Friday, August 30, 2013

Weakening a Weak Rule: Mortgage Backed Securities

Weakening a Weak Rule:  Mortgage Backed Securities

While many of us are winding up our summers, lobbyists have been hollowing out one of the key provisions of the Dodd-Frank law.  The original financial reform proposal required financial institutions to retain on its balance sheet 5% of any mortgage-backed securities that it decided to sell.  During the real estate bubble, banks and other lenders created pools of toxic mortgages, which they packaged up and sold off to investors.  The mortgage originators earned their fees and got all of the risk off their books.    The initial proposal was devised so that mortgage originators would be far more conservative in underwriting mortgages.  After all, if they underwrote bad mortgages they’d suffer along with outside investors, as they’d retain 5% of the exposure. The concept is called “having skin in the game.”

Castoff (1999)

As Dodd-Frank ground its way through the legislative process, banking and real estate interests were making progress in watering down this provision.  You may recall that former Senator Christopher Dodd had received a “special” mortgage from Countrywide, so there already was a close relationship between one of the legislation’s chief sponsors and the industry.  In the end, Dodd-Frank instructed the regulators to establish rules that exempt certain highly qualified (safe) mortgages from the 5% requirement. 

Even the provision enacted by Congress might have been bad news for financial executives if the final rule were too broad.  A broad rule would put a crimp in executive bonuses and the value of stock options.  If an institution had to set aside capital to cover 5% of a large proportion of the loans it decided to sell, the company’s return on capital would be lower, and its ability to generate additional mortgage business would be diminished. Not surprisingly, the lobbyists pushed the six regulatory agencies with oversight responsibility to promulgate a very narrow rule.  Sure enough, the Federal Reserve, the Department of Housing and Urban Development, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission have just agreed to exempt all but the most toxic mortgages from the 5% requirement.  Since most of those types of mortgages aren’t being underwritten at the moment, the new regulation will be meaningless.

The industry lobbyists are right when they argue that the set 5% set aside would slow down their clients’ businesses as well as mortgage issuance.  Frankly, that’s what the regulation should do.  It is unfortunate that Congress left wiggle room by allowing the regulators to create exceptions and didn’t enact a strict 5% requirement.  It is astounding to me that we insist on a margin of safety when it comes to tangible consumer products, prescription drugs, food, and aviation, but in finance we let our businesses operate on the edge of soundness.  Even animal feed has to have a margin of safety.

If the regulators finalize this rule you can count on two things.  First, Wall Street’s brightest minds will engineer new mortgage products that meet the letter of the rule, but foist all the risk on investors.  Second, we’ll eventually have a new generation of distressed homeowners who were seduced into selecting toxic mortgage products.  How can I be so certain of this outcome?  The last housing bubble and subsequent collapse wasn’t our first experience with the excessive risk of the mortgage business.  In the late 1980s we went through a similar period of improper mortgage lending.  Despite large losses and scandals (remember the Keating Five?[1]), Congress enacted ineffective reforms.  In little more than a decade, a new generation of operators were brewing up a toxic mortgage stew that ignited the Great Recession.

Sadly, it only took five years for all six government agencies with jurisdiction over this issue to be recaptured by the industry.  Only one SEC commissioner, Daniel Gallagher, issued a dissent.  So much for reform.  Here’s the reality. Our regulators are hard at work protecting Wall Street’s interests, while making sure that our next financial crisis comes sooner rather than later. 

[1] Charles Keating was the Chairman of Lincoln Savings, which became insolvent after a spree of mortgage lending.  When the regulator (Federal Home Loan Bank Board [FHLLB]) tried to move on the thrift, Senators McCain, Glenn, DeConcini, Cranston, and Riegle intervened.  In the wake of the savings and loan crisis, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act of 1989, which created the Office of Thrift Supervision to replace the FHLBB.  The OTS was an incredibly weak regulator that turned a blind eye to the latest mortgage crisis.  The OTS was swept away by Dodd-Frank.

Thursday, August 29, 2013

More Executive Pay Disclosure: False Reform

More Executive Pay Disclosure: False Reform

The Securities and Exchange Commission is about to propose a rule requiring public companies to show the difference in compensation between a company’s CEO and its median employee.  The requirement is contained in the Dodd-Frank reform law and was added by Senator Robert Menendez (D-NJ) at a markup session before the Senate Banking Committee.  Presumably, Senator Menendez was interested in drawing further attention to the wage disparity between top management and the average employee.  It turns out that calculating total compensation for the median employee can be an expensive undertaking, especially for multi-national companies.  As a result, corporations are hoping to defeat, or at least narrow, the SEC’s proposed rule.
Inflows (1999)
I think the requirement, contained in section 953(b) of the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act, is a complete waste of time and effort.  The gap between senior executives and rank and file employees isn’t going to narrow because companies will now be required to make this disclosure.  Corporate proxy statements (the materials shareholders receive before a company’s annual meeting) already contain page after page about every aspect of executive compensation.  We know exactly how much executives make, the size of their stock options, and the details of their severance arrangements.  We even can find out if they receive country club memberships, tax counseling, or home security systems.  None of these disclosures has had any discernible impact on executive compensation.  While the average American worker continues to lose in terms of real wages, executive pay gets better and better.

Disclosure represents the easy compromise.   On the one hand, market-oriented conservatives oppose most substantive regulation.  On the other hand, liberals prefer it.  When the two sides can’t agree, we wind up with more disclosure.  The conservatives don’t like the disclosure, but realize that it is better than substantive regulation.  The liberals hope that disclosure will create some combination of public outrage or corporate embarrassment, thereby addressing whatever it is that they find offensive.  At least in financial matters, disclosure doesn’t change any behaviors.  Proxy statements, prospectuses, and annual reports just get lengthier and harder to decipher.

In my view, we need more substantive regulation in a variety of areas when it comes to finance.  Free markets tend to lead to bubbles and excesses.  While a certain level of disclosure is helpful, it does little to change corporate behavior.  Nonetheless, progressive politicians claim victory when they can require a company to add several pages or more to their legal filings.  Section 953(b) of Dodd-Frank is merely one more example of disclosure masquerading as reform.

Wednesday, August 28, 2013

Faculty Salaries in 2012

The Elite Universities that are driving the salary race, and have the resources to do so.

NC's Salaries -- except from the top schools, it drops off quickly

Cozying Up to Entrepreneurs: State Pension Plans

Cozying Up to Entrepreneurs: State Pension Plans

I don’t know if it is coincidence or not, but a week ago two of the nation’s sole fiduciaries announced plans to increase their public pension plans’ exposure to local venture capital.  In New York, Comptroller Thomas P. DiNapoli is promoting Silicon Alley, New York City’s concentration of Internet and new media start-ups, through the pension’s In-State Private Equity Program.[1]  The Comptroller touted two investments, RebelMouse and CoopKanics, as signs that his program is leading to positive results for the State and the pension plan.

On the same day, North Carolina’s State Treasurer Janet Cowell talked about launching a second Innovation Fund and pushing North Carolina into the top five among entrepreneurial states.[2]  The first Innovation Fund[3], which seeks out a variety of in-state investment opportunities, will soon be fully committed.
Business Divisions Part 2 (1999)
I’ve had personal thirty years of experience with this kind of endeavor.  In the early 1980s, as part of New York Governor Hugh Carey’s administration, I worked with Comptroller Edward Regan on this type of proposal.  Then in the 1990s I discussed these kinds of initiatives with North Carolina Treasurer Harlan Boyles.  In 2001, I became responsible for overseeing the effort to put some small additional money to work in North Carolina venture capital and consulted with my counterparts in more than a dozen states.   While this type of investing makes for good press releases, it doesn’t do anything for public pensions, and it doesn’t stimulate economic development in meaningful way.  To be fair, as long as the pension plan doesn’t sink too much money in this kind of activity, it won’t produce any lasting damage.  However, it is a big waste of staff time, legal fees, and resources.

Nonetheless, generation after generation of comptrollers, treasurers, and pension trustees have pursued the dream of creating the next Silicon Valley in their state.  Moreover, it’s been in their political interest to rub elbows with the local venture community and entrepreneurs.  As a result, these kinds of initiatives will persist.

So what would it take for North Carolina to be ranked 5th when it comes to entrepreneurial investing?  According to the National Venture Capital Association, NC is currently ranked 15th for the first six months of 2013, and 13th since 2010.[4]  The 5th position is currently held by Washington State, which has seen 400 deals completed for an investment of $2.3 billion.  In the same period, NC has seen 166 deals completed at a value of $1.1 billion.  In order to match Washington State, NC would have to increase its annual investment in all sorts of venture, from early through late stage, by about $350 million per year and more than double the number of deals from 47 to about 100 per year.  It isn’t going to happen, because there simply aren’t enough deals out there. The rankings since 2010 are set out below.
 Here’s some unsolicited advice to our politicians.  First, those who spend their time carping about taxes (and I’m not speaking of the NY Comptroller or NC Treasurer) should look at the three most highly rated states.  They have the highest tax rates in the country and 69% of the venture capital.  While state taxes need to be reasonable and balanced, low taxes don’t create economic development.  Even in Texas, which doesn’t have an income tax, entrepreneurship is largely centered around  “keep it weird” Austin.

Second, investment capital, while necessary, is the least important ingredient in the entrepreneurial soufflé.  The money will find the deals, and it doesn’t require state pension money to get it done.  Since 2010, $57 billion has been raised for venture type deals alone.  Of course, local would-be entrepreneurs would say otherwise, but that’s probably because their business plans haven’t attracted any interest from the VCs.

The entrepreneurial environment exists where higher education, corporate and government R&D, and creative sorts of folks meet.  New York has a lot of these ingredients in Manhattan, and California enjoys them both in Silicon Valley and around Los Angeles. North Carolina might have a shot at moving up the rankings a bit if it weren’t intent on underfunding its schools, universities, and infrastructure.

Pension officials would love to play their part in pursuing exciting new investment opportunities for their states.  Frankly, they’d best help to foster the right economic climate by sticking to the big issues that drive the wellbeing of their pension plans.  On the other hand, the proper management of the pension plan doesn’t generate press releases or ribbon-cutting ceremonies.

[3] The NC Innovation Fund is $232 million, most of which has been committed.  It is managed by Credit Suisse on behalf of the state’s pension plans, and invests in a variety of growth and venture opportunities in the state.  The actual allocation of funds and performance are undisclosed.  The Treasurer stated (see fn 2) that the fund has earned 15% thus far.  For more information, see

Tuesday, August 27, 2013

The Problem of Education Finance

The Problem of Education Finance

After receiving a report that details students’ growing dependence on financial aid, Secretary of Education Arne Duncan lauded President Obama for making more student aid available in the face of rising tuition costs.[1] About a month ago, the Secretary commended the president for reaching an agreement capping interest rates for 11 million students currently servicing federal loans.[2]  The student loan compromise with Congress is like handing a life jacket to someone who is about to go over Niagara Falls.[3]  Student borrowers are in trouble, and no one is doing much about it other than making more debt available.  Secretary Duncan acknowledges the escalating cost of college in his most recent press release, but only can bring himself to gently admonish states and private institutions to do something.

Business Divisions Part 1 (1999)

President Obama weighed in with a proposal last week to tie federal grants to a series of rankings that measure net tuition costs, graduation rates, and economic prospects of graduates.  The President’s idea requires Congressional approval and wouldn’t apply until 2018.   Even it became law it wouldn’t do anything for many years.  My guess is that President Obama’s idea would do little to curb tuition inflation.  Rather, it would create a financial hole for expensive, non-elite private schools.  In any event, the proposal doesn’t do a thing about the looming crisis of student indebtedness.

In 1972, when I first went to college, the average cost of a year in a four-year college was $2,047 ($10,880 in 2012 dollars).  Since I graduated the cost of has been rising  1.9% per year faster than inflation, driven by an annual real increase of 2.6% in tuition.  Since 1999, the cost of college has been rising even faster in real terms (2.8%), and public institutions have borne the brunt of the increase (3.5%).  Today, my year in college would cost an average $23,666.[4]

The rate of inflation in higher education wouldn’t be half as troubling if it weren’t being fueled by debt, particularly student loans.  The National Post Secondary Student Aid Study (NPSAS-12) released on August 13, 2013, shows that 71% of all undergraduates are receiving financial aid of some kind, amounting to about $10,800 per recipient.  Fully 42% of all undergraduates utilized loans averaging $7,100.  70% of graduate students receive an average of $22,000 in aid with 45% of them drawing an average loan of $21,400.

How fast is student debt rising?  To get an idea, I looked at the New York Fed’s report, “Household Debt and Credit” issued this month.[5]  The data in the report only goes back to 2003, when total student debt was $241 billion.  As of the second quarter of 2013, the total had risen to $994 trillion, an annual rate of increase of about 15% per year!  To put that figure in perspective, overall consumer debt has only risen 4.4% per year.  While mortgage debt is still the biggest consumer obligation at $7.8 trillion ($8.4 including home equity loans), household real estate is worth $18.4 trillion.[6]  In other words, an asset backs the mortgage, even if the value of that asset isn’t as high as it was in 2008.  By the way, auto debt is $814 billion, and has only grown at a rate of 2.4%.  Student loans are big, growing fast, and backed by nothing more than a student’s ability to eventually pay principal and interest. Trouble is brewing.

Which type of consumer loan has the highest delinquency rate?  Student loans at 10.9%.  Credit card delinquencies are running at 10% and mortgages at 4.9%.  While mortgage and credit card delinquencies have fallen since the Great Recession, student loan delinquencies have risen. 

What happens if the delinquency turns into a default? The Federal government informs us that “the consequences of default can be severe, and then goes on to list eleven bad things that are likely to happen.[7]  And thanks to 11 USC 523(a)(8), student loans cannot be restructured or forgiven in bankruptcy.  As horrible as defaulting on a car loan or home loan can be, the consequences aren’t as dire.

While tuition continues to rise substantially faster than inflation, state support for higher education has been cut by $8.7 billion or 11% between 2008 and 2012.  Your state tax bill may have fallen a tad, but the short-fall has been made up by increases in federal aid, particularly Pell Grants, which aren’t subject to sequester.  The remaining gap has mainly been filled by student debt.

The student debt problem is not nearly as large as the mortgage crisis of 2007.   However, it is concentrated in a key demographic that has been critical to our economic prosperity and upward mobility over the years.  The children of the wealthy will enter the work world largely debt-free as they always have.  Millions of others will discover that they can’t move forward because they are weighed down in debt. 

[3] To see a more colorful critique of student loans, see, “Ripping Off Young America: The College-Loan Scandal” by Matt Taibbi in Rollingstone.
[4] Digest of Educational Statistics, US Department of Education, Table 381 (2012)
[6] Flow of funds Report, Federal Reserve, Table B100 (1Q 2013)