Tag Archives: Wall Street

Big Bank Profits and Government Intervention

Zachary Goldfarb had an interesting piece in the Washington Post this week. He writes:

President Obama has called people who work on Wall Street “fat-cat bankers,” and his reelection campaign has sought to harness public frustration with Wall Street. Financial executives retort that the president’s pursuit of financial regulations is punitive and that new rules may be “holding us back.”

But both sides face an inconvenient fact: During Obama’s tenure, Wall Street has roared back, even as the broader economy has struggled.…Wall Street firms — independent companies and the securities-trading arms of banks — are doing even better. They earned more in the first 21/ 2 years of the Obama administration than they did during the eight years of the George W. Bush administration, industry data show.…

Behind this turnaround, in significant measure, are government policies that helped the financial sector avert collapse and then gave financial firms huge benefits on the path to recovery. For example, the federal government invested hundreds of billions of taxpayer dollars in banks — low-cost money that the firms used for high-yielding investments on which they made big profits.

Later, Goldfarb was interviewed on NPR. Near the end of the interview, he says:

But the president has also refrained from taking some of the toughest actions that some economists and outside analysts would like him to have taken. For example, forcing banks or attempting to force banks to forgive the debts of homeowners, or partially forgive the debts of homeowners, or forcing banks to break up into pieces and end, definitively, the too-big-to-fail problem.

So in a sense, Obama has tried to strike a middle ground, harnessing frustration, sharing in frustration of the public regarding the financial sector, but not taking the fundamental actions that would radically restructure the financial industry and perhaps cause there to be more fairness across the country when it comes to the disparate treatment of Wall Street and the rest of the country.

In my view, a “middle ground” would be to a) not bail out banks, and b) not break them up or force them to forgive debts. Instead, the conventional wisdom holds that the moderate position is to a) bail out private firms and then b) force their hands.

House Promises not to Bailout State Pension Funds

With the appropriately foreboding headline, “The corruption you see; the doomsday you don’t,” The Chicago Tribune reports:

Every indication suggests that, once again, [House Speaker] Madigan and [Senate President] Cullerton will be waving from the curb as this situation grows even more disastrous. We see no evidence that Madigan and Cullerton will use the legislative veto session that opens Tuesday to reduce future pension earnings, while protecting benefits already earned, for current employees.

Yesterday, the House took up a bill aimed at preventing union leaders from collecting pensions based on salaries that they earned working for a public sector union rather than the state. While the issue of pension fund abuse has provoked media outrage, this reform would do little to help the funds’ overall solvency.

Legislators remain reticent to enact major reforms, despite the growing pressure of insolvency that state and municipal funds are facing. Part of the reason that policymakers may not believe that they have to make the difficult decisions involved in reform may be that recent federal bailouts for Wall Street, Detroit, and state governments have led to moral hazard. Under a system where legislators do not believe that their taxpayers and recipients will bear the full cost of bringing the fund back to solvency, they are not concerned with making reforms, instead perhaps assuming that the federal government will step in to bail out the ailing fund.

However, the political climate has changed markedly since 2008 when the federal government looked at bailouts as stimulus. Last week, U.S. House Republicans issued a letter stating that Congress would not step in to help state pension funds remain solvent. The Chicago Sun Times reports:

The letter bearing signatures from U.S. Rep. Peter Roskam (R-Ill.) and other members of the Illinois GOP delegation along with the influential chairmen of eight House committees, including U.S. Rep. Paul Ryan (R-Wis.), urged Springfield to “seize the opportunity to appropriately reform the state’s public pension systems to address their massive unfunded liabilities – and to do so by your own means” during the veto session.

While state leaders say they expect no help from the federal government, they also don’t seem to be in a hurry to accept the difficult sacrifices that will have to be made now that Illinois’ pensions have the lowest funding ratio of all states. As Eileen Norcross and Ben VanMetre found in a recent working paper, Illinois’s budget woes have reached this precipice because the state’s budget rules allow for overspending and permit today’s policymakers to push bills on to tomorrow’s voters. Changing these institution won’t be easy, but this is where policymakers need to start if they want real reform for Illinois.

State and local pension plans: risky business?

The Washington Post reports on Census data that shows state and local pension plans on the mend.

The improvement in many state and local pension plans are a result of better recent stock market performance and increased contributions by both employers and workers as a result of pension reforms that were passed in 2009.  Additionally, some of the improvement is also due to lower payouts to current pensioners as a result of reforms to rein-in high benefit costs. But a caution is in order. Plans are still valuing their liabilities using discount rates that underestimate the potential for continued volatility in the stock market, potentially over estimating future expected market returns.  Rather, state and local pension plans should be using a discount rate based on Treasury rates that reflect the guaranteed, risk-free nature of these pension promises. In other words, the current accounting understates pension liabilities.

One claim strikes me in particular. According to one union official, plans are now starting to recover from Wall Street’s risky behavior. How does this remark square with the explicit outcome of how pensions are currently valued – that is- the incentive to take on more portfolio risk in order to realize high expected returns?

Pension accounting narratives

The controversy over just how expensive public pension plans are, and are likely to be, is growing more contentious. The reason is that some defenders of the current system cavalierly dispense with insights of financial economics in favor of a story that unravels on closer inspection.

Here is one current narrative. State budgets only require 3.8 percent of total spending to pay for pension obligations. This is taken from a report by the Center for Retirement Research at Boston College by Alicia Munnell, Jean-Pierre Aubry, and Laura Quinby.

Read the report more closely. This claim is based on what states contributed on average in 2008. First, it is an aggregate number. Second it is based on an 8 percent discount rate. That is, this is what states contributed, on average, based on the flawed notion that it is possible to lower the size of your debts by assuming high returns on your assets. Yes, they weren’t contributing very much. Their accounting is set up to ensure they underfund their pensions.

Secondly, some states have made a habit of deferring payments. So, what states contributed in 2008 tells us nothing about what they will need to contribute to make up for the shortfall. The next thing to keep in mind is that while some states are moderately funded, other states like Illinois and New Jersey are very badly underfunded. The aggregate “hides substantial variation” as the authors admit. The authors go on to calculate under more realistic discount-rate scenarios (Alicia Munnell adds one percentage point to the Treasury rate to get to 5 percent), Illinois and New Jersey will need to start contributing 12 to 13 percent of their budget. Now also consider a new report by Willshire Associates indicating no state will be able to meet its assumed investment returns over the next ten years.

The second claim being made by a few opinion makers is so deeply contradictory, I am not sure how it can be reconciled.

It is this. And, I quote two articles in full:

Nor are state and local government pension funds broke. They’re underfunded, in large measure because — like the investments held in 401(k) plans by American private-sector employees — they sunk along with the entire stock market during the Great Recession of 2007-2009. And like 401(k) plans, the investments made by public-sector pension plans are increasingly on firmer footing as the rising tide on Wall Street lifts all boats.

And, from today’s Washington Post:

“Public-employee unions say that although the occasional stories of workers who game the system make for good headlines, the real problem was reckless behavior on Wall Street, which caused the value of pension-fund assets to plummet. To force state and local employees to accept what now passes for retirement security in the private sector would amount to a race to the bottom for all workers, they contend.

AFSCME Secretary-Treasurer Lee A. Saunders said: “401(k)s have been around for a generation and the result is tens of millions of workers who lack retirement security. We need to figure out ways to expand effective retirement programs to more Americans. We gain nothing by destroying the defined benefit plans that public employees agreed to and funded over the course of their careers.”

Now, consider the primary critique of public sector defined benefit accounting. Current public sector pension accounting claims it’s possible to measure pension obligations according to what the assets are expected to return when invested in the market.  This has led plans to apply an 8 percent discount rate to value their liabilities. This in turn has led them to invest increasingly in higher-risk vehicles like hedge funds and real estate. The reason: they need to get 8 percent or better on average in order to have enough assets set aside to pay their obligations, which are already underestimated, because of this circular logic.

Economists have been stating consistently that  public plans should be valued using the yield on Treasury bonds (currently 4 percent) to reflect the safety and security of a government pension. What follows from this? An accurate calculation of the size of what is owed; and a more conservative investment strategy.

But defenders want to cling to the math that has led plans to embrace risk and underfund promises.  Remarkably, and without any sense of contradiction, the same defenders express dismay when the market doesn’t return what they anticipated.

What is so scary about 401(k)s? Investment risk must be borne by the individual worker and it cannot be made to disappear with actuarial alchemy.

Perhaps defenders of the accounting mess really think the numbers don’t matter and underfunding is nothing concerned about. After all, the government has a sure hedge against this risk: the taxpayer.

Tough Love

Last week, Michael Powell over at New York Times’s Economix blog characterized my position as one of “tough-love.” That is probably a fair way to put it. 

In an example of un-tough-love, yesterday’s Grey Lady featured an article by Christopher Edley Jr. (dean of the University of California, Berkeley, School of Law). In it, Dean Edley argues that states ought to be allowed to borrow directly from the Treasury:   

[S]tates are managing huge budget crises with the only tools they have, cutting spending and raising taxes — both of which undermine the federal stimulus.

That’s why the best booster shot for this recovery and the next would be to allow states to borrow from the Treasury during recessions. We did this for Wall Street and Detroit, fending off disaster. It’s even more important for states.

From my view, such a policy would permanently enshrine the notion that states are too big to fail. We know that states have a spending problem. According to data from the Bureau of Economic Analysis, for the last 9 years, the inflation-adjusted average annual growth rate of state and local government spending was 2.6%. At the same time, the private economy—on which state and local governments depend for their tax revenue—only grew at an average annual growth rate of 1.4%. In other words, states are already spending at a faster rate than the economy can create wealth. Furthermore, they are doing this without the power to deficit spend (for general operating expenses) or the power of the printing press. 

Allowing states the permanent ability to rely on the Federal Treasury would, of course, change all of that. How might we expect them to behave under those circumstances? Important research by the University of Rochester’s David Primo gives us some idea. It turns out that while all states save Vermont have balanced budget requirements, these requirements vary considerably from state to state. Some are allowed to carry deficits over from one year to the next while others are not. Furthermore, others are required to balance their planned spending, while others must balance their actual budgets at the end of the year. Lastly, some states are checked by independent courts, while others are not. In sum, some states face strict balanced budget requirements while others face weak balanced budget requirements. In his analysis, Professor Primo found that state and local spending in states with strict balanced budget requirements averaged $3,336 per citizen. In contrast, in states with weak requirements, the average was $3,756 per citizen.

The Federal Government’s balanced budget requirement isn’t weak; it is nonexistent (you might say they are on the honor system). So what might we expect spending to look like if every state in the union could borrow from the Federal Government whenever it was expedient?  I prefer tough love.

Municipal Bond Woes

With the recent exception of the Dubai World financial crisis, fall 2009 has been relatively kind to the stock market, which is comprised of the financial investments that generally get the most widespread media attention. The same is not true for the municipal bond market, however, whose index has fallen 5% since its September peak.

At present, Detroit looks to be the city with the most significant debt problem. Business Week reports:

A few years ago, Detroit struck a derivatives deal with UBS and other banks that allowed it to save more than $2 million a year in interest on $800 million worth of bonds. But the fine print carried a potentially devastating condition. If the city’s credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee.


The seeds of this looming disaster were sown during the credit boom, when Wall Street targeted cities big and small with risky financial products that promised to save them money or boost returns. Investment bankers sold exotic derivatives designed to help municipalities cut borrowing costs.

Last year, Jefferson County, Alabama made headlines for coming close to defaulting on its bonds but has managed to continue making payments. Now, the county has filed suit against JPMorgan for underwriting this debt, asserting that the investment bank sold the county financial instruments of little value.

The common angle in this all too common story is to come down harshly against Wall Street, which is taking heat for issuing debt with fine print attached that gives banks the right to vary their offerings depending on municipalities’ bond ratings.

Another, lesser examined take is that city, county, and state officials are taking ever-increasing risks with taxpayer money, which could either benefit or harm the people whose money they are spending. For an individual this would be an expression of a higher risk tolerance, but it is unclear whether or not the same option should be open to those in charge of the public coffers.

In the subprime mortgage crisis, banks took flack for loaning money to consumers who did not understand the fine print in the contracts that they signed. Even if we can excuse this ignorance in consumers, can we really do the same for public officials?

Rather than being angry at Wall Street for underwriting municipal debt, taxpayers should hold their politicians accountable for lacking the diligence or competency to understand the debt that they issue.

Spam Artists, Electronic Pickpockets and Online Jobs

Hard Times can lead to acts of desperation. During the Great Depression rural areas saw increased petty property crimes – illegal fishing and crop picking, as well as a violent crime wave by notorious and newly-minted public enemies.

The current recession has produced its own wave of burglaries, robberies, and scam artists. Neighborhood Watches have intensified in Las Vegas and Miami as residents contend with a sudden up-tick in break-ins, car-thefts and other “crime of opportunity.” Copper, (which has been steadily rising in value), is increasingly being pilfered, everywhere from foreclosed homes, to Bangor Hydro Electric Co. in Maine, to Pennsylvania’s mines.

Perhaps more fitting with these times is  the increase in financial and online fraud. According to NPR, the  poor economy is also leading to increases in “data breaching”: identity theft, credit card fraud, and insurance schemes. Reports of online crimes are up one-third from last year to 350,000 complaints.

But not all of the fraudsters are professional criminals, or big-time Ponzi scheme masterminds. In fact, many often come from the ranks of disgruntled employees. Risk managers are most worried about embezzlement plots and organized data theft by insiders: “administrative staff, back-office employees, traders and tellers.”

According to the Association of Certified Fraud Examiners the number of embezzlement crimes are likely to continue increasing. Times are rough and layoffs are leaving holes in companies’ internal fraud controls.

It’s not just Wall Street that should worry. Employee embezzlement happens in other sectors too. Last week, the ex-Chief Financial Officer of Michigan Public Health Institute, was charged with embezzling $120,000 from the non-profit.

Budget Gimmickry Goes from Bad to Worse

Earlier this week, Moody’s downgraded New Jersey’s credit outlook from “stable” to “negative” in light of, as the rating agency put it, “the persistent and growing structural imbalance exacerbated by nonrecurring and temporary budgetary solutions.”

Moody’s writes, “The depletion of the state’s rainy day fund, enactment of temporary tax increases and significant reliance on nonrecurring expenditure reductions including minimal pension contributions contribute to both short-term and longer term budgetary pressures resulting in the state’s negative outlook.”

In other words, Wall Street sees right through the budget gimmickry that, while especially prevalent this year, has been a feature of New Jersey’s budget process for two decades. Budget tricks may fool voters, but they’re less likely to fool creditors. And many of the stopgap measures used to balance this year’s budget will not be available next year.

But New Jersey looks positively restrained compared with this new scheme from California, which arguably leads the nation in creative intergovernmental lending:

The cash-strapped University of California plans to loan $200 million to the even more cash-strapped State of California so that—get this—the state can give the money back to UC.

Here’s how we got to this crazy place: First, California’s enormous budget deficit sent the state’s credit rating into a death spiral and prompted massive cuts to a vast array of state-funded enterprises, including UC. The state cut UC’s budget by $813 million, prompting the university to raise student fees, furlough faculty and enact a range of other painful cost-cutting measures. But as bad as things are for UC, the university has managed to maintain a better credit rating than the state. Which means it can borrow money at a low interest rate and loan it to the state at a somewhat higher rate.

Here’s the story from the San Francisco Chronicle.

State Tax Rates and Health Care Reform

E.J. McMahon of the Manhattan Institute calls it a “sledgehammer” to New York City.

This week, the Tax Foundation released this table. It shows what each state’s top tax rate looks like with the House Bill’s three surtaxes, targeted at high earners, to pay for nationalized health care.

Three states meet the 57 percent tax rate mark: Oregon (57.54%), Hawaii (57.22%), and New York (56.9%). At the very top of the list is New York City with a 58.68% top tax rate.

There is not much improvement for the remaining 47 states; the bottom ten states face a top rate of 47.25 percent.

What is the likely scenario in Manhattan? It’s not just Wall Street’s top earners who will bear the burden (or flee for other professions or places): it is small and/or growing businesses. As the New York Post writes, “The legislation is especially onerous for business owners, in part because it penalizes employers with a payroll bigger than $400,000 some 8 percent of wages if they don’t offer health care.”

Here’s a picture, courtesy of the New York Post:

Farmland Prices and Suburbia

Rick Harrison at Newgeography.com has an article on the relationship between rising farmland prices and the construction of new suburbs. He looks at the Minneapolis-St. Paul region:

As the tiny towns outside the Urban Boundary attracted more development, they also attracted the national developers. All of the nation’s Top Ten Home Builders discovered this region. Each year 25,000 or so new homes were built and quickly sold to suburbanites who preferred a 30 to 40 mile commute over living near the city core….

Much of the escalation in home pricing was due to a bidding war over developable farmland. National builders, using their Wall Street dollars, competed for desirable acreage. If Farmer Fred was able to sell his property for $50,000 an acre, when Roy next door put his farm up, the starting price was $50,000 and the final fee was likely to be $60,000, the starting point of the next site for sale. By 2005 the outer small town land that could have been bought for $12,000 an acre a decade earlier was worth more than 10 times that amount.

Last month the Wall Street Journal reported a steep decline in farm prices. Data from the Chicago Fed are available here. In  much more land-constrained Britain, prices have dropped as well.