WordPlay - Language, Culture, Media, and Meaning

The Notch Effect

    I have often used the 'belling the cat' metaphor as shorthand for the difference between high concept strategy (always extremely easy) and actual implementation (always extremely difficult). I'm way overdue for a concrete example. Given the current discussion about health care reform, the 'notch effect' is a good illustration.

    The notch effect bedevils social welfare schemes. I first learned the phrase in a book published by Daniel Patrick Moynihan in 1971, 'The Politics of A Guaranteed National Income'. It may be hard to believe post-Watergate, but the first Nixon Administration actually produced some innovative ideas. Many environmentalists would be astonished to learn that the EPA was founded then. Moynihan, the resident token Democrat intellectual in the Cabinet, attempted a massive overhaul of the welfare system, based on the notion of a guaranteed base income, which was borrowed from Milton Friedman's concept of a negative income tax. The reform failed completely, under merciless fire from both Left and Right. Moynihan wrote about the experience in the book I mentioned. Good reading, although the ordinary arithmetic (sic - not math) becomes mind bending within the first hundred pages. In any case, it was in that reading I became aware of the Notch Effect.

    Suppose you are a conscientious Out. You make sincere speeches to the effect that a nation that can create the Internet can provide decent education, housing, health care to all the uninsured Poor. Now, suddenly, you are an In, and you have to translate that goal into practice. How do you do so?

    I'll use 1970 type numbers for convenience. Who exactly are the Poor? You are a reformer, not a mad man, so you eliminate able bodied adults who can support themselves even if they choose not to. You restrict the definition to the disabled, and families with dependent children, with income of  less than $5,000, You structure a system of education, housing, and health benefits to remedy the effects of this poverty. Well and good.

    It is here that the notch effect shows up. When you set the poverty line at $5000 and provide substantial benefits for those below, you create a notch at that level. Someone who earns $4,999 a year receives benefits worth a several thousand dollars. However, if that someone works one more hour at the Burger King, and end up with $5,001, he or she gets nothing. A 2 dollar difference makes a (say) $5,000 difference. You unutterable fool. You are going to pin down the poor to permanent welfare dependency, unless the family (improbably) can leapfrog to an income position at which it can do without the subsidized benefits.

       That obviously won't do, so you are going to have to include some graduated scale according to which benefits are phased in, and then fazed out. Well and good, but your simple little system just went up several levels in complexity. (That's why the arithmetic in Moynihan's book began simple but became mind numbing).

    And of course, we are only thinking of income as a simple, one dimensional variable.  What about illegal and non cash income? Drug dealers? Madams? Applicants with huge undisclosed cash resources? That clearly won't do. You obviously can't effectively police this sort of fraud at the administrative level, but you can regulate against it and criminalize the receipt of benefits when such conduct is turned up by other police investigations? But that's a whole new set of regulations, and another layer of complexity.

    Are you talking about one income or two? The core issue of American social aid systems. Are you going to determine poverty on the basis of individual or family income? Individual? You fiscal idiot. By that measure, every minor child qualifies, no matter that his daddy's rich and his ma is good looking. You'll break the bank.

    Ok. so eliminate minor kids and determine their eligibility by reference to parent's income. Sorry, but you still have a problem. Every stay-at-home mom with a conniving soul has suddenly become eligible, no matter that her loyal husband is a rock star. You fiscally irresponsible rad-lib.

    Ok, so let's include the husband's income. WHAT????? You've just disincentivized and demoralized the most marginal fathers in society, if the benefits you are offering equal or exceed the income the father can provide.

    Ooooooooooookay . . .  why don't we include a 'presumptive minim income' from the father, regardless of actual earnings, so that he has no motive to leave? WHAT???? You heartless bastard. You are going to deny or limit benefits to needy families on the basis of PRESUMPTIVE income? Money that is non existent? Don't you know how difficult it is for a single mother of limited education actually enforce her rights?

    And on and on and on. What about parental support? What about families headed by single women with children of multiple fathers? And I am simplifying by treating housing and health as unitary variables. Easy enough with the basics, but what about the grey area? Take acne with adolescents. Maybe it's a single zit below the lip of an impossibly vain cheerleader, or maybe it's the kind of major disfigurement that turns a formerly well-adjusted child into a social misfit. How do you decide coverage? By pimple count?

    I have made (I hope) my point, without (I hope) insulting anyone's intelligence. The target here isn't anyone on the Left or Right. The target is empty sloganeering. For what it's worth, I think there's a moral imperative to assist the poor, and in such a way -  to the extent practicable - that they are not disempowered. (This is my version of belling the cat.) I think most Americans have exactly the same value. Persons who are skeptical about this program or that do not necessarily have different values. They may have a different view of just what the task of belling involves, and how well it will really work.

What Happened to the Family Farm

You have owned the family farm for a couple of generations. It has endured some hard times, but you endured. About 30 years ago, times got a little better. You could finally plant the crops you thought would do well, you did just that, and you made some money. Some of this gee-whiz computer stuff made your operation a little quicker, and you did much better. So did every one else.

So good that you relaxed. You started to spend more than you could sell the crops for. No problem, since the Great Bank of China (Warlords with a Heart!) was willing to loan you all you needed, and the market for the crops seemed unlimited. Then times got tough overseas, some of your workers went off to war, and you lost some ground there. You became a little lazy, and let a few of your seed fields go to flower. Not good - you'd gone from a pretty good manager to a lousy one.

But at least you knew this. You also knew you'd been there before and found a way out. Acts of mismanagement can be corrected by acts of good management. You deserved a good kick in the rear for all your complacency, but at least you had identified the problem. Nothing for it, but to solve it.

That is, until your youngest son came home and told you that he'd lost the deed to the farm in a poker game. That, you had not counted on. That knocked you for a loop.

 . . .

A little parable about the comparison between the problems with economic fundamentals in this society, and the disaster that has occurred in the financial institutions. I have been trying for two months now to get someone with more economic acument than I have - there are a ton of 'em - to tell me I'm wrong - but no one ever does. Meanwhile, I keep reading editorials deploring the management of Fannie Mae and Freddie Mac. It's true, of course, that they were mismanaged - but that's not why we're in this mess.

Fannie Mae and Freddie Mac are mortgage insurers. Their predecessors were founded during the New Deal to make home ownership possible to the middle class. After the Second World War, their ambit was vastly expanded to provide home ownership benefits for returning veterans.

The impact and importance of the program cannot be underestimated. Unless you are a very exceptional individual, you and every one you know owns a home based on a 15 or 30 year mortgage (and I am including ARM's, which in theory are amortized over that period.) It might surprise to you to know that that feature of the American middle class landscape is solely due to the creation of Federal mortgage insurance. In the 19th century and the first decades of the last, real estate mortgages were 5 year renewable notes. That's because lenders knew that collateral could lose value as well as gain, which was the case in the 19th Century. They would not loan on the collateral for longer than 60 months. (That's the reason you could have melodramas with Snidely Whiplash beasting about, threatening to foreclose on little Nell. He's not there because she missed a payment on a 30 year fully amortized note. He's there because the five years are up, the real estate market has changed, and the family farm is no longer adequate security.)

Fannie Mae changed all that by guaranteeing the mortgage so that the lender doesn't have to worry about collateral losing value. Nearly every middle class family in the US has benefited from that program. It was a valuable innovation, as important in its way as Federal deposit insurance. There would be very, very few families that would own homes did this institutional machinery not exist.

O.K. Bear with me. Sometime ten or 12 years, this mortgage insurance company began to lose its bearings. It encouraged lending that was too high risk and guaranteed the same. Its risk analysis was way, way off. No question that's bad. It's going to cause a real issue with the reserves that have to be allocated to pay off bad loans, etc. Like any other insurer, it's going to have to take stepso insure its liquidity and the adequacy of its cash reserves. BUT . . . . .

  . . . IT SHOULD NOT TRIGGER A GLOBAL BANKING CRISIS. The reason why all these financial institutions are in trouble is NOT the (still relatively low) level of foreclosures in the subprime market. It's that this home ownership was monetized, collaterized to a fare-thee-well, and traded between large institutions.

And why did this happen? What on earth is the point of monetizing and trading collaterized debt obligations? It bears absolutely no relation to the original point of Fannie Mae policy, which is to promote home ownership. It bears absolutely no relationship to the conventional creditor-debtor relation of bank and homeowner. It exists, so far as I know, only because the extremely sophisticated computer programs by which financial instruments are analyzed seduced financial managers of large institutions into believing they could make huge, 'safe' trading profits - and pay themselves huge bonuses accordingly. The market for these 'securities', if it can be called that, is entirely artificial. Traditionally, no one thought of home equity as a marketable security on which someone could make trading profits. There has never been a trading market for home mortgages.

Let me make the same point another way. Assume that me and a number of other men and women have bought term life insurance with a given company. That produces a cash flow of premiums, against which ultimately the company will have to pay certain cash sums, discounted over time. Assume that in some Alice-in-Wonderland world, the company, and others like it, are allowed to monetize the premiums, turning the cash flow into one large bond, and sell it. Assume further that the financial managers of the world have sophisticated analytical programs, with which they can analyze the actuarial assumptions of the company, compare them with others, and decide which of the life insurance bonds are irregular, i.e., the cash flow from the premiums is going to be a little more than necessary to pay off the contracted payouts, so the bond has economic value due to the projected surplus. Of course the differential is too small to make any significant trading profit - so it buys the bond at the insurance company par, leverages it thirty to one, and sells it at a premium based on the anticipated surplus - believing of course that the premium cash flow is absolutely safe.

(Does this seem like madness? In macro economic terms, it sure is. (Don't confuse this monetization with coinsurance, a type of risk sharing, which is another thing altogether.) The purpose of the term life insurance was to provide policy holders with protection against certain assumed risks. These policies aren't investment vehicles, and were never intended as such. The fact that you can ascertain a market irregularity with a variant of the Black-Scholes equation doesn't mean you have identified a marketable secutiry.)

If the insurance company has miscalculated its actuarial assumptions, it may run short of money to pay benefits and maintain reserves. That's serious, but correctable. You can raise premiums to new policy holders, and take various measures. But you are not going to collapse the banking system. That can only happen if you have monetized the premium flow, collaterized it to astronomical heights, and sold it highter and yon - insurance policies which were never meant to be traded, and for which there is no regular market. When the actuarial assumptions fail then, so does the colalterized bond, and the walls a'come a tumblin' down.

One final trope - if you're going to be stabbed by a knife, you'll do a lot better if you're fit, trim, with firm solid musculature, than you will if you're flabby and out of shape. (Note to me: stick to that New Year's resolution.) But the big problem is the knife wound, not the being out of shape.

Here's a link to a really good 12 minute 60 Minutes presentation on the same subject.

I close noting that all this is subject to correction. But I have yet to receive it. My tentative thought is that trading in this stuff is madness, and must be stopped or subjected to the strictest regulation.

A Reckoning for The Newspaper of Record

    I am of two minds about the New York Times. On the one hand, the existence of at least one newspaper with the resources and expertise to do in-depth reporting on complex current issues seems to be essential. Its current series on the financial crisis ("The Reckoning") is superb. On the other, the Times can degenerate into the crassest type of propaganda. Its columnists are bad enough - an incessant preaching to the choir, conducted at a deafening decibel level.

    But it is even worse when the propaganda comes disguised as 'objective' journalism. Its coverage of continuing news stories such as the Iraqi War and the recent Presidential campaign reflected an editorial bias that became downright embarrassing. This heart-before-head approach to factual stories damages the credibility of the institution as newspaper of record - a fact that may be reflected in its declining circulation and its financial difficulties.

    So a dose of reality may be a good idea for the paper itself. It is about to get two of them. First, it seems the Pulitzer Prize people are seriously considering revoking the Pulitzer Prize awarded to the dreadful Walter Duranty in 1932 for his coverage of the famine in the Ukraine. About time. Duranty is one of the most embarrassing figures in the history of the New York Times. Even more embarrassing is the fact that an entire series of editors never cottoned on to the fact that he was a propagandist, not a journalist. (The rumor is that the NKVD caught him in a honey trap and effectively dictated his stories.) To its credit, the story is carried by the Times itself.

    Even more interesting is the claim of slander filed by Vicki Iseman last Tuesday. Iseman was the lobbyist whom the Times linked to John McCain, in what was easily the most notorious and deplorable article of the Presidential campaign - a sewer of innuendo and speculation that would have been unworthy of the National Enquirer, let alone the newspaper of record. Ms. Iseman has her work cut out for her. To prevail, she has to either show negligence (if she is not a public figure) or malice (if she is) on the part of the Times. She can expect to meet a well-funded, determined resistance from the Times, aimed at ending the lawsuit with summary judgment, i.e., a decision by a judge that the case is without merit. If Ms. Iseman wins there, she can expect a generous settlement offer.

    But I sure hope that she wins the summary judgment and refuses the settlement offer.  My fondest hope is that the lawsuit does NOT resolve short of trial, and that the Times is forced to wash in open court all of the dirty linen that led to the publication of the article. I can't think of anything that would do it more good.

    I do believe that the editors of New York Times believe that credibility is theirs by divine right, a gift from a just and generous creator. Well, so did the FBI and the Office of the Presidency, once upon a time. Those institutions have both seen the implicit public trust that was once near absolute, damaged or destroyed by the abuse of the power with which they were entrusted. The same thing can happen - is happening - to the Times, as disbelieving as its principals might be. A chastening trip to the woodshed is long over due. 

 

What Happened to the Family Farm

You have owned the family farm for a couple of generations. It has endured some hard times, but you endured. About 30 years ago, times got a little better. You could finally plant the crops you thought would do well, you did just that, and you made some money. Some of this gee-whiz computer stuff made your operation a little quicker, and you did much better. So did every one else.

So good that you relaxed. You started to spend more than you could sell the crops for. No problem, since the Great Bank of China (Warlords with a Heart!) was willing to loan you all you needed, and the market for the crops seemed unlimited. Then times got tough overseas, some of your workers went off to war, and you lost some ground there. You became a little lazy, and let a few of your seed fields go to flower. Not good - you'd gone from a pretty good manager to a lousy one.

But at least you knew this. You also knew you'd been there before and found a way out. Acts of mismanagement can be corrected by acts of good management. You deserved a good kick in the rear for all your complacency, but at least you had identified the problem. Nothing for it, but to solve it.

That is, until your youngest son came home and told you that he'd lost the deed to the farm in a poker game. That, you had not counted on. That knocked you for a loop.

 . . .

A little parable about the comparison between the problems with economic fundamentals in this society, and the disaster that has occurred in the financial institutions. I have been trying for two months now to get someone with more economic acument than I have - there are a ton of 'em - to tell me I'm wrong - but no one ever does. Meanwhile, I keep reading editorials deploring the management of Fannie Mae and Freddie Mac. It's true, of course, that they were mismanaged - but that's not why we're in this mess.

Fannie Mae and Freddie Mac are mortgage insurers. Their predecessors were founded during the New Deal to make home ownership possible to the middle class. After the Second World War, their ambit was vastly expanded to provide home ownership benefits for returning veterans.

The impact and importance of the program cannot be underestimated. Unless you are a very exceptional individual, you and every one you know owns a home based on a 15 or 30 year mortgage (and I am including ARM's, which in theory are amortized over that period.) It might surprise to you to know that that feature of the American middle class landscape is solely due to the creation of Federal mortgage insurance. In the 19th century and the first decades of the last, real estate mortgages were 5 year renewable notes. That's because lenders knew that collateral could lose value as well as gain, which was the case in the 19th Century. They would not loan on the collateral for longer than 60 months. (That's the reason you could have melodramas with Snidely Whiplash beasting about, threatening to foreclose on little Nell. He's not there because she missed a payment on a 30 year fully amortized note. He's there because the five years are up, the real estate market has changed, and the family farm is no longer adequate security.)

Fannie Mae changed all that by guaranteeing the mortgage so that the lender doesn't have to worry about collateral losing value. Nearly every middle class family in the US has benefited from that program. It was a valuable innovation, as important in its way as Federal deposit insurance. There would be very, very few families that would own homes did this institutional machinery not exist.

O.K. Bear with me. Sometime ten or 12 years, this mortgage insurance company began to lose its bearings. It encouraged lending that was too high risk and guaranteed the same. Its risk analysis was way, way off. No question that's bad. It's going to cause a real issue with the reserves that have to be allocated to pay off bad loans, etc. Like any other insurer, it's going to have to take stepso insure its liquidity and the adequacy of its cash reserves. BUT . . . . .

  . . . IT SHOULD NOT TRIGGER A GLOBAL BANKING CRISIS. The reason why all these financial institutions are in trouble is NOT the (still relatively low) level of foreclosures in the subprime market. It's that this home ownership was monetized, collaterized to a fare-thee-well, and traded between large institutions.

And why did this happen? What on earth is the point of monetizing and trading collaterized debt obligations? It bears absolutely no relation to the original point of Fannie Mae policy, which is to promote home ownership. It bears absolutely no relationship to the conventional creditor-debtor relation of bank and homeowner. It exists, so far as I know, only because the extremely sophisticated computer programs by which financial instruments are analyzed seduced financial managers of large institutions into believing they could make huge, 'safe' trading profits - and pay themselves huge bonuses accordingly. The market for these 'securities', if it can be called that, is entirely artificial. Traditionally, no one thought of home equity as a marketable security on which someone could make trading profits. There has never been a trading market for home mortgages.

Let me make the same point another way. Assume that me and a number of other men and women have bought term life insurance with a given company. That produces a cash flow of premiums, against which ultimately the company will have to pay certain cash sums, discounted over time. Assume that in some Alice-in-Wonderland world, the company, and others like it, are allowed to monetize the premiums, turning the cash flow into one large bond, and sell it. Assume further that the financial managers of the world have sophisticated analytical programs, with which they can analyze the actuarial assumptions of the company, compare them with others, and decide which of the life insurance bonds are irregular, i.e., the cash flow from the premiums is going to be a little more than necessary to pay off the contracted payouts, so the bond has economic value due to the projected surplus. Of course the differential is too small to make any significant trading profit - so it buys the bond at the insurance company par, leverages it thirty to one, and sells it at a premium based on the anticipated surplus - believing of course that the premium cash flow is absolutely safe.

(Does this seem like madness? In macro economic terms, it sure is. (Don't confuse this monetization with coinsurance, a type of risk sharing, which is another thing altogether.) The purpose of the term life insurance was to provide policy holders with protection against certain assumed risks. These policies aren't investment vehicles, and were never intended as such. The fact that you can ascertain a market irregularity with a variant of the Black-Scholes equation doesn't mean you have identified a marketable secutiry.)

If the insurance company has miscalculated its actuarial assumptions, it may run short of money to pay benefits and maintain reserves. That's serious, but correctable. You can raise premiums to new policy holders, and take various measures. But you are not going to collapse the banking system. That can only happen if you have monetized the premium flow, collaterized it to astronomical heights, and sold it highter and yon - insurance policies which were never meant to be traded, and for which there is no regular market. When the actuarial assumptions fail then, so does the colalterized bond, and the walls a'come a tumblin' down.

One final trope - if you're going to be stabbed by a knife, you'll do a lot better if you're fit, trim, with firm solid musculature, than you will if you're flabby and out of shape. (Note to me: stick to that New Year's resolution.) But the big problem is the knife wound, not the being out of shape.

Here's a link to a really good 12 minute 60 Minutes presentation on the same subject.

I close noting that all this is subject to correction. But I have yet to receive it. My tentative thought is that trading in this stuff is madness, and must be stopped or subjected to the strictest regulation.