Sunday, October 19, 2008
I had to interrupt the book I was reading because the events occurring in the global financial markets dutifully called for such action. Instead of reading the daily news and agonizing over what was unfolding, I decided to turn back in time, not long ago, when new, creative financial instruments were allowing private equity firms to takeover companies by running up enormous debt. This process is known as a Leveraged Buyout (LBO) and it was rife on Wall Street in the Geckoesque period of the mid 1980's.
The creativity of our modern day financiers is amazing. Without launching into the populist calls for their heads that one could read in the newspapers these days (not me though), the fundamental truth remains that out capitalist system, with its constant evolution, require such magical tools of finance. They are required in order to maintain the same growth levels that investors of all types have become accustomed to. However, the Western world is no longer in a post-war boom phase. The conditions are much more mature in nature and we need to start considering how our societies should be shaped in the "post-modern economy". There are only so many financial spells to cast; cheap-labor arbitraging opportunities to exploit, and wars to start. However, lets not get to far ahead of ourselves.
"Barbarians" tells the story, over a six month period, of the takeover of RJR Nabisco, the maker of Ritz crackers, Oreo cookies and Doral cigarettes by KKR, a major private equity firm. We do not need to look as far back as the 1930's to draw similarities to today's dilemmas. Just as barely- employed recent graduates were snapping up two bedroom condos over the last year with ridiculous amount of leverage, i.e. no money down on a $300,000 condo, private equity firms, with the help of Wall Street investment bankers, were purchasing Main Street companies, either private or publicly held, using enormous leverage ratios (little cash and lots of junk bonds). In both situations, the problems began when repayment on the loan amounts was brought into question.
I can only imagine what is being said in the newspapers and online over the last month. Why were the bankers so greedy? Didn't they see it coming? Are profits never enough? The answers - yes, yes, no. My favorite metaphor in the book was told by one investment banker. If you have 11 beauty pageant contestants in a room and in walks a $100 prostitute, you still have 11 beauty pageant contestants and a hooker. But if a prostitute walks in and tells them she earns $1m, the room is immediately made up of 12 hookers. The investment banks, just like the friends of our condo-buying recent graduate, have a hard time resisting when others around them are making money. Equally, once you are making lots of money, you are not going to stop out of goodwill for mankind. Oil companies know their resources will one day finish and drilling next to the house of a cute polar bear is the wrong thing to do just as a guy slinging mortgages out of his guestroom making $25,000 a month knew that he was probably selling a mortgage or two too many to people who would have been better off renting. Finally, the rampant growth opportunities are simply going to be harder and harder to come by.
Every cloud has a silver lining. The true tragedy would be if we live through the difficult upcoming years without giving thought to the direction we are going. It is this "pioneering capitalism" which needs to be reevaluated. There need to be checks in place along the way. Government does not have to be the enemy of economic growth. In truth, it can and will need to be an enabler by improving infrastructure that allow for smoother business and by educating its people to be the most competitive in changing times. And, yes, it needs to remember that it is often the last line of defense for untethered economic pursuits whose long term costs for society often dwarf the short term profits of a few.