School districts are notoriously short of funding -- so short that some California districts have succumbed to Capital Appreciation Bonds that will cost taxpayers as much is 10 to 15 times principal by the time they are paid off. By comparison, California's Prop. 51, the school bond proposal currently on the ballot, looks like a good deal. It would allow the state to borrow an additional $9 billion for educational purposes by selling general obligation bonds to investors at an assumed interest rate of 5%, with the bonds issued over a five-year period and repaid over 30 years. $9 billion -- 5% -- 35 equals $15.75 billion in interest -- nearly twice principal, but not too bad compared to the Capital Appreciation Bond figures.
However, there is a much cheaper way to fund this $9 billion school debt. By borrowing from its own state-chartered, state-owned bank, the state could save over $10 billion -- on a $9 billion loan. Here is how.
A Look at the Numbers
First it would need to charter a bank. In California this can be done with an initial capitalization of $20 million; but for our purposes, assume an initial capitalization of $1 billion.
Where to get this money? The state's public pension funds are always seeking good investments. Today they are looking for a return of about 7% per year (although in practice they are getting less), and they have wide leeway in the sorts of things in which they can invest. So assume the capital comes from the pension funds, which are promised a 7% annual dividend and the return of principal after 35 years.
At a 10% capital requirement, $1 billion in capitalization is sufficient to back $10 billion in new loans, assuming the bank has an equivalent sum in deposits to provide liquidity.
Where to get the deposits? One possibility would be the California Pooled Money Investment Account (PMIA), which contains $68.3 billion earning a modest 0.61% as of the quarter ending September 30, 2016. This huge pool of rainy day, slush and investment funds is invested 46% in US Treasuries, 20% in certificates of deposit and bank notes, 11% in commercial paper, and 8% in time deposits, along with some other smaller investments. $10 billion of this money could be deposited into a savings account at the state-owned bank, on which the bank could pay 0.61% interest, the same average return the PMIA is getting now.
At a 10% reserve requirement, $1 billion of this money would need to be held by the bank as reserves. The other $9 billion could be lent or invested -- a sufficient sum to provide the funds sought by Prop. 51.
The annual cost of financing this $9 billion loan would thus be $1 billion -- 7% = $70 million for the pension funds, and $10 billion -- 0.61% = $61 million for the PMIA. So the total cost of funds would be $131 million annually -- 35 years = $4.585 billion. That is less than one-third of the $15.75 billion in interest anticipated under Prop. 51 -- a savings of $11.165 billion over 35 years on a loan of $9 billion.
If at the end of the 35 year period, the bank repays the pension funds their $1 billion initial capital investment, the net savings will be $10.165 billion -- a huge sum.
What about the other costs of setting up a bank -- buildings, staff and the like? These would actually be minimal. Like the Bank of North Dakota (BND), currently the nation's only state-owned depository bank, the California state bank would not need to advertise, would not need multiple branches or tellers, and would not need ATMs. It would be a "bankers' bank" or "money center bank," providing capital and liquidity for local banks and large institutional investors.
For purposes of funding this one infrastructure loan, the bank could arguably be run by one man sitting in an office in the statehouse, shuffling numbers around on a computer screen. Bonds would not even need to be issued. The state could just make the loan to itself.
What about Risk?
The objection typically raised by legislators is, "We can't afford to lend our deposits. We need our revenues for our state budget." But those concerns assume that banks actually lend their deposits. They don't. In March 2014, in a bombshell report titled "Money Creation in the Modern Economy," the Bank of England officially set the record on this issue straight. The BOE economists wrote that many common assumptions about how banking works are simply wrong. Banks are not merely intermediaries that take in money and lend it out again. They actually create the money they lend in the process of making loans:
The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
. . . Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money. [Emphasis added.]
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