The CERF Blog

“Value at Risk is like an air bag that works well all the time except when you have an accident”

David Einhorn

Value at Risk (VaR) is a well-accepted measure of market risk.  It is defined as the minimum loss that could be expected to occur over a specified (short) horizon with a specified (low) probability.  For example, the 99% one day VaR would be the amount of daily loss that should be expected to be exceeded one day in a hundred.  The VaR measure is ubiquitous today; part of the risk measurement or risk management process of nearly all commercial banks, investment banks and insurance companies, and many if not most money management firms and hedge funds.  Regulated companies typically have minimum capital standards that are tied to a VaR calculation. 

A nice thing about one day VaR is that you get a lot of feedback on the quality of the measure.  Each day you compute your actual gain or loss and then compare that to the VaR calculated at the prior day’s market close.  If the calculation is reasonably accurate, you should expect to observe actual losses in excess of the calculated 99% VaR 2 to 3 times per year.  If you cannot produce a VaR calculation that meets this criterion then your risk management process needs some work.  By observing the trend in VaR over time, you can get a sense of the trend in the amount of risk that is being taken.  That is, unless the nature of the risk changes a lot.

But having a successful daily VaR calculation does not mean that you are prepared for an extreme scenario.  In an extreme scenario, you might easily see losses many times the VaR.   This is partly because the typical VaR calculation is based on recent data and most of the time recent data does not include extreme scenarios.  It is also partly because the VaR focuses on the minimum loss that could be expected every hundred days or so.  The VaR does not estimate how serious the loss could get in the extreme event.  Nor does it capture the effects of a series of successive VaR violations.  It is generally assumed that each day’s market move is independent of the prior day’s move.  In a severely negative scenario this is not likely to be the case.

Criticisms

As indicated by the above quote, VaR has come in for its share of criticism.  Some critics argue that VaR is worse than useless because it gives a false sense of security.  Others claim that it amplifies cycles.  Are these criticisms deserved?  I think the answer is that VaR is highly useful for its intended purpose as a risk measurement and monitoring device.  But, it is not the proper tool for estimating potential losses in an extreme scenario.    

Many people associate VaR with the worst case outcome.  This interpretation can lead to problems.  If the calculated VaR is small relative to capital, naïve senior executives might incorrectly conclude that the firm’s risk profile is too low, and that they should take on heightened risk. This is an understandable but unfortunate misreading of the meaning of VaR, which is that it is reliable only for normal times.

If you are trying to assess tail risk, VAR should be supplemented by a methodology that aims at estimating the magnitude of loss that could be expected to occur in an extreme event.  This is the province of stress testing.  Stress scenarios should be based on the worst case that we have seen or believe to be plausible.  It seems to me that capital levels for a company that intends to be a going concern should be based on such a calculation.  What happens in extreme scenarios for the major risk factors that impact your performance?  Does your profit/loss profile look like a smile or a frown?

My view is not shared by all.  Many commentators argue that hold capital against extreme scenarios is overkill.  Under this approach, they say, many useful investment projects would not be undertaken.

But, I think we have learned at least two things over the recent past.  First, worst case outcomes occur rather frequently, certainly more frequently than we expect.  Second, it is not good for long-term returns when investments are periodically wiped out.  I think it is reasonable for equity investors to expect that management maintains a sufficient capital cushion to handle extreme scenarios.

The October 29, 2009 issue of Time Magazine had an article titled “Why California is America’s Future.”  I sure hope not.  California is fast becoming a post-industrial hell for almost everyone except the gentry class, their best servants and the public sector.

We only need a few numbers to demonstrate that California is clearly on the wrong track:

• California’s unemployment rate is over 12 percent, about a third higher than the United States.
• Only eight of California’s 58 counties have unemployment rates in single digits.
• California has lost jobs in four of the past six months for which we have data, while the United States has gained or had no change in jobs in each month over that period.
• California’s poverty rate is 16.1 percent compared to the United States 15.1 percent.  The rate goes way up when adjusted for the cost of living.  For example, the respected Public Policy Institute of California estimated that Los Angeles County’s 2007 poverty rate increased 11 percentage points from 15 to 26 percent, when adjusted for cost of living.
• Two California cities, Fresno and San Bernardino, are among the ten poorest American cities with populations over 200,000.  In fact, San Bernardino’s 34.6 poverty rate is the second highest of these cities, exceeded only by Detroit.
• Unemployment among college educated is 34 percent higher in California than in the United States, while Los Angeles’ college educated unemployment rate is almost a whopping 80 above the United States’.
• According the California Department of Education, California’s public colleges and universities graduate over 150,000 students a year, while California’s Economic Development Department is forecasting less than 50,000 openings a year for jobs that require a college degree.

Of course, that’s not the future that Time was selling.  Time’s future was a “dream state,” a magical place where enlightened pioneers, guided by their superior vision and funded by venture capital, would lead the world in innovation and environmental bliss.  California firms, like Solyndra, would lead the competition to a competitive new green economy.  No kidding, they named Solyndra:

“It’s (California) building massive power plants for utilities, as well as roof panels for big-box stores, complete subdivisions and individual homes. Prices are plummeting, and competition is fierce, most of it from California firms like BrightSource, Solar City, eSolar, Nanosolar and Solyndra.”

Along the way to this brave new world, there would be a new, “green” gold rush “beckoning dreamers who want to cook Korean tacos or convert fuel tanks into hot tubs.”

That vision turned out to be about as real as Disneyland — but not as profitable.

Time wasn’t alone.  Brett Arends had a similar piece, The Truth about California, in November 2010, and the ever-optimistic duo of Bill Lockyer and Stephen Levy had a December 2010 piece, California isn’t Broken.

Visitors can be forgiven for seeing California as a bit of paradise on earth.  It is.  I  am a native myself who could not wait to return from my job at the Federal Reserve in Washington DC.  I remember going to Santa Barbara in October for my UCSB job interview.  Santa Barbara was magical to me, after enduring weeks of dreary and increasingly cold East Coast weather.  Santa Barbara was warm and sunny, and people were wearing the minimum legal requirements, and State Street was alive and vibrant with a happy energy I hadn’t seen since I’d left California for my East Coast job over a year before.

I wanted that job.

You can still have that experience in certain spots in  California.  There’s no doubt, California has abundant charms.  It can seduce almost anyone.

But, there is a lot of California that visitors don’t see.  They don’t see the many communities in California’s central valley where unemployment rates of over 15 percent are typical, where people live in substandard housing and face the prospect of a lifetime in an ignored underclass.

Well, they are not exactly ignored.  They receive food stamps and other subsidies, but they are denied opportunity, social mobility, or the confidence and pride that come with self-sufficiency.

You don’t have to leave Santa Monica or Santa Barbara to see poverty without opportunity though.  Just blocks from Santa Barbara’s State Street or Santa Monica’s Third Street Promenade, over-crowded units , packed sometimes by several families, are the norm, because Coastal California’s housing prices are not related to the local economy. Statewide, 28 percent of California’s children live in crowded housing.  This is the highest rate in the nation, tied only with Hawaii.

When you live here, you can’t avoid the signs of California’s decline.  Beaches I walked with High School dates are no longer safe at night.  Water lines in Los Angeles burst with alarming frequency.  Our roads are approaching gridlock and are littered with potholes.  Electrical cutbacks are common in hot weather.  Water is increasingly scarce, except in very rainy years.  Our primary schools are clearly in decline.  Even California’s higher education system, once the envy of the world, has passed its prime. Places like the University of Texas or University of North Carolina are now real competitors.

It wasn’t always this way, and it doesn’t have to be in the future.  When I started my career, California was a place of opportunity.  One could have a career, own a home, and raise a family.

Not any more – not unless you have a trust fund or a secure pensioned public employee job.

That’s why California’s middle class is leaving, looking for opportunity and affordable housing.  The evidence is in the migration data.  Domestic migration has been negative for over a decade.  Perhaps even more telling, only 23 percent of U.S. illegal immigrants are coming to California today, down from about 42 percent in 1990.  Even the lowest skilled newcomers know there’s shrinking opportunity here.

California has a problem, and it’s high time the political class accepted the fact.

Two steps need to be taken before any problem can be solved.  You need to recognize you have a problem.  Then you need to identify the problem.  Unfortunately, it appears that among Sacramento’s leadership, only Gavin Newsom even recognizes that California has a problem.  Governor Brown gives lip service to jobs, but like Schwarzenegger before him, identifies the failed command and control policies of the green movement as the source of the new jobs.  Solyndra has become the poster child for this fantastical policy failure.

California’s economic future is pretty grim, until Sacramento takes off the blinders and admits it has a problem. Until then, things are likely to get much worse before they get better.

This appeared previously at newgeography.com

Thomas Sargent and Christopher Sims were awarded the Nobel Price in Economics today.

When Robert Lucas won the Nobel Prize in 1995 I wondered if Professor Sargent and Professor Sims could win the prize. Certainly, their contributions were important. Professors Sargent and Sims, along with Professor Lucas, published in the Macroeconomics field, an area I was studying. While I did not research the Nobel committee’s search and decision process, I decided that Sargent and Sims were unlikely to win. Most likely, the Nobel committee would find Sargents’ and Sims’ work too technical or too hands on. It lacks the general applicability to broad human goals of, say, Lucas’s “On the Mechanics of Economic Development”.

I was wrong, and I am happy to be wrong. I have been a student of Professors Sargent and Sims work since about 1992. I still re-read certain articles of theirs. I also benefit from their contributions in my daily work as a forecaster of the United States economy and as professor of economics.

One of the many contributions of Professor Sargent’s that I use in my work includes suspicion of the Phillips Curve as a useful empirical device. See his early article here. I have always felt that the Phillips Curve attempted to measure a relationship that was too complex to measure with just one linear equation. Factors that drive the unemployment rate include but are not limited to: population dynamics, household labor force choice, the business cycle, sectoral changes, productivity, and macroeconomic policy choices. Factors that drive the inflation rate include but are not limited to: commodity markets, expectations, demand and supply pressures, technology, anticipated monetary policy, and unanticipated monetary policy.

When I build my forecast models, I do not explicitly link unemployment and inflation in a Phillips Curve. I try to provide a reasonable measure of the factors listed above for each of these indicators independently. This implies that sometimes there is a tradeoff and sometimes there is not. While it is more often the case that the resulting forecast maintains a tradeoff but there are times where the tradeoff does not exist. I remind the reader than for much of 2008, inflation was rising and the unemployment rate was rising.

As an economic forecaster it is impossible to do my job without using one of Professor Sims’ contributions, the Vector Autoregression model, or VAR. This model-building technique, one that was forcefully brought to macroeconomists’ attention by Sims in 1980, has become an important competitor to the main alternative method of forecast model-building, the structural approach. The VAR approach is in some ways easier to implement and perhaps more importantly, is an approach that “lets the data do the talking” more than the typical structural approach. The VAR approach is agnostic to model structure, attempts to capture any and all inter-related forces among all indicators, and provides a convenient testing and diagnostic apparatus for examining the properties of the model economy.

I use the VAR approach for some of my work, and I teach the VAR approach as an important tool in our M.S. in Economics program here at California Lutheran University.

While I am happy for Professors Sargent and Sims, perhaps I am the biggest winner, as I benefit from their insights any day that I am in the office.

Weakness in housing activity and housing prices continues to be a major drag on the overall economy.  My colleagues at CERF have long maintained that the homeownership rate (HOR) needs to fall back to its historical norm of 64% before housing can recover.  Their view has been that the attempt to increase the HOR by loosening credit standards contributed to creating financial instability.  In a classic case of unintended consequences, the attempt to improve the homeownership rate contributed to rising home prices which ended up lowering affordability for first-time buyers. 

A rising homeownership rate has been a major goal of public policy for several decades under both Republican and Democratic administrations.  The rationale was multi-part.  First, it was believed that communities are stronger where homeownership is greater.  Second, building equity in a home was viewed as the primary path to improving a family’s financial condition.  Finally, lower homeownership among minorities was felt to be an indicator of bias. 

Policies directed towards increasing the rate of homeownership included subsidizing first time home buyers, reducing required down payments, and streamlining the application process.  Weaker underwriting standards increased the effective demand for housing and helped propel a boom in housing activity and home price appreciation between 1995 and 2006.  The overall HOR rose from 65% in 1990 to 69% in 2006 which was applauded on both sides of the political aisle. 

However, rising home prices eventually reduced affordability and, along with excess supplies of housing due to overbuilding, led to a peak and then decline in housing prices.  The decline in housing prices eventually set in motion forces that generated severe losses to mortgage investors and homeowners alike.  The underwriting pendulum shifted from easy to tight and effective demand for houses plummeted.  Millions of people have lost their homes and even more have zero or negative equity in their homes.  The homeownership rate has now declined from 69% to 66% and appears headed lower. 

Another fundamental indicator of housing weakness is the large number of delinquent mortgages and the implied backlog of future foreclosures.  Of course, as the foreclosure backlog is worked through, the result will be a decline in the homeownership rate as former home owners become renters.  Thus, this issue is not separate from the HOR issue.

A third measure of housing market health is the large number of vacant homes.  During the period 2002 through 2005 the housing industry massively overbuilt.  The degree of overbuilding can seen by comparing the rate of household formation (about 1.1 million new households per year during this period) with total housing starts, which is the number of new units (including rentals) completed each year.

Total housing starts exceeded two million units per year during the boom.   Since the end of the housing boom, total starts have fallen dramatically to around 600,000 per year.  If the rate of household formation had remained at 1.1 million per year, then the surplus developed during the boom would have been eliminated by now.  However, an important yet obscure statistic maintained by the Census Department, the Vacant Homes For Sale (VHFS), remains at more than one million above its long-term average.  What is going on? 

I suspect that the rate of household formation dramatically declined following the crisis and subsequent recession.  Presumably, this is because more young adults returned to their family homes and multiple families are occupying the same housing unit.

The problem is too much housing stock and too few households.  This problem will not be resolved purely by a lower HOR.  It will be resolved by rising household formation (even if the new households are renters instead of owners).  What we need is more people.  One strategy to accelerate the process is to streamline legal immigration and to lift or eliminate quotas on the number of people who can legally come to this country.

Previously published September 28 in the “California Economic Forecast”:

The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

In the 1960s, the Federal Reserve attempted to conduct an operation to lower longer term yields and raise short-term yields.  This maneuver was called “Operation Twist” and the purpose was to stimulate private sector borrowing and spending.  It is generally agreed that the policy was modestly successful in temporarily pushing long-term rates lower.

There are rumblings of a similar operation being considered today by the Fed.  The Fed has already indicated that it expects to keep short-term rates very low for an extended period, through mid-2013.  One effect of this commitment is to flatten the yield curve out to two years.  Supposedly, the Fed is considering taking the additional step of buying longer term Treasury bonds and selling shorter term securities in order to flatten the curve beyond two years, perhaps out to ten years.  Lower long-term rates, it is believed, would generate mortgage refinance activity and other private sector borrowing. 

Is this a good idea?

Is it likely to work?

Bill Gross, co-Chief Investment Officer of Pacific Investment Management Company (PIMCO), believes the answers are NO and NO.  He suggests in a Financial Times editorial¹ that the likely consequences of such a strategy, were it to be successful in flattening the curve, would actually be to destroy credit expansion.  In a flat curve, his argument goes, there is little incentive for banks to lend or investment companies to lever.  So, further Fed easing would be contractionary.

PIMCO appears to be betting on this analysis.  After dramatically reducing Treasury positions and portfolio duration last spring, based on a forecast of rising Treasury yields, Gross appears to have reversed this strategy in recent weeks.  Treasury positions are sharply higher as of August 30, and portfolio duration has increased by two years.  This suggests that PIMCO has been buying longer Treasuries in size.  This position will look good if the Fed does deploy a twist strategy, and will look doubly good if the consequence of that strategy is to destroy credit creation and further weaken the economy.

Yield Curve Theory

Economists generally believe that long-term interest rates reflect the market’s expectation of future short term rates plus risk premiums that are higher the further out on the yield curve that you go.  The existence of positive risk premiums is the reason the yield curve typically has a positive slope.  This positive slope enables banks and investors to make profits by investing in longer term securities to enjoy higher yields and “roll-down” profits as the securities mature.   

When overall interest rates are low, the slope of the yield curve tends to be steeper than normal, due to market expectations of rising rates.  A steeper curve provides an incentive to go out farther on the curve and utilize greater leverage, if available.  It also generates increased risks.

Typically, the part of the curve with the greatest slope is from zero to two years.  But today, thanks to the Fed commitment to keep rates low for two years, the curve is flat out to two years and then steepens.  If the Fed does conduct Operation Twist II (QE3), then the curve might be flat out to five years or more.  Gross says that this would depress credit expansion by forcing banks and investors to hold cash.  Of course, it would be possible to move aggressively into even longer term maturities, but Gross suggests that is unlikely as “regulators generally frown on these maturity extensions.”

They sure do.  Regulators still remember the thrift crisis which was launched by thrifts holding long-term fixed rate mortgages funded with short-term deposits during a period of rising interest rates.  Thrift executives were excoriated at the time for their willingness to be exposed in this way.  Of course, they had little choice in that most loan customers wanted fixed loans, most deposit customers wanted short-term deposits, and hedge vehicles were not available back then.

Today there is greater flexibility.  If you want, you can emulate the PIMCO strategy of reaching out along the yield curve.  Should you do so?  After rising from the 1950s through the early 1980s, interest rates have been generally falling for the past thirty years.  Rates today are at 60 year lows.  The “ride the yield curve” strategy works when rates are flat or falling but does not work well when interest rates are rising, even if the slope of the curve remains positive.  There are bond portfolio managers who entered the business in the early 1950s, retired by the early 1980s, and spent an entire career watching every bond they bought decline in value.  But, at least they were able to reinvest coupon payments at higher yields.

Conversely, people entering the business in the early 1980s have enjoyed a long-term bond rally.  Every Treasury bond they ever bought has risen in value (at times you may have had to wait a year or so).  I think many people have learned to ignore the risk of rising interest rates. 

In all likelihood, PIMCO will be sufficiently nimble to reverse the maturity extension strategy once the next rising rate cycle begins.  But will you?

^{1 “}’Helicopter Ben’ risks destroying credit creation.”  Financial Times. September 6, 2011.

Europe has been in the news a lot lately. One day it has a plan to, temporarily at least, deal with the debt problems of delinquent members, and markets climb. The next day there is a glitch and markets fall. What is going on here? Why are markets so spooky?

We’re witnessing what are almost surely the dying gasps of the European Union (EU) as we know it. By that, I mean the number of countries in the Euro’s common currency zone will decline. The markets are spooked, because how it happens will have huge economic consequences.

Most economists — I’ve seen references that it is as many as 70 percent — thought that Europe was making a mistake when it became a common currency zone in 1999. Milton Friedman said that it would not make it past the first large recession. He was correct.

There are two fundamental ways that economists look at currency unions. One question is: What is the likelihood that countries will stay in a currency zone? This is the traditional theory of optimal currency zones. The other asks: What are the challenges to individual countries in a currency zone? This is what economist Greg Mankiw calls the fundamental trilemma of International finance.

The traditional theory of optimal currency zones holds that, for a currency zone to be successful, the countries need to be similar in fundamental ways. Inflation rates need to be similar. Openness to trade needs to be similar. The countries should be diversified in what they produce. Policy should be integrated, as should the countries’ financial sectors. Capital and labor should be mobile between countries.

In Europe, the countries are just too diverse to create a long-lasting currency zone. Languages and cultures are very different across European countries.

A large currency zone works better in the United States. There are fewer differences between, say, New York and California than between, say, Greece and Germany.

Still, even in the United States, states would choose different monetary policies if they could. For instance, California today would prefer a more expansionary policy than would Texas. This is because the Texas economy is doing far better than is California’s, and Texas has fewer fiscal challenges than California faces. An expansionary monetary policy would presumably stimulate California’s economy, while simultaneously allowing the state to inflate away part of its debt.

This reflects the trilemma. Here’s an abbreviation of how Mankiw described the trilemma in a 2010 New York Times op-ed:

“What is the trilemma in international finance? It stems from the fact that, in most nations, economic policy makers would like to achieve these three goals:

Make the country’s economy open to international flows of capital.
Use monetary policy as a tool to help stabilize the economy.
Maintain stability in the currency exchange rate.

But here’s the rub: You can’t get all three. If you pick two of these goals, the inexorable logic of economics forces you to forgo the third.”

As Mankiw goes on to say, the United States has chosen the first two options, while China has chosen the second and third, and Europe has chosen the first and third. Right now, Greece and many of the other peripheral countries would like the ability to use the second option.

The troubled European countries not only have no monetary policy choices, their fiscal options are limited, too. In trying to force countries to meet the characteristics of an optimal currency zone, the EU puts severe limits on fiscal policy choices. This is why at least one country, Greece, has simply lied about its debt.

In the end, the Greeks and the citizens of other peripheral countries will demand that their governments use all the economic tools available to a sovereign country. The governments will have to comply. The euro zone will shrink.

This appeared previously at newgeography.com

Interest rate spreads are returning to higher levels, levels that indicate financial and economic instability. This could indicate that an economic regime shift may occur this year.

The normalized TED, which is the 3 month LIBOR minus the 3-month Treasury divided by the 3-month Treasury, has reached a level not seen since the fall of 2008. The TED, i.e. the numerator or the LIBOR minus the Treasury, is normally interpreted as a wholesale banking spread. When this rises, there is greater perceived risk to the banking sector. The normalized TED can also rise if the 3-month Treasury falls, which can happen in “flight to quality” situations, as is also the case now. This spread appears to be indicating a rising probability of a change to the European Union. We at CERF now believe that it is not if the European Union will break up, but when. However, this spread is just one of many indicators that we have watched to form this opinion.

The second chart shows the ten-year Treasury, TB10Yr, and the triple-A corporate bond rate (ten-year) and the normalized spread between these two measures. The normalized spread has almost reached levels that occurred in late 2008. This measure is also indicating a “flight to quality” in financial markets because the ten-year Treasury rate is falling faster than the triple-A corporate bond rate.

I have argued in this blog-space that these indicators helped us see the regime shift to a serious recession that occurred in late 2008. The current levels are uncomfortably close to indicating another regime shift.

In a widely read NYT editorial, famous investor Warren Buffett has proposed tax increases for the rich, like himself.  Although one of the richest men in the world, Mr. Buffett claims that he pays a lower tax rate than the secretaries in his office.  That seems really strange.  The data put forth by Warren are as follows:  in 2010 he paid total tax of $6 million, which constituted a 17% average tax rate on his taxable income.  Warren argues that most of the people in his office, including some secretaries, have a higher tax burden than this.

Applying the magic of arithmetic, that implies that Buffett’s taxable income in 2010 was about $35.3 million.  But what form did this income take?  His primary asset is his approximate 25% stake in Berkshire Hathaway where he is the Chairman of the Board.  His salary at Berkshire has been $100,000 for many years.  In 2010, Berkshire had after-tax income of $12.9 billion.  This means that the book value of Buffett’s investment rose by $3.2 billion.  But this “income” is not taxable to him (however, the company did pay $5.6 billion in corporate taxes, Warren’s share of this was $1.4 billion).  Berkshire does not pay a dividend.  Further, it appears that Warren did not sell any shares in Berkshire.  Therefore, his entire taxable income from Berkshire was the salary of $100,000 and the value of miscellaneous benefits that came to about $450,000.

So, where did the $35 million of taxable income come from?  Warren did not specify exactly, but it is likely that he holds ownership stakes in investments aside from BRK/A.  For example, suppose he holds a bond portfolio that is equally divided between corporate bonds (tax rate 35%) municipal bonds (tax rate 0%), this would generate interest income with an average tax rate of about 17%.  Or, perhaps he sold some securities with total capital gains of $35 million, most of which were long-term gains (tax rate 15%) and a little of which were short-term gains (tax rate 35%).  Again, the average rate would be around 17%.  Finally, and I suspect most likely, Warren holds a substantial portfolio of stocks aside from Berkshire.  If this portfolio had a market value of $1.75 trillion and a dividend yield of 2%, it would generate $35 million of dividend income, with tax rate 15%.

In any of these possibilities, the bulk of his income is capital income not wage income.  Some have interpreted Warren’s proposal as eliminating the Bush tax cuts that lowered the top income tax rate from 39.6% to 35%.  Actually, Warren appears to be proposing to create a higher tax bracket on people, like him, that have taxable income greater than $1 million, and a yet higher bracket on those with taxable income greater than $10 million.  Most of such income is income on capital.  If you raise taxes on capital, the likely outcomes include lesser capital formation and slower long-term economic growth.  It would have little effect on the Buffett fortune, but it would deter future fortunes from being created.

If you really wanted to attack the Buffett fortune, then a tax on wealth would be the ticket.  How about an X% tax on all net worth above a floor level?   Warren appears to want to target the top .3% of the wealth distribution.  Well, the best estimates are that the top .1% of the wealth distribution includes people with net worth greater than $20 million, and these folks cumulatively have about $9 trillion, or about 15% of total household wealth.  If we were able to collect 20% on all net worth above a threshold of $20 million, then in theory we would collect approximately $1.4 trillion of additional tax revenue (the tax base would be $7 Trillion = $9 trillion less the $20 million threshold for each household; the revenue would be this tax base times 20%).  This would largely wipe out the current federal deficit!  In future years, of course, the revenues would be lower as the cumulative wealth of the richest folks would decline.  

This 20% wealth tax would be highly original (and catchy too, we could call it the “20 on 20” plan), but there are some problems with the concept. Putting aside the moral aspect of confiscating wealth, is it feasible to expect to collect this tax?  Currently, the primary wealth tax is the property tax that is generally in the range 1-2%.  And this is on property that is not movable.  If a 20% tax were imposed on assets that are transferable (out of the country, or into non-taxable foundations) then it would likely be the case that the tax base in fact would turn out to be well below the expected $7 trillion.

Even if this wealth tax could be effectively implemented, would it be a good way to go?  Warren’s editorial has inspired a lot of comment.  One theme is that if rich people want to increase their tax contribution, then they are free to do so.  Warren has chosen to give the bulk of his estate to the Bill and Melinda Gates Foundation.  Apparently, he feels that they will put the funds to better use than would the U.S. government. 

Warren Buffet.  Stop Coddling the Super-Rich. The New York Times, August 14, 2011.

http://www.nytimes.com/2011/08/15/opinion/stop-coddling-the-super-rich.html

A bank’s capital ratio is a ratio in which the numerator is a measure of capital (like common equity) and the denominator is a measure of assets (usually risk-weighted assets). Bank executives sometimes take the reciprocal of this ratio and call it “leverage.” More commonly, leverage is defined to be the ratio of debt to equity rather than assets to equity. Any way you define it, higher bank capital ratios mean lower leverage, and vice versa.

Many banks and investment companies seek to attain the highest leverage allowable. If they are constrained to hold a higher capital ratio than a competitor (so that the competitor enjoys greater leverage), they will loudly assert that this gives the competitor a “competitive advantage.” If banks headquartered in the United States are required to hold capital ratios in excess of foreign banks, then it is argued that foreign banks will take over the market.

What is the basis for this claim? Why does management seek to maximize leverage? A first answer is that greater leverage means higher return on equity (ROE). Suppose you have equity of $100 and you buy an asset with a return of $6 per year. Your return on equity is 6%. Then suppose you are able to borrow another $100 at a borrowing cost of 4%. Now your total dollar return will be $6+$2=$8, and your ROE will be 8%. If you could borrow $1,000 at 4% and invest at 6% then your ROE will be 26% (the formula is ROE=Return + Leverage*(Return-Borrowing cost)). So long as your return is greater than your cost of funds, higher leverage means higher ROE.

Of course, if the return turns out to be smaller than borrowing cost, then the effect of greater leverage is to reduce ROE and possibly turn it negative. In the financial crisis, returns did turn strongly negative and many highly levered financial institutions had their capital positions decimated. In the aftermath of the financial crisis many observers have called for higher regulatory capital requirements on banks. Some have called for substantially higher capital levels. Alan Greenspan argues that the capital ratio should rise from 10% to 15%. He believes that 15% is the maximum feasible capital ratio.1 Any requirement greater than this would mean that banks could not attract capital. Financial experts at the Stanford Business School2 dispute the Greenspan logic and support even higher capital requirements. Why not 30% capital?

The answer, according to bankers, is that banks cannot earn an adequate return on equity if equity levels are increased substantially. Let’s suppose that 30% equity to assets became the regulatory minimum. The banker calculation would be something like this: depending on the type of loan, yields net of expected losses may be 4% or 5% today. Assume 5% yield and 1% cost of funds and operating expenses equal to 1% on assets. Then the pre-tax ROE will be

           (5%-1%)+2.33*(5%-1%-1%)=11%

The after-tax return would be well under 10% making the bank unattractive to equity investors.
The academics dismiss this argument. While they agree that average ROE may be lower, they assert that the required return is lower as well; with lower leverage the riskiness of the income stream is lower and so the required return is lower. Besides, if investors want more leverage, they can manufacture it themselves by buying on margin.

A hundred years ago or so, banks in the United States carried substantially greater capital than today, something fairly close to 30%. Back then banks were subject to runs during difficult times. Federal deposit insurance introduced in 1932 largely eliminated the risk of runs and made bankers comfortable with much lower capital levels. To the extent that deposit insurance is underpriced (banks are levied premiums proportional to the amount of insured deposits), deposit insurance is a subsidy and bank shareholders naturally support maximizing the subsidy.

The problem with low capital levels is that even modest loan losses jeopardize the soundness of banks thereby threatening financial stability. Economists call this a “negative externality.” Since the largest banks are too big to fail, this means the taxpayer is on the hook to bail out creditors of these banks. According to the professors, a primary benefit of dramatically higher capital levels for banks is that the negative externality is reduced and so is the taxpayer subsidy. The financial system would be much less prone to instability.

But even if you agree that the financial system would be stronger if large banks held more capital, the problem is that we have to get from here to there. Bank assets today are approximately $11 trillion and bank equity capital is about $1.3 trillion. Assuming that assets stayed the same, then banks would need to raise approximately $2 trillion of equity in order to meet a 30% equity to asset standard. If such a standard were to be imposed, it would require a very long phase-in period. Admati, et.al., assert that a clear policy implication is that regulators should prevent banks from paying dividends, buying back stock or making other equity payouts until higher capital levels are achieved. If imposed, this restriction probably would not help entice investors to buy bank stocks.

1 Alan Greenspan. On the crisis. 2009.

2 Admanti, DeMarzo, Hellwig, and Pfleiderer. Why bank capital is not expensive. Stanford Graduate School of Business Research Paper. 2010.