The Governor's Dilemna: Can We Afford Public Education?

President Obama met this week with the National Governors Association to discuss, among other things, the impending federal spending cuts and the expansion of existing Medicaid plans that are phasing in this year as part of the Affordable Care Act.  State governors are particularly interested in these topics because they could have such a significant effect on state budgets: Medicaid, which is largely funded through Federal reimbursement, still makes up approximately 9% of total state spending.  The governors are concerned that the Federal government, as part of its goal to reduce the deficit, might find it convenient to push more of the funding responsibility for Medicaid onto the states themselves.  The governors warn that the recent economic downturn has severely weakened state and local fiscal standing, and that any increased burdens from a spending program as large as Medicaid would send them over the edge.  Well, what if there was an even larger spending program that was devouring a quarter of state tax revenue and producing no measurable economic benefits?

Public k-12 education is often put forward as a fundamentally sound economic investment and we are constantly told of how lack of education funding is leaving our children behind their global contemporaries.  However, more and more data is piling up to make us question this long held belief that public education is actually a good economic investment.  Let me first stay that I am huge proponent of education for our youth and that not only did I attend public school my entire life, but my mother was also a teacher in a public school for 15 years.  I make that qualifier because public education is an incredibly sensitive topic in American political discussion and it is not my intention to provoke an ideological debate, but rather to illuminate some alarming trends in the fundamental tenant of public education: that a well educated population is a more productive population and, therefore, public spending on education is a sound economic investment.

There are two alarming trends in public education today: 1) the annual cost of public education per student is rising rapidly; and 2) the median income for an American household is declining rapidly.  Those two trends do not bode well for the economic value of public education spending.  In order to get a more detailed understanding, let’s look at the data:

The figure above plots the real (inflation adjusted) cost of education versus median household income each displayed as a percentage of the year 2000 figure.  There are two key takeaways from this chart: 1) beginning in 1993, America began investing more heavily in public education, but median income increased proportionally to support the increased investment; and 2) starting in 2000, median income began declining but public education investments continued to increase, defying all economic fundamentals.  The reality of the situation is startling: in 2011, Americans earned the same income as they did in 1990 but received 33% more in educational spending.  That is $36,000 more spent per student with no measurable increase in economic productivity.  And that is only at the K-12 level: more Americans than ever are also attending higher education institutions with tuition rates at all-time highs.  Let me stress that point: the cost data above only included k-12 and not higher education, while the income data includes the economic benefits from both high school graduates and college degree holding graduates.  Plus, we are comparing individual education expense to household income when the average household has more than one adult.  And the economics still look bad!  That sounds like trouble, but is public education really a bad investment?

To answer this question, I have put together a pretty simple analysis. My methodology is as follows: for each student “vintage,” I have assumed that they go through a 13 year (k-12) schooling period followed immediately by a 35 year working career (implies a retirement age of ~55).  For every student, I assume that all 13 years of education cost the same amount and that the student’s earnings are equal for each of the 35 years of their career.  In each year, I assume that the public recoups a 15% income tax on all income, which is roughly in line with the expected effective tax rate for a middle income American.  Notably, I assume that this entire tax revenue is dedicated to recouping investment in public education and no other government functions.  Finally, in order to account for the time value of money, I discount each payment at a rate of 3.5%, which is selected to reflect the target real GDP growth in the USA (and globally).  Let me take 1990 vintage for example: education cost for the 1990 vintage student was $8,509 annually or $110,621 for all years k-12.  Using a 3.5% discount rate, the cost of the 1990 vintage’s k-12 education at the time of graduation would be $137,111.  The median income for a person in 1990 was $49,950, so tax revenues each year would be $7,493 or $262,238 over the 35 year working career.  Using a 3.5% discount rate, the value of that tax revenue at the time of graduation would be $149,855, which compares favorably to the cost of education of $137,111.  This would imply a positive investment outcome for the public, all else being equal.  Here is how that same calculation has evolved over the past 20 years:

A key takeaway here is that the investment opportunity turned negative for the public starting roughly in 2002.  That isn’t overly surprising considering we already knew that income growth stalled in 2000 while costs continued to surge, but the magnitude of the losses are pretty staggering: by 2010, the public is losing almost 25% of its investment.  Or put another way, in order to make public education a defensible investment on the same terms as it was in 1990, we would need to reduce the amount we spend on education by 25% back to its 1990 levels.

One final note on this topic is the choice of a 3.5% discount rate.  The discount rate is enormously important in determining whether or not public education (or any government spending, for that matter) is a viable investment.  Many people, particularly congressmen, would argue that we should use the Treasury rate (the rate at which the US government can borrow money) in determining the discount rate for financial decisions such as this.  This view is incorrect in today's global capital markets: we can use the Treasury rate as a proxy for the expected real GDP growth, but not as a fundamental replacement.  In today’s free global capital markets, resources will almost always flow to where they can be most productively put to use.  Resources, in this sense, constitute anything with economic value: monetary savings, commodity goods like coal and oil, as well as human capital in the form of immigration (the most constrained resource in today’s market).  That means that everyone looking to utilize capital (borrowing money, for instance) is governed by the same global cost of capital.  That cost of capital is the expected real (inflation adjusted) growth of global GDP.  Thus, when determining whether an investment is viable or not, we need to be assuming that our cost of capital is the same as our global competitors because that’s how global investors will view it.  This is true whether you are an individual business owner, a corporate CEO or the United States Treasury.  So, in a world where developing economies are growing at rates in excess of 7.0% annually and Germany has consistently delivered growth above 3.5% annual, we cannot be assuming that America will be able to borrow at 2.0% interest forever.

Ratings Arbitrage: How to Use Student Loans to Maximize Mortgage Subsidies

In this post, we are going to look further at the connection between student loans and mortgages – particularly conforming loans that are guaranteed by Fannie Mae and Freddie Mac.  Navigating the interwoven world of government subsidized finance can be difficult and, at times, totally mind bending, as the government often times contradicts or deceives its own underwriting standards.  One such example of this is the treatment of student loans by Fannie and Freddie.  In the following, we are going to examine how the next-generation of homeowners can use student loan refinancing in order to receive much better treatment from Fannie and Freddie.

Fannie Mae was created in 1938 as part of the New Deal.  Fannie existed as a government agency until the 1960’s, at which point it was partially privatized with an “implicit” guarantee from the US Treasury.  Freddie Mac, Fannie’s identical twin, was created at this same time to provide adequate competition to Fannie Mae.  Both Fannie and Freddie collapsed with the housing crisis in 2008 and were subsequently re-absorbed by the government after a substantial taxpayer bailout.  The entities exist today in an awkward limbo: they are still private companies but are essentially 100% owned by the government with a direct line of credit to the US Treasury.  One might wonder why these entities continue to exist in this convoluted structure.  The simplest answer is: keeping them as a GSE under an “implicit” guarantee allows Congress to forego accounting for the liabilities of Fannie and Freddie as part of its budget and debt calculations.

Despite their messy ownership structure, Fannie and Freddie still perform the same basic function they did before 2008: they buy “conforming” mortgages from local banks, guarantee the mortgage payments and then re-sell the packaged loans as mortgage backed securities (MBS) to global investors.  This process allows local banks to originate mortgages and then sell them to Fannie/Freddie for cash, which allows those same banks to then make new loans to more borrowers.  In today’s market, 90% of all mortgages are sold to either Fannie or Freddie.  This means that essentially all mortgages today are underwritten according to Fannie/Freddie’s definition of “conforming loans.”

The definition of a conforming loan is the single most important delineation in the American consumer financial market.  It is also one of the most rudimentary and unsophisticated.  There are essentially four criteria that Fannie/Freddie use to determine the status of a potential mortgage borrower:

• Loan to Value (LTV): the ratio of the mortgage amount to the appraised value of the property; 
• Credit Score: middle score from the three credit bureaus; 
• Debt-to-Income (DTI): the ratio of monthly debt payments to monthly gross income;
• Minimum Reserve Requirement: required number of monthly payments a borrower must have as a reserve of liquid assets 

We are particularly interested in the DTI criteria.  The table above is the “eligibility matrix” for Fannie Mae, which delineates the qualifications for a conforming loan.  As shown, the maximum DTI at which a borrower can qualify for a conforming loan is 45%; and, there are several other delineations that restrict borrowing limits if DTI is above 36%.  This is important because DTI is calculated as the ratio of monthly income to monthly obligations, including both proposed mortgage payments and existing installment debts, including student loans.  As a result, recent graduates who are paying too much on their existing student loans will also have more difficulty in obtaining government mortgages.  Fortunately, there is a simple solution: refinance with Prime Student Loan.

To illustrate this point, let’s look at what that calculation might look like.  Let’s assume that a borrower is buying a single family home for $300,000 and is looking to obtain a 95% LTV mortgage for $285,000.  Let’s further assume that the borrower is a recent college graduate with $80,000 in student loan debt, gross annual income of $60,000, and a FICO score of 720.  We can then calculate their DTI under their current student loan portfolio and a post-refinancing portfolio.  The results are shown below left.

As one can see, under their current student loan repayment strategy, this borrower would not qualify for a conforming loan with the current terms.  The borrower would have to either reduce the loan amount (increase the down payment) or lower their offering price.  Alternatively, if the borrower refinanced their existing student loans into a lower rate and longer term, they would simultaneously reduce their DTI, as calculated by Fannie and Freddie.  Under this new refinancing strategy, this borrower would be approved for the mortgage and on their way to home ownership!  

At PSL, we are constantly imploring student loan borrowers to capitalize on refinancing opportunities in order to lower their monthly payments and maximize their financial flexibility.  While this financial flexibility might seem unnecessary to some borrowers, it is my hope that this example helps illuminate why that flexibility is so valuable.  In addition to obtaining better mortgage opportunities, I would note that FICO scores include a similar DTI calculation, as do auto loans and credit cards.  So, in conclusion, if you are thinking about buying a home, buying a car or taking out a new credit card, then you could be greatly harming yourself if you do not look into student loan refinancing before you solicit other forms of consumer debt.

 

 

The New Gold Standard: How We Are Anchoring Monetary Value to Real Assets

In this post, we will temporarily depart from the student loan discussion in order to bring forward a financial concept that I believe is tremendously important in understanding today's consumer credit markets and, therefore, today's student loan market.  The main discussion of this post will be around how the global financial markets have adjusted to the abolition of the gold standard and the rise of the Chinese economy and structural trade deficit.  This may seem very far afield from the discussion of student loans, however we hope to show that there is an inextricable connection between the two.  We describe this connection as the phenomenon of anchoring monetary value to real assets.

In 1971, President Nixon officially "closed the gold window" and floated the US currency.  There are a number of opinions on what affect this decision has had on the global financial markets, but the one that we focus on here is quite simple: the value of the US dollar changed from being a universal means of exchange and into a representation of the creditworthiness of the US Treasury.  In other words, the US dollar changed from being exchangeable into a real good (gold) into being exchangeable into a monetary good (a US Treasury security).  This is an enormous shift: before 1971, anyone looking to buy a US dollar would simply buy gold instead; after 1971, anyone looking to buy a US dollar would simply buy a US Treasury security instead.

The fundamental demand for US dollars is driven by a the desire to interact with the US economy.  A very good approximation for this demand is the US economy's share of global GDP.  As the chart above illustrates, the US's share of global GDP stabilized between 25% and 30% of global GDP, which should have correspondingly stabilized the demand for US dollars.  As we previously discussed, because the demand for the US dollar is essentially equal to the demand for US Treasury securities, we would expect the demand for US debt to have stabilized and would expect US debt as a percentage of GDP to remain equally stable over this period.  As we know, that has not been the case: US debt to GDP was 35% in 1975 and is over 100% today.  This makes no fundamental economic sense: the US share of global GDP has not increased, but the demand for US debt has increased seemingly without limit.  We note that the European Union is an even bigger example of this curiosity: the EU's share of global GDP declined from 35% to 28% since 1970, and yet the sovereign debt to GDP within the EU has climbed to 90%.  How can it be possible that as the US/EU share of the global economy declines the demand for their currencies can increase so astronomically?  The simple answer is China.

During the recent election cycle, we heard a lot about how China is manipulating its currency and how politicians need to "get tough with China" about its currency policy.  What we did not hear is how China's decision to manipulate its currency has artificially inflated the demand for the US currency and, therefore, allowed the government to borrow nearly limitless amounts of money.  On a simplified scale, this is how the transaction plays out: the US runs a trade deficit with China (~$300 billion in 2012) in which US consumers buy real goods in exchange for paper dollars.  In order to rectify this trade imbalance, China then needs to reinvest those dollars in the global market.  However, the market demand for US dollars is constrained by the US economy's share of global GDP, which has not changed since 1970 even while the Chinese deficit has ballooned since 1990.  Thus, so long as the US economy maintains its steady share of the global GDP, then any attempt by the Chinese to increase the supply of dollars would produce a decline in the value of the dollar.  This presents a problem for China: if it sells its US dollars on the market, the dollar will decrease in value with respect to China's currency and therefore make Chinese exports less attractive to US consumers.  Thus, in order for China to maintain its artificially low currency exchange rate, China must purchase US dollars on the open market in equal value to its trade deficit.  China can do this by purchasing US Treasuries or by purchasing any security that is guaranteed by the US Treasury. 

This last point is critical: the Chinese currency policy is driving an enormous demand for US sovereign debt for no other economic purpose except to maintain an artificial exchange rate.  If the Chinese only purchased US Treasury securities, then this would be a pretty innocuous transaction: China would receive dollars from US consumers in exchange from real goods, which it would then use to buy US Treasuries whose real value would decline over time as inflation of the currency outpaced the interest on the bonds.  That is a bad outcome for the Chinese - they traded real goods for paper money - but otherwise it would be relatively harmless to the US consumer.  However, the US government has put in place programs through which it uses the US Treasury to guarantee forms of consumer debt: most notably the federal mortgage program and the federal student loan program.  

When the US Treasury lends to homeowners through guaranteed mortgages, it turns American houses into conduits for China to purchase US dollars in order to offset its trade surplus.  When the US Treasury lends to students through the student loan program, it turns American students into conduits for China to purchase US dollars in order to offset its trade surplus.  This is extremely dangerous: China does not believe that US houses are good investments, it just wants to buy guaranteed mortgages in order to satisfy its demand for US Treasuries; China does not believe that US higher education is a good investment, it just wants to buy guaranteed student loans. In both cases, we are "anchoring" the value of our paper currency to the value of real assets - houses and tuition.  In both cases, this simply produces massive price inflation of the underlying assets: historic increases in both housing prices and tuition.  As a way to illustrate this connection, we put forward  the chart below that maps the American trade deficit with China alongside the price of both housing and higher education in the US over the same period.