Book notes: Finance and philosophy, by Alex J Pollock

From Central Banking:

Pollock started his working life as a banker. In 1970, he was a management trainee in the international banking department of the Continental Illinois Bank of Chicago. He stuck with it, but in 1984 – by which time he was a senior vice-president – Continental Illinois Bank failed.

He writes it was “intellectually stimulating – indeed, a highly educational experience”.

Read the rest here.

Zimbabwe Monetary Theory

Published in Barron’s.

A more instructive name for so-called Modern Monetary Theory is Zimbabwe Monetary Theory, or ZMT (“Do Budget Deficits Matter? Not to Today’s Left or Right,” Up & Down Wall Street, March 1).

It is hardly a new idea, The core issue, however, is not whether a currency is issued by fiat or instead is said to be tied to some other value. The real issue is the nature of governments and their eternal monetary temptation.

In the wake of the destruction of its old fiat currency under ZMT, Zimbabwe has not saved itself from renewed monetary debasement and confusion by trying to link to the U.S. dollar. Likewise, promising that the dollar was tied to gold under the Bretton Woods Agreement did not prevent the U.S. government from defaulting on its Bretton Woods commitments and feeding the great inflation of the 1970s.

The paradigm for government monetary behavior was perfectly explained by Max Winkler in his lively study of government defaults, Foreign Bonds: An Autopsy. In 1933, Winkler looked back a couple of millennia to a great story of Dionysius, the tyrant of Syracuse. Having gotten himself excessively in debt and being unable to pay, Dionysius ordered his subjects to turn in all their silver coins on pain of death. After collecting them, he had each one drachma coin restamped “two drachmas,” and then had no trouble paying off the debt. Dionysius, Winkler said, thereby became the father of currency devaluation. He also became the father of Zimbabwe Monetary Theory.

Re: Comments/ RIN 2590-AA98: Validation and Approval of Credit Score Models by Fannie Mae and Freddie Mac

Published by the R Street Institute.

Dear Mr. Pollard:
Thank you for the opportunity to submit these comments on the Proposed Rule on Credit Score Models:

1. In my opinion, the Proposed Rule overall is sensible and well-considered, and consistent with sound housing finance.

2. Since credit scores are part of the analysis and management of credit risk, the principal decisions about their use should rest with those who take the credit risk—in this case, with Fannie Mae and Freddie Mac. The process as defined by the Proposed Rule thus puts the primary responsibility for analysis and decisions in the right place, with Fannie and Freddie, with review by the FHFA as regulator.

3. It certainly makes sense for Fannie and Freddie to consider various available alternative credit score models, as provided in the Proposed Rule, but the primary decision criterion should always be each model’s contribution to accurately predicting future loan credit performance. The Proposed Rule reasonably suggests consideration of each model’s accuracy and reliability on its own, as well as when used within Fannie and Freddie’s credit management systems, but the latter is clearly the more important question.

4. As the Proposed Rule importantly observes, “Credit scores are only one factor considered by [Fannie and Freddie] in determining whether to purchase a loan.”

5. It is essential, as reflected in the Proposed Rule, for considerations of credit score models to take into account the time, effort, complexity, uncertainty, and costs (direct and indirect) to the mortgage industry of alternative decisions. In particular, the effects on smaller mortgage lenders should be addressed.

6. It is a good idea to have the possibility of small-scale experiments or “pilot programs,” if appropriate, as the Proposed Rule provides.

7. The Proposed Rule suggests using the standard definition of default with a time horizon of two years from loan origination. Consistent with the very long term of mortgage loans, I believe longer time horizons should also be tested for the extent of continuing predictive power of credit score models.

These are my personal views. It would be a pleasure to discuss any of them further.

Respectfully submitted,

Alex J. Pollock

Is Dodd-Frank oversight council still relevant?

Published in American Banker.

“The biggest thing on FSOC’s to-do list is to designate Fannie Mae and Freddie Mac as the SIFIs they so obviously are in fact,” said Alex Pollock, distinguished senior fellow of finance, insurance and trade at the R Street Institute. “If Fannie and Freddie are not SIFIs, then no one in the world is a SIFI.

Bigger, Fewer, Riskier: The Evolution of U.S. Banking Since 1950

Published in The American Interest.

The total assets of JPMorgan Chase, the biggest U.S. bank, are now about $2.6 trillion. The total assets of the entire American commercial banking system in 1950 were $167 billion. In nominal dollar terms, Morgan by itself is more than 15 times as big as all the banks in the country together were in 1950, when Harry Truman was President and the United States was enjoying an economic boom after the cataclysms of the Depression and the Second World War. The fourth largest bank today, Wells Fargo, with $1.9 trillion in assets, is 11 times as big as the whole banking system was then.

Of course, there has been a vast price inflation and depreciation of the dollar over that time, so that a dollar today is worth about what a dime was in 1950. Adjusting the 1950s number for total banking assets to 2018 dollars brings it to $1.7 trillion. Thus in inflation-adjusted terms Morgan alone is still about 1.5 times as big—and Wells Fargo 1.1 times as big—as the whole banking system in the 1950s. Are these banks “too big to fail”? Of course they are. But so were the biggest banks in 1950.

On average over the past seven decades, banking assets and loans have grown more rapidly than the U.S. economy. In 1950, total banking assets were 56 percent of a GDP of $300 billion. Now at about $16.5 trillion, they are more than 80 percent of a GDP topping $20 trillion. Total bank loans relative to GDP grew even faster than banking assets did, from 18 percent of GDP in 1950 to 45 percent today.

Thus banking both in absolute terms and relative to the economy has gotten much bigger over the decades, but there are many fewer banks than there used to be.

“Ours is a country predominantly of independent local banks,” approvingly said Thomas McCabe, then Chairman of the Federal Reserve, in a commencement address in 1950. As McCabe observed, banking was then mostly a local business. There were at that point 13,446 commercial banks. The U.S. population was 153 million. Now there are 4,774 commercial banks for a population of 329 million. So as the American population has more than doubled, the number of commercial banks dropped by 64 percent.

In 1950, there were also 5,992 savings and loan institutions. Today there are 703, so the total of insured depositories fell from 19,438 in 1950 to 5,477 today, or by 72 percent. The previous multitude of banks was the result of unique American politics in which agrarian interests protected small, local institutions.  The reduced numbers have moved closer to what a market outcome would ordain. We can expect the consolidation to continue.

As to risk, in the entire decade of the 1950s, there were a mere 28 commercial bank failures—only 0.2 percent of the average number of banks. But banking got a lot riskier as time went on, particularly in the financially disastrous 1980s. In that decade, 1,127 commercial banks failed—40 times the failure rate of the 1950s. Maybe the bankers hadn’t gotten smarter, although they certainly employed more MBAs. State and Federal regulators didn’t appear any smarter either.

In addition to the bank failures, 909 savings and loans failed in the 1980s, bringing the total depository failures for the decade to 2,036—about four per week over ten years. Tough times! When the savings and loan industry collapsed, its government deposit insurer, the Federal Savings and Loan Insurance Corporation, also went broke, triggering a $150 billion taxpayer bailout.

The 1990s were not as bad as the 1980s, but 442 commercial banks (16 times as many as in the 1950s) and 483 savings and loans failed, for a total of 925.

The Federal Reserve optimistically announced that the 21st century heralded a new, stable era—“The Great Moderation.” Soon after that, however, came financial crisis and panic, showing once again that bankers and regulators have not gotten smarter, despite the addition of many PhDs in mathematics and science to the ranks of the MBAs in the finance industry. Ben Bernanke, then Chairman of the Federal Reserve, judged in 2006 that “banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.” That was just before the 2007-09 financial crisis. Apparently they hadn’t made such big strides after all.

Since 2000, 573 depository institutions have failed, of which 486 have been commercial banks. There would have been more failures without the government’s emergency TARP investments in banks, improvised government guarantees, and other forms of bailouts. These include the bailouts of the insolvent Fannie Mae and Freddie Mac, much of whose debt was held by banks, as was encouraged by regulation.

Should we want a banking system with no failures, as was virtually the case in the 1950s? Of course not. As the distinguished economist Alan Meltzer put it, “Capitalism without failure is like religion without sin.” Economic growth requires risk-taking and hence the failures that go with it. But we don’t want too much systemic risk, or for the banking system to collapse from time to time. Since 1950, the United States has experienced both extremes. No one knows how to achieve the golden mean.

We can see how much American banking has changed in the course of one lifetime. But one thing did not change: the tight connection between banking and the government. As banking scholar Charles Calomiris has convincingly summed it up, all banking systems are a deal between the politicians and the bankers.

Of course, the details of the deal shift over the decades. Congress frequently legislates about banking (as detailed further below).  One watershed banking enactment was the Federal Reserve Act of 1913, which created the U.S. central bank, the proper role of which was still being debated in 1950. At the time of its origin, it was thought that the Federal Reserve would end financial crises and panics: obviously it didn’t and relative to this hope the act was a failure.  But the act was a definite success at creating what it called an “elastic currency”—the ability of the Federal Reserve to create more money and allow banks to expand.  This ability in its original form was subject to the gold standard, which meant keeping dollars freely convertible to gold. We today can hardly imagine then-prevailing idea that you could go to your bank any time and turn in your paper dollars for gold coins minted by the United States at a fixed parity rate. This idea was only a memory by 1950, but under the 1944 Bretton-Woods agreement, the U.S. government was still promising to foreign governments that they could redeem dollars for gold.

In 1971, after various dollar crises, the government reneged on this commitment, which was the last vestige of the gold standard.  With that, the dollar became far more elastic than the authors of the Federal Reserve Act could ever have imagined. The Federal Reserve became able to expand the currency and the credit base of banking by as much as it wanted. It could either print up more paper dollars, or more directly, simply credit the deposit accounts banks have with it to expand the supply of money.  This can be done without limit except for the Federal Reserve’s own judgment and the extent of political controversy it is willing to endure.

Since 1950, an essential banking system development is that the Federal Reserve has grown ever more prominent, more prestigious and more powerful. Whether a republic should trust such immense money power to the judgment (which is actually the guessing) of its central bank is a fundamental political question to which the answer is uncertain.

But it is certain that the banking system, including the central bank as a key component, is highly useful to governments, especially to finance wars. A well-developed banking system that can lend large sums of money to the government is a key military advantage. This is a classic element in banking. The deal between politicians and bankers that created the Bank of England in 1694 was that the new bank would lend the government money to finance King William’s wars, in exchange for monopoly currency issuing privileges. U.S. national banks were created in 1863 to finance the Union armies in the Civil War; they bought government bonds and in exchange got to issue a national currency. The Federal Reserve first established its importance by lending money for the purchase of government bonds to finance American participation in the First World War. The young Fed “proved in war conditions an extremely useful innovation,” as a 1948 study of American banking observed.

The banks of 1950 were stuffed with Treasury securities as a result of their having helped finance the Second World War. At that time, the Federal Reserve was buying as many Treasury bonds it took to keep the interest rate on long bonds at 2.5 percent, to keep down the interest cost to the government. This was also meant to keep the market price of the banking system’s huge bond portfolio steady.

At that point, the banks in total owned more Treasury securities than they had in loans. Treasuries were 37 percent of their total assets—an unimaginably high proportion now. Total loans were only 31 percent of assets—now unimaginably low. These proportions made the balance sheet of the banking system very safe. In remarkable contrast, banks today have merely 3 percent of their assets in Treasury securities (see graph 3).

In the banking system of 1950, reflecting the experience of the 1930s, the government was intent on protecting the banks by reducing competition for and among them. Arthur Burns, who was Chairman of the Federal Reserve 1970-78, looked back from 1988 in The Ongoing Revolution in American Banking to explain the 1950s banking regime:

The legislation suppressed competition not only among banks but also between banks and other financial institutions. The ability of banks to compete with one another geographically was limited by rules on chartering and branching. No new bank could set up business without acquiring a national or state charter, and the authorities were disinclined to grant a charter if existing banks would suffer. . . . The ability of banks to compete with one another for demand deposits was limited by a prohibition against payment of interest on such deposits. . . . Banks could offer interest on time and savings deposits . . . but the amount they could pay was limited by a regulation known as Reg Q. . . . Competition between banks and other financial institutions was limited by restrictions on the kind of services each could offer.

In short, the government restricted competitive entry and limited price and product competition. The design was to promote safety by effectively having a banking cartel, with the government as the cartel manager.

This cartel idea was removed step by step in succeeding decades. The Regulation Q price controls, a big political deal in their day, proved a painful problem in the severe “credit crunches” of 1966 and 1969. They were obviously outdated by the time interest rates went into double digits in the 1970s and 1980s, and were belatedly removed. As the 1960s became the 1970s, U.S. banking had become more competitive, innovative, international and interesting, but also riskier. Banking scholars could discuss “the heightened entrepreneurial spirit of the banking industry” in 1975. Of course, there cannot be a competitive market without failures, in banking as in everything else, and we have observed the failures of the 1980s, 1990s and 2000s. But the tight link between banking and the government continued.

By the 1950s, banks had become accustomed to depending on having a lot of their funding guaranteed by the government in the form of deposit insurance. Although many banks had originally opposed the idea as promoting weak and unsound banking, they became and remain today absolutely hooked on it. It has come to seem part of the natural financial order.

But government guarantees of deposits, as is known to all financial economists, tend to make banks riskier, although it simultaneously protects them against bank runs. This combination of effects is because their depositor creditors no longer have to worry about the soundness of the bank itself. Consequently, unsound banking ventures can still attract plenty of funding: This is called “moral hazard,” and its importance in every financial crisis of recent decades can hardly be overstated. To try to control the risk to itself generated by moral hazard, the government must regulate more and more—but its attempt to control risk in this fashion has often failed.

Nonetheless, the extent of deposit insurance has been increased over time. The year 1950 saw a doubling in the amount of deposit insurance per depositor from $5,000 to $10,000. Since then, it has grown 25 times larger in nominal terms, to $250,000, and three times bigger in real terms. These increases are shown below.

As Arthur Burns observed, banks were formerly forbidden to pay interest on demand deposits (checking accounts). In 1950, these deposits comprised the great majority of the banks’ funding—75 percent of the total liabilities of the banking system. That meant that by law 75 percent of the funding had zero interest cost. I well remember as a bank trainee in 1970 having an old banker explain to me: “Remember that banks succeed or fail according to this one number—demand deposits.”

Those days are gone. Demand deposits now are only 11 percent of bank liabilities, and banks can pay interest on them. The graph below shows the historical decline of demand deposits in bank balance sheets.

One of the riskiest classes of credit are real estate loans, which are central to most banking crises. In 1950, real estate loans were only 26 percent of the total loans of the banks. But since then, having accelerated in the 1980s, they have grown to be the predominant form of bank credit, reaching 57 percent of all loans in 2006, just before the real estate collapse. They are now 47 percent of all bank loans, and in the majority of banks, those under $10 billion in total assets, are 72 percent of loans.

We still use the term “commercial banks,” but a more accurate title for their current business would be “real estate banks.”

We may consider together the trends of reduction in the lowest-risk assets, the decline of demand deposit funding, and the shift to riskier real estate credit by combining graphs 3, 4 and 5 into graph 6. The balance sheet of the banking system from 1950 to now has utterly changed.

During these seven interesting banking decades, Congress has been busy legislating away. This is natural: As long as the close connection of the government and banks continues, so will their dynamic interaction through politics, and so will congressional attempts to direct or improve the banking system, or to fix it after the busts that recur in spite of repeated attempted fixes.

Below is a list of the remarkable amount banking legislation since 1950. The mind boggles at the vast volume of congressional hearings, lobbyist meetings, and political speeches all this legislation entailed.

• Federal Deposit Insurance Act of 1950

• Bank Holding Company Act of 1956

• Bank Merger Act of 1960

• Bank Merger Act of 1966

• Bank Holding Company Act Amendments of 1966

• Interest Rate Adjustment Act (1966)

• Financial Institutions Supervisory Act of 1966

• Fair Housing Act (1968)

• Truth in Lending Act of 1968

• Emergency Home Finance Act of 1970

• Fair Credit Reporting Act (1970)

• Bank Holding Company Act Amendments of 1970

• Equal Credit Opportunity Act (1974)

• Real Estate Settlement Procedures Act of 1974

• Home Mortgage Disclosure Act of 1975

• Fair Debt Collection Practices Act (1977)

• Community Reinvestment Act (1977)

• Federal Reserve Reform Act of 1977

• International Banking Act of 1978

• Financial Institutions Regulatory and Interest Rate Control Act of 1978

• Depository Institutions Deregulation and Monetary Control Act of 1980

• Garn-St Germain Depository Institutions Act of 1982

• Competitive Equality Banking Act of 1987

• Financial Institutions Reform, Recovery, and Enforcement Act of 1989

• Federal Deposit Insurance Corporation Improvement Act of 1991

• Housing and Community Development Act of 1992

• Riegle Community Development and Regulatory Improvement Act of 1994

• Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

• Economic Growth and Regulatory Paperwork Reduction Act of 1996

• Gramm-Leach-Bliley Act of 1999

• International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001

• Sarbanes-Oxley Act of 2002

• Check Clearing for the 21st Century Act (2003)

• Fair and Accurate Credit Transactions Act of 2003

• Federal Deposit Insurance Reform Act of 2005

• Financial Services Regulatory Relief Act of 2006

• Housing and Economic Recovery Act of 2008

• Emergency Economic Stabilization Act of 2008

• Helping Families Save Their Homes Act of 2009

• Credit CARD Act of 2009

• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

• an Act to instruct the Inspector General of the Federal Deposit Insurance Corporation to study the impact of insured depository institution failures (2012)

• Reverse Mortgage Stabilization Act of 2013

• Money Remittances Improvement Act of 2014

• Credit Union Share Insurance Fund Parity Act (2014)

• an act to enhance the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, increase individual savings, and for other purposes (2014)

• American Savings Promotion Act (2014)

• FAST Act (this cut Federal Reserve dividends to large banks) (2015)

• Economic Growth, Regulatory Relief and Consumer Protection Act (2018)

In conclusion, we may consider three different perspectives on long-term banking change.

In the 1980s an old employee was retiring after 45 years with the Bank of America, so the story goes. The chairman of the bank came to make appropriate remarks at the retirement party, and thinking of all the financial developments during those years, asked this long-serving employee, “What is the biggest change you have seen in your 45 years with the bank?” His reply: “Air conditioning.” Arthur Burns summed up 1950s banking in this way: “This was a simple system, operating in a simple financial world.” But that is not how it seemed at the time, or at any time. As William McChesney Martin, Chairman of the Federal Reserve 1951-70, said in a 1951 speech to the American Bankers Association: “We are all painfully aware today of the manifold and overpowering complexities of our modern life.”

That feeling characterizes all the years from then to now.

Global financial market risks: Entering unchartered territory

Hosted by the American Enterprise Institute.

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The end of ‘too big to fail’ remains difficult to picture

Published in the Financial Times.

If you buy shares of stock for $100 and they fall to $30, we say, “Oh well, that’s the stock market.” If you buy a bond for $100 and it ends up paying 20 cents on the dollar, we say, “Oh well, that’s the bond market.”

But if your deposits in big banks are going to pay 97 cents instead of par, that is a financial crisis, and the government must intervene to protect you.

That is why Simon Samuels is so right that “we are a long way from ending ‘too big to fail’” (“The ECB should resist the lure of bigger banks,” Jan. 31). As long as we insist that no one can lose money on bank deposits, too big to fail can never end and never will.

Banking expert warns Federal Reserve could go bankrupt if interest rates rise

There is growing concern among financial experts that the Federal Reserve will soon be bankrupt if interest rates continue to rise. One America’s Neil W. McCabe spoke with R Street’s Alex Pollock, who fears another financial crisis may be near.

Changes to capital rules should be part of GSE overhaul

Published in American Banker.

Changes to capital rules should be part of GSE overhaul

Acting Federal Housing Finance Agency Director Joseph Otting has certainly gotten the mortgage market’s attention.

To the great interest of all concerned, but especially to the joy of the speculators in Fannie and Freddie’s shares, he recently told agency staff that the FHFA and the Treasury would be working on a plan to soon take Fannie and Freddie out of their 10 years of government conservatorship. Their share prices jumped.

The joy — and the share prices — have since moderated, after more careful comments from the White House. Still, it appears that any near-term change would have to be done by administrative action, since there is zero chance that the divided Congress is going to do so by legislation.

The FHFA and Treasury can do it on their own. They put Fannie and Freddie into conservatorship and constructed the conservatorship’s financial regime. They can take them out and implement a new regime.

But should they? Only if, as part of the project, they remove the Fannie and Freddie capital arbitrage which leads to the hyper-leverage of the mortgage system.

Running up that leverage is the snake in the financial Garden of Eden. As everybody who has been in the banking business for at least two cycles knows, succumbing to this temptation increases profits in the short term but leads to the recurring financial fall.

Leverage is run up by arbitraging regulatory capital requirements in order to cut the capital backing mortgages. Before their failure, when they had at least had some capital, Fannie and Freddie still served to double the leverage of mortgage risk by creating mortgage-backed securities.

Here’s the basic math. The standard risk-based capital requirement for banks to own residential mortgage loans is 4% — in other words, leverage of 25 to 1. Yet if banks sold the loans to Fannie or Freddie, then bought them back in the form of mortgage-backed securities, Fannie and Freddie would have capital of only 0.45% and the banks only 1.6%, for a total of 2.05%, due to lower capital requirements for the government-sponsored enterprises. Voila! The systemic leverage of the same risk jumped to 49 from 25. This reflected the politicians’ chronic urge to pursue expansionary housing finance. Now that Fannie and Freddie have virtually no capital, even the 0.45% isn’t there.

The risks of the assets are the same no matter who holds them, and the same capital should protect the system no matter how the risks are moved around among institutions — from a bank to Fannie or Freddie, for example. If the risk is divided into parts, say the credit risk for Fannie or Freddie and the funding risk for the bank, the sum of the capital for the parts should be the same as for the asset as a whole.

But the existing system abysmally fails this test.

If 4% is the right risk-based capital for mortgages, then the system as a whole should always have to have at least 4%. If the banks need 1.6% capital to hold Fannie and Freddie mortgage-backed securities, then Fannie and Freddie must have 2.4% capital to support their guarantee, or about 5 times as much as their previous requirement. If Fannie and Freddie hold the mortgages in portfolio and thus all the risks, they should have a 4% capital requirement, 60% more than their former requirement.

The FHFA is working on capital requirements and has the power to make the required fix.

Bank regulation also needs to correct a related mistake. Fortunately, Mr. Otting is also Comptroller of the Currency. Banks were encouraged by regulation to invest in the equity of Fannie and Freddie on a super-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a risible 1.6%, since changed to a still risible 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (Your broker’s margin desk wouldn’t let you do that!)

In short, the banking system was used to double leverage Fannie and Freddie. To fix that, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so it really would be equity from a consolidated system point of view.

All in all, if Treasury and the FHFA decide to end the conservatorships, that would be fine. That is, provided they simultaneously stop the systemic capital arbitrage and add the two highly-related reforms.

Fannie and Freddie will continue to be too big to fail, even without the capital arbitrage, and will continue to be dependent on and benefit enormously from the Treasury’s effective guarantee. They need to pay an explicit fee for the value of this taxpayer support. The fee should be built in to any revision of the existing senior preferred stock purchase agreements between them and the Treasury.

Finally, Fannie and Freddie are without question systemically important financial institutions. To address their systemic risk, Treasury and the FHFA should get them formally designated as the SIFIs they so obviously are.

How to Fix the Unhealthy Concentration of Corporate Voting Power In the U.S.

Published in Real Clear Markets.

The popularity of index and other mutual funds, combined with the current rules for voting shares of stock, has had an unexpected ill effect: concentration of corporate voting power in the hands of a few giant asset management companies.  Nobody did or would intend this outcome.  Fortunately, the voting rules can be changed. A great way for the SEC to start 2019 would be to take on and then fix this threat.

The asset managers holding the concentrated voting power are, economically speaking, mere agents.  They are not principals. One hundred percent of the risks and rewards of ownership belong to the beneficial owners of the funds: they are the economic owners.  The agent asset managers simply pass through these risks and rewards (minus their fees, course).  They have the stock registered in the fund name, but they are in no economic sense the owners.

They are in economic terms in exactly the same position as broker-dealers holding stock registered in street name, of which 100% of the risks and rewards (minus commissions) likewise belong to the customers.

The current voting rules for shares in mutual funds accelerate the famous “separation of ownership and control” in precisely the wrong direction: away from the substantive owners and into the hands of agents. As corporate governance scholar Bernard Sharfman has written to the SEC, “BlackRock, Vanguard, and State Street Global Advisors (the Big Three) now control enormous amounts of proxy voting power without having any economic interest in the shares they vote.”

The celebrated creator of index funds, John Bogle, rightly warned that “a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.”  In fact, the control would be exercised by a few senior employees of those institutions—the agents of the agents.  Said Bogle, “I do not believe that such concentration would serve the national interest.”  It certainly wouldn’t.

It also does not serve the interests of the economic owners, who are under current rules deprived of any ownership voting rights.  This contrasts strikingly with the case when investors economically own stock that is legally registered in their broker’s street name.  In that case, the rules work hard to align voting rights with economic ownership, as they should.

There is an additional problem with concentrating voting power in the hands of a few agents.  These highly visible organizations are subject to political pressure and influence on how they cast their votes.  They cannot fail to be tempted to take positions through voting on contentious issues which are politically and economically advantageous to themselves, doubtless accompanied by pious speeches, rather than to the principals. The temptation to signal political “virtue,” rather than vote the interests of the real owners, may be irresistible.  The severe agency problem is obvious.

What do the principals want?  You should ask them, just as the brokers have to do.

We are confronted with a problem of a concentration of not only economic, but also of political power, needing to be fixed, sooner rather than later.

The public discussion of the issue has included the charge that index funds, because they may own all the major public companies in an industry, will promote cartel and oligopoly behavior to favor the industry, not the individual competitors in it—an influence which, if true, is certainly not to be desired.  This led financial commentator Matt Levine to suggest that index funds “pose a problem under the antitrust laws.”

But the problem is not that these funds hold shares registered in their name on behalf of the beneficial owners.  The problem is that the funds are allowed to vote such shares without instructions, to suit themselves.  It’s not the surface “ownership,” it’s the voting power that must be addressed.  They don’t need to have anti-trust laws applied, just to have their voting rules fixed.

The analogy is compelling: in economic substance, the status of the shares held by a mutual fund and that of the shares held by a broker in street name is exactly the same.  They should have exactly the same rules for voting the related proxies.

So the fix is quite straightforward:  Apply the same proxy voting rules to asset managers as already exist in well-developed form for brokers voting shares held in street name.  In short, the asset managers could vote uninstructed shares for routine matters, just like brokers, assuring the needed quorums.  But for non-routine matters, including the election of corporate directors, they could vote only upon instructions from the economic owners of the shares.   Thus the economic owners of shares through brokerage accounts and through mutual funds would be treated exactly the same.  The intermediary agents would be treated exactly the same.

Of course, the asset managers would whine about the trouble and expense of getting mutual fund holders to vote their proxies.  But the brokers already have the same problem.  Overall operating efficiency would be enhanced by allowing the real owners to provide revocable standing instructions to both asset managers and to broker-dealers for non-routine matters with a choice like this:

1.       Vote my shares only upon specific instructions from me.

2.       Vote my shares for the recommendations of the board of directors of each company.

3.       Vote my shares for whatever the asset manager or broker-dealer decides.

It would be gigantic mistake to let a handful of big asset managers amass discretionary voting dominance of the whole U.S. corporate sector, including pursuit of political agendas, all without having any economic interest in the shares they vote.  We should instead create instead a governance structure which ensures that the principals control the votes.

In Finance, the Blind Spots Will Always Be With You

Published in Law & Liberty.

“Where are our blind spots?” is an excellent question to ask about systemic risk, one I recently was asked to speak on at the U.S. Treasury. Naturally, we don’t know where the blind spots are, but they are assuredly there, and there will always be darkness when it comes to the financial future.

Finance and Politics

The first reason is that all finance is intertwined with politics. Banking scholar Charles Calomiris concludes that every banking system is a deal between the politicians and the bankers. This is so true. As far as banking and finance go, the 19th century had a better name for what we call “economics”—they called it “political economy.”

There will always be political bind spots—risk issues too politically sensitive to address, or which conflict with the desire of politicians to direct credit to favored borrowers. This is notably the case with housing finance and sovereign debt.

The fatal flaw of the Financial Stability Oversight Council (FSOC) is that being part of the government, lodged right here in the Treasury Department, it is unable to address the risks and systemic risks created by the government itself—and the government, including its central bank—is a huge creator of systemic financial risk.

For example, consider “Systemically Important Financial Institutions” or SIFIs. It is obvious to anyone who thinks about it for at least a minute that the government mortgage institutions Fannie Mae and Freddie Mac are SIFIs. If they are not SIFIs, then no one in the world is a SIFI. Yet FSOC has not designated them as such. Why not? Of course the answer is contained in one word: politics.

A further political problem with systemic financial risk is that governments, including their central banks, are always tempted to lie, and often do, when problems are mounting. The reason is that they are afraid that if they tell the truth, they may themselves set off the financial panic they fear and wish at all costs to avoid. As Jean-Claude Juncker of the European Union so frankly said about financial crises, “When it becomes serious, you have to lie.”

Uncertainty and the Unknowable

We often consider “known unknowns” and “unknown unknowns.” Far more interesting and important are “unknowable unknowns.” For the financial future is inherently not only unknown but unknowable: in other words, it is marked by fundamental and ineradicable uncertainty. Uncertainty is far more difficult to deal with and much more intellectually interesting than risk. I remind you that, as famously discussed by Frank Knight, risk means you do not know what the outcome will be, but you do know the odds; while uncertainty means that you do not even know the odds, and moreover you cannot know them. Of course, you can make your best guess at odds, so you can run your models, but that doesn’t mean that you know them.

Needless to say, prices and the ability of prices to change are central to all markets and to the amazing productivity of the market economy.

But a price has no sustainable existence. As we know so well with asset prices in particular, the last price, or even all the former prices together, do not tell you what the next price will be.

With housing finance audiences, I like to illustrate the risk problem with the following question: What is the collateral for a mortgage loan? Most people say, “The house, of course.” That is wrong. The right answer is that it is the price of the house. In the case of the borrower’s default, it is only through the price of the house that the lender can collect anything.

The next question is: How much can a price change? Here the answer is: More than you think. It can go up more in a boom, and down a lot more in a bust than you ever imagined.

One key factor always influencing current asset prices is the expectation of what the future prices will be, and that expectation is influenced by what the recent behavior of the prices has been. Here is an important and unavoidable recursiveness or self-reference, and we know that self-reference generates paradoxes. For example, the more people believe that house prices will always rise, the more certain it is that they will fall. The more people believe that they cannot fall very much, the more likely it is that they will fall a lot.

The Nature of Financial Reality

Financial reality is a fascinating kind of reality. It is not mechanical; it is inherently uncertain, not only risky; it is not organic; it is full of interacting feedback relationships, thus recursive or reflexive (to use George Soros’ term); unlike physics, it does not lend itself to precise mathematical predictions.

Therefore we observe everybody’s failure to consistently predict the financial future with success. This failure is not a matter of intelligence or education or diligence. Hundreds of Ph.D. economists armed with all the computers they want do not succeed.

The problem is not the quality of the minds that are trying to know the financial future, but of the strange nature of the thing they are trying to know.

Another troublesome aspect of financial reality is its recurring discontinuous behavior. “Soft landings” are continuous, but “hard landings” are discontinuous. Finance has plenty of hard landings.

From this odd nature of financial reality there follows a hugely important conclusion: Everybody is inside the recursive set of interacting strategies and actions. No one is outside it, let alone above it, looking down with celestial perspective. The regulators, central bankers and risk oversight committees are all inside the interactions along with everybody else, contributing to the uncertainty. Their own actions generate unforeseen combinations of changes in the expectations and strategies of other actors, so they cannot know what the results of their actions will be.

Another way to say this is that there are no financial philosopher-kings and there can never be any, in central banks or anywhere else. No artificial intelligence system can ever be a philosopher-king either.

Odin’s Sight

We can conclude that blind spots are inevitable, because of politics, and because of the unknowability of the outcomes of reflexive, expectational, interacting, feedback-rich combinations of strategies and actions.

I will close with a story of Odin, the king of the Norse gods. Odin was worried about the looming final battle with the giants, the destruction of Valhalla, and the twilight of the gods. Of course he wanted to prevent it, and he heard that the King of the Trolls had the secret of how to do so. Searching out this king by a deep pool in a dark forest, he asked for the secret. “Such a great secret has a very high price,” the troll replied, “one of your eyes.” Odin considered what was at stake, and decided to pluck out one of his eyes, which he handed over.

“The secret is,” said the King of the Trolls, “Watch with both eyes!”

When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one.

Is the Fed Broke? — Grant’s Interest Rate Observer Podcast w/Alex Pollock Ep. 75

From Grant’s Interest Rate Observer Podcast:

Alex J. Pollock, distinguished senior fellow at the R Street Institute in Washington and former president of the Federal Home Loan Bank of Chicago, calls in to discuss the state of our central bank’s own finances. @RSI @FHLBC

3:07 Unrealized losses and the printing press

6:27 Treasury issuance and the Fed

9:45 Negative capital.  Does it matter?

15:55 Partially paid-in capital;  echoes of the banking partnerships of old

Subscribe to the Grant’s Current  Yield Podcast on iTunes, Stitcher, iHeart Radio, Google Play Music or listen from our website, www.grantspub.com

Golden Years

Published in Barron’s.

After considering the many problems of retirement finance in a lower-return world, the article (“The New Retirement Strategy,” Jan. 5), gets to David Blanchett’s suggestion: “It might be better to simply work longer.”

Yup. The best way to finance retirement is not to retire, at least not too soon. Shorten the time to be financed. Lengthen the time when savings can be generated. The math is simple and inescapable.

The Fed is technically insolvent. Should anybody care?

Published in American Banker.

As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?

The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.

If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.

The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.

And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?

All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.

Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.

People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.

About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?

Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.

When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.

It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.

It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?

Higher interest rates and the looming end of the second real estate double bubble

Published in Housing Finance International Journal.

At this point, the most important thing about U.S. housing finance is that long-term interest rates are rising. The rate on 30-year fixed rate mortgages, the benchmark U.S. mortgage instrument, has since September 2017 gone from less than 4 percent to close to 5 percent. This is in line with the rise in 10-year U.S. Treasury note yields from something over 2 percent to more than 3 percent. The massive manipulation of long-term interest rates by the Federal Reserve is belatedly winding down, step by step. The house price inflation the Fed thereby promoted also must inevitably end.

The real (inflation-adjusted) interest rate on the 10-year Treasury note has gone from about 0.4 percent to just over 1 percent. These rate movements from extraordinarily low levels to somewhat higher levels are shown in Graph 1.

Read the rest here.

Testimony on The Bipartisan Housing Finance Reform Act of 2018

Published by the R Street Institute.

KEY POINTS

1. We should be heading for a reform which transforms the system into one which is 80% private and only 20% government.

2. The best place for mortgage credit risk to reside is with the lender who makes the loan in the first place, who should retain significant credit risk "skin in the game" for the life of the loan.

3. The best we can do to dampen price distortions is to move toward the goal of making the housing finance system 80% private.

4. Guarantee fees for the GSEs must be calculated to include the cost of capital that would be required for a regulated private financial institution to bear the same credit risk.

5. Congress should remove Fannie and Freddie's special government privileges and make them pay for their formerly free Treasury guarantee, turning them from GSEs into normal competitors, and creating a competitive, instead of duopolistic, mortgage securitization market.

6. The FHLBs should be authorized to form, own and manage a joint subsidiary dedicated to mortgage finance, including securitization and also advancing structures with lender skin in the game, on a national basis.

The bipartisan discussion draft advances the development of fundamental housing finance reform. As it proposes, we need to move toward a system with greater private capital at risk, more competition, and more robust risk distribution to achieve sustainable home finance for the American people.

Predicting is hard…

Published by the R Street Institute.

From Reuters, on June 27, 2017:

U.S. Federal Reserve Chair Janet Yellen said on Tuesday that she does not believe there will be another financial crisis for at least as long as she lives.

From CNBC, on Dec. 11, 2018:

There could be another financial crisis on the horizon, warned former Federal Reserve Chair Janet Yellen in a speech Monday night.

The financial future is murky, but one of these predictions will be right.

The Bill Walton Show: Finance, Philosophy and more with Alex Pollock

Published by the Bill Walton Show.

People look to the government to prevent future financial crises and trust that politicians and economic experts can create policies to protect us and our 401(k) plans. We shouldn’t trust them. These experts are smart, mostly well-intentioned people but they can’t prevent the next crisis. No one can. Why is that? Why is a future crisis inevitable? I discuss these and many other questions with “Finance and Philosophy” author Alex Pollock.

India’s Central Bank Debates Remind Us the Fed Is Far From ‘Independent’

Published in Real Clear Markets.

Should central banks be “independent” from the elected parts of the government?  If so, should they be independent in all things, or just some things?  Or should they not be independent at all? These are classic questions.  Of course, central bankers themselves like the idea of independence, as do many economists, who believe they know better about economic and financial affairs than mere politicians.  Larry Summers, a leading economist, former Secretary of the Treasury and former contender for the office of Federal Reserve Chairman, recently wrote about President Trump’s criticism of Federal Reserve policy:

“No self-respecting central banker can be seen as yielding to pressure from a politician.”

Of course Professor Summers knows that there have been many instances over the decades of U.S. presidents and administrations exerting pressure on the Fed.  As Allan Meltzer wrote in his monumental A History of the Federal Reserve, “Missing from most explanations by economists is the political dimension.  By law the Federal Reserve was an independent agency.  In practice, it responded to political pressures.”

Interestingly, at the same time as President Trump’s criticisms, half a world away, the government of India’s Prime Minister Narendra Modi is putting much more pressure on India’s central bank, the Reserve Bank of India.

So India, a huge country with a big economy, a parliamentary democracy and a sophisticated central bank, has been having a highly interesting debate of the issue.  The Reserve Bank has maintained that its independence is a central principle, with its Deputy Governor Viral Acharya pronouncing that “Governments that do not respect the central bank’s independence will sooner or later…ignite economic fire and come to rue the day.”  Does this mean he thinks a central bank has no boss, no political accountability?

Under the original Federal Reserve Act of 1913, the executive branch was assumed to have an important voice in central bank affairs, since the Secretary of the Treasury was by law the Chairman of the Federal Reserve Board. This provision was removed in the Banking Act of 1935, which certainly pleased the new Fed Chairman, Marriner Eccles, when he assumed the role in that year.

In the Indian context, the Prime Minister’s government has a stronger hand than does a U.S. administration.  The central bank’s chartering act, the Reserve Bank of India Act of 1934, provides:

“The Central Government may from time to time give such directions to the Bank as it may, after consultation with the Governor of the Bank, consider necessary in the public interest.”

Although this power apparently has never been explicitly used, it could not be clearer: Have a discussion about the issues with the central bank, and then if you think it “necessary in the public interest,” tell the bank what to do and the bank has to do it.  While “the market and the banking system have been abuzz that the rift between the government and the RBI had reached a point of no return,” as India Today put it, the government has been forcefully and publicly reminding the Reserve Bank about this unambiguous provision of its chartering act.

Professor Summers, in the same essay as quoted above, added like a good two-handed economist, that on the other hand:

“There is a need for pragmatism regarding the independence of central banks.”  And: “It is foolish to suppose that a nation’s financial policies should be conducted independently of its elected officials.”

So the unelected central bankers should not be so independent, after all?  Arthur Burns, Chairman of the Fed in the inflationary 1970s, reportedly characterized such pragmatism, or political realism, in these memorable terms:  “We dare not exercise our independence for fear of losing it”!

What does the present Indian government consider necessary in the public interest?  First, it wants to get its hands on what it says are the “excess” retained earnings of the Reserve Bank, and more of the bank’s annual profit, in order to have the money to spend.

It may be of interest to compare the Federal Reserve’s situation in this respect.  The Congress has three times taken some of the retained earnings of the Federal Reserve Banks—half of their surplus in 1933 to fund the new Federal Deposit Insurance Corporation; $19 billion in 2015 to fund highways in a transportation act; and another $2.5 billion in 2018 to fill a gap in a budget deal.  Although it was “a raid on the capital base of the nation’s central bank,” as one critic said, it happened anyway.  As for profits, the Fed pays almost all of its annual profit, about 99%, right over to the U.S. Treasury.  The resulting consolidated Federal Reserve balance sheet has a trivial capital ratio of 0.9%.  Is that enough?  Who gets to say?

Prime Minister Modi’s idea of getting money to spend from the central bank’s reserves and profits is hardly a new idea.

Second, the Indian government wants the Reserve Bank to ease its regulatory constraints on banks which already have high ratios of bad loans, in order to promote more lending now, with as is often noted, an election coming up. That may be a bad idea, but who is the boss when it comes to financial regulation?  In the U.S., it is certainly the Congress, although the Fed and other regulators have significant discretion in interpretation.

After a marathon meeting of the Reserve Bank of India’s board on November 19, the bank agreed to reassess its policy on reserves and its rules for troubled banks. It does not seem too hard to guess what direction the “reassessment” will take.

While the immediate issues are about regulatory policy and helping out the government budget, the classic “independence” argument is that central banks should be independent in monetary policy, as their essential mandate. This aspect of independence has also been debated in India.  In contrast to its government’s preferences and to President Trump’s comments, recent Federal Reserve reform bills in the House of Representatives which would have subjected the Fed to significantly increased oversight, nevertheless always protected monetary policy independence.  Is that distinction a sacred principle or a sacred cow?  In U.S. history, the Truman administration, wanting the Fed to help finance the Korean War, certainly didn’t believe in it.  Will it be respected as the government of India continues to push the Reserve Bank?

It will be instructive to observe the continuing developments there, including the competing rationales and rhetoric.  As an example of the latter, “The independence of the central bank is still intact,” said one economist after the November board meeting—perhaps he proposes to redefine “independence.” “We don’t think that this issue has been fully solved yet,” said another.  For sure not–stay tuned.

Saving for Retirement

Published in Barron’s.

A house with no mortgage left on it is a classic retirement asset and a good way to save for one’s older years (“Remaking Retirement,” Cover Story, Nov. 19). A big issue not mentioned in your otherwise informative articles on 401(k) and other retirement savings accounts is how to utilize these accounts, now completely focused on stocks and bonds, to address the hardest financial problem of many young families. This is how to finance the down payment on their first house, which is also an excellent retirement asset.

In my view, Congress should amend the governing acts for retirement accounts to provide for a simple and penalty-free withdrawal from 401(k) and individual retirement accounts for the down payment on a first house, with the tax deferred on the income withdrawn (perhaps starting amortization at age 70½). We should give investing in a house of your own the same retirement-account tax treatment as investing in stocks and bonds.

Congress did have bills introduced in this direction in the 1990s—it would be a good bipartisan project to actually do it now.