Give Fannie, Freddie the same capital standards as everybody else

Published in American Banker.

Taking up a key issue in housing finance reform, one within his control as the new director of the Federal Housing Finance Agency, Mark Calabria told a conference recently that Fannie Mae and Freddie Mac must in the future have a strong capital position.

He’s absolutely right. And this would be in vivid contrast to the 0.2% capital ratio they have now.

Calabria stated that “all large, systemically important financial institutions should be well capitalized,” specifically including Fannie and Freddie. “That would seem non-debatable at this point.”

Indeed it does. No one can plausibly disagree.

But what is the number? What is the explicit capital ratio which would implement Calabria’s excellent principle?

I believe his remarks in effect gave us the answer by asking the question in this pertinent way: “How do we level the playing field to where all large financial institutions have similar capital” so that Fannie and Freddie do not have “lower standards than everybody else?”

The answer to this well-framed question is obvious: Give the government-sponsored enterprises the same capital requirement for mortgage risk that everybody else has. In short, the answer is 4%. This is the internationally recognized standard for mortgage risk, which represents virtually all of Fannie and Freddie’s assets. The FHFA should, in my view, immediately establish a minimum capital requirement for Fannie and Freddie of tangible equity equal to 4% of total assets.

Considering them on a combined basis, 4% of Fannie and Freddie’s assets of $5.5 trillion results in a required capital of $220 billion between the two of them. That is 22 times their current capital and $210 billion more capital than they’ve got right now.

Naturally, Fannie and Freddie cannot retain or raise any more capital while subject to the “profit sweep” to the Treasury, but let us suppose the senior preferred stock purchase agreements between the Treasury and the FHFA as conservator could be renegotiated. This outcome would not be unreasonable, since the Treasury now has an internal rate of return on its preferred stock investment of about 12% — which is pretty good — and much better than the original 10% agreement. On top of that, Treasury still has warrants to acquire 79.9% of Fannie and Freddie’s common stock at an exercise price of virtually zero (0.001 cents per share). That could be a nice pop for the taxpayers on top of the 12% average annual return.

As President Trump’s March 27 memorandum on housing finance reform makes clear, as part of any renegotiation, Fannie and Freddie will need to pay the Treasury for its ongoing credit support, implicit or otherwise. This should absolutely be required.

How much in fees should they pay? That is debatable, to be sure, but definitely not nothing. We might consider that the lowest rated banks on the FDIC’s deposit insurance fee table pay a range of 16 to 30 basis points of total liabilities per year for their government guarantee. Let’s give the critically undercapitalized Fannie and Freddie the benefit of the doubt and assume the lowest end of that range: a fee to the Treasury of 16 basis points.

What kind of return on equity could a Fannie and Freddie capitalized at 4% then expect? Here’s one estimate. Fannie and Freddie’s combined net profits for the first quarter of 2019 were $3.8 billion. That annualized is $15.2 billion — let’s call it $16 billion. Subtract from that the 16 basis point fee to the Treasury assessed on liabilities, which after tax would be $7 billion. Add the fact that they would have $210 billion more cash worth 2.5%, or approximately $4 billion, after tax. In sum, that gives $13 billion in net profit pro forma, or an ROE of about 6%. If the fee to Treasury were dropped to 10 basis points, the pro forma ROE would rise to a little over 7%.

That seems like a reasonable starting range. It compares to the 5-year average ROE of U.S. banks of 9.6%. From the 6% to 7% range, there are lots of actions in pricing, greater efficiency and improved methods for management to pursue. But running at hyper-leverage as in the old days and in the conservatorship days would not be possible. That would move the mortgage market toward the more competitive state that Calabria correctly envisions.

What should happen next? The FHFA should set a 4% capital standard for Fannie and Freddie. The Financial Stability Oversight Council should designate Fannie and Freddie as the “systemically important financial institutions” they so obviously are, treating them the same as others of their size. The Treasury should exercise as a gain for the taxpayers its warrants for their common stock, removing any uncertainty about the warrants.

When capital has become sufficient, the FHFA should end the conservatorships and implement regulation which ensures that Fannie and Freddie’s credit risk stays controlled and tracks how the more competitive, less GSE-centric mortgage system evolves.

Congress does not have to do anything in this scenario. That is good, because it is highly unlikely that it will do anything.

Echoes of the US savings and loan industry’s collapse

Published in the Financial Times.

Metro Bank has the problem so pointedly observed by the great Walter Bagehot in 1873: “Every banker knows that if he has to prove he is worthy of credit . . . in fact his credit is gone.”

Your editorial “Metro panic shows need for proactive regulation” (May 14) says “Metro’s loan book . . . is fully covered by customer deposits.” Of course, customer deposits are not inherently stable — they are inherently unstable. Their stability, as you suggest, is solely due to the guarantee provided by the government.

This fact, so humbling for bankers, has powerful effects, most strikingly shown by the collapse of the US savings and loan industry in the 1980s. Savings institutions that were irredeemably insolvent were nonetheless able to keep their deposits because they were guaranteed by a government deposit insurance fund. However, this fund, the Federal Savings and Loan Insurance Corporation, was publicly admitted to be itself broke! But the depositors correctly believed that behind it all the time was the US Treasury, as in fact it was. This allowed many insolvent S&Ls to keep funding disastrous speculations, which made the ultimate cost to the Treasury far bigger.

Treasury’s Phillips Says GSEs Have Paid Back Taxpayers

Published in Seeking Alpha.

In the video above he’s responding to a question from Alex Pollock, who put together an article on the 10% moment. The theory behind the 10% moment is to ignore the accounting fraud and the net worth sweep and to calculate the cash ROI on taxpayer dollars invested into Fannie and Freddie. Alex suggests that the current cash on cash ROI is 11.5%. His logic is that because this exceeds the original 10%, the government can say it’s been paid back. Craig Phillips calls Alex his hero for coming up with this concept and says that taxpayers have been paid back.

Inflation and the Fed

Published in Barron’s.

Forsyth suggests that a “‘complete financial externality’…would aptly describe the Great Financial Crisis of 2007-09.” I don’t think so. That crisis, like many others, was “endogenous,” as my old friend, Hy Minsky, used to say—reflecting the internal dynamics of interacting leverage, inflated asset prices, moral hazard, and risk in the financial system. Central banks are part of the system, and its internal interactions are not above the system in some celestial role. If you are prone to believe in “the control asserted by central banks over economies,” recall the hapless announcement by central banks that they had created the “Great Moderation,” which proved instead to be the Great Bubble. Widespread belief that central banks are in control may be another endogenous risk factor.

House Report on Consumers First Act

Published by the House Financial Services Committee.

In the 115th Congress, the Committee held a hearing entitled “A Legislative Proposal to Create Hope and Opportunity for Investors, Consumers and Entrepreneurs,” on April 26 and April 28, 2017. Testifying were Mr. Peter J. Wallison, Senior Fellow and Arthur F. Burn Fellow, Financial Policy Studies, American Enterprise Institute; Dr. Norbert J. Michel, Senior Research Fellow, Financial Regulations and Monetary Policy, The Heritage Foundation; The Honorable Michael S. Barr, Professor of Law, University of Michigan Law School; Mr. Alex J. Pollock, Distinguished Senior Fellow, The R Street Institute

The unstable stability council

From American Banker’s Bankshot Podcast:

R Street’s Alex Pollock appears on the most recent Bankshot Podcast. At first the Financial Stability Oversight Council wanted to target individual nonbanks that pose a risk to the economy. Now it wants to target activities rather than firms. Is that a good idea or a political ploy? 

Click here to listen to the pull podcast.

Is Dodd-Frank council evolving, or throwing in the towel?

Published in the American Banker.

“In my judgment at the time” the FSOC was established was that “it was not well constructed,” said Alex Pollock, a senior fellow at the R Street Institute. “It’s set up to be naturally a logrolling operation among bureaucratic agencies. It’s a very hard kind of structure to get to work well, because everybody wants to defend his own territory from encroachment by somebody else.” 

Pollock said the council’s ability to prevent crises should not be the sole criteria for judging the shift toward an activities-based approach, because the alternative of designating firms one by one might not succeed, either. “I think it’s worth a try.”

What Does the Fed Know that Nobody Else Knows?

Published in Law & Liberty and in the Federalist Society.

When it comes to the financial and economic future, everybody is myopic. Nobody can see clearly. That includes the Federal Reserve.

As François Villeroy de Galhau, the Governor of the Bank of France, recently said in a brilliant talk, central banks are subject to four uncertainties. These are, in my paraphrased summary:  

1) They don’t really know where we are.

2) They don’t know where we are going.

3) They are affected by what other people are going to do, but don’t know what others will do.

4) They know there are underlying structural changes going on, but don’t know what they are or what effects they will have.  

Yet it appears that central banks usually feel the urge to pretend to know more than they can, in order to inspire “confidence” in themselves, and to try to manage expectations, while they go on making judgments subject to a lot of uncertainty, otherwise known as guesses.

A refreshing exception to this pretense was the speech Federal Reserve Chairman Jerome Powell gave in last August at the annual Jackson Hole symposium, 2018. He reviewed three key “stars” in monetary policy models: u* (“u-star),” r* (“r-star”) and ϖ (“pi-star,”), which are respectively the “natural rate of unemployment,” the “neutral rate of interest,” and the right rate of inflation.  None of these are observable and all are of necessity theoretical, so in a clever metaphor, Powell candidly pointed out that these supposedly navigational stars are actually “shifting stars.” Bravo, Mr. Chairman!

Let’s consider this question: What does the Fed know that nobody else knows? Nothing.

Can the Fed know what the right rate of inflation is? No. Of course, it can guess. It can set a “target” of steady depreciation of the dollar at 2% per year in perpetuity. Can it know what the long-term results of this strategy will be? No.

Moreover, nobody knows or can know what the right interest rate is. That includes the Fed (and the President). Interest rates are prices, and government committees, like the Federal Open Market Committee, cannot know what prices should be. That (among many other reasons) is why we have markets.

The Wall Street Journal recently published an article by James Mackintosh, “Fed Is Shifting the Goal Posts, and Investors Should Care.” With shifting goalposts or shifting stars, the Fed cannot know where they should be, but investors should and do indeed care very much about what the Fed thinks and does.

This is because, as we all know, the Fed’s actions or inaction, and also, financial actors’ beliefs about future Fed actions or inaction, can and do move prices of stocks and bonds substantially. Indeed, the more financial actors believe that Fed actions will move asset prices, the more it will be true that they do.

Mackintosh discusses whether the Fed’s inflation target will become “symmetric”—that is, the target would change into an average of periods both over it and under it, rather than a simple goal. Thus, sometimes “inflation above 2% is as acceptable as inflation below 2%.” Ah, the old temptation of governments to further depreciate the currency never fades for long.

“Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds,” the article reports, and opines that the change could have “big implications for markets,” that is, for asset prices. That seems right.

But the 2 percent inflation, whether as an average or as a simple goal, “isn’t up for debate.” Why not? The Humphrey-Hawkins Act of 1978, the same act that gave the Fed the so-called “dual mandate” which it endlessly cites, also set a long-term goal of zero inflation. What does the Fed think about that provision of the laws of the United States?

A true sound money regime has goods and services prices which average about flat over the long term. But being prices, they do fluctuate around their stable trend. The Fed, like other central banks, is in contrast committed to prices which rise always and forever. Discussing which of these two regimes we should want would focus consideration on where the goalposts should be.

Mackintosh worries that there may be a “loss of faith in the Fed’s ability.” On the contrary, I think a lack of faith in the Fed’s ability is rational, desirable, and wise.

Colleges need to have skin in the game to tackle student loan debt

Published in The Hill.

Republican Senator Lamar Alexander of Tennessee rightly wants to make colleges more accountable for the results of student loans. With these federal loans, the government lends with no credit underwriting, the students get in debt, but who gets all the money? The colleges. If the students fail to repay the loans, who takes the hit? The taxpayers. This is a perverse incentive structure. It leads to, as his committee report found, “nearly half of all borrowers not making payments on their student loans.”

Alexander proposes a “new accountability system for colleges based upon whether borrowers are actually repaying their student loans.” Great idea! In a similar vein, the annual White House budget correctly observes a “better system would require postsecondary institutions that accept taxpayer funds to share in the financial responsibility associated with student loans.” Indeed, each college should share the risk of whether its students repay the money they borrowed and the college spent. Nothing improves your behavior like having to share in the risk you are creating. In his book “Skin in the Game,” Nassim Nicholas Taleb wrote, “If you inflict risk on others, and they are harmed, you need to pay some price for it.”

In student loans, with their abysmal repayment rate, colleges play the same role as subprime mortgage brokers did in the infamous housing finance bubble. They promote the loans without regard to how they might be repaid, they make money from the loans, and they pass all the risk on to somebody else. In the housing finance case, the risk went ultimately to the taxpayers. In the student loan case, it goes directly to the taxpayers. Just as the flow of easy mortgage credit induces higher house prices then takes even more debt to pay the higher price, the flow of easy student credit induces higher college prices then takes even more debt to pay the higher tuition. It is a sweet deal for colleges that create the risk, keep all the money, and stick the taxpayers with all the losses.

A Brookings Institution research paper points out that with low repayment rates, the federal student loan program represents a “sizeable taxpayer funded transfer” to the colleges. It rightly asks how much of the taxpayer losses the college should have to pay back. It proposes that each cohort of college borrowers be measured at the end of five years of required payments, and each college has to pay at least 25 percent of the amount by which the actual principal reduction has fallen short of 20 percent of the total of the original loans after five years. The 20 percent principal reduction results from what would happen with a 15 year amortization of the loan pool as the standard used. That seems perfectly reasonable.

This proposal is a good stab at it, but I would say do not wait for five years to address the problem. Do it every year. Take the total loan pool of each borrower cohort of the college. Establish a 15 year amortization schedule for the principal of the pool. Measure every year how much principal has actually been paid in the pool as a whole. Each year the college should pay to the Treasury, I suggest 20 percent of any repayment shortfall against the standard. That would be a steady financial feedback loop.

After 15 years, the college will have reimbursed taxpayers for 20 percent of whatever loan principal was not paid. Of course, taxpayers would still be paying for 80 percent of the losses. The 20 percent loss participation would be enough to give the college the right incentives to improve its repayment performance and control instead of constantly bloating the debt of its students. Student loan borrowers, like mortgage borrowers, are hurt being saddled with thousands of dollars in debt they cannot pay.

Colleges should have maximum flexibility for how to work on this. They could increase efficiency, reduce their costs and their prices, or shorten the time to graduation to scale back the need for borrowing. They should make sure the students understand what loans mean and how they are expected to repay, consider their ability to pay, guide the students to programs with the most promising job prospects for them, and adjust their mix of programs. They can do all of the above plus other ideas and managing the tradeoffs involved. Colleges should no longer play the role of subprime mortgage brokers. They need some skin in the game now.

Cuestionan definición de servicios esenciales

Published in Metro PR.

Amanda Rivera, directora ejecutiva del Instituto del Desarrollo de la Juventud de Puerto Rico; Ana Cristina Gómez, profesora de la Escuela de Derecho de la Universidad de Puerto Rico (UPR), y Alex Pollock, del R Street Institute, también presentaron sus ponencias ante el comité cameral.

Demócratas y republicanos parecen ir por caminos distintos sobre la ley Promesa

Published in El Nuevo Dia.

El experto en finanzas Alex Pollock, del grupo R Street y quien fue invitado a la audiencia por la minoría republicana, recomendó que la JSF tenga más poderes y pidió al Congreso nombrar un jefe de finanzas que también funcione por encima del gobierno electo de Puerto Rico.

Como varios congresistas republicanos, Pollock criticó que el gobierno de Puerto Rico no haya publicado los informes financieros auditados de 2016, 2017 y 2018.

U.S House Natural Resources Committee Holds Hearing on Puerto Rico

Published in The Weekly Journal.

The U.S. House Committee on Natural Resources holds a hearing today on the status of Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA): Lessons Learned Three Years Later.

Natural Resources committee Chairman Raúl Grijalva presides the 10 a.m. oversight hearing at the Longworth House Office Building.

Gov. Ricardo Rosselló, Natalie A. Jaresko, Executive Director, Financial Oversight and Management Board for Puerto Rico; Martín Guzmán, Non-Resident Senior Fellow for Fiscal Policy, Espacios Abiertos; Amanda Rivera, Executive Director, The Institute for Youth Development of Puerto Rico; Ana Cristina Gómez-Pérez, Associate Professor, University of Puerto Rico; and Alex J. Pollock, Distinguished Senior Fellow, R Street Institute are part of the witness list.

Testimony to the House Committee on Natural Resources at Hearing on “The Status of the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA): Lessons Learned Three Years Later”

Published by the R Street Institute.

Six Lessons

Mr. Chairman, Ranking Member Bishop, and Members of the Committee, thank you for the opportunity to be here today.  I am Alex Pollock, a senior fellow at the R Street Institute, and these are my personal views.  I have spent almost five decades working in and on the banking and financial system, including studying the recurring insolvencies of municipal and sovereign governments.  I have personally experienced and studied numerous financial crises and their political aftermaths, and have authored many articles, presentations, testimony and two books on related subjects.  Prior to R Street, I was a resident fellow at the American Enterprise Institute 2004-2016, and President and CEO of the Federal Home Loan Bank of Chicago 1991-2004.

In my view, there are six key lessons about PROMESA, the massive insolvency of the government of Puerto Rico, and the role of the Oversight Board we should consider.  These are:

1. The fundamental bargain of PROMESA was sound. But it could be improved.

2. In such situations, a lot of conflict and controversy is unavoidable and certain.

3. The Oversight Board should have more power: in particular, it should have the same Chief Financial Officer provisions as were so successfully used in the Washington DC reforms.

4. Oversight boards are likely to last more than three years. In Puerto Rico, all the problems were of course made more difficult by the destructive hurricanes, and the flow of federal emergency funds into the Puerto Rican economy now makes the financial problems more complex.

5. Large unfunded pensions are a central element in these situations and set up an inescapable conflict between the claims of bondholders and pensioners.

6. Progress must operate on three levels of increasing difficulty:

7. Equitable reorganization of the debt (including pension debt)

8. Reform for efficiency and reliability in the fiscal and financial functioning of the government

9. Reforms which allow a growing, enterprising successful market economy to emerge from the historic government-centric economy.

1. The fundamental bargain of PROMESA was sound. But it could be improved.

As it considered PROMESA, the Congress was faced with a municipal insolvency of unprecedented size.  As one analyst correctly wrote, “There is no municipal borrower remotely as insolvent as Puerto Rico.”  Indeed, adding together its $70 billion in bond debt and $50 or $60 billion in unfunded pension debt, the government of Puerto Rico has debt of more than six times that of the City of Detroit, the previous all-time record holder, as it entered bankruptcy.

The fundamental bargain Congress constructed in PROMESA to cope with Puerto Rico’s financial crisis made and makes good sense.  It may be described as follows:

     -To the Puerto Rican government:  We will provide reduction and restructuring of your unpayable debts, but only if it is accompanied by fundamental financial and government reform.

     -To the creditors:  You will get an appointed board to oversee and reform Puerto Rico’s finances, but only if it also has debt reduction powers.

This is a sound bargain.  The resulting Oversight Board created by the act was and is, in my judgment, absolutely necessary.  But its members, serving without pay, were as we all know, given an extremely difficult responsibility.  So far, significant progress has been made, but much remains to do.  Let us hope the Senate promptly confirms the existing members of the Board, so that its work may continue uninterrupted.

In the negotiations leading to PROMESA, it was decided to create an Oversight Board, less powerful than a control board.  I thought at the time, and it seems clear in retrospect, that it would have been better—and would still be better–for it to have more of the powers of a financial control board, as discussed further under Lesson 3.

Two well-known cases of very large municipal insolvencies in which financial control boards were successfully used were those of New York City and Washington DC.  In 1975, New York City was unable to pay its bills or keep its books straight, having relied on, as one history says, “deceptive accounting, borrowing excessively, and refusing to plan.”  In 1995, Washington was similarly unable to pay its vendors or provide basic services, being mired in deficits, debt and financial incompetence. 

Today, New York City has S&P/Moody’s bonds ratings of AA/Aa1, and Washington DC of AA+/Aaa.  We should hope for similar success with the financial recovery of Puerto Rico.

• In such situations, a lot of conflict and controversy is unavoidable and certain.

Nothing is less surprising than that the actions and decisions of the Oversight Board have created controversy and criticism, or that “the board has spent years at odds with unhappy creditors in the mainland and elected officials on the island.”

As one Oversight Board member, David Skeel, has written, the Board “had been sharply criticized by nearly everyone.  Many Puerto Ricans and economists…argued that our economic projections were far too optimistic….  Creditors…insisted that the economic assumptions in the fiscal plan were unduly pessimistic and…provided too little money for repayment.”

The settlement of defaults, reorganization of debt and creation of fiscal discipline is of necessity passing out losses and pain, accompanied by intense negotiations.  Of course, everyone would like someone else to bear more of the loss and themselves less.  It is utterly natural in the “equitable reorganization of debt” for insolvent debtors and the creditors holding defaulted debt to have differing views of what is “equitable.”

If only one side were critical of the Oversight Board, it would not be doing its job.  If it is operating as it should, both sides will complain, as will both ends of the political spectrum.  In this, I believe we must judge the Oversight Board successful.

The financial control boards of New York City and Washington DC are now rightly considered as a matter of history to have been very successful and to have made essential contributions to the recovery of their cities.  But both generated plenty of complaints, controversy, protests and criticism in their time.

In Washington, for example, “city workers protested by blocking the Control Board’s office with garbage trucks during the morning rush hour.”  In the board’s first meeting, “protesters shouted ‘Free D.C.’ throughout the meeting, which was brought to an end by a bomb threat.”  Later, “in one of its most controversial actions, the Board fired the public school superintendent, revoked most of the school board’s powers, and appointed its own superintendent to lead the system.”

In New York, the board “made numerous painful, controversial decisions that the administration of Mayor Abraham D. Beame was unwilling or unable to make.  It ordered hundreds of millions of dollars in budget cuts above those proposed by the administration and demanded the layoffs of thousands of additional city workers.  It rejected a contract negotiated by the city’s Board of Education…it also rejected a transit workers’ contract.”

What did this look like at the time?  “In the eyes of many people in the city, it was most distasteful,” said Hugh Carey, then Governor of New York State.  “They saw the control board as the end of home rule, as the end of self-government.”  Another view: “The city of New York was like an indentured servant.”

In restructurings of debt and fiscal operations, it has been well observed that a “key factor is making sure that the sacrifice is distributed fairly.”  But what is fair is necessarily subject to judgment and inevitably subject to dispute.

• The Oversight Board should have more power: in particular it should have the same Chief Financial Officer provisions as were so successfully used in the Washington DC financial reforms.

As PROMESA came into effect, as has been observed, “The most obvious obstacle…was that no one really knew what Puerto Rico’s revenues and expenditures were.” This financial control mess, stressed by expert consultants at the time, highlights the central role in both creating and fixing the debt crisis, of financial management, reporting and controls.  Progress had been made here with efforts of both the Oversight Board and Puerto Rico, as the certified fiscal plan has been developed.  But the government of Puerto Rico still has not completed its audited financial statements for 2016 or 2017, let alone 2018.

Of the historical instances of financial control boards in municipal insolvencies, there is a key parallel between Puerto Rico and Washington DC:  in both cases, there is no intervening state. The key role played by New York State, or by Michigan in the Detroit bankruptcy, for example, is missing. The reform and restructuring relationship is directly between the U.S. Congress and the local government.

The most striking difference between the Washington DC board and the Oversight Board is the greater power of the former.  This was true in the initial design in 1995, but when Congress revised the structure in 1997 legislation, the Washington board was made even stronger.  Most notably, the Washington design included the statutory Office of the Chief Financial Officer, which answered primarily to the control board and was independent of the mayor.  Puerto Rico has created its own Chief Financial Officer, as good idea as far as it goes, but it lacks the reporting relationship to the Oversight Board and the independence which were fundamental to the Washington reforms. 

Today, long after Washington’s financial recovery, the independence remains.  As explained by the current Office of the Chief Financial Officer (OCFO) itself:

“In 1995, President Clinton signed the law creating a presidentially appointed District of Columbia Financial Control Board…. The same legislation…also created the position of Chief Financial Officer, which had direct control over day-to-day financial operations of each District agency and independence from the Mayor’s office.  In this regard, the CFO is nominated by the Mayor and approved by the DC Council, after which the nomination is transmitted to the U.S. Congress for a thirty-day review period.

“The 2005 District of Columbia Omnibus Authorization Act…reasserted the independence and authority of the OCFO after the Control Board had become a dormant administrative agency on September 30, 2001, following four consecutive years of balanced budgets and clean audits.”

If PROMESA were ever to be revised, for example trading additional financial support for additional reform and financial controls, as happened in the Washington DC case in 1997, I believe the revision should include structuring an Office of the Chief Financial Officer for Puerto Rico on the Washington DC model.

• Oversight boards are likely to last more than three years. In Puerto Rico, all the problems were of course made more difficult by the hurricanes, and the flow of emergency funds into the Puerto Rican economy now makes the financial problems more complex.

As we come up on the third anniversaries of PROMESA and the Oversight Board, we can reflect on how long it may take to complete the Oversight Board’s responsibilities of debt reorganization and financial and fiscal reform.  More than three years.

The New York City control board functioned from 1975 to 1986, or eleven years.  There was a milestone in 1982, which was the resumption of bank purchases of its municipal bonds. That took seven years.

The Washington DC control board operated from 1995 to 2001, or six years.  (Both boards still remain in the wings, capable of resuming activity, should the respective cities backslide in their financial disciplines.)

Everything in the Puerto Rico financial crisis was made more uncertain and difficult by the destruction from the disastrous hurricanes of 2017.  Now, as in response, large amounts of federal disaster aid are flowing into the Puerto Rican economy. 

How much this aid should be is of course a hotly debated political issue.  But whatever it turns out to be, this external flow makes the formation of the long-term fiscal plan more complex.  Whether the total disaster relief is the $82 billion was estimated by the Oversight Board, the $41 billion calculated as so far approved, or some other number, it is economically a large intermediate-term stimulus relative to the Puerto Rican economy, with its GDP of approximately $100 billion.

There are significant issues of how effectively and efficiently such sums will be spent, what the economic boost will be as they generate spending, employment and government revenues, whether they can result in sustainable growth or only a temporary effect, and therefore how they will affect the long-term solvency and debt-repayment capacity of the government of Puerto Rico.  Even if none of these funds go to direct debt payment, their secondary effects on government revenues may.  How to think through all this is not clear (at least to me), but a conservative approach to making long-term commitments based on short-term emergency flows does seem advisable.

The Oversight Board will have to come up with some defined approach to both long and short-term outlooks, as it continues its double project of debt reorganization and fiscal reform.  That is yet another difficult assignment for them, requiring time and generating controversy.

• Large unfunded pensions are a central element in these situations and set up an inescapable conflict between the claims of bondholders and pensioners.

Puerto Rican government pension plans are not only underfunded, they are basically unfunded.  At the time a PROMESA, a generally used estimate of the pension debt was $50 billion, which added to the $70 billion in bond debt made $120 billion in all.  It appears that there is in addition $10 billion in unfunded liabilities of government corporations and municipalities, making the pension debt $60 billion, and thus the total debt, before reorganization haircuts, $130 billion.  As I learned from an old banker long ago, in bankruptcy, assets shrink and liabilities expand.

How are the competing claims of bondholders and pensioners equitably to be settled?  This is an ever-growing issue in municipal and state finances—very notably in Illinois and Chicago, for example, as well as plainly in Puerto Rico.  The bankruptcy settlement of the City of Detroit did give haircuts to pensions—a very important precedent, in which the state constitution of Michigan was trumped by federal bankruptcy law.  But the pensions turned out in Detroit, as elsewhere, to be de facto senior to all unsecured bond debt. This reflects the political force of the pensioners’ claims and needs.

On April 30, the Oversight Board demanded that the government of Puerto Rico act to enforce required contributions to pension funds from several public entities and municipalities.  It is “unacceptable to withhold retirement contributions from an employee and not immediately transfer that money into the individual retirement account where it belongs,” wrote our colleague on the panel, Natalie Jaresco.  She is right, of course.  Except that it is worse than “unacceptable”—it is theft.

Pensions as a huge component of municipal insolvencies will continue to be a tough issue for the Oversight Board, as well as for a lot of other people.

• Progress must operate on three levels of increasing difficulty:

• Equitable reorganization of the debt (including pension debt)

• Reform for efficiency and reliability in the fiscal and financial functioning of the government

• Reforms which allow a growing, enterprising successful market economy to emerge from the historic government-centric economy.

Three years into the process, the first of these requirements is difficult and controversial, but well under way.

The second is harder, because it is challenging government structures, embedded practices, power, and local politics.  Relative to addressing insolvency, the most important areas for reform are of course the financial and fiscal functions.  Reform would be advanced by the creation of an Office of the Chief Financial Officer on the Washington DC model.

The third problem is by far the most difficult.  Solving the first two will help make solving the third possible, but the question of how to do this is not yet answered, subject to competing theories, and major uncertainty.  We all must hope for the people of Puerto Rico that it will nonetheless happen.

Thank you again for the chance to share these views.

Federal Lending to Insolvent Pension Plans Is Code for Bailout

Published in Real Clear Markets.

Here’s a remarkable lending opportunity to consider:  Let’s make billions of dollars in loans to borrowers which “are insolvent” or in “critical or declining status.”  These loans would be unsecured and no payments of principal would be due for 30 years.  At that point, in case of default, the loans would be forgiven.  Would you make such a loan?  Obviously not, and neither would anybody else—except maybe the government.   This idea is one only politicians could love, since it gives them a way to spend the taxpayers’ money without calling it spending.

Making such loans is proposed in a bill before the House Ways and Means Committee, entitled “Rehabilitation for Multiemployer Pensions Act” (HR 397). The borrowers would be multiemployer (union) pension funds which are deeply underfunded, insolvent in the sense of having obligations much greater than their assets, and won’t have the money to pay the benefits they have promised.  A more forthright title for the bill would be the “Taxpayer Bailout of Multiemployer Pension Funds Act.”

The bill’s primary sponsor, Congressman Richard Neal (D-MA), who is Chairman of the Ways and Means Committee, has stated, “This is not a bailout.”  But a bailout by any other name is still a bailout.  “These plans would be required by law to pay back the loans they receive,” said Chairman Neal.  But the bill itself provides on pp.18-19:

          “(e) LOAN DEFAULT.—If a plan is unable to make any payment on a loan under this section when due, the Pension Rehabilitation Administration [PRA] shall negotiate with the plan sponsor revised terms for repayment, which may include…forgiveness of a portion of the loan principal.”

No limit is set on how big the “portion” may be.  Why not 100%?  Of course, all loans of all kinds are in principle required to be repaid, but are nonetheless not repaid if the borrower becomes insolvent, and pension funds demonstrably can go broke like anybody else.  As one actuary recently observed, “It seems very likely that the default rate on PRA loans will be significant.”  Indeed it does.

It is highly convenient for the politicians that under the bill no default on principal repayment could occur by definition until the balloon payment in 30 years.  Assuming defaults start to occur in 2050, a member of Congress who is now 60 years old would be 91, if still living.  “I’ll gladly pay you Tuesday for a hamburger today,” said the instructive cartoon character, Wimpy.  Likewise, “We’ll gladly pay in 30 years for a bailout today” is a natural human response to financial failure.

Chairman Neal said that with his bill, “The federal government is simply backstopping the risk.”  But the federal government is already backstopping the risk of these pension plans through its implicit guarantee of the Pension Benefit Guaranty Corporation (PBGC). 

How has that worked out?  The PBGC’s insurance program for multiemployer pension funds is itself broke.  Its net worth is a negative $54 billion, according to the PBGC’s 2018 annual report.  The net position of $54 billion in the hole is composed of total assets of only $2.3 billion and liabilities of $56 billion, thus the liabilities are 24 times the assets.  Since PBGC’s accounting only takes into account the budget window, its long term position is even worse.

So it is not a surprise that by the time you get to the last paragraph on the last page of the bill, you find it also includes a bailout of the PBGC’s failing multiemployer program:

     “(b) APPROPRIATIONS.—There is appropriated to the Director of the Pension Benefit Guaranty Corporation such sums as may be necessary for each fiscal year.” 

These sums are for direct financial assistance from the PBGC to “critical and declining” and “insolvent” multiemployer pension plans.  There is virtually no limit to the amount (“such sums as may be necessary”) or the time (“for each fiscal year”) of these appropriations.  They are for sending cash in addition to the loans from the bill’s proposed Pension Rehabilitation Administration.  Also on its last page, the bill provides that the PBGC “shall not require the financial assistance to be repaid before the date on which the [PRA] loan…is repaid in full.”  That may be never.  The Congressional Budget Office estimated the probable taxpayer cost of a similar previous bill at more than $100 billion.

In theory and under its Congressional charter, the PBGC was supposed to be a financially stand-alone, actuarially sound insurance company, not guaranteed by the government and never needing any appropriated funds.  As its annual report says, “PBGC receives no funds from taxpayer dollars.”  Not yet, anyway.  The PBGC has always had an implicit guaranty from the U.S. Treasury, and we can once again observe that implicit government guarantees tend to become bailouts.

In short, the bill is a convoluted way to a simple end: to have the taxpayers pay the pensions promised but not funded by the multiemployer plans.  If enacted, the bill will encourage other plans to make new unfunded promises in the very logical expectation of future additional bailouts.

To adapt a famous line of the great philosopher and economist, David Hume, “It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London than to give a politician the ability to guarantee pension plans.”

Asset Managers Should Not Vote Shares They Don’t Own

Published in The Wall Street Journal.

“Maybe it is time for the SEC to require index funds to poll their investors and vote their shares only as specifically directed,” say Phil Gramm and Michael Solon (“Enemies of the Economic Enlightenment,” op-ed, April 16). They are so right, except it is not “maybe,” it’s time, period.

Asset managers should not be able to vote the shares they do not own to pursue their political notions or business purposes. Instead, they should be able to vote only when instructed by the real owners. That means voting by the principals, not by the agents. In this way, the asset managers would be treated exactly like the broker-dealers who control huge numbers of shares registered in street name, but must ask the real owners how to vote. It is indeed high time for the SEC to fix this very troubling anomaly in corporate governance.

Pollock participates in a discussion with Professor Mark H. Rose

Hosted by the American Enterprise Institute.

R Street Distinguished Senior Fellow Alex J. Pollock took part in a March 27 panel at the American Enterprise Institute to discuss economic historian Mark Rose’s new book, “Market Rules: Bankers, Presidents, and the Origins of the Great Recession.” Other panelists were Rose himself, Richard Sylla of the National Bureau of Economic Research and moderator Paul H. Kupiec of AEI.

Thoughts on the Source of International Economic Advantage

Published in Real Clear Markets.

What are the possible sources of America’s international economic advantages and success at creating a superior standard of living for its people?  Each fundamental factor of production gives rise to a potential competitive advantage.  According to the classic list of Adam Smith, these factors are Land, Labor and Capital.  A more compete list would contain five fundamental factors:

1.       Natural Resources

2.       Labor

3.       Capital

4.       Knowledge

5.       Social Infrastructure.

In the revised list, Natural Resources is a more general version of Land.  Labor must be understood to include the essential element of education, as well as a crucial kind of labor: that of the entrepreneur.  Capital is what allows risks to be taken and economic growth to accumulate.  Knowledge most importantly means science and its offspring, technology of all kinds.  Knowledge also includes knowing how to manage large, complex organizations.  Social Infrastructure means the laws, property rights, financial practices, enforcement of contracts, culture friendly to enterprise, the lack of stifling or corrupt bureaucracy, and the essential political stability that together allow markets, including financial markets, to function well.

Historically, America had important advantages in all five fundamental factors, leading to its establishment by 1920, a hundred years ago, as the dominant economy in the world.  But global development, a very good thing for mankind in general, makes it harder to maintain America’s former advantages.  This suggests the U.S. political economy will be continuingly challenged at how to provide higher pay than elsewhere in the world—otherwise known as a higher standard of living.  It means we have less room than before for subsidizing political drag.

In the global competition of the ongoing 21st century, America no longer has as great an advantage as it previously did in the first four factors, but a continuing and central advantage in the fifth.  This advantage, however, can be weakened by unwise politics and bureaucracy.

Let us consider each of the factors in turn in a globalized world.

1. Natural Resources.  Commodities trade actively in world markets, move among countries with very low transportation costs, historically speaking, and are available almost everywhere.  Being a natural resources-rich country, as the U.S. is, matters less than before.  For example, making Land more productive by the scientific agriculture of the 19th century, as symbolized by the institution of land grant colleges, and by the continuing advances in agricultural science since then, is available everywhere in the world.

2. Labor.  The great historical revolution of public education has spread around the world, while the struggles of large parts of U.S. public education are well known.  The ability to organize and manage large, capital-intensive enterprises to make labor productive has also spread around the world.  Large pools of educated, technically proficient labor are increasingly available, notably in China and India.  Napoleon thought China a sleeping giant and recommended not waking it up.  Now we have two giants awake, as well as other countries, with increasingly educated labor.  If America wants to provide higher pay than they do for work with the same level of education, this must be based on a different fundamental advantage.

3. Capital.  Capital is essential to all risk-bearing, economic growth and productivity.  Savings available for investment as capital now flow quickly around the world, seeking and finding the best opportunities wherever they may be.  While capital is raised and employed in huge amounts in the U.S., we are not the leaders in savings.

4. Knowledge.  The incredible economic revolution of the last 250 years, or modernization, which empowered first Britain, then Western Europe and America with vast leadership advantages, has as its most fundamental source science based on mathematics.  Scientific Knowledge, turned to technology and harnessed to production by entrepreneurial energy, then matched with learning how to manage large organizations, created the modern world.  Mathematical science began as a monopoly of Europe and America, but is now the most cosmopolitan of human achievements.  America has world-leading research capabilities, including top research universities, but Knowledge is now available everywhere and incorporated into international scientific endeavor.

5. Social Infrastructure.  The political stability, clear property rights and safety of America have long served to attract investment as a safe haven and supported the role of the U.S. dollar as the dominant reserve currency.  By designing a stable political order which continued to work for an extremely large republic, the American Founding Fathers also created a powerful economic competitive advantage.  This advantage was augmented when Europe destroyed itself in the First World War, and New York replaced London as the center of world capital markets, and when Europe again destroyed itself in the Second World War.  This key advantage continues and helps explain how the U.S. can finance its continuous trade and budget deficits.  It may be an “exorbitant privilege” as viewed from France, but it is one earned by superior Social Infrastructure.

As John Makin instructively wrote a decade ago, “The fact that global savers accommodate U.S. consumers…is simply a manifestation of America’s competitive advantage at supplying wealth management services.”

This advantage in wealth storage, reflecting an advantage of Social Infrastructure, yields not only economic, but also large political and military benefits.  But no competitive strength is incapable of being lost over time, as former world economic leader Britain found out.  The strongest advantages can be weakened by political, bureaucratic, legal and regulatory drag.  The constant effort to maintain these advantages also maintains the ability to pay more for work than other countries do.

This Week in Financial Regulation, March 6th

Published in the Captured Economy.

The American Interest gives the history of the banking industry since the 1950s. As the Federal Reserve gained more authority, the industry became riskier and more concentrated.

President makes the smart call for reforming housing finance system

Published in The Hill.

In a recent White House memorandum, President Trump said, “It is time for the United States to reform its housing finance system.” He is right about that. He is also right about principal elements of reform, as listed in the memorandum, notably reducing taxpayer risks, expanding the role of the private sector, establishing “appropriate” capital requirements for Fannie Mae and Freddie Mac, providing that the government is properly paid for its credit support of Fannie and Freddie, facilitating competition, addressing the systemic risk of Fannie and Freddie, defining what role they should have in multifamily mortgage finance, and terminating their conservatorships only when the other reforms are put in place.

In all this, the Treasury is instructed to distinguish between what can be done by administrative action and what would require legislation. This seems to set the stage for carrying out the former, even if Congress cannot agree on the latter, which it probably cannot. The memorandum provides that for “each administrative reform,” the Treasury housing reform plan will include a “timeline for implementation.” This timetable instruction represents a pretty clear declaration of intent to proceed.

Needless to say, the general directions can only be implemented after being turned into specifics. While that seems impossible for Congress to agree on, the executive branch can define the specific administrative actions it wishes to take. As the administration comes to decisions about the details, is there an appropriate model to consider for Fannie and Freddie? Is there some way to simplify thinking about the issues they present, which entails swarms of lobbying interests?

I think there is. The model should be too big to fail and systemically important financial institutions. Fannie is bigger than JPMorgan Chase. Freddie is bigger than Citigroup. There is no doubt Fannie and Freddie remain too big to fail. They are an essential point of vulnerability of American residential mortgage finance, the biggest credit market in the world except for Treasury debt. Should they implode, the government will again rush to the rescue of their global and domestic creditors.

Vast intellectual and political efforts have gone into lowering the odds that too big to fail banks will need bailouts or generate systemic crisis. We need to apply the results of that effort to Fannie and Freddie, which now run with virtually no capital. But before the crisis, they already ran at extreme leverage. Indeed, they leveraged up the whole housing finance system, making the system, as well as themselves, much riskier.

What about their capital requirements? Following our model, simply apply the risk based capital standards of systemically important banks to Fannie and Freddie. The same risks need the same capital, no matter who holds them. Fannie or Morgan? Freddie or Citi? The same risk and the same risk based capital. This would result in a required capital for the two on the order of $200 billion, or about $190 billion more than they have.

How much should they pay the government for its credit support? The same as the too big to fail banks pay. For them, this is called a deposit insurance premium. For Fannie and Freddie, you could call it a credit support fee, which would replace the profit sweep in their deal with the Treasury. Deposit insurance fees are assessed on total bank liabilities. Apply the same to Fannie and Freddie credit support fee and at the same level as would be required for a giant bank of equivalent riskiness.

I estimate this would be about 0.18 percent per year, but recommend the administration ask the Federal Deposit Insurance Corporation to run its big bank model on Fannie and Freddie and report on what level of fee results. Note that the Treasury stands behind the Federal Deposit Insurance Corporation, just as it stands behind Fannie and Freddie.

With such a serious amount of capital, Fannie and Freddie would need to charge guarantee fees that would allow greater competition in the private sector. This would be consistent with the law, which requires that their guarantee fees be set at levels that would cover the cost of capital of private regulated financial institutions. If they have the same risk based capital requirement, then that should follow for Fannie and Freddie.

With $200 billion in capital and a credit support fee of 0.18 percent, I estimate that Fannie and Freddie could sustain a return on total capital of 8 percent or so, which is quite satisfactory. The Treasury should exercise its warrants for about 80 percent of their common stock to share in this return until Treasury sells the stock, which will generate a large gain for the taxpayers. It seems to me that virtually all of this might be done by administrative action. Let us hope the administration will proceed apace.

Ten years later, the U.S. is still debating Fannie and Freddie

Published in Housing Finance International.

The giant U.S. government-guaranteed mortgage companies, Fannie Mae and Freddie Mac, were and are unique features of American housing finance compared to other countries. In the days before their 2008 fall into insolvency and government conservatorship, which also saw their previously feared political power fizzle, Fannie and Freddie used to claim they were “the envy of the world.” In those days, they could always get many members of the U.S. Congress to repeat that claim, even though it wasn’t true.

But Fannie and Freddie were huge and still are – their combined 2018 total assets are $5.5 trillion. (This amount is about the same as the combined GDPs of the United Kingdom and France.) Fannie and Freddie were, and continue to be, dominant factors in U.S. housing finance markets. But they remain in government conservatorship more than 10 years after the collapse of the housing bubble they helped inflate and after the government bailed them out. Even after more than 10 years of debating, the government can’t figure out what to do with them next. All kinds of plans have been proposed by various politicians, trade associations, financial commentators, think tanks and investors. None has been adopted. The amount of talk has been vast, but no agreed-upon path has emerged out of the fog of endless debate.

The central problem is this: Fannie and Freddie have always been dependent on the guarantee of their obligations by the U.S. government. The guarantee was said to be “implicit,” but it was absolutely real, as events proved. Based on this guarantee, they sold trillions of dollars of bonds and mortgage-backed securities around the world. They never could have done this without their credit support from the government, and when they failed, the government protected the buyers. Although there is still not a formal guarantee, their backing by the government is even more indubitable now, since the U.S. Treasury has agreed to put in enough new senior preferred stock to keep the net worth of each from falling below zero.

Before the housing bubble shriveled, Fannie and Freddie did have some capital of their own, though a small amount relative to their obligations. In 2006, before their fall, they had combined total equity of $66 billion. That may sound significant, but it was to support assets plus outstanding guarantees already totaling $5.5 trillion, giving them a capital ratio of a risible 1.2 percent. In other words, they were leveraged 83 to 1. Such was the advantage of being darlings of the government. To get up to international risk-based capital standards, I calculate they would then have needed $90 billion more in capital than they had.

Now, 10 years after their government bailout, their combined equity is $10.7 billion, giving them a capital ratio of a mere 0.2 percent. In other words, their capital rounds to zero, and their leverage is 514 to one. To meet international standards, they would now require an additional $124 billion in capital. Without capital, Fannie and Freddie at this point rely not just in large measure, but utterly and completely, on their government guarantee. Indeed, they could not stay in business for even one more minute without it, and this has continued for 10 years.

In good times, running on the government’s credit can be very profitable, and so Fannie and Freddie have been, following the recovery of U.S. house prices which began in 2012. Why have they not built up any capital at all since then? Well, in that same year, the U.S. Treasury Department and the conservator for Fannie and Freddie (the Federal Housing Finance Agency), agreed that each quarter, essentially all of the profits of Fannie and Freddie would be paid to the Treasury, thence going to offset the federal deficit.

This agreement between two parts of the government that the government would take all the profits until further notice has been viewed as unfair and illegal by investors in the common and junior preferred stocks of Fannie and Freddie, which continue to exist. Hedge fund investors, employing top legal talent, have generated various lawsuits against the government, none of which has succeeded.

It is essential to understand the most important macro effect of Fannie and Freddie. This was and is to run up the leverage and therefore the risk of the entire mortgage and housing sectors. Thanks to them, the aggregate leverage of the system is much higher than would otherwise have been possible, and house prices get inflated relative to incomes and down payments. As this leveraging proceeds, it shifts more and more of the risk of mortgage credit from the lenders and from private capital to the government and to the taxpayers. Fannie and Freddie did and do create major systemic risk.

This sounds like a bad idea, and it is. But once the government has gotten itself deeply committed to such a scheme, and the mortgage and housing sectors have gotten used to enjoying the credit subsidy and economic rents involved, it is very hard to change.

Numerous important interest groups benefit from Fannie and Freddie’s running up the systemic leverage and risk. These include:

• Homebuilders, who benefit from more easily selling bigger and more profitable houses.

• Realtors, who likewise profit when selling houses is made easier and get bigger commissions when house prices rise.

• Wall Street firms, whose business of selling mortgage-related securities around the world is easier and bigger when they have government guaranteed bonds to sell.

• Banks, who have become organized to make mortgage loans and pass the credit risk to the government.

• Mortgage banks, who do not have the capital to hold loans themselves and likewise can pass the risk to somebody else.

• Municipal governments, who like the higher real estate taxes generated by high property prices.

• Investors in mortgages who don’t want to have to worry about credit risk because the taxpayers have it instead.

• Affordable housing groups, who get subsidies from Fannie and Freddie.

• Politicians, whose constituents and contributors include the aforementioned groups.

This daunting Gordian knot of private and political interests, all of whom get advantages from the economic distortions of Fannie and Freddie, all of which are always busy lobbying or being lobbied, makes it highly unlikely that the currently divided Congress will do any better at reform than its predecessors of the last decade. My own view is that the probability of meaningful legislation for Fannie and Freddie over the next year is zero.

But a different source of change is now a frequent subject of discussion and speculation. This is direct administrative action by the Federal Housing Finance Agency (FHFA) and the U.S. Treasury. The FHFA has a new director coming, Mark Calabria, nominated by President Donald Trump and apparently headed for confirmation by the Senate. Mr. Calabria has deep experience in the issues of Fannie and Freddie and might use his wide powers as their conservator and regulator for reform, including renegotiating their bailout deal with the Treasury.

Two essential reform items are putting Fannie and Freddie’s capital requirements on the same basis as every other too-big-to-fail financial institution; and making them pay a fair price to the government for its ongoing credit support. This should be in line with what all the big banks have to pay for deposit insurance, which is their form of government guarantee.

Might such things happen by administrative action? They might. But not without a lot of lobbying, arguing and complaining by all of the interest groups listed above.