By the end of the Greenspan bubble, therefore, the United States was getting poorer by about $2 billion each and every day, owing to its hemorrhaging current account and the orgy of consumption which it enabled. Yet the financial system had become so divorced from the Main Street economy that even as the latter grew poorer, the value of financial assets and especially the stock market averages clambered to new highs on the back of corporate financial engineering gone wild.
$13 TRILLION OF FINANCIAL ENGINEERING GAMES AND THE SIMULACRUM OF PROSPERITY
The stock market’s daily narrative, especially as conveyed by financial TV, only appeared to embody the traditional focus on corporate profits and the business outlook. In reality, the proximate drivers of the stock averages were Wall Street financial engineering games: mergers, stock buybacks, and LBOs. These transactions generated the arithmetic of EPS growth by shrinking the share count, thereby giving Wall Street traders financial rabbits to chase.
The massive capital markets churning attendant to financial engineering maneuvers, however, was rooted in state policy, not the free market. The common catalyst was cheap and ample debt, the Greenspan-Bernanke Put, and the tax-favored status of leveraged balance sheets. After the Fed’s easing panic began in 2001, these catalysts caused the pace of financial engineering transactions to accelerate and never look back.
Altogether, the value of M&A transactions in the United States over the years 2001 through 2008 totaled about $8 trillion, along with $2.5 trillion of stock buybacks and another $2.5 trillion of LBOs. During the course of the Greenspan bubble, therefore, these financial engineering deals cumulated to $13 trillion.
Moreover, all three types were designed to drive up the price of existing common stock by shrinking the pool of available shares. Wall Street thus cycled a sum equivalent to the nation’s entire GDP into these stock market transactions. Yet none of this raised a dime of new equity capital for productive investment.
This point goes to the heart of the bubble finance fostered by the Greenspan-Bernanke Fed. The purpose of secondary share trading on the free market is to create sufficient liquidity for savers and investors so that there is a dynamic capital market that companies can tap when they need funds for growth. By contrast, aside from the temporary insanity of the dotcom IPOs, there were only trivial amounts of primary equity raised during the entire run of the two Greenspan stock market booms.
The trading frenzy which peaked in 1999–2000 and then again in 2006–2007 consisted almost entirely of secondary market speculation where the driving force was the opposite of capital raising; which is to say, stock prices were being lifted by the liquidation of shares through buybacks, buyouts, and M&A takeovers. Even in the latter case, the overwhelming majority of M&A deals were for cash, not shares of the acquiring company, as had been the case historically.
In fact, the “Flow of Funds” data published by the Federal Reserve reveals that the maestro presided over a two-decade trend of corporate equity decapitalization. During the entire span between 1988 and 2008, there were only three years in which nonfinancial businesses actually raised net equity, and those were during the recession of the early 1990s. After that, the rate of net equity withdrawal from the business sector soared as the Fed’s prosperity management model became increasingly more aggressive.
Thus, nonfinancial corporations extinguished $300 billion of net equity during 1988–1994, owing to the excess of buybacks and cash M&A takeovers compared to new equity issuance. This was followed by nearly $700 billion of net equity liquidation during the next seven years. So, while this latter period coincided with the tech boom, corporate equity was actually being drastically shrunk, the mantra of growth notwithstanding.
But it was after the Fed slashed interest rates in 2001, causing business debt issuance to explode, that the cash-out of corporate equity went parabolic. Buyout and buyback transactions drained nearly $2.3 trillion of corporate equity out of the system over the period 2002–2008. In 2007 alone, the “Flow of Funds” reports show that “net new equity issues” amounted to negative $800 billion. Hurtling this much buyback cash at a rapidly diminishing supply of common stock levitated the stock market to the wholly artificial and unsustainable peaks of 2007–2008.
Needless to say, the Bernanke Fed was sleepwalking, furtively looking-out for deflationary goblins as it went along. Accordingly, it did not notice that the balance sheets of corporate America were being strip-mined in a manner similar to the mortgage-driven assault on household balance sheets. In fact, owing to these financial engineering transactions there had been nearly $3.5 trillion of corporate equity withdrawal, or CEW, during the two decades ending in 2008. Thus did the avalanche of credit enabled by the Fed warp and weaken the financial foundations of the nation’s private economy.
STRIP-MINING CORPORATE CASH:
THE FREE MARKET DIDN’T DO IT
The rise in equity prices which resulted from these financial engineering maneuvers did not increase the national wealth. Nor did these transactions promote economic efficiency, job growth, or improved corporate management. Beyond that, there was a still more insidious aspect; namely, the false impression promoted by Wall Street and often echoed by the maestro himself that financial engineering and equity liquidation on this massive scale was a good thing because it was the work of the free market.
The idea at work here was that takeovers and buyouts arise from the so-called market for corporate control and represent the verdict of the marketplace just as in the case of a successful product or invention. Consequently, it is claimed that shareholder interests are served when poorly run companies are taken over by more competent managements. Likewise, society is said to benefit from economic efficiency gains when equity-incentivized LBO executives squeeze out waste and sloth from “underperforming” companies.
In fact, corporate control transactions on the free market can generate these salutary effects. But the crucial caveat is that debt capital needs to be priced at market rates and the tax régime must be reasonably neutral. The underlying reality during the Greenspan bubble era, however, was more nearly the opposite, suggesting that the $13 trillion explosion of financial engineering transactions during 2001–2008 was inherently suspect.
The tip-off is the extremely high failure rate of M&A transactions and the fact that stock buyback programs often resembled giant financial laundering schemes (see chapter 22), wherein corporations purchased their shares from the public in order to issue new stock options to top executives. Likewise, as detailed in chapters 24 and 25, LBOs have been mainly cash strip-mining operations, not a unique arrangement for conducting business more efficiently. These financial engineering transactions, therefore, did not really reflect a market-driven quest for tangible economic gains, as claimed by Wall Street salesmen and free market triumphalists alike.
Instead, the boom in financial engineering transactions points to another motivating force; namely, the taxation and monetary policies of the state. It goes without saying that after the turn of the century debt became pitifully cheap. That was even more true on an after-tax basis, reflecting the long-standing deductibility of corporate interest payments but not dividends. Yet the most powerful force unbalancing the playing field was a radical reduction in the capital gains tax.
THE K STREET STORM FROM GUCCI GULCH
Alongside the Fed’s cheap credit régime, there arose a noxious distortion of the tax code best summarized as “leveraged inside buildup.” The linchpin was successive legislative reductions of the tax rate on capital gains that resulted in a wide gap between high rates on ordinary income and negligible taxes on capital gains. This huge tax wedge became a powerful incentive to rearrange capital structures so that ordinary income could be converted into capital gains.
To his everlasting credit, Ronald Reagan faced down the lobbies of Gucci Gulch and had gotten income taxes on a level capitalist playing field in the Tax Reform Act of 1986. The top income tax rate had been lowered to 28 percent, but this was done und
er a policy framework in which the tax base was also greatly broadened. Consequently, all forms of personal income—wages, salaries, dividends, and capital gains—were taxed at the same 28 percent maximum rate.
When the technology mania got going in the 1990s, however, the K Street lobbies for venture capital, private equity, hedge funds, real estate developers, and assorted other special interest groups formed a mighty coalition in the name of entrepreneurs and “job creators.” By the mid-1990s, it had lined up both the Rubin Democrats and the Gingrich Republicans behind the proposition that technological progress and business invention were crucially dependent upon low rates of taxation on the winnings from successful acts of capitalism.
By then, of course, some of the most stupendous acts of capitalism in all recorded history had already happened. The great companies of the technology revolution—Microsoft, Intel, Cisco, Apple, Dell, and legions more—had been born and grown to giant size. Yet the tax rate on capital gains during their several decades’ gestations had never been lower than the 28 percent rate achieved in the 1986 Reagan tax reform and mostly had been far higher.
Nevertheless, Washington cut the capital gains rate to 20 percent in 1997, ostensibly to further liberate entrepreneurs from the alleged yoke of taxes. In so doing, however, it also left in place the top rate on ordinary income, which it had raised to 39 percent a few years earlier to help balance the budget. The tax code was now back to its historic wide gap, with top-bracket “ordinary” income taxed almost twice as heavily as capital gains.
Although the playing field was thus decidedly unlevel when the Bush Republicans took over Washington in 2001, it did not take long for it to go full tilt. Presently, K Street lobbyists came storming out of Gucci Gulch clamoring for a further reduction to 15 percent. At that moment, of course, the smoldering ruins of the dot-com bust proved that wild risk-taking by investors could be readily accomplished at the existing 20 percent rates. Betting billions on the ability of Silicon Valley start-ups to monetize eyeballs, for example, had required no extra incentives from the IRS.
Nevertheless, when the dust settled there was a huge gap between the top rate of taxation on ordinary income at 35 percent and the new rock-bottom rate of 15 percent on capital gains. Cynics were wont to refer to this as the tax accountants’ full-employment act, but it was actually far worse.
It not only enabled tax planners to find ingenious new ways to convert ordinary income to capital gains, but also biased the entire warp and woof of the financial system toward the leveraged “inside buildup” of corporate value. The idea was to load companies with debt so that current income would be absorbed by tax-deductible interest payments and cash flow would be allocated to paying down debt. During a holding period of three, five, or even ten years current taxes would thus be minimized.
Then when the company was eventually sold, the equity value gain would be captured on a one-time basis and taxed at only a 15 percent rate. In this manner, high-tax current income would be systematically converted into low-tax capital gains, a potent incentive for highly leveraged capital structures.
Indeed, tax policy and monetary policy now conjoined to generate a potent financial deformation. The leveraged inside buildup had long been the financial modus operandi of real estate developers. Now it became a universal template that caused leverage to swell throughout the business economy.
The folly of the ultra-low capital gains rate was thus not the low rate per se, but its combination with the tax preference for debt versus equity capital. Moreover, the heavy tax bias in favor of “leveraged inside buildup” was a gift to LBO speculators, not to backyard inventors.
It thus happened that Robert Noyce and Gordon Moore, the genius founders of Intel and the semiconductor industry, made all their breakthroughs when the capital gains rate was 35 percent. Even more to the point, the actual rate was much higher because the calculation of the gain was not even indexed during that era of high inflation.
Likewise, Bill Gates and Michael Dell each created multibillion giants which dominated the personal computer space at a time when the tax rates on capital gains and ordinary income were the same. In the most pointed case of all, Steve Jobs created Apple, got fired by the board, and then returned to launch a final blaze of glory, all before the capital gains rate was lowered to the Bush levels.
Needless to say, as long as governments are paying their bills, lower tax rates on income are better than higher rates. Yet a huge differential between capital gains and ordinary income is always a source of economic mischief, and this was especially so under the circumstances of the Greenspan bubble. Indeed, it actually became an immense obstacle to economic growth and long-run financial health because it contributed heavily to Wall Street’s massive pursuit of CEW in the final years of the bubble.
THE $12 TRILLION TOWER OF BUSINESS DEBT AND THE MYTH OF PLENTIFUL CORPORATE CASH
This debt-fueled financial engineering spree took a deep toll on the balance sheets of American business, especially after the Greenspan Fed went all-in with cheap credit beginning in December 2000. At that point in time, total debt on American nonfinancial businesses stood at $6.6 trillion, and it amounted to just over 50 percent of the replacement value of operating assets; that is, structures, equipment, and inventories.
During the next eight years business debt soared and operating assets didn’t. Consequently, the numbers map out to the equivalent of a collective LBO on American business. By the time of the financial panic in September 2008, business debt had grown to $11.4 trillion. This nearly $5 trillion gain represented a 7.5 percent annual growth rate. By contrast, business operating assets had grown at only a 2.8 percent rate during the Greenspan bubble.
Accordingly, the huge wave of business borrowing had not funded a commensurate expansion of productive assets; it had simply increased the level of business leverage. Business sector debt thus rose to 60 percent of the replacement value of operating assets.
Contrary to the urban legend assiduously promoted by Wall Street, however, American business is not now sitting on a sea of cash, basking in the pink of financial health. Cash holdings have increased by about $650 billion since the business cycle peak in late 2007, but business debt is now $850 billion higher. In effect, the much ballyhooed surge of business cash holdings represents nothing more than borrowed money that has been parked on the other side of company balance sheets.
The business debt burden today actually stands at an all-time high of $11.6 trillion. This tower of borrowings self-evidently dwarfs the $3.3 trillion of cash balances currently held by the business sector as a prudential reserve against the vast uncertainty arising from the nation’s broken economy. The real truth is that American business buried itself in debt during the financial engineering games of the Greenspan bubble. After three and a half years of alleged recovery, it still has not even begun to dig itself out.
One thing is certain, however. The American economy had never experienced a Great Moderation, only a phony, debt-driven boom fostered by the Fed’s 1 percent money. Likewise, the stock market ramp of 2003–2007 had never been real. It resulted from a state-enabled financial engineering raid on corporate balance sheets which left American business saddled with nearly $12 trillion of debt.
CHAPTER 22
THE GREAT RAID ON
CORPORATE CASH
THE SECOND GREENSPAN BUBBLE WAS THUS INFLATED BY A VAST financial strip-mining machine that rumbled across corporate America. In the process of goosing the stock market, it ripped cash and equity out of business balance sheets to the tune of $13 trillion during the eight years ending in 2008. So doing, it drastically weakened the nation’s financial foundation, even as it enabled CEOs and boards to raid their own treasuries for the purpose of boosting share prices and the value of executive options.
It goes without saying that the $2.5 trillion of LBOs during this period pleasured shareholders with cash that wasn’t earned, but was simply stumped-up by hocking corporate assets. But the blistering pace of st
ock buybacks and M&A takeovers were driven by the same bias toward debt and capital gains. As a mild form of leveraged buyout, they too effectively distributed corporate cash to the marauding bands of “fix” hungry speculators who came to dominate the stock market during the era of bubble finance.
BACKDOOR LBOS: SHARE BUYBACKS AND TAKEOVERS
Like other forms of corporate equity withdrawal (CEW), stock buybacks and cash financed M&A deals channel cash into shrinking the share count and thereby boosting stock prices. They result in capital gains to outside shareholders and the inside buildup of debt on business balance sheets.
In this scheme of things, stock buybacks are a particularly insidious progeny of the Greenspan bubble. Under the seemingly wholesome banner of “returning cash to shareholders,” they enable top management to subtly disguise the appropriation of corporate resources; that is, stock buybacks help managements obfuscate the heavy, shareholder-unfriendly dilution which results from massive stock option programs.
This stock recycling syndrome is baldly evident in the case of many of the big-cap blue chip corporations. Buyback programs undertaken in recent years have been truly massive, yet share counts have typically been reduced only modestly. The reason is that a substantial portion of shares bought from public stockholders were handed right back to inside executives as new option awards.
Stock buybacks and M&A deals are also triggering events, or what are known as “catalysts” among the momentum (“momo”) traders. Both rumors and announcements of these financial engineering actions typically trigger sharp inflows of speculative buying and thereby push stock prices upward, quite apart from any change in the underlying earnings fundamentals.
Accordingly, top managements can be easily seduced into financial engineering maneuvers. They produce a pop in the stock and opportunities to haul down stock option compensation in that special envelope marked “tax once over lightly” (at 15 percent). Self-evidently, these stock pops become addictive, encouraging CEOs and boards to bang the deal lever over and over.
The Great Deformation Page 62
