Tuesday, January 26, 2016

An Infrastructure Proposal Using Asset-Backed Securities, Shadow Banking, and Public Capital (if necessary)

As I've briefly mentioned in other posts, there is deficient infrastructure in many parts of the United States. Usually, most people think of infrastructure issues as roads and bridges, but those are often the most useless kinds of infrastructure (even though roads and bridges are still very important). In the United States, almost all infrastructure is done by state and local governments due to the decentralized nature of the American Republic. Most infrastructure needs are also localized and dependent on the specific areas in question. So when discussing ways to finance American infrastructure, we need to be aware of the geopolitical necessities of the areas in question. With that in mind, the geopolitical needs of infrastructure in the United States are primarily local, not federal--which we must also be mindful of.

For this post, I'll split it up into several sections
1. The Basic Underlying Financial Structure
2. Capital Structure for Federal Infrastructure Financial Intermediary (FIFI)
3. Ways to Manage Bubbles
4. Shifts in the Underlying Financial System

1. Basic Underlying Financial Structure:
So the question is, how can we properly align the interests of the financial system in these projects to the long-term interests of the local/state populace? We can first begin by having some sort of a tax being issued by the local or state authorities after the completion of a local infrastructure project. If a local community has an issue with water being clean or has a problem with a sewer system, the financing received by the local/state government can be used to build a system to bring clean water or to upgrade existing water systems or renovate a sewer system. Then, we can take x% revenues (say 10%) of the local company controlling the water networks, pipe networks, or sewer networks or whatever else for the next 20-40 years and this would be sent into some other newly formed state or regional company that gets revenues from similar types of projects in the state or region concerned. This newly formed company would issue equity, which would be bought by some financial intermediary that could either be a private financial institution or a public financial institution if private capital proves unwilling or insufficient to do so.

From here, we can now take these equities for accumulated by the financial intermediary in question and then issue some asset-backed security (ABS) for a certain set of projects in a regional area. We could split up these ABSs into different types of infrastructure investment split into regional areas for specific kinds of projects. For example, we could have a sewer system infrastructure ABS (IABS) that is centered in the South. You could also have an ABS that consists of road networks in the Midwest. We could have an ABS for ports on the West Coast. Cities or localities could use these IABS to create localized, or even state-wide or regional, public transportation systems. You could have another set of IABS for international airport reconstruction across the entire country too so we could even have IABS for federal projects as well.

Each of the localized and specific IABS could be used to create collateralized debt obligations (CDOs) for specific regions that can be bought and sold as general securities rather than for specific goals. There would be several reasons why we would want to do this, including as a way for the federal government to limit excessive asset bubbles in specific areas generally (like, say, the South) without specifically having to divert financing from Southern sewer systems more than Southern rail or public transportation.

Ideally, we could split up the United States into various regional components like the South, New England, Atlantic Coast, Midwest, Southwest, Pacific Northwest, and the Mountain West. Different types of securities based on regional locations could be issued by some regional or state authority that would use the equity of local/state infrastructure companies created.

2. Capital Structure for the Federal Infrastructure Financial Intermediary (FIFI):
The initial equity capital for FIFI could be provided for by either private or public institutions. We could have some sort of an initial public offering where the total equity capital of the FIFI would be, say, $2-3 trillion for a 20-30 year charter. The IPO of the FIFI could be run like a regular IPO through primary dealers in investment banks or through other means if necessary. Private investors could be allowed to bid for shares in the FIFI, and if the private sector or the financial system provides unwilling to provide enough capital or provides insufficient funds for FIFI, the rest of the capital can be provided for by the federal government.

Then, we can set strict equity capital requirements of, say, 40% so that the total assets held by FIFI cannot exceed approximately 2.5 times the initial equity capital requirements of FIFI. The assets of FIFI would be equity of the local infrastructure companies. The liabilities of FIFI would be the various kinds of IABSs that would be publicly tradeable assets on private exchanges.

Due to the fact that it's the equity of local/state companies that would be being securitized, if we were to see a rise in the volatility of the income streams of these companies, we could easily see the returns of the assets to investors in both FIFI and in the private sector firms holding the IABSs to get larger returns. So not only do would we have a framework to finance necessary productive infrastructure projects, but we'd also have a system whereby a rise in the volatility or uncertainty of the earnings of these individual infrastructure projects would lead to an increase for private investors and for the federal government.

3. Reducing Impacts of Possible Financial Bubbles:
In the framework and proposal I laid out, there's a major risk of a speculative infrastructure and overproduction boom coming out of this kind of investment system. So one way we can reduce the damage from the possible boom or bust resulting from this kind of system is to get the Federal Reserve involved. Currently, the Federal Reserve holds MBS and Treasuries as its primary assets. In the case that this proposal gets through or taken up in some form, I suggest that the Federal Reserve could buy IABS in addition to both MBS and Treasuries.

In other words, the Fed could sell some of its MBS or Treasuries and instead swap them for IABS so that it could sell IABS in specific regions to curb local bubbles. If there was a specific bubble that was occurring in the South or Midwest, but not enough investment in the Pacific Nortwest, the Fed could sell its IABS related to the South or Midwest and buy IABS in the Pacific Northwest as a way to prevent the booms and busts from getting too out of hand.

The primary mechanisms through which catastrophic booms involving excess capacity and overproduction would be avoided or prevented is by ensuring that investment is highly centralized while being kept a relatively small percentage of GDP, using equity financing as a way to limit the amount of debt financing involved for the state and local governments in question, and by ensuring a consumption driven economy with virtually no restrictions on consumption.

4. Shifts in the Underlying Financial System:
In the infrastructure proposal I'm currently proposing, I'm also advocating for a shift in the current financial and monetary system. Currently, the Federal Reserve controls the short term money market rate of interest by buying and selling T-bills, Treasury bonds, and MBS. In this proposal, I'm saying that we should strongly consider shifting away from setting the short term money market rate of interest and instead focus on curbing possible bubbles and financial regional instability in the United States.

Instead, the short term money market rate of interest would now not be the primary target for the Federal Reserve. Instead, the Fed would be focused on dealing with regional bubbles and the short term money market rate of interest would be allowed to fluctuate. Private consumption would be a role for the private sector that'd be in the hands of households and financial institutions to do whatever they want.

In other words, the tools of this mechanism would be to finance localized infrastructure projects without changing the underlying economic system to an infrastructure driven model. Basically, we would still have a financial and economic system that'd be primarily driven by private consumption, but investment could still take place, and be tightly directed if necessary by either federal or local authorities as needed.

Note: This financial system and basic procedure to finance infrastructure spending using existing financial institutions can still be done without a Federal Reserve. With the Federal Reserve, there is an easy way to stop bubbles from a centralized position. Without a central bank, it would be up to regional, state, and local areas to tighten liquidity.

Note #2: This program should happen alongside the elimination of Fannie Mae and Freddie Mac. Rather than securitizing household debt through some agency while then claiming the need for "regulation", it'd simply make more sense to create ABSs via equity financing so that debt and excessive leverage doesn't become an issue.

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