This Crisis is Solely About Lack of Government Regulation

You see, kids, government has to closely regulate evil capitalists, because these capitalists sometimes make investment mistakes, like making highly leveraged investments in risky bubble assets.  The government must be the one to watch over their shoulder, because well-meaning public servants would never make such a mistake themselves:

The California Public Employees' Retirement System (CalPERS)is now warning California's cities that they may have to cough up more money to cover the retirement and other benefits the fund provides for 1.6 million state workers, reports the Wall Street Journal. Some communities are already cutting municipal services and they are blaming CalPERS, not Proposition 13. Dan Cort, mayor of Pacific Grove, has been quoted as saying, "CalPERS could bankrupt us faster than anything else."

According to the Journal, CalPERS has lost almost a quarter of the $239 billion in assets it held in June of this year. Stock market losses are an obvious cause of the fund's distress, but less well known is that CalPERS makes extensive investments in real estate -- investments that have been largely financed by borrowing. Some deals involved as much as 80 percent of borrowed money. While this worked well in a rising market, now that real estate has tanked CalPERS expects to report paper losses of 103 percent on its housing investments for the fiscal year ending in June.

Note especially the text in bold.  It takes some effort to lose more than 100% of your investment in one year.  They would have been better off investing with Bernie Madoff, since a 100% loss would have been better than 103%.

The inherent flaw in every call for government action is not the "insight" that business people sometimes are wrong, even way wrong.  The flaw is assuming that anyone in government is more capable, or has superior incentives, to make better decisions.


  1. Bob Smith:

    The 103% loss is somewhat misleading. It's an artifact of mark-to-market accounting. If you buy a $100 property with $80 in debt that is now worth $75, you have technically lost $25. You won't realize that loss until you sell though, and if the property's income covers debt service you can't be forced to realize it. Real estate is a long-term game, it makes no sense to apply mtm to it.

    The article fails to cover a very salient point, which is that whatever shortfall CalPERS is experiencing would be a whole lot less problematic were it not for the outrageously generous pension benefits the state offers its workers.

  2. George Weinberg:

    You can bet the property's income doesn't cover debt service, though. If it did, the property would be worth more.

  3. Allen:

    I agree the losses are on paper. But there is the loss incurred on the interest paid on that $80 of debt. That doesn't go away until the debt is paid off. But what maters most for CalPERS is where that price is going to be 3, 5, 7 years from now. And unless they see a 175% increase in prices on those properties 5 years from now, they're screwed. They need that to just realize a 5-7% return depending on the interest rate on that debt.

  4. morganovich:

    is it my imagination, or is it all of the heavily regulated industries that fail all of the time? banks, airlines, and automakers seem to run into quite a bit of trouble on a recurring basis and then need bailouts. odd how this does not seem to happen to chip makers or makers of heavy equipment.

    i have heard the argument that the heavily regulated industries are more prone to failure based on their business characteristics, but i find this unpersuasive. there are too many counter examples. banks and insurance companies have failed left, right and center in the recent crisis and needed bailouts etc, yet the much vilified hedge funds have not. sure, many will shut down, but none have been bailed out. they have not pulled anyone down with them. as an asset class, they have lost half of what the more regulated mutual funds have this year. i find the current calls for more regulation of hedge funds to be utterly wrongheaded. they just outperformed just about everyone else. regulating them will just make them perform more like the other assets classes that got hurt more deeply.

    i grant that the unions have done much of the damage at the big three, but other concerns like Caterpillar have strong unions as well. how is it CAT manages not to fail whereas the big 3 are in and out of bankruptcy every couple of decades?

    i have yet to hear a convincing argument that more regulation reduces risk. replacing sense and judgment with rules is very dangerous...

  5. morganovich:


    i think you are missing some very salient points about real estate. let's take your example:

    you borrow $80 and use it to buy a property worth $100 which implies that you have put down $20 of cash in the deal. if the value of the property drops to $75, you are now floating a 125% loss on invested capital. all you had was $20. you still owe the other $80. almost no properties purchased in the last couple years in california paid for themselves through rent. this is especially true of the sorts of large projects in which CALPERS could invest. and with values dropping, rents drop as well. after taxes and insurance, the loaded cost on these properties is likely 8.5% annually. they would be lucky to recoup 5% of value in rent (implies $4200 monthly rent per $1mm in value) and that assumes full occupancy. 50% is a better number for new projects. it also assumes that they are rental units and not condos.. if they are condos, renting them may not be possible per the project documents and local regulation.

    let's assume 5% annual losses on cost as an all in number. over 5 years, that's another 28% in the hole they go. add to that the 25 points they are already down. so they are 50 points in the hole to use a round number. that means that just to break even the properties have to be worth $125 in 5 years, a 67% increase from current prices. that requires a compounded price increase of 11% every year for 5 years. and this is just to break even.

    these guys are screwed.

    and mark to market does make sense for them. they can't just hold these at a loss forever. and loans will need to be refinanced. who will lend them $80 on a $75 property? they are going to need to add more cash. insurance and debt payments take cash too. keep in mind that a 6% mortgage with 20% down means that your cost annually is 30% of invested capital. so our 5% overall assumed loss is 25% of invested capital annually. that's a helluva ways behind the start to be at the word go.

    welcome to leverage.

  6. K:

    Public pension funds should not be allowed to use leverage i.e. borrow. They should invest the funds they receive very widely and operate with minimum expense and complexity.

    But politicians demand high returns to make them look good and keep contributions - which in the final analysis are taxes - lower. So the hired money managers say they can produce those returns and take risks to prove it.

    The managers arrange their bonus plans so that they can retire for life after a single good year of investing. That seems fair in good years; why shouldn't good work be highly rewarded?

    And if the year is not good? They face some consequence but usually very little; they can honestly point out that nearly everyone else also had a bad year.

  7. Methinks:

    People, let's get one thing straight, please. It is not a subtle point. There is NO difference between a paper loss and a real loss EXCEPT the volatility of the position (there is zero volatility in a closed out position). "Paper" losses are very real because the amount the next guy is willing to pay for your asset today is less than what you paid for it. Similarly, "paper" gains are real gains. I think you guys are getting confused between IRS treatment of gains and losses and economic gains and losses.

    All that regulation typically does is tip the playing field toward professional traders and industry insiders. It'll weigh industry insiders down with more paperwork and there will be more regulators coming around to make sure that companies have a clearly stated anti-money laundering policies as well as a sexual harassment policies (which is all the regulator can really do since most of the people they send have no idea what they're looking at when they see the trades). In return, the regulator will create more economic rents for these insiders. The public will be told (falsely) that it is better protected and it will be willing to pay higher transactions costs and accept a lower return because it (falsely) believes it is being protected by the extra regulation. Since all this will suck the liquidity out of the market and make the U.S. markets less competitive, some smart person at the SEC will start a campaign to loosen useless regulation (which most of it is). The industry insiders will scream bloody murder, complaining that the small guy will get "hurt" and there will be this that and the other negative consequence. Of course, the only negative consequence is that insiders will have more competition. The uptick rule and locate rule are perfect examples. Market makers were exempt from both locating for short sales and the uptick rule. Other professional traders and money mangers had many ways to get around the rule (boxing against the firm's position, for example). The only people who were ever inconvenienced by locate requirements and uptick rules were Joe Blow investor. Meanwhile, the market makers used the excuse that there were so few liquidity providers (because regulation cut liquidity providers out of the market) that they HAD to widen their bid/ask spreads as a liquidity premium. Guess who was paying the spreads? The customer - the same one who begged the SEC to protect it...from paying lower transactions costs and the ability to hedge. Good job, regulation. Bring it on.

  8. SecondGuesser:

    Just a quick note to let you all know that I enjoy reading this blog and your comments.

    I don't have much time to write a lengthy exposition on the topic, but I tend to feel that the crisis, while exacerbated by non-natural forces, was mostly a function of the free market at work. Knowingly or not, risks were taken by consumers and Wall Street in a very interdependent market. Washington ended up being useless (as always) when it came to informing us about the gravity of the situation.

    The risk was so pervasive and systemic that we all ended up losing. But this crisis, for the most part, is exactly what I would expect to happen. Easy to say in hindsight, I know.