One Year after Obama’s Election: Regulatory and Fiscal Challenges

At the time of his election in November 2008, President Obama faced with a severe recession, frozen credit markets, record job losses and tumbling home prices. A year later, the economy is out of recession and the administration has boosted investor and consumer confidence by standing ready to back-stop the financial system and stimulate the economy. Of course, myriad problems remain. The unemployment rate is set to cross 10%, credit for American consumers and companies remains tight and (foreign) investor are concerned on how the administration will address the fiscal burden. In this one year, President Obama has initiated most of the proposals he laid out during the election campaign—a large fiscal stimulus, financial sector regulatory reform, relief for troubled homeowners, healthcare reform, and proposals to raise taxes on high-income households and corporations—albeit with mixed results. With a weak economic recovery and mid-term elections scheduled in November 2010, the administration will need to consider additional fiscal stimulus and passage the new healthcare legislation. There is uncertainty about how fast it can move on fiscal and regulatory reform.

Treasury Inches Forward on Financial Regulation

On June 17, Treasury Secretary Tim Geithner presented a Comprehensive Plan for Regulatory Reform. The new framework calls for several changes, including:

• Giving the Fed new powers as a systemic risk regulator and supervisor of too-big-to-fail institutions, and for the establishment of a “Council of Regulators.” 
• Requirements that the originator, sponsor or broker of a securitization retain a financial interest in its performance (“skin in the game”). The plan would also regulate all financial derivatives for the first time. 
• The establishment of a Consumer Financial Protection Agency to strengthen investor protection and rules against predatory lending.
• The introduction of a new resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system, including large hedge funds and major insurers such as AIG.
• Finally, the plan calls for reform internationally as well as domestically.

On October 27, the House Financial Services Committee presented a draft bill along these lines, including a Financial Company Resolution Fund (FCRF) to be pre-funded through risk-based assessments of all financial institutions with US$10+ billion in assets. However, in a sign that a final agreement is still far from unanimous, the Senate Committee is preparing an alternative bill that would consolidate the four current bank regulators into a single supervisory body in a move that would significantly curtail the Fed’s authority by making it one among equals in the Council of Regulators whose task it is to monitor systemic risk.

Compensation Reform Looks Less Than Perfect

In October 2009, the U.S. Treasury announced measures to review compensation at firms drawing heavily on TARP funds. This comes after the Treasury delivered compensation-reform legislation to the Congress in July 2009. The government’s proposed requirements that a large share of employee compensation be paid in long-term restricted stocks and after the repayment of TARP money to the government would be welcome reforms. So too are proposals to mandate shareholder vote on executive compensation and golden parachutes, for not just TARP recipients but all publicly traded financial and non-financial companies. However, the core reform proposed—to attach a nominal cap to compensation—seems less constructive, and only shows that the administration wants to meddle in the management of banks to address public anger over bonuses.

Compensation trends in recent months underscore the fact that the government’s crackdown on compensation has done little to reform the pay culture on Wall Street. Compensation and bonuses at top banks remained high in 2008 and are forecast to grow strongly in 2009. Top notch employees are moving away from the TARP recipient banks to the non-regulated banks. To prevent talent exodus, banks are raising base salaries to offset the legal cap on compensation and bonuses, and some are also guaranteeing bonuses. Banks are looking to pay back government money quickly to escape excessive government oversight. Given the role of compensation structure in promoting excessive risk-taking by bankers in the current crisis, the push for compensation reform by Washington is here to stay. In this regard, compensation reform proposed by the Fed is a better tool to manage risk-taking. The Fed has plans to review and rectify, if needed, the pay practices at all the institutions it supervises in order to make compensation structure consistent with the firms’ risk-management.

Extension of the Homeowner Affordability Plan: The HFA Initiative

In the October 2009 review, Fitch called the results of the government sponsored loan modification programs disappointing, given that 65-75% of modified loans re-default within twelve months. Moreover, Fitch reports that as of September 1, only 1,711 of the over 360,000 loans placed on a trial modification under the “Making Home Affordable” program had been converted to permanent status. As a response, on October 20, 2009, Treasury announced the HFA Initiative to support state and local housing finance agencies (HFA) with two programs: first, the Temporary New Issue Bond Program (NIBP) for HFA to issue new mortgage revenue bonds, and second, the Temporary Credit and Liquidity Program (TCLP) to reduce the costs of maintaining existing financing for HFAs. According to press reports, housing officials said that to be effective, the programs will likely need to result in as much as US$20 billion in purchases and US$15 billion in Treasury-financed liquidity. In addition, Treasury officials stress that the two programs will be paid for by state and local HFAs, through fees, and not by taxpayers, although Treasury is next in line after the HFA’s first loss position, followed by Fannie Mae and Freddie Mac.

Economy and Congress Yearn for (Unaffordable) Fiscal Stimulus

Only 25% of the US$787 billion fiscal stimulus has been spent so far and its impact on the economy has been rather disappointing. The White House claims the stimulus has saved or created over 600,000 jobs so far but it seems that most of this number represents jobs saved, not created.

With the mid-term elections in November 2010, the Congress is raising pressure on the White House to implement additional fiscal stimulus. The impact of the current stimulus on the economy will peak in H2 2009 and start fading by mid-2010, raising concerns of a "double-dip." The unemployment rate will be over 10.5% by then and close to 8 million Americans will be unemployed. Households will also be concerned about higher taxes in the future.

Since tax cuts given out earlier this year have been largely saved and infrastructure spending has been slow to kick-off, Washington wants the stimulus to be well targeted. And amid fiscal concerns, it wants to keep the stimulus bill below US$150 billion. The administration and the Congress are right to consider extending the duration and benefits under unemployment benefits, continuing with the health insurance tax credits for unemployed workers, and granting additional funds for the states and local governments. While Washington will likely approve the additional stimulus by late 2009 or early 2010, it will exacerbate concerns about fiscal sustainability. Additional stimulus is unlikely to fill the budget gaps of states, which will continue to cut jobs, reduce spending on education, healthcare and other public services, and raise taxes. Voter angst will increase since these states also suffer from high unemployment and/or housing and auto sector downturns.

The Congress will also extend the tax credit for first-time homebuyers until 2010, given its success in boosting home sales and residential investment. The "cash for clunkers" program shows that such tax credits are well targeted at sectors but boost the economy only temporarily and merely shift consumer spending forward. Such populist programs also raise the fiscal burden. Several U.S. representatives and think tanks are proposing tax credits for companies to encourage hiring, especially among small businesses. But past experiences suggest that such incentives are fiscally expensive and yet ineffective in boosting hiring since companies face weak consumer demand—and that the boost they provide for employment comes merely from shifting hiring forward temporarily.

Fiscal Burden Will Only Surge

Fiscal stimulus, financial sector support, and lower corporate and financial sector tax revenues have pushed the U.S. fiscal deficit to over US$1 trillion during 2009-10. The deficit is likely to remain close to US$1 trillion over the next decade for three main reasons: an increase in entitlement spending; lower revenues due to sluggish economic recovery; and high interest payments on public debt.

Social Security, Medicare and Medicaid already accounted for over 40% of total federal spending in 2008. With the aging population, the U.S. Congressional Budget Office (CBO) forecasts that spending on Social Security, Medicare and Medicaid will rise from 10% of GDP in 2009 to 12% by 2019 and 17% by 2035. The trustees of the Social Security and Medicare funds estimate that the Social Security fund will fail to pay full retirement benefits after 2037 while the Medicare fund will exhaust its reserves by 2017. The increase in spending will emanate not just from demographic changes but also from high healthcare costs and delayed reform of the Social Security system. Healthcare costs are expected to rise from 16% of GDP in 2009 to 18% of GDP by 2019 and 25% by 2025.

The public debt to GDP ratio will surge from close to 50% currently to 80% in the next decade and over 100% if intra-governmental holdings (securities held by government trust funds, revolving funds, special funds and government accounts) are included. Interest on public debt will rise from less than 1.5% of GDP currently to over 3.5% by 2019. With the Congress likely to raise the debt ceiling soon from the current level of US$12 trillion, investors and foreign central banks are right to be concerned. Foreign central banks are likely to diversify their reserves away from the U.S. dollar only gradually over the next few years, but they will be willing to finance the U.S. deficit only at higher yields. Yields will surpass GDP growth in the coming years and crowd out private sector spending. Going forward, the frugal consumer, housing sector and easy money will no longer drive economic growth. But with a high debt burden, the public sector will also be a drag on the economy rather than driving growth.

Entitlement Reform Will Entail Fiscal Costs

President Obama has proposed to fund the Social Security shortfall by removing the current income cap on payroll taxes and to start taxing the above-US$250,000 income group. But again, the timing and extend of tax hike will be constrained by the weak economic recovery. Other reforms, such as raising the retirement age and modifying benefits, will be necessary to address the shortfall.

The administration’s and Congress’ stance to increase coverage and mandate health insurance will by itself increase the cost of healthcare reform, especially in a scenario where insurers are mandated to enroll everyone including the less healthy people. President Obama's support for a single-payer system and proposals to reform doctor malpractice abuses and de-link insurance from employment (given job losses related to business cycles and globalization) are welcome.

However, most reforms proposed by the White House and Congress will entail fiscal costs and negative economic effects. The final outcome is likely to include some form of “public option” (that President Obama supports) which will compete with private insurers by offering subsidies. Subsidies for low-income groups to purchase insurance via “insurance exchange” will also add to the fiscal cost. Mandating employers to offer insurance will raise labor costs and affect hiring and wages. Taxing insurers will be counterproductive as insurance companies will pass on the cost to consumers in the form of higher premiums. Raising taxes to fund healthcare reform will be constrained by the sluggish economic recovery. Washington’s estimates about cost savings in healthcare system and revenue generation by taxing expensive premiums and employer-provided insurance will not be sufficient to finance the reform. More importantly, these cost-saving measures do not ensure improved quality of healthcare outcomes. Any healthcare reform legislation will add to the fiscal deficit over the next decade.

Weak Recovery Will Constrain Washington's Tax Hike Rhetoric

President Obama supports phasing out the Bush era tax cuts starting 2011 to finance the fiscal deficit and healthcare reform. This will raise the tax burden for the above-US$250,000 income households and taxes on dividends and capital gains. He has signaled support to tax “carried income” of fund managers at a higher tax rate and change the tax treatment of foreign subsidiaries of U.S. corporations. The administration is also gearing up to close tax exemptions and loopholes for households and corporations. To avoid political backlash, President Obama has said in public that taxes will go up only for the above-US$250,000 income groups (while the low and middle income groups will face lower tax burden), and for the excessive risk-taking fund managers and tax evading multinational corporations.

The administration has reiterated that it will cut spending and raise taxes to address the fiscal burden. However in reality, there is little space to reduce spending since any possible cut in defense and pet projects will be more than offset by higher spending on entitlements and debt servicing. The U.S. economic recovery is likely to be sluggish and U-shaped than a faster and stronger recovery that the administration expects. Tax revenues will be lower than what is estimated by the White House due to a jobless recovery and less buoyant financial sector, and entitlement reform will not be deficit neutral. To reduce the fiscal deficit therefore, taxes will have to go up for most income groups not just the above-US$250,000 income group. But raising taxes will be challenging as Washington doesn’t want to clip a weak economic recovery.

Yet the administration can adopt two things to ease concerns among foreign investors about fiscal sustainability, even without hiking taxes and cutting spending in the short-term. First, the administration and the Congress can pass a legislation that says the government will be bound to adopt a credible plan after a sustainable economic recovery sets in—to cut entitlement costs and spending on defense and federal and state projects; increase the progressivity of the tax system; and reduce exemptions and tax credits. Second, the administration can raise taxes gradually in phases instead of raising taxes to high levels all at once in 2011. In phase one, the Bush tax cuts on only the high-income group and capital gains and dividends will be phased out by hiking tax rates partially rather than raising the rates back to the pre-2001 levels. In phase two (when the economy begins to grow strongly), these tax rates can be increased to their pre-2001 levels plus the tax burden on the middle and upper-middle income groups can be raised.