Financialisation relies on financial engineering to generate earnings and wealth. Increasingly, industrial businesses have sought to improve earnings or increase their share price by means not necessarily directly linked to the provision of goods and services.
Companies have increased the use of lower cost debt financing, taking advantage of the tax deductibility of interest. In private equity transactions, the level of debt is especially high. Complex securities have been used to arbitrage ratings and tax rules to lower the cost of capital.
Mergers and acquisitions as well as various types of corporate restructurings (such as spin-off, carve-outs etc) have been used to create “value”. Given the indifferent results of many such transactions, the major benefits appear to have accrued to insiders, bankers and consultants. Share buybacks and capital returns, sometimes funded by debt, have been used to support share prices. In January 2008, US companies were using almost 40 per cent of their cash flow to repurchase their own shares.
Tax arbitrage, especially by international companies operating in multiple jurisdictions, has increased post tax earnings. The use by many companies of special vehicles in low tax jurisdictions, such as Ireland, is evidence of this trend.
Some companies have used trading to increase earnings. Oil companies can make money from trading or speculating in oil. They can make money irrespective of whether the oil business is good or bad, the price high or low, profiting from uncertainty and volatility. It is not necessary to actually produce, refine or consume oil to benefit from price fluctuations.
Feted as a traditional investor with legendary stock picking skill, Warren Buffet’s Berkshire Hathaway makes significant gains through financial engineering, including the use of leverage and derivative contracts. Berkshire Hathaway uses the insurance premiums received as “free float”, to finance investments. In the last decade, the company has sold long dated options on international stock indices, credit default swaps on US corporate credits, and insurance against municipal bonds. The premiums received augment its investment capital.
In both cases, the leverage derives from the receipt of cash up front against a promise to make a contingent payment sometime in the future. The advantage is attenuated by the fact that the risk is back-ended and Berkshire does not have to post collateral to secure the risk with payment only required when the contracts are unwound or expire.
Nothing has changed post crisis. Low interest rates have encouraged additional borrowing. Artificially low capital costs have allowed unsustainable businesses to continue, generating sub-standard returns.
Corporate restructurings, while below peak levels, have recovered as companies seek glib solutions to complex problems of earning adequate returns by re-engineering their finances rather than their operations. Since 2009, US share buybacks, frequently financed by low cost debt, total nearly $2 trillion and now make up an increasing proportion of the value of stocks traded.
Interestingly, governments are increasingly borrowing and adapting private sector financial engineering techniques to deal with economic problems.
Governments have increased their debt levels, in some cases resorting to forcing purchases of bonds by central banks, domestic banks and captive institutions like state pension funds.
Conventional and innovative monetary policies have supported aggregate demand and helped maintain economic activity to prevent even deeper recessions. Policies that have engineered a sharp decline in real and nominal interest rates to ultra-low levels have resulted in redistribution of income and wealth.
According to a 2013 report from the McKinsey Global Institute, between 2007 and 2012, governments in the US, eurozone and the UK collectively benefited by $1.6 trillion, primarily through reduced debt-service costs and increased profits remitted from central banks. The bulk of this transfer had come from households, pension plans, insurers and foreign investors, mainly through lower interest earnings on savings.
Low interest rates and higher asset prices, boosted by accommodative monetary policies, have helped banks defer recognition of non-performing loans. Low interest rates also provide an implicit subsidy to banks.
Lower rates reduce the cost of deposits, which can then be reinvested in low risk government bonds at a substantial profit. This subsidy, in combination with interest paid to banks on excess reserves held with the central bank, is designed to increase bank capital levels, facilitating write-off of bad loans and, ultimately, greater levels of lending.
Central banks have engaged in similar carry trades.
In 2012, Citibank’s UK economist suggested that the UK Government could use the “accumulated profits from quantitative easing (QE) to finance a special temporary tax cut”. The profits related to the interest paid by the government to the central bank (which was purchasing its bonds), financed by the creation of reserves that did not technically incur any cost. The total “profit” was in the vicinity of £30bn.
Perversely, funds, effectively transferred from one arm of government to another, are recorded as a normal payment under this practice. Interestingly, under this logic, the larger the central bank’s QE program, the larger its profit!
The apogee of monetary engineering is the suggestion of debt cancellation. Debt issued by the government and held by the central bank could simply be cancelled as the issuer and investor were effectively the same entity. Effectively, this is exactly the opposite of the separation that allows attribution of profit.
The European Union has even experimented with leveraged structures such as CDOs (collateralised debt obligations) in developing facilities, as with the now defunct EFSF (European Financial Stability Facility), or loss layering to finance bailouts of troubled European countries.
Like their corporate counterparts, governments have increasingly resorted to creative accounting to deal with difficult problems.
In the period prior to the introduction of the euro, many eurozone countries, such as Italy and Spain, used derivatives transactions to allegedly understate their debt levels. More recently, governments have used off-balance sheet structures and have often delayed payments to massage the level of borrowings. Unsatisfactory public accounting standards allow governments to understate liabilities, such as unfinanced commitments for future healthcare, elderly care and retirement benefits.
Constrained by limited funds for recapitalising banks, the Spanish government has agreed that major banks can reclassify €30bn worth of deferred tax assets as tax credits to bolster their regulatory capital. At the same time as the EU is seeking to improve the solvency of banks by improving capital reserves and improving the quality of core capital, the adoption of a strategy of financial manipulation which does little to improve the real equity loss absorption capacity of the banks is extraordinary.
Borrowing from private banks, governments have increasingly sought to avoid recognising unrecoverable investments in some European nations. In November 2012, Chancellor Angela Merkel was only able to honour her promise that Germans would not suffer any losses from the bailout by agreeing to the fiction of very low-coupon long-term Greek debt. There is now talk of a zero- coupon long-term loan to Greece to avoid immediate losses.
Financial engineering masks true performance and the real position of enterprises and nations. But its damage is far deeper, deluding decision makers into not dealing with problems. As Fyodor Dostoyevsky wrote in The Brothers Karamazov: “The man who lies to himself and listens to his own lie comes to a point that he cannot distinguish the truth within him, or around him...”
Satyajit Das is a former banker. His latest book is ‘A Banquet of Consequences’ (published in North America as ‘The Age of Stagnation’ to avoid confusion as a cookbook). He is also the author of ‘Extreme Money’ and ‘Traders, Guns & Money’.
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