IN THE WAKE OF THE Bubble [Mortgage Banking]

Trying, but failing, to escape Pollock's Law.

The dominant financial and economic fact of 2011 is that we are still living in the wake of the great 21st-century bubble. * The dominant problem with being in the wake of the bubble is that we cannot escape Pollock's Law of Finance, which states: Loans that cannot be paid will not be paid. Because they will not be paid, the loans will default and impose losses. * In the wake of a bubble, the losses are unavoidably massive. This applies both to the American housing and commercial real estate bubble, and to the European sovereign debt bubble. * Because this iron law and its implications are highly unpleasant, financial actors and politicians strive mightily to escape them in spite of the fact that they cannot, with scheme after scheme. All to no avail, of course. The massive losses must ultimately be taken.

So the questions are not: Will the loans default? They will. Or: Will the losses be huge? They will be. The only real questions are: What form will the defaults take? Who will take the losses? And when will the losses be recognized by those who are going to take them? These real questions provide plenty of room for lawyers, accountants and politicians to operate.

Guided by these insights, we can make more sense of financial crises and their accompanying rhetoric.

Obviously, who will take the losses is open to vast amounts of debate, negotiating, whining, politics, fingerpointing, lawsuits and subterfuge. Naturally, each party would prefer that losses be moved to someone else. Of course, one notable move is from unwise or unlucky investors, lenders and borrowers - by way of governments - to taxpayers.

But losses are also moved among lenders by way of deposit insurance; by way of legal wrangling, from investors to lenders; or by way of politics, from borrowers to investors.

Much financial ink and discussion have been spent trying to ensure that in future market busts, significant losses can be moved to the bondholders of financial companies; for example, by designing contingent convertible bonds, or "co-co's." But what an odd discussion this is, to be sure. Of course bondholders should take losses ahead of taxpayers. Who could argue with that as a fundamental principle?

And yet, the bondholders of Fannie Mae and Freddie Mac will get 100 cents on the dollar of all principal and interest on time, experiencing not a single penny of credit loss. The losses have been moved to the taxpayers, who will take a trimming of $160 billion or so.

Depositors: Protected but also victims of the bubble

Depositors play a key role in the wake of a bubble. Viewed in a hard-minded way, depositors are simply lenders to financial institutions, who are taking credit risk and should take losses like any other lenders if the debtors fail.

Needless to say, however, governments all over the world have decided the opposite - that depositors should never take any losses at all (at least up to some large amount of deposits), no matter how bad their credit judgment was in lending to a particular bank or how broke the bank may be.

We are so used to this theory of deposits that we may not see how odd it looks when viewed from other per spectives. For example, if ordinary people buy a stock for $100 a share and it goes down to $50, we say, "Too bad, but that's the way it goes." If they lend money to a company by buying its bonds, and the bonds go down to 50 cents on the dollar, we say, "Well, too bad." If they lend money to a brother-in-law who doesn't pay it back, we say, "How could you be so dumb?"

But if deposits fall in value to 99 cents on the dollar, we call that a financial crisis and rush to pay off the depositor at par and move the loss to someone else.

In the first instance, the loss is taken by the deposit insurance fund. But the Federal Deposit Insurance Corporation (FDlC) deposit insurance fund was itself insolvent in the wake of the most recent bubble, and dependent for credibility on the fact that it is guaranteed by the U.S. Treasury (a guaranty completely at odds, by the way, with the intent of the legislative fathers of the FDIC - former Sen. Carter Glass and Rep. Henry Steagall).

Furthermore, the FDIC fund could never have survived if it had to cover the losses that would have followed from the failures of the really big institutions, which were bailed out in other ways. Recall that the old savings-and loan deposit insurance fund (FSLIC or Federal Savings and Loan Insurance Corporation) never recovered from its 1980s descent into insolvency, and that the depositors it covered were then made whole by the taxpayers directly.

So depositors are in one way an especially protected and favored group: By government policy, they must not explicitly participate in bearing any of the massive losses of the bubble. This protection fully covers the nominal value of their deposits.

However, in another way, if we count in real rather than nominal terms, their deposits and their savings are being expropriated by the government's attempts to address the bust.

To try to help debtors, restore banking profits, make it cheap to carry leveraged financial positions, induce higher prices of financial assets, reduce the cost of financing government deficits and encourage investment - in the name of trying to do all those things - short-term interest rates, as we all know, have been reduced to just about zero.

We have by now gotten used to this situation, but to see how truly remarkable it is, try this experiment. Imagine yourself as you were in 1999, before the great 21st-century bubble had emerged.

In the middle of 1999, the Federal Funds Rate was more than 5 percent and 10-year Treasury notes were yielding 5.8 percent. At that point, what did you think, or what would you have thought, if someone had predicted that the Federal Funds Rate would round to zero and so would the interest on savings?

My guess is that you would have said that was impossible or at least extremely unlikely.

If pushed, in 1999, what probability would you have assigned that outcome - 1 percent? Less than 1 percent? Zero? As physicist Freeman Dyson once said, there are many things considered impossible that nevertheless come to pass.

What has this remarkable movement in interest rates done, and what is it doing, to savers and depositors? Obviously, it is crushing them - especially if they are retired. Conservative savers, who depended on interest income on certificates of deposit and money market deposit accounts, are getting virtually no income instead of the 4 percent or 5 percent they expected.

Moreover, it is much worse than that in real terms. Suppose you are earning 0.3 percent on your deposits. You have to pay taxes even on this meager amount. Now consider that inflation, as measured by the Consumer Price Index (CPI), is running about 3.5 percent. In inflation-adjusted terms, your interest rate is worse than negative 3 percent. Your reward for saving is to be more than 3 percent poorer at the end of the year.

What this means is that consistent with Pollock's Law of Finance, the losses of the bubble continue to be taken, but a significant amount of them are being moved to savers by the Federal Reserve. In terms of the old Aesop's Fable, this is an instructive example of favoring the grasshoppers at the expense of the ants.

Borrowers of 30-year FRMs: Sometimes protected, sometimes punished

A different group experiencing losses from the bubble is made up of borrowers who have old 30-year fixed-rate mortgages (FRMs), which cannot be refinanced for lack of equity at current house prices. Indeed, one of the reasons the U.S. mortgage market in particular is in such bad shape is precisely the prevalence of our famous 30-year FRMs.

This may sound odd to us, because the rhetoric and political theater of American housing finance give a shining religious aura to these loans. They provide, among other things, the last refuge for the defenders of besieged Fannie Mae and Freddie Mac. They argue that we have to have Fannie and Freddie, or some other government guaranty, so we can continue to have 30-year FRMs. This argument that we need the government in order to have them is not true, but the more important point is that 30-year FRMs are far from the unmitigated blessing that the Fannie and Freddie loyalists imply.

Let us consider the dark side, as well as the advantages, of this particular kind of mortgage. That it has a dark side should come as no surprise, for no financial position is universally good in all times, all interest rate environments and all economic situations.

For borrowers of 30-year FRMs, the advantageous situation is when interest rates are rising and house prices are also rising - in other words, an inflationary housing market. Then, 30-year FRM borrowers keep the same mortgage payments in spite of rising interest rates, and they get to keep the entire inflationary premium in the house price. There is naturally a bright side to the 30-year FRM, and this is it.

Now for the dark side. Suppose interest rates have fallen to very low levels and house prices have also fallen steeply - in other words, a deflationary housing market. This situation is, needless to say, our current reality - the reality in the wake of the bubble.

Now a great many of the 30-year FRM borrowers are locked into their mortgages, which have become very expensive. They cannot refinance because of the drop in house prices, so they are stuck with what have become very high nominal and real interest rates.

Their payments, in spite of falling incomes, stay the same even though market interest rates have fallen dramatically. The entire deflationary loss is imposed on them. Defaults rise; house prices are pushed further down; refinances become even more difficult to obtain; cash is drained out of the households by the high-rate 30-year FRMs.

In this situation, as we know only too well, it becomes very difficult to modify the 30-year FRMs, which cannot be refinanced, as many struggling government modification efforts have demonstrated. In contrast, a floatingrate mortgage, for example, of the classic British variety, does not need to be modified to reduce the payments of borrowing households: Its interest rate falls automatically with market rates. This relieves the cash-payment burden on the borrowers. Thus it shares the impact of the deflation with the lenders.

Of course, American mortgage borrowers and lenders did not expect the massive house-price deflation that reduced the aggregate market value of U.S. residential housing by about $7 trillion. Nor did they expect to see historically low interest rates that could not translate into widespread refinancing. But they got them anyway.

The housing market deflation was visited on mortgage actors in large measure because they believed so earnestly in house-price inflation - an irony typical of financial market behavior. The deflation we face today means a market in which the 30-year FRM turned out to be a bad deal, as a great many American borrowers are experiencing while the housing bust drags on. No single loan type is best for all seasons. Nor is any particular form of funding mortgages always best.

The housing bust dealt a crippling blow to private mortgagebacked securities (MBS). The deep insolvency of Fannie and Freddie has cast a shadow over these government-sponsored enterprises (GSEs) and their governmentguaranteed MBS.

Will different mortgage funding arrangements emerge as the new winners? Not unlikely. Perhaps these will include a revitalized market for trading whole loans; the often-discussed U.S. covered bond market; and forms of mortgage funding with originator credit enhancement, on the model of the Federal Home Loan Banks' well-performing Mortgage Partnership Finance(TM) (MPF) structures.

How could they not have known?

Another kind of loss in the wake of the bubble is the loss of credibility on the part of central bankers and economists. As economist Henry Kaufman recently wrote, "My own profession, economics, has not distinguished itself in recent decades."

Observers could count zero U.S. bank failures in 2006, and as late as the second quarter of 2007, it seemed that bank profitability and capital were high and that the world had plenty - maybe a surplus - of liquidity.

How quaint and ironic it already seems that even as the housing bubble was in the process of inflating, central bankers convinced themselves they had discovered how to create and sustain the so-called "Great Moderation." This is reminiscent of the equally quaint, long-agocollapsed 1960s belief that economists had discovered how to "fine-tune" economies.

At this point, we are more likely to wonder how in the world they could not have foreseen the financial disasters that were descending on them and everybody else. This question, often asked, probably has more to do with our unreasonable faith in benevolent experts and bureaucracies than with the actual capabilities of human minds and institutions.

This is nicely summed up by a Barron's book review: "Even as failed forecast follows failed forecast ... we humans crave future knowledge."

Here is a test. Fill in the blank in the following statement about "the Great Recession" by a prominent economist and guess the year in which it was written. "In the years ______ , the world economy passed through its most dangerous adventure since the 1930s."

The correct answer to the blank is the years 1973-1976. This was written by Otto Eckstein in a 1979 book entitled The Great Recession. He went on to make the following insightful comments, which are most applicable to our recent and current financial experience of three decades later: "Historical model analysis is easier work than forecasting the future. Looking backwards, there are fewer surprises. ... It is possible to construct the model so it tracks the past very well. No such assurance exists in forecasting."

Alas, how true. The lesson is not that we should stop thinking about the future, but that we should give up the faith that wise central bankers and learned economists can make the financial world safe. They can't.

We equally should not kid ourselves about the losses that must be taken and distributed - in one way or another - among the contending parties. Because of this working out of Pollock's Law of Finance, the wake of the bubble inevitably extends for an agonizing and extended time. Still, it will not last forever.

History makes it clear that booms and busts, cycling however around a rising long-term trend, are normal. I venture to forecast that this history will continue to repeat.

Some commentators long for the financial stability of the post-World War II-era United States. Unfortunately for these longings, the 20 years after that horrifically destructive war were a unique and unsustainable period of international economic and financial dominance by the United States. Its anomalous character means it cannot form our model for stability. Indeed, economic reality is never lasting stability, but constant adjustment and transition.

In considering the financial adventures of the past, present or future in America, Europe or elsewhere, we cannot too often reread that profound dictum of economist Joseph Schumpeter: "The problem that is usually being visualized is how capitalism administers existing structures, whereas the relevant problem is how it creates and destroys them."

One of the reasons the U.S. mortgage market in particular is in such bad shape is precisely the prevalence of our famous 30-year FRMs.

Another kind of loss in the wake of the bubble is the loss of credibility on the part of central bankers and economists.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. Washington. D.C. He was president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He can be reached at [email protected].