Large parts of modern finance seem to fit this definition. In some cases, particularly the private equity sector and the tax avoidance industry, financial sector profits depend heavily on tax loopholes and zero-sum exploitation of working people. The following are some examples.
The Portfolio Management Industry
It has long been known that low-cost indexed portfolios nearly always outperform active asset management. While indexing has been making inroads in recent decades, active management still dominates in pension plans and endowments, and in almost all individually directed investment accounts. The high fees paid by many retail investors are a clear case of information failure and/or market power, probably exacerbated by deceptive advertising and the industry’s concentration. Even the hedge fund industry, open only to wealthy and institutional investors, has an unimpressive overall record. Net of the high fees that hedge funds charge, the industry has barely outperformed US Treasury bonds over the last twenty years. There are, of course, exceptions: Warren Buffett, George Soros, and several others come to mind. But for every Buffett or Soros, there are many who don’t deserve their very high incomes.
High-Frequency Trading
Hedge fund billionaire Jim Simons, a former star mathematics professor at Stony Brook, has for years made extraordinary returns by using powerful computers and proprietary trading algorithms to exploit tiny market trends invisible to humans, and which often last only a fraction of a second. The trading is entirely automatic—computers make all the decisions and execute all the trades. The net effect is a small tax, a form of skimming, on the whole market. Normal investors who don’t own gigantic computer systems end up paying slightly more for stock trades and have slightly lower investment returns, while Simons and his imitators pile up micro-pennies by the billions.
There is no social benefit at all from high-frequency trading; the positions often last only for milliseconds and have no economic utility. It is a pure drag on the economy, albeit a small one, like spam e-mail. The massive trading volumes the strategy requires impose substantial costs, mainly for computer systems, and on at least two occasions high-frequency trading has caused market disruptions called “flash crashes”.
Simons’s personal earnings are in the billions, making him one of the highest-paid hedge fund managers in the world. Naturally, all large players now emulate this strategy, and it now accounts for the majority of total trading volume. Indeed, an increasing fraction of hedge fund management is game playing of this kind, exploiting very small, short-lived market imperfections to pile up wealth while providing no social benefit.
Obscuring Debt, National and Otherwise
All readers of the financial pages know that Greece has been mired in a debt crisis. An initial question, naturally, was how much did Greece owe? A team from the European finance authority reported in 2010 on “the difficulties in . . . [getting] complete and reliable information” on Greek debt. No surprise, because modern banking practices had been there first.
Goldman Sachs arranged a series of highly favourable currency swaps for Greece, creating an immediate gain of 2.4 billion euros, which was applied against the country’s apparent debt. Normally, such a trade should have triggered a cash payment from Greece to Goldman to cover the gain. But Goldman covered that by structuring another swap, but a deferred long-term one. The entire transaction improved the looks of Greece’s books and also produced fees for Goldman. Several other investment banks have been criticized for doing essentially the same thing for a variety of domestic and foreign companies and local governments.
Tax Avoidance
An unknown but clearly significant fraction of American tax attorneys and financial advisers obtain very high incomes from wealthy individuals and corporations for the sole purpose of avoiding taxes. It is greatly to the benefit of these people that the tax code has become extremely complex and that it contains many provisions that can be used to avoid the payment of legitimately owed taxes.
These activities, and their effects, have grown enormously over the last quarter century as a combined result of increasing economic inequality, legal and tax loopholes, and weakened enforcement. In the early 1980s, US corporate taxes equalled over 40 percent of corporate profits; in 2010, it was 26 percent. The effect for wealthy individuals has been even more dramatic. The US Internal Revenue Service has reported that the effective tax rate of the nation’s four hundred wealthiest families, most of them billionaires, declined from 30 percent in 1995 to only 18 percent in 2005, the last year for which data are available (as of early 2012). Some of these declines in tax payments represent changes in tax rates; for example, the Bush tax cuts. But a major fraction of the declines, both corporate and individual, have come from tax avoidance.
On 27 November 2011, the New York Times published a long article on the tax avoidance schemes of the billionaire Ronald S. Lauder, who inherited a fortune from his parents, the founders of the Estée Lauder cosmetics firm. According to the report, Mr Lauder’s own contribution to the American economy has been, let us say . . . unclear. Although Mr Lauder has a net worth of over $3 billion, he and his family have used a series of highly aggressive tax shelter strategies implemented by their lawyers and financial advisers. These strategies have included offshore corporate structures in tax havens; trusts that shelter stock tax-free for long periods; forward contracts for the eventual sale of stock, permitting immediate and tax-free access to cash; derivatives strategies such as “shorting against the box”; tax-free borrowing against unsold stock; “fractional donations” of a portion of an artwork whose possession he retained; and others. It was a family affair. The company, its owners, and their heirs have used aggressive tax avoidance since Estée Lauder went public in the 1980s.
Many American corporations now behave similarly. When the transformation of American finance began in the 1980s, very few American corporations used even the tax avoidance methods then available, such as registering subsidiaries in offshore tax havens. It was, quite simply, considered both unseemly and unnecessary. Now, however, most large multinationals do this. Some, such as General Electric, correctly regard tax strategy as a major driver of profits, and maintain large permanent staffs of attorneys and financial planners dedicated purely to tax avoidance. In addition, of course, these companies make extensive use of investment banks and outside law firms.
No matter what you think about tax rates—even if you think that taxes should be lower for billionaires—this is pointless, wasted activity. And if you think that billionaires, and companies with billions of dollars in profits, probably should pay more taxes than construction workers and secretaries, then it isn’t simply wasteful; it’s highly destructive.
The Private Equity Industry
Private equity companies may be the most efficient money-seeking organisms in the world. The campaigning journalist Matt Taibbi has immortalized Goldman Sachs as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” Maybe. But in 2006, when Goldman’s Lloyd Blankfein earned $44 million, which made him Wall Street’s highest-paid investment banker, Blackstone’s Steve Schwarzman made $398 million, or twice as much as the top five Goldman earners combined. On top of that, due to the “carried interest” tax loophole, most of Schwarzman’s income was taxed at a 15 percent rate, equivalent to that paid by ordinary workers in the bottom income tax bracket. Blackstone and all the other major private equity firms use the same fee structure—they charge 2 percent per year of assets under management, plus 20 percent of all profits, with no responsibility for losses.
The best that can be said about private equity companies is that they might not be any worse than many of their publicly owned peers. They are very rough on their rank-and-file employees, but many companies are today—perhaps in part because of the pressures from private equity firms. They do cut costs—at least operational costs. But they often greatly increase the financial costs of the companies they own. They are br
utally expert offshorers and outsourcers of jobs. Undoubtedly, there must exist some private equity deals that have produced real economic gains, when incompetent managers are replaced through an acquisition. But there is abundant evidence that this is not the norm.
A great deal of the success of private equity firms comes from exploiting various hidden government subsidies and tax loopholes. A considerable number of companies acquired by private equity firms go bankrupt even though the private equity buyers make money. This is not a marginal matter. Of the ten largest leveraged buyouts made by Bain Capital when Mitt Romney was its CEO, four went bankrupt, even though Bain made money. Private equity owners have no liability for a company’s debts, so they face relatively little risk. Therefore, they often force the company to borrow huge amounts of money, which the company then pays to the private equity firm as fees and/or dividends. The result is often bankruptcy, as the company runs out of money. But it doesn’t stop there. Bankrupt companies are legally prohibited from paying dividends, but they can pay “fees”. And, not infrequently, the same private equity firm buys the company again, out of bankruptcy, after many of its debts have been reduced or restructured.
Additionally, private equity firms sometimes force employee retirement plans to purchase stock in the company, or even the whole company. This allows the private equity firm to cash out, even (perhaps especially) if the company is failing. This occurred, for example, with Simmons Bedding, a company that I discuss in more detail below. If the company later goes bankrupt, the private equity firm has no liability to pay employee pensions. Either the employees must see their retirement income destroyed, or, if the company is eligible, their pensions are paid not by the private equity firm but by the Pension Benefit Guaranty Corporation, a US government agency. In 2010 the PBGC paid out $5.6 billion to failed pension plans, and had an accumulated deficit of $23 billion. It is not known what fraction of the deficit derives from private equity transactions.
Another recent case of gaming government subsidies involves forprofit universities, which are nearly entirely dependent upon federal student-loan programmes for their tuition revenues. In 2006 a group of private equity firms led by Goldman Sachs bought the Education Management Corporation for $3.4 billion; Goldman owned 41 percent.10 This acquisition coincided with a change in US law that had been championed by the Republican leader of the House of Representatives, John Boehner, and which eliminated the prior requirement that loans be restricted to schools where the majority of students attended a physical campus. After the change, schools were eligible for government student loans even if they barely existed physically, and even if the overwhelming majority of their students were online.
Immediately following its private equity acquisition and the legal change, Education Management started extremely aggressive recruiting efforts, and the number of online students increased sharply. So did dropout rates. From 2006 to 2011, Education Management’s revenues increased from less than $1.5 billion to $2.8 billion. Recruiting allegedly became extremely manipulative, even fraudulent; allegedly, for example, students with felony records were told that after obtaining criminal justice degrees, they could work in law enforcement, which is false. Recruiters were paid bonuses very similar to the yield-spread premiums that were paid to mortgage brokers during the housing bubble. But once students received their loans and paid their tuition, Education Management had its money whether the students graduated or not. Education Management had no liability for the loans, even when they defaulted in high numbers.
In 2010 the attorneys general of Florida and Kentucky initiated investigations of Education Management. In 2011 a whistle-blower lawsuit was filed. The US Justice Department and four states joined the suit, and accused Education Management of fraudulent recruiting, and of fraudulently obtaining a total of $11 billion in tuition derived from government student aid. The complaint, however, is only against Education Management; Goldman Sachs has not been sued or charged.11 As of early 2012, no one has been criminally prosecuted.
More frequently, private equity transactions depend heavily on the favourable tax treatment of dividends and of extreme leverage. Companies owned by private equity firms almost never pay corporate taxes, because they have such huge interest bills. This is because private equity firms force the companies they own to take on enormous levels of debt, often for very nasty reasons (discussed shortly). Interest rates have been extraordinarily low for many years now, so it has been an ideal environment for private equity–owned companies. Falling rates allowed them to continually refinance debt, allowing their private equity owners to extract more and more cash with minimal impact on debt service, in a manner very similar to the refinancing boom during the housing bubble. When a Blackstone-led group bought Freescale Semiconductor in 2005, its debt immediately ballooned elevenfold, from $832 million to $9.4 billion.
Why so much increased debt for the companies they buy? Private equity firms add debt to pay themselves “special dividends”, sometimes to the tune of $1 billion or more, distributed among the private equity firm partners and their limited partners in the deal. Firm partners typically have little or none of their own capital in their deals. The equity comes from their limited partner investors, and it is usually completely returned within the first few years from these debt-funded “special dividends”. There is an additional benefit to this trick. Often, private equity firms give stock to a small number of senior managers of the companies they buy. These managers therefore receive dividends, too, which are taxed at 15 percent rather than at the far higher rates that apply to “ordinary income”.
Moreover, a significant fraction of private equity firms’ profits come in a very direct way from screwing the employees of the companies they buy. The US has very weak protections for most workers, and even those protections have been insufficiently enforced. In addition to wage cuts, private equity firms often attack benefits, especially pensions and retirement health care.
In late 2009 the New York Times published a remarkable series of articles on the looting of the Simmons Bedding Company by its private equity owners and the management they installed.12 After the private equity firm THL (for Thomas H. Lee, its founder) bought Simmons from another private equity firm (Simmons had already been flipped several times by other private equity firms), THL ordered the Simmons company to borrow over $1 billion. Simmons then paid huge amounts of this borrowed cash—$375 million—to THL in the form of “special dividends”, as well as paying additional, large transaction fees for THL and to the investment banks that arranged the financings. Employees’ wages and benefits, including their retirement plans, were cut severely, even for blue-collar workers with over twenty years’ seniority. Indeed, the employees’ retirement fund had already been victimized by the actions of an earlier private equity owner, William Simon (who was Treasury secretary in the Nixon administration). Simon had forced the employees’ retirement plan to purchase Simmons stock from him at an inflated price. When the stock price declined, Simmons was purchased by another private equity firm at a far lower price, devastating the employees’ retirement savings.
During much of the time that Simmons Bedding was owned by THL, the company’s CEO (approved and installed by THL) was a man named Charlie Eitel, who ran Simmons remotely from his homes in Jackson Hole, Wyoming, and Naples, Florida, as well as from his yacht, Eitel Time. He also forced Simmons to hire his son. Eitel made more than $40 million, keeping it all even when Simmons was forced into bankruptcy, which caused its employees and bondholders to lose enormous sums. The company laid off a thousand people, over 25 percent of its workforce, including employees with more than twenty years’ seniority, giving them little severance pay or retirement benefits. THL was not harmed by the bankruptcy and in fact made a large profit on Simmons, because it had paid itself in cash long before, as well as taking large special dividends and transaction fees from the proceeds of the debt financings that bankrupted the company.
Was this all legal? It is hard to know which answer
would be worse—that it was illegal but nothing was done, or that this was all, in fact, perfectly legal in America. As it is also, apparently, perfectly legal to construct and sell a security with the intent of betting on its failure.
There are other ways in which private equity firms may depend upon dubious behaviour for their profits. In 2006 the SEC investigated the industry with regard to alleged “club deals”, whereby supposedly competing private equity firms would secretly collude in order to reduce the prices they needed to pay for companies. The SEC closed the investigation without filing charges, but several investors filed a major private antitrust suit, which was still proceeding as of 2012. In early 2012 the SEC opened another investigation centred on the possibility that private equity firms inflated the value of their assets when trying to attract new investors.13
And without question, private equity firms are superb at avoiding taxes. Mitt Romney’s ability to pay a 14 percent tax rate on income of over $20 million per year, much of it coming from Bain Capital a decade after he left the firm, is no accident; nor is it unusual. So whatever limited economic contribution might be made by private equity firms, it is outweighed by their practice of redirecting managers’ attention to skimming off the maximum financial rewards for themselves.
IT IS EASY TO multiply such examples, and data on the growth of financial transactions volume fills in the rest of the picture. Over recent decades, securitized transactions have increased from nearly zero to trillions of dollars annually. Foreign exchange trading has grown thirty times faster than global GDP. Daily oil futures trading, which used to run at about the same value as the underlying physical supply, is now ten times the underlying supply, while market volatility seems to have increased.14
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