Tuesday, August 9, 2011

IMHO: Why Congress is the Wrong Body to Fix The Financial Crisis

Congress will never fix the financial crisis. At least, this Congress with their current rules will never fix the financial crisis. My profession could do better ... much better.

Let's consider the incredibly stupid negotiated settlement of one week ago. It raised the debt limit and allowed us to continue to prosper. Bullfeathers!

Moody's and Fitch affirmed their AAA credit ratings for the US although both (to my memory) have given us negative future outlooks. Then, Standard & Poor's came through and downgraded the US credit rating to AA+. And the President squawked. And the Republicans squawked and the Democrats squawked. Sure, S&P has a fairly recent history of mis-rating companies and various financial instruments. But, look at those mis-ratings. For the most part, they rated debt too optimistically. That is, they gave AAA ratings when B- might have been more appropriate. You can't find as many situations where they gave a B-, but AAA was justified.

What does this all have to do with actuaries, my profession? I'm getting there, hold on just a minute.

So, we had this great debt deal. It is to cut something like $2.5 trillion from the baseline budget over the next 10 years. Here is the problem. Roughly $1 trillion of that is specified and that amount is largely backloaded (meaning the cuts come toward the end of the 10-year period as compared to the beginning). The other $1.5 trillion will come from the Super-Congress, 12 hand-picked Congresspeople (Senator Reid (D-NV) picks 3, Senator McConnell (R-KY) picks 3, Rep Boehner (R-OH) picks 3, and Rep Pelosi (D-CA) picks 3) will need to get together and find the other $1.5 trillion. That is, when they get back from their vacations, they will start work on this. And, if they don't find that trillion and a half, then some pre-determined cuts (not particularly specific) will kick in.

Can you imagine running a business that way? Can you imagine running your household that way?

There is this apparently nerdy little group called the Congressional Budget Office (CBO). Each time that Congress is going to vote on a bill with financial implications, the CBO gets to score it. And, by rule, the CBO scores it over 10 years with static assumptions, compared to a baseline, and with no discounting for the time value of money.

Where are the actuaries when we need them?

Do you know how stupid the results that such a process produces can be? Consider health care reform (PPACA, if you prefer) for a moment. According to CBO estimates, it is supposed to save money. Bullfeathers! The system can be manipulated. When you start the revenue raisers in Year 1 and start the expenditures in Year 4, is the annual expenditures do not exceed roughly 1.4 times the annual savings (once the expenditures start), then the law saves money. How does that work? 10*1=10. 7*1.4=9.8. Voila, savings! Of course, Years 11 through 20 (by the same math) have expenditures of 14 and savings of 10 producing a large cost, but that's not part of the CBO forecast.

Where are the actuaries when we need them?

Suppose we gave this problem to actuaries. What would they do differently?

  • They would make assumptions about things like inflation, growth in the economy, growth in savings and expenditures, discount rates.
  • They would do more than a 10-year forecast (actuaries do forecasts all the time called actuarial valuations that tend to forecast costs more than 75 years into the future).
  • They would use Actuarial Standards of Practice.
  • Where the assumptions that were used were not those of the actuaries, but were chosen by someone else (Congress), the actuaries would disclose that fact, and would either concur with the assumptions or say which ones they did not concur with.
  • To the extent that they found the assumptions chosen by Congress to be unreasonable, the actuaries would estimate the answers based on reasonable assumptions as well.
  • All of these calculations would be disclosed.
Where are the actuaries when we need them?

When individuals aspire to become actuaries, they take a series of examinations. These exams are not easy. The competition is tough, and while I'm not sure what percentage of candidates passes each exam these days, 25 years ago, a number of the exams had fewer than 40% of candidates pass. That is 40% of a group that is generally considered pretty smart. And, that is on just one exam in order to get to the next one which may also pass fewer than 40% of candidates.

How about Congress? How much training does a typical Congressperson have in financial matter? Does the number ZERO come to mind? It does for me. Yet, they are the ones who are going to fix our problems, albeit using flawed methods. Bullfeathers!

Where are the actuaries when we need them?

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