AEI Event: Will digital currencies and fintech shape the financial system of tomorrow?

Hosted by the American Enterprise Institute.

Event Summary

On January 28, AEI’s Paul H. Kupiec hosted an event delineating the roles and risks that stablecoins, central bank digital currencies, and other fintech developments might develop in our financial system. Panelists also discussed the actions financial regulators might take to manage financial markets.

Oonagh McDonald of Crito Capital outlined her reservations with the claim that stablecoins will improve upon the financial system. Current fintech developments already are sufficient to increase financial inclusion and efficiency in payments systems.

Charles Calomiris of Columbia University, however, foresees a useful role for stablecoins in the future economy. Stablecoins can develop a more safe, efficient, and rich payment system. For fintech developers, Dr. Calomiris urged that stablecoins should look less like bank deposits and more like perpetual preferred stock. However, large banks have much to lose if fintech companies expand their economic importance.

The Mises Institute’s Alex J. Pollock described the conflict between the government’s monopoly on currency and the issuance of private stablecoins. If a digital currency is tied to the dollar, one is merely creating a new payment system, not a new currency. Dr. Pollock is doubtful a currency not backed by an asset or cash flow can succeed.

— John Kearns

Event Description

Cryptocurrency, stablecoins, central bank digital currency (CBDC), and other fintech technologies are vying to change the way we borrow, lend, and pay one another. Pending financial regulation and potential CBDC issuance will shape the financial system’s evolution and shift the importance of central banks, banks, investment banks, cryptocurrencies, stablecoins, and related exchanges.

Will banks, mutual funds, and traditional broker-dealer exchange markets continue to be the systems we rely on to save, borrow, and make payments? Or will new nonbank fintech ventures and blockchain transactions displace them?

Join AEI as a panel of experts discusses the innovations, regulations, and other factors that will shape the future financial system and affect the broader economy.

Agenda

10:00 AM
Introduction:
Paul H. Kupiec, Senior Fellow, AEI

10:10 AM
Panel discussion

Panelists:
Charles Calomiris, Henry Kaufman Professor of Financial Institutions, Columbia University
Oonagh McDonald, Senior Adviser, Crito Capital
Alex J. Pollock, Senior Fellow, Mises Institute

Moderator:
Paul H. Kupiec, Senior Fellow, AEI

11:30 AM
Q&A

12:00 PM
Adjournment

The Economics Review Podcast: Ep. 36 - Alex J. Pollock

The Economics Review Podcast

Alex J. Pollock is a Senior Fellow with the Mises Institute, previously the Distinguished Senior Fellow at the R. Street Institute, and the former Principal Deputy Director of the U.S. Department of Treasury's Office of Financial Research. He is also the former President and CEO of the Federal Home Loan Bank of Chicago. Holding advanced degrees from the University of Chicago, and Princeton University, he is the author of the legendary book, Finance and Philosophy: Why We’re Always Surprised.

Click here to listen.

The Federal Reserve KeepsBuying Mortgages

Published by the Housing Finance International Journal.

Runaway house price inflation continues to characterize the U.S. market. House prices across the country rose 15.8% on average in October 2021 from the year before. U.S. house prices are far over their 2006 Bubble peak, and remain over the Bubble peak even after adjustment for consumer price inflation. They will keep on rising at the annual rate of 14-16% for the rest of 2021, according to the AEI Housing Center.

Unbelievably, in this situation the Federal Reserve keeps on buying mortgages. It buys a lot of them and continues to be the price-setting marginal buyer or Big Bid in the mortgage market, expanding its mortgage portfolio with one hand, and printing money with the other. It should have stopped before now, but the purchases, financed by newly created fiat money, or monetization, go on. They proceed at the rate of tens of billions of dollars a month, stoking the house price inflation, making it harder and harder for new families to afford a house. A recent Wall Street Journal opinion piece was entitled, “How the Fed Rigs the Bond Market” – it rigs the mortgage market, too.

The balance sheet of the Federal Reserve has grown to a size that would have amazed previous generations of Federal Reserve governors and economists. Although we have become somewhat accustomed to it, so fast do perceptions adjust, it would also have surprised readers of Housing Finance International of five years ago, and readers of 15 years ago would probably have judged the current reality simply impossible. Over time, we keep discovering how feeble are our judgments of what is possible or impossible.

The total assets of the Federal Reserve reached $8.7 trillion in November 2021. This is just about double the $4.5 trillion of November 2016, five years before – and we thought it was really big then. Today’s Federal Reserve assets are ten times what they were in November 2006, 15 years ago, when they were $861 billion, and none were mortgages.

The Federal Reserve now owns on its balance sheet $2.6 trillion in mortgages. That means about 24 % of all outstanding residential mortgages in this whole big country reside in the central bank, which has thereby earned the remarkable status of becoming by far the largest savings and loan institution in the world. Like the historical U.S. savings and loans associations, the Federal Reserve owns very long- term mortgages, with their interest rates fixed for 15 to 30 years, and neither marks its investments to market in its financial statements nor hedges its substantial interest rate risk. It accounts for its mortgages at par value, not what it paid for them, and separately reports $338 billion of unamortized premiums (net of discounts) on securities – presumably a significant proportion of this is premiums paid on mortgages and thus additional investment in them.

This $2.6 trillion in mortgages is 48% more than the Federal Reserve’s $1.76 trillion of five years ago, and of course, infinitely greater than the zero of 2006. Remember that from the founding of the Federal Reserve until then, the number of mortgages it owned had always been zero. That was what was normal. Whether moving into directly subsidizing mortgages and inflating the price of houses be considered progress or deterioration, or perhaps first the former and then the latter, it was certainly a big change. It was an emergency action in both the financial crisis of 2007-09 and the financial panic of 2020. Should a giant Federal Reserve mortgage portfolio be permanent or temporary? If temporary, how long should it go on?

The Cincinnatian Problem

An abiding problem is how you can reverse central bank and government crisis interventions, initially thought and meant to be temporary, after the crisis passes. The idea that government intervention, required in times of crisis, should be withdrawn in the renewed normal times which follow, I call the Cincinnatian Doctrine. It is named for the ancient Roman hero Cincinnatus, who was called from his plow to save the State, became temporary Dictator, did save the State, and then, mission accomplished, went back to his farm. (I introduced this term at the IUHF World Congress in 2006, just before the housing bubble of the time imploded.)

However sincere the intent that they should be temporary, the emergency interventions inevitably build up economic and political constituencies who profit from them and want them continued indefinitely. The difficulty of winding them back down, once they have become established, I call the Cincinnatian Problem. There is no easy answer to the problem. How, so to speak, do you get the Federal Reserve to go back to its farm, once it has enjoyed becoming the dominant mortgage investor in the world?

In the 1960s, the Congress pushed the Federal Reserve to support the housing market by buying the debt issues (not mortgages) of Fannie Mae and other federal agencies involved with housing. The Federal Reserve of the time resisted. Fed Chairman William McChesney Martin testified that such an idea would “violate a fundamental principle of sound monetary policy in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

That seems to me exactly the right principle for normal times. In the last two crises, the Federal Reserve has decided to do precisely the opposite, that is “to use the credit-creating powers of the central bank to subsidize” a particularly political sector of the economy, namely housing finance. When the crises are over, and the interventions have become huge distortions, what next? Can we now even imagine a Federal Reserve which owns zero mortgages? At this point, can the Federal Reserve itself imagine that?

“Tapering”

In November 2021, the Federal Reserve belatedly announced it would begin to “taper” its purchases of mortgages (as well as of Treasury debt) and in December announced further that it would “taper” more quickly. This still means with ongoing, unabated inflation in house prices, the Federal Reserve is going to continue buying mortgages – only it will buy less than before. It will reduce the rate at which it increases its mortgage portfolio.

Specifically, the Federal Reserve had been buying enough mortgages to make its portfolio go up by $40 billion a month, after replacing all principal repayments and prepayments. Now the net increase will be reduced by $10 billion a month. If it proceeds at this rate, the Federal Reserve will add $60 billion to its mortgage portfolio over three months before getting to a zero net addition. What happens then? Will it keep buying to maintain the size of its massive portfolio? Will it let the portfolio run off? – which would take a long time, perhaps lasting to the next financial crisis. Will it ever sell a single mortgage security? I believe nobody knows, including the Federal Reserve.

Our closing questions on the outlook are: If the Federal Reserve stops being the Big Bid for mortgages, how much higher will mortgage interest rates go from their present abnormally low level? When the mortgage rates rise, how quickly will the house price inflation end? Will it reverse? How will the Federal Reserve, and the country, address their Cincinnatian Problem?

William Isaac Announcements: December 23, 2021

From William Isaac’s email campaign and website:

December 23, 2021

Alex Pollock and Ed Pinto, two long-time friends of mine, who are THE leading experts on government housing programs, have written an important article on the past, present and future of government housing programs. I encourage you to read their new article on my website.

• Federal Housing Regulators Have Learned and Forgotten Everything by Alex J. Pollock and Edward J. Pinto

The full article can be found at williamisaac.com. Be safe and be well.

Biden's approval is down. Student debt forgiveness won't help.

Published in The Week.

There's a strong case for helping these Americans, who bear the costs of higher education but enjoy none of the benefits — and for making universities risk their own money on the financial trajectory of their students. But concentrating benefits on an already successful group is a slap in the face to precisely the non-professional, older, and more rural voters whom Democrats need to court.

Read the full piece here.

Federal Housing Regulators Have Learned and Forgotten Everything

Published in Law & Liberty and in Real Clear Markets.

Should the government subsidize buying houses that cost $1.2 million? The answer is obviously no. But the government is going to do it anyway through Fannie Mae and Freddie Mac. The Federal Housing Finance Authority (FHFA) has just increased the size of mortgage loans Fannie and Freddie can buy (the “conforming loan limit”) to $970,080 in “high cost areas.” With a 20% down payment, that means loans for the purchase of houses with a price up to $1,212,600.

Similarly, the Federal Housing Administration (FHA) will be subsidizing houses costing up to $1,011,250. That’s the house price with a FHA mortgage at its increased “high cost” limit of $970,800 and a 4% down payment.

The regular Fannie and Freddie loan limit will become $647,200, which with a 20% down payment means a house costing $809,000. The median U.S. price sold in June 2021 was $310,000. A house selling for $809,000 is in the top 7% in the country. One selling for $1,212,600 is in the top 3%. To take North Carolina for example, where house prices are less exaggerated, an $809,000 house is in the top 2%. For FHA loans, the regular limit will become $420,680, or a house costing over $438,000 with a 4% down payment—41% above the national median sales price.

Average citizens who own ordinary houses may think it makes no sense for the government to support people who buy, lenders that lend on, and builders that build such high-priced houses, not to mention the Wall Street firms that deal in the resulting government-backed mortgage securities. They’re right.

Fannie and Freddie, which continue to enjoy an effective guarantee from the U.S. Treasury, will now be putting the taxpayers on the hook for the risks of financing these houses. Through clever financial lawyering, it’s not legally a guarantee, but everyone involved knows it really is a guarantee, and the taxpayers really are on the hook for Fannie and Freddie, whose massive $7 trillion in assets have only 1% capital to back them. FHA, which is fully guaranteed by the Treasury, has in addition well over a trillion dollars in loans it has insured.

By pushing more government-sponsored loans, Fannie, Freddie, its government conservator, the FHFA, and sister agency, the FHA, are feeding the already runaway house price inflation. House prices are now 48% over their 2006 Housing Bubble peak. In October, they were up 15.8% from the year before. As the government helps push house prices up, houses grow less and less affordable for new families, and low-income families in particular, who are trying to climb onto the rungs of the homeownership ladder.

As distinguished housing economist Ernest Fisher pointed out in 1975:

[T]he tendency for costs and prices to absorb the amounts made available to prospective purchasers or renters has plagued government programs since…1934. Close examination of these tendencies indicates that promises of extending the loan-to-value ratio of the mortgage and extending its term so as to make home purchase ‘possible for lower income prospective purchasers’ may bring greater profits and wages to builders, building suppliers, and building labor rather than assisting lower-income households.

The reason the FHFA is raising the Fannie and Freddie loan-size limits by 18%, is that its House Price Index is up 18% over the last year. FHA’s limit automatically goes up in lock step with these changes. These increases are procyclical acts. They feed the house price increases, rather than acting to moderate them, as a countercyclical policy would do. Procyclical government policies by definition make financial cycles worse and hurt low-income families, the originally intended beneficiaries.

The contrasting countercyclical objective was memorably expressed by William McChesney Martin, the longest-serving Chairman of the Federal Reserve Board. In office from 1951 to 1970, under five U.S. presidents, Martin gave us the most famous of all central banking metaphors. The Federal Reserve, he said in 1955, “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Long after the current housing price party has gotten not only warmed up, but positively tipsy, the Federal Reserve of 2021 has, instead of removing the punch bowl, been spiking the punch. It has done this by, in addition to keeping short term rates at historically low levels, buying hundreds of billions of dollars of mortgage securities, thus keeping mortgage rates abnormally low, and continuing to heat up the party further.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more.

In fact, the government has been spiking the housing party punch in three ways. First is the Federal Reserve’s purchases of mortgage securities, which have bloated its mortgage portfolio to a massive $2.6 trillion, or about 24% of all U.S. residential mortgages outstanding.

Second, the government through Fannie and Freddie runs up the leverage in the housing finance system, making it riskier. This is true of both leverage of income and leverage of the asset price. It is also true of FHA lending. Graph 1 shows how Fannie and Freddie’s large loans have a much higher proportion of high debt-to-income (DTI) ratios than large private sector loans do. In other words, Fannie and Freddie tend to lend more against income, a key risk factor.

Graph 1: Percent of loans over 43% DTI ratio

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Fannie and Freddie also make a greater proportion of large loans with low down payments, or high loan-to-value (LTV) ratios, than do corresponding private markets. Graph 2 shows the percent of their large loans with LTVs of 90% or more—that is, with down payments of 10% or less—another key risk factor.

Graph 2:  Share of loans with LTV ratios over 90%

Source: Fisher, Lynn M., et al. “Jumbo rates below conforming rates: When did this happen and why?.” Real Estate Economics 49.S2 (2021): 461-489.

Now—on top of all that– the FHFA, by upping the loan sizes for Fannie and Freddie, is bringing to the party a bigger punch bowl. That the size limit for Fannie and Freddie is very important in mortgage loan behavior, we can see from how their large loans bunch right at the limit, as shown by Graph 3.

The third spiking of the house price punch bowl consists of the government’s huge payments and subsidies in reaction to the pandemic. A portion of this poorly targeted deficit spending money made its way into housing markets to bid up prices.

A key housing finance issue is the differential impact of house price inflation on lower-income households. AEI Housing Center research has demonstrated how the spiked punch bowl has inflated the cost of lower-priced houses more than others. This research shows that rapid price increases crowd out low-income potential home buyers in housing markets. Thus, as Ernest Fisher observed nearly 50 years ago, government policies that make for rapid house price inflation constrain the ability to become homeowners of the very group the government professes to help.

In general, what a robust housing finance system needs is less government subsidy and distortion, not more. The question of upping the size of Fannie and Freddie loans, and correspondingly those of the FHA, is part of a larger picture of what the overall policy for them should be. Should we favor making their subsidized, market distorting, taxpayer guaranteed activities even bigger than the combined $8 trillion they are already?  Should they become even more dominant than they are now?  Or should the government’s dominance of the sector and its risk be systematically reduced?  That would be a movement toward a mortgage sector that is more like a market and less like a political machine.

In short, what about the future of the government mortgage complex, especially Fannie and Freddie: Should they be even bigger or smaller?  We vote for smaller.

How might this be done? As a good example, Senator Patrick Toomey, the Ranking Member of the Senate Banking Committee, has introduced a bill that would eliminate Fannie and Freddie’s ability to subsidize loans on investment properties, a very apt proposal. It will not advance with the current configuration of the Congress, but it’s the right idea. Similarly, it would make sense to stop Fannie and Freddie from subsidizing cash-out refis, mortgages that increase the debt on the house. Another basic idea, often proposed historically, but of course never implemented, would be to reduce, not increase, the maximum size of the loans Fannie and Freddie can buy, and by extension, FHA can insure.

In the meantime, the house price party rolls on. How will it end after all the spiked punch?  Doubtless with a hangover.

Alex J. Pollock is a senior fellow at the Mises Institute and the author of Finance and Philosophy: Why We're Always Surprised. His five decades of financial experience include being the Principal Deputy Director of the U.S. Treasury’s Office of Financial Research and the president and CEO of the Federal Home Loan Bank of Chicago.

MORE BY THIS AUTHOR

Edward J. Pinto is an American Enterprise Institute (AEI) senior fellow and director of AEI’s Housing Center. The Center monitors the US markets using a unique set of Housing Market Indicators. Active in housing finance for over 40 years, he was an executive vice president and chief credit officer for Fannie Mae until the late 1980s.

MORE BY THIS AUTHOR

The Mystery of Banking

The bank has ten billion this year,

But the money is surely not here—

It’s been quite lent away,

Pending some future day,

So it’s only a promise , that’s clear.

Is it borrowers then with their share

Who have the bank’s money to spare?

Nope!  They’ve spent it all,

To get profits next fall,

So the money is clearly not there.

One may begin wondering where

Is this something not here and not there—

There’s a ten billion list,

But does money exist?

Such thoughts only lead to despair.

                             Alex J. Pollock, c. 1970

Waltzing

For your light feet and graceful steps

I offer praise and thanks,

I’d rather dance a waltz with you

Than own a hundred banks.

Sonnet

Since we will vanish, oh my one, my own,

Together with the burnt out candle’s flame,

And nothing, nothing, meriting the name

Of You or Me remain, though bright we’ve shown;

Since too no verses, certainly not mine,

Can hold the light or stand against the dark,

No lines recall a glow, no rhymes a spark,

And this is true, although you are divine—

Divine, I say, I also (if with scars),

Two miracles of thought, will, passion, breath,

But since stone blind to miracles is death,

Who snuffs as well as spirits, worlds and stars,

Therefore love me while we burn and be—

Thus purest logic, truest poetry.

Lines on Holbein’s “Dance of Death”

He stalks unseen through all our days,

While puffing self-importance, we

Tote up our wealth, dine richly fed,

Make speeches.  He, all mockery.

Sniggers as our flesh betrays.

We push from thought the end we dread,

He waits and grins in parody.

April in Chicago

The zephyrs turned to gusts and chills,

It’s snowing on the daffodils!

Too cold for any vernal fling,

Rough winds do shake Chicago’s spring.

Lines While Riding the Chicago L

Oh, you cannot make a poem out of riding on the L train,

Though you’re clever, Alexander, so my Muses will explain,

It’s for certain not a pleasure—it’s too boring to be pain,

It’s only jerky, crowded, noisy and obnoxiously mundane!

Moonbeams Needed

The daily tasks that never end,

Cling like cobwebs to our minds,

Entangle in a thousand strands

Our souls in lilliputian binds.

They hide the essence from our view,

Intruding even in our dreams,

We must escape! And freely rise,

Like Cyrano, upon moonbeams.

Social Distinction

“I think that I think,

And feel that I feel,

But,” sighed the philosopher,

“What’s really real?”

With eyebrows raised

Behind her mask,

Dame Nature sniffed,

“Who is he to ask?”

Herrick

Robert Herrick, cavalier free,

And ever perfect metrically,

Your loves were bold,

Your verse controlled.

In poetry a mistress’ knee

Can be a subject properly,

      If every rhyme

Arrives on time.

You were immoral we can see,

But still immoral gallantly—

Your sin? An ounce.

It’s style that counts!

Variation on Pope

Radiation wandered blind across the endless night,

God made the Eye, and there was light.

Liquidity

(with apologies to Shakespeare)

Tell me, where’s Liquidity bred,

In the world or in your head?

How begot, how nourish’ed?

      It’s in your mind and eye.

But when the FED so great and fair

Starts printing by the trillions there,

You know Big Brother’s taking care

      And you go out and buy!

Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion

Posted in Audio Mises Wire.

After thirteen years with on average negative real returns to conservative savings, it is time to require the Federal Reserve to address its impact on savers.

Click here to listen.

No, the United States Has Not Always Paid Its Debts

Published in Reason:

In 1934, Roosevelt officially devalued the dollar by increasing the price of gold from $20.67 to $35. Although contemporary press accounts characterized the government's actions as an abrogation (see the Wall Street Journal on May 4, 1933), Treasury securities issued in June and August 1933 were oversubscribed and a February 1935 Supreme Court decision upheld the government's actions. While these actions are generally portrayed today as an attempt to halt gold hoarding or end price deflation, they also appear to have had a fiscal motivation. In fiscal year 1933, the ratio of interest expense to federal revenues reached 33.15 percent, the only time this ratio has exceeded 30 percent since the post-Civil War era. The Roosevelt administration needed more funds to implement New Deal programs and wanted the flexibility to issue new Treasury securities unimpeded by gold convertibility.

An Incredibly Misguided Nomination for Comptroller of the Currency

Published in Real Clear Markets:

The Biden administration has certainly made the most misguided nomination for Comptroller of the Currency in history with its nominee, Saule Omarova. Professor Omarova has published proposals displaying deep ideological commitments which make her obviously unacceptable for this key responsibility in the banking system. Even after this has become apparent, the Biden administration has very surprisingly not withdrawn her name and a Senate Banking Committee hearing on the nomination has been scheduled for this week, November 18.

Concerning this hearing, every Democratic senator on the Banking Committee should be asked in public:

- Do you subscribe to the proposals published by Professor Omarova?  

- Do you support taking all deposits away from private banks?   

- Do you support making the Federal Reserve in charge of "economy-wide credit allocation"? 

- Do you support making the Federal Reserve a deposit monopoly?  

- Do you support having the New York Federal Reserve Bank short investments it [somehow] decides are too expensive and buy to boost the price of investments it [somehow] decides are too cheap?  

- Do you support giving the government seats on privately owned companies' boards of directors, with the government having "disproportionate voting power"?  

All these remarkably unwise and naive proposals are explicitly made in her published articles.

Honorable Senators:  If you support these proposals, you should stand up and say so out loud, so everybody can hear you.  If you don't support them, you should obviously vote No on this nomination.