Tag Archives: financial meltdown

Private Equity Parallels the Mortgage Business

I’ve been trying to ignore all the discussion in the presidential campaign about Bain Capital and leveraged buyouts and private equity, but pull is too strong and I can no longer resist. Must….write…blog…entry.

First off, let me say that buyouts* are neither inherently good nor bad. People who are completely bashing buyouts as inevitably bad, as rapacious tools for the 1%, are simply wrong. People who are utterly defending buyouts as inevitably good, as the perfect form of free market capitalism, are also wrong. I mean, duh. Nothing as complicated as a buyout is going to just be good or just be bad.

Good: having a buyer focus a complacent or bloated company on its core products is often very productive. Bad: having a buyer stop investing in R&D and shut down pensions while continuing to pay itself fees and dividends is often very troubling.**

Rather than delve more into the good or the bad, I do want to point out one thing that isn’t often mentioned: how similar the buyout business is to the mortgage business as practiced on Wall Street. Both businesses are leveraged gambles with the government picking up at least some of the tab if you lose. We all know how Wall Street borrowed massively to bet on mortgage-backed securities. And they made jillions, paying out huge bonuses, until it went wrong, and the government bailed all of Wall Street out. Heads they win, tails we lose.

Buyout barons have a similar deal. Not quite as good, but similar. They borrow heavily to amplify the returns on their deals. If it goes well, they make tons; that is why Mitt Romney is so rich. But if it goes poorly, the Bains and KKRs of the world get to walk away, using the government bankruptcy code, and leaving the workers’ pension plan in the hands of the Pension Benefit Guaranty Program, a government agency. I don’t want to overstate the case: sometimes private equity firms lose money on bad deals. They don’t fully socialize their losses. But their losses are limited to that deal; the structure is such that they can walk away from bad deals.

In the meantime, they are borrowing against the assets of the company and paying themselves dividends with the money. You might say “they can’t be applying too much leverage, or banks wouldn’t lend them the money.” Sure, just like banks would never give mortgages to pool cleaners who made $25,000 per year. Oh wait, they did, repeatedly. To quote Mike Konczal, who is quoting Josh Mason, “It was a common trope in accounts of the housing bubble that greedy or shortsighted homeowners were extracting equity from their houses with second mortgages or cash-out refinancings to pay for extra consumption. What nobody mentioned was that the rentier class had been doing this longer, and on a much larger scale, to the country’s productive enterprises.”

Finally, I should also note that buyouts are structured as giant tax dodges. Again, this is not inherently bad; we expect companies and investors to legally minimize their taxes. But the fact is that a big part of the value of buyouts is their tax efficiency. That is why buyout firms continually sell companies to each other in a round robin of tax avoidance; they aren’t all adding “operational value.” There is only so much a bunch of ex-investment bankers can do to change the operations of a company, but each time a company is sold there is a new set of tax avoidance strategies.

How does this work? First of all, because interest payments are tax deductible, the leverage applied in a buyout is essentially subsidized. Much like homeowners are encouraged to take out larger home loans by the tax deductibility of mortgage interest, buyout firms are encouraged to leverage up as much as possible. This enables the company’s operating income be used on debt payments, amplifying returns, rather than going into taxable income. In addition, at the time of acquisitions, assets of the company can be written up to fair market value and then depreciated, with the non-cash depreciation expense also tax-deductible. That step-up in asset value at acquisition is precisely why buyout firms keep flipping companies to each other. In a perfect deal, the post-acquisition company will have taxable income below zero, but positive cash flow. In other words, regardless of whatever operational improvements a buyout firm might implement, a huge part of the value that accrues to that buyout firm is due to financial engineering, specifically financial structuring to avoid taxes.

* I will use the term “buyouts” here, which are usually leveraged but don’t need to be. Since “private equity” also refers to venture capital, I will avoid using that term.

** From a recent Vanity Fair article:
“According to Kosman, “Bain and Goldman—after putting down only $85 million … made out like bandits—a $280 million profit.” Dade’s debt rose to more than $870 million. Romney had left operational management of Bain that year, though his disclosures show that he owned 16.5 percent of the Bain partnership responsible for the Dade investment until at least 2001.
Quite soon, however, a fragile Dade faced adverse conditions in the currency markets, and it had to start in effect cannibalizing itself, cutting into the core of its business. It filed for bankruptcy in August 2002 and Bain Capital departed. When Dade emerged from bankruptcy, its new owners invested in long-term R&D, and it flourished again.”

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How Free Markets Should Work

If you really believe in the free market, you don’t think governments should bail out private entities. The whole essence of free marketeerism is the belief that markets will most efficiently allocate resources. Econ 101, and all that.

So why are so many “conservatives” defending too big to fail banks and pushing for Iceland to pay off investors in its private banks? Check out my friends at Baseline Scenario here and here for more investigation and analysis.

Ditto

See yesterday’s post, and repeat. Names change, facts remain the same.

The Myth of the Sophisticated Investor

This article in The Big Money discusses how Goldman Sachs’ defense in the Abacus CDO case – that the buyers were sophisticated investors – isn’t entirely accurate, since those sophisticated investors (banks and pension funds) get a significant amount of money from regular folks like you and me. This is true, but it only gets at half the story. In the context of Wall Street, banks and pension funds are not considered the most sophisticated players.

The reality is that Wall Street has a hierarchy, and it’s measured by compensation. Generally speaking, the smartest people go to where they can make the most money. So if you are really sharp, you’re not likely to end up managing a pension fund’s investments and being a civil servant making $200k per year. You might settle for being a bond portfolio manger at a bank, making $500k. But if you are really smart and aggressive – in other words, a sophisticated player – you are going to end up at an investment bank putting together deals that can pay you several million dollars per year.

So Goldman’s “these were big boys” defense has two flaws. One, as The Big Money points out, the big boys got their money from the little guys. But two, the buyers may have been big boys, but the Goldman bankers pushing the CDOs were men. Speaking metaphorically, of course.

Economists: Incredibly Stupid for Smart People

The New Yorker recently (I am perpetually 4-6 weeks behind in my New Yorker, so I consider the March 1 issue to be recent) profiled Paul Krugman, the Nobel Prize winning economist and NY Times columnist. A section of this article made me realize that economists, despite being generally very smart and well-educated, are just incredibly stupid. And I say this as someone who was an econ major in college and very seriously considered going on for a Ph.D.

Krugman was exploring why there were geographic specialties in business: carpets produced in Georgia, cars in Detroit, technology in Silicon Valley, etc. This was an outgrowth of his work on international trade, for which he won the Nobel. He saw that once a company started in a place, an entire ecosystem built up in that place. Trained workers, relevant support businesses (eg. lawyers), and transportation infrastructure – all this tended to create an economy of scale which drew similar businesses to the area.

To this you undoubtedly say, as I did, “duh.” That theory just describes common sense. Which Krugman admits: he explained this idea to a non-economist friend “who replied in some dismay, ‘Isn’t that pretty obvious?’ And of course it is.” But Krugman was the first to mathematically model this common sense phenomenon. Before that, “because it had not been well modeled, the idea had been disregarded by economists.”

So just to be clear: even if a phenomenon is so obvious that my 16-year old nephew could figure it out, mainstream economists, all with Ph.D.s from Ivy League schools, choose to ignore it because a model for it doesn’t exist. No wonder the country just went through a financial crisis. We all knew there was a housing bubble. It was obvious to me and everyone I talked to that Starbucks baristas and migrant farm workers and cocktail waitresses can’t afford $750,000 homes. But the economists at Treasury and the Fed who were supposed to be watching this? Their models didn’t incorporate these sorts of housing hijinks, and so they ignored the gathering storm.

Economists: smart enough to understand Bayesian math, but too stupid to realize that meth heads can’t afford houses.

Goldman Fraud and John Paulson

Finally, more than a year after the financial crisis began, the first legal action took place with the SEC charging Goldman with fraud. I don’t have much to say about the actual fraud charge, except that in prior cases like this, the first charge is rarely the last. Once discovery begins and subpoenas start being issued, all the dirty documents and emails start to come out, and the dominoes begin to fall.

I do want to talk about John Paulson’s role in this affair. Paulson was not charged with fraud, and rightly not: he didn’t misrepresent anything. From a legal standpoint, Paulson didn’t do anything wrong. But what he did – paying Goldman to create a security purely so he could bet against it – just feels wrong. As Daniel Gross of Slate put it, this is like paying a construction company to build a shoddy high-rise so that you can buy insurance that pays off if the high-rise collapses, which you know it will, because you built it out of crappy materials. I was discussing this with my friend Bark for Daddy yesterday, and I fully admit that I can’t logically make a case for why Paulson was wrong. But there is just something unseemly about it.

Although not only do Paulson’s actions feel wrong, but if you take a step back and look at the big picture, a case can be made that they really were wrong. Paulson, as much as anyone on earth, knew that we were in a housing bubble; that’s why he was betting so hard against mortgage securities. So when he paid Goldman to create a $1 billion security made up of mortgages, he was adding to the bubble, and he knew it. He knew investors were going to lose an additional $1 billion, just so he could make more money.

And make money he did: Paulson took home $3.7 billion in pay in 2007. And speaking of feeling wrong, the fact that hedge fund managers – individuals – are regularly making $1 billion per year is also unseemly. Yes, they are doing so by producing big returns for their investors, and working within the system, but then maybe something is wrong with the system. Scoring $1 billion paydays by simply trading stocks, compared to entrepreneurs who get rich by building companies, again, just feels wrong.

Business Schools Adding Creative Thinking

The NY Times recently wrote a story about how business schools are, in the wake of the financial meltdown, realizing that they need to teach future business leaders to think in creative, flexible and interdisciplinary ways. This is news? I’m no captain of industry, but to me it seems incredibly obvious that in business, like in the rest of life, the right way to make decisions is to pull together disparate data points to draw a conclusion, and then be willing to change that decision as new data comes in. Maybe the fact that this is news is what has been wrong with business schools all along.