WHAT’S A FREE MARKETEER TO THINK? Volume 7
As you perhaps have memorized by now, two weeks ago, in response to our nation’s financial emergency, I invited think tank and other colleagues from around Minnesota and the nation to take on the question: “What’s a free marketeer to think?” What follows is installment Number Seven of the remarkably well-received series: three new columns, bringing the running total to 26.
I extend my thanks this time around to Greg Kaza of the Arkansas Policy Foundation; Roger Conant of CRI, Ltd. in Minneapolis; and John McClaughry of the Ethan Allen Institute in Vermont.
We will bring the project to a close with another four pieces or so on Friday. To read any of the previous volumes, see the links below or go to our website at AmericanExperiment.org.
Many thanks, and as always, I welcome your comments.
Found & President
Center of the American Experiment
Transparency, Government-Sponsored Enterprises and Financial Derivatives
By Greg Kaza
The states, in the 1990s, were innovative laboratories for market-based conservatives and libertarians.
In December 1994, Orange County, California lost $1.6 billion and was forced into bankruptcy when interest-rate sensitive financial derivatives collapsed after a series of Federal Open Market Committee rate hikes. The derivatives included structured notes issued by government-sponsored enterprises (GSEs) like Federal National Mortgage Association (Fannie Mae). Taxpayers demanded a policy response, and Michigan lawmakers responded by mandating transparency for government units. The law, signed by Republican Gov. John Engler (1991-2003) requires government units using derivatives to disclose them in reports subject to the Michigan Freedom of Information Act. It permits derivatives’ legitimate use to hedge but creates a disincentive against the bad behavior that forced Orange County into bankruptcy.
Sunshine (transparency) is a powerful disinfectant, and should be advanced in Washington. I noted in a 2004 article for Pensions, a London-based academic journal (http://www.palgrave-journals.com/pm/index.html) that Michigan’s action was unique among the 50 states. It can serve as a model for other market advocates.
Why do derivatives matter in the ongoing crisis that has exposed cracks in the U.S. credit structure? The misuse of derivatives by GSEs including Fannie Mae contributed to an epic housing bubble that has collapsed, leaving failed financial institutions in its wake. Fannie Mae, the second largest borrower next to the U.S. government itself is at the heart of a financial debacle where profits have been privatized and losses socialized by American taxpayers. Market advocates should stand with taxpayers and shareholders, not Washington GSE’s like Fannie Mae.
Markets work best when there is an umpire and transparency. The umpires (regulatory authorities) have been calling strikes on Fannie Mae’s suspect use of derivatives for years. Consider the following:
- The Office of Federal Housing Enterprise Oversight criticized Fannie’s accounting under Statement No. 133 (“Accounting for Derivative Instruments and Hedging Activities”) in September 2004. The OFHEO report, released in 2006, found “an arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from 1998 to 2004.”
- OFHEO found Fannie Mae implemented No. 133 “in a manner that placed minimizing earnings volatility and maintaining simplicity of operations above compliance with GAAP.” OFHEO found Fannie Mae “did not assess and record hedge ineffectiveness,” and “applied hedge accounting to hedging relationships that did not qualify.” Fannie Mae treated “many hedge relationships as perfectly effective when they were not, improperly ignored ineffectiveness in hedge relationships, and failed to perform assessment tests.” Fannie Mae applied the “short-cut” method or the “matched terms” method “for a broad range of hedge relationships where those methods were inappropriate.
- The Securities and Exchange Commission ordered Fannie Mae to restate its earnings (Dec. 15, 2004), noting its accounting practices “did not comply in material respects” with Statement No. 133. No. 133 requires certain derivatives to be carried on the balance sheet at fair value. The SEC noted:
“Fannie Mae internally developed its own unique methodology to assess whether hedge accounting was appropriate. Fannie Mae’s methodology, however, did not qualify for hedge accounting because of deficiencies in its application of Statement No. 133. Among other things, Fannie Mae’s methodology of assessing, measuring and documenting hedge ineffectiveness was inadequate and was not supported by the Statement.”
Congress should pay heed to the umpire’s call. Market advocates must insist that any new financial architecture provide for increased transparency of derivatives used by GSEs. They should note economist Joseph A. Schumpeter’s observations about the evolutionary role of financial architecture in market economies. The financial architecture underlying an advanced market economy like the U.S. must be built on a rock solid foundation, not a GSE’s shifting political sands.
Greg Kaza is executive director of the Arkansas Policy Foundation and author of the 1996 Michigan transparency act.
The Inevitable Apocalyptic Crash
By Roger Conant
After the 1974 crash, the government effectively promised that it would eliminate further recessions. It proudly kept that promise. Every time the markets stumbled, the Fed would throw massive amounts of cash at the economy. Thus, the 1987 slowdown was terminated in just a couple of months. The accompanying property boom and bust, which had been fueled by the savings and loans abusing their enhanced lending authority, was turned into a continuing boom by the government´s mitigation of losses through such vehicles as the Resolution Trust Corporation.
In 2000, the fed injected massive amounts of cash to avert the Y2K crash that showed no signs of occurring.
Financial risk had been eliminated! Wall Street celebrated. Conservative investors were fools. Leverage became the name of the game. No investment was too risky because there was no risk. Banks created structured investment vehicles to hide their violation of capital requirements. New, highly profitable instruments like collateralized debt obligations were invented that accomplished nothing except to hide risk by pushing it around.
Property values were sure to go up forever. Therefore, the only smart tactic was to borrow more to buy more property. As financial risk had been eliminated, diversification was stupid, regulation unnecessary.
The results were as widely recognized as they were ignored. Aggregate savings were negative. Housing became unaffordable. Personal and corporate balance sheets were bloated with debt. As a country, we fueled our appetite for risk by borrowing heavily from friends and enemies abroad.
But, of course, since risk is immutable it hadn´t gone away. It had merely been deferred. By this year, the financial pressures had grown so strong that even our great and magnificent government could no longer resist them.
The great un-leveraging that had to occur is now occurring. In truth, despite the inevitable pain experienced by some, it isn´t all that serious. Some overleveraged businesses have failed. Some Wall Street zillionaire
s will see their earnings reduced to sustainable levels. Asset prices are dropping towards their true underlying values. Housing prices have declined to their levels of a couple of years ago and, accordingly, housing is becoming affordable again. The great benefit is that we are all relearning the basic truth of finance: risk can only be contained, it can´t be ignored.
But let us imagine that the government´s bailout is a total, immediate success. The stock market recovers all its losses within days. Housing prices return to record levels. Financial instruments in default regain their prime status. Wall Street executives buy even bigger yachts. All is well again. The celebration continues.
The result? Risk again will be viewed as an anachronism. Leverage will come thundering back and balance sheets will become even more bloated. As a society we will borrow and spend more and more.
But, of course, risk will not have gone away. It will still be there, sure to return with even greater force. The next time, nothing will stop it. It will crush us all.
The lesson to be drawn is that the expression of risk is an inevitable part of our economy. The only way it can be controlled is to let downturns run their course. Such downturns are the precursors of booms. (As the great economist Milton Friedman and others have shown, the Great Depression of the 1920s was a whole other thing, with no relevance to our present situation.)
After the 1974 crash, the economy entered into a 30-year period of unparalleled prosperity. The way to ensure the next prosperous period is to let the present shakedown clear out our economic cobwebs. Accordingly, the newly enacted bailout bill is a mistake of historic proportions, assuring an incomplete correction and thereby setting the stage for the now inevitable forthcoming apocalyptic crash.
Roger Conant, who is trained as an economist, is president of the financial consulting firm CRI, Ltd.
Jefferson, Jackson and Van Buren Would Have Understood
By John McClaughry
Reviewing the economic carnage of the last few months, where socialism has again been summoned to the rescue of what passes for capitalism, a committed free marketeer would have to say that we ought not have allowed government to entice and force people to alter their behavior in a way likely to promote this kind of calamity.
For instance, we ought to have demanded a monetary unit of value impervious to political meddling: say, a unit measured by a market basket of real commodities (trade-weighted quantities of plywood, zinc, pork bellies, petroleum, gallium arsenide, gold, etc.). Then a politically created central bank could not manipulate interest rates to a level that made credit so cheap that irresponsible mortgage lending took off like a rocket.
We ought never to have required private banks, in return for regulatory approvals, to make high-risk loans to borrowers with very small likelihood of repaying them (cf. Community Reinvestment Act.)
We ought never to have put an implied but well-publicized government guaranty behind such “private” money making institutions as Fannie Mae and Freddy Mac.
Having created such institutions, our political leadership (Clinton) ought not to have directed them to make high-risk loans to appease clamoring voter blocs.
Our fiduciary code ought to have prohibited depository institutions from investing in other institutions whose “value” is almost entirely pieces of paper representing still more pieces of paper representing, hopefully, some ultimate thing of value.
Our common law ought to have required guarantors (credit agencies) to have and publicize their holdings of assets sufficient to cover losses guarantied against.
That’s just a quick summary for openers. What we should have not have done is allow our government to erect a politician- and lobbyist-promoted array of opportunities for sharp operators to pocket gains, leaving losses to the ultimate suckers, the bewildered and angry taxpayers.
Presidents Jefferson, Jackson and Van Buren would have understood.
John McClaughry is president of the Ethan Allen Institute in Concord, Vermont.