Interview With Congressional Candidate Vern McKinley On The Financial Crisis

The Implode-o-Meter is pleased to present an exclusive interview with Vern McKinley, economist, lawyer and congressional candidate in Virginia's 10^thDistrict, commenting on the financial crisis and related regulatory questions. Vern describes himself as a "limited government conservative running for Congress to bring his experience to Washington." Currently, he is an advisor to central banks and foreign governments based on his experience at the Federal Reserve, Resolution Trust Corporation and the Treasury’s Office of Thrift Supervision. He met his wife Nona in Armenia, and they have two beautiful children. His supporters plan a fundraising "money bomb" on May 1^st, which you can go to here. Read more about Vern and his campaign here. He will also be appearing on the Korelin Economics Report in the next few days for a voice interview, so you may want to check that out.

In the below "AK" is Aaron Krowne of the Implode-o-Meter asking the questions, and of course "VM" is Vern McKinley responding.

Without further ado, here is the interesting stuff:

ON THE GSE'S AND THE HOUSING BUBBLE

AK: I noticed in your analysis of an "implicit" guarantee for the GSE [1] the plethora of examples of failure of such entities during a time of systemic difficulty. in fact the correlation is so strong that I wondered if maybe the very nature of these beasts creates the systemic difficulties down the road -- as if a market undergirded by a blasè "we'll just mop up later" attitude simply cannot work. Do you agree? If so, what do you say about the fact that the public just seems to never get it. How can we get off this treadmill?

VM: One of the main themes throughout my work on Fannie Mae and Freddie Mac is that when you structure a government sponsored enterprise (GSE) you are giving out a benefit that as I have noted "is a classic case of a narrowly provided legislative subsidy that the beneficiaries will fight vigorously to maintain" and you are creating incentives for special interests to wield political influence.

Because the entire concept of a secondary market in mortgages is beyond the comprehension of most casual observers the only ones willing to expend the time to get involved in any changes to the GSE's charters, especially when there are systemic difficulties are those that benefit from the structure (Fannie, Freddie) or those who are damaged (those put at a competitive disadvantage by Fannie, Freddie). Policy makers need to be judged by their results not their intentions. Because of the enormous benefits conferred by the charter Fannie and Freddie will always have the resources to win this fight. You "get off this treadmill" by avoiding the GSE structure.

AK: You also wrote that "mortgage-backed securities require a relatively small amount of capital to insure against risk, given their low risk compared to other types of assets", therefore the situation at the GSEs appears worse than it really is. Would you modify that statement in light of the recent housing bubble?

VM: There is obviously anecdotal evidence that the risk in these instruments has increased--and that a lot of lenders and homeowners have suffered as a result. Before the crisis the thought was that if you have an investment that has such a broad-based range of risks underlying it that risk goes down. I would have to see more data on this issue. If you use losses as a proxy for risk I would need to see that data on a long term time series basis.

But if the anecdotal evidence is to be believed, then markets have to rethink the investment vehicle in that light and that is the churning that is going on in the markets as there is more hesitancy to undertake the same risks that were readily accepted a few years ago. If one cares about the human consequences to the market distortions, one has to allow this process to work its way through. The problem is that proposed legislation would put a moratorium on foreclosures or otherwise alter the assumptions underlying the agreements which will add to the uncertainty.

AK: In your arguments that the GSEs should be privatized you say that they really are no longer necessary because of the secondary market. I think Milton Friedman was arguing essentially the same thing when he sought to measure the impact of the GSEs and found no significant beneficial lowering of interest rates. Greenspan would likely have agreed. Yet now, many would point out that it is likely rates are only as low as they are because the GSEs have more or less taken over the market (along with various other goverment or quasi-governmental entities like the FHA and FHLBs) and bring to the table that "implied guarantee". The sentiment out there seems to be "even if these entities aren't helpful in calm times, its a good thing we have them for times of crisis, like these". People seem to have almost instantaneously forgotten the horrid patronage and accounting scandals at the GSEs, or feel these problems are worth tolerating for the "damage control" benefits. How would you address those kind of arguments? Would you modify anything you said about the secondary market?

VM: I think there is some lowering of interest rates that flows from the implicit guarantee. If you compare rates for conforming and non-conforming there has always been a differential. Fannie and Freddie point to this as evidence of the benefits that flow from the GSE structure, but it really only points up the borrowing benefits from the implied guarantee, a small amount of which flows to homeowners and the bulk of which flows to the GSEs. The General Accountability Office (GAO) and Congressional Budget Office (CBO) did quite a bit of analysis of these benefits back quite a few years ago.

As for the patronage and accounting scandals these flowed from the arrogance of these organizations. The feeling was that because of their special status that they were above the law and could push the limits on the accounting and reporting issues. As for the idea that it is good to have them in troubled times, I disagree. Because they have essentially a duopoly in the markets they operate in (although I would need to see more recent updated data on this phenomenon) risk is more concentrated rather than dispersed.

AK: Do you think the GSEs were active culprits in this past bubble, given that in it (especially '04 and after) their business actually trailed off, and FHA dropped off dramatically? In fact the GSEs were capped, though they did continue to securitize. Or instead would you say the Fed had more to do with it... or something else?

VM: I think there were two components to the bubble. First of all, government policy pushed people into homeownership in an unnatural way and now homeowners and lenders--and possibly soon taxpayers--are all paying the price. During the 1980s the rate of home ownership was at a level in the low-60s percentage wise. From the time of the early Clinton years through the Bush years government policy -- whether it be through Fannie and Freddie, programs through Federal Housing Administration (FHA) or the Department of Housing and Urban Development (HUD) or Community Reinvestment Act -- was full force behind driving up homeownership rates, especially by focus on the subprime market. The Clinton and Bush Administrations trumpeted the increases in homeownership as it eventually pushed to 69% before the bubble burst. I noted the push into the subprime market by the GSEs back in 1997 and questioned whether this was a good move for a government sponsored enterprise to take:

"Freddie Mac also is pushing headlong into the subprime mortgage market, which involves lending to riskier applicants who have been late on paying monthly credit cards or other debt. Freddie Mac plans to buy up to $2.5 billion of such loans in the coming year and ultimately take a 50 percent market share in the subprime market…Freddie Mac's foray into the subprime market, just discussed, is a departure from limiting GSE activities to high-quality purchases. More specifically, the charters of Fannie Mae and Freddie Mac limit mortgage purchases to loans 'of such quality, type, and class to meet, generally, the purchase standards imposed by private institutional mortgage investors.' A major justification for this limitation is to reward those home purchasers who have maintained a strong credit standing. Furthermore, limiting purchases to high-quality mortgages also reduces potential taxpayer exposure if one of the GSEs fails."

The second component of the bubble was accommodative monetary policy. The accommodative policy lowered interest rates below a natural rate based on market factors. That distortion sent false price signals to lenders and homeowners who then made what they thought were good decisions but were in fact based on bad information. That malinvestment is the root cause of the housing finance turmoil affecting homeowners, lenders and shareholders.

AK: You advocate more widely used sunset provisions in legislation. Should the GSEs and the other various rescue measures from the Great Depression have been sunsetted?

VM: They should either be sunsetted or not initiated in the first place. As I noted in the article on sunsetting the problem with such provisions is that there builds pressure to extend sunset dates into perpetuity. The example I cite in the article is of the Commodity Futures Trading Commission (CFTC) which was originally supposed to sunset, but it still lives because the sunset date kept being extended.

The principles of good government mandate that policy makers set objective targets to measure the success of each program. Any activities not meeting their objectives must be reformed or eliminated.

ON CREDIT REGULATION

AK: You argued against the Community Reinvestment Act [2], as well as its "sibling statutes", the Equal Credit Opportunity Act (ECOA), the Home Mortgage Disclosure Act (HMDA), and the Fair Housing Act (FHA). A few (but not many) voices have pointed out that these "pro-lending" statutes may have contributed significantly to the latest bubble. Indeed, we know of lenders who went from being punished for "red-lining" to later engaging in what the authorities call "reverse red-lining" -- and if they were not punished again by the authorities, many went bankrupt when forced to buy back the resulting bad loans. Law suits are even pending against some big names, filed by municipalities, for this "reverse red-lining." Do you think these laws were a significant contributor to the housing bubble?

VM: As noted above, I do think these were a contributor. Whether they were a significant contributor or not would be something I would have to research further. My sense is that the GSEs, because they are such dominant players in the market, were a much more significant contributor, but again I would have to research this issue further. I think these statutes would be further examples of politicians ostensibly doing good but with unintended consequences causing significant problems in the real world.

AK: Couldn't we just "fix" reverse-red lining by mandating lower interest rates to vulnerable borrowers, similar to how we used to limit credit card rates and savings & loan deposit rates? And of course (the obligatory question): how will poor and disadvantaged people ever get credit without laws like these?

VM: I am not a fan of mandates because of the distortions that flow from them. Markets should determine the level and form of credit flows, not government mandates. Using government to allocate credit incentivizes political influences for special interests--that change rewards corruption at the expense of everyone else.

BANKRUPTCY LAW

AK: You argue [3,4] for stricter limits on consumer bankruptcy, because of rising numbers. Do you think the bankruptcy act of 2005 (which notably eliminated negotiability of mortgage debt) was good? You also point out that the government and even consumer interest groups had encouraged the general assumption of mortgage debt (even if they opposed credit card debt), and acknowledge this leads to bankruptcy. Would you alter your stance given the sheer magnitude this effect has reached -- millions of people likely never able to pay off their debts in an environment of falling real incomes?

VM: I testified regarding consumer bankruptcy before a subcommittee on Judiciary in 1998 on behalf of changes to the bankruptcy code, some of which were incorporated into the 2005 changes. The general direction of my recommendations and the changes that were made was to make it more difficult or in other ways to limit the option of consumer bankruptcy. I would have to look at the data since that time further, but as I recall there was a dramatic drop-off in filings after that legislation, in large part because the new system was seen as a less attractive option than under prior law. As for the mortgage debt issue, this gets back to the unnatural push into homeownership I have previously discussed. Again government policy has to get away from encouraging or discouraging various types of credit in this way.

AK: What do you think of the trend of borrowers "walking away" from mortgages when they are underwater? Major banks have admitted this effect is becoming noticeable. Is this unethical, or do profligate lenders deserve it? Should the truly needy go into bankruptcy instead? Do you think there is any interplay with the 2005 bankruptcy rules in creating this effect?

VM: We're in this mess in large part because of GSE and Fed-caused distortions so I don't want to morally judge people or make a value judgment on people who walk away from mortgages. In the full range of the different types of contracts (consumer and commercial) people can get involved in, the law contemplates falling short of fulfilling contracts. That is why remedies to breaking contracts are written into contracts. The usual remedy is foreclosure. Both sides have to deal with the consequences of this, whether it be the consumer that has to go through foreclosure and has a black mark on a credit report or a lender that has to write down a consumer or mortgage loan. The reason that federal bankruptcy was put into the Constitution (see Article I, Section 8) was to discourage people from moving to the most attractive jurisdiction before filing, but given the existence of such law I think the benefits should be as narrow as possible.

[Ed. Note: Vern suggests for further information on the history and Constitutional basis for bankruptcy see the writings of Joe Pomykala (http://pages.towson.edu/jpomy/). ]

AK: This interviewer has wondered if corporate bankruptcies aren't too easy-going as well. For example, many telecom companies complained about the ease with which MCI sprung from the MCI/Worldcom bankruptcy, and the "unfair competitive advantage" it then had. More recently, United emerged from bankruptcy and almost immediately tried to buy Delta, and seemed to only back down when authorities suggested this would be distasteful. Do you think there is a real issue here, and do you have an opinion on corporate bankruptcy policy as well as consumer?

VM: Obviously the distortions that flow from such an unfair competitive advantage should be revisited. However, this is not an area I have researched very much (other than a class in law school more than a decade ago.

CENTRAL BANKS

AK: You have written about [5] central bank accountability and efficiency. Do you think the Fed is accountable? Do you think its focus in practice is long-term or short term, and is the focus to your liking?

VM: The primary means for this is the Humphrey-Hawkins semi-annual Congressional testimony. As best I can recall in all the testimony I have seen over the years there is a mix of focus on short-term and long-term matters. Unfortunately, except for Rep. Ron Paul, few of the politicians understand the workings of the Federal Reserve and the monetary policy implications.

AK: Many are now criticizing many aspects of the Fed's recent policies -- "bailing out" Bear Stearns (or really JP Morgan), low interest rates, expanding bank and primary dealer borrowing/collateralizing facilities, "too low" interest rates in 2003/2004, advocating ARMs during this time period, failure to use its powers to "police" subprime, etc. What do you think about these criticisms and any like them? Do we have a renegade Fed or has the Fed been doing a good job given its objectives and the data available at the time? Or is the Fed not really independent, and it was merely serving its political masters?

VM: I have argued in my writings that central banks, as they are currently structured around the world, should have a narrow objective that focuses on price stability. All these other activities tend to concentrate power too heavily in central banks and take them away from their core function, as well as all their authorities to supervise banks, take on responsibilities for payment systems and all matter of activities that they have taken on as I have previously detailed.

AK: The Fed has eliminated M3 reporting (As of spring 2006), saying it is effectively meaningless. Yet the ECB still compiles and watches M3, considering it a useful indicator of long-run inflation. Obviously there is a conflict here regarding how important money and credit are to price stability. Do you think it is possible to truly maintain price stability while forcing or allowing continuous money and credit creation throughout the banking system? I should note that the Fed seems to answer "yes" by virtue of subverting M3, but its recent actions which have restricted the growth of the monetary base essentially contradict that position. The ECB says "no", yet it has done little to reign in its own M3. Needless to say, we are receiving conflicting signals!

VM: I am worried about the potential to "monetize the debt" in the coming years. The turmoil in the financial and housing markets--and consumers paying higher prices--are a result. In addition, the fall of the value of the dollar reduces our ability to attract the foreign investment which perpetuates the vicious cycle as this continues to drive down the value of the dollar.

As spending on entitlements rise there will be pressure to either increase taxes, decrease benefits or monetize the debt. I think the best of those options is to decrease benefits (unsustainable promises). In the medium term, we need to put limits on the Federal Reserve's discretion through a monetary rule or inflation targeting.

AK: You write on the question of whether commercial bank supervision should belong to the central bank or with a separate oversight authority. Do you favor one or the other? The Fed seems to have eschewed bank supervision, with Treasury (OCC and OTS) having served as the prime national banking regulators in recent years. Now the Paulson proposal calls for much banking regulatory authority to be returned to the Fed. Is that a good idea? Even Bernanke seemed cool to the suggestion.

VM: Concentration of power in a central bank worries me, and the powers should be narrow. As Lord Acton warned, "Power tends to corrupt; absolute power corrupts absolutely."

We have career politicians deferring to bureaucrats often lacking real world experience. In addition, as I've explained on many occasions, we need to strip the Fed down to a simple mission of price stability. I would prefer to separate the roles of supervision and monetary policy to allow focus on price stability; and also avoid any conflicts between the objectives of price stability and supervision.

I have extensive experience working at the Federal Reserve and the Office of Thrift Supervision--as well as cleaning up the Savings & Loan bailout while at the Resolution Trust Corporation--so I understand these bureaucracies. After that, I went into the private sector and have advised governments all over the world on how to deal with these questions. Now I look forward to the opportunity to serve in Congress so I can use my experience to fix the problems my family and other Americans face today.

AK: On Fed transparency: it is our suspicion that this is not really genuine, since the Fed seems cognizant of the fact that its own statements and decisions are the most watched indicators in the world financial economy. In fact we have observed that bond market behavior inverted in the mid-90s when the Fed reformed itself to be "more transparent", and the market began expecting "telegraphed" information regarding interest rate policy. There is even a Fed funds "futures" market now which is largely based on these statements. So now, perceived direction has become more important than interest rate level, and interpreting Fed statements has become a black art.

Do you think the Fed is transparent? Can the Fed be more transparent, should it try, or will it inevitably undermine its own objectives and influence?

VM: Obviously as a public entity the Fed should be transparent, but this is not an area that I have studied as much as the efficiency issue. I know there have been Congressional proposals to increase transparency of the Fed and especially its open market operations. While I'd have to look at the specific legislative language, I would work to increase Fed transparency if elected to Congress.

AK: Is Bernanke conservative or profligate? Fed watchers seem to be acrimoniously divided on that question. How is he handling the financial crisis?

VM: Given that we have a financial crisis, I have to question the job he is doing, but like all actions of the Fed it will be difficult to judge how good a job he is doing until many years into the future. To the extent that Chairman Bernanke has suggested that market failure is to blame in the crisis and that government policy has to address excesses in the market I have disagreed with him.

AK: Thanks so much for taking the time to discuss these issues for our audience, Vern.

VM: Thanks for this opportunity to make my case. Sites like yours help to keep the system more honest and transparent--now we need some changes in Congress too!

REFERENCES:

[1] The GSE REPORT: Special Supplement (April 1999), American Enterprise Institute (AEI) Seminar, Fannie Mae and Freddie Mac: Public Purposes and Private Interests, March 24, 1999 http://www.gsereport.com/SSS/AEIConferenceMarch99.pdf

[2] McKinley, Vern, Regulation, 1994 No. 4

[3] McKinley, Vern, REGULATION • FALL 1997 http://www.cato.org/pubs/regulation/reg20n4f.pdf

[4] Testimony of Vern McKinley Before the Subcommittee on Commercial and Administrative Law Committee on the Judiciary, U.S. House of Representatives, March 10, 1998 http://judiciary.house.gov/legacy/5181.htm

[5] McKinley, Vern and King Banaian, Central Bank Modernisation, Rethinking the Scope of the Central Bank, Central Bank Operational Efficiency: Meaning and Measurement, 31 August 2005. http://www.centralbanking.co.uk/publications/books/PDF/efficiency_meaning_and_measurement.pdf