So, he trusted them too much, it turned out. Sunday night at 8 00 eastern on cspans q a. Next, economic scholars and banking experts discuss Monetary Policy and the impact of past Federal Reserve actions on small and large Financial Institutions. This was held by the American Enterprise institute. Its about an hour and 45 minutes. Good morning and welcome to the American Enterprise institute. This morning we have a very interesting policy session entitled how has a decade of extreme Monetary Policy changed the Banking System . Weve assembled a panel of experts, who well introduce you to in a minute. But before that, let me just set the stage here. As you all know, the financial crisis changed the Banking System. The resolutions that happened in the crisis integrated commercial and Investment Banking like never before. These resolutions created todays too big to fail institutions. The crisis led to greatly expanded fed emergency liquidity support. The fed became the lender of first resort instead of the lender of last resort. Tarp temporarily nationalized the Banking System, and the Congress Passed the dodd frank act to extend the posttarp control over the system. It gave regulators extensive new powers and responsibilities over the Financial System. Deposit insurance limits decreased by a factor of 2. 5, and the slow recovery triggered fed qe stimulus, which kree crated massive Bank Reserves, which required new fed operating procedures. So this morning were going to discuss all these changes with a panel of experts, and instead of me introducing a panel of experts, im going to introduce our moderator of the panel. Alex j. Pollak is a distinguished senior fellow at the r. Street institute. Alex was previously a resident fellow at aei, my colleague here, and president and ceo of the Federal Home Loan Bank of chicago from 1991 to 2004. Alex is a recognized authority on financial policy issues, including financial cycles, governmentsponsored enterprise, Housing Finance, banking, central banking, retirement finance, corporate governance, and political responses to financial crisis. Hes the author of boom and bust, numerous articles, congressional testimonies, and what is perhaps his most consulted work by those of us who know him well, known as pollaks laws of finance. So, with no further adieu, with further adieu, here is our moderator, alex pollak. Thank you, paul, and ladies and gentlemen, let me join paul in welcoming you to our conference this morning on how has a decade of extreme Monetary Policy changed the Banking System. Youll all remember the most famous line about the Federal Reserve from its long serving and former chairman, which is that the fed is supposed to remove the punch bowl just as the party is really warming up. But what about a Federal Reserve which spikes the punch when the party is warming up instead . Or changing the beverage in the metaphor, consider the dominant personality in the Federal Reserve of his day, benjamin strong, who memorably said in 1927 that he was giving the stock market a little drink of whiskey, that is. What a piker strong was, compared to his successor of seven decades later, ben bernanke, who gave the stock, bond, and house markets a barrel of whiskey. The feds longterm bond and mortgage buying spree, plus zero or so nominal Interest Rates, plus negative real Interest Rates, as we all know, has set off asset price inflations of notable magnitudes in stocks, bonds, and houses, and how about what its done to the Banking System . This amalgam of 5,787, as of june 30th, fdic insured depository institutions with total assets of 17 trillion, which are equal to about 90 of gdp. Or we might argue that the Banking System actually and properly understood includes the fed itself, which is part of, indeed, an integral part of the Banking System. Then we would add the feds 4. 5 trillion in assets to the size of the Banking System, and wed get a greater Banking System, we might call it, of 21. 5 trillion, or 112 of gdp. However we think about the Banking System and the fed, how have years of extreme monetary and bond market manipulations by the fed changed the Banking System . Our outstanding panel of experts is about to tell us, and let me introduce them in the order in which theyll speak. First will be chris whalen, who is an investment banker, author, chairman of whalen global advisers, focusing on financial services, mortgage finance, and technology. Previously chris was director of research at the kroll bond rating agency, cofounder of institutional Risk Analytics and was with bear sterns and prudential securities. Among his books is inflated how money and debt built the american dream, and as we think about this topic today, we have plenty of money and debt to consider. Second will be norbert michelle, who is with Research Fellow and regulation, Financial Markets, and Monetary Policy, including reform of the dodd frank act and a fannie mae and freddie mac. Norbert, i wanted to say since both dodd and frank were big proponents and supporters of fannie and freddie, these issues go well together. Norbert also addresses ways to address credit difficulties of large or too big to fail financial companies, as paul said, and on issues concerning the role of the Federal Reserve, as well be discussing today. Next will be nely leon, senior fellow at the hutchisons center of fiscal and Monetary Policy at the brookings institution, also a consultant to the International Monetary fund and is a member of the congressional budget offices panel of economic advisers. Her Research Specialties include Financial Stability, credit markets, and the intersection of monetary and financial policy. Just on the topic of today, she was previously director of the office of Financial Stability policy and research at the Federal Reserve board. And finally, well have paul kubiak, resident scholar at aei, who brings insights to the study of banks and Financial Markets, issues of Systemic Risk, and the impact of financial regulations on the u. S. Economy. Previously, he was director of the center for Financial Research at the federal deposit insurance corporation, chairman of the Research Task force at the Basel Committee on banking supervision, and held positions at the International Monetary fund, jpmorgan, Federal Reserve, and, as you know, hes the organizer of this conference, for which we all thank you. Each panelist is going to speak with opening remarks of ten or 11 minutes, after which well give the panel the chance to exchange views or clarify points, and then we will open the floor to your questions and we will adjourn promptly at noon. Chris, you have the floor. Well, thank you, alex. And thanks very much to paul and aei for organizing todays session. Weve had a lot of fun over the years considering various bubbles, and today im going to talk about the Banking Industry and how its been affected by Monetary Policy, not just over the last decade or so, but really over many decades. And i think thats actually some of the most interesting things to talk about. First and foremost, its top level, the fed is part of a much larger effort by global Central Banks to essentially take both public and private securities out of the market. They buy them using reserves from banks or money made up out of thin air, but essentially they are taking duration out of the market. If you think of it in technical terms, its kind of like jurassic park. You have these big dinosaurs all looking for earning assets to put on their Balance Sheets and theres less and less available, and this is a deliberate act of social engineering that says that if we cant get you to borrow and engage in Economic Activity merely by lowering the suggested price for benchmark Interest Rates, then we will forcibly change the pricing of risk, and, thereby, get investors and intermediaries to boost employment and consumption. Its a totally different perspective and one thats also been largely discredited by the published research, which is what is so interesting that the central bankers persist. I think the obvious observation is that debtors are the particularly Public Sector debtors. So, this very quickly, this chart shows us issuance and youll notice the big, big green bars, that was mortgage securitizations during the 2000s. We were doing trillions of dollars some quarters countrywide was the leading issuer and we were literally turning over bank Balance Sheets several times a year with mortgage securitization activities, and it has declined almost by half now. It has been replaced by the u. S. Treasury, whose issuance has gone up dramatically, and also by corporations, who use issuance and low rate environment provided by the Central Banks to buy back their shares. This is not very productive activity. This is practiced by our friends in japan many decades ago. Its exactly the same. So when people say were not japan, yes, we are. And i think its very evident from the record bond issuance weve seen in the u. S. Bond market over the past five years. Spreads, this is the chart from our friends at the st. Louis fed. You can see the big, big surge in high yield spreads during the crisis. The real object of Monetary Policy, and i think chairman bernanke understands this, was to get spreads down. Because spreads, particularly highyield spreads, is what tells you if the economy is working or not. Today they are quite low, very tight. In fact, so tight that i would argue many banks, larger banks, have a hard time making money. When you think citi bank has a 1. 6 growth spread on their commercial and industrial loan book and that the average cost of funds for that bank is 72 basis points, thats not a great business, you know, you would assume those are reasonably decent credits in that portfolio, but still they are not getting paid enough. The average for most fdic insured banks are 4 , and the big banks, wells, the rest of them, are twice. And even then they are still not making a lot of money. So, we, i think, know in general terms whats been going on for the last few years, but the key thing i think we have to accept is over the past 30 to 40 years, going back to chairman volcker, the use of lower and lower Interest Rates to goose Economic Growth has had a cost, and the cost you can see in the return on earning assets for banks, which used to be well over 1 and has since declined down to around 72 basis points. Even though the systems getting bigger, they are making less money on every dollar of assets, and thats why especially for the larger banks that tend to have relatively low spreads, dependence on nonbanking activities, security derivatives, et cetera, they are almost pressured to get into exotic activities because they dont make money on core businesses, especially the retail side of the bank. And this is, again, this is partly demographics, partly Monetary Policy, but it does have an impact on bank behavior. This is derivatives. You can see jpmorgan, the top red line, but now the blue line, citigroup, is once again the largest derivatives house on wall street, and when you look at their business mix, when you look at the fact theyve sold their mortgage business, theyve sold asset management, there isnt a lot left to the bank, so in this environment, again, where its difficult to generate returns and get large assets to feed these very large Balance Sheets, they tend to go back to synthetics and, in fact, citi Just Announced they are going back into collateralized debt obligations, which are a purely synthetic asset. Notice the line at the bottom, thats the average for all large banks in the United States. Most of them dont play in derivatives. Its a highly concentrated market. The top six banks or so. In fact, you could argue that citi and jp probably face each other on more than half of their trades, so its the snake eating its tail in many respects. Now, just quickly think about the schizophrenia of the fed on the one hand trying to boost activity through a variety of means and the prudential regulators on the other hand through dodd frank and the basel accord telling banks to take less risk, and in particular the guidance thats come from regulators over the past seven, ten years, really, has been avoid default and i want to see lower loan to value ratios on commercial loans, construction loans, this sort of thing. What that means is, theres less leverage in the economy. If i as a home builder have to put up 50 equity on all of my projects instead of 30 or less, which i could have done before the crisis, im going to build fewer homes. And that change in the structure of leverage throughout the u. S. Economy gives you less growth. Its basic Irving Fischer 101, but they dont really think about this. Nobody that gets everyone into a room and says what do we want, because i think, you know, there were so many aspects of policy that were not connected and not thought out, unfortunately one of them is we have less leverage on the book today. And i think thats why its so difficult to get growth to where people think we ought to be. Now, this, again, is another part of the story. How did the fed keep the Banking System aloft . Well, two ways. They drove the cost of funds down to almost nothing. At one point it went down to single digits, you know, if you look at the top of that red line basis points. Well, basis points, but no, it was in actual billions of dollars, too. The cost of funds for u. S. Banks around the time of the crisis was around 100 billion a quarter, and it went down to less than ten. And that is money thats transferred directly from depositors to the banks, and the same thing in the marketplace, the cost of funds dropped, so debtors had the advantage of that and earning assets for a while were a lot higher, which boosted the returns for the banks. But to see, you know, how its barely 20 billion this past quarter, so that gives you some measure of just how much transfer there is. Its around 400 billion a year. Thats a lot of money. Now, the thing that really keeps me up at night is i see signs of skewing that we saw during the 2000s, but its even more pronounced this time. And this has to do with both residential mortgages, commercial real estate, and also some other Asset Classes. First and foremost, this is all bank loans. You can see loss given default, which is charge offs, less recoveries, is actually pretty low, 75 for the entire 6, 7 trillion in loans on the u. S. Banking industrys books. You can see theres been periods when it was also very low, but those if you look at it, that was the roar in 2000s and back in the early 90s, none of which were particularly good periods, but again when you watch this it gives you a sense of whats going on in the underlying loan markets. Now, this is one of the four family mortgages. One of four family mortgages are at the lowest net loss rate that weve ever observed, and i think this is two things. This is home prices have been going up double digits in many markets for years, far higher than the reported inflation rate, but the board of governors refuses to look at it in part of their deliberations. The other thing is, again, less leverage on the book. The ltvs of current production mortgages are lower than they were before the crisis, so i think that may be a factor, as well. I havent been able to isolate it, but i suspect its more than just, you know, topping home prices involved here. This is, i think, an even more striking book. This is construction development. Construction Development Loans are almost not on the menu for banks today. Regulators have told them not to do it. After the crisis, the portfolio got cut in half from about 600 billion to, literally, 300 billion. A lot of those loans were charged off or paid off or whatever, but the banks were discouraged from going back there and have been told to have much higher amounts of capital from the client than they would have required previously. However, look at the numbers. Theyve been skewing for quarters, which means that when a loan defaults, they are making th