Thursday, July 12, 2007

The Private Equity Industry--Billionaire Vultures Strip Your Bones

Some of you may have read my post on how Wall Street is destroying the value of pension funds by investing their money in mortgage-backed securities based on subprime mortgages, which are mortgages granted to people with lousy or no credit. To make a long story short, many pension funds for middle class workers such as teachers and policemen invested in these securities, which are now looking like the German mark during the Weimar Republic, where 1 million marks couldn't buy you a loaf of bread.

Private equity firms use these kinds of bonds to buy public companies, strip them to the bone by firing everyone, then resell the companies at a handsome profit. These deals are known as leveraged buyouts, leverage meaning debt. In other words, in order for a private equity firm such as Blackstone or Kravis Kohlberg to buy, for instance, Chrysler for $65 billion dollars, they borrow $2000 for every $100 they put in, then use the combined $2100 to buy Chrysler. (Not all of Chrysler. Just giving this as an example of how they operate.) Private equity firms don't risk any of their own money, they use Other People's Money (OPM) to make these deals, collect the profits, and pay capital gains tax rates on them (15%). Everyone else including the secretaries at their firms pay 35% on their income.

Why is this important? Because Congress is trying to bring the private equity tax rate in line with ordinary income and tax it at 35% instead of 15%. This makes the private equity firms very upset. Right now, Henry R. Kravis, billionaire founder of the corporate buyout movement, is roaming the halls of Congress, hoping to kill the legislation that would raise his taxes and those of other investment firm executives.

He sees private equity enterprises as good for the little guy, citing examples of how his firm produced many jobs by turning around troubled businesses. The lower tax rate benefits all Americans, he insists, and the increase in tax rates would harm American competitiveness abroad. When asked if the higher tax rates would affect pension fund returns, first he said no, then an adviser to KK said he believed the legislation could have an adverse effect on pension fund returns.

$15 billion per month of tax payer money goes to pay for the wars in Iraq and Afghanistan. The Democrats are looking for additional revenue to help finance educational tax credits, broaden health programs for lower-income families and other initiatives to improve the lot of the American people.

The Big Moment for this tax legislation will come when the Joint Committe on Taxation in Congress estimates how much money the proposals would raise if they became law.

Henry Kravis has some good connections, though.

Kravis' ties to the Bush family go back decades, to the time when his father was friends with Senator Prescott Bush, the president's grandfather.
The private equity firms have hired an army of lobbyists to fight this legislation. They call it unpatriotic. Wayne Berman, managing director at Ogilvy Government Relations and a major Republican fundraiser, said, "It will be ...a fight about the fairness of capital gains having a lower tax rate. It will be about rewarding risk and recognizing when you reward risk you create economic growth." Then he growses about capital's enemy, labor. "This is about politics. This is about the AFL-CIO's longstanding policy objectives of ending the beneficial tax treatment of risk versus the treatment of wages from work. It is not about Steve Schwarzman's birthday party."

Who the hell is Steve Schwarzman and what about his birthday party? As reported in the Times and on Page Six of the Post on 2/14/07, glittering guests such as John Thain, the Chief Executive of the New York Stock Exchange Group which operates the NYSE, Donald & Melania Trump, Barbara Walters and Vernon Jordan were there. It was held at the Seventh Regiment Armory, which is a huge space on Park Avenue, decorated like the Hall of Mirrors at Versailles. There were non-stop gourmet meals, free flowing wine and a $1,000,000 concert by Rod Stewart. The party was estimated to cost $3 million.

Steve Schwarzman, is the Chairman of Blackstone, a prominent private equity firm. The party celebrated his 60th birthday like a coronation. He is an active Republican donor with tentacles into the worlds of finance, politics and the arts. Maybe he's not too much like the little guy. As Damon Silvers, associate general counsel at the AFL-CIO, which has been lobbying in support of increasing the tax rates, said:

The tax subsidy to the wealthiest Americans created by these lower rates on equity funds is a significant drain on the ability to do important things for the good of the country. The top 25 individuals in the industry got paid over $10 billion taxed at 15%. These 25 people got paid 3 times the amount that was paid to all 80,000 people who teach in the New York City schools, and they paid roughly one-half to one-third taxes on a percentage basis.

An article in the Times blog Dealbook from 3/11/07 mentions the pending legislation introduced by Charles Grassley (R-IA), the ranking Republican on the Senate Finance Comittee, which will tax the enormous fees that the private equity firms take on the profit of investments as ordinary income instead of as a capital gain. The question is, should the 20% fees that private equity firms collect from the profits of its investments be considered capital gains or as regular income? The writer says of course, no doubt about it:

The Internal Revenue Service should clearly be considering it regular income. After all, [the private equity firms'] own money is not at risk--it's a fee. (By contrast, when they invest their own money in the funds, the profit is obviously a capital gain.)

Let's be honest: it is a charade that private equity firms have claimed their 20% performance fees at the lower capital gains rate. To qualify, they invest a nominal amount of their own money to demonstrate that they have put something at risk, but it's a ruse. They are paying capital gains rates for doing their job, which should be taxed at the regular income rate.

You would think that all the buyout kings who wear American flags on their suit lapels would be proud to pay a big tax bill.

The reason I bring up this lengthy explanation is that I want this tax legislation passed. Unfortunately, private equity firms are swimming in cash. They have strong connections with both parties. They gave millions to presidential and Congressional campaigns. They are counting on the support of powerful Democratic lawmakers who rely on Wall Street as a major source of political contributions. They include Senators Chuck Shumer and Chris Dodd, and Representative Rahm Emanuel. The Congressmen have not taken a public position on the bills.

Let them know we know which way the wind blows. If Congress sells us out on this golden opportunity to fund our programs, then money does buy influence (duh!).

Monday, July 9, 2007

Irrational Exuberance Runs Amok

Alan Greenspan, the party-crossing Chairman of the Board of Governors of the Federal Reserve for 20 years, was very circumspect in his pronouncements, positively cryptic. As the Wall Street dot-com frenzy hit its peak in 1999, he actually ventured into straight talk. He called what was going on "irrational exuberance", as share prices of dot-coms grew higher and higher, unjustified by any existence of profits. Even dot-coms which were barely more than domain names managed to collect millions of dollars from eager investors, until the frenzy peaked and share prices collapsed.

Maybe Greenspan should have said something before that happened, but "irrational exuberance" caught on as an apt expression of a market bubble, that is, bidding up the price of something until it's all out of proportion and the next stage is a collapse of prices. Wall Street seems like a rollercoaster with each car filled with gamblers betting on the next big thing until they reach "irrational exuberance", irrational meaning "deprived of reason" and exuberance meaning "effusive and almost uninhibited enthusiasm". They're riding high and there's no end in sight. They refuse to believe despite all evidence to the contrary that reality will set in and prices without foundation will collapse.

That is what is happening in the housing market. It accelerated in value from (year) until (year), when the tipping point occurred and housing prices began their descent. It was inevitable that the housing boom would start to bust, or that the housing bubble would begin to burst (whichever metaphor you prefer). The boom was fueled by an atmosphere of low inflation and cheap, easy credit And Wall Street introduced some innovations to the previously staid practice of granting mortgages.

It used to be that you'd go to a bank for a home loan (mortgage) and the bank would determine whether you were creditworthy by assessing factors such as whether or not you were employed, whether you paid your bills on time, had a steady income and could make monthly mortgage payments. In exchange for giving you money, the bank wanted to know if it could be repaid. The quality of your creditworthiness would determine the interest rate on the mortgage. If your credit was good, you'd get a lower interest rate. If it wasn't so good, you'd get a higher interest rate. And if you were deemed a bad risk, you didn't get a mortgage, period, until you could build up your creditworthiness.

Then the lending structure changed. Wall Street smelled the opportunity to make a lot of money from so-called subprime mortgages--mortgages given to people who wouldn't normally be considered qualified buyers. Instead of banks granting mortgages, Wall Street investment firms would hire a lender who would in turn hire a mortgage broker who would grant the loans to unqualified buyers so they could become homeowners.

There were plenty of incentives to sell these loans: brokers and lenders could charge exorbitant fees (much more than with prime loans) to grant these loans and Wall Street could turn around, repackage the loan into something called a "collateralized debt obligation" and sell it to investors on the premise that even though these CDOs were based on bad credit, the interest rates were higher than junk bonds and housing prices kept going up. In turn, they wouldn't look very deeply into the creditworthiness of the borrowers. In fact, in Wall Street circles these subprime loans were known as "liar loans" because the borrowers often lied about their income. Wall Street wasn't too concerned as to whether or not the borrowers could pay them back; housing prices kept escalating so the value of their homes kept increasing. If a borrower couldn't meet his obligations, he would just borrow some more money (refinance) based on the higher equity he could extract from his home. Everything was jake until housing prices stabilized and buyers began withdrawing from the housing market because they couldn't automatically "flip" the house (resell it for more money). Sellers began outnumbering the buyers and prices went down. So did the equity in these sub-prime financed homes. Borrowers in over their heads with these subprime loans couldn't refinance and became delinquent in their mortgage payments. Foreclosures multiplied. Soon whole neighborhoods were dotted with empty, boarded-up houses, which had the effect of driving down the value of the perfectly nice borrower next door who did have a prime mortgage. So even those with good credit began being affected. The inventory of unsold existing homes increased. There are still construction contracts requiring builders to build new homes in the face of an oversupply of existing homes.

Most subprime mortgages are ARMs (adjustable rate mortages). An ARM is a mortgage with an interest rate that may change, usually in response to the Treasury Bill rate or the prime rate. The purpose of the interest rate adjustment is primarily to bring the interest rate on the mortgage in line with market rates. ARMs usually start with better rates than fixed rate mortgages in order to compensate the borrower for the added risk that future interest rate fluctuations will create. So far the subprime borrowers have been paying the lower rates; soon the mortgages will adjust and monthly mortgage rates will increase, leading to more foreclosures. And around and around it goes, the roller coaster turning into the ferris wheel, an endless loop of cause and effect with no end yet in sight.

Wednesday, July 4, 2007

"Made In China" Means "May Be Hazardous To Your Health"

China is importing dangerous, sometimes toxic products to the United States. The American people are just finding out about this practice, although the Food and Drug Administration (FDA) has known about it and does little to protect us. There is no oversight either in China or here in the U.S.

The problem rose to the surface when dogs and cats began dying of kidney failure after eating pet food. The pet food was analyzed and melamine, an industrial product, was found in the wheat gluten used to bind pet food ingredients, making the "gravy" in wet pet food. Melamine is normally used to make plastic kitchen utensils and fertilizers. It was traced to a Chinese manufacturer who was not certified to make agricultural products. Menu Foods, the leading North American manufacturer of wet pet food products, had to recall more than 100 brands consisting of millions of cans of pet food. Some were sold under well-known brand names (i.e. Mighty Dog). Menu Foods currently produces more than 1 billion cans of pet food per year.

Then came the problem with diethylene glycol (DEG). DEG is a chemical cousin of anti-freeze that causes kidney and neurological damage if ingested. An industrial solvent, it is an odorless, colorless, sweet tasting syrup, used by unscrupulous manufacturers as a substitute for the more expensive product glycerin.

In 1937 more than 100 people died in the U.S. after ingesting a DEG-contaminated drug used to treat infections. That led to the enactment of the Federal Food, Drug and Cosmetic Act, the nation's primary statute on the regulation of drugs.

In September 2006, dozens of Panamanian citizens were hospitalized and at least 40 were dead from ingesting cough syrup laced with DEG. Investigators from 4 countries identified the manufacturer of the "glycerin" ingredient in the cough syrup as the Taixing Glycerin Company in Hengxiang, China. The factory is not certified to sell any medical ingredients.

When the investigators examined the records for the shipment, they found that the names of the suppliers were removed from the shipping documents as they passed from one place to another. The manufacturer's certificate of analysis showed the batch of "glycerin" to be 99.5% pure.

At the end of May 2007, federal officials found Chinese-made toothpaste loaded with DEG in U.S. stores. They said it was only in discount stores. In fact, the toothpaste was distributed much more widely. 900,000 tubes containing DEG have turned up in hospitals for the mentally ill, prisons, juvenile detention centers and some hospitals serving the general public. Four states (Georgia, North Carolina, South Carolina and Florida) reported receiving Chinese-made toothpaste tainted with DEG. A major national pharmaceutical distributor said it was recalling the toxic toothpaste.

In response, the FDA has advised Americans to discard all Chinese-made toothpaste. As Dough Arbesfeld, spokesman for the FDA, said, "This stuff doesn't belong in toothpaste, period."

The Case of the Chinese Tires: According to, the National Highway Traffic Safety Administration has ordered Foreign Tire Sales (FTS), a tire importer based in New Jersey, to recall 450,000 light truck tires that are at risk for tire tread separation because they lack a gum strip (which costs a few cents) that holds the tread together. Tread separation is the same defect that led to the recall of millions of Firestone tires in 2000.

FTS had a contract with the Chinese company Hangzhou Zhongce Rubber Company to manufacture tires according to FTS' specifications. Initially, there were no problems. Gradually, however, customer complaints rose in volume. Then in August 2006 two men died and another sustained permanent brain damage when their Chevrolet van rolled over after the tire tread separated. When FTS was named as a defendant in a suit against them regarding this accident, it performed tests on the tires and found that they had an insufficient gum strip or no gum strip. A gum strip is a rubber feature that helps prevent the tire from separation or from damaging the rubber. FTS also found that the tire treads begin to come apart after 25,000 miles.

Originally the tires were exclusively imported to FTS, but now they are sold to several other importers.

Hangzhou Zhongce told the Wall Street Journal on 6/25/07 that in its own testing, there were no defects. They said the recall may be an effort by foreign competitors to hamper the company's exports to the United States. Quoting from The New York Times 6/27/07 article, "Chinese Company Denies Tire Defect", Xu Yourning, manager of legal affairs at Hangzhou Zhongce, said that, "This is concocted out of thin air. The structure of a tire cannot be decided by an individual. Any change in the tire requires technical assistance. Zhongce couldn't possibly leave out the gum strip on purpose."

NO RECALL is actually taking place. FTS claims in documents filed with the NHTSA that it simply cannot afford the expense of recall. The NHTSA is threatening FTS with retaliatory action if it doesn't comply. Meanwhile, millions of people are driving around on dangerous, possibly deadly, tires.

The case of the tainted seafood: On June 28, 2007, the FDA blocked the sale of 5 types of farm-raised seafood from China. It was contaminated with carcinogens and other banned additives. The FDA had been aware of tainted Chinese seafood for at least 6 years. It warned the Chinese about it and even visited Chinese fish ponds. Dr. David Acheson, the FDA's assistant commissioner for food protection, stressed that the seafood posed no immediate health threat, though long-term consumption could result in health problems.

China is the world's largest producer of farm-raised fish. It is the biggest foreign supplier of seafood to the United States.

The FDA issued an "import alert" covering the following seafood: shrimp, catfish, eel, basa (similar to catfish) and dace (similar to carp). Some of the contaminants have been known to cause cancer in laboratory animals, and others increase resistance to antiobiotics that are used to fight anthrax poisoning. The FDA asserts that the seafood can only be sold in the United States if importers provide independent testing that it doesn't contain contaminants.

Chinese seafood farmers often use the banned contaminants to prevent disease caused by pond overcrowding. "You may have 10-20 times the density of fish that you have in a natural environment," said Robert Romaire, professor of aquaculture at Louisiana State University.

Shipments of imported Chinese seafood were valued at $1.9 billion in 2006, a 193% increase since 2001.

The Food and Water Watch, a Washington-based nonprofit group, found that more than 60% of the seafood rejected at the border by the FDA came from China.

The percentage of seafood shipments pulled out for laboratory analysis has declined from 0.88% in 2003 to 0.59% in 2006.

One of the most serious problems in China is that the government lacks the power to control the nation's businessmen. Bribery and government corruption are rampant.

"China effectively has no oversight over anything," said Oded Shenkar, a business professor at Ohio State University and the author of "The Chinese Century: The Rising Chinese Economy and Its Impact on the Global Economy, The Balance of Power and Your Job." "People have this idea that they are Big Brother and everyone's under watch," Mr. Shenkar said. But that's entirely false. "In China, local authories often turn a blind eye to problems because maybe they're invested in it."

How can the United States allow its citizens to be endangered? Keep in mind several factors: 1) The Chinese government doesn't want to scare off foreign investors; 2) Multinational corporations want to set up shop in China (they're probably already there) and take advantage of its cheap labor force and billions of consumers; 3) Chinese businessmen can be as unscrupulous as any American businessman: In some of these cases, a Chinese businessman gets a big contract from a United States importer (like FTS), promises to deliver the product according to specifications, then substitutes cheaper, sometimes toxic and/or dangerous ingredients or leaves out an item entirely; 4) It can be extremely difficult to trace a dangerous shipment. It could come with forged documents or it could have been transshipped. Transshipping refers to the practice of "trade laundering", whereby products are transferred and shipped out through another country to avoid detection of their origin. So far the Chinese have denied there is a problem and the FDA is, at best, ineffectual at protecting us.