Budget Nomenclature

Here's something that's a little fun...Every time a new President submits their budget proposal to Congress, they give it a catchy slogan. You’ve got to hand it to these Presidential wordsmiths, they are nothing if not consistent. See if you can match the official budget slogan with the right administration:

1) “A vision of change for America”
2) “Building a better America”
3) “America’s new beginning”
4) ”A new era of responsibility”
5) “A blueprint for new beginnings”

a) Barack Obama
b) George Bush
c) Bill Clinton
d) George H.W. Bush
e) Ronald Reagan

Very creative.

Comparing the future- a historical look at budgets

Unprecedented, or unremarkable?
Radical, or reasonable?
Foolish, or prudent?

These are just some of the adjectives being used to describe the 2010 budget proposal submitted to Congress by President Obama. The Republican opposition has already begun to refine its red scare messaging, while liberal special interest groups are salivating over the pork that’s coming out of the budgetary oven. The seemingly optimistic economic assumptions underpinning the budget’s spending goals have led some economists to question whether the President can get what he wants without raising taxes, while others are goading him to spend more.

So where does this budget stand in relation to his predecessors’ proposals?

A quick look at previous budget proposals reflects a lack of connection between a president’s initial budget and what ends up happening. President Obama’s proposed increases in receipts might be a bit rosy given the current economic downturn, but they are in line with previous administration’s increases. The same can be said of proposed increases in spending.

Some consistencies emerge….

Receipts forecasted to grow over prior periods, but the actuals usually end up lagging predictions...

Spending is usually forecasted to grow over previous periods, but always increases even more than predicted…


Concordantly, deficits continue to outpace expectations…

The concern held by many is that Obama's spending priorities will further exacerbate deficits, but if the historical data is any indication, anything can happen. The unique combination of Bill Clinton, a conservative congress and a booming economy resulted in a government that took in more than it forecasted, spent less than it expected, and brought the first surplus in decades.

A little help for the FDIC

The FDIC is taking a little breather from bailing out failed banks to... wait for it... be bailed out itself. Turns out that this "no cost to the taxpayer" program that was supposed to be funded by deposit insurance premiums was charging too low of a rate, and is now stock dangerously undercapitalized (thanks to a provision that the FDIC's fund should be capped at 1.25% of deposits). So Senator Chris Dodd (D-CT), Chairman of the Senate Banking Committee, introduced a bill at the behest of FDIC Chairwoman Sheila Bair to raise the FDIC's borrowing maximum from $30B to $500B, a better than 10x increase.

This is a prudent move. The FDIC's deposit insurance fund is running dangerously low, with only $35B in the insurance fund as of Q3 2007, dropping to $19B by year end. The result is a paper-thin base of capital to insure deposits: the FDIC's $19B of capital amounts to 0.4% of U.S. deposits (known as the Deposit Insurance Fund Ratio, or DIF ratio). This is a substantial drop from the usual 1.2%+ range. To raise this ratio, the FDIC has two options: borrow from Treasury, or make the banks pay more. Making the good banks pay for the bad banks' mistakes during a credit contraction has drawn howls of protest (including from this space). Eliminating any doubt of the FDIC's solvency is the right move at this moment in the crisis... let's hope Congress speeds through this policy change.

Stimulus 2009 – Tax Relief for Debt Repurchase

On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009. A portion of the bill allows for tax relief to companies that repurchase their own debt at a discount. The bill will provide significant benefits for private equity funds that repurchase debt on behalf of their portfolio companies. The rationale behind the bill is to incent cash strapped, highly levered companies to repurchase their debt; the reduced burden of the high debt service (interest and amortization payments) would leave the companies more nimble and less likely to layoff employees in the downturn. The tax relief is estimated to cost the Treasury $1.6B over the decade; however, it will be more costly in the near term – $42B reduction in tax receipts over the next three years.

Part IV – Rules Relating to Debt Instruments (starting on page 224), Section 1231 lays out the specifics regarding the repurchase of debt; the law firm Sidley Austin LLP provides a good summary of the new legislation as well.

‘‘(1) IN GENERAL.—At the election of the taxpayer, income from the discharge of indebtedness in connection with the reacquisition after December 31, 2008, and before January 1, 2011, of an applicable debt instrument shall be includible in gross income ratably over the 5-taxable-year period beginning (in 2014)

Current tax requires a company that repurchases its own debt at a discount to recognize income in the current year in the amount of the discount of the debt. For instance if the company issued $1.0mm of debt, but repurchased the debt for $700,000 to recognize $300,000 ($1,000,000 - $700,000) of cancellation-of-debt (COD) income -> resulting in a ~$100,000 tax bill if taxed at 34% marginal tax rate.

New tax legislation allows companies or related parties (private equity funds) that repurchase debt a discount in 2009 and 2010 to defer the COD income over a five period beginning in 2014. In the above example, the Company would recognize $60,000 ($100,000 / 5) of COD income in each tax year 2014-2018.

The legislation also allows for tax deferral if the debt is restructured via a debt-for-debt exchange, from significant modification of the existing debt instrument, or from complete debt forgiveness – which may the case for ‘debt’ provided by financial sponsors.

The legislation should provide the appropriate incentives for companies to delever and maintain a prudent capital structure. The reduced leverage and cash savings also should reduce the number of bankruptcies and out of court restructurings, hopefully reducing layoffs. Critics point out that companies with enough cash to repurchase debt are not in need of a stimulus, thus the $42B in tax relief could be more effectively placed in other areas of the economy. While these companies may have the cash today, the bill is designed to reduce the likelihood that currently solvent & liquid companies become insolvent and/or illiquid.

Reinstate the Draft

President Obama sports an ambitious agenda that includes restarting the economy, fixing unemployment, rebuilding infrastructure, improving government efficiency/accountability, all while playing nursemaid to the regeneration of individual civic responsibility. There is one stone that could be used to kill all of these birds simultaneously. Reinstate the draft.

A 21st century “draft” would go beyond military service and resemble the service obligations in place throughout Europe. Even though the last draft notices were mailed out by the Department of Defense in 1973, male Americans from the ages of 18-25 are required to register for the selective service draft in the event that they may be called up to serve in the military. Co-opting that process for a broader purpose, the federal government could create a program that requires all American citizens to provide 24 months of civil service by their 25th birthday.

Projects

One of President Obama’s favorite tag lines is the “shovel-ready project”, referring to a project that lacks only money and manpower. These programs evoke the spirit of the Civilian Conservation Corps, (CCC) which employed low-skilled workers in the construction of national parks and forest management. In today’s world, one can imagine a whole host of projects that could receive these workers. Existing governmental organizations like the military, homeland security and infrastructure maintenance (DOT) could swallow millions. NGOs ranging from the United Nations to the Salvation Army could take thousands more. Other recipients could include domestic non-profits, state and local governments, schools and universities, foreign aid programs, federal research facilities and government-funded arts programs. The only requirement for eligibility would be non-profit status and the demonstrated provision of benefits to the public. Hypothetical examples would include:

· A college graduate with an economics degree working as an analyst for the Dept. of Commerce
· A high school graduate working as a firefighter for the Forest Service
· A law school graduate clerking in a state appellate court
· A vocationally-certified diesel mechanic working as a volunteer contractor for a U.S. peacekeeping force.

Employment

According to 2000 census data, roughly 1.5% of the population turns nineteen each year, requiring of educational institutions and the job market to absorb 4.5 million people. With an economy that once consistently grew faster than the rest of the world, this once wasn’t a problem. But the recent crisis highlights an alarming trend. Over the past ten years, the unemployment rate of young workers has been on an upward pace. The graph below compares unemployment levels for the 19-24 and 25-54 age groups.

The relative gap in unemployment for the two groups has increased 25% in the last ten years (going from 4% to 5%), and at the end of 2008, the nominal unemployment rate for the 19-24 age group hit 11.3%. There are many possible reasons for this, but one sobering possibility is that our school systems are failing to provide this generation of workers with the skills required by an increasingly competitive global economy, putting new entrants to the job market at a disadvantage. At the top and the bottom of the skills spectrum, opportunities seem to remain relatively stable for young workers, but in the middle, those opportunities seem to be narrowing. This is overwhelmingly hitting those that should hypothetically comprise the middle-class: high school graduates, alumni of community colleges, vocational schools and, increasingly, four year universities.

As the average educational debt burden grows (in 2008, the average loan debt for college graduates was north of $20,000, a 6% increase over last year), a widening post-graduation employment gap will drive many students into financial distress. Faced with that possibility, 18-year olds may choose to postpone or avoid college, diminishing the overall productivity of the workforce and reducing America’s global competitiveness.

A civil service draft would provide a cushion for those students, giving them a two-year period to defer their loan costs and build a financial buffer. During those two years, they would also have the opportunity to continue their training and education, making it more likely that they would find employment after completing their obligation. The resultant unemployment curve would instead look something like this:

Paying for the program

The financial cost of the civilian service program would be large, but manageable. Assuming that the government subsidized an average fully loaded salary of $35,000 per year, with 15% defrayment coming from the participating organizations, the program could be supported at a cost of 3.5% of total government spending. It is assumed that state and local governments would shoulder a portion of the costs, with federal transfers covering the rest.

The true economic costs the program would be difficult to measure, given that some “crowding out” of the private sector would undoubtedly occur. Furthermore, for high-productivity individuals, the two year obligation might destroy some private sector wealth creation. These figures also do not factor in the costs for implementing and managing such a massive program, which would involve twice the number of people as are currently serving in the military.

At the same time, the potential benefits of the program could hypothetically dwarf any costs. Marginal increases in worker productivity would payout over the life of each worker, and the improvements in physical and organizational infrastructure would reduce systemic inefficiencies that add to the economic cost structure of the country. The program could create a improved sense of personal responsibility and shared cultural identity. This could serve to reduce crime, increase civic participation and increase domestic stability. It would also help to ease the burden on our taxed military forces and stimulate a increase in foreign volunteer work, improving foreign relations and increasing global stability.

From an implementation perspective, this idea is more of a thought exercise than an actual policy suggestion. Political resistance to the idea could be insurmountable, and the sheer logistics of incorporating the structure of this program into our society would create serious cultural dislocation. Simply put, it is a bit of a wacky idea. But given the dramatic steps taken by the government in the last few months, which includes nationalizing banks and taking effective control over automotive industry planning, nothing seems that wacky anymore.

Bailing out banks: who's in, and who's out?

Wall Street's latest fascination with Washington comes over the subject of bank nationalization. Senator Christoper Dodd, Chair of the Senate Banking Committee, suggested nationalization might be necessary, sending the markets plunging. The White House wasted no time in responding at the daily press conference, noting, "[T]his administration continues to strongly believe that a privately-held banking system is the correct way to go, ensuring that they are regulated sufficiently by this government. That's been our belief for quite some time and we continue to have that."

Nationalization is scary to banks because it means some investors will be saved while others are wiped out. At the extremes, who's in and who's out is obvious. Holders of common equity will almost definitely be wiped out in nationalization; deposit holders would be made whole. The intermediate providers of capital, senior and subordinated creditors, counterparties to derivative contracts, trust-preferred holders, and preferred stock holders, have differing levels of ambiguity as to whether they would be bailed out, wiped out, or something in between. This ambiguity relates to the property rights the holders of these securities possess. This ambiguity causes tremendous problems.

First, capital that has no restrictions on its withdrawal will be withdrawn. That is, there will be a bank run. Since the FDIC insures deposits, retail deposits won't run, but other short-term funding will either be withdrawn, or for short-dated maturities, will be difficult to refinance with new debt (roll over). The FDIC stepped in to limit the difficulty in rolling over senior debt by agreeing to insure this debt through the Temporary Liquidity Guarantee Program, solving in part this problem.

The second problem is that existing securities will trade with every rumor floating around as to whether the banks will be nationalized or not, AND on every rumor of whether a particular secruity will be included in the bailout or not. This particularly relevant post on the very good Bronte Capital blog describes the problem with including different securities in different situations, as shown through FDIC takeovers of banks. Indeed, this is evident in the common stock fluctuations of the major banks through the course of last Friday - the higher a chance of nationalization, as determined by Dodd's statements, the lower the share price.

It is worth noting that while management is concerned about the common equity price (WSJ, gated) to which their personal economics is tied, the common equity price is of less concern to regulators. Banks could continue to operate at any equity price, as long as the creditors of the bank do not take the low equity price to be indicative of an imminent default on the bank's debts.

The third challenge is that it makes it difficult (impossible?) to attract new private capital. New capital providers are hesitant to invest when they face the possibility of losing their capital to nationalization.

Each statement by regulators, legislators, or the Administration increases the ambiguity banks operate under, necessitating new bailout programs, increasing security volatility, and limiting the ability of banks to raise new private capital. The Administration's current approach, denying nationalization as a possibility (even while other key decision makers discuss it's virtues), has little credibility. The market's are understandbly sceptical that the Administration would rule out a course of action that many noted commentators are advocating for. Instead, the Administration should clarify the property rights of these security holders under any circumstance.

Exactly what rights need be clarified? First, what banks would be considered for nationalization, if it should come to that stage. Clearly the government would have criteria as to what banks would be nationalized (or bailed out in some other fashion). Clarifying these criteria will allow borderline banks to have a clearer sense of their future. Second, and perhaps most importantly, the government must clarify what classes of securities and other claimants would be bailed out. A best guess, as a simple starting point, is that existing depositors, counterparties, and senior creditors would be made whole (including rollovers of existing debt), while subordinated debtholders and all forms of equity-holders (including preferred, trust, common, and all options and warrant holders) would be extinguished.

Merely this clarification would have several immediate effects. Debt holders would freely leave capital committed and would permit rollovers of maturing debt. Securities markets would immediately adjust: bank securities that would be protected under nationalization would trade to prevailing yields. Equity holders, while concerned about nationalization, would benefit from the banks' ability to again conduct business free from uncertainty of solvency concerns.

Paired with this announcement, the government could encourage additional private capital into the banking market by allowing equity capital issued after the announcement to be put back to the government at par (or some fixed ratio to par, say 90%) upon a nationalization event in the next five years (at which point it would convert to common equity). With this effective government guarantee in place, the banks would be able to raise equity capital in the private markets. If nationalization never occurs, the government never intervenes or uses any taxpayer capital. If banks are nationalized, it would not be due to the very fear of that nationalization, but rather a belief that banks are deeply insolvent and that no injection of capital would produce an attractive return. (That is, losses at the bank would be so great as to swamp earnings for years to come).

This approach would minimize the disruption caused by nationalization rumors, would reopen the private capital markets, and would help to align interests. Managers could be compensated on un-guaranteed equity, re-establishing the investors balance between fear and greed. They would have the incentive to avoid nationalization by raising substantial new capital and making prudent lending decisions - they would fear losing their equity stake. On the flipside, they would want to deploy capital intelligently to maximize the return to their equity stake - the greed to maximize their options.

This solution is clearly a bridge approach - the market and regulatory failures that brought the current crisis into existence still need remedy. Other issues would also need to be considered - restarting lending, moral hazard, and agency costs - before implementation. But, this approach would stabilize markets, limit the intervention of government into the private markets, and rely predominately on private capital, virtues all.