Sunday, October 18, 2009

“You Lie!” The American Health Care Debate

In my lifetime no domestic issue has raised more rancor in America than the debate raging over health care. Representative Joe Wilson’s outburst has been repeated over and over by both sides, from the capitol to my own dinner table, as we wrestle with what may be the seminal issue of the Obama presidency’s first year. So, is government-funded health care just one more Unfunded Liability? Let’s take a look.

Support for the Senate version of health care reform got a boost this month when the CBO, in a letter from Director Douglas Elmendorf to Senator Max Baucus, said, “…enacting the Chairman’s mark, as amended, would result in a net reduction in federal budget deficits of $81 billion over the 2010-2019 period.” [1]

The “Chairman’s mark” of the America’s Healthy Future Act is a marked up version of the proposed legislation that came out of the Senate Committee on Finance.[2] It is not the legislation. As Director Elmendorf’s letter states, “…analysis is preliminary in large part because the Chairman’s mark, as amended, has not yet been embodied in legislative language.”

Payment for reform comes from two sources: new revenue and cost savings in existing government funded programs. So as I thought about how to approach an analysis it occurred to me there are two steps: The first is to look at the line items to see who pays and the second is to ask the question of how likely these items, if passed, will survive and generate the revenue or savings envisioned. At the very least the analysis provides a baseline from which to track the legislation to see what passes and what doesn’t and to monitor its performance over time.

The cost for the proposal is broken down into the following three categories: Medicaid and Children’s Health Insurance Program (CHIP), insurance exchange subsidies, and tax credits for small employers. The total estimated cost is $829 billion. Cost offsets (revenue) in the form of additional taxes amount to $311 billion and are divided into these four categories: a tax on high premium insurance plans, penalty payments by uninsured individuals, penalty payments by non-offering employers, and tax revenue from the expansion of insurance. Two thirds of the revenue (or $201 billion) is tax on premium plans. How likely are those plans, once the rules are set, to be modified to avoid some or all of the tax? Beware the law of unintended consequences. Nevertheless the net result still leaves a half trillion dollar hole.

Now we look at the intangibles

Of the total $420 billion in savings $404 billion comes from reductions in direct spending, or in other words, savings on existing government outlays. There are 19 categories and multiple sub categories. I will focus on the largest.

Excluding the Medicare Improvement Fund, which I will address later, I see these five major categories: (1) savings from reduction in direct benefits under current programs; (2) reductions in payments to health care providers; (3) savings in payments to drug companies; (4) reductions in payments to health care facilities primarily hospitals; (5) and modification of current plans.

Figures in Billions of Dollars
1. Reduced benefits..........................................................$ 18.8
2. Reduced payments to health care providers.....................$ 73.7
3. Reduced payments to drug companies............................$ 28.6
4. Reduced payments to health care facilities.......................$168.4
5. Modification of Medicare Advantage (Part C)..................$117.4

Benefit reductions are accomplished by means testing and raising co-payments on higher earning individuals. Savings pertaining to payments to health care providers are made by reducing and/or capping the growth of payments to doctors and other providers. Reductions in payments to drug companies are accomplished by switching to generics. Reduced payments to facilities come from a significant shift from emergency room use to other facilities, presumably primary care providers. The last savings is a modification of a current program called Medicare Advantage that has resulted in significantly higher delivery costs than Medicare A and B. Medicare Advantage lets a beneficiary shift the administration of Medicare to other plan providers such as Health Maintenance Organizations (HMO), Preferred Provider Organizations (PPO), Private Fee-for-Service Plans (PFFS), Special Needs Plans (SNP) and Medical Savings Account Plans (MSA).

While there is little doubt the expense side of the ledger will survive, one must question the revenue side. As pointed out earlier none of the proposals are in legislative language. We can only imagine the depth of lobbying going on. We can also imagine a world where the legislation actually passes as envisioned. What are the consequences? For example if we drain $168.4 billion of revenue from the hospitals in this country, how many will survive? With shorter patents on drugs and reduced cash flow to drug companies how much capital will flow into innovation? And how likely is sapping doctors, nurses, hospice care providers and homecare providers of $73.7 billion in income to promote better care and service if in fact it happens? As we shall see shortly, for the doctors it won’t.

But the real question in my mind is this: can the government execute? For example, in the past, cuts scheduled in fee-for-service to physicians have been routinely overridden by congress. From the 2009 annual report for the trust funds of Medicare parts A and B, “Congressional overrides of scheduled physician fee reductions…could jeopardize Part B (payments for doctor visits) solvency… Part B costs have been increasing rapidly, having averaged 7.8 percent annual growth over the last 5 years, and are likely to continue doing so. Under current law, an average annual growth rate of 5.5 percent is projected for the next 5 years. This rate is unrealistically constrained due to multiple years of physician fee reductions that would occur under current law, including a scheduled reduction of 21.5 percent for 2010. If Congress continues to override these reductions, as they have for 2003 through 2009, the Part B growth rate would instead average roughly 8.5 to 9.0 percent.”[3] To watch Secretary Giethner’s press conference releasing the report click here.

So what did Congress do? The answer is sleight of hand. $22.2 billion, 5% of the “savings” in the current legislation, are from funds scheduled to be spent between 2014 and 2019 from the Medicare Improvement Fund.[4] They were actually moved to a budget resolution for Fiscal Year 2010 and increased to a whopping $285 billion overriding past and future reductions in one fell swoop. So the way the current bill became “deficit neutral” was to actually authorize a quarter of a trillion dollars of Medicare spending that will occur during the years the bill covers but keep it out of the bill.[5] Where is Joe Wilson when we need him?

The last item I will address is the Medicare Commission. From Director Elmendorf’s letter to Senator Baucus, “The projected longer-term savings for the proposal also assume that the Medicare Commission is relatively effective in reducing costs—beyond the reductions that would be achieved by other aspects of the proposal—to meet the targets specified in the legislation. The long-term budgetary impact could be quite different if those provisions were ultimately changed or not fully implemented. (If those changes arose from future legislation, CBO would estimate their costs when that legislation was being considered by the Congress.)” The Medicare Improvement Fund[6] was created by Congress in 1999 with complete implementation by 2003 with three objectives:

• the design of a premium support system,
• improvements to the current Medicare program, and
• financing and solvency of the Medicare program

So can the government execute? Can we trust Congress to pass the legislation they are proposing without bowing to pressure from lobbies? Even if passed will Congress avoid tinkering either with the level of benefits or the adjustments in compensation? All evidence suggests the answer is no. Each year we continue to add one unfunded liability to another. The most dangerous four words in the English language be it investing or government spending are, “This time is different.” Albert Einstein defined insanity as, “Doing the same thing over and over again expecting different results.”

But the most frightening result of this is that if it succeeds at all levels it is only deficit-neutral. With an unfunded liability of $107 trillion in the current Social Security and Medicare[7] can we afford to just spin our wheels?

Sunday, October 11, 2009

Subsidized Housing; America's Iceberg

Friday’s issue of the New York Times has an article about the pending problems with the Federal Housing Administration (FHA).(1) For those of you who read this blog that is old news. But it is just the tip of the housing iceberg. The real danger lies within the Government Sponsored Enterprises (GSEs).

The Federal National Mortgage Association was part of the FHA until 1968 when, under mounting budget pressures brought on by his policy of “guns and butter,” President Lyndon Johnson privatized Fannie Mae taking it off the federal government’s balance sheet. Unfortunately he didn’t disconnect it from the government’s guarantee. Two years later the Federal Home Loan Mortgage Corporation, later known as Freddie Mac, was formed to “compete” with Fannie Mae. Both became public companies and were two of the largest companies in the Fortune 500.

Initially both GSEs operated like great big savings and loans borrowing from the public and purchasing mortgages for their portfolios. In addition to the implied government guarantee the GSEs were exempt from state and federal income tax and, unlike any other companies in the Fortune 500, were not required to report potential financial difficulties in their annual filings. In the early 1980s Fannie Mae faced bankruptcy because of a mismatch between assets and liabilities and a surge in foreclosures. Losing $1 million a day, by 1983 its net worth had fallen below zero. But the government came to the rescue and under an accounting change sponsored by then President Regan, both Fannie and Freddie were able to capitalize the losses on their portfolio loans, some worth only seventy cents on the dollar, sell the loans as mortgage backed securities and amortize the loss over the next 20 to 30 years. This policy, called “forbearance” allowed the lenders to operate with negative net worth. Fannie president David Maxwell increased lending standards and moved the portfolio into adjustable loans to reduce the sensitivity to short term borrowing costs.(2) The sensitivity between assets and liabilities improved as both GSEs extended the maturities by issuing longer term debt and securitizing and selling many of their loans. As the yield curve steepened Fannie recovered but the same fate that befell Fannie Mae hit the savings and loan industry leading to the failure of over 740 institutions at a cost to the taxpayer of $124 billion.(3)

Not content to let the mere subsidization of housing rest with the benefits already bestowed on Fannie and Freddie successive congresses and administrations pressed their own agendas on the agencies. The profits of Fannie and Freddie were ripe for use as subsidies to the under-served segment of the market, the euphemism for low to moderate income home buyers. The Federal Home Loan Mortgage Corporation Act updated Freddie’s charter in 2005, “to provide ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities)…”(4) Much of this subsidy was provided to bring in the very borrowers who today cannot afford the homes they were encouraged to buy.

And then came the Great Panic of 2008. With the future financing of the GSEs very much in doubt the Bush administration released a proposal that would temporarily authorize the Department of the Treasury to purchase $100 billion each, up from $2.25 billion, of Fannie Mae and Freddie Mac obligations. At the time the CBO estimated the chance of this occurring at less than 50% and “that the expected value of the federal budgetary cost from enacting this proposal would be $25 billion over fiscal years 2009 and 2010.” The CBO assigned only a 5% probability the price tag would reach $100 billion between them. On September 7, 2008 Fannie Mae and Freddie Mac became wards of the U. S Government. At the end of March, 2008 the combined portfolio of mortgage loans and guarantees of the GSEs stood at $5.2 trillion(5) and by July 2009 the bailout was fast approaching that $100 billion mark. Mortgage analyst Bose George of Keefe, Bruyette & Woods said, “We’re assuming they each will cross the $100 billion mark fairly soon.”(6)

Today the picture is only bleaker. Losses continue to mount. Renegotiated loans are re-defaulting at a rate in excess of 50%(7) and the default rate on the current portfolio is approaching 10%. On September 9, 2009 the Congressional Research Service released a report entitled “Options to Restructure Fannie Mae and Freddie Mac”.(8) The table below from that report shows that total taxpayer support for Fannie and Freddie now stands at $1.058 trillion dollars.

In a recent interview Rep. Barney Frank (D-Mass.) responding to a question of becoming Secretary of Housing and Urban Development said, “I want at least two years with President Obama and a solidly Democratic Senate so that we can get the federal government back in the housing business.” With the government insuring 90% of current home loan activity I am having a real tough time finding what’s left for the government to "get...back in..."

And see the debt ticker to the right of this blog? Add the $5.2 trillion of debt guaranteed by the GSEs that isn’t yet shown on the government’s balance sheet. Including the GSEs government debt now stands at a mind-boggling 122% of GDP. There are only three countries in the world with a higher percentage; Lebanon, Japan and Zimbabwe.(9) I wonder which one we are aspiring to?

(2) “Getting Fannie Mae in Shape” NY Times, December 26, 1985
(4) Federal Home Loan Mortgage Corporation Act, 12 U.S.C. Sec. 1451 Note. Sec. 301(b)3.
(5) CBO Report to the Committee on the Budget, U. S. House of Representatives by Peter R. Orszag, CBO Director, July 22, 2008
(8) Options to Restructure Fannie Mae and Freddie Mac, N. Eric Weiss, September 9, 2009

Monday, October 5, 2009

The FDIC: Fuzzy Math?

Like clockwork each Friday since January 16, save three, the FDIC has released a list of banks it has closed. This Friday there were three.(1) The mounting closures now total 98 and are taking a toll on another government run insurance company, the Federal Deposit Insurance Corporation. The fund within the FDIC that insures deposits is called the Deposit Insurance Fund (DIF). For 2008 the DIF’s loss totaled $35.1 billion compared to income of $2.2 billion for the previous year. As a result, the DIF balance declined from $52.4 billion to $17.3 billion as of December 31, 2008.(2)

2009 has not been kinder. Despite the strength in financial stocks since the end of March, the FDIC issued another grim quarterly report Thursday on the health of the nation’s banks. In the second quarter of 2009 the banking industry lost $3.7 billion amid a surge in bad loans made to home builders, commercial real estate developers and small and midsize businesses. Meanwhile the FDIC’s deposit insurance fund dropped to $10.4 billion, its lowest level in nearly 16 years. And the number of “problem banks” increased to 416, from 305 in the first quarter, and is expected to remain high.(3)

Without action to replenish it, the DIF will have a negative balance as of September 30, while its longer-term liquidity will dry up in the first quarter of 2010.(4) On September 30 Federal regulators said the likely cost of failed banks to the FDIC over the next 4 years will be $100 billion up from $70 billion forecast in March, an increase of almost 50%.(5)

The FDIC was created in 1933 in response to the thousands of bank failures that occurred in the 1920s and early 1930s. Like the FHA it has never cost the taxpayer anything since its founding and has only had a negative balance one year. Now it too is staring into the abyss.

So what’s the plan? Sheila Bair wants to accelerate the annual fees collected from insured institutions taking the next three years of fees into current income. Let’s forget that this is in fact an accounting trick that depletes bank cash but doesn’t deplete their book capital. It amounts to only $45 billion. So to plug a $100 billion gap the FDIC is going to forgo all its fee income for the next three years. And by the way since when does 0+45=100? One might also ask why the assessment revenue, which in 2008 was $4.42 billion will average $15 billion over the next three years? Part of that might be from the larger account balances insured, up to $250,000 from $100,000, and part will be from an increase in the insurance premium of .03%. But that doesn’t add up either. Non assessment revenue from 2007 to 2008 was roughly flat at $2.5 billion so once again where does all the revenue growth come from? And this is all predicated on a loss estimate that has increased almost 50% in the last 6 months.

Will the FDIC be dipping into its credit line from the US Treasury (aka taxpayer) for the first time in its 75 year history? Today that credit line stands at a staggering $500 billion.
Comic courtesy of Oak Norton
(4) in-advance-to-restore-deposit-insurance-fund/

Thursday, October 1, 2009

The FHA and Subprime America: House on Fire!

The Federal Housing Administration, the longtime self-funded mortgage arm of government insurance programs, is now taking a number and waiting in turn for its taxpayer-financed government bailout. Get out your checkbooks.

Created in 1934 the FHA’s purpose was to stimulate mortgage underwriting by insuring mortgages for risk-averse banks and encouraging a new wave of home-loans. The program worked during the depression and continued to work even as an increasingly privatized mortgage industry developed ever-more creative loan packaging to insure sub-prime mortgages. Promoted by politicians the FHA evolved in the 21st century to underwrite home loans for low and moderate-income buyers whose shaky credit would otherwise lock them out of the housing market. Whether or not you agree that every low-income American with Swiss-cheese credit deserves to own his or her own home is beside the point. As a taxpayer, and therefore a stakeholder in the FHA, you could rest easy knowing that “the FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing.”(1) But that was in 2006, when the FHA insured just 2.7% of the single-family mortgage market. By the second quarter of 2009 its market share was 23% and self-funding was as viable as General Motors’ Hummer.

Led by the government’s attempt to stem the housing collapse this 10-fold increase in market share was due in large part to the Housing and Economic Recovery Act of 2008 which then-President Bush signed into law on July 29, 2008. Sponsored by Reps. Barney Frank (D-Massachusetts) and Maxine Waters (D-California) the bill included new authority for FHA to insure up to $300 billion of troubled mortgages. FHA is working overtime to accomplish the task.

FHA loans are packaged by mortgage bankers and sold in pools of Ginnie Maes then distributed by Wall Street dealers to investors either as Mortgage Backed Securities (MBS’s) or as Collateralized Debt Obligations (CDO’s). Ginnie Maes carry the full faith and credit guarantee of the U. S. Treasury. Their losses are covered by the FHA. So Ginnie Mae, a full faith and credit issuer of the government is on track for a record issuance of securities and the taxpayer’s backstop is the FHA. On September 10, 2009, Ginnie Mae announced it had issued $45 billion of mortgage backed securities in August alone, the fifth consecutive month of record issuance.(2)

Swamped with increasing delinquencies the FHA is “probably going to need a bailout at some point because they’re making loans in a riskier environment,” says Edward Pinto, a mortgage-industry consultant and former chief credit officer at Fannie Mae. “…I’ve never seen an entity successfully outrun a situation like this.” The problem stems from the FHA’s cash flows. As an insurance company, the FHA earns a percentage of loan payments on its insured mortgages. When its market share was in the single digits and home-owners were actually paying their bills, things worked well. But FHA delinquencies have increased from 5.4% a year ago to 7.8% today and accelerating default rates are rapidly eating through the FHA’s reserves. David Stevens, the FHA Commissioner, told Congress that the agency will fall below the 2% minimum reserve required in its charter, down from a 6.7% reserve in 2007.(3) In 2007 FHA earned $1.521 billion and gross costs (government speak for expenses) were $3.89 billion for a net cost of $2.369 billion, the first loss in 75 years of operation. In 2008 revenue was down slightly at $1.471 billion and costs soared nearly tripled to $11.378 billion for a net cost of $9.9 billion! (4)

And how is the program created in 2008 to help troubled borrowers working? On Wednesday the Office of the Controller of the Currency and the Office of Thrift Supervision reported re-default rates on troubled borrowers is running in excess of 50%.

With 5 months of record issuance behind us, and ostensibly many more to come, why isn’t the FHA on track for record profits? The FHA funds itself by receiving an ongoing percentage of the interest payment made by the borrower for insuring each mortgage. But now delinquencies are increasing faster than even the government can issue debt. Revenue on the portfolio is 37.5 basis points or approximately 1/3 of 1 percent. At the end of Fiscal Year 2008 the outstanding portfolio was $534 billion generating roughly $2 billion in revenue and defaulting at a rate of almost 8%. At September 30, 2008 the FHA surplus reserve fund was $12.9 billion. That number is expected to fall below $10 billion by September 30, 2009, the end of this fiscal year, for a net decline of $4.7 billion dollars. This gives the FHA a leverage ratio of 54:1 nearing twice the highest leverage of the major banks prior to the 2008 crash on a portfolio with only 3.5% down payment. Do the math.

And this is a drop in the bucket compared to our next discussion: Fannie Mae and Freddie Mac. With the combined entities of FHA, Fannie Mae and Freddie Mac, the American taxpayer is now guaranteeing 90% of all the home mortgages made in America. And then the Federal Reserve is purchasing those loans so we are first guaranteeing the loans then buying them! Huh?

4. 2008 Department of Housing and Urban Development Annual Performance and Accountability Report (Available on request)