Alex Pollock speaks at the House Financial Services Committee’s Subcommittee on Monetary Policy and Trade

R Street Distinguished Senior Fellow Alex J. Pollock’s opening statement to the House Financial Services Committee’s Subcommittee on Monetary Policy and Trade, at their Jan. 10, 2018 hearing “A Further Examination of Federal Reserve Reform Proposals.”

Testimony of Alex J. Pollock: Federal Reserve accountability and structure

Published by the R Street Institute.

Testimony of

Alex J. Pollock

Distinguished Senior Fellow

R Street Institute

Washington, DC

To the Subcommittee on Monetary Policy and Trade

Of the Committee on Financial Services

United States House of Representatives

Hearing on “A Further Examination of Federal Reserve Proposals”

January 10, 2018

Federal Reserve Accountability and Structure

Mr. Chairman, Ranking Member Moore, 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.  As part of my many years of work in banking and on financial policy issues, I have studied the role and history of central banks, including authoring numerous articles, presentations and testimony regarding the Federal Reserve.  Before joining R Street, I was a resident fellow at the American Enterprise Institute 2004-2015, and the president and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

The proposals under consideration today are all parts of a timely and fundamental review of America’s central bank.  As Congressman Huizenga has rightly said, “With the Federal Reserve having more power and responsibility than ever before, it is imperative the Fed…become more transparent and accountable.”

From James Madison, who wanted to protect the new United States from “a rage for paper money,” to now, money has always been and is an inherently political issue, involving many questions which are not amenable to technocratic solutions, but require judgments about the general welfare. For example, Congress instructed the Federal Reserve in statute to pursue “stable prices.”  But the Federal Reserve decided on its own that the term “stable prices” means perpetual inflation–at the rate of 2% a year.  This reasonably could be viewed as a contradiction in terms, but certainly raises the question: Who should have the power to make such judgments?  The Fed by itself?

Under the current monetary regime, with the Fed as the creator of the world’s dominant fiat currency, busy manipulating money, credit, and interest rates, we have experienced the great inflation of the 1970s, the financial crises of the 1980s, and the bubbles and financial crises of the 1990s and 2000s.  (The outcome of the bubbles of the 2010s is not yet known.)

The problems are not due to bad intentions or lack of intelligence, but to the unavoidable uncertainty of the economic and financial future.  Since this future is unknown and unknowable, the Fed is incapable of knowing what the results of its own actions will be. It will inevitably be faced with “conundrums” and “mysteries.”   Monetary manipulation always involves judgments, which can also be called guesses and gambles.  How should the Fed be accountable for its various judgments, guesses and gambles, and to whom?  And at the same time, how should it be accountable for how it spends the taxpayers’ money and how it makes decisions?

I believe there are four general categories which should organize our consideration of today’s draft bills.  These are, along with the related drafts:

1. Accountability of the Federal Reserve

-Bring the Fed into the appropriations process

-Define the blackout period

1. Checks and balances appropriate to the Fed

-Vice Chairman for Supervision’s reports to Congress

-Disclosures of highly paid employees and financial interests

1. Centralized vs. federal elements in the Fed’s structure

-Revise the membership of the Federal Open Market Committee

-FOMC to establish interest rates on deposits with the Fed

-Modify appointment process for presidents of Federal Reserve Banks

1. Dealing with uncertainty

-Staff for each Fed governor

Accountability 

The power to define and manage money is granted by the Constitution to the Congress.  There can be no doubt that the Federal Reserve is a creature of the Congress, which can instruct, alter or even abolish it at any time.   Marriner Eccles, the Chairman of the Fed after whom its main building is named, rightly described the Federal Reserve Board as “an agency of Congress.”  As the then-president of the New York Federal Reserve Bank testified in the 1960s, “Obviously, the Congress which has set us up has the authority and should review our actions at any time they want to, and in any way they want to.”  He was right, and that is the true spirit of “audit the Fed.”

To whom is the Federal Reserve accountable?  To the Congress, the elected representatives of the People, for whom the nature and potential abuse of their money is always a fundamental issue.

It is often objected that such accountability would interfere with the Fed’s “independence.”  In my opinion, accountability is an essential feature of every part of the government, which should never be compromised.  If accountability interferes with independence, so much the worse for independence.

In any case, the primary central bank independence problem is independence from the executive, not from the Congress.  The executive naturally wants its programs and especially its wars financed by the central bank as needed.  This natural tendency goes far back in history.  The deal which created the Bank of England was its promise to lend money for King William’s wars on the continent.  Napoleon set up the Bank of France because “he felt that the Treasury needed money, and wanted to have under his hand an establishment which he could compel to meet his wishes.”

The Federal Reserve first made itself important by helping finance the First World War.  To finance the Second, as a loyal servant of the Treasury, the Fed bought all the bonds the Treasury needed at the constant rate of 2 ½%.  The Fed’s desire to end this deal with the Treasury in 1951, six years after the world war ended, gave rise to a sharp dispute with the Truman administration.  That administration was by then having to finance the Korean War, a war that wasn’t going so well.  For his role in making the Fed more independent of the Treasury, Fed Chairman William McChesney Martin was considered by Truman as a “traitor.”  Two decades later, Fed Chairman Arthur Burns was famously pressured by President Nixon to match monetary actions to the coming election.  Burns was marvelously quoted as saying that if the Fed doesn’t do what the President wants, “the central bank would lose its independence.”

The Federal Reserve Reform Act of 1977 and the Humphrey-Hawkins Act of 1978 were attempts under Democratic Party leadership to make the Fed more accountable to Congress.  I think it is fair to say these attempts were not successful, but instead led principally to scripted theater.

The most fundamental power of the legislature is the power of the purse.  If Congress wants to get serious about Federal Reserve accountability, it could make use this essential power.  Every dollar of Fed expense is taxpayer money, which would go to the Treasury’s general fund if not spent by the Fed on itself.  Since it is taxpayer money, the proposal of one draft bill to subject it to appropriations like other expenditures of taxpayer funds makes sense.  The draft limits the expenditures so subject to those for non-monetary policy related costs.  In fact, I think it would be fine to subject all Fed expenses to appropriations.

A second draft bill defines blackout periods for communications from the Fed, including communications to Congress, around Federal Open Market Committee meetings.  The draft would precisely set the blackout period as a week before and a day after the relevant meeting.  This certainly seems a reasonable definition.

Checks and Balances

Checks and balances are essential to our Constitutional government, and no part of the government, including the Federal Reserve, should be exempt from them.  But how should the Fed, so often claiming to be “independent,” fit into the system of checks and balances?

The required appropriation of some or all of the Fed’s expenses would be one way.  Another way is additional required reporting regarding its regulatory plans and rules, since the Fed has amassed huge regulatory power.  It tends to get more regulatory power after a crisis, no matter how great its mistakes and failings were beforehand, as it did after the last crisis, including getting a Vice Chairman for Supervision.

One draft bill requires that this Vice Chairman for Supervision, or others if the position is vacant, regularly report to Congress in writing and in person on “the status of all pending and anticipated rulemakings.”  Given the increase of the Fed’s regulatory power, especially its powerful role as the dominant regulator of “systemic risk,” this seems appropriate.

Another draft bill would require disclosures regarding highly paid Federal Reserve Board employees (those making more than a GS-15). The draft also would require disclosures of financial interests.  Federal Reserve actions and announcements are market moving events.  Addressing potential conflicts of interest is a standard policy.

Centralized vs. Federal Elements of the Fed’s Structure

The original Federal Reserve Act of 1913 tried to balance regional and central power.  Hence the name, “Federal Reserve System,” as opposed to a single “Bank of the United States.”  Carter Glass, one of the legislative fathers of the 1913 Act, it is said, liked to ask witnesses in subsequent Congressional hearings: Does the United States have a central bank?  The answer he wanted was “No, it has a federal system of reserve banks.”

This theory lost out in the Banking Act of 1935, when power in the Fed was centralized in Washington, as promoted by Marriner Eccles (who still knew, as noted above, that the Federal Reserve Board is “an agency of Congress”).

Centralization in the Fed reached its zenith with the elevation of the Fed Chairman to media rock star status, as in the title, “The Maestro.”  Some adjustment back to more dispersed power within the Fed arguably would make sense.  Three of the draft bills move in this direction.

The first would expand the membership of the Federal Open Market Committee to include the presidents of all the Federal Reserve Banks, instead of five of them at a time.  Since all the presidents already attend and participate in the discussions of the committee, the old voting rule does seem pretty artificial, especially since the Committee by and large operates on a consensus basis.  If some proposal of the Chairman and the Board of the Fed were so controversial that it was opposed by a super-majority of the presidents, such a proposal surely would deserve additional consideration rather than implementation under the old voting rules.

A second draft bill would make the FOMC responsible for the setting the interest rate on deposits with Federal Reserve Banks.  Since this interest rate has now become a key element of monetary policy, placing it with related monetary decisions is quite appropriate.

A third draft in this area would return the election of Federal Reserve Band presidents to the whole Board of Directors of the bank in question.  This reflects the principle that in every board of directors, all directors, however elected or appointed, have the same fiduciary responsibilities.  The Board of Governors will continue to appoint one-third of the directors of each Federal Reserve Bank.

Dealing with Uncertainty

I have asserted the essential uncertainty characterizing Federal Reserve decisions.  One approach to uncertainty is to promote intellectual diversification within the organization rather than a party line.

The staff of a body like the Fed naturally tends to be focused on serving a successful, powerful and dominant chairman.  This risks promoting group-think.  A well-known problem for the other Fed governors is lack of staff support for other directions they may want to investigate or pursue.

A good provision of the draft bills is “Office staff for Each Member of the Board of Governors,” which would provide each non-chairman governor at least two staff assistants.  It seems to me this might provide these other governors greater ability to pursue their own ideas, theories and research, and thus allow them to be more effective members of the Board and potentially provide greater intellectual diversification to the Fed’s thinking.

In sum, the Federal Reserve without question needs to be accountable to the Congress, be subject to appropriate check and balances, and be understood in the context of inherent financial and economic uncertainty.  It would benefit from rebalancing of centralized vs. federal elements in its internal structures.

Thank you again for the chance share these views.

Who is this ‘we’ that should manage the economy?

Published in Law & Liberty.

Adair Turner, the former Chairman of the British Financial Services Authority, has written a book about the risks and unpredictability of financial markets which has many provocative insights. It also has a frustrating blind spot about how government actions can and do contribute to financial crises.

Turner clearly addresses the failure of governments to understand what was going on as the crises of the 2000’s approached, including his notable mea culpa discussed below. But there is no discussion anywhere of the culpability of government actions which greatly contributed to inflating the bubble of housing debt and pumping up leverage on the road to the U.S. housing finance collapse.

The fateful history of Fannie Mae and Freddie Mac is not discussed, even though Turner rightly emphasizes how dangerous leveraged real estate is as a key source of financial fragility. Fannie and Freddie, with $5 trillion in real estate risk, do not rate an entry in the index.

The problems of student debt make it into a footnote in chapter six, where its rapid growth in the United States is observed, along with the judgment that “much of it will prove unpayable,” but it is not mentioned that this is another government loan program.

The role of government deposit insurance in distorting credit markets, so notable in the U.S. savings and loan collapse of the 1980s, is not considered. That instructive collapse gets one passing sentence.

The Federal Reserve, along with other central banks, created the Great Inflation of the 1970s that led to the disastrous financial crises of the 1980’s. Seeking a house price boom and a “wealth effect” in the 2000’s, the Federal Reserve promoted what turned out to be a house price bubble. Turner provides no proposals about how to control the obvious dangers of central banks, although he does point out their mistake in thinking that they had created a so-called “Great Moderation.” That turned out to have been instead a Great Overleveraging.

There can be no doubt of Turner’s high intelligence, as his double first in history and economics at Cambridge and his stellar career, leading to his becoming Lord Turner, attest. But as an old banking boss of mine memorably observed, “it is easier to be brilliant than right.”

This universal principle applies as well to leading central bankers, regulators, and government officials of all kinds as it does to private actors. The bankers “that made big mistakes,” Turner correctly says, “did not consciously seek to take risks, get paid, and get out: they honestly but wrongly believed that they were serving their shareholders’ interests.”  So also for the authors of mistaken government actions: they didn’t intend to make mistakes, but wrongly believed they were serving the public interest.

When former Congressman Barney Frank, for example, the “Frank” of the bureaucracy-loving Dodd-Frank Act, said before the crisis said that he wanted to “load the dice” with Fannie and Freddie, he never intended for the dice to come up snake eyes, but they did. Throughout the book, Turner displays the tendency to assume the consequences of government action to be knowable and benign, rather than unknowable and often perverse.

Debt and the Devil opens with the remarkable confession of government ignorance shown in the following excerpts.  As he became Chairman of the Financial Services Authority in 2008, Turner relates:

“I had no idea we were on the verge of disaster.”

“Nor did almost everyone in the central banks, regulators, or finance ministries, nor in financial markets or major economics departments.”

“Neither official commentators nor financial markets anticipated how deep and long lasting would be the post-crisis recession.”

“Almost nobody foresaw that interest rates in major advanced countries would stay close to zero for at least 6 [now it’s 8] years.”

“Almost no one predicted that the Eurozone would suffer a severe crisis.”  (That crisis featured defaults on government debt.)

“I held no official policy role before the crisis.  But if I had, I would have made the same errors.”

If governments, their regulators, and their central banks cannot understand what is happening and the real risks are, then it is easy to see why their actions may be unsuccessful and indeed generate perverse results.  So we have to amend some of Turner’s conclusions, to make his partial insights more complete.

“Central banks and regulators alone cannot make the financial system and economies stable,” he says.  True, but we must add:  but they can make financial systems and economies unstable by monetary and credit distortions.

We are “faced with a free market bias toward real estate lending” needs additionally: and an even bigger government bias and government promotion of real estate lending.

Turner quotes Charles Kindleberger approvingly: “The central question is whether central banks can contain the instability of credit and slow speculation.” This needs a matching observation:  The central question is whether central banks can hype the instability of credit and accelerate speculation. They can.

“Banking systems left to themselves are bound to create too much of the wrong sort of debt” needs amendment:  Banking systems pushed by governments to expand risky loans to favored political constituencies are bound to create too much of the wrong sort of debt, which will lead to large losses.  This will be cheered by the government until it is condemned.

“At the core of financial instability in advanced economies lies the interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate.” Insightful, but incomplete.  Here is the complete thought: At the core of financial instability lies the interaction between the potentially limitless supply of the punchbowl of central bank credit, bank credit, government guarantees of real estate credit, and the inelastic supply of real estate.

“Private credit creation is inherently unstable.” Here the full thought needs to be: Private and government credit creation is inherently unstable. Indeed, Turner supplies a good example of the latter: Japanese government debt has become so large relative to the Japanese economy that it “will simply not be repaid in the normal sense of the word.”

According to Turner, what is to be done?  He supplies a deus ex machina: “We.” So he asserts that “We need to manage the quantity and influence the allocation of credit,” and “We must influence the allocation of credit among alternate uses,” and “We must therefore deliberately manage and constrain lending against real estate assets.” Who is this “We”?  Lord Turner and his friends?  There is no “We” who know how credit should be allocated.

In an overall view, Turner concludes that “All complex systems are potentially unstable,” and that is true. But it must be understood that the complex system of finance includes inside itself all the governments, central banks, regulators and politicians, as well as all the private financial actors. Everybody is inside the system; nobody is outside the system, let alone above the system, looking down with ethereal perspective and the ability to manage everything. In particular, there is no “We” outside the complex system.  “We,” whoever they may be, are inside the complex system with its inherent uncertainty and instability, along with everybody else.

The Cincinnatian Doctrine revisited

Published by the R Street Institute.

The attached policy study originally appeared in the Winter 2016 edition of Housing Finance International.

Ten years ago, in September 2006, just before the great housing bubble’s disastrous collapse, the World Congress of the International Union for Housing Finance, meeting in Vancouver, Canada, devoted its opening plenary session to the topic of “Housing Bubbles and Bubble Markets.” That was certainly timely!

Naturally, knowing what would come next is easier for us in retrospect than it was for those of us then present in prospect. One keynote speaker, Robert Shiller, famous for studies of irrational financial expectations and later a winner of a Nobel Prize in economics, hedged his position about any predictions of what would come next in housing finance. Six months later, the U.S. housing collapse was underway. The second keynote speaker argued, with many graphs and charts, that the Irish housing boom was solid. Of course, it soon turned into a colossal bust. As the saying goes, “Predicting is hard, especially the future.”

Some IUHF members, in the ensuing discussion, expressed the correct view that something very bad was going to result from the excess leverage and risky financial behavior of the time. None of us, however, foresaw how very severe the crisis in both the United States and Europe would turn out to be, and the huge extent of the interventions by numerous governments it would involve.

Later in the program, also very timely as it turned out, was a session on the “Role of Government” in housing finance. On that panel, I proposed what I called “The Cincinnatian Doctrine.” Looking back a decade later, it seems to me that that this idea proved sound and is highly relevant to our situation now. I am therefore reviewing the argument with observations on the accompanying “Cincinnatian Dilemma” as 2016 draws to a close.

The two dominant theories of the proper role for government in the financial system, including housing finance, are respectively derived from two of the greatest political economists, Adam Smith and John Maynard Keynes.

Smith’s classic work, “The Wealth of Nations,” published in the famous year 1776, set the enduring intellectual framework for understanding the amazing productive power of competitive private markets, which have since then utterly transformed human life. In this view, government intervention into markets is particularly prone to creating monopolies and special privileges for politically favored groups, which constrains competition, generates monopoly profits or economic rents, reduces productivity and growth, and transfers money from consumers to the recipients of government favors. It thus results in less wealth being created for the society and ordinary people are made worse off.

Keynes, writing amid the world economic collapse of the 1930s, came to the opposite view: that government intervention was both necessary and beneficial to address problems that private markets could not solve on their own. When the behavior underlying financial markets becomes dominated by fear and panic, when uncertainty is extreme, then only the compact power of the state, with its sovereign authority to compel and tax, and its sovereign credit to borrow against, is available to stabilize the situation and move things back to going forward.

Which of these two is right? Considering this ongoing debate between fundamental ideas and prescriptions for political economy, the eminent financial historian, Charles Kindleberger, asked, “So should we follow Smith or Keynes?” He concluded that the only possible rational answer is: “Both, depending on the circumstances.” In other words, the answer is different at different times.

Kindleberger was the author (among many other works) of “Manias, Panics and Crashes,” a wide-ranging history of the financial busts which follow enthusiastic booms. First published in 1978, the book was prescient about the financial crises that would follow in subsequent decades, and has become a modern financial classic. A sixth edition of this book, updated by Robert Z. Aliber in 2011, brought the history up through the 21st century’s international housing bubbles, the shrivels of these bubbles that inevitably followed and the crisis bailouts performed by the involved governments. Throughout all the history Kindleberger and Aliber recount, the same fundamental patterns continue to recur.

Surveying several centuries of financial history, Kindleberger concluded that financial crises and their accompanying scandals occur, on average, about once every 10 years. In the same vein, former Federal Reserve Chairman Paul Volcker wittily remarked, “About every 10 years, we have the biggest crisis in 50 years.” This matches my own experience in banking, which began with the “credit crunch” of 1969 and has featured many memorable busts since, not less than one a decade. Unfortunately, financial group memory is short, and it seems to take financial actors less than a decade to lose track of the lessons previously so painfully (it was thought) learned.

Note that with the peak of the last crisis being in 2008, on the historical average, another crisis might be due in 2018 or so. About how severe it might be we have no more insight than those of us present at the 2006 World Congress did.

The historical pattern gives rise to my proposal for balancing Smith and Keynes, building on Kindleberger’s great insight of “Both, depending on the circumstances.” I quantify how much we should have of each. Since crises occur about 10 percent of the time, the right mix is:

• Adam Smith, 90 percent, for normal times

• J.M. Keynes, 10 percent, for times of crisis.

In normal times, we want the economic effi­ciency, innovation, risk-taking, productivity and the resulting economic well-being of ordinary people that only competitive private markets can create. But when the financial system hits its periodic crisis and panic, we want the interven­tion and coordination of the government. The intervention should, however, be temporary. This is an essential point. If prolonged, it will tend to monopoly, more bureaucracy, less innovation, less risk-taking and less growth and less eco­nomic well-being. In the extreme, it will become socialist stagnation.

To get the 90 percent Smith, 10 percent Keynes mix, the state interventions and bailouts must be with­drawn after the crisis is over.

This is the Cincinnatian Doctrine, named after the Roman hero Cincinnatus, who flourished in the fifth century B.C. Cincinnatus became the dictator of Rome, being “called from the plough to save the state.” In the old Roman Republic, the dictatorship was a temporary office, from which the holder had to resign after the crisis was over. Cincinnatus did—and went back to his farm.

Cincinnatus was a model for the American founding fathers, and for George Washington in particular. Washington became the “modern Cincinnatus” for saving his country twice, once as general and once as president, and returning to his farm each time.

But those who attain political, economic and bureaucratic power do not often have the virtue of Cincinnatus or Washington. When the crisis is over, they want to hang around and keep wielding the power which has come to them in the crisis. The Cincinnatian Dilemma is how to get the government interventions withdrawn once the crisis is past. In other words, how to bring the Keynesian 10 percent crisis period to end, and the normal Smith 90 percent to resume its natural creation of growth and wealth.

The financial panic ended in the United States in 2009 and in Europe in 2012. But the interventions have not been withdrawn. The central banks of the United States and Europe are still running hugely distorting negative real interest rate experiments years after the respective crises ended. Fannie Mae and Freddie Mac, effectively nationalized in the midst of the crisis in 2008, have not been reformed and are still operating as arms of the U.S. Treasury. The Dodd-Frank extreme regula­tory overreaction, obviously a child of the heat of its political moment, has not yet been reformed.

The Cincinnatian Doctrine cannot work to its optimum unless we can figure out how to solve the Cincinnatian Dilemma.

What have the massive guarantees of mortgages by the U.S. government achieved?

Published in the Winter 2017 edition of Housing Finance International.

R Street link.

The U.S. government, through multiple agencies, indulges in massive guarantees of U.S residential mortgages. Much, but not all, of this happens through the formerly celebrated, then failed, humiliated and notorious, Fannie Mae and Freddie Mac. These companies, now owned principally by the U.S. Treasury and completely controlled by the government as conservator, are still mammoth, with $5 trillion in combined assets. And there are trillions of dollars of additional government involvement in the U.S. housing finance sector, which with $10.4 trillion in outstanding rst lien loans, is the largest loan market in the world.

In the early 2000s, in the days B.B.B. [Before the Bursting Bubble], I had the pleasure to meet in Copenhagen with representatives of the Danish Mortgage Banking Association. They presented their highly interesting, efficient and private mortgage bond-based housing finance system, and I presented the government-centric, Fannie and Freddie-based mortgage system of the United States. (I was describing, by no means promoting, this system.) When I had finished my talk, the chief executive of one of the Danish mortgage banks made this unforgettable observation, “You know, in Denmark we always say that we are the socialists and America is the land of free enterprise and free markets. But I see that in housing finance, it is just the opposite!”

He was so right.

What has all the U.S. government intervention in mortgage credit achieved, if anything?

In 1967, the U.S. home ownership rate was 63.6 percent. Today, in 2017, it is 63.7 percent. After fifty years of intense government mortgage credit promotion and guarantees, the home ownership rate is just the same as it was before. The government mountain labored mightily and brought forth less than a mouse, at least as far as the home ownership rate goes.

The scale of the U.S. government’s absorption of mortgage credit risk boggles the mind of anyone who prefers market solutions. Fannie Mae guarantees or owns more than $2.7 trillion in mortgages. Freddie Mac guarantees or owns more than $1.7 trillion. Fannie and Freddie are said to be “implicitly guaranteed” by the U.S. Treasury, but whatever it is called, the guarantee is real. This was proved beyond doubt by the $187 billion government bailout they got when they went broke in 2008.

Then we have Ginnie Mae, a wholly-owned government corporation which is explicitly guaranteed by the U.S. Treasury. It guarantees another $1.7 trillion in mortgage-backed securities, with its total slightly greater than Freddie’s.

The three together absorb $6.2 trillion of mort- gage credit risk, all of it ultimately putting the risk on the taxpayers. This is more than 59 percent of the total mortgage loans outstanding. The U.S. government is in the mortgage business in a big way!

But this is not all. There is, interlocked with Ginnie Mae, the Federal Housing Administration [FHA], a part of the federal Department of Housing and Urban Development. The FHA is the U.S. government’s official subprime lender. (Of course, they don’t say it that way, but it is.) It insures very low down-payment and otherwise risky mortgage loans to the total amount of $1.4 trillion.

The federal Veterans Administration insures mortgages for veterans of the armed services to the amount of $596 billion.

The Federal Home Loan Banks, another government-sponsored housing finance enterprise, have total assets of $1.1 trillion.

Even the federal Department of Agriculture gets into the mortgage credit act. It guarantees housing loans of $108 billion.

A more recent, but now huge government player in mortgage credit is America’s central bank, the Federal Reserve. The Fed is the largest investor in mortgage-backed securities in the world, owning $1.8 trillion of very long term, fixed rate MBS guaranteed by Fannie, Freddie and Ginnie. So, one part of the government guarantees them, taking the credit risk, and another part of the government buys and holds them, taking the interest rate risk.

How does the Fed finance this long-term investment? By monetization – creating floating-rate deposits on its own books. This results in the Fed having the balance sheet structure of a 1980s American savings and loan: holding very long-term fixed-rate assets financed with variable rate liabilities. There is no doubt that this would have astonished and outraged the founders of the Federal Reserve System, and that for most of the Fed’s history, its new role as mortgage investor would have been thought impossible.

We can see that the U.S. now has a giant Government Housing Combine. It has a lot of elements, but most importantly there is a tight interlinking of three principal parts: the U.S. Treasury; the Federal Reserve; and Fannie-Freddie-Ginnie. It is depicted in Figure 1 as an iron triangle.

Let us consider each leg of the triangle:

(1) The U.S. Treasury guarantees all the obligations of Fannie, Freddie and Ginnie, which allows them to dominate the mortgage- backed securities market. The Treasury owns 100 percent of Ginnie, and $189 billion of the senior preferred stock of Fannie and Freddie, plus warrants to acquire 79.9 percent of Fannie and Freddie’s common stock for a minimal price, virtually zero. Essentially 100 percent of the net profits of Fannie and Freddie are paid to the Treasury as a dividend on the senior preferred stock. Fannie, Freddie and Ginnie are financial arms of the U.S Treasury.

(2) The Federal Reserve owns $1.8 trillion in mortgage-backed securities, mostly those of Fannie and Freddie. Without monetization of their securities by the Fed, Fannie and Freddie would either have much less debt, or have to pay a significantly higher interest rate to sell it, or both. Without the guarantee of the Treasury, Fannie and Freddie could sell no debt whatsoever. The Fed earned $46 billion on its MBS investments in 2016, almost all of which was sent to the Treasury. The U.S. government is reducing its budget deficit by running its big mortgage business.

(3) The Federal Reserve finances the Treasury, as well as Fannie and Freddie. The Fed owns $2.5 trillion of long-term Treasury notes and bonds, in addition to its $1.8 trillion of MBS. Almost all, about 99 percent, of the Fed’s profits are sent to the U.S. Treasury to reduce the budget deficit.

You can rightly view all this as one big government mortgage business. As my Danish colleague wondered, who is the socialist?

We asked before what this massive government intervention in housing finance has achieved. There are two very large, but not positive, results: inflating house prices and inducing higher debt and leverage in the system. Government guarantees and subsidies will get capitalized into house prices, and with the impetus of the Government Housing Combine, U.S. average house prices are now back up over their bubble peak. This makes it harder for new households to buy a house, and it means on average they have to take on more debt to do so.

Confronted with these inevitable effects, one school of politics always demands still more government guarantees, more debt, and more leverage. This will result in yet higher house prices and less affordability until the boom cycle ingloriously ends. A better answer is instead to reduce the government interventions and distortions, and move toward a housing finance sector with a much bigger private market presence.

I propose the goal should be to develop a U.S. housing finance sector in which the mortgage credit risk is at least 80 percent private, and not more than 20 percent run by the government. That’s a long way from where we are, but defines the needed strategic direction.

The word ‘fintech’ is a contrast of two halves

Published in the Financial Times.

Sir, Your instructive report “Online lenders count cost of push for growth” (Dec. 15) recounts their rising defaults and credit losses. This points out the contrast between the two halves of “fintech” when it comes to innovation. The “tech” part can indeed create something technologically new. Alas, the “fin” part — lending people money in the hope that they will pay it back — is an old art, and one subject to smart people making mistakes. In finance, “innovation” can be just an optimistic name for lowering credit standards and increasing risk, with inevitable defaults and losses following in its train.

Time to reform Fannie and Freddie is now

Published in American Banker.

The Treasury Department and the Federal Housing Finance Agency struck a deal last week amending how Fannie Mae and Freddie Mac’s profits are sent to Treasury as dividends on their senior preferred stock.

But no one pretends this is anything other than a patch on the surface of the Fannie and Freddie problem.

The government-sponsored enterprises will now be allowed to keep $3 billion of retained earnings each, instead of having their capital go to zero, as it would have done in 2018 under the former deal. That will mean $6 billion in equity for the two combined, against $5 trillion of assets — for a capital ratio of 0.1 percent. Their capital will continue to round to zero, instead of being precisely zero.

Here we are in the tenth year since Fannie and Freddie’s creditors were bailed out by Treasury. Recall the original deal: Treasury would get dividends at a 10 percent annual rate, plus — not to be forgotten — warrants to acquire 79.9 percent of both companies’ common stock for an exercise price of one-thousandth of one cent per share. In exchange, Treasury would effectively guarantee all of Fannie and Freddie’s obligations, existing and newly issued.

The reason for the structure of the bailout deal, including limiting the warrants to 79.9 percent ownership, was so the Treasury could keep asserting that the debt of Fannie and Freddie was not officially the debt of the United States, although de facto it was, is, and will continue to be.

Of course, in 2012 the government changed the deal, turning the 10 percent preferred dividend to a payment to the Treasury of essentially all Fannie and Freddie’s net profit instead. To compare that to the original deal, one must ask when the revised payments would become equivalent to Treasury’s receiving a full 10 percent yield, plus enough cash to retire all the senior preferred stock at par.

The answer is easily determined. Take all the cash flows between Fannie and Freddie and the Treasury, and calculate the Treasury’s internal rate of return on its investment. When the IRR reaches 10 percent, Fannie and Freddie have sent in cash economically equivalent to paying the 10 percent dividend plus retiring 100 percent of the principal.

This I call the “10 Percent Moment.”

Freddie reached its 10 percent Moment in the second quarter of 2017. With the $3 billion dividend Fannie was previously planning to pay on December 31, the Treasury’s IRR on Fannie would have reached 10.06 percent.

The new Treasury-FHFA deal will postpone Fannie’s 10 percent Moment a bit, but it will come. As it approaches, Treasury should exercise its warrants and become the actual owner of the shares to which it and the taxpayers are entitled. When added to that, Fannie reaches its 10 percent Moment, then payment in full of the original bailout deal will have been achieved, economically speaking.

That will make 2018 an opportune time for fundamental reform.

Any real reform must address two essential factors. First, Fannie and Freddie are and will continue to be absolutely dependent on the de facto guarantee of their obligations by the U.S. Treasury, thus the taxpayers. They could not function even for a minute without that. The guarantee needs to be fairly paid for, as nothing is more distortive than a free government guarantee. A good way to set the necessary fee would be to mirror what the Federal Deposit Insurance Corp. would charge for deposit insurance of a huge bank with 0.1 percent capital and a 100 percent concentration in real estate risk. Treasury and Congress should ask the FDIC what this price would be.

Second, Fannie and Freddie have demonstrated their ability to put the entire financial system at risk. They are with no doubt whatsoever systemically important financial institutions. Indeed, if anyone at all is a SIFI, then it is the GSEs. If Fannie and Freddie are not SIFIs, then no one is a SIFI. They should be formally designated as such in the first quarter of 2018, by the Financial Stability Oversight Council —and that FSOC has not already so designated them is an egregious and arguably reckless failure.

When Fannie and Freddie are making a fair payment for their de facto government guarantee, have become formally designated and regulated as SIFIs, and have reached the 10 percent Moment, Treasury should agree that its senior preferred stock has been fully retired.

Then Fannie and Freddie would begin to accumulate additional retained earnings in a sound framework. Of course, 79.9 percent of those would belong to the Treasury as 79.9 percent owner of their common stock. Fannie and Freddie would still be woefully undercapitalized, but progress toward building the capital appropriate for a SIFI would begin. As capital increased, the fair price for the taxpayers’ guarantee would decrease.

The New Year provides the occasion for fundamental reform of the GSEs in a straightforward way.

R Street’s Pollock on jumpstart legislation, capital reserves for SIFIs

Hosted by Investors Unite.

The podcast summarizes how to have realistic, fundamental reform of Fannie Mae and Freddie Mac. This requires having them pay a fair price for the de facto guarantee from the taxpayers on which they are utterly dependent, officially designating them as Systemically Important Financial Institutions (SIFIs) which they obviously are, and having Treasury exercise its warrants for 79.9% of their common stock. Given those three steps, when Fannie and Freddie reach the 10% Moment, which means economically they will have paid the Treasury a full 10% rate of return plus enough cash to retire the Treasury’s Senior Preferred Stock at par, Treasury should consider their Senior Preferred Stock retired. Then Fannie and Freddie could begin to accumulate retained earnings and begin building their capital in a sound and reformed context.

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.