Jul 232014

by Phillip Swagel, CFP Senior Fellow and Professor of International Economic Policy at the Maryland School of Public Policy

Read the full paper here:  Economic_Contributions_of_Fraternal_Benefit-Societies.pdf


Executive Summary

For more than one hundred years, lodge-based fraternal benefit societies have enriched the lives of millions of people across the United States while making immense contributions to the U.S. economy and society.   Since the mid-19th century, individuals have joined others with a common bond to establish a local lodge and pool resources to provide insurance protection to their membership.   Modern fraternal benefit societies have evolved into member-owned, not-for-profit mutual aid organizations structured under state and federal law that (1) have a fraternal purpose, (2) operate under a lodge system, and (3) insure members and their families against death, disease, disability.  The charitable and social activities of the more than nine million fraternal members organized in local lodges across the United States today are made possible by the resources generated through providing  insurance products to fraternal members, as required under Section 501(c)(8) of the Internal Revenue Code and various state laws.  These resources support a vast network of ready member-volunteers and ample opportunities to help others and give back to their communities.

This study measures these benefits to society from the charitable and voluntary activities of fraternal benefit societies using a rigorous economic framework originally developed in a September 2010 Georgetown University McDonough School of Business study authored by Phillip Swagel, currently a Professor at the University of Maryland School of Public Policy.  Dr. Swagel previously served at the White House Council of Economic Advisers in the administrations of presidents George W. Bush and Bill Clinton, and was a senior official at the U.S. Treasury Department under President George W. Bush from 2006 to 2009.

From 2007 to 2011, even during a severe recession, fraternal benefit societies produced more than $3.8 billion in benefits on average to the U.S. economy each year, for a total of nearly $19 billion over the five-year period.  In direct contributions alone, fraternal benefit societies together produced $2.4 billion in charitable and community assistance from 2007 to 2011, an average of $478.3 million per year.  Members of fraternal lodges also volunteered nearly 400 million hours of their time during the five-year period considered in this study, with a direct on average value of $1.6 billion in each year. 

In addition to direct economic contributions of time and money, this study demonstrates how fraternal benefit societies generate enormous indirect economic benefits by creating social capital, which encompasses the bonds between individuals that deepen reciprocity and trustworthiness within a community.  The creation of social capital generates quantifiable economic and societal benefits.  When members of fraternal benefit societies gather together to help others, volunteer to improve the lives of children and families, or carry out any of their myriad other activities, they bring communities together to deepen societal interconnections and generate social capital that benefits both individuals and communities as a whole.  The efforts of members of local fraternal lodges improve people’s lives today and into the future.

During the five years studied, fraternal benefit societies generated social capital valued at an average of $1.7 billion annually, or $8.6 billion total.  These enormous contributions vastly outweigh the estimated foregone $50 million annual cost of the federal tax exemption that makes the fraternal model possible, producing a 76-to-1 return on the public investment.  The support of the tax code gives rise to immense benefits to society, thanks to the efforts of the members of fraternal benefit societies.

Moreover, these benefits are above and beyond the positive impact fraternal insurance protection has on the individuals that purchase it.  In addition to providing financial security and a safety net for millions of fraternal members and their families, research shows that individuals with a sense of financial security are significantly more willing and able to participate in service activities and help others in their communities.  The fraternal model embodies this concept: fraternals help their members achieve financial security while the network of local lodges offers the opportunity for fraternal members to give back their time, talents and resources to help others in their local communities and beyond.

Without the current tax rules in place that govern fraternal benefit societies, the $19 billion in total benefits that this study finds that fraternals provide society over five years would be at risk.  These benefits are impossible to replicate by corporations or government agencies, because they arise out of the public-spirited acts of fraternal members coming together for the common good.  Indeed, changes to the tax code that put the fraternal system at risk would add great pressures to already stretched local, state and federal government budgets or leave more needs in communities unmet.   Considering the extraordinary return on the public investment in their model, fraternal benefit societies represent a tax policy solution with an enormously positive ratio of benefits to costs.


* This paper is an update to a previously published paper:


Jul 212014

Center for Financial Policy Senior Fellow, Dr. David Kass, recently published his notes from the annual Berkshire Hathaway meeting on his widely followed blog dedicated to the oracle of Omaha.  The meeting touches on a variety of topics from executive compensation to corporate governance.  The full text can be found here.

Here’s an excerpt on Berkshire’s views on the mortgage market:

Audience: Should the U.S. change the way it finances home purchases and is there a role for Berkshire?

Buffett: The 30 year fixed loan is good for home owners.  It kept costs down.  Government guaranteed part to keep cost down.  No private organization can do it.  It is an $11 trillion market.  Private industry cannot do it, rates would be higher.  How do you keep government in the picture without politics?  Fannie and Freddie did some dumb things on their own, but they were also prodded into doing dumb things by politicians.  I wrote an article when the savings and loans were falling apart.  I suggested the FDIC get the private sector into pricing and evaluating, with the government as the main insurer.  There might be a way that model works in terms of home mortgage insurance.  Berkshire likely would not be a player.  Others would be more optimistic in setting rates.  Private industry might price 5% and the government 95%, and maybe guaranteeing the privates if they went broke.  It is important to get the correct national policy.  It is being worked on.  It is unlikely that Berkshire would play any role.

Munger: When private industry was allowed to take over the system, we got the biggest thieves screwing it up.  As much as I hate government, I’m not trustful of private industry in this field.  The existing system is probably sound.  At the moment, Fannie and Freddie are being conservative and I think that is okay.  I’m not anxious to go back to the race to the bottom with investment banks creating phony securities.  Let them keep doing what they are doing.

Buffett:  The one thing that led Fannie and Freddie astray was serving two masters trying to deliver double digit earnings increases. It would have been fine if they just insured rather than buying portfolios and turning themselves into big hedge funds, and just borrowed cheap and lent long.

Munger:  I think it is a mistake to have private companies taking over the whole mortgage market.  There is no need to have private portfolios. I think that particular experiment in privatization was a total failure.  And we made a billion dollars out of it.  (Note:  Berkshire purchased a large stake in Freddie Mac in 1989 and sold it in 2000.)

Buffett:  I was not going to mention it.


Jul 172014

If booming asset prices go bust, the central bank’s credibility would be severely damaged.

by Phillip Swagel, Professor in International Economic Policy, Maryland School of Public Policy and Academic Fellow, Center for Financial Policy and Marc Sumerlin, Managing Partner at Evenflow Macro

This post was originally published as an Opinion in the July 17, 2014 edition of the Wall Street Journal which can be found here.

Federal Reserve Chair Janet Yellen in her testimony on Capitol Hill this week was candid, as she has been in the past, in telling lawmakers that the biggest economic risk she sees facing the country is the possible emergence of a new permanent class of unemployed workers.

To head off this possibility, the Fed is holding monetary policy accommodative longer than traditional monetary models would recommend. Opinions on the wisdom of this policy are split, but the Fed’s openness about its policy is heralded almost universally as a desirable development.

We are not so sure.

In today’s world the heads of the central bank determine what is immediately deemed common knowledge, and only investors with long time horizons (and a strong stomach) can resist their pronouncements. Ms. Yellen sees considerable labor-market slack, believes this will hold down inflation, and therefore pronounces that the Fed’s near-zero interest-rate policy will continue far into the future. The conventional wisdom is that low rates and low inflation are consistent with an environment in which asset prices rise, so that is what has happened.

This is now the third episode in the past 15 years in which asset-price growth has significantly outstripped income growth. From 1997 to 2000, the net worth of American households rose 40% while national income grew 20%, and in 2002-07, net worth grew 60% as national income grew 30%. Asset prices corrected after each of these rapid increases.

Janet Yellen, chairman of the U.S. Federal Reserve, from left, and Federal Reserve governors Daniel Tarullo, Sarah Bloom Raskin, Jeremy Stein, and Jerome Powell attend an open meeting of the Board of Governors of the Federal Reserve in Washington, D.C.., on Feb. 18, 2014. Bloomberg News

Over the past two years, net worth has grown more than 20% (a similar annual pace as the past two episodes) during a period when national income struggled to grow 6%—and interest rates are still near zero. When the Federal Reserve signals that monetary conditions will remain easy, behavior shifts and a self-fulfilling rise in asset prices is the result.

On Tuesday the Fed stated in its semiannual Monetary Policy Report that valuations were “substantially stretched” in some sectors like biotechnology and social media. Ultimately, however, asset prices should reflect expectations of future income, making them vulnerable to correction when they become too high relative to income.

A problem of having too much certainty on monetary policy is that once the market has come to accept the Fed’s views, changes in the story can be unnecessarily disruptive. Harvard economist Jeremy Stein, a former Fed governor and its leading thinker on financial stability before returning to teaching at the end of May, articulated in his final speech why the Fed’s change in rhetoric in the spring of 2013 was so disruptive.

Mr. Stein noted that a number of investors perceived that quantitative easing would essentially last forever, and they repositioned abruptly when then Fed Chairman Ben Bernanke suggested the program could be finished in a year’s time. The Fed is not responsible for investors who take losses, but the centrality of monetary policy to investment returns leads people to put too much weight on their predictions of Fed actions and too little on fundamental analysis of individual investments.

Mr. Stein warned that “the market is not a single person” and that there might be a similar event if the Fed alters its view on interest rates. This is the big risk for the market now. Ms. Yellen has successfully defined conventional wisdom as a future in which the Fed keeps overnight rates near zero even while inflation and employment approach their respective targets. Indeed, the success of the Fed’s communications in convincing investors that rates will remain low has contributed to low volatility across asset classes, encouraging yet higher valuations. If there is less slack than the Fed believes, monetary accommodation will reverse at a more rapid pace than markets expect.

Imagine a swimmer drifting easily with an ocean current who suddenly discovers he is a long way from shore. Asset prices could be in for a sharp correction. If the U.S. economy were to go through another asset bust cycle, the Fed’s credibility would be severely damaged, and its strategy on reducing unemployment would backfire.

Many monetary experts refer to the 2000 equity crash as a benign event. But the unemployment rate rose by 2½ percentage points after the decline, and the monetary policy response to that rise in unemployment contributed to the housing bubble and the 2008 financial crisis. The Fed will not achieve the stability that it seeks until financial stability concerns are given an equal weight when determining monetary policy.

 Mr. Sumerlin, former deputy director of the National Economic Council (2001-02), is managing partner of Evenflow Macro, where Mr. Swagel, former assistant secretary of Treasury for economic policy (2006-09), is an adviser.


Jul 162014

On July 10, 2014 the Center for Financial Policy and The Clearing House jointly hosted “The Financial Industry in a Post-Crisis World Symposium” in Washington, DC. Panelists from regulatory, academic, and business communities exchanged views on three topics of relevance to the financial industry landscape under the impact of post-crisis regulatory changes: regulation and the shadow banking system, risks in central clearing, and post-crisis changes in bank balance sheets.  Richard Berner, Director of the Office of Financial Research, delivered the keynote speech.


I. Regulation and the Shadow Banking System

Shadow banking, or financial intermediation without explicit government backstops, has declined but will likely increase in the post-crisis financial environment. Several trends support the growth of shadow banking: cyclical pressures on yield; structural changes in regulations, technology, and demographics; and developmental factors of emerging markets.

The demand for safe assets has driven yields steadily lower.  Some believe that average institutional hedge fund return expectations are inconsistent with unlevered global risk premium and alpha opportunities. This search for yield can lead funds to increase their leverage and total portfolio risk, or to engage in shadow bank activities. The potential profit gained from creating new safe assets via risk transformation may drive hedge funds to create products they cannot guarantee in a crisis. The issue for regulators is whether that risk is then being passed onto the government through backstops.

Structural changes after the financial crisis to Basel III capital and liquidity requirements make traditional banking more expensive, thus some forms of banking are moving to shadow banks. Technological advances have helped new business models emerge to perform traditional bank activities, such as peer-to-peer lending companies Prosper and Lending Club in the US, and Zopa in the UK. At the same time, the aging world population means more investors are searching for yield to help them save for retirement. This is especially a problem in emerging market countries, where shadow banks have proliferated to meet demand. Products like sweep accounts, which let investors lend in the money markets overnight, can end up financing mortgages or risky local government debt. Wealth management products, private finance companies, and real estate investment trusts (REITS) have all grown significantly in emerging markets, outside the traditional system of regulatory oversight and support.

The panel agreed that improved governance using both pre-emptive measures and backstops is needed to allow shadow banking to help finance economic growth.  Establishing the appropriate interaction between macroprudential policies (leverage and liquidity ratios), fiscal/monetary policy balance (interest rates and the supply of short-term government debt), and the role of the regulators is crucial to mitigate the risk of another crisis.


II. Identifying Risks in Central Clearing

The standardization and netting of obligations can improve the position of clearinghouse members, but central clearing also concentrates the risk of default within a single central counterparty (CCP). The panel discussed the potential evolution of the clearinghouse system, as the thrust of the regulation in the wake of the crisis has been on banks and their interconnectedness.  The possibility of moving to a single CCP for each product or perhaps even across all products has been floated as one solution.  In a bilateral world it is relatively easy for a bank to estimate their exposure to each of their counterparties across product lines.  A system of central clearers means at least one entity in the economy (the CCP) has a broad view of the whole market, which can allow them to spot market shifts or crowded trades that previously no one could individually perceive, but regulators would still have to aggregate the central clearers exposures.  It is also significantly more difficult to model and estimate whether a CCP is adequately capitalized versus a bank.  Individual banks would previously choose their counterparties and then dynamically hedge their exposure though credit default swaps.  In a CCP system, risk is managed through a default fund that isn’t dynamically calculated, leaving counterparty risk management fundamentally less responsive to market conditions.  Regulators continue to focus on the robustness of the CCP system, and to improve pricing and transparency.


III. Post-Crisis Changes in Bank Balance Sheets

Cash and cash equivalents have grown in a huge amount from Q2 2007 to Q2 2014, with more punitive requirements on supplementary leverage ratio. Regulatory changes such as Basel III risk-based capital ratio and the leverage ratios, along with other liquidity ratios are just a few of the changes prompting shifts in the bank’s business models.  Many of the regulatory ratios are deliberately set to discourage products that are (and were) perceived as risky investments.  Banks can no longer in a position to take directional or proprietary risk, which has hindered their ability to facilitate market transactions in some cases, but also caused their daily value-at-risk (VAR) to steadily decline. Traditional activities, such as mortgage servicing, have or are moving out of the banking sector and into nonbanking entities. Banks must adjust their business models in order to move closer to compliance.  As banks exit businesses or products with outsized operational risks, these activities will likely migrate to the shadow banking sector.  The traditional banking system is undoubtedly stronger since the 2008 crisis: banks have raised over $500bn in capital, Tier 1 capital ratios have tripled and overnight repo is down 40%. It’s not clear whether some of the post-crisis changes to the banking system, such as improved asset quality and declined risk-weighted asset density are due to regulatory changes, or simply due to banks’ learning from past mistakes and re-assessing risk. Meanwhile, from the bankers’ perspective, convergence among the globally systemic banks is more likely than divergence. All will likely continue to stockpile cash, minimize their use of overnight repo, exit non-core businesses and perhaps even discontinue business with select clients.


Keynote Remarks

Full Text

Office of Financial Research (OFR) Director Richard Berner commented on the ongoing work at the OFR to improve analysis, data, and policy tools for financial institutions. He noted that regulation of banks is pushing services to the shadow banking system, fueling capital arbitrage, which can ultimately transmit and amplify the effect of financial shocks. At the same time, tools for analyzing shadow banking are not as developed as for banks. Director Berner recommended the starting point for regulators should be to focus on the activities in which shadow banks engage. Significant data gaps in the shadow banking arena make it difficult to even quantify this activity. OFR is working to implement and expand a funding map across the financial industry, to help identify what the specific gaps are, as well as analyze the counterparties in shadow bank relationships to monitor and understand financial vulnerabilities wherever they arise.

To date, his Office has focused their shadow banking efforts on identifying risk in short-term wholesale funding markets, including repo and securities lending. OFR is seeking to fill major gaps in US repo data, particularly bilateral repo, as well as gaps in securities lending data and separate accounts holdings. At the same time, OFR is engaging its global counterparts to facilitate data sharing across countries, such as by leading the global Legal Entity Identifier initiative that helps standardize data collection across the financial system.

Director Berner also commented on the three main topics of the panel sessions. He noted that a CCP system doesn’t eliminate risk, and that significant creditor default risks as well as operational risks remain.  He highlighted how changes in bank business models simply mean more services will move to shadow banks. Leveraged lending, mortgage servicing, and market making were three specific activities leaving the banking system, so financial economists should pay attention to what institutions an activity is moving to and what that means for our ability to monitor risk. Director Berner closed his remarks by noting that positive economic conditions may mask risk, but OFR and its counterparts’ job is to identify those vulnerabilities, to be forward-looking while acknowledging we can’t be predictive.



The CFP thanks Robert H. Smith School of Business Finance students Julia Zhu (M.Fin) and Ben Munyan (Ph.D) for their significant contributions to this article.

Jun 262014

The CFP and the Clearing House will be jointly  hosting “The Financial Industry in a Post-Crisis World Symposium” on July 10, 2014 in Washington, DC.  This conference will bring together leading thinkers from the regulatory, academic, and business communities to discuss how the financial industry will be impacted by regulatory changes in the wake of the 2008-2009 crisis. The emphasis will be on the implications of the new financial landscape for market and economic stability.  Richard Berner, Director, of the Office of Financial Research will deliver the keynote speech.

Panel discussions among academics, regulators and practitioners will include:

  • Regulation and the Shadow Banking System
  • Identifying Risks in Central Clearing
  • Post-Crisis Changes in Bank Balance Sheets

Please click here for additional information and registration.  Registration closes July 7th.