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FDR’s Nomination Address, 1932 These are unprecedented and unusual times. . . the fail- ure to solve our troubles may degenerate into unreasoning radicalism. . . Wild radicalism has made few converts, and the greatest tribute that I can pay to my countrymen is that in these days of crushing want there persists an orderly and hopeful spirit on the part of millions of our people who have suffered so much. To fail to offer them a new chance isnotonlytobetraytheirhopesbuttomisunderstandtheir patience. To meet by reaction that danger of radicalism is to invite disaster. Reaction is no barrier to the radical. It is a challenge, a provocation. The way to meet that danger is to offer a workable program of reconstruction. . . This, and this only, is a proper protection against blind reaction on the one hand and an improvised, hit-or-miss, irresponsible opportunism on the other. There are two ways of viewing the Government’s duty in matters affecting economic and social life. The first sees to it that a favored few are helped and hopes that some of their prosperity will leak through, sift through, to labor, to the farmer, to the small business man. . . This is no time for fear, for reaction or for timidity. . . Now it is inevitable - and the choice is that of the times - that the main issue should revolve about the clear fact of our economic condition. . . Let us look a little at the recent history and the simple economics, the kind of economics thatyouandIandtheaveragemanandwomantalk...Enor- mous corporate surpluses piled up - the most stupendous in history. Where, under the spell of delirious speculation, did those surpluses go?. . . They went chiefly into the call- money market of Wall Street, either directly by the cor- porations, or indirectly through the banks. Those are the facts. Why blink at them? Then came the crash. You know the story. . . purchasing power dried up; banks became frightened. . . Those who had money were afraid to part Make Markets Be Markets In 2009, the Roosevelt Institute launched a policy center focused on the de- velopment and promotion of some of the most innovative, rigorous voices and ideas inspired by the courage and progressive values that Franklin and Eleanor Roosevelt brought to the twentieth century. The center’s first projects focus on global finance and the architecture of a 21st century economy. This report on restoring the integrity of the U.S. financial markets is the result of research and discussion among some of the country’s leading financiers, market experts, academics and former regulators. Volume Editors Robert Johnson Erica Payne The Roosevelt Institute is a nonpartisan 501(c)3 organization. The views ex- pressed in this volume are those of the authors and do not necessarily reflect the views of the Institute, its officers, or its directors. Robert Johnson is Senior Fellow and Director of the Project on Global Fi- nance at the Roosevelt Institute. He is former Chief Economist to the Senate Banking Committee and former Senior Economist to the Senate Budget Com- mittee. He has a Ph.D. in Economics from Princeton University. Erica Payne is Senior Advisor to the Roosevelt Institute and is founder and principal of the Tesseract Group and the Agenda Project. She is author of The Practical Progressive: How to Build a 21st Century Political Movement. She has an MBA from the Wharton School at the University of Pennsylvania. The volume editors would like to acknowledge the contributions of Madeleine Ehrlich, Caitlin Howarth, Danielle Mazzeo, and Lynn Parramore. “We have had to struggle with the old enemies of peace – business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering.” I wish these words, spoken in 1936 by my grandfather Franklin D. Roosevelt, were not as true today as then. Yet over the past eigh- teen months this nation has faced a financial crisis second only to the Great Depression. It is a crisis that in many ways was predict- able and preventable – one that experts had seen on the horizon for years. In the end, like the market crash that fueled the Great Depression, the current financial crisis may have been inevitable, fueled by systemic flaws that require systematic repair. By many accounts, we did not lack the ability to foresee the loom- ing crisis. Rather, too many of us lost sight of the need to guard against it. We lacked some of the courage and commitments that my grandparents – both of them – brought to the last century, commitments that might have made us question the sources of dizzying profits for a few and the decay of security and prosperity for the many. We can continue on this course and attempt to endure the next crisis. Or now, in the breathing space between crises, we can think critically about the path ahead. I am pleased that the In- stitute that is named for my grandparents and inspired by their progressive values is helping to chart this latter course. In this vol- ume, the Institute compiles expertise from some of the country’s leading scholars and practitioners to offer a reasonable blueprint for restoring the integrity of the U.S. financial system. During his first term as president, my grandfather remarked that he hoped that in his administration, the forces of selfishness and of lust for power had met their match. They may have then, but unfortunately, the struggle continues. I hope the ideas in this vol- ume will make a productive contribution in the days ahead. Co-Chair, Board of Directors The Roosevelt Institute launched a new policy center soon after I became president in 2009. The center is focused on developing and promoting some of the most rigorous, innovative ideas and the leaders who are their strongest proponents – all with an eye to shaping the public dialogue in ways that carry forward the cou- rageous spirit and progressive values that the Roosevelts brought to the last century. We began our work with a focus on the crisis in the financial sec- tor and its effects on the broader economy. President Roosevelt has an exceptional legacy of creating effective financial market regulation in the 1930s – rules that contributed to relatively stable financial markets for more than fifty years, until conservatives began the process of dismantling them in the 1980s. Precisely because it was an area that enjoyed relative stability for many decades, “non-conservatives” – for lack of a better term: all those who believe we need rules both of and for the game – had de- veloped relatively little policy capacity until the financial collapse occurred. Today, the collapse has become the unfortunate cata- lyst in reinvigorating policy work on the economic principles first articulated during the Depression era, principles that proved that rules beget prosperity. Under the leadership of Nobel Prize winning economist Joe Stiglitz and Rob Johnson, former chief economist to the Senate banking committee, we have convened top scholars, practitio- ners, and opinion leaders for many weeks to discuss and debate ideas for restoring health to the financial system. This volume is a product of that work. I want to thank each of the authors who have contributed their time and ideas to the chapters. In the months ahead, the Roosevelt Institute will continue to en- gage the challenges in the financial sector and questions concern- ing the future of the American economy, and we will broaden our focus to additional subjects in need of new leadership and ideas. President and Ceo Table of Contents Introduction: Make Markets Be Markets 9 Robert Johnson The Doom Cycle 15 Peter Boone and Simon Johnson The Giants Fall: Eliminating Fannie Mae & Freddie Mac 23 Raj Date Regulator’s Incentives 35 Richard Scott Carnell Credit Rating Agencies & Regulation: Why Less Is More 43 Lawrence J. Wright The Broken Consumer Credit Market 51 Elizabeth Warren Out of the Shadows: Creating a 21st Century Glass Steagall 61 Raj Date and Michael Konczal Securitization: Taming the Wild West 73 Joshua Rosner Bring Transparency to Off-Balance Sheet Accounting 85 Frank Partnoy and Lynn Turner Out of the Black Hole: 99 Regulatory Reform of the Over-the-Counter Derivatives Market Michael Greenberger Credible Resolution: 117 What it Takes to End Too Big to Fail Robert Johnson About the Roosevelt Institute 135 Introduction Make Markets Be Markets Robert Johnson Eighteen months after the most devastating financial crisis since the Great De- pression, our financial system remains critically flawed. The United States has not yet enacted the financial reforms necessary to repair the broken financial system.1 We have a financial system that continues to be sustained by taxpayers through the fiscal side door of the Federal Reserve’s balance sheet. All legislative pro- posals offered by the Administration, House and Senate fall far short of what is needed for proper reform. Independent experts across the political spec- trum have clearly identified the dangers of large complex financial institutions that are intertwined through the proliferation of derivative instruments. Those introduction experts have also prescribed remedies that are concise, clear and well devel- oped. Many of the fault lines in the current system and their remedies were well known long before this latest crisis unfolded. The crisis of 2008 was predictable. Unless we go far beyond current legislative proposals the next crisis is inevitable. The structure of our current financial markets does not reflect the critical mar- ket principles that once allowed our economy to flourish– principles like trans- parency, competition, and free flow of information. And it has not been subject to the most important principle of all — the opportunity for market participants to fail. We all know the result. Financial sector CEOs have relied on taxpayer support. They have benefitted from express taxpayer bailouts as well as secret “back door” deals. They continue to lead companies that seem to make profit but actually only thrive because of government subsidies and taxpayersupport. Make Markets Be Markets: Restoring the Integrity of the U.S. Financial System is the result of months of discussions among the country’s leading financiers, market experts, academics and former regulators. These discussions, on issues ranging from ‘theory failures’ to ‘regulatory incentives,’ have culminated in the development of a concrete plan for a financial system that can manage the flow of capital, price risk appropriately, reduce fraud and collusion, protect taxpay- ers, and provide liquidity – all without compromising innovation or stability. The purpose of this report is to present a comprehensive plan for what must be done to fix our broken financial system. It provides a set of recommenda- tions that together serve to prevent, detect, and credibly resolve financial cri- ses. Making markets work as a system is the focus — emphasizing transparency, competition, and the important discipline of failure. The goal is to restore the integrity of the market system with a realistic, rather than romantic, perspective on the role that government must play in the making and enforcing of the laws and regulations that are essential support for the market system. 9 Without the reforms outlined in this report, we cannot restore confidence in the U.S. financial markets, in the role of New York as an international financial center, and in the continuing use of the dollar as the primary reserve currency of the world economy. Ultimately we cannot ensure our national budgetary soundness, because we cannot rule out the wasteful and unnecessary budget burden of another crisis and bailout. If unaddressed, we will likely spiral into the amplifying “doom cycle” described by Simon Johnson in the first chapter. Topics are addressed in the spirit of putting the markets back on sound foot- introductionhey include: the reform of GSEs dependent on an unhealthy open spigot of government capital and guarantees; the reform of ratings agencies; the im- portance of regulatory incentives in determining rules versus discretion in the design of the government’s oversight role; the establishment of a strong con- sumer protection system that will stop toxic instruments and incomprehensible documents from fouling our economic bloodstream; the reform of the shadow banking system that exposed our financial system to runs; reform of the securi- tization process through which over 50 percent of capital flows were intermedi- ated in the years prior to the crisis but which now lies largely dormant; the end- ing of deceptive and damaging off balance sheet practices that were revealed and not reformed by the Enron scandal; the move away from the dark mark to model world of OTC markets to a world in which well-designed derivatives function in transparent, properly-cleared and settled markets where informa- tion flows freely; and finally, perhaps most importantly, the ability to credibly resolve Large Complex Financial Institutions whose current government guar- antee serves as a illegitimate burden on the American people and a moral stain on the legitimacy of the market system. This set of topics by no means exhausts the terrain of important reforms. Oth- er critical themes will be developed as part of this project in subsequent re- ports, including the definition of the appropriate scope and scale of guarantees of financial institution liabilities; mortgage foreclosure modification; the gover- nance of the central bank and its role in financial resolution; the registration andsystemicmonitoringoftheaggregatedpositionsofhedgefundsandprivate equity funds; the role of executive incentives and corporate governance; and the important role of venture capital and small capitalization equity markets in transforming the structure of the economy and providing new paths to employ- ment. The purpose of setting out the recommendations put forth in the present re- port is twofold. First, they provide a roadmap for financial reform and as such can help advise efforts already underway. Second, they provide a critical litmus test for citizens and the media can use to measure the progress of our political system. This report defines the minimum we must do before we can restore the integrity of the U.S. financial markets. By defining that threshold of reform, we also illuminate the vast gap between what is happening in Washington D.C. and what reasonable, un-encumbered experts believe is necessary. Our government leaders have shown little capacity to fix the flaws in our market system. Admittedly the issues involved are complex, even for finance profes- sionals. Yet the complexity of the subject is no reason to defer to those who cloak themselves in a mantle of expertise in order to clandestinely advance their gross self-interest. The pressure from industry groups is enormous – and the money at stake for the Large Complex Financial Institutions is measured in billions of dollars of earnings each year. They have powerful incentives to impede reform at every turn – and are willing to invest enormous sums to block reform and keep their dangerous money making structures alive. Forces that protect dysfunctional businesses, rather than ensuring competitive markets, are rampant. As Univer- sity of Chicago Professor Luigi Zingales put it, “most lobbying is pro-business, in the sense that it promotes interests of existing business, not pro-market, in the sense of fostering truly free and open competition”. 2,3 The $400 million dollars financial institutions spent on lobbying last year, and their successful effort to introduction stymie reform is convincing evidence of this. When businesses rely on government bailouts instead of on innovation and in- vestment, they are weakened. Once upon a time, the American auto industry was the best in the world. But years of using political muscle instead of intellec- tual or creative muscle - relying on lobbying rather than R&D and productivity improvements – took its toll. Wall Street despised manufacturing protectionism. Yet now Wall Street is seeking protectionism of its own. It is trying desperately to maintain an opaque and unsustainable system that imposes heavy costs on therestofsociety. Theleadersoftheseinstitutionsarehidingbehindtheskirts of the American taxpayer. The toxic side effects for society of Wall Street protectionism are substantial. Detroit’s automakers embraced government for protection, and they ended up bankrupt. Ironically, it will require the tough love of proper reform from Washington and the American people to save Wall Street from going bankrupt a second time. With the reforms suggested in this volume, another crisis is preventable. With- out them, another crisis – a bigger crisis that weakens both our financial sector and our larger economy – is more than predictable, it is inevitable. Endnotes 1. It may well be that the improvisation by the Federal Reserve was necessary given the ill-formed regulatory system and resolution structures that existed at the onset of the financial crisis. At the same time the massive fiscal role that the Federal Reserve has played, the extensive and inconsistent use of their Section 13(3) powers to bail out insti- tutions that were not banks at the end of 2007, and the unacceptable structure of Fed- eral Reserve governance, particularly the governance of the New York Federal Reserve Bank which is thrust into the primary fiscal/bailout role, combine to reveal a resolution process that is badly designed and crying out for reform. Public confidence in the Fed- eral Reserve has plummeted since the onset of the crisis. For more on this theme and 11 Gallup poll data see, “Unmet Duties in Managing Financial Safety Nets” by Dr. Edward J. Kane, February 10, 2010. Available at http://www2.bc.edu/~kaneeb/ 2. CapitalismAftertheCrisis,NationalAffairs, Issue1Fall2009. http://www.nationalaffairs. com/publications/detail/capitalism-after-the-crisis 3. See the illuminating collection of writings on the history of struggles between business interests and the politics of American society contained in Thomas Ferguson’s extraor- dinary book entitled Golden Rule, University of Chicago Press, 1995. Robert Johnson Rob Johnson is Senior Fellow and Director of the Project on Global Finance at The Roosevelt Institute; he also serves on the United Nations Commission of introduction Experts on Finance and International Monetary Reform. Previously, Dr. Johnson was a managing director at Soros Fund Management and a managing director at the Bankers Trust Company. He has served as chief economist of the U.S. Sen- ate Banking Committee and was senior economist of the U.S. Senate Budget Committee. Theviewsexpressedinthispaperarethoseoftheauthoranddonotnecessarilyreflectthepositions of the Roosevelt Institute, its officers, or its directors. 13 1 The Doom Cycle Peter Boone and Simon Johnson Wehaveletanunsustainableandcrazy‘doomsdaycycle’infiltrateoureconomic system. Thiscyclehasseveralsimplestages.Atthestart,creditorsanddeposi- tors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will effectively bail them out. This is the “boom” phase – leading inevitably to an overexpansion of credit, a traumatic market, corporate, and household “bust” and, for as long as we can afford it, to huge bailouts roughly along the lines we saw in 2008-09. This cycle will not run forever. One day soon, we’ll have the boom and bust phases, but when we try the usual bailouts, they won’t work. The destructive power of the down-cycle will overwhelm the restorative ability of the govern- ment,justlikeitdidin1929-31,whenboththefinancialshockandthegovernment capacity to respond were on a much smaller scale. The result, presumably, will be something that looks and feels very much like a Second Great Depression. Risky Business At the heart of this problem are today’s mega-banks such as Citigroup and Goldman Sachs – and many others in this past cycle – which use borrowed funds to take large risks, with the aim of providing dividends to shareholders and bonuses to management. Through direct subsidies (such as deposit insur- ance) and indirect support (such as central bank bailouts, including both special the doom cycle credit programs and cheap credit), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. This used to be known, somewhat light heartedly, as the “Greenspan put”, but there is nothing funny about our current predicament – which has become even worse since Greenspan left office. And do not make the mistake of thinking that the costs of this “put” are en- tirely monetary, i.e., off balance-sheet as far as the fiscal authority is concerned. Privately held debt as a percent of GDP in the US will increase by about 40 percentage points as a direct result of the measures – including automatic stabi- lizers, discretionary stimulus, and direct bailout costs – that the federal govern- ment was forced to take. This moves us into dangerous territory with regard to our overall debt level, particularly given the lack of a credible medium-term framework for debt sustainability, making us more vulnerable to financial col- lapse in the future – a number of European countries, for example, have already somethinglikea“debtlimit”beyondwhichtheycannotusefiscalstimulusunder any circumstances. We are heading in the same direction. Irresponsiblerisk-takingbythebiggestplayersinourfinancialsectorhasplaced us in fiscal jeopardy. But that is not the worst of it. We haven’t fixed – and, in fact, are not seriously addressing, the incentive problems of huge banks. They 15 will make similar “mistakes” again because, from their perspective, these are not mistakes – these are legitimate ways to maximize returns (as they see them) “over the cycle”. The bankers, to be honest, are just doing their jobs – to make money. Regula- tors are supposed to prevent dangerous risk-taking. Adair Turner, chairman of the UK Financial Services Authority, is calling for more radical change than most regulators. In this regard, he is on the same page as Paul Volcker, former chair- man of the Federal Reserve Board. But these are lonely voices. Many bankers and policy-makers do well – financially or in terms of career ad- vancement – during the collapse that they helped to create. They have very littlepersonalorprofessionalincentivetobreakthiscycle,atleastuntilitbreaks the economy. In the US and Western Europe today, banks wield substantial political and finan- cialpower,andbecausethesystemhasbecomeremarkablycomplex,regulators the doom cycle are effectively captured. The extent of regulatory failure ahead of the current crisis was mind-boggling. Prominent banks, including Northern Rock in the UK, Lehman Brothers in the US, and Deutsche Bank in Germany, convinced regula- tors that they could hold low amounts of capital against large and risky asset portfolios. The whole banking system built up many trillions of dollars in expo- sures to derivatives. This meant that when one large bank or quasi-bank failed, it could bring down the whole system. Giventheinabilityofourpoliticalandsocialsystemstohandlethehardshipthat would follow economic collapse, we rely on our central banks to cut interest ratesanddirectcreditssoastobailouttheloss-makers.Whilethefacestendto change, each central bank and government operates similarly. This time, it was BenBernankeandTimGeithnerwhooversawpolicyasthebubblewasinflating. These same men are now designing our “rescue”. When the bailout is done, we start all over again. This has been the pattern in many developed countries since the mid-1970s – a date that coincides with sig- nificantmacroeconomicandregulatorychange,includingtheendoftheBretton Woods fixed exchange rate systems, reduced capital controls in rich countries, and the beginning of 30 years of regulatory easing. The real danger is that as this cycle continues, the scale of the problem is get- ting bigger. If each cycle requires greater and greater public intervention, we will surely eventually collapse – it is highly unlikely that we will always be able to counteract (growing) financial shocks with appropriately sized monetary and fiscal policy responses. To stop the doomsday cycle, we need far greater reform than is currently under discussion.Theheadline-grabbingactionsofGordonBrownandAlistairDarling, calling for financial transactions taxes and a one-year super tax on bonuses – or Barack Obama and Paul Volcker calling for limits on proprietary trading – have no impact on the fundamental problems in our system. Indeed, they are po- tentially harmful to the extent that they mislead taxpayers who want real solu- tions. New Policies Needed We need quite different and much more focused policies. These policies must be implemented across the G-20, with international coordination and monitor- ing – the US, the UK, and others with financial capabilities can take the lead on this front. Otherwise, financial services will move to the least regulated parts of the world, and it will be much more difficult for each country to maintain a tough stance So what should be done? First, consider the regulatory problem: there are two broad ways to view past regulatory failures that have brought us to such a dan- gerous point. One is to argue it is a mistake that can be corrected through bet- ter rules. ThathasbeenthepathofsuccessiveBaselcommittees,whicharenowdesigning comprehensive new rules to ensure greater liquidity at banks and to close past loopholes that permitted banks to reduce their core capital. We both worked for many years in formerly communist countries, and this project reminds us of central planners’ attempts to rescue their systems with additional regulations until it became all too apparent that collapse was imminent. the doom cycle In our view, the long-term failure of regulation to check financial collapses reflects deep political difficulties in creatingregulation.Thebanks have the money, they have the best lawyers and they have the funds to finance the political system. Politicians rarely want strong regulators – except after a major col- lapse (like the 1930s). There are also big opera- tional problems. For example, how should regulators decide the risk capital that should be allocated to new and ar- cane derivatives, which banks claim will reduce risk? When faced with rooms full of pa- pers describing new instruments, and bank-hired experts bearing risk assess- ments, regulators will always be at a disadvantage. The operational difficulties are further complicated by the intellectual under- currents. When the economy is booming, driven by more leveraged bets, there is a tendency for the academic world to provide theories that justify status quo policies. This is clear from the growth of efficient markets theories, which in- filtrated regulators’ decision-making during the boom that preceded the most recent crisis. No wonder that Tim Geithner, while president of the Federal Reserve Bank of New York, or Alan Greenspan and Ben Bernanke, as Fed chairman, did little to arrest the rapid growth of derivatives and off-balance sheet assets. It requires a strong leap of faith to believe that our regulatory system will never again be captured or corrupted. The fact that it has spectacularly failed to limit costly risk should be no surprise. In our view, the new regulations proposed for Basel 3 will fail, just as Basel 1 and Basel 2 have failed. the doom cycle Such detailed proposals sound smart because they are correcting egregious er- rors of the past. But new errors will surface over the next five to ten years, and these will be precisely where loopholes remain, and where the system gradually becomes corrupted, again. The best route towards creating a safer system is to have very large and robust capital requirements, which are legislated and difficult to circumvent or revise. If we triple core capital at major banks to 15-25% of assets – putting capital-asset ratios back to where they were in the United States before the formation of the Federal Reserve in 1913 – and err on the side of requiring too much capital for derivatives and other complicated financial structures, we will create a much safer system with less scope for ‘gaming’ the rules. Once shareholders have a serious amount of funds at risk, relative to the win- nings they would make from gambling, they will be less likely to gamble in a recklessmanner.Thiswillmakethejobofregulatorsfareasier,andmakeitmore likely our current regulatory system could work. Second, we need to make the individuals who are part of any failed system expect large losses when their gambles fail and public money is required to bail out the system. While many executives at bailed-out institutions lost large amounts of money, they remain very wealthy. Some people have clearly become winners from the crisis. Alistair Darling ap- pointed Win Bischoff, a top executive at Citigroup in the run-up to its spec- tacular failure, to be chairman of Lloyds. Vikram Pandit sold his hedge fund to Citigroup, who then wrote off most of the cost as a loss, but Pandit was soon named their CEO. Jamie Dimon and Lloyd Blankfein, CEOs at JP Morgan and GoldmanSachsrespectively,areoutrightwinnersfromthisprocess,despitethe fact that each of their banks also received federal bailouts – and they agreed to limit their bonuses for 2009. Goldman Sachs was lucky to gain access to the Fed’s ‘discount window’; its con- version to a bank holding company averted potential collapse. We must stop sending the message to our bankers that they can win on the rise and also sur- vive the downside. This requires legislation that recoups past earnings and bo- nuses from employees of banks that require bailouts. Third, we need our leading fiscal and monetary policy-makers to admit their role in generating this doomsday cycle through successive bailouts. They need to develop solutions so that their institutions can credibly stop this cycle. The problem is simple: most financial institutions today have now proven too big to fail, as our policy-makers have bailed them all out. The rules need to change so that creditors do not expect another bailout when the next crisis happens. There is some encouraging progress with plans for ‘liv- ing wills’ and measures to reduce the interdependency of financial institutions. But the litmus test for this will be when our leading policy-makers start calling for the break-up of large financial institutions and permanent robust limits on their size relative to the economy in the future. Smaller institutions are naturally easier to let fail, and this will make creditors nervous when lending to them, so we can have more confidence that creditors the doom cycle will not lend to highly risky small institutions. There are feasible ways of doing this: for example, we could impose rising capital requirements on large institu- tions over the next five years, thus encouraging them to develop orderly plans to break up and shrink their banks. Doom Cycle Continues So where are we going with our current reforms? It is now obvious that risk- taking at banks will soon be larger than ever. Central banks and governments aroundtheworldhaveproved(onceagain)thattheyarewillingtobailoutbanks atenormouspubliccostwhenthingsgowrong.Marketsarenowagainproviding very cheap loans to banks, with the comfort that the state will bail them out. Today, Bank of America and the Royal Bank of Scotland are each priced to have just 0.5% annual risk of default above their sovereigns during the next five years in credit markets. This is a remarkably low implied risk, considering that both banks were near to collapse just a few months ago. Creditors are clearly very confident that they will be bailed out again if necessary. Indeed, they are more comfortable lending to large risky banks than to many successful corporations. There is no doubt that the regulatory environment is going to be tougher for the next few years. But nothing has changed to make us believe the regulatory system will succeed this time, when it has failed so enormously – and repeat- 19 edly–intherecentpast.Tobringaboutthedramaticchangethatisneededalso requires international cooperation and consistency. Many of our current policy-makers – including Ben Bernanke – are the same ones that inflated the last bubble. So we know with great confidence that they are the types that will bail us out each time things go wrong. They are all cur- rently on course for seeding our next rise and collapse: cheap rates and credit, with large moral hazard, are the initial stages of each cycle. Very few of these people, apart perhaps from Mervyn King (and Paul Volcker, if he is really back in a more active role), appear prepared to recognize their past role in creating our current problems and then to discuss resolutely how to change it. The danger this system poses is clear. With our financial system now well-oiled to take on very large risk once again, and to gamble excessively, can we be sure that we can continue this cycle of bailing out eventual failures? At what point will the costs be so large that both fiscal and monetary policies are simply inca- pable of stopping the collapse? the doom cycle In 2008-09, we came remarkably close to another Great Depression. Next time, we may not be so “lucky”. The threat of the doomsday cycle remains strong and growing. Over the last three decades, the US financial system has tripled in size, as mea- sured by total credit relative to GDP. Each time the system runs into problems, the Federal Reserve quickly lowers interest rates to revive it. These crises ap- pear to be getting worse and worse – and their impact is increasingly global. Not only are interest rates near zero around the world, but many countries are on fiscal trajectories that require major changes to avoid eventual financial col- lapse. Whatwillhappenwhenthenextshockhits?Wemaybenearingthestagewhere the answer will be – just as it was in the Great Depression – a calamitous global collapse. Endnotes 1. Thischapterisbasedon“Thedoomsdaycycle,”whichappearedintheLondonSchoolof Economics’ “Centerpiece,” published by the Center for Economic Performance, Winter 2009/10 (http://cep.lse.ac.uk/centrepiece/). This material is used here with permission. 2. Andrew Haldane, executive director for financial stability at the Bank of England, has written an excellent paper describing a similar idea – the ‘doom loop’ (http://www. bankofengland.co.uk/publications/speeches/2009/speech409.pdf). Peter Boone Peter Boone is a research associate in CEP’s globalization program and chair- man of Effective Intervention (http://www.effint.org), a charity based in Britain. He is also a principal at Salute Capital Management. Simon Johnson Simon Johnson is a professor at MIT’s Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and a member of the Congressional Budget Office’s Panel of Economic Advisers. He is co-author, with James Kwak, of 13 Bankers (Pantheon, forthcoming, March 2010). Peter and Simon write for The Baseline Scenario, a leading economics blog (http://baselinescenario.com), and are co-authors of ‘Our Next Financial Crisis’, published in The New Republic in September 2009 (http://www.tnr.com/article/ economy/the-next-financial-crisis) and “Shooting Banks” published in The New Republic in February 2010. The views expressed in this paper are those of the authors and do not necessarily reflect the posi- tions of the Roosevelt Institute, its officers, or its directors. the doom cycle 21 The Giants Fall Eliminating Fannie Mae & Freddie Mac Raj Date In the three full years since the first emergence of the credit crisis, market par- ticipants and policymakers have offered a variety of competing narratives re- garding its genesis. The commonsense perspective of nearly all those compet- ing narratives is that the U.S. residential mortgage market was at the center of global financial market turbulence. Despite that seeming consensus, policymakers remain undecided as to the fate of the largest (and to taxpayers, the most costly) participants in the U.S. mort- gage business: the government sponsored enterprises, Fannie Mae and Fred- die Mac (together, the “GSEs”).1 Fannie and Freddie’s central function, guarantying mortgage credit through government-sponsored private firms, is fatally flawed. Although they arguably provide other systemic benefits beyond credit guaranties (liquidity support, in- terest rate risk absorption), those benefits could be more transparently and efficiently delivered through other means. As a result, there is no logically de- fensible reason for the GSEs’ survival. They should be eliminated. Evaluating GSE Functions The GSEs’ mandated mission is to provide liquidity, stability, and affordability to the U.S. residential mortgage market. In practical terms, that mission has been executed through two business lines: guaranteeing MBS issues; and hold- ing mortgage and MBS portfolios. Those lines of business, in turn, serve three broad functions: (1) the extension of credit; (2) the provision of liquidity; and (3) the absorption of interest rate risk. (See Figure 1) Fannie & Freddie Extend Credit The first of the GSE functions, the extension of credit guarantees on mortgage pools, is at the very core of the GSEs’ purpose and strategy. And that core ac- tivity is irretrievably flawed. In concept, Fannie and Freddie are meant to enable, through their secondary marketoperations,primarymarketcreditextensiontoborrowersthatotherwise would not qualify.3 Of course, the GSEs do not intend to lose money through credit operations, so they can only logically achieve their credit goals if at least one of two conditions are true: (1) the GSEs can make otherwise non-economic credit risks viable because they enjoy a lower cost of capital, or (2) the GSEs, owing to scale, longevity, and sophistication, are superior to the private market as underwriters of credit risk. (See Figure 2) 23 Figure 1 GSE Lines of Business and Functions Guaranty Business • What is it? • The “core” business Extend • Providing guaranty of principal and interest payments Credit • How do they make money? • Guarantee fee (‘G fee’) in excess of net credit losses • What could go wrong? • Credit risk Stabilize Portfolio Business Liquidity • What is it? • The “growth” business • Borrowing in capital markets to buy loans, GSE MBS, or private label MBS Absorb • How do they make money? • Spread between asset yieldand Rate GSE funding costs Risk • What could go wrong? • Credit risk Fannie & Freddiee risk (prepayment, extension) • Liquidity risk • Counter-party risk (derivatives counter-parties) Source: Fannie Mae; Freddie Mac; Cambridge Winter Center The first of those conditions is almost certainly true, but the second has proved false — so false, in fact, that the waywardness of the GSEs’ poor credit decisions has overwhelmed the advantage of their low cost of capital. It would appear that Fannie and Freddie’s realized losses on credit extended at the end of the housing boom (particularly 2006 and 2007) will be some 10 to 20 times worse than they had originally forecasted. Affordability Mission TheGSEs,bycharter,areintendedtofacilitatemortgagefinancetolower-income homeowners, and to traditionally under-served communities. Given that, it is tempting to ascribe the GSEs’ disastrous credit performance to that “affordabil- ity”aspectoftheirmission. Afterall,theGSEs’large-scalepurchasesofsubprime private-label MBS were motivated in large measure by a Congressional mandate to promote homeownership rates. Even now, between them, Fannie and Freddie hold roughly $100 billion in private-label subprime securities in their portfolios. Figure 2 Conceptual Impact of GSEs on Credit Availability Credit-worthy with GSE’s t Credit-worthy wtthout GSE’s No. of HouseBetter risk Lower cost of capital modeling Subprime Super-prime Credit Quality Source: Cambridge Winter Center But the affordability mission does not explain the vast majority of the GSEs’ credit woes. (See Figure 3) The $100 billion of subprime securities in portfolio, while astonishing in nominal terms, is roughly 2% of the combined firms’ $5 trillion credit ex- posure.And within the guaranty business, subprime exposure is actu- ally quite modest. At Freddie, for example, only 4% of the single-family mortgage credit book is tied to borrowers with FICO scores below 620. Fannie & Freddie Moreover, the very worst performing GSE loans (that is, the loans where losses are the greatest multiple of original forecasts) were made to prime borrowers, not subprime. Again using Freddie as an example, both the “Alt-A” and “Inter- est Only” portfolios are already facing serious delinquencies of 11% and 16%, respec5ively, despite having solidly prime average borrower FICO scores of 722 and 720. These were market share-driven loans made to people with good credit; they were not mission-driven loans made to people with bad credit. Put simply, the subprime fraction of the GSEs’ credit exposure is too small, and the GSEs’ overall credit deterioration too large, to pin their woes on the afford- ability mission alone. Merely tweaking that mission, therefore, will not remedy the GSEs’ ills. The problem is more fundamental. 25 Lack of Debt Market Discipline Fannie and Freddie’s credit-decisioning processes, in large measure, rest on quantitative credit models. Such models have real benefits: they are reliably free of the primary market’s sometimes checkered fair lending practices; they are efficient and scalable; and they take advantage of the GSEs’ size and ability to gather loan-level performance data across the market. But, as the crisis has made painfully clear, model-based credit decisioning has its drawbacks. Most importantly, backwards-looking, data-driven credit models are subject to a pro-cyclical bias. In other words, because most credit models relyprimarilyonhistoricalperformancedata,theywilltendtogeneratethemost optimistic predictions at precisely the wrong time — at the end of a long period of low credit losses. That bias, combined with the asymmetric risk bias of the management and board of any privately owned, highly leveraged firm, inevitably creates an outsized risk appetite during benign parts of the credit cycle. In an ideal market, that risk appetite would be checked by fixed income inves- tors, who stand to lose if management is too aggressive over time. Such debt market discipline is crucial: in any highly leveraged system of credit allocation, debt markets serve as the most important line of defense against the positive risk biases of customers, management teams, and boards of directors. As the experience of this financial crisis indicates, the ability of regulators alone — that is, without debt investor assistance — to hold back credit bubbles is debatable at best. (See Figure 4) FannieFigure 3ie Freddie Mac Serious Delinquenczy, 3Q09 $ Billions of 90+ Day Delinquency UPB 70 60 50 33 40 55 2 30 20 21 10 9 9 Subprime Interest Only Option ARM Other Prime Total Note: UPB is ‘unpaid principaled balance’; subprime prime subprime is all FICO<620; I/O, Option ARM, and Other Prime include estimated FICO>620 components only. Source: Cambridge Winter Center But the very nature of the government sponsored enterprises meant that this debt market check was absent. The GSEs’ MBS and unsecured fixed income investors, secure in the (quite sensible, it turns out) knowledge that the tax- payer would ultimately back GSE debt, continued to fund Fannie and Freddie throughout the credit bubble and even after the bubble had begun to burst. Of course, the wide-ranging failure of private sector mortgage markets demon- strates that the existence of non-taxpayer supported debt investors is a neces- sary, but by no means a sufficient, condition for sound credit allocation. The private credit markets had their own well-publicized structural shortcomings. For example, debt market discipline was diluted by the migration of capital into ABS-funded vehicles, and ABS investors, in turn, appear to have imprudently relied on the fallible judgments of credit rating agencies. At the same time, some large banks and broker dealers seem to have been viewed (correctly) as “too big to fail,” so creditors sustained their asset growth despite increasingly untenable credit exposures. Viewed in this light, the GSEs’ credit allocation decisions suffered from the same general kind of structural difficulties as private-label mortgage markets during the bubble: primary market origination by banks and brokers with little economic stake in the outcome; inherently backwards-looking credit modeling techniques; and, crucially, debt market investors who were not especially inter- ested in, or capable of, creating a substantive check on underwriting. Figure 4 Credit Systems and Risk Biases Regulators protect systemic ttability, deposit Debt Marketsund Fannie & Freddie disciplineBoards’ trisk-taking (Rating Agencies) t PositivePositive Equity Markets riskt tarisk bias discipline management tisk-taking, but have pro-risk biases too Manage- Consumers (Boards of Directors) ment Source: Cambridge Winter Center 27 Absent any meaningful counterbalance to the natural pro-risk and pro-cyclical credit biases faced by all financial firms, the GSEs’ credit guaranty function was doomed to fail. Stabilize Liquidity Beyond their credit allocation function, the GSEs are intended to provide a stable source of liquidity in what can otherwise be a volatile market for residen- tial mortgage finance. And, indeed, the GSEs provided one of the only sources of liquidity for new mortgages during the course of the credit crisis. Unfortunately, the power of this liquidity backstop stems from two sources, nei- ther of which seems necessary or prudent. The first source is the implicit taxpayer backing of the GSEs’ credit guaranty business. To the extent that investors believe that the United States stands behind a Fannie or Freddie credit guaranty, then an investor should be will- ing to invest in GSE-guaranteed MBS even in an otherwise full-blown credit crisis. But, as seen above, the credit guaranty business, precisely because of its implicit government backing, is not viable. It cannot be expected to make good risk-adjusted credit decisions without a substantive debt market check. To the extent that the GSEs’ powers to backstop liquidity, then, are dependent on their credit decision-making, they rest on an irreparably shaky foundation. 8 The second source of the GSEs’ power to backstop liquidity is their portfolios. Because the GSEs are able to obtain debt financing from investors who fully Fannie expect a taxpayer bailout in a crisis, their ability to maintain, and even grow, an investment portfolio of mortgages and MBS can defy free-market gravity: their assets can climb as others sink. This is a real benefit. But it is not additive to what the government can already accomplish, through the “official” lender of last resort, the Federal Reserve. During this financial crisis, for example, the Fed opened its funding to an un- precedented range of financial institutions, and both purchased and advanced loans against a wide range of assets — including GSE and private-label MBS. 9 And when the Fed puts taxpayers at risk through such liquidity mechanisms, it is, ultimately, taxpayers that benefit if circumstances turn out well. With the GSEs, by contrast, considerable upside is captured by a number of private par- ties aside from taxpayers — GSE equity holders, GSE management, and GSE bondholders. So it is true that the GSEs have served as important sources of liquidity to the markets. But their ability to do so has been entirely contingent on the gov- ernment; and the government has better mechanisms to achieve precisely the same ends. Absorb Rate Risk American homeownership rates are markedly higher than those of most other developed nations. Although a cultural predilection might contribute, elevated homeownership is also the consequence of a number of artificial economic sub- sidies — which extend from niche programs (e.g. the VA credit guaranty pro- gram) to large, expensive features of the tax code (e.g. the mortgage interest deduction, the exemption from income tax of certain gains from home sales). One of those subsidies is the widespread availability of long-term, fixed-rate mortgages. For most banks, the conventional 30-year fixed rate mortgage is an awkward as- set to hold on balance sheet, because of its inherent interest rate risk. Given this risk profile, a subsidy-free market should gravitate towards a higher share of adjustable rate mortgages (to better match asset yields with funding costs), shorter fixed rate periods on hybrid mortgages, and high pre-payment penalties (to mitigate prepayment risk). Other developed countries, like Canada, feature 11 mortgage markets with combinations of precisely these characteristics. The principal difference, in the US, is the existence of the GSEs. The GSEs’ guaranty business does not, directly, make the interest rate risk associated with fixed rate mortgages more palatable, because the GSE guaranty compensates MBS investors for credit losses, but not prepayment or extension risk caused by changes in the rate environment. By contrast, the GSEs’ portfolio business does absorb some amount of interest rate risk, and thereby might arguably in- crease the availability of fixed rate mortgages. This absorption of rate risk is driven by two features of the GSEs. First, the GSEs would appear to have some level of “natural” hedge to the interest rate risk inherent in fixed rate mortgages. But that is, at best, a partial hedge to the GSEs’ rate risk, and it is not different in kind to the natural hedge that would be enjoyed by any bank involved in the origination of mortgages. Thus, it is not clear that the GSEs’ natural hedge encour12es more fixed rate mortgage pro- Fannie & Freddie duction than would exist without them. Second, given Fannie and Freddie’s size and government-sponsored status, the firms might arguably be able to offload interest rate 13sk in the rate derivatives markets more efficiently than smaller, private firms. By doing so, though, they become systemically important counterparties within the rates markets, whose failure would create cascading crises across major market participants. Thus, the GSEs enable fixed rate mortgages only through the introduction of systemic risk, which, inthe eventuality of the GSEs’ failure, was ultimately borne by the taxpayer. Given that taxpayers bear the systemic risk of the GSEs’ rate risk absorption, it would be more straightforward to directly subsidize fixed rate mortgages, rather than through the intermediation of the privately owned and managed GSEs. 29 Implications Careful analysis, then, reveals the irredeemable flaws underpinning the GSEs: their putative benefits in the provision of liquidity, and in the subsidization of fixed-rate mortgages, exist solely because they enjoy the implicit backing of taxpayers. But it is precisely that implicit taxpayer backing that destroys the integrity of their credit decision-making processes. To correct those flaws, housing finance reform, at minimum, must abide by a handful of principles — which together mean eliminating Fannie Mae and Fred- die Mac: 1. Privatize the GSEs’ credit guaranty business. Taxpayer-supplied sub- sidies for homeownership cannot be effectively delivered through taxpayer-backed credit extension. The fact of taxpayer backing de- stroys debt market discipline, which is a necessary ingredient for ra- tional credit allocation. 2. Eliminate the GSEs’ portfolio business, thereby nationalizing the emergency liquidity function. There is no benefit provided by the GSEs’ portfolio business that is not entirely the consequence of tax- payer backing. The portfolio business achieves that which could be provided through more direct means, but needlessly transfers eco- nomic wealth from taxpayers to GSE shareholders, GSE manage- ment, and GSE bondholders. 3. Create transparent homeownership subsidies, or none at all. It is an appropriate time to reconsider whether homeownership is a judi- Fannie & Freddicious choice for lower and middle-income Americans — or at least whether it is so obviously judicious that it justifies massive taxpayer subsidization. If, after that review, policy-makers decide to continue promoting artificially high levels of homeownership, more straightfor- ward cash subsidies (through refundable low-income tax credits, for example) would be both simpler than GSE intermediation, and less prone to catastrophic error. 4. Create a transparent fixed-rate mortgage subsidy, or none at all. In a similar vein, if policy-makers wish to continue to support the avail- ability of long-term, fixed-rate mortgages, they should consider doing so directly. For example, Congress could authorize a Fed-managed rate swap facility, which would offer subsidized fixed-to-floating inter- est rate swaps to banks or securitization vehicles that hold fixed-rate mortgages. This would require that rate risk be absorbed by taxpay- ers, but taxpayers bear that risk today as well, given the systemic risk created by the GSEs’ interest rate risk positions. 5. Mandate standards for private-label transparency. Due to both their dominant market share and a certain inflexibility in their IT platforms, the GSEs over time created de facto standards for the sprawling U.S. mortgage business (e.g. loan delivery standards, servicing standards) — standards that have proven alarmingly elusive in the private-label MBSmarket. AstheGSEsareeliminated,regulatorsshouldtakecare to ensure that necessary market standards are promulgated (by ei- ther private sector associations, or if necessary by regulation) in both the primary and secondary mortgage markets. Fannie and Freddie are needlessly complex and irretrievably flawed; they must be eliminated. The resulting mortgage market will be more structurally sound, less prone to systematic credit misallocation, and less burdensome to taxpay- ers. Endnotes 1. For simplicity, this research note does not use the term “GSEs” to include the Federal Home Loan Banks, but only Fannie and Freddie. 2. See, e.g., 12 U.S.C. 1716 et seq.; Fannie Mae, “About Fannie Mae”, available at http://www. fanniemae.com/kb/index?page=home&c=aboutus, accessed February 6, 2010. 3. The “primary market” refers to the market for individual mortgage loans themselves; the “secondary market” refers to mechanisms by which loans, once extended to borrowers, are sold, pooled, guaranteed, and securitized. The federal government and a variety of government sponsored enterprises participate in both the primary (the FHA, VA, and USDA) and secondary markets (Fannie, Freddie, Ginnie Mae, and the 12 Federal Home Loan Banks). See Special Inspector General for the Troubled Asset Relief Program, Quarterly Report to Congress, pages 111-126 (January 30, 2010). 4. Freddie Mac, Form 10-Q for Quarter Ending September 30, 2009, note 4; Fannie Mae, Form-10Q for Quarter Ending September 30, 2009, note 6. Note that the $100 billion figure relates to unpaid principal balance; mark-to-market fair value is rather lower. 5. See Freddie Mac, Third Quarter 2009 Financial Results Supplement, pages 18-19 (No- vember 9, 2009). The same general trends hold at Fannie Mae as well. See Fannie Mae, 2009 Third Quarter Credit Supplement, pages 11-12 (November 5, 2009). 6. SeegenerallyLucianA.Bebchuk,TestimonyBeforetheCommitteeonFinancialServices of the U.S. House of Representatives, Hearing on Compensation Structure and Systemic Risk (June 11, 2009), available at http://www.house.gov/apps/list/hearing/financialsvcs_ dem/bebchuk.pdf, accessed Jan. 14, 2010. 7. Because both private-market and GSE performance suffered from precisely the same kind of problems, traditional partisan arguments regarding the GSEs tend to ring hollow. The GSEs were neither, strictly speaking, the “cause of” nor the “victim of” private-label mortgage market dysfunction. They were simply examples (albeit, by far, the largest and most costly examples) of the broad structural shortcomings within the mortgage market. 8. In theory, the Federal Home Loan Banks, which themselves enjoy some measure of implicit government backing, should be able to provide advances to member banks to Fannie & Freddie provide liquidity without taking residual credit risk. In practice, though, it appears that manyoftheFHLBstookrathermorecreditriskduringthebubblethantheyhadperhaps intended. 9. See,e.g.FederalReserveBankofNewYork,FormsofFederalReserveLending,available at http://www.newyorkfed.org/markets/Forms_of_Fed_Lending.pdf, accessed February 7, 2010. 10. As interest rates rise, banks’ funding costs also rise, but fixed rate mortgages, defini- tionally, do not generate more income. The resultant squeeze in net interest margin is compounded by borrowers’ tendency to reduce early prepayments of fixed rate mort- gages in a rising rate environment, so the now-less profitable fixed rate mortgages also, unhelpfully, stay on bank balance sheets longer. This “extension risk” has an analog, “prepayment risk”, in a falling rate environment. As rates drop, borrowers quite naturally refinance fixed rate mortgages, leaving banks to reinvest prepaid mortgage balances in a now-lower ambient rate environment. 11. See John Kiff, Canadian Residential Mortgage Markets: Boring but Effective?, Interna- tional Monetary Fund Working Paper WP/09/130 (June 2009). 12. To the extent that GSE revenue is driven, in part, by new mortgage deliveries, then that 31 revenue should increase as interest rates decline, because lower interest rates typically drive higher delivery volumes. At the same time, declining interest rates should trigg
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