AIPIS 159 - Too Big to Save: How to Fix the U.S. Financial System, with Bob Pozen

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It's my pleasure to welcome Bob Posen. He is Chairman Emeritus of MFS Investment Management, a senior lecturer at MIT's Sloan School of Management, a Senior Research Fellow at the Brookings Institution, and former Associate General Counsel for the sec, the securities Exchange Commission, and author of Too Big to How to Fix the US Financial System. Bob, welcome. How are you?

Okay. Thanks for having me on your show.

Good to have you on. Give our listeners a sense of geography and tell us where you're located.

Well, I'm located in Cambridge, Massachusetts because I'm sitting in my office here at MIT Sloan School of Management.

Fantastic. Well, you know, I just want to make sure we cover this because so much of our audience is interested in real estate estate investing. You know, one of the things you talk about is Dodd Frank and this is this onerous piece of legislation about 2200 pages long that has wide ranging impact on the real estate in business, whether it be investing or for homeowners or, or trading notes and mortgage interest instruments on the secondary market. What do you think? I mean, Trump has specifically addressed Dodd Frank. I know what, what do you think will happen to Dodd Frank under a Trump administration?

I do not think that Dodd Frank will be repealed because it would take 60 votes in the Senate to repeal it. And I don't think that the Republicans can get another eight Democratic votes. However, there is a consensus on a number of issues that really need change and many of these issues were dealt with in the Obama administration through regulation and those can be changed. So the first thing, probably the most important to homeowners is how small and middle sized banks are being treated.

There was a lot of concern about too big to fail and there were a huge number of regulations passed to deal with the very largest banks. Unfortunately, many of those regulations came also to cover small medium sized banks. And so I think that probably we can expect that the regulation of small medium sized banks will decrease. And specifically if they can come up and meet the new capital requirements, then they're going to be able to be free to do a lot more things and I think that will be very important in terms of loan volume of all sorts. Second of all, I think we have a special council, it's called the Stability Council, which is empowered to name not only large banks that are too big to fail, but insurance companies and any other financial institution. Now I think that's very controversial. They've so far named Prudential and Met and metlife is in the process of suing them. And I believe that that whole process is going to be slowed down, that we're not going to see a lot of non banks being deemed to be.

Too big to fail and then subject to a whole new set of regulations. And then third of all, we have this consumer financial agency which at the moment is headed by one person and I think it's pretty clear that that's going to be restructured so that it will be more like, more like most agencies and it will have three Republicans and two Democrats.

Yeah, and so you're, you're talking about the Consumer Financial Protection Bureau that is sort of being run by it like a little, you know, a little kingdom. Right. I mean one person.

Well, it is one person who's head of IT and he's not very accountable to anybody.

He gets, he's a czar basically.

Well, he has those characteristics because he, he doesn't have other commissioners and he's got a budget which he gets indirectly from the Fed, but the Fed doesn't have the right to sort of really holds him accountable. So I think, except for the courts, I think he does have much more power than almost any other agency and I think that's going to definitely change.

Yeah, I hope so. So I mean is the, when we talk about Dodd Frank, this has wide ranging impact on, on real estate of every, you know, you know, for investors and for homeowners, of course, and for hard money lenders and these small to medium sized banks that you mentioned when we began is, is the consensus that, you know, Frank is just too onerous for the small players and you know, maybe the big players should be saddled with it because they can deal with the regulatory issues, but the small players should be exempted or it should be softened.

I think there is a consensus that there has been too much regulation of small and medium sized banks which really were not the cause of the financial crisis and are unlikely to be, you know, systematically important and ca year round. And so we've had very, very few new small banks start and a lot of them would tell you that they're overwhelmed by Regulations on money laundering and just all sorts of detail stuff that really causes great compliance costs. So I think that will change. The one thing Dodd Frank didn't do is they did not address Fannie and Freddie. These are the two previously shareholder own.

And they continue to buy mortgages, but they're owned by the federal government now, effectively because they're in conservatorship. Everybody would like to change them, but the difference of opinion is huge. Some people would like to get rid of them totally and let the mortgages go back to the normal market. Others will say, well, what we need is to turn them into government agencies and stop making believe that they're owned by shareholders. So there's still a tremendous disagreement on that point and I'm not sure that that's going to be resolved sooner than later.

Just out of curiosity, can I ask where you fall on that? I mean, do you favor Fannie and Freddie becoming truly governmental agencies or do you favor privatization or somewhere in between? I guess.

I actually think that.

We already have a government agency that insures mortgages called the fha and then we have the vha. So I think we ought to decide what we want to do of government's insurance of.

Mortgages and run it through them. I think the problems with Fannie and Freddie is they were neither private nor public. I think I would favor something which was where they became private institutions, but real true private institutions, meaning that the government didn't provide support and that when people sold mortgages to them, they weren't the people who were sellers would retain some of the risk. I think the biggest problem that caused the biggest factor behind the mortgage crisis was that you had lots of mortgage brokers that could sell mortgages to Fannie or Freddie and then they didn't seem to care what happened because they were out of the loop. And I think we need to have some capital at the lender level, some risk retention at the lender level so that they have some skin in theoret.

They can force them to buy back the bad mortgages when they, if they go bad In I think 18 months, the lender can be forced to buy them back. You know, I don't know how much that really happens.

Yes, it's not happened very often and.

Usually, well then these companies are so paper thin they'll just declare bankruptcy, you know, and then just start a new company.

Well, that's what I, that's what I mean is if you're going to have a true private market, then people make these mortgages, have to have a Little capital. I mean, that's part of the deal. I mean, you can't have people in the business of making mortgages who have no capital to back their processes. Then you're just asking for trouble.

Yeah, well, and you're right. I agree with you completely. I just want to say that the counter argument to that is that, you know, that'll reduce competition in the marketplace, it'll increase cost for consumers, et cetera. I mean, you know what I'm going to say there? Right. So it's a tough. I mean, it's a tough line to walk, isn't it?

Yeah. No, I think there's all a question of what's a reasonable balance. And the answer is that we have lots of banks that originate mortgages that have capital. And I'm perfectly okay with lots of other types of institutions that originate mortgages, but if a mortgage broker originates a lot of mortgages and sells 100% of them to the federal government or to Fannie Mae, then they no longer have a stake in that mortgage really being done properly. So I think it's. If you don't want to have capital, then you can have some risk or retention or some representations or something. But you've got to. You've got. It is a moral hazard to tell somebody you can make money by issuing a mortgage, but then you can sell the mortgage the day after 100% of it, and you no longer care enough about what happens to the mortgage.

Absolutely. No question. Yeah, yeah, yeah. The whole system was incentivized improperly. And I remember reading an article in one of the major magazines about that in, you know, circa 2002 or 2003. And I've owned a couple of mortgage companies over the years, and it's just unbelievable. I mean, these mortgage brokers, so many of them. I would just say it. I mean, they're such crooks, you know, they'll just. They'll just put together any loan. I couldn't believe the type of people I started meeting when I. When I had a mortgage company, you know.

Well, you have the government. Now, this is the parallel thing. We have the government FHA, VA insuring 100% of mortgages that are made by banks. If the government insured 95% of the mortgages, these banks would make them, but they would be more diligent about making them. We don't really want the government to take 100% of the risk because if they do, then we don't have enough incentives on the private side to do a good job.

Yeah, I Couldn't agree more. So just one more thing on Dodd Frank. So you don't believe it'll be repealed under Trump? It sounds like you do believe there will be some changes, maybe it'll be softened. I don't know.

I think there'll be, there'll be. See, I think there are two different things. One is lots of things that were done under Dodd Frank were done through regulation. There were literally thousands of pages of regulation. Those can all be changed without legislation. So the fact that you don't have 60 votes in the Senate to repeal Dodd Frank doesn't mean you can' those regulations. And there are lots of them. There are lots of regulations on derivatives, on loan to value ratios, on, you know, money laundering. They're just, you know, so many different regulations and those are the ones that are going to change. And I think they'll change in a way that helps small and medium sized banks. And I think that's very important.

So I just want to follow the flow here though. If that happens, or probably more like when it happens, that will cause more money to flow into the real estate market. Right, because lending requirements will be loosened a bit, softened and the pendulum will swing. You know, I think it swung too far. They've overcorrected, in my opinion.

Yeah, no, I agree. I think that's exactly what will happen. Banks now are afraid to make anything. A small and medium sized bank is afraid to make anything but a gilt edged loan because they think the examiner will come and beat them up about it. So we've got to have some more flexibility on this and I think that's what we're going to have.

So just to follow that flow, more money comes into the real estate market. That means upward pressure on prices. Because your typical supply and demand equation. Right.

Well, I think that will be one factor that will influence supply and demand. Other factors will be, you know, the degree to which.

Wages go up so people have more money, the relative rise in the housing prices. And we have a counter force here which is rising interest rates, which tends to, as you know, go against homebuilding. And we already have seen a very steep rise in rates. And if President Elect Trump does pass a number of these tax cuts and infrastructure spending, I think it's predictable that interest rates will rise further. So we've already seen that reflected in the mortgage rates. So we have in a sense two different forces. The forces that are helping mortgages, helping home mortgages, which include less bank regulation, more jobs for people, higher wages, more economic growth. On the other hand, we've already seen a rise in housing prices. So that discourages some people and rates are very important. And I think that probably mortgage rates will be the key for a lot of housing markets as to how far they're going to go up.

And just to throw in some of my experience into that mix, it's interesting when you see rates go up, it causes a dramatic amount of urgency and people get off the fence and they start buying. Of course, that only works to a point because then rates move out of the affordability category. And you know, affordability has been quite good in the linear markets that aren't the high flying markets that we, you know, see around the.

Well, you make a good point is when rates start to go up, people, it actually helps home buying because then people fear that if they don't get in now, it's going to get worse. But once they settle in at a higher plateau level, then it does discourage home buying.

Yeah, yeah. Interesting stuff. So you're a Democrat, yet you were appointed by Bush and Romney to head up economic planning. How did this happen?

Well, I was appointed by President Bush when he put together a special commission to strengthen Social Security. And the commission, and of course when.

I say Romney, I'm talking about as governor, I say, no, this is Bush.

When he was president.

Right.

But I'll talk about them separately. Okay. And so when Bush became, when he started this commission, it was constructed to have both half Democrats and half Republicans. So therefore it's very understandable that I, as a Democrat was part of the commission because that was necessary in order to have a bipartisan commission. In Romney's case, it was much more surprising, know Mitt Romney. But in Massachusetts, it's mainly a Democratic state. At the time he was elected, we had a severe budget crisis. I had just retired as being president of Fidelity and he was looking for someone with financial savvy who could help navigate the state out of this crisis. And he was really keen on getting the best talent and he didn't really care that much about whether anyone was a Republican or a Democrat because basically the legislature was all Democrats.

I think he was just trying to get the best people and he did a very good job in getting us out of that budget crisis for the first year and a half. Then he started running for president and sort of took his eye off Massachusetts.

Talk to us a little bit about the securities and Exchange Commission, the sec, what some have jokingly called the Scoundrels Encouragement Commission. I love that one.

Well, I don't think I would call that I think the departing chairman, Mary Jo White, has had a very strong enforcement rationale and enforcement and she's done a pretty good job at bringing that to bear. But there are lots of other things.

Let me give you a little ammunition, a little fodder here to make it interesting, okay? And talk about whatever you like. But the one thing that just bugs the heck out of me is when companies can hire these government employees that work for the fda, the sec, they can sort of, they're investigated by the companies and then the companies, you know, get friendly with them and end up offering them a job or dangling that carrot out there. You know, that's just, that's gotta end. I mean, right?

Well, there are rules now that constrain that. They don't prevent it, but they constrain it in the sense that depending on what level you are, if you leave the sec, you're not allowed to work for a year or two on any matter that you were, had participated in when you were at the sec. And that goes for a lot of other agencies. And then there are certain bans on other people about lobbying an agency where you were a very senior official. But having said all that, those are short term constraints and after a year or two.

You can do what you want. But you know, that's a double edged sword because if we were a country like say France, there all the bureaucrats stay in the government for years. They all go to a certain number of universities and get trained and there's very little intersection here. I think it's actually a good thing that we have people in the government who have private experience and then people who come from the government who then go into the private sector. So to some degree that's a positive. But I agree with you, we have to be wary about conflicts of interest.

Yeah, yeah, yeah. Okay, talk to us. Let's, you know, direct the rest of our talk quickly here to, you know, your book specifically, Too Big to Save, how to Fix the US Financial System. Just give us some of the broad strokes on that, if you would.

Well, the biggest things are, first of all that we should increase the capital requirements of financial institutions, which we've pretty much done. And then probably the biggest thing that we didn't think about was liquidity. Liquidity turns out to be much more important than people previously thought. You may have an asset that's good, but the question is, if you get a financial crisis, can you really sell it? So now we have more rules that require financial institutions to hold liquid assets. And I think that's A second thing that's very important and you know, the.

The third thing is we have a very broad range of institutions that are under the radar and a good one now is online lenders. So a lot of these online lenders and they become very big and they're lending and the question is, you know, is there a regulator for them? Who are they lending to, what are the rates, what are the disclosures involved? And you know, so it's again a two edged sword. We want to encourage lending, we want to encourage innovation. But sometimes I wonder whether these people who are giving their money to various portals.

For new businesses and online lending, sometimes I wonder whether these people really know what they're getting into.

Are you addressing peer to peer lending when you say that? Yes, peer to peer, right. And that's not really much for real estate. I mean it is in the crowdfunding world. And I don't know if you're talking about crowdfunding when you say both of.

Us in the crowdfunding area. The question is, do people, you know, it's okay with me if people want to take a fling and try it a new business. I don't think a lot of these people realize that most of these new businesses go belly up. And the question is, are people really knowledgeable about the risk that they're taking? So that's the issue with crowdfunding. Most of these crowdfunding companies don't have detailed business plans, they don't have any financials. And so it's perfectly okay with me. If sophisticated investors put their money in, then they either lose it or not. But I hate to see people who are in a position where they really can't afford to lose the money, lose it when they really don't know what risk they're getting in. The peer to peer lending is a separate question. It's just they're lending now to a lot of small businesses, medium sized businesses, probably partly because of the thing we just talked about, where small medium sized banks aren't working, willing to serve these people. So they're getting their loans from peer to peer lending, they're paying very high rates. And you know, again, we have to question, you know, are these things being done in a proper manner? They're pretty much unregulated at the moment. But there are talk about having some.

Oversight that'll be interesting to see what happens. I can imagine that the world of crowdfunding and peer to peer lending has dramatically increased litigation.

Well, it's predictable that crowdfunding will in the next five or 10 years, generate a lot of litigation, a lot of very unhappy people because they won't realize what they put their money into. And I think that's a, that's a tough one because you don't want to, you know, people, everyone has the right to, you know, try and buy a lottery ticket. Question is, you know, a, do they know what they're getting into? And B, we don't want them in the situation where their family has no food if the lottery ticket doesn't work.

You know, Absolutely. That's why we have the accreditation rules and all of that kind of stuff. So one other thing I just want to ask you before you go. What is going on with the banks? You know, they, they're stabilized, they've got money, yet it seems like they're hoarding it. Is that true or is that just a perception people have, you know, where banks are buying Treasuries rather than making loans? You know, take a stab at that, if you would.

Well, it's a, you know, it's interesting you say that because every time I go to a meeting of businessmen and banks, the banks say, oh, they'd love to lend more, but there aren't enough good credits around. And the business people say, oh no, we want to, you know, borrow. And we're, you know, we're good credits, but they don't look at us. So it's, it's a conundrum as to why this is happening, but partly it is that banks can now put money at the Federal reserve and get 25 basis points or a half a percent interest, essentially risk free. And so that's a bit of an incentive for them to put money with the Fed rather than lend it out. And so I would like to see that changed because I think that's something that was done for a totally different reason, but now sort of acts as an incentive for banks not to lend. And the other thing banks will say is that, you know, they have to, the capital requirements are too high, the liquidity requirements are too high, so then it's not profitable for them to lend. And, you know, I think there are a lot of good credits for them to lend, but banks are starting to lend a little more now and, you know, as the economy strengthens, hopefully they'll be lending more. But as long as they can get a risk free rate.

That'S pretty good as that the Federal Reserve, that's a bit of a disincentive to lend, don't you think?

Oh, absolutely, of course, yeah. No question about it, Bob. Give out your website.

My website is bob posen.com b o b p lichen peter o z liken zebra en.com and I the book Too Big to Save is there and I also wrote a book two or three years ago called Extreme Productivity about how you can personalize increase your own productivity. So that's been a bit of a hit.

Good stuff. Good stuff. Bob Posen thank you so much for the enlightening conversation. We appreciate you joining us.

Okay, take care. Bye bye.

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