"Tax Entitlements" for Housing : When Tax Expenditures Finance Inequality Part 2

 The federal tax breaks for middle class home ownership and renters are sharply different in size: they are just as dramatically different in how they are delivered.

The largest federal source of funding for increasing the supply of rental housing is the Low income housing Tax Credits (LIHTC). These are subsidies to developers of apartment complexes granted in the form of federal income tax credits. In exchange, the developer agrees to rent a portion of the apartments in the development to low-income families. Provided the property complies with all requirements, investors receive a dollar-for-dollar credit against their federal tax liability each year for 10 years. This program represents about half of the bar in the graph labeled Tax Expenditures for Rental Housing in Part 1.

Primary among the requirements for obtaining the credits are the resident income profiles. The receipt of tax credits depends on the developer reserving units for low-income tenants. Federal code requires that a minimum of 20% of the apartment units in every development be reserved for the very poor - those with incomes at 50% or less of the Area Median Family Income (AMFI); or that 40% be occupied for households with incomes at 60% or less of AMFI. The process includes a public comment process, whereby community organizations can support or object to proposed low income housing developments.

Proponents of LIHTC point out that the program is responsible for about half of the low income rental housing built nationally. But that reflects the withdrawal by the federal government from the low income housing construction business since the beginning of the Reagan administration. It was introduced as a provision of the Tax Reform Act of 1986 when it was realized that with dramatically reduced federal construction money and removal of tax shelter incentives for building rental housing, that there would probably be an end to new low income housing and that the “affordable housing” situation was not likely  to solve itself. In other words, LIHTC is praised for producing a high fraction of the low income housing built when it is essentially the only game around.

From: Government Accountability Office, GAO/GGD/RCED-97-55 Low-Income Housing Tax Credit

Following the numbered lines on the diagram:

(1) Internal Revenue Service Apportions Tax Credits to the Allocating Agencies, typically the state housing finance agency: the allocation is currently limited to $1.75 per state resident,
(2) Developers Apply to the state allocating Agencies for Tax Credits

(3) Allocating Agencies in each state Award Tax Credits to Selected Housing Projects: according to their state’s qualified allocation plans.
(4) Tax Benefits Provide a Return on Equity Investments:
syndicators (investment partnerships) are the primary source of equity financing for tax credit projects. They recruit investors who are willing to become limited partners in housing projects based on expected tax advantage.

As tax advantaged limited partnerships, LIHTC deal structures are not exceptionally complicated but as a source of capital for financing low income apartment complexes, they have some important disadvantages.

The LIHTC is at the core of a very shaky business model.

Untimely funding source

Allocating, awarding, and then claiming the LIHTC is complex and time consuming. On average, only one application in five submitted by developers receive a tax credit allocation. As a result, a lot of administrative capacity (grant writing, and all the follow-up responsibilities) is wasted on failed applications. Generally, developers exchange the tax credits with a real estate investor for equity. Since the tax credits cannot be claimed until the development is operating, more than a year or two can pass between the time of tax credit allocation and the time the credit is claimed.

Uncertain value of the credit is determined by developers and investors.
 

LIHTC investors who buy the credits do not expect their real estate developments to generate income. Their returns on investment come from offsetting their income tax liabilities. The value of the
tax credit is therefore dependent on the prevailing effective corporate tax rate and not the demand for low income housing. Financial institutions are typically the best candidates as investors
because, among profitable corporations, they have relatively few ways to shelter their profits from taxation. Banks are also motivated by the fact that investing in LIHTCs gets them points for their Community Reinvestment Act rating, one of the hurdles for moving branches or engaging in mergers or acquisition with other banks. When banks are unprofitable the value of the credits decline. The market for these credits collapsed in 2008 when the sub prime problems started to hit the bottom line of the large banks.

Bare Bones Construction Budgeting

There are a lot of forces that prevent subsidized rental units from ever resembling a luxury complex. Limited access to funds restricts unit size and amenities that any given project can build. The  uncertain LIHTC is a partial source of equity capital to be complemented with debt. Restrictions on the ability to raise rent reduce the ability to absorb any unexpected costs. Constraints on tenant income mixes and upper limits on rent rates make adjustments to uncontrolled variable operating costs such as utilities and insurance encourages unconstructive measures such as deferring maintenance. Although there no limits on the rents charged to tenants in “unsubsidized units”, the tendency is to maximize the number of low income dedicated units to make the application for the credits more competitive. This is why, among other factors, so many low income apartment complexes are in disrepair.

Housing projects, especially the urban variety have the reputation of being physically unattractive, even resembling Stalin era soviet apartment blocks, validating “Not-in-my-back-yard” community resistance. To avoid this, sponsors  may rely on help from private foundations or the participation of a community development bank to help with the financing.

Required local government approvals and cooperation can invite corrupt practices in some jurisdictions. Local elected officials have been known to expect to be compensated for their necessary support of the project application.

A recent case involved Dallas city council officials and a Texas state legislator taking payments from a low income housing developer, Southwest Housing in exchange for facilitating approvals for their development projects.

Is LIHTC productive from the federal government's point of view?

1. In other words, is the program efficient? How many of the tax credits dollars handed out by the government actually end up in the construction of  homes?
2. How effective is the program in addressing the shortage of affordable housing?
3. Is there equitable treatment among citizens seeking housing assistance?

Efficiency

From the time that the IRS  allocates the credits to the states, we know how much the federal government has spent: about one hundreds cents on each dollar of the credits distributed to the states. Some of that money will be returned to the IRS if it has not been awarded to housing projects or was awarded to projects that subsequently failed. What’s much less clear is how many of those dollars get used in construction expenses.
First, investors never pay 100 cents on the dollar for the credits. Second, the transaction costs incurred by fees to syndicators, consultants and the paperwork involved in applying for, and complying with the tax credit process are unavoidable. It’s not a popular way for program proponents to look at the program, but it’s hard to see how more than 50 cents on each tax credit dollar winds up in construction. During 2008 and 2009, the demand for the tax credits collapsed along with the taxable profits of the usual customers: large commercial banks, Freddie Mac and Fannie Mae. The tax credits that had been awarded to housing developers became unsaleable.

Is it an effective solution?

Some critics argue that LIHTC simply enhances the profits of developers and that the housing that gets built would have been built without the tax credit. Since there are a wide variety of developers – for profit, non profit, government agencies – with different priorities, the conclusion that LIHTC does not add to the volume of housing built is not so obvious. The arguments are based on a lot of assumptions about developer behavior, but it raises legitimate questions about how effectively the funds actually reach the target areas. These critics also compare the tax credit form of supply subsidy unfavorably to a more market-oriented demand subsidy such as Section 8 vouchers.

What about Equity?

But the more interesting contrast is with the type of tax subsidy available to  middle class homeowners. In addition to the generous and politically unassailable tax deductions on mortgage interest payments there are other tax-derived subsidies for middle class home ownership: the first-time home buyer credit, the exclusion for capital gains on the sale of the home, and the deductibility of state and local property taxes. The mortgage interest deduction represents about 65 percent of the tax expenditures for home ownership in the Federal Support for Housing chart, shown in Part 1. The process to claim these benefits is simple and takes a matter of minutes when filing your tax return.

Conclusion
When congress visits the tax code for solutions to the federal deficit, will tax breaks built into our social welfare system be a serious part of the check list? Should we be subsidizing home ownership for the well-housed while low income families scramble to avoid homelessness? Shouldn’t  we at least expose the hidden ways in which federal government programs actually increase the economic inequality that has been expanding over the last three decades?

"Tax Entitlements" for Housing: When Tax Expenditures Finance Inequality Part 1

“The most important difference between the United States and other rich countries is not how much it transfers, but rather how, through whom, and to whom transfers flow.”

-from Wealth and Welfare States: Is America a Laggard or Leader? by Irwin Garfinkel, Lee Rainwater, and Timothy Smeeding

“Big Government” is getting a lot of headline space this year. Most of the noise (most of the words don’t rise to the level of debate) is about the cost of government growth, the dangerous levels of debt, and the many aspects of our lives the government now touches.

The book quoted above points out that, if education is included with health care, housing and retirement benefits, the U.S. welfare state is not so different in size from that of other developed countries. However, there is a difference in the distribution of benefits.

Picking up the discussion on tax expenditures (or what I’m dubbing as “tax entitlements” from a previous posting), federal financial assistance in housing illustrates how strongly distinctions in domestic spending are made between economic classes. Aid to low income families is not only less generous when compared to aid to upper income families, but the assistance is less reliable, more bureaucratic and politically vulnerable the poorer you are. Those sharply distinct methods have led to radically different outcomes for low income renters versus upper income homeowners: for renters, underfunded, under-maintained, stigmatized housing projects  while for homeowners, overpriced, over-sized single family suburban tracts that periodically experience finance-enabled booms and busts.

The first class distinction you need to know about when discussing tax breaks is that they are only directly useful to tax payers. Low income families can’t use tax deductions because they don’t itemize deductions when filing their tax returns and because of features introduced into the code by the Tax Reform Act of 1986, investment-related tax credits are really only useful to tax paying corporations. So how and why are tax credits used by congress to build low income housing and how do they compare to the tax breaks given to homeowners? First some history.

All the History of Housing Policy you need to know

In common with other federal social programs, federal intervention in the housing market started with efforts to recover from the Great Depression. A simplified but useful way to think about the federal approach to helping families with housing is to follow the development of a simple financial transaction - the so-called traditional 30 year amortizing fixed rate or prime home loan. Until the Depression, most home mortgages were short-term loans that had to be rolled-over every five years or so. When the banking system collapsed, a foreclosure crisis followed the inability to refinance.

Congress encouraged the development of the saving and loan industry by passing the Federal Home Loan Bank Act in 1932. This legislation set up the  Federal Home Loan Bank system that provided funding for long term, self-amortizing (as opposed to short term loans with balloon payment) home loans. The Homeowners Refinancing Act created the Home Owners' Loan Corporation (HOLC) in 1933 to refinance homes in order to avoid foreclosures by making available self-amortizing long term mortgages to replace the short term balloon payment mortgages that were coming due in early stages of the Great Depression. The bank could finance the loan with deposits with a cost that was largely fixed by federal regulation (regulation Q).

The Federal National Mortgage Association (Fannie Mae) was established in 1938 as a federally chartered government-sponsored enterprise to provide liquidity in the mortgage market by selling bonds and then, with the proceeds, purchasing mortgages from lenders, primarily savings and loan associations and commercial banks. Fannie Mae was privatized 30 years later and joined by Freddie Mac two years later to give it some competition.

This tightly wrapped package started to unravel with the high inflation of the 1970s when interest rates could no longer be held down to the level that banks were engineered to assume. Congress tried to adjust to the new conditions with step-by-step deregulation of the system. Some observers suggest that the loosening-up that started in 1980 accumulated speed and ran off the tracks twice: the Saving and Loan crisis of the late 1980s and then the recent “sub prime” collapse.

Critical to the story line: this government model did not apply to all Americans. Redlining, or the practice of delineating neighborhoods where banks would not lend became an operating convention of the prime mortgage industry. It originated with the racial rhetoric of the management handbooks of the HOLC and found a secure home at Fannie Mae and the private banking industry, assuring that the traditional mortgage was almost exclusively available for white families. 

By the 1960s, the effects of preferential treatment for segregated suburbs were clear to most.

Families that were not covered by the prime mortgage umbrella were sent on a separate track called subsidized rental housing: a.k.a., the projects. The Housing Act of 1949 greatly expanded the federal role in building low income housing that had started slowly in 1937.

Who gets the “tax entitlements?”

Both low income renters and upper income homeowners are on the receiving end of special federal tax treatment to assist with their housing needs. The following graphs from the Congressional Budget Office gives an idea of the difference in generosity.

Federal Support for Housing, 2009

(Billions of dollars)

Sources: Congressional Budget Office (for spending amounts); Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2008–2012 (2008) (for tax expenditure amounts).

However, there are more interesting differences than the volume of dollars available. 

To be continued in "Tax Entitlements for Housing: When Tax Expenditures Finance Inequality Part 2"

Cutting “Tax Entitlements” is Only Fair

Before the end of 2010, but safely after the November 2 congressional election, the National Commission on Fiscal Responsibility and Reform, better known as the Deficit Commission will present recommendations on how the federal government can alter its current financial collision course.

The Congressional Budget Office forecasts annual federal budgets deficits in excess of $ 1 trillion for the foreseeable future. This is a conclusion with which few disagree, at least not very loudly. The news media suggest parallels with a debt-ridden Europe. Will the U.S. follow Greece into fiscal collapse? Do America and the weaker sisters of the European Union share the similar futures of ruin because they all indulge in the same addictions: entitlements?

Entitlement programs, as the name implies, bestow specified benefits to individuals as a matter of right. Recipients are entitled to collect benefits as long as certain conditions hold; and the government is obligated to deliver them. They are not supposed to be subject to budget negotiations or legislative appropriations.

The history of entitlements in the U.S. starts with Depression era Social Security, unemployment compensation; welfare - the 1935 Aid to Families with Dependent Children (AFDC) which was transformed in 1996 into the Temporary Aid to Needy families (TANF);  education and unemployment for veterans; reduced-price school lunches; the Great Society’s Medicare and Medicaid; Earned Income Tax Credits that supplement low wages, and carries through to programs like the State Children’s Health Insurance Program started in 1997.

A Wall Street Journal article of September 14, 2010 “Obstacle to Deficit Cutting: A Nation on Entitlements” is typical of those who argue that cutting entitlements are the necessary and inescapable steps that must be taken toward fixing federal deficits. An important observation comes early in the piece:

"We have a very large share of the American population that is getting checks from the government," says Keith Hennessey, an economic adviser to President George W. Bush and now a fellow at the conservative Hoover Institution, "and an increasingly smaller portion of the population that's paying for it."

The tax base Hennessey refers to is not shrinking just because of the falling fraction of the population paying taxes, but because of the decreasing portion of income that is still taxable as a result of another form of “entitlement”: tax expenditures.

Tax expenditures , more commonly called tax breaks or loopholes, are revenue “losses” incurred by the government due to provisions in the tax code that give tax relief to defined categories of taxpayers for engaging in certain activities. Some critics object to referring to these provisions as leading to revenue “losses” because the use of that term implies it was the government’s money to lose in the first place. However, since the provisions are deliberate departures from the regular treatment of taxable income to subsidize a particular objective, they are the functional equivalent of a budgeted and appropriated expenditure. In other words, giving some a tax break in the hope, expectation or requirement that they spend the incremental funds has the same budget impact as the government writing a check. Moreover, unlike appropriations or grants, tax expenditures are not, in practice, subject to congressional approval every year and are thereby at a lower risk of modification and/or cuts. Once a tax expenditure is granted, it’s difficult to reduce or eliminate. From a political point of view, the reduction in a tax expenditure is labeled a tax increase. They become almost as difficult to shrink as traditional entitlements.

On top of all those similarities, tax expenditures to individuals (as opposed to business) serve some of the same social purposes as ordinary entitlements including medical care and child care as seen in the numbers below. (The table was developed by the Tax Policy Center and can be found in their Tax Policy Briefing Book. As indicated on the graphic, the figures are from the Table 19.1 of the Analytic Perspectives section of the U.S. Government Budget Fiscal Year 2010.)

Searching for deficit-cutting opportunities among conventional entitlements without a similar inspection of the tax breaks would amount to a deliberately incomplete search for budget solutions. Such a selective search would also be questionable on grounds of equity.

There are two more important features of tax expenditures that are critical to include if fairness is to be taken seriously.

An obvious but often neglected point: tax breaks are only useful to those who have substantial tax liabilities. Moreover, the value of the tax expenditures increases with your taxable income. Skipping tax expenditures would leave benefits that go exclusively to upper income taxpayers largely untouched. One of the few exceptions is the Earned Income Tax Credit which performs as a negative income tax for low income households, primarily with children.

Tax breaks don’t come under the scrutiny of the Civil Rights act of 1964. Title VI of this landmark law, in part, says “No person in the United States shall, on the ground of race, color, or national origin, be excluded from participation in, be denied the benefits of, or be subjected to discrimination under any program or activity receiving Federal financial assistance”.  Although weakly enforced, it is intended to prevent discrimination by government agencies that receive federal funding for transportation, education and community development. It’s also the legal foundation of what is now known as environmental justice.

There are few, if any, available mechanisms to address racially or economically disparate impacts of federal subsidy through the tax code. That would include the most familiar tax expenditure of them all, the interest deduction on home mortgage that fostered so much middle class suburban home ownership.

Additional postings will address additional issues of fairness and equity embedded in what amounts to spending programs administered by the Internal Revenue Service.

An Alternative Perspective on Immigration

Fiscal Focus

Massive immigration, especially the undocumented variety, is a “hot” topic because it resists discussion without the thinly veiled presence of hostility to foreigners, particularly if those foreigners are not white.

The “cooler” heads try to conclude debate by pointing out that the pluses and minuses of immigration by low income workers come close to balancing out.  The wages lost by low skilled native workers due to increased labor competition enhance the profits of business owner/employers. The increases in social security, income and sales taxes will more than pay for the social welfare benefits that these immigrants are likely to receive.

The bottom line claim is that since the negative impact on the losing individuals is so small, the complaints are really motivated by xenophobia and racism.

The key word in the previous text was “balance”. It’s difficult to calculate with any confidence the benefits and costs to all the people and governments that are impacted by large scale increases in low wage workers and residents, but by declaring that the net sum of all the winning and losing as a draw avoids a treatment of whether it’s overall, a good or bad thing. Move along. There’s nothing to see here.

The losers are left to survive by their wits in competitive America. According to some libertarian critics, it’s the losers’ fault for putting themselves in a position so vulnerable to this competition in the first place.

The fact that benefits and costs are distributed unevenly among individuals is one of the few points of agreement. My focus here is the ways in which the distribution of benefits and costs disfavors the states, and more importantly, the local governments and school districts where individuals on the losing side happen to reside.

The pattern of difficulties for cities and counties flow from the familiar sources of economic stress: one old one, poverty; and one with a new name, globalization.

Partly because of the regressive structure of Social Security and Medicare contributions when compared to state income taxes, revenue collections from low income families tend to flow to the federal level.

It should be noted here that most unauthorized immigrants are precluded from receiving federal benefits through Social Security, Food Stamps, Temporary Assistance to Needy Families (TANF – welfare) and Medicaid other than emergency services. At the same time, federal mandates require that local governments provide certain services, regardless of legal status:

•    Education – children who are unauthorized immigrants represent about 4% of school age population. Another 6% are U.S. born citizens born to unauthorized immigrants.

•    Health care – many times through emergency rooms and public hospitals

•    Law enforcement

States execute these responsibilities at various levels of generosity within the guidance of court decisions.

However, the methods used to distribute federal and state funds to local agencies usually disfavor places with low income populations. High concentrations of undocumented residents make it worse.

By definition, low income and poor families put disproportionate demands on social services when compared to the rest of the population. Again, the problems are further amplified with lack of documentation:

•    Dependence on health care services, but the undocumented are even less likely to have health care insurance coverage

•    Subsidized low income housing, but the undocumented may be reluctant to register for waiting lists

•    State cuts to social welfare services for low income families are further justified by the increased political acceptance for denying access by unauthorized residents

•    Cuts in K-12 education funding are exacerbated by the fact that educating English learners drives up per student costs by 20% to 40%.

In recent decades, local governments have tended toward increased fiscal dependency on the state capitals. States like California have restrained local capacity to tax its own citizens while the state confiscates local funds. Low income communities tend to have weaker tax bases in any case because of lower property values and fewer businesses. Then starting most notably with the Interstate Highway System, the federal government encouraged new economic development in outlying suburban settings, further diminishing tax revenue streams in central cities and older suburbs. Several states also participated in a “race to the bottom” in which social benefits are cut and explicit barriers are erected to avoid attracting low income families from other states.

Beginning with the 1986 “immigration amnesty”, federal programs were initiated to mitigate the impact of service demands attendant to the newly recognized residents. The federal programs aimed at compensating local agencies for immigration-related costs do not provide 100% reimbursement.  In 1994 the Department of Justice started providing assistance to states for incarcerating unauthorized immigrants who were convicted of crimes other than immigration-related offenses (State Criminal Alien Assistance Program– SCAAP). The program only covers those incarcerated for felonies or multiple misdemeanors who have been in custody for at least four days and only covers the salaries of correction officers – not housing, meals or medical care.

Under No Child Left Behind education assistance, states are given money to help with language-related instruction issues, but not general education costs.

Ironically, other federal programs that might be used to help with local costs are impaired by the census under-count. Targeted funds never reach some of the very populations that tend not to get fully counted.

Here are cases where under-counts could be critical because of the targeted nature of the program: 

1.    Special Programs for the Aging, Title III, Part C, Nutrition Grants for nutrition service and home delivery are calculated using share of the state’s population age 60 and over

2.    Part of the allocation for Maternal Child Health grant is in proportion to the state’s fraction of the nation’s low income children

3.    Child Abuse and Neglect state grants as well as parts of the Runaway and Homeless Youth Act are base on the distribution of children under age 18.

4.    Community Development Block Grants (CDBG) amounts are driven by:

• population

• the number of persons below the poverty level

• housing overcrowding (number of overcrowded housing units. A housing unit is overcrowded when more than 1.01 persons per room are living in the unit),

• and the age of the housing - age is the number of housing units built before 1940.

• population growth lag - growth lag is the shortfall in population that a city or

county has experienced when comparing its current population to the population it would have had if it grew like all metropolitan cities since 1960.

The rapid increase in undocumented residents during the 1990s was of course, missed by the 1990 census.

So far, the equity of reimbursement to states has been the main subject here. The murkier arena of eventual distribution down to local government agencies will be the subject of future postings.

While resolving the disposition of the 10-20 million unauthorized immigrants is held up by political uncertainty, there is less doubt about the increased burden falling on communities already stressed by reduced sales and property tax, foreclosures, reduced state aid for education and health care.

Sometimes the objections to the increased presence of low income immigrants are not about race: sometimes it’s just about money.

Keep Morgan Stanley Wannabes away from my Medicare

In a previous posting, “Shouldn’t we be careful what we feed to growth stocks?", companies using a high growth stock performance strategy were shown to be a questionable choice as the core of an intentionally stable and low risk market such as the residential mortgages. One could convincingly argue that aggressive pursuit of the growth model in the wrong industry brought on the accounting scandals when Fannie Mae, MCI, and ENRON manufactured growth in earnings by way of accounting fraud. These companies could not deliver the “promised” earnings so they made them up and helped usher in Sarbanes-Oxley.

Innovation is applauded as the indispensable ingredient to economic progress. Financial innovation in a lightly regulated market produced some unexpected and undesirable results in the run-up to 2006. The identity of those who actually benefited from financial innovations wasn’t always obvious but it’s probably not a very large group. Who incurred the collateral damage when the experiment went wrong is even less clear but is bigger and more diverse collection of people. When financial innovators explore a profitable but mature and stable business, it’s unlikely that the typical customer will benefit from the encounter.

Innovation itself may be over-rated. As Paul Volker said about recent financial innovation, the only useful one he had seen in the last 30 years was the automated teller machine (ATM) (http://www.telegraph.co.uk/finance/economics/6764177/Ex-Fed-chief-Paul-Volckers-telling-words-on-derivatives-industry.html).

Innovation is certainly indispensable if we are to find technical fixes to widespread problems: most obviously in energy production and storage. But it can’t be the excuse for tolerating wide divergence between client needs and shareholder preferences.

Health care alternatives

Last year’s health care “debate” featured the role of private sector for-profit companies as a legislative “deal breaker”. A government-run “public option” was contrasted with private health insurance companies: DMV versus IBM. The private choice was, for the most part, represented by the currently operating array of private health insurance companies. These companies are, on a region-by-region basis, functioning with relatively little competition. They manage profit growth by restricting their customer base (through filtering out certain pre-existing patient conditions) and controlling costs by denying treatment. This works for the senior management and the shareholders, but doesn’t serve well as a model if universal service is your objective.

The health care reform negotiations exposed several conflicts between lowering health cost and the likely behavior of the companies currently engaged in health care products and services. It’s difficult to imagine where a growth company fits into the health care delivery set out in anyone’s health reform scheme designed to expand coverage and reduce unit costs.

For instance, leading drug companies should not be counted on to produce cures, especially for “minor diseases”. The preferred product for a growth company has an increasing and long term revenue stream: a drug you have to take for the rest of your life subject to price increases, for instance, the cholesterol pills you see advertised on TV.

Among the least appealing revenue profile would be a cure that can be completed in a single cheap treatment: exactly what you’d want if your aim is to reduce overall costs.

Growth stock producers won’t be low cost source for medical devices such as scanners or for hospital management and health insurance. We currently have care providers that are motivated to increase revenue for each unit of production, whether they are doctors or expensive scanners located in a hospital. The doctor is expensive because she is trying to recover her cost incurred since entering medical school. The maker of the scanner is trying to make a high profit on top of recovering research and development costs. The hospital thinks it needs the scanner to compete for patients and then has to use it as much as possible to pay for it.

“Growth” companies may be good for some purposes, but they just won’t always give us what we consumers need. It’s a public policy error to assume they usually will.

It’s easy to point out ineffective management by government agencies, but operating under the assumption that profits will always drive in the direction of public interest has no foundation. In fact the banking collapse should be serving as a harsh warning.

Shouldn’t we be careful what we feed to growth stocks?

Conflicts between what’s good for shareholders and what’s good for society are subject to debate. Even those with a high priority on social welfare don’t necessarily want all their pension dollars to be invested in a “socially responsible” fund.

So why do so many assume that the private sector is always better than the government alternative. It may be because they are relying on a selective memory of their favorite companies with the benign, reliable customer service department. Or maybe they are just not aware of the less attractive side of corporate capital. Maybe we don’t have a clear idea of the damage excesses of free enterprise because they are not as well publicized. The banking sub prime meltdown should serve as a curb on enthusiasm about the cleansing attributes of free enterprise, but only if you know how we got here.

Since the 1960s, some of the larger U.S. commercial banks started to take on the profile of growth stock companies. Traditionally, banks had been content to earn steady and modest profits by serving the needs of mostly corporate clients. The so-called money center banks and their large regional competitors increasingly want to have their shares traded like the stocks of  glamor “growth companies”. Instead of steady and stable profits, growth companies are able to maintain high stock prices with respect to their earnings (high price–to-earning ratio) if they can deliver reliable growth in quarterly earnings over several years. They preferred to be valued more like Polaroid in the 1950s, IBM in the 60s and 70s, or CISCO and Microsoft in the 90s. They participate in the quarterly earnings season frenzy promoted by outlets like CNBC where stocks prices are rewarded and punished depending on how well they matched the market expectations of their earnings per share. To maintain their growth status, they must increase their earnings per share from one quarter to the next.

To accomplish this, banks must continually, either grow or find new higher margin (increasingly profitable) activities to replace the older maturing lower profit business lines or somehow enhance the profitability of a current line. For banks that meant supplementing commercial lending with services that were paid for with fees instead of interest rates. Commercial banks increasingly eyed the profit making skills of their investment banking brothers. Until the late 1970s, investment banks (also called securities firms) were not publicly traded. Investment banks did not have to concern themselves with quarterly stock market reactions to quarterly earnings as they managed their much riskier businesses and the accompanying fluctuations in profitability. The activities of commercial and investment banks were kept in separate types of institutions by the Glass-Steagall Act of 1933. After the late 1970s, securities firms with substantial trading operations steadily converted to publicly traded companies.

During the 1980s, commercial banks began to lobby for permission to cross the Glass-Steagall barriers to engage in higher margin businesses. Citicorp, JP Morgan and Bankers Trust were probably the most aggressive in penetrating the securities domain. Incidentally, many of the large securities firms became public or were acquired by publicly traded firms. In many cases those acquiring firms were foreign banks. Glass-Steagall was eventually largely repealed in 1999 with the enactment of the Gramm-Leach-Bliley Act (GLB), also known as the Financial Services Modernization Act of 1999. 

How do companies increase profitability? One way is to produce a unique and useful product in a growing market. That’s hard to do in banking. One strategy is to make the product so complicated that the customer can’t realistically determine the true cost to duplicate it. The other source of profit is the ability to charge clients for their market risk. These are two of the reasons that trading “over-the-counter” derivatives (the type that is not traded on exchanges) can be so profitable.

The route to complexity is math. The appetite for extreme mathematical, data and computational complexity explains the presence of so many professionals trained in the mathematical and computational sciences at Wall Street firms. It represents an overwhelming technical mismatch when compared to investment management firms and pension funds or non-financial corporate clients. 

But since this investment in technology is expensive, it must be utilized to advantage. So when a highly profitable window opens up, it gets exploited immediately until it is exhausted. When collateralized bond obligations linked up with sub prime loans, the game was on.

Growth Road to Ruin

Between 1980 and the early 1990s, the mortgage bond business was moderately profitable – due to high liquidity and low perceived risk of the underlying home mortgages - and was several positions down the banking glamour scale below emerging derivatives trading and high profile mergers and acquisitions. The low perceived risk came from the pervasiveness of mortgage insurance issued by Fannie and Freddie. Market participants, including foreign investors felt little concern for defaults because the insurance came from “government agencies”. Although Fannie stopped being a government agency when it was privatized in 1968 to help balance the federal budget, its bonds, along with those issued by Freddie Mac, established soon after to promote competition, were referred to as agency paper until recently. Wall Street took advantage of the perception of safety for mortgage bonds and started to issue bonds using cheaper collateral (sub prime and “alt-A” loans) uninsured by the “agencies”. The business grew dramatically in size and profitability so much that the GSEs started to worry about losing market share to this “shadow banking system”. They accelerated their acquisition of sub prime-based assets. This is around the same time (2004) that the GSEs are just recovering from an accounting scandal so they were concerned about keeping the stock price up. The GSEs, in order to remain market dominant, were eager to grow and needed sub prime to satisfy their appetite. That’s why they didn’t protest the HUD guidelines (see previous posting, The Tragedy of the [Growth] Common [Stock]).

The only ways that the big banks, Freddie and Fannie could achieve their profit objectives all lead them to excessive risk: increased leverage, increased use of substandard loans, and speculating in derivatives with under-capitalized trading partners.

A corporate strategy based on high growth in earnings is intrinsically not long-term sustainable. It should not expect to support the foundations of a stable, low risk market delivering low cost loans. It never belonged at the center of the residential mortgage business.