Jul 212011

by Phillip L. Swagel

Academic Fellow, Center for Financial Policy

This post was originally featured in Bloomberg on July 18, 2011.

Here is one clear lesson from the economic meltdown of 2008: Any future U.S. administration will intervene directly and heavily if faced with a potentially devastating economic crisis. Market purists might not like it, but it is a fact I witnessed firsthand at the Treasury Department during the George W. Bush administration.

As a corollary, it is also true that the government will be compelled to step in if it becomes concerned that American families cannot obtain mortgages at reasonable interest rates. Indeed, it is inevitable that the government will also intervene if secondary mortgage markets — that is, the trade in securities and bonds made up of bundled mortgages — lock up.

The math is simple: Home mortgages represent $10 trillion out of $53 trillion in total U.S. credit market debt; remember that the Treasury and Federal Reserve felt compelled to stabilize money-market mutual funds in the fall of 2008 when they held just under $4 trillion.

Acknowledging these facts is central to solving a problem Congress is finally taking seriously: deciding the future of the government-sponsored enterprises at the center of the housing collapse, Fannie Mae and Freddie Mac.

Members of Congress, who began debating several bills to reform Fannie and Freddie last week, must start from this implicit promise of government intervention. Thus it makes little sense for Republicans to push for an ideal, purely market-based system. That head-in-the-sand approach will only help those like Representative George Miller, Democrat of California, who call for increasing government involvement.

Instead of holding out for an unattainable goal, conservatives would be wise to move forward with housing reform that specifies an explicit, but limited, government role.

The centerpiece of any proposal should be protecting taxpayers. The best way to make that happen is to bring private capital back into the market and ensure that it would take losses ahead of any government guarantee on mortgages and securities composed of them.

Fortunately, Congress already has a good model to follow: a bipartisan proposal now before the House sponsored by John Campbell, a California Republican, and Gary Peters, Democrat of Michigan. Under the plan, at least five private firms would be set up to finance and securitize high-quality conventional mortgages. The government would guarantee the resulting financial instruments, but the companies would have to pay insurance premiums for that backstop. The firms themselves would not be guaranteed — only the mortgage-backed securities they created would be protected.

Such a program would create a competitive market in which Fannie and Freddie would become just two of many firms involved in securitization, and neither would be too important to fail. Over time they would probably be sold back into private hands or wound down.

Critics will no doubt make the case that Fannie and Freddie made housing possible for the less affluent, who would be left behind in a freer system. Under such a proposal, a portion of the insurance premiums could be earmarked for affordable-housing initiatives.

More important, an open market is also the best way to spur useful innovation in mortgages, as lenders would compete to find ways to help credit-worthy borrowers with modest incomes become owners. An irony is that the large banks so many Americans blame for the economic crisis are the companies most likely to compete effectively with Fannie and Freddie. (Disclosure: I have done consulting work for some large banks on reforming those enterprises.)

In order to give all competitors equal footing, regulators should require all firms involved to issue standardized mortgage-backed securities, as opposed to the current system in which Fannie’s and Freddie’s securities trade separately from other mortgage-backed instruments. This would have side- benefits: unifying the market would improve mortgage liquidity and thus probably lower interest rates for borrowers.

There are a few caveats. There is a risk in having the government price insurance — something that it has done a terrible job at with flood insurance, for example. But any price it charges will be better than zero, which was the de facto rate in the Fannie-Freddie system that was ostensibly private but had its implicit federal guarantee.

The larger concern is what would happen to interest rates as the government backstop receded. If private investors overwhelmingly balked at taking on housing risk, it could lead to a surge in interest rates and further depress home sales and construction. Thus the prudent path would be to go quickly to a competitive system but phase out the current federal role at a slower pace, namely by gradually bringing in private capital ahead of a secondary government guarantee.

The longer Fannie and Freddie stay in government hands, the more likely they will become permanent wards of the state. This would be the worst of possibilities, yet it becomes more likely as conservatives push for a supposedly private housing financing system that has no hope of enactment. The government will always be part of the housing market; let’s make sure we keep its role as small and contained as possible.

(Phillip L. Swagel is a professor at the University of Maryland School of Public Policy. He was assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.)

“Stall Speed” GDP Growth and Escalating Risks

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Jul 182011

By Bill Longbrake
Executive-in-Residence at the Center for Financial Policy

This is an excerpt of the July 2011 Longbrake Letter.  To read more, click here

Last month I commented that U.S. GDP growth was approaching stall speed.  If anything, the outlook has worsened, not brightened, over the last month.  The June employment report was extraordinarily awful; consumer and small business confidence has continued to decline and is now at levels consistent with past recessions; Congress and President Obama have not yet been able to craft a budget deficit and debt ceiling compromise, although resolution is still likely, if only because the alternative of default is unimaginable; and the European sovereign debt and banking system crisis is building in fits and starts in a pattern eerily similar to the meltdown in U.S. financial markets during 2007 and 2008.

Nonetheless, most forecasters remain optimistic that GDP will accelerate during the second half of 2011 from a dismal pace of less than 2% in the first half to about 3% or a little more.  The Fed is even more optimistic, expecting growth to reaccelerate in the second half to 3.5% or more.

Optimism is based upon several assumptions.  First, consumer spending will rise as gas prices retreat, but is this likely given declining consumer confidence and deterioration in employment prospects?  Moreover, while gas prices are down from their peak they remain 25% above year ago levels.  Second, Japan’s disaster-induced global supply impacts will dissipate.  True enough but this factor seems overrated in the larger scheme of things.  Third, the global soft patch may be nearing an end as China makes progress in reducing stockpiles of commodities and in containing consumer price inflation.  This assumes that the economies of emerging nations, which have been the engines of global growth in recent years, will shortly reaccelerate.  While this is possible, and the better than expected growth in Chinese GDP (annual rate of 9.5% versus expected 9.3%) during the second quarter lends credence to this belief, broad-based evidence is not yet in place that assures that reacceleration will occur.  Indeed, an equally strong case can be made that the global soft patch will continue for a while, given that inflation is still rising in China, Europe is stumbling and growth in the U.S. is weaker than expected.

In addition to these cautions about optimism, fiscal policy in the U.S. is transitioning from net favorable to net unfavorable impacts on growth.  For example, an increasing number of unemployed workers are exhausting extended benefits.

Putting this all together, odds of economic growth near stall speed seem more likely than growth above 3%.  That’s the bad news.  The good news is that re-emergence of negative GDP growth, in others words renewed recession, is not a likely prospect.  But, as consumer opinion polls document, with low confidence and high unemployment most will continue to feel like we’re in an ongoing recession, even though the published data indicate that we are in recovery, albeit a very sluggish one.

Read more…

Jul 142011

Center for Financial Policy (CFP) Director Lemma Senbet and CFP faculty associates, Russ Wermers and Ethan Cohen-Cole, recently had a dialogue with Michael Tae, Senior Policy Advisor of the Financial Stability Oversight Council (FSOC).  FSOC reached out to the Center to get an academic perspective on the newly proposed rules for the “systemically critical” designation of non-bank financial institutions.

The dialogue focused on the systemic risk designation of investment funds and the role of compensation incentives in systemic risk, as well as academic basis for quantitative metrics, such as leverage, interconnectedness, liquidity and maturity structure.  It was emphasized in the dialogue that there should be no over-reliance on size.  Institutions of modest size (e.g., Long-Term Capital Management) can be systemically critical by virtue of interconnectedness resulting from shared risk exposure or linked risk exposure.   It is important to distinguish between these two connections because they imply different policy implications.

On the investment fund management arena, the rules are not clear as to whether the designation pertains to institutions engaged in investment management advisory or the investment funds, but we think both should be considered. Although the assets of investment advisors are segregated from investment funds, their business is affected by how well these funds perform, given the linkage between asset size and fees. Moreover, the viability of investment advisors could have a negative spillover, since it could lead to massive redemptions. However, there should be a differentiation in terms of regulatory intensity between investment funds and other non-bank institutions, since the former are already subject to strong SEC scrutiny as a result of the Investment Advisors Act of 1940.

Finally, the proposed rules have no mention of global exposure of the US-based non-bank institutions. There should be due consideration to the global dimension so as not to distort the systemic designation. On the other hand, such companies may also be subject to global regulation, which should have an impact on the need for systemic risk designation. The designation that is devoid of global considerations opens to competitive disadvantage and regulatory arbitrage.

Jul 082011

In a June 21 interview at University of Maryland’s Robert H. Smith School of Business, Executive-in-Residence at the Center for Financial Policy Bill Longbrake talked to Michelle Lui, CFP’s Assistant Director, about the economy recovery, employment, the U.S. deficit, and debt ceiling.



The rate of economic recovery has been decelerating, as indicated by the discouraging recent employment reports.  According to Longbrake, the stimulus policies that have been used are ineffective at stimulating job growth.  Since there have been structural changes in the global economy, policymakers need to focus on “investments that create competitiveness and ultimately lead to creation of jobs, rather than putting all of the government stimulus to boost spending within the context of an assumption that the world hasn’t changed.”  He identified some opportunities for investment including energy independence, research and development in new technologies, and intentional job skill training programs.

When asked about the upcoming August 2 deadline to raise the debt ceiling, Longbrake predicted that an agreement will probably be made because “everybody agrees that it’s unthinkable to miss the date and create uncertainty that threatens default of U.S. Treasury securities.”  He mentioned that the debt ceiling needs to be raised by at least $2 trillion and that the deficit reduction must equal or exceed that amount in order for Republicans to agree to the resolution.  He predicts that the budget cuts will come from adjustments in farm subsidy programs, federal retiree benefit programs, and Medicare and Medicaid provider payments.  In addition, discretionary spending caps may be implemented.

In the full length interview, Longbrake addresses other issues such as the Fed’s monetary policies and the Greek debt crisis.

The Center for Financial Policy was launched in November 2009 and develops thought leadership in financial policy that impacts corporate performance, capital allocation and the stability of the global financial system. Located in both College Park, MD and Washington, D.C., at the Smith’s School’s campus in the Ronald Reagan Building and International Trade Center, the Center is well-situated to take a leadership role with its globally recognized faculty and its extensive relationships with key policymakers, practitioners and academics.