Congress Moves to Put Pension Benefit Guaranty Corporation On Taxpayer Dole

Published by Real Clear Markets.

The Ways and Means Committee of the House just approved a bill for a big taxpayer bailout of private multi-employer/union-sponsored pension plans.  Many of these plans are hopelessly insolvent.  In other words, they have committed to pay employee pensions far greater than they have any hope of actually paying. In the aggregate, the assets of multi-employer plans are hundreds of billions of dollars less than what they have solemnly promised to pay.

There is an inescapable deficit resulting from past failures to fund the obligations of these plans. This means somebody is going to lose; somebody is going to pay the price of the deficit.  Who?  Those who created the deficits? Or instead: How about the taxpayers? The latter is the view of the Democratic majority which passed the bill out of committee in a 25-17 straight partyline vote on July 10.

“Wait a minute!” every taxpayer should demand, “aren’t all these pension plans already guaranteed by an arm of the U.S. government?”  Yes, they are–by the government’s Pension Benefit Guaranty Corporation (PBGC). But there is a slight problem:  the PBGC’s multi-employer guarantee program is itself broke.  It is financially unable to make good on its own guarantees. The proposed taxpayer bailout is also a bailout ofthis deeply insolvent government program.

This was not supposed to be able to happen.  In creating the PBGC, the Employee Retirement Income Security Act (ERISA) required, and has continued to require up to now, that the PBGC be self-financing.  But it isn’t–not by a long shot. Its multi-employer program shows a deficit net worth of $54 billion.  The PBGC was not supposed ever to need any funds from the U.S. Treasury.  But it is now proposed to give it tens of billions of dollars from the Treasury, and the bill does not have any limiting number.

“ERISA provides that the U.S. government is not liable for any obligation or liability incurred by the PBGC,” says the PBGC’s annual report every year.  But here we have another of the notorious “implicit guarantees,” which pretend they are not guarantees until it turns out that they really are.  Consider that if the PBGC’s multi-employer program were a private company, any insurance commissioner would have closed it down long ago.  No rational customer would pay any premiums to an insurer which is demonstrably unable to pay its committed benefits in return.  Only the guarantee of the Treasury, “implicit” but real, keeps the game going.

Bailing out guarantees which were claimed not to put the taxpayers on the hook, but in fact did, is the familiar pattern of “implicit” guarantees.  They are originally done to keep the liability for the guarantees off the government’s books, an egregious accounting pretense, because everybody knows that when pushing comes to shoving, the taxpayers will be on the hook, after all.

In such “self-financing,” off-balance sheet entities, the government generally does not charge the fees which their risk economically requires. This is true even if their chartering acts theoretically require it.  Undercharging for the risk, politically supported by the constituencies who benefit from the cheap guarantees, allows the risk to keep increasing.  So in time, the day of the taxpayer bailout comes.

Notable examples of this are the bailouts of the Farm Credit System, the Federal Savings and Loan Insurance Corporation (FSLIC), Fannie Mae, and Freddie Mac.  However, the bailout of Farm Credit included serious reforms to the System, and the bailout of FSLIC, serious reforms to the savings and loan industry.  The bailouts of Fannie and Freddie were combined with putting them in conservatorship under the complete control of the Federal Housing Finance Agency, where they remain today.

Now for the PBGC, when we read all the way to the very last paragraph on the last page of the bill, page 40, we find that the PBGC’s multi-employer program, which was supposed never to need any appropriated funds, is to get generous taxpayer funds forever.  “There is appropriated to the Director of the Pension Benefit Guarantee Corporation,” says this paragraph, “such sums as may be necessary for each fiscal year.”  The multi-employer pensions would thus become an entitlement, on the taxpayer dole.  There is no limiting number or time.  Nor in the previous 39 pages is there any reform of the governance, operations, or ability of these pension plans to finance themselves on a sustainable basis.

In short, the bill passed by the Ways and Means Committee is a bailout with no reform.  But the governing principle for all financial bailouts should be instead: If no reform, then no bailout.

Multi-Employer Pension Bailout Needs a Good Bank/Bad Bank Strategy

Published in Real Clear Markets.

The stock market is high, unemployment is low, but many multi-employer, union-sponsored pension plans are hopelessly insolvent and facing their own financial crisis. So is the government’s program that guarantees those pensions through the Pension Benefit Guaranty Corporation (PBGC). “Insolvent” means that while they have not yet spent their last nickel of cash (although that day is coming), their liabilities are vastly greater than their assets, and all the liabilities simply cannot be paid. In short, many multi-employer pension plans are broke and so is their government-sponsored guarantor. Unsurprisingly, the idea of a taxpayer bailout arises, although its proponents do not wish to call it a bailout.

The PBGC’s multi-employer program has a net worth of a negative $54 billion, according to its September 30, 2018 annual report. It has assets of only $2.3 billion, and liabilities of $56 billion—it has $24 in liabilities for each $1 of assets. And this striking deficit only counts the probable losses for the next ten years, not the unavoidable further losses after that. PBGC estimates the total unfunded pension liabilities of the multi-employer plans at $638 billion. Making financial promises is so much more enjoyable than keeping them.

One of the causes of these deficits is the government guarantee itself, which can induce these pension plans to make bigger pension commitments than they funded or can fund, reflecting the expectation of a taxpayer bailout. This displays the moral hazard of getting the government to guarantee pensions, an unintended but natural risk of creating the PBGC in the first place.

The deficits in the insolvent pension plans and in the PBGC are facts. We know for certain that losses which already exist will necessarily fall on somebody. On whom? That is the question. From where we are now, there is no possible outcome in which nobody loses.

The Employee Retirement Income Security Act of 1974 (ERISA), in establishing the PBGC, specified that it would never take any money from the Treasury. As the PBGC annual report explains, “ERISA requires that PBGC programs be self-financing.” Whoops. Furthermore, “ERISA provides that the U.S. Government is not liable for any obligation or liability incurred by the PBGC.” Should we ever believe such protestations? The same provision was made for the debt of Fannie Mae and Freddie Mac, but they got bailed out anyway.

Last year, Congress set up the Joint Select Committee on Solvency of Multiemployer Pension Plans to figure out what to do. The name was nicely diplomatic, since the core issue was rather the “Insolvency” of these plans. The special committee held hearings and did its best, but disbanded without issuing its required report.

Now it inevitably occurs to many politicians that there should be a bailout to benefit the pensioners, unions, employers, and the PBGC, while moving losses to the taxpayers. A bill to this effect, the “Rehabilitation for Multiemployer Pensions Act,” was introduced this year and is headed to a mark-up in the Ways and Means Committee of the House.

Suppose you have decided that a taxpayer bailout is less bad than having pensions cut, unions embarrassed, employers faced with unaffordable pension contributions, and watching the PBGC’s multi-employer program head to default. How would a bailout best be structured? I suggest the following essential points:

Congress should be honest about what it is doing. You can’t think clearly about the principles and effectiveness of bailouts if you don’t face up to the fact that you are designing a bailout.

Congress should adapt for use in this case a globally tried and true method for dealing with hopelessly insolvent financial entities: the Good Bank/Bad Bank structure. This structure should be required for any pension plan receiving appropriated taxpayer funds in any form.

A fundamental principle is reform of the governance of bailed out entities. Those who ran the ship on the rocks should not be left in command. They should not be in charge of spending the money taken from other people to make up their deficits.

The Good Bank should contain what has a high probability of being a successful, self-sustaining entity going forward.

The Bad Bank should contain the deficits and unfunded obligations from past unsuccessful operations, plus the bailout funding. It should be run as a long-term liquidation. It will make clear the real cost of the bailout and dispense with the need for further bailouts in the future.

The Good Bank should begin and continue on a fully funded basis. The required contributions of the employers should be determined as a mathematical result of the committed pensions, not be a result of bargaining subject to the moral hazard of the government guarantee. This calculation should use the discount rates required for single-employer plans. Employers should have to book as their own liabilities their pro rata share of any underfunding which might occur. Finally, data and reporting should be revised to be made timely and more transparent.

The Bad Bank should have whatever assets, if any, are left over after forming the Good Bank, all the plan’s pension commitments already made but not funded, the obligations of employers for contributions to those commitments, and the bailout funding. It should purchase high quality annuities to meet its pension obligations, not try to run risky asset portfolios. In time, it would disappear, with remaining funds, if any, returned to the Treasury.

The Good Bank should be governed by a board of independent directors with fiduciary responsibility for the good management of the plan.

The Bad Bank should be run by a government-appointed conservator.

If you are going to have a bailout of the insolvent multi-employer pension plans, a Good Bank/Bad Bank structure along these lines would be highly advisable.

Is the Fourth of July really the Second?

Published by the R Street Institute.

We all know about Fourth of July picnics, parades and fireworks. We all know the celebration is about the Declaration of Independence and the birth of our country. But how much else do we know about the beginning of American independence?  Here is a little quiz to help celebrate the Fourth with some history.

1. On what date was the decision made to declare American independence?

The answer is not July 4, but July 2, 1776. This was when the truly decisive event occurred, the vote of the Second Continental Congress that America should separate itself from England. The vote was preceded by days of debate about a motion of June 7.

That these United Colonies are, and of right ought to be, free and independent States, that they are absolved from all allegiance to the British Crown.

On July 2 this motion was adopted, with 12 colonies in favor, none against and one abstention (New York, which later added its affirmative vote).

July 2 “marked the great decision from which there was no turning back,” as one historian wrote.

1. What happened July 4?

On July 4, Congress approved the final, revised text of the full document of the Declaration, which not only declared independence but gave philosophical and historical reasons for it. The Declaration was signed that day by President of the Congress John Hancock and Secretary of the Congress Charles Thomson. None of the other signatures were added until Aug. 2 or later.

The printer worked all that night to make copies for distribution. The published text bears the famous date of July 4 and began to be sent around America July 5.

1. What about July 3?

July 3 marked a painful experience for Thomas Jefferson, the Declaration’s principal drafter. Having already made the great decision, the Congress sat down to edit, criticize and revise the draft which Jefferson had prepared. Anybody who has had a paper amended by a committee can especially sympathize with Jefferson each July 3.

1. What is most of the Declaration about?

Much of the Declaration, about 55 percent of its text, is devoted to listing all the faults and misdeeds of King George III. This list is about three times as long as the most famous passage setting forth the truths held to be self-evident.

The Declaration has four basic parts:

• An introduction (“When in the course of human events”)

• A philosophical justification (“We hold these truths to be self-evident”)

• The list of King George’s misdeeds

• The concluding resolutions of independence, of which the heart is the original motion quoted above.

The third, longest part concludes that King George is “a prince whose character is marked by every act which may define a tyrant.”

1. Does the Declaration discuss a new country?

This question is a little tricky, because it depends on the idea of “a” or one new country. The Declaration always refers to the 13 colonies in the plural. It says, “These United Colonies are Free and Independent States.”

The new states that set out to be free and independent immediately began working on how they would form a confederation or a union. This question was not settled until the implementation of the Constitution in 1789—or it might be argued, not until the conclusion of the Civil War in 1865.

1. Did the Declaration begin the Revolutionary War?

No, the Declaration grew out of a war already begun more than a year before. The fighting at Lexington and Concord, Massachusetts, occurred April 19, 1775, or more than 14 months before the decision to declare independence.

1. When did America achieve independence?

It is one thing to announce plans and another to carry them out. The Revolutionary War dragged on for years after the Declaration, with great difficulties and despair, as well as vision and courage. These years also included high inflation, caused by the Continental Congress printing paper money to finance the army.

Independence was finally achieved when Great Britain acknowledged it by the Treaty of Paris in 1783, seven years after the Declaration.

1. How long has it been since you read the Declaration of Independence?

It is an excellent read, for its world-historical importance, dramatic setting, intellectual substance and eloquent language.

The U.S. can reform housing finance without any action from Congress

Published in Housing Finance International.

The U.S. came out of the 2007-12 housing bust with a housing finance system even more government-centric than it was before, because the Government completely took over Fannie Mae and Freddie Mac by way of a regulatory conservatorship. Most people assumed that Fannie and Freddie’s financial collapse would inspire the U.S. Congress to reform them, which would mean fixing the excessive leverage of their own balance sheets and the excessive leverage the Government promoted through them in the whole housing finance sector. This, as it has turned out, was a bad assumption. Congress tried to create reform legislation, and the accompanying debates were long and energetic, but in the end nothing happened.

Meanwhile Fannie and Freddie remain dominant and huge operations. Their combined assets are a staggering $5.5 trillion. These assets are supported by virtually no capital. Their latest quarterly financial statements show a capital ratio of a risible 0.2 percent, or a leverage of 500 to 1. Under current rules, the Government does not let Fannie and Freddie retain any earnings to speak of, so they are utterly dependent upon the continuing credit support from the U.S. Treasury. Without this support, they could not exist even for one minute. Their government conservatorships are in their 11th year – an outcome nobody anticipated and nobody wants.

It now appears there is virtually zero probability of reform legislation in the current divided Congress.

However, significant reform can occur with-out needing Congress to act. A determined administration – the president, the Treasury Department, and the Federal Housing Finance Agency (which is the regulator and conservator) – can do a lot on its own, without any legislation. It looks like they intend to do so .

President Trump recently told a conference of the National Association of Realtors:

“My administration is committed to reforming our housing finance system…Fannie and Freddie still dominate the market with no real competition from the private sector. And tax-payers are still on the hook…That’s why I recently directed the Department of Treasury and HUD [the Department of Housing and Urban Development] to develop a framework for a modern housing finance system…one that welcomes private sector competition, protects taxpayers and preserves home ownership.” (The transcript adds: “Applause.”)

The president was referring to his formal “Memorandum on Federal Housing Finance Reform” of March 27, 2019. This memorandum includes the following:

“The Secretary of the Treasury is hereby directed to develop a plan for administrative and legislative reforms.”

As stated above, the legislative part of the reforms is very unlikely to happen, but the administrative ones can. The goals of the plan are to include:

• “Ending the conservatorships” of Fannie and Freddie”

• “Facilitating competition in the housing finance market”

• “Providing that the federal government is properly compensated for any explicit or implicit support is provides” to Fannie and Freddie”

• “Establishing appropriate capital and liquidity requirements” for Fannie and Freddie. The capital requirements will need to be a lot higher than the current virtually zero. Personally, I am recommending a 4 percent tangible equity to assets requirement, reflecting that 4 percent is the global capital standard for prime mortgage credit risk. The Treasury will pro-duce its own recommendation.

• “Increasing competition and participation of the private sector in the mortgage market”

• “Heightened prudential requirements and safety and soundness standards, including increased capital requirements” for Fannie and Freddie

And of special interest to my former colleagues in the Home Loan Bank of Chicago, the former home of the Secretariat of the IUHF: “Defining the mission of the Federal Home Loan Bank system and its role in supporting Federal housing finance.”

About all of these goals, the Memorandum directs that “the Secretary of the Treasury must specify whether the proposed reform…could be implemented without Congressional action. For each administrative reform, the Treasury Housing Reform Plan shall include a timeline for implementation.” That sounds serious.

And: “The Treasury Housing Reform Plan shall be submitted to the president for approval…as soon as practicable.”

If the administration does implement administrative reforms, here are some suggestions for additional things it has the power to do:

• The FHFA should set for Fannie and Freddie, like for all other financial institutions, both a leverage capital requirement (for Fannie and Freddie, 4 percent of total assets) and a risk-based capital standard, requiring whichever is higher.

• Fannie and Freddie should pay a fee to the Treasury for its credit support based on what the Federal Deposit Insurance Corporation would charge an equally huge bank of equivalent riskiness for deposit insurance.

• The Financial Stability Oversight Council should designate Fannie and Freddie as the Systemically Important Financial Institutions [SIFIs] they are, since they have proven they can put the whole financial system at risk.

• The FHFA should ensure emphasis on sound credit risk management throughout the inevitable cycles.

• The Federal Home Loan Banks should especially expand the role of secondary mortgage finance in which the original lender retains credit expo-sure (“skin in the game”) for the life of the loan, which ensures an alignment of incentives superior to the Fannie and Freddie model.

• The Treasury should exercise the options it owns to acquire 79.9 percent of Fannie and Freddie’s common stock at an exercise price of one-thousandth of a cent per share. This will represent a nice and well-deserved profit for the taxpayers who bailed Fannie and Freddie out.

Will the administration really act to implement reform through its purely administrative powers? I think there is a good probability that it will. Congress will, it appears, be left to continue debating without acting.

Who should pick credit-risk-scoring models?

Published by the R Street Institute.

American residential mortgage finance is the second-largest credit market in the world, behind only U.S. Treasury debt. Its immense size, at $10.4 trillion in outstanding loans, perhaps alone justifies the endless debates about how to reform it and improve its risk structures. In addition, the subject of mortgages is always political, being central to homeownership and to large housing-related industries and constituencies.

One relevant issue in the inside baseball of mortgage finance is the question of credit-scoring models. Credit scores and the models that calculate them are deeply imbedded in the credit decisions about mortgages. The purpose of the scores is to contribute to the credit consideration statistical estimates of the probability of default. Since credit underwriting is all about predicting and controlling the frequency and patterns of defaults, and therefore the credit losses experienced by the risk-taking lenders, this is a key idea.

Because Fannie Mae and Freddie Mac dominate the great middle of the mortgage market, the “conforming loan” sector, how they use credit scores has become a subject of congressional action, regulatory rulemaking and ongoing discussion. I just got a question on this issue when testifying to the Senate Banking Committee this week. In particular, the issue concerns Fannie and Freddie’s use of the FICO score, the incumbent mortgage-finance leader, or the challenger VantageScore. But it applies in principle to any other credit score that may be developed.

How to decide among competing scores is a highly technical matter. The more pertinent question from the political and economic perspective is who should decide. The answer to who is clear and definitive: whoever is taking the credit risk should decide how to use credit scores and which to use. That is the party that will bear the losses resulting from credit decisions, the one with skin in the game. Those without credit skin in the game should not get to choose which credit scores to use.

In short, the right principle is: the risk-taker decides. If Fannie and Freddie are taking the credit risk, they should decide which credit scores to use and how to use them, based on the most analytical, most objective criteria they can discover. And the same for any other risk-taker.

Should there be competition among credit scores?  Of course, competition is essential in this market, as anywhere. The right locus for competition is for the producers of credit scores to make the best cases they can to the risk-takers about the performance of their scores. May the most predictive, highest-performing score win.

Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?

Published by the R Street Institute.

Testimony of

Alex J. Pollock

Distinguished Senior Fellow

R Street Institute

Washington, DC

To the Committee on Banking, Housing, and Urban Affairs

United States Senate

           Hearing on “Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?”

June 25, 2019

Fannie and Freddie Are Obviously SIFIs

Mr. Chairman, Ranking Member Brown, 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 housing finance system.  This included serving as President and CEO of the Federal Home Loan Bank of Chicago 1991-2004, and as a resident fellow of the American Enterprise Institute 2004-2015.  I have personally experienced and studied numerous financial cycles, crises and their political aftermaths, and have authored many articles, presentations, testimony and two books on related subjects, including the nature of systemic financial risk.

To begin with the essence of today’s question: Are Fannie Mae and Freddie Mac, which guarantee half the credit risk of the massive U.S. housing finance sector, and which have combined assets of $5.5 trillion, systemically important?  Obviously, they are.  Are they financial companies?  Of course.  So they are systemically important financial institutions as a simple fact.

This is true if you consider them as two of the largest and most highly leveraged financial institutions in the world, but it is equally true if you consider them as an activity that generates systemic risk.  Guaranteeing half the credit risk of the biggest credit market in the world (except for U.S. Treasury securities) is a systemically important and systemically risky activity.  Leveraged real estate is, and has been throughout financial history, a key source of credit collapses and crises, as it was yet once again in 2007-2009.  The activity of Fannie and Freddie is 100% about leveraging real estate.  Moreover, they have been historically, and are today, themselves hyper-leveraged.

To use the words of the Dodd-Frank Act, could Fannie and Freddie “pose a threat to the financial stability of the United States”?  They have already demonstrated that they can.

The Financial Stability Board has stated this fundamental SIFI characteristic: “the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie and Freddie displayed at the time of their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability.  As we all know, in 2008, U.S. public authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out, with ultimately $190 billion of public funds.  In addition, they pledged the credit support from the U.S. Treasury which protected and still protects Fannie and Freddie’s  global creditors.

Fannie and Freddie continue to represent giant moral hazard, as they always have.  Since they now have virtually zero capital, they are even more dependent on the Treasury’s credit support and its implicit guarantee than they were before.

That Fannie and Freddie are SIFIs in financial reality no reasonable person would dispute.

Yet so far, the Financial Stability Oversight Council (FSOC) has not designated Fannie and Freddie as official SIFIs. To a non-political observer, judging purely on the merits of the case, this would be highly surprising. FSOC’s historical inaction in this instance has certainly not added to its intellectual credibility. To Washington observers, naturally, it just seems like ordinary politics.

This hearing requires us to consider how FSOC should deal with the fact of Fannie and Freddie’s systemic importance.  Should FSOC recognize the reality by formally designating Fannie and Freddie as the SIFIs they so obviously are?  Or should FSOC keep ignoring the issue?

I believe FSOC should formally designate Fannie and Freddie as SIFIs and strongly recommend that action.  That would be consistent with the clear provisions of the Dodd-Frank Act.  In my opinion, the country needs Fannie and Freddie to be integrated into the efforts to understand and deal with systemic risk.  Without including Fannie and Freddie, these efforts are woefully incomplete.

Let us consider the SIFI factors of size, interconnectedness, substitutability, leverage, maturity mismatch and liquidity risk, and existing regulation.

Size

In total assets, Fannie is far larger than even the biggest SIFI banks.  The following table ranks by size the ten largest existing SIFIs plus Fannie and Freddie.  As it shows, Fannie is bigger in assets than JPMorgan Chase and Bank of America, and Freddie is bigger than Citigroup and Wells Fargo.  On this combined table of twelve huge financial institutions, Fannie is #1 and Freddie is #4.

Size of Fannie, Freddie and the Largest Ten Existing Official SIFIs

Total AssetsFannie Mae$ 3.42 trillionJPMorgan Chase 2.74Bank of America 2.38Freddie Mac 2.09Citigroup 1.96Wells Fargo 1.89Goldman Sachs 0.93Morgan Stanley 0.88U.S. Bancorp 0.48PNC Financial Services 0.39TD Group US 0.38Capital One Financial 0.37

Sources: S&P Global Market Intelligence; Fannie Mae, 1st Quarter 10-Q 2019; Freddie Mac, 1st Quarter 10-Q 2019

Interconnectedness

The obligations of Fannie Mae and Freddie Mac are widely held throughout the U.S. financial system and around the world.  U.S. depository institutions hold well over $1 trillion of their securities.  The Federal Reserve itself holds $1.6 trillion in MBS, mostly those of Fannie and Freddie.  Could Fannie and Freddie be allowed to fail and impose credit losses on the Fed? Presumably not.  Preferential banking regulations promote Fannie and Freddie, including low risk-based capital requirements for their MBS and debt, creating an incentive for depository institutions to hold large exposures to those securities. These low risk-based capital requirements for depository institutions compound the hyper-leverage of Fannie and Freddie themselves, and amplify their systemic risk.

Moreover, U.S. banks are allowed to buy the equity, preferred stock and subordinated debt of Fannie and Freddie, and fund these investments with government-insured deposits.  This combination results in systemic double leverage.

The interconnectedness of Fannie and Freddie’s mortgage-backed securities and debt with the global financial system became vivid in 2008. As then-Secretary of the Treasury Henry Paulson correctly judged, a default on Fannie and Freddie’s obligations would have dramatically exacerbated the financial crisis on a global basis.

As Paulson recounted in his memoir of the crisis, On the Brink:

“From the moment the GSEs’ problems hit the news, Treasury had been getting nervous calls from officials of foreign countries that were invested heavily with Fannie and Freddie.  These calls ratcheted up after the [2008 HERA] legislation.  Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee”—and also “what this would imply for other U.S. obligations, such as Treasury bonds.”

As Fannie and Freddie reported large losses, Paulson relates that he instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.”  In an even more revealing comment, Paulson added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the overwhelming global systemic risk of not bailing them out, Paulson’s assurance turned out to be true for all of Fannie and Freddie’s debt and MBS holders.  Even those who had bought subordinated debt, thereby intentionally taking more risk, were protected.

Substitutability

Fannie and Freddie’s systemic role is critical and cannot be replaced in the short or medium term—there are no substitutes.  They play a unique, systemically central role and remain the dominant force in the funding of U.S. mortgages.   There are no meaningful competitors because of their huge, ongoing risk subsidies from the government.  In 2018, they guaranteed $917 billion in MBS.  In the first quarter, 2019 they had a 63% market share of MBS issuance (including Ginnie Mae, the government has a 94% market share.) Their balance sheets represent about half of total U.S. mortgage loans outstanding.  Thousands of mortgage originators, servicers, domestic and international investors and derivatives counterparties depend on their continued functioning and government-dependent solvency.    This is one reason that the U.S. Congress has been unable to pass any legislation to end their conservatorship.

Leverage

In addition to their massive size, Fannie and Freddie have historically displayed extreme leverage and continue to do so.  As of March 31, 2019, their balance sheets show a combined capital ratio of a risible less than 0.2% and they are hyper-leveraged at over 500 to 1.  Of course, under the bailout agreement, the government will not let them build retained earnings, but the fact of the hyper-leverage remains.

Maturity Mismatch and Liquidity Risk

The American 30-year fixed-rate, freely prepayable mortgage loan is one of the most complex financial instruments in the world to finance and hedge. Unlike the fixed-rate mortgages of most other countries, the prepayment risk of these mortgages is not offset by prepayment fees. This necessitates a complex derivatives market which trades in the risks of prepayment behavior.  Fannie and Freddie together own about $400 billion of mortgages in their own portfolios, on an extremely leveraged basis.  They are major counterparties in interest rate derivatives and options markets.  Their MBS spread the complex interest rate risks of American 30-year fixed rate mortgages, while concentrating the credit risk of U.S. house prices, now again at an all-time high.  The liquidity of Fannie and Freddie’s securities and of Fannie and Freddie themselves completely depends on the implicit guarantee of the U.S. Treasury.

Existing Regulation

Fannie and Freddie of course have an existing regulator, the Federal Housing Finance Agency (FHFA).  But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system.

U.S. residential mortgages constitute the largest loan market in the world, with $10.4 trillion in outstanding loans.  The risks of this huge market include the holdings by banks of the MBS and debt of Fannie and Freddie.  There are no limits on the amount of Fannie and Freddie obligations which can be owned by banks.

As discussed above, the risks of Fannie and Freddie also flow into the banking system because banks are allowed to invest in Fannie and Freddie’s equity on a highly-leveraged basis, which creates systemic double leverage.  In the financial crisis of 2007-2009, many banks took large losses and a number failed because of their exposure to Fannie and Freddie’s preferred stock, an exposure which was encouraged by regulation.  This is an issue the Federal Reserve, as a systemic risk regulator, would want to consider.

A major systemic risk is that Fannie and Freddie are by definition 100% concentrated in the risks of leveraged real estate.  Indeed, they are by far the largest concentration of mortgage credit risk in the world. Leveraged real estate, needless to say, has a long and painful record of being at the center of banking collapses and financial crises.

Fannie and Freddie’s primary regulator is likewise devoted only to housing finance. Such a regulator always faces the temptation to become a cheerleader and promoter of housing and housing finance.  This brought down the old Federal Home Loan Bank Board, abolished in 1989, and arguably also the Office of Thrift Supervision, abolished in 2010.

In sum, Fannie and Freddie are huge in size, huge in risk, close to zero in capital, tightly interconnected to thousands of counterparties, and force risk on the U.S. Treasury. They meet the criteria specified by the Dodd-Frank Act and its implementing regulations for designation as a SIFI, both as institutions and considered as a systemically risky activity.  They also meet the international criteria of the Financial Stability Board for designation as a Global SIFI.

If Fannie and Freddie are not SIFIs, then nobody in the world is a SIFI, and if any institution is a SIFI, then so are Fannie and Freddie.  Addressing their systemic risk through designation as a SIFI would logically match their systemically important role and riskiness.

Conservatorship

In September 2008, as we know, the Federal Housing Finance Agency determined that Fannie and Freddie each were “in an unsafe or unsound condition to transact business,” and “likely to be unable to pay its obligations or meet the demands of its creditors in the normal course of business.” The government placed them into conservatorship, and thus assumed “all rights, titles, powers, and privileges of the regulated entity, and of any stockholder, officer, or director of such regulated entity with respect to the regulated entity and the assets of the regulated entity.”

Conservatorship was never intended to be a perpetual status for Fannie and Freddie, but it continues in its 11th year, an outcome altogether unintended and undesired.

Should designating Fannie and Freddie as SIFIs be delayed because they are in conservatorship?  The answer, it seems to me, is clearly No.  They are just as systemically important and systemically risky in conservatorship as out of it. They create just as much or more moral hazard.  The Conservator cannot manage their systemic risk.  Indeed, because of the “net worth sweep” deal between the Treasury and the FHFA as Conservator, Fannie and Freddie are even more highly leveraged than before.  Meanwhile, under the Conservator, they continue to expand mortgages with high debt service to income ratios, another form of increased leverage.

The Federal Reserve as Additional Regulator

If—I hope it is when—Fannie and Freddie are formally designated as the SIFIs they economically are, the Federal Reserve will become an additional, systemic risk regulator for them.  This seems to me a good idea, since the Fed is the best placed of all existing regulatory agencies to consider the risks Fannie and Freddie pose from the view of the financial system as a whole.  Of course, the statute assigns this responsibility to the Fed for all SIFIs.  If you don’t like this outcome of SIFI designation, should you therefore claim that Fannie and Freddie are not SIFIs?

Suppose we grant that the Fed, like everybody else, has numerous shortcomings.  That does not mean that Fannie and Freddie are not SIFIs. Let us concede that the Fed, like everybody else, is far from perfect.  It should still take on, as the only available authorized actor, the essential task of understanding and addressing what Fannie and Freddie are doing to systemic risk.

Of course, Fannie and Freddie already have a primary regulator, but so do all other SIFIs.  That the FHFA regulates Fannie and Freddie is no more an argument against their being SIFIs than the fact that the Comptroller of the Currency regulates national banks would prevent banks from being SIFIs.

The Fed should be able to consider, and should consider, for such “large, interconnected financial institutions,” in the words of the Dodd-Frank Act, “establishment and refinement of prudential standards and reporting and disclosure requirements…taking into consideration their capital structure, riskiness, complexity, financial activities…size, and any other risk-related factors.”

For example, the Fed might usefully consider with respect to Fannie and Freddie such questions as:

-Whether their capital requirements and their leverage cause capital arbitrage and thereby increased risk in the financial system as a whole.

-Whether the same risks should be capitalized in the same way between private financial institutions and Fannie and Freddie.

-How Fannie and Freddie’s concentration in leveraged real estate risk affects the risk of the financial system.

-How or whether Fannie and Freddie’s activities contribute to house price inflation and thereby reduce housing affordability.

-Whether their heavy concentration in California mortgages amplifies earthquake risk.

-How much banking regulations which favor Fannie and Freddie increase the riskiness of banks.

-Whether the double leverage in the financial system created by allowing banks to invest in Fannie and Freddie’s equity makes sense.

-Whether Fannie and Freddie’s market dominance decreases or increases systemic risk.

-How much risk is being pushed on the Treasury and the taxpayers by Fannie and Freddie, at what economic cost.

I believe is that the Fed as systemic risk regulator of Fannie and Freddie would be a force for sound and well-capitalized housing finance, which would be better understood in the context of its interaction with the rest of the banking and financial system.  That should be everybody’s goal.

Concluding Questions and Answers

Are Fannie and Freddie SIFIs?  Yes, without a doubt.

Do Fannie and Freddie cause systemic financial risk?  Yes.

Is the Federal Reserve a reasonable place to try to understand and address the systemic risks?  Yes.

Should FSOC recognize these facts by formally designating Fannie and Freddie as SIFIs?  Yes.

When?  The sooner, the better.

Thank you again for the chance to share these views.

Why did economists think negative interest rates were impossible?

Published by the R Street Institute.

“Many things that had once been unimaginable nevertheless came to pass.” So it is with negative interest rates, a very good case of this insightful saying of physicist Freeman Dyson.

Many economists once confidently discussed how there was a “zero bound,” so interest rates could not go below zero in nominal terms. They had a nice theoretical argument, which seemed logical, and which they repeated over the years, for why this had to be so.

The world has a lot of negative interest rates anyway. Last week, the global total of bonds with negative interest rates reached $12.5 trillion, with a “T.”

So much for the zero bound and so much for the argument. Why did the economists believe what is manifestly not the case—with the proof of the opposite case now in trillions?

The argument was that as long as paper currency was available, which is always worth par and has an interest rate of zero, nobody would ever choose to hold a note, or deposit or bond with a negative interest rate. They would always pick a zero return over less than zero. This sounds OK. Why isn’t it true in real life?

The problem is that it applies for relatively small amounts on a personal basis, but not for huge amounts on an institutional basis. It is easy to imagine keeping $5,000 or $10,000 in currency instead of in a deposit account or money-market investment or paying $500 in cash to your plumber. You could readily have a wallet, or a box or a safety deposit box full of paper currency.

But suppose you are an institution with hundreds of billions of dollars to invest—that would be a lot of $100 bills. Or try to imagine the astronomical daily trading of financial markets trying to settle in paper currency. Or a corporation with 100,000 employees deciding it would go back to payrolls made in envelopes of currency and coins. Currency is simply not a substitute for the accounting money of banks and central banks at institutional size. Q.E.D.

There is a further intriguing issue. How negative can interest rates get? Negative 1 percent? Negative 2 percent? More? When would something blow up? Nobody knows.

A final speculation: I believe that a free financial market would never on its own create negative interest rates, which is the inherently silly idea that the lenders should pay the borrowers for the privilege of lending them money. Only in a world of the manipulations of fiat currency central banks, I believe, can negative interest rates happen. But that, of course, is the world we have.

Letter to Financial Stability Board on SIFI Oversight

Published by the R Street Institute.

Alex J. Pollock and Thomas H. Stanton

Washington DC.

                                                                                         June 11, 2019

Secretariat

Financial Stability Board

c/o Bank for International Settlements

CH-4002

Basel, Switzerland

By E-Mail: fsb@fsb.org

Dear Sirs, Mesdames:

Re.: A Large Gap in Global TBTF Reforms

We write in reference to the announcement of the “Evaluation of too-big-to-fail reforms” in your memorandum of May 23, 2019. We respectfully point out that, while the 3 July 2017 Framework refers broadly to evaluating “G20 Financial Regulatory Reforms,” and the May 23 Summary Terms of Reference refer to SIFIs broadly, the May 23 press release calls for evaluation only of Systemically Important Banks.

We urge that FSB solicitations with respect to evaluating TBTF reforms must address SIFIs that are not Banks. It could be that, without saying so, that is the intention of the FSB, and we are submitting this comment letter just to be sure. Specifically, we recommend that this Evaluation must include the obviously TBTF firms, Fannie Mae and Freddie Mac.

As is well known, these two grossly undercapitalized firms failed and were bailed out in the financial crisis of 2008, having become one of the most vulnerable points in the financial system.

Fannie Mae and Freddie Mac today have $5.5 trillion in combined assets, representing half the credit risk of the massive U.S. mortgage market. They are unquestionably systemically important, but they have not been designated as SIFIs by the U.S. Financial Stability Oversight Council. On the merits, this seems highly surprising. We believe it represents a major gap in the global response to implementing global systemic risk and TBTF reforms, which the Evaluation should address.

We suggest the following points from your terms of reference are particularly relevant:

1. “The TBTF problem arises when the threatened failure of a SIFI—given its size, interconnectedness, complexity, cross-border activity or lack of substitutability—puts pressure on public authorities to bail it out using public funds.”

Fannie Mae and Freddie Mac displayed at the time of their failure and display now the attributes of extremely large size, interconnectedness, complexity, cross-border activity and lack of substitutability. As demonstrated by the history of the financial crisis, public authorities not only felt overwhelming pressure but did in fact bail them out with $190 billion of public funds.

1. “G20 leaders endorsed the FSB framework for Reducing the moral hazard posed by SIFIs.”

Fannie Mae and Freddie Mac continue to represent enormous moral hazard. Since they are now even more dependent on the U.S. Treasury’s implicit guarantee than before, the moral hazard they represent is even greater than in 2008.

1. “The evaluation will focus on…requirements for additional loss absorbency through higher capital buffers.”

Fannie Mae and Freddie Mac are much more highly leveraged than TBTF banks were in 2008, and now have far less capital than before their collapse. In fact, their equity capital is virtually zero. As of March 31, 2019, their combined capital ratio is a risible 0.2% and they are hyper-leveraged at 500 to 1.

1. “The evaluation will cover…cross-border and cross-sectional effects.”

Fannie Mae and Freddie Mac’s $5.5 trillion in mortgage-backed securities and debt are sold and traded in global capital markets.

1. “The FSB will engage with relevant stakeholders (market participants, academics, civil society, etc.).”

It would be a pleasure to provide any further information which would be helpful in adding Fannie Mae and Freddie Mac to the scope of the Evaluation.

With sincere thanks for your consideration,

Respectfully submitted,

Alex J. Pollock                                                   Thomas H. Stanton

Distinguished Senior Fellow                              Fellow

R Street Institute                                             Johns Hopkins University

Washington, DC                                          Washington, DC

Attachment: Brief bios of the authors

Cc: Financial Stability Oversight Council

Attachment

Alex J. Pollock is a distinguished senior fellow at the R Street Institute in Washington, DC. Previously, he was a resident fellow at the American Enterprise Institute from 2004 to 2015, and President and Chief Executive Officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He is the author of Boom and Bust (2011) and Finance and Philosophy (2018), as well as numerous articles and Congressional testimony. His work focuses on financial policy issues, financial cycles, risk and uncertainty, housing finance and banking systems, and the interactions of these with politics. Mr. Pollock is a director of CME Group; Ascendium Education Group; and the Great Books Foundation; and a past-president of the International Union for Housing Finance. He is a graduate of Williams College, the University of Chicago, and Princeton University.

Thomas H. Stanton served as President of the Association for Federal Enterprise Risk Management, a member of the federal Senior Executive Service, a board member of the National Academy of Public Administration (NAPA), and as Chair of the NAPA Standing Panel on Executive Organization and Management. In 2017 NAPA honored him with the George Graham Award for Exceptional Service to the Academy. In 2018 he received the Enterprise Risk Management Hall of Fame award. Mr. Stanton teaches as an adjunct faculty member at the Center for Advanced Governmental Studies at Johns Hopkins University. He is the author of A State of Risk: Will Government Sponsored Enterprises be the Next Financial Crisis? (HarperCollins, 1991), which presented the idea of contingent capital that is now being applied to reduce vulnerability of financial institutions globally, and of Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis (Oxford University Press, 2012). Mr. Stanton’s degrees are from the University of California at Davis, Yale University, and the Harvard Law School. Many of his publications can be found at www.thomas-stanton.com.

Too big to fail or bail

From Peacefare:

On June 4 the American Enterprise Institute hosted a panel discussion titled “Europe’s Populist and Brexit Economic Challenge” moderated by Alex J. Pollock of the R Street Institute and featuring Lorenzi Forni (Prometeia Associazione), Vitor Gaspar (International Monetary Fund), Desmond Lachman (AEI) and Athanasios Orphanides (MIT). The panel discussion was centered around Italy’s rising populism and economic woes, with a short discussion about the possibility of a no-deal Brexit causing damage to the European economy.

PRO: Taxpayers shouldn’t get stuck with a $1.5 trillion loan default tab

From Richmond Times-Dispatch, Austin American-Statesman, Chicago Tribune, and The Guam Daily Post.

As the noted financial scholar Alex J. Pollock, former president and CEO of the Federal Home Loan Bank of Chicago, suggests: Make the schools pay 20% of the debt obligations of former students facing loan delinquency or default.

Negative Interest Rates

Published in Barron’s.

In “The World Created by Upside-Down Interest Rates” (Current Yield, May 24), Jim Grant rightly observes how remarkable it is that the world’s monetary system has produced more than $10 trillion in debt with negative nominal interest rates. That would have been judged simply impossible by virtually everybody until it happened.

To understand this curious outcome, I believe we have to see it as deriving from a previous monetary event that also had no historical precedent: the world-turning-upside-down arrival of the whole global monetary system becoming based on pure fiat currencies—on the mere paper or accounting creations of central banks.

This system appeared in 1971—quite recently, historically speaking. About its prospects, Milton Friedman later wrote, “The ultimate consequences of this development are shrouded in uncertainty.” The consequences so far have included making central banks so powerful that they can render a huge swath of interest rates negative, a result certainly not foreseen.

How has the fiat system otherwise performed? Well, we have had financial crises in the 1970s, 1980s, 1990s, 2000s, and 2010s. Quite a record. The pure fiat currency, central-bank-trusting system might possibly be the least bad monetary system, but it is evidently far from perfect. Its further long-term consequences still remain “shrouded in uncertainty.” 

Is the monetary universe Newtonian or Einsteinian?

Published by the R Street Institute.

Is there an absolute standard of monetary or economic value? Nope. The monetary universe is not Newtonian, with a fixed frame of reference, but Einsteinian, with frames of reference moving with respect to each other. Prices are exchange rates with no substantive existence.

As the monetary economist Hans F. Sennholz instructively wrote:

There is no absolute monetary stability, never has been, never can be. Economic life is a process of perpetual change. People continually choose between alternatives, attaching ever-changing values to economic goods… [T]he exchange ratios of their goods are forever adjusting…nothing is fixed.

Money…is subject to man’s valuations and actions in the same way that all other economic goods are. Its subjective, as well as objective, exchange values continually fluctuate. … There is no true stability of money, whether it is fiat or commodity money. There is no fixed point or relationship in economic exchange…[in] this inherent instability of economic value.

– Hans F. Sennholz, Money and Freedom (1985), p 37.

As part of all this, governments and central banks can depreciate the currencies they control, run down the purchasing power of wages and savings and, in extreme but repeated cases, create hyperinflations.

There can be better or worse, but no perfect monetary system. All of them—whether the gold standard, gold and silver, a gold exchange system, the Bretton-Woods system, pure fiat currencies, independent or dependent central banks, inflation targets or not, fixed or managed or floating exchange rates—have various combinations of problems and advantages, and chances of breaking down.

Reality is so difficult.

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.