During the heyday of the financial blogosphere, even when this site’s following was much smaller than it is now, readers were keenly interested in getting to the bottom of hidden sources of risk, chicanery, and other “man behind the curtain” aspects of the operation of finance.
These issues are even more important now. We are 35 years into a finance-led counter-revolution where conservative interests are rolling back not just the New Deal, but are also pushing as far as they can in reducing the political and economic rights of laborers. And “laborers” is anyone who lives off earned income and does not have his pay directly or indirectly tied to the use of capital.
If you care about income inequality, student loan debt slavery, foreclosure abuses, and other products of the success of this effort, it behooves you, as Sun Tzu urged, to understand your enemy. And they have very cleverly set out to make that difficult. As we wrote in ECONNED:
But opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the innovations. No one at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing…
Viewing the underlying problem as one of bubbles misses the true dynamic. When borrowed funds pump up asset values, the unwind damages financial intermediaries, and that has far more serious repercussions than the loss of paper wealth alone. Leverage offers a strategic point at which regulators can intervene.
Regulators can tackle debt levels surgically by barring certain types of instruments and practices. But this effort can take place only if authorities do not cede control of the financial system to the inmates. Unfortunately, to a large degree, that has already happened.
The crisis and its aftermath represented the largest looting of the public purse in history. Former IMF chief economist Simon Johnson described how financial oligarchs had captured government in his landmark 2009 Atlantic article, The Quiet Coup.
Sadly, it seems that the bulk of this site’s readers is no longer interested in these matters, despite their significance.
As we have moved into open opposition against Big Finance, it’s become harder to straddle the interests and needs of our audiences. Our following among members of the financial services industry not surprisingly has thinned. We have retained and even expanded a strong readership among regulators, people on the Hill, journalists, and others interested in banking policy and economic issues. We also have a larger “social justice” following than in the runup to the crisis. But comments on finance posts remain puzzlingly anemic.
Some readers complain that our posts are too difficult. Yes, we do shoot for Economist-level discussions, a step or two down from insider wonkery but still more technical than USA Today. But to make these posts more accessible, we would have to remove essential information, making them ineffective. Influencers come to NC because we explain accurately how products, markets, and institutions work and draw out implications for policy. That requires that we show that we understand the nitty-gritty details so that we can debunk industry talking points.
We hope that you, readers, can become influencers. And so we are doing what we can to educate citizens so that when you encounter neoliberal or finance industry talking points, you can rebut them effectively. And in finance, that means you need to grapple with how these products work. You need to be a soldier in the war to demystify finance, because its supposedly arcane and impenetrable nature is one of its biggest weapons. It’s easy to dismiss critics if they can be depicted as ignorant. There are costs to citizenship. One such cost is knowing your enemies, their strategies, their tactics, and the terrain on which they fight. That requires not passing familiarity with finance, but knowledge of it.
The lack of obvious reader interest (in the form of comments) isn’t just demotivating for NC posters and our silent allies in other realms; it also reduces our potential to have an impact. We’ve had insiders tell us how specific posts made a real difference in particular battles, although we haven’t made noise about them because it would put our contacts in an awkward position. But when we are working on longer-term campaigns, like our work on foreclosure abuses and chain of title issues, our private equity series, or our focus on SEC Chairman Mary Jo White’s slavish support of entrenched interests, low comment counts on meaty finance posts signal a lack of reader engagement on that topic to the influencers who read our work regularly. In other words, you are telling them Big Finance has won the argument and citizens don’t care.
Here’s an example. In 2012, we wrote two posts on whistleblower allegations of out-of-control bank risk-taking during the crisis that came to light only years later. Our first: Deutsche Bank hadn’t bothered modeling a big risk in what came to be the biggest derivatives exposure in the bank, a so-called “leveraged super senior” trades and had also mismarked its positions. Deutsche was 65% of that market, and the notional value of its book was $130 billion. If the exposure for its “gap option” had been properly modeled and booked, it would have reduced the bank’s Tier One capital, potentially to the point where the bank would have been undercapitalized by German regulatory standards. Moreover, had this risk been measured correctly, this trade would never have been booked at the size it was. And when the leveraged super senior trade got in trouble, it blew up the Canadian commercial paper market, which necessitated a rescue. In other words, as obscure as this sounds, it had significant implications (including looting, since Deutsche showed $270 million in profits that would never have been “earned” absent the deficient modeling, and hefty bonuses were paid that otherwise never would have been entered into absent the deficient modeling). This post got a respectable 22 comments.
Our second 2012 post on the leveraged super senior trade gave a detailed (as down-in-the-weeds technical) account of how the deals worked and why they mattered. It got 23 comments.
Last week, Deutsche entered into a $55 million settlement with the SEC over the whistleblower charges. Our post on the denoument got one (1) comment. What kind of message does that send?
It has been frustrating to see readers take little interest in finance topics like private equity, which are far more obviously connected to an undue concentration of wealth at the expense of workers and communities than CDOs, and where the bad practices are also much easier to explain.
We’ve pointed out of how private equity has played a major role in the growing chasm between the top wealthy and everyone else. The 0.1% consists disproportionately of private equity and hedge fund principals. So it isn’t surprising to see private equity kingpins exhibit a sense of vulnerability, even though they too often lapse into grandiosity and paranoia when they express it. For instance, venture capitalist Tom Perkins compared “the progressive war on the American one percent”* to the persecution of Jews in Nazi Germany. Steve Schwarzman likened the Obama’s threat to close a tax loophole that allows private equity financiers’ income to be taxed at low capital gains rates to “when Hitler invaded Poland in 1939.”**
Private equity funds buy companies with borrowed money and by virtue of all the fees they take, make money whether the deals do well or not. That gives them incentives to be indifferent to bankruptcy risk. It’s thus no surprise that PE owned companies fail at a greater rate than companies as a whole.*** Private equity owned companies also squeeze headcount at twice the rate of similar, non-PE owned firms. One popular strategy among private equity buyers is “rollups,” as in consolidation in an industry niche. That not only allows them to achieve scale economics and pressure vendors on pricing, but can also enable them to obtain a monopoly or oligopoly position. That in turn allows them to have pricing power, and their market position can also allow them to set product/service standards, such as engage in crapification.
While all these issues help make the case that private equity is an extractive industry we would all be better off bringing to heel, they don’t provide leverage points. We’ve been pursuing an angle that has potential, namely, the belief among investors that they must invest in private equity because it delivers returns they can’t find elsewhere. That is particularly important – what the German general staff would have called a schwerpunkt – since as the first post in our PE investigation, provided by an industry insider, pointed out, private equity is a government sponsored enterprise:
Some readers may know that private equity relies heavily on tax subsidies. Private equity firms engage in debt-leveraged buyouts of public and private companies, and the interest charges on this debt are tax deductible. But most members of the public do not know that close to half the investment capital in private equity funds is contributed directly by government entities. In this respect, private equity is little different than companies like Fannie, Freddie, and Solyndra that are regularly criticized in the media as recipients of government subsidies.
Their decisions to invest government funds in private equity reflect assumptions by government officials that have gone unchallenged and, we contend, are quite likely incorrect….
The single largest source of capital to the private equity industry is governmental pension funds. According to Preqin, a commercial database that tracks investment in private equity, approximately 30 percent of capital in U.S. private equity funds was contributed by governmental pension funds. Governmental pension funds are more often referred to as “public” pension funds, but this can be confusing because it doesn’t make clear the basic reality that, in the U.S., the funds are essentially always administered by government employees and governed by officials who are directly elected by the public or appointed by elected officials. For example, the New York State Common Retirement System is administered by employees of the New York State Comptroller’s Office, and the Comptroller is the sole trustee for the fund and is elected state-wide by the people of New York….
A second major type of government investor in private equity funds is sovereign wealth funds, such as the Abu Dhabi Investment Authority, the Australian Future Fund, and Singapore’s Temasek. Preqin estimates that sovereign wealth funds comprise approximately 10 percent of the capital in private equity funds.
Public university endowments play a smaller role as sources for private equity investments, probably no more than a couple of percent.
All these governmental entities are vulnerable to political pressure from, for example, you, dear reader, especially if your pension fund is involved. As you may have inferred from our focus on CalPERS, the biggest public pension fund and also the largest investor in private equity, public pension funds are subject to much greater transparency requirements and public accountability than other investors. They are also responsive to pressure from legislatures. And remember, it is easier to effect change on the state level than the Federal level, particularly since activists can focus on venues that look particularly promising.
It would be in everyone’s interest (well, except that of the private equity firms themselves and their well-compensated partners like top law firms and major banks) to wean public pension funds of their private equity habit. Again, from the inaugural PE post:
Far from being a sort of steroids for weakened investment portfolios there is substantial academic evidence that private equity net returns consistently underperform lower risk public market alternatives….[T}he industry uses methodologies for calculating their returns that result in much higher reported returns than studies that are based on actual cash flows. There are many important implications of this finding, one of which is that private equity managers may receive as compensation more than 100 percent of any net returns they generate relative to lower risk alternatives.
We’ve provided considerable evidence since showing how private equity returns are overstated. Indeed, in a tacit admission of disappointing performance, even private equity stalwart CalPERS has cut its allocation to the strategy from a peak level of 15% to 10% as of July 1.
We’ve also drilled into private equity fee and expense abuses after the SEC exposed how widespread they are. These are important because the extent of embezzlement and grifting shows that private equity kingpins don’t merit the considerable trust that they insist they deserve. Even worse, these revelations show how clueless and complicit the institutions that invest in PE are. This should be of deep public concern as far as government investors are concerned, since every dollar stolen from these investors is a dollar stolen from taxpayers.
And as the SEC’s very much former head of examinations Andrew Bowden stressed in a speech in May 2014, limited partnership agreements do a poor job of protecting investors, belying the notion that they are negotiated on a fair-and-square basis (one big reason investors are overmatched: Law firms are more eager to curry favor with ginormous fee-dispensing PE firms than their putative clients).
We are certain this series is having an impact; we’ve had more discussions with influencers on this topic than on any other we’ve followed. But if we are to carry this effort and other initiatives forward more effectively, we need your active support. And that includes being willing to spend the time and effort to learn more about the topics at hand if some of the terms or ideas aren’t familiar. Readers did that well after the crisis had abated, but that appetite for engagement seems to have dulled.
Admittedly, the problem with fights like this, which turn on changing perceptions and narratives, is that progress is not terribly visible. What Richard Kline wrote in 2010 about protest applies to other forms of political activism:
The nut of the matter is this: you lose, you lose, you lose, you lose, they give up. As someone who has protested, and studied the process, it’s plain that one spends most of one’s time being defeated. That’s painful, humiliating, and intimidating. One can’t expect typically, as in a battle, to get a clean shot at a clear win. What you do with protest is just what Hari discusses, you change the context, and that change moves the goalposts on your opponent, grounds out the current in their machine. The nonviolent resistance in Hungary in the 1860s (yes, that’s in the 19th century) is an excellent example. Communist rule in Russia and its dependencies didn’t fail because protestors ‘won’ but because most simply withdrew their cooperation to the point it suffocated.
And this process explains the hypersensitivity of financiers like Tom Perkins and Steve Schwarzman, who become outraged by even mild criticisms of or attempts to regulate their industry. They recognize that the biggest threat to them is delegitimation. As long as they can maintain the illusion that their profits are fairly earned by their own efforts (as opposed to extensive government subsidies and backstops), that all of their services, as currently configured, are essential for commerce, and that it’s all so complicated and difficult that no one can replace them, they will continue to have the whip hand. Over you. And your pension, if you have one. And your workplace, if they buy it for one of their asset-stripping projects.
That is why it is important to penetrate their veils of opacity and complexity. Pay attention to these men behind the curtain. They don’t have superpowers and their know-how is not as lofty as they pretend. Their secrecy and sleight of hand are meant to disguise that many of their services are socially destructive (like most over-the-counter derivatives, which are used for tax or accounting gaming) or extractive by virtue of being overpriced, which might be defensible in a truly private industry but not one that is even more heavily supported by the government than the defense industry. In other words, your apathy and resignation play straight into the hands of the banksters. Do you really want to make their lives easier?
* If progressive efforts to combat the political and economic power wielded by the 1% have reached the level of effort and organization to be correctly called a “war,” that’s news to me.
** And of course we all know how serious that threat was….
*** That trend has ameliorated somewhat in recent years due to access to super-cheap money, which means more troubled deals are being restructured than going into bankruptcy. However, as Eileen Appelbaum and Rosemary Batt recount in their landmark book Private Equity at Work, private equity firms have figured out how to to extract more profit from these restructuring exercises as well.