Posts Tagged ‘Finance’

Hillary Clinton and Donald Trump agree on one thing: Managers of private equity funds should pay ordinary tax rates on their carried interest, not the lower rates that apply to long-term capital gains and dividends. They differ, of course, on what those rates should be. But if we made that change today, managers would pay taxes at effective federal rates of up to 44 percent, rather than the up-to-25 percent rates that apply currently.

I agree. Fund managers should pay ordinary rates on their carried interest. In a new paper, I argue that this is the right approach for a reason distinct from, and in addition to, the conventional concern about wealthy fund managers paying low tax rates. Taxing carried interest as capital gains creates a costly loophole when benefits to managers are not offset by corresponding costs to investors. Such offsets exist when investors are taxable individuals. In that case, carried interest merely transfers the capital gains preference from investors to managers. But there’s no offset when investors are tax-exempt organizations or corporations, neither of which gets a capital gains preference. By transferring their capital gains to the manager, rather than paying in cash, these investors create a capital gains preference that would otherwise not exist. Taxing carried interest as ordinary income eliminates that loophole.

This perspective on the carried interest problem yields a second insight: Current proposals to reform carried interest taxation are incomplete. If carried interest is taxed as ordinary income for managers, the investors who provide that compensation should be able to deduct it from their ordinary income as an investment or business expense. That’s how we treat cash management fees. There is no reason to treat carried interest differently.

To see why this matters, consider a fund—it might be a buyout fund, a venture capital fund, or a syndicate of angel investors—that invests in companies, improves their business prospects, and then sells to other investors. The managers receive a cash management fee and a 20 percent carried interest, their share of the fund’s profits from dividends and capital gains.

If the fund generates $100 in long-term capital gains, managers get $20 and investors get $80. Under current practice, managers pay capital gains taxes, individual investors pay capital gains taxes, and endowments and other tax-exempt organizations pay nothing.

Many reformers, including President Obama, would tax carried interest as labor income while making no changes for investors. Under this partial reform, managers pay labor income rates on their $20, and investors pay capital gains taxes on their $80.

Under my full reform, managers would pay labor income taxes on their carry, as under the Obama plan. Investors, however, would pay capital gains taxes on all $100 of the fund’s gains and then deduct the $20 of carried interest from their ordinary income.

For tax-exempt investors, there is no difference between partial and full reform. They don’t pay taxes, so they only care about their net income, not how the tax system characterizes it. The same is true for corporations, which pay the same tax rates on any income.

But taxable individuals do care. As long as they can use most of their deductions, they would prefer to deduct carried interest against their ordinary income. Better to pay capital gains taxes on $100 and deduct $20 from ordinary income than to just pay capital gains taxes on $80.

Individual investors in these funds are quite well-off, so why would we want to give them a bigger deduction? Two reasons. First, our goal should be a tax system that treats private equity funds neither better nor worse than other ways of structuring investments.

Current practice fails that test. Because of the carried interest loophole I described above, overall fund returns are often under-taxed relative to other forms of investment. Partial reform fixes that problem, but pushes the pendulum slightly too far the other way, over-taxing fund returns when investors are taxable individuals. Full reform gets the balance exactly right.

Second, our goal should be a tax system that treats cash compensation and carried interest equivalently. Current practice again fails, encouraging managers to employ various games to convert cash fees into carried interest. Partial reform fixes that, but again goes slightly too far, making cash more attractive than carry. Full reform treats them identically.

Full reform also solves the most legitimate concern of people who defend current practice. They typically argue that lower tax rates on capital gains reward entrepreneurship, financial risk taking, and sweat equity in new or struggling businesses. And they are right. Love it or hate it (that’s a debate for another day), our tax code provides lower tax rates on capital gains and dividends from creating or improving businesses.

There is no reason those lower rates should not be available for investments made through funds. But partial reform eliminates these lower rates for any gains distributed as carried interest. Full reform solves that problem by crediting all the gains to investors. That’s probably not what many defenders of current practice have in mind. But it does ensure that all capital gains are treated as such.

Managers thus pay labor income taxes, and investors get the usual benefits associated with capital gains. And managers and investors are free to negotiate whatever fund terms are necessary—perhaps including more carried interest—to make their funds viable businesses. This being the tax code, there are some pesky details, especially about how investors can deduct carried interest. But the bottom line is that full reform would tax carried interest just right.

Disclosure: I am currently evaluating whether to invest in an angel syndicate. I have family and friends who manage and invest in private equity funds.

Read Full Post »

On Monday, the Government Accountability Office (GAO) defended the current method for budgeting for federal lending programs, known as “credit reform.” By endorsing the status quo, GAO puts itself at odds with the Congressional Budget Office (CBO), which has championed a “fair value” alternative. The details are wonky but the stakes are big. Over a decade, federal lending support for mortgages, student loans, and the Export-Import Bank could appear $300 billion more costly under fair-value budgeting than under credit reform.

CBO is right to question the way we budget for these programs. But GAO is right that CBO’s version of fair value is the wrong solution. Instead, we need a new approach that captures the strengths of both ideas, while avoiding their flaws. I laid out that alternative in a recent report.

One reason we need a new approach is that credit reform violates fundamental principles of good budgeting, for reasons that have nothing to do with the fair value debate.

The problem

Credit reform uses present values to measure the budget impact of federal loans, recording any expected gains or losses the moment a loan is made. But the rest of the budget operates on a cash basis, recording the budget effects of tax and spending policies as they happen over time. These two approaches do not mix well together. By using present values, credit reform can make federal lending appear to mint money out of thin air. It also credits the budget today for earnings it won’t see until well beyond the official budget window.

Consider a simple example: the government lends $1,000 to a business for four years expecting a 4 percent annual return, or $40-a-year for a total of $160. To finance the loan, the government issues $1,000 in Treasury bonds that pay 1.5 percent interest. At $15 per year, interest costs total $60. Thus, the government would net $100.


New New Table

How should we budget for those expected gains? One possibility would be to track cash flows, as we do for other government activities. The government lends $1,000 in year one, nets $25 in each of the four following years, and gets repaid $1,000 in year five. Its overall gain would be $100, just as it should be.

That gets the cash flows right, but the timing is ill-suited to budgeting. The upfront cost can make the loan look costly even though it actually brings in money. If Congress focused on a three-year budget window, for example, the loan would look like it costs $950 even though it actually earns $100 over its full life.

A poor solution

We can avoid that problem by eliminating the confusing lumpiness of the cash flows. Credit reform does so by calculating the net present value of the return on the loan, discounted using the government’s borrowing rate. That calculation (the second row in the table) shows an instant gain of $96 when the loan is made. (The $96 is slightly less than the $100 because of pesky technical details.)

Credit reform thus eliminates the lumpiness but at a big cost: it misleadingly claims the returns to lending happen instantly. In reality, those returns accumulate gradually over the life of the loan. In its zeal to get rid of the lumpiness bathwater, credit reform mistakenly throws out the timing baby. As a result, lending programs can look like a magic money machine.

Unlike tax increases or spending cuts, lending programs get instant credit for returns they won’t see for years, sometimes far beyond the official budget window. To take an extreme case, a 100-year loan on the above terms would score as almost $1,300 in immediate budget gains under credit reform, all before the government collects a dime in interest.

To the best of my knowledge, no other person, business, or organization budgets or accounts for loans this way (please share any counterexamples; Enron doesn’t count). Instead, they either accept the lumpiness of the cash flows or use an approach that avoids the lumpiness while reflecting the real timing of returns.

A better answer

It isn’t hard: Instead of tracking all the cash flows, we can report just the net returns on the loan. When the loan is first made, there aren’t any. In our example, the $1,000 loan exactly offsets $1,000 in borrowing to finance it. The reverse happens in year five when the loan gets paid off. In between, the government nets $25 each year: $40 in interest payments less $15 in annual financing costs.

Tracking net returns is a highly intuitive way to report the budget effects of making the loan. It would match the way we budget for tax and spending programs, and would respect the budget window.

The government can and sometimes does make money from its lending programs, but not instantly. The budget community should disavow the credit reform approach and recognize that earnings accumulate gradually over time. CBO, GAO, and budget wonks should join hands to fix this problem regardless of where they sit in the fair value debate.

Note: For more on the technical details, including how to deal with loan guarantees, how the fair value debate reappears in deciding how to measure net returns, and a second challenge in budgeting for lending programs, see my report and policy brief.



Read Full Post »

The Department of Energy snookered the media last week with a report that seems to show that its clean energy lending programs are profitable. “Remember Solyndra? Those loans are making money,” went a typical headline.

Unfortunately, that’s not true. Taxpayers are losing money on DOE lending. Less than originally expected, and less than you would expect given media coverage of Solyndra, Fisker, and a few other failed loans. But smaller losses are still losses, not profits.

To understand DOE’s spin, consider a simple example. Suppose your spouse borrows $10,000 from a bank at 5 percent interest over 10 years so that you can lend it to your friend Bob on the same terms.

Everything goes well in the first year. Bob pays you, and your spouse pays the bank.

If your aunt asks how the deal is going, what would you say? A good answer would be, “We are breaking even; let’s hope Bob keeps paying us back.” You and your spouse are in this together, the loans from the bank and to Bob offset one another, and your best hope is for that to continue.

If DOE were asked, however, it apparently would say, “Things are great; Bob paid me $500 in interest, and I am on track to earn $5,000.” DOE takes credit for the interest that companies pay on their loans, but it doesn’t subtract—or even report—the interest costs that taxpayers pay to finance those loans. That’s like claiming profits on your loan to Bob, while ignoring the interest your spouse pays the bank.

ELO Report

DOE’s report does not address this issue, except in a footnote in a table (cut and pasted above) revealing that its $810 million of “interest earned” was “calculated without respect to Treasury’s borrowing cost.” In other words, DOE reports gross interest received, not the net interest taxpayers have earned after subtracting Treasury borrowing costs. The incomplete figures in the table seem to suggest that DOE has eked out a $30 million profit on its lending ($810 million in interest less $780 million in loan losses). But when we account for Treasury borrowing costs, taxpayers are actually well behind.

The report does not allow us to say just how far behind. We do know, however, that DOE loans are typically made at small, sometimes zero, spreads above Treasury rates. So a large portion of DOE’s “interest earned” must have been offset by borrowing costs. That puts taxpayer losses in the hundreds of millions of dollars.

The same concern applies to DOE’s statement that interest payments on these loans will eventually top $5 billion. Some media outlets are reporting that as $5 billion of profit. It’s not. That $5 billion does not include the cost of Treasury financing or of any defaults. DOE’s $5 billion figure is like claiming your loan to Bob is scheduled to bring in $5,000 in interest; it’s technically true, but tells you nothing about profits. Indeed, the Obama administration still predicts that DOE’s loans will lose money over their lifetimes.

DOE’s lending programs should not be evaluated solely or even primarily based on their profitability or lack thereof. What matters is their overall social impact. How much are they advancing new technologies? How much are they reducing future pollution? Have they created jobs and economic growth? And are any gains worth the taxpayer subsidies? Those are the questions we should be trying to answer.

If DOE wants to play the profitability card, however, it should do so in an accurate and transparent way. Last week’s report falls woefully short. DOE owes taxpayers an honest accounting of the financial performance of its lending programs.

P.S. In recent work, I raised concerns about how the government budgets for lending programs. One issue is whether we should measure profitability against Treasury borrowing rates (as currently done) or against market rates (which the government could earn by unsubsidized lending). I expected that issue to arise in DOE’s accounting. Instead, the agency ignored the cost of capital entirely. Budget policymakers eliminated that ploy more than two decades ago, so it is stunning DOE would resurrect it.

Read Full Post »

Lending programs create special challenges for federal budgeting. So special, in fact, that the Congressional Budget Office estimates their budget effects two different ways. According to official budget rules, taxpayers will earn more than $200 billion over the next decade from new student loans, mortgage guarantees, and the Export-Import Bank. According to an alternative that CBO favors, taxpayers will lose more than $100 billion.

Those competing estimates pose a $300 billion question: Which budgeting approach is best?

As I document in a new report and policy brief, the answer is neither one. Each approach tells only part of the story. Congress would be better served by a new approach that fairly reflects all the fiscal effects of lending.

Compared with what?

If lending programs perform as CBO expects, they will bring in new money that the government can use to reduce the deficit, increase spending, or cut taxes. In that sense, taxpayers may come out more than $200 billion ahead.

But these programs do not fully compensate taxpayers for their financial risk. If the government took the same risk by making loans and guarantees at fair market rates—perhaps by investing in publicly traded bonds—taxpayers would make much more. Taxpayers are subsidizing the students, homeowners, and companies that borrow through these programs. In that sense, taxpayers come out more than $100 billion behind.

The same issue can arise in personal life. Suppose your aunt asks for a $10,000 loan to start a business. You’ve got exactly that much in a government bond fund earning 2.5 percent, and she offers to pay 5 percent. She’s got a good head for business, so the risk of default is very low; realistically you expect a 4 percent annual return.

The loan sounds like a winner, right? Her 4 percent beats the bond fund’s 2.5 percent, if you can handle the risk. But there’s one other thing: your brother-in-law, equally good at business, would like a similar loan, and he’s willing to pay 6 percent, with an expected net of 5 percent.

Now the loan to your aunt sounds like a loser. Your brother-in-law’s 5 percent beats her 4 percent. You might still prefer to lend to her, but you would come out behind in financial terms.

The competing CBO estimates reflect this dichotomy. One approach compares the financial returns of lending with doing nothing (the $200 billion gain in CBO’s case, 4 percent versus 2.5 percent in yours). The other compares the returns with taking similar risks and being fully compensated (the $100 billion loss in CBO’s case, 4 percent versus 5 percent in yours).

Both comparisons provide useful information. If you want to predict the government’s future fiscal condition, you should compare the financial returns of lending with doing nothing. If you want to measure the subsidies given to borrowers, you should compare returns with the fair market alternative.

When you discuss your aunt’s proposal with your spouse, you would be wise to mention not only the potential financial gain (“4 percent is better than 2.5 percent”) but the subsidy to your aunt (“4 percent is less than the 5 percent your brother would pay”). Only then can you have an open discussion of your family’s financial priorities.

Today’s approaches

The same information is necessary for an open discussion of federal budgeting. But official budget rules, created by the Federal Credit Reform Act of 1990 (FCRA), require CBO to use just the first approach in its budget analyses. Official estimates thus measure the fiscal effects of lending, not the subsidies provided to borrowers. CBO rightly believes, however, that policy deliberations are incomplete without measuring the subsidies, which CBO calculates separately using an approach known as fair value.

Policy analysts have vigorously debated the pros and cons of FCRA and fair value for years. Neither side has scored a decisive win for a simple reason: both approaches are incomplete. Fair value measures subsidies well, but tells us nothing about fiscal effects; this is its missing-money problem. FCRA measures lifetime fiscal effects well, but tells us nothing about subsidies.

By recording expected fiscal gains the moment a loan is made, moreover, FCRA makes lending appear to be a magic money machine. Lending may pay off over time, but the gains do not happen the moment the loan’s ink is dry. Like any lender, the government must be patient to earn those returns. It must hold the loan, perhaps for many years, and bear the associated financial risk.

A better approach

For those reasons, I believe we should replace both approaches with a more accurate budgeting method, which I call expected returns. As the report and brief describe, the expected-returns approach forecasts the fiscal effects of a loan by projecting the government’s expected returns year by year, rather than collapsing them into a single value at the time the loan is made, as both FCRA and fair value do.

Expected returns accurately tracks the fiscal effects of lending over time, thus avoiding both fair value’s missing-money problem and FCRA’s magic-money-machine problem. It also provides a natural framework for reporting the fiscal effects of lending and the subsidies to borrowers. Expected returns would give policymakers and the public a more accurate assessment of federal lending than either of the approaches we use now.

Read Full Post »

Suppose your aunt decides to start a business making pizza ovens. She will design and build the ovens, and her daughter will manage operations. A bank is ready to lend her $100,000 to get started, but it wants someone to co-sign and be on the hook if she misses any payments. She offers to pay you $6,000 to do so.

A business-savvy friend tells you that missed payments on such a loan average $2,000, usually less, occasionally much more. He also reports that $7,000 is the going rate for co-signing.

Those insights spark lively family debate. Your aunt believes her proposal is a no-brainer. She would get to start her business, your niece would get a better job, and you would come out $4,000 ahead on average. It’s a win-win-win for the family.

Your spouse disagrees. Yes you’d net $4,000, on average, but you would get $5,000 by co-signing a similar loan in the marketplace. Your aunt is asking you to bear the financial risk of her loan without fully compensating you. In a worst case scenario, you might end up owing the bank $100,000. You deserve to be fairly compensated for taking that risk. Co-signing would help her and your niece and may be best for the family. But the deal is not a win all around. You would be bearing real financial risk, effectively giving your aunt $1,000, and everyone in the family should acknowledge that.

Co-signing the loan would thus make you $4,000, according to your aunt, or cost you $1,000, according to your spouse. But which is it? And should you co-sign the loan?

Those questions are at center stage as Congress debates the fate of the Export-Import Bank, whose charter expires September 30. The details are more complex—imagine the Bank co-signing a loan to a restaurant in Ethiopia that wants to buy an oven from your aunt—but the issues are the same.

Like your aunt, Bank proponents argue that guaranteeing loans is a win-win-win. American exporters will sell more abroad, a win for shareholders and a win for their workers. Bank fees more than cover expected losses, so taxpayers win as well. Indeed, the Congressional Budget Office estimates the Bank will net $14 billion from new guarantees over the next decade.

Like your spouse, however, others reject the idea that the Bank is really a win for taxpayers. While it might generate $14 billion over the next decade, the Bank would gain even more—$16 billion—if taxpayers were fairly compensated for the risks they would be taking. By offering loan guarantees at below-market rates, the Bank will effectively lose $2 billion over the next decade, again according to CBO.

Your view of the Bank’s profitability thus depends on what you measure it against. Official budget accounting, which shows the gain, compares the Bank’s performance to a scenario in which it doesn’t exist. CBO’s alternative, which shows the loss, compares the Bank’s performance to a scenario in which it does exist but charges fair market rates.

Both comparisons are important. The $14 billion represents the expected fiscal gain if the Bank is reauthorized for another decade, while the $2 billion represents the subsidy that exporters get from taxpayers who aren’t fully compensated for bearing new financial risks. The Bank’s specific activities are costing taxpayers, but in purely monetary terms that is more than offset by the gains from being a commercial lender.

If the Bank’s purpose were solely to make money, we’d do better to replace it with a commercial venture that operates on market terms. But making money is not the Bank’s mission. Instead, its goal is to support American exporters, particularly in competition with foreign firms that also receive government backing.

Policymakers thus confront the same tradeoffs that arise for almost any policy. The Bank creates winners and losers. Just as you need to balance the personal cost of co-signing your aunt’s loan at below-market rates against the potential benefits to your family, so must Congress balance the costs and benefits of the Export-Import Bank. It might still be worthwhile, but it’s not a win-win-win.

Read Full Post »

Eugene Fama, Lars Peter Hansen, and Robert Shiller won the Nobel Prize in Economics this morning for their work studying asset prices. In one sense, they are a motley trio: Fama is famous for emphasizing efficient markets, Shiller for emphasizing investor psychology and inefficient markets, and Hansen for high-tech econometric techniques that are used well beyond finance. The unifying theme is their shared interest in understanding the predictability, if any, of asset prices.

The Royal Swedish Academy of Sciences posted an accessible summary of their work. Here’s the intro:

There is no way to predict whether the price of stocks and bonds will go up or down over the next few days or weeks. But it is quite possible to foresee the broad course of the prices of these assets over longer time periods, such as, the next three to five years. These findings, which may seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

Fama, Hansen, and Shiller have developed new methods for studying asset prices and used them in their investigations of detailed data on the prices of stocks, bonds and other assets. Their methods have become standard tools in academic research, and their insights provide guidance for the development of theory as well as for professional investment practice. Although we do not yet fully understand how asset prices are determined, the research of the Laureates has revealed a number of important regularities that are helping us to arrive at better explanations.

The predictability of asset prices is closely related to how markets function, and that’s why researchers are so interested in this question. If markets work well, prices should have very little predictability. This statement may seem paradoxical, but consider the following: suppose investors could predict that a certain stock would increase a lot in value over the next year. Then they would buy the stock immediately, driving up the price until it is so high that the stock is no longer attractive to buy. What remains is an unpredictable price pattern, with random movements that reflect the arrival of news. In technical jargon, prices then follow a “random walk.”

There are, however, reasons why prices may follow somewhat predictable patterns even in a well-functioning market. A key factor is risk. Risky assets are less attractive to investors, so on average, a risky asset will need to deliver a higher return. A higher return for the risky asset means that its price can be predicted to rise faster than for safe assets. To detect market malfunctioning, then, one would need to have an idea of what a reasonable compensation for risk ought to be. The issue of predictability and the issue of normal returns that compensate for risk are intertwined. The three Laureates have shown how to disentangle these issues and analyze them empirically.

Read Full Post »

Since the day of Alexander Hamilton, the United States has never defaulted on the federal debt.

That’s what we budget-watchers always say. It’s a great talking point. One that helps bolster the argument that default should not be an option in Washington’s latest debt limit showdown.

There’s just one teensy problem: it isn’t exactly true. The United States defaulted on some Treasury bills in 1979 (ht: Jason Zweig). And it paid a steep price for stiffing bondholders.

Terry Zivney and Richard Marcus describe the default in The Financial Review (sorry, I can’t find an ungated version):

Investors in T-bills maturing April 26, 1979 were told that the U.S. Treasury could not make its payments on maturing securities to individual investors. The Treasury was also late in redeeming T-bills which become due on May 3 and May 10, 1979. The Treasury blamed this delay on an unprecedented volume of participation by small investors, on failure of Congress to act in a timely fashion on the debt ceiling legislation in April, and on an unanticipated failure of word processing equipment used to prepare check schedules.

The United States thus defaulted because Treasury’s back office was on the fritz in the wake of a debt limit showdown.

This default was temporary. Treasury did pay these T-bills after a short delay. But it balked at paying additional interest to cover the period of delay. According to Zivney and Marcus, it required both legal arm twisting and new legislation before Treasury made all investors whole for that additional interest.

The United States thus did default once. It was small. It was unintentional. But it was indeed a default.

And the nation still stands. But that hardly means we should run the experiment again and at larger scale. Zivney and Marcus examined what happened to T-bill interest rates as a result of this small, temporary default. They find a surprisingly large effect. As best they can tell, T-bill interest rates increased about 60 basis points after the first default and remained elevated for at least several months thereafter. A simple way to see that is to look at daily changes in T-bill yields:

1979 Treasury Default

T-bill rates spiked upwards four times in the months around the default. In November 1978, Henry “Dr. Doom” Kaufman predicted that interest rates would rise. They did. Turn-of-the-year cash management disrupted rates as 1978 became 1979. And rates spiked and fell in October 1979 when Paul Volcker announced that the Fed would target monetary aggregates rather than interest rates (the “Saturday night special”).

The fourth big move was the day of the first default, when T-bill rates rose almost 0.6 percentage points (i.e., 60 basis points).There’s no indication this increase reversed in the days that followed (the vertical line on the chart is just a marker for the day of default). Indeed, using more sophisticated means, including comparing T-bill rates to interest on commercial paper, the authors conclude that default led to a persistent increase in T-bill rates and, therefore, higher borrowing costs for the federal government.

The financial world has changed dramatically in the intervening decades. T-bill rates hover near zero compared to the 9-10 percent range of the late 1970s; that means a temporary delay in payments would be less costly for creditors. Treasury’s IT systems are, one hopes, more reliable that 1970s vintage word processors. And one should take care not to make too much of a single data point.

But it’s the only data point we have on a U.S. default. Not surprisingly it shows that even small, temporary default is a bad idea. Our leaders shouldn’t come close to risking it.

P.S. Some observers believe the United States also defaulted in 1933 when it abrogated the gold clause. The United States made its payments on time in dollars, but eliminated the option to take payment in gold. For a quick overview of this and related issues, see this blog post by Catherine Rampell and the associated comments.

P.P.S. This post originally appeared in May 2011. This version has been slightly edited.

Read Full Post »

Older Posts »