speeches · August 3, 2002

Speech

William Poole · President

Financial Stability CouncilofStateGovernments SouthernLegislativeConferenceAnnualMeeting NewOrleans,Louisiana August4,2002 PublishedintheFederalReserveBankofSt.LouisReview,September/October2002,84(5),pp.1-7 Iam pleased to be here to address this ses- day,butnotforthereasonsincorporatedinthe sionoftheannualmeetingoftheSouthern establishedwisdom. Legislative Conference. Since becoming Mypurposetodayistwofold—toprovide president of the St. Louis Fed, I’ve gotten someperspectiveonhowthestockmarketmatters to know pretty well a good part of the 16-state andtodiscusspossibleapproachestocreating region that comprises the Southern Conference. greaterfinancialstability. The Eighth Federal Reserve District, headquar- Beforeproceeding,Iwanttoemphasizethat tered in St. Louis and with branches in Little theviewsIexpressherearemineanddonot Rock, Memphis, and Louisville, includes all of necessarilyreflectofficialpositionsoftheFederal Arkansas and parts of Kentucky, Mississippi, ReserveSystem.Ithankmycolleaguesatthe Tennessee, and Missouri. (The Eighth Federal FederalReserveBankofSt.Louis,especially Reserve District also includes the southern por- RobertRascheandWilliamEmmons,fortheir tionsofIllinoisandIndiana.)I’vetraveledexten- comments,butIretainfullresponsibilityfor sively in this region, meeting bankers, business errors. leaders, community and university leaders, and elected officials at all levels of government. This is a region full of vitality and, I might add as an GOODS AND CLAIMS ON GOODS easterner for most of my life, delightful southern OneofSmith’sessentialinsights,astrue hospitality. todayasin1776,wasthatgoldhadtobeviewed Mychargetodayistodiscussthecondition ofthenationalandSLCstateeconomies.There asaclaimongoods.Thereasonthatpeopleval- arealwaysmanyelementstoanalyzingtheecon- uedgoldwasthatitcouldbeusedtobuygoods omy;I’vedecidedtoconcentrateontheaspect theywanted—food,clothing,shelter,land,and ofthecurrentenvironmentthatseemsmost anythingelseavailableinthemarketplace.From troubling—theconditionoftheequitymarkets. theperspectiveofanyoneindividual,goldpro- Twohundredandfiftyyearsagoitwasestab- videdcommandovergoodsandthereforewasa lishedwisdomthatthemeasureofanation’s componentoftheindividual’swealth.Butfrom materialwealthwasthesizeofitsstockofgold. theperspectiveofallindividualstakentogether— AdamSmith,inhisgreatbook,TheWealthof theentirenation—commandovergoodsdepended Nations,publishedin1776,arguedthatthisview onthesupplyofgoods.Anationcannot,except wasdeadwrong—thatthetruemeasurewasthe temporarily,consumegoodsbeyondwhatitpro- nation’soutput.Today,alltoooften,peoplemake duces.Foranationasawholetoenjoyahigh asimilarmistakeastheyjudgeanation’swealth materialstandardofliving—tohavealargecom- bythelevelofitsstockmarket.Goldwasimpor- mandovergoods—ithadtoproducealotofgoods. tantinSmith’sday,asisthestockmarketinour ThusSmitharguedthatthewealthofanation 1 FINANCIALMARKETS dependsontheproductivityofitspeople,which toriesorbuyingnewcapitalequipment.Thusthe permitsittoproduceahighlevelofoutputfrom levelofstockpricesaffectsthecostofcapital, thehoursoflabordevotedtoproduction. whichinturnaffectstherateofbusinessinvest- Nothinghaschangedinthisregardfrom mentinphysicalcapital.Asecondmechanism Smith’sday.Thestockmarketwealthofthree istheeffectofwealthonhouseholdconsumption. yearsagoprovidedeachpersonholdingashare Whenwealthishigh,householdstendtospend ofthatwealthwithacommandovergoodsthat moreoftheircurrentincome,becausetheysee seemed,andintheaggregatewas,large.Itwas lessneedtosaveforthefuture.Whenwealth notpossible,however,forallindividualstogether declines,householdstendtoconsumelessand tocashinthatwealth;forallindividualstogether, tosavemore.Thusthelevelofthestockmarket thegoodsthatpeoplecouldbuywerelimitedto canaffecthouseholds’demandforcars,TVs, thegoodstheeconomycouldproduce.Giventhat vacationtravel,andalltheotherthingspeople weliveinaglobaleconomy,wecanapplythat spendtheirincomeon.Itisimportant,however, statementtoalltheworld’scitizenstakentogether. tothinkaboutthewealtheffectintermsoftotal householdwealth,whichincludesthevalueof bondsandrealestateaswellascommonstock. Finally,theevidencesuggeststhatthewealth BUYERS AND SELLERS effectisspreadoutovertimeandissmallrelative BeforeIdiscusstheroleofthestockmarketin totheeffectofhouseholdincome. theeconomyIhavetogetanissueoutoftheway— Intheshortrun,stockmarketfluctuations thesimplefactthateveryshareofstocksoldis arefar,farlargerthanfluctuationsinthenation’s alsoonepurchased.Stockmarketanalystswho production,whichwemeasurebytheinflation- explaintheupsanddownsofstockpricesinterms adjustedgrossdomesticproduct(GDP).Forexam- ofinvestorsgettingintooroutofthemarketarenot ple,overthefourquartersendingwiththesecond makinggoodsense.Investorsasawholecannot quarterofthisyear,realGDProseby2.1percent. getintooroutofthemarket.Aneffortofinvestors Overthesameperiod,theS&P500stockindexwas togetoutofthemarketdepressesstockprices down16percent.Relativetothestockmarket, sufficientlythatotherinvestorsarepersuadedto realGDPissosteadythatwecanformanypur- buy.Ofcourse,thenumberofsharesofstockout- posesthinkofGDPasbeingfixedintheshortrun. standingdoeschangeovertimethroughbank- GiventhatGDPisverysteadycomparedwith ruptcies,companysharerepurchasesthatretire thestockmarket,thebehaviorofstockprices stock,andnewissuesthataddtothetotalout- primarilyaffectswhogetshowmuchofGDP standing.Thesefactorsareoftrivialimportance ratherthanthetotalofGDPitselfintheshort forthenumberofsharesoutstandingdaybyday. run.Ifyouareluckyenoughtosellstockatthe Becausesharessoldequalssharespur- peak,yougetmore;ifyouareunfortunateenough chased,allinvestorstakentogethercannotcon- tosellatthebottom,yougetless.Ineithercase, vertclaimsonwealthintogoods.Ifoneinvestor thebuyerofthesharesyousellisgettingeither sellsstockforthepurposeofusingtheproceeds lessormore,thenecessarymirrorimageofwhat tobuy,say,anewcar,thensomeotherinvestor youaregettingthroughtheaccidentofyourtim- mustforegospendingongoodsinordertobuy ingofstocksales. thesharesthatthefirstinvestorisselling.The Thisredistributionofwhogetswhatsome- effectofsharepricesontheeconomyisnecessarily timesmakespeopleangry,andtheyhavegood indirect. reasontobeangryiftheredistributionreflects Economistsemphasizetwomechanisms marketmanipulationofsomesort.Thisisoneof throughwhichsharepricesaffecttheeconomy. thereasonsthatreformstoreducethelikelihood Oneisthatinarisingmarketcompaniescanmore ofmarketmanipulationeffectedthroughaccount- easilyraisefundstodevotetobuildingnewfac- ingfraudandothermeansissoimportant.ButI 2 FinancialStability dowanttopointoutthatmuchoftheredistribu- Thosestockmarketlossescouldnothave tionbetweenstockmarketwinnersandlosers occurredifthemarketdidnotexhibitsuchlarge reflectsoutcomesthataresomewhatsimilarto fluctuations.Suppose,hypothetically,thatstock thoseofalottery.Nooneisforcedtobuyalottery pricesgrewconsistentlyalongasmoothpath. ticket,andthosewhodoshouldnotbelievethat Takeastockmarketchartfrom1950totodayand theredistributionofwealthfromlotterylosersto drawasmoothlinebetweenthestartingandend- lotterywinnersisunfairinanyrespect,provided ingpoints.Ifstockpricesgrewsmoothlyalong thattheselectionofthewinnersisnotmanipu- suchapath,allthepromiseofrapidgainswould latedinanyway. beabsent,aswouldalltheanguishofhavingasset Everyseriousstudentofthestockmarket valuesdisappear.Eachstockmarketinvestor knowsthatthetrackrecordofpresumedexpert wouldhaveahighdegreeofcertaintyabouthis stockpickersisnotconsistentlybetterthanpure orherfinancialconditionduringretirementyears. randomstockselection.I’mnotlookingtodrum Wouldinvestorsinfactconfinethemselves uphundredsofangrye-mailmessagesfrominvest- tosuchstableandpredictableinvestments?I mentprofessionals,andsoletmeaddthatIbelieve suspectnot.Indeed,Iamquitecertainthatmany thatinvestmentprofessionalshavealottooffer. wouldpursuestrategiestheybelievedwouldyield Itisjustthattheirclientsshouldnotbelievethat higherreturns.Afterall,investorswhowent theirinvestmentservicesincludereliablestrate- heavilyintothestockmarketseveralyearsago giestoconsistentlypickstocksthatwilloutper- didhavealternativesthatwerehighlystableand formtheoverallmarketandconsistentlyidentify predictable,suchasgovernmentbonds,andthey therighttimestobuyandsell. chosenottoconfinethemselvestothosesafe havens.SoI’mnotsurethatcreatingastable stockmarket,ifweknewhowtodoit,wouldbe WHY THE STOCK MARKET successfulinstabilizingtheretirementprospects ofmanypeople. MATTERS Ifthestockmarketdoesnotmeasurethe WhenAdamSmitharguedthatgoldwasnot nation’swealth,whatdoesitmeasureandwhy therightmeasureofanation’swealth,hewas doesitfluctuatesomuch?Thepriceofacom- notsayingthatgoldwasirrelevanttoanation’s pany’sstockreflectsmarketexpectationsabout prosperity.Inhisday,themonetarysystemwas thefutureearningsofthecompany—thestock basedongold,andmonetaryinstabilityclearly priceisthepresentdiscountedvalueofthe hadnegativeeffectsontheeconomy.Today,the expectedfutureincomestream.Forallcompanies monetarysystemisnotbasedongold,andforthis takentogether,thoseexpectationsthereforecon- reasongoldhaslittlemacroeconomicsignificance. cernthecountry’sfutureoutputandnotitscurrent Thestockmarket,thoughnotitselfanadequate output.Expectationsarechangeablebecausethe measureofanation’swealth,hasgreatimportance. futureisuncertainandbecausetheymaybe Themarket’seffectonbusinessinvestmentand influencedbywavesofoptimismorpessimism. householdspendingonconsumptiongoodsis Thoseexpectationsdoaffectcurrenthousehold onlypartofthestory. andbusinessbehavior,buttheyarefarfromthe Letmezeroinonamatterofgreatconcernto onlydeterminants. manyfamiliestoday.Inrecentyearsmillionsof Somedecrywhattheyseeastheirrational peoplehaveplacedtheirretirementsavingsinthe fluctuationsinthestockmarketreflecting,they stockmarket.Thosewhoplacedahighfraction believe,expectationsthatgetcarriedawayon oftheirassetsincertainstockshaveseentheir theupsideordownside.Imyselfdonotbelieve retirementdreamsandtheirfinancialsecurity thatitisatalleasytoidentifyexpectationsthat disappearinthebearmarketunderwaysince areirrational.Weliveinanationthatisgenerally early2000. exuberantaboutfuturepossibilities.Tomytaste, 3 FINANCIALMARKETS wearefortunatetoliveinasocietythatnurtures omy.Wewantastockmarketthatisreceptiveto invention.Ourrisk-takingmentalityhastwosides newenterprisesanddoesthebestjobpossible toit.Ontheonehandistheentrepreneurial insendingcapitaltowardthemostpromising spiritthatdevelopsnewtechnologiesandbrings endeavors. themtomarket.Manyofthesenewtechnologies createastonishingimprovementsinourmaterial standardofliving.Ontheotherhandisagambling PUBLIC POLICIES TO PROMOTE mentalitythatissometimesfoolish.Aheadof FINANCIAL STABILITY time,itisrarelyeasytotellwhichbetsonnew businesseswillworkandwhichwillnot. Thereisnorealisticprospectofdevising Theimportanceofthestockmarketforthe publicpoliciesthatwillyieldstockpricesthat long-runperformanceoftheeconomyisconsider- arealways“right.”Thefutureisalwaysuncertain. able.Thelongerthespanofyearsconsidered,the Newtechnologiesareinherentlyexperimental— lessaccurateistheassumptionthatGDPisroughly somewillworkandotherswillnot.Froma constant,unaffectedbythebehaviorofthestock broaderperspective,thenewenterprisesthatfail market.TherateofgrowthofGDPdependscriti- arenotsignsofsocietalfailure.Abusinesscom- callyontherateofproductivitygrowth—the munitythatneverfailsisonethatnevertries. growthofoutputperhouroflaborinput.Product- Still,wecertainlywanttoavoidpublicpoli- ivitygrowthflowsfrominnovationandentrepre- ciesthatpermit,orencourage,avoidablemistakes. neurship.Aproductivitygrowthrateof1.5percent Thecurrentdebateoveraccountingprinciplesis peryear,aboutwhatwasachievedfrom1968to veryhealthy.Penaltiesforfraudulentaccounting 1995,increasespercapitaGDPby16percent andincreasedenforcementeffortswillyieldsub- after10years.Since1995,productivitygrowth stantialsocietalbenefits.Isay“societal”andnot hasbeenabout2.5percentperyear.Thatrateof just“economic”becauseamarketeconomythat productivitygrowthincreasespercapitaGDPby isfair,andwidelyperceivedasfair,hasbenefits 28percentin10years.Thereisabigdifference farbeyondahighermaterialstandardofliving. between16percentand28percentGDPgrowth Wewillcomeouttheothersideofourcurrent overthecourseofadecade. experiencewithaccountingirregularitiesina Productivitygrowthdependsonmany muchstrongerpositionthanweenteredit.Cor- things:Oneofthosethingsistheefficiencywith porateboards,seniormanagement,andauditfirms whichtheeconomyallocatesinvestment,which willnottakerisksonaccountingissueslightly. inturndependsinpartonthestockmarket.It Thecombinationofgovernmentactionandmar- canbearguedthattheboomingstockmarketin ketdisciplinehasbroughtsomeprominentand thelate1990spermittedtelecomcompaniesto long-establishedfirmsdownquickly,andevery- financeinvestmentsincomputerequipmentand oneinvolvedincorporategovernancewillremem- fiberopticcablethatwerewastefulinthesense bertheseeventsforalongtime.ThefateofArthur thatthiscapital,eventoday,severalyearsafter Andersen,Enron,WorldCom,andotherfirms beingputinplace,isnotgeneratingoutputand illustratesthattheUnitedStatesdoeshavemech- income.Wewouldhavehadhighercurrentoutput anisms—bothgovernmentalandmarket-based— iftheinvestmenthadgoneinsomeotherdirection. toimposelastingeconomicreforms.Consider Fromthestandpointofthisparticularstory,the someotherexamples. economy’sproductivitywasdamagedandnot Bankfailuresinthe1930sledtodeposit enhancedbythestockmarketboomintelecom insurance.Thatreformcontributedgreatlyto shares.Butthetelecommistakewasnotobvious improvedbankingstability,butitturnedoutto atthetimeitoccurred.Ifithadbeencompletely haveaflaw.Theconsequenceofaninadequate obvious,itwouldnothavehappened.Investment regulatorysystemwasthefailureoftheFederal mistakesareaninevitablepartofadynamicecon- SavingsandLoanInsuranceCorporation,as 4 FinancialStability scoresofinsuredsavingsandloanassociations accountingandauditpractice.Similarly,itwas failed.Tomakegoodonthedepositinsurance easytolookbackin1990andwishthatsomebody, guarantee,thecosttothetaxpayersintheearly somehow,haddonemoretostrengthenregula- 1990swasintheneighborhoodof$150billion. tionofS&Ls,topreventthelossof$150billion Butwelearnedalesson.Regulatoryrequirements oftaxpayerfunds.Whatcanwedorightnowto werestrengthened;themostimportantofthese, lookahead,toseewhatvulnerabilitieswemight inmyopinion,wasmuchmorerigorousenforce- face,andtodosomethinginadvancetoensure thatsomenewsourceoffinancialinstability mentofcapitalrequirementsforinsureddeposi- doesnotbiteus? toryinstitutions. Periodsofgreatmarketinstabilityarise Weshouldnotunderestimatethecontribution whenthreeconditionsaremet.First,something ofthisreformforimprovingfinancialstability. happensthathaswidespreadsignificance—is Failuresofdepositoryinstitutionsinthelate largeenoughtomattertolotsofpeople.Second, 1980sandearly1990srestrictedtheavailability thetriggeringeventisasurprise;ordinarily,events ofcredittomanyborrowers,especiallythose longanticipatedarenotaproblembecausecor- thathadtraditionallyreliedonbanksandS&Ls. rectiveactionoccursbeforeproblemsarise.Third, Thecreditrestrictionwasoneofthereasonsthe substantialuncertaintycloudsresolutionofthe economyrecoveredslowlyfromthe1990-91 problem.Itisespeciallydifficultforinvestorsto recession.Incontrast,lastyear’srecessionwas knowwhattodowhenthegovernment’sresponse relativelymildinpartbecausethebankingsystem toanunfoldingsituationishighlyuncertain. wasstableandabletolendtoreasonablebusiness Letmeproposetwovulnerabilitiesweface risks.Thestabilityofthebankingsystemcertainly thatreallyneedtobeexaminedcarefully.One helpedtheeconomycopewithrecession. isfamiliartoeveryone—thestateoftheSocial Onemoreexample,thoughasmallerone: SecurityandMedicaresystems.Theissuecer- WhenthePenn-CentralRailroaddeclaredbank- tainlymeetstwoofmythreecriteria.Thepotential ruptcyin1970,thecommercialpapermarketwas problemishugeandthereisgreatuncertainty disruptedasinvestorswonderedwhatotherfirms aboutwhatthegovernmentwilldo.Eventhough werealsosuspect.Thesuspicionwasinmany theproblemisnotasurpriseinonesense,it waysasmall-scaleversionofwhatweareseeing couldquicklyturnintoone.Thefactisthata today.UntilJune1,Penn-Centralcommercial changeineconomicconditionscouldquickly paperwasratedhighly,andthecompany’sbank- increasetheestimatedsizeoftheproblemand ruptcyonJune21wasashock.Investorsrefused moveforwardthetimewhentheproblemwould torollovercommercialpaperofmanyhighlyrated becomeacute. companiesbecausetheywerenolongersurewhat Ifthenationfindsitselfinaperiodoffinancial theratingsmeant.Sincethatexperience,compa- instabilitybecauseofanunexpectedandrapid nieshaveroutinelyarrangedback-uplinesof escalationofthefinancialproblemsfacedby creditatbanks,whichtheycanrelyonshould SocialSecurityandMedicare,wewilllookback andwonderwhy,withthevulnerabilityknown thecommercialpapermarketturnunreceptive. forsolong,nothingwasdonetoreduceit.The Thatchangeinbusinesspracticepreventedany nationhastimetoact,butdisagreementonwhat recurrenceofthegeneralizeddisruptionofthe shouldbedonehasledtoastalemate.Maintain- commercialpapermarketthatwewitnessedin ingfinancialstabilityrequiresawillingnessto 1970. findsomewaytoengineeracompromisetoreduce thenation’svulnerabilitythatafinancialcrisis willsomedayflowfromSocialSecurityand LOOKING AHEAD Medicare. Itiseasytodaytolookbackandwishthat ThesecondvulnerabilityIwouldliketosee somebody,somehow,haddonemoretoimprove morewidelydiscussedconcernsgovernment- 5 FINANCIALMARKETS sponsoredenterprises,orGSEs.TheGSEsinclude theearly1930s.Goodandbadbanksalikewere FannieMae,FreddieMac,theFederalHomeLoan affected.Foranotherexample,in1970thePenn- BankSystem,andanumberofsmallerentities. Centralbankruptcyaffectedtheentirecommercial TheGSEsmeetallthreeofmycriteriaforthe papermarket,asinvestorsdidnotknowwhich potentialofcreatingfinancialinstability. commercialpaperissuerswereinfactprime First,theGSEsarecertainlylarge.Inthe creditsandwhich,thoughratedprime,werenot. UnitedStatestoday,GSEsecuritiesandgovern- Thisyear,accountingproblemsidentifiedinafew ment-relatedmortgagepoolsecuritiesoutstand- firmshaveraisedquestionsininvestors’minds ing,excludingdeposits,exceedthetotal aboutalmostallfirms.Wemaybelievethatonly outstandingsecuritiesissuedbyall—Irepeat, onefirmintwenty,orinfifty,hassuspectaccounts, all—otherprivatefinancialsectorfirmstaken buthowdoweknowwhichfirms?Wedon’t,and together.FannieMaeandFreddieMacalone,as thereforeinvestorstreatallfirmsassuspectuntil oflastDecember31,hadsecuritiesoutstanding theaccountingtreatmentsareverified.Whenthere of$1.3trillionandhadguaranteedanother$1.8 isanissueofthiskind,ittakesawhiletoget trillionofmortgage-backedsecurities(MBS). everythingsortedout;inthemeantime,securities Lookedatanotherway,thetotalofGSEdirect pricesarepusheddown. andguaranteeddebtis40percentlargerthanthe InthecaseoftheGSEs,themassivescaleof federalgovernment’sdebt.Thatdebt,whichwe theirliabilitiescouldcreateamassiveproblem looselycallthe“nationaldebt,”has,ofcourse, inthecreditmarkets.IfthemarketvalueofGSE beenamatterofconsiderablediscussionin debtweretofallsharply,becauseofambiguity recentyearsinthedebatesaboutfederaldeficits aboutthefinancialsoundnessofGSEsandabout andsurpluses. thewillingnessofthefederalgovernmenttoback- Second,althoughfinancialexpertsunder- stopthedebt,whatwouldhappen?Idonotknow, standthevulnerability,myjudgmentisthattoo andneitherdoesanyoneelse. fewinthemarketsandingovernmentunderstand LikeSocialSecurity,therearedifferentviews theissues.Consequently,ifthereiseveraprob- onwhat,ifanything,shouldbedoneaboutthe lem,itwilltakemanybysurprise. GSEs.Inthemeantime,theprevailingviewseems Third,thereistremendousambiguityabout tobethataGSEdebtmeltdowncouldnotoccur, thestatusoftheGSEs.ThemarketpricesGSE orcouldnotoccursoon.Idonotseeanyimme- debtasifthereisafederalguarantee,orahigh diateriskofaGSEdebtproblem,butamnotwill- probabilityofaguarantee,standingbehindthe ingtoassumethatindifferentconditionsinthe debt.Yet,thereisnoexplicitguaranteeinthelaw. futureonecouldnotoccur.Ajudgmentthatthere Nooneshouldunderestimatethepotential isnopotentialvulnerabilityseemstometobe importanceoftheambiguityoverthefinancial unwarrantedinlightofthefinancialhistoryof statusoftheGSEs.Itisnotsufficientforanysingle theUnitedStatesandothercountries.Onething GSEtoarguethatitsownfinancialconditionis Iknowforsureisthatiftheproblembecomes sound.IfoneGSEcomesunderacloud,others immediateandreal,thendealingwithitwillbe mayalso.Thathasbeenourexperienceagainand verydifficultbecausetheurgencywillbesogreat. again.Itistheprocesseconomistscall“contagion” Letmethrowoutfordebatetwostepsthe wherebyuninvolvedorinnocentfirmsareaffected federalgovernmentmighttake.First,various becausethemarkethasdifficultydistinguishing aspectsoffederalsponsorshipthatthemarket solidfirmsfromthoseatrisk. interpretsasprovidinganimpliedguaranteeof Perhapsthemostfamousexampleofconta- GSEdebtshouldbewithdrawn.1TheSecretary gioninU.Shistoryistheseriesofbankrunsin oftheTreasuryhastheauthoritytobuyGSEobli- 1 FarmerMac,anotherGSE,wasmuchinthenewsinrecentmonths.AnarticleintheNewYorkTimesnotedthatoneoftheadvantagescon- ferredbygovernmentsponsorshipis“theabilitytoborrowalmostascheaplyasthegovernmentdoesbecauseofaperceptionofgovernment 6 FinancialStability gations;inthecaseofFannieandFreddie,the During2001,FannieMaeissued$5billionof authorityisuptoamaximumof$2.25billionfor subordinateddebtthatreceivedaratingofAA eachfirm.TheGSEscouldeasilyreplacethis fromStandard&Poor’sandAa2fromMoody’s potentialsourceofemergencyfinancialsupport InvestorsService.FannieMae’ssubordinated debtservesasasupplementtoFannieMae’s withcreditlinesatcommercialbanks,following equitycapital,althoughitisnotacomponent thewidespreadpracticeamongissuersofcommer- ofcorecapital.Itprovidesarisk-absorbing cialpaper.Theamountavailableatthediscretion layertosupplementcorecapitalforthebenefit oftheSecretaryoftheTreasuryisfartoosmallin ofseniordebtholdersandservesasaconsis- anyeventtodealwithacrisisintheGSEdebt tentandearlymarketsignalofcreditriskfor market.EliminatingtheTreasury’sauthorityto investors.Bytheendof2003,FannieMae lendtotheGSEswouldprovideasignalthatthe intendstoissuesufficientsubordinateddebt governmentisseriouswhenitsaysthatthereisno tobringthesumoftotalcapitalandoutstanding governmentguaranteeofGSEdebt.Second,over subordinateddebttoatleast4percentofon- atransitionalperiodofseveralyears,theGSEs balancesheetassets,afterprovidingadequate shouldaddtotheamountofcapitaltheyhold. capitaltosupportoff-balancesheetMBS.Total capitalandoutstandingsubordinateddebt Capitaliscriticalbecause,whenthereisa represented3.4percentofon-balancesheet crisisinthesecuritiesmarkets,financiallystrong assetsatDecember31,2001.(pp.44-45) firmscanstandthepressurewithoutlastingdam- age.Capitalprovidesacushionagainstmistakes ThecapitalsituationatFreddieMacisabout andunforeseeablecircumstances.Withadequate thesameastheoneatFannieMae.Thecapital capital,afirmcanalmostalwaysraiseemergency adequacystandardsapplyingtothesetwoGSEs loanstocoveritsliquidityproblems. wereestablishedbytheFederalHousingEnter- Theimportanceofadequatecapitalbecame prisesFinancialSafetyandSoundnessActof cleartopolicymakersastheS&Lproblemsaccu- 1992.Thecorecapitalrequirementis2.5percent mulatedinthelate1980s.Tighteningofcapital ofon-balancesheetassetsand0.45percentof standardsforinsureddepositoryinstitutionsand outstandingmortgage-backedsecuritiesandother theadministrationofthoserequirementswasa off-balancesheetobligations.Theoff-balance keypartofthereformsputinplaceatthattime. sheetobligationshaveacapitalrequirement CapitalisimportantfortheGSEsbecause becausetheyareguaranteedbyFannieand theirshort-termobligationsarelarge.FannieMae Freddie. andFreddieMachavedebtobligationsduewithin Intheprivatesector,governmentsecurities oneyearofabout45percentoftheirdebtliabili- dealerscarrycapitalintheneighborhoodof5 ties.Anyprobleminthecapitalmarketsaffecting percent,andotherfinancialfirmsconsiderably thesefirmscouldbecomeverylargeveryquickly. more.Forexample,FDIC-insuredcommercial CapitalonthebooksofFannieandFreddie banksholdequitycapitalandsubordinateddebt iswellbelowthelevelsrequiredofregulated ofnearly11percentoftotalassets. depositoryinstitutions.Letmequoteaparagraph TheissuewithFannieandFreddieisnot fromthe2001AnnualReportofFannieMae,the oneofdisclosure.Theirannualreportsdisclose largestsingleGSE. quitewellthehighdegreeofcomplexityoftheir backingthatemanatesfromasinglesectioninitscharter.ThatprovisionallowstheTreasury,incertaincircumstances,toprovideupto$1.5 billioninloanstoFarmerMactosupporttheguaranteesthecompanyextendsonfarmloans”(9June2002,p.8,col.1). AnearlierarticleintheNewYorkTimessaidthefollowing:“Theboldfacedisclaimers[onGSEdebtofferings]statethatthesecuritiesare notguaranteedbyanddonotconstitutedebtsorobligationsoftheUnitedStatesgovernment.Butthewarningsareroundlydismissedbythe analystswhofollowtheissuers’stocks,theagenciesthatratetheirseniordebtandthemoneymanagerswhoputtheircommercialpaperin moneymarketfunds.Ininterviewafterinterview,marketprofessionalssaidthatevenifthepaperdidnotcarryanovertgovernmentguarantee, therewasanimpliedguarantee,whichwasjustasgood,andthegovernmentwouldnotallowweaknessinthesecuritiestowreakhavoc.That marketconfidenceisevidentinthelowinterestratesthattheorganizationshavetopayinvestorsforfinancing,oftenonlyhalfapercentage pointmorethanwhattheUnitedStatesTreasurypays”(21May2002,p.1,col.5). 7 FINANCIALMARKETS operations,andthesmallamountofcapitalthey tofinancialinstability?Thetaxlawcouldbe carryoverthatrequiredbylaw.Myquestionsare changedinarevenue-neutralwaytoeliminate these:Giventhecomplexityoftheiroperations, thisproblem.Ithinkweshoulddoso. isthecapitalstandardinthelawadequate?Why isthestandardsofarbelowthatrequiredoffed- erallyregulatedbanks?Whatwillhappentothe CONCLUDING COMMENTS housingmarketifFannieandFreddiebecome Thedeclineinthestockmarketsinceearly unstable? 2000,andespeciallythissummer,hasbeen I’vebeenemphasizingtheimportanceof painful.Weshouldnot,however,thinkofthe strengtheningpublicpolicytoaddresspotential stockmarketasadirectmeasureofthenation’s problems.Letmeaddonefurtheritemtobecon- wealth.Allyouhavetodoislookatchartsside sidered—whetherfederaltaxlawshouldcontinue bysideofthestockmarketandGDPtorealize toencouragesubstitutionofcorporatedebtfor thatthereisalonghistoryofstockmarketfluctu- equity. ationsthatarefarlargerthanGDPfluctuations; Incalculatingincomesubjecttotax,corpora- moreover,thetwoarenotallthathighlycorre- tionscandeductinterestpaidbutnotdividends lated.Iamnottryingtotellyouthatthestock paid.Thatprovisionencouragescorporationsto marketdoesnotmatter,butIamtryingtoputthe issuedebtinsteadofequitytofinanceexpansion matterinproperperspective.Fromwhatweknow, andacquisitions.Firmssometimesissuedebtand itisreasonabletoexpectthattheeconomicrecov- usetheproceedstoretireequity.Manycorpora- erywillcontinueandthatthestockmarketwill tionstodaypaylittleornodividendsatall,pre- intimesettledown. ferringtoprovideareturntoshareholdersthrough Thisexperienceshouldmakeusthinkabout expectedcapitalgainsontheshares,whichare whatpublicpoliciescouldhelptoreducethe taxedatalowerratethandividendsintheper- severityofmarketinstabilityinthefuture.Reforms sonalincometax. toaccountingandcorporategovernancenowbeing Thereisnodoubtthatahighlevelofdebt putinplaceareconstructive.I’vesuggestedsome increasestheriskoffinancialinstability.Firms otherthingsweshouldlookat,particularlythe failwhentheycannotpaytheirbills.Whenalarge SocialSecurityandMedicaresystems,theGSEs, fractionofrevenueisdevotedtopayinginterest andthecorporatetaxlaw.Mylistisnotmeantto insteadofdividends,firmsaremorevulnerable beexhaustive,butsurelyhasenoughitemsforone tofailurewhenrevenuesfall.Adividendcanbe speech.Ifanyoftheseareascomebacktobiteus cutoreliminated;interestpaymentscannot.Does inthefuture,we’llknowthattheenemyisus. itmakegoodsensetomaintainafeatureofthe taxlawthatmakestheeconomymorevulnerable 8

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APA

William Poole (2002, August 3). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20020804_poole

BibTeX

@misc{wtfs_speech_20020804_poole,
  author = {William Poole},
  title = {Speech},
  year = {2002},
  month = {Aug},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20020804_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}