Lest We Forget

Published in Law & Liberty.

Fannie Mae and Freddie Mac, then staggering under huge losses from bad loans, were put into government conservatorship on September 6, 2008—eleven years ago today. Once considered financially golden and politically invulnerable, they were the lynchpins of the giant American housing finance market. But in 2008, instead of inspiring the fear and admiration to which they were previously accustomed, they were humiliated. “O what a fall was there, my countrymen!” This was an essential moment in the intensification of the 2007-2009 financial crisis. Naturally, Fannie and Freddie were bailed out by the U.S. Treasury. All the creditors got paid every penny on time, although the common stockholders from peak to trough lost 99%.

On the anniversary of Fannie and Freddie’s arrival in conservatorship, we consider Firefighting, the instructive and often quite personal memoir of the crisis and their own roles in it by three principal government actors—Hank Paulson, then Secretary of the Treasury; Ben Bernanke, Chairman of the Federal Reserve; and Tim Geithner, President of the Federal Reserve Bank of New York (and later, Paulson’s successor as Treasury Secretary).

To paraphrase the opening lines of the famous History of Herodotus from ancient Greece, using first names as they do in the book, “These are the memories of Hank and Ben of Washington and Tim of New York, which they publish in the hope of thereby preserving from decay the remembrance of what they have done, and of preventing the great and wonderful actions of the Treasury and the Federal Reserve from losing their due meed of glory; and withal to put on record what were the grounds of their actions.” This memoir will be able to be read usefully by future generations, if they are smart enough to study financial history.

The personal dimension of this account impresses us with the unavoidable uncertainty and the fog obscuring understanding, not to mention the emotions and then the exhaustion, which surround those who must act in a crisis. As they struggle to update their expectations and make decisions adequate to the threatened collapse, surprising disasters keep emerging in spite of their efforts.

As the authors reflect: “None of us was ever sure what would work, what would backfire, or how much stress the system would be able to handle.” So “We had to feel our way through the fog, sometimes changing our tactics, sometimes changing our minds, with enormous uncertainty.”

The pervasive uncertainty in part reflects the fact that crises “are products of human emotions and perceptions, as well as the inevitable lapses of human regulators and policymakers.” And “regulators and policymakers aren’t immune to those manias. Human beings are inherently susceptible to irrational exuberance as well as irrational fears.” This is not a new thought, to be sure, but certainly an accurate one.

In a crisis, all are faced with “the infinite expandability and total collapsibility of credit.” This wonderful phrase is from Charles Kindleberger, in his classic Manias, Panics, and Crashes. But how can those in responsible positions know when the collapsibility is going to be upon us? It may not be so easy to figure that out in advance.

“In the early phase of any crisis, policymakers have to calibrate how forcefully to respond to a situation they don’t yet entirely understand,” says the book. This seems right, but pretty delicately stated. A more honest wording would have been “have to guess how to respond to a situation they don’t understand.” While guessing, they are faced with this problem: “Governments that routinely ride to the rescue at the first hint of trouble can create. . . reckless speculation. . . . But underreacting can be even costlier and more damaging than overreacting.” Which is it to be? “Unfortunately, crises don’t announce themselves as either idiosyncratic brush fires. . . or systemic nightmares.” So, as the book describes, “Policymakers have to figure it out as they go along.”

As they strove to do so, “The three of us would work together as a team throughout the crisis, talking to one another every day, usually multiple times.” And talking to many financial executives, too: “Sometimes we just needed to hear how much fear was in their voices. Sometimes they professed confidence, sometimes they pleaded for assistance. Often they didn’t know that much about the risks ahead. We had to sort through all the confusion and self-interest.” In general, “Policymakers can’t trust everything they hear from market participants.” Of course.

Indeed, whose word can be trusted? Government officials worry that speaking truly about their fears may set off the very panic they are trying to avoid. “When it becomes serious, you have to lie,” said Jean-Claude Juncker about this aspect of the crisis in Europe. “The mere act of publicly advocating for [the] TARP [bailout] carried some risk,” write our authors. “Excessively alarmist rhetoric could end up inflaming the panic.” There seems to be no way to escape this dilemma.

Here is the authors’ confession: “Even in the months leading up to it, we didn’t foresee how the scenario would unfold”—how it would “unravel” would be a better term. This was not for lack of effort. “All three of us established new risk committees and task forces within our institutions before the crisis to try to focus attention on systemic threats. . . calling for more robust risk management and humility about tail risks.” But “none of us recognized how they were about to spiral out of control. For all our crisis experience, we failed to anticipate the worst crisis of our lifetimes.”

This experience leads the authors to a reasonable conclusion: such a lack of foresight is likely to repeat itself in the future. “For us,” they muse, “the crisis still feels like yesterday,” but “markets have short memories, and as history has demonstrated, long periods of confidence and stability can”—I would say almost certainly do—“produce overconfidence and instability.” So “we remain worried about the next fire.” This is perfectly sensible, although the book’s overuse of the “fire” metaphor becomes tiresome.

Failed foresight and future financial crises and panics are possible or probable. With that expectation and their searing experiences, the authors believe that it is essential to maintain the government’s crisis authorities and bailout powers. This includes the ability to invest equity into the financial system when it would otherwise go broke, and they deplore the Dodd-Frank Act’s having curtailed these powers.

To correct this, “Washington needs to muster the courage to restock the emergency arsenal with the tools which helped end the crisis of 2008—the authority for crisis managers to inject capital into banks, buy their assets, and especially to guarantee their liabilities.” This would hardly be politically popular with either party now, because it would be seen as favoring bailouts of big banks. It would increase moral hazard, but would also reflect the reality that government officials will intervene in future financial crises, just as in past ones. “The current mix of constraints on the emergency policy arsenal is dangerous for the United States,” conclude the most prominent practitioners of emergency financial actions of our time. Thus they end the book with their contribution to the perpetual debate of preparing for government intervention versus creating moral hazard.

In the meantime, they have related a history which, in the spirit of Herodotus, does deserve its due meed of remembrance.

Key points in the Treasury’s paper on Fannie/Freddie reform

Published by the R Street Institute.

The important parts of the Treasury’s new paper on Fannie Mae and Freddie Mac reform are not the legislative recommendations, since legislation is not going to happen. They are the administrative steps that can be taken now, with political will. Of these, the key ones are:

• Increased capital requirements for Fannie and Freddie, under which the same risks, whether taken by private institutions or by Fannie and Freddie, have the same capital protection;

• Removing regulations which especially favor Fannie and Freddie over other competitors;

• An ongoing fee from Fannie and Freddie to the Treasury to pay for the taxpayer credit support, without which Fannie and Freddie could not exist;

• Rewarding the taxpayers for their bailout of Fannie and Freddie by having Treasury exercise its warrants for 79.9 percent of Fannie and Freddie’s common stock. Since the exercise price is one-thousandth of a cent per share, this will be a nice and well-deserved profit for the taxpayers.

The Treasury’s articulated direction of a more competitive mortgage market with less taxpayer risk is certainly correct.

Greenland gambit finds echo in US frontier deals

Published in the Financial Times.

Theo Vermaelen’s ironic letter about the idea of purchasing Greenland (“Trump and Greenland: it’s a winner all around,” August 30) was fun, but ended with a serious point: “The current frontiers of countries are mainly the result of wars.” However, the frontiers of the United States were heavily influenced by purchases: the 1803 Louisiana Purchase of 827,000 square miles, the 1854 Gadsden Purchase of 30,000 square miles, and the 1867 Alaska Purchase of 586,000 square miles. In this context, one cannot help noticing similarities between Alaska and Greenland.

Taxpayers are the GSEs’ true stockholders

Published by the American Enterprise Institute and National Mortgage News.

At a conservative 16 basis points per year, taxpayers would earn some $7 billion annually after taxes, according to one estimate.

Central Bank Independence: A Canadian Contrast

Published by the R Street Institute.

Whether central banks are or should be or could be “independent” of the rest of the government is a key question in political economics and political finance.  Given the great power of the unelected managers of central banks in a fiat currency system, the potentially huge costs of their mistakes, and their obvious ability to move markets, it is a question of substantial magnitude.

Unsurprisingly, the Federal Reserve itself is a big proponent of its own independence.  Former Fed chairmen Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen took to the Wall Street Journal on August 6 to make the independence case.

An interesting, perhaps more balanced, approach is taken by Canada, another economically advanced, democratic country with a sophisticated financial system, for its central bank, the Bank of Canada.  The Bank of Canada Act strikingly contrasts with the theory of independence in this respect.

Specifically, the Bank of Canada Act has a section entitled “Government Directive.”  This section provides for the explicit coordination between the central bank and the executive, and the ultimate superior authority of the Parliamentary government in monetary actions.  To understand the provisions I am about to quote, “Minister” means the Minister of Finance, equivalent to the Secretary of the Treasury in the U.S. government.  “Governor” means the head of the Bank of Canada, equivalent to the Chairman of the Federal Reserve System. “Governor in Council” means quite a different Governor, namely the Governor General of Canada, acting on advice of the Prime Minister and the Cabinet, formally representing the authority of the Crown.

Says this section of the Bank of Canada Act (with italics added):

“Consultations

14 (1) The Minister [of Finance] and the Governor [of the Bank of Canada] shall consult regularly on monetary policy and on its relation to general economic policy.

Minister’s Directive

(2) If, notwithstanding the consultations provided for in subsection (1), there should emerge a difference of opinion between the Minister and the Bank concerning the monetary policy to be followed, the Minister may, after consultation with the Governor and with the approval of the Governor [General] in Council, give to the Governor [of the Bank] a written directive concerning monetary policy, in specific terms and applicable for a specified period, and the Bank shall comply with that directive.”

That’s pretty clear.  Although such a directive to the central bank has never been issued, every Governor of the Bank has the strongest incentives never to have one issued.  The possibility is there, in the framework for the required consultations.

Other democracies with statutory provisions for the government to issue directions to the central bank include Australia, England, India and New Zealand (all, like Canada and the U.S., formerly parts of the British Empire).  Thus:

The Australian Reserve Bank Act: “The Treasurer may then submit a recommendation to the Governor-General, and the Governor-General, acting with the advice of the Federal Executive Council, may, by order, determine the policy to be adopted by the Bank.”

Bank of England Act: “The Treasury, after consultation with the Governor of the Bank, may by order give the Bank directions with respect to monetary policy if they are satisfied that the directions are required in the public interest and by extreme economic circumstances.”

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

Reserve Bank of New Zealand Act: “The Governor-General may, by Order in Council, on the advice of the Minister, direct the MPC [Monetary Policy Committee] to formulate, and the Bank to implement, monetary policy [objectives] specified in the order.”

Do these Canadian and other countries’ related provisions give too much power to the politicians?  Does the U.S. structure give too much power to the unelected managers of the central bank?  Where is the right balance?  Here we find ourselves in the domain of political philosophy, so the debates will surely continue.  These debates will benefit if better informed of the ideas of other important democracies.

The golden 2% has created the modern world

Published in Financial Times.

Of course Vaclav Smil is correct that Moore’s Law-type growth rates of 35 per cent per year will not go on forever, however astonishing the record so far (“Infinite growth is a pipe dream”, August 9). But how about 2 per cent? Professor Smil turns up his nose at a growth rate of a mere 2 per cent real per capita per year. Yet that very 2 per cent continued over long times is the true miracle that has created the modern world. At 2 per cent compounded, in a century, people are on average seven times economically better off. So we ordinary people are seven times better off than our ancestors were as Woodrow Wilson et al negotiated the Treaty of Versailles in 1919.

This is amazing. Can we imagine that people in 2119 will again be on average seven times better off that we are today? That would be the result of the golden 2 per cent. Whether 2 per cent can continue indefinitely is a far more interesting question than whether 35 per cent can.

Steering Central Banking Past Scylla and Charybdis (the Technocrats and the Politicians)

Published in Law & Liberty.

Napoleon was clear about why he set up the Bank of France in 1800: He wanted a bank to lend his government money when he needed it. As monetary economist George Selgin wrote, “The idea of credit which existed in the mind of General Bonaparte boiled down to this: that he might have all the credit he wanted, if only he could establish a bank he could control, and award it a monopoly of currency.” This nicely sums up one essential function of central banks: financing the government of which they are a part. If you want your government debt to be thought of as nearly risk-free, the central bank has to be willing to buy it at all times.

Somehow, the central banks don’t discuss this service of theirs in their brochures or their public statements. Nonetheless, it is a critical element of whether central banks are, or ought to be, “independent” as they wield their great financial and economic power. If independent, how they are to be accountable, and to whom? Upon the answers to these questions depends the legitimacy (or lack thereof) of these unelected wielders of power in a democracy.

A detailed consideration of what should be meant by central bank independence, accountability, and legitimacy may turn out to be quite complex, as Paul Tucker’s Unelected Power—The Quest for Legitimacy in Central Banking and the Regulatory State certainly is.

Sir Paul, knighted for his contributions to central banking and now a fellow at Harvard University, writes: “Unelected power is one of the defining features of modern governance,” and “central banks are, today, the epitome of unelected power.” He is unambiguous that “What we are dealing with here is power—who has it, for what purposes, and on what terms.”

In turn, this involves “the interconnectedness of events, beliefs, values, norms, laws, and institutions,” with not only domestic issues of economic growth and employment, attempts at financial stability, perpetual inflation (as is these days the central banks’ goal), financial regulation, government finance, and dealing with financial crises, but also necessarily involving international cooperation by central bankers, who thus may be perceived as part of a “transnational elite.”

Pondering Power

Over the last century, central banks have become a worldwide institution. In the 1920s, the League of Nations prescribed that “in countries where there is no central bank of issue, one should be established.” In the 1990s, “the International Monetary Fund and the World Bank began prescribing independent central banks and . . . inflation targeting.” In the most recent financial crisis, “central bankers were the leading players.” They “emerged from the crisis with more, not fewer, responsibilities and powers.” Reflecting on this dominant financial institution of our times, “the consolidation of power should make us ponder,” says Tucker. Indeed it should.

Central banks must operate in three interacting aspects of government, in Tucker’s terms: “The Fiscal State, the Regulatory State, and the Emergency State.” As Napoleon saw, the central bank is essential to the Fiscal State; it has become an essential regulator and hoped-for controller of risk for the Regulatory State; and it is essential to coping with financial emergencies and panics for the Emergency State. Central banks “are built to be emergency institutions,” Tucker writes, with emphasis—this is certainly the main reason why the Federal Reserve was created. At this high level of abstraction, the unavoidable complexity is already apparent.

Tucker is well-prepared through long practical experience, having risen to Deputy Governor of the Bank of England, and by much theoretical reflection, to ponder these matters. He spends the first 568 pages of the book carefully examining innumerable aspects of how and under what conditions central banks can legitimately have so much power. He does not sufficiently explore, in my opinion, the dilemma that central bankers can never have the knowledge of the future they would need to carry out their grand goals. Otherwise, the treatment is exhaustive.

The Central Banking Golden Mean

The author wants to avoid two extremes in his search for what might be thought of as the central banking golden mean.

The first extreme is having central banks and money completely controlled by the politicians currently in office, who are ready to manipulate and depreciate the currency in the pursuit of short-term political advantage. Then, as history demonstrates, the central bank can become subject to the government’s whims, as Martin Wolf recently described it. To direct the central bank is doubtless a natural desire of the executive.

President Trump and India’s Prime Minister Modi have both been explicit about this. So, notably, were Presidents Harry Truman, Lyndon Johnson and Richard Nixon, and the executive branch completely controlled the Federal Reserve during the Second World War. Tucker would like a central bank independent enough to resist this natural pressure, except of course, during a big war.

The opposite extreme is a central bank that is too independent, operated by a self-styled set of Platonic guardians who do not have to answer to any mere elected politicians (as they see it), and who by “their professional expertise would improve the welfare of the people.” President Woodrow Wilson helped negotiate and signed the original Federal Reserve Act in 1913. Purely independent central banks would represent Wilson’s theory that independent agencies would be “improved on scientific lines, occupying a sphere separate from politics.” Tucker knows that is not possible in a democratic government, nor is it desirable, leading as it would, in a favorite phrase of his, to “unelected overmighty citizens.” In historical context, Wilson’s “classic celebration of administration looked back to the same exemplars of executive government [as Hegel did]: the Prussian and Napoleonic states.”

Tucker sets out to define in detail a middle ground for central banks. This is to be achieved by conscious design, well considered institutional frameworks, ongoing oversight by the legislature, and informed public debate, which will avoid short-term political domination of central bank actions “without surrendering republican democracy in favor of technocracy.”

When we reach page 569 of this careful and thoughtful book, we find a four-page long list of all the principles needed to construct this central banking golden mean. Entitled “The Principles for Delegation to Independent Agencies Insulated from Day-to-Day Politics,” the list includes “Delegation Criteria,” “Design Precepts,” “Multiple-Constraints,” and “An Ethic of Self-Restraint.”

It’s a reasonable, if lengthy, set of requirements, though naturally some of its points are debatable. Tucker sums up his approach to framing monetary regimes as follows:

a clearly articulated regime, simple instruments, principles for the exercise of discretion,  transparency that is not deceptive, engagement with multiple audiences, and, most crucially, testimony to legislative committees; all directed at establishing and maintaining a reputation for reliable, legitimate authority.

Does any existing central bank meet all these criteria? Probably not, Tucker admits. This suggests the unfortunately missing chapter of the book: one that applies the principles to existing major central banks to see how they measure up and that identifies what institutional reforms would be indicated.

It would have been most interesting had Tucker added such an analysis of current central bank designs, judged against his principles. These studies could have included the Federal Reserve, the Bank of England, the European Central Bank, the Bank of Japan, or the Swiss National Bank, for example.

Accountability?

In the case of the Federal Reserve, I believe the conclusion of such an exercise would be that the Fed could not legitimately, and should not have claimed to be able to, set a 2 percent inflation target on its own. This should instead have resulted from an extensive consultation with the legislature. In particular, to unilaterally set goal of having 2 percent inflation forever is of highly dubious legitimacy, when the law instructs the Fed to pursue “stable prices.”

Such an analysis would also lead one to question whether the United States meets Tucker’s standard that “the legislature has the capacity, through its committee system, properly to oversee” the central bank. Any fair consideration, I believe, would find that under current circumstances, the U.S. Congress does not. I have previously suggested that a specialized new joint committee, perhaps called the Committee on the Federal Reserve and the Currency, would have a better chance of carrying out what is, under Tucker’s principles, a mandatory legislative duty.

This is the essential question of the accountability of central banks, which is “the riddle at the heart of this book.” Tucker thinks that “sensible central bankers will want to invest in reasoned debate and criticism of their policies.” (Emphasis in original.) The responsibility of the legislature is “for the people’s representatives to fulfill their own role as higher-level trustees, setting clear objectives and constraints.” One might say in such a design that the central bank is the management of the monetary regime and the legislature is, or should be, the board of directors.

The Claim of Expertise

Supporters of pure central bank independence stress the Wilsonian claim of expertise, the technocratic argument. But although they are monetary and economic experts, do central banks have the requisite knowledge of the financial and economic future they would need for consistent success? It is apparent that they do not. Tucker rightly observes that “bad results are from time to time inevitable.” By analogy, you could be a great expert in the stock market but still be unable to say what stock prices will do today, let alone tomorrow.

Central bankers might have “unparalleled status, power and prestige” but, “as they well know, they, like the rest of us, have a more tenuous grasp of what is going on in the economy than anyone ever expected,” Tucker admits. Or in more informal terms (to quote Wolfgang Muenchau), “The proverbial monkey with a dartboard would have outperformed the ECB’s forecasting department in the past decade.” Hence it is no surprise, as Tucker writes, that we have “a world that combines market failure with government failure.” To expect otherwise would be foolish.

The Governor of the Bank of France, Francois Villeroy de Galhau, in a brilliant talk, pointed out how central banks face four fundamental uncertainties. In my paraphrased summary, these are:

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

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

3. They are affected by what others will do, but don’t know what the others will do.

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

The unelected power of central banks, however well designed for legitimacy, must always be understood as faced with such inescapable uncertainty.

So, as Tucker says, “Our central bankers are not a priesthood” nor are they “philosopher kings, maestros or celebrities . . . Nor, more modestly, is the chair of a central bank its country’s chief economist.” Not being elected, “they must work within clear democratic constraints and oversight.”

In short, we should be neither idealistic nor cynical about central banks and bankers, merely realistic.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Published in Real Clear Markets.

If You Believe In Dodd-Frank, You Can’t Also Believe In Fannie, Freddie

Members of Congress whose financial markets credo begins with “I believe in the Dodd-Frank Act,” experience severe cognitive dissonance when faced with the systemic financial risk created by Fannie Mae and Freddie Mac. Of course, this applies principally to Congressional Democrats. Here is the logic of their problem:

If you believe in the Dodd-Frank Act, you must believe in the concept of SIFIs (Systemically Important Financial Institutions).

If you believe in the Dodd-Frank Act, you must believe that SIFIs should be regulated by the Federal Reserve in addition to any other regulator, and that the Fed must be able to set “more stringent” regulations to reduce systemic risk.

If you believe in the concept of SIFIs, you cannot escape the obvious fact that Fannie and Freddie are SIFIs.

So if you believe in the Dodd-Frank Act, you must believe that Fannie and Freddie should be regulated by the Fed to address systemic risk.

But many politicians who wish to believe in the Dodd-Frank Act also wish to escape this inescapable conclusion. “Wait!” they say, “If the Fed regulates Fannie and Freddie, maybe that will hurt housing, so don’t do it!” There is the cognitive dissonance. Stating it in more candid terms, they fear that regulating the systemic risk of Fannie and Freddie in accordance with the Dodd-Frank Act would limit political schemes to run up mortgage risk, and likewise limit the ability to push all that risk onto the Treasury and the taxpayers. Indeed it would, especially recalling that Dodd-Frank authorizes “more stringent” regulations for SIFIs. Presumably, for starters, Fannie and Freddie would no longer be able to run at hyper-leverage.

The Dodd-Frank faithful cannot have it both ways. They cannot both believe in the Dodd-Frank Act and oppose the Fed as systemic risk regulator of Fannie and Freddie. It’s one or the other, not both.

Others do not have this logical problem. For example, my good friend, Peter Wallison of the American Enterprise Institute, opposes recognizing that Fannie and Freddie are SIFIs (thereby disagreeing with me), because he does not want to give the Fed any more power than it already has. Peter can do this with intellectual consistency because he doesn’t believe in the Dodd-Frank Act in the first place.

Another approach to opposing the Fed as systemic risk regulator of Fannie and Freddie would be to deny its supposed ability to regulate any systemic risk at all. This approach would observe the deep uncertainty of the financial future, which is constantly displayed, and argue that neither the Fed nor anybody else can have the knowledge to be a successful systemic risk regulator. But if you think this, you obviously do not believe in the Dodd-Frank Act.

Neither these nor any other arguments against making the Fed a Fannie and Freddie regulator are available to those who recite the Dodd-Frank creed. They must agree with the accuracy of this syllogism:

1. SIFIs must be regulated by the Fed.
2. Fannie and Freddie are obviously SIFIs.
3. Therefore, Fannie and Freddie must be regulated by the Fed.

If you believe in the Dodd-Frank Act, it is simply “Q.E.D.”

Fannie Mae and Freddie Mac need to be labeled as systemically important

Published by The Hill.

The Senate Banking Committee held a hearing this summer on whether Fannie Mae and Freddie Mac should be designated as systemically important financial institutions (SIFIs). Absolutely nobody there, no witness and no senator, tried to argue that Fannie Mae and Freddie Mac are not systemically important.

That would be a hopeless argument indeed, since Fannie Mae and Freddie Mac guarantee half the credit risk of the giant United States housing finance sector and have combined assets of $5.5 trillion. Fannie Mae is bigger than JPMorgan Chase and Bank of America, and Freddie Mac is bigger than Citigroup and Wells Fargo. They have already demonstrated that they can “pose a threat to the financial stability of the United States,” to use the words of the Dodd Frank Act. Are they systemically important? Of course. Are they financial companies? Of course. They are systemically important financial institutions, as a matter of 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 (second only to United States debt) 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 entirely about leveraging real estate. Moreover, they have been historically, and are today, themselves hyper leveraged.

The Financial Stability Board has stated this fundamental description of a SIFI: “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 in their 2008 failure and continue to display the attributes of extremely large size, interconnectedness, complexity, cross-border activity, and lack of substitutability. As everybody knows, in 2008, federal authorities not only felt overwhelming pressure to bail them out, but did in fact bail them out. In addition, they pledged the credit support from the Treasury which protected and continues to protect Fannie and Freddie’s global creditors. Fannie and Freddie remain utterly dependent on Treasury’s credit support.

As Treasury Secretary Henry Paulson recounted in his memoir of the financial crisis, “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.” Paulson 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.” He memorably added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the bailout he directed, Paulson’s assurances turned out to be true for all of Fannie and Freddie’s creditors, even holders of subordinated debt. In short, that Fannie and Freddie are SIFIs in reality no reasonable person can dispute. Yet so far, the Financial Stability Oversight Council has not designated them officially as such. Judging purely on the merits of the case, this is indefensible. Of course, Fannie and Freddie 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 as a whole.

Fannie and Freddie are by definition 100 percent concentrated in the risks of leveraged real estate. A matching systemic risk is that their regulator is likewise devoted only to housing finance. Such an agency is always pushed by powerful political forces to become a cheerleader for housing credit. This brought down the old Federal Home Loan Bank Board, abolished in 1989, and also the Office of Thrift Supervision, abolished in 2010. It is easy to picture a future FHFA, under the appointments of a future administration, behaving similarly in that perpetual fount of systemic risk, leveraged real estate.

Designating Fannie and Freddie as SIFIs should not be delayed because they are in regulatory conservatorship. They are just as systemically important in conservatorship as out of it. The answer to the Senate Banking Committee’s excellent question is that it is high time to recognize reality and designate Fannie and Freddie as the SIFIs they so obviously are.

Power Struggle

Published by Barron’s.

To the Editor:

Discussing the tension between President Trump and Fed Chairman Powell, Steven Sears describes it as “this historically unusual relationship between two of the world’s most powerful people” (“Playing the Fed’s Next Rate Move,” July 11). But it’s not so unusual for there to be serious tension between the holders of these two high offices.

President Truman was greatly provoked when the Fed wanted to raise interest rates while he was fighting and financing the Korean War. He summoned the entire Federal Open Market Committee to the White House—and they came—to tell them what to do. But they didn’t follow his instructions. This dispute ended up with the resignation of the Fed chairman, Thomas McCabe. “McCabe was informed that his services were no longer satisfactory,” Truman later said.

President Lyndon Johnson was likewise made furious when Fed Chairman William McChesey Martin’s raised interest rates while Johnson was trying to finance both a war and big welfare programs. Johnson summoned Martin to his Texas ranch, where he pushed him around the living room, yelling in his face, “Boys are dying in Vietnam and Bill Martin doesn’t care!”

The pressure brought by President Nixon on Fed Chairman Arthur Burns is legendary. Said Nixon, “I respect [Burns’] independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”

It’s hardly surprising that “two of the world’s most powerful people,” whoever holds those positions at the time, should occasionally clash.

Alex J. Pollock, R Street Institute, Washington, D.C.

Crypto mining and buying under threat from US Congress?

Published in Crypto Disrupt.

Many of the committee members warned that having such a central system could amplify the risk of bank runs with several major institutions already recoiling against the idea. A senior person at the R Street Institute, Alex Pollock, slammed the idea of CBDC at the hearing on Wednesday when he said it is “a terrible idea – one of the worst financial ideas of recent times.”

The Parallel Democratic Dilemmas of the Court and the Fed

Published by Law & Liberty.

As a result, critics like Alex Pollock have argued: “When a crisis hits, their own interventions usually, if not typically, create the conditions for future crises.” One interesting result of comparing the Supreme Court to the Fed is to wonder whether this criticism should apply to the Court as well. That is, one might question the institutional capacity of the Court to predict the long-term constitutional needs of the republic and use their discretion to update the law accordingly.

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.