Social Security entitlements also represent a derivative, albeit a different type: interest rate swaps. These entitlements are simply cash flows with an indeterminate end date or, put in market terms, swaps with an element of optionality. The value of derivatives such as these has been calculated by actuaries for ages.
Unfortunately, in real life, there is no marketplace to provide holders of these derivatives with an opportunity to cut their losses by selling these rights for a price, either to the writer itself or to some opportunistic risk taker that might envision a better situation down the road.
But take heart! The thought experiment was designed for just such a problem.
Imagining the existence and likely behavior of such a market might just provide us with another way to analyze the strengths and weaknesses of the current situation in a more clinical way than we would ordinarily do. By determining the reasons to be long or short these derivatives, we might just be able to arrive at some interesting conclusions.
Clearly, the longs (which are all of us) are faced with some major concerns, namely:
As mentioned earlier, there is a credit issue on the part of the writer (the US Treasury) and some doubt as to whether it will be able to live up to the obligations it presently has, much less the additional ones it will absorb going forward. These obligations are euphemistically referred to as “unfunded liabilities” by market observers. This problem is confounded by the fact that there is virtually only one major issuer of the derivatives. But there are other issuers of entitlements out there in the form of healthcare insurance companies and the like, so we must take their prospects and ability to lighten Uncle Sam’s load into consideration.
Liquidity and pricing are problems in our thought market because of the lopsided nature of writers and holders. The one major short -- the US Treasury -- effectively controls the pricing. Not good for a free market’s fair price-discovery mechanism.
The longs did not choose to take the position that they hold. Rather, they were forced to acquire the positions by the seller. If disposing of these positions were permitted, people in desperate financial straits would sell in a minute. After all, desperate people have been known to sell such vital items as blood and organs, something far more valuable to them than the questionable derivatives they are required to own.
The holders of the rights run the risk of having their rights diluted or, in some cases, eliminated completely.
This last one is the key point.
That last bullet represents the ultimate issue. While the recent arguments in the halls of power in Washington, DC, over fiscal cliffs and the like appear to revolve around income and income redistribution, this may prove to be a relatively minor factor when compared to where we are headed. The really significant issue deals with assets and asset redistribution.
But let’s be clear. When we say “asset redistribution,” we aren’t suggesting that the government is going to seize your bank accounts or house. We are talking about entitlement assets. Through the miracle of means testing, we see a scenario whereby one’s financial condition determines whether his or her claim on Medicare, Social Security and the like is now valid. Simply put, your rights are based upon your net worth at a certain age. Have a net worth of $3 million at age 65? To paraphrase Seinfield’s Soup Nazi, “No Medicare for you! No Social Security for you! Next!”
To financial types like us, this represents a breach of contract. We will argue that we had an “Entitlement” and the government is reneging on its obligation. “That’s not the right we bought!” we will shout.
“Hmmm.” the government will say. “Maybe, but that’s the one you got. Tell your story walking.”
Interestingly, this position will be defended on moral grounds. In effect, your option was based not upon the value of the underlying service or cash flow, but rather on the state of your net worth at age 65 or 70 or even 80, depending on the government’s financial position. Since, in the view of the government, you don’t need it, then your option is determined to have expired; therefore, you don’t get it.
Haven’t you wondered why, during this huge fight over the fiscal cliff, entitlement reform was hardly discussed? It’s because tax policy is income redistribution. Only asset redistribution will generate the kind of numbers necessary to resolve this problem. Albert Einstein’s approach takes us to a vision of President Obama in a mustache, wearing a chef’s hat and standing behind a counter yelling, “Next!”