American Oligarchy - 30-Sep-2008

American Oligarchy

http://blog.alancoffey.com/?p=249

A sobering thought.

“One
of the most discouraging parts of the debate over the Paulson Plan was
the discussion about limiting executive compensation for those firms
that might benefit from the plan. While trying to help rebuild
confidence in American capitalism, Mssrs. Paulson and Bernanke tried to
convince Congress that bank executives would prevent their institutions
from participating in the bailout if it meant that their compensation
would be capped. One would think, as the financial system teeters on
the brink of collapse, that the Secretary of the Treasury and the
Chairman of the Federal Reserve could make a more persuasive argument
than one that poses the likelihood that corporate executives would
knowingly violate their fiduciary duty and refuse to participate in a
plan to rescue the financial system because it might limit their
compensation. If troubled financial institutions are going to be run by
individuals who would conduct themselves in such a manner, there isn’t
much hope that any plan is going to work. The mentality that led two of
our best and brightest public officials to attempt to defend the kind
of avaricious conduct that played a central role in the current crisis
is something that must be changed if we are to avoid future market
crises.7

This brings HCM to two related areas that need to be
legislated immediately: financial institution leverage; and the
taxation of highly compensated financial executives. There is a point
when free enterprise tips over into a degree of economic and social
inequality that is politically

unacceptable, and the United States has reached that point. HCM is well
aware that its views on this topic genuinely anger many of its readers,
but this is an issue that must be addressed as an essential component
of any program that will return confidence to the financial system.
Free market economic policies, in particular tax policies, have led to
the creation of an American oligarchy whose wealth and power is
excessive. While not as pernicious as the oligarchy that rose from the
ruins of the Soviet Union and now lords over Russia and spends its
money garishly over the world, an American oligarchy has unduly
benefitted from ill-advised tax and economic policies and must be
reigned in as a sign to Main Street that the game will no longer be
rigged against it.

We
do not believe it is presumptuous to state that the debate over whether
Wall Street firms were too leveraged is over. The decision by Goldman
Sachs and Morgan Stanley has decidedly ended the leveraged investment
banking model that brought down Bear Stearns, Lehman Brothers and
Merrill Lynch. The profits that Wall Street generated over the past few
years were not the result of some new-found genius in the executive
suites, but were merely the product of adding unprecedented amounts of
leverage to balance sheets. Unfortunately, compensation schemes did not
take into account the fact that adding leverage is far different than
adding value (i.e. compensation schemes were not properly
risk-adjusted). As a result, compensation structures for these
executives were largely asymmetrical, particularly with respect to the
portion of their pay that was distributed in cash. Multimillion dollar
cash payments for profits earned in a single year were not subject to
being repaid if losses in later years wiped out those earlier profits.
Too much cash exited these firms each year in the form of compensation,
significantly weakening their capital bases. Fortunately, a significant
amount of compensation was also paid in stock, which did not weaken
these firms’ balance sheets but still failed to instill sufficient
caution in management when it came to assuming balance sheet risk.

In
addition to the gargantuan amounts of compensation being paid out, the
taxes paid on these amounts continued to drop over recent years. This
is a result not only of reduced taxes on capital gains and dividends,
which are only good economic policy up to a point, but on tax deferral
schemes and other aggressive tax stances taken by corporate, private
equity and hedge fund executives to reduce their taxes to
unconscionably low levels.8 Private equity managers, for example, are
able to treat their “carried interests” as capital gains and pay taxes
at only a 15% rate. Yet these earnings are no less the product of their
labor than a teacher’s or a policeman’s earnings are a result of his or
hers. Last year, several private equity billionaires actually had the
gall to lobby on Capitol Hill to retain the 15 percent tax rate on
their “carried earnings.” These individuals argued that if their taxes
were raised, they would no longer be willing to take the kinds of
business risks that lead to new job formation and economic growth.
Attempts to require these over-indulged [fill in the blank]9 to pay the
same taxes on their income as ordinary Americans were derailed in what
must go down as one of the most cynical lobbying efforts in history. It
would be one thing if private equity firms were funding innovation and
job creation, but in the last few years they have done little more than
use cheap financing to engage in speculative transactions that generate
fees for themselves and what are going to turn out to be at best
mediocre returns for their investors.

Hedge fund managers play
their own games. The most popular tax reduction technique among this
crowd is the formation of offshore trusts that enable them to defer
their management and performance fees for periods as long as ten years.
A ten year deferral of taxes reduces the effective tax rate paid on
these managers’ already huge earnings to virtually zero on a present
value basis while they continue to enjoy the ability to profit from
investments in America’s (once) free markets. This tax deferral scheme,
which comes in a number of variations, further separates the interests
of those hedge fund investors who are paying taxes on their income from
those of managers who are not. (Of course, investors don’t mind as long
as they are making money. Investors never mind as long as they are
making money. That’s the problem.) As one memorable television
commercial put it, “it’s not what you earn, it’s what you keep.” And
hedge fund managers have figured out how to keep virtually everything
for themselves. Now that the bloom has come off the rose for many hedge
fund strategies, investors are going to discover just how one-sided was
the deal they made with their managers. Redemption requests from hedge
funds are expected to reach epic levels this year, yet many investors
are going to be greeted with the unhappy news that they can’t get their
money back right now (or anytime soon) because it is stuck in illiquid,
hard-to-value investments. Others will be told that it would be unwise
for their funds to liquidate positions to meet redemptions in the
middle of a financial crisis, failing to be informed of the likelihood
that many of these securities will most likely be worth less in the
future.

Fairly taxing the upper 1/10 of 1 percent isn’t going
to plug the gaping U.S. budget deficit, but it will go a long way to
returning a sense of fairness to a system that has lost its moral
compass.”

From Michael Lewitt of Hegemony Capital Management .

H/T to John Mauldin