Government-sponsored Enterprises: Fannie Mae and Freddie Mac
Carlos M. Pelaez
In a perfectly competitive economy maximum efficiency is attained when the economy produces output for all goods and services at which price equals marginal cost. The definition of marginal cost is the increase in cost resulting from the production of an extra unit of output of goods or services. Costs include normal profits or the remuneration required for entrepreneurs to organize production. Government intervenes directly by fixing maximum or minimum prices of goods and services.
First, the fixing of prices by the government below marginal cost, or maximum price, causes a shortage or less output of the good or service than optimal. The sale of an extra unit brings in a price that is lower than the cost of producing that extra unit, resulting in a loss, such that the extra unit is not produced. New York real estate prices are frozen for certain residences but not for new construction. The city has had a perennial housing “shortage” with the coexistence of frozen rents of a few hundred dollars with monthly rents of $6000 for a two-bedroom apartment. The elimination of frozen rents would increase construction to the point where the cost of housing in the city would move toward the optimum. There is a social welfare loss because output or construction is less than what is required by the preferences (needs) of society.
Second, the government can also fix a minimum price above marginal cost. The producer would increase output because an extra unit of production, or price, would bring in more revenue than what it costs, or marginal cost. In this case there is a surplus of unsold output. Agricultural support programs in the US by minimum prices caused perennial unsold surpluses purchased and stockpiled by the government. The situation is more complex when the supply of the good or service depends on past prices. For example, the coffee tree planted today only provides full output in three years. Brazil had a majority share of world coffee output and engaged in withdrawals by the government of coffee from the market after 1906 to maintain high prices that induced higher production in a few years as analyzed by Antonio Delfim Netto (Pelaez, ed., Essays on Coffee and Economic Development). The continuing support of coffee prices eroded Brazil’s advantage by encouraging other producers that gained market share. There is a welfare loss in that capital, labor and natural resources are used to produce more than what is desired (needed) at the expense of other goods that could have been produced. There is also a transfer of income from taxpayers to the subsidized producers benefitting from the minimum prices.
The current credit/dollar crisis and global recession originated in one of the largest subsidies in US history that caused overproduction of housing. The various forms of this housing subsidy or minimum housing price occurred as follows (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4):
●30-year Treasury Bond. On August 9, 2001, Treasury ceased the auction of the 30-year Treasury bond and did not auction this security again until August 2005. The objective was to reduce mortgage rates in an effort to lower monthly payments of mortgages that actually injected more money effectively in homeowners’ pockets than through tax rebates. The 30-year Treasury is used as an asset to match the liabilities of long-term contracts such as pensions. The sudden disappearance of new 30-year Treasury bonds caused an increase in demand for mortgage bonds that raised their prices, which is equivalent to a reduction of mortgage rates (Pelaez and Pelaez, Government Intervention in Globalization, 52-6).
●Zero Interest Rate. The fed funds rate is the rate at which banks sell to each other excess reserves deposited at the Federal Reserve Banks (FRB). The fed funds rate is an approximation of the marginal cost of funding of banks and influences the levels of most other rates charged by banks to their clients. The Fed lowered the fed funds rate by decrements in periodic meetings of the Federal Open Market Committee (FOMC) from 6 percent on January 3, 2001, to 1 percent on January 25, 2003, maintaining it at that level until June 30, 2004, and then raising it in increments to 5.25 percent by June 29, 2006. The lowering of the fed funds rate to 1 percent and the announced intention of lowering it to zero if required in avoiding deflation that never materialized distorted the calculations of risk and return in almost every activity in the world. Near zero interest rates encourage excessive debt with risk priced at very low levels; low liquidity and leverage are induced because of the hunt for high yields to remunerate capital. The flood of cheap liquidity encouraged unsound credit. The rapid increase in rates from 1 percent to 5.25 percent shows the current Fed trap of lowering rates close to zero because of the pain caused by their subsequent sharp increase.
●Housing Subsidy. Dwight Jafee and John Quigley published in the Brookings-Wharton Papers on Urban Affairs of 2007 an estimate of the US housing subsidy in 2006 of $221 billion composed of $37.9 billion in government expenditures for low-income housing, $156.5 billion in federal tax subsidies for housing and $26.7 billion in credit subsidies (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 44, Regulation of Banks and Finance, 219).
●Fannie and Freddie. In 1990, the total portfolio of Fannie and Freddie amounted to $604 billion of which $135 billion in the retained portfolio and $604 billion in guarantees of mortgage-backed securities (MBS) equivalent to 25.4 percent of total mortgages in the US of $2911 billion. In the third quarter of 2008 the total portfolio stood at $5243 billion of which $1498 billion in the retained portfolio and $3744 billion in guarantees of MBS equivalent to 43.5 percent of total mortgages in the US of $12,057 billion (data from the OFHEO in Pelaez and Pelaez, Financial Regulation after the Global Recession, 45).
The Chief Economist of the National Association of Realtors (NAR) estimates that the loss of homeowner equity from the peak of house prices in 2006 to mid 2009 accumulated to $5.5 trillion (http://www.realtor.org/research/economists_outlook/commentaries/ehs0609ly ). The loss is equivalent to 38.9 percent of estimated GDP for 2009 of $14,140 billion. Total house value in the US stood in mid 2009 at $17 trillion about equal to the value in 2003. The gain in home equity between 2000 and 2005 was $4 trillion (calculation of the NAR cited in Pelaez and Pelaez, The Global Recession Risk, 224). This fluctuation in home values can be explained by the above factors. Mortgage rates declined significantly from 7.91 percent in 1999 to 6.68 percent in mid 2006 (Pelaez and Pelaez, The Global Recession Risk, 224, citing data of Freddie Mac). Part of the decline originated in the more benign inflation environment but it was reinforced by the discontinuance of the auctions of 30-year treasuries, the zero interest rate, the housing subsidy and the operations of Fannie and Freddie. Lower mortgage rates and accessibility to housing loans in the flood of cheap credit attracted homeowners and investors, causing significant increase in demand for houses and thus their prices. As in the case of agricultural commodities, construction of a house takes time from the initial decision as developers plan projects, buy land and begin building and marketing of houses for future delivery. The $4 trillion gain in homeowner equity calculated by the NAR reflects the increase in house prices that motivated more construction. More units kept on reaching the market after prices began declining.
In testimony before the US House of Representatives on December 9, 2009, the former chief credit officer of Fannie Mae, Edward Pinto, stated that Fannie and Freddie purchased about half of the outstanding 25 million nonprime mortgage loans in the value of $4.5 trillion with leverage ratio of 75:1 (cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 46, Regulation of Banks and Finance, 80). Nonprime mortgages were purchased or guaranteed by what turned out to be the US federal government (taxpayers) as everybody anticipated. The zero interest rate of the Fed created the impression that housing prices would increase forever. Homeowners believed that the downside was to live in a better residence for a couple of years before reset of mortgage rates and principal and then sell the house for a capital gain after repaying the mortgage. Lenders believed that the downside was early repayment of the mortgage or sale at market value in foreclosure. Low interest rates caused high house and stock prices making everybody feel artificially wealthier (Pelaez and Pelaez, Financial Regulation after the Global Recession, 234-6, Regulation of Banks and Finance, 175-7, Globalization and the State Vol. II, 212, Government Intervention in Globalization, 183). Mortgagors began defaulting after the peak in prices in 2006. Many of the nonprime mortgages were in MBS and derivatives known as collateralized mortgage obligations (CDO) that were financed with commercial paper issued by structured investment vehicles (SIV) often related to banks (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). The origin of the credit/dollar crisis was the default of mortgages because of the minimum price to housing artificially created by zero interest rates, the housing subsidy, Fannie and Freddie and not the financial innovations in securitization and structured products or irresponsible bankers.
Over the last nine quarters Fannie lost $120.5 billion and Freddie lost $67.9 billion (reported by www.bloomberg.com on December 25, 2009). On December 24, 2009, Treasury announced the elimination of the limit of $200 billion each for Fannie and Freddie of Treasury equity infusions that can now exceed the combined $400 billion of which the two companies have used $111 billion. Ideal and critical regulatory change should consist of gradual sale of the portfolios of Fannie and Freddie, returning residuals if any to shareholders. Housing subsidies if any should be incorporated in the federal budget but there should not be government-sponsored enterprises taking major risks that cause shocks in housing and financial markets. Guarantees of mortgages if any could be considered by Congress in a federal agency with prudent management and supervision. The heavy regulatory agenda focuses on irresponsibility of bankers in pursuit of bonuses but has ignored the actual causes of the credit/dollar crisis and global recession. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Securitization, Derivatives and the Wall Street Act of the House of Representatives
Carlos M. Pelaez
Clear thought on financial regulation and understanding lending by banks require analysis of the functions of banks. Providing transformation services is a critical function of banks. In the model of bank runs of Diamond and Dybvig, banks can be conceptualized as converting monitored, illiquid loans and investments into liquid fed funds. Banks deposit required regulatory reserves at the Federal Reserve Banks (FRB), lending their reserves above those required by the Fed to other banks in overnight loans of fed funds (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). Loans and investments only begin to provide cash flows in the future but require cash immediately to pay for construction, machinery, working capital, wages and the like. Banks accept deposits from the public and provide the funds to business and investors so that they can initiate their projects that provide employment in producing goods and services. Monitoring consists of evaluating the feasibility of projects, a function that banks acquire through their relations with customers and developing techniques of project evaluation. Monitoring also ensures that borrowing companies and investors do not use resources for activities riskier than those in the loans agreement, such as using a loan for buying equipment while investing instead in high-risk stocks. The banking model of Diamond and Rajan analyzes the fragility of banks by the threat of bank runs. A bank can become insolvent if the value of the assets such as loans and investments cannot honor the value of the liabilities or deposits.
Investment in production of goods and services occurs now but cash is first received months and even years in the future. Financial institutions provide the liquidity now so that production and employment can start immediately. The funds for most loans are obtained through risk transfer or securitization (Pelaez and Pelaez, Financial Regulation after the Global Recession, 48-52, Regulation of Banks and Finance, 59-60). A potential home owner requiring money to buy a house enters into a mortgage with a mortgage lender. The money does not originate in a bank or other financial institution. The mortgage originator obtains the money by bundling mortgages of similar credit, maturity and rate into a bond called mortgage-backed security (MBS) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-48). This security is sold to multiple investors including mutual funds and pension funds where many people invest their savings for emergencies and retirement. The payment of interest and principal of the MBS is obtained from the underlying mortgages. If there were not the funds to finance the mortgage, there would not be the construction and employment generated by building houses. The same is true of nearly all loans for business or consumers such as auto loans, credit cards, student loans and so on. Banks generate funds for credit by bundling loans of similar credit rating, maturity and rates in bonds known as asset-backed securities (ABS). Some of the MBS and ABS may be held for investment. A significant part of MBS and ABS are converted into immediate liquidity by means of the repo market or sale and repurchase agreements. The financial institution buys the MBS or ABS with funds obtained by selling the security in exchange for cash with a promise to repurchase it overnight or in a short period paying the interest on the loan with the MBS or ABS serving as collateral. The counterparty financing the MBS or ABS imposes a haircut or reduction in the price in the sale and repurchase contract to protect against a decline in the price of the MBS or ABS in the event that the repurchase agreement is not honored.
The engine of growth of the economy is what Joseph Schumpeter identified as waves of innovation or the application of technology to production or business organization. The world has experienced a second industrial revolution since about the 1970s characterized by new technology. Innovation requires financing for business to invest in plants and equipment and also for credit to consumers to buy the products, students to finance education and so on. The technological revolution created huge new needs of financing that were met with innovations in financial services. The role of regulation is to provide rules for orderly conduct of financial business but without frustrating innovation.
There has been significant growth of credit, interest and foreign exchange derivatives over the counter, that is, in contracts among entities, and in formal exchanges. Consider an example of a derivative used by a German exporter of $10,000 to the US at the rate of $1.3374/euro (Pelaez and Pelaez, Government Intervention in Globalization, 71-2). The exporter would receive 7,477 euros (10,000 divided by 1.3374). But the revenue could decline in a year to 6,403 euros if the dollar devalued to $1.5618/euro (10,000 divided by 1.5618). One hedge would be for the exporter to buy the euro relative to the dollar for delivery in months ahead by means of a forward exchange contract from the exporter’s bank to ensure the exchange rate for conversion of the revenue in euros of selling in the US. In contrast with futures markets for foreign exchange, the bank can tailor the forward contract to the precise needs of the exporter in terms of total value, start date and maturity.
The official interpretation of the credit/dollar crisis and global recession is that banks and financial institutions engaged in an “era of irresponsibility” by taking excessive risks in pursuit of bonuses. According to this view, banks and financial institutions require the sober tutelage of government to prevent excessive risks and the repetition of another financial crisis. The Wall Street Act approved by the House requires that “all standardized swap transactions between dealers and major swap transactions would have to be cleared and traded on an exchange or electronic platform.” A major swap participant is defined as a holder of a substantial net position in swaps, excluding hedging for commercial objectives, or creating significant exposure to counterparties requiring monitoring.
Government does not know better than banks and financial institutions how to control risks so as to prevent financial crises and recessions. Available theory is equivocal and empirical evidence mixed. The credit/dollar crisis and global recession originated in errors of economic policy. The reduction in 2003-2004 of the fed funds rate to 1 percent with the announced intention to keep it near zero as long as required eroded the discipline of calculating risk/rewards by business, households, government, banks and financial institutions (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). These low interest rates caused excessive risk taking and leverage, low liquidity and unsound credit in the expectation that central banks had mastered a technique of promoting sustained economic growth without inflation. The debacle in derivatives originated primarily in underlying nonprime mortgages that were given a seal of government approval by the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie Mae and Freddie Mac. The announcement in September 2008 of the need of $700 billion for the withdrawal of bank “toxic” assets or the world would face a catastrophe contracted counterparty financing of MBS and ABS, paralyzing financial markets. None of the programs of withdrawing toxic assets in September 2008 and February 2009 withdrew one dollar of toxic assets. Confidence eventually returned when counterparties had the time to evaluate the soundness of assets. It is possible to conclude that the crisis would not have occurred had it not been for the wide swings of interest rates caused by the Fed.
The Wall Street Act restricts the volume of financing, increases the cost of credit, weakens banks and financial markets, and frustrates innovation precisely when financing is critical for business and consumers in the effort to increase production and create employment. There is still time to consider more sober banking and financial regulation that recognizes the need for financing and innovation together with the cooperation of government and business in promoting growth and employment. Excessive intrusion on business by regulation can reduce the volume of financing required for future prosperity. Financial regulation that is stricter than in other countries can export the financial industry outside the US as it happened with Regulation Q created by the Banking Act of 1933 in a depression rush of regulation (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

The Wall Street Reform and Consumer Protection Act
Carlos M. Pelaez
The US House of Representatives passed by a vote of 223-202 on December 11, 2009, the H.R. 4173 Wall Street Reform and Consumer Protection Act (Wall Street Act). This writing analyzes the Wall Street Act by means of two main approaches to the causes, duration and depth of the credit/dollar crisis and global recession, which lead to different evaluations of banking and financial regulation.
First, the proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by banks that were motivated in generating short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance themselves in the market. Systemic effects consisted of paralysis of credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Second, the alternative Finance View (FV) claims that the credit/dollar crisis and global recession were caused by government policies (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The reduction of the interest rates on interbank loans or fed funds to 1 percent in 2003-4 with the announced determination to keep them at that level indefinitely distorted decisions on risk and returns of households, banks, companies and government. The interest-rate subsidy caused overproduction of housing and rising real estate prices fueled by the gigantic housing subsidy of the US of $221 billion per year, the purchase or guarantee of $1.6 trillion of non prime mortgages by Fannie and Freddie and the reduction of mortgage rates by elimination of the 30-year Treasury bond. The result of low interest rates and the housing subsidy was excessive construction of houses, laxity in borrowing and lending because house prices were expected to increase forever as central banks kept low interest rates, excessive risk exposures and leverage, low liquidity and unsound credit. Mortgage decisions based on permanently low interest rates turned sour when the Fed increased interest rates from 1 percent to 5.25 percent in 2004-2006, disrupting securitization and derivatives markets. The alarmist proposal of TARP in the second half of September 2009 as if it were required in avoiding another Great Depression because of “toxic assets” in all banks, instead of the failure of Lehman Bros, caused a crisis of confidence that stopped financing in many segments. Markets recovered on their own without withdrawal of toxic assets as first proposed by TARP and in the new administration by the Financial Stability Plan (FSP). Policy prolonged and deepened the credit/dollar crisis and global recession. The regulation passed by the Wall Street Reform and Consumer Protection Act is analyzed below by means of these two approaches.

(1)Cram down. The high moment of the US House of Representatives was the rejection by 241-188 votes of the “cram down,” allowing bankruptcy judges to reduce principal and interest rates on mortgages, extending repayment periods. Securitization of mortgages dates at least to the charter of Freddie Mac in 1970 to guarantee securities backed by mortgages and worked well until the zero interest rate and housing subsidy caused the credit crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-52, Regulation of Banks and Finance, 58-60, 79-80). Securitization allows a critical function of finance by bundling many small loans in large securities purchased by investors such as mutual and pension funds where individuals deposit their savings and build their retirements. Generalized default of mortgage-backed securities by bankruptcy judges as proposed in the cram down process would fracture the source of finance required for reconstruction of housing finance, economic growth and creation of employment. Investors and savers would not invest again in mortgage-backed securities and there could be a repetition of the credit crunch. The objective of the cram down of scaring ultimate holders of claims to modify mortgages failed but it scared investors financing new mortgages required for economic growth and employment creation.
(2)Financial Stability Oversight Council (Council). The Wall Street Act establishes an “inter-agency oversight council that will identify financial companies that are so large, interconnected, or risky that their collapse would put the entire economy at risk.” Systemic risk is a concept in search of a definition for rigorous measurement. As Professor Hal C. Scott states, Congress should appoint “a new expert commission designed to fully investigate the extent and consequences of interconnectedness before any new regulation of systemically important institutions is actually adopted” http://www.capmktsreg.org/pdfs/09-Dec-11_Do_We_Really_Need_a_Systemic_Regulator_by_Hal_S_Scott(WSJ).pdf
(3)Large, Interconnected Financial Firms. The Council will apply stricter standards and regulation to financial companies posing threats to financial stability, imposing higher capital requirements and limits on leverage and concentration of risk exposures. The twelve members of the Council and limited staff will determine the size, structure and risk decisions of 11 banking organizations that in 2006 had $4.6 trillion of assets equivalent to 44 percent of total US banking assets of $10.5 trillion and 96 percent of US foreign banking assets of close to $1 trillion (Pelaez and Pelaez, Globalization and the State Vol. II, 147). The Council of the Wall Street Act will undermine the competitiveness of American banks to finance American companies of optimum size and technology in world markets. Decisions on reducing the size of financial companies may have similar consequences on financial instability as the alarmist announcement of TARP in September 2008: anticipation of problems in a company will drive the stock price toward zero, causing its disorganized illiquidity and bankruptcy as it happened with Bear Stearns, Lehman Bros, Fannie and Freddie. The Wall Street Act is predicated on the assumption that the Council of 12 agencies is superior in financial management to the entire financial market. The consequences of regulatory failures that may occur will be magnified by these exceptional powers without definition and rigorous measurement of the elusive concept of “interconnectedness. “
(4)Role of the Fed. The Council is a far more politicized agency than the Federal Reserve System (FRS), which is the evident loser in legislation perhaps because of its tradition of independence. The FRS will be the “agent of the Council” in regulating systemic risk consolidated across banks and wherever found individually. The Government Accountability Office (GAO) would examine the FRS to increase transparency of the FRS and its actions. There is significant risk of political decisions on economic events at the wrong time. Surveillance of the actions of the Federal Open Market Committee (FOMC) could frustrate monetary policy as financial markets and the public anticipate reversals because of political pressure of what could be correct policy that still has not had time to be processed. The relation of the Council and the Fed resembles several individuals simultaneously handling the steering wheel and stepping on accelerators and breaks of a vehicle. The best informed driver, the Fed, would not have control of the vehicle as it moves into frontal collision.
(5)Dissolution Authority. The Wall Street Act declares the end of the doctrine of “too big to fail.” Regulators will dissolve large, very complex financial institutions in an “orderly and controlled manner.” These are the same regulators that managed the resolution of Bear Stearns, Lehman Bros, AIG, CountryWide, Washington Mutual, Fannie, Freddie and over 100 banks now armed with the elusive definition and measurement of interconnectedness. The main objective of the new authority is that shareholders and unsecured creditors instead of taxpayers bear the burden of dissolution. The new process will be different from bankruptcy because it will prevent “contagion and disruption to the entire system and the overall economy.” There is no new knowledge on defining, measuring and preventing systemic risk. There is no such thing as orderly resolution of a financial crisis. The Wall Street Act creates a Systemic Dissolution Fund with assessments on financial companies for a total of $150 billion. This Fund would be insufficient to deal with Fannie and Freddie whose fate and pivotal role in the financial crisis are not even mentioned in the Wall Street Act.
(6) Consumer Financial Protection Agency (CFPA). The CFPA is designed to protect the public from unfair and deceptive financial products and services in avoiding another financial crisis. The actual deception of the public was in encouraging excessive risk and debt by the promise of nearly zero interest rates during an indefinite period and the housing subsidy that could make true the dream of owning a house bought at peak real estate prices with guaranteed mortgages and the interest rates near historical lows. The CFPA will restrict the volume of consumer loans and increase interest rates in consumer credit much the same as the credit card bill because of the lack of investors and lenders providing funds under regulation that prevents sound assessment of lending risk.
The major weakness of the Wall Street Act is its sole reliance on OPSR. Constructive regulation should be based on Functional Structural Finance (FSAF) by which the government would induce the spirals of innovation that have contributed to past prosperity with balanced regulation. The uses and limitations of regulations are not properly blended in the Wall Street Act, which can frustrate financial functions for growth of output and employment creation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

Regulation, Trade and Devaluation Wars
Carlos M. Pelaez

The influential economist Joan Robinson analyzed “beggar-my-neighbor remedies for unemployment” as the use of protectionism or impediments to foreign trade in promoting domestic employment, causing unemployment in other countries, which characterized the Great Depression (Robinson, Essays in the Theory of Employment, Macmillan, 1937). The credit/dollar crisis and global recession after 2007 is typically exaggerated as the “worst” financial and economic crisis since the Great Depression of the 1930s. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The cumulative decline of inflation adjusted GDP of the United States during the current recession in the last two quarters of 2008 and first two quarters of 2009 was 4.7 percent. GDP increased in the third quarter of 2009. The hyperbole has been used in proposing massive fiscal/monetary stimulus as required in “avoiding another Great Depression” and, subsequently, in the argument that in the absence of such stimulus there would have been another Great Depression and that the stimulus should be maintained indefinitely. There is no convincing method to disprove the assertion because it is a “counterfactual” or what would have been economic conditions in the absence of the stimulus, which cannot be fully resolved because there are no data without the stimulus and even if available no decisive method to isolate multiple effects in a comparison with the available data with stimulus. The current credit/dollar crisis and global recession bears more resemblance in dimensions to the world debt crisis that required interest rates of fed funds of 19.08 percent in January 1981 because of the inflation shock resulting from the fine tuning of the late 1970s exacerbated by the oil price increases following the Iranian revolution. The current worldwide regulation, trade and devaluation wars are reminiscent of the analysis by Joan Robinson of beggar-my-neighbor remedies for unemployment (Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 174-84, Globalization and the State, Vol. I, 157-206, and Globalization and the State, Vol. II. 205-13). The troubled world economic environment of regulation, trade and devaluation is analyzed below in turn.
First, Regulation. There is a heavy agenda of regulation of finance worldwide. The Banking Act of 1933 prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks. Interest rate controls imposed by Regulation Q and the rise of banking by buying money through certificates of deposit (CD) to lend in large volumes encouraged the permanent exodus of banking from New York to London (Pelaez and Pelaez, Regulation of Banks and Finance, 74-5). Regulation Q was a costly government failure. The objective of regulation is to correct “market failures” or the use of collective action by the government to attain improvements over freer markets. The approach of the new institutional economics (NIE) is that both markets and governments may fail (Pelaez and Pelaez, Government Intervention in Globalization, 83-4, Globalization and the State Vol. I, 139-43, and Globalization and the State Vol. II, 211-3). That is, there is no assurance that the intervention by the government could improve over the state of no intervention and the similar counterfactual difficulty in analyzing government intervention after it occurs. It is quite difficult or nearly impossible with the available knowledge and institutional structure for the government to control systemic risk without exacerbating it such as in downsizing large banks. Banking panics were more common and pernicious in the United States than in other countries because of the large number of small banks, so-called unit banks, restricted by regulation to operate with only one office or within the boundaries of states. Research by Calomiris and Gorton concludes that unit banking systems are more prone to banking panics (Pelaez and Pelaez, Regulation of Banks and Finance, 202-3). Smaller banks may not be able to provide the volume of loans and financial services required by large business. American banks and companies would lose in world markets competing with international companies and banks that attain optimum scale, that is, produce at minimum costs. The replacement of the Federal Reserve System (FRS) with less independent regulators may lead to more politicized decisions on monetary policy and regulation, similar to the debacle of Fannie and Freddie, which could increase financial instability causing a worst future crisis. Rushed recession regulation has seldom improved regulatory structure and its effectiveness.
Second, Devaluation. The regulatory agenda in parliaments departs from the analysis of the credit/dollar crisis and global recession as caused by “an era of irresponsibility” in the form of excessive leverage and risk motivated by compensation of bankers without relation to performance. An alternative interpretation is that the credit/dollar crisis and global recession was caused by the zero interest rate on fed funds in 2003-2004 that eroded the discipline of risk/return calculations, encouraging high leverage and risk, low liquidity and unsound credit. Overproduction of housing was induced by lowering mortgage interest rates by eliminating the 30-year Treasury bond, the yearly housing subsidy in the United States of over $200 billion and the purchase or guarantee by Fannie Mae and Freddie Mac of $1.5 trillion of nonprime mortgages (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The erosion of bank discipline in risk management was caused by policy impulses. The zero interest rate in 2008 caused the carry trade of shorting the dollar and going long in commodities and emerging market stocks (Pelaez and Pelaez, Government Intervention in Globalization, 70-4). The dollar firmed as haven for risk aversion in world markets after the alarmist proposal of the Troubled Assets Relief Program (TARP) in September 2008 and then devalued after March 2009 with the return of risk appetite. World trade imbalances are primarily the trade deficit of the United States and the trade surplus of China. The Chinese renminbi needs to revalue, that is, fewer renminbi to buy a dollar, which cheapens imports into China and makes its exports more expensive. China moved in the path of adjustment by revaluing the renminbi from 8.28/dollar in 2005 to 6.83/dollar, or 17.5 percent reverse devaluation, but it fixed the renminbi against the dollar again in July 2008 to prevent an erosion of its competitiveness in exports during the global recession. The devaluation of the dollar caused significant loss of competitiveness especially in Asian exporting countries that intervened in their foreign exchange markets to arrest the appreciation of their currencies relative to the dollar. The employment report on November 4 showing loss of only 11,000 jobs and decline in the rate of unemployment raises the possibility that the Fed may increase interest rates in 2010, which are now at 0-0.25 percent per year on fed funds. The dollar would appreciate against most currencies making American exports more expensive and imports cheaper, contributing to the deterioration of the trade deficit. The zero interest rate could be considered a regulatory failure, causing financial instability. The world competitive devaluation would resemble those in earlier episodes such as the Asian crisis of 1997-1998. The countries that abandoned the gold standard in 1931 performed better than those that remained in gold as shown in vast literature on the Great Depression (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217).
Third, Trade. Jobless recoveries encourage the use of collective action by the government to restrict the entry of foreign-produced goods and services or the protectionism for promoting domestic employment at the expense of foreign employment deplored by Joan Robinson. A recent Gallup Poll shows that keeping jobs in the United States by not importing goods and services is the most favored employment-creation measure of Americans even beating tax reduction. This is likely the view of populations across the world. The competitive devaluation and ongoing measures to create trade barriers may complement each other. There may well be a return of the image of throwing rocks in ports to prevent trade perhaps also frustrating the international transmission of ideas, raising frictions in international relations. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)

The Fed and Reducing Government Deficits and Debt
Carlos M Pelaez
Macroeconomic policy during the credit/dollar crisis and the global recession has been characterized by monetary and fiscal stimulus (Pelaez and Pelaez, Regulation of Banks and Finance, 217-27, Financial Regulation after the Global Recession, 155-70). Confidence in financial markets collapsed after the Troubled Asset Relief Program (TARP) proposed in September 2008 to avoid economic catastrophe by purchasing toxic assets held by banks. TARP alarmism on devastating impact of write downs of assets on bank balance sheets caused exacerbated perceptions of default risk in counterparty transactions. Banks and investors ceased trusting themselves or other banks and investors. The volume of financing in sale and repurchase agreements (SRP) of asset-backed securities plummeted, resulting in fire sales and lower prices of those securities. The decline of security prices eroded capital of financed entities that were forced to sell positions, causing further declines of security prices across market segments. Confidence in financial transactions returned with higher risk appetite by investors around March 2009 that had no clear link to the monetary and fiscal stimulus. In fact, the same withdrawal plan of toxic securities was proposed in imitating the Swedish bank plan of 1992-3 under the different name of Financial Stability Plan (FSP) of February 2009, which again failed in implementation. Banks facing both the initial TARP in 2008 and the FSP in 2009 would rather hold the securities and assets than sell them at temporarily depressed prices that would bankrupt them (Financial Regulation after the Global Recession, 164-6 and 170-1). The recovery of prices of the derivatives portfolio of AIG illustrates the inconsistency of the toxic withdrawal plans. Panicking by the authorities with toxic securities caused the financial panic. The major part of toxic securities originated in the purchase or guarantee of $1.5 trillion nonprime mortgages by Fannie and Freddie. It is also difficult to find a clear link to the fiscal stimulus in the recovery of real economic activity after the second quarter of 2009. Definitive judgment awaits rigorous econometric analysis, which may never be fully conclusive. The policy issue at the moment is not the effectiveness of the monetary and fiscal stimulus but the potential threats to future economic activity in not implementing a timely and effective exit strategy of the combined monetary and fiscal stimulus. Both strategies are considered in turn. First, the exit strategy of the monetary stimulus requires an adjustment of the policy rate of the Fed of 0 to ¼ percent paid on uncollateralized loans among banks of deposits at the Fed (or fed funds) and a reduction of the portfolio of securities of the Fed in the value of $1.7 trillion. At some point, quite difficult in timing and dose, interest rates must increase again. Expectations of interest rate increases are influenced by the lowering of the fed funds rate by 525 basis points in 2000-2003 followed by an increase of 425 basis points in 2004-2005 and then by a decrease of 425 basis points in 2007-2008. Markets fear that the there may be another episode in the future of sharp increases in interest rates by the Fed. Monetary policy in the form of fixing fed funds rates is conducted by the Federal Open Market Committee (FOMC) of the Federal Reserve System (FRS) composed of the seven governors of the Board of Governors of the FRS, the president of the Federal Reserve Bank (FRB) of New York and four rotating presidents of the 12 regional FRBs of which one is chosen from each of four groups of FRBs organized by region (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 33-5, Financial Regulation after the Global Recession, 74-7, Regulation of Banks and Finance, 102-8). The FOMC and the FRS have been characterized by competent choices of prominent professionals for governors and presidents of the regional FRBs and elite staff in research, supervision and regulation. It is imprudent to replace this system during this difficult adjustment by a new risk agency, which would lack the technical excellence and independence of the FRS, being subject to political capture and influence as Fannie and Freddie. Debates on policies are constructive and occur within the FOMC but recession regulation dismantling the FRS poses a major risk to financial stability, economic activity and employment. The minutes of the FOMC meeting on November 3 document the ongoing work on the exit strategy of the monetary stimulus. An important analysis considered in that meeting is that the low fed funds rate of 0 to ¼ percent could lead to excessive risk taking but that possibility is not considered as important currently. A key likely cause of the credit/dollar crisis and global recession is that the 1 percent fed funds rate in 2003-2004 distorted risk/returns decisions, encouraging excessive risk/leverage, low liquidity and unsound credit (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27). The 0 to ¼ percent fed funds rate in 2008 caused the mirage of ever increasing commodity prices such as oil futures at $145/barrel, which is behind debacles similar to Dubai real estate. The necessary increase in interest rates will cause oscillation of exchange rates and emerging markets overvalued by the carry trade stimulated by low fed funds rates. These policy errors abound because the changing forecasts on the economy disguised as scenarios are commonly worst in predictive value than those of palm readers and astrologers. Economic policy has uncertain effects. The staff of the Fed is conducting research on the alternative policy tools to adjust interest rates and the portfolio of securities in the Fed balance sheet. There are four policies and alternative combinations in the tool kit of the Fed: (1) reverse sale and repurchase agreements (RSRP) in large scale and even with counterparties other than approved dealers; RSRPs are short-term collateralized loans consisting of the sale by the Fed of qualified securities in its portfolio with an agreement to repurchase the securities in the near term at the agreed price plus interest, resulting in withdrawal of bank reserves (Pelaez and Pelaez, Globalization and the State, Vol. I, 34-7, Government Intervention in Globalization, 34-5, 38-9, Financial Regulation after the Global Recession, 75-7, Regulation of Banks and Finance, 99-116); (2) a term deposit facility at the FRS available to depository institutions, reducing bank reserves during the term of the deposit and renewed when necessary; (3) linking the interest rate paid on reserve balances of banks held at the FRBs and the fed funds rate, directly raising interest rates; and (4) final sale of assets in the securities portfolio, withdrawing bank reserves. There is no magic in the tools for exiting: the withdrawal of bank reserves causes an increase in interest rates in all alternatives or possible combinations. The recovery of the economy will increase demand for bank loans with resulting withdrawal of all or part of the $1.1 trillion of bank deposits in the Fed balance sheet that largely financed the portfolio of $1.7 trillion of securities, causing an increase in interest rates. Second, the fiscal stimulus, decline in government revenue following contraction of economic activity, special programs and legislative agenda are causing significant increase in the public deficit and internal debt. The Cross Country Fiscal Monitor of the International Monetary Fund (IMF) for November 2009 analyzes the deficit and debt of G20 countries. The IMF is projecting that government debt in the advanced economies of the G20 will reach 118 percent of GDP in 2014 even after the end of temporary stimulus. The structural primary balance is defined as government revenue less government expenditures, excluding interest payments on the debt while adjusting for the cycle of the economy and onetime factors. Controlling government debt at 60 percent of GDP by 2030 requires an increase in the average structural balance of 8 percentage points of GDP relative to 2010. There would have to be an elimination of the current primary deficit of 3.5 percent of GDP and the creation of a primary surplus of 4 percent of GDP. Such adjustment has occurred in the past but requires firm policy and its execution. The Congressional Budget Office (CBO) baseline budget outlook projects the federal deficit to continue at more than 3 percent per year in all of the next ten years. If there is no effort of fiscal restraint, which is the assumption of that baseline outlook because the CBO does not know currently what the government will do, the debt may become explosive, forcing more costly adjustment in terms of declining growth. Major deviations from projections are common. Stabilizing the debt at levels after the credit crisis would raise interest rates in advanced G20 economies by 2 percentage points, according to the IMF. Economic policy should focus on an exit of monetary and fiscal stimulus with more prudent government expenditures. The failure of timely and effective adjustment may cause a future debt crisis with high costs in loss of production and employment. The lag of fiscal adjustment behind the monetary adjustment already discussed within the FOMC would result in much higher interest rates from continuing high federal deficit and debt issuance while monetary policy must increase short-term interest rates and also likely long-term rates by the sale of the Fed portfolio of $1.7 trillion securities. Fiscal restraint requires more delayed Congressional action and should begin to be considered immediately as the key national priority or interest rates will be higher than necessary for adjustment, restricting employment and growth. Taxing to spend will crowd out the private sector’s ability to produce and create jobs, frustrating fiscal restraint because actual government outlays are likely to exceed revenue by more than intended. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

The Fed, the Carry Trade and the Misleading Bubble

The current carry trade consists of shorting the dollar against other currencies and simultaneously taking long positions in futures of commodities such as gold, other metals and oil or emerging stock markets. The term “carry” means that the position is financed or “carried” with a loan in the low yielding currency to profit from positions in higher yielding liquid assets. These are high risk uncovered positions that can cause losses if the dollar appreciates and/or if commodity prices and stock markets lose value (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). The carry trade at the turn of the millennium consisted of shorting the yen because of the near zero interest rates of Japan and simultaneously taking positions in high yielding currencies such as the Australian dollar and the New Zealand dollar. The Japanese yen (JPY) depreciated by 40 percent versus the US dollar (USD) in 1995-7, reaching an eight-year low of JPY147.26 per USD on August 11, 1998. In October 6-9, 1998, the JPY reversed the strong trend of depreciation and appreciated 15 percent versus the USD. The IMF observed a “cascade” of USD/JPY selling by institutional investors including hedge funds. There were no resulting shocks to the economy of Japan or the world economy but this episode has been used as illustration of instability caused by unwinding carry trades. The Fed has been aggressive and volatile in fixing the rate of fed funds or interbank loans of reserves deposited at the Fed, which is a proxy of the interest cost of an additional unit of bank lending. The Fed lowered the fed funds rate from 6.50 percent in May 2000 to 1.00 percent by June 2003 and left it at 1.00 percent until June 2004 when it increased it to 1.25 percent and then rapidly increased it to 5.25 percent by June 2005. In rollercoaster fashion the Fed lowered the rate to 4.25 percent by September 2007 rapidly lowering it to 0-0.25 percent by December 2008. The Fed lowered the fed funds rate by 525 basis points followed by an increase of 425 basis points and then by a decrease of 425 basis points in a time period of six years. These policy impulses resemble traders who successfully shorted stocks reversing by going long in the same trading session to benefit from the undershooting during the 22 percent decline of the market on Black Monday, October 19, 1987. Central banks should not induce these swings of financial variables. The credit/dollar crisis carry trade consisted of shorting the dollar and simultaneously going long in oil futures that reached $145/barrel in September 2008. The alarmist proposal of TARP in the second half of September 2008 caused a crisis of confidence, analyzed by Cochrane and Zingales, which encouraged panic inflow into dollars, reversing the carry trade with the price of oil collapsing toward $40-$50 per barrel. The combination of the 0-0.25 percent fed funds rate with the recovery of confidence and risk appetite encouraged the current carry trade with devaluation of the dollar toward $1.50/euro and increase in gold futures prices by 64 percent to $1150/ounce. Governments threatened intervention in oil futures routing the carry trade to metals futures. The fluctuation of the dollar without piercing forcefully $1.50/euro reflects two related problems. First, traders are fully aware of the aggressiveness of the Fed in raising or lowering interest rates by hundreds of basis points. A minor change in perception of Fed policy could cause appreciation of the dollar, collapse of gold prices and major losses in the carry trade, explaining the hit and go behavior of dollar positions. Second, the Fed balance sheet in the last monthly report shows holdings of securities of $1690 billion, with the largest holdings of $775 billion of treasuries and $774 billion of agency-guaranteed mortgage-backed securities; the major item of liabilities is $1083 billion of deposits at the Fed by depository institutions or banks. The Fed financed the balance sheet initially with deposits of banks remunerated with interest payments and Supplementary Financing or loan by Treasury that has virtually disappeared, being replaced with issue of notes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). If the economy recovers more rapidly than in the current outlook of the Fed, banks will want to withdraw their deposits to earn higher interest from loan spreads than what the Fed pays in interest. The Fed would raise interest rates, increasing the marginal cost of lending of banks and thus the short-term interest rate. The Fed would also have to sell in the market about $1.7 trillion of securities, lowering their price which is the same as increasing their yields. The entire yield curve would shift upward, which means increases in both short and long-term interest rates. The dollar would appreciate unwinding the carry trade. The misleading use of the term “bubble” in the context of the carry trade and others implies that market participants are ignorant and follow trends recklessly while governments and analysts after the fact are rational and never err. The fact appears to be that traders have protected the funds entrusted to their management by taking defensive positions against the shocks of policy that threaten to reduce the wealth of their clients, which in this case is a zero interest rate. The problem of the credit/dollar crisis has not been positions by investors or unsound lending by banks but the aggressive, shifting, fast changes in central bank policy of hundreds of basis points and trillions of dollars. What is needed is not more regulation of banks and finance but rather recognition of the ambiguity of knowledge on central banking and less volatility in policy impulses. The aggressive change in interest rates in attempts by central banks to stay ahead of the lag in effect of policy by half a year or more caused the credit/dollar crisis and global recession by distorting risk/return decisions throughout the economy (Pelaez and Pelaez, International Financial Architecture, 18-28, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27). Central bank balance sheets of trillions of dollars have created a tough adjustment trap complicated by a fiscal deficit of more than 10 percent of GDP with the federal debt approaching 100 percent of GDP. The adjustment to the monetary and fiscal stimulus can restrict growth and job creation. (For a briefer version go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )

The Federal Reserve System
Nobody owns the Federal Reserve System (FRS), which is an independent central bank that can take decisions without ratification by the President, Congress or anyone else. Members of the Board of Governors of the FRS are appointed to terms that extend over presidential and congressional terms. The FRS is subject to oversight and changes of statutes by Congress and must function within the general framework of government policy. The first major function of the FRS is monetary policy to ensure financial stability. According to 12 USC 225a, “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” The role of “independence within government,” appointment of prominent members to the Board, the technical nature of monetary policy and decentralized appointment of the 12 presidents of the regional Federal Reserve Banks (FRB) resulted in an institution that is freer from political influence and characterized by elite staff. The FOMC reaches decisions on the basis of information obtained from the research and supervisory functions of the FRS and the state of the art on the conduct of monetary policy (Pelaez and Pelaez, Regulation of Banks and Finance, 99-116, Financial Regulation after the Global Recession, 84-90). Errors have abounded in the decisions of the FOMC and central banks worldwide because of the ambiguous analysis of current and future economic conditions, which is a deficiency of a nonexperimental science such as economics. In addition, policy simulation models suffer from the Lucas Critique, by which expectations of economic agents may reverse policies, resulting in effects different than those intended. The errors and deficiencies in the credit/dollar crisis and global recession were by nearly all central banks in the world and not only by the FOMC because of insufficient knowledge of how the economy functions (Pelaez and Pelaez, The Global Recession Risk, 221-5, Financial Regulation after the Global Recession, 155-71, Regulation of Banks and Finance, 217-33). A proposed financial stability agency or systemic risk council would not be able to attain the technical excellence of the FOMC and the traditional political independence of the FRS. Monetary policy could be captured for political purposes during cycles of presidential elections and midterm elections for Congress, causing future instability. Independence of the chief monetary authority is highly desirable if sound policy management is the main objective. The second function of the FRS is provided by the Federal Reserve Act 12 USC 248 (a-r) that empowers the FRS with supervisory and regulatory functions. The Federal Reserve has created over the years competent staff to implement these powers. The United States has four federal supervisors and regulators of financial institutions, FRS, OCC, FDIC and OTS, with multiple state bank supervisors and regulators (Pelaez and Pelaez, Financial Regulation after the Global Recession, 69-77). Each of these agencies has developed own staff and procedures. The elimination of the supervisory and regulatory powers of the agencies for concentration in a sole federal regulator may prove unfeasible and undesirable in the United States, which has thousands of financial institutions of different sizes that are focused on diverse segments of the financial markets. The logistics of consolidation of these agencies could create a chaotic and difficult transition period during high unemployment. The FOMC would lose key information on supervised banks. An ambitious agenda of single regulatory agency, centralized systemic risk council, reduction of size of banks, consumer protection agency and other proposals (Pelaez and Pelaez, Financial Regulation after the Global Recession, 171-5, Regulation of Banks and Finance, 229-36) conflicts with the immediate objective of promoting tranquil, growing financial markets required for recovering full employment. The regulatory shock could increase the premium of bank capital, reducing lending capacity. None of these proposals addresses the true causes of the credit/dollar crisis and global recession, which were errors of central banks in lowering policy rates to nearly zero in 2003-4 and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. Congressional oversight failed in detecting policy errors and proposed regulation can cause more harm. The regulatory proposals can jeopardize the work of the FOMC and existing regulatory agencies, preventing the recovery of credit required for faster economic growth and employment creation. There are much higher returns in terms of employment creation in devising an exit strategy for the Fed balance sheet and the fiscal deficit than in proposing complex new controls.

How Big a Bank
Carlos Manuel Peláez's Latest Blog Posts

How Big a Bank
5:56 PM PST, November 8, 2009
Agendas of financial regulation in parliaments, international official institutions and monetary authorities include limits on the size of banks or how big a bank should be. These proposals imply that regulators would decide the total value of assets held by banks. Assets would have to be weighted by risk, which is the best practice applied in the Basel capital accords. Regulators would decide not only the total value of assets but also the structure or percentage share of assets by risk class and credit rating such as how much in consumer credit, real estate lending, securities holding, corporate lending and so on. If the regulators decide on the total value of assets and their risk, they effectively micro manage bank decisions on risk and return. Managers would only implement regulatory criteria with little decision power on how best to reward shareholder capital. Regulators would mandate maximum assets and their risk distribution by leverage, credit and liquidity regulation. There are two concerns on the regulation of how big a bank should be. First, there is the issue of best practice in bank management and its consequences for financing prosperity. Banking is characterized by declining costs because of bulky fixed investments required for initiation of lines of business (Pelaez and Pelaez, Regulation of Banks and Finance, 82-9, Financial Regulation after the Global Recession, 63-9). There has been a new industrial/technological revolution in the past three decades centered on information technology (IT). Banking is highly intensive in the creation, processing, transmission and decision use of information. The first transaction of a $100 million IT facility costs $100 million but the hundred millionth costs only one dollar. Competitive banking requires a large volume of transactions to reach the minimum cost of operations. At the time of the call report for the implementation of Basel II in 2006, 11 banking organizations had total assets of $4.6 trillion, equivalent to 44 percent of total US banking assets of $10.5 trillion, and about $978 billion in foreign assets, equivalent to 96 percent of US foreign banking assets of $1 trillion (Pelaez and Pelaez, Globalization and the State: Vol. II, 147). Concentration likely increased during the credit/dollar crisis and its reversal by regulation could cause another confidence shock. The regulation of how big a bank should be would disrupt investment in the best practice of using technology and delivery of products at lowest cost by US banking organizations. It would also undermine the competitiveness of US banks in international business, violating the essential principle of the Basel capital accords of maintaining fair competitive international banking. Second, the regulation of how big a bank should be is based on an inadequate interpretation of the credit crisis/global recession. The panic of confidence in financial markets is commonly attributed to the failure of Lehman Bros. in September 2008. Cochrane and Zingales have shown that the crisis of confidence originated in the proposal of the Troubled Asset Relief Program (TARP) of $700 billion two weeks after the failure of Lehman Bros. TARP was proposed in negative terms of: withdraw "toxic" assets from bank balance sheets of banks or there would be an economic catastrophe similar to the Great Depression. Counterparty risk perception rose sharply because of fear of banking panics, paralyzing sale and repurchase transactions and causing illiquidity of multiple market segments. The "toxin" was introduced by zero interest rates in 2003-4 that induced high leverage and risk, low liquidity and imprudent credit together with the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie on the good faith and credit of the US. Regulatory micro management of the volume and structure of risk of banks and financial markets will weaken banks, reducing the volume of credit required for steering the world economy from currently low levels of activity. It will also restructure markets with arbitrary concession of monopolistic power to less efficient banks, creating vulnerabilities to new crises. There is need for less intrusive regulation that induces a sustainable path of prosperity, using effectively the staff, expertise and resources of existing regulatory agencies.

Regulation and the Cost and Availability of Credit
4:14 AM PST, November 2, 2009
An influential view explains the transmission of the business cycle by the effects of a primary shock on balance sheets, income and liquidity of households, companies, financial institutions and the government. Internal financing of families is provided by savings, assets and liquid deposits while external financing consists of credit unsecured or collateralized with assets such as home equity. Internal financing of companies consists of retained earnings and liquid assets while external financing consists of unsecured or collateralized bank loans and issue of debt securities and equity. A primary shock in the form of lack of confidence could reduce the value of assets that households and business could pledge to lenders in raising external financing. The weakening of balance sheets of debtor households and companies would raise the credit default probabilities of loan portfolios of financial institutions, resulting in further contraction of external financing as lenders become more selective in providing credit. Declines in wealth and income of households, business and financial institutions lower the revenue of government, which may raise taxes. Consider the credit/dollar crisis and global recession. Central banks caused the credit crisis by lowering interest rates to nearly zero, inducing households, companies and financial institutions to take high leverage and risk and low liquidity, while Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages. The official, misleading version of the cause of the resulting credit/dollar crisis and global recession by the G20 was an alleged "era of irresponsibility" by financial institutions instead of actual regulatory errors in the form of zero interest rates and purchase or guarantee of nonprime mortgages by Fannie and Freddie. Intrusive proposals of financial regulation are creating adverse expectations that restrict the conditions and increase the interest rates of external financing to households and companies. Reduced external finance at higher cost restricts expenditure and production, which would move the economy out of recession. The effect is the same as that of the new credit card law, CARD, which caused reduction in credit limits and increase in fees for everybody. The cost of bank capital is significantly increased by proposals of full powers to government agencies controlling executive compensation, consumer credit, systemic risk, volume and structure of assets, cyclical capital, bankruptcy insurance fees and general management decisions. Imperfect knowledge on the functioning of regulation prevents success in fostering stability. Financial institutions would not be effectively managed by regulators with excessive work burdens, without superior business acumen and subject to political/corporate influence. The increase in costs of capital of financial institutions will restrict external financing to families and private companies, preventing recovery of full employment output. Regulation should induce balanced risks but without frustrating innovation promoting growth and effective bank management.

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Regulation typically results in effects opposite to those intended, causing social harms (Peláez and Peláez, Globalization and the State: I, 143-7). The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession, 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Milton Friedman analyzed in 1970 that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as "due from head office" while the head office changed the liability to "due to foreign branches" instead of "due on CDs." Friedman predicted the future as revealing as his forecast of 1970's stagflation: "the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York." People of modest means with lower income and wealth having no alternatives other than bankbook accounts received rates on their savings below those that would prevail in freer markets. Regulation transferred income from poorer depositors to endow banks with market power. The financial system was forced into costly readjustments while highly-paid financial jobs and economic activity were exported to foreign countries. The interest rate is the main compass of allocating savings and capital in a market economy but it was distorted by ill-conceived Great Depression regulation that is still emulated currently. The approach of official prudential supervision and regulation (OPSR) blames the irresponsibility of banks for the current financial crisis/global recession. OPSR proposes intrusive new regulation with powers to control business decisions at banks in executive remuneration, capital, liquidity, transactions, portfolio choice and others as if regulators are superior business executives (Pelaez and Peláez, Financial Regulation after the Global Recession, Regulation of Banks and Finance). The effects of laws are reversed by preemptive decisions as proved again by the Credit Card Accountability, Responsibility and Disclosure Act (CARD). By anticipated increasing costs and risks of credit card issuers resulting from CARD before going in effect in February 2010 nine months after its enactment in May 2009, CARD is causing higher fees and tighter credit conditions irrespective of creditworthiness. This will likely be the unintended potential consequence of proposed stiff regulation of consumer credit when consumers are reducing expenditures required for recovery. Frustrating securitization and structured products would have consequences similar to Regulation Q: higher costs to banks partly passed on to all but especially low-income consumers in the form of higher rates, lower financing volume, tighter credit conditions and flight of finance and high-pay jobs away from the United States. New York could decay to the perilous condition during the 1960s. Excessive regulation could create major social losses. Sound weights for prosperity and stability should be used in regulation, avoiding frustration of financial innovation that could restrict future growth and prosperity.


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In the current issue of the BIS Quarterly Review, Tarashev, Borio and Tsatsaronis define a systemic event as one generating losses sufficiently large that could disrupt the functioning of the system. The three drivers of systemic risk are (1) the individual riskiness of firms; (2) the concentration of the system in relatively large institutions; and (3) the exposure of firms to common risks or to interconnectedness of transactions. There is significant emphasis on technical research and practical policy proposals in creating a regulatory architecture for prevention of systemic risk and its control when it occurs. There are specific proposals of a consolidated supervisor of systemic risk. A risk council composed of all supervisors of financial institutions would conduct oversight by monitoring and identifying systemic risk throughout institutions supervised by the Fed, FDIC, OCC, OTS and everything under the SEC. All institutions posing systemic risk such as investment banks, insurance companies, finance companies (GMAC) and capital companies (GE) would be subject to systemic risk supervision. There are four hurdles to systemic risk architecture. First, an effective oversight council would require consolidation of all supervisors and regulators, which may be unfeasible in practice because of the division of oversight functions in Congress and agencies. Second, winding down the balance sheet of Lehman with worldwide exposures illustrates the technical challenge of creating a global regulatory model for measurement and simulation of systemic risk that could provide analysis, prediction and policy solutions. Third, the credit/dollar crisis originated in nonprime mortgages encouraged by the near zero interest rate in 2003-4, the $220 billion yearly housing subsidy and the purchase or guarantee of $1.6 trillion nonprime mortgages by Fannie and Freddie as analyzed in the previous post. Fourth, the alleged systemic event originating in Lehman and AIG has been disproved by Cochrane and Zingales who have shown that the confidence shock in the financial system originated after Lehman by the proposal of TARP as required in avoiding devastating financial crisis. The key function of transforming illiquid assets such as mortgages in immediate liquidity by means of sales and repurchase agreements was fractured by confidence uncertainty caused by policy. The systemic event originated, widened and deepened by the effects of policy impulses. Regulatory architecture of systemic risk should be based on clear analysis of the origins and propagation of the credit/dollar crisis to avoid future regulatory confidence shocks. Policy with imperfect knowledge and tools may accentuate instability and frustrate financial innovation and economic growth.

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10#postPMCA14VSEK76VRCYUat1255311958

1:50 AM PDT, October 5, 2009, updated at 6:46 PM PDT, October 11, 2009
In the current issue of the BIS Quarterly Review, Tarashev, Borio and Tsatsaronis define a systemic event as one generating losses sufficiently large that could disrupt the functioning of the system. The three drivers of systemic risk are (1) the individual riskiness of firms; (2) the concentration of the system in relatively large institutions; and (3) the exposure of firms to common risks or to interconnectedness of transactions. There is significant emphasis on technical research and practical policy proposals in creating a regulatory architecture for prevention of systemic risk and its control when it occurs. There are specific proposals of a consolidated supervisor of systemic risk. A risk council composed of all supervisors of financial institutions would conduct oversight by monitoring and identifying systemic risk throughout institutions supervised by the Fed, FDIC, OCC, OTS and everything under the SEC. All institutions posing systemic risk such as investment banks, insurance companies, finance companies (GMAC) and capital companies (GE) would be subject to systemic risk supervision. There are four hurdles to systemic risk architecture. First, an effective oversight council would require consolidation of all supervisors and regulators, which may be unfeasible in practice because of the division of oversight functions in Congress and agencies. Second, winding down the balance sheet of Lehman with worldwide exposures illustrates the technical challenge of creating a global regulatory model for measurement and simulation of systemic risk that could provide analysis, prediction and policy solutions. Third, the credit/dollar crisis originated in nonprime mortgages encouraged by the near zero interest rate in 2003-4, the $220 billion yearly housing subsidy and the purchase or guarantee of $1.6 trillion nonprime mortgages by Fannie and Freddie as analyzed in the previous post. Fourth, the alleged systemic event originating in Lehman and AIG has been disproved by Cochrane and Zingales who have shown that the confidence shock in the financial system originated after Lehman by the proposal of TARP as required in avoiding devastating financial crisis. The key function of transforming illiquid assets such as mortgages in immediate liquidity by means of sales and repurchase agreements was fractured by confidence uncertainty caused by policy. The systemic event originated, widened and deepened by the effects of policy impulses. Regulatory architecture of systemic risk should be based on clear analysis of the origins and propagation of the credit/dollar crisis to avoid future regulatory confidence shocks. Policy with imperfect knowledge and tools may accentuate instability and frustrate financial innovation and economic growth.
http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10

The origin of the credit crisis and global recession is explained in the Pittsburgh G20 statement by an “era of irresponsibility” in the form of excesses in risks and leverage in banks motivated by bankers’ compensation. The alternative view in growing professional literature and also in our seven books published by Palgrave Macmillan is that the crisis could have been caused by regulatory errors: the lowering of the Fed funds rate to nearly zero in 2003-4, collapse of mortgage rates by the elimination of the 30-year Treasury bond, the prolonged housing subsidy of $220 billion per year and the purchase or guarantee of $1.6 trillion of nonprime mortgages by Fannie and Freddie. These policies distorted risk/return decisions not only in finance but also by families, business and government. Interest rates near zero caused high leverage, low levels of liquidity and bad loans. The credit/dollar crisis manifested primarily in nonprime mortgages bundled in derivatives because the central bank created the impression of writing a put or providing insurance against falling real estate prices. House prices would increase but never fall below the level in the mortgage contract. Elementary economics concludes that subsidies cause overproduction of housing. The lowest interest rates in five decades created the impression that house prices would increase forever. Borrowers and lenders believed that the downside would be early repayment of the mortgage or sale at principal value in foreclosure. The sober approach is that of Functional Structural Finance (FSF) developed by Robert C. Merton and Zvi Bodie, which is ideology-free because the financial functions can be provided by the private-sector, government and family institutions. FSF posits that spirals of financial innovation, including structured products, academic landmarks such as Black-Scholes-Merton option pricing and risk-management techniques as by RiskMetrics®, improve the functions of finance required for economic growth. Excessive regulation can distort risk/returns decisions, preventing efficient financial functions, flattening the expansion path of the economy and preventing full employment. Carlos Manuel Peláez, 9/28/09 http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10