Wednesday, December 10, 2008

Shocked, shocked I tell you!

Yesterday's arrest of the Governor of Illinois, Rod Blagojevich, may have surprised people with its timing, but it was widely known that he had been under investigation for several years. Most people I knew when I worked in Illinois expected him to be indicted someday, as several of his top appointees already had been.

The scale of corruption in Illinois politics - state and local - is beyond comprehension. When I was a visiting faculty member at the University of Illinois at Springfield, several faculty members warned me to think carefully about my voter registration: state officials were likely to look at my party affiliation if I was ever considered for a state research contract. I taught an ethics class at UIS with a class full of mid-career MPA students, most of whom worked in the state government. When we read case studies that examined political cultures in Illinois and several other Midwestern states, Illinois stood out for the degree of ongoing corruption and the pernicious extent of patronage appointments. The students' response was overwhelmingly "So what?" They weren't bothered by the degree to which getting a job as a gas meter-reader, a sanitation worker, or an administrative assistant at the water utility depended on personal connections and party affiliation. To them, that was just the way the world worked.

It seems that government in Illinois exists to distribute spoils to the winners of the elections, not to provide services to the citizens. I knew good people who worked in state government in Illinois (I was a state employee, after all), but politics in the state seem overwhelmingly driven by rent-seeking behavior. When highway construction plans are discussed here in North Carolina, the public discourse focuses on issues like funding, traffic congestion, environmental and neighborhood impact; i.e., services provided and their costs. When Blagojevich proposed a highway construction program last year, the discussion in the paper was all about construction jobs, not about any services provided by the new highways or whether there was a need for them.

Three of the last six governors of Illinois have served or are serving time in jail, and Blagojevich could make that four of seven. He may be a particularly egregious example of corruption in the state, but it will take a lot more than jailing him to change the way the state works.

Thursday, September 25, 2008

At what price bailout?

Treasury Secretary Paulson's bank bailout proposal has now been subject to public scrutiny for a week. Most analysts agree that the bailout is necessary, but many have questions about the specific proposal.

Alan Meltzer, an economist at Carnegie-Mellon, argued against any bailout at all when he appeared on The Newshour this week. If a bailout is necessary, then he suggested mimicking what Chile did in 1982 in response to a financial crisis. At that time the Chilean government offered up loans with interest to distressed companies, and the companies were required to pay back the loan before they could pay out any bonuses or dividends. Most repaid the loans quickly. If applied to the current crisis, then it would help banks deal with short-term liquidity and punish shareholders and bonus-deprived managers until the loans were repaid. If the company were to fail, the government would have first claim on any assets in bankruptcy. Taxpayers would not put up free money, and it would only help banks with short-term liquidity problems, not banks that are doomed to fail anyway.

Paul Krugman provides an excellent discussion of the shortcomings and implicit purpose of Paulson's plan: it only helps markets if the Treasury buys distressed assets at prices higher than current market prices. It's a direct subsidy to holders of securities that are likely to have high default rates. Taxpayer money saves the banks that hold the debt but taxpayers get no equity in the banks in return. It's free money for the banks.

Many financiers and analysts have estimated that private investors are only willing to pay 20% to 30% of face value for the debt right now, and that the debt would probably be worth anywhere from 50% to 65% of face value if held to maturity. That could leave a spread of 30% or so between current market prices and the estimates of fair value. These analysts argue the current credit shortage and a short-term excessive amount of risk aversion are causing the securities to sell for far less than their actual worth. If the default rates on the securities' underlying loans are as low as projected, or if the credit market loosens up in the next couple of years, then these securities would trade at a higher price relative to face value. The gap between the estimated fair value and the current market value would create an opportunity for Treasury and the banks owning the securities to deal and benefit both parties. But how much would Treasury pay, and what assurance is there that Treasury will pay a low enough price to make taxpayers gain? Paul Samuelson has a good discussion of this in the Washington Post.

Paulson proposed a reverse auction, which, as I understand its application here, might work something like the following. Treasury would announce that it intends to buy $10B of mortgage-backed securities from banks on a given date. (It would be best to start small to get the market going and provide price information for future sales. Treasury could buy larger amounts on a weekly basis over a several month period.) Holders of the securities could offer up, say $1B for a price of 40% of face value, or $1.7B at 43% of face value, etc. Treasury would spend the $10B on the securities offered at the lowest percentage of face value; i.e., at the deepest discount to face value.

Even with this format there remains a problem. A reverse auction can work if all the securities being offered are of similar quality, but not all debt is equal. Imagine soliciting offers from car dealers trying to sell you a new car. You are given five envelopes labeled dealer #1, dealer #2, etc., each with a price. But you don't know whether the price applies to a Chevy, a Lexus, or a Yugo. The lowest price probably applies to the lowest quality product, and might not be much of a bargain.

It's hard to know the value of these securities. Each security could represent thousands of mortgages from different housing markets and different brokers. Some bundles could be full of NINJAs (I love this acronym) - No Income, No Job or Assets; i.e., mortgages issued without documentation of income or assets. Others could have been sold by brokers that screened applicants more diligently. Some bundles could include lots of loans from depressed housing markets like South Florida, Las Vegas, and California with high default rates while others come from North Carolina where housing prices have not seen large declines and where default rates are much lower. It seems that the documentation on the securities can be as poor as the documentation on income, so that it would require great effort to assess the quality of the mortgages backing up any given security. The securities are further complicated because they don't just bundle individual loans directly in their entirety but slice them up and combine them into complex instruments. An article in yesterday's NY Times analyzes a set of bonds issued by Bear Sterns. Over 2800 mortgages with a combined value of $1.3B were assembled into 37 different types of securities with varying degrees of risk. The ratings from the debt-rating companies have not been very helpful for these products.

Paulson's proposal gave all the decision-making authority on purchases (and subsequent resale of the securities in future years) to the Secretary of the Treasury, with no review by Congress or the courts. Constitutional government is based on trust in laws, not trust in government officials. Paulson's proposal goes completely against this idea, and the Bush administration has demonstrated amply why lack of oversight is a bad idea. In recent days several different oversight mechanisms have been proposed. It sounds like legislation might require that the government take some kind of equity or warrant, but even that requires trust in the government administrator to negotiate a favorable price for taxpayers to take on a given amount of risk and equity.

I would propose instead to structure the sale procedure to rely on a mechanism that promotes honesty by the debt sellers. Warren Buffet and others have said it's possible for the Treasury to earn a return of 7% or more per year on these securities, but that depends on what the purchase price is. How about using the reverse auction mechanism, with a guarantee from the seller that the Treasury will earn a minimum return? Each deal should guarantee that Treasury makes at least, say a 6% annual return on the purchased security. If Treasury ultimately resells the security for a price less than that or holds it to maturity and the default rate is so high it fails to receive that 6% return, then the original seller of the equity must make up the shortfall plus a 25% penalty, paid with company stock. Any company that hasn't gone bankrupt in the interim will do whatever it can to pay back the difference to avoid the penalty. If it can't, then Treasury gets equity in the company that exceeds the value of the shortfall. With a rule like this, the sellers of the debt will put a check on the government administrator (whether the Secretary of the Treasury or the head of some independent agency) from overpaying for the securities. I'd feel a lot better giving a government agency greater independence selling under rules like that.

Thursday, May 15, 2008

Loving legalized in California

The California Supreme Court today ruled that the state must allow the same marriage rights by the same name to gay couples that the state grants to straight couples. They ruled by the reasoning presented in this very blog, which follows the reasoning of the Massachusetts high court in 2004. One of the precedents cited by the court was California's own version of Loving v. Virginia, the 1947 case Perez v. Sharp in which the California Supreme Court, 19 years ahead of the US Supreme Court, became the first court in the nation to rule that a ban on interracial marriage was unconstitutional.

The decision was based on equal protection provisions of the California state constitution. It appears likely that a referendum will be on the November ballot to change the California constitution to ban gay marriage. The state legislature has already voted twice to enact gay marriage in the state, and Governor Schwarzenegger has twice vetoed the measure, but he has already said he will oppose the referendum if it appears on the ballot in the fall (yeah, go figure).

California already allowed almost (but not quite) all the same rights to same-sex couples as to opposite-sex couples. The California court says the state must supply all the same rights and the same name. This is like Brown v. Board of Education (1954) and Loving v. Virginia all in one. New Jersey's high court last year ruled the state had to provide the same rights to same-sex couples but not the name and allowed the state legislature to establish civil unions with the same rights under state law as marriage. That advanced same-sex couples in New Jersey to the separate-but-equal status of Plessy v. Ferguson of 1896. The New Jersey court did suggest they would be willing to reconsider the name issue in the future and possibly advance gay rights in that state past 19th century jurisprudence.

There is an additional legal benefit to full-on marriage beyond the name. Civil unions or domestic partnerships are defined differently in each state and aren't necessarily recognized in other states that allow civil unions, and couples might have to register a new union or partnership if they move to a new state. Marriage, however, is clearly defined and states automatically recognize marriages conferred in other states (with the exception of gay marriages, courtesy of the Defense of Marriage Act). So a couple married in California would still have the protections of marriage if they moved to Massachusetts or any other state that recognizes gay marriage. It also means that gay couples married in Massachusetts and currently residing in California could get divorced in California, should that be necessary. It's a little more complicated for married gay couples who move from California or Massachusetts to New Jersey.

I think it is inevitable that all state courts and eventually the US Supreme Court will rule that states must allow gay marriage, absent constitutional amendments expressly banning it. It took 19 years from the first state court's ruling in favor of interracial marriage until the Supreme Court applied the reasoning nationwide. By that precedent, we could see the gay marriage equivalent of Loving v. Virginia at the federal level around 2023.

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Loving and more

Ruth Marcus, in yesterday's Washington Post column discusses Loving v. Virginia in the context of John McCain's recent railings about "unelected judges" ignoring the "will of the people." She takes McCain to task for these statements. She also wonders whether the current court would have reached the same conclusion that was reached in 1967 and wonders how McCain and other critics would have reacted to the Loving decision.

The Supreme Court is not supposed to be driven by the "will of the people." The constitution is anti-majoritarian, putting limits on the powers of government and protecting the rights of individuals against persecution by the majority. People may disagree with the logic of specific Supreme Court decisions, but statements like McCain's (and many other politicians and pundits, mostly from the right side of the political spectrum) show a lack of respect for the Supreme Court's constitutional role as well as a lack of respect for the constitution itself.

Before denouncing a court's decision it would also be wise to take the time to understand the court's rationale. When state or a federal courts rule legislative actions to be unconstitutional, they are finding that the legislative actions violate principles of the state or federal constitution. Many constitutional provisions concerning civil liberties are broad statements to guide how our society should be governed. It is the courts' role to ensure that we meet the standards that we aspire to through the constitution and reject laws that fail to meet those standards. A little reflection should be in order to ponder what those basic principles mean before trashing the decisions implementing them.

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Monday, May 12, 2008

In Memory of Loving

Mildred Loving died May 2 at age 68. She was the part American Indian (how she preferred to identify herself), part black woman married to a white man, Richard Loving, whose case went to the Supreme Court in 1967. In their unanimous decision the court struck down laws that banned interracial marriage in Virginia and at least 16 other states. At the time of their marriage in 1958, at least 22 states had miscegenation laws. When Barack Obama’s parents wed in Hawaii in 1960, their marriage would have been illegal in those same 22 states.

The case is cited by the most appropriate name I’ve ever seen for any Supreme Court decision, Loving v. Virginia. These two people loved each other and wanted to be married, and the Commonwealth of Virginia arrested them because of that. Virginia hasn’t always been for lovers.

The decision required that Virginia and any other state recognize the marriage of two adults, regardless of race, provided they met other legal requirements. The decision also did not require that any church, synagogue, or other religious organization perform interracial marriages, only that the states couldn’t deny them.

This case is relevant today not only because it made possible the marriage of a current Supreme Court justice (Clarence Thomas), but also because it provides the basis for courts to overturn bans on gay marriage. Even though Virginia law allowed Richard Loving to marry a white woman and Mildred Jeter to marry a black man, banning them from marrying each other based on race violated the equal protection and due process clauses of the fourteenth amendment.

The same logic applies to the case of gay marriage. A marriage is a contract between two adults entered freely. It is recognized by the state and provides privileges and imposes responsibilities. For the state to restrict the contract to one man and one woman rather than two men or two women, the same test should be applied that was used in Loving v. Virginia. It is not up to the state to protect the “sanctity (synonym, holiness) of marriage.” Any holiness is defined and conferred in a religious ceremony by a religious organization.

Mildred Loving was very quiet and did not expect her case to go to the Supreme Court. She wrote a letter to Attorney General Robert Kennedy in 1963 and he passed it along to the ACLU. Last year, on the 40th anniversary of the decision, she issued a statement urging that gay couples be allowed to marry.

Note that it took over 100 years for the Supreme Court to apply the fourteenth amendment to anti-miscegenation laws. One hundred years of tradition of anti-miscegenation laws was not reason enough and prejudice was not reason enough to uphold the practice. Nor should it be the case with same-sex marriage.

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Wednesday, April 16, 2008

The senator's got a gas problem

John McCain laid out his economic policies yesterday. He dropped his promise to balance the budget by the end of his first term in office and added a bunch of new tax cuts to his endorsement of making Bush's tax cuts permanent. So much for the fiscal responsibility he advocated when he voted against the Bush tax cuts before he decided to vote for them.

He's also developed a gas problem. He wants to suspend the federal gasoline taxes this summer, from Memorial Day to Labor Day. He's pandering appealing to voters who are bitter angry over high gas prices. We should be careful before mucking around with prices, though. The $.184 per gallon federal gas tax finances federal highway funding for states. It's also a form of a user fee for use of the publicly financed highways and a good tool to discourage energy consumption. A study by Resources for the Future, a Washington-based environmental policy think tank, concluded in 2002 that the optimal US gas tax would be about $1 per gallon, with the largest component of that reflecting the congestion effects of driving on crowded highways. Inflation would make that figure higher now.

Of course Obama and Clinton have their own gas problems. Both have endorsed federal subsidies for ethanol production, pandering, appealing to Democratic voters who mistakenly think that corn-based ethanol makes a significant contribution to improving the environment. Once you factor in the fossil fuels used to fertilize, harvest, and process the corn you get a small reduction in greenhouse gases compared to burning gasoline. Ethanol can also raise ground level ozone levels (smog) worse, although NRDC lays out a long-term (over several decades) strategy that could lead to reduced ozone with widespread ethanol combustion. I can also personally attest to about a 10% reduction in fuel efficiency from driving E10 (10% ethanol blend gasoline) around Illinois.

There's another agenda in promoting ethanol as well, pandering pandering (there's no cover here) to corn farmers in Iowa and other midwestern states, like Obama's home state of Illinois. And this causes a second problem: grain prices are rising sharply.

Corn prices first rose starting a few years ago. Then a lot of land previously planted with soybeans or wheat was planted with corn, reducing supplies of those grains and leading to rises in their prices too. High grain prices are now a global problem affecting poor people in developing countries. International aid programs are unable to buy as much food due to the high prices while more people are in need of aid because they can't afford to feed themselves.

Instead of trying to pick winners, it would be better to raise fuel efficiency standards for automobiles and raise the gas tax. I'd like to see the federal government commit to a program of slowly and steadily raising the gas tax. Raise it by $.02 every month for the next fifty months. That would push it up to $1.184 per gallon. It would rise slowly and people could plan ahead, knowing that high gasoline prices are here to stay. The additional revenue could be exactly offset by a cut in income taxes. Sell it to the public by saying "wouldn't you rather have your gas money go to an income tax reduction than to Hugo Chavez or the Middle East?"