Altus Insight September, 2017

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: September 30, 2017
FR: Forrest Jinks
RE: Moral Hazard and When the Chickens Come Home to Roost

 

“‘Moral Hazard’ is defined as a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.”

The Economic Times

Moral Hazard was a big topic of conversation during the Great Recession, both in regards to the bail outs received by big banks and insurance companies (Citibank is heavily back in the market of synthetic CDOs[1]), and in relationship to the government bailout programs for individual home owners (e.g. HAMP). In both cases those in favor of such bailouts argued those bailouts were a necessity to stave off certain ruin of the country’s economy. The argument against such bailouts was that they would create moral hazard, a situation where people or entities would partake in riskier behavior than they would otherwise normally have, knowing that the government would bail them out. A government bailout should really be called a tax payer bailout, because all government funds come on the backs of some tax payer somewhere. In the case of the individual homeowners, the argument then followed that those receiving the bailout not only were being rewarded for poor decisions, but since the bailouts were being paid for by those that didn’t need the bailouts, those that made responsible decisions were being penalized for the benefit of those that made poor decisions.

Fast forward to Hurricane Harvey and the damage done in Houston. For the first time since taking office[2] President Trump cooperated with democratic lawmakers to rush through a massive aid package and debt ceiling extension[3]. From a humanitarian perspective it is hard to argue with such efforts and I am sure a part of all of us is heartily in favor the benefit afforded. There are, however, counter arguments. One of the best I have seen was presented many years ago in a speech on the Congress floor by Representative Davy Crockett. The speech was recorded in William Groneman’s “David Crockett: Hero to the Common Man” and can now be found here. This was, of course, prior to Crockett going to Texas to assist General Sam Houston (small world, huh?) in the fight for Texas’s independence from Mexico. (A Sam Houston fun fact: He was later the Governor of the state of Texas and the only southern governor to oppose the South’s secession from the North.) This is another case of moral hazard. Many people in the area had flood insurance, many did not. Those with flood insurance have borne the cost of such insurance, taking funds they could have otherwise spent on any number of other items or investment. Now, with government funds being dropped on those without insurance (and remember, government funds are really taxpayer funds), those with insurance not only bore the cost of their own insurance, they are now bearing the cost, through their taxes, of paying for the property of their neighbor who didn’t get insurance in the first place. And while I am sure they are rare in occurrence, there are those that have collected on government funds to rebuild their properties several times over.

For clarity, the above presentation of opinion doesn’t mean I believe Houston (and Florida, and Puerto Rico – who pay no federal taxes at all) shouldn’t receive help. I am just presenting that the help in its current form creates moral hazard and social winners and losers. I am much more in favor of direct donations, made out of the concern of the heart and without coercion. Such donations can be made to the Hurricane Harvey relief fund here or here[4].

We are just getting started with moral hazard. I am a huge believer in a true capitalistic democracy as the imperfect but best method of government and economy. However, our system of elected officials has created a case of massive moral hazard, not seen at any point in the history of our country. Simply put, our elected officials bear no responsibility for the outcomes of the decisions they make and laws they pass while in governance. This is most easily seen in the promises made that at best will be borne by those of future generations and at worst are impossible to keep and will blow up in the face of and on the backs of future generations. The following three examples are large (massive even), but are only a few of many that could have been presented.

  1. Deficit Spending: There is a school of thought that so long as the economy, and hence the source of tax revenue, is growing faster than a country (or business’s) debt that the growth is not unhealthy. I can understand this argument, especially when such debt is used to fund investment in future revenue/profit production. Unfortunately, very little of our deficit is used to fund investment, and more unfortunately, the country’s debt is, and has been, growing faster than the economy -- much faster. Since George W. was elected in 2000, the economy (in real terms) has grown at an annual rate of 1.7%. The debt over those same 17 years has grown at an annual rate of 7.5%. Is nominal GDP growth a better comparison? Over that same time period the economy grew at a nominal rate of 3.55%. The debt still grew over twice as fast as the economy. In case you are thinking that part of the reason for the low economic growth rate is the recession, measuring from the end of the recession forward gives us a nominal economic growth rate of 3.7% while we the debt has grown at 7.4%, still twice the rate of the economic expansion, and measured ONLY during an economic expansion. We are not in a situation of growing the economy faster than the debt.

President JFK said, “It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the tax rates.” Readers of the Altus Insight know that I dislike taxes as much as anyone[5]. And I fully support a tax system overall, a massive one, not nibbling around the edges. Our tax code is antiquated and far too complex, full of loopholes that turns a highly progressive tax structure that on the surface taxes those in the higher tax brackets at one of the top five rates in the world (seriously, I can show you if you are curious) into a system where savvy individuals willing to spend large sums of money on top accountants can cut their tax rates below that of a typical middle class W2 wage earner. With apologies to Presidents Kennedy and Trump, I don’t see the current efforts to reduce taxes stimulating the economy the way it is hoped. I love the reduction in corporate taxes. Corporate taxes are a small percentage of the total tax receipts anyway, and I do think this is an area where President Kennedy’s quote will absolutely hold true. The rest of the tax cuts will largely benefit high income earners, which since they pay a vast majority of taxes already, is pretty much unavoidable. I don’t see high income earners not already reinvesting into the economy. The 2.7% of tax filers making over $250,000 pay half of all personal income tax collected. If the tax cuts don’t lead to increased spending/investment all we have done is decrease the government’s revenue without decreasing spending. In fact, thus far President Trump has shown no inclination to decrease federal expenditures.

Instead, we are in a situation where the debt continues to increase, funded by additional borrowing. As investors and business owners we all understand that borrowed money eventually has to be paid back. What our national elected officials are doing by being irresponsible with spending is putting a huge financial burden on future generations for the benefit of the current voting public. These elected officials will be out of office collecting their comfortable pension and health insurance by the time the hens come home to roost, and if not they will get voted out of office, only to go collect their comfortable pension and health insurance. Good luck to our kids.

  1. Social Security and Medicare: Not included in the debt numbers as discussed above are what are referred to unfunded liabilities. The main buckets in unfunded liabilities are future, but easily estimated, totals of Social Security, Medicare, and Medicaid. Contrary to popular belief, Social Security isn’t the largest of the issues. Medicare dwarfs the Social Security problem. And to be clear, this isn’t money that is owed in the future. All of us have been paying into Social Security and Medicare for years with the full and reasonable expectation it will be there for us upon retirement. We even receive letters from the federal government showing us what our future distributions will be based on what we have paid in to date. Except that the money to make those distributions doesn’t currently exist, and also isn’t calculated in the Federal Debt. It is a giant Ponzi scheme that depends on the contributions of future workers to pay the benefits of current recipients (mostly retirees). Ponzi schemes work okay when the amount of new suckers coming into the scheme far outnumbers the people at the topic of the pyramid receiving the benefits, but starts to crumble when the base of the pyramid narrows or the height of pyramid elongates. Both are currently true. Well known demographic trends have resulted in a far lower worker to recipient ratio that originally imagined as possible. Additionally, life expectancy has increased dramatically, meaning recipients are receiving benefits longer than ever anticipated. According to a report released by the Social Security Administration[6] there were 2.8 workers for every social security recipient. In 1955 there were over 8. By 2034 it is projected there will be just over 2 workers for each recipient. That also happens to be when social security is forecast to be insolvent. Here is the kicker, Social Security is roughly 24% of the federal budget while Medicare/Medicaid/etc. makes up 25% of the federal budget, and is growing at an increasing rate. None of our elected federal officials have shown any inclination to touch either of these two programs. Touching Social Security or Medicare is the death sentence for a politician, so they kick the can down the road, reaping the benefits of elected office but not having to deal with the future outcomes being created.
  2. State and Local Pension: A smaller problem from a dollar quantity standpoint, but maybe a larger issue from a business and investing impact perspective is the exploding issue of state and local pensions. As with federally elected politicians, those elected locally have long agreed to sweet benefit and retirement packages for local and state employees. Many states and municipalities are only solvent in name, which is due to unrealistic assumptions used in the financials models. For instance, last December CALPERS reduced their portfolio return estimate from 7.5% to 7%, a change that is going to be phased in over three years. Because of laws requiring certain portfolio structure this implies that CALPERS has to achieve close to 11% return on their stock portfolio every year into perpetuity. Raise your hand if you believe this to be achievable? How about if I told you their portfolio returned a whopping .6% return for the fiscal year ending June 30, 2016? And that one month after reducing their return assumption to 7% the fund administrators admitted they expected to return only 5.8% for that year?

Why is this your problem you ask? While CALPERS is the largest public pension fund, it is only one of thousands of similar funds across the country. By law the recipients of the pensions have to receive their minimum distributions. If there isn’t money enough in the fund to make the required distributions the state or municipal government has to fund the shortfall from their general fund. By law. At the very least this means a reduction in services. More likely it means an increase in taxes and fees, and in many places it will have to be substantial. Since tax increases require voter approval, usually 66%, but in some cases 55%, the process will pit one retired neighbor, who will see their property or sales tax increase dramatically, against the other retired neighbor who continues to receive their golden retirement parachute[7] on the back of the first neighbor. This will not make for an easy election or lead to social harmony. Raising fees is an easier route, but will be borne almost entirely by business and investors, since that is who currently pays the majority of fees collected by the municipalities. The neighbor to neighbor issue is not moral hazard, the politicians that have approved, and continue to approve future benefits that will be impossible to pay are the moral hazard in this example. They will not bear the consequences of the decisions made, whether in good intention or in order to get votes.

I believe this state and local issue to be larger than the federal issue in consequence. For one, states and municipalities can’t print money like the federal government can[8]. Also, it is considerably more difficult to move out of a person’s home country than it is to move outside the city limits or to a new state. Think of the number of businesses that are already fleeing high tax, high regulation states for more business friendly locals. That migration is only going to accelerate if taxes and fees increase dramatically in the state or locale in which the business is based.

So, as investors and business owners, what do we do about the eventual results of the moral hazards? For the first item, I don’t have an answer, other than thoughtfulness in how we vote.

The second issue will be a like a tsunami. It won’t be something we have to deal with until suddenly it will be, and it will be massive. For starters, any of us not already collecting social security, or scheduled to start collecting social security soon, should assume that we won’t receive any. If we haven’t already done so, we should adjust our retirement investment plans to make sure we have the investment needed to fund the retirement we are hoping for without Social Security’s assistance.  We should assume that we will incur far greater health bills than our parents. And, depending on our family situation we might want to make provision for family members who would have otherwise depended on Social Security as an important part of their retirement. Additionally, it may be worth adjusting investment portfolios into assets that will have less exposure to tax increases. Maybe this means we liquidate and pay tax on certain positions now (or after the Trump tax cuts) to avoid paying the higher future rates. Maybe it means we move into assets that are not as easily valued on a mark to market basis (expect a wealth tax in the future). Maybe we do what we can now to reduce future living expenses so that a reduction in our post tax income doesn’t have as large of an impact on our discretionary spending. Almost certainly we should make sure we have a good tax accountant.

My sense is the state and local pension issue is where we have the greatest ability to make adjustments, though some of those adjustments, like moving our business location, may be an action taken in the future once the picture becomes clearer. Unlike Social Security and Medicare, this issue will not reveal itself all at once. Because underfunding varies among pension programs, the implosion of those select pensions will likewise vary across several years. As pensions start to have trouble we will be able to make adjustments. Real estate prices will be impacted through increased property tax and/or population migration from or to certain locales following the jobs associated with the relocating businesses. If real estate is owned in areas that face major problems it should probably be liquidated as quickly as possible before the population drops or the rest of the investor population awakens to issue. Likewise, areas that can be expected to attract the relocating businesses could see outsized real estate price growth. My understanding of this pension issue, and its tangential effects is recent, but we will be adding governmental pension plan underfunding to our list of items we use in determining our emerging market criteria. What we haven’t yet determined is at what point a pension plan should be considered to be in danger. Is it 5% underfunded? 20% underfunded? Research is ongoing on this topic and anything discovered will be shared with Insight readers.

 

Happy Investing.

 

fjinks_sig.png 

 

 

Forrest Jinks

Altus Equity Group, LP

off: 707/932-5887

fax: 707/544-2972

www.altusequity.com

 

[2] At least what has been reported in the mainstream press.

[3] There is irony in Senator Cruz from Texas pushing hard to receive federal funds after opposing federal funds be provided to New York after Hurricane Sandy.

[4] Additionally, donations to help those in Florida can found here, and Puerto Rico can be found here.

[5] My biggest issue with taxes is not paying them, but rather the highly inefficient way in which they are used.

[7] I believe in the sanctity of a contract and feel like the retirees who were promised the retirement and benefits need to receive them. It isn’t their fault the elected officials were lax (to put it mildly) in their duties.

[8] Understanding the technicalities that it is the Fed that creates money, not the Treasury