Financial Crisis Inquiry Commission: Republican “Financial Crisis Primer”

When I first learned who had been appointed to the Financial Crisis Inquiry Commission ("FCIC"), which Congress set up in 2009 to investigate and report on the causes of the 2008 financial crisis, I thought there would likely be a majority and minority report. The reason for my doubts that there would be a unanimous report was that I knew something about two of the members, Brooksley Born and Peter Wallison. Ms. Born, the former Chairman of the CFTC, has been basking in the accolades thrown her way because she is viewed by many as having been right about the dangers of OTC derivatives. Mr. Wallison, who was General Counsel of the Treasury Department during the Reagan Administration, has been a fixture at the American Enterprise Institute, a conservative think tank in Washington, DC, for quite some time. One of his main preoccupations has been the dangers posed by Fannie Mae and Freddie Mac. I thought that Ms. Born would likely see much of the cause of the financial crisis to be due to OTC derivatives and Mr. Wallison would heap the blame on the two GSEs.

I was consequently pleasantly surprised in April, when I watched a FCIC hearing, that the members seemed to be getting along well, though I subsequently heard a rumor that they had all agreed to play nice in public, since it would not help any of them to engage in public disputes. I also was surprised at the tone of some of the questions asked by Vice Chairman Thomas of witnesses, which had more of a populist tone than one would expect from the former Republican Chairman of the House Ways and Means Committee.

Now the harmonious illusion has been shattered by the publication on December 15 of a short "Financial Crisis Primer" signed by all four Republican commissioners. It is easy to find criticisms of this paper on the web. For example, both Bethany McLean (in Slate) and Joe Nocera (in his New York Times column), whose recent book I commented on in the previous post, have provided devastating critiques of the "Primer." I agree with their comments.

It seems that the Primer was issued prior to the FCIC's report being finalized for political reasons. The Republicans want to head off any efforts at restrictive regulations, which the majority might recommend, while pushing their agenda to end the role of the GSEs and to combat the deficit, presumably by decreasing social spending. They are not wrong that the government played a role in the crisis, but they ignore the major role of private actors, including financial institutions ("Wall Street") and the rating agencies.

As for the GSEs, there has long been a Treasury view that these entities should probably never have been created and, in any case, never been allowed to get so big. Antipathy to Fannie Mae and Freddie Mac has been common to both Democratic and Republican administrations. The institutional view of Treasury has been that Fannie Mae was wrong in saying that the GSE model was one that worked. When I was at Treasury, we saw the dangers of mixing private profit incentives with a government backstop ("the implicit guarantee"). However, the GSEs were latecomers to the subprime mortgage party. Putting the degree of blame on them that the Primer does is a distortion of what happened.

Nevertheless, it is clear that something has to be done about Fannie and Freddie. The FCIC members do not need to exaggerate to make sure that this issue continues to be part of the Congressional agenda.

The concern expressed in the Primer about the budget deficit seems to be tacked on. The current fiscal situation cannot be said to have caused the crisis that took place more than two years ago. Why this is in the paper is not at all clear, since it will likely have no effect in the coming debates about taxes and spending.

What is a shame is that the Primer could have been written without any of the investigation that FCIC has undertaken. It was not written by people with an open mind, and it will probably have little effect except to minimize the impact of the FCIC's report. That may be the intent. Of course, that report, while probably presenting much useful and interesting information, may have its own exaggerations, but of course it is not possible now to tell how good or bad it will be. The signatories to the Primer, though, should hope that it is quickly forgotten, and they should strive to have something more thoughtful to say when the final FCIC report is issued.

Book Review: All the Devils Are Here: The Hidden History of the Financial Crisis by Bethany McLean and Joe Nocera

While I have some criticisms of Bethany McLean and Joe Nocera's new book, All the Devils Are Here: The Hidden History of the Financial Crisis, I would put it on the required reading list for anyone seeking to understand the financial crisis. Its focus is on the financing of the housing bubble, and it assigns blame widely. Mortgage originators, Wall Street firms, rating agencies, regulators, and government sponsored enterprises all played a role.

There have been a large number of books about the financial crisis. Many of these books are interesting and shed light on specific events. For the most part, they have been written by reporters who covered the story as it was happening. A common shortcoming to most of these books is their narrow focus and lack of analysis. For example, Andrew Ross Sorkin's book, Too Big to Fail, focuses on the actions and meetings of some key top Wall Street executives and government officials during the crisis. This is interesting, but it does not tell the larger story of the crisis to which these top people were reacting.

One of the best books to come out of the financial crisis is Gillian Tett's Fool's Gold: The Inside Story of J.P. Morgan an How Wall Street Greed Corrupted its Bold Dream and Created a Financial Catastrophe. This book, too, is narrow in scope, but it provides interesting history and analysis of the development and use of credit default swaps and collateralized debt obligations. For those seeking to understand this aspect of the crisis, this book should also be on the required reading list.

Bethany McLean and Joe Nocera's new book on the financial crisis does attempt to provide both history and analysis of the developments leading to the financial crisis. It focuses its attention on the mortgage industry, which is appropriate since the crisis was the result of the inevitable end of a housing bubble. The book puts a large measure of blame on Wall Street with it insatiable demand for badly underwritten mortgages with high interest rates which could be transformed into high yielding securities with AAA ratings conferred by the rating agencies. The rating agencies are singled out especially for their utter failure to manage the conflict of interest inherent in their business model – being paid by issuers to rate their securities.

The appetite for bad mortgages encouraged mortgage originators, some notable ones wanting to grow quickly, in reducing their underwriting standards in order to supply product to Wall Street. Some mortgage lenders convinced borrowers to get into riskier products, such as option ARMs, because there were greater profits for the originators in these types of loans. The underlying assumption was that housing prices always go up.

While this was all going on, the regulators did very little. Federal Reserve Chairman Alan Greenspan had faith in market discipline correcting any problems and, consequently, the Fed did not use its authority to curtail problems in the mortgage industry. The Office of the Comptroller of the Currency ("OCC") steered national banks from originating many bad loans, but its state law preemption policies, the authors argue, contributed to the problem, since the Office of Thrift Supervision ("OTS"), in competition with OCC, followed the OCC lead and was a weaker regulator. In addition, states were reluctant to impose tougher requirements on state-chartered institutions than those applicable to federally-chartered competitors supervised by the OTS. The authors do, though, credit John Dugan, then the Comptroller of the Currency, with "fretting to other regulators about the growth in nontraditional – i.e., subprime – mortgages…" in 2006. The authors, referencing an unnamed Treasury official, state that Main Treasury did not take the Comptroller's warning that seriously. The economists working on housing issues and the staff working on financial markets did not talk on a regular basis. (From personal experience, I can attest that communication and coordination between various parts of Main Treasury is less than optimal and that this "silo" problem is very resistant to attempts to address it.) In addition, Treasury officials were inclined, according to a "former Treasury official" to be relaxed about increased leverage. The authors quote the official as saying: "It was a gradual process that got us to where we were … So you'd think it would be a gradual process that got us out." The authors comment – "In this assumption, however, they could not have been more wrong." (Disclosure: I worked for eight months at the OCC on detail from Main Treasury in 2007, an assignment I requested and was facilitated by Mr. Dugan. In 2006, I was not working in the Domestic Finance section of Treasury nor was I working on issues related to the housing crisis or problems in financial markets, which is another way of saying I have never had any contact with either author. I do not know whom they spoke to at the Treasury Department.)

The authors also discuss Fannie Mae and Freddie Mac. Some observers, with perhaps an ideological perspective, would like to assign the lion's share of the blame for the crisis on the two major housing government sponsored enterprises; the authors have a more balanced view – the two GSEs had major problems, but they followed the private sector into subprime.

As with the Gillian Tett book, this book is invaluable for those seeking to understand what happened. The book, though, is not without flaws.

I wish the authors had discussed in their book the analysis Bethany McLean offered as to the cause of the financial crisis in one of the interviews of the authors as they made the rounds to promote their book. She said that while incomes except for the very wealthy stagnated, the way the economy was able to continue to grow and for corporations to be profitable was for consumers to use their houses as ATMs. They refinanced their houses in order to borrow more, and kept consumption up with this borrowed money. This was made possible by the housing bubble and relaxed lending standards. Of course, this could not continue indefinitely. Others have made this point, but it would have been helpful if the authors had discussed more fully this process of maintaining consumer demand with borrowed money while incomes stagnated. Perhaps they considered income stagnation beyond the scope of the book, but it would not seem to have been difficult to find various economists and others willing to give their analysis of this subject.

The authors assign some blame, as is fashionable, to Secretary Rubin's opposition to CFTC Chairman Brooksley Born's attempt to regulate the OTC derivatives market. (I have written posts about this here, here, and here.) While the authors are fairer to Rubin than many have been, they missed that Brooksley Born rejected his proposal outright that the President's Working Group on Financial Market's ask the questions posed by the draft CFTC's concept release rather than having the CFTC do it. The reason for Rubin's proposal was that it would not have implied that the CFTC might consider some existing OTC derivatives, such as total return swaps based on equity securities, to be illegal, and hence unenforceable, futures contracts. The authors also do not mention that the statement of the Secretary Rubin, Chairman Greenspan, and SEC Chairman Arthur Levitt criticizing the CFTC concept release was issued because of concern of market reaction to the CFTC's implying that some OTC derivatives contracts were unenforceable.

Moreover, at the time of the meeting in 1998, the market for credit default swaps, which would prove to be so troublesome later on, had not yet taken off to any significant extent nor had synthetic CDOs. The major contracts people were focused on at the time, such as interest rate, foreign currency, and total return swaps, were not implicated in the 2008 crisis, though, admittedly, some of the variations on these contracts were extremely complex and made pricing these contracts an issue of legitimate concern.

The authors, though, do make a reasonable point that Secretary Rubin could have worked harder to regulate OTC derivatives in some way, if he was concerned about the risks, regardless of his personal animus to Chairman Born. However, with respect to the failure of the hedge fund, Long-Term Capital Management ("LTCM"), the authors imply that this episode vindicated Born's concerns. What they fail to mention is that a regulatory initiative to address excessive leverage at hedge funds need not focus on particular instruments but on hedge funds themselves. For instance, in LTCM's case, the use of OTC derivatives was only one of a set of trading strategies the fund used. Since the institutions that pose systemic risk issues with respect to OTC derivatives are also involved in other types of speculative activities and investments, whether to key regulation off the players or the instruments is a policy issue that needs to be analyzed. Doing both, and assigning responsibility to different regulators, as the Dodd-Frank legislation does, is likely to lead some regulatory dysfunction. (A previous post addresses this topic.)

Also, even if Chairman Born had been successful in regulating OTC derivatives, it is not at all clear that this would have prevented the crisis, which as the authors rightly argue started with a housing bubble and extremely relaxed underwriting standards. Regulating interest rate swaps or foreign currency swaps or forcing these products on to exchanges would have done nothing to prevent the crisis. What the CFTC would have done, if it had the authority, if anything, about credit default swaps is unknown. Would they have caught the concentration of risk at AIG any better than the OTS, and, if they had, what would they have done about it? How would the inevitable clashes with the bank regulators and the SEC have played out? After all, the regulatory failure associated with the financial crisis was not due to a shortage of regulatory authority but to existing authority not being used. Maybe the CFTC would have done something, but perhaps not. It is a small agency and would have been operating in the same environment and under similar pressures as the other regulators.

Moreover, when it comes to unregulated OTC derivatives, the authors sometimes confuse these instruments with securities. For example, they cite Orange County's bankruptcy as the result of its investment in derivatives, when in fact much of the problem was caused by Orange County's investment in structured securities which was a way to bet on interest rates. While structured securities can be used to speculate as can OTC derivatives, the important point is that securities are regulated by the SEC, and this regulation did not prevent some big problems. I would also note that CDOs and synthetic CDOs, which had in them credit default swap positions, were subject to SEC jurisdiction. This did not prevent problems with these securities.

While the authors are critical of Secretary Paulson for missing the housing problem, they praise him for "a hugely ambitious project to revamp the regulatory system." What the authors fail to mention is that the exercise to reform the regulatory system began as an effort to lighten up on regulation.

There was the idea before the crisis hit that New York was losing business to London because of the lighter touch of the U.K.'s Financial Services Authority. Senator Charles Schumer and New York Mayor Michael Bloomberg commissioned a report by McKinsey & Company which was released in January 2007 – Sustaining New York's and the US' Global Financial Services Leadership. As an example of the tone of this report, its Executive Summary says about derivatives: "'The US is running the risk of being marginalized' in derivatives, to quote one business leader, because of its business climate, not its location. The more amenable and collaborative regulatory environment in London in particular makes businesses more comfortable about creating new derivative products and structures there than in the US." Another more interesting paper – Interim Report of the Committee on Capital Markets Regulation (November 2006) – also argued that the U.S. should adopt a lighter touch. This study, by prominent industry leaders and academics, was influential at the time. Both studies provided support for Secretary Paulson's initial efforts to lighten regulation ("principles-based" rather than "rules-based").

Of course, by the time The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure was published in March 2008, the situation had of course changed, and the report was recast as one advocating regulatory reform rather than focusing on a lighter regulatory touch. The report is not one of Treasury's best efforts, and it is incidentally not that easy to find on Treasury's recently redesigned website. However, Secretary Paulson should not be given a pass on what his real agenda had been, but his spinning of this to date has been remarkably successful.

Finally, while the book does an excellent job of tracing the roots of the financial crisis to the housing bubble and the associated lowering of underwriting standards, it is U.S. centric. There were, and continue to be, problems in Europe. For example, there was a housing bubble in the U.K., and one of the early signs of trouble was the classic bank run, with account holders lining up in the street to get their money out, on Northern Rock in 2007. The institutional arrangements for financing housing in the U.K. and its regulation are of course different than in the U.S., but still there was a housing bubble there. On the other hand, the major banks of Canada, a country which obviously cannot insulate itself from economic developments in the U.S., did not experience the financial difficulties experienced by U.S. banks. Putting the U.S. crisis into an international context would have been a much more ambitious project than the authors attempted, though more mention of the international problems would have been appropriate. The international crisis and its causes have yet to be analyzed or understood to any great extent.

Nevertheless, in spite of these criticisms, there is much to recommend about this book. It is one of the better accounts of the financial crisis in the U.S. and its assignment of blame for the most part is not reflexive but based on solid reporting. It deserves the accolades it has been receiving.

A Note on Government Shutdowns, the Debt Limit, Continuing Resolutions, and Appropriations

There is a misconception, unfortunately reinforced occasionally by press reports, that the failure to enact legislation to increase the federal government’s debt limit leads to a government shutdown. This is not true. Government shutdowns occur due to a failure to enact legislation granting the federal government the authority to spend money.

This confusion was reinforced by the government shutdown during the Clinton Administration when a failure to pass appropriation bills or continuing resolutions (“CRs”) occurred simultaneously with a failure to increase the debt limit, which the Treasury was bumping against.

Currently, the specter of a government shutdown looms because the federal government is operating under CR. Congress typically enacts CRs when it has failed to pass the yearly appropriation bills. CRs are usually for a limited time; the current one expires on December 3. The lame-duck Congress will have to pass another CR in order to avoid a shutdown. It is expected to pass one of short duration, but then will have to pass another one before it adjourns, unless it passes a spending bill.

In a debt limit crisis, the government continues to operate normally unless there is a concurrent lapse in spending authority. The Treasury begins to take some extraordinary actions to avoid breaching the debt limit but retaining enough cash to meet current expenditures. The fear during a debt limit crisis is that Congress or the Administration may carry the charade too far, and the Treasury will not have enough cash to make an interest payment or to make payments, such as the large Social Security payments at the beginning of each month. This has never happened.

In the past, when Treasury has reached the debt limit and Congress has not passed an increase, the Treasury has found a way to keep the government funded. For example, one of the first actions Treasury takes is to disinvest certain government trust funds (the securities in these funds count against the debt limit), such as the Exchange Stabilization Fund (“ESF”) and certain trust funds, such as the G Fund which is part of the Thrift Savings Plan (“TSP”) for government employees and invests in non-marketable Treasury securities. This frees up room to issue more securities to the market and thus raise cash.

To show how ridiculous this is, by law when the G Fund is disinvested, it is credited with the interest it would have received if it had been fully invested. The ESF, on the other hand, loses out on the interest.

In an exercise of spin, the Treasury has called such maneuvers as disinvesting the G Fund “a statutory tool” for managing a debt limit crisis. In fact, the reason for the legislation that reimburses the G Fund for missed interest due to it being disinvested during a debt limit crisis is to protect federal employees.

The first director of the TSP was Francis X. Cavanaugh, who had a long career at Treasury and had been the director of an office at Treasury which was responsible for, among other issues, managing the public debt. (I reported to Mr. Cavanaugh for about six years during the 1980s.) He knew that the Treasury would likely disinvest the G Fund during a debt limit crisis and asked Congress to pass legislation to protect federal employees when that happened.

Once Treasury has used a particular maneuver to remain solvent during a debt limit crisis, Congress knows about it and expects Treasury to use it again. Meanwhile, Treasury starts sending increasingly frantic letters to the Hill asking for an increase.

While this is all theater, and everyone knows that Congress will eventually do the right thing and pass debt limit legislation, it is not costless. There are market effects as Treasury cancels auctions and takes other actions such as suspending sales of special securities to state and local governments. Also, top Treasury officials, including the Secretary, have to spend an inordinate amount of time monitoring the level of the debt, the Treasury’s cash balance, and the daily projections of cash inflows and outflows. They also have to consider how to deal with the political problem. This time drain diverts them from dealing with real issues, because of the requirement to handle this artificial crisis.

The debt limit does not lead to a government shutdown. If the Treasury ever did run out of cash and began defaulting, all bets are off, but, as I recall Secretary Rubin saying in 1995, default is “unthinkable.”

A Comment on the U.S. Treasury Department’s PR

I have never liked what has commonly become called “spin.”  For me, detecting spin is tantamount to detecting an insult – how stupid do they think I am? Whether or not to call people on spin when that is possible is a judgment call.  Sometimes it seems not worth it and, letting it pass noncommittally, may leave the spinners wondering whether or not their message has been accepted in its entirety.

Given my attitude towards spin, I have not been happy to come across incidents of – how can we say this nicely?  – the Treasury coloring or sometimes obscuring the facts.  Readers of this blog know that I have criticized Treasury from time to time for this.  (For a specific example, see my first post to this blog.) 

I do admit to some sympathy to Treasury Secretaries who have to reaffirm that the U.S. has a “strong dollar” policy while at the same time encouraging certain countries to let their currencies appreciate.  Everyone knows that there is little meaning to this statement and that, in this context, the meaning of the word “strong” approaches infinite elasticity.  But if the Secretary tries to say something with more meaning, as I recall Paul O’Neill tried to do, then foreign exchange traders go berserk, acting as if something fundamental has changed.  Treasury Secretaries seem compelled to repeat periodically the “strong dollar” mantra.  (For an example of a recent incantation, click here.) 

  

I am less forgiving of spin than that when Phyllis Caldwell, the Treasury’s “Chief of the U.S Treasury's Homeownership Preservation Office,” said at a recent hearing of the TARP Congressional Oversight Panel:  “At this point in time there is no evidence that there is systemic risk to the financial system.”  (Click here for quote.)  In fact, there is no point in time when there is no systemic risk; the question is how much risk there is.  If the risk is deemed to be too high, then the task is to identify and to take measures to reduce it.  Despite pleas from one of her questioners to modify her statement, since such statements may look particularly bad in the future, Ms. Caldwell refused.  She was clearly uncomfortable, but probably felt she could not go beyond what she had been authorized to say when she was preparing for her appearance back at the Treasury.

I am also less understanding of another apparent PR maneuver of the Treasury Department.  Recently, I was searching the Treasury’s website for information about the Office of Financial Stability, which administers TARP.  I was particularly interested in finding out who had replaced Herb Allison as Assistant Secretary for Financial Stability.  I searched in vain for a press release announcing Herb Allison’s resignation or about his replacement.  Also, the Office of Financial Stability had disappeared from the Treasury’s website, even though the Office reports (or reported?) to the Treasury Under Secretary for Domestic Finance.  Finally, in reply to my inquiry, a reporter I know directed me to another government website, FinancialStability.gov, where one can find that Tim Massad is Acting Assistant Secretary for Financial Stability and Chief Counsel.

While the TARP program has ended in the sense that no new money is being committed, there are existing investments to manage as the program is wound down. What is the point of trying to hide the existence of this office?  It is almost as if someone wants to dump it down an Orwell memory hole.  

These are perhaps small points, but they do not provide any confidence that the Treasury currently possesses the PR savvy to deal with what will be a much harsher political climate for it next year.  While senior Treasury officials no doubt believe their harshest critics on policy issues are wrong, they should not leave themselves open to charges of prevarication.  It is much better to have good policies you believe in and then to tell that story.

Is the U.S. Treasury in Control of Debt Management?

Early on in my career in the Domestic Finance section of Treasury, my then boss, a career civil servant who even by that time had been at Treasury for a long time, told me that it was the Fed’s policy to keep the maturity structure of its permanent portfolio similar to what the Treasury had issued, so as not to impact debt management. I did not run the numbers at that time to check if what my boss had told me was correct, but it is clear that this is not current Fed policy.

The Treasury is of course aware of this but seems to want to minimize the issue. In the November 3 quarterly refunding press conference, Assistant Secretary for Financial Markets Mary J. Miller made a point of saying that Treasury decisions with respect to debt issuance are made independently of the Fed and even quoted a Treasury Borrowing Advisory Committee (“TBAC”) member as saying that the Fed should be just considered as a big investor.

I am more inclined to agree with the sentiment of the TBAC member, who, according to the minutes, said that “the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.”

Of course, that is not quite right. Not only is the Fed reducing the amount of Treasury notes available to the market, it is reducing the total amount of debt securities needed to be in the market in order to keep the government financed. As for bills, their relative importance to debt management is increased, but not necessarily their quantity.

With respect to T-bills, though, I note that the Treasury continues to have issued bills it does not need to keep the government financed in an amount of nearly $200 billion. The proceeds of these bills are deposited in the Supplementary Financing Program Account. Treasury’s issuance of bills to borrow money it does not need and depositing it at the Fed serves to drain banking system of reserves. Why Treasury is still doing this when the Fed has an announced policy of increasing reserves is not clear, but I am sure that, even with all the talk of Treasury independence from the Fed, the Treasury and the Fed from time to time discuss this program. (It is noteworthy that Treasury is emphasizing its independence from monetary decisions, not the Fed insisting on its independence from Administration policy.) One can be sure, though, that when the Treasury bumps up against the debt limit next year and the likely debt limit theater again puts on one of its periodic performances in Washington, the Supplementary Financing Program Account will be tapped. (Previous comments of mine on the Supplementary Financing Program Account and Treasury cash can be found here and here.)

I am not going to assess the wisdom of the Fed’s new policy here. What I would like to note, though, is that, while the Fed is not permitted by statute to lend to the Treasury, it is effectively monetizing the deficit by buying record amounts of Treasury securities in the secondary market. While the Federal Reserve Banks are technically private institutions, there is no way other than to view them as part of the government for policy analysis. They are not just another investor, albeit large. The interest the Treasury pays on the securities the Fed owns comes back to Treasury in the form of “interest on Federal Reserve notes.” The Fed subtracts its expenses from the amount it remits to the Treasury. This used to mean that Treasury got virtually all the interest it paid on securities newly acquired by the Fed, since the Fed’s increasing its balance sheet did not affect its expenses. Now it does, since the Fed pays 25 basis points on bank reserves, but there will still be funds remitted to the Treasury from the notes the Fed acquires under the new program.   

Of course, at some point, the Fed will want to drain bank reserves from the banking system. It is unclear when that will happen, but, when it does, Fed sales of Treasury notes will compete with the Treasury’s own sales. 

While it is true that the Treasury, not the Fed, makes the final decisions about what the Treasury will auction, it is silly to claim that the Fed is just another investor and to give the impression that Treasury debt management is not impacted by Fed actions of the current magnitude. Much of the audience for the quarterly refunding press conferences knows this; what is the point of pretending otherwise?    

MERS Legislation?

John Carney, a senior editor at CNBC.com, posted an article on Friday with the headline, “Get Ready for the Great MERS Whitewash Bill.” Mr. Carney concluded: “I wouldn't be at all surprised if Congress manages to pass a bill that bails MERS out of its legal issues.” Today, Carney posted another article, “Do the Enemies of MERS Know What They Are Asking For?” In this later article, Carney argues that it is not a foregone conclusion that the courts will destroy MERS, given the practicalities involved. (This AP article discusses the costs to banks if the legal attack on MERS for avoiding the payment of local recording fees is successful.)  

One way or another, a way will be found to avoid the worst consequences to banks that the legal attacks on MERS imply. This may involve addressing some tax issues concerning the trusts underlying mortgages which have been securitized, if that is indeed a problem, as well as the more obvious legal issues surrounding foreclosures.

If legislation with retroactive applicability is deemed necessary, then there will be legislation passed with bipartisan support. Most (but probably not all) legislators with a fondness for quoting the Tenth Amendment to the Constitution would probably be silent on that point. They would effectively assent to arguments that mortgages are traded across state lines and therefore the Interstate Commerce Clause grants the Congress the power to legislate on this issue, even though real property, by its very nature, stays put. The Supremacy Clause might also be invoked by proponents as meaning any federal statute on this subject will preempt any state or local laws governing recording requirements and associated fees. (Given the amounts of money involved with these fees, California and other states might challenge the constitutionality of any such legislation to the Supreme Court, which would prove interesting.)

On the other side, many legislators usually concerned with unfair practices of banks towards consumers also would likely not oppose MERS legislation if it is deemed necessary by the Administration. They would be swayed by arguments made by the Administration and financial institutions. For example, proponents of legislation could argue that, if MERS is not granted legal certainty, then there would potentially be enormous costs to financial institutions, which could require another bailout or sink the economy into another recession.

Carney suggests that those arguing for struggling homeowners should not aim for total victory against MERS in the courts but should negotiate a global “Spitzer-style” settlement. In Carney’s words, this “would involve a trade-off of mortgage modifications in exchange for forgiving the flaws and frauds MERS allegedly enabled.” (Carney credits Trace Alloway of ft.com/Alphaville for suggesting a Spitzer-style settlement. See “The mother-of-all MERS fixes” and “The Spitzer settlement for mortgages.”)

Whatever the resolution of the legal uncertainty surrounding MERS, it is clear that those setting up MERS years ago brushed away any legal concerns. The foreclosure mess underlines the importance for the financial community to make the necessary investments to minimize legal and operational risks, rather than acting as if extreme events never happen. 

Does the Mortgage Electronic Registration Systems ("MERS") Legally Work?

Officials at the Mortgage Electronic Registration Systems (“MERS”) have been attempting to dismiss the concerns that have been raised about whether their system conforms to local laws governing real estate. Though the company, whose motto is “process loans, not paperwork,” is putting on a brave front, one suspects that there are some very worried people at its Reston, Virginia headquarters.

An article in The Washington Post last month, “Reston-based company MERS in the middle of foreclosure chaos,” provides some useful background to this company, which was until recently little-known, even though, according to the Post article, it “tracks more than 65 million mortgages throughout the country.” MERS was created in the 1990s to reduce the paperwork involved in transferring mortgages, especially those which had become securitized. The system started operations in 1997. MERS states that its “mission is to register every loan in the United States” on its system.

Legal issues are now being raised about whether the MERS system actually works. Christopher L. Peterson, a law professor and associate dean at the University of Utah, S.J. Quinney College of Law, has posted online a working draft for a forthcoming issue of Real Property, Trust and Estate Law Journal  – “Two Faces: Demystifying the Mortgage Electronic System's Land Title Theory.”  Floyd Norris of The New York Times has a good summary of the issues in his article: “Some Sand in the Gears of Securitizing.”

Mr. Peterson points out that some boilerplate legal language MERS uses “is confusing to courts, borrowers, and even foreclosure attorneys.” It states that “MERS is a separate corporation that is acting solely as nominee for Lender and Lender's successors and assigns. MERS is the mortgagee under the Security Instrument.” Peterson remarks: “It is axiomatic that a company cannot be both an agent and a principal with the same right.”

He goes on to say that there are “significant legal problems” whether MERS is an agent or the actual mortgagee. If it is the agent, this may run afoul of state land title recording acts, whose point is “to provide a transparent, reliable, record of actual – as opposed to nominal – land ownership.” If it is the mortgagee, then the mortgage has been separated from the promissory note. An 1872 Supreme Court case (Carpenter v. Logan) held that a mortgage assigned without the note “is a nullity.” That would seem to mean that MERS has no right to bring a foreclosure action.

Moreover, in this time of constrained local budgets, local governments are not happy that recording fees have not been paid on mortgages in the MERS system that have been assigned. This issue presents another legal challenge to MERS.

MERS seems to be blowing smoke in defending itself. For example, see its comment to Mr. Norris, which he quotes on his blog.  (Those interested in a detailed summary of court cases involving MERS can find one here.) 

The U.S. Treasury Department, seems to be trying to minimize the MERS issue. In an appearance before the Congressional Oversight Panel, a Treasury official with the peculiar title “Chief of the Homeownership Preservation Office,” Phyllis Caldwell asserted that regarding MERS litigation “at this early stage, it does not appear to be a fundamental legal risk.”

Well, perhaps, but the handwriting on the wall for MERS is becoming clearer; for example, James Dimon has announced that J.P. Morgan Chase will no longer use MERS for foreclosures. Also, in a recent development, the outgoing Attorney General for the District of Columbia, Peter Nickles, has issued a statement saying that MERS does not meet the legal requirements to commence foreclosure proceedings in the District.

It must be galling to officials at the Treasury and at financial institutions that MERS has created this legal problem with foreclosures. After all, the people who are being foreclosed on have defaulted on their mortgage loans.  

But if Peterson is right, at a minimum foreclosures will be slowed down as financial institutions endeavor to prepare paperwork that will satisfy legal requirements. (There are of course other issues such as "robosigning" that have been widely reported on.) In some cases, Peterson argues that the true loan owner could be treated as holding “an equitable mortgage,” but he says “it is likely that an equitable mortgage could be avoided in bankruptcy.” The effect of this will give homeowners in default more bargaining power.  Peterson comments: “The judicial threat of invalidating mortgages and replacing them with less tactically useful equitable mortgages could decrease court's dockets by forcing securitization trustees and servicers to the negotiating table.”

This may not be the worst result, but there may be concern in some quarters on the effect of this on financial institutions. The Treasury Department after all at times gives the impression to have substituted “Wall Street” for “General Motors” in Charlie Wilson's famous statement about what is good for the country, or maybe the Treasury has just added Wall Street to the statement.  (I'm sure, though, that some in the financial community do not have this impression, since they are not happy with some Treasury actions and some provisions of the Dodd-Frank legislation.)    

There is also another possible issue with MERS, though I should note that I have not researched this. There may be questions regarding whether the requirements of tax law facilitating the creation of various types of asset backed securities have been met with mortgage loans where the mortgage is recorded in MERS and not in local offices.  

It is hard to imagine that when MERS was set up that at least some lawyers involved did not recognize that there were some troublesome legal issues. There were probably told, at least implicitly, to keep their reservations to themselves by hard charging business people wanting to set this up because of the efficiencies and lower costs MERS would provide. Now the financial institutions may be betting on the courts not wanting to upset a system this significant to the financial community. There are, however, a lot of local courts and federal bankruptcy courts to convince of this.

Also, it is not clear how much the federal government can do about this if court decisions regarding MERS appear to harm financial institutions. It would seem that laws regarding real property are the province of state and local governments, not the federal government.

For those interested in this subject, another good article can be found in Bloomberg Businessweek, “Mortgage Mess: Shredding the Dream.”

A Comment on the Recent TIPS Auction

There has been some comment about the negative yield realized on the October 25 auction of 41/2 year Treasury Inflation Protected Securities (a reopening of a security originally issued with a maturity of 5 years.)  Excluding accrued interest, winning bidders paid $105.508607 for an original par value of $100 of the security.

Most commentary said that, based on the spread between the negative yield on this security with conventional Treasury securities in the five-year maturity area, this implied that market participants believe that inflation will be increasing.

I did not see any commentary that mentioned that TIPS also provide more real yield under certain circumstances when there is deflation. I discussed this in a previous post. In short, purchasers of TIPS are assured of getting $100 back at maturity for an original par value of  $100 in the event of deflation over the life of the security.

Given the index ratio of 1.00725 for the issue date of the reopened securities, deflation would have to run at an average annual rate of more than approximately -0.16% for the next 4 1/2 years for Treasury to be required to pay a supplement to the adjusted value of the principal at maturity. Any supplement payment would mean that the negative real yield of the TIPS would be reduced, and, if deflation were severe enough, the realized real yield could become positive.

New Information on the CFTC Administrative Law Judge Mess

Michael Hiltzik has a column in the Los Angeles Times about CFTC Administrative Law Judge Painter, which advances the CFTC ALJ story.

Hiltzik says he has spoken with Painter and found him “perfectly lucid.” He also writes that “Douglas Painter, a Los Angeles attorney [and Judge Painter's son], contends that Ritter overmedicated his father in preparation for the Alzheimer's tests and tried to isolate him from his friends and family, and that no one else has reported seeing the symptoms in his father that Ritter [his wife] reports.”

While Hiltzik effectively admits to being an admirer of Painter because of his actions in the past, he also presents Elizabeth Ritter’s side of the story. “She [Ritter] says Painter's son, Douglas, and other relatives improperly removed him from the center, got him a lawyer to file for divorce, and have kept him on the move cross-country to keep him isolated and disoriented.” Hiltzik also quotes her lawyer, Kim Viti Fiorentino as saying, “Elizabeth just wants what's best for him to protect his well-being and his dignity.” According to the article, Painter’s lawyer said in response to that: “He's in full control of his affairs, and if he needs assistance he can make his own choices.”

From this, we can infer that Painter is probably in the Los Angeles area. Also, this family law case complicates an already messy situation at the CFTC, given Painter’s charges against the other CFTC ALJ, Bruce Levine.

Some think that the CFTC will do its best to sweep this under the rug. For example, see this post at the Seeking Alpha website.

Evidence that the CFTC wants this to go away is on the agency’s website. The CFTC has issued an order transferring six of the seven reparation cases that Painter wanted assigned to an ALJ from another agency to Bruce Levine. The order states that Painter “lacks authority to make this unusual request.” (It is not clear from the document what will happen or has happened to the seventh case Painter wanted reassigned to an outside ALJ -- An Li v. Forex Capital Market, LCC, 09-R054.)

While press coverage of this issue has been spotty, it seems likely that it will not go away as quietly as some might want. At a minimum, lawyers involved in CFTC reparation cases may want to raise questions about either Levine or Painter if they believe it serves their clients' interests. In this connection, Hiltzik writes: “Steven Berk, an investor protection attorney in Washington, says, ‘It's an open secret among my brethren that if you get Levine, he's not going to rule for the investor.’”

In addition, some in Congress may want to look into this matter, and some CFTC commissioners may not be all that happy with Levine. For example,  Hiltzik notes that, in 2007, “the CFTC concluded that Levine committed ‘procedural errors’ and ‘severely prejudiced’ an investor in his $74,000 complaint against a futures broker. The commission awarded the investor more than $32,000.”

CFTC Administrative Law Judge Developments -- It 's Getting Nasty

Sarah N. Lynch of Dow Jones Newswire has a story today that begins: “An administrative law judge [Judge George H. Painter] at the Commodity Futures Trading Commission heard and decided cases during a period when his wife said he struggled with mental illness and alcoholism, court records show.”  (The WSJ Online version can be found here. Subscription is probably required, but you can use Google News to search for information about CFTC ALJs.)

According to the article, Judge Painter is seeking to divorce his wife, Elizabeth Ritter, a long-term CFTC lawyer. She is seeking to be Judge Painter's guardian, but Painter's son and a niece are contesting this. The article states that the son and niece said in legal filings that "the judge doesn't exhibit the mental problems described in court records by his wife. Judge Painter's lawyer, Ms. Galloway Ball, said he intends to fight the guardianship case."

From what is now on the public record, the CFTC clearly has a big problem. Now that a reporter has apparently been steered to search court records involving a severe family dispute at the same time that Judge Painter's accusations concerning another ALJ's bias have become public, it seems probable we will learn more.

Regulatory Capture? -- A CFTC Administrative Law Judge Accuses

This morning there is a rather amazing article in the Washington Post about a retiring CFTC administrative law judge accusing the one other ALJ of bias against complainants. In a Notice and Order dated September 17, 2010, ALJ George H. Painter recommends that seven reparation cases currently before him not be reassigned to the other CFTC ALJ, Bruce Levine.

Regarding Levine, Painter writes: “On Judge Levine's first week on the job, nearly twenty years ago, he came into my office and stated that he had promised Wendy Gramm, then Chairwoman of the Commission, that we would never rule in a complainant's favor. A review of his rulings will confirm that he has fulfilled his vow.”

Futures Magazine has posted the document online. It includes as an attachment a December 13, 2000 Wall Street Journal article by reporter Michael Schroeder about charges that Judge Levine was biased against complainants -- “If You've Got a Beef With a Futures Broker, This Judge Isn't for You -- In Eight Years at the CFTC, Levine Has Never Ruled In Favor of an Investor.”  (The Futures Magazine article on this can be found here.)

All this raises some questions. Why did Judge Painter take this long to come forward, or did he do so in the past, but this is the first time his accusation has become public? Why did the CFTC do nothing about the accusations of bias detailed in the WSJ article?

To be fair to the CFTC, ALJ's have some protections and insulation from the heads of the agency they work for, and I am not sure what the CFTC can do. The Commission apparently can seek to have Levine removed at a hearing before another ALJ working for the Merit System Protection Board, but that probably requires a high standard of proof.

In addition to deciding what to do about the seven cases currently assigned to Painter, one assumes the CFTC will determine that it needs to figure out how to restore the credibility of its reparation program.

Some Further Thoughts on "QE2"

Those who believe that the economy needs more stimulus are worried because the likelihood of it coming from fiscal policy in the near-term seems unlikely. Laurence Myer in his presentation this weekend said that, since the Fed has reached its lower bound of zero on the fed funds rate, it is time for fiscal stimulus. That, though, seems politically impossible. He went on to say that, if the Fed wants to lower longer-term Treasury yields, it can either choose a quantity of Treasury notes and bonds to buy or target a specific yield for Treasury 10-year rates. The second option is more risky for the Fed; it loses control of its balance sheet because it does not know the amount of securities it needs to buy in order to hit its target.

Also, I would note that, as the Fed buys massive amounts of Treasury notes and bonds, market participants may worry about future inflation. In other words, while the Fed may reduce the supply of Treasury notes and bonds, demand for them may also fall. The Fed will not likely want to end up owning all the Treasury 10-year notes. If it did, what would be the price of private debt obligations in the absence of a Treasury reference yield?

An alternative, of course, is for the Fed to buy private securities in order to reduce the spread between them and Treasuries, but this also raises issues, such as selection and potential charges of favoritism. It would also contribute to the decline in the quality of the assets the Fed holds.

Mr. Myer concluded that, if the Fed's policy of increasing its balance sheet does not work and unemployment continues to rise, there will be fiscal stimulus. It would be different than the first stimulus, since Republicans more partial to tax cuts will have more say. He suggested one possibility might be a payroll tax holiday.

I agree that, if the unemployment rate increases, additional fiscal stimulus will ultimately be undertaken. Whatever their ideologies or economic beliefs (Ricardian equivalence?), politicians will heed the calls for the government to do something if the economy worsens.

I was somewhat surprised at the pessimism I heard from the people in the financial sector who descended on Washington last week and were here through the weekend. The possibility of a slow recovery seems to be discounted, but that may be what happens. One reason for the pessimism of this international crowd is  the specter of currency wars, and that is indeed worrying.

Another reason to worry, but the international bankers seemed less focused on it, is the U.S. foreclosure crisis. There has been an amazing disregard for the importance of state laws governing transferring of ownership of real estate in the securitization of mortgages. How this will be resolved is at this point uncertain, but financial intermediaries are likely to be hurt.

In any case, Keynes' "animal spirits" were hard to find among the international financial sector representatives in Washington last week. Will a new dose of quantitative easing fix that or cause more anxiety?

Monetary Policy and Treasury Debt Management -- A New Operation Twist?

In reaction to economic weakness and little likelihood in the near-term of any significant fiscal stimulus, the Federal Reserve seems ready to buy a significant amount of longer-term Treasury securities. This has been popularly called "QE2" -- a second round of quantitative easing -- with some no doubt enjoying that this name sounds more like a luxury ocean liner than a policy.

In a speech at a conference sponsored by Deutsche Bank this weekend in Washington, DC coinciding with the World Bank/IMF annual meetings, former Fed governor Laurence Myer said that calling the likely new policy quantitative easing was somewhat misleading -- reserve creation (increase in Fed liabilities) is just a by-product of the Fed increasing the asset side of its balance sheet. I think his point is that, since banks are sitting on a significant amount of excess reserves, the reserve creation is secondary to the effort to decrease longer-term Treasury yields.

Another former Federal Reserve governor (and vice chairman), Alan Blinder, in an appearance on Sunday at the annual meeting of the Institute of International Finance in Washington said that there might be tension between debt management and a Fed policy of buying longer-term Treasury securities.

Indeed there might. Mr. Blinder indicated that if he were in Secretary Geithner's shoes, he might want to issue more long-term Treasury securities in light of low interest rates and that this could result in a "Mexican standoff" between the Fed and the Treasury. In fact, as I discussed in a previous post, the Treasury has already reversed the shortening strategy of both the Clinton and George W. Bush Administrations and is lengthening the average maturity of the public debt.

We have seen this before. In the early 1960s, the Treasury and the Fed embarked on "Operation Twist."  The desire was to increase short-term interest rates to protect the dollar in the foreign exchange markets and to lower long-term interest rates in order to promote economic growth. The idea was that both Fed open market operations and Treasury debt management would be conducted to increase the supply of T-bills in the market and reduce the amount of longer-term debt. The result of this exercise was, at best, inconclusive. There is some question how hard Treasury tried to play its part, since the average maturity of the public debt after briefly declining started increasing.

At some point under the likely new Fed initiative, Treasury may think it is losing control of debt management policy, especially if the Fed purchases in the neighborhood of a trillion dollars of Treasury notes and bonds.  While the Treasury will control what it issues to finance the government, it will be ceding to the Fed the authority to determine the quantity of long-term debt in private hands unless it tries to undo the Fed's policy.  (For this purpose, though the Federal Reserve banks are technically private, they are really part of the government, and the interest they earn on Treasury securities above the amount the Federal Reserve System needs for expenses -- including paying interest on reserves -- is remitted to Treasury.) Also, when the Fed at some future date decides the time has come to shrink its balance sheet, the sale of Treasury securities will complicate Treasury's debt management.

The Fed, while not shy about giving the rest of the government advice, resists any statements or advice from the Administration on monetary policy. In this case, though, one hopes that there is close consultation between the Fed and the Treasury since a core function of Treasury is impacted. The Mexican standoff that Blinder worries about should be avoided.

Finally, whether or not the new Fed policy will work, even if the Treasury cooperates, is  an open question.

Treasury TIPS -- Treasury's Motivations

Perhaps the most contentious issue I had to deal with during my tenure at Treasury was the controversy over issuance of inflation-indexed bonds. It certainly was the longest lasting. Now a new paper ("Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle") by three professors at the UCLA Anderson School written for the National Bureau of Economic Research (Mattthias Fleckenstein, Francis A. Longstaff, and Hanno Lustig) argues that TIPS (Treasury Inflation-Protected Securities) are a costly form of finance and asks why the Treasury "leaves billions of dollars on the table by issuing securities that are not as highly valued by the market as nominal Treasury bonds." (A September 6 draft version of the paper is available for download here.)

When it comes to academics, Treasury just can't win on this issue. It was, after all, academic economists who were the loudest proponents of Treasury issuing the bonds. Proponents included such luminaries as James Tobin, Milton Friedman, and Stanley Fischer. Now that Treasury has been issuing TIPS for almost 14 years, Treasury is being attacked by academics for issuing these securities.

During the Reagan Administration, there was a big push by some Administration economists to get the Treasury to issue inflation-indexed securities. The Domestic Finance section of Treasury was consistently opposed. One senior political appointee joked that the way to market inflation-indexed bonds was to use the membership mailing list of the American Economic Association. Others at Treasury, though, were strong proponents, including Under Secretary for Monetary Affairs Beryl Sprinkel, to whom the Assistant Secretary for Domestic Finance reported (the organizational chart at Treasury has since changed.). However, even with that high level support for inflation-indexed bonds, the proponents were never able to convince the various Treasury Secretaries to issue this new type of security.  It is useful to remember that at the time of these debates, inflation had been high but was being brought under control.

In the George H.W. Bush Administration, the issue receded at Treasury even if academics wanted to pursue it. The political leadership of Domestic Finance at Treasury was just not interested. (Interestingly, Vice President Dan Quayle had been a proponent of inflation-indexed bonds as a Senator and raised the issue at a hearing of the Joint Economic Committee, but, as far as I know, he did not press the issue as Vice President.)

During the Clinton Administration, inflation-indexed bonds became a live issue again. Two strong proponents of inflation-indexed bonds were Larry Summers and Alicia Munnell, both of whom had an academic background. Fed Chairman Alan Greenspan was also a strong proponent. Secretary Rubin, reflecting the consensus view of the major government security dealers at the time, was initially dubious, but eventually he became convinced. The political leadership of Domestic Finance was more ambivalent about the issue than their predecessors had been, and, in any case, taking on Larry Summers is not something one does lightly. When it became clear that Rubin was likely to decide to issue inflation-indexed bonds, I began work on the technical details.

The case against inflation-indexed bonds was mainly based on doubts that they would be cost-effective from Treasury's point of view. Reason for these doubts included: (1) lesser liquidity than conventional Treasuries; (2) limited demand because the appreciation of principal would be taxed currently even though it was not paid out; and (3) no evidence that inflation indexation was something for which there was a lot of demand (efforts to issue price level adjusted mortgages had not been successful).

The proponents' main argument was that inflation-indexed bonds would be cost-effective because investors would be willing to pay up for the inflation insurance these securities offered. In addition, proponents said that the bonds would act as a "sleeping policeman," because Treasury's interest costs would soar on these securities if inflation got out of control. The bonds also could motivate the private market to come up with more inflation-indexed products, such as inflation adjusted annuities (though some, but not all, opponents viewed this as a drawback because it would reduce the size of the anti-inflation constituency.)  In addition, the bonds would provide both the market and policymakers information about inflation expectations which would lead to better decisions.

During the initial years of TIPS issuance, it was clear that the securities had not been cost-effective up to that point. There was always hope that as the market grew and became more liquid, the pricing Treasury received at its auctions would improve.

At this point, though, getting rid of TIPS would be difficult for Treasury to do. A surprise announcement, such as Peter Fisher's announcement of stopping the issuance of 30-year bonds, would not be good policy. Moreover, the Treasury has made numerous statements confirming its commitment to TIPS, and any sudden reversal of policy would be viewed as breaking faith with the market. For example, the sponsors and investors in TIPS mutual funds would be very unhappy if these securities were no longer issued.

While a gradual reduction of TIPS issuance is a possible policy course, I think that Treasury career staff would be hesitant to recommend major changes to the TIPS program on their own initiative, given what a hot potato this subject has been. In any case, I do not know if they agree with the UCLA authors that the program is currently an expensive form of financing. Any decision to review possible major changes in TIPS issuance would have to come from the political appointees. Even if they were inclined to reduce substantially or eliminate TIPS issuance, I think most political appointees would be hesitant to face the criticism that would be hurled at them on this particular issue.

If the authors of the NBER article are correct that TIPS continue to be expensive, there are reasons why Treasury is likely to continue with the program. What the authors do not discuss but is an interesting question is how TIPS will fare if the U.S. enters a long period where inflation is negligible. At the moment, even though there are deflation fears, there is also a concern about he eventual reemergence of inflation. No one knows if the fear of future inflation will lessen, but, if it does, that would certainly impact the TIPS market.

The Maturity Structure of the Public Debt

Over the decades there has been a debate about the maturity structure of U.S. Treasury debt. At one time, not only was there a debt limit but also a limit on the amount of bonds Treasury could issue with an interest rate greater than 4 percent. Bonds are similar to notes but with longer maturities. Currently, the dividing line is 10 years; it has in the past been shorter. When Treasury was given room in the late 70s and 80s to issue more bonds without regard to the 4% ceiling, Treasury officials took great pride in growing the market for 30-year bonds and were distressed during the Reagan Administration when some political appointees wanted to halt this progress by shortening the maturity of the public debt.

This did not happen during the Reagan Administration, but in the latter part of the Clinton Administration the issuance of 30-year bonds was reduced, and then it was eliminated for a time during the George W. Bush Administration.

Now Treasury has reversed course. In a letter to the Wall Street Journal published on September 18, Assistant Secretary Mary J. Miller proudly states: "We have explicitly pursued a strategy of reducing reliance on short-term debt. Over this period, the average maturity of the debt has extended at the fastest pace in history—from 49 months to more than 58 months today."

There is no easy answer as to the proper maturity of the public debt, and, after hearing and sometimes participating in arguments about this over many years, I have come to the conclusion that it may not matter that much as long as one does not follow extreme policies. I think, thought, that it is good policy to issue 30-year bonds, since different maturity sectors attract different investors, and Treasury needs as many investors as it can get. Also, it is useful for the economy to have a long-term benchmark interest rate.

I should note that the arguments about the maturity structure often focused on the average maturity of the public debt, which masked how sensitive interest costs are to short-term interest rates. Miller, in her letter, states that 55 percent of the public debt matures with three years. It is not clear whether she is referring to the total public debt, that held outside of government accounts, or that held outside of government accounts and the Federal Reserve system. But no matter. A change in interest rates will impact the budget fairly quickly.

In the Bush Administration, two arguments were used to justify the elimination of the 30-year bond. The first argument, at the beginning, was that the budget was in surplus and we did not need to issue long-term debt. There was, unbelievable as it may sound now, a concern at the end of the Clinton Administration and the beginning of the Bush Administration that the surpluses would continue for such a long-time that the Fed would have to look to other securities with which to conduct open market operations. (I remember thinking at the time how misplaced this concern was; budget surpluses would not continue because they were politically unsustainable and a recession, which at some point would happen, would cause it to go away. The Congress would either spend it or enact tax cuts, probably both. This in fact did happen, along with expenditures for wars in Iraq and Afghanistan that I did not foresee.)

It soon became clear in the Bush Administration that the budget surplus rationale for eliminating the 30-year bond was not valid. The argument then shifted to the shape of the yield curve; since it is usually positively sloped (that is, long-term yields are higher than short-term yields), the Treasury could over time save money by issuing only short-term debt. Note that this argument pushed to the extreme would mean that Treasury should only issue bills, though no one advocated that.

In the event, it was Under Secretary Peter Fisher who made the decision to eliminate the 30-year bond and it was reversed after he left, though not immediately. As I recall, the Treasury made some convoluted and unconvincing arguments that this was not a change in policy, but of course it was.

A flaw in the argument that Treasury could save money over the long-term by issuing mainly short-term debt was revealed by this episode. Political appointees are at Treasury for the short-term, and cannot stop their decisions from being reversed. (Of course, some decisions are easier to reverse than others.)

The current repudiation of the shortening strategy begun in the Clinton Administration and pursued with a vengeance at the beginning of the Bush Administration is striking. Treasury is probably right to pursue the current policy.

I am of the school that says that Treasury debt management should normally be very boring except to traders. The Treasury is too big to try to beat the market consistently. As one Assistant Secretary in the George H.W. Bush Administration remarked, it 's tough for an elephant to dance.

Simon Johnson and Peter Boone -- "Brady Bonds for the Eurozone"

I was surprised to see that Simon Johnson and Peter Boone are advocating "Brady bonds" for countries such as Ireland and Greece.  Their article on this can be found here, and a useful March 2000 "primer" on Brady Bonds (published by Salomon Smith Barney) is available here.

The reason I am surprised is that these bonds are based on an accounting trick designed to mask what was really going on.  I hope Simon Johnson and Peter Boone are not advocating this because of the accounting.

Brady bonds were named after Treasury Secretary Nicholas Brady, who advocated an exchange of bank loans to developing countries in financial trouble for these bonds.  This program began in the late 1980s and continued into the 90s.  

The  principal of a Brady bond was collateralized by a zero-coupon Treasury bond.  In many cases, the Treasury issued this zero-coupon bond as a non-marketable special issue; in other cases, the zero-coupon collateral was obtained in the market by buying Treasury STRIPS.  (There was an internal dispute early on about the pricing of the non-marketable zero-coupon bond issued to Mexico, which became public and was both the subject of a Congressional hearing and a GAO report.)

Because the principal was collateralized by a Treasury security, the banks could hold these bonds at par on their balance sheets.  However, the value of a long-term bond is more dependent on the periodic interest payments than it is on the principal payment.  This was the accounting trick.  The loans had to be marked down but the bonds would not have to be, even if the payment of interest was subject to significant credit risk.  For the country restructuring its debt, a 20-year or 30-year zero-coupon Treasury could be obtained quite cheaply at the interest rates prevailing at the time.

I am not sure whether this scheme would work now, since accounting standards have evolved to force more mark-to-market valuations, and zero-coupons are of course more expensive for a given maturity currently because of the very low interest rate environment.  I also am skeptical of a policy relying on accounting mirage.

Simon and Boone need to make a better case addressing these points if they want to be convincing in their advocacy of Brady bonds.

Interest Rates for Short-Term Savings -- Money Market Mutual Funds and Bank Accounts

The current low rates of interest are painful for those with cash to invest, and particularly painful for those living off their investments in retirement.

The interest rates obtainable in money market mutual funds is currently pathetic. For example, the year-to-date rate as of September 9 of Vanguard's Prime Money Market fund is 0.04%. Though there has been an outflow, inertia has served to keep many individual invested in the money market funds. Banks, though, are offering much higher, though historically low, rates on various types of savings accounts and CDs. A quick Google search will provide links to online banks offering around 1.3% interest for savings accounts with a transaction limit of six withdrawals per month. Also, the bank accounts are safer than the money market mutual funds, because they benefit from FDIC insurance. The federal government's insurance for money market mutual funds, which was provided for existing accounts during the 2008 crisis was quietly ended.

This rate disparity is reminiscent of the late 70s and 80s, when "disintermediation" was the word bankers hated to hear. The popularity of  money market mutual funds began in the 1970s -- a period during which banks and savings and loans were restricted in the rate of interest they could pay by Regulation Q. These funds essentially helped save the mutual fund industry during a period when individuals were not interested in investing in the stock market. Money flowed out of banks and into money market mutual funds in a period of high and increasing interest rates.

Now, the reverse seems to be happening in this new, low interest rate environment. Banks are providing higher rates than the competition, and, if this persists, money market funds will shrink much more than they already have. Individuals will find the bank CDs and savings accounts attractive, especially since this is now a period where one does not fear looking stupid in avoiding the stock market. For individuals, the bank accounts also look good since these government-backed accounts provide higher rates than Treasury bills. One-year T-bill rates are currently 0.24%, and shorter-term bills have lower rates.

Of course how long banks will be able to offer higher rates depends on their ability to invest this money, such as in new loans, at a profit. Part of what is going on is that some banks are trying to obtain funding that will be cheap over the long term, if not currently, since demand deposits and savings accounts are sticky once established. But if the flow into bank accounts pick up to an extent that the banks cannot profitably use the money, the relative attractiveness of the rates they offer will have to diminish.  

There does not seem to be much written about the macroeconomic effects of this.  I suspect that analysts looking at this are not sure what to make of it, just as economists, in general, are at sea about the likely course of the economy.

Deflation or inflation?  Recession, depression, or slow recovery?  The elaborate economic models of some forecasters are not of much guidance since no one has experienced the current mix of economic factors. Government policymakers cannot rely on models, and  policy will be the result of a combination of judgement and politics. Currently, politics appears to be clouding judgement.

What Next for Monetary and Fiscal Policy?

It is now pretty obvious that government policymakers are in a quandary. The economy is not growing the way they had hoped; criticism abounds as does confusion; and usable policy instruments are in short supply. Alan Blinder, a former vice chairman of the Federal Reserve Board, wrote an interesting op-ed for the August 26 Wall Street Journal on the dwindling options the Fed has to deal with the current situation ("The Fed is Running Low on Ammo", subscription required). He states that there are four additional measures available to the Fed.

1. The Fed could adopt a quantitative easing policy of buying private securities rather than Treasuries. 
2. The FOMC could change its wording to say that its commitment to a near-zero fed funds rate is even longer than the "an extended period," as it now says.
3. The Fed could lower the interest rate the Fed pays on bank reserves. It is currently set at 25 basis points.  Blinder suggest that it could be lowered to below zero -- a minus 25 basis points, in order to induce banks not to hold idle reserves. 
4. Fed bank examiners could ease up on questioning bank loans and indicate "that some modest loan losses are not sinful, but rather a normal part of the lending business."

Blinder concludes: "So that's the menu. The Fed had better study it carefully, for if the economy doesn't perk up, it will soon be time to fire the weak ammunition."

There are obvious problems with these tools. Buying private securities needs to be done carefully to avoid charges of favoritism. Changes in the wording of FOMC statements can have a transitory effect on markets but it is a rather weak tool. Blinder is "dubious that there is much mileage here." A negative rate of interest on reserves or excess reserves is an intriguing idea, but the Fed appears to be leery of what this would do to money markets. Finally, using bank examiners for macroeconomic goals establishes a bad precedent and may not work in any case. (I wrote a post related to this suggestion in February 2009 -- "The Regulators' Dilemma.")

Given the limited ability of the Fed to do much in addition to flooding the economy with money, which may not work and would cause great anxiety in any case, which would not be helpful for either consumer or investor confidence, one presumes that Administration policymakers are considering what fiscal policies they might take. One school of thought is that increased government spending, for example on repairing and improving infrastructure such as water and sewer systems, bridges, roads, and public transportation systems, should be undertaken. According to this school, the current deficit should not be a concern in an economy with unused resources, but the increased spending in the near-term should be coupled with a long-term plan to reduce the budget deficit once the economy recovers. Others argue that tax incentives are a better way to go than than increased government spending.

The fear of deficits and its use in political arguments (by conservatives against increased spending initiatives and by liberals against tax cuts) have appeared to make any changes in fiscal policy for the time being impossible. I do not know if the economy will continue to be weak or deteriorate, but, if the economy does get noticeably worse, the Administration and Congress, regardless of the outcome of the November elections, will face deafening calls to take action. Already, the Tea Party movement, which has no discernible economic prescription to current problems except perhaps to think that reduced taxes and reduces government spending should be the goal, is holding large rallies as the growing economic unease serves to swell its ranks. That must worry politicians, even though it is hard to know how to assuage the Tea Party movement. Most will probably eventually conclude that the best response is to take measures they hope will improve the economy, even if this meets with political criticism from Tea Party activists and others. 

The Administration likely believes that it has no ability to address the current bad economy in any meaningful way before the November elections. They must be hoping that the pessimists are wrong and that the economy will improve, if only slowly. However, if that does not happen and the economy worsens, some sort of fiscal stimulus (by a different name, no doubt) will be enacted. If the Administration and Congress do not do this in response to a bad economy, then U.S. politics has fundamentally changed more than I think it has. 

Some Comments on the FOMC Statement

The FOMC statement on Tuesday indicated that the Fed now thinks the economy is weaker than previously thought. In view of this, the Fed has committed to keeping its balance sheet roughly the same size by reinvesting the proceeds of principal payments of the securities it acquired during the financial crisis in Treasuries, mainly those with a maturities ranging from two to ten years.

Given the uncertainty about the outlook for the economy and prices, it is no surprise that the Fed decided to take this middle course. Those who think the risk of deflation and another recession (or worse) is serious, such as Paul Krugman, argue that the Fed should expand its balance sheet. There is, however, no consensus about this among economists, and some are worried if the Fed acts too aggressively to forestall potential deflation, we will get unacceptable rates of inflation instead. While many commenters on this sound awfully sure of themselves, the fact is that no one really knows what the Fed should do.

The stock market fell significantly on Wednesday, the day after the FOMC announcement. The common explanation is that this was in reaction to the Fed’s more pessimistic outlook on the economy. Well maybe, but I am skeptical of most explanations of daily stock market moves. You can always find some news item to “explain” the move after the fact. No one does a comprehensive survey asking the sellers of securities why they sold or the buyers why they bought on a particular day.  

For anyone paying attention, there was no need for the Fed to verify that the economy was stalling, nor was it any surprise that that the Fed was concerned about it. If the market had gone up, the explanation would likely have been that the Fed was optimistic enough about the economy that it considered it unnecessary to increase the size of its balance sheet at this time. As a thought experiment, one might consider what the likely market reaction would have been if the Fed had decided not to reinvest principal payments or had decided to increase the monetary base by expanding its balance sheet.  It is not so easy before the fact.

As to how the FOMC announcement may affect the Treasury, the Fed’s purchases will affect the maturity structure of marketable Treasury securities held by the public (excluding the Federal Reserve Banks). My guess is that Treasury will not alter its current debt management strategy in light of this, but, at some point, maybe Treasury debt managers need to think about this, since the Fed’s holdings of private securities are quite large.

Also, the Treasury should consider why it is issuing Treasury bills and depositing the proceeds into the supplementary financing program account at the Fed. As of Wednesday, there was almost $200 billion in this Treasury account at the Fed. The reason for this program was to help the Fed reduce the amount of reserves held by the banks at a time when the Fed’s holdings of Treasury securities that it could sell had declined. But with the Fed’s holdings of Treasuries increasing as the principal balance of the private securities it holds decreases, the question arises why this program is still necessary. (I have expressed concerns about this program on this blog.)