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Peter J. Wallison

How Dodd-Frank is a big obstacle to closing down Fannie and Freddie

By Peter J. Wallison

February 6, 2012, 1:55 pm

On Friday, Treasury Secretary Geithner said that the Obama administration is preparing to move forward with closing Fannie Mae and Freddie Mac and bringing back a robust private housing market. Ironically, the secretary’s statement was made almost one year to the day after the administration released its white paper on reform of the housing market. Since then, there has been virtual silence on the administration’s plans, while the private housing market has continued to grow weaker. Many banks, large and small, are abandoning the mortgage business, and MetLife had to close down its own large mortgage business when it couldn’t find a buyer.

One of the options in the administration’s white paper was a fully private market; in response, I and my AEI colleagues Alex Pollock and Ed Pinto circulated our own white paper in March 2011 in the belief that a deal between the administration and House Republicans that produces a wholly free housing finance market was possible. Although House subcommittees have considered some important legislation that moves toward reviving the private market, it is unlikely that anything will get through this Congress without the administration’s support.

Accordingly, we welcome the Treasury secretary’s renewed interest, but it is important for him and the administration to understand that it will be extremely difficult to close down Fannie and Freddie without amending the Dodd-Frank Act in significant ways. Among them, and by no means all, are the following impediments to the return of a robust private market:

· Although Fannie and Freddie might be privatized or otherwise eliminated over time, a robust private market cannot develop as long as FHA is able to insure mortgages up to $729,500 and remains exempt from the 5 percent risk retention requirement in Dodd-Frank. No matter what standards are ultimately adopted for the Qualified Residential Mortgage, FHA will always be able to out-compete private securitizers as long as it does not have to bear this additional cost and is able to insure most mortgages issued in the United States.

· In addition, the 5 percent retention requirement strongly favors the biggest banks, which alone have balance sheets large enough to hold the retention amount and still carry on an active securitization business. This would be bad enough as a competitive matter, but given the fact that many of the large banks are now substantially reducing their mortgage financing activity, the continued application of the risk retention requirement will prevent the growth of any private sector substitutes for the GSEs or FHA.

· The Volcker rule, which has already drawn opposition in many other quarters, is also an impediment to the development of a private securitization market. That market depends heavily on the ability of lenders to hedge their interest rate risks while they are assembling a pool of mortgages for securitization. The Volcker rule applies to any firm that is affiliated with an insured bank, and prohibits proprietary trading, which is very difficult to distinguish from hedging transactions. Until there is a safe harbor for hedging transactions, the risks of running afoul of the Volcker rule may prevent many bank-affiliated securitizers from entering the private housing finance market.

It is good news that the administration is now willing to go forward with GSE reform, but if it is serious about privatizing or eliminating Fannie and Freddie it will have to propose some serious reforms in Dodd-Frank at the same time.

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Categories:  Economic Policy, Financial Services, Regulation   |   Tags: , , ,

My meeting with Treasury Secretary Tim Geithner

By James Pethokoukis

January 26, 2012, 3:11 pm

You won’t have Treasury Secretary Tim Geithner to kick around any more:

Treasury Secretary Timothy Geithner has told Bloomberg Television that he wouldn’t expect President Obama to ask him to stay on for a possible second term, and even if asked, Geithner had planned on doing “something else,” MSNBC reports.

“He’s not going to ask me to stay on, I’m pretty confident,” Geithner told Bloomberg. “I’m confident he’ll be president, but I’m also confident he’s going to have the privilege of having another secretary of the Treasury.”

Geithner had thought about resigning last summer, but he agreed to stay on through the 2012 election at Obama’s request.

I recall a 2010 interview I had with Geithner in his office at the Treasury Department. The conversation was off-the-record, so I will not divulge any details. But I can tell you this: He looked like one tired puppy, even then. When I arrived, he moved out from behind his desk and sort of schlepped over to the meeting area of his office, collapsing into a chair. Jacket off, shoulders sunk—like he’d been smashing rocks all day. I kept thinking that James Baker or Robert Rubin would have trotted briskly over—jacket on—as they attempted to reflect the confidence that one would expect to see in the financial minister of the richest, most powerful country that has ever existed. But Geithner looked beat. That being said, I found him well briefed and candid, and his communications team was always very helpful.

Who would replace him in a second Obama term? Well, when rumors popped up last summer about Geithner leaving, I wrote this when I was at Reuters:

But I have been working my sources to compile a speculative short list of whom might replace Geithner should that become necessary. Kind of a “I could see so and so …” Among the names popping up: Gary Gensler of the CFTC, OMB head Jack Lew, former Clinton economist Laura Tyson, and Facebook COO Sheryl Sandberg.

Other names from other media outlets: NYC Mayor Michael Bloomberg, JPMorgan CEO Jamie Dimon, investment banker Roger Altman, former Clinton chief of staff Erskine Bowles, outgoing FDIC boss Sheila Bair, current White House chief of staff Bill Daley, former Obama economist Larry Summers and GE CEO Jeff Immelt. My sources are particularly dubious about Bair, Dimon, Bloomberg, and Summers. No one mentioned Elizabeth Warren who would be unconfirmable. And for the heck of it: Hillary Clinton. If she’s good enough for the World Bank (or not) … [An add: investment banker Roger Altman.]

And the good folks at Business Insider have compiled their own list.

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Categories:  Economic Policy, Financial Services, U.S. Politics   |   Tags:

Defending Bain, Romney, and Schumpeterian capitalism

By James Pethokoukis

January 10, 2012, 3:48 pm

My pal Bill Kristol contends “there’s a lot of silliness on all sides of the Bain Capital debate.” Now, I agree with Bill that the attacks on Romney by his fellow GOP candidates are “unfair …  and over-the-top.” And I agree that you don’t need to have private sector experience to be an effective American president.

But then there’s this:

And the unqualified defense of the virtues of Bain Capital by some on the right is also silly. Criticism of any behavior by a private firm? Outrage! An Assault on Capitalism! Haven’t they read Schumpeter? Don’t they know the glories of Creative Destruction? And, of course, all such destruction must be assumed to be creative!

Yikes. If this is where some in the conservative movement and the Republican party are inclined to go—four cheers for finance capitalism!—good luck.  … Post 2008, capitalism needs its strong defenders—but its defenders need also to be its constructive critics. The Tea Party was right. What’s needed is a critique of Big Government above all, but also of Big Business and Big Finance and Big Labor (and Big Education and Big Media and all the rest)—and especially a critique of all those occasions when one or more of these institutions conspire against the common good. What’s needed is a willingness to put Main Street (at least slightly) ahead of Wall Street, and a reform agenda for capitalism that strengthens it, alongside an even more dramatic reform agenda for government that limits it.

Bain Capital shouldn’t be demonized. It may not even deserve to be criticized. But in laying out a way forward, conservatives might remember that Bain Capital isn’t capitalism, that capitalism by itself isn’t freedom, and that there are more things in heaven and earth than are dreamt of in the Gospel of Wealth.

Sure, conservatives have been nowhere to be found, for the most part, on a needed reform agenda for the financial industry. But both private equity and venture capital have been critical in creating a leaner, more efficient, more productive, more competitive Corporate America over the past generation. They are part of the Big Business reform agenda, not an obstacle to it. Heck, I know they must be doing something right since the Obamacrats keep trying to devise new ways of taxing them.

To grow at even its historical rate, the U.S. economy will need to become even more innovative in the future. And countries unwilling to reward entrepreneurs or penalize/restrict/hamper the, yes, creative destruction that accompanies their innovation have found themselves facing slow growth and stagnation. Big Business loves the status quo and loves using Big Government to preserve the status quo, while marketing it as a form of (false) economic security for workers. Firms like Bain disrupt the status quo for the betterment of most though not all:

A society cannot reap the rewards of creative destruction without accepting that some individuals might be worse off, not just in the short term, but perhaps forever. At the same time, attempts to soften the harsher aspects of creative destruction by trying to preserve jobs or protect industries will lead to stagnation and decline, short-circuiting the march of progress. Schumpeter’s enduring term reminds us that capitalism’s pain and gain are inextricably linked. The process of creating new industries does not go forward without sweeping away the preexisting order.

Not to say that highlighting the “harsher aspects” doesn’t make for an effective campaign ad.

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Categories:  Economic Policy, Financial Services   |   Tags: , ,

Coming next: Obama’s anti-Romney tax

By James Pethokoukis

January 10, 2012, 2:46 pm

Back in the fall, President Barack Obama wanted to partially pay for his American Jobs Act with one of the most wrong-headed tax hike ideas you’ll ever hear about. See, when an entrepreneur sells his business or takes it public, any profit on the transaction is traditionally taxed as a capital gain, currently subject to a 15 percent rate. This has been true whether the business is a private equity manager, an oil partnership, or a comic book store.

But Obama wanted to change the rules of the game by targeting an unpopular sector of the economy: Wall Street. Specifically, Obama sought to tax profits from the sale of investment management partnerships—such as private equity, venture capital, or hedge fund firms—at the top ordinary income rate of 35 percent. (Soon to be 40 percent if the Bush tax cuts are not extended for 2013 and beyond.)

In other words, a special tax just for financial entrepreneurs. (An earlier version was somewhat broader.) The Private Equity Growth Capital Council had a solid point when it said that such a tax hike “violates basic tax fairness policy and seems to single out the private equity, venture capital, and real estate industries in a punitive fashion.” But for the White House, those are features not bugs. It hoped the move would both boost the chances of getting Congress to pass a tax hike as well as embarrass those Republicans who opposed. (The Occupy movement was cresting right around this time.)

Indeed, the tax provision is so bizarre that some Washington tax mavens thought it a bizarre clerical error when they first noticed it. Penalizing the “sweat equity” of entrepreneurs—and people who start and build financial firms are entrepreneurs just like those who start technology companies—would be a radical change in tax policy.

Even worse, the administration tried to hide what it was doing by intentionally conflating the issue with that of carried interest, the performance fee fund managers earn as part of their compensation. Carried interest is also currently taxed at the lower capital gains tax rate. Team Obama and other Democrats—and Warren Buffett—have argued that wealthy fund managers shouldn’t pay a lower tax rate than their secretaries.

The “enterprise value” tax, however, is something completely different. But, like many carried interest proposals, it is intended to smack investment funds. Combining an EVT with an effort to raise taxes on carried interest creates the misperception that both tax measures are ending unfair loopholes. Now, that might be true with carried interest. It is undeniably untrue when it comes to the EVT. Indeed, of the $21 billion in new revenue that might come from the two tax hikes—assuming no negative economic impact—two-thirds would come from the EVT.

But this is about more than just raising a bit of revenue for Uncle Sam. The EVT, likely to arise again as a way to pay for a full-year extension of the payroll tax cut, gives Obama another cudgel to pound the financial industry as part of his neo-populist presidential campaign. And imagine if his Republican opponent is Mitt Romney, a veteran of both private equity and venture capital when he ran Bain Capital. Obama would surely use Romney’s likely opposition to an EVT as more evidence that Romney and his fellow Republican only serve the needs of the wealthy.

The EVT may make for good politics, but it is simply horrible policy when Washington should want to a) encourage venture capital to finance the companies and industries of the future and b) encourage private equity to make existing companies more productive.

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Categories:  Economic Policy, Financial Services, Fiscal Policy and Taxes   |   Tags: , , , ,

Another conservative wants to break up the big banks on Wall Street

By James Pethokoukis

December 22, 2011, 8:29 am

My pal Charlie Gasparino of Fox Business adds his voice to growing number of conservatives who think the mega-bank model is bad for America (via the NY Post):

Three years after the financial crisis and the bailouts, and we’re not much better off: “Too big to fail” remains, banking profits are sinking and those big, overregulated banks can’t manage to lend to small businesses.

Maybe it’s time to stop protecting this failed business model — and finally begin to break up the nation’s largest banks.

Making them smaller and less “systemically” important may be the only way to get them to lend more. If they hold less capital, they can start taking some risks without a chance of blowing up the whole financial system.

The obvious way to force the banks to get small and fast is to again split commercial from investment banking — that is, making it so that no bank can roll the dice in the securities markets if it wants its deposits backed up by federal insurance. …

The sales job from Wall Street told us that being big had competitive advantages — it let US banks go toe to toe with huge foreign players. But as profits exploded, the banks’ fatal flaw was largely ignored: They were too big to manage. …

But it only became obvious when the banking crisis hit, and the guys managing the megabanks suddenly found out they were basically insolvent and sitting on countless billions in toxic loans and investments — and that without a taxpayer bailout, the collapse of such large and interconnected banks threatened to bring down the global financial system.

Somehow, that experience failed to convince the banks’ overseers that bigger isn’t better, after all — far from it. From the Dodd-Frank law to the new Basel global-banking standards, the trend is just the opposite.

The result: Fewer than a dozen US banks now hold about 75 percent of all bank assets. But because they’re so big, regulators force them to hold mountains of capital — lest they crater the global financial system with a single screw-up. …

At least some people, like Republican presidential aspirant Jon Huntsman, see the benefits of the smaller-is-better banking model and are starting to talk about the need to make the banks smaller and nimbler.

As I mentioned, it is not just Gasparino and GOP presidential candidate Jon Huntsman. The concern among some on the right is as follows: a) Big  Government will always choose bailout over bankruptcy for Big Money—privatized profits with socialized risk; b) Too Big To Fail increases financial fragility and the odds of further crises; c) concentration of economic power should be avoided just like concentration of economic power.

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Did the payroll tax deal just make privatizing Fannie and Freddie $36 billion harder?

By James Pethokoukis

December 17, 2011, 11:38 am

The Senate this morning, by a vote of 89-10, approved a two-month extension of the payroll tax cut and jobless benefits. And here’s how it will be paid for (via Politico):

The two-month extension of the payroll tax holiday would cost the government $20.4 billion in lost revenue; unemployment benefits costs $8.3 billion; and the so-called “doc fix” costs $4.1 billion. The new Fannie and Freddie fees cut the deficit by $35.7 billion.

Here’s your trouble: This bill counts on nearly $36 billion that comes from increasing the fees (known as g-fees) that Fannie Mae and Freddie Mac charge for guaranteeing mortgages. In other words, this bill  turns Fannie and Freddie into sources of funds for the government. As my colleague Peter Wallison points out, “If Congress is ever to do anything to eliminate or privatize Fannie and Freddie it will be necessary to find substitute funds or expense cuts of an equivalent amount.”

Now Republicans argue that these higher fees will enable private securitizers to compete more effectively with Fannie and Freddie. If they’re right, the higher fees might resurrect the private securitization market that has been dead in the water since the 2008 financial crisis. But it probably isn’t true, as Wallison argues:

 At the margin, the theory is correct. Higher g-fees do indeed make it more likely that the private sector can compete with Fannie and Freddie, but sad to say this is highly unlikely to happen until a large number of additional obstacles—many of them in the Dodd-Frank Act—are cleared away. In testimony that I gave on November 3 at a hearing in the House Financial Services Committee, I listed nine impediments to the revival of a private market securitization market, in addition to the difficulty of competing with Fannie and Freddie. These include the high conforming loan limits at Fannie and Freddie (and now there are even higher ones for FHA that Congress adopted only a few weeks ago); the fact that Fannie, Freddie, and FHA are exempted from the risk-retention requirements of the Dodd-Frank Act; the threat that risk-retention poses to a “true sale” under accounting rules; and the effect of the Volcker rule on the ability of securitizers to hedge their risks.

So not only has Congress extended a short-term Keynesian tax cut unlikely to do much good, the way it is being paid for makes privatizing Fannie and Freddie just a little bit harder.

UPDATE: A Senate GOP source make this counter-argument: 1) Those fees do need to go up to make private securitizers more competitive; 2) this will “not be a well” Congress returns to again and again; 3) every year that goes by, the money that would need to be made up in case of privatization or other major reform would be less and less; and 4) the value of the government’s credit guarantee subsidy to Fannie and Freddie is $53 billion over the next decade. So if they were privatized, it would merely mean the CBO-counted savings would be less.

This chart shows the subsidy:

 

Me: Still a bad and potentially costly precedent.

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Categories:  Economic Policy, Financial Services   |   Tags: , ,

Alex J. Pollock

‘TBTF is too big’ vs. Canada

By Alex J. Pollock

December 13, 2011, 12:24 pm

A common argument these days runs like this: Banks which are too big to fail (TBTF) are just too big. They are so large they can put the whole financial system at risk. They should be broken up since they make the system unstable.

However, an observation equally frequent is that the Canadian banking system has performed far better than that of the United States, and indeed seems to be a leading example of relative stability. This was true not only in the financial crisis of 2007-09, but also in the much greater crisis of the 1930s. Yet the Canadian banking system is composed almost entirely of five TBTF banks, which are nationwide in operation and combine multiple financial businesses. If banks that are just too big create the problem, how do we understand Canadian banking’s performance? Do the proponents of the too big theory insist that Canada should break up its big banks? If not, why not?

A required project is to weigh the too big argument against the Canadian experience. What will emerge from such a study? It will perhaps lead us back to more fundamental problems, such as excess leverage—what Walter Bagehot in 1873 rightly called “smallness of capital”—as opposed to bigness per se.

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5 reasons why Obama wants to double U.S. tax rates

By James Pethokoukis

December 13, 2011, 12:15 pm

I almost missed this. At the end of today’s New York Times story on declining income inequality is a quote from economist Emmanel Saez, co-author of much-cited research on the topic (bold for emphasis):

The income shares of the top 1 percent became a common metric of inequality after a 2003 study by the economists Thomas Piketty and Emmanel Saez, which traced trends back to 1913. It peaked at 24 percent in 1928, just above its 2007 level. Mr. Saez, of the University of California, Berkeley, sides with those who think the rich will soon get richer.

“Barring an economic cataclysm ahead, top earners will be recovering faster than the other 99 percent,” he wrote in an e-mail. “The inequality problem is not going away and won’t until drastic policy changes are made (as happened during the New Deal).”

“Drastic policy changes” like those “during the New Deal.” Wow, whatever could Saez mean? Strange that the reporter didn’t ask or if he did, chose not to include the answer.

But I think I have a pretty good idea of what Saez meant, especially given the New Deal reference. According to his research, Saez thinks the top U.S. income tax rate should more than double to 80 percent, putting it back at levels seen during the 1930s and 1940s. Indeed, Saez and Piketty are playing a key role in reinvigorating the old liberal consensus that taxes need to return to pre-Reagan era levels. Back to the 1970s!

Saez has also done research with Peter Diamond, whose nomination by President Obama to the Federal Reserve sunk in the Senate, that suggests the top income tax rate should go back to 70 percent, right where it was when President Reagan took office. Hey, 70 percent, 80 percent, who cares, really. Just start cranking that baby up! Naturally, liberal economists such as Paul Krugman and Brad DeLong are very excited by all of this.

But does this mean President Obama also thinks the top marginal tax rate should return to at least 70 percent from 35 percent today, if not higher? I think there is strong evidence, though not conclusive, that he does:

1. As it is, Obama’s policies, if fully enacted, would push the highest marginal tax rate up to 44.8 percent.

2. In his Osawatomie speech, Obama repeatedly said how the U.S. had gone off track the “last few decades,” which is exactly when tax rates started falling dramatically.

3. In his book “The Audacity of Hope,” Obama suggested he didn’t buy the theory that the high marginal tax rates that existed when Reagan took office hurt incentives to save and invest.

4. The foundational economic theory of Obamanomics is that even though the economy expanded during the “last few decades,” the middle class stagnated. In short, the rich took all the money. And now it’s time they give it back. As he told “60 Minutes” last weekend:

But you can’t get away from the basic concept that either we have a system in which the people who have benefited the most from this new economy — by a magnitude of 200%-300% increases in their income. And the middle class in America has really taken it on the chin, during this period. They haven’t seen their wages go up, they haven’t seen their incomes go up.

5. Obama rejected the recommendations of his own debt panel. This is key. Recall that the Bowles-Simpson Commission would have reduced or eliminated tax breaks while lowering the top tax rate to no higher than 29 percent. But even though all those changes would still have resulted in a huge net tax increase, the amount of new revenue would not be enough to balance the budget without an equally huge restructuring of entitlements. By 2035, both spending and revenue would be 21 percent of GDP under Bowles-Simpson. And liberals know there is no way to keep government spending that low without a Paul Ryan-style, market-based approach to Medicare reform.

To fund a federal government where Obamacare is fully operation, Social Security is fully solvent and domestic “investments” are fully financed, the Obamacrats need dramatically higher tax revenue. And they think sharply higher income tax rates on the “rich” — and eventually hitting everybody else through a value-added tax — is how to get their hands on the dough. So there’s no way Obama could have supported the Bowles Simpson plan and the lower tax rates it recommended.

Think this high-tax scenario could never happen? Liberals sure believe this is America’s fiscal endgame and time is on their side. If the U.S. should face its own sovereign debt crisis, you’ll surely hear Democrats say “all options should be on the table.” And you’ll know exactly what they mean.

 

 

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Categories:  Economic Policy, Financial Services, Uncategorized   |   Tags: , ,

Peter J. Wallison

Senate GOP right to demand restructuring of new consumer agency

By Peter J. Wallison

December 9, 2011, 5:22 am

No matter what you may think of Richard Cordray, President Obama’s nominee to head the Consumer Financial Protection Bureau, it is important to remember why the Senate Republicans refused to allow a vote on his nomination yesterday.

Several months ago, 44 Republicans signed a letter to the president, advising him that they would vote against the consideration of any nominee to head the CFPB unless the structure of the agency is substantially changed. This was an unusual stance, but the CFPB is an unusual agency. Its regulatory jurisdiction is unprecedentedly broad—far wider than any other agency of the government—extending nationwide and covering every business that had financial dealings with consumers, from the largest banks to the smallest check-cashing firm. Its decrees could mean life or death for whole industries.

Yet, the CFPB appears to be inconsistent with the governmental structure set up by the U.S. Constitution. The Framers of the Constitution believed that the liberties of the American people would best be protected by a government of divided functions. The Congress would appropriate funds and make the laws, the president would be accountable for executing the laws, and the judiciary for interpreting the laws. No one branch would have complete authority over the people, and the political branches would be subject to regular elections where they could held accountable by the people.

The CFPB appears to violate this constitutional structure. First, the agency would be headed by a single director, appointed for a five-year term, and removable by the president only for inefficiency, neglect of duty, or malfeasance in office. In other words, the director—unlike most other members of the executive branch—does not serve at the pleasure of the president. Once appointed, the director could operate independently of the president, although the president is supposed to be accountable for the director’s decisions. Second, the CFPB—unlike other agencies with such plenary authority over the entire country—does not have to go to Congress for annual appropriations; by statute, it is given access to the funds of the Federal Reserve Board, and is thus both outside the government’s budget process and insulated from the congressional appropriations process.

In their letter to the president, the Senate Republicans asked for changes in this structure—changes that would turn the CFPB into a five-member board, like the SEC, CFTC, and FCC, with members from each political party. This would assure that the agency’s decisions are subject to some collegial consideration—with the opportunity for expression of different points of view. The president would still appoint the chair, but the other members could bring additional judgments to bear on its decrees. In addition, the board would, like all other similar regulatory bodies, have to seek appropriations from Congress and be subject to congressional supervision.

These requirements would restore at least a minimal accountability to the political branches, and would fit within the Framers’ unique concept for assuring the liberties of the American people.

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Phillip Swagel

Why we shouldn’t break up the big banks

By Phillip Swagel

December 7, 2011, 5:51 pm

Today, I testified before the Senate Banking Committee on the new regime for regulating large, complex financial institutions. If you don’t have the time to read the whole testimony, here are some key takeaways:

 Large financial institutions can be good:

Indeed, there are important benefits to the U.S. economy from having financial institutions with large and diverse balance sheets that can best make liquid markets for large transactions and across a broad range of assets. Large banks are best able to help end-users deal with risks, and to serve large clients in trade finance, global lending, and cash management. Smaller banks also play a vital role in the U.S. financial system and in the economy. But it is a reality that large financial institutions are best able to undertake commercial transactions for large multinational clients that are a hallmark of the globalized economy.

Better oversight is better than breaking big banks up:

The Dodd-Frank Act takes a better approach, which is to strengthen regulation and oversight of large, complex financial institutions, including with features that will help regulators detect, avoid, and respond to future crises. The Financial Stability Oversight Council in particular will help avoid a repetition of the problems in which no regulator had clear responsibility for AIG.

The new regulatory regime in Dodd-Frank does not break up large financial institutions or reinstitute the Glass-Steagall separation of commercial and investment banking. This is appropriate. The repeal of Glass-Steagall is not well correlated with the failures in the crisis. Bear Stearns and Lehman Brothers, for example, both remained investment banks, while JPMorgan Chase combined investment banking and commercial banking but weathered the strains of the crisis. I would focus instead on the riskiness of firms’ particular assets and activities.

Raising capital standards leads to a tradeoff between stability and strength:

Increased capital and liquidity requirements on large financial institutions will provide a greater buffer for firms to absorb losses and weather market strains. But there will be an impact on financial intermediation and thus on the economy. Real-world banks react to binding capital requirements by making fewer loans, and increased capital requirements could drive lending activity once again into the less-regulated shadow banking system. Higher capital standards are useful, but they do not escape the tradeoff between stability and economic vitality.

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Categories:  Economic Policy, Financial Services   |   Tags: , ,

Nick Schulz

Yes, I’d trust a Randian banker (if only more banks were like BB&T)

By Nick Schulz

December 6, 2011, 9:32 am

Noah Kristula-Green has a strange post here asking “Would You Trust a Randian Banker?” (h/t Mark Thoma) He takes shots at former BB&T CEO John Allison, suggests Allison didn’t understand the mortgage crisis, and says “just because the person talking has a lot of money doesn’t mean they always know what they are talking about, especially if they never grew out of their Ayn Rand phase.”

This struck me as odd because I remembered reading BB&T had done quite well relative to the rest of the banking industry during the financial crisis. If results are any indicator, Allison does, in fact, know what he’s talking about. Here’s Morningstar’s take:

BB&T is a large regional bank operating in the southeastern United States. Average returns on equity—13.6 percent between 2003 and 2008—before the crisis gave way to low, but continual profits during the crisis. The bank took advantage of its capital position and its solid reputation to expand during the recession…

BB&T has gained market share from struggling local competitors. BB&T saw a steady stream of deposits and new commercial customers flow in, seeking the safe haven this conservative company provides…

BB&T’s results during the crisis were much better than its peers…

For the best take on Rand, see Charles Murray’s essay here.

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Can financial reform help the GOP occupy the White House?

By James Pethokoukis

November 25, 2011, 11:10 am

It’s already clear what sort of reelection campaign Barack Obama is going to run. He will attempt to rebrand the Republican Party as the One Percent Party, extremist obstructionists doing the bidding of big banks and superwealthy at the expense of the rest of the American people. This was going to be the strategy even before the Occupy movement emerged, though the rabble a) helped provide the “1% vs. 99%” political vocabulary and b) made the MSM to focus on inequality as a substantive 2012 issue.

But it seems as if the GOP should be able to turn Obama’s populist argument against him, particular as it concerns Wall Street. It was the Obama White House, after all, that a) pushed Dodd-Frank which has perpetuated Too Big To Fail (as evidenced by big banks getting bigger and their continued funding advantage over smaller rivals, b) supported the no-strings-attached TARP bailout, and c) rejected a FDIC-like takeover of troubled banks. And these are the guys trying to run an anti-bank, class-warfare campaign?

Except that Republicans, including most of the presidential candidates, have had little to say about financial reform other than advocating a repeal of Dodd Frank, a status quo argument. Until now, that is. Next week Jon Huntsman will unveil his financial reform plan, which I have previewed. And this will be Huntsman’s message: “Real financial reform will mean breaking the Faustian bargain between Wall Street and Washington that helped fuel the housing bubble, drove a series of bailouts, and prevented meaningful reform in the aftermath of the financial crisis.”

His Republican rivals would be wise to fashion plans at least as comprehensive. While many may doubt financial reform as a top issue — especially compared to unemployment — a full-blown EU financial crisis and resulting global contagion could quickly change that political calculus. What does the GOP field think about caps on bank size, fees on big banks, or market-based triggers for bank bankruptcy? There is a difference between advocating markets as the best allocators of capital and reflexively bashing financial regulation without providing an alternative. Fixing Wall Street may not be a big enough primary issue to get Huntsman the GOP nod, but it could help nudge the eventual nominee into the Oval Office.

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Jon Huntsman declares war on big banks and Too Big To Fail

By James Pethokoukis

November 23, 2011, 1:44 pm

With a brand new proposal, Republican presidential candidate Jon Huntsman is the only GOP 2012er to have moved beyond “repeal Dodd Frank” (which sounds like a return to the status quo) and fashioned a serious and comprehensive — and bold — financial reform plan. He’s for repealing Dodd Frank, of course, but also a) reducing bank leverage by axing the deduction for interest payments and b) shutting down Fannie and Freddie.

But eliminating “too big to fail” is really the core of what he’s trying to do. As Team Huntsman correctly notes, the six largest U.S. financial institutions are significantly bigger than they were before the financial crisis. These banks now have assets worth over 66 percent of gross domestic product—at least $9.4 trillion, up from 20 percent of GDP in the 1990s. And the major banks’ too-big-to-fail status gives them a huge advantage in bor­rowing over their competitors. This funding subsidy amounts to at least 25 basis points and perhaps as much as 50 basis points. Indeed, that edge is proof TBTF still exists.

We need banks that are small and simple enough to fail, not financial public utilities. Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality.

Here’s how Huntsman wants to kill TBTF and break the crisis-bailout-crisis-bailout cycle:

 1. Set a hard cap on bank size based on assets as a percentage of GDP. (This cap would be on total bank size, not using any of the illusory “risk-weights” currently central to thinking about bank accounting. The lowest risk assets for banks in Europe, supposedly, are sovereign debt—yet this very same debt is now at the heart of the current crisis.

2. We should have a similar cap on leverage—total borrowing—by any individual bank, relative to GDP.

3. Explore reforms now being considered by the U.K. to make the unwinding of its biggest banks less risky for the broader economy.

4. Impose a fee on banks whose size exceeds a certain percentage of GDP to cover the cost they would impose on taxpayers in a bailout, thus eliminating the implicit subsidy of their too-big-to-fail status. The fee would incentivize the major banks to slim themselves down; failure to do so would result in increasing the fee until the banks are systemically safe. Any fees collected would be used to reduce taxes for the broader non-financial corporate sector.

5. In addition, focus on establishing an FDIC insurance premium that better reflects the riskiness of banks’ portfolios. This would provide an incentive for banks to scale down, allowing the financial system to absorb them organically in the event of a collapse.

6. Strengthen capital requirements, moving far beyond what is envisaged in the current Basel Accord. The Accord is a mixture of regulatory oversight and political compromise. As a result, the U.S. has allowed its banking policy to be determined by the “least common denominator” among European and Asian countries, many with a long history of not being prudent.

About the only things not in there are a) a Tobin tax on trading, b) reinstating of Glass Steagall and c) what to do if banks still get in trouble (debt-equity swaps, good bank/bad bank). The stuff on capital requirements is great, and using a bank tax to cut taxes on non-bank firms is quite interesting. (It also avoids the creation of a bailout slush fund that Congress could raid.) Reforming the financial system is low-hanging fruit that Republicans have been reluctant to pick. Huntsman just did.

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Should Occupy Wall Street become Occupy Foreclosures?

By James Pethokoukis

November 18, 2011, 10:02 am

The wonderful Political Math blog lays out an intriguing proposition (excerpts):

There seems to be a very loose relationship between what the protesters say they want and their method of protesting. Giving this some thought, I think there is an civil disobedience action the Occupiers can take that would make a great deal more sense. And that is occupying foreclosures. Hear me out here… I’m not the most sympathetic toward the Occupy movement, but occupying foreclosures has the following benefits:

2. The action is directly related to the financial sector (although they would quickly discover that Fannie Mae and Freddie Mac are bigger culprits than Goldman Sachs).

3.  It would be genuinely disruptive to the financial sector. Don’t fool yourselves, sleeping in a park is more disruptive to a bagel shop than to a hedge fund manager.

5. They could actually get arrested for peaceful civil disobedience (trespassing) rather than for jaywalking or public indecency.

6. Good optics if they keep the houses clean & leave when they are sold.

9. They can attach themselves closely to the individual stories of woe within the local community.

10. If banks decided it would be better to sell foreclosures for a loss rather than risk an occupation, it might move inventory, actually help solve one of the problems.

11. Filter out the antagonistic element from Occupy. I suspect anarchists are less interested in playing house with a half dozen people than with running down the streets smashing windows.

Those last two points are key. First, my experience with OWS is that the anarchist-to-signal ratio is awfully bad. Frankly, if you separate out the anarchists, mentally unbalanced, homeless, and hipsters, there might not be much of a movement left — certainly not many protesters who would want the unglamorous task of occupying a house and keeping it up.

Second, we need to speed up foreclosures so the market can clear. As Cato’s Mark Calabria notes:

The massive shadow inventory of homes yet to hit the market, numbering in the millions, is keeping potential buyers on the sidelines. Why buy now when a future massive increase in supply will likely depress prices more? It is best to get that supply to the market now. We also, by my estimate, have about 500,000 borrowers still in their homes that have not made a single payment in over 2 years. These borrowers will likely never get current.

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No good news from eurozone as debt crisis worsens

By James Pethokoukis

November 15, 2011, 7:46 am

I think this analysis from ZeroHedge nicely sums up the utter mess of Europe right now:

It took Europe two days to go from fixed to fully broken all over again. Those curious why they are waking up to a see of red, Italian 10 Year yields back over 7%, stock futures tumbling, the EUR/$ sliding, Italian, French and Belgian CDS at fresh records, and a record scramble for Bund short-dated bonds (2 Year under 0.030%) is due to two main things: a failed Spanish auction now that contagion is back to sleepy Iberia, which sold €3.2 billion of bills, below the €3.5 billion target, with the yield soaring to 5.02% from 3.61% at Oct. auction leading to Spanish 2-, 10-yr yield spreads to Germany both significantly wider to records. The second main factor is the realization that Mario Monti is not the second coming and will in fact face major resistance to form a government. B … And if Monti can’t do it, nobody can. Which explains why the fulcrum European security, the Italian 10 year BTPs, just fell off a cliff, and is now yielding back over 7% at a euro price of under 85 cents. This could well be crunch time: there are no more magic rabbits in the hat, or deus ex prime minister resignations in the hat for Italy.

The red circle on the above chart is where the ECB  started buying, knocking yields back down… solving nothing. Again, here is why Italian bond yields are important (via IHS Global):

Although rising bond yields will not affect Italy’s current debt structure as most of the public debt is held under fixed interest rates, it will be an increasing burden on the economy with Italy facing a prolonged period of heavy financing needs as its public debt ratio peaks at just over 120 percent of GDP. Given that the average yield on current government debt stands at 4.125 percent, bond yields higher than 7 percent would present a significant jump in the cost of rolling over sovereign debt in the next few years.

I couldn’t agree more with this guy quoted by Reuters:

“The danger is — and the markets are keenly aware of this — that this crisis, like most, turn on a dime and can blow up very, very quickly,” said Oliver Pursche, president of Gary Goldberg Financial Services in Suffern, New York.

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The GOP 2012ers on housing: Grow, foreclose, rinse, repeat

By James Pethokoukis

November 10, 2011, 11:10 am

The Republican presidential candidates spent a good deal of time — finally — at last night’s CNBC debate talking about America’s housing depression. They were asked about a half dozen questions, eliciting some fairly lengthy answers, though all were pretty much the same. Mitt Romney hit on the all the major points:

1. Create more demand. “The best thing you can do for housing is to get the economy going, get people working again, seeing incomes, instead of going down, incomes coming up so people can afford to buy homes.”

2. Let prices find a bottom, ASAP. “What we know won’t work is what this president has done, which is to try and hold off the foreclosure process, the normal market process.”

 3. No government help for homeowners. “… to have the federal government go out and buy all the homes in America? That’s not going to happen in this country.”

4. Government caused the housing crisis. ”The federal government came in with Fannie Mae and Freddie Mac, and Barney Frank and Chris Dodd told banks they had to give loans to people who couldn’t afford to pay them back.”

Oh, and special mention to Ron Paul for doing his best Andrew Mellon impression and embracing 8 million more foreclosures:

No, you have to let it — you have to let it liquidate. … So, yes, you want to liquidate the debt. … If you don’t liquidate this and clear the market, believe me, you’re going to perpetuate this for a decade or two more, and that is very, very dangerous.

Team CNBC really needed to explore with the candidates how the moribund housing market is sand in the economy’s gears: Falling homes prices and underwater homes hurt consumer spending, make labor markets more rigid since people can’t move to take a new jobs, and prevent budding entrepreneurs from using home equity to finance start-ups. While the Tea Party GOP isn’t going to support cutting checks, again maybe something like this from economist Luigi Zingales:

We envision a reform of the bankruptcy code that, in areas where house prices have dropped precipitously, would require lenders to give homeowners the option of resetting their mortgages to the current value of their houses. In exchange, the lenders would get 50 percent of the houses’ future appreciation. To keep homeowners honest—that is, to prevent them from doing minimal upkeep in the knowledge that they stood to gain less from a home-price increase—the capital gain would be measured based on an average of houses selling in the area, rather than on the change in the value of the actual house.

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How would President Romney handle another bank crisis?

By James Pethokoukis

November 9, 2011, 1:34 pm

For me, this was the best bit of the Republican debates by far:

BLOOMBERG’S GOLDMAN: Governor Romney, it’s 2013, and the European debt crisis has worsened. Countries are defaulting. Europe’s largest banks are on the verge of bankruptcy. Contagion has spread to the U.S. And the global financial system is on the brink. What would you do differently than what President Bush, Henry Paulson, and Ben Bernanke did in 2008?

ROMNEY:  Clearly, if you think the entire financial system is going to collapse, you take action to keep that from happening. … But I can tell you this—I’m not interested in bailing out individual institutions that have wealthy people that want to make sure that their shares are worth something. I am interested in making sure that we preserve our financial system, our currency, the banks across the entire country. …  There is no question but that the action of President Bush and that Secretary Paulson took was designed to keep not just a collapse of individual banking institutions, but to keep the entire currency of the country worth something and to keep all the banks from closing, and to make sure we didn’t all lose our jobs. My experience tells me that we were on the precipice, and we could have had a complete meltdown of our entire financial system, wiping out all the savings of the American people. So action had to be taken.

Mitt Romney and the other GOPers might get a similar question tonight given what’s happening in EU credit markets. I wonder if Romney, if he gets a second bite at the apple, might suggest a plan created by his economic adviser Glenn Hubbard of Columbia, as well as Hal Scott of Harvard and Luigi Zingales of the University of Chicago. If not, he should.

Here are basics (via the WSJ): It is basically a version of the good bank/bad bank—also incorporating a debt-equity swap—solution run by the FDIC. The Bad Bank would assume all the troubled assets and long-term debt, and would also received a loan from the Good Bank. The Good Bank would have all the remaining assets, as well as insured deposits and  FDIC-guaranteed short-term debt as liabilities. After the split, the good bank could be cut loose from FDIC receivership. Long-term debtholders would get equity in the Good Bank, old shareholders would get equity in the Bad Bank.

The debate version of that plan: “I would have the FDIC take over the failed bank, fire the top execs, split it in two and put the healthy half back on the market ASAP.”

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Edward Pinto

Quick primer: Origins of the housing crisis

By Edward Pinto

November 4, 2011, 3:35 pm

Fannie and Freddie’s affordable housing goals (authorized by the ironically named Federal Housing Enterprises Financial Safety and Soundness Act—the GSE Act—and enforced by HUD) were responsible for many distortions of the housing finance market. One of the most significant was that Fannie and Freddie (the GSEs) were required to compete with FHA and subprime lenders for loans that qualified under one or more of the affordable housing goals. The GSEs’ competition with FHA started in 1993 and by the mid-1990s had expanded to subprime. This competition combined with the National Homeownership Strategy required the GSEs (and the market generally) to progressively reduce down-payment requirements. By the early 2000s zero down loans had become commonplace across all market segments including subprime and Alt-A.

The GSE Acts also set low capital standards for Fannie and Freddie. These allowed them to operate at extraordinary leverage levels (for example: 220:1 on their MBS guarantee business).

The resulting high levels of leverage greased the slippery slope of declining standards and fueled the housing boom. It is now five years after home prices started declining and we have yet to deal with excessive leverage.

Michael Cembalest, Chief Investment Officer of JPMorgan, wrote an article that makes use of research from my Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study relating to diminishing down payments and Fannie’s competition with FHA.

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9 reasons the scary EU debt crisis is—gasp!—intensifying

By James Pethokoukis

October 25, 2011, 10:54 am

Do you think this month’s stock market rebound means Americans can stop worrying about the EU debt crisis? (One big bank estimates a full-on financial crisis over there could send U.S. unemployment to 12 percent.)

If so, I have some terrible news for you. AEI’s Desmond Lachman makes the case that the terrifying case that Euro Crisis is actually intensifying:

1. The Greek economy now appears to be in virtual freefall as indicated by a 12 percent contraction in real GDP over the past two years and an increase in the unemployment rate to over 15 percent. This makes a substantial write down of Greece’s US$450 billion sovereign debt highly probable within the next few months. Such a default would constitute the largest sovereign debt default on record.

2. Contagion from the Greek debt crisis is affecting not simply the smaller economies of Ireland and Portugal, which too have solvency problems. It is now also impacting Italy and Spain, Europe’s third and fourth largest economies, respectively. This poses a real threat to the Euro’s survival in its present form.

3. The Euro-zone debt crisis is having a material impact on the European banking system. This is being reflected in an approximate halving in European bank share prices and an increase in European banks’ funding costs. French banks in particular are having trouble funding themselves in the wholesale bank market.

4. There are very clear indications of an appreciable slowing in German and French economic growth. It is all too likely that the overall European economy could soon be tipped into a meaningful economic recession should there be a worsening in Europe’s banking crisis. A worsening in the growth prospects of Europe’s core countries reduces the chances that the countries in the European periphery can grow themselves out of their present debt crisis.

5.  The IMF now acknowledges that Greece’s economic and budget performance has been very much worse than anticipated and that the Greek economy is basically insolvent. The IMF estimates that Greece’s public debt to GDP ratio will rise to at least 180 percent or to a level that is clearly unsustainable. The IMF is proposing that the European banks accept a 50-60 cent on the dollar write-down on their Greek sovereign debt holding. This would have a material impact on the European banks’ capital reserve positions.

6. The European Central Bank (ECB) is correctly warning that a hard Greek default would have a devastating effect on the Greek banking system, which has very large holdings of Greek sovereign debt. This could necessitate the imposition of capital controls or the nationalization of the Greek banking system. The ECB is also rightly fearful that a Greek default will soon trigger similar debt defaults in Portugal and Ireland since depositors in those countries might take fright following a Greek default. This has to be a matter of major concern since the combined sovereign debt of Greece, Portugal, and Ireland is around US$1 trillion.

7. Since July 2011, the Italian and Spanish bond markets have been under substantial market pressure. This has necessitated more than EUR 75 billion in ECB purchases of these countries’ bonds in the secondary market. An intensification of contagion to Italy and Spain would pose an existential threat to the Euro in its present form given that the combined public debt of these two countries currently around US$4 trillion.

8.  While to a large degree European policymakers are right in portraying Italy and Spain as innocent bystanders to the Greek debt crisis, Italy and Spain both have pronounced economic vulnerabilities. Italy’s public debt to GDP is presently at an uncomfortably high 120 percent, while it suffers from both very sclerotic economic growth and a dysfunctional political system. For its part, Spain is presently saddled with a net external debt of around 100 percent of GDP, it still has a sizeable external current account deficit, and it is still in the process of adjusting to the bursting of a housing market bubble that was a multiple the size of that in the United States.

9. Sovereign debt defaults in the European periphery would have a major impact on the balance sheet position of the European banking system. The IMF estimates that the European banks are presently undercapitalized by around EUR200 billion, while some private estimates consider that the banks are undercapitalized by more than EUR300 billion. It is of concern to the European economic outlook that there are already signs of the European banks selling assets and constraining their lending to improve their capital ratios.

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Peter J. Wallison

Another political fumble: New Obama refi plan would leave housing ‘flat on its back’

By Peter J. Wallison

October 25, 2011, 10:11 am

They keep doing it. Yesterday, the Obama administration offered a new plan for easing the housing crisis—a modification of the previously unsuccessful HARP program that would permit more underwater homeowners to apply for refinancing of their mortgages so that they could take advantage of the lower interest rates.

Apparently, the White House talking points said that this would make lower cost mortgages available to four million homeowners (a number used by Housing Secretary Sean Donovan). This would reduce monthly mortgage costs by an average of $250 dollars, and produce a total reduction of $12 billion annually.

Even if it actually worked for all those homeowners, $12 billion in savings is not going to revive the housing market—although of course it would be wonderful relief for those underwater homeowners who have acted responsibly to meet their mortgage obligations month after month.

But while many media reports duly followed the White House talking points (NPR somehow managed to report this morning that the saving would be $50 billion, and suggested that it would be like a tax cut of that size), a few things must have been left out.

—The program only applies to those mortgages that are held or guaranteed by Fannie Mae and Freddie Mac—probably 800,000 mortgages, according to their regulator, the Federal Housing Finance Agency. This means that the total saving for these homeowners would be $2.4 billion annually.

—If the interest on these mortgages is reduced, the losses will be taken in part by Fannie and Freddie, meaning that the taxpayers will pick them up.

—If the losses are taken by the holders of securities guaranteed by Fannie and Freddie, the losses will be taken by the investors in these securities, and this new government intervention will mean that it will be harder to sell Fannie and Freddie securities to investors in the future.

—Finally, the vast majority of the holders of these Fannie and Freddie securities are banks and S&Ls, which are already weak because they suffered vast losses on mortgages and mortgage-backed securities they held in the past. Reducing their revenues further at this point will of course reduce the funds they have to lend to businesses, thus keeping unemployment high.

The remarkable thing about all of this is that the administration keeps doing the same thing—adopting programs to “fix the housing market” that are far too puny to have any significant effect overall, but advertising them as game changers.

Beyond the political fumbling, the administration’s continuing intervention in the housing economy is also counterproductive. This program, if everyone eligible applies and gets the promised relief, might free up $2.4 billion to go—hopefully—to retailers. But it will also reduce the earnings of banks by some substantial portion of this number, and the rest will be further liabilities for the taxpayers.

These results were not in the White House talking points, and the compliant media that reported the story based on the talking points will then be surprised in the future when the economy in general—and the housing economy in particular—remains flat on its back.

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Do U.S. homeowners need tough love, not a refi plan?

By James Pethokoukis

October 24, 2011, 11:44 am

When it comes to housing, conservative economist Martin Feldstein is a man with a plan. A $350 billion plan:

 If the bank or other mortgage holder agrees, the value of the mortgage would be reduced to 110 percent of the home value, with the government absorbing half of the cost of the reduction and the bank absorbing the other half. For the millions of underwater mortgages that are held by Fannie Mae and Freddie Mac, the government would just be paying itself. And in exchange for this reduction in principal, the borrower would have to accept that the new mortgage had full recourse—in other words, the government could go after the borrower’s other assets if he defaulted on the home. This would all be voluntary.

Certainly this would be far more expansive and expensive than what President Obama is proposing today. But would it be a good idea? The folks at e21 have a number of criticisms: a) it assumes the economy needs more consumption and less savings; b) to the extent, if any, that oversaving is a problem right now, the Fed should lower the interest it pays on banks holding deposits at the Fed, which would encourage the circulation of those deposits in the real economy; c) the price effects of foreclosure are relatively small and local in nature; d) it would take a massive—and unfair—amount of principal reduction to prevent foreclosures; d) debt relief would actually hurt economic mobility by keeping people in these underwater homes.

And e21′s preferred approach is … I’m not quite sure. But this bit gives a hint: “It’s time to wean the American economy off of a government-bloated housing sector, rather than doubling down on the reason we’re in a mess in the first place.” That to me sounds like we need to speed up the foreclosure process and get people out of homes they really can’t afford. Move from weak hands to strong hands. But that’s not everybody underwater is it? I would like a closer look at the Zingales Housing Plan:

We advocate a legal reform that would allow homeowners to reduce principal while giving mortgage holders an equity interest. Such a plan would give homeowners an incentive to keep or resell their homes, thus reducing the market value loss of homes while protecting the effective value of creditors’ interests. Two further elements of the plan are that it uses prices based on the average house price in a particular ZIP code; and it is automated.

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Obama’s underwhelming housing plan

By James Pethokoukis

October 24, 2011, 9:30 am

President Barack Obama’s latest proposal to help struggling homeowners—to be followed soon by a student debt initiative—isn’t likely to be much more successful than previous efforts. An analysis by MF Global’s Washington Research Group estimates the plan to make it easier for homeowners to refinance their mortgages will target just “600,000 to 1 million more refinancings of underwater borrowers. … For those who get HARP refinancings, this offers economic help. But we don’t see how this turbo charges the economy.”

If that analysis is accurate, this housing relief effort by the Obama White House won’t accomplish more than previous attempts. Back in early 2009, Obama promised to help “as many as three to four million homeowners to modify the terms of their mortgages to avoid foreclosure.” But just 816,000 homeowners have received permanent mortgage modification through federal housing programs.

That’s small potatoes. Tiny potatoes, really. According to CoreLogic, some 11 million, or nearly a quarter, of all residential properties are in negative equity. Another 2.4 million have less than five percent equity. More than 4 million mortgages are at least 90 days delinquent or in some stage of foreclosure, with another 3.4 million mortgages likely on their way during the next year, according to some analysts.

Sure, any little bits helps. But it’s hard not to conclude that this meager plan is little more than an effort in political theater, a campaign-season sop to worried middle-class voters and the Occupy Wall Street movement. Given the small scope of the housing plan, it’s likely that the student loan piece will be little more than a recycling of previous proposals. All in all, just enough to garner positive headlines but not so much as to scare taxpayers or bankers. Obama wants to be seen as compassionate yet fiscally responsible. A little bit OWS, a little bit Tea Party.

Economists, however, do have some ideas that might help. One comes from Columbia University’s Christopher Mayer, which would allow every—more or less—current homeowner with a GSE mortgage to refinance to a new mortgage with a 4.2 percent rate or less. Mayer estimates mortgage payments would fall by about $70 billion for 25 million borrowers (vs. Obama’s 600,000), or nearly $3,000 in average savings.

But some people just can’t afford their underwater homes, even with lower rates. In those cases, foreclosures, ASAP, are the answer. Or at least more of an answer than what Obama is offering.

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Rogoff on the ‘Second Great Contraction’

By James Pethokoukis

October 20, 2011, 11:22 am

Some interesting stuff from a McKinsey interview with economist Kenneth Rogoff on the current economic troubles America faces. In the book This Time Is Different: Eight Centuries of Financial Folly, he and fellow economist Carmen Reinhart explained how recessions linked to a severe financial crisis produce impacts that are deep and long lasting. In this chunk, he explains the nature of economies that are cutting debt:

It’s not easy, because a postfinancial-crisis recession is characterized by an overhang of private and public debt that is much more severe than it is after a normal recession. There are many mortgages still under water—perhaps 25 percent—and people are more cautious about extending their borrowing than they were before 2007. That leads to slower consumption growth. Businesses in turn invest more slowly.

In 2008, policy makers placed too much confidence in the Keynesian idea that you can jump-start the economy with a big temporary stimulus and then step back and watch the private sector take over. Of course, Reinhart and I argued otherwise, based on the results of a seven-year research project, and our results certainly were acknowledged by practitioners, academics, and policy makers. Nevertheless, most policy makers and markets still insisted, “Well, yes, maybe that is how things always were in the past, but this time it’s different because the policy response was so aggressive.” In fact, the policy response is always very aggressive. Every country does everything it can to claw its way back from a deep financial crisis.

So, unfortunately, there is no easy out. Perhaps the best chance would be to find a way to get ahead of the mortgage defaults—that is, to have restructurings and debt forgiveness, albeit with some kind of quid pro quo. That is very hard to do. But if there were a way to write down and forgive some of the mortgage debt, that would be money well spent. In ten years, we will probably end up forgiving a big chunk of it. As Carmen has noted, this is a little like Third World debt that was carried on the books forever, even though it was a joke.

Rogoff also seems to worry more about the size of Wall Street’s political power than its market capitalization or balance sheets:

I think financial innovation has been overly blamed for everything. Financial-sector lobbying is another matter—regulators of the financial sector lost sight of the risks. .. I believe that size is overrated as the issue. There is this view that if we can just break up the big banks into smaller ones, we won’t have a problem. But if you look at systemic crises, usually a lot of banks are doing the same thing. So if we take one big bank and break it up into ten smaller banks that act similarly, I’m not sure how much we really would have bought ourselves. The incentives that would make a big bank go whole hog in one direction would probably make ten smaller banks do the same thing.

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Andrew Biggs

Who invests in hedge funds?

By Andrew Biggs

October 20, 2011, 7:48 am

The Occupy Wall Street movement has gone from fringe to mainstream. Not only has President Obama endorsed some of the Occupiers’ rhetoric, labor unions are supporting OWS with both money and manpower, sending their members to New York and elsewhere around the country to support the “99 percent” of Americans who apparently labor under the yoke of Wall Street profiteers. (If interested, you can sign up here courtesy of the Service Employees International Union.)

But I think unions need to go further. As with any good boycott, you can’t just target the producers—you need to convince their customers that hedge fund managers aren’t pulling their weight in society. But who is it that invests their money with these blood-suckers?

As it turns out, according to the investment research firm Prequin, the largest single investor in hedge funds is public employee pensions; that is, retirement plans that benefit many of the very people who currently are protesting against them. Public pensions hold 16 percent of all hedge fund assets, with private sector pensions—many of which serve heavily unionized industries—holding 14 percent. Oh, sweet irony.

Moreover, rather than turning against hedge funds, public pensions have almost doubled their hedge fund holdings over the past three years.

Ok, but maybe it’s not the employees’ choice to invest in hedge funds. After all, it’s pension boards—not employees themselves or their unions—that decide what investments to hold. But according to the Public Plans Database, current or retired public employees make up the majority of most public pension boards. Public employees and their unions know very well what they are investing in, and why. And while I may think that paying a hedge fund 2 percent of assets and 20 percent of profits (or more) is excessive, apparently public employees believe they are getting their money’s worth.

And that’s the point: It’s their money to spend and they get to decide whether the fund manager is delivering returns to the fund that are worth what he charges. If not, there are plenty of other managers—and even passive index funds—that charge far less. But public pensions have decided that hedge funds are worth it. They get paid a lot of money because they create a lot of money. In simple terms, public employees have decided that hedge fund managers have earned what they are paid.

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EU debt crisis could devastate U.S. economy, crush housing

By James Pethokoukis

October 19, 2011, 12:27 pm

Earlier this month, Treasury Secretary Timothy Geithner warned the Senate Banking Committee that a full-blown EU financial crisis would be bad for America. Really bad. Here’s Geithner:

Europe is so large and so closely integrated with the U.S. and world economies that a severe crisis in Europe could cause significant damage by undermining confidence and weakening demand.

Now Barclays Capital has put some details into that forecast. And they are not pretty:

Our baseline forecast assumes that policymakers will prevent the turmoil in Europe from leading to a full-blown financial crisis similar to 2008 and that US policymakers will not impose excessive fiscal tightening starting in 2012. If, by contrast, either of these risks is realized, the potential for another recession will increase substantially. We use the Fed’s stress scenario under the Comprehensive Capital Analysis and Review (CCAR) as an alternative scenario to our baseline, but ratchet up the intensity modestly and analyze its effect on the outlook for house prices.

1) Our modelling suggests that in a recession scenario, house prices, as measured by the CoreLogic headline index, could decline another 7% in 2012 . … The scenario posits declining real GDP for four consecutive quarters, with Q2 12 having the deepest decline at 6% (q/q saar).

2) Real disposable personal income also declines for four consecutive quarters, albeit with a one-quarter lag relative to the decline in GDP, and the unemployment rate moves  persistently higher, peaking at 12.1% by the end of our forecast horizon.  …

3) Furthermore, the rising unemployment rate suggests that delinquencies would push shadow inventory higher, putting downward pressure on distressed home prices. Together, the two effects send home prices significantly lower in 2012.

 

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