Government Incentives

When I review tax programs, whether they are for local, state, or federal governments, there are two critical criteria:

– Effectiveness – does the tax program raise the revenue in a manner that is cost-effective and have the lowest level of harm and distortion to the overall economy?
– Incentives – if the tax program is designed to promote a certain type of activity or “deter” a different type of activity, do the incentives actually drive the behavior that the law is intended to achieve?

I thought about the “incentives” element of the program as my parents rushed out to take advantage of the “cash for clunkers” program which provides a credit (on the spot, to the dealer) for turning in cars that basically get less than 18 mpg and purchasing a new car off the dealer lot. This program has their own website (where they unhelpfully refer to the program as “Cars” or “Car Allowance Rebate System” rather than the far more effective “cash for clunkers”). My father’s car barely made the cut because it was right around 18 mpg and they have been clarifying the program and making him sign form after form (to prove that he has owned it for several years, that he had it scrapped, etc…) but generally this program was a “shining star” of an incentive because 1) the government wanted him to go out and buy a new car off a dealer’s lot right now 2) they wanted to make sure that his old 18 mpg car was taken off the road 3) they wanted to make sure that he actually owned the car and didn’t just swap it with someone else to get the $4500 in trade in when the car was only worth maybe $1000. All of these criteria were met, in this case.

While the FDIC isn’t a tax program, the agency that guarantees deposits at insured banks (with your tax dollars) also provides incentives. I was involved in the early 1990’s when the Resolution Trust Corporation was created by our Federal government in order to take control of insolvent banks (basically banks that made dud loans, generally for property) and pay back depositors. I was on one of the teams that would go into banks right at the time they were being shut down and secure the cash and assets as a lowly auditor. We weren’t exactly the CIA – we sat in cars outside the bank and everyone knew it was coming and the staff were generally very polite – but that was where I frequently heard the phrase

Heads – I win, Tails – the FDIC loses

By this phrase they exactly summed up the banking game at the time – make a lot of big and risky loans with “guaranteed” customer deposits, and if it goes well and the loans are repaid, you make a bunch of money. If the loans go sour, oh well, you just walk away and leave the FDIC holding the bag.

I have a CD (way below the insured minimum) with the Mutual Bank of Harvey, Illinois. Or I did, until recently, when the FDIC took over the bank (press release here) and named the United Central Bank of Garland, Texas as the receiver (they get the deposits and the “good” assets, the FDIC gets all the “bum” assets to work through).

When I purchased this CD I followed the incentives that the government has given me like bread crumbs – Mutual Bank of Harvey offered amongst the highest CD interest rates and since purchasing any FDIC insured CD was pretty much as good as any other (you wouldn’t want to put all of your money in failed banks because it may take some paperwork to get it all straightened out if you needed the funds right away, but an occasional failure shouldn’t dent you very much), I bought from Harvey.

Why was Harvey offering higher rates? Probably because they were in trouble (verified by the fact that they were just taken over) and raising money through CD’s can then be used to prop up the bank (and continue paying executive salaries) that much longer. The FDIC was reviewing whether to limit the amount of “excess” interest that banks could offer above the average if they were thinly capitalized here but I don’t know if this was actually put into practice or not.

With the fact that CD’s can be purchased electronically, the government is in effect using this program to bring in US taxpayer savings to prop up banks. In the old days, when you had to physically visit a branch, this wasn’t very viable, but today it is easy through your brokerage account to purchase CD’s from any institution with just a click of your mouse (check here if you are interested in learning more).

As far as Harvey was concerned, if I had any stake in the outcome of their eventual failure, would I buy a CD from them? Hell to the no. Harvey is located in a relatively impoverished area (I would not have been excited to drive there back in the days before you could do this all electronically) which unfortunately is the type of area most likely to be hit hard in the current wave of foreclosures. If you think your little suburb or town is in the middle of the foreclosure wave, take a tour of anyplace in the inner city where complex loan products like interest only mortgages were peddled by the ton, and where the recipients of the loan proceeds were not likely to use those proceeds for income producing ends. These areas are just demolished.

Even though I guessed (correctly) that the Harvey bank was in trouble, I did just what the Federal government “wanted” me to do based on their incentives – to put more money in that bank which likely flowed right into losses and salaries of bank officers that should have been shut down months or years ago. The government allowed Harvey to offer more for my CD, and so now the government has to find another bank to pick up that CD, and presumably the government gets less back “net” on the total portfolio as a result.

In these cases the incentives both worked as designed – but what are the consequences of each?

Your government at work.

Cross posted at LITGM

9 thoughts on “Government Incentives”

  1. I think the vast majority of people have no clue as to the role of risk in finances or business. This in turn causes them to support government policies that reduce risk.

    Risk is the feedback mechanism that prevents people from making unsound investments. Specifically, it helps control for the lack of information about economic activities. For example, in the old days no one in Texas would put their money in a bank in Illinois because they would have had no idea how sound the bank or the community it depended on were. This in turn required banks to depend on deposits from people in the community with intimate knowledge local conditions. Banks in turn had to convince these knowledgeable investors that the Bank was making sound loans.

    With FDIC, however, depositors do not have to know anything about the bank or local conditions. They just shop for the highest interest from a list, plop down their money and if things go sour they at least get their principle back. This severs the feedback between bank loans an deposits. Banks make loans subject only to the very wide parameters of FDIC regulators which allow almost every loan as long as it is not outright fraudulent.

    The same loss of feedback was a primary cause of residential mortgage bubble. The GSE (Freddie Mac, Fanny Mae etc) and various loan guarantee programs, severed the feedback between risky housing loans and investors. We can tell this because 50% of the money sunk in the bubble came from foreign investors. No Dubai sheik is going to invest in a residential mortgage in a small town in Missouri on his own because he knows nothing about the bank or the community. However, he will invest in a residential securities that contains that Missouri mortgage when in is bundled by the GSE and backed by U.S. Federal government.

    In the 20th century we began to think that all negative economic events were bad and that the government had both the obligation and the ability to prevent any negative economic consequence regardless of the cause. This in turn lead us to treat risk as something the government should prevent.

    And here we are.

  2. Phew you had me scared there a bit. The CD is insured not only for principal but also for all accrued interest. Just checked at the FDIC site.

    Given that this bank is in Harvey right near Chicago I’ll bet that many of these soured loans don’t even meet the “outright fraudulent” standard that you set.

  3. By your utilitarian standards:

    “- Effectiveness – does the tax program raise the revenue in a manner that is cost-effective and have the lowest level of harm and distortion to the overall economy?
    – Incentives – if the tax program is designed to promote a certain type of activity or “deter” a different type of activity, do the incentives actually drive the behavior that the law is intended to achieve?”

    I think the best tax would be a 100% tax on all retirees without waiting for them to die. It would not distort the overall economy and would be easy to collect. Argentina and Ecuador have recently just confiscated everybody’s bank account.

    The incentives would be perfect too: The tax would drive old farts to commit suicide or emigrate, eliminating problems of maintaining them in old age. It would also deter people from living past their useful age of 65.

  4. Carl… Ginny,

    Beginning in late-2005 and ending in late 2007, I and my partners (who are something of a boutique consulting and audit firm, specializing in international due diligence, risk assessment, and asset assurance/recovery), began working on a base-line evaluation of Morning Stars risk rating reports, in particular with respect to non-traditional financial instruments and asset categories, which they have a monopoly in, and which pretty much every asset manager, banker, pension manager, and etc. relied (and relies) on to determine how best to allocate assets within they and their clients portfolios, as well as to make sure they’re in compliance with Federal and State (re Pensions) fiduciary regulations. Basically it was boring as hell, as we’d already determined via experience that the product was consistently misleading and that the monopoly was destructive. The question was, if their monopoly was as destructive as we suspected, how would one go about establishing a base metric to serve in a worst case scenario for post hoc evaluation and adjustment (if not litigation or prosecution). To make a boring story short, the financial sector and sectors with traditionally heavy operating capital requirements, like GM, which disproportionally rely on exactly the specialized financial instruments went nuclear at the very end of our second “cycle”… (which made us look very clever at the time)

    For reasons that were never explained to us, the administration and several other entities responsible for very very large institutional funds, including the Department of Defense, whom we’d warned very early during our own evaluative process, determined to adopt a succession of reactive stop gap policies (wait and see) that were politically expedient, fraught with conflicts of interest and amounted to both factions of the Washington establishment handing Wall St. and London get out of jail free cards and assuring they and their staffers and Political Parties would be flush with cash from grateful bankers at main street Americans expense.

    Using the same basic criteria noted for evaluating tax programs, neither the Bush nor Obama administration, nor the accounting industry can claim to have addressed the financial crises with policies or programs that satisfy the critical assessment. And frankly, it’s my sincere opinion that Chicago Boyz readers should avoid the temptation to try to catch the equity upswing to make up for recent losses, and instead revisit all of your estate and retirement plans with a heavy weighting towards municipal bonds… as it’d be naive to believe the Virginian profiteers in charge of Defense procurement, or anyone in the Capital currently spending trillions of dollars at deficit today, are going to suddenly wake up tomorrow and act responsibly. Neither the Democrats nor Republicans safely gerrymandered as our “Representatives” from the distant Capital cares that the Average American already works a third of the year just to pay taxes, and the only way to SPEND MORE money is to RAISE TAXES. So if you don’t want to find yourself eating cans of dog food in your old age because you took politicians promises seriously today, plan and prepare for the worst.

    A sincere and honest politician or statesmen would not tell his or her peers to HOPE wicked cynical and shameless Political leaders are REALLY REALLY going to keep their promises THIS TIME AROUND, rather he or she would urge people to act in their own, their families and their local communities interests first and foremost, and to EXPECT and prepare for the future so that you CAN “hope” without risking ruination if your audacity to hope suddenly gets up and leaves you with the bill.

  5. I agree with a lot of your assessment except for the part about recommending municipal bonds… I am not an expert on risk valuation but there are a lot of states and local governments that are going down, weighed by heavy pension obligations, rising union costs, and an already-crushing tax burden that can’t be raised.

    But I guess in the sickest part… probably the municipal bonds will get backed up by the Federal government anyways, so maybe I am just the dumb guy.

    I have some investments with a big firm and they recently recommended, that, for my age, I ought to be 85% in equities. Um… that’s terrible advice, I am probably 1/3 equities, 1/3 CD’s, and 1/3 real estate. That’s enough risk for me.

  6. Carl,

    LOLOLOL. Unless you’re 15 years old, you should run like hell from that big firm. The basic rule is that one should base the mixture between equity and bonds proportionally on ones age, or alternately based on your expected age of retirement. The quick rule is: your portfolio should have a percentage of bonds thats around your age, and the rest should be split between equity and other classes of asset). If you can get the big firm to put the 85% equities recommendation in writing, show it to someone familiar with Illinois business law, as the firm might be guilty of financial malpractice (hahaha…. obviously you’d need to go to a harassment lawyer).

    I recommend muni’s because there’s typically a tax benefit as with treasuries and the yields going to be several points higher. The catch with municipal bonds (except those issued under New York State law) is that the reinsurance estimate in the case of a default is priced by the reinsurers at 10% of the total issuing value, but in practice that never happens (outside of the State of New York). Because the vast majority of municipal bonds are reinsured, in practice when a State or city is about to default the issuing banks pay the mature bond off, and reissue a new bond at a premium. For the small bond holder, the risk is the lowest after Treasuries.

    My assumption is that Congress with raise the Capital Gains tax next year, and on dividends next year or shortly after the midterm elections to avoid stirring up the grey panthers. I very doubt very much that anything will be done to curb excessive interest charged on student loans or credit card debt, as that’s were a lot of banks are going to make a profit in the short term. Moreover everyones tax bill next april will be when the party ends and the hangover kicks in. But for the next couple of quarters the market will continue to excessively rise… mostly because people will listen to brokers and politicians saying “Recovery” ten times a day, and convince themselves that they “can’t afford” to miss out on the equity rebound even if it means moving 85% of their savings into risky equity products and taking a penalty on their bonds to do so. Delaying paying off their personal high interest debt, and neglecting to shore up their estate planning before the Bush tax cuts expire.

    And all this suggests that muni’s will be the where risk remains dependably overstated, and yields that are already strong for bonds compared to equities that have been prone to bubbling, will look even better when the various tax hikes arrive and tax cuts most people have grown used to are allowed to expire. Moreover, for people a couple decades away from retirement, it is completely crazy to imagine social security will be solvent (or that you’ll ever get all the money you’ve poured into it back).

    As to your basic split. If 1/3 in real estate means home equity, then depending on your rate and term, it’s worth considering whether your resale expectations are realistic. Let’s say you’ve got a twenty year note at 6% and have been there ten years… you’re probably WAY ahead, but 10-20% less than you think. If you have about as much savings in CDs as home equity, and as much again at a giant brokerage here’s my sincere advice:

    The extra $1500+ or so a year it costs to sign on with a top accounting firm will likely result in a notable net profit after two or three tax cycles. In your particular case, you should call DT&Ts (or PW) tax specialists on Monday and ask to meet with the senior partner in estate planning, which in chicago could easily be a 200 year old man (so be prepared). Tell him you need an accountant/estate planner and that you’re looking for a firm to spend the rest of your life with…. and ask him which of the partners closer to your own age he’d recommend; if the other partner is available and the 200 year old partner introduces you, cut them a retainer check then and there. Otherwise see how the second meeting goes, and if you don’t hate the guy, hire him.

    Then my advice is to ask his advice and follow it.

    The Democrats are never going to be able to afford a fraction of their programs without substantially raising taxes, and because the Bush Tax Cuts expire next year. And because no one in Washington has any interest in fixing the structural problems that currently plague the financial markets, getting the best tax accountant you can find is going to be way more important for the next couple of years than any stock broker.

  7. When thinking about munis, or any other form of fixed-income investment, don’t forget about inflation risk. We may see a few years of modest deflation, but after that it is very likely, IMNSHO, that the combination of monetary and fiscal policy will result in significant inflation–probably not Weimar-level or Zimbabwe-level, but enough to hurt bond prices.

  8. Carl from Chicago

    I think that your plan is similar to my favorite Monty Python skit
    “We should tax all foreigners living abroad”

    That’s called selling them Treasury Notes and then monetizing the debt. Which, also takes care of those overhangs of unfunded pensions costs.

    Not that our leaders would ever do anything like that. Yet.

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