We shouldn’t dread the debt limit
“Have a drink out there, folks, and just know that your kids and grandkids will be out there picking grit with the chickens,” says former U.S. Senator Alan Simpson in the video above. Simpson’s quip is the best summary I’ve ever heard of the public’s lack of understanding of the severity of the nation’s fiscal crisis. The federal government is currently borrowing 42 cents of every dollar that it spends. Thanks to the Federal Reserve’s quantitative easing and the strong global demand for U.S. Treasury debt, the nation has been able to borrow heavily at low interest rates to cover its budget shortfalls.
But the debt is piling up so high that the country might face a borrowing shock if there were a black swan event or if bond vigilantes forced higher interest rates. It’s not a question of whether rates will rise – they certainly will. What we don’t know is when it will happen. The same politicians who created this fiscal quagmire have now tasked themselves with fixing it. Despite numerous proposals on how to get our debt under control, the political dynamics of the issue make it likely that nothing will be resolved in Congress until after November’s election. The Washington Post reports:
But once the election is over … the issue of the debt will quickly rise to the top of the agenda – and not just because of the debt limit. In January, policymakers also will be facing the first round of harsh, across-the-board spending cuts adopted last summer, as well as the expiration of a host of tax cuts that benefit every American household. Unless Congress agrees on an alternative deficit-reduction strategy, the policies threaten to deliver a fiscal shock that could throw the nation back into recession.
Earlier this week at the Peterson Foundation’s Fiscal Summit 2012, House Speaker John Boehner gave a speech in which he laid out his plans for tax reform and vowed not to increase the borrowing limit:
Any sudden tax hike would hurt our economy, so this fall – before the election — the House of Representatives will vote to stop the largest tax increase in American history [the expiration of the Bush tax cuts]. This will give Congress time to work on broad-based tax reform that lowers rates for individuals and businesses while closing deductions, credits, and special carveouts. Eyebrows go up all over town whenever I talk about this, but when I say ‘broad-based’ tax reform, I mean it. We need to do it all … deal with the whole code, personal and corporate it’s fairer and more productive for everyone.
Meanwhile the Senate Republicans found an obscure Senate rule that allowed them to take control of the Senate for a day and hold a series of votes on their proposed budgets. From Bloomberg:
Will Puerto Rico’s governor part ways with Grover Norquist?
Last month, Puerto Rico Governor Luis Fortuño delivered a speech at the libertarian Reason Foundation on “how Puerto Rico avoided becoming “America’s Greece.” In his talk, the governor espoused the anti-government ethos of Grover Norquist, whom he cited as a friend in the first minute of his remarks. Fortuño has been a staunch advocate of “right-sizing” government: Soon after taking office, he laid off a substantial number of the commonwealth’s employees and reduced the island’s personal, corporate and property taxes.
Despite these cuts, Puerto Rico’s budget is still unbalanced. Fortuño has been relying on bond issuance through COFINA, the government’s off-balance-sheet, special-purpose vehicle, to make up for annual shortfalls to his budget.
Now, Republicans in Congress are working to blow another hole in Fortuño’s budget. As part of their effort to stave off the impending, automatic cuts to the defense budget, House Republicans passed legislation that kills a special provision of the Affordable Care Act increasing Medicaid grants to Puerto Rico. Faced with the threat of losing billions of dollars in federal payments each year, Fortuño now seems to think that lower federal spending is not that appealing. He pushed back on these cuts in an op-ed on CNN.com:
Historically, Puerto Rico’s Medicaid program has been chronically underfunded by the federal government. In 2010, Puerto Rico and the other territories secured corrective legislation to provide $6.3 billion in Medicaid funding over 10 years, which includes $5.4 billion for Puerto Rico.
[...]
Now, House Republicans have assembled a package of budget cuts to replace the automatic, across-the-board sequester. The proposal does not cut the Medicaid expansion funds for the 50 states, but Puerto Rico’s $5.4 billion Medicaid provision has been singled out for elimination.
It’s important to note that residents of Puerto Rico are already treated differently in the federal government’s eyes, at least when it comes to the tax code. Its residents do not pay federal income tax on money earned within Puerto Rico, making federal tax collections there much smaller than in any U.S. state. The most recent data available showed federal per capita collections of $888; West Virginia, the state with the second-lowest federal per capita collections, took in $3,599. According to the AARP, Puerto Rico has a higher percentage of residents receiving Social Security than the national average, and only half of those recipients are retirees.
When the food stamp program was modified in 1977 to cover Puerto Rico, 56 percent of the island’s residents signed up to receive those benefits. Although Puerto Rico represents barely more than 1 percent of the national population, Puerto Ricans accounts for about 8 percent of federal dollars spent through the food stamp program. After Congress later modified the program, the percentage of Puerto Rico’s population on food stamps fell, to about 25 percent today, but that’s still well over the national usage rate of 15 percent.
I believe First of All things should be put in perspective before making statements such as “Puerto Rico is a very poor place and needs support from the mainland.” & “Given the fragility of the island’s economy”…
Perhaps the actual Times Magazine’s Cover story said it best…”Are You Mom Enough?”
Now, doesn’t the analogy makes you want to take the breast out of the 114th year old child’s mouth. (the boy pants was very clever btw)
We must ask ourselves what are we missing here?…because what I just read sounds almost verbatim from Murat Halstead late 19 century books. -The infamous definition of the word Insanity comes to mind.
Now going back to the ‘Breast Feeding Time’ analogy I was asking myself this question earlier today…
Could a Mom still have milk in her breast to feed a child so late into their lives?
Well, here is a video that might help put things in perspective by a layman in Economics…Sir Tony Robbins. So you don’t just settle for my breast feeding analogy and question.
Enjoy It
http://www.youtube.com/watch?v=jboTeS9Ok ak&feature=youtube_gdata_player
Muniland’s huge Dodd-Frank win
A huge win for muniland was finalized last week when the SEC approved new rules that will shine light on the municipal bond underwriting process. This Bloomberg headline says it all: “Bond-Disclosure Rules Backed by SEC to Protect States From Banks”:
The rules were proposed by the Municipal Securities Rulemaking Board last year and are aimed at preventing Wall Street underwriters from steering public officials toward complicated debt financing without disclosing the risks. They were approved May 4 by the SEC, which will enforce them.
The disclosures are part of the effort to reshape financial regulations to prevent a repeat of the credit-market crisis of 2008, and stem from Congress’s decision to provide added protections for state and local governments. The economic crisis hit taxpayers with billions of dollars in unexpected costs when complex bond deals, once pitched as money savers, backfired as credit markets seized up.
I spent almost a year on Capitol Hill leading an open-source financial reform project as Dodd-Frank was being written. This is about the only area of the legislation in which there was no pushback from banks. Spencer Bachus, the Republican chairman of the House Financial Services Committee, was the committee’s ranking member at the time the legislation was being developed. Bachus’s home district in Alabama includes Jefferson County, the bankrupt county that has been buried under a series of deals with JPMorgan on interest-rate derivatives deals. Whether the banks explicitly held off challenging tighter municipal bond rules out of deference to Representative Bachus or whether they decided other parts of the legislation were higher priority is unknown.
In any event, the new rules are sweeping. Alan Polsky, the chairman of the Municipal Securities Rulemaking Board, said as much in a statement:
These new rules are the biggest development in protection of the financial interests of state and local governments since the MSRB was established in 1975.
The new rules detail a number of ways that underwriters must disclose their conflicts of interest to states, cities and other entities that issue municipal bonds. But the heart of the new rules addresses the sale of interest-rate derivatives tied to municipal bond offerings. Reuters blogger Felix Salmon described the practice like this in 2010:
I can guarantee you that every time a swap was sold, the person selling it got a nice fat up-front commission, and the unsophisticated small municipality buying it wound up getting a very unattractive deal. And the more complex the swap, and the higher the up-front payment to the town, the more the municipality was likely to be ripped off.
The underlying problem here is that interest-rate swaps tend to be sold rather than bought. If municipal treasurers came up with these plans on their own, and then asked a few banks for bids on the exact swap that they wanted, many of the rip-offs would never have happened. But instead, like subprime borrowers encouraged to monetize their home equity, they got talked into bad deals by sleazy financial professionals working on commission.
A smarter way for Congress to talk about muni tax code
Chris Mauro, head of U.S. municipal strategy at RBC Capital Markets, sent around a comment note suggesting that the media coverage of the Senate Finance Committee hearing Wednesday that included discussion of possible changes to the taxation of municipal bonds was overheated:
Yesterday, the Senate Finance Committee held a hearing entitled “Tax Reform: What It Means for State and Local Tax and Fiscal Policy”. A simple reading of the media accounts of this hearing would lead one to believe that the entire event was dedicated to a detailed discussion of the future of the tax-exempt status of municipal bond interest. So we decided to review the tape of the hearing in order to see what in fact was discussed. In reality, the vast majority of the hearing was focused on two issues – the deductibility of state and local taxes by federal taxpayers and the ability of state and local governments to collect sales taxes on internet and catalog purchases.
Both Committee Chairman Max Baucus and Ranking Member Orrin Hatch made some passing comments about tax-exempt bonds and the federally subsidized taxable Build America Bond (BABs) program, with Baucus making generally positive statements about BABs and Hatch making generally negative ones. Senator Maria Cantwell of Washington State expressed some concern about the importance of tax-exempt bond financing to public power utilities in the northwest, but beyond that, there wasn’t a whole lot of discussion about the muni tax exemption.
In our view, the biggest take-away from the hearing was just how far away we seem to be from a comprehensive tax reform package actually becoming reality. We found it informative that at several points during the hearing, Senator Baucus discussed the difficulty Congress has in identifying which tax expenditure items need to be cut in order to lower overall tax rates, asking the witnesses during one exchange to contribute some creative ideas in that regard. This confirms something that the market already knows but needs to be continually reminded of – real comprehensive tax reform is extremely difficult to pull off and will take a considerable amount of time to accomplish.
I didn’t watch the hearing but it sounds as if RBC’s Mauro read the tea leaves pretty well. I’m sure that Congress is having difficulty identifying where to amend the tax code to make it fairer and raise additional revenue or have revenues remain neutral. The deliberative congressional process gives all the issue’s players a chance to be heard, and tax matters are often the most fiercely fought. But the other thing I noticed in Mauro’s note was that Congress is looking for new ideas to address this complex issue.
One idea that I’m interested in is having Congress more narrowly define what constitutes a “municipal bond” issued for the public good. In muniland there are a lot of private activity bonds that do not provide infrastructure or services for the general public but rather for a select audience that must pay substantial amounts to gain access. The tax-exempt bonds of “non-profit” hospitals offer the most obvious example, as I wrote several weeks ago:
As the legislative and executive branches thrash out the exact standard for how much charity care a hospital must provide, the deeper issue of for-profit entities using most of the physical space in a tax-exempt, non-profit building needs more attention. The original county review that sparked Illinois to look more closely at non-profit hospitals, that of the Provena Covenant Medical Center, detailed the extent of for-profit activity in the system:
“Provena Covenant Medical Center allows outside, for-profit entities to use the facilities to generate personal and/or corporate profit. There are multiple outside physicians’ groups and service providers who use the hospital to serve patients. These physicians’ groups are for-profit entities that practice in the hospital and then bill patients for work done in what is claimed as a tax-exempt property…”
I’ve also written about Exxon Mobil and Koch Industries, which have tax-exempt bonds for refinery facilities and waste treatment plants, respectively, in Louisiana. As Congress thinks about creating greater fairness in the tax code, the tax exemption for private activity bonds is one place to look, and I’m sure there are other areas where changes could be made.
Forget Volcker — bring back Glass-Steagall
Imagine you are a financial regulator whose agency is underfunded, understaffed and under-trained and that firms under your jurisdiction are likely to pick off your best employees by offering them triple the salary you pay them.
Furthermore, imagine that Congress has written an 800-page law that instructs you to write and enforce new regulations on banks and securities firms to ensure financial stability for the system. The most complex part of this new law, the Volcker Rule, would require you to cooperate with three other agencies to jointly issue a 530-page Proposed Rule that asks 1,300 questions.
Now imagine that in the course of honing this rule, 17,000 comment letters will flow into your agency, the majority of which promote the status quo.
After going through this thought experiment, you’d probably say: “What a headache! Why can’t we just bring back Glass-Steagall and split up banks into risky trading machines and safe depository institutions? This monstrosity of a regulatory fiat will never be properly defined or adequately enforced.”
The Volcker Rule is supposed to isolate the risk of a bank trading its own assets and separate that from depositors’ assets. In other words, the Volcker Rule should isolate the risk of a big derivatives or fixed-income loss on the house account from the cash savings of retired teachers and other customers of the bank. By design, it is aimed at the heart of the nation’s largest banks, the five institutions that use their enormous staffs and FDIC-insured balance sheets to dominate trading and commercial banking.
Take JPMorgan Chase, for instance. Tuesday it released the employee headcount of its investment bank: 2,500 salespeople and 2,000 traders on 110 trading desks in 20 trading centers, in addition to its 2,000 investment bankers. JPMorgan trades securities in 12 asset classes using its risk-weighted assets of $467 billion. Although JPMorgan and other banks are less leveraged than they were prior to the financial crisis, they are still pumped up trading engines attached to slow-moving, deposit-taking banks. In the derivative space alone JP Morgan’s total credit exposure was 285 percent of its risk-based capital in Q3 2011, according to the Office of the Comptroller of the Currency (graph 5A).
The core issue in attempting to define the Volcker Rule is that federal securities and banking regulators have never really supervised the fixed-income and derivatives markets. Dodd-Frank has many provisions for the regulation of derivatives but entirely skips over any requirement to regulate bond trading. The SEC heavily regulates stock trading but conducts little to no oversight of bond markets. Bonds are an enormous, dark market that few people understand, hence all the laments that eliminating prop trading of bonds will dry up liquidity — a ridiculous idea. If there are larger profits in bond trading because the five major banks are limited, new entrants will expand into the market to capture those profits and provide liquidity.
It’s true that there aren’t quote reporting requirements in the bond markets like there are in the stock markets. But that’s because there are literally millions of distinct bonds outstanding versus around 8,000 equities. It is impossible to quote all bonds actively as is done with equities. Dealers only provide bond quotes when their customers ask. And, there are detailed FINRA and MSRB markup and fair pricing rules that apply to the prices dealers dealers can charge for bonds. Moreover, the rules related to price transparency are completely unrelated to Gramm Leach Bliley and wouldn’t change if Glass Stegall came back. The GLBA had practically nothing to do with regulating the bond markets.
Even more important, there are extensive regulations that apply to almost all aspects of the bond markets. The SEC, FINRA and the MSRB all have thick rule books that relate to the bond business, and those rule books are getting thicker as Dodd-Frank is implemented. It simply isn’t the case that regulators conduct “little to no oversight of bond markets.”
Finally, under Glass-Stegall before the GLBA, banks were heavily involved in the fixed income markets. Government, agency, mortgage-backed and most municipal securities were all “bank eligible,” meaning that commercial banks could underwrite and trade them. Bringing back Glass-Stegall as it was before the GLBA wouldn’t keep banks out of the fixed income business.
The impact of defense cuts
Reductions to our outsize military budget are scheduled to take effect in 2013. Congressional Republicans have vowed to reverse these mandated reductions, but so far organized resistance in Congress has not appeared. President Obama has vowed to veto any legislation that would overturn the cuts.
I previously described the size of the annual reductions:
President Obama proposed spending approximately $924 billion on defense, veterans care and international affairs for 2012. This represents about 24.7 percent of the $3.729 trillion federal budget. The automatic cuts to these areas required by the Budget Control Act of 2011 will equal about $75 billion per year over eight years. This would be on top of already enacted Defense Department reductions of $45 billion per year over 10 years. The combined $120 billion of annual spending cuts will equal about 12.9 percent of the joint budget for defense and intelligence. It’s a big cut, but it would barely dent the capabilities of the biggest military force on earth.
Annual reductions of 13 percent are substantial, but the nation will still spend significantly more than any other on earth. And it’s important to remember we will be spending 25 percent of our federal budget on the military even though, it is hoped, we will not be fighting a war. It’s not clear that the U.S. would have the “fiscal space” to ramp up spending to fight another big war and care for Social Security, Medicare and Medicaid beneficiaries.
Where will these cuts come from, and who will be affected? Politicians, credit-rating agencies and defense contractors have been poring over the bits and pieces of information coming out of the Pentagon. Today the Department of Defense released the following:
Lessons from MF Global
The October bankruptcy of MF Global has been the subject of several Congressional hearings recently. 38,000 MF Global clients lost $1.2 billion in the collapse, and numerous regulators, as well as the Department of Justice, have been trying to unravel hundreds of thousands of transactions to discover how this client money disappeared. Weeks later, it’s still unknown whether clients will have their funds returned or whether any laws were broken. What is certain, though, is that even after the passage of Dodd-Frank, our regulatory system has large supervisory gaps.
The derivatives and futures businesses in which MF Global operated are complex, and it’s easiest to understand the firm as a large transaction processor that served its futures clients by connecting them to exchanges around the world. MF Global was both a broker-dealer and a futures commission merchant, meaning it was regulated by the SEC as well as the CFTC. In addition, MF Global was overseen by the Financial Industry Regulatory Authority (FINRA) and the CME, two self-regulatory organizations empowered by the SEC.
The big problem with oversight of MF Global within the U.S. is that there were too many regulators with only a small window into the firm’s activities and none with the ability to see the full scope of risks and capital of the holding company. How can we fix this?
I would disagree with the idea that regulators are not paid enough and that is why they do a bad job. The laws that they work with are written by the people they are regulating. The outcome of such a corrupt system is what we have today. Furthermore, the notion that the system is too “complex” and we need smarter people regulating is laughable. Credit default swaps are not complex. They are insurance policies and should be regulated as car or home insurance. The problem is clearly the entire legal system and the unabashed corruption in writing laws that restrict financial institutions’ activities then expecting an equally corrupt judicial and executive branch to do anything that changes the status quo.
Drum circle of the war hawks
The war hawks, desperate to avoid huge impending cuts to the defense budget, have formed a drum circle to stall the reductions and are beginning to pound out a rhythm. Seung Min Kim of Politico reports:
Congressional Republicans are still full throttle in their efforts to dismantle the automatic spending cuts that would be particularly painful to the Pentagon.
A quartet of Senate defense hawks [Republican Senators Lindsey Graham of South Carolina, John McCain of Arizona, Kelly Ayotte of New Hampshire, and Jon Kyl of Arizona] announced on Wednesday they’ll introduce legislation to undo hundreds of billions of dollars in defense cuts by replacing it with budget savings elsewhere. Those across-the-board cuts were mandated by the supercommittee’s inability to strike a deal slashing the nation’s deficit by at least $1.2 trillion over the next decade.
The U.S. government faces massive deficits as far as the eye can see. We’ve been very fortunate to fund these deficits with borrowing at historically low rates as global investors sought the safety of U.S. Treasuries. But our fiscal imbalances, like those of many European nations, are unsustainable in the long run. We cannot continue to spend more than we take in. We must shrink every part of the federal budget and get more efficiency from what we do spend. The arguments of fiscal expansionists that stimulus spending is necessary to jumpstart the economy have proven unpopular. Government spending must shrink, and a major component of that is defense spending. The war hawks defend military spending with the patriotism mantle, but that’s a worn-out cliche that can’t pass scrutiny.
While the United States is in a serious financial problem with huge government and trade deficits I fear that deep cuts into the US military will lead to a seriously weakened force. The article I just read and am commenting on states that the US far outspends other nations in the military sector with China a far second place. The other nations listed I am not concerned about as they are US allies but China is actively modernizing and expanding their military and they can do this for far less capital than the US because China can do so with little profit in the equation. We must remember that most industry in China is run by it’s military. Couple this with low labor costs and it’s acquisition of western technology through US corporations that have moved production to China, entered into required agreements for licensed and joint production of high technology systems such as aircraft, communication, computing systems and others and China can produce high technology military systems for far less than the US.
The days of the Pentagon being a ‘cash cow’ for US defense companies is coming to an end. US defense contractors must reduce huge overhead such as high salaries for multiple executives by thinning out the upper ranks and concentrating on producing products for the military with a sense of nationalism such as China’s military suppliers. US defense contractors have always viewed military systems as high profit ventures and this mentality must change. Profit should be in the equation but realistic. The term COTS (commercial off-the-shelf) is becoming more common in use by the Pentagon in incorporating technologies in future weapons systems in dealing with funding cuts but the same is available for China to use. The US must maintain a strong, technologically advanced and sizable force as China continues to gain strength economically and militarily and has demonstrated that it is engaged in gaining power through control of the world’s dwindling natural resources and increasingly becoming bolder in international matters such as territorial rights and the issue of Taiwan. China is on a mission to replace the US as the world’s superpower and the US must be in a position to counter China as it becomes more vocal and forceful in it’s intentions.
Franchise the Post Office
Since the news came out that the United States Postal Service lost about $10 billion in the last fiscal year, various proposals have been swirling around to make it profitable going forward. Some have called for the closure of half of the mail processing centers, the elimination of Saturday home delivery, and the possible closure of about 3,650 rural post offices.
But instead of closing those 3,650 rural post offices, how about we convert them to franchises using the model of United Parcel Services?
… jobs would be created….” Maybe you can help me understand how a post office integrated into an existing business would create jobs. The business will simply be handled by someone earning minimum wage and selling lottery tickets and beer as their main occupation. Of the 3650 rural post offices threatened, how many are in a community where a suitable business base exists? The population density of Loving County, TX is less than 2 per square mile. I doubt there is a critical mass there.
Washington’s misguided pension panic
Many state and local pension funds are still struggling from the financial crisis. Between 2007 and 2008, they recorded a loss of 27 percent. Pension assets have bounced back some – they stood at $2.664 trillion at the end of Q3 2011 – but are still approximately 17 percent below their 2007 high. Although many state legislatures and city councils have taken steps to shore up their pension funds, including the elimination of cost-of-living adjustments and requirements for higher contributions from employees and taxpayers as well as later retirement ages, there are still struggles ahead.
There is less money to investment management companies from public pension funds and social security than there is from 401K/IRA plans. Structurally, individuals are much better off in a collaborative plan which can stay fully invested in the market forever, but the management fees are better for individual plans. As to the rest, find me any time or place in history when at least some government officials could not be bought and sold.
As markets become increasingly efficient, as the margins earned by management companies become increasingly compressed, expect the desperation to dismember public plans to increase.
When the golden cake is not passed around anymore, it is very hard to scrape crumbs from it, and a great many people on Wall Street and Washington cannot see themselves eating bread.
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Resident Muniland expert
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It’s not the debt limit people fear, it’s the politicizing of the debt limit. Neither Dems nor GOP will give one inch to the other in this battle, both wanting to achieve their own agenda.
Fear the results of a broken, entrenched political system trying to agree on anything.