"Free-enterprise Critics are Intellectually Bankrupt"

When Paul Simon sang “Mama don't take my Kodachrome” in 1973, he claimed he'd “read the writing on the wall,” but he couldn't have foreseen how a transformative technology — making photos from digits — would render obsolete his precious color film. The global brand icon that revolutionized photography, making it affordable and convenient for ordinary people, now teeters on the brink of bankruptcy. Unfortunately for Kodak workers and the residents of Rochester, N.Y., consumer choice — not Mama — vaporized Kodachrome.

Because election season coincides with economic stagnation, lost jobs and defunct companies are political hot potatoes, putting capitalism on trial. Before joining free-enterprise bashers who bemoan investors who find opportunity in “the gales of creative destruction,” Think Again.

Since we're on the subject, I suppose I'll post this I put together. As somebody else explained to me recently:

Too many people are defending Romney as just being a good little capitalist, when this isn't really the case. He was playing shell games and essentially committing fraud with investors. I think most agree that the government should probably punish somebody selling watered-down gas… so why not punish dishonest debt instruments? I think most agree that if a minority shareholder uses company money to issue himself a big paycheck, this is embezzlement from the other shareholders. When Romney does this with his multi-million dollar consulting fees, this isn't different?

Now the crux of this problem is of course the government. Their corporate limited liability laws unfairly rip up contracts between creditors and debtors. Making debt financing tax deductible, but not equity financing, has seriously skewed the corporate structure. And lastly, the Federal Reserve issuing so much debt (largely indirectly) and then bailing out said debt (→ moral hazard) is a significant problem in aiding and abetting private equity craziness of reckless LBOs, etc.

Specifically how the system works: A bank overflowing with money they created from low Fed Reserve interest rates meets with a private equity firm to talk about taking over firm. The bank provides ~80/20 the money and they together purchase the take over target. The PE firm immediately loads up the acquired firm with debt for the bank to get their money. The debt is structured as a huge balloon payment set to self-destruct in about 5 years. The bank realizes this is ticking time bomb, so unloads this debt ASAP to other banks, hedge funds, insurance companies and pension funds. The smarter investors realize this is a hot potato and keep passing it around. Recently they've been hiding this bad debt in CLOs (almost identical in concept to real estate CDOs). Hidden amongst other debt, people have no idea the mess they purchased. The PE firm on the other hand wastes no time in borrowing HEAVILY again to finance corporate mergers (they don't want to do it from the PE firm directly because they could be liable for the debt). They also borrow heavily to finance huge dividends that more than make up for what they paid for the firm. They justify the dividend legally by jacking up short term profits (price increases, job cuts, quality reductions) that threaten the long term health of the company, and by money saved from tax deductible interest as well. If possible, the PE firm tries to dump their acquired firm before the balloon payment comes up… but even if they're stuck with the firm they usually do very well given all the consulting fees they charge and the huge dividends they give themselves.

As ZeroHedge also explains in a nutshell:

"Lately, Bain founder and GOP presidential candidate Mitt Romney has found himself in a spirited defense of the private equity industry, doing all he can to spin decades of data which confirm, without failure, that PE Leveraged Buy Outs are nothing but "efficiency maximizing" transactions whose only goal is the "maximization" of EBITDA in the pursuit of dividend recap deals, IPOs or outright sales, while loading up the company with untenable amounts of leverage. All this with a 3-5 year investment horizon, which ignores the long-term viability of a company and seeks to streamline (read fire as many as possible) operations as quickly as possible in the goal of maximizing short-term returns. We wish him luck in his endeavor."

Also note that Romney relied on corporate welfare. Take a walk down the list here:

A comparison of the 1999 Bain portfolio obtained by the Los Angeles Times to the information in the Subsidy Tracker database my colleagues and I at Good Jobs First created (as well as other sources), yields examples such as the following:
Steel Dynamics Inc. In 1994 this company, among whose financial backers at the time was Bain, got a $77 million subsidy package—including grants, property tax abatements, tax credits and reimbursement for training costs—for its steel mill in DeKalb County, Indiana (Fort Wayne Journal Gazette, June 23, 1994).
GS Industries. In 1996 American Iron Reduction LLC, a joint venture of GS Industries (which had been taken private by Bain in 1993) and Birmingham Steel, sought some $20 million in tax breaks in connection with its plan to build a plant in Louisiana’s St. James Parish (Baton Rouge Advocate, April 6, 1996). As the United Steelworkers union noted recently, GS Industries later applied for a federal loan guarantee, but before the deal could be implemented the company went bankrupt.
Sealy. A year after the 1997 buyout of this leading mattress company by Bain and other private equity firms, Sealy received $600,000 from state and local authorities in North Carolina to move its corporate offices, a research center and a manufacturing plant from Ohio (Greensboro News & Record, March 31, 1998). In 2004 Bain and its partners sold Sealy to another private equity group.
GT Bicycles. In 1997 GT, then owned by Bain and other investors, decided to move its manufacturing operations to an enterprise zone in Santa Ana, California. Being in the zone gave the company, which was later purchased by Schwinn, special tax credits relating to hiring and the purchase of equipment (Orange County Register, July 9, 1999).

Why don’t you just come out and declare yourself a Socialist? Government should have as small a footprint as possible in all matters. Let me take a few of your points:

>>I think most agree that the government should probably punish somebody selling watered-down gas… so why not punish dishonest debt instruments?<<

>>I think most agree that if a minority shareholder uses company money to issue himself a big paycheck, this is embezzlement from the other shareholders.<<

That is a matter between the shareholders. If someone is both a shareholder and an employee or consultant it is the responsibility of the Board to establish the compensation rules. If the shareholders don’t like those rules they have the power to change the Board and the management to accommodate their desires. It is not your, my or the gummit’s place to challenge how a private company (even one with public stock) goes about its operations.

“Their corporate limited liability laws unfairly rip up contracts between creditors and debtors.”

You want to rip up all the basis for liability limitations back to the Magna Carta? Without limited liability there would be no corporations, since the risk level would be intolerable. The USA would be like Africa or the Middle East, based on a tribal concept of economics and the exchange of goods and services.

>>And lastly, the Federal Reserve issuing so much debt (largely indirectly) and then bailing out said debt is a significant problem in aiding and abetting private equity craziness of reckless LBOs, etc.<<

Agreed — the government’s hand should be as light as possible. You may recall the S&L crisis of the 80s was a result of the government protecting bad investments - essentially removing the risk from risk/reward. That ain’t capitalism, that is command-and-control Communism.

A “debt instrument” is not a gallon of gasoline. All “debt instruments” are some variation of one thing: IOU’s. There is always the risk that when the time comes to redeem the instrument there will be no funds. That is why one component of the interest rate represents that risk (the other component is the repayment for encumbering the debt). The only potential for a “dishonest debt instrument” is if the value of collateral is not as stated — which is the responsibility of the purchaser in due course of due diligence. Flat out lying is illegal and punishable.

To clarify, I'm not actually advocating that government should regulate any of this—it was really more of a rhetorical point. I'd prefer that government have little to no role whatsoever. For example, I'd like to see the SEC abolished and I'd even make the case that insider trading is a good thing, because it communicates valuable pricing information to the rest of the market.

That is a matter between the shareholders. If someone is both a shareholder and an employee or consultant it is the responsibility of the Board to establish the compensation rules. If the shareholders don’t like those rules they have the power to change the Board and the management to accommodate their desires. It is not your, my or the gummit’s place to challenge how a private company (even one with public stock) goes about its operations.

Agreed. I'm not saying there should be laws regulating any of this. This is only to point out the ethics involved, not advocate a legal solution.

You want to rip up all the basis for liability limitations back to the Magna Carta? Without limited liability there would be no corporations, since the risk level would be intolerable. The USA would be like Africa or the Middle East, based on a tribal concept of economics and the exchange of goods and services.

Perhaps. I currently view corporations as creatures of the state, and believe that the legal condition of limited liability actually distorts free-market processes, by promoting inordinate moral hazard and skewed time preference valuation. I'm open to being convinced otherwise.

Agreed — the government’s hand should be as light as possible. You may recall the S&L crisis of the 80s was a result of the government protecting bad investments - essentially removing the risk from risk/reward. That ain’t capitalism, that is command-and-control Communism.

Indeed.

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