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You Say Tomato, I Say "Bad Idea"

by Mytheos Holt, published

Amidst the storm of budget "compromises" currently being turned into cause for a full-blown election circus, one in particular seems to be getting a disproportionate amount of attention, given its seemingly apolitical nature.

That measure is Proposition 1C, a proposal to, as the Legislative Analyst's office euphemistically puts it, "allow the State lottery to be modernized."

However, what the bill actually does (as the Legislative Analyst later admits) is allow California's government to borrow against future Lottery profits in order to pay off the mountain of debt we already have to pay off and seem unable to do without making genuinely courageous political moves. This is a bit like walking into a bank and asking to put a second mortgage on a house you may buy in the future so that you can pay off the mortgage on the house you have now.

Sounds exceedingly silly, right?

No politician would ever borrow against the creation of future wealth in order to bail out contemporary failures, right?

The Legislative Analyst's Office has certainly picked up on the bill's rather tenuous connection to remedying fiscal reality, as well as a graver problem. That is, the analyst reports that even "after the increased lottery profits are used to make debt-service payments to investors, the remaining profits probably would not be enough to cover the General Fund's higher payments to education for most of the next 20 to 30 years." Lovely! So glad to know that the 40% of our budget we spend on education is an even larger obstacle to the salvation of the current budget crisis than we thought. And how pleasant that our second mortgage on our hypothetical house won't even pay for the mortgage on the first rundown wreck!

This pessimistic angle put forward by the Legislative Analyst's Office is by no means the only perspective available. In fact, Schwarzenegger's primary economic advisor, David Crane, recently blasted the LAO report as incorrect in a meeting with the San Diego Union-Tribune.

"The LAO was dead wrong to liken it to conventional borrowing," Crane argued, adding that the misunderstanding sprang from the Legislative Analyst's Office's failure to comprehend the difference between securitization and outright borrowing.

The distinction is worth making, but unfortunately, hardly encouraging. As any follower of the current economy knows, many would hear "securitization" and have a sudden urge to bolt as fast as they could in the opposite direction. Why? Because, as one finance website puts it, "A typical example of securitization is a mortgage-backed security (MBS), which is a type of asset-backed security that is secured by a collection of mortgages."

Yes, that's right, the typical example of what Crane and his friends are doing is precisely the unsustainable, irresponsible practice that got the financial system into this mess.

However, the problem isn't with securitization itself, which basically means taking large numbers of a particular type of asset-backed debt, pooling them all together and then selling pieces of the pool to other people. In finance, this is a relatively routine process, but its main success lies in the part where the pieces of debt are sold. So what does the California lottery proposal wish to do? Borrow against the California lottery, and then sell pieces of the debt back to private investors. There's just one very substantial problem - who is going to buy debt from a State as lax about that very subject as California? Perhaps a terribly optimistic financier or two may take pity on the State, but otherwise, these securities are likely to sit and rot with their originators, meaning that large portions of the measure are very likely to reduce to borrowing.

So as far as David Crane's argument that borrowing and securitization are not the same goes, the argument is semantically correct, and that is almost all. In practice, Mr. Crane might want to pronounce "borrowing" as "securitization," but whether you call a tomato a to-mah-to or not, it's still a terrible idea.

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