Thursday, March 18, 2010

Frankenstein at College

The enduring name “Frankenstein” must surely be some indication of how indelibly effective the half-man half-machine hybrid creature is as a horror story device. There is an analogous creature in economics, and it is all the more scary because it’s not a work of fiction: you cannot walk out of the theater and make it go away. It is the species known as government-sponsored enterprise. Its kind are known by quaint sounding monikers like “Fannie-Mae” or “Freddie-Mac.” While these are names that make you think of your cousins down South, don’t be fooled by them. The damage these creatures can inflict is real. The half-man part of the GSE acts like a regular private enterprise. It enters into a market and competes with regular private enterprises. However, because of the half-machine part – the “government sponsorship” – it has competition-devastating advantages of cost and scale that can enable it quickly to dominate the market, driving out genuine private enterprises. Now Frankenstein has access to the marketplace but is immune to its main guidance system: competition, and thus the monster may undertake an unrestrained haywire binge.

GSE’s don’t have to make money. It would be nice if they did, but it isn’t essential for their survival. Thus this frightening Frankenstein has, unluckily, a power-supply that is as close to a perpetual-motion machine as is known to man: a taxpayer subsidy. Eek. This horror can destroy the market and taxpayer wealth virtually indefinitely, leaving in its wake all the evils associated with “bad money:” a schizophrenic, distorted market, deprived of the healthy competition which regulates prices and forces a measure of quality; a legacy of bad management decisions that includes unwise investments; a financial black-hole which sucks up money and sends it who-knows-where.

Today we consider for a moment a recent story about kissing-cousin Sallie Mae – the Student Loan Marketing Corporation. Her job is to subsidize student loans. If you’ve noticed that “higher education” just isn’t what it used to be, she just might be the main reason why. Like a tramp at the prom, her virtues are illusory. Her image of sanctity – that pesky government sponsorship – makes her appear to be as safe as a US Treasury bond to the capital markets, so she was -- until the credit markets began reevaluating the depths of taxpayer pockets -- able to borrow all she wanted without having to pay the risk premium that a real private enterprise would have to pay. Amassing mountains of cheap money (aka “bad money”), her job is to entice higher people to finance higher education by borrowing from her at below-market rates (the competition-killer) and to entice education institutions to enroll students to loan that money to. This they are glad to do, because they are in business, it appears, to do just that: manufacture degrees, and the more the merrier. No less eager are the young, apprently, to hang out on college campuses being cool thanks to easy-to-obtain-deferred-repayment-low-cost-loans.

Mass production is rarely associated with the highest quality, and never was it more rarely associated with it than in the mass production of college graduates. Mass production is instead a useful way to stamp out countless identical components to be assembled into roughly identical products. The defective gizmo in the process is the one that isn’t like its millions of peers. It’s the outlier, the non-conformist, the part whose dimensions aren’t so much like all the others as to be indistinguishable from them. The application of such standards of conformity might be a laudable in the production of blenders or automobiles or cans of cat food, but when applied to people it’s called “mediocrity.” Its long term effects on a society remain to be seen, but the early indications are frightening.

But we digress. The inspiration for this little yarn was the article in Bloomberg about Sallie Mae’s efforts to refinance $11 billion in bonds coming due in the next year. It seems that they have recently lured buyers for $1.5 billion at 8.25%. Marvelous. Or not so. After all, the Fed Funds rate at this writing is 0.18%. Sallie is paying nearly double what you’d pay to finance a home for 30 years on a fixed-rate basis. This isn’t as sweet a deal as a GSE might have demanded in happier times; it appears, however, to be very sweet for the buyers of the debt. A bailout by any other name is still a bailout, even if it's for bondholders. The market seems to be assessing a risk premium after all, despite the taxpayer backstop.

Another annoying detail is that the interest that Sallie receives on her student loans – her bread-and-butter -- is fixed at 5.6%, a guaranteed loss of 2.65% for Sallie – well, actually, for Sallie’s “government sponsor”, that is, we the taxpayers. If they make such arrangements with the remaining $9.5 billion coming due, the loss will be $291,500,000.00 over the term of the notes (that's almost a third of a billion dollars). Do you see what we mean by “bad management decisions?” Bear in mind that this deficit will itself have to be financed, likely at higher rates. You might want to scratch second homes, luxury cars, vacations, and other non-essentials (like a college degree?) off your budget for the remainder of your lifetime.

In the article in question, some “expert” is quoted as saying that Sallie Mae “is in a virtuous cycle right now.” If a guaranteed 3% loss on $11 billion is virtuous, I’d hate to see what Sallie’s like when she’s wanton. This does raise questions for us: what with the multi-trillion-dollar deficits that have become so fashionable so fast these days, might there be some future scramble to raise cash when said deficits just as suddenly go out of fashion? What lengths will Frankenstein go to in order to make up for that $333,000,000.00 loss? What claim will it lay upon futures recipients of those mass market degrees? And where did that expert get his degree, at Sears and Roebuck?

Sallie is only half-machine. She’s also half-man – that is, she acts like a genuine private enterprise, and has enjoyed the benefits of the private enterprise system with none of the responsibilities. But when her borrowing costs arise, she might find it more difficult to mint taxpayer losses under some future, more responsible administration. This would remove her luster of irresistibility: her cost advantage. She would definitely be less attractive to would-be borrowers under such circumstances. She would have seen better days, like the harlot who becomes an old maid. Her doom was inevitable, and obvious to anyone paying attention.

It’s an ugly prospect. The world will be better off without her, but it would have been better if she’d never shown up to begin with.


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