The FHFA Kills PACE

Mortgage guarantees and PACE assessments

The Property Assessed Clean Energy (PACE) program would allow municipal governments to finance the up-front costs of home improvements designed to reduce energy and water consumption and provide clean power.   Under the PACE program, municipalities issue a bond and lend money to homeowners for energy conservation and environmental projects on the property.  The homeowner would pay back the loan through tax assessments, typically over a 15-year or a 20-year period.  The tax lien is attached to the property, not to the person who took out the loan.    A new owner continues to pay the tax lien once the property is sold.  In the case of a mortgage default, the tax lien on the property used to pay for the home improvement would take priority over the mortgage payments due the lender and guaranteed by Freddie Mac or Fannie Mae.

The Federal Housing Finance Agency (FHFA)  prohibited Fannie Mae and Freddie Mac from acquiring mortgages on homes that participated in the PACE program.  In 2011, a U.S. District Judge ordered FHFA to adopt rules codifying its action.  The ninth circuit   court of appeals has ruled that FHFA need not adopt formal rules when it acts as a conservator of the two agencies.

This post provides my thoughts on PACE and the FHFA decision.

Comment One: Financial risks imposed by the PACE program on Fannie Mae and Freddie Mac appear small compared to the myriad of problems ignored by FHFA prior to the housing market meltdown that led to the bankruptcy of the two housing agencies.

Comment Two:  The concern that PACE assessments will lead to higher foreclosure losses is valid but not unique.  There already exists a wide dispersion of tax assessments across states and communities because of dispersion in the general level of taxation and in the reliance on real estate taxes.  Neither Fannie Mae nor Freddie Mac restrict guarantees on mortgages in jurisdictions with high real estate tax assessments even though tax assessments always take priority over mortgage payments.  It would be useful to understand why the FHFA treats tax assessments for energy projects differently than tax assessments for other spending projects.

Comment Three:   It seems as though a PACE assessment on a home that does not have a current mortgage guaranteed by Freddie Mac or Fannie Mae would not impose any risk on the two agencies.  The agencies would simply have to avoid buying a loan on any property with a PACE assessment.

It also seems as though homes with PACE assessments should still be able to obtain financing through the jumbo market or other government guarantee programs.   Moreover, PACE projects on larger homes financed with jumbo loans should result in greater energy savings.  Even though Freddie Mac and Fannie Mae are the big players in this industry the other sectors are not insignificant.
Comment Four:  A recent paper found that mortgages on homes that have adopted fuel-savings projects have a lower default rate than mortgages on other homes.

http://uncnews.unc.edu/content/view/5933/1/

The primary determinant of whether a homeowner defaults on his or her mortgage is whether household equity is negative.  However, most  homeowners with negative equity actually do not default on their home and lower energy costs reduces the likelihood of defaulting because the owner will experience an increase in costs at the new home.

The lower default rate for homeowners with energy savings improvements on their homes would decrease losses to Freddie Mae and Fannie Mac; thereby, offsetting some losses from the priority of the PACE assessment.

Comment Five:   FHFA does not oppose energy loans as long as the mortgage has priority in foreclosure.  However, the cost of the energy loan might be higher than PACE financing and payment problems from the new loan could increase defaults relative to the number of defaults that would have ocurred under a PACE program.

Moreover, households who anticipate moving are often reluctant to take out a loan with a longer duration than their expected time in the home. This reluctance is quite practical given uncertainty about the future value of the home.

Concluding thoughts:  I understand the FHFA is troubled over the priority that PACE assessments have over mortgage debt but I believe their reaction is disproportionate to the potential harm.  Where was this regulatory energy during the  housing bubble?

The FHFA decision to prohibit the PACE program is arbitrary.  Many states and communities have extremely high real estate assessments and mortgage payments are always secondary to tax liens.  The FHFA does not have general restrictions on loan guarantees in high real estate tax assessment jurisdictions.   Why has the PACE program been singled out?

Here are some other concerns and questions:

Taxes are not the only source of risk to Freddie Mac and Fannie Mae. A much larger source of risk is second mortgages and piggy back liens.   Often second mortgage holders demand and receive a payment from the first mortgage holder in order to restructure loans in foreclosure.    Could FHFA prohibit Freddie Mac and Fannie Mae from issuing piggy back loans.  Now that FHFA is the conservator could this change be done without a formal order?

Does the FHFA restriction on Freddie Mae and Fannie Mac create a profit making opportunity for a private firm willing to guarantee mortgages on homes with PACE assessments?

Would the restriction on PACE lending result in some support for a GSE reform or privatization proposal that would allow for a private entity to guarantee mortgages with PACE assessments?

Why did the FHFA decide to prohibit Freddie Mac and Fannie Mae from guaranteeing all  PACE loans?  Wouldn’t a risk-based guarantee price achieved a similar effect?

Here is some reading material on PACE.  Enjoy!!!!!

http://en.wikipedia.org/wiki/PACE_financing

http://energycenter.org/policy/property-assessed-clean-energy-pace

http://www.sfgate.com/science/article/Court-upholds-ruling-on-clean-energy-loans-4368223.php

http://online.wsj.com/news/articles/SB10001424052748704534904575132123115802584

Reviews of two books on education reform

Two Books on Education Reform

This post reviews two books on education reform.  One book, “The Bee Eater” provides a discussion of Michelle Rhee’s effort to turn the DC school system around.  The other book  “The Great American School System,” discusses problems with current reform efforts and the increased reliance on standardized tests to evaluate both teacher and school performance.

“The Bee Eater: Michelle Rhee Takes on the Nation’s Worse School System,” by Richard Whitmire  

http://www.amazon.com/dp/0470905298

Even those who disagree with Michelle Rhee’s approach to education are likely to admire this woman’s moxie after reading this book.

Ms. Rhee is credited with making some very tough decisions, which resulted in noticeable improvement in DC schools.   Her tenure in DC was short.  The stated goal of the teacher’s union was to “kill the bitch”.  Her efforts to improve the school system in DC were viewed as favoring whites over black.  Her boss lost the mayoral election and Michelle Rhee left, her experiment cut short.

Many of the DC teachers who Rhee attempted to fire were of the view that poor students and parenting prevented their students from learning.  While smart students in good situations will usually out perform poor students in poverty there is wide dispersion in educational outcomes among poor and disadvantaged students.   Rhee’s efforts to fire poorly performing DC teachers appears justifiable since minority students in DC lagged behind similar students in other urban school districts.

Teacher performance was only one part of the problem in DC.  The DC school system inherited by Rhee had high administrative expenses and too much school space.  Discussions of how to deal with problems was often tainted by racial politics with Rhee constantly being accused of favoring white communities over black ones.

School closures in minority neighborhoods became the most controversial issue.  I suspect it is far easier to replace poorly performing departments than close entire schools.

Time stops for no one, except perhaps for some kids caught in the failing DC system.   I  am left with questions about what happens next.

  • During her short stay in Washington, the proportion of students proficient in math and reading rose in several schools and administrative costs fell.  Have these improvement persisted?
  • Near the end of her tenure a substantial number of DC teachers classified as underperforming were to be asked to improve or leave.  Was this policy enacted after her departure.

With Rhee gone and the teacher’s union opposed to reforms the case could be made that charter schools are the only possible alternative to public schools in DC.  Substantial statistical evidence indicates that charter schools often do not out perform public schools.  It would be ironic in a lot of ways if the departure of Rhee accelerated the growth of charter schools in DC.

“The Great American School System:  How Testing and Choice are Undermining Education,” Dianne Ravitch

http://www.amazon.com/Death-American-School-System-ebook/dp/B005P0YXKI

Diane Ravitch is an education historian and a former Assistant Secretary of Education in the Administration of the first President Bush.   She has been on both sides of the school reform debate.  Her job in the Bush Administration was to advance alternatives to the public school system.  After leaving government she spent some time at the conservative Hoover Institute at Stanford.  Her work after Stanford, including this book, is more critical of school reform efforts.

Ravitch offers a lot of evidence indicating that school choice, efforts to hold teachers accountable for the performance of their students, and curriculum choices made by school reforms often do not improve educational outcomes.  A reform effort in San Diego did not appear to lead to improved results, imposed substantial pressures on many teachers, and ended after voters ousted the school board.  She cites a flawed study of educational reform efforts in New York, which did not account for simultaneous changes in the socioeconomic characteristics of the school district being studied.

Mayor Bloomberg has been highly praised for improving the school system in New York.  Diane Ravitch believes these improvements have been exaggerated.  Her observations:

  • New York City under Bloomberg moved resources towards the teaching of math and reading and cut resources for art, music, socials studies and science.  Test scores in science and social studies fell in New York relative to other parts of the state.
  • After the enactment of new rules prohibiting social protection the State Legislature in New York made rules governing promotion less strict.
  • City wide scores on state test rose but scores did not rise on federal tests.  Was the city teaching to the test or did state standards change?
  • Test scores, especially those that determined teacher salaries, were volatile.  In 2009 83 percent of schools received a grade of an A compared to 23 percent in 2007.
  • The Bloomberg Administration substantially expanded charter schools in New York.   Entrance to charter schools is determined by lottery and some charter schools in New York have higher test scores than comparable public schools.  Consequently, advocates of charter schools have concluded that charter schools provide superior results than public schools.  Ravitch points out that admission to charter schools requires effort, favors motivated families, and that charter schools enroll few homeless children.
  • New York replaced large high schools with smaller high schools.   The evidence cited by Ravitch indicates the initial better performance of smaller high schools stemmed from the lower percent of disadvantaged  and non-english speaking students in the smaller high schools.  The move to smaller high schools in New York appears to have left many students behind in deteriorating public schools.

Ravitch has an especially negative view of the increase in teacher testing, especially when test results are used to measure teacher performance or for the decision to close a school.  Her concern is that teachers and schools teach to a test, that results vary widely and are unreliable, and that the current system has unfairly stigmatized some highly effective teachers.

But there are differences in teacher and school performance and the first step towards rectifying such problems involves gathering data to document their existence.

All of the problems that Ravitch discusses about excessive testing and the use of tests to evaluate schools and teachers are fixable.   Schools and teachers can be evaluated based on results from bi-weekly computerized quizzes  rather than a single test at the end of the year. (End-of-year results are too late to help anyone.)  Teachers should be compared to other teachers in schools with similar socio-economic characteristics and past performance levels. Teacher evaluations should be based on multiple-year performance in a variety of class room setting.

Ravitch advocates the adoption of a common core curriculum.  I don’t see how a common core curriculum would help given the wide variance in student circumstances and skill levels.

Ravitch does a great job in documenting problems with school reform efforts but her book does not provide solutions for the situation when school systems and teachers fail students.

 

Competition in the Education Industry

Competition in the Education Industry

Many education reform advocates believe the most effective way to improve education is through the creation of charter schools.  The evidence on whether charter schools actually improved academic outcomes for students is at best mixed.  Many studies found that academic outcomes in charter schools are often no better, and sometimes worse, than outcomes in public schools.  In addition, the growth of charter schools in an area, by taking resources and students out of public schools, may worsen the public system.

An alternative more efficient approach to facilitating choice in education would be to create a system where courses taught by outside private firms substitute for courses taught in the public school.   Competition in the education industry could be similar to changes that occurred in the electric utility industry.  Prior to deregulation, one firm controlled both the transmission and generation of electricity.  Deregulation allowed many firms to provide electricity for sale.  Similarly, in education it is possible for a school to allow outside teachers or small firms offering specific courses to compete for students inside a school or a school system.

At this point in time the education industry consists of many local monopolies.  A reformed industry might be monopolistically competitive.  There would be many potential producers but services offered by different producers are not perfect substitutes.

The first section of this post discusses the growth of charter schools.  The second section discusses the possibility of competition between schools and private providers of academic courses.

Charter Schools:

A public charter school is a publicly funded school that is governed by a group or organization under a contract or charter but is not directly run by the local school board or municipality.   The charter school is exempt from many of the rules and regulations governing public schools.  A school’s charter is reviewed periodically and charters can be revoked.  From 1999-2000 to 2009-2010 the number of students enrolled in public charter schools rose from 0.3 million to 1.6 million.  Around 5.0% of public schools are now charter schools.   Over half of charter schools are elementary schools.  Around 55% of charter schools were located in cities.

Some facts on charter schools below:

The growth of charter schools appears to be fastest in cities where the traditional school system is viewed to be of low quality and is struggling.  Charter schools can be created when public schools are closed due to poor performance.  New Orleans, Detroit, Washington DC, and Saint Louis all place more than 30% of students in a charter school.

A large city or market could sustain more than one system while scale economies might prevent growth of separate systems in a smaller market.

The evidence on whether charter schools actual produce better results than traditional public schools is mixed at best.  Some recent studies indicate that charter schools often do not outperform traditional public schools.

Comparison of performance between traditional public schools and charter school may actually overstate potential improvements from the growth of charter schools because charter schools often are able to pick better students and expel poorer ones.

Competitions Between Course Providers:

An alternative way to foster competition in the education industry would involve facilitating choice between teachers provided to schools through the school system and courses and teachers provided to students through private course providers.   This could be accomplished by requiring public schools to give credit to approved courses taught by approved private firms.

There are several reasons why competition between course providers would provide greater improvement in education outcomes at lower cost than would competition between schools.

There is almost always intense political opposition to policy changes that would drastically reduce the number of students going to a public school. Often due to scale economies and the size of the education district there is only enough room for one large school or system and the introduction of private charter school can leave students who are struggling the most in a weaker public system.

Teacher quality varies widely in both traditional public schools and charter schools.  A student who gets a poor teacher in a charter school is no better off than a teacher who gets a poor student in a traditional charter school.  Competition among teachers or firms providing courses is a more direct way to mitigate problems caused by poor teacher performance than is the establishment of a new school.

Economies of scale are lower for a firm teaching one course than for a firm teaching all subjects.  If there are 6 periods to a day one teacher instructing 25 students per period will teach 150 students.  By contrast, one teacher teaching all students in one day will only reach 25 students.

The dollar cost of a voucher to pay for one course is much less than the dollar value of a voucher to pay for enrollment of a student in a competing full-time school.   As a result, the use of a voucher to pay for a course rather than an entire new school enrollment removes fewer resources from the existing public system.

Students differ widely in their abilities.  Public school teachers often are forced to teach to the median student (or even lower) in order to avoid leaving some students behind.  Specialized courses that substitute for or complement an existing curriculum could allow for specialized instruction geared towards a wide range of abilities.   A gifted student could be placed in a program similar to the one offered by Johns Hopkins University.

A less gifted student could be placed in a different course.

The cost of private school could be lowered by providing instruction either fully or partially on line.  There are now many high-quality on-line resources that complement and could compete with in-school instruction.

 Links to resources here:

Increasingly parents have chosen these private sources to complement school work.  Competition between teachers and private course providers would likely increase use of these new on-online resources.

Concluding Thoughts:

The emphasis of school reformers on the creation of charter schools that compete directly with traditional public schools is in my view misguided.  Fixed costs associated with a completely separate school are too high.   Existing public schools  (the existing firm) have a large advantage over potential entrants.  Often the market is only big enough for one school system. Students and teachers vary widely in their needs and ability.  Competition among course providers and teachers is a more cost efficient and direct way to provide educational choices than is competition between schools.

 

Review of “Capital Offense” by Michael Hirsh

Capital Offense: How Washington’s Wise Men Turned America’s Future Over to Wall Street, by Michael Hirsh.

Most people view politics as a conflict between democrats and republicans. Similarly, economics is viewed as a debate between those who favor free markets and low taxes versus those who believe that government should play a role in mitigating market imperfections and helping create a fairer and more just society. Michael Hirsh’s portrayals of Washington’s wise men suggest these stereotypes are often not apt. One of these examples, presented in the first chapter, involves the treatment of Brooksley Born, the head of the Commodity Futures Trading Commission. Her attempt to reign in financial abuse was squashed by two Democrats, Robert Rubin and Larry Summers.

The book has a lot of informative portrayals of policymakers, thinkers and the events they shaped.  These include: Milton Friedman and his impact on the futures and options markets, the conflicts between Larry Summers and Joseph Stiglitz, the influence of Ayn Rand on Alan Greenspan, and Paul O’Neil’s opposition to the Bush tax cuts during his short tenure at Treasury.  There are differences among policy makers, with some being highly ideological and others being pragmatic.  However, the book also suggests that corporate interests dominate both political parties.

Capital Offense is well written, informative and a pleasure to read

Long Term Care Insurance in Transition

I tried to get this oped piece published a couple of months ago.   There was some interest but at the end the editors passed.  Here are more of my thoughts on current issues on long term care insurance.  Interested readers should consider my longer paper, which is on both Kindle and Nook.

Long Term Care Insurance in Transition

Americans are living longer and the large baby boom cohort is beginning to prepare for the likelihood that they will need substantial assistance in their last years of life.  Many financial planners believe that long term care insurance should be part of a standard retirement package.  It has become increasingly evident that individuals cannot plan on the government covering all costs of end-of-life long term care.  Under these circumstances, one would expect a robust demand for private long term care insurance.  Instead, this is a challenging time for the industry.

Interest rates and returns on investment are low.  Long term insurance contracts are difficult to price correctly and premium increases only a few years after the issuance of a policy are now commonplace.   The usage of derivatives to hedge risks has led to more stringent capital requirements.   Many of the more prestigious firms, MetLife, Prudential, and Unum, are exiting the industry or curtailing their presence.

Long term care insurance firms are allowed to increase premiums on existing policies if they can show that the total of premiums and investment returns will not cover benefit.  Historically, the actual cost of long term care insurance almost always exceeds the cost anticipated when the policy was purchased.    The frequency of premium increases may diminish once interest rates rise and the investment environment improves.  In the meantime, premium increases are occurring at a time when many retirees can least afford them.

Insurance firms now allow policyholders to accept reduced benefits instead of a higher benefit.   A reduction in benefits is almost always preferable to allowing the policy to lapse.  However, benefit reductions generally cover policy features, like inflation protection, that were described as essential when the policy was purchased.  Ex-post changes in benefits entail an economic loss.  Chronic requests for premium increases or benefit reductions erode credibility.   It is essential for the industry to fix the pricing errors that have led to chronic increases in premiums after the policy is originated.  This might be accomplished by tying benefits to rates of return in the market.

Long term care insurance is not suitable for everyone.   Individuals without substantial liquidity or individuals who are not preparing adequately for retirement should increase their savings rate rather than purchase long term care insurance.  Individuals entering retirement with a positive mortgage balance should probably pay down their mortgage rather than take on an additional financial obligation.

The cost of long term care insurance to consumers entails both premium payments and the foregone investment income.  Consumers need to consider the impact of all costs on the amount of wealth and income they will have throughout their retirement.  Consumers who purchase long term care insurance in their working years need to consider their ability to sustain payments if they become unemployed or when their income falls in retirement.  The consumer needs to budget for the likelihood of future premium increases.

Long term care insurance policies vary in price depending on the features of the policy.   A long term care insurance contact with lifetime benefits and inflation protection is too expensive even for many well-heeled households.   Around 7% of men and around 15% of women who are admitted to a nursing home will stay there for more than 5 years.   Many conservatives maintain that the reason for the low level of interest in long term care insurance is the existence of Medicaid.  Ironically, even for most purchasers of LTCI, the only viable protection against a long stay in a nursing home is Medicaid.

Medicaid has many flaws. Medicaid does not assure access to a quality nursing home.  The availability of Medicaid coverage for home-based care varies across states.  Increasingly, Medicaid does not cover the entire cost of care. In order to obtain access to the Medicaid long term care benefit a person must spend down assets.  There is something fundamentally wrong with a system that provides an incentive for individuals to impoverish themselves in order to qualify for a benefit.  However, private long term care insurance is not a viable alternative for most households.  Most European countries and Japan have chosen public funding over private options for long term care services.  Even fiscally conservative Germany has adopted a mandatory long term care financing program paid for equally by employers and employees.

Some policymakers believe the private long term care insurance market can be stimulated with additional tax incentives. Tax incentives for the purchase of long term care insurance would primarily benefit the wealthy and scarce tax subsidies would provide greater benefit to society if they were allocated to individuals with lower savings rates.  A less expensive way to subsidize the purchase of private long term care insurance is through expansion of the long term partnership program.  A partnership long term care insurance program allows individuals who have exhausted their insurance benefits to keep assets equal to the benefits they received and still qualify for Medicaid.  It is difficult to understand why a person would, all else equal, purchase a long term care insurance policy that did not provide asset protection over one that did.

While there is no chance that private insurance will replace Medicaid as the primary source of funding for long term services it is possible that long term care insurance and other private sources of funding can play a larger role in the future.  The industry has to recognize that for the overwhelming majority of their potential customers a comprehensive lifetime long term care insurance policy is not an affordable option and that a strong Medicaid is in the industry’s best interest.

David Bernstein recently retired as an economist at the U.S. Treasury after 25 years of service.  His book “Things to Consider before Purchasing Long Term Care Insurance” can be purchased or borrowed on Kindle or Nook.

Kindle Link:

http://www.amazon.com/consider-purchasing-insurance-Economic-ebook/dp/B008N5QO8G

Nook link:

http://www.barnesandnoble.com/w/things-to-consider-before-purchasing-long-term-care-insurance-david-bernstein/1113578815?ean=2940015509168

Is long term care insurance a viable product?

Many financial planners maintain that long term care insurance (LTCI) is an essential purchase.  Many policy makers and politicians believe that the Medicaid long term care benefit needs to be reduced and that private long term care insurance is a viable substitute for Medicaid.  Let’s agree that the political issue of how to reform Medicaid is separate from the personal decision on how you should prepare for retirement.  In my view, private LTCI is not a suitable investment for most individuals preparing for retirement.  Furthermore, private LTCI may not be a viable product.

Many households have insufficient levels of liquid asset and insufficient savings in their retirement accounts.  Studies conducted before the financial crisis indicated that only around one half of the baby generation were adequately preparing for retirement.  These households need to focus on increasing their saving rate rather than divert savings towards an illiquid asset.

Comprehensive multi-year LTCI insurance with inflation protection is extremely expensive.   Ironically, even most LTCI purchasers have only a few years of coverage and must rely on Medicaid for long stays in the nursing home.

LTCI almost always costs more than anticipated at the time the policy is purchased.    Insurance firms cannot raise premiums on a policy simply because a person claims benefits.  However, an insurance company can raise premiums on an entire class of policies if actuaries determine that the sum of premiums and investment income will not cover benefits.    Premium increases, even among the strongest and most conservative firms, are now commonplace only a few years after a policy is issued.

Premium increases are in part attributable to poor investment returns and low interest rates.    Perhaps premium increases will be less prevalent in the future.  However, current premium increases are occurring when individuals can least afford them, when their own portfolios are down in value.

Many of the better-run insurance companies are currently leaving the industry altogether.   (MetLife left the industry and I believe Prudential stopped selling on the individual market.)    This is what Fitch had to say about LTCI in a recent report.

“In addition to higher than expected claims, historically low interest rates have negatively affected LTC results.  We believe the long-tail nature of the product and future renewal premiums make the LTC business more vulnerable to interest-rate risk.  Low rates continue to curb investment income needed to help fund LTC benefits.

We believe mispricing of the LTC product will continue to weigh on the insurers’ earnings and capital, but we note the current in-force individual LTC business accounts for less than 2% of industry reserves and premiums.”

There is one LTCI product that intrigues me.  Many states participate in the LTCI partnership program.  Individual who purchase a partnership policy can keep assets equal to their amount of coverage and still qualify for Medicaid.

It is highly likely that if you live long enough you will need long term care.  You need to prepare.  However, for most of us the purchase of LTCI is not the appropriate option.  More on my views on LTCI can be downloaded on Kindle.  The article can be purchased for $4.99 or borrowed for free.

http://www.amazon.com/Things-consider-purchasing-insurance-ebook/dp/B008N5QO8G/ref=sr_1_1?s=books&ie=UTF8&qid=1342917035&sr=1-1&keywords=thing+to+consider+before+purchasing