Posts by PeterWallison:

    The New York Times needs to shape up

    August 4th, 2017


    By Peter J. Wallison.


    The “Failing New York Times,” as Donald Trump calls it, deserves to fail if it continues to publish articles like the one by Michael Shear in Sunday’s newspaper. The article reported on Trump’s tweet in this way: “Mr. Trump set up the Presidential Advisory Commission on Voting Integrity to find evidence for his debunked claim that millions of votes were cast illegally in the 2016 presidential election.”

    This description is and should be an affront to every reader who wants the truth and facts from a newspaper. At the very least, Shear should have reported by what authority Trump’s claim was “debunked” — that is, shown to be incorrect — then readers could decide for themselves. Was this claim, for example, debunked by an authoritative and unbiased source, or was it debunked by one of the very people who might have been at fault in allowing ineligible people to vote?

    Shear’s support for his outrageous statement is the Mississippi secretary of state, who said about the commission: “They can go jump in the Gulf of Mexico.” The fact that he is a Republican is apparently some kind of validation for Shear, who would almost certainly have reported the comment somewhat differently if what the commission was looking for was evidence of discrimination against African-American voting. The Mississippi Secretary of State is the top voting official in the state. The fact that he would not respond to the commission should be seen as an admission that he has something to hide, not — as Shear presents it — as support for his biased position.

    It is not as though election fraud is unknown in the United States. We have all laughed for years at the widely believed idea that in Chicago being dead is not a disqualification for voting. More seriously, there is considerable evidence that the close election of 1960 was purloined for the Kennedy-Johnson ticket by Mayor Daley in Chicago and Lyndon Johnson’s machine in Texas. Nixon, the loser in that context, decided not to challenge the results because of the harm it would do to the country.  In 2000, a presidential election was decided by only a few votes. A presidential commission to determine whether our voting system is accurate should be important to all Americans.

    It is a favorite trick of both the left and right to claim that something was debunked as a signal to unwitting or witless supporters that it is not worth considering. It is the equivalent of the policeman’s command to gawkers at a crime scene, “Move along, folks, nothing to see here.” The idea that there might have been illegal voting in 2016 is not debunked by the fact that Trump made that claim, and if a biased reporter can get by his editors with that assumption the once great New York Times has indeed become one long editorial page.

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    Curtains for Global Financial Regulation

    May 8th, 2017


    By Peter J. Wallison.


    Last Wednesday was Daniel Tarullo’s last day as a Federal Reserve governor. As the Fed’s point man on banking regulation since 2009, he played a key role in the Obama administration’s attempt to create an international system of financial oversight. But the election of Donald Trump ended any realistic hope of achieving that goal. When Mr. Tarullo announced in February that he would step down, even though his term runs until 2022, no one should have been surprised.

    The plan was audacious in its scope. When a Democratic Congress passed the Dodd-Frank financial overhaul law in 2010, it was by far the most restrictive financial regulation in the U.S. since the New Deal. But the proposal hatched at a 2009 meeting of the Group of 20 countries was even larger and more intrusive. The goal was to create a common set of financial regulations governing the activities of financial firms in all G-20 countries—from the U.S. and the European Union to Russia, Turkey, India and Argentina.

    The G-20 plan was to be carried out by a newly deputized international body called the Financial Stability Board, made up of regulators from around the world, including the U.S. Treasury, the Fed and the Securities and Exchange Commission. Mr. Tarullo was the Fed’s representative on the FSB and helped develop its regulatory program.

    There were two principal objectives: First, the G-20 wanted to impose more-stringent regulation on systemically important financial institutions, or SIFIs. Second, it wanted to put new regulatory controls on risk-taking by what the FSB called “shadow banks,” which it defined as any financial firm operating without a regulator for its risk-taking.

    But the FSB did not have the independent authority—even under the auspices of the G-20—to impose these regulations on companies in the various countries. Instead G-20 members were supposed to use the laws and processes in their respective jurisdictions to put the FSB’s proposals into effect.

    In the U.S., the main legal authority was the Financial Stability Oversight Council established by Dodd-Frank. The FSOC, led by the Treasury secretary, was authorized to designate “systemically important” firms and to restrict “ongoing activities” that could pose a threat to financial stability.

    The Obama administration easily accomplished the G-20’s first goal, stricter regulation of SIFIs. The FSOC dutifully designated as systematically important every American financial institution the FSB had deemed as such. GE Capital, AIG , Prudential andMetLife were referred to the Fed, as required by Dodd-Frank, for what the act calls “stringent” regulation.

    The G-20’s second goal was trickier in the U.S., because determining what constituted a shadow bank proved difficult. For the FSOC to regulate these institutions without new legislation, the definition of a shadow bank had to fit within its existing statutory authority.

    Former Fed Chairman Ben Bernanke was particularly eager to control shadow banks’ risk-taking. In a 2012 speech to a Fed conference he argued that any firm that participated in “maturity transformation”—turning short-term liabilities into long-term assets—was a potential threat to the stability of the financial system. He cited as an example a firm that provides short-term funds for the purchase of a pool of five-year auto loans.

    The FSB ultimately adopted this approach—and expanded on it. In a November 2013 paper, the FSB argued that any firm that participated in a “complex chain of transactions” resulting in a maturity transformation would count as a shadow bank and had to be subject to controls on its risk-taking. The Obama administration probably would have tried to impose this rule under the FSOC’s authority to control “activities” that could cause financial instability.

    Despite regular urging by the FSB, the FSOC was never able to publish a regulation that adequately defined a “complex chain of transactions” in a way that aligned with its authority. Still, it was only a matter of time. A Hillary Clinton administration would have gotten it done.

    Donald Trump’s victory has interrupted this march toward greater government power over global finance. Mr. Trump’s statements about regulatory relief have made clear that he will never sign on to the G-20’s agenda. Indeed, the FSB—unable to get its rules adopted in the world’s largest economy—will probably fold up its tent. The U.S. has dodged a bullet.

    Mr. Tarullo rightly sensed that the opportunity to establish a global financial regulatory system had evaporated. The most sensible course was resignation.

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    Politics Behind NYT’s Misuse of Language

    January 28th, 2017



    By Peter J. Wallison.



    The country’s wide political divisions are causing a serious corruption of the language we use daily in the United States. Important and descriptive words that once had a clearly understood meaning are now being distorted for political or ideological use, and nowhere more so than in the New York Times, once an authority on proper usage.

    For example, a front-page headline in the Times on January 24 stated, “Meeting With Top Lawmakers, Trump Repeats an Election Lie.” Calling something a “lie” was once at the top of the opprobrium scale; it meant a false statement, known by the speaker to be false at the time it was made, and intended by the speaker to deceive his listeners. This definition cannot be applied to Trump’s statement, which most news organizations and fact-checkers have said was made “without evidence.”

    In that sense, Donald Trump’s statement was not a lie unless he actually knew that the statement was false (apart from whether it was intended to deceive). And though Trump’s statement has been disputed by fact-checkers and others, there is some evidence that supports it. For example, before the 2014 midterm election, three political science scholars published an article in Elsevier’s Electoral Studies series under the title, “Do non-citizens vote in U.S. elections?” Their conclusion: “We find that some non-citizens participate in U.S. elections, and that this participation has been large enough to change meaningful election outcomes including Electoral College votes, and congressional elections.” The point here is not that Trump’s assertions are correct—they seem greatly exaggerated—but only that what he said was not what would be considered a “lie” in proper discourse.

    This was not an isolated incident for the Times. In an editorial on December 25, the newspaper noted the refusal of Sen. Mitch McConnell and others to fill Antonin Scalia’s seat at the Supreme Court until after the election. McConnell’s justification, that the American people should make the choice during coming election was, according to the Times, “a patent lie.

    Why a “lie?” Because, according to the Times, “The people spoke when they re-elected Mr. Obama in 2012, entrusting him to choose new members for the court.” This is a rational argument, but to assert that anyone who doesn’t subscribe to it is lying is an obvious stretch.

    Other examples of the Times misusing language and defining various serious epithets down for political purposes are also shared by other news organizations, but the Times—because of its importance to educated discourse—is the worst abuser. Another example is the misuse of the word “racism.” Trump became well known to the American people as one of the principal sponsors of the “birther” movement, which claimed, falsely, that Barack Obama was not born in the United States, and thus not eligible for the presidency.

    Whether Trump’s involvement in this issue was promoting a lie is not the issue here. He might in fact have known that his statements about Obama’s birthplace were false, but enjoyed the publicity he was receiving. This would be reprehensible and could actually have been a lie. However, the Times, together with other news outlets, persistently called this “racism”—an ugly slur which is normally reserved for efforts to denigrate a person because of his or her race or ethnicity.

    However, there is no indication that the birther campaign was fueled by Obama’s African-American heritage. The idea that this was racism is a misuse of a term that should be kept available for real cases where a person is mistreated or abused because of his or her race, not for a case where a person is accused of something that has nothing to do with race. It appears that the racism epithet was thrown in for political purposes, because saying Trump and his fellow birthers were wrong—or even liars—was not strong enough.

    One final example of the Times’ abuse of language is the headline that the newspaper put on the article about President Trump’s choice of Scott Pruitt for director of the Environmental Protection Agency: “Trump Picks Scott Pruitt, Climate Change Denialist, to Lead E.P.A.” Like the racism epithet, “denialist” has a connotation that makes it more offensive than anything the nominee might have done in his public position as an official in Oklahoma. The term “denier” first entered the language to refer to someone who denied the reality of the Holocaust, perhaps the greatest act of evil in human history.

    Yet the Times was willing to employ it to express contempt for a political appointee with whom it disagreed on policy.

    The Times’ willingness to misuse—in effect to define down—important and meaningful English words for its own political and ideological purposes is a blot on American journalism that will last far longer than the Trump presidency and perhaps even the New York Times itself.

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    What Dismantling Dodd-Frank Can Do

    December 19th, 2016

    By Peter J. Wallison.

    The market bump from Donald Trump’s win is peanuts compared with what regulatory relief can bring.

    The sharp rise in the Dow Jones Industrial Average after Donald Trump’s election could be short-lived, but based on what the president-elect has promised to do it is an accurate assessment of the U.S. economy’s prospects. All through his campaign, Mr. Trump said regulatory relief for the economy was a priority, including the repeal of the Dodd-Frank Act. Repeal or thoroughgoing reform of that destructive law is certainly a key step toward an economic recovery.

    Signed into law in 2010, Dodd-Frank was based on the idea that insufficient regulation, particularly of Wall Street, had allowed a buildup of subprime mortgages, a housing bubble and, ultimately, the 2008 financial crisis. The Democrats who controlled the Congress elected in 2008 acted quickly to follow out the implications of this diagnosis by adopting Dodd-Frank, the most restrictive financial legislation since the New Deal.

    Strikingly for such important legislation, there was no significant debate in Congress about whether the cause of the crisis had been correctly identified.

    A later study, in 2014 by my colleague at the American Enterprise Institute Edward Pinto, showed that by 2008 more than half of all mortgages in the U.S. were subprime or otherwise risky, and 76% of those were on the books of government agencies. This leaves no doubt that government housing policies—and not a lack of regulation—created the demand for these risky mortgages. But by then it was too late.

    It is not difficult to find connections between Dodd-Frank and the historically slow recovery from the financial crisis. Here’s a sampling.

    The Financial Stability Oversight Council, a Dodd-Frank invention, was empowered to designate large financial firms as systemically important financial institutions, or SIFIs, turning them over to the Federal Reserve for “stringent” regulation. One of the council’s earliest actions, in July 2013, designated GE Capital as a SIFI.

    GE soon recognized that its huge financial subsidiary was wilting under the Fed’s control. Seeking an exit, GE wound down GE Capital, eliminating from the market an important source of funding for small and innovative firms.

    The Volcker rule, another Dodd-Frank provision, prohibited banks and their affiliates from trading securities for their own account, although there was no evidence that this activity had any role in the financial crisis.

    Soon, trading desks all over Wall Street were closing down, and traders were complaining that the debt markets were dangerously short of liquidity. The Treasury Department, deeply tied into Dodd-Frank, said it was “studying” the issue. It still is, and spreads are still historically wide.

    Small banks, the credit sources for small businesses and startups, faced new and costly regulation, requiring them to hire compliance officers instead of lending officers.

    One regulation on mortgage lending from the Consumer Financial Protection Bureau—a Dodd-Frank agency—was over 1,000 pages long. Imagine that landing on your desk in a small bank.

    No wonder, as this newspaper recently reported, banks are no longer the nation’s principal mortgage lenders. Worse still, as reported last week, job gains at startup firms, which are major sources of new employment and technological innovation, are at their lowest level in 20 years.

    Fortunately, some reforms take care of themselves because of the people Mr. Trump is likely to choose for his administration. The Financial Stability Oversight Council (FSOC) is headed by the secretary of the Treasury and composed of the heads of all the major financial regulators. It is unlikely that Mr. Trump’s new Treasury secretary or any other new appointees will be interested in designating SIFIs, so that threat to the economy is probably off the table.

    A bonus is that the Financial Stability Board, a largely European body of which the Treasury and Fed are members, needs an active FSOC in the U.S. to implement its plan for regulating what it calls “shadow banks.” The Fed and the Treasury have been driving the stability board’s effort on this, but are now likely to stand down. Shadow banks—which the stability board defined as all financial firms, of any size, without a regulator of their risk-taking—are safe.

    Other provisions must be addressed with legislation. Fortunately, House Republicans have laid the groundwork. The House Financial Services Committee, under Chairman Jeb Hensarling, has already voted through the Choice Act, which would let banks avoid costly regulations by holding significantly more capital, and which substitutes a tangible asset-based leverage ratio for the complex Basel risk-based capital rules.

    Once made law, the Choice Act will create a new, less costly landscape for small banks and help revive small businesses and startups with the credit they’ve lacked under Dodd-Frank.

    The Choice Act also turns the Consumer Financial Protection Bureau—now headed by a single administrator accountable to no one—into a bipartisan commission, funded by Congress as the Constitution intended for all executive agencies. Rulings that require 1,000 pages to explain, produced without consulting anyone, should be a thing of the past. The act would also repeal the Volcker rule, returning liquidity to the markets for debt securities.

    These are among the most important provisions of the Choice Act, but other initiatives might also be considered.

    Dodd-Frank authorized the Commodity Futures Trading Commission and the Securities Exchange Commission to make rules for trading derivatives, including requirements for mandatory clearing of most derivatives transactions. Because mandatory clearing could make clearinghouses the sources of systemic risk, the FSOC voted to give them access to the Federal Reserve’s discount window, setting up another government backstop that will impair market discipline. The Trump administration should consider removing that backstop, together with mandatory clearing itself.

    With a Republican House and Senate, President-elect Trump has an opportunity to eliminate many of the regulations that have held back economic growth. As Ronald Reagan used to say, “If not us, who? If not now, when?”

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    A Fannie Mae and Freddie Mac Background Check

    December 7th, 2016



    By Peter J. Wallison.


    President-elect Trump’s nominee for Treasury secretary, Steven Mnuchin, said on Wednesday that Fannie Mae and Freddie Mac should be “privatized.” This comment sent their share prices soaring, as investors speculated that the two firms will be allowed to recapitalize and return to the mortgage markets as the dominant players they once were.

    This outcome is highly unlikely, as a little history shows, and that’s why Mr. Mnuchin’s comment was probably misinterpreted by investors.

    As originally conceived during the New Deal, Fannie Mae was a government agency that would borrow funds in the credit markets and buy mortgages from banks and other originators. The idea was that this would provide a secondary market for mortgages, giving lenders the cash to make more loans.

    As a government agency, however, Fannie Mae was on-budget and its expenditures added to the deficit during the Vietnam War.

    In 1968, accordingly, Fannie Mae was given a congressional charter as a corporation and allowed to sell shares to the public. This permitted the Johnson administration to argue successfully that Fannie should be excluded from the budget. But it also raised questions about whether Fannie could operate profitably without government backing.

    As a buyer of mortgages, Fannie could only be profitable if its cost of funds was substantially lower than the mortgages themselves.

    The Johnson administration tried to solve this problem by giving Fannie sufficient connections to the government so that, even as a private shareholder-owned firm, it would still be treated by the credit markets as though it was government-backed.

    Thus Fannie was blessed with many special connections to the government, including a line of credit at the Treasury, a government “mission” and the appointment of some of its directors by the president. This signaled the markets that it was still implicitly government supported without the explicit guarantee that would put it back on the budget.

    The idea worked. The market believed—despite legislative language that stated otherwise—that the government would in fact stand behind Fannie. And when Freddie Mac was given an identical government charter in 1970, creditors were willing to lend to both firms at rates that were close to the Treasury’s own favorable rate. Indeed, they were called “the agencies” by the market, which signaled something government-like.

    All this makes clear why Fannie and Freddie cannot be privatized and returned to the markets in the form they were before their 2008 insolvency. The fiction that Fannie and Freddie weren’t government-guaranteed has now been exposed. The markets now know for sure that if the two fail again they will be rescued by the government. If there is any honesty in budgetary accounting, their borrowings will have to be treated as government debt and added to the deficit.

    It is unlikely that the Trump administration or Secretary Mnuchin will be happy to add several trillion dollars in debt to the already bloated U.S. debt load. On the other hand, Fannie and Freddie clearly cannot act profitably as secondary mortgage-market players—buying mortgages from banks and others—unless they have a lower cost of funds than the mortgages they will buy.

    That might be possible with the capital levels that support a triple-A rating, but even the Johnson administration realized that this wouldn’t work. Capital levels that high probably cannot be achieved or sustained without promising investors levels of profitability that are unavailable to mortgage-market participants.

    Thus, there is only one alternative if Fannie and Freddie are to be “privatized” and still expected to act as secondary market players. As truly private firms, without triple-A ratings, they will able to securitize mortgages through the structured transactions that many banks and others used before the mortgage meltdown in 2008. This is a viable and important business, and needs to be restored, but its capital requirements are modest and there will be many competitors.

    Most certainly, they won’t have the financial advantages that allowed them to dominate the housing finance market before 2008. Nor will they earn the profits that are exciting the speculators who—on the strength of Mr. Mnuchin’s statement—have been bidding up their shares.

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    How can Trump support deregulation and Glass-Steagall?

    October 16th, 2016


    By Peter J. Wallison.


    The Republican platform’s proposal to reinstate Glass-Steagall is hard to understand, even in the confused policy mishmash created by Donald Trump. The best interpretation is that it’s an awkward outreach to the disappointed “progressive” supporters of Elizabeth Warren and Bernie Sanders. The worst is that it calls into question whether Donald Trump really supports financial deregulation.

    The key problem for those Republicans who are now warily supporting their presidential nominee is that it is not clear where he will lead the party in this election—and the country—if he wins. Is he committed to anything, really, or is he just twisting and turning to win the presidency, only to decide later what he wants to do? In this sense, favoring the reinstatement of Glass-Steagall is a bad omen.

    Glass-Steagall was modified in 1999—permitting bank holding companies (but not banks themselves) to engage in the securities business—for a simple reason. Since the mid-1980s, the securities markets had been outcompeting banks in the business of financing corporate America. The reasons for this are complex, but have much to do with advances in communication technology.

    As it became possible for investors to get full financial information about companies directly from the files of the SEC, they could decide for themselves what investments to make. The traditional intermediary role of banks—taking deposits and making commercial loans—was eroding quickly. It was far less expensive for a firm in need of credit to sell bonds, notes or commercial paper to investors than negotiate complex financing arrangements with a bank.

    If that trend continued, banks would eventually be forced out of financing all but the smallest businesses. This had been predicted in the Reagan administration, when the idea of modifying Glass-Steagall was first proposed. These competitive issues had become obvious by 1999, providing the foundation for the repeal of the Glass-Steagall language that prohibited affiliations between banks and securities firms. Since then, the gap between bank and securities market financing has only grown wider, but at least banking organizations—through their securities affiliates—have been able to compete in this market.

    Glass-Steagall reform added major new competitors to the securities markets, further reduced investor costs and spurred innovation. As important, it also enabled banking organizations to compete again for the financing business of their traditional corporate customers. For most banking organizations today, their securities operations are their most profitable activities. Smaller securities firms are bearing the brunt of this competition, but more deregulation will bring back the IPO market, which is their natural role.

    Reinstating Glass-Steagall will reverse this process. Banking organizations will again be frozen out of the securities markets. They will become less profitable and less able to support their subsidiary banks, making bank failures and taxpayer bailouts more likely.

    Those who advocate the reinstatement of Glass-Steagall should be careful what they wish for.

    But it is the symbolic importance of reinstating Glass-Steagall, endorsed by the Trump campaign, that should concern us. Trump and some of his “free market” advisers have proposed deregulation of the economy, including a repeal of the Dodd-Frank Act and a temporary suspension of all new regulations. Good. That, plus a sensible tax policy, will restore the economic growth that the Obama policies have suppressed.

    But how can we believe any of this? More than anything else, the reinstatement of Glass-Steagall suggests that the government, and not private decision-making, should determine the structure of the economy. One can’t believe in the reinstatement of Glass-Steagall and still believe in the repeal or significant modification of Dodd-Frank. It’s like saying free markets work, but price controls can help.

    One of the key arguments that Donald Trump has advanced to secure the support of Republicans is to assure us that if he’s elected he will appoint Supreme Court Justices in the mold of Antonin Scalia. However, the author of “The Art of the Deal” has also presented himself as a dealmaker. He wants to improve trade arrangements that have already been formalized in treaties, start another reset with Vladimir Putin and extract more financial support from NATO nations and those we protect in Asia. This will be dealmaking indeed.

    But what happens when his Supreme Court nominees are opposed by the Democrats in Congress? Will dealmaking produce someone closer to Justice John Paul Stevens than Justice Scalia, or can Mr. Trump be relied upon to stay the course?

    The Trump proposal to reinstate Glass-Steagall—only a technical idea of no particular consequence to most American voters—has major implications for the credibility of the candidate in whom so many Republicans have now placed their trust. Like the canary in the coal mine, it’s small but significant.

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    It’s the economy, stupid

    October 14th, 2016



    By Peter J. Wallison.

    The Democratic convention in July was impressive, but primarily because it was a clever distraction from what should be the real issues in the current campaign – ironically summed up as, “It’s the economy, stupid.” Anyone who remembers the first successful Clinton campaign in 1992 will recognize immediately what was missing from this year’s Democratic Party celebration of patriotism, diversity and inclusiveness.

    The recent news that the economy grew only 1.2 percent in the second quarter – and that the first quarter was revised downward to a meager .8 percent growth – only emphasizes the intractable problem that Hillary Clinton faces in trying to both follow and apologize for President Barack Obama’s economic policies.

    Yes, Clinton’s acceptance speech noted that she and the Democrats have not done a good enough job in recognizing the economic pain that people across the heartland have been suffering. But these are only words of palliation. What she said she would do about it showed that she would continue the same policies – higher taxes and more government spending – that, combined with excessive regulation, are responsible for the economy’s sluggishness throughout the two Obama terms.

    Normally, this would be a laydown for the Republican candidate, and we would see a revolt against economic drift and disappointment that would shift the presidency from the Democrats to the Republicans, the kind of reversal of party control after a two-term presidency that has been customary in the post-World War II period. But it happens that the Republicans have nominated a candidate this year who will make this race much closer than it should be.

    Until his economic speech this week, Donald Trump had not shown any skill at exploiting the weakness of the Democratic argument for continuing to hold power. Instead, he continued to add new material to the Democratic argument that he doesn’t have the temperament, honesty and perhaps the basic knowledge of policy to be president. Unless Trump radically changes his message and his method of presenting it – one speech on the economy is not enough – the highly unpopular Hillary Clinton will become president by default.

    What can Trump do to recover? Start by adopting the successful 1992 slogan, “It’s the economy, stupid.” That would do much to emphasize that Clinton has both moved away from her husband’s successful economic policies and is running to create a third Obama term; it would also put the Republican campaign back on the normal track, making the out-party’s strongest argument for change when the incumbent’s economic policies have failed.

    Where Clinton has emphasized attacks on Wall Street, and further extension of the Dodd-Frank financial regulation law, Trump should point out that it was precisely these policies – pursued by Obama and the Democratic Congress elected in 2008 – that have led to the economic malaise of today. Every day in which Trump wastes his time raising divisive issues about race or displaying his over-the-top sensitivity to criticism, is a day he has cast his campaign into further irrelevance.

    At this point, everyone should understand that the economy is failing. Two consecutive quarters of less than 2 percent growth could actually be signaling a recession on the way. In any event, it’s just a continuation of the slowest economic recovery since 1949. It’s so easy to link these numbers to Democratic policies that any sensible Republican campaign would have long ago made the slow economic recovery its central theme.

    Tax increases under Obama have come through increased income taxes – a rise in the top marginal rate to 39.9 percent (Clinton indicated in her convention speech that it would go higher), a phase out of personal exemptions, a phasedown of itemized deductions – and an increase in tax rates on dividends and capital gains. Obamacare has added other taxes on employers and on medical devices.

    Remember when the Republicans were arguing that higher taxes on small business would reduce jobs and growth? It’s happened. Then there is Dodd-Frank, by far the most far-reaching and costly regulation of business and finance since the New Deal. The new regulation of community banks, in particular, has stifled the growth of business start-ups, which are the single largest source of employment growth in the economy. (Clinton says she would go beyond Dodd-Frank.)

    But who would have imagined that the Republican nominee, who has been dealt a winning hand, would squander it with his own distractions. Even if Trump has been talking about weak economy, it’s not been reported because he continues to raise irrelevant issues with outlandish and often absurd statements at rallies or in tweets.

    The numbers on the economy are there for anyone to see. There’s ample reason for Clinton and the Democrats to create distractions from the “the economy, stupid.” The reason for the Republican candidate to do it is inexplicable.

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    GE capital and the coyote’s leg

    October 12th, 2016


    By Peter J. Wallison.


    The Financial Stability Oversight Council’s decision to release GE Capital from its designation as a systemically important financial institution (SIFI) was praised by Treasury Secretary Jack Lew for showing that there is an “off-ramp” after a firm has been designated and turned over to the Fed for the special regulation mandated by the Dodd-Frank Act.

    This cheery report obscures the real lesson, which is that a firm must become effectively an empty husk before the FSOC will let it go free. And that is exactly what GE Capital has become, having sold off most of its $500 billion in financial assets and promising now to function merely as a finance company for its parent company’s various businesses.

    If you are wondering why the recovery from the last recession has been so historically slow, the designation of GE Capital as SIFI, the downsizing of its staff, and the selling off of its assets provides a clue. In this case, the government used the Dodd-Frank Act to remove from the market a major source of financing for mid-size companies and one of the few large lenders that could take risks on innovative ideas. Less dramatically, Dodd-Frank is doing the same in suppressing growth throughout the US economy.

    GE’s decision to wind down GE Capital also tells us something important about the nature of the Fed’s regulation. Although a designation as a SIFI might be seen as a government certification that a firm is too big to fail, and thus provide some competitive advantages, the Fed’s regulation is apparently so oppressive that it was better to wind down GE Capital than to keep it in business under the Fed’s control. One is reminded of the coyote that gnaws off its own leg to escape the trap.

    GE Capital is an unusual case; it’s a subsidiary of a larger company which is able to operate even though its subsidiary is significantly reduced in size. In other words, GE had more latitude to make the GE Capital wind-down decision than the managements of the only two firms still in SIFI detention, AIG and Prudential Financial.

    A third firm, MetLife, had decided to litigate and take the consequences rather than accept designation as a SIFI. Thus far, this looks like the right decision. FSOC was unable to make a compelling case for MetLife’s designation, and several months ago the Federal District Court for the District of Columbia nullified MetLife’s designation. Among other things, the court found that the FSOC did not have sufficient evidence to show that MetLife’s “material financial distress” could cause “instability” in the US financial system. GE Capital could have offered a similar defense. Instead, it paid the price for its timidity.

    The irony of all this is that the whole idea for designating SIFIs is based on a faulty interpretation of the financial crisis. The belief that Lehman’s bankruptcy caused the financial crisis and thus that large nonbank financial firms should never be allowed to fail was responsible for the creation of FSOC and the SIFI designation process. The theory was that these large firms were all interconnected, and that the failure of one would drag down the others, triggering a systemic event.

    This is not what happened in the financial crisis. No other large firm failed as a result of Lehman’s bankruptcy. The large scale failures which occurred after Lehman—AIG, and the banks Wachovia and Washington Mutual—were caused by their exposure to subprime mortgages fostered by government housing policies. The same policies that brought down Lehman, Fannie Mae and Freddie Mac.

    The chaos after Lehman’s bankruptcy resulted not from the fact that Lehman had failed, but from the government’s own shocking and illogical failure to rescue Lehman after bailing out Bear Stearns—a much smaller company—six months earlier. That misplaced and unnecessary rescue created a classic case of moral hazard, with market participants assuming that the government would protect them against another large firm collapse. When the government reversed its policy, allowing Lehman to fail, chaos ensued because market participants no longer knew who was safe and who was not.

    Jeb Hensarling, the chairman of the House Financial Services Committee, has proposed a path to prevent SIFI designations from continuing in the future. His comprehensive Dodd-Frank reform legislation would repeal the Financial Stability Oversight Council’s authority to designate SIFIs. If the House enacts this legislation in the current session, it would show that the Republicans mean business about economic growth.

    Despite eliminating GE Capital as a significant source of credit, the Council has yet to lay out what will keep a large firm out of SIFI detention, or what—other than a complete surrender of its business—will let it out of Fed’s grasp. Thus, FSOC remains a threat to U.S. economic growth as long as the administration in power believes—against all evidence—that stringent regulation of large firms will prevent financial instability.

    Comments Off on GE capital and the coyote’s leg

    New Questions About the Financial Crisis Inquiry Commission

    June 22nd, 2016

    By Peter J. wallison.



    The report of the Financial Crisis Inquiry Commission (FCIC) is frequently cited as the authoritative source for the causes of the 2008 crisis, but its key findings are contradicted by documents in its own files that were never disclosed in its final report.


    • By 2008, most mortgages in the US were subprime or otherwise weak. Of these risky loans, 76 percent were on the books of government agencies, principally Fannie Mae and Freddie Mac.
    • The FCIC claimed that Fannie and Freddie bought these loans primarily because they were profitable, and not because of the government’s housing policies—particularly the affordable housing goals.
    • However, the FCIC documents discussed in this paper show that Fannie and Freddie knew these loans would be unprofitable and in some cases loss-producing.
    • As a government study commission, the FCIC failed in its obligation to report fairly on all the evidence it collected, not just the evidence for the story it wanted to tell.


    The Financial Crisis Inquiry Commission (FCIC) is often cited as the definitive source for information about the causes of the 2008 financial crisis. I was a member of the FCIC and dissented1 from its majority report,2 which was issued in January 2011.3 However, in my subsequent research for a book on the financial crisis,4 I found that the principal findings and conclusions in the commission’s report were contradicted by materials in the commission’s own files—materials that were never made available to me or, I believe, to the FCIC’s other members. Whether this was error or deception is not clear, but clearly, a major report by a publicly funded commission appointed by Congress did not adequately inform the American people or their representatives.


    The Fundamental Question


    Everyone agrees that the precipitating event of the financial crisis was a “mortgage meltdown”—that is, defaults among a large number of subprime and other risky mortgages5 that were in the US financial system in 2007 and 2008. The meltdown caused a sharp decline in mortgage and housing values, weakening the financial condition of many banks and other financial firms that held these assets and leading eventually— after Lehman Brothers’ bankruptcy—to the 2008 financial crisis.

    The fundamental question for the commission, therefore, was why there were so many subprime and other risky mortgages in the US financial system in 2007 and 2008. In my dissent, which was based on the research of my AEI colleague Edward Pinto,6 I argued that government housing policies—principally the affordable housing goals7—were responsible for this phenomenon. I had not seen much of the data in this paper until I had begun work on my book.

    In 1992, Congress adopted the affordable housing goals, which required the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac to meet certain quotas when they acquired mortgages

     The Increase in the Affordable Housing Goals and the GSEs’ Efforts to Comply


    from banks and other originators. Before and after 1992, the GSEs were the dominant players in the US housing finance system. As noted by a US Department of Housing and Urban Development (HUD) commission as early as 1991, their underwriting standards set the standards for the market as a whole.8 The GSEs did not make mortgages; they bought mortgages from banks and other originators, thus creating a liquid secondary market that fostered vigorous mortgage lending by banks and other originators. By 2008, Fannie and Freddie together held about $1.5 trillion in whole mortgages and mortgage-backed securities (MBS), and had guaranteed mortgage-backed securities totaling approximately $3.5 trillion. They were thus, by far, the largest holders of mortgages and mortgage credit risk in the United States.

    The government’s affordable housing goals required that a certain number of the mortgages acquired by the GSEs each year be made to borrowers who were at or below the median income in their communities. At first, the quota was 30 percent—that is, in any year, 30 percent of all mortgages bought by the GSEs had to be made to these borrowers. There were also other special goals for low-income borrowers and minorities. HUD was given authority to increase these goals, and it did so, aggressively, between 1996 and 2008. Chart 1 shows the increases in the goals. The top set of lines are the low- and moderate-income (LMI) goals; the two lower sets of lines are special goals for underserved (i.e., minority) borrowers and very-low-income borrowers (80 percent or 60 percent of median income).

    The increases in the goals had a major effect on the GSEs’ underwriting standards. Before the goals were enacted, the GSEs generally bought only prime mortgages (a prime mortgage had a 10–20 percent down payment, a borrower credit score above 660, and borrower debt-to-income ratio of no more than 38 percent). After the goals came into force and especially as they were increased between 1996 and 2008, the GSEs found that they could not find a sufficient number of prime mortgages to meet the goals; there were simply not enough prime borrowers below median income. Accordingly, Fannie and Freddie gradually reduced their underwriting standards through the 1990s and into the 2000s in order to acquire nonprime loans and thus meet the affordable housing quotas.

    Reduced standards could not be limited to low-income borrowers. Even homebuyers who could have afforded prime mortgages were happy to take mortgages with much lower (or zero) down payments. By 2007

    37 percent of loans with down payments of 3 percent went to borrowers with incomes above the median.9 Thus the lower underwriting standards—meant to assist low- or middle-income borrowers—spread to the wider market.

    This produced the largest housing price bubble in modern history between 1997 and 2007, when it finally began to deflate, as shown in Figure 2.

    It’s easy to see how lower underwriting standards can result in a housing bubble. If a potential buyer has saved $10,000 to buy a home and the underwriting standard requires a 10 percent down payment, he can buy a $100,000 home. But if the underwriting standard is reduced to 5 percent, he can buy a $200,000 home. Instead of borrowing $90,000, he borrows $190,000. This not only puts upward pressure on home prices, but also makes the borrower a weaker credit risk.

    Thus, my explanation for why there were so many subprime and other risky mortgages in the financial system pointed to the government’s policies—principally the affordable housing goals—that required Fannie and Freddie to reduce their underwriting standards and to acquire large numbers of these mortgages. As they reduced their underwriting standards, the wider market followed. When the bubble finally deflated, the defaulting mortgages weakened many financial 3

    institutions. Fannie and Freddie themselves became insolvent in September 2008 and were taken over in a government conservatorship.

    The commission’s majority report never cited any particular numbers for subprime and risky mortgages in the financial system before the crisis, but Pinto’s analysis concluded that 31 million such mortgages were outstanding in 2008.10 This was more than a majority of the 55 million US mortgages outstanding at the time. Of these 31 million, as shown in Figure 3, 76 percent were on the books of government agencies, principally Fannie and Freddie. This shows, without question, that the government had created the demand for these mortgages.

    The FCIC’s View


    The FCIC’s explanation for the GSEs’ acquisition of these risky mortgages was entirely different. According to its majority report, the banks and other mortgage originators had acted on their own to reduce their underwriting standards—because they were greedy, insufficiently regulated, and took too many risks. Here is a typical statement from the FCIC’s report:

    There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady


    Entities Exposed to the Credit Risk of Subprime and Other High-Risk Mortgages as of June 30, 2008


    regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a fundamental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activities that produced hefty profits.

    This was at least a plausible explanation for why private firms might have been willing to take substantial risks on mortgages, but as I’ve shown in Figure 3, most of these mortgages were acquired by government agencies, primarily Fannie and Freddie. Yes, they were initially made by banks and other private lenders, but they were bought by the GSEs. Indeed, if the GSEs had not been eager to buy these loans—to meet the affordable housing quotas—these loans would never have been made. The banks and other originators that made them certainly did not want to hold most of these subprime and risky mortgages on their books; they wanted to sell them to the government, primarily Fannie and Freddie. So in my view it is not a difficult question why Fannie and Freddie would abandon their traditional prime mortgage standards and buy so many of these

    risky mortgages. The affordable housing goals were the answer, and that’s the answer I pressed upon the FCIC.

    The FCIC refused to accept this view, but it was still necessary to explain why the GSEs had acquired so many subprime and other risky mortgages. Accordingly, the commission’s majority report adopted the idea that Fannie and Freddie wanted these mortgages for profit and market share, in order to please investors on Wall Street:


    Our examination revealed stunning instances of governance breakdowns and irresponsibility. You will read, among other things, about . . . Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking.11

    We find that the risky practices of Fannie Mae . . . particularly from 2005 on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices.12


    Not coincidentally, FCIC Chairman Phil Angelides favored this explanation. Angelides was a Democrat, a friend of then-House Speaker Nancy Pelosi, and a strong believer that the crisis was caused by insufficient regulation of an irresponsible private financial sector. He saw the commission as another opportunity, like the Pecora hearings in the 1930s, to blame the private sector for a financial disaster. The Pecora hearings, conducted by Ferdinand Pecora, the chief counsel of the Senate Banking Committee, blamed the Depression on the country’s largest financial institutions, and Angelides mentioned several times in commission meetings that he saw the FCIC as a new Pecora inquiry. A strong report supporting the idea that the private sector was responsible for the mortgage collapse would provide a foundation—as the Pecora Commission did— for tough new regulatory legislation. This goal was realized in 2010 with the enactment of the Dodd- Frank Act.


    Did the GSEs Acquire Subprime and Alt-A Mortgages for Profit?


    Fannie and Freddie were by far the largest buyers of both whole subprime mortgages and private mortgage-backed securities that were backed by subprime or other risky mortgages. Had they bought these mortgages because they were profitable assets, that would have been a plausible explanation for the GSEs’ substantial exposures. A profit motive for buying these mortgages would also have supported the notion that the affordable housing goals were irrelevant (or “marginal” as the FCIC report described them) as a reason for the GSEs’ purchases. To sustain this idea, the majority report minimized the GSEs’ difficulties in meeting the goals, with statements such as:

    In 2003 and 2004, Fannie Mae’s single- and multifamily purchases alone met each of the goals; in other words, the enterprise would have met its obligations without buying subprime or Alt-A13 mortgage-backed securities. In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.14

    This statement, for which no support was provided, is directly contradicted by a 2005 memorandum to Fannie’s CEO, Dan Mudd, from Adolfo Marzol, then Fannie’s chief credit officer. In his report, Marzol states that “large 2004 private label [private MBS] volumes were necessary to achieve challenging minority lending goals and housing goals.”15 This is only one example of the commission’s failure to report what was in its own

    records, where those documents were inconsistent with the case the commission was trying to make.

    Indeed, I found a great deal of material in the commission’s files that contradicted the conclusions in the majority report. This evidence shows that the mortgages acquired by the GSEs between 2003 and 2008 (the period covered by the FCIC’s majority report) not only were unprofitable but in some cases were producing losses for both Fannie and Freddie.

    It is impossible to know whether Angelides, who hired the staff and controlled what the commission studied and who it interviewed, was aware that the commission had received documentary information that was inconsistent with its assertion that the GSEs were buying subprime and other risky mortgages for profit.

    One peculiarity of the FCIC’s investigation is that it developed much of its evidence from interviews. These were not generally taken under oath, and the commission members were not told when these interviews were occurring or given an opportunity to attend. In the transcripts I’ve seen, the witnesses were not confronted with documentary evidence that would at least refresh their memories, and there was no cross-examination. The commission’s report, accordingly, is dominated by statements from witnesses whose motives or recollections were never challenged. This enabled the commission to cherry-pick statements in the interviews that supported its position.

    Documentary evidence that the GSEs were suffering losses on the mortgages they bought to meet the goals is widespread throughout the commission’s files, and it is difficult to believe that Angelides and the top staff were not aware of it. I am reasonably sure, however, that the members of the commission, even those who voted for the final report, were not aware that these documents existed. With very few exceptions, the commission members were never given an opportunity to review the information the commission had collected.

    In the discussion below, I cite numerous examples of documents in the commission’s files that show the GSEs’ difficulties in meeting the affordable housing goals and the plain fact that the loans they bought for this purpose were not profitable. This does not necessarily mean that these loans caused losses in all cases, but simply that they were not—as the FCIC alleged— bought for purposes of profit. None of the materials cited below were included in the FCIC’s report, even though they either had been received by the commission in the course of its investigation or were public documents that were published while the commission was preparing its report.


    A M E R I C A N E N T E R P R I S E I N S T I T U T E

    Unreported Documentary Evidence That Contradicts the Commission’s Conclusions


    The commission’s report persistently downplayed the pressures that the goals placed on the GSEs. For example, the FCIC majority stated that before 2005 “the goals were intended to be only a modest reach beyond the mortgages that the GSEs would normally purchase.”16 Yet, as early as 2003 a Fannie Mae document outlined the severe disruptions associated with meeting the goals and the fact that the loans acquired for that purpose were not profitable:

    In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably the most challenging environment we’ve ever faced. Meeting the goals required heroic 4th quarter efforts on the part of many across the company. Vacations were cancelled. The midnight oil burned. Moreover, the challenge freaked out the business side of the house. Especially because the tenseness around meeting the goals meant that we considered not doing deals—not fulfilling our liquidity function—and did deals at risks and prices we would not have otherwise done.17

    Relying on statements by interested parties rather than documentary materials, the FCIC’s report also noted that “all but two of the dozens of current and former Fannie Mae employees and regulators interviewed on the subject told the FCIC that reaching the goals was not the primary driver of the GSEs’ purchases of riskier mortgages.”18 But in a speech to Fannie’s top staff after almost a year as chairman and CEO of Fannie, Daniel Mudd stated:

    We project extreme difficulty meeting our minority goals in 2005, and a progressive squeeze on HUD goals from 2006 on. . . . There is no easy work left here. It is clear to me that after a full year of managing the goals lending efforts—the primary market is simply not going to deliver us the business it should. We meet monthly to review the numbers and the deals. We have studied FHA, new products, new channels, and alternative structures . . . and concluded that there is only one place to change the market and acquire the business in sufficient size—subprime.19

    Similarly, the FCIC’s report quoted Robert Levin, the chief business officer of Fannie, for the idea that “there was no trade-off [between making money and hitting goals],”20 but in a slide presentation to HUD on October 31, 2005, entitled “Update on Fannie Mae’s Housing Goals Performance,” Fannie noted several 6

    Undesirable Tradeoffs Necessary to Meet Goals.” These included “Deal economics are well below target returns; some deals are producing negative returns” and “G-fees may not cover expected losses.”21

    On the simple question of whether the goals-related mortgage purchases were made because they were profitable, the FCIC’s position is contradicted by a Fannie staff slide presentation in June 2005 entitled “Costs and Benefits of Mission Activities.” The authors noted:


    Meeting Future HUD Goals Appear Quite Daunting and Potentially Costly. . . . Based on 2003 experience where goal acquisition costs (relative to Fannie Mae model fees) cost between $65 per goals unit in the first quarter to $370 per unit in the fourth quarter, meeting the shortfall could cost the company $6.5–$36.5 million to purchase sufficient units.22


    The presentation concluded with slide 20: “Cost of mission activities—explicit and implicit—over the 2000–2004 period likely averaged approximately $200 million per year.23


    The FCIC ignored even published reports, easily accessed on the Securities and Exchange Commission (SEC) website, when they were inconsistent with its position that subprime mortgages were bought because they were profitable. In its 2006 10-K report to the SEC, for example, Fannie noted:


    [W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products [i.e., private MBS] that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.24


    Fannie and Freddie both used models that stated their mortgage risks in terms of what they called “guarantee fees” or G-fees; the riskier the mortgage, according to their analysis, the higher the guarantee fee they would expect to receive for holding or guaranteeing it. A guarantee fee that is not adjusted for the riskiness of the mortgage it covers would be likely to produce a loss rather than a profit. On June 22, 2007, a Fannie staff meeting considered three plans to meet the 2007 goals. One of the plans was forecast to result in “opportunity costs” of $767.7 million, while the other two plans


    Fannie Mae Took Losses on Higher-Risk Mortgages Necessary to Meet the Affordable Housing Goals.


    A M E R I C A N E N T E R P R I S E I N S T I T U T E


    resulted in opportunity costs of about $817 million.25 An opportunity cost was the difference between acquiring a mortgage that was profitable under Fannie’s guarantee fee model and one that was not—that is, where anticipated losses were projected to reduce, eliminate, or exceed anticipated profits. In other words, Fannie was anticipating that to meet the affordable housing goals quota for 2007 it would either have to forgo profits in acquiring those loans or actually suffer losses.

    A sense of how difficult it became for the GSEs to meet their goals in the mid-2000s is given by a summary of the problem in a Fannie staff presentation on the 2007 housing plan: “Regular business misses goals by a significant amount. Execution of special initiatives [will be] required to meet the goals; will come down to the wire again.”26 The “special initiatives” were such special deals as My Community Mortgage (MCM), Expanded Approval (EA), and DU Boost (occasionally called DU Bump)—all of which referred to tweaks in Fannie’s automated underwriting system (called Desktop Underwriter or DU) so that it would accept loans and private MBS that would otherwise have been rejected as too risky.

    In this connection, Fannie used the term “G-fee gap” to describe the difference between the G-fee that they should receive to hold or guarantee a loan and the G-fee they actually offered to acquire the loan. If the loans were expected to be profitable, the G-fee gap would be zero. The mere fact that Fannie was buying loans with a G-fee gap was irrefutable evidence that the loans did not meet Fannie’s profit expectations—in fact, that they were likely losers. 7

    Obviously, it was wrong for the FCIC majority to conclude that the GSEs were acquiring these loans because they were profitable; in fact, in many cases Fannie Mae’s staff expected them to be losers. It is equally obvious that the GSEs acquired them only to meet the affordable housing goals. Table 1, prepared by Fannie staff for a meeting on various plans to meet the goals, shows the costs of these subprime loans in terms of the G-fee gap. Although other riskier options were considered, I will focus only on the 30-year fixed-rate product, shown in bold type in the table.

    The table shows that the base product, the 30-year FRM, with a zero down payment should be priced according to Fannie’s model at a G-fee of 106 basis points (bps). However, the Fannie staff memo reports that Fannie was actually buying loans like that at a price consistent with an annual G-fee of 37.50 bps, producing a gap (or loss from the model) of 68.50 bps. The reason the gap is so large is shown in the table: the anticipated default rate on that zero-down mortgage was 34 percent. The table then looks at other possible loan alternatives, with the results made clear in the table.

    From this table, it is clear that to meet the affordable housing goals Fannie had to pay up for goals-rich mortgages, taking a huge credit risk along the way. In no sense were these loans profitable in the opinion of the Fannie staff who were making this decision; they were more like deferred losses, and when the losses came, both Fannie and Freddie became insolvent.

    Everything that was true of Fannie Mae was also true of Freddie Mac. In a 2009 report to a committee of the  board of directors, Freddie’s management summarized several points that show Freddie’s experience was almost identical to Fannie’s:


    • “Our housing goals compliance required little direct subsidy prior to 2003, but since then subsidies have averaged $200 million per year.”
    • “Higher credit risk mortgages disproportionately tend to be goal-qualifying. Targeted affordable lending generally requires ‘accepting’ substantially higher credit risk.”
    • “We charge more for targeted (and baseline) affordable single-family loans, but not enough to fully offset their higher incremental risk.”
    • “Goal-qualifying single-family loans accounted for the disproportionate share of our 2008 realized losses that was predicted by our models.”27
    • “In 2007 Freddie Mac failed two subgoals, but compliance was subsequently deemed infeasible by the regulator due to economic conditions. In 2008 Freddie Mac failed six goals and subgoals, five of which were deemed infeasible. No enforcement action was taken regarding the sixth missed goal because of our financial condition.”28
    • “Goal-qualifying loans tend to be higher risk. Lower household income correlates with various risk factors such as less wealth, less employment stability, higher loan-to-value ratios, or lower credit scores.”29
    • “Targeted affordable loans have much higher expected default probabilities. . . . Over one-half
    of targeted affordable loans have higher expected default probabilities than the highest 5% of non-goal-qualifying loans.”30


    These examples show that, contrary to the FCIC’s report, Fannie and Freddie had great difficulty meeting the goals, especially as they increased after 2003. Although these loans did not cause losses in the early 2000s, beginning in 2002 or 2003 they certainly did.

    Did the GSEs Acquire Subprime and Other High-Risk Loans for Market Share?


    The idea that the GSEs were interested in market share—as a business matter—vis-à-vis the private sector was never very plausible. Of course, they were fierce competitors with one another, and market share was important in that context, but because of their perceived government backing they could increase their share of the prime market virtually at will by reducing their guarantee fees. Doing that made them a lower-cost provider of mortgage securitization services for banks and other originators, and would attract more business.

    However, Table 2, a table published by their former regulator, the Office of Federal Housing Enterprise Oversight, shows that they did not lower their guarantee fees between 2003 and 2007, the period covered in the FCIC table. During this period, as the table below makes clear, their average guarantee fee increased, which would inevitably reduce their market share.


    A M E R I C A N  E N T E R P R I S E  I N S T I T U T E


    Fannie Mae Credit Profile by Key Product Features: Credit Characteristics of Single-Family Conventional Mortgage Credit Book of Business


    They likely had to increase their average G-fees during this period to make up for the lower G-fees they had to accept for riskier loans.

    So the commission was also wrong to hypothesize that the GSEs were acquiring high-risk loans for market share, just as it was wrong to claim that the GSEs acquired these mortgage for profit. The fact that the commission’s conclusions can be questioned based on public records is particularly troubling because it casts doubt on the thoroughness of its entire report.


    The GSEs Own Public Reports


    Nothing more effectively confirms the FCIC’s disinterest in the alternative explanations for the financial crisis than its failure to discover or acknowledge what the GSEs were publicly reporting at the very time the commission was placing lack of regulation and Wall Street greed at the center of the financial crisis. In 2009, after both Fannie and Freddie were taken over by a government conservatorship, Fannie finally published a complete credit supplement to its annual 10-K report to the SEC. A table from this supplement—issued on August


    A M E R I C A N  E N T E R P R I S E  I N S T I T U T E


    6, 2009, for the quarter ended June 30, 2009—is reproduced as Table 3. I have highlighted the key data.


    There are two things to note about the Fannie report. First, across the top of the table are the kinds of loans that the GSE considered to be its riskiest investments. These include mortgages to borrowers with credit scores less than 660 (the accepted definition of a subprime loan), mortgages with down payments less than 10 percent, and Alt-A loans.31

    These are the very loans they had to acquire to meet the affordable housing goals. It is true that these loans were not as risky as those securitized by the private sector, but they amounted to $878 billion in unpaid principal balances on Fannie’s books and were risky enough, according to the table, to cause 81.3 percent of Fannie’s losses in 2008, the year it became insolvent and was taken over by the government. They are also precisely the mortgages that Edward Pinto had identified—and the FCIC report had denied—as the source of the GSEs’ insolvency. To acquire these loans, the GSEs had reduced their underwriting standards and thus set off a general reduction of underwriting standards in the wider housing market.

    Second, Fannie’s report was issued in June 2009, shortly before the commission began its work, but like

    all the other evidence I have cited, it was not included or commented on in the commission’s report. Omitting this data, whether deliberately or otherwise, enabled the commission to claim that the financial crisis was caused by insufficient regulation of the private sector, primarily Wall Street, and that government policy, implemented through Fannie Mae and Freddie, had only a marginal role.




    Thus, despite a charge to inform the American people, Congress, and the president about why the US experienced a financial crisis, the FCIC failed in this mission, and its majority report should not be regarded as the definitive account of what caused the 2008 financial crisis.


    © 2016 by the American Enterprise Institute. All rights reserved.

    The American Enterprise Institute (AEI) is a nonpartisan, nonprofit, 501(c)(3) educational organization and does not take institutional positions on any issues. The views expressed here are those of the author(s).


    A M E R I C A N  E N T E R P R I S E  I N S T I T U T E






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    They’re coming for your bonus

    June 21st, 2016




    By Peter J. Wallison.




    America’s economic recovery since the recession ended in 2009 has been the weakest in decades, principally because the 2010 Dodd-Frank financial law suppresses risk-taking. Now another Dodd-Frank rule—proposed restrictions on incentive pay in the financial industry—could be the coup de grace for U.S. growth.

    The proposed restrictions have been agreed to by the six major financial regulatory agencies, including the Securities and Exchange Commission and the Federal Reserve, and would apply to thousands of executives and traders in the largest banks, asset managers, broker-dealers and others.

    The new rules impose limits on incentive pay such as bonuses, and require that 60% of any incentive compensation be deferred for at least four years. Bonuses would also be subject to “claw back” by financial firms for up to seven years after being paid in the event of losses attributable to poor judgment or undue risk-taking by the recipient.

    The best way to understand the effect of these proposals is to consider them in the context of the legal principle known as the “business judgment rule.” This rule holds that corporate boards of directors cannot be sued for a decision made with the best information available and in the good-faith belief that it was in the best interests of the corporation.


    This is a judge-made rule long embodied in the common law and upheld by courts over many years. The underlying policy for the rule is clear: If directors are liable for suit any time they approve a corporate action, it will be difficult to get them to approve anything, and corporate risk-taking—as in mergers or other major transactions—will grind to a halt. To gain the protection of the rule, boards go to extraordinary lengths to be sure their decisions are adequately documented with approvals by independent experts.

    The financial compensation rules now under consideration raise the same questions about risk-taking. For example, assume a bank officer is presented with a company’s application for a substantial loan for the construction of a new plant. The corporation is solvent, but the plant will be making a product that hasn’t been tested in the market. If the plant is built but the product fails to make the grade with consumers, the company could be in financial jeopardy.

    Many considerations go into the bank officer’s decision, including the interest rate on the loan, the value of the collateral, the management skills and likely tenure of the firm’s CEO, and the possibility of a long-term relationship between the bank and a successful customer. Can the bank officer adequately document these known unknowns to defend himself if the loan goes sour?

    Of course not. But if the proposed new rule is implemented, the officer has a personal incentive not to take the risk. It isn’t just the bank’s financial health but also the bank officer’s—the contemplated new house, the kids’ college tuition—on the line. The bank officer may choose to put his own financial well-being above his customer’s, resulting in far more loans being turned down.


    Now imagine this scenario playing out thousands of times across the country every day for years. You can easily see that this will result in less financial risk-taking and significant limits on available credit. That means less growth and innovation for the U.S. economy, with fewer jobs and lower compensation.

    How did we get here? The answer is the widely adopted explanation for the 2008 financial crisis. Although there is a great deal of evidence that the government’s housing policies were at the root of the crisis, the 2008 subprime mortgage meltdown and ensuing recession were blamed on “excessive risk-taking” on Wall Street. This gave rise to Dodd-Frank and the notion—popular among academics and regulators—that compensation in American finance had contributed to the problem.

    This is a barely plausible explanation for a phenomenon as widespread as the massive housing bubble that developed between 1997 and 2007, and fails to account for the deterioration of mortgage underwriting standards throughout the U.S. after Fannie Mae and Freddie Mac were subjected to the Department of Housing and Urban Development’s “affordable housing” goals. These initially required a 30% quota of loans that Fannie and Freddie acquired to come from borrowers who were at or below the median income where they lived. That quota eventually rose to 56%, forced a deterioration in underwriting standards, and precipitated the subprime fiasco.

    These new rules are based on the same false idea about the causes of the financial crisis that underlies Dodd-Frank, a law that has discouraged credit expansion and resulted in the 2% growth rate of the past seven years. We should not double down on that mistake by further sapping the risk-taking that drives economic growth.


    More than the financial industry should be protesting these regulations. Congress should insist that the consequences for future economic growth be fully explored before the rules are allowed to go into effect.


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    The MetLife decision affects asset management, too.

    June 20th, 2016


    By Peter J. Wallison.




    Treasury Secretary Jack Lew took to the Wall Street Journal’s digital commentary page on Tuesday night to take issue with “Opponents of financial reform [who] are cheering a court decision to rescind the Financial Stability Oversight Council’s designation of MetLife for heightened regulatory supervision.” “Leaving aside whether the decision will be overruled on appeal,” he wrote, “efforts to depict the court’s decision as a positive for our financial system are mistaken and dangerously ignore the lessons of the financial crisis.”

    The secretary’s article breaks no new ground, nor does it explain why the court may have gotten it wrong. Instead, he used this opportunity to explain why the council — which has the ability to look “over the horizon, to where future risks may develop” — is closely examining the asset management industry.

    I don’t mean to be disrespectful, but the article reminds me of the hilarious scene in a Monty Python film, where a knight is gradually dismembered by an opponent, but keeps issuing more and more over-the-top threats as he gradually loses his arms and legs. Eventually, he’s just a trunk, but is still issuing threats.


    Figure: Monty Python in “Monty Python and the Holy Grail.”


    This isn’t to say that the FSOC is doomed by a single decision of a district court, but the scope of the decision raises questions about whether the FSOC will ever be able to take any action against the asset management industry unless it can overcome the court’s simple requirement that it have evidence for its predictive rulings.

    The Dodd-Frank Act certainly gives FSOC the authority to declare that a particular “activity” of an asset manager—or the industry as a whole—could be subject to censure and restriction if FSOC can establish that the activity “could pose a threat to the financial stability of the United States.”

    That’s the rub. In the MetLife case, where MetLife challenged its designation by FSOC as a systemically important financial institution (SIFI), the court insisted that the FSOC make a “reasoned prediction”—i.e., provide evidence—that MetLife’s “material financial distress” could cause instability in the US.

    Under the MetLife decision, to attack an “activity” by an asset manager, or by the industry as a whole, the FSOC will have to show — with evidence — that the particular activity, in the future, could create something as serious as instability in the US financial system.

    Unless the appellate court, or the Supreme Court, relieves this burden, it will be extremely difficult for the FSOC to produce evidence that will validate and support such a prediction.


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    The TBTF fix no one’s discussing simpler capital ratios

    June 18th, 2016


    By Peter J. Wallison.



    When it was enacted, the Dodd-Frank Act was advertised as the answer to the too-big-to-fail problem: the threat of taxpayer bailouts because the government is unwilling to let a large bank fail.

    But the law is not a viable solution, and some other ideas — such as breaking up the biggest banks — are not workable either. In reality, fixing TBTF is a waste of time. The right policy is to ensure that the largest banks are never in trouble, and that means adopting a simplified assets-to-equity “leverage” ratio and an improved system of prompt corrective action for the largest banks.

    Let’s look at some of the problems with the current TBTF debate, which overlooks certain key facts. First, serious questions hamper the government’s ability to implement the primary Dodd-Frank section addressing TBTF, known as Title II.


    Title II allows the Federal Deposit Insurance Corp. to resolve a systemically important financial company. But, as I point out in a paper with my AEI colleague Paul Kupiec, that title applies to nonbank financial firms, and bars the FDIC from placing a large bank subsidiary in its own Title II resolution.

    That leaves the FDIC with two bad options. The FDIC can resolve a subsidiary bank through the Federal Deposit Insurance Act. But to take over and resolve a failing bank requires the FDIC to tap the Deposit Insurance Fund, which would be insufficient to resolve a trillion-dollar institution. Also, in bank resolutions, the FDIC typically sells the failing bank to a healthy acquirer. If we are really worried about TBTF, selling a trillion-dollar bank to another trillion-dollar bank isn’t the answer.


    In the second option, the FDIC deals with the subsidiary bank under a Title II resolution of its parent. But the FDIC’s “single point of entry” strategy — the agency’s most-discussed method for implementing Title II — is also unworkable for the largest banks. Under SPOE, the FDIC would close the holding company and use its assets to recapitalize the bank, keeping the bank operating. However, Title II makes clear that this can be done only if the holding company is insolvent.

    If the bank’s failure was the basis for triggering Title II, legal questions would likely arise about whether the holding company had failed. Regulators would likely cite “source of strength” doctrine, arguing in effect that a bank failure equals that of the holding company, but legal basis for that doctrine is unproven. And, as Kupiec and I point out, holding companies for the largest banks have other profitable subsidiaries, allowing them to remain solvent even if their largest bank failed — meaning the FDIC will not be able to use its SPOE strategy for the very banks that create the TBTF problem.


    Nor can we solve TBTF by breaking up the biggest banks, as some commentators have urged. In practical terms, a bank is only TBTF if the Federal Reserve believes its failure will have systemic effects. But since no one can know how the Fed will act in a future situation, it’s silly to suggest that the largest banks should be reduced in size until they are no longer TBTF. It is impossible to know what that size is.

    Finally, consider this: our four largest banks have total combined assets of approximately $6 trillion. If we arbitrarily decide that $250 billion is the right ceiling, we could break them up into in 24 separate $250 billion banks. What happens then if one of them fails? It can’t be sold to one of the others, because the acquiring bank would then be larger than the limit. Nor could any other existing bank—of any size—merge with it. So the FDIC would have to take over the failing bank and resolve it by selling off the pieces to whatever other banks could buy them without violating the $250 billion ceiling. It would take years—even if the FDIC had the funds and the technical ability to operate the bank while selling off its assets. Meanwhile, the losses to the taxpayers and disruption in the economy would be substantial.


    So what are we to do? We have four trillion-dollar banks, and many others much larger than the $250 billion size we arbitrarily chose. The failure of any could cost the taxpayers billions and seriously disrupt the economy, and there is no practical way to address this problem under existing law. We can’t break them up without assurance that their parts won’t still be TBTF—in the eyes of the Fed—at whatever level is chosen; they can’t be merged with a healthy bank without making the healthy one even more TBTF; and the FDIC doesn’t have the financial resources to resolve them if they fail.

    The answer is that these very large banks cannot be allowed to fail. That sounds impossible, but it’s not. Their capital level can be increased substantially, and backed up with an effective system of prompt corrective action and continuous examination. Prompt corrective action hasn’t worked well for small banks because they are not widely diversified and can lose substantial capital between examinations. The largest banks, however, are examined on a continuous basis, and their diversification is further protection against unforeseen events.


    A thoroughgoing reform like this would abandon the risk-based capital system — a complex and nontransparent way for governments to measure banks’ capital. In its place, we should substitute a leverage ratio — the simpler the better. A non-risk-based capital ratio is already a component of the international Basel capital regime, but it should be the only component. A risk-based capital system allows too much room for error and manipulation. It can even become a form of credit allocation. For example, before the crisis, private mortgage-backed securities were considered low risk, meaning banks would set aside less capital to cover loss in a risk-based system. But that was a recipe for disaster.

    On the other hand, data shows that investors and creditors reward a high equity-to-assets leverage ratio, probably because they have confidence that the banks’ capital is real and not simply a gaming of the risk-based capital system.


    The traditional objections to higher capital requirements are that they would encourage greater risk-taking (to raise return on equity) or higher lending costs (to cover capital costs). But a credible leverage ratio will attract financing at lower cost, increasing return on equity. Excessive risk-taking would be counteracted by continuous examination and prompt corrective action to spot problems before they significantly diminish a bank’s capital cushion.

    Given that there is no other viable solution to the TBTF problem, let’s try this one.


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    Dodd-Frank Hasn’t Eliminated TBTF Banks

    June 17th, 2016



    By Peter J. Wallison



    The reason the administration doesn’t “trumpet” Dodd-Frank’s elimination of too-big-to-fail is simple: the act doesn’t do that.

    In answer to Alan Blinder’s “Why Trump, the ‘King of Debt,’ Hates Dodd-Frank” (op-ed, June 7): The reason the administration doesn’t “trumpet” Dodd-Frank’s elimination of too big to fail is simple—the act doesn’t do that. Not even close. Title II of the act, contrary to Prof. Blinder’s account, doesn’t apply to banks at all, but only to nonbank financial firms. Banks are specifically excluded from the title and left to resolution by the FDIC. The FDIC doesn’t have the resources, financial or otherwise, to keep open a failing trillion-dollar bank and of course cannot sell it to a healthy trillion-dollar bank—the agency’s usual tack—without making the TBTF problem worse. So the only recourse under Dodd-Frank is a taxpayer bailout. It’s important to read the statute, and a good reason—as House Financial Services Committee Chairman Jeb Hensarling has just proposed—to open Dodd-Frank and start over.

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    Letter to the editor

    June 16th, 2016


    By Peter J. Wallison.



    To the Editor:

    Re “President Trump, Unbound,” by Eric Posner (Op-Ed, June 4):

    The sad fact is that, if he is elected, Donald Trump will follow in office a president who has shown less regard for the Constitution than any president in history. If a President Trump wants to carry out many of the things he has talked about, he will be able to cite President Obama for actions and ideas that fall well outside our constitutional structure.

    Mr. Obama was the first and only president to claim that he had authority to take action on immigration because Congress has refused to do so; the first and only president to have decided for himself when the Senate was actually in recess and made appointments later struck down by the Supreme Court; and the first and only president required to defend a lawsuit by the House of Representatives because he spent funds — in this case on Obamacare — that Congress had never appropriated.


    The writer, who was White House counsel for President Reagan, is a fellow in financial policy studies at the American Enterprise Institute.


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    Mitch McConnell will stay the course on the Garland nomination

    April 21st, 2016



    By Peter J. Wallison.




    The media drumbeat on a replacement for Justice Scalia continues unabated. The nomination of Merrick Garland has been hailed as a brilliant Obama move to increase pressure on GOP leader Mitch McConnell, and the agreements of several senators to meet with Garland have been described as important leaks in the GOP dike that will eventually cause the whole thing to collapse.

    But this is a media fantasy, which fails to understand Senator McConnell’s strategy and why his position won’t change.

    Several weeks ago, shortly after Justice Scalia’s death and McConnell’s statement that there would be no hearings and no vote on any Obama nomination, I wrote in this space that it was a virtual certainty no action by the Senate would occur before January 2017. The reason is that Mitch McConnell’s dominant interest is maintaining GOP control of the Senate. To do this, he has to protect GOP Senators running this year in five blue states — Wisconsin, Illinois, Ohio, Pennsylvania, and New Hampshire.

    If these senators, and perhaps others, have to vote on this nomination, there can be no good outcome for them. If they vote against the nominee, it will enrage the left, which will use the vote to increase turnout on election day; if they vote for him, it will enrage the right, which will stay home in November. Look, for example, at the pressure from the right that is now being brought on Senator Jerry Moran of Kansas, who only said he favored holding hearings on the nominee.

    It’s obvious that whatever criticism a GOP senator might face for not voting on Merrick Garland, the results of an actual vote — either way — would be far worse. If he wants to keep GOP control of the Senate, Mitch McConnell will stay the course.




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    Obama’s parting ‘gift’ to the financial industry

    April 20th, 2016


    By Peter J. Wallison.


    A White House meeting which took place in early March could have wide-ranging implications for the future of U.S. financial markets. Although regulators are supposed to be independent of the president and his policies, all principal federal financial regulators were summoned a few weeks ago to the White House to meet with President Barack Obama about the implementation of the Dodd-Frank Act. In the past, Obama has ignored appearances of impropriety and has successfully pressed regulators to follow his policies. This most recent meeting should be taken as a warning sign for the financial community that it will face serious new regulatory challenges before the end of the Obama administration.

    Before the meeting with the president, the Fed prepared the way for strict new regulations on banks, proposing to limit interbank lending to 15% of capital. This applies to banks the erroneous Dodd-Frank notion that interconnections between financial institutions caused the breakdown and panic in 2008. In reality, despite the chaos that ensued after Lehman’s bankruptcy, no other large financial institution failed because Lehman could not meet its obligations. The Fed’s action, however, signals that Dodd-Frank will be used aggressively in the months ahead to cement in place President Obama’s regulatory legacy.

    But this is only the beginning. There is a real danger that prudential regulation — in which regulators control credit allocation and risk-taking and impose capital requirements — will be extended to the rest of the financial system. In effect, under the guise of creating “stability,” a prudential regulatory system will replace today’s unfettered financial market with a regulator-managed market in which risk-taking is controlled by the government.


    A focus on “shadow banks”


    This is not far-fetched idea. Both the Treasury and the Fed are members of the Financial Stability Board (FSB), a mostly European group of finance ministers and central bankers, deputized by G-20 leaders (including President Obama) in 2009 to reform the international financial system. For several years, the Board has been developing theories for imposing prudential regulation on “shadow banks” — a term it uses to define and regulate financial institutions that are not subject to bank-like regulation, including broker-dealers, asset managers, mutual funds, hedge funds and insurance companies, among others.

    In his most recent message to Financial Stability Board (FSB) members, in late February, FSB board chairman Mark Carney noted that “the FSB’s priorities for 2016” will be “the full and consistent implementation of post crisis reforms,” which include the prudential regulation of shadow banks.

    Although large financial firms — such as broker-dealers, hedge funds insurers and money managers of all kinds — have received most of the attention as shadow banks, the FSB has made clear that small firms will not escape prudential regulation. In the FSB’s definition, a firm is designated as a shadow bank if it participates in “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”

    Normally, maturity transformation — the risky business of converting short-term deposits into long-term loans — applies only to banks. But as defined by the Financial Stability Board, maturity transformation will affect any size financial firms if they play a part in a series of transactions that eventually convert a short-term loan into a long-term credit. Thus, a firm that makes short-term loans to an auto dealer would be taking part in a maturity transformation if at some future time the dealer sells its auto loans into a securitized pool.


    Obama’s regulatory legacy


    Almost six years after the passage of Dodd-Frank, it seems likely that the prudential regulation of shadow banks is intended to become part of the Obama legacy. That’s the reason for the White House meeting with the regulators. Such a plan would fit well with the FSB chairman’s expectation that all its members — including the Treasury and the Federal Reserve in the U.S. — will implement the Board’s reforms in their respective jurisdictions this year.

    In America, this would be the job of the Financial Stability Oversight Council, led by Treasury Secretary Jack Lew. It is not yet clear exactly how the Council will follow Obama’s plans, but there is little doubt that it will try. In the past, the Council has made sure that all decisions and directives of the Financial Stability Board are implemented in the U.S. For example, it designated as Systematically Important Financial Institutions (SIFIs) the same three insurers — AIG, Prudential and MetLife — that were designated as SIFIs by the Board. Unfortunately, with a compliant judiciary, it’s possible that the broad language of the Dodd-Frank Act could be used for this purpose.

    If the financial community wants to avoid prudential regulation, this is the time to make its objections known to Congress and the regulators.

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    Shadow Banks Are Not a Source of Systemic Risk

    April 18th, 2016

    By Peter J. Wallison.



    Last week, my friend Eugene Ludwig wrote an article on American Banker headlined: “Unregulated Shadow Banks Are a Ticking Time Bomb.” The gist of the article was that there are risks building in the “shadow banking sector” — the term that bank regulators use to describe the capital markets — that could bring about a crisis similar to what we experienced in 2008. To Ludwig and others, the capital markets are dangerous because they are generally not subject to prudential regulation, which is fundamentally the regulation and suppression of risk-taking.

    As reluctant as I am to disagree with Ludwig, a deservedly respected former regulator, I must. There are so many false assumptions in his article that they can’t be allowed to go uncorrected.

    First, it is necessary to understand what actually happened in 2008. Leaving aside the question of why there were so many subprime and other risky mortgages in the U.S. financial system, the question is why the meltdown of these mortgages caused a financial crisis.

    The answer is that these mortgages were tied to debt on the balance sheets of the largest financial institutions, particularly banks. Obviously, when a widely held asset is carried with debt, and falls substantially in value, the result is a serious loss on the balance sheets of the affected firms. Liabilities remain the same, but assets decline. The firm’s capital position deteriorates and it may look unstable or even insolvent. This is what happened to the banks and investment banks (and of course, Fannie Mae and Freddie Mac) that were holding large portfolios of mortgages or mortgage-backed securities when the great housing bubble began to deflate in 2007.


    There are four important points that come out of this and show that we would gain nothing and lose much by introducing prudential regulation into the capital markets. First, of course, prudential regulation failed to prevent the financial crisis. The regulators, in many cases embedded in the banks that got into trouble, were unable to see the crisis coming. This included the Federal Reserve Board, with its extraordinary staff of first-rate economists. The Fed’s chair, Ben Bernanke, was telling the markets that the subprime problem was “contained” until late 2007. As a result, while lightly regulated Bear Stearns, AIG and Lehman Brothers failed or had to be rescued, so did heavily regulated and supervised Wachovia, WaMu and IndyMac — in addition to hundreds of smaller heavily regulated banks. In other words, the prior presence or prudential regulation made no difference when the crisis struck. So we can conclude that there is no good reason to spread it to other sectors of the financial economy.

    The second point is that leveraged entities, funded by debt instead of equity, were especially vulnerable to the mortgage losses that exacerbated the financial crisis. Where assets are backed with equity — as is true of the mutual funds, private equity funds, and investment vehicles and conduits of all kinds that were cited in Ludwig’s article — a sharp decline in the value of those assets, as occurred in the financial crisis, will fall on the investors in those entities rather than on the entities themselves. That will not cause a financial crisis for the same reason that the collapse of the dot-com bubble in 2001 did not cause a financial crisis, even though the losses were even greater than the losses in 2008. The losses in that event fell on an enormous pool of capital — shareholders — not on individual large firms.

    Third, even in cases where the entities that suffer the losses are carrying the assets with debt, no financial crisis will result unless many large entities are affected at the same time. That’s why the mortgage meltdown was so devastating; it was the sudden collapse of a whole class of assets widely held by large firms. The bankruptcy of many relatively small entities — which characterize the capital market players that make up the shadow banking system — will not produce a financial crisis.

    Indeed, there is good evidence that the failure of even large nonbank financial entities will not cause a financial crisis. Although there was chaos after Lehman failed, this was because the government had suddenly and accountably reversed the policy of rescuing large financial firms — a policy it had established with the rescue of Bear Stearns. The important point is that no other large financial institution failed as a result of Lehman’s failure. All additional failures (such as AIG) resulted from the same exposure to bad mortgages. This shows that large nonbank financial firms are not dangerously “interconnected” as some have claimed; large nonbank firms are likely to be highly diversified and thus unaffected by the failure of counterparties, even other large ones.

    Finally, there is the concern about risk-taking. Ludwig worries that risks are building in shadow banking. We should hope so. Risk-taking is the source of innovation and growth. Risk-taking among the various capital markets firms — broker-dealers, mutual funds, hedge funds, private equity and others — is what has been driving the meager growth we have had since 2008. Banks, hamstrung by excessive regulation, have not been able to contribute much to the recovery, especially for small-business startups.

    What’s behind the concern about shadow banking risk is the hope that banking regulators will eventually get the opportunity — in the name of stability — to impose prudential regulation on the capital markets sector. If that happens, growth will decline further.

    Meanwhile, because of risk-taking, there will certainly be failures among the so-called shadow banks. That’s the price that entrepreneurs pay for the right to innovate. We can be sure, however, that none of these failures, nor all of them together, will cause another financial crisis.


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    The FCIC Misled The American Public

    April 17th, 2016

    By Peter J. Wallison.



    Everyone agrees that the 2008 financial crisis was the result of a “mortgage meltdown,” the default of an unprecedented number of subprime and Alt-A mortgages (often called nontraditional mortgages, or NTMs) in the U.S. financial system. The central question, then, is why so many of these NTMs were outstanding in 2008. The majority report of the Financial Crisis Inquiry Commission blamed insufficient regulation, which it said allowed the private sector — led by Wall Street — to originate and sell these deficient mortgages to unsuspecting buyers.

    As a member of the FCIC, I argued that U.S. government policies — particularly the affordable housing goals (AH goals) imposed in 1992 on the government-backed mortgage giants Fannie Mae and Freddie Mac — were the real cause of the financial crisis. The goals required Fannie and Freddie, when they acquired mortgages from originators, to meet a quota of mortgages that had been made to homebuyers at or below the median income.

    The U.S. Department of Housing and Urban Development was given authority to increase the goals and it did so, aggressively, over time. This forced Fannie and Freddie — which previously had limited their purchases to prime loans — to lower their underwriting standards; they could not find a sufficient number of prime mortgages to meet the goal quotas. Figure 1 shows the increases in the AH goals between 1996 and 2007.




    Because Fannie and Freddie dominated the housing-finance system, the deterioration in their underwriting standards caused the standards in the mortgage market as a whole to decline. This built the enormous 1997 to 2007 housing-price bubble. When the bubble collapsed, the result was a nationwide decline in housing and mortgage values, the mortgage meltdown and, eventually, the financial crisis. I made this point in my dissent from the FCIC’s report and, with more data, in my 2015 book, “Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again.”[2]

    The FCIC majority refused to consider this idea seriously, and focused its report entirely on the private sector:

    [I]t was the collapse of the housing bubble — fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages — that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.[3]

    About Fannie Mae, the report said:


    We find that the risky practices of Fannie Mae…particularly from 2005 on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices.[emphasis added]


    Thus, the FCIC’s claim was that Fannie bought the subprime and risky mortgages that ultimately caused their insolvency because these loans were profitable or enhanced their mar­ket share — what Wall Street wanted; the AH goals contrib­uted only marginally. However, even I was surprised to find, when I finally got access to some of the FCIC’s records after the commission closed down, that the FCIC had received and ignored a great deal of documentation from Fannie and Freddie that contradicted its claims.

    The examples are numerous, but a few are included below. They are all from Fannie, which is where the FCIC focused its attention, but Freddie’s documents are fully consistent with Fannie’s.

    The report says that Fannie and Freddie had no difficulty meeting the goals. As evidence, the report states: “In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.”[5] But here is a Fannie report to HUD from 2002 about its difficulty meeting the goals:

    In 2002, Fannie Mae exceeded all our goals for the ninth straight year. But it was probably the most chal­lenging environment we’ve ever faced. Meeting the goals required heroic fourth quarter efforts on the part of many across the company. Vacations were canceled. The midnight oil burned. Moreover, the challenge freaked out the business side of the house. Especially because the tenseness around meeting the goals meant that we considered not doing deals — not fulfilling our liquidity function — and did deals at risks and prices we would not have otherwise done.[6] [emphasis added]

    In an Oct. 31, 2005 presentation to HUD, Fannie further cited several undesirable tradeoffs needed to meet the agency’s goals, including that “[d]eal economics are well below tar­get returns; some deals are producing negative returns” and that “G-fees may not cover expected losses.”[7] Similarly, in a July 2007 staff meeting, the cost of meeting that year’s goals was placed at $1.156 billion.[8] It doesn’t sound as though Fan­nie expected these loans to be profitable, or that they would please Wall Street.

    What about the FCIC’s statement that Fannie and Freddie bought these loans for market share? If Fannie and Freddie actually wanted to increase their market share, the way to do it was to reduce the fees they charged to guarantee mortgage-backed securities. That way, they would become a lower-cost provider than other channels that originators might use to sell their loans. But as shown in the following 2008 summary by their regulator, Fannie increased its average guarantee fees between 2004 and 2007.





    Average guarantee fee (basis points)














    Perhaps the most telling exclusion from the report were data published with Fannie’s 10-Q report for the second quarter of 2009 – after the firm was taken over by the government but almost two years before the FCIC issued its report. Table 2 includes an excerpt from the 10-Q that shows all the NTMs they held at that time. These amounted to $838 billion, less than a third of Fannie’s $2.8 trillion book of business, but they were responsible for 81 percent of its 2008 credit losses.




    Product feature

    Unpaid principle ($B)

    Percent of credit losses (%)

    Negative-amortizing loans



    Interest-only loans



    Loans with FICO < 620



    Loans with FICO ≥ 620 and <660



    Loans with original LTV ration    > 90%



    Loans with FICO < 620 and original LTV > 90%



    Alt-A loans



    Subprime loans



    Subtotal of key product features



    Overall book



    SOURCE: Fannie Mae


    The FCIC majority thus seemed to have made up its analysis for why Fannie and Freddie bought all these risky NTMs in order to fit the conclusion it wanted to reach: that insufficient regulation and Wall Street greed — and not government housing policy — caused the financial crisis.

    This was a gross disservice to the American public, whose view of the financial crisis was deliberately distorted. The consequences include the 2010 Dodd-Frank Act, which has slowed the economy’s growth, and the absurd fight in the current Democratic presidential race about who will punish Wall Street the most.



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    Why the MetLife Case Bears Watching Well Beyond Wall Street

    April 16th, 2016




    By Peter J. Wallison.


    Judge Rosemary Collyer


    A ruling against federal regulators could mean a brake on the wild growth of the administrative state.

    Federal district Judge Rosemary Collyer sent a shock through the financial community on March 30 by striking down the designation of MetLife as a systemically important financial institution (SIFI). Her opinion, released to the public last week, is more than a challenge to the authority of the Financial Stability Oversight Council. It is a challenge to the power of the entire federal bureaucracy.

    The Treasury Department intends to appeal her ruling, and whatever happens at the next step of litigation, the case is likely to reach the Supreme Court. MetLife v. Financial Stability Oversight Council bears watching far beyond Wall Street: Ultimately, this case could determine whether the administrative state will be contained within judicially and statutorily created boundaries, or continue its unrestrained growth.

    The Financial Stability Oversight Council, a creature of the Dodd-Frank Act, is a 15-person board composed largely of the heads of the federal agencies that regulate financial services. It can designate any nonbank financial firm as a SIFI, singling it out for stringent oversight by the Federal Reserve, if the council believes that the “material financial distress” of the firm “could pose a threat to the financial stability of the United States.” The council can also determine whether “the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities” of any financial company could pose a similar threat.

    Judge Collyer’s decision challenges whether the council—or, for that matter, any other federal administrative body—can base its decisions on nothing more than a prediction about the future that is unsupported by evidence. The council’s designation of MetLife as a SIFI was clearly that. The financial conditions that might exist in the future, when MetLife might suffer “material financial distress,” are unknown and indeed unknowable.

    The Justice Department, representing the council, told Judge Collyer that because of the council’s expertise in financial regulation, its opinion about this matter must be given deference by the court.

    MetLife’s counsel argued instead that the council’s decision to label the company a SIFI, with no evidentiary foundation of any kind, was ipse dixit (a Latin phrase that means, essentially, “because I said so”). Judge Collyer agreed. An agency, she said, must engage in “reasoned decisionmaking” or its action will be deemed arbitrary and capricious. But the council’s analysis of MetLife “never projected what the losses would be . . . or how the market would destabilize as a result.” She concluded that a “predictive judgment must be based on reasoned predictions,” and “a summary of the company’s assets and financial exposures is not a prediction.”

    In other words, Judge Collyer found that the discretion provided to the council by Dodd-Frank violated the underlying policies of the Administrative Procedure Act, which authorizes courts to dismiss federal agency decisions that are not based on evidence. For this reason, the ruling has far-reaching ramifications.

    It is difficult to see how the council, or any other federal agency, can meet Judge Collyer’s standard, except where there is clear supporting evidence for a prediction—for example, where the weight of scientific evidence supports its view that a certain action will cause a predicted result.

    Other cases are not so easy. In February 2014, the Federal Reserve adopted enhanced prudential standards such as stricter liquidity requirements for bank holding companies, with the proviso that the standards will get “more stringent” as these firms become more “systemically important.” Systemic importance is clearly a prediction about the future effect of a firm’s “material financial distress” for which an administrative agency must have supporting evidence. Judge Collyer’s ruling thus calls into question whether any firm can be considered “systemically important” unless an agency, like the council or the Fed, can produce such evidence.

    The MetLife case is not about statutory authority. Dodd-Frank unambiguously grants the council discretion to designate financial firms as SIFIs on whatever grounds it chooses. The issue raised by Judge Collyer is whether—no matter what Congress says—this or any other agency can base a decision on nothing more than an opinion about what may happen in the future.

    Federal courts used to rein in the discretionary authority of administrative agencies by ruling that Congress had unconstitutionally delegated its exclusive authority to make the laws. But this practice has fallen into disuse. Instead, federal courts now often validate agency discretion, holding that these bodies, staffed by alleged experts, deserve “deference” when they fill in the blanks left open in laws that Congress has enacted.

    At the Supreme Court, this validation has often satisfied both sides: conservative justices, who believe in judicial restraint, and liberal justices, who generally support administrative power. Lately, however, Chief Justice John Roberts, and Justices Clarence Thomas and Samuel Alito, have begun to question this course.

    The deference idea encourages Congress to dodge tough decisions by giving administrative bodies, whose members don’t run for re-election, broad mandates over controversial issues. As a result, these agencies have grown into what is essentially a fourth branch of government, what many call an administrative state. The MetLife case could test whether Congress, in Dodd-Frank, finally went too far.



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    Hollywood’s misleading history

    March 1st, 2016


    The film called The Big Short differs in a significant way from the book of the same name on which it is based, and this difference reveals how the film-makers made it more politically charged in order to blame Wall Street for the financial crisis.

    In the book, the Wall Street experts who were approached to bet against the housing market almost all refused.

    This showed something that was true, and for that reason interesting: that even people on Wall Street, always on the lookout for a money-making opportunity, could not believe the housing market was in any danger of collapse. In the film, this was demonstrated by the skepticism of the FrontPoint group that was initially approached as investors, as well as the eagerness of the financial firms such as Goldman Sachs and others to take the other side of the bet against the housing market.

    Adam McKay (L) and Charles Randolph, winners of Best Adapted Screenplay for "The Big Short", at the 88th Academy Awards in Hollywood, California February 28, 2016. REUTERS/Mike Blake.

    In the book, the tension in the narrative was created when the book’s protagonists — the first people to bet against the housing market — had persuaded their investors to place bets against the housing market many months before the coming failures actually became evident. As a result, in the book their financial backers became impatient. The predictions of a collapse did not happen fast enough, and they sought to withdraw their funds. Some of this impatience was present in the film, but the context was changed.

    In the film, the collapse actually occurred, but the there was no movement in the market prices of the privately-issued mortgage-backed securities or the credit default swaps that were used to bet against them. This was attributed in the film to a conspiracy among the big banks on Wall Street: they somehow kept the market from moving against them while they sold off their holdings to less informed buyers.

    It should be obvious that a conspiracy like this is impossible. There are too many buyers and sellers in the financial markets for something like the price of mortgage-backed securities or credit defaults swaps to be rigged. In reality, as soon as an index of housing defaults began to signal danger, investors fled the market.

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