Grayscale Investors, the world’s largest digital asset manager, told Bloomberg that they expect pension funds and endowments to fuel their future growth. Grayscale owns 3 percent of all shares of Bitcoin, and most of their $2 billion to $25 billion asset growth over the last year has been from Bitcoin.

Recently, the California Public Employee Retirement System (CalPERS), the nation’s largest public pension system, disclosed that it increased its investment in RIOT Blockchain Inc., a bitcoin mining company, from $49,000 in 2017 to $1.6 million in 2020.

Pension funds like CalPERS typically search for higher investment yields by investing in private equity. But in recent years, returns from private equity have underperformed in comparison to the S&P 500. Analysis of private equity returns (net of fees) has essentially matched the performance of the S&P since 2009.

The reasons for this decline are varied, but this trend can largely be attributed to the fact that private equity is a relatively mature industry in where attractive investments at low cost are hard to come by. The term “alpha” in investing refers to the amount of excess returns generated by excess risk—in essence measuring the value add of an external fund manager. In the case of private equity, alpha during the last decade was close to zero percent,  compared to hedge funds which saw an alpha of negative 1 percent.

As a result of these market trends, institutional investors have been showing an interest in even riskier assets that may produce higher yields. This search has lead public pension systems like Virginia’s Fairfax County Employees and Police Officers Retirement Systems as well as the University of Michigan’s pension plan to invest in Bitcoin and other cryptocurrencies.

While the growth in cryptocurrencies has been stratospheric in recent months, these assets have also seen massive volatility apart from the most recent price drop, with one of the largest price drops in 2018. Bitcoin had its first major peak at $20,000 per share during the end of 2017 but then plunged 75 percent in less than a year. This peak-to-trough decline is comparable to the dot-com bust, which dropped 78 percent from its peak.

The jury is still out on whether Bitcoin can hold water in the long run. Even if Bitcoin isn’t a bubble, it is likely to see a correction in the future with the flood of investors pouring in and prices will likely continue to fluctuate.

In any case, it’s not wise for public pension funds and taxpayers to be exposed to such financial risk. Public pension benefits are constitutionally protected and taxpayers—who would be asked to make up for pension shortfalls—should not be subject to the risks of such volatile investments.

Although current pension investment allocations towards Bitcoin and other crypto assets are small, California’s large increase in crypto shares could spark interest in other states. Pension funds and other asset managers may believe they can time the market and jump in on Bitcoin at the perfect time, but with something like cryptocurrencies, that is much easier said than done.

While the goal of public pension funds trying to improve yields and make up for lost growth in 2020 is admirable, Bitcoin is just too volatile at this point and the significant risks to public pension systems, retirees, and taxpayers far outweigh the benefits. A much better goal for public pension funds would be to lower their investment return assumptions and adjust other expectations to lower market yields.

Update 5/17/2021: CalPERS’s 2020 cryptocurrency investments were made through a passive index fund rather than an active investment. While this does not change the fact that cryptocurrencies are risky investments for pension funds, an investment made through a passive index fund should not be seen as a commitment to a certain asset or asset class. 

The post Should Public Pension Funds Be Investing In Cryptocurrency? appeared first on Reason Foundation.

If shelter-in-place restrictions are lifted quickly and everything gets back to normal immediately, most of these properties would probably be able to continue servicing their mortgages. But, if the U.S. is instead entering a new normal of telecommuting, reduced travel, and increased online shopping, then thousands of office buildings, hotels and malls are at risk of default.

This potential default wave would first expose the folly of poorly structured, over-rated CMBS deals. On the ratings side, the reckoning began on March 20, when Standard and Poor’s downgraded 60 bonds in 15 deals with concentrated retail exposure. In its downgrade announcement S&P stated, “While COVID-19 will likely have an accelerated effect on performance declines for properties with retail exposure, today’s rating actions do not specifically address the outbreak of the virus.” So further ratings “adjustments” may occur once the full retail impact of the coronavirus is understood.

The most dramatic downgrades were meted out to poorly diversified single-asset/single-borrower securities that Joe Pimbley and I highlighted in a previous Wolf Street article, which focused on AAA securities backed by two mortgages on Destiny USA, a mega-mall located in Syracuse, NY. That mall is partially closed until further notice. S&P has now reduced the ratings on these bonds by five notches to A.

S&P dealt an even steeper downgrade to another single borrower deal:  Starwood Retail Property Trust 2014-STAR. This CMBS transaction is backed by mortgages on four shopping malls owned by Starwood Retail Partners. Although geographically diversified, three of the four malls have lost anchor tenants. Starwood wrote down the value of its investment in the four properties by nearly 50 percent last May and payment defaults on the underlying mortgage began in November, suggesting that S&P’s action is not especially timely. S&P made up for its tardiness by downgrading the AAA notes nine notches to BBB-, just one notch above junk. S&P stated:

Although we believe the credit risk on class A has increased, we also believe its senior position in the waterfall somewhat mitigates principal losses and interest shortfalls concerns; and, as a result, we opined that the certificates continue to exhibit the credit characteristics of a low-investment-grade rated security. However, if there are any reported negative changes in property performance beyond what we have already considered, we may re-visit our analysis and adjust the rating as necessary.

Thus, S&P has left the door open to quickly downgrade the security into junk territory as the coronavirus situation evolves. Potential buyers of this security would have been better served by more active monitoring of this deal, which would have resulted in several smaller downgrades, rather than the sudden markdown of a supposedly risk-free security to the precipice of high-yield.

But rating agencies have little incentive to perform the necessary monitoring. They are paid by deal issuers and competitively dumb down credit standards to get issuer business. They also receive pressure from the owners of securities who hate to see downgrades, which may necessitate markdowns or forced sales of instruments in their portfolios (since some asset managers require their holdings to be at or above a certain rating).

To S&P’s credit, they have been faster to recognize their folly than other agencies.  As of March 22, for example, Kroll Bond Rating Agency still rated the Destiny USA senior notes at AAA. And DBRS Morningstar Ratings showed the Starwood 2014 senior notes at AAA. It appears the newer, smaller rating agencies are not yet improving the rating business’s surveillance capabilities.

Although the bond issuers and credit rating agencies could not be expected to predict the coronavirus pandemic, they should not encourage the creation of AAA securities that are so exposed to event risk. A single property is not only vulnerable to pandemics, but to a wide range of events, including terrorist attacks, weather catastrophes, and even the financial distress of anchor tenants such as Macy’s.

But the overrating of poorly diversified CMBS securities continued right up to the start of the coronavirus outbreak. On March 5, Moody’s and DBRS Morningstar both assigned provisional AAA ratings to Class A certificates issued by BX Commercial Mortgage Trust 2020-VIVA. This deal is collateralized by a mortgage on the MGM Grand and Mandalay Bay resorts in Las Vegas. With the Las Vegas strip closed indefinitely, one has to wonder how that will work out.

The post Coronavirus May Deliver the Final Blow to Overrated Commercial Real Estate Deals appeared first on Reason Foundation.

Southern California, which has seen Orange County and San Bernardino go bankrupt in recent decades, should be well versed on the significant risks that come with financial mismanagement. Nevertheless, in November, Los Angeles voters will weigh in on whether or not the city should launch a publicly-owned (read taxpayer-backed) bank.

The public banking idea seems especially relevant now, as the U.S. commemorates the tenth anniversary of the 2008 financial crisis, which was caused in part by banking shenanigans. The crisis put the country into a recession and led to Congress passing a controversial $700 billion federal bailout package for financial institutions. And although private banks ultimately repaid their taxpayer-funded bailouts with interest, public hostility toward the big banks and bailouts are totally understandable.

So if we can’t trust private, for-profit banks, why not give public banking a try? As proponents point out, financial firms charge cities and counties a lot in fees and interest. These costs — over $100 million a year for Los Angeles, they argue, could be avoided entirely by bringing banking functions in-house. Advocates also point to the Bank of North Dakota (BND), which is returning large sums to the state treasury each year. But we should be cautious about the example set by BND, the only public bank in the United States. The city of Los Angeles has five times as many people as North Dakota, and a more diversified economy, meaning that an LA public bank would likely be a more complex and present greater financial risk.

Larger public banks in Germany offer cautionary, and more relevant, tales. After World War II, German states created seven “Landesbanken” — state banks. The largest of the Landesbanken, WestLB, was forced into liquidation by the European Commission in 2012 after a series of losses and trading scandals. The German state of North Rhine-Westphalia had partially divested itself of the problem, but taxpayers were still on the hook for a large portion of the $23 billion in financial losses the dying bank produced.

Another major Landesbank, HSH Nordbank, was sold to a group of private equity firms earlier this year after generating massive losses for two state owners. Reuters reported that Hamburg and Schleswig-Holstein expected to lose between 10.8 billion and 14 billion Euros (or in US dollars — $12.6 to $16.3 billion at recent exchange rates) on the crippled banks.

Finally, there’s the case of Bankgesellschaft Berlin, which triggered a financial crisis in the city of Berlin after reporting a 1.6 billion Euro loss for the year 2000. The bank, which was 57 percent-owned by the local government, fell victim to bad real estate deals, some involving political cronies, and ill-conceived investment funds. In these deals, the well-connected investors enjoyed the potential financials upsides, while the downside risks were borne by the bank’s owners — government and citizens.  The city government turned off its water fountains and put multiple cultural renovation projects on hold to bail out the failing bank.

If the German experience doesn’t give public banking advocates pause, there’s a cautionary tale closer to home. Although Orange County did not have a formal public bank in the 1990s, it was forced into Chapter 9 bankruptcy after mismanaging funds entrusted to it by municipalities. The county treasurer used interest rate swaps to juice returns from 1991 to 1993, but Fed rate hikes in 1994 inflicted massive financial losses on the county.

Similarly, the city of San Bernardino recently spent five years in bankruptcy and is still struggling to pay creditors and get back on track.

If Southern California cities want to divorce themselves from major banks, governments can shift more of their banking business to credit unions and other alternative institutions. Or, it can do more business with places like Amalgamated Bank, a union-owned bank which recently transitioned to being a certified “B” corporation,  which has responsibilities to workers, customers, the community and environment.

While public banks might sound like a way to stick it to big banks, it could spell financial ruin for cities — and taxpayers who will get stuck with the bills.

This column originally ran in The Orange County Register.

The post If Southern California Cities Start Public Banks, Taxpayers Should Prepare for Massive Bailouts appeared first on Reason Foundation.

Californians share responsibility for the US federal debt, which is growing at a rate of $1 trillion per year. The widely-reported national debt, which recently surpassed $21 trillion, includes only a portion of federal obligations.  Unfunded obligations are a growing problem at all levels of government. When unfunded federal employee retirement obligations, Social Security, Medicare, and other long-term costs are added in, the total federal debt burden is closer to $79 trillion — four times the nation’s Gross Domestic Product (GDP).

Similarly, here in California, state and local governments have extensive unfunded pension and retiree health obligations, plus substantial bonded debt. My review of financial disclosures for the 2015 fiscal year revealed $1.3 trillion of obligations across the state — equal to more than 50 percent of economic output.

While the $16 billion worth of bonds on the statewide ballot this November may look like a mere rounding error next to some of these other massive debt numbers, rejecting the initiatives would give California’s voters a chance signal a desire to stop burdening our children and grandchildren with our unpaid bills.

In thinking about what the state wants to borrow money for, it is useful to revisit the promises made by proponents of previous state bond measures. The high-speed rail bond was supposed to match $10 billion of debt with federal and private funds to build a bullet train that would whisk travelers from Los Angeles to San Francisco by 2020. The cost of the project has skyrocketed, no private funds have materialized, and the completion date has been pushed back to at least 2033.

The $3 billion stem cell bond passed in 2004 created the California Institute for Regenerative Medicine, which has yet to produce a single federally-approved therapy. Nor has it produced the large volume of royalty income proponents predicted. Given disappointments like those, voters should take a skeptical view of the potential benefits of this season’s crop of state bond measures.

Proposition 1’s affordable housing wouldn’t put much of a dent in the state’s homeless problem. Nor will Proposition 2, which would allow the state to securitize income tax revenues to build supportive housing for the mentally ill. In 2004, voters approved a one percent surtax on incomes over $1 million to fund mental health services. Prop. 2 would divert some of this mental health funding into debt service for new housing bonds. When the next recession arrives and the millionaire tax revenues decrease, the bond payments could force cuts to mental health services or oblige the state to dip into its general fund.

Proposition 3 is supposedly a water bond measure, but none of the $8.9 billion of Prop. 3 money would fund new dams or desalination – the two best solutions to California’s water supply problem. Much of the proceeds would be spent on wetland habitats, which is why duck hunting interests are donating to the campaign.  Further, Californians already approved a water bond in June, as well as three others between 2006 and 2014. Much of the debt from these measures has yet to be issued.  Voters should wait to see how the previously approved bonds are utilized before authorizing more.

Finally, Proposition 4 would finance new projects at children’s hospitals. While it may be hard for voters to say no to children and hospitals, they should wonder whether these institutions need further taxpayer subsidies. The children’s hospitals that would benefit from these bonds reported combined net income of $276 million in recent filings and combined net assets of $4.6 billion, which suggests the hospitals could afford to finance expansions without asking state voters for an extra $1.5 billion in bond funding.

Proponents of all four of this year’s state bonds have compelling stories for voters — affordable housing, water supply, and children’s hospitals. But, sooner or later, voters and political leaders have to grapple with, and stop adding to, the high levels of federal, state and local debt we are already imposing on future generations.

This column originally ran in The Orange County Register.

The post Voters Should be Leery of Approving More State Borrowing appeared first on Reason Foundation.

Sen. Gillibrand claims this bill would help nearly 35 million underbanked or unbanked Americans, who often lack access to checking, savings accounts, and other retail banking services, and whose only legal access to loans comes in the form of “payday lending,” a segment of the financial industry Sen. Gillibrand wishes to see “wiped out.”

A 2014 Inspector General report saw a USPS banking system as a means to revive its finances. USPS lost $1.3 billion in the first three months of 2018 and has lost well over $50 billion since 2007.

But banking services should be left to the banking industry. In 2014, then-Postmaster General Patrick Donahoe expressed concern over postal banking:

“We don’t know anything about banking. We’d be perfectly interested in talking to someone who would want to use the facility to accept a deposit, but to set a banking system up and lend money to the unbanked. We don’t know anything about that.”

While Sen. Gillibrand’s desire to reach individuals who lack access to banking services is admirable, in practice, a USPS banking regime would likely drive the government agency further into financial straits, place taxpayers at risk, and hurt low-income borrowers.

Japan Tried Postal Banking: USPS Shouldn’t Follow Suit

Japan Post Holdings Co. (JP Holdings)—the holding company of Japan Post Co., Japan Post Bank, and Japan Post Insurance—was partially privatized in 2015. The government of Japan retains 57 percent ownership of JP Holdings, which in turn holds 74 percent of Japan Post Bank (JPB). The formerly state-owned JPB highlights the clear dangers that can arise when a government-owned postal bank has the capacity to make risky loans.

Japan Post’s deposits from savings previously funded public projects through the Ministry of Finance (MOF) under the Fiscal Investment and Loan Program (FILP) until 2001. After 2001, an overhaul expanded a reform from the 1990s that gave Japan’s post office the authority to invest small shares of funds at its own discretion, rather than surrendering the funds to the MOF. By 2012, Japan’s Post Office had no deposits going into FILP and was operating more autonomously with investments from deposits.

Why were JPB’s lending practices problematic? JPB has a record of issuing  below-market-rate loans to insolvent borrowers known as “zombie companies.” The government-backed guarantee from bank deposits that were supporting the zombies produced an ineffective program to maintain employment. Therefore, the usual competitive process where these zombie companies would cut workers and lose market share was halted. The zombies also crowded out profitable companies and dissuaded them from entry and investment into the market.

This would present a challenge for a USPS bank because politicians having access to a government-owned bank could expose it to large-scale corruption. A postal banking regime like the one Sen. Gillibrand’s bill proposes could permit USPS with the same capacity to engage in the type of irresponsible lending that Japan Post Bank exhibited.

Government Lending Has Already Had Dire Consequences

The troubled history of government loaning money to individuals can be observed when examining student loan debt, which experienced more than 1.1 million students defaulting on federal student loans in 2016.

Postal banking loans could be similar to student loans in that postal banking loans would have highly-subsidized interest rates that would hardly get priced according to risk and would be backed by an implicit government guarantee (i.e. taxpayers).

Recovering defaulted loans could be a painful process for postal banking borrowers because government regulations already prevent student loan debt from being discharged in bankruptcy.

Sen. Gillibrand‘s aim to “wipe out” an entire industry of payday lenders and replace it with another lender—the government—could result in placing taxpayers on the hook for millions of dollars should borrowers default on their loans.

Payday lenders already experience a 20 percent default rate on their loans to over 12 million individuals. One would expect at least similar default rates from USPS-granted loans. And when adding a portion of the nearly 35 million underbanked/unbanked individuals that proponents of this bill seek to serve, the amount of defaulted loans could be significantly higher—regardless of how low-interest rates would be—because most payday loans are used for emergencies by those already in financial straits.

A Better Option to Postal Banking

Rather than expanding USPS’ scope with a new non-essential, non-core service to offer consumers, turning the USPS into a publicly-traded corporation through an initial public offering (IPO) would be a better, less risky alternative for improving USPS’s financial situation.

Many countries, including Germany, Britain, the Netherlands, Japan, Belgium, and France, have corporatized their postal systems, or fully- or partially-privatized them. The results demonstrate that privatizing a national postal service is not only possible but can yield positive results.

Under corporatization, the government typically retains a majority stake ownership of the company until it feels comfortable selling off their shares. A corporatized USPS would be free to operate more like a private entity and less like the USPS of today, which remains under strict congressional control. It’s imperative that any privatized USPS not engage in any risky endeavors that mirror Japan’s postal banking arm, precisely the sort of behavior that Sen. Gillibrand’s proposed legislation invites.

Germany’s Deutsche Post has had great success privatizing its postal system. Its strategic partnerships and acquisitions have been a major key to success in postal privatization. Deutsche Post’s 2002 acquisition of DHL—a global express shipping company with 71,000 employees worldwide—gave it access to an international network. It also acquired UK Mail in 2016 and further expanded their European cross-border parcel network. Also, in 2016, DFS Deutsche Flugsicherung, Deutsche Telekom,  DP DHL, and RWTH Aachen University launched a joint research project with drones.

USPS currently doesn’t have the financial capacity to engage in such acquisitions and partnerships due to the many constraints Congress has placed on it, along with its struggle to innovate and adapt to changing times. However, a publicly traded USPS with less government interference—that had a responsibility to seek profits for itself and other shareholders—could seek access to equity markets for capital investment, which would help them obtain the necessary financial capital to innovate.

The optimal privatization path would be to transform USPS into a publicly-traded company to allow private investment while opening its first-class letter delivery monopoly up to competition. Given the political difficulties of turning the USPS to a private company, to limit opposition the government could retain a majority stake in the new company to ensure the universal service obligation is still fulfilled.  When politically palatable, the private USPS entity could enlarge its capital base by selling off shares from the government’s majority stake to private investors, gradually making government a smaller, minority shareholder.

USPS has government-created privileges such as cheap loans from the Treasury at highly-subsidized interest rates, which would give it an unfair advantage over its potential banking competitors, payday lenders. Undermining the payday lending industry that has priced in credit risk would distort the true cost of loaning money and individuals defaulting on their loans would further threaten taxpayers to compensate for those losses.

Despite government-created privileges, the USPS still loses hundreds of millions of dollars annually. Their financial challenges derive largely from a declining first-class mail volume—their main source of revenue—from a high of 103.7 billion pieces in 2001 to 58.7 billion pieces in 2017, a 43 percent drop.

Instead of a postal banking regime that would threaten taxpayers, while leaving the door open for massive corruption and irresponsible lending, USPS should consider postal privatization. International postal privatization demonstrates the levels of success that can be achieved, and USPS could pursue that option instead of perilous endeavors for which the USPS admits it has no capacity to undertake. As stated by former Postmaster General Patrick Donahoe, “we don’t know anything about banking” so using USPS to “set a banking system up and lend money to the unbanked” could end up doing more damage to borrowers and taxpayers than good.

The post ‘Postal Banking Act’: Return to Sender appeared first on Reason Foundation.

The flawed Dodd-Frank bill was the legislation that arose from the 2008 financial crash and the ensuing recession. This new banking bill comes at an interesting time for Southern California’s economy. The region’s housing market is hitting record-high prices in many areas, meaning prices are back at, or near, their bubble peaks of 2006 and 2007. “The median home price – or price at the midpoint of all 2017 sales — hit $492,000 in Southern California,” the Orange County Register reported.

The state’s unemployment rate is at its lowest point in decades — 4.3 in California in December 2017, with even lower unemployment numbers in Los Angeles County, 4.2 percent, and Orange County, 2.8 percent.

And, of course, the stock market spent much of the last year booming. In this potentially bubbly economic environment, bond investors are looking to rating agencies to warn of possible trouble ahead. But the big three dominant rating agencies continue to suffer from the same conflicts of interest they had during the last financial meltdown.

Credit rating agencies still rely primarily upon an issuer-pays business model, which means banks seeking to issue debt securities pay the rating agencies to evaluate their bonds. The credit rating agencies have financial incentives to give the bond issuers whatever rating they want. The Dodd-Frank financial reforms were supposed to fix this problem but the issuer-pays model remains in place and the U.S. economy remains vulnerable to systemic credit rating errors.

Similarly, Dodd-Frank identified another problem – government agencies using credit ratings in regulations.  Taking rating assessments from private rating agencies and putting them into government regulations gives the opinions of these for-profit companies significant regulatory power that they can monetize.  Congress should insist that regulators complete, and then maintain, the full separation between ratings and regulations that were called for in Dodd-Frank.

This is also an opportunity to encourage innovation in the credit rating industry. Today it is extremely difficult for new companies to enter the ratings market. The Securities and Exchange Commission has set up rules that protect the entrenched interests of existing rating agencies and make it nearly impossible for new companies to compete in the industry. More competition could spur analytical advancements that the status quo is preventing.  The rating agencies have no need to evolve or improve their quality, but with today’s abundant and inexpensive computing power, new credit rating agencies could quickly gather data, analyze large volumes of securities, and potentially develop innovative ways of evaluating financial risks.

The federal government could further lower the cost of entering the credit rating business by updating its archaic systems and migrating financial filings from PDFs to “machine-readable” data formats. Consumers of financial disclosures, such as rating agencies, would have access to large data sets at little or no cost. This reform could be accomplished by the passage of a financial transparency bill sponsored by Rep. Darrell Issa, R-Vista.

By fully divorcing credit ratings from regulations, and then lowering the cost of entering the credit rating business, Congress could reduce the risk that bad credit ratings pose to the financial system and economy.

Adding new voices to the credit rating industry — ideally, voices freed from the conflicts inherent in the issuer-pays model — would increase the chances that investors receive accurate credit analysis, helping avoid the traps of the opaque, poorly understood, toxic debt securities that hammered the economy and home values in 2007. Hopefully, lawmakers don’t need another global financial crisis to finally fix the credit rating system.

This column first appeared in the Orange County Register

The post As housing and stock markets boom, has Congress learned from the last crash? appeared first on Reason Foundation.

The credit rating business began in the early 20th century when John Moody and his competitors started publishing letter grades in the corporate and municipal bond manuals they marketed to investors. By consolidating copious volumes of financial data and commentary in a single source, early rating agencies provided fixed income investors with a then-unheard-of level of transparency. But while the rating business began as a disruptive fintech innovation (more than 100 years before “fintech” became a word), decades of federal regulation have had the unintended consequence of stymying progress in the field of institutional credit risk analysis. Credit rating agencies are slow to embrace new analytical techniques that would create value for fixed income investors, while often competing for issuer business by lowering their credit standards.

For decades, consumer credit reporting firms have been using computer models to automatically rate individuals on a continuous numeric scale. By contrast, corporate credit rating agencies rely heavily on human analysts and continue to use opaque letter grades. This difference may be attributed to the fact that consumer credit reporting firms are lightly regulated, while the traditional corporate credit ratings business model has been cemented into federal regulations since 1931.

For decades, consumer credit reporting firms have been using computer models to automatically rate individuals on a continuous numeric scale. By contrast, corporate credit rating agencies rely heavily on human analysts and continue to use opaque letter grades.

In the 1930s regulators were seeking a way to determine which companies should be included in or excluded from bank commercial lending portfolios. They decided to use the letter grades in rating manuals for this purpose. In 1975, regulators employed ratings for broker-dealer capital requirements, and by the end of the 20th century had embedded ratings in hundreds of securities, pension, banking, real estate, and insurance regulations. They also created a system for licensing and regulating rating firms, known in regulation as Nationally Recognized Statistical Rating Organizations (NRSROs)—an ironic moniker given the agencies’ limited use of statistical techniques.

Bond issuers and rating agencies realized that ratings had become a device for determining whether many institutional investors could legally purchase particular fixed income securities. Because ratings now provided a regulatory license, they were especially valuable to issuers. Rating agencies monetized this regulatory power by charging issuers for ratings instead of selling them to investors.

Because ratings now provided a regulatory license, they were especially valuable to issuers. Rating agencies monetized this regulatory power by charging issuers for ratings instead of selling them to investors.

The unintended consequence was the phenomenon of “ratings shopping” in which issuers pitted rating agencies against one another to win rating mandates through lower standards. This was exacerbated by a less obvious unintended consequence of regulation, which is that it stunted the growth of alternative credit analysis providers who found it more difficult to sell their services to fixed income investors, given the availability of issuer-paid credit ratings at no out-of-pocket cost. In other words, companies that might have provided more accurate ratings were crowded out by the regulatory privileges created by NRSRO status.

Far from protecting investors, the regulatory privileges given to NRSROs made it more difficult for investors to understand the true risks of bonds, with far-reaching consequences. This became apparent during the great financial crisis when it emerged that from the early 2000s NRSROs had assigned inflated ratings to thousands of Residential Mortgage Backed Securities (RMBS) as well as derivative instruments such as Collateralized Debt Obligations (CDOs). The lenient ratings attracted excessive mortgage finance capital that exacerbated a home price bubble—and a wider asset price bubble. It was the bursting of this bubble that triggered the Great Recession of 2007–2009.

Other notable rating agency failures in the aughts included the investment grade ratings they maintained on Enron and WorldCom until shortly before their respective bankruptcies; AAA ratings for bond insurers, most of whom experienced credit events during the Great Recession; and inflated ratings on aircraft receivable and manufactured housing securitizations.

The 2010 Dodd-Frank Act addressed the credit rating agency issue, but the benefits have been limited. On the positive side, Dodd-Frank mandated the removal of credit ratings from regulations—a process that unfortunately remains incomplete. On the downside, it stiffened NRSRO registration and reporting requirements, increasing the cost of entry for prospective entrants and thus limiting the prospects for new competition and much- needed industry disruption. Even today, three firms continue to dominate the credit rating market.

The Financial CHOICE Act, passed by the House in June 2017, relaxes some Dodd-Frank regulations but leaves most of the regulatory framework in place. If and when the CHOICE Act is taken up in a House-Senate conference, lawmakers should consider further pro-competitive reforms, or, better yet, they should eliminate the system of NRSRO registration and regulation entirely.

If and when the CHOICE Act is taken up in a House-Senate conference, lawmakers should consider further pro-competitive reforms, or, better yet, they should eliminate the system of NRSRO registration and regulation entirely.

 If the regulatory straitjacket was removed, credit analysts would be free to compete with one another on a level playing field. The results would likely be less pro-issuer bias and much greater use of information technology in the assignment and monitoring of credit ratings. The benefit would be a more effective credit rating industry—one better positioned to safeguard the economy against systemic disruptions like those that triggered the Great Recession.

Full Study — Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link

The post Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link appeared first on Reason Foundation.

As of June 30, 2016, KRS and Kentucky’s Teachers’ Retirement System (TRS) each reported annual losses 0.5% and 1%, respectively. These numbers are disconcerting given both plans have a long-term assumed average annual return of 7.5%. The return rates are even more concerning in light of the fact that the benchmarks for KRS and TRS were negative 0.2% and positive 1.5%, respectively, so despite a very low bar, the systems still failed to hit their targets.

The returns for KRS and TRS are a weighted average for returns across several asset classes. For example, on a positive note KRS’s investments in real estate had a positive return of 9.2% as of June 30, 2016. At the same time, TRS’s investments in domestic equities lost 1.8% during the past fiscal year. So in any given year different asset classes will be winners or losers for the pension system’s portfolio, with a total return reflecting the efficacy of a plan’s investment strategy.

Unfortunately, hedge fund investments have consistently been in the loser category for KRS.

Earlier this year, state legislators have roundly criticized one fund, Prisma Capital Partners’ Daniel Boone Fund, which lost KRS 8% of its investment during the 2014-15 fiscal year. And despite this performance — one of the lowest-performing assets in KRS’s portfolio —the KRS board of trustees voted to allocate 5% of assets to the fund earlier this year, up from 3.3% last year.

It’s no mystery why KRS has been investing in hedge funds and other exotic assets over traditional assets like bonds and domestic equity. KRS currently assumes a 7.5% rate of return, an unrealistic assumption for any portfolio made up of safer assets. To (attempt to) meet these assumptions, fund managers opt to invest in assets like hedge funds that offer higher returns, but at substantially higher risk.

In 2010, less than 1% of the KRS portfolio was invested in the hedge fund sector. That has grown to a total of 10% in hedge funds and 10% total in private equity in 2016. Yet between the fiscal years ending 2011 and 2016, the cumulative returns from hedge funds for KRS has been 3.93%.

The Issue is Transparency

However, this is not to say that privately developed investment strategies are inherently problematic. The hedge fund industry has obviously had its share of wild success, as some hedge funds are able to “beat” the market by leaps and bounds. In 2015, the top performing hedge fund, Perceptive Life Sciences, netted a 51.8% return. Other top hedge funds saw returns above 20%.

And having hedge fund managers invest pension assets has worked out for other plans. Since 2010, 50 more state plans have added hedge funds to their portfolio, increasing the total to 282. The average hedge fund allocation has also increased during this period, with systems allocating an average of 9.2% of assets, up from 7.5%.

The issue is whether public sector pension plans should be allocating any assets at all to fund managers where there is a lack of complete transparency.

Because Prisma is a hedge fund, it does not need to publish its investment portfolio. This practice is defended as a way to protect their investments from competitors — and understandably so. But that may very well disqualify hedge funds from being part of the investment strategy used on a pool of assets for which taxpayers are the effective backstop for losses. While Prisma does allow “key decision-makers” to request a private briefing, there isn’t the ability for the general public to scrutinize the investment decisions in the same way that is possible with much of the rest of the portfolio.

The Risk of Alternative Investment Strategies May Not Be Worth It

The reality is that though some hedge funds create a splash with their strong returns, the same isn’t always true for the industry as a whole. According to the 2016 Preqin Global Hedge Fund Report, across the board, hedge funds only netted returns of 2.02%, with many reporting substantial losses.

Thus, there is a certain degree of expertise that a public plan needs when assessing how to allocate assets amongst hedge fund managers and strategies. The risks investment managers at KRS might take with pension plan assets may not be inline with the risk tolerance of the taxpayers backing those assets. But without transparency on the overall investment strategy, it is difficult for taxpayers and voters to hold accountable their elected leaders who appoint the investment managers in the first place.

And unfortunately, not every pension plan has the internal expertise needed to do a good job allocating assets to non-transparent investment strategies.

A Cliffwater LLC report found that two thirds of pension systems that invested in alternatives outperformed a simple 65/35 mix of stock and bond index funds. But KRS and other pensions systems were not so lucky. The report accredits this gap to differences in the capability of different pension systems, stating that certain pension systems “just appear more effective in implementing asset allocation compared to others.”

How is such variance possible? To begin, beating the market is difficult. It requires specialized knowledge that can be challenging for fund managers to acquire. A 2009 study found that only those performing above the 90^th percentile of actively managed hedge funds were able to beat the market through skill. The rest, they found, failed to outperform a large number of randomly simulated hedge funds. The authors considered these to be the “lucky” investors.

Additionally, when trying beat the market, hedge funds can find themselves underperforming or even making losses through investments that don’t pan out. Because most investors rely on news sources the public can access (anything else would be insider trading), their only way to beat the market is to act on information more quickly rather than act on “better” information. This is why many investors themselves include low-cost index funds in their own portfolios. Very often, the additional fees that come from active management simply aren’t worth it.

Diversification is For the Private Sector; Low Risk Stability is For the Public

Proponents of investing in hedge funds argue that increased investment in hedge funds is good for institutional investors like pension funds on the grounds that diversification is an important way to hedge against losses. While portfolio diversification is important, diversification for diversification’s sake is not a sound strategy. Called “di-worse-ification” by investors, shifting investments towards riskier asset classes needlessly exposes funds to more risk — and in particular erroneously exposes taxpayers to unaccounted for risk. The prudent strategy would be to diversify within safer asset classes. It’s wiser for public plans to invest in a variety of equities and bonds across different industries to protect against one firm or sector’s sudden downturn rather than risk some of the portfolio on high variance assets.

Unfortunately, many pension funds still feel pressure to make these risky investments to chase unrealistically high assumed returns. Lowering the assumed rate of return means making other tradeoffs to fully fund the pension system. But moving out of risky assets the Commonwealth has a poor history with is a step in the right direction to address the misfortune that KRS currently faces. Revising assumptions so they better reflect a market where low returns are here to stay minimizes the chance investment in volatile assets leaves KRS, and other systems, worse off than before.

The post Goodbye (and Good Riddance) to Kentucky’s Hedge Fund Investments appeared first on Reason Foundation.

The rise of these new services – with typically lower prices, much better cars and service quality, and the convenience of summoning a ride with the push of a button – should be leading to a more competitive and better market for paid rides, not calls for new regulations. The draft regulations put together by city staff are very restrictive. Uber left Broward County and other cities in response to similar over-regulation, and you have to wonder how that makes citizens better off.

For those of you not familiar with Uber and similar services, here is how they work. Drivers with their own vehicles register to be drivers for one or more of the ride-sharing companies. They get checked out and are put into the system. When they log in on their smart phone that they are available to pick up passengers, the system looks to match them with a customer. Most drivers for these ride-sharing companies drive part-time, logging in to provide rides to make some money.

Customers get the appropriate app on their phones and register as users. When a customer asks for a ride with the smart phone app, the system matches them with a nearby driver and shows the customer the driver’s name, picture and a picture of the car, and the rating other customers have given, as well as what the fare will be. The driver picks up the customer, drops him off, and payment is made automatically from the credit card registered at sign-up. No tipping, no time taken at the curb trying to pay.

Afterward, the driver and passenger are asked to rate each other, and a driver or passenger who gets more than a few bad ratings is banned from using the service.

I use these services a lot as I travel around the nation, especially Uber and Lyft. I find them to be almost without exception better quality, lower price, and quicker, with nicer cars and friendlier drivers than traditional taxis. I’ve taken Uber from Tampa International Airport to my home in Sarasota, and it was significantly less expensive, quicker and more pleasant than a taxi or a shuttle.

But new companies coming in and disrupting a highly regulated market like the taxi market naturally stir up controversy. This year the Legislature considered regulations for these ride-sharing services.

The Senate bill, which sought to treat drivers as fully commercial operators with heavy insurance requirements, passed. The House bill, which sought to regulate many aspects of operations and management of ride-sharing services as well as insurance requirements, and also would have forbidden cities from adding additional regulations, did not pass.

Both state and local moves to regulate ride-sharing services are not driven by widespread problems or market failures. Instead they look at hypothetical future problems and seek to prevent them, often with the lobbying support of taxi companies, which benefit financially by a constraints on competitors.

More important, we already have a market for similar services with taxis, which is heavily regulated, so too often the first response to the rise of these new ride-sharing services is to cram them into the existing regulatory system.

Instead, the response should be to give the market a chance to work. Remove most of the regulations on taxi companies and let them compete with the new ride-sharing services.

The main justification for regulating taxi markets has always been information problems – customers don’t know the quality of a taxi they hail down or call to come pick them up, and if they don’t like the service they have no good way to pass that information on to other potential customers.

But smart phones and ride-sharing companies have solved that problem. By allowing drivers and customers to share information on the quality of each other, it is hard for a bad driver or bad customer to get away with it. The market failure is solved.

I once wrote an academic journal article titled “Do Economists Reach a Conclusion on Taxi Deregulation?” in which I found that the vast majority of economic research on taxi regulations finds no justification for them – that free markets in taxis would work. And Dr. Sam Staley at Florida State University recently completed a study finding that consumers in cities with the most stringent taxi regulations are no better off than consumers in cities with the least taxi regulations.

Restricting taxi competition leads to higher prices for consumers. That is why almost always the prices the new, unregulated, ride-sharing companies charge are lower than taxi fares – they are charging the actual market price. In fact, economic research typically finds that taxi market regulations have a number of pernicious effects on consumers, while benefiting taxi companies handsomely.

Typical taxi regulations limit the number of taxis and create substantial, if not total, barriers to new entry. The result is inevitably too few taxis, with long waits and lousy service for customers. When has less competition ever made consumers better off?

But the proliferation of these ride-sharing services actually increases jobs, especially in the flexible, part-time job market, and creates a wide field of ride options to serve the preferences of consumers.

Taxi regulations stifle innovation. You would think taxi companies would have invented a convenient new way to summon a ride with an app on your phone. But they did not come up with this innovation and are the leading opponents.

Ride-sharing services make it easier for people who don’t own cars to travel throughout the community and enjoy all of Sarasota’s amenities. That is good for young people, visitors and many of the elderly.

These ride-sharing services are the future. Regulating against them in preference of an outdated paradigm will move Sarasota backward. Rather than try to fit ride-sharing into the existing “regulatory compact” between taxi companies and city government, the city should open up the market, deregulate the taxi companies and let consumers choose while drivers compete and innovate.

Adrian Moore is vice president of policy at Reason Foundation. This article originally appeared in the Sarasota Observer.

The post Let Uber and Taxis Compete appeared first on Reason Foundation.

Even a Wall Street Journal article praised these “chariots for hire,” joining a chorus of reports that such micro-transit services go beyond serving tourists and provide transportation that buses and standard taxis don’t. They also provide economic opportunities for entrepreneurs that don’t require special training, and they even provide an exciting green business model.

They are certainly popular on Siesta Key. On almost any night, you can see charming bright and colorful pedicabs and golf cart shuttles hauling quiet couples, rowdy partiers or entire families from the beaches to restaurants and bars and to homes.

As Michael Shay, president of the Siesta Key Association, told The Observer, “We need the pedicabs and golf cart guys.”

But lately there has been discussion of the need to regulate pedicabs and similar services on Siesta Key. Which begs the questions: Why? What we are trying to fix? What market failure is occurring that we need regulations to solve?

The answer appears to be: none.

Siesta Key, and the rest of unincorporated Sarasota County, has had a free market in pedicab and tourist shuttle services for years without mounting complaints or frequent problems or anything to indicate the free market isn’t working just fine.

The calls for regulation concern me because for 20 years I have been an economist working on regulatory issues, including helping design some new ones and helping figure out how to deregulate others. Plus I read a lot of empirical studies on what does and does not work in regulation.

There are significant downsides to regulations – which is why they are normally only considered a good thing when there is a significant problem the market cannot solve. We often are much too quick to regulate markets in response to minor problems because we don’t know about or don’t think about the failures that also occur in regulated markets.

We rarely even consider if regulations improve things compared with the alternative. Pedicabs are a great example.

The city of Sarasota heavily regulates pedicab services, yet there is no evidence that they enjoy a safer pedicab market than Siesta Key or the rest of the county. The utter lack of problems in the laissez-faire free market parts of the county is essentially proof that the regulations in the city of Sarasota don’t benefit the public in any significant way. What is less often considered is how regulations in general can hamper markets and consumer benefits.

Regulations stifle innovation. When entrepreneurs come up with a new idea that doesn’t fit into the regulatory definitions or rules, it is often not possible even to try the new idea to see if it works, or for a new and better idea to replace an outdated one.

The kerfuffle going on these days over ride-sharing companies such as Uber and Lyft is a good example. Ride-sharing apps are enormously popular and a huge innovation to the taxi market that dramatically improves service and reduces costs of getting a ride.

But it wasn’t the regulated taxi companies that came up with the idea. And ride-sharing services don’t fit in current regulations, so all over the country cities and states are trying to cram these new services into old regulatory models or just trying to prevent them from operating at all.

In fact, the ride-sharing apps solve the original problem used to justify regulating taxi markets – customers not having enough information about taxis and drivers and not enough accountability for bad service. But no city I know of is talking about deregulating the market now that the problem has been solved.

Regulations also inevitably limit entry and reduce competition. Even modest requirements and costs to get a license to operate, when added to a market that was free and open and not experiencing problems, pushes some operators out or prevents some new ones from getting into the business.

Pedicabs and golf-cart shuttles are not usually full-time jobs; they are a way to have fun, meet people and make a little money on the side. If it is a hassle, requiring trips to the county offices and fees and waiting for a license to come through, some people just won’t do it.

At the same time, there are stacks of books written about the problem of businesses in regulated industries having too much influence with regulators and using that influence to steer the rules to keep competition out. Those calling for new rules insist they just want to protect the public. But regulations tend to grow.

Once a market is regulated, when new problems occur, no one looks to the market to solve it, but to the regulators, bringing about yet more regulations. And the regulators themselves often get proactive, thinking up potential future problems and creating new rules to prevent what they imagine from coming to pass. It is rare to see a lightly regulated market stay that way.

For the growing Siesta Key pedicab market, putting on the brakes would likely mean less competition, less service, less opportunity for entrepreneurs and less innovation, making it harder for visitors to enjoy all of the island’s amenities and businesses.

It is not as though the existing pedicab and golf cart shuttle companies on Siesta Key don’t have standards. Some do background checks on drivers or check their driving records, require commercial insurance or put extra safety features on their vehicles.

Which suggests a better alternative to new regulations. Rather than fixing what isn’t broken, it would be helpful to try to improve the market for pedicab services.

The Siesta Key Association, or some other interested group, could develop some simple voluntary standards that, if met, earn a pedicab a seal of approval in the form of a highly visible sticker or the like. Then educate visitors and residents encouraging them to make sensible decisions about using pedicabs, like they would any service, and to look for the seal of approval.

This would add valuable new information to the current pedicab market on Siesta Key and help improve and expand the market.

That would be far better than unnecessary new regulations.

Adrian Moore vice president of policy at Reason Foundation. This article originally appeared in the Sarasota Observer.

The post Pedicab Market in Siesta Key, FL Doesn’t Need to Be Regulated appeared first on Reason Foundation.

We all know what happened in 2008. Lehman made some bad bets that caused it to become insolvent and in the subsequent panic, banks stopped lending to one another causing a short-term liquidity crisis. That crisis was quickly solved by governments supplying needed financing and things rapidly returned to normal. Except, of course, that is not at all what happened.

What actually happened is that for at least a decade banks and other finance companies had been leveraging their assets in order to make increasingly risky investments. If all – or even most – of these investments had been directed toward the development of innovative products or production processes, the resultant returns on investment could have paid off the debts. But they didn’t; a significant proportion went toward the construction of houses that were bought by people without the ability to repay the loans.

When the inevitable happened and some people actually stopped paying off their loans, real estate prices began to fall, triggering a decline in the nominal value of mortgage backed securities. Some of the banks and other financial organizations that held these mortgage-backed securities (MBSs) as capital became technically insolvent. But because many MBSs – and related derivatives called collateralized debt obligations – were so complex, it was unclear to counterparties which banks were insolvent and which were not. That is why credit markets seized up.

To “solve” this problem, governments around the world stepped in to bail out banks and other financial organizations that held MBSs or relied on short term credit markets for their working capital. While these actions unfroze the credit markets, it did not solve the underlying problem. In fact, it made the problem worse because it transferred risk from private individuals, who had some incentive to take responsibility, to government officials who had incentives at best to avoid blame. And what did these blame avoiding bureaucrats do? They continued to pump liquidity into the system, first by lowering interest rates and then, when those were at zero, by printing money (euphemistically called “quantitative easing”). None of these actions made the bad debts go away.

Why rehearse this story once again? Because those bad debts are now stalking us once again. But this time it is the governments that are bust. And governments that are bust are in no position to provide any form of bailout – no matter how much economists like Paul Krugman protest to the contrary. So when analysts claim that there is no Lehman type event to justify fears of credit risk, remember that Lehman was merely the most visible sign of an underlying problem.

In the present case, Greece is the most visible sign. Greece is insolvent. And as we are learning to our cost, insolvency cannot be resolved by injections of liquidity. So far, however, fear of a “Lehman type event” has been used to justify injections of liquidity into Greece. But these are effectively transfers from German taxpayers to Greek government workers and pensioners – and have solved nothing. In fact, they have made the problem worse, by delaying the inevitable default and Greece’s departure from the Euro.

So, what is coming down the line? First and foremost, the Greek government will default on more of its debt and will almost certainly exit the Euro. Meanwhile, it looks increasingly likely that governments in Spain, Portugal and Italy will default on some of their debt too. (The alternative of continued bailouts by a collective of European governments merely delays the inevitable and fools nobody.) This will negatively impact the companies that hold substantial quantities of government debt, some of which may become insolvent, with knock-on consequences for all their counterparties. It will likely result in a widespread recession in Europe.

In the meantime, we are beginning to see how a slowing of economic activity in Europe can impact other countries, with Chinese and Indian growth declining. And as growth in those countries slows, so, too, does demand for raw materials from Australia, Brazil and South Africa. Meanwhile, the U.S. could see yields on government bonds rise significantly if the Chinese government substantially reduces its purchases (as exports fall). This has the potential to create a vortex in which the entire global economy slows down. So now you can see that when people say they don’t understand why markets are pricing in a “Lehman type event.” They just don’t understand: a “Lehman type event” is in process right now.

So, what can be done? Let’s go back again and look at how this all came about. In the standard analysis, the financial crisis is blamed on malfeasance by banks. Some of that blame is justified: making a 60:1 leveraged play on the presumption that housing prices will always rise is irresponsible. But that irresponsibility was underpinned by government policies. The U.S. Federal Reserve and its counterparts in Europe and Japan set interest rates too low for too long. Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac bought up over $1 trillion in sub-prime and alt-A mortgages. The interpretation of Basel rules on capital adequacy ratios resulted in MBSs being treated as less risky than the underlying mortgages, resulting in massive levels of regulatory arbitrage – effectively creating trillions of dollars in synthetic credit.

On this analysis, we can see more clearly how the response by governments to the financial crisis – the bailouts and money creation – made the problem so much worse by continuing to effectively subsidize investments in non-productive assets. And we can see also what the solution has to be – at least in the U.S. The Federal government must extract itself from housing finance (the GSEs currently underwrite over 90 percent of new mortgages) and allow prices to adjust according to what buyers, sellers and financiers are willing to accept voluntarily.

The federal government also should end its massive money-creation program, which is distorting private incentives to save and invest, delaying the deleveraging that must come – and is bolstering asset price inflation at the expense of productive investments. Governments at all levels – from the local to the federal – must cut spending dramatically. And governments at all levels must cut regulatory red tape that acts as a massive drag on economic activity.

This combination of stable money (preferably backed by gold or another scarce commodity), lower government spending and less red tape would unleash productive economic forces that would rapidly offset any temporary decline in economic activity resulting from the withdrawal of government largess. It might even enable the U.S. to escape from the vortex.

Julian Morris is Vice President of Research at the Reason Foundation.

The post Europe’s Economic Troubles Have Worldwide Impact appeared first on Reason Foundation.

This journal article aims to present a history on the causes of the financial crisis that first emerged in the U.S. in 2007. Then it will analyze the roots of the current state of the economic crisis in Europe and the U.S. It will also assess the effects of the crises on the European and American economies. Consequently, a range of topics are discussed in the article, some of which have received deeper treatment elsewhere in economic literature, but have not been pieced together to provide a coherent past and present picture of the situation. The article concludes briefly on how this story relates to today’s economic environment and the next steps that need to be taken going forward.

Dr. Murat Yulek is vice dean of THK University in Ankara, Turkey and can be reached at mayulek@thk.edu.tr. Anthony Randazzo is director of economic research for Reason Foundation and can be reached at anthony.randazzo@reason.org. The article was originally published by the journal Insight Turkey in Vol. 14, No. 2.

The post Refining the Story of the Financial Crises in Europe and the USA appeared first on Reason Foundation.

So what’s Congress’ plan to turn things around? Run a public relations campaign, of course. Its most recent effort comes in the form of the Stop Trading on Congressional Knowledge (STOCK) Act – a bill that’s been in the making for six years but recently got a big push after a “60 Minutes” investigation raised serious questions about the success some members of Congress have had buying and selling stocks while in office.

The STOCK Act is supposed to ban members of Congress from insider trading. The trouble is, Congress is already subject to the same insider trading laws that apply to everyone else. The STOCK Act is just a feel-good law aimed at improving Congress’ tattered image. And if anything, the bill creates problematic loopholes by too narrowly focusing congressional insider trading laws on pending legislation, thus excluding information obtained in hearings and meetings. Just as troubling, what should have been the obvious financial targets for the law, such as stock options and real estate holdings, aren’t even covered in the STOCK Act.

STOCK’s current language, as introduced in the House, merely makes it clear that insider trading laws apply to Congress and requires members and their staffs to report financial transactions within 90 days instead of annually. A Senate panel has passed a version requiring lawmakers to disclose their stock trades of more than $1,000 within 30 days.

At a recent Financial Services Committee’s STOCK Act hearing, Rep. Stevan Pearce, New Mexico Republican, asked the Securities and Exchange Commission’s enforcement director, “Would you take this legislation and go to work on members of Congress who have been getting by with things?”

“No. I don’t think that’s the case,” replied Robert Khuzami, the SEC’s chief enforcer.

That’s because the STOCK Act is just theater, not good governance. This bill might make Congress look like it got something done, but it won’t stop many of the trades Congress has been making. To prevent members of Congress and their staffs from cashing in on their positions while in office, a law needs to require them to report all financial transactions in real time, on the date they are made and prevent them from capitalizing on any nonpublic information they receive from any source gathered in the course of their public service.

The proposed STOCK Act has enough loopholes to drive a truck through. A simple fiduciary duty law that covers all financial vehicles and transactions – stocks, real estate, derivatives, etc. – would be more likely to protect taxpayers’ interests. This law would be better able to spot Congress’ dubious financial deals because it includes all avenues by which members are able to use their privileged positions to enrich themselves, and it immediately shares the details of the members’ financial activity.

To give the law some teeth and make members of Congress think twice about using their positions to get rich, the SEC or the Justice Department must commit to forming an independent unit actively monitoring congressional stock activity and prosecuting offenders, which isn’t happening now.

While Congress skates by, consider that Comcast CEO Brian L. Roberts was just fined $500,000 by the Justice Department for failing to report stock purchases. Could it be trusted to levy similar charges against one of its own? Will the government actually police what Congress is doing or will it continue to let the fox guard the henhouse?

For six years, the STOCK Act sat idle, practically unknown by many members of Congress. Now it has more than 220 co-sponsors who don’t seem to be concerned with whether it actually solves any problems. If members want to try to fool the public while continuing their curious financial dealings, this is the bill for them. But if members of Congress are truly intent on preventing their own from trading on their influence and benefiting financially from their positions, the STOCK Act isn’t the answer.

This article first appeared in The Washington Times on December 19, 2011

The post Congress Plays Charades with Insider Trading appeared first on Reason Foundation.

The lender of last resort (LLR) idea was first developed in the 19th century by two British economic writers, Walter Bagehot, who coined the phrase in his book Lombard Street, and Henry Thornton, considered to be the father of the modern central bank.

Essentially, a lender of last resort should be an institution that protects the monetary system from contractions in the face of bank runs and financial panics-i.e., it makes sure there is money to borrow if liquidity freezes without good cause. The supporting thesis is that if a company is healthy, with good collateral to put on the line for a loan, but can’t find a lender because of an abnormal lock-up of money, they shouldn’t be forced to fail. In this instance, a LLR can step in and prevent an unnecessary bankruptcy and “lend freely, but at a penalty rate,” as Bagehot wrote.

On this logic, many have defended the Federal Reserve’s recent lending not as a bailout, but as fulfilling its duties as lender of last resort. The problem with this logic is that the Fed’s emergency lending programs have deviated far from the classical model of the LLR. The Fed did not lend to creditworthy borrowers, it did not ensure good collateral for the loan, and it did not charge an interest rate above the going market rate (a “penalty rate” to avoid banks becoming dependent on the source of funds).

Let’s consider each of these accusations and the evidence.

First, the most important principle for LLRs is that they only lend to solvent companies that would otherwise be able to get a loan from the private sector. If a firm is unsound and failing it will naturally have trouble getting access to credit and go bankrupt. The LLR exists for the times when healthy companies can’t get credit for extraordinary reasons but are otherwise healthy institutions. To highlight how far away from this principle the Fed has ventured, consider the financial institutions that the Federal Reserve has recently lent to:

• American International Group-so full of toxic credit default swap contracts that it couldn’t get a loan at any price and was hours from running out of cash before the Fed stepped in with an initial $85 billion loan. It’s equity has since been diminished to near zero value.
• Bank of America-weighed down by losses from bad mortgage investments on its books so large that it required $94.1 billion in loans and has remained teetering on the edge of technical insolvency ever since.
• Citigroup-facing a $18.72 billion total loss for 2008, it borrowed $99 billion over a six day period in January 2009.
• Morgan Stanley-took $107 billion in Fed loans in September of 2008 and still posted a massive $2.3 billion loss in just the fourth quarter of 2008 alone (10 times the consensus estimate of bank analysts at the time).

The list could go on for pages because the Fed lent to nearly any financial institution it could find. And since no one could convincingly value all those toxic mortgage-backed securities during the height of the crisis (one of the reasons Treasury Secretary Henry Paulson decided to use TARP for equity injections instead of buying the toxic debt from the banks directly), it is hard to see how the Fed could justify determining that all the financial firms it lent to were creditworthy. The Fed knowingly violated the foremost tenet for a lender of last resort.

Bernanke’s letter to Congress says it is misleading for articles to “depict financial institutions receiving liquidity assistance as insolvent.” But since regulators like the Fed get to officially determine technical solvency or insolvency, Bernanke has the power to ignore the numbers and pass a letter of the law test in bailing out the entirety of the financial industry.

Second, while the Fed could have mitigated some of its risk in lending to unsound financial institutions by demanding good collateral, it didn’t. The Fed went ahead and also violated this tenet for lenders of last resort.

Former Richmond Federal Reserve Senior Economist Thomas Humphrey wrote in the summer of 2010 that the collateral the Fed had accepted through its special lending programs was “complex, risky, opaque, hard-to-value, and subject to default.”

He pointed out that banks could even offer the rights to be paid back for loans they’d issued to Fannie Mae and Freddie Mac as quality collateral. That meant that if the bank failed to return the Fed’s loan, the Fed could get those interest and principal payments from the GSEs-but in early 2008 the GSEs were considered by the government as near insolvent. In fact the Treasury Department decided in August 2008 that Fannie and Freddie were so unsound they had to be taken over by the government to avoid bankruptcy (and they’ve now cost taxpayers $182 billion in bailouts, and counting). How could the Fed consider GSE debt to be good collateral?

The reason why the Fed was able to accept risky and worthless collateral is because it set the terms for defining good collateral under its own lending programs. For instance, the framework governing the Term Auction Facility-just one of the many murky, awkwardly named programs the Fed launched as lender of last resort-notes that the local Federal Reserve branch for the institution getting the loan determines the value of any posted collateral. This allowed the Fed to price collateral however it wanted to ensure it could technically provide bailout loans to any firm.

Third, the Fed has charged a near zero penalty rate when conducting its extensive emergency lending operations. The final tenet of lending as last resort is designed to discourage banks from taking advantage of the LLR and to avoid political favoritism in determining the recipients of the loans.

Bernanke’s letter to Congress claimed that, “most of the Federal Reserve’s lending facilities were priced at a penalty over normal market rates so that borrowers had economic incentive to exit the facilities as market conditions normalized.” But consider the Term Auction Facility (TAF).

TAF was designed so that commercial banks could borrow from the Fed anonymously and avoid the negative stigma that came with publicly borrowing from the “discount window” (the Fed’s traditional source of credit for banks). This amounts to a tacit devaluing of truth in the marketplace, favoring asymmetric information that misdirects the use of capital (I’ll leave that discussion for a separate article). Over a 27-month period ending in March of 2010, the Fed lent out $3.8 trillion through TAF. This money was spread out over 4,000 different loans, with terms ranging from 13 days to 85 days, and with most institutions borrowing more than once from the program.

For 85 percent of program, the Fed lent at rates below the “discount window primary rate”-the market measure for what banks would normally borrow. If the Fed were charging a penalty, it would be charging at least the primary rate plus an additional amount.

Contrary to Bernanke’s statement that most were charged a penalty rate, most were actually underpriced loans. The ultimate result was the Federal Reserve lending to unsound institutions, against poor collateral, and with no penalty-i.e., giving money away for free to the Fed’s closest friends.

The Fed effectively put aside any concerns for moral hazard with its actions, and instead focused on short-term aims over long-term negative consequences. The result has been an outrageous carry trade, with some financial institutions taking in virtually free money, buying Treasuries that yield about 3 percent (lending it back to the government that just gave it to them), and banking the difference. Bloomberg estimates that banks have made about $13 billion from this, which those banks have then used to pay large compensation packages.

Lending to everyone, accepting whatever is available as collateral, subsidizing the entire operation, and ensuring that financial players suffer no consequences for their own foolish actions is not the free market at work. When the Occupy Wall Street crowd complains about illicit gains, this is the source of their anger. We have a crony capitalist system and the government is doing everything in its power to avoid changing it.

Anthony Randazzo is director of economic research at the Reason Foundation. This commentary first appeared at Reason.com on December 9, 2011.

The post Trillion Dollar Bailouts Equal Crony Capitalism appeared first on Reason Foundation.

Given this moral and practical failing, it is a shame that envy plays such a large role in the Occupy Wall Street protests spread around the country. And, yet, the Occupy movement does have a point that transcends this negative emotion: the financial industry has grown large on the backs of government handouts, manipulated regulation, and taxpayer bailouts.

While there is no objective size the financial industry should be, it is fair to say it would never have become this large without the crony capitalist system that has masqueraded as a free market. In the process, the financial industry has absorbed resources that could better be used elsewhere while imposing large, systemic risks on the economy. Watching others grow rich from special privilege understandably leads to envy, but from this perspective, the high compensation received by financial industry leaders is merely a symptom of a much larger problem.

Big finance has achieved its present girth on the back of numerous policy decisions – some going back centuries. Many of these policies had the intention of protecting the general public, but often had the unintended consequence of enriching bankers beyond the product of their labor.

For example, central banks often seek to encourage growth by lowering interest rates for small businesses and individuals. But in the process it is mainly large banks that benefit from higher margins, as the Fed provides lendable funds at a steep discount – not all of which is shared with borrowers. Federal policies designed to assist homebuyers also benefit mortgage investors and grant them taxpayer supported guarantees they will get paid (bailing out Fannie Mae and Freddie Mac has already cost $182 billion as a result).

Subsidized mortgages also result in higher home prices – undermining affordability goals. Over the long term, consumers become more leveraged, while financial firms collect more interest and fees.

But special privileges to the financial industry predate discretionary monetary policy and subsidized lending. Indeed, these privileges are so embedded in our system, they never occur to us. Perhaps the most distortionary of these is banking licenses that offer limited liability. Without such licenses, bank owners would have to use their personal assets to redeem deposits if borrowers default. Limited liability reduces the bank owners’ risk to just their initial investment. The large number of state banking licenses granted during the nineteenth century allowed “one-percenters” of that era to profit from borrowing and lending, without worrying about large losses. They could also grow their institutions by making loans to less creditworthy borrowers, thereby creating systemic risk.

This risk was usually shouldered by depositors, who often lost money during bank runs. During the Depression, the federal government solved this problem by creating deposit insurance. FDIC insurance enabled banks to grow even more, and it also freed them to take on even greater risks, since depositors no longer worried about how their funds were being deployed.

As financial institutions have grown and consolidated over the years, some have become so systematically important that they have been deemed too big to fail. These institutions are now effectively eligible for bailouts in which all creditors – and not just small depositors – are made whole while management can either remain in place, or walk away with all their previous compensation plus a severance package to boot.

These protections and hidden subsidies have enabled the financial industry to achieve enormous size and profitability, while placing the overall economy at great risk. Usually, these protections were accompanied by regulations such as capital requirements or size restrictions. These regulations usually failed to achieve their intended results – especially over the long term – because financial institutions are able to wear down the restrictions by lobbying and by hiring away key regulators.

Instead of adding to the quantity of regulation, thereby creating more opportunities for the financial industry to game the system, we should tame the financial beast through greater accountability. One way to do this is to add a 10 percent co-insurance feature to FDIC insurance for deposits above $10,000. Depositors with $11,000 in a failed bank would receive $10,900; while those with a $250,000 balance would get $226,000.

Depositors would not be wiped out in the event of a failure, but they would have an incentive to select banks that are more careful with their money (while the poorest are still fully protected). Banks would then have to compete for depositor business, in part, by demonstrating that they have strong risk management.

Those with exposure above the FDIC limit should take at least a 25 percent haircut through the resolution process in the event of a bank failure. These stakeholders are often large financial institutions, acting as counterparties, who have the skill and resources to more closely monitor the banks with which they deal. This reform would address one of the most disturbing episodes of the financial crisis: Goldman Sachs’ full recovery on CDO insurance contracts that triggered the AIG bailout. Certainly low and middle income taxpayers had better uses for this money than awarding it to the highly compensated financial wizards at Goldman.

Bank managers should also have more skin in the game. If a bank fails or receives a bailout, directors, senior managers and highly compensated employees should have to repay creditors or the government at least a portion of past compensation they received from their failed institutions – particularly compensation tied to performance. Fear of impoverishment would have a substantial impact on the risk appetites for those leading major financial institutions.

Finally, federally subsidized or guaranteed loans should be restricted to the truly needy. Today, mortgages of up to $625,500 can be purchased by Fannie Mae and Freddie Mac on the federal government’s credit card. This subsidy should be limited to homes that are below the median price for a given area. If financial industry players want to originate mortgages to members of the upper middle class, they should be willing to assume the full risk of providing these loans.

Indiscriminately taxing the rich is an envy-driven policy that only marginally addresses Wall Street’s size, profitability and systemic risk. Vindication should always be discarded in favor of an effective reprieve. Policies that require financial industry participants to shoulder more of the risks they create will reduce the burden Wall Street imposes on the general public, will shrink the industry, and will release human talent for higher and better purposes.

Rather than demotivate the next Steve Jobs, or reduce the resources Bill Gates deploys to fight AIDS and malaria, let’s instead focus the Occupiers’ energy on advocating solutions that truly improve the lives of the 99 percent.

This article was originally published at RealClearMarkets on November 22, 2011.

The post How Government Props Up Big Finance appeared first on Reason Foundation.

For instance, Walmart, as the largest retailer in the U.S., naturally welcomes the new legislation, and the estimated $485.2 million it stands to gain annually.

The new regulation was ordered by the so-called Durbin Amendment, a law within the Dodd-Frank Act passed in 2010 with the intent of preventing another financial crisis. Instead of providing a price break to consumers at the check-out as the law intends, the amendment has forced banks to cancel rewards programs and raise various fees. Because the billions banks were getting in revenue were hardly “extra” income but rather used to fund debit card issuance, customer service operations, and security systems for checking accounts, the consumer is now getting hit hard.

Instituting monthly fees on customers making purchases with debit cards-which would be a straightforward way to fund the provision of debit card services-has resulted in public outcry and a substantial outflow of customer deposit accounts forcing financial institutions to change tact and find other sources of revenue. Banks are planning to charge checking account fees for customers who do not meet minimum balance requirements, or who do not exclusively bank online and use online bill pay.

TD Bank has already raised fees on a host of services like wire transfers and money orders, and it has also created a $9 fee charging customers for making more than six withdrawals in a billing period. Some banks are exploring eliminating all overdraft and non-sufficient fund fee reimbursements. Banks may also place a $50 or $100 cap on the amount customers can charge per debit transaction.

Despite whether or not these fees are fair business decisions, they are not necessarily the actions of greedy bankers squeezing what they can from their customers. Even USAA, a part co-operative serving primarily America’s U.S. military personnel, veterans, and U.S. military family members, is cancelling programs as a direct result of the Durbin Amendment costing its banking customers an estimated $84 per year.

The Durbin Amendment will cost customers banking with Bank of America, JPMorgan Chase, and Wells Fargo close to $200 per year depending on the mix of fees they choose to adopt.

Meanwhile, prices are not falling at the check-out as the retail industry would like consumers to believe. The estimated $7 billion in increased revenue for the retail industry will mostly fall in their own pockets.

These unintended consequences of higher fees and costs to the consumer via the Durbin Amendment had been forecasted and forewarned by a wide array of economists, industry experts, and concerned Americans long before the law was implemented. Still, it got pushed through, and now we’re all paying for it.

The Durbin Amendment wasn’t even part of the original Dodd-Frank bill. It was quickly written as an addendum to the Dodd-Frank Act by Senator Dick Durbin and passed into law along with hundreds of other new rules that have not ended too big to fail and still leave taxpayers on the hook for financial industry losses. Big box retailers like Walmart lobbied hard to get this amendment added in the final hour-even though it has nothing to do with the financial crisis nor is it providing any measurable benefit to consumers. Passing a law as part of a bigger piece of legislation, in this case Dodd-Frank, is much easier than passing it on its own. The Durbin Amendment by itself would have been dead-on-arrival, but proponents of the Dodd-Frank Act needed Senator Durbin’s vote on the larger legislation, and so allowed his addition.

On the surface, it may appear confusing as to why legislators would sponsor, push, and ultimately enact legislation that places such a big burden on so many individuals despite early, legitimate, and plentiful warnings. But legislators know they can just divert the blame by villainizing an already demonized banking sector seeking to cover its costs. “Bank of America is trying to find new ways to pad their profits by sticking it to its customers. It’s overt, unfair and I hope their customers have the final say,” Senator Durbin said following the announcement of Bank of America’s $5 debit card fee, which has subsequently been canceled.

Customers may very well leave Bank of America and other banks as a result of new fees, but it is shameful and un-American that it has to be because of legislators who redistribute and transfer money from the pockets of many to the coffers of few.

This article first appeared in Minyanville on November 9, 2011.

The post Consumers to Dick Durbin, Walmart: Thanks for the New Banking Fees! appeared first on Reason Foundation.

We can, however, stop a bailout going on right now: taxpayer money flowing through Fannie Mae and Freddie Mac to mortgage investors to ensure they don’t suffer losses from families defaulting on mortgage payments.

Three years ago, Treasury Secretary Hank Paulson coordinated a SWAT-like invasion of Fannie and Freddie’s corporate offices, taking the government-sponsored enterprises (GSE) into federal control. Since then the Federal Housing Finance Agency has been pulling the GSE’s strings behind the scenes, and the Treasury Department has used them to funnel $169 billion of taxpayer money to mortgage investors.

Since 40 percent of taxes are paid by the top 1 percent, Occupy Wall Street protestors can be satisfied knowing that at least some of the wealth of the elite has been wasted on this bailout-but since a lot of those getting this money are themselves most likely in at least the top 10 percent, that $169 billion bailout ends up flowing right back to them.

But try putting that on a sign.

These mortgage investors had paid fees to Fannie and Freddie to guarantee payment on the mortgage-backed securities they had invested in, but nowhere in their contracts were they promised that the government itself would step in to cover the guarantees if Fannie and Freddie ran out of money. Nevertheless, that is what the government has done-all under the guise of the need to protect the housing market. (If you’re reading this on a generator-powered MacBook Air in Liberty Square, click here for more details on how this all works.)

Yet it turns out that keeping Fannie and Freddie perpetually in federal conservatorship is hurting the housing market.

The future housing market cannot depend on taxpayer guarantees of financial industry investment in mortgages. But right now Fannie Mae and Freddie Mac are keeping alternative housing finance systems from emerging by monopolizing the mortgage market. In fiscal year 2011, Fannie, Freddie, and the Federal Housing Administration bought or guaranteed 95 percent of new mortgages.

Yes, 95 percent. Every one of those mortgages is backed by taxpayer guarantees.

The reason is because Fannie and Freddie charge way below what private mortgage insurers would demand to insure mortgage investment. And that is basically the point, because if they charged the market rate there wouldn’t be a need for Fannie and Freddie. The idea is that more people will invest in mortgages, making it easier to get a mortgage, if investors can get cheaper guarantees. The nature of the GSEs is to create subsidized risk at the expense of taxpayer funded bailouts.

Here is how out of whack the situation is: Fannie and Freddie currently charge around 0.25 percent of what investors make from buying mortgage-backed securities. The Congressional Budget Office suggests that the GSEs should really be charging 4.4 percent.

That may or may not be good material for a wonky sign, but it is a seriously distorted subsidy for the financial industry. It means that instead of collecting $12.5 billion for investor insurance on the GSE’s $5 trillion in mortgage-backed securities, they should have $220 billion. That should inspire some rage among protestors.

The Federal Housing Finance Agency finally hinted last month that it will consider raising the g-fee, but likely no higher than doubling the current rate. Which would mean that the GSEs would still be significantly undercharging the financial industry for a guarantee that the taxpayers will cover their investments.

So what can we do about this? There are lots of proposals for how to dissolve Fannie Mae and Freddie Mac in a responsible way. The best method would be to raise the fee charged for guaranteeing mortgage investments steadily over five years to a level where no one wants to do business with Fannie and Freddie anymore, while at the same time forcing the GSEs to limit their business to smaller and smaller sized mortgages. After all, why should someone buying a $500,000 home need federal financing?

But even if you believe the government should help poor people become homeowners, Fannie Mae and Freddie Mac are a terrible way to do it. Public risk for private profit is not good public policy-which I think is the text on a protestor sign somewhere in lower Manhattan. It is one of the roots of the subprime crisis and subequent financial collapse. At most, subsidies for low-income families should be part of the budget and made transparent for debate-they shouldn’t distort financial behavior and bail out risky investment failures.

So why haven’t we done anything about this yet? Again, Fannie and Freddie were taken over three years ago. Both the Bush and Obama administrations have had an opportunity to address the failure of the GSE model. The Treasury Department even issued a White Paper in February this year arguing we do not need Fannie and Freddie to support the American housing industry.

Yet nothing has happened.

The Democrat-led Congress from 2009-2010 talked a lot about the financial crisis and spent a year debating reforms for Wall Street, but in the end passed the Dodd-Frank Act, which left in place the bailout for mortgage investors and tens of billions flowing from taxpayers to the financial industry. The Republicans have now had almost a year to address the GSE failure through their control of the House of Representatives, but aside from a handful of bills passed out of a House subcommittee this year, Congress has chosen to let Fannie and Freddie continue to subsidize mortgage investment risk with taxpayer funded guarantees.

This failure of leadership should inspire an Occupy Washington movement demanding that Fannie and Freddie be dissolved and taxpayer funded bailouts and guarantees for mortgage investors be stopped. We will not have a housing recovery until the GSEs are out of the way.

The Tea Party movement started with CNBC’s Rick Santelli’s rant about taxpayer funded mortgage modifications for delinquent borrowers. Occupy Wall Street can turn its fury on the same issue and possibly inspire our elected leaders to finally have the courage to end the policies that are keeping the American housing market down.

Anthony Randazzo is director of economic research at the Reason Foundation. This article first appeared at Reason.com.

The post Stop Mortgage Investor Bailouts appeared first on Reason Foundation.

In The Megabanks Mess, Herbert M. Allison, Jr., looks at this structural evolution and tells a story of competition, deregulation, and constant change to market structure that culminated in the current financial industry of huge, highly-diversified institutions. Allison argues that before this evolution took place, competition amongst bankers was “low-key, genteel, and localized.” Because of the fixed nature of many prices and rules, he notes, the need for financiers to expand and “innovate” was unnecessary.

Over the past few years, the deregulation narrative has taken firm root as a leading explanation for what caused the financial crisis. Never mind that the financial industry was one of the most heavily regulated in the decades leading up to the crisis-with more regulations added than taken away in the George W. Bush years. While this irony is lost in the tale of The Megabanks Mess, it is true that there were some big regulations removed in 1980s and 1990s.

Allison argues that as the rules changed, the market structure was modified, and this led to plunging profits for traditional financial products and businesses. Banks and securities firms were forced to find new ways of growing revenues and profits; these came in the form of new financial theories, products, and activities. The modern portfolio theory was developed, including CAPM (capital asset pricing model) and Black-Scholes mathematical modeling. Trading activity mushroomed in swaps, options, futures, FX, commodities, and tailored derivatives. Profits ballooned, and firms flourished.

Such immense growth in size and profits revolutionized the financial industry, changing its focus to short-term gains as opposed to long-term value-previously, the financier’s creed. Allison fails to note that contributing to this shift in mindset was the growing sense within the industry that the new, larger-than-ever financial institutions were becoming too big to fail. The incentive structure to ensure responsible risk management was left behind.

Allison interprets this as greed (meant in a pejorative sense). He writes that it drove short-term minded players into innovations like junk bonds, exotic OTC derivatives, and an increasing amount of cross-selling and creative accounting, whereby, in an effort to increase the amount of fees garnered from transactions, financial firms would sell (1) as many products as possible (2) numerous times (3) to seemingly any buyer (4) with significant concomitant risks being imposed on clients.

Whatever the cause, The Megabanks Mess chronicles well that the outgrowth of market structure changes and innovation was a prolonged boom in financial assets that grew tremendously for almost forty years until the industry was abruptly brought to its knees during the financial crisis.

Allison points to flaws in the megabanks’ business model as root cause of the crisis. He notes the obsession with short-term profit, excessive compensation plans, conflicts of interest with clients, and misaligned pricing structures as direct contributing factors. Though the actors, both junior level and board level, should clearly be faulted, the industry, itself, exerted perverse influence, as well. Allison writes: “Far more useful than ‘greed’ in explaining the bankers’ excessive risk-taking is that they dutifully responded to the industry’s prevailing pressures and incentives, and to stakeholders’ expectations, without stepping back to reflect on the gradual distortion of corporate principles and personal behavior that was almost imperceptible in their day-to-day pursuit of narrow goals.”

This is a fair point, and one that should be worked into the standard free market narrative. Yes, loose monetary policy and federal housing subsidies were key drivers in the financial crisis. But, the catalyst was a financial system that lost its way. The reason it lost its way is still important-those nasty misaligned incentives-but we should understand the way that market actors perform, and how challenging it can be to reject the ebb and flow of the financial industry.

Ideally, The Megabanks Mess would have articulated how this analysis highlights the need to remove particular rules, subsidies, or lack of enforcement in prosecuting fraud. Instead, Allison skips over the root and offers a proposal for transforming megabanks. The way forward, as he puts it, must begin with a return to the industry’s guiding principle: “The clients’ interest comes first.” An outline is put forth containing the necessary steps to achieve this path which suggests breaking-up the banks, adopting client centric business models, changing compensation policies, and empowering shareholders. He also calls for the rewriting and restructuring of the financial regulatory framework stating that the current financial overhaul, the Dodd-Frank Act, is much like the failed regulations of the past in that it is reactive and not preventative.

The goals of more accountability for managers by shareholders, less politically powerful banks engaged in perverse rent seeking or market-manipulating practices, and compensation practices that better align the interests of financial institutions are all good intentions, and Allison’s observations of the financial industry’s transformation over the past forty years offer clear and concise insight into the revolution that led to The Megabanks Mess. But, his solution to the problems these banks present is misguided, unattainable, and a bit naive.

Although well-intentioned, to think that bankers would rather “connect with a mission that makes a difference to others in society as opposed to simply maximizing profit,” and that “shareholders should be able to communicate easily with each other and call special meetings,” is pie-in-the-sky. And, his solution to use the power of the government to dictate changes for shareholders, compensation, and bank size simply perpetuates the system of narrowly-defined rules by a group of supposedly enlightened men who will make every effort to save us, but just lead us right back down the path to destruction through a series of unforeseen and unintended consequences.

The post A Messy Story appeared first on Reason Foundation.

Ms. Elizabeth M. Murphy
Secretary
U.S. Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-1090

Re: Solicitation of Comment to Assist in Study on Assigned Credit Ratings
Release No. 34-64456: File No. 4-62

Ms. Murphy:

The Reason Foundation welcomes the opportunity to comment on the feasibility of the federal government establishing a system in which a public or private utility or self-regulatory organization assigns nationally recognized statistical rating organizations to determine the credit rating of structured products.

Our understanding is that the purpose of such a system would be to eliminate conflicts of interest that compromised structured finance ratings prior to the recession in 2008-2009 and subsequent economic contraction.

We acknowledge that a system with an assigned ratings procedure would eliminate the need for Nationally Recognized Statistical Ratings Organizations (NRSROs) to market their services to issuers, and would prevent issuers from engaging in “ratings shopping,” i.e. selecting the rating agency that has the most lax standards for the securities it issues. Unfortunately, the assigned ratings approach would have to overcome a number of potential problems. Among these are:

(1) Conflicts of interest at the assignment organization. If this organization employs junior analysts who aspire to work at a high paying investment bank, it will have the same problem that has historically affected ratings analysts: employees would have a motive to build good relationships with issuers who may one day become their employers. At the assignment organization, analysts could further their careers by assigning a more lenient agency to the issuer’s deal.

(2) Issuers and investors being deprived of the ability to choose the highest quality rating firm, and depriving rating agencies of the motivation to improve their quality. While some issuers may simply want the highest rating, some may wish to attract sophisticated investors by obtaining the rating of an agency that has established a reputation for expertise and quality in rating a certain asset class. Rating agencies can and do compete with one another by publishing rating methodology papers that they hope will impress the community with their analytical excellence. Assigned ratings could remove incentives to compete in this manner, and could thus result in worse rating methodologies. If a firm obtains no competitive benefit from publishing a more analytically robust methodology, it may stop making the investment in research to improve its methodologies.

(3) First Amendment concerns. In the past, credit ratings have been successfully defended as opinions meriting free speech protections. The government cannot decide which newspapers, broadcasters or bloggers cover a particular political issue, nor can it create an organization that would do so. Likewise, government intervention into the selection of who can or cannot render an opinion about the creditworthiness of assets could attract litigation on First Amendment grounds. This issue is especially relevant in light of recent criticism of Standard & Poor’s decision to downgrade the U.S. sovereign credit rating. Government actions that penalize or appear to penalize rating agencies for stating their views of U.S. creditworthiness could hamper the free flow of opinions in investment markets and thus the ability of investors to make fully informed decisions.

While we have concerns about the assigned ratings approach, we agree that rating agency performance is a legitimate issue. We believe that alternative mechanisms are available to regulators to improve ratings quality.

Specifically, we advocate lowering barriers to entry into the structured finance security assessment market. If the costs of complying with regulations and accessing required data are minimized, more firms and individuals could cost-effectively serve investors directly, using a subscriber-paid or advertiser-based revenue model. A number of organizations independent of rating agencies have or could rapidly develop expertise needed to assess individual deals. These organizations include Corelogic, Intex Solutions, Lewtan, PF2 Securities Evaluations and Andrew Davidson and Company. New entrants, potentially employing open source models and/or crowdsourcing of insights using Wiki technologies could also enter the fray.

Ideas already under consideration by the SEC promise to lower the cost of entry for these potential competitors. Requiring issuers to provide a standardized loan level data set and a cashflow waterfall program, as envisaged under Proposed Rule 33-9117, would make it easier for non-NRSRO analytical firms to assess deals coming to market as long as these inputs are made publicly available several business days prior to deals being marketed.

Corporate securities markets provide an excellent analogy. Because data for publicly listed firms is universally available via EDGAR, investors have access to a plethora of opinions regarding stocks and bonds. If data for structured finance securities were also widely available, investors would have access to a wider range of opinions.

In a perfect world, we would advocate the NRSRO system be completely phased out. In the context of this study by the SEC, however, we argue that NRSRO regulations should be carefully vetted to ensure that they do not restrict the activities of or impose compliance costs on firms that rate structured finance instruments unless they receive compensation from issuers. If it is clear to existing and prospective firms that they can issue opinions-even in the form of letter ratings-without regulatory barriers, they would have a strong incentive to do so.

While the presence of additional voices may help investors avoid deals with inferior collateral or disadvantageous structures, it does not address the implications for bank capital adequacy. To the extent that new Federal Reserve regulations still permit the use of NRSRO ratings for capital calculations, overly lenient ratings produced by issuer-paid NRSROs could still threaten bank solvency.

One alternative available to the regulatory community with the empowerment of non-NRSRO participants would be a procedure for third party rating challenges. Under such a system, an independent credit assessment firm could submit a statement to the Federal Reserve challenging the rating assigned by an NRSRO. If the Federal Reserve determined that the challenge had merit, it could ask the NRSRO to respond and potentially hold a public hearing to determine the validity of the challenge. If the Federal Reserve determined that the rating was flawed, the affected securities would attract a maximum capital charge until the rating agency issued a rating supported by the challenger or another rating agency selected by the issuer published a rating.

Non-NRSRO assessment firms could establish or burnish their reputations through successful challenges while NRSROs would have an incentive to properly rate deals and thus avoid the embarrassment of seeing their ratings dismissed.

In summary, an assigned ratings system is a well-intentioned solution to the very real problem of ratings quality. However, it is also a highly engineered solution that is thus vulnerable to unintended consequences. We believe that regulators can address this problem at lower cost and with greater confidence by fostering greater competition to incumbent rating agencies.

Sincerely,

Anthony Randazzo
Director of Economic Research

Contact at: (202) 986-0916 or anthony.randazzo@reason.org

The post Letter to SEC Regarding Assigned Ratings appeared first on Reason Foundation.

Early in August, Fannie Mae (read: taxpayers) agreed to buy the mortgage servicing rights (MSRs) of a portfolio of 400,000 loans with an unpaid principal balance of $73 billion from Bank of America. In exchange for these rights to collect payments from homeowners in this portfolio, Bank of America reportedly received “more than $500 million.”

Strangely, the actual purchase price is unknown. So, too, are the contents of the mortgage portfolio, because neither Fannie Mae, its regulator the Federal Housing Finance Agency, nor the selling bank itself is talking.

Whatever the quality of the MSRs, though, Fannie Mae stands to lose a bundle if President Obama’s national refinance program, proposed officially in his jobs speech last week, is pushed forward by the White House and Treasury. Anything that causes borrowers to refinance or prepay mortgages causes the value of MSRs to decline. A revamp of the Home Affordable Refinance Program-which has so far been a total failure-to streamline reducing interest rates would significantly reduce the value of the recently purchased MSRs overtime and possibly lead to serious losses beyond just delinquencies.

Of course, discussion of a more streamlined refinance program has been on the table for months now. Fannie Mae and its regulator, the Federal Housing Finance Agency, knew about this possibility and went ahead with the deal anyway. Considering the lack of transparency and the possibility for millions in losses for Fannie (i.e., taxpayers) on this deal, the transaction is more than a little suspicious.

At least five or six private financial institutions were given access by Bank of America to analyze the mortgage portfolio and perform due diligence before potentially bidding on the MSRs. However, Bank of America didn’t wait for even a single competing bid. Perhaps Bank of America decided that Fannie Mae’s offer was far above anything it could get from the private sector. Or even worse, perhaps Bank of America knew the delinquency risks in the portfolio were so high that no private actor would want to consider acquiring such a toxic asset.

If either of these cases turned out to be true, the Fannie Mae offer amounts to nothing less than a bailout. And if the government did overpay for the MSRs, the only possible reason is that the Treasury wanted to infuse Bank of America with cash to keep it stable.

Given Bank of America’s recent struggles-its stock has fallen 55 percent from the beginning of 2011 to its lowest point last month-it has had a not-so-clandestine need for capital and confidence. Warren Buffett’s $5 billion capital injection to this end was a much-discussed event in August. The Treasury Department’s $500 million-plus capital injection via Fannie Mae two weeks before the Oracle of Omaha got back in the bank saving game was not.

The secrecy is a problem, particular given the absurdity of Fannie Mae-which itself needed a $5.1 billion bailout just two months ago-bringing more liabilities onto its balance sheet.

Mortgage servicing rights can be particularly challenging to assign a value, particularly during volatile interest rate environments. And without a liquid secondary market for MSRs, each portfolio must be valued independently. But since the characteristics of the loan pool that Fannie Mae purchased are unknown to the public, it is impossible to assign a value to the mortgage servicing rights, and to know whether $500 million is a fair price.

However, there are a few things we do know that would suggest the taxpayers are yet again getting a raw deal.

Earlier this year Bank of America was forced to buy back $2.5 billion in misrepresented toxic mortgages from Fannie Mae. Who knows how many of those might be underlying the servicing rights just sold to taxpayer supported Fannie Mae?

Even though Bank of America estimates the pool of loans has a 13 percent delinquency rate, many outside analysts believe the default rate on the mortgages that underlie the MSRs could be as much as double that. One financial institution that reviewed a portfolio of Bank of America MSRs, which looked suspiciously similar to what Fannie Mae purchased, estimated the loans had a delinquency rate of 25 percent.

Of course, it is possible that this is just bad housing policy and a lack of transparency. But even if it turns out that the portfolio’s risks are low, and the MSRs turn a nice profit for Fannie Mae, there remains a question: Why are the taxpayers outbidding the private sector for mortgage servicing rights? If this truly is a profitable asset, then a healthy bank could benefit both its shareholder and the economy by using the cash flow to increase loans to businesses and individuals. Is that not what the White House wants?

Adding to the confusion of this bizarre story, FHFA recently filed lawsuit against Bank of America and 16 other banks for mortgage-related fraud. Why bail out a bank only to turn around and sue it? Imagine the scandalous possibility of Bank of America settling for $500 million in this new legal drama.

Given all the condemnation of bailing out banks, you would think the Democrats, who blame the financial crisis on Wall Street, would be outraged over the idea that another big financial institution receiving a cash infusion. We should at least see the Republicans and Tea Party wanting to get to the bottom of this suspicious purchase. And it is especially urgent with a streamlined refinance program in the wings that might only be stopped with evidence that it will hurt the taxpayers more than help them. With Congress back from their August recess, hopefully someone will stand up to discover exactly what Fannie Mae purchased, and whether Bank of America got yet another backdoor bailout.

This commentary was originally published in Minyanville, on September 13, 2011.

The post Did Fannie Mae Bail Out Bank of America? appeared first on Reason Foundation.