Do you believe central bank assurances?

Published by the R Street Institute.

To reassure savers worried about the safety of their deposits, the Reserve Bank of India (India’s central bank) recently announced it “would like to assure the general public that Indian banking is safe and stable and there is no need to panic.”

The problem is that when government officials issue such assurances, do you believe them?

Governments confronted by the risk of a banking crisis have to say the same thing regardless how severe the risk really is. They must say that the system is safe and you should not panic, because they are afraid that, by sharing any doubts, they would themselves set off the panic they fear. Therefore, their statements of assurance have no informational substance.

“When it becomes serious, you have to lie,” Jean-Claude Juncker, then head of the eurozone finance ministers, with admirable candor said of the European financial crisis of the 2000s.

“We have no plans to insert money into either of those two institutions,” Treasury Secretary Henry Paulson said of Fannie Mae and Freddie Mac in the summer of 2008. One month later, he began inserting into both of them what became $187 billion of bailout money.

Governments and banks in stressed situations are up against Walter Bagehot’s insight into the fragility of credit. “Every banker knows that if he has to prove he is worthy of credit,” Bagehot wrote in 1873, “in fact his credit is gone.” I imagine that will always be true.

The term “credit” comes from credo = “I believe.” In a threatened crisis, you suddenly realize that you have not much ground, if any, for believing in a bank’s soundness or believing the government’s assurances that things are fine.

Actually, Sovereigns Do Go Broke

Published in Law & Liberty.

The ballooning debt of the United States government is an especially large and interesting case of sovereign debt. One chronicler of sovereign debt’s long, global, colorful history, Max Winkler, concluded that “The history of government loans is really a history of government defaults.” More moderately, we may say that at least defaults figure prominently in that history.

In a vivid recent example, the government of Greece, in its 2012 debt restructuring, paid private holders of its defaulted debt 25 cents on the dollar, so these creditors suffered a 75 percent loss from par value. Greek government debt was at the vortex of Europe’s 21st century sovereign debt crisis. Various governments of Greece have defaulted seven times on their debt, which has been in default approximately half the time since the 1820s.

With such a record, how soon would the lenders be back this time?

Pretty soon, as usual. Defaults were the past; new loans proclaim a belief in the future. Thus in July, the print edition of the Financial Times informed us, “Greek debt snapped up as investors seek higher yields”! That’s a headline that would not have been predicted a few years ago—except by students of financial history who have observed the repeating cycles of sovereign borrowing, default, and new borrowing.

“Greece has seen vigorous demand for its latest bond sale,” read the Financial Times article. “The Mediterranean country received orders of more than €13 billion for the seven-year bonds, well above the €2.5 billion on offer.” And the “higher yield”? A not very impressive 1.9 percent. The recently again-defaulting Greek government has succeeded in borrowing at the same interest rate as the United States government was at the same time for the same tenor. Of course the currencies are different, but this is nonetheless remarkable.

Note the common but inaccurate figure of speech used in the article. It talks about the country borrowing, when it is in fact the government of the country that borrows. That these two are not the same is an important credit consideration. Governments can be overthrown and disappear, while the country goes on. Governments can and do default on their debt with historical regularity.

Breaking the Faith

Notorious in this respect is the government of Argentina, which has “broken good faith with its creditors on eight occasions since it declared independence from Spain in 1816,” as James Grant reminds us. That is a default on average about once every 25 years. Obviously the lenders reappeared each time—in 2017, they bought Argentine government bonds with a maturity of 100 years. That is long enough on average to cover four defaults. In August 2019, the Argentine government announced it would seek to restructure its debt once again, and its 100-year bonds at the end of the month were quoted at 41 cents on the dollar.

In contrast to this, an optimistic columnist for Barron’s pronounced in that same August that sovereign bonds “have minimal to no credit risk because they are backstopped by their governments.” This financially uneducated statement is reminiscent of the notorious Walter Wriston line that “countries don’t go bankrupt.” Wriston, then prominent in banking as the innovative chairman of Citicorp, was defending the credit expansion that would shortly lead to the disastrous sovereign debt collapse of the 1980s. While sovereign governments indeed do not go into bankruptcy proceedings, they nevertheless do often default on their debt.

The great philosopher, economist and historian, David Hume, famously argued two and a half centuries ago, “Contracting debt will almost infallibly be abused, in every government.”

Max Winkler shared a realistic appreciation of the risk involved, as he was writing during the sovereign debt collapse of the 1930s. His instructive and entertaining book, Foreign Bonds: An Autopsy (1933), provides a simple but convincing explanation for the recurring defaults. Considering “politicians in the borrowing countries, from Abyssinia to Zanzibar,” Winkler memorably observed:

The position they occupy or the office they hold is ephemeral. Their philosophy of life is carpe diem. . . . Tomorrow they may be swept out of office. Today they can live only by yielding to the multiple undertaking of expenditures, proposed by themselves and their temporary adherents. . . . In order to enjoy the present they cheerfully mortgage the future, and in order to win the favor of the voter they . . . exceed the taxable possibilities of the country.

This sounds familiar indeed. We only need to update Winkler’s A to Z country names—we could make it “from Argentina to Zimbabwe.” Otherwise, the logic of the politicians’ behavior he describes is perpetual. It applies not only to national governments but to the governments of their component states, cities, and territories, like over-indebted Illinois and Chicago; New York City, which went broke in 1975; and Puerto Rico, now in the midst of a giant debt restructuring, among many others.

The observation fits the governments of advanced, as well as emerging, economies. This political pattern includes the expanding debt of the United States government, although it has not defaulted since 1971. In that year, it reneged on its Bretton Woods agreement to pay in gold. The U.S. government also defaulted on its gold bonds in 1933. Then Congress declared that paying these bonds as their terms explicitly provided had become “against public policy.”

The always insightful Chris DeMuth, writing in The American Interest and pondering the long-term trend of rising U.S. government debt, proposes that we have seen “the emergence of a new budget norm.” This is “the borrowed benefits norm.” “Voters and public officials,” he writes, have forged “a new political compact: for the government to pay out benefits considerably in excess of what it collects in taxes, and to borrow the difference.” He points out that the benefits “are mainly present consumption and are not going to generate returns to pay off the borrowed funds. Borrowing for consumption leads to immoderation now, immiseration down the road.”

This scholarly language captures the same behavior Winkler described in more popular terms in 1933.

A Habit of Default that Few Seem to Have Noticed

How frequent are defaults on sovereign debt? In their modern financial classic, This Time Is Different (2009), Carmen Reinhart and Kenneth Rogoff counted 250 government defaults on their external debt between 1800 and 2006, or 12 sovereign defaults per decade on average (of course, there have been more since 2006). In addition, they found 70 defaults on domestic public debt over that period.

A study by the Bank of Canada finds that, since 1960, 145 governments “have defaulted on their obligations—well over half the current universe of 214 sovereigns.” That is on average 24 defaulting governments per decade.

The study considers “a long-held view among some market participants . . . that governments rarely default on local currency sovereign debt [since] governments can service such obligations by printing money.” It points out that “high inflation can be a form of de facto default on local currency debt.” Holders of U.S. Treasury bonds found that out in the Great Inflation of the 1970s, when the bonds became called “certificates of confiscation.” But not counting the inflation argument, the Bank of Canada still finds 31 sovereigns with local currency defaults between 1960 and 2017. “Sovereign defaults on local currency debt are more common than is sometimes supposed,” it concludes.

The Wikipedia “List of sovereign debt crises,” relying heavily on Reinhart and Rogoff, shows 298 sovereign defaults by the governments of 88 countries between 1557 and 2015.

“The regularity of default by countries on their sovereign debt” is how Richard Brown and Timothy Bulman begin their study of the Paris Club and the London Club. These are organizations of governmental and private creditors, respectively, to negotiate with over-indebted governments. The first Paris Club debt rescheduling was in 1956 for Argentina; the London Club’s first was in 1976 for Zaire. (A to Z again.) The clubs have been busy since then. “Reschedulings increased dramatically from 1978 onwards,” Brown and Bulman observed in 2006. The current webpage of the Paris Club reports that in total it has made 433 debt agreements with the governments of 90 debtor countries.

The cycle of sovereign borrowing, default, and new borrowing has a long and continuing history. “Defaults will not be eliminated,” Winkler wrote in 1933. He further predicted that “debts will be scaled down and nations will start anew,” and that “all will at last be forgotten. New loans will once again be offered, and bought as eagerly as ever.” He was entirely right about that, and now we observe once again “Greek debt snapped up.”

How far back in time do government defaults go? Over 2,300 years in Greece. As Sidney Homer, in A History of Interest Rates, tells us: “In 377-373 B.C., thirteen [Greek] states borrowed from the temple at Delos, and only two proved completely faithful; in all, four-fifths of the money was never repaid.”

Shall we expect the fundamental behavior of politicians and governments to change?

Unfunded Pensions: Watch out, bondholders!

Published in Real Clear Markets.

A reorganization plan for the debt of the government of Puerto Rico was submitted to the court Sept. 27 by the Puerto Rico Oversight Board. It covers $35 billion of general obligation and other bonds, which it would reduce to $12 billion.

On average, that is about a 66 percent haircut for the creditors, who thus get 34 cents on the dollar, compared to par. Pretty steep losses for the bondholders, but steep losses were inevitable given the over-borrowing of the Puerto Rican government and the previous over-optimism of the lenders. Proposed haircuts vary by class of bonds, but run up to 87 percent, or a payment of 13 cents on the dollar, for the hapless bondholders of the Puerto Rican Employee Retirement System.

In addition to its defaulted bonds, the Puerto Rican government has about $50 billion in unfunded pension obligations, which are equivalent to unsecured debt. But the pensioners do much better than the bondholders. Larger pensions are subject to a maximum reduction of 8.5 percent, while 74 percent of current and future retirees will have no reduction. Those with a reduction have the chance, if the Puerto Rican government does better than its plan over any of the next 15 years, to have the cuts restored.

The Oversight Board’s statement does not make apparent what the overall haircut to pensions is, but it is obviously far less than for the bondholders. “The result is that retirees get a better deal than almost any other creditor group,” as The New York Times accurately put it. This may be considered good and equitable, or unfair and political, depending on who you are, but it is certainly notable. The Times adds: “Legal challenges await the plan from bondholders who believe the board was far too generous to Puerto Rico’s retired government workers.”

The Puerto Rican debt reorganization plan demonstrates once again, in municipal insolvencies and bankruptcies, unfunded pension obligations are de facto a senior claim compared to any other unsecured debt, including general obligation bonds that pledge the full resources and taxing power of the issuing government. This is not because they are legally senior, but because they are politically senior.

By running up their unfunded pensions, municipalities have not only stressed their own finances, but have effectively subordinated the bondholders. When it comes to unfunded pensions, the Puerto Rico outcome, like that of Detroit and others, announces: Bondholders, Watch Out!

Surprised again

Published by the Housing Finance International Journal.

“Why We’re Always Surprised” is the subtitle of my book, Finance and Philosophy. The reason we are so often surprised by financial developments, I argue in the book, is that “The financial future is marked by fundamental uncertainty. This means we not only do not know the financial future, but cannot know it, and that this limitation of knowledge is ineluctable for everybody.” That certainly includes me!

At the end of last year (in December 2018), interest rates had been rising, and it seemed obvious that they would likely rise to a normal level, at last adjusting out of the abnormally low levels to which central banks had pushed them in reaction to the financial crisis. The crisis began in 2007 with the collapse of the subprime lending sector in the United States and of the Northern Rock bank in the United Kingdom, and ran to 2012, which saw the trough of U.S. house prices and settlement of defaulted Greek sovereign debt at 25 cents on the dollar.

Six years had gone by since then, it seemed that it was high time for normalization. This view was shared during 2018 by the chairman of the Federal Reserve Board and its Open Market Committee. It also seemed that the long period of imposing negative real interest rates on savers, thus transferring wealth from savers to leveraged speculators and other borrowers, needed to end.

What would “normal” be? I thought a normal rate for the 10-year U.S. Treasury note would be about 4 percent and correspondingly for a 30-year U.S. fixed-rate mortgage loan about 6 percent, assuming inflation ran at about 2 percent. I still think those would be normal rates. But obviously, it is not where we are going at this point.

For the final 2018 issue of Housing Finance International, I wrote, “The most important thing about U.S. housing finance is that long-term interest rates are rising.” Surprise! Long-term interest rates have fallen dramatically. The United States does not have the negative interest rates, once considered impossible by many economists, which have become so prevalent in Europe, remarkably spreading in some cases to deposits and even mortgage loans. But the United States does have negative rates in inflation-adjusted terms. The 10-year U.S. Treasury note is, as I write, yielding about 1.5 percent. The year-over-year consumer price index is up 1.8 percent, and “core inflation” running at 2.2 percent, so the investor gets a negative real yield once again, savers are again having their assets effectively expropriated, and we can once again wonder how long this can continue.

What do the new, super-low interest rates mean for U.S. housing finance?

The higher U.S. mortgage loan rates, which reached almost 5 percent for the typical U.S. 30-year fixed-rate loan in late 2018, “would have serious downward implications for the elevated level of U.S. house prices, which already stress buyers’ affordability,” I wrote then. Had those levels been maintained, they definitely would have put downward pressure on prices. But as of now, seven years after the 2012 bottom in house prices, the U.S. long-term mortgage borrowing rate has dropped again to about 3.8 percent. This has set off another American mortgage refinancing cycle and is helping house prices to continue upward.

In the U.S. system, getting a new fixed-rate mortgage to refinance the old one is an expensive transaction for the borrower, with fees and costs which must be weighed against the future savings on interest payments. The fees depend on state laws and regulations; they range among the various states from about $1,900 on the low end to almost $6,900 on the high end, according to recent estimates. On the lender side, the post-crisis increases in regulatory burden had raised the lenders’ cost to originate a mortgage loan to as much as $9,000 per loan – the increased volume from “refis” (as we say) may have reduced this average cost to the lender to about $7,500. It is expensive to move all the paper the American housing finance system requires in order for the borrower to obtain a lower interest rate.

Meanwhile, with the new low interest rates and high house prices, “cash out refis” are again becoming more popular. In these transactions, not only do borrowers increase their debt by borrowing more than they owe on the old mortgage loan, but they reset their amortization of the principal further out to a new 30-year schedule. In both ways, they reduce the buildup of equity in their house, making it more likely that they will still have mortgage debt to pay during their retirement.

In general, there are no mortgage prepayment fees in the United States. The old, higher rate loans are simply settled at par. This continues to make prices of mortgage securities in the U.S. system very sensitive to changes in expected prepayment rates. If investors have bought mortgage loans at a premium to par, which they often do, upon prepayment they have lost and must write off any unamortized premiums they paid.

The most notable American investor in mortgage securities is the central bank, the Federal Reserve. As of Aug. 21, 2019, it had on its books $115 billion (with a B) of unamortized premium, net of unamortized discounts. Not all of this may be for its $1.5 trillion mortgage portfolio; still, a refi boom might be expensive for the Fed.

Speaking of the Federal Reserve, then-Chairman Ben Bernanke wrote in 2010 about his bond buying or “quantitative easing” programs: “Lower mortgage rates will make housing more affordable and allow more homeowners to refinance.” The latter effect of promoting refis is always true, but not the former claim of improved affordability. It ceases to be true when low mortgage rates have induced great increases in house prices, as they have. The high prices obviously make houses less affordable, and obviously mean that more debt is required to buy the same house, often with higher leverage – notably higher debt service-to-income ratios.

U.S. house prices are now significantly above where they were at the peak of the housing bubble in 2006. They have risen since 2012 far more rapidly than average incomes. The Fed’s strategy to induce asset price inflation has succeeded in reducing affordability.

According to the Federal Housing Finance Board’s House Price Index, U.S. house prices increased another 5 percent year-over-year for the second quarter of 2019. “House prices rose in all 50 states…and all 100 of the largest metropolitan areas,” it reports. Its house price index has now gone up for 32 consecutive quarters.

The S&P Case-Shiller National House Price Index has just reported a somewhat lower rate of increase, with house prices on average up 3.1 percent for the year ending in June. There is art as well as science in these indexes – the FHFA’s index notably does not include the very high (“jumbo,” in American terms) end of the market. According to Case-Shiller, in some particularly expensive cities, house price appreciation has distinctly moderated, with year-over-year increases of 1.1 percent for New York, 0.7 percent for San Francisco, and negative 1.3 percent for Seattle.

The AEI Housing Center of the American Enterprise Institute has house price indexes that very usefully divide the market into four price tiers. It finds that at the high end of the market, the rate of increase in prices is now falling, while the most rapid increases are in the lowest-priced houses – just where affordability and high leverage are the biggest issues, and where the U.S. government’s subprime lender, the Federal Housing Administration, is most active.

On a longer-term view, Case-Shiller reports that national U.S. house prices are 57 percent over their 2012 trough, and 14 percent over their bubble peak. When U.S. interest rates rise again, whether to normal levels or something else, these prices are vulnerable. How much might they fall? That may be another surprise.

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Published by the R Street Institute.

EDWARD J. PINTO and TOBIAS J. PETER                       ALEX J. POLLOCK

AEI Housing Center                                         R Street Institute

September 26, 2019

Department of Housing and Urban Development

Regulations Division

Office of the General Counsel

451 7th Street SW

Washington, DC 20410

Submission via www.regulations.gov

Dear Sir/Madam:

Re.: Docket No. FR-6111-P-02; RIN: 2529-AA98

HUD’s Implementation of the Fair Housing Act’s Disparate Impact Standard

Thank you for the opportunity to comment on this proposed rule on the Disparate Impact Standard. The authors of the comment have many years of experience in housing finance, as operating executives, analysts, and students of housing finance systems and their policy issues.  We believe this rulemaking has the potential to significantly improve the existing standard.

Our fundamental recommendation is that the consideration of disparate impact issues must be able to include credit outcomes, i.e. default rates, not only credit underwriting inputs.  Specifically:

1. Mortgage lenders, including smaller lenders, should have the option to use a credit outcomes-based statistical approach, as defined below, which qualifies as a valid defense under the Disparate Impact rule. This would improve the fairness, operation, and statistical basis of the rule.

2. HUD should develop a credit outcomes-based statistical screening approach that allows it to assess with a high degree of confidence, whether differences in mortgage lending results raise disparate impact questions for further review.

In both cases, the ability to use credit outcomes would enhance clarity and reduce uncertainty.

Problems with the Pure Input Approach

Applying its credit standards in a non-discriminatory way, regardless of demographic group, is exactly what every lender should be doing.  Typically, the question of whether this is being carried out has been approached by looking only at inputs to a lending decision.  This results in a focus on differing credit approval/credit decline rates between protected and non-protected classes.  The argument is then made that the existence of differing credit approval/credit decline rates between classes is evidence of discrimination even if a lender applies exactly the same set of credit underwriting standards to all credit applicants.[1]

Read in full here.

Fund managers are the agents of shareholders

Published in the Financial Times.

“Large institutional shareholders, notably BlackRock, State Street and Vanguard, recognise that companies must serve broader social purposes,” writes Martin Lipton (Opinion, September 18). There is one big problem with this statement: these firms are not shareholders. They are mere agents for the real shareholders whose money is at risk. They are moreover agents that display all the conflicts of classic agency theory. Yet they go about calling themselves “shareholders”, pushing the personal political agendas of their executives.

What they should be doing is finding out what the real shareholders desire and voting shares accordingly as faithful agents, not pontificating about personal ideas, which are irrelevant as far as what shareholders want.

The New Campus Housing Bubble

Published in Forbes, The Independent Institute, Ohio University College of Arts & Sciences Forum, and Catalyst.

My good friend, banker-scholar Alex Pollock of the R Street Institute, has shared with me some startling new data. High priced, comparatively luxury college student housing has been popular, and in this century lots of apartment complexes have been built with many amenities —granite or marble counter-tops, fancy swimming pools or saunas, etc. With unemployment rates below four percent and  low overall real estate delinquency since recovering from the traumas of a decade or more ago, this sector should be booming. But according to a story published by Wolf Street (Wolf Richter), delinquencies are rising dramatically.

Have Fannie and Freddie Paid the Taxpayers Back Yet?

Published in the Real Clear Markets.

The distinguished judges of the U.S. Court of Appeals for the Fifth Circuit have considered how much Fannie Mae and Freddie Mac have paid the Treasury Department to compensate the taxpayers for the giant bailout which kept Fannie and Freddie in existence and business.  The court observed in its September 6 judgment:

“The net worth sweep transferred a fortune from Fannie and Freddie to Treasury.”  Specifically, “Treasury had disbursed $187 billion and recouped $250 billion.”

The “net worth sweep” is the dividend on the senior preferred stock in Fannie and Freddie acquired by the Treasury in the bailout.  Originally set at 10% per year in 2008, the dividend was changed in August 2012—in the “Third Amendment” to the governing agreement—to essentially, “just send in all your profit” each quarter, hence a “sweep.”  The Treasury then owned $187 billion of senior preferred stock acquired for cash, as the court suggested, and another $2 billion in exchange for the original credit support agreement, for a total of $189 billion.  (Now it owns $199 billion.)

Fannie and Freddie should, said the court, “of course…pay back Treasury for [their] draws on the funding commitment.” And “Treasury was also entitled to compensation for the cost of financing.”  No one could disagree.  “But the net worth sweep continues transferring [Fannie and Freddie’s] net worth indefinitely, well after Treasury has been repaid,” it critically points out.  This must make us ask: Have Treasury and the taxpayers been repaid at this point?  The answer is not obvious, as sometimes has been asserted, and requires a little arithmetic.

In short, does having been paid $250 billion vs. a $189 billion principal amount automatically mean full repayment?  As every banker knows, it doesn’t.

Consider a simple analogy.  Suppose you borrowed $1,000 at an interest rate of 10%, under a $5,000 commitment with a commitment fee of 1% per year.  Suppose you pay only the interest and the commitment fee, but never a penny of principal.  After ten years, you will have paid $1,500.   You could truly observe that “You lent me $1,000 and I have paid you $1,500.”  But how much principal do you still owe?  You still owe all $1,000, without a doubt.

We can apply the same logic to Fannie and Freddie and see what happens.

Let us go back to August 2012, and suppose that the Third Amendment and the “net worth sweep” had never happened.  There is outstanding $189 billion of senior preferred stock.  The dividend remains the original 10%.  That is a dividend of $18.9 billion a year.  In addition to the dividend, as the court rightly noted, the original deal provides for Treasury also to charge an ongoing commitment fee. This was to compensate the taxpayers for their continuing credit support, which backed up and continues to back up all Fannie and Freddie’s liabilities.  Nine Fifth Circuit judges in an accompanying opinion call this support “a virtually unlimited line of credit from the Treasury.”  It effectively guarantees liabilities totaling $5.5 trillion—you don’t get that for free.  With vast liabilities and effectively zero capital, Fannie and Freddie could not function for even a minute without taxpayer support.  The Housing Reform Plan just published by the Treasury clearly provides for Fannie and Freddie to pay a commitment fee—and they undoubtedly should.

What would be a fair price for the taxpayers’ credit commitment?  Based on what the FDIC would charge a severely undercapitalized bank for the credit guarantee which is called deposit insurance, I believe 0.18% of total liabilities per year is a good guess.  This credit support fee on $5.5 trillion in liabilities gives an annual fee of $9.9 billion.

Thus, going back to our hypothetical 2012 with no profit sweep, Fannie and Freddie should have been paying Treasury $18.9 billion plus $9.9 billion or a total of $28.8 billion a year.  That was seven years ago.  Had Fannie and Freddie been paying that instead of the profit sweep for seven years the aggregate payment for dividends and commitment fee only, would have been $202 billion.  That payment would provide no reduction of the $189 billion of principal.

But Fannie and Freddie paid $250 billion.  That is $42 billion more than $202 billion, which might fairly be used to retire some of the $189 billion principal.  If we credit Fannie and Freddie with the going rate of interest, say 2%, on this amount, we might make that $45 billion.  That gives us $189 billion less $45 billion, leaving $144 billion of principal still to be repaid.

Suppose you think my suggested commitment fee is too high.  Let us cut it in half, to 0.09 %.  Then by analogous math, Fannie and Freddie’s required payment of 10% dividends plus commitment fees would be $23.9 billion a year, or $167 billion in total for seven years.  That would leave $83 billion, or $88 billion with interest, for principal reduction.  Result: they would have $101 billion still to pay.

Even when we remove by hypothesis Treasury’s claim on the perpetual net worth sweep criticized by the court, it is far from the case that Treasury has been repaid.

These considerations must be taken into account as Treasury and the Federal Housing Finance Agency (as conservator for Fannie and Freddie) revise the Preferred Stock Purchase Agreement as part of the administration’s housing finance reform plan.

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.