for this instructive quotation.

June brings to mind weddings, homeownership and their paradoxical relationship

Published by the R Street Institute.

June, we learn from the National Association of Realtors, is “National Homeownership Month.” Since June is also a traditional month for weddings, it is a good time to address an important and logical, but little understood and virtually never-discussed connection: that between homeownership and marriage.

Homeownership is much higher for married than for not-married households. This makes intuitive sense. But the difference in homeownership rates is pretty remarkable: for the United States as a whole, more than 78 percent of married households own their home, nearly double the 43 percent for those not married. Thus, the overall homeownership rate of 63.5 percent is composed of two very different parts by marital status. This difference holds for all major demographic groups. The married versus not-married dynamic, in turn, gives rise to an intriguing homeownership paradox that we explore below.

We examine homeownership in this context over 30 years, from 1987 to 2017. This makes the homeownership effects of the housing bubble-and-bust into a temporary anomaly in the course of the three decades. That U.S. homeownership was artificially pumped up and then fell back to its trend now looks like a blip in the midst of the longer-term pattern. The artificial homeownership inflation was, of course, heavily promoted by the U.S. government, notably by the Clinton administration’s unwise “National Homeownership Strategy.” This strategy may be summarized as: pump up homeownership by making bad mortgage loans. Naturally, they didn’t say it that way—what they said was by making “innovative” mortgage loans. But it turned out the same.

Looking at the longer term, in 1987, the U.S. homeownership rate was 64 percent. Thirty years later, in 2017, it was 63.5 percent, according to the U.S. Census Bureau’s Current Population Survey.

But the homeownership rate for married households went up significantly over the same period: from 76.2 percent to 78.4 percent. And the homeownership rate for not-married households also went up a lot, indeed by a lot more than the married rate did: from 35.3 percent to 43 percent.

The sum of married plus not-married households are all the households there are. Their homeownership rates both went up from 1987 to 2017. So how is it possible that the overall homeownership rate went down?  That is the paradox. It is summarized in Table 1.

The explanation of the paradox is that the mix of married versus not-married households in the U.S. population changed a lot over these years. The proportion of married households, with their much higher homeownership, fell dramatically from 70.2 percent to 57.8 percent of U.S. households. The proportion of not-married households, with their much lower homeownership rate, correspondingly increased. This is shown in Table 2.

Adjusting out the effect of this shift in household mix, U.S. homeownership rates fundamentally rose over these three decades, as many of us would have hoped.

In sum, to understand trends in homeownership, we must include, as is seldom done, its interaction with marriage.

Let’s get rid of Puerto Rico’s triple-tax exemption

Published by the R Street Institute.

Let’s ask a simple and necessary question: Why in the world is the interest on Puerto Rican bonds triple-tax exempt all over the United States, when no U.S. state or municipality gets such favored treatment?

The municipal bond market got used to that disparity, but in fact, it makes no sense. It is an obvious market distortion, on top of being unfair to all the other municipal borrowers. It helped lure investors and savers, and mutual funds as intermediaries, into supporting years of overexpansion of Puerto Rican government debt, ultimately with disastrous results. It is yet another example of a failed government notion to push credit in some politically favored direction. Investors profited from their special exemption from state and local income taxes on interest paid by Puerto Rico; now, in exchange, they will have massive losses on their principal. Just how big the losses will be is still uncertain, but they are certainly big.

Where did that triple-tax exemption come from?  In fact, from the Congress in 1917. The triple-tax exemption is celebrating its 100th anniversary this year by the entry of the government of Puerto Rico into effective bankruptcy. Said the 1917 Jones-Shafroth Act:

All bonds issued by the government of Porto Rico or of by its authority, shall be exempt from taxation by the Government of the United States, or by the government of Porto Rico or of any political or municipal subdivision thereof, or by any State, or by any county, municipality, or other municipal subdivision of any State or Territory of the United States, or by the District of Columbia.

That’s clear enough. But why?  Said U.S. Sen. James K. Vardaman, D-Miss., at the time: “Those people are underdeveloped, and it is for the purpose of enabling them to develop their country to make the securities attractive by extending that exemption.” All right, but 100 years of a special favor to encourage development is enough, especially when the result was instead to encourage massive overborrowing and insolvency.

It’s time to end Puerto Rico’s triple-tax exemption for any newly issued bonds (as there will be again someday). As we observe the unhappy 100th birthday of this financial distortion, it’s time to give it a definitive farewell.

Seven decades of the inflation-adjusted Dow Jones Industrial average

Published by the R Street Institute.

Everybody has observed the renewed volatility of stock prices during the last few months. But for all the volatility, so far, the stock market has moved basically sideways since the end of 2017. The Dow Jones industrial average closed at 24,787 yesterday (April 17), only 0.3 percent different from the 24,719 it was at the end of December—with a lot of storm and stress in between.

Of course, it has moved sideways at a high level. How high?  For perspective, the following graph shows the DJIA over seven decades on an inflation-adjusted basis, expressing the history in March 2018 constant dollars.

We see immediately how much real stock prices can move over time, and how long the basic directional moves can last. The chart falls into five sections. We observe the great bull market of 1949-1966, followed by the great bear market of 1966-1982. Then another great boom from 1982 to the 1990s, which morphs into the runaway bubble of the late 1990s. Then a truly volatile decade which ends up in the big bust bottoming in 2009. Since then, the real DJIA is three times as high as at the 2009 low. In a longer view, it is 14 times what it was in 1949, 12 times as high as at the 1982 bottom and more than three times as high as the 1966 peak—all after adjusting out the endemic inflation of the times.

How high are stock prices now?  Pretty high. The boom and its acceleration last year bears a worrisome resemblance to the shape of the 1990s. However, so far the bull market has lasted only about half as long as those of 1949-1966 or 1982-1999.

What’s next?  Alas, to paraphrase Fred Schwed in his classic 1940 book, “Where Are the Customers’ Yachts?,” the one thing we all want most to know is the one thing we never can know. That’s the future, of course, especially the future of financial markets.

What’s in a name of a Banking Committee?

Published by the R Street Institute.

Adair Turner, whose insights into finance among other contributions got him promoted to Lord Turner, has concluded that lending on housing and other real estate is by far the largest creator of systemic financial risk and banking busts. This conclusion is clearly correct. Among the principal recommendations of his highly interesting 2016 book, Between Debt and the Devil, is that governments must therefore work to constrain banks’ real estate loans and act to limit their recurring tendency to expand into booms and bubbles.

This is precisely the opposite of the historical policy of the American government, which has usually been to enthusiastically promote the inflation of housing credit and denounce the ensuing busts.  Currently, the U.S. government guarantees about 60% of all outstanding mortgage loans and its central bank has created money to the tune of $1.8 trillion to inject into housing finance.

In this context, we reflect on the highly suggestive symbolic shifts in the names of the Congressional committees with jurisdiction over banking.

From 1913, when it was formed, to 1971, the relevant committee of the U.S. Senate was named the Committee on Banking and Currency—a logical and consistent name.  In 1971, the name was changed to the Committee on Banking, Housing, and Urban Affairs—a very different combination of ideas, displaying interest in very different political constituencies. Shortly before, the Congress had restructured Fannie Mae into a government-sponsored housing finance enterprise, and created another one in Freddie Mac, both actions with momentous but unintended future results.

The Committee on Banking, Housing, and Urban Affairs the Senate committee remains.  This displays, as Lord Turner’s view suggests, an overemphasis on housing.  And “Urban Affairs”? The name change is strikingly supportive of Charles Calomiris’ theory that the dominant coalition in U.S. banking politics shifted in the latter 20th century from an alliance of small banks and rural populists, to one of big banks and urban populists.

The relevant committee in the U.S. House of Representatives for 110 years, starting in 1865, had the same historical name: the Committee on Banking and Currency.  In 1975, this was changed to the Committee on Banking, Currency, and Housing.  Promoting housing finance was gaining focus.  Then in 1977, the name became the Committee on Banking, Finance and Urban Affairs.  “Currency” had lost out.  This was during the 1970s, a decade of runaway consumer price inflation, in which an emphasis on controlling the currency might have been useful.  As in the Senate, “Urban Affairs” represented important Democratic Party constituencies and accompanied the government promotion of expanding housing finance.

The House committee’s name changed in the opposite direction in 1995, with a Republican Party majority in the House for the first time in four decades, mostly maintained since then.  It became the Committee on Banking and Financial Services, then in 2001, simply the Committee on Financial Services.  The new name reflected the committee’s greatly expanded jurisdiction, most notably to include the securities industry.  In recent years, this committee has been the Congressional center of trying to reform housing finance along market lines, and in particular, to reform Fannie Mae and Freddie Mac.  These efforts have yet to succeed, unfortunately.

“What’s in a name?”  Nothing, as Shakespeare makes Juliet argue?  Or, over the last several decades, would committees which focused on “banking and currency” have behaved differently from ones diligently expanding their banking interventions to include “housing and urban affairs”?

Real estate debt, the devil and U.S. national banks

Published by the R Street Institute.

The attached policy study originally appeared in the Spring 2018 issue of Housing Finance International. 

Housing finance, as we all know, is lending on fundamentally illiquid assets, taking risk on their prices, which are subject to boom and bust cycles, and doing so on a highly leveraged basis for both the borrowers and the lenders. Naturally this business of ours gets us periodically into severe problems, as has been experienced in numerous countries over time.

Adair Turner, the former chairman of the British Financial Services Authority, goes further. In his provocative book, Between Debt and the Devil (2016), he puts the principal culpability for financial crises – and thus the identity of the Devil – on real estate lending.

He points out that banks in recent decades have changed from being primarily lenders to commerce and industry, to being primarily real estate lenders. In the U.S., this fundamental shift in bank credit toward concentration in real estate dates from the 1970s.

Lord Turner writes:

“In 2007, banks in most countries had turned primarily into real estate lenders.”

“Before the mid-twentieth century, banks in several advanced countries were restricted or at least discouraged from entering real estate lending markets.”

“Lending against real estate… generates self-reinforcing cycles of credit supply, credit demand, and asset prices.” (The interaction of real estate prices and lending is without question a key risk dynamic.)

“At the very core of financial instability in mod-ern economies thus lies an interface between an infinite capacity [to inflate mortgage credit] and an inelastic constraint [real estate].”

Thus, the conclusion: real estate finance and mortgages “are not just part of the story of financial instability in modern economies, they are its very essence.”

Quite an indictment. If it is not the whole truth, it has at least an important element of truth.

In this context, we should consider the instructive history of the laws governing real estate lending by U.S. national banks. These are the banks chartered by the U.S. Government and regulated by the Comptroller of the Currency in Washington, D.C., as opposed to the banks chartered by individual states of the United States. Both exist, but before the American Civil War of 1861-65, all banks were state banks. There are now 943 national banks in the U.S. with aggregate assets of $11 trillion, and 4,075 state-chartered banks with assets of $5 trillion.

National banks make a good study in real estate lending because we can go right back to their creation by the National Currency Acts of 1863 and 1864, later renamed the National Banking Act.

The authors of the original National Banking Act took an unfavorable view of having real estate loans and real estate risk included in the assets of the new national banks, the liabilities of which were going to form the nation’s new currency. They addressed their concern in a simple way: the new national banks were prohibited from making any real estate loans at all!

This seems amazing now, when national banks have $2.5 trillion of real estate loans, or 43 percent of all their loans. On top of that, they own $1.3 trillion of securities based on real estate (mortgage-backed securities), which represent 58 percent of their bond portfolios. (For state banks, real estate loans are 57 percent of total loans and mortgage backed securities are 55 percent of their total bonds.)

The prohibition of real estate loans for national banks lasted about 50 years, until 1913. Although the sponsors of the National Banking Act had intended for national banks completely to replace the state banks, instead the state banks survived and then multiplied, and the national banks felt the competitive pressure.

The first statutory permission for national banks to expand into real estate came as part of the Federal Reserve Act of 1913. This allowed national banks to make real estate loans on farm land only. (In those days, half the population of the U.S. was rural. Congress would expand agricultural lending further with the creation of the Federal Farm Credit System in 1916.) But loans from national banks were limited by the law to 50 percent of the farm property’s appraised value – very conservative, we would say.

The 1913 Act included another basic financial constraint: that real estate loans had to be explicitly tied to more stable bank funding. So, at that point, total real estate loans were limited to a maximum of 33 percent of a national bank’s savings deposits. The idea was that deposits payable on demand should not be invested in real estate financing. The same idea was shown in traditional mortgage lending theory with what used to be called the “special circuit” for funding housing finance. This meant using more stable savings accounts, often in earlier days viewed as “shares,” a kind of equity, and not as deposits – the point being to match more appropriate funding to longer-term residential mortgages. Today we pursue the same goal by the creation of mortgage-backed securities or covered bonds.

An additional limitation of the law was that real estate loans were limited to 25 percent of a national bank’s capital. In contrast, for national banks as a whole today, they represent 256 percent of the tangible capital. For state banks, this ratio is 359 percent.

The limitation to farm real estate for national banks lasted only to 1916, when the law was changed to allow loans on nonfarm real estate, but with a maximum maturity of one year. In 1927, this was expanded to five years on improved urban real estate, with the loan still limited to 50 percent of appraised value.

Vast defaults and losses on real estate lending marked the Great Depression of the early 1930s. Jesse Jones, the head of the Reconstruction Finance Corporation, memorably described “the remains of the banks which had become entangled in the financing of real estate pro-motions and died of exposure to optimism.”

However, in following decades the long-term trend for more expansive real estate lending laws continued apace. Allowable loan-to-value ratios increased to two-thirds, in some cases to 90 percent, maximum maturities were increased to 30 years, and the limit on total real estate loans to 70 percent and then 100 percent of time and savings deposits. In 1974, unimproved land was added as acceptable collateral for national banks. In 1982, the final step in statutory evolution was taken: all statutory real estate lending ratios and formulas were removed by the Garn-St. Germain Act of that year. The 1980s and early 1990a featured euphoric real estate credit expansions and then multiple real estate busts.

In 1994, pursuing further expansion of real estate credit, the administration of President Clinton adopted a political real estate lending campaign: the “National Homeownership Strategy.” The idea was to promote so-called “creative financing” – in other words, the U.S. government was pushing for low and no-down payment mortgages and other risky and low-quality loans. The authors of the National Banking Act would have been appalled by this project. They would have accurately fore-casted its disastrous outcome, which arrived in due course as a contributor to the Great Housing Bust and panics of 2007-08.

That, of course, was the crisis which gave rise to Lord Turner’s book, its diagnosis so unflattering to real estate lending, and to his key prescription:

“To achieve a less credit-intensive and more stable economy, we must therefore deliberately manage and constrain lending against real estate assets.”

In this context, “we” means the government, which must, on Lord Turner’s view, constrain real estate lending, not promote it.

Representatives of housing finance like us may or may not agree that this is the right answer, but we can observe that it is consistent with the statutory limitations on real estate lending provided in the National Banking Act as originally designed and during its first century.

How much has the dollar shrunk since you were born?

Published by the R Street Institute.

The depreciation of the U.S. dollar’s purchasing power has been endemic from the post-World War II years up to today. It got completely out of control in the 1970s and has continued apace since then, although at a lower rate. Our fiat currency central bank, the Federal Reserve, has formally committed itself to perpetual depreciation of the purchasing power of the currency (otherwise known as 2 percent inflation), every year forever.

It is hard intuitively to realize how big the effects of compound interest are over long periods of time, whether it is making something get bigger or smaller. In this case, it means how much average prices are multiplying and how much the dollar is shrinking.

The following table simply shows the Consumer Price Index over seven decades, starting with 1946. For each year, it calculates how many times average prices have multiplied from then to now, and how many cents were then equivalent to one 2017 dollar. For example, in 1948, I was in kindergarten. Since then, prices have multiplied by a factor of 10 times. Today’s $1 is worth what $0.10 was then. Taking another example, in 1965, I graduated from college and luckily met my future wife. Prices have since multiplied 7.8 times. And so on.

You may find it interesting to pick a year—say the year you were born, graduated from high school, first got a regular paycheck, got married or bought a house—and see how much average prices have multiplied since. Next, see how many cents it took at that point to have the equivalent purchasing power of $1 now. In my experience, most people find these numbers surprising, including the changes from more recent times – say, the year 2000. They become inspired to start remembering individual prices of things at various stages of their own lives.

Multiplying Prices and the Shrinking Dollar over Time, 1946-2017

You can also project the table into the future and see what will happen if the future is like the past.

Since average prices can go up over 10 times in the course of an single lifetime—as the table shows they, in fact, have—it is easy to see one reason it is hard to generate sufficient savings for retirement. You have to finance paying what prices will be in the future when you are retired. In the last 40 years (see 1977 on the table), average prices have quadrupled. Then, $0.25 bought what $1 does now. So if you are 40 years old now, by the time you are 80, prices would quadruple again. Good luck with your 401(k)!

Competing Mortgage Credit Scores: A decision for those who take the risk

Published by the R Street Institute.

The use of credit scores by Fannie Mae and Freddie Mac, as one part of their decisions about which mortgages they will buy and guarantee, is by nature an “inside baseball” mortgage-finance discussion, but it has made its way into the regulatory reform bill passed by the Senate March 14.

How such scores are statistically created, how predictive they are of loan defaults, how to improve their performance, whether to introduce new scoring methods and the relative predictive ability of alternative methods are above all technical matters of mortgage credit-risk management. These questions are properly decided by those who take the mortgage credit risk and make profits or losses accordingly. This applies to Fannie and Freddie (and equally to any holder of mortgage credit risk with real skin in the game). Those who originate and sell mortgages, but bear no credit risk themselves, and those with various political positions to advance, may certainly have interesting and valuable opinions, but are not the relevant decision makers.

Should Fannie and Freddie stick with their historic use of FICO credit scores, or use VantageScores instead, or both or in some combination?  Naturally, their own scores are favored by the companies who produce them and they should make the strongest cases they can. Should Fannie and Freddie more experimentally use other “alternative credit scores” different from either?  This can also be argued, although it remains theoretical.

The Senate bill requires Fannie and Freddie to consider alternative credit-scoring models and to solicit applications from competitive producers of the scores for analysis and consideration. That is something a rational mortgage credit business would want to do from time to time in any case, and in fact, Fannie and Freddie have analyzed alternative credit scores. The bill further requires that the process of the review and analysis of credit score performance must itself be reviewed periodically, which is certainly reasonable.

Thus the bill would require a process. But when it comes to the actual decisions about which credit scores to use and how to use them in managing the credit risks they take, Fannie and Freddie themselves are the proper decision makers. In my view, they would not necessarily have to make the same decision. Moreover, either or both could decide to run pilot program experiments, if they found that useful.

The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator and conservator, has in process a thoughtful and careful project to consider these questions, has solicited and is gathering public comments from interested parties and displays a very good grasp of the issues involved. But I do not think that, at the end of this project, the FHFA should make the decision. Rather, Fannie and Freddie should make their own credit-scoring decisions, subject to regulatory review by the FHFA—and of course in accordance with the regulatory reform bill, if it becomes law, as I hope it will.

Fannie has reached the 10% moment, after all

Published by the R Street Institute.

After receiving thoughtful inquiries from two diligent readers (to whom, many thanks) about our calculation of the U.S. Treasury’s internal rate of return (IRR) on its senior preferred stock investment in Fannie Mae, we have carefully gone back over all the numbers starting with 2008, found a couple of needed revisions, and recalculated the answer.

The result is that Fannie has indeed reached its “10 percent moment.” Even after its fourth quarter 2017 loss, and counting the resulting negative cash flow for the Treasury in 2018’s first quarter, we conclude that Treasury’s IRR on Fannie is 10.04 percent. Freddie, as we previously said, was already past 10 percent and remains so.

So the 10 percent Moment for both Fannie and Freddie has arrived. We believe the stage is thus set for major reform steps for these two problem children of the U.S. Congress, but that the most important reforms would not need congressional action. They could be taken by agreement between the Treasury as investor and risk taker, and the Federal Housing Finance Agency (FHFA) as conservator and regulator of Fannie and Freddie.

Since Treasury has received in dividend payments from both Fannie and Freddie the economic equivalent of repayment of all of the principal of their senior preferred stock plus a full 10 percent yield, it is now entirely reasonable for it to consider declaring the senior preferred stock retired—but only in exchange for three essential reforms. These could be agreed between Treasury and the FHFA and thus be binding on Fannie and Freddie. The Congress would not have to do anything in addition to existing law.

These reforms are:

1. Serious capital requirements.

2. An ongoing fee paid to Treasury for its credit support.

3. Adjustment of Fannie and Freddie’s MBS guarantee fees in compliance with the law.

CAPITAL: Fannie and Freddie’s minimum requirement of equity to total assets should be set at the same level as for all other giant, too-big-too-fail regulated financial institutions. That would be 5 percent.

CREDIT SUPPORT FEE TO TREASURY:  Neither Fannie nor Freddie could exist for a minute, let alone make a profit, without the guarantee of their obligations by the Treasury (and through it, the taxpayers), which, while not explicit, is entirely real. A free guarantee is maximally distorting and creates maximum moral hazard. Fannie and Freddie should pay a fair ongoing fee for this credit support, which is essential to their existence. Our guess at a fair fee is 15 to 20 basis points a year, assessed on total liabilities. To help arrive at the proper level, we recommend that Treasury formally request the Federal Deposit Insurance Corp. apply to Fannie and Freddie their large financial institution model for calculating required deposit insurance fees. This would give us a reasonable estimate of the appropriate fee to pay for a government guarantee of institutions with $2 and $3 trillion of credit risk, entirely concentrated in real estate exposure and, at the moment, with virtually zero capital. It would thus provide an unbiased starting point for negotiating the fee.

ADJUSTMENT OF MBS GUARANTEE FEES:  Existing law, as specified in the Temporary Payroll Tax Cut Continuation Act of 2011, requires that Fannie and Freddie’s fees to guarantee mortgage-backed securities be set at levels that would cover the cost of capital of private regulated financial institutions engaged in the same risk—this can be viewed as a private sector adjustment factor for mortgage credit. Whether you think this is a good idea (we do) or not, it is the law. But the FHFA has not implemented this clear requirement. It should do so in any case, but the settlement of the senior preferred stock at the 10 percent moment would make a good occasion to make sure this gets done.

These three proposed steps treat Fannie and Freddie exactly like the giant, too-big-to-fail, regulated, government guaranteed financial institutions they are. Upon retirement of the Treasury’s senior preferred stock with an achieved 10 percent return, the reformed Fannie and Freddie would be able to start accumulating retained earnings again, building their capital base over time. As their equity capital grows, the fair guarantee fee to be paid to the Treasury would decline.

The 10 percent moment is here. Now a deal to move forward on a sensible basis can be made.

Fannie falls further from its ’10 Percent Moment’

Published by the R Street Institute.

When Fannie Mae and Freddie Mac were bailed out by the U.S. Treasury, which bought enough of the firms’ senior preferred stock to bring the net worth of each up to zero, the original deal was that the Treasury, on behalf of taxpayers, would get a 10 percent return on that investment.

For some time now, Fannie, Freddie and their supporters have ballyhooed how many dollars they have paid the Treasury in dividends on that stock, but that is an incomplete statistic. The question is whether those dollars add up to a completed 10 percent return. For that to happen, the payments have to be the equivalent of retiring all the principal plus providing a 10 percent yield; this is what I call that the “10 Percent Moment.” We can easily see if this has been achieved by calculating the internal rate of return (IRR) on the Treasury’s investment. Have Fannie and Freddie at this point provided a 10 percent IRR to the Treasury or not?

The answer is that Freddie has, but Fannie, by far the larger of the two, has not.

Freddie’s net loss in the fourth quarter of 2017 means the Treasury has to put $312 million back into it to get Freddie’s capital up to zero again. This negative cash flow for Treasury will reduce its IRR on the Freddie senior preferred stock, but only to 10.7 percent. Freddie has still surpassed the 10 percent hurdle return.

On the other hand, Fannie’s fourth quarter loss means the Treasury will have to put $3.7 billion of cash back into it, dropping the Treasury’s IRR on Fannie from 9.79 percent in the fourth quarter of 2017, to 9.37 percent. That’s not so far from the hurdle, but the fact is that, as of the first quarter of 2018, Fannie has not reached the 10 Percent Moment. Fannie and its private investors need to stop complaining about paying all its profits to the Treasury until it does.

When both Fannie and Freddie achieve the 10 Percent Moment, it would be reasonable for the Treasury to consider declaring its senior preferred stock in both fully retired, in exchange for needed reforms. At that point, Fannie and Freddie’s capital will still be approximately zero. They will still be utterly dependent on the Treasury’s credit and unable to exist even for a day without it. Reforms could be agreed to between the Treasury and the Federal Housing Finance Agency (FHFA)—as conservator and therefore boss of Fannie and Freddie—and carried out without needing the reform legislation, which is so hard to achieve. There will be a new director of the FHFA in less than 11 months.

Surely a restructured deal can emerge from this combination of factors.

The Fed as a Piggy Bank? Of Course!

Published by the R Street Institute.

The Bipartisan Budget Act passed last week had a little item in it to help government revenues by confiscating $2.5 billion of the retained earnings (they call it “surplus”) of the Federal Reserve Banks.  When they found out about it, the commercial banks, which own all the stock of the Federal Reserve Banks, weren’t happy.

“Critics say the plan is yet another example of Congress turning to the Fed as a source of funding,” the American Banker reported.  It is now “common to use the Fed as a piggy bank,” complained the Independent Community Bankers association.

The Fed as a piggy bank?  Of course, what else?  According to the Federal Reserve’s own press release, the Federal Reserve Banks paid $80.2 billion of their 2017 profits to the Treasury.  In other words, 99 percent of their estimated net profit for the year of $80.7 billion goes to the government to help reduce the budget deficit.  To confiscate another $2.5 billion only increases the aggregate take by 3 percent.

The Federal Reserve Banks have the highest rate of profitability of any bank, with a 2017 return on equity of about 195 percent.  Of course, they are also astronomically leveraged, with assets of about 107 times equity, or a tiny capital ratio of a 0.9 percent.  Almost all of that leveraged profitability goes right into the Treasury, every year.

The Federal Reserve Banks paid aggregate dividends to their shareholders of $784 million in 2017, or less than 1 percent of what they paid the government, which is a greedy business partner, it seems.

The Federal Reserve System is many things, but one of them is a way for the government to make a lot of money from the seignorage arising from its currency monopoly.  The Fed creates money to buy bonds from the Treasury, collects the interest, then gives most of the interest back.  It also uses its money power to buy mortgage-backed securities from Fannie Mae and Freddie Mac, which are owned principally by the Treasury, collects the interest on them, and then sends most of it to the Treasury.

As my friend and banking expert Bert Ely always reminds me, it is easier to understand what is going on if you simply consider the Treasury and the Fed as one interacting financial operation, and consolidate their financial statements into one set of books, clarified by consolidating eliminations.  Then you can see that on a net basis, the consolidated government is creating money instead of borrowing from the public in order to finance its deficits and in order to generate vast seigniorage profits for itself.  The Fed makes a very useful front man for the Treasury in this respect.

The first congressional confiscation of Federal Reserve retained earnings was in 1933.  Then they were taken to provide the capital for the newly formed Federal Deposit Insurance fund.  So as usual in financial history, taking the Fed’s retained earnings is not a new idea.  The Federal Reserve Banks are a politically useful piggy bank, to be sure.

A state-owned bank for New Jersey?

Published by the R Street Institute.

New Jersey Gov. Phil Murphy and some supportive state legislators are promoting the idea to establish a bank owned by the state, holding the state’s deposits and making loans considered politically popular. Is this controversial proposal a good idea?  It’s certainly not a new one.

In the 19th century, banks with majority ownership by the states were set up by Alabama, Georgia, Illinois, Indiana, Kentucky, Missouri, South Carolina, Tennessee, Vermont and Virginia. None of these has survived. An instructive case is the State Bank of Illinois, which “became entangled in public improvement schemes” and went bankrupt in 1842.

“In nearly all states” before the Civil War, report John Thom Holdsworth and Davis Rich Dewey, “provision was made in the charters requiring or permitting the State to subscribe for a portion of the stock of banks when organized.” Among the reasons were that the state “should share in the large profits” which were expected, and “because ownership would place the state in the light of a favored customer when it desired to borrow,” Dewey and Robert Emmert Chaddock note in their State Banking Before the Civil War.

Ay, there’s the rub. Such ideas led a number of states to sell bonds and invest the proceeds in bank stock, hoping the dividends on the stock would cover the interest on the debt. “Every new slave state in the South from Florida to Arkansas established one or more banks and supplied all or nearly all of their capital by a sale of state bonds.”

There is one (and only one) state-owned bank operating today, the Bank of North Dakota. The bank is owned 100 percent by the state and its governing commission is chaired by the governor of the state. Its deposits are not insured by the Federal Deposit Insurance Corporation, but are instead guaranteed by the State of North Dakota, which has bond ratings of AA+/Aa1 (In contrast, New Jersey’s bond ratings are A-/A3.) The bank has total assets of about $7 billion and is thus not a large bank. But it has strong capital and is profitable, the profits helped by being exempt from federal and state income taxes. The Bank of North Dakota was founded in 1919, so is almost a century old.

A less hopeful analogue is the Government Development Bank for Puerto Rico, owned by the Commonwealth of Puerto Rico and designed to operate as an inherent part of the government. It was established in 1942 under the leadership of Rexford Tugwell, the Franklin Roosevelt-appointed governor of the island, an ardent believer in central planning. The Government Development Bank, which had total assets of about $10 billion in 2014, has been publicly determined to be insolvent and will impose large losses on its creditors.

According to a report from the Federal Reserve Bank of Minneapolis, Alexander Hamilton, the father of the federally chartered and 20 percent-government/80 percent privately owned First Bank of the United States, “concluded that a national bank must be shielded from political interference: ‘To attach full confidence to an institution of this nature, it appears to be an essential ingredient in its structure that it shall be under a private not a public direction under the guidance of individual interest, not public policy.’” If this principle applies as well to state-owned banks, how is such a bank to devote itself to politically favored loans?

Would a Bank of New Jersey be likely to resemble more the Bank of North Dakota or the Government Development Bank of Puerto Rico?  Or perhaps the State Bank of Illinois?