Yesterday, the Dow Jones dropped 300+ points, down over 400 at its low for the day. Today, it will probably be just as volatile as it has been, but the shape of things to come is not good. We can only ride this irrational over-exuberance about the market for so long before we have to pay the piper. It’s quite simple. While the market was setting a new record July 20th by breaking 14,000, the actual financial underpinnings of the country were growing quite bleak.
Virtually unreported over at the Washington Post, Michael J. de la Merced was citing a significant crack in the debt dike preventing a flood of defaults on leveraged buyout deals. Most of the run-up on Wall Street has been based on the idea that there is an unlimited amount of debt that can be piled up to buy and flip companies, kind of like the housing market speculators. In fact some of them are the same people. To them the important thing is that they collect fees at every transaction along the way.
What the general public doesn’t understand is that the wealthy have been taking their extra money from tax breaks and investing it in speculation. The theory of trickle down economics is that the rich will invest it in increased production capacity, hire more people and generally lift everyone (“a rising tide lifts all boats”). But, true to human behavior, that’s not what happens. Instead, when people have extra money over their needs they tend to invest it in more speculative investments because the potential loss won’t affect their lifestyle while the potential gains are higher than from a more stable but slow-growing investment. In other words, a cabbie might make a bunch of $5 bets on long shots at the track and even may splurge on the Trifecta but a CEO can afford to make $10,000 bets. Both are gambling an amount that, if he loses, doesn’t impact his lifestyle, but if he wins, he wins big.
Private Equity and Hedge Funds have been the chief investment vehicles used by the wealthy to speculate on these long shots. Wealthy investors, institutional funds (pension) and other money pools have been joyously jumping on the bandwagon. As more and more people and funds (up to 9,000 hedge funds now) scout for undervalued companies to buy, the competition has grown fierce, driving up prices. In fact, many of the companies bought don’t justify the price, but what the heck? Neither did that $100,000 house you bought for $150,000 because it was going to be worth $175,000 next week. Right?
Much of their supposed profit does not expand production/create wealth but only increases profits based on tax advantages of their structure and the speculative behavior that inflates the value. The key to all of this is that these buyouts are not occurring with much real money involved. The initial investor in a Private Equity or Hedge Fund usually borrows up to 80% of the money they invest in the fund. The funds pool this capital from multiple investors and then use it to borrow up to 95% of the money they use to purchase the company. Then once the company is purchased and their fees paid, the newly owned company sells bonds, which the company hopefully will pay back.
But not to worry, the Private Equity and Hedge Fund boys make their money off of the amount of money they manage (2% fee) and a percentage of the profit (20%). The investment bankers made a bunch of money from arranging the financing and a bunch of others made money from issuing the bonds. Just like the mortgage brokers and investment houses that bundled the mortgages and resold them as bonds, their profits came from the transaction fees. These bonds have been typically easy to sell because of the high interest return as their risk increases (like subprime loans) and the cheap cost of financing.
Several indicators say that the end of this bubble is near. One of the first is when Hedge and Private Equity Funds go public as several have attempted to do recently. What this means is they believe the best times are over and they are selling their track record to get one last big bite of the apple before the downtrend comes. Everyone wants a crack at the action, not realizing that most of the action is over. Read the fine print on any stock purchase, past performance is no guarantee of future earnings. Having made millions and billions already at the peak of the frenzy, they now sell off a portion of their ownership for a big ka-ching. Even if the stock value of their remaining holdings in the company goes down they are still way ahead. Indeed billionaires became multibillionaires by selling off some of their ownership in these firms, only to see their stock price go below the Initial Public Offering (IPO) price within weeks. Losses in housing notes caused Bear Stearns to have to bail out two failed hedge funds in one week. It’s just reality that when there are more and more dollars chasing fewer and fewer deals that someone is going to lose and previous gains will not be as big as those in the past, even for the winners.
Another is that debt buyers are getting a belly full and beginning to question the value of the debt whether in the form of loans or bonds. Merced reports that 20 recent debt offerings, including debt to finance the Chrysler Group buyout, have joined $235 billion dollars in loans sales that have been have been postponed. Bond sales are also suffering with billions in offerings being put off by First Data, Alliance Boots, U.S. Foodservice, Service Master International and Dollar General.
Investment bankers jumped on the deals to get the high interest rates and fees, even putting up part of the money themselves to get the loan and bond action. Now they are stuck, unable to resell their equity. JP Morgan, Bank of America and Citigroup provided $1.5 billion in equity bridges that they now can’t sell without sweetening the pot or waiting for things to get better.
The housing market has only revealed the tip of the iceberg in defaults. Last week, Country Wide Mortgage, one of the biggest in the business, revealed that creditworthy mortgagees are falling behind in their payments and the decline in the housing market would continue until 2009. That may be optimistic as almost $1 Trillion of adjustable rate mortgages (ARMs) will reset this year.
Almost unnoticed is the commercial real estate market that is badly overbuilt and is starting to show its weakness. Local banks, shut out of the mortgage market and not wanting to be left out, have lent heavily in the commercial real estate market, sometimes at a rate of four to five times their reserve requirements. And we thought the S&L scandal was bad.
Inflation is low according to the government but that is “core inflation” and excludes food and energy costs, by far the biggest costs to the middle class other than housing. According to Mark Felsenthal in a Reuters article on July 12th, food prices have risen faster than core inflation every month since February and energy prices every year for the last four years. And it shows. The banks report that credit card sales and missed payments are both reaching all-time highs, indicating a worsening financial situation for the middle class. Retail sales are down across the board except at WalMart who had to make big price cuts in over 60,000 products to shed inventory. Those weren’t new sales. They were taken from other retailers.
Sadly, with crude oil reaching $75 a barrel and, as John Kilduff of Man Financial said, “We are one headline away from $100 a barrel.” The credit card is the last fading hope of the middle class. This drives up the cost of other necessities, like food. Of course the Fed doesn’t include the cost of gas or food in the “Core Inflation Rate” because it doesn’t affect the investor class much; you can only eat so much caviar.
Cheap financing advanced to consumers in the middle and working classes, who have had declining real income since the ’70s, has been purposeful public policy that forces consumers to borrow more and more to maintain their lifestyle. Incomes have not kept up with inflation, off shored manufacturing jobs have been replaced with service jobs that pay an average of 20% less, federal and state governments have shifted more cost to local entities, increasing property taxes, and the costs to participate in the legal economy for everything from daycare, to college, to medical insurance have been shifted to the worker. The result is a massive transfer of wealth over time from the general population to a very small percentage of super wealthy.
This process began during the Reagan administration and has continued, except during the Clinton years, until the present. It is nearing its inevitable end. As we learned in 1929, great disparity of wealth (which this process has increased tremendously) leads to a disproportionate investment in speculation, driving up prices to unsustainable amounts that then crash back to their real worth. Eventually the transfer of wealth from the working and middle class through increased debt deprives them of both purchasing power and the ability to borrow more, triggering deflation. Of course the devastation occurs mostly to the middle and working class who were already deprived of sharing the wealth of the speculative bubble, but now pay the consequences with layoffs and pension losses.
Our whole economy is built on consumer spending and as we produce less, ship good paying jobs overseas, increase our national and trade deficits, we have become a nation mired in debt. It’s no accident; we long ago passed the point were we “needed” more stuff, so we used advertising and planned obsolescence to create need and cheap financing to acquire it. Debt itself became the primary product. Whether it is the working poor at the window of the payday loan outlet, the Hedge fund manager at the conference table of Goldman Sachs or George W. Bush racking up $10 million an hour in Iraq, debt is the major creative enterprise in America today. In fact it is that government production of money to pay the cost of the war and recycled by the rich after low tax rates into speculative “high yield debt” that propels over inflated prices and over valued assets.
Most money being made today is from the financial transactions—the interests, the fees, and the creation of new kinds of exotic financial products that parse debt and resell it. Dealing in debt is quite lucrative. None of this actually produces wealth; it merely redistributes it more and more to the people at the top who have the money to lend.
The seventies stagflation were produced when the government stopped printing money to pay for the Viet Nam War and will happen again when this war ends. But it may happen sooner because as the economy becomes less secure and deflation becomes an eminent threat, China, Japan and Middle Eastern oil countries that are buying that debt may decide the Euro may be a better bet. When that happens as the old saying goes, “It will be Katie bar the door” to stop the rush to the exits.
At some point this must come unraveled in a rather nasty way. Whether it happens tomorrow or not is not the question, the answer is, it will happen and when it does it will be catastrophic for individuals, businesses, and government entities at all levels. What will happen to the big boys who created all of this? Well, most of them learned from the experience of Michael Milken the “Junk Bond King” who developed junk bonds, or “high yield debt”, to (guess what) finance leveraged buyouts. Indicted on 98 counts of racketeering and securities fraud, he pled guilty to six securities charges. He served twenty-two months. According to Forbes, he paid a total of $900 million in settlements and fines and still had a net worth of over $1 billion upon his release. His current net worth is estimated at $2.1 billion.
The private equity and hedge funds are not regulated by the SEC and most are registered offshore for tax and liability purposes. When it all falls apart most will be able to retire to their homes in the Mediterranean and live off their money in the Caymans, while the rest of us pick up the pieces.