Knowledge, Risk, and the Surprised Banker: A Conversation with Alex Pollock

Published in Law and Liberty’s LibertyLawTalk podcast.

Longtime Law and Liberty contributor Alex Pollock joins this edition of LibertyLawTalk to discuss his new book Finance and Philosophy.

Better late than never

Published by the R Street Institute.

September brought endless discussions of the 10th anniversary of the bankruptcy of Lehman Brothers and the failures of Fannie Mae and Freddie Mac. Tomorrow, Oct. 3, brings the 10th anniversary of congressional authorization of the Troubled Asset Relief Program (TARP) bailouts created by the Emergency Economic Stability Act.

After all this time, we still await reform of American housing finance – the giant sector that produced the bubble, its deflation, the panic and the bust.

During the panic in fall 2008, in the fog of crisis, “We had no choice but to fly by the seat of our pants, making it up as we went along,” Treasury Secretary Henry Paulson has written of the time. That is no longer the problem.

In retrospect, it is clear that the panic was the climax of a decadelong buildup of leverage and risk, much of which had been promoted by the U.S. government. This long escalation of risk was thought at the time to be the “Great Moderation,” although it was in fact the “Great Leveraging.”

The U.S. government promoted and still promotes housing debt. The “National Home Ownership Strategy” of the Clinton administration—which praised “innovative,” which is to say poor-credit-quality, mortgage loans—is notorious, but both political parties were responsible. The government today continues to promote excess housing debt and leverage though Fannie and Freddie. It has never corrected its debt-promotion strategies.

A profound question is why the regulators of the 2000s failed to foresee the crisis. It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is the mismatch between prevailing ideas and the emergent, surprising reality when the risks turn out to be much greater and more costly than previously imagined.

There is a related problem: regulators are employees of the government and feel reluctant to address risky activities the government is intent to promote.

At this point, a decade later, reform of the big housing finance picture is still elusive. But there is one positive, concrete step which could be taken now without any further congressional action. The Financial Stability Oversight Council (FSOC), created in 2010, was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions (SIFIs) for increased oversight of their systemic risk. In general, I believe this was a bad idea, but it exists, and it might be used to good effect in one critical case to help control the overexpansion of government-promoted housing finance debt.

FSOC has failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important and systemically risky. This failure to act may reflect a political judgment, but it is intellectually vacuous.

Fannie and Freddie should be forthwith designated as the SIFIs they so unquestionably are. Better eight years late than never.

The adventures of investing in Fannie Mae and Freddie Mac stock, or how to lose 99% in a government deal

Published in Housing Finance International.

Fannie Mae and Freddie Mac are the most important housing-finance institutions in the United States—and therefore, in the world—with combined assets of a remarkable $5.4 trillion, which include nearly half of all the $10.6 trillion in outstanding U.S. residential mortgages. They are without question “systemically important”: any default on their obligations would rock both the domestic U.S. and the global financial markets. The largest investor in their mortgage-backed securities is the U.S. central bank, which holds about $1.7 trillion of them.

Fannie and Freddie have a hybrid legal form: they are basically government agencies, “implicitly guaranteed” by the U.S. Treasury, as it was often said, but in reality fully guaranteed. At the same time, they also have private shareholders and publicly traded stocks. The shareholders expected to profit greatly by trading on the credit of the United States and the numerous other special advantages that Fannie and Freddie had been granted by politicians and regulators.

How did the shareholders do? For a long time, their optimistic expectations were more than justified. Then they lost close to everything. After that, Fannie and Freddie’s stocks became purely speculative vehicles, which made, first, big profits and then big losses. This essay chronicles the adventures of investing in the stock of these companies sponsored by, guaranteed by and later entirely controlled by the U.S. government.

Fannie’s all-time high stock price was $86.75 per-share in December 2000. Ten years before, the price had been $8.91, so the aggregate gain in price over the 1990s was 874 percent. This means Fannie’s stock price went up on average 25 percent per-year for a decade. Not bad! Fannie created a powerful, ruthless and feared lobbying organization to protect its no-fee government guaranty and its other competitive privileges. Its political clout and its arrogance became legendary.

“Pride goeth before destruction and a haughty spirit before a fall,” says the Book of Proverbs. This was certainly true of Fannie with matching consequences for its private shareholders. From its peak, after Fannie’s massive losses put it into government conservatorship, its stock price dropped to a low of 20 cents per share in November 2011. That was a loss for the shareholders of 99.8 percent. Now, at the end of July 2018, Fannie’s stock price is somewhat higher, at $1.51. This still represents a loss of 98.3 percent from its peak.

Who would have thought that could happen? Probably nobody. But a fundamental characteristic of prices in a financial bust is that they can go down a lot more than you thought possible.

The shareholders of Freddie Mac experienced a similar elation and then collapse. Freddie’s all-time stock price high was $73.70 in 2004. Ten years earlier it had been $12.63, so the shareholders in this government deal had enjoyed a 484 percent aggregate gain over the decade, or on average over 19 percent per year. Then came the losses, the conservatorship, and the shriveling of its stock price to the trough of the same 20 cents per share in 2011. That meant a 99.7 percent loss from the peak. From the peak to now, the loss is 97.9 percent.

Reviewing the losses for the equity investors in these former political and stock-market darlings, one can only exclaim, “Mirabile dictu!” They form a memorable lesson.

The history of this adventure in investing to trade on the government’s guaranty is shown in Graph 1, which displays three decades of stock prices for Fannie and Freddie, from 1990 to July 2018.

At their stock price bottom of 20 cents per share, Fannie and Freddie were completely controlled by the government, but the two stocks continued to exist and trade. They became and remain a pure speculation on political events and the outcomes of various lawsuits that investors brought against the government. The lawsuits have been unsuccessful and the politicians, although they have debated the matter mightily, have not been able to agree on any legislative restructuring. As the Washington saying goes, “When all is said and done, more is said than done.” In this case, vast volumes have been said, but nothing has been done.

Fannie and Freddie continue to live on the government’s guaranty. They could not exist for one minute without it. Under the conservatorship agreement, the U.S. Treasury takes essentially all their profits, so their capital continues to round to zero. As long as this situation lasts, there can never be any cash for the shareholders, so the price of the shares is a pure gamble on the situation changing by some political outcome. This speculative essence has made Fannie and Freddie’s shares over the last seven years extremely volatile.

Had you had the courage to buy at 20 cents, you might have multiplied your investment up to 29 or 27 times, as the intervening highs have been $5.82 for Fannie and $5.52 for Freddie. But had you been tempted by the optimism of those highs while investing based on the possible actions of the government, you could once again have had huge losses – of over 70 percent.

Table 1 shows your returns had you bought Fannie or Freddie stock at the lows, or had you bought at various subsequent dates, including at the post-2011 highs, and in each case held the shares to July 2018.

As the table makes clear, such purchases during the speculative phase generated very large profits at first, and very large losses afterward, measured on the assumption that you held the shares until now. Of course, the results of interim purchases and sales could have varied a lot in both directions.

The end of this eventful history of Fannie and Freddie’s stockholders has not yet been written. Whatever future chapters may add, the story has demonstrated that, however attractive the deal is at first, the government can be a dangerous business partner over time.

Federal Reserve brings the real Fed Funds Rate up to about zero

Published by the R Street Institute.

As everybody knew it would, the Federal Reserve Board announced today it is bringing its target federal funds rate up to a range of 2 percent to 2.25 percent—in shorter form, to about 2.25 percent. That is still a very low rate, especially translated, as is economically required, to a real interest rate—that is, one adjusted for inflation. The new Federal Reserve target rate, in real terms, is more or less zero.

To adjust for inflation, you have to choose a measure of inflation. The Consumer Price Index over the 12 months through August 2018 rose 2.7 percent. Thus, using the CPI, the new inflation-adjusted Fed Funds target is 2.25 percent minus 2.7 percent, or a real rate of -0.45 percent.

Suppose as an inflation measure you like the Personal Consumption Expenditures Index (PCE) instead. Over the 12 months ended in July 2018, it went up 2.3 percent, so 2.25 percent is still a slightly negative real interest rate.

But the Fed likes to use the “core” PCE, which excludes food and energy prices. This is especially good for people don’t have to buy things to eat or gas for their car. Core PCE rose 2 percent for the same period. That would result in a slightly positive real interest rate of 2.25 percent, minus 2 percent, or 0.25 percent.

Averaging these three estimates together gives a real fed funds target rate of negative 0.08 percent—close enough to zero for monetary policy work, given its vast uncertainties.

Zero is a remarkably low real fed funds rate nine years after the end of the last recession, nine years after the end of the 2007-2009 financial crisis, in a time of strong economic growth and, more to the point, in the midst of a remarkable asset price inflation in houses, commercial real estate and securities.

Nobody, including the Federal Reserve, knows what real interest rates should be, but there is little doubt that a free market, without central bank manipulation, would by now have set them higher.

When and how will the current asset price inflation end?  Nobody, including the Fed, knows that either.

Ten Years After the 2008 Crisis: The Downside of the 30-year Fixed-Rate Mortgage

Published by the R Street Institute.

Here’s a lesson on the 10th anniversary of the 2008 financial crisis that almost nobody seems to have noticed:  the serious downside of the standard U.S. 30-year fixed rate mortgage, as displayed during the collapse of the housing bubble.

To hear politicians, promoters of government mortgage guarantees, proponents of Fannie Mae and Freddie Mac, and typical American housing-finance commentators at all times loudly singing the praises of the 30-year fixed-rate mortgage, you would think it has no downside at all. But of course, like everything else, it does.

Glenn Hubbard, former chairman of the Council of Economic Advisers, wrote recently of the crisis: “Millions of homeowners who were current on their mortgage payments were unable to refinance to lower rates because they were underwater” — in other words, the price of their house had fallen below what they owed on the mortgage. But that is only half of the explanation; the other half is that these homeowners could not get a lower interest rate because they had a fixed-rate mortgage. Therefore, they were stuck with what had become a burdensome interest rate relative to the market.

In contrast, the interest rate on floating-rate mortgages automatically goes down, even if the falling price of the house has put the loan underwater. This automatically reduces the mortgage payments due, reduces the financial pressure on the borrowers, and improves their cash position. Mortgage borrowers in many countries benefited from this reality during the financial crisis, but not the unlucky Americans who had a 30-year fixed-rate mortgage combined with a sinking house price.

Floating-rate mortgages naturally do become more expensive if interest rates rise, but are less expensive when interest rates fall — as they did dramatically during the crisis. Conversely, our 30-year fixed-rate mortgages are fine if house prices inflate upward forever, but in a housing deflation with falling interest rates, they are terrible for the borrowers. As the housing bubble shriveled, they turned out not to be a “free lunch” of a continuous option to refinance, but a very expensive lunch for, as professor Hubbard says, “millions of homeowners.” The more highly leveraged the mortgages were, the more expensive it was.

There is no doubt that the prevalence of the 30-year fixed-rate mortgage made the American housing finance crisis worse. Few people understand this.

It’s time for the Fed to be made accountable for its actions

Published in The Hill.

The U.S. Constitution assigns responsibility for the nature of money to the Congress. As Article I, Section 8 famously says, “Congress shall have Power…To coin Money [and] regulate the Value thereof.”

How can this be consistent with the idea that the Federal Reserve should be “independent,” as it is so often proclaimed, especially by the Fed itself? The answer is that it is not consistent.

Last week, the House Financial Services Committee approved the Federal Reserve Reform Act of 2018, H.R. 6741, which was sponsored by Rep. Andy Barr (R-Ky.), the chairman of the Subcommittee on Monetary Policy and Trade. The full committee passed the bill 30-21, with the vote along party lines.

This is an important effort to move toward the proper constitutional ordering of authority over money and regulating the value thereof, which we now call “monetary policy,” whatever the future of the bill may be.

Who should be in charge of money and its value? The Fed all by itself or the Fed as accountable to Congress? Almost all of the very many economists I know think that the Fed, a very large employer of economists, should be independent.

But that cannot be the right answer in a government whose essential character requires robust checks and balances.

I believe proponents of Fed independence tend to view it as a committee of economic philosopher-kings. But this fits neither its existence as part of a democratic government, nor the inherent uncertainties and limitations of its knowledge of the economic present, let alone the future.

Section 2 of the bill, Monetary Policy Transparency and Accountability, requires the Fed to discuss with Congress what the Fed is trying to do, in some specificity and in plain English, as distinct from “Fedspeak.”

The Fed would be required to discuss what its monetary strategy for each coming year is, how it plans to use the various instruments at its disposal, what monetary policy rules it has adopted and how these might change.

After the fact, it must discuss how the monetary strategy did change, if it did. This seems a pretty reasonable discussion for the Fed to have with the elected representatives of the people, who have the constitutional responsibility for the value of money.

Section 11 C (b) contains a nice definition of what money should mean in the pure fiat currency system we now have:

A generally acceptable medium of exchange that supports the productive employment of economic resources by reliably serving as both a unit of account and store of value.

This is what the bill instructs the Fed to produce. It is in notable contrast to the endemic inflation the Fed has presided over for the last several decades, which has resulted in a dollar today being worth what a dime was in 1950.

In the bill as originally proposed, a Section 12 would have changed the Fed’s so-called “dual mandate” of “maximum employment [and] stable prices” to simply “stable prices.” This vividly contrasts with the current Fed’s formal commitment to perpetual inflation. This provision did not make it into the committee’s approval, but is such an important idea that it deserves discussion.

The “dual mandate” was enacted in the 1970s, when people believed in the Phillips Curve theory that you would increase employment by running up inflation.

If it were up to me, on the next opportunity, I would write this new mandate somewhat differently, along these lines: “All Federal Reserve strategies are to be consistent with stable prices on average over the long run.”

This is because in an innovative, free-market economy with sound money, prices will rise sometimes and sometimes fall, but have a basically flat trend over the long run. It must not be forgotten that the Fed’s original 1913 mandate, “to furnish an elastic currency” to finance crises, is still there.

Section 3 (a) of the bill, “Returning to a Monetary Policy Balance Sheet,” would require the Fed’s investment portfolio to be essentially held in Treasury securities (with a few exceptions for gold certificates, foreign central bank obligations or the International Monetary Fund).

The real point is to take the Fed out of being a massive investor in real estate mortgage securities, thus out of being a promoter of house price inflation and out of effectively being a giant savings and loan vehicle. The Fed would have to give all non-qualifying investments to the U.S. Treasury in exchange for Treasury securities.

This is not as strict as the “Bills Only” policy adopted by the Fed under Chairman William McChesney Martin in the 1950s, but reflects similar ideas. Martin’s policy required that all Fed investments be in short-term Treasury bills.

To show how much things can change, the Fed for the last several years owned zero Treasury bills, and today, bills represent about 2 percent of its assets.

The Federal Reserve has grown over time to be an institution that combines immense power with a yearning for “independence.” Rep. Barr is right that, faced with this behemoth, the Congress should be improving its oversight and exercising its duty to define money and regulate its value.

Efforts to close the ‘doom loop’ are destined to fail

Published in the Financial Times.

Thomas Huertas (“Bank holdings of sovereign debt need scrutiny,” September 7) makes very reasonable proposals of how to control the “doom loop” of government debt making the banking system more risky, while the banks make the government’s finances more risky. But the sensible reforms he recommends won’t happen and can’t happen. This is for a simple and powerful reason: the financial regulators who would have to take the actions are employees of the government which wants to expand its debt. A top priority of all governments is to be able to increase their debt as needed. The regulators will not act against this fundamental interest of their employer.

An egregious example of this problem in the U.S. context is that as the bubble inflated the banking regulators did, and still do, allow the banks to hold unlimited amounts of the debt of Fannie Mae and Freddie Mac, the government-backed mortgage firms, long since failed and in conservatorship. Moreover, the regulators allowed (and indeed promoted, through low risk-based capital requirements) banks to own and finance with deposits the preferred equity of Fannie and Freddie. These were distinctly bad ideas. But what were the poor regulators to do? Their employer, the US government, wanted to expand housing debt and leverage through Fannie and Freddie, and they went along.

What will cryptocurrency be like in 10 years?

Published in ReadWrite.

The second issue the subcommittee raised was that of government-created cryptocurrencies. Alex J. Pollock of the R Street Institute said that: “In short, to have a central bank digital currency is a terrible idea — one of the worst financial ideas of recent times.” Pollock argued that “[The Federal Reserve] would automatically become the overwhelming credit allocator of the financial system. Its credit allocation would unavoidably be highly politicized. It would become merely a government commercial bank, with the taxpayers on the hook for its credit losses. The world’s experience with such politicized lenders makes a sad history.”

Two books that will enrich your understanding of banking and bank crises

Published in Real Clear Markets.

Over the summer, I had the pleasure of reading the prerelease versions of two books about banking and financial crises: Finance and Philosophy: Why We’re Always Surprised, by Alex J. Pollock, (Paul Dry Books, October 16, 2018), and Borrowed Time: Two Centuries of Booms, Busts, and Bailouts at Citi, by James Freeman and Vern McKinley (Harper Business, 2018). Pollock’s book is being released in October, and Freeman and McKinley’s book is already available. If the history of banking and financial crises interests you, I think you will find both books to be rich in content and enjoyable to read. I know I did.

In Finance and Philosophy Alex Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, applies his formidable intellect and a lifetime of banking experience to explain in a simple and entertaining way why we continue to have banking crises and why post-crisis regulatory reforms are doomed to fail.

Banking systems will be prone to crises so long as investors confuse risk and uncertainty writes Pollock. Risk can be modeled, assessed and managed, but not so uncertainty.

[…]

Pollock recounts numerous historical examples where the accuracy of heuristic models evaporated once investors and regulators adopted models to guide their actions. For example, in the recent financial crisis, institutions relied on models to parse the risk in subprime mortgage-backed securities. To describe the impact of uncertainty, Pollock quotes Tony Saunders “[t]he rocket scientists built a missile which landed on themselves.”

In Pollock’s view, over confidence in heuristic models is especially problematic when models are sanctioned by bank regulators or the Federal Reserve. For example, time and again, investors have been crushed when uncertainty reveals that investments like government bonds—presumed to be “riskless” in regulatory models— aren’t. Or markets presumed to be deep and dependably liquid—like commercial paper—cease to function.

The confusion between risk and uncertainty is not limited to private bankers and investors—in Pollock’s view, it is endemic among the modern central bankers entrusted with managing the economy. Unable to anticipate economic uncertainty, their economic models often misinterpret the economic tea leaves and lead central bankers (Pollock’s would-be “philosopher kings”) to adopt policies that magnify financial instability as they did in the great inflation of the 1970s and the great moderation (a.k.a. the housing bubble) more recently.

Pollock’s observations and historical examples are compelling, and his wide-ranging discussion of banking and financial crises is not only accessible, but a pleasure to read.

Is the Senate banking bill a big win for Wall Street? Yes and no

Published in Politifact.

Phone interview with Alex Pollock, senior fellow with the R Street Institute, March 15, 2018

Subcommittee examines ways to reform the Federal Reserve

Published by the House Financial Services Subcommittee on Monetary Policy and Trade.

“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.’… 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.” — Alex J. Pollock, Distinguished Senior Fellow, R Street Institute

Remarks at AEI’s ‘Conference on the 10th anniversary of the financial crisis’

Published by the R Street Institute.

Thanks, Peter. It’s a pleasure to be in a panel with such distinguished colleagues.

I’d like to begin by pointing out that, in addition to being the instructive 10th anniversary we have been discussing, today is also a notable 11th anniversary: On Sept. 14, 2007, Northern Rock bank, a major British mortgage lender, could no longer fund itself in wholesale markets, and an emergency lender-of-last-resort facility from the Bank of England was announced. That day, long lines of depositors began to form outside branches of Northern Rock, its website collapsed and its phone lines were jammed.

The first bank run in England since the days of Queen Victoria was underway. So was the first bailout of the 2007-2009 financial crisis. The crisis reached its peak panic just one year later, as Lehman Brothers went down.

Let’s review a few of the events as the ultimate panic approached.

In June 2008, Larry Lindsay wrote an article for AEI entitled, “It’s Only Going to Get Worse.” He was so right.

In July, Congress passed the law authorizing the Treasury to put money into Fannie and Freddie. Secretary Paulson said he wouldn’t need to. “Nervous calls” from officials of foreign countries to the U.S. Treasury were urging that their large investments in the securities of the tottering Fannie Mae and Freddie Mac be protected by the U.S. government.

On Sept. 7, Fannie and Freddie were put into conservatorship along with their Treasury bailout. Fannie’s common stock had closed at $7 a share Friday, Sept. 5. On Monday, Sept. 8, it was 73 cents.

A week later, Friday, Sept. 12, Lehman’s common stock closed at $3.65 a share. By Monday, Sept. 15, it was 21 cents.

On Sept. 16, losses on Lehman commercial paper forced the Reserve Primary money market fund to “break the buck”; also the Federal Reserve loaned AIG $85 billion.

On Sept. 20, the Bush administration submitted TARP legislation to Congress.

The times were frightening, to be sure and obscured by the “fog of crisis.” As Secretary Paulson later wrote, “We had no choice but to fly by the seat of our pants, making it up as we went along.”

Imagine you are a Treasury secretary, finance minister or head of a central bank. You are in the fog of crisis, but you can see that you and your colleagues are standing on the edge of a cliff, staring down into the abyss of potential debt deflation. Will you choose to risk the eternal obloquy of being the one who did nothing?  Of course not. You will intervene and keep intervening with whatever bailouts seem necessary. Your only objective will be to survive the crisis. That’s what you would do, if you were in office, and so would everybody else, just as is always done.

Only, of course, in 2008, they didn’t bail out Lehman. Would you have done so, under the circumstances of the time?

But more fundamentally, the panic was the climax of more than a decade of a long buildup of leverage and risk, and much of this, as has been rightly said, was promoted by the U.S. government. How had the long increase in risk seemed at the time?

Well, the central bankers believed they had created the “Great Moderation,” which turned out to be the “Great Leveraging.” Tim Geithner, then-president of the Federal Reserve Bank of New York, thought in 2006 that “[f]inancial institutions are able to measure and manage risk more effectively,” a belief common at the time.

But: “The reality is that we didn’t understand the economy as well as we thought we did,” as Fed Vice Chairman Don Kohn candidly reflected. “Central bankers, along with other policymakers, professional economists and the private sector failed to foresee or prevent a financial crisis.”

That is reasonably close to a mea culpa, although he sweeps in a lot of other people in his confession. Does the Fed understand the economy any better today than it did in the 2000s?  Is it ever, as Peter Fisher has asked, “candid about the uncertainty” it always faces?

The government promoted housing debt. Most notoriously, the “National Home Ownership Strategy” of the Clinton administration pushed for “innovative” – that is, poor credit quality – mortgage loans. It goes without saying that the government promoted excess housing debt and leverage though Fannie and Freddie, as it continues to do today. These debt-promotion strategies never have been rejected by the U.S. government.

The crisis ended in the spring of 2009, after the Fed had the very good sense to replace mark-to-market tests with “stress tests.” That was an ingenious way out of a problem. Whether by cause or coincidence, the stock market started back up on its long bull run. The S&P Bank Index, which had been at 281 on Sept. 12, 2008, bottomed at 77 on March 5, 2009, after a loss of more than 70 percent. It has since then gotten up over 500.

In the boom, it seems like the boom will last forever. In the bust, it seems like the bust will last forever. Of course, neither is the case, but it feels that way.

By midyear 2009, it was clear we had survived the crisis. Now, it was time for the inevitable political reaction to it, as happens in every financial cycle. Now was the hour for the politicians, including those who had pushed the policies that made things worse, to show how they could fix the problems.

Imagine you are a politician. What would you do in the wake of a huge crisis and bust?

First of all, you certainly have to Do Something!  You can’t just stand there, any more than the central bankers and regulators could during the panic.

Some of us, including Peter Wallison, Ed Pinto, Chairman Jeb Hensarling and me, thought it was a great opportunity to restructure U.S. housing finance into a primarily private, market system, with private capital bearing the risk of its actions.

In 2010, I proposed, in a piece called “After the Bubble,” a list of reform actions which included these:

-Create a private secondary market for prime, middle-class mortgages;

-Design a transition to having no government-sponsored enterprises;

-Stop using the banking system to double-leverage the GSEs, should they survive;

-Facilitate credit-risk retention by mortgage originators;

-Develop countercyclical loan-to-value discipline;

-Create bigger loss reserves in good times;

-Use a one-page key mortgage information form focused on whether the borrower can afford the loan;

-Address the banking system’s overconcentration in real estate risk; and

-Rediscover savings as an explicit goal of housing finance.

It still seems like a good list to me, but needless to say, this wasn’t the direction taken.

A different path was chosen, one always available to the legislature: to expand regulations and the regulatory bureaucracy, with orders that they are not to allow such problems again. This was in spite of the fact that “[n]o regulator had the foresight to predict the financial crisis,” as Andrew Haldane of the Bank of England said, adding, “although some have since exhibited supernatural powers of hindsight.”

But the most interesting question is why did regulators fail to foresee the crisis?  It was not because they were not trying—they were diligently regulating away. It was not because they were not intelligent. Instead, the problem was and always is one of knowledge of the future, not of effort. The problem is the inherent uncertainty, the ineluctable lack of knowledge of the future—the mismatch between prevailing ideas and the emergent, surprising reality.

There is another problem: regulators are employees of the government and cannot be expected to stop activities the government is intent on promoting, or act against the interests of their employers. As Bill Poole so convincingly wrote in his paper for this conference:

“An obvious first observation is that the affordable housing policy and mortgage goals given to the GSEs were policies of the Congress, President Clinton and President Bush.” He asks rhetorically, “Should the Fed somehow have undercut the stated policies of the president and the Congress?” The same question applies to all the other regulators.

In spite of these problems, the politicians did what they usually do in the wake of the bust: expand the regulatory bureaucracies and give them more power, renewing Woodrow Wilson’s faith in “expert” bureaucracy. The resulting many thousands of pages of new rules protect the politicians who had to Do Something from the charge of not doing anything or of not doing enough. There is no doubt that the thousands of man-years that went into negotiating and writing the new rules were spent by intelligent, informed, well-intentioned people intent on making the financial system into a mechanism with less chance of failure, although we all know the chance of failure never becomes zero. This is a fine goal, but suffers because financial markets are not a mechanism. (Of course, the bureaucratic excesses of Dodd-Frank were enabled by the temporarily overwhelming congressional majorities of the Democratic Party, which only lasted until they were lost in 2010.)

In the wake of the crisis, the power of the Federal Reserve was also greatly expanded, its role in feeding the bubble and its complete failure to anticipate the collapse notwithstanding. This is the latest of numerous examples in history of Shull’s Paradox, which is that the Fed always gets more powerful, no matter what blunders it makes.

Another action always available to politicians is to set up a committee and give them a big, great-sounding assignment. In this case, the committee was FSOC (the Financial Stability Oversight Council) and its assignment was to figure out, address and avoid systemic risk. There is no evidence that FSOC has the ability to do this, but creating it was a perfectly sensible action from the politicians’ point of view. No one can accuse them of ignoring systemic risk!

FSOC was given the power to designate large financial firms, in addition to the big banks, as Systemically Important Financial Institutions, or SIFIs. FSOC has designated a few firms, then de-designated most of them, but it has utterly failed to designate as SIFIs the most blatantly obvious SIFIs of all:  Fannie and Freddie. FSOC has not admitted, let alone acted on, a fact clear to everybody in the world: that Fannie and Freddie are systemically important. This may be politically prudent on its part, but is intellectually vacuous. I believe Fannie and Freddie should be designated as the SIFIs they so obviously are immediately. Better late than never.

The Fannie and Freddie problem displays the more general fatal flaw in FSOC. It cannot control or even point out the systemic risk created by the government itself. Its members cannot criticize their employer.

The last point I will mention here is a key one: the post-crisis political reaction insisted that there had to be more equity capital in the financial system. This was a good idea, agreed upon by almost everybody. But note that the banks’ capital was able to get so small in the first place, only because the government was correctly believed to be guaranteeing the depositors. Fannie and Freddie’s capital was able to get even smaller because of the correct belief that the government was guaranteeing their creditors.

In the wake of the bust, the Federal Reserve set out to create a “wealth effect” by pushing back up the prices of houses and the prices of financial assets, in order in theory to stimulate economic growth. As we all know too well, it pursued this by massive purchases of long-term Treasury bonds (while reducing its portfolio of short-term Treasury bills to zero) and of very long-term mortgage-backed securities, increasing the Fed’s own balance sheet, as is well-known, up to $4.5 trillion. The Fed also kept real short-term interest rates negative for the better part of seven years.

Whatever the arguments for doing these things as short-term measures, the Fed has kept them as long-term, unquestionably distortionary programs, even now reducing its balance sheet only slightly and getting real short-term interest rates up to approximately zero. The result has been a massive asset price inflation in real estate, financial assets and other assets.

The Fed got its renewed house price boom, all right. Nominal house prices are now well over their bubble peak.

The Fed also instituted the payment of interest on excess reserves held with it by banks. This allowed it to suppress the credit expansion that would have occurred in classic banking theory, and to itself allocate credit instead. To what did it allocate credit?  To housing and to the government deficit.

Where and how will the Fed-induced remarkable asset price inflation end?  I don’t know. The Fed doesn’t know. The financial regulators don’t know. That is hidden in the uncertainty of the economic future. It may be the Fed’s hoped-for soft landing, but then, it might not be.

Finally, here is a reminder of some essential things not done by the politicians or the regulators or the central bank in the wake of the crisis, among others:

• They did not create a primarily private secondary market for prime mortgages.

• They did not design a transition to having no GSEs.

• They did not develop countercyclical LTV discipline.

• They did not address the overconcentration of the banking system in real estate risk.

• They did not rediscover savings as an explicit goal of housing finance.

They did get equity ratios increased, which was good.

They did preside over an efflorescence of bureaucracy and a giant asset price inflation.

What next?  This is a period of uncertainty, just like every other period.

Former FHLB Chicago President and CEO, Alex J. Pollock, named Finzat Block Senior Advisor

Published in Markets Insider.

Finzat Block LLC., a Block One Capital portfolio company, announced that Alex J. Pollock has become a Senior Advisor to the firm.  Mr. Pollock, former President and CEO of the Federal Home Loan Bank of Chicago, will provide Finzat with guidance regarding business strategy, product innovation, and executive leadership.

“Blockchain is emerging as a potential paradigm-shifting technology in mortgage finance.  I look forward to working with Finzat Block on using blockchain to restructure the technological underpinnings of mortgage market transactions,” Mr. Pollock said.

Mr. Pollock is currently a distinguished senior fellow at the R Street Institute in Washington, DC. Previously, he was a resident fellow at the American Enterprise Institute. As President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004, Mr. Pollock was the creator of the MPF mortgage origination program that was the first to provide community financial institutions a way to share credit risk and provide a meaningful alternative to selling mortgages to Freddie Mac and Fannie Mae.

Mr. Pollock currently serves as a director of the CME Group (Chicago Mercantile Exchange), Great Lakes Higher Education Corporation and the Great Books Foundation, and is a member of the Advisory Board of the Heller College of Business at Roosevelt University.  He was also the past-President of the International Union for Housing Finance.

Mr. Pollock has written extensively on economic cycles, risk and uncertainty, mortgage markets, central banking and the politics of finance.  His new book, “Finance and Philosophy“, is expected to be published by Paul Dry Books in October of this year.

Mr. Pollock is a graduate of Williams College. He completed his MA at the University of Chicago and MPA in international affairs at Princeton University.

“We are fortunate to have Alex’s considerable experience and mortgage market knowledge on the team as Finzat strives to bring the benefits of blockchain into the mortgage mainstream”, said Gnanesh Coomaraswamy, Finzat founder and CEO.

Did Congress just settle for less than best plan to reform housing finance?

Published in The Hill.

House Financial Services Committee Chairman Jeb Hensarling (R-Texas) has long worked to move the American housing finance sector toward private and competitive markets and away from the distortions and disasters of government guaranteed debt with huge risks to taxpayers.

His previous policy direction, exemplified in his sponsorship of the Protecting American Taxpayers and Homeowners Act, was the correct one, both economically and philosophically. But up against the many well placed interests that feast on subsidies from the government dominated system, it could not succeed politically. The history of American mortgage lending should make us modest as a country. Our housing finance system has collapsed twice in the last four decades, first in the 1980s then again in the 2000s. We should certainly try to do better going forward.

Now Hensarling, working across the aisle with John Delaney (D-Md.) and Jim Himes (D-Conn.), has introduced a discussion draft of the Bipartisan Housing Finance Reform Act, which he hopes will prove a “grand bargain” to create a “sustainable housing finance system for the 21st century” after 10 years of a stalemate in Congress. But central to this new proposal is vastly increasing the government guarantee of mortgage backed securities by using Ginnie Mae, a wholly owned government corporation whose liabilities deliver the full faith and credit of the United States. Thus, the government and taxpayers would explicitly guarantee virtually the whole secondary mortgage market.

Has Hensarling given up on his principles? No, but he has decided that, with the best choice unavailable, he will settle for what may be the second best, arguing that it would be an improvement from where we are and where we have been stuck for a decade. The new bill requires private capital to bear a junior position in mortgage credit risk, taking losses ahead of Ginnie Mae, which is to say, ahead of taxpayers. It abolishes the federal charters of Fannie Mae and Freddie Mac, while allowing them to become private credit risk takers, among other such private institutions. It also allows the Federal Home Loan Banks to aggregate mortgage loans for their members. I especially like this last idea because my team developed it while I was running the Chicago Home Loan Bank.

Consider the following series of options. The best choice is a primarily private and competitive housing finance system, but it cannot happen politically. As a second best choice, a system is proposed that uses big government guarantees, but fits in as much private risk bearing and competition as it can. A third choice would be a bad decision to stay where we are now, with Fannie and Freddie perpetually in conservatorship but dominating the housing finance system nonetheless. Finally, the worst choice is to return to the old and failed Fannie and Freddie model.

Given where we are, is it better to wish for the best and never get it, or try to move toward a second best option, which might be politically feasible? This second best strategy is understandable and reasonable. But is the structure proposed in the new bill actually the second best available? That is debatable. For example, when it comes to the key idea of having private capital bear the principal credit risk, the bill unfortunately misses an essential principle that the best place for the junior credit risk to reside is with the institution that made the loan in the first place. That is the party with the most knowledge of the credit and the only one with direct knowledge of the borrower. Keeping the credit risk there provides by far the best possible alignment of incentives for a sound housing finance system. It also spreads the credit risk bearing across the country.

This is demonstrated by the unquestionably superior credit performance through the financial crisis of the mortgage portfolio built on this principle by the Federal Home Loan Banks in their mortgage partnership finance program, the first loan of which was completed by the Chicago Home Loan Bank in 1997. The risk principle in this program provides more than 20 years of instructive experience to draw on in moving toward a better housing finance system for the United States, even if, as Chairman Hensarling has concluded, we cannot attain the best.

FR-6111-A-01 Reconsideration of HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Published by the R Street Institute.

Department of Housing and Urban Development

Regulations Division

Office of the General Counsel

Washington, DC 20410

www.regulations.gov

Dear Sir/Madam:

Re.: FR-6111-A-01   Reconsideration of HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Thank you for the opportunity to comment on this advanced notice of proposed rulemaking, which we believe has the potential to significantly improve the existing standard.  The authors of this comment each have many years of experience in housing finance, both as operating executives and as students of housing finance systems and their policy issues.

Our comments are in particular directed to your Question #6: “Are there revisions to the Disparate Impact Rule that could add to the clarity, reduce uncertainty, decrease regulatory burden, or otherwise assist regulated entities and other members of the public in determining what is lawful?”

The short answer to this question is Yes.  We recommend one major, fundamental change which would great enhance clarity and understanding, while greatly reducing uncertainty, in the concepts and operation of the rule: This is to add to the analysis of HMDA data the default rates on mortgages, organized by the same demographic categories as used in HMDA reporting.

Discussion

Applying one’s credit standards in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing.  Is it evidence of discrimination if a lender applies exactly the same set of credit underwriting standards to all credit applicants, but this results in different demographic groups having different credit approval-credit decline ratios?  And is this result evidence of discrimination?

There is a straightforward, data-based way to tell.  It is to add the default rates on the mortgages for each group, and compare them to the approval-decline ratios by group, adjusting for ex ante credit risk factors.

If a demographic group A has a lower credit approval rate and therefore a higher credit decline rate than another group B, the revised rule should require comparing their default rates.

There are three possible outcomes:

1. If group A has the same default rate as group B, then the underwriting procedure was effective and the different approval-decline ratios were appropriate and fair, since they resulted in the same default outcome. Controlling and predicting defaults is the whole point of credit underwriting. Here there is no evidence of disparate impact.

2. If the default rate for group A is higher than for group B, that shows that in spite of the fact that group A had lower credit approval and higher decline rates, it was nonetheless being given easier credit standards. The process was evidently biased in its favor, not against it, even if this was not intended. Again, there is no evidence of disparate impact.

3. If on the other hand, group A’s default rate is lower than that of group B, that shows that group A is experiencing a higher credit standard, even if this is not intended. This may be evidence of disparate impact.

As Nobel laureate in economics Gary Becker wrote, “The theory of discrimination contains the paradox that the rate of default on loans approved for blacks and Hispanics by discriminatory banks should be lower, not higher, than those on mortgage loans to whites.”

In short, if the default rate of group A is equivalent or higher than that of group B, then the claim of disparate impact disappears.

Some discussions of the disparate impact issue have analyzed different demographic groups by household income or other credit factors, but while these factors may be indicators of future default rates, they are not the experienced reality.  Any sufficient analysis must add the reality of the actual default rates.

In sum, we need the facts of default rates to address this issue objectively.  We recommend that HUD’s revised rule should require them to be provided as an essential part of the analysis of any possible disparate impact issue.

The default data by HMDA category is not now readily available from typical mortgage servicing records, but research at the AEI Center on Housing Markets and Finance has shown that the required matching of HMDA to relevant risk and performance data is practicable, as well as theoretically required in order to, as a factual matter, determine any disparate impact.

For example, the experience of FHA loans for the years 2013 to 2017, comparing credit approval ratios to default rates by demographic group is shown in Attachment A.  In all cases, although the credit approval ratios for minorities are lower, their default rates are higher, as are their risk-adjusted default rates, indicating no disparate impact in the aggregate.

We look forward to sharing with you with the further data the Center is developing to help advance the appropriate policy considerations.

It would be a pleasure to discuss this recommendation further with you at your convenience, should you so desire.

Thank you again for the chance to participate in this timely reconsideration.

Yours respectfully,

Alex J. Pollock                                                       Edward J. Pinto

Distinguished Senior Fellow                                 Co-director

R Street Institute                                                  AEI Center on Housing Markets and Finance

Letters to Barron’s: Rediscovering Minsky

Published in Barron’s.

Hyman Minsky is featured in Randall W. Forsyth’s “Musk’s Buyout Plan May Signal Market Woes Ahead,”(Up & Down Wall Street, Aug. 11). About Hy, who was a good friend of mine and from whom I learned a lot, Forsyth says that his “insights were rediscovered after the financial crisis,” meaning the crisis of 2007-09. That is true, but Hy was previously rediscovered in the financial crises of the 1990s, and before that was discovered during the financial crises of the 1980s. The popularity of his ideas is a coincident indicator of financial stress.

Hy’s most important insight, in my opinion, is that the buildup of financial fragility is endogenous, arising from the intrinsic development of the financial system, not from some “shock” that comes from outside. I believe this key contribution to understanding credit cycles can be improved by adding that “the financial system” includes within itself all of the financial regulators, central banks, and governments. All are within the system; no one is outside it, looking down. They all are part of the endogenous process that generates the crises, which periodically cause Hy Minsky to be rediscovered again.
Alex J. Pollock
R Street Institute
Washington

Minneapolis Fed’s TBTF plan has some GSE-sized holes

Published in American Banker.

The Federal Reserve Bank of Minneapolis this winter finalized its “Minneapolis Plan to End Too Big to Fail” — that is, a plan intended to end the problem of “too big to fail” financial institutions, including both banks and nonbank financial companies.

But here is something remarkable: Fannie Mae and Freddie Mac, among the most egregious cases of “too big to fail,” appear nowhere at all in the plan.

Have the Federal Reserve Bank of Minneapolis authors forgotten how Fannie and Freddie blew masses of hot air into the housing bubble, then crashed, then got a $187 billion bailout from the U.S. Treasury? Have they not noticed that Fannie and Freddie remain utterly dependent on the credit guaranty of the Treasury, remaining TBTF to the core?

Since the plan focuses on excessive leverage as the fundamental cause of “too big to fail” risk, have they not considered that Fannie and Freddie each had capital of less than zero at the end of last year, so they had infinite leverage along with their $5.4 trillion in liabilities?

Defenders of Fannie and Freddie will cry that they can’t build capital when the Treasury takes all their profits every quarter. But whoever may be to blame does not change the overwhelming fact: the government-sponsored enterprises are “too big to fail.”

The Minneapolis plan notes that, under the current regime, firms “can continue to operate under their explicit or implicit status as TBTF institutions potentially indefinitely.” This is true — and it is especially true of Fannie and Freddie. So the plan should say instead: “Under the current regime, banks and nonbank financial firms, including notably Fannie Mae and Freddie Mac with their $5 trillion in risk exposure, can continue as TBTF institutions potentially indefinitely.”

What should be done about the TBTF nonbank companies? According to the Minneapolis Fed, the answer is for the Congress to impose a “tax on leverage” that offsets the advantages of running at high leverage and low capital. This tax on leverage will apply to any company with more than $50 billion in total assets. Since Fannie has over $3 trillion of assets and Freddie over $2 trillion, it is safe to say they would qualify.

If the secretary of the Treasury certifies that the company in question does not pose systemic risk, the tax would be 1.2 percent of liabilities under the plan. It is certainly hard or impossible to imagine that any Treasury secretary could certify that Fannie and Freddie pose no systemic risk. So in their case the tax on leverage would be 2.2 percent of total liabilities — 2.2 percent of “anything other than high quality common equity.”

Among the types of firms that the plan would consider for the leverage tax are “funding corporations, real estate investment trusts, trust companies, money market mutual funds, finance companies, structured finance vehicles, broker/dealers, investment funds and hedge funds.” Again, and amazingly, Fannie and Freddie are not on the list.

But if this proposal applies to any these entities, or indeed to anybody at all, it certainly applies to Fannie and Freddie. That is especially true since the market arbitrages across capital requirements of different financial institutions. It sends mortgages to Fannie and Freddie, not because they are most skilled at managing risk, but rather because they have the highest leverage. This was true even before they crashed, since Fannie and Freddie had charters granting them far greater leverage than any other financial institutions.

We’ve calculated how much the proposed Minneapolis tax on leverage would cost these financial behemoths. For Fannie, total liabilities are $ 3.35 trillion, so the annual tax would be 2.2 percent times that, or $74 billion. Fannie’s profit before tax for the year 2017 was $18.4 billion, so the tax in the size proposed by the Minneapolis Plan would be four times Fannie’s total pretax profit.

For Freddie, the corresponding numbers are liabilities of $2.05 trillion and a leverage tax of $45 billion, which would be 2.7 times its 2017 pretax profit.

In short, instead of paying about 100 percent of their profits to the Treasury, Fannie and Freddie together would pay Treasury well over 300 percent of their profits. This would obviously cause them to operate at a huge pro forma loss.

As a first step, we make the much more modest proposal that Fannie and Freddie should be required to pay the Treasury for its credit support, which makes their existence possible, an annual fee of 0.15 percent to 0.20 percent. Such a fee would be consistent with what undercapitalized banks must pay for a government guarantee from the Federal Deposit Insurance Corp., which is also assessed on their total liabilities. Fannie and Freddie’s effective, though not explicit, guarantee from the Treasury is extremely valuable and should be paid for, without question. As is the intent of the Minneapolis plan, charging a fair price for it would significantly reduce the capital arbitrage the GSEs exploit, reduce the distortions and vulnerabilities they introduce into the mortgage market and reduce the massive taxpayer subsidies they have heretofore enjoyed.

As the foremost “too big to fail” institutions in the country — indeed, in the world — Fannie and Freddie must be included in any TBTF reform plan that is to be taken seriously.

Booming housing market today presents serious risk for future

Published in The Hill.

We are currently in the midst of a six-year boom in home prices. Aided by a growing economy, favorable demographic trends, monetary accommodation, […]

EU Parliament report calls for CBDCs to level competition in cryptocurrency market

Published in Live Bitcoin News.

Last week, Alex Pollock, senior fellow at the R Street Institute, argued during a U.S. Congressional Subcommittee on Monetary Policy and Trade that “a central-bank digital currency is one of the worst financial ideas of recent times.” However, he added that “it’s still quite conceivable.”

US Congress: Yes to crypto, no to central bank crypto

Published in Coingeek.

Alex Pollock, a senior fellow at the R Street Institute, took to the microphone to discuss central bank-digital currency (CBDC). He said, “[To] have a central bank digital currency is one of the worst financial ideas of recent times, but still it’s quite conceivable…” He further asserted that a central bank’s digital currency would increase the power of the bank that could lead to the Federal Reserve becoming the “overwhelming credit allocator of the U.S. economic and financial system” if the Reserve were to adopt a CBDC.