Is the Federal Reserve Heading Towards Insolvency?
A recent statement from the Shadow Financial Regulatory Committee, points out that both rounds of quantitative easing by the Federal Reserve have dramatically altered the maturity structure of the Fed’s balance sheet. Normally the Fed conducts monetary policy using short-term Treasury bills, which allows the Fed to avoid most interest rate risk. In loading up its balance sheet with long-dated Treasuries and mortgage-backed securities, the Fed has exposed itself to significant interest rate risk.
Recall that the yield, or interest rate, on a long term asset is inversely related to its price. So if you’re holding a mortgage that yields 5% and rates go up to 6%, then the value of that mortgage falls below par. The same holds for Treasury securities. I think it is a safe assumption that rates will be higher at some point in the future. When they finally do rise, and if the Fed still maintains a large balance sheet of long-dated assets, those assets will suffer losses.
Of course the Fed is not subject to mark-to-market rules and can avoid admitting losses by holding these assets to maturity. But if the Fed, at some point in the future, wants to fight inflation, the most obvious way of doing so would be to sell off assets from its balance sheet. It is hard to see the Fed engaging in substantial open-market operations without using its long-dated assets. But if it is to sell these assets, it will have to do so at a loss (once again, because of higher rates).
Now the Fed claims to have other avenues by which to tighten, besides open-market operations. For instance, it can raise the interest rate on excess reserves. But then this would further erode the value of assets on its balance sheet. Not to mention that they have to find the money somewhere to pay these higher rates on reserves.
Ultimately the Fed can continue to pay its bills, not out of earnings from its balance sheet, but by electronically crediting the accounts of its vendors and employees, but that would also be inflationary. The real danger, again pointed out by the Shadow Committee, is that the Fed may avoid raising rates in order to minimize the losses embedded in its balance sheet. One of the very real dangers from QE1 and QE2 is that the Fed has exposed itself to potential losses that are correlated with any efforts to fight inflation, raising serious questions as to its willingness to fight inflation.
If Not Fannie, then Who?
A common defense offered for keeping Fannie Mae and Freddie Mac, or something like them, is that the market simply cannot absorb the same level of mortgage lending without them. The central flaw in this argument is that Fannie and Freddie themselves must be funded by the market. So if the financial markets can absorb X in GSE debt, then the financial markets can absorb X in mortgages.
Different market participants currently face different capital requirements for the same assets. To some extent, Fannie and Freddie were a vehicle for shifting mortgage risk from higher capitalized institutions to less capitalized. If the Obama administration and bank regulators are serious about closing “regulatory gaps” then all entities backed by the govt, implicit or otherwise, should hold the same capital against the same risks. In the following I will thus assume that differences in capital requirements behind mortgages are irrelevant.
So to determine who could absorb the GSEs’ buying of mortgages, let’s look at who holds GSE debt. Of the approximately $5 trillion in GSE debt and mortgage backed securities (MBS), about a trillion is held by commercial banks and thrifts. Another trillion is held by insurance companies and pension funds. Close to a trillion is held by mutual funds. That quickly gets one to 3 trillion. Households and state/local governments also hold close to a trillion. That leaves us with about a trillion left, held mostly by foreign governments (usually central banks). For this analysis, I am using data pre-Federal Reserve purchases of GSE debt/MBS.
Given that banks hold about a trillion in excess reserves and over 9 trillion in deposits, I think its fair to assume commercial banks could easily absorb another $1 trillion in mortgages, as represented by foreign holders. Some holders of GSE debt are legally prohibited from holding mortgages. These entities can generally hold bank commercial paper (think mutual funds) which could then fund the same level of mortgages.
The point here should be clear, by swapping out GSE debt for mortgages, our financial markets have sufficient capacity to replace Fannie and Freddie. In fact, we are the only advanced country that does not fund our mortgage market primarily or exclusively with bank deposits. This analysis also does not assume any reduction in the size of our mortgage market, which should actually be an objective of reform. We devote too much capital to mortgages, at the expense of more productive sectors of our economy.
SEC vs. Goldman Sachs: Legislation by Demonization
The Obama administration thinks it has discovered the perfect formula to cram legislation through in a hurry: Demonize some prominent firm within an industry you plan to redesign, and then pass a law that has nothing to do with the accusation against the demonized firm. They did this with health insurance and now they’re trying it with finance.
With health insurance, the demon was Anthem Blue Cross Blue Shield of California, which Obama accused of raising premiums by “anywhere from 35 to 39 percent.” Why didn’t some curious reporter interview a single person who actually paid 39% more, or quote from a letter announcing such an increase? Because it didn’t happen. Insurance premiums are regulated by the states, and California wouldn’t approve such a boost. Yet the media’s uncritical outrage over that 39% rumor helped to enact an intrusive, redistributive health bill that has nothing to do with health insurance premiums (which remain regulated by the states).
Today, the new demon de jour is Goldman Sachs, a handy scapegoat to promote hasty financial rejiggering schemes The SEC’s suspiciously-timed civil suit against Goldman looks as flimsy as the last month’s health insurance story. It also looks unlikely to win in court.
As Washington Post columnist Sebastian Mallaby explains, “This is a non-scandal. The securities in question, so-called synthetic collateralized debt obligations, cannot exist unless somebody is betting that they will lose value.” In such a zero-sum contest, big investors who went long knew perfectly well that other investors had to be taking the other side of the bet. Goldman lost $90 million by betting this CDO would go up; John Paulson went short.
Columnists have moralized about the unfairness of the short investor (Paulson) negotiating the terms of this deal with a long investor, ACA Management, which had the last word. This too, notes Mallaby, “is another non-scandal. An investor who wants to bet against a bundle of mortgages is entitled to suggest what should go into the bundle. The buyer is equally entitled to make counter-suggestions. As the SEC’s complaint states clearly, the lead buyer in this deal, a boutique called ACA that specialized in mortgage securities, did precisely that.”
Like the earlier fuming about Anthem California, this new SEC publicity stunt is likewise irrelevant to the pending legislation. Congress hopes to get standardized derivatives traded on an exchange. But synthetic collateralized debt obligations dealing with a customized bundle of securities could not possibly be traded on an exchange, and would therefore be untouched by reform.
Losses sustained by a few financial speculators on one exotic derivative had nothing to do with starting a global recession in December 2007 or the related financial crisis of September 2008. The core of the latter crisis was mortgage-backed securities per se, yet Goldman was only the 12th largest private MBS issuer in 2007. Fannie Mae and Freddie Mac were and are the biggest risk; any reform that excludes them is a fraud.
The SEC’s dubious civil suit against Goldman is a wasteful diversion at best. It has nothing to do with the Obama administration’s suicidal impulse to impose more tough regulations and taxes on banks to encourage them to lend more.
Is the Obama Mortgage Foreclosure Plan Legal?
While considerable attention has rightly focused on the failure of President Obama’s various mortgage foreclosure plans to actually lower the rate of foreclosures, few have bothered to even ask whether the plan is allowable under the TARP statute.
Alex Pollock at AEI first raised this issue during testimony before the Congressional Oversight Panel. Alex’s point is that TARP only allows the modification of mortgages that are actually acquired by the government. Recall the original purpose of the TARP was to buy “troubled assets.” In managing those assets, Congress required the executive branch to come up with a plan to assist the borrowers behind those troubled assets.
Apparently unlike the Treasury department, I believe we should go back to the language of the statute in determining what it allows and doesn’t allow. Section 110(b)(1) is quite clear: “to the extent that the Federal property manager holds, owns, or controls mortgages, mortgage backed securities…” Nowhere else in TARP is there any other ability to establish a mortgage modification program. In using TARP funds to pay for modifications of loans not owned by the federal government, the Obama administration is acting far outside of its legal authority under TARP.
Many, including myself, have criticized the TARP as a massive delegation of spending power from Congress to the Treasury Department. Such delegation is, in my mind, clearly unconstitutional. However, even within such a broad delegation, there are parameters in which Treasury must act. Treating TARP as simply a large pot of money to spend however Treasury chooses is nothing short of illegal.
Fannie, Freddie, Peter, and Barney
Last week, after Rep. Barney Frank (D-MA) said that holders of Fannie Mae and Freddie Mac’s debt shouldn’t be expected to be treated the same as holders of U.S. government debt, the U.S. Treasury took the “unusual” step of reiterating its commitment to back Fannie and Freddie’s debt.
If ever there was case against allowing a few hundred men and women to micromanage the economy, this is it.
Fannie and Freddie, which are under government control, are being used to help prop up the ailing housing market. If investors think there’s a chance Uncle Sam won’t back the mortgage giants’ debt, mortgage interest rates could rise and demand for housing dampen. Therefore, Frank’s comments caused a bit of a stir. However, with the government bailing out anything that walks or crawls, investors apparently weren’t too concerned with Frank’s comments as the spread between Treasury and Fannie bonds barely budged.
As I noted a couple weeks ago, the Treasury is in no hurry to add Fannie and Freddie’s debt and mortgage-backed securities to the budget ($1.6 trillion and $5 trillion respectively). Congress certainly isn’t interested in raising the debt ceiling to make room. And as Arnold Kling points out, putting Fannie and Freddie on the government’s books would actually force the government to do something about the doddering duo.
All of which points to what an unfunny joke budgeting is in Washington. Take a look at what current OMB director Peter Orszag had to say about the issue when he was head of the Congressional Budget Office:
Given the steps announced by the Treasury Department and the Federal Housing Finance Agency on September 7, it is CBO’s view that the operations of Fannie Mae and Freddie Mac should be directly incorporated into the federal budget. The GSEs’ revenue would be treated as federal revenue and their expenditures as federal outlays, with appropriate adjustments for the manner in which credit transactions (like a mortgage guarantee) are reflected in the federal budget.
Note that Orszag wrote that statement less than two years ago. And since then, the bond between the government and the mortgage giants has only gotten tighter.
The same people that say Fannie and Freddie shouldn’t be on the government’s books are often the same people who once dismissed concerns that the two companies were headed toward financial ruin. In 2002, Orszag co-authored a paper at Fannie’s behest that concluded that “the probability of default by the GSEs is extremely small.”
Another one of those persons, Congressman Frank, has his fingerprints all over the housing meltdown. In 2003, a defiant Frank stated that “These two entities – Fannie Mae and Freddie Mac – are not facing any kind of financial crisis.” Frank couldn’t have been more wrong. Yet there he remains perched on his House Committee on Financial Services chairman’s seat, his every utterance so important that they can move interest rates.
Week in Review: Health Care Battles, Pay Caps and North Korean Prisoners
Will Obama Raise Middle-Class Taxes to Fund Health Care?
President Obama is promoting an expansion in federal health care spending, and Democratic leaders are scrambling to find ways to pay for it. The plan is expected to cost about $1.5 trillion over the next decade, but the administration has promised that health care legislation won’t add to already huge federal budget deficits. In a new paper, Cato scholars Michael D. Tanner and Chris Edwards argue that expanding government health care will likely involve huge tax increases on the middle class.
Tanner warns of “Obamacare” to come, saying that Obama’s new health care plan will give “government control over one-sixth of the U.S. economy, and over some of the most important, personal, and private decisions in Americans’ lives.” Don’t miss Tanner’s in-depth analysis of the new health care plan that is making its way through Congress, which “would dramatically transform the American health care system in a way that would harm taxpayers, health care providers, and — most importantly — the quality and range of care given to patients.”
A part of the plan would include “public option” (read: government-run) health care, which would allow the government to compete against private health care providers. Tanner says it would be the first step toward wiping out the private insurance market as we know it:
Regardless of how it is structured or administered, such a plan would have an inherent advantage in the marketplace because it would ultimately be subsidized by taxpayers. It could, for instance, keep its premiums artificially low or offer extra benefits, then turn to the U.S. Treasury to cover any shortfalls. Consumers would naturally be attracted to the lower-cost, higher-benefit government program.
…It is unlikely that any significant private insurance market could continue to exist under such circumstances. America would be firmly on the road to a single-payer health care system with all the dangers that presents. That would be a disaster for American taxpayers, physicians, and—most importantly—patients.
Treasury Seeks to Control Executive Pay Across the Private Sector
Fox Business reports, “The Treasury Department on Wednesday took new steps to rein in executive compensation, saying the Obama Administration would introduce legislation that could create stricter limits on pay; it also appointed an official to head up efforts on the issue.”
In a 2008 Policy Analysis Ira T. Kay and Steven Van Putten explain the misconceptions many people have about executive pay, and why the market is a better arbiter than any bureaucrat in Washington:
Such populist sentiments are often based on misunderstandings about the role of corporate executives in the economy and the vigorous competition that exists for these highly skilled leaders. In the past, federal regulatory efforts based on such misunderstandings have generated unintended consequences, which have damaged the economy and hurt the ability of the market for executives to self-regulate over time.
The labor market for executives and the associated pay levels are already subject to high levels of regulation. Indeed, U.S. corporations are subject to more stringent executive pay disclosure requirements than corporations anywhere else in the world. Before additional regulatory and legislative efforts are unleashed, policymakers should examine the rationale for current pay structures and the strong links between executive pay and corporate performance.
In a Washington Times op-ed, Alan Reynolds says efforts to cap executive pay are wholly misguided:
Congressional hearings to barbecue Wall Street executives are as fun as a circus, but with more clowns. Presidential politics is now taking such political distractions to a lower level.
…Most top executives who were actually in charge during the craze of overinvestment in mortgage-backed securities have been fired. Executives who are fired are not in a position to be “giving themselves” anything.
In reality, top executives are mainly paid by accumulating a big stockpile of company stock and stock options. Estimates of annual CEO pay that Congress and the press have been focusing on look as high as they do only because of the high value of restricted stock or stock options at the time.
Writing in 2007 (before the first round of major bailouts), Cato scholars Jerry Taylor and Jagadeesh Gokhale took it a step further: “Pay Bosses More!”:
Excessive executive compensation harms no one but perhaps the stockholders who put up with it. And stockholders put up with it because there’s good reason to believe that sizable CEO compensation packages help — not harm — corporate performance, which redounds to their benefit, and that of the firms’ workers.
Companies pay workers what they must to deliver their products and services to the market, and supply and demand establishes executive compensation packages the same way it establishes consumer prices. Any overcompensation comes out of the firm’s bottom line — at a loss to the shareholders, not the workers.
North Korea Sentences Two U.S. Journalists to 12 Years Hard Labor
Two American journalists were convicted of entering North Korea illegally while on assignment, and exhibiting “hostility toward the Korean people.” This week, a North Korean court sentenced them to 12 years in a labor prison.
Cato scholar Doug Bandow comments:
Washington should publicly downplay the controversy and present the issue to the Kim regime as a humanitarian matter. The Obama administration should indicate its willingness to open a broader dialogue with North Korea, but indicate that positive results will be possible only if Pyongyang responds with cooperation instead of confrontation. Releasing the two journalists obviously would provide evidence of the former.
Regrettably, Laura Ling and Euna Lee are political pawns. As such, Washington’s best strategy to achieve their release is to simultaneously reduce their perceived value to Pyongyang and ease tensions between the U.S. and North Korea. Patience may be the Obama administration’s highest virtue and Ling’s and Lee’s greatest hope.
In a Cato Daily Podcast, Bandow discusses what can be done for the American prisoners, and how the U.S. government should react.
More Cheap Money from the Fed
The Federal Reserve announced that it would create $1.2 trillion out of thin air and use it to buy mortgage-backed securities and Treasury bonds, even though
Some Fed leaders have resisted buying Treasurys in the past because they were unsure whether it would help reduce borrowing costs and because they feared that it would appear that the central bank was simply printing money to finance the government’s deficit, a hallmark of countries with poorly managed economies.
Why Bank Stocks Rose on Bernanke’s Remarks
In a CNBC spot with Steve Liesman & Erin Burnett, I tried to explain why investors in bank stocks had good reason to be pleased with part of Fed Chairman Ben Bernanke’s speech. Judging by the response of Steve and Erin, and others on CNBC over the following day, I must not have been persuasive.
For clarification, I am quoting the exact language from Bernanke’s talk, with my emphasis added.
My main point is that Bernanke admitted that when it comes to the “financial crisis” of some big banks, this is largely an artifact of unduly harsh regulation being applied at the worst possible time:
There is some evidence that capital standards, accounting rules, and other regulations have made the financial sector excessively procyclical–that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes.
For example, capital regulations require that banks’ capital ratios meet or exceed fixed minimum standards for the bank to be considered safe and sound by regulators. Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. We should review capital regulations to ensure that they are appropriately forward-looking. . .
Bernanke emphasized the regulators’ dangerous habit of raising capital requirements and loan loss reserves simply because of a strict mark-to-market misinterpretation of the “fair value” of mortgage-backed securities.
He noted that:
Determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loan loss reserves over the cycle. As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency.
The key here is Bernanke’s criticism of the rigid use of Basel capital standards, not mark-to-market information per se (which would be harmless if it did not trigger foolish regulations). When combined with Barney Frank’s similar comments on the same day, it begins to look as though sensible economics might finally take priority over dubious bookkeeping.
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