Topic: Finance, Banking & Monetary Policy

Will Senate Use Energy Bill to Weaken FHA Mortgages?

As I recall from my time in the Senate, there’s nothing like an energy bill to attract misguided proposals.  This week the Senate begins consideration of S.2012 — the Energy Policy Modernization Act of 2015.  Among the almost two hundred filed amendments is a proposal (Amendment #3042) from former real estate broker, Senator Isakson, to mandate that the Federal Housing Administration (FHA) reduce the quality of its loans in order to encourage more efficient energy use.

The two most concerning aspects of Amdt 3042 are 1) it would allow “estimated energy savings” to be used to increase the allowable debt-to-income (DTI) ratios for the loan and; 2) require “that the estimated energy savings…be added to the appraised value…”

These changes might not be so bad in the abstract but when combined with existing FHA standards, they set the borrower up for failure and leave the taxpayer holding the bag. Let’s recall that borrowers can already get a FHA mortgage at a loan to value (LTV) of 96.5%, and that’s assuming an accurate appraisal.  If borrowers were required to put 20 percent down, then this amendment would be a minor problem, but under existing standards, borrowers would mostly likely leave the table with an LTV over 100%, that is already underwater before they’ve even moved in.  Did Congress learn nothing from the crisis?

The increase in DTI might not matter if FHA did not already allow a DTI as high as 43% of income.  Under Amdt 3042 borrowers could easily leave the closing table devoting over half their income to their mortgage.  Again, did Congress learn nothing from the crisis?

To illustrate that the intent of the proposal is to have the taxpayer take more risk, Amdt 3042 actually prohibits FHA from imposing any standards that would offset this risk.  If these new loans perform worse, as one would expect, FHA cannot put them back to the lenders.   And let’s not forget FHA allows the borrower to have a credit history deep in the subprime range.  So you could have a subprime borrower, say FICO down to 580, LTV > 100% and DTI > 43% - what could go wrong?

If indeed energy savings actually increased the value of the home, that would be reflected in the price.  There would be no need to mandate such.  Not only does this proposal weaken FHA standards, and expose the taxpayer to greater risk, it takes us further down the path of an already politicized housing policy, where instead of relying on market prices, values are dictated by Soviet-style bureaucratic guesswork.

The Fed’s Lack of Appreciation for the Healing Power of Markets

In my recent Cato Institute policy analysis, “Requiem for QE,” I analyze the transcripts of the 2008 and 2009 Federal Open Market Committee (FOMC) meetings in some detail.  Among them, the March 2009 transcript stands out as particularly troubling, as it reveals the FOMC’s failure to appreciate an economy’s ability to heal itself through market mechanisms following an adverse macroeconomic shock.

Yet market economies do have self-correcting mechanisms: relative prices change, resources get reallocated, and consumer and business expectations adjust to new realities.  In the case of the financial crisis, expectations had to adjust to the fact that house prices were significantly out of line with economic fundamentals.  As they did,  perceptions of wealth declined in line with house prices.  Workers, particularly those in construction, began the process of acquiring new skills, finding alternative employment, starting new businesses, and so on.  That these self-correction processes were already at work prior to the March 2009 FOMC meeting is one reason why the recession ended just three months later, in June 2009.

The same self-correcting mechanisms can be seen in the very markets in which the financial crisis began.  Put simply, the financial crisis was precipitated by a decline in house prices which, in turn, sparked concerns about the default risk of banks and other financial institutions with large holdings of mortgage-backed securities (MBS).

Fed Disclosure

Earlier this month, the Federal Reserve released FOMC transcripts and related materials from 2010. One of the issues—an important one—discussed in October and November of 2010 concerned Fed disclosure of inside information. Those transcripts hit one of my hot buttons. Fed leadership, instead of being defensive as shown in the 2010 transcripts, should be vocal in explaining why non-public activities further the cause of sound monetary policy.

Consider first an extreme view, a view that will help to frame disclosure issues. Would we want the Fed to confine its contacts with outsiders to public meetings at which press were present, or could be present? In that case, the FOMC would make its policy decisions solely on the basis of publically available information, such as that released by the Bureau of Labor Statistics and other statistical agencies. Keep in mind that under this view Fed officials would not only cease to have any non-public meetings with private sector individuals but also with government officials.

I add government officials to the mix because it is well known that some members of Congress and congressional staff make stock trades based on inside information.

FOMC practice has long been to gather nonpublic information, some of which is presented in FOMC meetings. The beginning of every FOMC meeting is occupied with presentation, and discussion, of anecdotal information. I always made an effort to smoke out expectations about the future from my sources. Forward-looking information is especially important because there is little formal statistical data on business plans for hiring and investment. As an example, I routinely asked my contacts at FedEx and UPS about their plans to add capacity in the busy holiday season and what their customers were telling them about their expectations. I asked my Wal-Mart contact about his interpretation of retail sales. Did he think that recent sales reflected idiosyncratic issues for his own company or were the trends more general?

The FOMC has long believed that such information strengthened the policy process. I know of no study that has attempted to quantify the policy value of anecdotal information, but have to believe that this approach is sound. Fed critics remind me of the old saw about the weatherman. Look out the window. Can’t you see that it is snowing? Do you want the Fed to stop looking out the window? Would it not have been helpful in 2008 if the Fed had had some detailed inside information about the condition of Lehman and AIG?

The Federal Reserve has long had robust policies, and active internal controls, to prevent insider trading by all employees, especially those with access to confidential policy information. Yes, nonpublic contacts with industry insiders do raise the risk of improper disclosure. What is the evidence on that score?

I know of only three prominent, evident or possible violations of this confidentiality. One is ongoing today: an unresolved case concerning an alleged leak of FOMC information in 2012 to Medley Global Advisors. In the second case, Rohit Bansal, a former Goldman-Sachs employee, was convicted this past November of obtaining inside information from Jason Gross, a former bank examiner at the New York Fed, who was also convicted. In the third case, Robert A. Rough, a former director of the New York Fed pleaded guilty in 1989 to disclosing discount rate actions to securities traders while he was in office. The New York Times story on the case noted that, “Samuel A. Alito Jr., the United States Attorney for New Jersey, said Mr. Rough was the first director in the 75-year history of the Federal Reserve System to be convicted of criminal wrongdoing.”

As far as I know, that is it. A damn good record, I would say. I challenge anyone to find an agency of this size and longevity with a superior record. The very highest level of integrity is built into the Fed’s day-to-day procedures and its DNA. Fed leadership should be defending its disclosure and research policies rather than dancing away, dodging the issue.

A CBS segment on 60 Minutes in November 2011 discussed insider trading by some members of Congress and congressional staff. Public outrage ensued and led Congress to pass the Stock Act, which became law April 4, 2012. By April 15, 2013 Congress had modified the Act, largely gutting it.

The most gentle way I know to summarize the concerns of some members of Congress over Federal Reserve disclosure is that they represent rank hypocrisy.

Does Drug Prohibition Inhibit Economic Development?

Even the most dedicated opponent of drug prohibition might not guess that this policy harms economic development.

Yet claims in a recent WSJ story, combined with research on the relation between banking and development, suggests just such an impact.

The reason is that drug prohibition fosters anti-money laundering laws; which then discourage U.S. banks from doing business in Mexico; which then impedes Mexican banking; which then negatively impacts development.

The WSJ story says,

U.S. banks are cutting off a growing number of customers in Mexico, deciding that business south of the border might not be worth the risks in the wake of mounting regulatory warnings.

At issue are correspondent-banking relationships that allow Mexican banks to facilitate cross-border transactions and meet their clients’ needs for dealing in dollars—in effect, giving them access to the U.S. financial system. The global firms that provide those services are increasingly wary of dealing with Mexican banks as well as their customers, according to U.S. bankers and people familiar with the matter.

And why are U.S. banks worried about regulation?  Because 

U.S. financial regulators have long warned about the risks in Mexico of money laundering tied to the drug trade. The urgency spiked more than a year ago, when the Financial Crimes Enforcement Network, a unit of the Treasury Department, sent notices warning banks of the risk that drug cartels were laundering money through correspondent accounts … Earlier, the Office of the Comptroller of the Currency sent a cautionary note to some big U.S. banks about their Mexico banking activities.

As for evidence that banking is important for economic development, see this paper by Scott Fulford of Boston College (featured soon in a Cato Research Brief).  Fulford writes:

Do banks matter for growth and how? This paper examines the effects of national banks in the United States from 1870–1900. I use the discontinuity in entry caused by a large minimum size requirement to identify the effects of banking. For the counties on the margin between getting a bank and not, gaining a bank increased production per person by 10%. National banks in rural areas improved agriculture over manufacturing, moving counties towards geographic comparative advantage. Since these banks made few long-term loans, the evidence suggests that the provision of working capital and liquidity matter for growth.

Bad policies (drug prohibition) breed more bad policies (anti-money-laundering laws), which have additional adverse consequences that few could plausibly have forseen.  This is one reason why any government interference with liberty, no matter how well intentioned or seemingly well justified, should face extreme skepticism.

One Sentence, or, Unpacking the Truth about the Founding of the Bank of France

When, in my days as a professor, I occasionally assigned term papers, I used to smile when students wondered out loud how they could possibly come up with enough to say to fill a whole 20 (or 15, or 5, or whatever) pages.  After all, the problem, once you got to be where I was, wasn’t having too much space: it was not having space enough to say what needed saying.  It was all I could do sometimes to squeeze my ideas into the 25 double-spaced typescript page-limit that prevailed among scholarly economics journals.

These days I’m no longer compelled to wrestle with academic journal editors, thank goodness.  But I still face strict length limits now and then, like the one I’m confronting as I finally get around to writing my long-overdue review of Roger Lowenstein’s America’s Bank: The Epic Struggle to Create the Federal Reserve. I’m supposed to limit the review to 1000 words.  Yet I could easily write 20,000 words about that book.  In fact I have written 20,000, and then some, in the shape of a Cato Policy Analysis called “New York’s Bank: the National Monetary Commission and the Founding of the Fed.” Our respective titles give you some idea of where Lowenstein and I differ.  Anyway, the PA isn’t ready yet.  When it is, probably about a month from now, I will let you know.

Despite that PAs length, it also leaves much unsaid.  It says nothing at all, for example, about the seemingly innocuous sentence in chapter five of America’s Bank that reads: “The Bank of France was chartered in 1800 as an antidote to the financial turmoil of the French Revolution.”

Portugal-Style Bail-ins: The New Norm under Dodd-Frank?

As 2015 came to an end, so perhaps did a central tenet of resolving failed companies, the notion that “similarly situated” creditors ought to be treated equally, or, as the lawyers like to say “pari passu” (Latin for “on the same footing”).*  The turning point was Portugal’s treatment of creditors of Novo Banco SA.

Until its failure in August of 2014, Banco Espirito Santo SA had been Portugal’s second largest bank.  When it failed, the Banco de Portugal, acting as receiver, divided the failed bank into  “good” and “bad” components, as the FDIC commonly does in the event of a large U.S. bank failure.  Banco Espirito Santo SA continued as the “bad bank,” which was to be liquidated in an orderly process.  The “good bank” became Novo Banco SA, which would stay in business.

In such “good bank-bad bank” resolutions, all equity holders usually remain with the bad bank, while more senior creditors are transferred to the good bank.  In any event all creditors of the same class are treated alike.  Creditors assigned to the good bank are much more likely to recover some part of their investment.

Venezuela’s Lying Statistics

Surprise! Venezuela, the world’s most miserable country (according to my misery index) has just released an annualized inflation estimate for the quarter that ended September 2015. This is late on two counts. First, it has been nine months since the last estimate was released. Second, September 2015 is not January 2016. So, the newly released inflation estimate of 141.5% is out of date.

I estimate that the current implied annual inflation rate in Venezuela is 392%. That’s almost three times higher than the latest official estimate.

Venezuela’s notoriously incompetent central bank is producing lying statistics – just like the Soviets used to fabricate. In the Soviet days, we approximated reality by developing lie coefficients. We would apply these coefficients to the official data in an attempt to reach reality. The formula is: (official data) X (lie coefficient) = reality estimate. At present, the lie coefficient for the Central Bank of Venezuela’s official inflation estimate is 3.0.