Is The Goldman Sachs Case Mary Schapiro's Waterloo?

Despite the anger and the populist sentiment against the investment banks and a general populace belief that the banks caused the housing bust, the banking crisis and the economic recession, many knowledgeable attorneys, based on the facts as presented by the SEC in its civil complaint against Goldman Sachs, believe that Goldman Sachs did not violate any existing securities laws.

Unfortunately, SEC Chairman Mary Schapiro's timing looks political despite claims of denial by the White House and the SEC. The SEC filed its case against Goldman just before Congress began consideration of financial reform legislation and as President Obama pushed financial reform as a priority. Additionally, she was the deciding 3-2 vote to bring the case against Goldman.

Goldman Sachs is looking to rid itself of this case as soon as possible to protect its remaining reputation and to put a chill on other governmental investigations and investor lawsuits.

Settlement at this point is out of the question. The SEC will extract too high a price from Goldman. One of Goldman's options is to ask the court to either dismiss the case or grant summary judgment. Goldman will almost certainly file court motions for dismissal or summary judgment. It is just a matter of when.

If the court grants either a dismissal or summary judgment in Goldman's favor, it will make the SEC look even more politically motivated in bringing the case then it does now. It will be another major embarrassment for the SEC, along with the embarrassing settlement attempt with Bank of America over the Merrill Lynch deal, and the Madoff and Stanford scandals. Major changes will be called for at the SEC including a call for a new SEC Chairman.

Mary Schapiro is a loyal public servant with years of service at the SEC, the CFTC, NASD and FINRA. The Goldman Sachs case could turn out to be the end of Mary Schapiro's career at the SEC and possibly in government service. In being a loyal public servant in a populist administration, she may have put her career on the line in being the SEC Chairman and the deciding vote to bring an extremely weak case against Goldman Sachs.

Comment On Bankruptcy Reform Will Limit Bailouts Article In Wall St. Journal

A comment I posted to the Wall Street Journal article, "Bankruptcy Reform Will Limit Bailouts" by Thomas Jackson And David Skeel.

This is an old issue. The 1982 revision to the Bankruptcy code put in place exemptions for derivative contracts from the automatic stay provisions of Bankruptcy law. The automatic stay of filing for bankruptcy gives a firm time. It means a firm does not have to pay its debts immediately. The exemption to the stay means that going into bankruptcy does not prevent a firm from having to pay its derivative debts immediately even while it is in bankruptcy proceedings.

At least two professors, Columbia Business School Prof Franklin R. Edwards and Columbia Law School Prof Edward R. Morrison believe this provision increased the systemic risk of the Long Term Capital Management hedge fund collapse in 1998 and created the need for the Federal Reserve to step in after LTCM suffered investment losses.

See their 2005 paper, "Derivatives and the Bankruptcy Code: Why the Special Treatment?" at:
https://scholarship.law.columbia.edu/faculty_scholarship/2425/
It is ironic because the derivative exemptions to the bankruptcy stay were added to do just the opposite and decrease systemic risk.

House Congressional Democrats 2010 Reelection Chances Hurt By Goldman Charges

Surprisingly, the Democrats chances of maintaining control of the US House of Representatives declined from Friday to Monday after the SEC charges against Goldman Sachs were announced. The Intrade share price dropped 6 points from 56 to 50 on Monday and dropped another 3.2 points to 46.8 as of close of trading on Tuesday, April 20. The decline from 56 to 46.8 is a loss of almost 16.5 percent.

Following is the Intrade security for 2010 US House of Representatives Control as of close April 20, 2010:

The Democrats to control the House of Representatives after 2010 Congressional Elections:

Following is the Intrade security for 2010 US House of Representatives Control as of close April 20, 2010:

The Republicans to control the House of Representatives after 2010 Congressional Elections:

The Republicans chances of gaining control of the US House of Representatives increased from Friday to Monday after the SEC charges against Goldman Sachs were announced. The Intrade share price rose 3.2 points from 46.8 to 50 on Monday and rose to 50.3 as of close of trading on Tuesday, April 20. The increase from 46.8 to 50.3 is an increase of almost 7.5 percent.

Goldman's Abacus 2007 AC1 Flipbook

The Goldman Sachs Abacus Flipbook is no long available at the below article link, but is available on the NYU faculty webpage of Marco Avellaneda, Professor of Mathematics, Courant Institute of Mathematical Sciences, New York University at http://www.math.nyu.edu/faculty/avellane/ABACUS.pdf

Goldman Sach's Abacus 2007 AC1 Flipbook (from ritholtz, aka Barry Ritholtz of The Big Picture blog). It contains information about the synthetic CDO that is the basis of the SEC fraud complaint against Goldman Sachs:
30036962-Abacus-2007-AC1-Flipbook-20070226
The Goldman Sachs Abacus Flipbook is no longer available at the above link, but is available on the NYU faculty webpage of Marco Avellaneda, Professor of Mathematics, Courant Institute of Mathematical Sciences, New York University at http://www.math.nyu.edu/faculty/avellane/ABACUS.pdf

Another Comment On Goldman Vs SEC

Another comment I wrote to a Wall Street Journal article, "The SEC vs. Goldman: More a case of hindsight bias than financial villainy."

Goldman could have structured the whole deal and allowed Paulson to both own the equity position and short at the same time. Paulson would only have had to increase his short position to offset the addition of the equity portion. The fact that that there is no need to go through a charade of Paulson taking equity when he could have taken a real equity position to perpetrate the fraud, shows that no one was trying to perpetrate a fraud on the investors.

The WSJ opinion piece is correct that this appears to be nothing but a political play by Obama to get his financial reform passed.

The fact that the SEC asked Goldman in 2008 for info on this deal does not clear the SEC of politics. The SEC often asks Wall St firms for additional info about deals and securities. The SEC went to its file and found this older info inquiry about CDOs to make it appear non-political.

Emails from employees that the sky is falling are also irrelevant. Who has not worked in a company and heard the employees say the firm does not know what it is doing, or that it is ripping off customers, or if the customers only knew. It is normal office talk among cohorts, who think they know more than their bosses and everyone else. Many times the employees are just reflecting their own job frustrations.

Comment On Sec Challenges With Materiality Of Goldman Charges

A comment I posted to a Wall Street Journal article, "SEC Faces Challenges With Goldman Case" by Kara Scannell:

As a first step, the SEC will have to show that Paulson's involvement and shorting was material information to investors. I do not see it.

Paulson had no control or non-public information about the individual default rates of the mortgages. His involvement was to suggest more mortgages in the few states with the biggest housing bubble and with borrowers with lower fico scores. The mortgages in the pool and the selection criteria are disclosed in the offering documents. Furthermore, there is nothing to indicate that ACA did not have a final say about mortgage inclusion as the independent adviser.

Sophisticated investors at the time knew generally, that Paulson was shorting the residential mortgage market, as were other investors. Paulson's shorting did not begin with this offering and he had lost money shorting during the earlier stages of the housing bubble.

The fact that Paulson asked for Goldman to put together a portfolio to short against is not material. The fact that Paulson asked for more mortgages in bubble states with high risk borrowers is also not material since the mortgages are disclosed in the offering documents and by definition subprime mortgages are high risk borrowers and most likely in hot real estate bubble markets.

In fact, given Paulson's poor track record in shorting at the time, knowledge of his involvement probably would have led to more interest in the portfolio than less.

Paulson's involvement and shorting does not change the risk or expected returns of investing in subprime mortgages and the mortgages were fully disclosed by Goldman.

Investors who invested in the Goldman portfolio would have done so at the time even knowing Paulson was shorting it and asked for its creation.

Remember, all the parties involved were questioned by the SEC after they had all lost money investing in subprimes. Of course, they are going to say it was not their fault and Goldman misled them by not telling them of Paulson's involvement. They are just trying to protect their reputations by saying it was Goldman's fault.

This case will never go to trial. A judge will dismiss the complaint as a matter of law for a lack of materiality.

Comment On Goldman Sachs' SEC Complaint

The following is a comment I posted to the Wall Street Journal article, "Goldman Is Charged With Subprime Fraud" by Joe Bel Bruno, Fawn Johnson and Joseph Checkler:

Paulson & Co did not engage in any fraud. Shorting is a legal activity, even when one knows another party is long securities. It is also legal to submit requests of securities to include in a portfolio. There is often a give and take between institutional investors and underwriters about structure, portfolio and pricing so that the underwriting sells and meets the needs of the buyers.

There is no claim in the SEC complaint that the securities in the portfolio were misrepresented or that the portfolio was not as described. Saying that they were mostly from a few states and low fico scores is irrelevant because those were the states with the hottest home markets and all mortgage portfolios were heavy in those mortgages. If it were not the case, only this portfolio would have collapsed, but just about all subprime portfolios from all underwriters from the same time period lost most, if not all their value.

ACA was hired to select the portfolio and was named in the offering documents. The SEC is saying that Paulson influenced ACA's MBS selections and that Goldman should have disclosed Paulson's involvement and his short interest.

Even if ACA was influenced by Paulson, it is unclear Goldman had any duty to inform investors that Paulson & Co was involved or that it t had an effective short interest in those securities. ACA was not forced or coerced to accept Paulson's recommendations and could have objected to specific securities to include in the portfolio or removed itself from the underwriting.

ACA either agreed with Paulson's assessments or was completely negligent is accepting them. ACA and not Goldman may be at fault here but the SEC cannot sue ACA for a bad analysis or for outsourcing the analysis to Paulson.

The SEC will have to show that Goldman intended to defraud investors and set ACA up as a front to hide Paulson's involvement. It does that appear to be the case.

With or without Paulson's involvement, the offering would have lost a lot of its value shortly after issuance due to the collapse of the subprime mortgage and housing markets.

ACA seems to be covering itself and rewriting history to make it appear the subsequent portfolio losses were not due to its poor analytical ability to assess MBS and CDOs.

As often happens, after a risky investment loses a lot of its value, the SEC sues. Lawyers and SEC personnel do no understand risky investments and that risky investments can lose most or all their value without any fraud by the underwriter.

The issue is not that the investments lost most of their value. The issue is Paulson's involvement and whether Goldman had a duty to disclose Paulson's activity with ACA.

SEC's Civil Complaint Against Goldman Sachs For Securities Fraud

SEC's civil complaint against Goldman Sachs for securities fraud in underwriting a [synthetic] mortgage backed security (MBS) collateralize debt obligation (CDO) of subprime mortgages in early 2007. Specifically, Goldman failed to disclose Paulson & Co. was actively involved in selecting the mortgage portfolio while effectively holding a short position in the same mortgage portfolio through a credit default swap:
SEC Complaint - Goldman Sachs

Obama And Biden 2010 Income Tax Returns For 2009 Taxable Year

President Obama and Vice President Biden released their 2010 tax returns for the 2009 taxable year.

The Obama's reported an adjusted gross income of $5,505,409 and paid $1,792,414 in federal taxes. They paid $163,303 in Illinois state income taxes.

The Biden's reported an adjusted gross income of $333,182 and paid $71,147 in federal income taxes for 2009. They paid $12,420 in Delaware income taxes and $1,477 in Virginia income taxes.

The president's and Vice President's 2009 tax returns filed April 2010 are embedded below.

Obama and Biden taxable year 2010 tax returns filed April 2011 are available here.

President Obama's 2010 tax return for 2009 taxable year:
President Obama 2010 Complete Tax Return

Vice President Biden's 2010 tax return for 2009 taxable year:
VP Biden 2010 Complete Return For 2009 Taxable Year

Cutting Funding For Education Without Negatively Affecting Student Outcomes

Despite the more than double per pupil expenditure of inflation adjusted tax dollars on k-12 education from 1970 to 2005, there has been little, if any, improvement in student outcomes. Reading, Math levels and high school graduation rates have remained flat and unaffected by the increase in education expenditures.

The above chart is from the September 2008, Heritage Foundation report "Does Spending More on Education Improve Academic Achievement?"

The above chart is from the 2002, Hoover Institution report "Can Money Buy Better Schools?"

The obvious question, during these very difficult fiscal times of state and local finances and large federal budget deficits, is can we significantly cut k-12 per pupil expenditures without negatively affecting student outcomes?

If we can double per pupil outlays without positive impacts on student educational results, can we substantially reduce our education expenses, maybe by even half, without reducing student reading and math scores and without reducing high school graduation rates?

It seems likely.

See also the following, among many others, consistent studies of the lack of any positive relationship between per pupil education outlays and student outcomes, "Spending Increases Don't Improve Student Achievement: Report" and "PUBLIC SCHOOL SPENDING AND STUDENT ACHIEVEMENT: THE CASE OF NEW JERSEY."

CBO Discusses Limtations And Challenges Of Health Care Budgetary Estimates

Congressional Budget Office Presentation to the World Health Care Congress, "The Effects Of Health Reform on the Federal Budget" on April 12, 2010 by Douglas W. Elmendorf, Director, CBO.

The Effects Of Health Reform on the Federal Budget

Federal Regulators Faulted For Poor Bank Supervison

Regulators failed for years to properly supervise the giant savings and loan Washington Mutual, even as the company wobbled under the weight of risky subprime mortgages, a federal investigation has concluded.

The two agencies that oversaw Washington Mutual, the investigation found, feuded so much that they could not even agree to deem the company “unsafe and unsound” until Sept. 18, 2008.

By then, it was too late. A week later, amid a wave of deposit withdrawals, the government seized the bank and sold it to JPMorgan Chase for $1.9 billion. It was by far the largest bank failure in American history.

From "U.S. Faults Regulators Over a Bank" by Sewell Chan in The New York Times, April 11, 2010.

Are Lower Wages American Workers' Future?

The only way many of today's jobless are likely to retain their jobs or get new ones is by settling for much lower wages and benefits. The official unemployment numbers hide the extent to which American workers are already on this downward path. But if you look at income data you'll see the drop.

Among those with jobs, more and more have accepted lower pay and benefits as a condition for keeping them. Or they have lost higher-paying jobs and are now in new ones that pay less. Or new hires are paid far lower wages than the old. (In January, Ford Motor Co. announced that it would add 1,200 jobs at its Chicago assembly plant but didn't trumpet that the new workers will be paid half of what current workers were paid when they began.) Or they have become consultants or temporary workers whose pay is unsteady and benefits nonexistent.
***
The likelihood, therefore, is that as the economy struggles to recover and today's jobless begin to find work, the median wage will continue to fall—as it did between 2001 and 2007, during the last so-called recovery.

More Americans will be working, but for pay they consider inadequate. The approaching recovery will be tepid because so many people will lack the money needed to buy all the goods and services the economy can produce.

From "The Jobs Picture Still Looks Bleak" by Robert Reich in the Wall Street Journal Opinion, April 12, 2010. Reich is a professor of public policy at the University of California at Berkeley and former secretary of labor under President Clinton.

SEC Proposal On Asset Backed Securities

SEC Proposes Rules to Increase Investor Protections in Asset-Backed Securities

FOR IMMEDIATE RELEASE
2010-54

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Video: Open Meeting

Chairman Schapiro Discusses ABS:
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Washington, D.C., April 7, 2010 — The Securities and Exchange Commission today proposed rules that would revise the disclosure, reporting and offering process for asset-backed securities (ABS) to better protect investors in the securitization market.

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Additional Materials

• Proposal on Asset-Backed Securities
• Submit comments on this proposal

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The proposed rules are intended to provide investors with more detailed and current information about ABS and more time to make their investment decisions. The proposed rules also seek to better align the interests of issuers and investors by creating a retention or "skin in the game" requirement for certain public offerings of ABS.

"The rules we are proposing stem from lessons learned during the financial crisis," said SEC Chairman Mary L. Schapiro. "These rules if adopted would revise the regulatory regime for asset-backed securities in order to better protect investors."

Asset-backed securities are created by buying and bundling loans — such as residential mortgage loans, commercial loans or student loans — and creating securities backed by those assets, which are then sold to investors. Often, a bundle of loans is divided into separate securities with different levels of risk and returns. Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities.

Most public offerings of ABS are conducted through expedited SEC procedures known as "shelf offerings." ABS offerings also are sold as private placements which are exempt from SEC registration. ABS private placements are typically sold to large institutional investors known as qualified purchasers (QIBs).
Public comments on the proposed rules should be received by the Commission within 90 days after its publication in the Federal Register.

# # #

FACT SHEET

Overview:

During the financial crisis, ABS holders suffered significant losses and the securitization market has been relatively dormant ever since. The crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets and over-relied on credit ratings assigned by rating agencies, which, in many cases, turned out to be wrong.

The proposed rules seek to address the problems highlighted by the crisis and to head off the next one, by giving investors the tools they need to accurately assess risk and by better aligning the interests of the issuer with those of the investor.

The Proposed Rules:

Specifically, the Commission's proposals would:

Require the Filing of Tagged Computer-Readable, Standardized Loan-Level Information

Under the current ABS rules, information about the loans in an ABS pool is required only at the pool level. The SEC will consider whether to propose new disclosure rules that would require ABS issuers to provide specific data for each loan in the asset pool both at the time of securitization and on an ongoing basis.

The loan-level data would cover items such as the terms and underwriting of the loan, credit information about the borrower, and/or characteristics of the property securing the loan. To make the required information comparable among issuers of the same asset class and more useable to investors, the rules require that the data be provided according to proposed standards and in a format tagged in eXtensible Markup Language (XML) so that it may be processed by computer. This would enable investors to synthesize large amounts of data about the underlying assets.

Examples of the types of information that would be provided for each loan in the pool include:

• A number identifying each loan so that the loan and its performance can be tracked throughout the life of the security.
• Disclosure of whether or not the loan was made without following the stated loan underwriting standards.
• Disclosure of the extent to which the obligor's income was verified (e.g. did the lender look at W-2 forms and tax returns?).
• Detailed information about the steps being taken by the servicer to limit losses on loans that are not being paid in full.

The proposal requiring loan-level information would apply to ABS issuers that offer securities backed by residential mortgages, commercial mortgages, automobile loans and leases, equipment loans and leases, student loans, floorplan financings, corporate debt, and ABS backed by other ABS.

ABS that are backed by credit card receivables may have millions of accounts in the pool, so those offerings would be exempt from loan-level information requirements. However, proposed new rules would require issuers to disclose more granular information regarding the underlying credit card accounts in tagged, computer-readable and standardized groupings. Under the proposed rules, issuers of ABS backed by credit cards would present statistical data about accounts with similar characteristics grouped by credit score range, age of account, payment status, and geographic location.

Require the Filing of a Computer Program That Gives Effect to the Waterfall

The SEC will consider a proposal requiring, along with the filing of a prospectus for an ABS transaction, the filing of a computer program that demonstrates the effect of the "waterfall." As noted above, the waterfall dictates how borrowers' loan payments are distributed to investors in the ABS, how losses or lack of payment on those loans is divided among the investors and when administrative expenses such as servicing those loans are paid to service providers. Currently, a narrative description of the waterfall must be disclosed to investors in the prospectus. The computer program of the waterfall would allow the user to input the loan level data that would also be required to be provided, as described above, giving investors and the markets better tools to analyze an ABS offering.

Provide Investors with More Time to Consider Transaction-Specific Information

The SEC will consider whether to impose time limits before a sponsor of the ABS can conduct the first sale in a shelf offering. Under current rules, issuers may sell ABS almost immediately, without providing investors a minimum amount of time to review the disclosure in the offering materials.

The SEC will consider whether to propose requiring that issuers, for each off-the-shelf takedown or offering, file a preliminary prospectus at least five business days before the first sale in the offering. This would give investors time to consider transaction-specific information, including the loan level data described above, before an investment decision needs to be made.

Repeal the Investment Grade Ratings Criterion for ABS Shelf-Eligibility

Under existing rules, an ABS offering is not eligible for an expedited offering unless the securities are rated investment-grade by a credit rating agency. The SEC will consider whether to propose new ABS "shelf" eligibility criteria to enhance the type of securities that are being offered and the accountability of participants in that securitization chain.

The proposals would require, as a condition for shelf-eligibility, that:

The chief executive officer of the ABS issuer certify that the assets have characteristics that provide a reasonable basis to believe that they will produce cash flows as described in the prospectus.

The ABS sponsor hold five percent of each class of asset-backed securities and not hedge those holdings.

The ABS issuer provide a mechanism whereby the investors will be able to confirm that the assets comply with the issuer's representations and warranties, such as representations and warranties that the loans in the ABS pool were underwritten in a manner consistent with the lenders' underwriting standards.

The ABS issuer agrees to file Exchange Act reports with the Commission on an ongoing basis (rather than stop reporting with the Commission in the first year, which the Exchange Act currently permits many ABS issuers to do).

While ratings would continue to be allowed for ABS offerings, the proposed rules would eliminate the ratings requirement from the SEC's expedited shelf-eligibility test. Additionally, the added information and time provided under the proposals should allow investors to perform their own analyses and rely less on ratings.

Increase Transparency in the Private Structured Finance Market

The SEC will also consider whether to propose disclosure requirements that would increase transparency in the exempt private structured finance market where some types of asset-backed securities, such as collateralized debt obligations (CDOs), are sold. Under these proposals, where an SEC safe harbor (e.g., Rule 144A or Regulation D) is relied upon for the unregistered sale of securities, the issuer must provide investors, upon request, at the time of the offering and on an ongoing basis, the same information that would be required if the offering were registered with the SEC or if the issuer were required to report with the SEC under the Exchange Act.

The SEC also will consider a proposal to require that an ABS issuer file a public notice of the initial placement of securities to be sold under Securities Act Rule 144A. This notice would require information about those ABS offerings and would be publicly filed with the SEC in its EDGAR database. Form D, the notice of an offering made in reliance on Regulation D, also would be revised to collect information on structured finance products.

Make Other Revisions to the Regulation of ABS

The SEC also will consider whether to propose other revisions regarding ABS. Among other things, the SEC will consider whether to propose to:

• Standardize certain static pool disclosure.
• Amend the Regulation AB definition of an "asset-backed security" to better ensure that investors have sufficient information about the securities.
• Require additional information regarding originators and sponsors, such as information for certain identified originators and the sponsor relating to the amount of the originator's or sponsor's publicly securitized assets that, in the last three years, has been the subject of a demand to repurchase or replace.
• Lower the threshold change in the material pool characteristics that triggers the filing of a Form 8-K (pursuant to Item 6.05) from five percent to one percent.
• Specify, in addition to the loan-level proposed requirements, the disclosure that must be provided on an aggregate basis relating to the type and amount of assets that do not meet the underwriting criteria that is described in the prospectus.

http://www.sec.gov/news/press/2010/2010-54.htm

Bond Markets Predicting An Almost Doubling Of The 5 Year Treasury Rate

The US Treasury Bond Market, as of 2:00 PM in NY, is predicting an almost doubling of the interest rate on future 5-year US Treasury Bonds.

Bloomberg reported yields show the 10-year Treasury yield at 4.00 percent and the 5-year Treasury yield at 2.75 percent.

The market is expecting 5-year US Treasury Bond yields to jump to 5.27 percent. Rates are expected to rise by more than 2.5 percent, or almost double the current rate.

The market expectation of the 5-year bond interest rate after the maturity of the current 5-year US Treasury bond can be derived from the yields on the current 5 and 10-year bonds.

The 10-year yield is the average of the yield of the current 5-year Treasury bond and the expected yield of a 5-year Treasury bond issued at the maturity of the current five year bond for the remaining 5 years until the end of the term of the current 10-year Treasury bond.

Similar types of calculations can also be computed for inflation from the Treasury Inflation bonds (TIPS) and the regular US Treasury Bonds.

The inflation rate for the next five years is expected to average around 2.2 percent and then rise to an average 2.3 percent for the following five years.

The modest change in expected inflation shows that the increase in future interest rates will mostly come from an increase in the real rate of interest. The real rate of interest is expected to rise from the current .52 percent to around 2.37 percent, as the Federal Reserve stops artificially keeping short-term interest rates low, and as the economy recovers.

Markets Bet Against The Discovery of A Higgs Boson Particle

Observation of the Higgs Boson Particle
Higgs Boson Particle to be observed on/before 31 Dec 2013.


Intrade markets bet against a Higgs Boson particle found before December 31, 2013. The price has dropped from 50 to 29 in the last few months even as the Large Hadron Collider began to smash sub-atomic particles together and record the data of their collisions for analysis.

The Higgs Boson is considered the most likely current candidate for our understanding of mass. If the LHC does not find a Higgs Boson then alternative theories of mass will become much more likely.

if the Higgs Boson does not exist, then the very successful Standard Model of particle physics will have to be reworked.

To date all tests confirm the Standard Model, which unites and explains the three of the four main forces of nature, the weak force, the strong force and the electromagnetic force. It does not explain or unite with the other three forces, the fourth force, gravity. It also does not explain dark matter or dark energy.

Broken Window Fallacy Video

(HT: Cafe Hayek, Don Boudreaux)

ObamaCare Highlights Weaknesses Of CBO Cost Estimating Process

To prevent unrealistic Congressional Budget Office projections of the effects of proposed legislation on the US deficit and budget, CBO must make changes to its process for evaluating the cost of new legislation.

In passing health care reform, Congress was mindful of the Congressional Budget Office's tally over the next decade of the net cost of the final legislation. In particular, Congress manipulated the structure and timing of the law's taxing and spending provisions to meet Obama's $900 billion cost target.

CBO does an honest, best guess analysis of the expected costs of proposed legislation, but CBO works within the cost estimating guidelines established by Congress. For example, CBO projects expected revenues and costs from new legislation under the assumption of a static economy, and it ignores the effect of other likely legislation.

Unrealistically, CBO estimates that new taxes or new mandated employer costs do not change consumption or tax revenue estimates. When economists model tax or price changes, they use more realistic dynamic stochastic general equilibrium (DSGE) models and not static models. DSGE models attempt to accurately reflect behavioral changes caused by tax, cost and price changes. DSGE models of the new health care reform law would show that the new law slows economic growth, slows employment growth, and that tax revenue will be lower than expected.

Furthermore, CBO follows rules that require it to evaluate only the legislation under review and not to consider other likely Congressional laws. For example, in recent years, Congress passed a one-year law delaying legally mandated Medicare cuts. When CBO evaluated ObamaCare, it included the new Medicare cuts in ObamaCare as potential cost savings because they are legally mandated. It ignored the high likelihood that Congress would pass another law delaying or reducing the proposed Medicare cuts. It also ignored that Medicare cost increases were unsustainable and that Congress would pass cuts out of necessity without the passage of ObamaCare.

As a result of CBO's process, the new health reform law contains tax and cost saving provisions that reduce CBO's cost estimate and increase CBO's revenue estimates but that do not reflect realistic, real world, estimates of those numbers.

A President and a Congress who truly cared about the long-term US deficit, the looming high taxes, and the continued affordability of government social programs would modify CBO's process for assessing the costs and revenues of new programs, taxes, and legislation to reflect real world effects.

To accurately reflect the growth, employment, tax and cost effects of new legislation, the CBO must modify its legislative cost and revenue estimating process. CBO needs to switch to a dynamic, as opposed to static, modeling of the economic effects of new legislation. It also needs to take into account likely subsequent legislation that would undo part of the revenue or cost benefits of the legislation under review.

It would make a lot more sense for CBO to give separate numbers and a range as part of its analysis instead of one net number. CBO should give a range, under dynamic modeling, for likely costs and likely revenue of the new legislation and a likely high and low net cost. Additionally, CBO should forecast the effects of the passage of other likely legislation that would significantly affect the costs or revenue impacts of the legislation under review.

The proper changes to CBO's cost estimating process would eliminate a lot of the unrealistic political budget deficit gamesmanship that occurred during the debate for health care reform. The suggested changes would improve the accuracy and usefulness of CBO's forecasts. A better CBO forecasting process will also help the US reduce its long-term budget deficit.

The New Health Care Law Is a Temporary Duct Tape Solution: It Ignores The Basic Economic Forces At Play

Drafting a good [health care reform] bill would have been easy, he [Nobel Economist Gary Becker] continues. Health savings accounts could have been expanded. Consumers could have been permitted to purchase insurance across state lines, which would have increased competition among insurers. The tax deductibility of health-care spending could have been extended from employers to individuals, giving the same tax treatment to all consumers. And incentives could have been put in place to prompt consumers to pay a larger portion of their health-care costs out of their own pockets.

"Here in the United States," Mr. Becker says, "we spend about 17% of our GDP on health care, but out-of-pocket expenses make up only about 12% of total health-care spending. In Switzerland, where they spend only 11% of GDP on health care, their out-of-pocket expenses equal about 31% of total spending. The difference between 12% and 31% is huge. Once people begin spending substantial sums from their own pockets, they become willing to shop around. Ordinary market incentives begin to operate. A good bill would have encouraged that."

From "'Basically an Optimist'—Still: The Nobel economist says the health-care bill will cause serious damage, but that the American people can be trusted to vote for limited government in November," by Peter Robinson in the Wall Street Journal on March 27, 2010.

Just because the new health care reform law was a tough political battle, it will not be the end or the solution to US health care problems.

The new health care law, including its amendments, does little or nothing to undo the economic incentives and forces created by the tax deduction to the employer of the health care employee benefit, the exclusion from employee taxable income of the value of their health care benefit, the expectation that health insurance will cover all health related costs, that health related costs are primarily paid by third party payers with no incentive for the user to limit or negotiate costs, government mandates of excessive minimum coverage, and the inability to risk price insurance.

Any architect who ignores the physical laws of nature, such as gravity and the structural strength of his materials, will watch his building collapse before his eyes. The new health reform law ignores all the economic and incentive forces at play in current health care and attempts to contain these forces through patches and duct tape. The new health care law is doom to failure. It is just a matter of time until the forces created by the employer tax deduction, the third party insurance payment system, and the lack of price transparency to the end user make the new law unworkable.

Additionally, the new law uses extensive government subsidy to avoid accurate price setting and price transparency. Without market pricing, poor allocation of resources and rationing will occur.

Just as gravity never ceases, the old economic forces that remain after health reform will create a mess of US health care costs and use under the new law.

See my December 15, 2009, post, "Health Care Reform Is Easy: Politics Is Hard"

What's Next For US Healthcare?

The new health care law, with or without amendments, is a yet to be built structure. It is an architect's plan of an interpretation of a vision of health care. There are stated and unstated goals that will or will not be met in the final structure once it is erected.

No one truly knows what the final health care system will look like. No one understands how all the parts, all the regulations, all the economic forces, all the wealth distribution, all the changes to health insurance, health care, Medicare, and taxes will interact.

No one knows what GDP effects the new law will have on the health care sector or the entire US economy. No one knows what effect the new spending and most likely increased US debt will have on the Treasury market and on the US dollar.

It will be years before the law is fully implemented and the parts that are set into motion are then again stable.

The Second World War wage freeze indirectly created the employer health care employee benefit and it became one of the prime movers of health care problems 60 years later. Likewise, the new law in a couple of decades will put the US in an economic and political situation it never envisioned.

There are risks to rolling stones down hills. Sometimes, they create avalanches. Sometimes, they are just a few stones rolling down hill.

It is impossible for anyone to say the US will be better or worse for the new law at this time. It will be years before any accurate assessment of the new law will occur.

Like any new house built from plans, there will be some good parts, some minor, easily fixed structural problems, some emergency repairs, some wish list changes and some I learned my lesson never to do again problems.

As of Tuesday, US health care is a ship that has entered uncharted waters. Whether it easily reaches port or faces dangers along the way is unknown. Let us hope enough watchful eyes know how to keep health care on course as it navigates new, uncharted waters. Let us hope the architect's plans of the new structure were enough to build a lasting and sound edifice.

My best guess is that the parts of current health care that people like that are no longer available will be put back into health care. The new parts that people like will stay. Proposed spending cuts that are politically difficult will not be made.

In the end, the US will wind up with an amalgam of old and new health care in a structure that no one envisioned as part of the new legislation with a cost structure very different than projected.