Relevant and even prescient commentary on news, politics and the economy.

24/7 Wall St reports twenty best financial blogs

Twenty best independent financial blogs 24/7 Wall St reports March 31, 2010:

The Angry Bear www.angrybearblog.com. Half a dozen professionals, including a tax law expert, a historian, PhDs in economics, business consultants and financial professionals provide perspectives on the financial world. Despite their expansive coverage of economic issues, their articles are as deep as their coverage is extensive. Topics include world trade, industrial production, U.S. Government programs, and major regulatory issues.

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Overfixing Social Security: the Importance of Honest Scoring

by Bruce Webb

And I could add honest definitions and honest framing to that.

In Dec 2005 three former staffers to Bill Clinton, John McCain and GW Bush respectively released the Liebman-MacGuineas-Samwick Non-Partisan Social Security Reform Plan (9 pg PDF) or LMS. The authors proposed a package of changes to Social Security comprised of a 1.5% across the board payroll tax increase, an adjustment of the payroll gap back to the 90% level (it had drifted down to 84%) for the equivalent of another 1.0% of payroll, and adjustment in retirement age scored at 0.62% of payroll, and a change in indexing of initial benefits that scored at 2.08% of payroll for a total worker financed ‘fix’ of 5.2% of payroll. Interestingly enough in that year the total 75 year actuarial gap was scored at 1.92% of payroll, meaning that an immediate hike of that amount would deliver 100% of scheduled benefits over the 75 year window traditionally used to score Social Security solvency. So why a 5.2% solution to a problem scored 1.92%?

Well therein lies a tale, and an important one when we are faced with a so-called Deficits Commission whose leaders make it clear that Social Security is front and center, as workers and future retirees we owe it to ourselves to understand what problem ‘reformers’ are actually addressing. Because LMS at least is not focused on retirement security, not at least in the dollars and cents sense. Much more under the fold. (It wouldn’t hurt to bring along your tin-foil hat).

My first introduction to LMS came the summer before publication when co-author Prof. Andrew Samwick outlined it in a guest post at DeLong. In the course of discussion he casually claimed that the payroll gap was 3.5%. When in comments I asked “Whence 3.5% Samwick?” and pointed to the standard 1.92% 75 year number reported by the Trustees, both he, and by e-mail DeLong, informed me that he was referencing the gap projected over the Infinite Future Horizon and pointed to Table IV.B7 in the Report. Well sure enough alongside the $3.5 trillion dollar 75 year gap was a $10.5 trillion Infinite Future one.

Well I had been reading and comparing Trustees Reports since 1997 and never heard of such a thing, was I just a sloppy reader? Well no, it turns out this particular measure was relatively new having been introduced with the 2003 Report. Why was it so introduced? And why should we prefer it to the previously satisfactory 75 year window? Well a tale within a tale. From the Report, bolding mine

Consistent with practice since 1965, this report focuses on the 75-year period from 2003 to 2077 for the evaluation of the long-run financial status of the OASDI program on an open group basis (i.e., including both current and future participants). Table IV.B7 shows that the present value of open group unfunded obligations for the program over that period is $3.5 trillion. Some experts, however, have described the limitations of using a 75-year period. Overemphasis of summary measures (such as the actuarial balance and open group unfunded obligations) for the 75-year period can lead to incorrect perceptions and policy that fails to address sustainability.
In order to provide a fuller description of long-run unfunded obligations of the OASDI program, this section presents estimates of obligations that extend to the infinite horizon.

Hmm, “some experts”, “incorrect perceptions”, “address sustainability”. What the heck is sustainability in context? Why should workers care? Got a name for any of those experts or an explanation of why an alternate perception that focuses on outcomes within our own lifetime and not on retirement of people not yet born is somehow “incorrect”? Why so? Well I suggest that the answer is that retirement security for current workers is simply not the focus of these unnamed “experts”, and that somehow the Trustees in 2003 rather silently adopted that same focus for reasons unstated.

Returning to LMS. In the description of the authors we get the following, once again bolding mine:

Andrew Samwick is Professor of Economics and Director of the Nelson A. Rockefeller Center for Public Policy at Dartmouth College. From 2003 to 2004, he was Chief Economist on the staff of President Bush’s Council of Economic Advisers, where his responsibilities included Social Security.

Well “responsibilities” is a broad term, but you would expect that an implicit change in the focus in Social Security from 75 year solvency to Infinite Future ‘sustainable solvency’ might suggest the involvement of the CEA Chief Economist, and certainly Samwick qualified as an “expert”, but Prof Samwick has informed me personally that he was not in fact responsible for this particular change. And Andrew is a truly nice guy and is often described along with Bruce Bartlett as one of a small number of “honest conservative economists” by people like Brad DeLong, still it is interesting to me that the introduction to LMS starts off with these sentences:

The three of us – former aides to President Clinton, Senator McCain, and President Bush – did an experiment to see if we could develop a reform plan that we could all support.
The Liebman-MacGuineas-Samwick (LMS) plan demonstrates the types of compromises that can help policy makers from across the political spectrum agree on a Social Security reform plan. The plan achieves sustainable solvency through progressive changes to taxes and benefits, introduces mandatory personal accounts, and specifies important details that are often left unaddressed in other reform plans.

So while Prof. Samwick was maybe not the engineer here, he certainly was willing to board the train in time to draft LMS.

To which we return once again with an examination of Table 2 on page 7 along with this accompaning text:

Sustainable solvency is achieved – The Social Security actuaries find that actuarial balance would improve by 2.14 percent of taxable payroll over the 75-year projection horizon. The current Social Security deficit is 1.92 percent of payroll. Therefore, the changes in the plan would lead to a 0.22 surplus. Trust fund balances in the last year of the actuaries’ projection period are positive and increasing. (See http://www.ssa.gov/OACT/solvency/Liebman_20051117.pdf).

Okay we have a 1.92% payroll gap and a 2.14% solution, reasonable enough. But what was this about a 5.2% solution? Where is the extra 3.06%? Well 1.56% percent of it is accounted for in the Table, that amount gets diverted to a new PRA, Private Retirement Account, leaving us missing only 1.5%. And where is that? Well buried in the text on page 1, LMS proposes a mandatory deduction of 1.5% credited directly to the individuals PRA and so not properly speaking contributing to Actuarial Balance and so excluded from Table 2.

Well I have to cry foul here. We have a problem scored 1.92% and a solution that includes a package of tax increases totaling 2.5% between the across the board increase and the payroll cap increase, that is more than enough to deliver 100% of scheduled benefits if simply applied to the Trust Fund. But we ALSO have an additional package of benefit cuts totaling 2.7% which itself would have closed all of the gap and then some. On the other hand the individual comes out of this with a PRA funded with a total of 3.06% of his wage income over that period. Perhaps the end result is a BETTER than 100% of scheduled benefit? Well no, a look at Table 1 shows that a retired couple can expect to get a result from 85% (low earner one worker) to 109% (high earner two worker) compared to the baseline schedule.

Well but what about Ownership Society? You have your PRA, surely you can pass those assets onto your heirs? Well no. Not unless you die quickly.

All payments from PRAs would be paid as annuities, which would initially be required to be fixed, inflation-indexed annuities provided by the Social Security Administration as part of a beneficiary’s regular Social Security benefit. Full annuitization by age 68 is required, but beneficiaries can choose to spread annuitization between 62 and 68 if so desired. Married beneficiaries would be required to purchase joint and two-thirds survivor annuities. Annuities would be 10-year certain annuities to provide payouts to heirs of those who die soon after annuitization. The total balances in the accounts of the two spouses in a married couple would be split equally in the case of divorce.

So what would workers see out of LMS? Well a joint survivor fixed income, inflation indexed annuity paid out monthly by the Social Security system. Which sounds identical to what happens today, except the result in the case of LMS is exposed to the market, the results in Table 1, bad as they are, assume “Expected Yield on Mixed Portfolio”. Meaning it is kind of a crap-shoot.

Does LMS do some good things? Well yes, but none of them particularly rebound to the benefit of most workers and certainly not lower earning workers. Instead they are asked to chip in a combination of 1.5% in ‘contributions’ (they obviously would not be exposed to the cap increase) and take a guaranteed 2.7% cut in benefits hoping to make up around half of that through returns on their PRAs. How did the authors possibly proposed to sell that?

Time to put that Tin Foil Hat on. If you bury the 1.5% increase in the text and address all the other changes you have workers giving up 3.7%, or 2.7% for those earning under the old cap. Which is a lot to only partially solve a problem scored at 1.92% over 75 years. But not a lot to solve a problem scored at 3.5% over the Infinite Future. It is really the odd coincidence to have a new number pop up in the 2003 Report so useful for the purposes of selling a Privatization Plan that on one accounting requires just that amount of offset. How do you sell a plan that proposes a 5.2% solution to a problem scored 1.92%? Easy hide 1.5% of the solution and re-score the problem by 1.58%. Tin Foil Hat off.

As we confront the work of the new Deficit Commission it will be important for workers to firmly keep their own self-interest in mind and ask some serious questions. One what problem is the Commission actually addressing. Two how much of that problem if any was actually caused by Social Security. Three if the solution to that problem only calls for sacrifices by workers in the form of benefit cuts where is the equity. We know the way the problem will be framed, it will be expressed in dollar terms over the Infinite Future Horizon, it will be blamed on excessive Backward Transfers to previous generations, there will be attempts to blame Boomers for ruining the whole world with their greed. Because that is what the ‘reformers’ have been doing for years, trying to find some way to stick workers with the tab.

Make them honestly define the problem they are solving. Make sure they use honest scores. Don’t let them frame this as some problem created by workers when it is nothing of the sort. And above all don’t let them bill you 5% for a problem that in 2009 was scored 2.01%. Social Security faces a real actuarial gap much as it has in various years past. And given that it is a plan financed for workers by workers it is incumbent on workers to suggest a solution. Dale, Arne and I have proposed a solution that delivers 100% of the scheduled benefit via a phased in set of payroll tax increases. Other workers might decide that it would be better to combine a lower set of increases with some changes in indexing or retirement age, or throw in some increase in cap levels. All of which is legitimate enough. What isn’t legitimate is for some Commission to use some bait and switch tactic like LMS does.

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Declining Progressivity in US Taxes

by Linda Beale

Maybe at this juncture, when Congress is beginning to talk about what to do about the sunsetting Bush tax provisions, it’s an appropriate time to remind ourselves about our historic commitment to progressivity in our tax system. A good source for thinking about this is an article by Tom Piketty and Emmanuel Saez, How Progressive is the U.S. Federal Tax System? A Historical and International Perspective, 21 J. Econ. Perspectives 3 (2007).

What they show by looking at income and taxes over the period from 1960 to 2004 is revealing. While our system remains progressive to some extent, the progressivity has declined significantly. This is primarily, they say, because of the cuts in the corporate tax and the estate tax–taxes that impact the very wealthiest more than others because of their high ownership of financial assets. Our concept of distributive justice has always demanded that we should determine the tax burden based on individuals’ relative abilities to pay–that means that those with lots more should pay proportionately more of their income, since those with very little need all of their income just to meet daily needs, and those with considerable wealth won’t even notice whether they have another few dollars or not.

The decades since Reagan took office have taken a huge toll on that sense of shared commitment. Fueled by a religious-like belief in the mathematically elegant but unrealistic assumptions of the “free market” economists from the Chicago School (see Yves Smith’s book, Econned, for a good take-down of the freshwater economists), the GOP in Congress passed huge tax cuts for the wealthy accompanied by increasingly heavy payroll taxes for others at the same time that spending continued apace–in fact, Reagan, Bush1 and Bush2 all greatly increased the military budgets and the Bushes embarked on wars of choice that imposed significant budgetary demands. The wealthy have fought for laws that favor them–deregulation, zero capital gains taxation, lower corporate taxes, the ability to offshore businesses and assets freely, privatization of social security and other programs (that would put more dollars under direct control of investment bankers and insurers), and lowering of individual tax rates and provisions that phased out deductions for the wealthy (like the phase out of the itemized deduction, which was repealed under Bush, etc.).

There are some really great graphs in the article–so look at it rather than just reading these excerpts. But if you only have time for excerpts, here are some key ideas.

Progressivity of the overall tax code has unambiguously declined in the United States and in the United Kingdom. The average share of income paid by those at the very top of the income distribution has dropped substantially. Id. at 21

***

Large reductions in tax progressivity since the 1960s took place primarily during two periods: the Reagan presidency in the 1980s and the Bush administration in the early 2000s. The only significant increase in tax progressivity since 1960 took place in the early 1990s during the first Clinton administration. Id. at 23

***

many of the recent tax provisions that are currently hotly debated in Congress, such as whether there should be a permanent reduction in tax rates for capital gains and dividends, or whether the estate tax should be repealed, affect primarily the top percentile of the distribution—or even just an upper slice of the top percentile. This pattern strongly suggests that, in contrast to the standard political economy model, the progressivity of the current tax system is not being shaped by the self-interest of the median voter .12 Id. at 23.

12 Permanent reductions in dividend and capital gains combined with a repeal in the estate tax would certainly reduce the current progressivity of federal taxes and favor large wealth holders. The Alternative Mininum Tax, which is not indexed for inflation and hits more and more tax filers, will mostly increase tax burdens on the upper middle class but will not affect much the top 0.1 percent.

***

The federal individual income tax is the largest tax, typically collecting 7–10 percent of GDP in most years since the 1960s. Individual income taxes declined sharply from 2000 to 2004 following the tax cuts of the Bush administration, falling from 10.3 percent of GDP in 2000 to 7.0 percent of GDP in 2004. The payroll tax financing Social Security and Medicare has increased significantly, climbing from about 2 percent of GDP in the 1960s to 6.4 percent of GDP by 2004. The corporate income tax has shrunk dramatically: it was typically 3.5– 4.0 percent of GDP in the 1960s, but had fallen to 1.6 percent of GDP by 2004. The estate and gift tax has always been very small relative to the other taxes, although it is important for distributional analysis because it disproportionately affects those with higher incomes. The estate tax collected about 0.6 percent of GDP in the 1960s, and 0.25 percent of GDP in 2004.

***

The greater progressivity of federal taxes in 1960, in contrast to 2004, stems from the corporate income tax and the estate tax. The corporate tax collected about 6.5 percent of total personal income in 1960 and only around 2.5 percent of total income today. [emphasis added] Because capital income is very concentrated, it generated a substantial burden on top income groups. The estate tax has also decreased from 0.8 percent of total personal income in 1960 to about 0.35 percent of total income today. As a result, the burden of the estate tax relative to income has declined very sharply since 1960 in the top income groups.

[Hat tip to fellow Angry Bear rdan for reminding me about this article.]

crossposted at ataxingmatter

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Can’t help but put ISM and Confidence surveys together: looks a little off

by Rebecca Wilder

Today I digress from my recent Eurozone obsessions to compare the U.S. Consumer Confidence report (released today) to the PMI production surveys, a “soft” comparison of supply and demand. According to the Conference Board today:

The Conference Board Consumer Confidence Index, which had decreased in February, rebounded in March. The Index now stands at 52.5 (1985=100), up from 46.4 in February. The Present Situation Index increased to 26.0 from 21.7. The Expectations Index improved to 70.2 from 62.9 last month.

Consumers’ assessment of current-day conditions was less negative in March. Those claiming conditions are “bad” decreased to 42.8 percent from 45.1 percent, while those claiming business conditions are “good” increased to 8.6 percent from 6.8 percent. Consumers’ assessment of the labor market was also less pessimistic. Those saying jobs are “hard to get” declined to 45.8 percent from 47.3 percent, while those saying jobs are “plentiful” increased to 4.4 percent from 4.0 percent.

This report is nothing to write home about. Consumer confidence remains at excruciatingly low levels.

In a post back in September, I argued that the expectations index is a better indicator of consumer spending. As such, the expectations component remains stronger than the composite, having rebounded to its level at the onset of the recession. However, like the composite index, the expectations index is moving rather laterally since May 2009.

Notice the bigger picture, with the Confidence survey illustrated alongside the ISM manufacturing and non-manufacturing surveys. The story remains to be very one-sided on the production side, which is more likely to drop back to meet weak consumer demand UNLESS THE JOBS MARKET IMPROVES…FOR REAL. See my previous post on the temporary effects of the Census hirings.

The underlying demand for goods and services, as determined by the 70% of the economy that is the Consumer, is weak, especially at this stage of the recovery (having already posted a positive quarter of economic growth). (By the way, if you want National Income data, the BEA offers an exceedingly easy way to download it here.)

These numbers challenge even the most optimistic of us all (that used to be yours truly).

Rebecca Wilder
crossposted with News N Economics

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Matthew S on Obama’s Picks to the Debt Commission

lifted from Bruce’s e-mail

Hi Bruce,

I really enjoyed your recent post to OpenLeft about the war on Social Security. I wrote a related piece deconstructing Obama’s latest picks to the Debt Commission:

Alternet: Obama Packs Debt Commission with Social Security Looters?

Any feedback about the article or thoughts on the matter would be greatly appreciated.

I run a watchdog website called LittleSis.org that tracks ties between corporate and government elites, with an emphasis on Wall Street. We’re gearing up for a sustained investigation into the networks of funding and influence behind the latest attack on Social Security, and I wanted to just say hello and touch base. It seems that there could be more coordination happening between various folks keeping watch on this.

Best,
Matthew

I have Matthew’s full contact info if serious people want it. But the piece is very good regardless.

(Update: Lifted from comments:
Movie Guy: “Matthew Skomarovsky wrote an excellent piece. It strikes me that it deserved a stronger presentation at Angry Bear. I doubt that many casual drive-by readers bothered to click on the main post sublink. But what a piece”)

Worth saying twice. Click and read.

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Thoughts on the Eurozone, Greece, and the EMF

I was asked by Periódico Diagonal to answer a few questions related to the Eurozone, based on several articles that I wrote (here, here, and here). I don’t know if these will be published, but “enquiring minds want to know”. Here we go:

1. In a recent article you announced that the next cycle of crisis in Europe will be determined by the struggle for exports. Does that mean that the country which lags behind in this struggle for exports will suffer from falling wages?

Rebecca: What I meant was that the Eurozone might find itself in a “race to the bottom”. The prescript coming out of the IMF and the European Union is one of harsh and deep reductions in nominal income (wages) and prices in order to reduce relative prices enough to drive export income. Normally, downward pressure on internal prices via recession occurs alongside a sharp devaluation in the currency, where external demand pulls the economy back onto its feet. But the main problem across the Eurozone IS ITS CONSTRUCT, one currency “to rule them all”. Greece, nor any of the other GIIPS countries – Greece, Italy, Ireland, Portugal, and Spain – can devalue the currency in order to drive export growth.

The problem is that without proper export growth, the internal devaluation would more accurately take the form of “infernal devaluation”. Cuts to nominal income, wealth (via pensions), and other labor variables will restrict current consumption and aggregate spending to a point where such measures then pressure government deficits. It’s a vicious circle, not to mention a fallacy of composition to think that the aggregate can export its way out recession if wages are falling – spending, by definition, must be falling, too.

2. In this sense, the IMF´s advice is to decrease wages and promote privatization of common services. Are we facing the first IMF´s serious intervention in (¿most developed?) the North countries? In that case, what is the aim of these adjustment policies? Do you think they will benefit countries like Greece or Iceland? Or is it just a matter of financial balance and euro´s credibility?

Rebecca: The Iceland economy received IMF support in November 2008, but IMF lending comes at the cost of conditional fiscal austerity programs and macroeconomic measures, including trimming the government-funded pension system, reduced wages, and other related budget cuts. Iceland has muddled through, though, because it has something that Greece (nor any other Eurozone country) doesn’t have: a free-floating, non-convertible currency.

The Iceland case is very different from Greece (or any of the GIIPS), though, because it issued a lot of debt that is denominated in foreign currency. But nevertheless, the Iceland krona depreciated around 50% against the US dollar between July 2008 and December 2009, driving exports and reducing imports. In 2009, real GDP in Iceland fell 6.5%, the biggest drag came from government spending that shaved 12.2% off of GDP growth. However, the contribution coming from exports and imports was +14.2%, which more than offset the drag from the IMF’s “austerity measures”.

Greece doesn’t have this option, since it cannot devalue its currency. Greece can only reduce wages and prices enough to generate internal devaluation resulting in the prescribed export growth. That’s just not going to fly when the Eurozone as a whole is fighting for export income.

But worse yet, there’s a positive feedback loop here that will likely result in a debt deflation scenario, normally resulting in private-sector default. Let’s use Iceland, again, as an example. In 2009, private consumption dragged GDP growth a large 7.8%. In Greece’s case, the effect on consumption would be magnified, since without the benefit of external income generation the private sector must take a larger hit. As consumption falls, so too do tax receipts and the primary deficit rises once more – the positive feedback loop.

3. You say it is impossible for all European countries to decrease wages in order to increase exports because –we suppose- this would reduce, in some way, domestic demand and, therefore, trade within the European Union, seeming to be no other way out. How can we get out of this situation? Could it be the end of the monetary union -so that some countries prefer currency devaluation in order to gain competitiveness?

Rebecca: It probably won’t be the end of the EMU, but I wouldn’t be surprised if some countries defaulted, which then increases the likelihood of the “end of the EMU”. What we have is an unsustainable situation in the Eurozone, as key countries face “infernal devaluation”. Without an epic surge in export growth, the government austerity programs called upon by the E.U. (or the IMF) will force the private sector to accumulate debt in order to balance out the aggregate forces of income and spending. That’s just fact.

The Eurozone was built upon the premise that there would be a unified currency and an un-unified fiscal system. In order to balance the inherent fiscal challenges that come along with inherently different saving motives across the 16 EMU countries, strict rules were set in place: no government is “allowed” to run fiscal deficits in excess of 3% nor accumulate debt in excess of 60% of GDP. Countries are fined, but that didn’t stop them from hiding government obligations from the European Union via sophisticated derivative securities. In the end, you have a band-aid plan to satisfy markets so that Greece can attempt to rollover its near-term debt. This “bailout” comes with no specifics as to threshold levels that must be crossed in order to get the central E.U. players to offer support, which is no doubt by design. Nothing has changed here; no lessons learned; the Eurozone is still just as flawed as it was ten years ago.

What has now become obvious to those who did not see this coming, is that the Eurozone, in its construct, was never meant to withstand the financial contagion and ensuing global recession of 2007-2009.

4. The European media are suggesting this week that the European Union should “let Greece fall” as a sign of credibility. What do you think of this issue?

Rebecca: Unless the structure of the EMU was changed for the better, meaning fiscal consolidation, the Eurozone would be no more “credible” after the default of Greece.

5. What is your opinion concerning the possibility of creating a European Monetary Fund, which has recently come up in the news?

Rebecca: It is an awful idea and ridden with disruptive side effects. In essence, the EMF would be established to prevent sovereign default from causing contagion throughout the Eurozone. If funds are dispersed immediately, the obvious result is the lop-sided power engendered to those countries that contribute, rather than borrow, from the fund. From the get-go, the EMF would generate political pressures from the creditor countries to the unduly strained debtor countries.

With such power comes abuse, as illustrated by the International Monetary Fund’s involvement during the Asian Financial Crisis. The IMF proved itself to be highly intrusive into local sovereignty and adopted a one-size-fits-all policy to its conditional lending programs. There is a reason that capital controls are the policy du jour in Asia, and consequently not part of the IMF’s “prescription”.

It is NOT unlikely that the same [abuse] would happen under the EMF.

Rebecca Wilder

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Banks, repos and transparency in accounting

by Linda Beale

Banks, repos and transparency in accounting

A repo transaction is essentially a collateralized financing. For tax purposes, everybody knows that it will be treated as a loan, no matter that it is called a “sale” with an agreement for a repurchase later. For accounting purposes, though, some repo transactions have been able to slide by and look like a “real” sale rather than debt on the financial statement. That’s a perfect example of the fact that tax theory pays attention to economic substance, whereas accounting somehow sets up rather arbitrary categories that may end up letting a repo count as a sale instead of a loan on an entity’s financial statement.

As most everybody is aware by now, the 2000+ page report on the Lehman breakup found that the firm had engaged in repo transactions to make its capital position look better than it actually was by reducing the leverage showing on its books. It concluded that the Lehman executives and the company’s outside auditor (Ernst & YOung) had improperly allowed the repos to temporarily reduce leverage on the firm’s books, which contributed to the company’s ultimate downfall.

Now the SEC is asking 24 large financial institutions and insurance companies to provide information about their accounting and disclosure practices in connection with their use of repos. The sample SEC letter is available here.

Financial institution reform needs to deal with a myriad of factors–over-leverage is one of them. Transparency in accounting, and focus on economic substance rather than form, should be high on the list of reforms needed.

crossposted with ataxingmatter

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More on derivatives

by cactus

Last week I wrote A Simple Explanation of How The Use of Derivatives Created The Great Recession.

I want to clarify things with an analogy that at first glance may seem unrelated. Let’s talk about poker. Its a game that seems to have grown in popularity in the last decade, especially with the advent of on-line poker, even if the rate of increase seems to me (and I haven’t had time to pay much attention lately so take it for what it is) to have slowed in recent years.

Poker is different from most casino games in that you only play against other players, not against the house. The casino – online or glitz and mortar takes a rake, which is a piece of each pot. In a tournament, the casino’s rake comes off the sum total of the entry fees (“buy-ins”); what is left after the rake is the prize pool.

When the rakes are small enough, and they usually are, a good player can have a positive expected return. So… investors willing to risks can finance players by covering the buy-ins of the players in exchange for a percentage of their winnings. Though poker is a game of skill, luck still matters a great deal, so it probably makes sense to spread one’s investment either across a large number of tournaments by the same player, or across a large number of entrants in the same tournament. I know of examples where this is being done informally, and I have seen business plans for web-based versions of these approaches on a wider scale, but the market, as such, is currently very unsophisticated. Its good for the players – they can enter more tournaments, at lower risk. Despite giving up a share of their winnings, they stand to make more money by being able to play more tournaments and tournaments with more expensive buy-ins. I understand that one well-known professional player, Chris Moneymaker (and yes, that is his real name) produced a monster return both for himself and his backer by qualifying for and winning the World Series of Poker with this sort of financing scheme.

Its not difficult to imagine how such a market could evolve… if the money is there. Over time, buying shares of a player’s winnings in a package of tournaments (say ten) in exchange for a share of the player’s winnings might become common for good players. Over time, some enterprising individuals who know and are trusted by many of the better players might find themselves a niche aggregating players together. The result – instead of being able to buy into the earnings of a single individual in a ten tournament package, you could buy into the earnings of ten or fifteen players over ten (or more) tournaments. It diversifies the risk a bit for all involved, especially if there was some sort of limited prize sharing among the players in the package. Of course, that’s a lot more expensive than financing one player… so that would lead to two additional developments.

Development 1 – exchange markets would develop. That would allow for liquidity (investors could more easily get into and out of investments). It would also allow securities to change value over their lifetime. (If none of the players cashed in the first tournament or two, the value of the security would drop, for instance.)

Development 2 – margins. Some deep pocket entities would be willing to loan investors money in order to buy into such packages.

If the market got to this point, perhaps some really sophisticated investors would jump in. They might find – using sophisticated math – that it pays to pepper each package of players with a long shot or two. They might notice other thing – perhaps their models would show that a given security contains too many players with a similar style, or who likely to knock each other out of a given tournament. Short it.

Meanwhile, the aggregators might notice the growth in demand, and start packaging more marginal players together. Its all good though – someone with a Ph.D. in econ (or even better, Math or Physics) could demonstrate that a bunch of marginal players put together do, on average, do almost as well as the top players, and hey, its Poker, all you need is a chip and chair. And a bunch of MBAs could put that proof on 17 powerpoint slides and sell it to the county treasurer in any number of locations in this country (and elsewhere), and we’re not just talking the sticks either.

If the money keeps flowing in, and the story resonates like tulips, Florida swampland or Pets.com, eventually you have rubes all over the country who think they’re going to finance a comfy retirement by plonking down for the buy-ins for some slicks who will draw to an inside straight every time. And you can even get insurance on your expected winnings, so what could possibly go wrong? Especially when every taxi driver and waiter in the country, not to mention every editor at the National Review, will happily give you advice on how best to play the derivatives market for poker. Heck, the guy in the Oval Office starts suggesting that this is probably what the country should be doing with its Social Security – everybody could direct their own account.

That’s about when the doo-doo will hit the fan. And here’s how it starts… a big investor loses big time. His package of “Poker Geniuses from Blowing Rock, North Carolina, Class B-7” comes up a dud. Unfortunately, the dude is leveraged up 50 to 1. Which makes sense, because he couldn’t lose so it was guaranteed money. Unfortunately, he did lose. So he’s gotta pay his creditors, and he does so by liquidating some other positions. Due to leverage, a lot of positions. That pushes down the value of those positions, and similar securities. But it does something worse… for some reason, it makes a few people re-evaluate the likely pay-offs of the securities that they themselves are holding. And if “Poker Geniuses from Blowing Rock, North Carolina, Class B-7” can come up empty, what about the “Potted Plant Poker Playas of Playa del Rey, L Team?” The folks holding the last tranche to pay off on something they just realized is a dog, and which has already lost value on the market when the big guy started selling left and right to meet his obligations – what are they going to do? Bear in mind, Goldman beat them out the door by six months, and they’re leveraged up. 50 to 1. And a payment is due at the end of the week and nobody is answering their calls.

So the market collapses. In fact, a few other markets collapse – who knows who has lost so money on Poker derivatives that they are going to go under, and that big multinational that wants a bridge loan does have a division that plays in this kind of thing, right? No bridge loan for you. It turns out that some of the big guys – the folks who aggregated the players in the first place, and thus understood what sort of dogs were being financed in the first place – bought into their own sales pitch and are holding piles of this crud. Inevitably, there’s a bail-out for some of the big boys. The Fed or the Treasury takes the crud off their hands, and gives them top dollar to boot. After all, they’ve convinced the government that without that market, nobody is going to finance a company that manufactures patio furniture in Indiana. Of course, none of them does get around to loaning money to that company that manufactures patio furniture in Indiana, but that’s a trivial detail. Enough of the big boys are made whole that everyone who counts is happy. And there is little thing called blackjack…

So, what did I miss?

by cactus

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What Works About the FDIC?

reads Ezra Klein and Matt Yglesias (between the two of them they have more years than I do).

Klein thinks the FDIC works well. Yglesias notes that it keeps eating banks every Friday and has doubts about the quality of its prudential regulation. I will argue that the FDIC has more of an incentive to make banks prudent than the SEC, the Fed, the Treasury or the comptroller of the currency.

The key point is that the FDIC has a trust fund and wants to keep it. This is the reason that Stiglitz, Sachs, and Krugman were totally wrong and the PPIP was not a huge give away (Tom Bozzo and I explained it to them at the time but they don’t read this blog). So long as the FDIC doesn’t run out of money, it doesn’t have to go begging to Congress.

Robert Waldmann

The SEC and the comptroller don’t put their own money on the line. They regulate but they don’t bail out. Failures mean they have more egg on their face but no less cash on hand. The Treasury has broad responsibilities and has to explain economic policy to Congress in any case. The FED can just print all the money it wants. The FDIC is independent so long as it stays within its means.

This makes a difference. It is true that the FDIC has had to spend some of its money lately. IIRC it hasn’t had to ask congress for any extra appropriations – at all. This in spite of the fact that the FDIC agreed to insure money market funds which therefore got insurance without paying for it. The scale of failures of FDIC insured institutions are tiny compared to the scale of failures of non FDIC insured institutions.

See the secret is to have an intertemporal budget constraint. That tends to cause forward looking behavior.

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Told Him So

Robert Waldmann

told Paul Krugman so

About 21 months ago Paul Krugman had a question

lower and middle-income Americans would be substantially better off under the Obama plan. But where is the money for health care reform?

I proposed an answer

there are two puzzles in Obama’s proposals
1) How does he plan to pay for both health care reform and his middle class tax cut ?
2) Why is he raising the social security tax even though it is probably not needed to pay old age and disability pensions ?

I think the two questions answer each other. I think that Obama is planning to pay for health care reform with the donut FICA increase (taxing individual labor income over $250,000).

Now we know. Yes most of the money for health care reform came from planning to have the CMS squeeze hospitals and nursing homes, then much from eliminating the Medicare advantage boondoggle (not eliminating the program just paying private insurance companies the same per policy holder as the CMS spends), then from the tax on expensive health plans.

However, when cutting that unpopular tax, expanding subsidies, making the special deal for Nebraska universal and making the special deal for collectively bargained health insurance benefits universal, Obama was short a few hundred billion. So in the Obama compromise proposal (the first proposal from the Obama administration) the donut tax returned.

The bill imposes new taxes on wealthier people. Individuals making more than $200,000, and families making more than $250,000, will have to give up more of their paycheck to the Hospital Insurance payroll tax. Instead of paying 1.45 percent like most workers, they’ll pay 2.35 percent. And a new 3.8 percent tax will be added to income from interest, dividends, annuities, royalties, and rents.

OK so it’s described as an increase in the Medicare plan A tax not the social security old age and disability pension tax. It starts at income of 200,000 or family income of 250,000. It applies to capital income too. The rate is lower than I guessed way back then (I just assumed it was 6.25%). Still I now type “I told you so.”

It was always there in his mind in case it was needed.

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