Planning Decisions, Inc.

THE BOTTOM LINE FROM CHUCK LAWTON

Margin Calls Are Coming for Everyone

Published Sunday March 23, 2008

Leverage is using given resources in
such a way that the potential positive
or negative outcome is magnified.
~Wikipedia

If nothing else, the last several weeks have given both ends of the income spectrum a harsh lesson in the dangers of playing with other people’s money. Billionaire currency speculators on Wall Street and special needs children in Wilton have both been getting margin calls.

In the case of the trader who bet on Bear Stearns, his mistake was assuming that the storied firm could always get short-term money from fellow banks to tide it over till its long-term mortgages regained their value. In the case of the Maine’s social service program managers who switched special needs children from the State General Fund to Medicaid, their mistake (if that’s what it proves to be) was assuming that they could always get enough short-term money from Augusta legislators to cover the federal match required to maintain their service levels.

Will these bets prove to be losers? It’s not yet clear. The lobbying in Augusta last week was no less intense than that in New York and Washington. Will the Manhattan investment bank and the Maine health care provider both fall victim to cyclical declines in their underlying assets—national home sales and state income and sales tax revenues? Or, will national and state legislators craft some form of bailout to prevent a crash? Stay tuned.

In either case, the ultimate consumers—a foreclosed former home owner and a child moving to her next foster home—are left in the dark, scratching their heads, wondering what mysterious forces have so suddenly and so completely turned their lives upside down. They are the ones left to bear witness to the truth that leverage magnifies the negative as well as the positive outcomes of resource use.

The answer to their questions, of course, lies not in the legitimacy of their needs, or in the ultimate, long-term propriety of their goals. Home ownership and internally secure and self-confident children are both worthy goals. Both warrant substantial investments. The answers to their questions, rather, lie in the way they (or, in the end, we) have chosen to pay for these investments.

In the case of the housing market, the Federal Reserve kept interest rates too low for too long, did not monitor loan writing and credit rating practices adequately and failed (along with everyone else) to realize the extent to which exotic monetized mortgage instruments had spread throughout the economy. Too many middlemen made too much money pushing a little more hot air into the balloon. And the rest of us were too captivated with the ever-expanding bubble to get out of the way before it burst. In the case of the health care market, Maine’s program managers worked diligently to magnifying their returns by moving people in programs funded 100 percent by the state into programs that were 65 percent funded by the federal government. While this 2 to 1 leverage is truly child’s play in comparison to the 30 to 1 ratio at Bear Stearns, it still means that a 10 percent fall in the state “equity” will mean a 30 percent cut in program services—a serious hit for those involved—if we don’t put up more “collateral” in the form of new sources of state funds.

The solution going forward is to find a more stable source of revenue to amortize the investment. For mortgages—don’t lend to someone with no income; don’t lend without a down payment, and resist lending to speculators whose only interest is flipping the property on the usually reliable “greater fool” theory. For social services, don’t rely on cyclical revenue sources. We have a state infrastructure bank for roads. We ought to have a human infrastructure bank for people. We should borrow funds to provide a stable revenue stream to programs that save money in the long run. They call themselves an investment in our future and justify their current costs on the grounds that they save money in the long run. If that’s truly the case, let’s treat them like investments, monitor the returns and pay them off over the long run.

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