Thursday, April 01, 2010

Public Ponzi Schemes

In the middle 1980s the then treasurer of Michigan, Robert Bowman, went around the country preaching the virtues of the Michigan Education Trust.   The MET was created after some private experiments in pre-paid tuition plans that would supposedly would help families save for college.  Bowman claimed that the MET would guarantee that for a small investment now, families could be assured of having the money for college in the future.

Bowman was an original snake oil salesman.  His proposal was picked up by Tom Hayden who was then a member of the California legislature.  In one hearing on Hayden's proposal Bowman claimed that he was so good at investing Michigan's pooled money fund that he could produce safe and secure investments that produced a good 8-10% more than all the other state pooled funds.   At the time I went to Jess Unruh, who was California's Treasurer at the time, and asked him about Bowman's claim.  Jess, who was a very good state treasurer (and whose pooled money fund was earning about half what Bowman claimed he could earn) looked at me and said Mr. Bowman was engaging in some "fanciful" talk.

Almost all of the prepaid plans offered in the states have turned out to be ponzi-like structures.  That is because there is no relationship between the projected future value, the investment vehicles and the people making the decisions on pricing.   California, at the time, had some of the lowest public university fees in the country.   But since then they have risen smartly as the state has lurched from one deficit to another.  The internal rate of return required to meet those tuition increases would have had to be monumental.   Fortunately, California did not go for Mr. Bowman's snake oil.   The problem with these schemes is like a lot of other promises made by politicians, the future value comes due after the politician has moved on.  As states have experienced the deficits of the last couple of years which have combined increases in tuition and lower returns on all investments, some have had to make the choice of robbing Peter (in this case student aid funds for needy students) to pay Paul (the investors who relied on the prepaid guarantee to plan for college expenses).  Inside Higher Education had a story about that dilemma.

Mr. Bowman left the Treasurer's spot in 1990 and since then has served as a corporate director for such economic powerhouses Blockbuster and World Wrestling Entertainment.  (Interesting that at least for those two Mr. Bowman has continued to work in areas where fantasy is important and bankruptcy has been present.)

There is one prepaid plan that seems to work.  That is called i529 - which serves a group of independent colleges and universities.  In that plan the relationships and the risk sharing a clearly defined.  Independent colleges that participate agree to take the proceeds from the fund for a unit of tuition (based on the initial asset value).  If investment returns do not reach the internal rate of tuition increases the college or university still has to accept the amount in the fund.  If they exceed the amount in the fund, the investors have exchanged certainty on tuition charges in exchange for giving up some potential future returns.

While many commentators have yammered about the allure of false promises that the financial markets have offered in recent years, few have understood that the same kinds of promises are often made by politicians.   In the political arena, the victims of the false expectations are not only the investors but the taxpayers too.

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