Reform of the Housing Finance System

The U.S. Department of the Treasury
The U.S. Department of Housing and Urban Development
Washington, D.C.

Re.: Request for Comments on Reform of the Housing Finance System

Dear Sirs/Mesdames:

Thank you for the opportunity to provide comments on the desired future structures and practices of U.S. housing finance, which is the largest credit market in the world. I respectfully submit my suggestions concerning your Questions 4 through 7, as follows.

Question 4: How should the current organization of the housing finance system be improved?

1. Create a private secondary market for prime, conforming mortgage loans

The future mortgage finance system should have a robust private secondary market for the largest segment of the business: prime, conforming mortgage loans. In this market, private investors should put private capital at risk, and prosper or lose as the case may be. This is the most obvious case where the risks are manageable and no taxpayer subsidies or taxpayer risk exposures are required or desirable.

There may, decades ago, have been a case for GSEs (Fannie Mae and Freddie Mac) to guarantee the credit risk of prime mortgage loans in order to overcome the geographical barriers to mortgage funding, which were created by government regulation. There was lately a case for using GSEs to get through the financial crisis which they themselves did so much to exacerbate. But as we move into the future mortgage finance system, the prime mortgage market should stand on its own. Covered bonds, as well as securitizations, might well be part of this evolution.

A private secondary market for prime mortgages should have been a natural market development. Why did it never develop? The answer is obvious: no private entity could compete with the government-granted advantages of the GSEs. There could be no private prime conforming mortgage loan market while they used those advantages both to make private competition impossible, and to extract duopoly profits ("economic rents") from the private parties.

This duopoly element of the old housing finance system should not survive.

2. Transition to No GSEs

A direct way to take the old GSE duopoly out of the prime market is to structure a transition to a world of no GSEs. The Congress should take up Congressman Jeb Hensarling's bill, the "GSE Bailout Elimination and Taxpayer Protection Act" (HR 4889), which lays out how this might be done, and how an orderly transition might actually be put in gear.

Housing finance inflation was at the center of the financial crisis, and the GSEs were at the center of housing finance inflation. No mortgage system reform can be meaningful which fails to address Fannie Mae and Freddie Mac--as everyone now agrees.

In my view, the core issue about GSEs is this: You can be a private company, with market discipline; or you can be part of the government, with government discipline. But you can't be both. Trying to be both, in other words, a GSE, means you avoid both disciplines. Fannie and Freddie, or parts of Fannie and Freddie, should become one or the other.

The desired transition has become somewhat easier because at the moment Fannie and Freddie are no longer GSEs. They are government housing banks, owned overwhelmingly and controlled entirely by the government.

Therefore it is clear that, as recommended by the Congressional Budget Office, they should be on the federal budget. Fair and transparent accounting demands that they not get off-balance sheet accounting treatment, which comes in for so much criticism in other areas. In this context, I recommend that Congressman Garrett's bill, the "Accurate Accounting of Fannie Mae and Freddie Mac Act" (HR 4653) should also be taken up by the Congress.

3. Divide Fannie and Freddie into Private Companies and Government Agencies, So No GSE is Left

The world famous, now infamous, Government-Sponsored Enterprises, Fannie Mae and Freddie Mac, made a huge contribution to inflating the housing and mortgage bubble. Now that they are broke, it is essential to remember that their ongoing taxpayer bailout is a government intervention to save a previous government intervention.

The GSE risk turkey, weighing in at $5 trillion, is now roosting in the dome of the U.S. Capitol. Like Edgar Allan Poe's celebrated raven, it won't go away, so the elected representatives of the people can remember the mistakes they made in fattening it up so much.

Once past the crisis, Fannie and Freddie's prime mortgage loan securitization and investing businesses should be privatized and sent out into the world to compete like anybody else, sink or swim, flourish or fail.

The other element of the former Fannie and Freddie consists of those activities which are not businesses, but can only exist as part of the government: principally conveying housing subsidies in one form or another and providing non-market financing for risky loans. These should stay in the government as explicit government activities. Their funding should have to be appropriated by Congress in a transparent way, instead of escaping the democratic discipline of appropriations by being hidden in the GSEs.

Such governmental functions of Fannie and Freddie should be merged into the structures of the Department of Housing and Urban Development-FHA-Ginnie Mae.

The end result of this restructuring would be that no GSEs are left.

4. If there Should be Surviving GSEs, Do Not Use Government-insured Banks to Promote their Finances

If we do not succeed in transitioning to no GSEs, and Fannie and Freddie survive in some GSE form, an essential reform to prevent financing them from being promoted through the regulations and capital rules of the banking system. Banks have been encouraged through government policy to invest in GSE preferred stock (to their sorrow), unsecured debt and MBS. This channels government-insured deposits into GSE balance sheets. It is double-dipping on the government guarantee and a doubling down on the financial system's concentration in real estate risk.

I suggest that in a continuing GSE world, banks should have to hold 100% equity against equity investments in GSEs, and that exactly the same concentration limits on credit exposure to one entity be applied to GSEs as to any other debt issuer.

Question 5: How Should the Housing Finance System Support Sound Market Practices?

1. Facilitate Credit Risk Retention by Originators

The retention of credit risk or "skin in the game" by mortgage lenders is a lesson drawn by a great many observers from the mistakes of the bubble. In my view, there is indeed a fundamentally important idea here (which I worked on developing, starting in 1994). What should be more natural to ask of someone creating and then wishing to sell you credit risk than, "How much are you keeping?"

I propose that the retention of credit risk by mortgage originators should be facilitated, but not required, by public policy. One size is very unlikely to fit all, and the painful risks of "originate to sell" models are unlikely to be forgotten for several years. During that time, we should bend our efforts to make sales with originator credit retention, in various forms as the market develops, a real and robust alternative. I believe many investors will prefer such loans and they may well command premium prices. We should focus on removing the regulatory and accounting obstacles to this healthy development.

I believe the essential locus of credit risk retention is the originator of the loan--the place at which the credit decision is made and controlled. Naturally, some originators will provide enhancements which are more credible than others. What we want is the market always asking about this factor.

One of the lessons painfully taught by the savings and loan collapse of the 1980s was that for depository institutions to keep long-term fixed rate mortgages on their own balance sheet, while funding them with their short-term deposits, was extremely dangerous. The danger was interest rate risk, not credit risk.

The answer of the markets, strongly promoted by government policy, was securitization. Mortgage loans were sold through securitization trusts to bond market investors in order to divest the interest rate risk to those better able to bear it. As a side effect, the credit risk was also divested, so the lender making the credit decision did not have to live with the credit results.

In the wake of the mortgage bubble and bust, everybody has belatedly realized that divesting the credit risk created big problems on its own, breaking the alignment of incentives between the lender making the credit decision and the ultimate investor actually bearing the credit risk. I say "belatedly," because in 1997 my colleagues and I launched the "Mortgage Partnership Finance" program of the Federal Home Loan Banks, in which the originating lenders keep a credit interest for the life of the loan. The resulting mortgage portfolio has superior credit performance and is probably the highest credit quality mortgage portfolio existing today.

Some commentators have now referred to the "good old days" when the savings and loans kept the loans for themselves, displaying their ignorance and how short the memories are of the disaster that caused.

The right synthesis of the competing historical lessons is for securitization to continue to address interest rate risk, while encouraging structures in which significant credit risk is retained by the original lender. There are unfortunately numerous regulatory and accounting obstacles to this approach, but its obvious superiority makes it worthwhile to work on getting them removed. The assignment to do so should be forcefully given by Congress to an appropriate group of regulators and accountants.

2. Develop Countercyclical Strategies

Financial cycles, particularly in real estate, are inevitable. But they could be moderated by developing countercyclical elements to the mortgage finance system. This is one of the most important things we could do.

Two promising ideas of this kind are countercyclical loan-to-value ratios (LTVs) and bigger (countercyclical) loan loss reserves in good times.

a. Countercyclical LTVs

Bubbles involve an unstable positive feedback loop between asset prices and credit availability.

For a possibly extended period of time, higher asset prices (of houses, in this case) can call forth more aggressive lending with higher LTVs, and more aggressive lending allow buying which drives the price of the asset still higher. This insidious self-reinforcing feedback loop between asset prices and increasing leverage cannot last forever, of course, but it can last a number of years--six years in recent experience. The 21st century housing bubble presents a perfect example of this disequilibrating interaction.

To address this profound problem at the most fundamental level, we should be working on countercyclical behavior to moderate the upside overexpansion. Specifically for mortgage finance, we should create countercyclical loan-to-value limits (LTVs). Of course, this also means countercyclical down payment requirements.

Such LTV limits/down payment requirements should be transparent, easy to apply and understand, and relatively free from political interference.

As house prices rise in a housing bubble, more debt and more leverage always seem better. Both borrowers and lenders see their profits and the return on their leveraged equity get (temporarily) bigger. A great many people are making money as the bubble expands.

As long as house prices keep rising, delinquencies, defaults and losses on mortgage loans are all low. This experience makes lenders and investors more confident, just as borrowers become more optimistic. Risk appears contained. Politicians are happy and cheering increasing home ownership and credit "access." Leverage keeps rising.

At the mortgage loan level, leverage is measured by the LTV ratio: how big a mortgage are you willing to grant relative to the current market price of the house? But what does the current price mean if prices have been rapidly inflating on a tide of credit expansion? Lenders should view skeptically the current price of greatly appreciated houses.

As house prices inflate higher and higher in a bubble, and further and further above their trend line, the risk of their subsequent fall is becoming greater and greater. So although the risk of the loans is felt to be decreasing, in fact it is greatly increasing. In this context, what should happen to LTVs and down payments?

What does happen in a bubble is that with increasing optimism and apparent profits on all sides, LTVs rise and down payments fall, reflecting the apparent success. "Innovative" no-down payment and low-down payment mortgages are promoted. This helps inflate the price and credit bubble still further. Rising leverage and inflating house prices are in their insidious and ultimately fatal feedback loop.

What should happen is the opposite: rational, countercyclical management of LTVs would reduce LTV ratios. It would not increase them, or even hold them constant, as the price of houses escalates. Correspondingly, down payments should be increased, not reduced or maintained. In short, we are trying to make a long-term loan against the underlying, sustainable value of the house, not merely its current price.

Once you think about it, this is the obviously logical path. We need to create a countercyclical relationship between house price changes and LTVs/down payments.

b. Old-fashioned loan loss reserves

Successful private credit risk bearing requires much bigger loan loss reserves to be created in the good times. If a lender levers up during the boom and doesn't build reserves, it will probably end up in the government's clutches when the bust comes.

This was forcefully stated by George Champion, who was the Chairman of Chase Manhattan Bank in the 1960s. He recommended that banks "increase the reserve for bad debts to the point of having at least 5% of total loans. This would not be out of line with the enormous losses that had to be written off in the last few years," he observed, speaking in 1978. This reminder is most apt once again.

Champion continued, "Don't apply for privileges in Washington. You lose your strength. You lose your independence. Don't get in a position where you are going to have to rely on the government to bail you out."

The whole issue is perfectly summed up by the dictum of an old chief credit officer of the 1950s: "Bad loans are made in good times."

This eternal financial truth is all you need to know in order to understand why the accounting theoreticians of the SEC and the FASB were wrong once again when they opposed building reserves in the aforementioned good times. They claimed this would mean "cookie jar accounting during periods of bumper profits." But the "bumper profits" of a bubble, are not real--they are an illusion created by the credit expansion itself.

This illusion then turns into real cash outflows from the banks: big bonuses, dividends, and outsized stock repurchases, to be later very much regretted, since they made equity disappear and vulnerability increase.

With bigger, more old-fashioned loss reserves, we can do better in the next cycle. We will also be reflecting wisdom which long antedated even classic old credit officers: Genesis, Chapter 41. This is Pharaoh's dream of the seven fat cows and the seven lean cows, from which Joseph drew the correct lesson: make provision during the fat years for the coming lean years.

3. Address the Banking System's Extreme Concentration in Real Estate Risk

From 1974 to now, the American banking industry has developed a truly remarkable structural concentration in real estate risk.

Without considering this long-term trend, we cannot understand the Double Bubble in residential and commercial real estate credit, the inevitable Double Bust, the consequent hundreds of bank failures, or the insolvency of the FDIC, in the current financial cycle.

A simultaneous long-term trend is the disappearing role of demand deposits as a funding source for commercial banks. These deposits were formerly considered (for example, by the old bankers who instructed me in the business) to be the essence of banking.

Banks used to be legally and intellectually defined as institutions that take demand deposits and make commercial loans. Academic discussions of "why banks are different" from other businesses still focus on their role in providing checkable deposits for the operation of the payments system.

But checkable or demand deposits have become an almost trivial part of the funding of the banking assets. In 1950, checkable deposits were about 65% of the total assets of all U.S. commercial banks. (At that point they were also about 200% of total loans.) By 1969, when I was a bank trainee, they were still 39% of banking assets. By 2008 they were a mere 5%.

What then is special or different about the rest of bank funding? Only that most of it is guaranteed by the government.

How about the other half of that old definition of what banks are: that they make loans to finance commerce, or commercial loans? This has been replaced by the fact that most bank loans are now real estate loans.

The evolution of real estate loans as a percent of total loans for all U.S. commercial banks from 1946 to 2008 is striking, though virtually unknown.

For three decades after the end of the Second World War, it is flat at about 25%. Then, starting in 1974, it heads inexorably up, pausing temporarily after the last real estate bust of the early 1990s before resuming its climb. With the Double Bubble well inflated in 2006, over 55% of the total loans of the entire commercial banking system were real estate loans.

If we look at the smaller banks, those whose assets are less than $1 billion, we find the risk concentration is even more intense. This group represents 90% of all banks. By 2008, 74% of their total loans were real estate loans.

Nor is the real estate concentration of the banking system's risk limited to its loans. The other principal category of banking assets, securities, has come to display the same heavy real estate risk exposure.

By 2006, 74% of the total securities owned by U.S. commercial banks were either mortgage-backed securities or the debt of housing GSEs. In other words, the banks' investments displayed the same fundamental risk as their loans, heavily encouraged through government sponsorship of real estate lending.

What allowed banks to continuously expand their real estate risk? This risk expansion was made possible through government guarantees delivered through the FDIC and the Federal Home Loan Banks.

It is a banking adage that real estate developers will borrow as much as anybody is willing to lend them. This is a constant temptation to banks that want to increase their lending and their short-term profits. All banking experience, moreover, testifies to the vicissitudes and cyclical crises of real estate credit. Needless to say, here we are again.

But focus on the huge difference of entering a real estate bust with 25% of your loans in real estate, the postwar level, versus entering one with 55% of your loans in real estate--let alone 74% of your loans for smaller banks! Add to this having 74% of your investment securities in real estate.

It couldn't possibly have turned out to be pretty, and of course it hasn't.

The old definition of banks, "take demand deposits and make commercial loans," has been changed in practice to a new one: "borrow money guaranteed by the government and make real estate loans." The implications of this structural shift for systemic financial risk must be addressed.

4. Remove Government Support of Credit Rating Agencies

The credit rating agencies were central to the housing finance crisis. These companies say they are in the business of publishing opinions, and they are. All opinions are liable to error, and opinions based on models are liable to systemic error of vast proportions, as the mortgage bust has made obvious.

The U.S. government should not anoint certain opinions as having preferred, indeed mandatory, status. It should not, but it did, require regulated institutions to use certain favored rating agencies, a requirement enshrined in scores of regulations of numerous regulators and also in various statutes.

The resulting "NRSRO" ("nationally recognized statistical rating organization") system thus set up by regulation played a key role in helping inflate the housing bubble.

In considering the riskiness of any system, we should look for concentrated points of possible failure. The government-sponsored NRSRO system made the dominant rating agencies into just such a point of concentrated possible failure--which then indeed failed.

All regulatory requirements to use the ratings of certain preferred rating agencies should be eliminated. When it comes to opinions about the future, the rule should be: the more, the merrier. Having more rating agency competitors, especially those paid by investors, not the issuers of securities, increases the chances that new insights into credit risks--and how to conceptualize, analyze and measure them--will be discovered. It will also reduce the economic rents (duopoly profits) which were granted by government sponsorship to the old cartel.

Of course, any sources of opinions which are too often mistaken, late or uninformative, will have little value to investors and other credit market actors. They would not be purchased in a free market.

5. Reintroduce Savings as an Explicit Goal of Housing Finance

Savings and loan associations were once central providers of mortgage finance. But the original leaders of the "movement," as it then was--for they considered themselves a movement for personal and social improvement--were very clear about the order of things: first the savings, then the loan.

Our subsequent political development has forgotten about the "savings," and put all the emphasis on the "loan." Even savings in the form of building up equity in the house by retiring the mortgage loan has turned into ways of extracting the equity instead.

A successful mortgage finance system of the future will finds ways to rediscover and reemphasize thrift and savings. This sounds old-fashioned, and of course, like all the other eternal verities of financial prudence, it is.

Question 6: What is the Best Way for the Housing Finance System to Help Ensure Consumers are Protected from Unfair, Abusive or Deceptive Practices?

National use of the Pollock one-page form

Should ordinary people be free to take a risk to own a home, if they want to? Of course they should: provided they understand what they are getting in to. (This is a pretty modest risk, to say the least, compared to those our immigrant and pioneer ancestors took!)

Should lenders be able of make risky loans to people with poor credit records, if they want to? Of course they should: provided they tell borrowers what the loan obligation involves in a straightforward, clear way.

A good mortgage finance system requires that the borrowers understand how the loan will work and how much of their income it will demand. Nothing is more apparent than that the current American mortgage system, with its reams of confusing disclosures mandated by regulation, has not yet achieved this.

By far the most important use of mortgage disclosures is for borrowers to be able to underwrite themselves--that is, to decide whether they can afford the debt service commitments they are making. In the ideal case, the borrowers would be able correctly to complete the one-page form themselves.

The best consumer protection is the ability to exercise personal responsibility in making informed decisions about underwriting yourself for the credit and about how much risk you want to take. This is the best reason to have clear and straightforward disclosures.

In Congressional testimony in the spring of 2007, I proposed a one-page mortgage form so borrowers could readily focus on what they really need to know. This form, "Basic Facts about Your Mortgage Loan," is available at The one-page form idea was included in bills in both the House and Senate, but not enacted, unfortunately. It was accompanied by two pages of avuncular explanations of mortgage terms and concepts. It remains my opinion that something like this form would represent a huge improvement in mortgage finance.

Federal Reserve Board staff members were kind enough to discuss this proposal with me, and to include it in the consumer testing they carried out in developing amendments to Regulation Z.

Their and my goals are identical: presentation of key information about the credit commitments a borrower is making in clear, straightforward, useful, and brief fashion. I put more stress on answering the question: "Can I afford this loan?" In my view, this is definitely a more important question than "Is this the cheapest loan?" The cheapest loan, with the lowest combination of rate and fee, does me no good if I can't afford it.

Because I believe the most important question is "Can I Afford This Loan?", borrowers should focus on this key question. The summary information provided to borrowers should correspondingly include:

(a) The borrower's pre-tax monthly income used in underwriting the loan

(b) The estimated total loan payment, including principal, interest, property taxes, house insurance, and mortgage insurance premium (if any)

(c) The total monthly payment as a percent of monthly income, i.e. (b) divided by (a)

(d) If the loan has adjustable features, what (b) is estimated to be when fully indexed

(e) The estimated future, fully indexed monthly payment as a percent of monthly income, i.e. (d) divided by (a).

Having my accompanying "avuncular explanations," or something like them, is also required.

The key information form would be more psychologically effective if signed by both the borrower and the organization which is approving the loan (not the loan broker).

The key information form should also supply a contact with phone number and e-mail address at the organization approving the loan, whom the borrower can call with questions about the information presented, which should always match the data used in underwriting the loan.

If the information provided to the borrower matches the same items as used in underwriting and approving the loan, that should constitute a safe harbor for the lender with respect to the key information form.

Question 7: Do Housing Finance Systems in Other Countries Offer Insights that can Help Inform US Reform Choices?

The Canadian Example

The Canadian housing finance system, and Canadian banks, have come through the financial crises of 2007-09 in far better shape than their U.S. counterparts. A recent AEI conference, "Canadian vs. U.S. Housing Finance: Comparison and Implications" (February 18, 2010), addressed a number of factors which make Canada's mortgage credit practices more conservative and less vulnerable than those of the U.S.

Suppose we agree that we would like our society to have widespread home ownership and a property-owning democratic citizenry. Does it take government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, with "implied" taxpayer guarantees; tax advantages for the interest paid on home mortgages; and government pressure for "creative," that is, riskier, mortgage lending to achieve this?

The Canadian experience shows that it doesn't.

Canada makes a useful comparison for the U.S. It is in population and economic size much smaller of course, but otherwise very similar. Both countries are rich, advanced, stable, have sophisticated financial systems and pioneer histories, and stretch from Atlantic to Pacific. But Canada has no housing GSEs. Mortgage interest is not tax deductible. It does not have 30-year fixed rate, freely prepayable mortgage loans. Mortgage lending is more conservative and much more creditor-friendly.

Canadian mortgage lenders have full recourse to the mortgage borrower's other assets and income, in addition to the security interest in the house. This means there is little incentive for borrowers to "walk away" from their mortgage. No tax deduction for mortgage interest probably increases the incentive to pay down debt. Most Canadian mortgage payments are made through automatic debit of the borrower's checking account--a technical but important point. Canadian fixed rate mortgages typically have prepayment penalties and are fixed for only up to five years.

This relative creditor conservatism has meant that Canada and Canadian banks have so far come through the international financial crisis in much better shape than their U.S. counterparts. Canada shared in financial pressure and recession, but mortgage delinquencies have so far remained well-behaved, with serious delinquencies at a fraction of the U.S. level.

What about the home ownership rate--the percentage of all households owning their own home? Isn't there is a home ownership price to pay for this Canadian credit conservatism? No, there doesn't appear to be. But didn't the U.S. mortgage finance system, with its tax subsidies and all the risk that we have come to realize it created, also create the world's highest home ownership rate? No, it didn't.

Here's the home ownership rate score: Canada 68%, U.S. 67%. The U.S. rate unsustainably peaked at the top of the housing bubble at 69%. In other words, two very different housing finance systems, one much riskier than the other, produced virtually the same home ownership rate.

This must cause us to call into question longstanding U.S. beliefs about the relationship of government-subsidized housing finance to home ownership.

The former savings and loan industry justified its special tax and regulatory privileges at the time, including its right to pay more interest on deposits than commercial banks were then allowed to, by appealing to its role in home ownership--until the savings and loan collapse of the 1980s.

Fannie Mae and Freddie Mac took over the home ownership mantra. In the vast risk expansion of their arrogant days, with very high rates of profitability made possible by government-granted privileges, they justified these privileges by appealing to home ownership. It was often said by their supporters that the GSE-dominated U.S. housing finance system generated the highest home ownership rates in the world, which was false, and that this system was the "envy of the world." At least as represented by the international mortgage professionals I knew, this was also false. Fannie's annual reports regularly featured a house with an American flag flying.

Now Fannie and Freddie, having done so much to help inflate the bubble and having been dragged into insolvency by its deflation, are wards of the government. The taxpayer bailout of these GSEs is likely to cost much more than the bailout of the saving and loans did a generation ago. The U.S. Treasury has unilaterally signed the taxpayers up for unlimited support of these bankrupt purveyors of government-advantaged mortgage finance.

So the widespread previous beliefs about the desirability of having GSEs were wildly mistaken. It ought to be clear by now that an entity can be a private company, with market discipline; or it can be a government body, with governmental discipline; but it can't be both. Trying to be both--i.e. a GSE--means it escapes both disciplines.

In this context, it is important to recognize that Canada does have a government body to promote housing finance: the Canada Mortgage and Housing Corporation. Whether or not you like the idea of such a government financing operation, at least its status is perfectly clear and honest. It is a 100% government-owned corporation. Its guaranty from the government is explicit. It provides housing subsidies which are on budget and must be appropriated.

Let's remember that the original sin of making Fannie a GSE in 1968 was to get it off the federal budget so the deficit looked smaller. Canada in this respect looks superior to the U.S. in candor, as well as credit performance, as it achieves equivalent home ownership levels.

Thank you for your consideration. It would be a pleasure to provide any further comments or information which would be helpful.

Yours truly,

Alex J. Pollock

Resident Fellow

American Enterprise Institute

Washington, D.C.

Alex J. Pollock is a resident fellow at AEI.

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