Saturday, November 01, 2008

Leveraging Turned Upside Down

Listening today to some economists trying to make their way through the garbage that our economy has become, I was brought up short by that old familiar term, "leverage". The term applies to use of loans based the potential worth of a firm to buy up the firm, and I first became aware of it as the means used for employee buyouts. Taking out a loan based on the potential for a firm's eventual worth, leverage was used to estimate what the employees could use for value. Later it was used as a tool for potential non-employee buyers.

The leverage factor assumes that the firm is going to be used for the purposes it was founded for. When executives take hold a firm in order to drain its worth, such as taking out huge CEO salaries, benefits, and even stock offerings, that potential is no longer actualized. Manufacturing widgets is no longer the firm's purpose, though it may be manufacturing widgets, if it is used for something else entirely. Future earning capacity was severely miscalculated, because the firm's purpose was misrepresented when executives began going after their own personal enrichment at the expense of the business they took over.

'Deleveraging' is a term to me until recently, like 'upside down' mortgages that refer to a home that is worth less than its mortgage holder owes. It refers to those loans made on assumptions that a firm would do its best to make traditional profits. The loans instead were used to fund extracurricular activities to make funds for those executives that ran it. Those loans, like all those subprime mortgages, have been bundled and sold off to investment banks, to investors all over the world. They are just as toxic as the subprime loans. That is what you aren't hearing about. The toxic loans aren't just mortgages, not just bad credit. They include carefully crafted business loans that assume executives will be doing their job of running a profitable firm. That is the self-preservation factor. It is another myth, one that is making lenders really, really nervous.

Looking back at Alan Greenspan declare that he never envisioned that executives would not protect their own firms' 'self-interest', there is no way he could be sincere. Only total ignorance of the actual behavior of the market over several decades would allow him to have no knowledge of executives' acting against their firms' 'self-interest'.

Self-interest is nonexistent, of course, if the firm's well-being is not the source of executive remuneration. Under the concept of leveraged buyouts, executive motivation should always have been reviewed as integral to the value of the firm. In order to make a loan on the basis of future profit, it may well be necessary to institute contracts with penalties based on any executive misfeasance in the firm's purpose of being, whether making widgets or mortgage loans. I particularly would like to see Sen. Obama's work to keep jobs from being outsourced enabled, and am sure too that an emphasis on increasing jobs and salaries would be a basis for a sound economy. That might be the best requirement we can make of any firm changing hands, that it provide employment and living wages for its workers, rather than boundless enrichment for the CEOs.

Loans are the object of the occupied White House action, claiming its measuresare making the loans trustworthy again. That isn't going to happen as long as executives' self-interest does not equate with the firm's self-interest.

This is going to be a long, long workout for the market to reach stability again. Those at the top have destroyed its principles. Needless to say, its principals went into the tank with them.

Once burned, twice shy, for any investor. In the case of proven misfeasance, that shy effect is necessarily going to be factored in for some time to come.

Labels: , , ,


Blogger shrimplate said...

Excellent post. You nailed it.

1:25 PM  
Anonymous Anonymous said...

When I first moved to New Zealand from London I found in the course of my computer systems admin work with the NZ banking system that there were some functions not being done that could easily be achieved by combining certain features of software products that we already had installed.

I therefore wrote a memo suggesting that we exploit these features to achieve whatever it was.

To my surprise I found that pearls were being clutched, fainting fits being staged, and that people were talking about me behind their hands.

Eventually the penny dropped, and my later suggestions as to how matters could be improved used the word (if it even is a word) "leverage" rather than "exploit".

I found that interesting.

Phil Palmer.

2:01 PM  
Blogger Ruth said...

Thanks. Sometimes we realize that the stuff we're being told holds the right info, but is worded so that we're not supposed to 'get it'. Economists are the worst. Makes you wonder if they're feeling as guilty as they ought to.

4:54 PM  
Anonymous Anonymous said...

I am convinced that AIG was raided from within. Their (risky)mortgage insurance business was set up in London, and I am sure that the pirates set up themselves as beneficiaries of those mortgage insurance policies. And I suspect that most of the bail-out $$ is going to pay off those policies.

10:27 PM  

Post a Comment

<< Home