Wednesday, April 18, 2012

Pro Bono Finance

Lawyers fight to save death row inmates. Doctors provide charity care – treating the indigent, often without government reimbursement. In the financial services industry, volunteer work usually takes the form of pitching in at schools and cleaning parks. We finance folks lack a tradition of using our skills for public service. With our reputation in tatters, perhaps it is time to begin such a tradition.

Fears of sovereign and municipal debt crises offer a worthy volunteer opportunity. Government debt problems can easily become matters of life and death. Argentina’s sovereign debt crisis claimed 24 lives in December 2001. In Greece, crisis-related protests have claimed at least 5 lives and caused over 300 injuries. Annual suicide rates are up about 20 percent, as people despair over their diminished circumstances.

A US federal debt crisis could similarly lead to violent protests, fatalities and widespread psychological damage; it could also be accompanied by high levels of inflation and sudden, sharp cuts in benefits. Older people dependent on savings and social insurance payments would be especially hard hit.

Because hurricanes and tornados kill and injure, scientists have invested substantial time and effort in forecasting these natural disasters and helping members of the public avoid them. Fiscal crises – a type of human-made disaster – can also be anticipated and potentially curbed, or even avoided.

Last summer’s debt ceiling debate was a failed opportunity to avoid a US fiscal crisis. As we look back on the debate, it becomes evident that false and misleading rhetoric frequently crowded out accurate information. Among the myths that plagued last year’s discussion:

  • Failing to raise the debt ceiling would have inevitably triggered a default.1

  • The US government has never defaulted in its entire history (see our earlier blog post for the facts).

  • The nation’s long term budget imbalance can be resolved simply by controlling domestic discretionary spending or allowing the Bush tax cuts on high earners to expire (neither of these steps generate enough savings to avoid future problems).<

  • A 90% Debt-to-GDP ratio will trigger a fiscal crisis (see Japan).

  • We need to balance the budget to avoid a fiscal crisis (the Debt-to-GDP ratio will improve as long as the stock of debt grows more slowly than GDP).

  • Rapid economic growth is impossible if the federal government spends more than 20% of GDP (see 1999 economic and fiscal statistics for a refutation of this contention).

The financial community can provide a useful community service by educating the public about sovereign, state and municipal credit issues. And when I say educate, I don’t mean pontificate. Many of us - this writer included - hold views about what should be done about taxes and spending. Mixing these opinions with facts is not an unambiguous public service. Just as we strive to dispassionately evaluate credit and select investment opportunities, we can and should separate fact from opinion when informing voters about their fiscal options.

Mary Meeker and her colleagues issued a free report entitled “USA, Inc.” that provided the type of service I am suggesting. The report, which received substantial publicity, analyzed the nation’s fiscal position in a manner similar to that of an equity investor analyzing a business – with hundreds of slides describing revenue and expense drivers.

The next challenge is to broaden the scope of analysis to provide a credit perspective with its focus on default risk and recovery. Also, rather than misapply corporate or structured debt analytics, we need a fresh approach that directly addresses the unique challenges of assessing government debt. We’ll also be better positioned if the analysis is ongoing, or even real-time, rather than a “snapshot” analysis provided in the Meeker report.

Ideally, having a well-structured, up-to-date model on which to base policy positions seems enviable. If would assist Congress and the Administration in defining the task at hand and dispelling myths surrounding the task – and it would encourage an environment in which commentators would be required to support their opinions with quantifiable data, not simply foggy criteria.

At PF2, we will kick-start the effort to dispel the fog of opinion by offering a free, open source Public Sector Credit Framework (PSCF). Our framework will be accompanied by a timely, transparent US federal budget simulation model, which we’ve designed to estimate the likelihood of a fiscal crisis in each of the next thirty years. Although we don’t know everything about this topic, we do know that many financial professionals are equipped to improve the software and the model. We encourage you all to join us in enhancing the analysis.

Few can afford to provide pro bono services exclusively – and we are no exception. If the framework generates interest, we may use it as a platform for valuing sovereign and municipal bonds – a service we hope to monetize. But that notwithstanding, the software and model are being supplied at no charge under GNU’s Lesser General Public License, for anyone to use and improve. Assuming interest is sufficient, we will regularly update the US federal model as a public service.

Many of us in the financial service industry have done quite well. Having reaped some of the rewards, we think we have found a great way to give back. We look forward to your collaboration.

1 Treasury could have avoided a default through some combination of asset sales and spending reductions. The President could have invoked a clause in the 14th Amendment of the Constitution to mandate principal and interest payments that would have exceeded the debt ceiling. Congress would then have had to file a legal case to overturn the President’s order.

Contributed by PF2 consultant Marc Joffe. Marc previously researched and co-authored Kroll Bond Rating Agency’s Municipal Default Study. This posting is the third in a series of posts leading up to May 2nd. The prior pieces can be accessed by clicking here and here.

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