Showing papers in "Federal Reserve Bank of New York Economic policy review in 2003"

Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature

Abstract: 1. INTRODUCTION Most organizations are governed by a board of directors. In fact, having a board is one of the legal requirements for incorporation. Many nonincorporated entities also have a governing board of some sort, such as a state university's board of regents. Given the myriad boards in place today, it is reasonable to ask, Why do they exist? What do they do? Can they be "improved"? These questions are at the heart of governance and, to a certain extent, management. As such, they have motivated much of the research on this topic. This paper surveys the research on boards of directors in the economics and finance literature. Boards of directors are an economic institution that, in theory, helps to solve the agency problems inherent in managing an organization. Although boards satisfy numerous regulatory requirements, their economic function is determined by the organizational problems they help to address. Yet formal economic theory on boards has been quite limited. For example, the characteristics of agency problems that could lead to boards being the equilibrium solution have not yet been specified. Similarly, the conditions under which regulation of boards will lead to improvements are unknown. Despite the absence of formal theory, we have a strong intuitive sense of the problems facing boards. A major conflict within the boardroom is between the CEO and the directors. The CEO has incentives to "capture" the board, so as to ensure that he can keep his job and increase the other benefits he derives from being CEO. Directors have incentives to maintain their independence, to monitor the CEO, and to replace the CEO if his performance is poor. To some extent, the vacuum in formal theory has been filled by empirical work on boards. The "cost" associated with this approach, however, is that little of the empirical work on boards has been motivated by formal theory. Rather, it has sought to answer one of three questions: 1. How do board characteristics such as composition or size affect profitability? 2. How do board characteristics affect the observable actions of the board? 3. What factors affect the makeup of boards and how do they evolve over time? A key issue in this empirical work is how to proxy for the board's degree of independence from the CEO. Much of this work starts from the sometimes implicit assumption that observable board characteristics such as size or composition are related to the level of board independence. (1) Research thus far has established a number of empirical regularities. First, board composition, as measured by the insider-outsider ratio, (2) is not correlated with firm performance. (3) However, the number of directors on a firm's board is negatively related to the firm's financial performance. Second, board actions do appear to be related to board characteristics. Firms with higher proportions of outside directors and smaller boards tend to make arguably better--or at least different--decisions concerning acquisitions, poison pills, executive compensation, and CEO replacement, ceteris paribus. Finally, boards appear to evolve over time depending on the bargaining position of the CEO relative to that of the existing directors. Firm performance, CEO turnover, and changes in ownership structure appear to be important factors affecting changes to boards. Two important issues complicate empirical work on boards of directors, as well as most other empirical work on governance. First, almost all the variables of interest are endogenous. The usual problems of joint endogeneity therefore plague these studies. For instance, firm performance is both a result of the actions of previous directors and itself a factor that potentially influences the choice of subsequent directors. Studies of boards often neglect this issue and thus obtain results that are hard to interpret. Second, many empirical results on governance can be interpreted as either equilibrium or out-of-equilibrium phenomena. …

Executive Equity Compensation and Incentives: A Survey

Abstract: 1. INTRODUCTION Corporate governance is generally considered to be the set of complementary mechanisms that help align the actions and choices of managers with the interests of shareholders. Monitoring actions by the board of directors, debtholders, or institutional blockholders can have an important impact on the economic performance of an organization (for example, Jensen [1989], Mehran [1995], Core, Holthausen, and Larcker [1999], and Holderness [2003]). Another important and often debated component of the governance structure is the compensation contract selected for providing remuneration to managers (for example, the level of remuneration or choice of performance measures). Executive compensation has been the subject of extensive prior research, and excellent general reviews already exist for the interested reader (for example, Murphy [1999]). For our purposes here, we will not reproduce this discussion but rather focus on the more narrow, but crucial, topic of stock-based compensation and incentives. Stock and option compensation and the level of managerial equity incentives are aspects of corporate governance that are especially controversial to shareholders, institutional activists, and governmental regulators. Similar to much of the corporate finance and corporate governance literature, research on stock-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. Not surprisingly, many fundamental questions remain unanswered, and one of our goals is to highlight topics that seem especially appropriate for future research. Within the corporate governance literature, and more specifically within the executive compensation literature, there are alternative views on the efficiency of observed contracting arrangements between firms and their executives. For the purposes of this survey and as an organizing principle of our literature review, we follow a traditional agency-theory framework and define an efficient contract as one that maximizes the net expected economic value to shareholders after transaction costs (such as contracting costs) and payments to employees. An equivalent way of saying this is that we assume that contracts minimize agency costs. Clearly, the types of contracts that are efficient at any particular time or in a particular sector of the economy are a function of various transaction costs. For instance, a contract that was efficient in the United States fifty years ago may not be efficient today because information costs have fallen greatly and the optimal organizational form has changed as a result. Over time, optimal contracting arrangements evolve with changes in contracting technology. As part of this evolutionary process, firms are experimenting with new contracting technologies. Some experiments succeed and others fail as firms update their beliefs and learn about the efficiency of their governance structures. Throughout this process, firms may be uncertain about the optimal contracting technology. As a result of this uncertainty and because of differences in beliefs about optimal incentive levels, one would expect variation in the observed contracts across firms. However, unless beliefs are systematically biased, we expect that compensation contracts are efficient, on average, and that average equity incentive levels across firms are neither "too high" nor "too low." (For an example and discussion of how an evolutionary process converges to an efficient outcome, see Lazear [1995, pp. 8-10].) In contrast to this economic perspective, a number of scholars and practitioners either implicitly or explicitly take the view that contracting arrangements are largely inefficient and do not minimize agency costs (for example, Morck, Shleifer, and Vishny [1988], Crystal [1991], and Jensen [1993]). A view that sees most firms behaving inefficiently is hard to support. At the opposite extreme is the view that transaction costs in the labor market, the stock market, and the market for corporate control are so small that all agency costs are eliminated. …

A Survey of Blockholders and Corporate Control

Abstract: 1. INTRODUCTION The notion of diffuse stock ownership is well entrenched among economists. It started with Adam Smith's legendary warning in Wealth of Nations about the "negligence and profusion" that will result when those who manage enterprises are "rather of other people's money than of their own." A century and a half later, another lawyer, Adolf Berle, along with a journalist, Gardiner Means, returned to the theme of diffuse stock ownership. Since the dawn of capitalism, Berle and Means reasoned, most production had taken place in relatively small organizations in which the owners were also the managers. Beginning in the nineteenth century with the Industrial Revolution, however, technological change had increased the optimal size of many firms to the point where no individual, family, or group of managers would have sufficient wealth to own a controlling interest. As a result, enterprises faced "the dissolution of the old atom of ownership into its component parts, control and beneficial ownership" (Berle and Means 1932, p. 8). Ultimately, this separation of ownership from control threatens "the very foundation on which the economic order of the past three centuries has rested." The arguments of Berle and Means on the dangers of diffuse stock ownership, written during the depths of the Great Depression, had an immediate and profound impact. (1) Most notably, their arguments helped to shape the federal securities legislation of the 1930s. That legislation was intended to protect diffuse shareholders from professional managers, and it remains the primary federal securities law to this day. The notion of diffuse ownership has also had a profound influence on contemporary economists. This can perhaps best be seen in one of the pivotal papers of the postwar era, Jensen and Meckling's (1976) agency paper. Much of the focus of that paper is on the conflict between diffuse shareholders and professional managers: Since the relationship between the stockholders and manager of a corporation fit the definition of a pure agency relationship, it should be no surprise to discover that the issues associated with the "separation of ownership and control" in the modern diffuse ownership corporation are intimately associated with the general problem of agency. We show ... that an explanation of why and how the agency costs generated by the corporate form are born leads to a theory of the ownership (or capital) structure of the firm. As economists started to employ this agency perspective, it was mainly in the context of diffuse shareholders and professional managers. This, for example, can be seen in the papers in a special issue of the Journal of Financial Economics on the market for corporate control in 1983. Many of these papers have become widely cited. It is illuminating, however, that among the sixteen papers in the special issue, there is little mention of large-percentage shareholders or managerial stock ownership. (2) In the issue's review article (Jensen and Ruback 1983), stock ownership, be it by mangers or by outsiders, was not listed as a direction for future research. After the volume was published, researchers began to discover that some public corporations had large-percentage shareholders, many of whom were top managers or directors. Researchers also discovered that some of these corporations were large and well known. Concentrated stock ownership, it appeared, was not limited to a few anomalous firms. Soon, academics began to study the impact of large-block shareholders. Three empirical papers in the mid-1980s set the tone and the agenda for much of the research into ownership structure that has ensued over the following fifteen years. Demsetz and Lehn (1985) address the question of the types of public corporations that are likely to have high levels of managerial stock ownership. Holderness and Sheehan (1988) address the question of whether major corporate decisions are different when a corporation has a large-percentage shareholder. …

The Impact of Building Restrictions on Housing Affordability

Abstract: 1. INTRODUCTION A chorus of voices appears to proclaim unanimously that America is in the midst of an affordable housing crisis. Housing and Urban Development Secretary Andrew Cuomo asserted the existence of such a crisis in his introduction to a March 2000 report that documents a continuing and growing housing affordability crisis throughout the nation. Indeed, Secretary Cuomo regularly justified aggressive requests for funding by pointing to this crisis. Advocacy groups for the poor such as the Housing Assistance Council pepper their documents with assertions that "the federal government should commit to a comprehensive strategy for combating the housing affordability crisis in rural America." Trade associations such as the National Association of Home Builders decree that "America is facing a silent housing affordability crisis." The National Association of Realtors agrees: "there is a continuing, growing crisis in housing affordability and homeownership that is gripping our nation." Does America actually face a housing affordability crisis? Are home prices high throughout the United States, or are there just a few places where housing prices become extreme? In those places that are expensive, why are home prices so high? Is subsidized construction a sensible approach to solving this problem--relative to other, deeper reforms? This paper examines whether America actually does face an affordable housing crisis, and why housing is expensive in high-price areas. In general, housing advocates have confused the role of housing prices with the role of poverty. Both housing costs and poverty matter for the well-being of American citizens, but only one of these factors is a housing issue per se. Certainly, the country should pursue sensible antipoverty policies, but if housing is not unusually expensive, these policies should not be put forward as a response to a housing crisis. (1) To us, a housing affordability crisis means that housing is expensive relative to its fundamental costs of production--not that people are poor. Therefore, we will focus entirely on housing prices, not on the distribution of income. A second key concept in thinking about a housing affordability crisis is the relevant benchmark for housing costs. Affordability advocates often argue for the ability to pay (for example, some percentage of income) as a relevant benchmark, but this again confuses poverty with housing prices. We believe that a more sensible benchmark is the physical construction costs of housing. If we believe that there is a housing crisis, then presumably the correct housing response would be to build more housing. Yet the social cost of that new housing can never be lower than the cost of construction. For there to be a "social" gain from new construction, housing must be priced appreciably above the cost of new construction. This argument is not meant to deny that the existence of poor people who cannot afford housing is a major social problem. However, if housing does not cost appreciably more than new construction, then it is hard to understand why policies oriented toward housing supply would be the right response to this problem. Hence, we focus on the gap between housing costs and construction costs. To look at the housing affordability issue, we use the R.S. Means Company's data on construction costs in various U.S. metropolitan areas (hereafter, the Means data). These data give us information (based on the surveying of construction companies) on the costs of building homes with various characteristics. As a basic number, the Means data suggest that construction costs for the lowest of the four quality types they track (termed an economy home) are about $60 per square foot. Construction costs for the next highest quality type (termed an average home) are about $75 per square foot. Ultimately, we compare this information with data on housing prices. To get a better sense of the distribution of housing prices throughout the United States, we turn to the American Housing Survey (AHS), but for a quick look at the affordability issue, it is useful to examine the 2000 U. …

Incentive Features in CEO Compensation in the Banking Industry

Abstract: 1. INTRODUCTION The topic of corporate governance in general, and top-management compensation in particular, has received enormous attention in recent years. (1) Although an increasing literature has examined various aspects of the corporate governance of manufacturing firms in the United States and abroad, the corporate governance of banks and financial institutions has received relatively less focus. Alignment of the incentives of top management with the interests of shareholders has been characterized as an important mechanism of corporate governance. (2) Managerial ownership of equity and options in the firm, as well as other incentive features in managers' compensation structures (such as performance-related bonuses and performance-contingent promotions and dismissals), serves to align managerial incentives with shareholder interests. In fact, there is a large theoretical and empirical literature on the role of incentive contracts in ameliorating agency problems. (3) The empirical literature has emphasized the role of the relationship between pay and performance, measured as the pay-performance sensitivity of managerial compensation structures. Jensen and Murphy (1990) document that the pay-performance sensitivity of large manufacturing firms is only $3.25 per $1,000 increase in shareholder value. Recent studies show that this sensitivity has increased over time, and most of it comes from option and stock holdings (see Murphy [1999]). (4) It is important to understand corporate governance and the degree of managerial alignment in banks for several reasons. First, banks differ from manufacturing firms in several key respects. For one, banks are regulated to a higher degree than manufacturing firms. Do the regulatory mechanisms play a corporate governance role? (5) For example, supervision that ensures that banks comply with regulatory requirements may play a general monitoring role. Does this monitoring substitute for or complement other mechanisms of corporate governance? In particular, does regulatory monitoring substitute for the need for incentive features in managerial compensation? (6) By understanding the interaction of regulation and corporate governance, we can gain insight into the optimal design of regulation and corporate governance of banks. An understanding of the incentive structure that motivates the key decision makers in banks can also be important in designing effective regulation. For example, if top management is very closely aligned with equity interests in banks, which are highly leveraged institutions, it will have strong incentives to undertake high-risk investments (risky loans, risky real estate investments), even when they are not positive net-present-value investments. (7) Regulatory oversight has to take such incentive distortions into account when regulatory procedures are established. John, Saunders, and Senbet (2000) argue that regulation that takes into account the incentives of top management will be more effective than capital regulation in ameliorating risk-shifting incentives. They argue that pay-performance sensitivity of top-management compensation in banks may be a useful input in pricing Federal Deposit Insurance Corporation (FDIC) insurance premiums and designing bank regulation. Another important aspect that differentiates banks from manufacturing firms is the significantly higher leverage of banks. How does leverage interact with corporate governance and managerial alignment? In addition to conventional agency problems, these highly leveraged financial institutions are susceptible to the well-known risk-shifting agency problems. In these institutions, where depositors are the primary claimholders, the objective of corporate governance is not to align top management closely with the equity holders. Top management should also be given incentives to act on behalf of debtholders to an adequate degree. In such cases, providing managers with compensation structures that have low pay-performance sensitivity may be optimal. …

The Corporate Governance of Banks. (Part 2: The Governance of Banks)

Abstract: 1. INTRODUCTION Few public policy issues have moved from the wings to center stage as quickly and decisively as corporate governance. (1) Virtually every major industrialized country as well as the Organisation for Economic Co-operation and Development and the World Bank has made efforts in recent years to refine their views on how large industrial corporations should be organized and governed. Academics in both law and economics have also been intensely focused on corporate governance. (2) Oddly enough, despite the general focus on this topic, very little attention has been paid to the corporate governance of banks. This is particularly strange in light of the fact that a significant amount of attention has been paid to the role that the banks themselves play in the governance of other sorts of firms. (3) In this paper, we explain the role that corporate governance plays in corporate performance and argue that commercial banks pose unique corporate governance problems for managers and regulators, as well as for claimants on the firms' cash flows such as investors and depositors. The intellectual debate in corporate governance has focused on two very different issues. The first concerns whether corporate governance should focus exclusively on protecting the interests of equity claimants in the corporation, or whether corporate governance should instead expand its focus to deal with the problems of other groups, called "stakeholders" or nonshareholder constituencies. The second issue of importance to corporate governance scholars begins with the assumption that corporate governance should concern itself exclusively with the challenge of protecting equity claimants, and attempts to specify ways in which the corporation can better safeguard those interests. The Anglo-American model of corporate governance differs from the Franco-German model of corporate governance in its treatment of both issues. The Anglo-American model takes the view that the exclusive focus of corporate governance should be to maximize shareholder value. To the extent that shareholder wealth maximization conflicts with the interests of other corporate constituencies, those other interests should be ignored, unless management is legally required to take those other interests into account. The Franco-German approach to corporate governance, by contrast, considers corporations to be "industrial partnerships" in which the interests of long-term stakeholders--particularly banks and employee groups--should be accorded at least the same amount of respect as those of shareholders. (4) The Anglo-American model of corporate governance also differs from the Franco-German model in its choice of preferred solutions to the core problems of governance. Specifically, the market for corporate control lies at the heart of the Anglo-American system of corporate governance, while the salutary role of nonshareholder constituencies, particularly banks and workers, is central to the Franco-German governance model. At the outset, we note that it is strange that paradigms of corporate governance differ on the basis of national boundaries rather than on the basis of the indigenous characteristics of the firms being governed. Of course, the extent to which either the Anglo-American model or the Franco-German model of corporate governance exists as more than theoretical constructs is a matter of debate. There is doubt about the extent to which the European system really protects the interests of nonshareholder constituencies, just as there is debate over whether the interests of U.S. management are as closely aligned with those of shareholders as is generally claimed. However, differences in corporate governance systems do exist. Moreover, the distinctions between these two paradigms of corporate governance are quite useful in framing the analysis in this paper. We begin with an overview of the topic of corporate governance and proceed to a discussion of the particular corporate governance problems of banks. …

Remarks on the Measurement, Valuation, and Reporting of Intangible Assets

Abstract: I. INTRODUCTION Intangible assets are both large and important. However, current financial statements provide very little information about these assets. Even worse, much of the information that is provided is partial, inconsistent, and confusing, leading to significant costs to companies, to investors, and to society as a whole. Solving this problem will require on-balance-sheet accounting for many of these assets as well as additional financial disclosures. These gains can be achieved, but only if users of financial information insist upon improvements to corporate reporting. 2. THE MAGNITUDE OF INTANGIBLE ASSETS In a recent paper, Leonard Nakamura of the Federal Reserve Bank of Philadelphia uses three different approaches to estimate the corporate sector's amount of investment in intangible assets. (1) The first approach is based on accounting for the investments in research and development (R&D), software, brand development, and other intangibles. The second uses the wages and salaries paid to "creative workers," those workers who generate intangible assets. The third approach, which is quite innovative, examines the changes in operating margins of firms--the difference between sales and the cost of sales. Dr. Nakamura argues, persuasively, that the major reason for improvement in reported gross margin is the capture of value from intangible assets, such as cost savings from Internet-based supply chains. Although all three approaches yield slightly different estimates of the value of investments in intangible assets, the estimates converge around $1 trillion in 2000--a huge level of investment, almost as much as the corporate sector's investment in fixed assets and machinery that year. Dr. Nakamura estimates the capitalized value of these investments using a quite conservative depreciation rate. His conclusion is that the net capitalized value is about $6 trillion, a significant portion of the total value of all stocks in the United States. One way to determine if this estimate of the value of intangible assets is reasonable is to compare the market values of companies with the book values (the net assets) that appear on their balance sheets to see if there is a large unmeasured factor. Data for the S&P 500 companies, which account for about 75 percent of the total assets of the U.S. economy, reveal that since the mid-1980s, there has been a large increase in the ratio of market value to book value, albeit with very high volatility. At its peak in March 2000, the ratio of market value to book value was 7.5. At the end of August 2002, it was 4.2, and it may still go down. However, even if the ratio fell to 4 or even 3, it would be sufficiently higher than it was in prior periods, and high enough to confirm that an amount of value equal to between one-half and two-thirds of corporate market values reflects the value of intangible assets. Recently, Federal Reserve Chairman Alan Greenspan has been discussing what he calls "conceptual assets." In testimony to the House of Representatives in February 2002, he noted that the proportion of our GDP that results from the use of conceptual, as distinct from physical, assets has been growing, and that the increase in value-added due to the growth of these assets may have lessened cyclical volatility. However, he then argued that physical assets retain a good portion of their value even if the reputation of management is destroyed, while intangible assets may lose value rapidly. The loss in value of intangible assets by Enron was noted by Chairman Greenspan. Two weeks later, a major article in the Wall Street Journal asked where all the intangible assets have gone, mentioning Enron and Global Crossing specifically. To investigate this issue, I asked one of my Ph.D. students to review the financial reports of these firms. The result was astounding: these companies did not spend a penny on research and development. …

Productivity Measurement Issues in Services Industries: "Baumol's Disease" Has Been Cured

Abstract: I. INTRODUCTION It is now well known that after 1995, labor productivity (LP, or output per hour) in the United States doubled its anemic 1.3 percent average annual growth between 1973 and 1995 (see chart). Labor productivity in the services industries also accelerated after 1995. As we documented in a longer version of this paper (Triplett and Bosworth forthcoming), labor productivity growth in the services industries after 1995 was a broad acceleration, not just confined to one or two industries, as has sometimes been supposed. Using the 1977-95 period as the base, we showed that fifteen of twenty-two U.S. two-digit services industries experienced productivity acceleration. Both the rate of LP improvement in services after 1995 and its acceleration equaled the economywide average. That is why we said "Baumol's Disease has been cured." (1) We also examined the sources of labor productivity growth. The major source of the LP acceleration in services industries was a great expansion in services industry multifactor productivity (MFP) after 1995. It went from essentially zero in the earlier period to 1.4 percent per year, on a weighted basis. As MFP is always a small number, that is a huge expansion. Information technology (IT) investment played a substantial role in LP growth, but its role in the acceleration was smaller, mainly because the effect of IT in these services industries is already apparent in the LP numbers before 1995. Purchased intermediate inputs also made a substantial contribution to labor productivity growth, especially in the services industries that showed the greatest acceleration. This finding reflects the role of "contracting out" in improving efficiency. 2. RESEARCH METHODOLOGY In the now standard productivity-growth accounting framework that originates in the work of Solow (1957)--as implemented empirically by Jorgenson and Griliches (1967) and extended by both authors and others--labor productivity can be analyzed in terms of the contributions of collaborating factors, including capital and intermediate inputs, and of multifactor productivity. To analyze the effects of IT within this model, capital services, K, are disaggregated into IT capital ([K.sub.IT]) and non-IT capital ([K.sub.N]), and the two types of capital are treated as separate inputs to production. Thus, designating intermediate inputs--combined energy, materials, and purchased services--as M: (1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] A number of researchers have calculated the contributions of IT and MFP to the post-1995 acceleration of labor productivity growth at the aggregate, economywide level (at the aggregate level, of course, the intermediate inputs net out, except for imports, which typically are ignored). The most prominent examples are Jorgenson and Stiroh (2000), Oliner and Sichel (2000), Gordon (2000), and Council of Economic Advisers (2000). Although there is broad agreement among these studies, a major issue concerns the degree of MFP improvement in IT-using industries, on which the aggregate-level studies reach different conclusions. Because the most intensive IT-using industries are services industries, the impact of IT on IT-using sectors and the extent of MFP in IT-using sectors provide part of the motivation for our focus on services industries. In addition, we have been leading a Brookings Institution project on the measurement of output and productivity in the services industries (an earlier report on this subject is Triplett and Bosworth [2001]). Clearly, services industry productivity remains a challenging issue with many unresolved puzzles. We explored the impact of IT and of MFP on services industries by estimating equation 1 separately for each of twenty-seven two-digit services industries. Although our study uses the same level of two-digit detail employed by Stiroh (2001) and Nordhaus (2002) to examine LP, and also begins from the Bureau of Economic Analysis (BEA) database that they use, our research approach is most nearly similar to that of Jorgenson, Ho, and Stiroh (2002), who estimate labor productivity, MFP, and IT contributions for thirty-nine sectors. …

Transparency, Financial Accounting Information, and Corporate Governance. (Part 1: A Review of the Literature on Corporate Governance)

Abstract: 1. INTRODUCTION Vibrant public securities markets rely on complex systems of supporting institutions that promote the governance of publicly traded companies. Corporate governance structures serve: 1) to ensure that minority shareholders receive reliable information about the value of firms and that a company's managers and large shareholders do not cheat them out of the value of their investments, and 2) to motivate managers to maximize firm value instead of pursuing personal objectives. (1) Institutions promoting the governance of firms include reputational intermediaries such as investment banks and audit firms, securities laws and regulators such as the Securities and Exchange Commission (SEC) in the United States, and disclosure regimes that produce credible firm-specific information about publicly traded firms. In this paper, we discuss economics-based research focused primarily on the governance role of publicly reported financial accounting information. Financial accounting information is the product of corporate accounting and external reporting systems that measure and routinely disclose audited, quantitative data concerning the financial position and performance of publicly held firms. Audited balance sheets, income statements, and cash-flow statements, along with supporting disclosures, form the foundation of the firm-specific information set available to investors and regulators. Developing and maintaining a sophisticated financial disclosure regime is not cheap. Countries with highly developed securities markets devote substantial resources to producing and regulating the use of extensive accounting and disclosure rules that publicly traded firms must follow. Resources expended are not only financial, but also include opportunity costs associated with deployment of highly educated human capital, including accountants, lawyers, academicians, and politicians. In the United States, the SEC, under the oversight of the U.S. Congress, is responsible for maintaining and regulating the required accounting and disclosure rules that firms must follow. These rules are produced both by the SEC itself and through SEC oversight of private standards-setting bodies such as the Financial Accounting Standards Board and the Emerging Issues Task Force, which in turn solicit input from business leaders, academic researchers, and regulators around the world. In addition to the accounting standards-setting investments undertaken by many individual countries and securities exchanges, there is currently a major, well-funded effort in progress, under the auspices of the International Accounting Standards Board (IASB), to produce a single set of accounting standards that will ultimately be acceptable to all countries as the basis for cross-border financing transactions. (2) The premise behind governance research in accounting is that a significant portion of the return on investment in accounting regimes derives from enhanced governance of firms, which in turn facilitates the operation of securities markets and the efficient flow of scarce human and financial capital to promising investment opportunities. Designing a system that provides governance value involves difficult tradeoffs between the reliability and relevance of reported accounting information. While the judgments and expectations of firms' managers are an inextricable part of any serious financial reporting model, the governance value of financial accounting information derives in large part from an emphasis on the reporting of objective, verifiable outcomes of firms. An emphasis on verifiable outcomes produces a rich set of variables that can support a wide range of enforceable contractual arrangements and that form a basis for outsiders to monitor and discipline the actions and statements of insiders. (3) A fundamental objective of governance research in accounting is to investigate the properties of accounting systems and the surrounding institutional environment important to the effective governance of firms. …

Effects of Homeownership on Children: The Role of Neighborhood Characteristics and Family Income

Abstract: 1 INTRODUCTION A recent press release from the US Department of Housing and Urban Development (HUD) captures the wide-ranging benefits increasingly being attributed to homeownership: "Homeowners accumulate wealth as the investment in their homes grows, enjoy better living conditions, are often more involved in their communities, and have children who tend on average to do better in school and are less likely to become involved with crime Communities benefit from real estate taxes homeowners pay, and from stable neighborhoods homeowners create" (US Department of Housing and Urban Development 2000) This credo undergirds the last decade's push to extend homeownership to all Americans, particularly low-income families and racial minorities Because it is believed to strengthen not only families but communities, homeownership is being promoted as an important strategy for regenerating distressed urban neighborhoods Enormous amounts of money, both public and private, are being invested in increasing the homeownership rate From the $2 trillion "American Dream Commitment" of Fannie Mae, to the multimillion-dollar homeownership programs of the Enterprise Foundation, the Local Initiatives Support Corporation, and the Neighborhood Reinvestment Corporation, to the millions of dollars of programs and incentives under HUD's control, a consistent view of homeownership as a "silver bullet" has emerged, Incentives for homeownership even appear in the welfare reform plans of a number of states Despite this significant investment, there is remarkably little known about the real effects of homeownership on either homeowners, their children, or their communities This paper focuses on one aspect of homeownership: its potential long-term effects on children Several recent studies have found that growing up in a homeowning family exerts positive effects on children's development and outcomes (Green and White 1997; Aaronson 2000; Boehm and Schlottman 1999; Haurin, Parcel, and Haurin 2000) But what accounts for these positive effects, and whether other features may either strengthen or weaken them, is unclear One such feature is the neighborhood Since many families who will become new homeowners under current policies promoting homeownership for the poor will purchase homes in areas traditionally thought of as troubled of distressed, it is important to understand whether neighborhood characteristics play a role in the effects of homeownership on children's outcomes To our knowledge, only Aaronson (2000) has explored this link He finds that parental homeownership in low-income census tracts has a more positive effect on high-school graduation than it does in high-income census tracts This intriguing result suggests that homeownership may buffer children against the damaging effects of growing up in distressed neighborhoods But Aaronson also finds that neighborhood residential stability enhances the positive effects of homeownership on high-school graduation, which suggests that at least some of the positive effects of homeownership found in other studies may be attributed to the greater residential stability of the neighborhoods where homeowners live Very different policy recommendations emerge from these two results According to the first, homeownership should be promoted even--or especially--in very low-income neighborhoods According to the second, neighborhoods that are residentially stable are preferred, and efforts to stabilize distressed neighborhoods by encouraging low-income families to purchase homes there may carry significant risks for the "pioneers," the first homeowners in a distressed area Another neighborhood feature that may play a role is the homeownership rate, which has largely been ignored in the sizable and growing body of research on the effects of distressed neighborhoods on the life chances of children (see reviews by Jencks and Mayer [1990], Haveman and Wolfe [1995], Gephart [1997], Ellen and Turner [1998], and Moffitt [2001]) …

Price Hedonics: A Critical Review

Abstract: 1. INTRODUCTION Price hedonics is a statistical technique developed more than seventy years ago to assess product quality issues. It had enjoyed a quiet and respectable life since coming of age in the early 1960s, but in the past few years, it has gained a degree of notoriety through a series of highly visible assessments of the consumer price index (CPI). This attention prompted a reassessment of price hedonics and its role in the CPI, which in turn has led to important new dimensions in the study of price hedonics. This paper focuses on these developments. The new debate began in early 1995, when Federal Reserve Chairman Alan Greenspan testified before the Senate Finance Committee that he thought that the CPI was biased upward by perhaps 0.5 to 1.5 percentage points per year. This remark did not surprise specialists who understood the technical difficulties involved in constructing accurate price indexes, but it created a small sensation in the political arena. Here at last was a chance to get around one of the most difficult issues in the debate over balancing the federal budget: what to do about the social security program. Here was a way to reduce expenditures to balance the federal budget and rescue the social security trust fund from insolvency in the next century. The beauty of it all was that the solution did not involve raising new taxes or changing benefit formulas. Instead, the solution involved "fixing" a biased method of adjusting social security benefits for the effects of price inflation, that is, by fixing the way the U.S. Department of Labor's Bureau of Labor Statistics (BLS) handles problems such as those posed when a new, improved product appears on the market. These political considerations may seem tangential to the subject of price hedonics, but the events following from Greenspan's remark have linked the two issues. First, the Senate Finance Committee consulted a panel of experts, and that panel reached a consensus supporting Greenspan's estimate. Congress subsequently established the Advisory Commission to Study the Consumer Price Index (better known as the Boskin Commission, after its chairman) to estimate the level of the CPI bias. Boskin et al. (1996) arrived at an estimated bias of 1.1 percentage points per year--a level almost identical to Greenspan's estimate. Furthermore, the report said that about half (0.6) of that bias could be attributed to product innovations that were being overlooked in the CPI. A parallel study by Shapiro and Wilcox (1996) came to the same conclusion, estimating an overall bias of 1 percentage point per year, with 0.45 of that bias coming from quality changes and new goods. The study also observed that this bias was the most difficult to correct, likening the quality-adjustment process to house-to-house combat. Price hedonics enters this picture because it offers the best hope for dealing with the bias that comes from product innovation. Although Boskin et al. (1996) did not explicitly recommend that the BLS expand the use of this technique in the CPI program (as a report by Stigler [1961] did), the BLS moved in this direction by increasing the number of items in the CPI treated with price hedonic techniques. In 1998, the BLS also requested that the Committee on National Statistics of the National Research Council (NRC) set up a panel of experts to investigate the conceptual issues involved in developing a cost-of-living index, including the use of price hedonic methods. This committee, chaired by Charles Schultze, released its report in early 2002 (National Research Council 2002). The NRC panel did not provide unanimous support for the underlying philosophy of the CPI as a pure cost-of-living index, and, in its own words, differs from the Stigler and Boskin et al. reports in this regard (National Research Council 2002, p. 3). The NRC panel was cool to the BLS's expanded commitment to price hedonics. On the one hand, the NRC report endorsed hedonic techniques as a research tool, commenting that they "currently offered the most promising approach for explicitly adjusting observed prices to account for changing product quality. …

What Market Risk Capital Reporting Tells Us about Bank Risk

Abstract: * Since 1998, U.S. bank holding companies with large trading operations have been required to hold capital sufficient to cover the market risks in their trading portfolios. The capital amounts that each institution must hold, disclosed in publicly available regulatory reports, appear to offer new information about the market risk exposures undertaken by these institutions. * An empirical analysis suggests that the market risk capital figures do, in fact, provide information about the evolution of individual institutions' risk exposures over time that is not found in other regulatory report data. In particular, changes in an institution's capital charges prove to be a strong predictor of changes in the volatility of its future trading revenue. * By contrast, the market risk capital figures provide little information about differences in market risk exposure across institutions beyond what is already conveyed by the relative size of an institution's trading account. 1. INTRODUCTION In recent years, financial market supervisors and the financial services industry have placed increased emphasis on the role of public disclosure in ensuring the efficient and prudent operation of financial institutions. In particular, disclosures about financial institutions' risk exposures have frequently been cited as an important way for debt and equity market participants to get the information necessary to exercise "market discipline" on the risk-taking activities of these institutions. Such market discipline is often viewed as an important means of influencing the behavior of financial institutions, especially with regard to their risk-taking activities. For instance, a 1994 report by the Euro-currency Standing Committee of the Bank for International Settlements stated that "financial markets function most efficiently when market participants have sufficient information about risks and returns to make informed investment and trading decisions." (1) Similarly, in recent proposed amendments to the minimum regulatory capital requirements for internationally active banks, the Basel Committee on Banking Supervision included market discipline as a primary pillar, and the proposals themselves contained extensive recommendations for disclosures about banks' risk exposures (see Basel Committee on Banking Supervision [2001]). Finally, a group of senior officials of large financial institutions recently issued a report acknowledging the role of public disclosure, among other practices, in maintaining market discipline and shareholder value (see Working Group on Public Disclosure [2001]). This emphasis on disclosure and market discipline rests on the assumption that the disclosures made by financial institutions provide meaningful information about risk to market participants. Various recommendations have been made by supervisors and the financial services industry about the types of information that would be most effective in conveying an accurate picture of financial firms' true risk exposures as they evolve over time. This article assesses one particular source of information about the risk facing certain large U.S. banking companies to see how welt it captures variation in risk exposures, both across institutions and over time. The data examined are derived from publicly disclosed regulatory report information on minimum regulatory capital requirements. Since 1998, banks and bank holding companies (BHCs) in the United States have been subject to a new set of regulatory minimum capital standards intended to cover the market risk in their trading portfolios. Market risk is the risk of loss from adverse movements in financial rates and prices, such as interest rates, exchange rates, and equity and commodity prices. The market risk capital standards were introduced as a supplement to the existing capital standards for credit risk for institutions with large trading portfolios. …

The Impacts of New Neighborhoods on Poor Families: Evaluating the Policy Implications of the Moving to Opportunity Demonstration

Abstract: 1. INTRODUCTION The U.S. Department of Housing and Urban Development's (HUD) Moving to Opportunity for Fair Housing Demonstration, or MTO, is a large, federally funded social experiment designed to test whether improved neighborhood opportunities may significantly affect the life chances of low-income public housing residents. This paper provides the first systematic overview of the design of the MTO and describes its key features. The paper also offers the first cross-site analysis of research findings and explores the MTO's relevance to social science research concerning housing and neighborhood effects. We begin with the social science background to MTO and discuss the purposes of the demonstration. We then describe the key features of the demonstration and how its experimental design addresses methodological issues that have long limited neighborhood effects research. The implementation of the demonstration and how that implementation shapes and limits the research is discussed next, followed by a description of the major research results from a number of MTO studies. We conclude with a discussion of future research needs and policy issues. 1.1 Research Background Research over the last decade has shown that poverty in the United States has become increasingly concentrated in "high-poverty" neighborhoods, and that such concentrations appear to have a range of detrimental effects on the well-being and future opportunities of residents of those areas (Jargowsky 1997; Wilson 1987, 1996; Brooks-Gunn, Duncan, Klebanov, and Saland 1993; Aneshensel and Sucoff 1996; Sampson 2000; Morenoff, Sampson, and Raudenbush 2001; Catsambis and Beveridge 2001). The harmful effects of high-poverty areas are thought to be especially severe for children; their behavior, choices, and prospects may be particularly susceptible to neighborhood-based events and characteristics, such as peer group influence, school quality, and the level of violent crime (Galster and Killen 1995; Ellen and Turner 1997; Leventhal and Brooks-Gunn 2001). Social scientists have also focused recently on the possible theoretical causes of both the positive and negative effects of neighborhoods (Manski 1993, 2000; Galster and Killen 1995; Galster, Quercia, and Cortes 2000; Leventhal and Brooks-Gunn forthcoming). The core question is whether there are clear, independent effects from a neighborhood. If so, then social science must next attempt to identify the causes and processes through which such effects appear in the lives of children, adolescents, or adults. While there has long been social science evidence of the harmful effects of living in concentrated-poverty neighborhoods, evidente and discussion about how neighborhood environments may exert positive influences on behavior and life chances are more recent (Brooks-Gunn, Duncan, and Aber 1997; Sampson, Morenoff, and Gannon-Rowley 2002). Galster and Killen (1995) have noted the complexity of the causal influences linking metropolitan and neighborhood based opportunities; they point out the dynamic nature of opportunities, and the critical issue of residents' willingness and ability to take advantage of contextually positioned resources. Ellen and Turner's (1997) summary of the literature in this area suggests various mechanisms by which middle-class (often predominantly white) neighborhoods shape, of reshape, the lives of residents. The effects of neighborhood appear to be more pronounced for children rather than for adults. Leventhal and Brooks-Gunn (2001) offer evidence that neighborhood influences on achievement measures--such as IQ--are most important below five years of age. Despite considerable progress over the last decade, researchers have only a limited understanding of which neighborhood effects are most likely to appear first, in what types of households or family members they may appear, under what circumstances, and with what durability of persistence. …

Is Corporate Governance Different for Bank Holding Companies? (Part 2: The Governance of Banks)

Abstract: 1. INTRODUCTION In the wake of the recent corporate scandals, corporate governance practices have received heightened attention. Shareholders, creditors, regulators, and academics are examining the decision-making process in corporations and other organizations and are proposing changes in governance structures to enhance accountability and efficiency. To the extent that these proposals are based on academic research, they generally draw upon a large body of studies on the governance of firms in unregulated, non financial industries. Financial institutions, however, are very different from firms in unregulated industries, such as manufacturing firms. Thus, the question arises as to whether these proposals and reforms can also be effective at enhancing the governance of financial institutions, and, in particular, banking firms. The question is a difficult one to answer, though, given the little research on the governance of banking firms. Therefore, in order to evaluate reforms to the governance structures of banking firms, it is important to understand current governance practices as well as how governance differs between banking and unregulated firms. Otherwise, governance proposals cannot be fine-tuned. Significantly, uniformly designed proposals that do not take into account industry differences at the very least may be ineffective in improving the governance of financial institutions, and at worst may have unintended negative consequences. Accordingly, this article examines corporate governance in banking firms. In particular, we study corporate governance variables identified as relevant by academics and practitioners and describe their differences and similarities vis-a-vis banking firms and manufacturing firms. Because public information on governance characteristics is generally available only for publicly traded bank holding companies (BHCs), we examine the governance of BHCs and not banks. We also discuss the effect of regulation--such as supervisory and regulatory requirements at the state and Office of the Comptroller of the Currency (OCC) levels--prior to 2000 on banking firm behavior. Many typical external governance mechanisms, such as the threat of hostile takeovers in the industry, are absent in the case of banking firms; therefore, we focus primarily on internal governance structures and shareholder block ownership. Our goal is to provide useful information and a road map for thinking about the governance of financial institutions, in terms of reform as well as research. We discuss the potential benefits and costs associated with some of the corporate governance variables for an average firm. However, we stress that all of these variables are ultimately part of a simultaneous system that determines the corporation's value and the allocation of such value among claimants. Also, different governance mechanisms may be substitutes for one another. For example, certain executive pay packages can vary across firms, even in the same business environment, for good reason. Firms with more effective boards may have more equity-based CEO compensation in their structure, while firms with greater CEO ownership may have more cash compensation (Mehran 1995). Thus, the quality of governance of any organization must he evaluated along a number of dimensions. Our sample consists of thirty-five bank holding companies over the 1986-96 period. For these BHCs, we construct governance variables or proxies that have received attention by researchers in law, economics, organization, and management who argue that the variables are correlated with governance practices. We also compare variables in our sample with those for manufacturing firms compiled in other studies. Our comparison of BHCs and manufacturing firms yields several key findings. First, BHC board size (18.2 members versus 12.1 members) and the percentage of outside directors (68.7 percent versus 60.6 percent) are significantly larger on average. …

The Twenty-Fifth Anniversary of the Community Reinvestment Act: Past Accomplishments and Future Regulatory Challenges. (Session 4: Housing Subsidies and Finances)

Abstract: I. INTRODUCTION AND SUMMARY (1) The U.S. Congress passed the Community Reinvestment Act (CRA) in 1977 to encourage depository institutions to meet the credit needs of lower income neighborhoods. The CRA was built on the simple proposition that deposit-taking banking organizations have a special obligation to serve the credit needs of the communities in which they maintain branches. At the time of the CRA's passage, banks and thrifts originated the vast majority of home purchase loans. The CRA's initial focus on areas where CRA-regulated institutions maintained branches made sense because restrictions on interstate banking and branching activities were limiting the geographic scope of mortgage lending operations. Today, the CRA continues to provide significant incentives for CRA-regulated institutions to expand the provision of credit to lower income and/or to minority communities where those institutions maintain deposit-taking operations. Yet in the quarter century since the act's passage, dramatic changes have transformed the financial services landscape, especially in home mortgage lending. These changes have combined to weaken the link between mortgage lending and the branch based deposit gathering on which the CRA was based. Today, less than 30 percent of all home purchase loans are subject to intensive review under the CRA. In some metropolitan areas, this share is less than 10 percent. With a substantial portion of home purchase lending no longer subject to detailed scrutiny under the CRA, the issue of how best to modernize the CRA has emerged as an important public policy challenge. Some argue that the CRA's costs exceed its benefits. Others advocate expanding regulatory oversight. Congress considered changes to the CRA in the debate leading up to the passage of the 1999 Gramm-Leach-Bliley Financial Modernization Act (GLBA), but in the end it did little to make the CRA conform to the realities of the financial services marketplace. Although the CRA continues to provide significant benefits to lower income households and communities, reform is needed for the act to encourage financial services providers to meet the continuing needs of the communities they serve. 1.1 Summary of Key Findings This paper draws on a more extensive Joint Center for Housing Studies assessment of the CRA, funded by the Ford Foundation. The larger study not only assesses the impact of the CRA on home purchase and home refinance lending, it also presents commentary on the CRA's impact on small-business and multifamily lending, as well as on the provision of financial services more generally. In addition, the Ford Foundation study presents qualitative findings concerning the CRA's impact on the operation of banks and mortgage lenders as well as the impact on the relationship between mortgage lenders and community-based advocacy organizations. Our paper focuses on the regulatory and legislative challenges that confront the act at age twenty-five. In addition to providing a brief review of the evolution of CRA regulations, we document the impact that the CRA has had on home mortgage lending to lower income people and communities and assess changes in industry structure. We conclude with a discussion of current legislative and regulatory challenges. The CRA Has Expanded Access to Mortgage Capital Working in combination with the Home Mortgage Disclosure Act (HMDA) and the closely related Fair Housing and Fair Lending Legislation, the CRA continues to expand access to capital for CRA-eligible borrowers. Here, CRA-eligible borrowers include those with an income of less than 80 percent of the area median income and/or those living in census tracts with a median income of less than 80 percent of the area median. CRA-regulated lenders refer to federally regulated banks and thrifts as well as their mortgage company and finance company affiliates. * In both 1993 and 2000, CRA-regulated lenders operating in their assessment areas (areas where they maintain deposit-taking operations) had shares of conventional, conforming prime home purchase loans to CRA-eligible borrowers that exceeded the equivalent shares for out-of-area lenders or noncovered organizations. …

Comparing the Costs of Federal Housing Assistance Programs

Abstract: 1. INTRODUCTION For more than sixty years, the federal government has provided assistance to improve the condition and reduce the cost of rental housing for low- and very low-income households. (1) The focus of federal assistance has changed over time, as illustrated by the major policy reviews of the last four decades--the Kaiser Committee in 1968, the President's Commission on Housing in 1982, and the National Housing Task Force of 1988. The focus of these reviews shifted from increasing the physical quality of the housing stock in the Kaiser Committee, to increasing housing affordability in the President's Commission on Housing, to addressing housing availability and affordability in the National Housing Task Force. (2) Production programs dominated federal housing policy until the early 1980s. Since then, the voucher program has been one of the fastest growing federal housing assistance programs. Although there is little debate that vouchers will remain a dominant form of housing assistance, there is still considerable debate concerning the appropriate role for production programs. A major concern with production programs is their cost, particularly when compared with vouchers. Much of the housing cost literature cited in this debate is more than twenty years old and evaluates production programs that are no longer active. In this paper, we describe the housing provided by vouchers and five active federal production programs, and estimate the total costs of each program. In addition, we examine who pays the costs of each program. Today, six active federal housing programs continue to increase the number of households assisted. These programs include the Housing Choice Voucher program (housing vouchers)--the largest source of federal funds for housing assistance--and tire production programs, which currently receive federal funds to constructor substantially rehabilitate units. In this paper, we examine the characteristics of the housing provided and the total costs of providing that housing under these six active programs: (3) * Housing vouchers (produced about 1.6 million households) supplement tenants' rental payments in privately owned, moderately priced apartments chosen by the tenants. * Low-income housing tax credits (produced about 700,000 units) provide tax incentives for private equity investment and are often used in conjunction with other federal, state, and local government and private subsidies in the production of new and rehabilitated affordable housing units consistent with state-determined housing priorities. * HOPE VI (produced about 65,000 units) provides grants--coupled with funds from other federal, state, local, and private sources--to revitalize severely distressed public housing, support community and social services, and promote mixed-income communities. (4) * Section 202 (produced about 66,000 units) provides grants to develop supportive housing for the elderly and project-based rental assistance. (5) * Section 811 (produced about 18,000 units) provides grants to develop supportive housing for persons with disabilities and project-based rental assistance. * Section 515 (produced about 485,000 units) provides below-market loans to support the development of housing for families and the elderly in rural areas and project-based rental assistance through the Section 521 program. The housing provided under the six active federal programs can be quite diverse, varying in age, type, size, and in level of services and amenities provided. We find that for units of the same size and in the same general location, the total costs of production programs are greater than the total costs of vouchers, but the difference in costs is smaller than suggested in earlier literature. In addition, these cost differences generally diminish as unit size increases. Compared with vouchers, we estimate that the average total thirty-year costs of one-bedroom units in metropolitan areas range from 8 percent more under the Section 811 program to 19 percent more under the tax credit program. …

Formulating the Imputed Cost of Equity Capital for Priced Services at Federal Reserve Banks

Abstract: * To comply with the provisions of the Monetary Control Act of 1980, the Federal Reserve devised a formula to estimate the cost of equity capital for the District Banks' priced services. * In 2002, this formula was substantially revised to reflect changes in industry accounting practices and applied financial economics. * The new formula, based on the findings of an earlier study by Green, Lopez, and Wang, averages the estimated costs of equity capital produced by three different models: the comparable accounting earnings method, the discounted cash flow model, and the capital asset pricing model. * An updated analysis of this formula shows that it produces stable and reasonable estimates of the cost of equity capital over the 1981-2000 period. 1. INTRODUCTION The Federal Reserve System provides services to depository financial institutions through the twelve Federal Reserve Banks. According to the Monetary Control Act of 1980, the Reserve Banks must price these services at levels that fully recover their costs. The act specifically requires imputation of various costs that the Banks do not actually pay but would pay if they were commercial enterprises. Prominent among these imputed costs is the cost of capital. The Federal Reserve promptly complied with the Monetary Control Act by adopting an imputation formula for the overall cost of capital that combines imputations of debt and equity costs. In this formula--the private sector adjustment factor (PSAF)--the cost of capital is determined as an average of the cost of capital for a sample of large U.S. bank holding companies (BHCs). Specifically, the cost of capital is treated as a composite of debt and equity costs. When the act was passed, the cost of equity capital was determined by using the comparable accounting earnings (CAE) method, (1) which has been revised several times since 1980. One revision expanded the sample to include the fifty largest BHCs by assets. Another change averaged the annual estimates of the cost of equity capital over the preceding five years. Both revisions were made largely to avoid imputing an unreasonably low--and even negative--cost of equity capital in years when adverse market conditions impacted bank earnings. The latter revision effectively ameliorates that problem but has a drawback: the imputed cost of equity capital lags the actual market cost of equity by about three years, thus making it out of sync with the business cycle. This drawback does not necessarily result in an over- or underestimation of the cost of equity capital in the long run, but it can lead to price setting that does not achieve full economic efficiency. (2) After using the CAE method for two decades, the Federal Reserve wanted to revise the PSAF formula in 2002 with the goal of adopting an imputation formula that would: 1. provide a conceptually sound basis for economically efficient pricing, 2. be consistent with actual Reserve Banks' financial information, 3. be consistent with economywide practice, and particularly with private sector practice, in accounting and applied financial economics, and 4. be intelligible and justifiable to the public and replicable from publicly available information. The Federal Reserve's interest in revising the formula grew out of the substantial changes in research and industry practice regarding financial economics over the two decades since 1980. These changes drove the efforts to adopt a formula that met the above criteria. Of particular importance was general public acceptance of and stronger statistical corroboration for the scientific view that financial asset prices reflect market participants' assessments of future stochastic revenue streams. Models that reflected this view--rather than the backward-looking view of asset-price determination implicit in the CAE method--were already in widespread use in investment banking and for regulatory rate setting in utility industries. …

Housing Production Subsidies and Neighborhood Revitalization: New York City's Ten-Year Capital Plan for Housing. (Session 3: The Impact of Housing on People and Places)

Abstract: 1. INTRODUCTION A perennial question in housing policy concerns the form that housing assistance should take. Although some argue that housing assistance should be thought of as a form of income support and advocate direct cash grants to needy households, others favor earmarked assistance--but they differ over whether subsidies should be given to the recipients as vouchers or to developers as production subsidies. The appropriate composition of housing assistance has recently taken on particular import. In 2000, Congress created the Millennial Housing Commission and gave it the task of evaluating the "effectiveness and efficiency" of methods to promote housing through the private sector. As part of its mandate, the commission is examining changes to existing programs as well as the creation of new production programs to increase affordable housing. This paper reexamines the debate over the appropriate form of housing assistance. First, we briefly summarize and evaluate arguments in favor of demand-oriented housing subsidies (such as Section 8 vouchers) and supply-oriented housing subsidies (such as production subsidies). We conclude that although demand-oriented subsidies are preferable to supply-oriented subsidies on a number of grounds, government support for production may, at least theoretically, be justified as a way to promote positive spillover effects and neighborhood revitalization. Whether sufficient spillovers exist is, in the end, an empirical question. Although much of the existing research finds little evidence of spillover effects, our findings on the New York City experience suggest that spillovers may be significant and large enough to justify government support for production. Next, we describe the most extensive experiment in the United States in which a city used supply-oriented subsidies to rebuild neighborhoods--New York City's Ten-Year Capital Plan for Housing (the "Ten-Year Plan"). Born out of the necessity to rebuild communities devastated by years of abandonment and arson, the program, launched by New York City in 1986, ultimately led to the investment of more than $5.1 billion in housing in many of the city's poorest neighborhoods. Finally, we describe the results of several empirical studies we have recently completed on the effect of the Ten-Year Plan on property values in New York City. Our results suggest that the use of production subsidies can indeed generate positive spillovers and contribute to neighborhood revitalization. Furthermore, by comparing and contrasting New York City's experiences with those of other cities, we explain why New York was so successful, and identify aspects of its program that could be transplanted to other cities. 2. JUSTIFICATIONS FOR HOUSING ASSISTANCE: REVISITING THE SUPPLY-VERSUS-DEMAND DEBATE Although housing subsidies have become commonplace in the United States, it is still worthwhile to consider whether household financial assistance might be tied to housing rather than just provided as unrestricted cash grants. If the only housing-related problem facing Americans was insufficient income among poor families to purchase adequate housing, then a strong argument could be made that unrestricted cash grants would be best. In a liberal society dedicated to free choice, allowing individuals to make their own decisions with respect to consumption would generally seem desirable. Furthermore, considerable evidence suggests that unrestricted cash grants would lead to increases in housing consumption that fall short of the grant amount (Polinsky and Ellwood 1979). The implication is that earmarking subsidies for housing would be a less efficient way than cash grants to enhance household welfare. Finally, earmarked housing assistance carries an additional inefficiency--the cost of administration necessitated by the requirement that the money be spent on a specific good. Despite the inefficiency, since the end of World War II, federal, state, and city governments have repeatedly tied subsidies to housing consumption. …

State of New York City's Housing and Neighborhoods: An Overview of Recent Trends. (Session 1)

Abstract: 1. INTRODUCTION New York City is well-known for the special challenges it faces in providing the largest urban population in the United States with quality affordable housing. The city's housing problems are frequently the subject of intense debate. It is sometimes said that housing problems in New York City are exceptional and cannot be compared with those of other cities. In this paper, we provide this comparative perspective through an examination of certain housing indicators for New York City, the nation as a whole, and several comparison cities. Our results suggest that New York is not as exceptional as some might think. Many housing and neighborhood indicators improved substantially in New York City over the late 1990s. Although a large number of New Yorkers live in poor-quality housing or pay extraordinarily high proportions of their incomes for rent, housing problems by and large either stabilized or, in some instances, moderated during the late 1990s. Nevertheless, significant housing problems remain and not all improvements were felt everywhere in the city. Much of the information on New York City presented here is taken from our recent report, "State of New York City's Housing and Neighborhoods 2001." (1) In that report and in this presentation, we derive many indicators from the New York City Housing and Vacancy Survey (HVS). This survey, which is modeled on the Census Bureau's American Housing Survey (AHS), is conducted every two to three years and is based on a sample of approximately 18,000 housing units--a substantially larger sample than the metropolitan area surveys of the AHS, which range from 1,300 to 3,500 housing units. Because the HVS is unique to New York City, AHS data for New York, the United States, and six comparison cities are also presented to place the city's housing situation in context. (2) 2. VACANCY RATES AND HOUSING CREATION The scarcity of housing in New York City is well-known. As shown in Chart 1, rental vacancy rates in New York are consistently lower than rates for the United States as a whole, reflecting the fact that the city has one of the tightest housing markets in the nation. According to the HVS, from 1996 to 1999, rental vacancy rates in New York declined from 4.0 percent to 3.2 percent. This decline may be an indication of a reversal of the generally upward trend in the vacancy rate since 1984, when only 2 percent of rental units were vacant and available. The current vacancy rate is well below the 5 percent level that statutorily constitutes an official housing emergency in the city. As shown in the chart, the decline in New York City's vacancy rate contrasts with the change in the nation as a whole. According to the AHS, from 1995 to 1999, the nationwide rental vacancy rate increased slightly, from 7.2 percent to 7.4 percent. [GRAPHIC OMITTED] New York City's housing market is not the tightest in the nation, however (Table 1). According to the 2000 U.S. census, two other cities--San Francisco (2.5 percent) and Boston (3.0 percent)--had lower rental vacancy rates. Los Angeles also had a very low vacancy rate of 3.5 percent. At the other extreme are Philadelphia, which has experienced substantial population loss and has a relatively high vacancy rate of 7.0 percent, and Houston, an expanding city, which has the highest vacancy rate of the cities examined, 8.7 percent. Within New York City, there is substantial variation in rental vacancy rates. (3) As Chart 2 indicates, the areas of New York that have the most vacancies are generally those neighborhoods with high populations of low- and moderate-income families, such as the South Bronx and Central Brooklyn. One exception is southern Staten Island, where land is more available and construction levels are relatively high. [ILLUSTRATION OMITTED] Low vacancy rates can be thought of as reflecting strength or weakness. On the one hand, the extremely tight housing market indicates high demand for residence in the City of New York. …