Puerto Rico: A big default—what next?

Published in the Library Of Law And Liberty.

Rexford Tugwell, sometimes known as “Rex the Red” for his admiration of the 1930s Soviet Union and his fervent belief in central planning, was made governor of Puerto Rico by President Franklin Roosevelt in 1941. Among the results of his theories was the Government Development Bank of Puerto Rico, a bank designed as “an arm of the state,” which is a central element in the complicated inner workings of the Puerto Rican government’s massive insolvency.

The bank has just defaulted on $367 million of bonds – the first, but unless there is congressional action, not the last, massive default by the Puerto Rican government and its agencies on their debt. The Government Development Bank was judged insolvent in an examination last year, but the finding was kept secret. The governor of Puerto Rico has declared a “moratorium” on the bank’s debt, which means a default. A broke New York City in 1975 also defaulted and called it a “moratorium.”

Adding together the Puerto Rican government’s explicit debt of about $71 billion and its unfunded pension liabilities of about $44 billion amounts to $115 billion. This is six times the $18 billion in bonds and pension debt of the City of Detroit, which holds the high honor of being the largest municipal bankruptcy ever.

Puerto Rico’s government-centric political economy goes back to Rex the Red, but its budget problems are also long-standing. In this century, the government has run a deficit every year, borrowed to pay current expenses, and then borrowed more to service previous debt until the lenders belatedly ceased lending and the music stopped. Its debt and its real gross domestic product definitively parted company in 2001 and have grown continuously further apart, as shown Graph 1.

As its debt skyrocketed, the credit ratings of its bonds fell and then crashed.  See Graph 2.

Where do we go from here? Addressing the deep, complicated, and contentious problems requires three steps:

1. The creation of an emergency financial control board to assume oversight and control of the financial operations of the government of Puerto Rico, which has displayed incompetence in fiscal management (or mismanagement), is a central aspect of the solution. This control board can be modeled on those successfully employed to address the insolvencies and financial mismanagement in the District of Columbia in the 1990s, in New York City in the 1970s and in numerous other places. More recently, the City of Detroit got an emergency manager along the same lines.

Such a board would be and must be quite powerful. The sine qua non for financial reform is to establish independent, credible authority over all books and records; to determine the true extent of the insolvency of the many indebted government entities—in particular to get on top of the real condition of the Government Development Bank; and to develop fiscal, accounting, control and structural reforms which will lead to future balanced budgets and control of the level of debt.

Needed reforms cited by Puerto Rican economist Sergio Marxuach in congressional testimony include:

[I]ncrease tax revenues by improving enforcement efforts, closing down ineffective tax loopholes, and modernizing its property tax system; crackdown on government corruption; significantly improve its Byzantine and unduly opaque financial reporting; reform an unnecessarily complicated permitting and licensing system that stifles innovation; … lower energy and other costs of doing business.

That’s a good list of projects.

Does all this take power and responsibility away from the Puerto Rican government?  Of course it does – it needs to and it can be done. Under the Constitution, Congress has complete jurisdiction over territories like Puerto Rico. Just as in Washington and New York City, when the problems are straightened out, financial management will revert to the normal local government.

1. Pollock’s Law of Finance states that “Loans which cannot be repaid, will not be repaid.” Naturally, this law applies to the $115 billion owed by the Puerto Rican government, which is on its way to some form of restructuring and reorganization of debts. It seems clear that this should be done in a controlled, orderly and equitable process, which takes into account the various levels of seniority and standing among the many different classes of creditors.

The pending House bill puts the proposed oversight board in the middle of the analysis and negotiations of competing claims. If the reorganization cannot be voluntarily agreed upon, the process can move to the federal court, where the plan of reorganization would come from the oversight board.

Three objections have been made to this approach.  One that has been advertised heavily claims that it is a “bailout.” Since no taxpayer money is planned to go to creditors, this is simply wrong and ridiculous. Bondholders taking losses is the opposite of a bailout.

A second is that bondholders may be disadvantaged versus pension claims, and this may affect the whole municipal bond market. Indeed, in the Detroit bankruptcy, the general obligation bonds got 74 cents on the dollar, while the general city employee pensions got 82 cents— an important haircut, but a smaller one. The political force of pension claims in insolvencies is a credit fact that all investors must take into account. If the national municipal bond market internalizes and prices the risks of unfunded pensions, thereby bringing more discipline on the borrowers, that seems like progress to me.

A third objection is that the bill’s approach would set a precedent for financially struggling states like Illinois, which they might follow. In my judgment, there is zero probability that Illinois or any other state would volunteer to have a financial control board imposed on it. Even leaving aside the fact that Puerto Rico is not a state, this argument is vacuous.

1. Of fundamental importance is that in the medium term, Puerto Rico must develop a sustainable economy—that is, a market economy to replace its historically government-centric one. Various ideas have been proposed relevant to this essential goal, and much more work is required. This is the most challenging of all the elements of the problem. Steps 1 and 2 must be done first, but Step 3 must be achieved for ongoing success.

One thoughtful investor in municipal bonds, reflecting on Puerto Rico, Illinois and other troubled political entities, concluded, “We don’t trust governments.” That made me think of how there have been more than 180 defaults and restructurings of sovereign debt in the last 100 years and how, further back, a number of American states defaulted on their debts and even repudiated them. So I wrote him, “I think that’s wise.”

Nonetheless, the immediate requirement to deal with the Puerto Rican debt crisis is government action.

Risk doesn’t stand still

Published in Library Of Law And Liberty.

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe explores the movement and transformation of risks in adapting, self-referencing systems, of which financial systems are a notable example. In this provocative new book, the Wall Street Journal’s chief economics commentator Greg Ip contemplates how actions to reduce and control risk are often discovered to have increased it in some other way, and thus, “how safety can be dangerous.”

This is an eclectic exploration of the theme, ranging over financial markets, forest fires, airline and automobile safety, bacterial adaptation to antibiotics, flood control, monetary policy and financial regulation. In every area, Ip shows the limits of human minds trying to anticipate the long-term consequences of decisions whose effects are entangled in complex systems.

In the early 2000s, the central bankers of the world congratulated themselves on their insight and talent for having achieved, as they thought, the Great Moderation. It turned out they didn’t know what they had really been doing, which was to preside over the Great Leveraging. Consequently, and much to their surprise, they found themselves in the Great Collapse of 2007 to 2009, and then, with no respite, in the European debt crisis of 2010 to 2012.

Ip begins his book two decades before that, in 1989, at a high-level conference on the topic of financial crises. (Personally I have been going to conferences on financial crises for 30 years.) He cites Hyman Minsky, who “for decades had flogged an iconoclastic theory of business cycles that fellow scholars had largely ignored.” Minsky’s theory is often summarized as “Stability creates instability”—that is, periods of safety induce the complacency and the mistakes that lead to the crisis. He was right, of course. Minsky (who was a good friend of mine) added something else essential: the rise of financial instability is endogenous, arising from within the financial system, not from some outside “shock.”

At the same conference, the famous former Federal Reserve Chairman Paul Volcker raised “the disturbing question” of whether governments and central banks “end up reinforcing the behavior patterns that aggravate the risk.” Foolproof shows that the answer is yes, they do.

Besides financial implosions, Ip reflects on a number of natural and engineering disasters, including flooding rivers, hurricane damage, nuclear reactor meltdowns, and forest fires, and concludes that in all of these situations, as well, measures were taken that made people feel safe, “and the feeling of safety allowed danger to re-emerge, often hidden from view.”

The natural and the man-made, the “forests, bacteria and economies” are all “irrepressibly adaptable,” he writes. “Every step we take to suppress the risks . . . will provoke some other, offsetting step.” So “neither the economy nor the natural world turned out to be as amenable to human management” as was believed.

As Velleius Paterculus observed in the history of Rome that he wrote circa 30 AD, “The most common beginning of disaster was a sense of security.”

Why are we like this? Ip demonstrates, for one thing, how quickly memories fade as new and unscarred generations arrive to create their own disasters. Nor is he himself immune to this trait, writing: “The years from 1982 to 2007 were uncommonly tranquil.”

Well, no.

In fact, the years between 1982 and 1992 brought one financial disaster after another. In that time more than 2,800 U.S. financial institutions failed, or on average more than 250 a year. It was a decade that saw a sovereign debt crisis; an oil bubble implosion; a farm credit crisis; the collapse of the savings and loan industry; the insolvency of the government deposit insurer of the savings and loans; and, to top it off, a huge commercial real estate bust. Not exactly “tranquil.” (As I wrote last year, “Don’t Forget the 1980s.”)

“Make the most of memory,” Ip advises. After the Exxon Valdez oil spill disaster, he says, the oil company “used the disaster to institute a culture of safety . . . designed to maintain the culture of safety and risk management even as memories of Valdez fade.”

We often do try to ensure that “this can never happen again.” After the 1980s, many intelligent and well-intentioned government officials went to work to enact regulatory safeguards. They didn’t work. As Arnold Kling pointed out in an insightful paper, “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008,” some of the biggest reforms from the earlier time became central causes of the next crisis—a notable example of Ip’s conclusions.

We are forced to realize that the U.S. housing finance sector collapsed twice in three decades. We may ask ourselves, are we that incompetent?

Consider a financial system. The “system” is not just all the private financial actors—bankers, brokers, investors, borrowers, savers, traders, speculators, hucksters, rating agencies, entrepreneurs, principals and agents—but equally all the government actors—multiple legislatures and central banks, the treasuries and finance ministries who must constantly borrow, politicians with competing ambitions, all varieties of regulatory agencies and bureaucrats, government credit and subsidy programs, multilateral bodies. All are intertwined and all interacting with each other, all forming expectations of the others’ likely actions, all strategizing.

No one is outside the system; all are inside the system. Its complexity leaves the many and varied participants inescapably uncertain of the outcomes of their interactions.

Within the interacting system, a fundamental strategy, as Ip says, is “to do something risky, then transfer some of the risk to someone else.” This seems perfectly sensible—say, getting subsidized flood insurance for your house built too near the river, or selling your risky loans to somebody else. But “the belief that they are now safer encourages them to take more risk, and so the aggregate level of risk in the system goes up.”

“Or,” he continues, “it might cause the risky activity to migrate elsewhere.” Where will the risk migrate to? According to Stanton’s Law, which seems right to me, “Risk migrates to the hands least competent to manage it.” Risk “finds the vulnerabilities we missed,” Ip writes. This means we are always confronted with uncertainty about what unforeseen vulnerabilities the risk will find.

Finally, the author puts all of this in a wider perspective. “My story, however, is not about human failure,” he writes, “it is about human success.” There can be no economic growth without risk and uncertainty. The cycles and crises will continue, so what we should look for is not utter stability but “the right trade-off between risk and stability.” The cycles and crises are “the price we pay for an economic system that encourages and rewards risk.” This seems to me profoundly correct.

Where is OCC in court battle over state usury limits?

Published in American Banker with William M. Isaac.

A surprising decision of the Second Circuit Court of Appeals in the case of Midland Funding v. Madden threatens the functioning of the national markets in loans and loan-backed securities. The ruling, if it stands, would overturn the more than 150-year-old guiding principle of “valid when made.”

The effects of the decision could be wide-ranging, affecting loans beyond the type at issue in the case. It is in the banking industry’s interest for the Supreme Court, at the very least, to limit its applicability. And since the Madden case could deal a blow to preemption under the National Bank Act, it is time for the Office of the Comptroller of the Currency to voice an opinion.

Under the valid-when-made principle, if the interest rate on a loan is legal and valid when the loan is originated, it remains so for any party to which the loan is sold or assigned. In other words, the question of who subsequently owns the financial instrument does not change its legal standing. But the appeals court found that a debt buyer does not have the same legal authority as the originating bank to collect the stated interest.

In the words of the amicus brief filed before the U.S. Supreme Court on behalf of several trade associations:

Since the first half of the nineteenth century, this Court has recognized the ‘cardinal rule’ that a loan that is not usurious in its inception cannot be rendered usurious subsequently. ” U.S. credit markets have functioned on the understanding that a loan originated by a national bank under the National Banking Act is subject to the usury law applicable at its origination, regardless of whether and to whom it is subsequently sold or assigned.

This, the argument continues, “is critically important to the functioning of the multitrillion-dollar U.S. credit markets.” So it is. And such markets are undeniably big, with hundreds of billions of dollars in consumer credit asset-backed securities, and more than $8 trillion in residential mortgage-backed securities, plus all whole loan sales.

Marketplace lenders and investors have already raised intense concerns about the decision, but the impact could go further. The validity of numerous types of loan-backed securities packaged and sold on the secondary market could suddenly be called into question. Packages of whole loans, as well as securitizations, include the diversified debt of multiple borrowers from different states with different usury limits, and then sold to investors. But the Madden decision suggests those structures are at risk of violating state usury laws.

A possible interpretation to narrow the impact of the case would be for future court decisions to find that the Madden outcome only applies to the specific situation of this case, namely to defaulted and charged-off loans sold by a national bank to an entity that is not a national bank. Thus, only the buyers of such defaulted debt would be bound by state usury limits in their collection efforts, and the impact will largely be limited to diminishing the value of such loans in the event of default.

The Second Circuit decision might not, based on this hypothesis, apply to performing loans or to the loan markets in general. However, as pointed out in a commentaryby Mayer Brown: “it will take years for the Second Circuit to distinguish Madden in enough decisions that the financial industry can get comfortable that Madden is an anomaly.” The law firm’s commentary presented many potential outcomes, including that the Madden case could be “technically overturned” but without the high court providing explicit support for the “valid-when-made” principle. That “would be a specter haunting the financial industry,” according to the firm’s analysis.

In the meantime, what happens?

It would be much better for the Supreme Court to reaffirm the valid-when-made principle as a “cardinal rule” governing markets in loans, and the Supreme Court is being petitioned to accept the case for review.

But at this point, one would also expect the OCC, the traditional defender of the powers of national banks and the preemption of state constraints on national bank lending, to be weighing in strongly. The comptroller of the currency should protect the ability of national banks to originate and sell loans guided by the valid-when-made principle. But the OCC seems not to be weighing in at all and is strangely absent from this issue.

Everyone agrees that national banks can make loans under federal preemption of state statutes, subject to national bank rules and regulations. Everyone agrees, as far as we know, that the valid-when-made principle is required for loans to move efficiently among lenders and investors in interstate and national markets, whether as whole loans or securities.

In our view, the OCC ought to be taking a clear and forceful public position to support the ability of national banks to originate loans which will be sold into national markets.

Puerto Rico: Time for Congress to act

Published by the R Street Institute.

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

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

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

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

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

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

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

Puerto Rico bill proceeds with oversight board and no bailout

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Your retirement dream may require working much longer

Published in Real Clear Markets.

A recent Citigroup monograph, “The Coming Pensions Crisis,” begins with some questions very much in the spirit of our time:  “What’s your dream for retirement?  Is it living on the beach, traveling on cruise ships…relaxing and enjoying the good life”?

Personally speaking, my dream for retirement is not to retire—at least, not now. I think if Warren Buffett can keep running the world’s greatest investment company at 85, and Alan Greenspan could run the world’s most powerful central bank until 79 before going on to lecture and write books, and Maurice R. “Hank” Greenberg can be battling the goliath of the government at 90, why would I stop at 73?  How much sitting on the beach, going on cruises and relaxing can you stand?

What, after all, is “the good life”?

As used by Citigroup, “the good life” means consuming without producing. The words of an old hymn admonish us to “work, for the night is coming.” Here the suggestion is instead: “play, for the night is coming.”

I understand that tastes differ, so may you may prefer the latter. But no one can escape the accompanying question: how many years can you afford to play without working, to consume without producing? If you retire at 63 and live to 85, you will have been retired for a quarter of your life. Should you live to 95 instead, you will have been retired for a third of your life. On average, such an arrangement cannot work financially.

As average lives grow longer, “the reality for many of us,” Citigroup rightly says, “is that there isn’t enough in the piggy bank to last throughout their retired life.” The same problem confronts many pension funds, both private and public, upon which workers rely. They don’t have nearly enough money in the piggy bank, either—not by a long shot.

This daunting problem – in total, an $18 trillion shortfall, by Citigroup’s estimate – is staring us in the face. There are only two answers. Put more money in the piggy bank while you are working—and as retirements grow longer, this means a lot more. Or make the retired years fewer by working longer. Or both. The math of the matter all comes down to this.

An essential element in the math is what I call the “W:R Ratio,” which measures how many years you work compared to how many years you will be retired. All the money spent in retirement is the result of what is saved, in one fashion or another, during one’s working years. This may be what you personally saved and invested, or what your employer subtracted from your compensation and invested, or the money the government took from your compensation and spent, but promised to pay back later.

The surest way to finance your retirement is to keep your W:R ratio up by not retiring too soon.

In 1950, the average age of retirement in the United States was 67. Average life expectancy at birth was 68. Average life expectancy for those who reaches age 65 was 79. Suppose you started work at 20 and retired at 67—working 47 years and ultimately living to age 79. Your W:R ratio was 47 working years divided by 12 retired years, or 3.9. You worked and could contribute to savings for about four years for every year of retirement.

Contrast the current situation. The average retirement age is much lower, at 63. Average life expectancy once you get to 65 is up to 86. Retirement has gotten longer from both ends. Also, many more people have post-secondary education and begin work later. Suppose you work from 22 to 63-years-old and live to age 86. Your W:R ratio is 41 divided by 23, or only 1.8. You have worked less than two years for each year of retirement. Can that work financially? No.

So the crux of the W:R relationship is: how many years do you have to work in order to save enough to pay your expenses for one year of retirement?  What is your guess?  One year of work for one year of retirement—say retiring after 30 years at 55 and living to 85?  No way. Two years?  That would take a heroic and implausible savings rate.

Calculations show that with retirement savings of about 10 percent of income, and historically average real returns of 4 percent a year on the invested savings, the W:R ratio needs to be 3:1. That means if you start working at 22 and live to 86, the financeable retirement age is 70. Or if you start work at 25, the financeable retirement age is 71. All of this is speaking of averages, of course, not necessarily in any individual case.

If the savings are lower, the rate of return is lower or both, the W:R ratio and the age of retirement must rise even more. The Federal Reserve is now making the problem much worse for retirement savings with low, zero or negative real interest rates. We have to hope this expropriation of savers by the Fed is temporary, historically speaking.

What certainly proved to be temporary was the idea that those still in good health and capable in many cases of productive work in a service economy should instead expect to be paid comfortably for long years of play. When combined with greatly extended longevity, this 1950s dream was simply unrealistic; indeed, it was impossible. Today’s savings and pension fund shortfalls bear witness to this financial reality. We must adjust our expectations and plans back to higher average W:R ratios and later retirements than in recent times.

On Puerto Rico, Congress is moving in the right direction

Published by the R Street Institute.

The draft bill to address Puerto Rico’s debt crisis – released late last week by House Natural Resources Committee Chairman Rob Bishop, R-Utah – marks a step in exactly the right direction. It realistically faces the fact that the government of Puerto Rico has been unable to manage its own finances, has constantly borrowed to finance its deficits and is now broke.

What is to be done as the Puerto Rican government displays its inability to cope with its debt burden — which, adding together its explicit debt plus its 95 percent unfunded pension liabilities, totals about $115 billion?

As the draft bill provides, the first required step is very clear: Congress must create a strong emergency financial-control board (“oversight board” is the draft’s term) to assume oversight and control of the commonwealth’s financial operations. This is just as Congress did successfully with the insolvent District of Columbia in 1995; what New York State, with federal encouragement, did with the insolvent New York City in 1975; and what the State of Michigan did with the appointment of an emergency manager for the insolvent City of Detroit in 2013. Such actions have also been taken with numerous other troubled municipal debtors. They are hardly an untried idea.

This should be the first step. As the bill provides, other steps will need to follow. To begin, the oversight board will need to establish independent authority over books and records, publish credible financial statements, and determine the extent of the insolvency of the various parts in the complex tangle of Puerto Rican government borrowing entities—especially of the Government Development Bank, which lends to the others. Then it will have to help develop fiscal, accounting, tax-collection and structural reforms that lead to future fiscal balance.

The oversight board will have to consider and report to Congress on the best ways to deal with the current excessive and unpayable debt, including pension liabilities. The draft bill provides a key role for the board in debt restructuring issues.

Puerto Rico has a failing, government-centered, dependency-generating political economy. The draft bill envisions the oversight board assisting with economic revitalization, which will be a key consideration going forward.

Needless to say, the current government of Puerto Rico does not like the idea of having its power and authority reduced. But this always happens to those who fail financially. The people of Puerto Rico understand this: 71 percent in a recent University of Turabo poll favored “a fiscal control board…that has broad powers.” In time, revitalized finances will lead to a more successful local government.

The draft bill is headed for introduction and hearings. Stay tuned.

Sizing up the FCIC report five years later

Published by the R Street Institute.

Ongoing debates about the financial crisis of 2007 to 2009 keep reminding us that economics is not a science. It can’t be used by governments to manage economic and financial affairs to some preordained outcome. Not only is it rather poor at predicting the future, but its practitioners often are unable to agree even on how to interpret the past.

Nonetheless, accepted economic stories or myths do get established in the media and political mind. One example from a different crisis is that Herbert Hoover was a donothing president in the face of the developing depression. In fact, he was an energetic and ardent interventionist. The real question is whether his many interventions were good or bad.

What are the myths of our more recent crisis?

When it comes to the Financial Crisis Inquiry Commission, created by Congress in May 2009 to study the causes of the crisis, we must remember that the “report” the 10-member commission finally delivered in January 20112 was actually three separate reports:

• The majority report, voted for by the six Democratic-appointed commissioners and no Republican-appointed commissioners, essentially concluded the primary cause was insufficient government intervention.

• A minority dissent of three of the Republican-appointed commissioners concluded the causes of the crisis were many and interacting, with plenty of blame to go around.

• A separate dissent by Peter Wallison argued in detail that the biggest problem was too much government intervention, resulting in extreme distortions in housing-finance market.

In the five years since these reports, what more have we learned? From this distance, can we put the FCIC’s majority and dissenting reports, and the crisis itself, into a convincing overall perspective?

The R Street Institute convened panel of experts, including two former FCIC members, for a Feb. 4, 2016 conference on these issues. The gathering served to provide an informed, insightful and provocative discussion. We are pleased to present this summary of their presentations.

The temptations of housing finance bubbles

A version of this policy short originally appeared in the Winter 2015 issue of the journal Housing Finance International.

Running up the leverage is the snake in the housing finance Garden of Eden. It is a constant set of alluring temptations to enjoy the fruit of increased risk in the medium term, while setting ourselves up for the inevitable fall.

Let us view this famous painting by Lucas Cranach:

The woman is Fannie Mae. The man is Freddie Mac. The snake is whispering, “If you just run up the leverage of the whole housing finance system, you will become powerful and rich.” Fannie and Freddie are about to eat the apple of risk, which will indeed make them very powerful and very rich for a while, after which they will be shamed, humiliated and punished.

Bubbles in housing finance have occurred in many countries and times. They always end painfully, yet they keep happening. As the prophet said (slightly amended), “There is nothing new under the financial sun. The cycle that hath been, it is that which shall be.” Why is this?

Consider this quotation: “The [banking] failures for the current year have been numerous…In many cases, however, the unfavorable conditions were greatly aggravated by the collapse of unwise speculation in real estate.” What year was that? It could have been 2008, to be sure, but it is actually from 1891, as the then-U.S. comptroller of the currency looked sadly at the wreck of many of the banks of his day.

Some people say the problem is that housing lenders who go broke need to be personally punished, to get their incentives right. Economists are big, not without reason, on worrying about economic incentives. But a bigger problem is that it is so hard to know the future. Housing lenders don’t create housing-finance collapses on purpose, but by mistake.

The city of Barcelona in the 14th century decided to manage the incentives of bankers by decreeing that those who defaulted on their deposits would be subject to capital punishment. And as one financial history tells us, “at least one banker, Francesch Castello, was beheaded directly in front of his counter in 1360.” But this did not stop banks from failing.

One of the most important reasons that housing-finance bubbles are so hard to control is that they make nearly everyone happy while they last. Who is making money from a housing-finance bubble? Almost everybody. This is why the experience of a bubble is so insidious.

For example, take the most recent American experience. For a long time, the seven years of 2000-2006, the housing-finance bubble generated profits and wealth. A lot of the profits and wealth turned out to be illusory in the end, but at the time, some of it was real and all of it seemed real. As house prices rose, borrowers made more money if they bought more expensive houses with the maximum amount of leverage. Property flippers bought and sold condominiums for quick and repetitive profits, even if no one was living in them. Housing lenders had big volumes and profits. Their officers and employees got big bonuses. Numerous officers of Fannie Mae and Freddie Mac made more than $1 million a year each. Real estate brokers had high volumes and big commissions. Equity investors saw the value of their housing-related stocks go up. Fixed-income investors all over the world enjoyed the returns from subprime mortgage-backed securities, which seemed low risk, and from Fannie Mae and Freddie Mac securities, which seemed to be, and actually were, guaranteed by the U.S. government.

Most importantly, the 75 million households that were homeowners saw the market price of their houses keep rising. This felt like, and was discussed by economists as, increased wealth. Of course, this was politically popular. The new equity in their houses at then-market prices allowed many consumers to borrow on second mortgages and home-equity loans, so they could spend money they had not had to earn by working. Then-Federal Reserve Chairman Alan Greenspan smiled approvingly on this housing “wealth effect,” which was offsetting the recessionary effects of the collapse of the previous bubble in technology stocks in 2000.

Homebuilders profited by a boom in new building. Local governments got higher real-estate-transaction taxes and greater property taxes, which reflected the increased tax valuations of their citizens’ houses. They could increase their spending with the new tax receipts. The investment banks, which pooled mortgages, packaged them into ever more complex mortgage-backed securities, and sold and traded them, made a lot of money and paid big bonuses to the members of their mortgage operations, including the former physicists and mathematicians who built the models of how the securities were supposed to work. Bond-rating agencies were paid to rate the expanding volumes of mortgage-backed securities and were highly profitable. Bank regulators happily noted that bank capital ratios were good, and that zero banks failed in the United States in the years 2005 and 2006 – the very top of the bubble. In the next six years, 468 U.S. banks would fail.

The politicians are not to be forgotten. The politicians trumpeted and took credit for the increasing home ownership rate, which the housing finance bubble temporarily carried to 69 percent, before it fell back to its historical level of 64 percent. The politicians pushed for easier credit and more leverage for riskier borrowers, which they praised as “increasing access” to borrowing. (The snake had most certainly been whispering to the politicians, too.)

The bubble was highly profitable for everybody involved – as long as the house prices kept going up. As long as house prices rise, the more everybody borrows, the more money everybody makes. This general happiness creates a vast temptation to keep the leverage increasing at all levels.

This brings us to two essential questions.

The first is: What is the collateral for a mortgage loan?

Most people answer, “That’s easy – the house.” But that is not the correct answer.

The correct answer is: Not the house, but the price of the house. The only way a housing lender can recover from the property is by selling it at some price.

The second key question is: How much can a price change? To this question, the answer is: A lot more than you think. It can go up a lot more than you expected, and it can then go down a lot more than you thought possible. It can go down a lot more than your worst-case planning scenario dared to contemplate.

So the temptations of housing-finance bubbles generate mistaken beliefs about how much prices can go down. American housing experts knew that house prices could fall on a regional basis, but most were convinced that house prices would not fall on a national average basis. Of course, now we know they were wrong, and that national average house prices fell by 30 percent. And they fell for six years.

By then, Fannie Mae and Freddie Mac had been banished from their pleasant housing finance Garden of Eden. Here they are, being sent into government conservatorship, as depicted by Michelangelo:

In conservatorship they remain to this day, more than seven years after their failure. Having played a key role in running up the leverage of the whole system, they had suffered a fall they never thought possible.

Puerto Rico needs a financial control board

Published in Real Clear Markets.

The government of Puerto Rico is broke. Having run a long series of constant budget deficits, financed by escalating borrowing, it has accumulated about $71 billion in debt which cannot be paid as agreed. To this must be added an estimated $44 billion of virtually unfunded public-employee pension liability, giving a total debt problem of at least $115 billion. This dwarfs in size the bankruptcy of the City of Detroit, the former municipal insolvency record holder.

What to do? The situation is complex and what all the needed reforms are is not yet clear, but the first required step is very clear: Congress should promptly create an emergency financial control board to assume oversight and control of the financial operations of the government of Puerto Rico.

This is just as Congress successfully did in 1995 with the insolvent Washington, D.C.; as New York State, with federal encouragement, successfully did with the insolvent New York City in 1975; and as the State of Michigan did with the appointment of an emergency manager for the insolvent City of Detroit in 2013. Such action has also been taken with numerous other municipal debtors.

Under the U.S. Constitution, Congress has complete sovereignty over territories like Puerto Rico and the clear authority to create a financial control board. Given the Puerto Rican government’s severe and longstanding financial mismanagement, Congress also has the responsibility to do so.

This should be the first step, before other possible actions. The sine qua non for financial reform is to establish independent, credible authority over all books, records and other relevant information; to determine what the true overall deficit is; to determine which Puerto Rican government bodies are insolvent, in particular to understand the financial condition of the Government Development Bank, which lends to the others; and to develop fiscal, accounting and structural reforms which will lead to future balanced budgets and control of debt levels. Of course, it must also consider how to address the current excessive and unpayable debt.

Should Puerto Rico follow Washington and New York, working its way through its management, bureaucratic and debt problems without a bankruptcy proceeding? Or should it follow Detroit, with a bankruptcy included along with reforms? The financial control board should be charged with recommending to Congress whether a municipal bankruptcy regime for Puerto Rico should be created.

Does all this take responsibility and power away from the current Puerto Rican government? Of course it does. As one harsh, but accurate, assessment put it: if you are a subsidiary government and “you screw up your finances bad enough,” you are going to get control and direction from somebody else. This is as it is, and as it should be.

In the current century, the government of Puerto Rico has run a budget deficit every single year: 15 years in a row. As debts multiplied, debt service was met by additional borrowing and new debt issued to pay the interest on the existing debt. This is the definition of a Ponzi scheme.

Such debt escalations always end painfully when the lenders belatedly stop lending, as has now occurred in Puerto Rico. What must inevitably follow is reform of fiscal operations, default on or restructuring of debt in bankruptcy or otherwise, bailout funding or combinations of these. What in particular must be done is what the financial control board should take up, preferably sooner rather than later.

As the government of Puerto Rico (“the Commonwealth”) has disclosed:

• “The Commonwealth cannot provide an estimate at this time of when it will be able to complete and file its audited financial accounts.”

• “The Commonwealth faces an immediate liquidity crisis.”

• “The budget deficit of the Commonwealth’s central government during recent years may be larger than the historical deficits of the General Fund.”

• “The assets of the Commonwealth’s retirement system will be completely depleted within the next few years.”

• “The Commonwealth has frequently failed to meet its revenue projections.”

• “Each fiscal year, the Commonwealth receives a significant amount of grant funding from the U.S. government. A significant portion of these funds is utilized to cover operating costs.”

• “The Government Development Bank’s financial condition has materially deteriorated… [it faces] the inability of the Commonwealth and its instrumentalities to repay their loans.”

• “The Commonwealth has failed to file its financial statements before the 305-day deadline in ten of the past thirteen years.”

• “The Commonwealth does not have sufficient resources to pay its debt obligations in accordance with their terms.”

They themselves have said it. It is high time for an emergency financial control board. The board may be given a politically friendlier name, but its formidable task will be the same.

An Emergency Financial Control Board for Puerto Rico

 Testimony of 

Alex J. Pollock

Resident Fellow

American Enterprise Institute 

To the Committee on the Judiciary

United States Senate 

Hearing on Puerto Rico’s Fiscal Problems

December 1, 2015

An Emergency Financial Control Board for Puerto Rico

Mr. Chairman, Ranking Member Leahy, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Immediately before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on financial systems and credit crises, including municipal debt crises.

The government of Puerto Rico, having run a long series of constant budget deficits, has accumulated a very large debt which according to its own statements, it cannot pay. It is cut off from all normal municipal bond market financing and is running out of cash. The credit ratings of its many debt issuing entities are at the bottom of the scale, with a preponderance of CC ratings from S&P and Fitch and Ca ratings from Moody’s, with additional defaults on or restructurings of government debt expected.  With its current budget operations, financial control systems and government structure, it cannot produce clear, audited financial statements.  The study performed by former IMF officers earlier this year concluded that “the overall deficit is larger than recognized, its true size obscured by incomplete accounting” and cited “weak budget execution and opaque data.”  In addition, public pension obligations, which in insolvency pit pensioners against creditors, are virtually unfunded and an estimated $44 billion pension liability must be added to the $71 billion in debt. 

It is my recommendation that the Congress should promptly create an Emergency Financial Control Board to assume oversight and control of the financial operations of the government of Puerto Rico, as Congress successfully did in 1995 with Washington, DC; as New York State, with federal encouragement, successfully did with the insolvent and defaulting New York City in 1975; and as the State of Michigan did with the appointment of an Emergency Manager for the insolvent City of Detroit in 2013.  Such Boards have also been used in Cleveland (1980), Philadelphia (1991), and Springfield, Massachusetts (2004).  There is plenty of precedent. 

Under the United States Constitution, Congress has sovereignty over territories and the clear authority to create such a Control Board.  In my opinion, with Puerto Rico’s severe and longstanding financial problems, Congress also has the responsibility to do so.

This should be the first step, prior to other possible legislative actions.  I believe that the initial requirement is to establish independent, credible authority over all books, records and other relevant information; to analyze what the true overall financial deficit is; to determine which Puerto Rican government bodies are insolvent, in particular understanding the financial condition of the Government Development Bank which lends to the others; to consider fiscal, accounting and structural reforms which will lead to future balanced budgets and control of debt levels; and to consider in the light of all of these, how the current excessive levels of debt should be addressed.  The Control Board should analyze and report to Congress on whether creating a bankruptcy regime for Puerto Rico is warranted as a subsequent legislative action.

The Administration’s statement on “Puerto Rico’s Economic and Fiscal Crisis” includes this proposal: “Enact strong fiscal oversight and help strengthen Puerto Rico’s fiscal governance…Congress should provide independent fiscal oversight.”  This goes in the right direction, but is vague.  I believe it needs to be something more specific, thus more likely to work: a Control Board.  The Administration says financial oversight should “respect Puerto Rico’s autonomy,” but in fact Congress has unquestioned jurisdiction here.  As one harsh, but accurate, assessment has it: if you are a subsidiary government and “you screw up your finances bad enough,” you are going to get control and direction from somebody else.

The details of the Puerto Rican government’s financial situation are complex, but the fundamentals are simple and make a familiar pattern. The government of Puerto Rico is broke.  In the current century, it has run a budget deficit every single year-- 15 years in a row.  Operating deficits have been financed by borrowing.  As debts multiplied, debt service was met by additional borrowing.  As one municipal bond expert wrote, “The Commonwealth [was] utilizing debt issuance to pay interest on existing indebtedness.” This is the definition of a Ponzi scheme.   

Such debt escalations always end painfully when the lenders stop lending, as has now occurred.  What must inevitably follow is reform of fiscal operations, default on or restructuring of debt, bailout funding, or permutations and combinations of these.  What in particular must be done, and what the complete financial condition is, the proposed Emergency Financial Control Board must take up.

As the government of Puerto Rico recently disclosed:

     -“On October 30, 2015 the Commonwealth filed a notice that the Commonwealth would not file its audited financial statements for fiscal year 2014 by October 31, 2015.” 

     -“The Commonwealth cannot provide an estimate at this time of when it will be able to complete and file its audited financial accounts.”

A municipal bond analyst from UBS opined that the “inability to produce an audited financial statement for a fiscal year that ended almost sixteen months ago is inexplicable.”  On the contrary, it is all too explicable, given a financially stressed, insolvent borrower. 

Among the “Risk Factors” for investors in its debt, the government currently cites the following:

     -“The Commonwealth faces an immediate liquidity crisis.” 

     -“The Commonwealth does not have sufficient resources to pay its debt obligations in accordance with their terms.”

     -“The budget deficit of the Commonwealth’s central government during recent years may be larger than the historical deficits of the General Fund because they do not include the deficits of various governmental funds, enterprise funds, and Commonwealth instrumentalities.”

     -“The Puerto Rico Planning Board recently acknowledged the existence of certain significant deficiencies in the calculation of its macroeconomic data.”

     -“The assets of the Commonwealth’s retirement system will be completely depleted within the next few years unless the Commonwealth makes significant additional contributions…the Retirement Systems will continue to have large unfunded actuarial accrued liability and a low funding ratio for several decades.” 

     -“Each fiscal year, the Commonwealth receives a significant amount of grant funding from the U.S. government.  A significant portion of these funds is utilized to cover operating costs.”

     -“The Commonwealth’s accounting, payroll and fiscal oversight systems have deficiencies due to obsolescence and compatibility issues…this has affected the Commonwealth’s ability to control and forecast expenses.” 

     -“The Commonwealth has frequently failed to meet its revenue projections.”

     -“The Government Development Bank’s financial condition has materially deteriorated and it could become unable to honor all its obligations.”

     -The Government Development Bank has historically served as the principal source of short-term liquidity for the Commonwealth and its instrumentalities,” but faces “the inability of the Commonwealth and its instrumentalities to repay their loans.”

     -“The Commonwealth has failed to file its financial statements before the 305-day deadline in ten of the past thirteen years, including the most recent fiscal years (2012, 2013 and 2014).”

They themselves have said it.  All indications are of a government much in need of emergency, authoritative management help which is not dependent on short-term local politics. 

In addition, one Puerto Rican expert testified to the Senate Finance Committee that “Puerto Rico has an excessively bureaucratic and inefficient central government…when it comes to fiscal policy, budgeting, financial recordkeeping, tax collection, business permitting, professional contracting, use of modern technology and overall performance….Anyone who has dealt with the Puerto Rican government knows how opaque and difficult to navigate it can be.” Another expert has described “significant government corruption and predatory rent-seeking behavior,” along with “substantial tax evasion.”  Are these assertions true?  A Control Board will need to make judgments and then decisions accordingly.

I previously mentioned the robust precedents for Emergency Financial Control Boards.  As one analyst correctly observed, “The fundamentals of Puerto Rico resemble those of New York City in the mid-1970s and of other municipalities on which a Financial Control Board has been imposed.” 

The closest legal parallel is Washington DC, which had become a financial quagmire by the mid-1990s. Like Puerto Rico, Washington DC, not being a state, is Constitutionally subject to the direct jurisdiction of Congress. Congress responded with the District of Columbia Financial Responsibility and Management Assistance Act of 1995, which created the District of Columbia Financial Responsibility and Management Assistance Authority.  (A good political title, which might be adapted for use in Puerto Rico.)  

The Act was developed, approved and implemented as a successful bipartisan effort and the Board was given broad powers and authority.  These included approving or disapproving financial plans and budgets, implementing recommendations on financial stability and management, approving the appointment of the Inspector General of the District government, having total access to official reports and data, holding hearings, issuing subpoenas, and requiring District officers and employees to carry out its orders.

A very important power, worthy of note, was to approve the appointment of an independent District Chief Financial Officer—an office which continues today.

Two years later, Congress followed up with the National Capital Revitalization and Self-Government Improvement Act of 1997, which set tighter controls.  The purposes included: “to improve the ability of the District of Columbia government to match its resources with its responsibilities”—in other words, to run a balanced budget.  Another explicit goal of this act is very relevant to Puerto Rico: improvement in tax collection.

Although there were disputes and difficulties along the way, the Washington DC Control Board achieved clear success in financial management and controls, efficiency, and indeed reaching balanced budgets.  It adjourned in 2001, after Washington DC achieved its fourth consecutive balanced budget. The city’s bond ratings greatly improved; they have now reached AA/Aa.  However, the Board remains in the wings, authorized for a possible return, should Washington DC’s budget discipline ever again slide into aggregate deficits.

Another strong precedent is New York City. Like Puerto Rico, it had run a long series of budget deficits, financed them with ever more debt, and finally needed new loans to service the old ones.  In the spring of 1975, the market for the city’s debt closed.  By that fall, the city government was out of money and was, with the support of many of its prominent citizens, lobbying desperately for a federal bailout.  President Ford wisely turned this down.

Instead a deal was worked out among the federal, state and city governments, resulting in the establishment by New York State of the New York City Emergency Financial Control Board.  Other elements of the deal were the default, called a “moratorium,” on the city’s short-term notes; later Congressionally-approved provision of seasonal emergency financing for three years by the U.S. Treasury; and restructuring of debt through bonds issued by the Municipal Assistance Corporation, also established by New York State.  The necessity of the Control Board was primary.  

Intensely needed reforms of New York City’s spending, management, budget discipline, financial reporting and financial controls were achieved. New York City by now has also improved its bond ratings to AA/Aa.  Here is another success story for Control Boards and their ability to bring outside authority and resulting action.  As then-Treasury Secretary William Simon later wrote, “The city and state were required to make decisions of a type they had heretofore refused to make.” 

The State of Michigan, facing several municipalities in serious financial difficulty, adopted the Local Government and School District Accountability Act in 2011, authorizing the appointment of Emergency Managers, individuals rather than a board, with very broad financial and operating powers.  The best known was Kevyn Orr in the City of Detroit, appointed in 2013, but four other Michigan cities have had similar appointments. (It seems to me that the more common practice of appointing a board, with the balance of multiple perspectives and expertise, is a preferred structure.) 

In Detroit, the first step was the Emergency Manager.  Having analyzed the massive problems and the debt, he concluded that the city’s deep insolvency required a municipal bankruptcy.  This largest municipal bankruptcy ever was concluded in 20­­14, with major losses to creditors, including smaller but significant losses to pension claims.  Following the settlement of the bankruptcy, the Emergency Manager has been succeeded by the Detroit Financial Review Commission, which will continue to oversee the city’s budgets and financial management.

Should Puerto follow Washington DC and New York City, working its way through its management and debt problems without a bankruptcy proceeding? --or should it follow Detroit, with a bankruptcy included along with reforms?  I believe Congress should first appoint the Control Board for Puerto Rico, and charge it with getting on top of the financial situation, pursuing management reforms, considering the debt servicing issues, and then recommending to Congress whether or not a bankruptcy, which would involve new bankruptcy legislation, is required.

Let’s compare the debt burdens of three of the cases. The government of Puerto Rico’s $71 billion in total debt is 15% greater than the $62 billion, when re-stated to 2015 dollars, of New York City during its 1975 debt crisis.  Detroit’s debt, in 2015 dollars, was $19 billion.  Since the populations of the three are very different--Puerto Rico, 3.6 million; New York City 7.9 million; City of Detroit, 700 thousand-- we need to view the per capita local government debt.  These were, at the time of each crisis, expressed in 2015 dollars:

                               Puerto Rico             $20 thousand     

                              New York City          $ 8 thousand

                              City of Detroit          $27 thousand 

Puerto Rico is much more heavily indebted per capita than New York City was, but less so than Detroit.

One of the most distressing economic statistics of Puerto Rico is its labor participation rate of less than 40%.  There is additional work in the “informal” sector, but that does not generate taxes to pay the government’s debt.  So let’s look at local government debt per officially employed person in 2015 dollars:

                              Puerto Rico            $71 thousand 

                              New York City         $19 thousand

                              City of Detroit          $90 thousand 

Again, the Puerto Rican debt level per employee is much worse than New York City, but 20% less bad than Detroit.  Maybe in Puerto Rico the Emergency Financial Control Board will be sufficient to work through the reforms while debts are restructured outside of bankruptcy. I do not think it is possible to say at this point.

In any case, the financial and managerial problems are severe, cash is running out, and time is wasting.  In my judgment, Congress should establish the Emergency Financial Control Board for Puerto Rico as a high priority.

Thank you again for the opportunity to share these thoughts.

The Federal Reserve’s Second 100 Years

Published by the American Enterprise Institute.

The Federal Reserve has had a remarkable career in the 100 years since Congress created it on December 23, 1913. What are the Fed’s next 100 years likely to bring?

It is daunting but also liberating to make such guesses about the very long term, since one is bound to get many things wrong. The human mind is incapable of imagining in advance the novelties that so much time will bring. For example, the authors of the Federal Reserve Act could certainly not have even imagined, let alone expected, what their creation has become in a century. They would have been utterly dumbfounded at a Federal Reserve that:

— Is formally committed to, and is producing on purpose, perpetual inflation.

— Has no link of any kind to a gold standard.

— Thinks it is supposed to, and that it is capable of, “managing the economy.”

— Invests vast amounts in, and monetizes, real estate mortgages.

— Has chairmen who achieve media star status, as for example, “The Maestro.”

— Wields the authority of a unitary central bank, centralized in Washington D.C., rather than being a federal system of regional “reserve banks.”

Can we have any hope of making some good predictions? Perhaps. Consider the 100-year predictions that the brilliant F.E. Smith, Lord Birkenhead, made in 1930 in his book, The World In 2030.

Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.

Birkenhead predicted, for example, the then-future revolutions in genetic science, atomic energy, and global communications media, and that in the future “women … will be found at the head of government departments [and] as managing directors of great commercial undertakings.” On the other hand, he did not discuss the monetary system at all, and did not predict the vast experiment in world-wide fiat currency in which we have been living since 1971, whose ultimate outcome is still unknown. Also, Birkenhead imagines that an undergraduate in 2030 preparing to write about the 22nd century would sit down at his typewriter, rather than not even know what a typewriter was.

Birkenhead offered some instructive general observations on the matter of the long future:

— “Remembering a thousand other changes, mechanical, ethical, social, political, and constitutional, we shall, it may be repeated, be wise to declare little impossible in the [next] hundred years.” Yes, including fundamental changes in our ideas about central banking and the beliefs of central bankers.

— “The future stretches before us in this year 1930 murky, obscure, and terrible.” In January, 2014, it still stretches before us murky and obscure but, it seems, less terrible than in 1930. I hope.

Another notable 100-year forecast made in 1930, this one specifically focused on economics, was by John Maynard Keynes in his essay, “Economic Possibilities for Our Grandchildren.” Starting by observing the “bad attack of economic pessimism” in “the prevailing world depression,” Keynes nonetheless predicted an optimistic economic future, about which he was entirely correct.

“In the long run,” he wrote in the midst of the world crisis, “mankind is solving its economic problem. I would predict that the standard of life in progressive countries 100 years hence will be between 4 and 8 times as high as it is today [in 1930].” As of 2013, per capita GDP in the United States was 5 times what is was in 1930, which is an average real growth rate of about 2 percent per year since 1930. If the 2 percent growth continues to 2030, the standard of life will be about 7 times what it was when Keynes made his prediction of 4 to 8 times. A great call.

Looking ahead in the spirit of Keynes for an additional 100 years to 2130, another increase of 7 times would bring it to a level of 49 times that of 1930. Can we imagine that?

If such real growth continues, it will be the result of advances in scientific knowledge, technical innovation, and entrepreneurship. Turning to the Federal Reserve, we find a different 2 percent growth rate: the Fed’s targeted rate of inflation, or depreciation of the currency it issues.

Since 1913, the U.S. consumer price index has increased over 23 times: in other words, a quarter now is about what a penny was when Woodrow Wilson signed the Federal Reserve Act. If the Fed produces a 2 percent annual inflation for its next 100 years, a dollar will be far less than a penny was; it would take about $1.70 to equal the original penny. Merely to stay even in real terms with today, an average household would then need an income of about $350,000. Can we imagine that?

This brings me to a dozen predictions about the Fed’s second century:

1. Lender of Last Resort

Consider a 1994 book, The World in 2020 (a 26-year forecast). “The debt crisis of the 1980s,” it says, “forced the banks to adopt much more cautious lending policies.” As is obvious from the multiple debt crises since 1994, extrapolating post-crisis banking caution is a mistake. Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes. As Paul Volcker wittily said, “About every ten years, we have the biggest crisis in 50 years.” A decade seems like about enough for the waning of institutional memory.

Bankers, borrowers, investors, regulators, and central bankers continue to forget the temporarily burning lessons of crises and then repeat their mistakes.

An “elastic currency” was the most important purpose of the original Federal Reserve Act and remains a robust idea, as recently demonstrated once again in the panics of 2007-2009, although these also demonstrated once again that having the Federal Reserve does not prevent panics. Going forward, it will be claimed from time to time that we have outgrown financial crises. We won’t have.

Thus my first prediction: The Fed’s lender-of-last-resource function, or the ability to create “elastic currency” in a crisis, will continue to be necessary for at least another 100 years.

2. Shull’s Paradox

Professor Bernard Shull, in his provocative book, The Fourth Branch: The Federal Reserve’s Unlikely Rise to Power and Influence, propounds what I call “Shull’s Paradox,” which is that no matter how many or how great are the inflationary and deflationary blunders made by the Fed, its power, prestige, and authority nevertheless always increase. Shull’s book, published in 2005, demonstrated this perverse relationship over the Fed’s first nine decades, and how the Fed, “established as a small and almost impoverished institution,” has nonetheless “emerged as the most influential organization ever established by Congress.” He then speculated, “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”

Shull’s speculation was fully confirmed. The Fed first stoked the great housing bubble from 2002 to 2005, then utterly failed to anticipate the magnitude of its collapse, and on top of that, failed to predict the ensuing steep recession. But in the subsequent legislative reaction, the notorious Dodd-Frank Act, the Fed’s jurisdiction and authority were expanded.

How can we explain the paradox? Perhaps it is the emotional yearning of many people, including politicians, to believe in a wise, “Maestro”-like force to orchestrate unpredictable events — even though no one, including the Fed, can actually do this. The Fed does seem able to inspire a puzzling, naive will to believe.

So I predict that Shull’s Paradox will continue to hold, and the Fed will gain even more power from the next crisis, even if it causes that crisis.

3. Independence

Is the Fed independent, as is often claimed? No. A better description is that of

Chicago Federal Reserve Bank President Charles Evans, who has referred to the “measure of independence” of the Fed.

William McChesney Martin, Fed chairman in the 1950s and 1960s, spoke of the Fed being independent “within the government” — i.e. not independent. Arthur Burns, Fed chairman in the 1970s, reportedly said, “We dare not exercise our independence for fear of losing it.”

Yet many economists are attracted to the idea of a truly independent Fed. It flatters the importance of their macro theories to think it should be so. I believe that inside every macro economist is a philosopher-king trying to get out, and that being part of the Federal Reserve is the closest an economist can ever get to being a philosopher-king, or at least an assistant deputy philosopher-king.

But since the Fed is always “within the government,” I predict that in 2113 it still will not be independent, although the economists of that future day will still be writing about how it should be.

4. Systemic Risk

The Federal Reserve has the greatest power of any institution anywhere to create systemic financial risk for everybody else by its fiat money creation and interest rate manipulations. Given the global role of the dollar, this power runs around the world.

The Dodd-Frank Act has resulted in large banks being called “Systemically Important Financial Institutions,” or “SIFIs.” As such, it is maintained they need extra oversight. It is apparent that the Fed itself is the biggest SIFI of them all.

A good example of this is the massive interest rate risk of its own balance sheet.

Because of this risk, I predict that in the intermediate term the Federal Reserve will be insolvent on a mark-to-market basis.

Let’s go through the math. With so-called “QE,” or quantitative easing, the Fed now owns $2.1 trillion in long government bonds as part of its successful manipulation (so far) to get bond yields lower. In an entirely unprecedented fashion, it also owns $1.5 trillion of fixed rate mortgage securities. That is a total of $3.6 trillion in unhedged outright long positions. The Fed does not disclose the duration of this remarkable portfolio, but 7.5 years would probably be a fair guess.

Suppose interest rates rise a mere 2 percent. The mark-to-market loss would be $3.6 trillion X 2% X 7.5. This would be a mark-to-market loss of $540 billion. The Federal Reserve’s total capital is $55 billion. So the economic loss would be about ten times the Fed’s capital. Q.E.D.

One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.

Would the world care if its principal central bank were so insolvent on a mark-to-market basis? Many Fed defenders say absolutely not, but I don’t think anyone really knows. However, I also predict that the Fed will never admit any such insolvency on its own books. It has already developed for itself a version of “regulatory accounting,” not dissimilar to that practiced by savings and loans in the 1980s, to prevent any such admission. One respect in which the Fed actually is independent is that it sets its own accounting standards for itself, although this power might be lost in some future reform.

5. Big Surprises

During the history of the Fed so far, four major changes in the fundamental monetary regime have occurred: going off the gold standard in the 1930s; going on the Bretton Woods system of fixed exchange rates and a gold exchange standard in 1945; the collapse of the Bretton Woods system in 1971; and its replacement by the current global regime of pure fiat currencies and floating exchange rates (a regime which is quite prone to recurring crises).

It does not seem reasonable to assume that any monetary regime will last forever, and that the next hundred years will somehow be immune from fundamental changes. So I predict that in the course of the Fed’s next century, further major changes in monetary regimes will occur, surprising our current expectations — only we don’t know what they will be.

6. Central Banking and Dentistry

Keynes ends his essay on the “Economic Possibilities” of 2030 by thinking about economists and dentists. “The economic problem” — presumably including central banking — he puckishly suggests, “should be a matter for specialists — like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!”

However, since then, central banking has still not become scientific like dentistry, nor do its specialists display the progress in scientific knowledge and technique that dentists so admirably do. In another century, I believe central banking, and macro economics, will be no closer to becoming a science like dentistry. Instead, they will, in accordance with their essential nature, continue to be debatable, contestable, uncertain, and ideological.

In other words, in 2113 the Fed will still be heavily political.

7. Maestroism

From the dissimilarity to dentistry, it follows that in the next 100 years, like the last, no Federal Reserve chairman can or will be a sustained, successful “Maestro,” as Alan Greenspan was unfortunately dubbed by the silly media, until he wasn’t. It is more likely that central bankers, like investment managers, will have good runs alternating with bad ones. This is by no means a matter of intelligence, talent, hard work, or leadership, but of the ineluctable uncertainty involved.

8. The Bernanke Legacy

One intriguing uncertainty in the Federal Reserve’s new century is how the Fed under Chairman Bernanke will be judged by future financial historians. It seems certain that its unprecedented quantitative easing, that vast manipulation of long-term bond and mortgage markets, will be heavily discussed. But will economists now in kindergarten or unborn judge “QE” a success or a failure? No one knows, including the Fed itself.

But will economists now in kindergarten or unborn judge ‘QE’ a success or a failure? No one knows, including the Fed itself.

It appears to me that the probability is bimodal: for his QE experiment, Bernanke is likely to go down in future history as either a great hero or a great bum, one or the other, but we don’t know which.

9. Inflation

What 21st-century central bankers had convinced themselves was the “Great Moderation” turned out to be in reality the Era of Great Bubbles and their collapse. In recent decades, the Fed and central banks generally have come to believe in inflation targets, usually of 2 percent a year or so inflation — in other words, perpetual inflation. Is this belief in perpetual inflation sustainable?

Perhaps financial systems with perpetual inflation may break down into crisis too often — the current monetary regime has obviously had plenty of financial crises. So perhaps the cognitive structures and psychological beliefs of central bankers may shift back to a commitment to a long-term stable value of currency, rather than inflation forever.

Such a shift in dominant ideas is certainly possible in 100 years.

10. Government Finance

The first mandate of most central banks is to lend money to the government as necessary. I believe the Federal Reserve will continue to be absolutely essential to the U.S. government, not because of its economic skills, forecasting ability, or financial wisdom, but because it is the reliable and expandable source of deficit finance for the government.

A fiat-currency issuing and government debt buying central bank, of which the Fed is the most important instance, is a hugely valuable asset for the government. I imagine it will still be so in 2113.

11. Legislative Reform

Legislation has been introduced in the U.S. House of Representatives to have a formal congressional review of the performance of the Fed since 1913 (mixed, to be sure) and of its future. Of course, the Fed is a creation of the Congress, and subject to legislative revision at any time. Twice in its first century, in 1935 and again in 1977-78, major reform legislation was enacted. I see no reason to assume that the politicians of the future will always be satisfied with the status quo of today.

In 2113 the Fed will still be heavily political.

So I predict that there will be a “Federal Reserve Reform Act” of 2000-something and/or 2100-something, at least once or twice, in the Fed’s second century.

12. Econocracy

An intriguing trend in recent decades is how economists have tended to take over the Fed, including the high office of chairman of the Board of Governors and the presidencies of the Federal Reserve Banks. But there is no necessity in this, especially once we no longer believe that macro economics is or can be a science.

Financially famous Fed chairmen who were not professional economists include William McChesney Martin, who among other things was the president of the New York Stock Exchange; and Marriner Eccles, who was a banker and businessman from Salt Lake City. Both have Federal Reserve buildings in Washington named after them.

I predict the Fed’s next 100 years will again bring a Federal Reserve chairman who is not an economist.

Finally: Not Rocket Science

Lord Birkenhead, introducing his 100-year predictions, reflected that in the long term, “The results of scientific research control the wealth of nations.” As we have said, central banking, while highly important for better and for worse, is not science.

Robert Solow recently asserted that “central banking is not rocket science.” True, and it will be neither science nor rocket science in 2113. But Solow meant that central banking was easier, while in fact it is harder than rocket science, now and in the future. This is because it must confront the inescapable uncertainty of human minds and deeds interacting, with their strategies, politics, adaptations, creations, surprises, intentions, mutual learning, guessing, risk-taking, cognitive herding, emotions, cupidity, fear, courage, and frequent mistakes, in their financial and economic dimension. This includes the minds and deeds of the central bank itself interacting with all of the others.

It is certain that the Fed will continue to be an interesting and debatable topic in its next 100 years.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.

This essay is adapted from Pollock’s address at the Loyola University of Chicago Symposium “The Federal Reserve at 100: The First 100 Years, the Present, and the Next 100” on December 6, 2013.

How Many Mandates Does the Fed Have? How Many Can It Achieve?

 Written Testimony of 

Alex J. Pollock

Resident Fellow

American Enterprise Institute 

To the Committee on Financial Services

U.S. House of Representatives

Hearing on “The Many Mandates of the Fed”

December 12, 2013 

How Many Mandates Does the Fed Have?  How Many Can It Achieve?

Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to submit this written testimony.  I am Alex Pollock, a resident fellow at the American Enterprise Institute where I focus on financial policy issues, and these are my personal views.  Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general.

My discussion has two main themes: 

1. Discretionary fiat-currency central banking is subject to high uncertainty.  Therefore the attempts of central banks to “manage” financial and economic stability are inevitably subject to mistakes, and recurring big mistakes.  The naive belief that any central bank, or anybody, could actually know enough about the future, and in particular about the future of complex, recursive globalized economies and financial markets, to be an economic “Maestro”, is a fundamental error.

2. While the Federal Reserve is often said to have a “dual mandate,” which would be difficult enough, it fact it has six mandates.  The combination of these mandates has created in the Fed a remarkable concentration of power.  But the Fed does not, and because the future is unknowable, cannot, succeed at all its mandates.   

Uncertainty and the Lack of Knowledge

In the early 21st century, the Fed and other central bankers gave themselves great credit for having engineered what they thought they observed: the so-called “Great Moderation.”  But the Great Moderation turned out to be the Era of Great Bubbles.  The U.S., in successive decades, had the Tech Stock Bubble and then the disastrous Housing Bubble.  In addition, other countries had destructive real estate and government debt bubbles. 

Presiding over the Era of Great Bubbles as Chairman of the world’s principal central bank from 1987 to 2006, was Alan Greenspan, a man of high intelligence and wide economic knowledge, with scores of subordinate Ph.D. economists to build models for him.  He was then world famous as “The Maestro,” for supposedly being able to always orchestrate the macro economy to happy outcomes.  In reality, the idea that anyone, no matter how talented, could be such a Maestro is absurd, but it was widely believed nonetheless, just as the idea that national house prices could not fall was widely believed.

In his new book, Chairman Greenspan relates, with admirable candor, that at the outset of the financial crisis in August, 2007, “I was stunned.”  He goes on to discuss the failure of the Fed to anticipate the crisis.  For example: “The model constructed by the Federal Reserve staff combining the elements of Keynesianism, monetarism and other more recent contributions to economic theory, seemed particularly impressive,” but “the Federal Reserve’s highly sophisticated forecasting system did not foresee a recession until the crisis hit.  Nor did the model developed by the prestigious International Monetary Fund. 

Even extremely complex models are abstract simplifications of reality and they do not do well with discontinuities like the panicked collapse of bubbles, so it is not surprising that “leading up to the almost universally unanticipated crisis of September, 2008, macromodeling unequivocally failed when it was needed most, much to the chagrin of the economics profession,” as Greenspan writes.

Central banking is not and cannot be a science, cannot operate with determinative mathematical laws, cannot make reliable predictions of an ineluctably uncertain and unknowable future.  We should have no illusions about the probability of success of such a difficult attempt as central banks’ “managing” economic and financial stability, no matter how intellectually impressive its practitioners may be.  “We did not anticipate that the decline in house prices would have such a broad-based effect on the stability of the financial system,” as another impressive intellect, Fed Chairman Ben Bernanke, has admitted.

Before the Era of Great Bubbles, a vast Federal Reserve mistake was the Great Inflation of the 1970s, under the Fed chairmanship of distinguished economist Arthur Burns, when annual inflation rates in the U.S. got to double digit levels.  In the aftermath of this decade of inflation was a series of financial crises of the 1980s, involving among other things, the failure of 2,237 U.S. financial institutions between 1983 and 1992, and the international sovereign debt crisis of the 1980s.  The Great Inflation was created by the Fed itself and its money printing exertions of those days.

In the next decade, the 1980s, with some success and by imposing a lot of pain, the Fed undertook “fighting inflation”—the inflation it had itself caused.  In the 2000s, it performed a variation on this pattern: the Fed first stoked the asset price inflation of the colossal Housing Bubble, then worked hard to bail out the Bubble’s inevitable collapse.

The Fed and other fiat-currency central banks are in the money illusion business, trying to affect the costs of real resources by depreciating the currency they issue at more or less rapid rates, by money creation and financial market manipulations.  The business of money illusion often turns into the business of wealth illusion, since central banks can and do fuel asset price inflations.  Asset inflations of bubble proportions create “wealth” that will evaporate.

Asset price inflation can be intentional on the part of the Fed when it is trying to bring about ”wealth effects,” as it did with the housing boom in 2001-2004 and is now doing again with so-called “quantitative easing,” including its unprecedented $1.5 trillion mortgage market manipulation.

Future financial histories will reflect something their authors will know, but we cannot: what the outcome of the Bernanke Fed’s massive interventions in the long-term government debt and mortgage markets will have been.  About this at present we, and the Federal Reserve itself, can only guess.  In the 1920s, the then-dominant personality in the Fed, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.”  The current Fed has given the bond and mortgage markets a barrel of whiskey, in a way which would have astonished previous generations of Fed governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

The final outcome of this intervention will probably render the Bernanke Fed in future histories as either a great hero or else as a great bum.  The probability distribution appears to me as bimodal, with nothing in between.  It represents a remarkable central banking gamble—one which without doubt has greatly increased the interest rate risk of the entire financial system, as well as of the Fed’s own balance sheet.  It reflects the ultimate in discretionary central banking with multiple mandates. 

How Many Mandates?

We constantly hear, not least from the Fed itself, about how it has a “dual mandate” of price stability and maximizing employment.  Experts have debated whether the Fed or any central bank can achieve balancing these two mandates successfully.  This question much oversimplifies the problem, for the Fed has not two mandates, but six.

To begin with, the provision of the Federal Reserve Reform Act of 1977 that gives rise to all the talk of a dual mandate actually assigns the Fed three mandates.  It provides that the Fed shall: “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  Obviously, that is three goals—a triple mandate, not a dual mandate.  However, the “moderate long-term interest rates” idea, perhaps because it is impractical, usually gets conveniently left out.

In addition, the Fed has three more mandates.  Two are from the original 1913 Act: to provide an elastic currency, and to regulate and promote financial stability.  The final mandate is the real essence of central banking: to finance the government as needed.

That makes six mandates.  How is the Fed doing on each?  Can it ever be expected to achieve them all? 

Let us start with “stable prices.”  This mandate in its literal sense was dropped by the Fed long ago and is now a dead letter.  The Fed’s frequently announced goal is not stable prices, but a relatively stable rate of increase in prices, with a target of 2% inflation a year, continuing indefinitely.  Bluntly put, the Fed is committed to perpetual inflation (although I cannot recall seeing it use this honest term) at a rate which will cause average prices to quintuple in the course of an average lifetime. With a straight face, the Fed and other central bankers call this “price stability”—a remarkable example of Orwellian newspeak.  While it is confused on the actual legal mandate, a recent article discussing the Fed in Barron’s correctly describes the current practice: “Half of its dual mandate, inflation.”  

A classic rationale for inflation is that real wages can be reduced without reducing nominal wages, and that real debts can be reduced without (as much) default on nominal debts.  Nonetheless, it is my opinion that the current commitment of the Fed and other fiat-currency central banks to perpetual inflation will be judged in the long run as inconsistent with financial stability, and instead part of the decades of financial instability which began in the 1970s.  However that may be, price stability is what we intentionally don’t have.

When the goal of “maximum employment” was added to the governing statute in 1977, many people, including the Democratic sponsors of the bill, believed there was a simple-minded trade-off between inflation and employment.  Shortly after enactment of this mistaken idea, the stagflation of the late 1970s demonstrated its error.  No one believes it now, but its presence in statute gives the Fed much increased power to exercise inherently uncertain discretionary central banking.

Within a few years of enactment of the “moderate long-term interest rates” mandate, the Fed was pushing interest rates to all-time highs, with the 10-year Treasury interest rate reaching 15% in the early 1980s.  This was hardly a “moderate” rate, to be sure. 

The history of the Fed and manipulation of long-term rates is instructive.  During the 1940s, the Fed was a big buyer of long-term government bonds to finance World War II and to suppress the cost of borrowing for the U.S. Treasury.  This was a major precedent considered by Chairman Bernanke for “quantitative easing.”  After the war, the Fed continued to hold down interest rates; at length it was debated whether it should.  President Truman and his Treasury Secretary thought it should, but in the 1951 “Accord,” the Treasury and the Fed agreed the purchases would end.  In the ensuing three decades, interest rates kept rising, making a 30-year bear bond market, until their 1980s peak.

Now we have had an equivalent three-decade long bull bond market and the Fed, of course, is again a big buyer of bonds.  It has again been a success at manipulating long-term interest rates downward, to near zero or even negative real rates.  That is also not a “moderate” interest rate.

Of far greater seniority and standing is the fourth mandate of the Fed, which stood very first in the Federal Reserve Act in 1913.  The legislative fathers of the Fed told us clearly what they wanted to achieve.  The original Act begins:

     “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”

In 1913, an elastic currency meant the ability to make loans from the Federal Reserve Banks to expand credit and print money to match the economic exigencies of the moment, whether reflecting the agricultural seasons, the business cycle or a financial panic.  In the background was the experience of the Panic of 1907.  One hundred years after that, in the Panic of 2007 to 2009, elastic currency was furnished with great energy by the Fed.  Although the panic is over, the elastic currency is still very expanded, now called “quantitative easing.”

As intended by the original Federal Reserve Act, an elastic currency is most certainly what we have got, not only in the U.S., but given the global role of the dollar, in the world.  That is one mandate fully achieved.  It is, as designed, very helpful in panics, but it also fits well with the more recent goal of perpetual inflation.

The fifth mandate is expressed in the beginning of the Federal Reserve Act as “to establish a more effective supervision of banking in the United States,” now also thought of as ensuring financial stability.  Although it was hoped at the creation of the Fed that it would make financial crises “mathematically impossible,” in fact in the one hundred years since then there have been plenty of crises, right up to the most recent one.  The Fed has full command of a very elastic currency, but the crises keep happening.  “Financial crises will always be with us,” as Bernanke has written, “That is probably unavoidable.”  I believe that is correct, optimistic hopes about the most recent expansion of the Fed’s supervisory power notwithstanding.

If only the governors, officers and staff of the Fed could know the future!  Then they could doubtless avoid the crises.  Since they do not and cannot know the future, it is plausibly argued that instead they help cause the crises by discretionary money creation and financial interventions which induce debt, leverage, asset inflation and illusory “wealth,” with recurring unhappy endings. 

The sixth and most basic central bank mandate of all is financing the government when needed.  In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the Treasury’s interest cost.  At three years old, it had lent its full efforts to finance the government during the First World War.  It is monetizing Treasury bonds as we discuss it.  So convenient a thing it is for a government to have a central bank that almost every government has one. 

This fundamental relationship is exemplified in the deal which formed the quintessential central bank, the Bank of England, in 1694.  The deal was that the Bank would lend money to the government, in exchange it got a monopoly in the issuance of currency.  This is still the basic structure of the Fed’s balance sheet.  Equally instructive is the founding of the Bank of France in 1800: “Bonaparte…felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes”—a natural political desire.   

Hence the ambivalence of Federal Reserve “independence.”  As William McChesney Martin, Fed Chairman in the 1950s and 1960s, said, the Fed is independent “within the government.”

Yet it is true that “the Fed has also become a colossus,” as the provocative historian of the Fed, Bernard Shull, has written.  The combined six mandates, whether or not successfully achieved, make what Shull calls “an enormous concentration of power in a single Federal agency that is more autonomous than any other and one in which a single individual, the Chairman, has assumed an increasingly important role.”

The accumulated power of the Fed gives it the greatest potential to create systemic financial risk of any institution in the world, while it is claiming and trying to reduce systemic risk.  This fact alone warrants the review of the Federal Reserve and its many mandates which the Committee has wisely undertaken.

Thank you very much for the opportunity to share these views.

The Fed Is as Poor at Knowing the Future as Everybody Else

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Monetary Policy and Trade

Of the Committee on Financial Services

U.S. House of Representatives

Hearing on “The Fed Turns 100: Lessons Learned from a Century of Central Banking”

September 11, 2013 

The Fed Is as Poor at Knowing the Future as Everybody Else

Mr. Chairman, Ranking Member Clay, and Members of the Subcommittee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  I have published numerous articles on banking and financial systems, including the role of the Federal Reserve and central banks in general. 

A striking lesson of the 100-year history of the Federal Reserve is how it has been able from its beginning to now to inspire entirely unjustified optimism about what it can know and what it can accomplish. 

Upon the occasion of the Federal Reserve Act in 1913, an American Banker writer opined, “The financial disorders which have marked the history of the past generation will pass away forever.”  Needless to say, the Fed has not made financial disorders disappear, and not for lack of trying, while it has often enough contributed to them.  

In 1914, the then-Comptroller of the Currency expressed the view that with the creation of the Fed, “financial and commercial crises, or panics…seem to be mathematically impossible.”  They weren’t.

The unrealistic hopes continued.  As a forthcoming history says, “The bankers at the Federal Reserve kept the money flowing in to the American economy at a pitch that held interest rates low and kept expanding business and consumer credit… [but] there was no rise in prices.  The business cycle…had finally been tamed—or so it seemed.  Economists around the world praised the Federal Reserve.  Some even predicted that a ‘new era’ in economics had begun.”  This passage sounds like it is describing the central bank optimism of the early 2000s with the so-called “Great Moderation,” but in fact it is describing the 1920s.  We know what came next, and the Fed is widely blamed for its deflationary blunders in the crisis of the early 1930s, and again in 1937.

In the 1940s, the Fed was the willing servant of the Treasury Department in order to finance the war and hold down the interest rates on government debt, thus doing in great scale exactly what the fathers of the Federal Reserve Act had tried to prevent: monetizing government debt.  (The Fed had also lent its full efforts to finance the government during the American participation in the First World War.)

After enjoying the American global economic hegemony of the 1950s, the 1960s brought a new high point in optimism about what discretionary manipulation of interest rates and financial markets could achieve.  Otherwise intelligent and certainly well-educated economists actually came to believe in what they called “fine tuning”: that the Fed and government policy “could keep the economy more or less perfectly on course,” as discussed by Fed Chairman Bernanke in his new book, The Federal Reserve and the Financial Crisis.  Some economists even held a conference in 1967 to discuss “Is the Business Cycle Obsolete?”  It wasn’t. 

The fine tuning notion “turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s,” Bernanke writes, “so one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.”  Very true.

Indeed, the performance of the Federal Reserve at economic and financial forecasting in the last decade, including missing the extent of the Housing Bubble, missing the huge impact of its collapse, and failing to foresee the ensuing sharp recession, certainly strengthens the case for humility on the Fed’s part, especially when it attempts to forecast financial market dynamics.  The poor record of economic forecasting is notorious, and the Fed is no exception to the rule.

If only the Chairman, the Governors, the Presidents and the scores of economists of the Federal Reserve could really know the future!  Then they could carry out their discretionary actions without the many mistakes, both deflationary and inflationary, which have marked the history of the Fed.  These mistakes should not surprise us.  As Arthur Burns, Fed Chairman in the 1970s and architect of the utterly disastrous Great Inflation of that decade, said: “In a rapidly changing world, the opportunities for making mistakes are legion.”

In a 1996 speech otherwise famous for raising the issue of “irrational exuberance,” then-Fed Chairman Alan Greenspan sensibly discussed the limits of the Fed’s knowledge.  “There is, regrettably, no simple model of the American economy that can effectively explain the levels of output, employment and inflation,” he said.  (Since it is effectively the world’s central bank embedded in globalized financial markets, the Fed would need not merely a model of the American economy, but one of the world economy.) 

“In principle,” Chairman Greenspan continued,” there may be some unbelievably complex set of equations that does that.  But we [the Fed] have not been able to find them, and do not believe anyone else has either.”  They certainly have not, as subsequent history has amply demonstrated.  Moreover, in my view, not even in principle can any model successfully predict the complex, recursive financial and economic future—so the Fed cannot know with certainty what the results of its own actions will be. 

Nonetheless, the 21st century Federal Reserve and its economists again became optimistic, and perhaps hubristic, about the central bank’s abilities when Chairman Greenspan had been dubbed “The Maestro” by the media and knighted by the Queen of England.  It is now hard to remember the faith he and the Fed then inspired and the confidence financial markets had in the support of what was called the “Greenspan put.”

Queen Elizabeth would later quite reasonably ask why the economists and central banks failed to see the crisis coming.  One lesson we can draw from this failure is that a group of limited human beings, none of whom is blessed with knowledge of the future, with all the estimates, guesses, and fundamental uncertainty involved, by being formed into a committee, cannot rationally be expected to fulfill the mystical notion that they can guarantee financial and economic stability.

In the early 2000s, of particular pride to the Fed was that the central bankers thought they were observing a durable “Great Moderation” of macro-economic behavior, a promising “new era,” and gave their own monetary policies an important share of the credit.  With an eye on a hoped-for “wealth effect” from rising house prices, the Fed pushed interest rates exceptionally low as the housing bubble was rapidly inflating, which many observers, including me, view as a critical mistake.  Chairman Bernanke has since insisted that the Great Moderation was “very real and striking.”  Yet, since it is apparent that the Great Moderation led to the Great Bubble and then to the Great Collapse, how could it have been so real?

Economic historian Bernard Shull has explored the paradox that throughout its 100 years, no matter how many mistakes the Fed makes, or how big such mistakes are, it nonetheless keeps gaining more power and prestige.  In 2005, he made the following insightful prediction:  “We might expect, on the basis of the paradoxical historical record, still further enhancements of Federal Reserve authority.”  Indeed, in the wake of the bubble and collapse, the political and regulatory overreaction came, as it always does each cycle.  The Dodd-Frank Act gave the Fed much expanded regulatory authority over financial firms deemed “systemically important financial institutions” or “SIFIs,” and a prime role in trying to control “systemic risk.”

But the lessons of history make it readily apparent that the greatest SIFI of them all is the Federal Reserve itself.  It is unsurpassed in its ability to create systemic risk for everybody else through its unlimited command of the principal global fiat money, the paper dollar.  As former-Senator Bunning reportedly asked Chairman Bernanke, “How can you regulate systemic risk when you are the systemic risk?”  A good question!  Who will guard these guardians?

A memorable example of systemic risk is how the Fed’s Great Inflation of the 1970s destroyed most of the savings and loan industry by driving interest rates to levels previously thought impossible.  In the 1980s, the Fed under then-Chairman Paul  Volcker, set out to “fight inflation”--—the inflation the Fed had itself created.  In this it was successful, but the high interest rates, deep recession and sky-high dollar exchange rate which resulted, then created often-fatal systemic risk for heartland industries and led to a new popular term, “the rust belt.”  A truly painful outcome of some kind was unavoidable, given the earlier inflationary blunders.

A half-century before that, in 1927, the then-dominant personality in the Federal Reserve, Benjamin Strong, famously decided to give the stock market a “little coup de whiskey.”  In our times, the Fed has decided to give the bond market and the mortgage market a barrel or so of whiskey in the form of so-called “quantitative easing.”  This would undoubtedly have astonished previous generations of Federal Reserve Governors, and have been utterly unimaginable to the authors of the Federal Reserve Act.

How will this massive manipulation of the government debt and mortgage markets turn out?  Will it make the current Fed into a great success or become another historic blunder?  In my opinion, neither the Fed nor anybody else knows—about this all of us can only guess.  It is a huge and fascinating gamble, which has without doubt induced a lot of new systemic interest rate risk into the economy and remarkable concentration of interest rate risk into the balance sheet of the Federal Reserve itself.

In the psychology of risky situations, actions seem less risky if other people are doing the same thing.  That is why, to paraphrase a celebrated line of John Maynard Keynes, a “prudent banker” is one who goes broke when everybody else goes broke.  That other central banks are also practicing versions of “quantitative easing” may induce the same subjective comfort.  A decade ago, bankers felt a similar effect when they all were expanding mortgage debt together.

Robert Solow recently claimed that “Central banking is not rocket science.”  Indeed, it isn’t: discretionary central banking is a lot harder than rocket science.  This is because it is not and cannot be a science at all, because it cannot operate with determinative mathematical laws, because it cannot make reliable predictions, because it must cope with ineluctable uncertainty and an unknowable future.  We should have no illusions, in sharp contrast to the 100 years of illusions we have entertained, about the probability of success of such a difficult attempt, no matter how intellectually brilliant and personally impressive its practitioners may be.

It is often debated whether the Fed can successfully achieve two objectives, the so-called “dual mandate,” rather than one.  It does seem doubtful that it can, but the question oversimplifies the problem, for the Fed has not two mandates, but six.

The precise provision of the Federal Reserve Reform Act of 1977, which gives rise to the discussion of the “dual mandate,” is almost always mischaracterized, for that provision assigns the Fed three mandates, not two.  The Fed shall, it says, “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  This is a “triple mandate,” at least.  The third statutorily assigned goal is almost always forgotten.  It is doubtful indeed that the Fed can simultaneously do all three. 

But in addition to these, the Fed has three more mandates.  These are: to furnish an elastic currency, the historically first mandate and the principal reason for the existence of the Fed in the first place; to act as the manager of the risks and profits of the banking club, now expanded to include other “SIFIs”; and finally, to provide ready financing for the deficits of the government of which it is a part, as needed.

Let us do a quick review of how the Fed is doing at each of its six mandates.

To begin with “stable prices”:  this goal was in fact dropped long ago.  The Fed’s goal is not and has not been for decades stable prices, but instead permanent inflation—with a relatively stable rate of increase in prices.  In other words, the Fed’s express intention is a steady depreciation of the currency it issues, another idea which would have greatly surprised the authors of the Federal Reserve Act.  At its “target” of 2% inflation a year, average prices will quintuple in a normal lifetime.  Economists can debate whether a stable rate of price increases rather than a stable price level is a good idea, but you cannot term perpetual inflation “price stability” with a straight face.

Turning to “maximum employment”:  Nobody believes any more, as many people believed when this goal was added to the governing statute in 1977, that there is a simple trade-off between inflation and sustained employment.  It was still believed when the Humphrey-Hawkins Act of 1978 was passed, although it was already being falsified by the great stagflation of the late 1970s.  Humphrey-Hawkins added a wordy provision requiring the Fed to report to and discuss with Congress its plans and progress on the triple mandate.  Did these sessions succeed?  They obviously did not avoid the financial disasters of the 1980s and 2000s, or the inflation of giant bubbles in tech stocks and housing.

On “moderate long-term interest rates”:  As the Treasury’s servant in the 1940s, the Fed kept the yield on long-term government bonds at 2 ½%.  After this practice was ended by the “Treasury-Fed Accord” of 1951, a 30-year bear bond market ensued, which ultimately took long-term interest rates to 15% in the early 1980s—this was not a “moderate” interest rate, to be sure.  With the Fed’s current massive bond buying, rates on long-term government bonds got to 1½%-2%, which was zero or negative in real terms—also not a “moderate” interest rate.

The fourth mandate stood right at the beginning of the original Federal Reserve Act in 1913.  The authors of the Act told us clearly what they wanted to achieve:

     “An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency….”

An elastic currency is most definitely what we have got, not only in the U.S., but given the global role of the dollar, in the world.  Indeed, we have one much more elastic than originally intended.  This is very handy during financial panics when the Fed is acting as the lender of last resort.  The unanswered question is:  given a pure paper currency (not originally intended, of course) with unlimited elastic powers, what limits should there be other than the demonstrably fallible beliefs and judgments of the members of the Federal Reserve?  

Charles Goodhart’s monograph, The Evolution of Central Banks, makes a strong argument that it helps to understand central banks, including the Fed, by thinking of them as the manager of the banking club, which tries to preserve and protect the banking industry.  This becomes most evident in banking crises.  It was explicitly expressed in an early Fed plaque:  “The foundation of the Federal Reserve System is the co-operation and community of interest of the nation’s banks.”  Such candor is not currently in fashion—the fifth mandate is now called “financial stability.”  As discussed, this mandate has been expanded by Dodd-Frank beyond banks to make the Fed the head of an even bigger financial club. 

Sixth is the most basic central bank function, and Fed mandate, of all: financing the government, a core role of central banks for over three centuries.   As economist Elga Bartsch has correctly written, “The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank.”  Thus for governments that wish to finance long-term deficits with debt, like the United States, central banks are exceptionally useful, which is one reason virtually all governments have one-- no matter how disappointing the central bank’s performance at stable prices, maximum employment, moderate long-term interest rates, and financial stability may be.  Needless to say, the power of financing the government is also dangerous. 

Allan Meltzer, an eminent scholar of the Federal Reserve and our colleague on this panel, near the end of his magisterial A History of the Federal Reserve, quotes the classic wisdom of monetary thinker Henry Thornton from 1802-- 211 years ago, who proposed:

     “to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction: in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself….  To suffer the solicitations of the merchants, or the wishes of the government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.”

These are sensible guidelines, as my friend Allan suggests.  But another lesson of 100 years of Federal Reserve history is that we have still not figured out how to implement them.

Thank you again for the opportunity to share these views.

We Don’t Need GSEs

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Financial Services

U.S. House of Representatives

Hearing on Learning from Mortgage Finance Systems of Other Countries

June 12, 2013

We Don’t Need GSEs 

Mr. Chairman, Ranking Member Waters, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a resident fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I was the President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.  From 1999 to 2001, I also served as President of the International Union for Housing Finance (IUHF), a trade association devoted to the international exchange of housing finance ideas and information. In fact, I have just returned to the U.S. from an IUHF conference at which representatives of 42 countries met to share issues and experiences in this sector, which is economically and politically important to all countries. 

The American housing finance sector has collapsed twice in the last three decades, once as a government promoted savings and loan-based system, and once as a government promoted GSE-centric system.  We should never assume that the particular, highly unusual,  historical development of U.S. housing finance should define the limits of our considerations.  There is no doubt that there is much to learn of much practical import from examining U.S. housing finance in international perspective, including how experts from other countries view our system from outside.

Comparing our housing finance sector to other countries, the one thing most unusual about it was and is the dominant and disproportionate role played by Fannie Mae and Freddie Mac, as government-sponsored enterprises or GSEs.  Fannie and Freddie’s role and was and is unique among housing finance systems.  The GSEs themselves used to claim that this made U.S. housing finance “the envy of the world,” a view not shared by the world.  When Fannie and Freddie were the darlings of Washington and the stars of Wall Street, they would come to IUHF meetings and boastfully promote their GSE model.  But mortgage professionals from other countries were not convinced. 

Let us begin by asking and answering five essential questions from an international perspective:

1.      Are GSEs like Fannie and Freddie necessary for effective housing finance?

                       No.  This is obvious from the many countries which achieve similar or higher  home ownership than the U.S. without them. 

2.     Did GSEs get for the U.S. an internationally high home ownership rate?

                      No.

3.     Well, did GSEs get for the U.S. an above-average home ownership rate?

                      No.

4.     Are GSEs necessary to have long-term, fixed rate mortgages?

                      No.

5.     Even if they had a disastrous actual outcome, are GSEs the best model in theory?

                      No. 

Along with incorrectly saying that GSEs made U.S. housing finance “the envy of the world,” it was often additionally claimed (without supporting data) that the U.S. had the highest home ownership rate in the world.  This seemed plausible to Americans, but was wrong.  Interestingly, people in England also claimed that they had the highest home ownership.  In fact, England, with a completely different housing finance system and no GSEs, has been and is effectively tied with the U.S. in home ownership rate—both now at 65%, and both in the bottom half, as you will see in the ranking below.

Based on the free use of the U.S. Treasury’s credit, through the so-called “implicit” but very real (as events  made clear) guaranty, massive amounts of Fannie and Freddie’s debt securities were sold around the world.  The GSEs ran up the leverage of the housing finance sector.  As a market distortion which pushed credit at housing, they inflated house prices and escalated systemic risk.  Foreign investors helped pump up the housing bubble through the GSEs while being fully protected from the risk, and then were bailed out by the taxes of ordinary Americans.  Of course, other countries also made housing finance mistakes, but nobody else made this particular, giant mistake.

The political interest in housing finance begins with what I think is a valid proposition: that in a democracy it is advantageous to have widespread property ownership among the citizens.  The experiences of other countries make it obvious that high home ownership levels can be attained without GSEs—and moreover without tax deductions for mortgage interest; without our very unusual practice of making mortgage loans into non-recourse debt; without government orders to make “creative”—that is riskier—mortgage loans, which were part of being a GSE; and with prepayment fees. 

The following table, “Comparative Home Ownership Rates,” is an update with the most recent available data of a comparison I presented to the Congress in 2010.  It displays home ownership in 28 economically advanced countries.  The U.S. ranks 20th, just behind England.  The median home ownership rate among these countries is 68%, compared to our 65%. 

Comparative Home Ownership Rates

Source:  AEI research

How do financial professionals in other countries view the U.S. housing finance sector?

More than a decade ago, when Fannie and Freddie were still riding high, and Fannie in particular was a greatly feared bully boy whom both Washington politicians and Wall Street bankers were afraid to cross or offend, I presented the GSE-centric U.S. housing finance system to the Association of Danish Mortgage Banks in Copenhagen.  When I was done, the CEO of one of their principal mortgage lenders memorably summed things up: 

          “In Denmark we always say that we are the socialists and America is the land of free enterprise.  Now I see that when it comes to mortgage finance, it is the opposite!”

He was so right.  But now, with Fannie and Freddie continuing to be guaranteed by the U.S. Treasury, able to run with zero capital and infinite leverage, being granted huge loopholes by the Consumer Financial Protection Bureau, and being heavily subsidized by the Federal Reserve’s buying up their MBS, they have a bigger market share and more monopoly power than before.  The American housing finance sector is more socialized than ever. 

Here’s a view from Britain, where a senior financial official said recently: 

          “We don’t want a government guaranteed housing finance market like the United States have.”

They don’t want what we have—and we don’t want it either.  How do we conceptualize the range of alternate possibilities?

Every housing finance system in the world must address two fundamental questions.  The first is how to match the nature of the mortgage loan with an appropriate funding source, so you are not lending long and borrowing short.  Different approaches distribute the interest rate risk among the parties involved—lenders, investors, borrowers, governments, taxpayers--in various ways. 

Basic sustainable variations observed in different countries include variable rate mortgages funded with short-term deposits; medium term fixed-rate mortgages funded with medium-term fixed rate deposits or bonds; long-term fixed rate mortgages funded with long-term fixed rate bonds or covered bonds. In general, to soundly fund long-term fixed-rate mortgages, you have to have access to the bond market.  In an advanced financial system, it does not require a GSE to do this.  

The classic example of not achieving the needed interest rate match was the collapse of the American savings and loan industry in the 1980s.  What broke the savings and loans was the combination of their interest rate mismatch with the soaring interest rates of the great inflation created by the Federal Reserve in the 1970s.  While the lenders were crushed, borrowers who had old 30-year fixed rate mortgages in this period of rising interest rates and inflating house prices did very well. 

In contrast, the 30-year fixed rate mortgage was terrible for great numbers of borrowers in the U.S. crisis of the 2000s.  With the floating rate mortgage system of England, the rapid fall of interest rates in the housing crisis was automatically passed on to the borrowers in the form of lower payments, which helped contain the crisis.  American borrowers faced with falling interest rates and house price deflation, on the other hand, were often locked in to high payments and punished by their 30-year fixed rate mortgages, which thereby made the housing bust worse in this country.   

The second fundamental question of housing finance systems is who will bear the credit risk.  In most countries, the lender retains the credit risk, which is undoubtedly the superior alignment of incentives.  With covered bonds, which are used in many countries, you can simultaneously achieve fixed-rate funding while keeping the lender fully on the hook for the credit performance of the mortgage loans being funded. 

The American GSE approach (and also that of private MBS) systematically separates the credit risk from the lender-- so you divest the credit risk of the loans you make to your own customers.  This was and is a distinct outlier among countries.  It had disastrous results, needless to say.

The most perfect conceptual solution to the two fundamental questions of housing finance, which functions very well in practice in its national setting, is the housing finance system of Denmark.  This system has been justifiably admired by many observers.  It operates in a small country, but represents big basic ideas.

The Danish mortgage approach to interest rate risk in its funding market is explicitly governed by what it calls the “matching principle.”  This means that the interest rate and prepayment characteristics of the mortgage loans being funded are passed on entirely to the investor in Danish mortgage covered bonds.  This allows long-term fixed rate mortgages, as well as variable rate mortgages. 

At the same time, the entire credit risk is retained by the mortgage bank lenders.  They have 100% “skin in the game” for credit risk, in exchange for an annual fee, thus insuring alignment of incentives for credit performance.  Deficiency judgments, if foreclosure on a house does not cover the mortgage debt, are actively pursued.  In other words, mortgage loans are always made with recourse to the borrower’s other income and assets.  This is true in most countries.  The U.S. state laws or practices of non-recourse mortgage lending are again a distinct outlier. 

The fundamentals of the Danish mortgage system go back over 200 years, to the 1790s.  There are no GSEs.  The Danish system can deliver long-term fixed rate loans of up to 30 years with a prepayment option.  This is a private housing finance system build on quite robust principles, which claims that no mortgage bond holder has suffered a credit loss in over two centuries. Denmark can and in the last decade did have a housing price bubble and bust, but the housing finance sector performed much better through it than did ours, and its covered bonds were sold throughout 2007-09.   We should note that the Danish system generates a home ownership rate of 54%, on the low side.

Another interesting case of the splitting of bond market funding and credit risk is that of Cagamas, or the National Mortgage Company of Malaysia.  Cagamas buys mortgage loans from lenders, and then issues bonds to finance them, but the mortgage purchases are with full recourse to the lender, so the lender retains 100% of the credit risk and the alignment of incentives.  

Cagamas is 80% owned by the banks and 20% by the Malaysian central bank, so it is a GSE, but not a Fannie and Freddie-style GSE.  Instead it functionally resembles the Federal Home Loan Banks (FHLBs).  FHLBs provide bond market funding for mortgages through advances to banks, but the banks retain all the credit risk.  FHLBs also buy mortgages, but only when the bank credit enhances the mortgages it has made.  (It may be of interest that of all sizeable American GSEs, considering Fannie, Freddie and the Farm Credit Banks, the FHLBs are the only ones which have never gone broke.) 

A very stable, sound, and very conservative housing finance market is that of Germany.  Some of its banks got into trouble in this cycle by buying U.S. mortgage securities, but their domestic mortgage market did not experience either a housing price boom-bust or a mortgage credit crisis.  The problem is that the German system generates a very low home ownership rate, only 43%--as well as a relatively late age at which people are on average able to buy houses.  I imagine that neither of these would be politically acceptable in the U.S.

Nevertheless, there are two German ideas worthy of study.  One is the German version of mortgage covered bonds (“Pfandbriefe”).  With a statutory basis more than one hundred years old (and, it is claimed, a history going back to Frederick the Great in the 18th century), these covered bonds form and large and relatively stable source of bond-based mortgage funding with no GSE.  The issuing bank retains all the credit risk of the mortgage loans. Mortgage loans funded with these covered bonds have a maximum LTV of 60%.

Many people have proposed, and I agree, that the U.S. should introduce covered bonds without a government guaranty as a mortgage funding alternative, as part of escaping from the mortgage market’s subservience to GSEs.

A second German housing finance idea worth considering is their emphasizing the role of savings as an essential part of sound housing finance.  The German building and savings banks (“Bausparkassen”) continue to practice the savings contract, which was once also common in this country.  By such a contract, the borrower commits to regular savings as part of qualifying for a mortgage loan.  This is, in my opinion, a very old-fashioned, very good idea.

Canada makes a pertinent comparison for the U.S., both countries being advanced, stable, financially sophisticated and North American. The Canadian housing finance system, like most in the world, has no GSEs.  It is primarily funded on the balance sheets of banks, although Canadian banks are also becoming issuers of covered bonds under new legislation, and it came through the crisis of 2007-09 in much better shape than did we did.  Mortgage lending is more conservative and creditor-friendly, and the Canadian system currently produces a higher home ownership rate of 67%.

Although it has no GSEs, Canada does have a very important government body to promote housing finance, which plays a substantial role in the mortgage sector.  This is the Canada Mortgage and Housing Corporation (CMHC).  Its principal activity is insuring (i.e. guaranteeing) mortgage loans—and it guarantees approximately half of all Canadian mortgages.  This is about the same proportion as the combined Fannie and Freddie have of outstanding the U.S. mortgage credit exposure.

But in contrast to the game the U.S. played of pretending that Fannie and Freddie were “private,” and that the government exposure was not really there (it was only “implicit”), CMHC’s status is refreshingly clear and honest.  It is a 100% government-owned and controlled corporation.  It has an explicit guaranty from the government.  It also provides housing subsidies which are on budget and must be appropriated by Parliament.  So Canada, while having this large government intervention in the mortgage market, is definitely superior to us in candor and clarity about it.

This exemplifies what I believe to be a core principle:  You can be a private company.  Or you can be part of the government.  But you should never be allowed to pretend you are both.  In other words, Fannie and Freddie should cease to be GSEs.  Considering the international anomaly and the disastrous government experiment they represent, we should all be able to agree on this.

Thank you again for the opportunity to share these views.

Boom and Bust: Financial Cycles and Human Prosperity (Values and Capitalism)

Published by American Enterprise Institute (AEI) Press. Order here.

While the recent economic crisis was a painful period for many Americans, the panic surrounding the downturn was fueled by an incomplete understanding of economic history. Economic hysteria made for riveting journalism and effective political theater, but the politicians and members of the media who declared that America was in the midst of the greatest financial calamity since the Great Depression were as wrong and misguided as the expansionists of the Roosevelt era. In reality the cyclical nature of market economies is as old as the markets themselves. In a free market system, financial downturns inevitably accompany economic prosperity-but the overall trend is upward progress in living standards and national wealth. While it is helpful to understand what caused the recent crisis, the more important questions to consider are ‘What makes the ‘boom and bust’ cycle so predictable?’ and ‘What are the ethical responsibilities of the citizens of a free market economy?’ In Boom and Bust: Financial Cycles and Human Prosperity, Alex J. Pollock argues that while economic downturns can be frightening and difficult, people living in free market economies enjoy greater health, better access to basic necessities, better education, work less arduous jobs, and have more choices and wider horizons than people at any other point in history. This wonderful reality would not exist in the absence of financial cycles. This book explains why.

The Subprime Bust and the One-Page Mortgage Disclosure

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

Washington, DC 

To the Senate Banking and Financial Institutions Committee

State of Michigan

The Subprime Bust and the One-Page Mortgage Disclosure 

November 28, 2007

Mr. Chairman, Vice Chairmen Sanborn and Hunter, and members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I spent 35 years in banking, including 12 years as President and CEO of the Federal Home Loan Bank of Chicago, and am a Past President of the International Union for Housing Finance.  I have both experienced and studied many credit cycles, of which the housing and subprime mortgage boom and bust is the latest example.  Before all that, I grew up in Michigan, in the City of Detroit, graduating from Redford High School.

The deflation of the housing bubble and the subprime mortgage bust is, as everyone now knows, the biggest financial issue of the year, and nowhere more so than in Michigan.  I will address two aspects of this issue: understanding the fundamental pattern in which we are caught; and making sure future borrowers are better equipped to protect themselves than those of today.

The severe problems of all the industries involved in housing and mortgage finance, as well as of a great many mortgage borrowers, can best be understood as the deflation of a classic asset bubble.  The boom is always marked by rapid and unsustainable asset price increases, inducing and fueled by a credit overexpansion marked by unwise optimism, which leads to unwise credit decisions on the part of both lenders and borrowers.  The inevitable bust follows with defaults, losses and a credit contraction.  We are in the midst, and by no means near the end, of the contraction.

American residential mortgages represent the largest credit market in the world, and residential real estate is a huge asset class and component of household wealth. The negative effects of the deflating bubble on macroeconomic growth are sizeable and significant—some forecasters believe negative enough to cause a recession, which will in turn worsen the mortgage credit problems.

Among possible political responses are temporary programs to bridge and partially offset the impact of the bust, and to reduce the risk of a housing sector debt deflation or self-reinforcing downward spiral.

We can also take long term steps to fundamentally improve the functioning of the mortgage market.  Today I will focus on a very simple but powerful proposal, which has been introduced into both houses of the U.S. Congress, passed as a local ordinance in by the Washington, DC Council, and could be used at a state level: a one-page mortgage disclosure which tells borrowers what they really need to know about their mortgage loan in a clear and straightforward way.  This would both better equip borrowers to protect themselves and make the mortgage market more efficient.

1. Understanding the Fundamental Pattern

Needless to say, the unsustainable expansion of subprime mortgage credit and the great American house price inflation of the new 21st century are both over.  Former enthusiasm at rising home ownership rates and financial innovation (now a little hard to remember) have been replaced by an international credit market panic, layoffs, closing or bankruptcy of more than a hundred subprime lenders, still accelerating delinquencies and foreclosures, a deep recession in the homebuilding industry, tens of billions of dollars of announced losses by financial firms, tightening or disappearing liquidity, increasingly pessimistic forecasts, and of course, recriminations.

A few months ago, typical estimates of the credit losses involved were about $100 billion.  Then they grew to $150 billion, a number Federal Reserve Chairman Bernanke recently cited, and which I believe to be a reasonable estimate.  Other forecasts have the total losses at $250 billion, $300 billion, and even $400 billion—well, uncertainty is high.  Those are the losses for the lenders; for the borrowers, as you all know only too well, rising foreclosures are an obvious social and political issue.  

All these elements display the classic patterns of recurring credit overexpansions and their aftermath, as colorfully discussed by students of financial cycles like Charles Kindleberger, Walter Bagehot and Hyman Minsky.  Such expansions are always based on optimism and the euphoric belief in the ever-rising price of some asset class—in this case, houses and condominiums.  This appears to offer a surefire way for lenders, investors, borrowers and speculators to make money, and indeed they do, for a while.  As long as prices always rise, everyone can be a winner.

A good example of such thinking was the 2005 book by an expert housing economist entitled, Are You Missing the Real Estate Boom? Why the Boom Will Not Bust and Why Property Values Will Continue to Climb Through the Rest of the Decade. 

This time, we had several years of remarkably rising house prices—the greatest U.S. house price inflation ever, according to Professor Robert Shiller of Yale University.  The total value of residential real estate about doubled between 1999 and 2006, increasing by $10 trillion.  The great price inflation stimulated the lenders, the investors, the borrowers and the speculators.   If the price of an asset is always rising, the risk of loans seems less and less, even as the risk is in fact increasing, and more leverage always seems better.

A key point is that in the boom, many people experience financial success.  This so-far successful speculation is extrapolated.  Subprime borrowers could get loans to buy houses they would otherwise be unable to and benefit from subsequent price appreciation.  A borrower who took out a very risky 100% LTV, adjustable rate mortgage with a teaser rate to buy a house which subsequently appreciated 30% or 40% now had substantial equity and a successful outcome as a result of taking risk.

Should people be able to take such risks if they want to?  Yes, but they should have a clear idea of what they’re doing.

Of course, we know what always happens sooner or later: the increased risk comes home to roost, prices fall, and there is a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of fraud and swindles, and the search for the guilty.  You would think we would learn, but we don’t.  Then come late-cycle political reactions.

With regard to the last point, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, the Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988.  (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.)  Kindleberger estimated that over the centuries, financial crises recur about once a decade on average, and so apparently do emergency housing acts.  It seems probable to me that, given the current problems, this fall or winter will bring an emergency housing act of 2007 or 2008. Indeed, the “Emergency Home Ownership and Mortgage Equity Protection Act of 2007” has been introduced in to the Congress.

A year ago, it was common to say that while house prices would periodically fall on a regional basis, they could not on a national basis, because that had not happened in the large U.S. market since the Great Depression.  Well, now house prices are falling on a national basis, as measured by the S&P/Case-Shiller national index. 

House sales have dropped steeply, and for-sale inventories of new and existing houses and condominiums are high.  At the same time, rising mortgage delinquencies and defaults, along with the collapse of funding through securitization, have caused lenders to drop subprime products or exit the business altogether and generally raise credit standards. The Chairman of Countrywide Credit has announced, “We are out of the subprime business.”  Sharply reduced mortgage credit availability reduces housing demand.

With excess supply and falling demand, it is not difficult to arrive at a forecast of further drops in house prices.  The recent Goldman Sachs housing forecast, pointing out “substantial excess supply” and that “credit is being rationed,” projects that average house prices will fall 7% a year through 2008.  This is along with projected falling home sales and housing starts.

Professor Shiller has suggested that this cycle could see “more than a 15% real drop in national home price indicies.”  Certainly a return to long term trends in house values would imply a significant adjustment.

The Bank of America’s current forecast has nominal house prices falling 15% (real prices over 30%) over four years, having started this year and not bottoming until 2011. 

Thus the “HPA” or house price appreciation of credit models has now become “HPD”—house price depreciation.

The June 30, 2007 National Delinquency Survey of the Mortgage Bankers Association reports a total of 1,090,300 seriously delinquent mortgages.  Serious delinquency means loans 90 days or more past due plus loans in foreclosure.  Of the total, 575,200 are subprime loans.  Thus subprime mortgages, which represent about 14% of mortgage loans, are 53% of serious delinquencies. 

The survey reports 618,900 loans in foreclosure, of which 342,500 or 55% are subprime.

The ratio of subprime loans in foreclosure peaked in 2002 at about 9%, compared to its June 30 level of 5.5%.  Seriously delinquent subprime loans peaked during 2002 at 11.9%, compared to 9.3%. These second-quarter ratios are not as bad as five years ago, but they are still rising. 

A systematic regularity of mortgage finance is that adjustable rate loans have higher defaults and losses than fixed rate loans within each quality class.  Thus we may array the June 30, 2007 serious delinquency ratios as follows:

                  Prime fixed              0.67%              Prime ARMs             2.02%

                  FHA fixed                4.76%              FHA ARMs               6.95%

                  Subprime fixed        5.84%              Subprime ARMs     12.40%

The particular problem of subprime ARMs leaps out of the numbers. The total range is remarkable: the subprime ARM serious delinquency ratio is over 18 times that of prime fixed rate loans. 

Mortgage finance has some reliable systematic risk factors.  The mortgage boom had all the systemic risk factors operating together:

-Subprime loans have higher defaults and losses than prime loans.

-Adjustable rate loans of all kinds have higher defaults and losses than fixed rate loans.

-High loan-to-value (LTV) loans have higher defaults and losses than low LTV loans.

-Low documentation loans have higher defaults and losses than standard documentation loans. 

-Loans for investment properties have higher defaults than loans for owner-occupied houses.

The subprime mortgage lenders knew all these statements were true, but the risk acceleration of the boom outstripped the expectations of their models.  As Moore’s Law of Finance states, “The model works until it doesn’t.” 

A central problem is that during the boom the subprime market got very much larger than it used to be.  In the years of credit overexpansion, it grew to $1.3 trillion in outstanding loans, up over 8 times from its $150 billion in 2000.  So the financial and political impact of the subprime level of delinquency and foreclosure is much greater than in earlier years. 

But for Michigan, it is not only a subprime problem.  Michigan’s serious delinquency rate for all mortgage loans is 4.61%, almost twice the national average of 2.47%.  This reflects the employment problems of the domestic auto industry, on top of the housing deflation, as is also the case for the neighboring high-delinquency states of Ohio and Indiana.

Michigan’s serious delinquency rates are more or less double the national average in all mortgage loan categories, with the June 30 comparisons as follows: 

                                                        Michigan               U.S.                 Michigan/U.S.

Subprime ARMs                               21.08%              12.40%                    1.7X 

FHA ARMs                                       13.78%                6.95%                    2X

FHA fixed rate                                   10.75%                4.76%                    2.3X 

Subprime fixed rate                             9.47%                5.84%                    1.6X 

Prime ARMs                                        4.65%                2.02%                    2.3X

Prime fixed rate                                   1.34%                 0.67%                    2X

For the country as a whole, fixed rate FHA loans have a serious delinquency rate similar to that for fixed rate subprime loans.  This is also true for Michigan, which also has the highest FHA serious delinquency rate of any state.

The American residential mortgage market has about $10 trillion in outstanding loans.  Residential real estate is a huge asset class, with an aggregate value of about $21 trillion, and is of course the single largest component of the wealth of most households. 

A 15% average house price decline would mean a more than $3 trillion loss of wealth for U.S. households, which would be especially painful for those who are highly leveraged.  It would certainly put a crimp in getting cash to spend through cash-out refinancing and home equity loans.

The deflation of a bubble centered on such large stocks of debt and assets always causes serious macroeconomic drag.  Housing busts have typically translated into recessions.  It goes without saying that the current bust has already been and will continue to be a significant negative for economic growth.  Moody’s recently forecast that the “unexpectedly steep and persistent downturn” in the mortgage and housing sector would last until 2009. 

At an AEI conference last March, my colleague Desmond Lachman predicted that the economic impact of the housing problems would be much worse than was generally being said at the time, including what he considered the overoptimistic view of the Federal Reserve, and that they would become a major political issue.  These were certainly good calls. 

Large losses from the deflating housing and mortgage bubble have already happened and must unavoidably work their way through the financial and economic system.  Reductions in household wealth and tighter credit constraints on consumers might be enough to turn consumption growth negative and cause a recession.

This would be, my colleague John Makin has suggested, “the price we pay” for the housing bubble.

2. A Simple Proposal for Fundamental Improvement: The One-Page Form

The mortgage market, like all financial markets, is constantly experimenting with how much risk there should be. The subprime mortgage boom obviously overshot on risk creation; lenders, borrowers and the economy are now paying the price.  “Risk,” as an old boss of mine used to say, “is the price you never thought you’d have to pay.”

Should ordinary people be free to take a risk in order to own a home, if they want to?  Yes, provided they understand what they are getting into.  (This is a pretty modest risk, to say the least, compared to those our immigrant and pioneer ancestors took, such as my great-grandfather, heading out to his homesteaded farm in Michigan.)   

Should lenders be able to make risky loans to people with poor credit records, if they want to?  Yes, provided they tell borrowers the truth about what the loan obligation involves in a straightforward, clear way. 

A market economy based on voluntary exchange and contracts requires that the parties understand the contracts they are entering into.  A good mortgage finance system requires that the borrowers understand how the loan will work and how much of their income it will demand.

Nothing is more clear than that the current American mortgage system does not achieve this.  Rather it provides an intimidating experience of being overwhelmed and befuddled by a huge stack of documents in confusing language and small type presented to us for signature at a mortgage closing.  This complexity results from legal and compliance requirements; ironically, past regulatory attempts to insure full disclosure have made the problem worse.  This is because they attempt full, rather than relevant, disclosure. 

Trying to describe 100% of the details in legalese and bureaucratese results in essentially zero actual information transfer to the borrower.  The FTC recently completed a very instructive study of standard mortgage loan disclosure documents, concluding that “both prime and subprime borrowers failed to understand key loan terms.” 

Among the remarkable specifics, they found that:

          “About a third could not identify the interest rate” 

          “Half could not correctly identify the loan amount” 

          “Two-thirds did not recognize that they would be charged a prepayment penalty” and 

          “Nearly nine-tenths could not identify the total amount of up-front charges.”

As the events of the current bust have demonstrated, this problem is especially important in, though by no means limited to, the subprime mortgage market.

To help address these shortcomings of the mortgage market which are evident, I believe a new, superior disclosure approach is needed.  The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal.  Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments. 

The superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower well before closing.

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties.  The total monthly obligation needs to be put clearly in the context of the borrower’s income.

To have informed borrowers who can better protect themselves, the key information must be simply stated and clear, in regular-sized type, and presented from the perspective of what commitments the borrower is making and what that means relative to household income.  The borrowers can then “underwrite themselves” for the loan.  They have a natural incentive to do so—and can if they have the relevant intelligible, practical information. 

The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as principal loan terms.  The “housing expense ratio” means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income.  This should be shown for both the initial interest rate and the fully-indexed interest rate.  In typical types of subprime loans, as has become so painfully obvious, the fully-indexed expense ratio can be a remarkably larger burden than the initial or “teaser” rate suggests.

I have called the one-page form, “Basic Facts About Your Mortgage Loan.”  With it are brief explanations of the mortgage vocabulary and some avuncular advice for borrowers. Borrowers should receive it from the lender in time to ensure understanding and the ability to make a decision to seek alternatives.  A copy of the proposed form accompanies this testimony, as well as a copy of a Washington Post editorial recommending it. 

I believe mandatory use of this form would help achieve the required clarity, make borrowers better able to protect themselves by understanding what the mortgage really means to them, and at the same time would promote a more efficient mortgage finance system.  This seems to me a completely bipartisan idea, which should be implemented as a fundamental reform, whatever else is done or not done.

Thank you again for the opportunity to share these views.

Attachments:  

     The One-Page Form (“Basic Facts About Your Mortgage Loan”)

     Washington Post editorial (“The Next Financial Crisis—How to Avoid It”)

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Hearing on Systemic Risk and Regulation

Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Committee on Financial Services

United States House of Representatives

Hearing on Systemic Risk and Regulation 

October 2, 2007

Mr. Chairman, Ranking Member Bachus and members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a Resident Fellow at the American Enterprise Institute, and these are my personal views.  Before joining AEI, I spent 35 years in banking, including twelve years as President and CEO of the Federal Home Loan Bank of Chicago.  I am a Past President of the International Union for Housing Finance and a director of three companies in financial businesses. 

My career has included many credit cycles which involved issues of systemic risk, from the credit crunch of 1969, the commercial paper panic of 1970, and the real estate investment trust collapse of 1975 (in which the entire commercial banking system was thought by some to be insolvent) to the current example of the credit panic triggered by the ongoing subprime mortgage and housing bust, and a number of others in between.  Moreover, I have studied the long history of such financial events and their recurring patterns. 

Booms and Busts in Context

To begin with, let me try to put the issues of financial booms and busts and the related question of systemic risk in context.

The fundamental principle is that long term growth and the greatest economic well being for ordinary people can only be created by market innovation and experimentation.  Markets for goods and services must be accompanied by markets in financial instruments, which by definition place a current price on future, thus inherently uncertain, events.  This much is obvious but easy to forget when addressing the results of a bust with the benefit of hindsight, when it seems like you would have to stupid to make the mistakes that smart people actually made.

Dealing with putting prices on the inherently uncertain future, all financial markets are constantly experimenting with how much risk there should be, how risks are distributed, what the price of risk-bearing should be, and how risk trades off with financial success or failure.  Should individuals and institutions be free to take financial risks if they want to?  Yes, they should.

In the boom, many people succeed, just as many people succeeded for a long time in the subprime mortgage and housing boom.  This success gets extrapolated, supports optimism and makes lenders and investors, including private pools of capital, confident.  Lender and investor confidence tends to the underestimation of risks, in particular, the risk that the price of the asset in favor, most recently houses, could fall or fall very much; and underestimation of the risk that if prices fall, especially in a leveraged sector, asset and credit markets could become illiquid.

In my opinion, the principles stated by the President’s Working Group for private pools of capital are professional and sensible.  But even if everybody followed them, we would not avoid the inevitable times of financial turbulence.

We know for certain that markets will create long term growth and also cyclical booms and busts, but just what or when the outcome of a particular innovation will be cannot be known in advance.  It can only be discovered by running the market experiment, as so brilliantly discussed in Friedrich Hayek’s “Competition as a Discovery Procedure.”

How hard it is to outguess this discovery procedure is shown by the fact that a mere three months ago, the financial and economic world was constantly treated to statements by very intelligent and well-informed people that there was “abundant liquidity” or even a “flood of liquidity,” which would guarantee a firm market bid for risky assets and narrow spreads.  Then we were suddenly confronted with a lack of bids, nonfunctioning markets and the “evaporation of liquidity.”

Likewise, some very intelligent and well-informed people said, up until August, that the subprime mortgage bust would be “contained” and not cause wider financial or economic problems.  Now we have had a subprime-induced credit panic and an ongoing credit crunch, with falling house prices, but the stock market has gone back up to near its high.  How do we interpret that?  

A fundamental point is that markets are recursive.  Whatever opinions influence buying and selling and hedging, whatever models of financial behavior are relied on, whatever is done to regulate them, are all fed back into the system of interactions and change behavior in unpredictable ways.  Thus models of financial behavior, themselves changing the market, tend to become less effective or obsolete, as did subprime credit models. 

Regulations likewise change financial behavior, are arbitraged, and may end up producing the opposite of their intent.  This is why regardless of what any regulator or legislator may do, markets will always create however much risk they want.  Then when the bust has begun, regulatory actions to reduce or control risk may turn out to be procyclical, reinforcing the downward momentum.

Models  

To successfully avoid booms and busts, regulatory operations or market actors would have to know the future.  They often attempt to do so through creating models.

Of course, there is always a difference between financial models, however mathematically refined, and financial reality.  This is so whether the models are those of Wall Street “rocket scientists” structuring securities, credit rating agencies, hedge funds or other private pools of capital, sophisticated institutions, the Federal Reserve or other regulators, or investment analysts.  Finance cannot in principle be turned into physics. 

John Maynard Keynes memorably observed that a prudent banker is one who goes broke when everybody else goes broke.  One way to do this is to use models with the same assumptions that everybody else has.  Then you can be confident when everybody else is confident and afraid when everybody else is afraid. (We can be skeptical of the models approach of Basel II in this respect.)

Once a Decade, On Average

The classic patterns of booms based on credit overexpansions and their following busts are colorfully discussed by such students of financial cycles as Charles Kindleberger, Walter Bagehot and Hyman Minsky. 

Kindleberger, surveying several centuries of financial history, observed that financial crises and scandals occur, on average, about once every ten years.  This matches my own experience.  Every bust is followed by reforms, but the next bust arrives nonetheless.  Still the trend of market innovation and long term growth continues.

The increased risk accumulated in credit overexpansions ultimately comes home to roost and prices of the favored asset fall.  There is a hangover of defaults, failures, dispossession of unwise or unlucky borrowers, revelations of frauds and swindles (always), and then the search for the guilty.  There is a sharp restriction of credit.  For example, the chief executive of Countrywide recently announced, “We are out of the subprime business.” 

There is a generalized retreat from risky assets, and a new danger arises: fire sales of assets turning into a debt deflation and the ruin of the financial system—systemic risk has arrived.  Our students of financial cycles all support government intervention to stabilize the downward momentum.  This is the correct answer as long as it is temporary.

To come to the current situation, it is evident that the present combination of the excess inventory of houses and condominiums, with the rapid restriction of mortgage credit—in other words, increased supply plus falling demand, equals a trend of falling house prices.  The models used to analyze, rate and price subprime securitizations include as a key factor house price appreciation (“HPA” in the trade jargon).  Now that we have house price depreciation, what will happen if prices fall much more and much more broadly than the models, the investors, the lenders and the regulators thought they could?

Unfortunately, a vicious cycle of falling house prices, more defaults, further credit tightening, less demand, further falls in prices, more defaults, and so on, is possible for a while, though of course not forever.  Financial market result: Fear. 

The fear is increased by great uncertainty about the value of subprime securities if no one wants to buy them anymore.  What are they worth as assets to an investor, notably a leveraged investor?  What are they worth as collateral to a lender—especially a very risk-averse repo dealer or commercial paper buyer?

Greater disclosure and transparency are reasonably suggested, although financial accounting, at least, is never truly “transparent.”

For example, what does “value” even mean when there are few or no buyers?  How can assets be marked to market if there is no active market?  Should everybody’s portfolio be marked to fire sale prices, or instead to some estimate of intrinsic value?  Who is actually broke and who isn’t?  The answers to these classic questions of the bust are never clear, except in retrospect.

Liquidity

As Bagehot wrote, “Every great crisis reveals the excessive speculations of many houses which no one before suspected.”  So has our current bust, and these unpleasant surprises reinforce the uncertainty make about who is broke and who isn’t (perhaps including yourself).  With this uncertainty and personal as well as institutional risk, everyone becomes conservative at once.  When all investors and lenders, institutionally and personally, try quite logically to protect themselves by avoiding risk, the result is to make liquidity disappear and to put the whole at risk. Note that possibility of regulatory or political punishment arising from the search for the guilty will increase the risk aversion.

In other words, it is belated risk aversion which creates systemic risk. To understand why this can happen, we have to see that “liquidity” is not a substance which can “flow,” be a “flood,” “slosh around,” or be “pumped” somewhere, to use a number of misleading expressions.

In fact, liquidity is a figure of speech.  It is verbal shorthand for the following situation:  

     -A is ready and able to buy an asset from B on short notice

     -At a price B considers reasonable

     -Which usually means  C has to be willing to lend money to A

     -And if C is a dealer, both A and C have to believe the asset could readily be sold to D

     -Which means A and C believe there is an E willing to lend money to D.

Good times, a long period of profits, and an expansionary economy induce financial actors and observers to take this situation, “liquidity,” too much for granted, so liquidity comes to be thought of as how much you can borrow.  When the crisis comes, it is found to be about what happens when you can’t borrow, except from some government instrumentality.

At this point we have arrived at why central banks exist.  The power of the government, with its ability to compel, borrow, tax, print money, and credibly guarantee the payment of claims, can intervene to break the everybody-stops-taking-risk-at-once psychology of systemic risk.

The key is to assure that this intervention is temporary, as are credit panics by nature.  As historically recent examples of government interventions in housing busts, since 1970 we have had the Emergency Home Finance Act of 1970, the Emergency Housing Act of 1975, the Emergency Housing Assistance Act of 1983, and the Emergency Housing Assistance Act of 1988.  (I do not count the Hurricane Katrina Emergency Housing Act of 2005, a special case.)  This is in line with Kindleberger’s estimate of about once a decade on average, and an emergency housing act of 2007 would fit the pattern.

The liquidity crunch won’t last forever.  Large losses will be taken,  the market get used to the idea, who is broke and who isn’t sorted out, failures reorganized, risks reassessed, models rewritten, and revised clearing prices discovered.  A, B, C, D and E will get back into business trading and lending to each other again. 

Liquidity will return reasonably quickly for markets in prime instruments.  One long time observer of finance, whose insights I value, has predicted that “the panic about credit markets will be a memory by Thanksgiving.”

I believe this is probably right; however, the severe problems with subprime mortgages and securities made out of them, related defaults and foreclosures, and falling house prices will continue long past then.  They will continue to cause macroeconomic drag and financial difficulties, but the moment of systemic panic will have passed. 

The “Cincinnatian Doctrine”

In conclusion, my view is that it is not possible to design society, no matter what regulatory systems may be implemented, to avoid financial booms and busts and their resulting risk of systemic panics.  We do need temporary interventions of the government periodically, when the financial system is threatened by a downward spiraling debt deflation.  In other words, booms and busts are endemic to market economies with financial markets in which people are free to take risks and engage in borrowing against the uncertain future.  They are a price well worth paying in return for the innovation and growth only such markets can create.

In normal times, that is, about 90% of the time, we predominately want the economic efficiency, innovation, productivity and the resulting well-being for ordinary people produced by competitive markets.  But when the financial system hits its inevitable periodic crises, about 10% of the time, the intervention of the government is often necessary.  This intervention should be temporary.  If prolonged, it will tend to cartels, bureaucracy, less innovation, and less growth.  In the extreme, of course, it becomes socialist stagnation. 

Thus I suggest a 90%-10% policy mix.  I have elsewhere explored this idea as the “Cincinnatian Doctrine.”

In the wake of every bust, various plans are put in place to prevent all future ones, but the next bust arrives in about ten years anyway. Such plans suffer from the assumption that financial group behavior is mechanistic and can be addressed by designing mechanisms.  In fact, it is organic, creative, recursive and emergent. That is the source of its strength in creating wealth, also of its weakness in getting periodically carried away.  I do not believe any regulatory structures can alter these fundamental characteristics.

Thank you again for the opportunity to share these views.

Hearing on Bank Mergers and Subprime Mortgage Credit Problems

From Testimony of

Alex J. Pollock

Resident Fellow

American Enterprise Institute

To the Subcommittee on Domestic Policy Committee on Oversight and Government Reform

United States House of Representatives

Hearing on Bank Mergers and Subprime Mortgage Credit Problems

Cleveland, Ohio May 21, 2007

***

The One-Page Mortgage Disclosure Proposal

When considering borrowers in financial trouble, whether from unwise borrowing, not having understood the loan, or even induced into loans by misrepresentation, there is a natural political reaction to try to protect them through credit regulation.

I believe a superior strategy is to equip borrowers to protect themselves by requiring short, simple and clear disclosures of the key mortgage loan terms and their relation to household income. The borrowers can then “underwrite themselves.” They have the natural incentive to do so—we need to add intelligible, practical information.

To help address the shortcomings of the subprime market which have become evident, I believe a new, superior disclosure approach is needed, whether or not we do anything else. The key is to realize that complex, lengthy statements in regulatoryese and legalese do not achieve the goal. Moreover, the simple, clear disclosure should be focused on the financial impact on the borrower, not on the financial instruments.

Thus I propose there should be a required one-page form which gives the essentials of the loan and its monthly cost, which must be given to every mortgage borrower three days before closing. 2

A good mortgage lender wants a borrower who understands how the loan will work, including any possible future interest rate increases and prepayment penalties. The total monthly obligation needs to be put clearly in the context of the borrower’s income.

Current American mortgage loan documents certainly do not achieve this. Most of us have had the experience of being overwhelmed and befuddled by the huge stack of documents full of confusing language in small print presented to us for signature at a mortgage closing. The complexity results from legal and compliance requirements. Ironically, past regulatory attempts to insure full disclosure have made the problem worse. That is because they attempt full, rather than relevant, disclosure.

To achieve an informed borrower, the key information must be simply stated and clear, in regular-sized type: 90% of the relevant information which is clear and understandable is far better than 100% of the details which are complex and hard to read. Trying to describe the details in specific legal and bureaucratic terms results in essentially zero information transfer to the borrower.

The one-page form should include key underwriting concepts, including the borrower’s income and housing expense ratio, as well as principal loan terms. The “housing expense ratio” means the sum of the monthly interest payment, principal payment, property tax, and house insurance premium, expressed as a percent of the borrower’s monthly income. This should be shown for both the initial interest rate and the fully-indexed interest rate. In typical types of subprime loans, the fully-indexed expense ratio can be a remarkably larger burden than the initial or “teaser” rate suggests.

The proposed one-page “Basic Facts About Your Mortgage Loan” form, with accompanying common sense explanations and avuncular advice, is Attachment 1.

One of the deans of mortgage journalists has written of how the one-page proposal is distinct from previous regulations and simplification attempts. His article is also attached.

Whatever else is done or not done, I believe the one-page disclosure would be an important step forward for America’s and Ohio’s mortgage borrowers and housing finance system.