We can’t help feeling that we today are smarter

Published in the Financial Times.

Martin Wolf is certainly correct that “further financial crises are inevitable” (March 20). Let me add one more reason why this is so — another procyclical factor rooted in human nature. This is the intellectual egotism of the present time: the conviction we can’t help feeling that we are smarter than people in the past were, smarter than those old bankers, regulators, economists and politicians of past cycles, and that therefore we will make fewer mistakes. We aren’t and we won’t. The intellectual egotists of the future will condescendingly look back on us in their turn.

Over a century, which years were inflation-control champions and which booby-prize winners?

Published by the R Street Institute.

How much can the rate of inflation move around? A lot.

The Consumer Price Index (CPI) began in 1913, the same year the Federal Reserve was created. The CPI’s path over the 106 years since then displays notable variations in inflation — or alternately stated, in the rate of depreciation of the purchasing power of the U.S. dollar. In this post, I consider the average inflation rates during successive 10-year and five-year periods, starting in 1913. (The very last period, 2013-2018, includes six years.) I also note the context of historical events. Wars, especially, induce accelerated government money-printing, but the history displays constant inflation since 1933, sometimes slower, sometimes much faster.

Which decades and half-decades are the inflation-control champions, meaning the lowest average inflation rate without descending into serious deflation?  The decade champion is that of Presidents Eisenhower and Kennedy, 1953-1962. Its average inflation rate was 1.31 percent.

The booby prize goes to 1973-1982, when inflation averaged the awful rate of 8.67 percent per year. No wonder Arthur Burns, who was chairman of the Federal Reserve from 1970 to 1978, afterward gave a speech entitled “The Anguish of Central Banking.” In second place for the booby prize is 1913-1922, with an average inflation rate of 5.60 percent. That was the result of the first World War. The decade included, first, double-digit inflation then a short, very sharp depression in 1921-1922, but high inflation overall.

The inflation-control champion among half-decades is 1923-27, during the boom of the “Coolidge Prosperity,” when inflation averaged only 0.47 percent. In second place is 1953-57 at 1.24 percent. At that time, William McChesney Martin, who considered inflation “a thief in the night,” was chairman of the Fed.

Table 1 shows the record by 10-year periods in chronological order. It also shows what $1 at the beginning of each period was worth in purchasing power at the end of each 10 years. The last column shows what $1 in 1913 was worth in purchasing power, as it depreciated over the entire 106 years.

Table 2 shows the five-years periods, this time in order of lowest average inflation to highest, with historical notes on the context. It contrasts the lowest third of the observations with the highest third.

The average annual inflation over the 106 years was 3.11 percent. That reduced the $1 of 1913 to about 4 cents by the end of 2018, as shown in Graph 1. Note that, because of the scale of the graph, the change looks smaller in recent decades, but it isn’t. For example, the drop in purchasing power from 1983 to 2013 is the same as that from 1943 to 1973—about 60 percent in 30 years in each case.

Many central banks, including the Federal Reserve, now believe in perpetual inflation of 2 percent. Had that inflation rate been maintained since 1913, instead of the actual 3.11 percent, the dollar’s purchasing power from then to now would have followed the dashed line on the graph and fallen to 12 cents, instead of 4 cents.

We know from history that big wars will always be financed, in part, by depreciation of the currency of the winners, while the losers’ currencies will often be wiped out. There were several wars in addition to the two world wars in the 106 years under consideration, but was the constant inflation since 1933 necessary? Perhaps there was no other way for the government to deal with the debt automatically produced when taxes are forever less than government expenditures, war or no war, and the Federal Reserve is always there to help the Treasury out by monetizing its debt.

Thanks to Daniel Semelsberger for research assistance.

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

Published by the R Street Institute.

On behalf of National Taxpayers Union, R Street Institute, Citizens Against Government Waste, Institute for Liberty and Taxpayers Protection Alliance (“the undersigned”), we respectfully submit these comments to the Federal Housing Finance Agency (FHFA) concerning its Notice of Proposed Rulemaking for the validation and approval of credit score models. The undersigned are pleased to comment in favor of the proposed rule, which we believe represents a fair and reasonable interpretation of section 310 of the “Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.” Our organizations have long been involved in financial services issues and are prominent voices on housing finance matters. Importantly, we all follow the same housing policy fundamentals: a system that promotes broad access to credit for qualified borrowers, a significant private capital buffer, and administrative actions that promote competitive markets and protect taxpayers.

Since Fannie Mae and Freddie Mac (the GSEs) were placed into conservatorship more than a decade ago, our organizations have called for Congressional and administrative actions to mitigate taxpayer exposure to risky activity. Taxpayers have expressed concern about greatly expanded GSEs activities in the private market while enjoying the unique competitive advantages of government backing. With the GSEs having more than $5 trillion of mortgage risk on their extremely leveraged balance sheets, which are by extension underwritten by taxpayers, the federal government holds a considerable level of risk.

Economists widely agree that the significant increase in housing foreclosures that fueled the 2008 financial crisis and subsequent recession was a result of a weakening of GSE mortgage standards through affordable housing goals. These goals required the GSEs meet annual quotas of low- and moderate-income mortgages. As time went on and the number of prime borrowers dried up, the GSEs had to expand operations in the subprime market in order to meet their annual quotas. As the market shrank, the GSEs found it harder and harder to find creditworthy borrowers causing them to lower their standards to meet their affordable housing goals. This involved either reducing the accepted credit score, lowering the required down payment, raising the debt-to-income ratio, or accepting low or no documentation.

Accepting lower credit standards certainly expanded the number of people who were eligible for a mortgage, but it allowed a greater number of under-qualified borrowers to obtain a loan who would have otherwise been denied such a large line of credit. Once defaults skyrocketed and the housing bubble burst, the GSEs were wired more than $190 billion from taxpayers to keep them afloat and were placed into conservatorship where they remain to this day.

If there is one lesson from the 2008 housing crisis that should have been learned, it is that overly ambitious affordable housing goals and the rush to qualify numerous borrowers by any means can put the economy, and taxpayers, at great risk. GSEs utilize credit scores in several ways including benchmarks for risk fees, loan eligibility guidelines, and (for Freddie Mac) one of many attributes in making a credit assessment. They are also used internally to balance counterparty risk, an often-overlooked but very important role. Thus, allowing new credit score models into the GSE framework could have major consequences for their operations, their risk, and in turn taxpayer liabilities.

Such consequences would also reverberate throughout the private sector, as lenders, loan servicers, mortgage insurers, and other parts of the industry would face all manner compliance and implementation costs. New credit scoring methods in the GSEs could also eventually spill over into taxpayer-backed lending programs at the Federal Housing Administration, the Small Business Administration, and other agencies. In an environment where GSEs and FHA appear to be more heavily weighting their portfolios with higher-risk loans, the introduction of new credit scores could even affect the overall systemic risk calculation at an especially delicate point in financial markets. These factors are discussed in greater detail in a Policy Paper that National Taxpayers Union filed separately with FHFA.

It is of particular concern to free market, limited government groups to see how the “Credit Score Competition Act,” included as Section 310 of S. 2155, “the Economic Growth, Regulatory Relief, and Consumer Protection Act” that passed in 2018, will be implemented. Section 310 directs FHFA to create a process for evaluating new credit scoring models for use by the GSEs but does not mandate they accept more just one type of credit score. We believe FHFA interpreted the legislative text in a careful and thoughtful manner that complies with legislative intent. The proposed rule issues standards for compliance, which sets forth several factors that must be considered in the validation and approval process, including the credit score model’s integrity, reliability, and accuracy, its historical record of predicting borrower and credit behaviors, and consistency of any model with GSE safety and soundness.

Further, FHFA rightly notes in the proposed rule that alternative scores may immediately gain a competitive advantage in the market. As such, the rule specifically “prohibits an Enterprise from approving any credit score model developed by a company that is related to a consumer data provider through any common ownership or control, of any type or amount.” In addition, the proposed rule not only calls for sound cost-benefit analysis in evaluating new models, it also builds in conflict-of-interest guardrails (which are standard in other regulatory spheres) to ensure that those models compete on a level playing field. This holds promise for creating a true market-driven competitive environment with an opportunity for innovation.

Additionally, we are supportive of the straightforward, four-step process which the Enterprises evaluate and implement alternative credit-scoring models. The process is summarized below:

1. Solicitation of applications from credit score model developers; Proposes that solicitation for new applications occur at least every seven years, or as determined necessary by FHFA.

2. Initial review of submitted applications;
   ● Each GSE would obtain the data from the data provider on behalf of the applicant.

3. Credit score assessment;
   ● During this assessment phase, each credit score model would be assessed for accuracy, reliability, and integrity.
   ● Approaches for assessing accuracy include: 1) Comparison-based. This approach will not require the applicant’s credit score to be more accurate than the existing credit score in use by the GSEs. This approach would be more subjective and indicate reasonableness of the credit score’s accuracy. 2) Champion-Challenger. The applicant’s credit score must be more accurate than the existing credit score in use by the GSEs. This would be a bright line test.

4. Enterprise business assessment;
   ● During this phase, a GSE would assess the credit score model in conjunction with the GSEs business systems and processes.
   ● In addition, the GSE must consider impacts on the mortgage finance industry, assess competitive effects, conduct a third-party vendor review, and any other evaluations established by the GSE.

The validation and approval process, which produces the resulting approved credit score model, must meet these five statutory requirements:

(i) satisfy minimum requirements of integrity, reliability, and accuracy; (ii) have a historical record of measuring and predicting default rates and other credit behaviors; (iii) be consistent with the safe and sound operation of the corporation; (iv) comply with any standards and criteria established by the Director of the Federal Housing Finance Agency under section 1328(1) of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992; and (v) satisfy any other requirements, as determined by the corporation.

Taxpayers have a significant stake in the housing finance market and FHFA must do everything in its power to ensure that taxpayer risk is mitigated to its fullest extent. The proposed rule will undoubtedly help to protect from a potential “race to the bottom” effect to qualify as many possible borrowers as possible through political manipulation of tools that are supposed to be reliable predictors of risk. Significant innovation in the credit scoring space is already occurring through the advent of refinements and expansions to existing standard tools, which themselves are being subjected to rigorous testing. We believe these modernizations can be balanced with the benefits of a stable, predictable system of lending and finance that measures and protects against risk, not only to borrowers and lenders, but also to taxpayers.

Thank you for the opportunity to offer our views on this proposed rule. We urge FHFA to adopt the rule as is and implement it in a timely manner.

Pete Sepp, President
National Taxpayers Union

Alex J. Pollock, Distinguished Senior Fellow
R Street Institute

Tom Schatz, President
Citizens Against Government Waste

David Williams, President
Taxpayers Protection Alliance

Andrew Langer, President
Institute for Liberty

The Fed Has Not Been Independent – Perhaps It Should Be Restructured

Published in The Heritage Foundation.

The Federalist Society recently posted a podcast of me and R-Street’s Alex Pollock discussing Federal Reserve independence. This topic is always fun because so many people assume that (1) the Federal Reserve should be independent; and, (2) the Federal Reserve has always been independent.

The Inescapably Political World of Banking and Finance

Published in Law & Liberty.

Banking always involves political economy, as professor Mark Rose observes, or as we might more precisely say, political finance. This is the central lesson of Rose’s Market Rules. The book nicely shows how banking and politics have been constantly intertwined in the United States over the 50 years beginning in the 1960s, as much bigger banks have been created and the banking system has consolidated. (Although today there are 5,477 banks and savings associations in the United States, in 1950 there were 19,438.)

The book’s anecdotes of forceful personalities of American banking history, both those in the business and those in government during the times it covers, are engaging, at least to those of us in the trade, and fun to read. In addition, its theme has much broader application than the text suggests: namely to all countries in all times. As banking scholars Charles Calomiris and Stephen Haber have concluded, all banking systems reflect deals between bankers and politicians, which they call “the Game of Bank Bargains.” The study of this idea in their book, Fragile by Design—The Political Origins of Banking Crises and Scarce Credit(2014), covers a number of countries in detail and a long history going back to the 17th century. This gives us a wider framework in which to view the arguments and events related by Rose and reinforces his local variations on the theme that banking is politically entwined.

However, unlike Fragile by Design, don’t read Market Rules for economic or financial concepts or for careful economic or financial arguments. They aren’t there. Likewise, don’t read it for theoretical insights into politics or banking systems. Its discussion of political finance is journalistic, with a left-of-center slant. The book displays a pronounced bias against markets and competition, repeatedly dismissing them as “market talk.” “Citing markets” is characterized as a “rhetorical obsession.” There is throughout a positive bias for governments and for government control.  Discussing the financial crisis bailouts, for example, Rose reflects that “For that moment at least, government authority and prestige were in the ascendance”—just the way he likes it. Still, the book’s rendition of banking debates and developments is interesting and useful, describing how the economically critical banking sector evolved over five decades.

A more balanced view of banks and governments than the book conveys would stress that both banks and governments are made up of human beings, and that both demonstrate the aspirations, insights, and achievements always mixed with the failures, mistakes and hypocrisy natural to mankind. We should not be surprised that these same attributes appear in their interaction and the deals they make with each other. Moreover, both banks and governments often make big mistakes at forecasting the economic and financial future and cannot know what the long-term results of their own actions will be.

We naturally observe this mix of strengths and weaknesses in all parties in the course of banking history. Nothing human is perfect, or even close. The pursuit of profit, subject to competition and innovation, will on average get much better economic results for the people than will the pursuit of bureaucratic power using the government’s monopoly of force and coercion. Rose is right, however, that in banking we always find some combination of the two.

Market Rules brings out in what remarkable fashion banking times and ideas change, and how what seems like a great issue at one point, becomes difficult to remember at some later point. In discussing the Hunt Commission, appointed by President Richard Nixon to consider how to improve the American financial system, the book says:

Hunt and his commissioners determined not to explore in detail the boldest question of all, which is whether the nation needed a separate and distinct group of S&Ls [savings and loans] and another group of separate and distinct commercial banks.

That was the boldest question of all? It seems hard for us to believe, but in 1970, the S&Ls were a political force to be reckoned with. They had their own powerful trade association, the U.S. League for Savings, and their own cheerleading regulator, the Federal Home Loan Bank Board. Those names are probably unfamiliar, because both have long since disappeared and been merged into the respective banking organizations. Of course, at the time of this debate, the 1980s collapse of the S&L industry was more than a decade in the future.

The Hunt Commission did propose numerous reforms, but “criticism of Hunt’s report arrived hard and fast,” Rose relates. One of the commissioners arose “to denounce the ‘blurring of distinctions between financial institutions.’” “Blurring of distinctions” hardly sounds like a stirring battle cry, or even a clear thought, but since it really meant “protect me from competition,” it was.

A similar thought arose in the 1990s: “Large and small bankers alike feared that insurance companies like State Farm would purchase a thrift [S&L] charter and use it to offer bank services.” In Rose’s phrase, this was a “horrifying prospect.” By now, State Farm has operated its S&L, which is called State Farm Bank, for two decades. I have an account there. It doesn’t seem too horrifying.

Another big battle of past years was that over the then well-known “one-quarter point.” To any readers under the age of 50: does that mean anything to you? Probably not. The context is that in the 1960s and 1970s, the U.S. government practiced national price fixing for the interest rates that banks and S&Ls could pay on deposits. The point of this 1930s idea was to limit competition, so that deposit banking was a cartel with the government as cartel manager. The “quarter point” meant that the price fixing rules allowed the maximum rate the S&Ls could pay to be 0.25 percent higher than what commercial banks could pay their depositors.

As the book relates, “Insiders knew the government’s ability to determine interest rates paid to savers by its official name, the Federal Reserve’s Regulation Q,” commenting that it was “curiously named.” So it was, but famous in banking at the time. I well remember an old banking lawyer explaining to me that “Reg Q,” as it was called, was a permanent and unchangeable part of the American banking system. A bad prediction, as it turned out, since Reg Q has now disappeared from the memory of all but financial historians. Nonetheless it was a big deal in its day.

The book further explains: “In 1966, President Johnson and the Congress approved the Interest Rate Control Act, which authorized S&L executives to pay a higher rate of interest to savers than banks paid them. Nervous S&L officers had urged this action.” Rose does not mention that they had urged it because the government’s interest-rate fixing had brought on the Credit Crunch of 1966. “Federal Reserve officers in turn approved a 0.25 percent differential.” Then S&Ls were “passionate in defending the regulation…as a vital protection to their firms and to American home construction.”

Passionate? Vital? A quarter-point? Reg Q? Times change.

One of the most instructive examples of intertwined finance and government is the history of Fannie Mae and Freddie Mac. Fannie and Freddie played a large role in inflating the disastrous housing bubble of the 2000s. The most important thing about them is that they were government-sponsored, government-promoted and government guaranteed, while having their stock privately owned—a fundamental conflict which turned out to have bankrupting results. Fannie and Freddie were known by the acronym, “GSEs,” for “government-sponsored enterprises.” In 2008, they also became majority government-owned.

But in its less than one-page treatment of them, Market Rules describes Fannie and Freddie as “privately owned firms,” without mentioning their GSE status or the tight political connections and political clout they enjoyed in their glory days. Fannie was a Washington bully, including attacking the individual careers of those who dared to criticize or oppose them, and inspired genuine fear. James Johnson, its 1990s CEO and a highly influential political insider and operator, presided over a huge institution which seemed at the time an unstoppable colossus, both financial and political. Although he is a most impressive example of its main thesis, he rates not even a mention in the book.

Many other interesting characters do appear. Featured roles are given to James Saxon, William McChesney Martin, Wright Patman, Walter Wriston, Arthur Burns, Bill Simon, Hugh McColl, Don Regan, Gene Ludwig, Robert Rubin, Phil Gramm, Sandy Weill, Paul Volcker. If you are interested in political finance but you don’t know who all these gentlemen are, you should. Also appearing is a whole series of U.S. presidents from John Kennedy on.

Of everybody in this history, my favorite is James Saxon, the comptroller of the currency from 1961-1966, who on Rose’s telling got the whole ball rolling of introducing more competition into a financial system previously designed to suppress competition.

“Saxon, often intemperate in his public language,” Rose writes, “asserted that investment bankers’ control of revenue bonds constituted a ‘full-fledged monopoly.’” To be exact, it was an oligopoly, but of course Saxon was basically right.

“In March 1964, Saxon told members of the Senate Banking Committee that the Federal Reserve’s regulation of the interest rates that banks paid savers amounted to price fixing.” Rose comments primly, “Presidential appointees did not speak in that fashion about the Federal Reserve.” My reaction is, “Saxon was absolutely right!”

Being right may not be popular: Saxon “had thrown state-chartered bankers into a more competitive environment, which they resisted.” And Saxon had “encouraged powerful enemies” who demanded his ouster. Rose does not like him either and writes with satisfaction of how President Lyndon Johnson declined to reappoint him in 1966, so that “Saxon returned to anonymity.” Like we all do, but it seems to me he had a great run.

In conclusion, as this book illustrates with lots of examples, political finance it is.

When my successor as president of the Federal Home Loan Bank of Chicago asked me for advice, I told him, “Remember that this job is 50 percent banking and 50 percent politics.” That seems to sum it up.

Fed ‘independence’ is a slippery slope

Published in American Banker, The Federalist Society, The American Conservative, and Live Trendy News.

Many observers, like Captain Renault in Casablanca, were “shocked, shocked!” at President Trump’s sharp criticism of the Federal Reserve and his attempt to influence it against raising interest rates, inquiring whether the president can fire the Fed chairman.

Yet many presidents and their administrations have pressured the Fed, going back to its earliest days, when the Woodrow Wilson administration urged it to finance bonds for the American participation in the First World War. The Fed compliantly did so, proving itself very useful to the U.S. Treasury.

That was not surprising, since the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board, and the board met in the Treasury Department.

In the decades since then, lots of presidents have worked to influence the Fed’s actions. Their purpose was usually to prevent the Fed from raising interest rates, exactly like Trump. It was also often to cause the Fed to finance the U.S. Treasury and to keep down the cost of government debt, just as “quantitative easing” does now.
But has a president ever fired a Federal Reserve Board chairman?

Yes, in fact. President Truman effectively fired Fed Chairman Thomas McCabe in 1951. “McCabe was informed that his services were no longer satisfactory, and he quit,” Truman said. Being informed by the president that your performance is not satisfactory is being fired, I’d say. One might argue that McCabe didn’t have to resign, but he did.

The background to McCabe’s departure was a heated and very public dispute between the Truman administration, including Truman personally, and the Fed about interest rates and financing the Korean War. Truman had even summoned the entire Federal Reserve Open Market Committee to the White House, where he made plain what he wanted, which was straightforward. Since the Second World War, the Fed, as the servant of the Treasury, bought however many Treasury bonds it took to keep their interest rate steady at 2.5% — this was the “peg.” In the middle of the Korean War, Truman understandably wanted to continue it.

The Fed, on the other hand, was understandably worried about building inflation, and wanted to raise interest rates. As the two sides debated in January 1951, American military forces were going backwards down the Korean peninsula, in agonizing retreat before the onslaught of the Chinese army. Although financial historians always tell this story favoring the Fed, I have a lot of sympathy for Truman.

By now we have been endlessly instructed, especially by the Fed itself, that the Fed is and must be “independent,” and this has become an article of faith, especially for many economists. However, the opposite opinion has often been prominent, including when the Fed and the Treasury completely coordinated their actions during the financial crisis of 2007-2009 — as they should have.

What exactly does Fed “independence” mean? Allan Sproul, a long-time and influential president of the Federal Reserve Bank of New York, maintained that the Fed “is independent within the government.” That is masterfully ambiguous. It expresses a tension between the executive branch, Congress and the Fed, searching for an undefined political balance.

When McCabe resigned, Truman appointed, he thought, his own man, William McChesney Martin from the Treasury Department. Martin is often viewed as the hero of establishing Fed independence — correspondingly, Truman later considered him a “traitor.” But Martin’s understanding of what Fed “independence” means was complex: He “was always careful to frame his arguments in terms of independence from the executive branch, not from Congress,” a history of Fed leadership says.

“It is clear to me that it was intended the Federal Reserve should be independent and not responsible to the executive branch of the Government, but should be accountable to Congress,” Martin testified in 1951. “I like to think of a trustee relationship to see that the Treasury does not engage in the natural temptation to depreciate the currency.”

Seven decades later, how accountability to Congress should work is still not clear, and Martin would certainly be surprised that the current Fed has formally committed itself to the perpetual depreciation of the currency at 2% per year.

Martin stayed as Fed chairman until 1970, which allowed him to experience pressure from five different administrations. The most memorable instance was the personal pressure applied by President Johnson. In late 1965, the Fed raised interest rates with the war in Vietnam, domestic spending and government deficits expanding.

“Johnson summoned the Fed Chairman to his Texas ranch and physically shoved him around his living room, yelling in his face, ‘Boys are dying in Vietnam and Bill Martin doesn’t care!’” one history relates.

That’s quite a scene to imagine.

One may wonder whether Fed independence is a technical or a political question. It is political. The nature and behavior of money is always political, no matter how much technical effort at measuring and modeling economic factors there may be.

For example, the Fed over the last decade systematically took money away from savers and gave it to leveraged speculators by enforcing negative real interest rates. Taking money from some people to give it to others is a political act. That is why the Fed, like every other part of the government, should exist in a network of checks and balances and accountability.

There is also a fundamental problem of knowledge involved in the idea of independence. How much faith should one put in the judgments of the Fed, which are actually guesses? The answer is very little — about as much faith as in any other bunch of economic forecasts, given that the Fed’s record is as poor as everybody else’s. The Fed’s judgments are guesses by sophisticated, intelligent and serious people, but nonetheless guesses about an unknowable future.

Arthur Burns, the Fed chairman from 1970 to 1978, observed that among the reasons for “The Anguish of Central Banking” is that “in a rapidly changing world the opportunities for making mistakes are legion. Even facts about current conditions are often subject to misinterpretation.”

Very true — and moreover, the world is always changing.

In the light of the political reality of Federal Reserve history, a completely independent Fed looks impossible. In the light of the unknowable future, it looks undesirable.

The Fed Has Not Been Independent – Perhaps It Should Be Restructured

Published in Forbes.

The Federalist Society recently posted a podcast of me and R-Street’s Alex Pollock discussing Federal Reserve independence. This topic is always fun because so many people assume that (1) the Federal Reserve should be independent; and, (2) the Federal Reserve has always been independent.

Fannie And Freddie Need More Capital

Published in Forbes.

Another reason for ending the sweep would be that the Treasury has already been paid back its $187.5 billion injection plus the 10% compound dividend payments required under the terms of the conservatorship. Any GSE revenues flowing to Treasury exceeds what it is rightfully owed, and accomplishes little else that could be construed as positive.

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.

text

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