You Say Tomato, I Say “Bad Idea”

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.