Saturday, April 25, 2009

Goodfriend Principles

To maintain the Fed’s independence in monetary policy and its ability to successfully fight inflation (and deflation) the Fed and the Treasury need to sign a Federal Reserve Credit Policy Accord, says economist Marvin Goodfriend. He offers six principles to guide such an accord.

By Robert Stowe England

April 25, 2009

A call for a Federal Reserve Credit Policy Accord between the Fed and the U.S. Treasury was issued yesterday (April 24) by Marvin Goodfriend, professor of economics and chairman of the Gailliot Center for Public Policy at the Tepper School of Business at Carnegie-Mellon University in Pittsburgh.

He was speaking at a symposium conducted by the Shadow Open Market Committee ( at Cato Institute in Washington, D.C.

Goodfriend’s concern was aimed at the Fed’s decision to provide more than $1 trillion of credit through the Term Asset Lending Facility (TALF) and other arrangements. The effort includes loans to banks and other financial institutions, as well as loans to special purpose entities to finance the acquisition of commercial paper and asset-backed securities.

These Fed lending efforts are “pure credit policy.” The endeavor is “therefore, taking a fiscal action and invading the territory of the fiscal authorities,” namely Congress and the U.S. Treasury, Goodfriend stated in his paper titled “We Need an ‘Accord’ for Federal Reserve Credit Policy.”

By expanding into fiscal matters, the Fed risks increased political interference that could undermine its ability to continue its successful management of monetary policy, including fighting the considerable inflationary policies that some are predicting from trillions of dollars of monetary and fiscal stimulus in the last six months, Goodfriend said.

Treasury and the Fed did, in fact, issued a four-point joint statement March 24 indicating agreement on the the role of the Federal Reserve in preserving financial and monetary stability, a step that garnered very little notice in the press at the time. The text of the statement can be found at this link:

The joint statement concludes with a notice that ultimately the facilities set up by the Federal Reserve to improve the functioning of credit markets, known as the Maiden Lane facilities, should will be removed or liquidated by the U.S. Treasury.

Goodfriend said "it is a matter of urgency" to expand the March 24th agreement to include the six principles he outlined to the symposium.

The six principles are as follows:

1. As a long run matter, a significant sustained expansion of the Fed credit policy beyond ordinary, temporary last resort lending to banks is incompatible with sustained Fed independence. The Fed should adhere to a ‘Treasuries only’ asset acquisition policy except for occasional and limited discount window lending to banks.

2. The Treasury and the Fed should agree to co-operate, as soon as the current credit crisis allows, to shrink the central bank’s lending reach by letting Fed credit programs run off or by moving them from the Fed’s balance sheet to be managed elsewhere in the government. Any further expansion of Fed credit programs in the current credit crisis should be undertaken by agreement with Treasury to minimize the risk of committing to a course of action that proves subsequently to be ill-advised.

3. The Fed has employed monetary policy in the service of credit policy in the current emergency by creating over 1 trillion dollars of bank reserves to finance its credit policy initiatives, with the possibility of more to come before the credit crisis ends. The Treasury and the Fed should co-operate so that the Fed’s fiscal support through its credit policy initiatives for banking and credit markets does not undermine price stability.

4. To strengthen the nation’s commitment to price stability, the Treasury and the Fed should agree on a long run inflation objective to anchor inflation expectations against rising inflation or deflation. Such an agreement will not only improve the effectiveness of monetary policy, it will help hold down the inflation premium that the Treasury must pay to borrow long term.

5. The Treasury should help the Fed to secure the power of “interest on reserves” to put a floor under the federal funds rate. The Treasury and the Fed should do so by making sure that every institution that trades in the federal funds market holds deposits at the Fed and receives interest on these deposits as set by the Fed. This institutional fix is necessary to guarantee the Fed’s operational power to raise its federal funds rate target against inflation, regardless of the size of the Fed’s balance sheet. (See footnote)

6. The Treasury and the Fed should agree as soon as possible to co-operate as above to credibly secure the commitment to price stability so that the Fed can act preemptively, flexibly, and aggressively in the short run against either inflation, or a deepening contraction and deflation, whichever proves to be the greater risk. The credibility of monetary policy to act aggressively against deflation, if need be, depends crucially on the Fed having the power to raise interest rates against inflation if and when that should become the problem.

Marvin Goodfriend, “Interest on Reserves and Monetary Policy,” Federal Reserve Bank of New York Policy Review, (May 2002), pp. 77-84.

Copyright 2009© by Robert Stowe England

Tuesday, April 21, 2009

Reviving the Secondary Market

Mortgage finance experts, regulators, lawmakers and industry groups are wrestling with the challenge of remaking the secondary mortgage market into a sustainable model for the long term.

By Robert Stowe England

Mortgage Banking, April 2009

For printable copy, click this link:

Trust -- once it's lost, how do you get it back?

For the world of mortgage finance, that is the paramount question. It is essential to the success of any efforts at reviving the secondary mortgage market on a sustainable basis with and without a federal government role.

Restored trust is essential in the near and mid-term to restarting the private-label mortgage-backed securities (MBS) market, which collapsed in August 2007. That is the part of the secondary market reserved for jumbo prime, alternative-A and subprime loans -- the loan products that made up the once formidable private-label MBS market.

And restored trust is essential in the longer term for whatever reforms and future roles lie ahead for the government-sponsored enterprises (GSEs) or their successor replacements. Until trust is restored, investors will not feel confident enough to return to the U.S. mortgage securitization markets they fled.

Former Federal Reserve Chairman Paul A. Volcker summed up the despair in the financial markets to Congress' Joint Economic Committee on Feb. 26: "The rising debt, particularly mortgage credit, was facilitated and extended by the modern alchemy of financial engineering. Mathematic techniques that have [been] developed in an effort to diffuse and limit risk turned out in practice to magnify and obscure risks, partly because in all their complexity and opacity, transparency was lost,"Volcker said.

For now, the U.S. government's greatly expanded role is keeping the wheels on mortgage finance while also powering it forward. For example, the GSEs - Fannie Mae and Freddie Mac - have greatly expanded their role in conservatorship out of necessity to help the foundering housing market find a bottom. The Federal Housing Administration (FHA) and Ginnie Mae have greatly expanded their roles as well.

In 2008, the GSEs' share of mortgage originations rose to 73.5 percent, according to Inside Mortgage Finance. In 2006, before the collapse of private-label, their share stood at less than 35 percent.

In the fourth quarter of 2008, the government share of mortgage originations - FHA, Department of Veterans Affairs (VA) and the GSEs - stood at 92 percent, according to Inside Mortgage Finance. (When one counts home-equity loans, however, the FHA/VA/GSE combined share of all mortgages originated falls to 87 percent, according to Inside Mortgage Finance.)

"We have effectively nationalized housing finance in the U.S., [where nearly] 95 percent of recent mortgages were touched by or guaranteed by the government," says Nicolas Retsinas, director of Harvard University's Joint Center for Housing Studies, Cambridge, Massachusetts. "Absent that, there would be barely a heartbeat of housing finance."

The gains in market share by the GSEs and FHA/Ginnie Mae are troubling to James B. Lockhart III, director of the Federal Housing Finance Agency (FHFA), whose agency oversees conservatorship of the GSEs and regulates them for safety and soundness.

"A very worrisome issue to any insurance program, but especially a government one, is very rapid growth, because it may indicate that risk is being underpriced," Lockhart told a meeting of the Association of Government Accountants in Washington, D.C., on Feb. 19.

For now, however, trust is so absent from the markets that only federal government guarantees, whether explicit or implicit as an effective guarantee in the case of the GSEs, along with massive interventions in terms of cash infusions by Treasury and purchases of mortgage securities by the Fed are keeping the market functioning. One could say the U.S. government is the mortgage market for now.

Absent government intervention, the amount of mortgage credit available would have cratered last September. Indeed, as Lockhart says, FHFA "could not have put Fannie and Freddie into conservatorship without Treasury's $100 billion Senior Preferred Stock Facility, which provides effective guarantees of the enterprises' debt and mortgage-backed securities by ensuring each enterprise has a positive net worth."

By mid-March, Freddie Mac had accessed about $13.8 billion from the Senior Preferred Stock Facility and had requested an additional $30.8 billion after reporting a $23.9 billion loss in the fourth quarter for 2008 and a $50.1 billion loss for all of 2008. Fannie Mae announced it will need $11 billion to $16 billion to cover its fourth-quarter losses.

On Feb. 18, Treasury Secretary Timothy Geithner and President Obama announced that Treasury had doubled the Senior Preferred Stock Facility to $200 billion "to remove any possible doubt in the minds of investors that the U.S. government stands behind Fannie Mae and Freddie Mac," Lockhart said.

Lockhart also reported that by late February the Federal Reserve Bank had purchased $115 billion in Fannie, Freddie and Ginnie Mae mortgage-backed securities as part of its plan to purchase up to $500 billion in agency MBS. The Federal Reserve has also purchased $30 billion in Fannie, Freddie and Federal Home Loan Bank notes as part of its plan to buy $100 billion in debt from the GSEs and home loan banks.

Indeed, since mid-November 2008, the extraordinary actions of the Fed in pledging to buy assets have driven down interest rates, and they have mostly remained lower.

A focus on rebuilding

With the mortgage market functioning on government steroids, attention has turned toward rebuilding the secondary market from the ground up so that it can function in the future without massive government involvement.

The Mortgage Bankers Association (MBA) took the lead last year in promoting discussion about the future of mortgage finance when it set up the Council on Ensuring Mortgage Liquidity. The council, made up of 25 leaders in the real estate finance industry, came together to work to provide a framework for renewing the secondary mortgage market, with an initial focus on the GSEs. The council is chaired by Michael Berman, CMB, president and chief executive officer of Needham, Massachusetts-based CWCapital and MBA vice chairman.

"The council's mission is to look beyond the current crisis to what a functioning market should look like for the long term," Berman wrote in a joint statement with John Courson, president and chief executive officer of MBA. The letter accompanied a white paper titled Key Considerations for the Future of the Secondary Mortgage Market and Government-Sponsored Enterprises, which was published in January 2009 to reflect ideas put forth at a Nov. 19, 2008, council event titled Ensuring Mortgage Liquidity: A Summit on the Future of the Secondary Mortgage Market and GSEs.

The summit's panel of economists, market experts and former regulators "did focus on the question of what went wrong, using that as a whiteboard to try to determine from what went wrong, what we need to do to fix the system," says Berman.

At this point, the blackboard for the future schematic outlining how the mortgage finance market will look is blank. People are in the early thinking stages and imagining what would work best - and how we get there from here.

The future of mortgage securitization, in the end, is likely to be strikingly different from the world that existed prior to August 2007 for the private-label market and September 2008 for the GSEs.

We may get a glimpse at just how receptive investors will be to new securitizations by watching the response to the $200 billion consumer-lending program known as the Term Asset-Backed Securities Loan Facility (TALF). In March, under the TALF program, the Federal Reserve Bank of New York began lending to owners of certain triple-A-rated asset-backed securities (ABS) backed by newly and recently originated auto loans, credit-card loans, student loans and Small Business Administrationguaranteed loans. The Fed's support for the securitization of these consumer loans is expected to create new lending capacity for future loans.

The launch of TALF was preceded by the Feb. 10 announcement by the Federal Reserve and Treasury of plans to expand TALF to $1 trillion to support the securitization to include other asset classes. The Fed and Treasury indicated they expect the April funding to support ABS backed by rental equipment, commercial and government vehicle equipment, and agricultural equipment loans and leases. The Fed and Treasury have also been analyzing the appropriate terms and conditions for accepting commercial mortgage-backed securities (CMBS).

Bring them to market

It's been hard to keep track of the many trillions of dollars in loans, guarantees and other efforts to stabilize the banks and the entire financial system. Yet, the Herculean efforts of the federal government to get banks to lend and credit to flow again continue to run aground of the so-called toxic mortgage securities and derivatives that banks still hold on their balance sheets - many of which are actually performing assets and "toxic" in name only.

Some observers believe that the securitization market, like bank lending, is not going to revive and prosper until banks and other institutions and firms that hold those assets can dispose of them at true market prices. That's the view, for example, of Robert Albertson, principal and chief strategist at Sandler O'Neill & Partners LP, New York.

Albertson believes a lot of financial pipes would come unclogged and a lot of investors would again be willing to buy mortgage securities and derivatives if the markets could place a market value on existing securities and derivatives that is more realistic than the distressed fire-sale prices that have occurred.

"It's simple, really," says Albertson. "All you have to do is capitalize a trading organization and start bringing assets to market."

Albertson contends that many good triple-A mortgage-backed assets, now going for 50 cents on the dollar in forced sales, "could get good prices" in a properly functioning bid/ask market. The startup costs would be low, as the effort starts out small and grows, Albertson contends.

The government could, for example, fund a Wall Street firm to the tune of $50 million or $100 million to get the market off the ground. It would, however, require government initiative - and so far the federal government has not been able to figure out how to sell the toxic assets without further creating systemic risks, leading to more markdowns at firms still holding the assets. Albertson is skeptical. "100 to 1, they'll never do it," he says. "The government has no conscious clue on how the private sector works," he says. Part of the problem is that few people in government have experience on Wall Street, so they cannot imagine how the process might actually work, he says.

How would it work? With a functioning market mechanism, the troubled securities are "really being transparently priced to the private sector through bid and ask," Albertson says. "The bank is saying, 'Here's my ask.' The buyer is saying, 'Here's my bid.' Eventually you get closure and price discovery," he says.

While recognizing that the TALF program eventually could help provide financing to buyers of the assets - as it is doing with ABS - the government role should remain limited to getting the market off the ground, he says.

"At some point it's self-defeating to have government funding. It has to run on its own. You have to take the training wheels off," Albertson says.

The call for transparency

The American Securitization Forum (ASF), New York, has been exploring ways since last year through its Project Restart to inject a massive new dose of transparency into the securitization market in an effort to help restore the investor trust and confidence needed to revive the private-label residential mortgage-backed securities (RMBS) market. The ASF advocates for the securitization industry's interests and is a forum sponsored by the Securities Industry and Financial Markets Association (SIFMA), New York. ASF's membership includes securities issuers, investors, financial intermediaries, rating agencies, legal and accounting firms, trustees, servicers, guarantors and other market participants.

Tom Deutsch, deputy director of ASF and a securities attorney, sees Project Restart as "a necessary but insufficient mechanism" to restart the secondary market.

"Two big issues need to be addressed from an economic standpoint prior to the effectiveness of Project Restart getting the secondary market going," he explains. One is the stabilization of home prices and the other is absorbing the excess supply of mortgage securities dumped on the market by overleveraged mortgage securities investors who have fled the market.

First, Deutsch does not see home prices stabilizing any time soon. "While they continue to decline - and to decline in some areas precipitously - that creates a lot of disincentive to lend money," he says. "Now we're seeing nationwide practically everybody has to put 20 percent down" to get a mortgage, he says, while "mortgage insurance is very difficult to obtain, even for the most creditworthy borrowers."

Banks are reluctant to lend, Deutsch says, because a 20 percent down payment today could dissipate within a year or two as house prices continue to fall.

Deutsch sees further sharp house price declines of 20 percent or more. In some markets it could be worse. "I live in New York. I fully expect Manhattan home prices to drop anywhere from 25 percent to 45 percent over the next few years," he says.

"That's a huge amount of money that's at risk for banks if they are to lend," he adds. It means an 80 percent loan-to-value (LTV) mortgage today could be a 100 percent LTV or 130 percent LTV mortgage in two years. "Those are dangerous lending conditions and high-risk lending conditions," he adds. Without the GSE guarantees, "you obviously wouldn't see conforming loans being originated anywhere near the levels they are being originated now," Albertson adds.

On the second precondition for reviving the secondary market, the market still needs to absorb "massive amounts of RMBS and consumer ABS originations from 2005 and 2006," Albertson says.

One of the chief reasons that these assets cannot be absorbed is that 70 percent of buyers of RMBS and ABS have left the market and are no longer buyers of securitized assets.
"Virtually all of those leveraged investment vehicles are now dissipated, whether they are SIVs [structured investment vehicles], collateralized debt obligation [CDO] collateral managers or hedge funds that are working off leverage," Deutsch explains. "Very few, if any, are still in the market to be able to hold those asset-backed and mortgage-backed securities."

The departure of most of those market players has led to a "massive disequilibrium between supply relative to demand, which ultimately leads to artificially low prices on these bonds." says Deutsch. And, he further notes, "If you have artificially low [prices for] outstanding bonds, it makes new issuance of new bonds impossible."

Mortgage lenders that operate under the private securitization model for originating new loans would have to sell them into the secondary market for a loss. "And generally, institutions are not in the business of losing money," Albertson says.

Even if and when the two big problems of excess housing supply and excess RMBS (and ABS) supply are resolved, it still does not mean that the private-label RMBS market could be restarted, according to Deutsch.

"Institutional investors have learned a great deal from the significant losses they have taken, particularly in subprime and alt-A MBS," says Deutsch. "There's been a lot of talk about skin in the game - institutional investors are the ones who really have skin in the game," he says. "So, they ultimately have to have confidence in buying securities to move forward into a new market."

The best way to restore trust, he says, is to dramatically improve transparency both on new issues and on current issues, and to set up a process whereby there can be continuous reporting that updates the status of loans backed by securities. In that way, transparency is maintained about changing underlying conditions, such as loan performance.

During the housing boom, many investors increased their purchase of subprime and alt-A RMBS without learning a lot about the characteristics of the underlying loans. "Many investors were caught up in the euphoria at the time, and investors either ignored data or failed to match data
from one originator to the next," Deutsch says.

Project Restart seeks to address the discrepancies between one originator and another by establishing precise rules to describe key terms and data in a mortgage at the time of origination. Deutsch gives an example: "In 2006, the definition of full documentation for New Century [Financial Corporation] may have been very different from [the definition used by] a higher-quality lender like Wells Fargo [Home Mortgage]."

Project Restart's proposed RMBS disclosure package does not require that loans be full-documentation, for example, but they do require a precise definition of documentation. There are five levels of borrower income-verification documentation in one of the data fields for the initial reporting package in the Feb. 9 revision of the RMBS disclosure package, which was first launched in July 2008. The Feb. 9 version reflects comments and suggestions from the securitization community that reviewed the earlier proposed disclosure standards.

MBA's Courson responded to the original RMBS disclosure package in a letter to Deutsch last August. "MBA agrees that using the draft plan to collect and report loan-level information will enhance transparency in the residential MBS market," Courson wrote. "However, MBA is concerned that the informational utility of certain elements of the draft plan may be overshadowed by the varied challenges of implementation."

Courson recommended that in some instances, "ASF reassess whether a modified approach would provide a comparable level of investor confidence, but in a manner that is less costly/burdensome."

In one example of how this might be done, Courson wrote about the underwriter-discretion field in the proposed disclosure package. "Any meaningful analysis using the underwriter-discretion field would not be possible because of the variations in underwriting criteria and exception thresholds in the industry," he stated in his letter to ASF.

"MBA requests ASF also consider whether collecting information on underwriting discretion may have a negative impact on the availability of affordable financing options," Courson wrote. "For example, if lenders adopt a 'no-discretion' policy because of the new data field, borrowers at the margin of qualifying would not be able to augment their background information, which would result in their being denied credit," he added.

The American Securitization Forum, in response to comments, has deleted underwriting as a data field. "Ultimately what we've decided is that it's very difficult to provide underwriting data in the disclosure package," says Deutsch. "Although we moved it out of [RMBS] disclosure, it will reappear in some other form," he adds.

Project Restart also has a proposed RMBS reporting package that can track material changes in the characteristics of a borrower, as well as loan performance. The ASF proposal comes with due-diligence standards to make sure the data are accurate and the data will also be reported to the Securities and Exchange Commission (SEC). By making standards for terms and data specific, the proposed RMBS disclosure package seeks to avoid the problems that created the market crash.

"In 2006, there wasn't a standard here. People could claim differing things [when using the same term, such as "full documentation"]. Ultimately, that creates a race to the bottom [in underwriting standards]," maintains Deutsch. The proposed disclosure standards of Project Restart change incentives for the better for lenders and securitizers, he contends.

By the end of April, the ASF is expected to approve a final version of the disclosure package and "hopefully" the reporting package, Deutsch says. By May, Wall Street issuers will know what they have to produce in terms of data and information, he says.

MBA President Courson sent further comments to ASF in a March 24 letter, commending ASF's efforts to "address systemic capital markets confidence issues." However, the letter stated that MBA objects to "the unilateral and exclusive way in which ASF has gone about developing proposed industry standards and communicated its intent to impose those standards on the mortgage industry."

Courson urged ASF to ensure there is sufficient representative samples of originators, servicers and other market participants taking part in all phases of Project Restart, including representations and warranties, repurchase procedures, due diligence, model servicing provisions, standard review committees and global coordination committees. He said that MBA "recommends that ASF actively solicit the feedback and involvement of industry segments that have not expressed their views," and offered help in facilitating input and interaction "from all segments of the housing finance system."

ASF expects to offer due-diligence procedures and representations and warranties for public comment sometime during the second quarter of 2009.

Meanwhile, the federal government and the Federal Reserve- through the Troubled Asset Relief Program (TARP) or TALF, or some other program - could be potential buyers of RMBS. Even Fannie Mae and Freddie Mac could be potential buyers of the new RMBS if and when they come to market.

"It's certainly a possibility," says FHFA's Lockhart. "It would depend very much on the framework that was done," he says, referring to the proposed disclosure standards from Project Restart. In the end, however, Lockhart thinks it is important for the private sector to step up to the plate and restart the private-label RMBS market. "If it's really going to be revived, it has to be done with private investors," he says.

Are there GSEs in the future?

Can we imagine the future without a government role? Without GSEs? Given the 60-year-plus history of government involvement in mortgage finance, it seems unlikely the future will not have an important role for the federal government.

Yet, there are voices for no government or GSE role.

"It's my view that although you may have needed Fannie and Freddie 20 or 30 years ago for prime mortgage securitization, you wouldn't need them today outside the panic," says Alex J. Pollock, resident fellow at the American Enterprise Institute, Washington, D.C.

"Most countries - many countries - have mortgage finance systems without GSEs," he says. "It would be good to look forward to a market where prime mortgages are securitized without GSEs," he says.

Pollock thinks the private-securitization market can function properly and meet the demand for housing finance if the system is properly set up. First, he would have the originator of the mortgage always retain a significant share of credit risk for the life of the mortgage, even - and perhaps especially - when it is placed into a pool for securitization.

Pollock points to the Mortgage Partnership Finance® (MPF) program as an example of having the originator keep a significant exposure to the loan. Under the MPF Program, which has been adopted by the Federal Home Loan Bank of Chicago and the Federal Home Loan Bank of Topeka (Kansas), among others, mortgage lenders continue to manage all aspects of their customer relationships rather than selling them to a secondary market agency.

Currently, however, these programs are facing funding challenges because the bonds that fund the mortgages do not have explicit government guarantees, notes Pollock so "it's hard to get long-term funding," he says. Nevertheless, the concept behind this program could be tied to securitization and could work, Pollock contends.

If there are GSEs in the future, then anyone in the mortgage business with significant credit risk as an owner of mortgages "should be practicing the old-fashioned banking idea of building up loan-loss reserves in good times," Pollock says. Unfortunately, during the recent boom, "no one was doing that," he says.

Indeed, the SEC "was going in the opposite direction in not wanting to let people do it," he says. The SEC considered the loan-loss reserves in good times as a technique to manage earnings. "It's not earnings management, it's reality - because bad loans are made in good times," says Pollock. "By the time you know they're bad, it's too late," he says.

A framework for the long term

The efforts of MBA's Council on Ensuring Mortgage Liquidity give some guidance on how a framework for the GSEs might be restructured in the future. For starters, the white paper released by the council in January, as noted earlier, provides useful information to advance the discussion about the future of the secondary market. The paper spells out key considerations for restoring the secondary market, from risk assessment to ensuring capital adequacy to controlling fraud. The white paper also provides descriptions of the characteristics of nine secondary market finance models that policy makers will want to consider as they construct a mortgage finance system for the future - from a fully privatized model to a system of covered bonds, the open-charter model, the improved current GSE model, the utility model and an
FHA/Ginnie Mae-type model.

The summit, white paper and ongoing efforts of the council are aimed at fulfilling two missions, according to Berman. "The first mission is to help create a baseline of knowledge among the folks on the Hill," he says. "So it was important that MBA take the leadership role ... so that when we start to discuss issues, there will be a common jargon and common understanding of what the issues are," he says.

The idea was to address the fact that there are many in the administration and in Congress who do not have a background in mortgage securities and the secondary market arena, he explains. "So, creating the building blocks, the underlying foundation, if you will, that the debate can then be articulated [from] was our first step," he adds. The feedback from the white paper's outreach efforts to educate people on Capitol Hill and within the Obama administration has been "very, very positive," Berman says.

"The second goal is then to help actually shape the debate and create our advocacy position with respect to secondary market and to, obviously, promote and ensure liquidity and address the future of the GSEs, Fannie Mae and Freddie Mac," Berman says. The first step was "to adopt a series of what we call guiding principles," he explains. Those principles were first approved by MBA's Commercial Real Estate/Multifamily Finance Board of Governors (COMBOG) and the Residential/Single-Family Board of Governors (RESBOG) and, finally, by MBA's board of directors.

MBA's guiding principles "will be the filters by which we will analyze and evaluate the various models of how secondary market liquidity can be established and how Fannie Mae and Freddie Mac should be reformulated in the future," Berman says.

While the text of MBA's guiding principles remains an internal document, Berman said he could "talk about some of the concepts we articulated that are key to understanding the positions."

It was important to the council and to MBA to spell out that the goal was to establish a secondary market driven by private investment, Berman says. "Much of our focus addressed the issue of how do we get the private investors back into the secondary market" for the long term without disturbing the "very, very fragile" secondary market that is operating today, he says. While MBA recognized that "there are primary market corrections that need to take place," Berman says, that was not the focus of the council's efforts.

The council identified transparency as the key to "reigniting investor demand." Transparency, he explains, is needed at all levels - from loan-level information to bond-structuring information, to risk assessments by the rating agencies and bond underwriters.

Transparency is needed not only at the time of origination of the loan and issuance of the mortgage-backed securities, but there also needs to be a flow of information throughout the life of the securitized instruments.

There should be an alignment of interests among issuers of securities and investors and various parties throughout the chain of secondary market participants, and they all should have some "skin in the game," says Berman. In addition, he adds, various participants in the chain need to be adequately capitalized.

Another goal for any future design for the secondary market is that it needs to attract not only the largest of sophisticated investors, but also "smaller institutional investors - not only within the U.S., but globally," says Berman. This means "an independent risk-assignment body needs to be re-established to bring in those second- and third-tier institutional investors, in terms of size, into the market to re-create a robust secondary market," Berman says.

In terms of regulation, the guiding principles include the idea that there should be a strong regulatory scheme and that various regulatory bodies need to be well coordinated. "Regulators also need to have sufficient resources and expertise to keep pace with an ever-changing secondary market and environment," Berman says.

The government should also provide a credit-guarantee program for the residential secondary
mortgage market, as well as a liquidity backstop in times of financial crisis. "As we have become fond of saying, we need to plan on a liquidity backstop for the 100-year flood, which seems to occur every eight to 10 years," Berman says.

The guiding principles also identify the need to address accounting issues- such as mark-to-market rules and true sale and consolidation rules - that some say have unduly intensified the financial meltdown. If those two accounting issues "are not properly addressed, we think those will be obstacles to ensuring liquidity in the secondary mortgage market," says Berman.

Another concept behind the guiding principles addresses one of the practices that got the GSEs into trouble - namely holding large portfolios of mortgage-backed securities. "We don't have a specific proposal at this point in time, but we do have a principle, if you will, that the GSEs or whatever GSE-like entity comes out of Capitol Hill should be focused on the securitization function," says Berman. "And while there would be limited purposes [for] maintaining a portfolio, that would not be the main focus or drivers of their activity."

Berman expects that issues of containing and addressing systemic risk will dominate the legislative agenda in the coming months, and that any proposals to address the mortgage market will surface after Congress deals with the broader systemic issues.

Expect change

One central lesson learned from the current turmoil is that the GSEs should not go back to being what they were, according to the Harvard Joint Center for Housing Studies' Retsinas. "I do not believe one of the options is turning the clock back and re-creating these entities in the form they were before, even though that form and structure added value over several decades," he says.

One option to consider is to have no GSEs at all, although probably few- if any - will make this suggestion, says Retsinas.

On the other hand, he believes the current crisis in housing finance demonstrates that "the government role as a backstop to a viable market is necessary and appropriate."

Indeed, the government is just about the only functioning player in the market currently.

What the government should not do is saddle future GSEs or government agencies with unrealistic mandates that work to destabilize them over time. For example, Retsinas believes the Department of Housing and Urban Development (HUD) made a fundamental mistake about a decade ago when it decided to classify the purchase of subprime mortgage-backed assets by the GSEs as counting toward their "goal credit" in reaching ever-higher affordable-lending goals as a share of overall business, he says.

Buying subprime was profitable at the time. Yet, the combination of unsound mandates and riskier markets proved financially harmful, leading to the accumulation of assets that, while temporarily making the GSEs look profitable, were, in the long term, setting them up for their demise.

Retsinas, like virtually everyone else, also points to greater transparency as key to the revival and long-term survival of mortgage finance. However, he points out, "In the current environment that we are in, transparency alone is not going to restore investor confidence in the mortgage market . . . and while it is necessary and appropriate and will help, I don't know that it is the magic wand."

The goal of reviving the secondary market, whether in the short term or long term, is now captive to the larger issue of systemic risk. "Systemic risk is paramount. It has to be addressed," says Retsinas.

"It's hard to imagine how you make any progress on any part of financial services unless you deal with the issue of systemic risk," he says. "As you look, for example, at the regulatory architecture for housing finance, it has to be a bridge to the larger issue of the regulation of the financial services industry."

The goal of reviving the secondary market, whether in the short term or long term, is now captive to the larger issue of systemic risk.

Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at

5538 words
1 April 2009
Mortgage Banking 26, Volume 69; Issue 7; ISSN: 07300212 English

© 2009 Mortgage Banking. Reprinted Here By Permission. All Rights Reserved.

Saturday, April 18, 2009

Are Bonds the New Stocks?

Q&A with Robert D. Arnott

This prominent financial analyst contends that the ‘cult of equities’ has obscured for many the importance of bonds, which can outperform equities for extended periods of time.

By Robert Stowe England

April 18, 2009

Highlights of Arnott’s Study and the Q&A Below

In an article published in the Journal of Indexes, Rob Arnott reports two key findings from his fresh review of the historical performance data comparing returns on stocks with yields on 20-year Treasuries over the very, very long term, from 1803 to February 2009. The article is titled “Bonds: Why Bother?” and is available on line at this link:

The first significant finding is that there are long periods during which bonds outperform stocks: namely, 1803-1871, 1929-1949 and the period from 1968 to February 2009.

The second notable finding is that while stocks still outperform bonds over the entire review period of 1803 to February 2009, the equity risk premium (see footnote 1) is only half of what people currently accept as the norm: namely, a 2.5 percent premium instead of a 5 percent premium. Indeed, Arnott says, “the much-vaunted 5 percent risk premium for stocks is at best unreliable and is probably little more than an urban legend of the finance community!”

Even so, the equity risk premium, even at 2.5 percent, is not shabby. As Arnott notes in the article, the return on stocks from 1803 to February 2009 would give an investor 4 million times his original investment after 207 years. At the same time an investment in bonds would have returned 27,000 times the original investment. But, the periods in which stocks underperform can be very costly. For example, from the peak in 2000 to year-end 2008, the equity investor lost nearly three-fourths of his wealth, relative to the investor who invested in long-term Treasuries. That could mean eating “cat food instead of caviar” for hapless investors entering their retirement years with 80 percent in stocks in 2007, Arnott quips.

Arnott’s findings suggest that investors should rethink a lot of assumptions about how they invest. Stocks should still be part of any portfolio, but investors need to be sure the price they pay for stocks is sufficiently low so that the dividend yield and the potential from gains in earnings and dividend growth is attractive.

While current stock prices make them generally attractive investments based on dividend yields and anticipated returns, comparisons with bond yields today is complicated by the wide divergence of bond yields. They range from the very low yields of U.S. Treasuries on one hand, and the high yields of investment-grade corporate bonds, convertible bonds and high-yield bonds on the other.

Indeed, while the stock of a given company may be attractive, the yield on the same company’s corporate bonds could be even more attractive, Arnott points out. Further, investors need to differentiate across broad classes. Within the stock market, the deep value stocks are more attractive than growth stocks even though the deep value stocks have risen 25 percent from their lows.

Arnott, born in 1954, is the chairman of Research Affiliates, LLC, of Pasadena, California and served as editor of the CFA Institute’s Financial Analysts Journal from 2002 to 2006. His writing and editing has focused on articles about quantitative investing. He has authored over 100 peer-reviewed articles for financial publications, including Financial Analysts Journal, the Journal of Portfolio Management and the Harvard Business Review. Arnott is on the product advisory board of the Chicago Mercantile Exchange and the Chicago Board of Options Exchange. He was previously chairman of First Quadrant, LP; a global equity strategist at Salomon (now part of Citigroup); and president of TSA Capital Management (now TSA/Analytic). He has also served as Visiting Professor of Finance at the University of California at Los Angeles. He graduated from the University of California at Santa Barbara in 1977. Mr. England caught up with Mr. Arnott at his Pasadena office early Friday afternoon, April 17, 2009.

The Interview

ENGLAND: I first read about your forthcoming article in Barron’s a few weeks ago. I was fascinated by what was reported. Then Jane Bryant Quinn mentioned it in a column in the Washington Post just about a week ago. So, kudos to you for generating some excitement about the article ahead of its publication date.

ARNOTT: Thank you.

ENGLAND: Can you explain this high level of interest?

ARNOTT: Well, it plows some interesting territory, that’s for sure, so it’s been an exciting project.

ENGLAND: There are two thoughts in this paper that seem to me to be new. One is that bonds outperform stocks for significant periods of time. The other is that the equity premium is only 2 ½ percent instead of 5 percent.

ARNOTT: Correct. That’s exactly right. Basically the thing I have issue with is the widely-held view that stocks should always be our core investment regardless of what you should pay for them. That’s the whole stocks-for-the-long-run thesis. I don’t take issue with the notion that stocks have a risk premium. And I certainly don’t want people to infer from the article that because stocks lost to bonds over 40 years ended February that they are going to lose over the next 40 years. Far from it. But, it’s a sobering reminder if you don’t pay attention to what you pay when you first get in, stocks-for-the-long-run might be [something for] your great grand-kids, not something that you can enjoy. Ultimately the main purpose of the article is to draw people’s attention to the fact that price matters, that stocks are not automatically the best place to invest; that [instead] they’re the best place to invest when they are sensibly priced.

ENGLAND. This flies in the face of what people have been saying for so long. It’s so hard for investors to digest that immediately.

ARNOTT: I think that’s right. And the reason that it’s so hard for people to swallow the idea is that it has been drummed into their heads again and again and again that if you are patient, the stocks will win. And that is simply not always true.

ENGLAND: So, what does this say about some other investment strategies, such as constantly buying stocks a bit at a time because you never know how to time the market? How should you invest? Should you look for a benchmark, like price to equity? How do you know when to buy a stock?

ARNOTT: I think people need to pay attention to yield. I think they need to compare yield on stocks to yields available on bonds. If the yields available on stocks are materially below the yields on bonds, they need to ask hard questions about how plausible it is that earnings and dividend growth can make up the difference. For instance today [April 17], if you look at the stock market yielding three and long bonds yielding three and a half, well what kind of growth do you need to beat the bonds? You need a half of a percent growth. How plausible is that? It’s more than plausible. It’s pretty easy. But, if you compare stocks with their own bonds. Investment-grade [corporate] bonds yield about seven and so [the equities] have to have four percent growth to beat their own bonds.

ENGLAND: Four percent being the difference between the yield on stocks and the company’s own corporate bonds.

ARNOTT: Yes, because that’s the yield difference. What does history tell us about that? Well, if you go back over the last century, average earnings and dividend growth has been four and a half percent. That’s not much of a premium to reward you for risk-bearing. So, I think right now, stocks are utterly compelling relative to Treasuries. They weren’t 40 years ago. That’s why bonds won for the next 40 years [with a higher return over stocks from 1968 to February 2009.] And stocks are not so compelling relative to their own corporate bonds.

ENGLAND: This means you will be throwing a lot of other conventional wisdom out the door.

ARNOTT: Exactly.

ENGLAND: For example, people believe today that individuals should be determining their asset allocation based on age. As they approach retirement, they are supposed to transfer more and more wealth from stocks to bonds. Your findings would do what to the age-related investment theories?

ARNOTT: It would rejigger them. Certainly one should have more preference for stocks when they are young and have that long horizon ahead of them and more preference for bonds when they are old and can’t bear the downside risk. I feel really horrible about retirees who might have been duped into putting 80 percent of their money in stocks two years ago. And now have to have cat food instead of caviar.

I think it’s still true that the longer your [time] horizon the more risk tolerant you should be. This does change that picture a little bit, in that risk tolerance doesn’t necessarily mean willingness to buy regardless of price. I think those who bought stocks in preference to long Treasuries at the top of the [high-tech] bubble in the year 2000 will not live long enough to see their stocks ahead of those bonds. And I know that’s a pretty powerful statement. They’ve already lost 75 percent of their wealth relative to those who put it in bonds.

ENGLAND: You could make an even stronger statement in that regard if they had put their money into high tech stocks instead of the broad stock market.

ARNOTT: Oh, absolutely. Absolutely.

ENGLAND: A person could invest in stock at any point if they thought the return was worth it and it is priced right.

ARNOTT: Exactly. The article was misconstrued by some that people shouldn’t like stocks. That’s not the point at all. The point is that stocks are great if you buy them when they are cheap and they are terrible if you buy them when they are expensive. Right now you have the bizarre situation where bonds are both the most overpriced and the most underpriced assets, depending on which part of the bond market you’re looking at. High yield bonds are priced for Armageddon. So, if you think Armageddon isn’t coming, high yield is a bargain. At the other end of the spectrum, Treasuries are priced at extraordinarily low yields. So, unless you think there’s no risk of inflation in the years ahead, Treasuries are a terrible investment.

ENGLAND: So, an investor who wants to be in bonds is facing a strange dichotomy. Could both stocks and bonds be right as a good investment?

ARNOTT: Oh, absolutely. You could find that 10 years ahead that your best performing major asset class is high-yield bonds and your worst performing is Treasury bonds and stocks are somewhere in the middle.

ENGLAND: Unlike some comparisons of data, you look back beyond the Depression back to 1803. Why is that people have been looking only at the period since the Great Depression to compare stocks to bond and to come up with a 5 percent equity premium?

ARNOTT: Roger Ibbotson and Rex Sinquefield did an enormous project in the 1970s, assembling long-term numbers back to 1926 (see footnote 2). That has been the Bible of the investment community for gauging long-term investment expectations ever since. And, of course they’ve updated their data ever since on a regular basis. Now, the problem is most folks have generally been too lazy to explore other data. Bob Shiller (see footnote 3) went and gathered the data from the Cowles Commission (see footnote 4), the 1930s commission that looked at long-term returns, back to 1872, attached that data to the Ibbotson data, and wound up giving us a 130-year history. That was wonderful. Then Bill Schwert (see footnote 5) at the University of Rochester dug deep into old data from the 1800s.

So, people used the data that is easiest for them to get hold of. And, for a long time the data that was easy to get hold of was 1926 to date. The data that is easy to get hold of is also U.S. [data.] Remember World War I and World War II were for the most part not fought on U.S. soil.

The U.S. has what is statistically referred to as survivorship bias. It did not have the experience of German, Italian and Japanese stock and bond market devastation in World Wars I and II. It didn’t have the nationalization of all capital markets that occurred in Russia and China and Argentina and Egypt in the last century.

In the U.S., we've had the benign experience of seeing how markets perform during a period of political stability for our country. And people use that data as if these markets are entirely normal. To some extent they are normal. Political stability has been, and remains the norm in the U.S. and probably will remain the norm. We shouldn’t ignore the fact that our data has survivorship data and that it covers a very benign span in which yields were generally falling, boosting stock market returns over the course of many decades and boosting the perceived advantage of holding stocks.

ENGLAND: So you have the bias in the modern period, but what did the 19th century U.S. data bring to the picture and why was the period from 1803 to 1871, when bonds outperformed stocks for 69 years, so different?

ARNOTT: That was an environment in which equities were largely unregulated and whoever held the majority stake in the stock could scoop the primary benefits. Dividends were paid out just sufficient to keep the minority shareholders content, but leading to returns that were not competitive with bonds. An interesting result in the early 1800s is that U.S. went through a difficult period of time from the War of 1812, several depressions and then to the Civil War. Ultimately wars are usually the result not of religion or ideology but of economics. The economic depression we went through in the 1840s and 1850s sowed the seeds for the Civil War and savaged the equity investor. Note also that our data does not include CSA [Confederate States of America] assets, which went to zero.

ENGLAND. The bonds you were using for comparison in the early 19th century was still the 20-year Treasuries?

ARNOTT: You know the bond data back in the 1800s was terribly scattered. There was even a period of time during the Andrew Jackson (see footnote 6) Administration when there were no government bonds when the U.S. national debt was zero. That’s something people overlook when we are accustomed to seeing multi-trillion-dollar national debt. But we had no national debt during the latter part of [Andrew Jackson’s] Administration. So, what we used was historical yields for long-government bonds, when they were available, and railroad and canal bonds, which were generally considered the ultimate blue chip bonds, when there were no Treasuries. And we converted those yields into the equivalent of a 20-year bond and a total return history as if there were 20-year bonds available at the time.

ENGLAND: And this was something you did?

ARNOTT: Yes. So, I would say that the data before 1871 has to be taken with something of a grain of salt. It is not terribly reliable data, but it wouldn’t be more than a percent or two per year off from what would have been achieved if you actually had the historical data base on the bonds that we’re looking at.

ENGLAND: And I guess you relied on the work of the people you mentioned who built up a record of the historical data.

ARNOTT: Exactly. Schwartz’s work has been vetted by lots of folks and is considered to be the definitive pre-1871 history for stocks and bonds. And it also mirrors the results that you see in the U.K. if you go back that far. In the U.K., after the Napoleonic wars, they had national debt totaling 250 percent of [gross domestic product]. They had a crippling debt burden. And, as a consequence of that, the economy struggled for decades to pay that down and the yields on government bonds were juicy.

ENGLAND: It was hard for stocks to beat that.

ARNOTT: Exactly. And so, back in the 1800s you had parallel experience in the U.K., which adds additional support to the legitimacy of these results.

ENGLAND: The other period that is interesting to me, at least, is 1968 to February 2009, which is . . . .

ARNOTT: 41 years of bonds beating stocks.

ENGLAND: Right. And during that time there was a huge variance in the comparative performance of stocks and bonds, but still at the end you were better off if you had been in bonds.

ARNOTT: Not only better off with bonds, but better off with plain vanilla long Treasuries, just about the dullest long-bonds you can imagine.

ENGLAND: For any body that is at any period in their lifetime of accumulating assets, this has to be something that should grab their attention.

ARNOTT: You’d think so; because we have had such an equity-centric view of the world that I think it’s fair to characterize it as a "cult of equities." People believed in stocks as a core investment without examining that belief at all.

ENGLAND: Just about every thing we do is built on that assumption.

ARNOTT: Right. And it’s just an assumption. It’s almost a religious view: Stocks are good. Stocks are powerful. Stocks are right. If you roll back the clock to the peak of the bubble in 2000, stocks were yielding one percent and inflation-linked government bonds were yielding four [percent]. Now, for stocks to beat those bonds, stocks would have had to have had earnings and dividend growth of at least 3 percent a year above inflation. There’s no historical support for that. The only time stocks have seen earnings and dividend growth faster than 3 percent real [growth] is coming off of deep Depression bottoms, not off the peak of a bubble. That’s why I say people who bought stocks in preference to bonds in the year 2000 probably won’t live long enough to see their stocks win.

ENGLAND: As I mentioned, this should complicate the decisions people make when they decide how to allocate or re-allocate their assets. As this point, what is the exercise they should do? Should they do as you suggest; that is, look at what the stock yield is compared to stock, just for a generic asset class decision?

ARNOTT: Yes, I think that’s right. The comparison I like to make on the Treasury side is with TIPS [which are Treasury Inflation-Protected Securities](see footnote 7) where the coupon rate grows with inflation. So, if stocks yield more than TIPS, that will typically mean that stocks are more attractive than Treasuries because earnings and dividends tend to grow with inflation plus one to two percent.

ENGLAND: Stocks should be compared to 20-year TIPS?

ARNOTT: Yes, I’d say so. So, 20-year TIPS right now yield 2.2 percent. Stocks yield 2.8 percent. That would mean that stocks are a little more attractive than Treasury bonds.

ENGLAND: You could proceed from there to make your investment decisions, even if you are just an index investor.

ARNOTT: Yes, except there is an added complication in that bonds themselves are less of a monolithic asset class than they have ever been historically, because the yield spreads are wider than they’ve ever been in history. Convertible spreads and high-yield spreads never reached these levels, even in the Great Depression. Which, in turn, means that when you compare stocks with their own bonds, you have to ask the question: Will the company see earnings and dividend growth fast enough to make up the difference? There the picture is much more ambiguous and in many cases I think the answer will be no.

I’ve heard the expression ‘bonds are the new stocks’ and in a very real sense they are because bonds, especially on the high-yield side are bets on the survival of the company, as are stocks – and give you the reward for that survival in form of yield instead of in the form of capital appreciation. The yields are double digit. Well, that gets to be pretty interesting.

ENGLAND: It’s hard to argue with double digit yields.

ARNOTT: Unless you’re expecting massive defaults every year for the coming six or eight years.

ENGLAND: Which could also possibly be a worry for some companies, while not necessarily on a massive scale?


ENGLAND: For the average investors, this means picking the right bond fund rather than trying to pick a specific corporate, convertible or high-yield bond.

ARNOTT: Right. From that perspective, I rather like investment grade corporate bond funds, convertible bond funds, and high-yield bonds more than I like broad stock market portfolios. One exception I would make is that the deep value end of the stock market is cheap.

ENGLAND. The deep value end is attracting a lot of attention, especially the financial stocks.

ARNOTT: Right, exactly. The deep value stocks were hammered beyond recognition and even though they have rebounded sharply in the last three weeks, I think they still represent the low hanging fruit within stocks. And I think growth stocks are darned expensive and very vulnerable. Health care is one example. The health care stocks have performed very nicely as if the nationalization of the U.S. health system isn’t going to affect their profitability.

ENGLAND: We don’t know what’s going to happen with health care and there is the risk of any number of outcomes.

ARNOTT: That’s exactly right.

ENGLAND: Thanks for taking time to talk about your article.

ARNOTT: You’re welcome. All the best.


Copyright 2009 by Robert Stowe England

1. In the article “Bonds: Why Bother?” Robert D. Arnott states that he uses the term “risk premium” in the article advisedly. The paper states the following in a footnote: The “risk premium” is the forward-looking difference in expected returns. Differences in observed, realized returns should more properly be called “excess return.” Many people in the finance community use “risk premium” for both purposes, which creates a serious risk of confusion. I use the term here, wrongly but deliberately, to draw attention to the fact that the much-vaunted 5 percent risk premium for stocks is at best unreliable and is probably little more than an urban legend in the finance community!
2. Roger G. Ibbotson and Rex A. Sinquefield, “Stocks, Bonds, Bills, and Inflation: Year-By-Year Historical Returns (1926-1974),” The Journal of Business 49, No. 1 (January 1976), pp. 11-47.
3. Robert J. Shiller, professor of economics, Yale University.
4. Alfred Cowles, Common Stock Indices, Principia Press, Bloomington, 1939.
5. G. William Schwert, professor of finance and statistics and the University of Rochester’s William E. Simon Graduate of Business Administration.
6. Andrew Jackson was the seventh President of the United States from 1829 to 1837. He is the only president in U. S. history to have paid off the national debt. However, this accomplishment was short lived. A severe depression from 1837 to 1844 caused a ten-fold increase in national debt within its first year.
7. Treasury Inflation-Protected Securities or TIPS provide investors protection against inflation. The principal of a TIPS increase or decreases with inflation or deflation, as measured by the Consumer Price Index. When the TIPS reaches maturity, the investor is paid the adjusted principal or original principle, whichever is greater. TIPS also pay interest two times a year at a fixed rate. Interest payments are paid against the adjusted principal so that interest payments rise with inflation and fall with deflation. You can find more information about TIPS from TreasuryDirect® at this link:

Copyright 2009© by Robert Stowe England

Wednesday, April 15, 2009

Geithner Plan 'Another Bailout'

Q&A with Allan H. Meltzer

This leading monetary policy scholar contends that the Geithner plan, like the bank rescue efforts of earlier Administrations, is part of a flawed and unsustainable approach where 'the bankers make the profits and the public, the taxpayers, take the losses.'

April 2, 2009

By Robert Stowe England

Allan H. Meltzer is professor of political economy at Carnegie Mellon University's Tepper School of Business in Pittsburgh, Pennsylvania. Born in 1928, he is widely viewed as one of the foremost experts on monetary policy. He served on the Council of Economic Advisors for both Presidents Kennedy and Reagan. Meltzer also served as chairman of the Shadow Open Market Committee from 1973 to 1999. The SOMC is a group of economists, analysts and bankers who meet periodically to discuss, evaluate and comment on the actions of the Federal Reserve's Federal Open Market Committee. For more than two decades, Meltzer has also been a visiting scholar at the American Enterprise Institute in Washington, D.C. He is the author of dozens of papers and books on the Federal Reserve, and is currently working on the second volume of his History of the Federal Reserve Bank, which covers the period from 1951 to the present day. Mr. England caught up with Dr. Meltzer at his office in Pittsburgh.

ENGLAND: What do you think of the Public-Private Investment Program (PPIP) recently announced by Treasury Secretary Timothy Geithner?

MELTZER: This is another bailout because most of the money is coming from the government and not the private sector. So, while it’s called a public-private partnership, the costs of the partnership are heavily skewed to the taxpayers.


MELTZER: So, let’s go to the fundamentals first. The system that we have had cannot survive for very much longer if the bankers make the profits and the public, the taxpayers, take the losses. That’s a system that the Obama Administration, and the [former Treasury Secretary Hank] Paulson [and the Bush] Administration and previous administrations have developed.

ENGLAND: What do you think should be done in the alternative?

MELTZER: I proposed [to them] months ago when the Paulson Treasury was still there that they have a system which says to banks that need financing: You raise half the capital in the marketplace and we’ll give you concessional loans for the other half. If you can’t raise the [first] half [of needed capital] in the capital markets, then you’re going to be subject to the law called FDICIA [the Federal Deposit Insurance Corporation Improvement Act of 1991], which means we can take you over, wipe out the management, take over the stockholders and sell the parts of the bank that are still viable. That’s what I think they should do. Where they can’t do that or think they can’t do that, then they should use the bankruptcy law as an incentive to raise the private capital.

ENGLAND: Now, FDICIA was the law that came out of the savings and loan crisis in the early 1990s?

MELTZER: Right. And why did that law come out? It’s very important to recognize why it came out. At a time when the Administration is saying what we need is a super regulator like the Fed, that law came out because the Fed would hold on to banks much too long by lending to them to keep them solvent or appearing solvent, and then dump the problems on the FDIC. Congress was alarmed at the fact that FDIC funds were running down, so they passed FDICIA to tell the banks they should have structured early recognition [by regulators of deteriorating conditions at a given financial depository institution].

ENGLAND: Taking over the banks brings up the question of nationalization. Somehow when that term is brought up, it tends to bring the debate to a halt because people get frightened of that idea. But, is it really nationalization?

MELTZER: No. Nationalization would mean that the government takes over the bank and owns it. My proposal is that they do what they did with, say . . . Continental Illinois [National Bank and Trust Company].

ENGLAND: From 1981?

MELTZER: I think 1984. Anyway they took it over, put in new management, took out the stockholders, and sold it to the Bank of America later.

ENGLAND: After it was in better shape, I guess they disposed of bad assets.

MELTZER: They sold them off and took the losses. The same thing [happened], by the way, with the savings and loans. We didn’t nationalize the savings and loans. We closed them down and sold off the bad assets.

ENGLAND: Since both of these examples show that this approach can work, why is it that policy makers today don’t look to that past success as something to emulate?

MELTZER: Because the Federal Reserve has always been captured by a combination of the New York banks and the Congress.

ENGLAND: The Geithner plan was probably originated in the New York Fed. At least that’s what people are saying.


ENGLAND: So, basically it appears that within the Fed the New York Fed has an inordinate influence.

MELTZER: The New York Fed has always had a big influence, not as big now as it did in the early days of the Fed, but still big. They are there and they know the people, all that stuff.

ENGLAND: They are on the ground, so to speak, with the too-big-to-fail institutions.

MELTZER: Right. And they have people in there every day looking at what they are doing.

ENGLAND: At these banks?

MELTZER: Yes. They have an army of people [from the Fed] at the banks.

ENGLAND: And now they would also have Fed people at such firms as Goldman Sachs.

MELTZER: Wherever they have lent money.

ENGLAND: Plus Goldman Sachs has become a bank holding company.

MELTZER: Right, the golden rule applied in this case is that he who has the gold, rules.

ENGLAND: And the Fed does not appear to be about to bite the bullet and move to shut down insolvent banks and dispose of their assets in a timely manner.

MELTZER: [They] never have. The reason we have such a crisis is that in March [2008] the Fed followed its usual predilection and it bailed out Bear Stearns. It had been doing this with very, very few exceptions for 40 years. Then, suddenly, without any prior announcement [in September 2008], it let Lehman [Brothers] fail. That scared the devil out of the people who had money involved. In writing up my version of this [for my history of the Federal Reserve], I say if I had been running a portfolio at that point, I would have rushed for cash, too. And that’s what they did. You didn’t know what was going to happen next. There was no warning that you were going to let Lehman fail. And it deviated from a policy they followed for 40 years. Now I don’t like the policy. And, I believe . . . that the best way to protect ourselves, that is the taxpayers, is to tell the banks if you’re too big to fail, you’re too big.

ENGLAND: That would mean they have to be broken up.

MELTZER: Or made to hold additional capital as the size increases. But, they don’t do that [at the Fed]. And then they suddenly did it. And then you had Secretary Paulson, who couldn’t make up his mind from morning to night what he was going to do.

ENGLAND: He was practically Hamlet.

MELTZER: Well, that did not inspire confidence in the midst of a crisis.

ENGLAND: Going back to PPIP, how do you think that will function or work, the way it is set up?

MELTZER: The subsidy is so great to the investors, it’s generally believed it will push the price of these mortgages up. That will help the sellers to unload them.

ENGLAND: Or even be willing to sell.

MELTZER: Yes, or even be willing to sell – because the problem you saw before was if you sold them in mass, the price would almost certainly go down, so that people who were not bankrupt would be bankrupt or insolvent. The [PPIP] proposal seems to have developed a way to prevent that from happening by giving a big enough subsidy so that the buyers will share the subsidy with the sellers.


MELTZER: The taxpayers, of course, will be at risk.

ENGLAND: Now, as one person I interviewed has said, PPIP looks like it was designed by the people who want to buy the assets. Do you think the potential investors – who have to have under management $10 billion in similar assets – are the same people who helped design PPIP?

MELTZER: Yes; that is, it appears to have been made as favorable as it possibly could be [towards potential investors] and to hide the way it has been made favorable, as governments often do, by talking about sharing the costs and public-private partnership and all that.

ENGLAND: And by calling them legacy assets instead of troubled assets.


ENGLAND: Do you think that the announcement today [April 2] from the Financial Accounting Standards Board (FASB) on mark-to-market accounting will affect the success of PPIP? The stock market has responded very well to the announcement and the Dow is above 8,000.

MELTZER: Well, sure, because it’s going to relieve pressures on the bank. Here’s the problem. Mark-to-market is a great idea if there is a market. Unfortunately there isn’t much of a market, so they use things like the ABX index to price these mortgages. The ABX index has very little to do with the value of the mortgages, and so [by relaying on the index to establish fair market value] we have generated losses. And because of Enron, the accounting firms are afraid to do anything about it.

ENGLAND: Right. Sure.

MELTZER: And you can’t blame them after what they did to . . . .

ENGLAND: Arthur Anderson. They were completely destroyed – talk about an incentive for accounting firms to be aggressive in marking down asset values.

MELTZER: I had this discussion with the honorable Lawrence Summers last summer and he said to me you’re supposed to be a market-oriented person. Why are you against mark-to-market? I said that I am not against mark-to-market when there is a market. When there isn’t a market, I don’t know what mark-to-market is. So, I want to use a substitute, which is discounted cash flow.

ENGLAND: I think that might be allowable under the new FASB interpretation.

MELTZER: [Summers] didn’t like that idea because he said, well, you can play games with choosing the discount rate. I think that’s a manageable problem. But anyway that’s where the discussion ended. So, I’m glad to see that they are going to do this. [And], despite all the warnings that people wouldn’t like it, you tell me the market is way up.

ENGLAND: Yes, it is. Not just financials, but the whole market is up. The Dow was up 8,000 earlier today [April 2].

MELTZER: That’s good.

ENGLAND: How would this affect the pricing of the assets under PPIP – or the willingness of the banks to sell if suddenly they don’t have to get rid of them?

MELTZER: Well, they don’t have to sell them all and they’ll undoubtedly want to diversify what they have and they should want to diversify what they have. They surely will want to reduce their risk.

ENGLAND: So, if they’re loaded up with a certain type of mortgage, they’ll get rid of some of that.

MELTZER: They’ll probably hold some and hope for the best.

ENGLAND: Some of the calculations on the rate of return for investors in the troubled assets range from 25 percent to over 40 percent, even taking into consideration that leverage will raise the price of the assets.

MELTZER: It’s because the government is putting up all the money.

ENGLAND: Do you know if anyone considered your idea of having the regulators tell banks to raise 50 percent in needed new capital and the government will guarantee a loan for the rest at favorable rates?

MELTZER: The only comment I got is from a Paulson Treasury, which is where I presented the idea, and the answer was the banks didn’t like that. It didn’t seem to me to be a very responsive answer. They may feel differently now that they’ve seen what the Congress has done [since then in proposals to limit bonuses and compensation]. But at the time they preferred to take the money from the government at concessional rates.

ENGLAND: Yes, now that we’ve seen the AIG lynch mob. . . .

MELTZER: Yes, it wasn’t as cheap as they thought it was.

ENGLAND: No. Does the fact that the mark-to-market rule has been changed before the implementation of PPIP ultimately reduce risks to the government and the taxpayer?

MELTZER: Yes. It means that if the banks actually use the new rule, and many of them will, then their losses will be smaller.

ENGLAND: I guess you saw the op-ed by Joseph Stiglitz in the New York Times yesterday [April 1] titled “Obama’s Ersatz Capitalism.”


ENGLAND: He has similar concerns to those expressed by you.

MELTZER: Yes, but he wants to make the banks fail; that is, force them into bankruptcy and have the government take them over. That’s not what I want. I want to force them to raise the capital privately. And if they can’t do that, then to declare them bankrupt or at least insolvent and then sell them off, not hold them.

ENGLAND: So, you think this can be done even with a very large institution without causing the kind of trouble we had when Lehman failed.

MELTZER: Yes. I think if you announced what you’re doing, there may be a market hit when you announce it because we would be giving up too big to fail, but we’ve got to give up too big to fail. There’s no long- term solution to these problems that doesn’t end up with less of too big to fail. We just can’t have a system, which we now have, in which the taxpayers take the losses and the bankers make the profits. Some politician is going to be smart enough to recognize that and campaign against it and it will be popular with the public. It just isn’t a good idea. That’s not the way the capitalist system is supposed to work.

ENGLAND: That’s sort of what Stiglitz was saying, but his proposal was a little bit harsher. Do you think your proposal can work and we wouldn’t have the terrible fallout we had with Lehman?

MELTZER: Correct. Provided you announce and prepare people for it. The problem with Lehman was not what they did, but the fact that they suddenly changed the policy they had followed for 40 years without making any prior warning.

ENGLAND: I see. Letting Lehman fail overnight could be the dumbest move ever, I think.

MELTZER: I think it ranks as one of the dumbest moves ever.

ENGLAND: What else needs to be done to address the current economic situation, especially the weak housing sector, which is still a cloud over the economy.

MELTZER: I proposed months ago [that Congress adopt] a plan that says that if you have unsold new houses, that the government, instead of doing all the finagling in the mortgage market, . . . . should tell buyers that if you make a down payment, we will give you a tax credit for the next year or two to clean up the stock of unsold houses. And several Congressmen called me about that and introduced it as part of the stimulus package.

ENGLAND: That’s the $8,000 tax credit.

MELTZER: And it stayed in the stimulus package until the very end at which time the Democrats in Congress in a caucus removed most of it. And the reason they removed most of it was because they were concerned that people might buy a second house because they were much more interested in redistribution than in solving the problem. If they had been interested in solving the problem, they wouldn’t care whether people bought a second or a third house. When they asked me about this I said I didn’t care if [former Presidential candidate, Senator] John McCain bought an eighth house.


MELTZER: The problem we want to solve is not to worry so much about whether we help people buy second houses but whether we get rid of the unsold stock of houses. That would do two very important things. One, it would lower the number of defaults in the future while the housing prices fall. And the second is, it would, of course, after awhile, stimulate [new housing] production. . . . You don’t have to know much about business recoveries to know that when recovery begins, it’s housing that leads the way. Well, that’s not going to happen this time, certainly not to the same degree. Now, I understand from [California Republican] Congressman [David] Dreier’s office that they either have or are about to re-introduce that – and that would be a good thing.

ENGLAND: I see all these real estate ads touting the $8,000 tax credit. Didn’t that make it into the stimulus bill?

MELTZER: Only for first time home buyers.

ENGLAND: So that part stayed in.

MELTZER: They don’t mind giving the subsidy; they just don’t want to give it to people who already own one house.


MELTZER: If you look at the stimulus package, it should be called the Redistribution Package. What they are concerned about is who gains. Goodness knows that taxpayers should not be the people who get a benefit from this!

ENGLAND: That seems to be the new ruling philosophy.


ENGLAND: So, Congressman Dreier might reintroduce the provision to cover anyone buying a house.

MELTZER: He’s going to put it back in. Yes. It’s slightly different now, from what I understand from his office, I believe they may have already offered it.

ENGLAND: Some states are also offering a credit – California, for example.

MELTZER: Yes, and they have a high enough [income] tax rate that it might help. But the federal [income] tax rate would do a lot. And, in my proposal I said that if you didn’t pay taxes you would get the benefit any way. We’d give you the cash.

ENGLAND: Did that survive?

MELTZER: I think it was in the bill Congressman Dreier and others offered.

ENGLAND: That’s redistributive, too, but it is not redistributive for the purpose of being redistributive, but because we’re trying to get rid of the excess supply of unsold houses.

MELTZER: Look, this crisis is not going to end until we clean up the housing stock and clean up the banking mess.

ENGLAND: I couldn’t agree more. Thank you for taking time to talk about these developments and issues.



i Allan Meltzer is correct. Continental Illinois was taken over in 1984.
ii The ABX Index is a series of credit-default swaps based on 20 bonds backed by subprime mortgages. A decline in the ABX Index reflects investors’ sentiment that subprime mortgage holders will face increased financial losses, while an increase represents the opposite. Credit quality assumptions are made in quarterly indexes: Second-quarter 2007 subprime RMBS are generally viewed to have better credit quality than those from first-quarter 2007. Historical trends can be found at the Web site for the ABX indexes (
iii Lawrence Henry "Larry" Summers, a noted economist, is currently the Director of the White House's National Economic Council for President Barack Obama. He is also the Charles W. Eliot University Professor at Harvard University's Kennedy School of Government. He was Secretary of the Treasury near the end of the second term of Clinton Administration.
iv FASB's new guidance on mark-to-market accounting allows banks to use "significant judgment" when placing a value on illiquid assets such as residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs). The new approach, which relaxes the standard, is allowed when there is "significant decline of a market for new issuances," or, in plain English, there is no longer a new market for the class of securities being evaluated. The change came in response to pressure from Congress, which held hearings on mark-to-market accounting March 12, where FASB Chairman.

Copyright 2009© by Robert Stowe England