Federal Health Care Expenses

2006, Dollars in millions.
Here are the numbers for Federal health care expenditures. By way of background, Medicare Part A, hospitalization, is paid from payroll deductions while Parts B and D are paid from premiums and general revenues. Part A is currently self funding, but projected to fall into major deficit in the short and long run. In addition, Parts B and D are drawing from the general funds at a level that requires the President to propose modifications by 2009. What all of that means is the costs of health care are expected to increase dramatically and there has been no trust fund established for the bulk of the costs.

All of the numbers come from Tables 2.4, 3.2, and 8.5 of The Office of Management and Budget (OMB) 2008 Budget Of The United States Government Fiscal Year 2008 Historical Tables except for Premiums, Taxes on Benefits and Interest which came from Status of Social Security and Medicare Programs, A Summary Of The 2007 Annual Report.

To sum this up, the Federal Government spends 22.7 cents of every dollar it collects (over and above payroll deductions) on health care. If you are an "average" taxpayer making $50,000 per year and paying 12.45% of your income in federal taxes, then you are contributing $1,414 to health care from income taxes and $725 from payroll deductions (1.45%) for a grand total of $2,139.00. This is in addition to any non-governmental health care you may be paying for.

For Social Security go here.
For welfare go here.
For the balance of the budget go here.

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Classless Warfare

I was working last evening and had the television on in the background. I had the set tuned to CNBC and I heard parts of a debate over the poor in the United States. Some of the things I heard were stunning. For example, the poor really don’t have it so bad in this country. Even the poor have air conditioners. What? “Keep working,” I thought. Then there was tax debate, standard fair on this show, complete with the remark (paraphrased) “like the wealthy don’t already pay too high a share of the taxes.” After hearing that remark I could not continue to focus on what I was doing. The not-so-subtle class warfare was ringing in my head. Now, I must admit that I could do a lot more for those less fortunate than I, and I am not trying to claim I am any better than most who could do more than they do. But it annoys me when someone with a wide reaching public platform uses that platform to fight this kind of war against those without one. Especially when the ones fighting are among the most privileged people in the world and sound like they are complaining about it. Are they really that afraid of Congressman Rangel’s tax proposal? No class.

Before I get into the numbers, I want to be clear about things. I don’t want to leave the impression that I am against profits or high incomes or, for that matter, capitalism in general. I have worked in positions that pay very well, and I understand that there is a huge opportunity cost to get to these positions in the first place (for many of us) and that people in these positions work very hard. So if you fall into that category and you are reading this, understand I am not belittling what you have accomplished or what you do. I also understand that many, many people of means do amazing things to contribute to society and to improve the lives of the less fortunate, and I solute them and bow to their generosity. I have witnessed such acts and my heart skips a beat when I recall them. My rant is focused on those who have the audacity to sit in judgment over the adequacy of the standard of living of the least fortunate among us while at the same time complaining about their current tax burden. Now lets look at some of the numbers.

First of all, who says the 12.3% or so of the population (that’s approximately 36,500,000 people) living in poverty (see pg. 11 here: http://www.census.gov/prod/2007pubs/p60-233.pdf) have air conditioners? I want to see that report. If anyone can find it please send me a link. How low is the income level to be living in poverty in the United States of America? Can’t be too bad if those “poor people” have air conditioning, right? Well, for a family of three, two parents and one child, the threshold level is $16,227 per year (2006 number). On average the income for a family living in poverty is, of course, substantially below this threshold (that sometimes gets lost). So, most families of three included in the poverty numbers in the US live on less than $1,352 per month. We’ll see just how little that is in a minute. Granted, people in poverty in other countries may have even less still, but so what? Are we now globalizing poverty standards as well?

Looking at these numbers prompted me to do a little research, so I went to the Bureau of Labor Statistics (BLS) here: http://www.bls.gov/cex/csxann05.pdf and looked up some figures. First, the average “consumer unit” in the US is 2.5 people, and they make on average $58,712 before taxes (2005 numbers). They annually spend on average $41,548 (that’s about $800/week) per consumer unit before payroll taxes and pension savings. So, the average 2.5-person unit spends over 2.5 times the total income of the “wealthiest” 3-person unit in poverty. To get an idea what it would be like to be a rich poor person, imagine supporting three people on $314/week. If you are at 75% of the poverty threshold, then it’s about $236/week for three people. But hey, at least you would have air conditioning! (How absurd does that sound now?)

I think that’s a good place to begin a discussion of the tax issue. I went to those recently released IRS statistics here http://www.irs.gov/pub/irs-soi/05in05tr.xls to get income and tax numbers to work with, and I used the BLS statistics on consumer spending. I know there are a lot of “adjustments” that should be made to these numbers, but who benefits most from making all the adjustments is not clear to me. You can make them if you like, but I don’t think they change the bottom line. I also assume in every case the average income as reported to the IRS represents a family of 3, which is obviously not correct. But I am consistent between the categories (and unlike some, I am pointing that out to you right now).

I assume in each case a return filed represents a consumer unit that I define to approximate a working couple in New York State with one child. Incomes and taxes are based on the 2005 IRS statistics using averages in each category, and “Average Annual Expenditures” is based on the BLS report referred to above. New York State taxes are ballpark using standard deductions without dependant deduction.

Number of Returns	66,305,818	33,152,910
Filers	AVG Bottom 50%	AVG Top 50-25%
Income	$14,525.63	$44,501.95
Income Tax Federal	$432.47	$3,084.37
Income Tax State	$0	$1,770.00
SSI	$1,045.85	$3,204.14
After Tax Income	$13,047.32	$36,443.43
Avg Annual Expend.	$41,584.00	$41,584.00
Times Expense Coverage	0.31	0.88
Excess (shortfall)	$(28,536.68)	$(5,140.57)

My Times Expense Coverage shows how well the after tax income of each group covers the average consumer unit’s annual expenditures. If you are in the bottom 50% of all filers (that’s half of the returns filed), your after tax income covers about 31% of the average consumer unit expenditures. Now, I understand that many of these returns may be single folks, but even so you come up short because they can’t even cover one third of the average expenditures. The filers between the bottom 50% and the top 25% come up a bit short too. They cover about 88% of the average annual expenditures with their income. Those who are single in this category are doing OK. Those with families must be very budget conscious.

Number of Returns	31,826,793	1,326,116
Filers	AVG Top 25-1%	AVG Top 1%
Income	$109,270.95	$1,200,280.00
Income Tax Federal	$13,687.84	$277,601.66
Income Tax State	$6,691.06	$88,777.56
SSI	$7,867.51	$12,960.00
After Tax Income	$81,024.55	$820,940.78
Avg Annual Expend.	$41,584.00	$41,584.00
Times Expense Coverage	1.95	19.74
Excess (shortfall)	$39,440.55	$779,356.78

Moving on to those filers in the top range who do better than 75% of all filers but not as well as the top 1%, we see some real improvement. They cover the average annual expenditures by almost 2 times assuming they avoid the temptation to spend money on college (see expenditures table below). This 24% of filers may just be able to save some income for retirement. As expected, the top 1% do just fine, covering the average annual expenditures by a multiple of almost 20 times. That’s right, 20 times after tax.

Before we go any further, lets take a look at where those average expenditures are going:

	Dollars	Percent
Food	$5,931	14.3%
Alcohol	$426	1.0%
Housing	$15,167	36.5%
Apparel & Services	$1,886	4.5%
Transportation	$8,344	20.1%
Healthcare	$2,664	6.4%
Entertainment	$2,388	5.7%
Personal Care Pr.&Srv.	$541	1.3%
Reading	$126	0.3%
Education	$940	2.3%
Tobacco & Suppl.	$319	0.8%%
Miscellaneous	$808	1.9%
Cash Contributions	$1,663	4.0%
Personal Insurance & SSI	$5,204	12.5%
Less SSI	$(4,823)	-11.6%
Total	$41,584	100.0%

(From the BLS statistics.)

Well, I guess if everyone stopped drinking and smoking that would add a little – but not enough to cover expenses. Then again, they could forego that pricey $940/year education for three, or that extravagant $796/year/person entertainment expense (or whatever it works out to if you divide it by 2.5 instead of 3).

I ran a few other series of numbers showing how a flat tax would unduly burden the lower income levels but I decided to end my analysis of the numbers here because I believe just looking at the numbers I have already presented tells the story that needs telling. The high-income earners may pay a larger share of the income taxes collected in this country, but they do so because they can afford to. And if we need to collect any more anytime soon, I know exactly where I would go to collect it. You can be sure it would not place any further burden on the bottom 50% and it would be heavily skewed toward the top 1%. In fact, it would be skewed toward the top 1/2 % first. I don’t need elaborate models with charts and graphs to show me where the money is or how altering the tax code will shrink the pie and blah blah blah. Especially when the blended rate at the top is 23.13%. I just need a simple table showing the total after tax income per group and per filer within each group in 2005.

Number of Returns	66,305,818	33,152,910
Filers	AVG Bottom 50%	AVG Top 50-25%
Group After Tax Income (millions)	$934,459	$1,373,113
Per Filer	$14,093.17	$41,417.57

Number of Returns	31,826,793	1,326,116
Filers	AVG Top 25-1%%	AVG Top 1%
Group After Tax Income (millions)	$3,042,104	$1,223,579
Per Filer	$95,583.11	$922,678.71

I’m sure there are lots of interesting conclusions that can be reached using statistical analysis and assumptions, and these things should be done in order to arrive at actual tax policy. But for now it looks pretty simple to me. By the way - none of these numbers pick up all of those 36.5 million people living in poverty because they may not have filed a return with a positive adjusted gross income. Many don’t even make it to this level. They’re probably too busy playing around with those air conditioners to file a return anyway.

I think we should refrain from deriding the less fortunate by classifying them all into one giant group called “the poor” and discussing how they don’t really have it all that bad. Rather than declaring how unfair it is that the high earners pay a higher share (to support the very society that permits the attainment of such earnings in the first place), lets discuss how to improve the lot of all of those “others” whose daily toiling generates the income in the first place. I would like that conversation a whole lot better than the one I heard last evening.

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Dirty Little Secrets of Subprime

I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:

1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?

2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.

3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.

“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”

At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:

“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.

4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.

5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”

Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html

6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.

I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.

Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.

All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.

Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html

Looks like all the lose ends are getting tied up nicely.

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Subprime Socialization

I was responding to a post in The Informed Reader section of The WSJ Online Edition (here: http://blogs.wsj.com/informedreader/2007/10/24/the-problem-with-holding-third-parties-liable/#comment-3131) regarding His Honor Richard Posner’s discussion of third party liability. The question is whether a bartender or host should be liable for another person who drinks too much, gets in their car, and then causes a seriously unfortunate accident.

Because I have been following this whole subprime mortgage debacle I decided to take the opportunity for an analogy. Here is what I wrote:

“I wonder what His Honor would think about holding the Wall Street securitization players (banks, bankers, rating agencies, etc.) liable for the devastation caused in the mortgage, commercial paper, and real estate markets. That’s where a lot of the profits went, but it looks like much of the cost will ultimately fall to the taxpayers, the note holders, and the homeowners. I suppose one important question would be whether they are third parties or conspirators. If they are third parties, perhaps we could apply a Grokster inspired logic and find them contributorily liable: “When a widely shared product [MBS, SIV, ABCP Conduit, etc.] is used to commit infringement [fraud by mortgage bankers and clients], it may be impossible to enforce rights in the protected work [prevent the fraud] effectively against all direct infringers [fraudsters (mortgage bankers, etc.)], so that the only practical alternative is to go against the device’s distributor [Wall Street et. al.] for secondary liability on a theory of contributory or vicarious infringement [fraud]. One infringes [commits fraud] contributorily by intentionally inducing or encouraging direct infringement [fraud], and infringes vicariously by profiting from direct infringement [fraud] while declining to exercise the right to stop or limit it.” (From the Grokster syllabus here: http://www.supremecourtus.gov/opinions/04pdf/04-480.pdf, pg. 2.) Hum, it definitely needs some work and it sounds a lot like conspiracy, but it’s not too much of a stretch. I guess I am assuming that people in the securitization stream had actual knowledge that these mortgages were not what they were supposed to be, and I do not really know that for sure. It could just be a massive case of due diligence failure or, if the loans are actually what they were supposed to be, stupidity.

“In any event, it seems to this admittedly smaller legal mind that the moral hazard of a social solution is far worse than the financial losses of those who profited from this misadventure. Of course, that’s just my opinion, and I already hear Mr. Becker speaking up about the social costs of a major credit de-leveraging throughout the economy should we let the liability fall to these parties through whichever legal theory you like. In the interim, I really hope someone is checking the documentation on those loans Countrywide is transferring to FHA loans because I have a guess about just how good the due diligence has been there lately and I, for one taxpayer, do not feel the need to pick up the tab for this one.”

This issue of third party liability comes up a lot, and there is a current third party liability case in front of the Supreme Court now, STONERIDGE INVESTMENT V. SCIENTIFIC-ATLANTA, INC. ET AL. The issue in this case:

Plain language version:
Company A enters into transactions with Company B that have no real business purpose, but which allow Company A to report more earnings than it really had using hocus-poke-us accounting. Company A publishes its financial reports and its stock goes up. People buy the stock. Then the hocus-poke-us stuff is revealed, and the stock tanks. Now the stockholders want Company B to pay because without its participation in the scheme the fraud would not have happened (so they claim).

The way lawyers do it:
The issue presented is whether shareholders of a company that committed fraud resulting in losses to those shareholders can recover damages for deceptive conduct from a third party company that engaged in transactions with the public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where the third party themselves made no public statements concerning those transactions. (Butchered from the court records)

Well, this raises all kinds of questions. If you allow Company B to get away with this, investors will be unprotected and invest less. This dries up available capital and slows the economy. On the other hand, the Banks (often third parties in these misadventures) argue that if they are held to account for the sins of their clients, they will stop lending (and/or it will cost more) and that could dry up capital and hurt the economy. Oh yes, there is also the usual lawyer bashing with claims that it’s the lawyers pushing for liability because they want to be able to bring law suits against all of those third party companies (probably some truth to that too).

Decision due out soon. I have my money on no liability for third parties here. My reason is simple; the banks are on that side and it seems to me that the banks have been getting whatever the banks want these days.

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You Know What They Say About Opinions (Laffer Curve)

One thing I really enjoy about writing opinion pieces is that you don’t always need to do a lot of research. I know this because I do it – note the warning on your right!

That said opinion pieces are ripe for controversy for just that reason. For example, I was reading one today published in The Wall Street Journal Online Edition here http://online.wsj.com/article/SB119189497675953035.html?mod=opinion_main_review_and_outlooks (pg A16 in the print edition) that really caught my attention. In it, someone (no author noted) is opining on the shrinking deficit, noting that faster growth, not taxes, is the way out of deficits. Unfortunately, the piece goes on to say, this will be short lived because congress has its eye on lots of spending.

Well, I agree that Congress should spend less. I also like lower taxes, especially mine (see what I mean about opinion pieces?). In fact, if Congress could spend a lot less and lower my taxes by a lot, I think that would be great! Unfortunately, that doesn’t save this opinion piece. What gets lost is the connection between lower taxes and growth.

You know, I can earn less income and spend more. That would produce a really nice result, for a while. Things would be great, and for a time, I may even be able to spend more than I borrow. The numbers may even look good, at that point. That’s why the author of this article can point to a shrinking deficit and claim victory that tax cuts create growth, and the growth produces even more tax revenue. Hooray!

Maybe. But lets look at some of the facts here (darn those things). From the end of 2000 (the beginning of the Bush policies) to the end of 2006, GDP (current dollars) increased at a compound annual growth rate of 5.1% (I got my numbers here http://www.bea.gov/national/xls/gdplev.xls). Not Bad. What happened to the national debt over that time period? Well, from January 31, 2001 to January 31, 2007, the national debt grew at an annual compound rate of 7.3% (these numbers come from here http://www.treasurydirect.gov/NP/NPGateway). So, the shrinking deficits? These numbers do not appear to support the hypothesis that the writer claims. OK, so what if we look at just the past year? Well, GDP increased 6.12% while the national debt increased 6.24% (2005-2006, and January 2006 to January 2007, respectively). Better, but still not supportive of the writer’s conclusion. Now add the fact that Congress changed hands last year and the lower deficit numbers come into context. Is it possible that less is being spent this year because the Democratic Congress is limited by the Republican administration? Wouldn’t that be a surprise? I think the hypothesis needs a little more testing. Perhaps a good statistical analysis is in order. When the WSJ is ready, I think I know someone named Tom who can do that. Give me a call.

UPDATE: I found this link today at Paul Krugman's blog. Be sure to scroll down to the second table of numbers! Link to Paul's blog on your right.
http://www.cbo.gov/ftpdoc.cfm?index=8654&type=0

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Wash & Spin (Commentary on Forbes Commentary)

Nothing gets me more fired up than a politically skewed description of a problem, especially when the spin is so clearly evident (and when it spins away from my point of view). I ran across one of these today when reading an article in Forbes Magazine (found here http://www.forbes.com/home/free_forbes/2007/1015/021.html) authored by Mr. Forbes himself. I planned to take the day off, but I just could not resist this one.

In the commentary under “Too Bad We Can’t Tax Economic Idiocy” Mr. Forbes sounds the tired old cry that the Democrats (and some Republicans) want to tax you, and if this happens we will have devastation in the form of recession and crashing financial markets. Let’s examine some of the logic used in this argument. First of all, expiration of the Bush tax cuts is referred to as tax increases. The real truth is that the Bush tax cuts are temporary because congress could not have passed them if they made them permanent. So they used a congressional rule to pass tax cuts that they try to extend whenever they can. Mind you this was done when the Republicans controlled Congress and the White House. He then argues that if these “tax increases” go through, it will devastate small business because most are Subchapter S Corporations paying the individual tax rates. Because small business creates jobs, any tax rate increase will destroy job creation.

Well, this devastation did not occur all throughout the 1990s before the Bush tax CUTS were passed by THE REPUBLICANS, so I would like to see the evidence for his conjecture. In fact, I think there were a few pretty good small business venture success stories in that decade. Another question I have about this is why it is assumed that small business must be organized as pass through tax entities? They do not, and any small business owner is free to use the C form over the S form. Looks like we can avert that disaster too. In addition, I want to point out that the Republican Congress passed The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This act makes it more difficult for individuals to file a Chapter 7 bankruptcy proceeding and wipe the slate clean (note the title of the act vs. its actual purpose). Talk about discouraging entrepreneurship in this country! We know that many, if not most, entrepreneurs fail at least once. They then settle their affairs (which often includes credit card debt used as seed capital), pick themselves up, and try again. If instead they are strapped to payments over a long period of time, they are much less likely to garner the resources necessary to try again. Talk about damaging the job creation process. Oh, by the way, who was behind this act to protect the consumers? If you think credit card issuers and their benefactors you will get there.

Mr. Forbes then goes on to make the link between taxing the income of hedge fund managers at normal rates (the ones you and I pay) to pension funds. This argument cannot stand up to even the most common-sensical analysis. This argument is that if hedge fund managers are forced to pay the same tax rates that you and I pay, they will stop what they are doing and pension funds of (yes, here we go again) teachers and firemen (not Mr. Forbes’ words in this comment, but the words of others making the same argument) will be negatively impacted by the loss of these great investment vehicles. First of all, I have never seen the research behind this claim. How much MORE have pensioners earned because of the existence of hedge funds? In addition, if hedge fund managers have their multi-million dollar annual incomes taxed at normal rates, they will stop doing this and go where to earn more? Oh yes, the argument that if you tax this more you will get less of it, and that’s bad. Well, if that’s how we should look at it, then let’s just tax the teachers and firemen less. Why not go directly to the source?

The last point in Mr. Forbes’ commentary is that we need to cut corporate tax rates. So, we need to keep the current tax cuts, cut taxes on corporations, and he also mentions we should eliminate the estate tax (referred to by the Republicans as the “death tax,” another tired ploy). He points out that the rest of the world is cutting taxes, even Old Europe! Well, cutting taxes from what to what? Where are the numbers? Even if the numbers show (after a careful analysis including all of the corporate welfare) that our corporate tax rates are high, what can we do about it? Just cut taxes so we can compete? Well, unfortunatley those thrifty Republicans have gotten us bogged down in Iraq, and that costs a few dollars to support. Old Europe doesn’t have to worry about that. Those thrifty Republicans have also dug us deep into the largest deficit in our history just when we should be saving for future entitlement outlays (like my social security that I have paid into for over 20 years and at a much higher percentage of my compensation than Mr. Forbes). So, the reality is, we cannot afford to simply cut taxes because we need the revenue because the Republicans have created a huge national debt and ongoing deficit. Those darn Democrats are at it again!

OK, to be fair, Mr. Forbes does say that “a number of GOPers” are also thinking wrong on these issues. But I challenge anyone to read the commentary and then tell me it is not meant to bash the Democrats. His conclusion is that if Republicans make low taxes the major issue in the upcoming campaign, a Republican can win the election notwithstanding the Republican Party’s unpopularity. I hope this is a vast underestimation of the American electorate.

Finally, I must say that I agree with Mr. Forbes on the issue of new taxes from areas such as real estate. This is not the time to be looking there. An expansive example of his point is occuring in Long Island, with the proposed Brookhaven Community Preservation Fund. Talk about spin, the advertising for this “transfer fee” of 2% of the sale price of real property in excess of the first $250,000.00 “will not affect sales taxes or your property taxes” (the quoted portions in this paragraph come from the advertising flyer from The Town of Brookhaven). This is not a tax, it is a “real estate transfer fee that most residents will never pay.” Why will most residents never pay it? Because the purchaser of the property pays it. Does that mean there is no cost to current homeowners? If you read up to this point, you already know the answer. By the way, spin is bi-partisan.

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Sub-Prime Commentary - updated 10/11

I have been talking a lot about the sub-prime mortgage mess, as have many other people. One thing that I find striking is the sub-prime nature of some of this commentary coming from unexpected places. Who would have thought that the Chairperson of the FDIC would make a statement suggesting that mortgage servicers simply keep adjustable rates on sub-prime mortgages low to avoid problems? I will discuss many of the issues raised by this in a minute. I also heard a HUD representative commenting on the news one evening, I think it was The Nightly Business Report. The representative, who I believe was HUD Secretary Alfonso Jackson (it was pretty late and I was on may way to slumberland), said they want to help the teachers and firemen, but not those yuppies who just wanted to have a bigger house with more stuff – I couldn’t believe my ears (yes, he used the words yuppies, teachers, and firemen in this context). In Congress, your tax dollars are hard at work passing legislation that takes away the taxes that would be due if your lender decided to give you a gift and reduce the amount you owe on your mortgage or decided not to sue you for the balance if they sold the house but didn’t collect enough to pay themselves back (something I am sure many people who lost their homes in the past only to find out they owed income tax for the privilege are simply giddy about). This Congressional action is the set-up, I believe, for the next round of bail out action.

All of this is simply sub-prime. What are people in the highest levels of our government thinking? Lets look at some of the implications.

As reported in an article in the October 5 WSJ Online Edition that can be found here http://online.wsj.com/article/SB119154525624049715.html?mod=hps_us_whats_news (or on page A12 in the print edition), FDIC Chairperson Sheila Bair has urged loan servicers to convert those sub-prime variable rate loans that are about to adjust to fixed rate loans. She would like the rates to stay at the initial teaser rates. This would apply to all of those who are current on their payments and occupying the home in question, but not to others. In other words, bail out the people who used financing trickery to purchase a home they really could not afford or maybe they could but wanted the really low rate up front. Ms. Bair is very concerned because there are approximately $600 billion in sub-prime mortgages that are about to rate-adjust and many may fall into default when they do. Forget about those who have already lost their home. Too late for you.

Well, here we go again messing around with the economic fundamentals. Of course, when you do this there are always winners and losers. At first blush, it would appear that the winners are overstretched homeowners who could use a break and the losers are those yuppies and the big Wall Street financial firms we read about. Just who the heck are those “servicers” anyway? But is this really the end of the story? I think not.

First of all, I am not convinced that all of the people who took a sub-prime mortgage are in need of a bail out, and this would be like handing them a holiday present for no reason. Many sub-prime borrowers are placed in the sub-prime category because they do not report their income (they get paid in (or collect from their customers in) cash). Do we really want to bail those people out? If we want to bail out the less fortunate, shouldn’t we first make sure they are?

If we do bail out those people who collectively owe close to $600 billion by resetting their interest rates (in effect renegotiating their mortgages for better terms) I see other indirect effects that are not pretty. For example, who actually pays for this bail out? If we just let the borrowers keep their low interest rates, then nobody really loses, right? Wrong – someone purchased those mortgages based on the contractual obligations of the borrowers to pay the higher interest rates. If all of those borrowers are handed a windfall gain of lower rates, then the value of the mortgages goes down and those who purchased them lose. Who purchased them? Well, in this day of securitization, we don’t really know. However, don’t be at all surprised if your pension fund owns some of them, because that would be part of its normal operations. As a result, Ms. Bair’s recommendation shifts the burden of this problem from homeowners and the lenders who made the loans to those who purchased the loans. Shouldn’t we at least analyze who owns those loans now before we do that? After all, it could be the pensions of teachers and firemen! Now, Ms. Bair may argue that the losses from doing nothing will be greater than the losses created by reformation of all of those loans, but I haven’t seen that analysis, nor have I heard any commentators discuss it.

In addition to shifting the losses and bailing out many who don’t need it, there are other losers. Those who are struggling, working several jobs and foregoing all luxury to make their mortgage payments will be very upset. I know some of these people. Some purchased a home to accommodate a growing family just at the peak, and got stuck on the sale side because the buyer walked or the financing fell through. What about them? They may not have a sub-prime mortgage, but they are in a mess created by the same set of forces and at no fault of their own. Many of these people are teachers or firemen, and some are even yuppies! How do these people feel about bailing out the people responsible for this mess in the first place? I’ll tell you from my observational experience – angry. In their eyes people took a risk buying homes they could not afford on the bet that prices would continue to rise and they could profit. That bet turned out to be a loser, and in a free market system they should lose. Even worse, why should they get bailed out but not those otherwise stuck holding the bag from this mess? People with sub-prime mortgages took a risk and lost, simple as that. They were told their rates and payments would go up and they knew what they were doing. If not, then the companies (and the people) that loaned them the money should suffer for not making lawful disclosures, period. If those disclosures were not being made, then I would like to know where Ms. Bair and Mr. Jackson have been for the past few years.

In the short term, a bail-out provides an incentive for those who can pay their sub-prime mortgage to default so they can benefit from the bail-out. In the long term this also creates a huge moral hazard. What do we tell people who buy more than they can afford only to get bailed out from the debt they incur? What happened to all of those arguments I heard when the financial industry was pushing for bankruptcy reform about those who cause the system to suffer should be the ones who pay? The system needs reform because the current system creates a moral hazard? How different the spin when it is the financial industry trying to “reform” the bankruptcy laws so they can make more profit as opposed to trying to get bailed out of its own mess. Maybe I’ll do a little research on this point if I have some time. If anyone can add to it please do.

There is another, less obvious victim of a sub-prime mortgage bailout. Since labels are getting applied to people here, I will use one. The good people. Those who knew they could not afford a house without first saving for a down payment. Those who deferred their consumption until they could afford it. They are also victims of any bail out. If people who cannot really afford the homes they are in are bailed out of their mortgages by giving them below market interest rates, then the prices of homes will be artificially inflated because there will be less supply on the market. At the same time interest rates are now moving up because of the risk in this market caused by bad lending practices. So, Mr. and Ms. America who waited to purchase a home until they could afford one? They are now locked out of the market altogether. Prices will remain higher than they should and their interest rate and payment will be more than they can afford.

Where have all the free market pundits gone? Gone to hide from everyone. As expressed by a friend, privatize the profits, socialize the costs (thanks for that one).

Update: Check out the statistics from The WSJ about who these sub-prime borrowers are by going to Page one and reading the article "The United States of SubPrime", online here: http://online.wsj.com/article/SB119205925519455321.html?mod=hps_us_pageone. Also rising to the surface today, and in The WSJ, is a story about Beezer Homes and some funny business with mortgage applications. That article is available on the online edition at http://online.wsj.com/article/SB119210834369455953.html?mod=hps_us_whats_news. Finally, follow the drumbeat for the public bailout by going here: http://ap.google.com/article/ALeqM5iQqh0d4LCfDFnVXGOv7py6acvOCgD8S6L9000.

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A Tale of Two Cities: New York and Detroit (Wall Street Competitiveness)

A Tale of Two Cities: New York and Detroit (revised)

The other day I wrote about the recent UAW/GM contract negotiations, and some commentary about the outcome. The bottom line of my piece is that US autoworkers are being forced down the standard of living scale by a shift in power from labor to business, and the main argument used to support this shift is competition from the global economy. Whether this is actually the case remains unclear, but it is certainly the reason given by business and the media in general for the decline in US manufacturing job compensation in Detroit. (For more on that see my post.)

I was reading an article in The WSJ Online edition today regarding Sen. Jeff Sessions promotion of a bill favoring financial institutions over accepted intellectual property rights, and I was struck by the way the rules are changed when the “victim” is an industry with very strong ties to the rule makers. (Of course, we all know there was gambling at Rick’s, but at least it was in the back room.)

Being interested in this example of the imbalance of power, I began to poke around a little, and came upon a recent report published by The Senate Republican Policy Committee which can be found at http://rpc.senate.gov/_files/061907competitivenessDK.pdf . The report (the “Senate Report”) is entitled Excesses Threaten U.S. Competitiveness, When Excess Damages Success: Have Litigation, Taxation, and Regulation Gone Too Far? This report, dated June 19, 2007 explains that US banks (Wall Street) are losing competitiveness to foreign markets. The conclusion of this report is:

"The declining competitiveness of the United States’ capital markets may be a canary in the coal mine of a much deeper problem. The trends of excessive regulation, litigation, and taxation in our capital markets are being replicated in other parts of our economy. Unless Congress, the Administration, and the business community create a clear and unified blueprint for maintaining our nation’s competitiveness, capital and jobs will continue to move overseas."

One of the major resources relied on for this finding is a report (the “McKinsey Report”) generated by McKinsey & Company for Mayor Blumburg of New York and United States Senator Charles Schumer entitled Sustaining New York’s and the US’ Global Financial Services Leadership which can be found at http://www.senate.gov/~schumer/SchumerWebsite/pressroom/special_reports/2007/NY_REPORT%20_FINAL.pdf . Citing this report, the Senate Report states that

“Regulatory and litigation burdens are two major drivers of declining
competitiveness for capital markets.

In a large survey of industry leaders, McKinsey & Company, a premier management consulting firm, found that about two-fifths of CEOs surveyed expected that New York City—and by extension the United States—would become less attractive as a place to do business. McKinsey found that what clearly dominated these views were fears that two factors would not be present: 1) a fair and predictable legal environment and 2) a strong but responsive regulatory environment.”

In other words, the problems causing New York banks to lose market share are taxes, the lawyers bringing too many frivolous lawsuits against companies in the US, and over-regulation of US companies. This is causing companies to go overseas and sell their stock in foreign markets. Now, to be fair, there is some merit to these claims, and I am all for rationalizing our regulatory systems. There is a price to be paid, however, for transparency and safety and I do not believe we should go too far. (This is the stuff of a future blog piece.) All of this got me thinking about the competitiveness issue for investment banks. Being a former analyst and having just written a piece regarding global competition, the first question that came to mind was how much of this competitive loss is being caused by these factors as compared to good old competition from lower cost global competitors?

Well, I reviewed the McKinsey Report (though I will admit I did not read all 142 pages of it in its entirety), and was startled at what I did not find. What I did not find in all of the 142 pages of the McKinsey Report was a material discussion of the impact of lower fees charged by banks in other countries having an impact on the competitiveness of New York banks. Not to digress, but how can one of the premier consulting firms on the face of the Earth, engaged by The City of New York and the United States Congress, produce a report that purports to study why US Banks are losing competitiveness to banks overseas not consider the prices being charged by overseas competitors? Either the researchers were instructed to report only on select issues, or the research is completely flawed. You be the judge. Here is what they had to say about the fees:

“Another explanation put forward by some commentators as to why international issuers are staying away from US equity markets is the fact that the underwriting fees charged by investment banks are significantly higher for US listings than in competing markets. One study reveals that underwriting fees for non-domestic listings were 5.6 percent and 7.0 percent on the NYSE and NASDAQ, respectively, compared with just 3.5 percent on London’s man market. But while such figures may seem significant when looked at in isolation, their importance relative to the overall value of an IPO s fairly low, and easily outweighed by the benefits of a more liquid market and superior execution. Surveys conducted for this report corroborate this thesis: when asked to rate the importance of underwriting fees in the overall process of listing a company on the public equity markets, survey respondents ranked underwriting fees last among seven factors, with just 4 percent judging the issue ‘very important.’” (See pg 49 of the McKinsey Report.) (Note that they did not site the LSE Report discussed below here, as that would show a larger fee discrepancy.) Who are these respondents who deem it not important that the fees charged are almost double? “… a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 75 additional global financial services senior executives through a separate on-line survey.” (See McKinsey Report pg 8.) So the people who say the vast differential in the fee is not important are the very people running these businesses and charging these fees. Sounds conclusive to me.

As it turns out there has been a study that identifies the fee differentials between international markets for investment banking services. I found it in a footnote to the McKinsey Report (so they looked at this report). You can find the report (the “LSE Report”), published by The London Stock Exchange, here http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .

The LSE Report finds "Gross spreads of IPOs on the US exchanges are found to be highest, averaging 6.5% for the NYSE sample and 7% for Nasdaq IPOs. In comparison, median spreads of IPOs on the LSE’s Main Market are 3.25% and those on AIM somewhat higher at 4%. Thus, there is a cost saving of three percentage points for a UK transaction compared with a US transaction." (See pg 18 of the LSE Report.) How much is 3%? Well, for the over $4 billion Blackstone initial public offering, that would be at least (.03X4,000,000,000) $120 million! That's just the excess of US over other markets. How does this compare to the first year’s cost of compliance with Sarbanes-Oxley? That cost is estimated at $4.4 million according to a 2005 survey cited in the LSE Report (LSE Report pg. 33).

So let’s review. The fee charged is by far the largest component of the cost of issuance in the US, and fees in the US are by far the largest among international competitors. This fee differential is not, however, why US banks are losing competitiveness. The reason is the cost of these darn law suits and regulations that companies in the US must put up with. That’s the New York tale. The Detroit tale? US workers at GM, Ford, and Chrysler must reduce their standard of living because we cannot compete with lower cost labor from foreign competitors. My conclusion? Perhaps Wall Street should lower the standard of living of its employees so that it can better compete with the foreign competition just like those on main street in Detroit are doing. Otherwise, stop spending my tax dollars on stupid reports that ignore the most obvious issues. Now don’t get me wrong. I am all for US competitiveness. We need to continue to study our competitiveness and actions we should take to ensure our future. I, however, would prefer to do so with full information applied across all of the US constituents rather than targeted reports used to influence the rule making process for the benefit of those in power (which is my interpretation of the McKinsey Report).

PS – if you think the higher fees charged by the New York banks has to do with the cost of living in New York, forget it. The studies show that is not the case.

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UAW/GM (Free Trade)

An opinion comment on the UAW/GM deal posted here for discussion. Criticism is welcome, however kindly refrain from labels such as “communist”, “socialist”, and “protectionist”. Rather, please post thoughtful comments that address the issues raised.

“The UAW’s Awakening”, an article that appeared in the WSJ Online and can be found here - http://online.wsj.com/article/SB119103039313343439.html (subscription required) [and here in print - September 29, 2007; Page A8] - discusses the recent deal struck between GM and the UAW. The deal includes some major givebacks by the Union, and the article in essence makes the claim that this was inevitable given global competition. US workers cannot maintain their hold over business when business is competing with global producers or the inevitable result is bankruptcy. I have several issues with this basic assumption.

My first point is that GM is not suffering just at the hands of global competition. It is largely domestic foreign manufacturers cleaning its clock. This is not globalization, but rather opening our vast consumer market to foreign competitors without restriction. I would like the writer of the WSJ article to compare the openness of the US consumer market for autos to other markets around the globe. Will we begin to see there is a large political element to the destruction of UAW power? In addition, if GM management had focused on managing its product line to better meet the needs of its customers rather than on building gas hog SUVs would GM be in its current situation? (Remember that tax incentive to purchase vehicles over 5,000 pounds congress passed after 9/11? Did GM have a hand in that? Was that an example of the free market at work? For those of you who react to this article by worshipping free markets, please address how this incentive, which naturally skewed the allocation of consumption resources in GM's favor, is a free market phenomenon.)

My second point is an even if. Even if we assume it is globalization that is undermining GM's ability to compete given its current labor contracts, what if anything is being done to protect the US workforce from the impact of poor labor conditions around the globe? Apparently it is better to allow labor to be exploited so long as it is “over there.” Unfortunately, the impact over here is seen in the reduced standard of living domestic autoworkers will now be forced to accept.

Finally, if globalization is causing a reduction in the ability of the US to profit from its economic endeavors, why are the stock market, corporate profits, and corporate officer compensation at all time highs? It seems painfully obvious that what is occurring is a shift from labor to capital masked by terms like “globalization” and “free market economy.” In reality, we gave up on completely free markets long ago when labor was at the door with sticks and rocks. Our democratic form of government was able to react and to reverse the imbalance of power of business over labor by passing laws to protect workers. By opening our borders to imports from overseas where labor has limited rights, we are bypassing those laws. Who benefits most from this? Follow the money….

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