The Fed: Can the world’s biggest S&L get back to normal?

Published in the Library Of Law And Liberty

The balance sheet of today’s Federal Reserve makes it the largest 1980s-model savings and loan in the world, with a giant portfolio of long-term, fixed-rate mortgage securities combined with floating-rate deposits. This would certainly have astonished the legislative fathers of the Federal Reserve Act, like congressman and later Sen. Carter Glass, who strongly held that the Fed should primarily be about discounting short-term commercial notes.

It would equally have amazed the Fed’s past leaders, like its longest-serving chairman, William McChesney Martin, who presided over the Fed under five U.S. Presidents, from 1951 to 1969.  Martin thought the Fed should confine its open-market activities to short-term Treasury bills and instituted the “bills only doctrine” in 1953. He would have been most surprised and we can imagine displeased at the amount of Treasury bills now included in the Fed’s bloated $4.5 trillion of assets.  As of June 7, 2017, the Treasury bills held by the Fed are exactly zero. This is as radical on one end of the maturity spectrum as the long-term mortgages are on the other.

As part of its so-called “quantitative easing” program—a more respectable-sounding name for buying lots of bonds—the Fed reports its mortgage securities portfolio as $1.77 trillion as of June 7.  Its investment is actually somewhat larger than that, since the Fed separately reports $152 billion of unamortized premiums net of discounts it has paid. If we guess half of those premiums are attributable to the MBS, the total becomes $1.85 trillion. The Fed owns 18 percent of all the first mortgages in the country, which total $10 trillion. It owns nearly 30 percent of all the Fannie Mae, Freddie Mac and Ginnie Mae MBS that are outstanding. It is big, a market-moving position, and that was indeed the idea: to move the market for MBS up, mortgage interest rates down and house prices up.

The Fed has in its portfolio $2.46 trillion of long-term Treasury notes and bonds. Adding in the other half of the unamortized premiums brings its investment to $2.54 trillion. The Fed owns 24 percent of all the Treasury notes and bonds that are in the hands of the public. Again, a remarkably large, market-moving position.

The Fed’s problem is now simple and obvious: once you have gotten into positions so big relative to the market and moved the market up, how do you get out without sending the market down?  The Fed is expending a lot of rhetorical energy on this problem.

As Federal Reserve chairman half a century ago, Martin was rightly skeptical of the advice of academic economists, but the control of the Fed is now dominated by academic economists. The former gold standard, whose last vestige disappeared when the United States reneged on its Bretton Woods commitments in 1971, has been replaced by what James Grant aptly calls “the Ph.D. standard.”

The Ph.D. standard is accompanied by the strident insistence that the Fed must be entirely and unconstitutionally independent, so that it can carry out whatever monetary experiments the debatable theories of its committee of economists lead to. Since 2008, nine years ago, these theories have concluded that the Fed should create “wealth effects,” which means manipulating upward the prices of houses, bonds and equities by buying a lot of long-term securities. In promoting asset-price inflation, the Fed, in company with the other major central banks, has greatly succeeded. Is that good?

It is one thing to try this in the midst of a crisis and a deep recession. But the last recession ended in mid-2009, eight years ago. The stock market has been rising for eight years, since the first quarter of 2009, passed its 2007 high in 2013 and has been dramatically booming since. House prices bottomed in 2012, have been rising much faster than incomes for five years and are, amazingly, back over their 2006 bubble peak.

So why is the Fed still buying long-term mortgages and bonds? It is definitely still a big bid in both markets, because it is continuing to buy in order to replace all the maturities and prepayments in its huge portfolio. Why doesn’t it just stop buying, instead of endlessly talking about the possibility of stopping, eight years after the end of crisis? Well, the Fed’s leaders want to manage your expectations, so you won’t think it’s a big deal–they hope–when it finally does really stop buying.

That time has still not come, the Fed just announced June 14. Perhaps later this year, although even this timing was hedged, it expects to allow a slight bit of runoff—but not now! The Fed would then still be buying, but a little less.  This “very gradual and predictable plan” would start with reducing securities purchases by $10 billion a month. Annualizing that rate, in a year, the portfolio would go from $4.4 trillion to $4.3 trillion.

The Fed will continue its status as the world’s biggest S&L.

The major central banks form a tight fraternity. They have all been engaged in long-term securities-buying programs, the ultimate effects of which are subject to high uncertainty. Predictable human behavior, when subject to high uncertainty, is to herd together, to have the comfort of having the colleagues you respect all doing the same thing you are doing. This includes all thinking the same way and making the same arguments, that is, cognitive herding. Central banks are clearly not exempt from this basic human trait.

To paraphrase a famous line of John Maynard Keynes, “a prudent banker is one who goes broke when everybody else goes broke.” A central banking variation might be, “a prudent central banker is one who makes mistakes when everybody else is making the same mistakes.” Will this turn out to be the case with the matching “quantitative easing” purchases they did together?

Here are the long-term securities portfolios of the elite of the central bank fraternity:

The European Central Bank has a slightly bigger bond portfolio than even the Fed does, but one significantly larger relative to the size of the economy. All these “quantitative easing” programs are definitely huge relative to the respective GDPs, the champion being the Swiss central bank with the remarkable size of 149 percent of gross domestic product. For better or worse, they are all in it together.

As a result of this massive central bank intervention, it is reasonably argued that there are no real market prices for bonds now—only central bank-manipulated prices. “Yields are too low in the U.S.,” as Abby Joseph Cohen of Goldman Sachs recently told Barron’s, and “there is no major economy with yields where they should be.”

What would happen to the Fed’s savings and loan-style balance sheet if interest rates did go back to normal?  We know what happened to the savings and loan industry when interest rates went sharply up: they became insolvent. Could that happen to the Federal Reserve? Indeed. Let’s do the simple bond math.

What is the average duration of all the Fed’s long-term mortgages and bonds?  A reasonable guess might be five years–if anything, this guess is easy on the Fed, and the duration of its mortgages will extend if rates rise. But let’s say five years. That means if long-term interest rates would rise by only 1 percent–not much—the market value of the Fed’s portfolio will fall by 1 percent x 5 = 5 percent.  A 5 percent market loss on $4.4 trillion is $220 billion. Let’s compare that to the Federal Reserve System’s total capital, which is $40.8 billion. The Fed’s loss of market value on a 1 percent rise in long-term interest rates would be more than five times its capital.

Of course, interest rates might go up by more. A 2 percent rise would mean a market value loss of $440 billion, or more than 10 times the Fed’s capital. No wonder the Fed adamantly refuses to mark its securities portfolio to market!

Most economists confidently assert that no one would care at all if a fiat currency issuing central bank like the Fed became deeply insolvent on a mark-to-market basis. They may well be right. But in that case, why hide the reality of the market values?

The Swiss National Bank is required by its governing law to mark its securities portfolio to market and reflect that in its published financial statements.  Why does the Federal Reserve lag behind the Swiss in disclosure and financial transparency?

Glass-Steagall never saved our financial system, so why revive it?

Published in The Hill.

The Banking Act of 1933 was passed in an environment of crisis. In March of that year, all of the nation’s financial institutions were closed in the so-called “bank holiday,” which followed widespread bank runs over the prior months.

Sen. Carter Glass, D-Va., a chief author of the bill and senior member of the Committee on Banking and Currency, was determined not to “let a good crisis go to waste.” Though he did not like the proposals from Chairman Henry Steagall, D-Ala., for federal deposit insurance, he agreed to support it on the condition that the legislation include Glass’ own pet idea that commercial banking be separated from much of the securities business.

It was poor policy from the start, but it took more than six decades to get rid of it. Now some political voices want to revive it. Financial ideas — like financial markets — have a cycle. Reviving Glass-Steagall would be an action with substantial costs, but no benefits. Its primary appeal seems to be as a political slogan.

Not having Glass-Steagall had nothing to do with the housing bubble or the resulting financial crisis of 2007 to 2009, except that being able to sell failing investment banks to big commercial banks was a major advantage for the regulators. And not having the law, in fact, had nothing to do with the crises of Glass’ own time, including the banking panic of 1932 to 1933 and the Great Depression.

Meanwhile, having Glass-Steagall in force did not prevent the huge, multiple financial busts of 1982 to 1992, which caused more than 2,800 U.S. financial institution failures, or the series of international financial crises of the 1990s.

While Glass-Steagall was in place, it required commercial banks to act, under Federal Reserve direction, as “the Fed’s assistant lenders of last resort,” whenever the Fed wanted to support floundering securities firms. This happened in the 1970 collapse of the commercial paper market, which followed the bankruptcy of the giant Penn Central Railroad, and in the “Black Monday” collapse of the stock market in 1987.

The fundamental problem of banking is always, in the memorable phrase of great banking theorist Walter Bagehot, “smallness of capital.” Or, to put the same concept in other words, the problem is “bigness of leverage.” So-called “traditional” commercial banking is, in fact, a very risky business, because making loans on a highly leveraged basis is very risky, especially real estate loans. All of financial history is witness to this.

Moreover, making investments in securities — that is, buying securities, as opposed to being in the securities business — has always been a part of traditional commercial banking. Indeed, it needs to be, for a highly leveraged balance sheet with all loans and no securities would be extremely risky and entirely unacceptable to any prudent banker or regulator.

You can make bad loans and you can buy bad investments, as many subprime mortgage-backed securities turned out to be. As a traditional commercial bank, you could make bad investments in the preferred stock of Fannie Mae and Freddie Mac, which created large losses for numerous banks and sank some of them.

Our neighbors to the north in Canada have a banking system that is generally viewed as one of the most stable, if not the most stable, in the world. The Canadian banking system certainly has a far better historical record than does that of the United States.

There is no Glass-Steagall in Canada: all the large Canadian banks combine commercial banking and investment banking, as well as other financial businesses, and the Canadian banking system has done very well. Canada thus represents a great counterexample for Glass-Steagall enthusiasts to ponder.

In Canada, there is now a serious question of a housing bubble. If this does give the Canadian banks problems, it will be entirely because of their “traditional” banking business of making mortgage loans — the vast majority of mortgages in Canada are kept on banks’ own balance sheets. If the bubble bursts, they will be glad of the diversification provided by their investment banking operations.

To really make banks safer, far more pertinent than reinstating Glass-Steagall, would be to limit real estate lending. Real estate credit flowing into real estate speculation is the biggest cause of most banking disasters and financial crises. Those longing to bring back their grandfather’s Glass-Steagall should contemplate instead the original National Banking Act, which prohibited real estate loans altogether for “traditional” banking.

Among his other ideas, Glass was a strong proponent of the “real bills” doctrine, which held that commercial banks should focus on short-term, self-liquidating loans to finance commercial trade. His views were reflected in the Federal Reserve Act, which, as Allan Meltzer has described it, had “injunctions against the use of credit for speculation” and an “emphasis on discounting real bills.” This approach which does not leave a lot of room for real estate lending.

If today’s lawmakers want to be true to Sen. Glass, they could more strictly limit the risks real estate loans create, especially in a boom, and logically call that “a 21st century Glass-Steagall.”

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

Published by the R Street Institute with Clark Packard.

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

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

Accountability of banks

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

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

Accountability of regulatory agencies

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

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

Accountability of the Federal Reserve

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

Reform for community banks

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

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

Detroit and Puerto Rico: Which is the worse insolvency?

Published in Real Clear Markets.

Over four decades beginning in the 1970s, the U.S. financial system had one big municipal debt crisis per decade.  These were New York City in the 1970s, the Washington Public Power Supply System (“Whoops!”) in the 1980s, Orange County, California in the 1990s, and Jefferson County, Alabama in the 2000s.

But our current decade, not yet over, has already set two consecutive all-time records for the largest municipal insolvencies in history: first the City of Detroit, which entered bankruptcy in 2013, and then Puerto Rico, which is now in an equivalent of bankruptcy especially created for it by Congress (under Title III of the PROMESA Act of 2016).

Between bonds, unfunded pensions, and other claims, Detroit’s record-setting debt upon bankruptcy was $18.8 billion.  Puerto Rico has far surpassed that.  Its comparable debt is $122 billion, or 6.5 times that of Detroit, with $74 billion in bonds and $48 billion in unfunded pensions.

On the other hand, Puerto Rico is five times bigger than Detroit, with a population of 3.4 million, compared to 687,000.  We need to look at the problems on a per capita basis.

The result is not optimistic for the creditors of Puerto Rico.  As shown below, Puerto Rico’s debt per capita is much bigger—33% higher– than Detroit’s was in 2013: about $35,800 versus $26,900.

Total debt      Population   Debt per capita

Puerto Rico         $122 billion       3,411,000           $35,800

Detroit                $ 18.8 billion        687,000           $27,400

On top of more debt, Puerto Rico has much less income per capita—23% less—than Detroit did.  So as it arrives in court for a reorganization of its debts, its ratio of debt per capita to income per capita is 3.1 times, compared to 1.8 times for Detroit.  As shown below, this is 70% greater relative debt—or alternately stated, Puerto Rico’s per capita income to debt ratio is only 59% of Detroit’s.

Puerto Rico          Detroit           PR/ Detroit      Detroit/ PR

Total debt per capita                   $35,800              $27,400              131%                   77%

Income per capita                       $11,400              $14,900              77%                     131%

Per capita debt / income             3.14x                   1.84x                  170%                   59%

Puerto Rico’s unemployment rate is very high at over 12%.  This not as huge as Detroit’s 22%, but Puerto Rico’s abysmal labor participation rate of 40%, compared to Detroit’s already low 53%, offsets this difference.  This leaves Puerto Rico with proportionally even fewer earners with lower incomes to pay the taxes to pay the much higher debt.

On a macro basis, then, it appears that the creditors of Puerto Rico can expect to do even more poorly than those of Detroit.  How poorly was that?

At its exit from a year and a half of bankruptcy, Detroit’s total debt had been reduced to $10.1 billion.  Overall, this was 53 cents on the dollar, or a loss of 47% from face value, on average.  However, various classes of creditors came out very differently.  Owners of revenue bonds on self-supporting essential services came out whole on their $6.4 billion in debt.  If we exclude this $6.4 billion, leaving $12.4 billion in claims by everybody else, the others all together got $3.7 billion, or a recovery of 30 cents on the dollar, or a loss of 70%, on average.

Recoveries in this group ranged from 82 cents on the dollar for public employee pensions, to 74 cents for the most senior general obligation bonds, to 44 cents on more junior bonds, to 25 cents for settling swap liabilities, to 13 cents on certificates of participation, to 10 cents on non-pension post-retirement benefits and other liabilities.  It is noteworthy that the public employee pensions did take a meaningful haircut, although they came out far better than most others.  The pension settlement also included special funds contributed by the State of Michigan and special funds contributed by charitable foundations to protect the art collection of the Detroit Institute of Arts.  These latter factors will not be present in the Puerto Rico settlement.

As a macro estimate, if we take as a baseline Detroit’s average settlement of 53 cents on the dollar and multiply it by Puerto Rico’s 59% of Detroit’s ratio of per capita income to debt, we get a guess of 31 cents on average for all the creditors.  This is not extremely different from the official fiscal plan approved by the Puerto Rico Oversight Board, which estimates cash available for debt service of about 24% of the contractual debt service over the next ten years.

What will happen in the debt reorganization bargains, what role pension debt will play, how various classes of creditors will fare with respect to each other, what political actions there may be—all is up in the air as the court begins its work.

The lenders and borrowers responsible for the huge financial mistakes which led to deep insolvency need to seriously think through, as in every debt disaster, “How did we get ourselves into this mess?!”  They are a long way from getting out of it.

The Fed must be held accountable and the CHOICE Act will make it so

Published in The Hill.

This week, the House Financial Services Committee passed Chairman Jeb Hensarling’s Financial CHOICE Act. Most of the public discussion of this bill is about its changes in banking regulations, but from a constitutional point of view, even more important are the sections that deal with the accountability of regulatory agencies and the governance of the administrative state.

Accountability is a central concept in every part of the government. To whom are regulatory agencies accountable? Who is or should be their boss? To whom is the Federal Reserve, a special kind of agency, accountable? Who is or should be its boss? To whom should the Consumer Financial Protection Bureau (CFPB) be accountable? Who should be its boss?

The correct answer to these questions, and the answer given by the CHOICE Act, is the Congress. Upon reflection, we should all agree on that. All these agencies of government, populated by unelected employees with their own ideologies, agendas, and will to power — as vividly demonstrated by the CFPB — must be accountable to the elected representatives of the people, who created them, can dissolve them, and have to govern them in the meantime. All have to be part of the separation of powers and the system of checks and balances that is at the heart of our constitutional order.

But accountability does not happen automatically: Congress has to assert itself to carry out its own duty for governance of the many agencies it has created and its obligation to ensure that checks and balances actually operate.

The theme of the Dodd-Frank Act was the opposite: to expand and set loose regulatory bureaucracy in every way its drafters could think of. It should be called the Faith in Bureaucracy Act.

In the CHOICE Act, Congress is asserting itself at last to clarify that regulatory agencies are derivative bodies accountable to the Congress, that they cannot be sovereign fiefdoms — not even the Dictatorship of the CFPB, and not even the money-printing activities of the Federal Reserve.

The most classic and still most important power of the legislature is the power of the purse. The CHOICE Act accordingly puts all the regulatory agencies, including the regulatory part of the Federal Reserve, under the democratic discipline of Congressional appropriations.

This notably would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB — which was designed precisely to evade the democratic power of the purse. It is sometimes objected that appropriations “inject politics” into these decisions. Well, of course! Democracy is political. Expansions of regulatory power are political, all pretense of technocracy notwithstanding.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. It provides that actions whose costs exceed their benefits should not be undertaken without special justification. That’s pretty logical and hard to argue with. Naturally, assessing the future costs and benefits of any action is subject to uncertainties — perhaps very large uncertainties. But this is no reason to avoid the analysis — indeed, forthrightly confronting the uncertainties is essential.

The CHOICE Act also requires an analysis after five years of how regulations actually turned out in terms of costs and benefits. This would reasonably lead — we should all hope it will — to scrapping the ones that didn’t work.

Further Congressional governance of regulatory agencies is provided by the requirement that Congress approve major regulatory rules — those having an economic effect of $100 million or more. Congress would further have the authority to disapprove minor rules if it chooses by joint resolution. This is a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

On the Federal Reserve in particular, the CHOICE Act devotes a title to “Fed Oversight Reform and Modernization,” which includes improving its accountability.

“Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to,” once succinctly testified a president of the New York Fed. Under the CHOICE Act, such reviews would happen at least quarterly.

In these reviews, I recommend that the Federal Reserve should in addition be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers.

The CHOICE Act requires of new regulatory rules that they provide “an assessment of how the burden imposed … will be distributed among market participants.” This good idea should by analogy be applied to burdens imposed on savers by monetary actions.

By my estimate, the Federal Reserve has taken since 2008 over $2 trillion from savers and given it to borrowers. The Federal Reserve may want to defend its sacrifice of the savers as a necessary evil — but it ought to openly and clearly quantify the effects and discuss the economic and social implications with the Congress.

In sum, the CHOICE Act represents major improvements in the accountability of government agencies to the Congress and ultimately to the people. These are very significant steps forward in the governance of the administrative state to bring it under better constitutional control.

Puerto Rico’s inevitable debt restructuring arrives

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

CHOICE Act would be major progress for financial system

Published by the R Street Institute.

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

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

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

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

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

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

Accountability of the Administrative State

Accountability is a, perhaps the, central concept in every part of the government. To whom are regulatory agencies accountable? Who is or should be their boss? To whom is the Federal Reserve, a special kind of agency, accountable? Who is or should be its boss? To whom should the Consumer Financial Protection Bureau be accountable? Who should be its boss?

The answer to all these questions is of course: the Congress. We should all agree on that. All these agencies of government, populated by unelected employees, must be accountable to the elected representatives of the people, who created them, can dissolve them and have to govern them in the meantime. All have to be part of the separation of powers and the system of checks and balances which is at the heart of our constitutional order. This also applies to the Federal Reserve. In spite of its endlessly repeated slogan that it must be “independent,” the Federal Reserve must equally be accountable.

But accountability does not happen automatically: Congress has to assert itself to carry out its own duty for governance of the many agencies it has created and for its obligation to ensure that checks and balances actually operate.

The CHOICE Act is an excellent example of the Congress asserting itself at last to clarify that regulatory agencies are derivative bodies accountable to the Congress, that they cannot be sovereign fiefdoms—not even the dictatorship of the CFPB, and not even the money-printing activities of the Federal Reserve.

The most classic and still most important power of the legislature is the power of the purse. The CHOICE Act accordingly puts all the regulatory agencies, including the regulatory part of the Federal Reserve, under the democratic discipline of congressional appropriations. This notably would end the anti-constitutional direct grab from public funds which was originally granted to the CFPB—and which was designed precisely to evade the democratic power of the purse. It is sometimes objected that appropriations “inject politics” into these decisions. Well, of course! Democracy is political. Regulatory expansions are political, all pretense of technocracy notwithstanding.

The CHOICE Act also requires of all financial regulatory agencies the core discipline of cost-benefit analysis. It provides that actions whose costs exceed their benefits should not be undertaken without special justification. That’s pretty logical and hard to argue with. Naturally, assessing the future costs and benefits of any action is subject to uncertainties—perhaps very large uncertainties. But this is no reason not to do the analysis—indeed, forthrightly to confront the uncertainties is essential.

The CHOICE Act also requires an analysis after five years of how regulations actually turned out in terms of costs and benefits. This would reasonably lead—I hope it will—to scrapping the ones that didn’t work.

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

Further congressional governance of regulatory agencies is provided by the requirement that Congress approve major regulatory rules—those having an economic effect of $100 million or more. Congress would further have the authority to disapprove minor rules if it chooses by joint resolution. This strikes me as a very effective way of reminding everybody involved, including the Congress itself, who actually is the boss and who has the final responsibility.

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

Accountability of the Federal Reserve

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

• “An independent central bank is essentially undemocratic.”

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

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

In my view, all these points are correct.

The president of the New York Federal Reserve Bank testified to the 1964 committee: “Obviously, the Congress which set us up has the authority and should review our actions at any time they want to, and in any way they want to.” That is entirely correct, too.

Under the CHOICE Act, such reviews would happen at least quarterly. I would like to suggest an additional requirement for these reviews. I believe that the Federal Reserve should be required to produce a Savers Impact Statement, quantifying and discussing the effects of its monetary policies on savings and savers.

The CHOICE Act requires of new regulatory rules that they provide “an assessment of how the burden imposed…will be distributed among market participants.” This good idea should by analogy be applied to burdens imposed on savers by monetary actions. By my estimate, the Federal Reserve has taken since 2008 more than $2 trillion from savers and given it to borrowers. The Federal Reserve may defend its sacrifice of the savers as a necessary evil—but it ought to openly and clearly quantify the effects and discuss the economic and social implications with the Congress.

Accountability of Banks

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

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

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

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

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

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

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

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

Accountability for Deals with Foreign Regulators

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

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

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

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

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

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

Accountability for Emerging Financial System Risks

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

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

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

Thank you again for the chance to share these views.

Data transparency and multiple perspectives

Published in Data Coalition.

One question underlying the very interesting data project and proposed legislation we are considering today is the relationship of data transparency to multiple perspectives on financial reality. In a minute, we will take up the question: Of all the possible views of a statue, which is the true view?

But first, let me say what a pleasure it is to participate in these discussions of financial transparency; the new Financial Transparency Act, a bill introduced in Congress last night; data standardization; and of course, greater efficiency— we are all for making reporting and compliance less costly.

Let me add to this list the separation of data and analysis, or what we may call the multiplication of perspectives on the financial object. The potential separation of data and analysis may allow a richer and more varied analysis and deeper understanding, in addition to greater efficiency, in both government and business.

As the new white paper “Standard Business Reporting,” by the Data Foundation and PricewaterhouseCoopers, says: “By eliminating documents and PDFs from their intake, and replacing document-based reporting with open data…agencies…gained the ability to deploy analytics without any translation.” Further, that standardized data “will allow individuals to focus on analytics and spend time understanding the data.”

In historical contrast to these ideas, it is easy for me to remember when we couldn’t do anything like that. When I was a young international banking officer working in Germany, one day—4,000 miles to the west, back in the Chicago headquarters—the head of the international banking department had lunch with the chairman of the board. Picture the chairman’s elegant private dining room, with china, silver and obsequious service. In the course of the lunch, the chairman asked: “For our large customers, can we see in one place all the credit exposure we have to them in different places around the world?” Said the executive vice president of international banking: “Of course we can!”

The next day, all over the world, junior people like me were busy with yellow pads and calculators, wildly working to add up all the credit exposure grouped into corporate families, so those papers could be sent to somebody else to aggregate further until ultimately they all were added up for the chairman.

That was definitely not data independent of documents. Imagine the high probability, or rather the certainty, of error in all those manually prepared pages.

A classic problem in the philosophical theory of knowledge turns out to be highly relevant to the issues of data transparency. It is the difference between the real object, the “thing in itself,” and any particular representation or perspective on it. In philosophical terms, the object is different from any particular perspective on it, but we can only perceive it or think about it or analyze it from particular perspectives.

Likewise, a reporting document is a composite of the data—the thing—and some theory or perspective on the data which form the questions the report is designed to pursue and answer.

Let’s consider a famous type of report: GAAP financial statements.

Somewhere far underneath all the high-level abstractions, reflecting many accounting theories, are the debits and credits, myriad of them doing a complex dance.

I think of my old, practical-minded instructor in Accounting 101. This essential subject I studied in night school when I was a trainee in the bank. I would ride the Chicago “L” train to my class, my feet freezing from the cold draft blowing under the doors. But this lesson got burned into my mind: “If you don’t know what to debit and what to credit,” he said, “then you don’t understand the transaction from an accounting point of view.” This has always seemed to me exactly right.

Later on, in this spirit, I used to enjoy saying to accountants advising me on some accounting theory: “Just tell me what you are going to debit and what you are going to credit.” This usually surprised them!

I wonder how many of us here could even begin to pass my old accounting instructor’s test when considering, say, the consolidated financial statements of JPMorgan. What would you debit and credit to produce those?  Of course we don’t know.

For JPMorgan, and everybody else, the debits and credits are turned into financial statements by a very large set of elaborate theories and imposed perspectives. These are mandated by thousands of pages of Financial Accounting Standards pronounced by the Financial Accounting Standards Board. Many of these binding interpretations are highly debatable and subject to strongly held, inconsistent views among equally knowledgeable experts.

Any large regulatory report has the same character: it is a compound of data and theory.

An articulate recent letter to the editor of the Wall Street Journal argues that: “The CPA profession has made the accounting rules so convoluted that GAAP financials no longer tell you whether the company actually made money.” This, the letter continues, is “why companies are increasingly reporting non-GAAP. Investors are demanding this information. …Why should public companies not supply shareholders with the same metrics that the management uses?” Why not, indeed?

In other words, why not have multiple interpretative perspectives on the same data, instead of only one?  This is a fine example of the difference between one perspective—GAAP—and other possibly insightful perspectives on the same financial object. Why not have as many perspectives readily available as prove to be useful?

We are meeting today in Washington, D.C., a city full of equestrian statues of winning Civil War generals. (The losing side is naturally not represented.)  Think, for example, of the statues of General Grant or Sheridan or Sherman or Logan—all astride their steeds. Perhaps you can picture these heroic statues in imagination.

I like to ask people to consider this question:  What is the true view of a statue?  Is it the one from the front, the top, the side (which side?), or what?  Every view is a true view, but each is partial. Even the view of such an equestrian statue directly from behind—featuring the horse’s derriere—is one true view among others. It is not the most attractive one, perhaps, but it may make you think of some people you know.

Likewise, what is the true view of a company, a bank, a government agency, a regulated activity or a customer relationship?  Every document is one view.

Pondering this brings back a memory of my professor of 19th century German philosophy. “The object,” he proposed, “is the sum of all possible perspectives on it.”

Similarly, we may say that a financial structure or a policy problem or an entity or an activity is the sum of many perspectives on it. The ideal of open data available for multiple reports, analyses and purposes is a practical application of this metaphysical idea.

The ideal is not new. In 1975, I went to London to work on a project to define all the elements—what were supposed to become the standardized data—for characterizing all the bank’s corporate customer relationships. The computing technology expert leading the project convincingly explained how these data elements could then be combined and reordered into all the reports and analyses we would desire.

Then, as now, it was a great idea—but then it never actually happened. It was before its time in technical demands. But now I suspect the time has really come. Fortunately, since then, we have had four decades of Moore’s Law operating, so that our information capacities are more than astronomically expanded.

So:

• By freeing transparent, open data from being held captive in the dictated perspectives of thousands of reporting documents;

• By saving data from being lost in the muddle of mutually inconsistent documents;

• Can we provide transparent data, consistently defined, which will promote a wide variety of multiple perspectives to enrich our analysis and create new insights;

• Not to mention making the process a lot cheaper?

This would be a great outcome of the project under consideration in our discussions today.

FSOC is too political to be taken seriously

Published in American Banker.

The Financial Stability Oversight Council is a political body masquerading as an analytical one. A dubious creation of the Dodd-Frank Act, it reflects that law’s urge to expand the power of bureaucrats, in turn reflecting the implausible credo that they can control “systemic risk” because they know the financial future better than other people. They don’t.

The expected result of a committee of heads of federal agencies chaired by the Treasury secretary is a politicized process. This was undoubtedly the case with the council’s attempt to designate MetLife as a “systemically important financial institution.” It should not be surprising that a U.S. District Court judge threw out the designation, ruling that it was “arbitrary and capricious,” and “hardly adhered to any standard when it came to assessing MetLife’s threat to financial stability.” In dissenting from the council’s action on MetLife, S. Roy Woodall — the FSOC’s statutorily required independent member with insurance expertise — said the designation relied on “implausible, contrived scenarios.”

Decisions concerning “systemic risk,” an unclear term in any case, cannot be purely analytical and objective. They involve generalized and debatable theories. They are, to a significant extent, inherently judgmental, subjective and political. The FSOC effectively sits as a miniature, unelected legislature. That is a bad idea.

The fundamental problem is the structure of the FSOC as designed by Dodd-Frank. To begin with, it is chaired by the Treasury secretary, a senior Cabinet member who always has major partisan interests at stake. No company can be considered for SIFI status without the Treasury secretary’s approval. This means that, by definition, the FSOC’s work is not a disinterested, analytical process. An administration is positioned to pick winners and losers. Under the Obama administration, MetLife was in the crosshairs, but Fannie Mae, Freddie Mac and Berkshire Hathaway were off-limits.

Meanwhile, most other FSOC members are heads of independent regulatory agencies, strongly motivated by bureaucratic self-interest to defend their jurisdictional turf from intrusions by the others, and to defend their regulatory records from criticism.

This conflicts with the ostensible purpose of the FSOC: to provide the combined substantive deliberation and development of insights into evolving risks from a diverse group of officials. The expectation that that purpose could be achieved was naive. When I asked one former senior FSOC official from the Obama administration if the meetings of the FSOC members had ever provided a new insight, he gave me a candid answer: No. One can hypothesize that the authors of Dodd-Frank were in fact not naive — that they welcomed another way to expand the reach of the administrative state.

The FSOC’s decision-making authority grants significant regulatory power to Treasury, as well as to members who help decide which firms are SIFIs and which are not. But that’s only the beginning, since the designation process also grants enormous power to the Federal Reserve. If an insurance company becomes designated by the FSOC, it falls under the Fed’s supervisory authority, even though the Fed has little or no experience in insurance regulation. Every head of the central bank who participates in FSOC designations is an interested and conflicted party in discussions that result in expanding the Fed’s authority. The politicization also leads the FSOC to ignore companies that more objectively deserve the SIFI label. The most egregious case of this, of course, is the council’s utter failure to address Fannie Mae and Freddie Mac, which are without question very systemically risky. On top of being huge, they are incarnations of these systemic risk factors: highly leveraged real estate and the moral hazard created by government guarantees.

Dodd-Frank assigns the FSOC the task of “eliminating expectations on the part of shareholders, creditors and counterparties that the Government will shield them from losses.” But Fannie and Freddie are pure cases of the government shielding creditors and counterparties from losses. But the staff of the FSOC was ordered not to study them—a bankruptcy of the FSOC’s intellectual credibility.

It appears that the FSOC has so much baggage that the best approach is simply to scrap it. If a truly independent, analytical systemic risk regulator is desired, it should be created outside of the Treasury’s political control.

Colleges are acting like subprime loan brokers

Published in the Financial Times.

Rana Foroohar, in “Dangers of the college debt bubble,” points out a lot of problems with the U.S. student loan program, but misses the main point: the corruption of colleges by the flow of government money.

For a great many students, colleges play a role similar to that of a subprime mortgage broker: promoting risky loans with a high propensity to default. The college takes all the cash up front and spends it (perhaps, indeed, on “hiring more administrators” and “building expensive facilities”) and just like the subprime broker, it passes all the credit risk on to some sucker — in this case, the taxpayer.

An essential step to address this government-designed bubble is to make all colleges responsible for a significant part of the risk they promote and create. This is the lesson we thought we learnt from the housing bubble: give the pushers of credit some skin in the game. This might logically be done by making the colleges pay the first 20 percent of the loan losses of each student cohort.

I have come across one private college that has credit-enhanced the loans to its students under a fully private program for years, with excellent experience in terms of incentive alignment and financial results.

Do most colleges want to be responsible for their own risk-creating actions? Of course not. Should they be? Of course.

What’s next for U.S. housing finance?

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Murphy’s Law and a banking career

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

Pollock before Oversight Subcommittee

Here’s more from R Street Distinguished Senior Fellow Alex Pollock’s testimony before the House Committee on Financial Services on the arbitrary and inconsistent non-bank SIFI designation process.

A flawed process generated by a flawed structure

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Barron’s LTE (Copy)

Published in Barron’s.

In asking “Is the Federal Reserve Using Overheated Data?” (Up & Down Wall Street, March 11), Randall W. Forsyth did the math: “If the Fed fulfills its own expectations of three [interest rate] hikes this year, it would put its target at 1.25 percent to 1.5 percent.” Let’s call it 1.5 percent at the end of this year. That is still a very low and substantially negative real interest rate. Against the Fed’s own goal of perpetual inflation at 2 percent a year, it is a real rate of negative 0.5 percent. Against the 2.5 percent increase in the consumer price index year over year through January 2017, it is a negative 1 percent real rate.

Although negative real interest rates during a crisis are usual, continuing them for nine years after the crisis ended, as it will be a year from now, serves powerfully to distort asset prices and rob savers.

U.S. banks’ real estate boom could be signaling next crisis

Published in Inside Sources.

Excessive real estate credit is the most common cause of banking booms, busts and collapses, throughout history, right up through the most recent financial crisis and around the world.

The U.S. commercial banking system has gotten much bigger relative to the U.S. economy than it used to be, although there are many fewer banks. The principal source of this growth is that banks have vastly increased their real estate exposure relative to the U.S. economy as a whole. This acceleration in real estate risk has fundamentally changed the nature of the banking system and its systemic risk.

Looking back to 1960, there were in the United States: 13,126 commercial banks and 18,962 depository institutions. By the end of 2016, depositories totaled only 5,913, of which 5,113 were commercial banks. That’s a 69 percent reduction in the number of depository institutions, and a 61 percent reduction in commercial banks.

On the other hand, in 1960, the total assets of the commercial banking system were only $256 billion. Though hard to believe, the entire banking system had total assets of only about one-tenth of today’s JPMorgan-Chase, and only 1.6 percent of today’s banking assets of $15.6 trillion. Citibank — which wasn’t Citibank then, but the dignified First National City Bank of New York — had less than $9 billion in assets. To our minds, now muddled by decades of constant inflation — including a central bank that has formally committed itself to creating perpetual inflation — these all seem like very small numbers.

Instead of measuring in nominal dollars, to see through the fog of long years of inflation, we can measure banking assets consistently relative to the size of the economy, as a percent of annual gross domestic product. The $256 billion of commercial banking assets in 1960 was 47 percent of the $541 billion in GDP.

The increase is striking: by 2016, banking assets had gone from 47 percent to 83 percent of GDP. That is more than a 75 percent increase in the banking system’s size relative to the economy, at the same time the number of banks fell by more than 60 percent. At present, this ratio is close to its all-time bubble peak.

What is driving this growth? It’s not commercial and industrial loans. On the trend, their percent of GDP is flat at 8 percent to 10 percent since 1960. On average, the commercial and industrial loans of the banking system have kept up with the growth of the economy, but not more.

The real driving factor is real estate credit. The commercial banking system’s real estate loans rose relentlessly from 5 percent of GDP in 1960, to more than 26 percent at their bubble peak, and are now at 22.5 percent.

Nor is this the whole real estate story. With the popularization of mortgage securitization, the banking system’s securities portfolio, not only its loan portfolio, shifted to real estate risk. Going back to 1992, the sum of banks’ real estate loans and mortgage-backed securities as a percent of GDP has risen to 32 percent — six times the 1960 level.

In short, the vast bulk of the dramatic increase in the size of the banking system relative to the economy comes from the acceleration of real estate exposure — a rising trend for more than six decades. How can the banks keep doing this? Well, it helps to have your liabilities guaranteed by the government, both explicitly through deposit insurance and implicitly through bailouts and central banking.

Should the banking system keep getting bigger relative to the economy, and should this increase continue overwhelmingly to reflect real estate risk? That is a dubious proposition. As Columbia University’s Charles Calomiris has written (in a not-yet-published paper): “The unprecedented pandemic of financial system collapses over the last four decades around the world is largely a story of real estate booms and busts. Real estate is central to systemic risk.”

Very true. But as Calomiris notes, the Financial Stability Oversight Board, set up as part of the Dodd-Frank Act to oversee the U.S. financial system, “seems to be uninterested.”

The Bank Holding Company Act of 1956 defined a bank as an institution that accepts demand deposits and makes commercial loans. Neither part of this old definition still touches on the main point. A bank now is for the most part an institution that makes real estate loans and funds them with government-guaranteed liabilities.

This banking evolution poses a huge systemic question: How do you deal with a banking system whose risks are concentrated in real estate prices and leverage? To this question we are, as yet, without an answer. Do the supposed systemic thinkers at the Financial Stability Oversight Council even understand the magnitude of the historic shift in risk? Maybe a future FSOC with new members will do better.

What is the actual collateral for a mortgage loan?

Published in Real Clear Markets.

“Economics and finance are like going to the dog races,” my friend Desmond Lachman of the American Enterprise Institute is fond of saying. “Stand in the same place and the dogs will come around again.” So they will.

U.S. financial markets produced sequential bubbles – first in tech stocks in the 1990s and then in houses in the 2000s.

“What is the collateral for a home mortgage loan?” I like to ask audiences of mortgage lenders.  Of course, they say, “the house,” so I am pleased to tell them that is the wrong answer.  The correct answer is the price of the house.  My next question is, “How much can a price change?”  Ponder that.  The correct answer is that prices, having no independent, objective existence, can change a lot more than you think. They can go up a lot more than you think probable, and they can go down a lot more than you think possible. And they can do first one and then the other.

This is notably displayed by the asset price behavior in both the tech stock and housing bubbles.  As the dogs raced around again, they made a remarkably symmetrical round trip in prices.

Graph 1 shows the symmetrical round trip of the notorious “irrational exuberance” in dot-com equities, followed by unexuberance. It displays the NASDAQ stock index expressed in constant dollars.

Now consider houses.  Graph 2 shows the Case-Shiller U.S. national house price index expressed in constant dollars.  Quite a similar pattern of going up a lot and then going down as much.

The mortgage lending excesses essential to the housing bubble reflected, in part, a mania of politicians to drive up the U.S. homeownership rate. The pols discovered, so they thought, how to do this: make more bad loans—only they called them, “creative loans.” The homeownership rate did rise significantly—and then went back down to exactly where it was before. Another instructive symmetrical round trip, as shown in Graph 3.

The first symmetrical up and down played out in the course of three years, the second in 12 years, the third in two decades. Much longer patterns are possible. Graph 4 shows the amazing six-decade symmetry in U.S. long-term interest rates.

Is there magic or determinism in this symmetry? Well, perhaps the persistence of underlying fundamental trends and the regression to them shows through, as does the reminder of how very much prices can change. In the fourth graph, we also see the dangerous power of fiat currency-issuing central banks to drive prices to extremes.

Unfortunately, graphs of the past do not tell us what is coming next, no matter how many of them economists and analysts may draw. But they do usefully remind us of the frequent vanity of human hopes and political schemes.

George Kaufman: 57 years of banking changes and ideas

Published by the R Street Institute.

57 Years of Banking Changes and Ideas

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

Nov. 17, 2016

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

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

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

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

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

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

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

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

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

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

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

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

1. Rhetorical fun

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

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

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

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

Nope.

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

Nope.

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

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

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

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

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

2. Citibank

3. Chase Manhattan

4. Manufacturers Hanover

5. Morgan Guaranty

6. Continental Illinois

7. Chemical Bank

8. Bankers Trust

9. First National Bank of Chicago

10. Security Pacific

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Ladies and Gentlemen:

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

To George!

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

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

Published by the R Street Institute.

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

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

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

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

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

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

Borrowers and speculators benefit at savers’ expense

Published in the Financial Times.

As your report “Fed balance sheet moves up agenda” makes clear (Jan. 19), the Federal Reserve’s quantitative easing experiment is still buying bonds and mortgage securities eight years after the crisis ended and five years after U.S. house prices bottomed. Why? What hath the Fed wrought?

It has helped out the government by seriously reducing the cost of financing federal deficits; it has allocated huge resources to its favoured uses of government spending and rapid inflation of house prices; and it has expropriated the wealth of savers by running years of negative real interest rates. Far from it being the case that “all boats were lifted,” I calculate, using long-run average real interest rates, that since 2008, the Fed has purloined about $2 trillion from conservative savers and given it to borrowers and leveraged speculators. The biggest borrower of all, and thus the biggest beneficiary, is of course the government itself, of which the Fed is such a useful part.