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OpenMarket: Banking and Finance

  • Ignoring the Government's Role in the Financial Crisis, Five Years Later

    September 19, 2013 11:27 AM

    When it comes to reporting on the 2008 financial crisis, many journalists are experts at ignoring the elephant in the room: the government's role in spawning the crisis through perverse mandates and incentives. Peter Wallison, who predicted years earlier that mortgage giants Fannie Mae and Freddie Mac would run into trouble, highlights this in The Wall Street Journal. As he observes, on "the fifth anniversary of the Lehman Brothers collapse, the media have been full of analyses about what happened in those fateful days." But "any discussion of the government's central role in the disaster is neatly avoided. This historical airbrushing is something of a feat, given the facts."

    As he points out, "At the time of Lehman's failure, half of all mortgages in the U.S.—28 million loans—were subprime or otherwise risky and low-quality. Of these, 74% were on the books of government agencies, principally the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac." But the media barely mentions this, as if "the vast majority of the subprime mortgages that the" government-sponsored mortgage giants "bought didn't exist." For example, they ignore the key role of the federal Department of Housing and Urban Development in causing the mortgage crisis:

    In 1992, Congress adopted the ironically named Federal Housing Enterprises Financial Safety and Soundness Act, also known as the GSE Act, giving HUD the authority to administer the legislation's affordable housing goals. The law required Fannie Mae and Freddie Mac, when they acquired mortgages from lenders, to meet a quota of loans to borrowers who were at or below the median income where they lived. At first, the quota was 30%, but HUD was authorized to raise the quota and over time it did, eventually requiring a quota of 56%. In those heady days, HUD was pleased with its work.

    In 2000, for example, when then-HUD Secretary Andrew Cuomo was raising the quota to 50%, the agency actually sounded boastful about its role. Describing the gains in homeownership that had been made by low- and moderate-income families, HUD noted: "most industry observers believe that one factor behind these gains has been improved performance of Fannie Mae and Freddie Mac under HUD's affordable lending goals. HUD's recent increases in the goals for 2001-03 will encourage the GSEs to further step up their support for affordable housing." Credit scores or down payments were not relevant; only income and minority status would satisfy the goals.

    HUD was still at it in 2004, stating that "Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market . . . rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market, more borrowers will benefit from the advantages that greater stability and standardization create."

    That statement is all you need to understand why, in 2008, 74% of the subprime mortgages outstanding in the U.S. financial system were on the books of government agencies, particularly Fannie and Freddie.

    But then Lehman folded, and suddenly the government [changed its tune]. Instead, in 2010, the new HUD secretary, Shawn Donovan, told the House Financial Services Committee: "Seeing their market share decline [between 2004 and 2006] as a result of a change of demand, the GSEs made the decision to widen their focus from safer prime loans and begin chasing the non-prime market, loosening longstanding underwriting and risk management standards along the way."

  • New Estimate: Public Pensions Underfunded by $4.1 Trillion

    September 4, 2013 12:08 PM

    One of the challenges in addressing the underfunding of public pensions is determining how big the funding gaps are. Estimates vary because of disagreement over accounting methods. State pension actuaries calculate pension plans' future funding using discount rates based on high rates of expected returns on investments. State officials have an incentive to engage in this kind of fudging because higher expected returns tomorrow mean lower contributions into the pension funds today.

    This has resulted in states low-balling their future pension obligations. Now a new State Budget Solutions (SBS) report goes some way toward clarifying the picture. The report, by SBS' Cory Eucalitto, estimates the nation's state-level defined benefit pension plans to be underfunded by $4.1 trillion, with a funding ratio of only 39 percent -- well below the 73 percent shown through official reporting.

    The SBS report arrived at this estimate by focusing not on expected investment returns, but on the fixed nature of the liability itself:

    Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.

    Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.

  • MoveOn admits: "[I]f younger, healthier people don't participate, then costs will skyrocket and Obamacare will fail."

    August 30, 2013 1:14 PM yesterday sent me an appeal asking for $5 to help fund a $250,000 social media campaign supporting ObamaCare targeted to reach young adults. Here’s why they need my five bucks:

     [R]ight-wing groups have launched a multi-million-dollar campaign to torpedo Obamacare before it even gets started. Their plan: Mislead young people about how the law works so they get scared and don't enroll. The problem is that it really could work because if younger, healthier people don't participate, then costs will skyrocket and Obamacare will fail. [Emphasis in original] footnotes a Washington Post article, which explains that last sentence. From the Post Wonkblog article by Sarah Kliff: “Young adults tend to have lower medical bills, which would hold down premiums for the entire insurance market. If only the sick and elderly sign up, health costs would skyrocket.”

    So, as MoveOn itself acknowledges, ObamaCare is based on using insurance premiums from younger, healthier people to subsidize health care for older, sicker people. Yet, that is exactly the correct information free market and conservative groups opposed to ObamaCare are trying to get to young folks, so that they understand the racket they are being cajoled to join.

    So then what does the “multi-million dollar right-wing misinformation campaign” aimed at young adults entail? It seems that the purpose of’s social media campaign is to keep the wool pulled over young people’s eyes to protect them from the painful reality that ObamaCare is a con game designed to fleece them. Otherwise, why would they sign up for it?

  • Detroit's Pension Fight: Coming to a City Near You?

    August 21, 2013 1:04 PM

    The bankruptcy of Detroit is an unusual event, but its uniqueness lies mainly in its severity. Municipal governments across the nation are struggling to bring their own finances under control, and for many of them, unfunded pension obligations are a huge driver of deficits. If other municipalities want to avoid a similar fate (even if in milder form), they first need to get a handle on the size of the problem.

    The good news is that this is possible. The bad news is that efforts to clarify the pension obligations picture will meet stiff resistance from government employee unions. Yet, the union can only kick against fiscal reality for so long.

    In Detroit, a major point of dispute between public pension funds and the city's state-appointed emergency manager is just how large is the pension gap -- specifically, how it is calculated. Pension officials have argued that they are adequately funded, but those claims appear based on overly optimistic projections of future investment returns.

    In July, emergency manager Kevyn Orr argued that the city's pensions face a shortfall of at least $3.5 billion -- five times the figure of previous estimates, according to The Wall Street Journal. But the shortfall is likely much greater.

  • ALEC Puts Forth Ideas for State Pension Reform

    August 16, 2013 12:32 PM

    Public awareness of the scope of the state public pension crisis seems to be growing every day. That's a welcome development, in that it has led to state officials to look for ways to reform their underfunded pension systems. The question they face is: How?

    For ideas for reform, they should look to a new report by former Utah state Senator Dan Liljenquist, who led his state's wide-ranging and successful pension reform. The report, published this week by the American Legislative Exchange Council (ALEC), puts forth ideas for reform based on some basic principles. First, all new employees should join a defined contribution (DC) system. Second, payments that are due under state's current pension systems must be paid and reasonable adjustments to current benefits should be made, as courts allow.

    For specific reforms, the study offers three basic options: 1) defined contribution plans, such as 401(k) plans; 2) cash balance (CB) plans, which have aspects of both defined benefit (DB) and defined contribution plans; and 3) hybrid plans, in which the employer makes a fixed contribution, as in a defined contribution plan, and employees have the option of joining with other employees to create a defined benefit option.

  • Federal Income-Based Repayment Plan Encourages Skyrocketing Law School Tuition

    August 13, 2013 10:17 AM

    A recent item in The Washington Post explains "how Georgetown Law gets Uncle Sam to pay its students’ bills," averaging $158,888 over three years, taking advantage of perverse incentives in a federal student-loan program. A federal income-based repayment plan forgives the student loan debt of law students who go to work for the government or a "public interest" law firm 10 years after they graduate, as long as they pay a small percentage of their income in the first ten years after graduation towards paying off part of their student loans. Typically, much of those law students' loans are not paid off by the end of 10 years, and thus are forgiven at taxpayer expense. But Georgetown has figured out a way to take things even further and make taxpayers pick up the entire tab through creative accounting. Under its Loan Repayment Assistance Program, a student can get his law degree "absolutely free of charge," and entirely on the taxpayer's tab. As the Post notes,

    Georgetown has found a very clever way to exploit recent reforms to federal student loan programs so as to greatly reduce the price of law school for students without costing the school anything either. Georgetown Law students who use LRAP use loans from Grad PLUS — the federal government’s student loan program for grad students — to fund the entire cost of going to law school. That includes not only tuition and fees but living expenses like housing and food. Grad PLUS has no upper limit on the amount you can borrow, so there isn’t any constraint on how much you take out.

    Once out of school, the students enroll in an income-based repayment program, in which, if they’re working for a nonprofit, the federal government forgives all loans after 10 years. For that 10-year period, however, the borrower has to pay a share of their income. But under LRAP, Georgetown commits to covering all of those payments.

    Upon first glance, it looks like what’s happening is that Georgetown is paying for part of the cost of law school and the federal government is forgiving the rest. But as Jason Delisle and Alex Holt at the New America Foundation discovered, Georgetown’s cleverer than that. The tuition paid by new students — tuition they’re often paying with federal loans — includes the cost of covering the previous students’ loan payments.

    So Georgetown is ultimately paying its share with money its students borrow from the federal government. The feds are paying back themselves. At no step in the process does Georgetown actually have to pay anything. The feds are picking up the entire bill.

  • Not With Banks, Not With Retailers, But With Freedom

    August 9, 2013 2:55 PM

    In explaining my policy positions, I often find myself pointing out I am neither pro-business nor pro-bank, but pro-market. My Competitive Enterprise Institute colleagues and I might have a position that lines up with a particular industry group on one issue but opposes it on another. The only guide we have is which policies further consumer choice and the free market, and which restrict it.

    Two events that have arisen over the past couple weeks illustrate this principle. Banks and retailers often are at opposite ends of a policy fight, and this is reflected in some high-profile provisions of the 2,500-page Dodd-Frank financial "reform" legislation. I find myself siding with bankers against retailers in one instance and with retailers against bankers in another.

    In one instance, the Durbin Amendment controls prices on debit card processing fees for retailers. On this, I line up with the banks – and credit unions and community banks for that matter.

    Retailers like the increased sales debit and credit cards provide as well as the lessened risk of fraud and theft when compared to cash and checks. But they want the government to put caps on what the banks and credit unions that issue the cards can charge them. The Durbin price controls within Dodd-Frank already have shifted the costs of debit-card processing from big retailers, such as Wal-Mart, to consumers, who have seen free checking virtually disappear from low-balance accounts.

  • Detroit Bankruptcy Focuses Attention on Public Pensions

    July 31, 2013 4:05 PM

    For people watching it from afar, the bankruptcy of Detroit -- the biggest municipal bankruptcy in American history -- may have brought a sense of relief in the fact that they live somewhere else. But it's also brought needed public attention to the state of city finances around the nation. While Detroit is an egregious case of municipal incompetence, corruption, and mismanagement, its problems are not unique.

    In fact, one of the drivers of debt that brought the Motor City to its knees is common among states and cities: defined benefit pension plans, which guarantee payments independently of the level of the plan's funding. This week's cover story in The Economist brings some needed attention to the problem:

    Most public-sector workers can expect a pension linked to their final salary. Only 20% of private-sector workers benefit from such a promise. Companies have almost entirely stopped offering such benefits, because they have proved too expensive. In the public sector, however, the full cost of final-salary pensions has been disguised by iffy accounting.

    Pension accounting is complicated. What is the cost today of a promise to pay a benefit in 2020 or 2030? The states have been allowed to discount that future liability at an annual rate of 7.5%-8% on the assumption that they can earn such returns on their investment portfolios. The higher the discount rate, the lower the liability appears to be and the less the states have to contribute upfront.

    Even when this dubious approach is used, the Centre for Retirement Research (CRR) at Boston College reckons that states’ pensions are 27% underfunded. That adds up to a shortfall of $1 trillion. What is more, they are paying only about four-fifths of their required annual contribution.

  • On Dodd-Frank's 3rd Anniversary, "North Star" is Further Out of Reach

    July 22, 2013 12:15 PM

    Over the weekend, President Obama hailed the third anniversary of the enactment of the Dodd-Frank "financial reform." In his weekly radio address, the president also hailed the confirmation of Consumer Financial Protection Bureau Director Richard Cordray, which occurred last week after Senate Republicans caved to Majority Leader Harry Reid's "nuclear option" threat to end the filibuster.

    The president began his address, "Three years ago this weekend, we put in place tough new rules of the road for the financial sector so that irresponsible behavior on the part of the few could never again cause a crisis that harms millions of middle-class families." And he concluded, "If we keep moving forward with our eyes fixed on that North Star of a growing middle class, I’m confident we’ll get to where we need to go."

    Sorry, Mr. President, but just the opposite is true. Dodd-Frank has declared certain large financial institutions to be "Systemically Important Financial Institutions," enshrining too-big-to-fail in law. And the volumes of regulations emanating from the law's 2,500-plus pages have harmed community banks, credit unions, small businesses, farms and manufacturers that had nothing to do with the crisis.

    Here are some articles my colleagues and I have written on Dodd-Frank's devastating toll as well as some its just plain silly, but still destructive, provisions:

  • The Government's Wasteful Obsession with Subsidized Homeownership

    July 22, 2013 12:11 PM

    The government has spent vast sums of money promoting homeownership through subsidies, tax exemptions, and bailouts. For example, in prosperous Alexandria, Virginia, certain people who never saved up enough money for a down payment received interest-free loans from the federal government to enable them to make a down payment. They do not have to repay those loans until they sell their home. Thrifty people with savings were not eligible for such a handout, penalizing them for their thrift.

    Supporters of taxpayer subsidies for homeownership falsely claim it promotes political stability and prosperity. But As George Mason University's Michael Greve notes, "there’s actually very little support that home ownership correlates with—let alone promotes—democratic stability. If anything, the data suggest that ownership rates are inversely correlated with political stability and the rule of law." Bankrupt, unstable Greece has a much higher homeownership rate than does the United States. Stable, prosperous Germany and Switzerland have much lower homeownership rates than the U.S. does. European countries facing fiscal crises, like Italy, Spain, and Portugal, have higher homeownership rates.

    Similarly, The Washington Post reports that a recent study found that "higher levels of homeownership can kill jobs":

    Andrew Oswald and Dartmouth’s David G. Blanchflower have a brand new working paper (pdf) suggesting that homeownership has an even bigger and wider effect on unemployment than anyone has realized. Here are the key points:

    "We find that rises in the home-ownership rate in a US state are a precursor to eventual sharp rises in unemployment in that state. …A doubling of the rate of home-ownership in a US state is followed in the long-run by more than a doubling of the later unemployment rate."

    . . .the authors argue that homeownership has a much broader — and negative — impact on the labor market as a whole.

    Why is that? The authors find that higher levels of homeownership in a state appear to be associated with lower levels of labor mobility, higher commute times, and fewer new businesses created. Taken together, those three factors tend to increase the unemployment rate.


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