1:11:34 Right or wrong, every time safety and soundness becomes an issue, policy ends up interfering with regulation. – Josh Rosner
Doom Transcripts: Index & Guide
Housing Doom is pleased to present complete unauthorized annotated transcript VI.D for the American Enterprise Institute’s November 12, 2009 event "Is It Possible to Reprivatize the U.S. Financial System?".1 The event site has some further resources including a summary and both an audio and a video of the proceedings. There is as yet no official transcript.
Table of Contents
[link navigation works best when full article displayed]
- 0:00:00 – Alex Pollock intro
- 0:09:13 – Jay Brinkmann presentation
- 0:20:01 – Robert Eisenbeis presentation
- 0:34:06 – Mark Olson presentation (brief preview post)
- 0:44:49 – Josh Rosner presentation
- 1:00:30 – Panel discussion
- 1:15:15 – Q&A
- 1:16:08 – Peter Whitney question
- 1:16:32 – Eisenbeis response (with Pollock)
- 1:19:42 – Steven Lee question
- 1:24:57 – Jill Naamane question
- 1:25:18 – Rosner response (with Pollock)
- 1:26:00 – Bert Ely question
- 1:31:05 – Andrew Parmentier question
- 1:37:22 – Andrea Psoras question
- 1:40:46 – Bill Coleman question
- 1:46:56 – Michael (last name omitted) question
- 1:51:53 – Nils Remmel[ph] question
- 1:52:13 – Alex Pollock response
- 1:53:08 – Benjamin Nefussi question
- 1:55:37 – Rosner question (response is vote by audience)
- 1:56:32 – Bob Long question
- 1:56:54 – Eisenbeis response
- 1:57:57 – Pollock brief wrap-up
- 1:16:08 – Peter Whitney question
- 1:58:03 (end)
Alex Pollock: [0:00:00] Good afternoon. Thank-you all for being here on this miserable day, but we hope for a very interesting discussion.
Welcome ladies and gentlemen to our conference: "Is It Possible to Reprivatize the US Financial System". This conference is jointly sponsored by AEI and the Professional Risk Managers International Association. I’m Alex Pollock, a Resident Fellow at AEI, and I have the honor of moderating our discussion today.
As we all know, the deflation of the immense 21st Century housing bubble, beginning early in 2007, then the remarkably extended international financial panic, which began in August 2007 (that’s 27 months ago), that we’ve been having these interesting experiences. And that panic lasted, then, till the spring of 2009, an extended panic in which we once again learned that liquidity is ephemeral when needed.
In the wake of the bubble and the panic, as we all know, there’s a huge inflow of government, including central bank, refinancing, guaranteeing and making equity investments in the financial system.
It’s hardly necessary to enumerate all the various ways this has been done, but we can’t fail to mention the TARP, called by my colleague Peter Wallison "the TARP baby," and it’s certainly true that the government is stuck in the TARP with both hands and both feet. And how should the equity investment in various financial firms, let alone automobile companies, be managed to de-nationalize ownership going forward?
There’s also been the nationalization of Fannie Mae and Freddie Mac. Of course they deserved it, along with the vast expansion of Federal Housing Administration credit, the FHA as being of course the government’s own subprime lender. And we’re now going through interesting discussions of their financial condition.
Mortgage funding is now almost wholly being done by government credit, including the highly interesting use of the Federal Reserve’s balance sheet to finance Fannie and Freddie so that they can buy mortgages.
And of course this then brings us to the balance sheet of the Federal Reserve, and the balance sheet of the Federal Reserve Bank of New York in particular. The total Fed balance sheet, as we know, has grown to in excess of $2 trillion, and now, in some respects, looks interestingly like the balance sheet of a commercial bank, as opposed to a central bank, with big deposits on one side, and with assets on the other side, including a lot of mortgage backed securities, bonds of corporations, commercial paper and derivatives.
As pointed out so forcefully by Robert Higgs in his book, "Crisis and Leviathan", (and for those of you who may not remember your Hobbes, Leviathan is the metaphor for the State, or the Government) crisis always calls forth a great expansion of government intervention and government control. But what happens when the crisis is past?
I always think in this context of the Roman legendary hero Cincinatus, or Quincinatus[ph], who was called from the plow, as the story goes, to become temporary dictator of Rome, and to save the state. Once he had saved the state, he went back to his farm, setting an example that George Washington, The Modern Cincinatus, as he was called, later followed.
But it looks harder to apply this example to the few huge financial interventions of our day, and to the financial stakes that the government now has in the financial system and in other places, in the wake of the bubble and the crisis.
Mark Carney, the Governor of the Bank of Canada said recently,2 "The financial panic required a bold response. The response has profoundly shifted risk from the private to the public sector. The expedient should not become permanent," he said, "Risks must be returned to and born by the private sector." [0:05:00]
Most everyone would agree, but how? How would we get out of this? Is it possible to reprivatize the US financial system from where we are?
Our outstanding panel will, no doubt, tell us the answers to these questions, so let me introduce them in the order in which they will speak.
Our first speaker will be Jay Brinkmann at the far end from me, who is the Chief Economist and Senior Vice President of Research and Economics for the Mortgage Bankers Association, where his responsibilities include economic forecasting, mortgage industry analysis and legislative and regulatory issues. Jay previously worked for Fannie Mae and was on the faculty of the Business School at the University of Houston, specializing in financial institution regulation and energy derivatives markets. He’s also been a commercial banker, Deputy Chief of Staff to the Governor of Louisiana, and on Capital Hill, and Jay knows a lot about the mortgage market and how it works at a detailed level.
Our second speaker would be Bob Eisenbeis, who is the Chief Monetary Economist of Cumberland Advisors, where he advises the company’s asset managers on US economic and financial market developments and their implications for investment and trading stategies. Bob was previously Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta, working on monetary policy for the Federal Open Market Committee [FOMC] deliberations, basic research and policy analysis. Before that he was Wachovia Professor of Banking at the Kenan-Flagler School of Business at the University of North Carolina, Chapel Hill, and he’s held senior positions at the Federal Reserve Board and the Federal Deposit Insurance Corporation [FDIC].
Our next speaker after that will be Mark Olson, who is co-Chairman of the Board of Corporate Risk Advisors. Mark has spent more that 40 years in the financial services industry, holding top-level executive positions both in the public and private sectors. He joined Corporate Risk Advisors after being Chairman of the Public Company Accounting Oversight Board, — I guess we’re still discussing whether that’s a private organization or a public organization [crosstalk, laughter] — He was a member of the Federal Reserve Board of Governors and the Federal Open Market Committee [FOMC], and he served as Staff Director of the Securities Subcommittee of the US Senate Banking Committee. Mark is also past-President of the American Bankers Association, and was the National Director of the financial services regulatory consulting practice for Ernst & Young, and was also President and CEO of Security State Bank in Minnesota.
Our last speaker will be Josh Rosner, a Managing Director at the independent research firm of Graham Fisher & Company, where he advises regulators and institutional investors on housing and mortgage finance issues. Previously he was Managing Director of Financial Services for Medley Global Advisors, working on monetary, fiscal and regulatory developments for many of the world’s leading institutional investors. He’s been Executive Vice President at CIBC World Markets, and a Senior Vice President at Oppenheimer and Company. Josh was among the first to identify operational and accounting problems at the Government Sponsored Enterprises Fannie and Freddie, the peak in the housing market, the likelihood of contagion in credit markets, and the weaknesses of the credit rating agencies’ rating assumptions. I well remember in my conversations going back 3 years and more with Josh on all these exceptionally important issues.
Each panelist will speak for 15 minutes, after which we’ll give them a chance to respond to each other. Then we’ll open the discussion to your questions, and we will adjorn promptly at 4 o’clock.
So Jay, you have the floor.
Jay Brinkmann: Thank-you Alex.[slide3 1] When I was invited to speak this afternoon on the subject of reprivatizing the GSEs, the first throught was, well, … How do you privatize something with "Government Sponsored" in its name? [slide 2] So perhaps we are not talking about re-privatizing. I also am reminded that I think it was here at an AEI meeting where someone made the comment that one advantage that the French have over us is that when they nationalize a financial institution they tend to do it while it is still profitable. We apparently haven’t learned that lesson.
I think when we look at what a new structure should be for the secondary market, and rather than just explicitly dealing with these two companies, but looking at a model that we are proposing for essentially [0:10:00] replacing them.
And a problem overall in terms of the nature of what needs to be privatized in goverment involvement, it’s really a question of — What are the implicit guarantees that come with any particular organization? In other words, is it a case of explicit things being supported by the government, or is it an issue with open ended, ill defined, implicit guarantees, then, that only manifest themselves after the fact? I can imagine that had I called up 3 years ago, Alex, and suggested a session on — What should be the government’s policy in paying off credit default swaps at AIG at par? — I would have been laughed out of this city, perhaps, that that is just so absurd we ever actually would do something like that, but in fact we have seen those results.
So this implicit guarantee, it essentially comes down to, who do you want to trust with the keys to the Treasury, and what kind of limits do you want to put on them as to what doors you allow them to open or not?
So as I see the issues going forward for Fannie Mae, and even beyond that to Fannie Mae, Freddie Mac and other institutions is — If the government is going to support a financial institution, what exactly is supported, and what is not supported? In other words, is it an open ended guarantee for the entire corporate structure, or are we just going to guarantee a specific function that plays some sort of crucial role for the economy?
And second, what are the explicit costs that will be charged or demanded as compensation from those entities for that explicit guarantee? … That if you guarantee it and you’re properly compensated for extending that guarantee (there are certain guarantees that the government is uniquely situated to offer), but are the taxpayers adequately compensated for the risks that they’re taking on?
And then the third issue is then — What are the implicit costs of an explicit guarantee? We’re seeing that, of course, with some of the TARP programs, that how often have you seen the headline: "This Bank is Receiving TARP Funding, So Why Aren’t They Doing X"? We expect them to do "this" because they’re receiving this type of funding. How much then would this be extended to — "They are now receiving this support, therefore you want them to do something else"? And how then do you factor in those implicit costs on the structure?
So when we looked at what needs to be done with the GSEs, with Fannie and Freddie, we pretty much came up with a series of principles, a series of ideas that we thought needed to be supporting these institutions as we actually moved them more away from this implicit guarantee, but to a structure of what’s explicitly guaranteed and what is explicitly excluded from that guarantee. [slide 3]
And the first step was to make sure that private capital is the first defense against any kind of losses, with a structure with a number of firms to try to get around the too-big-to-fail issue. That we need a system where we can have multiple entities chartered by a regulator outside of Congressional control that would allow several of them to develop, and that if any one of them went under there’d be sufficient capacity elsewhere to support them.
As a second line of defense, some sort of insurance fund similar to what we have for bank deposits. That if there’s an explicit fund to support these institutions should … I mean not support the institutions but to support the guarantee should one of the institutions fail — that would be funded, that would be part of the structure that would support it.
Only after that we believe that we would have an explicit support for the mortgage-backed securities as a government wrap that would ultimately give the things the amount of liquidity that would be needed to trade.
But we would make explicit in these institutions what is supported and what isn’t. For example, the credit risk in mortgage-backed securities would be supported by this federal wrap. Absolutely nothing else would be. So there would be no support for the debt, we would limit the type of products that would be supported, it would only be 30-year or similar 15-year fixed rate type mortgages, perhaps an ARM product. A very limited set of products. It would not be an open-ended implicit guarantee for the institution if they decided, like Fannie and Freddie did, to extend out into pay option ARMs or Alt-A product or some of the other issue … loans that are giving them so much trouble.
And then once this explicit guarantee is established, what are the costs of compensating the government? What are the actual payments that would [0:15:00] be made up to the insurance fund, to the regulator, etc. so that there would be compensation to the government for this.
And then finally we would remove all of the other indicia of implied federal support: the members of the Board, SEC registration, you name it; the exemption from taxation that the institutions have used. My impression is that the … when they operated domestically, Fannie and Freddie were very adept at saying, "No we do not have government support." That implicit support, however, turned explicit as soon as the jet went wheels-wet over the Pacific as the debt marketers and others then headed out there to sell the debt structure … the debt of the institutions, where it was much more of a case of … "Well, look at all the indicia. The Government’s really behind us." So that you’re not just buying debt from a fully private institution.
With that, I will show you [slide 4] how we think this market should operate. We would have lenders, existing as they have, passing core loans through a structure — the types of loans within the more narrowly defined band that had been going to Fannie and Freddie; setting up a set of credit guarantor entities that would be fully privately capitalized, having adequate risk-based capital behind them, that would then pay into a deposit insurance fund that would provide protection against the failure of one of these … again chartered institutions, not in Congress, but by a federal regulator that would be subject to federal regulation, that would look at it and would provide just this overall wrap that would let the securities trade, that would allow us in this environment to tap the international capital markets.
So it would have the combination of private capital explicitly paying for an explicit guarantee that is limited to just certain types of loans and certain types of MBS, not extending to the rest of the capital structure, so that the equity holders, the debt holders at these institutions would be at risk and would have adequate reason then to oversee what’s taking place.
And then the FHA, Ginnie Mae and private label market could develop on the outside of this structure.
Well, how do we get there? [slide 5] We’re looking at an extensive, I think, transition process. I think we’re probably looking at a 3 year process to roll out something like this by the time you draw up the legislation, the regulations, create the regulator, create the charters, set up all the internal mechanisms.
We can convert, we can … we can transition Fannie and Freddie, certainly, into these new types of organizations, as well as other organizations that are out there that could potentially become some of these institutions. Certainly the co-op model that we see in the Federal Home Loan Banks; that sort of thing would be a candidate for this. But it’s going to take some time.
The issue, however, is we have interim problems we need to address. How do we deal with the phase-out? How do we deal with the phasing out of the GSEs, bringing in the new one? Who provides support for the mortgage market as it goes forward? As Alex mentioned, the Federal Reserve has been buying a number of the Fannie / Freddie securities. People call me up and say, "Gee, Jay, when’s the Jumbo market going to be coming back?" And I’m saying, "Well, gee, the Federal Reserve’s buying about 100 percent of all new Fannie / Freddie issuance, you tell me when the conventional conforming market is going to come back, and it’s going to be adequate private demand? Once we answer that question, maybe I can give you a date on the Jumbos."
Perhaps we might need some interim guarantees on the Fannie / Freddie structure to keep the things trading. I don’t know, but the important thing is: When we look at what the interim steps are there to perhaps take it to a much more private model, or model with explicit private components and explicit … explicit private, explicit government … It will, any interim model, make it easier or harder then to achieve that goal. I think that’s one of the things we really have to keep our eyes on over the next few months as we try and deal with some of these issues.
And I think a final issue then is … The taxpayers have already put $100 billion into these two institutions, with the number expected to climb over the next year. How, if ever, do we have to structure the taxpayers being compensated or getting back some of that money?
So that is what we’re facing.
And with that, Mr. Pollock [slides 6-17 not addressed in depth] …
Alex Pollock: Thanks, Jay. … Yeah, Bob, you’re up? …
[crosstalk; several seconds of dead air ...] [0:20:00]
Robert Eisenbeis: Thank-you, Jay [crosstalk] I’m going to take a look at the overall problem and try to give a helicopter view from 10,000 feet as to what we’re dealing with at this point in time. [slide4 1] Jay gave us some specific recommendations with regards to GSEs. I’m going to touch a little bit on some of the issues that he’s raised, but also try to scope out the bigger picture that we’re facing as well.
And the way I look at it, [slide 2] we’re now faced with the situation where as a result of a whole series of ad hoc rescue solutions to short-run problems, we now have deep involvement of the government in the financial system with no end-game or exit strategy in sight, or in place to begin with as these plans and these various rescue operations were undertaken.
The problem now, as I see it, is really two-fold. And I don’t hear a lot of discussion about this, and that is first of all — What’s the new financial architecture going to look like in the broadest sense? What’s the competitive structure going to be, and how will institutions relate to each other in a competitive marketplace, if we’re going to have a competitive marketplace?
And the second issue is — How do we unwind if, once we’ve decided where we want to go, the support packages that have already been put in place?
So I think there are a number of dimensions of the problem, and Jay has already touched upon the Freddie and Fannie situation. [slide 3] Right now I want to provide a little bit of some numbers. We’ve talked about the fact that the government has invested about $112 billion worth of taxpayer money in the form of equity in these institutions, and we read in the paper in the last couple of days5 that there’se obviously requests for more to come. The government has pledged up to $200 billion in terms of the amount of equity it would put in, and so if we know what the amount has been pledged, there’s probably a good chance that we’ll reach that amount at some point before we start to deal with the problem.
Both institutions have indicated that they’re going to ask for more. And I think … Jay has addressed, I think, one of the key things, and that is there is no plan at this point to unwind these institutions at this juncture, and so we’re faced with this continuing potential drain on taxpayer funds going forward.
Alex mentioned the fact that the Federal Reserve is now a very significant holder of Freddie and Fannie obligations, and I want to put some numbers around this. First of all, the Fed now holds $146 billion of federal agency debt securities, and they also hold $774 billion in mortgage-backed securities guaranteed by Freddie, Fannie and Ginnie Mae.
All of these have maturities in excess of 10 years, and on top of it, the Fed now has expanded its holdings of long-term treasuries such that 46 percent of its securities, government securities, holdings now have maturities in excess of 5 years.
Now keep in mind that if the Fed’s talked about how it’s going to exit from this printing-money strategy that it’s followed and essentially, literally, what it’s done is printed money to buy mortgages — essentially laundering them through Freddie and Fannie in a cooperative arrangement.
Question is — How are they going to unwind this? And one of the things they said they’re going to do is, well, they’ll just let their portfolio run off and liquidate it. Well, it’s going to take a long time for that to run off, and that’s not going to be the way that you can tighten monetary policy, by selling assets.
And if the Fed’s holding of these obligations isn’t enough, the Treasury also holds $177 billion in mortgage-backed securities guaranteed by Freddie and Fannie and Ginnie Mae. So the government is essentially a major holder of obligations in Freddie and Fannie at this point.
The second problem is the fact that the US is also a major shareholder of AIG. [slide 4] It’s provided $182 billion of total assistance, with about $120 [billion] outstanding. Just to put this number in perspective, this is about what the estimate was of the total cost of the thrift crisis, previously, [0:25:00] the last one around.
So we’ve got more invested in this one institution than the taxpayer incurred in terms of cost to deal with the S&L problem. This is more than "a billion here and a billion there."
Assistance to AIG has taken the form of loans, equity, investments, commercial paper facility and loans by the New York Fed to Special Purpose Vehicles that were used to purchase residential mortgage-backed securities [RMBS] out of the portfolio of AIG. Treasury has provided $46 … $41.6 billion in preferred stock funding, and $3.2 billion of equity from an authorized amount of almost $30 billion in potential equity investments in AIG. This institution … The stategy has been — It can be put back on its feet and run as a private entity down the road — but it’s going to come at big cost to the taxpayer if, in fact, that’s even feasible to do.
The next problem [slide 5] is the fact that the US has injected about $204.7 billion of capital into something on the order of over, now, 588 US financial institutions, of which about $70.8 billion has been repayed. They talk about 28 institutions being potentially systemically important, but we potentially have 588 additional GSEs now, beneficiaries of government capital injection.
Little discussion has been forthcoming with regards to the guarantees of bank liabilities that have also been provided, particularly by the FDIC. This includes guarantees of all checking accounts, the guarantees of debt and deposits. All this needs to be wound down in some sort of strategy that is not disruptive to financial markets.
All of this (with the track focusing on the restructuring issues) raises three, I think, major questions. [slide 6]
- The first is — What’s government housing policy going to be going forward?
- The second, as I’ve already suggested is — What’s this vision for the financial structure in a competitive landscape going to look like?
- And finally — How do we address the too-big-to-fail issue?
With regards to housing policy, are we going to continue to subsidize housing through direct government guarantees and lending, or indirect subsidization through some kind of financial institution, be it Freddie, Fannie or a host of cut-up institutions along the lines that Jay has already suggested? [slide 7]
What are we going to do about the Fed’s subsidization and the printing of money that it’s engaged in. Almost half of its portfolio now consists of mortgage loans. It’s probably the biggest (next to Freddie and Fannie) the biggest mortgage lender in the country.
How do we return to financial … private financial structure that has private-sector competitors? I think what we’re going to potentially going to face is a two-tiered system. And that is — those institutions that are the [beneficiaries] of the explicit and implicit government guarantees, and smaller institutions that aren’t the beneficiaries of those guarantees. That has huge implications for competitive equity and what the competitive situation is going to look like, particularly for smaller banks.
We haven’t really talked about the international dimensions, but the international environment is one in which other countries have institutions that have government guarantees, even if we evolve to a situation where we no longer have government guarantees.
There is the risk that government guarantees in other countries are going to beget the demand for government guarantees for our institutions, and we’re already well down that particular road. And I think there is a risk in the end that implicit guarantees may win in the short run and to the extent that they do we may be opening the door to other financial crises down the road.
Then, of course, there’s the issue of how we deal with too-big-to-fail, and I’ll offer a comment on that in just a minute.
With regards to Freddie and Fannie, there are essentially just three options that I see.
The first is to spin them off in a form that’s reminiscent of what they were before they were put into [0:30:00] conservatorship. The problem there is that this just revives the implicit government guarantees and doesn’t solve any problem.
The second, which is along the lines of what Jay suggested, and that is to carve them up into several segments; but the key here is to devise a mechanism that the marketplace will believe that they are truly private sector entities. And given past behavior, and government policy towards housing, I think that’s going to be a very difficult task to achieve.
Of course the alternatative is the third one, and that’s essentially to sell off and liquidate all the assets, and let the private market deal with the housing problem and devise another, perhaps better, way of subsidizing housing; perhaps through direct grants or tax policy as an alternative. We’ve tried indirect subsidization and it’s failed miserably on multiple accounts, so I think we need to pursue other alternatives.
The next problem is how to unwind the commitments to banks and AIG. [slide 8] And here I’m not so optimistic. Large, at least in terms of systemic risk, now includes at least 28 institutions, as well as those that may be on some explicit or secret list. I understand that there may be such a list now, or in the process of being put together. The other issue I’ve already mentioned is this problem of how you deal with the expanded deposit and debt guarantees.
We are at a point where I think that one of the desirable options, which was greater reliance on subordinated debt as a mechanism to provide market discipline for institutions, is probably out the window, because the government’s already stepped in and guaranteed subordinated debt, and debt issuance by large institutions. So I don’t think we can look to that as a credible source for market discipline.
I think the current policy with regards to uninsured debt really creates a limbo situation because people don’t know, and market participants don’t know, what will be guaranteed and covered and what won’t.
And my bottom line here is that no public statement about "no more bailouts or guarantees" is credible at this point in time.
The current approach being taken is simply one of more regulation. [slide 9] The Congress says we have to do something, so we’re going to require more capital, we’re going to break up large firms, we’re going limit the use of derivatives, we’re going to put restrictions on pay, we’re going to return to Glass-Steagall, as if Glass-Steagall was [sic] a problem to begin with. None of these proposals, in my mind, deal with the fundamental issues that I’ve already outlined, nor do they extract the government, I think, from future guarantees and bailout schemes.
No one is focusing on the future competitive landscape, and I think that’s the main issue.
Now as for too-big-to-fail … Oops! what happened to it? My cartoon [slide 10] got left. I will describe one to you that I was gonig to show. It says, "What to do about too big to fail," and it shows, from Non Sequitur, the comic strip, a limousine pulled up in front of a big mansion, and on the back of the limousine it says, "Just Got my Bonus," and the driver is saying, "I suggest you leave your window down so that you can get the full impact of your "Too Big To Fail celebration." Thank-you.
Alex Pollock: Thank-you. Mark?
Mark Olson: Thank-you very much, Alex, and thanks for including me.
Like Jay, I had an initial response when I saw the topic of this meeting, which is "Can We Reprivatize?" and I thought, … the short answer is, "Yes." Anything with a discrete income stream can be privatized, as I think Josh spent much of his career doing, and perhaps can talk about [in the next presentation following this one].
But it seems to me that there are really two issues, and I’ll have some thoughts on the issues that have already been covered about the immediate … how we unwind what has recently taken place. But then I think [0:35:00] that the more fundamental question — and each of the other two panelists has addressed it in some ways, is — There are really in my mind three key questions that we have to be addressed, because it seems to me that over a period of time we have implicitly established a policy in that regard. And the manner in which the Congress addresses these three — and of course as we know the Congress acts only in a crisis or a consensus, but what it does ultimately is it reflects the will of the public, and that imperfectly, but it does.
With respect to the TARP money, that’s the one that I’m perhaps the most optimistic about, ultimately unwinding, for different reasons — for a number of reasons. First of all, as many of you are aware, participation in the TARP was involuntary for a lot of the … for the largest institutions. Hank Paulson and Ben Bernanke got the largest financial institutions in a room and said, "You will take the TARP money," and of course the idea of their being that they knew the TARP had to be broadly spread, and if those who were the largest and obviously most healthy at that time did not, it might have a perverse impact on those that actually did receive the money, so that the Wells Fargos and the JP Morgan Chases, involuntarily found themselves with TARP money, many of whom have gotten rid of that money.
As we go forward, the rest of the — Bob indicated 588 — there are a number of ways in which that will be done.
First of all, many of those institutions do not want to see that infusion revert to capital, one way or the other, as it will. Particularly you don’t want to do it involuntarily. So under those, I think there will be an incentive to try to come out from under the TARP payment.
Second, those that are really on the margin, and 2010 is going to be a very difficult year, I think, for the financial services world. My … There are now guesses as to how many additional banks will go through resolution over the course of 2010. I think the number will probably be in the range or close to 200 this year. I would not be surprised if it’s 400 in the next year.
And in the process of those resolutions, which are conducted by the FDIC, the TARP money in each of those, I think, will be addressed.
The good news is that there is an astonishing amount of private capital money looking to … looking to participate in the rollups of some of these financial institutions.
Many of you remember the mid-’80s or the late-’80s where we saw a fundamental … essentially realignment or reevaluation of commercial real estate as a result of the work of the RTC. In that case it was the real estate itself that went through the resolution process. This time around it will not be. We’re getting at it earlier and it’s the loans, as opposed to the properties themselves.
So it will be resolved through financial institutions making those bids, and the FDIC has put out, I think pretty clearly, the manner in which that will be conducted, including the manner in which that will be available to private equity investors, which I think is … I think that it is going to be critical in order for it to happen this time around.
I am not nearly as optimistic about the unwinding of the positions on Fannie and Freddie. In part because I think one of the metrics that the Fed will look at very carefully — in fact there are two.
The first, that they will look at, and is always the priority, at least in my judgment, is the impact of inflation. And what you hear some of the Fed Governors talking about now — just a little bit different from what we were hearing 20 years ago — is "What is the appropriate level of inflation." Not trying to get to zero inflation, recognizing that we don’t want to get caught in the Japanese style liquidity trap of a decade ago. So there is some … There will be some incentive to have some level of inflation.
That said, the economy could really be in trouble if we do not have an active loan market for real estate. And the only game in town is Fannie and Freddie. And so Fannie and Freddie, that stream, if you will, needs to be kept going, and the Fed recognizes that and will keep it going as long as necessary until the secondary market … until an active secondary market develops.
It is also important that ultimately the secondary market come back, I think, for the non-conforming product, but that might take longer.
But there are three fundamental questions, I think, that need to be addressed. And these are … these can only be addressed by the Congress. And the first is, "What sort of a risk tolerance do we have?" or "What sort of a tolerance will we have for economic volatility in this country?" Because what we have seen is that tolerance for volatility [0:40:00] narrow. And I’ll get back to it.
Point number 2 is the extent to which we will continue to provide support or incentives for societal values that we find to be positive. And the 3rd question we can, we will have. is the extent to which Congress, what will Congress’ next response be to the next …? actually what we will find out in 2010, what will be Congress’ response to this past fiscal crisis.
And let me go back and just talk about these three.
If you go back to when we first started seeing anti-trust legislation develop, it was pretty clear that we were going to limit, that we as a society were going to limit the impact, for example, of the John D. Rockefellers, or anybody who could corner markets. And we established anti-trust limits. We came up with what we in the banking industry know as the HHI index, the Herfindahl-Hirschman Index, that defined purchasing power, or market power that was thought to be anti-competitive. And every bank merger goes through that index at the FDIC.
And I was amused one time when I was looking at one as a Fed Governor, that was involving mergers in California, and none of the banks were named Bank of America, or Wells Fargo or any of the prominent names, yet it still had to go through that fundamental test.
I think also, if there is a threat to consumer confidence, that we will … And again, it goes back to the establishment of the FDIC, and as you move forward, that trend has indeed continued. The escalating intervention in financial institutions, ultimately ending up in what I think is truly the repudiation of too-big-to-fail. I’m sure we’re going to have some discussion on that point and will come back to it.
Regarding the promotion of societal values, if you look at … there are certain values, or there are certain industries that Congress does, and will continue to promote. Maybe top of that list is housing, and we’ve talked about that already and I think that will continue to be the case
If housing isn’t number 1, then agriculture is number 1. I’m stunned, actually, that we continue to maintain the level of support for that industry, that now accounts for roughly 2 percent of the population of the US. When I was born, it was … unlike many people in this country, which I think is part of the issue, both my maternal and paternal side of the family — I come from farm stock. And many of us did, and I think that that has had a significant impact on the support for agriculture that we have in this country.
Small business? It’s clearly the case … consumption is a societal value that we support. How many years ago was it that we allowed the deductability on all interest on all consumer transactions and not just housing? But on the other hand, we discourage certain others, as a society, like savings, and wealth accumulation and the like. And I think that that pattern, probably, will continue.
Then the Congressional response, and to me this is key. It is fundamental to the federalist concept that in the US the initial assumption of government was that all commerce would be regulated by the States, and not by the federal government. And as you look at the panoply of federal government agencies, each one of them, I think without exception (certainly in the financial institutions area) were the result of a reaction to a crisis, real or perceived. Every single one of them.
So the other … the other implicit assumption is that at the federal level you do not have … you do not regulate until it’s obvious that you need to — at the federal level. And that has allowed, for significant segments of the economy over the years, to be unregulated until the determination was made that regulation should extend to them.
So we still have this environment where we have a significant amount of silo-ing; a significant amount of regulatory arbitrage, which because of the size and complexity of the economy, has now left us really vulnerable to very significant economic threats of significant size.
So to me in terms of how the question ultimately gets answered, will truly be in the hands of the Congress and we may actually … Alex I’m sure you’ll get into the manner in which some of the bills that are now being introduced or talked about will address those issues.
Alex Pollock: Thank-you. Josh.
Josh Rosner: And I’ll probably be the most scattered …
But in terms of the question, "Is it possible for us to reprivatize and see the government pull back?" the answer’s obviously "Yes." [0:45:00] Obviously there’s a number of factors that have to be considered.
I would point out or argue that the more aggressively we continue with the stance of kicking the can down the road and failing to force the recognition of losses throughout the system, the larger the losses become and the harder it becomes to extract ourselves. And that actually becomes even more problematic as the losses increase. As we see further deterioration in credit quality, we see further asset price deflation, etc.
We’ve also got a couple of headwinds which for the time being are going to make it harder. And we also forget that a lot of what drove this prior boom cycle included some secular features that I still think we’re not appreciating, and are part of the reason tjat the government is as aggressive, or is needing to be as aggressive, without even realizing it, as they’ve been.
We had the baby boom generation coming out the late … out of the ’80s recession entering peak earnings years, which supported consumption. We had the beginning of the democratization of consumer credit, which supported consumption. We had the move from single-income families to two-income families, which supported consumption and actually allowed us to also create, or support, increased purchasing power for homes, as example, which drove, or hid some of the affordability problems there, and inflated the asset price.
And so now we’re on the other side of those. Those are actually all headwinds, as opposed to being tailwinds.
So I think that is going to make it harder for us to actually pull out of the system very easily.
It’s interesting that we’re talking about how to reprivatize, and yet not one of us has said that you really can’t reprivatize until you have an honest discussion about how losses are allocated. And neither the Dodd Bill that we saw, the 1,100 pages, nor the Barney Frank discussion draft explicitly point out that in this country we do have general rules on capital and capital structures, and the equity holders are supposed to get wiped out first. And theoretically, the taxpayer’s supposed to take the hit after the rest of the capital structure is wiped out.
And we have not seen those losses apportioned throughout the system, nor are we actually seeing any of the legislative offerings suggest that happen, or be explicitly stated.
So I think that once you’re down that path, once you’re starting to talk about a systemic risk regulator, it becomes harder and harder and harder to see anything but miles and miles and years of years of government entrenchment in the industry; to the point where I would point out that the approach offered by both Barney Frank and Chris Dodd ignore the unanswerable question of, "What defines systemically risky institutions?"
I would posit it’s actually sort of like that question that was put to the Supreme Court of — What defines pornography? And there is no clear, very easy answer. In fact, if you go back as late as the spring, May of 2007, we heard Fed and the New York Fed make comments like, "The larger global financial institutions …" this is May of 2007, "… are generally strong in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue."
We also heard, you know, "There are good reasons to think that these developments have made financial systems more resilient to shocks originating in the real economy." That was May of ‘07, by the people who would be systemic risk regulators. The point being — you can’t really see systemic risk until it comes out of left field. And I think that needs to be considered in how we start thinking about what the problem is and how to extract ourselves.
Now onto the issue of too-big-to-fail, I’m going to go a little deeper than the other panelists on the issue.
I point out that, prior to this crisis, we really accepted that there was no such thing as an institution that was too big to fail in public policy. And we heard regulators, legislators and policymakers suggest that with liquidity, even if it had to be government provided liquidity, in time we could unwind any institutions.
Hank Paulson threw that notion out in a single sentence, where he said, "We have to recognize, perhaps, that there are institutions that are too big to fail." To that point I would, by the way, just highlight that in Long Term Capital, we had the industry put up what was essentially 80 cents for every dollar of expected loss to unwind Long Term Capital. We’ve now seen the Treasury and the Fed put up [0:50:00] 3 dollars for every dollar of expected loss for the financial industry, and we haven’t even begun to unwind any of the exposures.
So it’s about will. There’s this silly notion that’s being bandied about that we can actually charge the industry to resolve its brethren who failed. And we saw the numbers, lets actually talk about it for a second.
Between AIG, Fannie and Freddie, we are already on the hook to the tune of about $585 billion of exposure — not losses, exposure. Are we really expecting that the too-big-to-fail institutions are going to be able to fund (either pre-fund or at the time of crisis) a fund that would actually be 20 percent of its capital base? And do we think it’s a really smart idea that the most well-managed institutions have to actually assume that [they] will be funding the losses of the worst? Does that create an incentive to race to zero?
And I would think that these are the problems that we have to contend with, so again it seems to me that we have to recognize that before there is a dollar of risk to the taxpayer we have to make it explicitly clear that the entire capital structure first gets wiped out, and that if the government has to put up money for the unwinding and recoupment, that’s one thing. But no one is either … is talking about too-big-to-fail as being too-big-to-exist, other than by putting together these rules in both Houses.
(The draft proposals I think are sort of funny, because essentially the metaphor that I would draw is — both the House bill and the Senate bill on too-big-to-fail and systemic risk essentially say, "Here’s what we’re going to do, we’re going to call in the bomb squad, and we’re going to tell it to stand around the bomb until it’s about to explode.")
I thought that the goal was to call in a bomb squad and have it safely dismantle, or safely detonate the bomb as soon as possible.
There are alternatives. Now there is the ideological issue of too-big-to-fail: can we really force a company, a private company, to break itself up. And that goes on the one hand to a trust issue, and trust-busting. But I think there is, as we saw late with TARP, ways to structure incentives so that the banks will actually think about whether they want to be on that too-big-to-fail list; such as …
Why haven’t we seen an ammendment suggested that would help pull us out of this crisis and help the notion of reprivatization that said, "If you are a too-big-to-fail institution, and you have to rely on government asset purchases, government debt guarantees, access to the Fed window for more than a 60 day period, etc., your board members and your executives will all be considered to be working under a supervisory action, immediately, replaced as soon as possible, and your board and senior officers will all be prohibited from working for a regulated financial institution for a period of five years."
Now if you had that actually in place, you would have management either …
- decide to get their risk management practices up to snuff so that if a credit trader blew up a trading desk they wouldn’t be banned from the industry; or,
- you would see them very quickly start talking about how they could release economic value to shareholders by spinning off businesses and doing special dividends and breaking themselves up to get off that too-big-to-fail list.
We’re not really talking about the substance of the problems at this point, and I don’t think that we can get out of it — out of the crisis, out of the government entrenchment and involvement — until we do.
Now some might say that unwinding the firms would demonstrate that they’re insolvent and that’s why we can’t do it, because there’d still be massive losses to be taken by the taxpayer, after you wiped out the rest of the capital structure. And that may be true, so what we’re seeing is regulators proposing resolution authorities.
Now I don’t know what’s wrong with the bankruptcy code, but it’s been decided somewhere that there’s real problems with the bankruptcy code, so we need to have resolution authorities given to regulators, which are agents of policy, rather than agents of the public, at times.
If there’s something fundamentally wrong with the bankruptcy code, you would think that someone might suggest that we fix the bankruptcy code, so that we could actually resolve these institutions in a regular way. And that leads to the other issue, which is the international aspects of home-host bank regulation that need to be addressed, and we’re avoiding that. So the government will remain overly involved until we get to that point where we’re willing to actually close some of the loopholes on home-host in terms of the banking industry.
On … which I’ll actually just go [0:55:00] one step further into that.
Now Basel allows host country branches of foreign home country holding companies to operate in another country without any capital as long as they meet the home country’s capital requirements. We keep hearing [about] the large too-big-to-fail institutions, talking about if we force them to break up we’d lose some efficiencies, we’d lose competitiveness, etc. To allow foreign branches … domestic branches here of foreign banks to operate in the US without the capital that is required of smaller US institutions seems to me to be about as an unlevel a playing field as we could have. And yet we’re not hearing anyone screaming about the fact that Deutche Bank’s US branches, Bank of Montreal, TD’s branches here operate with essentially no capital relative to US institutions, and therefore can acquire at more attractive terms. We haven’t addressed that and so this unlevel playing field notion, this competitive notion, doesn’t make a lot of sense.
On housing policy and the GSE’s; you know, we also have failed to discuss that the GSEs, if they had been kept to their charter and run for the purpose of their charter, to provide liquidity to the secondary mortgage market, they probably would have been run more like utilities. They would have retained earnings, they would today be adequately capitalized, they would not have actually been as relied upon to provide liquidity where liquidity was ample in the prior cycle. They wouldn’t have been able to use in portfolio as aggressively as they were for earnings management purposes, and we would be in a very different place right now, because after all now is the time that, theoretically, the GSEs were chartered to actually be able to provide liquidity to the secondary mortgage market when it disappeared. OK?
And that might be something we talk about and consider in terms of how to restructure — if there’s a social benefit to having a provider of liquidity to the secondary mortgage market — we may want to consider, "Should they have a very limited counter-cyclical role?" … where they’re actually building up enormous equity cushions, they’re dividend companies, they’re private, their portfolios are really reduced and we essentially take the portfolio side of the existing GSEs and put them into self-liquidating REIT structures, run them off. And that becomes another part of the discussion.
I would say that there’s other pieces here that we’re not considering that scare me in terms of the pulling away, and "How are we going to do that?"
I would think that we should start talking honestly about the fact that perhaps the worst impact of the housing side, not the market side of this crisis, may not be felt for another decade. Traditionally you took out a mortgage at the time you got married, in your early 30s. Traditionally you made monthly payments of principal and interest, the house was a forced savings plan. It was an illiquid instrument. It ended up at about the time you were retiring, you had a mortgage burning party, and you retired with your single largest asset for retirement and the single largest inter-generational transfer of wealth asset.
As the Baby Boom generation moves towards retirement, there will be an increased burden on the social safety net in this country, because our Baby Boomers are going to be retiring with less equity in their homes than any generation previously.
Part of that has its root in the 1986 tax code, which did away with the deductability of non-mortgage interest, which created great incentives, in combination with low interest rates, the liquification of housing equity. And so what we saw was the draining of home equity to maximize the mortgage interest deduction, where affordability was a problem. We, as opposed to having housing have incentives to save, we created incentives through perversion of the mortgage interest deduction, to extract home equity.
And we’re going to be living with that for a while, to the point where I think we should also probably be considering (and I’m working on a paper on this) reconsidering the mortgage interest deduction either allowing it to phase in, so that you don’t get the full benefit until 20 percent. … Or I would argue that we turn to reduce the impact of the social safety net problem, or we turn the mortgage interest deduction into an equity tax credit, that you end up actually getting tax credit for every dollar you save. Because it has social merit of reducing the burden on the social safety net.
I do think that we haven’t begun to really think about the structural imbalances. We haven’t begun to have an honest conversation about the capital structure and how losses should be apportioned.
The second you start talking about systemic risk regulator, we’re really saying that the government is going to [1:00:00] remain more deeply involved in the industry, because we need to have the bomb squads standing around the bomb, rather than dismantling it.
And unfortunately: can we? Yes. Do I see any will to pull back and reprivatize? No.
We’re not actually recognizing any of the losses. We’re probably actually only about half way through the losses in the market economy, and that’s not even considering the fact that we’ve got significant larger losses ahead in the real economy.
Alex Pollock: Thank-you all for a series of very interesting comments. I want to give the panel a chance to add anything, or react to each other. Maybe we’ll start with Jay and just go down the table if you want to briefly make additional comments or rejoinders on anything.
Jay Brinkmann: Not a rejoinder, but I’m sitting here trying to remember my bank regulatory history, and for some reason I’m thinking the Italian city states of the 1300s / 1400s and the first sign of government regulation of limiting the types of assets that those financial institutions could invest in, because it was recognized back then the important and unique role that banks played in the domestic economy, and that when one of them failed, it tended to have a much greater impact than the failure of a merchant or a restaurant or something like that.
So I think when we talk about systemic risk, when we talk about privatization, we have to realize that this has been an area that the government’s been trying to get right now, for hundreds and hundreds of years, and it’s not clear to me that any particular bill in Congress represents the solution as much as sort of one more forlorn hope into how to deal with this. That bankers fears to come[ph] will figure out some way to lose money and create these problems going forwards.
Alex Pollock: Thank-you, Jay. I’ll just mention as I have in some previous [tape-skip] speaking of limitation of assets, the National Banking Acts, in their original form of 1863 and 1864, prohibited the new national banks from having any real estate loans whatsoever.
And since real estate is generally tightly connected to financial crises, maybe they had something figured out. Bob.
Robert Eisenbeis: I had just a couple of observations.
First, I have a real problem with systemic risk as a concept. Usually when you yank a definition of systemic risk, it runs something like this: "Systemic Risk is a problem caused by systemically important institutions." Now I was always told that you shouldn’t use the word that you’re defining as part of the definition, but somehow that seems to be characteristic of how we define systemic risk.
And so until we come up with a better definition I don’t think we should create a regulatory body to deal with it.
I would argue that we should have a simple goal, and that is to make the failure or closure of an individual institution an individual isolated event. And that’s what was terribly wrong with the TARP. It tried to hide the bad apples among the good. It was the same thing that Paul Volcker did when Continental Illinois failed. First thing he did was to get all the major money institutions to lend money to Continental Illinois. That’s not the way you create independence of failure. So that should be the objective.
I’ve got one question for Josh, and that is — If I heard you right, you were suggesting that it really makes a difference in an institution, not only the amount of capital that it has, but where it’s housed. And that I don’t understand, and it seems to me capital is capital, and it doesn’t matter where it’s housed.
Josh Rosner: I wasn’t talking about where it’s housed.
Robert Eisenbeis: Well you were talking about having capitalization in a branch, and I don’t know what capitalization of a branch is. I mean, if an institution has capital, it either has it or it doesn’t. I’m not sure where it’s located makes a difference.
Alex Pollock: Why don’t you answer that, Josh? Then we’ll go to Mark.
Josh Rosner: … So the point of that really is, Bob, in a crisis, in a cross-border crisis, what you end up with is the understanding that where a domest- a US branch of a foreign bank ends up in a capital problem, the regulator … will direct that branch to call home and say, "Downstream the money to the US branches from home country." The home country regulator may actually find that the home country institution has capital problems at home, and therefore may not want the capital to cross borders, because they want to keep it at home for the holding company. Which is– we actually saw in this crisis.
Alex Pollock: OK, Josh. Mark?
Mark Olson: Well I have two [1:05:00] observations, one of them getting back to the systemic risk point. And I have … Let me just relate to you two experiences.
A little different perspective from what Bob, just because I really think that the ability to … we do have the capacity to see certain elements of risk coming on. Now we can’t define at the front end what they’re going to be, and let me give you an example, and this is the subprime mortgage market.
We had, and everybody in this room knows it but I’ll just go over it very quickly. It was the perfect storm. You had global pools of liquidity, low interest rates, which had the combined effect of allowing for an increase in housing values, rapid increase in housing values, because of the fact that you could buy more house with the same … with the same payment. And a secondary market that had developed for the non-conforming product.
In that environment, also, with the global pools of liquidity and a low interest rate environment, there was a huge premium for 25 or 30 basis points of interest rate. And we saw, very clearly at the Fed, that combination. And one more element to it also. One more element was that the … because mortgages were being originated and sold almost exclusively, we lost the discipline at the front end of the process, particularly on that non-conforming product.
So what we saw was the complete mispricing of risk. And it was so clear.
I remember we would have people from Jay’s organization come in, and we’d have a number of others, and we’d talk about the development of the subprime … or all of the fancy mortgage products — the Alt-A products, and the no-doc products, and the teaser rates, and bankers first came in and said, "We’re not offering teaser rates." Six months later someone would come in and say, "Well, we’re offering teaser rates, but we’re not underwriting to the teaser rates, we’re underwriting to the full phased-in rate."
And then pretty soon they were coming in and saying, "We are underwriting to the market." Which means that the market … whatever the market would purchase that they could originate and sell.
Now what we didn’t know, and we couldn’t find out exactly, was where all of that risk was being housed. We were … we thought we were keeping most of it off the balance sheets of banks, because that product was not being originated and putting on the banks’ … on the banks’ portfolio.
I can’t tell you the impact it had when I heard Bob Rubin, one of the smartest people who has ever been in the financial services world, saying that as a Vice Chairman of Citicorp, he didn’t realize that while they had shut it down on the mortgage side of the portfolio, they were buying that same product on the investment side of the portfolio.
If we would have had the capa– … if we would have thought as a central bank that we had the capacity to explore that question in greater depth, and I think everybody in this room knows what would have happened to the Fed if they would have said, "We’re going to exert our authority on housing far beyond what the Congress has had in mind for us." You know where that would have led, and we knew where that would have led, so we didn’t go down that path to any extent. I think many of us would regret that we didn’t, but at least I certainly do. But there is a … We do have the capacity, I think, collectively, to identify and define systemic risk on an episodic basis.
On the other side, you remember … I remember very clearly, not long ago, when Tim Geithner was still at the New York Fed, and Bob, I’m sure, remembers this. When it became clear to the New York Fed and others in New York that we had a very aggressive explosion of derivatives contracts, and a back room where the clearing and settlement of derivative contracts were done apparently on the back of an envelope and in orange crates and the like. And a number of people in New York, including some of the key investment bankers, and I think orchestrated by Tim, got everybody in the room and said, "We’ve got to fix this right now, or we’re going to have a systemic meltdown."
So there is the capacity, I think, to address some of those systemic issues … some of those issues. I’m not sure what now … I’m not sure and I’ve no particular confidence in the manner in which Congress is addressing it, but I really think it can be done. And I really think that that’s one of the … one of the gaps that we collectively ought to take a look at.
John Rosner: A couple of observations. First, [1:10:00] I don’t think that they actually did fix the derivative clearing issue. I think they came to an agreement to agree to fix it. And there wasn’t actually all that much done, other than a general agreement, and that was that Corrigan-led process.
That the regulator actually could see it was an ongoing discussion that I had, and actually it’s part of the reason that Alex pointed out early conversations he and I had.
I was in DC banging my head against the wall because I was screaming to those exact regulators about where the risk was, and that they did eat it. And for regulators actually to exist in a world where they can say, "We didn’t know that our institutions actually held the risk, still," really speaks to part of the problem here.
I would also agree, though, on the other side, that even if they did identify it, there would have been push-back from the political side, and we saw this in terms of Fannie and Freddie. OK, every time that someone actually did, at OFHEO, try and do something (and I’m not suggesting that they were an effective regulator [laughs]) but every time they did try and do something in the name of safety and soundness, it became a political process where they were tasked or argued to be trying to destroy or harm housing policy and the increase in homeownership.
And that was frankly part of the driver of Fannie & Freddie’s reduced underwriting standards. If you were to remember, Fannie and Freddie’s original automated underwriting system was investigated by Department of Justice to see if it was actually unfair to certain borrowing groups, and they were forced to settle with the OJ and actually reduce underwriting stardards.
Right or wrong, every time safety and soundness becomes an issue, policy ends up interfering with regulation. Which is another part of the reason that we really need to think about how we structure … [crosstalk]
Alex Pollock: We’ll move on … I think a theme we just heard is how since in the crisis, finance becomes political finance, or ever more political finance. In answering the question, how do we get out of the nationalization of the financial services system, at least in very large part is politics, looms very large.
Let me just ask one question to the panel, which involves that political issue. If we do a lot of the things that have been suggested, move toward privatization, it seems to me that of necessity the price of credit will go up. That is to say, that if you put into the interest rate on assets a true measure of the riskiness of the asset, you put into the interest rate on assets a larger capital requirement.
If, to be specific, the Federal Reserve stops buying MBS and says, "Well let’s see if anybody else wants to buy them," price of MBS goes down, the [mortgage] interest rate goes up, and one of the major drivers, as it seems to me, of all intervention is the attempt to keep interest rates and the price of credit down (on the part of politicians in the government).
So are we faced, as we try to reprivatize, with the following problem:
To the extent we succeed, the cost of credit must go up? … and that will be politically unpopular. Do you agree with that, or is my logic wrong somehow?
Mark Olson: … ah, yes. But there’s another element to it, and I’m equally concerned about this.
I think … What has happened. If you look at it from the … If you go back over like a 30 year period in the development of financial products, it seems to me over a 30 year period the overwhelming winner has been the consumer. Because in a consumer financial products are becoming … the credit process has becoming increasingly democratized. It has become increasingly race-blind, gender-blind and age-blind. And we have developed products that have been available to more people.
And so I think if you look at it … And a significant part of that is the … is the ability of the marketplace to deliver products more efficently. Take the mortage product for a while. The mortgage … that had been described earlier was the one that had been originated by a financial institutions, kept on that book and serviced on that book during its entire life.
We now have origination, servicing and holding of that mortgage to maturity and it’s three different products, three different products that are separately priced. And as a result of that it has … there’s a lot of efficiency added to that.
I’m afraid we might lose something of that in the name of cutting down what I think was terrible, the excesses that occurred in the market and the people that were hurt by it.
… [1:15:00] I think it’s important that we try to address both of those iss– both the costs of regulation and the cost of stopping at some place the increase in efficiency and product innovation.
Alex Pollock: We could have a lot of fun talking with each other, but we’re going to open the floor to your questions. We have a microphone in the back here. Let me remind you of how this works. When you are ready … when you are called on with your question, please wait for the microphone; please give us your name and your affiliation, and your question. If you feel unavoidably compelled to make a statement, or an assertion in addition to a question, keep it short or I’ll have to remind you that it’s time for your question.
I’m going [laughs] … I’m going to start here, please, and we’ll move across this way.
Peter Whitney: Peter Whitney at Duke University. I have a question for Bob. I liked your point about letting failure be independent. What would you have done if you were Hank Paulson last year? And what do you think might have happened? I’m fascinated by your comments. Thank-you.
Robert Olson: That’s a fair question. One of the problems that I think surfaced was the uncertainty that the Bear Stearns, Lehman and AIG sequence caused. And if you look … I think that was a watershed event in the following sense: that if you look at what happened to business and consumer confidence and consumer spending, consumer confidence and business confidence actually had been improving for several months. And at that time, at the AIG time, consumer confidence and business confidence, particularly small business confidence tanked. And I think that was a significant factor in helping it transfer the uncertainties in the financial sector into the real sector.
So I think they should have had a better policy for dealing with the AIG, the Lehman Brothers and Bear Stearns. What they should have done to begin with was had a plan in place, once the problems in a Bear started to emerge, in advance. And this was no secret. Bear Stearns was not a liquidity problem. It never was a liquidity problem and we lost a whole year because they misdiagnosed the crisis as a liquidity problem when it was a solvency problem.
And so I think they should have asked a different set of questions rather than reacting to the immediacy of the particular event. And that is — Why are we having this manifestation of a liquidity problem? I think they misread the problem, and as a result they got trapped into making the wrong … If they had diagnosed it correctly I don’t think we would have had the same situation.
Now going back, I think they should have treated all three of those firms the same, either let them all go, or rescue them all. But you can’t see-saw back and forth.
Alex Pollock: OK, …
[crosstalk -- Pollock puts audience response on the record just below]]
Robert Olson: … Oh I think that was a terrible mistake …
Alex Pollock: … excuse me, let me just state the question on the record here, and this is the only second question that you get. The question is what about the TARP? How does that fit into what you would have done if you’d been Secretary Paulson?
Robert Olson: Well, … As I tried to say, the TARP was a situation where they tried to hide the bad apples among the good. I think they should have used the TARP in the same way the Bank Holiday was used, and that was to to essentially separate the good from the bad, and that would have forced the loss recognition much quicker, and that’s what I would have done.
Alex Pollock: OK? Question here? Gentleman right in front of you. Thank-you.
Steven Lee:: Hi. I’m Steven Lee from Global Client Consulting. I just, to full up on the point that was made regarding other Fed purchases of MBS and other assets.
Now this seems to be a [1:20:00] policy action which potentially have a significant other costs. What are the costs tp society and the others? I mean there is a moral question as to the validity of diluting the values on things like savings, etc.
I’ve caution that one of the things which the easy money policy has done is to dilute the distant[ph - future?] value of debt. Now as a whole making it easier for some of these assets to go away.
So the question is that, … If this was to continue, is this something that will really be good for the society as a whole? or, … What are some of the other considerations that really should be considered before this embarking on this easy money policy?
Alex Pollock: A volunteer for that one? You want to try it? …
Jay Brinkmann: I can talk about some of the techincal market aspects of it, but I think in terms of the overall Fed approach, and societal impact and money supply, that is … perhaps I can defer to the former Fed Governor, if he would want to comment on it [laughs] …
Mark Olson: Ah, Bob is the macro-economist, but let me give you my take.
I grew up in the … I guess the post-Depression environment where we in this country and people of my generation, certainly my parents’ generation, were willing to support almost any policy that would keep us from another Depression. That was the mentality.
There were many, many years, I think, in the US where inflation was not only tolerated, and at times encouraged, and we certainly did not have an anti-inflation mentality in the US (much like they had, for example, in Europe and other parts of the world that had seen the ravages of inflation) until the late ’70s, early ’80s, where we first felt the ravages of inflation and Paul Volcker was instumental in unwinding that.
I think there are two things that we’re trying to … that monetary policy tries to achieve. Number one of it is maximum performance of the economy over time (and cost of capital has an impact on that) and guarding against inflation. So you have to do two of them simultaneously.
And I think in terms of the limited opportunity that money has– that monetary policy has to impact the economy (and it’s more limited, I think, than is … it is widely recognized) I think at this particular point in time where there’s a tremendous … where the economy is so soft and … I think the Fed has the right policy of maintaining a low interest rate. And I think that Ben Bernanke is conscious of the fact that that was one of the fundamental errors of the post-Depression era, when there was a … when there was a concern about cutting off inflation too early, that I think it caused a real contraction of the economy.
So I think that to the extent that you’ll see monetary policy impact on that, you will see a low inflation environment until they start to sense inflationary pressures that perhaps need to take a change in that approach.
Bob, I think, as many of you know, was the economic advisor to the President of the Atlanta Fed for many years. You may have a slightly different impression.
Alex Pollock: Good comment, specifically on the Fed buying MBS, Bob, if you will.
Robert Eisenbeis: Well first of all, I think the Fed kept interest rates too low for too long coming out of the 2001 recession period. And at the same time, there was the politics of housing, because housing was what was driving part of the economic recovery.
Now what concerns me about the MBS is the fact that … Someone said that the Fed now has virtually 100 percent of the market. If the Fed has 100 percent of the market, there is no private sector alternative going to step in, because no private sector can fund the purchase of MBS by creating money the way the Fed can.
So waiting for the private sector to come in and pick up the slack is like waiting for Godot.
Alex Pollock: I had a question here …
Jill Naamane: Jill Naamane from the GAO. [1:25:00] In other countries that have nationized banks or made significant capital injections in the banks over there[ph], what plans or discussions do these governments have for reprivatization, if any that you are aware of?
Alex Pollock: Josh?
Josh Rosner: Yeah, I mean there’s not much. That’s actually just a …
The plans at this point, as we’re seeing in Europe right now is the three of the largest banks in Europe are about to be chopped up into pieces: KBC, Lloyd’s, and I think that’s the approach that we probably end up at some point having to come to. I don’t know what gets us there.
Alex Pollock: That succeeds in repaying the investment of the government, when that happens?
Josh Rosner: It depends on how high in the capital structure you’re willing to actually force losses.
Alex Pollock: I want it go all the way to the back? The gentleman with the beard, far in the back.
Bert Ely: Bert Ely, banking consultant. [laughs] First time I’ve been called upon that way.
You know, one of the things that we saw in the recent crisis was a lot of maturity mismatching, particularly in off-balance-sheet vehicles, SIVs and so forth. And of course that’s very reminiscent of how the first S&L crisis arose — again, maturity mismatching. It seems to me that maturity mismatching is a fundamental in the financial markets, because a positive sloping yield-curve incents folks to take a gamble on rates.
As it relates to housing, to what extent might we be able to, shall we say, reduce the amount of maturity mismatching that goes on in housing finance if there was a development of a covered bond market in this country? Because one of the thing about Europe, and of course its very successful experience with covered bonds, is … Covered bonds tend to be of longer maturity, much more closely matched with the maturity of the mortgages, so that you eliminate, or greatly reduce anyway, the liquidity issues that arise when you have severe maturity mismatching.
And by the way I have a piece of good news for you with regard to politics and the Fed maybe being reluctant to crack down on the mortgage market. When we get this new CFPA, Consumer Financial Protection Agency, that’s not’s going to be a problem. They will not be impeded politically at all to do the right thing. [laughs] Correct?
Alex Pollock: Thank-you Bert. How about covered bonds and its roll in the future mortgage finance system, or perhaps even in addressing our agency issue of reprivatatization? Jay? Bob, go ahead.
Robert Eisenbeis: Yeah, I’d like to make a couple of observations about that, and then I’ll turn it over to Jay.
The maturity mismatching point was … is a good one, and it’s really rampant, and it was rampant rather in AIG, because AIG, through its securities swap program — securities lending program, essentially used 1 to 3 week money to buy 5-year MBS. So that’s an extreme case of maturity mismatching along the problems you said.
One of the problems that generated the huge increase in these mortgage-backed securities was the fact that there was a big demand for triple-A rated securities, and the mortgage-backed securities provided a way to essentially create those investments.
I don’t know that covered bonds are going to be an issue. Insurance companies are the ones who have the long-term assets, and they were the ones that were investing in the mortgage securities in the first place, but they devised a way to take huge … unwind that by the way they took their interest rate risk exposures.
So I don’t know where the demand for covered bonds would come from sufficient to meet the mortgage demand problem that we’re talking about, if that friction were put in place.
Alex Pollock: Jay? Covered bonds?
Jay Brinkmann: Yeah, I think covered bonds in general are a good thing, but they do use up a lot of capital. And so I guess the question is in a capital constrained system that we have at the moment in the financial institutions whether or not they’ve got the capital to support a program of the volume that would be needed.
In terms of the maturity mismatching, I guess one of the advantages of the Fed buying all these things is I don’t know the Fed has to worry about maturity mismatch, and at least at this point.
But actually you bring up a point with the Consumer Financial Product Safety Commission. When you look at mortgage structures in other countries, [1:30:00] for example, I guess, the Canadian system, which is essentially is a series of 5-year balloon mortgages, then that have to be renewed. To deal with some of that maturity issue so the financing is limited to 5 year periods. It’s not clear to me that any of those mortgages would survive surveillance by the new consumer financial group, because they’re not fixed rate 30s.
So I think … You know, when you’re shifting interest rate risk sort of away from financial intermediaries who supposedly know what they’re doing, or at least saying whether or not you’ve got sufficient long term investers to invest in long term mortgages, and shift that risk over to consumers, there’s another series of problems that come up.
Alex Pollock: Jay, let me remind the audience that we will be having a conference at AEI early in next year comparing the Canadian mortgage finance system with the US system. Question here …
Andrew Parmentier: Thanks, Alex. Andrew Parmentier, Managing Partner in Height Analytics. I guess my very short stump statement would be that I don’t agree that we have to go down the ING, Lloyds path, where we have to make all the wooden blocks the same size. I in fact don’t think that that’s what’s going to happen here in the US.
What I’m really surprised that nobody’s brought up is the idea of CoCo’s, contingency capital,6 [but appears to be more often termed contingent capital, see below] convertible debt instruments that not only Mervyn King is talking about, but also Bill Dudley. We have banks at the Treasury Department day in and day out talking about this.
To Mr. Olson, to you point about getting out from under the thumb of the government and TARP, how does a Wells Fargo that owes $25 billion and also has to save capital going into whatever the new capital regime that we’re going into is; how do they achieve that without something to facilitate that capital regime? Because I don’t know that the market wants to know or expects dilutive capital to come.
And I guess my real question on the CoCo’s is — If they were to materialize, would it be viewed by the Fed as Tier 1 Capital, and could it be used, could the proceeds off of that issuance be used to repay TARP, theoretically?
Alex Pollock: … I heard two questions there, one is about Contingent Capital. Let me ask Josh to comment on that, including defining for the audience what it means; and then Mark, you can take up the Wells Fargo Question.
Josh Rosner: Well, contingent capital has become sort of the next mantra of, you know, "Let’s play hide the — whatever we want to call it." It’s a proxy for equity capital, and it’s not equity capital. It’s debt until we theoretically will need it to convert, which when it would convert to equity. It’s a theoretically preordained ratio.
The problem is that the truth is there’s no substitute for equity capital. And we’ve got an undercapitalized banking system. We’ve seen the stock market run to 10,000 and rather than force banks to raise real equity (we forgot to do so), and we’re now talking about contingent capital, which is problematic for several reasons, and I’ll just give you the two most obvious.
We saw trust-preferred securities, which actually were similar to contingent capital. They were neither equity nor debt, they were a hybrid instument that could count — did count — as Tier 1 equity capital. The problem with trust-preferreds was that the banks all invested in each others’ trust-preferreds. And so the notion of conver– of convertability became a non-starter, because you’d end up having a wipe-out — in wiping out one bank, all the other banks.
So that was problem one. Problem two is … Can you imagine us getting to the place where one of these too-big-to-fail institutions was told that it was time to convert this debt to equity? They would essentially say to the regulators (and if they couldn’t get the regulators to agree, to Capital Hill), "If you convert us, it will create a systemic crisis and a liquidity event, because you’ll be telling the world how sick we are." In which case it would never convert.
Alex Pollock: Let me just add that in a marked-to-market world these is presumably a terrific mark …
Josh Rosner: That’s right.
Alex Pollock: … at the point of that conversion. Now I want to ask, speaking of "mark," Mark to comment on the Wells Fargo question, and then Bob has a comment on that contingent capital.
Mark Eisenbeis: Well, more broadly, I think that there are … There’s one question as to what the regulators would consider to be Tier 1 capital, or appropriate capital, and my first reaction to the CoCo’s is exactly as Josh said, is this a successor [1:35:00] to trust preferred, that it will … or look look like the panacea for a period of time, and then not be.
But I think the broader question, I think even beyond what the regulators think are appropriate … I’m hoping that we will come back to an environment where there is a tighter correlation between regulatory capital and economic capital. And if we can get to that point, that will, I think … should be the ultimate determinant.
No in terms of what … how I see the market today, I think the market is saying, "The only thing that we are trusting right now is tangible common equity, and anything beyond tangible common equity is suspect." So I think that a Wells Fargo is going to have to make the case to the market as to what– on that basis. That is my current impression.
Alex Pollock: Bob?
Robert Olson: I think contingent capital is the latest pig in a poke, for a couple of reasons. First of all, there are really only two kinds of liabilities in a financial institution. That which is guaranteed, and that which is available to absorb losses. We don’t know what’s available to absorb losses now, because of the policies that have been put in place. That’s the fundamental problem. That’s why the only thing that people trust is real equity, to begin with.
Secondly — Who gets to determine what the trigger is? If it’s the regulators then you’ve got the forebearance problem and all the rest of the kinds of issues. If you have a market trigger, there will always be some reason to say, "Well, the market is forcing us to mark stuff down, and that’s artificial, and so we’ll get a change in the law, to change the underlying nature of the conversion."
The only way contingent capital makes sense is if you regard it as a form of early resolution, in the sense that it enables you to wipe out the existing equity holders, substitute a new class of equity holders without closing down the institution. But I don’t know of any of the contingent capital requirements / proposals that have that feature embedded in them.
Josh Rosner: The reason is because the cost of issuance would be prohibitive, no one would buy it.
Alex Pollock: Can I have a question here? … Hang on just a minute for the microphone?
Andrea Psoras: Hello. Andrea Psoras, and I’m a bank analyst from New York. And I don’t want to make a statement, necessarily about how much production we’ve offshored, which has put an increasing concentration of the power of banks in the United States, but speaking to the point of where … Although we have great credit products now for the block-and-tackle Americans, we’ve got a decreasing wealth effect.
So we have a lack of the breadth of wealth, and depth of wealth across middle class America, and I think that’s actually in a way … I wouldn’t call it a coincidence.
And then we’ve known from Brooksley Born, and speaking again to the power of banks, but where the Fed seems to have only seen the systemic crisis coming out of left field, I think people like Brooksley Born early on, when she was, like, Clinton’s or somebody’s CFTC Chairman, called out over-the-counter derivatives for what they were, and that was they were going to be … a problem. Wherein that they not … these instruments not clearing were going to in time cause a problem, and Robert Rubin had the power as the Treasury Secretary, from after having left Goldman, to get the legislation that he got after that plumed[ph] these instruments.
So, without checks and balances, so speaking now to the … where we have to, in a way, rein in banks, because the Fed and OTS and the OCC, which are all politically manipulated organizations, and the power of campaign contributions, if not to buy influence in legislation in Congress in turn. These major banks become employers to the regulars, so …
Alex Pollock: OK, we’ve got to stop there, and I’m going to take that as a question about how do we (in the reprivatization), how do derivatives fit in, and this notion of a putting derivatives on exchange, one, and then see if anybody else has comments on the consumer income, OK? Josh? Do you want that?
Josh Rosner: Yeah, I mean, I think the whole derivative thing has been made actually artificially complex. Obviously we’d like to move things towards standardized products. I think the more standardized products, the less bespoke product you have, the easier it is to see price and value converge, which after all price and value, we’ve forgotten somewhere along the line, and they’re two different things.
And moving to a market or an exchange helps that convergence.
And I think that that actually, the definition of a price bilateral margin. Both parties [1:40:00] need to actually put up margin.
The margin rates end up being determined over time, but I think that’s actually where we have to go. I don’t think that it’s a lot more complex than that.
Alex Pollock: Anybody else on politics and banking?
Robert Eisenbeis: Well I’d just like to echo what Josh said as relates to the derivatives thing. I think putting the derivatives on an organized exchange, where the deriv– where the exchange is the intermediary essentially eliminates that systemic interrelationship, and that’s … We should be looking at instruments with that perspective in mind.
Alex Pollock: Other questions here? … (wait for the microphone)
Bill Coleman I’m Bill Coleman. I’m a partner in O’Melveny & Myers. I’d like to ask three questions:
- When has the federal government ever done anything in banking which turned out to be successful? [laughter]
- I don’t understand why you didn’t at least suggest what JP Morgan Chase did that apparently got out of the box without the government really helping.
- Perhaps if Hank Paulson had stayed in, we wouldn’t be in the problem we are now.
Alex Pollock: Tell us your second question again? We’re having a little trouble hearing. Is that microphone working? … OK …
Bill Coleman The 2nd question was that Chase, JP Morgan Chase, had difficulties. It got out of them pretty soon, and seems to be on the right track.
- Fourthly, if you look at the automobile industry, all of them took the money but Ford Motor Company. Ford Motor Company’s doing better than the others, and it just set up a big operation in China, and doing quite well in the United States.
Alex Pollock: OK? …
Mark Olson: First of all, Mr. Couturier[ph] it’s very nice to see you. [crosstalk ... laughter] Well, a couple of things. … First of all, something we haven’t talked about here, but if you talk about the winners and losers in the financial markets, and I suspect in the general economy, the fundamental difference is management. There are huge differences in the quality of management. There are some financial institutions faced with identical kinds of circumstances, some of them managed well through it, and some of them didn’t.
I’m sure many of you have heard anecdotes, and I have heard anecdotes, on … in those directions, but I think that that is the case.
Now where the government has been successful in banking, I’ll have to think about that one and I’ll have to get back to you for a while, but I think that that would … And the case regarding Ford Motor I think is really an interesting case, too, as to how that differentiates itself. I know a lot less about the management of the automobile industry than I do about the banking industry, but there is … When the history of this time period is written there will be, I hope, the people sort out the differences in how some institutions were managed vis a vis others of similar size and of similar product mix.
Alex Pollock: Any other comment?
Josh Rosner Yeah. First of all, I think it’s interesting when you talk about the autos, and it is to a management point, that there was a company that was essentially forced to … management was forced to take actions that it didn’t see in the best interest of its shareholders, and Rick Wagoner seems to have left on that basis.
So where we talk about the banks having been forced to take money under TARP, there was already an already existing example of a management who said, "No." And that was part of the Ken Lewis problem in terms of the management.
Now I’m not sure, by the way, that in the revision, or where we stand now in terms of the difference in managements, that JPM really did get it that much better. I think their problems happened earlier. I think they pulled back when they saw their problems happening, from especially in the subprime market.
And then the other piece is on the derivative exposures. You know, every bailout that we did ultimately made them more capable of standing up and saying, "We’re solvent." Which is another piece of the equation that I think we should discuss.
Mark Olson: There’s one other point I’d like to mention, and that is — There’s a tendency to talk about the problems in the financial services industry as a banking problem, but if you look at (and there’s a very interesting chart in the October 2007 Bank of England Financial Stability Report that shows the pattern of the origination of [1:45:00] non-traditional MBS.
And the dominant originals, originators, were US investment banks, not commercial banks. And the second biggest issuers were foreign banks in Europe and the UK. The third, the bottom tier, was US commercial banks. This is not a banking problem, per se, it was a problem in investment banks.
Alex Pollock: However, the commercial real estate bubble is a banking problem. And we’re also living through that.
I’m trying to think of the answer to the question of what the government did well in banking. I think the old payroll deduction for savings bond program [laughter] would qualify, and there … Mark made a point before, and I think Josh as well, about savings.
A lot of Savings & Loans have changed their name to "Bank," of course, but if you think about the old name "Savings & Loan," what happened in the public policy of the United States is we forgot about the savings part. All of the emphasis went on the "Loan" part, on making the loans cheaper, making the loans, quote, "more accessible," and we completely forgot about what in the minds of the originators of the Savings & Loans was very clear, which was first came savings, and only then came loans. … Other questions? Michael.
Michael [last name not announced, hints appreciated 
]: I just want to make sure that I caught the tenor of this panel right. It seems to me that Alex is right that this is now "political finance." There is only one answer to the question of this panel, and it has to be "No." Right?
It’s … Look, the system came to a brink, and you’re now living in a mixed economy, and in response to a crisis that brought us to the brink, it is doing precisely what brought us to the brink, except on a larger scale, right? It’s keeping credit cheap, and creating more moral hazard, more GSEs and so on and so forth.
Why isn’t the most likely scenario (and I just want you to give me odds) that the system will do the same thing until it finally encounters a crisis with which which it cannot cope?
Alex Pollock: Very good question, and who want to take this …
[crosstalk]
Robert Eisenbeis: … You’re exactly right, and that’s why I put in my slides the fact that you have to deal with the issue first and foremost of what you think the future landscape is going to look like from a competative situation.
If you don’t have that model, if you don’t have an answer to that question, the scenario that you are articulating is the most likely one to occur, I’m afraid.
Alex Pollock: Mark?
Mark Olson: Fif– [tape skip] years from now people in power, people in positions of authority want to be recognized as the next FDR, not the next Herbert Hoover. [laughter] Just to put it real bluntly, Herbert Hoover, one of the most misunderstood policymakers in history, I think.
But there will be an activist response. Now we can … If you ask me what’s going to happen between now and election day, I’ll … Two things will happen. There will be a bill, and we will have a new Agency. And all of our … all of our responses to previous economic crises have ended up with that sort of a scenario. So that is what I think will happen.
Josh Rosner: I would point out two things. One, as Bob highlighted, while he put his point first, which I think is a good point, that’s why also put — Take losses as the first thing we need to do. So that we know how much we need to print, otherwise we are actually causing further distortions.
I’d also throw one light of optimism here, which is that there is an entirely vibrant financial service industry in this country, and that’s the buy side. It is flush with capital, it has become over the past cycle effective allocators of capital. It has actually turned the traditional bank into little more than a utility, OK?
And that’s part of the problem. That’s why the banks have been sceaming for leverage is because they’re actually not efficient, and they’re just a balance sheet to lend. And unfortunately I don’t think we’re contending with that, so I think that we’re blowing up to recapitalize and reinflate the side of the industry that really doesn’t matter as much anymore, which is creating the distortions that …
I think you’re right, we’ll end up right back where we just came from.
Alex Pollock: OK Jay, I want you to weigh in this on mortgage mortgage finance in particular. [1:50:00] … Are we going to get to the reprivatization, or, as Michael suggested, just to the expansion of more of the same?
Jay Brinkmann: I think a lot will be determined over the next 4 to 5 months, that some interim steps need to be taken by the Obama administration. We haven’t had any signals from them as to what direction that will be, and I think that will then tell a lot as to whether or not they will put in place[ph] …
Alex Pollock: … We’re talking about mortgages. … signals on mortgages …
Jay Brinkmann: … Talking of mortgages, signals for the GSEs and what they perceive with mortgages, and what the answer is as to whether or not they see as an interim step to sort of deal with some of the immediate problems, and then say that perhaps Fannie and Freddie, if we had actually had some of the regulation proposed back in the early part of this decade or that, if that had been in place we wouldn’t have had these issues. Why don’t we simply go back to that? And then we’ll be back to this goal of low-cost mortgages.
In terms of the cost, I, you know … We look at whatever the number ultimately ends up being, whether it’s $150 billion or more that’s put into these companies, that sure tells a lot about, I think, the mispricing. Now some portion of that goes with the portfolio losses, but I think that also on the credit side speaks to the miscredit, mispricing of credit, that took place.
And I think any model, any proposal in dealing with mortgages that doesn’t recognize what the ultimate true cost of those mortgages originated over the last 5 / 7 years, etc. really was, you can’t then look at any new proposal coming forward as being, "Gee, that’s going to cost too much." Well, the real cost was a lot higher.
Alex Pollock: Any other questions? I have one in the back here?
Nils Remmel[ph] Hi. Schnitz Remmel[ph] from Switzerland, University of St. Gallen. You just mentioned the risks in the commercial real estate sector, which seems to be mostly beyond the regional level, so could you just comment briefly on the prospects and the risks in the regional banking sector and maybe scenarios how you see these evolving, given the economic impact. Thank-you.
Alex Pollock: Well I’m the one who mentioned the regional banks. If you … A statistic I have shared at a previous conference is that if you take the banks in the United States whose assets are $1 billion or less in each bank, which is the vast majority of banks (that’s about 6,500 of the 7,000 commercial banks) and you add up all their loans, 74 percent of the total loans are real estate loans. I think that’s all you need to know to work out the answer to your question.
And by the way, St. Gallen is a favorite city of mine.
Any other questions? … right here …
Benjamin Nefussi: Benjamin Nefussi, French Embassy. I have a question about the Fed. We have moved maybe from a Fed that takes care about inflation and employment, and now it seems that the Fed takes into account many, many different rates, many different segments of the financial markets. Do you think we’ll have … such this move in the future, will you think the Fed more takes into account asset prices or … what do you think about that?
Alex Pollock: Mark?
Mark Olson: My strong sense is that the Fed Board was invoking … which is the fundamental role of, I think, the central bank, to be the lender of last resort. And that’s … I think that is the role in which they saw themselves, and with the emphasis on "last resort."
I don’t think that Chairman Bernanke, or any of the other mix of the current Governors are looking to fundamentally expand the footprint of the Fed by moving in those directions.
And I know that Ben in particular, and I think Don Kohn and the whole group of them have looked at that role in comparison to the way some of the other central banks have used that role — Bank of England for example, or the European central bank.
And I think that it was the judgment that was made (and I think on balance it was the right judgment) that the lender of last resort needed to be very aggressive at that period of time. You needed … They needed to come in and they needed to be aggressive and they were.
I think actions will be examined very carefully for many, many, many years. But I think that they were aware that that was the case, and they decided that if they were going to sin, [1:55:00] they were going to be sins of commission, and not sins of omission.
Robert Eisenbeis: … But if I could add one point to that, I think one of the real questions in the immediate future’s going to be, "How do you define Fed independence?" What’s going to be the future role of that; that Congress is going to be looking at, "Gee! The Fed now has all of these tools at its disposal. What should be the role of Congress in determining how these tools now are deployed in the future for projects that we think are important." And I think that’s a real danger that the Fed’s going to be facing in the years to come.
Alex Pollock: One of our panelists has a question.
Josh Rosner: It’s nicely off that comment, which is, … I think everyone would understand that interest rates are probably, on prime mortgages, should be about 50 basis points higher if it wasn’t, or more, if it wasn’t for the Fed purchase. They’ve already extended their mortgage … the MBS purchase program from the end of this year to the end of March of next year.
Do you expect, or what does anyone think the likelihood of them extracting themselves from that program at that point is? … Or do we extend them?
Alex Pollock: Since the panel isn’t answering, [laughter] how many people in the audience think that the Fed will allow its MBS purchase program to expire at the end of this coming March? … How many people think they’ll extend it? … There we go. … OK, we have one, now, final question right here. … Bob.
Bob Long: Bob Long, President of Ariba Asset Management. There doesn’t seem to be a short term answer, so may I ask a longer term question? Has anyone thought about the demographics of 75 million Baby Boomers who are transitioning from spenders to savers, and could that be a long term positive to end the meeting?
Robert Eisenbeis: I’ve thought about that, and essentially, what it means is that we’re in the midst of one of the biggest wealth transfers that’s ever taken place in history, I think. In the next couple / three years we’re looking at something on the order of $7 / $8 trillion that’s going to change hands from the parents of the baby boomers to the baby boomer people.
So it’s not only are they moving into the period of time when they’re going to move from borrowers to savers, but they’re going to have a huge amount of wealth to save.
That says that there’s potentially a lot of funds there, but it’s … I’ve argued in the past that what that means is that financial institutions are going to have to make money on the liability side of their balance sheet if they’re going to service those people, rather than on the asset side of the balance sheet, which, of course, is good for money managers, on the other side too.
Alex Pollock: All right, we have reached the hour of our adjournment, let’s show our appreciation for an excellent panel … [applause] [1:58:03] (end)
[1]: "Is It Possible to Reprivatize the U.S. Financial System?", AEI event homepage, November 12, 2009.
[2]: "Reforming the global financial system" (PDF), by Mark Carney, BIS, October 26, 2009.
An integrated approach to return risk to the private sector
The financial panic required a bold response. While absolutely necessary, the response has profoundly shifted risk from the private to the public sector. The expedient should not become permanent. Risks must be returned to and, borne by, the private sector. However, this can only happen if banks are resilient and if markets are built on solid foundations.
[3]: "Reprivatizing The GSEs?" (PDF slide deck), by Jay Brinkman, Mortgage Bankers Association, November 12, 2009.
- Title
- Reprivatize the GSEs?
- Seeking the Right Balance – MBA’s Plan for the GSEs
- Core Secondary Mortgage Market: Recommendation
- The Problem – How Do We Get There From Here?
- Addressing Investor and Borrower/Originator Demands
- Key Aspects of the Plan
- Core Secondary Mortgage Market: Recommendation
- Core Secondary Mortgage Market: Current State
- Mortgage Credit-Guarantor Entities (MCGEs)
- Federal Government Guaranteed “Wrap” (GG) Securities
- Regulator
- Similarities/Differences Between Recommended and Current Models
- Similarities/Differences Between Recommended and Current Models (continued)
- Transition
- About MBA’s Council on Ensuring Mortgage Liquidity
- Membership: Council on Ensuring Mortgage Liquidity
[4]: "Is It Possible to Reprivatize the US Financial System? Or, What’s the Exit Strategy?" (PDF slide deck), by Robert Eisenbeis, Cumberland Advisors, November 12, 2009.
- Title
- The Problem
- Dimensions of the Problem: Gov’t Commitment to Financial Institutions (1)
- Dimensions of the Problem: Gov’t Commitment to Financial Institutions (2)
- Dimensions of the Problem: Gov’t Commitment to Financial Institutions (3)
- Restructuring Raises Three Key Issues
- Options to Reprivatize F&F
- Options to Unwind Commitments to Banks and AIG
- Current Approach
- Elephant In the Room
[5]: "Fannie’s Draws From Emergency Treasury Fund Reach $60 Billion", by Dawn Kopecki, Bloomberg, November 6, 2009.
[6]: "The Johns Hopkins Health System Policy & Procedure: ALLOCATION OF CAPITAL FUNDS" (PDF), Johns Hopkins, January 1, 2008. [obviously not what they're talking about in the above discussion]
Contingency Capital
Contingency capital is funds available for unanticipated needs that are financially and/or clinically justified. Similar to minor capital, contingency capital is budgeted in total and approved through the annual budget process. As unforeseen needs arise, requests are made from the various departments to use this capital.
