Christopher Papagianis

In many ways, we’ve already fallen off the cliff. The focus by government and market analysts on the potential medium-term impact on GDP has obscured some themes that deserve far greater attention.

Entitlement reform is no longer something that can be pushed aside. If the government had used GAAP accounting (generally accepted accounting principles), as do practically all private-sector companies (and even local governments), the deficit in 2011 would have been $3.7 trillion higher. This would have been on top of the $1.3 trillion official deficit that was recorded by the Congressional Budget Office and the president’s Office of Management and Budget.

While John Williams of Shadow Stats has been writing about this theme for years, mainstream outlets like USA Today are starting to cover how the government basically exempts itself from including the costs of promised retirement and healthcare costs in its deficit calculation. Including the growing costs of future Social Security and Medicare liabilities, the deficit in 2011 was $5 trillion.

Despite an accumulated “Trust Fund” of nearly $3 trillion, Social Security is already losing $165 billion in cash annually. This is partly due to the recent payroll tax cut. But the financial capacity of the Trust Fund also peaked in 2008 and is set to decline steadily for the next 30 years. At the same time, Medicare expenses are shown to exceed dedicated payroll tax receipts by $255 billion per year. The current accounting conventions distract us from the obviously perilous situation of spending $400 billion more per year on these programs than the U.S. is taking in – even before considering the much larger annual cash flow imbalances of future liabilities.

For the government to meet its future Social Security promises, it would have to set aside more than $20 trillion and find a place to park these reserves to earn some interest. USA Today notes that this figure is almost double what would have been required as recently as 2004.

The Fed’s decision to begin open-ended purchases of Fannie Mae and Freddie Mac mortgage-backed securities comes on the heels of the European Central Bank’s decision to purchase unlimited quantities of short-duration government bonds across the euro zone.

The ultimate goal of the central banks’ action is to influence the prices and yields of financial assets. In turn, they hope to have an impact on households and businesses by lowering borrowing costs and encouraging an increase in spending to boost GDP.

However, there is a growing worry that these actions can’t solve the underlying problem and that the returns on these actions are diminishing fast. Against this backdrop, fiscal authorities are warning that they see central bankers and the decisions that emerge from their closed meetings as going “deeper and deeper into fiscal-type waters,” jeopardizing central bank independence. As John Cochrane has noted, “central banking really is the last refuge of central planners, which should embolden [us] to search for rules, institutions, and mechanisms to do a better job.”

Recent changes to a mortgage refinancing program finally have it running smoothly and helping “underwater borrowers”: Can Congress really ignore this?

Fannie Mae and Freddie Mac’s Home Affordable Refinance Program (HARP) helps borrowers who are underwater (and only those who are current on their payments) refinance their mortgage at lower interest rates. While it took lenders a few months to implement the changes, hundreds of thousands of borrowers have already refinanced their mortgage or are in the pipeline to do so. The new HARP 2.0  includes a pricing regime that encourages borrowers to refinance into mortgages with shorter terms, which means borrowers are building back equity in their homes faster. And that is good.

Congress just broke for its August holiday, so we will have to wait until September for the next flare-up in housing policy. However, a debate was recently reignited that leaves plenty of room for thought.

Sandy Weill’s comments this week are just the latest dustup in the debate about the existence of financial institutions that are labeled by regulators and market participants as being too big to fail. Despite the criticisms leveled at these firms, the largest banks have only gotten bigger over the last few years – and U.S. regulators still appear underprepared to resolve a future failure of a systemically important financial institution without setting off broader market panic.

Against this backdrop, new bank reform proposals are likely to get a lot more attention on Capitol Hill heading into the November election. Catalysts for this debate are sure to include the stories around JPMorgan’s London Whale trader and the brewing Libor scandal.

In a recent paper, academics Frederic Schweikhard and Zoe Tsesmelidakis examined the borrowing advantage that large financial institutions had from 2007 to 2010 as result of the market’s perception that their liabilities were backed by the federal government. Taxpayers subsidized TBTF banks to the tune of $130 billion, according to their findings. Citigroup was the single biggest beneficiary of government support, totaling $50 billion, but even well capitalized JPMorgan is estimated to have gained $10 billion in value from taxpayer guarantees.

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

Just as the recession in the early 2000s became linked with the bursting of the tech bubble, for many the financial crisis in 2008 has been synonymous with the blow-up of subprime mortgages.

But there was more to 2008 than that.

Gary Gorton, an economist at Yale, recently published an analysis that shows how well some subprime mortgage-backed securities have performed over the past few years – a very counterintuitive conclusion. Citing one of his graduate students, Gorton explains that AAA/Aaa-rated subprime bonds issued in the peak bubble years (when mortgage underwriting was arguably the weakest in history) were only down 0.17 percent as of 2011. In other words, the highly rated subprime bonds – or toxic assets so associated with the financial crisis – have experienced only minimal losses since the bubble popped.

The policy response that perhaps best connects the U.S. financial crisis and the still brewing eurozone problem is that regulators have endeavored to make financial institutions more resilient. Policymakers on both sides of the Atlantic have focused on increasing financial institutions’ capital and liquidity positions to try to limit future bank failures and systemic risk. Both goals are served by increasing banks’ holdings of “safe assets” that are easily sold and retain value across different global economic environments.

But what if there simply aren’t enough safe assets to go around? After all, safe assets aren’t only being gobbled up in the name of financial stability. Today, the global investor universe is undoubtedly more risk-adverse and is naturally hungrier for these same stores of value. From insurers to pension funds, the demand for safe assets – and the corresponding dearth of supply – has led to strange, if not ominous, distortions in the market.

For example, over the last few years there have been numerous periods where the yields for short-term U.S. and German sovereign debt have turned negative. The real yields, or the amount earned after adjusting for inflation, on front-end Treasury notes are currently less than -1 percent. This means investors have been putting aside their search for yield, willing to lock in (small) losses with their new purchases because there were very few alternative and liquid markets where they could park their money on better terms.

There are about 1 billion cars on the world’s roads today. By mid-century, forecasts have that number climbing to 4 billion. Meanwhile, Congress is mired in a debate over whether to pass a new highway bill. Senator Barbara Boxer, a chief negotiator of the pending bill, lamented recently that she was “embarrassed for the people of this country” that this measure had not been enacted. After all, she said, passing highway bills used to be as popular and as important as “motherhood and apple pie.”

As with all previous highway bills, proponents generally wrap their arguments in projections for new jobs, or rhetoric that links fresh infrastructure spending to unclogging the arteries of commerce. For the president, a highway bill fits his campaign theme of getting America back to work. In a recent speech in Cleveland, the president issued a call to “rebuild America” and to do “some nation-building here at home.” The main obstacle remains how to pay for new spending and investment.

Flashback to 1998 and 2005: Those were the last years Washington enacted “highway bills,” or measures to reauthorize federal infrastructure spending programs. Now that the economy is sputtering in 2012, many would like to see Congress pull a page from the playbooks of those years. The taxpayer price tags for the ’98 and ’05 multiyear highway bills were $218 billion and $286 billion, respectively. Count President Obama as part of today’s infrastructure-stimulus choir, as he has proposed a $556 billion six-year bill.

The recent jobs and GDP numbers released by the government were a broad disappointment, and plenty of analysts have discussed the implications of the data. Yet, most of the analysis has focused on two dimensions – whether it’s now more or less likely that Congress or the Fed will act on either the fiscal or monetary fronts to try to boost the economic recovery.

The consensus is that the odds are marginally higher now that the Fed will signal something stimulative at its next meeting on June 19-20, while Congress is still hopelessly deadlocked, and the economy will have to show significantly more weakness for this dynamic to change.

However, there is a third dimension happening at the state level. The state-by-state GDP numbers out this week suggest that the probability that Republicans will take the Senate is rising. The weak economic growth numbers in some battleground states imply that Republicans could pick up several key U.S. Senate seats and probably take back the majority for the first time since 2006.

This post is adapted from the author’s testimony at a recent hearing before the U.S. Senate Banking, Housing, and Urban Affairs Committee.

Many of the major negative housing trends that dominated the headlines since the crisis are now well off their post-crisis peaks. While prices are only flat to slightly down year-over-year, there is finally some optimism for probably the first time in more than three years. But before we get ahead of ourselves, let’s examine some of the economic fundamentals and also assess the policy and regulatory headwinds that are still blowing from Washington.

New delinquencies are trending lower on a percentage basis. The decline in home prices also appears to be leveling off or approaching a bottom on a national basis. Data from CoreLogic suggests that house prices have increased, on average, across the country over the first three months of 2012 when excluding distressed sales. Even the numbers from the Case-Shiller Index out this week suggest that a floor in home prices has been reached.

In light of JPMorgan Chase’s bad derivatives trades, the media’s spotlight has appropriately turned to the pending Volcker Rule. That’s the moniker for the still-under-development regulation that might restrict big banks from pursuing hedging strategies across their entire portfolio, including their own bets. Proponents say banks shouldn’t be able to do this, since banks hold consumer deposits that are effectively guaranteed by taxpayers and since taxpayers could be forced to bail out a foundering bank if it’s deemed too big to fail. On the other hand, the underlying law for the Volcker Rule, the Dodd-Frank financial reform law, specifically exempts or allows hedging related to individual or “aggregated” positions, contracts or other holdings, which may very well have covered JPMorgan’s recent trade.

Inside the beltway, a fresh dispute is now emerging between regulators and policymakers on whether the current draft of the Volcker Rule can even apply to scenarios like JPMorgan’s, given how explicit Dodd-Frank is on this topic. On the one hand, there is the Office of the Comptroller of the Currency, which is starting to argue that these JPMorgan trades would likely have been exempted from the not-yet-final Volcker Rule. But then there are policymakers (namely, Senator Carl Levin) who are trying to make the case that Congress never intended for the law’s language to be interpreted so broadly.

While all the details around JPMorgan’s failed trading strategy emerge, there is an even more interesting backdrop to consider – whether JPMorgan Chase and other banks are still too big to fail. It was only a week ago that the Senate Banking Committee held a hearing where Paul Volcker, Thomas Hoenig and Randall Kroszner testified on “Limiting Federal Support for Financial Institutions.” While they each expressed different viewpoints, it was newly installed FDIC Director Hoenig who made the most news. He used the stage to discuss a paper he wrote in May 2011 on “Restructuring the Banking System to Improve Safety and Soundness.”