HIGH LEVERAGE FINANCE CAPITALISM: ETHICAL ISSUES AND POTENTIAL REFORMS NEILSON
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1 HIGH LEVERAGE FINANCE CAPITALISM: ETHICAL ISSUES AND POTENTIAL REFORMS NEILSON Involuntary poverty is usually a bad thing. Poverty, like war, often brings out the worst in people Schumpter analyzed how all forms of capitalism have important creative and destructive phases and that there has been no golden age of capitalism without important destructive elements Capitalism is by nature a form of method of economic change that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one Leverage generally refers to the amount of money borrowed by an investor/;trader relative to the amount of secure capital owned or invested by the investor/trader Leverage also can enable business investors to start and expand businesses and economic development projects with only ten to twenty percent of the cost of the investment project Originally, hedging referred to an investment strategy designed to reduce rather than increase risk by investing some portion of investment resources in a direction relatively opposite to the main investment The attraction of the modern hedge fund was more the high leverage than the hedging itself, that is, the higher return potential offered to investors through the high leverage Types of products that hedge funds invested in expanded to include stocks, bonds and other debt products Hedge funds and their investors engaged in triple high leverage A more accurate name for a modern hedge fund might be a high leverage investment fund The problem further intensifies when may hedge funds invest in the same direction and many of them experience deleveraging together, as happened in the high leverage, subprime mortgage and private equity leveraged buyout Large, exponential losses by hedge funds are less a problem when investors are informed of and understand the high risks, invest and potentially lose their own money and can afford to lose their capital The original purpose and practice of private equity firms was to invest long-term equity capital to develop and grow start up businesses in anticipation of long term returns Since there is a transparency problem with PE-LBO firms it is difficult to determine the proportion of PE LBO firms that leans toward high debt leverage and cash dividend payments relative to investment in business/technology development PE LBO firm borrows most of its investment capital from banks and other financial institutions
2 There is, in a sense double leverage here. More borrowed than invested money is used to buy a company This can be very risky for the acquired company and the people and institutions making the loans to the PE LBO firms Since banks made most othe loans to PE LBO firms, this contributed greatly to the banks enormous bad loans lossess The traditional private equity firm invests in and develops the business content over the long term, such as in the development of new technologies Subprime mortgages: when all did not go well, and incomes and or property values did not rise to meet the required increased mortgage payments or when incomes declines, the properties had to be sold. This often resulted in large losses for the investors and the bankers who held the loans as assets and or the people and institutions who bought packages of such subprime mortgages Before the housing bubble burst, the subprime mortgages were very profitable for mortgage brokers who collected large fees and commission for originating and distributing the loans to others as parts of packages of structured investment vehicles and collateralized loan obligations with the overvalued homes as the weak collateral Traditional banking is very different from the types of financial deal making of the current high leverage, subprime, corporate, consumer and banking financial crisis The loans are considered relatively high risk because the borrowers before or after the loans have less than the normally required income cash flow or capital to support loan repayments and or already have relatively high debt repayment obligations Packaging many individual high-risk loans into a much larger package of high risk loans is not diversification in this sense since it is packaging very similar and highly correlated high risk assets Banks borrowed large amounts of money to lend to consumers and businesses. They then packaged these loans and sold them to other investors and financial institutions instead of originating and holding the loans There are t least five important types of ethics issues that are structurally related to the above types of finance capitalism 1. Harm to others 2. Leverage proportionality and prudence 3. Moral hazard 4. Transparency 5. Social control and regulation There is less consensus about how much of the harm was due to the more or less normal cyclical excesses within the financial system and how much was caused by structural problems with the high-leverage finance capitalism system considered above
3 High unemployment benefits help moderate downward swings in consumption due to unemployment In addition to high unemployment numbers total debt levels have also increased There is even some evidence to suggest that the solution to the subprime consumer and subprime corporate debt bubbles has been the creation of a government debt bubble. Debt bubbles can hinder future economic growth and increase risk of another round of deleveraging of debt The unequal distribution of income in the US during this period of high leverage finance capitalism is also increase: those with the top 1% of wealth more than doubled their share of national income to 23% of total annual US income While individual researches differ in the precision of their estimates of these declines, there is little disagreement that the size of the damages is enormous The extent of the bailout measures adopted by various governments throughout the world is unprecedented. Financial institutions have directly and indirectly done enormous harm to others Not borrowing money would be bad for wealth creation, the Aristotelian end of economic and business activity Many of the financial institutions could make more money from short term commissions and fees for advising, arranging the financing and trading the new types of large, securitized and highly leveraged subprime corporate debt financial transactions than they could from returns on long term assets These leverage levels were both very high and very different from historical norms and far from what might be considered within a reasonable, Aristotelian proportionate and prudent range The moral hazard argument is that intervention skews the risk and rewards trade-off in the minds of many, by reducing both the likelihood and the scope of future losses It appears that ordinary people are, in effect, subsidizing the bailouts and transferring income and wealth to recapitalize financial institutions while average incomes are stagnating and declining in real terms although the incomes of the upper 2% are rising exponentially One ofthe key issues that even many people within the financial services industry admit is the essential lack of transparency arising from the private nature of many of these large and often highly leveraged subprime financial transactions This lack of transparency itself makes it much more difficult to collect and evaluate data about these types of financial deals and thus to reach conclusions about their associated ethical and social issues
4 The Aristotelian criterion of proportionality might again provide an appropriate perspective for considering the issue of too much or too little, or inappropriate social control and regulation Passage of re-formed legislation follows, which leads to a continuing process of experience-ethics-politics-legal reform At least in Europe i appears that there will be significantly greater social control and regulation of financial institutions In some contrast in the US financial institutions and their political lobbyists appear to be vigorously and effectively resisting tighter social control and regulation It appears that there was far too little regulation and social control of the high leverage finance capitalism system A conflict of interest exist for many elected political officials who supervise and intervene in the regulatory process in response to financial contributions of lobbyists Four important areas for potential reform: leverage, compensation, transparency and lobbying, cronyism and campaign finance A key cause of the economic crisis and the enormous harm to ordinary people, the financial system and the economy was historically unusual and excessive leverage A high consumer debt burden was certainly a contributory factor but I would argue that it was the leverage that had built up within the financial systems that turned slowdown into slump When the leveraged buyout firms greatly increased the debt levels f the companies they took over and the leveraged buyout bubble burst, the acquired companies had to greatly reduce their costs by cutting employment and business development costs More than half of the corporate bankruptcies in 2008 were companies that had gone through the leveraged buyout process The regulatory power to restrict home finance and banking finance leverage already exists with the Federal Reserve, which is charged with regulating banks There are at least two important issues with respect to compensation reform: short term versus long term compensation and income/wealth distribution High leverage plays an important role in boosting compensation to very high levels One of the key motivations for high leverage finance is this potential for very high short term yearly, compensation without having to return that compensation if the deals are problematical in future years An important reform would be a requirement to tie he compensation of financial firms to the long term profitability of the financial deals
5 Objections to this high compensation stem from concerns about distribution of income wealth and about high compensation achieved at least in part through taxpayer financed government assistance to financial institutions The size of the bonuses financial services paid is similar to the size of the aid received from the federal government and Federal Reserve It appears unethical for financial institutions, to pay its employees billions of dollars in bonuses financed largely with government and taxpayer funds The high compensation issue is further aggravated by the US trend toward increasingly unequal distribution of income and wealth of the last 25 years Those gaining most from the financial crisis are the financial institutions that caused the crisis We cannot control what we cannot see. There are at least four areas for which transparency is needed: hedge funds, leveraged buyout firms, derivatives trading and off balance sheet banking We could require that hedge funds and leverage buyout firms meet the same reporting requirements as publicly traded companies It often costs millions of dollars to finance election campaigns and other political expenses required to support and a politicians political organization. Politicians salaries cover little to none of these expenses Wealthy individuals and corporations often expect and ask for something back for their money political support for convenient There are important conflicts of interest that are entangled with such cronyism and campaign financing. Such entanglements and conflicts of interest make it difficult for the politicians and financiers to act independently and in the interest of the common good These included managerial capitalism, trust capitalism large family business capitalism and small family business capitalism The too big to fail rationale for bailouts of these types of financial institutions contains serious issues of moral hazard
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