Financial policy: Looking forward

Washington is turning its attention to the future, having put out most of the financial fires. The crisis seems to be over, but questions remain about how to manage under-capitalized banks and, especially, how to design a financial system for the future that is more robust to adverse shocks. With fiscal stimulus in place and no likelihood of more, financial policy by the Fed and the Treasury is the only active possibility for further action to offset the recession.

The current state of the economy

The stock market thinks that the economy is turning around, and the financial press greeted last Friday’s payroll report with a positive spin, for once. But the news is not good. Here’s payroll employment, compared to  the severe recession of 1981-82:

 

The good news is only the almost invisible inflection in the downward path of jobs.

Apart from the successful effort to prevent the collapse of the financial system, the primary financial action to offset the recession has been the Fed’s  adoption of an interest-rate target for interbank lending of essentially zero. Rates on short-term safe assets–Treasury obligations and private instruments enjoying explicit or implicit government guarantees–are close to zero. But, sadly, rates actually paid by most private decision makers are almost as high, or in some cases higher, than before the recession began. The Fed and Treasury’s policies to lower these rates have delivered fairly little so far. Here is the record:

Rates paid by individuals–credit cards, pesonal loans, car loans, and mortgages–have fallen slightly, but by less than the decline in inflation, so the real rates are up a bit. Rates paid by corporations, measured here as BAA bond rates, have risen substantially in nominal terms and even more in real terms. Rates paid by state and local governments have also risen in slightly in nominal terms and more in real terms.

The notion that monetary policy has been highly expansionary–promoted by those looking only at safe government (Treasury) interest rates and at the volume of bank reserves–is plainly incorrect. Rather, higher interest rates are discouraging spending and production.

Monetary expansion

The Fed is attacking high interest rates by purchasing private debt. Higher demand for any class of debt will drive down the interest rate for that class. One of the important lessons of the past year has been that various interest rates do not all move together in times of severe financial stress (or at other times either). Thus, the Fed has not run out of options after it drives the Fed funds rate to zero. Unfortunately, the Fed is not able to expand its holdings of private securities efficiently. The efficient borrower is the Treasury, which floats short-term debt at very low rates in the world credit market. The buyers placing the highest value of Treasury debt outbid the others, so the debt finds its most desirable home. By contrast, the Fed borrows only from American banks. The Fed currently pays twice as high an interest rate on its borrowings as does the Treasury for its shortest-term borrowings (25 basis points for the Fed; 14 for the Treasury). The Fed displaces other asset holdings in  American bank portfolios, whereas the Treasury places its debt in many portfolios around the world. Earlier in the crisis, the Treasury did borrow and place the funds at the Fed’s disposal, providing the efficient approach to Fed expansion, but the Treasury has withdrawn most of those funds. It’s time for the Treasury to resume its past practice on a much larger scale and for the Fed to cut reserves back to more normal levels. The political obstacle to this move is the ceiling on the national debt, which fails to count reserves as part of the debt, so the government can circumvent the ceiling by creating reserves instead of issuing Treasury securities, at a somewhat higher cost.

Current policy for weak financial institutions

Economists are increasingly puzzled by the government’s treatment of banks and other financial institutions that are teetering near insolvency. The doctrine is widely accepted that institutions in this state are a danger to the economy (because their incentive is to take some big risks to try to get out of the hole, as the S&Ls did in the 1980s) and that regulators should take prompt, aggressive action to return them to sound financial condition. This doctrine calls for institutions to be reorganized or recapitalized so that they are unambiguously solvent and the consequences of risk-taking are mainly their own. The government’s actions for Chrysler and General Motors follow the doctrine. In Chrysler’s case, bankruptcy converts the claims of debtholders into equity, making its new relationship with Fiat financially attractive to Fiat. General Motors may be able to continue as a stand-alone automaker if the claims of its debtholders, including the debt-like claims of retirees, become equity.

By contrast, the government’s current policy for all large financial institutions is to dribble taxpayers’ funds into the institutions so that they can meet their stated obligations to all parties, including debtholders, but just barely. The government injects funds into AIG, Citigroup, the Bank of America, and many other institutions to keep them just above water. The government has forgotten the doctrine of immediate full recapitalization in the case of financial institutions, despite the clear lessons of international experience. The Scandinavian countries aggressively reorganized and recapitalized banks after the crisis of the early 1990s and quickly restored full employment and growth; the Japanese followed the policy of supporting marginal banks for what became the “lost decade.”

The celebrated stress tests, just completed, illustrate the current policy perfectly. The test asks if it is likely that a bank can sustain its current status through the end of 2010. “Sustain” means earn enough from operations and asset returns to cover losses that would occur under a pessimistic macro forecast. The Fed’s white paper describing the tests contains the following remarkable sentence: “While this approach [the stress test] likely captures the bulk of the losses that might be realized on these assets, it is important to note that it does not include the substantial losses that have already been taken.” (page 3) The stress test takes the current condition of the bank as the goal for the future. If the bank can just squeak through the next 20 months with enough profit from operations and margins of investment earnings over the cost of funds to offset increases in reserves for loan losses, then it passes the test. If the bank would have inadequate capital at the end of 2010 under the scenario, it flunks the test and needs more capital. Many large banks including Citigroup and the Bank of America flunked. They need to raise capital to be barely solvent at the end of next year. The test has nothing to do with ensuring that banks are heavily capitalized, ready to resume their normal roles in the economy.  The stress test is the right way to figure out the minimum amount needed to inject in weak banks to keep them barely afloat, but that is the wrong policy. The government turned to stress tests, it appears,  out of discomfort with the answers the standard capital tests gave, based on seeing that properly measured capital was adequate in relation to obligations.

Unfavorable developments since the design of the stress test raise questions about its interpretation as the most pessimistic reasonable forecast. In the “more adverse” forecast that claimed that character, the unemployment rate is 8.9 percent for 2009 and 10.3 percent for 2010. The rate as of April 2009 was already 8.9 percent and almost certain to rise more during the coming months. The “more adverse” projection of 3.3 percent decline in real GDP in 2009 over 2008 is close to the current consensus. The figure for 2010 of 0.5 is below the consensus.

The market for bank debt tells an interesting story about the current policy (data are available to the public from FINRA’s TRACE database). Citigroup’s debt maturing in the next few years sells at par. The market believes the government’s pronouncement that it will keep Citigroup solvent in the near term. For longer maturities, the debt is deeply discounted. A large issue maturing in 2032, with a coupon rate of 6.625 percent, sold on May 8 for $65 per $100 of par value, to yield 10.8 percent. The market assigns a significant probability to default after the crisis clears up.

The effect of the government’s current policy is to pay off all claimants on financial institutions at face value, including those which, when they were first issued,  had no expectation of federal bailout and received substantial interest premiums on account of their willingness to accept the risk of default. This policy is hugely expensive and stands in stark contrast to the losses that the government has expected investors in the debt of automakers to recognize. The Treasury has proposed legislation to empower the government to reorganize financial institutions but has not indicated that the new powers would focus on reorganizations that would recapitalize financial institutions without handing debtholders huge capital gains. The continuation of current policy would automatically give those capital gains. Holders of the Citigroup debt mentioned above would enjoy a large capital gain (from $65 to somewhere near $100) if investors came to believe that the government would keep dribbling funds into Citigroup to enable it to meet all its future obligations, including paying the interest and principal on that debt issue.

Because Congress, acting on behalf of the taxpayers, seems reluctant to vote new bailout funds for most financial institutions and is firmly opposed in the case of AIG, the government needs a better alternative for stabilizing weak institutions. There are much better uses for federal money than handing capital gains to debtholders.

We can easily describe the desirable policy in terms of goals, though implementation is more of a challenge. A primary goal is to avoid interference with the high-speed transactions of modern financial institutions. As the unwinding of Lehman Brothers shows, traditional bankruptcy can be a disorderly method for reorganizing modern financial institutions. The reorganization needs to start with a clear statement that the institution will meet its short-run obligations in full. In other words, some minimal amount of capital gains to claimants is involved in a practical reorganization. If an institution has substantial amounts of debt outstanding that is subordinated to all other claims, reorganization is fairly simple. The danger to the institution is that the subordinated claimants will put the institution into barnkruptcy at some future time when the institution fails to make required payments to those debtholders and that the bankruptcy will plunge the entire organization into Lehman-like chaos. To sidestep this danger, the reorganization alters the claims of the subordinated debtholders so that they cannot trigger a bankruptcy or so that the bankruptcy that they can trigger does not interfere with the activities of the institution.

The first approach is easy. It is the one that the government pushed on the debtholders of the automakers–convert debt to equity. With new powers granted by Congress, the government could figure out a conversion value  for a large amount of debt that gave the debtholders the same market value as equity as they currently enjoy. The debtholders would suffer no capital gain or loss. As the experience with automakers’ debt showed, it is virtually impossible to achieve such an exchange voluntarily, because both sides will play “chicken” until adult supervision intervenes. The compulsion of new law is necessary. Finding the conversion value is easier said than done, but is at least a well-posed question.

If a borderline institution lacks enough fully-subordinated debt to achieve an adequate level of capital by converting debt to equity, longer-term debt could be treated as if it were fully subordinated. Again, the debtholders could be given equity equal in value to the market value of the debt they gave up. In this case, the claimants subordinate to the converted debtholders would enjoy a captial gain, at the cost of the shareholders. One could imagine some kind of redistribution to deal with this inequity, but it is a complication. In the case of Citi, the claimants subordinated to the debt to be converted are mainly the foreign depositors.  Foreign depositors stand to absorb losses before the debt-holders do. Because the foreign deposits can be withdrawn on demand, even a hint of a policy that failed to deliver full value would trigger a run.  Averting the potential for a run in the midst of a bankruptcy, which would surely bring chaos, is the point of the reorganization.

Actual exchanges of debt for equity are not needed to  recapitalize shaky institutions. Recall that the goal is to prevent bankruptcy from interfering with substantive business, not to prevent bankruptcy entirely. Reorganizing an institution so that the debtholders retain a debt claim is practical. If the institution suffers further losses in value which cause it to default on the debt, a bankruptcy will occur. Our earlier post described how to do this. In brief, the debtholders’ and existing shareholders’ claims are moved to a holding company (if they are not already in a holding company) which owns all of the equity in the operating institution. Some people, including us in our earlier post, called the holding company the “bad bank” and the operating entity the “good bank.” If the earnings of the operating institution are insufficient to meet the obligations to the debtholders at some future time, the holding company does a simple Chapter 7 bankruptcy in which the debtholders become the shareholders in the holding company, with no implications for the operating institution. This type of reoganization involves quite a few alterations in the contracts between the operating institution and its customers and counterparties, so it definitely requires the kinds of new powers that the Treasury has sought recently from Congress.

The bottom line is that Congress and the taxpayers are intolerant of continued expenditures for bailouts that generate large capital gains for debtholders, that the bailout policy maintains shaky financial institutions while a better policy would deliver fully capitalized, reliable ones, and that Congress should enact legislation promptly that would make these reorganizations possible. 

Reform for the longer run

Among economists, a consensus is forming that regulation of the financial instutitons that enjoy the government’s protection should compel those institutions to have a structure that eases the type of reorganization discussed above (see the statement of the Squam Lake Working Group, an alliance of leading financial economists). The simplest version is to require that banks hold fully subordinated debt and equity of, say, 40 percent of assets, in a holding company, in such a way that the bankruptcy of the holding company would not interfere even briefly with the immediate operations of the bank.  As we discussed above, if the operations of the bank, paid as dividends to the holding company, could not meet the obligations to the debtholders, the holding company would go through a Chapter 7 bankruptcy and the bondholders would take over as shareholders.  The Squam Lake proposal would sidestep the bankruptcy by designing the debt to convert to equity on its own terms under adverse conditions.

The idea that banks should have large amounts of fully subordinated debt is hardly new. The only novelty in this line of thought is methods for protecting banks and similar institutions from breakdowns in high-speed financial transactions. And this novelty arises because our financial institutions have new moving parts they did not have even 25 years ago, and because it has been such a long time since our largest banks were so close to insolvent.  The regulatory structure has not kept up.

Under a requirement of substantial amounts of subordinated debt, bank deposits would become almost completely safe. Banks would be limited to financing their activities through deposits to the remaining fraction, 60 percent in our example above. For larger banks, this would not be a binding limitation.

The Fed Needs to Make a Policy Statement

More and more one hears the concern that the Fed has embarked on an expansionary policy that will result in high inflation once the economy returns to normal. John Taylor, a leading expert in this area, put the argument as follows, in recent Congressional testimony:

… the enormous increase in reserves is potentially inflationary. Many people ask me if it is inflationary, so I know it is on people’s minds. With the economy in a weak state and commodity and many other prices falling, inflation is not now a problem, but at some time the Federal Reserve will have to remove these reserves or we will have a large increase in inflation…Recall that increases in money growth affect inflation with a long lag. The question is whether the Fed will be able to reduce the reserves in time and whether people will expect the Fed to do so. If reserves get to the level [implicit in recent policy announcements] it will have to sell a huge amount of securities backed by consumer credit, mortgages, student loans, and auto loans. This will be difficult to do politically.

Chairman Bernanke responded to this view in January, but his answer–basically what we view as the correct one–received little attention and did not alleviate the misconception of incipient inflation that has spread widely since then.

A common way to express the concern is that the Fed has created huge amounts of money and that it will not be able to shrink the money supply in time to avert inflation as the economy recovers. This way of expressing the issue is completely confusing, because it equates reserves with money. The Fed now pays interest on reserves, so the connection of reserves to money is not mechanical but requires a modern analysis that includes the role of the interest rate on reserves. Though many central banks now pay interest on reserves, the extension of monetary theory to include that new factor has remained obscure. Only little-known academic studies such as “Controlling the Price Level” and “Optimal Fiduciary Monetary Systems” considered the issue.

Reserves are interest-bearing obligations of the Federal Government, enjoying the same safety and liquidity as Treasury bills. Reserves form the core of the payments system. Anybody can trade reserves dollar-for-dollar for currency by cashing a check, withdrawing from an ATM, or depositing currency in a bank account. Financial obligations stated in dollars can be met definitively by writing a check, which is an instruction to one bank to transfer reserves to another bank.

Banks must hold reserves of 10 percent of the amounts in their depositors’ checking accounts (required reserves), but this requirement is not binding today, as banks are holding vastly more than their required reserves.

When the Fed pays interest on reserves at a rate well below market rates–in particular, well below the Fed funds rate governing borrowing and lending among banks–banks economize on reserves. If the margin between the Fed funds rate and the reserve rate is large, say several percentage points, banks will hold only required reserves. In this case, standard old-fashioned monetary theory applies, taught to generations of freshman principles students as the “multiple expansion of deposits.”  Suppose we start with deposits of $100 billion and reserves of $10 billion, so banks hold no reserves in excess of requirements. Then the Fed creates another $1 billion of reserves. Banks will expand their activities to try to avoid holding excess reserves, which are undesirable because they pay interest far below market rates. The economy expands as a result, depositors hold more in their checking accounts–$110 billion to be precise–and banks no longer hold excess reserves. The economic expansion is a combination of more real activity and higher prices. An expansion of reserves raises the rate of inflation over some period, generally thought to run from about a year after the expansion to around four years.

This conventional analysis always applied when the Fed paid zero interest on reserves and market rates were in the range of 5 percent or more. Banks used sharp-pencil policies to avoid holding excess reserves. Manipulation of the quantity of reserves gave the Fed powerful and direct and direct control over economic activity and inflation.

When reserve interest rates and the Fed funds interest rate are close to each other, the situation is quite different. Banks are happy to hold excess reserves which pay just as much as could be earned on other safe investments. Expansion of reserves results mainly in expansion of excess reserves and has little effect on bank lending. Rather than stimulating economic activity and raising the volume of bank deposits, an expansion of reserves just adds to banks’  holdings of reserves. The Fed loses its control over economic activity. In particular, expansion of reserves is not inflationary when the reserve rate and Fed funds rate are the same. There is no risk of excess inflation in today’s economy.

Equality of the reserve rate and the funds rate comes about in two ways. One is for the funds rate to fall toward the reserve rate. Prior to October 2008, the reserve rate was always zero. Thus, as the funds rate approaches zero, the mechanical connection between reserves and economic activity vanishes. This limitation on the Fed’s ability to stimulate the economy has long been known.

The second way the two rates could become equal is for the reserve rate to rise to the level of the funds rate (or even a bit above, as it has since October). Note that both factors have operated in recent months. When the Fed started to pay interest on reserves in October, it set the rate at 0.75 percent or 75 basis points. The current rate is 25 basis points.

Raising the reserve interest rate is a contractionary measure.  A higher interest rate on reserves makes banks more likely to hold reserves rather than increasing lending. The Fed’s decision to raise the reserve rate from zero to 75 basis points just as the economy entered a sharp contraction in activity is utterly inexplicable. Fortunately, the Fed lowered the reserve rate subsequently, but the continuation of a positive reserve rate in today’s economy is equally inexplicable.  Some economists have proposed that the Fed charge banks for holding reserves, an expansionary policy worth considering. With the Fed funds rate at around 15 basis points, it would take a charge to restore the differential that drives banks to lend rather than hold reserves. Were the Fed to charge for reserves, they would become the hot potatoes that they were in the past, when the reserve rate was zero and the Fed funds rate 4 or 5 percent. Banks would expand lending to try not to hold the hot potatoes and the economy would expand. There is no basis for the claim that the Fed has lost its ability to steer the economy. (However, the Fed would have to go to Congress to get this power, as it did to get the power to pay positive interest on reserves.)

The basic point emerging from the analysis of the role of the reserve interest rate is simple: The margin between the Fed funds rate and the reserve rate is a potent new tool for stabilizing the economy. When the Fed wants to expand, it should raise the margin. In today’s economy, this would call for a negative reserve rate, that is, a charge to banks for holding reserves. When the time comes to move to a tighter policy, the Fed should lower the margin. At that time, the Fed would raise the reserve rate for two reason: first to reduce the margin and second to follow increases in market interest rates that will occur in a recovery.

So the question John Taylor posed–how can the Fed control inflation in coming years when it is committed to have a large volume of reserves outstanding to finance its purchases of illiquid assets?–has a simple and effective answer: The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.

How should the Fed pick the level of the reserve interest rate? The policy for the reserve rate should be basically the same as the successful policy for the Fed funds rate that delivered exceptional stability to the economy from the mid-1980s until the current crisis. During that period, the Fed set the funds rate adaptively–when the economy seemed headed for overheating and excess inflation, it raised the funds rate to cool the economy off. When the economy stumbled, as in 2001 and in 2008, the Fed cut the funds rate to low levels. The resulting record on inflation was outstanding–the inflation rate remained in a tight band centered on about 2.5 percent.  One of the best ways to judge the performance of the Fed is to look at the consensus forecast for inflation over the coming two years. For the past 20 years, the forecast was right on 2 to 3 percent with few exceptions. Today the consensus is for too little inflation–only 1.2 percent in 2009 and 2010 and 1.7 percent in 2011. So inflation forecasts call for expansion. Once the forecast rises to around 2.5 percent for the coming two years, the Fed should raise the reserve interest rate and reduce the volume of reserves (to the extent permitted by the liquidty of its portfolio at that time) as needed to keep the forecast at around 2.5 percent. The Fed can pick a combination of a higher reserve rate and a lower volume of reserves to cool the economy sufficiently to keep inflation on tdarget.

The Fed needs to issue a pronouncement along the following lines to assure the public that there is no need for concern about inflation after the receovery and to reaffirm its historical commitment to stable and low inflation:

The Federal Reserve is fully committed to a policy of stable and low inflation. Though the Fed has not adopted a quantitative target for a specific measure of inflation, its actual performance over the period from 1987 through 2007 is indicative of its goal for the future. The Fed will continue its efforts to expand the economy this year, when inflation appears to be well below its normal range. Its past and planned expansionary policies during the current period of extreme stress will result in a large expansion of reserves. The Fed will use its authority to pay interest on reserves as needed to prevent excessive inflation as the economy recovers.

 Even the St. Louis Fed has missed the point that reserve interest policy can take care of an overhang of reserves. An article in its Review that discusses interest on reserves nonetheless concludes.

The key is that the Fed will have to drain reserves when the economy begins to recover if it is to prevent a rapid acceleration of inflation. That necessity drives the current discussion of exit strategies.

The (incorrect) logic suggested by this sentence is that as long as the Fed has a high volume of reserves outstanding, they must be held by the banking system and thus the monetary base must be large and inflationary. It misses the point that banks can be coaxed into just the right demand for excess reserves to ensure the desired inflation rate, by paying the right interest rate on reserves. The exit strategy from the Fed’s holdings of illiquid asssets need not be constrained by concerns about inflation, becuase reserve-rate policy can take care of inflation.

The author responds:

I like your website and this article, though, I think I was misrepresented (but not too badly). 

I understood the point made by Woodward and Hall when I wrote the article on recent changes in the monetary base. To quote, “The difficulty of maintaining price stability will depend on the size the balance sheet reaches before the crisis ends, the quality of the assets in the portfolio, and the policy followed to manage the interest rate paid on reserves.” (Italics added, page 57) The article is correct in that I chose to downplay this aspect of policy. For a model of the suggested policy, I recommend “Divorcing Money from Monetary Policy,” by Todd Keister, Antoine Martin and James McAndrews at the New York Fed.

It is not necessarily true that the Fed alone (that is, without further appropriations from Congress) could raise the interest rate on excess reserves high enough to prevent inflation. It is relatively easy to imagine situations in which the interest cost paid on reserves would absorb most or all of the Fed’s income. Such conditions might include an inverted yield curve, reduced income from the GSEs, and/or a rising portfolio of nonperforming assets from bank rescue operations.

Employment decline compared to Depression

The March payroll employment data showed that the decline in employment from the peak in December 2007 is now larger in percentage terms than the decline in the worst recession since 1960, in 1981-82. The plot below shows, however, that the decline is small in comparison to the Depression. The government did not collect monthly employment data during the Depression, so we have fitted a smooth curve through the annual data. The peak before the Depression was in August 1929, according to the NBER.

The right way to create a good bank and a bad bank

Policymakers continue to struggle to figure out how to turn a troubled bank into a good bank and a bad bank. Under the good-bank/bad-bank policy, the good bank will operate free from concerns about troubled assets, because these assets will be held by the fully independent bad bank. Most discussions of the separation of a bank in this way presume that the government must inject a lot of new capital to create a well-capitalized good bank together with a still-solvent bad bank. The math seems simple–the troubled bank has almost no capital, so if the capital has to be split between the two banks, a well-capitalized bank will need new capital.

But this math is incomplete. We can create a good bank with a big cushion of capital while keeping the bad bank as solvent as the existing integrated bank. The key idea–from Jeremy Bulow–is that the bad bank owns all of the equity in the good bank.

We illustrate with data from Citicorp (in billions of dollars):

The left column shows Citicorp’s balance sheet roughly marked to market. The company’s value in the stock market of $11 billion is $76 billion less than reported book equity value. We deduct that amount from the reported value of long-term assets, which is where the troubled real-estate related assets are most likely to reside.

The other two columns show the balance sheets of the new good bank and bad bank. The good bank will continue to operate under the Citi brands as a well-capitalized operating entity. The bad bank will be a financial fund with no operating functions.  The good bank gets the short-terms assets and the “other” assets because many of these are related to its operating activities. It gets the better half of the long-term assets, taken to have book value, while the bad bank gets the poor half, where the impairment has already occurred and suspicions of further price declines persist. The bad bank holds the valuable equity in the good bank to the tune of $427 billion.

The deposits remain as liabilities of the good bank. Because the good bank is heavily capitalized, the deposits are safe. Most are uninsured, so the creation of the good bank eliminates the danger of a run on the bank by those depositors. All of the debt goes to the bad bank. The holders of the debt were never promised a government guarantee. The shareholders in Citicorp become the shareholders in the bad bank. They are indirectly shareholders in the good bank as well, because the bad bank owns the good bank.

The bad bank is thinly capitalized. In fact, it has exactly the same amount of capital that Citi had in the first place. With further declines in the values of the troubled assets, the bad bank may become insolvent. In that case, the bondholders will need to negotiate diminished values or the bad bank will need to be reorganized. In either case, the shareholders will lose all their value, just as they would have lost that value had Citi not been divided and there had been no further bailout from the government. The bondholders will lose part of their value, because there is no reason or justification for bailing them out.

The key property of this approach is that neither the shareholders nor the bondholders suffer any impairment of their existing intrinsic values. At present, the shareholders own an out-of-the-money call option on the assets. The bondholders own the assets subject to the shareholders’ call. Their combined value declines by the amount of any further decline in the value of the troubled assets. As claimants on the bad bank, they would be in the same situation, sharing the same decline in value, with the losses of bad-bank shareholders equal to the losses of Citi’s shareholders absent the separation and the same for the bondholders.

The adoption of the proposed good- and bad-bank separation would result in capital losses for the shareholders and bondholders, because the new policy would eliminate the benefit that they might receive from further bailout money from the government. The potential reorganization of the bad bank made necessary by future insolvency would not create any kind of financial emergency, so there would be no reason for the government to bail out the bad bank. There is no reason not to inflict the capital losses on the shareholders and bondholders, as they represent the capitalization of possible bad policies and are unrelated to the assets that the shareholders and bondholders actually own.

Now one might wonder, given that the intrinsic claims of neither the bond holders nor the equity holders has changed, why bother?  Pundits talk about the toxic assets in the banking system as if somehow they were infectious, and the good assets would become infected by the bad assets. One envisions the mold on one piece of cheese taking up residence on an adjacent piece in the frig. Or that somehow if the bad, hard-to-value, assets were moved somewhere else, both sets of assets would be easier to value and the banking system somehow more sound.  We don’t think the bad assets are infectious. Nor do we think this re-arrangement increases or changes values or facilitates the valuations of the assets behind the banking system.  What the change does do is make ever-so-clear what the priorities are in an insolvency.  Note that in this re-arrangement, the debt claims, including the short-term commercial paper, are direct liabilities of the bad bank.  If the bad bank cannot re-fund its commercial paper one morning, the bad bank must be re-organized.  Some of its claims must be turned into equity.  This is the standard sort of Chapter 11 re-organization.

Thus, what this re-organization of the ownership claims does is show how easy and orderly a garden-variety Chapter 11 reorganization of a large bank could be, and how unnecessary it is to throw additional public money into insolvent institutions.  And thinking about public money in insolvent institutions, consider that Citi’s present market cap of $11 billion (as of the close on Friday, 20 Feb 2009) includes the Treasury’s (that is, the public’s) investment of $50 billion in preferred stock (10/28/2008 and 12/31/08), and asset guarantees (1/16/09) are unambiguously underwater.

At the most practical level, the advantage of the good-bank/bad-bank separation is to prevent the emergency that would occur if a large bank threatened insolvency. For Citibank, which has large amounts of uninsured deposits, which would remain in the good bank, the first symptom would be a run on the bank by those depositors. At that time, the pressure for offsetting the emergency by an injection of public money would be overwhelming. By contrast, no run would occur on the heavily capitalized good bank in our example. Reorganization could proceed peacefully while the good bank went about its banking business. The claims of the shareholders and bondholders, which are inferior to those of the depositors, can be sorted out without interfering with the operation of the bank.

Much thinking about bank policy takes an old-fashioned point of view by assuming that a bank finances all of its assets through deposits. The good-bank/bad-bank separation has no advantage in that traditional setting. But for a bank that is mostly financed by non-deposit borrowing, moving the non-deposit liabilities to the bad bank has an advantage in dealing with insolvency.

Employment crosses the line

With the January figure, payroll employment has crossed the line of the worst previous recession, the one beginning in July 1981, rescaled to the size of today’s labor force. One more bad month and the current recession will become the worst on record, apart from the Great Depression.

The Fed contracts

The Fed has indicated that it plans to pursue a policy of quantitative easing, that is, expanding its portfolio by borrowing in financial markets at low rates and investing the proceeds in higher-yielding private investments. The Fed’s acquisition of large amounts of Fannie and Freddie’s debt was a notable success of that strategy, as it lowered their borrowing rates and thus lowered mortgage rates. But, as the graph below shows, the Fed has engaged in quantitative tightening over the past month, reducing its borrowing and reducing its holdings of higher-yielding investments. The line labed “Other assets” measures that type of investment. So far, no explanation for the Fed’s announcements of moving in an expansionary direction while actually contracting.

Venture Capital in the Recession

 

While plant and equipment spending for the entire economy was down in the fourth quarter, it only fell by 4.4 percent from its level in the fourth quarter of 2007.  By contrast, venture capital investment was down by 31 percent.  In the fourth quarter of 2007, $8.1 billion was invested in 850 venture deals.  In the fourth quarter of 2008, $5.6 billion was invested in 790 deals. The number of deals is not abnormally small—over the last five years, the fourth quarter has seen 750 deals on average, but the total invested is down a lot from last year.

 

This bodes ill for the 2000 vintage of venture capital.  Compare and contrast two vintages of venture:  1992 and 2000.  First note that we look at venture vintage years a bit differently from how other analysts look at them.  Others look at the year a venture fund originated.  Our vintages represent a set of companies that got their first round of venture funding in a given year.  In our analysis, the 1992 vintage year is all companies who received a first round of venture funding in 1992. 

 

1992 was a good year and a typical year for venture capital. By our reckoning, 1995 was the best year.  Reason is that the companies were mature enough to exit (go public or be acquired) at a time when the stock market was high.  Here’s the evolution of that 1992 vintage: 

 

 

To produce this chart, we add up all the investments made in the 1992 vintage companies, both in 1992 and all subsequent years.  We benchmark that total at 100 to make years easy to compare.  The blue line shows the total capital to be invested in the companies, and it declines over time as investments are made.  The red line shows the value of portfolio companies that are in venture portfolios, only from the 1992 vintage.  The black line shows cumulative distributions to investors from acquisitions and IPOs.  (This chart does not follow companies after they go public.  We figure there are already enough folks tracking public companies.)   Then there is the purple “total” line, the sum of capital that will be invested, value carried in private companies, and distributions to investors. Notice how the total line slopes upward most steeply in the early years, typically years 3-6, as the best investments exit.  The best exits are among the earliest, it seems for no more profound reason than the best ideas are evidently the best fairly early.  As time passes, the additional exits are middling.  Chances are, after 7 or 8 years, that if a company has not done something great for its investors as yet, it is not going to. This is a bit less true for the life science sector of venture than for information technology. But then, life science is the less risky sector of venture capital by every metric.

 Note how the rising tide of the stock market raised all values in 2000. For venture capital 2000 was an extraordinary year, as $95 billion was invested in venture companies during that year (vs. $30 billion in 2008).  But the prices paid for investments in that year were high.  Here’s the vintage year evolution for 2000: 

 

For 2000, distributions (from IPOs and acquisitions) are still below the amount invested. The “total” value line (purple) is above 100 near its end only because of the value at which portfolio companies are being carried.  With the recent blow to asset prices, these must fall.  Thus, it looks like 2000 will be the first year that venture capital as a whole will fail to return capital to investors. 

 

Note that these figures are before  the general partners’ take (a percent of invested funds and a fraction of capital gains), and are thus gross results, not net results to investors.  They are compiled from the database at Sand Hill Econometrics,built from data from Thomson, DowJones VentureOne, and a lot of our own research to fill in holes for valuations, shutdowns, and acquisition values.  We believe that this data comprise very close to the universe of venture-funded companies from 1989 to the present.

Fiscal stimulus: More needed?

The House has passed HR1 and the Senate is working on a counterpart fiscal stimulus bill. We will discuss HR1 for the sake of specificity and in the belief that the final law will be fairly similar to HR1.

The table below shows the Congressional Budget Office’s estimates of the spending increases and tax cuts under HR1. The government’s fiscal year ends on September 30, so the first period is the 8 months from now until the end of September. One of the major concerns about the program is the lag in ramping up the stimulus. Recall that the economy will be about $900 billion below trend in the middle of the year, but spending programs up to then will only pay out $107 billion and taxes will have been cut by $63 billion. The stimulus is much larger in the following 12 months, starting in the fall of this year, when spending will be up by $236 billion and taxes cut by $120 billion. Then in the following fiscal year, 2010 to 2011, the stimulus falls to roughly half its peak level. Effects in later years are tiny.

 The spending increases under HR1 are wonderfully diversified. We had been concerned that the program would involve large amounts of spending in certain favored, narrow areas, and that the supply of the corresponding products would have bottlenecks. In that case, the direct employment effects would be smaller and the spending would have driven up the incomes of some lucky workers. But in 2009 and 2010, broadband gets only $250 million, school building repairs $9 billion, and health information technology $500 million, to mention three areas that the new administration had been singling out earlier as especially suitable. Though the spending side of the program has been widely criticized as diffuse, we see that characteristic as a virtue.

The biggest piece of the tax side of the program is a conventional tax rebate, similar to the one in the summer of 2008. Because it would be refundable-that is, it could result in a taxpayer receiving money back rather than paying less tax-the government accounts for it partly as spending (the refunds) and partly as reduced taxes. The total amount is $144 billion for 2009 and 2010. On the business side, speeding up depreciation and allowing earlier recovery of tax benefits from operating losses would result in a drop in tax collections of $90 billion, to be made up with higher collections in subsequent years-this is an interest-free loan program more than a tax cut.

Effects of fiscal stimulus

How much does real GDP respond to the two forms of fiscal stimulus, government purchases and tax cuts? The incoming Obama administration released the Romer-Bernstein study of fiscal stimulus to answer the question. The table below shows the main conclusions. When the government increases its purchases of output, say concrete for new bridge, GDP rises immediately by about the amount of the purchase (1.05 in the first quarter) and then rises to about 1.6 times the amount of the purchases. The calculation assumes that the flow of purchases remains higher for the whole 16-quarter period shown in the table. For tax cuts or other programs that give families more purchasing power, the immediate response is more like half the amount the government spends; the other half goes into savings. In both cases, the multipliers rise as time passes because of follow-on effects-increased spending by those influenced by the immediate effects.

 

 Fiscal Multiplier Estimates from the Romer-Bernstein study of fiscal stimulus

The measurement of these multiplier effects is intensely controversial. Having followed this area of macroeconomics carefully for many years, we believe that both columns overstate the responses somewhat, especially in the case of tax cuts. All macro models agree that increases in government purchases increase real GDP. That multiplier is probably around one, we believe, but we would not rule out 1.5. Most macro models place the tax-cut multiplier quite a bit lower, and we agree. Here we are referring to tax cuts that hand families more purchasing power, such as the one n the summer of 2008. Later we discuss tax changes that give focused incentives for immediate spending, where the effect could be much larger.

Last summer, consumers enjoyed a moderate tax cut paid out to most people as an immediate rebate. The experience demonstrated that the federal government is capable of a speedy fiscal action, but it also showed that consumers don’t go out and spend rebate money when they receive it. Instead, just as the received theory of consumption predicts, consumers smooth the spending increase, reserving most of it for future consumption, by saving it or using it to pay down debt. It raises their standard of living more than their immediate spending. It’s good news that most Americans do not have their backs to the wall financially, but it makes an income- tax rebate ineffective as a stimulus concentrated at the time most needed. Rather, rebates result in consumption increases spread well into the future. We discussed John Taylor’s graphic analysis of the tdax cut in an earlier post.

Effect of Government Purchases

HR1’s focus on government purchases raises the natural question of the effect of purchases on total GDP. Does government spending stimulate other categories of spending, especially consumer spending? Or does government spending displace other categories, so GDP rises by less than the amount the government spends? What does research say about the left column in the table above? An earlier post addressed this question.

What could have been done

The most desirable time-concentrated stimulus would raise consumer spending during 2009 without changing it much in future years. The government lacks the power to compel consumers to spend more, so it must rely on a incentives. Britain has just cut its sales tax (VAT) by 2.5 percentage points for the next 13 months to provide a small incentive concentrated in the period when the recession is expected to be most severe.

An important article in the American Economic Review in September 1986 by James Poterba, Julio Rotemberg, and Lawrence Summers demonstrated the high potency of a sales-tax cut as a stimulus. They studied the reverse situation, where a big increase in the British sales tax caused a severe recession.

Because the U.S. lacks a national sales tax or VAT, the logistics of a temporary consumption subsidy would be a little more complicated. The Kotlikoff-Leamer proposal would operate through state sales taxes. All but a few small states have sales taxes-the exceptions are Alaska, Delaware, Montana, New Hampshire and Oregon. Under the plan, the federal government would buy out sales taxes for the period of the needed stimulus, say the year 2009. The states without sales taxes or with low sales taxes would receive comparable federal funds to cut other types of taxes. Sales tax revenue is currently $440 billion per year, so the proposal would cost around half of what the Obama administration appears to be planning to spend on stimulus.

The plan needs to take effect soon after it is announced. The announcement will cause consumers to defer purchases until the tax cut takes effect. Similarly, toward the end, they will accelerate purchases and then buy less after the sales tax resumes. Phasing in the resumption might be a good idea.

Critics of consumer subsidies point out that some consumer goods are imported, so the stimulus benefits the producing country, not the U.S. Often that country is said to be China, though Japan is also a major source because of its dominance of the world car market. Given that the U.S. has pledged to engage in joint stimulus with its major trading partners, including China, the stimulus to the import source countries is entirely appropriate. But imports of consumer goods are only 18 percent of consumer spending on goods (excluding services), so the leakage into import stimulus is not a major consideration anyway.

We feel that a temporary elimination or reduction in sales taxes would be an effective stimulus to consumer spending, concentrated in the period when it is needed most and phased out later. It should be part of the stimulus plan.

Tax cuts to reduce the cost of labor or improve incentives to work

If the objective of a stimulus is to lift employment, why not operate directly on that margin, by improving incentives? The Senate is considering a program called Making Work Pay (see the Brookings Institution evaluation) as part of its version of the stimulus bill. This program would buy out the first $500 of the payroll tax that all workers have to pay, even those who do not pay income tax. This program has a definite effect on the incentive to work for those without jobs and for those who are currently paying less than $500 in payroll tax (those earning less than about $8,000 per year), but for most workers, the $500 would be just like a standard tax cut, without any special incentive effect.

In a standard supply-and-demand diagram, with the pre-tax wage on the vertical axis, giving an improved incentive to workers shifts the supply curve to the right-people are willing to work more hours at a given pre-tax wage because the tax that they used to pay has been removed, the equivalent of an increase in the wage.  The market clears at a point down the demand curve, with higher employment. That is the hope of a plan to cut the wage tax paid by workers. Notice that the pre-tax wage as to fall to stimulate demand. If the wage is sticky, nothing happens-workers would like work harder, but that message does not get passed on to employers through a lower pre-tax wage. Thus another reason that Making Work Pay may not stimulate much job-creation is that the needed decline in pre-tax wages won’t occur.   

Why not overcome this problem by giving the incentive to the employer? The federal government has a completely straightforward way to do this, because it levies a 7.65 percent rate on employer payrolls for virtually all employment. The tax yields just under $500 billion per year. Elimination of the tax for the year 2009 would provide a substantial incentive to employment concentrated during the year. As with the temporary removal of sales taxes, both anticipation effects and ending effects would occur. See the Bils-Klenow proposal.

One problem with the employment stimulus is that the funds go in the first instance to the owners of businesses and not to consumers generally. Ownership is highly concentrated in the U.S., so the distribution of the immediate benefits is skewed. By contrast, a worker or consumer rebate can be directed to lower-income consumers because it is part of the income tax.

If the response of employment to the payroll tax cut were strong enough, its contribution to the incomes of workers might be enough to overcome the disadvantage of its business-subsidy character. If business hiring responded aggressively to the subsidy, profits would decline as business put more output on the market and the winners would be workers rather than owners. Everything turns on the strength of the employment effect. But, alas, the strength of the effect depends on one of the most unsettled issues in macroeconomics, the role of supply increases in raising the quantity of output produced in the short run. One line of thought treats this issue just as one would in a standard market, where an increase in supply raises the quantity sold by the principles of the standard supply-and-demand diagram of elementary economics. Another line believes that special principles operate in the short run that makes demand the controlling factor-an increase in supply has little effect on the quantity sold in the short run in this view. We are among the few economists who regard this issue as still open. Most are doctrinaire believers in one or the other view. We are sufficiently concerned about the potential validity of the demand-limiting view that we are reluctant to state with confidence that a supply-based stimulus such as the payroll-tax suspension would have a large effect on employment.

Will the economy need more stimulus after the current program goes into effect?

The answer seems obviously yes. Current forecasts were made with pretty good knowledge of the nature and magnitude of the Obama stimulus program and they say that the economy will be in deep recession through the middle of the year and below trend with excess unemployment for several more years. Further, from Tables 2 and 3, it is clear that the increases in purchases and increases in consumer purchasing power from the program, after applying the Romer-Bernstein multipliers, would have effects quite small in relation to the GDP shortfall of close to a trillion dollars a year.

Conclusions on stimulus

We foresee a mixture of stimulus policies for the coming year. Monetary policy can contribute by driving down mortgage and other interest rates. Income-tax rebates seem to have little support and would probably have relatively small effects within the year, with undesirable continuing effects in later years. We are enthusiastic about removing sales taxes and then brining them back gradually, to stimulate immediate consumptions spending. We are not sure that an employment stimulus from a reduced business payroll tax would raise employment enough to be a contender as a stimulus. Thus the sales-tax buyout seems to be the best way to spend the bulk of future stimulus dollars.

The recession finally hits plant and equipment

We had pointed out earlier that, despite all the downdrafts in the economy and a recession that started at the end of 2007, real plant and equipment spending was still on its normal growth path as of the third quarter of 2008. The first estimates for the fourth quarter show plant and equipment below trend. Here is our decomposition of the changes in the composition of real GDP since the first quarter of 2006:

	Excess over trend (billions of dollars)
Consumer durables	-181
Consumer non-durables and services	-273
Residential construction	-371
Plant and equipment	-68
Inventories	-52
Imports	277
Exports	182
Government	-7
Real GDP (sum)	-493

The collapse of residential construction and of consumption is still the main negative effect visible in the breakdown of real GDP.  A decline in plant and equipment investment, all in the fourth quarter, is a new negative factor, as is the decline in inventory investment from its normal level. On the other hand, both parts of international trade are still remarkably favorable–over the course of the recession, imports have fallen $277 billion relative to trend, relieving the negative effect that high imports had in the past. And exports are $182 billion above trend. Real GDP is now almost half a trillion dollars below trend.

The consensus among forecasters is that real GDP will decline by about 1.5 percent to a trough in the middle of this year (3 percent annual decline on average over the first and second quarters), which would place GDP about $900 billion below trend.

What to do about Fannie Mae and Freddie Mac?

 

  Here are our recommendations. A discussion follows.

1. The GSEs should be preserved, mainly because they are the most effective institutions for providing liquidity to the mortgage market.  Most mortgage investors, including depositories, prefer to hold liquid securities rather than illiquid whole loans. Wall Street securitization is not a substitute.
2. Fannie and Freddie should be chartered as special-purpose banks, playing their historical roles of securitizing mortgages and holding some portfolio of loans.  Their debt should be federally insured or guaranteed, as are the deposits of banks, and as with banks, the equity of the institutions should be the first backup to bondholders as the capital (or equity) of banks is the first backup to deposits. Their insured or guaranteed debt should not be counted as part of federal debt, as the insured deposits of banks are not. They should be subject to capital standards and supervision of their activities, and subject to restrictions on their activities, like banks.  The capital standards, activity restrictions, and supervision need not be identical to those of banks.
3. It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools.  Guarantee fees are not posted prices, but negotiated in secret.  As a result, the pricing of guarantee fees is not collusive but  close to perfect (Bertrand) competition with two GSEs. In the trade-off of standardization and homogeneity to promote liquidity (which calls for fewer GSEs) vs. competition to assure competitive pricing (which calls for more), two gets an excellent result, likely the best result.
4. There are three choices for F&F ownership:  1) owned by the government, like FHA and Ginnie Mae; 2) owned as a cooperative, by member institutions, as both once were, and 3) owned by the general public. Fannie and Freddie should be owned by public shareholders, as banks are.  We advocate ownership as public companies, but with explicit and priced federal backing, like banks.

Securitization is most efficiently done by institutions that isolate default risk and create homogeneous securities.

The most important reason to preserve the role of the GSEs is that they bring standardization and liquidity to the mortgage market, both in terms of the loans they securitize and in the structure of the mortgage-backed securities (MBSs) created from mortgages.  This standardization makes their MBSs more liquid, and as a result of greater liquidity, more valuable.  More valuable MBSs feed back to lower interest rates for mortgage borrowers.  There are two features of GSE securitization that are valuable.

The very first effort at mortgage securitization was undertaken by Ginnie Mae, a 100% full-faith-and-credit government institution, designed by bureaucrats. This was part of the reorganization of Fannie Mae in 1968, done to get Fannie’s debt off the federal books.  Ginnie Mae securitized already federally-insured mortgages made through FHA.  The additional guarantee of timely payment of interest and principal from Ginnie Mae was a small extension of the federal backing.  But the results were dramatic:  the creation of Ginnie Mae lowered FHA borrowing rates by 60 to 80 basis points.  With the real, long-term mortgage interest rates in the region of 4 to 5%, this was a large, not small, change. This seemingly small transformation of a federally-insured mortgage into a federally-insured liquid security made a big change in the cost of homeownership.

Evidently, all holders of mortgages, even the banks and thrifts who originated loans, preferred holding liquid, securitized mortgages over illiquid whole loans.  Depositories (banks and thrifts with insured deposits) and other federally affiliated institutions (Freddie, Fannie, and the Federal Home Loan Bank) remain the largest investors in the outstanding MBSS created by Ginnie, Freddie, and Fannie today. 

Ginnie Mae could only securitize loans insured by FHA or guaranteed by the Veterans Administration.  So the thrifts quickly created Freddie Mac to securitize mortgages for the part of the market known as “conventional”, the slice larger than FHA will insure but smaller than “jumbo”. Freddie was up and running by 1970.  Fannie began to securitize mortgages in the late 1970s. 

Why is their approach to securitization so successful and why can’t Wall Street financial institutions duplicate it?

First, Freddie and Fannie isolate the default risk on their MBSs by guaranteeing them against default risk.  Investors in F&F MBSs bear only the risk of changes in value coming from interest rate fluctuations, including prepayment risk. Risk from default losses remains with the shareholders of F&F. It is not the elimination of risk so much as the elimination of the need for continuous re-evaluation of risk on individual MBSs that is important. Guaranteeing the pool of loans against default relieves the security holders of the necessity of re-analyzing and re-valuing the default risk of the security. If security holders did have this burden, investors would put a lower value on the securities because of the cost of investigation necessary before undertaking an investment, and because different MBSs hold mortgages from different parts of the country, their default risk would vary from security to security. Isolating this ongoing re-valuation is efficient. Once the loans are made, they cannot be unmade, so time spent analyzing them only contributes to reckoning what today’s price should be, and cannot retroactively improve the allocation of capital.

Continuous analysis of the risk is necessary regarding the equity claims on F&F. Assigning the default losses to the single pool of equity claims in F&F is better than having the default losses fall on individual MBSs, which would vary in value depending on their different default rates. 

When private entities such as individual banks or investment banks securitize mortgages, (all subprime MBSs were private-label securities, not Fannie or Freddie MBSs) they do two things differently.  First, the default risk is borne within the MBS. The risk is generally not taken on by the issuer (as with Fannie and Freddie), or laid off to an insurer (as with FHA mortgages securitized into Ginnie Mae MBSs).  Second, a private-label MBS is then divided into pieces or tranches depending on when and if principal payments are made. Some pieces have greater risk exposure to defaults by borrowers.  Some pieces have more exposure to prepayment risk by borrowers.  And some piece, however small, has a high probability of repayment and can thus be rated AAA. Because the pieces are not standardized, they cannot be as liquid.

The F&F default risk guarantees do for MBSs what insurance does for municipal bonds.  Many municipalities are small, or obscure, and it would be a burden for the market to gather and process the information to keep up-to-date on them.  To relieve the market of this burden, the municipalities who issue the bonds buy insurance against default.  Their bonds are guaranteed against default by the insurer. Thus, the burden of investigating and monitoring lies with the insurance company, not the market.  So long as the insurance company is solid (an issue in the recent crisis) the market can trade bonds of the same maturity but different locales as essentially identical.

A second feature of Fannie and Freddie’s MBSs is that they efficiently suppress information about the location of mortgages in individual MBS pools. Even with the guarantee against default, investors face another risk that varies slightly (much less than default risk) from one region to another:  different speeds of loan prepayment.  Some areas have higher turnover, and loans prepay when people move, and partly because from the point of view of an investor in an MBS with a default guarantee, a default looks like a prepayment:  the investors gets her money back when the loan either prepays or defaults (with a guarantee.)  So how do the GSEs keep the MBS market liquid despite some geographical differences in prepayment speeds?  By not revealing the geography of loans in any given MBS. Wait!  What about market transparency?     

More transparency is not always better.  This can be seen in another institution in the municipal bond market.  A structure used for promoting liquidity in the municipal bond market is a random call feature used for bonds that fund small but long-lived projects. Take a dam, for example. Bondholders are repaid from citizens’ water bills. Such bonds are often structured in sets that repay at different times, for example, 10 years, 11 years, and so on up to 40 years. For little projects, each slice may be too small to find a liquid market. Instead, the entire issue is given the same maturity, but a specified fraction of it is called at random for repayment each year. The investors buy many such issues, and thus have a good idea of when they will be repaid, easily tolerate the uncertainty, and value the greater liquidity.

Suppose that right after the bonds were sold, the issuer spun the wheel to select the call date of each bond. Would it be efficient to release the information early, prior to the call? NO! Once the call dates were known, the bonds would degenerate into the tiny, illiquid serial bonds that the market was trying to avoid. What’s more, the issuer and the investors agree that the best arrangement is not to reveal early. This is a clear case where the optimal level of information is not the fullest.

In principle, the value of an MBS could be either increased or decreased revealing information that distinguishes them from one another. More pieces might accommodate a greater variety of investors with pieces precisely tailored to their risk tolerance.  Or, it could be that liquidity concerns dominate, and that a larger, more homogeneous, more liquid market in MBSs tightens spreads and lowers prices.  There are different ways of addressing risk, including pooling risk (MBSs vs. whole loans, even S&P500 futures vs. individual stocks in the S&P500) (see information theorist Hal Varian’s provocative ideas on subprime koolaid ), providing ratings (professional opinions on risk to make clear where similarities lie), and providing insurance (assignment of risk to a professional evaluator of risk for a fee).  Each has its pros and cons.

The experiment to show which is more important has been done:  Some years ago Freddie Mac was persuaded to reveal more about the geography of its MBS pools on the theory that this would make the pricing more accurate.  Since then, Fannie’s securities (MBSs) have consistently sold for a slightly higher price than Freddie’s because Freddie tells the market more about each one, and hence they are less like one another, and a bit less liquid.  The Fannie MBSs are more alike because the market has no information with which to make distinctions among them.  The really interesting thing is that the market prefers the security about which it is less informed. Over the period since 1998, the current coupon yield for Freddie MBSs has been above that for Fannie MBSs by on average 3 basis points, with a standard deviation of 1.5 basis points.  From January 1998 to December 2008, the yield on the Freddie security was never below that on the Fannie security. And this is despite the feature that the Freddie securities pay the security holder slightly earlier, which in principle should make them more valuable.  Yes, more transparency makes the securities of lower, not higher, value, on average.

So perhaps the Freddie securities are more accurately priced, but they are less valuable as a result. 

By the way, the most complete federal guarantee does not necessarily imply that there is a substantial federal subsidy.  FHA mortgage insurance has, through its history since 1934, covered costs through its insurance premiums (with periodic adjustments).  The single-family part of Ginnie Mae has been a solid money-maker since inception.

 

The 30-year, fixed-rate, prepayable mortgage is unique and is not obviously viable without special federal support.

A large fraction of Fannie, Freddie, and Ginnie MBSs are still held by banks and thrifts with insured deposits, the Federal Home Loan Bank system, or by Fannie and Freddie themselves—in other words, under the federal umbrella. These MBSs contain almost exclusively 30-year, fixed-rate, prepayable mortgages.

The United States is unique in having a 30-year, fixed-rate, prepayble mortgage.  Other industrialized countries have mortgages with long (25-30) lives, but only in the US do they have an interest rate that is fixed for the full term and the loan is prepayable.  Only Denmark, population 6 million, has anything close. Other industrialized countries do have long-term (25 to 30 years) amortizing loans, but the rates adjust at least once every 5 years.  As even we in the US have experienced, long-term, fixed-rate prepayable loans can cause systemic trouble.

The prevailing mortgage rate must anticipate the rate of inflation over the life of the loan. When the rate of inflation rises (as it did in the 1970s), loans become less valuable. Depositories who borrowed short (in the form of deposits) and leant long (in the form of mortgages) became insolvent when inflation rates and interest rates rose.  By allowing federally-related institutions to make and hold mortgages of this design, we assign the systemic risk to taxpayers (who insure deposits explicitly, and stand behind Fannie and Freddie either implicitly or explicitly depending on your reading of current events).  Given that nearly all income taxes are paid by homeowners, and that nearly all homeowners begin their home ownership with a mortgage, the beneficiaries of the system (homeowners, who are comforted by the fixed nominal payments) and the bearers of risk (the taxpayers) are ultimately the same folks. Only a country that was fairly optimistic about its ability to manage monetary policy would undertake such a program.  

If the loans are at some times a problem, why not, like the other industrialized countries, allow only adjustable rate loans?  Why bother to support the 30-year fixed-rate prepayable loan?  Because the payment fixed in dollars comforts borrowers so much.  This is evident first, from the observation that borrowers only choose ARM loans when interest rates are high and the term structure steep; when rates fall, all but the least-cash-constrained ARM borrowers refinance into fixed-rate loans.  It is also evident in focus groups.  Anyone who has observed focus groups discussing mortgage choice cannot but come away with a new appreciation for the security borrowers feel they get from loans with constant nominal dollar payments. Alan Greenspan may be right that this is an irrational, or silly, view, but as we saw when he suggested we do away with the 30-yr fixed-rate loan and make all mortgages adjustable-rate, the general public does not agree.

 

What about the portfolios?     

F&F both have substantial portfolios of loans. Their portfolios are close to three-quarters of a trillion dollars each. We do not have a strong opinion on how large the F&F portfolios should be.  But we do expect that any policy to whittle down the portfolios would only result largely in depositories holding more mortgages and MBSs than they now hold.  In other words, the 30-year fixed-rate loans are not likely to leave the Federal umbrella, but only move to another place under it. Reducing the portfolios of F&F would not be without pain for the mortgage and housing markets.  Even in the early 1990s, when the mortgages held by the insolvent thrifts had to find a new home, mortgages rates were clearly elevated by this displacement. We cannot imagine that policy makers would choose any time soon to force F&F to sell their portfolios, as this would just depress mortgage values and force already beleaguered banks to make down their assets once again.  If the portfolios of F&F are to be whittled down, the least disruptive option may be to simply not have them buy any more loans for portfolio.  As loans in the existing portfolios mature, the portfolios will shrink.

 

What about covered bonds? 

Covered bonds have been promoted by some as superior to asset-backed securities.  We see them as nearly identical, especially to Fannie and Freddie MBSs.  Covered bonds are, like asset-backed securities, backed by the cash flows on a pool of assets, in the case of the mortgage market, a pool of mortgages.  And covered bonds, like F&F MBSs, have more resources behind them than just the mortgages in their pools to cover losses. There are two differences between covered bonds and the MBSs issued by F&F, both essentially cosmetic.  One is that the mortgages backing the bonds remain on the balance sheet of the issuer.  Another is that the pool of assets backing the covered bond is usually larger in principal value than the bonds themselves, so that the security is over-collateralized. The MBSs issued by F&F are essentially also over-collateralized because they are guaranteed against default by F&F, but not by any explicit pool.  If the default losses on a given pool were sufficiently large to invade the principal value of the pool, F&F are obliged to make up the difference from other assets.  Thus, in essence, F&F MBSs are over-collateralized.  So long as the securities outstanding as MBSs, and the experience on the mortgages behind them (in terms of defaults and prepayments) are well-disclosed, and the other assets are also fully disclosed, as those of F&F are, it should make no difference whether the securities are called covered bonds or MBSs or whether the recording of the securities is on the balance sheet or in some other part of their regular reports.

Private-issue MBSs are seldom over-collateralized.  Instead, there is a single pool of loans, and it is securitized, usually with the default risk isolated in a particular part of the pool.  If defaults exhaust the principal in this the high-risk part of the pool, then additional losses invade the other, higher-grade pieces. This happened with the securitized subprime loans.  Anticipating that there was a large fraction of the principal value due on subprime loans that would surely be repaid, some pieces or tranches were rated AAA.  As losses threatened to exceed the value of the pieces bearing the first losses, these additional losses threatened the higher-grade tranches, which caused them to be downgraded and to fall in value.  This decline in value was then marked-to-market on the balance sheets of institutions holding them, (both F&F and larger commercial banks and mortgage banks), and some were, as a result, insolvent.  It appears that the banks that securitized the loans (Bear Stearns, Merrill Lynch, Lehman, Citigroup, Countrywide…) were holding the first-loss, riskiest pieces.

 

Organization and Charter

What about the conflict of private profits and public mission at F&F? 

We do not see any more conflict in having Fannie and Freddie owned by public stock holders and operating with a federal guarantee than we see for banks and thrifts organized in the same way. It is true that part of why F&F are so successful at funneling capital to the housing market is that they had implicit, now explicit, federal backing.  This is true of the entire banking system as well.  Indeed, it appears that the 30-year fixed-rate prepayable mortgage loan is not sustainable in a free market, and that government support is necessary for its existence.  The bulk of such mortgages have been held in institutions that are under the federal umbrella, either depositories, F&F, or the Federal Home Loan Banks, since they were created by FHA in 1934. 

The continuous hostility of the Wall Street Journal and the American Enterprise Institute to Fannie and Freddie is somewhat baffling.  They complain in particular that F&F operated with the presumption of federal backing but earn profits like private institutions.  How is this so different from what insured depositories (banks and thrifts) do?  The WSJ never complains about deposit insurance for banks.

The banks themselves are also not exempt. Ken Lewis, the head of Bank of America (an insured depository), said just a few months ago, in November 2008 at a gathering in Detroit:

…the financial crisis also exposed the inherent conflict in the structure of Fannie Mae and Freddie Mac. The GSEs were asked to serve the interests of private shareholders while fulfilling a public mission, all with “implicit” backing of the government. …. Their move in recent years to purchase lower-credit quality loans helped to fuel that market.   … It was heads, investors win… tails, the taxpayers lose. We don’t think that’s a sustainable model.

Was there no similar conflict at the Bank of America? We imagine he feels a bit foolish about these comments today, having resisted one capital infusion on the grounds that his bank did not need it, but now pleading for, and about to receive, another.  But he should have felt foolish long before, even been inhibited from making such comments, given that he runs an institution that also operates with federal backing, and could leave the taxpayers with vast liabilities. Bank of America should have deposit insurance, but it should fess up to not being an entirely free-market entity.

 

Ownership Structure

Why not a coop?  Time was when F&F were each organized as cooperatives, (though not at the same time, see the short history of F&F at the end of this discussion) owned by the lenders whom they served. In those times, the largest commercial bank in the US had less than one percent of bank assets. While US banking is still competitive today, it is more concentrated now, and a handful of banks now hold close to half of bank assets. The conflict between smaller banks and larger banks in how the GSEs should be run would be greater now than it was in their former co-op days. We believe there are good reasons not to allow the largest banks to run the GSEs to the disadvantage smaller banks. Smaller banks deserve an important place in our banking system.  There is accumulating evidence that smaller depositories treat their customers in a less exploitive way than do newer and less regulated financial institutions. In particular, they are less inclined to exploit financial confusion on the part of borrowers.   See Stango and Zinman, Buck and Pence, and Agarwal et al. on the mortgage counseling experiment in Illinois.

Why not a government program like FHA?  FHA and Ginnie Mae are playing a large and important role right now, with a market share of originations in 2008 of 25 to 30%. For some years, FHA has operated at a disadvantage to the conventional market because of the rigidities inherent to being part of the bureaucracy.  First, FHA originations are slower than originations through F&F.  According to FHA’s January 15, 2009, report on recent originations, average processing time was 2.5 months, roughly 10 weeks, from application to closing, even though most transactions used streamlined systems. FHA was slower to create automated underwriting systems, introducing them only after Freddie and Fannie both had systems in place.  Second, FHA is more vulnerable to exploitive policies on the part of lenders. Fannie and Freddie have more flexibility for thwarting and discouraging exploitation by lenders. F&F can also adjust its guarantee fees to reflect its experience with a given lender, while FHA insurance premiums are one-size-fits-all. There have been episodes of lender exploitation of FHA (seller “gifts” of downpayments to borrowers, implicitly raising the loan-to-value ratios and default rates) that required legislation to fix that would have been promptly corrected by internal policies at Freddie and Fannie.

Why two GSEs?

One might think that with only two organizations securitizing mortgages, we would see tacit collusion outcome such as we get when two gas stations are on opposite corners.  If one station lowers its price, its rival across the street sees that change at least as soon as any customer.  The rival can respond instantly.  The first mover sells no more gas, he just sells the gas for less. Thus, there is no incentive to lower price when the rival sees the change at least as soon as the customers do.

Freddie and Fannie don’t post their guarantee fee.  Each deal is negotiated, customized, and secret.  The ultimate results are seen only in quarterly summaries of business activity.  Thus, customers do know price before rivals do, and know much more about the details of each deal.  Two GSEs thus reach an outcome close to competitive, but give the maximum benefit of standardization and size for liquidity.

In principle, the Federal Home Loan Bank system could have created a third securitizing GSE.  It has not, despite some efforts in that direction.  We imagine that the reason it has not is that there are some conflicts of interest among the members about how the entity should be structured, with larger institutions wanting more power than smaller ones.  They have a collective action problem.  They cannot create a facility only for some members, and have been unable to negotiate to create a facility appealing to all. 

 

What should be different?

The new charters for Freddie and Fannie should 1) establish higher capital requirements for Fannie and Freddie, and 2) have different capital requirements for different lines of business, in particular higher-default risk business. 

We won’t go on too long about this issue because we have already written about it earlier.  We are not optimistic that we can alter asset markets to entirely avoid price bubbles (we seem to have had them from time to time as long as we have had asset markets, and they can be produced in experimental settings too), either in the stock market or the housing market.  But if our financial institutions are less levered, the bursting of a price bubble is of less consequence.  Given the big decline in house prices, it was inevitable that we would have a big decline in residential construction (the high prices resulted in over-building), which means a recession.  Did the credit crisis make things worse? It is not yet clear how much the financial crisis and credit freeze added to this recession, but surely, it cannot have made it less severe. 

Did Freddie and Fannie cause the subprime crisis?

The charters of the GSEs preclude them from securitizing subprime loans.  Thus, they were unable to support subprime lending by any commitment to funding or securitizing them.  They were followers, not leaders. When Fannie and Freddie did buy was some higher-rated pieces of subprime MBSs created by Wall Street.  The ratings on these securities fell when the subprime loans began to default in large numbers. Freddie and Fannie also bought some Alt-A loans (these are loans to borrowers with good credit scores, but which are not as fully documented with respect to borrower income and assets as are prime loans) for their portfolios. They have lost money on these also. Despite their losses, their loss rate is less than one-third the loss rate of the 67 mortgage banks with assets of more than $10 bn.

We would hope that going forward, there would be more regulatory oversight of Fannie and Freddie, and that they would have higher capital standards. Of course these recommendations are not unique.  Nearly everyone is calling for more oversight of any entity with any connection to mortgage lending.

How big a difference do Fannie and Freddie make?

Most of the time, rates on mortgages that were eligible for purchase or securitization by Freddie or Fannie have been cheaper than larger, ineligible loans (“jumbo” loans) by 25 to 40 basis points.  When the credit crisis began, one of the early manifestations of it was a great widening of the jumbo-conforming spread, out to 140 basis points (that’s 1.4 percentage points) and higher.  The gap still stands at about 140 basis points. 

 

A short history of Fannie Mae and Freddie Mac, and the Federal Role in housing markets.

The 30-year, fixed-rate, prepayble amortizing mortgage was created by the FHA in 1934 as part of a program to revive the market for home loans: to encourage besieged banks to lend and wary consumers to borrow.  Prior to the creation of FHA, loans for buying homes and farms had much shorter terms (three to ten years) and borrowers paid interest regularly, but the principal amount was all due at the maturity of the loan, as the principal on a bond is due upon the maturity of a bond.  Homeowners either saved aggressively (creating their own sinking fund, in effect) as they were paying interest or planned on refinancing to a new loan when the term was up.  We would now call this structure a balloon mortgage.  So both the long term (30 years vs. three to ten) and the amortizing nature (paying both interest and principal each month) of the payment stream represented a new loan design. 

Around this time Congress passed two other pieces of legislation regulating financial institutions, the Glass-Steagall Act and the McFadden Act.  Together, they inhibited the movement of capital among banks and across State boundaries.  The McFadden Act prohibited banks from having branches in more than one State.  The Glass-Steagall Act prohibited banks from creating and selling securities.  With nationwide branches, a bank could move capital from Idaho to North Carolina when more capital was demanded in North Carolina.  If banks could have created and sold securities, they could have obtained new capital to lend by selling loans they had already made.  Congress saw the difficulty created by Glass-Steagall and McFadden, and in 1938, established the Federal National Mortgage Association, FNMA, which came to be known as Fannie Mae, to compensate for the barriers to capital movement erected by Glass-Steagall and McFadden.

Fannie was originally organized as a cooperative.  Banks that did business with Fannie (by selling loans to Fannie) also were investors in Fannie and provided Fannie’s capital in proportion to the amount of business done. Fannie grew slowly from 1938 until after WWII. 

In the 1960s, there were many pressures on the federal budget, including the war in Viet Nam and the programs of the Great Society, and Fannie Mae’s debt, which was at that time counted as part of the federal debt, loomed.  A federal budget task force was organized in 1968. One of its assignments was to get Fannie’s debt off the federal balance sheet.

This was done by two substantial re-arrangements.  The first was to re-organize Fannie as a public corporation, with stock owned by the general public, not just by banks, and traded on the stock exchange. The corporation would issue bonds in its own name and use the proceeds to buy mortgages for its portfolio. Fannie would no longer be a bank co-operative.

The second was to take the FHA-insured loans (which represented an explicit Federal liability because of the full-faith-and-credit insurance) out of the Fannie Mae portfolio and pool them into mortgage-backed securities, then to sell these securities. A given security gave its holder the right to the payments of a specific set or pool of loans. The FHA insurance relieved the security holder of any risk coming from defaults by FHA borrowers.  If borrowers prepaid, however, prepayments would flow straight through to security holders.  Thus, if interest rates fell and homeowners refinanced at lower rates, Ginnie Mae security holders would get their principal back at a time when their reinvestment opportunity would be at a lower rate. On the other side, if interest rates rose, the likelihood of prepayment would fall, making it more likely that the loan would remain outstanding for its full 30-year term. This interest-rate risk, in which the investor loses due to prepayments if interest rates fall, and loses by virtue of a lower-valued loan if interest rates rise, is an important and defining feature of the 30-year, fixed-rate, prepayble mortgage loan. The risk for MBS holders was not different for the risk banks had always taken in making such mortgages, but it was a new feature for a liquid, traded security.

The securities created from FHA mortgages were then given a further guarantee of timely payment of interest and principal, through the newly created Government National Mortgage Association, known as Ginnie Mae. Ginnie Mae’s guarantee is a full faith and credit US federal guarantee.  The additional burden to the federal government from this additional guarantee is de minimis, because the loans are already insured by FHA against loss of principal from default. Ginnie only has to pony up when a loan defaults, giving the security holder her principal back immediately, then waiting to collect the principal from FHA once foreclosure is complete. Ginnie gets 6 basis points of interest from the loan pool for this promise and has lost no money on the deal.

The success of Ginnie Mae was immediate and astounding.  Within a year, it became clear that the creation of Ginnie Mae and its ability to turn illiquid, hard-to-evaluate, hard-to-sell, whole loans into liquid, easy-to-sell securities lowered interest rates on FHA loans by 60 to 80 basis points!  Given that the real (inflation-adjusted) rate of interest on FHA mortgages had averaged around 4 to 4.5 percent, this was a big change, not a small one. 

Ginnie Mae’s success made the thrifts (also known as Savings and Loan Associations, which have insured depositories, like banks) want a similar facility for loans larger than what FHA would insure.  Within two years, by 1970, the Federal Home Loan Bank Board, which then governed the thrifts, had such an entity up and running in the Federal National Mortgage Corporation, now known as Freddie Mac.  

Freddie was also operated as a cooperative.  The thrifts (and banks) who did business with Freddie put up the money to provide its capital, and were in essence its owners (through their ownership in the district-level Federal Home Loan Banks, and these district banks held Freddie’s stock directly). Freddie’s activities were very different from those of Fannie. Fannie issued bonds and bought mortgages and held them.  Freddie issued a few bonds, and used the money to buy mortgages, but then packaged the mortgages, attached its own guarantee against default risk, collected a little fee for this guarantee, (like FHA’s, but not explicitly federal), and sold the packaged loans as securities, much the same as Ginnie Mae did. Freddie’s primary activity was to securitize mortgages, not to hold them in portfolio. Freddie’s portfolio was essentially just a small liquidity facility until Freddie was privatized in 1989 as part of FIRREA. 

Okay, now for a diversion into the thrift crisis.  Be patient.  In a page and a half we got from 1934 to 1980. 

The rate of inflation had been rising through the 1960s, and by the 1970s it was up in double digits. The lenders who had made 30-year mortgage loans at 5 percent, 6 percent, and 7 percent were facing much higher rates than this to be paid for funds, and as a result, were insolvent.  The value of their assets, the loans on their books, was lower than the value of their liabilities.  The essence of their problem is that they borrowed short-term and invested long-term (in mortgages).  If interest rates rose, what they had to pay for money also rose, but the rates they got on their old loans did not. The interest they received on their assets did not cover the interest they paid on their liabilities.  The interest rate on one-month Treasury Bills reached a maximum of 21 percent in early (February) 1980.

The thrifts and Fannie Mae were essentially in the same tough place, seriously under water, on a market-value basis in 1980. The thrifts had assets with a market value of $700 billion, and liabilities of $800 billion.  Fannie had assets with a market value of $70 billion, and liabilities worth $80 billion. But the deal between them and their guarantors (the federal government itself and insured federal depositories) was written in terms of book values, not market values, and there were no requirements to use mark-to-market accounting, so the institutions—banks and thrifts and Fannie—continued doing business while praying (along with a host of policy makers) for lower interest rates.  The contrast between this insolvency, which was profound but not manifested in lender operations due to the prevailing accounting rules, and the current one, in which recognition of the insolvency has resulted in a full-blown credit crisis, is stark. We still speak of the “thrift crisis”, but the current financial crisis is much more crisis-full than was the thrift crisis. This does not necessarily mean the old way was better, but more on that later.

Note that as of 1980, when interest rates were at their peak, Freddie was entirely solvent.  By virtue of only securitizing mortgages, and not holding and financing them in great volumes, Freddie faced no great interest rate risk. 

So what happened in this great insolvency?  Well, first we had a recession.  Not because the thrifts were broke and wouldn’t make loans, but because the efforts that were made to bring the rate of inflation down first resulted in a sharp rise in short-term interest rates. The rise in interest rates starting in 1979 brought a decline in residential construction of more than 40% from 1979 to  1982, and then, as now, construction is a sufficiently large sector (about 5% of GDP) that when construction contracts by this amount, this contraction resounds around the entire economy.  It was a very costly recession.

But the policies put in place to bring lower inflation succeeded, and in fits and starts, rates fell through the 1980s.  Along the way some thrifts became insolvent on a book-value basis and had to be dissolved. More thrifts were insolvent on a market-value basis, and took extra risk because if they took risk and won, fine. If they took risk and lost, that was fine too, because they were in the hole anyway and the new risk was taken with Other People’s Money (mainly the taxpayers’).  The obvious strategy for an insolvent thrift was to take some risk and try to get out of the hole. In 1989 Congress acknowledged this problem and provided the funds to close the remaining insolvent thrifts through the Financial Institutions Reform, Recovery and Enforcement Act, FIRREA (pronounced Fie-REE-Ah).  In the meanwhile, Fannie Mae had become solvent again from lower interest rates.  

Once Freddie was privatized (also part of FIRREA), it immediately issued bonds on a great scale and accumulated a portfolio of mortgage loans. And as Freddie’s securitization program had been obviously successful, Fannie had begun securitizing loans also by the early 1980s.  Thus, by the early 1990s, their structures and activities were essentially identical. 

Okay, that’s the end of the history lesson.