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Posts Tagged ‘bailout’

Are States Preparing for Bankruptcy?

From coast to coast, states and municipalities are facing significant budget deficits.  The recent recession has clearly taken its toll on state and local revenues, but there is more to the story.  Like the federal government, states and local governments have obligations that are creating structural deficits, which extend beyond the effects of the recession.

The long-term obligations of Social Security and Medicare are large contributors to the structural deficit of the U.S. Government.  The states’ biggest problems are Medicaid and public employee pension plans.

Reports are starting to come out of Washington that Congress may consider legislation that will allow states to declare bankruptcy.  Legal experts cite Constitutional issues that make it difficult for states to declare bankruptcy.  Bankruptcies are generally governed under federal law. Since states are sovereign entities, new legislation may be required before states can file for bankruptcy protection.

If you want a summary of some of the issues involved, you can read this article published in the New York Times.  As stated in the article, “Bankruptcy could permit a state to alter its contractual promises to retirees, which are often protected by state constitutions, and it could provide an alternative to a no-strings bailout.”

Recent bankruptcy filings by the airlines and auto manufacturers resulted in amendments to their union benefit and retiree obligations.  Rather than successfully negotiating contract changes with the unions that allowed the companies to prosper, a bankruptcy judge mandated the changes.

You may have your opinions about the necessity and benefits of bankruptcy laws, which may be influenced by your status as a creditor or debtor.  Aside from the debate about bankruptcy, there is a dangerous precedent being set.  Instead of parties looking to negotiate contract changes for everyone’s benefit, they look to a lone judge to make the tough decisions.

Political leaders should not be able to shift difficult decisions to the judiciary.  Changes to public employee and retiree benefits are not popular.  No one wants to take away money or benefits from another person, especially someone who is retired.  This is not a good way to score political points.  It might seem a lot easier to get an appointed judge to do the dirty work, but that is not what our leaders were elected to do.

Instead of trying to persuade Congress to change the bankruptcy laws, state and local leaders should be investing their energy in addressing their structural deficit issues. If a state or municipality can’t afford their contractual benefits, they need to work with the various parties to find a resolution.  In my opinion, it’s cowardly and wrong to transfer that responsibility from elected officials to an appointed judge.

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The Cycle of Spending, Deficits and Bailouts

 As much as the economic recession has roiled the federal budget, it has taken its toll on state finances as well.  Reduced tax revenues and plummeting property values has made it difficult for state and local governments to balance their budgets.  One of the easiest ways to fill the state coffers is to look to the US Treasury.  After all… if Wall Street and the automakers got bailed out, why shouldn’t state governments get some help too?

Yesterday, Congress passed, and President Obama promptly signed the Education Jobs and Medicaid Assistance Act.  It provides $26 billion of federal funds to help states balance their budgets.  The law specifically allocates $10 billion for local schools to prevent layoffs of teachers.  Who can be against retaining teachers who help educate our children?

The current money is in addition to billions of dollars that was distributed to the states as part of the $787 billion Stimulus Bill, which passed less than 18 months ago.  The Stimulus funds helped states balance their budgets last year, but the continued languishing of the economy caused many states to need money again this year, so Congress came to the rescue.

The legislation sparked a little dustup in the State of Texas.  Rep. Lloyd Doggett accused Gov. Rick Perry of using $3.2 billion of Stimulus money to balance Texas’ budget, rather than increasing education spending.  Therefore, Rep. Doggett got an amendment included in the bill that requires Texas to certify that state education expenditures will remain at a certain level until 2013 in order to receive the new money.  The Governor responded that the Texas Constitution prevents him from committing to future state spending.

With an election only a few weeks away, politics are certainly at play in this issue.  Because of Texas’ population, there is $800 million at stake in this little tussle.  Despite the political rhetoric, it’s real money and will significantly affect education spending in the state.

Aside from an issue specifically affecting Texas and politics as usual, there is a bigger issue involved.  To me, the problem with the Doggett Amendment is the codification of the circular nature of spending, budget deficits and the need for more bailouts.  If Texas, or any other state, is unable to reduce education spending for the next 3 years, the ability to balance a budget becomes more difficult, exacerbating budget deficits, which casues the need for more stimulus/bailout money.

My primary complaint with the recent legislation is the way that states handled the original money from the Stimulus Bill.  Rather than using the money as a one-time gift which gave them time to figure out how to operate with less money, most states simply used the money to plug their current hole and avoided making difficult choices that would alienate their constituents.  The result…  a year later, they were back asking for more help. 

I wonder what state and local governments will do with the current money.  Do they see it as a bridge that helps them lessen the impact of altering future programs and services, or do they just plug another hole, spend the same money and be facing a similar crisis a year from now.

Everyone needs help and assistance from time to time.  In dealing with people, you have to be cautious that your help doesn’t enable them to continue their bad or destructive behavior.  Same goes for the government. Continually providing money to states to balance their budget, may prevent them from making the tough choices and decisions necessary to get them back on sound financial footing.

I’m sure Congress’ intent is to help, but it seems like they are beginning to enable the states to continue their spending ways and defer making substantive changes.  What do you think… is the government assistance helping or enabling?

The Economy Built on Confidence

You may have heard the term consumer confidence bantered around by economists and journalists.  The consumer confidence index is an attempt to determine the opinion of the public at-large regarding the economy.  It’s supposed to be an indicator of spending and savings habits.  In a consumer-driven economy, consumer spending has a tremendous impact on the overall state of the economy.

Confidence has a much larger impact on the US economy than the number of new cars, flat-screen televisions and iPhones that will be purchased.   To a certain extent, the entire economy is built upon confidence.

It starts with confidence in the US government, or at least in the money they print.  If you read my prior article on the Value of Money – Part III, you’ll recall that US currency is fiat money.  Since value is not determined by gold or any other asset, its value is solely derived from the full faith and credit of the US government.  Consequently, the confidence that people and investors have in the US government affects the value of the dollar. Should people lose confidence in the US government, the value of the US dollar will drop.  Considering the size of the current foreign trade deficit, it would instantly result in higher prices of things like oil and gasoline.  It would also raise the cost of borrowing, further exacerbating the current annual budget deficit and total debt obligation.

Confidence also plays a huge role in the banking and financial sector.  How would you react if you seriously questioned the long-term viability of the bank that holds all of your money?  You may be a loyal customer, but no one would be surprised if you transferred your funds to another institution.  Even if all of your money was FDIC insured, would you want to take the risk that some of it could be unavailable while the regulators sort through the mess?

The entire financial system was facing a crisis of confidence in September 2008.  Lehman Brothers declared bankruptcy on September 15, 2008; on the next day, the Federal Reserve Bank put up $85 billion to save AIG from a similar fate; and the Reserve Primary Fund money market broke the buck later in the day.  These historic events happening in a matter of days caused many people to speculate that it was the beginning of another Great Depression. The lack of confidence in the financial market was causing paralysis.  Everyone wanted their money to be safe but didn’t know where to put it, for fear that any institution could be the next to fail.

To instill confidence back into the markets, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke rolled out the Troubled Asset Relief Program (TARP) on September 19, 2008.  We can debate the merits of TARP, but at the time, it did appear to bring enough confidence back into the markets to stave off a complete meltdown.

A lack of confidence can also wreak havoc on a company.  General Motors and Chrysler are two good examples.  As they were teetering on the brink of bankruptcy, potential buyers questioned the survival of the automakers and were very reluctant to buy their vehicles.  People were concerned about the companies’ ability to honor their warranties and the future availability of repair parts.   Once again the US government intervened in an unprecedented manner and guaranteed the warranties of all new cars being purchased.  The government guarantee provided consumers with the confidence they needed to make the purchase.  Again, we can debate the propriety of this move, but would you want to buy a product from a company you didn’t think would exist in a few months or years?

Confidence has become the underpinning of the entire economy.  Confidence determines the value of your money.  It determines the security of your savings and provides you with the ability to save, spend and transact business with others.  It also can determine the success or failure of the company you own or work for.  

Now you can understand why the President, government officials and business leaders do their best to instill a sense of confidence in the economy.  It’s more than politics and positive thinking.  Once you witness the downward spiral that a lack of confidence brings, you get a better appreciation why consumer and economic confidence, whether real or perceived, is necessary.

Like trust, confidence is hard to gain and easy to lose.  In an economy built on confidence, maintaining a sense of confidence becomes the most significant economic indicator of success or failure.

Moral Hazard of Financial Reform

At 5:39am this morning, conferees between the US House and Senate agreed to a compromise to the sweeping Financial Reform bill that will make the largest changes to the US banking system since the Great Depression.  It still needs to pass both the House and Senate and then be sent to President Obama for his signature, all which are expected to happen before July 4th.

The legislation is intended to address many problems and issues.  One of the primary purposes of the bill was to eliminate the “moral hazard” of the “too big to fail” justification for the unprecedented government intervention in the financial markets in the fall of 2008. 

Part of the impetus for the creation of the $700 billion TARP  was to prevent certain financial institutions from failing.  Government and industry leaders were concerned that the US financial system (and potentially the global system) would collapse if these large institutions went under.  Their influence had grown so large that they were too big to fail.

Democrats, Republicans, Independents, liberals and conservatives all had concerns with a perceived bailout of Wall Street bankers.  Liberals were reluctant to use taxpayer dollars to save billion-dollar firms with a reputation for paying out multi-million dollar bonuses to employees.  Conservatives were opposed to government intrusion into the free market system.  

Most people were concerned with the “moral hazards” of the bailout.  Rescuing the firms was viewed as rewarding bad behavior by shielding the companies from the consequences of their poor business decisions.  Furthermore, once you are protected from the results of risky or bad choices, what’s to stop you from engaging in similar behavior down the road?

There were multiple players and many factors that contributed to the financial meltdown in 2008.  Two of those players were Fannie Mae and Freddie Mac (Fannie and Freddie).  They may not be primarily at fault, but they share in the culpability.  These institutions effectively allowed banks and mortgage companies to issue subprime and other high-risk mortgages.

You can blame traders and investment bankers for gambling with things such as credit default swaps.   However you must also look to the underlying assets they were betting on… home mortgages packaged into mortgage backed securities guaranteed by Fannie and Freddie.  The rise in mortgage defaults caused the mortgage backed securities to implode in value, which resulted in the banks coughing up billions of dollars to cover their losses from derivatives trading. Are Fannie and Freddie solely at fault?  Absolutely not.  However, they did have a role, yet they are noticeably absent from the Financial Reform legislation.

The legislation is supposed to kill the notion that any institution is too big to fail and address the moral hazard issue.  Time will tell if it’s successful.  However, there is one moral hazard from this crisis that has yet to be addressed – Fannie Mae and Freddie Mac.

I believe that Fannie and Freddie also possess a moral hazard.  It’s doubtful that banks would have written many subprime loans if they had to hold those loans on their books.  It would have been too risky.  Fannie and Freddie’s willingness to buy these loans and guarantee payment gave the mortgage originators an incentive to write more of the loans.

In September 2008, the US Government put Fannie and Freddie under conservatorship.  Although still a publicly held company, the US taxpayers own 80% of each enterprise.  To date, we’ve put over $140 billion into them to keep them afloat.  Earlier this year, President Obama lifted the $400 billion cap to the government guarantee, which basically ensures that any security backed by Fannie and Freddie will be fully paid by the US government.  Therein lies the same moral hazard as with the Wall Street banks.  If the government  the losses at Fannie and Freddie, what’s to stop them from taking on the next wave of high-risk mortgages, with the intent of increasing home ownership or stimulating the residential real estate sector?

Congressional leaders have said they will address Fannie and Freddie at a later date.  Excuse my skepticism, but I don’t see it happening any time soon.  It took over a year to get this legislation passed.  I doubt that Congress wants to immediately jump back in the fray on this issue, plus they have many other priorities and issues to contend with, including an election in four months.

With all the publicity of TARP and Wall Street bailouts, Fannie and Freddie may be the granddaddy of all bailouts.  The government has already pumped $140 billion into these companies, and there doesn’t appear to be an end in sight.  These companies have loaned or guaranteed about half of the $12 trillion in US mortgages.  With an estimate of 15-20% of all homes in the US currently worth less than their mortgage and a steadily climbing foreclosure rate, it’s scary to think of how big this could get.  There was probably a reason that President Obama lifted the $400 billion cap.

A lot of this may seem political and irrelevant to you, but remember that’s your tax dollars at stake.  I also think the moral hazard principle applies to Wall Street bankers, government entities and individuals.  If you don’t have to pay the price for your actions, what’s to keep you from making stupid mistakes or engaging in risky behavior?  Positive encouragement can be a great incentive to changing behavior, but the pain of failure can be the greatest incentive to change.

This applies to all areas of life, including finances.  Unless you have someone funding your lifestyle, you may not have a moral hazard with your own money.  You are not too big to fail and will pay the price of any poor decisions you make.  However, the principle of the “moral hazard” applies anytime you make a financial decision without regard to the consequences because someone else is picking up the tab.  You may not be paying, but in the end, it will cost someone.