Category: Progressive Center

University Industry Specialization

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There has long been a divide between liberal arts colleges, research universities and institutes of technology.  The gap between traditional four-year colleges/universities and commercial or technical schools generally remains. 

In a fifty year period of growing enrolments, our major public universities have become larger and more complex.  They have added colleges and majors.  They have increasingly focused on winning research dollars.  They have learned to compete for students.  They have nearly all adopted the same brand strategy focused on “academic excellence”.   The college ratings game essentially focuses on the ranking of entering student SAT scores.   To succeed, universities have improved their facilities, increased financial aid packages and developed programs that attract high SAT students.

State universities secure alumni and corporate funding so that they can compete with other highly rated schools.  State universities that were once positioned as teachers colleges, normal schools, agricultural and technical or urban universities all compete for the same academic rankings, investing in research labs, notable faculty and sports teams.  Some clever universities specialize in a few niche colleges like insurance, architecture, entrepreneurship or media.  They use brand excellence in a professional school or two as a substitute for higher rankings in the more prestigious arts and sciences.

Given the business world’s strong preference for industry specialization and experience, a more satisfying strategy for their students might be to specialize in a single broad industry.   Charter and magnet schools do this at the secondary school level.  Community/technical colleges often merge industry and professional skills into technical programs.  A few older colleges like agriculture still produce ag communications, ag business and ag engineering majors.

A university could adopt a broad industry like medicine, distribution, trade, communications, government/NFP, manufacturing, agriculture or financial services.  Professional and associate/technical degrees could be offered.   In addition, degrees in support fields like business, marketing, communications, finance, IT, engineering and science could be offered.  Courses could be developed to provide an industry overview, highlight industry firms, describe international opportunities and teach industry terminology. 

If state universities want to contribute to state level economic development, they could make an immediate and lasting impact by specializing by industry.

Framing Politics With a Ruler

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Peggy Noonan’s suggestion to use a 36 inch ruler to gauge right versus left in politics does help to explain the opposing views of tea partiers, Republicans and Democrats.  Noonan describes 0 inches as pure right and 36 inches as pure left (opposite of what you might expect).  She bemoans her perception that modern-day politicians negotiate between the 25 and 30 inch mark on the far left end of the ruler.  She asserts that tea partiers will try to move back to the 5 inch mark.

In politics, he who sets the framework usually wins the game.  Using American history since the agricultural 1770’s, urbanizing 1860’s, industrial 1920’s or depression 1930’s as a base, a case can be made that post-war politics and economics has been debated on the left end of the ruler, with a mixed economy government share of GDP at 20% and government spending/taxing share of GDP at 25-30%.  These shares of the economy double those of laissez-faire capitalism, the roaring twenties or the depression.  Noonan takes this long-run historical view of how the yardstick should be labeled.

Noonan is right in pointing out that politicians of both parties in a democratic system inherently seek to spend more money.  The rise in government spending in the Bush presidency after the unusual decline in government spending in the Clinton presidency (with Republican congress) is a modern reminder.  Tea partiers are right to have gut level concerns that government spending will continue to climb unchecked.  The trend in 2000-2008 was up.  Extraordinary banking and industry bail-out funds were piled on top of the stimulus spending for the Great Recession.  Health care and social security spending increases are expected in the next two decades.  Whether the various spending increases are justified or not, the trend is clearly up, without any clear countervailing force in Washington.

Those on the left might agree with the challenge to be faced, but they use a different scale to gauge left versus right, object to the accusation that they have driven up government spending, hold the Republicans responsible for inciting anger in the tea partiers and offer different long-run solutions.

If the scale is set between 100% individual, 0% government pure libertarianism versus 0% individual, 100% government pure socialism, the Democrats argue that the post-war game has all been played on the right (0-18 inch) side of the ruler.  Government share of GDP is 20%.  Government spending and taxes share of GDP is 30-35%, including all transfers.  This did not increase between 1960 and 2008.  The US tax burden at 27% of GDP is only 75% of the 36% average level for 30 developed countries.  Only Mexico, Turkey, Korea and Japan spend less than the US.  Total government spending in western European democracies is 40-55%.  Government spending did increase with the Vietnam War and Great Society policies, but was reduced by the Reagan revolution.  Government spending fell from 37.2% of GDP in 1992 to 32.6% in 2000. 

Democrats argue that their fiscal discipline was demonstrated in 1992 to 2000 when they balanced the federal budget and reduced the deficit, employing the “pay as you go” policy to force spending cuts to offset spending increases.  They point to Bush led Medicaid and defense spending increases as the cause of increased government by 2008.  They see the Bush tax cuts as redistribution to the wealthy and don’t see the overall tax-cut initiated economic growth claimed to increase net tax revenues.

Democrats argue that they have not purposely increased the long-run share of government in the economy.  They claim that the one-time investments/guarantees for the banking/auto industries were necessary for the whole economy, addressed issues that had grown for decades, will be partially recaptured and do not require continued funding.  Similarly, they pursued a moderate one-time Keynesian fiscal stimulus in response to a deep recession, just as was done by other governments of all parties in all countries for the last 60 years.  The stimulus spending lies between the 4.7% of GDP boost in 1982 and the 2.3% growth in 1992. Democrats argue that these actions are necessary and moderate and would have been undertaken by a responsible Republican successor to the Bush administration.

Democrats argue they are unfairly characterized as “big spenders” by the Republicans.  This simple accusation has stirred a populist response from “regular Americans”.  While Democrats have historically focused populist rage on big business and big banking, the Republicans and tea partiers have effectively used big government, Washington, elites, foreign countries and religions as targets, tying them to the Democratic Party.  Democrats argue that the monetarist, supply side, tax cut economic policies of the Republican Party since Reagan have been adopted for their populist simplicity and political effectiveness alone, further polarizing economic policy making.

Finally, Democrats have adopted part of the Republican play book in fundamentally looking to the private sector to drive the future economic growth required to support even the historic level of government spending.  The stimulus spending was partially focused on future industrial growth and infrastructure.  The banks and auto firms are returning to pure private ownership.  Small business lending and investment tax credits have become a focus.  Health care reform maintained private providers and insurers as the core of the system.  The costs of the war in Iran have been reduced.  A bipartisan group has been appointed to work on the Medicare/social security future.  Steps are being taken to promote exports.  A reduced public sector role for the mortgage industry has been proposed.  Obama and many Democrats have continued the pro-business approach used by Clinton.

On the other hand, Republicans can fairly point to steps taken by the Democrats that indicate a continued desire to “tax and spend”.  The stimulus bill benefited state government, construction and other Democratic interests disproportionately.  Health care reform achieved growth in government commitments without structural cost solutions.  Labor unions were given special treatment in the auto bail-out.  Fannie Mae and Freddie Mac’s roles were not touched in the banking reform.  The financial consumer protection agency smacks of unlimited and uninformed regulation.  The proposed increase in taxes for high earners is significant and is not coupled with structural spending reforms.  A second mini-stimulus has been approved and unemployment benefits have been extended to record lengths.

The current economic situation has raised the stakes for politics.  We should expect to see ongoing attempts to define the ruler and place the participants at marks that favor one group or another in the public eye.

Book Reviews

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I’m very busy in my new role with Tripp-Lite in Chicago.  I have published many book reviews on Amazon.com in the last 2 months, including:

Pontoon, Garrison Keillor

Pere Goriot, Balzac

The Limits to Power, Bacevich

The City, Kotkin

Hitchhikers Guide to Universe, Adams

Ragtime, Doctorow

Siddhartha, Hesse

What’s the Matter with Kansas?, Frank

The American, James

No Ordinary Time, Goodwin

Prize Winner of Defiance, Ohio, Ryan

Enjoy!

High ROI Suburbs

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Many of America’s highest income, politically conservative suburbs have successful pursued high amenity public service strategies.  How is this high spending approach economically and politically justified?

http://en.wikipedia.org/wiki/Tiebout_model

In 1956, economist Charles Tiebout developed a model of competing suburban governments providing different levels and combinations of services to match the varied preferences of groups.  Subsequent research on suburbs and private real estate communities has confirmed that individuals prefer to choose amenity/payment bundles which match their values.

http://www.springerlink.com/content/r1v378785j2588j8/

Why would members of this usually tax and government-averse high income group willingly choose to live in a high amenity suburb?

The sociological observation that individuals prefer to belong to groups of like individuals is a partial explanation.  Exclusive communities are more homogeneous.

Brand name communities also provide some luxury goods type value from their exclusive status as high income, wealth and service communities.

High income, wealth, tax and service communities screen out criminal elements and benefit from low service costs to security services, delivering a safe environment.

High service communities provide signaling benefits in a world of imperfect information.  Transferred corporate executives rely upon education and amenity cues in choosing a residence.  Universities rely upon the reputation of school districts in selecting among applicants. 

Most importantly, a high service strategy delivers a great financial return on investment – especially for the initial group of residents.  High service communities proactively pursue strategies to minimize the cost to existing residents.

They invest in all service dimensions to ensure that the community is recognized as “a” or “the” leader in the metropolitan area and region.  Schools, roads, utilities, zoning, parks, transportation, libraries and cultural institutions achieve recognition.

They increase the tax base through annexation, selective density increases and attracting commercial firms.

They pursue “good government” initiatives, outsourcing services, consolidating services, utilizing volunteers and boards, leveraging regional, state and federal funds, employing specialized consulting firms and retaining highly qualified staff that benefit from the community’s growth and financial stability.

They invest in economic development, using Tax Increment Financing districts, user fees, economic development incentives, balanced zoning and negotiation to take advantage of the economic value of their attractive locations.  Retail, office, distribution, services, logistics and light manufacturing firms are welcome in the right zoned areas.

High service communities make capital investments to provide future economic returns.  Schools, parks, roads, libraries, utilities, cultural services, transportation and recreation assets are created through donations, local and regional government actions.

Suburbs compete with other metropolitan suburbs for residents and with other regional centers for commercial investments.  The right investments provide an atmosphere with low taxes, high services and a high quality of life. 

A Midwestern suburb of 75,000 has invested almost $1 billion in the last 20 years in its schools, roads, utilities, library, parks, infrastructure, cultural institutions and economic development incentives.  In essence, each of the existing 25,000 households has made a $40,000 bet on the future.  There has been some political and journalistic opposition.  A typical residence is valued at $250,000.  There are another 3,000 commercial firms with $250,000 property investments, making the total property value $7 billion. 

The community has annexed the unincorporated areas, increased density, attracted new businesses and continued its build-out towards a 120,000 population.  The number and value of commercial enterprises is expected to grow from .75B to $4B in 20 years.  Through zoning measures, growth and increased demand for a singular resource, the average residence will be valued at $400,000, with the existing residences appreciating from $250,000 to $325,000.  The built out residential market value will be $16B, for a total property value of $20B.

The original 25,000 households will gain a real $75,000 on their housing values.  Because of the community’s economic and population growth, their capital investment will be reduced to less than $20,000.  The early residents will clearly benefit from this high service and investment strategy.  The new residents will benefit from the investments and have the opportunity to “vote with their feet” in determining if the services delivered are worth the property values and taxes required.

High income families demand high quality services and are willing to pay for them.  They also require their municipal governments to take all possible steps to increase the cost effectiveness of these services.

Tale of Two Cities

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In a recent speech at the Carmel Rotary Club, Indianapolis Star editor Dennis Ryerson warned the audience of the risk of a central city meltdown in Indianapolis as he had observed in Cleveland 20 years ago.  As someone who has lived in each region for more than 20 years, this prompted me to collect some historical statistics and speculate on the differential success of these two mid-sized Midwest areas.

In 1900, Indy was two-thirds the size of Cleveland, which at 654,000 people, was the nation’s seventh or eighth largest urban area by various definitions.  Indianapolis was in the 21st-25th range.

By 1930, Cleveland had grown by an astonishing 173%, adding 1.1 million people for a total of 1.8 million, reaching a peak national ranking of 6th to 8th.  Indianapolis was the turtle in this race, adding a mere 200,000 residents to grow by 50% to reach Cleveland’s 1900 650,000 population level, while maintaining a 21st-25th highest population ranking.

By 1960, Cleveland had added another one million residents (50%), reaching 2.7 million residents and maintaining a top 10 population ranking.  Indianapolis grew a little faster on a percentage basis, adding 400,000 residents to reach the 1.1 million population level.  Its national population rank slid to 26th as Sunbelt and west coast cities began to grow.

In the next five decades to 2009, Indianapolis continued its modest 1-1.5% annual growth rate, adding 750,000 residents to reach a population of 1.8M, while sliding to 34th place in the national metro population rankings.  Cleveland reached a peak population of 3M in 1970 before declining to 2.8M in 2009, good for a 26th place metro population ranking. 

In summary, Cleveland grew by 1 million people from 1900-1930 and from 1930-1960, but added ZERO population in the next 50 years!   Indianapolis added a quarter, half and three-quarters of a million people in those 3 periods.  What could possibly account for these divergent trends in cities located only 300 miles apart?

The locations are not very different.  Indy claims to be the “crossroads of America”, while Cleveland has said it is “the best location in the nation”.  Cleveland is on the New York to Chicago train line, the Great Lakes and interstates I-80, I-90 and I-77.  Indy boasts I-70, I-65, I-74 and I-69 interstate access.  Indy has leveraged its location and lower labor costs to become a greater distribution hub.  Cleveland has enjoyed a decade as a mini-hub for Continental, while Indy once served as a minor USAir hub.  Both cities have attracted rural residents from a 100 mile circle, but Cleveland’s area is only half as large due to Lake Erie.

Both cities had strong historic banking companies.  All of the Indy companies are gone.  Cleveland maintained National City Bank and KeyCorp as major banks through most of the period.

Cleveland has maintained a large Fortune 500 headquarters lead.  Firestone, Republic Steel, Uniroyal, Goodrich. TRW, Std Oil, White Motor, Eaton, Sherwin-Williams, Cleveland-Cliffs, Hanna Mining and Reliance Electric appeared in the 1960 list.  Cleveland had grown from 12 to 15 firms by 2009, adding Progressive Insurance, National City, KeyCorp, Parker-Hannifin, PolyOne, Lubrizol and Travel Centers of America.  Indy had 5 firms in 1960: RCA, Lilly, Curtis Publishing, Stokely Van Camp and Inland Containers.  It maintained only Lilly, WellPoint and Conseco in 2009.

On the professional sports scene, Cleveland has maintained football and baseball teams, while adding basketball, but dropping the second level hockey Barons.  Indy added the Colts and moved the Pacers from the ABA to the NBA.  Indy has successfully pursued an amateur sports strategy, attracting the Pan-Am games, the NCAA and many collegiate tournaments.

The cities share historical strengths in their art museums and orchestras, with Cleveland’s ranked higher.  Indy has added the Children’s Museum and Eiteljorg Museum, while Cleveland added the Rock n Roll Hall of Fame museum and lost the Salvador Dali museum.  Neither city has a major state university, with IUPUI and Cleveland State growing in parallel.  Cleveland has Case Western Reserve as a local research university.  Greater Cleveland has a much stronger community college system.  The Cleveland Playhouse and theatre groups offer more than Indy’s scene.  Cleveland’s Coventry/University Heights area is more vibrant than Indy’s Broad Ripple.  Cleveland adopted Michael Stanley while Indy embraced John Mellencamp.

Both cities focused on manufacturing for growth, especially automotive and metal forming manufacturing.  Cleveland had a greater emphasis on basic manufacturing in steel, rubber and plastics.  Indianapolis attracted a significant amount of investment from Japanese manufacturers.  Indianapolis’ health care industry has benefited from Lilly, Roche and IU, while Cleveland has leveraged CWRU University Hospitals and the Cleveland Clinic.

Net, net, Cleveland should have continued to grow slightly faster based on the factors above.  The drivers for Indianapolis’ positive differential growth include:

Better public relations regarding momentum.  Cleveland’s river fire and “mistake on the lake” moniker have hurt.  Indy was able to overcome the “naptown” label through continued positive growth and publicity.

Indianapolis and Indiana have maintained a low tax and low service environment conducive to business investment.

Indy has benefited from being the state capital and the only large city in Indiana, while Cleveland has battled Columbus and Cincinnati for state leadership.

Indianapolis has avoided major racial conflicts.  The 1966 Hough riots in Cleveland contrast with the calming Bobby Kennedy speech after Martin Luther King’s 1968 assassination.

Indianapolis public schools have not fallen as far as IPS.  Busing and white flight had a bigger negative impact in Cleveland where a more established Catholic school system option existed.

Downtown Indianapolis has recovered based upon major public and private investment in the Circle Center Mall, convention center and sports arenas.  Cleveland’s investment in the Brown’s stadium, Jacobs Field, Cavaliers arena, major office buildings and “the flats” has never reached the critical mass required for downtown growth.  Indianapolis’ downtown residential growth has been modest, but adequate.

Indianapolis pioneered the concept of uni-gov, merging the city into the county.  Cleveland has remained an island within Cuyahoga County and a small island within the metro area. 

Indianapolis civic leaders found a variety of ways to preserve and grow the central city and avoid having widespread areas of decay.  As Mr. Ryerson noted, this strategy will be more difficult to maintain as the surrounding counties grow at the expense of Marion County.  Both cities could benefit from some degree of regional government and taxing authority that aligns the interests of suburbs with the central city.

  Cleveland Indy  
  7 counties 9 counties  
       
1900          654         429 66%
1910          913         489 54%
1920       1,426         569 40%
1930       1,784         656 37%
1940       1,817         702 39%
1950       2,154         829 38%
1960       2,734       1,071 39%
1970       3,000       1,248 42%
1980       2,833       1,305 46%
1990       2,759       1,381 50%
2000       2,844       1,605 56%
2009       2,791       1,824 65%
       
1900-30       1,130         227  
  173% 53%  
       
1930-60          950         415  
  53% 63%  
       
1960-2009            57         753  
  2% 70%  

Things Fall Apart

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California voters in every county except far left San Francisco County and far right Orange County approved Proposition 14 which changes the state constitution to require the primary election to select the two highest vote recipients, without respect to their political party.

http://en.wikipedia.org/wiki/California_Proposition_14_(2010)

California may once again be on the leading edge of American history.  This change seems to be a rejection of the current primary system where candidates in both parties are required to pander to the extremists and activists before tacking back to the center to win in general elections.  Ironically, the Tea Party movement seems to be tapping some of this frustration by the average centrist voter, while at the same time pulling the Republican Party even further to the right.

In the shadow of “The Great War”, William Butler Yeats wrote:

Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.

http://www.online-literature.com/donne/780/

http://en.wikipedia.org/wiki/The_Second_Coming_(poem)

The optimistic progressive consensus of 1880-1910 among the leading classes had been severely weakened by the war.  World War II shattered the last idealistic sentiments in Europe, leading to the post-war time of European community, skepticism and limited idealism.  The United States picked up the progressive banner with the New Deal, WWII, post-war global organizations and economic recovery, the cold war, New Frontier and Great Society.  Temporarily derailed by the Vietnam War, Energy Crisis and Japanese competition, the U.S. once again embraced the optimistic progressive spirit in the 1980’s, but with a distinctively right-wing flavor following the Reagan revolution.  Twenty years of economic and geopolitical progress delivered a new sense of American exceptionalism, leading to the Bush administration’s overreach in Iraq in response to the perceived terrorist threats after 9/11.   Most commentators agree that we now face a more uncertain multi-polar future (see 2/1/2010).

How did the American public reach this point where most voters clearly see that the political system does not work (see 1/26/2010)? 

Congressional and state legislator gerrymandering has played a major role.  The average voter can see that many legislators are simply incompetent party hacks with extremist, populist rhetoric, but no sense of responsibility for governing on behalf of the citizens.  The advantages of incumbents have lead to their re-election and increased voter cynicism (see 12/12/2009).    This year, unprepared voters elected Alvin Greene as the Democratic SC senate candidate and nominal Democrat, 29 year-old Tim Crawford to oppose Dan Burton.

http://en.wikipedia.org/wiki/Gerrymandering

As the financial and volunteer resources required for election have grown, the power of extremist/activist groups in both political parties has grown significantly.   As the country’s population and standard of living have grown, narrow economically rational voters have reduced their participation, thereby increasing the power of those with strong ideological views.

Citizens of all political views have become more independent, decreasing the role of many individual and institutional influencers who once promoted the center (think US News & World Report in the 1960’s).   Politicians and political parties have become far more sophisticated in identifying and capturing the resources of those with the strongest beliefs.

After the break-up of the Democratic Party’s “solid south” position following passage of the 1960’s civil rights legislation, the Republican Party developed a more philosophically consistent right wing position on all economic, military and cultural issues.  The Democrats have tried to move towards the center, but the left-right and Democratic-Republican dimensions of American politics have become synonymous for almost 40 years.  The Republicans have effectively attracted millions of Catholic, Baptist, working and middle class voters from Democratic strongholds, while the Democrats have rode demographic trends and recaptured some socially moderate and upper middle class voters on the coasts.

The modern media has returned to its 19th century roots, adopting explicit political and populist positions in order to sell advertising.  This promotes partisan posturing and coverage.

Politics no longer attracts citizen legislators with moderate views.  Political positions have very low compensation compared with other options for highly competent citizens.  The price of entering a campaign is so high that only individuals with hopes for a 20 year political career, radical idealists or the very wealthy rationally pursue elected office.

Non-party primaries, campaign finance reform, independent districting commissions and grass-roots political participation can all help to return our political system to the center, where reasonable compromises can be found for the benefit of all.  Without some structural changes, we run the risk of having the divisive and unproductive political results seen in Italy, Greece, Mexico, Venezuela, Japan and Germany.  A solid majority of the American people desire centrist solutions to our challenges.  Structural changes can help to ensure that we have a self-improving system, or at least that we do not see “things fall apart”.

The Knee Bone’s Connected to the Shin Bone

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In simplest terms, the mortgage lending industry collects deposits to make loans possible.  As mortgage lending has grown increasingly complex, the checks and balances of a simpler time have been lost.  Like the proverbial frog boiled as the water temperature rose, bankers did not perceive the changes in systemic risks.  Like the subjects in Hofstadter’s “Escher, Gödel and Bach”, a strange loop has been formed that could not be predicted from its components.

http://en.wikipedia.org/wiki/G%C3%B6del,_Escher,_Bach

In place of the original triplet of depositor, banker and borrower, today we have no less than 14 actors to consider: borrower, mortgage broker, mortgage product, mortgage broker firm, mortgage lender, guarantor, consolidator, mortgage-backed security, securitized asset, credit default swap, credit rating agency, investment banker, investors, regulators and auditors.

In 1776, Adam Smith provided scientific, philosophical, ethical and political support for free markets of independent buyers and sellers. Academic economists from Alfred Marshall through the Chicago School provided sophisticated theoretical, historical and statistical support for free markets.  Ronald Reagan and Margaret Thatcher consolidated political support for free markets.  NONE of them had a 14 step conga line in mind.

http://www.youtube.com/watch?v=RKtPrOiMj3o

At every step, we have the risks of self-interest creating failure rather than an efficient market with optimal social welfare.

Borrowers have an incentive to lie to mortgage brokers about their income.

Mortgage brokers have an incentive to process as many successful mortgages as possible, coaching borrowers and appraisers.

Mortgage lenders and firms have an incentive to devise mortgage products that are most attractive to borrowers, including no money down, variable interest rates and negative amortization beauties. 

Mortgage broker firms have an incentive to generate volume, without regard to the risks that will be born by the lenders or investors.

Mortgage lenders have an incentive to book as much volume as possible; locking in profit spreads for 30 years.

Fannie Mae and Freddie Mac serve a pivotal role, consolidating and guaranteeing individual loans and collections of loans in support of the American ideal of home ownership.  As quasi-government agencies, they have an incentive to capture congressional support through campaign contributions.

http://www.diffen.com/difference/Fannie_Mae_vs_Freddie_Mac

Mortgage backed securities provide the key gap in the chain of responsibilities.  They allow the mortgage brokers and lenders to transfer liability for mortgage defaults to investors.  Theoretically, these financial instruments greatly increase the sources of funds and through the portfolio effect reduce risks for everyone.

http://en.wikipedia.org/wiki/Mortgage-backed_security

The most sophisticated financial engineering is used to transform a portfolio of mortgages into a new set of securities that separate risks into layers, theoretically allowing some investors to have low risks and returns while others assume moderate and higher risks and returns.  This financial alchemy also increases the pool of potential investors and fine-tunes the risks assumed.

http://en.wikipedia.org/wiki/Securitization

Investors in mortgaged backed securities and their derivatives are not fools.  They understand that risks accompay these innovative instruments and that there are inherent underlying risks.  As sophisticated investors, familiar with derivatives of all flavors, they seek ways to limit their risks.  Credit default swaps were created to provide them with additional security about the risks involved in investing in securitized mortgage based securities.

http://en.wikipedia.org/wiki/Credit_default_swap

Credit default swaps and mortgage-backed securities are evaluated by credit rating agencies.  The growing complexity of financial instruments greatly increased their business volume and relations with investment banks.  They provided overly positive ratings historically.  They were paid by the firms that created the securities.  No one should be surprised by the results.

http://en.wikipedia.org/wiki/Credit_rating_agency

Investment bankers have played a key role in the growth of the securitized mortgage industry. They collect fees as advisors in the creation of products and as advisors to mortgage brokers, mortgage lenders,  guarantors,  consolidators and investors.In their banking role, they have invested directly in these securities, provided funds for others to invest and developed derivatives to allow bets against the securities.  Investment bankers have supported both political parties.

The securitization of mortgages has allowed a wide variety of individuals and firms to invest in these assets, including banks and investment banks as part of their overall portfolios.

Regulators have tried to keep pace with these innovations, but failed.

Auditors have invested their resources complying with the details of the Sarbanes-Oxley legislation, but missed the change in risks in this complex system.

The mortgage world has become very complex in the last 30 years.  The proponents of “financial reform” in both parties need to closely review the reality of a 14 actor system.  There is a trade-off between the benefits of financial innovation and the regulatory costs of financial complexity.  We have clearly crossed the line where the costs of complexity (regulatory and risk) have exceeded the benefits of innovations (funding and reduced risks).

Banking in Bedford Falls

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As the Great Recession moves along into its third calendar year, the focus in Washington is on “Financial Reform”.   The backlash at Democrats and Republicans alike over the “bank bailout” continues to grow.  The politicians are posturing to allocate credit for the so-called reforms, but seem destined to “give the people what they want”.  It might help the politicians and the people if there was a shared understanding of the inherent factors universally at play in the home lending market.

I propose that everyone take an evening off and watch the classic 1946 film “It’s a Wonderful Life”, starring James Stewart as George Bailey, the initially reluctant but eventually heroic, manager of the Bailey Building & Loan Association in Bedford Falls.

http://en.wikipedia.org/wiki/It’s_a_Wonderful_Life

The essentials of banking are exhibited in this film.  Bedford Falls is the whole universe.  All of the actors know one another.  The cast is composed of depositors, owners, board members, bankers, borrowers, regulators and landlords. 

There are inherent conflicts between the roles.  Depositors don’t really trust the bank as shown by the bank run.  Landlords would like to see lending restricted to boost rents.  The owners are motivated by self-interest (enlightened or not) and set policy accordingly.  The board seeks a trustworthy banker to be its agent, and provides incentives to attract and retain him.  The banker has fiduciary and personal motives.  The regulators enforce the laws, unaware of all key facts.  The borrowers want loans, even if they can not afford them, in order to escape the costs of the landlords.  People act out of self-interest.  They respond to incentives.  There are trade-offs to be evaluated and decisions to be made.

A bank fills a valuable social role, attracting deposits in order to lend money.  A bank profits by the spread.  A bank is in business to lend money whenever it sees a profitable opportunity, irrespective of the moral concerns of owners, depositors or borrowers.  Banking is subject to real risks such as bank runs.  Banks are subject to poor decisions by bankers, mistakes by employees and fraud by anyone involved in any transaction. 

Historically, banks have operated by the 4 C’s of credit: capacity/cash flow, capital/collateral, conditions and character.  This is especially effective in a small town such as Bedford Falls.  Although George and the audience might hope that every citizen should qualify for a loan, some may not have the earnings to cover the principle, interest, insurance and maintenance of a home.  Some may not be able to save for a down payment to create adequate collateral.  As business conditions change, the income of the citizens is at risk and the ability of the bank to manage its affairs fluctuates.  A banker with a long-term perspective and proper incentives adjusts lending accordingly.  Finally, character counts.  Past financial and personal performance are good predictors of future performance.  Character is part objective and part subjective.

Even in this simplified setting, risks abound.  Public pressure for universal home ownership can result in too many loans.  Regulators can enforce laws mechanically while missing larger problems.  Institutional knowledge can be lost through staff turnover.  A single fraudulent act can threaten a bank.  Changing external business conditions can disrupt the bank.  Lending policies can be too loose or too tight.  Business judgments can be wrong.

The film delivers an escapist, idealist, overly simplistic view of life.  Mr. Potter is the evil bank owner and plotting, fraudulent landlord.  George Bailey is the selfless hero.  Yet, behind the scenes, we have a social institution performing a social function.  We need banks to provide the social function of collecting deposits, allocating credit and collecting from borrowers.  In spite of the vastly more complex institutional structures today, the role of a “building & loan association” is essentially the same.  As a society, we allow these institutions to connect savers and borrowers across varied time frames because this is a necessary function.  Our laws and regulations should be based on this real-world understanding, not upon the simplistic dualism of “good and evil”.

Labor and Tax Law Changes to Create Jobs

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The U.S. labor market remains mired in a post WWII land of large employer paternalism that is unsuited to the needs of global competition.  Major changes to labor laws should be made to lower the full costs of hiring employees.  At the same time, major changes to unemployment insurance should be made to provide a meaningful safety net, without reducing the incentives for the unemployed to actively seek re-employment, even at lower wages when needed.

In return for a variety of actions to reduce the unit cost of labor by more than 20%, employers should be required to fund one-half of an unemployment insurance fund that provides meaningful benefits.  Employees would fund the other half through payroll deductions.  Unemployed workers would receive an initial payment of one-half of six months’ worth of wages.  Additional 50% payments would be made at the beginning of third and fourth quarters of unemployment.  This lump-sum approach maintains the incentive to actively seek new employment, while providing a true safety net in a world where 6 month bouts of unemployment are recurring career experiences at all levels.

The federal government could lower the transaction costs of employment by maintaining a national ID card system that qualifies individuals for employment and removes the hiring cost and risk to employers.  The federal government could certify 3-5 firms to operate a standardized resume/profile system that records and certifies the basic education and employment history for individuals in one place. 

Employees would be more attractive to employers if they invested more in their professional skills.  A continuing education tax credit would improve candidate skills and remove the need for employers to offer most internal training and educational benefits.

Employers would hire more individuals if the terms of employment were more flexible.  Labor laws could more clearly allow “paid time off” banks to be used in place of overtime compensation.  The trigger for required overtime premiums could be raised from 40 to 48 hours for the first 10 weeks of annual overtime.  Seasonal positions could be exempted from employer unemployment compensation responsibility.  A new employment category could be created to clearly allow 100% incentive based sales positions.  The IRS rules defining employees and contractors could be simplified to reduce administrative costs and risks.

Federal labor laws and regulations could be simplified to reduce administrative costs and limits could be placed on potential liabilities.  The equal employment opportunity, family medical leave, disability and other employee “rights” acts incentivize employers to take extreme defensive steps and avoid hiring in order to avoid potential liabilities.

The federal government could incentivize the creation of new positions directly by paying half of the first six-months of wages.  The rules for unpaid internships could be clarified, allowing students to work up to 700 hours per year within win-win educational programs which lead to employment.  The labor laws could be clarified to allow “no fault” dismissals within 180 days.

In a globally competitive environment, labor laws need to benefit employers and employees.  Steps can be taken to reduce the total cost of employment and protect employed and unemployed workers.  The cost to employers and society through taxes is modest.

In addition to macroeconomic steps to improve the economy and administrative steps to provide meaningful unemployment compensation benefits and lower employment costs and risks, the federal government could change tax policies to significantly reduce the incremental costs of employing workers.

The federal government could incentive continuing education through tax credits.  Unemployment compensation insurance could be shared by employers and employees.  Family medical leave benefits could be funded by the federal government as is done in other developed nations.

Tax changes could be made to incentivize individuals to invest in their own life and disability insurance plans.  Tax credits could be used to promote individual charitable contributions and reduce the need for corporate gifts and matching programs.  The dollar and percentage limits for tax –deferred retirement plan contributions could be raised, increasing the value of compensation.  The rules for qualified plans could be modified to allow a greater share of “highly compensated” employee pay to be made on a pre-tax basis.

Finally, the two biggest fringe benefits – social security and health benefits – could be migrated to government and employee funded programs over a decade, releasing employers from this responsibility.  Social security can be funded from federal income tax revenues or simply made employee deduction.  Health care insurance programs could lose their tax-deductible status.  If no better option is found, employer contributions to consumer choice (HAS/HRA) plans could retain their tax-deductible status.

Allowing American employers to focus on creating jobs, operating their firms and making money will unleash incentives to increase productivity, competitiveness and our standard of living.  Finding the political will to fund desired public services will not be easy, but the total benefits justify the short-term challenges.