A Look Into the Fed's Role In the Mortgage Market

Published in RealClear Markets:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse. 

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy.  Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages.  This caused severe rationing of mortgage loans.  The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems. 

In the 1970s, the Fed unleashed the “Great Inflation.”   Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%. 

This meant the mortgage-specialist savings and loans were crushed in the 1980s.  With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-to-market basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios.  So did Fannie Mae.  More than 1,300 thrift institutions failed.  The government’s deposit insurance fund for savings and loans also went broke.  The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen.  Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991.  Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom.  This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro”—until he wasn’t.  For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century.  It began deflating in 2007 and turned into a mighty crash—setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years.  The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022.  It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgage-backed securities.  As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds.  This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans.  The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century. 

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher—to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world.  It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%.  That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates.  The Fed also began letting its long-term bond and mortgage portfolio roll off.  U.S. 30-year mortgage interest rates increased to over 7%.  That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers.  A lot of people, including me, thought this would cause house prices to fall significantly. 

We were surprised again.  Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023.  Then they started back up, and have so far risen about 6%, up to a new all-time peak.  Over the last year, Case Shiller reports an average 3.9% increase.  Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7%--slightly ahead of inflation.  How is that possible when higher mortgage rates have made houses so much less affordable? 

Of course, not all prices have gone up.  San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks.  The median U.S. house price index of the National Association of Realtors is down 5% from June 2022.  The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% year-over-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses.  (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010.  They are “on track for their worst performance since 1992,” Reuters reported. The lack of mortgage volume has put the mortgage banking industry into its own sharp recession.  So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell-- highly interesting bifurcated effects.  The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply.  A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses.  It has the simple problem of an old-fashioned savings and loan:  its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments.  As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity.  The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money—so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion.  Since September 2022, it has racked up more than $122 billion in losses.  It is certain that the losses will continue.  These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency.  Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio.  On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities.  A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion.  This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

Central Banks and Housing Finance

Published in Housing Finance International Journal:

Although manipulating housing finance is not among the Federal Reserve’s statutory objectives, the U.S. central bank has long been an essential factor in the behavior of mortgage markets, for better or worse, often for worse.

In 1969, for example, the Fed created a severe credit crunch in housing finance by its interest rate policy. Its higher interest rates, combined with the then-ceiling on deposit interest rates, cut off the flow of deposits to savings and loans, and thus in those days the availability of residential mortgages. This caused severe rationing of mortgage loans. The political result was the Emergency Home Finance Act of 1970 that created Freddie Mac, which with Fannie Mae, became in time the dominating duopoly of the American mortgage market, leading to future problems.

In the 1970s, the Fed unleashed the “Great Inflation.” Finally, to stop the runaway inflation, the now legendary, but then highly controversial Fed Chairman, Paul Volcker, drove interest rates to previously unimaginable highs, with one-year Treasury bills yielding over 16% in 1981 and 30-year mortgage rates rising to 18%.

This meant the mortgage-specialist savings and loans were crushed in the 1980s. With their mandatory focus on long-term, fixed rate mortgages, the savings and loan industry as a whole became deeply insolvent on a mark-tomarket basis, and experienced huge operating losses as its cost of funding exceeded the yields on its old mortgage portfolios. So did Fannie Mae. More than 1,300 thrift institutions failed. The government’s deposit insurance fund for savings and loans also went broke. The political result was the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which provided a taxpayer bailout and, it was proclaimed, would solve the crisis so it would “never again” happen. Similar hopes were entertained for the Federal Deposit Insurance Corporation Improvement Act of 1991. Of course, future financial crises happened again anyway.

In the early 2000s, faced with the recessionary effects of the bursting of the tech stock bubble, the Fed decided to promote an offsetting housing boom. This I call the “Greenspan Gamble,” after Alan Greenspan, the Fed Chairman of the time, who was famed as a financial mastermind of the “Great Moderation” and as “The Maestro” – until he wasn’t. For the boom, fueled by multiple central bank, government and private mistakes, became the first great housing bubble of the 21st century. It began deflating in 2007 and turned into a mighty crash – setting off what became known as the “Global Financial Crisis” and the “Great Recession.” Fannie Mae and Freddie Mac both ended up in government conservatorship. U.S. house prices fell for six years. The political result was the Dodd-Frank Act of 2010, which engendered thousands of pages of new regulations, but failed to prevent the renewed buildup, in time, of systemic interest rate risk.

Faced with the 2007-09 crisis, the Federal Reserve pushed short term interest rates to near zero and kept them abnormally low from 2008 to 2022. It also pushed down long-term interest rates by heavy buying of long-term U.S. Treasury bonds, and in a radical and unprecedented move, buying mortgagebacked securities. As the Fed kept up this buying for more than a decade, it became by far the largest owner of mortgages in the country, with its mortgage portfolio reaching $2.7 trillion, in addition to its $5 trillion in Treasury notes and bonds. This remarkable balance sheet expansion forced mortgage loan interest rates to record low levels of under 3% for 30-year fixed rate loans. The central bank thus set off and was itself the biggest single funder of the second great U.S. housing bubble of the 21st century.

In this second housing bubble, average house prices soared at annualized rates of up to 20%, and the S&P CoreLogic Case-Shiller National House Price Index (Case-Shiller), which peaked in the first housing bubble in 2006 at 185, rose far higher – to 308 in June 2022, or 67% over the peak of the previous bubble.

The Fed financed its fixed rate mortgage and bond investments with floating rate liabilities, making itself functionally into the all-time biggest savings and loan in the world. It created for itself enormous interest rate risk, just as the savings and loans had, but while the savings and loans were forced into it by regulation, the extreme riskiness of the Fed’s balance sheet was purely its own decision, never submitted to the legislature for approval.

Confronted with renewed runaway inflation in 2021 and 2022, the Fed pushed up short-term interest rates to over 5%. That seemed high when compared to almost zero, but is in fact a historically normal level of interest rates. The Fed also began letting its long-term bond and mortgage portfolio roll off. U.S. 30-year mortgage interest rates increased to over 7%. That is in line with the 50-year historical average, but was a lot higher than 3% and meant big increases in monthly payments for new mortgage borrowers. A lot of people, including me, thought this would cause house prices to fall significantly.

We were surprised again. Average U.S. house prices did begin to fall in mid-2022, and went down about 5%, according to the Case-Shiller Index, through January 2023. Then they started back up, and have so far risen about 6%, up to a new all-time peak. Over the last year, Case Shiller reports an average 3.9% increase. Compared to consumer price inflation of 3.2% during this period, this gives a real average house price increase of 0.7% – slightly ahead of inflation. How is that possible when higher mortgage rates have made houses so much less affordable?

Of course, not all prices have gone up. San Francisco’s house prices are down 11% and Seattle’s are down 10% from their 2022 peaks. The median U.S. house price index of the National Association of Realtors is down 5% from June 2022. The median price of a new house (as contrasted with the sale of an existing house) fell by over 17% yearover-year in October, according to the U.S. Census Bureau, and home builders are frequently offering reduced mortgage rates and other incentives, effectively additional price reductions, in addition to providing smaller houses. (Across the border to the north, with a different central bank but a similar rise in interest rates, the Home Price Index of the Canadian Real Estate Association is down over 15% from its March 2022 peak.)

The most salient point, however, is that the volume of U.S. house purchases and accompanying mortgages has dropped dramatically. Purchases of existing houses dropped over 14% year-over-year in October, to the lowest level since 2010. They are “on track for their worst performance since 1992,” Reuters reported.1 The lack of mortgage volume has put the mortgage banking industry into its own sharp recession. So, the much higher interest rates are indeed affecting buyers, but principally by a sharply reduced volume of home sales, not by falling prices on the houses that do sell – highly interesting bifurcated effects. The most common explanation offered for this unexpected result is that home owners with the exceptionally advantageous 3% long-term mortgages don’t want to give them up, so they keep their houses off the market, thus restricting supply. A 3% 30-year mortgage in a 7% market is a highly valuable liability to the borrower, but there is no way to realize the profit except by keeping the house.

As for the Federal Reserve itself, as interest rates have risen, it is experiencing enormous losses. It has the simple problem of an old-fashioned savings and loan: its cost of funding far exceeds the yield on its giant portfolio of long-term fixed rate investments. As of November 2023, the Fed still owns close to $2.5 trillion in very long-term mortgage securities and $4.1 trillion in Treasury notes and bonds, with in total over $3.9 trillion in investments having more than ten years left to maturity. The average combined yield on the Fed’s investments is about 2%, while the Fed’s cost of deposits and borrowings is over 5%.

Investing at 2% while borrowing at 5% is unlikely to make money – so for 11 months year to date in 2023 the Fed has a colossal net operating loss of $104 billion. Since September 2022, it has racked up more than $122 billion in losses. It is certain that the losses will continue. These are real cash losses to the government and the taxpayers, which under proper accounting would result in the Fed reporting negative capital or technical insolvency. Such huge losses for the Fed would previously have been thought impossible.

When it comes to the mark-to-market of its investments, as of September 30, 2023, the Fed had a market value loss of $507 billion on its mortgage portfolio. On top of this, it had a loss of $795 billion on its Treasuries portfolio, for the staggering total mark-to-market loss of $1.3 trillion, or 30 times its stated capital of $43 billion.2

While building this losing risk structure, the Fed acted as Pied Piper to the banking industry, which followed it into massive interest rate risk, especially with investments in long-term mortgage securities and mortgage loans, funded with short-term liabilities. A bottoms-up, detailed analysis of the entire banking industry by my colleague, Paul Kupiec, has revealed that the total unrecognized market value loss in the U.S. banking system is about $1.27 trillion.3

If we add the Fed and the banks together as a combined system, the total mark-to-market loss- a substantial portion of it due to losses on that special American instrument, the 30-year fixed rate mortgage- is over $2.5 trillion. This is a shocking number that nobody forecast.

We can be assured that the profound effects of central banks on housing finance will continue with results as surprising to future financial actors as they have been to us and previous generations.

_______________

1 “Home sales fell to a 13-year low in October as prices rose,” Reuters, November 21 2023.

2 Federal Reserve financial data is taken from the weekly Federal Reserve H.4.1 Release, and from the Federal Reserve Banks Combined Quarterly Financial Report as of September 30 2023.

3 Paul Kupiec, “Forget Climate Change and NBFIs, the Biggest Systemic Risk are the Unrealized Losses in the Banking System,” American Enterprise Institute, November 2023, and personal correspondence with the author.

Time for colleges to pay, Dem ‘swells’ ‘blinded by privilege’ and other commentary

Published in the New York Post:

Ed desk: Time for Colleges to Pay

“It’s time that the cost of nonpayment of student loans be shared” by “colleges and universities themselves,” argue Arthur Herman and Alex J. Pollock at The Hill. Schools now “get and spend billions in borrowed money and put all the loan risk on somebody else,” which “incentivizes them to push” costs “ever higher — by an average of 169 percent since 1980.” We need a “model that realigns incentives and rewards,” and “the first principle should be that the more affluent the college is, the higher its participation in the losses should be.” Joe Biden has shifted $132 billion “of student debt from borrowers to taxpayers.” “It’s high time to give the rest of us a Christmas present of a new model for government student loans.”

It’s time for universities to share the burden of student loan defaults

Published with Arthur Herman in The Hill.

While the nation is rightly worried about the proliferation of antisemitism on its college campuses, another higher education abuse also needs prompt attention.

On Dec. 6 – St. Nicholas Day – President Biden handed student loan defaulters another $5 billion gift in debt forgiveness. The administration’s eagerness to win the votes of student loan borrowers by shifting the cost of student debt from borrowers to taxpayers now adds up to $132 billion of student loans those borrowers will not have to pay — even though the Supreme Court ruled a related scheme unconstitutional last June.

But if borrowers don’t pay the debts they incurred and default on their debts, someone else has to pay. Right now, that someone else is American taxpayers. Now it’s time that the cost of nonpayment of student loans be shared by those who have benefitted the most directly from federal student loans: namely, the colleges and universities themselves.

By inducing their students to borrow from the government, higher education institutions collect vastly inflated tuition and fees, which they then spend without worrying about whether the loans will ever be repaid. This in turn incentivizes them to push the tuition and fees, and room and board, ever higher — by an average of 169 percent since 1980, according to a Georgetown University study.

In short, in the current system the colleges get and spend billions in borrowed money and put all the loan risk on somebody else — including those student borrowers who responsibly pay off their own debt and those who never borrowed in the first place, not to mention taxpayers, whether they attended a college or not.

This perverse pattern of incentives and rewards must stop. A more equitable model would insist that colleges have serious “skin in the game.” It would insist that they participate to some degree in the losses from defaulted and forgiven loans to their own students.

This idea has been thoughtfully discussed and proposed in Congress before, but now is the time to implement a model that realigns incentives and rewards in our national student loan system and distributes the burden of risk more equitably.

The first principle should be that the more affluent the college is, the higher its participation in the losses should be. The wealthiest colleges with massive endowments should be covering 100 percent of any losses on federal loans to their students, which they can easily afford. Others can cover a lower, but still significant, percentage, but every college that finances itself with federal student loans should assume some real cost when its students default on their loans. Four million student loans enter default each year, not counting the Biden scheme for student loan “forgiveness,” which creates even more losses.

Specifically, we propose the following “skin in the game” requirements for colleges on losses from federal student loans to their students, based on their endowment size:

Endowment Size     Cumulative Rank in Endowments   Coverage of Losses

Over $10 billion                           Top 0.6%                                          100%

$5 billion to $10 billion                Top 1.1%                                            80%

$3 billion to $5 billion                  Top 1.7%                                            60%     

$2 billion to $3 billion                  Top 2.6%                                            40%

All others                                         100%                                            20%

Any fair observer would have to conclude that this represents a rational and efficient matching of benefits and costs.

Moreover, we propose that the most affluent colleges that participate in federal student loans, such as Harvard, Yale and Stanford, should contribute to a “Trust to Offset Losses from Federal Student Loans” through an excise tax on their endowments — some of which are larger than the GDP of sovereign countries. 

This tax would apply to only about the top 1 percent or 2 percent of college endowments. The trust would then be used to offset some of the remaining losses the less affluent colleges cannot pay, thus sharing the wealth of the top 1 percent or 2 percent to help others in need.

For the excise tax to fund the Trust to Offset Losses, we propose:

Endowment Size           Cumulative Rank In Endowments          Tax Rate                     

Over $5 billion                             Top 1.1%                               1% per annum

$2.5 to $5 billion                          Top 2%                                   0.5% per annum

It seems only fair that the wealthiest colleges be asked to contribute to cover the student loan losses the Biden administration is sticking taxpayers with. After all, they benefited the most from the Great Tuition Bubble since the 1980s, just as subprime mortgage brokers benefited in the Great Housing Bubble in the early 2000s.

Since Biden’s St Nicholas Day gift to student borrowers simultaneously gave a large lump of coal to the taxpaying public, not to mention to those borrowers who made every sacrifice to meet their loan obligations, it’s high time to give the rest of us a Christmas present of a new model for government student loans. The proper model should be one that will keep on giving as colleges and universities take on the responsibility and accountability they have shirked until now.

Letter: Bitcoin loses its lustre next to gold bullion

Published in the Financial Times.

Your editorial, “Bitcoin’s bounceback déjà vu” (FT View, December 6), is oh so right that bitcoin “has no intrinsic value, nor is it backed by anything” and is different from gold. Indeed, a mere electronic accounting entry like a bitcoin is utterly unlike a gold coin — the gold coin being a notable piece of physical reality, not dependent on anybody’s accounting system to exist. Yet at the top of your page one of December 5, illustrating your story, “Bets on cuts boost bitcoin”, you misleadingly depict bitcoin precisely as a large gold coin stamped with a “B.” This silly illustration promotes the fallacy that bitcoin is like a gold coin and flatly contradicts the sound and sensible statements of your editorial.

I suggest that FT policy should eliminate depicting bitcoin as a gold coin. Of course, it is difficult to illustrate bitcoin as the mere electronic accounting entry it is, but you should try to reflect the reality.

Alex J Pollock Senior Fellow, Mises Institute,

Lake Forest, IL, US

The Federal Reserve Is Running Losses. Does This Cost Anyone Anything?

Published in Zero Hedge.

The debate has raged in the banking and finance communities. Two investigators, Paul Kupiec at the American Enterprise Institute and Alex Pollock at the Mises Institute, have analyzed Fed financial statements and presented their findings about these Fed losses in publications such as the Wall Street Journal and on the websites of the American Enterprise Institute, the Mises Institute, the Federalist Society, and Law and Liberty. The Wall Street Journal has produced a nontechnical video explaining how the Fed makes (and loses) money.

…

Kupiec and Pollock responded with a letter to the editor of the Wall Street Journal to reiterate their earlier conclusions that American taxpayers will ultimately bear the cost of the Fed’s losses. When asked by email how he can justify his claim that no one, including taxpayers, actually bears the cost of the Fed’s losses, Professor Furman responded as follows:

The Fed’s losses do lead to higher debt. And its gains to lower debt. On net it has reduced the debt. But it is a public entity and we didn’t assign it the job of maximizing profits—and for good reason—we should leave that to the private sector. Instead we assigned it macroeconomic goals which it has done well at times and done badly at other times—like in not responding fast enough to inflation in 2021.

Common Fallacies in the 2023 Debt-Ceiling Debates

Published in the Mises Institute’s Quarterly Journal of Austrian Economics.

Abstract: This article investigates the veracity of three claims made by current and former government officials in the context of the 2023 debt-ceiling debates: it would be unconstitutional to enforce the debt ceiling; the U.S. government has never defaulted; and there are no measures that could be taken to avoid a government default except raising the debt limit. None of these claims is true.

As Congress and the Biden administration carried out the combative negotiations that led to the passage of the Fiscal Responsibility Act of 2023 (H.R. 3746), the news media was replete with stories and opinion pieces about the debt-ceiling debates. Many of these repeated claims made by administration officials and surrogates were designed to promote a political narrative. Such claims included the following: it is unconstitutional for the United States to default on its debt (Blinder 2023); the U.S. has never defaulted on its debt (Biden 2023); there are no additional measures that can be taken to prevent default (Janet Yellen, quoted in Condon and Hordern 2023); and finally, the sole solution to averting a debt crisis is to raise the debt ceiling (Powell 2023). This article will analyze these claims and explain why they are exaggerations, if not demonstrably untrue.

Read the full paper here.

Video: How to Reform the Fed

Speech from the Mises Institute 2023 Supporters Summit. Watch the video here:

How Can It Be That a ‘Thief in the Night’ Is Loosed by the Federal Reserve Under the Nose of a Passive Congress?

And what would it mean if Congress were active in the decisions?

Published in The New York Sun and also the Federalist Society.

The Federal Reserve is a problem for the constitutional order of our republic. How can it be that the central bank considers itself able to unilaterally impose permanent inflation on the country, without legislative debate or approval?

The shifting theories believed by central banks are among the most important of macro-economic factors. The chairman of the Federal Reserve Board between 1951 and 1970, William McChesney Martin, characterized inflation as “a thief in the night.” 

In remarkable contrast, the Fed under Ben Bernanke, chairman between 2006 and 2014, explicitly committed itself and the country to inflation forever at the rate of 2 percent a year, thus assuming that constant inflation should not only be taken for granted, but pursued. 

If the purchasing power of the currency continuously depreciates at the rate of two percent per year, as the Fed now promises, in the course of a single lifetime, average prices would quintuple. At three percent, as is sometimes suggested, prices in a lifetime would multiply by ten times. At four percent, they would multiply by 23 times.

Is this the kind of money the American people want? I don’t think so. Congress did acquiesce in the 1970s to the executive move to fiat money, untied to gold, as previously required by the Bretton Woods agreement, and later removed legislative ties of the dollar to gold. 

That’s the kind of money wanted by those who long to expand government power and finance it by an unlegislated inflation tax. The Congress didn’t, though, call for, enact, or approve a policy of pursuing inflation per se.  It wrote into the Federal Reserve Reform Act of 1977 a requirement that a principal goal of the Fed is “stable prices.”

The nature of money and the stability of its value is an essential political and social question. William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” On the other hand, we may proclaim, “You shall not drown mankind in a flood of paper money.” Who gets to choose between inflationist money and sound money?

Not the Fed by itself. Coining money, and regulating the value thereof,  are questions profoundly requiring the Congress. They are specifically enumerated in the Constitution as among the powers granted, in Article One, Section Eight, to Congress.

The press is full of references to “the Fed’s” two percent inflation target. But if there is to be such a target, it should be “the country’s” target, not “the Fed’s” target. The Fed’s proposal to constantly depreciate the people’s money should have been presented to the elected representatives of the people for approval or rejection. It wasn’t.

How in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and depreciation of the currency at some rate of its own choosing? The only explanation I can think of is pure arrogance. 

Being the most powerful financial institution in the world and the purveyor of the dominant fiat currency might lead the Fed to an excessively high opinion of its own authority. At the same time, the Fed has crucial and dangerous inherent weaknesses.

It has demonstrated beyond question its inability to predict the financial and economic future. It can inflate disastrous asset price bubbles as well as consumer prices. It is unable to know what the results of its own actions will be.

This inability is notably shown by its own financial performance: a net loss of $111 billion since September 2022, as reported on October 19, tens of billions in net losses still to come, and a mark to market loss on its investments of more than $1 trillion.

Congress should, first and foremost, amend the Federal Reserve Act to make it clear that setting any “inflation target” requires review and approval by Congress, as a public choice between kinds of money. And make it clear that the Fed lacks  unilateral power to decide the nature of the money the Congress provides.

Congress should also cancel the two percent inflation target announced by the Fed, until the Congress has approved such an action or provided some other guidance — say, “stable prices” — a goal that is already stated in the Federal Reserve Act, but is being evaded.

Stable prices imply a long-run average inflation rate of approximately zero — in other words, a goal of sound money. All in all, we need to control the powerful and dangerous Federal Reserve by using the checks and balances of our constitutional republic.

Letter: Fed rates slogan should read: ‘Normal for longer’

Published in the Financial Times.

From Alex J Pollock, Senior Fellow, Mises Institute, Lake Forest, IL,

With your page one headline “Fed’s ‘higher for longer’ interest rate message weighs on stocks and bonds” (Report, September 28), the Financial Times joins the chorus of commentators singing a similar tune.

But interest rates are not particularly high — they are normal, historically speaking.

For example, in the half-century from 1960 to 2010, before a decade of suppression of interest rates to abnormal lows by the Federal Reserve and other central banks, the 10-year US Treasury note yielded more than 4 per cent, for 90 per cent of the time.

Interest rates only seem high because we got used to the abnormal lows.

So the right slogan now is not “higher for longer,” but “normal for longer”.

The Federal Reserve loses billions on mortgages

Published in Housing Finance International.

Can house prices achieve a soft landing?

The largest holder by far of residential mortgages in the United States, a country often supposed to favor private markets, is none other than the central bank, the Federal Reserve. The Fed owns the remarkable sum of $2.5 trillion (that’s “trillion” with a T) in mortgage-backed securities (MBS).[1] That is more than one-quarter of the entire federal agency residential MBS market, the dominant U.S. source of housing finance. The Fed has mainly invested this enormous amount in the typical American 30-year fixed rate, freely prepayable, mortgage, an instrument of notorious interest rate risk. This risk infamously sank the savings and loan industry in the 1980s, and in 2023 was a principal factor in sinking Silicon Valley Bank, the second largest bank failure in U.S. history at the time of its collapse.

In this Fed MBS investment program, the entire risk of the mortgage is absorbed by the government: the credit risk of the Fed’s MBS investments is taken by other government organizations (Fannie Mae, Freddie Mac, Ginnie Mae), but the Fed itself bears 100% of the interest rate risk. How has the Fed managed this risk as interest rates have dramatically risen since 2022? Not well.

Faced with the runaway inflation of 2021- 22, the Fed pushed short-term interest rates rapidly up from close to zero to 5 ½% after it belatedly stopped buying MBS. Interest rates on 30-year mortgage loans have more than doubled from less than 3% to more than 7%. The resulting mark-to market on the Fed’s MBS portfolio is a loss of $394 billion as of June 2023, or more than 9 times the Fed’s total capital of $42 billion. Striking numbers![2]

The Fed’s huge purchases of mortgage securities began as an emergency, “temporary” action in the crisis of 2008, accelerated again in the Covid financial crisis of 2020, and lasted longer than needed—until March 2022. These central bank purchases drove the interest rates on 30-year fixed rate mortgage loans down to under 3% in late 2020 and 2021-- as low as 2.7% in late 2020—not much return for a 30-year risk! —and the yields on MBS can run 1% or so lower than the mortgage loan rates. The Fed bought a lot of MBS at the bottom in MBS yields—that is, it bought a lot at the market top in MBS prices which its own buying created.

In a leveraged balance sheet like the Fed’s, mark to market losses move into operating results through negative interest spreads. The Fed now has a $2.5 trillion MBS portfolio yielding a little over 2%, which to finance, it pays its depositors and repurchase agreement lenders over 5%. So this massive investment is now running at an interest rate spread of about negative 3%.

One hardly needs to say that lending at 2% and borrowing at 5% is a losing proposition. The $2.5 trillion MBS investment at a negative 3% spread is costing the Fed (and the Treasury and the taxpayers) about $75 billion a year. When added together with the rest of the Fed’s operations, principally the profits from issuing currency and losses from investing in long-term Treasury securities, the Fed accumulated from September 2022 through the end of August 2023 net losses of the notable sum of $95 billion.[3]

The losses will clearly continue for the rest of 2023, by which time the Fed will have lost on operations about three times its capital, and on into the future if interest rates stay at their current historically normal levels. Since the Fed’s profits mostly go to the Treasury, its losses mean that the U.S. Treasury and the taxpayers also lose. The many banks which also bought MBS and hold fixed-rate mortgage loans acquired at 3%, also have very large mark-to-market losses and negative spreads on them. These banks, like the failed Silicon Valley Bank, could correctly claim that they were only doing the same thing the Federal Reserve was.

From the point of view of mortgage borrowers, those who borrowed at 3% or less for 30 years obviously got a great and very attractive deal. A current borrower at 7.2% has to pay 2.5 times as much in monthly interest to buy the same house at the same price as a lucky 2.7% borrower did. On a house in the median price range costing $400,000, that is $1,500 more a month. Naturally, this much more expensive mortgage financing puts a downward pressure on house prices, but it also gives former borrowers a strong motivation to stay in their current houses and keep them off the market, in order to preserve the large financial advantage of the great 30-year mortgage rate the Fed created.

The astronomical house price increases of the second great American house price bubble of the 21st century are over. National average house prices, according to the S&P CoreLogic Case-Shiller Index, fell 1.2% yearover-year in June 2023. Over the same period, U.S. consumer price inflation was 3%, so in inflation-adjusted (real) terms, house prices fell 4.2%. That is a far cry from the bubble’s annualized increases in nominal terms which reached 18% and more in 2021 and early 2022. However, U.S. house prices have not fallen as much as many, including me, expected.

Serious reductions in house prices have indeed occurred in overpriced cities in the U.S. West. These year-over-year decreases reported by Case-Shiller as of June 2023 include the following. In real terms, the drops are in double digits.

House Price Changes Year-Over-Year June 2023

| Nominal | Real

San Francisco | -9.7% | -12.7%

Seattle | -8.8% | -11.8%

Las Vegas | -8.2% | -11.2%

Phoenix | -7.5% | -10.5%

These drops are, however, from very high peaks, and prices in these areas remain historically high.

The two metropolitan areas with the largest price increases in the June Case-Shiller report are the Midwestern cities of Chicago, at +4.2%, and Cleveland, at +4.1%, being in real terms, 1.2% and 1.1%, respectively, which are similar to the long-term growth rate in real house prices.

The AEI Housing Center finds that in July 2023, national average house prices increased year-over year by 3.5%, or by +0.3% real, after falling year-over-year in real terms for eight months in a row. Can falling real prices becoming more or less flat make for a “soft landing” of U.S. average house prices? Maybe--considering that 7% is in a historically normal range of mortgage interest rates. It only seems so high to us because of the previous suppression of mortgage rates to abnormally low levels by the Fed.

Still, many observers wonder why U.S. house prices have not fallen more, given the large reduction in buying power for most people from the sharply increased cost of mortgage loans.

Two measures which have dropped like a rock are the volume of home sales and of mortgage originations. Sales of existing houses were down 40% in July 2023 compared to the pre-pandemic July 2019[4] . The volume of interest rate commitments for new mortgage loans is down about 30%- 40% from 2019, and the volume of mortgage refinancings (“refis” in U.S. parlance) simply to lower the interest rate, is correspondingly down 95%.[5] The mortgage banking and brokerage businesses are experiencing heavy stress and their own painful recession with the disappearance of business volumes. Their total staffs have been cut by 43,000 employees or about 11% over the last year.[6]

How can house prices stay high while sales volume shrivels?

One factor is that while sales of existing houses are way down, so is the inventory of houses being put up for sale. The July 2023 inventory of houses for sale was down 36% from July 2019, which helps support house prices.[7]

A popular and plausible theory is that this low inventory at least in part reflects the desire of the lucky mortgage borrowers at 3% or less to hang on to their great mortgages by simply staying in their current houses. As a typical article explains, “Borrowing costs have not had the expected effect of cooling house prices [because] most US homeowners…have in effect been trapped in their properties by [the] low rates.” So the Fed’s manipulation of mortgage interest rates to exceptionally low levels created an unexpected factor to later restrict the supply of houses for sale and help hold house prices up. In addition, when working from home, the borrowers don’t have to change houses to change jobs, which supports the ability to hang on to the old mortgage.

These factors help slow prepayments of 30-year mortgage loans, extend the duration of the Fed’s MBS portfolio, and increase the Fed’s mark-to-market and operating losses.

It doesn’t help right now, but as a long-term strategy the Federal Reserve needs to return the amount of MBS in its balance sheet to what it always was from its founding in 1913 to 2008--namely zero.

_________

1 Federal Reserve H.4.1 Release, August 31, 2023, Section 5.

2 Federal Reserve Banks Combined Quarterly Financial Report, June 30, 2023.

3 Federal Reserve H.4.1 Release, August 31, 2023, Section 6.

4 AEI Housing Center, Home Price Appreciation Index report, July 2023.

5 AEI Housing Center, Housing Market Indicators report, August 1, 2023.

6 “Nonbank mortgage jobs undergo a seasonal dip,” National Mortgage News, September 1, 2023.

7 AEI Housing Center, Home Price Appreciation Index report, July 2023.

8 “Investors keep close eye on US mortgage rates,” Financial Times, September 3, 2023.

Why the Fed’s Unprecedented Losses Matter

Published in The Wall Street Journal.

The Federal Reserve’s risky policy has backfired.

Mr. Furman excuses the Fed’s unprecedented losses, which have surpassed $100 billion on their way to $200 billion or more, suggesting taxpayers shouldn’t care. To the contrary, taxpayers should care that the Fed will spend, without authorization, $200 billion or more that will be added to their future taxes.

These Fed losses are the result of a radical and exceptionally risky Fed choice to build a balance sheet resembling a giant 1980s savings and loan. In the process, it stoked bubbles in bonds, stocks, houses and cryptocurrencies, in addition to inducing enormous interest-rate risk in the banking system. Those risks have now come home to roost.

Mr. Furman argues that the Fed’s negative capital position doesn’t matter. If so, why cook the books to avoid reporting it? The Fed books its cash losses as a “deferred asset” so that it can obscure its true negative capital position. The Fed changed its own previous accounting rules precisely so it could do so. We know what would happen if Citibank tried that.

Who authorized the Fed to take an enormous interest-rate bet, risking taxpayer money? Nobody but the Fed itself. Does “independence” give the Fed the right to spend hundreds of billions of taxpayer dollars without congressional approval? That question needs to be debated.

Alex J. Pollock and Paul H. Kupiec

Mises Institute and AEI

Lake Forest, Ill., and Washington

The Fed’s losses have passed $100 Billion: What’s next?

Published in The Hill and RealClear Markets.

There has just been a landmark event at the Federal Reserve: Its accumulated operating losses have passed $100 billion. This startling number, which would previously been thought impossible, was reported on Sept. 14, 2023, in the Fed’s H.4.1 Release.

It is essential to understand that these are not mark-to-market paper losses; they are real cash losses resulting from the Fed’s expenses being to this remarkable extent greater than all its revenue. These are equally losses to the U.S. Treasury and thus costs to the taxpayers; nonetheless the Fed keeps officially insisting that its losses don’t matter. (Meanwhile the Fed’s mark-to-market losses are more than $ 1 trillion in the most recent public report.)

The Fed started posting operating losses in September 2022, so it has taken only 12 months to produce this ocean of red ink. Looking forward, annualizing the year-to-date results suggests the Fed’s net loss for calendar year 2023 will be about $117 billion. 

We must add the $17 billion it lost in the last four months of 2022, so at the end of 2023, the accumulated losses of the Fed may be about $134 billion. That means the losses will have run through the Fed’s entire capital of $43 billion, plus another $91 billion, for losses of more than three times its capital. What comes next?

The losses will continue into 2024. As long as short-term interest rates stay at their current historically normal levels of around 5 percent (that is, if we have “normal for longer”), what the Fed has to pay on its deposits and borrowings will create a punishing negative spread against the Fed’s trillions of very long-term, low yielding investments. 

Since the Fed bought heavily at the top of the market and the bottom in yields, these investments yield on average only about 2 percent. It doesn’t take a Ph.D. in finance to see that lending at 2 percent while borrowing at 5 percent will not be a winner.

The Fed owns $5 trillion of Treasury securities, of which $4 trillion have more than one year left to run, $2.3 trillion more than five years and $1.5 trillion more than 10 years.  (One of its investments is in the Treasury 1.25 percent of 2050, for example.)  

The average yield on these Treasury securities is 1.96 percent, according to the most recent Fed Quarterly Financial Report. The Fed also owns $2.5 trillion of 30-year mortgage-backed securities (MBS), of which $2.4 trillion have remaining maturities of more than 10 years. 

The MBS have an average yield of 2.20 percent. Combined, that suggests an overall yield of 2.04 percent, which compares to a current funding cost of deposits and repurchase agreements of about 5.37 percent. Voila the Fed’s problem: A negative spread of more than 3 percent on investments with very low yields locked in for years to come. In short, the Fed made itself into a gigantic version of a 1980s savings & loan.

An estimate of the Fed’s running rate of losses in very rounded numbers is as follows.  It has $7.5 trillion of investments yielding 2 percent. Of this, $2.3 trillion are financed at zero interest cost by circulating dollar bills, so the Fed is making about $46 billion a year from its government-granted monopoly of currency issuance. There are about $5.2 trillion of remaining investments financed at a -3 percent spread for an annual loss of $156 billion. There are $9 billion in overhead expenses. The approximate annualized running rate is thus:

                           Profit from currency monopoly                        $46 billion

                           Loss on leveraged investments                        ($156 billion)

                           Operating expenses                                           (9 billion)

                           Net (Loss)                                                            ($119 billion)

By mid-2022, the Fed knew it had serious operating losses looming and published a projection of them. Its base case projection was for a peak cumulative loss of $60 billion — the reported $100 billion loss is already a lot more than that, let alone the $134 billion loss likely by the end of 2023. And the ultimate peak losses will be far greater still — if 2024 is anywhere near as bad as 2023, that alone takes it far over $200 billion. (The Fed also considered a remote, “tail risk event” of its mark to market losses reaching $1.1 trillion. With its current mark to market loss, the “tail risk event” has already happened.)

The Fed should regularly provide Congress updated calculations of the possible path of its future losses. From what has been reported so far, we know that to struggle back to break even, the Fed will have to wait what looks like years for its underwater investments to roll off, or short-term rates would have to fall a lot, or some combination of these. 

We might guess that, for example, it will take a runoff of $3 trillion of its long-term investments with a drop in short-term interest rates to 4 percent to get close to break even.

Failing that, and in the meantime, the Fed itself, the Treasury and the taxpayers will be suffering continuing huge losses. We will simultaneously be running an interesting test of the Fed’s claim that these losses don’t matter.

Reforming the Federal Reserve

Published in Law & Liberty.

The Federal Reserve creates and manipulates the dominant fiat currency of the world. It produces the inflation of its supply and the continuous depreciation of its purchasing power. It manipulates dollar interest rates and the cost of debt, makes elastic the availability of credit (especially during financial crises), finances the government, and monetizes federal deficits in amounts limited only by the statutory debt ceiling. It is often imagined to be “managing the economy,” although, in fact, no one can successfully do that. It is a central bank not only to the United States, but to the entire dollar-using world. In short, the Fed is the most powerful financial institution there is or ever has been. That such a power is concentrated in a single, unelected institution is a problem for the constitutional order of the American republic.

Equally fundamental is that the Fed is always subject to deep uncertainty. It has clearly demonstrated its inability (like everyone else’s) to predict the economic or financial future, and it is inherently unable to know what the results of its own actions will be. Its remarkable power combined with its inescapable lack of knowledge of the future makes it the most dangerous financial institution in the world. This is true no matter how intelligent or brilliant its officers may be, however good their intentions, however many hundreds of economists they hire, or however complex the computer models they build. 

At the famous Jackson Hole central banking conference in August 2023, Fed Chairman Jay Powell, with admirable candor, pointed out some essential uncertainties in the current Federal Reserve debates. “We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty” about monetary policy, which is “further complicated by uncertainty about the duration of the lags” with which the policy operates and the “changing dynamics [that] may or may not persist.” He continued, “These uncertainties, both old and new, complicate our task.” They certainly do, and this is true of the Fed’s monetary issues at all times.

Powell used an apt metaphor in this respect: “We are navigating by the stars under cloudy skies.” The President of the European Central Bank, Christine Lagarde, used a different metaphor: “There is no pre-existing playbook for the situation we are facing.” But the former Governor of the Bank of England, Mervyn King, in his book, The End of Alchemy, drew a blunter conclusion from it all: “If the future is unknowable, then we simply do not know and it is pointless to pretend otherwise.”

All this should increase our skepticism about how much independent power central banks should have, and whether there is a meaningful path for reform.

Uncertainty and Big Losses 

A good example of the results of uncertainty is the Fed’s own dismal financial performance and growing technical insolvency. The Federal Reserve made net losses of $105 billion as of September 27, 2023 since September 2022. That shocking number is getting rapidly bigger. The Fed continues to lose money at the rate of about $9.5 billion a month or $114 billion a year and the losses may continue for a long time. The accumulated losses are already more than double the Fed’s total capital of $43 billion—indeed, the losses had shriveled its capital, when properly measured under Generally Accepted Accounting Principles (GAAP), to negative $50 billion when Chairman Powell was speaking at Jackson Hole. The Fed’s properly measured capital is likely headed for a negative $100 billion or worse by early 2024. The Fed finances this negative capital by borrowing, which increases the consolidated government debt and is a cost to taxpayers. 

The scale of the losses it is suffering doubtless came as a surprise to the Fed. This is apparent from the woefully inaccurate forecasts of continued “lower for longer” interest rates which it made while amassing trillions of investments in long term, fixed-rate Treasury and mortgage securities with very low yields—including, for example, the 1.25% Treasury bond not maturing until 2050—and funding them with floating rate liabilities. In doing so, the Fed created for its own balance sheet a $5 trillion interest rate risk position similar to that of a giant savings and loan. Such a position would inevitably produce huge losses if interest rates rose to anything like historically normal levels of 4% or 5%. They did, and the losses have followed.

It is impossible to believe that the leadership of the Federal Reserve planned and consciously intended to lose over $100 billion. (As you read this, ask yourself if you believe it.) Fed officials knew they had created a very large interest rate risk position, but as an old boss told me long ago, “Risk is the price you never thought you would have to pay.” The combination of the unknowable future with great financial power joined forces to put this massive cost on the taxpayers without a vote of the Congress.

An Independent Power?

Should the Fed have been able unilaterally to commit the country to perpetual inflation and perpetual depreciation of the dollar’s purchasing power at the rate of 2% per year? The correct answer is “no.”

The media is full of references to “the Fed’s” 2% inflation target—but it should be “the country’s” target. The Fed’s proposal about the nature of the people’s money should have been presented to the elected representatives of the people for approval. The U.S. Constitution provides among the powers of the Congress: “To coin Money [and] regulate the Value thereof.” Regulating the value of the national money and deciding whether it should be stable, or perpetually depreciating, and if so, at what rate, involve inherently political questions. 

Let us review the always-striking math of compound growth rates and apply it to inflation. Stable prices imply a long-run average inflation of approximately zero. At 1% inflation, average prices will more than double in a lifetime of 80 years. At 2% inflation, prices will quintuple. At 3%, they will go up by 10 times. At 4% inflation, prices in a lifetime will go up by 23 times. Which would the sovereign people through their representatives choose? William Jennings Bryan famously proclaimed, “You shall not crucify mankind upon a cross of gold.” How about “You shall not drown mankind in a flood of fiat money”? This is not up to the Federal Reserve to decide on its own.

The Federal Reserve Act specifies “stable prices” as an institutional Fed goal. The concept of “stable prices” is not the same as “a stable rate of inflation,” which the Fed now calls “price stability,” a misleading rhetorical shift.

It is often claimed, especially by the Fed itself, that the Federal Reserve is, or at least ought to be, “independent.” Supporters of the Fed, especially academic economists, join this chorus. Earlier generations of Fed leaders were more realistic. They spoke of the Fed as “independent within the government”—that is, not really independent. In this context, we may recall that the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board.

“Independent” might mean independent of the U.S. Treasury, so that the Treasury cannot require the Fed to print up money to finance its deficits. However, the Fed has had significant experience as the willing servant of the Treasury. This was especially prominent during wars, such as when the Fed committed to buy however many long-term Treasury bonds it took to keep their yield down to 2.5% during World War II. Similarly, the Fed’s “quantitative easing” artificially lowered the cost of financing Treasury deficits for years. In financial crises, as it did in the Covid crisis, the Fed works hand in glove with the Treasury to finance bailouts.

Alternately, “independent” might mean independent of the Congress. In this sense, the Fed should not be independent. As a matter of fundamental government design, it should be in a system of effective checks and balances to which the Congress is essential. 

Since the original Federal Reserve Act in 1913, there have many amendments to the act, with notable Federal Reserve reform legislation in the 1930s and in 1977–78. After its unprecedented actions in the twenty-first century so far, I suggest that it is time again for serious reform of the Federal Reserve.

Reforming the Fed

With the foregoing problems in mind, I recommend eight specific reforms to promote responsibility to the elected representatives of the people in a system of Constitutional checks and balances, bring greater emphasis on genuine price stability, and align expectations with the realities of limited knowledge and pervasive uncertainty.

1. First and foremost, the Congress should amend the Federal Reserve Act to make it clear that the Fed does not have the authority unilaterally to decide on the nature of U.S. money, an essential public question. The revised act should provide that the maintaining or setting of any “inflation target” requires review and approval by Congress. This would make it consistent with the practice of other democratic countries, notably the father of the inflation targeting theory, New Zealand, where the inflation target has to be an agreement between the central bank and the parliamentary government. The original New Zealand target was zero to 2%. But no long-term target for depreciating the money the government provides and imposes on the people should be set without legislative approval.

A true public discussion of the “Money Question,” as they called it in the long debates that ultimately gave birth to the Federal Reserve, would be salutary.

In contrast to those historic debates, how in the world did the Fed imagine that it had the authority all on its own to commit the nation to perpetual inflation and perpetual depreciation of the currency at some rate of its own choosing? A new reform would straighten it out on that, establishing that the Fed is not a committee of independent economic philosopher-kings, but “independent within the government,” subject to the checks and balances reflecting a constitutional republic.

2. Consistent with the first reform, the Congress should cancel the 2% inflation target set unilaterally by the Fed until it has approved that or some other guidance. For better guidance, I recommend price stability, or a long-run average target inflation of approximately zero, cyclically varying in a range of perhaps -1% to +1%. This would be a modern form of “sound money.” A range is needed, because it is entirely unrealistic to think the inflation rate should be the same at all times, when every other economic factor is always changing. As an interim step, one could live with New Zealand’s original range of zero to 2%. 

3. From 1913 to 2008, the Fed’s investments in mortgages were exactly zero, reflecting the fundamental principle that the central bank should not use its monopoly money power to subsidize specific sectors or interests. The Fed’s buying mortgage securities was an emergency action in a housing finance crisis that has now been over for more than a decade. Its mortgage investments should go back to zero. The Fed made itself into the world’s biggest savings and loan; its mortgage portfolio totaled $2.5 trillion in August 2023. So the run-off will take a long time, but the Fed’s mortgage investments should finally go to zero and stay there, at least until the next mortgage finance crisis.

4. The fundamental structure of the Fed’s consolidated balance sheet, and the balance sheets of the 12 individual Federal Reserve Banks, should be reviewed by Congress, including their capitalization. An iron principle of accounting is that operating losses are subtracted from retained earnings and therefore from capital. Unbelievably, the Fed’s accounting does not follow this principle, but embarrassingly pretends that its operating cash losses are an intangible asset. This is in order to avoid reporting its true capital. Properly measured, using GAAP, at the end of August 2023, the Fed’s consolidated capital was negative $52 billion.

All Federal Reserve member banks have bought only one-half of the Fed stock to which they have subscribed, and the other half is callable at any time by the Federal Reserve Board. The Fed could raise $36 billion in new capital by issuing a call for the other half. It should do this, with due notice, to bolster the depleted or exhausted capital of the various Federal Reserve Banks.

In addition, the Fed is authorized by the Federal Reserve Act to assess the member bank shareholders up to 6% of the member’s own capital and surplus to offset Federal Reserve Bank losses. Since these losses otherwise become costs to the taxpayers, the Fed should discuss with Congress whether it should proceed to make such assessments.

5. The Fed should be required to use standard U.S. GAAP accounting in reporting its capital. It would not have to go as far as the Central Bank of Switzerland, which by law reports its earnings and capital on a mark-to-market basis, making its earnings and capital reflect the realities of market prices. The Fed’s mark-to-market loss as of June 2023 is over $1 trillion. Recognizing the Fed’s argument that these are “paper losses,” the Fed could continue to disclose them but not book them into capital. However, operating cash losses like the Fed is experiencing without question reduce capital and the Fed should be instructed to adopt GAAP in this respect. As Bishop Joseph Butler said, “Things and actions are what they are. … Why then should we desire to be deceived?”

 6. Dividends on Fed stock should be paid only out of Federal Reserve Bank profits. The Federal Reserve Banks pay attractive dividends, defined by the Federal Reserve Act, to their member bank shareholders: 6% dividends to small banks and the 10-year Treasury note rate, now over 4%, to larger banks. This is fine as long as the Fed is making money, but, as is little known, the act does not require profits to pay dividends and also makes the dividends cumulative, so they have to be paid, now or in the future. These statutory provisions obviously never contemplated that the Federal Reserve would someday be making gigantic losses. If Federal Reserve Banks have lost so much money that they have negative retained earnings, let alone negative total capital, they should not be paying dividends, and any dividends should not be cumulative. Otherwise, such dividends are being paid in effect by the taxpayers. 

7. Congress should revoke the Fed’s payment of the expenses of the Consumer Financial Protection Bureau. When the Fed is losing more than $100 billion a year, it is ridiculous for it to be paying over $700 million a year in the expenses of an unrelated entity for which it has no management responsibility. Far worse than ridiculous, it is against the Constitutional structure of the U.S. government, depriving Congress of its essential power of the purse. This issue may be decided by the Supreme Court in a current case involving whether the CFPB’s funding by the Fed violates the U.S. Constitution. It seems obvious to many of us that it does, and that whatever amount of money the Congress wants to spend on the Consumer Financial Protection Bureau, it ought to be appropriated in the normal way.

8. In general and throughout all considerations of the Federal Reserve, all parties, including the Congress and the Fed itself, should be realistic about the inherent inability of the Fed to reliably forecast the economic or financial future or to “manage the economy” or to know what the results of its own actions will be. In the memorable phrase of F. A. Hayek’s Nobel Prize Lecture, there should be no “pretense of knowledge” about central banking.

These proposed reforms reflect the lessons of the Federal Reserve’s eventful twenty-first-century career so far. As it heads for its 110th birthday, they would move the Fed, with its power and with its danger, toward operating more effectively in the context of our Constitutional republic.

Federalist Society Event: October 2nd: How Risky Are the Banks Now? What Regulatory Reforms Make Sense?

Hosted by the Federalist Society. RSVP to attend virtually.

October 2, 2023 at 1:00 PM ET

Six months ago, we experienced bank runs and three of the four largest bank failures in U.S. history. Regulators declared there was “systemic risk” and provided bailouts for large, uninsured depositors. What is the current situation? While things seem calmer now, what are the continuing risks in the banking sector? Banks face huge mark-to-market losses on their fixed-rate assets, and serious looming problems in commercial real estate. How might banks fare in an environment of higher interest rates over an extended period, or in a recession? Reform ideas include a 1,000-page “Basel Endgame” capital regulation proposal. Which reforms make the most sense and which proposals don’t? Our expert and deeply experienced panel will take up these questions and provide their own recommendations in their signature lively manner.

RSVP to attend virtually.

PANELISTS

William M. Isaac - Chairman, Secura/Isaac Group

Keith Noreika - Executive VP & Chairman, Banking Supervision & Regulation Group, Patomak Global Partners

Lawrence J. White - Robert Kavesh Professorship in Economics, Leonard N. Stern School of Business, New York University

MODERATOR

Alex J. Pollock - Senior Fellow, Mises Institute

The Illusion of Control: Unmasking the Federal Reserve with Alex J. Pollock

Hosted by The Rational Egoist.

In this compelling episode of "The Rational Egoist," host Michael Leibowitz sits down with Alex J. Pollock, a senior fellow at The Mises Institute and former Principal Deputy Director of the Office of Financial Research in the U.S. Treasury Dept. Together, they delve into the fascinating yet fraught world of the Federal Reserve, an institution often misconceived as a central economic manager.

The Federal Reserve, in its simplest form, comprises 12 regional banks attempting to regulate the U.S. economy. Its original mandate was to inject liquidity into the financial system during times of crisis. However, as Michael and Alex point out, the persistent and unrestrained expansion of money supply even after crises have been resolved has converted this mechanism into an ongoing problem, rather than a solution.

The conversation takes a historical turn when they discuss the U.S. government's suppression of the gold standard and its unilateral ban on citizens owning gold. Remarkably, while American civilians were barred from gold ownership, the U.S. government continued to accumulate large reserves of gold by purchasing it overseas.But the real kicker comes when our experts examine the ramifications of divorcing the U.S. dollar from gold in 1971. This shift has led to a monetary system with virtually no constraints on the amount of currency that can be printed, setting the stage for escalating inflation and subsequently, complex political challenges.

Despite its numerous failings, the power of the Federal Reserve continues to grow, becoming increasingly centralised. The paradox is as disconcerting as it is true: the more mistakes the Federal Reserve makes, the more potent it becomes.

Join Michael and Alex as they unravel these complicated threads, offering keen insights into an institution whose influence stretches far and wide but whose true impact remains poorly understood. This episode is not just an analysis but a cautionary tale, highlighting the perils of placing too much power in the hands of a single entity.

Listen to the podcast here.

Lots of Red Ink at the Fed

Published by the Mises Institute and RealClear Markets.

The Federal Reserve has officially reported a loss of $57 billion for the first six months of 2023. Quite a number! So the “Federal Reserve Banks Combined Quarterly Financial Report as of June 30, 2023” (CQFR)—a little-known document—is especially notable for its red ink. We can anticipate an annual loss of over $100 billion for 2023 and for the losses to continue into 2024. 1

How does a central bank, especially the world’s greatest and most important central bank, lose tens of billions of dollars in six months? An average person, influenced by the mystique of the Fed, might understandably be baffled by this fact.

To understand what is happening, we need to recall that in addition to being a media star as the manipulator of the world’s dominant currency, the Federal Reserve is a bank—well, actually 12 Federal Reserve Banks (FRBs), covering districts across the United States. Added together they are huge, with total assets of $8.3 trillion (with a T). The FRBs have loans, investments, deposits and borrowings, interest income and interest expense, and profit or loss like other banks do. They also have private shareholders: the commercial banks which are “Fed member banks,” and the FRBs have over them the Washington Federal Reserve Board, which charges them for its expenses.

The combined FRBs are intended to always be profitable because of their unique monopoly in issuing U.S. dollar paper currency. This is a very lucrative privilege which means together they have $2.3 trillion of zero interest cost funding from the dollar bills circulating around the country and the world, which they can invest in interest earning assets. (They print up some money and use it to buy Treasury bonds, simply said.) But instead of making profits, as the combined Fed reliably did for more than 100 years, it is now making giant losses, a historic reversal.

The CQFR shows that in the first six months of 2023 the combined Fed had $88 billion in interest income, but $141 billion in interest expense. So it paid out in interest $53 billion more than it received, and also had to pay its overhead expenses of over $4 billion. 

Why doesn’t it have more interest income? Because the Fed engaged to the tune of about $5 trillion in one of the most classic of financial risks: borrowing short and lending long, and now interest rates have gone very far against it and the risk has turned into real losses. 

The CQFR shows on page 22 that on June 30 the combined Fed owned $5.5 trillion in Treasury Securities with an average yield of 1.96%, and $2.6 trillion of mortgage-backed securities yielding on average 2.20%. In short, it invested in massive amounts of very long-term fixed rate assets and locked in for years a historically low yield of about 2%. Meanwhile, it was funding $5 trillion of these assets with floating rate deposits from banks and borrowings in the form of repurchase agreements, the cost of which rose to over 5%.

You don’t need a degree in banking or a Ph.D. in economics to know that lending money at 2% while you are borrowing money at 5% is a losing proposition. That is what our Federal Reserve Banks did and continue to do.

On top of this, as disclosed in the footnotes of the CQFR on page 7, when the combined Fed’s investments were marked to market on June 30, they had a market value loss of over $1 trillion, or a market value loss of 23 times the Fed’s stated capital.

The CQFR reports a total capital of about $42 billion ($35.6 billion of paid-in capital from the member commercial banks and $6.8 billion of retained earnings, called “surplus”). But note: This total capital is much less than the $57 billion reported loss for the six months of 2023, to which must be added the loss for the later months of 2022 of $17 billion. This total $74 billion of accumulated losses by June 30 must be subtracted from the retained earnings and thus from total capital. But the Fed does not do this—it misleadingly books its losses as an asset (!), which it calls a “deferred asset”-- a practice highly surprising to anyone who passed Accounting 101. Why does the Fed do this? Presumably it does not wish to show itself with negative capital. However, negative capital is the reality.

Here are the combined Fed’s correct capital accounts as of June 30, based on Generally Accepted Accounting Principles. They result in a capital of negative $32 billion:

Paid-in capital            $36 billion

Retained earnings   ($68 billion)

Total capital               ($32 billion)

The Fed wants you to believe that neither its negative capital nor its giant losses matter because it is the Fed and can print money. Many economists agree.

But does it matter that the Fed’s losses will cost not only it, but also the Treasury and the taxpayers, over $100 billion this year and more in the future? Does it matter that on a combined basis its accumulated losses are greater than its private stockholders’ paid-in capital? Does it matter that with negative equity under standard accounting, it is technically insolvent? All of these can be debated, but the numbers certainly do get one’s attention.

We conclude with a simple question: Did the leaders of the Fed intend to lose $57 billion in six months? Did they intend to be looking at a loss of more than $100 billion for this year? Did they intend to have a mark to market loss of more than $1 trillion? It is impossible to believe they did. The liberal supply of red ink they have delivered certainly does not help the Fed’s reputation for knowing what it is doing.

The New Bank Bailout

Taxpayers are covering Federal Reserve losses, for which member banks are supposed to be liable.

Published in the Wall Street Journal with Paul H. Kupiec.

Taxpayers are bailing out Federal Reserve member banks—institutions that own the stock of the Fed’s 12 district banks—and hardly anyone has noticed. For more than 100 years, our central-banking system has made a profit and reliably remitted funds to the U.S. Treasury. Those days are gone. Sharp rate hikes have made the interest the Fed pays on its deposits and borrowing much higher than the yield it receives on its trillions in long-term investments. Since September 2022, its expenses have greatly exceeded its interest earnings. It has accumulated nearly $93 billion in cash operating losses and made no such remittances.

The Fed is able to assess member banks for these losses, but it has instead borrowed to fund them, shifting the bill to taxpayers by raising the consolidated federal debt. That tab is growing larger by the week. Under generally accepted accounting principles, the Fed has $86 billion in negative retained earnings, bringing its total capital to around negative $50 billion.

Each of the Fed’s 12 district banks, except Atlanta, has suffered large operating losses. Accumulated operating losses in the New York, Chicago, Dallas and Richmond, Va., district banks have more than consumed their capital, making each deeply insolvent. A fifth district bank, Boston, is teetering on insolvency. At the current rate of loss, five others will face insolvency within a year and the taxpayers’ bill will grow by more than $9 billion a month until interest rates decline or the Fed imposes a capital call or assessments on its member banks.

The Federal Reserve Act requires that member banks subscribe to the shares issued by their district bank in a dollar value equal to 6% of a member institution’s “capital” and “surplus”—the definitions of which depend on the depository institution’s charter. Member banks must pay for half their subscribed shares, while the remaining half of the subscription is subject to call by the board.

The act empowers the Fed to compel member banks to contribute additional funds to cover their district reserve bank operating losses up to an amount equal to the value of their membership subscription. The provision reads: “The shareholders of every Federal reserve bank shall be held individually responsible, equally and ratably, and not one for another, for all contracts, debts, and engagements of such bank to the extent of the amount subscriptions to such stock at the par value thereof in addition to the amount subscribed, whether such subscriptions have been paid up in whole or in part” (emphasis added).

In the century when district banks were reliably profitable, these provisions posed only a remote risk to Fed shareholders. The central bank didn’t need member banks to make any additional contributions. As district banks’ consolidated losses approach $100 billion, however, the risks to Fed stockholders have risen. If called on, member banks are legally responsible to make these payments. At a minimum, they should disclose this potential liability.

The risk is that the more than 1,400 Fed-shareholder banks could receive a call on their resources equal to as much as 9% of their capital and surplus—a call for a 3% additional equity investment and 6% cash payment to offset district bank losses. Member banks could be on the hook to contribute three times the capital they currently own in their district bank, or $108 billion in total for the central-bank system.

The Securities and Exchange Commission requires every registered firm to include in its annual 10K reports “an explanation of its off-balance sheet arrangements.” The provision applies to securities issued by banks and bank holding companies that are traded on national exchanges, but enforcement is delegated to the federal regulatory agencies that aren’t requiring Fed member banks and their holding companies to disclose the Fed’s contingent resource claim as a material risk or as a contingent liability.

Consider the Goldman Sachs Group, which includes at least two Fed member banks. The company’s 10K for 2022 includes page after page devoted to discussion of the group’s regulatory, market, competition, operational, sustainability and climate-change risks. Not included in that list is the risk of being compelled to recapitalize and share in the losses of its Fed district banks.

The larger of the two is a member of the New York Federal Reserve Bank, a district bank with accumulated losses of nearly $62 billion, or more than four times its $15 billion stated capital. A smaller Goldman Sachs Trust bank is a member of the Philadelphia Fed, a bank with $821 million in accumulated losses.

Goldman’s member banks had almost $44 billion in capital and surplus, according to our analysis of its June regulatory-call report data. Applying the 3% equity-investment and 6% cash-payment requirements, we calculate that Goldman would face a maximum contingent call of approximately $4 billion—a sum that would exceed the combined 2022 income of its two Fed member banks.

Those sums aren’t mere rounding errors, and they shouldn’t be placed on taxpayers’ tab. Federal bank regulators should require Fed member banks that are registered with the SEC and their holding companies to disclose their risks of being called on to prop up the finances of their Federal Reserve district banks.

WKXL: Facing The Future: Will We Learn the Necessary Lessons from Past Economic Crises?

Published in WKXL:

This week on Facing the Future, we revisit a conversation from earlier this year with Alex Pollock and Howard Adler, authors of a new book entitled “Surprised Again: The COVID Crisis and the New Market Bubble.” The book examines the recent economic crises, including the COVID related economic shutdown and the Great Recession of 2008-10, and asks why these types of events always seem to take us by surprise.

Though inflation has come down somewhat from its peak in the last year, it is still a problem for our economy, brought about in large part by the federal government’s responses to the two most recent economic crises. Not to mention the trillions of dollars these crisis responses added to our national debt.

WKXL - NH Talk Radio · Facing The Future: Will We Learn the Necessary Lessons from Past Economic Crises?

The Fed Is Losing Tens of Billions: How Are Individual Federal Reserve Banks Doing?

Published in the Mises Institute with Daniel J. Semelsberger. Also published in RealClear Markets.

The Federal Reserve System as of the end of July 2023 has accumulated operating losses of $83 billion and, with proper, generally accepted accounting principles applied, its consolidated retained earnings are negative $76 billion, and its total capital negative $40 billion. But the System is made up of 12 individual Federal Reserve Banks (FRBs).1 Each is a separate corporation with its own shareholders, board of directors, management and financial statements. The commercial banks that are the shareholders of the Fed actually own shares in the particular FRB of which they are a member, and receive dividends from that FRB. As the System in total puts up shockingly bad numbers, the financial situations of the individual FRBs are seldom, if ever, mentioned. In this article we explore how the individual FRBs are doing.

All 12 FRBs have net accumulated operating losses, but the individual FRB losses range from huge in New York and really big in Richmond and Chicago to almost breakeven in Atlanta. Seven FRBs have accumulated losses of more than $1 billion. The accumulated losses of each FRB as of July 26, 2023 are shown in Table 1.

Table 1: Accumulated Operating Losses of Individual Federal Reserve Banks [2]

New York ($55.5 billion)

Richmond ($11.2 billion )

Chicago ( $6.6 billion )

San Francisco ( $2.6 billion )

Cleveland ( $2.5 billion )

Boston ( $1.6 billion )

Dallas ( $1.4 billion )

Philadelphia ($688 million)

Kansas City ($295 million )

Minneapolis ($151 million )

St. Louis ($109 million )

Atlanta ($ 13 million )

The FRBs are of very different sizes. The FRB of New York, for example, has total assets of about half of the entire Federal Reserve System. In other words, it is as big as the other 11 FRBs put together, by far first among equals. The smallest FRB, Minneapolis, has assets of less than 2% of New York. To adjust for the differences in size, Table 2 shows the accumulated losses as a percent of the total capital of each FRB, answering the question, “What percent of its capital has each FRB lost through July 2023?” There is wide variation among the FRBs. It can be seen that New York is also first, the booby prize, in this measure, while Chicago is a notable second, both having already lost more than three times their capital. Two additional FRBs have lost more than 100% of their capital, four others more than half their capital so far, and two nearly half. Two remain relatively untouched.

Table 2: Accumulated Losses as a Percent of Total Capital of Individual FRBs [3]

New York 373%

Chicago 327%

Dallas 159%

Richmond 133%

Boston 87%

Kansas City 64%

Cleveland 56%

Minneapolis 56%

San Francisco 48%

Philadelphia 46%

St. Louis 11%

Atlanta 1%

Thanks to statutory formulas written by a Congress unable to imagine that the Federal Reserve could ever lose money, let alone lose massive amounts of money, the FRBs maintained only small amounts of retained earnings, only about 16% of their total capital. From the percentages in Table 2 compared to 16%, it may be readily observed that the losses have consumed far more than the retained earnings in all but two FRBs. The GAAP accounting principle to be applied is that operating losses are a subtraction from retained earnings. Unbelievably, the Federal Reserve claims that its losses are instead an intangible asset. But keeping books of the Federal Reserve properly, 10 of the FRBs now have negative retained earnings, so nothing left to pay out in dividends.

On orthodox principles, then, 10 of the 12 FRBs would not be paying dividends to their shareholders. But they continue to do so. Should they?

Much more striking than negative retained earnings is negative total capital. As stated above, properly accounted for, the Federal Reserve in the aggregate has negative capital of $40 billion as of July 2023. This capital deficit is growing at the rate of about $ 2 billion a week, or over $100 billion a year. The Fed urgently wants you to believe that its negative capital does not matter. Whether it does or what negative capital means to the credibility of a central bank can be debated, but the big negative number is there. It is unevenly divided among the individual FRBs, however.

With proper accounting, as is also apparent from Table 2, four of the FRBs already have negative total capital. Their negative capital in dollars shown in Table 3.

Table 3: Federal Reserve Banks with Negative Capital as of July 2023 [4]

New York ($40.7 billion)

Chicago ($ 4.6 billion )

Richmond ($ 2.8 billion )

Dallas ($514 million )

In these cases, we may even more pointedly ask: With negative capital, why are these banks paying dividends?

In six other FRBs, their already shrunken capital keeps on being depleted by continuing losses. At the current rate, they will have negative capital within a year, and in 2024 will face the same fundamental question.

What explains the notable differences among the various FRBs in the extent of their losses and the damage to their capital? The answer is the large difference in the advantage the various FRBs enjoy by issuing paper currency or dollar bills, formally called “Federal Reserve Notes.” Every dollar bill is issued by and is a liability of a particular FRB, and the FRBs differ widely in the proportion of their balance sheet funded by paper currency.

The zero-interest cost funding provided by Federal Reserve Notes reduces the need for interest-bearing funding. All FRBs are invested in billions of long-term fixed-rate bonds and mortgage securities yielding approximately 2%, while they all pay over 5% for their deposits and borrowed funds—a surefire formula for losing money. But they pay 5% on smaller amounts if they have more zero-cost paper money funding their bank. In general, more paper currency financing reduces an FRB’s operating loss, and a smaller proportion of Federal Reserve Notes in its balance sheet increases its loss. The wide range of Federal Reserve Notes as a percent of various FRBs’ total liabilities, a key factor in Atlanta’s small accumulated losses and New York’s huge ones, is shown in Table 4.

Table 4: Federal Reserve Notes Outstanding as a Percent of Total Liabilities [5]

Atlanta 64%

St. Louis 60%

Minneapolis 58%

Dallas 51%

Kansas City 50%

Boston 45%

Philadelphia 44%

San Francisco 39%

Cleveland 38%

Chicago 26%

Richmond 23%

New York 17%

The Federal Reserve System was originally conceived not as a unitary central bank, but as 12 regional reserve banks. It has evolved a long way toward being a unitary organization since then, but there are still 12 different banks, with different balance sheets, different shareholders, different losses, and different depletion or exhaustion of their capital. Should it make a difference to a member bank shareholder which particular FRB it owns stock in? The authors of the Federal Reserve Act thought so. Do you?

______________

1. In order of their district numbers, which go from east to west, the 12 FRBs are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

2. Federal Reserve H.4.1 Release, July 27, 2023

3. Our calculations based on the July 27 H.4.1 Release.

4. Ibid.

5. Ibid.