Tuesday, August 11, 2009

Arizona’s Budget Breakthrough - An alternative to California’s tax and spend model

Arizona’s Budget Breakthrough. WSJ Editorial
An alternative to California’s tax and spend model.
WSJ, Aug 11, 2009

Perhaps states are starting to learn the right fiscal lessons from the red-ink blowouts in high-tax California and New York. Today, the legislature in Arizona will vote on a tax reform designed to entice more employers and high-income taxpayers to the state. Sponsored by Republican Governor Jan Brewer, the plan would cut state property taxes, the corporate tax and personal income taxes, in exchange for a temporary rise in the sales tax.

Most economic studies agree that states have more jobs and higher income growth when they tax consumption rather than savings, investment and business profits. This explains why most of the nine states with no income tax at all—such as Texas, Florida and Tennessee—have been economic high-flyers in recent decades.

Ms. Brewer’s proposal reflects this economic logic. Effective January 1, 2011, her plan would reduce the state’s corporate income tax rate to 4.86% from 6.97%, which would be one of the largest business tax cuts in the nation in recent years. The proposal also cuts all personal income tax rates by 6.6%, thus lowering the top marginal rate to 4.24% from 4.54%. A hated statewide tax on commercial and residential property would also be abolished.

Arizona has been hit especially hard by the housing slump, and its budget woes were compounded thanks to former Governor Janet Napolitano’s spending spree before she joined the Obama cabinet. On her watch the budget grew by more than 50% in five years—to $10.2 billion from $6.5 billion in 2004. The state now has a $1 billion budget gap, and to close it the legislature will also vote on a one percentage point increase in the sales tax to 6.6% in 2010 and 2011; in the third year the sales tax would fall to 6.1%, and in the fourth year would revert to its current 5.6% rate.

We’d rather see the legislature cut more spending than raise the sales tax, but on the other hand the sales tax would only take effect if it is approved on the November ballot. The political class is giving voters a say in the matter. The sales tax increase also has the advantage of a built-in expiration date, while the tax cuts are permanent.

Democratic opponents are calling this a tax giveaway to big business. But lawmakers needn’t apologize for trying to retain Arizona’s status as a business-friendly state—particularly when jobs are so scarce. Small employers also benefit from the lower property tax rates and the personal income tax reductions. Lower tax payments will enable them to reinvest more in their enterprises.

The opponents should consult a new study of state business taxes by former U.S. Treasury economist Robert Carroll for the Tax Foundation. He examined 50 states and found that states with lower corporate tax rates have higher wage gains and more productivity over time. This tax cut sounds like a high-return investment.

Republicans control both houses of the Arizona legislature, and as we went to press the main obstacle to passing the reform was the Arizona Senate’s antitax conservatives. They oppose the higher sales tax. These Republicans should look to one of the triumphs of the Reagan Presidency, the 1986 tax reform, which broadened the tax base but substantially lowered tax rates and thus sustained the 1980s expansion.

Arizona has the chance to be the anti-California, closing the budget deficit by growing the economy, not by raising taxes. We hope legislators don’t blow it, because the U.S. desperately needs an alternative to the tax, spend and tax again philosophy of Sacramento and Albany.

The Next Fannie Mae: Ginnie Mae and FHA are becoming $1 trillion subprime guarantors

The Next Fannie Mae. WSJ Editorial
Ginnie Mae and FHA are becoming $1 trillion subprime guarantors.
The Wall Street Journal, p A16, Aug 11, 2009

Much to their dismay, Americans learned last year that they “owned” Fannie Mae and Freddie Mac. Well, meet their cousin, Ginnie Mae or the Government National Mortgage Association, which will soon join them as a trillion-dollar packager of subprime mortgages. Taxpayers own Ginnie too.

Only last week, Ginnie announced that it issued a monthly record of $43 billion in mortgage-backed securities in June. Ginnie Mae President Joseph Murin sounded almost giddy as he cheered this “phenomenal growth.” Ginnie Mae’s mortgage exposure is expected to top $1 trillion by the end of next year—or far more than double the dollar amount of 2007. (See the nearby table.) Earlier this summer, Reuters quoted Anthony Medici of the Housing Department’s Inspector General’s office as saying, “Who would have predicted that Ginnie Mae and Fannie Mae would have swapped positions” in loan volume?

Ginnie’s mission is to bundle, guarantee and then sell mortgages insured by the Federal Housing Administration, which is Uncle Sam’s home mortgage shop. Ginnie’s growth is a by-product of the FHA’s spectacular growth. The FHA now insures $560 billion of mortgages—quadruple the amount in 2006. Among the FHA, Ginnie, Fannie and Freddie, nearly nine of every 10 new mortgages in America now carry a federal taxpayer guarantee.

Herein lies the problem. The FHA’s standard insurance program today is notoriously lax. It backs low downpayment loans, to buyers who often have below-average to poor credit ratings, and with almost no oversight to protect against fraud. Sound familiar? This is called subprime lending—the same financial roulette that busted Fannie, Freddie and large mortgage houses like Countrywide Financial.

On June 18, HUD’s Inspector General issued a scathing report on the FHA’s lax insurance practices. It found that the FHA’s default rate has grown to 7%, which is about double the level considered safe and sound for lenders, and that 13% of these loans are delinquent by more than 30 days. The FHA’s reserve fund was found to have fallen in half, to 3% from 6.4% in 2007—meaning it now has a 33 to 1 leverage ratio, which is into Bear Stearns territory. The IG says the FHA may need a “Congressional appropriation intervention to make up the shortfall.”

The IG also fears that the recent “surge in FHA loans is likely to overtax the oversight resources of the FHA, making careful and comprehensive lender monitoring difficult.” And it warned that the growth in FHA mortgage volume could make the program “vulnerable to exploitation by fraud schemes . . . that undercut the integrity of the program.” The 19-page IG report includes a horror show of recent fraud cases.

If housing values continue to slide and 10% of FHA loans end up in default, taxpayers will be on the hook for another $50 to $60 billion of mortgage losses. Only last week, Taylor Bean, the FHA’s third largest mortgage originator in June with $17 billion in loans this year, announced it is terminating operations after the FHA barred the mortgage lender from participating in its insurance program. The feds alleged that Taylor Bean had “misrepresented” its relationship with an auditor and had “irregular transactions that raised concerns of fraud.”

Is anyone on Capitol Hill or the White House paying attention? Evidently not, because on both sides of Pennsylvania Avenue policy makers are busy giving the FHA even more business while easing its already loosy-goosy underwriting standards. A few weeks ago a House committee approved legislation to keep the FHA’s loan limit in high-income states like California at $729,750. We wonder how many first-time home buyers purchase a $725,000 home. The Members must have missed the IG’s warning that higher loan limits may mean “much greater losses by FHA” and will make fraudsters “much more attracted to the product.”

In the wake of the mortgage meltdown, most private lenders have reverted to the traditional down payment rule of 10% or 20%. Housing experts agree that a high down payment is the best protection against default and foreclosure because it means the owner has something to lose by walking away. Meanwhile, at the FHA, the down payment requirement remains a mere 3.5%. Other policies—such as allowing the buyer to finance closing costs and use the homebuyer tax credit to cover costs—can drive the down payment to below 2%.

Then there is the booming refinancing program that Congress has approved to move into the FHA hundreds of thousands of borrowers who can’t pay their mortgage, including many with subprime and other exotic loans. HUD just announced that starting this week the FHA will refinance troubled mortgages by reducing up to 30% of the principal under the Home Affordable Modification Program. This program is intended to reduce foreclosures, but someone has to pick up the multibillion-dollar cost of the 30% loan forgiveness. That will be taxpayers.

In some cases, these owners are so overdue in their payments, and housing prices have fallen so dramatically, that the borrowers have a negative 25% equity in the home and they are still eligible for an FHA refi. We also know from other government and private loan modification programs that a borrower who has defaulted on the mortgage once is at very high risk (25%-50%) of defaulting again.

All of which means that the FHA and Ginnie Mae could well be the next Fannie and Freddie. While Fan and Fred carried “implicit” federal guarantees, the FHA and Ginnie carry the explicit full faith and credit of the U.S. government.

We’ve long argued that Congress has a fiduciary duty to secure the safety and soundness of FHA through common sense reforms. Eliminate the 100% guarantee on FHA loans, so lenders have a greater financial incentive to insure the soundness of the loan; adopt the private sector convention of a 10% down payment, which would reduce foreclosures; and stop putting subprime loans that should have never been made in the first place on the federal balance sheet.

The housing lobby, which gets rich off FHA insurance, has long blocked these due-diligence reforms, saying there’s no threat to taxpayers. That’s what they also said about Fan and Fred—$400 billion ago.

Corporate Earnings Are No Sign of Recovery

Corporate Earnings Are No Sign of Recovery. By ZACHARY KARABELL
WSJ, Aug 09, 2009

Despite grim predictions, most major U.S. companies have reported positive earnings for the second quarter of 2009. Given how wrong past predictions have been, the fact that earnings have blown away expectations shouldn’t be so surprising. Still, the numbers are genuinely impressive: More than 73% of the companies that have reported so far have beaten earnings estimates—and stocks have rightly rallied.

Yes, profits are down sharply from a year ago, but this is in the context of an overall global economy that is shrinking. If a company made $30 million on $100 million in revenue a year ago, and made “only” $20 million this quarter, it’s accurate to have a headline that says its profits fell 33%. But making $20 million, or a 20% margin, in an economy that contracted is nonetheless startling, or should be.

The same Wall Street culture that failed to anticipate the tipping point in the financial system is just as prone to a herd mentality of negativity. Having overlooked the gaping fissures in the system last year, most analysts went to the other extreme in their analysis of what would happen this year. A similar process occurred in 2002 and 2003, as views whipsawed from unrealistic optimism to irrational pessimism.

This time, the slew of better earnings has also led to the conviction that the worst of the economic travails are behind us. As the stock market has soared, many have declared the recession either over or ending. These voices range from public officials at the Federal Reserve to notable pessimists such as New York University economist Nouriel Roubini. This rosy view assumes a connection between how listed companies are fairing and how the national economy will fair. That assumption is wrong.

The delinkage of the fate of corporate profits from that of the overall economy is not new. Beginning earlier in this decade, profits began to accelerate far in excess of either global or U.S. economic growth.

In 2004, for instance, earnings for the S&P 500 grew 22%; in 2005 and 2006 they grew just under 20%. Those same years global growth barely exceeded 3%. As we now know, some of those elevated earnings were due to the leverage-fueled profits of the financial-service industry. And there’s little doubt that mortgage-laced derivatives artificially elevated growth. But even discounting those factors, the growth of corporate profits would have substantially exceeded the expansion of national economies.

Then, in the second half of last year and the first months of this year, profits plunged along with U.S. and global economic activity. That gave succor to the belief that companies can only grow as much as the economies in which they function grow. For years, most analysts argued that if there was too wide a variance between the two, something had to give. Either profits had to descend or national economic growth had to accelerate. As profits shrank over the past nine months, those who argued that a reversion to the mean was inevitable seemed to be vindicated. But that belief is wrong. Companies are increasingly less constrained by any national economy, and their success is no harbinger of national economic growth or sustained economic health for the United States.

First, companies have been profiting because they can cut costs aggressively. It’s not as if demand in the U.S. or Europe has picked up. Take Starbucks, which reported a surprising surge in profits. Little of that was due to American consumers suddenly becoming comfortable with $5 grande mocha lattes. Instead, it was because Starbucks—faced with weak demand and sluggish sales—closed stores and laid off workers. That has been a trend across industries.

Second, many larger companies have been profiting because they can focus on where the growth is around the globe. Companies such as Intel, Caterpillar, Microsoft and IBM now derive a majority of their revenues from outside the U.S., with the dynamic economies of the Asian rim and above all China assuming an ever-larger role. Companies are thriving in spite of economic activity in the U.S., not because of it.

That suggests the connection between corporate profits and robust economic recovery in the U.S. is tenuous at best. In fact, the financial crisis hastened the trend toward efficiencies, toward leaner inventories, and towards integrating both technology and global supply chains that has been taking place over the past decade.

That has led to severe pressure on the American working class and eroding employment. As these companies profit from global expansion and greater efficiency, they have little or no reason to rehire fired workers, or to expand their work force in a U.S. that is barely growing. If you are a global company, you want to hire and expand where the most dynamic growth is. Unfortunately for Americans, that’s not the U.S.

So we are facing a conundrum: Companies can grow by leaps and bounds—by double-digits—and yet unemployment can skyrocket and remain high. There is nothing on the horizon that would lead one to expect a turnaround in the employment picture.

Job losses slowed slightly last month as the unemployment rate fell to 9.4% in July from 9.5% in June, but that’s a far cry from any sign of job creation. The weight of more than 20 million marginally employed or unemployed, combined with the increasing pace of economic activity outside the U.S., presents the prospect of permanent change in the American economic landscape: high unemployment, moderate to weak growth, and soaring corporate profits.

The ability of companies—large ones especially, but even more modest ventures that assemble and source globally—to become more efficient and go where the growth is has never been greater. This is undoubtedly good for stocks and positive for investors, but it is also a challenge for American society that we have not even begun to confront.

Mr. Karabell is president of River Twice Research. His new book, “Superfusion: How China and America Became One Economy and Why the World’s Prosperity Depends on It,” will be published by Simon & Schuster in October.