Bank regulators are demanding greater capital levels.  The primary regulatory capital measure is Tier 1 capital to risk weighted assets.  The minimum standard for this measure formerly was 5% for well-capitalized banks, and is now in the process of moving higher to 7%.  In addition, the largest banks, those deemed systemically risky, are required to hold additional capital.

Meanwhile, banks are arguing that moderate increases in capital levels are acceptable, but large increases are not feasible and in fact are counterproductive.  The effect will be, they argue, to increase the cost of capital for banks and will reduce lending.  As a matter of arithmetic, higher leverage means higher return on equity (ROE), at least it does so long as the investment yield is greater than the cost of funds.  Banks generally operate with a fairly small spread between the yield on earning assets and the cost of deposits and borrowings, so bank ROE would be quite modest absent leverage. 

Former Federal Reserve Chairman Alan Greenspan agrees with the banks that there is an upward bound on capital requirements.  Here is his argument:  There is a minimum return that is required to induce investors to invest in banks.  This can be measured by the minimum historical ROE of 5%.  Furthermore, bank profitability can be measured by the historical average ROA of 75 basis points.  Putting these two factors together, the former Chairman concludes that maximum sustainable bank capital levels are 15% (.0075/.05) of assets.

I think the former Chairman is missing the fundamental point that the ROA will vary with leverage, in particular, as the ratio of equity to assets increases, ROA will increase as well.  Also, the minimum ROE will vary with the riskiness of the bank.  As the ratio of equity to assets increases, the minimum acceptable ROE will be lower.  So, his conclusion that 15% is the maximum feasible capital ratio is dubious.

In their new book “The Bankers’ New Clothes” economists Admati and Hellwig (AH)¹ directly address and dismantle banker arguments about the negative consequences of higher bank equity levels.  In particular, AH address what they refer to as the main banker myths:  first, higher bank capital level will mean less lending and less economic growth, and second, equity is expensive.  AH argue that capital (equity) is not a cash reserve and has nothing to do with bank lending.  Capital requirements only affect the funding mix between debt and equity, and should have no bearing on how the assets are deployed.  In order to increase capital levels, banks can issue new stock or can reduce dividends and stock buybacks.  The effect will be to increase asset levels (for a given level of debt) thus enabling greater lending, not less.

Regarding the cost of equity, or the required return on equity, AH point out that the cost of equity is an increasing function of leverage, and that the weighted average cost of equity and debt capital is determined by the riskiness of the bank’s assets, not by the mix between equity and debt.  In short, reduced leverage will reduce the required return on equity.

AH argue that the appeal of debt (including deposits and borrowings) to bankers primarily stems from subsidies including deposit insurance and the “too big to fail” (TBTF) policy.  These policies artificially lower the cost of debt to large banks by eliminating depositor or bank debt investor concerns about being paid back.  The consequences of these policies include increased fragility in the financial system and susceptibility to financial crises. 

AH favor large increases in minimum bank capital levels (to 20% or 30% of assets).  This will improve financial stability and long-term economic growth.  The mechanism they propose for achieving this is to require banks to stop paying dividends or buying back stock until bank capital levels have increased to the new higher minimum levels.

One counter-argument

Douglas Elliott² of the Brookings Institute (and former a bank analyst for JP Morgan) believes we need to be more careful in pushing for much higher bank capital.  He believes the effect of higher capital requirements will be to raise loan rates and slow economic growth.  He points out that while the Modigiliani-Miller (MM) theorem about the irrelevance of capital structure is correct under their rarified assumptions, it does not hold in the real world of taxes and deposit insurance.   The effect of tax deductibility of interest payments means that debt is subsidized and is lower cost than in the MM world.  This effect is doubled in the case of banks due to deposit insurance (not to mention “too big to fail” policies).  Thus, as leverage increases the cost of debt does not increase thanks to the guarantees.

It is possible that AH would accept this point, but still argue for much higher capital requirements because the consequence of high bank leverage is greater financial fragility.

How would this work out?  Let’s take an example

Let’s explore further the Elliott argument that higher bank capital means higher loan rates.  Suppose we start a bank with capital of $1 billion and we decide to maintain the equity to asset ratio at 50%, as was common in the 19^th century (before deposit insurance).  So we set out to raise deposits of $1 billion.  In today’s market, we only have to pay about 1% interest rate to accomplish this.  So we have interest expense of $10 million per year and annual operating expenses of about 1% of deposits or $10 million.  We now have $2 billion of funds to deploy ($1 billion capital and $1 billion deposits).  Suppose we buy or originate $2.0 billion jumbo mortgage loans and hold them for investment (for this exercise we ignore the bank’s need to hold cash reserves).  The going rate today would be about 4% giving us $80 million of interest income.  Suppose lending and deposit fees and provisions for loan losses exactly offset each other.

Our bank appears to be quite profitable:  net interest income of $70 million less operating expenses of $10 million leaves a pre-tax income of $60 million and after-tax income of approximately $40 million.  This is a return on assets (ROA) of 2% or 200 basis points.  But it is a return on equity (ROE) of just 4%.  This seems pretty meager, and unlikely to be adequate to draw investors.  However, the professors say that the required return on equity will be low because the riskiness of this bank is low.

How fast can our bank grow?  This depends on our dividend payout strategy.  Suppose we pay out 50% of income, or $20 million per year.  This leaves retained earnings of $20 million and represents annual growth in capital of 2%.  So, how are our investors doing?  They have an asset with a 2% dividend yield and earnings that are growing at 2% per year.

What is the value of our bank?  Well, it depends on the cost of equity capital. In view of the relatively low risk profile of the bank, the cost of equity will be pretty low.  How low can it be?  Surely, it must be greater than the mortgage interest rate of 4%.  Assuming 4% cost of equity and applying the Gordon Dividend Discount model, the fair value of equity is next year’s dividend ($20.4 million) divided by .02 (the difference between 4% cost of equity and 2% growth rate).  This formula yields a value of $1.02 billion, equal to the book value of equity.  At any higher cost of equity capital the value of the bank’s equity would be below book value.  So, surely new investors will not be drawn to this investment, and if this bank did exist, the best course of action would be to wind down operations and return funds to investors.

This is an extreme case, with an extremely high ratio of equity to assets.   But our profitability assumptions have been pretty aggressive as well, with no non-earning assets and only $10 million of operating expenses.  It does appear that mortgage rates would have to be higher to make our bank attractive to investors.  Or, our bank would have to drop the “portfolio lending” strategy and focus on originating loans for sale (the “originate to distribute” model), or find some other source of fee income. 

¹Admati and Hellwig, The Bankers’ New Clothes, 2013.

²Douglas Elliott, “Excessive Bank Equity Rules Would Slow the Economy,” Brookings Institution, 2013.

Over the past few months I’ve been privileged to hear two members of California’s Black Caucus speak, and I’ve been mightily impressed.

Last fall, Sen. Roderick Wright (D-Inglewood) gave two presentations to a Southern California Association of Governments (SCAG) economic summit. He painted a portrait of California’s industrial past, presenting statistics on the percent of the world’s aircraft, tires, and automobiles that used to be produced in California. He talked about how those jobs provided dignity and opportunity for folks in his district. He lamented the decline of opportunity his constituents have witnessed. The passion and energy he displayed provided a much needed energy to the conference, and earned him two standing ovations. It was clear Wright was speaking from the heart.

More recently, I had the opportunity to witness Assemblywoman Shirley Weber’s (D-San Diego) keynote address to the California Energy Action Summit in Buellton. Weber told how her father, a sharecropper farmer with only a sixth-grade education, moved from Hope, Ark., to Southern California, because as she said “There was no hope in Hope.” Her father found a job in a California steel mill. That job allowed her father to raise many children–I think it was seven–and to purchase a home. Shirley Weber earned a Ph.D. from UCLA at 26, finishing with little debt.

Weber didn’t display the same energy as Wright, but she spoke with just as much passion, and from the heart. Her story is an example of the American Dream that is increasingly difficult to obtain in California. Weber knows this, and she regrets that journeys of her family aren’t possible today. I think she intends to do what she can to restore that dream to California.

It’s nice to finally see some California policy makers talking about jobs and opportunity. Far too often California policy makers ignore the economy as they push other agendas. Most of the time, they deny that California even has economic problems. This, of course, requires ignoring lots of disturbing economic data, such as jobs data, unemployment data, and poverty data.

When asked about California’s economic data, they have an excuse for every bad data point, and they assert something like “California will always recover” or “It doesn’t matter what we do in Sacramento.” This is the same as saying that California has such an abundance of economic assets that no amount of bad policy can hurt California’s economy.

This is absurd. California does have abundant economic assets, but it is possible to make conducting business in California so time consuming, so uncertain, and so expensive that businesses that don’t have to be here aren’t here.

California’s leadership has become increasingly dominated by representatives from relatively wealthy communities populated by a college educated upper middle class and public service unions. Policy goals have mostly been about the environment and about meeting the demands of the public services unions. Very little thought and less action has been given to creating opportunity for California’s least advantaged.
Sacramento Bee columnist Dan Walters said immediately after the last election that the Democrat’s supermajority would reveal differences among the Democrats; they wouldn’t be a monolith. Enter Weber and Wright and the Black Caucus.

No group has suffered more under existing California policy than Blacks. Nobody knows this better than the Black Caucus. This has me thinking that California’s Black Caucus just might be able to save California.

Given the Democrats slim supermajority, the Black Caucus has the opportunity to act like a minority party in a parliamentary system. Their votes are needed on any vote that needs a supermajority. This is leverage, and I hope they use it to demand policies that promote an opportunity economy.

Of course, Pye’s problem was a little different in that he was retiring early.  Also, like Mr. Bengen, Professor Pye had significant analytical skills and he applied them to this problem.  What he discovered is what he calls the Retrenchment Rule¹.  The basic idea is to identify the optimal level of spending in retirement, avoiding as much as possible painful reductions in spending either at retirement or thereafter.  Pye refers to such reductions in spending as “retrenchment.”

The Rule

The first step is to estimate portfolio withdrawal amounts that preserve pre-retirement living standards.  Call this the “Desired Withdrawal Amount” (DWA).  The second step is to select a discount rate, called the “Retrenchment Discount Rate” (RDR) that provides the “optimal retrenchment.”  Pye’s working assumption is that most people will be faced with retrenchment in retirement.  The key to optimal retrenchment is to avoid a sharp and painful drop in living standards, particularly at the retirement date.  Pye’s recommendation is to select an RDR in the range 6-8%. 

The second step is to determine annual spending as the minimum of the DWA and a fixed annuity calculation based on your current wealth, your remaining lifetime and the RDR.  That is, the annuity calculation is to find the constant annual payment that can be made over your remaining lifetime given the discount rate and current portfolio (using your financial calculator, N is your remaining lifetime (110 minus current age), I is the RDR, PV is your current portfolio, then push PMT). 

Finally, at the start of each year as you proceed through retirement, you re-compute the fixed annuity given the RDR, the remaining number of years until age 110, and the current portfolio amount, which will be dissipated by the prior year withdrawal but expanded by investment returns over the course of the year.  Your spending for the year is the minimum of last year’s spending and the fixed annuity calculation.

Whew!

After exhaustive simulations, using an assumed probability model for investment returns, Pye concludes that the Retrenchment rule, using an RDR of 6% or 8%, offers the optimum retirement spending plan.  It is much more generous in the early years than the Bengen plan.  For example, using an RDR of 8% implies a portfolio withdrawal rate of 7.5% in the first year, nearly double the Bengen 4% rule.  However, the cost of this is that down the road the probability is high that there will be further retrenchment.  This might be prevented by positive investment returns but even if not, Pye believes retrenchment is much more easily accommodated if it takes place gradually over many years rather than immediately upon retirement.

Assessment of the Retrenchment Rule

This is good advice for those people who have not saved enough to avoid the strong likelihood of significant retrenchment in spending during the retirement years. But I think a better strategy is to not get yourself into a situation where you face serious retrenchment.  That means saving more and spending less in the working years, and careful management of your investment portfolio.

A simple way to accomplish this is to keep spending as a share of wealth (where wealth includes the value of human capital) no greater than the after-tax real rate of return.  How do you do this?  I’m glad you asked.  The answer is the Sustainable Spending Rule.  It applies to equally well to people in retirement and to people that are currently working.

The Sustainable Spending Rule (SSR)

Step 1:  Estimate the after-tax real rate of return, δ

Step 2:  Measure total wealth, W, including financial capital and human capital

Step 3:  Set consumption spending = δ*W

The key to the SSR is the choice of the rate of return δ.  Unlike Pye’s RDR which is selected in order to obtain a desirable retrenchment path, the SSR δ is a projected rate of return.  To really be sustainable, this projection should be conservative or at least realistic, not optimistic.  In my view, in today’s environment 3% is the highest after-tax real return that is reasonable (actually, my preferred implementation of the rule, the Speakes Sustainable Spending Rule (SSSR), uses an assumed rate of return equal to 1%)

By following the SSR (with a reasonable return assumption) you will have no need to reduce your consumption spending in retirement, you will have a cushion to handle unexpected events, and you will probably be able leave a bequest for your heirs to put to some productive use.

Example

Take the median household, with $50,000 in after-tax income, 40 year-old breadwinner, and $150,000 of financial net worth including home equity.  Assuming an after-tax real return of 3%, total wealth is approximately $1.25 million and the SSR calls for consumption spending of $37,500.  This is 75% of disposable income leaving a savings rate of 25%. 

Naturally, not all households will follow the SSR (and even fewer would follow the SSSR).   But suppose they did, what would be the macro consequences?  First, the overall savings rate would rise a lot, by approximately five times (that is, personal consumption spending as a fraction of disposable income would increase from the current 5% level to something closer to 25%).  Consumption (and imports) would decline and investment would increase.  Capital goods industries would boom and consumer goods industries would slow down, at least for a while.  Over time, the capital stock would rise rapidly and the rate of productivity growth would increase.   

Why won’t most people follow this advice? I think there are several answers, but the key ones are impatience and over-confidence.  People are impatient and this leads them to consume almost all of their disposable income.  Also, people are inherently optimistic and prone to over-estimate the likely return on investment.  For example, if our median household had assumed a 5% after-tax real return, then total wealth would have been estimated at $980,000 and 5% of wealth means consumption of $49,000 and a savings rate of 2%.  This is pretty close to the norm.  In effect, everyone is following an SSR-like rule, but most people are over-estimating the rate of return.

¹Gordon Pye, “The Retrenchment Rule,” GPB Press, 2012.

Our most recent economic growth forecast was for 1.5 percent for the quarter just ended, where this forecast was based on a continuation of demure consumption growth and inventory investment from 2012 quarter 4. The estimated consumption growth rate of 3.2 percent is the most rapid since the fourth quarter of 2010. This consumption rate is consistent with a noticeable fall in the BEA’s personal savings rate, from 4.7 percent of disposable personal income in quarter 4 to 2.6 percent in 2013 quarter 1.

Why might early 2013 consumption growth have strengthened relative to 2011 and 2012 consumption growth rates? Two possible factors are the labor market and wealth. While no one would say that the current U.S. labor market is strong, the year-on-year nonfarm job growth rate has exceeded 1.5 percent in every quarter since the start of 2012. Also, the current 7.6 percent unemployment rate is almost 2 percent lower than the 9.5 percent rate that existed at the end of 2010.

Net household wealth has been improving of late as well, where a three trillion dollar increase during the second half of 2012 brought wealth to a new high of $66 trillion dollars.

In our March 19 U.S. forecast release we wrote that we finally see the possibility that the United States economy could transition from a post-financial-crises malaise to a more normally functioning economy within our two-year forecast horizon. We forecasted weak but gradually strengthening growth during 2013, and 2014 economic growth that would be strong relative to most of the post-Great Recession experience.

So far, our 2013 forecast is pessimistic.

Sarah Conly is a Bowdoin College philosophy professor who has recently gained some fame/notoriety/attention with a New York Times piece Three Cheers for the Nanny State (which argues that sometimes government should protect us from ourselves.). That piece has been rebutted by, among others, Jean Yarbrough, another Bowdoin College professor. However, Yarbrough’s rebuttal includes a quote from Conly’s university website that brings up an entirely new set of issues.

Here’s the quote: “opposition to population regulation is based on a number of mistakes: that the right to have a family doesn’t entail the right to have as many children as you may want; that the right to control one’s body is conditional on how much harm you are doing others; and that nothing in population regulation entails that those who break the law can be forced to have abortions, or subject to any sort of punishment that is horrific. If population growth is sufficiently dangerous, it is fair for us to impose restrictions on how many children we can give birth to.”

Apparently, in Conly’s world forced abortions and prison for overly prolific parents is just fine. There is so much wrong with this.

To begin with, the assumption that the world is facing inexorable population growth is wrong, and demographers have known it’s wrong for decades. Birthrates are declining worldwide. By the end of this century, the world’s population will be declining, presenting an entirely new set of challenges.
If we did have a population problem, it wouldn’t take government action to fix it. For thousands of years prior to the industrial revolution people worldwide lived in a Malthusian Economy, an economy where population size is constrained by food availability. Gregory Clark has shown, in his book A Farewell to Alms: A Brief Economic History of the World, populations adjusted to constraints by adjusting the birth rate, through later marriage, fewer marriages, decreased fertility in marriage, and the like. Often, these adjustments were made counter to the exhortations of religious and government leaders.

The biggest problem that I have with the Conly quote is the idea that babies are dangerous. Babies, across time and culture, have always been welcomed into the world with joy and celebration, except when it is known that a baby’s life will be terrible, such as in war, famine, and concentration camps.
In these cases, the baby’s birth is greeted with sorrow. The sorrow is not because of the baby’s impact on society. It’s the baby’s own prospects that cause the dismay at its birth.

In economic terms, Conly is saying that the present value of the baby’s negative externalities exceed the present value of its expected benefits to society. So, we should kill the kid.
That can’t be though. Finance theory tells us that an option’s value increases in volatility. An infinitely variable option is infinitely valuable. So it is with babies. The baby may be a Lincoln, a Hitler, a Newton, or incapable of learning to read. We don’t know. In economic terms, the baby is an option with infinite variability. Immediately after birth, red, wrinkled and lying on its mother, a baby is infinitely valuable.

People who are terrified of more people forget that every advance in the world’s quality of life came about because of people. The wheel, the miracles of modern medicine, the super crops that have so reduced world starvation, they all came about because of what statisticians call outliers, people with the rare combinations of skill that allowed them to change the world.

We need more outliers. So, we should continue to welcome every baby with joy. That little person may change the world.

The New York Times loves California. Well, parts of it, anyway. Adam Nagourney, writing a few weeks after voters approved a temporary income- and sales-tax hike, reported that the state’s economic gloom was “starting to lift,” even before the tax had taken effect. Last month, Timothy Egan found “California Beaming.” Then Paul Krugman offered a column lauding Governor Jerry Brown’s recent proclamation of California’s comeback.

Inconveniently, however, Krugman’s Sunday column appeared a few days after state auditor Elaine Howle released a report showing that California has a negative net worth of $127.2 billion. Howle’s assessment didn’t even take into account the state’s unfunded pension liability, which may be as high as $500 billion. Even worse, the day after the Times ran Krugman’s piece, a federal judge allowed the city of Stockton’s bankruptcy to proceed. What should we make of these apparent contrasts?

Part of the explanation is political. The Times and many of its readers are happy that Californians voted last year to raise taxes. For the moment at least, the state has a projected budget surplus. Krugman, Egan, and their colleagues are also pleased that Democrats control all of California’s statewide political institutions and enjoy supermajorities in both houses of the state legislature. They are elated that California is about to embark on two vast new projects (that it cannot afford): a high-speed rail line between Los Angeles and San Francisco, and a ditch or tunnel around the San Joaquin-Sacramento River Delta that will supposedly restore freshwater habitat.

The other part of the explanation is that California is full of contrasts. Searching for the world’s most dynamic entrepreneurial economy? Look no further than the San Francisco-San Mateo County region. How about grinding poverty, where people live in dirt-floor dwellings with no running water and no electricity? California has that, too. The truth is, you can find anything you want to find in California. The New York Times wanted to find good news.

Egan wrote his story with a dateline from San Simeon—a beautiful, somewhat remote place on California’s central coast. Publishing tycoon William Randolph Hearst built his castle on a hill there. It’s easy to feel that all is right with the world when you’re in such a locale. Krugman is from the east coast, but he’s been to California; I had lunch with him in Santa Barbara when I was a graduate student. Still, he displays his ignorance about the state when he writes, “California’s longer-term economic growth has slowed, too, mainly because the state’s limited supply of buildable land means high housing prices.” Only a man whose Golden State experience is limited to coastal enclaves or San Francisco could believe something like that. Drive north from the greater Los Angeles metropolitan area on any one of several major highways—say, Interstate 5 to Stockton or I-15 to Las Vegas—and you’ll see buildable-land acreage exceeding the size of several states. Even Santa Barbara has plenty of buildable land. California is saddled with high home prices because it chooses to limit new housing, not because of a lack of available land. Yes, high housing prices are slowing California’s economic growth, but that’s by choice, not an act of God.

In short, any fair evaluation of California would conclude that the Golden State has major strengths and weaknesses. The strengths are either natural or the legacy of wise policies from the past. The weaknesses are the result of policies, too—bad ones. Beyond the coasts, California’s distress is glaring. According to the U.S. Census Supplemental Poverty Measure, California’s poverty rate is the nation’s highest. And though the state accounts for about 12 percent of the nation’s population, it hosts more than 32 percent of its welfare recipients.

Economically, California’s greatest strengths are its location on the Pacific Rim, its tech centers, and its climate. California was once the headquarters of several world-leading banks, but that time has passed. Given its location between America’s consumer markets and Asia’s manufacturing centers, California should be a center of trade and international finance. It isn’t. The ports of Los Angeles and Long Beach are the largest in the United States, but they can no longer handle the largest container ships or tankers. California’s failure to upgrade and expand its infrastructure is leading shippers to bypass it for Louisiana and elsewhere.
True, California companies remain leaders in technological innovation. And with almost half of the world’s venture capital invested in these firms, the state’s tech sector is phenomenal, the source of the Bay Area’s vibrantly entrepreneurial economies. But even this advantage may not be as strong as it appears. While California companies receive a large share of global venture capital, that total is smaller than it once was and is likely to decrease in coming years, as structural changes in venture capital and tech entrepreneurship cut into the state’s dominance. And many of the jobs funded by venture capital are now located outside of the Golden State.

Economically, San Francisco and San Mateo counties are doing well compared with the rest of the state. In San Francisco, employment stands at 102 percent of pre-recession levels, while San Mateo boasts 102.1 percent. But outside of these two tech-heavy counties, California is languishing. Los Angeles, Orange, and San Diego counties have 94.3, 91.7, and 96.7 percent, respectively, of their pre-recession jobs. By comparison, Texas has 108.7 percent of its pre-recession jobs. Employment in California lags overall at 96.2 percent of pre-recession levels, compared with 98.5 percent nationally.

California’s climate remains its greatest economic advantage. Many will pay for the privilege of living in the state. Yet people are leaving and will continue to leave. The state’s Department of Finance notes that migration between California and other states has been negative, on California’s side of the ledger, for all but two years since 1991. In that time, a net 2,987,433 people have left California—more than the combined populations of San Diego, San Jose, and San Francisco. The 2010 Census shows that California’s population increased by 3,382,308 between 2000 and 2010, thanks to births and immigration. But the state’s population of people ages 15 and under declined by 155,581, while the population between the ages of 30 and 45 fell by 414,684.

California may enjoy a budget surplus now, but the respite is temporary. Proposition 30 created more volatility in future state revenues, in effect guaranteeing budget challenges while failing to address the long-term problems of high costs and pension liabilities. California cities continue to struggle, and more bankruptcies are all but guaranteed. Middle-class families with children will continue to flee the state, taking California’s future with them. Outside of a few coastal enclaves, the state’s economy will stagnate. But the New York Times will continue telling us how wonderfully California is doing.

Although this is certainly good news for prospective home buyers, there is an argument that mortgage rates should be substantially lower.  The mortgage rate paid by the borrower is called the “primary market rate” and is usually established as a spread over the “secondary market rate” which is the current market yield on mortgage backed securities (MBS).  Thanks in large part to the Federal Reserve program of quantitative easing, the secondary market rate has declined in the past three years by 200 basis points (a basis point is 1/100 of a percent) to 2.75%.  Meanwhile, the primary market rate, the rate actually paid by home buyers, has only fallen 150 basis points.   The reason for the discrepancy is that the primary/secondary “spread” has risen by 50 basis points.

Historically, the primary/secondary spread has averaged about 50 basis points.  For example, suppose a borrower takes out a loan with a note rate of 3.5% and pays 1 point in fees.  The borrower’s effective rate (the primary market rate) is approximately 3.75%.  Now, further suppose that this loan is put into an MBS with a 3.0% coupon and that security trades in the market for a price of 99 (1% discount to par). Then the secondary market yield would be near 3.25% and the spread between the primary and secondary market rates would be 0.5% (50 basis points).  But in today’s world, MBS prices have been pushed higher so that the yield on the MBS is closer to 2.75% leaving a 100 basis point spread between the primary and secondary rates.

The primary/secondary spread reflects several factors including the cost of credit enhancement (most mortgage-backed securities are credit enhanced), the cost of servicing the loan, and the profit of the various participants in the securitization process including the loan originator.  Most loans made today are guaranteed by Freddie Mac or Fannie Mae (the GSEs), and the GSE guarantor fee (in return for which the GSEs guarantee principal and interest payments to the investor in the MBS) had gone up a lot, even though the actual risk transferred is lower.  The actual risk transfer is lower because it has become apparent that the GSEs are much more aggressive in pushing lenders to buy back loans that go bad than in the past.

Thus, lenders are actually taking on more credit risk, even as they pay higher GSE fees.  Lender costs are also going up due to greater regulatory demands stemming from the Dodd-Frank Law.  Yet, even with the higher costs, lender profits are soaring.  For example, the leading lender is Wells Fargo (WFC).  WFC reported for mortgage originations volume for the quarter ended December 31, 2012 of $125 billion and pre-tax profits on mortgage originations of $3.1 billion.  This is more than twice the historical average profit margin.  What is going on is a decline in lending capacity as many banks have stepped away from the business (most notably, Bank of America) at the same time as mortgage volume is rising due to relatively low interest rates and an improving housing market. 

CFPB Standards

Meanwhile, the consumer financial watchdog, the Consumer Financial Protection Bureau (CFPB), has released a rule requiring mortgage lenders to consider consumers’ ability to repay before extending credit.  The rule establishes the standard to be classified as a “qualifying mortgage loan.” Loans originated under this standard will have legal protection against lawsuits in the event that the borrower subsequently defaults.  The standards include:  maximum payment to income of 43%, full documentation of income, no “exotic” features like 40 year loans, interest only mortgages or negative amortization mortgages.   

One good thing about this rule is that it provides some degree of certainty about what defines a qualifying mortgage and therefore provides some degree of legal protection for lenders.  That may induce more lenders to enter the market (with the result being downward pressure on the primary mortgage rate).

The standards set forth in this rule are not onerous.  In fact, they appear to be more lax than traditional underwriting standards.  There is no mention of down payment or credit score, and the back end payment to income ratio of 43% is pretty high.  And it can be even looser than that.  For the next seven years, any loan which does not meet the CFPB standard but does qualify for insurance by Freddie Mac, Fannie Mae or the FHA also meets the qualifying loan standard.  In this way the CFPB standards perpetuate the role of government agencies in the mortgage market.  This presents the private market with a giant competitor with an unfair advantage. 

Future of the GSEs – repeating the cycle

Supposedly, the plan is to wind down GSE operations over time.  After the financial crisis, no one had the stomach for another $200 billion taxpayer bailout.  Yet, five years later, 90% of new mortgage loans are guaranteed by the GSEs or the FHA.  As noted above, originator profit margins are historically high so there is an incentive for private firms to enter the market.  However, there is no operating secondary market for non-agency loans, so if originators choose to make such loans they must retain them in portfolio.  Not many lenders today wish to do that.  So, they concentrate on loans that can be sold, that is, loans guaranteed by the GSEs or FHA. 

One of the mechanisms being used to wind down Freddie and Fannie is to raise GSE guarantee fees.  A lot has been done here already and there are more GSE fee hikes coming.  Apparently, the theory is that eventually primary/secondary mortgage spreads will be pushed high enough that either private sector securitization or portfolio lending will make sense.  There is a certain irony in this.  Back in the 1970s the U.S. mortgage market was dominated by savings banks and savings and loan associations (collectively, “thrifts”).  The thrift business was killed by dramatic expansion in GSE portfolio activities.  That is, with very low capital requirements and debt implicitly guaranteed by the U.S. government, the GSE’s were able to operate profitability with much lower spreads than the thrifts.  The effect was to drive the primary mortgage rate so low that portfolio lending was not profitable for thrift institutions (admittedly, the interest rate spike of the late 1970s and early 1980s did not help either).  Now we appear to be trying to go back to the beginning.  Bring back the thrifts?

Meanwhile, both Freddie and Fannie are reporting record profits.  Indeed, Fannie’s 2012 profit exceeded $17 billion, easily exceeding the mortgage profit of the largest private sector mortgage participant (Wells Fargo).  At this rate, the GSEs will fully pay back the U.S. Treasury within the next five years.  Then what? 

I think the most likely scenario is that Freddie, Fannie and the FHA will continue to insure mortgage loans and thereby define underwriting standards for the industry.  And these underwriting standards will follow a cycle.  Eventually, public support for homeownership, particularly for low-income families, will create pressure to lighten up on underwriting standards.  To the extent that underwriting standards have become too strict in recent years, this may be a good thing.  But if history is any guide, as housing prices improve and mortgage delinquencies and foreclosures abate, there will be increasing pressures to loosen standards and replay the boom/bust cycle once again.

I encountered the phrase “A well-ordered anarchist society” in Michael Huemer’s book The Problem of Political Authority. The phrase grabbed my imagination, and it hasn’t really let it go.

For most of us, those words just don’t go together. Our vision of anarchy is chaotic and violent. Huemer, one of our great modern philosophers, argues convincingly that our vision is wrong. He contends that society’s unthinking decision to grant authority to government is misplaced. He starts with a very few basic principles that most of us would agree with, and systematically builds his case.

In his section, “Society Without Authority”, where the phrase is found, Huemer describes how an anarchist society would function. He argues that markets would provide all the services that governments currently provide. This might help us understand the private provision of traditionally government provided services that we see today.

The standard economic discussion of government is one of decreasing returns to scale. Initially, government spending has big returns, providing defense, police, laws, courts, and such. As government grows, it gets harder to find those big returns, and the return on marginal investment gets smaller. I believe that the returns eventually turn negative. My socialist and communist friends disagree.

Total government spending (federal, state, and local) in the United States today is about what it was at the peak of WWII, more than 35 percent of gross product. It is reasonable to believe that we might be in the range where marginal gains are low, and there is evidence. Examples of well-funded, but apparently useless, studies abound, such as the almost $1 million study that found male fruit flies are more attracted to younger female fruit flies than to older female fruit flies.

What happens, though, when governments have to cut back? Cities lay off police officers and close fire stations. California Gov. Jerry Brown recently extracted a major tax increase by threatening more cutbacks on education. When sequestration hit, no one talked about ending studies of fruit fly mating preferences, but we saw talk of cutting air traffic controllers and airport security.

Part of what we see can be explained by powerful constituencies or a desire to punish an uncooperative electorate. But, a big problem is that governments at all levels genuinely have very little flexibility when it comes to spending.

At the federal level, entitlements (mostly Social Security and Medicare) are consuming ever-greater portions of the budget, crowding out all other federally provided government services. In California, prisons, schools, and pensions are crowding out other state-provided services, consuming increasing portions of the budget and apparently yielding little in return. In California cities and counties, ever-increasing personnel costs and pensions are driving out locally provided services.

Government is becoming a wealth-transferring institution, and in the process it is abandoning traditionally provided government services. As if on cue, private markets are stepping in to fill demand.

At least three media outlets (Contra Costa Times, KHOY Houston, Christian Science Monitor) have recently published articles about neighborhoods across the country hiring private security firms to replace police service withdrawn because of budget cutbacks.

Private firms are even providing money. As central banks worldwide vastly increase their money supply, people are questioning the value of their money. Private markets are there to offer an alternative. Bitcoin is a decentralized open-sourced virtual currency that is becoming increasingly popular, and you will soon be able to access it at your local ATM.

We may end up with Huemer’s society where private firms provide traditional government services. The irony is that it could be because of too much government, not a lack of government.

First, here is some of what they said:

“Stephen Levy, Director and Senior Economist of the Center for Continuing Study of the California Economy: “”The minimum wage increase will not have a huge impact on the overall economy. There are probably some jobs that would not be filled at a higher minimum wage. There really are conflicting studies on that.”

“Levy says a minimum wage increase would be the least of California’s worries.

“For California, the minimum wage increase is a less important economic issue than, say, the sequester or immigration reform or funding for investments in R&D,” Levy said. “To make it a big deal about the economy would be a mistake.”

“Christopher Thornberg, founding partner at Beacon Economics, said that the discussion is driven by the extreme proponents and opponents.

“You hear lots of, I think, really aggressive points of view on both sides of the fence, and they’re both highly exaggerating the situation,” Thornberg said. “On one side of the fence, you have those in favor of raising it that claim it’s such a wonderful thing. You even have some clowns at Berkeley that have their so-called papers, where some way or another raising the minimum wage will increase employment, which begs the question if it’s that easy, why don’t we raise it to $1000 an hour? It’s preposterous how they twist it out of proportion.

“On the other side of the fence, those against it scream it will destroy small businesses and make unemployment rates go sky high. I don’t think it’s going to destroy businesses by any stretch of the imagination. If going from eight to nine dollars an hour bankrupts you, you have other problems,” Thornberg said.

These quotes, and the piece, are all about how the change in minimum wage will impact California’s economic statistics.  Levy and Thornberg are correct.  The impact on the state’s data will be small, because the increase is not particularly large, and unless indexed, it is temporary, as inflation will effectively drive it back down.

All this is completely beside the point.  The appropriate question is how will the proposed change impact Californians?

Most Californian’s will not notice any impact.  Their wages are above the minimum wage, and the price impacts will be small.  A few Californians will receive a pay raise.  A very few could suffer personal tragedies, and these are the people we should be thinking about.

The people displaced by a minimum wage increase will be disproportionally young and minority, because they are disproportionally the ones receiving the minimum wage.  They are already suffering way too much. For example, as of January, the unemployment rate for African Americans 16 to 19 was 37.8 percent.  For African American men over 20, the unemployment rate was 13.4 percent, while African American women had a 12.3 percent unemployment rate.

It’s a big event when an African American teenager loses a job.  A job loss could change the entire trajectory of his life.  It increases the probabilities of drug abuse, crime, prison, and teenage pregnancy.

Thornberg is right.  The change is unlikely to destroy any businesses.  It is, however, likely to destroy some lives.

We spend a lot of money on social programs for young minorities, but the best social program is a job.  It makes absolutely no sense to implement a policy that puts even one at increased risk.

This piece appeared previously in the Orange County Register

I seriously considered working in one of Southern California’s aircraft manufacturing facilities. Good thing I didn’t, instead going into banking and later academia. Most California aircraft manufacturing jobs are gone. Lots of other jobs are gone too. In 1972, Southern California was a major manufacturing center. Beside aircraft, Southern Californians built cars, tires, ships, and lots of other things.

It was also a time of optimism and economic growth. California was still the place anything could be done. Since then, I’ve watched California lose one industry after another.

Today, California has few sources of economic growth. Our trade is increasingly threatened by an expanded Panama Canal, increased capacity in Mexico and Canada, and our own unwillingness to expand our ports and supporting infrastructure. Our entertainment industry is threatened by changing technology and increased competition from other geographies. Our education sector is threatened by funding challenges, bureaucracy, and a reluctance to adapt to a rapidly changing environment.

But, we still have one really good sector. Tech, with its venture-capital infrastructure and concentration of talent, will be a persistent source of economic strength for California. Or, so I thought before I recently met Dino Vendetti.
Vendetti is a serial entrepreneur and a veteran venture capitalist. He’s a Silicon Valley insider. He’s a threat to California’s tech future.

Startups used to require $10 million to $30 million to get going. The big investment was associated with big burn rates (rate at which losses ate up capital). They required big teams and big infrastructure. Because of this, they located in the Silicon Valley, New York, or Boston.

Not any more according to Vendetti. He talks about structural changes going on in early-stage tech entrepreneurship. According to him, the cloud, open-source development tools, low-cost bandwidth, web 2.0 as a distribution channel, modern accelerators, and scalable business models have allowed low burn rates by delaying scaling until revenues materialized.

This shift toward lean-start-up methodologies is changing the way start-ups are financed. It allows more risk taking, because smaller individual investments allow increased portfolio diversification. This is a threat to the Silicon Valley’s dominance. It is an opportunity for other California cities. If other cities don’t capitalize on the opportunity, it’s a threat to California.

All this is leading to what Vendetti calls a Democratization of Entrepreneurship. It’s reduced but not eliminated the disadvantages of a start-up located outside the traditional centers of venture-capital driven entrepreneurship. It’s made vibrant regional tech clusters feasible.

Vendetti says that anywhere with a university, risk capital, and accelerators can grow a tech cluster. I would add that you also need plenty of bandwidth and an airport with easy access to the traditional tech centers.

Vendetti is putting his money where his mouth is. He’s building what looks to me to be an entrepreneurial farm system in Bend Ore. It’s a complete venture-capital infrastructure that includes Start-up Weekends, where ideas undergo vigorous vetting for market and profit potential; mini three-week programs to follow the start-up weekends; and finally an accelerator,  (an intensive, few-months-long, process of building a business plan and firm to the point where it’s ready for initial-stage venture capital). He’s also organizing investors around a venture capital fund.

It’s not just Vendetti’s money. He has investors and partners from the Silicon Valley. This is a big deal for Californians. Entrepreneurial tech is our last economic engine. Somebody from Sacramento needs to talk to Vendetti and find out what it would take to keep him and others like him in California.

This previously appeared in the Orange County Register