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Vultures: Buyout Kleptocrats

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Nice illustration of criminal tricks used by private equity (from comment by jomellon  to [Mar 30, 2009]The revival of American populism Will there be blood The Economist)

March 29, 2009

The Problem that The Economist wants to talk about? Public Outrage a.k.a. Populism.

The other less important problem that a magazine called The Economist might want to address, but which it doesn't want to talk about: the economy is bust, and why.

Typical scenario for the last 18 years:

This happens 100 times so the banks are bust too, but get bailed out by the taxpayer (that's those guys who lost their jobs and pensions at Widgets)

PEI lives happily in The Bahamas with the 550 million which he 'earned' in a fabulous year of 'value creation' made possible by the power of free and light touch regulated markets.

Sadly, due to the complexity of all this the bright chaps at The Economist can not quite see why this is a slightly problematic way to run an economy... Honi suit qui mal y pense.

And if you are wondering whether firms like hedge funds and private equity funds -- significant parts of the "shadow" banking system -- add real value to the economy, you might enjoy this article by Harlan Platt about private equity, The Private Equity Myth. Download Platt. The Private Equity Myth.

The juggernaut of Kohlberg Kravis Roberts & Co. began rolling in 1976 when Jerome Kohlberg and cousins Henry Kravis and George Roberts left Bear, Stearns with about $120,000 to spend. The three invented and dominated the leveraged buyout as they sought investors and borrowed money to acquire Fortune 500 companies in dizzying succession.

Time after time, the KKR men presented a tempting offer. The CEO could cash out his company's existing shareholders by agreeing to sell the company to a new group that would be headed by KKR, but would include a lot of room for existing management. The new ownership group would take on a lot of debt, but aim to pay it off quickly. If this buyout worked out as planned, the KKR men hinted, the new owners could earn five times their money over the next five years. Presented with such a choice in the frenzied takeover climate of the 1980s, manages and corporate directors again and again said yes… To top management a leveraged buyout was the most palatable way to ride out the merger-and-acquisition craze."

They put up very little money of their own funds, but their partnerships made out like bandits. Consider the case of Owens-Illinois: KKR pup up only 4.7 percent of the purchase price. The company's chairman earned $10 million within a few years, the takeover advisors got $60 million, Owens-Illinois was left "gaunt and scaled back," and about five years later, KKR took it public at $11 a share, more than twice what the KKR partnership had paid for it.

Discussing the $26.4 billion buyout of RJR Nabisco Inc., ``Anders goes beyond what has been previously published,'' Bianco wrote, with his convincing assertion that RJR's post-deal crises pushed KKR close to ruin. Leveraged buyouts in general Anders terms ``one of the most profoundly undemocratic ventures the United States had ever seen.'' Their only lasting impact, he says, was to shift wealth from the mass of corporate employees to a managerial elite allied with Wall Street.

"For the first fourteen years of KKR's existence, the buyout firm's hallmark could be expressed in one word: debt… As KKR grew evermore powerful, Kravis and Roberts derived their economic clout from a single fact: They could borrow more money, faster, than anyone else," according to the chronicler of this high-flying firm. KKR acquired $60 billion worth of companies in wildly different industries in the 1980s: Safeway Stores, Duracell, Motel 6, Stop & Shop, Avis, Tropicana, and Playtex. They made piles of money by deducting interest expenditures from their taxes, cutting costs in their new companies and riding a long-running bull market.

This behind-the-scene accounts shows the ambition, pride, envy and fear that characterized the debt mania largely engineered by KKR, a mania that put millions out of work and made a very few very rich.


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[Apr 26, 2017] Wolf Richter Private Equity in the Thick of Bricks and Mortar Retail Implosion naked capitalism ,

Notable quotes:
"... Whether Josh Kosman's outstanding book, The Buyout of America , or Eileen Appelbaum's marvelous work, the PE swineherds have been dismantling the American (and other countries') economy for quite a few years now ..."
"... The retail market, by and large, is hosed, especially if they've decided to get into bed with PE. Amazon might be filling out the areas left bare by the collapse, but Amazon itself has a major problem in the form of counterfeit inventory which is going to blow up in its face. ..."
"... If retail's currently fried, and you can't trust what you buy on Amazon, what's left? The correction is going to take a while, and will be deeply felt, I fear. ..."
"... Philip Augar, a former banker (Schroeders, NatWest etc.) and author (Reckless Capitalism, Decline Of Gentlemanly Capitalism etc.), dedicated one of his books to Leeds United, his childhood club, "one of the early victims of this madness". ..."
"... Yet another unintended (?) consequence of QE ∞. The ZIRP simultaneously made pension funds and endowments desperate for returns and enabled PE firms to raise large amounts of money at low rates. ..."
"... But on the bright side, QE saved us over the last 8 years from the horror of meaningful fiscal stimulus and infrastructure investment. So we should thank Drs. Bernanke and Yellen and their enablers for letting the market work its magic and protecting us from the dead hand of state intervention ..."
"... interest rates are low; making payments will be easy ..."
"... Most retail jobs are already part time and now 2017-18 looks to be the death of retail altogether. Which sector is absorbing these legions of workers? ..."
"... trade means affordable junk commensurate with stagnant or declining real wages. ..."
"... Just curious. First they killed off family farms; then mom and pop stores; then they wiped out mainstreet; now they are busy demolishing brick and mortar malls. What comes next? It looks like PE might be killing itself. ..."
"... In destroying malls they are also distroying a class of investor who wanted the income based on that capital. ..."
"... Parasites destroy hosts ..."
"... There are often clauses which allow Courts to revoke Limited Liability where Fraud is suspected. A few cases of Unlimited Liability would change business practices at Board level immensely ..."
"... The Western economic model has been built around Liquidation for decades and the ramping up of liabilities within shell businesses so looters can extract equity and cash. It is so transparent that only criminals do not notice ..."
Apr 26, 2017 | www.nakedcapitalism.com
Vedant Desai , April 25, 2017 at 3:17 am

That's a new angle for evaluating Amazon : it's not that retailers are closing because Amazon is expanding . Rather its seems that Amazon is expanding Because retailers are closing. Bezos probably should thank PE firms for their destructive activities.

Art Eclectic , April 25, 2017 at 11:49 am

Exactly. The crappified shopping experience and lack of inventory came first. A miserable brick and mortar experience drove shoppers into the welcoming arms of Amazon because they just wanted to buy stuff and retail made it hard.

Vatch , April 25, 2017 at 12:46 pm

lack of inventory

A couple of days ago, reader Heron pointed this out:

http://www.nakedcapitalism.com/2017/04/amazon-com-effect-retailers-say-theyre-not-selling-consumers-report-buying.html#comment-2804851

Whether it's called "slim inventory" or "JIT", it's a problem for shoppers.

sgt_doom , April 25, 2017 at 2:01 pm

Indeed!

I'm sure an old junk bond Wall Street dood like Bezos is already pals with 'em!

Great article, and should be enlightening for those not in the know.

Whether Josh Kosman's outstanding book, The Buyout of America , or Eileen Appelbaum's marvelous work, the PE swineherds have been dismantling the American (and other countries') economy for quite a few years now , and the kings of debt, led by Peter G. Peterson who spends his free time decrying debt (?!?!?!?), are the villains of our age!

AnotherTosser , April 25, 2017 at 6:18 pm

The retail market, by and large, is hosed, especially if they've decided to get into bed with PE. Amazon might be filling out the areas left bare by the collapse, but Amazon itself has a major problem in the form of counterfeit inventory which is going to blow up in its face.

If you look at the comments on HN, more than a few people mention how they got something that was sold (sometimes by Amazon) as legit, but turned out to be fake – this stems from Amazon's practice of commingling inventory when you participate in their "fulfilled by" program. Considering their expansion into grocery and other food-type items, a counterfeit scandal is one they can ill afford.

If retail's currently fried, and you can't trust what you buy on Amazon, what's left? The correction is going to take a while, and will be deeply felt, I fear.

cnchal , April 25, 2017 at 10:06 pm

> If retail's currently fried, and you can't trust what you buy on Amazon, what's left?

Manufacturers cooperating or colluding to develop their own sales platform and cutting out Amazon and Wal Mart and selling direct to the customer.

fajensen , April 26, 2017 at 10:53 am

I do believe that alibaba.com and dealextreme.com has cornered that market opportunity already.

These days you can buy an insurance for your shipment so if your package is nailed by customs they will send another one until one finally makes it. I buy components that way, one can buy hundreds-off components at the 2-5k price levels offered by f.ex. digikey.com. Exotic stuff too.

The reason to still use Digikey & co are mainly for traceability, assured quality, genuineness and convenient re-ordering but for personal use it doesn't matter so much.

Colonel Smithers , April 25, 2017 at 5:26 am

Thank you, Yves.

You won't be surprised to hear about this scam operating in the UK. It has been the case for about thirty years and forms part of the "financial engineering" that has replaced metal bashing in Blighty.

It's not just retail, but football (aka soccer) that has fallen victim. Many clubs were similarly divided between the operating company / team and the ground. Some still are, e.g. Chelsea and Stamford Bridge.

Around the turn of the century, a former footballer (ex West Ham and Manchester City and one of the mobile chicanes negotiated by Diego Maradona for his second goal against England at the World Cup in 1986) who had made a small fortune at the Lloyd's insurance market, approached my employer, HSBC, for a loan, if not a partnership, to take over Aston Villa, which operates from a big site in Birmingham (Villa Park). His plan was to split the football club from the ground / stadium and get the club to pay the landlord rent, develop the ground for residential and retail purposes, and get the club to share a stadium with another Birmingham / Midlands region club, e.g. Birmingham City, Wolverhampton Wanderers (Wolves) or Port Vale.

HSBC wisely declined. It was still just about a boring trade bank then, but was embarking on a spree under John Bond.

Not long after, Barclays (a future employer at the time) became adviser to Leeds United. I don't know if Leeds split between club and ground (Elland Road), but the club began leasing, not buying players, and securitising the income stream. After some success, including an appearance in Europe's top competition, Leeds fell apart and is languishing in the lower divisions (minor leagues).

Philip Augar, a former banker (Schroeders, NatWest etc.) and author (Reckless Capitalism, Decline Of Gentlemanly Capitalism etc.), dedicated one of his books to Leeds United, his childhood club, "one of the early victims of this madness".

The footballer I mentioned above is still active in the City, not so much at Lloyd's (opposite one of my two offices), but with financial engineering in sport. He was widely quoted in the FT a few weeks ago.

With regard to retail, the scam played a part in the collapse of a retail chain, British Home Stores. The former chairman and main shareholder, "Sir" Philip Green, split the retail operations from the stores. He / his Monaco company owns many of the (former) sites, including what was BHS HQ in Marylebone (just down the road from Baker Street station and Mme Tussaud).

Colonel Smithers , April 25, 2017 at 5:33 am

I forgot to add that said player was still hawking the same "financial solutions" (snake oil) in the FT. The paper did not mention how the solutions had worked out. The thing is, in many cases, the solutions seem / are designed to fail, after some roaring success, and (or so) the insiders can profit from the wreckage ("disaster capitalism") as they are often creditors (e.g. the knight of the realm above) and can salvage what they consider to be the valuable bits.

Colonel Smithers , April 25, 2017 at 5:40 am

Just one more thing to add, sorry, is that many UK retailers are under similar pressure. One hears in the City that one or two household names are nearing collapse.

One well known US Main Street store merged with a well known and similar UK High Street store a couple or so years ago. They are run / owned from Switzerland, I think, by an Italian, whose PE firm, again based off shore, is one of the biggest shareholders in the group. The Italian billionaire ran the UK firm before the merger. They are rumoured to be one, if not the, next domino.

allan , April 25, 2017 at 6:58 am

Yet another unintended (?) consequence of QE ∞. The ZIRP simultaneously made pension funds and endowments desperate for returns and enabled PE firms to raise large amounts of money at low rates.

But on the bright side, QE saved us over the last 8 years from the horror of meaningful fiscal stimulus and infrastructure investment. So we should thank Drs. Bernanke and Yellen and their enablers for letting the market work its magic and protecting us from the dead hand of state intervention .

Jim A. , April 25, 2017 at 8:06 am

And the great recession meant that there were plenty of stressed business which PE funds could gain controlling interests in for relatively low cost.

Grumpy Engineer , April 25, 2017 at 9:58 am

ZIRP also made it easier to load all of these retailers up with excess debt. Management could borrow more money than necessary, pay themselves lavish bonuses with the excess, and claim that " interest rates are low; making payments will be easy ". They could even show you the math.

Of course, that math assumed that sales would steadily climb into the future. If sales fell even slightly, the payments became an oversized burden. And paying off the enormous loan principal was beyond all hope.

Companies with little debt can generally survive a reduction in sales. They can engage in cost-cutting exercises, maybe encourage some employees to retire earlier, etc. It's even easier if they own their own property and don't have to renegotiate a lease. But when you've got a lot of debt and servicing that debt requires that sales continue to rise quarter after quarter after quarter without fail, then things get a LOT more fragile. The effects of even a single bad quarter get greatly amplified. ["Leverage" can work both ways.] And steadily-declining sales are the kiss of death.

Oh, yes. Ultra-low interest rates "helped" retailers a lot. Helped set them up for failure, that is.

HBE , April 25, 2017 at 8:14 am

Most retail jobs are already part time and now 2017-18 looks to be the death of retail altogether. Which sector is absorbing these legions of workers?

It's certainly not manufacturing and I'm fairly certain 60,000 new Uber drivers didn't hit the streets.

RUKidding , April 25, 2017 at 8:48 am

I dunno but seems like every time I turn around I discover someone else I know who's driving for Uber and/or Lyft. All age groups. All struggling to survive.

The demise of retail is especially chilling as it used to be a sort of fall-back job. Not no more.

Where's all the zillions of jawbs Trump is going to magically provide??

justanotherprogressive , April 25, 2017 at 9:39 am

I see that Trump today is claiming he's created 500,000 new jobs in his first 100 days, but he doesn't say what these jobs are or where these jobs are – obviously they aren't in my state

RUKidding , April 25, 2017 at 10:17 am

Maybe Trump's claiming responsibility for creating 500,000 new Uber and Lyft jawbs?

Guess a huge component of Boeing workers are about to become Uber drivers in Seattle in May. Woo hoo!

Thanks, Trump!

MyLessThanPrimeBeef , April 25, 2017 at 2:35 pm

Technology is doing its best to hide the misery of the 99% temporarily.

"Take out a loan and get a car. Defer maintenance. Get cash flow now!"

"Get more cash flow renting out your bathroom and living room."

sgt_doom , April 25, 2017 at 2:04 pm

" Which sector is absorbing these legions of workers?"

That's a good one (LFMAO)!

Ed , April 25, 2017 at 10:10 am

I know some firm bought Friendlys the ice cream/restaurant took the ice cream in a box business and split it off then left the restaurant part to die. It was American businesses​ best friend Sun Capital.

McWatt , April 25, 2017 at 10:36 am

Interestingly, it seems to me, that the off shoring of clothing manufacturing to China, and the subsequent fall in inventory cost to retailers and the incredible margins they operate on hasn't done anyone any good in the end.

FedUpPleb , April 25, 2017 at 10:47 am

I have found retail shopping over the last ten years to be a poor now bordering on depressing experience. Poor selection, sparse stores, uncompetitive prices,staff either untrained or trained only to nag about loyalty cards, and the quality of items has nosedived across the board. Even the "luxury" items are cheap and poorly made. The only consistent exception to this trend is toy stores. I guess kids are tougher customers.

I hate shopping online. I hate the uncertainty. I hate the delay. I hate the decision fatigue. But what choice do I even have anymore? It costs me more petrol to go shopping than they charge for delivery.

sgt_doom , April 25, 2017 at 2:05 pm

Thanks, FedUpPleb - I keep telling this to the stooges who keep prattling on about the low cost of items - which are far too expensive, last only several washings (delicate cycle only, of course) or several months and are of the poorest quality, completely different from my youth!

Sutter Cane , April 25, 2017 at 12:28 pm

Given the post and the comments, it actually sounds like the future for retailers that survive doesn't seem so bleak, IF (big if):

1. They manage to avoid private equity takeover
2. Don't take on debt
3. Make customer service a priority
4. Sell quality goods a step above the usual Chinese garbage found everywhere else (or at least that can't be shipped as easily)
4. Keep their stores updated and pleasant to visit

What with all of the closures, there might be opportunities for the retailers that survive if they avoid the mistakes of their fallen competitors. But are there any examples of companies out there that are doing these things? Nordstrom? Costco? Anybody?

MyLessThanPrimeBeef , April 25, 2017 at 2:42 pm

There retailers are national chain retailers.

Before them, there were mom-and-pop retailers. They had bleak-future-moment a long, long time ago.

Perhaps they will come back one day, when people make enough money to value service again, instead of supporting 'trade' as a WSJ poll shows, because trade means affordable junk commensurate with stagnant or declining real wages.

Ancient 1 , April 25, 2017 at 12:52 pm

You can blame the present situation that Neiman Marcus is dealing with on it managers, especially Ms. Katz, who were paid a lot of money in the sell out to PE. These people have destroyed an old Dallas brand with their greed and mismanagement. A brand that has a history of innovation and customer service driven by Stanley Marcus. A real loss for Dallas and for retail history,

anonymous , April 25, 2017 at 1:00 pm

I stopped buying clothes at brick and mortar stores starting around a decade ago because of crapification. If you need tall sizes for shirts, you used to be able to get these at most every department store, but over the last decade or two almost every department store around these parts was sold and restructured; after these changes the stores always have less inventory for higher prices. Now the only place you can find a wide selection of tall sizes is the internet.

Retail clothiers have essentially said we're not interested in selling things to tall men. And they're not interested in selling things to large men, or large women, or short people, or old people.

How badly should I feel about the disappearance of an industry that decided they had no interest in me whatsoever?

Dave , April 25, 2017 at 10:15 pm

Asians, Hispanics and teenagers are a more important market to them than tall white and black men.

Susan the other , April 25, 2017 at 1:26 pm

Just curious. First they killed off family farms; then mom and pop stores; then they wiped out mainstreet; now they are busy demolishing brick and mortar malls. What comes next? It looks like PE might be killing itself.

Synoia , April 25, 2017 at 1:49 pm

In destroying malls they are also distroying a class of investor who wanted the income based on that capital.

Many of the 10% are heavily invested in mall real estate,

Paul Greenwood , April 26, 2017 at 1:42 am

Parasites destroy hosts

Lambert Strether , April 26, 2017 at 2:02 am

Not all of them. Looks like ours might, though.

allan , April 25, 2017 at 2:20 pm

April 25 – Guitar Center :

Guitar Center's latest jam: Future threatened by its huge debt burden
[Marketwatch]

Is the big leveraged buyout wave of 2005-2007 about to claim another victim?

Bonds issued by Guitar Center, the biggest retailer of musical instruments in the world, are languishing at record lows on growing concern that the company is going to be overwhelmed by its roughly $1 billion of outstanding bond debt, part of a debt burden that totals about $1.6 billion, once loans and other borrowings are included.

in 2007, the company was taken private by Mitt Romney's former private-equity firm Bain Capital in an LBO valued at $2.1 billion that left it saddled with $1.6 billion of high-yield debt. Coming just ahead of the 2008 financial crisis, the company struggled with its high interest payments for several years.

In 2014, its main creditor, private-equity firm Ares Management LLC, took a controlling stake in the company in a deal in which it converted some of its debt into equity, and left Bain as a partial owner with representation on the board.

As Mitt would say, why don't they get a loan from their parents?

Yves Smith Post author , April 25, 2017 at 2:22 pm

We had several posts on Guitar Center:

http://www.nakedcapitalism.com/2014/08/guitar-center-private-equitys-magical-growth-curve.html

http://www.nakedcapitalism.com/2015/02/end-guitar-center.html

http://www.nakedcapitalism.com/2016/02/eric-garland-seven-lessons-from-how-private-equity-wrecked-guitar-center.html

Sutter Cane , April 25, 2017 at 3:44 pm

I used to enjoy Garland's writing about Guitar Center. Too bad he embarrassed himself and became the epitome of the deluded Clintonite liberal with his "Time for some game theory" tweetstorm.

MyLessThanPrimeBeef , April 25, 2017 at 2:37 pm

Who was the smarter private equity kid in the room – Bain or Ares?

Pwelder , April 25, 2017 at 6:55 pm

Ares had a deal down in West Texas with Clayton Williams Energy Inc. (You remember Clayton – he ran for Governor of Texas against Ann Richards) Unfortunately Clayton decided not to hedge his production for 2015-6, just before the Saudis pulled the plug on the oil price in November 2014.

All of a sudden CWEI, whose share price had been bouncing around above $100, was two jumps ahead of the sheriff with bankruptcy a real threat. The stock got down to 7.

Beginning last March Ares put in a bunch of equity and debt, and it turned out Clayton had squirreled away a ton of acres in the best part of the Permian Basin. With BK off the table the stock price recovered, Noble Energy bought them out for $130+ per share, and Ares made about six times their money in less than a year.

What's interesting for present purposes is there was no asset-stripping or any other shenanigans. Ares took a risk – which looked huge at the time – and made out like bandits. That's how it's supposed to work. And the funny thing is, Ares is owned by a bunch of Arabs out in the Middle East.

Great piece by Richter and Yves – and a lot of smart commentary from out here in the bleachers. Thanks to all.

Paul Greenwood , April 26, 2017 at 1:42 am

There are often clauses which allow Courts to revoke Limited Liability where Fraud is suspected. A few cases of Unlimited Liability would change business practices at Board level immensely

jo6pac , April 25, 2017 at 5:17 pm

I buy about 50% my stuff on line and stores that have figured out to make themselves web friendly are best buy, home depot, osh, and then some manufacture like Haynes underwear have friendly sites. These 3 box stores site went from impossible to use to very friendly to use and shipping is normally free over small amount.

I had to buy a new blue tooth the other day and amazon wanted $170.00 I then went to the company site and it's very much improved bought recondition one for $39.00 free shipping. The new one there was $69.00 they have a third party sell through their site.

JustAnObserver , April 25, 2017 at 6:30 pm

Very interesting. Could Amazon suffer the fate that people go there to browse what's available but then buy online direct from the maker's site ? As you remarked many of the manufacturers' sites have vastly improved as well as their access to fast shipping channels.

This is already a known defense against the proliferation of counterfeit goods on generic online sites like Amazon that really don't give a f**k about the fakes problem as long as they get their cut of the price.

Laura weaver , April 25, 2017 at 8:21 pm

Big box retailers appear to be the " canary in the coal mine " !!

Mark , April 25, 2017 at 10:36 pm

I am a sales rep who sells retailers, both big and small. My accounts are struggling to stay even. No one mentions Amazon as competition, but it is a huge factor.

My three reasons why retail is in decline:

1. Amazon

2. Anyone younger than 35 just doesn't buy or even want to accumulate stuff. They just want wifi and to play with their phones. I wanted everything when I was young and for the most part, still do.

3. The economy. 2% GDP isn't exactly blazing.

Good luck

Paul Greenwood , April 26, 2017 at 1:40 am

private equity fund managers do have an incentive not to burn private equity limited partners,

So they flip it at an inflated value to another PE buyer to keep portfolio performances looking good and churn regularly until a secondary-fund picks it up to forward to a Liquidation Front Company. It is exactly what Philip Green did at BHS having stripped a £1 billion dividend courtesy of HBOS corruption.

This game was well exposed under Robert Campeau decades ago. It is amazing how the old shell games continue. Same story at Karstadt in Germany with Thomas Middlehof and the Arcandor disaster.

The Western economic model has been built around Liquidation for decades and the ramping up of liabilities within shell businesses so looters can extract equity and cash. It is so transparent that only criminals do not notice

[Aug 25, 2012] Romney Tax Files: Converting Management Fees Into Carried Interest

August 24, 2012 | Jesse's Café Américain

When Gawker first published the Bain Capital tax return data I remember reading somewhere that one should not bother even looking at them because they are not relevant and won't tell you anything.

That struck me as odd at the time. How could someone just dismiss information like this as not even worth reading? Move on, don't look at them?

Well, apparently that is not the case. They seem to contain some nuggets of information suggesting that Romney was being particular aggressive (euphemism for engaging in extra-legal activity) in misstating not trivial income for the purpose of avoiding taxes.

One can only wonder what those undisclosed personal returns might contain.

I don't want to pick on Mitt in particular, although he is starting to look like a setup to make the other guy look good. And what he had done with his income from Bain is certainly open to interpretation as the author admits.

But rather, this speaks to the 'rule of law' issue and how there is a duality in the US, and some animals are more equal than others. And strangely enough, the barnyard hoots its approval.

"Private equity fund managers are compensated in two primary ways: management fees and carried interest. The management fee, traditionally two percent annually, is paid to the managers to cover overhead, salaries, and so forth. The carried interest, traditionally twenty percent, is a share of the profits from the underlying investments. My paper Two and Twenty described the typical arrangement.

Management fees are taxed at ordinary income rates; carried interest is often taxed at capital gains rates (around 15 percent - Jesse). I focused in the article on why the carried interest portion is better viewed like bonus compensation and should be taxed at ordinary income rates.

Current law on carried interest is already a sweetheart tax deal for private equity, but why not make it better? Private equity folks are not the type to walk past a twenty-dollar bill lying on the sidewalk.

In the 2000s it became common for private equity fund managers to "convert" their management fees into carried interest. There are many variations on the theme, but here's how many deals worked: each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don't foresee any future profits, they won't waive the fees, and they will take cash instead.)

In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.

The problem is that it is not legal. Because the deals vary in their aggressiveness, there is some disagreement among practitioners about when it works and when it doesn't. But in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it's unlikely that they would have stood up in court.

Gawker today posted some Bain documents today showing that Bain, like many other PE firms, had engaged in this practice of converting management fees into capital gain. Unlike carried interest, which is unseemly but perfectly legal, Bain's management fee conversions are not legal. If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income."

Victor Fleischer, Romney's Management Fee Conversions

Read the entire article here.

[Jan 23, 2012] How Private Equity Firms Like Bain Capital Earn Profits The New Yorker

Jan 30, 2012 | http://www.newyorker.com/
At this point, the people who run America's private-equity funds must be ruing the day Mitt Romney decided to run for President. His fellow Republican candidates, of all people, have painted a vivid picture of private-equity firms-including Bain Capital, where he worked for fifteen years-as job-destroying vultures, who scavenge the meat from American companies and leave their carcasses by the side of the road. Not since the days of "Wall Street" and "Barbarians at the Gate" have the masters of leveraged buyouts looked quite so bad.

Given the weak job market, it makes sense that the attacks have focussed on layoffs. But the real problem with leveraged-buyout firms isn't their impact on jobs, which studies suggest isn't that substantial one way or the other. A 2008 study of companies bought by private-equity firms found that their job growth was only about one per cent slower than at similar, public companies; there was more job destruction but also more job creation. And, while private-equity firms are not great employers in terms of wage growth, there's not much evidence that they're significantly worse than the rest of corporate America, which has been treating workers more stingily for about three decades.

The real reason that we should be concerned about private equity's expanding power lies in the way these firms have become increasingly adept at using financial gimmicks to line their pockets, deriving enormous wealth not from management or investing skills but, rather, from the way the U.S. tax system works. Indeed, for an industry that's often held up as an exemplar of free-market capitalism, private equity is surprisingly dependent on government subsidies for its profits. Financial engineering has always been central to leveraged buyouts. In a typical deal, a private-equity firm buys a company, using some of its own money and some borrowed money. It then tries to improve the performance of the acquired company, with an eye toward cashing out by selling it or taking it public. The key to this strategy is debt: the model encourages firms to borrow as much as possible, since, just as with a mortgage, the less money you put down, the bigger your potential return on investment. The rewards can be extraordinary: when Romney was at Bain, it supposedly earned eighty-eight per cent a year for its investors. But piles of debt also increase the risk that companies will go bust.

This approach has one obvious virtue: if a private-equity firm wants to make money, it has to improve the value of the companies it buys. Sometimes the improvement may be more cosmetic than real, but historically private-equity firms have in principle had a powerful incentive to make companies perform better. In the past decade, though, that calculus changed. Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge "special dividends." This allowed them to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value-they just redistributed money from the company to the private-equity investors.

As a result, private-equity firms are increasingly able to profit even if the companies they run go under-an outcome made much likelier by all the extra borrowing-and many companies have been getting picked clean. In 2004, for instance, Wasserstein & Company bought the thriving mail-order fruit retailer Harry and David. The following year, Wasserstein and other investors took out more than a hundred million in dividends, paid for with borrowed money-covering their original investment plus a twenty-three per cent profit-and charged Harry and David millions in "management fees." Last year, Harry and David defaulted on its debt and dumped its pension obligations. In other words, Wasserstein failed to improve the company's performance, failed to meet its obligations to creditors, screwed its workers, and still made a profit. That's not exactly how capitalism is supposed to work.

The people who ran Harry and David into the ground have a defense: economic conditions changed in unforeseeable ways. But that's precisely why loading firms with debt in order to reap short-term benefits is bad. It leaves companies unable to weather tough times, and allows private-equity firms to make money even if things go wrong.

As if this weren't galling enough, taxpayers are left on the hook. Interest payments on all that debt are tax-deductible; when pensions are dumped, a federal agency called the Pension Benefit Guaranty Corporation picks up the tab; and the money that the dealmakers earn is taxed at a much lower rate than normal income would be, thanks to the so-called "carried interest" loophole. The money that Mitt Romney made when he was at Bain Capital was compensation for his (apparently excellent) work, but, instead of being taxed as income, it was taxed as a capital gain. It's a very cozy arrangement.

If private-equity firms are as good at remaking companies as they claim, they don't need tax loopholes to make money. If we capped the deductibility of corporate debt, and closed the carried-interest loophole, it would not prevent private-equity firms from buying companies or improving corporate performance. But it would reduce the incentives for financial gimmickry and save taxpayers billions every year. Private-equity firms are excellent at gaming the rules. Time to change them.

Chapter 19 – The Leveraged Buyout Mob

During the entire decade of the 1980's, the policies of the Reagan Bush and Bush administrations encouraged one of the greatest paroxysms of speculation and usury that the world has ever seen. Starting especially in the summer of 1982, a malignant and cancerous mass of speculative paper spread through all the vital organs of the banking, credit, and financial system. Capital had long since ceased to be used for the creation of new productive plant and equipment, and new productive manufacturing jobs; investment in transportation, power systems, education, health services and other infrastructure declined well below thje break even level. Wall Street investors came more and more to resemble vampires who ranged over a ghouilish landscape in search of living prey whose blood they could suck to perpetuate their own lively form of death.

Industrial employment was out, the service sector was in. The post-industrial society meant that the production of tangible, physical wealth, of hard commodities, within US borders was being terminated. The future would belong to parasitical legions of lawyers, financial services experts, accountants, and clerical support personnel, but the growth in the balance of payments deficit signalled that the game could not go on forever.

On the surface, wild speculation was the order of the day: there was the stock market boom, which underwent a crash in 1987, but then, thanks to James Brady's drugged futures and index options markets, kept rising until the Dow had passed 3,000, although by that time no one could remember why it was still called the industrial average. The stock market provided the right atmosphere for a much broader speculative boom, the one in commercial and residential real estate, which kept going until almost the end of the decade, but which then began to crash with a vengeance. When real estate began to implode, as in Texas at the middle of the 1980's or the northeast after 1988, savings banks and commercial banks by the scores became insolvent. Thus, by the third year of the Bush administration, a bankrupt savings and loan was being seized by federal regulators on almost every business day, and Congressman Dingell of Michigan had to announce that Citibank, still the largest bank in the USA, was indeed "technically" bankrupt. Depositors in Hong Kong started a run on the Citibank branch there; their US counterparts were slower to react, perhaps because deluded by the pathetic faith that the Federal Deposit Insurance Corporation could still cover their deposits.

Even more fundamental than speculation was the absolute primacy of debt. During the Reagan and Bush years, unprecedented federal deficits pushed the public debt of the United States into the ionosphere, with the total almost quadrupling over a little more than ten years to approach the fantastic total of $3.25 thousand billion. In 1989, it was estimated that total debt claims in the US economy had attained almost $25 thousand billion, and their total has increased exponentially ever since. The debt of state and local governments, corporate debt, consumer debt –all expanded into the wild blue yonder. In the meantime, the Great Lakes industrial region became the rust bowl, the Sun belt oil and computer booms collapsed, the great cities of the east were rotten to the core with slums, and farmers went bankrupt more rapidly than at any other time in the memory of man.

Living standards had been in a gradual but constant decline since the days of Nixon, and it began to dawn on more and more families who considered themselves members of the middle class that they could no longer afford their own home, nor hope to send their children to college, all because of the prohibitive costs. The Bureau of the Census made sure in 1990 not to count the number of those who had become homeless during the 1980's, since the real figure would be an acute political embarrassment to George Bush: were there 5 million, or 6, as many as the total population of Sweden, or of Belgium?

New jobs were created, but most of them were dead-ends for losers at or below the mimimum wage that presupposed illiteracy on the part of the applicant: hamburger sales and pizza home delivery were the growth areas, although a smart kid might still aspire to become a croupier. Behind it all lurked the pervasive narcotics trade, with hundreds of billions of dollars a year in heroin, crack, marijuana.

For the vast majority of the US population (to say nothing of the brutal immiseration in the developing countries) it was an epoch of austerity, sacrifice, and decline, of the entropy of a society in which most people have no purpose and feel themselves becoming redundant, both on the job market and ontologically.

But for a paper thin stratum of plutocrats and parasites, the 1980's were a time of unlimited opportunity. These were the practioners of the monstrous financial swindles that marked the decade, the protagonists of the hostile takeovers, mergers and acquisitions, leveraged buy-outs, greenmail and stock plays that occupied the admiration of Wall Street. These were corporate raiders like J. Hugh Liedkte, Blaine Kerr, T. Boone Pickens, and Frank Lorenzo, Wall Street financiers like Henry Kravis and Nicholas Brady.

... ... ...

Henry Kravis's epic achievements in speculation and usury perhaps had something to do with the fact that he was a close family friend of George Bush.

As we have seen, when Prescott Bush was arranging a job for young George Herbert Walker Bush in 1948, he contacted Ray Kravis of Tulsa, Oklahoma, whose business included helping Brown Brothers, Harriman to evaluate the oil reserves of companies. Ray Kravis had quickly offered George a job, but George declined it, preferring to go to work for Dresser Industries, a much larger company. That was how George had ended up in Odessa and Midland, in the Permian basin of Texas. Ray Kravis over the years had kept in close touch with Senator Prescott Bush and George Bush, and young Henry Kravis had been introduced to George and had hob-nobbed with him at various Republican Party and other fund-raising events. Henry Kravis by the early 1980's was a member of the Republican Party's elite Inner Circle.

Bush and Henry Kravis became even more closely associated during the time that Bush, ever mindful of campaign financing, was preparing his bid for the presidency. Among political contributors, Henry Kravis was a very high roller. In 1987-88, Kravis gave over $80,000 to various senators, congressmen, Republican Political Action Committees, and the Republican National Committee. During 1988, Kravis gave $100,000 to the GOP Team 100, which meant a "soft money" contribution to the Bush campaign. Kravis's partner George Roberts also anted up $100,000 for the Republican Team 100. In 1989, the first year in which it was owned by KKR, RJR Nabisco also gave $100,000 to Team 100. During that year, Kravis and Roberts gave $25,000 each to the GOP.

During the 1988 primary season, Kravis was the co-chair of a lavish Bush fundraiser at the Vista Hotel in lower Manhattan at which Henry's fellow Wall Street dealmakers and financier fatcats coughed up a total of $550,000 for Bush. Part of Kravis's symbolic recompense was to be honored with the prestigious title of co-chairman of Bush's Inaugural Dinner in January, 1989. One year later, in January 1990, Kravis was the National Chairman of Bush's Inaugural Anniversary Dinner. This was a glittering gala held at the Kennedy Center in Washington for a thousand members of the Republican Eagles, most of whom qualify by giving the GOP $15,000 or more. The entertainment was organized as an "oldies night," with Chubby Checker, Tony Bennett, and B.B. King. When George Bush addressed the Eagles, he was prodigal in his praise for Henry Kravis as one of "those who did the heavy lifting on this." [fn 5 ]

According to Jonathan Bush, George Bush's brother and the finance chiarman of the New York State Republican Party, Henry Kravis was "very helpful to President Bush in fundraisers." According to brother Jonathan, Kravis "admired the President. And also, significantly, on a personal level, his father, Ray, and [George Bush] were friends from way back. And that meant a lot to Henry. He wanted to be part of that."

Henry Kravis had married the former Janey Smith of Kirksville, Missouri, who now called herself Carolyne Roehm. Carolyne Roehm had been introduced into New York Nouvelle Society by Oscar de la Renta. She and Henry Kravis cultivated a frenetically sybaritic lifestyle in the company of a social circle that included Bush's patron Henry Kissinger, American Express Chairman Jim Robinson and his wife Linda, Donald and Ivana Trump, Anne Bass, corporate raider Saul Steinberg, cosmetics magnate Ronald Lauder, and Bush's finance operative Robert Mosbacher and his wife Georgette. It was very much a Bushman crowd. Kravis and his "trophy wife" lived in a Park Avenue apartment large enough to be a Hollywood sound stage, and also had a 270 acre estate in Weatherstone, Connecticut. The palatial house there, which is listed in the National Historic Register, has nine fireplaces. Henry and Carolyne added a $7 million, six-building, 42,000 square foot "farm complex" for their seven horses. This was Henry Kravis, chief stoker of the bonfire of the vanities, celebrated by Vice President Dan Quayle as the New York Republican Party Man of the Year.

It was to such an apostle of usury that George Bush turned for advice on public policy in economics and finance. According to Kravis, Bush "writes me handwritten notes all the time and he calls me and stuff, and we talk." The talk concerned what the US government should do in areas of immediate interest to Kravis: "We talked on corporate debt–this was going back a few years–and what that meant to the private sector," said Kravis.

Henry Kravis certainly knows all about debt. The 1980's witnessed the triumph of debt over equity, with a tenfold increase in total corporate debt during the decade, while production, productive capacity, and unemployment stagnated and declined. One of the principal ways in which this debt was loaded onto a shrinking productive base was through the technique of the hostile, junk-bond assisted leveraaged buyout, of which Henry Kravis and his firm were the leading practitioners.

The economist Franco Modigliani had written in the 1950's about the theoretical debt limits of corporations. Small scale leveraged buyouts were pioneered by Kohlberg during the late 1970's. In its final form, the technique looked something like this: Corporate raiders looked around for companies that would be worth more than their current stock price if they were broken up and sold off. Using money borrowed from a number of sources, the raider would make a tender offer (once again, a la Jimmy Gammell in the Liedkte United Gas buyout) or otherwise secure a majority of the shares. Often all outstanding shares in the company would be bought up, taking the company private, with ownership residing in a small group of financiers. The company would end up saddled with an immense amount of new debt, often in the form of high-yield, high-risk sunbordinated debt certificates called junk bonds. The risk on these was high since, if the company were to go bankrupt and be auctioned off, the holders of the junk bonds would be the last to get any compensation.

Often, the first move of the raider after seizing control of the company and forcing out its existing management would be to sell off the parts of the firm that produced the least cash-flow, since enhanced cash flow was imperative to start paying the new debt. Proceeds from these sales could also be used to pay down some of the initial debt, but this process inevitably meant jobs destroyed and production diminished.

These raiding operations were justified by a fascistoid-populist demagogy that accused the existing management of incompetence, indolence and greed. The LBO pirates professed to have the interests of the shareholders at heart, and made much of the fact that their operations increased the value of the stock and, in the case of tender offers, gave the stockholders a better price than they would have gotten otherwise. The litany of the corporate raider was built around his committment to "maximize shareholder value;" workers, bondholders, the public, and management were all expendable. Ivan Boesky and others further embroidered this with a direct apology for greed as a motor force of progress in human affairs.

An important enticement to transform stocks and equity into bonded and other debt was provided by the insanity of the US tax code, which taxed profits distributed to shareholders, but not the debt paid on junk bonds. The ascendancy of the leveraged buyout therefore proceeded pari passu with the demolition of the US corporate tax base, contributing in no small way to the growth of federal deficits. Plutocrats are always adept in finding loopholes to avoid paying their taxes. Ultimately, the big profits were expected when the companies acquired, after having been downsized to "lean and mean" dimensions, had their stock sold back to the public. KKR reserved itself 20% of the profits on these final transactions. In the meantime Kravis and his associates collected investment banking fees, retainer fees, directors' fees, management fees, monitoring fees, and a plethora of other charges for their services.

The leverage was accomplished by the smaller amount of equity left outstanding in comparison with the vastly increased debt. This meant that if, after deducting the debt service, profits went up, the return to the investors could become very high. Naturally, if losses began to appear, reverse leverage would come into play, producing astronomical amounts of red ink. Most fundamental was that companies were being loaded with debt during the years of what the Reagan-Bush regime insisted on calling a boom. It was evident to any sober observer that in case of a recession or a new depression, many of the companies that had succumbed to leveraged buyouts and related forces of usury would very rapidly become insolvent. The Reagan-Bush regime was forced to argue that supply-side economics and Bush's deregulation had abrogated the business cycle, and that there never would be any more recessions. This is why the "recession" (in reality the exacerbation of the pre-existing depression) that George Bush was forced to acknowledge during late 1990 was so ominous in its implications. The leveraged buyouts of the 1980's were now doomed to collapse. The handwriting on the wall was clear by September-October of 1989, the first year of George Bush's presidency, when the $250 billion market for junk bonds collapsed just in advance of the mini-crash of the New York Stock Exchange.

All in all, during the years between 1982 and 1988, more than 10,000 merger and acquisition deals were completed within the borders of the USA, for a total capitlization of $1 trillion. There were in addition 3500 international mergers and acquisitions for another $500 billion. [fn 6 ] The enforcement of antitrust laws atrophied into nothing: as one observer said of the late 1980's, "such concentrations had not been allowed since the early days of antitrust at the beginning of the century."

George Bush's friend Henry Kravis raised money for his leveraged buyouts from a number of sources. Money came first of all from insurance companies such as the Metropolitan Life Insurance Company of New York, which cultivated a close relation with KKR over a number of years. Met was joined by Prudential, Aetna, and Northwest Mutual. Then there were banks like Manufacturers Hanover Trust and Bankers Trust. All these institutions were attracted by astronomical rates of return on KKR investments, estimated at 32.2% in 1980, 41.8% in 1982, 28% in 1984, and 29.6% in 1986. By 1987, KKR prospectus boasted that they had carried out the first large LBO of a publicly held company, the first billion-dollar LBO, the first large LBO of a public company via tender offer, and the largest LBO in history, Beatrice Foods.

Then came the state pension funds, who were also anxious to share in these very large returns. The first to begin investing with KKR was Oregon, which shovelled money to KKR like there was no tomorrow. Other states that joined in were Washington, Utah, Minnesota, Michigan, New York, Wisconsin, Illinois, Iowa, Massachusetts, and Montana. The decisions to committ funds were typically made by state boards. An example is Minnesota: here the State Board of Investment is made up of the Governor, the state Treasurer, the state auditor, the Secretary of State, and the Attorney General, currently Skip Humphrey. Some of these funds are so heavily committed to KKR that if any of the highly-leveraged deals should go sour in the current "recession," pensions for many retired state workers in those states would soon cease to exist. In that eventuality, which for many working people has already occurred, the victims should remember George Bush, the political godfather of Henry Kravis and KKR.

KKR had one other very important source of capital for its deals: this was the now-defunct Wall Strreet investment firm of Drexel, Burnham, Lambert, and its California-based junk bond king, Michael Milken. Drexel and Milken were the most important single customers KKR had. (Drexel had its own Harriman link: it had merged with Harriman Ripley & Co. of New York in 1966.) During the period of close working alliance between KKR and Drexel, Milken's junk-bond operation raised an estimated $20 billion of funds for KKR. Junk bonds were high-risk, high-yield, junior debt securities that Milken floated. He started off with junk bonds issued by fly-by-night insurance companies owned by financiers seeking to emerge from the penumbra of Meyer Lansky. These included Carl Lindner and his Great American; Saul Steinberg and his Reliance Insurance Co., Meshulam Riklis and his Rapid American group; Laurence Tisch and CNA; Nelson Peltz; Victor Posner; Carl Icahn; Thomas Spiegel and his Columbia Savings and Loan; and Fred Carr, a financial gunslinger of the 1960's and his First Executive Corp. insurance firm. Later, the circle of Milken's customers would expand to include commercial banks, savings and loans, mutual funds, upscale insurance companies and others who could not resist the high yields. These robbery barons of modern usury were dubbed "Milken's monsters" by one of their number, Meshulam Riklis.

All of these personages pranced at Milken's annual meetings in Beverley Hills, which were followed by evenings of sumptuous entertainment. These became known as "the predators' ball," and attracted such people as T. Boone Pickens, Icahn, Irwin Jacobs, Sir James Goldsmith, Oscar Wyatt, Saul Steinberg, Boesky, Lindner, the Canadian Belzberg family, Ron Perelman, and other such figures.

First Executive Corp. was the first great bankruptcy among the insurance companies in early 1991, giving the depression of the 1990's a dimension that the economic-financial conflagration of the 1930's did not possess. First Executive Life succumbed to losses on its junk bond portfolio, and it will be the first of many insurance companies to find bankrutpcy via this route. Shortly thereafter, Mutual Benefit Life Insurance Company of New Jersey was seized by state regulators. Mutual Benefit was also the victim of combined real estate and junk bond losses, and more retirement plans were threatened with annihlitation. Those whose pensions are lost must recall the junk bond united front that reached from Milken to Kravis to Bush.

Spiegel's Columbia S&L is a classic case of a thrift institution that went wild in its acquisition of Milken's high-yield junk. At one time this instutution had about $10 billion of junk in its portfolio. Columbia S&L was seized by federal regulators during the early months of 1990. Although many savings and loan bankruptcies have been caused by real estate speculation, many must also be attributed to a failed quest for a junk bonanza.

Milken's silent partner was Ivan Boesky, the arbitrageur who went beyond program trading to become a silent partner in advancing Milken's stockjobbing: sometimes Milkenm would have Boesky begin to acquire the stock of a certain company so as to signal to the market that it was in play, setting off a stampede of buyers when this suited Milken's strategy.

The Beatrice LBO illustrates how necessary Milken's role was to the overall strategy of Bush backer Kravis. Beatrice was the biggest LBO up to the time it was completed in January-February 1986, with a price tag of $8.2 billion. As part of this deal, Kravis gave Milken warrants for five million shares of stock in the new Beatrice corporation. These warrants could be used in the future to buy Beatrice shares at a small fraction of the market price. One result of this would be a dilution of the equity of the other investors. Milken kept the warrants for his own account, rather than offer them to his junk bond buyers in order to get a better price for the Beatrice junk bonds. Later in the same year, KKR bought out Safeway grocery stores for $4.1 billion, of which a large part came from Milken.

After 1986, Kravis and Roberts were gripped by financial megalomania. Between 1987 and 1989, they acquired 8 additional companies with an aggregate price tag of $43.9 billion. These new victims included Owens-Illinois glass, Duracell, Stop and Shop food markets, and, in the landmark transaction of the 1980's, RJR Nabisco. RJR Nabisco was the product of a number of earlier mergers: National Bisucuit Company had merged with Standard Brands to form Nabisco Brands, and this in turn merged with R.J. Reynolds Tobacco to create RJR Nabisco. It is important to recall that R.J. Reynolds was the concern traditionally controlled by the family of Bush's personal White House lawyer, C. Boyden "Boy" Gray.

The battle for control of RJR Nabisco was lost by RJR Nabisco chairman Ross Johnson, Peter Cohen of Sherason Lehman Hutton and the notorious John Gutfruend of Salomon Brothers. KKR opposed this group, and a third offer for RJR came from First Boston. The Johnson offer and the KKR were about the same, but a cover story in the Luce-Skull and Bones Time Magazine in early December, 1988 targetted Johnson as the greedy party. The attraction of RJR Nabisco, one of the twenty largest US corporations, was an immense cash flow supplied especially by its cigarette sales, where profit margins were enormous. The crucial phases of the fight corresponded with the presidential election of 1988: Bush won the White House, so it was no surprise that Kravis won RJR with a bid of about $109 per share compared to a stock price of about $55 per share before the company was put into play, giving the prebuyout shareholders a capital gain of more than $13.3 billion. How much of that went to Boy Gray of the Bush White House?

The RJR Nabisco swindle generated senior bank debt of about $15 billion. The came $5 billion of subordinate debt, with the largest offering of junk bonds ever made. Then came an echelon of even more junior debt with payment in securities and junk bonds that payed interest not in cash, but in other junk bonds. But even with all the wizardry of KKR, there could have been no deal without Milken and his junk bonds. The banks could not muster the cash required to complete the financing; KKR required bridge loans. Merrill Lynch and Drexel were in the running to provide an extra $5 billion of bridge financing. Drexel got Milken's monsters and many others to buy short-term junk notes with an interest rate that would increase the longer the owner refrained from cashing in the note. Drexel's "increasing rate notes" easily brought in the entire $5 billion required.

In November of 1986, Ivan Boesky pleaded guilty to one felony count of manipulating securities, and his testimony led to the indictment of Milken in March, 1989, some months after the RJR Nabisco deal had been sewn up. In order to protect more important financial players, Milken was allowed to plead guilty in April 1990 a five counts of insider trading, for which he agreed to pay a fine of $600 million. On February 13, 1990, Drexel Burnham Lambert had declared itself bankrupt and gone into liquidation, much to the distress of junk bond holders everywhere who saw the firm as a junk bond buyer of last resort.

By this time, many of the great LBOs had begun to collapse. Robert Campeau's retail sales empire of Allied and Federated stores blew up in the fall of 1989, bring down almosty $10 billion of LBO debt. Revco, Freuhauf, Southland (Seven-Eleven stores), Resorts International, and many other LBOs went into chapter eleven proceedings. As for KKR's deals, they also began to implode: SCI-TV, a spin-off of Storer Broadcasting, announced that it could not service its $1.3 billion of debt, and forced the holders of $500 million in junk bonds to settle for new stocks and bonds worth between 20 and 70 cents on the dollar. Hillsborogh Holdings, a subsidiary of Jim Walker, went bankrupt, and Seamans Furniture put through a forced restructuring of its debt.

It was clear at the time of the RJR Nabisco LBO that the totality of the company's large cash flow would be necessary to maintain payments of $25 billion of debt. That will take a lot of animal crackers and Winstons. If RJR Nabisco had been a foreign country, it would have ranked among the top 15 debtor nations, coming in between Peru and the Phillipines. Within a short time after the LBO, RJR Nabisco proved unable to maintain payments. KKR was forced to inject several billion dollars of new equity, take out new bank loans, and dunning its clients for an extra $1.7 billion. RJR Nabisco by the early autumn of 1991 was a time bomb ticking away near the center of a ruined US economy. If citizens are bright enough to follow the line that leads back from Milken to Kravis to Bush, RJR and similar horror stories could politically demolish George Bush.

In September 1987, Senator William Proxmire submitted a bill which aimed at restricting takeovers. Two weeks later, Rep. Rostenkowski of Illinois offered a bill to limit the tax deductability of the interest on takeover debt. The LBO gang in Wall Street was horrified, even though it was clear that the Reagan-Bush team would oppose such legislation using every trick in the book. Later, LBO ideologues blamed the Congress for causing the crash of October, 1987.

Kravis has always been adamant in opposing any restrictions on the kind of insanity we have briefly reviewed. "I'm very much of a free-market person," says Kravis. I don't want interference. My life…you've listened to my life story, I don't want interference! The best thing to happen to people and this country is a free market system, and I'm very concerned, if we don't keep the right people in office, that we're not going to have this free-market environment. And we should have it!" [fn 7]

This corresponds exactly to Bush's policy. During the 1988 campaign, Bush presented his views on hostile takeovers, using the forum provided by his old friend T. Boone Pickens' USA Advocate, a monthly newsletter published by the United Shareholders Association, which Pickens runs. In the October, 1988 issue of this publication, Bush made clear that he was not worried about leveraged buyouts. Rather, what concerned Bush was the need to prevent corporations from adopting defenses to deter such attempted hostile takeovers. Bush indicated he wanted to ban poison pill defenses, which often take the form of a new class of stock in a company that lets its holders buy stock in the successor company at rock-bottom prices after a buyout. Poison pills were invented by New York lawyer Marty Lipton, and did not deter raider Sir James Goldsmith from seizing control of Crown Zellerbach in the mid-1980's, although Goldsmith's costs were increased.

Bush also railed against "golden parachutes," which provide lucrative settlements for top executives who are ousted as the result of a takeover:

Bush was clearly hostile to any federal restrictions on hostile takeovers. If anything, he was closer to those who demanded that the federal government stop the states from passing laws that interfere with LBO activity. For that notorious corporate raider and disciple of Chairman Mao Liedtke, T. Boone Pickens, the message was clear:

The expectations of Pickens and his ilk were not disappointed by the Bush cabinet that took office in January, 1989. The new Secretary of the Treasury, Bush crony Nicholas Brady, was only a supporter of leveraged buyouts; he had been one of the leading practitioners of the mergers and acquisitions game during his days in Wall Street as a partner of the Harriman-allied investment firm of Dillon Read.

The family of Nicholas Brady has been allied for most of this century with the Bush-Walker clan. During his Wall Street career at Dillon, Read, Brady, like Bush, cultivated the self-image of the patrician banker, becoming a member of the New York Jockey Club and racing his own thorougbred horses at the New York tracks once presided over by George Herbert Walker and Prescott Bush. Brady, like Bush, is a member of the Bohemian Club of San Francisco and attended the Bohemian Grove every summer. Inside the Bohemian Grove oligarchic pantheon, Brady enjoys the special distinction of presiding over the prestigious Mandalay Camp (or cabin complex), the one habitually attended by Henry Kissinger, and sometimes frequented by Gerald Ford. When Senator Harrison Williams of New Jersey was driven out of office by the FBI's "Abscam" entrapment operation, Brady was appointed to fill out the remainder of the term to which Williams had been elected. Brady is also reportedly a victim of dyslexia.

At the Regency in Lower Manhattan, Brady rubbed elbows each morning at breakfast with Joe Flom and the rest of the the Skadden Arps crowd, Arthur F. Long of D.F. King and Co., Marty Lipton, Arthur Liman, Felix Rohatyn, Boesky's friend Marty Siegel, and Joe Perella of First Boston.

Brady's LBO experience goes back to the 1985 battle for control of Unocal, the former Union Oil Company. T. Boone Pickens and Mesa Petroleum attempted a hostile takeover of Unocal through a complex "two-tiered" tender offer by which those shareholders willing to help Pickens to a majority stake in Unocal would receive cash payment for their stocks, but those forced to sell to Pickens after he had gone over the top would be compelled to accept junk securities. In order to defend against this two-tier, front-loaded hostile tender offer, Unocal management called in Brady's Dillon Read together with Goldman Sachs.

Working with Goldman Sachs, Brady helped to devise a new form of anti-takoever defense for Unocal: it was in effect a self-inflicted leveraged buyout, a self-tender for a large portion of Unocal's stock which the company offered to buy back at a higher price than the one stipulated in the Pickens tender offer, although Unocal would refuse to accept any of the shares held by Pickens. Pickens tried to overturn this selective self-tender in the courts of Delaware, but he was defeated.

The self-tender sponsored by Brady's investment bankers was actually a usurious chicken game: Unocal's tender offer to buy 80 million shares at an astronomical $72 per share in comparison with the $54 offered by Pickens. This meant $5.8 billion in new high-interest junk-bond debt for Unocal, in another triumph of debt over equity. The premiss was that if Pickens insisted on going ahead, he might very well take over Unocal, but the new debt burden would mean that the company would soon go bankrupt and Pickens would lose all his money. In this case, the Unocal management advised by Nick Brady was more than willing to gamble with the existence of their entire company, and thus with the livelihoods of thousands of workers and their families, to ward off the advances of Pickens. In the end, this device would load Unocal with a crushing $3.6 billion of high-interest debt as a result of the plan advocated by Brady's firm.

Nick Brady got the job he presently occupies by heading up a study of the October, 1987 stock market crash, the results of which Brady announced on a cold Friday afternoon in January, 1988, just after the New York stock market had taken another 150 point dive.

The study of the October, 1988 "market break" was produced by a group of Wall Street and Treasury insiders billed as the "Presidential Task Force on Market Mechanisms." At the center of the report's attention was the relation between the New York Stock Exchange, American Stock Exchange, and NASDAC over-the-counter stock trading, on the one hand, and the future, options, and index trading carried on at the Chicago Board of Trade, Chicago Board Options Exchange, and Chicago Mercantile Exchange. The Brady group examined the impact of program trading, index arbitrage and portfolio insurance strategies on the behavior of the markets that led to the crash. The Brady report recommended the centralization of all market oversight in a single federal agency, the unification of clearing systems, consistent margins, and the installation of circuit breaker mechanisms. That, at least, was the public content of the report.

The real purpose of the Brady report was to create a series of drugged and manipulated markets using funds from the Federal Reserve and other sources. The Brady group realized that if the Chicago futures price of a stock or stock index could be artifically inflated, this would be of great assistance in propping up the value of the underlying stock in New York. The Brady group focussed on the Major Market Index of 20 stock futures traded on the Chicago Board of Trade, which roughly corresponded to the principal stocks of the Dow Jones Industrial Average. As long as the MMI was trading at a higher price than the DJIA, the program traders and index arbitrageurs would tend to sell the MMI and buy the underlying stock in New York in order to lock in their stockjobbing profits. The great advantage of this system was first of all that some tens of millions of dollars in Chicago could generate some hundreds of millions of dollars of demand in New York. In addition, the margin requirements for borrowing money for use to buy futures in Chicago were much less stringent than the requirements for margin buying of stocks in New York. Liquidity for this operation could be drawn from banks and other institutions loyal to the Bush-Baker-Brady power cartel, with full backup and assistance from the district banks of the Federal Reserve.

The Brady "drugged market" mechanisms, with the refinements they have acquired since 1988, are a key factor behind the Dow Jones Industrials' seeming defiance of the law of gravity in attainting a new all time high well above the 3000 mark during 1991.

Brady's exercise was nothing new: during the collapse of the Earl of Oxford's South Sea bubble in 1720, the South Sea Company attempted to support the astronomically inflated price of its shares by becoming a buyer of its own stock until its cash and credit reserves were exhausted. Such maneuvers can indeed delay the onset of the final collapse for some period of time, but they guarantee that when the panic, crash and bankruptcy finally become overwhelming, the aggregate damage to society will be far greater than if the crash had been allowed to occur according to its own spontaneous dynamic. For this reason, a large part of the fearful price that is being exacted from the American people as the depression unfolds in its full fury is a result of the Bush-Brady measures to postpone the inevitable reckoning beyond the 1988 election.

One important case study of the impact of Bush's Task Force on Regulatory Relief is the meat-packing industry. In February 1981, when Reagan gave Bush "line" authority for deregulation, he promulgated Executive Order 12291, which established the principle that federal regulations "be based upon adequate evidence that their potential benefits to society are greater than their potential costs to society." In practice, that meant that Bush threw health and safety standards out the window in order to ingratiate himself with entrepreneurs. In March 1981, Bush wrote to businessmen and invited them to enumerate the 10 areas they wanted to see deregulated, with specific recommendations on what they wanted done. By the end of the year Bush's office issued a self-congratulatory report boasting of a "significant reduction in the cost of federal regulation." In the meatpacking industry, this translated into production line speedup as jobs were eliminated, with a cavalier attitude towards safety precautions. At the same time the Occupational Safety and Health Administration sharply reduced inspections, often arriving only after disabling or lethal accidents had already occured. In 1980 there were 280 OSHA inspections in meat packing plants, but in 1988 there were only 176. This, in an industry in which the rate of personal injury is 173 persons per working day, three times the average of all remaining US factories. [fn 8]

Bush used his Regulatory Relief Task Force as a way to curry favor with various business groups whose support he wanted for his future plans to assume the presidency in his own right. According to one study made midway through the Reagan years, Bush converted his own office "into a convenient back door for corporate lobbyists" and "a hidden court of last resort for special interest groups that have lost their arguments in Congress, in the federal courts, or in the regulatory process." "Case by case, the vice president's office got involved in some mean and petty issues that directly affect people's health and lives, from the dumping of toxic pollutants to government warnings concerning potentially harmful drugs." [fn 9]

There were also reports of serious abuses by Bush, especially in the area of conflicts of interest. In one case, Bush intervened in March, 1981 in favor of Eli Lilly & Co., a company of which he had been a director in 1977-79. Bush had owned $145,000 of stock in Eli Lilly until January, 1981, after which it was placed in a blind trust, meaning that Bush allegedly had no way of knowing whether his trust still owned shares in the firm or not. The Treasury Department had wanted to make the terms of a tax break for US pharmaceutical firms operating in Puerto Rico more stringent, but Vice President Bush had contacted the Treasury to urge that "technical" changes be made in the planned restriction of the tax break. By April 14 Bush was feeling some heat, and he wrote a second letter to Treasury Secretary Don Regan asking that his first request be withdrawn because Bush was now "uncomfortable about the appearance of my active personal involvement in the details of a tax matter directly affecting a company with which I once had a close association." [fn 10] Bush's continuing interest in Eli Lilly is underlined by the fact that the Pulliam family of Indiana, the family clan of Bush's later running mate Dan Quayle, owned a very large portion of the Eli Lilly shares. Bush's choice of Quayle was but a re-affirmation of a pre-exisiting financial and political alliance with the Pulliam interests, which also include a newspaper chain.

The long-term results of the deregulation campaign that Bush used to burnish his image are suggested by the September, 1991 fire in a chicken-processing plant operated by Imperial Food Products in Hamlet, North Carolina, in which 25 persons died. One obvious cause of this tragedy was an almost total lack of adequate state and federal inspection, which might have identified the fire hazards that had built up over a period of years. This fire led during October, 1991 to the bankruptcy of the Imperial Food Products Company, which could not obtain financing to roll over its short-term and long-term debt obligations. 225 workers at the Hamlet plant lost their jobs, as did 200 workers at the company's other plant in Cumming, Georgia.

Bush's idea of ideal labor-management practices and corporate leadership in general appears to have been embodied by Frank Lorenzo, the most celebrated and hated banquerotteur of US air transport. Before his downfall in early 1990, Lorenzo combined Texas Air, Continental Airlines, New York Air, People Express, and Eastern Airlines into one holding, and then presided over its bankruptcy. Now Eastern has been liquidated, and the other components are likely to follow suit. Along the way to this debacle, Lorenzo won the sympathy of the Reagan-Bush crowd through his union-busting tactics: he had thrown Continental Airlines into bankruptcy court and used the bankruptcy statutes to break all union contracts, and to break the unions themselves as well. Continental pilots had been stripped of seniority, benefits, and bargaining rights, and had been subjected to a massive pay cut under threat of being turned out into the street. In 1985, the average yearly wage of a pilot was $87,000 at TWA, but less than $30,000 at Continental. The hourly cost of a flight crew for a DC-10 at American Airlines was $703, while at Continental it was only $194. It is an interesting commentary on such wage gouging that Lorenzo neverthless managed to bankrupt Continental by the end of the decade.

George Bush has been on record as a dedicated union-buster going back to 1963-64, and he has always been very friendly with Lorenzo. When Bush became president, this went beyond the personal sphere and became a revolving door between the Texas Air group and the Bush Administration. During 1989, the Airline Pilots' Association issued a list of some 30 cases in which Texas Air officials had transferred to jobs in the Bush regime and vice versa. By the end of 1989, Bush's top Congressional lobbyist was Frderick D. McClure, who had been a vice president and chief lobbyist for Texas Air. McClure had traded jobs with Rebecca Range, who had worked as a public liasion for Reagan until she moved over to the post of lead Congressional lobbyist for Texas Air. John Robson, Bush's deputy Secretary of the Treasury, was a former member of the Continental Airlines board of directors. Elliott Seiden, once a top antritrust lawyer for the Justice Department, switched to being an attorney for Texas Air. [fn 11]

When questioned by Jack Anderson, McClure and Robson claimed that they recused themselves from any matters involving Texas Air. But McClure signed a letter to Congress announcing Bush's opposition to any government investigation of the circumstances surrounding the Eastern Airlines strike in early 1989. Bush himself has always stonewalled in favor of Lorenzo. During the early months of the landmark Eastern Airlines strike, in which pilots, flight attendants, and machinists all walked out to block Lorenzo's plan to downsize the airline and bust the unions, the Congress attempted to set up a panel to investigate the dispute, but Bush was adamant in favor of Lorenzo and vetoed any government probes. [fn 12]

Lorenzo's activities were decisive in the wrecking of US airline transportation during the Reagan-Bush era. When Carl Icahn was in the process of taking over TWA, he was able to argue that the need to compete in many of the same markets in which Lorenzo's airlines were active made mandatory that the TWA work force accept similar sacrifices and wage cuts. The cost-cutting criteria pioneered with such ruthless aggressivity by Lorenzo have had the long-term of effect of reducing safety margins and increasing the risk the travelling public must confront in any decision to board an airliner operating under US jurisdiction. Eastern has disappeared, and Continental has been joined in bankruptcy by Midway, America West, while Pan American sold off a large part of its operations to Delta while teetering on the verge of liquidation. Icahn's TWA is bankrupt in every sense except the final technicalities. Northwest, having been taken through the wringer of an LBO by Albert Cecchi, is now busy lining up subsidies from the state of Minnesota and other sources as a way to stay afloat. It is widely believed that when the dust settles, only Delta, American, and perhaps United will remain among the large nationwide carriers. At that point hundreds of localities will be served by only one airline, and that airline will proceed to raise its fares without any fear of price competition or any other form of competition. With that, air travel will float beyond the reach of much of the American middle class, and the final fruits of airline deregulation will be manifest. In the meantime, it must be feared that the erosion of safety margins will exact a growing toll of human lives in airline accidents. If such tragedies occur, the bereaved relatives will perhaps recall George Bush's friend Frank Lorenzo.

And how, the reader may ask, was George Bush doing financially while surrounded by so many billions in junk bonds? Bush had always pontificated that he had led the fight for full public disclosure of personal financial interests by elected officials. He never tired of repeating that "in 1967, as a freshman member of the House of Representatives, I led the fight for full financial disclosure." But after he was elected to the vice presidency, Bush stopped disclosing his investments in detail. He stated his net worth, which had risen to $2.1 million by the time of the 1984 election, representing an increase of some $300,000 over the previous five years. Bush justified his refusal to disclose his investments in detail by saying that he didn't know himself just what securities he held, since his portfolio was now in the blind trust mentioned above. The blind trust was administered by W.S. Farish & Co. of Houston, owned by Bush's close crony William Stamps Farish III of Beeville, Texas, the descendant of the Standard Oil executive who had backed Heinrich Himmler and the Waffen SS. [fn 13]


Return to the Table of Contents

NOTES:

1. Walter Pincus and Bob Woodward, "Doing Well With help From Family, Freinds," Washington Post, August 11, 1988.

2. Houston Chronicle, February 21, 1963. See clippings available in Texas Historical Society, Houston.

3. Thomas Petzinger, Oil and Honor (New York, 1987), pp. 244-245.

4. See Washington Post, February 5, 1989.

5. For the relation between George Bush and Henry Kravis, see Sarah Bartlett, The Money Machine: How KKR Manufactured Power & Profits (New York, 1991), pp. 258-259 and 267-270.

6. Roy C. Smith, The Money Wars (New York, 1990), p. 106.

7. Bartlett, pp. 269-270.

8. Washington Post, September 29, 1988.

9. Judy Mann, "Bush's Top Achievement," Washington Post, November 2, 1988.

10. William Greider, Rolling Stone, April 12, 1984.

11. "Bush Denies Influencing Drug Firm Tax Proposal," Washington Post, May 20, 1981.

12. Jack Anderson and Dale Van Atta, "The Bush-Lorenzo Connections," Washington Post, December 21, 1989.

13. James Ridgway, The Tax Records of Reagan and Bush, Texas Observer, September 28, 1984.

(from comment to

[Aug 31, 2010] Mega Private Equity Deal in 2010: Some Fundamentals in Place

Submitted by Static Chaos on 08/21/2010 19:45 -0500

By Static Chaos

With Merger and Acquisition really picking up steam in the last month, the question arises whether private equity will be able to complete a major move in the remainder of 2010. This past week Intel acquired software security firm McAfee for $7.7 billion in an all cash deal and the prior week BHP offered $40 Billion to take over Potash Corp. from shareholders.

In contrast, the latest deal involving private equity -- Blackstone acquiring Dynergy for $543 million--is a far cry from the heyday of private equity deals back in 2006, when deals such as Harrah`s Entertainment, Hospital Corp. of America, Clear Channel Communications, Kinder Morgan, and Freescale Semiconductor each worth more than $17 Billion dollars took place. In 2007, Blackstone acquiring Equity Office Properties Trust for $38.9 billion, and TXU went for a $42 Billion three way deal with Goldman Sachs, Kohlberg Kravis Roberts, and TPG.

So, all this M&A activity begs the question--where the heck is private equity? Can they still compete with large companies sitting on a pile of cash?

I understand the financing travails and the freezing up of the credit markets in 2008, but this is late 2010 and supposedly private equity has all this money from investors that they have been unable to utilize for deals over the last three years. In short, what could private equity be waiting for?

There are some great bargains out there in undervalued companies that have huge cash flows, little debt, large cash stockpiles, and there is a low cost of capital right now for financing deals. Do you need an engraved invitation to the ever-present M&A party? If you cannot complete a major deal now, then when will you be able to do a major deal?

The cost of capital is only going to go up in the future, in a major way. Frankly, it seems that the private equity community is like the proverbial deer in headlights, and still stuck in the malaise, fear, and uncertainty of the past three years that they are slow to react to the changing landscape of deal making. And this is their core business deal making.

It is apparent that the dynamics have changed in the private equity buyout game, and maybe the firms are waiting for the good old days. But the good old days are long gone, and you have capital to deploy, so you'd better either start adapting to the new environment or start giving your capital back to investors so they can realize a better return on their money.

There is the stigma of all those bad private equity sham deals that have occurred over the last decade that probably makes many banks weary of private equity when they inquire about financing deals. So, yes the days of the sham deals are over where you buyout some garbage company that has a declining business model, uncompetitive business, but little debt, and you take it private, lever up the balance sheet with monstrous debt obligations, pay yourself a huge dividend recapping your original investment, and then taking it back public in a better market with higher multiples. The reason this type of deal is dead is because there will always be a bag holder, and banks have ultimately been caught in the crossfire too many times as the one picking up the pieces in the end.

Most likely, all future private equity deals will involve more of the firm`s own money in the deal. But private equity, by most accounts, has been sitting on large amounts of capital, so the money is there for deals. Furthermore, there are plenty of legitimate value enhancing, highly attractive deals out there, which this cash may be applied to right now, as there are great fundamentals (outlined below) in the marketplace for the private equity model.

So, how likely is it that we have a$100 Billion private equity deal in the remainder of this year? Well, at the beginning of this year it would have seemed impossible, but the dynamics are there for a deal to occur. Things really just have to fall into place. With the latest rumblings of M&A activity, there is an increasing chance that we witness a Mega Private Equity deal that really shakes up the current valuation models regarding what public companies are worth.

A case in point is a company like HP with a trailing P/E around 11, has solid growth, leader in numerous business segments within technology, sits on a large amount of cash, and is grossly mispriced in the market place compared to a firm like Dell with a trailing P/E around 16.

HP has many of the components necessary for a private equity mega deal, solid company with a bright future, extremely low multiple, assets are worth more than the current market cap if sold separately, low relative debt, strong cash flows, large cash reserves, relevant industry due to demands from corportations to increase productivity, lacks a CEO, leverageable, and most of all--very financeable for a major deal to banks.


This is one of my candidates for a Mega Private Equity deal. What are some of the companies that you think will make for great Mega Private Equity Deals for the remainder of 2010?

Selected Comments

williambanzai7:

Sham deal is synonymous with private equity, at least in the M&A sense.

Bartanist :

My experience with private equity is that the entire model is based on borrowing money from banks at libor +1.25% paying the acquisition price and then financing the target company in a couple of tranches at 7% to 9% then the secondary tranche at 14% to 17%.

The target companies are cash strapped and have to free cash through consolidation and firing all expensive people then hiring cheap people, but the PE company has plenty of cash flow as the target company shrinks its balance sheet and expenses.

The only hitch with the PE companies is that they then want to sell the target companies before the shit hits the fan due to a complete lack of investment during the PE company's ownership.

My guess is that the banks and others have caught onto the scam.

Monkey Craig:

PE is also reliant on few, if any, covenants and credit officers may push for these in the future if leverage levels increase or acquisitions get sillier....a vibrant PE market was a bubble activity, think 2005 or 2006

Mitchman :

PE has a 5 to 7 year time horizon on their investments and the outlook is way too uncertain to take the risk that they will be able to get out at a profit in that time frame.

Market Analyst :

Another potential candidate would be GS with a p/e around 8, and a current market cap around $77 Billion, and too high profile as a public company, need to get out of the spotlight. Shareholders might want more of a dividend going forward instead of those excessive bonuses.

Dismal Scientist :

Time to take GS private then. Am waiting for the first MBO's to come in this cycle. Not to mention a continuation of the M&A we are seeing, which is just as well for those pesky investment banker types....

http://en.wikipedia.org/wiki/Differential_accumulation

Itsalie :

PE are playing musical chairs in Europe and Asia - those raising new funds are busily selling their portfolio to those trying to spend some of the $500b of dry powder to fend off limited partners seeking a reduction in the fat 2% fee. Its window dressing a la PE. But don't shed tears for the investors/limited partners, they are nothing like the long suffering retail investors pulling out record sums from mutual funds. The LPs are exclusively the Harvards, Princeton, Yale (Swensen hah!), Calpers and xICs - they manage money belonging to faceless organization and fly around attending LP meetings all year round. They won't be jeopardising their relationship with the PE funds - that would be like firing themselves from their jobs; besides I know of no LP who do not enjoy the LP meetings aka pilgrimage to Hawaii or Half Moon Bay to paly golf, or Shanghai/Macau to be "entertained".

MichaelG :

Aren't HP pretty big on leasing? I'm just wondering if they'd be much affected by the accounting rules changes Bruce Krasting mentioned the other day.

http://www.zerohedge.com/article/how-much-debt-does-sp-500-have

Monkey Craig :

I'm not a CPA, but I understand that the new rules will hurt retailers which lease their facilities (think SBUX). The retailers will have to bring their liabilities on balance sheet and this will increase debt levels. Obviously, the sophisticated bond buyers and lenders have been reading the operating leases (disclosed in the Notes of the Audit) for years.

TGT, by the way, owns the bulk of their store locations.

Washington DeCoded Inside Casino Capitalism

Inside Casino Capitalism Barbarians at the Gate: The Fall of RJR Nabisco
By Bryan Burrough and John Helyar
Harper & Row. 528 pp. $22.95

By Max Holland

In 1898, Adolphus Green, chairman of the National Biscuit Company, found himself faced with the task of choosing a trademark for his newly formed baking concern. Green was a progressive businessman. He refused to employ child labor, even though it was then a common practice, and he offered his bakery employees the option to buy stock at a discount. Green therefore thought that his trademark should symbolize Nabisco's fundamental business values, "not merely to make dividends for the stockholders of his company, but to enhance the general prosperity and the moral sentiment of the United States." Eventually he decided that a cross with two bars and an oval – a medieval symbol representing the triumph of the moral and spiritual over the base and material – should grace the package of every Nabisco product.

If they had wracked their brains for months, Bryan Burrough and John Helyar could not have come up with a more ironic metaphor for their book. The fall of Nabisco, and its corporate partner R.J. Reynolds, is nothing less than the exact opposite of Green's business credo, a compelling tale of corporate and Wall Street greed featuring RJR Nabisco officers who first steal shareholders blind and then justify their epic displays of avarice by claiming to maximize shareholder value.

The event which made the RJR Nabisco story worth telling was the 1988 leveraged buyout (LBO) of the mammoth tobacco and food conglomerate, then the 19th-largest industrial corporation in America. Battles for corporate control were common during the loosely regulated 1980s, and the LBO was just one method for capturing the equity of a corporation. (In a typical LBO, a small group of top management and investment bankers put 10 percent down and finance the rest of their purchase through high-interest loans or bonds. If the leveraged, privately-owned corporation survives, the investors, which they can re-sell public shares, reach the so-called "pot of gold"; but if the corporation cannot service its debt, everything is at risk, because the collateral is the corporation itself.

The sheer size of RJR Nabisco and the furious bidding war that erupted guaranteed unusual public scrutiny of this particular piece of financial engineering. F. Ross Johnson, the conglomerate's flamboyant, free-spending CEO (RJR had its own corporate airline), put his own company into play with a $75-a-share bid in October. Experienced buyout artists on Wall Street, however, immediately realized that Johnson was trying to play two incompatible games. LBOs typically put corporations such as RJR Nabisco through a ringer in order to pay the mammoth debt incurred after a buyout. But Johnson, desiring to keep corporate perquisites intact, "low-balled" his offer. Other buyout investors stepped forward with competing bids, and after a six-week-long auction the buyout boutique of Kohlberg, Kravis, Roberts & Company (KKR) emerged on top with a $109-a-share bid. The $25-billion buyout took its place as one of the defining business events of the 1980s

Burrough and Helyar, who covered the story for The Wall Street Journal, supply a breezy, colorful, blow-by-blow account of the "deal from hell" (as one businessman characterized a leveraged buyout). The language of Wall Street, full of incongruous "Rambo" jargon from the Vietnam War, is itself arresting. Buyout artists, who presumably never came within 10,000 miles of wartime Saigon, talk about "napalming" corporate perquisites or liken their strategy to "charging through the rice paddies, not stopping for anything and taking no prisoners."

At the time, F. Ross Johnson was widely pilloried in the press as the embodiment of excess; his conflict of interest was obvious. Yet Burrough and Helyar show that Johnson, for all his free-spending ways, was way over his head in the major leagues of greed, otherwise known as Wall Street in the 1980s. What, after all, is more rapacious: the roughly $100 million Johnson stood to gain if his deal worked out over five years, or the $45 million in expenses KKR demanded for waiting 60 minutes while Ross Johnson prepared a final competing bid?

Barbarians is, in the parlance of the publishing world, a good read. At the same time, unfortunately, a disclaimer issued by the authors proves only too true. Anyone looking for a definitive judgment of LBOs will be disappointed. Burrough and Helyar do at least ask the pertinent question: What does all this activity have to do with building and sustaining a business? But authors should not only pose questions; they should answer them, or at least try.

Admittedly, the single most important answer to the RJR puzzle could not be provided by Burrough and Helyar because it is not yet known. The major test of any financial engineering is its effect on the long-term vitality of the leveraged corporation, as measured by such key indicators as market share (and not just whether the corporation survives its debt, as the authors imply). However, a highly-leveraged RJR Nabisco is already selling off numerous profitable parts of its business because they are no longer a "strategic fit": Wall Street code signifying a need for cash in order to service debts and avoid bankruptcy.

If the authors were unable to predict the ultimate outcome, they still had a rare opportunity to explain how and why an LBO is engineered. Unfortunately, their fixation on re-creating events and dialogue – which admittedly produces a fast-moving book – forced them to accept the issues as defined by the participants themselves. There is no other way to explain the book's uncritical stance. When, for example, the RJR Nabisco board of directors tried to decide which bid to accept, Burrough and Helyar report that several directors sided with KKR's offer because the LBO boutique "knew the value of keeping [employees] happy." It is impossible to tell from the book whether the directors knew this to be true or took KKR's word. Even a cursory investigation would have revealed that KKR is notorious for showing no concern for employees below senior management after a leveraged buyout.

The triumph of gossip over substance is manifest in many other ways. Wall Street's deft manipulation of the business press is barely touched upon, and the laissez-faire environment procured by buyout artists via their political contributions is scarcely mentioned, crucial though it is. Nowhere are the authors' priorities more obvious than in the number of words devoted to Henry Kravis's conspicuous consumption compared to those devoted to the details of the RJR deal. In testimony before Congress last year, no less an authority than Treasury Secretary Nicholas Brady – himself an old Wall Street hand – noted that the substitution of tax-deductible debt for taxable income is "the mill in which the grist of takeover premiums is ground."

In the case of RJR Nabisco, 81 percent of the $9.9 billion premium paid to shareholders was derived from tax breaks achievable after the buyout. This singularly important fact cannot be found in the book, however; nor will a reader learn that after the buyout the U.S. Treasury was obligated to refund RJR as much as $1 billion because of its post-buyout debt burden. In Barbarians, more time is spent describing Kravis's ostentatious gifts to his fashion-designer wife than to the tax considerations that make or break these deals.

Fulminations about the socially corrosive effects of greed aside, the buyout phenomenon may represent one of the biggest changes in the way American business is conducted since the rise of the public corporation, nothing less than a transformation of managerial into financial capitalism. The ferocious market for corporate control that emerged during the 1980s has few parallels in business history, but there are two: the trusts that formed early in this century and the conglomerate mania that swept corporate America during the 1960s. Both waves resulted in large social and economic costs, and there is little assurance that the corporate infatuation with debt will not exact a similarly heavy toll.

As the economist Henry Kaufman has written, the high levels of debt associated with buyouts and other forms of corporate restructuring create fragility in business structures and vulnerability to economic cycles. Inexorably, the shift away from equity invites the close, even intrusive involvement of institutional investors (banks, pension funds, and insurance companies) that provide the financing. Superficially, this moves America closer to the system that prevails in Germany and Japan, where historically the relationship between the suppliers and users of capital is close. But Germany and Japan incur higher levels of debt for expansion and investment, whereas equivalent American indebtedness is linked to the recent market for corporate control. That creates a brittle structure, one that threatens to turn the U.S. government into something of an ultimate guarantor if and when things do fall about. It is too easy to construct a scenario in which corporate indebtedness forces the federal government into the business of business. The savings-and-loan bailout is a painfully obvious harbinger of such a development.

The many ramifications of the buyout mania deserve thoughtful treatment. Basic issues of corporate governance and accountability ought to be openly debated and resolved if the American economy is to deliver the maximum benefit to society and not just unconscionable rewards to a handful of bankers, all out of proportion to their social productivity. It is disappointing, but a sign of the times, that the best book about the deal of deals fails to educate as well as it entertains.

Merchants of Debt Kkr and the Mortgaging of American Business

Merchants of Debt: KKR and the Mortgaging of American Business
By George Anders
2002/09 - Beard Books
1587981254 - Paperback - Reprint - 354 pp.
US$34.95

Selected as one of the best business books of 1992 by Business Week.

Publisher Comments

Categories: Banking and Finance

This title is part of the Business Histories list.

Of interest:

Takeover: The New Wall Street Warriors: The Men, the Money, the Impact

The Money Machine: How KKR Manufactured Power and Profits

The Money Wars: The Rise & Fall of the Great Buyout Boom of the 1980s

The Titans of Takeover

With borrowed money, borrowed management, and a lot of nerve, Kohlberg Kravis Roberts acquired one Fortune 500 company after another in the 1980s, epitomizing both the best and worst of Wall Street's stunning rise to power in the age of casino capitalism. In the compelling book, the author explains why American business became so enchanted by debt; how KKR partners Jerome Kohlberg, Henry Kravis, and George Roberts became billionaires; and how their takeovers affected America's economic strength. This fascinating, behind-the-scenes account show how pride, jealousy, fear, and ambition fueled Wall Street's debt mania - with repercussions to millions of people.

From the back cover blurb:

With borrowed money, borrowed management, and a lot of nerve, Kohlberg Kravis Roberts acquired one Fortune 500 company after another in the age of casino capitalism, KKR epitomized both the best -- and the worst -- of Wall Street's stunning rise to power in the 1980s. In this book, the author explains why American business became so enchanted by debt; how KKR partners Jerome Kohlberg, Henry Kravis and George Roberts became billionaires, and how their takeovers affected America's economic strength. This fascination, behind-the-scenes account shows how pride, jealousy, fear, and ambition fueled Wall Street's debt mania -- with consequences that affected millions of people. Investors and businesspersons alike will find this expose engrossing and informative reading. This book was selected as one of the Best Business Books of 1992 by Business Week.

Referring to an earlier version:

For more than a decade, Henry Kravis and George Roberts have been archetypes, first of Wall Street's boom years and then of its excesses. Their story and that of their firm--the biggest, most successful, and most controversial participant in the age of leverage--illuminates an entire era of financial maneuvering and speculative mania. Kravis and Roberts wrote their way into the history books by concocting one giant takeover after another. Their technique: the leveraged buyout, an audacious way to acquire a company with borrowed money, borrowed management--and a lot of nerve. Their firm, Kohlberg Kravis Roberts & Co., dominated the Wall Street scene in the late 1980s, acquiring one Fortune 500 company after another, including Safeway, Duracell, Motel 6, and RJR Nabisco. Merchants of Debt draws on more than 200 interviews, including recurring access to the central figures and their KKR associates, as well as court documents and private correspondence to couch giant financial issues in human terms. The story of KKR shows how pride, jealousy, fear, and ambition fueled Wall Street's debt mania--with consequences that affected hundreds of thousands of people. Anders addresses three questions: Why did American business become so enchanted by debt in the 1980s? How exactly did Kravis and Roberts rise to the top of the heap? What have buyouts, especially KKR's deals, done to America's economic strength? Here is a gripping saga that takes readers behind closed boardroom doors to show how star-struck young bankers, ruthless deal-makers, and nervous CEOs changed one another's lives--and the whole American economy--over a fifteen-year span.

Thayer Watkins' Summary of Merchants of Debt:
Available here.

From Turnarounds and Workouts, February 15, 2003
Review by Gail Owens Hoelscher

"For the first fourteen years of KKR's existence, the buyout firm's hallmark could be expressed in one word: debt… As KKR grew evermore powerful, Kravis and Roberts derived their economic clout from a single fact: They could borrow more money, faster, than anyone else," according to the chronicler of this high-flying firm. KKR acquired $60 billion worth of companies in wildly different industries in the 1980s: Safeway Stores, Duracell, Motel 6, Stop & Shop, Avis, Tropicana, and Playtex. They made piles of money by deducting interest expenditures from their taxes, cutting costs in their new companies and riding a long-running bull market.

The juggernaut of Kohlberg Kravis Roberts & Co. began rolling in 1976 when Jerome Kohlberg and cousins Henry Kravis and George Roberts left Bear, Stearns with about $120,000 to spend. The three wunderkind shortly invented and dominated the leveraged buyout as they sought investors and borrowed money to acquire Fortune 500 companies in dizzying succession. They put up very little money of their own funds, but their partnerships made out like bandits. Consider the case of Owens-Illinois: KKR pup up only 4.7 percent of the purchase price. The company's chairman earned $10 million within a few years, the takeover advisors got $60 million, Owens-Illinois was left "gaunt and scaled back," and about five years later, KKR took it public at $11 a share, more than twice what the KKR partnership had paid for it.

In this reprint of his 1992 books, George Anders tells us how they worked: "(t)ime after time, the KKR men presented a tempting offer. The CEO could cash out his company's existing shareholders by agreeing to sell the company to a new group that would be headed by KKR, but would include a lot of room for existing management. The new ownership group would take on a lot of debt, but aim to pay it off quickly. If this buyout worked out as planned, the KKR men hinted, the new owners could earn five times their money over the next five years. Presented with such a choice in the frenzied takeover climate of the 1980s, manages and corporate directors again and again said yes… To top management a leveraged buyout was the most palatable way to ride out the merger-and-acquisition craze."

The author includes a detailed appendix of KKR's 38 buyouts during the period 1977-1992 that presents the following on each purchase: price paid by KKR; percentage of the purchase price paid by KKR's equity funds; length of time KKR owned the company; financial payoff for the ownership group; and the annualized profit rate for investors over the life of the buyout. KKR used less than 9 percent of its own funds in 18 of the 38 cases. In only four cases did KKR put up more than 30 percent of the price. KKR owned the 38 companies for an average of about 5 years. As Anders puts it, "(a)s quickly as the KKR men had roared into a company's life, they roared off."

This behind-the-scene account shows the ambition, pride, envy and fear that characterized the debt mania largely engineered by KKR, a mania that put millions out of work and made a very few very rich. This book is a must read in understanding what happened to corporate America in the 1980s.

George Anders is the West Coast bureau chief of Fast Company magazine. He worked for two decades at the Wall Street Journal, and was part of a seven-person reporting team that won the Pulitzer Prize for national reporting in 1997.

From BusinessWeek.Com
The Best Business Books of the Year (1992)
http://www.businessweek.com/1989-94/pre94/b32981.htm

In Merchants of Debt: KKR and the Mortgaging of American Business, George Anders of The Wall Street Journal explores not just Kohlberg Kravis Roberts & Co. but also the impact of the leveraged buyout deals it popularized. Reviewer Anthony Bianco found the book well-researched, fair-minded, and thorough in its history of transactions.

Discussing the $26.4 billion buyout of RJR Nabisco Inc., ``Anders goes beyond what has been previously published,'' Bianco wrote, with his convincing assertion that RJR's post-deal crises pushed KKR close to ruin. Leveraged buyouts in general Anders terms ``one of the most profoundly undemocratic ventures the United States had ever seen.'' Their only lasting impact, he says, was to shift wealth from the mass of corporate employees to a managerial elite allied with Wall Street.

Bianco faulted Anders for shying from sharp judgments and for failing to delve deeply into the motivations and character of KKR's dealmakers. But Anders won unparalleled access to Henry Kravis and his cousin and partner, George Roberts, Bianco noted. Crediting Anders with ``devastating reportage,'' Bianco said, ``His exhaustively researched book provides the closest look yet at KKR's inner workings.''

With borrowed money, borrowed management, and great nerve, Kohlberg Kravis Roberts acquired one Fortune 500 company after another--and changed the face of American business. Excerpted in the Wall Street Journal.

From New York Times Book Review, June 14, 1992

"[S]omething refreshing and important: a book that reckons seriously with Wall Street's innovations and achievements, even as it chronicles its recklessness and intrigues... [A] far more enduring contribution to understanding one of the most dynamic and disturbing periods in American business history."

From Michael Lewis, Author of Liar's Poker and The New Thing

"Excellent... One of the few books that a person can use to evaluate what happened in the financial 1980s. It should be required reading for anyone who got rich, lost a job or watched in consternation as Wall Street's juggernaut swept the U.S. economy."


From Library Journal, June 14, 1992

Kohlberg Kravis Roberts & Co. (KKR) was founded in New York in 1976 by three . . . investment bankers, Jerry Kohlberg, George Kravis, and George Roberts, with the simple purpose of assisting companies to participate in management-led buyouts or leveraged buyouts (LBOs). . . . {The author} chronicles the rise of KKR during the 1980s, the 'age of debt,' and . . . {argues that} a simple formula using borrowed money could be successfully repeated over and over again in corporate takeovers.

This compelling book is recommended for all business collections

Casino capitalism continues to baffle

Oct 06, 2005

In my humble opinion, the instability of financial trading markets all over the world exemplifies the fact that free market behavior is not always rational behavior. Although right-wing liberal economic types like to portray packs of investors as some sort of "hive mind", judging the value of stock in real-time and acting accordingly, investor behaviour is typically more instinctive and random than that. People might sell their stock in Telstra, for example, because they want to go on a holiday. If enough Telstra shareholders want to go on a holiday at the same time, the value of Telstra shares will drop if the numbers of sellers outweighs the numbers of interested buyers. It's a pretty dumb example but it holds true. What does such a decision have to do with the actual value of Telstra? SFA, but markets are blind to that, and market analysts will try to rationalise the stock price movement in any remotely credible way that they can.

And what prompted this anti-market spray? The Australian stock market had $21 billion wiped off it yesterday in the biggest single-day loss since the week of the 9/11 attacks. The purported reason for the loss hardly justifies the reaction:

Local traders were anxious after a plunge on Wall Street, which was sparked by a US Federal Reserve warning that interest rates were likely to rise and energy prices were driving inflation higher.

Anything that can devalue Australian companies by $21 billion in a single day sounds more like a corporate disaster than anything else. It's barmy. Put simply, the global marketplace could do without the ridiculous volatility that often ensues in financial markets. Sometimes it seems as though investors might do well to just go and put their surplus capital on red at the roulette table at Star City instead of pumping it into the stockmarket. At least there is a sense of immediate certainty about that sort of transaction. I'm not seriously advocating gambling as much as trying to make a point here, but gambled monies are at the very least not subject to the often inscrutable and senseless whims of shareholders across the country.

Unsurprisingly, given market volatility and the sense that one is gambling, not investing, when buying shares, critical theorist Susan Strange once labelled the instability of modern financial markets "casino capitalism". Make no mistake, investing in financial markets these days is in many ways closer to being a form of gambling than buying property, or putting your money in the bank.

Posted by Guy at October 6, 2005 07:44 AM

Comments

This is just the usual October correction. Its a good thing, because it allows investors to get some bargins before the market climbs up again. We just came off a new high, it may look like a crash but the market is still very healthy. This dip is predicted to last only a month or two, or even only a few weeks.

Posted by: Nic White at October 6, 2005 09:15 PM

You have obviously never invested in the stock market. For a long-term investor it is nothing like a casino. If a stock price goes down that is a paper loss, you do not actually loose money unless you sell the stock.

To a wise investor an event like this is an opportunity. As Nic said, this is a chance to get bargains before the market goes up again.

The market can be irrational. But the great thing about the stock market is you can control your risk. You could invest in bank shares, this way you'd get a relatively stable stock that pays a good dividend. Or you could invest in a speculative stock that might go up exponentially or vanish altogether.

A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire.

Posted by: Chris Fryer at October 7, 2005 12:04 PM

Posted by: Chris Fryer at October 7, 2005 12:06 PM

"A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire."

So it's a bit like betting on a few favourites and a few long-shots at the horsetrack, right? ;) I know some gamblers who don't think that they've lost money until they've left the gambling establishment of their choice for the day. Until then, it's just $50 up or $50 down, and the betting continues.

I guess the point I am trying to make is that $21 billion was wiped off the supposed value of companies in a single day, and hardly anything at all changed in a material sense.

It's like if banks decided to randomly revalue the money sitting in your savings account on a real-time basis. On a whim, a significant proportion of your savings could disappear, without anything particularly tangible or real justifying that reduction in value.

Posted by: Guy at October 8, 2005 11:32 PM

The October correctio, as I understand it, is literally a correction - meaning those companies have been over valued in the last year or so, and that is being rectified. As the correction results in a bid, investors and traders panic and sell like mad, and the market dips further before levelling off and climbing again.

Theres relaly nothing to see here, but the media is beating it up something chronic.

Washington DeCoded Inside Casino Capitalism

Inside Casino Capitalism Barbarians at the Gate: The Fall of RJR Nabisco
By Bryan Burrough and John Helyar
Harper & Row. 528 pp. $22.95

By Max Holland

In 1898, Adolphus Green, chairman of the National Biscuit Company, found himself faced with the task of choosing a trademark for his newly formed baking concern. Green was a progressive businessman. He refused to employ child labor, even though it was then a common practice, and he offered his bakery employees the option to buy stock at a discount. Green therefore thought that his trademark should symbolize Nabisco's fundamental business values, "not merely to make dividends for the stockholders of his company, but to enhance the general prosperity and the moral sentiment of the United States." Eventually he decided that a cross with two bars and an oval – a medieval symbol representing the triumph of the moral and spiritual over the base and material – should grace the package of every Nabisco product.

If they had wracked their brains for months, Bryan Burrough and John Helyar could not have come up with a more ironic metaphor for their book. The fall of Nabisco, and its corporate partner R.J. Reynolds, is nothing less than the exact opposite of Green's business credo, a compelling tale of corporate and Wall Street greed featuring RJR Nabisco officers who first steal shareholders blind and then justify their epic displays of avarice by claiming to maximize shareholder value.

The event which made the RJR Nabisco story worth telling was the 1988 leveraged buyout (LBO) of the mammoth tobacco and food conglomerate, then the 19th-largest industrial corporation in America. Battles for corporate control were common during the loosely regulated 1980s, and the LBO was just one method for capturing the equity of a corporation. (In a typical LBO, a small group of top management and investment bankers put 10 percent down and finance the rest of their purchase through high-interest loans or bonds. If the leveraged, privately-owned corporation survives, the investors, which they can re-sell public shares, reach the so-called "pot of gold"; but if the corporation cannot service its debt, everything is at risk, because the collateral is the corporation itself.

The sheer size of RJR Nabisco and the furious bidding war that erupted guaranteed unusual public scrutiny of this particular piece of financial engineering. F. Ross Johnson, the conglomerate's flamboyant, free-spending CEO (RJR had its own corporate airline), put his own company into play with a $75-a-share bid in October. Experienced buyout artists on Wall Street, however, immediately realized that Johnson was trying to play two incompatible games. LBOs typically put corporations such as RJR Nabisco through a ringer in order to pay the mammoth debt incurred after a buyout. But Johnson, desiring to keep corporate perquisites intact, "low-balled" his offer. Other buyout investors stepped forward with competing bids, and after a six-week-long auction the buyout boutique of Kohlberg, Kravis, Roberts & Company (KKR) emerged on top with a $109-a-share bid. The $25-billion buyout took its place as one of the defining business events of the 1980s

Burrough and Helyar, who covered the story for The Wall Street Journal, supply a breezy, colorful, blow-by-blow account of the "deal from hell" (as one businessman characterized a leveraged buyout). The language of Wall Street, full of incongruous "Rambo" jargon from the Vietnam War, is itself arresting. Buyout artists, who presumably never came within 10,000 miles of wartime Saigon, talk about "napalming" corporate perquisites or liken their strategy to "charging through the rice paddies, not stopping for anything and taking no prisoners."

At the time, F. Ross Johnson was widely pilloried in the press as the embodiment of excess; his conflict of interest was obvious. Yet Burrough and Helyar show that Johnson, for all his free-spending ways, was way over his head in the major leagues of greed, otherwise known as Wall Street in the 1980s. What, after all, is more rapacious: the roughly $100 million Johnson stood to gain if his deal worked out over five years, or the $45 million in expenses KKR demanded for waiting 60 minutes while Ross Johnson prepared a final competing bid?

Barbarians is, in the parlance of the publishing world, a good read. At the same time, unfortunately, a disclaimer issued by the authors proves only too true. Anyone looking for a definitive judgment of LBOs will be disappointed. Burrough and Helyar do at least ask the pertinent question: What does all this activity have to do with building and sustaining a business? But authors should not only pose questions; they should answer them, or at least try.

Admittedly, the single most important answer to the RJR puzzle could not be provided by Burrough and Helyar because it is not yet known. The major test of any financial engineering is its effect on the long-term vitality of the leveraged corporation, as measured by such key indicators as market share (and not just whether the corporation survives its debt, as the authors imply). However, a highly-leveraged RJR Nabisco is already selling off numerous profitable parts of its business because they are no longer a "strategic fit": Wall Street code signifying a need for cash in order to service debts and avoid bankruptcy.

If the authors were unable to predict the ultimate outcome, they still had a rare opportunity to explain how and why an LBO is engineered. Unfortunately, their fixation on re-creating events and dialogue – which admittedly produces a fast-moving book – forced them to accept the issues as defined by the participants themselves. There is no other way to explain the book's uncritical stance. When, for example, the RJR Nabisco board of directors tried to decide which bid to accept, Burrough and Helyar report that several directors sided with KKR's offer because the LBO boutique "knew the value of keeping [employees] happy." It is impossible to tell from the book whether the directors knew this to be true or took KKR's word. Even a cursory investigation would have revealed that KKR is notorious for showing no concern for employees below senior management after a leveraged buyout.

The triumph of gossip over substance is manifest in many other ways. Wall Street's deft manipulation of the business press is barely touched upon, and the laissez-faire environment procured by buyout artists via their political contributions is scarcely mentioned, crucial though it is. Nowhere are the authors' priorities more obvious than in the number of words devoted to Henry Kravis's conspicuous consumption compared to those devoted to the details of the RJR deal. In testimony before Congress last year, no less an authority than Treasury Secretary Nicholas Brady – himself an old Wall Street hand – noted that the substitution of tax-deductible debt for taxable income is "the mill in which the grist of takeover premiums is ground."

In the case of RJR Nabisco, 81 percent of the $9.9 billion premium paid to shareholders was derived from tax breaks achievable after the buyout. This singularly important fact cannot be found in the book, however; nor will a reader learn that after the buyout the U.S. Treasury was obligated to refund RJR as much as $1 billion because of its post-buyout debt burden. In Barbarians, more time is spent describing Kravis's ostentatious gifts to his fashion-designer wife than to the tax considerations that make or break these deals.

Fulminations about the socially corrosive effects of greed aside, the buyout phenomenon may represent one of the biggest changes in the way American business is conducted since the rise of the public corporation, nothing less than a transformation of managerial into financial capitalism. The ferocious market for corporate control that emerged during the 1980s has few parallels in business history, but there are two: the trusts that formed early in this century and the conglomerate mania that swept corporate America during the 1960s. Both waves resulted in large social and economic costs, and there is little assurance that the corporate infatuation with debt will not exact a similarly heavy toll.

As the economist Henry Kaufman has written, the high levels of debt associated with buyouts and other forms of corporate restructuring create fragility in business structures and vulnerability to economic cycles. Inexorably, the shift away from equity invites the close, even intrusive involvement of institutional investors (banks, pension funds, and insurance companies) that provide the financing. Superficially, this moves America closer to the system that prevails in Germany and Japan, where historically the relationship between the suppliers and users of capital is close. But Germany and Japan incur higher levels of debt for expansion and investment, whereas equivalent American indebtedness is linked to the recent market for corporate control. That creates a brittle structure, one that threatens to turn the U.S. government into something of an ultimate guarantor if and when things do fall about. It is too easy to construct a scenario in which corporate indebtedness forces the federal government into the business of business. The savings-and-loan bailout is a painfully obvious harbinger of such a development.

The many ramifications of the buyout mania deserve thoughtful treatment. Basic issues of corporate governance and accountability ought to be openly debated and resolved if the American economy is to deliver the maximum benefit to society and not just unconscionable rewards to a handful of bankers, all out of proportion to their social productivity. It is disappointing, but a sign of the times, that the best book about the deal of deals fails to educate as well as it entertains.

Reviews 'Cowardly capitalism' by Daniel Ben-Ami Prospect Magazine December 1998 issue 36

The dominant image of the financial markets is that of a giant casino. Brash young men in red braces, driven by insatiable greed, gamble with huge sums every day. When the bets go wrong the innocent suffer. Reckless financial markets pose an immediate threat to the future prosperity of humanity.

Susan Strange, who died just after the publication of her lastest book, was one of the most compelling academic advocates of the view that the global casino is out of control. Although she is not a household name, she played an important role in developing the intellectual framework to support the casino thesis. Her Casino Capitalism (1986) is a Keynesian account of the damage inflicted on the world as a result of financial deregulation which was taken up by many better known writers such as William Greider in the US and Will Hutton in Britain.

With the onset of the Asian financial crisis Strange's account of financial markets has become almost mainstream. Her ideas inform many of the discussions about a "new international financial architecture." Economists who would once have scorned her views now agree with her that deregulation has gone too far and that new forms of regulation are needed. The British government has floated the idea of a world financial authority to regulate global finance. The IMF, once a bastion of free market economics, has conceded that capital controls may be necessary under some circumstances.

Mad Money, the sequel to Casino Capitalism, takes into account the impact of information technology and the rise of financial crime. It also places new emphasis on the role of international institutions. For example, she backs George Soros's plan for an international credit insurance corporation as a complement to the IMF.

Yet there is one striking omission from Mad Money. She points out that the dominant theme of her earlier work was the danger of volatility-the gyrations in the price of financial assets. But then she fails to notice that the decade since the publication of Casino Capitalism has been one of relatively low financial volatility. This assertion appears to be contradicted by everyday experience. Every week there is news of a record fall on the London stock market-often followed by a record rise. But such impressions do not take account of long-term stock market growth. A 200-point fall when the FTSE 100 index is at 6000 does not have the same significance as when it is at 1000.

The low volatility of the main world stock markets can be precisely measured. And William Schwert, a professor of finance and statistics in the US, has produced a comprehensive study of the US, Britain, Germany, Japan, Australia and Canada which states that "all of the evidence leads to the conclusion that volatility has been very low in the decade since the 1987 crash."

Strange is not alone in misreading volatility. The striking feature of the past decade is the gap between the fear of risk-taking and the real level of risk. The obsession with risk management is at an alltime high. Financial markets are characterised by fear rather than greed. We should talk of cowardly capitalism, not casino capitalism.

Cowardly capitalism, for example, lies behind the explosive growth in derivatives, normally seen as one of the instruments of financial madness. Derivatives are bets on the way in which the price of financial assets move. They can be used for speculation-and often are-but they are mainly used to reduce financial uncertainty. (A survey of derivative use by non-financial US companies in 1994-95, at the University of Pennsylvania, found that the main use of derivatives was to manage cash flow and reduce risk.)

How do derivatives work? Imagine a British plastics manufacturer that depends on imports of crude oil-priced in US dollars-as its main raw material. The business suffers if the dollar strengthens. One way it can protect itself against this is to bet on a rising dollar. If it does rise the extra cost of the oil will be offset by the money it makes from its derivative contract. This practice is known as hedging. It is similar in principle to life insurance which can be seen as a bet that the policy-holder will die in a given period.

It is certainly possible, through dishonesty or incompetence, to lose huge amounts through speculation in derivatives, but the market is driven by risk aversion rather than recklessness.

Derivatives are far from the only instance of cowardly capitalism. Another example is fund management. Back in 1957 almost two thirds of the London stock market was owned by private investors. Today it is dominated by investment funds such as pension funds, insurance funds and unit trusts. The main rationale of such investment funds is to manage risk. Their guiding principle is: "Don't put all your eggs in one basket." If an investor holds a few shares his portfolio is likely to suffer from high volatility. But a fund manager with a large number of shares can diversify risk. Increases in the prices of some shares can cancel out falls in others.

The intellectual rationale for fund management explicitly casts risk as a problem. In his seminal paper on portfolio theory, Harry Markowitz argues that "the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing." The suspicion of risk-taking is embedded in the intellectual heart of cowardly capitalism.

If the financial markets are so risk averse it is not clear why they should be seen as irresponsible risk-takers. In reality both perceptions are closely related. Financial markets are seen as reckless precisely because of the strength of risk aversion in the contemporary world.

But the act of risk-taking should not be stigmatised, otherwise markets will cease to function properly. Susan Strange's notion of casino capitalism should be ditched or at least modified. And grand regulatory schemes based on the notion of out of control financial markets should be handled with care. In the world of cowardly capitalism, where risk aversion rules, it is more accurate to see money as sad rather than mad.

Mad money

Susan Strange

Stefan Stern - Rise of 'casino capitalism ...

Rise of 'casino capitalism' shakes faith of moderate Monks

By Stefan Stern

Published: November 21 2006 02:00 | Last updated: November 21 2006 02:00

"The prototype of the successful man in modern society is not the scientist, the inventor, the scholar. It is the financier, the gambler and those with social pull. The others share [in the winnings] sometimes, it is true, but their share is modest compared with the oligarchs and tycoons; and they don't usually keep their share for long. They are no match for the commercial prowlers."

A snap-shot of London's Mayfair district, home to the burgeoning hedge-fund phenomenon, in November 2006? Actually, no. The above words were written in 1952 by the Labour politician Aneurin Bevan in his book In Place of Fear. Bevan had a gift - his most passionate supporters would say a genius - for exposing the truth of a situation in language that could be both scintillating and pungent.

Fifty years ago, he criticised the prime minister of the day, Sir Anthony Eden, for his reckless actions during the Suez crisis. "[He] has been pretending that he is now invading Egypt in order to strengthen the United Nations," Bevan said in a famous speech in Trafalgar Square. "Every burglar of course could say the same thing: he could argue that he was entering the house in order to train the police. So, if Sir Anthony Eden is sincere in what he is saying, and he may be . . . then he is too stupid to be a prime minister!" Here was political rhetoric with a touch of prophesy about it.

It was the enduring appeal of speeches such as these that helped draw a good crowd to the fifth annual Bevan memorial lecture in London last week. The lecture was to be given by John Monks, formerly general secretary of the British Trades Union Congress, now the Brussels-based leader of the European trade union confederation.

No one in the audience would have been expecting Bevanite rhetorical fireworks from Mr Monks. That has never been his style. Between 1993 and 2003, he led the British trade union movement with modesty and distinction. He was the moderate's moderate: avoiding confrontation wherever possible and advocating partnership at work between management and employees. Business leaders were happy to do business with him.

They would not have found this lecture so easy to deal with. Confronted by today's turbo-charged capitalism, Mr Monks cast off his former moderation. He even seemed to be on the verge of recanting his commitment to the partnership model. "Partnership with who?" he asked. There has been, he said, a "disintegration of the social nexus between worker and employer - a culture containing broad social rights and obligations. The new capitalism wants none of it."

Mr Monks contrasted businesses' healthy profitability with the ruthless way some have treated their staff recently, whether through large-scale redundancies or the constant threat that jobs may be sent off-shore or outsourced. While median wages have stagnated, record executive salaries are legion.

He admitted that he had possibly been a bit naive in the past. "I did not fully appreciate what was happening on the other side of the table," Mr Monks said. While he sympathised with business leaders for the relentless pressure they find themselves under - "It cannot be easy running a firm . . . when you are up for sale every day and every night of every year" - he was appalled by the increasingly "shameless", short-termist behaviour of overpaid corporate executives. "More and more they resemble the Bourbons - and they should be aware of what eventually happened to the Bourbons."

For someone like me, who has sat through 10 years of reasonableness from John Monks, this speech was remarkable, devastating stuff. Maybe there is something in the Brussels water. Perhaps the ghost of Nye Bevan was speaking through him. Or was it just anxiety over the career choice of his daughter's boyfriend? He is now working for - you guessed it - a hedge fund. Whatever its cause, a challenge was being thrown down.

"All this is too important to be left to the practitioners who have a vested interest in obscuring what they do from the rest of us," he said. And, with bonus season fast approaching, he took one final, sweeping aim at the high rollers of "casino capitalism". Their actions are "dangerous to economic stability, traditional industry and jobs", he said. "I would like to see the City pages of the press more challenging and less respectful on these matters . . . Our future - the world's future - is too important to place in the hands of the new capitalists."

Will corporate leaders - those that have read this far anyway - simply shrug their shoulders and get back to their slashing and burning ways? Is Mr Monks merely offering a wholly predictable, knee-jerk, lefty rant? I do not think so. This general secretary just does not do lefty rants. So business people should take note. When the John Monkses of this world say enough is enough, that the capitalist system itself is sick, you can be sure that elsewhere in the world there is deep-seated, lingering resentment and unhappiness.

Half a century ago, Nye Bevan expressed a similar concern. In In Place of Fear he wrote: "There is a sense of injustice in modern society, and this induces a feeling of instability even in normal circumstances. The rewards are not in keeping with social worth, and the consciousness of this, both among the successful and the unsuccessful, will simmer and bubble, blowing up into geysers of political and social disturbance in times of economic stress."

Reading these words, you can see why so many people were prepared to come out on a dark Tuesday night to see if the spirit of Bevan still had something to communicate 46 years after his death.

"CASINO CAPITALISM" AND THE RISE OF THE "COMMERCIALISED" SERVICE CLASS-AN EXAMINATION OF THE ACCOUNTANT

Gerard Hanlonf1
Institue for the Study of the Legal Profession, Law Faculty, University of Sheffield, Crookesmoor Building, Conduit Road, Sheffield, U.K., S10 1FL
Received 24 February 1994; revised 1 May 1995; accepted 1 May 1995. ; Available online 24 April 2002.

The central contention of this paper is that a new paradigm is emerging within the area of professional or expert labour. This process entails a shift from a "social service" evaluation mechanism to a "commercialised" mechanism. This change is but one element in a wider range of alterations entailed in the change from a Fordist regime of accumulation to a Flexible Accumulation regime. The paper examines these issues with regard to the chartered accountancy profession. It analyses the socialisation processes experienced by accountants and the evaluation criteria involved in the promotional process to partnership. The evidence for this paper was gathered from qualitative and quantitative research undertaken in the Big Six accountancy practices in Ireland and the USA.

Accountants as "new guard dogs" of capitalism: Stereoty...

Casino capitalism

Covenanting for justice

The call to a church process

The globalization of economic life

Casino capitalism

Faith, globalization, fullness of life

An economy in the service of life (1997-2004)

Covenant and confess

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Colloquium 2000

Controlling speculation in world financial markets Progressive Christians Uniting by Gordon K Douglass November 9 2002

Financial markets 101
Early history
The Bretton Woods system
The power of financial actors
Consequences of global financial flows
Policy options
Theological and ethical considerations
A new financial architecture
What Christians can do
Want to know more?
Questions For Discussion


"During my whole career at Goldman Sachs - 1967 to 1991 - I never owned a foreign stock or emerging market bonds. Now I have hundreds of millions of dollars in Russia, Brazil, Argentina and Chile, and I worry constantly about the dollar-yen rate. Every night before I go to bed I call in for the dollar-yen quote, and to find out what the Nikkei is doing and what the Hang Seng Index is doing. We have bets in all these markets. Right now Paul [one of my traders] is long [on] the Canadian dollar. We have bets all over the place. I would not have worried about any of these twenty years ago. Now I have to worry about all of them."

Leon Coopermann, hedge fund manager1


Economic globalization is probably the most fundamental transformation of the world's political and economic arrangements since the Industrial Revolution. Decisions made in one part of the world more and more affect people and communities elsewhere in the world. Sometimes the consequences of globalization are positive, liberating inventive and entrepreneurial talents and accelerating the pace of sustainable development. But at other times they are negative, as when many people, especially in less-developed countries, are left behind without a social safety net. Globalization undermines the ability of the nation to tax and to regulate its own economy. This weakens the power of sovereign nations relative to that of large transnational corporations and distorts how social and economic priorities are chosen.

Economic globalization is most often associated with rapid growth in the flow of goods and services across international borders. Indeed, the economic "openness" of a nation is often measured by the value of its exports, imports, or their sum when compared to the size of its economy. Economic globalization also involves large investments from outside each nation, often by transnational corporations. These corporations often combine technology and know-how with their investments that enhance the productive capacity of a nation. Previous position papers of the Mobilization, contained in Speaking of Religion & Politics: The Progressive Church Tackles Hot Topics2, have dealt with globalization primarily in these terms.

But international trade and investment are only part of the openness that has come to be called globalization. Another part, and arguably the most important, is the quickening flow of financial assets internationally. While a small portion of this flow is directly associated with the "real" economy of production and exchange, its vast majority is composed of trades in the "paper" economy of short-term financial markets. This paper economy is enormous: The value of global financial securities greatly exceeds the value of annual world output of goods and services. Moreover, the paper economy often contributes to crises in the real economy. Thus it is important to the well being of humanity and the planet as a whole, yet it is little understood by most people. This essay undertakes to provide a basic understanding of this paper economy, especially as its more speculative features have multiplied during the last two or three decades, so that Christians and others concerned about what is happening in our world can join in an intelligent discussion of how the harmful consequences of financial markets can be controlled.


Financial markets 101

To better understand this paper economy, one first needs to know something about foreign exchange markets, international money markets, and "external" financial markets.

In an open economy, domestic residents often engage in international transactions. American car dealers, for example, buy Japanese Toyotas and Datsuns, while German computer companies sell electronic notebooks to Mexican businessmen. Similarly, Australian mutual funds invest in the shares of companies all over the world, while the treasurer of a Canadian transnational corporation parks idle cash in 90-day Bank of England notes. Most of these transactions require one or more participants to acquire a foreign currency. If an American buys a Toyota and pays the Japanese Toyota dealer in dollars, for example, the latter will have to exchange the dollars for yens in order to have the local currency with which to pay his workers and local suppliers.

The foreign exchange market is the market in which national currencies are traded. As in any market, a price must exist at which trade can occur. An exchange rate is the price of a unit of domestic currency in terms of a foreign currency. Thus, if the exchange rate of the dollar in terms of the Japanese yen increases, we say the dollar has depreciated and the yen has appreciated. Similarly, a decrease in the dollar/yen exchange rate would imply an appreciation of the dollar and a depreciation of the yen.

Foreign exchange markets can be classified as spot markets and forward markets. In spot markets currencies are bought and sold for immediate delivery and payment. In forward markets, currencies are bought or sold for future delivery and payment. A U.S. music company, say, enters into a contract to buy British records for delivery in 30 days. To guard against the possibility of the dollar/pound exchange rate increasing in the meantime, the company buys pounds forward, for delivery in 30 days, at the corresponding forward exchange rate quoted today. This is called hedging.

Of course, there has to be a counterpart to the music company's forward purchase of pounds. Who is the seller of those pounds? The immediate seller would be a commercial bank, as in the spot market. But the bank only acts as an intermediary. The ultimate seller of forward pounds may be another hedger, like the music company, but with a position just its opposite. Suppose, for example, that an American firm or individual has invested in 30-day British securities that it wants to convert back into dollars after the end of 30 days. The investor may decide to sell the pound proceeds forward in order to assure itself of the rate at which the pounds are to be converted back into dollars after 30 days.

Another type of investor may be providing the forward contract bought by the music company. This is the speculator, who attempts to profit from changes in exchange rates. Depending on their expectations, speculators may enter the forward market either as sellers or as buyers of forward exchange. In this particular case, the speculator may have reason to believe that the dollar/pound exchange rate will decrease in the next 30 days, permitting him to obtain the promised pounds at a lower price in the spot market 30 days hence.

The main instruments of foreign exchange transactions include electronic bank deposit transfers and bank drafts, bills of exchange, and a whole array of other short-term instruments expressed in terms of foreign currency. Thus, foreign exchange transactions do not generally involve a physical exchange of currencies across borders. They generally involve only changes in debits and credits at different banks in different countries. Very large banks in the main financial centers such as New York, London, Brussels and Zurich, account for most foreign exchange transactions. Local banks can provide foreign exchange by purchasing it in turn from major banks.

Although the foreign exchange market is dispersed in many cities and countries, it is unified by keen competition among the highly sophisticated market participants. A powerful force keeping exchange rate quotations in different places in line with each other is the search on the part of market participants for foreign exchange arbitrage opportunities. Arbitrage is the simultaneous purchase and sale of a commodity or financial asset in different markets with the purpose of obtaining a profit from the differential between the buying and selling price.

When foreign exchange is acquired in order to engage in international transactions involving the purchase or sale of goods and services, it is said that international trade has taken place in the real economy. When international transactions involve the purchase or sale of financial assets, they are referred to as international financial transactions. They constitute the paper economy.

Financial markets are commonly classified as capital markets or money markets. Capital markets deal in financial claims that reach more than one year into the future. Such claims include shares of stock, bonds, and long-term loans, among others. Money markets, on the other hand, deal in short-term claims, with maturities of less than one year. These include marketable government securities (like Treasury bills), large-denomination certificates of deposit issued by banks, commercial paper (representing short-term corporate debt), money market funds, and many other kinds of short-term, highly liquid (easily transferable) financial instruments. It is these short-term money market securities that account for most of the instability in the global paper economy.

Buying or selling a money market security internationally involves the same kind of foreign exchange risk that plagues buyers or sellers of merchandise internationally. If one wishes to guard against the possibility of an increase or decrease in the foreign exchange rate, one can insure against such fluctuations by "covering" in the forward market. By the same token, the decision about whether to own domestic or foreign money market securities is not simply a comparison of the rates of interest paid on otherwise comparable securities, because one must also take into account the gain (or loss) from purchasing foreign currency spot and selling it forward. Thus, choosing the security with the highest return does not necessarily imply the one with the highest interest rate.

People who trade in international money markets, moreover, need to take into account many other variables, including the costs of gathering and processing information, transaction costs, the possibility of government intervention and regulation, other forms of political risk, and the inability to make direct comparisons of alternative assets. Speculating in international money markets is a risky proposition.

International money markets involve assets denominated in different currencies. External financial markets involve assets denominated in the same currency but issued in different political jurisdictions. Eurodollars, for example, are dollar deposits held outside the United States (offshore), such as dollar deposits in London, Zurich, or even Singapore banks. The deposits may be in banks owned locally or in the offshore banking subsidiaries of U.S. banks. Deutsche mark deposits in London banks or pound sterling deposits in Amsterdam banks also are examples of external deposits. They are referred to as eurocurrency deposits. (The advent of a new common currency in the European Community - the Euro - will require the development of new nomenclature for external financial markets)

External banking activities are a segment of the wholesale international money market. The vast majority of eurocurrency transactions fall in the above $1 million value range, frequently reaching the hundreds of millions (or even billion) dollar value. Accordingly, the customers of eurobanks are almost exclusively large organizations, including multinational corporations, government entities, hedge funds, and international organizations, as well as eurobanks themselves. Like domestic banks, eurobanks that have excess reserves may make loans denominated in eurocurrencies, expanding the supply of eurocurrency deposits. The eurocurrency market funnels funds from lending countries to borrowing countries. Thus, it performs an important function as global financial intermediator.


Early history

The origins of what Karl Polanyi3 called haute finance can be traced to Renaissance Italy, where as early as 1422 there were seventy-two bankers or bill-brokers in or near the Mecato Vecchio of Florence.4 Many combined trade with purely financial business. By the middle of the fifteenth century, the Medici of Florence had opened branches in Bruges, London and Avignon, both as a means of financing international trade and as a way of marketing new kinds of financial assets. Many banking terms and practices still in use today originated in the burgeoning financial centers of Renaissance Europe.

By the early seventeenth century, the Dutch and East India Companies began issuing shares to the public in order to fund imperial enterprises closely linked to Holland and Britain. Their shares were made freely transferable, permitting development of a secondary financial market for claims to future income. Amsterdam opened a stock exchange in 1611, and shortly thereafter, the British government began issuing lottery tickets, an early form of government bonds, to finance colonial expansion, wars and other major areas of state expenditure. A lively secondary market in these financial instruments also emerged.5

Throughout these early years, financial markets were anything but riskless and stable. Consider the famous Dutch tulip mania of 1630, for example. This speculative bubble saw prices of tulip bulbs reach what seemed like absurd levels, yet "the rage among the Dutch to possess them [tulips] was so great that the ordinary industry of the country was neglected." Some investors in Britain and France shared this "irrational exuberance," though it was centered mostly in Holland. Then, not unlike speculative bubbles of more recent vintage, prices crashed6, pushing the economy into a depression and leaving many investors angry and confused.

Paris developed into an early financial center in the eighteenth century, but the Revolution of 1789 dissipated its power. The New York Stock Exchange was formally organized in 1792 and the official London Stock Exchange opened in 1802. The expansion westward of the railroads in the U.S. offered the financial community opportunity to sell railway shares and bonds that quickly became dominant in the financial markets. Indeed, the bond markets of London, Paris, Berlin, and Amsterdam were vehicles for collecting massive amounts of European savings and transferring it at higher returns to the emerging markets of the U.S., Canada, Australia, Latin America and Russia in the century preceding World War I.

Forward markets soon developed, especially in the U.S., in order to counter the impact of long distances and unpredictable weather. As capital and money markets expanded, other new financial instruments came into use. Joint stock companies were formed, enabled by legislation that clarified the distinction between the owners and managers of corporations. This, in turn, helped stimulate the growth of the American stock market in the late nineteenth century. To be sure, financial markets did not grow continuously in the nineteenth century. Lending to the emerging markets was interrupted by defaults in the 1820s, 1850s, 1870s and 1890s, but each wave of default was confined to a relatively small number of countries, permitting growth of financial flows to resume.7

In the four decades leading up to World War I, a truly worldwide economy was forged for the first time, extending from the core of Western Europe and the U.S. to latecomers in Eastern Europe and Latin America and even to the countries supplying raw materials on the periphery. Central to this expansion of trade and investment was an expanding system of finance that girded the globe. The amount was enormous: between 1870 and 1914 something like $30 billion,8 the equivalent in 2002 dollars of $550 billion, was transferred to recipient countries, in a world economy perhaps one-twelfth as large as today's.

During this "Gilded Age" of haute finance, the risks of participating in international trade and investment were generously shared with governments and the banking system. The reason is that foreign exchange rates were kept reasonably stable by the commitment of most governments to the "high" gold standard. In this way, businesses and individuals engaging in international transactions were reasonably certain that the value of their contracts was not going to change before they matured. Their exchange risk was shared with government by its willingness to buy or sell gold in order to keep the exchange rate constant. Because of this assurance, financial flows were reasonably free of regulation.

They were not immune from crises, however. When the sources of financial capital temporarily dried up, capital-importing countries occasionally found they could not expand export earnings sufficiently to avoid suspending interest payments on their debts or abandoning gold parity. On two occasions, the United States faced this possibility. The first was in 1893, when it switched in a sharp economic downturn to bimetallism (which caused William Jennings Bryan to denounce the "cross of gold"), and the second was in 1907, which led to the creation of the Federal Reserve System, handing to the government the function of lender of last resort previously carried out by Wall Street banks under the tutelage of J. Pierpont Morgan.

In his magisterial book The Great Transformation, Karl Polanyi reflected on the pervasive influence of haute finance on the policies of nations even in this "Gilded Age." The globalising financial markets and the gold standard, according to Polanyi, left very little room for states, especially smaller ones, to adopt monetary and fiscal policies independent of the new international order. "Loans, and the renewal of loans, hinged upon credit, and credit upon good behavior. Since, under constitutional government ..., behavior is reflected in the budget and the external value of the currency cannot be detached from the appreciation of the budget, debtor governments were well advised to watch their exchanges carefully and to avoid policies which might reflect upon the soundness of budget positions." Thus, even one hundred years ago the then-dominant world power, Great Britain, speaking as it did so often through the voice of the City of London, "prevailed by the timely pull of a thread in the international monetary network.9

Following World War I, the United States emerged not merely as a creditor country but as the primary source of new international financial flows. At first, the principal borrowers were the national governments of the stronger countries, but as the boom in security underwriting developed in the U.S, numerous obscure provinces, departments and municipalities found it possible to sell their bonds to American investors.10 Just as domestic construction, land, and equity markets went through speculative rises in the 1920s, so too did the U.S. experience a speculative surge in foreign investment. In the aftermath of successive defaults by foreign debtors in 1932, the Senate Committee on Banking and Currency concluded:

The record of the activities of investment bankers in the flotation of foreign securities is one of the most scandalous chapters in the history of American investment banking. The sale of these foreign issues was characterized by practices and abuses that violated the most elementary principles of business ethics.11

Speculation in the stock markets leading up to 1929 offers still another window on the instability of short-term financial flows. A speculative market can be defined as one in which prices move in response to the balance of opinion regarding the future movement of prices rather than responding normally to changes in the demand for and supply of whatever is priced. Helped by the willingness of Wall Street to allow people to buy stocks on margin, people were only too ready to bet prices would rise as long as others thought so too. Day after day and month after month the price of stocks went up in 1927. The gains by later standards were not large, but they had an aspect of great reliability. Then in 1928, the nature of the boom changed. "The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.12

Following World War I, the gold standard itself took on new form. Nations were allowed to hold their international reserves in either gold or foreign exchange. This worked for a while in the 1920s, but as speculation mounted and balances of payments disequilibria grew, fears of devaluation led central banks to try to replace their foreign-exchange holdings with specie in a "scramble for gold." The worldwide result of these shifts in central bank portfolios was an overall contraction of the supply of money and credit that sapped aggregate demand and forced prices to fall and output levels to shrink. Thus, it can be argued - persuasively in our view - that the Great Depression of the 1930s was as much, if not more, the result of mismanagement of money and credit as it was the result of protectionist policies. Protectionist policies were more likely the result of slowed growth and stalled trade. Countries that broke with the gold-exchange standard early, such as Britain in 1931, and pursued more expansionary monetary policies fared somewhat better.


The Bretton Woods system

During the darkest days of World War II, a radically new economic architecture was designed for the postwar world at a New Hampshire ski resort called Bretton Woods. With the competitive devaluation and protectionist policies of the 1930s still fresh in their minds, the mostly British and American delegates to the conference wanted most of all to design a system with fixed exchange rates that did not rely on national gold hoards to keep exchange rates stable. They decided to depend instead on strict controls of international financial movements. In this way, they hoped to allow countries to pursue full-employment policies through appropriate monetary (money and credit) and fiscal (tax and spending) policies without some of the anxieties associated with open financial markets. The role of monetary and financial stabilizer was given to the International Monetary Fund (IMF), which was provided with modest funds to assist nations to adjust imbalances in their external payments obligations. The International Bank for Reconstruction and Development (IBRD, later the World Bank) assumed the task of helping to finance post-war reconstruction.13

The IMF as it emerged from Bretton Woods had inadequate reserves to advance money for the long periods that many countries require for "soft-landings" from big current-account deficits. It would make only short-term loans. To make sure that borrowing nations were constrained, "conditionality" attached to IMF loans became standard practice, even in the early years of the Fund's operation. Policy limitations and "performance targets" tied to credit lines advanced under "standby agreements" began in the middle 1950s and were universal by the 1960s, long before the notions of "stabilization" and "structural adjustment" came into common parlance.

The Bretton Woods agreement also imposed a foreign exchange standard by which exchange rates between major currencies were fixed in terms of the dollar, and the value of the dollar was tied to gold at a U.S. guaranteed price of thirty-five dollars per ounce. By devising a system that controlled financial movements and assisted with the adjustment of countries' balances of payments, the new system succeeded in keeping exchange rates remarkably stable. They were changed only very occasionally, e.g., as when the value of sterling relative to the dollar was reduced in 1949 and again in 1966. This meant that companies doing business abroad did not need to worry constantly about the risk of exchanging one currency for another.

Among the reasons for this remarkable stability was the willingness of the central banks of other countries to hold an increasing proportion of their official reserves in the form of U.S. dollars. It was an essential part of the system that the dollars held by other countries would be seen as IOUs backed by the U.S. offer to exchange them for gold at a fixed pre-war price. But as the balance-of-payments of the U.S. moved more deeply into deficits in the 1960s, there were more and more U.S. dollars held by other countries, and this so-called "dollar overhang" became disturbingly large.15 General de Gaulle called it "the exorbitant privilege," meaning that the Americans were paying their bills - for defense spending to fight the Vietnam War among other things - with IOUs instead of real resources in the form of exports of goods and services.

Strict control over financial movements began to weaken as early as the 1950s, when the first eurodollar (later eurocurrency) deposits were made in London. At first a trickle, limited originally to Europe, these offshore banking operations soon expanded worldwide. The American "Interest Equalization Tax" (IET) instituted in 1963 raised the costs to banks of lending offshore from their domestic branches.16 The higher external rates led dollar depositors such as foreign corporations to switch their funds from onshore U.S. institutions to eurobanks. Thus, the real effect of the IET was to encourage the dollar to follow the foreigners abroad, rather than the other way around. Eurobanks paid higher interest rates on deposits and loaned eurocurrencies at lower rates than U.S. banks could at home. Still another large inflow of eurodeposits occurred in 1973-74 as the Organization of Petroleum Exporting Countries (OPEC) began "recycling" their surplus dollar earnings through eurobanks. Because of their existence, a country such as Brazil could arrange within a reasonably regulation-free environment to obtain multimillion-dollar loans from a consortium of offshore American, German and Japanese banks and thereby finance its oil imports. Net eurocurrency deposit liabilities that amounted to around $10 billion in the mid-1960s, grew to $500 billion by 1980.

These eurocurrency transactions taught the players in financial markets how to shift their deposits, loans, and investments from one currency to another whenever exchange rates or interest rates were thought to be ready to change. Even the ability of central banks to regulate the supply of money and credit was undermined by the readiness of commercial banks to borrow and lend offshore. Hence, the effectiveness of regulatory mechanisms that had been put in place to implement the Bretton Woods agreement - interest rate ceilings, lending limits, portfolio restrictions, reserve and liquidity requirements - gradually eroded as offshore transactions started to balloon.

The world economy developed at unprecedented rates during the roughly twenty-five years immediately following World War II. Growth and employment rates during these years were at historic highs in most countries. Productivity also advanced rapidly in most developing countries as well as in the technological leaders. These facts suggest that the system devised at Bretton Woods worked reasonably well, despite occasional adjustments. To be sure, it helped to sow the seeds of its own destruction by failing to retain operational control of international financial flows. But the twenty-five years of its survival leading up to August 15, 1971, when President Nixon closed the gold window, have nonetheless come to be called by some economic historians the "Golden Years."

Controlling private risk

Fixed exchange rates did not last long after the U.S. stopped exchanging gold for claims on the dollar held by foreign central banks. The pound sterling was allowed to float against the dollar in July, 1972. Japan set the yen free to float in February, 1973, and most European currencies followed suit shortly thereafter. The Bretton Woods gold-dollar system was doomed.

The fact that exchange rates no longer were fixed meant that companies doing business in different countries had to cope with the day-to-day shifts in the dollar's rate of exchange with other currencies. The risks of unexpected changes in the value of international contracts suddenly had shifted from the public to the private sector. Corporate finance officers now had to hedge against possible exchange losses by buying a currency forward and investing the equivalent in the short-term money market, or by investing in the eurocurrency market. The corporations' banks, in turn, tried to match each foreign currency transaction with another contrary transaction in order not to leave each of the banks exposed to foreign exchange risk overnight. Since no single bank was likely to balance its foreign exchange positions exactly, the need arose to swap deposits in different currencies in order to match corporate hedging transactions and to square the bank's books.

The price of this forward cover on inter-bank transactions - that is to say, the premium or discount on a currency's spot value - has tended to accord with the differences between interest-rates offered for eurocurrency deposits in different currencies. This is the connection between the foreign exchange market and the short-term credit markets, between exchange rates and interest rates. Whenever exchange rates move up or down, therefore, their influence is immediately transmitted through the eurocurrency markets to the credit markets.

It is this scramble to avoid private risk that accounted for the dramatic rise in international financial movements following the demise of the Bretton Woods system. By 1973, daily foreign exchange trading around the world varied between $10 and $20 billion per day. This amount was approximately twice the value of world trade at the time. Bank of International Settlements data suggests that the daily average of foreign exchange trading had climbed by 1980 to about $80 billion, and that the ratio between foreign exchange trading and international trade was more nearly ten to one. The data for 1992 was $880 billion and fifty to one, respectively; for 1995, $l,260 billion and seventy to one; and for 2000, almost $1,800 and ninety to one.

There is very little doubt, therefore, that the lion's share of international financial flows is relatively short-run. Indeed, about eighty percent of foreign exchange transactions are reversed in less than seven business days. Only a very small proportion is used to finance international trade and direct foreign investment. The vast majority must be used with the expectation of gain or to avoid losses that may result from changes in the value of financial assets. In general terms, they are speculative, made in hope of capital gain or to hedge against potential capital loss, or to seek the gains of arbitrage based on slight differences in rates of return in different financial centers.


The power of financial actors17

Foreign exchange markets and markets for money and credit seem remote and abstract to most people. This section introduces the real institutions that operate these markets and assesses the nature of their power.

According to recent work by political scientists, the power of these financial actors is based in part on a complicated "process of multiplication" of loans, assets and transactions. Many investors in financial markets buy financial instruments on very thin margins, based on loans obtained by pledging the assets as collateral. This is called "leverage" in the jargon of financial markets. In turn, the borrowed funds are invested in other financial assets, multiplying the demand for credit and financial assets. As demand rises, more sophisticated financial assets are invented, including many forms of financial derivatives. A major portion of the accumulated debt remains serviceable only as long as the prices of most assets will rise or at least remain relatively stable. If prices turn down, they easily can lead to a chain-reaction. If investors respond instinctively like a herd, they will bring a far-reaching collapse that constitutes a crisis.

As the flow of financial assets climbs, some bankers, brokers, and managers of financial institutions become prominent players in the competition for investor dollars. Some become known for picking profitable places to invest and for promoting their selections successfully. This can influence markets if people have confidence in their advice. A notorious example of the influence of prominent players was the attack on British sterling in 1992 by George Soros' Quantum Fund. Believing that sterling was overvalued, the Fund quietly established credit lines that allowed it to borrow $15 billion worth of sterling and sell it for dollars at the then "overvalued" price. Its purpose, of course, was to pay back the loan with cheaper pounds after they had depreciated. Having gone long on dollars and short on sterling, Soros decided to speak up noisily. He publicized his short-selling and made statements in newspapers that the pound would soon be devalued. It wasn't long before sterling was devalued; he made $1 billion in profit.

The point can be made more generally: financial markets are subject to manipulation because they have become socially structured. Market leaders and financial gurus are admired and followed (at least until very recently). The heavyweights thus dominate the business. An obvious consequence of this is that there is a strong tendency in financial markets for further concentration of resources.

Another source of the power of financial actors is their obvious affinity for the rampant free-market philosophy of neo-liberalism. The freedom with which they move financial capital around depends, of course, on the market-friendly policies of the so-called Washington Consensus.19 As long as they are seen as part of the governing coalition, they derive special powers to regulate themselves rather than be controlled by an independent government agency or civil society. Their power also is reinforced by the activities of several collective associations of financial actors,20 which lobby on their behalf.

One more source of power for the financial actors is their knowledge that if they are big enough and sufficiently interlaced with other financial actors, then the "system" will keep them from failing. Consider the case of Long-term Capital Management, a hedge fund partnership started in 1994. It was able to borrow from various banks the equivalent of forty times its capitalization in order to make bets on changes in the relative prices of bonds in the U.S. and abroad. When the Russian government announced a devaluation and debt moratorium in August, 1998, it produced losses that the fund could not sustain. Nor could some of the banks that had loaned large amounts to the fund. Accordingly, the Federal Reserve Bank of New York, fearful that the risk to the entire system was too high, orchestrated a private rescue operation by fourteen banks and other financial institutions, which re-capitalized the company for $3.5 billion.

Financial actors also have the power indirectly to influence non-financial actors such as firms or states. By providing economic incentives to gamble and speculate on financial instruments, global financial markets divert funds from long-term productive investments. In all probability, they also encourage banks and financial institutions to maintain a regime of higher real interest rates that reduce the ability of productive enterprises to obtain credit. The volatility of global financial markets, moreover, brings uncertainty and volatility in interest rates and exchange rates that are harmful to various sectors of the real economy, particularly international trade.

The above stories about George Soros and Long-term Capital Management are good illustrations of the consequences for non-financial actors of actions by financial actors. Both episodes are examples of games that are basically zero-sum, at least in the short-run. Nothing new was produced; no new values were created. In the 1992 case about speculating against sterling, the Quantum Fund's profits were at the expense of the British government, especially the Bank of England, and British taxpayers. In 1998, the losses suffered by Long-term Capital Management came out of the pockets of the stockholders of the banks that bailed it out, as the stock-market value of their shares depreciated. Hence, the financial system tends to feed itself by drawing more resources from other sectors of the economy, undermining the vitality of the real economy.


Consequences of global financial flows

The dominant economic ideology of the last twenty-five years has been embodied in the so-called Washington Consensus. It is a "market-friendly" ideology that traces its roots to longstanding policies of the IMF that encourage macroeconomic "stabilization;" to adoption by the World Bank of ideas in vogue in Washington early in the Reagan period concerning deregulation and supply-side economics; to the zeal of the Thatcher government in England for privatizing public enterprises; and perhaps most of all to the neo-liberal tendencies of the business community and the economics profession in the U.S. The implementation of these policies of economic "reform," by first "stabilizing" the macro-economy and then "adjusting" the market so that it can perform more efficiently, are supposed to pay off in the form of faster output growth and rising real incomes

Among these policy prescriptions is financial liberalization in both the developed and the developing countries. Domestically it is achieved by weakening or removing controls on interest and credit and by diluting the differences between banks, insurance and finance companies. International financial liberation, on the other hand, demands removal of controls and regulations on both the inflows and outflows of financial instruments that move through foreign exchange markets. It is the implementation of these reforms that is perhaps the single most important cause of the surge in global financial flows. To be sure, the influence of technological advances has broken the natural barriers of space and time for financial markets as twenty-four hour electronic trading has grown. The fact that throughout most of the 1980s and 1990s the developed countries suffered from over-capacity and overproduction in manufacturing may also have led the owners of financial capital to look for alternative profit opportunities.

It now is time to ask whether the implementation of all these reforms, on balance, has produced good or bad results. The focus of this section will be mostly on the consequences of large and expanding international financial flows. After all, they are the main concern of this essay. But first, we should ask whether or not the policies of growth and rising real incomes promoted by the Washington Consensus have borne fruit.

Growth and income

There is little doubt that the introduction of the Washington Consensus' policy mix expanded the volume of international trade. As a result, trade in goods and services has grown at more than twice the rate of global gross domestic product (GDP), and developing countries' share of trade has risen from 23 to 29 percent. Increasing numbers of firms from developing countries, like their industrial-country counterparts, engage in transnational production and adopt a global perspective in structuring their operations. The flow of foreign direct investments and foreign portfolio investments has multiplied even more rapidly than trade, despite the financial instability experienced in Asia, Brazil, Russia, and elsewhere in recent years.

The effects of liberalization have not been uniformly favorable, however. After at least ten full years of experience with the Washington Consensus, several recent studies have begun to assess the consequences for developing countries of this experiment in more open markets.21 Except for the years of crisis in a number of the countries studied, most developing countries achieved moderate growth rates of gross domestic product in the 1990s - considerably higher than in the l980s in Africa and Latin America during the debt crisis, but remarkably unchanged in most other regions. Moreover, average annual growth in the 1990s was slightly lower than in the twenty-five years preceding the debt crisis when a strategy of substituting domestic production for imports was in fullest use. When population growth rates are taken into consideration, the growth rate of per capita income in the developing countries studied during the 1990s also was somewhat lower than in the 1960s and 1970s. Toward the end of the 1990s, growth tapered off in many countries due to emerging domestic financial crises or external events. There is little evidence in these figures, therefore, to suggest the strategy of liberalization boosted growth rates appreciably.

Nor did the distribution of income improve in most developing countries in the 1990s. On the contrary, virtually without exception the wage differentials between skilled and unskilled workers rose with liberalization. The reasons for this varied widely among countries, but one of the most important reasons was the fact that the number of relatively well-paid jobs in sectors of the economy involved with international trade, though growing, was insufficient to absorb available workers, forcing many workers into more precarious and poorly paid employment in the non-traded, informal trade, and service sectors or where traditional agriculture served as a sponge for the labor market. Between the mid-1960s and the late-1990s, the poorest 20 percent of the world population saw its share of income fall from 2.3 to 1.4 percent. Meanwhile, the share of the wealthiest quintile increased from 70 to 85 percent.22

Risk and reward

While all markets are imperfect and subject to failure, financial markets are more prone than others to fail because they are plagued with three particular shortcomings: asymmetric information, herd behavior and self-fulfilling panics. Asymmetric information is a problem whenever one party to an economic transaction has insufficient information to make rational and consistent decisions. In most financial markets where borrowing and lending take place, borrowers usually have better information about the potential returns and risks associated with the investments to be financed by the loans than do the lenders. This becomes especially true as financial transactions disperse across the globe, often between borrowers and lenders of widely different cultures.

Asymmetric information leads to adverse selection and moral hazard. Adverse selection occurs when, say, lenders have too little information to choose from among potential borrowers those who are most likely to use the loans wisely. The lenders' gullibility, therefore, attracts more unworthy borrowers. Moral hazard occurs when borrowers engage in excessively risky activities that were unanticipated by lenders and lead to significant losses for the lender. Yet another form of moral hazard occurs when lenders indulge in lending indiscriminately because they assume that the government or an international institution will bail them out if the loans go awry.

A good illustration of asymmetric information is the story of bank lending following OPEC's large increase in oil prices following 1973. Awash in cash, the oil exporters deposited large amounts in commercial banks that then perfected the Euro-currency loan for developing countries. Eager to put excess reserves to use, the banks spent little time discriminating among potential borrowers, in part because they believed host governments or international agencies would guarantee the loans. At the same time, developing countries found they could readily borrow not only to import oil, but also to increase other kinds of expenditures. This meant they could use borrowed funds to maintain domestic spending rather than be forced to adjust to the new realities of higher prices for necessary imports. There is considerable evidence that moral hazard also was present in the Mexican crises in 1982 and 1994, and in the Southeast Asian crises in 1997-8.

Yet another illustration of asymmetric information is the tendency of financial firms, especially on Wall Street and in the City of London, to invent ever more complex derivatives to shift risk around the financial system. The market for these products is growing rapidly, both on futures and options exchanges (two of the several places where derivatives are traded). A financial engineer, for example, can take the risk in, say, a bond and break it down into a series of smaller risks, such as that inflation will reduce its real value or that the borrower will default. These smaller risks can then be priced and sold, using derivatives, so that the bondholder keeps only those risks he wishes to bear. But this is not a simple task, particularly when it involves assets with risk exposures far into the future and which are traded so rarely that there is no good market benchmark for setting the price. Enron, for instance, sold a lot of these sorts of derivatives, booking profits on them immediately even though there was a serious doubt about their long-term profitability. Stories of huge losses incurred in derivative trading are legion. The real challenge before central banks and regulatory bodies is to curb speculative behavior and bring discipline in derivative markets.

A second source of risk in financial markets is the tendency of borrowers and lenders alike to engage in herd behavior. John Maynard Keynes, writing in the 1930s, suggested that financial markets are like "beauty contests." His analogy was to a game in the British Sunday newspapers that asked readers to rank pictures of women according to their guess about the average choice by other respondents. The winner, therefore, does not express his own preferences, but rather anticipates "what average opinion expects average opinion to be." Accordingly, Keynes thought that anyone who obtained information or signals that pointed to swings in average opinion and to how it would react to changing events had the basis for substantial gain. Objective information about economic data was not enough. Rather, simple slogans "like public expenditure is bad," "lower unemployment leads to inflation," "larger deficits lead to higher interest rates," were then the more likely sources of changes in public opinion. What mattered was that average opinion believed them to be true, and that advance knowledge of, say, more public spending, lower unemployment, or larger deficits, respectively, offered the speculator a special advantage.

A financial market that operates as a beauty contest is likely to be highly unstable and prone to severe changes. One reason for this is that people trading in financial assets, even today, know very little about them. People who hold stock know little about the companies that issued them. Investors in mutual funds know little about the stocks their funds are invested in. Bondholders know little about the companies or governments that issued the bonds. Even knowledgeable professionals are often more concerned with judging how swings in conventional opinion might change market values rather than with the long-term returns on investments. Indeed, since careful analysis of risks and rewards is costly and time consuming, it often makes sense for fund managers and traders to follow the herd. If they decide rationally not to follow the herd, their competence may be seriously questioned. On the other hand, if fund managers follow the herd and the herd suffers losses, few will question their competence because others too suffered losses. When financial markets are operated like a beauty contest, everyone wants to sell at the same time and nobody wants to buy.

The financial markets behaved as predicted shortly after several industrial countries, including the U.S. and Germany, abolished all restrictions on international capital movements in 1973. The new system proved to be highly volatile, with exchange rates, interest rates, and financial asset-prices subject to large short-term fluctuations. The markets also were susceptible to contagion when financial tremors spread from their epicenter to other countries and markets that seemingly had little connection with the initial problem. In less than five years, it already was clear that both the surpluses and the deficits on the major countries' balance of payments were getting larger, not smaller, despite significant changes in the exchange rates.

In some cases, a financial crisis can be self-fulfilling. A rumor can trigger a self-fulfilling speculative attack, e.g. on a currency, that may be baseless and far removed from the economic fundamentals (unlike the Soros story above). This can cause a sudden shift in the herd's intentions and lead to unanticipated market movements that create severe financial crises. Consider, for example, the succession of major financial crises that have pock-marked the recent history of international financial markets, including Latin America's Southern Cone crisis of 1979-81, the developing-country debt crisis of 1982, the Mexican crisis of 1994-95, the Asian crisis of 1997-98, the Russian crisis of 1998, the Brazilian crisis of 1999, and the Argentine crisis of 2001-02.

Perhaps the Asian crisis of 1997-98 is the most interesting in this regard, for there were relatively few signals beforehand of impending crisis. All the main East Asian economies displayed in 1994-96 low inflation, fiscal surpluses or balanced budgets, limited public debt, high savings and investment rates, substantial foreign exchange reserves and no signs of deterioration before the crisis. This background has led many analysts to suppose that the crisis was a mere product of the global financial system. But what could have triggered the herd to stampede out of Asian currencies? No doubt several factors were at work. Before the crisis that started in the summer of 1997, there was a rise in short-term lending to Asians by Western and Japanese banks with little or no premiums, a fact that the Bank for International Settlement raised questions about. Alert investors, especially hedge funds, also noticed that substantial portions of East and Southeast Asian borrowings were going into non-productive assets and real estate that often were linked to political connections. In fact, some of the funds pouring into non-productive assets were coming out of the productive sector, mortgaging the longer-term viability of some real economies. Information about the structure and policies of financial sectors was opaque. Thus, opinions began to change among key lenders about the regulation of financial sectors in several Asian countries and their destabilizing lack of transparency. Suddenly, several important hedge funds reduced their exposure by shorting currency futures, followed quickly by Western mutual funds. The calling of loans led quickly to deep depression in several Asian countries. It has been estimated that the Asian crisis and its global repercussions cut global output by $2 trillion in 1998-2000.

Loss of government autonomy

Both economic theory and the experience of managing the external financial affairs of nations tell us that it is virtually impossible to maintain (1) full financial mobility, (2) a fixed exchange rate, and (3) freedom to seek macro-economic balance (full employment with little inflation) with appropriate monetary and fiscal policies. Only two of these policy objectives can be consistently maintained. If the authorities try to pursue all three, they will sooner or later be punished by destabilizing financial flows, as in the run up to the Great Depression around 1930 and in the months before sterling's collapse 1992. If a government tries to stimulate its economy with lax monetary policy, for example, and players with significant market power like George Soros sense that at a fixed exchange rate, foreigners will be unwilling to lend enough to finance the country's current account deficit, they will begin to flee the home currency in order to avoid the capital losses they will suffer if and when there is a devaluation. If reserve losses accelerate and more players follow suit, crisis ensues. The authorities are forced to devalue, interest rates soar, and the successful attackers sit back to count their profits.

For nations wishing to retain reasonably independent monetary and fiscal authority in order to cater to domestic needs, the solution is to allow the exchange rate to move up or down as conditions in the foreign exchange markets dictate, or to establish some sort of control over the movement of financial instruments in and out of the country, or to devise some combination of these two adjustment mechanisms. The debate over whether fixed or flexible exchange rates is the wiser policy continues to rage in academic quarters and in finance ministries all over the world. For the most part, the international business community prefers reasonably fixed exchange rates in order to minimize their costs of hedging foreign currency positions. Thus instituting some form of control over speculative financial movements may be an appropriate solution to the "trilemma."

The capacity of a nation to levy enough taxes to finance needed public expenditures is another important reason to retain independent authority. A central function of government has been to insulate domestic groups from excessive market risks, particularly those originating in international transactions. This is the way governments have maintained domestic political support for liberalizing trade and finance throughout the postwar period. Yet many governments are less able today to help citizens that are injured by freer markets with unemployment compensation, severance payments, and adjustment assistance because the slightest hint of raising taxes to pay for these vital public services leads to capital flight in a world of heightened financial mobility.

This is a dilemma. Increased integration into the world economy has raised the need of governments to redistribute tax revenues or implement generous social programs in order to protect the vast majority of the population that remains internationally immobile. At the same time, governments find themselves less able to maintain the safety nets needed to preserve social stability. It seems reasonable to suppose, therefore, that doing things that will bolster the ability of governments to levy sufficient taxes - curbing tax avoidance by transnational corporations, controlling offshore tax havens, regulating capital flight - would help make globalization slightly more democratic.

Winners and losers

The people who benefit from speculative financial movements are, for the most part, better educated and wealthier than the vast majority of fellow citizens. They are the elites, whatever the country. As noted above, they have fewer connections to the real economy of production and exchange than most people. And their purpose in trading financial assets, again for the most part, is to make a profit quickly rather than wait for an investment project to mature.

People who do not participate directly in the buying and selling of short-term financial instruments are nonetheless influenced indirectly by the macroeconomic instability and contagion that often accompany interruptions in financial market flows. This is true for people both in developed and developing countries. In developed countries, the voracious appetite of financial markets for more and more resources saps the vitality of the real economy - the economy that most people depend upon for their livelihood. It has been shown that real interest rates rise as a result of the expansion of speculative financial markets. This rise in real interest rates, in turn, dampens real investment and economic growth while serving to concentrate wealth and political power within a growing worldwide rentier class (people who depend for their income on interest, dividends, and rents).23 Rather, the long-term health of the economy depends upon directing investable funds into productive investments rather than into speculation.

In developing countries, attracting global investors' attention is a mixed blessing. Capital market inflows provide important support for building infrastructure and harnessing natural and human resources. At the same time, surges in money market inflows may distort relative prices, exacerbate weakness in a nation's financial sector, and feed bubbles. As the 1997 Asian crisis attests, financial capital may just as easily flow out of as into a country. Unstable financial flows often lead to one of three kinds of crises:

Although these three types of crises sometimes appear singly, they more often arrive in combination because external shocks or changed market expectations are likely to occur simultaneously in the market for government bonds, the foreign exchange market, and the markets for bank assets. Approximately sixty developing countries have experienced extreme financial crises in the past decade.24

The vast majority of people in the developing world suffer from these convulsive changes. They are tired of adjusting to changes over which they exercise absolutely no control. Most people in these countries view Western capitalism as a private club, a discriminatory system that benefits only the West and the elites who live inside "the bell jars" of poor countries. Even as they consume the consumer goods of the West, they are quite aware that they still linger at the periphery of the capitalist game. They have no stake in it, and they believe that they suffer its consequences. As Hernando deSoto puts it, "Globalization should not be just about interconnecting the bell jars of the privileged few."25

Social solidarity

Karl Polanyi in The Great Transformation sought to explain how the "liberal creed" contributed to the catastrophes of war and depression associated with the first half of the twentieth century. Polanyi's central argument, which in fact can be traced back to Adam Smith, is that markets do indeed promote efficiency and change, but that they achieve this through undermining social coherence and solidarity. Markets must therefore be embedded within social institutions that mitigate their negative consequences.

The evidence of more recent times suggests that the global spread of free-market policies has been accompanied by the decline of countervailing institutions of social solidarity. Indeed, a main feature of the introduction of market-friendly policies has been to weaken local institutions of social solidarity. Consider, for example, the top-down policy prescriptions of the IMF and World Bank during the developing world's debt crisis in the 1980s. These policies evolved into an intricate web of expected behaviors by developing countries. In order for developing countries to expect private businesses and financial interests to invest funds within their borders and to boost the growth potential of domestic economies, they needed to drop the "outdated and inefficient" policies that dominated development strategies for most of the postwar period and adopt in their place policies that are designed to encourage foreign trade and freer financial markets. Without significant adjustments in the ways economies were managed, it was suggested, nations soon would be left behind.

The list of Washington Consensus requirements was long and daunting:

In a provocative article, Ute Pieper and Lance Taylor point out that market outcomes often conflict with other valuable social institutions. In addition, they emphasize that markets function effectively only when they are "embedded" in society. The authors then look carefully at the experience of a number of developing countries as they struggled to comply with the policy prescriptions of the IMF and the Fund. In almost every case, they demonstrate conclusively that the impact of these efforts was to make society an "adjunct to the market."26

An appropriate balance is not being struck between the economic and non-economic aspirations of human beings and their communities. Indeed, the evidence is mounting that globalization's trajectory can easily lead to social disintegration - to the splitting apart of nations along lines of economic status, mobility, region, or social norms. Globalization not only highlights and exacerbates tensions among groups; it also reduces the willingness of internationally mobile groups to cooperate with others in resolving disagreements and conflicts.


Policy options

History confirms that free-markets are inherently volatile institutions, prone to speculative booms and busts. Overshooting, especially in financial markets, is their normal condition. To work well, free markets need not only regulation, but active management. During the first half of the post-war era, world markets were kept reasonably stable by national governments and by a regime of international cooperation. Only lately has a much earlier idea been revived and made an orthodoxy - the idea adopted by the Washington Consensus that, provided there are clear and well-enforced rules-of-the-game, free markets can be self-regulating because they embody the rational expectations that participants form about the future.

On the contrary, since markets are themselves shaped by human expectations, their behavior cannot be rationally predicted. The forces that drive markets are not mechanical processes of cause and effect, as assumed in most of economic theory. They are what George Soros has termed "reflexive interactions."27 Because markets are governed by highly combustible interactions among beliefs, they cannot be self-regulating.

The question before us then, is what could be done to better regulate financial markets and to bring active management back into the task of "embedding" markets in society, rather than the other way around? Monetary authorities such as the Federal Reserve System in the U.S. and the central banks of other countries were formed long ago in order to dampen the inherent instabilities of financial market in their home countries. But the evolution of an international regulatory framework has not kept pace with the globalization of financial markets. The International Monetary Fund was not designed to cope with the volume and instability of recent financial trends.

Capital controls

Given the problems outlined above about short-term speculative financial transactions, one might wonder why national policy-makers have not insulated their financial markets by imposing some sort of control over financial capital. The answer, of course, is that some have continued trying to do so despite discouragement from the IMF. For example, some have put limitations on the quantity, conditions, or destinations of financial flows. Others have tried to impose a tax on short-term borrowing by national firms from foreign banks. This is said to be "market-based" because it operates by altering the cost of foreign funds. If such transactions were absolutely prohibited, they would be called "non-market" interventions.

A more extreme form of financial capital controls, one that controls movement of foreign exchange across international borders, also has been tried in a number of countries. This form of control requires that some if not all foreign currency inflows be surrendered to the central bank or a government agency, often at a fixed price that differs from that which would be set in free market. The receiving agency then determines the uses of foreign exchange. The absence of exchange controls means that currencies are "convertible."

The neo-liberal argument opposing financial capital controls asserts that their removal will enhance economic efficiency and reduce corruption. It is based on two basic propositions in economic theory that depend for their proof on perfectly competitive markets in the real economy and perfectly efficient gatherers and transmitters of information in financial markets. Neither assumption is realistic in today's world. Indeed, a number of empirical studies have reported the effectiveness of capital controls in controlling capital flight, curbing volatile capital flows and protecting the domestic economy from negative external developments.

Developing countries have only recently abandoned, or still maintain, a variety of control regimes. Latin American countries traditionally have used market-based controls, putting taxes and surcharges on selected financial capital movements or tying them up in escrow accounts. Non-market based restrictions were more common in Asia until the early 1990s. Many commentators believe that their sudden removal in the early 1990s was a contributing cause to the Asian financial crises in 1997-8. The experience of two countries, Malaysia and Chile, with capital controls is especially instructive.

Malaysia, unlike its Asian neighbors, was reluctant to remove its restrictions on external borrowing by national firms unless they could show how they could earn enough foreign exchange to service their debts. Then when the Asian crises hit, its government imposed exchange controls, in effect making its local currency that was held outside the country inconvertible into foreign exchange. After the ringget was devalued, exporters were required to surrender foreign currency earnings to the central bank in exchange for local currency at the new pegged rate. The government also limited the amount of cash nationals could take abroad, and it prohibited the repatriation of earnings on foreign investments that had been held for less than one year. Thus, Malaysia's capital controls were focused mostly on controlling the outflow of short-term financial transactions. Happily, the authorities were able to stabilize the currency and reduce interest rates, leading to a degree of domestic recovery.28

Chile, on the other hand, tried to limit the inflow of short-term financial transactions. It did so by imposing a costly reserve requirement on foreign-owned capital held in the country for less than one year. Despite attempts to stimulate foreign direct investment of the funds, most of the reserve deposits were absorbed in the form of increased reserves at the central bank. In turn, this created a potential for expanding the money supply, which the government feared would lead to inflation. Rather than allow this to happen, the government "sterilized" the inflows by selling government bonds from its portfolio. But this pushed down the prices of bonds and pushed up the interest rates on them, discouraging business investment. Finally, when prices of copper (Chile's primary export) fell sharply in 1998, the control regime was scrapped.29

The tobin tax

A global tax on international currency movements was first proposed by James Tobin, a Yale University economist, in 1972.30 He suggested that a tax of one-quarter to one percent be levied on the value of all currency transactions that cross national borders. He reasoned that such a tax on all spot transactions would fall most heavily on transactions that involve very short round-trips across borders. In other words, it would be speculators with very short time-horizons that the tax would deter, rather than longer-term investors who can amortize the costs of the tax over many years. For example, the yearly cost of a 0.2 percent round trip tax would amount to 48 percent of the value of the traded amount if the round trip were daily, 10 percent if weekly and 2.4 percent if monthly. Since at least eighty percent of spot transactions in the foreign exchange markets are reversed in seven business days or less, the tax could have a profound effect on the costs of short-term speculators.

Of course, for those who believe in the efficiency of markets and the rationality of expectations, a transactions tax would only hinder market efficiency. They argue that speculative sales and purchases of foreign exchange are mostly the result of "wrong" national monetary and fiscal policies. While we readily admit that national policies sometimes do not accord with desired objectives, they nonetheless have little relevance for speculators focused on the next few seconds, minutes or hours.

Tobin did not intend for his proposal to involve a supranational taxation authority. Rather, governments would levy the tax nationally. In order to make the tax rate uniform across countries, however, an international agreement would have to be entered into by at least the principal financial centers. The revenue obtained from the tax could be designated for each country's foreign exchange reserve for use during periods of instability, or it could be directed into a common global fund for uses like aid to the poorest nations. In the latter case, the feasibility of the tax also would depend on an international political agreement. The revenue potential is sizeable, and could run as high as $500 billion annually.

There are two other advantages often cited by proponents of the Tobin tax. Tobin's original rationale for a foreign exchange transactions tax was to enhance policy autonomy in a world of high financial capital mobility. He argued that currency fluctuations often have very significant economic and political costs, especially for producers and consumers of traded goods. A Tobin tax, by breaking the condition that domestic interest rates may differ from foreign interest rates only to the extent that the exchange rate is expected to change (see p. 10), would allow authorities to pursue different policies than those prevailing abroad without exposing them to large exchange rate movements. More recent research suggests that this is only a very modest advantage.31

An additional advantage of the tax is that it could facilitate the monitoring of international financial flows. The world needs a centralized data-base on all kinds of financial flows. Neither the Bank for International Settlements nor the IMF has succeeded in providing enough information to monitor them all. This information should be regularly shared among countries and international institutions in order to collectively respond to emerging issues.

The feasibility issues raised by the Tobin tax are more political than technical. One of the issues is about the likelihood of evasion. All taxes suffer some evasion, but that has rarely been a reason for avoiding them. Ideally all jurisdictions should be a party to any agreement about a common transactions tax, since the temptation to trade through non-participating jurisdictions would be high. Failing that, one could levy a penalty on transactions with "Tobin tax havens" of, say, double the normal tax rate. Moreover, one could limit the problem of substituting untaxed assets for taxed assets by applying the tax to forwards, swaps and possibly other contracts.

Tobin and many others have assumed that the task of managing the tax should be assigned to the IMF. Others argue that the design of the tax is incompatible with the structure of the IMF and that the tax should be managed by a new supranational body. Which view will prevail depends upon the resolution of other outstanding issues. The Tobin tax is an idea that deserves careful consideration. It should not be dismissed as too idealistic or too impractical. It addresses with precision the problems of excessive instability in the foreign exchange markets, and it yields the additional advantage of providing a means to assist those in greater need.

Reforming the IMF

The IMF was established in 1944 to provide temporary financing for member governments to help them maintain pegged exchange rates during a period of internal adjustment. With the collapse of the pegged exchange rate regime in 1971, that responsibility has been eclipsed by its role as central arbiter of financial crises in developing countries. As noted above (p. 20), these crises may be of three different kinds: fiscal crises, foreign exchange crises, and banking crises.

Under current institutional arrangements, a nation suffering a serious fiscal crisis that could easily lead to default must seek temporary relief from its debts from three different (but interrelated) institutions: the IMF, which is sometimes willing to renegotiate loans in return for promises to adopt more stringent policies (see above); the so-called Paris Club that sometimes grants relief on bilateral (country to country) credits; and the London Club that sometimes gives relief on bank credits. This is an extremely cumbersome process that fails to provide debtor countries with standstill protection from creditors, with adequate working capital while debts are being renegotiated, or with ways to ensure an expeditious overall settlement. The existing process often takes several years to complete.

There is a growing consensus that this problem is best resolved with creation of a new international legal framework that provides for de facto sovereign bankruptcy. This could take the form of an International Bankruptcy Code with an international bankruptcy court, or it could involve a less formal functional equivalent to its mechanisms: automatic standstills, priority lending, and comprehensive reorganization plans supported by rules that do not require unanimous consent. Jeffrey Sachs recommends, for example, that the IMF issue a clear statement of operating principles covering all stages of a debtor's progression through "bankruptcy" to solvency. A new system of emergency priority lending from private capital markets could be developed, he suggests, under IMF supervision. He also feels that the IMF and member governments should develop model covenants for inclusion in future sovereign lending instruments that allow for priority lending and speedy renegotiation of debt claims.32

At the Joint Meeting of the IMF and the World Bank in September, 2002, the policy committee directed the IMF staff to develop by April, 2003, a "concrete proposal" for establishing an internationally recognized legal process for restructuring the debts of governments in default. It also endorsed efforts to include "collective action" clauses in future government bond issues to prevent one or two holdout creditors from blocking a debt-restructuring plan approved by a majority of creditors. The objective of both proposals is to resolve future debt crises quickly and before they threaten to destabilize large regions, as happened in Southeast Asia in 1997-98.

Member countries rarely receive support from the IMF any longer to maintain a particular nominal exchange rate. Because financial capital is so mobile now, pegged exchange rates probably are unsupportable. But there are special times when the IMF still might give such support during a foreign exchange crisis. International lending to support a given exchange rate is legitimate if the government is trying to establish confidence in a new national currency, or if its currency is recovering from a severe bout of hyperinflation. Ordinarily the foreign exchange should be provided from an international stabilization fund supervised by the IMF.

National central banks usually supervise and regulate the domestic banking sector. Thus, banking crises normally are handled by domestic institutions. This may not be possible, however, if the nation's banks hold large short-term liabilities denominated in foreign currencies. If the nation's central bank has insufficient reserves of foreign currencies to fund a large outflow of foreign currencies, there may be circumstances when the IMF or other lenders may wish to act as lenders-of-last-resort to a central bank under siege. Nations like Argentina that have engaged in "dollarization" are learning about the downside risks of holding large liabilities denominated in foreign currencies. The best way to avoid this problem is for governments and central banks to restrict the use of foreign currency deposits or other kinds of short-term foreign liabilities at domestic banks.

Overall, what is most needed is the availability of more capital in developing countries and much quicker responses, amply funded, to emerging financial crises.. George Soros has argued powerfully that the IMF needs to establish a better balance between crisis prevention and intervention.33 The IMF has made some progress in prevention by introducing Contingency Credit Lines (CCLs). The CCL rewards countries that follow sound policies by giving them access to IMF credit lines before rather than after a crisis erupts. But CCL terms were set too high and there have been no takers. Soros also has recommended the issuance of Special Drawing Rights (SDRs) that developed-countries would donate for the purpose of providing international assistance. Its proceeds would be used to finance "the provision of public goods on a global scale as well as to foster economic, social, and political progress in individual countries."34

A growing number of civil society institutions, however, oppose giving more money to the IMF unless it is basically reformed. They point out that it is a committed part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. They see the IMF as an instrument of the U.S. government and its corporate allies. The conditions it attaches to loans for troubled countries often do more to protect the interests of first world investors than to promote the long-term health of the developing countries. The needed chastening of speculative investors does not occur under these circumstances. There is evidence that in several major crises, IMF requirements for assisting nations have in fact worsened the situation and protracted the crises. The IMF opposed the policies that enabled Malaysia to weather the crisis in Southeast Asia, for example, while it urged the failed policies of other Southeast Asian nations. The vast literature cited by Pieper and Taylor (p. 22) is a convincing chronicle of earlier missteps. For such reasons as these, some civil society institutions argue that, unless IMF policies are changed, giving the institution more money will do more harm than good.

Fortunately, the IMF's policies are beginning to change, partly as a result of criticisms by civil society institutions, but more through recognition of the seriousness of the problems with the present system. In the wake of recent financial crises, leaders in the IMF as well as the World Bank are looking for ways to reform the international financial architecture. Arguably, their emphasis is shifting away from slavish devotion to the prescriptions of the Washington Consensus and toward more state intervention in financial markets. Joseph Stiglitz, the Nobel Laureate who has been particularly critical of the IMF, nonetheless acknowledges that its policy stances are improving.35

The IMF has begun to recognize the importance of at least functional public interventions in markets and the need to provide more supporting revenues. It has realized that controls on external financial movements and prudent regulation can help contain financial crises. It has abandoned the doctrine, long the backbone of structural adjustment policies, that raising the local interest rate will stimulate saving and thereby growth. Both the IMF and the World Bank have rolled over or forgiven the bulk of official debt owed by the poorest economies.

Whether these and other promising changes in IMF thinking and policy formation are sufficient to assure that its future responses to crises will be benign still is not clear. While celebrating what they view as belated improvements, many critics of the IMF among civil society institutions are not convinced that they are sufficiently basic. Even if the IMF avoids repeating some of its more egregious mistakes, some believe that it is likely to continue to function chiefly for the benefit of the international financial community rather than the masses of people. Rather, they believe that, at least in the long term, it would be much better for control over international finance to reside in new institutions under a restructured United Nations. They favor the U.N. because it has a broader mandate, is more open and democratic, and, in its practice, has given much greater weight to human, social, and environmental priorities.

Many civil society institutions want the primary focus of reform to be on taming speculation, restoring the control of their economies to nations, and embedding economies in the wider society. They believe that if these policies are adopted there will be less need for large funding to deal with financial crises. There remains, however, the fact that such crises are occurring and will continue to occur for some time. The IMF is the only institution positioned to respond to these crises. Hence, even for those who sympathize with the goals of the civil society institutions, there is a strong argument for more financing for the IMF.

A world financial authority

A variety of public and private citizens and institutions have recently proposed the establishment of a World Financial Authority (WFA) to perform in the domain of world financial markets what national regulators do in domestic markets. Some believe it should be built upon the foundation of global financial surveillance and regulation that have already been laid by the Bank for International Settlements in Basel, Switzerland. Others regard it as a natural extension of the activities of the IMF. Still others are less interested in the precise institutional form it would take than in the clear delineation of the tasks that need to be done by someone.

Its first task probably should be to provide sufficient and timely financial assistance during crises to avert contagion and defaults. This requires a lender-of-last-resort with sufficient resources and authority to disperse rescue money quickly. Perhaps the best example to date is the bailout loan to Mexico by the U.S. Treasury and the IMF at the end of 1994. It supplied sufficient liquidity for Mexico to make the transition back to stability and to pay back the loans ahead of time. The management of the Asian crises in 1997-8, on the other hand, was badly handled. The bailout packages offered by the IMF were not only significantly smaller than in the Mexico case; they also were constrained with so many conditions that a year later only twenty percent of the funds had been disbursed. This slow response to the crisis probably worsened the contagion. Surprisingly, the error was repeated in the Russian crisis in 1998 and the Brazilian crisis in 1999.

A World Financial Authority also should provide the necessary regulatory framework within which the IMF or a successor institution can develop as a lender-of-last-resort. As long as domestic regulatory procedures function properly, there will be no need for a world authority to be involved, any more than to certify that domestic regulatory procedures are effective. In countries where domestic financial regulation is unsatisfactory, the WFA would assist with regulatory reform. In this way, the WFA could aid financial reconstruction, reduce the likelihood of moral hazard, and give confidence to backers of the operation.

There is little appetite today, especially in Washington, to create a new international bureaucracy. This fact gives support to the idea of building the WFA from the existing infrastructure of the Bank for International Settlements (BIS). The BIS is a meeting place for national central bankers who have constructed an increasingly complicated set of norms, rules and decision-making procedures for handling and preventing future crises. Its committees and cooperative cross-border regulatory framework enjoy the confidence of governments and of the financial community. It may well be the best place to govern an international regulatory authority at the present time.


Theological and ethical considerations

While Christian theology cannot provide us with detailed recommendations on how to correct the adverse consequences of speculative financial movements, it can provide us with an empowering perspective or worldview. Our theological expressions of the faith describe the source of our spiritual energy and hope. They betray our ultimate values and the source of our ethical norms. They shape how we perceive and judge the "signs of the times."

God's world and human responsibilities

Nothing in creation is independent of God. "The earth is the Lord's and all that is in it, the world, and all those who live in it." (Ps. 24:1 NRSV) Thus, no part of the creation - whether human beings, other species, the elements of soil and water, even human-made things - is our property to use as we wish. All is to be treated in accord with the values and ground rules of a loving God, their ultimate owner, who is concerned for the good of the whole creation. All of God's creation therefore deserves to be treated with appropriate care and concern, no matter how remote from one's daily consciousness or existence.

The doctrine of creation reminds us that our ultimate allegiance is not to the nationalistic and human-centered values of our culture, but rather to the values of the loving Maker of heaven and earth. When we seek plenty obsessively, consume goods excessively, compete against others compulsively, or commit ourselves to Economic Fate, we are worshiping false gods. Modern idolatries are often encountered in economic forms, just as in the New Testament's warnings about the spiritual perils of prosperity in the parables of the rich, hoarding fool (Luke 12:15-21) and the rich youth (Matt. 19:16-24 and Luke 18:18-25).

The fact that so much of financial speculation is divorced from the real economy of production and exchange suggests that its paper transactions are more like bets in a casino than an essential component of God's real economy, which seeks the good of all creation. It is wrong to subject people to the effects of wholesale gambling. The fact that the practice of financial speculation is secretive, compulsively competitive, and frequented by lone rangers, moreover, hints at a cult of false idols. Its practitioners, including especially day-traders, seem interested only in exceedingly short-term personal financial advantage, unconcerned about the long-term consequences of their actions or their impact on others. This also indicates a degree of idolatry that contradicts the doctrine of creation.

Image of God

The conviction that human beings have a God-given dignity and worth (Gen. 1:26-28) unites humanity in a universal covenant of rights and responsibilities - the family of God. All humans are entitled to the essential conditions for expressing their human dignity and for participation in defining and shaping the common good. These rights include satisfaction of basic biophysical needs, environmental safety, full participation in political and economic life, and the assurance of fair treatment and equal protection of the laws. These rights define our responsibilities in justice to one another, locally, nationally and - because they are human rights - internationally.

Financial speculation often leads to unmanageable floods of funds into and out of host societies, creating unwanted bubbles and panics. Financial speculators normally ignore the human consequences of their activities on the rights of people in host societies, where economic adjustments are shared widely and painfully. Their primary interest is short-term personal financial gain. The absence of a sense of covenantal unity with their brothers and sisters of the developing world is a sad commentary on the governing ethic of speculators in the capital markets. Their arrogance calls for some form of control over foreign exchange and financial capital markets.

Justice in covenant

The rights and responsibilities associated with the image of God are inextricably tied to the stress on justice in Scripture and tradition. We render to others their due because of our loving respect for their God-given dignity and value. The God portrayed in Scripture is the "lover of justice" (Ps. 99:4, 33:5, 37:28, 11:7; Isa. 30:18, 61:8; Jer. 9:24). Justice is at the ethical core of the biblical message. Faithfulness to covenant relationships, moreover, demands a justice that recognizes special obligations, "a preferential option" to widows, orphans, the poor, and aliens, which is to say the economically vulnerable and politically oppressed. Hence, the idea of the Jubilee Year (Lev. 25) was meant to prevent unjust concentrations of power and poverty. Jesus' ministry embodies concern for the rights and needs of the poor; He befriended and defended the dispossessed and the outcasts.

The fact that the liberalization of trade and finance has failed to improve the distribution of incomes, indeed, that it has widened the gap between rich and poor in virtually every country, is not a sign of distributive justice but of its opposite. The standard of living for the least skilled, least mobile, and poorest citizens of many developing countries has declined absolutely. This, too, is an unjust result of a broken system. The fact that governments that wish to assist the vulnerable and weak of their societies are less able to do so, in part because they no longer can levy sufficient taxes on foreign interests, is a violation of justice in community.

Sin and judgment

Sin is a declaration of autonomy from God, a rebellion against the sovereign source of our being. It makes the self and its values the center of one's existence, in defiance of God's care for all. Sin tempts us to value things over people, measuring our worth by the size of our wealth and the quantity of goods we consume, rather than by the quality of our relationships with God and with others. Sin involves injustice because its self-centeredness defies God's covenant of justice, grasping more than one's due and depriving others of their due.

Sin is manifested not only in individuals, but also in social institutions and cultural patterns. These structural injustices are culturally acceptable ways of giving some individuals and groups of people advantage over others. Because they are pervasive and generally invisible, they compel our participation. They benefit some and harm many others. Whether or not we deserve blame as individuals and churches for these social sins depends in part on whether we defend or resist them, tolerate or reject them.

The fact that the freeing of financial markets has permitted financial speculators to engage in high-risk gambles without regard to the consequences for others is abundant evidence of both individual and institutional sin. The policies of the Washington Consensus frequently lead to adverse consequences for the poor and the environment, even as its proponents gain advantages from the implementation of such policies. They are another serious expression of social sin in our time. These policies inevitably increase the concentration of economic power in fewer hands. The fact that the global spread of free-market policies has led to the decline of countervailing institutions of

social solidarity means that it is easier for the centers of economic power to corrupt governments, control markets, alienate neighbors, manipulate public opinion, and contribute to a sense of political impotency in the public.

The Church's mission and hope

The church is called to be an effective expression of the Reign of God, which Jesus embodied and proclaimed. This ultimate hope is a judgment on our deficiencies

and a challenge to faithful service. God's goal of a just and reconciled world is not simply our final destiny but an agenda for our earthly responsibilities. We are called to be a sign of the Reign of God, on earth as it is in heaven, to reflect the coming consummation of God's new covenant of shalom to the fullest extent possible.


A new financial architecture

In her path-breaking book, Casino Capitalism,36 Susan Strange likens the Western financial system to a vast casino. As in a casino,

"the world of high finance today offers the players a choice of games. Instead of roulette, blackjack, or poker, there is dealing to be done - the foreign-exchange market and all its variations; or in bonds, government securities or shares. In all these markets you may place bets on the future by dealing forward and by buying or selling options and all sorts of other recondite financial inventions. Some of the players - banks especially - play with very large stakes. There are also many quite small operators. There are tipsters, too, selling advice, and peddlers of systems to the gullible. And the croupiers in this global finance casino are the big bankers and brokers. They play, as it were, "for the house.' It is they, in the long run, who make the best living."

She goes on to observe that the big difference between ordinary kinds of gambling and speculation in financial markets is that one can choose not to gamble at roulette or poker, whereas everyone is affected by "casino capitalism." What goes on in the back offices of banks and hedge funds "is apt to have sudden, unpredictable and unavoidable consequences for individual lives."

It is this volatility, this instability in financial markets that has given rise to recurring financial crises. They must be tamed. In the wake of recent financial crises, people are beginning to look for ways to reform the international financial architecture. Although it is difficult to move from general theological convictions to specific proposals, we offer the following suggestions for consideration by Christians and other persons of good will.

Of these recommendations, perhaps the most controversial is that more funds be given to the IMF. We noted above that much of the criticism of the IMF is justified. We also acknowledged that the IMF is improving its policies. We hope that these improvements will continue. Meanwhile, there is no other viable candidate to serve as lender-of-last-resort - an absolutely essential feature of any new financial architecture.

The major reason some civil society institutions resist funding the IMF further is its history of misguided structural adjustment policies, policies that are now widely recognized to have caused widespread suffering. We hope that recent changes will improve this situation as well and enable the IMF to perform the important role we recommend for it.

Along with the World Bank, it is beginning to contextualize its performance criteria and conditionalities, taking much more seriously the unique circumstances of particular economies. It is listening more and nitpicking less. To be sure, the IMF is not likely to abandon its policy of making its loans conditional on the adoption by borrowing countries of mutually agreed economic policies. Even so, there is considerable evidence that when it has had more resources on hand, conditionality has been correspondingly wiser and less draconian.

The IMF now recognizes that it can leave more decisions to developing countries partly because these have better informed and more sophisticated employees than was once the case. Certainly in Latin America and Asia and increasingly in Africa, country economic teams are better qualified technically than the lower rung Ph.D.s from American and European universities to whom the IMF and World Bank entrust their missions. Local economists can do financial programming and standard macroeconomic modeling as well as or better than the people from Washington can; they also know how to do investment project analysis. To be sure, decisions about financial and project plans must include input from many other elements of a society.

We can encourage the IMF (and World Bank) to reverse the typical procedure in setting conditions for multilateral loans. Instead of waiting for it to specify the policies that must be followed to justify additional financing, country economic teams, in consultation with other agencies of their government, should be allowed to propose economic programs to the IMF. Disagreements between Washington staff assessments and the local teams could be resolved directly or by third-party arbitration. The scope of economic conditionality could also be restricted, for example, just to a balance-of-payments target, while the country could pursue its own agenda regarding inflation, income distribution, and growth.


What Christians can do

A primary part of the "principalities and powers" referred to in the Bible is composed of the political-economic institutions and processes that govern how people relate economically to each other and to God's whole creation. The church has a stake in their design. Yet many church members feel powerless to change basic political-economic reality. They think either that the economic conditions of society result "naturally" from the forces of markets that are only marginally within the power of human control, or that economic conditions result from powerful interests that are beyond the reach of ordinary citizens. Thus, there's nothing that can be done about it, or there's nothing we can do about it.

On the contrary, Mobilization for the Human Family believes that the political economy is shaped by deliberate social policy decisions; that conditions at any given time are the result of those decisions; that conditions can be changed by human decisions; and that the will of a nation's and the world's citizens about what the commitments and purposes of the nation and the world should be can be expressed in the political economy through the framework of democratic process provided in our national and transnational polity. Accordingly, we offer below some suggestions for action that may be taken by individual Christians and by our churches and their denominations to correct some correctable flaws of financial globalization.

Actions by individual Christian

Actions by churches and denominations


Want to know more?

Globalization is a vast topic. For a general introduction, see Sarah Anderson and John Cavanagh, Field Guide to the Global Economy (New York: New Press, 2000) and Thomas Friedman, The Lexus and the Olive Tree: Understanding Globalization (New York: Farrar Straus Giroux, 1999). A classic introduction to the financial side of globalization is Susan Strange, Casino Capitalism, (New York: Mnchester University Press, 1986). See also Kavaljit Singh, The Globalisation of Finance: A Citizen's Guide (London: Zed Books, 1999) and John Eatwell and Lance Taylor, Global Finance at Risk: The Case for International Regulation (New York: The New Press, 2000). The best introduction to the Tobin Tax is Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996). For how church people might react, see Pamela Brubaker, Globalization at What Price? (Cleveland: Pilgrim Press, 2001).


Questions For Discussion

  1. How have the linkages and interconnections of international finance impacted your life? On balance, do you regard them as advantages or disadvantages for a healthy Christian life?
  2. The frequency and severity of recent financial crises have fueled calls for a radical redesign of the rules of global finance. If you were the advisor to an international commission asked to design "A New International Financial Architecture," what would you recommend?
  3. Do you favor allowing sovereign nations to declare bankruptcy? What Christian traditions might be invoked to support or deny such an action?
  4. A growing number of civil society institutions oppose giving more money to the IMF. They point out that it is part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. Yet this paper suggests that the IMF needs more money. As a committed Christian, which view do you favor?
  5. Is it too late to expect justice in a globalizing world? Since much of the direction the global economy has taken is irreversible, how can a balance between market and society be negotiated? How might Christians play a role in those negotiations?

[Mar 30, 2009]The revival of American populism Will there be blood The Economist)

Nice illustration of criminality of private equity

jomellon wrote:

March 29, 2009 12:02

The Problem that The Economist wants to talk about? Public Outrage a.k.a. Populism.

The other less important problem that a magazine called The Economist might want to address, but which it doesn't want to talk about: the economy is bust, and why.

Typical scenario for the last 18 years:

  • January - Private Equity Investor (PEI) has 20 million. He uses it a security to borrow 200 mio from Bank1 to buy a company Widgets. Widgets is a solid manufacturing business with assets of land, factories, patents, a brand, good will and no debts.
  • March - Widgets borrows 300 million from Bank2 – no problems, its a solid business – but here comes the bit where it all goes criminal, but not illegal... Widgets pays out 300 million to PEI its owner as a dividend, who repays 200 to Bank1. PEI now has 100 million cash, and has done nothing for it. Widgets however has to pay 20 million in interest per year. PEI now has 100 million.
  • July - Widgets also sells its assets: land, patents and so on and leases them back for 30 million a year. The sales bring 200 million which Widgets also pays out to PEI its owner. PEI now has 300 million.
  • August - Widgets Pension Fund is 'restructured' bringing a liquid 150 million onto the balance sheet. Widgets has liabilities to its pensioners with little to back them. 150 million is paid out to PEI as a special dividend., PEI now has 450 million.
  • December - PEI sells the business to a pension fund, for 100 million, less than he paid as it has a lot of debt, but it is a good business. PEI now has 550
  • Recap: Widgets now has 300 million debt causing 20 million a year in interest, plus 30 million in leasing payments. It has pension liabilities and the pension fund is almost worthless. PEI had 20 million at the start of the year and now has 550 million. But the business is still viable, as Widgets can meet its payments.
  • 5 years later - Sadly hard times come. Turnover drops, prices drop, costs are cut, people lose their jobs, including engineers, managers, the shop floor and the sales team who did real work for years, created real value, invented the patents, built the brand. It doesn't help. The company has no stores of fat - it goes bust. The banks loans are sour. People lose their jobs, the pensioners cannot be paid.

This happens 100 times so the banks are bust too, but get bailed out by the taxpayer (that's those guys who lost their jobs and pensions at Widgets)

PEI lives happily in The Bahamas with the 550 million which he 'earned' in a fabulous year of 'value creation' made possible by the power of free and light touch regulated markets.

Sadly, due to the complexity of all this the bright chaps at The Economist can not quite see why this is a slightly problematic way to run an economy... Honi suit qui mal y pense.

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The ubiquitous leveraged buyout management buyout or management sellout

Business Horizons
  • My objective in this article is to discuss certain elements of the leveraged buyout (LBO), sometimes referred to as taking a corporation private. In this practice, the company's management and other private investors buy out (hence "buyout") all the other shareholders, almost entirely with borrowed funds (hence "leveraged").

    I am mindful, however, of the sage journalistic advice that suggests that the writer should capture the interest of the readers very early on by establishing the essentiality of the topic, its impact, or, at the very least, sharing provocative examples that highlight its salience. In no particular order, try these:

    Related Results: bribing management in taking private

    A Quibble

    A recent special report by Fortune (1989) educates us with regard to "How Ross Johnson Blew the Buyout." F. Ross Johnson, of course, was the CEO of RJR Nabisco who put his company into play by proposing to take it private via the leveraged buyout. Among other things, it has been suggested that his bid (initially $75 per share, ultimately $109 by Kohlberg, Kravis, and Roberts [KKR]) was preposterously low. The compensation package for Johnson and a few (very few) managerial colleagues was judged by most observers to be outrageously high. Beyond that, certain of Johnson's strategies (for lack of a better word) led to a fair amount of enmity between himself and the special committee of outside directors enchartered to decide the final fate and ultimate ownership of RJR.

    There is apparently some substance to these reports. At a minimum, there is an unusual amount of consistency among many observers that the RJR leveraged buyout did illustrate some excesses that can be associated with such a play. Perhaps, but permit me a quibble.

    If we rely on these reports in their entirety, we might be led to believe that F. Ross Johnson lost. He lost his job, presumably one of great status and reward, as the CEO of a Fortune 500 company. He lost to KKR, for it is KKR who now own and operate RJR. He may have lost some reputation. The word "greed" crops up repeatedly in some descriptions of this LBO. Beyond that, his professional competence has been questioned. It has been alleged, for example, that he was totally outmaneuvered by KKR. Taken in the aggregate, a grim picture and humiliating loss.

    Maybe. Maybe not. We may want to consider one other factor before we decide whether or not Mr. Johnson "lost." It turns out that Mr. Johnson set another record of sorts with his departure from RJR -- the largest golden parachute in history. A recent Business Week (1989) reports that F. Ross Johnson, former CEO of RJR, walked away from this embarrassing loss with "separation pay" of more than $53 million.

    I will be among the very first to concede that wealth, as well as winning or losing, is in the proverbial eye of the beholder. I must say, however, that I find it difficult to brand anyone a "loser" who after the fray walks away with $53.8 million. That really does sound like a safe landing. Mr. Johnson deliberately put the company in play; nearly all observers feel that he lost. Even so, it has to be reported that the consolation prize in this tournament is most impressive.

    A Bribe?

    Rand V. Araskog, Chairperson of ITT Corporation, has recently written a book, The ITT Wars: A CEO Speaks Out on Takeovers. Araskog reports that in 1983, Jay Pritzker and Philip Anschutz were interested in gaining control of ITT through a leveraged buyout. The actual financial details are of little consequence here. Suffice it to say that the "deal" would have involved several transactions. Among other things, ITT's senior management would be given a 10 percent stake in the new company. This stake would have garnered Araskog some $30 million or so. Araskog explains in this book that he perceived this $30 million windfall to be little more than a gargantuan bribe.

    Just A Family Affair

    Richard P. Simmons took a specialty steel unit of what is now Allegheny International private in 1980. To his credit, this company has done very well. Two years ago, this same company was once again taken public. Stock was sold and has also done well.

    CEO Simmons requested that the board of directors approve an investment of corporate money into a LBO fund. There is nothing manifestly wrong with that. LBO funds are designed to allow companies (like KKR) to raise money to take companies private. Obviously, one invests in such a fund in the hope that these ventures will be profitable and provide an attractive return on the investment. Mr. Simmons evidently believed that corporate funds invested in such a vehicle was a prudent use of these assets.

    So far, so good. This LBO fund has three general partners. The problem is that one of these three partners is Brian Simmons, the son of Richard P. Simmons, CEO of Allegheny Ludlum.

    THE LBO AND ETHICS

    That there may be some potential for ethical issues to arise in LBO transactions will come as no surprise to anyone. Certainly, I do not presume to suggest that the prior examples are representative of all LBO transactions. Indeed, I fervently hope that only a modest few would have the character of those cited. Still, since 1981 (the LBO was relatively infrequent prior to that) more than 1,550 public companies have gone private, nearly as many as are listed on the New York Stock Exchange. I will argue that there are a number of factors common to every one of these LBO transactions that are most troubling. In fact, they raise the issue of whether current management of any publicly traded company should be party to an LBO. These issues include, but are not limited to:

    • An Obvious Conflict of Interest
    • What is the Incentive for an LBO?
    • The Ultimate in Inside Information
    • The Quality of Privileged Information
    • Full Disclosure
    • Life After the LBO
    • The Final Irony: Going Public Again

    An Obvious Conflict of Interest

    The CEO of a publicly traded corporation has a fiduciary responsibility to shareholders. This responsibility is rather simply described: It requires that the interests of the stockholder be considered prior to, ahead of, and superior to the self-interest of the manager at all times and in all circumstances. Clearly, that sets an omnibus and challenging standard.

    Obviously, it is in the interest of the shareholders to have the value of their common stock at as high a level as possible. This is particularly evident when the stockholder may have some immediate interest in selling the stock. Just as obviously, it is in the interests of the potential buyer of the stock to have the price set somewhat lower. Most of us would be inclined to purchase stock when we believe that the stock is undervalued, when we think we are getting a "good buy." The value of this stock is going to increase. Accordingly, we'll buy some of it at its currently undervalued price.

    More specifically for these purposes, CEOs as managers should seek to place as high a value as possible on the common stock of the corporation. CEOs, as rational individuals, who are acting in their capacity as principals in an LBO, can have no such incentive. On the contrary, it is in their obvious interests to have the common stock valued somewhat lower.

    What Is The Incentive For An LBO?

    Why would any manager be interested in being involved in a LBO? Maybe, in one of the great understatements in recent memory, they believe there may be a few dollars in it. Maybe, more benignly, they believe that the company could be run a bit more efficiently. Suppose that an officer (or group of officers) of the corporation believes that certain assets could be redeployed, divisions divested, products launched, and so forth. Is there not a mature argument that these individuals are legally, as well as ethically, bound to identify and execute these strategies for the benefit of the stockholders?

    It would seem that there are any number of dynamics that underscore such concerns. One, when is the last time that the board of directors accepted the first offer and conditions when a management group proposed a buyout? On the contrary, it is commonplace that the board finds the first offer to be insufficient (the RJR event is a classic case, among hundreds of others). In other words, the management group typically provides a low-ball offer, much the same that you might do when making an offer on a new home. The obvious difference in that you do not have a fiduciary responsibility to the seller of the home.

    It is also considered to be textbook procedure for the board of directors to immediately market the corporation to all suitors when faced with a LBO offer. The object of this is to invite "competition," to be certain that a "fair" price is put on the assets and so forth. What do you suppose this exercise is all about? Is it possible that there are some folks who are not altogether confident that the current management would act in the absolute best interests of their constituency short of these strategies?

    Moreover, it is considered de rigueur to appoint a group of outside directors (because they are purportedly independent, a questionable assumption) to review and make the final recommendation concerning the management proposal. Why do we do this? Do we do it because we can count on the LBO group to provide us with a "fair" price from the onset?

    Also, it is typical to solicit the opinion of investment banks to determine the "fair market" price of such a transaction. Once again, why is this necessary? Do we not trust the very managers who serve as fiduciaries of the shareholders? There must be some doubt in someone's mind.

    We can all agree that some notion of the "fair price" of the company should be set. What is less clear is that the management involved in the bid should set it. Moreover, it is not as though this number can be independently and easily arrived at to the satisfaction of all observers. On the contrary, in one bidding war for Stokely Van Camp, three different investment advisors provided an opinion, sometimes referred to as a fairness letter, to three prospective buyers, all at different values ranging from a low of $50 to a high of $75 per share. If it is true that this "true value" is apparently subject to some debate, many would be quite disturbed if individuals with rather substantial self-interests are serious parties to establishing the price.

    The Ultimate in Inside Information

    The most cursory examination of the leading business and financial periodicals over the past several years would suggest some near crisis regarding inside information. Fundamentally, it is a violation of federal securities law for insiders (for example, company officers, members of the board) to profit from any transaction inspired by certain knowledge not available to stockholders generally. Suppose, for example, that a CEO knew that on Tuesday he would report the lowest dividend in the company's history. When this information is public, it would probably result in at least a short-term reduction in the value of the company's common stock. This CEO could not, then, legally sell shares in his company short on Monday. In short selling, of course, you hope that the price of the stock will fall.

    The CEO has made a good bet, too good. He is almost certain that the price will fall. The problem is he knows that because he is privy to information not generally available to others. Under SEC rule 10b-5, he cannot act in this manner: It is patently illegal. If prosecuted, he would at a minimum forfeit any and all profits derived as a function of this transaction. Beyond that, he would be subject to criminal penalties as well.

    If trading on inside information for a few thousand shares (one share, for that matter) is in violation of federal securities law, then how can the LBO be conducted in anything resembling good faith? Who on the planet has more pertinent information about the strengths, weaknesses, threats, and opportunities facing an organization that its management?

    More directly, if it is illegal to profit on the basis of "inside" information with just a few shares of the company's stock, how can we profit on the basis of the ultimate stock purchase, the company in its entirety? Frankly, I find it incredible that the standing management of a company does not have access to information available neither to its stockholders nor, most certainly, to the public at large.

    The Quality of Privileged Information

    One of the chief arguments often used in defense of the LBO is that there is no monopoly of the right to offer to buy. It is true that management-led groups, or groups with substantive management interests, can propose an LBO. It is also argued that excesses in this area are unlikely. Suppose, for example, that the management-involved group makes an offer below a reasonable estimate of the market value for a company. It is only reasonable to expect that some other suitor would enter the bidding, provide a more responsible bid and carry the day. In fact, it has been suggested:

    Once anyone initiates an LBO, the directors should put the company up for auction. And they should make sure that all serious bidders have access to all the information needed to make an offer (Business Week December 1988, p. 30).

    It seems that there are two pertinent issues here. One concerns whether it is indeed possible for any other bidder to have the quality of information available to it that is enjoyed by the management-involved team. Once again, who could possibly have the wealth of information available to the current management team? It is hard to contemplate a scenario wherein the management team would not have a substantive edge with regard to the quality of information.

    Beyond that, however, we may face an interesting catch-22. As the prior quote indicates, it is sensible to put the company to auction (presumably to encourage some competition and a check on the reasonableness of the management offer) and provide access to all the information needed to make the offer (possibly to reduce the management information edge.) Surely, much of the information that would be "needed to make an [informed?] offer" would be proprietary. Before suitors could make an informed bid, wouldn't they need information regarding state of development of new products, pending lawsuits and settlements, illness of key executives, and so forth? After all, the current executives are privy to this information.

    It is not immediately clear that the interests of the stockholders are met by divulging this information to "outsiders" irrespective of the LBO. Would such information be considered "inside information" by SEC standards? Would the bidding companies, then, be constrained from relying on this information for purposes of profit? I think that there is an excellent argument that such companies would be so constrained. If, however, it would be illegal for such a company to profit by such information, how could we allow the current officers of the corporation to profit by the same information?

    Full Disclosure

    Management-involved groups cannot take a publicly traded company private at their own initiative. Among other things, they will need the "permission" of the shareholders. Naturally, this is accomplished through the proxy process. Benjamin Stein, a lawyer and economist, has raised a fascinating question regarding this issue. Essentially, the proxy material to a stockholder must include full disclosure of any material fact involving the action. In theory, the stockholder reads the proxy material, becomes acquainted with the major aspects of it, and votes either to approve the LBO or otherwise. The Supreme Court has ruled that there must be such full disclosure of any fact "if there is a substantial likelihood that a reasonable stockholder would consider it important in deciding how to vote."

    This leads Mr. Stein to a persuasive point:

    But insiders never disclose the crucial fact that they plan to make vastly more from the corporate assets than they pay the stockholders for them. I am a stockholder in a few companies in a small way, and I hope I am reasonable. I consider it extremely important if management plans to make $50 from something it paid me $1 for, and it would assuredly make a difference in how I voted (Stein 1985, p. 170).

    Why would CEOs and other highranking officers of prestigious firms risk their security and their reputations if the opportunity for reward was not correspondingly great? Do you think that such information should be disclosed to the stockholders to better inform their vote?

    Let's assume that by whatever means the LBO has been approved. What now? The period after the LBO raises even more troubling issues.

    Life After the LBO

    Not all LBOs are successful, as Revco and Freuhauf could attest. Even so, it has recently been recently reported that the profit margins for LBO companies were 40 percent higher than their industries' median two years after the buyout. It would seem reasonable, then, to conclude that many of these LBOs do very well. As might be expected, there has been some speculation about why this might be the case.

    Consider this. Tadd Seitz ran a profitable division of ITT. This company was divested in an LBO by ITT in 1986. Mr. Seitz continued to run the new company. According to some, when under the control of ITT, is overhead was too high, inventories too large, and management a bit relaxed with respect to wooing new clientele. These, and other "problems" were addressed and the company has prospered. That, however, is not the issue. The better question is why wait until the company was private to make these rather elementary moves. Why were these strategies not employed for the benefit of the initial shareholders?

    This is by no means an uncommon scenario. Time after time LBO companies divest poorly performing subunits, drastically reduce administrative overhead, pare the workforce, renegotiate contracts, and moderate executive perquisites (for example, executive jets, first class accommodations), among a host of other initiatives. E. E. Bergsman of McKinsey & Co. adds some interesting perspective to this: "These LBOs are so immensely successful because they are better managed" (Business Week June 1988).

    Notes

    1. Reported by Thomas L. Friedman, The Lexus and the Olive Tree (New York: Farrar Staus Giroux, 1999) p.101.

    2. John B. Cobb, Jr., (ed), (Claremont, CA: Mobilization for the Human Family, 2000)

    3. Karl Polanyi, The Great Transformation. The Political and Economic Origins of Our Time (Boston: Beacon Press, 1957/1944)

    4. Denys Hay (ed), The Age of the Renaissance (New York: McGraw-Hill, 1967) p.22.

    5. Heikki Patomaki, Democratising Globalization (London: Zed Books, 2001) p.40.

    6. Peter Garber, Famous First Bubbles: The Fundamentals of Early Manias (Cambridge, MA: MIT Press, 2000). The quotation is from Charles Mackay, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds (London: Bentley, 1841) p.142.

    7. For a summary of the vast literature on pre-World War I foreign lending, see Albert Fishlow, "Lessons from the Past: Capital Markets in the 19th Century and the Interwar Period," in M. Kahler (ed), The Politics of International Debt (Ithaca: Cornell, 1985).

    8. Ibid, p.90.

    9. Polanyi, op. cit. p.14.

    10. J. T. Madden et al, America's Experience as a Creditor Nation (Englewood Cliffs, N.J.: Prentice-Hall, 1937), p.74.

    11. Reprinted in Madden et al, p.205.

    12. John Kenneth Galbraith, The Great Crash, 1929 (Boston: Houghton Mifflin, 1954), p.16.

    13. For a helpful summary of the British and American plans at Bretton Woods, see Raymond F. Mikesell, The Bretton Woods Debates: A Memoir (Princeton: IFC Essays in International Finance no.192, 1994)

    14. Jacques J. Polak, The Changing Nature of IMF Conditionality (Princeton: IFS Essays in International Finance, no. 184, 1991.

    15. Robert Triffin, Gold and the Dollar Crisis (New Haven: Yale University Press, 1961.

    16. The IET taxed foreign borrowings in the U.S. with the intention of reducing the acquisition of dollars by foreigners; the U.S. government thought the dollar "overhang" was getting too large.

    17. This section draws upon Heikki Patomaki, Democratizing Globalization: The Leverage of the Tobin Tax, (New York: Zed Books, 2001), chap. 2.

    18. The prices a company charges itself for goods or services purchased from one of its entities and sold by another. Multinational corporations with business operations in many different countries try to charge prices that minimize their overall tax liabilities.

    19. Roughly, a consensus between the U.S. Treasury, the IMF, the World Bank, and the business community about the policies most likely to achieve free trade and rapid growth: fiscal austerity, privatization, deregulation, and free movement of financial capital.

    20. International Organization of Securities Commissions, the Joint Forum on Financial Conglomerates, the International Swaps and Derivatives Association, and the Institute of International Finance..

    21. See, for example, Amartya Sen, Development as Freedom. (New York: Alfred A. Knopf, 1999); Lance Taylor (ed), External Liberalization, Economic Performance and Social Policy.(New York: Oxford University Press, 2000); Dani Rodrik, The New Global Economy and the Developing Countries: Making Openness Work. (Washington: Overseas Development Council, 1999); Enrique Ganuza, Lance Taylor, and Rob Vos (eds), Economic Liberalization and Income Distribution in Latin America and the Caribbean. (New York: United Nations Development Programme, 2000).

    22. United Nations Development Programme, Human Development Report. New York: Oxford University Press, 2000.

    23. David Felix, "Asia and the Crisis of Financial Globalization," in Dean Baker et al., (eds) Globalization and Progressive Economic Policy (Cambridge, U.K: Cambridge University Press, 1998) pp.163-91.

    24. Jeffrey D. Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca, N.Y: Cornell University Press, 1998)

    25. The Mystery of Capital, (New York: Basic Books, 2000) p.207.

    26. "The Revival of the Liberal Creed: the IMF, the World Bank, and Inequality in a Globalized Economy," in Dean Baker op cit., pp. 37-63.

    27. See his Underwriting Democracy (New York: The Free Press, 1991), part 3, and his On Globalization (New York: Public Affairs, 2002) ch. 4.

    28. For additional details, see K. S. Jomo (ed), Malaysian Eclipse: Economic Crisis and Recovery, (New York: Zed Books, 2001)

    29. For more information, see Kavaljit Singh, Taming Global Financial Flows New York: Zed Books, 2000) pp. 158-78. See also Carmen & Vincent Reinhart, "Some Lessons for Policy Makers Who Deal with the Mixed Blessing of Capital Inflows," Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca: Cornell, 1998) pp. 93-124.

    30. Given in 1972 at Princeton University and published subsequently as "A Proposal for International Monetary Reform," Eastern Economic Journal 4 (July-October, 1978) pp 153-9.

    31. Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996) passim.

    32. Jeffrey Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Kahler, op. cit., pp. 256-59.

    33. George Soros, On Globalization, op cit, ch. 4.

    34. Ibid, appendix.

    35. Joseph E. Stiglitz,, Globalization and Its Discontents (New York: W.W. Norton, 2002)

    36. (Manchester, U.K: Manchester University Press, 1986)

  • The crime and oppunity thesis [in Casino capitalism Insider trading in Australia] The crime and oppunity thesis

    Published in:
    Casino capitalism? Insider trading in Australia / R Tomasic
    Canberra : Australian Institute of Criminology, 1991
    ISBN 0 642 15877 0
    (Australian studies in law, crime and justice series) ; pp 69-78


    You can succeed by relying on fundamentals but inside information beats fundamentals.
    (A Sydney broker)

    The reasons for the apparent proliferation of insider trading both in Australia and overseas are manifold. The recent rash of insider trading activity is often attributed to the level of greed which is said to drive the securities industry. This factor should not be discounted, but it is clear that other factors are also at work not the least of which has been the unprecedented range of opportunities for insider trading in recent years. The relationship between crime and opportunity is well established within the criminological literature but little has been written about how this relationship arises in the context of insider trading, a crime theoretically punishable theoretically until recently by five years gaol and/or a $20,000 fine in the case of individuals and a fine of $50,000 in the case of corporations.

    Likely insider trading situations

    Almost exclusively, brokers said that insider trading would take place in the market for shares and not in the options market. The range of opinions about the types of shares involved was very wide. On one view, it would depend on "what was flavour of the month". The most commonly identified risk groups were mining, speculative, exploration and gold shares. Various explanations were put forward as to why mining stocks attract insider trading. One broker said that insider trading is most likely to occur in this broad area because "there are all sorts of people on the site". Other reasons were that this is "where there are things like drilling reports" and "a leak from a geologist could create insider trading". Also, "drillers and assayers know and word filters through". As the mining boom of the late 1960s and early 1970s showed, there is ample scope for mine site workers to insider trade or to act as agents for brokers and others in transmitting the latest data.

    Among the less specific opinions was one that insider trading is more likely in new, up and coming super stocks which involve newer players". It was said to occur "in less professional areas where there are more opportunistic stocks". A Melbourne broker said that it is more likely in relation to "smaller less frequently researched stocks, rather than larger [company securities]". An obvious point often referred to is that for insider trading to be successful, it is necessary to move the price and in this respect gold mining stocks were described as the most reactive to any information. Where the companies have lower capitalisation insider trading will have greater effect on prices and it is easier to move prices of these stocks. Shares in entrepreneurial mining companies, described as Western Australian cowboy companies, and perhaps in high technology companies, are said to be tightly capitalised and likely to move quickly on a rumour. The number of people in a company was also said to be a factor as "insider trading tends to occur more in smaller companies controlled by one or two people" or in second board stock "which is more tightly held by a small group of people".

    There was no consensus amongst brokers about whether insider trading is more or less likely in second board stock. But despite their differences on this point most brokers shared an uncomplimentary opinion of second board companies. However, the financial advisers agreed uniformly that the area of the market where insider trading is most likely to occur seems to be in the lower quality stocks, such as the speculative, mining and second board stocks. An interesting observation was that originally insider trading was limited to tightly held stock, but in the last two years vast amounts of money have been available and this leads to more insider trading. Cross directorships, trading on rumours, stocks that respond to good news, and stocks whom players are share trading to enlarge their business profits, were seen as situations which led to insider trading. There was no common view among Stock Exchange officials on this matter.

    The general view among the market observers was that insider trading is more likely to happen in lower quality stock. One observation was that insider trading occurs across the whole spectrum but another was that "it is less likely in trading bank stock. It happens on a bulk scale in speculative stock. The second board is an invitation to misbehaviour". A journalist said that "insider trading occurs even in reputable companies and share dividend schemes using options are the likely methods". The views about the second board were as conflicting here as they were amongst other groups. On the one hand "the second board is not deep enough", and on the other, "insider trading occurs in the second board, but not exclusively".

    It was rare to find lawyers saying that insider trading was likely to be found in industrial or blue chip securities. The nearest exceptions to this occurred when they were speaking of takeover stocks generally, although it seemed likely that "insider trading will occur in relation to anything which is volatile". Generally, the lawyers considered that insider trading would be most likely to occur in relation to speculative, volatile, mining, second board, or lower quality securities, or in respect of securities in smaller companies where there was a high level of ownership by a relatively small number of shareholders. To this extent, their expectations were similar to those of the brokers. The regulatory community saw speculative, mining, takeover, high technology and low price/high volume stock as the most likely areas. Gold stocks in particular were often identified. Many of the regulators took the view that insider trading was prevalent "over the whole range of market activity".

    It seems likely that insider trading occurs throughout the whole of the Australian securities market, but it is more likely to occur in certain specific areas than in others. The market's evaluation of particular classes of securities, such as mining and exploration stock during the late 1960s mining boom, and high technology and takeover stocks in the early 1980s, gave rise to insider trading which suggests strongly that insider trading is often a matter of opportunity. The extent of insider trading can also be influenced by the volatility of the stock in question and the degree to which the ownership of securities is tightly held amongst a relatively narrow group of shareholders. This is not to suggest that insider trading does not occur in relation to the "blue chip" securities of large public companies, but it is more likely to be successful in moving market prices in lower quality stocks. The likelihood of insider trading occurring in large Australian public companies should not be discounted, especially in takeover situations.

    Opportunities for insider trading

    Insider Trading has been described as an opportunistic crime. It is carried out when an opportunity presents itself and by persons who take advantage of the opportunity. The difficulties of quantifying the extent of insider trading and perhaps in detecting it, might be due to the opportunistic and random nature of the practice. It was therefore of particular interest to find out what opportunities existed for insider trading. The first questions on this topic asked interviewees about the frequency of conflicts of interest arising from access to price sensitive information. The brokers reported that conflicts of interest were a constant factor in the industry or, at least, that they were very common. They were said to arise especially when a broker is engaged in corporate advisory work. It was claimed that these conflicts were usually resolved properly. In the context of conflicts it is useful to refer to comments with respect to the treatment of information gathered in the course of research, especially information provided to brokers by listed companies. A Melbourne broker explained that in his firm, "any research undertaken by the firm goes back to the company first". The same practice is followed by another Melbourne firm where "the research information is kept secret until it is checked with the company and then it is published".

    It was of interest to establish whether there is any house trading by brokers on the information collected by them in the course of research. Several brokers explained the position in their firms and at the same time described the process of gathering information. A Sydney broker responded, "some companies refuse to see brokers; they rely on section 128 to avoid them. Others, with less market status, are anxious to see them to build up the share price. Of those who talk, it is amazing what they say, but some companies do not tell the truth. There is a great deal of monitoring of companies these days. Here, there is no house trading but some institutional analysts are not prevented from trading". Another perspective on the practice was obtained from a senior broker who said that "market research is done in the hope that it picks up price sensitive information. This is only ever done on a formal basis; it does not disclose inside information. The information is ultimately used by the firm to disseminate to its clients. The firm does not trade on this information but we will pass it on early to institutions. Trading on research information is common elsewhere, especially in those stocks where a small amount could move the price".

    Another explanation of how research information is dealt with was provided by a broker who responded that "research obtains price sensitive information but how often is it inside? At presentations the companies should be more guarded. Information that is not generally available to the public comes out. The information then goes to clients. In this firm advisers would not go out and buy shares; the house would buy shares and disclose to clients that it is selling as a principal. It is more likely in small firms for brokers to trade on research information". An enigmatic statement was that "companies are always giving information but it is not insider trading. The research reports go to clients. Trading by the house before advising clients could go on but the information could be wrong or your interpretation wrong. Profit forecasts do not affect prices much".

    Another insight into industry practices came from a Sydney broker who asked, "how often is information from research price sensitive?" He pointed out that "high level executives do not give much away" and asked, "is it inside information or smart analysis?" In his firm, "there is no house trading on this information - it goes to the client first. It would be stupid to breach trust. Not many brokers have the same degree of self-control. This firm is always aware of surveillance and the potential danger to its business". Perhaps the frankest exposition of the treatment of information gathered from companies came from a broker who told us that he sees companies "at least once a week and gets superior information. Some managements talk freely and you get price sensitive information from them. With research information we either trade for the house or send it to institutions. We trade in big companies only if it is inside information from leaks from banks or advisers. It will be a problem with screen trading. All companies try to bull the price of their shares". When financial advisers were asked about the frequency of conflicts of interest, the overwhelming view was that it was a common event. There was little comment about the way in which such conflicts were resolved but it was interesting to note that the accountants made similar replies to the effect that, "professionals don't find it a problem". The merchant bankers suggested that they can handle conflicts better than brokers.

    The response to this question from the Stock Exchange officials suggested that they are not close enough to the daily workings of the market to be able to comment accurately. On the subject of the use of research, one official felt able to tell us that "in section 128 terms, brokers do engage in insider trading but some of the information could be found out by individuals". He admitted having "some difficulty with the practice of trading first before passing on the information to clients. It is unwise and unethical". From what the market observers reported, it seems that conflict of interest is ever present. When asked about the treatment of price sensitive information gathered during market research, the answers provided were varied. One observer reported that he was "not able to say how often price sensitive information is given out by companies". Another of the group was of the opinion that "brokers obtain price sensitive information but it is not devastatingly inside information. They probably trade on it and then pass it on to the client. Small investors are not treated as well. Some brokers are subsidiaries of the companies whose shares they are ramping". A more emphatic response was that "research is used before it is made public". But even stronger was the explanation that "analysts quite often get price sensitive information; boards tell them what they want to tell them; circulars are speculation, puffery, to get the price up. Larger companies are better scrutinised and much cleaner in insider trading terms. I would not be surprised if there is house trading nor if there was passing on to affiliates. This is consistent with the ethical standards in the broking world". An authoritative explanation came from the ex-broker who reported that "talks with companies are directed at getting sensitive information. A skilful broker will get it wittingly or unwittingly. Brokers do house trade on it. They buy shares to provide them to persons who are acting on their recommendation".

    The lawyers were able to appreciate the issue of conflicts better than other groups in the study. Their views were that conflicts of interest are a particular problem for persons in company management who trade in shares. Brokers were also identified as a group for whom conflict situations were common and several lawyers pointed out that brokers tend not to be able to manage such situations well. While the regulators considered that conflicts were not likely to arise in CACS, they tended to the view that conflicts would be common in the private sector for merchant bankers, advisers and within companies. One assessment was that "such conflict is probably quite frequent, it depends on the opportunities which arise".

    Insider trading and corporate control

    A view is sometimes put that traders deliberately build up their holdings in order to obtain price sensitive information to assist them in their trading. The almost universal view amongst brokers was that traders would not seek a place on the board solely as a method of obtaining price sensitive information. The main reasons for such a view were that "it is an expensive way of doing it; a long way for a quick trade" as one broker put it. Once on the board, "your hands are tied" said another broker. Those who did not dismiss the possibility said that "it could happen" and that "it is not common but it certainly happens" or that it might happen "in smaller companies".

    The qualifications to some responses provide insights into the process of obtaining information. A Melbourne broker responded that "boards do not necessarily know everything; the information flow is controlled by CEOs and accountants. It is not an efficient way of obtaining information". A Sydney broker explained that "a lot of information is wrong. Banks get better information than brokers; auditors get better information; lower level people get information probably before the directors do". The ease of obtaining price sensitive information was referred to by one broker when he responded that "some brokers might take this approach but it is too expensive. Non-brokers can obtain information and do research without going on to the board" Just how easy this was, was demonstrated by the comment that "brokers can go to the company and get information".

    This question also yielded some insights into how insider trading is conducted. A Sydney broker responded that "most is unplanned, it depends on information falling into your lap". According to a Perth broker "it is easier to insider trade off the board [of directors]" and according to another "it is sometimes better not to go on to the board". A Perth broker expressed the opinion that "going on to the board does not give rise to an insider trading problem, it is more a long-term propositions.

    Most of the financial advisers thought that it was not common to build up holdings in a company merely in an effort to obtain access to price sensitive information. Going onto the board was either a very expensive way of obtaining information or a means of achieving other goals such as the control of the company. The majority view of the ASX officials was that this does not happen, "[b]ut, a person would be dumb not to use a position on the board or to ignore information".

    The market observers had similar views to other groups. A wide range of views were provided by them. It was said to be "quite common" or "routine", that "it happens in second board and lower main board companies" and that "it often occurs". A different view was that "it is done mainly to get control and participate in the company". Another observer repeated the point that "it is a very expensive way of doing it. The board is the last place to do it". One of them responded that "they don't really need to, they can use contacts as Boesky did".

    Some lawyers shared the view that "some people who have got on to major company boards have only paid lip service to insider trading controls", but the more common view was that it would be a very expensive way of trying to obtain price sensitive information and that "there are usually better ways of getting price sensitive information". The regulators likewise felt that getting onto the board for this purpose would be rare because, as one regulator observed, "persons who insider trade can obtain the inside information without being on the board". Once on the board, additional constraints upon the traders are seen to operate - "... once a person is on the board he is an insider and the risks of being caught increase".

    Is price sensitive information necessary for success?

    For the most part, brokers believed that it was possible to succeed without access to price sensitive information and that success comes from relying on fundamentals. A Sydney broker thought that "price sensitive information is just a help. It is not vital". Another of his colleagues went so far as to say that "it is probably better not to rely on it". One surprising view was that "inside information is not important at all" to success in the stock market. Price sensitive information was, however, generally seen as valuable, particularly as fundamentals are of more long term importance. Price sensitive information is seen to be very important for making short term profits but over the long haul, success is seen to be based on the fundamentals. Access to price sensitive information, but not necessarily inside information, will enhance the prospects of success. For quick profits, it appears necessary to have access to price sensitive information.

    The almost unanimous view of the financial advisers was similar to that of the broke price sensitive information is not necessary for success. Good research, astuteness, and relying on the fundamentals were mentioned as the factors for success. It was pointed out by some that price sensitive information is not necessarily inside information and that if a person has access to such information the chances of success are greater. Likewise, the most common view of the market observers was that success is possible without price sensitive information and that the approach of relying on fundamentals was the best method for success. The view that price sensitive information was not essential was also held by most of the lawyers.

    The general view amongst Stock Exchange officials, predictably, was that success is possible without price sensitive information. One view was that "you can succeed without it. The Stock Exchange runs not on facts but on fashion - there is always good value stock that is ignored. Success does not depend on insider trading". The regulators' majority view was that it was possible to succeed without access to price sensitive information, but some had serious qualifications and there were a good proportion who doubted the possibility of success without it, especially in the long term.

    Market conditions and insider trading

    The overwhelming view within the broking group was that insider trading was more likely to occur during periods when the market is very active in a bull market and when there are takeovers. Most brokers felt that takeovers were more likely to occur during bullish market conditions. A bull market was said to be the most likely time for insider trading to occur because, "there is more activity" and "more people are interested". A development of this theme was that in a bullish period, the level of activity means a lower chance of detection. Special events, such as "during periods when there are takeovers and discoveries, special breakthroughs or sudden developments" were seen as likely to contribute to the level of insider trading. A comment consistent with the majority view was that insider trading "will occur in any market, but it can be pin-pointed more in a bear or drifting market".

    The financial advisers said that active markets and periods during which takeovers and major reconstructions were taking place were more likely to sustain insider trading. One fund manager thought that it was more likely to occur in "a bear market where assets have been undervalued". A merchant banker summarised the conditions in which insider trading is likely to be found as follows: "in a bull market, when there is good news, and in a bear market, when there is bad news". The Stock Exchange officials were once again unable to express a single community view. "It is more likely in an illiquid market" said one. Another replied that "I cannot say whether it would be a bull or bear market". Insider trading appears likely to be most prevalent during periods of heightened market activity, such as ill a bull market, takeover situations and in situations where major discoveries or innovations were known to have occurred. It was also evident however that insider trading could occur in a bear market, when there was bad news about to break. The level of volatility in the market could also be important in encouraging persons to insider trade. Volatility in prices is a critical factor in undertaking a successful insider trading operation.

    Takeovers and insider trading

    It has often been said, and other research tends to show, that there is a distinct relationship between takeover activity and the level of insider trading. Participants in the study were asked whether they could think of takeovers where they suspected that insider trading had taken place. Most brokers at least suspected that insider trading is associated with takeover activity. According to one, "takeovers are a great example of insider trading. The majority of cases involve leaks. This is the easiest form of insider trading to prove". Takeovers are regarded as the special events that are likely to move prices and create the climate for insider trading. The basis for this widely held suspicion is the movement in prices prior to the announcement. One broker considered it "interesting that share prices lift pre-takeover". An explanation commonly referred to was the fact that in just about every takeover, there are so many people involved. It is very rare that the price does not move and part of that movement comes from insider trading". According to a Sydney broker, "some merchant banks leak, especially on West Australian deals". Of course, it is possible that share prices move upward in the pre-takeover period because takeover targets are often identified in the course of market analysis and because prices tend to move on rumours of takeovers An interesting feature of this phase of the interviews was that even though participants were not asked to do so, it was not uncommon for them to name specific takeovers where they thought that there had been insider trading and, in fact, discuss chapter and verse the insider trading that took place.

    Financial advisers said that there is a link between takeovers and insider trading. Some said that they knew of specific cases while others suspected that there was a link. This question inspired a mixed reaction from the ASX officials. Some quite clearly doubted that there was such a link, but one replied that "in takeovers it is hard to believe that there is no insider trading". The observer group most strongly suspected that insider trading took place during takeovers. One respondent said that "it is frequent and it is demonstrated on graphs". An even more emphatic response was "hell yes-just look at the price movements and turnover a month to two weeks prior to a takeover. The leaks are in the targets - [from their] clerks, lawyers, CACS, bankers and accountants". On the subject of leaks, another view was that "the leaks vary. Sometimes they come from the board but more often well below the board in the advisory groups where there is terrible chicanery". One person who has been associated with many spectacular takeovers reported that it was common for members of the advisory team to be encouraged by directors to engage in share trading. The attitude of lawyers to this link was probably best summarised by a Sydney lawyer who explained that, "you often wonder about some large takeovers. Insider trading need not only occur in small corporations, but associate and warehousing questions are more common in takeovers". The regulators on balance believed that there was a relationship, although there was once again a problem of hard evidence of insider trading being available. It seems clear that there is often a connection between insider trading activity and takeovers. Those closest to the market, such as brokers and merchant bankers, were particularly certain of the existence of this relationship and most other groups on balance also saw a link. Only the ASX officials seemed to question the existence of this linkage. Their views need to be treated with caution in this regard in view of the preponderance of industry opinion to the contrary.

    Takeovers were pin-pointed as likely insider trading situations due to the profits which could be made by buying shares ahead of a takeover and because of the long chain of advisers and other persons who are involved in preparing the takeover.

    Insider trading as a crime - how serious?

    One might speculate whether, if insider trading is not regarded as a serious matter by people within the securities market, it is tolerated more than if it were seen to be serious. It was found that insider trading is generally not regarded by brokers to be serious or as significant as other forms of market conduct. A Melbourne broker responded that he could "think of many more examples of forms of abuse other than insider trading". The more significant forms of conduct were market rigging, which is "more serious and easier to do"; manipulation by false rumours; corporate fraud; churning of clients; staff malpractices; linked advisers; ramping; warehousing, and "other rorts such as loans to directors, and asset purchases by directors in smaller listed companies. The public is being ripped off left right and centre by these rorts". Perhaps the comment that best reflected the brokers' view was that "within the industry we are laid back about insider trading. Warehousing, circumventing the Takeovers Code and the actions of the big players are serious matters. Insider trading is one of a number of imperfections in the market".

    Only one of the financial advisers was prepared to describe insider trading as a serious problem but a number shared the view that "in terms of its frequency, insider trading is a small matter but it has the potential to destroy the market". None of the Stock Exchange officials ranked insider trading highly as a problem. One described it as "no more serious than other abuses". On the scale of market abuses one official observed that "insider trading is comparatively minor. Ramping is much more serious for shareholders than insider trading, as many shareholders are likely to suffer. Insider trading gets undue attention because of the public perception. We are very concerned about unenforced legislation or poorly written legislations. The lawyers generally did not rank insider trading as the most important form of market abuse but they acknowledged that it was often a difficult assessment to make. One explained in these terms, "it is hard to say how important insider trading is. Honesty is an important thing about securities markets. Emphasis should be placed upon making people tell the truth. Insider trading is in this category".

    It appears that the industry view of insider trading was that it was not as quantitatively serious as other examples of market abuse but that it was perhaps potentially more serious. Some of the evidence that emerged from the round of post1987 corporate collapses supports the view that there are forms of illegal and undesirable activity which are more common. Indeed, the example set by the high profile business identities could encourage insider trading. If it is not regarded as a serious matter in the range of things that happen in the market, where the opportunity arises to engage in insider trading, why not take it? When account is taken of the risks of being prosecuted, the attraction of insider trading is even greater.

    Conclusions

    The opportunities for insider trading in Australia have been, and continue to be, extensive. This is not simply a matter of greed but the result of a complex web of values, market conditions and professional or peer group tolerance of insider trading. As the Chief Manager of the AMP's Investment Operations Research Division said in evidence before the Griffiths Committee, "(t)he people who would have the clearest idea of what is happening are the people in the broking firms who are taking the orders. Of course, they have to be careful that they do not spoil any good business that they have by dobbing anybody in" (Griffiths Committee, Hansard, p. 207).

    The frequency and extent to which conflicts of interests occur within the securities industry are such that many cannot handle these conflicts well. This was particularly said of brokers, especially those who do not have a great deal of background and training in the industry. Price sensitive information gained on a selective basis from corporations seems to be widely used for principal trading especially by brokers and financial advisers, who not infrequently trade in this way before making such information public or releasing it to clients. This is an institutionalised opportunity for insider trading. Insider trading is not likely to be the main motivation for those seeking positions on the company boards. There is considerable pressure within the securities industry to obtain access to price sensitive information as mere good market analysis is often not enough to attract clients. Spectacular gains and quick profits are more easily achieved by insider trading but over the longer term the fundamentals are the more reliable route to success.

    One of the more blatant opportunities for insider trading arises from the readiness of companies to selectively divulge price sensitive information about their corporation to brokers, institutions and large shareholders. Often there may be good reasons from the company executives' point of view for doing this, but it is nevertheless grossly unfair and is contrary to the notions of a properly informed market. It has been all too convenient for brokers and others who receive such information to argue that the availability of this information does not guarantee a profit or that this information is often misleading or that it is research. Attempts to explain efforts at obtaining such information as the product of good research, are merely rationalisations. There is room for greater control of the release of corporate information to ensure that all investors are given an equal opportunity to take advantage of the market opportunities which this information creates.

    The market operates upon the basis of the comforting myth that success comes from market analysis; so long as your market analysis is correct or you study the fundamentals, you will be able to succeed. Brokers clearly have an interest in perpetuating this abstract, theoretical view of markets. Whilst it is true that this method is likely to bring success in the longer term, particularly with blue chip stock, most interviewees acknowledged that resort to inside information is superior to reliance upon fundamentals, particularly in the shorter term. In an over-analysed and competitive market, the temptation for financial intermediaries to obtain inside information is enormously attractive. Ironically, it is industry insiders, those who are arguably in the best positions to undertake analysis of fundamentals, who rely most upon inside information, rumour and herd instincts. Perhaps this is inevitable to a certain degree, but it seems that too much reliance may be being placed upon such short-cut methods for the market to be healthy and for the public to have confidence in it. Many in the industry seem to share this view. More timely disclosure of price sensitive information would reduce the premium value of that information and would reduce both the opportunity for and the scope of insider trading. Such disclosure would, as well, contribute positively to greater market efficiency.

    It is no surprise to find that situational factors in the market such as technological and mineral discoveries and company takeovers provide major opportunities for insider trading. A bull market, especially where share prices are highly volatile and there is a great deal of activity, provides many easy opportunities for insider trading. Finally, the apparent tolerance of insider trading and peer group support for insider traders who have not been convicted are important factors in enlarging the opportunities for insider trading. When this is associated with the perception of many market professionals that insider trading is not necessarily the most serious problem facing the market, the risks for insider traders seem to be much reduced. Although insider traders would not concede the point, insider trading is a more significant issue than most other forms of market abuse, because of the potentially devastating effects on market confidence and market participation of perceived widespread insider trading.

    October 06, 2005 Casino capitalism continues to baffle

    In my humble opinion, the instability of financial trading markets all over the world exemplifies the fact that free market behaviour is not always rational behaviour. Although right-wing liberal economic types like to portray packs of investors as some sort of "hive mind", judging the value of stock in real-time and acting accordingly, investor behaviour is typically more instinctive and random than that. People might sell their stock in Telstra, for example, because they want to go on a holiday. If enough Telstra shareholders want to go on a holiday at the same time, the value of Telstra shares will drop if the numbers of sellers outweighs the numbers of interested buyers. It's a pretty dumb example but it holds true. What does such a decision have to do with the actual value of Telstra? SFA, but markets are blind to that, and market analysts will try to rationalise the stock price movement in any remotely credible way that they can.

    And what prompted this anti-market spray? The Australian stock market had $21 billion wiped off it yesterday in the biggest single-day loss since the week of the 9/11 attacks. The purported reason for the loss hardly justifies the reaction:

    Local traders were anxious after a plunge on Wall Street, which was sparked by a US Federal Reserve warning that interest rates were likely to rise and energy prices were driving inflation higher.

    Anything that can devalue Australian companies by $21 billion in a single day sounds more like a corporate disaster than anything else. It's barmy. Put simply, the global marketplace could do without the ridiculous volatility that often ensues in financial markets. Sometimes it seems as though investors might do well to just go and put their surplus capital on red at the roulette table at Star City instead of pumping it into the stockmarket. At least there is a sense of immediate certainty about that sort of transaction. I'm not seriously advocating gambling as much as trying to make a point here, but gambled monies are at the very least not subject to the often inscrutable and senseless whims of shareholders across the country.

    Unsurprisingly, given market volatility and the sense that one is gambling, not investing, when buying shares, critical theorist Susan Strange once labelled the instability of modern financial markets "casino capitalism". Make no mistake, investing in financial markets these days is in many ways closer to being a form of gambling than buying property, or putting your money in the bank.

    Posted by Guy at October 6, 2005 07:44 AM

    Comments

    This is just the usual October correction. Its a good thing, because it allows investors to get some bargins before the market climbs up again. We just came off a new high, it may look like a crash but the market is still very healthy. This dip is predicted to last only a month or two, or even only a few weeks.

    Posted by: Nic White at October 6, 2005 09:15 PM

    You have obviously never invested in the stock market. For a long-term investor it is nothing like a casino. If a stock price goes down that is a paper loss, you do not actually loose money unless you sell the stock.

    To a wise investor an event like this is an opportunity. As Nic said, this is a chance to get bargains before the market goes up again.

    The market can be irrational. But the great thing about the stock market is you can control your risk. You could invest in bank shares, this way you'd get a relatively stable stock that pays a good dividend. Or you could invest in a speculative stock that might go up exponentially or vanish altogether.

    A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire.

    Posted by: Chris Fryer at October 7, 2005 12:04 PM

    Posted by: Chris Fryer at October 7, 2005 12:06 PM

    "A smart investor has a broad portfolio of stocks across different market sectors. That way you spread your risk and don't suffer when the market goes haywire."

    So it's a bit like betting on a few favourites and a few long-shots at the horsetrack, right? ;) I know some gamblers who don't think that they've lost money until they've left the gambling establishment of their choice for the day. Until then, it's just $50 up or $50 down, and the betting continues.

    I guess the point I am trying to make is that $21 billion was wiped off the supposed value of companies in a single day, and hardly anything at all changed in a material sense.

    It's like if banks decided to randomly revalue the money sitting in your savings account on a real-time basis. On a whim, a significant proportion of your savings could disappear, without anything particularly tangible or real justifying that reduction in value.

    Posted by: Guy at October 8, 2005 11:32 PM

    The October correctio, as I understand it, is literally a correction - meaning those companies have been over valued in the last year or so, and that is being rectified. As the correction results in a bid, investors and traders panic and sell like mad, and the market dips further before levelling off and climbing again.

    Theres relaly nothing to see here, but the media is beating it up something chronic.

    Reviews 'Cowardly capitalism' by Daniel Ben-Ami Prospect Magazine December 1998 issue 36

    The dominant image of the financial markets is that of a giant casino. Brash young men in red braces, driven by insatiable greed, gamble with huge sums every day. When the bets go wrong the innocent suffer. Reckless financial markets pose an immediate threat to the future prosperity of humanity.

    Susan Strange, who died just after the publication of her lastest book, was one of the most compelling academic advocates of the view that the global casino is out of control. Although she is not a household name, she played an important role in developing the intellectual framework to support the casino thesis. Her Casino Capitalism (1986) is a Keynesian account of the damage inflicted on the world as a result of financial deregulation which was taken up by many better known writers such as William Greider in the US and Will Hutton in Britain.

    With the onset of the Asian financial crisis Strange's account of financial markets has become almost mainstream. Her ideas inform many of the discussions about a "new international financial architecture." Economists who would once have scorned her views now agree with her that deregulation has gone too far and that new forms of regulation are needed. The British government has floated the idea of a world financial authority to regulate global finance. The IMF, once a bastion of free market economics, has conceded that capital controls may be necessary under some circumstances.

    Mad Money, the sequel to Casino Capitalism, takes into account the impact of information technology and the rise of financial crime. It also places new emphasis on the role of international institutions. For example, she backs George Soros's plan for an international credit insurance corporation as a complement to the IMF.

    Yet there is one striking omission from Mad Money. She points out that the dominant theme of her earlier work was the danger of volatility-the gyrations in the price of financial assets. But then she fails to notice that the decade since the publication of Casino Capitalism has been one of relatively low financial volatility. This assertion appears to be contradicted by everyday experience. Every week there is news of a record fall on the London stock market-often followed by a record rise. But such impressions do not take account of long-term stock market growth. A 200-point fall when the FTSE 100 index is at 6000 does not have the same significance as when it is at 1000.

    The low volatility of the main world stock markets can be precisely measured. And William Schwert, a professor of finance and statistics in the US, has produced a comprehensive study of the US, Britain, Germany, Japan, Australia and Canada which states that "all of the evidence leads to the conclusion that volatility has been very low in the decade since the 1987 crash."

    Strange is not alone in misreading volatility. The striking feature of the past decade is the gap between the fear of risk-taking and the real level of risk. The obsession with risk management is at an alltime high. Financial markets are characterised by fear rather than greed. We should talk of cowardly capitalism, not casino capitalism.

    Cowardly capitalism, for example, lies behind the explosive growth in derivatives, normally seen as one of the instruments of financial madness. Derivatives are bets on the way in which the price of financial assets move. They can be used for speculation-and often are-but they are mainly used to reduce financial uncertainty. (A survey of derivative use by non-financial US companies in 1994-95, at the University of Pennsylvania, found that the main use of derivatives was to manage cash flow and reduce risk.)

    How do derivatives work? Imagine a British plastics manufacturer that depends on imports of crude oil-priced in US dollars-as its main raw material. The business suffers if the dollar strengthens. One way it can protect itself against this is to bet on a rising dollar. If it does rise the extra cost of the oil will be offset by the money it makes from its derivative contract. This practice is known as hedging. It is similar in principle to life insurance which can be seen as a bet that the policy-holder will die in a given period.

    It is certainly possible, through dishonesty or incompetence, to lose huge amounts through speculation in derivatives, but the market is driven by risk aversion rather than recklessness.

    Derivatives are far from the only instance of cowardly capitalism. Another example is fund management. Back in 1957 almost two thirds of the London stock market was owned by private investors. Today it is dominated by investment funds such as pension funds, insurance funds and unit trusts. The main rationale of such investment funds is to manage risk. Their guiding principle is: "Don't put all your eggs in one basket." If an investor holds a few shares his portfolio is likely to suffer from high volatility. But a fund manager with a large number of shares can diversify risk. Increases in the prices of some shares can cancel out falls in others.

    The intellectual rationale for fund management explicitly casts risk as a problem. In his seminal paper on portfolio theory, Harry Markowitz argues that "the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing." The suspicion of risk-taking is embedded in the intellectual heart of cowardly capitalism.

    If the financial markets are so risk averse it is not clear why they should be seen as irresponsible risk-takers. In reality both perceptions are closely related. Financial markets are seen as reckless precisely because of the strength of risk aversion in the contemporary world.

    But the act of risk-taking should not be stigmatised, otherwise markets will cease to function properly. Susan Strange's notion of casino capitalism should be ditched or at least modified. And grand regulatory schemes based on the notion of out of control financial markets should be handled with care. In the world of cowardly capitalism, where risk aversion rules, it is more accurate to see money as sad rather than mad.

    Mad money

    Susan Strange

    Stefan Stern - Rise of 'casino capitalism ...

    Rise of 'casino capitalism' shakes faith of moderate Monks

    By Stefan Stern

    Published: November 21 2006 02:00 | Last updated: November 21 2006 02:00

    "The prototype of the successful man in modern society is not the scientist, the inventor, the scholar. It is the financier, the gambler and those with social pull. The others share [in the winnings] sometimes, it is true, but their share is modest compared with the oligarchs and tycoons; and they don't usually keep their share for long. They are no match for the commercial prowlers."

    A snap-shot of London's Mayfair district, home to the burgeoning hedge-fund phenomenon, in November 2006? Actually, no. The above words were written in 1952 by the Labour politician Aneurin Bevan in his book In Place of Fear. Bevan had a gift - his most passionate supporters would say a genius - for exposing the truth of a situation in language that could be both scintillating and pungent.

    Fifty years ago, he criticised the prime minister of the day, Sir Anthony Eden, for his reckless actions during the Suez crisis. "[He] has been pretending that he is now invading Egypt in order to strengthen the United Nations," Bevan said in a famous speech in Trafalgar Square. "Every burglar of course could say the same thing: he could argue that he was entering the house in order to train the police. So, if Sir Anthony Eden is sincere in what he is saying, and he may be . . . then he is too stupid to be a prime minister!" Here was political rhetoric with a touch of prophesy about it.

    It was the enduring appeal of speeches such as these that helped draw a good crowd to the fifth annual Bevan memorial lecture in London last week. The lecture was to be given by John Monks, formerly general secretary of the British Trades Union Congress, now the Brussels-based leader of the European trade union confederation.

    No one in the audience would have been expecting Bevanite rhetorical fireworks from Mr Monks. That has never been his style. Between 1993 and 2003, he led the British trade union movement with modesty and distinction. He was the moderate's moderate: avoiding confrontation wherever possible and advocating partnership at work between management and employees. Business leaders were happy to do business with him.

    They would not have found this lecture so easy to deal with. Confronted by today's turbo-charged capitalism, Mr Monks cast off his former moderation. He even seemed to be on the verge of recanting his commitment to the partnership model. "Partnership with who?" he asked. There has been, he said, a "disintegration of the social nexus between worker and employer - a culture containing broad social rights and obligations. The new capitalism wants none of it."

    Mr Monks contrasted businesses' healthy profitability with the ruthless way some have treated their staff recently, whether through large-scale redundancies or the constant threat that jobs may be sent off-shore or outsourced. While median wages have stagnated, record executive salaries are legion.

    He admitted that he had possibly been a bit naive in the past. "I did not fully appreciate what was happening on the other side of the table," Mr Monks said. While he sympathised with business leaders for the relentless pressure they find themselves under - "It cannot be easy running a firm . . . when you are up for sale every day and every night of every year" - he was appalled by the increasingly "shameless", short-termist behaviour of overpaid corporate executives. "More and more they resemble the Bourbons - and they should be aware of what eventually happened to the Bourbons."

    For someone like me, who has sat through 10 years of reasonableness from John Monks, this speech was remarkable, devastating stuff. Maybe there is something in the Brussels water. Perhaps the ghost of Nye Bevan was speaking through him. Or was it just anxiety over the career choice of his daughter's boyfriend? He is now working for - you guessed it - a hedge fund. Whatever its cause, a challenge was being thrown down.

    "All this is too important to be left to the practitioners who have a vested interest in obscuring what they do from the rest of us," he said. And, with bonus season fast approaching, he took one final, sweeping aim at the high rollers of "casino capitalism". Their actions are "dangerous to economic stability, traditional industry and jobs", he said. "I would like to see the City pages of the press more challenging and less respectful on these matters . . . Our future - the world's future - is too important to place in the hands of the new capitalists."

    Will corporate leaders - those that have read this far anyway - simply shrug their shoulders and get back to their slashing and burning ways? Is Mr Monks merely offering a wholly predictable, knee-jerk, lefty rant? I do not think so. This general secretary just does not do lefty rants. So business people should take note. When the John Monkses of this world say enough is enough, that the capitalist system itself is sick, you can be sure that elsewhere in the world there is deep-seated, lingering resentment and unhappiness.

    Half a century ago, Nye Bevan expressed a similar concern. In In Place of Fear he wrote: "There is a sense of injustice in modern society, and this induces a feeling of instability even in normal circumstances. The rewards are not in keeping with social worth, and the consciousness of this, both among the successful and the unsuccessful, will simmer and bubble, blowing up into geysers of political and social disturbance in times of economic stress."

    Reading these words, you can see why so many people were prepared to come out on a dark Tuesday night to

    The ubiquitous leveraged buyout management buyout or management sellout

    LBO Business Horizons

    My objective in this article is to discuss certain elements of the leveraged buyout (LBO), sometimes referred to as taking a corporation private. In this practice, the company's management and other private investors buy out (hence "buyout") all the other shareholders, almost entirely with borrowed funds (hence "leveraged").

    I am mindful, however, of the sage journalistic advice that suggests that the writer should capture the interest of the readers very early on by establishing the essentiality of the topic, its impact, or, at the very least, sharing provocative examples that highlight its salience. In no particular order, try these:

    Related Results: bribing management in taking private

    Video

    A Quibble

    A recent special report by Fortune (1989) educates us with regard to "How Ross Johnson Blew the Buyout." F. Ross Johnson, of course, was the CEO of RJR Nabisco who put his company into play by proposing to take it private via the leveraged buyout. Among other things, it has been suggested that his bid (initially $75 per share, ultimately $109 by Kohlberg, Kravis, and Roberts [KKR]) was preposterously low. The compensation package for Johnson and a few (very few) managerial colleagues was judged by most observers to be outrageously high. Beyond that, certain of Johnson's strategies (for lack of a better word) led to a fair amount of enmity between himself and the special committee of outside directors enchartered to decide the final fate and ultimate ownership of RJR.

    There is apparently some substance to these reports. At a minimum, there is an unusual amount of consistency among many observers that the RJR leveraged buyout did illustrate some excesses that can be associated with such a play. Perhaps, but permit me a quibble.

    If we rely on these reports in their entirety, we might be led to believe that F. Ross Johnson lost. He lost his job, presumably one of great status and reward, as the CEO of a Fortune 500 company. He lost to KKR, for it is KKR who now own and operate RJR. He may have lost some reputation. The word "greed" crops up repeatedly in some descriptions of this LBO. Beyond that, his professional competence has been questioned. It has been alleged, for example, that he was totally outmaneuvered by KKR. Taken in the aggregate, a grim picture and humiliating loss.

    Maybe. Maybe not. We may want to consider one other factor before we decide whether or not Mr. Johnson "lost." It turns out that Mr. Johnson set another record of sorts with his departure from RJR--the largest golden parachute in history. A recent Business Week (1989) reports that F. Ross Johnson, former CEO of RJR, walked away from this embarrassing loss with "separation pay" of more than $53 million.

    I will be among the very first to concede that wealth, as well as winning or losing, is in the proverbial eye of the beholder. I must say, however, that I find it difficult to brand anyone a "loser" who after the fray walks away with $53.8 million. That really does sound like a safe landing. Mr. Johnson deliberately put the company in play; nearly all observers feel that he lost. Even so, it has to be reported that the consolation prize in this tournament is most impressive.

    A Bribe?

    Rand V. Araskog, Chairperson of ITT Corporation, has recently written a book, The ITT Wars: A CEO Speaks Out on Takeovers. Araskog reports that in 1983, Jay Pritzker and Philip Anschutz were interested in gaining control of ITT through a leveraged buyout. The actual financial details are of little consequence here. Suffice it to say that the "deal" would have involved several transactions. Among other things, ITT's senior management would be given a 10 percent stake in the new company. This stake would have garnered Araskog some $30 million or so. Araskog explains in this book that he perceived this $30 million windfall to be little more than a gargantuan bribe.

    Just A Family Affair

    Richard P. Simmons took a specialty steel unit of what is now Allegheny International private in 1980. To his credit, this company has done very well. Two years ago, this same company was once again taken public. Stock was sold and has also done well.

    CEO Simmons requested that the board of directors approve an investment of corporate money into a LBO fund. There is nothing manifestly wrong with that. LBO funds are designed to allow companies (like KKR) to raise money to take companies private. Obviously, one invests in such a fund in the hope that these ventures will be profitable and provide an attractive return on the investment. Mr. Simmons evidently believed that corporate funds invested in such a vehicle was a prudent use of these assets.

    So far, so good. This LBO fund has three general partners. The problem is that one of these three partners is Brian Simmons, the son of Richard P. Simmons, CEO of Allegheny Ludlum.

    THE LBO AND ETHICS

    That there may be some potential for ethical issues to arise in LBO transactions will come as no surprise to anyone. Certainly, I do not presume to suggest that the prior examples are representative of all LBO transactions. Indeed, I fervently hope that only a modest few would have the character of those cited. Still, since 1981 (the LBO was relatively infrequent prior to that) more than 1,550 public companies have gone private, nearly as many as are listed on the New York Stock Exchange. I will argue that there are a number of factors common to every one of these LBO transactions that are most troubling. In fact, they raise the issue of whether current management of any publicly traded company should be party to an LBO. These issues include, but are not limited to:

    An Obvious Conflict of Interest

    The CEO of a publicly traded corporation has a fiduciary responsibility to shareholders. This responsibility is rather simply described: It requires that the interests of the stockholder be considered prior to, ahead of, and superior to the self-interest of the manager at all times and in all circumstances. Clearly, that sets an omnibus and challenging standard.

    Obviously, it is in the interest of the shareholders to have the value of their common stock at as high a level as possible. This is particularly evident when the stockholder may have some immediate interest in selling the stock. Just as obviously, it is in the interests of the potential buyer of the stock to have the price set somewhat lower. Most of us would be inclined to purchase stock when we believe that the stock is undervalued, when we think we are getting a "good buy." The value of this stock is going to increase. Accordingly, we'll buy some of it at its currently undervalued price.

    More specifically for these purposes, CEOs as managers should seek to place as high a value as possible on the common stock of the corporation. CEOs, as rational individuals, who are acting in their capacity as principals in an LBO, can have no such incentive. On the contrary, it is in their obvious interests to have the common stock valued somewhat lower.

    What Is The Incentive For An LBO?

    Why would any manager be interested in being involved in a LBO? Maybe, in one of the great understatements in recent memory, they believe there may be a few dollars in it. Maybe, more benignly, they believe that the company could be run a bit more efficiently. Suppose that an officer (or group of officers) of the corporation believes that certain assets could be redeployed, divisions divested, products launched, and so forth. Is there not a mature argument that these individuals are legally, as well as ethically, bound to identify and execute these strategies for the benefit of the stockholders?

    It would seem that there are any number of dynamics that underscore such concerns. One, when is the last time that the board of directors accepted the first offer and conditions when a management group proposed a buyout? On the contrary, it is commonplace that the board finds the first offer to be insufficient (the RJR event is a classic case, among hundreds of others). In other words, the management group typically provides a low-ball offer, much the same that you might do when making an offer on a new home. The obvious difference in that you do not have a fiduciary responsibility to the seller of the home.

    It is also considered to be textbook procedure for the board of directors to immediately market the corporation to all suitors when faced with a LBO offer. The object of this is to invite "competition," to be certain that a "fair" price is put on the assets and so forth. What do you suppose this exercise is all about? Is it possible that there are some folks who are not altogether confident that the current management would act in the absolute best interests of their constituency short of these strategies?

    Moreover, it is considered de rigueur to appoint a group of outside directors (because they are purportedly independent, a questionable assumption) to review and make the final recommendation concerning the management proposal. Why do we do this? Do we do it because we can count on the LBO group to provide us with a "fair" price from the onset?

    Also, it is typical to solicit the opinion of investment banks to determine the "fair market" price of such a transaction. Once again, why is this necessary? Do we not trust the very managers who serve as fiduciaries of the shareholders? There must be some doubt in someone's mind.

    We can all agree that some notion of the "fair price" of the company should be set. What is less clear is that the management involved in the bid should set it. Moreover, it is not as though this number can be independently and easily arrived at to the satisfaction of all observers. On the contrary, in one bidding war for Stokely Van Camp, three different investment advisors provided an opinion, sometimes referred to as a fairness letter, to three prospective buyers, all at different values ranging from a low of $50 to a high of $75 per share. If it is true that this "true value" is apparently subject to some debate, many would be quite disturbed if individuals with rather substantial self-interests are serious parties to establishing the price.

    The Ultimate in Inside Information

    The most cursory examination of the leading business and financial periodicals over the past several years would suggest some near crisis regarding inside information. Fundamentally, it is a violation of federal securities law for insiders (for example, company officers, members of the board) to profit from any transaction inspired by certain knowledge not available to stockholders generally. Suppose, for example, that a CEO knew that on Tuesday he would report the lowest dividend in the company's history. When this information is public, it would probably result in at least a short-term reduction in the value of the company's common stock. This CEO could not, then, legally sell shares in his company short on Monday. In short selling, of course, you hope that the price of the stock will fall.

    The CEO has made a good bet, too good. He is almost certain that the price will fall. The problem is he knows that because he is privy to information not generally available to others. Under SEC rule 10b-5, he cannot act in this manner: It is patently illegal. If prosecuted, he would at a minimum forfeit any and all profits derived as a function of this transaction. Beyond that, he would be subject to criminal penalties as well.

    If trading on inside information for a few thousand shares (one share, for that matter) is in violation of federal securities law, then how can the LBO be conducted in anything resembling good faith? Who on the planet has more pertinent information about the strengths, weaknesses, threats, and opportunities facing an organization that its management?

    More directly, if it is illegal to profit on the basis of "inside" information with just a few shares of the company's stock, how can we profit on the basis of the ultimate stock purchase, the company in its entirety? Frankly, I find it incredible that the standing management of a company does not have access to information available neither to its stockholders nor, most certainly, to the public at large.

    The Quality of Privileged

    Information

    One of the chief arguments often used in defense of the LBO is that there is no monopoly of the right to offer to buy. It is true that management-led groups, or groups with substantive management interests, can propose an LBO. It is also argued that excesses in this area are unlikely. Suppose, for example, that the management-involved group makes an offer below a reasonable estimate of the market value for a company. It is only reasonable to expect that some other suitor would enter the bidding, provide a more responsible bid and carry the day. In fact, it has been suggested:

    Once anyone initiates an LBO, the directors should put the company up for auction. And they should make sure that all serious bidders have access to all the information needed to make an offer (Business Week December 1988, p. 30).

    It seems that there are two pertinent issues here. One concerns whether it is indeed possible for any other bidder to have the quality of information available to it that is enjoyed by the management-involved team. Once again, who could possibly have the wealth of information available to the current management team? It is hard to contemplate a scenario wherein the management team would not have a substantive edge with regard to the quality of information.

    Beyond that, however, we may face an interesting catch-22. As the prior quote indicates, it is sensible to put the company to auction (presumably to encourage some competition and a check on the reasonableness of the management offer) and provide access to all the information needed to make the offer (possibly to reduce the management information edge.) Surely, much of the information that would be "needed to make an [informed?] offer" would be proprietary. Before suitors could make an informed bid, wouldn't they need information regarding state of development of new products, pending lawsuits and settlements, illness of key executives, and so forth? After all, the current executives are privy to this information.

    It is not immediately clear that the interests of the stockholders are met by divulging this information to "outsiders" irrespective of the LBO. Would such information be considered "inside information" by SEC standards? Would the bidding companies, then, be constrained from relying on this information for purposes of profit? I think that there is an excellent argument that such companies would be so constrained. If, however, it would be illegal for such a company to profit by such information, how could we allow the current officers of the corporation to profit by the same information?

    Full Disclosure

    Management-involved groups cannot take a publicly traded company private at their own initiative. Among other things, they will need the "permission" of the shareholders. Naturally, this is accomplished through the proxy process. Benjamin Stein, a lawyer and economist, has raised a fascinating question regarding this issue. Essentially, the proxy material to a stockholder must include full disclosure of any material fact involving the action. In theory, the stockholder reads the proxy material, becomes acquainted with the major aspects of it, and votes either to approve the LBO or otherwise. The Supreme Court has ruled that there must be such full disclosure of any fact "if there is a substantial likelihood that a reasonable stockholder would consider it important in deciding how to vote."

    This leads Mr. Stein to a persuasive point:

    But insiders never disclose the crucial fact that they plan to make vastly more from the corporate assets than they pay the stockholders for them. I am a stockholder in a few companies in a small way, and I hope I am reasonable. I consider it extremely important if management plans to make $50 from something it paid me $1 for, and it would assuredly make a difference in how I voted (Stein 1985, p. 170).

    Why would CEOs and other highranking officers of prestigious firms risk their security and their reputations if the opportunity for reward was not correspondingly great? Do you think that such information should be disclosed to the stockholders to better inform their vote?

    Let's assume that by whatever means the LBO has been approved. What now? The period after the LBO raises even more troubling issues.

    Life After the LBO

    Not all LBOs are successful, as Revco and Freuhauf could attest. Even so, it has recently been recently reported that the profit margins for LBO companies were 40 percent higher than their industries' median two years after the buyout. It would seem reasonable, then, to conclude that many of these LBOs do very well. As might be expected, there has been some speculation about why this might be the case.

    Consider this. Tadd Seitz ran a profitable division of ITT. This company was divested in an LBO by ITT in 1986. Mr. Seitz continued to run the new company. According to some, when under the control of ITT, is overhead was too high, inventories too large, and management a bit relaxed with respect to wooing new clientele. These, and other "problems" were addressed and the company has prospered. That, however, is not the issue. The better question is why wait until the company was private to make these rather elementary moves. Why were these strategies not employed for the benefit of the initial shareholders?

    This is by no means an uncommon scenario. Time after time LBO companies divest poorly performing subunits, drastically reduce administrative overhead, pare the workforce, renegotiate contracts, and moderate executive perquisites (for example, executive jets, first class accommodations), among a host of other initiatives. E. E. Bergsman of McKinsey & Co. adds some interesting perspective to this: "These LBOs are so immensely successful because they are better managed" (Business Week June 1988).

    See if the spirit of Bevan still had something to communicate 46 years after his death.



    Etc

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