The Subprime Crisis—Plan C

The just enacted $700 billion Plan B to put a floor on the market prices of mortgage related assets may not be enough to restore credit markets to normalcy, though the Treasury has yet to settle on just what Plan B is.  What should Plan C look like?

When the bursting of the real estate price bubble began to dramatically increase mortgage defaults and foreclosures in the spring of 2007 (especially for adjustable rate mortgage loans to subprime borrowers), banks began to horde liquidity and heavily indebted hedge funds and others began to deleverage. The three month LIBOR, the rate at which banks lend to each other, which normally averages between 0.1 and 0.2 percentage points above the overnight Federal funds rate, suddenly jumped starting in August 2007 to more than triple those spreads by mid September reflecting a lack of confidence in the borrowing banks.

In Plan A the Federal Reserve responded quickly to supply the increased liquidity demanded by the market and even introduced new facilities that extended the terms, increased the list of eligible collateral (all Federal Reserve Bank loans are collateralized), and broadened the institutions that could access these new facilities. The money supply (M2) grew above its normal rate throughout this period. Lenders were encouraged to renegotiate the terms of mortgages if foreclosure could be avoided and the lender incur a smaller loss. Plan A included bank by bank interventions and resolutions of failing commercial and investment banks starting with Northern Rock in the U.K, followed by Bears Stearns in the U.S. and later by Countrywide, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, Washington Mutual, Wachovia to name the bigger ones. But still the three month LIBOR spread over the fed funds rate persisted in the 0.7 to 0.8 percentage point neighborhood.[1]

Following the September 15th bankruptcy of Lehman Brothers and the government take over of AIG the next day financial markets panicked and by the end of the month the LIBOR spread more than tripling again from its already extremely large value (to 2.4 percentage points) and credit markets largely froze up. Regrettably more radical intervention was needed. Having largely addressed the “liquidity” problem the Federal Reserve and U.S. Treasury began to focus on the “capital” problem. The write offs of mortgage losses and the prospects of more to come led banks to question the soundness of their counterparties (those other banks to whom they generally lend short term money) and limited what they could lend even if they had the liquidity with which to do it. Thus the rapidly conceived and still unspecified Plan B for Treasury to buy up and insure mortgage related assets held by banks in order to help improve their capital. Plan B seeks to free up the flow of credit to “Main Street” by bailing out “Wall Street.” Depending on the details of its implementation it might succeed, especially if intervention takes the form of direct capital assistance (preferred shares) to all but the weakest banks (which should be resolved in the traditional way if they are not able to come up with enough capital on their own). The best plan would be to immediately guarantee that the government will take a significant, specific share of any actual loss on any mortgage. This plan could be implemented immediately with an immediate increase in the value of all questionable mortgages and of the capital of the banks that hold them.[2] It would share the loss with, and thus reduce it to, lenders but would not eliminate it completely.

Plan B does little to help homeowners unable to meet their mortgage payments. Reducing mortgage defaults is the most fundamental way to reduce Wall Street losses and increase bank capital. It is being called a “trickle up” rather than a “trickle down” approach. The administration and Congress have been rightly concerned not to tax those who borrowed prudently to bailout those who borrowed foolishly or who speculated on increasing housing prices, or to change lending rules in ways that increase the costs of mortgages in the future (such as court order debt restructuring). It has pressed for voluntary loan restructuring with HOPE and beefed up the FHAs assistance programs. However, we now need to carefully consider a radical Plan C that helps home owners with minimum unfairness and moral hazard of encouraging imprudent borrower behavior in the future.

Koppell and Goetzmann recommend that the government “pay off all the delinquent mortgages” by offering “to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 percent.” [3] McCain introduced a similar plan during the Presidential debates October 7. These proposals are bold but fail on many of the fairness, moral hazard criteria above. McCain’s plan spares the lenders any cost of their misjudgments and fully bails out borrows who can’t or won’t pay. A better plan, proposed by Henry Sanborn, is for the Federal government to offer to pay a share, say 30%, of the existing contractual mortgage payment in exchange for which the lender must pay (write off) a share, say 10% and the mortgagee the rest. The government’s payments would be a loan to struggling homeowners with attractive terms that encourage early repayment.[4] Replacing ARMs with Koppell and Goetzmann’s fixed rate mortgage could be usefully added to this plan. Actual and expected foreclosures should drop significantly to those levels that should not be prevented in any event and the market value of mortgages and mortgage backed securities would quickly increase, the associated losses to lenders decrease, and the capital of banks holding them increase.

To illustrate, a $200,000 30 year mortgage on a house valued at 220,000 with an initial teaser interest rate of 4% adjustable after two years, would require monthly principal and interest payments of $955 per month. After two years the remaining principle would be $192,812. If the interest rate on the adjustable rate mortgage (the category with the largest defaults) increased to 6% (most ARMs cap year to year adjustments at 2%), monthly payments would jump to $1,186 per month (or $1,440 per month at 8%), which might be more than the borrower could afford. Sanborn’s proposal is that if the lender can not agree on a voluntary restructuring satisfactory to the borrowing, the government would pay (as a loan) 30% of the monthly payments ($356) and the lender would eat (write off) 10% ($119) reducing the monthly payments for the borrower to $712. More likely that borrower would choose to borrow from the government the smaller amount needed to keep her payments at the affordable $955 per month. There is no firm data on the extent to which such measures would reduce mortgage defaults but it is likely to be considerable. Even if the market price of the house fell 20% to 180,000 (i.e. below the amount of the mortgage (serious home owners are not likely to walk away from their home as long as they can continue to make the monthly payments)

Let’s start discussing the details of Plan C before poorly designed versions are forced through a panicked Congress and before the unavoidable losses on other credits as the economy slows add to the erosion of capital.


[1] See Coats, “The D E Fs of the Financial Markets Crisis,” CATO Institute, September 26, 2008.

[2] See Coats,  "The Big Bailout–What Next?", CATO Institute, October 3, 2008.

 

[3] Jonathan G.S. Koppell and William N. Goetzmann, "The Trickle-Up Bailout", The Washington Post, October 1, 2008; Page A17

[4] Henry N. Sanborn, “A Different Solution to the Financial Mess” unpublished

 

Is America becoming Socialist?

I participate in an Internet discussion with a number of African free market thinkers who participated in the Mont Pelerin Society meetings in Nairobi last year. A number of them have commented on the financial crisis centered in the U.S. and whether the proposed Mortgage Backed Securities bailout was a surrender to Socialism. This morning I contributed the following to that discussion.

Stella, Rejoice, James, Leon and others raise a very important, fundamental, and difficult question about capitalism—what is the best relationship between individuals, enterprises, markets, and governments. Capitalism is not anarchy. Its incredible success in raising the standards of living of so many depends on an ever evolving set of rules and relationships within which we all interact. As James has said, “capitalism is about driving self interest…,” meaning directing self interest into serving the general welfare. Some market infrastructures are better than others, but the winners are generally sorted out Darwinian fashion over time. A critical corner stone in the foundation of capitalism is the efficient establishment and enforcement of property rights under the rule of law. These were not presented to the world on golden tablets but have evolved from experience. Capitalism is and always will be a work in process.

Some of capitalism’s infrastructure of practices, rules, and laws emerged from the private sector and some from government. America has been particularly successful because of the flexibility with which this infrastructure has adapted to new technology and knowledge and to experience. The unavoidable dark side of capitalism’s dynamism is that many fail along the way (the storms of the invisible hand). This may indeed raise moral questions but it certainly raises a practical one. The freest possible private market economy we believe in can not exist without very broad acceptance by our fellow citizens. Thus we offer safety nets to the losers to soften their fall in part to win their support for playing the game. Capitalism is prone to booms and busts and asset price bubbles and as with social safety nets for individuals we need to find that balance of government intervention that maximizes the freedom of the market that the public is prepared to accept.

With that background, yes, the government needs to help restore confidence and liquidity to American financial markets but with due regard for the potential moral hazards of how they do it. Doing so is not socialism. I addressed some of these issues in my blog posted here a few days ago. The FDIC assisted resolution of a very large U.S. bank (Wachovia) provides a good example of what in my view is the right balance. A major bank failed, wiping out its shareholders, with no damage to its depositors nor contagion to other banks. The FDIC’s interference in “pure” market solutions was in the best interest of the insurance fund (reducing the cost of an insurance pay out from bankruptcy) and the market more generally. Considerable (but not total) market discipline was preserved in a way acceptable to the market.

This does not mean that America is becoming socialist (I am not sure that such dichotomous terminology is useful). It means that it is forever searching for the right balance in the partnership between government and individuals in support of capitalism. It does not always get it right by any means but I am of the view that over time we learn from our mistakes more often than not and that we have thus generally enjoyed progress.

The Big Bailout: What Next?

The administration has told us that American financial markets are in a perilous state because of recent and prospective losses of financial institutions that threaten the adequacy of their capital[1] and because of the illiquidity and presumed market under pricing of Mortgage Backed Securities (MBSs). Both of these have increased banks’ demand for liquidity and tightened bank lending standards. A credit crunch, which would worsen an economic slow down, could result if markets for normally liquid assets such as MBSs and bank capital are not restored.

The root source of these problems is a higher than expected default rate on mortgages (mainly adjustable rate mortgages to subprime borrowers) AND uncertainty over how high default rates will go. The increase in defaults and foreclosures (the take over of the house collateral backing the defaulted loan) has followed closely the decline of grossly inflated housing prices, but they are not directly caused by falling housing prices. They are caused the inability of mortgage borrowers to meet their monthly payments or their decision that it is not economically advantageous for them to do so. Falling housing prices may affect the second of these, especially for flippers (those speculating that housing prices will rise).

A secondary source of these problems is the complexity of modern financial instruments, which has increased the interdependence of financial institutions on each other through credit default swaps (CDSs) and other forms of insurance and warrants and made it difficult to know who actually bears the losses from mortgage defaults.

A contributing factor in the excessive extension of mortgage loans to those now unable or unwilling to repay them (in addition to the government’s policy of promoting greater home ownership among low income households) was weak oversight of compliance with lending standards, which may also have been too low. The enforcement of these standards was made more difficult by the widespread securitization of mortgage loans (the sale of loans by their originators to other investors, which tends to reduce interest in loan soundness by the originator). These weaknesses will be corrected by loan originators and mortgage pool consolidators in order to protect their business and by, hopefully carefully focused, strengthening of the regulatory restrictions on lending. The market’s self corrects will be more complete the more heavily the costs of recently past weaknesses and mistakes are born by those who made them.

The administration faces the need to prevent an immediate credit crisis and to adjust the regulatory regime in order to reduce the prospects of similar problems in the future. Short run fixes, especially under the pressure of a crisis, always run the risk of undermining or weakening what is needed for the long run. Any short run help should be designed to minimize the “moral hazard” of bailing out the mistakes of those who took risks that have gone bad. Such accountability for our actions (accepting the consequences good or bad) is a cornerstone of the market’s regulation of economic activity.

The urgent, immediate need is to provide banks and the financial market with the liquidity they need in order to resume or maintain norm lending. The mystery of Secretary Paulson’s $700 billion proposal is that the Federal Reserve has been quick and imaginative in addressing the market’s liquidity problems. “Commercial banks and bond dealers borrowed $217.7 billion from the Federal Reserve as of yesterday [September 25, 2008], more than double the prior week….”[2]  In addition, AIG has drawn “down $44.6 billion on its $85 billion credit line from the Fed, up from $28 billion as of Sept. 17,…”[3] The use of MBSs as collateral for loans from the Fed has large advantages over their proposed purchase by the Treasury. The almost impossible task of pricing the very diverse MBSs correctly (near best estimates of their “true” value) for purchases by the Treasury is avoided by their use as collateral. The Fed’s lending facilities are in place and operating and do not require new legislation from Congress. While over pricing them would allow banks and other holders of comparable MBSs to reflect these higher values and thus improve reported capital in their financial statements, over valuation might discourage the revival of trading them in the market and hence market provided liquidity. Overpricing would be paid for by tax payers and underpricing by bank capital.

As noted above, the root cause of the crisis is the rising defaults on mortgages. Can and should these be prevented? The downward adjustment in housing prices from their severely inflated levels of two years ago should not be prevented. These are needed to make housing affordable again and to revive the housing market (both construction and resale). Though the pace of price decline has slowed[4] and sales of existing homes are recovering slightly from year end lows[5], prices will need to fall another 10% or so to return fully to the average affordability level of the 2000 to 2003 period.[6] Everything possible should be done to facilitate the restructuring of defaulting mortgages where borrowers are able and willing to pay reduced monthly charges if these adjustments preserve greater value to the lenders than they would receive for foreclosing on deflated homes. Lenders have every incentive to help borrowers avoid foreclosures in this way and hundreds of thousands of such loan restructurings have been undertaken voluntarily one by one. There is no conceivable way government bureaucrats could organize to perform this task better. Going beyond this to bailout borrowers will create a dangerous moral hazard that will encourage reckless borrowing in the future in the hopes of another bail out.

There is a growing consensus among economists outside of government and Wall Street that a better approach is to help banks increase their capital directly.[7] Such help might take the form of mandating the suspension of dividend payments (adding the retained earnings to capital) for any banks whose capital is below, say, 6% of risked weighted assets and requiring recapitalization through new share issues if needed. But these tools are already in place and in use though bank shareholders would naturally rather be bailed out than have to pay up themselves.[8] There is also a good case for lowering capital adequacy requirements cyclically during business downturns as long as estimates of loan and other losses are properly made and provisioned (reserves set aside to cover them should they be realized). 

In fact, there is little evidence of widespread serious capital deficiencies among banks. Only a small number of banks have failed and the U.S. has reasonably good and efficient procedures for resolving insolvent or critically undercapitalized banks. These procedures should be used (as they have been) one case at a time. Bear Stearns and AGI are not banks and the legal resolution tools for banks are not available to the authorities for dealing with them. Under the circumstances the Federal Reserve did about the best it could to remove them from play as smoothly and efficiently as possible. Consideration should be given to enacting similar tools for any class of financial institution that might pose systemic risks should it fail.

The general view in the market is that banks have already written off all or most of their expected losses. Are depositors and other creditors really panicking to the extent that a massive government intervention is needed to restore confidence in the system? The run on money market mutual funds last week clearly unnerved the authorities, but Fed lending to banks has enable them to replace withdrawn funds (by buying fund commercial paper) and fund depositors will need to put their withdrawn money somewhere.

But what if depositors lose confidence in banks more generally, creating a truly systemic crisis? While weak and poorly managed banks should be allowed to fail for their mistakes, it would not serve the public interest to let a large proportion of the banking system go under for reasons largely outside of their control. The government should in this unlikely situation intervene more forcefully. The Swedish approach for dealing with its banking crises in the early 1990’s has been raised as a model that the U.S. should consider. Stefan Ingves, who has been the governor of Sweden’s central bank (Riksbank) since January 1, 2006, oversaw the formulation and implementation of Sweden’s banking crisis resolution first as Under-secretary for Financial Markets and Institutions at the Swedish Ministry of Finance and then as Director General of the Swedish Bank Support Authority in 1993-94. Stefan was also my direct boss at the IMF from 1999 until I retired in 2003 and the lessons of the Swedish experience played an important role in IMF advise to the many countries that experienced banking crisis over the last fifteen or sixteen years.

The end of Sweden’s property boom in 1991 and the collapse of real estate prices in 1991-2 put a large number of its banks underwater (negative capital). In September 1992 Prime Minister Carl Bildt announced that the government was guaranteeing all bank deposits and other creditor claims on all banks in Sweden, thus immediately ending bank runs. It also ended any market discipline of bank soundness on the depositor side. The government focused instead on maximizing the discipline and oversight of shareholders (bank owners). Banks were required to immediately and fully write off all losses in order to have an honest picture of their condition. Those needing government funds to recapitalize (if they chose to stay in business) were required to surrender shares first putting the regulators temporarily in charge of such banks. Sweden earned high marks for its skillful and principled approach to its banking crisis.[9]

The situations in Sweden in the early 1990s and the U.S. now have similarities and important differences. Sweden did not have the legal bank resolution tools available in the U.S. now and thus had to improvise. Because of these tools, the U.S. can take over and resolve a failing bank without fear of systemic consequences. We need to continue applying these tools and to extend them to investment banks and insurance companies and the Fed needs to continue supplying all of the liquidity needed. If public confidence in banks erodes, deposit insurance limits might be raised. I see little purpose in injecting government capital directly into undercapitalized banks outside of the existing bank resolution mechanisms, but it would seem preferable to Secretary Paulson’s $700 billion purchase of MBSs.

Another proposal worthy of further consideration is to insure non agency (privately issued) MBSs in the same way those issued by Fannie and Freddie are insured.[10] This would nationalize such insurance along the lines of the Federal Deposit Insurance Corporation (FDIC). The contracted mortgage payments would be assured but the return to those buying and holding them would be reduced by an insurance premium that would reflect the expected loss from defaults by the ultimate borrowers. If the market is currently underpricing these MBSs, as is assumed by many,[11] such insurance would increase their market price (and the capital of banks holding them). Of equal importance it would remove further uncertainty over the value of such MBSs, which should restore their liquidity in the market. If MBSs could be correctly categorized by default risks from the underlying mortgages (a challenging task) and insurance premiums assigned accordingly, there would be no cost to tax payers. The new MBS insurance agency would be responsible for monitoring compliance by mortgage originators of the underwriting standards applicable to each risk (insurance premium) group. It is also quite a challenge (but not necessarily impossible) to put such a scheme in place in a matter of weeks. Until the premiums for each MBSs are determined they are not likely to be traded.

            If Congress eventually adopts a version of the Administration’s $700 billion MBS bailout proposal the most important decision will be how to price MBSs purchased by the Treasury (or some entity created by the legislation for this purpose) and the insurance premiums paid to guarantee them. If each MBS is correctly priced, i.e., if it is purchased at a price that matches it’s ultimate yield to the holder (which is unknowable in advance), the operation will cost the taxpayers nothing. Such a price will be above what these MBSs can be sold for in the market today because it will remove uncertainty over the price and thus the risk premium attached to current trading. It will provide a better price for valuing comparable MBSs in financial institutions’ portfolios. Banks that are still seriously undercapitalize after these repricings should be dealt with in accordance with existing bank insolvency legislation. Failing institutions considered to big to fail should be recapitalized by the Treasury (under the systemic emergency provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991 — FIDICIA) placing them under temporary government control. The draft legislation also authorizes “the Secretary to encourage the servicers of the underlying mortgages, considering net present value to the taxpayer, to take advantage of the HOPE for Home owners Program under section 257 of the National Housing Act or other available programs to minimize foreclosures.”[12]

            The use of reverse auctions to establish the Treasury’s purchase prices should break MBSs into the same risk classes as would be needed for setting premiums for an insurance program discussed above. This will be a challenging task as MBSs are very diverse. Banks will obviously offer their worst MBSs for sale in such auctions but if each auction pertains to a relatively narrow risk class, the range of actual expected values within each class will also be narrow. The auction price that clears supply and demand for that auction should then be relatively close to the best possible assessment of value given the information available at the time. Auctions should proceed quickly. Financial institutions that participate in sales to the Treasury will be subject to restrictions on executive compensation. “Troubled assets” may be guaranteed. These guarantees would be financed by premiums paid by issuers based on their risk class.

For best results all MBSs of each risk class purchased by the Treasury in reverse auctions should be insured using an insurance premium that matches the discount from face value of the auction price paid by the Treasury. To illustrate, if MBSs of risk class X with a face value of $100 are sold to the Treasury for $60, all such MBSs held by financial institutions subject to mark to market accounting would be valued at $60 per unit. All such MBSs would be guaranteed, i.e. the trusts or SPVs holding the mortgage pools backing this class of MBSs would be paid by the Treasury insurance fund any shortfalls or defaults in payments by the mortgagees. Thus the trusts would be guaranteed by the U.S. government to receive full value for their mortgage pools. The insurance premium they should pay for this guarantee should be exactly the $40 discount established by the reverse auction to the Treasury. Owners of this class of MBSs would receive the full value of the underlying mortgages less the insurance premium or $60 ($100 – $40). These combined measures will have accomplished several important things. MBSs that might have traded in a risk averse market at $50 or $45 per unit are now valued at $60 by all who hold them thus improving their capital. Furthermore that value is now guaranteed by the U.S. government and these MBSs can trade in the market at the price of $60 with the same risk as U.S government securities (i.e., no risk). This should ensure the marketability (liquidity) of these assets. If performance of the underlying mortgages improves or worsens over time the gain or cost accrues to the tax payers underwriting the guarantees. If mortgage performance deteriorates to $50 per $100 face value, for example, holders of the MBSs will still receive $60 and the insurance fund will incur costs of $50 or $10 more than the insurance premium of $40. Combining Treasury purchases of MBSs with guarantees for those MBSs remaining in the market should provide a substantial strengthening of market liquidity. The existing tools for providing liquidity to banks and for problem bank resolution will still be needed and should be sufficient.

            On Monday a majority of the House of Representatives rejected the Administrations proposals. No convincing evidence has been presented that existing liquidity and bank resolution tools are not up to the job of seeing us through the adjustments to earlier excesses now underway. As long as that remains the case the Federal Reserve and FDIC should continue to rely on them. Should fresh evidence indicate otherwise, the authorities should turn first to increasing deposit insurance limits, establishing a mortgage insurance agency (to replace Fannie Mae and Freddie Mac), and only as a last resort the injection of tax payer financed capital into (and thus government take over of) financial institutions judged too big to fail.

Bibliography

Warren Coats,  "The U.S. Mortgage Market: the Good, the Bad and the Ugly".

  Association of Banks in Jordan, June 22, 2008

"Fannie and Freddie: More Good, Bad and Ugly" July 31, 2008 

"The D E Fs of the Financial Markets Crisis", Cato Institute, September 26, 2008

and Aarno Liuksila, "Institutional and Legal Impediments to Efficient Insolvent Bank  Resolution And Ways to Overcome Them" USAID Conference, Banking Supervision in a Global Environment “Meeting International Standards” Sofia, Bulgaria, July 7-9, 1999


[1] According to Scott Lanman in "Federal Reserve Doubles Lending as Crisis Worsens", “The subprime-mortgage collapse has led to $522 billion of writedowns and losses at major financial institutions since the start of 2007.” Bloomburg.net, (September 26,2008)

[2] Ibid.

[3] Ibid.

[4] Laurie Goodman, “MBS: Update on the Crises”, UBS September 23, 2008 and S&P/Case Shiller Composite-20 Home Price Index.

[5] National Association of Realtors, "Existing Home Sales" 

[6] Deutsche Bank, “MBS Special Reports; Update: Projecting Mortgage Losses” September 22, 2008

 

[7] See the interesting contributions to Martin Wolf’s blog at the Financial Times "Economists’ Forum"

[8] Good bank supervisory practice and FIDICIA (designed to overcome supervisors’ reluctance to act as capital becomes weak) mandate that as capital falls below prudent levels supervisors MUST take increasingly sever actions before it has fallen to critically low levels (2%) at which point the FDIC MUST take the bank over. This puts great weigh on having adequate capital (shareholder stake in the successful management of a bank) as the basis of leaving most of the rest to market regulation.

[9] For a highly summarized account see Carter Dougherty, "Stopping a Financial Crisis, the Swedish Way", The New York Times, September 22, 2008.

[10] Over 60% of all MBSs outstanding were issued by the GSEs and are thus guaranteed already (now with the full backing of the government). The serious weaknesses of the GSEs and their contribution to the existing subprime crisis are discussed in "Fannie and Freddie: More Good, Bad and Ugly" July 31, 2008. Any insurance program contains potential moral hazard and requires careful monitoring of compliance with appropriately priced underwriting standards. A properly charted insurance fund is much more likely to be successful at this than was the mixed mandated, private GSEs. The FDIC provides a good example.

 

[11] Goodman, Op cit,

[12] Discussion Draft of ‘‘Emergency Economic Stabilization Act of 2008,” Section 109 (a).

The D E Fs of the Financial Markets Crisis

Treasury Secretary Paulson has asked Congress to authorize the government to buy up to $700 billion dollars worth of Mortgage Back Securities (MBS) in order to stabilize their market price, which reflects the underlying value of the mortgages that back them, and to improve the financial health of the banks and other financial institutions that own them. The proposal has raised more questions than it has answered. After a false start of forbearance in which insolvent Savings and Loan associations were artificially kept alive in the 1980, the elimination of 747 S&L with efficient bank resolution tools left the American banking section in much stronger condition in the 1990s, which helped drive the rapid economy growth of the last decade. Financial institutions that have made too many mistakes should be resolved (efficiently liquidated) not bailed out. Until last week the government’s measures in this area (Bear Stearns, Lehman Brothers, Merrill Lynch, Fannie Mae and Freddie Mac) where broadly appropriate. The as yet to be fully defined massive bail out of the MBS market is a much more questionable undertaking. I discussed the background to the current situation in "The ABCs of the Housing Crisis" and more extensively in "The U.S. Mortgage Market: the Good, the Bad and the Ugly".

The background to our current financial problems is that the United States as a whole is over leveraged. There is too much debt and too little saving. Efficient borrowing/lending can be very beneficial, but too little saving for the whole country and for individuals during their working years reduces productive investment and the income growth it produces and increases the economy’s vulnerability to shocks. As a nation our net savings rate became negative in 2005 and remained near zero until this year. This has been possible because of high savings rates in the rest of the world and the ability of foreign governments, firms and individuals to invest large amounts of these savings in the United States. Foreigners were willing to invest in the U.S. (largely in government and private sector debt and to a much lesser extent in equity) for only modest yields because of their confidence in the safety of U.S. investments and they were able to do so because our (previously) overvalued currency (the so called “strong dollar”) created a large current account deficit (excess of imports over exports) that foreign investments in the U.S. helped finance.[1]

The inflow of foreign savings has kept interest rates low in the U.S. in recent years. This is a so called “real” rather than a “monetary” phenomenon. During the period from December of 2001 until November of 2004 the Federal Reserve’s overnight interest rate (fed funds rate) target was below 2% and the unusually low interest rates of this period are thought to have feed the housing price bubble. Many have claimed that these low rates were the result of excessively easy monetary policy, but this claim is somewhat contradicted by the evidence. During this period of low interest rates the broad measure of the money supply (currency plus the publics’ deposits with banks—M2) grew on average at 6.2%, exactly the same average rate as between 1980 and now.[2] During the shorter period between December 2002 and June 2004, when the fed funds rate was below 1.25%, M2 grew on average at 6.1% per year. However, when the fed funds rate was above 5% from November 1994 through March of 2001 the average growth rate of M2 was 6.4%.[3] The Federal Reserve’s adjustments in its interest rate target were largely stabilizing the growth in the money supply. A significantly higher fed funds rate during the 2002 to 2004 period would have resulted in much lower if not negative M2 growth. Interest rates were determined largely by the inflow of foreign saving. None the less, interest rates were negative in real terms (less than the inflation rate) and contributed to market exuberance. A slower than trend M2 growth (and thus higher fed funds rate) might have been more appropriate. Furthermore, M2 began growing in March of 2004 and the Fed should have begun increasing its Fed funds target rate sooner than it did.

During this period of low interest rates housing prices rose dramatically and financial market innovations exploded. Among the most important innovations were the growth and heavy reliance on securitization of debt (reselling it) and the reliance on collateral rather than expected cash flow when approving loans. In the case of mortgages, mortgage originators often sold the mortgages they issued to Fannie Mae or Freddie Mac or to private sector consolidators who packaged them together as collateral for a type of bond called a mortgage backed security (see "The U.S. Mortgage Market: the Good, the Bad and the Ugly"). These MBSs were then sold far and wide around the world to investors whose funds financed the growth in home ownership and rising home prices.

With the inevitable bursting of the real estate bubble, the estimated mortgage delinquency and foreclosure rates priced into mortgage lending rates and the privately issued MBSs proved optimistic and the value of these MBS began to decline.[4] This, and uncertainty over how far housing prices will fall and foreclosures will rise, are core features of the financial crisis we are now in. The losses in value to investors in mortgages and mortgage backed securities, though very large, should be absorbable by the widely disbursed holders of such securities without too much difficulty. However, the considerable uncertainty over the ultimate magnitude of these losses and increased concern over the status of other complex financial assets as economic activity slows have reduced the ability to trade these instruments (reduced their liquidity) resulting in a scramble among commercial and investment banks to replace their lost liquidity and to replenish their reduced capital. Not knowing who held these risky MBSs, banks also became reluctant to lend to each other. The continued flow of normal bank lending has been tightened and a credit crunch threatened.

A number of factors have been assigned some blame for the unexpectedly high losses in value and liquidity of some MBSs. Lenders were pressured into expanding sub prime loans by government policy that wished to increase home ownership for lower income families. However, even the reduced standards for qualifying for a mortgage loan were sometimes exceeded or ignored by lax or negligent underwriters eager to collect commissions. As long as housing prices were rising the risks of default seemed small. Over reliance on collateralized rather than cash flow lending contributed to weakened underwriting standards or the monitoring of compliance with those standards. MBSs issued by Fannie Mae and Freddie Mac are guaranteed by them (ultimately by tax payers) while private issue MBSs were generally divided into risk tranches and rated by rating agencies.[5] The rating agencies grossly under estimated the risks of subprime and Alt-A mortgages, which had only a limited history in a rising market on which to base expected default rates.

Unregulated or lightly regulated capital markets have many advantages. Regulations impose restrictions and compliance costs on financial dealings. If these costs exceed the benefits to the market in the form of safer loans, the costs of raising and allocating capital are increased to the detriment of investment and growth. In unregulated markets financial engineers are limited in the instruments they can create only by the willingness of investors to buy them. But this is a serious and important limitation common to most all products and their markets. The contracts by which mortgage back securities are packaged and sold were carefully developed to reassure potential investors that their risks were carefully controlled and understood. Underwriting standards are clearly stated and their enforcement is generally guaranteed or insured by the issuer or by third party insurers (by Fannie Mae and Freddie Mac in the case of MBS issued by them). It is hard to imagine that better contracts could be designed by regulators and they facilitated the flow of large amounts of money into mortgages, most of which are sound and beneficial. Yet things went wrong.

Peter Fisher, former Treasury Undersecretary for Domestic Finance, has argued that over reliance on collateral (for a mortgage, the house itself is the collateral) rather than cash flow (an assessment of the ability of the borrower to pay) lending has contributed both to lax underwriting standards (e.g. no doc or liars loans) and lax monitoring of the enforcement of those standards. He anticipates the reduction of securitization (collateralized borrowing) either as a result of regulation or market forces.[6]

Heavy reliance on collateral leaves borrowers to decide whether they can afford the loan or not. Borrows have a knowledge advantage in making the assessment. Whether they use that knowledge wisely will depend in part on whether they expect to suffer negative consequences from wrong judgments. With rapidly rising housing prices both borrowers and lenders assigned low risks to default. In fact, many borrowers fully intended to resell homes they knew they could not afford at higher prices before being forced to default (flipping). A critical feature of keeping borrowers honest and thus of relying on borrower’s assessments of their own ability to meet their payment obligations is to insure that they have enough of their own money at risk. Thus a reasonable down payment is critical. The traditional norm was 20% but government sponsored FHA loans require as little at 3%. When borrows have little or no financial stake in the loan, stricter regulation and scrutiny of their income and credit worthiness is needed.

Some in Congress have proposed to give courts the authority to force a loan restructuring if in the judgment of the court the resulting loan could be serviced by the borrower and the lender would be better off then foreclosing. Lenders are already free to renegotiate loans under these conditions. Giving the courts such authority would add an additional risk to lenders that they would need to reflect in either higher interest rates or higher eligibility standards (as are now applied to second homes where the courts already have such authority).[7] The proposal would create a moral hazard among borrowers to enter into mortgages they cannot service in the expectation of a court ordered renegotiation.

The timely servicing of mortgages with low down payments or that are sold to or through Fannie Mae and Freddie Mac are insured. The insurer has its money at risk and thus has a financial incentive to carefully evaluate the borrower’s capacity to pay. Much of the mortgage insurance was provided by Fannie and Freddie, who gambled with taxpayers’ money and lost more often than they would have if they had been risking their own money. Privately issued MBS also accepted unrealistically low borrower standards gambling that home prices would continue to rise. Fraud played a role as well. While carefully targeting regulations to improve transparency and capital charges against contingent liabilities (credit lines and guarantees/insurance) might be helpful, the market losses of careless lenders is the strongest guarantee of more prudent behavior in the future. Thus short term measures to help borrowers or lenders that reduce the consequences to them of their actions run the risk of promoting such behavior again in the future (moral hazard). Successful market regulation of financial markets depends heavily on the participants bearing the consequences of their actions.

If banks have over exposed themselves to risky mortgages and mortgage related assets to the point of insolvency, the United States has a relatively good and efficient bank insolvency regime. The process of liquidation is orderly and minimizes any secondary disruptions to financial markets. Shareholder owners bear the losses of their mistakes providing a very important market discipline for the future. The same legal tools are not available for investment banks and thus the Federal Reserve was more constrained in its options for resolving the financial problems of Bear Stearns. While Bear Stearns shareholders should probably have been totally wiped out, the arranged sale to JPMorgan Chase, with the help of some Federal Reserve guarantees came about as close to a typical FDIC failed bank resolution as the law permitted. Whether the existing bankruptcy regime would have worked as well is an important question for investigation, but it was a risk the Federal Reserve considered too great to take at the time. The government’s take over of Fannie Mae and Freddie Mac is (hopefully) the necessary first step in correcting the government’s folly in creating them in the first place and perpetuating them as semi private entities with both private profit and social/public mandates. The subsequent hands off approach to Lehman Brothers and Merrill Lynch were a welcome return to full market disciple. This was followed by the Federal Reserve’s take over of AIG insurance potentially wiping out the existing shareholders equity.[8] AIG had extended its traditional insurance business into insuring bank credits through “credit default swaps”, upon which market confidence in credit instruments has increasingly depended. No one really knows what the knock-on effects of a failure of an insurer of trillion’s of dollars in bank credits would be and the Fed was not willing to risk finding out the hard way.

Treasury Secretary Paulson has now urged Congress to authorize the Treasury to buy up to $700 billion of MBS “from any financial institution having its headquarters in the United States”[9] under terms and conditions determined by the Treasury. The Treasury would be required to “take into consideration means for…protecting the tax payer.”[10] The motivation for this staggering program seems to be to replace now illiquid assets of unknown value on bank balance sheets with cash (or government securities) and to stabilize the secondary market for MBSs thus restoring their liquidity. As yet unanswered questions include which MBSs the Treasury will buy and what they will pay for them. Presumably they wish to buy those MBSs banks have the most trouble valuing or selling. George Will called the scheme “Lemon Socialism.”[11] If the Treasury pays more for MBS than they are subsequently worth, they will have subsidized the investors’ mistakes with tax payer money with potentially very serious moral hazard consequences. If they pay fair value somehow determined, this will shift any remaining uncertainty and risk from the investor (banks and other financial firms) to tax payers, which is indeed the intent. This should free up bank liquidity to continue normal lending. It would also lock in a potentially large profit for those sellers who bought the MBS at a steep discount.

If the intent is really to restore liquidity to MBSs rather than to raise their value and thus the capital of those institutions holding them, the scheme is unnecessary because the Federal Reserve can lend banks any amount against these MBSs as collateral and has already introduced new lending facilities with longer maturities. There are many advantages to the Fed’s lending against MBS collateral over the proposed Treasury purchase of them. Their valuation (or misevaluation) is much less important unless the borrowing bank fails because the MBSs remain the property of the borrowing banks and are returned to them when the Fed loan is repaid. The proposed Treasury scheme would exchange MBSs for treasury securities and thus would not increase base money and the money supply. Fed loans can also be extended without unwanted increases in the money supply by matching such loans to particular banks with open market sales of treasury securities owned by the Fed to other banks.[12] If the proposed Treasury scheme is not necessary as a means of increasing liquidity, the Treasury’s purpose must really be to raise bank capital by increasing the value of the MBS in their portfolios. This would be a tax payer subsidy of investor mistakes with serious moral hazard consiquences.

Sebastian Mallaby argues convincingly that the Treasury plan only superficial resembles the highly successful Resolution Trust Corporation (RTC) set up in 1989 to maximize the recoverable value of bad S&L loans. The RTC expedited the liquidation via purchase and assumptions or otherwise of failed S&Ls. It had no real choice over the problem loans it had to sell for which it paid the best estimate of a fair market price.[13] More importantly, the creation of the RTC was part of a broader strategy of resolving failed S&Ls via take over and bankruptcy that ended several years of forbearance. It is worth remembering that because of inadequate funds in the reserves of the deposit insurers insolvent S&Ls were artificially kept alive for several years with disastrous results that greatly increased the ultimate $150 billion or so cost to tax payers. This weekend’s Treasury proposals smell more like the banking forbearance that preceded the RTC than their resolution of which the RTC was a part. The Treasury would be choosing what MBSs to buy from still operating financial institutions. As noted above, these institutions are already able to borrow very large amounts from the Fed using these same MBSs as collateral. From the proposed law and what little the Treasury has said about how it would implement it, it is hard to see how it would contribute much beyond a huge injection of tax payer money to save those institutions that made bad investment decisions. Market discipline could suffer for many years virtually requiring a significant increase in supervision to take its place. According to Mallaby, “Within hours of the Treasury announcement Friday, economists had proposed preferable alternatives. Their core insight is that it is better to boost the banking system by increasing its capital than by reducing its loans.”[14]

It is appropriate for the government to intervene to restore or preserve stable financial market if doing so saves tax payers money in the long run. However, such interventions should be well targeted and should minimize to the extent possible creating moral hazard incentives for financial institutions to take risks with tax payers’ money. We are rapidly reaching the point where the credit worthiness of the United States government itself is coming into question as a result of the growing list of unfunded commitments it has made.

Both private sector and government debt has skyrocketed in recent years. Credit market debt stood at 2.3 trillion dollars in 1990, 6.4 trillion in 2000 and 12.9 trillion at the end of 2007. U.S. government debt (leaving aside state and municipal debt) was 3 trillion in 1990 (51% of total national output that year), 5.8 trillion in 2000 (59% of GDP), and 9.5 trillion (69% of GDP) at the end of June this year. Twenty eight percent of its (2.6 trillion) is foreign owned. The Treasury and Federal Reserve have just added a potential additional trillion dollars to this debt with their various rescue actions and proposals.[15] Annual interest on this debt at the 3.8% currently paid for 10 year government bonds (while below the average interest on the debt) would be almost 400 billion dollars or about 14% of the total Federal budget. This seems quit manageable until the true deficit including the unfunded liabilities of Medicare/Medicaid and Social Security are added. According to Richard Fischer, President of the Federal Reserve Bank of Dallas, these are ten times the existing debt.[16] Interest payments on the full true debt would exceed total Federal tax revenue. Existing government spending promises simply cannot be met. Some mix of reductions is existing entitlements and increases in tax revenue will be required. Our goal should be to minimize the negative impact on economic growth of that mix in order to maximize the additional government revenue arising from a higher tax base.[17]


[1] This suggests that foreign savings were pulled into the U.S., but an equally convincing case can be made that China’s and Japan’s desires to prevent or moderate the appreciation of their currencies against the U.S. dollar resulted in huge accumulations of dollars in the reserves of their central banks, which could only be invested in the U.S.

[2] Within this average, the year on year percent change varied considerably from zero to 13%.

[3] Federal Reserve Bank of St. Louis

[4] Payment of interest and principle on mortgages underlying MBS issued by Fannie Mae and Freddie Mac are guaranteed by them so the risk of delinquencies or defaults falls on them rather than on the investors in their MBSs.

[5] The role played by Fannie Mae and Freddie Mac in encouraging excessive mortgage lending are discussed in "Fannie and Freddie, More Good, Bad, and Ugly"

[6] Peter Fisher, "Lending’s Blind Spot" The Washington Post, September 20, 2008, P A19

[7] Appling this authority retroactively to established contracts would violate the constitution’s ex post facto restrictions in Article I Section 9.

[8] The Fed has yet to clearly explain the details of this operation.

[9] Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets, Sec. 2.

[10] Ibid.

[11] George F. Will, "Bailout on Wheels", The Washington Post, September 21, 2008 Page B07

[12] The Fed has already run out of treasury securities that it could sell but it is already achieving the same effect via the sale of treasury securities by the Treasury (at the request of the Fed) in excess of what the Treasury needs to sell for government financing. The proceeds of these extra sales are deposited in a special frozen treasury account at the Fed. The monetary effect is the same as if the Fed had treasury securities in its portfolio and sold them in the same amount.

[13] Sebastian Mallaby, "A Bad Bank Rescue" The Washington Post, September 21, 2008 Page B07

[14] Ibid.

[15] In fact the tax payer cost will be much smaller than this. In the latest proposal the Treasury will issue up to $700 billion in treasury securities to exchange for MBSs (an asset swap). Tax payers loose only to the extent that the MBSs are ultimately resold for less than the Treasury paid for them.

[16] "Storms on the Horizon" Speech to the Commonwealth Club of California, May 28, 2008

[17] Brice Bartlett, "Back to Square One" The Washington Post, September 21, 2008, Page B07

Is the Fed Running Out of Money?

“The Federal Reserve has requested that the Treasury Department deposit $40 billion with the central bank in an effort to help the Fed continue to stabilize the financial markets and address concerns about whether it is overstretched.”[1]

David Cho goes on to give a correct explanation of the above somewhat misleading statement. But another commentator pronounced that the money was needed to bolster the Fed’s balance sheet. Bolster the Fed’s balance sheet? The Fed prints money. It can lend any amount that it decides to without help from the Treasury. So what is going on?

For the past year banks and other financial institutions have had difficulty managing the inflow and outflow of funds through their balance sheets because their usual tools for balancing the two (liquidity management) stopped working (a slight exaggeration). An insurance company, for example, collects premiums from policy holders on a regular basis and disperses money when insurance claims are made at unpredictable irregular times. Over the long term these inflows and outflows largely balance (with a margin for operating expenses and profits). But over the short term they do not. Insurance companies invest premiums in assets that can be sold easily when they must pay claims. Carefully managing their liquidity in this way reduces the cost of providing insurance and thus lowers premium payments. This is but one type of liquidity management.

This past year many normally quite liquid assets (i.e. those that can be easily sold for cash at a reasonable price like high grade corporate bonds, treasury bills, and various collateralize securities) became illiquid (difficult to sell except at a steep discount) because markets lost confidence in the underlying value of these assets (especially mortgage back securities). It is one thing for the value of an asset to fall by a known amount (e.g. bond prices falls by well know amounts when interest rates in the market increase). It can only be sold in the market at the lower price but it remains liquid in the sense that it can be sold quickly and without difficulty at that lower price. But in current market conditions the underlying loss or potential loss in value is uncertain, making the sale of such assets much more difficult. An insurance company needing to sell assets to pay for claims arising from damage from Hurricane Ike can only do so be selling them well below their probable (but uncertain) future value. Their option of holding on to these assets and borrowing the money needed to satisfy claims is unattractive as well because borrowing from other financial firms or from the market (e.g., by issuing bonds or commercial paper) has become very expensive because firms are holding on to their cash to bolster their own liquidity or are adding larger risk premiums to lend to other financial firms.

In this environment the Federal Reserve has taken a number of steps to unblock the flow of funds in the market and to satisfy the increased demand for liquidity. Normally when the “market” needs liquidity the Fed buys treasury bills from some 25 or so primary dealers who then on lend the funds to other banks and financial firms needing it (or replenish their t-bill holdings by buying them from other sellers). When the market has too much liquidity, which pushing short term interest rates down, the Fed sells back some to the t-bills from its holdings to prevent inflation. Because of the large increase in uncertainty over the value of many financial assets and the soundness of financial firms, this “interbank” market for liquidity is not working well to spread adjustments in liquidity throughout the entire country (the Fed’s open market operations all take place in New York City). Thus the Fed has opened new lending facilities to a broader range of financial firms that can borrow directly from it in order to help the liquidity get to where it is needed. All Fed lending is collateralized so the risk of not being repaid is negligible.

The enormous amounts that the Fed is lending through these new facilities, while needed by the specific borrowers, provides more liquidity than is needed by the market as a whole given the Fed’s target for inflation. Thus the Fed reabsorbs some of it through its normal open market operations in New York (the sale of t-bills to its primary dealers in daily auctions). These operations keep the federal funds rate at the level targeted by the Federal Reserve in light of its inflation target. So the Fed is lending through one window and reabsorbing some but not all of that liquidity through another (open market sales of t-bills).

Normally the Fed can inject all the liquidity it wants to by buying t-bills or by lending through one “window” (facility) or another. It has no balance sheet limit on the amount of liquidity it can provide because as the central bank it can “print” all of the money it needs to. However, its ability to round trip (lend through one window while buying back some liquidity through another) is limited to the amount of t-bills it owns and can sell. The Fed as run out of t-bills to sell and unlike the money it can create (print) it cannot create t-bills. Some central banks in the world in this situation, issue their own bills (central bank bills).

A better solution, however, is for the Treasury to issue more of its own bills to the market than it needs for financing the government and to deposit the extra money with the central bank. Normally when the Treasury raises money by issuing t-bills and bonds, the money it receives is deposited in banks and thus remains in the private economy. Treasury borrowing of this sort does not effect bank liquidity (the money moves from the accounts of those buying the bills to the account of the Treasury. But if the money is deposited with the central bank it is taken out of the system (reduces liquidity). That money is not for the use of the central bank but rather to reduce liquidity in the market just as if the central bank sold t-bills it already owned or issued its own bills. The money deposited by the Treasury is impounded and not used just as the money collected by the Fed when it sells t-bills is impounded (it is wiped off the books). This is exactly what the U.S Treasury has just done at the request of the Fed. Its effect is identical to the liquidity reducing effect of a sale of t-bills by the Fed in a traditional “open market operation.” It does not reflect any financial weakness of the Federal Reserve. It reflects good cooperation between the Treasury and the central bank.


[1] David Cho, "Fed Asks Treasury Dept. for Funds to Backstop Intervention Efforts", The Washington Post, September 17, 2008

How to measure the size of government

What is the right size of government? Obviously our answers vary depending on our understanding of the facts and the value we each place on different activities. It should be possible, however, to narrow the range of answers to differences in individual preferences (values). A good starting place is to agree on how to measure the size of government. My real interest in this note, however, is in how best to finance whatever government we wind up having.

The size of government should be measured by the resources it commands. This is obvious with regard to the government buying goods and services and employing people. These resources are taken from the private sector and employed for government purposes. If these purposes have greater value to us than their alternative value in private use (what economists call their “opportunity cost”), society as a whole is better off as a result. This is the economist’s famous cost benefit test.

People sometime confuse the size of government with the taxes leveled to finance it. Reducing taxes without reducing the government’s command over resources does not reduce the size of government. Rather it shifts how the resources commanded by government are paid for. But how the government gets and pays for these resources is important too because it can impose additional costs over and above the cost of just taking command of them. So what are the options? Here are the Good, the Bad and the Ugly choices. I have been indulging in a Clint Eastwood retrospective, if you haven’t noticed, and I am impressed by how many things can be conveniently partitioned this way.

When it comes to paying for government it is a bit of a stretch to talk of the Good. Almost all ways of paying for government distort private decisions and thus resource allocations to some extent, but some methods are clearly better than others. The goal should be to share the burden of government fairly and with the least disturbance and distortion to the private economy as possible. The view that the free market is generally the best allocator of resources is now so widely accepted that Democratic Presidential candidate Barak Obama said “The market is the best mechanism ever invented for efficiently allocating resources to maximize production. And I also think that there is a connection between the freedom of the marketplace and freedom more generally.”[1] I start at the top and descend to the ugly.

User fees

If the government is providing goods and services to specific individuals, they should generally be willing to pay for them especially since they value them. If the government provides a passport for an American or an entry visa for a visitor, it is both economically more efficient and fairer for those getting these services to pay for them rather than for someone else to. This mirrors the resource allocation efficiency of the private sector where prices reflect supply and demand. The same principle applies to highways, airports, schools and medical facilities. Why should those without cars pay to build highways for those who have them? And if drivers are willing to pay more than the cost of building a highway, it should be built. Taxes on gasoline are an attempt to charge user of roads for the cost of building them as are tolls on highways.

Institutions such as colleges and hospitals present a mixed case. They mix the provision of services for those who benefit individually from them and can pay for them with income transfers to those who can’t. But these two aspects can and should be separated by charging for these services and subsidizing the payments from those who can’t afford them. A different argument is generally made for primary and secondary education where the argument is that all of society benefits from this level of general education and thus everyone should help pay for it and thus a user charge is not appropriate. People without children sometimes object to this argument. Applying wage taxes on workers to pay for their social security is another example of mixing things up. Social Security is not a pension from saving while working. It is a pay-as-you go tax on the currently working to pay the pension of those already retired. My thoughts on Social Security are here: "Saving Social Security"

General taxation

Government command of resources for the general benefit of the whole country should be paid for with taxes on the whole country that are fair and that distort economic decisions of the public as little as possible. User fees are infeasible and inappropriate in these cases. A properly designed comprehensive income or consumption tax (no exemptions for favored activities) at a flat marginal rate fits these criteria. Views differ on the fairness of progressivity. For me, it is “fair” that someone with twice the income pays twice the tax, which is what a flat tax rate does. A flat tax is actually modestly progressive because the tax rate is actually zero up to the level of income from which the flat marginal rate applies. I prefer the consumption version (VAT) because it does not distort saving and consumption decisions by taxing saving but not consumption. Business income taxes found in most countries are very hard to justify (other than relative ease of collection for companies that do not operate across borders) as such income is taxed twice, once at the company level and again as income to this shareholders. For example, Moldova recently reduced its business income tax rate to zero. My slightly more developed thoughts can be found in: "The Ideal Tax System"

Debt finance

Here we descend to the “bad.” Governments can finance their activities by borrowing from the public. This has the “virtue” that those lending to the government (buying is bills and bonds) do so voluntarily because of attractive interest rates and low risk (I leave aside the now thoroughly discredited practice of some earlier governments of mandating purchases of government securities in one way or another). However, this financing tool falls almost fully on capital. The diversion of saving from financing capital to financing government “crowds out” and thus reduces private capital formation. While it is possible in principle that the resulting increase in interest rates increases saving and thus takes some of the government financing out of consumption, empirical evidence suggests that this effect is very small.

Cyclically balanced budgets are much more defensible. When the budget is balanced over the business cycle, governments save (spend less than their tax revenue) during the boom phase of the cycle and dis-save (or borrow) during the recession phase. Such behavior results from maintaining constant government spending over the cycle and has an automatic stabilizing effect on output.

Discriminatory taxes

Some taxes look a bit like user fees but are not actually linked to the provision or use of a government services to those paying these taxes. They simply fall on particular economic activities and thus increase the cost and reduce the supply of those activities. These clearly distort resource allocation. Examples are import duties and excise taxes.

If, however, an activity is taxed (or subsidized) that has social costs (or benefits) not paid for (or received) by those undertaking the activity, the tax (or subsidy) can actually improve resource allocation. In other words, to the extent a tax reduces any gap between private and social costs of an activity it will bring private decisions with regard to the activity more in line with the true cost to the economy, which will improve the efficiency of resource allocation. The classic example is a pollution tax. If, for example, activities that add carbon dioxide to the atmosphere contribute to global warming (a scientific assertion that is still under some debate), such as burning coal or gasoline (when driving a car), are taxed by the amount of that damage, the public’s decisions about whether and how much carbon fuels to use will better reflect the true cost to society of its use. This would improve the efficiency of resource allocation. Simply prohibiting the use of carbon fuels runs the strong risk of imposing a cost (in the form of the next best alternative energy sources) far greater than the benefit.

Lotteries

I am not sure whether to categorize lotteries as “ugly” or “merely “bad.” They are voluntary, which is a virtue. However, they might be said to exploit human weakness for gambling. Gambling can be an acceptable entertainment for those with the money to pay for it, but can become the desperate effort to get ahead by those who cannot. Most jurisdictions restrict or even forbid lotteries except when offered by the tax authority. This is morally odd indeed. The state grants itself a monopoly in an activity considered generally inappropriate and thus forbidden to private enterprise, on the grounds that the state puts the money to good us. Lotteries are generally regressive (raising money disproportionately from lower income families).

Mandates (outsourcing)

This is a seductive form of financing the government’s command of resources. Government regulations from banking supervision to product safety and much more reflect government command of resources a bit more indirectly. The costs of these regulations are as real as if the government bore them directly, but they are generally paid for by the regulated entities. They should be subjected to the same cost benefit assessment as any other government program. The danger of mandates is that because the costs do not appear in the government budget it is too easy and thus tempting for the government to undertake such regulations and mandates as if they had no cost at all.

Inflation

Inflation is clearing in the “ugly” category. First it is the easiest of all taxes to administer. The central bank just prints the extra money to lend to the government to cover the cost of its activities (not covered otherwise). The government spends the money thus taking the resources away from the private sector. The private sector reduces its own spending as a result of the fall in the real value (purchasing power) of the cash held by the public. Thus economists refer to inflation as a tax on the holding of central bank money (currency and bank deposits with the central bank). While seductively easy to administer, the inflation tax has two serious shortcomings. First, it is generally hard to anticipate accurately and unfolds unevenly and thus tends to distort relative prices. Distorted relative prices distort resource allocation and thus slow the pace and quality of economic growth. Second, the inflation tax is regressive and thus fails the fairness test. Cash is held disproportionately by lower income families and thus the loss of purchasing power is born regressively.

The pernicious effects of inflation and the tempting ease with which government can “borrow” from its central bank have led to a world wide movement to protect central banks and their monetary policy from government by making them “independent.” Most central bank laws now prohibit or tightly limit central bank lending to government.

The health and well being of society and the economy depend in part on getting the size and nature of government right. But it also depends on financing those activities in the fairest and least distorting ways.


[1] Quoted in David Leonhardt, "How Obama Reconciles Dueling Views on Economy," The New York Times Magazine, August 20, 2008

Saving Social Security?

Without changes, the Social Security payroll tax will stop raising enough money to meet the system’s pension payment obligations in 2018, just 13 years from now. This funding shortfall can be corrected with only modest adjustments, if action is taken now. Indexing retirement benefits on the consumer price index rather than the average wage increases would eliminate most of the shortfall and modestly and gradually increasing the retirement age a few years would reduce the rest. Other adjustments are also being discussed. The change in the benefit index would reduce the planned increase in benefits and leave the real value of current benefits unchanged. Choose which ever way of saying it that sounds best to you. Both are correct.

The issue of privatizing or otherwise reforming the nature of the system is another matter all together. Evaluating such reforms calls for a clear understanding of the purposes we wish Social Security to achieve. Before we can intelligently debate whether SS should be a fully funded insurance program (whether with a defined benefit or a defined contribution) or continue as a pay-as-you-go entitlement, we need to debate the role we want it to play in our overall system of retirement income.

Traditionally most Americans’ retirement incomes come from employer based pensions and individual savings (home ownership, whole life insurance, and other investments). Schools taught the need for proper preparations. On August 14, 1935, when the country was still struggling to overcome the Great Depression, President Franklin D Roosevelt added a mandatory government pension when he signed the Social Security Act. In addition to old age pensions, the Act established unemployment compensation, and aid to children and to the ill.

Roosevelt intended for the old age pension provided by Social Security to be a mandatory, defined benefit pension financed by the contributions of the pensioner and his employers over his working life. The system provided a guaranteed minimum pension for those who worked and paid into it. However, the relationship between what a person paid in and ultimately received was never close. Those at or near retirement when the system started were allowed benefits that were financed by young workers who would not draw their own benefits for many years. Pay-as –you-go financing is the cause of the upcoming financing problem as baby boomers swell the ranks of the retired. “As a result, the ratio of workers paying Social Security taxes to people collecting benefits will fall from 3.3 to 1 today to 2.1 to 1 by 2031.”[1] It was over 8 in 1955. The tax burden on those currently working is raising fast.

In its current form, Social Security’s old age pension is a complicated structure that is neither a sound insurance or pension scheme nor a well-designed and targeted safety net. The payroll taxes that finance it “account for more than 25% of all federal revenue; its payments represent more than 20% of all federal spending. For almost two-thirds of American’s pensioners, Social Security payments make up over half their income.”[2] As a social safety net, it does not target benefits or redistribute income in a clear and defensible way. As a compulsory, government administered pension, it is not financially sound and is considered by many to be an inappropriate and unnecessary government intrusion into private life.

How the system should be reformed, if at all (rather than merely fixing its demographic based financing problems), depends on how as a nation we answer the following questions: “Is Social Security a planning vehicle that an individual uses for his or her own retirement, or is it a pooling of resources so that all of society can meet the needs of its older members? Is it about each person saving for himself, or is it a matter of young helping old and rich helping poor?”[3] Should Social Security be part of the social safety net that Ronald Reagan spoke of for a society in which individuals and families are basically responsible for their own lives, or should it be an instrument of collective social responsibility for public welfare? The attitudes behind different answers to these questions reflect the great divide that has always separated (in varying degrees) Republicans and Democrats. But there may be a proper place for each view.

World Bank research found “that financial security for the old—and economic growth—would be better served if governments develop three instruments, or ”pillars,” of old age security: a publicly managed pillar with mandatory participation and the primary goal of reducing poverty among the old; a privately managed, mandatory saving system; and voluntary savings. The first covers redistribution, the second and third cover savings, and all three coinsure against the many risks of old age. By separating the redistributive function from the saving function, the amount of spending in the public pillar—and the tax rate needed to support it—can be kept relatively small. Spreading the insurance function across all three pillars offers greater income security to the old than reliance on any single system.”[4]

“A central recommendation of the [World Bank] report is that countries should separate the saving function from the redistributive function and place them under different financing and managerial arrangements in two different mandatory pillars—one publicly managed and tax-financed, the other privately managed and fully funded—supplemented by a voluntary pillar for those who want more.

“The public pillar would have the limited object of alleviating old age poverty and coinsuring against a multitude of risks. Backed by the government’s power of taxation, this pillar has the unique ability to pay benefits to people growing old shortly after the plan is introduced, to redistribute income toward the poor, and to coinsure against long spells of low investment returns, recession, inflation, and private market failures.”[5]

For the United States, the World Bank’s advice suggests a much smaller public pillar (the existing Social Security system), targeted on the poor (means tested) whether they had worked and contributed to retirement income or not. It would be financed from the government’s general revenues, not from wages if there were any. This social safety net would be supplemented by the second, mandatory savings pillar, which should sharply limit the need to resort to the first pillar. This mandatory, defined contribution, second pillar would be satisfied by qualifying (and regulated as now) company pension funds, 401K plans, or social security tax contributions to private mutual funds. Reasonable, but not excessive, restrictions and safeguards would be required. Recent experiences with pensioner losses with defined benefit pensions when their employer goes bankrupt indicate that further reforms of the private pension system are still needed as well.

The system would insure that those who could, i.e. those with jobs, would save enough for minimally acceptable levels of retirement income, but would still protect those who had not adequately protected themselves, whether from inability, short sightedness, or bad luck. Allowing workers to manage more of their retirement savings has several advantages. More would be invested in stocks and private bonds, which historically have yielded more on average than government bonds. Such savings would be part of the pensioner’s estate and any unused part would be passed on to his/her heirs. Both the reduction in wage taxes and the real savings of private pensions would tend to increase the supply of labor and national savings and investment, and thus economic growth. Fully funded benefits from saving would be free of the demographic problems now besetting our pay as you go system. Benefits from the second tier would be closely related to contributions, which would tend to increase saving (and economic growth) and to be seen as fair. Workers would become capitalists and thus potentially more sensitive to the health of the economy. Those who could not contribute enough, or experience poor returns on their investments would be protected by the first, public pillar.

President George W. Bush’s current proposals for Social Security combine both financial fixes for the existing system and substantive reform of the system by introducing “personal accounts.” His recent proposals may be seen as transitional steps to the above system. However, like the existing system, current proposals constitute a mixed and rather incoherent collection of ideas. The final result will be more satisfactory to everyone if the details now being debated contribute to a coherent overall three pillar plan for the provision of retirement income and medical care.


[1] “Fast Facts and Figures About Social Security, 2004,” U.S. Social Security Administration. http://www.ssa.gov/policy/docs/chartbooks/fast_facts/2004/ff2004.html#financing

[2] “How to mend Social Security,” The Economist, February 12 2005 p 10.

[3] Steven Mufson, “FDR’s Deal, In Bush’s Terms,” The Washington Post, February 20, 2005, page B3

[4] “Averting the age old crisis for the old,” World Bank Policy Research Bulletin, August – October 2004, Volume 5, Number 4. http://www.worldbank.org/html/dec/Publications/Bulletins/PRBvol5no4.html

[5] Ibid.

The Commanders Emergency Response Program in Iraq: Effective or Wasteful?

The Washington Post has published an outstanding report on the Commanders Emergency Response Program (CERP) in Iraq with the provocative title "Money as a Weapon" [1] CERP is an effort to be smarter about ‘winning hearts and minds” in Iraq by behaving more like a private charity. It has good and bad aspects and illustrates the inherent disadvantages of government employees spending tax payers’ money compared to spending their own money or private enterprise (or charity) employees spending the owners’ (donors’) money.

Any economic activity by groups larger than a family faces the challenges of coordination and monitoring the performance of the individuals within the group. If you are a parent, you know that this challenge exists even within the family. These challenges exist for private sector enterprises operating in free markets as well as for government bureaucracies. On several occasions I have noted that governments suffer serious disadvantages in these regards, but as there are some things only governments can do we need to put up with them while limiting government as much as possible to what only it can do.

Private enterprises have the advantages that they are risking their own money and are thus able to take greater risks (both in how they address the coordination and monitoring challenges and in what goods or services they choose to provide), and that they are forced by competition to make good decisions or parish. They are disciplined by their bottom line (profitability). Governments, on the other hand, must be accountable to the public for the use of tax money. Thus they require more rigid and intrusive performance monitoring procedures (more reporting than doing). In addition to adding an extra layer of cost, this tends to under value and thus stifle creativity. Civil service employees, for example, tend to be rewarded by length of service rather than performance evaluations to ensure that bosses do not show favoritism to friends and relatives. Public school teachers in many states in the U.S. suffer from the performance stifling impact of seniority systems with tragic results for the quality of public education. Even efforts to introduce merit pay for government employees are fraught with risks because of the absence of a bottom line and competition.[2]

In addition to being a smarter approach to overcoming terrorists and insurgents in Iraq, CERP also attempts to overcome the sluggish bureaucracy inherent in government programs. “Soldiers walk the streets carrying thousands of dollars to pay Iraqis for doorways battered in American raids and limbs lost during firefights. Sheiks appeal to commanders to use larger pools of money locked away in Humvees and safes at military bases for new schools, health clinics, water treatment plants and generators, knowing that the military can bypass Iraqi and U.S. bureaucratic hurdles.”[3]

CERP “has so far spent at least $2.8 billion in U.S. funds.”[4] That will pay for a lot of battered doors. All of it was handed out in U.S. dollar bank notes by American soldiers. “The program is intended for short-term, small-scale ‘urgent humanitarian relief and reconstruction.’ But as the broader $50 billion effort to rebuild Iraq with big infrastructure projects runs dry, CERP is by default taking on more importance as a reconstruction program, something it may not be equipped to do in a coordinated, nationwide way.”[5]

It is obvious that solders walking the streets can make quick and beneficial judgments about where a few bucks will get the best result in ways that more bureaucratically controlled procedures could never dream of. Most of the solders I met in Baghdad were fine people and could be counted on to serve their country’s interests first. I seriously believe that very little of this cash found its way into our solders’ pockets (but reread Catch 22 or M*A*S*H for a different perspective). Thus the broken door and missing limbs payments and candy and t-shirts for the kids are surely some of the best money we are spending in Iraq. However, it suffers at the end of the day what all government programs suffer from: the solders are giving out taxpayers’ money and thus are not guided by a bottom line of their own. This particular innovative, responsive, and flexible program also suffers a lack of coordination with broader efforts to pacify and rebuild Iraq.

I have an additional problem with the way this program is implemented, which is modest but not trivial, which is that U.S. dollar bills are being used rather than Iraq’s own currency. Doing so undercuts the development of Iraq’s monetary system, makes the monetary policy of the Central Bank of Iraq more difficult, and pours hundreds of millions U.S. dollar bank notes into the country in ways the make anti money laundering and combating the financing of terrorism measures impossible. When Iraqis exchange these dollars for dinars, where do the dollars wind up? Iraqi dinars could and should be used for this operation.[6]

“CERP is, in fact, a reconstruction program in addition to being a counterinsurgency weapon.”[7] The real problem with the program comes with the larger expenditures—the “schools, health clinics, water treatment plants and generators, etc.” These are all good things potentially but schools with no teachers, health clinics with no medicine, are a waste of money. “A $33 million hotel, office and retail complex at Baghdad International Airport” may be the best use of that money, but it is very unlikely that the mechanisms for allocating CERP cash resulted in valuing this project against all others being financed by the U.S. or Iraqi governments. That is exactly what government budgeting is all about (or should be)—setting priorities. Resources (money) are limited and thus projects must be prioritized in order to finance the most valuable ones to get the highest value per tax payer dollar (or dinar). Furthermore, the value of one project, a farm irrigation system say, may depend on other projects, such as the roads needed to transport farm output to market. Thus an overview of all projects and coordination among them may also be important, which CERP does not provide but USAID does (or at least tries to).[8]

“Outside Kirkuk, in northern Iraq, an $8.3 million water treatment project completed in February with CERP funds took more than two years and was $1.7 million over budget — and it is not far from another water treatment system that USAID paid $4.1 million to build two years ago.” In another more successful example, “In the violence-prone city of Ramadi, Army Capt. Nathan Strickland and his battalion used CERP money to hire day laborers to clear away trash and rubble. The military strategy: Get young men to pick up shovels instead of guns.”[9] I remember in the early months of American occupation of Iraq Peter McPherson, assigned to the Coalition Provisional Authority to oversee the reconstruction of Iraq, killed a similar idea as wasteful welfare.[10]

Over a trillion dollars or more later we have learned a lot, made many adjustments, and things are going better in Iraq. The Post article is full of fascinating examples of successes and failures and the difficulties of making the government function more like the private sector. Of course, it raises the question that should always be raised of whether this was really something our government should be doing in the first place.


[1] Dana Hedgpeth and Sarah Cohen, “Money as a Weapon”, The Washington Post, August 11, 2008, Page A01.

[2] “David Whitman, in his book "Sweating the Small Stuff: Inner-City Schools and the New Paternalism," reports that in Chicago from 2003 through 2006, just three of every 1,000 teachers received an "unsatisfactory" rating in annual evaluations; of 87 "failing schools" — with below-average and declining test scores — 67 had no teachers rated unsatisfactory; in all of Chicago, just nine teachers received more than one unsatisfactory rating, and none of them was dismissed.” Quoted by George F Will in "Where Paternalism Makes the Grade", The Washington Post, August 21, 2008, page A15.

[3] Ibid.

[4] Ibid.

[5] Ibid.

[6] A modest problem with doing so currently is that the largest ID bill (25,000 ID) has a dollar value of only about $20.00.

[7] Ibid.

[8] In the interest of full disclosure, I am BearingPoint’s Senior Monetary Policy Advisor to the Central Bank of Iraq under a consulting contract financed by USAID. I am expressing my own views here only.

[9] Ibid.

[10] Warren Coats and Kenneth Weisbrode, "The Strange Tale of Financial Reconstruction in Iraq" October 25, 2003.

One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina

What follows is blatant self interested commercialism. Here is what my latest book (kind of makes it sound like I have a lot of them) is about and how to get it.

F O R  I M M E D I A T E   R E L E A S E

Book Launch:

Warren Coats’ One Currency for Bosnia:

Creating the Central Bank of Bosnia and Herzegovina.

349 pages

$42.50

Jameson Books

August 3, 2007

Washington, DC – Bosnia and Herzegovina has arisen from war-torn ruins to relative national stability in just ten years – in compelling contrast to the chaos of nation-building efforts elsewhere in the world. The story of rebuilding the monetary and banking systems from these ashes and their contribution the country’s healing and rebirth is a story of national triumph and world hope.

An architect of this historic feat, Dr. Warren Coats of the International Monetary Fund, now offers a chronicle starting before the fighting had stopped — and concluding with reflections about the on-going challenges of establishing stable monetary systems in post conflict countries.

For those who know of Coats’ reputation, the especially good news is that Coats provides insights into human and practical aspects monetary systems, and he offers lessons for those who would undertake similar quests.

What people are saying about One Currency for Bosnia:

  • Michael Lind, Author of The American Way of Strategy: “Now that the challenges of rebuilding failed states and shattered societies are central to U.S. foreign policy, his [Coats] lively and fascinating account of one effort at national reconstruction is as timely as it is informative.”
  • Mario I. Blejer, Director of the Centre for Central Banking Studies at the Bank of England: “His book not only clarifies potentially obscure economic concepts for the laymen but also illuminates the important interconnections between the economic and political aspects of post conflict reconstruction.”

About the author: Warren Coats is currently an advisor to the central banks of Afghanistan, Iraq, and Kazakhstan and is a director of the Cayman Islands Monetary Authority. During his twenty-six years at the International Monetary Fund he has provided IMF technical assistance to central banks around the globe including in Croatia, Bangladesh, China, Egypt, Nigeria, Turkey, the West Bank and Gaza Strip. He lives in Bethesda, Maryland.

  • Monetary stability is a necessary precondition to a healthy economy. The author demonstrates in plain language the means to achieving this goal.
  • Bosnia remains in the world’s headlines as a flashpoint of ethnic and religious conflict, especially the suffering of its Muslim inhabitants.
  • Beneath the political rhetoric of peace, democracy and nation-building are the hard realities of economics. Policy writers and academics will find this book an invaluable guide.
  • For all academic library collections dealing with history, foreign policy, economics, banking, and the Balkans.
  • The Berkeley, Chicago, New York, Boston, and Washington, DC top bookstores should have this on their history, foreign policy and economics shelves.
  • Milton Friedman’s more than 2,000 economics PhDs, like Coats, are a formidable market for serious works of economics and are likely avid reviewers.

Title

One Currency for Bosnia

Subtitle

Creating the Central Bank of Bosnia and Herzegovina

Author

Warren Coats, Ph.D. of Bethesda, Maryland

Author Bio

Warren Coats received his undergraduate degree at U.C. Berkeley and his Ph.D. at the University of Chicago. Currently advisor to central banks in four countries, he has led technical assistance missions to more than twenty countries, including China, Israel, Egypt, Iraq and the Czech Republic. For 26 years he held various positions at the International Monetary Fund.

This is both a fascinating personal narrative of the often colorful warriors rebuilding a part of war-torn Yugoslavia, and a detailed inside look at how experts can stabilize a nation’s currency and banking system. Written by an American who has led International Monetary Fund advisory missions to the central banks of more than twenty countries, this book, crafted in layman’s language — but of immense value to specialists in monetary and foreign policy initiatives — is an account of the behind-the-headlines work American and other economists do to bring peace and prosperity to former failed states.
Coats was involved in the creation of the Central Bank of Bosnia from before the Dayton Peace Accords. His “currency board” rules for monetary policy, and the creation of the bank, have resulted in the most successful state institution in the country.
Marking the tenth anniversary of the bank, the technical world of economics comes alive as the book unfolds like a mystery novel full of colorful and determined people determined to escape the disaster of a bloody civil war.

Order from Amazon:

Bosnia book endorsements

 

Front cover:

 

“Warren Coats’ well told account of the establishment of a currency board in war torn Bosnia and Herzegovina is fascinating and insightful reading.”

 

Robert Mundell, Nobel Prize in Economics in 1999

 

Inside before the title page

 

Robert Mundell,    Nobel Prize in Economics in 1999, Professor of Economics, Columbia University ram15@columbia.edu

 

“Currency board systems have become more popular since the collapse of the Soviet Union and with good reason: they provide a good option for monetary policy formation in countries where a suitable anchor currency is available. Warren Coats’ well told account of the establishment of a currency board in war torn Bosnia and Herzegovina is fascinating and insightful reading. His mastery of detail and intimate knowledge of that unusual environment, both political and economic, challenge and deepen our understanding of monetary systems and policies.”

 

Richard Rahn, Director of Cayman Islands Monetary Authority, former Chief Economist of the U.S. Chamber of Commerce, and syndicated columnist and author. rwrahn@noveconfinancial.com

 

“If you were going to build a monetary system that would heal the wounds of a civil war devastated country and help lay the foundation for economic recovery and development, what would you do? Warren Coats provides the answer given for Bosnia and Herzegovina in his well told story of the establishment of the Central Bank of Bosnia and Herzegovina. Readers of his book will follow the detective like uncovering of the workings of the unique Yugoslav banking and payment system and the challenges faced and overcome in replacing it with a modern, market based system.”

 

Mario I. Blejer,  Former Governor of the Central Bank of Argentina (2001 to 02) and Senior Advisor in the IMF (1980 to 2001). Currently Director of the Centre for Central Banking Studies at the Bank of England.

 

“Warren Coats describes and analyzes the very complicated and extremely relevant process of the establishment of Bosnia’s present monetary system in clear, highly readable prose. His book not only clarifies potentially obscure economic concepts for the laymen but also illuminates the important interconnections between the economic and political aspects of post conflict reconstruction.”

 

Back dusk jacket:

 

Carl Bildt, Former High Representative of the UN in Bosnia, Former Prime Minister of Sweden, Current Foreign Minister of Sweden carl.bildt@foreign.ministry.se

 

“The democratization process in Bosnia was one of the most exciting periods of my life. And in the lives of all the courageous people who were involved.  The history deserves to be told over and over again. I told parts of it in my own book. Now, Dr Coats has taken the trouble to recall his own fascinating experience with the establishment of the Central Bank of Bosnia and Herzegovina. His account is an invaluable contribution to the never ending story of the Balkans.”

 

Serge Robert, First Governor of the Central Bank of Bosnia and Herzegovina (Oct 1996 to October 1997)  sergejrobert@noos.fr

 

“This excellent book written by Warren Coats about the creation of the new Central Bank of Bosnia and Herzegovina is well worth reading. The author meticulously relates various aspects of history, monetary policy and human behavior in a clear, lively, humorous and enthralling style. The book reports how, after a grueling war, some men – still impregnated with rancor and distrust – bridled their own resentment, working together to build a monetary institution vital to their common future. Warren, with a great IMF team, played a major role in encouraging mutual understanding and co-operation. Today, on the eve of its 10th anniversary, the Central Bank has proved to be a real success. Warren Coats’ book will be an appropriate gift to mark such an event.”

 

Michael Lind,  Whitehead Senior Fellow, The New America Foundation and Author of The American Way of Strategy (Oxford, 2006) and other history and policy books and articles.  Lind@newamerica.net

 

“The mission of Warren Coats in Bosnia was as much diplomatic as economic.  Now that the challenges of rebuilding failed states and shattered societies are central to U.S. foreign policy, his lively and fascinating account of one effort at national reconstruction is as timely as it is informative.”

 

Steve Hanke, Professor of Applied Economics at Johns Hopkins U Baltimore MD and leading authority on currency boards.  hanke@jhu.edu

 

“The newly independent Bosnia and Herzegovina emerged in shambles from a bloody civil war in late 1995.  Warren Coats, a premier emerging market monetary expert, was central to the design and implementation of the currency board system that restored Bosnia and Herzegovina’s economy.  His book represents a scholarly and comprehensive, yet readable, realistic, and insightful account of one of the world’s most successful modern currency reforms.  One Currency for Bosnia should be required reading for all those who are serious about stable money.”

 

 

Fannie and Freddie, More Good, Bad and Ugly

By Warren Coats[1]

Should Uncle Sam have bailed out Fannie Mae and Freddie Mac and what should he do now?

Fannie and Freddie were created by the government to promote home ownership by lowering the cost of home mortgages. Whether it is good public policy to subsidizes home ownership in this and other ways is a separate issue. Fannie, and later Freddie, lowered the cost of mortgages by raising mortgage financing in the market at lower interest rates than previously possible. They reduced borrowing costs to home owners because they were able to borrow in the market in their own names at the risk free interest rates paid by the government and to pass the savings on to the mortgagees. After Fannie was privatized in 1968, it began to raise funds in the market with minimal risk by selling claims to pools of mortgages that met clearly stated minimum underwriting standards.[2] It guaranteed (insured) that private investors would receive the expected principle and interest payments on the underlying mortgages in each pool. Not only did the pooling and guarantee reduce the risk to market investors in such mortgage backed securities (MBSs), but the market fully trusted Fannie’s and later Freddie’s guarantees because of the widely held view that the government would not let them fail (implicit—now explicit—government guarantees).

These low funding costs could be passed on to ultimate mortgagees with lower spreads (the difference between Fannie and Freddie’s cost of funds and the rate they charged home owners) because of F&Fs high leverage. Fannie and Freddie were granted much lower capital requirements than other financial intermediaries. Investors didn’t worry about F&F’s small capital because of the implicit government guarantee of F&F obligations. These advantages over the competition allowed Fannie and Freddie to deliver very large amounts of relatively low cost funds to home buyers.

Why should we care if this arrangement channels more and cheaper financing to homeowners? The history of state owned banks almost every where they have existed in the world has been bad. For obvious political reasons, they are usually greatly overstaffed (with friends of the ruling party) and hold higher levels of non performing loans than privately owned banks as a result of politically motivated loans and poor management. It is too easy and tempting for politicians to push off the costs of government programs, such as loans to subprime borrowers with low or even zero down payments, to such institutions (off-budget expenditures).

Thus the privatization of Fannie Mae in 1968 should have been welcomed. Unfortunately, however, what was privatized was Fannie’s profits but not its risks. The same mistake was repeated with the later creation, then privatization, of Freddie Mac to provide more competition when the more sensible policy would have been to remove Fannie Mae’s special privileges (especially its very low capital requirement). As privately owned companies, F&F have taken a significant amount of their income to pay high dividends to their private owners,[3] very high salaries to their management,[4] and large payments for lobbying services.[5] These payments reduced the extent to which they were able to lower the cost of home ownership. According to The Economist “it has been an awful deal for the tax payer – a Fed economist calculated the implicit debt-guarantee was worth a one-off sum of between $122 billion and $182 billion. Because Fannie and Freddie barely lowered the cost of borrowing, little of this subsidy went toward busting home ownership. Instead, just over half—about $79 billion—went straight to their share holders.”[6]

Worse yet, the “The Department of Housing and Urban Development sets ‘affordable’ housing goals for Fannie Mae and Freddie Mac to dedicate a given amount of credit to poorer homeowners. One way Fannie and Freddie fulfilled these goals was to buy subprime mortgage securities — many of which have now gone bad.”[7] In other words, congress has pushed the cost of one of its programs off the government’s budget onto F&F, backs which is now coming back to the taxpayers.

Between them Fannie and Freddie guarantee two fifth of America’s 12 trillion dollars in mortgages by either owning them or packaging and reselling them to the market as mortgage backed securities of one sort or another. Stated differently three fifths of American mortgages have been financed without Fannie and Freddie’s help.

Basically F&F now provide investment banking services and guarantees to investors in mortgage back securities. But their guarantee, which should be backed by the capital provided by their private shareholders and their due diligence in vetting compliance with the stated underwriting standards, are actually backed by American tax payers. They do nothing that the private market cannot and is not doing already. They do it somewhat cheaper because the tax payer bears the ultimate risk of losses. For many many years a long list of economists and public servants have recommended breaking them up and or getting rid of them[8] and congress has delayed taking action until the latest Fannie and Freddie crisis of this last week.

Congress’s housing bill, signed by President Bush July 30, 2008, strengthened emergency arrangements by the Federal Reserve and the U.S. Treasury to open credit lines to F&F after their share prices collapsed on July 7, following an analysis by Lehman Brothers that potential accounting changes could leave their capital $75 billion short.[9] The new law confirms the Treasury’s pledge to provide liquidity against mortgage collateral and even capital if needed. In other words, the government’s implicit guarantee of F&F liabilities has been made explicit. F&F’s share prices immediate recovered following the earlier Treasury and Fed announcements. These steps were necessary because a loss of confidence in the market in F&F’s mortgage guarantees would freeze trading of, and/or cause very large losses in the value of, the $5.2 trillion mortgages guaranteed by F&F. This could do irreparable damage to the mortgage market and financial markets more broadly. It is impossible to know at this point whether F&F really needs any of this money, which depends on whether mortgage defaults over the next few years are more or less serious than now assumed.

The new law also provides much needed strengthened supervision of Fannie and Frieddie, but there are worrying signs that the underlying problems are just being postponed for yet another bailout rather than being fixed. F&F, along with Ginnie Mae,[10] will continue to have social responsibilities that potentially put tax payers at risk. At the same time that the new law authorizes tax payer money to cover F&F losses, it also taps future income (starting in 2010) to fund a new National Housing Trust Fund. Rather than liquidating F&F, congress has provided for the financing of the new NHTF with yet another off balance sheet scheme that builds a political constituency for the perpetuation of Fannie and Freddie. David Broder declared this an example of “lawmaking as it should be.” [11]

What should be done?

The government should stand ready to provide whatever capital Fannie and Freddie need to honor their existing obligations (and to provide adequately collateralized liquidity). However, such capital injections should come only after all shareholder capital has been used up. The condition for tax payer funded capital should be the surrender of current owners’ shares (a nationalization ala Northern Rock in the UK). Shareholders would lose everything in this case but all other obligations would be met. Once back in government hands these institutions should be gradually liquidated in an orderly way over a number of years.[12] Though investors in F&F guaranteed mortgage backed securities would be bailed out, shareholders would not. This compromise would retain considerable market discipline and is essentially the approach taken with failing banks, which are taken over by the FDIC and often resold over the same weekend. It is the approach advocated by Alan Meltzer for investment banks now that they have access to Federal Reserve credit.[13]

Refusing to bail out shareholders while protecting depositors (in the case of banks) and other creditors (mortgage backed securities in the case of Fannie and Freddie) is a compromise. Market discipline of investors in F&F guaranteed mortgage backed securities from potential loss in bankruptcy of F or F would be reduced, though it would be gradually transferred to privately guaranteed mortgages after the liquidation of F & F. However, full market discipline would be retained for shareholders who are in the best position to control the behavior of these institutions anyway. This is generally as much market discipline publics around the world are willing to accept, but we should insist on nothing less.


[1] Warren Coats, Bethesda, MD, retired from the International Monetary Fund in 2003 as Assistant Director of the Monetary and Financial Systems Department, where he lead technical assistance missions to central banks in over twenty countries. Prior to that he served as visiting economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at UVa from 1970-75. He is currently a director of the Cayman Islands Monetary Authority, Senior Monetary Policy Advisor to the Central Bank of Iraq for BearingPoint, an IMF consultant to both the central bank of Afghanistan, and to the Palestine Monetary Authority, and an Asian Development Bank consultant to the National Bank of Kazakhstan on inflation targeting. In 1989 he coauthored the World Bank’s World Development Report on “Financial Systems and Development.” His most recent book, One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina, was published in November 2007. He has a BA from UC Berkeley and a PhD from the U. of Chicago in Economics.

[2] The Federal Home Loan Mortgage Corporation (Freddie Mac) was chartered by the government in 1970 and “privatized” in 1989.

[3] For the year ended December 31, 2005, before the beginning of the current housing and mortgage crisis, Fannie reported profits of almost $6 billion from $50 billion in revenues. According to the Economist (July 19-25, 2008) a Federal Reserve economist “calculated the implicit debt guarantee [of Fannie and Freddie by the government] was worth a one-off sum of between $122 billion and $182 billion.” With just over half going to shareholders rather than lower borrowing costs to home buyers.

[4] “CEO Daniel Mudd received $12.2 million in total compensation last year [2007], down 15 percent from 2006,” when he received $14.45 million. Reuters January 31, 2008. In 2004, 20 of Fannie Mae’s top executives “received more than $1 million each in total compensation in 2002. Twelve received more than $2 million. Nine received more than $3 million.” Washington Post October 11, 2004. Fannie’s chairman and chief executive at that time, Franklin D. Raines, was subsequently fired over accounting “irregularities” that bolstered his and other executives’ performance bonuses.

[5] Fannie and Freddie reported lobbying expenditures over the last ten years of $167 million. The power and effectiveness of their lobbying efforts are legend.

[6] The Economist, “Twin Twisters” July 19, 2008 p 15.

[7] Robert J. Samuelson, “The Homeownership Obsession”. The Washington Post, July 30, 2008 p A15

[8] Peter Wallison has been a particularly articulate and persistent critic of F&F. Also see the resent article by William Poole, "Too Big to Fail, or to Survive" , NY Times, July 27, 2008

[9] Catherine Clifford, “Fannie Mae and Freddie Mac Plunge,” CNNMoney.com, July 7, 2008: 6:36 PM EDT

[10] Government National Mortgage Association, guarantees with the full faith and credit of the Federal Government pools of mortgages collateralize with loans insured or guaranteed by the Federal Housing Administration (FHA) the Department of Veterans Affairs (VA) the Department of Agriculture’s Rural Housing Service (RHS) and the Department of Housing and Urban Development’s Office of Public and Indian Housing (PIH).

[11] David S. Broder, “When Congress Works,” The Washington Post, July 31, 2008, P A19

[12] An alternative would be the outright nationalization of F&F compensating the shareholders with the estimated value of their shares (which might be negative). If later recovers from liquidation are greater than expected, shareholder compensation could be increased at that time. The government would accept the risk that it was less.

[13] Allan H. Meltzer. “Keep the Fed Away From Investment Banks” The Wall Street Journal, July 16, 2008; Page A17