The Tragedy of the [Growth] Common [Stock]

The fiscal and regulatory issues still awaiting solutions are monumental: generating new living wage jobs to bring down unemployment; addressing the budget shortfalls at all levels of government; repairing and upgrading our physical infrastructure, especially for transportation and the electric power grid. But for a couple of reasons, fixing the mortgage market may be particularly contentious. More than any other problem, proposed solutions tend to fall along ideological lines in accordance with what you think caused the collapse of the banking system.

The US Treasury and Housing and Urban Development Departments held a Conference on the Future of Housing Finance this past August 17 as part of policy development for this process.

The Treasury conference tried to adhere to its title and stick to the future. But it’s hard to separate cure from diagnosis with this disease. Participants tried to characterize what the solutions should look like while avoiding the blame routine

The “takeway”

Conference consensus seemed to form around the conclusion that, for the time being, we are stuck with a large federal role, but that will eventually be phased out, (or not, if you are Bill Gross of PIMCO). (See summary conference notes thanks to: http://www.thinkglink.com/blog/2010/08/17/live-blogging-conference-on-the-future-of-housing-finance)

I’d like to focus on three ideas about which most if not the entire panel, shared their opinion (not agreement).

1.    Federal housing subsidies have been excessive, they have been overwhelmingly in favor of middle and upper middle class homeownership; their market distortions have been harmful, and should be diminished.

2.    Government policies forced banks and the GSEs (government sponsored enterprises - Freddie Mac and Fannie Mae) to abandon traditional high credit standards and inspired the banking crisis

3.    Lightly regulated private financial institutions were not responsible for the crisis, and remain the salvation for the future of the credit markets.

First, where does all this subsidy come from and more important, where does it go? The Congressional Budget Office published “An Overview of Federal Support for Housing” in November, 2009. The three figures below excerpted from the report show the bias toward homeownership and away from renters. You can see a 4-to-1 ratio of support for homeowners over low income renters in the first graphic. It’s a peculiar arrangement that gives the most subsidies to those who need it least. It’s even worse when you see how much more difficult and bureaucratic the subsidy is to get the poorer you are - more on that in a different installment. It’s shouldn’t be a surprise that there was a bubble in middle class housing and a shortage of low income rental housing once you see how the subsidies were distributed.

Federal Support for Housing, 2009 (Billions of dollars) 

Federal Support for Homeownership, 2009 (Billions of dollars) 

Federal Support for Rental Housing, 2009 (Billions of dollars) 

The second is a favorite libertarian theme that the federal government forced the lowering of lending standards. The key word is “force”.

The specific federal actions held responsible were the 1990s enforcement of the Community Reinvestment Act of 1977(CRA) and the HUD affordable housing guidelines applied to the federally chartered government sponsored housing enterprises (GSEs- Freddie Mac and Fannie Mae). In short, the CRA said that, in exchange for federal deposit insurance, banks were obligated to lend to families and businesses in their branch neighborhoods, including low income customers, or else their bank merger applications might get stalled. Incidentally, turning down some of those requests may have prevented some of these banks from becoming “too big to fail”.

The HUD guidelines restricted new business for the GSEs unless growth included increased home loans to low income families. The motivation for this was that despite the great advantages that the federal government had given to the GSEs in the mortgage market, the beneficiaries were predominantly middle class suburban single family home owners. Although this had been Fannie Mae’s target market from its inception (1938), there was every reason to believe that urban, rural and renting Americans should also benefit from some version of the “American Dream”. The guidelines merely said that if you are going to continue growing you have to include these neglected markets as part your expansion. The simplest alternative was to slow the growth.

By the late 1990s, observers were noticing the increased risk of a rapidly growing and increasingly leveraged Fannie Mae and Freddie. Peter Wallison of American Enterprise Institute (AEI), points this out on several occasions well before the 2007 crisis. He warned in “Nationalizing Mortgage Risk; The Growth of Fannie Mae and Freddie Mac” with co-author Bert Ely that having fully penetrated the prime market, Fannie could only meet its growth targets by expanding into home equity, multifamily, and inevitably, the sub prime market. These risky departures from their traditionally safe product mix grew from following their own corporate growth strategies, not from HUD coercion.

Between 2002 and 2005, FNMA increased their purchases of sub prime mortgages from non-bank originators because they were concerned about losing market share in the mortgage-backed securities (MBS) business to the large investment banks and their affiliated originators.

The point is that both the banks and the GSEs had alternatives to making bad loans. They could slow their growth - which doesn’t sound like “forcing” unless you have no alternative but to grow. Unfortunately, some firms, including the “too big” banks and Fannie Mae never seriously considered slowing down. They were dedicated to their growth strategy. Their stock price, along with their stock options, depended on it. 

Third, is the for-profit private sector always the preferred alternative to a politically driven public agency? “Free enterprise” gets a lot of unchallenged praise for efficiency, and innovation, especially when compared to government. But what happens when the interests of the shareholders, senior management and the customers are not the same.

Conveniently enough, only a few days after the housing finance conference, a Wall Street Journal article appeared, The Case Against Corporate Social Responsibility by Aneel Karnani, an associate professor of strategy at the University of Michigan School of Business. His most relevant observation to private sector involvement in housing finance, especially low income housing comes early in the piece: “Very simply, in cases where private profits and public interests are aligned, the idea of corporate social responsibility is irrelevant: Companies that simply do everything they can to boost profits will end up increasing social welfare. In circumstances in which profits and social welfare are in direct opposition, an appeal to corporate social responsibility will almost always be ineffective, because executives are unlikely to act voluntarily in the public interest and against shareholder interests.”

The mismatch between the interest of senior management, shareholders and homeowners could explain at least as much of the credit market collapse as government housing policy. When a “growth company” encounters a traditional, mature, moderately profitable industry like residential mortgages, stability is not likely to continue. See the next article on inappropriate corporate models (Shouldn’t we be careful with what we feed to growth stocks?).

"Shovel-Ready" Stimulus Projects and "Earmarks"

Budget earmarks have gotten a lot of unwanted attention and have uniformly been equated with fiscal evils. Earmarks are provisions in legislation assigning funds to local entities or states for specific projects. They amount to evading the normal process where funds are first directed to federal executive agencies which in turn channels cash to the states and local agencies through a complex and lengthy grant process.
Earmarks have gained an extremely corrupt image because it is an example of congressional abuse of taxpayer money. It bumps favored projects to the front of the line where all the other projects are waiting. It also takes money out of the pot that the projects in line are waiting for. As an example of their toxic nature, earmarking has been explicitly banished from last year’s stimulus package (American Recovery and Reinvestment Act of 2009).
But that doesn’t mean there are not traces of earmarking in qualifying “shovel-ready” projects.  In fact, many projects would not be shovel-ready had it not been for earmarking.

Federal transportation funds are distributed to the states largely by formulas based on a state’s payments into the highway trust fund, the number of lane miles and vehicle miles traveled. States then select which projects will be funded. Congress can and does take funds out of the formula process and “earmarks” them for specific projects. Project sponsors, including cities and counties request earmark funding for their projects that are not selected by the state or county agency in the regular programming cycle so they can keep cranking out the reports and studies that keep them in the process. Since gas tax and other sources are never enough to fund all projects the states would like to advance, the earmarks tend to dilute the limited funds even further. But those earmarks can also keep projects in the process long enough to become and remain shovel-ready.
A project’s low priority in the state’s eyes does not mean it lacks merit.  Technical criteria such as arithmetic formulas give the impression of objectivity, but don’t always produce equitable or fair results. A good example is the method by which gas taxes are distributed back to the counties.  All motorists know that it is collected on the basis of the number of gallons purchased and in the case of heavy trucks, by their weight. But it is distributed back to the counties based on lane miles and vehicle miles driven, but not on vehicle weight. The freeways in Los Angeles County show the scars from heavy trucks serving the Ports of Long Beach and Los Angeles, but the formula does not appropriately compensate the region for their wear and tear.
Metropolitan Planning Organizations – part of the national network of regional transportation planning agencies - often propose congestion reducing/energy saving mass transit systems, but state transportation departments are traditionally highway-oriented. That leaning tends to favor highway projects.  Without some assurance of funding from federal and state entities, rail projects might have to be removed from regional transportation plans if it were not for earmarks. All of the current proposed Los Angeles area rail projects, both light and high-speed, have included “earmarks” in their survival strategy with varying degrees of success.
While earmarks may be the source of cash that keeps a project shovel-ready, they also tend to reflect political clout benefiting better off communities as well as construction companies and unions that are, incidentally, among the least racially integrated parts of the economy.

Race to the Top – Just Another Case of Winner Take All?

Race To The Top (RTTT), an Obama administration funding initiative aimed at encouraging states to implement certain K-12 education reforms and implement innovations, has drawn some serious criticism on several fronts. Some of the complaints are related to the types of education policies that are favored, specifically promotion of charter schools and the closely related confrontation with teachers’ labor unions. These include:

1. Pre-occupation with advancing the growth of charter schools
2. Over reliance on school closure as a solution for failing schools
3. Intensification of the least attractive aspects of No Child Left Behind (NCLB)- the Bush administration education reform program

• over reliance on standardized test scores
• inadequate funds for the solutions prescribed

My attention focuses on faults found with the non-education aspects of the program: the rules of the funding competition itself.  An artfully diplomatic, yet selectively harsh critique with a long title has been issued by a coalition of civil rights organizations (Framework for Providing All Students an Opportunity to Learn through Reauthorization of the Elementary and Secondary Education Act: Lawyers Committee for Civil Rights under Law, National Association for the Advancement of Colored People (NAACP), NAACP Legal Defense and Educational Fund, Inc., National Council for Educating Black Children, National Urban League, Rainbow PUSH Coalition, Schott Foundation for Public Education). They point out that selection of grant winners using competitive grants rather than “conditional incentive grants’ ensures that there will be “loser” states as well as winners. Further, students are doubly punished if they live in states that “do not have the capacity or because they lack the political will” [to apply].

One question that immediately comes to mind: Are the states that have applied expending as much political capital on educational equity in their own state or are they in it for the money? In other words, if you are in a disadvantaged community, are you that much better off by being in an applying state over one that didn’t apply? Observers may want to examine the track record of the states that are front runners in the race. When it comes to dealing with those same constituents is your state very fair?

Another objection focuses specifically on the process of picking the contest winners. How are the winners selected from the pool of applicants? The Economic Policy Institute (EPI) published a report, Let’s do the Numbers, which details, in their opinion, the “arbitrary and unfair” Department of Education rubric used to assign scores to state applications. The report basically claims that the scheme gives the impression of clinical objectivity with its reliance on lots of numbers: a possible case of precision parading as accuracy.

First, to be fair, RTTT is part of an experiment and not a general education funding program. The RTTT fund  was carved out of the State Fiscal Stabilization Fund within the American Recovery and Reinvestment Act of 2009 (ARRA). As such it is a one- time appropriation. The rest of the Stabilization fund (about $50 billion) is distributed on a formula basis is intended to help states avoid drastic reductions in operations.

Unlike NCLB, RTTT is not a re-authorization of The Elementary and Secondary Education Act (ESEA), part of President Johnson’s Great Society aimed at solving educational needs of low income minority communities. It was originally passed in 1965 and has been re-authorized every five years since 1970.  

Using a competition to fund experimentation is different from using it as a basis for continuous funding of operations. The administration is fairly clear that it is using the RTTT fund to get states to make reforms and experimentation in a particular direction, and not to fund operations or major “turnarounds”

However, both the Framework and the EPI criticisms of competitive grants in general and their questionable selection criteria in particular focus a useful light on the problems that occur when a politically disadvantaged community has to rely on their state capital to compete on their behalf to participate in federal programs. Regardless of whether the state allocation is based on a competition or a formula, the local jurisdiction is dependent on the state to award “their fair share” and for the state to administer the funds effectively.

The increasing use of competitions to allocate federal funds is troubling for all the reasons already mentioned, but the formula grant alternative has many of the same flaws. The formulas that determine what share each state gets, or in some cases what share in turn goes to the local agency, have the aura of mathematical objectivity, but were developed in a political environment, sometimes without a lot of analytic justification. Then again, the proceeds that go to the state may be formula driven, but further distribution to local agency might be a different, possibly more politically risky arena for those seeking funds.

But this lack of equity that shows up in government domestic spending is not the exception, but the rule. How do federally and state funds get divided up among counties, cities, towns and school districts? Even the mass media hints at how famously complex the U.S. tax code is. Tax filers get a tiny window into the easiest tip of that iceberg around April 15. But government spending is the domain of specialists. Few elected officials and almost no journalists have a working knowledge.
Any funding system should be assessed in terms of efficiency (how much of the allocated funds deliver actual benefits to the intended recipients?), effectiveness (how much of the problem got solved?) and equity (do all members among the potential beneficiaries have a reasonably equal chance of access?). From the perspective of the city or county, the diversion from population-based federal revenue sharing to block grants, particularly competitive block grants, introduces the state as a complicating factor. We now had three parties, each wanting to reduce their own administrative costs while achieving program effectiveness,
a. The federal agency wants to reduce the cost of selecting recipients, while achieving a high rate of project completions. Equity and targeting the neediest candidate may become secondary.
b. States have similar objectives to the federal grantor plus having to deal with compliance with federal regulations.
c. From the city or county or school district perspective, the federal agency and the state achieve their goals by off loading certain transaction costs to them. For example, the state may attempt to reduce its cost of searching for deserving counties by requiring elaborate grant applications. The state gathers valuable information contained in the application, but the higher costs may eliminate certain jurisdictions from the competition. Financially stressed towns don’t have the idle resources to attend the grant preparation meetings, gather the data, write, deliver and follow up on the submitted application, especially when highly competitive translates into a low probability of winning. Even if the application is successful, the winner needs the resources to monitor projects, file status reports, and manage the incremental funding procedures. Since many grants don’t fully cover administrative costs, the winning city can actually lose money from their general funds on the deal. Some state agencies will know these circumstances and disfavor less well off cities in awarding the grants to reduce the rate of project incompletion. As a result, some of the jurisdictions that need the grant funding the most are least likely to get it. From the city or county’s viewpoint, the grant is neither efficient nor equitable. Only the cities and counties rich enough to absorb the transaction costs of entering the grant “lottery” and execute the project are likely to receive grants.
Complexity comes not just in the application for funds. The grants are spread across dozens of programs, sponsored by different departments with different application cycles and funding timelines. The major projects that we normally associate with public investments - roads, bridges, subsidized low income housing, cultural or educational enhancement programs - are multi-year projects, not just in their construction and execution but in planning, assembling finances and political support. Additionally, because the funding systems are so fragment among scores of programs, they are typically funded from several sources, sometimes private as well as public. The project may also require approval and cooperation at several levels of government and are typically run on budgets with little room for miscalculations involving costs or revenue. As a result, they are vulnerable to collapse from many sources.
One simple example, in the case of low income housing, there are more “points of failure” than other types of plans. There are few opportunities for renegotiation with partners if major variables change. For example, unlike for-profit real estate, the possibility of changing rent fee schedules is not available. That’s partly why so many projects get introduced and publicized, but never get finished.
Small temporary grant programs are easier to get through legislatures than big comprehensive ones and they look good on lawmakers’ resume. That’s why there are so many.

The lawmakers, bureaucrat specialists pretend that the complexity is a virtue suggesting that technical fussiness is a pre-requisite to fairness, but it functions just as much as a screen covering an often very unfair game. Think of it as “Three Card Monty” with your tax dollars. And guess what? We never get to deal.