Skin in the student loan game

Published in Barron’s.

Sheila Bair (“Sheila Bair Sees the Seeds of Another Financial Crisis,” Interview, March 3) is so right about colleges having no skin in the troubled student loan game, which creates a fundamental misalignment of incentives. Colleges play a role like mortgage brokers did in the housing bubble: promoting the loans, getting the borrower to run up debt, and immediately benefiting financially from the loan but having zero economic interest in whether the loan defaults or not. Therefore, it has been too easy for colleges to inflate their costs into a bubble that floats on the government-sponsored debt, just as the bubble in house prices did. The solution is straightforward: Colleges should be fully on the hook for the first 20% of the student loan losses from each cohort of their students. This would make colleges care about their students’ future financial success, care about their defaults and losses, better control their costs, and in general create better outcomes for all concerned.

AEI Event: Eliminating Fannie Mae and Freddie Mac without legislation

Hosted by the American Enterprise Institute.

A panel of housing finance experts met at AEI last Tuesday to discuss how the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac could be eliminated without legislation.  Moderated by R Street’s Alex J. Pollock, the panelists detailed the distortions of the current housing finance system dominated by Fannie and Freddie, and proposed a reform plan that protects homebuyers and taxpayers and does not require Congress to act.

The Bubble Economy – Is this time different?

Hosted by the American Enterprise Institute.

Two decades after Alan Greenspan’s famous “irrational exuberance” speech at AEI in 1996, Dr. Greenspan spoke at AEI again, addressing record-high global stock and bond market prices following unprecedented central bank balance sheet expansions.  Following Greenspan’s keynote address, R Street’s Alex J. Pollock led an expert panel that discussed whether the world economy is now experiencing an asset market price bubble and what might be done about it.

Fannie has reached the 10% moment, after all

Published by the R Street Institute.

After receiving thoughtful inquiries from two diligent readers (to whom, many thanks) about our calculation of the U.S. Treasury’s internal rate of return (IRR) on its senior preferred stock investment in Fannie Mae, we have carefully gone back over all the numbers starting with 2008, found a couple of needed revisions, and recalculated the answer.

The result is that Fannie has indeed reached its “10 percent moment.” Even after its fourth quarter 2017 loss, and counting the resulting negative cash flow for the Treasury in 2018’s first quarter, we conclude that Treasury’s IRR on Fannie is 10.04 percent. Freddie, as we previously said, was already past 10 percent and remains so.

So the 10 percent Moment for both Fannie and Freddie has arrived. We believe the stage is thus set for major reform steps for these two problem children of the U.S. Congress, but that the most important reforms would not need congressional action. They could be taken by agreement between the Treasury as investor and risk taker, and the Federal Housing Finance Agency (FHFA) as conservator and regulator of Fannie and Freddie.

Since Treasury has received in dividend payments from both Fannie and Freddie the economic equivalent of repayment of all of the principal of their senior preferred stock plus a full 10 percent yield, it is now entirely reasonable for it to consider declaring the senior preferred stock retired—but only in exchange for three essential reforms. These could be agreed between Treasury and the FHFA and thus be binding on Fannie and Freddie. The Congress would not have to do anything in addition to existing law.

These reforms are:

1. Serious capital requirements.

2. An ongoing fee paid to Treasury for its credit support.

3. Adjustment of Fannie and Freddie’s MBS guarantee fees in compliance with the law.

CAPITAL: Fannie and Freddie’s minimum requirement of equity to total assets should be set at the same level as for all other giant, too-big-too-fail regulated financial institutions. That would be 5 percent.

CREDIT SUPPORT FEE TO TREASURY:  Neither Fannie nor Freddie could exist for a minute, let alone make a profit, without the guarantee of their obligations by the Treasury (and through it, the taxpayers), which, while not explicit, is entirely real. A free guarantee is maximally distorting and creates maximum moral hazard. Fannie and Freddie should pay a fair ongoing fee for this credit support, which is essential to their existence. Our guess at a fair fee is 15 to 20 basis points a year, assessed on total liabilities. To help arrive at the proper level, we recommend that Treasury formally request the Federal Deposit Insurance Corp. apply to Fannie and Freddie their large financial institution model for calculating required deposit insurance fees. This would give us a reasonable estimate of the appropriate fee to pay for a government guarantee of institutions with $2 and $3 trillion of credit risk, entirely concentrated in real estate exposure and, at the moment, with virtually zero capital. It would thus provide an unbiased starting point for negotiating the fee.

ADJUSTMENT OF MBS GUARANTEE FEES:  Existing law, as specified in the Temporary Payroll Tax Cut Continuation Act of 2011, requires that Fannie and Freddie’s fees to guarantee mortgage-backed securities be set at levels that would cover the cost of capital of private regulated financial institutions engaged in the same risk—this can be viewed as a private sector adjustment factor for mortgage credit. Whether you think this is a good idea (we do) or not, it is the law. But the FHFA has not implemented this clear requirement. It should do so in any case, but the settlement of the senior preferred stock at the 10 percent moment would make a good occasion to make sure this gets done.

These three proposed steps treat Fannie and Freddie exactly like the giant, too-big-to-fail, regulated, government guaranteed financial institutions they are. Upon retirement of the Treasury’s senior preferred stock with an achieved 10 percent return, the reformed Fannie and Freddie would be able to start accumulating retained earnings again, building their capital base over time. As their equity capital grows, the fair guarantee fee to be paid to the Treasury would decline.

The 10 percent moment is here. Now a deal to move forward on a sensible basis can be made.

Can bitcoin threaten market stability?

Published by Institutional Investor.

In a February 12 panel discussion at the American Enterprise Institute in Washington, Alex Pollock, a distinguished senior fellow at the R Street Institute, likened Bitcoin to “private currencies” such as 19th-century U.S. bank notes, which gave way to government fiat. He said that if Bitcoin became a threat to the monetary order, “it’s a good bet” that government would take it over.

Fannie falls further from its ’10 Percent Moment’

Published by the R Street Institute.

When Fannie Mae and Freddie Mac were bailed out by the U.S. Treasury, which bought enough of the firms’ senior preferred stock to bring the net worth of each up to zero, the original deal was that the Treasury, on behalf of taxpayers, would get a 10 percent return on that investment.

For some time now, Fannie, Freddie and their supporters have ballyhooed how many dollars they have paid the Treasury in dividends on that stock, but that is an incomplete statistic. The question is whether those dollars add up to a completed 10 percent return. For that to happen, the payments have to be the equivalent of retiring all the principal plus providing a 10 percent yield; this is what I call that the “10 Percent Moment.” We can easily see if this has been achieved by calculating the internal rate of return (IRR) on the Treasury’s investment. Have Fannie and Freddie at this point provided a 10 percent IRR to the Treasury or not?

The answer is that Freddie has, but Fannie, by far the larger of the two, has not.

Freddie’s net loss in the fourth quarter of 2017 means the Treasury has to put $312 million back into it to get Freddie’s capital up to zero again. This negative cash flow for Treasury will reduce its IRR on the Freddie senior preferred stock, but only to 10.7 percent. Freddie has still surpassed the 10 percent hurdle return.

On the other hand, Fannie’s fourth quarter loss means the Treasury will have to put $3.7 billion of cash back into it, dropping the Treasury’s IRR on Fannie from 9.79 percent in the fourth quarter of 2017, to 9.37 percent. That’s not so far from the hurdle, but the fact is that, as of the first quarter of 2018, Fannie has not reached the 10 Percent Moment. Fannie and its private investors need to stop complaining about paying all its profits to the Treasury until it does.

When both Fannie and Freddie achieve the 10 Percent Moment, it would be reasonable for the Treasury to consider declaring its senior preferred stock in both fully retired, in exchange for needed reforms. At that point, Fannie and Freddie’s capital will still be approximately zero. They will still be utterly dependent on the Treasury’s credit and unable to exist even for a day without it. Reforms could be agreed to between the Treasury and the Federal Housing Finance Agency (FHFA)—as conservator and therefore boss of Fannie and Freddie—and carried out without needing the reform legislation, which is so hard to achieve. There will be a new director of the FHFA in less than 11 months.

Surely a restructured deal can emerge from this combination of factors.

Housing bubbles always make mortgage books look good

Published in the Financial Times.

Thanks for Ben McLannahan’s very good Big Read survey of the house price and mortgage debt inflation in Canada (“Canada’s home loans crisis”, February 9). One point needs clarification, however.

Mr. McLannahan writes: “Many also note that mortgage books at the big banks look rock solid.” But this means little, for housing bubbles always make the credit performance of mortgage loans look good. As long as the borrowers can sell the houses for more than they paid, credit losses are minimal. As long as house prices keep rising, the lenders, like the borrowers, are happy. When the house prices ultimately fall, the defaults and losses appear and accelerate rapidly. The resulting contraction of credit makes them fall more.

It is the price of the house that is leveraged. The risk question is always: how much can prices fall? The answer is, more than you think.

Banks need more skin in the housing finance game

Published by American Banker.

We all know it was a really bad idea in the last cycle to concentrate so much of the credit risk of the huge American mortgage loan market on the banks of the Potomac River — in Fannie Mae and Freddie Mac.

But the concentration is still there, a decade later.

The Fannie and Freddie-centric U.S. housing finance system removes credit risk from the original lenders, taking away their credit skin in the game. It puts the risk instead on the government and the taxpayers.

Many realized in the wake of the crisis that this was a big mistake (although a mistake made by a lot of smart people) in the basic design of the inherently risk-creating activity of lending money. Many realized after the fact that the American housing finance system needed more credit skin in the game.

Skin-in-the-game requirements were legislated for private mortgage securitizations by the Dodd-Frank Act, but do not apply to lenders putting risk into Fannie and Freddie. Regulatory pressure subsequently caused Fannie and Freddie to transfer some of their acquired credit risk to investors — but this is yet another step farther away from those who originated the risk in the first place.

That isn’t where the skin in the game is best placed. The best place, which provides the maximum alignment of incentives, and the maximum use of direct knowledge of the borrowing customer, is for the creator of the mortgage loan to retain significant credit risk. No one else is as well placed.

The single most important reform of American housing finance would be to encourage more retention of credit skin in the game by those making the original credit decision.

In this country, we unfortunately cannot achieve the excellent structure of the Danish mortgage bond system, where 100% of the credit risk is retained by the lenders, and 100 percent of the interest rate risk is passed on to the bond market. The Danish mortgage bank which makes the loan stays on the hook for the default risk and receives corresponding fee income. The loans are pooled into mortgage bonds, which convey all the interest rate and prepayment risk to bond investors. This system has been working well for over 200 years.

There are clearly many American mortgage banks which do not have the capital to keep credit skin in the game in the Danish fashion. But there are thousands of American banks, savings banks and credit unions which do have the capital and can use to it back up their credit judgments. The mix of the housing finance system could definitely be shifted in this direction.

If you are a bank, your fundamental skill and your reason for being in business is credit judgment and the managing of credit risk. Residential mortgage loans are essential to your customers and are the biggest loan market in the country (and the world). Why do you want to divest the credit risk of the loans you have made to your own customers, and pay a big fee to do so, instead of managing the credit yourself for a profit? There is no good answer to this question, unless you think your own mortgage loans are of poor credit quality. For any bankers who may be reading this: Do you think that?

But, it will be objected: The regulators force me to sell my fixed-rate mortgage loans because of the interest rate risk, which results from funding 30-year fixed-rate loans with short-term deposits. True, but as in Denmark, the interest rate risk can be divested while credit risk is maintained. For example, the original 1970 congressional charter of Freddie provided lenders the option of selling Freddie high loan-to-value ratio loans by maintaining a 10% participation in the loan or by effectively guaranteeing them, not only by getting somebody else to insure them.

Treasury Secretary Steven Mnuchin recently told Congress that private capital must be put in front of any government guarantee of mortgages. That’s absolutely right — but whose capital? The best solution would be to include the capital of the lenders themselves.

In sharp contrast to American mortgage-backed securities in this respect are their international competitors, covered bonds. These are bonds banks can issue, collateralized by a “cover pool” of mortgage loans which remain assets of the bank. Thus covered bonds allow a long-term bond market financing, but all the credit risk stays on the bank’s balance sheet, with its capital fully at risk.

American regulators and bankers need to shake off their assumption, conditioned by years of Fannie and Freddie’s government-promoted dominance, that the “natural” state of things is for mortgage lenders to divest the credit risk of their own customers. The true natural state for banks is the opposite: to be in the business of credit risk. What could be more obvious than that?

The housing finance system should promote, not discourage, mortgage lenders staying in the credit business. Regulators, legislators, accountants and financial actors should undertake to reform regulatory, accounting and legal obstacles to the right alignment of incentives and risks. The Federal Housing Finance Agency should be pushing Fannie and Freddie to structure their deals to encourage originator retention of credit risk.

The result will be to correct, at least in part, a fundamental misalignment that the Fannie and Freddie model foisted on American housing finance.

The Fed as a Piggy Bank? Of Course!

Published by the R Street Institute.

The Bipartisan Budget Act passed last week had a little item in it to help government revenues by confiscating $2.5 billion of the retained earnings (they call it “surplus”) of the Federal Reserve Banks.  When they found out about it, the commercial banks, which own all the stock of the Federal Reserve Banks, weren’t happy.

“Critics say the plan is yet another example of Congress turning to the Fed as a source of funding,” the American Banker reported.  It is now “common to use the Fed as a piggy bank,” complained the Independent Community Bankers association.

The Fed as a piggy bank?  Of course, what else?  According to the Federal Reserve’s own press release, the Federal Reserve Banks paid $80.2 billion of their 2017 profits to the Treasury.  In other words, 99 percent of their estimated net profit for the year of $80.7 billion goes to the government to help reduce the budget deficit.  To confiscate another $2.5 billion only increases the aggregate take by 3 percent.

The Federal Reserve Banks have the highest rate of profitability of any bank, with a 2017 return on equity of about 195 percent.  Of course, they are also astronomically leveraged, with assets of about 107 times equity, or a tiny capital ratio of a 0.9 percent.  Almost all of that leveraged profitability goes right into the Treasury, every year.

The Federal Reserve Banks paid aggregate dividends to their shareholders of $784 million in 2017, or less than 1 percent of what they paid the government, which is a greedy business partner, it seems.

The Federal Reserve System is many things, but one of them is a way for the government to make a lot of money from the seignorage arising from its currency monopoly.  The Fed creates money to buy bonds from the Treasury, collects the interest, then gives most of the interest back.  It also uses its money power to buy mortgage-backed securities from Fannie Mae and Freddie Mac, which are owned principally by the Treasury, collects the interest on them, and then sends most of it to the Treasury.

As my friend and banking expert Bert Ely always reminds me, it is easier to understand what is going on if you simply consider the Treasury and the Fed as one interacting financial operation, and consolidate their financial statements into one set of books, clarified by consolidating eliminations.  Then you can see that on a net basis, the consolidated government is creating money instead of borrowing from the public in order to finance its deficits and in order to generate vast seigniorage profits for itself.  The Fed makes a very useful front man for the Treasury in this respect.

The first congressional confiscation of Federal Reserve retained earnings was in 1933.  Then they were taken to provide the capital for the newly formed Federal Deposit Insurance fund.  So as usual in financial history, taking the Fed’s retained earnings is not a new idea.  The Federal Reserve Banks are a politically useful piggy bank, to be sure.

Time for reform

Published in National Mortgage News.

The treasury department and the Federal Housing Finance Agency recently struck a deal 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.

Fannie and Freddie’s top regulator, Mel Watt, had worried about their running with exactly zero capital going forward, so any quarterly losses, perhaps from the vagaries of derivatives accounting, would force renewed bailout investments from the Treasury. That would have looked bad.

Additional bailout investments may well be necessary anyway, as Treasury and the FHFA admit, because by dropping the corporate tax rate, the new tax reform law implies major write-downs in Fannie and Freddie’s deferred tax assets. That will look bad, too.

Here we are in the 10th 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.

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 {ercent 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 Dec. 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.

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.

A state-owned bank for New Jersey?

Published by the R Street Institute.

New Jersey Gov. Phil Murphy and some supportive state legislators are promoting the idea to establish a bank owned by the state, holding the state’s deposits and making loans considered politically popular. Is this controversial proposal a good idea?  It’s certainly not a new one.

In the 19th century, banks with majority ownership by the states were set up by Alabama, Georgia, Illinois, Indiana, Kentucky, Missouri, South Carolina, Tennessee, Vermont and Virginia. None of these has survived. An instructive case is the State Bank of Illinois, which “became entangled in public improvement schemes” and went bankrupt in 1842.

“In nearly all states” before the Civil War, report John Thom Holdsworth and Davis Rich Dewey, “provision was made in the charters requiring or permitting the State to subscribe for a portion of the stock of banks when organized.” Among the reasons were that the state “should share in the large profits” which were expected, and “because ownership would place the state in the light of a favored customer when it desired to borrow,” Dewey and Robert Emmert Chaddock note in their State Banking Before the Civil War.

Ay, there’s the rub. Such ideas led a number of states to sell bonds and invest the proceeds in bank stock, hoping the dividends on the stock would cover the interest on the debt. “Every new slave state in the South from Florida to Arkansas established one or more banks and supplied all or nearly all of their capital by a sale of state bonds.”

There is one (and only one) state-owned bank operating today, the Bank of North Dakota. The bank is owned 100 percent by the state and its governing commission is chaired by the governor of the state. Its deposits are not insured by the Federal Deposit Insurance Corporation, but are instead guaranteed by the State of North Dakota, which has bond ratings of AA+/Aa1 (In contrast, New Jersey’s bond ratings are A-/A3.) The bank has total assets of about $7 billion and is thus not a large bank. But it has strong capital and is profitable, the profits helped by being exempt from federal and state income taxes. The Bank of North Dakota was founded in 1919, so is almost a century old.

A less hopeful analogue is the Government Development Bank for Puerto Rico, owned by the Commonwealth of Puerto Rico and designed to operate as an inherent part of the government. It was established in 1942 under the leadership of Rexford Tugwell, the Franklin Roosevelt-appointed governor of the island, an ardent believer in central planning. The Government Development Bank, which had total assets of about $10 billion in 2014, has been publicly determined to be insolvent and will impose large losses on its creditors.

According to a report from the Federal Reserve Bank of Minneapolis, Alexander Hamilton, the father of the federally chartered and 20 percent-government/80 percent privately owned First Bank of the United States, “concluded that a national bank must be shielded from political interference: ‘To attach full confidence to an institution of this nature, it appears to be an essential ingredient in its structure that it shall be under a private not a public direction under the guidance of individual interest, not public policy.’” If this principle applies as well to state-owned banks, how is such a bank to devote itself to politically favored loans?

Would a Bank of New Jersey be likely to resemble more the Bank of North Dakota or the Government Development Bank of Puerto Rico?  Or perhaps the State Bank of Illinois?

Confiscation of gold by the federal government: A lesson

Published in Real Clear Markets.

Historically as well as now, people in America tried to protect themselves against the government’s devaluation of their dollars by holding gold; and formerly, by buying Treasury bonds which promised to pay in gold.  The fundamental thought was and is the same that many holders of Bitcoin and other “cryptocurrencies” have now: hold something that the government cannot devalue the way it can its official currency.

Unfortunately for such an otherwise logical strategy, governments, even democratic governments, when pushing comes to shoving, may use force to control and even take away what you thought you had.  The year 1933 and the new Franklin Roosevelt presidency provide vividly memorable, though little remembered, examples.  First the U.S. Treasury defaulted on its promises to pay gold bonds in gold; then under notable executive orders, the U.S. government confiscated the gold of American citizens and threatened them with prison if they didn’t turn it in.  It moreover prohibited the future holding of any gold by Americans, an outrageous prohibition which lasted four decades, until 1974.

All this may seem unimaginable to many people today, perhaps including Bitcoin enthusiasts, but in fact happened.  Said Roosevelt in explanation, “The issuance and control of the medium of exchange which we call ‘money’ is a high prerogative of government.”

President Hoover had warned in 1932 that the U.S. was close to having to go off the gold standard.  Running for President, Roosevelt called this “a libel on the credit of the United States.”  He furthermore pronounced that “no responsible government would have sold to the country securities payable in gold if it knew that the promise—yes, the covenant—embodied in those securities was…dubious.”  The next year, during Roosevelt’s own administration, this “covenant” was tossed overboard.  Congress and the President “abrogated”—i.e. repudiated—the obligation of the government to pay as promised.  One can argue that this was required by the desperate economic and financial times, but about the fact of the default there can be no argument.

Roosevelt’s Executive Order 6102, “Requiring Gold Coin, Gold Bullion and Gold Certificates to Be Delivered to the Government,” of April 5, 1933 marks an instructive moment in both American monetary and political history.  To modern eyes, it looks autocratic, or perhaps could fairly be described as despotic.

The order begins, “By virtue of the authority vested in me by Section 5(b) of the Act of October 6, 1917,” without naming what act that is.  Why not?  Well, that was the Trading with the Enemy Act which was used to confiscate German property during the First World War.

The order states:

-“All persons are hereby required to deliver on or before May 1, 1933…all gold coin, gold bullion and gold certificates now owned by them or coming into their ownership.”

-“Until otherwise ordered any person becoming the owner of any gold coin, gold bullion or gold certificates shall, within three days after receipt thereof, deliver the same.”

-“The Federal Reserve Bank or member bank will pay therefore an equivalent amount of any other form of coin or currency”—in other words, we will give you some nice paper money in exchange.

Lastly, the threat:

-“Whoever willfully violates any provision of this Executive Order or of these regulations or of any rule, regulation or license issued hereunder may be fined not more than $10,000, or, if a natural person, may be imprisoned for not more than ten years, or both.”

Ten thousand 1933 dollars was a punitive fine—equivalent to about $190,000 today.  But the real punishment for trying to protect your assets was “We’ll put you in jail for ten years!”

A few months later the order was revised and tightened up by Roosevelt’s Executive Order 6260, “On Hoarding and Exporting Gold” of August 28, 1933.  It specifies that “no person shall hold in his possession or retain any interest, legal or equitable, in any gold,” and adds a reporting requirement: “Every person in possession of and every person owning gold…shall make under oath and file…a return to the Secretary of the Treasury containing true and complete information” about any gold holdings, “to be filed with the Collector of Internal Revenue.”  So the IRS was brought in as an enforcer, too.  The threat of fines and prison continued as before.

It’s a prudent idea to protect yourself against the government’s perpetual urge to depreciate its currency. But if pushing comes to shoving, how do you protect yourself against the government’s confiscating the assets you so prudently acquired—and its being willing to put you in prison if you try to keep them?  What governments, even democratic ones, are willing to do when under sufficient pressure, is a lesson Bitcoin holders and everybody else can usefully consider.

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.