Have Fannie and Freddie Paid the Taxpayers Back Yet?

Published in the Real Clear Markets.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lest We Forget

Published in Law & Liberty.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Published in Law & Liberty.

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

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

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

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

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

Pondering Power

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

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

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

The Central Banking Golden Mean

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

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

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

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

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

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

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

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

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

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

Accountability?

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

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

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

The Claim of Expertise

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

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

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

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

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

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

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

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

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

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

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

Published in Real Clear Markets.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Published by The Hill.

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

That would be a hopeless argument indeed, since Fannie Mae and Freddie Mac guarantee half the credit risk of the giant United States housing finance sector and have combined assets of $5.5 trillion. Fannie Mae is bigger than JPMorgan Chase and Bank of America, and Freddie Mac is bigger than Citigroup and Wells Fargo. They have already demonstrated that they can “pose a threat to the financial stability of the United States,” to use the words of the Dodd Frank Act. Are they systemically important? Of course. Are they financial companies? Of course. They are systemically important financial institutions, as a matter of simple fact.

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

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

As Treasury Secretary Henry Paulson recounted in his memoir of the financial crisis, “Foreign investors held more than $1 trillion of the debt issued or guaranteed by the GSEs, with big shares held in Japan, China, and Russia. To them, if we let Fannie and Freddie fail and their investments got wiped out, that would be no different from expropriation. …They wanted to know if the U.S. would stand behind this implicit guarantee.” Paulson instructed the Treasury staff to “make sure that to the extent we can say it that the U.S. government is standing behind Fannie Mae and Freddie Mac.” He memorably added, “I was doing my best, in private meetings and dinners, to assure the Chinese that everything would be all right.”

Thanks to the bailout he directed, Paulson’s assurances turned out to be true for all of Fannie and Freddie’s creditors, even holders of subordinated debt. In short, that Fannie and Freddie are SIFIs in reality no reasonable person can dispute. Yet so far, the Financial Stability Oversight Council has not designated them officially as such. Judging purely on the merits of the case, this is indefensible. Of course, Fannie and Freddie have an existing regulator, the Federal Housing Finance Agency (FHFA). But the FHFA is not, nor is it empowered to be, a regulator of the systemic risk created by Fannie and Freddie for the banking and financial system as a whole.

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

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

Congress Moves to Put Pension Benefit Guaranty Corporation On Taxpayer Dole

Published by Real Clear Markets.

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

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

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

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

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

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

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

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

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

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

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

Published in Real Clear Markets.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Give Fannie, Freddie the same capital standards as everybody else

Published in American Banker.

Taking up a key issue in housing finance reform, one within his control as the new director of the Federal Housing Finance Agency, Mark Calabria told a conference recently that Fannie Mae and Freddie Mac must in the future have a strong capital position.

He’s absolutely right. And this would be in vivid contrast to the 0.2% capital ratio they have now.

Calabria stated that “all large, systemically important financial institutions should be well capitalized,” specifically including Fannie and Freddie. “That would seem non-debatable at this point.”

Indeed it does. No one can plausibly disagree.

But what is the number? What is the explicit capital ratio which would implement Calabria’s excellent principle?

I believe his remarks in effect gave us the answer by asking the question in this pertinent way: “How do we level the playing field to where all large financial institutions have similar capital” so that Fannie and Freddie do not have “lower standards than everybody else?”

The answer to this well-framed question is obvious: Give the government-sponsored enterprises the same capital requirement for mortgage risk that everybody else has. In short, the answer is 4%. This is the internationally recognized standard for mortgage risk, which represents virtually all of Fannie and Freddie’s assets. The FHFA should, in my view, immediately establish a minimum capital requirement for Fannie and Freddie of tangible equity equal to 4% of total assets.

Considering them on a combined basis, 4% of Fannie and Freddie’s assets of $5.5 trillion results in a required capital of $220 billion between the two of them. That is 22 times their current capital and $210 billion more capital than they’ve got right now.

Naturally, Fannie and Freddie cannot retain or raise any more capital while subject to the “profit sweep” to the Treasury, but let us suppose the senior preferred stock purchase agreements between the Treasury and the FHFA as conservator could be renegotiated. This outcome would not be unreasonable, since the Treasury now has an internal rate of return on its preferred stock investment of about 12% — which is pretty good — and much better than the original 10% agreement. On top of that, Treasury still has warrants to acquire 79.9% of Fannie and Freddie’s common stock at an exercise price of virtually zero (0.001 cents per share). That could be a nice pop for the taxpayers on top of the 12% average annual return.

As President Trump’s March 27 memorandum on housing finance reform makes clear, as part of any renegotiation, Fannie and Freddie will need to pay the Treasury for its ongoing credit support, implicit or otherwise. This should absolutely be required.

How much in fees should they pay? That is debatable, to be sure, but definitely not nothing. We might consider that the lowest rated banks on the FDIC’s deposit insurance fee table pay a range of 16 to 30 basis points of total liabilities per year for their government guarantee. Let’s give the critically undercapitalized Fannie and Freddie the benefit of the doubt and assume the lowest end of that range: a fee to the Treasury of 16 basis points.

What kind of return on equity could a Fannie and Freddie capitalized at 4% then expect? Here’s one estimate. Fannie and Freddie’s combined net profits for the first quarter of 2019 were $3.8 billion. That annualized is $15.2 billion — let’s call it $16 billion. Subtract from that the 16 basis point fee to the Treasury assessed on liabilities, which after tax would be $7 billion. Add the fact that they would have $210 billion more cash worth 2.5%, or approximately $4 billion, after tax. In sum, that gives $13 billion in net profit pro forma, or an ROE of about 6%. If the fee to Treasury were dropped to 10 basis points, the pro forma ROE would rise to a little over 7%.

That seems like a reasonable starting range. It compares to the 5-year average ROE of U.S. banks of 9.6%. From the 6% to 7% range, there are lots of actions in pricing, greater efficiency and improved methods for management to pursue. But running at hyper-leverage as in the old days and in the conservatorship days would not be possible. That would move the mortgage market toward the more competitive state that Calabria correctly envisions.

What should happen next? The FHFA should set a 4% capital standard for Fannie and Freddie. The Financial Stability Oversight Council should designate Fannie and Freddie as the “systemically important financial institutions” they so obviously are, treating them the same as others of their size. The Treasury should exercise as a gain for the taxpayers its warrants for their common stock, removing any uncertainty about the warrants.

When capital has become sufficient, the FHFA should end the conservatorships and implement regulation which ensures that Fannie and Freddie’s credit risk stays controlled and tracks how the more competitive, less GSE-centric mortgage system evolves.

Congress does not have to do anything in this scenario. That is good, because it is highly unlikely that it will do anything.

What Does the Fed Know that Nobody Else Knows?

Published in Law & Liberty and in the Federalist Society.

When it comes to the financial and economic future, everybody is myopic. Nobody can see clearly. That includes the Federal Reserve.

As François Villeroy de Galhau, the Governor of the Bank of France, recently said in a brilliant talk, central banks are subject to four uncertainties. These are, in my paraphrased summary:  

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

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

3) They are affected by what other people are going to do, but don’t know what others will do.

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

Yet it appears that central banks usually feel the urge to pretend to know more than they can, in order to inspire “confidence” in themselves, and to try to manage expectations, while they go on making judgments subject to a lot of uncertainty, otherwise known as guesses.

A refreshing exception to this pretense was the speech Federal Reserve Chairman Jerome Powell gave in last August at the annual Jackson Hole symposium, 2018. He reviewed three key “stars” in monetary policy models: u* (“u-star),” r* (“r-star”) and ϖ (“pi-star,”), which are respectively the “natural rate of unemployment,” the “neutral rate of interest,” and the right rate of inflation.  None of these are observable and all are of necessity theoretical, so in a clever metaphor, Powell candidly pointed out that these supposedly navigational stars are actually “shifting stars.” Bravo, Mr. Chairman!

Let’s consider this question: What does the Fed know that nobody else knows? Nothing.

Can the Fed know what the right rate of inflation is? No. Of course, it can guess. It can set a “target” of steady depreciation of the dollar at 2% per year in perpetuity. Can it know what the long-term results of this strategy will be? No.

Moreover, nobody knows or can know what the right interest rate is. That includes the Fed (and the President). Interest rates are prices, and government committees, like the Federal Open Market Committee, cannot know what prices should be. That (among many other reasons) is why we have markets.

The Wall Street Journal recently published an article by James Mackintosh, “Fed Is Shifting the Goal Posts, and Investors Should Care.” With shifting goalposts or shifting stars, the Fed cannot know where they should be, but investors should and do indeed care very much about what the Fed thinks and does.

This is because, as we all know, the Fed’s actions or inaction, and also, financial actors’ beliefs about future Fed actions or inaction, can and do move prices of stocks and bonds substantially. Indeed, the more financial actors believe that Fed actions will move asset prices, the more it will be true that they do.

Mackintosh discusses whether the Fed’s inflation target will become “symmetric”—that is, the target would change into an average of periods both over it and under it, rather than a simple goal. Thus, sometimes “inflation above 2% is as acceptable as inflation below 2%.” Ah, the old temptation of governments to further depreciate the currency never fades for long.

“Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds,” the article reports, and opines that the change could have “big implications for markets,” that is, for asset prices. That seems right.

But the 2 percent inflation, whether as an average or as a simple goal, “isn’t up for debate.” Why not? The Humphrey-Hawkins Act of 1978, the same act that gave the Fed the so-called “dual mandate” which it endlessly cites, also set a long-term goal of zero inflation. What does the Fed think about that provision of the laws of the United States?

A true sound money regime has goods and services prices which average about flat over the long term. But being prices, they do fluctuate around their stable trend. The Fed, like other central banks, is in contrast committed to prices which rise always and forever. Discussing which of these two regimes we should want would focus consideration on where the goalposts should be.

Mackintosh worries that there may be a “loss of faith in the Fed’s ability.” On the contrary, I think a lack of faith in the Fed’s ability is rational, desirable, and wise.

Colleges need to have skin in the game to tackle student loan debt

Published in The Hill.

Republican Senator Lamar Alexander of Tennessee rightly wants to make colleges more accountable for the results of student loans. With these federal loans, the government lends with no credit underwriting, the students get in debt, but who gets all the money? The colleges. If the students fail to repay the loans, who takes the hit? The taxpayers. This is a perverse incentive structure. It leads to, as his committee report found, “nearly half of all borrowers not making payments on their student loans.”

Alexander proposes a “new accountability system for colleges based upon whether borrowers are actually repaying their student loans.” Great idea! In a similar vein, the annual White House budget correctly observes a “better system would require postsecondary institutions that accept taxpayer funds to share in the financial responsibility associated with student loans.” Indeed, each college should share the risk of whether its students repay the money they borrowed and the college spent. Nothing improves your behavior like having to share in the risk you are creating. In his book “Skin in the Game,” Nassim Nicholas Taleb wrote, “If you inflict risk on others, and they are harmed, you need to pay some price for it.”

In student loans, with their abysmal repayment rate, colleges play the same role as subprime mortgage brokers did in the infamous housing finance bubble. They promote the loans without regard to how they might be repaid, they make money from the loans, and they pass all the risk on to somebody else. In the housing finance case, the risk went ultimately to the taxpayers. In the student loan case, it goes directly to the taxpayers. Just as the flow of easy mortgage credit induces higher house prices then takes even more debt to pay the higher price, the flow of easy student credit induces higher college prices then takes even more debt to pay the higher tuition. It is a sweet deal for colleges that create the risk, keep all the money, and stick the taxpayers with all the losses.

A Brookings Institution research paper points out that with low repayment rates, the federal student loan program represents a “sizeable taxpayer funded transfer” to the colleges. It rightly asks how much of the taxpayer losses the college should have to pay back. It proposes that each cohort of college borrowers be measured at the end of five years of required payments, and each college has to pay at least 25 percent of the amount by which the actual principal reduction has fallen short of 20 percent of the total of the original loans after five years. The 20 percent principal reduction results from what would happen with a 15 year amortization of the loan pool as the standard used. That seems perfectly reasonable.

This proposal is a good stab at it, but I would say do not wait for five years to address the problem. Do it every year. Take the total loan pool of each borrower cohort of the college. Establish a 15 year amortization schedule for the principal of the pool. Measure every year how much principal has actually been paid in the pool as a whole. Each year the college should pay to the Treasury, I suggest 20 percent of any repayment shortfall against the standard. That would be a steady financial feedback loop.

After 15 years, the college will have reimbursed taxpayers for 20 percent of whatever loan principal was not paid. Of course, taxpayers would still be paying for 80 percent of the losses. The 20 percent loss participation would be enough to give the college the right incentives to improve its repayment performance and control instead of constantly bloating the debt of its students. Student loan borrowers, like mortgage borrowers, are hurt being saddled with thousands of dollars in debt they cannot pay.

Colleges should have maximum flexibility for how to work on this. They could increase efficiency, reduce their costs and their prices, or shorten the time to graduation to scale back the need for borrowing. They should make sure the students understand what loans mean and how they are expected to repay, consider their ability to pay, guide the students to programs with the most promising job prospects for them, and adjust their mix of programs. They can do all of the above plus other ideas and managing the tradeoffs involved. Colleges should no longer play the role of subprime mortgage brokers. They need some skin in the game now.

Federal Lending to Insolvent Pension Plans Is Code for Bailout

Published in Real Clear Markets.

Here’s a remarkable lending opportunity to consider:  Let’s make billions of dollars in loans to borrowers which “are insolvent” or in “critical or declining status.”  These loans would be unsecured and no payments of principal would be due for 30 years.  At that point, in case of default, the loans would be forgiven.  Would you make such a loan?  Obviously not, and neither would anybody else—except maybe the government.   This idea is one only politicians could love, since it gives them a way to spend the taxpayers’ money without calling it spending.

Making such loans is proposed in a bill before the House Ways and Means Committee, entitled “Rehabilitation for Multiemployer Pensions Act” (HR 397). The borrowers would be multiemployer (union) pension funds which are deeply underfunded, insolvent in the sense of having obligations much greater than their assets, and won’t have the money to pay the benefits they have promised.  A more forthright title for the bill would be the “Taxpayer Bailout of Multiemployer Pension Funds Act.”

The bill’s primary sponsor, Congressman Richard Neal (D-MA), who is Chairman of the Ways and Means Committee, has stated, “This is not a bailout.”  But a bailout by any other name is still a bailout.  “These plans would be required by law to pay back the loans they receive,” said Chairman Neal.  But the bill itself provides on pp.18-19:

          “(e) LOAN DEFAULT.—If a plan is unable to make any payment on a loan under this section when due, the Pension Rehabilitation Administration [PRA] shall negotiate with the plan sponsor revised terms for repayment, which may include…forgiveness of a portion of the loan principal.”

No limit is set on how big the “portion” may be.  Why not 100%?  Of course, all loans of all kinds are in principle required to be repaid, but are nonetheless not repaid if the borrower becomes insolvent, and pension funds demonstrably can go broke like anybody else.  As one actuary recently observed, “It seems very likely that the default rate on PRA loans will be significant.”  Indeed it does.

It is highly convenient for the politicians that under the bill no default on principal repayment could occur by definition until the balloon payment in 30 years.  Assuming defaults start to occur in 2050, a member of Congress who is now 60 years old would be 91, if still living.  “I’ll gladly pay you Tuesday for a hamburger today,” said the instructive cartoon character, Wimpy.  Likewise, “We’ll gladly pay in 30 years for a bailout today” is a natural human response to financial failure.

Chairman Neal said that with his bill, “The federal government is simply backstopping the risk.”  But the federal government is already backstopping the risk of these pension plans through its implicit guarantee of the Pension Benefit Guaranty Corporation (PBGC). 

How has that worked out?  The PBGC’s insurance program for multiemployer pension funds is itself broke.  Its net worth is a negative $54 billion, according to the PBGC’s 2018 annual report.  The net position of $54 billion in the hole is composed of total assets of only $2.3 billion and liabilities of $56 billion, thus the liabilities are 24 times the assets.  Since PBGC’s accounting only takes into account the budget window, its long term position is even worse.

So it is not a surprise that by the time you get to the last paragraph on the last page of the bill, you find it also includes a bailout of the PBGC’s failing multiemployer program:

     “(b) APPROPRIATIONS.—There is appropriated to the Director of the Pension Benefit Guaranty Corporation such sums as may be necessary for each fiscal year.” 

These sums are for direct financial assistance from the PBGC to “critical and declining” and “insolvent” multiemployer pension plans.  There is virtually no limit to the amount (“such sums as may be necessary”) or the time (“for each fiscal year”) of these appropriations.  They are for sending cash in addition to the loans from the bill’s proposed Pension Rehabilitation Administration.  Also on its last page, the bill provides that the PBGC “shall not require the financial assistance to be repaid before the date on which the [PRA] loan…is repaid in full.”  That may be never.  The Congressional Budget Office estimated the probable taxpayer cost of a similar previous bill at more than $100 billion.

In theory and under its Congressional charter, the PBGC was supposed to be a financially stand-alone, actuarially sound insurance company, not guaranteed by the government and never needing any appropriated funds.  As its annual report says, “PBGC receives no funds from taxpayer dollars.”  Not yet, anyway.  The PBGC has always had an implicit guaranty from the U.S. Treasury, and we can once again observe that implicit government guarantees tend to become bailouts.

In short, the bill is a convoluted way to a simple end: to have the taxpayers pay the pensions promised but not funded by the multiemployer plans.  If enacted, the bill will encourage other plans to make new unfunded promises in the very logical expectation of future additional bailouts.

To adapt a famous line of the great philosopher and economist, David Hume, “It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London than to give a politician the ability to guarantee pension plans.”

Thoughts on the Source of International Economic Advantage

Published in Real Clear Markets.

What are the possible sources of America’s international economic advantages and success at creating a superior standard of living for its people?  Each fundamental factor of production gives rise to a potential competitive advantage.  According to the classic list of Adam Smith, these factors are Land, Labor and Capital.  A more compete list would contain five fundamental factors:

1.       Natural Resources

2.       Labor

3.       Capital

4.       Knowledge

5.       Social Infrastructure.

In the revised list, Natural Resources is a more general version of Land.  Labor must be understood to include the essential element of education, as well as a crucial kind of labor: that of the entrepreneur.  Capital is what allows risks to be taken and economic growth to accumulate.  Knowledge most importantly means science and its offspring, technology of all kinds.  Knowledge also includes knowing how to manage large, complex organizations.  Social Infrastructure means the laws, property rights, financial practices, enforcement of contracts, culture friendly to enterprise, the lack of stifling or corrupt bureaucracy, and the essential political stability that together allow markets, including financial markets, to function well.

Historically, America had important advantages in all five fundamental factors, leading to its establishment by 1920, a hundred years ago, as the dominant economy in the world.  But global development, a very good thing for mankind in general, makes it harder to maintain America’s former advantages.  This suggests the U.S. political economy will be continuingly challenged at how to provide higher pay than elsewhere in the world—otherwise known as a higher standard of living.  It means we have less room than before for subsidizing political drag.

In the global competition of the ongoing 21st century, America no longer has as great an advantage as it previously did in the first four factors, but a continuing and central advantage in the fifth.  This advantage, however, can be weakened by unwise politics and bureaucracy.

Let us consider each of the factors in turn in a globalized world.

1. Natural Resources.  Commodities trade actively in world markets, move among countries with very low transportation costs, historically speaking, and are available almost everywhere.  Being a natural resources-rich country, as the U.S. is, matters less than before.  For example, making Land more productive by the scientific agriculture of the 19th century, as symbolized by the institution of land grant colleges, and by the continuing advances in agricultural science since then, is available everywhere in the world.

2. Labor.  The great historical revolution of public education has spread around the world, while the struggles of large parts of U.S. public education are well known.  The ability to organize and manage large, capital-intensive enterprises to make labor productive has also spread around the world.  Large pools of educated, technically proficient labor are increasingly available, notably in China and India.  Napoleon thought China a sleeping giant and recommended not waking it up.  Now we have two giants awake, as well as other countries, with increasingly educated labor.  If America wants to provide higher pay than they do for work with the same level of education, this must be based on a different fundamental advantage.

3. Capital.  Capital is essential to all risk-bearing, economic growth and productivity.  Savings available for investment as capital now flow quickly around the world, seeking and finding the best opportunities wherever they may be.  While capital is raised and employed in huge amounts in the U.S., we are not the leaders in savings.

4. Knowledge.  The incredible economic revolution of the last 250 years, or modernization, which empowered first Britain, then Western Europe and America with vast leadership advantages, has as its most fundamental source science based on mathematics.  Scientific Knowledge, turned to technology and harnessed to production by entrepreneurial energy, then matched with learning how to manage large organizations, created the modern world.  Mathematical science began as a monopoly of Europe and America, but is now the most cosmopolitan of human achievements.  America has world-leading research capabilities, including top research universities, but Knowledge is now available everywhere and incorporated into international scientific endeavor.

5. Social Infrastructure.  The political stability, clear property rights and safety of America have long served to attract investment as a safe haven and supported the role of the U.S. dollar as the dominant reserve currency.  By designing a stable political order which continued to work for an extremely large republic, the American Founding Fathers also created a powerful economic competitive advantage.  This advantage was augmented when Europe destroyed itself in the First World War, and New York replaced London as the center of world capital markets, and when Europe again destroyed itself in the Second World War.  This key advantage continues and helps explain how the U.S. can finance its continuous trade and budget deficits.  It may be an “exorbitant privilege” as viewed from France, but it is one earned by superior Social Infrastructure.

As John Makin instructively wrote a decade ago, “The fact that global savers accommodate U.S. consumers…is simply a manifestation of America’s competitive advantage at supplying wealth management services.”

This advantage in wealth storage, reflecting an advantage of Social Infrastructure, yields not only economic, but also large political and military benefits.  But no competitive strength is incapable of being lost over time, as former world economic leader Britain found out.  The strongest advantages can be weakened by political, bureaucratic, legal and regulatory drag.  The constant effort to maintain these advantages also maintains the ability to pay more for work than other countries do.

President makes the smart call for reforming housing finance system

Published in The Hill.

In a recent White House memorandum, President Trump said, “It is time for the United States to reform its housing finance system.” He is right about that. He is also right about principal elements of reform, as listed in the memorandum, notably reducing taxpayer risks, expanding the role of the private sector, establishing “appropriate” capital requirements for Fannie Mae and Freddie Mac, providing that the government is properly paid for its credit support of Fannie and Freddie, facilitating competition, addressing the systemic risk of Fannie and Freddie, defining what role they should have in multifamily mortgage finance, and terminating their conservatorships only when the other reforms are put in place.

In all this, the Treasury is instructed to distinguish between what can be done by administrative action and what would require legislation. This seems to set the stage for carrying out the former, even if Congress cannot agree on the latter, which it probably cannot. The memorandum provides that for “each administrative reform,” the Treasury housing reform plan will include a “timeline for implementation.” This timetable instruction represents a pretty clear declaration of intent to proceed.

Needless to say, the general directions can only be implemented after being turned into specifics. While that seems impossible for Congress to agree on, the executive branch can define the specific administrative actions it wishes to take. As the administration comes to decisions about the details, is there an appropriate model to consider for Fannie and Freddie? Is there some way to simplify thinking about the issues they present, which entails swarms of lobbying interests?

I think there is. The model should be too big to fail and systemically important financial institutions. Fannie is bigger than JPMorgan Chase. Freddie is bigger than Citigroup. There is no doubt Fannie and Freddie remain too big to fail. They are an essential point of vulnerability of American residential mortgage finance, the biggest credit market in the world except for Treasury debt. Should they implode, the government will again rush to the rescue of their global and domestic creditors.

Vast intellectual and political efforts have gone into lowering the odds that too big to fail banks will need bailouts or generate systemic crisis. We need to apply the results of that effort to Fannie and Freddie, which now run with virtually no capital. But before the crisis, they already ran at extreme leverage. Indeed, they leveraged up the whole housing finance system, making the system, as well as themselves, much riskier.

What about their capital requirements? Following our model, simply apply the risk based capital standards of systemically important banks to Fannie and Freddie. The same risks need the same capital, no matter who holds them. Fannie or Morgan? Freddie or Citi? The same risk and the same risk based capital. This would result in a required capital for the two on the order of $200 billion, or about $190 billion more than they have.

How much should they pay the government for its credit support? The same as the too big to fail banks pay. For them, this is called a deposit insurance premium. For Fannie and Freddie, you could call it a credit support fee, which would replace the profit sweep in their deal with the Treasury. Deposit insurance fees are assessed on total bank liabilities. Apply the same to Fannie and Freddie credit support fee and at the same level as would be required for a giant bank of equivalent riskiness.

I estimate this would be about 0.18 percent per year, but recommend the administration ask the Federal Deposit Insurance Corporation to run its big bank model on Fannie and Freddie and report on what level of fee results. Note that the Treasury stands behind the Federal Deposit Insurance Corporation, just as it stands behind Fannie and Freddie.

With such a serious amount of capital, Fannie and Freddie would need to charge guarantee fees that would allow greater competition in the private sector. This would be consistent with the law, which requires that their guarantee fees be set at levels that would cover the cost of capital of private regulated financial institutions. If they have the same risk based capital requirement, then that should follow for Fannie and Freddie.

With $200 billion in capital and a credit support fee of 0.18 percent, I estimate that Fannie and Freddie could sustain a return on total capital of 8 percent or so, which is quite satisfactory. The Treasury should exercise its warrants for about 80 percent of their common stock to share in this return until Treasury sells the stock, which will generate a large gain for the taxpayers. It seems to me that virtually all of this might be done by administrative action. Let us hope the administration will proceed apace.

The Inescapably Political World of Banking and Finance

Published in Law & Liberty.

Banking always involves political economy, as professor Mark Rose observes, or as we might more precisely say, political finance. This is the central lesson of Rose’s Market Rules. The book nicely shows how banking and politics have been constantly intertwined in the United States over the 50 years beginning in the 1960s, as much bigger banks have been created and the banking system has consolidated. (Although today there are 5,477 banks and savings associations in the United States, in 1950 there were 19,438.)

The book’s anecdotes of forceful personalities of American banking history, both those in the business and those in government during the times it covers, are engaging, at least to those of us in the trade, and fun to read. In addition, its theme has much broader application than the text suggests: namely to all countries in all times. As banking scholars Charles Calomiris and Stephen Haber have concluded, all banking systems reflect deals between bankers and politicians, which they call “the Game of Bank Bargains.” The study of this idea in their book, Fragile by Design—The Political Origins of Banking Crises and Scarce Credit(2014), covers a number of countries in detail and a long history going back to the 17th century. This gives us a wider framework in which to view the arguments and events related by Rose and reinforces his local variations on the theme that banking is politically entwined.

However, unlike Fragile by Design, don’t read Market Rules for economic or financial concepts or for careful economic or financial arguments. They aren’t there. Likewise, don’t read it for theoretical insights into politics or banking systems. Its discussion of political finance is journalistic, with a left-of-center slant. The book displays a pronounced bias against markets and competition, repeatedly dismissing them as “market talk.” “Citing markets” is characterized as a “rhetorical obsession.” There is throughout a positive bias for governments and for government control.  Discussing the financial crisis bailouts, for example, Rose reflects that “For that moment at least, government authority and prestige were in the ascendance”—just the way he likes it. Still, the book’s rendition of banking debates and developments is interesting and useful, describing how the economically critical banking sector evolved over five decades.

A more balanced view of banks and governments than the book conveys would stress that both banks and governments are made up of human beings, and that both demonstrate the aspirations, insights, and achievements always mixed with the failures, mistakes and hypocrisy natural to mankind. We should not be surprised that these same attributes appear in their interaction and the deals they make with each other. Moreover, both banks and governments often make big mistakes at forecasting the economic and financial future and cannot know what the long-term results of their own actions will be.

We naturally observe this mix of strengths and weaknesses in all parties in the course of banking history. Nothing human is perfect, or even close. The pursuit of profit, subject to competition and innovation, will on average get much better economic results for the people than will the pursuit of bureaucratic power using the government’s monopoly of force and coercion. Rose is right, however, that in banking we always find some combination of the two.

Market Rules brings out in what remarkable fashion banking times and ideas change, and how what seems like a great issue at one point, becomes difficult to remember at some later point. In discussing the Hunt Commission, appointed by President Richard Nixon to consider how to improve the American financial system, the book says:

Hunt and his commissioners determined not to explore in detail the boldest question of all, which is whether the nation needed a separate and distinct group of S&Ls [savings and loans] and another group of separate and distinct commercial banks.

That was the boldest question of all? It seems hard for us to believe, but in 1970, the S&Ls were a political force to be reckoned with. They had their own powerful trade association, the U.S. League for Savings, and their own cheerleading regulator, the Federal Home Loan Bank Board. Those names are probably unfamiliar, because both have long since disappeared and been merged into the respective banking organizations. Of course, at the time of this debate, the 1980s collapse of the S&L industry was more than a decade in the future.

The Hunt Commission did propose numerous reforms, but “criticism of Hunt’s report arrived hard and fast,” Rose relates. One of the commissioners arose “to denounce the ‘blurring of distinctions between financial institutions.’” “Blurring of distinctions” hardly sounds like a stirring battle cry, or even a clear thought, but since it really meant “protect me from competition,” it was.

A similar thought arose in the 1990s: “Large and small bankers alike feared that insurance companies like State Farm would purchase a thrift [S&L] charter and use it to offer bank services.” In Rose’s phrase, this was a “horrifying prospect.” By now, State Farm has operated its S&L, which is called State Farm Bank, for two decades. I have an account there. It doesn’t seem too horrifying.

Another big battle of past years was that over the then well-known “one-quarter point.” To any readers under the age of 50: does that mean anything to you? Probably not. The context is that in the 1960s and 1970s, the U.S. government practiced national price fixing for the interest rates that banks and S&Ls could pay on deposits. The point of this 1930s idea was to limit competition, so that deposit banking was a cartel with the government as cartel manager. The “quarter point” meant that the price fixing rules allowed the maximum rate the S&Ls could pay to be 0.25 percent higher than what commercial banks could pay their depositors.

As the book relates, “Insiders knew the government’s ability to determine interest rates paid to savers by its official name, the Federal Reserve’s Regulation Q,” commenting that it was “curiously named.” So it was, but famous in banking at the time. I well remember an old banking lawyer explaining to me that “Reg Q,” as it was called, was a permanent and unchangeable part of the American banking system. A bad prediction, as it turned out, since Reg Q has now disappeared from the memory of all but financial historians. Nonetheless it was a big deal in its day.

The book further explains: “In 1966, President Johnson and the Congress approved the Interest Rate Control Act, which authorized S&L executives to pay a higher rate of interest to savers than banks paid them. Nervous S&L officers had urged this action.” Rose does not mention that they had urged it because the government’s interest-rate fixing had brought on the Credit Crunch of 1966. “Federal Reserve officers in turn approved a 0.25 percent differential.” Then S&Ls were “passionate in defending the regulation…as a vital protection to their firms and to American home construction.”

Passionate? Vital? A quarter-point? Reg Q? Times change.

One of the most instructive examples of intertwined finance and government is the history of Fannie Mae and Freddie Mac. Fannie and Freddie played a large role in inflating the disastrous housing bubble of the 2000s. The most important thing about them is that they were government-sponsored, government-promoted and government guaranteed, while having their stock privately owned—a fundamental conflict which turned out to have bankrupting results. Fannie and Freddie were known by the acronym, “GSEs,” for “government-sponsored enterprises.” In 2008, they also became majority government-owned.

But in its less than one-page treatment of them, Market Rules describes Fannie and Freddie as “privately owned firms,” without mentioning their GSE status or the tight political connections and political clout they enjoyed in their glory days. Fannie was a Washington bully, including attacking the individual careers of those who dared to criticize or oppose them, and inspired genuine fear. James Johnson, its 1990s CEO and a highly influential political insider and operator, presided over a huge institution which seemed at the time an unstoppable colossus, both financial and political. Although he is a most impressive example of its main thesis, he rates not even a mention in the book.

Many other interesting characters do appear. Featured roles are given to James Saxon, William McChesney Martin, Wright Patman, Walter Wriston, Arthur Burns, Bill Simon, Hugh McColl, Don Regan, Gene Ludwig, Robert Rubin, Phil Gramm, Sandy Weill, Paul Volcker. If you are interested in political finance but you don’t know who all these gentlemen are, you should. Also appearing is a whole series of U.S. presidents from John Kennedy on.

Of everybody in this history, my favorite is James Saxon, the comptroller of the currency from 1961-1966, who on Rose’s telling got the whole ball rolling of introducing more competition into a financial system previously designed to suppress competition.

“Saxon, often intemperate in his public language,” Rose writes, “asserted that investment bankers’ control of revenue bonds constituted a ‘full-fledged monopoly.’” To be exact, it was an oligopoly, but of course Saxon was basically right.

“In March 1964, Saxon told members of the Senate Banking Committee that the Federal Reserve’s regulation of the interest rates that banks paid savers amounted to price fixing.” Rose comments primly, “Presidential appointees did not speak in that fashion about the Federal Reserve.” My reaction is, “Saxon was absolutely right!”

Being right may not be popular: Saxon “had thrown state-chartered bankers into a more competitive environment, which they resisted.” And Saxon had “encouraged powerful enemies” who demanded his ouster. Rose does not like him either and writes with satisfaction of how President Lyndon Johnson declined to reappoint him in 1966, so that “Saxon returned to anonymity.” Like we all do, but it seems to me he had a great run.

In conclusion, as this book illustrates with lots of examples, political finance it is.

When my successor as president of the Federal Home Loan Bank of Chicago asked me for advice, I told him, “Remember that this job is 50 percent banking and 50 percent politics.” That seems to sum it up.

Fed ‘independence’ is a slippery slope

Published in American Banker, The Federalist Society, The American Conservative, and Live Trendy News.

Many observers, like Captain Renault in Casablanca, were “shocked, shocked!” at President Trump’s sharp criticism of the Federal Reserve and his attempt to influence it against raising interest rates, inquiring whether the president can fire the Fed chairman.

Yet many presidents and their administrations have pressured the Fed, going back to its earliest days, when the Woodrow Wilson administration urged it to finance bonds for the American participation in the First World War. The Fed compliantly did so, proving itself very useful to the U.S. Treasury.

That was not surprising, since the original Federal Reserve Act made the Secretary of the Treasury automatically the Chairman of the Federal Reserve Board, and the board met in the Treasury Department.

In the decades since then, lots of presidents have worked to influence the Fed’s actions. Their purpose was usually to prevent the Fed from raising interest rates, exactly like Trump. It was also often to cause the Fed to finance the U.S. Treasury and to keep down the cost of government debt, just as “quantitative easing” does now.
But has a president ever fired a Federal Reserve Board chairman?

Yes, in fact. President Truman effectively fired Fed Chairman Thomas McCabe in 1951. “McCabe was informed that his services were no longer satisfactory, and he quit,” Truman said. Being informed by the president that your performance is not satisfactory is being fired, I’d say. One might argue that McCabe didn’t have to resign, but he did.

The background to McCabe’s departure was a heated and very public dispute between the Truman administration, including Truman personally, and the Fed about interest rates and financing the Korean War. Truman had even summoned the entire Federal Reserve Open Market Committee to the White House, where he made plain what he wanted, which was straightforward. Since the Second World War, the Fed, as the servant of the Treasury, bought however many Treasury bonds it took to keep their interest rate steady at 2.5% — this was the “peg.” In the middle of the Korean War, Truman understandably wanted to continue it.

The Fed, on the other hand, was understandably worried about building inflation, and wanted to raise interest rates. As the two sides debated in January 1951, American military forces were going backwards down the Korean peninsula, in agonizing retreat before the onslaught of the Chinese army. Although financial historians always tell this story favoring the Fed, I have a lot of sympathy for Truman.

By now we have been endlessly instructed, especially by the Fed itself, that the Fed is and must be “independent,” and this has become an article of faith, especially for many economists. However, the opposite opinion has often been prominent, including when the Fed and the Treasury completely coordinated their actions during the financial crisis of 2007-2009 — as they should have.

What exactly does Fed “independence” mean? Allan Sproul, a long-time and influential president of the Federal Reserve Bank of New York, maintained that the Fed “is independent within the government.” That is masterfully ambiguous. It expresses a tension between the executive branch, Congress and the Fed, searching for an undefined political balance.

When McCabe resigned, Truman appointed, he thought, his own man, William McChesney Martin from the Treasury Department. Martin is often viewed as the hero of establishing Fed independence — correspondingly, Truman later considered him a “traitor.” But Martin’s understanding of what Fed “independence” means was complex: He “was always careful to frame his arguments in terms of independence from the executive branch, not from Congress,” a history of Fed leadership says.

“It is clear to me that it was intended the Federal Reserve should be independent and not responsible to the executive branch of the Government, but should be accountable to Congress,” Martin testified in 1951. “I like to think of a trustee relationship to see that the Treasury does not engage in the natural temptation to depreciate the currency.”

Seven decades later, how accountability to Congress should work is still not clear, and Martin would certainly be surprised that the current Fed has formally committed itself to the perpetual depreciation of the currency at 2% per year.

Martin stayed as Fed chairman until 1970, which allowed him to experience pressure from five different administrations. The most memorable instance was the personal pressure applied by President Johnson. In late 1965, the Fed raised interest rates with the war in Vietnam, domestic spending and government deficits expanding.

“Johnson summoned the Fed Chairman to his Texas ranch and physically shoved him around his living room, yelling in his face, ‘Boys are dying in Vietnam and Bill Martin doesn’t care!’” one history relates.

That’s quite a scene to imagine.

One may wonder whether Fed independence is a technical or a political question. It is political. The nature and behavior of money is always political, no matter how much technical effort at measuring and modeling economic factors there may be.

For example, the Fed over the last decade systematically took money away from savers and gave it to leveraged speculators by enforcing negative real interest rates. Taking money from some people to give it to others is a political act. That is why the Fed, like every other part of the government, should exist in a network of checks and balances and accountability.

There is also a fundamental problem of knowledge involved in the idea of independence. How much faith should one put in the judgments of the Fed, which are actually guesses? The answer is very little — about as much faith as in any other bunch of economic forecasts, given that the Fed’s record is as poor as everybody else’s. The Fed’s judgments are guesses by sophisticated, intelligent and serious people, but nonetheless guesses about an unknowable future.

Arthur Burns, the Fed chairman from 1970 to 1978, observed that among the reasons for “The Anguish of Central Banking” is that “in a rapidly changing world the opportunities for making mistakes are legion. Even facts about current conditions are often subject to misinterpretation.”

Very true — and moreover, the world is always changing.

In the light of the political reality of Federal Reserve history, a completely independent Fed looks impossible. In the light of the unknowable future, it looks undesirable.

Bigger, Fewer, Riskier: The Evolution of U.S. Banking Since 1950

Published in The American Interest.

The total assets of JPMorgan Chase, the biggest U.S. bank, are now about $2.6 trillion. The total assets of the entire American commercial banking system in 1950 were $167 billion. In nominal dollar terms, Morgan by itself is more than 15 times as big as all the banks in the country together were in 1950, when Harry Truman was President and the United States was enjoying an economic boom after the cataclysms of the Depression and the Second World War. The fourth largest bank today, Wells Fargo, with $1.9 trillion in assets, is 11 times as big as the whole banking system was then.

Of course, there has been a vast price inflation and depreciation of the dollar over that time, so that a dollar today is worth about what a dime was in 1950. Adjusting the 1950s number for total banking assets to 2018 dollars brings it to $1.7 trillion. Thus in inflation-adjusted terms Morgan alone is still about 1.5 times as big—and Wells Fargo 1.1 times as big—as the whole banking system in the 1950s. Are these banks “too big to fail”? Of course they are. But so were the biggest banks in 1950.

On average over the past seven decades, banking assets and loans have grown more rapidly than the U.S. economy. In 1950, total banking assets were 56 percent of a GDP of $300 billion. Now at about $16.5 trillion, they are more than 80 percent of a GDP topping $20 trillion. Total bank loans relative to GDP grew even faster than banking assets did, from 18 percent of GDP in 1950 to 45 percent today.

Thus banking both in absolute terms and relative to the economy has gotten much bigger over the decades, but there are many fewer banks than there used to be.

“Ours is a country predominantly of independent local banks,” approvingly said Thomas McCabe, then Chairman of the Federal Reserve, in a commencement address in 1950. As McCabe observed, banking was then mostly a local business. There were at that point 13,446 commercial banks. The U.S. population was 153 million. Now there are 4,774 commercial banks for a population of 329 million. So as the American population has more than doubled, the number of commercial banks dropped by 64 percent.

In 1950, there were also 5,992 savings and loan institutions. Today there are 703, so the total of insured depositories fell from 19,438 in 1950 to 5,477 today, or by 72 percent. The previous multitude of banks was the result of unique American politics in which agrarian interests protected small, local institutions.  The reduced numbers have moved closer to what a market outcome would ordain. We can expect the consolidation to continue.

As to risk, in the entire decade of the 1950s, there were a mere 28 commercial bank failures—only 0.2 percent of the average number of banks. But banking got a lot riskier as time went on, particularly in the financially disastrous 1980s. In that decade, 1,127 commercial banks failed—40 times the failure rate of the 1950s. Maybe the bankers hadn’t gotten smarter, although they certainly employed more MBAs. State and Federal regulators didn’t appear any smarter either.

In addition to the bank failures, 909 savings and loans failed in the 1980s, bringing the total depository failures for the decade to 2,036—about four per week over ten years. Tough times! When the savings and loan industry collapsed, its government deposit insurer, the Federal Savings and Loan Insurance Corporation, also went broke, triggering a $150 billion taxpayer bailout.

The 1990s were not as bad as the 1980s, but 442 commercial banks (16 times as many as in the 1950s) and 483 savings and loans failed, for a total of 925.

The Federal Reserve optimistically announced that the 21st century heralded a new, stable era—“The Great Moderation.” Soon after that, however, came financial crisis and panic, showing once again that bankers and regulators have not gotten smarter, despite the addition of many PhDs in mathematics and science to the ranks of the MBAs in the finance industry. Ben Bernanke, then Chairman of the Federal Reserve, judged in 2006 that “banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.” That was just before the 2007-09 financial crisis. Apparently they hadn’t made such big strides after all.

Since 2000, 573 depository institutions have failed, of which 486 have been commercial banks. There would have been more failures without the government’s emergency TARP investments in banks, improvised government guarantees, and other forms of bailouts. These include the bailouts of the insolvent Fannie Mae and Freddie Mac, much of whose debt was held by banks, as was encouraged by regulation.

Should we want a banking system with no failures, as was virtually the case in the 1950s? Of course not. As the distinguished economist Alan Meltzer put it, “Capitalism without failure is like religion without sin.” Economic growth requires risk-taking and hence the failures that go with it. But we don’t want too much systemic risk, or for the banking system to collapse from time to time. Since 1950, the United States has experienced both extremes. No one knows how to achieve the golden mean.

We can see how much American banking has changed in the course of one lifetime. But one thing did not change: the tight connection between banking and the government. As banking scholar Charles Calomiris has convincingly summed it up, all banking systems are a deal between the politicians and the bankers.

Of course, the details of the deal shift over the decades. Congress frequently legislates about banking (as detailed further below).  One watershed banking enactment was the Federal Reserve Act of 1913, which created the U.S. central bank, the proper role of which was still being debated in 1950. At the time of its origin, it was thought that the Federal Reserve would end financial crises and panics: obviously it didn’t and relative to this hope the act was a failure.  But the act was a definite success at creating what it called an “elastic currency”—the ability of the Federal Reserve to create more money and allow banks to expand.  This ability in its original form was subject to the gold standard, which meant keeping dollars freely convertible to gold. We today can hardly imagine then-prevailing idea that you could go to your bank any time and turn in your paper dollars for gold coins minted by the United States at a fixed parity rate. This idea was only a memory by 1950, but under the 1944 Bretton-Woods agreement, the U.S. government was still promising to foreign governments that they could redeem dollars for gold.

In 1971, after various dollar crises, the government reneged on this commitment, which was the last vestige of the gold standard.  With that, the dollar became far more elastic than the authors of the Federal Reserve Act could ever have imagined. The Federal Reserve became able to expand the currency and the credit base of banking by as much as it wanted. It could either print up more paper dollars, or more directly, simply credit the deposit accounts banks have with it to expand the supply of money.  This can be done without limit except for the Federal Reserve’s own judgment and the extent of political controversy it is willing to endure.

Since 1950, an essential banking system development is that the Federal Reserve has grown ever more prominent, more prestigious and more powerful. Whether a republic should trust such immense money power to the judgment (which is actually the guessing) of its central bank is a fundamental political question to which the answer is uncertain.

But it is certain that the banking system, including the central bank as a key component, is highly useful to governments, especially to finance wars. A well-developed banking system that can lend large sums of money to the government is a key military advantage. This is a classic element in banking. The deal between politicians and bankers that created the Bank of England in 1694 was that the new bank would lend the government money to finance King William’s wars, in exchange for monopoly currency issuing privileges. U.S. national banks were created in 1863 to finance the Union armies in the Civil War; they bought government bonds and in exchange got to issue a national currency. The Federal Reserve first established its importance by lending money for the purchase of government bonds to finance American participation in the First World War. The young Fed “proved in war conditions an extremely useful innovation,” as a 1948 study of American banking observed.

The banks of 1950 were stuffed with Treasury securities as a result of their having helped finance the Second World War. At that time, the Federal Reserve was buying as many Treasury bonds it took to keep the interest rate on long bonds at 2.5 percent, to keep down the interest cost to the government. This was also meant to keep the market price of the banking system’s huge bond portfolio steady.

At that point, the banks in total owned more Treasury securities than they had in loans. Treasuries were 37 percent of their total assets—an unimaginably high proportion now. Total loans were only 31 percent of assets—now unimaginably low. These proportions made the balance sheet of the banking system very safe. In remarkable contrast, banks today have merely 3 percent of their assets in Treasury securities (see graph 3).

In the banking system of 1950, reflecting the experience of the 1930s, the government was intent on protecting the banks by reducing competition for and among them. Arthur Burns, who was Chairman of the Federal Reserve 1970-78, looked back from 1988 in The Ongoing Revolution in American Banking to explain the 1950s banking regime:

The legislation suppressed competition not only among banks but also between banks and other financial institutions. The ability of banks to compete with one another geographically was limited by rules on chartering and branching. No new bank could set up business without acquiring a national or state charter, and the authorities were disinclined to grant a charter if existing banks would suffer. . . . The ability of banks to compete with one another for demand deposits was limited by a prohibition against payment of interest on such deposits. . . . Banks could offer interest on time and savings deposits . . . but the amount they could pay was limited by a regulation known as Reg Q. . . . Competition between banks and other financial institutions was limited by restrictions on the kind of services each could offer.

In short, the government restricted competitive entry and limited price and product competition. The design was to promote safety by effectively having a banking cartel, with the government as the cartel manager.

This cartel idea was removed step by step in succeeding decades. The Regulation Q price controls, a big political deal in their day, proved a painful problem in the severe “credit crunches” of 1966 and 1969. They were obviously outdated by the time interest rates went into double digits in the 1970s and 1980s, and were belatedly removed. As the 1960s became the 1970s, U.S. banking had become more competitive, innovative, international and interesting, but also riskier. Banking scholars could discuss “the heightened entrepreneurial spirit of the banking industry” in 1975. Of course, there cannot be a competitive market without failures, in banking as in everything else, and we have observed the failures of the 1980s, 1990s and 2000s. But the tight link between banking and the government continued.

By the 1950s, banks had become accustomed to depending on having a lot of their funding guaranteed by the government in the form of deposit insurance. Although many banks had originally opposed the idea as promoting weak and unsound banking, they became and remain today absolutely hooked on it. It has come to seem part of the natural financial order.

But government guarantees of deposits, as is known to all financial economists, tend to make banks riskier, although it simultaneously protects them against bank runs. This combination of effects is because their depositor creditors no longer have to worry about the soundness of the bank itself. Consequently, unsound banking ventures can still attract plenty of funding: This is called “moral hazard,” and its importance in every financial crisis of recent decades can hardly be overstated. To try to control the risk to itself generated by moral hazard, the government must regulate more and more—but its attempt to control risk in this fashion has often failed.

Nonetheless, the extent of deposit insurance has been increased over time. The year 1950 saw a doubling in the amount of deposit insurance per depositor from $5,000 to $10,000. Since then, it has grown 25 times larger in nominal terms, to $250,000, and three times bigger in real terms. These increases are shown below.

As Arthur Burns observed, banks were formerly forbidden to pay interest on demand deposits (checking accounts). In 1950, these deposits comprised the great majority of the banks’ funding—75 percent of the total liabilities of the banking system. That meant that by law 75 percent of the funding had zero interest cost. I well remember as a bank trainee in 1970 having an old banker explain to me: “Remember that banks succeed or fail according to this one number—demand deposits.”

Those days are gone. Demand deposits now are only 11 percent of bank liabilities, and banks can pay interest on them. The graph below shows the historical decline of demand deposits in bank balance sheets.

One of the riskiest classes of credit are real estate loans, which are central to most banking crises. In 1950, real estate loans were only 26 percent of the total loans of the banks. But since then, having accelerated in the 1980s, they have grown to be the predominant form of bank credit, reaching 57 percent of all loans in 2006, just before the real estate collapse. They are now 47 percent of all bank loans, and in the majority of banks, those under $10 billion in total assets, are 72 percent of loans.

We still use the term “commercial banks,” but a more accurate title for their current business would be “real estate banks.”

We may consider together the trends of reduction in the lowest-risk assets, the decline of demand deposit funding, and the shift to riskier real estate credit by combining graphs 3, 4 and 5 into graph 6. The balance sheet of the banking system from 1950 to now has utterly changed.

During these seven interesting banking decades, Congress has been busy legislating away. This is natural: As long as the close connection of the government and banks continues, so will their dynamic interaction through politics, and so will congressional attempts to direct or improve the banking system, or to fix it after the busts that recur in spite of repeated attempted fixes.

Below is a list of the remarkable amount banking legislation since 1950. The mind boggles at the vast volume of congressional hearings, lobbyist meetings, and political speeches all this legislation entailed.

• Federal Deposit Insurance Act of 1950

• Bank Holding Company Act of 1956

• Bank Merger Act of 1960

• Bank Merger Act of 1966

• Bank Holding Company Act Amendments of 1966

• Interest Rate Adjustment Act (1966)

• Financial Institutions Supervisory Act of 1966

• Fair Housing Act (1968)

• Truth in Lending Act of 1968

• Emergency Home Finance Act of 1970

• Fair Credit Reporting Act (1970)

• Bank Holding Company Act Amendments of 1970

• Equal Credit Opportunity Act (1974)

• Real Estate Settlement Procedures Act of 1974

• Home Mortgage Disclosure Act of 1975

• Fair Debt Collection Practices Act (1977)

• Community Reinvestment Act (1977)

• Federal Reserve Reform Act of 1977

• International Banking Act of 1978

• Financial Institutions Regulatory and Interest Rate Control Act of 1978

• Depository Institutions Deregulation and Monetary Control Act of 1980

• Garn-St Germain Depository Institutions Act of 1982

• Competitive Equality Banking Act of 1987

• Financial Institutions Reform, Recovery, and Enforcement Act of 1989

• Federal Deposit Insurance Corporation Improvement Act of 1991

• Housing and Community Development Act of 1992

• Riegle Community Development and Regulatory Improvement Act of 1994

• Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

• Economic Growth and Regulatory Paperwork Reduction Act of 1996

• Gramm-Leach-Bliley Act of 1999

• International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001

• Sarbanes-Oxley Act of 2002

• Check Clearing for the 21st Century Act (2003)

• Fair and Accurate Credit Transactions Act of 2003

• Federal Deposit Insurance Reform Act of 2005

• Financial Services Regulatory Relief Act of 2006

• Housing and Economic Recovery Act of 2008

• Emergency Economic Stabilization Act of 2008

• Helping Families Save Their Homes Act of 2009

• Credit CARD Act of 2009

• Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

• an Act to instruct the Inspector General of the Federal Deposit Insurance Corporation to study the impact of insured depository institution failures (2012)

• Reverse Mortgage Stabilization Act of 2013

• Money Remittances Improvement Act of 2014

• Credit Union Share Insurance Fund Parity Act (2014)

• an act to enhance the ability of community financial institutions to foster economic growth and serve their communities, boost small businesses, increase individual savings, and for other purposes (2014)

• American Savings Promotion Act (2014)

• FAST Act (this cut Federal Reserve dividends to large banks) (2015)

• Economic Growth, Regulatory Relief and Consumer Protection Act (2018)

In conclusion, we may consider three different perspectives on long-term banking change.

In the 1980s an old employee was retiring after 45 years with the Bank of America, so the story goes. The chairman of the bank came to make appropriate remarks at the retirement party, and thinking of all the financial developments during those years, asked this long-serving employee, “What is the biggest change you have seen in your 45 years with the bank?” His reply: “Air conditioning.” Arthur Burns summed up 1950s banking in this way: “This was a simple system, operating in a simple financial world.” But that is not how it seemed at the time, or at any time. As William McChesney Martin, Chairman of the Federal Reserve 1951-70, said in a 1951 speech to the American Bankers Association: “We are all painfully aware today of the manifold and overpowering complexities of our modern life.”

That feeling characterizes all the years from then to now.

Changes to capital rules should be part of GSE overhaul

Published in American Banker.

Changes to capital rules should be part of GSE overhaul

Acting Federal Housing Finance Agency Director Joseph Otting has certainly gotten the mortgage market’s attention.

To the great interest of all concerned, but especially to the joy of the speculators in Fannie and Freddie’s shares, he recently told agency staff that the FHFA and the Treasury would be working on a plan to soon take Fannie and Freddie out of their 10 years of government conservatorship. Their share prices jumped.

The joy — and the share prices — have since moderated, after more careful comments from the White House. Still, it appears that any near-term change would have to be done by administrative action, since there is zero chance that the divided Congress is going to do so by legislation.

The FHFA and Treasury can do it on their own. They put Fannie and Freddie into conservatorship and constructed the conservatorship’s financial regime. They can take them out and implement a new regime.

But should they? Only if, as part of the project, they remove the Fannie and Freddie capital arbitrage which leads to the hyper-leverage of the mortgage system.

Running up that leverage is the snake in the financial Garden of Eden. As everybody who has been in the banking business for at least two cycles knows, succumbing to this temptation increases profits in the short term but leads to the recurring financial fall.

Leverage is run up by arbitraging regulatory capital requirements in order to cut the capital backing mortgages. Before their failure, when they had at least had some capital, Fannie and Freddie still served to double the leverage of mortgage risk by creating mortgage-backed securities.

Here’s the basic math. The standard risk-based capital requirement for banks to own residential mortgage loans is 4% — in other words, leverage of 25 to 1. Yet if banks sold the loans to Fannie or Freddie, then bought them back in the form of mortgage-backed securities, Fannie and Freddie would have capital of only 0.45% and the banks only 1.6%, for a total of 2.05%, due to lower capital requirements for the government-sponsored enterprises. Voila! The systemic leverage of the same risk jumped to 49 from 25. This reflected the politicians’ chronic urge to pursue expansionary housing finance. Now that Fannie and Freddie have virtually no capital, even the 0.45% isn’t there.

The risks of the assets are the same no matter who holds them, and the same capital should protect the system no matter how the risks are moved around among institutions — from a bank to Fannie or Freddie, for example. If the risk is divided into parts, say the credit risk for Fannie or Freddie and the funding risk for the bank, the sum of the capital for the parts should be the same as for the asset as a whole.

But the existing system abysmally fails this test.

If 4% is the right risk-based capital for mortgages, then the system as a whole should always have to have at least 4%. If the banks need 1.6% capital to hold Fannie and Freddie mortgage-backed securities, then Fannie and Freddie must have 2.4% capital to support their guarantee, or about 5 times as much as their previous requirement. If Fannie and Freddie hold the mortgages in portfolio and thus all the risks, they should have a 4% capital requirement, 60% more than their former requirement.

The FHFA is working on capital requirements and has the power to make the required fix.

Bank regulation also needs to correct a related mistake. Fortunately, Mr. Otting is also Comptroller of the Currency. Banks were encouraged by regulation to invest in the equity of Fannie and Freddie on a super-leveraged basis, using insured deposits to fund the equity securities. Hundreds of banks owned $8 billion of Fannie and Freddie’s preferred stock. For this disastrous investment, national banks had a risk-based capital requirement of a risible 1.6%, since changed to a still risible 8%. In other words, they owned Fannie and Freddie preferred stock on margin, with 98.4%, later 92%, debt. (Your broker’s margin desk wouldn’t let you do that!)

In short, the banking system was used to double leverage Fannie and Freddie. To fix that, when banks own Fannie and Freddie equities, they should have a dollar-for-dollar capital requirement, so it really would be equity from a consolidated system point of view.

All in all, if Treasury and the FHFA decide to end the conservatorships, that would be fine. That is, provided they simultaneously stop the systemic capital arbitrage and add the two highly-related reforms.

Fannie and Freddie will continue to be too big to fail, even without the capital arbitrage, and will continue to be dependent on and benefit enormously from the Treasury’s effective guarantee. They need to pay an explicit fee for the value of this taxpayer support. The fee should be built in to any revision of the existing senior preferred stock purchase agreements between them and the Treasury.

Finally, Fannie and Freddie are without question systemically important financial institutions. To address their systemic risk, Treasury and the FHFA should get them formally designated as the SIFIs they so obviously are.

How to Fix the Unhealthy Concentration of Corporate Voting Power In the U.S.

Published in Real Clear Markets.

The popularity of index and other mutual funds, combined with the current rules for voting shares of stock, has had an unexpected ill effect: concentration of corporate voting power in the hands of a few giant asset management companies.  Nobody did or would intend this outcome.  Fortunately, the voting rules can be changed. A great way for the SEC to start 2019 would be to take on and then fix this threat.

The asset managers holding the concentrated voting power are, economically speaking, mere agents.  They are not principals. One hundred percent of the risks and rewards of ownership belong to the beneficial owners of the funds: they are the economic owners.  The agent asset managers simply pass through these risks and rewards (minus their fees, course).  They have the stock registered in the fund name, but they are in no economic sense the owners.

They are in economic terms in exactly the same position as broker-dealers holding stock registered in street name, of which 100% of the risks and rewards (minus commissions) likewise belong to the customers.

The current voting rules for shares in mutual funds accelerate the famous “separation of ownership and control” in precisely the wrong direction: away from the substantive owners and into the hands of agents. As corporate governance scholar Bernard Sharfman has written to the SEC, “BlackRock, Vanguard, and State Street Global Advisors (the Big Three) now control enormous amounts of proxy voting power without having any economic interest in the shares they vote.”

The celebrated creator of index funds, John Bogle, rightly warned that “a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation.”  In fact, the control would be exercised by a few senior employees of those institutions—the agents of the agents.  Said Bogle, “I do not believe that such concentration would serve the national interest.”  It certainly wouldn’t.

It also does not serve the interests of the economic owners, who are under current rules deprived of any ownership voting rights.  This contrasts strikingly with the case when investors economically own stock that is legally registered in their broker’s street name.  In that case, the rules work hard to align voting rights with economic ownership, as they should.

There is an additional problem with concentrating voting power in the hands of a few agents.  These highly visible organizations are subject to political pressure and influence on how they cast their votes.  They cannot fail to be tempted to take positions through voting on contentious issues which are politically and economically advantageous to themselves, doubtless accompanied by pious speeches, rather than to the principals. The temptation to signal political “virtue,” rather than vote the interests of the real owners, may be irresistible.  The severe agency problem is obvious.

What do the principals want?  You should ask them, just as the brokers have to do.

We are confronted with a problem of a concentration of not only economic, but also of political power, needing to be fixed, sooner rather than later.

The public discussion of the issue has included the charge that index funds, because they may own all the major public companies in an industry, will promote cartel and oligopoly behavior to favor the industry, not the individual competitors in it—an influence which, if true, is certainly not to be desired.  This led financial commentator Matt Levine to suggest that index funds “pose a problem under the antitrust laws.”

But the problem is not that these funds hold shares registered in their name on behalf of the beneficial owners.  The problem is that the funds are allowed to vote such shares without instructions, to suit themselves.  It’s not the surface “ownership,” it’s the voting power that must be addressed.  They don’t need to have anti-trust laws applied, just to have their voting rules fixed.

The analogy is compelling: in economic substance, the status of the shares held by a mutual fund and that of the shares held by a broker in street name is exactly the same.  They should have exactly the same rules for voting the related proxies.

So the fix is quite straightforward:  Apply the same proxy voting rules to asset managers as already exist in well-developed form for brokers voting shares held in street name.  In short, the asset managers could vote uninstructed shares for routine matters, just like brokers, assuring the needed quorums.  But for non-routine matters, including the election of corporate directors, they could vote only upon instructions from the economic owners of the shares.   Thus the economic owners of shares through brokerage accounts and through mutual funds would be treated exactly the same.  The intermediary agents would be treated exactly the same.

Of course, the asset managers would whine about the trouble and expense of getting mutual fund holders to vote their proxies.  But the brokers already have the same problem.  Overall operating efficiency would be enhanced by allowing the real owners to provide revocable standing instructions to both asset managers and to broker-dealers for non-routine matters with a choice like this:

1.       Vote my shares only upon specific instructions from me.

2.       Vote my shares for the recommendations of the board of directors of each company.

3.       Vote my shares for whatever the asset manager or broker-dealer decides.

It would be gigantic mistake to let a handful of big asset managers amass discretionary voting dominance of the whole U.S. corporate sector, including pursuit of political agendas, all without having any economic interest in the shares they vote.  We should instead create instead a governance structure which ensures that the principals control the votes.

In Finance, the Blind Spots Will Always Be With You

Published in Law & Liberty.

“Where are our blind spots?” is an excellent question to ask about systemic risk, one I recently was asked to speak on at the U.S. Treasury. Naturally, we don’t know where the blind spots are, but they are assuredly there, and there will always be darkness when it comes to the financial future.

Finance and Politics

The first reason is that all finance is intertwined with politics. Banking scholar Charles Calomiris concludes that every banking system is a deal between the politicians and the bankers. This is so true. As far as banking and finance go, the 19th century had a better name for what we call “economics”—they called it “political economy.”

There will always be political bind spots—risk issues too politically sensitive to address, or which conflict with the desire of politicians to direct credit to favored borrowers. This is notably the case with housing finance and sovereign debt.

The fatal flaw of the Financial Stability Oversight Council (FSOC) is that being part of the government, lodged right here in the Treasury Department, it is unable to address the risks and systemic risks created by the government itself—and the government, including its central bank—is a huge creator of systemic financial risk.

For example, consider “Systemically Important Financial Institutions” or SIFIs. It is obvious to anyone who thinks about it for at least a minute that the government mortgage institutions Fannie Mae and Freddie Mac are SIFIs. If they are not SIFIs, then no one in the world is a SIFI. Yet FSOC has not designated them as such. Why not? Of course the answer is contained in one word: politics.

A further political problem with systemic financial risk is that governments, including their central banks, are always tempted to lie, and often do, when problems are mounting. The reason is that they are afraid that if they tell the truth, they may themselves set off the financial panic they fear and wish at all costs to avoid. As Jean-Claude Juncker of the European Union so frankly said about financial crises, “When it becomes serious, you have to lie.”

Uncertainty and the Unknowable

We often consider “known unknowns” and “unknown unknowns.” Far more interesting and important are “unknowable unknowns.” For the financial future is inherently not only unknown but unknowable: in other words, it is marked by fundamental and ineradicable uncertainty. Uncertainty is far more difficult to deal with and much more intellectually interesting than risk. I remind you that, as famously discussed by Frank Knight, risk means you do not know what the outcome will be, but you do know the odds; while uncertainty means that you do not even know the odds, and moreover you cannot know them. Of course, you can make your best guess at odds, so you can run your models, but that doesn’t mean that you know them.

Needless to say, prices and the ability of prices to change are central to all markets and to the amazing productivity of the market economy.

But a price has no sustainable existence. As we know so well with asset prices in particular, the last price, or even all the former prices together, do not tell you what the next price will be.

With housing finance audiences, I like to illustrate the risk problem with the following question: What is the collateral for a mortgage loan? Most people say, “The house, of course.” That is wrong. The right answer is that it is the price of the house. In the case of the borrower’s default, it is only through the price of the house that the lender can collect anything.

The next question is: How much can a price change? Here the answer is: More than you think. It can go up more in a boom, and down a lot more in a bust than you ever imagined.

One key factor always influencing current asset prices is the expectation of what the future prices will be, and that expectation is influenced by what the recent behavior of the prices has been. Here is an important and unavoidable recursiveness or self-reference, and we know that self-reference generates paradoxes. For example, the more people believe that house prices will always rise, the more certain it is that they will fall. The more people believe that they cannot fall very much, the more likely it is that they will fall a lot.

The Nature of Financial Reality

Financial reality is a fascinating kind of reality. It is not mechanical; it is inherently uncertain, not only risky; it is not organic; it is full of interacting feedback relationships, thus recursive or reflexive (to use George Soros’ term); unlike physics, it does not lend itself to precise mathematical predictions.

Therefore we observe everybody’s failure to consistently predict the financial future with success. This failure is not a matter of intelligence or education or diligence. Hundreds of Ph.D. economists armed with all the computers they want do not succeed.

The problem is not the quality of the minds that are trying to know the financial future, but of the strange nature of the thing they are trying to know.

Another troublesome aspect of financial reality is its recurring discontinuous behavior. “Soft landings” are continuous, but “hard landings” are discontinuous. Finance has plenty of hard landings.

From this odd nature of financial reality there follows a hugely important conclusion: Everybody is inside the recursive set of interacting strategies and actions. No one is outside it, let alone above it, looking down with celestial perspective. The regulators, central bankers and risk oversight committees are all inside the interactions along with everybody else, contributing to the uncertainty. Their own actions generate unforeseen combinations of changes in the expectations and strategies of other actors, so they cannot know what the results of their actions will be.

Another way to say this is that there are no financial philosopher-kings and there can never be any, in central banks or anywhere else. No artificial intelligence system can ever be a philosopher-king either.

Odin’s Sight

We can conclude that blind spots are inevitable, because of politics, and because of the unknowability of the outcomes of reflexive, expectational, interacting, feedback-rich combinations of strategies and actions.

I will close with a story of Odin, the king of the Norse gods. Odin was worried about the looming final battle with the giants, the destruction of Valhalla, and the twilight of the gods. Of course he wanted to prevent it, and he heard that the King of the Trolls had the secret of how to do so. Searching out this king by a deep pool in a dark forest, he asked for the secret. “Such a great secret has a very high price,” the troll replied, “one of your eyes.” Odin considered what was at stake, and decided to pluck out one of his eyes, which he handed over.

“The secret is,” said the King of the Trolls, “Watch with both eyes!”

When it comes to seeing the financial future, like Odin, we have to keep doing our best to watch with both eyes, even though we have only one.

The Fed is technically insolvent. Should anybody care?

Published in American Banker.

As the new year begins, we find that the Federal Reserve is insolvent on a mark-to-market basis. Should we care? Should the banks that own the stock of the Fed care?

The Fed disclosed in December that it had $66 billion in unrealized losses on its portfolio of long-term mortgage securities and bonds (its quantitative easing, or QE, investments), as of the end of September. Now, $66 billion is a big number — in fact, it is equal to 170 percent of the Fed’s capital. It means on a mark-to-market basis, the Fed had a net worth of negative $27 billion.

If interest rates keep rising, the unrealized loss will keep getting bigger and the marked-to-market net worth will keep getting more negative. The net worth effect is accentuated because the Fed is so highly leveraged: Its leverage ratio is more than 100 to one. If long-term interest rates rise by 1 percentage point, I estimate, using reasonable guesses at durations, the Fed’s mark-to-market loss would grow by $200 billion more.

The market value loss on its QE investments does not show on the Fed’s published balance sheet or in its reported capital. You find it in “Supplemental Information (2)” on page 7 of the Sept. 30, 2018 financial statements. There we also find that the reduction in market value of the QE investments from a year earlier was $146 billion. Almost all of the net unrealized loss is in the Fed’s long-term mortgage securities — its most radical investments. Regarding them, the behavior of the Fed’s balance sheet has operated so far just like that of a giant 1980s savings and loan.

And so, the question becomes, does this deficit matter? Would any deficit be big enough to matter?

All the economists I know say the answer is “no” — it does not matter if a central bank is insolvent. It does not matter, in their view, even if it has big realized losses, not only unrealized ones. Because, they say, whenever the Fed needs more money it can just print some up. Moreover, in the aggregate, the banking system cannot withdraw its money from the Federal Reserve balance sheet. Even if the banks took out currency, it wouldn’t matter, because currency is just another liability of the Fed, being Federal Reserve notes. All of this is true, and it shows you what a clever and counter-intuitive creation a fiat currency central bank is.

Of course, on the gold standard, these things would not be true. Then the banks and the people could take out their gold, and the central bank could fail like anybody else. This was happening to the Bank of England when Bonnie Prince Charlie’s army was heading for London in 1745, for example. But we are not on the gold standard, very luckily for an insolvent central bank.

People in the banking business may sardonically enjoy imagining Fed examiners looking at a private bank with unrealized losses on investments of 170 percent of its capital and exposure to losses of another 500 percent of capital on a 1 percentage point increase in interest rates. Those examiners would be stern, indeed. So, what would they say about their own employer? In reply to any such comparisons, the Fed assures us that it is “unique” — which it is.

About its unrealized losses, Fed representatives also are quick to say “we don’t mark to market,” and “we intend to hold these securities to maturity.” Those statements are true, but we may note that, in contrast, Switzerland’s central bank is required by its governing law to mark its securities to market for its financial statements. Which theory is better? A lot of economists are proponents of mark-to-market accounting — but not for the Fed?

Moreover, if you hold 30-year mortgages with low fixed rates to maturity, that will be a long time, and the interest you have to pay on your deposits may come to exceed their yield (think: a 1980s savings and loan). Still, even if the Fed did show on its accounting statements the market value loss and the resulting negative net worth — and on top of that was upside down on its cost to carry long-term mortgages — all the economists’ arguments about the counter-intuitive nature of fiat currency central banks would still be true.

When she was the Federal Reserve chair, Janet Yellen told Congress that the Fed’s capital “is something that I believe enhances the credibility and confidence in the central bank.” It would presumably follow that negative capital diminishes the credibility of and confidence in the Fed.

It is essential for the Fed’s credibility for people to believe there is no problem. As long as everybody, especially the Congress, does believe that, there will be no problem. But if Congress should come to believe that big losses display incompetence, then the Fed would have a big problem, complicating the political pressure it is already under.

It is clear from Fed minutes that its leadership knew from the beginning of QE that very large losses were likely. An excellent old rule is “don’t surprise your boss.” Should the Fed have prepared its boss, the Congress, for the eventuality, now the reality, of big losses and negative mark-to-market capital?