Surprised again

Published by the Housing Finance International Journal.

“Why We’re Always Surprised” is the subtitle of my book, Finance and Philosophy. The reason we are so often surprised by financial developments, I argue in the book, is that “The financial future is marked by fundamental uncertainty. This means we not only do not know the financial future, but cannot know it, and that this limitation of knowledge is ineluctable for everybody.” That certainly includes me!

At the end of last year (in December 2018), interest rates had been rising, and it seemed obvious that they would likely rise to a normal level, at last adjusting out of the abnormally low levels to which central banks had pushed them in reaction to the financial crisis. The crisis began in 2007 with the collapse of the subprime lending sector in the United States and of the Northern Rock bank in the United Kingdom, and ran to 2012, which saw the trough of U.S. house prices and settlement of defaulted Greek sovereign debt at 25 cents on the dollar.

Six years had gone by since then, it seemed that it was high time for normalization. This view was shared during 2018 by the chairman of the Federal Reserve Board and its Open Market Committee. It also seemed that the long period of imposing negative real interest rates on savers, thus transferring wealth from savers to leveraged speculators and other borrowers, needed to end.

What would “normal” be? I thought a normal rate for the 10-year U.S. Treasury note would be about 4 percent and correspondingly for a 30-year U.S. fixed-rate mortgage loan about 6 percent, assuming inflation ran at about 2 percent. I still think those would be normal rates. But obviously, it is not where we are going at this point.

For the final 2018 issue of Housing Finance International, I wrote, “The most important thing about U.S. housing finance is that long-term interest rates are rising.” Surprise! Long-term interest rates have fallen dramatically. The United States does not have the negative interest rates, once considered impossible by many economists, which have become so prevalent in Europe, remarkably spreading in some cases to deposits and even mortgage loans. But the United States does have negative rates in inflation-adjusted terms. The 10-year U.S. Treasury note is, as I write, yielding about 1.5 percent. The year-over-year consumer price index is up 1.8 percent, and “core inflation” running at 2.2 percent, so the investor gets a negative real yield once again, savers are again having their assets effectively expropriated, and we can once again wonder how long this can continue.

What do the new, super-low interest rates mean for U.S. housing finance?

The higher U.S. mortgage loan rates, which reached almost 5 percent for the typical U.S. 30-year fixed-rate loan in late 2018, “would have serious downward implications for the elevated level of U.S. house prices, which already stress buyers’ affordability,” I wrote then. Had those levels been maintained, they definitely would have put downward pressure on prices. But as of now, seven years after the 2012 bottom in house prices, the U.S. long-term mortgage borrowing rate has dropped again to about 3.8 percent. This has set off another American mortgage refinancing cycle and is helping house prices to continue upward.

In the U.S. system, getting a new fixed-rate mortgage to refinance the old one is an expensive transaction for the borrower, with fees and costs which must be weighed against the future savings on interest payments. The fees depend on state laws and regulations; they range among the various states from about $1,900 on the low end to almost $6,900 on the high end, according to recent estimates. On the lender side, the post-crisis increases in regulatory burden had raised the lenders’ cost to originate a mortgage loan to as much as $9,000 per loan – the increased volume from “refis” (as we say) may have reduced this average cost to the lender to about $7,500. It is expensive to move all the paper the American housing finance system requires in order for the borrower to obtain a lower interest rate.

Meanwhile, with the new low interest rates and high house prices, “cash out refis” are again becoming more popular. In these transactions, not only do borrowers increase their debt by borrowing more than they owe on the old mortgage loan, but they reset their amortization of the principal further out to a new 30-year schedule. In both ways, they reduce the buildup of equity in their house, making it more likely that they will still have mortgage debt to pay during their retirement.

In general, there are no mortgage prepayment fees in the United States. The old, higher rate loans are simply settled at par. This continues to make prices of mortgage securities in the U.S. system very sensitive to changes in expected prepayment rates. If investors have bought mortgage loans at a premium to par, which they often do, upon prepayment they have lost and must write off any unamortized premiums they paid.

The most notable American investor in mortgage securities is the central bank, the Federal Reserve. As of Aug. 21, 2019, it had on its books $115 billion (with a B) of unamortized premium, net of unamortized discounts. Not all of this may be for its $1.5 trillion mortgage portfolio; still, a refi boom might be expensive for the Fed.

Speaking of the Federal Reserve, then-Chairman Ben Bernanke wrote in 2010 about his bond buying or “quantitative easing” programs: “Lower mortgage rates will make housing more affordable and allow more homeowners to refinance.” The latter effect of promoting refis is always true, but not the former claim of improved affordability. It ceases to be true when low mortgage rates have induced great increases in house prices, as they have. The high prices obviously make houses less affordable, and obviously mean that more debt is required to buy the same house, often with higher leverage – notably higher debt service-to-income ratios.

U.S. house prices are now significantly above where they were at the peak of the housing bubble in 2006. They have risen since 2012 far more rapidly than average incomes. The Fed’s strategy to induce asset price inflation has succeeded in reducing affordability.

According to the Federal Housing Finance Board’s House Price Index, U.S. house prices increased another 5 percent year-over-year for the second quarter of 2019. “House prices rose in all 50 states…and all 100 of the largest metropolitan areas,” it reports. Its house price index has now gone up for 32 consecutive quarters.

The S&P Case-Shiller National House Price Index has just reported a somewhat lower rate of increase, with house prices on average up 3.1 percent for the year ending in June. There is art as well as science in these indexes – the FHFA’s index notably does not include the very high (“jumbo,” in American terms) end of the market. According to Case-Shiller, in some particularly expensive cities, house price appreciation has distinctly moderated, with year-over-year increases of 1.1 percent for New York, 0.7 percent for San Francisco, and negative 1.3 percent for Seattle.

The AEI Housing Center of the American Enterprise Institute has house price indexes that very usefully divide the market into four price tiers. It finds that at the high end of the market, the rate of increase in prices is now falling, while the most rapid increases are in the lowest-priced houses – just where affordability and high leverage are the biggest issues, and where the U.S. government’s subprime lender, the Federal Housing Administration, is most active.

On a longer-term view, Case-Shiller reports that national U.S. house prices are 57 percent over their 2012 trough, and 14 percent over their bubble peak. When U.S. interest rates rise again, whether to normal levels or something else, these prices are vulnerable. How much might they fall? That may be another surprise.

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Published by the R Street Institute.

EDWARD J. PINTO and TOBIAS J. PETER                       ALEX J. POLLOCK

AEI Housing Center                                         R Street Institute

September 26, 2019

Department of Housing and Urban Development

Regulations Division

Office of the General Counsel

451 7th Street SW

Washington, DC 20410

Submission via www.regulations.gov

Dear Sir/Madam:

Re.: Docket No. FR-6111-P-02; RIN: 2529-AA98

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Thank you for the opportunity to comment on this proposed rule on the Disparate Impact Standard. The authors of the comment have many years of experience in housing finance, as operating executives, analysts, and students of housing finance systems and their policy issues.  We believe this rulemaking has the potential to significantly improve the existing standard.

Our fundamental recommendation is that the consideration of disparate impact issues must be able to include credit outcomes, i.e. default rates, not only credit underwriting inputs.  Specifically:

1. Mortgage lenders, including smaller lenders, should have the option to use a credit outcomes-based statistical approach, as defined below, which qualifies as a valid defense under the Disparate Impact rule. This would improve the fairness, operation, and statistical basis of the rule.

2. HUD should develop a credit outcomes-based statistical screening approach that allows it to assess with a high degree of confidence, whether differences in mortgage lending results raise disparate impact questions for further review.

In both cases, the ability to use credit outcomes would enhance clarity and reduce uncertainty.

Problems with the Pure Input Approach

Applying its credit standards in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing.  Typically, the question of whether this is being carried out has been approached by looking only at inputs to a lending decision.  This results in a focus on differing credit approval/credit decline rates between protected and non-protected classes.  The argument is then made that the existence of differing credit approval/credit decline rates between classes is evidence of discrimination even if a lender applies exactly the same set of credit underwriting standards to all credit applicants.[1]

Read in full here.

Key points in the Treasury’s paper on Fannie/Freddie reform

Published by the R Street Institute.

The important parts of the Treasury’s new paper on Fannie Mae and Freddie Mac reform are not the legislative recommendations, since legislation is not going to happen. They are the administrative steps that can be taken now, with political will. Of these, the key ones are:

• Increased capital requirements for Fannie and Freddie, under which the same risks, whether taken by private institutions or by Fannie and Freddie, have the same capital protection;

• Removing regulations which especially favor Fannie and Freddie over other competitors;

• An ongoing fee from Fannie and Freddie to the Treasury to pay for the taxpayer credit support, without which Fannie and Freddie could not exist;

• Rewarding the taxpayers for their bailout of Fannie and Freddie by having Treasury exercise its warrants for 79.9 percent of Fannie and Freddie’s common stock. Since the exercise price is one-thousandth of a cent per share, this will be a nice and well-deserved profit for the taxpayers.

The Treasury’s articulated direction of a more competitive mortgage market with less taxpayer risk is certainly correct.

Is the Fourth of July really the Second?

Published by the R Street Institute.

We all know about Fourth of July picnics, parades and fireworks. We all know the celebration is about the Declaration of Independence and the birth of our country. But how much else do we know about the beginning of American independence?  Here is a little quiz to help celebrate the Fourth with some history.

1. On what date was the decision made to declare American independence?

The answer is not July 4, but July 2, 1776. This was when the truly decisive event occurred, the vote of the Second Continental Congress that America should separate itself from England. The vote was preceded by days of debate about a motion of June 7.

That these United Colonies are, and of right ought to be, free and independent States, that they are absolved from all allegiance to the British Crown.

On July 2 this motion was adopted, with 12 colonies in favor, none against and one abstention (New York, which later added its affirmative vote).

July 2 “marked the great decision from which there was no turning back,” as one historian wrote.

1. What happened July 4?

On July 4, Congress approved the final, revised text of the full document of the Declaration, which not only declared independence but gave philosophical and historical reasons for it. The Declaration was signed that day by President of the Congress John Hancock and Secretary of the Congress Charles Thomson. None of the other signatures were added until Aug. 2 or later.

The printer worked all that night to make copies for distribution. The published text bears the famous date of July 4 and began to be sent around America July 5.

1. What about July 3?

July 3 marked a painful experience for Thomas Jefferson, the Declaration’s principal drafter. Having already made the great decision, the Congress sat down to edit, criticize and revise the draft which Jefferson had prepared. Anybody who has had a paper amended by a committee can especially sympathize with Jefferson each July 3.

1. What is most of the Declaration about?

Much of the Declaration, about 55 percent of its text, is devoted to listing all the faults and misdeeds of King George III. This list is about three times as long as the most famous passage setting forth the truths held to be self-evident.

The Declaration has four basic parts:

• An introduction (“When in the course of human events”)

• A philosophical justification (“We hold these truths to be self-evident”)

• The list of King George’s misdeeds

• The concluding resolutions of independence, of which the heart is the original motion quoted above.

The third, longest part concludes that King George is “a prince whose character is marked by every act which may define a tyrant.”

1. Does the Declaration discuss a new country?

This question is a little tricky, because it depends on the idea of “a” or one new country. The Declaration always refers to the 13 colonies in the plural. It says, “These United Colonies are Free and Independent States.”

The new states that set out to be free and independent immediately began working on how they would form a confederation or a union. This question was not settled until the implementation of the Constitution in 1789—or it might be argued, not until the conclusion of the Civil War in 1865.

1. Did the Declaration begin the Revolutionary War?

No, the Declaration grew out of a war already begun more than a year before. The fighting at Lexington and Concord, Massachusetts, occurred April 19, 1775, or more than 14 months before the decision to declare independence.

1. When did America achieve independence?

It is one thing to announce plans and another to carry them out. The Revolutionary War dragged on for years after the Declaration, with great difficulties and despair, as well as vision and courage. These years also included high inflation, caused by the Continental Congress printing paper money to finance the army.

Independence was finally achieved when Great Britain acknowledged it by the Treaty of Paris in 1783, seven years after the Declaration.

1. How long has it been since you read the Declaration of Independence?

It is an excellent read, for its world-historical importance, dramatic setting, intellectual substance and eloquent language.

The U.S. can reform housing finance without any action from Congress

Published in Housing Finance International.

The U.S. came out of the 2007-12 housing bust with a housing finance system even more government-centric than it was before, because the Government completely took over Fannie Mae and Freddie Mac by way of a regulatory conservatorship. Most people assumed that Fannie and Freddie’s financial collapse would inspire the U.S. Congress to reform them, which would mean fixing the excessive leverage of their own balance sheets and the excessive leverage the Government promoted through them in the whole housing finance sector. This, as it has turned out, was a bad assumption. Congress tried to create reform legislation, and the accompanying debates were long and energetic, but in the end nothing happened.

Meanwhile Fannie and Freddie remain dominant and huge operations. Their combined assets are a staggering $5.5 trillion. These assets are supported by virtually no capital. Their latest quarterly financial statements show a capital ratio of a risible 0.2 percent, or a leverage of 500 to 1. Under current rules, the Government does not let Fannie and Freddie retain any earnings to speak of, so they are utterly dependent upon the continuing credit support from the U.S. Treasury. Without this support, they could not exist even for one minute. Their government conservatorships are in their 11th year – an outcome nobody anticipated and nobody wants.

It now appears there is virtually zero probability of reform legislation in the current divided Congress.

However, significant reform can occur with-out needing Congress to act. A determined administration – the president, the Treasury Department, and the Federal Housing Finance Agency (which is the regulator and conservator) – can do a lot on its own, without any legislation. It looks like they intend to do so .

President Trump recently told a conference of the National Association of Realtors:

“My administration is committed to reforming our housing finance system…Fannie and Freddie still dominate the market with no real competition from the private sector. And tax-payers are still on the hook…That’s why I recently directed the Department of Treasury and HUD [the Department of Housing and Urban Development] to develop a framework for a modern housing finance system…one that welcomes private sector competition, protects taxpayers and preserves home ownership.” (The transcript adds: “Applause.”)

The president was referring to his formal “Memorandum on Federal Housing Finance Reform” of March 27, 2019. This memorandum includes the following:

“The Secretary of the Treasury is hereby directed to develop a plan for administrative and legislative reforms.”

As stated above, the legislative part of the reforms is very unlikely to happen, but the administrative ones can. The goals of the plan are to include:

• “Ending the conservatorships” of Fannie and Freddie”

• “Facilitating competition in the housing finance market”

• “Providing that the federal government is properly compensated for any explicit or implicit support is provides” to Fannie and Freddie”

• “Establishing appropriate capital and liquidity requirements” for Fannie and Freddie. The capital requirements will need to be a lot higher than the current virtually zero. Personally, I am recommending a 4 percent tangible equity to assets requirement, reflecting that 4 percent is the global capital standard for prime mortgage credit risk. The Treasury will pro-duce its own recommendation.

• “Increasing competition and participation of the private sector in the mortgage market”

• “Heightened prudential requirements and safety and soundness standards, including increased capital requirements” for Fannie and Freddie

And of special interest to my former colleagues in the Home Loan Bank of Chicago, the former home of the Secretariat of the IUHF: “Defining the mission of the Federal Home Loan Bank system and its role in supporting Federal housing finance.”

About all of these goals, the Memorandum directs that “the Secretary of the Treasury must specify whether the proposed reform…could be implemented without Congressional action. For each administrative reform, the Treasury Housing Reform Plan shall include a timeline for implementation.” That sounds serious.

And: “The Treasury Housing Reform Plan shall be submitted to the president for approval…as soon as practicable.”

If the administration does implement administrative reforms, here are some suggestions for additional things it has the power to do:

• The FHFA should set for Fannie and Freddie, like for all other financial institutions, both a leverage capital requirement (for Fannie and Freddie, 4 percent of total assets) and a risk-based capital standard, requiring whichever is higher.

• Fannie and Freddie should pay a fee to the Treasury for its credit support based on what the Federal Deposit Insurance Corporation would charge an equally huge bank of equivalent riskiness for deposit insurance.

• The Financial Stability Oversight Council should designate Fannie and Freddie as the Systemically Important Financial Institutions [SIFIs] they are, since they have proven they can put the whole financial system at risk.

• The FHFA should ensure emphasis on sound credit risk management throughout the inevitable cycles.

• The Federal Home Loan Banks should especially expand the role of secondary mortgage finance in which the original lender retains credit expo-sure (“skin in the game”) for the life of the loan, which ensures an alignment of incentives superior to the Fannie and Freddie model.

• The Treasury should exercise the options it owns to acquire 79.9 percent of Fannie and Freddie’s common stock at an exercise price of one-thousandth of a cent per share. This will represent a nice and well-deserved profit for the taxpayers who bailed Fannie and Freddie out.

Will the administration really act to implement reform through its purely administrative powers? I think there is a good probability that it will. Congress will, it appears, be left to continue debating without acting.

Who should pick credit-risk-scoring models?

Published by the R Street Institute.

American residential mortgage finance is the second-largest credit market in the world, behind only U.S. Treasury debt. Its immense size, at $10.4 trillion in outstanding loans, perhaps alone justifies the endless debates about how to reform it and improve its risk structures. In addition, the subject of mortgages is always political, being central to homeownership and to large housing-related industries and constituencies.

One relevant issue in the inside baseball of mortgage finance is the question of credit-scoring models. Credit scores and the models that calculate them are deeply imbedded in the credit decisions about mortgages. The purpose of the scores is to contribute to the credit consideration statistical estimates of the probability of default. Since credit underwriting is all about predicting and controlling the frequency and patterns of defaults, and therefore the credit losses experienced by the risk-taking lenders, this is a key idea.

Because Fannie Mae and Freddie Mac dominate the great middle of the mortgage market, the “conforming loan” sector, how they use credit scores has become a subject of congressional action, regulatory rulemaking and ongoing discussion. I just got a question on this issue when testifying to the Senate Banking Committee this week. In particular, the issue concerns Fannie and Freddie’s use of the FICO score, the incumbent mortgage-finance leader, or the challenger VantageScore. But it applies in principle to any other credit score that may be developed.

How to decide among competing scores is a highly technical matter. The more pertinent question from the political and economic perspective is who should decide. The answer to who is clear and definitive: whoever is taking the credit risk should decide how to use credit scores and which to use. That is the party that will bear the losses resulting from credit decisions, the one with skin in the game. Those without credit skin in the game should not get to choose which credit scores to use.

In short, the right principle is: the risk-taker decides. If Fannie and Freddie are taking the credit risk, they should decide which credit scores to use and how to use them, based on the most analytical, most objective criteria they can discover. And the same for any other risk-taker.

Should there be competition among credit scores?  Of course, competition is essential in this market, as anywhere. The right locus for competition is for the producers of credit scores to make the best cases they can to the risk-takers about the performance of their scores. May the most predictive, highest-performing score win.

Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?

Published by the R Street Institute.

Testimony of

Alex J. Pollock

Distinguished Senior Fellow

R Street Institute

Washington, DC

To the Committee on Banking, Housing, and Urban Affairs

United States Senate

           Hearing on “Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?”

June 25, 2019

Fannie and Freddie Are Obviously SIFIs

Mr. Chairman, Ranking Member Brown, 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 almost five decades working in and on the banking and housing finance system.  This included serving as President and CEO of the Federal Home Loan Bank of Chicago 1991-2004, and as a resident fellow of the American Enterprise Institute 2004-2015.  I have personally experienced and studied numerous financial cycles, crises and their political aftermaths, and have authored many articles, presentations, testimony and two books on related subjects, including the nature of systemic financial risk.

To begin with the essence of today’s question: Are Fannie Mae and Freddie Mac, which guarantee half the credit risk of the massive U.S. housing finance sector, and which have combined assets of $5.5 trillion, systemically important?  Obviously, they are.  Are they financial companies?  Of course.  So they are systemically important financial institutions as a simple fact.

This is true if you consider them as two of the largest and most highly leveraged financial institutions in the world, but it is equally true if you consider them as an activity that generates systemic risk.  Guaranteeing half the credit risk of the biggest credit market in the world (except for U.S. Treasury securities) is a systemically important and systemically risky activity.  Leveraged real estate is, and has been throughout financial history, a key source of credit collapses and crises, as it was yet once again in 2007-2009.  The activity of Fannie and Freddie is 100% about leveraging real estate.  Moreover, they have been historically, and are today, themselves hyper-leveraged.

To use the words of the Dodd-Frank Act, could Fannie and Freddie “pose a threat to the financial stability of the United States”?  They have already demonstrated that they can.

The Financial Stability Board has stated this fundamental SIFI characteristic: “the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie and Freddie displayed at the time of their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability.  As we all know, in 2008, U.S. public authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out, with ultimately $190 billion of public funds.  In addition, they pledged the credit support from the U.S. Treasury which protected and still protects Fannie and Freddie’s  global creditors.

Fannie and Freddie continue to represent giant moral hazard, as they always have.  Since they now have virtually zero capital, they are even more dependent on the Treasury’s credit support and its implicit guarantee than they were before.

That Fannie and Freddie are SIFIs in financial reality no reasonable person would dispute.

Yet so far, the Financial Stability Oversight Council (FSOC) has not designated Fannie and Freddie as official SIFIs. To a non-political observer, judging purely on the merits of the case, this would be highly surprising. FSOC’s historical inaction in this instance has certainly not added to its intellectual credibility. To Washington observers, naturally, it just seems like ordinary politics.

This hearing requires us to consider how FSOC should deal with the fact of Fannie and Freddie’s systemic importance.  Should FSOC recognize the reality by formally designating Fannie and Freddie as the SIFIs they so obviously are?  Or should FSOC keep ignoring the issue?

I believe FSOC should formally designate Fannie and Freddie as SIFIs and strongly recommend that action.  That would be consistent with the clear provisions of the Dodd-Frank Act.  In my opinion, the country needs Fannie and Freddie to be integrated into the efforts to understand and deal with systemic risk.  Without including Fannie and Freddie, these efforts are woefully incomplete.

Let us consider the SIFI factors of size, interconnectedness, substitutability, leverage, maturity mismatch and liquidity risk, and existing regulation.

Size

In total assets, Fannie is far larger than even the biggest SIFI banks.  The following table ranks by size the ten largest existing SIFIs plus Fannie and Freddie.  As it shows, Fannie is bigger in assets than JPMorgan Chase and Bank of America, and Freddie is bigger than Citigroup and Wells Fargo.  On this combined table of twelve huge financial institutions, Fannie is #1 and Freddie is #4.

Size of Fannie, Freddie and the Largest Ten Existing Official SIFIs

Total AssetsFannie Mae$ 3.42 trillionJPMorgan Chase 2.74Bank of America 2.38Freddie Mac 2.09Citigroup 1.96Wells Fargo 1.89Goldman Sachs 0.93Morgan Stanley 0.88U.S. Bancorp 0.48PNC Financial Services 0.39TD Group US 0.38Capital One Financial 0.37

Sources: S&P Global Market Intelligence; Fannie Mae, 1st Quarter 10-Q 2019; Freddie Mac, 1st Quarter 10-Q 2019

Interconnectedness

The obligations of Fannie Mae and Freddie Mac are widely held throughout the U.S. financial system and around the world.  U.S. depository institutions hold well over $1 trillion of their securities.  The Federal Reserve itself holds $1.6 trillion in MBS, mostly those of Fannie and Freddie.  Could Fannie and Freddie be allowed to fail and impose credit losses on the Fed? Presumably not.  Preferential banking regulations promote Fannie and Freddie, including low risk-based capital requirements for their MBS and debt, creating an incentive for depository institutions to hold large exposures to those securities. These low risk-based capital requirements for depository institutions compound the hyper-leverage of Fannie and Freddie themselves, and amplify their systemic risk.

Moreover, U.S. banks are allowed to buy the equity, preferred stock and subordinated debt of Fannie and Freddie, and fund these investments with government-insured deposits.  This combination results in systemic double leverage.

The interconnectedness of Fannie and Freddie’s mortgage-backed securities and debt with the global financial system became vivid in 2008. As then-Secretary of the Treasury Henry Paulson correctly judged, a default on Fannie and Freddie’s obligations would have dramatically exacerbated the financial crisis on a global basis.

As Paulson recounted in his memoir of the crisis, On the Brink:

“From the moment the GSEs’ problems hit the news, Treasury had been getting nervous calls from officials of foreign countries that were invested heavily with Fannie and Freddie.  These calls ratcheted up after the [2008 HERA] legislation.  Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee”—and also “what this would imply for other U.S. obligations, such as Treasury bonds.”

As Fannie and Freddie reported large losses, Paulson relates that he instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.”  In an even more revealing comment, Paulson added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the overwhelming global systemic risk of not bailing them out, Paulson’s assurance turned out to be true for all of Fannie and Freddie’s debt and MBS holders.  Even those who had bought subordinated debt, thereby intentionally taking more risk, were protected.

Substitutability

Fannie and Freddie’s systemic role is critical and cannot be replaced in the short or medium term—there are no substitutes.  They play a unique, systemically central role and remain the dominant force in the funding of U.S. mortgages.   There are no meaningful competitors because of their huge, ongoing risk subsidies from the government.  In 2018, they guaranteed $917 billion in MBS.  In the first quarter, 2019 they had a 63% market share of MBS issuance (including Ginnie Mae, the government has a 94% market share.) Their balance sheets represent about half of total U.S. mortgage loans outstanding.  Thousands of mortgage originators, servicers, domestic and international investors and derivatives counterparties depend on their continued functioning and government-dependent solvency.    This is one reason that the U.S. Congress has been unable to pass any legislation to end their conservatorship.

Leverage

In addition to their massive size, Fannie and Freddie have historically displayed extreme leverage and continue to do so.  As of March 31, 2019, their balance sheets show a combined capital ratio of a risible less than 0.2% and they are hyper-leveraged at over 500 to 1.  Of course, under the bailout agreement, the government will not let them build retained earnings, but the fact of the hyper-leverage remains.

Maturity Mismatch and Liquidity Risk

The American 30-year fixed-rate, freely prepayable mortgage loan is one of the most complex financial instruments in the world to finance and hedge. Unlike the fixed-rate mortgages of most other countries, the prepayment risk of these mortgages is not offset by prepayment fees. This necessitates a complex derivatives market which trades in the risks of prepayment behavior.  Fannie and Freddie together own about $400 billion of mortgages in their own portfolios, on an extremely leveraged basis.  They are major counterparties in interest rate derivatives and options markets.  Their MBS spread the complex interest rate risks of American 30-year fixed rate mortgages, while concentrating the credit risk of U.S. house prices, now again at an all-time high.  The liquidity of Fannie and Freddie’s securities and of Fannie and Freddie themselves completely depends on the implicit guarantee of the U.S. Treasury.

Existing Regulation

Fannie and Freddie of course have an existing regulator, the Federal Housing Finance Agency (FHFA).  But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system.

U.S. residential mortgages constitute the largest loan market in the world, with $10.4 trillion in outstanding loans.  The risks of this huge market include the holdings by banks of the MBS and debt of Fannie and Freddie.  There are no limits on the amount of Fannie and Freddie obligations which can be owned by banks.

As discussed above, the risks of Fannie and Freddie also flow into the banking system because banks are allowed to invest in Fannie and Freddie’s equity on a highly-leveraged basis, which creates systemic double leverage.  In the financial crisis of 2007-2009, many banks took large losses and a number failed because of their exposure to Fannie and Freddie’s preferred stock, an exposure which was encouraged by regulation.  This is an issue the Federal Reserve, as a systemic risk regulator, would want to consider.

A major systemic risk is that Fannie and Freddie are by definition 100% concentrated in the risks of leveraged real estate.  Indeed, they are by far the largest concentration of mortgage credit risk in the world. Leveraged real estate, needless to say, has a long and painful record of being at the center of banking collapses and financial crises.

Fannie and Freddie’s primary regulator is likewise devoted only to housing finance. Such a regulator always faces the temptation to become a cheerleader and promoter of housing and housing finance.  This brought down the old Federal Home Loan Bank Board, abolished in 1989, and arguably also the Office of Thrift Supervision, abolished in 2010.

In sum, Fannie and Freddie are huge in size, huge in risk, close to zero in capital, tightly interconnected to thousands of counterparties, and force risk on the U.S. Treasury. They meet the criteria specified by the Dodd-Frank Act and its implementing regulations for designation as a SIFI, both as institutions and considered as a systemically risky activity.  They also meet the international criteria of the Financial Stability Board for designation as a Global SIFI.

If Fannie and Freddie are not SIFIs, then nobody in the world is a SIFI, and if any institution is a SIFI, then so are Fannie and Freddie.  Addressing their systemic risk through designation as a SIFI would logically match their systemically important role and riskiness.

Conservatorship

In September 2008, as we know, the Federal Housing Finance Agency determined that Fannie and Freddie each were “in an unsafe or unsound condition to transact business,” and “likely to be unable to pay its obligations or meet the demands of its creditors in the normal course of business.” The government placed them into conservatorship, and thus assumed “all rights, titles, powers, and privileges of the regulated entity, and of any stockholder, officer, or director of such regulated entity with respect to the regulated entity and the assets of the regulated entity.”

Conservatorship was never intended to be a perpetual status for Fannie and Freddie, but it continues in its 11th year, an outcome altogether unintended and undesired.

Should designating Fannie and Freddie as SIFIs be delayed because they are in conservatorship?  The answer, it seems to me, is clearly No.  They are just as systemically important and systemically risky in conservatorship as out of it. They create just as much or more moral hazard.  The Conservator cannot manage their systemic risk.  Indeed, because of the “net worth sweep” deal between the Treasury and the FHFA as Conservator, Fannie and Freddie are even more highly leveraged than before.  Meanwhile, under the Conservator, they continue to expand mortgages with high debt service to income ratios, another form of increased leverage.

The Federal Reserve as Additional Regulator

If—I hope it is when—Fannie and Freddie are formally designated as the SIFIs they economically are, the Federal Reserve will become an additional, systemic risk regulator for them.  This seems to me a good idea, since the Fed is the best placed of all existing regulatory agencies to consider the risks Fannie and Freddie pose from the view of the financial system as a whole.  Of course, the statute assigns this responsibility to the Fed for all SIFIs.  If you don’t like this outcome of SIFI designation, should you therefore claim that Fannie and Freddie are not SIFIs?

Suppose we grant that the Fed, like everybody else, has numerous shortcomings.  That does not mean that Fannie and Freddie are not SIFIs. Let us concede that the Fed, like everybody else, is far from perfect.  It should still take on, as the only available authorized actor, the essential task of understanding and addressing what Fannie and Freddie are doing to systemic risk.

Of course, Fannie and Freddie already have a primary regulator, but so do all other SIFIs.  That the FHFA regulates Fannie and Freddie is no more an argument against their being SIFIs than the fact that the Comptroller of the Currency regulates national banks would prevent banks from being SIFIs.

The Fed should be able to consider, and should consider, for such “large, interconnected financial institutions,” in the words of the Dodd-Frank Act, “establishment and refinement of prudential standards and reporting and disclosure requirements…taking into consideration their capital structure, riskiness, complexity, financial activities…size, and any other risk-related factors.”

For example, the Fed might usefully consider with respect to Fannie and Freddie such questions as:

-Whether their capital requirements and their leverage cause capital arbitrage and thereby increased risk in the financial system as a whole.

-Whether the same risks should be capitalized in the same way between private financial institutions and Fannie and Freddie.

-How Fannie and Freddie’s concentration in leveraged real estate risk affects the risk of the financial system.

-How or whether Fannie and Freddie’s activities contribute to house price inflation and thereby reduce housing affordability.

-Whether their heavy concentration in California mortgages amplifies earthquake risk.

-How much banking regulations which favor Fannie and Freddie increase the riskiness of banks.

-Whether the double leverage in the financial system created by allowing banks to invest in Fannie and Freddie’s equity makes sense.

-Whether Fannie and Freddie’s market dominance decreases or increases systemic risk.

-How much risk is being pushed on the Treasury and the taxpayers by Fannie and Freddie, at what economic cost.

I believe is that the Fed as systemic risk regulator of Fannie and Freddie would be a force for sound and well-capitalized housing finance, which would be better understood in the context of its interaction with the rest of the banking and financial system.  That should be everybody’s goal.

Concluding Questions and Answers

Are Fannie and Freddie SIFIs?  Yes, without a doubt.

Do Fannie and Freddie cause systemic financial risk?  Yes.

Is the Federal Reserve a reasonable place to try to understand and address the systemic risks?  Yes.

Should FSOC recognize these facts by formally designating Fannie and Freddie as SIFIs?  Yes.

When?  The sooner, the better.

Thank you again for the chance to share these views.

Why did economists think negative interest rates were impossible?

Published by the R Street Institute.

“Many things that had once been unimaginable nevertheless came to pass.” So it is with negative interest rates, a very good case of this insightful saying of physicist Freeman Dyson.

Many economists once confidently discussed how there was a “zero bound,” so interest rates could not go below zero in nominal terms. They had a nice theoretical argument, which seemed logical, and which they repeated over the years, for why this had to be so.

The world has a lot of negative interest rates anyway. Last week, the global total of bonds with negative interest rates reached $12.5 trillion, with a “T.”

So much for the zero bound and so much for the argument. Why did the economists believe what is manifestly not the case—with the proof of the opposite case now in trillions?

The argument was that as long as paper currency was available, which is always worth par and has an interest rate of zero, nobody would ever choose to hold a note, or deposit or bond with a negative interest rate. They would always pick a zero return over less than zero. This sounds OK. Why isn’t it true in real life?

The problem is that it applies for relatively small amounts on a personal basis, but not for huge amounts on an institutional basis. It is easy to imagine keeping $5,000 or $10,000 in currency instead of in a deposit account or money-market investment or paying $500 in cash to your plumber. You could readily have a wallet, or a box or a safety deposit box full of paper currency.

But suppose you are an institution with hundreds of billions of dollars to invest—that would be a lot of $100 bills. Or try to imagine the astronomical daily trading of financial markets trying to settle in paper currency. Or a corporation with 100,000 employees deciding it would go back to payrolls made in envelopes of currency and coins. Currency is simply not a substitute for the accounting money of banks and central banks at institutional size. Q.E.D.

There is a further intriguing issue. How negative can interest rates get? Negative 1 percent? Negative 2 percent? More? When would something blow up? Nobody knows.

A final speculation: I believe that a free financial market would never on its own create negative interest rates, which is the inherently silly idea that the lenders should pay the borrowers for the privilege of lending them money. Only in a world of the manipulations of fiat currency central banks, I believe, can negative interest rates happen. But that, of course, is the world we have.

Letter to Financial Stability Board on SIFI Oversight

Published by the R Street Institute.

Alex J. Pollock and Thomas H. Stanton

Washington DC.

                                                                                         June 11, 2019

Secretariat

Financial Stability Board

c/o Bank for International Settlements

CH-4002

Basel, Switzerland

By E-Mail: fsb@fsb.org

Dear Sirs, Mesdames:

Re.: A Large Gap in Global TBTF Reforms

We write in reference to the announcement of the “Evaluation of too-big-to-fail reforms” in your memorandum of May 23, 2019. We respectfully point out that, while the 3 July 2017 Framework refers broadly to evaluating “G20 Financial Regulatory Reforms,” and the May 23 Summary Terms of Reference refer to SIFIs broadly, the May 23 press release calls for evaluation only of Systemically Important Banks.

We urge that FSB solicitations with respect to evaluating TBTF reforms must address SIFIs that are not Banks. It could be that, without saying so, that is the intention of the FSB, and we are submitting this comment letter just to be sure. Specifically, we recommend that this Evaluation must include the obviously TBTF firms, Fannie Mae and Freddie Mac.

As is well known, these two grossly undercapitalized firms failed and were bailed out in the financial crisis of 2008, having become one of the most vulnerable points in the financial system.

Fannie Mae and Freddie Mac today have $5.5 trillion in combined assets, representing half the credit risk of the massive U.S. mortgage market. They are unquestionably systemically important, but they have not been designated as SIFIs by the U.S. Financial Stability Oversight Council. On the merits, this seems highly surprising. We believe it represents a major gap in the global response to implementing global systemic risk and TBTF reforms, which the Evaluation should address.

We suggest the following points from your terms of reference are particularly relevant:

1. “The TBTF problem arises when the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie Mae and Freddie Mac displayed at the time of their failure and display now the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability. As demonstrated by the history of the financial crisis, public authorities not only felt overwhelming pressure but did in fact bail them out with $190 billion of public funds.

1. “G20 leaders endorsed the FSB framework for Reducing the moral hazard posed by SIFIs.”

Fannie Mae and Freddie Mac continue to represent enormous moral hazard. Since they are now even more dependent on the U.S. Treasury’s implicit guarantee than before, the moral hazard they represent is even greater than in 2008.

1. “The evaluation will focus on…requirements for additional loss absorbency through higher capital buffers.”

Fannie Mae and Freddie Mac are much more highly leveraged than TBTF banks were in 2008, and now have far less capital than before their collapse. In fact, their equity capital is virtually zero. As of March 31, 2019, their combined capital ratio is a risible 0.2% and they are hyper-leveraged at 500 to 1.

1. “The evaluation will cover…cross-border and cross-sectional effects.”

Fannie Mae and Freddie Mac’s $5.5 trillion in mortgage-backed securities and debt are sold and traded in global capital markets.

1. “The FSB will engage with relevant stakeholders (market participants, academics, civil society, etc.).”

It would be a pleasure to provide any further information which would be helpful in adding Fannie Mae and Freddie Mac to the scope of the Evaluation.

With sincere thanks for your consideration,

Respectfully submitted,

Alex J. Pollock                                                   Thomas H. Stanton

Distinguished Senior Fellow                              Fellow

R Street Institute                                             Johns Hopkins University

Washington, DC                                          Washington, DC

Attachment: Brief bios of the authors

Cc: Financial Stability Oversight Council

Attachment

Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, DC. Previously, he was a resident fellow at the American Enterprise Institute from 2004 to 2015, and President and Chief Executive Officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He is the author of Boom and Bust (2011) and Finance and Philosophy (2018), as well as numerous articles and Congressional testimony. His work focuses on financial policy issues, financial cycles, risk and uncertainty, housing finance and banking systems, and the interactions of these with politics. Mr. Pollock is a director of CME Group; Ascendium Education Group; and the Great Books Foundation; and a past-president of the International Union for Housing Finance. He is a graduate of Williams College, the University of Chicago, and Princeton University.

Thomas H. Stanton served as President of the Association for Federal Enterprise Risk Management, a member of the federal Senior Executive Service, a board member of the National Academy of Public Administration (NAPA), and as Chair of the NAPA Standing Panel on Executive Organization and Management. In 2017 NAPA honored him with the George Graham Award for Exceptional Service to the Academy. In 2018 he received the Enterprise Risk Management Hall of Fame award. Mr. Stanton teaches as an adjunct faculty member at the Center for Advanced Governmental Studies at Johns Hopkins University. He is the author of A State of Risk: Will Government Sponsored Enterprises be the Next Financial Crisis? (HarperCollins, 1991), which presented the idea of contingent capital that is now being applied to reduce vulnerability of financial institutions globally, and of Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012). Mr. Stanton’s degrees are from the University of California at Davis, Yale University, and the Harvard Law School. Many of his publications can be found at www.thomas-stanton.com.

Is the monetary universe Newtonian or Einsteinian?

Published by the R Street Institute.

Is there an absolute standard of monetary or economic value? Nope. The monetary universe is not Newtonian, with a fixed frame of reference, but Einsteinian, with frames of reference moving with respect to each other. Prices are exchange rates with no substantive existence.

As the monetary economist Hans F. Sennholz instructively wrote:

There is no absolute monetary stability, never has been, never can be. Economic life is a process of perpetual change. People continually choose between alternatives, attaching ever-changing values to economic goods… [T]he exchange ratios of their goods are forever adjusting…nothing is fixed.

Money…is subject to man’s valuations and actions in the same way that all other economic goods are. Its subjective, as well as objective, exchange values continually fluctuate. … There is no true stability of money, whether it is fiat or commodity money. There is no fixed point or relationship in economic exchange…[in] this inherent instability of economic value.

– Hans F. Sennholz, Money and Freedom (1985), p 37.

As part of all this, governments and central banks can depreciate the currencies they control, run down the purchasing power of wages and savings and, in extreme but repeated cases, create hyperinflations.

There can be better or worse, but no perfect monetary system. All of them—whether the gold standard, gold and silver, a gold exchange system, the Bretton-Woods system, pure fiat currencies, independent or dependent central banks, inflation targets or not, fixed or managed or floating exchange rates—have various combinations of problems and advantages, and chances of breaking down.

Reality is so difficult.

Ten years later, the U.S. is still debating Fannie and Freddie

Published in Housing Finance International.

The giant U.S. government-guaranteed mortgage companies, Fannie Mae and Freddie Mac, were and are unique features of American housing finance compared to other countries. In the days before their 2008 fall into insolvency and government conservatorship, which also saw their previously feared political power fizzle, Fannie and Freddie used to claim they were “the envy of the world.” In those days, they could always get many members of the U.S. Congress to repeat that claim, even though it wasn’t true.

But Fannie and Freddie were huge and still are – their combined 2018 total assets are $5.5 trillion. (This amount is about the same as the combined GDPs of the United Kingdom and France.) Fannie and Freddie were, and continue to be, dominant factors in U.S. housing finance markets. But they remain in government conservatorship more than 10 years after the collapse of the housing bubble they helped inflate and after the government bailed them out. Even after more than 10 years of debating, the government can’t figure out what to do with them next. All kinds of plans have been proposed by various politicians, trade associations, financial commentators, think tanks and investors. None has been adopted. The amount of talk has been vast, but no agreed-upon path has emerged out of the fog of endless debate.

The central problem is this: Fannie and Freddie have always been dependent on the guarantee of their obligations by the U.S. government. The guarantee was said to be “implicit,” but it was absolutely real, as events proved. Based on this guarantee, they sold trillions of dollars of bonds and mortgage-backed securities around the world. They never could have done this without their credit support from the government, and when they failed, the government protected the buyers. Although there is still not a formal guarantee, their backing by the government is even more indubitable now, since the U.S. Treasury has agreed to put in enough new senior preferred stock to keep the net worth of each from falling below zero.

Before the housing bubble shriveled, Fannie and Freddie did have some capital of their own, though a small amount relative to their obligations. In 2006, before their fall, they had combined total equity of $66 billion. That may sound significant, but it was to support assets plus outstanding guarantees already totaling $5.5 trillion, giving them a capital ratio of a risible 1.2 percent. In other words, they were leveraged 83 to 1. Such was the advantage of being darlings of the government. To get up to international risk-based capital standards, I calculate they would then have needed $90 billion more in capital than they had.

Now, 10 years after their government bailout, their combined equity is $10.7 billion, giving them a capital ratio of a mere 0.2 percent. In other words, their capital rounds to zero, and their leverage is 514 to one. To meet international standards, they would now require an additional $124 billion in capital. Without capital, Fannie and Freddie at this point rely not just in large measure, but utterly and completely, on their government guarantee. Indeed, they could not stay in business for even one more minute without it, and this has continued for 10 years.

In good times, running on the government’s credit can be very profitable, and so Fannie and Freddie have been, following the recovery of U.S. house prices which began in 2012. Why have they not built up any capital at all since then? Well, in that same year, the U.S. Treasury Department and the conservator for Fannie and Freddie (the Federal Housing Finance Agency), agreed that each quarter, essentially all of the profits of Fannie and Freddie would be paid to the Treasury, thence going to offset the federal deficit.

This agreement between two parts of the government that the government would take all the profits until further notice has been viewed as unfair and illegal by investors in the common and junior preferred stocks of Fannie and Freddie, which continue to exist. Hedge fund investors, employing top legal talent, have generated various lawsuits against the government, none of which has succeeded.

It is essential to understand the most important macro effect of Fannie and Freddie. This was and is to run up the leverage and therefore the risk of the entire mortgage and housing sectors. Thanks to them, the aggregate leverage of the system is much higher than would otherwise have been possible, and house prices get inflated relative to incomes and down payments. As this leveraging proceeds, it shifts more and more of the risk of mortgage credit from the lenders and from private capital to the government and to the taxpayers. Fannie and Freddie did and do create major systemic risk.

This sounds like a bad idea, and it is. But once the government has gotten itself deeply committed to such a scheme, and the mortgage and housing sectors have gotten used to enjoying the credit subsidy and economic rents involved, it is very hard to change.

Numerous important interest groups benefit from Fannie and Freddie’s running up the systemic leverage and risk. These include:

• Homebuilders, who benefit from more easily selling bigger and more profitable houses.

• Realtors, who likewise profit when selling houses is made easier and get bigger commissions when house prices rise.

• Wall Street firms, whose business of selling mortgage-related securities around the world is easier and bigger when they have government guaranteed bonds to sell.

• Banks, who have become organized to make mortgage loans and pass the credit risk to the government.

• Mortgage banks, who do not have the capital to hold loans themselves and likewise can pass the risk to somebody else.

• Municipal governments, who like the higher real estate taxes generated by high property prices.

• Investors in mortgages who don’t want to have to worry about credit risk because the taxpayers have it instead.

• Affordable housing groups, who get subsidies from Fannie and Freddie.

• Politicians, whose constituents and contributors include the aforementioned groups.

This daunting Gordian knot of private and political interests, all of whom get advantages from the economic distortions of Fannie and Freddie, all of which are always busy lobbying or being lobbied, makes it highly unlikely that the currently divided Congress will do any better at reform than its predecessors of the last decade. My own view is that the probability of meaningful legislation for Fannie and Freddie over the next year is zero.

But a different source of change is now a frequent subject of discussion and speculation. This is direct administrative action by the Federal Housing Finance Agency (FHFA) and the U.S. Treasury. The FHFA has a new director coming, Mark Calabria, nominated by President Donald Trump and apparently headed for confirmation by the Senate. Mr. Calabria has deep experience in the issues of Fannie and Freddie and might use his wide powers as their conservator and regulator for reform, including renegotiating their bailout deal with the Treasury.

Two essential reform items are putting Fannie and Freddie’s capital requirements on the same basis as every other too-big-to-fail financial institution; and making them pay a fair price to the government for its ongoing credit support. This should be in line with what all the big banks have to pay for deposit insurance, which is their form of government guarantee.

Might such things happen by administrative action? They might. But not without a lot of lobbying, arguing and complaining by all of the interest groups listed above.

Over a century, which years were inflation-control champions and which booby-prize winners?

Published by the R Street Institute.

How much can the rate of inflation move around? A lot.

The Consumer Price Index (CPI) began in 1913, the same year the Federal Reserve was created. The CPI’s path over the 106 years since then displays notable variations in inflation — or alternately stated, in the rate of depreciation of the purchasing power of the U.S. dollar. In this post, I consider the average inflation rates during successive 10-year and five-year periods, starting in 1913. (The very last period, 2013-2018, includes six years.) I also note the context of historical events. Wars, especially, induce accelerated government money-printing, but the history displays constant inflation since 1933, sometimes slower, sometimes much faster.

Which decades and half-decades are the inflation-control champions, meaning the lowest average inflation rate without descending into serious deflation?  The decade champion is that of Presidents Eisenhower and Kennedy, 1953-1962. Its average inflation rate was 1.31 percent.

The booby prize goes to 1973-1982, when inflation averaged the awful rate of 8.67 percent per year. No wonder Arthur Burns, who was chairman of the Federal Reserve from 1970 to 1978, afterward gave a speech entitled “The Anguish of Central Banking.” In second place for the booby prize is 1913-1922, with an average inflation rate of 5.60 percent. That was the result of the first World War. The decade included, first, double-digit inflation then a short, very sharp depression in 1921-1922, but high inflation overall.

The inflation-control champion among half-decades is 1923-27, during the boom of the “Coolidge Prosperity,” when inflation averaged only 0.47 percent. In second place is 1953-57 at 1.24 percent. At that time, William McChesney Martin, who considered inflation “a thief in the night,” was chairman of the Fed.

Table 1 shows the record by 10-year periods in chronological order. It also shows what $1 at the beginning of each period was worth in purchasing power at the end of each 10 years. The last column shows what $1 in 1913 was worth in purchasing power, as it depreciated over the entire 106 years.

Table 2 shows the five-years periods, this time in order of lowest average inflation to highest, with historical notes on the context. It contrasts the lowest third of the observations with the highest third.

The average annual inflation over the 106 years was 3.11 percent. That reduced the $1 of 1913 to about 4 cents by the end of 2018, as shown in Graph 1. Note that, because of the scale of the graph, the change looks smaller in recent decades, but it isn’t. For example, the drop in purchasing power from 1983 to 2013 is the same as that from 1943 to 1973—about 60 percent in 30 years in each case.

Many central banks, including the Federal Reserve, now believe in perpetual inflation of 2 percent. Had that inflation rate been maintained since 1913, instead of the actual 3.11 percent, the dollar’s purchasing power from then to now would have followed the dashed line on the graph and fallen to 12 cents, instead of 4 cents.

We know from history that big wars will always be financed, in part, by depreciation of the currency of the winners, while the losers’ currencies will often be wiped out. There were several wars in addition to the two world wars in the 106 years under consideration, but was the constant inflation since 1933 necessary? Perhaps there was no other way for the government to deal with the debt automatically produced when taxes are forever less than government expenditures, war or no war, and the Federal Reserve is always there to help the Treasury out by monetizing its debt.

Thanks to Daniel Semelsberger for research assistance.

Comments/ RIN 2590-AA98: Validation and Approval of Credit Score Models by Fannie Mae and Freddie Mac

Published by the R Street Institute.

On behalf of National Taxpayers Union, R Street Institute, Citizens Against Government Waste, Institute for Liberty and Taxpayers Protection Alliance (“the undersigned”), we respectfully submit these comments to the Federal Housing Finance Agency (FHFA) concerning its Notice of Proposed Rulemaking for the validation and approval of credit score models. The undersigned are pleased to comment in favor of the proposed rule, which we believe represents a fair and reasonable interpretation of section 310 of the “Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.” Our organizations have long been involved in financial services issues and are prominent voices on housing finance matters. Importantly, we all follow the same housing policy fundamentals: a system that promotes broad access to credit for qualified borrowers, a significant private capital buffer, and administrative actions that promote competitive markets and protect taxpayers.

Since Fannie Mae and Freddie Mac (the GSEs) were placed into conservatorship more than a decade ago, our organizations have called for Congressional and administrative actions to mitigate taxpayer exposure to risky activity. Taxpayers have expressed concern about greatly expanded GSEs activities in the private market while enjoying the unique competitive advantages of government backing. With the GSEs having more than $5 trillion of mortgage risk on their extremely leveraged balance sheets, which are by extension underwritten by taxpayers, the federal government holds a considerable level of risk.

Economists widely agree that the significant increase in housing foreclosures that fueled the 2008 financial crisis and subsequent recession was a result of a weakening of GSE mortgage standards through affordable housing goals. These goals required the GSEs meet annual quotas of low- and moderate-income mortgages. As time went on and the number of prime borrowers dried up, the GSEs had to expand operations in the subprime market in order to meet their annual quotas. As the market shrank, the GSEs found it harder and harder to find creditworthy borrowers causing them to lower their standards to meet their affordable housing goals. This involved either reducing the accepted credit score, lowering the required down payment, raising the debt-to-income ratio, or accepting low or no documentation.

Accepting lower credit standards certainly expanded the number of people who were eligible for a mortgage, but it allowed a greater number of under-qualified borrowers to obtain a loan who would have otherwise been denied such a large line of credit. Once defaults skyrocketed and the housing bubble burst, the GSEs were wired more than $190 billion from taxpayers to keep them afloat and were placed into conservatorship where they remain to this day.

If there is one lesson from the 2008 housing crisis that should have been learned, it is that overly ambitious affordable housing goals and the rush to qualify numerous borrowers by any means can put the economy, and taxpayers, at great risk. GSEs utilize credit scores in several ways including benchmarks for risk fees, loan eligibility guidelines, and (for Freddie Mac) one of many attributes in making a credit assessment. They are also used internally to balance counterparty risk, an often-overlooked but very important role. Thus, allowing new credit score models into the GSE framework could have major consequences for their operations, their risk, and in turn taxpayer liabilities.

Such consequences would also reverberate throughout the private sector, as lenders, loan servicers, mortgage insurers, and other parts of the industry would face all manner compliance and implementation costs. New credit scoring methods in the GSEs could also eventually spill over into taxpayer-backed lending programs at the Federal Housing Administration, the Small Business Administration, and other agencies. In an environment where GSEs and FHA appear to be more heavily weighting their portfolios with higher-risk loans, the introduction of new credit scores could even affect the overall systemic risk calculation at an especially delicate point in financial markets. These factors are discussed in greater detail in a Policy Paper that National Taxpayers Union filed separately with FHFA.

It is of particular concern to free market, limited government groups to see how the “Credit Score Competition Act,” included as Section 310 of S. 2155, “the Economic Growth, Regulatory Relief, and Consumer Protection Act” that passed in 2018, will be implemented. Section 310 directs FHFA to create a process for evaluating new credit scoring models for use by the GSEs but does not mandate they accept more just one type of credit score. We believe FHFA interpreted the legislative text in a careful and thoughtful manner that complies with legislative intent. The proposed rule issues standards for compliance, which sets forth several factors that must be considered in the validation and approval process, including the credit score model’s integrity, reliability, and accuracy, its historical record of predicting borrower and credit behaviors, and consistency of any model with GSE safety and soundness.

Further, FHFA rightly notes in the proposed rule that alternative scores may immediately gain a competitive advantage in the market. As such, the rule specifically “prohibits an Enterprise from approving any credit score model developed by a company that is related to a consumer data provider through any common ownership or control, of any type or amount.” In addition, the proposed rule not only calls for sound cost-benefit analysis in evaluating new models, it also builds in conflict-of-interest guardrails (which are standard in other regulatory spheres) to ensure that those models compete on a level playing field. This holds promise for creating a true market-driven competitive environment with an opportunity for innovation.

Additionally, we are supportive of the straightforward, four-step process which the Enterprises evaluate and implement alternative credit-scoring models. The process is summarized below:

1. Solicitation of applications from credit score model developers; Proposes that solicitation for new applications occur at least every seven years, or as determined necessary by FHFA.

2. Initial review of submitted applications;
   ● Each GSE would obtain the data from the data provider on behalf of the applicant.

3. Credit score assessment;
   ● During this assessment phase, each credit score model would be assessed for accuracy, reliability, and integrity.
   ● Approaches for assessing accuracy include: 1) Comparison-based. This approach will not require the applicant’s credit score to be more accurate than the existing credit score in use by the GSEs. This approach would be more subjective and indicate reasonableness of the credit score’s accuracy. 2) Champion-Challenger. The applicant’s credit score must be more accurate than the existing credit score in use by the GSEs. This would be a bright line test.

4. Enterprise business assessment;
   ● During this phase, a GSE would assess the credit score model in conjunction with the GSEs business systems and processes.
   ● In addition, the GSE must consider impacts on the mortgage finance industry, assess competitive effects, conduct a third-party vendor review, and any other evaluations established by the GSE.

The validation and approval process, which produces the resulting approved credit score model, must meet these five statutory requirements:

(i) satisfy minimum requirements of integrity, reliability, and accuracy; (ii) have a historical record of measuring and predicting default rates and other credit behaviors; (iii) be consistent with the safe and sound operation of the corporation; (iv) comply with any standards and criteria established by the Director of the Federal Housing Finance Agency under section 1328(1) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992; and (v) satisfy any other requirements, as determined by the corporation.

Taxpayers have a significant stake in the housing finance market and FHFA must do everything in its power to ensure that taxpayer risk is mitigated to its fullest extent. The proposed rule will undoubtedly help to protect from a potential “race to the bottom” effect to qualify as many possible borrowers as possible through political manipulation of tools that are supposed to be reliable predictors of risk. Significant innovation in the credit scoring space is already occurring through the advent of refinements and expansions to existing standard tools, which themselves are being subjected to rigorous testing. We believe these modernizations can be balanced with the benefits of a stable, predictable system of lending and finance that measures and protects against risk, not only to borrowers and lenders, but also to taxpayers.

Thank you for the opportunity to offer our views on this proposed rule. We urge FHFA to adopt the rule as is and implement it in a timely manner.

Pete Sepp, President
National Taxpayers Union

Alex J. Pollock, Distinguished Senior Fellow
R Street Institute

Tom Schatz, President
Citizens Against Government Waste

David Williams, President
Taxpayers Protection Alliance

Andrew Langer, President
Institute for Liberty

Re: Comments/ RIN 2590-AA98: Validation and Approval of Credit Score Models by Fannie Mae and Freddie Mac

Published by the R Street Institute.

Dear Mr. Pollard:
Thank you for the opportunity to submit these comments on the Proposed Rule on Credit Score Models:

1. In my opinion, the Proposed Rule overall is sensible and well-considered, and consistent with sound housing finance.

2. Since credit scores are part of the analysis and management of credit risk, the principal decisions about their use should rest with those who take the credit risk—in this case, with Fannie Mae and Freddie Mac. The process as defined by the Proposed Rule thus puts the primary responsibility for analysis and decisions in the right place, with Fannie and Freddie, with review by the FHFA as regulator.

3. It certainly makes sense for Fannie and Freddie to consider various available alternative credit score models, as provided in the Proposed Rule, but the primary decision criterion should always be each model’s contribution to accurately predicting future loan credit performance. The Proposed Rule reasonably suggests consideration of each model’s accuracy and reliability on its own, as well as when used within Fannie and Freddie’s credit management systems, but the latter is clearly the more important question.

4. As the Proposed Rule importantly observes, “Credit scores are only one factor considered by [Fannie and Freddie] in determining whether to purchase a loan.”

5. It is essential, as reflected in the Proposed Rule, for considerations of credit score models to take into account the time, effort, complexity, uncertainty, and costs (direct and indirect) to the mortgage industry of alternative decisions. In particular, the effects on smaller mortgage lenders should be addressed.

6. It is a good idea to have the possibility of small-scale experiments or “pilot programs,” if appropriate, as the Proposed Rule provides.

7. The Proposed Rule suggests using the standard definition of default with a time horizon of two years from loan origination. Consistent with the very long term of mortgage loans, I believe longer time horizons should also be tested for the extent of continuing predictive power of credit score models.

These are my personal views. It would be a pleasure to discuss any of them further.

Respectfully submitted,

Alex J. Pollock

Higher interest rates and the looming end of the second real estate double bubble

Published in Housing Finance International Journal.

At this point, the most important thing about U.S. housing finance is that long-term interest rates are rising. The rate on 30-year fixed rate mortgages, the benchmark U.S. mortgage instrument, has since September 2017 gone from less than 4 percent to close to 5 percent. This is in line with the rise in 10-year U.S. Treasury note yields from something over 2 percent to more than 3 percent. The massive manipulation of long-term interest rates by the Federal Reserve is belatedly winding down, step by step. The house price inflation the Fed thereby promoted also must inevitably end.

The real (inflation-adjusted) interest rate on the 10-year Treasury note has gone from about 0.4 percent to just over 1 percent. These rate movements from extraordinarily low levels to somewhat higher levels are shown in Graph 1.

Read the rest here.

Predicting is hard…

Published by the R Street Institute.

From Reuters, on June 27, 2017:

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe there will be another financial crisis for at least as long as she lives.

From CNBC, on Dec. 11, 2018:

There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.

The financial future is murky, but one of these predictions will be right.

Hume’s Timely Political Advice from 1741

Published by the R Street Institute.

I am neither surprised nor upset by the divisive partisanship of current times. Emotional partisanship is nothing new in the world. But we certainly must condemn the bad manners it now engenders.

David Hume, the great philosopher, economist and historian, reflected calmly on partisan passions in 1741, in his Essays Moral and Political. Here are some relevant excerpts (with ellipses deleted):

“There are enow of zealots on both sides who kindle up the passions of their partisans, and under pretense of public good, pursue the interests and ends of their particular faction.

“Those who either attack or defend a minister in such a government as ours, where the utmost liberty is allowed, always carry matters to an extreme, and exaggerate his merit or demerit. His enemies are sure to charge him with the greatest enormities, both in domestic and foreign management, and there is no meanness or crime, of which in their account, he is not capable. On the other hand, the partizans of the minister make his panegyric run as high as the accusations.

“When this accusation and panegyric are received by the partizans of each party, no wonder they beget an extraordinary ferment on both sides, and fill the nation with violent animosities.”

Hume included this excellent and timely advice for us, reading it 277 years later:

“For my part, I shall always be more fond of promoting moderation than zeal. Let us therefore try, if it be possible to draw a lesson of moderation with regard to the parties into which our country is at present divided.”

Good manners should control our behavior, whatever our feelings may be inside, and moderation frees the mind to think. Like Hume, let us be fond of promoting it.

Government Debt: A Quiz

Published by the R Street Institute.

Government debt is a favored investment class all over the world, but it has a colorful history full of financial adventures. Often enough, historically speaking, it has resulted in investors gazing sadly on unpaid sovereign promises to pay, to paraphrase Max Winkler’s “Foreign Bonds: An Autopsy,” his chronicle of the long list of government defaults up to his day in the 1930s. The list has grown much longer since.

Here are six sets of years.  What do they represent?

1. 1827, 1890, 1951, 1956, 1982, 1989, 2001, 2014

2. 1828, 1898, 1902, 1914, 1931, 1937, 1961, 1964, 1983, 1986, 1990

3. 1826, 1843, 1860, 1894, 1932, 2012

4. 1876, 1915, 1931, 1940, 1959, 1965, 1978, 1982

5. 1826, 1848, 1860, 1865, 1892, 1898, 1982, 1990, 1995, 1998, 2004, 2017

6. 1862, 1933, 1968, 1971

All these are years of defaults by a sample of governments. For the first five of them, see Carmen Reinhart’s “This Time Is Different Chartbook: Country Histories.” They are, respectively, the governments of:

1. Argentina

2. Brazil

3. Greece

4. Turkey

5. Venezuela

And No. 6 is the United States.

In the case of the United States, the defaults were: The refusal to redeem greenbacks for gold or silver, as promised, in 1862. The refusal to redeem gold bonds for gold, as promised, in 1933. The refusal to redeem silver certificates for silver, as promised, in 1968. The refusal to redeem the dollar claims of foreign governments for gold, as promised, in 1971.

The U.S. government has since stopped promising to redeem money for anything else, making it a pure fiat currency, and stopped promising to redeem its bonds for anything except its own currency.  This prevents future defaults, but not future depreciation of both the currency and government debt.

Winkler related a great story to give us an archetype of government debt from ancient Greek times.  Dionysius, the tyrant of Syracuse, was hard up and couldn’t pay his debt to his subjects, the tale goes.  So he issued a decree requiring that all silver coins had to be turned in to the government, on pain of death. When he had the coins, he had them reminted, “stamping at two drachmae each one-drachma coin.” Brilliant!  With these, he paid off his debt, becoming, Winkler says, “the Father of Currency Devaluation.”

Observe that Dionysius’s stratagem was in essence the same as that of the United States in its defaults of 1862, 1933, 1968 and 1971.

So advantageous it is to be a sovereign when you are making promises.

Better late than never

Published by the R Street Institute.

September brought endless discussions of the 10th anniversary of the bankruptcy of Lehman Brothers and the failures of Fannie Mae and Freddie Mac. Tomorrow, Oct. 3, brings the 10th anniversary of congressional authorization of the Troubled Asset Relief Program (TARP) bailouts created by the Emergency Economic Stability Act.

After all this time, we still await reform of American housing finance – the giant sector that produced the bubble, its deflation, the panic and the bust.

During the panic in fall 2008, in the fog of crisis, “We had no choice but to fly by the seat of our pants, making it up as we went along,” Treasury Secretary Henry Paulson has written of the time. That is no longer the problem.

In retrospect, it is clear that the panic was the climax of a decadelong buildup of leverage and risk, much of which had been promoted by the U.S. government. This long escalation of risk was thought at the time to be the “Great Moderation,” although it was in fact the “Great Leveraging.”

The U.S. government promoted and still promotes housing debt. The “National Home Ownership Strategy” of the Clinton administration—which praised “innovative,” which is to say poor-credit-quality, mortgage loans—is notorious, but both political parties were responsible. The government today continues to promote excess housing debt and leverage though Fannie and Freddie. It has never corrected its debt-promotion strategies.

A profound question is why the regulators of the 2000s failed 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 the mismatch between prevailing ideas and the emergent, surprising reality when the risks turn out to be much greater and more costly than previously imagined.

There is a related problem: regulators are employees of the government and feel reluctant to address risky activities the government is intent to promote.

At this point, a decade later, reform of the big housing finance picture is still elusive. But there is one positive, concrete step which could be taken now without any further congressional action. The Financial Stability Oversight Council (FSOC), created in 2010, was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions (SIFIs) for increased oversight of their systemic risk. In general, I believe this was a bad idea, but it exists, and it might be used to good effect in one critical case to help control the overexpansion of government-promoted housing finance debt.

FSOC has 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 and systemically risky. This failure to act may reflect a political judgment, but it is intellectually vacuous.

Fannie and Freddie should be forthwith designated as the SIFIs they so unquestionably are. Better eight years late than never.

The adventures of investing in Fannie Mae and Freddie Mac stock, or how to lose 99% in a government deal

Published in Housing Finance International.

Fannie Mae and Freddie Mac are the most important housing-finance institutions in the United States—and therefore, in the world—with combined assets of a remarkable $5.4 trillion, which include nearly half of all the $10.6 trillion in outstanding U.S. residential mortgages. They are without question “systemically important”: any default on their obligations would rock both the domestic U.S. and the global financial markets. The largest investor in their mortgage-backed securities is the U.S. central bank, which holds about $1.7 trillion of them.

Fannie and Freddie have a hybrid legal form: they are basically government agencies, “implicitly guaranteed” by the U.S. Treasury, as it was often said, but in reality fully guaranteed. At the same time, they also have private shareholders and publicly traded stocks. The shareholders expected to profit greatly by trading on the credit of the United States and the numerous other special advantages that Fannie and Freddie had been granted by politicians and regulators.

How did the shareholders do? For a long time, their optimistic expectations were more than justified. Then they lost close to everything. After that, Fannie and Freddie’s stocks became purely speculative vehicles, which made, first, big profits and then big losses. This essay chronicles the adventures of investing in the stock of these companies sponsored by, guaranteed by and later entirely controlled by the U.S. government.

Fannie’s all-time high stock price was $86.75 per-share in December 2000. Ten years before, the price had been $8.91, so the aggregate gain in price over the 1990s was 874 percent. This means Fannie’s stock price went up on average 25 percent per-year for a decade. Not bad! Fannie created a powerful, ruthless and feared lobbying organization to protect its no-fee government guaranty and its other competitive privileges. Its political clout and its arrogance became legendary.

“Pride goeth before destruction and a haughty spirit before a fall,” says the Book of Proverbs. This was certainly true of Fannie with matching consequences for its private shareholders. From its peak, after Fannie’s massive losses put it into government conservatorship, its stock price dropped to a low of 20 cents per share in November 2011. That was a loss for the shareholders of 99.8 percent. Now, at the end of July 2018, Fannie’s stock price is somewhat higher, at $1.51. This still represents a loss of 98.3 percent from its peak.

Who would have thought that could happen? Probably nobody. But a fundamental characteristic of prices in a financial bust is that they can go down a lot more than you thought possible.

The shareholders of Freddie Mac experienced a similar elation and then collapse. Freddie’s all-time stock price high was $73.70 in 2004. Ten years earlier it had been $12.63, so the shareholders in this government deal had enjoyed a 484 percent aggregate gain over the decade, or on average over 19 percent per year. Then came the losses, the conservatorship, and the shriveling of its stock price to the trough of the same 20 cents per share in 2011. That meant a 99.7 percent loss from the peak. From the peak to now, the loss is 97.9 percent.

Reviewing the losses for the equity investors in these former political and stock-market darlings, one can only exclaim, “Mirabile dictu!” They form a memorable lesson.

The history of this adventure in investing to trade on the government’s guaranty is shown in Graph 1, which displays three decades of stock prices for Fannie and Freddie, from 1990 to July 2018.

At their stock price bottom of 20 cents per share, Fannie and Freddie were completely controlled by the government, but the two stocks continued to exist and trade. They became and remain a pure speculation on political events and the outcomes of various lawsuits that investors brought against the government. The lawsuits have been unsuccessful and the politicians, although they have debated the matter mightily, have not been able to agree on any legislative restructuring. As the Washington saying goes, “When all is said and done, more is said than done.” In this case, vast volumes have been said, but nothing has been done.

Fannie and Freddie continue to live on the government’s guaranty. They could not exist for one minute without it. Under the conservatorship agreement, the U.S. Treasury takes essentially all their profits, so their capital continues to round to zero. As long as this situation lasts, there can never be any cash for the shareholders, so the price of the shares is a pure gamble on the situation changing by some political outcome. This speculative essence has made Fannie and Freddie’s shares over the last seven years extremely volatile.

Had you had the courage to buy at 20 cents, you might have multiplied your investment up to 29 or 27 times, as the intervening highs have been $5.82 for Fannie and $5.52 for Freddie. But had you been tempted by the optimism of those highs while investing based on the possible actions of the government, you could once again have had huge losses – of over 70 percent.

Table 1 shows your returns had you bought Fannie or Freddie stock at the lows, or had you bought at various subsequent dates, including at the post-2011 highs, and in each case held the shares to July 2018.

As the table makes clear, such purchases during the speculative phase generated very large profits at first, and very large losses afterward, measured on the assumption that you held the shares until now. Of course, the results of interim purchases and sales could have varied a lot in both directions.

The end of this eventful history of Fannie and Freddie’s stockholders has not yet been written. Whatever future chapters may add, the story has demonstrated that, however attractive the deal is at first, the government can be a dangerous business partner over time.