“Meager yields leave America’s enterprising public-pension plan managers with a choice: Accept a lower return—forcing higher taxpayer contributions—or take on more risk to keep 8% returns flowing. My estimate, based on Treasury yields and analysis from economists at the Office of the Comptroller of the Currency, is that a pension today must build a portfolio with a standard deviation—how much returns vary from year-to-year—of 14%. Such high volatility means that a fund would suffer losses roughly one out of every four years.” Andrew G. Biggs

“This is another example of the huge unintended consequences of the Federal Reserve’s easy money policies. The truth is that even before the financial crisis, state and local politicians promised unsustainable benefit levels to government employees and these unsustainable benefit levels toxically combined with the Fed-manipulated, low rates for safe investments (U.S. Treasuries and highly-rated corporate and other bonds), making it impossible to relatively safely earn the assumed returns these pension funds needed to prevent shortfalls. As a result, some public pension funds decided to take inappropriate investment risks in (as Biggs notes below) ‘a double-or-nothing attempt to dig out of multi-trillion dollar funding shortfalls.’ My guess is some probably bought riskier private MBS and other derivative securities pre-crisis, stretching for yield (and later blamed their losses on others rather than themselves). I recall reading that some were even buying or selling long-term interest rate swaps with Wall Street! And it seems wrong to me that public pension funds are investing with illiquid and risky hedge funds and private equity firms. In hindsight, I don’t think it is unfair to say that these public pensions’ risky investing was a contributing factor in the financial crisis.” Mike Perry, former Chairman and CEO, IndyMac Bank

OPINION

The Hidden Danger in Public Pension Funds

Their investments expose government budgets and taxpayers to 10 times more risk than in 1975.

By ANDREW G. BIGGS

Dec. 15, 2013 6:26 p.m. ET

The threat that public-employee pensions pose to state and local government finances is well known—witness the federal ruling earlier this month that Detroit’s pension obligations are not sacrosanct in a municipal bankruptcy. Less well known is that pensions are larger and their investments riskier than at any point since public employees began unionizing in earnest nearly half a century ago.Public pensions have long been advertised as offering generous, guaranteed benefits for public employees while collecting low and stable contributions from taxpayers. But with Detroit’s bankruptcy filing, citing $3.5 billion in unfunded pension liabilities, and with four of the five largest municipal bankruptcies in U.S. history occurring in the past two years, reality tells us otherwise.How much riskier are public pensions now? According to my research, public pensions pose roughly 10 times more risk to taxpayers and government budgets than in 1975. And while elected officials—a few Democratic mayors included—are now pushing for reforms, even they may not realize the danger.

In 1975, state and local pension assets were equal to 49% of annual government expenditures, according to my analysis of Federal Reserve data. Pension assets have nearly tripled to 143% of government outlays today. That’s not because plans are better funded—today’s plans are no better funded than in 1980—but mostly because pension plans have grown as public workforces have aged.

In a photo from Monday, Dec. 2, 2013, an empty field in Brush Park, north of Detroit’s downtown is shown with an abandoned home. Associated Press

The ratio of active public employees to retirees has fallen drastically, according to the State Budget Crisis Task Force. Today it is 1.75 to 1; in 1950, it was 7 to 1. This means that a loss in pension investments has three times the impact on state and local budgets than 40 years ago.

And pensions can expect to take losses more often because of increased investment risk. Public plans have historically assumed roughly an 8% rate of return. But thanks to falling yields on safe assets, pensions must invest in riskier assets to have any hope of getting 8% returns. A one-year Treasury bond in 1975 yielded a 5.9% return. In 1980, it offered 14.8%, and in 1985 an investor could expect 6.5%. Today, the Treasury yield hovers at 0.1%.

Meager yields leave America’s enterprising public-pension plan managers with a choice: Accept a lower return—forcing higher taxpayer contributions—or take on more risk to keep 8% returns flowing. My estimate, based on Treasury yields and analysis from economists at the Office of the Comptroller of the Currency, is that a pension today must build a portfolio with a standard deviation—how much returns vary from year-to-year—of 14%. Such high volatility means that a fund would suffer losses roughly one out of every four years.

By contrast, in 1975 a plan could achieve 8% expected returns with a standard deviation of just 3.7%. Those portfolios would lose money once every 65 years. This level of risk varied little through the 1980s and 1990s: An 8% return portfolio in 1985 would require a standard deviation of 2.7%, and 4.3% in 1995. Risk began inching upward after 2000 and has increased rapidly since the recession as low-risk assets continue to fall.

These figures aren’t theoretical. They represent public pensions’ decades-long shift from safe bonds to risky stocks, along with the recent growth of “alternative investments” such as hedge funds and private equity. These alternatives are, according to Wilshire Consulting, 60% riskier than U.S. stocks and more than five times riskier than bonds.

Larger pensions and riskier investments combine to increase risk to state and local budgets. The standard deviation of public pension investments equaled 1.8% of state and local budgets in 1975. That figure crept upward to 2.2% in 1985, and reached 5.8% in 1995. Today it stands at 19.8%. Pension investment risk to budgets has risen roughly tenfold over the past four decades.

As pension plan managers in Detroit, California and elsewhere can attest, there aren’t easy solutions. Mature pensions should move their investments away from risky assets, but many plan managers are doing the opposite in a double-or-nothing attempt to dig out of multitrillion-dollar funding shortfalls. In most instances, significant benefit cuts for current retirees who made the contributions asked of them is difficult to justify and legally problematic.

The only real option, then, is to make structural changes, including more modest benefits and increased risk-sharing between plan sponsors and public employees. But that will only happen if elected officials accept that they can’t continue with business as usual without accumulating tremendous risk.

Mr. Biggs is a resident scholar at the American Enterprise Institute.

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“Another important example of our dysfunctional civil legal system here in the U.S. that is costing all of us hundreds of billions a year (as these unnecessary legal and litigation costs are added to the price of nearly every product or service sold in America today and passed on to consumers)  and destroying America’s competitiveness, entrepreneurial risk-taking spirit (Why try, I could get sued?), and culture of personal responsibility (my loss is someone else’s fault).” Mike Perry, former Chairman and CEO, IndyMac Bank

INFORMATION AGE

Jimmy Carter’s Costly Patent Mistake

His 1979 proposal has led to ill-conceived protection for software ideas and a tidal wave of litigation.

By L. GORDON CROVITZ

Dec. 15, 2013 6:31 p.m. ET

Washington doesn’t agree on much, but all three branches of government now have plans to reform the country’s patent system. What’s not widely understood is that this marks the failure of one of Washington’s most ambitious experiments in industrial policy.

Today’s patent mess can be traced to a miscalculation by Jimmy Carter, who thought granting more patents would help overcome economic stagnation. In 1979, his Domestic Policy Review on Industrial Innovation proposed a new Federal Circuit Court of Appeals, which Congress created in 1982. Its first judge explained: “The court was formed for one need, to recover the value of the patent system as an incentive to industry.”

The country got more patents—at what has turned out to be a huge cost. The number of patents has quadrupled, to more than 275,000 a year. But the Federal Circuit approved patents for software, which now account for most of the patents granted in the U.S.—and for most of the litigation. Patent trolls buy up vague software patents and demand legal settlements from technology companies. Instead of encouraging innovation, patent law has become a burden on entrepreneurs, especially startups without teams of patent lawyers.

Samsung and Apple attorneys battle over software patents, Nov. 15. Reuters

Until the court changed the rules, there hadn’t been patents for algorithms and software. Ideas alone aren’t supposed to be patentable. In a case last year involving medical tests, the U.S. Supreme Court observed that neither Archimedes nor Einstein could have patented their theories.

Many software patents simply describe ideas that happen to be carried out through digital technology. Amazon got a patent for the concept of “one-click checkout.” Apple last year applied for a patent on the idea of offering author autographs for e-books. There are so many software patents that smartphones include some 250,000 purportedly patented processes, which is why Google,Samsung and Apple are suing one another around the world.

In software, innovations build on one another so seamlessly there is no way to follow them. There is no national registry of software. Developers and engineers can’t track who claims patents to what processes. In contrast, drug researchers consult a publication called the Orange Book that lists all the patents for pharmaceuticals, enabling them to avoid infringements.

A system of property rights is flawed if no one can know what’s protected. That’s what happens when the government grants 20-year patents for vague software ideas in exchange for making the innovation public. In a recent academic paper, George Mason researchers Eli Dourado and Alex Tabarrok argued that the system of “broad and fuzzy” software patents “reduces the potency of search and defeats one of the key arguments for patents, the dissemination of information about innovation.”

The Government Accountability Office agrees. “Many recent patent infringement lawsuits are related to the prevalence of low-quality patents; that is, patents with unclear property rights, overly broad claims, or both,” it said in a recent report. “Claims in software-related patents are often overly broad, unclear or both.” Boston University law professors Michael Meurer and James Bessen have estimated the direct and indirect costs of litigation against technology companies at $80 billion per year.

Instead of focusing on the problem with software patents, reforms backed by the White House and Congress would tweak patent litigation for all industries. The House this month passed a bill requiring more specificity in claims and limiting costly discovery, but doing nothing about dubious software patents.

The House rejected a proposal that would have expedited the process for the Patent Office to review questionable software patents. Lobbyists from companies like IBM and Microsoft, which make billions of dollars a year from licensing software patents, helped block this reform.

For now, the best prospect for real reform is in the Supreme Court, which earlier this month agreed to hear CLS Bank v. Alice Corp., a case about whether a bank’s computerized process for settling transactions via an escrow can be patented. A judge on the appeals court noted this idea was “literally ancient,” developed during the Roman Empire, and should not get a patent now just because a computer is involved.

The Supreme Court has invalidated software patents in earlier cases, but the justices need to draw a brighter line with clear limits for the lower courts, especially the Federal Circuit. Simply qualifying ideas or business processes with the phrase “and do it on a computer” shouldn’t be enough.

The justices should also acknowledge that creating a special court to promote patents is an experiment gone awry. Far from helping the economy, software patents are a litigation tax on new technology. The Constitution calls for patents “to Promote the progress of Science,” not for patents to undermine innovation.

  

“Banca Monte dei Paschi’s troubles (but one example of scores of other distressed banks around the world) disprove two mainstream theories of the global financial crisis: 1) that it was caused by global finance and securitization (particularly securitization of U.S. mortgages and mortgage derivatives that were then spread around the world by Wall Street and caused distress at some foreign banks), and 2) greedy private sector bankers lent and invested recklessly in order to further their own short-term compensation. Italian banks were largely not involved in global finance and did not invest in U.S. mortgage and other securities packaged and sold by Wall Street or the GSEs. The Italian banks didn’t because most weren’t sophisticated in global finance and Italy wasn’t generating trade surpluses with the U.S. (The Germans and Chinese did buy these types of U.S. securities, because they held a lot of excess dollars from their huge trade surpluses with the U.S. that they needed to invest. Germany had a moderate banking crisis and China to-date has not.). Also, this particular bank was controlled by a charitable group who took their share of the bank’s profits and used them to support charities and other important activities of the regional community of Siena. No reckless and greedy bankers there and yet the oldest bank in the world is failing too! It’s time for the mainstream populist views in the U.S. regarding the causes of financial crisis to be discarded and replaced with more objective analysis and facts.” Mike Perry, former Chairman and CEO, IndyMac Bank

MARKETS

Financial Troubles at Italian Bank Worsen

Largest Shareholder of Banca Monte dei Paschi Threatens to Vote Against Proposal to Raise Capital by $4.1 Billion

By GIOVANNI LEGORANO

Updated Dec. 16, 2013 12:32 a.m. ET

MILAN—A clash between the management of Banca Monte dei Paschi di Siena SpA and the bank’s largest shareholder threatens to throw into chaos a plan to raise cash needed to stave off its full nationalization.

The Monte dei Paschi foundation, a charitable group that is the Siena-based bank’s biggest shareholder, with a 34% stake, is in financial straits due to the lender’s troubles, as well as the foundation’s attempts to keep control of Italy’s third-largest financial institution.

Now, it says it will vote against a €3 billion ($4.1 billion) capital increase unless the deal is delayed, a move that would upend a plan to rescue the bank. The collision raises the risk that the bank’s new management, charged with overhauling Monte dei Paschi, could resign, people familiar with the matter said.

The fates of the foundation and Monte dei Paschi—the world’s oldest bank—are intertwined. The foundation has long been the bank’s controlling shareholder, but Monte dei Paschi’s deep problems have inflicted heavy damage on the foundation. The charitable group is struggling to service €339 million in debt, the remaining portion of money it borrowed to take part in a €2.1 billion 2011 capital increase by the bank, money the lender raised in an effort to break into Europe’s big leagues.

The duo’s travails are the latest reminder of the persistence of Europe’s banking crisis and the pain involved in fixing past mistakes. Monte dei Paschi must sell €3 billion of new shares next year to pay back part of a €4.1 billion lifeline the Italian government threw it last February. It planned to do so in January.

But the foundation has slammed on the brakes. The foundation said it needs to sell all or part of its stake in the bank to address a “difficult” financial situation, and analysts and academics say it must raise cash to stay alive. The foundation says it is solvent.

The charitable group says it doesn’t have enough money to cover its share of the capital increase, so it would be left with a smaller holding in the bank if the deal goes through. And because the shares are likely to sell for far less than they are worth now, the foundation could raise less by selling them.

As a result, on Dec. 6, the foundation demanded that the transaction be put off at least until May, hoping to find a buyer for its holdings before then. The foundation has the power to stop the deal because low turnout at the bank’s shareholder meetings means it can wield a veto with its 34% stake.

“They destroyed their patrimony trying to keep their control over MPS,” said Tito Boeri, an economics professor at Bocconi University in Milan, referring to the foundation’s investment in the 2011 capital increase and an offering in 2008. “Now they are trying to destroy MPS in a desperate attempt to preserve their patrimony.”

Antonella Mansi, president of the MPS foundation, said the charitable group recognizes it made mistakes and favors recapitalizing the bank, but “can’t accept a solution that would wipe out our wealth.”

“We need to and it is our duty to protect our interests,” Ms. Mansi said.

The foundation is on the ropes. It is struggling to service its debt because its main source of income—the bank’s dividend—has dried up. Monte dei Paschi, which has lost €8.5 billion in the last three years, hasn’t paid a dividend since 2010 and has said it doesn’t expect to resume payouts before 2017.

The foundation’s situation stands in sharp contrast to the huge political and social power it once wielded in Siena, the fruit of charitable donations that totaled more than €1 billion between 2001 and 2011. It has cut its grants to the bone to hold on to its remaining reserves.

In 2008, it gave €203 million to recipients ranging from hospitals to trainers of the horses that run in Siena’s storied Palio race each summer. Last year, it gave a bit more than one-tenth of that amount and paid nothing to support the Palio, leaving the city of Siena to pick up the slack.

The foundation, which lost a total of more than €500 million in 2011 and 2012, has sold assets in a scramble to raise enough cash to pay its debts. This month, it sold its holdings of a complex bond called Fresh, issued by Monte dei Paschi, for just €95 million, a fraction of the securities’ €490 million face value. It has been trying to sell prized real estate, including Siena’s centuries-old Palazzo del Capitano, to stay afloat.

The foundation’s move has set the clock ticking, putting pressure on the bank’s management to find a solution before shareholders meet to vote on the cash call Dec. 27. The bank’s board met Thursday and said in a statement it disagreed with the foundation’s proposal, adding that delaying the transaction could cost the bank €120 million.

“These agencies (like the CFPB, FDA, FDIC, NSA, and SEC) have assumed frightening new powers over the everyday lives of American citizens, giving government entities free rein over you and me in ways unprecedented in our country’s history.” Sen. Rand Paul

“How our government regularly abuses American citizens and ignores their rights would’ve outraged our Founding Fathers. They did not fight a revolution against a tyrannical government in faraway England simply to implement the same kind of government on their own soil. As Benjamin Franklin famously said and our Founders knew well, those who trade liberty for security get neither. Freedom is not defined by safety. Freedom is defined by the ability of citizens to live without government interference. Government cannot create a world without risks, nor would we really wish to live in such a fictional place. Only a totalitarian society would even claim absolute safety as a worthy ideal, because it would require total state control over its citizens’ lives. Liberty has meaning only if we still believe in it when terrible things happen and a false government security blanket beckons.” Ron Paul

Scheper Kim & Harris Hands SEC Trial Loss in Suit Against Basin Water CEO

Los Angeles, CA – December 11, 2013 – In a resounding setback for the SEC, a federal judge in Los Angeles issued a sweeping ruling today dismissing all of the claims made against Peter Jensen, the former CEO of Basin Water, Inc., and the company’s former CFO Thomas Tekulve. The ruling followed a two-week trial in which the SEC accused Jensen and Tekulve of intentionally misstating Basin Water’s revenues by engaging in so-called “sham” transactions. The SEC further accused Jensen of selling stock while knowing that the transactions were accounted for fraudulently.

United States District Judge Manuel Real soundly rejected each of the SEC’s contentions. In a 44-page order, the Court concluded that there was “[n]o documentary evidence or witness testimony presented at the trial [that] tended to show that any of the transactions were shams. In fact, everybody involved in the various transactions testified that they were actual, legitimate deals.” Further condemning the SEC’s case, the Court concluded that the SEC failed to present evidence that Jensen or Tekulve knowingly or intentionally misled anybody or acted recklessly.

“We are pleased by the Court’s judgment. We believed from the day the SEC filed its complaint that it had no evidence whatsoever of fraud or insider trading,” said Jensen’s lead trial counsel David C. Scheper. “The Court’s ruling confirms what we have contended all along – that while reasonable minds, with the benefit of hindsight, can disagree about certain accounting judgments made years ago, not one witness or document showed that Mr. Jensen or Mr. Tekulve tried to
deceive anybody.”

In addition to David Scheper, Jensen was represented at trial by Scheper Kim & Harris partners William H. Forman and Jean M. Nelson. Scheper said his firm and Tekulve’s counsel, Carolyn Kubota and Seth Aronson of O’Melveny & Myers, “worked together to fully vindicate both our clients after their lives were needlessly disrupted and their reputations were needlessly tarnished by years of litigation. As the Court aptly noted, the evidence showed our clients acted with ‘absolute integrity, prudence, and honesty.’”

Media Contact: David C. Scheper, (213) 613-4670 and (626) 394-5424

“BP is running full page ads (like the two attached below) in the Wall Street Journal and other major newspapers. This is exactly what I was talking about in my blog posting, Statement #88 on November 25, 2013, when I said “Frivolous civil lawsuits have become a major U.S. industry, yet they reduce overall economic activity and are destroying our American culture of entrepreneurial risk-taking and personal responsibility (my loss is someone else’s fault).” And I also said, “In America, it is not unfair to say that plaintiffs’ lawyers legally ‘extort’ billions every year from honest institutions and individuals in the private sector. Our society today seems to accept the fact that we have become such a litigious nation. Some may even hope that that one day they might be the beneficiary of ‘millions’ from suing, America’s version of the ‘legal lottery winner’.” Thank you BP for standing up and helping to publicize this terrible civil legal system we have here in the U.S.” Mike Perry, former Chairman and CEO, IndyMac Bank

 Would you pay this claim? Claim XXX96

 Would you pay this claim? Claim XXX01

“Everyone knows that Americans who participate in government-run lotteries have improbable odds of winning. Economists have shown that these lotteries are essentially a regressive tax on lower income Americans and that consumers should not rationally participate. If the private sector was making profits from these lotteries, instead of government coffers being filled with billions, there would be claims of  abuse of low income Americans, fraud and deceit, lawsuits, and criminal investigations. Where is the Consumer Financial Protection Bureau? Many may argue: “Well, these folks are voluntarily choosing to buy a lottery ticket”. I don’t disagree, but what is the difference between that argument and the fact that Americans voluntarily took out their mortgage loans (and all the documents and disclosures they signed were government mandated forms)? Also, I haven’t commented on the Affordable Care Act until now, but the LA Times article below hit me as the height of hypocrisy. Think about it, this is the same government that sued major mortgage loan servicers alleging improper mortgage loan servicing practices, forced multi-billion dollar settlements down their throats (without much evidence of economic harm), mandated elaborate mortgage servicing standards and hired government monitors to enforce the settlement terms and these standards. And yet the roll-out of ACA proves the government is no better.” Mike Perry, former Chairman and CEO, IndyMac Bank

Mega Millions recipe: longer odds, bigger pots and fewer winners, Los Angeles Times, December 12, 2013

Many who enrolled in health plans still await confirmation, Los Angeles Times, December 12, 2013

“I agree that finance (same for the law, compliance, health care, and probably government) is extracting  too much from the rest of our economy. But the solution is not more regulation. It’s less regulation. It’s less compliance. It’s simple, effective rules (e.g. lot’s of capital). And most importantly it is free and fair competition (If you don’t see banks regularly failing, like you do any other business, then you don’t really have a competitive marketplace.); which will not occur until we break up all of the Too Big To Fail banks, Fannie and Freddie, and rein in too-powerful, unaccountable government bureaucracies like the CFPB. Read the article below; finance has taken an even greater piece of the economy post-crisis, because the Too Big To Fail banks have gotten even bigger and there is even less competition and more regulation today than ever. Our biggest risk is not another financial crisis (not any time soon anyway). Our biggest risk is excessive government rules and regulations that hinder competition and innovation (How many important banks have been established in the past 25 years? I can only name one; Capital One.) and inadvertently help monopolists, oligopolists, and crony capitalists. Our government’s number one focus should be to support and nurture a truly free enterprise system and yet in the name of protecting us (mostly from ourselves and our own decisions), they are doing just the opposite at a big, largely hidden cost to our economy and jobs.” Mike Perry, former Chairman and CEO, IndyMac Bank  

Excerpts from ProPublica’s Jesse Eisinger’s December 12, 2013, NY Times article, “Soothing Words on ‘Too Big to Fail,’ but With Little Meaning”:

“The way to really solve “too big to fail” is not by tinkering with the existing system, which leaves the great and fundamental problem still with us. The economy has become overly “financialized”.”

“Historically, finance’s share of the economy has been about 4 percent. Today, it’s about twice that. And the peak, occurred not in pre-bubble 2007, but in post-crash 2010, at just under 9 percent, according to Thomas Philippon of New York University. That represents a shift of more than $600 billion of wealth a year, as Wallace C. Turbeville, a former investment banker-turned-financial reformist has pointed out.”

“In other industries, like retail, technological innovation has led to lower prices and therefore decreased the size of the sector. In finance, the opposite has happened.”

“The regulator focus has been on reducing the chances and damage of financial crises, , and that is certainly vital. But it’s insufficient.”

“The financial sector has become a self-sustaining perpetual motion machine that extracts money from the rest of the economy. Shouldn’t it be a goal of society….Mr. Lew’s focus….to restore the financial industry to its traditional role as an intermediary between companies that need capital and savers who have it?”

Soothing Words on ‘Too Big to Fail,’ but With Little Meaning

Treasury Secretary Jacob J. Lew said “Dodd-Frank ended ‘too big to fail’ as a matter of law.”

This summer, President Obama’s new Treasury secretary, Jacob J. Lew, offered a financial reform litmus test: By the end of 2013, could we say with a straight face that we have solved the “too big to fail” problem?

Last week, Mr. Lew gave a sweeping overview of the efforts to overhaul financial regulation. It was the talk of a man who has been practicing his straight face in the mirror.

To judge by his performance, one technique for remaining stone-faced is to recite platitudes. Mr. Lew told the attendees: “Going forward, we cannot be afraid to ask tough questions, with an open mind and without preconceived judgments.” That requires that “we must remain vigilant as emerging threats appear on the horizon.” He reassured us that “we have made tough choices, and very significant progress toward reforming our financial system.”

This is not the stuff of persuasion. Simply asserting that the financial system becomes safer as regulators complete Dodd-Frank rules does not make it so. To those who don’t think those rules go far enough, the administration offers little. More important, the claim frames the issue in a discouragingly limited fashion.

In his speech, Mr. Lew claimed that his test had been passed. He said, more than once, that “Dodd-Frank ended ‘too big to fail’ as a matter of law.” That may sound soothing, but it is empty of meaning. “Too big to fail” was never literally the law of the land. Therefore, it wasn’t something that Dodd-Frank excised.

As long as there are gargantuan banks, Mr. Lew is left to make a faith-based argument that we can assume officials’ pre-battle boasts of courage will hold true as the fight is engaged.

“Too big to fail” is a generally held assumption that some entities are so central and vital to our markets that they will be backstopped by the government. For starters, it requires expecting that government officials will have the stomach to unwind a failing bank with a multitrillion-dollar balance sheet and impose losses on shareholders and, if required, bondholders and other creditors.

But that’s only a first step. The government must also have the ability to safely unwind the institution and all of its international operations. And that’s not even the most important aspect of “too big to fail.” The government won’t simply be able to unwind one failing giant financial institution and be done. Anything that is taking down JPMorgan Chase is highly likely to be also taking down Bank of America or Goldman Sachs — or both. What will the government do then? It’s at this point that the straight face becomes a look of terror.

Grant for a moment Mr. Lew’s argument that we’ve made progress on financial reform. I do. This week, the depressingly delayed Volcker Rule finally emerged from the regulatory cavern. And that rule is stronger than previous versions. But is it strong enough?

The process wasn’t encouraging. It was only in the last couple of weeks that the loopholes were closed. Now we are left to trust the enforcement efforts of regulators who only weeks ago were arguing about how many and how extensive the loopholes should be. Now we need them to uniformly become true believers in muscular Volcker enforcement.

The way to really solve “too big to fail” is not by tinkering with the existing system, which leaves the great and fundamental problem still with us. The economy has become overly “financialized.”

Historically, finance’s share of the economy has been at about 4 percent. Today, it’s about twice that. And the peak occurred not in pre-bubble 2007, but in post-crash 2010, at just under 9 percent, according to research from Thomas Philippon of New York University. That represents a shift of more than $600 billion of wealth a year, as Wallace C. Turbeville, a former investment banker-turned-financial reformist, has pointed out.

Despite technological innovation, finance costs more than it used to, even though prices have fallen for things like trading stocks.

Research from Professor Philippon shows that financial activities have gone up in the deregulatory era, and now cost about the same as in 1900, the last Gilded Age. In other industries, like retail, technological innovation has led to lower prices and therefore decreased the size of the sector. In finance, the opposite happened.

Society isn’t benefiting. Research by Jennie Bai, Professor Philippon and Alexi Savov shows that even as the differential between buying and selling stocks and bonds has fallen, prices aren’t better. Prices have displayed the same ability to forecast corporate futures steadily for the last 50 years.

The regulator focus has been on reducing the chances and damage of financial crises, and that is certainly vital. But it’s insufficient. Are we on the right path to fix the pathologies of our obese financial sector?

The financial sector has become a self-sustaining perpetual motion machine that extracts money from the rest of the economy. Shouldn’t it be a goal of society — Mr. Lew’s focus — to restore the financial industry to its traditional role as an intermediary between companies that need capital and savers who have it?

There are some modest signs in the right direction. Large banks are not as profitable as they were before the crisis. They clearly have more capital and less leverage, which makes them safer.

Regulators have incrementally raised the costs of risky activities, which may work to slow down the growth of finance.

“The effect of financial regulation is serendipitous,” Mr. Turbeville notes. “They accidentally got partly the way there.”

But part of the way isn’t good enough.

“In my view, Mr. Wallison’s outstanding Hillsdale speech below is a must read. It forcefully counters the false narrative that our government has allowed to take root in the mainstream press and public regarding the causes of the 2008 financial crisis (that imprudent bankers and inadequate regulation of financial markets were the primary cause). While Mr. Wallison rightly identifies our well-intended government housing policies as being a significant cause of the crisis, I respectfully disagree that it was the only important cause. His paper and its focus on U.S. housing policy and the GSEs, doesn’t explain why (at roughly the same time) there were asset bubbles and busts in other U.S. assets (commercial real estate, other debt and equity securities, LBOs, etc.) and also in housing and other assets (e.g. sovereign debt) in many other countries. And it doesn’t explain why today, despite current relatively tight lending standards, numerous housing (and other assets, like various types of U.S. debt) bubbles seem to have popped up around the world. As I have discussed on this blog, the crisis was a lot bigger than U.S. housing and mortgage lending policies. In particular, I have focused on this blog on two other important causes: 1) Fed and other central bank easy monetary policies pre-crisis, and 2) global trade and investment imbalances. And I have also noted on this blog that many economists are beginning to understand that rising income inequality in our new world economy, including in the U.S., have contributed to the unsustainable rise in consumer debt; a modern-day version of Marie Antoinette’s “Let them eat cake (credit)” in order to buy goods and services they really can’t afford.” Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpts from Peter J. Wallison’s November 5, 2013 Speech at Hillsdale College entitled: “Dodd-Frank: A Law like No Other”:

“The 2008 financial crisis was a major event, equivalent in its initial scope—if not its duration—to the Great Depression of the 1930s.”

“Why is it important at this point to examine the causes of the crisis? After all, it was five years ago, and Congress and financial regulators have acted, or are acting, to prevent a recurrence. Even if we can’t pinpoint the exact cause of the crisis, some will argue that the new regulations now being put in place under Dodd-Frank will make a repetition unlikely. Perhaps. But these new regulations have almost certainly slowed economic growth and the recovery from the post-crisis recession, and they will continue to do so in the future. If regulations this pervasive were really necessary to prevent a recurrence of the financial crisis, then we might be facing a legitimate trade-off in which we are obliged to sacrifice economic freedom and growth for the sake of financial stability. But if the crisis did not stem from a lack of regulation, we have needlessly restricted what most Americans want for themselves and their children.”

“It is not at all clear that what happened in 2008 was the result of insufficient regulation or an economic system that is inherently unstable. On the contrary, there is compelling evidence that the financial crisis was the result of the government’s own housing policies.”

“This widely assumed government support enabled these GSEs to borrow at rates only slightly higher than the U.S. Treasury itself, and with these low-cost funds they were able to drive all competition out of the secondary mortgage market for middle-class mortgages—about 70 percent of the $11 trillion housing finance market. Between 1991 and 2003, Fannie and Freddie’s market share increased from 28 to 46 percent. From this dominant position, they were able to set the underwriting standards for the market as a whole; few mortgage lenders would make middle-class mortgages that could not be sold to Fannie or Freddie.”

“In a sense, government backing of the GSEs and their market domination was their undoing. Community activists had kept the two firms in their sights for many years, arguing that Fannie and Freddie’s underwriting standards were so tight that they were keeping many low- and moderate-income families from buying homes. The fact that the GSEs had government support gave Congress a basis for intervention, and in 1992 Congress directed the GSEs to meet a quota of loans to low- and middle-income borrowers when they acquired mortgages.”

“In succeeding years, HUD raised the goal, with many intermediate steps, to 42 percent in 1996, 50 percent in 2000, and 56 percent in 2008.In order to meet these ever-increasing goals, Fannie and Freddie had to reduce their underwriting standards. In fact that was explicitly HUD’s purpose, as many statements by the department at the time made clear. As early as 1995, the GSEs were buying mortgages with three percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments. At the same time, they were also compromising other underwriting standards, such as borrower credit standards, in order to find the subprime and other non-traditional mortgages they needed to meet the affordable housing goals.”

“These new easy credit terms spread far beyond the low-income borrowers that the loosened standards were intended to help. Mortgage lending is a competitive business; once Fannie and Freddie started to reduce their underwriting standards, many borrowers who could have afforded prime mortgages sought the easier terms now available so they could buy larger homes with smaller down payments.”

“As a result of the gradual deterioration in loan quality over the preceding 16 years, by 2008, just before the crisis, 56 percent of all mortgages in the U.S.—32 million loans—were subprime or otherwise low quality. Of this 32 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies. This shows incontrovertibly where the demand for these mortgages originated.”

“With all the new buyers entering the market because of the affordable housing goals, housing prices began to rise. By 2000, the developing bubble was already larger than any bubble in U.S. history, and it kept growing until 2007, when—at nine times the size of any previous bubble—it finally topped out and housing prices began to fall.”

“Housing bubbles tend to suppress delinquencies and defaults while the bubble is growing. This happens because as prices rise, it becomes possible for borrowers who are having difficulty meeting their mortgage obligations to refinance or sell the home for more than the principal amount of the mortgage. In these conditions, potential investors in mortgages or in mortgage-backed securities receive a strong affirmative signal; they see high-yielding mortgages—loans that reflect the riskiness of lending to a borrower with a weak credit history—but the expected delinquencies and defaults have not occurred. They come to think, “This time it’s different”—that the risks of investing in subprime or other weak mortgages are not as great as they’d thought.”

 “With the largest housing bubble in history deflating in 2007, and more than half of all mortgages made to borrowers who had weak credit or little equity in their homes, the number of delinquencies and defaults in 2008 was unprecedented….Investors, shocked by the sheer number of mortgage defaults that seemed to be underway, fled the market for private label securities; there were now no buyers, causing a sharp drop in market values for these securities.”

 “This had a disastrous effect on financial institutions. Since 1994, they had been required to use what was called “fair value accounting” in setting the balance sheet value of their assets and liabilities….. Marking-to-market worked effectively as long as there was a market for the assets in question, but it was destructive when the market collapsed in 2007….Accordingly, financial firms were compelled to write down significant portions of their private mortgage-backed securities assets and take losses that substantially reduced their capital positions and created worrisome declines in earnings.”

“They (banks and other financial institutions) wouldn’t lend to one another, even overnight, for fear that they would not have immediate cash available when panicky investors or depositors came for it. This radical withdrawal of liquidity from the market was the financial crisis.”

“Thus, the crisis was not caused by insufficient regulation, let alone by an inherently unstable financial system. It was caused by government housing policies that forced the dominant factors in the trillion dollar housing market—Fannie Mae and Freddie Mac—to reduce their underwriting standards. These lax standards then spread to the wider market, creating an enormous bubble and a financial system in which well more than half of all mortgages were subprime or otherwise weak. When the bubble deflated, these mortgages failed in unprecedented numbers, driving down housing values and the values of mortgage-backed securities on the balance sheets of financial institutions. With these institutions looking unstable and possibly insolvent, a full-scale financial panic ensued when Lehman Brothers, a large financial firm, failed.”

“Given these facts, further regulation of the financial system through the Dodd-Frank Act was a disastrously wrong response. The vast new regulatory restrictions in the act have created uncertainty and sapped the appetite for risk-taking that had once made the U.S. financial system the largest and most successful in the world.”

PETER J. WALLISON holds the Arthur F. Burns Chair in Financial Policy Studies at the American Enterprise Institute. Previously he practiced banking, corporate, and financial law at Gibson, Dunn & Crutcher in Washington, D.C., and in New York. He also served as White House Counsel in the Reagan Administration. A graduate of Harvard College, Mr. Wallison received his law degree from Harvard Law School and is a regular contributor to the Wall Street Journal, among many other publications. He is the editor, co-editor, author, or co-author of numerous books, including Ronald Reagan: The Power of Conviction and the Success of His Presidency and Bad History, Worse Policy: How a False Narrative about the Financial Crisis Led to the Dodd-Frank Act.

The following is adapted from a speech delivered at Hillsdale College on November 5, 2013, during a conference entitled “Dodd-Frank: A Law Like No Other,” co-sponsored by the Center for Constructive Alternatives and the Ludwig Von Mises Lecture Series.

The 2008 financial crisis was a major event, equivalent in its initial scope—if not its duration—to the Great Depression of the 1930s. At the time, many commentators said that we were witnessing a crisis of capitalism, proof that the free market system was inherently unstable. Government officials who participated in efforts to mitigate its effects claim that their actions prevented a complete meltdown of the world’s financial system, an idea that has found acceptance among academic and other observers, particularly the media. These views culminated in the enactment of the Dodd-Frank Act that is founded on the notion that the financial system is inherently unstable and must be controlled by government regulation.

We will never know, of course, what would have happened if these emergency actions had not been taken, but it is possible to gain an understanding of why they were considered necessary—that is, the causes of the crisis.

Why is it important at this point to examine the causes of the crisis? After all, it was five years ago, and Congress and financial regulators have acted, or are acting, to prevent a recurrence. Even if we can’t pinpoint the exact cause of the crisis, some will argue that the new regulations now being put in place under Dodd-Frank will make a repetition unlikely. Perhaps. But these new regulations have almost certainly slowed economic growth and the recovery from the post-crisis recession, and they will continue to do so in the future. If regulations this pervasive were really necessary to prevent a recurrence of the financial crisis, then we might be facing a legitimate trade-off in which we are obliged to sacrifice economic freedom and growth for the sake of financial stability. But if the crisis did not stem from a lack of regulation, we have needlessly restricted what most Americans want for themselves and their children.

It is not at all clear that what happened in 2008 was the result of insufficient regulation or an economic system that is inherently unstable. On the contrary, there is compelling evidence that the financial crisis was the result of the government’s own housing policies. These in turn, as we will see, were based on an idea—still popular on the political left—that underwriting standards in housing finance are discriminatory and unnecessary. In today’s vernacular, it’s called “opening the credit box.” These policies, as I will describe them, were what caused the insolvency of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and ultimately the financial crisis. They are driven ideologically by the left, but the political muscle in Washington is supplied by what we should call the Government Mortgage Complex—the realtors, the homebuilders, and the banks—for whom freely available government-backed mortgage money is a source of great profit.

The Federal Housing Administration, or FHA, established in 1934, was authorized to insure mortgages up to 100 percent, but it required a 20 percent down payment and operated with very few delinquencies for 25 years. However, in the serious recession of 1957, Congress loosened these standards to stimulate the growth of housing, moving down payments to three percent between 1957 and 1961. Predictably, this resulted in a boom in FHA insured mortgages and a bust in the late ’60s. The pattern keeps recurring, and no one seems to remember the earlier mistakes. We loosen mortgage standards, there’s a bubble, and then there’s a crash. Other than the taxpayers, who have to cover the government’s losses, most of the people who are hurt are those who bought in the bubble years, and found—when the bubble deflated—that they couldn’t afford their homes.

Exactly this happened in the period leading up to the 2008 financial crisis, again as a result of the government’s housing policies. Only this time, as I’ll describe, the government’s policies were so pervasive and were pursued with such vigor by two administrations that they caused a financial crisis as well as the usual cyclical housing market collapse.

Congress planted the seeds of the crisis in 1992, with the enactment of what were called “affordable housing” goals for Fannie Mae and Freddie Mac. Before 1992, these two firms dominated the housing finance market, especially after the federal savings and loan industry—another government mistake—had collapsed in the late 1980s. Fannie and Freddie’s role, as initially envisioned and as it developed until 1992, was to conduct what were called secondary market operations, to create a liquid market in mortgages. They were prohibited from making loans themselves, but they were authorized to buy mortgages from banks and other lenders. Their purchases provided cash for lenders and thus encouraged home ownership by making more funds available for more mortgages. Although Fannie and Freddie were shareholder-owned, they were chartered by Congress and granted numerous government privileges. For example, they were exempt from state and local taxes and from SEC regulations. The president appointed a minority of the members of their boards of directors, and they had a $2.25 billion line of credit at the Treasury. As a result, market participants believed that Fannie and Freddie were government-backed, and would be rescued by the government if they ever encountered financial difficulties.

This widely assumed government support enabled these GSEs to borrow at rates only slightly higher than the U.S. Treasury itself, and with these low-cost funds they were able to drive all competition out of the secondary mortgage market for middle-class mortgages—about 70 percent of the $11 trillion housing finance market. Between 1991 and 2003, Fannie and Freddie’s market share increased from 28 to 46 percent. From this dominant position, they were able to set the underwriting standards for the market as a whole; few mortgage lenders would make middle-class mortgages that could not be sold to Fannie or Freddie.

Over time, these two GSEs had learned from experience what underwriting standards kept delinquencies and defaults low. These required down payments of 10 to 20 percent, good credit histories for borrowers, and low debt-to-income ratios after the mortgage was closed. These were the foundational elements of what was called a prime loan or a traditional mortgage, and they contributed to a stable mortgage market through the 1970s and most of the 1980s, with mortgage defaults generally under one percent in normal times and only slightly higher in rough economic waters. Despite these strict credit standards, the homeownership rate in the United States remained relatively high, hovering around 64 percent for the 30 years between 1964 and 1994.

In a sense, government backing of the GSEs and their market domination was their undoing. Community activists had kept the two firms in their sights for many years, arguing that Fannie and Freddie’s underwriting standards were so tight that they were keeping many low- and moderate-income families from buying homes. The fact that the GSEs had government support gave Congress a basis for intervention, and in 1992 Congress directed the GSEs to meet a quota of loans to low- and middle-income borrowers when they acquired mortgages. The initial quota was 30 percent: In any year, at least 30 percent of the loans Fannie and Freddie acquired must have been made to low- and moderate-income borrowers—defined as borrowers at or below the median income level in their communities. Although 30 percent was not a difficult goal, the Department of Housing and Urban Development (HUD) was given authority to increase the goals, and Congress cleared the way for far more ambitious requirements by suggesting in the legislation that down payments could be reduced below five percent without seriously impairing mortgage quality. In succeeding years, HUD raised the goal, with many intermediate steps, to 42 percent in 1996, 50 percent in 2000, and 56 percent in 2008.

In order to meet these ever-increasing goals, Fannie and Freddie had to reduce their underwriting standards. In fact that was explicitly HUD’s purpose, as many statements by the department at the time made clear. As early as 1995, the GSEs were buying mortgages with three percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments. At the same time, they were also compromising other underwriting standards, such as borrower credit standards, in order to find the subprime and other non-traditional mortgages they needed to meet the affordable housing goals.

These new easy credit terms spread far beyond the low-income borrowers that the loosened standards were intended to help. Mortgage lending is a competitive business; once Fannie and Freddie started to reduce their underwriting standards, many borrowers who could have afforded prime mortgages sought the easier terms now available so they could buy larger homes with smaller down payments. Thus, home buyers above the median income were gaining leverage through lower down payments, and loans to them were decreasing in quality. In many cases, these homeowners were withdrawing cash from the equity in their homes through cash-out refinancing as home prices went up and interest rates declined in the mid-2000s. By 2007, 37 percent of loans with down payments of three percent went to borrowers with incomes above the median.

As a result of the gradual deterioration in loan quality over the preceding 16 years, by 2008, just before the crisis, 56 percent of all mortgages in the U.S.—32 million loans—were subprime or otherwise low quality. Of this 32 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies. This shows incontrovertibly where the demand for these mortgages originated.

With all the new buyers entering the market because of the affordable housing goals, housing prices began to rise. By 2000, the developing bubble was already larger than any bubble in U.S. history, and it kept growing until 2007, when—at nine times the size of any previous bubble—it finally topped out and housing prices began to fall.

Housing bubbles tend to suppress delinquencies and defaults while the bubble is growing. This happens because as prices rise, it becomes possible for borrowers who are having difficulty meeting their mortgage obligations to refinance or sell the home for more than the principal amount of the mortgage. In these conditions, potential investors in mortgages or in mortgage-backed securities receive a strong affirmative signal; they see high-yielding mortgages—loans that reflect the riskiness of lending to a borrower with a weak credit history—but the expected delinquencies and defaults have not occurred. They come to think, “This time it’s different”—that the risks of investing in subprime or other weak mortgages are not as great as they’d thought. Housing bubbles are also pro-cyclical. When they are growing, they feed on themselves, as buyers bid up prices so they won’t lose a home they want. Appraisals, based on comparable homes, keep pace with rising prices. And loans keep pace with appraisals, until home prices get so high that buyers can’t afford them no matter how lenient the terms of the mortgage. But when bubbles begin to deflate, the process reverses. It then becomes impossible to refinance or sell a home when the mortgage is larger than the home’s appraised value. Financial losses cause creditors to pull back and tighten lending standards, recessions frequently occur, and would-be purchasers can’t get financing. Sadly, many are likely to have lost their jobs in the recession while being unable to move where jobs are more plentiful, because they couldn’t sell their homes without paying off the mortgage balances. In these circumstances, many homeowners are tempted to walk away from the mortgage, knowing that in most states the lender has recourse only to the home itself.

With the largest housing bubble in history deflating in 2007, and more than half of all mortgages made to borrowers who had weak credit or little equity in their homes, the number of delinquencies and defaults in 2008 was unprecedented. One immediate effect was the collapse of the market for mortgage-backed securities that were issued by banks, investment banks, and subprime lenders, and held by banks, financial institutions, and other investors around the world. These were known as private label securities or private mortgage-backed securities, to distinguish them from mortgage-backed securities issued by Fannie and Freddie. Investors, shocked by the sheer number of mortgage defaults that seemed to be underway, fled the market for private label securities; there were now no buyers, causing a sharp drop in market values for these securities.

This had a disastrous effect on financial institutions. Since 1994, they had been required to use what was called “fair value accounting” in setting the balance sheet value of their assets and liabilities. The most significant element of fair value accounting was the requirement that assets and liabilities be marked-to-market, meaning that the balance sheet value of assets and liabilities was to reflect their current market value instead of their amortized cost or other valuation methods.

Marking-to-market worked effectively as long as there was a market for the assets in question, but it was destructive when the market collapsed in 2007. With buyers pulling away, there were only distress-level prices for private mortgage-backed securities. Although there were alternative ways for assets to be valued in the absence of market prices, auditors—worried about their potential liability if they permitted their clients to overstate assets in the midst of the financial crisis—would not allow the use of these alternatives. Accordingly, financial firms were compelled to write down significant portions of their private mortgage-backed securities assets and take losses that substantially reduced their capital positions and created worrisome declines in earnings. When Lehman Brothers, a major investment bank, declared bankruptcy, a full-scale panic ensued in which financial institutions started to hoard cash. They wouldn’t lend to one another, even overnight, for fear that they would not have immediate cash available when panicky investors or depositors came for it. This radical withdrawal of liquidity from the market was the financial crisis.

Thus, the crisis was not caused by insufficient regulation, let alone by an inherently unstable financial system. It was caused by government housing policies that forced the dominant factors in the trillion dollar housing market—Fannie Mae and Freddie Mac—to reduce their underwriting standards. These lax standards then spread to the wider market, creating an enormous bubble and a financial system in which well more than half of all mortgages were subprime or otherwise weak. When the bubble deflated, these mortgages failed in unprecedented numbers, driving down housing values and the values of mortgage-backed securities on the balance sheets of financial institutions. With these institutions looking unstable and possibly insolvent, a full-scale financial panic ensued when Lehman Brothers, a large financial firm, failed.

Given these facts, further regulation of the financial system through the Dodd-Frank Act was a disastrously wrong response. The vast new regulatory restrictions in the act have created uncertainty and sapped the appetite for risk-taking that had once made the U.S. financial system the largest and most successful in the world.

What, then, should have been done? The answer is a thorough reorientation of the U.S. housing finance system away from the kind of government control that makes it hostage to narrow political imperatives—that is, providing benefits to constituents—rather than responsive to the competition and efficiency imperatives of a market system. This does not mean that we should have no regulation. What it means is that we should have only regulation that is necessary when the self-correcting elements in a market system fail. We can see exactly that kind of failure in the effect of a bubble on housing prices. A bubble energizes itself by reducing defaults as prices rise. This sends the wrong signal to investors: Instead of increasing risk, they tend to see increasing opportunity. They know that in the past there have been painful bubble deflations in housing, but it is human nature to believe that “this time it’s different.” Requiring that only high quality mortgages are eligible for securitization would be the kind of limited regulatory intervention that addresses the real problem, not the smothering regulation in Dodd-Frank that depresses economic growth.

The Affordable Care Act, better known as ObamaCare, has received all the attention as the worst expression of the Obama presidency, but Dodd-Frank deserves a look. Just as ObamaCare was the wrong prescription for health care, Dodd-Frank was based on a faulty diagnosis of the financial crisis. Until that diagnosis is corrected—until it is made clear to the American people that the financial crisis was caused by the government rather than by deregulation or insufficient regulation—economic growth will be impeded. It follows that when the true causes of the financial crisis have been made clear, it will become possible to repeal Dodd-Frank.

This has happened before. During the 1930s, the dominant view was that the Depression was caused by excessive competition. It seems crackpot now, but the New Dealers thought that too much competition drove down prices, caused firms to fail, and thus increased unemployment. The Dodd-Frank of the time was the National Industrial Recovery Act. Although it was eventually overturned by the Supreme Court, its purpose was to cartelize industry and limit competition so that businesses could raise their prices. It was only in the 1960s, when Milton Friedman and Anna Schwartz showed that the Depression was caused by the Federal Reserve’s monetary policy, that national policies began to move away from regulation and toward competition. What followed was a flood of deregulation—of trucking, air travel, securities, and communications, among others—which has given us the Internet, affordable air travel for families instead of just business, securities transactions at a penny a share, and Fedex. Ironically, however, the regulation of banking increased, accounting for the problems of the industry today.

If the American people come to recognize that the financial crisis was caused by the housing policies of their own government—rather than insufficient regulation or the inherent instability of the U.S. financial system—Dodd-Frank will be seen as an illegitimate response to the crisis. Only then will it be possible to repeal or substantially modify this repressive law.

http://imprimis.hillsdale.edu/file/archives/pdf/2013_11_Imprimis.pdf

“At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money. If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.”, Former Vice Chairman of The Federal Reserve, Alan Blinder, “The Fed Plan to Revive High-Powered Money”, WSJ December 11, 2013

“It’s a little scary to me to think that Alan Blinder was a former Vice Chairman of The Federal Reserve System! I have read nearly every one of his WSJ OpEd’s these past several years and frankly many (like the one today below) are just plain wrong. The Fed has a current balance sheet of just under $4 trillion. If they were one of the private banks they regulate, they would rate themselves unsafe and unsound. If you exclude the Fed’s monetary/economic role and government backing and look just at their balance sheet, the Fed is currently a giant hedge fund with a highly-leveraged, risky interest rate bet. About $2 trillion or roughly half of their assets (U.S. Treasuries and Fannie/Freddie MBS securities) have a greater than 10 year life. Another $860 billion or about 23% of their assets are in U.S. Treasuries with a 5 to 10 year life. They have another $860 billion or about 23% of their assets in U.S. Treasuries with a 5 to 10 year life. And yet most of their liabilities are less than one year in duration. And the Fed’s trillions in interest rate risk is supported by only $55 billion of capital; their capital is just 1.4% of assets. They have debt (leverage) that is about 70 times their capital!  As some have pointed out, given the duration mismatch of their assets and liabilities and their leverage, it doesn’t take much of a rise in interest rates before the Fed is insolvent on a mark-to-market basis. Yes, the Fed has a little over $2.4 trillion in excess bank reserves today, but they are not sitting idle as Blinder contends; they are being used to fund about 60% of the Fed’s assets. If the Fed reduces the interest rate they pay the banks on these excess reserves (IOER) or as Blinder recommends, charge the banks 0.25%, he is correct that the banks will take these funds back and the Fed will be forced to sell its U.S. Treasuries and MBS or finance them with reverse repurchase agreement (repos) liabilities. What does that accomplish? If the Fed can’t find enough repos and is forced to sell assets, then we go from QE tapering/reduced purchases (which received a bad market reaction), to zero QE/no purchases, to negative QE/sales, all at once. I imagine that would be a catastrophe and might force the Fed to realize losses (Rates would rise on long-term Treasuries and MBS as the Fed sold, just as they fell as the Fed bought them.) which might cause it to become insolvent. If the Fed is able to replace these excess reserves with repo funding, the Fed’s demand for these types of liabilities (given that there is only three or so trillion in money market funds) might push repo borrowing rates higher. So net, net, not much economic affect on the economy, but lot’s of risk for the already very risky Federal Reserve. Mr Blinder himself notes that his “idea” of charging banks IOER would result in banks pulling excess reserves from the Fed and investing these funds in short-term securities. As I noted already, the Fed is using these excess reserves to invest, albeit in a risky manner, in long-term securities (Treasuries and MBS), which is stimulating the housing recovery through low mortgage rates. Would shifting these reserves from the Fed to the banks and shifting investment from long-term securities to short-term securities be a positive or negative to the economy? My guess is a slight negative in the short-run, but certainly not a material impact. It’s not polite to say, but in my opinion, given Mr. Blinder’s pedigree, he would better serve our Country if he refrained from writing OpEd’s that don’t acknowledge that well-intended Fed and government housing policies (and trade imbalances) were the true-root cause of the financial crisis and don’t provide the right solutions for economic recovery.” Mike Perry, former Chairman and CEO, IndyMac Bank

Excerpts from December, 2013 Bloomberg Article Re. Fed Considering Reducing the “Interest (Paid) On Excess Reserves” (IOER) to Banks:

“In considering reducing IOER, Fed policy makers are revisiting a proposal they have rejected for the past five years, even as it was recommended by economists including former Fed Vice Chairman Alan Blinder.

Blinder argued that reducing IOER would encourage banks to lend out more of the money they now keep locked up at the Fed. That would spur growth and employment as companies use cheap money to hire and invest, he argued. Fed officials disagreed, concluding that such a move wouldn’t provide a powerful boost to the economy.

“The benefits of such a step were generally seen as likely to be small except possibly as a signal of policy intentions,” according to minutes of the FOMC’s October meeting.

“They’re grasping at straws for how to signal their plans for the fed funds rate, and lowering IOER could be part of that,” said Sam Coffin, an economist in New York at UBS Securities, one of the 21 primary dealers that trades directly with the Fed.

Michael Feroli, the chief U.S. economist at JPMorgan Chase & Co., said “I’m not sure what signal” lowering IOER would send, because the benchmark federal funds rate would remain little changed.

Opinion

The Fed Plan to Revive High-Powered Money

Don’t only drop the interest rate paid on banks’ excess reserves, charge them.

By Alan S. Blinder

Unless you are part of the tiny portion of humanity that dotes on every utterance of the Federal Open Market Committee, you probably missed an important statement regarding the arcane world of “excess reserves” buried deep in the minutes of its Oct. 29-30 policy meeting. It reads: “[M]ost participants thought that a reduction by the Board of Governors in the interest rate paid on excess reserves could be worth considering at some stage.”

As perhaps the longest-running promoter of reducing the interest paid on excess reserves, even turning the rate negative, I can assure you that those buried words were momentous. The Fed is famously given to understatement. So when it says that “most” members of its policy committee think a change “could be worth considering,” that’s almost like saying they love the idea. That’s news because they haven’t loved it before.

So what exactly are excess reserves, and why should you care? Like most central banks, the Fed requires banks to hold reserves—mainly deposits in their “checking accounts” at the Fed—against transactions deposits. Any reserves held over and above these requirements are called excess reserves.

Not long ago—say, until Lehman Brothers failed in September 2008—banks held virtually no excess reserves because idle cash earned them nothing. But today they hold a whopping $2.5 trillion in excess reserves, on which the Fed pays them an interest rate of 25 basis points—for an annual total of about $6.25 billion. That 25 basis points, what the Fed calls the IOER (interest on excess reserves), is the issue.

Unlike the Fed’s main policy tool, the federal-funds rate, the IOER is not market-determined. It’s completely controlled by the Fed. So instead of paying banks to hold all those excess reserves, it could charge banks a small fee, i.e., a negative interest rate, for the privilege.

At this point, you’re probably thinking: “Wait. If the Fed charged banks rather than paid them, wouldn’t bankers shun excess reserves?” Yes, and that’s precisely the point. Excess reserves sitting idle in banks’ accounts at the Fed do nothing to boost the economy. We want banks to use the money.

If the Fed turned the IOER negative, banks would hold fewer excess reserves, maybe a lot fewer. They’d find other uses for the money. One such use would be buying short-term securities. Another would probably be lending more, which is what we want.

A second reason for cutting the IOER answers some of the criticisms the Fed has taken for its asset-buying programs called quantitative-easing: Doing so would stimulate the economy without increasing the size of the Fed’s balance sheet. In fact, the Fed could probably shrink its balance sheet.

To understand why, think back to the good old days, when excess reserves were zero. When the Fed injected reserves into the banking system, banks would use those funds to increase lending, thereby creating multiple expansions of the money supply and credit. Bank reserves were called “high-powered money” because each new dollar of reserves led to several additional dollars of money and credit.

The financial crisis short-circuited this process. As greed gave way to fear, bankers decided to store trillions of dollars safely at the Fed rather than lend them out. High-powered money became powerless money.

The Fed compounded the problem in October 2008 by starting to pay interest on reserves. And these days, the 25-basis-point IOER looks pretty good compared with most short-term money rates. If banks were charged rather than paid 25 basis points, they would find holding excess reserves a lot less attractive. As some of this excess central-bank money became “high-powered” again, the Fed would want less of it. So its balance sheet could shrink.

What are the arguments against turning the IOER negative? Over the years, Fed officials have made three, none of them cogent.

One is that cutting the IOER would have only modest stimulative effects. Well, probably. But are there more powerful tools sitting around unused? Besides, there is at least a chance that we’d get more new lending than the Fed thinks.

Second, there is a limit to how far negative the IOER can go. After all, banks can earn zero by keeping paper money in their vaults. So if the Fed charged a very high fee for holding excess reserves, bankers might find it worthwhile to pay the costs of bigger vaults and more security guards in order to keep huge stockpiles of cash. Sure. But a mere 25 basis point fee is not enough incentive for them to do so.

Third, a negative IOER could drive short-term interest rates even closer to zero, as banks moved balances from their reserve accounts into money market instruments. And that, we are told, would wreak havoc in the money markets. Really? Perhaps that was a legitimate concern three years ago, but we have now lived with money-market rates hugging zero for years, and capitalism has survived.

Besides, the Fed paid no interest on reserves for the first 94 years of its existence, the European Central Bank has been paying its banks nothing since July 2012, and the Danes have been charging a fee since then. In no case did anything terrible happen.

That said, suppose the policy failed. Suppose the Fed cut the IOER from 25 basis points to minus 25 basis points, and banks didn’t react at all; they just held on to all their excess reserves. In that unlikely event, cutting the IOER would neither provide stimulus nor enable the Fed to shrink its balance sheet. However, the Fed would start collecting about $6.25 billion per year in fees from banks instead of paying them $6.25 billion in interest—a swing of roughly $12.5 billion in the taxpayers’ favor. Some downside.

“The Barron’s excerpts below (from the most recent issue) are just two examples of the market distortions caused by the Fed’s easy money policies. There is no growth going on here (S&P 500 revenues aren’t even up 3% in the third quarter of 2013). There are no jobs being created here. In fact, these activities; issuing debt and selling assets (especially to foreigners) to pay dividends and/or buy back shares, probably costs jobs and increases corporate risk. There is no long-term shareholder value being created here. This is just temporary financial arbitrage pure and simple.” Mike Perry, former Chairman and CEO, IndyMac Bank

“Valuations, especially relative to interest rates, are low, and earnings and cash-flow growth are quite reasonable. At the same time, there is an extraordinary situation in terms of allocating capital. The really strong market performers for the past few years in the consumer-discretionary sector…media, entertainment, and retailing….are companies that have been significantly repurchasing their stock. That should be the case for the next few years, too. For a company trading at a multiple of seven times pre-tax cash flow, its pretax cash-flow return is 14%. If the company has a 2% dividend yield and you adjust that dividend on a pretax basis, the yield is closer to 3% assuming a 33% tax rate. Many companies can borrow at less than 3% or slightly over 3% at the margin. So you can buy your own stock at a 14% return with a negative or zero or 1% to 2% cost of capital for at least a 12% spread. Companies that have been engaged in this form of arbitrage such as CBS, Viacom, and DirecTV have been really stellar market performers.” Larry Haverty, Portfolio Manager, Gabelli Multimedia Trust, Barron’s, December 9, 2013

Relevant Excerpts from Barron’s “Buy the Asset Sellers”:

“The Standard & Poor’s 500 index is up 27% this year, but its underlying revenue increased just 2.9% during the third quarter. Companies that are increasing revenue at a double-digit pace go for a median of 20 times this year’s projected earnings.”

“However, fast growth isn’t the only path to handsome stock returns. Companies can increase their profit margins, boost their overall growth rates or reduce risk by selling assets that have been holding them back, and putting the cash toward debt reduction or larger dividends. The results are often lucrative for shareholders.”

“WHEN SELLING ASSETS, it helps to have buyers who are willing to overpay because their motivations extend beyond profits. Countries such as China, Indonesia, and South Korea are keen to reduce dependency on foreign oil and diversify savings away from low-yield Treasury bonds. So far this year, government-controlled energy companies have scooped up assets worth $94 billion, JPMorgan reported in late November. That’s 12 times what they spent in 2006 and 78% higher than last year.”

Feature

SATURDAY, DECEMBER 7, 2013

Buy the Asset Sellers

By JACK HOUGH | MORE ARTICLES BY AUTHOR

Revenue growth may be hard to come by these days. Look for companies with assets to sell or businesses to unload.

It’s not easy to find bargains when U.S. stock prices have soared while revenue growth has slowed, especially since companies that are still growing quickly look expensive. One solution: Look for companies that can grow by shrinking—companies that can fetch higher stock prices by selling off underperforming assets and putting the cash to good use. Consider Dow Chemical, Royal Dutch Shell, General Electric and Time Warner .

The Standard & Poor’s 500 index is up 27% this year, but its underlying revenue increased just 2.9% during the third quarter. Companies that are increasing revenue at a double-digit pace go for a median of 20 times this year’s projected earnings. Weed out those whose revenue is up on acquisitions or rebounding from depressed levels, and what’s left are true fast-growers with much higher prices, like Chipotle Mexican Grill(ticker: CMG) at 50 times earnings; Whole Foods Market (WFM) at 33 times; and Netflix (NFLX), Amazon.com (AMZN), and Salesforce.com (CRM), all more than 100 times.

Stuart Goldenberg for Barron’s

Investors can improve their prospects by seeking out reasonably priced companies with assets to sell.

However, fast growth isn’t the only path to handsome stock returns. Companies can increase their profit margins, boost their overall growth rates or reduce risk by selling assets that have been holding them back, and putting the cash toward debt reduction or larger dividends. The results are often lucrative for shareholders. A 2008 study published in the Journal of Finance found that over the long term, U.S. stocks in the market’s bottom decile ranked by recent asset growth outperformed those in the top decile by 13 percentage points a year. A 2012 paper that focused on international markets reported similar findings. So while rising stock valuations may be better news for sellers than for buyers, buyers can improve their prospects by seeking out reasonably priced companies with plenty to sell.

For instance: Last week, Dow Chemical (DOW) announced it will sell chlorine, epoxy and other commodity businesses with revenue of $5 billion, or nearly 10% of total revenue. Since 2009, Dow has already sold businesses with revenue of about $10 billion. After the latest divestiture, three-quarters of the company’s revenue will come from high-margin businesses, according to Deutsche Bank. The sales have reduced payroll costs and helped Dow more than double its spending on dividends and share repurchases over the past three years. The stock yields 3.3%. Earnings per share are expected to increase 21% this year, to $2.29, and to grow even faster next year, hitting $2.84. That puts shares below 14 times next year’s earnings.

WHEN SELLING ASSETS, it helps to have buyers who are willing to overpay because their motivations extend beyond profits. Countries such as China, Indonesia, and South Korea are keen to reduce dependency on foreign oil and diversify savings away from low-yield Treasury bonds. So far this year, government-controlled energy companies have scooped up assets worth $94 billion, JPMorgan reported in late November. That’s 12 times what they spent in 2006 and 78% higher than last year.

Meanwhile, many big oil firms remain stuffed with under-developed assets ripe for spinning off. Royal Dutch Shell (RDS.B) has targeted $15 billion in sales over the next two years, or 7% of its recent stock market value, but JPMorgan says it holds twice that much in non-core assets that could fetch good prices. Shares of Royal Dutch go for nine times earnings and yield 4.9%.

In September, Barron’s wrote that General Electric (GE) shares look likely to shine after more than a decade of underperformance, based in part on the company selling off financial operations that don’t directly relate to its industrial businesses (Sept. 23, “GE: Not Too Big to Grow“). Last month, the company said it will sell up to 20% of its North American consumer finance business in an initial public offering next year and distribute the rest to stockholders. Shares of GE are up 12% since our story, versus 6% for the S&P 500. They still look affordable at 15 times next year’s earnings forecast. One reason is the 2.8% dividend yield. Another, according to Barclays, is that changes in profit margins are one of the best predictors of stock performance for industrial companies, and GE leads its peer group by that measure. One of its goals is to drive operating margins for its industrial businesses 0.7 percentage point higher this year to 15.8%. Last quarter, it reported a 1.2 percentage-point increase.

It’s a worrisome sign when companies build grandiose headquarters; think of the Sears Tower in Chicago, now called the Willis Tower, finished in 1973, before a long decline for the retailer. It’s probably a good sign, then, that Time Warner is reportedly unloading an ultra-posh retail and office development in Manhattan that holds its headquarters—to a group that includes Singapore’s sovereign wealth fund. The company also plans to spin off its publishing business next year. What’s left will be lucrative television and film properties, including Home Box Office, Turner Broadcasting System and Warner Brothers Entertainment. After the sale, about 35% of revenue will come from subscriptions and only 20% from advertising, and earnings per share should grow by 15% a year on falling corporate overhead and rising fees from TV affiliates, according to Morgan Stanley. Shares go for 16 times next year’s earnings forecast.