Conflicted Agents and Platonic Guardians: Interview with Alex Pollock

Shuffle NEW - Alex J. Pollock

Resident Fellow
Alex J. Pollock

Resident fellow Alex J. Pollock speaks to the Institutional Risk Analyst about accounting standards, regulatory oversight and reform, government-sponsored enterprises, the subprime mortgage bust, and corporate governance. He reflects on the need to create checks and balances for "independent" bodies like the Financial Accounting Standards Board, describes some of the problems associated with the fallout from the subprime mortgage market, and discusses "agents" versus "principals" in modern capital markets.

The IRA: So Alex, tell us what has your attention this week?

Pollock: I was just looking at the income statement for Fannie Mae (NYSE:FNM). It looks like they have a $10 billion accounting hit to earnings because they increased their "G-Fees."

The IRA: And what is a G-Fee, for the benefit of those who don't think about the GSEs or the secondary mortgage market every day.

Pollock: A guarantee fee. That is what FNM charges for guaranteeing the credit when they package mortgages into a mortgage-backed security. The bean counters at FASB make them put an asset on their balance sheet representing the present value of all the future G-Fees. Raising the G-Fee is something unambiguously good from the perspective of the price-raiser, that is, from FNM's point of view. But this increase in their prices means that FNM must discount the value of future fees at a higher rate and the result is a giant hit to current reported earnings. So we have yet another illustration of the absurdity of fair value accounting and the metaphysical bean counters who support it. I am thinking about writing something on this example.

The IRA: That's right. In fairness to the bean counters there is no answer here, is there? We keep trying to perfect something basically flawed like accounting, but there is no real truth at the end of the day.

Pollock: That is exactly right. There are only multiple accounting theories. Politicians are terrified to get into accounting issues. Politicians as a group believe that we have to leave it to "the experts."

The IRA: And our course you do not agree with that premise. Has there been any reaction in Washington to the fair value issue such that we might see the Congress get involved? What is your assessment of how the Congress has handled the subprime crisis and issues like fair value?

Pollock: You have to have sympathy for members of Congress. Think of the incredible variety of issues and topics with which they are presented all of the time, any one of which other people spend their whole lives studying. If you got into an accounting debate in front of a congressional committee you would almost certainly put them to sleep or make them believe that this was a level of detail which for an MC is difficult to be involved in.

The IRA: So there's no hope of getting the Congress to focus on this fiasco?

Pollock: You have to somehow get these topics into a bigger picture issue so that they can be interested in it. Even with the absurdities of FAS 133, it was hard to get the members focused. I testified against FAS 133 right before the FASB representatives on the next panel, who had to defend their unbelievably poor work. We had a very good hearing. I remember that one of the Senators had been prompted by the SEC to say that we should never overstate bank capital as a result of an accounting rule. I reminded them that is was very easy to create a scenario where FAS 133 resulted in an overstatement of the amount of a bank's capital. But nonetheless, nothing happened and the FASB just went on their merry way. Now the FASB has become a taxing body, with a fee imposed on companies to support their operations, but there are no checks and balances. The FASB has access to public funding, but no oversight from the Congress. They are funded as if they were a government agency, but they have no oversight. We've created a bureaucracy that is essentially immune from public oversight, except by the unelected SEC bureaucracy.

The IRA: And the SEC is a bit of a shambles anyway.

Pollock: People call for "independent" bodies to oversee things like accounting standards and think that the FASB is wonderful because it is populated with so-called experts, but this is the opposite of the democratic idea. The FASB has no checks and balances, none of the limitations that any republic requires, namely that no one is above being subject to regular oversight by elected officials.

The IRA: Why do you suppose that Americans are constantly looking for authoritarian figures, for heroes and Platonic guardians to act as "czars" and "leaders" instead of relying on democratic principles like checks and balances?

Pollock: It is a fundamental contradiction in terms. As a democracy and a republic, we should not believe in Platonic guardians, but we keep setting up these people and agencies that are not accountable. It is the progressive ideal of a hundred years ago that there must be experts that can be formed into a committee to address whatever problem exists. These experts are unelected and their power grows beyond anybody's control, including the political appointees who are supposedly managing their activities.

The IRA: Speaking of appointees, what your view of the Paulson plan for reforming the bank regulatory system?

Pollock: Well, this is highly relevant to our discussion, namely the urge by Washington to set up non-elected Platonic guardians to tell other people what to do because they are "experts"--just like the supposed experts at capturing truth via accounting at the FASB, who get you further and further from the truth the more they try to achieve it. So now you have the Paulson plan to reorganize regulatory bodies. Its fundamental drift is to consolidate regulatory authorities down into one, rather than have competing agencies. At least with competing agencies there is a little bit of check and balance from the viewpoint of the citizen banker who is being told what to do by the bureaucracies. The big idea in the Treasury plan seems to be to take away that competition and make regulation more "efficient," a model that is consistent with the progressive ideal of a century ago. We don't want messy private markets, according to the progressive model, we want the equivalent of an engineer to engineer society.

The IRA: Correct. And isn't it fascinating to see how the progressive orthodoxy was slowly eroded by the natural human tendency to take risk and, yes, occasionally self destruct? Hasn't the financial services industry rolled back a lot of the progressive regulatory structure of the 1930s?

Pollock: Well, you speak as someone who does not work for a regulated entity. The progressive ideal is impossible, but that does not mean that regulation is not oppressive. Now, look at another aspect of the Paulson plan, namely the "Super Fed." I wrote a piece recently called "The Greenspan Gamble" in which I point out that if you think back to the origins of the Fed in 1913, before Congress enacted the Glass Steagall division between commercial and investment banking, there should be no concern about the Fed having purview over both commercial and investment banking. In 1913, J.P. Morgan & Company (NYSE:JPM) was every bit an investment and a commercial bank. If you think of the Fed, pre-Glass Steagall, then I think the "Super Fed" idea is consistent with the Fed's origins. With the repeal of Glass Steagall in 1999, there seems to be no reason to object to the Fed acting as liquidity provider for all financial institutions.

The IRA: Agreed, but do we want the central bank to be the safety and soundness regulator? Does the Fed need to be regulator in addition to lender? The evidence seems to suggest that the Fed staff in Washington looks upon supervision and regulation as a secondary task compared with the role of central banker. This is not the case with the supervisory personnel at the Reserve Banks, but seems to be the case with the Washington staff of the Fed.

Pollock: If you are going to be the overall market risk Platonic guardian then I suppose you have to be in a position to know what is happening.

The IRA: You mean to have that perfect God's Eye View? Remember that in the Athenian polis the guardians represented passion while the philosophers were supposed to correspond to reason.

Pollock: Yes, at least if you are going to force people to endure your view. In the UK, they separated the roles between the consolidated FSA regulator and the Bank of England, which was assigned the status of keeping inflation moderate as a money printer. When they ran into Northern Rock, the UK did not find that the arrangement worked so well.

The IRA: And the BOE had to get involved directly.

Pollock: Correct. The British discovered that they could not get out of the crisis without the direct involvement of the BOE. The fact is, no matter how you organize any government agency or company, there is no perfect answer. After a period of time goes by, you will have to reorganize the agency or company again. There is no organizational outcome that is a perfect world. This goes back to the chief fallacy of the progressives and the theme of our discussion, namely that you can control outcomes by somehow engineering human behavior. And you always find out that however you engineer a market or industry, the reactions and adaptations to the regulatory engineering require another new organization, and another, and so on ad infinitum.

The IRA: A comforting thought.

Pollock: It is the same with accounting. The delusive dream of accounting is that you can create a set of financial statements that captures the truth. This is impossible in principle, it simply cannot be done, yet we continue to try. Whatever abstractions you agree upon for this or that version of "the rules" will reveal some aspects of a company's performance and obscure other things. No matter how many times you change the rules around, they will reveal some things and make other things opaque. A set of accounting statements that simultaneously captures all truth cannot exist. Truth is in multiplicity, truth is in multiple perspectives. There is no single perspective that tells you the truth. I think that applies generally to just about any human affair.

The IRA: Well, it is certainly true in politics. To that point, we notice that the Bush Administration is criticizing House Financial Services Committee Chairman Barney Frank (D-MA) for bailing out speculators and the big banks. What's your view of this legislation and the congressional response to the mortgage meltdown?

Pollock: As you know, I have written about the experience of the US in the 1930s, particularly the Home Owners Mortgage Corporation, and have suggested that that experience contains some good lessons. The legislation before both houses of the Congress reflect some of the main ideas, namely that when you get into a severe financial bust and housing bust, what is needed is refinancing, not merely modification of slow and troubled loans. Nobody emphasizes this part of it, but refinancing is the key to success is to take out the old lender or old investor for cash and thereby re-liquefy the lenders, but at a significant loss. The loss should be determined by putting the borrower in the refinanced loan in a position of positive equity, my benchmark is a 90% LTV position.

The IRA: So a 10% haircut on all underwater mortgage loans or more?

Pollock: No, no, whatever haircut it takes to get that loan from par to 90% LTV. That could be a lot more than a 10% haircut. We could see 30% haircuts on some loans.

The IRA: Does the banking industry have sufficient capital to sustain these losses?

Pollock: Well, remember first that the losses have already occurred. Economically speaking, the losses already exist. Second, in accounting terms, many of these assets have been written down by investors. What has not happened is a cash realization of the loss, so you just have a dead asset, written down but still sitting on a bank's books and illiquid. It seems like a big advantage to me for the financial system to make these economic losses realized cash losses, so that the markets can begin to function again. Maybe the lenders take a 30% loss from par, but at least the lender has the 70 cents back in cash so that they can make new loans to keep the market and the economy functioning. And the old asset is now restated on a sustainable basis for the borrower. The Home Owners Loan Corp only approved about half of the loans presented to them, so they did a serious job in terms of evaluating the situations.

The IRA: Well, half the mortgages in the US were in default at the time, so that sounds about right. Do you think that the industry is in serious enough shape that we need to resurrect something like the Home Owners Loan Corp?

Pollock: I think that all owners of mortgage portfolios that have significant exposure in recent vintage, last three or four years production, especially subprime and Alt-A collateral, have serious problems. Let me discuss two other aspects of the bills before Congress that touch on this point. First is the idea of sharing in the future house price appreciation, which given the inflationary bias of our society seems like a good idea for the public interest. At two percent inflation, prices double every thirty five years, so even though we think of inflation as being low, giving the government an option on the upside appreciation of homes is a good bet. House prices will correct from the sharp decline they are in now. OTS came up with the idea that the house appreciation should not be simply a windfall for the borrower and that is a good idea.

The IRA: And the other point?

Pollock: Finally, I would not have the Federal Housing Administration lead any borrower bailout effort. We need a temporary program for a temporary need that will go out of existence when the need is over. If you put it into a bureaucracy like the FHA, the program will never die. That creates yet another housing market distortion, like the retention of the GSEs after the Depression was over.

The IRA: The Congress likes to build monuments to itself. That's why we have dozens of housing programs now. What about the Bush Administration's plan to address the mortgage meltdown?

Pollock: The Bush Administration seems to be also fixated on using the FHA. I think that there is a political imperative to "do something," so I think that they, meaning the government in general, the Congress plus the administration, will do something. In economic terms, there are a lot of things that could be done which are worse than doing nothing. But that is not the political logic.

The IRA: Speaking of doing something, not nothing, the Congress finally bullied OFHEO into taking the capital restrictions off of FNM and Freddie Mac (NYSE:FRE). We just got a chance to sit with the senior officers of both organizations at a CSUITE event in New York sponsored by PRMIA. These folks are very focused on valuation and risk avoidance. They don't sound like they are aching to take more risk in this illiquid, dysfunctional market.

Pollock: I think that is probably right. In fact, FNM and FRE are certainly setting themselves up to be very profitable going forward after all of these accounting losses and write downs. They are in fact setting up to be in an even stronger position to manage their duopoly, their domination of the US mortgage market. In the intermediate term, they may be more profitable than before.

The IRA: If they can survive this year. You don't think that either organization has a solvency problem?

Pollock: No, I don't think that solvency is ever an issue. If you are a GSE, I don't think it matters if you are solvent. You are always solvent because you have unlimited implicit but real capital.

The IRA: And you don't see any prospect of the Congress rolling back the implicit monopoly of the GSEs over the housing market?

Pollock: No, I think the Congress is trying to expand it. You've got some members already talking about making the authority to buy jumbo mortgages permanent. As a fair trade for having the duopoly, the GSEs should be tasked with adding liquidity to the subprime mortgage market.

The IRA: So the US will continue with a largely government-run secondary market for mortgages with the banks trying to make a living around the periphery.

Pollock: Well, I view the banks as GSEs, as well. They are mostly smaller, more numerous and much more competitive, but they are still GSEs. The difference is that FNM and FRE were set up as market dominating GSEs with no ability for competition, while banks are far more numerous, with lower barriers to entry. The federal charter of a GSE carries many advantages and is exclusive to the duopoly, while the bank charter is less restricted and widely available. But they are both government-sponsored bodies. They both operate under government charters, their liabilities are supported by government guarantees, the FDIC and the Fed in the case of the banks. They are subject to all types of government direction in the name of progressive era social engineering. So I think of depositories as GSEs; they are just a lot more competitive because there are thousands of charters instead of two.

The IRA: Well fair enough, but don't we see the same concentration in banking as in the GSE markets? We saw the demise of the monoline credit card issuers earlier in the decade and now we see the large, specialty mortgage issuers getting into trouble. Will we ever see another Countrywide Financial (NYSE:CFC) come from literally nowhere to challenge the larger banks?

Pollock: Remember that CFC was not a bank until fairly late in its career. Before that it was truly a private company and not a GSE. It was an amazing story, but as history shows us over and over, no story lasts forever.

The IRA: Well, you have seen the comments we ran on CFC last week. We view the CFC shareholders as dead men walking.

Pollock: Well, you aren't dead until you run out of cash. As long as your lenders are willing to make you loans, then you can claim to be among the living.

The IRA: How is the market in the Chicago area? Have home prices fallen dramatically?

Pollock: The Chicago area has not had the severe problems visible in FL, AZ or CA. It is also blessed with a diversified economy and is the home to one of the world's leading financial markets, the CME Group, of which I am a director.

The IRA: No, we are big fans of the CME and all organized exchanges. As you know, we have been pounding the drum saying that the growth of the OTC market lies at the root of the subprime mess and events like the failure of Bear, Stearns (NYSE:BSC).

Pollock: Among the various forms of competition is a competition in organizational forms. So, you could think of competition between proprietorships and corporations, or a competition between socialist republics, market economy democracies, and Singapore-style authoritarian regimes. When you think of organizational types competing, one of the most interesting types of this competition is between OTC markets and organized exchanges. This competition goes back to the 1920s and one of the results of the bust of the 1930s was that the exchanges were widely recognized as the superior organizational form over what in derogatory terms were called "bucket shops" in those days.

The IRA: So how did we migrate from a national consensus that exchanges were the superior form of financial market structure to today where OTC is clearly in the ascendance? Is this just the natural progression of things?

Pollock: Of course, OTC contracts have been growing explosively. The notion of being able to speculate with an instrument that simply reflects the price of some other instrument without owning that underlying thing is an old idea that has gotten tremendous efflorescence in the past few decades. You can see that, from the point of a large actor in the OTC market, you don't want the pricing discipline of an exchange, you want a dealer market.

The IRA: Even if that creates an enormous amount of risk at the counterparty level and away from the aggregate risk of the exchange?
Pollock: Well, that's right, and if you get enough people worried about that structural issue, then maybe you see a migration to the centrally cleared, open price announcement, exchange model like the CME.

The IRA: In our discussions with CROs and vendors involved in OTC assets, we are constantly amazed at the amount of time and resources that institutions now devote to valuation and risk management. All of this activity would be completely unnecessary in an exchange model or even an OTC model with some degree of standardization and centralized clearing. We've heard one fund manager after another describe having to consult with the accountant before buying a given structured asset to make sure that the Level 3 accounting treatment under FAS 157 is correct.

Pollock: There is no doubt that the move to FAS 157 and similar rules has resulted in a shift of power toward accounting firms and away from corporate management, a shift that only adds to the change put in place by Sarbanes-Oxley. At the same time, we have this perverse situation where the accountant has to opine on accounting treatment, but they cannot provide advice to the client because that would violate their "independence." As a good friend reminds me constantly, Congress imposed Sarbanes-Oxley to manage corporate risk and it was so successful that we now have a global financial collapse.

The IRA: Well, when we look at a lot of the theoretical work done in risk management over the past decade, you see a lot of effort trying to justify products and market models that are increasingly unstable. To us, the lesson of the BSC collapse is that you cannot manage or predict the counterparty risk in an OTC market. So long as we continue to accept the fallacy that the growth in the OTC markets represent innovation, we expect to see more liquidity driven failures like BSC. There is no reason why the boys in Chicago cannot trade credit default swaps and even structured debt on exchange. And most clients don't want or need customization of an OTC asset. They need reliable liquidity and good pricing to get out of valuation hell.

Pollock: I think the boys in Chicago look very favorably on that idea. Now, Bob Citron in Orange County looked very favorably on customized, OTC contracts until they came back to bite him! He loved those customized bonds until they drove Orange County into bankruptcy.

The IRA: So what is next on your agenda?

Pollock: I have just finished an essay for AEI called "The Human Foundations of Financial Risk," a theme that comes back to our earlier points about trying to predict or engineer human behavior. You can never fully model human behavior, and human behavior will always defeat efforts to engineer it. I cite in this article one of my favorite episodes in the history of finance, the investment experience of Isaac Newton in the South Sea bubble. Newton, as it turns out, sold his investment in the South Sea Company at a 100% profit, but after a period he was overcome by buyer's remorse and bought back in - in time for the collapse and lost a huge amount of money. Newton left this warning: "I can calculate the motions of the heavenly bodies, but not the madness of people." One of the questions I pose in the essay is this: are today's models any better at calculating the madness of people? The answer is no.

The IRA: One of the striking insights that we heard at the PRMIA CRO session in New York last week was when one vendor described the difference between how his firm manages the risk of their portfolio vs. the systems which they sell to help clients manage portfolios. They said that when it came to managing internal risk, they used nimbleness and paranoia, admitting that markets are inefficient and that as long as they remained nimble and paranoid, they'd have time to react and fix any risks. But when it came to the systems that they sold to clients to manage these same risks in these same asset classes, they have to be very institutionalized, very staid and predictable in the approach to risk.

Pollock: You have just outlined a wonderful example of Darwinian competition between two organizational forms. The institutionalized, mechanized organizational form, which would be much beloved by financial regulators and a small group of well informed, motivated professionals who use imagination and nimbleness.

The IRA: What else are you working on?

Pollock: I recently did an essay for AEI entitled "Will the Real Shareholders Please Stand Up?" The point of this piece is that all academic and theoretical discussions talk about the so-called agency problem…

The IRA: Larry White of NYU had a comment on same in our last issue.

Pollock: The concept of the agency problem goes back to a famous book by Berle & Means, The Modern Corporation and Private Property, which said that there is a separation between investors who are principals versus managers who are agents, and who look after their own interests. So now we have constant discussions saying that the "stockholders" want this and the managers don't want to do it. But I point out that the agency problem as stated by Berle & Means is no longer true. Most of the people who call themselves "stockholders" are in fact agents. Virtually everyone now involved in the investment process is one type of agent or another, while the real beneficial owners rarely get involved at all. The hired managers of institutional funds are agents for institutions, which are themselves agents. The real owners are never part of the discussions. So the discussion about investment issues is only between various kinds of agents, including the accountants by the way who are also agents! And so you have all of these agents, all of whom have the same conflict over their individual self interests, engaged in the discussions regarding market structure or safety and soundness or whatever theoretically on behalf of their distant and silent principals. Don't you think that this distinction helps to understand the current situation?

The IRA: Yes, it adds great clarity to why we are in such a mess. Thanks Alex.

Alex J. Pollock is a resident fellow at AEI.

Resident fellow Alex J. Pollock speaks to the Institutional Risk Analyst about accounting standards, regulatory oversight and reform, government-sponsored enterprises, the subprime mortgage bust, and corporate governance. He reflects on the need to create checks and balances for "independent" bodies like the Financial Accounting Standards Board, describes some of the problems associated with the fallout from the subprime mortgage market, and discusses "agents" versus "principals" in modern capital markets.

The IRA: So Alex, tell us what has your attention this week?

Pollock: I was just looking at the income statement for Fannie Mae (NYSE:FNM). It looks like they have a $10 billion accounting hit to earnings because they increased their "G-Fees."

The IRA: And what is a G-Fee, for the benefit of those who don't think about the GSEs or the secondary mortgage market every day.

Pollock: A guarantee fee. That is what FNM charges for guaranteeing the credit when they package mortgages into a mortgage-backed security. The bean counters at FASB make them put an asset on their balance sheet representing the present value of all the future G-Fees. Raising the G-Fee is something unambiguously good from the perspective of the price-raiser, that is, from FNM's point of view. But this increase in their prices means that FNM must discount the value of future fees at a higher rate and the result is a giant hit to current reported earnings. So we have yet another illustration of the absurdity of fair value accounting and the metaphysical bean counters who support it. I am thinking about writing something on this example.

The IRA: That's right. In fairness to the bean counters there is no answer here, is there? We keep trying to perfect something basically flawed like accounting, but there is no real truth at the end of the day.

Pollock: That is exactly right. There are only multiple accounting theories. Politicians are terrified to get into accounting issues. Politicians as a group believe that we have to leave it to "the experts."

The IRA: And our course you do not agree with that premise. Has there been any reaction in Washington to the fair value issue such that we might see the Congress get involved? What is your assessment of how the Congress has handled the subprime crisis and issues like fair value?

Pollock: You have to have sympathy for members of Congress. Think of the incredible variety of issues and topics with which they are presented all of the time, any one of which other people spend their whole lives studying. If you got into an accounting debate in front of a congressional committee you would almost certainly put them to sleep or make them believe that this was a level of detail which for an MC is difficult to be involved in.

The IRA: So there's no hope of getting the Congress to focus on this fiasco?

Pollock: You have to somehow get these topics into a bigger picture issue so that they can be interested in it. Even with the absurdities of FAS 133, it was hard to get the members focused. I testified against FAS 133 right before the FASB representatives on the next panel, who had to defend their unbelievably poor work. We had a very good hearing. I remember that one of the Senators had been prompted by the SEC to say that we should never overstate bank capital as a result of an accounting rule. I reminded them that is was very easy to create a scenario where FAS 133 resulted in an overstatement of the amount of a bank's capital. But nonetheless, nothing happened and the FASB just went on their merry way. Now the FASB has become a taxing body, with a fee imposed on companies to support their operations, but there are no checks and balances. The FASB has access to public funding, but no oversight from the Congress. They are funded as if they were a government agency, but they have no oversight. We've created a bureaucracy that is essentially immune from public oversight, except by the unelected SEC bureaucracy.

The IRA: And the SEC is a bit of a shambles anyway.

Pollock: People call for "independent" bodies to oversee things like accounting standards and think that the FASB is wonderful because it is populated with so-called experts, but this is the opposite of the democratic idea. The FASB has no checks and balances, none of the limitations that any republic requires, namely that no one is above being subject to regular oversight by elected officials.

The IRA: Why do you suppose that Americans are constantly looking for authoritarian figures, for heroes and Platonic guardians to act as "czars" and "leaders" instead of relying on democratic principles like checks and balances?

Pollock: It is a fundamental contradiction in terms. As a democracy and a republic, we should not believe in Platonic guardians, but we keep setting up these people and agencies that are not accountable. It is the progressive ideal of a hundred years ago that there must be experts that can be formed into a committee to address whatever problem exists. These experts are unelected and their power grows beyond anybody's control, including the political appointees who are supposedly managing their activities.

The IRA: Speaking of appointees, what your view of the Paulson plan for reforming the bank regulatory system?

Pollock: Well, this is highly relevant to our discussion, namely the urge by Washington to set up non-elected Platonic guardians to tell other people what to do because they are "experts"--just like the supposed experts at capturing truth via accounting at the FASB, who get you further and further from the truth the more they try to achieve it. So now you have the Paulson plan to reorganize regulatory bodies. Its fundamental drift is to consolidate regulatory authorities down into one, rather than have competing agencies. At least with competing agencies there is a little bit of check and balance from the viewpoint of the citizen banker who is being told what to do by the bureaucracies. The big idea in the Treasury plan seems to be to take away that competition and make regulation more "efficient," a model that is consistent with the progressive ideal of a century ago. We don't want messy private markets, according to the progressive model, we want the equivalent of an engineer to engineer society.

The IRA: Correct. And isn't it fascinating to see how the progressive orthodoxy was slowly eroded by the natural human tendency to take risk and, yes, occasionally self destruct? Hasn't the financial services industry rolled back a lot of the progressive regulatory structure of the 1930s?

Pollock: Well, you speak as someone who does not work for a regulated entity. The progressive ideal is impossible, but that does not mean that regulation is not oppressive. Now, look at another aspect of the Paulson plan, namely the "Super Fed." I wrote a piece recently called "The Greenspan Gamble" in which I point out that if you think back to the origins of the Fed in 1913, before Congress enacted the Glass Steagall division between commercial and investment banking, there should be no concern about the Fed having purview over both commercial and investment banking. In 1913, J.P. Morgan & Company (NYSE:JPM) was every bit an investment and a commercial bank. If you think of the Fed, pre-Glass Steagall, then I think the "Super Fed" idea is consistent with the Fed's origins. With the repeal of Glass Steagall in 1999, there seems to be no reason to object to the Fed acting as liquidity provider for all financial institutions.

The IRA: Agreed, but do we want the central bank to be the safety and soundness regulator? Does the Fed need to be regulator in addition to lender? The evidence seems to suggest that the Fed staff in Washington looks upon supervision and regulation as a secondary task compared with the role of central banker. This is not the case with the supervisory personnel at the Reserve Banks, but seems to be the case with the Washington staff of the Fed.

Pollock: If you are going to be the overall market risk Platonic guardian then I suppose you have to be in a position to know what is happening.

The IRA: You mean to have that perfect God's Eye View? Remember that in the Athenian polis the guardians represented passion while the philosophers were supposed to correspond to reason.

Pollock: Yes, at least if you are going to force people to endure your view. In the UK, they separated the roles between the consolidated FSA regulator and the Bank of England, which was assigned the status of keeping inflation moderate as a money printer. When they ran into Northern Rock, the UK did not find that the arrangement worked so well.

The IRA: And the BOE had to get involved directly.

Pollock: Correct. The British discovered that they could not get out of the crisis without the direct involvement of the BOE. The fact is, no matter how you organize any government agency or company, there is no perfect answer. After a period of time goes by, you will have to reorganize the agency or company again. There is no organizational outcome that is a perfect world. This goes back to the chief fallacy of the progressives and the theme of our discussion, namely that you can control outcomes by somehow engineering human behavior. And you always find out that however you engineer a market or industry, the reactions and adaptations to the regulatory engineering require another new organization, and another, and so on ad infinitum.

The IRA: A comforting thought.

Pollock: It is the same with accounting. The delusive dream of accounting is that you can create a set of financial statements that captures the truth. This is impossible in principle, it simply cannot be done, yet we continue to try. Whatever abstractions you agree upon for this or that version of "the rules" will reveal some aspects of a company's performance and obscure other things. No matter how many times you change the rules around, they will reveal some things and make other things opaque. A set of accounting statements that simultaneously captures all truth cannot exist. Truth is in multiplicity, truth is in multiple perspectives. There is no single perspective that tells you the truth. I think that applies generally to just about any human affair.

The IRA: Well, it is certainly true in politics. To that point, we notice that the Bush Administration is criticizing House Financial Services Committee Chairman Barney Frank (D-MA) for bailing out speculators and the big banks. What's your view of this legislation and the congressional response to the mortgage meltdown?

Pollock: As you know, I have written about the experience of the US in the 1930s, particularly the Home Owners Mortgage Corporation, and have suggested that that experience contains some good lessons. The legislation before both houses of the Congress reflect some of the main ideas, namely that when you get into a severe financial bust and housing bust, what is needed is refinancing, not merely modification of slow and troubled loans. Nobody emphasizes this part of it, but refinancing is the key to success is to take out the old lender or old investor for cash and thereby re-liquefy the lenders, but at a significant loss. The loss should be determined by putting the borrower in the refinanced loan in a position of positive equity, my benchmark is a 90% LTV position.

The IRA: So a 10% haircut on all underwater mortgage loans or more?

Pollock: No, no, whatever haircut it takes to get that loan from par to 90% LTV. That could be a lot more than a 10% haircut. We could see 30% haircuts on some loans.

The IRA: Does the banking industry have sufficient capital to sustain these losses?

Pollock: Well, remember first that the losses have already occurred. Economically speaking, the losses already exist. Second, in accounting terms, many of these assets have been written down by investors. What has not happened is a cash realization of the loss, so you just have a dead asset, written down but still sitting on a bank's books and illiquid. It seems like a big advantage to me for the financial system to make these economic losses realized cash losses, so that the markets can begin to function again. Maybe the lenders take a 30% loss from par, but at least the lender has the 70 cents back in cash so that they can make new loans to keep the market and the economy functioning. And the old asset is now restated on a sustainable basis for the borrower. The Home Owners Loan Corp only approved about half of the loans presented to them, so they did a serious job in terms of evaluating the situations.

The IRA: Well, half the mortgages in the US were in default at the time, so that sounds about right. Do you think that the industry is in serious enough shape that we need to resurrect something like the Home Owners Loan Corp?

Pollock: I think that all owners of mortgage portfolios that have significant exposure in recent vintage, last three or four years production, especially subprime and Alt-A collateral, have serious problems. Let me discuss two other aspects of the bills before Congress that touch on this point. First is the idea of sharing in the future house price appreciation, which given the inflationary bias of our society seems like a good idea for the public interest. At two percent inflation, prices double every thirty five years, so even though we think of inflation as being low, giving the government an option on the upside appreciation of homes is a good bet. House prices will correct from the sharp decline they are in now. OTS came up with the idea that the house appreciation should not be simply a windfall for the borrower and that is a good idea.

The IRA: And the other point?

Pollock: Finally, I would not have the Federal Housing Administration lead any borrower bailout effort. We need a temporary program for a temporary need that will go out of existence when the need is over. If you put it into a bureaucracy like the FHA, the program will never die. That creates yet another housing market distortion, like the retention of the GSEs after the Depression was over.

The IRA: The Congress likes to build monuments to itself. That's why we have dozens of housing programs now. What about the Bush Administration's plan to address the mortgage meltdown?

Pollock: The Bush Administration seems to be also fixated on using the FHA. I think that there is a political imperative to "do something," so I think that they, meaning the government in general, the Congress plus the administration, will do something. In economic terms, there are a lot of things that could be done which are worse than doing nothing. But that is not the political logic.

The IRA: Speaking of doing something, not nothing, the Congress finally bullied OFHEO into taking the capital restrictions off of FNM and Freddie Mac (NYSE:FRE). We just got a chance to sit with the senior officers of both organizations at a CSUITE event in New York sponsored by PRMIA. These folks are very focused on valuation and risk avoidance. They don't sound like they are aching to take more risk in this illiquid, dysfunctional market.

Pollock: I think that is probably right. In fact, FNM and FRE are certainly setting themselves up to be very profitable going forward after all of these accounting losses and write downs. They are in fact setting up to be in an even stronger position to manage their duopoly, their domination of the US mortgage market. In the intermediate term, they may be more profitable than before.

The IRA: If they can survive this year. You don't think that either organization has a solvency problem?

Pollock: No, I don't think that solvency is ever an issue. If you are a GSE, I don't think it matters if you are solvent. You are always solvent because you have unlimited implicit but real capital.

The IRA: And you don't see any prospect of the Congress rolling back the implicit monopoly of the GSEs over the housing market?

Pollock: No, I think the Congress is trying to expand it. You've got some members already talking about making the authority to buy jumbo mortgages permanent. As a fair trade for having the duopoly, the GSEs should be tasked with adding liquidity to the subprime mortgage market.

The IRA: So the US will continue with a largely government-run secondary market for mortgages with the banks trying to make a living around the periphery.

Pollock: Well, I view the banks as GSEs, as well. They are mostly smaller, more numerous and much more competitive, but they are still GSEs. The difference is that FNM and FRE were set up as market dominating GSEs with no ability for competition, while banks are far more numerous, with lower barriers to entry. The federal charter of a GSE carries many advantages and is exclusive to the duopoly, while the bank charter is less restricted and widely available. But they are both government-sponsored bodies. They both operate under government charters, their liabilities are supported by government guarantees, the FDIC and the Fed in the case of the banks. They are subject to all types of government direction in the name of progressive era social engineering. So I think of depositories as GSEs; they are just a lot more competitive because there are thousands of charters instead of two.

The IRA: Well fair enough, but don't we see the same concentration in banking as in the GSE markets? We saw the demise of the monoline credit card issuers earlier in the decade and now we see the large, specialty mortgage issuers getting into trouble. Will we ever see another Countrywide Financial (NYSE:CFC) come from literally nowhere to challenge the larger banks?

Pollock: Remember that CFC was not a bank until fairly late in its career. Before that it was truly a private company and not a GSE. It was an amazing story, but as history shows us over and over, no story lasts forever.

The IRA: Well, you have seen the comments we ran on CFC last week. We view the CFC shareholders as dead men walking.

Pollock: Well, you aren't dead until you run out of cash. As long as your lenders are willing to make you loans, then you can claim to be among the living.

The IRA: How is the market in the Chicago area? Have home prices fallen dramatically?

Pollock: The Chicago area has not had the severe problems visible in FL, AZ or CA. It is also blessed with a diversified economy and is the home to one of the world's leading financial markets, the CME Group, of which I am a director.

The IRA: No, we are big fans of the CME and all organized exchanges. As you know, we have been pounding the drum saying that the growth of the OTC market lies at the root of the subprime mess and events like the failure of Bear, Stearns (NYSE:BSC).

Pollock: Among the various forms of competition is a competition in organizational forms. So, you could think of competition between proprietorships and corporations, or a competition between socialist republics, market economy democracies, and Singapore-style authoritarian regimes. When you think of organizational types competing, one of the most interesting types of this competition is between OTC markets and organized exchanges. This competition goes back to the 1920s and one of the results of the bust of the 1930s was that the exchanges were widely recognized as the superior organizational form over what in derogatory terms were called "bucket shops" in those days.

The IRA: So how did we migrate from a national consensus that exchanges were the superior form of financial market structure to today where OTC is clearly in the ascendance? Is this just the natural progression of things?

Pollock: Of course, OTC contracts have been growing explosively. The notion of being able to speculate with an instrument that simply reflects the price of some other instrument without owning that underlying thing is an old idea that has gotten tremendous efflorescence in the past few decades. You can see that, from the point of a large actor in the OTC market, you don't want the pricing discipline of an exchange, you want a dealer market.

The IRA: Even if that creates an enormous amount of risk at the counterparty level and away from the aggregate risk of the exchange?
Pollock: Well, that's right, and if you get enough people worried about that structural issue, then maybe you see a migration to the centrally cleared, open price announcement, exchange model like the CME.

The IRA: In our discussions with CROs and vendors involved in OTC assets, we are constantly amazed at the amount of time and resources that institutions now devote to valuation and risk management. All of this activity would be completely unnecessary in an exchange model or even an OTC model with some degree of standardization and centralized clearing. We've heard one fund manager after another describe having to consult with the accountant before buying a given structured asset to make sure that the Level 3 accounting treatment under FAS 157 is correct.

Pollock: There is no doubt that the move to FAS 157 and similar rules has resulted in a shift of power toward accounting firms and away from corporate management, a shift that only adds to the change put in place by Sarbanes-Oxley. At the same time, we have this perverse situation where the accountant has to opine on accounting treatment, but they cannot provide advice to the client because that would violate their "independence." As a good friend reminds me constantly, Congress imposed Sarbanes-Oxley to manage corporate risk and it was so successful that we now have a global financial collapse.

The IRA: Well, when we look at a lot of the theoretical work done in risk management over the past decade, you see a lot of effort trying to justify products and market models that are increasingly unstable. To us, the lesson of the BSC collapse is that you cannot manage or predict the counterparty risk in an OTC market. So long as we continue to accept the fallacy that the growth in the OTC markets represent innovation, we expect to see more liquidity driven failures like BSC. There is no reason why the boys in Chicago cannot trade credit default swaps and even structured debt on exchange. And most clients don't want or need customization of an OTC asset. They need reliable liquidity and good pricing to get out of valuation hell.

Pollock: I think the boys in Chicago look very favorably on that idea. Now, Bob Citron in Orange County looked very favorably on customized, OTC contracts until they came back to bite him! He loved those customized bonds until they drove Orange County into bankruptcy.

The IRA: So what is next on your agenda?

Pollock: I have just finished an essay for AEI called "The Human Foundations of Financial Risk," a theme that comes back to our earlier points about trying to predict or engineer human behavior. You can never fully model human behavior, and human behavior will always defeat efforts to engineer it. I cite in this article one of my favorite episodes in the history of finance, the investment experience of Isaac Newton in the South Sea bubble. Newton, as it turns out, sold his investment in the South Sea Company at a 100% profit, but after a period he was overcome by buyer's remorse and bought back in - in time for the collapse and lost a huge amount of money. Newton left this warning: "I can calculate the motions of the heavenly bodies, but not the madness of people." One of the questions I pose in the essay is this: are today's models any better at calculating the madness of people? The answer is no.

The IRA: One of the striking insights that we heard at the PRMIA CRO session in New York last week was when one vendor described the difference between how his firm manages the risk of their portfolio vs. the systems which they sell to help clients manage portfolios. They said that when it came to managing internal risk, they used nimbleness and paranoia, admitting that markets are inefficient and that as long as they remained nimble and paranoid, they'd have time to react and fix any risks. But when it came to the systems that they sold to clients to manage these same risks in these same asset classes, they have to be very institutionalized, very staid and predictable in the approach to risk.

Pollock: You have just outlined a wonderful example of Darwinian competition between two organizational forms. The institutionalized, mechanized organizational form, which would be much beloved by financial regulators and a small group of well informed, motivated professionals who use imagination and nimbleness.

The IRA: What else are you working on?

Pollock: I recently did an essay for AEI entitled "Will the Real Shareholders Please Stand Up?" The point of this piece is that all academic and theoretical discussions talk about the so-called agency problem…

The IRA: Larry White of NYU had a comment on same in our last issue.

Pollock: The concept of the agency problem goes back to a famous book by Berle & Means, The Modern Corporation and Private Property, which said that there is a separation between investors who are principals versus managers who are agents, and who look after their own interests. So now we have constant discussions saying that the "stockholders" want this and the managers don't want to do it. But I point out that the agency problem as stated by Berle & Means is no longer true. Most of the people who call themselves "stockholders" are in fact agents. Virtually everyone now involved in the investment process is one type of agent or another, while the real beneficial owners rarely get involved at all. The hired managers of institutional funds are agents for institutions, which are themselves agents. The real owners are never part of the discussions. So the discussion about investment issues is only between various kinds of agents, including the accountants by the way who are also agents! And so you have all of these agents, all of whom have the same conflict over their individual self interests, engaged in the discussions regarding market structure or safety and soundness or whatever theoretically on behalf of their distant and silent principals. Don't you think that this distinction helps to understand the current situation?

The IRA: Yes, it adds great clarity to why we are in such a mess. Thanks Alex.

Alex J. Pollock is a resident fellow at AEI.

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