Designation of Fannie Mae and Freddie Mac as SIFIs

Published by the R Street Institute.

Dear Secretary Mnuchin:

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

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

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

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

AEI Event: Is the Bank Holding Company Act obsolete

Hosted by the American Enterprise Institute.

Most of America’s 4969 are owned by holding companies, so the Bank Holding Company Act of 1956 is a key banking law. But do the prescriptions of six decades ago may not still make sense for the banks of today. The act for most of them creates a costly and arguably unnecessary double layer of regulation. Its original main purpose of stopping interstate banking is now completely irrelevant. One of its biggest effects has been to expand the regulatory power of the Federal Reserve–is that good or bad? Does it simply serve as an anti-competitive shield for existing banks against new competition? Some banks have gotten rid of their holding companies–will that be a trend? This conference generated an informed and lively exchange among a panel of banking experts, including the recent Acting Comptroller of the Currency, Keith Noreika, and was chaired by R Street’s Alex Pollock.

Central banks are useful but not that impressive

Published in the Financial Times.

Martin Wolf’s apologia for central banks (“Unusual times call for unusual strategies from central banks,” Nov. 13) asserts that critics of central bank financial manipulation assume that “in the absence of central bank policies, the economy would achieve an equilibrium.” As one such critic, I do not share the assumption claimed, since “equilibrium” in an innovative and enterprising economy never exists. As the great Joseph Schumpeter said: “Capitalism not only never is, but never can be, stationary.” It is always in disequilibrium, heading someplace else into an unknowable future.

Without doubt, central banks are very useful to finance panics and busts. They are also good at monetizing budget deficits to finance the government of which they are a part. Other than that, pace Mr. Wolf, their capabilities are not that impressive.

Puerto Rico: Storms and savings

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

FHFA’s g-fee calculation ignores the law

Published in American Banker.

In a recent report to Congress, the Federal Housing Finance Agency once again failed to satisfy a fundamental legal requirement. This is a requirement that the FHFA keeps ignoring, apparently perhaps because it doesn’t like it. But to state the obvious, the preferences of a regulatory agency do not excuse it from complying with the law.

The law requires that when the FHFA sets guarantee fees for Fannie Mae and Freddie Mac, the fees must be high enough to cover not only the risk of credit losses, but also the cost of capital that private-sector banks would have to hold against the same risk. This is explicitly not the amount of capital that Fannie and Freddie or the FHFA might think would be right for themselves, but the cost of the capital requirement for regulated private banks.

This requirement, created by the Temporary Payroll Tax Cut Continuation Act of 2011, was clear and unambiguous. The law mandated a radical new approach to setting, increasing and analyzing Fannie and Freddie’s g-fees, based on a reference to the private market. In setting “the amount of the increase,” the law said, the FHFA director should consider what will “appropriately reflect the risk of loss, as well as the cost of capital allocated to similar assets held by other fully private regulated financial institutions.”

In other words, the director of the FHFA is instructed to calculate how much capital fully private regulated financial institutions have to hold against mortgage credit risk, the required return on that capital for such private banks and therefore the cost of capital for private banks engaging in the same risk as Fannie and Freddie. This includes the credit losses from taking this risk and operating costs, both of which must be added the private cost of capital. The net sum is the level of Fannie and Freddie’s guarantee fees that the FHFA is required to establish.

The law also further requires the FHFA to report to Congress on how Fannie and Freddie’s g-fees “met the requirements” of the statute – that is, how they included the cost of capital of regulated private banks.

However, if you read the FHFA’s October 2017 report on guarantee fees, nowhere in it will you find any discussion — not a single word — about private banks’ cost of capital for mortgage credit risk. There is the same amount of discussion — zero — about how that private cost of capital enters the analysis and calculation of Fannie and Freddie’s required g-fees. Yet this is the information and annual analysis that Congress demanded of the FHFA.

Why has the agency failed to fulfill its legal obligation?

A reasonable hypothesis is that the FHFA doesn’t like the answer that results when this analysis and calculation are performed, so it is tap-dancing instead of answering the question and implementing the answer. In short, the calculation required by the law results in much a higher level of g-fees than at present. This reflects the whole point of the statutory provision — to make the private sector competitive and to take away Fannie and Freddie’s subsidized cost of capital and the distortions it creates.

The FHFA certainly understands the importance of this issue. Its report clearly sets out the components of the calculation of g-fees, saying, “Of these components, the cost of holding capital is by far the most significant.” That would be the perfect section to add the required analysis of the cost of capital for regulated private financial institutions and to use that to calculate the legally required g-fees.

But instead, the report treats us to a discussion of how “each [government-sponsored enterprise] uses a proprietary model to estimate … the amount of capital it needs.” The mortgage companies use “models to estimate the amount of capital and … [subject] that estimate to a target rate of return” to “calculate a model guarantee fee.”

That’s nice, but here are the two questions that must be answered:

• What is the cost of capital for a private regulated financial institution to bear the same credit risk as Fannie and Freddie?

• What is the g-fee calculation based on that cost of capital for private institutions?

The FHFA has not answered these questions. Instead, the agency said it had “found no compelling economic reason to change the overall level of fees.” How about complying with the law?

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

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

Giant ‘QE’ gamble: How will it end?

Published in the Library Of Law And Liberty.

The Federal Reserve made a colossal gamble with its so-called “Quantitative Easing” or “QE,” which is simply a euphemism for its $4.4 trillion binge of buying long-term bonds and mortgages. Its big bid for long bonds, along with parallel programs undertaken by other members of the international fraternity of central banks, has artificially suppressed long-term interest rates, and has deliberately fostered asset-price inflations in bonds, stocks and houses.

Will this gamble pan out?

The Fed now intends to reduce its buying and slowly shrink its portfolio by letting bond maturities and mortgage prepayments exceed new purchases. As its big bid is reduced, will the asset-price inflations it fostered end well in some kind of soft landing, or will they end badly in an asset-price deflation? Will the Fed be able to take its stake off the table and go away a winner—or will it ultimately lose?

Nobody knows, including the Fed itself. The officials who run the institution are guessing, like everybody else—and hoping.

In particular, they are hoping that by making the unwinding of the gamble very slow, with emphatic announcements well in advance, they will mitigate the potential negative price reactions in bond, stock and housing markets. Well, maybe this strategy will work—or maybe not. The behavior of complex financial systems is fundamentally uncertain. As Nobel laurate economist Robert Shiller said in a recent interview with Barron’s, “We don’t know what will happen in this unwinding.”

Shiller is right. But who are the “we” who don’t know? In addition to himself, “we” includes Nobel laureates, all other economists, financial market actors, regulators, the Federal Reserve, all the other central banks, and you, honored reader and me.

With its buying in the trillions, the Fed made asset prices go up and long-term interest rates go down, as intended. Simply reversing its manipulation by selling in the trillions, turning its big bid in the market into a big offer, would surely make asset prices go down and interest rates go up, perhaps by a lot. This outcome the Fed wants at all costs to avoid. So it is not selling any of its bonds or mortgages. The plan is to stop buying as much, a little at a time, while continuing the steady stream of rhetorical assurances. We don’t know, and Fed officials don’t know, if this will work as hoped.

The Fed did not strive to inflate asset prices as an end in itself, of course. The theory was that this would result in a “wealth effect,” which would in turn accelerate economic growth. Did it? Would economic growth have been worse or better without QE? Were the risks entailed in the inflation of asset prices worth whatever additional growth it may or may not have induced? In fact, U.S. real gross domestic product growth over the many years of QE has been generally unimpressive.

“Evaluating the effects of monetary policy is difficult,” as Stephen D. Williamson, an economist with the Federal Reserve Bank of St. Louis, writes in a new article in The Regional Economist, and “with unconventional monetary policy, the difficulty is magnified.” Williamson adds that “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case the QE is actually detrimental.” He points out that Canada without QE had better growth than the United States with it. As usual in macroeconomics, you can’t prove it one way or the other.

The Fed’s effect on asset prices seems clear, however. As one senior investment manager recently said about the price of the U.S. Treasury 10-year note, “What it tells you is the amount of distortion that quantitative easing is creating.” How much of that distortion is going to reverse itself?

With QE, the Fed has been practicing “asset transformation,” according to Williamson. That is economics-speak for borrowing short and lending long. The Fed is funding its long-term bonds and very long-term mortgage securities with short-term, floating-rate deposits. This is one of the most classic of all financial speculative gambles. In other words, the Fed has created a balance sheet for itself that looks just like a 1980s savings and loan, and has become, in effect, the biggest savings and loan in history.

Williamson reasonably asks if the Fed has any competitive advantage at holding such a speculative position, and doubts that it does. However, I believe the Fed does have two unique advantages in this respect: control of its own accounting, and lack of penalties for insolvency. The Fed uniquely sets its own accounting standards for itself, and Fed officials have decided never to mark its securities portfolio to market. More remarkably, even if it should realize losses on the actual sale of securities, officials have decided not to let such losses reduce its reported capital, but to carry the required debits to a hokey intangible asset account. No one else would be allowed to get away with that.

Suppose hypothetically that realized losses on the Fed’s giant portfolio come to exceed its small capital (less than 1 percent of the portfolio). Even then, it is not clear whether that would affect the Fed. Many economists argue that insolvency doesn’t matter if you can print the money to pay your obligations. Nonetheless, it would be embarrassing to the Fed to be technically insolvent, and its QE-unwind program is designed to avoid any realized losses while not disclosing any mark-to-market losses.

Although the GDP growth effects of the QE gamble are uncertain, it certainly has succeeded in two other ways besides inducing asset-price inflation: in robbing savers, and in allocating credit. By forcing real interest rates on conservative savings to be negative, the Fed has transferred billions of dollars of wealth from savers to borrowers—especially to the government, the biggest borrower of all, and to leveraged speculators. It has meanwhile assured the aggrieved savers that they are really better off being sacrificed for the greater good.

QE also means the Fed allocated trillions in credit to its favored sectors: housing and the government. In housing, this resulted in national average house prices inflating back up to their bubble levels, obviously making them less affordable. For the government, the Fed made financing its deficits cheaper and easier, and demonstrated once again that the real first mandate of any central bank is financing, as needed, the government of which it is a part.

As the Fed moves to unwind its big QE gamble, what will happen? It, and we, will find out by experience.

Taxpayers shouldn’t be asked to pay for Fannie and Freddie’s risk exposure

Published in The Hill.

As the old Washington saying goes, “When all is said and done, more is said than done.” This certainly applies to the years of congressional debates about how to reform Fannie Mae and Freddie Mac. They are dominant forces in the huge American mortgage market, operating effectively as arms of the U.S. Treasury.

Can you ever protect the taxpayers against the risk of Fannie and Freddie? In their current form, with virtually zero capital — and soon literally zero capital — they are and will continue to be utterly dependent on the taxpayers’ credit card for their entire existence. Every penny of their income depends on the credit support of the taxpayers.

Since 2008, Fannie and Freddie have been a $5 trillion risk turkey, roosting in the dome of the Capitol. The members of Congress are unhappy and greatly irritated by its presence, but didn’t know how to get rid of this embarrassment their predecessors created.

Of course, even before their humiliating government conservatorship, Fannie and Freddie traded every minute on the credit of the U.S. Treasury and were always were a risk to the taxpayers. Although in those days they had some positive capital of their own, it was not very much capital relative to their risks. Without their free use of the taxpayers’ credit card, they would have been much smaller, much less leveraged, much less profitable and much less risky.

Once the Congress had set up Fannie and Freddie as government-sponsored risk takers, was there any way to remove the taxpayers’ risk exposure? The historical record offers little hope. No matter what any Treasury secretary or any other politician says, or even what any legislation provides, the global debt markets will simply not believe that two institutions representing half of all U.S. mortgage credit and sponsored by the U.S. government will not be bailed out by the Treasury. And the debt markets will be right.

In 1992, while revising the legislation that governs Fannie and Freddie, Congress solemnly tried to wiggle out of the problem. It added to the statutes of the United States a provision entitled, “Protection of Taxpayers Against Liability” for Fannie and Freddie’s debts. This “protection” is still on the books, although it did not provide any protection to the taxpayers.

Title XIII, “Government-Sponsored Enterprises,” of the Housing and Community Development Act of 1992, Section 1304, pronounced:

This title may not be construed as obligating the Federal Government, either directly or indirectly, to provide any funds to the Federal Home Loan Mortgage Corporation [Freddie], the Federal National Mortgage Association [Fannie], or the Federal Home Loan Banks, or to honor, reimburse or otherwise guarantee any obligation…

But naturally, when push came to shove in the housing-finance crisis, the federal government, directly and indirectly, did fully honor, entirely reimburse and effectively guarantee all the obligations of Fannie and Freddie anyway.

The statute went on to say:

This title may not be construed as implying that any such enterprise or bank, or any obligations or securities of such enterprise or bank, are backed by the full faith and credit of the United States.

Nice try, but no cigar. All the bond markets in the world knew that this fine language notwithstanding, all Fannie and Freddie’s obligations were in fact backed by the credit of the United States, as they still are and will continue to be.

What do you suppose the members of Congress who wrote and voted for those provisions were really thinking? Did they foolishly imagine that Fannie and Freddie could never actually get in financial trouble? Were they simply cynical, knowing that their provisions would not in fact protect the taxpayers? Or did at least some members of Congress truly believe they were doing something meaningful? One wonders.

The “protection of taxpayers” included in the 1992 act obviously failed. Can Congress avoid taxpayer risk from Fannie and Freddie next time? It seems unlikely in the extreme. But you might take a number of steps to reduce the inevitable taxpayer risk, including much higher capital requirements for Fannie and Freddie than heretofore, and charging a meaningful fee for the use of the taxpayers’ credit card, which will cause them to use it less.

There is one additional key lesson: government-sponsored enterprises, if they are created, should never, never be given perpetual charters like those given to Fannie and Freddie. If they were instead given limited life charters, say for 20 years (like First and Second Banks of the United States), Congress could at least periodically consider whether it would like to end the taxpayer risk game by not renewing the charter.

Economics and politics are always mixed together

Published in the Financial Times.

Sir, Mark Hudson (Letters, Oct. 3) is certainly correct that “economics is not a science.” Nothing could be clearer than that! But he exaggerates in asserting that economics is “a subsidiary branch of politics.” Rather, economics and politics are in actual experience always mixed together. The old term “political economy” captures the reality nicely.

Mr. Hudson is also right that the tenets of political economy are inevitably based on some psychological generalisation — going back to Chapter 2 of The Wealth of Nations and “a certain propensity in human nature . . . to truck, barter, and exchange.” For this propensity, we should be ever grateful.

Why is Richard Cordray voting on FSOC?

Published by the R Street Institute.

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

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

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

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

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

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

Has Canada’s housing bubble finally reached bursting point?

Published by the R Street Institute.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

How does the United States rank in homeownership?

Published by the R Street Institute.

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

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

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

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

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

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

 Sources: Government statistics by country

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

Treasury should not bail out Fannie and Freddie’s subordinated debt

Published in Economics 21.

When the U.S. Treasury bailed out Fannie Mae and Freddie Mac in 2008, holders of $13.5 billion in Fannie’s and Freddie’s subordinated debt—debt paid off after senior debt is repaid—were completely protected. Instead of experiencing losses to which subordinated lenders can be exposed when the borrower fails, they got every penny of scheduled payments on time.

The structural reasons for the unusual occurrence should be carefully examined by the Treasury to avoid its repetition.

This outcome was the exact opposite of the academic theories that had for years pushed subordinated debt as the way to create market discipline for financial firms that benefit from government guarantees on their senior obligations. In the event, Fannie’s and Freddie’s subordinated debt produced, and its holders experienced, zero market discipline. So much for the academic theories, at least as applied to government-sponsored enterprises.

“Perhaps surprisingly,” a Federal Reserve 2015 post-mortem study of the bailout says, “the two firms maintained their payments on the relatively small amount of subordinated debt they had.”

In terms of the theory that subordinated debt will be fully at risk, this is very surprising. As economist Douglas Elmendorf, former director of the Congressional Budget Office, wrote in criticism of this bailout detail, “The crucial role of subordinated debt for any company is to create a group of investors who know they will lose if the company fails.” But the Fannie and Freddie bailout was structured so that it didn’t happen.

The $13.5 billion is certainly a material number. While small relative to Fannie’s and Freddie’s immense liabilities, it was a significant part of their overall capital structure. In June 2008, Fannie and Freddie combined reported common equity of $18.3 billion and preferred stock of $35.8 billion, giving them, with the subordinated debt, total capital of $67.6 billion. The subordinated debt was thus 20 percent of reported total capital at that point, but it did not carry out its function as capital.

“In fact, subordinated debt is part of regulatory capital since the Basel I Accord (1988) and was always meant to absorb losses,” says a 2016 study for the European Parliament. Fannie and Freddie were not subject to the Basel Accord, but this nicely states the general theory.

“Market discipline is best provided by subordinated creditors,” wrote banking expert Paul Horvitz in 1983. A Federal Reserve study group produced the report “Using subordinated debt as an instrument of market discipline” in 1999. In 2000, Fed economists considered “a number of regulatory reform proposals aimed at capturing the benefits of subordinated debt” and concluded that it would indeed provide market discipline. “Ways to enhance market discipline… focused in large part on subordinated debt,” as a study by Fannie and Freddie’s regulator observed. Consistent with these theories, in October 2000, Fannie and Freddie committed to begin issuing publicly traded subordinated debt, and did. But bailout practice turned out to be inconsistent with the theory.

The Treasury knew precisely what it was doing for the subordinated debt holders. “These agreements support market stability,” said then-Treasury Secretary Henry Paulson’s Sept. 7, 2008 statement about the bailout, “by providing additional security and clarity to GSE debt holders—senior and subordinated—and support mortgage availability by providing additional confidence to investors…etc.” Treasury slipped that “and subordinated” in there in the middle of the paragraph, without any further comment or explanation.

“Under the terms of the agreement,” Paulson continued, “common and preferred shareholders bear losses ahead of the new government senior preferred shares.” But the government’s new senior preferred shares would by definition bear losses ahead of the subordinated debt. Why have the taxpayers be junior to the subordinated debt?

It appears that the Treasury was trapped as an unintended result of the Fannie and Freddie reform legislation of earlier in that bailout year, the Housing and Economic Recovery Act of 2008. A major battle in the creation of that act was to include the potential for receivership for Fannie and Freddie in the event of their failure—so, in theory, the creditors would have to consider the possibility of loss. Overachieving, Congress in HERA Section 1145 made receivership not just possible, but mandatory, in the event that Fannie and Freddie’s liabilities exceeded their assets and the regulator confessed it.

But in the midst of the financial crisis, the last thing Treasury wanted was a receivership, because the last thing they it wanted was to panic the creditors around the world by the prospect that they would be taking losses on Fannie’s and Freddie’s trillions of dollars of senior debt and MBS. Instead, they wanted to convince these creditors that there would be no losses. Treasury theoretically could have arranged to guarantee all the senior debt and MBS formally, but that would have forced the U.S. government to admit on its official books that it had an additional $5 trillion of debt. That would have been honest bookkeeping, but was an obvious nonstarter politically.

Once having decided against receivership, Treasury had to put the taxpayers’ money in as equity. Officials calculated that if Fannie and Freddie’s net worth were zero, their liabilities would not exceed their assets, so kept putting in enough new equity to bring the equity capital to zero. But once they had done that, there was no way to give the subordinated debt a haircut.

“We have been directed by FHFA to continue paying principal and interest on our outstanding subordinated debt,” Fannie reported. The covenants of the subordinated debt provided that if it were not being paid currently, no dividends could be paid by Fannie and Freddie—that would have included dividends on the Treasury’s senior preferred stock.

One reform idea, the mandatory receivership, had knocked out the previous reform idea that subordinated debt must take losses, and neither happened.

So financial theory notwithstanding, Fannie and Freddie’s subordinated debt achieved nothing. Its holders got a premium yield but were fully protected by the U.S. Treasury. The purchasers had made a very good bet on the financial behavior of governments when confronted with the failings of government-sponsored enterprises.

The 10th year since the bailout of Fannie and Freddie, and of their subordinated debt, will begin in September. Will Treasury now begin to address the structural issues?

How big a bank is too big to fail?

Published by the R Street Institute.

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

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

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

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

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

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

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

Just how big is too big to fail?

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

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

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

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

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

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

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

Sovereign debt has a pretty poor record

Published in the Financial Times.

Sir, “Nations have historically been the world’s best credits,” says your report “Supranational debt issuance on a high” (Aug. 10). This sanguine view is contradicted by Lex in the same issue: “the ‘doom loop’ between sovereign bonds and banks … remains intact” (“Sovereign debt/banks: risk, waiting”). One of these statements must be wrong, and the wrong one is the former.

In fact, the history of sovereign debt is pretty poor. Carmen Reinhart and Kenneth Rogoff, in This Time is Different, count over the past two centuries 250 defaults on external sovereign debt, which have of course continued up to the present. Sovereign debt created a financial crisis in Europe in this century; in Russia, Asia and Mexico in the 1990s; and a global debt crisis in the 1980s. There were vast sovereign defaults in the 1930s.

Max Winkler, in his Foreign Bonds: An Autopsy, summed up the history as follows: “The history of government loans is really a history of government defaults.

Fannie and Freddie face the moment of truth on their taxpayer bailouts

Published in The Hill.

Almost nine years ago, in September 2008, Fannie Mae and Freddie Mac were broke and put into government conservatorship by the Federal Housing Finance Agency. Less than two months before, the regulator had pronounced them “adequately capitalized.” As everybody knows, the U.S. Treasury arranged to bail them out with a ton of taxpayer money, ultimately totaling $187.5 billion, in order to get their net worth up to zero.

The original form of the bailout was senior preferred stock with a 10 percent dividend. By agreement between two parts of the government, the FHFA as conservator and the Treasury, the dividend was changed starting in 2013 from the original 10 percent to essentially 100 percent of the net profit of the two companies, whatever that turned out to be, in this notorious “profit sweep.”

By now, under the revised formula, Fannie and Freddie have paid in dividends to the Treasury $276 billion in total. That sounds like a lot more than $187.5 billion, a point endlessly repeated by the speculators in Fannie and Freddie’s still-existing common and junior preferred stock. Does this mean that Fannie and Freddie have economically, if not legally, paid off the Treasury’s investment? Nope. Not yet. But almost.

Let us suppose—which I believe to be the case—that the original 10 percent is a reasonable rate of return on the preferred stock for the taxpayers, who in addition got warrants for 79.9 percent of Fannie and Freddie’s common stock with an exercise price that rounds to zero. The 10 percent compares to the interest rate of 2 percent or so on 10-year Treasury notes and is greater than the average return on equity of 8 percent to 9 percent for banks in recent years.

The question is: When would all the payments by Fannie and Freddie to the Treasury constitute first a 10 percent annual yield on the preferred stock and then have been sufficient to retire all its par value with the cash that was left over?

This is easy to calculate. We lay out all the cash flows, all the investment that went into Fannie and Freddie from the Treasury, and all the dividends they paid to the Treasury, and calculate the cash-on-cash internal rate of return. When the internal rate of return gets to 10 percent, the economic payoff will have been achieved. I call this the “10 percent moment.”

As of the second quarter of 2017, the internal rate of return is 9.68 percent, so the 10 percent moment is close. If Fannie and Freddie pay the third quarter dividends they have projected, on a combined basis, the 10 percent moment will arrive in the third quarter of this year. The internal rate of return will have reached 10.02 percent.

However, viewing Fannie and Freddie separately, it is slightly more complex. Fannie is at 9.36 percent and should get to 10 percent by the fourth quarter of this year. Freddie has already made it, with an internal rate of return of 10.11 percent as of the second quarter of 2017.

At the 10 percent moment, let’s say the end of 2017, the Treasury could very reasonably and fairly consider its senior preferred stock as fully retired and agree to amend the agreements accordingly. Treasury should then also exercise all its warrants, to assure its 79.9 percent ownership of any future retained earnings and of whatever value the common stock may develop, guaranteeing the taxpayers the equity upside which was part of the original deal, and also assuring its voting control.

At that point, should it develop, the capital of Fannie and Freddie would still be zero. In this woefully undercapitalized state, they would still be regulated accordingly, and still be utterly dependent on the Treasury. They should begin immediately to pay a fee to the Treasury for its effective guaranty of their obligations. This fee should be charged on their total liabilities and be equivalent to what the Federal Deposit Insurance Corp. would charge a large bank with their level of capital for deposit insurance — for starters, a bank with zero capital.

There are a few other requirements for this new deal for Fannie and Freddie. They should immediately be designated as the large and “systemically important financial institutions” they so obviously are by the Financial Stability Oversight Board. The massive systemic risk they represent should be supervised by the Federal Reserve, and their minimum capital requirement should be set at a 5 percent leverage capital ratio.

They must immediately start complying with the law that sets their guarantee fees at the level which a private financial institution would have to charge to cover its cost of capital. This requirement for guarantee fees is clearly established in the Temporary Payroll Tax Cut Continuation Act of 2011. Finally, they should pay the relevant state and local corporate income taxes, like everybody else.

Under these conditions, with the profit sweep and the senior preferred stock gone, but also with most of their economic rents and special government favors removed, Fannie and Freddie would have a reasonable chance to see if they could become successful competitors. They would still be too big to fail, of course, but they would be paying a fair price for the privilege.

Virgin Islands follow Puerto Rico into the debt day of reckoning

Published by the R Street Institute.

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

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

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

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

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

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

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

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

The Fed should be required to provide Congress a regular savers’ impact analysis

Published by the R Street Institute.

Mr. Chairman, Ranking Member Moore 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 the banking system, including studying the role of central banks in both normal times and crises. I was president and CEO of the Federal Home Loan Bank of Chicago for 12 years, then worked on financial policy issues at the American Enterprise Institute, and moved to R Street last year.

I believe this hearing is examining a critical issue:  What is the Federal Reserve doing to savers, notably including retirees?

To begin with my conclusion: Congress should require a savers’ impact analysis from the Federal Reserve at each discussion of the Fed’s policies and plans with the committees of jurisdiction. Under the CHOICE Act, this would be quarterly. This analysis should quantify, discuss and project for the future the effects of the Fed’s policies on savings and savers, so these effects can be explicitly considered along with other relevant factors.

Savings are essential to aggregate long-term economic progress and to personal and family financial well-being and responsibility. However, the American government’s policies, including those of the Federal Reserve, have subsidized and overemphasized the expansion of debt and have forgotten savings. The old theorists of savings and loans, to their credit, were clear that “savings” came first, and made possible the “loans.” Our current national policy could be described, instead of “savings and loans,” as “loans and loans.”

There is no doubt that among the very important effects of Federal Reserve actions from 2008 to now have been the expropriation of American savers, which has been especially painful for many retirees. This has been done through the imposition of negative real interest rates on savings during the remarkably long period of nine years, from 2008 to now. Negative real interest rates would be expected from the central bank in crisis mode, but it is a long time since that was over. The financial crisis ended in spring 2009, and the accompanying recession ended in June 2009, eight years ago. House prices bottomed in 2012—five years ago—and have reinflated rapidly. As we speak, they are back up over their bubble peak. The stock market has been on a bull run since 2009 and is at all-time highs. A logical question is: what is the Fed doing, still forcing negative real interest rates on savers at this point?  The Fed should be required to explain to Congress, with quantitative specifics, what it has done, what it thinks it is doing and what it plans to do, in this respect.

Consumer price inflation year-over-year in May 2017 was 1.9 percent. The Federal Reserve endlessly announces to the world its intention to create perpetual inflation of 2 percent, which is equivalent to a plan to depreciate savings at the rate of 2 percent per year.

Against that plan, what yield are savers getting?  The June 2017 Federal Deposit Insurance Corp. national interest rate report shows that the average interest rate on savings accounts is 0.06 percent. The national average money market deposit account rate is 0.12 percent, according to Bankrate, and the average three-month jumbo certificate of deposit 0.11 percent. Savers can do better than the averages by moving their money to the higher-yielding banks and instruments, but in no case can they get their yield up to anywhere near the inflation rate or the Fed’s annual inflation target. In the wholesale secondary market, for example, 90-day Treasury bills are yielding about 1 percent. And savers have to pay income taxes even on these paltry yields, making the negative real return worse.

Thrift, prudence and self-reliance, which should be encouraged, are instead being discouraged.

The CHOICE Act would require in general that the Federal Reserve be made more accountable, as it should be. No government entity, including the Fed, should be exempt from the constitutional design of checks and balances. To whom is the Fed accountable?  To the Congress, of course, which created it, can abolish or redesign it and must oversee its tremendously powerful and potentially dangerous activities in the meantime. The savers’ impact analysis is fully consistent with the provisions of the bill.

The CHOICE Act would also require that new regulations provide “an assessment of how the burden imposed…will be distributed among market participants.” This excellent principle should also be applied to the Fed’s reports to Congress of what they are doing. In particular, the Fed has been taking money away from savers in order to give it to borrowers. This benefits borrowers in general, but notably benefits highly leveraged speculators in financial markets and real estate, since it has made financing their leverage close to free. Even more importantly, it benefits the biggest borrower of all by far—the government itself. Expropriating savers through the Federal Reserve is a way of achieving unlegislated taxation.

By my estimate, the Federal Reserve has taken since 2008 about $2.4 trillion from savers. The specific calculation is shown in the table at the end of this testimony. The table assumes savers could invest in six-month Treasury bills, then subtracts from the average interest rate on them the inflation rate, giving the real interest rate, which on average is -1.32 percent. This rate is then compared to the normal real interest rate, based on the 50-year average, giving us the gap the Fed has created between the actual real rates to savers and the historically normal real rates. This gap, which has averaged 2.97 percent, is multiplied by the total household savings. This gives us, by arithmetic, the total gap in dollars.

Let me repeat the answer: $2.4 trillion.

The Federal Reserve, I imagine, wishes to defend its sacrifice of the savers as a necessary evil, “collateral damage” in the course of pursuing the greater good. But there can be no doubt that taking $2.4 trillion from some people and giving it to others is a political decision and a political act. As a clearly political act, it should be openly and clearly discussed with the Congress, quantifying the effects on various sections of savers, borrowers and investors, and analyzing the economic and social implications.

The effects of the creation and manipulation of money pervade society, transfer wealth among various groups of people and can cause inflations, asset-price inflations and disastrous bubbles, which turn into busts. The money question is inherently political—it is political economics and political finance we are considering. Therefore, in developing and applying the theories and guesses with which it answers the money question, the Federal Reserve needs to be accountable to the Congress.

If you believed that the Federal Reserve had superior knowledge and insight into the economic and financial future, you could plausibly conclude that it should act as a group of philosopher-kings and enjoy independent power over the country. But no one should believe this. It is obvious that the Fed is just as bad at economic and financial forecasting as everybody else is. It is unable to predict the results of its own actions consistently. There is no evidence that it has any special insight. This is in spite of (or perhaps because of) the fact that it employs hundreds of Ph.D. economists, can have all the computers it wants (having no budget constraint) and can run models as complicated as it chooses.

Moreover, the notion of philosopher-kings is distinctly contradictory to the genius of the American constitutional design.

Seen in a broader perspective, the Federal Reserve is an ongoing attempt at price fixing and central planning by committee. Like all such efforts, naturally, it is doomed to recurring failure. It cannot know what the right interest rate is, and it cannot know how much of the losses of the bubble it is right to extract from savers.

Since the Fed cannot operate on knowledge of the future, it must rely on academic theories, in addition to flying by the seat of its pants. Its theories and accompanying rhetoric change over time and with changing personalities. Grown-up, substantive discussions with the Congress about which theories it is applying, what the alternatives are, who the winners and losers may be and what the implications are for political economy and political finance—just as the CHOICE Act suggests—would be a big step forward in accountability. Of course, we need to add a formal savers’ impact analysis.

The table calculating the cost imposed on savers by the Fed’s nine years of negative real interest rates is on the next page.

Thank you again for the chance to share these views.

Presentation to IUHF World Congress

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

Fed is far too dangerous to be unaccountable

Published in the Financial Times.

I would replace the headline of your editorial “An independent Fed had never been more crucial” (June 16) with a different thought: “Making the Fed accountable has never been more crucial.” The Federal Reserve is the most dangerous financial institution in the world, with an immense potential for disastrous mistakes. How can anyone believe that, as the discretionary manipulator of the world’s dominant fiat currency, it should be guided solely by the debatable and changing theories of a committee of economists? How can such a committee insist that it should be an independent power? Much wiser was former Fed chairman Marriner Eccles, the leader of the restructuring of the Fed in 1935, who referred to the Fed as “an agency of Congress.”

To qualify as an independent philosopher-king you have to be possessed of superior knowledge, but it is obvious that the Fed has none. It is equally as bad at forecasting the economic and financial future as everybody else. There is no evidence that it has any kind of superior insight. It does not know what the results of its own actions will be. That, combined with its capacity for damage, means it needs to be be made accountable in a system of governmental checks and balances, which is consistent with the American constitutional order.

The Fed needs to hold regular grown-up discussions with the Congress about what it thinks it is doing, what theories it is trying to apply, how its ideas are changing and which sectors are being hurt or helped by its actions. Your editorial worries about the effects of the politics such discussions might entail, but everything about the money question is, has been, and will be, political.