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They both act irresponsibly with other people’s money. I am sure this is playing out in many states right now as it is here in my home state of New York. Our state is “suffering” through a projected $10 billion deficit. Last year, the state estimates that it raised $134.6 billion in revenue. The state expects to spend $145.3 billion this year if no actions are taken. In an effort to close the gap without imposing new taxes (ignore the fact that any new borrowing is akin to new taxes) Governor Cuomo has reduced the amount of aid the state provides to local school districts – which has grown over time for many reasons including property tax “reform” and school district equalization spending goals.

We’ll save for another day an analysis of  the arguments within the school districts about the proposed cuts – needless to say they will make your hair stand on end. I’d simply like to point out the following – the budget situation the local school districts find themselves in is exactly the budget situation that blew up  Wall Street firms during the financial crisis. However in the case of the schools I am talking about cash flows and in the case of Wall Street I’d need to be talking about stock measures.

Consider a simple investment opportunity. You are interested in buying an asset that costs $100. If you use $100 of your own money, you are said to be “unleveraged.” In this case, if the value of the asset increases by, say, 10%, then your $100 investment would grow to $110, leaving you with a 10% return. If the asset decreases in value by 10%, then you lose $10, or 10% of your investment.

Consider how your personal situation would change  if instead of buying the asset with your own money you used other people’s money. In this case, assume that you finance 40% of the asset purchase by borrowing money from your rich uncle. In this case, you use $60 of your own funds and $40 of your uncle’s funds to buy the $100 asset. Next year, your only obligation to your uncle is to return the $40. Now what happens to your financial position as the value of the asset changes? If the price of the asset rises 10% to $110, you have made $10. Remember now that you only had $60 of your own money, so rather than a 10% return on your investment, you now have earned 16.7% – a very fine return indeed. However, if the asset price falls to $90, you still need to pay your uncle back his entire $40. This leaves you with a net of $50 on your $60 investment. What earlier, when you used your own money, was a 10% loss, now has grown to a 16.7% loss. These potential gains and losses are magnified the larger the share of the purchase you fund with your uncle’s money. In the above example, the leverage ratio is actually rather small – 1.5 to 1 (the share of non-borrowed funds to borrowed funds).

Some Wall Street firms were doing this to an extraordinary degree – using leverage ratios as high as 30 to 1 and even as high as 50 to 1 (it wasn’t only them, some Federal agencies were doing the same thing). In a sense, this is exactly what the local school districts in New York have been doing. It used to be the case that for both fiscal reasons and management reasons local public schools were funded almost solely with property taxes from people within the community. Over time, this has eroded and now 53% of the spending in New York’s schools comes from their “rich uncles” while only 47% of the spending comes from the people in the local school district. Just so you remember, New York State spends more money per student, $17,173, than any other state in the nation, spending a total of $54.4 billion.

Consider what this does to the incentives of schools to spend money when times are flush, and consider the pressure it puts on schools when times are not. In good times, when tax revenues are robust and states are more “generous” school spending can escalate far beyond what the local districts would be able to do on their own. Indeed, this is the story of the last decade – with little regard for long-term stability. However, the piper now needs to be paid. Suppose the state faces a funding crisis, and needs to cut school spending by 10%, this would amount to a cut of $2.9 billion. If public schools wish to maintain their current levels of spending, then their taxes will have to be increased at far greater rates than they would have if there were no state funding. Or, if localities are unable to increase tax revenues (I live in the highest property tax county in the country already) then they are going to face spending and programming cuts that they would not have been susceptible to had they been prudently spending and raising local revenues in the first place.

I find it more than mildly ironic that many public school supporters correctly condemn Wall Street for gambling with other people’s money, leaving the rest of the taxpayers holding the bag when things blow up, and are completely blind to the fact that they are doing exactly the same thing. Only difference of course is that when Wall Street blew up, stockholders were totally wiped out, some investors were wiped out and tens of thousands of people lost their job – even as the taxpayers got hosed to protect the favored creditors of these firms.

8 Responses to “What Do School Districts and Wall Street Firms Have in Common?”

  1. Harry says:

    Part of the problem is the bureaucratic distance between the school district and the source of funding.

    Even though the great bulk of funding for our local school district has come from real estate taxes within the school district, over the years the district has relied also on state funding. The result has been a scramble to get as much money possible, which then is spent completely — on full-day kindergarden, bricks and mortar (prevailing wage), astroturf, you name it.

    Were our school district spending just local tax money, our school board members, who are elected by people they know personally, might be more careful with the district’s finances

    Presently, though, we have a situation where Tom Corbett, Republican Governor, is cutting back, and our Superintendent, a Democrat, is moaning about how this means full-day kindergarden, popular among yuppies as free day care, has to go.

    Of course, football will be the next painful cut.

    It happens that right in the middle of our district we have a private school that would offer competition, as well as a Catholic school, and many other alternatives half an hour a way.

    Were a parent to have a $10,000 voucher to spend on his kid, there are many places that kid could go as a day student.

    Now, I know that Kiowa, Kansas, is not near any private schools now, but competition might arise there if each student had a ten-thousand dollar voucher to spend on education for twelve years, and maybe the parents would pay for whatever pre-school they felt was needed.

  2. Harry says:

    I am beginning to decipher a thread in Wintercow’s thinking.

    His previous post included the principle that if someone had really good information, particurlary about the future and money, he would not tell you.

    This post, about the unwisdom of using leverage to act on a hunch about the future, is equally wise, and should be heeded by all of Wintercow’s students and we lucky readers.

  3. Greg says:

    How does the school in Brooklyn open its doors if it weren’t for state funding?

  4. Harry says:

    Correction: of us lucky readers, not we.

  5. Harry says:

    Greg, give a $14,000 dollar voucher to a high school kid. Let someone, say, a graduate from Amherst, start a school attractive enough to get 100 students/parents of similar needs, with a 1.4 million annual budget.

    Say they would find an apartment building big enough to house ten Oxford tutors and their families, plus ten small rooms for classrooms. Maybe they could buy something in Forest Hills, a $5 million foreclosure. The Oxford tutors would cost $800,000, the mortgage and heating bill would be $350,000, and you would have plenty left over for subway fare to boxes at the Met, or the Mets, or whatever one wanted, plus plenty to pay the headmaster from Amherst, even if he had a PhD from Cornell in a tough discipline, as opposed to a doctorate in education administration from Kutztown. That’s just one idea, and it would cost Brooklyn taxpayers a whole lot less.

    Ten Oxford tutors should be able to teach 100 tomatoes the times tables.

  6. Harry says:

    What else do they have in common? They are top-heavy. Too many Chiefs, too few Indians. The Seminoles run their casinos better.

  7. RIT guy says:

    Harry, Forest Hills is not in Brooklyn. Thats all.

  8. Harry says:

    I know Forest Hills is not in Brooklyn. That is not the point. Wintercow, being a native NYC person, could find a place somewhere within subway distance to finance a school for $1.7 million a year that would not be a crack house. Maybe the teachers would live in Hoboken and the school would be on 70 Pine Street in Manhattan and they could rig a cafeteria arrangement with Delmonico’s or the New York AC. For all I know, the sports program could be chess and gin rummy. It would be better tha the present system that, for example, pays millions to teachers to sit on their butts because they have been disqualified to mingle with children.

    I started with 1.7 million because it was a conservative figure, and I bet that spending per student is a lot more in Brooklyn. The point is the same: let the market be free, and thousands of flowers will bloom.

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