Alex J Pollock Alex J Pollock

Elizabeth Warren is really sad because the CFPB is ignoring her

Published in The Daily Caller.

Senator Elizabeth Warren (D-Mass.) has unintentionally provided great entertainment with an op-ed published last week in The Wall Street Journal. Her essay decries how terrible indeed it is that her political child, the Consumer Financial Protection Bureau (CFPB), is free of Congressional control — exactly as it was designed to be by the Dodd-Frank Act. Moreover, and much worse, under a new director, the CFPB now has no interest in paying attention to her!

To Senator Warren, this is outrageous. To any detached observer, it is funny.

The irony of Senator Warren’s plaint and of her frustration with her discovery that the bureaucratic agency of whose independence from Congress she was a prime author, is beyond the control of any senator, is delicious. The CFPB is beyond even that most basic of all checks and balances, the congressional power of the purse. This is exactly as intended by the Democratic congressional majorities which created it and gave it the power to simply dip into public funds without Congressional approval or appropriation. It does this by helping itself to money out of the Federal Reserve’s income, which is economically equivalent to dipping into the Treasury’s general fund.

That this independence now operates to frustrate Senator Warren is wonderful poetic justice. The irony, the poetic justice and the entertainment were not lost on the readers. In a day, they provided over 800 comments to the WSJ’s website, the vast majority of which enjoyed making similar points.

Here are some sample comments and excerpts:

“This article is the poster child of ‘be careful what you wish for.’ All her screaming cannot change the fact—she created an agency that cannot be controlled by elected officials—and now she is on the other side of that coin.”

“A Democrat creates and weaponizes a bureaucracy only to see her opponents take charge of it. Hoist on your own petard, eh?”

“Amusing to hear Warren rant about how the agency she helped create to be unaccountable to Congress, is now unaccountable to her!”

“Oh please, Ms. Warren. You purposely designed the CFPB to be above oversight. Your sour grapes that your creation in now in Republican control is amusing indeed.”

“In short, the CFPB was designed to be an unaccountable agency led by a single dictatorial director. That was fine with Warren when it was run by Richard Cordray, who aligned it with her. Somehow, things have changed now that the CFPB isn’t being run by one of her ideological cronies.”

“Testifying before Congress had absolutely no effect on Richard Cordray. The CFPB was specifically told its charter did not include consumer auto loans. But that did not stop him.”

“Wow, she was largely responsible for creating this monster and now that it doesn’t behave exactly as she would like, she whines.”

“This is rich. Warren intentionally created the unconstitutional agency with no accountability in order to protect it from changes in Congress that could threaten it. Now they’re not doing what she wants. Such a hypocrite.”

“Now the shoe is on the other foot and the GOP has the chair, and the sky is falling.”

“To see her most prized possession emasculated while she whines powerlessly is such sweet poetic justice.”

And so on.

All this suggests three questions that Senator Warren really should answer:

  1. Does she now support requiring Congressional appropriations for the CFPB?

  2. Does she now support governing the CFPB with a bipartisan board, rather than a single, authoritative director?

  3. Does she see herself — as others see her — sufficiently to understand how funny her article is?

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

Real estate debt, the devil and U.S. national banks

Published by the R Street Institute.

The attached policy study originally appeared in the Spring 2018 issue of Housing Finance International. 

Housing finance, as we all know, is lending on fundamentally illiquid assets, taking risk on their prices, which are subject to boom and bust cycles, and doing so on a highly leveraged basis for both the borrowers and the lenders. Naturally this business of ours gets us periodically into severe problems, as has been experienced in numerous countries over time.

Adair Turner, the former chairman of the British Financial Services Authority, goes further. In his provocative book, Between Debt and the Devil (2016), he puts the principal culpability for financial crises – and thus the identity of the Devil – on real estate lending.

He points out that banks in recent decades have changed from being primarily lenders to commerce and industry, to being primarily real estate lenders. In the U.S., this fundamental shift in bank credit toward concentration in real estate dates from the 1970s.

Lord Turner writes:

“In 2007, banks in most countries had turned primarily into real estate lenders.”

“Before the mid-twentieth century, banks in several advanced countries were restricted or at least discouraged from entering real estate lending markets.”

“Lending against real estate… generates self-reinforcing cycles of credit supply, credit demand, and asset prices.” (The interaction of real estate prices and lending is without question a key risk dynamic.)

“At the very core of financial instability in mod-ern economies thus lies an interface between an infinite capacity [to inflate mortgage credit] and an inelastic constraint [real estate].”

Thus, the conclusion: real estate finance and mortgages “are not just part of the story of financial instability in modern economies, they are its very essence.”

Quite an indictment. If it is not the whole truth, it has at least an important element of truth.

In this context, we should consider the instructive history of the laws governing real estate lending by U.S. national banks. These are the banks chartered by the U.S. Government and regulated by the Comptroller of the Currency in Washington, D.C., as opposed to the banks chartered by individual states of the United States. Both exist, but before the American Civil War of 1861-65, all banks were state banks. There are now 943 national banks in the U.S. with aggregate assets of $11 trillion, and 4,075 state-chartered banks with assets of $5 trillion.

National banks make a good study in real estate lending because we can go right back to their creation by the National Currency Acts of 1863 and 1864, later renamed the National Banking Act.

The authors of the original National Banking Act took an unfavorable view of having real estate loans and real estate risk included in the assets of the new national banks, the liabilities of which were going to form the nation’s new currency. They addressed their concern in a simple way: the new national banks were prohibited from making any real estate loans at all!

This seems amazing now, when national banks have $2.5 trillion of real estate loans, or 43 percent of all their loans. On top of that, they own $1.3 trillion of securities based on real estate (mortgage-backed securities), which represent 58 percent of their bond portfolios. (For state banks, real estate loans are 57 percent of total loans and mortgage backed securities are 55 percent of their total bonds.)

The prohibition of real estate loans for national banks lasted about 50 years, until 1913. Although the sponsors of the National Banking Act had intended for national banks completely to replace the state banks, instead the state banks survived and then multiplied, and the national banks felt the competitive pressure.

The first statutory permission for national banks to expand into real estate came as part of the Federal Reserve Act of 1913. This allowed national banks to make real estate loans on farm land only. (In those days, half the population of the U.S. was rural. Congress would expand agricultural lending further with the creation of the Federal Farm Credit System in 1916.) But loans from national banks were limited by the law to 50 percent of the farm property’s appraised value – very conservative, we would say.

The 1913 Act included another basic financial constraint: that real estate loans had to be explicitly tied to more stable bank funding. So, at that point, total real estate loans were limited to a maximum of 33 percent of a national bank’s savings deposits. The idea was that deposits payable on demand should not be invested in real estate financing. The same idea was shown in traditional mortgage lending theory with what used to be called the “special circuit” for funding housing finance. This meant using more stable savings accounts, often in earlier days viewed as “shares,” a kind of equity, and not as deposits – the point being to match more appropriate funding to longer-term residential mortgages. Today we pursue the same goal by the creation of mortgage-backed securities or covered bonds.

An additional limitation of the law was that real estate loans were limited to 25 percent of a national bank’s capital. In contrast, for national banks as a whole today, they represent 256 percent of the tangible capital. For state banks, this ratio is 359 percent.

The limitation to farm real estate for national banks lasted only to 1916, when the law was changed to allow loans on nonfarm real estate, but with a maximum maturity of one year. In 1927, this was expanded to five years on improved urban real estate, with the loan still limited to 50 percent of appraised value.

Vast defaults and losses on real estate lending marked the Great Depression of the early 1930s. Jesse Jones, the head of the Reconstruction Finance Corporation, memorably described “the remains of the banks which had become entangled in the financing of real estate pro-motions and died of exposure to optimism.”

However, in following decades the long-term trend for more expansive real estate lending laws continued apace. Allowable loan-to-value ratios increased to two-thirds, in some cases to 90 percent, maximum maturities were increased to 30 years, and the limit on total real estate loans to 70 percent and then 100 percent of time and savings deposits. In 1974, unimproved land was added as acceptable collateral for national banks. In 1982, the final step in statutory evolution was taken: all statutory real estate lending ratios and formulas were removed by the Garn-St. Germain Act of that year. The 1980s and early 1990a featured euphoric real estate credit expansions and then multiple real estate busts.

In 1994, pursuing further expansion of real estate credit, the administration of President Clinton adopted a political real estate lending campaign: the “National Homeownership Strategy.” The idea was to promote so-called “creative financing” – in other words, the U.S. government was pushing for low and no-down payment mortgages and other risky and low-quality loans. The authors of the National Banking Act would have been appalled by this project. They would have accurately fore-casted its disastrous outcome, which arrived in due course as a contributor to the Great Housing Bust and panics of 2007-08.

That, of course, was the crisis which gave rise to Lord Turner’s book, its diagnosis so unflattering to real estate lending, and to his key prescription:

“To achieve a less credit-intensive and more stable economy, we must therefore deliberately manage and constrain lending against real estate assets.”

In this context, “we” means the government, which must, on Lord Turner’s view, constrain real estate lending, not promote it.

Representatives of housing finance like us may or may not agree that this is the right answer, but we can observe that it is consistent with the statutory limitations on real estate lending provided in the National Banking Act as originally designed and during its first century.

Read More
Op-eds Alex J Pollock Op-eds Alex J Pollock

Federal Reserve will be judged by future on these years of low rates

Published in The Hill.

The government’s official interest rate price-fixing committee, otherwise known as the Federal Reserve, has just raised its target fed funds rate by a quarter-point. This surprised no one, as the Fed intended, since it works hard to manage expectations.

What would the rate be if it were set in private markets instead of by a government committee? No one knows, but presumably it would be higher.

The Fed’s latest move still leaves interest rates at remarkably low levels. In the 1980s and 1990s, most people would have considered it impossible for the fed funds rate to be under 2 percent. Now we have the Fed’s current target range of 1.5 to 1.75 percent—to make it easy, let’s just call it 1.75 percent. Not only is this rate low, but in real inflation-adjusted terms, it is negative. In February, the Consumer Price Index went up 2.2 percent year-over-year, so the new fed funds target in real terms is 1.75 percent minus 2.2 percent  =  negative 0.45 percent.

It looks like it will take one more increase, at least, to get the real fed funds rate up to around zero and numerous increases after that to approach a normal level. Needless to say, normal real interest rates are positive, not negative.

What might a normal level be? We can make a fair guess by looking at long-term averages. Graph 1 shows nominal fed funds rates and inflation rates from mid-1954 to year-end 2017.

Over this long term, the fed funds rate averaged 4.86 percent. The annual rate of inflation averaged 3.56 percent. So the long-term average real fed funds rate was 1.3 percent.

If inflation going forward runs at the Fed’s target inflation rate of 2 percent, it would suggest a normalized fed funds rate of 3.3 percent. To get there would take six more quarter-point increases. On similar logic, the normalized yield on the 10-year Treasury note would be 4.5 percent, instead of the current 2.8 percent, and the rate on a 30-year mortgage loan would be 6.2 percent, up from the current 4.4 percent level. Of course, if inflation turns out to move higher than 2 percent, the normalized fed funds rate, and also the other rates, will be correspondingly higher.

Graph 2 shows the real fed funds rates over the same years.

As is apparent from this graph, we have lived through and remain in an exceptionally long period of negative real fed funds rates. It is by far the longest stretch of such negative real rates in our six decades of data. While normal real fed funds rates are positive, it is not unusual for them to be negative for some periods, such as when the Fed is facing a recession, or a financial crisis, or both, or has a desire to inflate asset prices. Extended negative real interest rates are good at inducing asset-price booms.

Since the 1950s, there were negative real fed funds rates during the following times:

  • Six quarters during 1956-1958;

  • Two quarters during 1970-1971;

  • 15 quarters during 1974-1977;

  • Five quarters during 1979-1980;

  • Three quarters at about zero in 1992-1993;

  • 11 quarters during 2002-2005;

  • Three quarters in 2008.

And then the all-time champion run of negative real fed funds rates:

  • 30 quarters, equivalent to 7.5 years, during 2009 to now.

It is hardly surprising that this period has been accompanied by booms in equity, bond and house prices. Was the Fed’s strategy during these years wise? The future will judge that, looking back.

For now, we can say, in sum, that the Fed’s target fed funds rate remains remarkably low, is still negative in real terms, and has a long way to go to get back to normal.

Read More
Letters to the editor Alex J Pollock Letters to the editor Alex J Pollock

Macroeconomics and the unknowable future

Published in the Financial Times.

Martin Wolf is so right that “a macroeconomics that does not include the possibility of crises misses the essential” (“Economics failed us before the global crisis,” March 21). Indeed, institutions, debt and the temptations of leverage are essential to the theory, especially leverage, which is the snake in the financial Garden of Eden. The expectations of the most rational, intelligent and well-informed people are often enough surprised and shocked by events. That the financial and economic future is not only unknown, but unknowable, is what an adequate macroeconomic theory must incorporate.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

How much has the dollar shrunk since you were born?

Published by the R Street Institute.

The depreciation of the U.S. dollar’s purchasing power has been endemic from the post-World War II years up to today. It got completely out of control in the 1970s and has continued apace since then, although at a lower rate. Our fiat currency central bank, the Federal Reserve, has formally committed itself to perpetual depreciation of the purchasing power of the currency (otherwise known as 2 percent inflation), every year forever.

It is hard intuitively to realize how big the effects of compound interest are over long periods of time, whether it is making something get bigger or smaller. In this case, it means how much average prices are multiplying and how much the dollar is shrinking.

The following table simply shows the Consumer Price Index over seven decades, starting with 1946. For each year, it calculates how many times average prices have multiplied from then to now, and how many cents were then equivalent to one 2017 dollar. For example, in 1948, I was in kindergarten. Since then, prices have multiplied by a factor of 10 times. Today’s $1 is worth what $0.10 was then. Taking another example, in 1965, I graduated from college and luckily met my future wife. Prices have since multiplied 7.8 times. And so on.

You may find it interesting to pick a year—say the year you were born, graduated from high school, first got a regular paycheck, got married or bought a house—and see how much average prices have multiplied since. Next, see how many cents it took at that point to have the equivalent purchasing power of $1 now. In my experience, most people find these numbers surprising, including the changes from more recent times – say, the year 2000. They become inspired to start remembering individual prices of things at various stages of their own lives.

Multiplying Prices and the Shrinking Dollar over Time, 1946-2017

You can also project the table into the future and see what will happen if the future is like the past.

Since average prices can go up over 10 times in the course of an single lifetime—as the table shows they, in fact, have—it is easy to see one reason it is hard to generate sufficient savings for retirement. You have to finance paying what prices will be in the future when you are retired. In the last 40 years (see 1977 on the table), average prices have quadrupled. Then, $0.25 bought what $1 does now. So if you are 40 years old now, by the time you are 80, prices would quadruple again. Good luck with your 401(k)!

Read More
Op-eds Alex J Pollock Op-eds Alex J Pollock

Economic crises are invariably failures of the imagination

Published in Real Clear Markets.

A fundamental issue in all risk management is oversight vs. seeing.  You can be doing plenty of oversight, analysis, regulation and compliance, with much diligence and having checkers check on checkers, but is the whole process able to envision the deep and surprising risks that are the true fault lines under your feet?  Or are you only analyzing, regulating, writing up and color coding dozens of factors which while important, are not the big risk which is going to take you and perhaps the system of which you are a part, down?  For example, in the midst of your risk management oversight efforts, whether as a company or as the government, could you see in 2005 or 2006, or at the latest by 2007, that U.S. average house prices across the whole country, were likely to drop like a stone?  And see what would happen then?

Most people, including the most intelligent, experienced and informed, could not.

Former Treasury Secretary Timothy Geithner, in his memoir of the 2007-2009 financial crisis, Stress Test (2014), draws this essential conclusion: “Our crisis, after all, was largely a failure of imagination. Every crisis is.” If you can’t imagine it, if you consider that the deep risk event is unimaginable or impossible, your oversight will not see the risk. “For all our concern about ‘froth’,” Geithner continues, “we didn’t foresee how a nationwide decline in home prices could induce panic in the financial system.”

This is a profoundly important insight.  Geithner expands on it: “Our failures of foresight were primarily failures of imagination, like the failure to foresee terrorists flying planes into buildings before September 11.  But severe financial crises had happened for centuries in multiple countries, in many shapes and forms, always with pretty bad outcomes.  For all my talk about tail risk, negative extremes, and stress scenarios, our visions of darkness still weren’t dark enough.”

That was not for lack of effort, but for lack of seeing.  “The actual main failing was over-reliance on formal econometric models,” banking scholar Charles Goodhart suggests in his acute essay, “Central bank evolution: lessons learnt from the sub-prime crisis” (2016).  He points out that as the housing bubble was inflating, there was copious housing finance data which could be and was analyzed:

“There were excellent monthly data on virtually all aspects of mortgage finance in the USA starting from the 1950s.  By the 2000s such data provided over 50 years of all aspects of US mortgage finance.  During this period, there had only been a very few months in which the value of houses, and the mortgages related to them, of a regionally diversified portfolio of housing assets over the US as a whole had faced a loss, and then only a very small one.

“While there had been sharp declines in housing valuations in certain specific regions, i.e. the North East in 1991-2, the oil producing states in the mid-1980s, etc., a regionally diversified portfolio virtually never showed a loss, and then only a minor one, over these 50 years.”  The conclusion seemed clear enough at the time: house prices did not, so would not, fall on a national average basis.  A portfolio of mortgages diversified across regions would be protected.  “Virtually everyone was sucked into the general conventional wisdom that housing prices”—on average—“were almost sure to continue trending generally upwards.”

This clear, though in retrospect completely wrong, conclusion could be professionally quantified: “Put those data into a regression analysis, and then what you will get out is an estimate that any loss of value in a regionally diversified portfolio of greater than about three or four percent would be…highly improbable.”  But as the bubble got maximally inflated, its shriveling became highly probable instead of improbable.  As we know, average U.S, house prices went down by 27% and fell not for a few months, but for six years, in spite of all kinds of government interventions.  The housing market went down for longer than a great many people could stay solvent.

“Of course,” Goodhart reminds us, “econometric regressions are based on the implicit assumption that the future will be like the past.” The less of the past we know, the worse an assumption this is. In this case, fifty years and one country, even a very big country, were not enough.

To expand how much of the past we have studied, both in terms of more time and more places, is perhaps one way to improve our ability to see risks, imagine otherwise unimaginable outcomes, and thus improve our risk oversight.  Perhaps.  There are no guarantees of success.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

Competing Mortgage Credit Scores: A decision for those who take the risk

Published by the R Street Institute.

The use of credit scores by Fannie Mae and Freddie Mac, as one part of their decisions about which mortgages they will buy and guarantee, is by nature an “inside baseball” mortgage-finance discussion, but it has made its way into the regulatory reform bill passed by the Senate March 14.

How such scores are statistically created, how predictive they are of loan defaults, how to improve their performance, whether to introduce new scoring methods and the relative predictive ability of alternative methods are above all technical matters of mortgage credit-risk management. These questions are properly decided by those who take the mortgage credit risk and make profits or losses accordingly. This applies to Fannie and Freddie (and equally to any holder of mortgage credit risk with real skin in the game). Those who originate and sell mortgages, but bear no credit risk themselves, and those with various political positions to advance, may certainly have interesting and valuable opinions, but are not the relevant decision makers.

Should Fannie and Freddie stick with their historic use of FICO credit scores, or use VantageScores instead, or both or in some combination?  Naturally, their own scores are favored by the companies who produce them and they should make the strongest cases they can. Should Fannie and Freddie more experimentally use other “alternative credit scores” different from either?  This can also be argued, although it remains theoretical.

The Senate bill requires Fannie and Freddie to consider alternative credit-scoring models and to solicit applications from competitive producers of the scores for analysis and consideration. That is something a rational mortgage credit business would want to do from time to time in any case, and in fact, Fannie and Freddie have analyzed alternative credit scores. The bill further requires that the process of the review and analysis of credit score performance must itself be reviewed periodically, which is certainly reasonable.

Thus the bill would require a process. But when it comes to the actual decisions about which credit scores to use and how to use them in managing the credit risks they take, Fannie and Freddie themselves are the proper decision makers. In my view, they would not necessarily have to make the same decision. Moreover, either or both could decide to run pilot program experiments, if they found that useful.

The Federal Housing Finance Agency (FHFA), Fannie and Freddie’s regulator and conservator, has in process a thoughtful and careful project to consider these questions, has solicited and is gathering public comments from interested parties and displays a very good grasp of the issues involved. But I do not think that, at the end of this project, the FHFA should make the decision. Rather, Fannie and Freddie should make their own credit-scoring decisions, subject to regulatory review by the FHFA—and of course in accordance with the regulatory reform bill, if it becomes law, as I hope it will.

Read More
Op-eds Alex J Pollock Op-eds Alex J Pollock

House prices: What the Fed hath wrought

Published in The Hill.

After the peak of the housing bubble in 2006, U.S. house prices fell for six years, until 2012. Are these memories getting a little hazy?

The Federal Reserve, through forcing years of negative real short-term interest rates, suppressing long-term rates, and financing Fannie Mae and Freddie Mac to the tune of $1.8 trillion on its own vastly expanded balance sheet, set out to make house prices go back up.  It succeeded.  Indeed it has overachieved.  Average house prices are now significantly higher than they were at the top of the bubble.  This is shown in the following 20-year history of the familiar S&P Case-Shiller national house price index.

Read the full article here.

Read More
Letters to the editor Alex J Pollock Letters to the editor Alex J Pollock

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.

Read More
Event videos Alex J Pollock Event videos Alex J Pollock

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.

Read More
Event videos Alex J Pollock Event videos Alex J Pollock

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.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

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.

Read More
Alex J Pollock Alex J Pollock

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.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

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.

Read More
Letters to the editor Alex J Pollock Letters to the editor Alex J Pollock

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.

Read More
Op-eds Alex J Pollock Op-eds Alex J Pollock

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.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

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.

Read More
Alex J Pollock Alex J Pollock

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.

Read More
Policy papers and research Alex J Pollock Policy papers and research Alex J Pollock

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?

Read More
Op-eds Alex J Pollock Op-eds Alex J Pollock

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.

Read More