The Strange Matter of Stock Buybacks

buyhighselllow.jpg

Within the last 40 years as economic power shifted from workers to owners, corporate profits take of the US economy has more than doubled. Yet, despite corporate profits at an all-time high, job growth remains anemic, wages are flat, and the country can’t even afford its basic needs. A $3.6 trillion budget shortfall has left many roads, bridges, dams, and other public infrastructure in disrepair. Federal spending on economically crucial research has plummeted by 40%. Public college tuition has more than doubled since the 1980s, burying recent graduates under $1.2 trillion in student debt. Not to mention, many public schools along with police and fire departments are dangerously underfunded. So where did all the money go? After all, public companies have nearly $2 trillion in cash just sitting on their balance sheets. So Corporate America has the resources to deploy a lot of money, invest in new technologies to draw growth, give workers a much-needed raise across the board, hire and train employees, build new facilities, pay off loans, pay shareholders, and pay taxes to the government.

untitled1

Since the 1980s, stock buybacks have grown in popularity on Wall Street as this graph shows. As Sen. Elizabeth Warren told The Boston Globe, “stock buybacks create a sugar high for the corporations. It boosts prices in the short run, but the real way to boost the value of a corporation is to invest in the future, and they are not doing that.”

But no. Instead, companies keep spending more and more money on stock buybacks. Once illegal and considered insider trading until 1982, stock buybacks have become increasingly popular especially since the 2008 recession. Today, these buybacks have become one of the biggest trends in the post-financial-crisis stock market and the largest source of net demand since 2009. Since 2010, 1,900 companies have spent money on buybacks and dividends with a combined return of capital to shareholders for them equaling 113% of capital spending. So much that a growing number of companies are borrowing money to fund the buybacks. Thanks to Donald Trump’s massive corporate tax cuts, American companies have lavished Wall Street with $171 billion of stock buyback announcements this year, a record high. All in all, Corporate America has pledged 30 times more buying back its own stock than investing in its workforces. Thus, the money these companies make through their financial manipulations drives record-level profits.

Proponents say they reward these long-term shareholders by effectively increasing their company ownership and help boost a stock’s value by raising its earnings per share. When there’s no other compelling use for a company’s cash, this is a better alternative than risky spending or other big investments. But its critics think that buybacks only make things look better than they seem. Indeed, the EPS rise but not because earnings are growing. In other words, they just exist to make shareholders feel better but nothing really changes. Even some of their fiercest proponents claim they’re overused. And in recent years, evidence shows that buybacks haven’t helped boost stock values at all. Other critics argue that buybacks result in companies acting more like banks that hold assets and earn interests and less like a business making money off selling goods and services. Or invest their profits in their workforce and other productive ventures. According to the Academic-Industry Network’s William Lazonick, “Buybacks are not beneficial or necessary to household savers with diversified investments. The only ones who benefit are those who dump shares and are strictly in the business of timing.”

What are stock buybacks?

Also known as a “share repurchase,” is a company’s buying back its shares from the marketplace. Think of it as a company investing it itself or using its cash to buy its own shares. The concept is simple: because a company can’t be its own shareholder, it absorbs repurchased shares and reduces the number of outstanding shares on the market. When this happens, each investor’s relative ownership stake increases on the company’s earnings.

How are stock buybacks carried out?

They’re made in 2 ways:

1. Tender Offer– company may present shareholders with a portion of all their shares within a certain time frame. This will stipulate both the share number the company wants to repurchase and the price range they’re willing to pay (almost always at a premium to a market price). When investors take up the offer, they’ll state how many shares they want to tender along with the price they’re willing to accept. Once the company has received all the offers, it’ll find the right mix to buy the shares at the lowest cost. Tender offers can be a way for executives with substantial ownership stakes and care about a company’s long-term competitiveness to take advantage of the low stock price and concentrate ownership in their own hands. This can free them from Wall Street’s pressure to maximize short-term profits and allow them to invest in the business. But they should only be made when the share price is below the company’s intrinsic value of its productive capabilities and the company is profitable enough to repurchase the shares without impeding its real investment plans.

2. Open Market– company buys shares on the open market just like an individual investor would at market price. It’s important to know that when a company announces a buyback, the market usually perceives it as a positive thing, causing the stock price to shoot up. 95% of buybacks are these. Yet, they often come at the expense of investment in productive capabilities and aren’t good for long-term shareholders. When I discuss stock buybacks, I’m usually referring to the open market variety which used to be illegal and considered insider trading until 1982.

3. Dutch Auction– an alternative form of tender offer which specifies a price range within which the shares will be bought. Shareholders are invited to tender their stock if they wish at any price within it. The firm then compiles the responses, creating a demand curve for the stock. The purchase price is the lowest price allowing the firm to buy shares sought in the offer. And the firm pays that price to all investors who tendered at or below that price. If the share number exceeds the number sought, the company buys less than all shares at or below the purchase price on a pro rata basis to all tendering at these rates. If too few shares are tendered, the firm either cancels the offer or buys back all the tendered shares at the maximum price.

Why would a company want to use buybacks?

A firm’s management may tell you that a buyback is the best use of capital at a time since their goal is to maximize returns for shareholders. Buybacks generally increase shareholder value, at least on the surface. The prototypical line in a buyback press release is “we don’t see any better investment than in ourselves.” This can sometimes be the case but it’s not always true. Nonetheless, there are still sound motives driving companies to buy back shares. Management might think the market has discounted its share price too deeply due to weaker-than-expected-earning results, an accounting scandal, or a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it means management believes the market has gone too far discounting its shares. More importantly, share buybacks can be a fairly low-risk approach to use extra cash since reinvesting money into R&D or a new product can be very risky. If these hard-earned investments don’t pay off, then that hard-earned cash goes down the drain. Using cash to pay for acquisitions can also be perilous. Mergers hardly live up to their expectations.

Another reason is that companies don’t want to just sit on money, much for the same reason that investors don’t like holding piles of cash either: inflation erodes cash value, so putting it to work makes sense. During periods of economic growth, it’s better to allocate profits to capital (like a factory) or labor as an investment to the firm’s future. But it’s also risky because the economy could worsen. Though I’m not sure if I actually agree with this since I think stagnant wages are part of why the economy isn’t getting any better. So in periods of economic uncertainty, companies choose to give the cash to their shareholders, which should’ve went to their workers. As the head of S&P Investment Services Mike Thompson told Business Insider in 2016, “In an environment like this return cash to shareholders keeps them pleased with the short-term gains while not committing to large investments that could hurt performance.”

Increased Shareholder Value– there are many ways to value a profitable company but the most common measurements is Earnings Per Share (EPS). If earnings are flat but the number of outstanding shares decreases.

Increased Float– as the number of outstanding shares decreases, the remaining shares represent the float’s largest percentage. Increased demand and less supply means a potentially higher stock price.

Excess Cash– buybacks are usually financed with a company’s excess cash, demonstrating that it doesn’t have a cash flow problem. More importantly, it signals that executives feel that cash re-invested will get a better return than alternative investments.

Improving Financial Ratios– or improving metrics upon which the market seems heavily focused on, which is questionable. If reducing shares isn’t done to create more value for shareholders but rather make financial ratios look better, the management likely has a problem. However, if a company’s motive for initiating a buyback program is sound, its financial ratio improvement in the process might be the result of a good corporate decision. For one, share buybacks reduce outstanding shares. Once a company buys these, it often cancels them or keeps them as treasury shares. They also reduce assets on the balance sheet and increase return on assets and equity. They also improve a company’s price-earnings ratio as the market often thinks lower is better.

Dilution– another reason for a buyback may be a company’s wish to reduce the dilution often caused by generous employee stock option plans. Bull markets and strong economies often create a very competitive labor market. So companies have to compete to retain personnel and ESOPs which comprise of many compensation packages. Stock options increase the share number when exercised, which weakens a company’s financial disposition.

Price Support– companies with buyback programs in place use market weakness to buy back shares more aggressively during market pullbacks. This reflects confidence that a company has and alerts investors that it believes the stock is cheap. Often a company will buy back its stock after taking a hit, which is an overt action to take advantage of discount prices on its shares. This lends support to the stock’s price and ultimately provides security for long-term investors for rough times.

Higher Stock Prices– an increased in EPS will often alert investors that a stock is undervalued or has the potential for increasing in value. The most common result is an increase in demand and an upward movement in the stock’s price.

Tax Benefit– while a buyback is similar to a dividend in many ways, it has a major advantage over dividends of a lower capital gains tax rate. Whereas dividends are taxed at ordinary income tax rates.

Does that mean stock buybacks are good?

Not necessarily. Sometimes buybacks can be a great thing if a stock truly is undervalued and represents the best possible investment for a company. But a company must meet certain specific conditions:

1. The stock should be trading at price to economic book value below 1, meaning that the company is buying back shares for cents on the dollar.

2. The company’s balance sheet and free cash flow should be strong enough to support a buyback without jeopardizing future liquidity or investment opportunities.

3. The company should have more cash than it does profitable investment opportunities.

One company meeting all three criteria is Oracle who bought back $8.1 billion in stock (5% of its market cap), reducing outstanding shares by 120 million. Its shares currently trade at a PEBV of 0.9, meaning it’s buying back shares at a 10% discount rate to their zero-growth value. With $50 billion in excess cash on its balance sheet and $9 billion in annual free cash flow, Oracle has more than enough cash on hand to support its buyback program, and more than it could reasonably hope to profitably invest in the near term as of 2016. Oracle’s buybacks don’t just serve their shareholders’ interests, they also benefit the overall economy. When a company with excess cash and few investment opportunities buys back its stock, it puts that cash back in the marketplace for individual investors to distribute to companies needing capital. In buying back billions of dollars in its own stock, Oracle cheaply retired its shares without comprising its ability to invest in future growth.

While there are buybacks that make sense from a capital allocation standpoint and serve the investors’ best interests like in Oracle’s case, these are normally the exception rather than the rule. In fact most companies buying back stock aren’t in Oracle’s situation. If a company merely uses buybacks to prop up ratios, provide short-term relief to an ailing stock price, or get out from under excess dilution, watch out. Oftentimes, they can be a downright bad idea and can hurt shareholders. This can happen when buybacks are done in the following situations:

1. When Shares Are Overvalued– companies should only pursue buybacks when their shares are undervalued. A company that buys overvalued stock destroys shareholder value and would be better off paying that cash out as a dividend, so that investors can more effectively invest it. As Warren Buffett said to Berkshire Hathaway shareholders in 1999, “Buying dollar bills for $1.10 is not good business for those who stick around.”

2. To Boost Earnings Per Share– since buybacks can boost EPS, a company stock buyback in the market reduces outstanding share count. This means earnings are distributed among fewer shares, raising EPS. Thus, many investors applaud share buybacks since they see increasing EPS as a surefire approach to raising share value. However, contrary to popular belief, increasing EPS doesn’t raise fundamental value. Companies must spend cash to buy these shares. In turn, investors must adjust their valuations to reflect reductions in both cash and shares. Sooner or later this cancels out any EPS impact. In other words, lowering cash earnings divided between fewer shares won’t produce any net change to EPS. Of course, a major buyback announcement generates plenty of excitement since a prospect of even short-term EPS can give share prices a pop-up. But unless the buyback is wise, the only gains go to those investors selling their shares on the news. There’s little if any benefit for long-term shareholders.

3. To Benefit Executives– many executives get the bulk of their compensations from stock options. As a result, buybacks can serve a goal: while stock options are exercised, buyback programs absorb the excess stock and offset dilution of existing share values and any potential reduction in EPS. By mopping up extra stock and keeping EPS, buybacks are a convenient way for executives to maximize their own wealth as well as maintain share value and options. Some executives may even be tempted to pursue share buybacks to boost share buybacks to boost the share price in the short-term and sell their shares. In addition, big bonuses that CEOs receive are often linked to share price gains and increased EPS. Thus, they have an incentive to pursue buybacks even when there are many ways to spend the cash or when their shares are overvalued.

4. Buybacks Using Borrowed Money– the temptation using debt to finance EPS can be hard to resist for executives. The company might believe that the cash flow it uses to pay off the debt will keep growing, bringing shareholder funds back into line with borrowings in due course. If they’re right, they’ll look smart. If they’re wrong, investors will get hurt. Moreover, managers assume that their companies’ shares are undervalued regardless of the price. When done with borrowing, share buybacks can hurt credit ratings, since they drain cash reserves that can serve as a cushion when times get tough. One of the reasons given for taking on increased debt to fund a share buyback is that it’s more efficient since the debt’s interest is tax deductible. However, all debts must be repaid at some time. Because what gets a company into financial difficulties isn’t lack of profits but lack of cash. With debt, buybacks become more complicated which doubles the risk since a firm’s leverage levels may cause financial distress in the future and harm shareholders in the long-term.

5. To Fend Off an Aquirer– in some cases, a leveraged buyback can be used as a means to fend off a hostile bidder. The company takes on significant additional to repurchases stocks through a buyback program. Such leveraged buybacks can be successful in thwarting hostile bids by both raising the share value and adding a great deal of unwanted debt to the company’s balance sheet.

6. There Is Nowhere Else to Put the Money– it’s very hard to imagine a scenario where buybacks are a good idea, except when a company feels like its share price is far too low. But if the company’s right about undervalued shares, they’ll probably recover anyway. Thus, companies buying back shares are, in effect, admitting that they can’t invest their spare cash flow effectively. Even the most generous buyback program is worth little for shareholder if it’s done in the midst of poor financial performance, a difficult business environment, or a decline in the company’s profitability. By giving EPS a temporary lift, share buybacks can soften the blow. But they can’t reverse things when a company is in trouble.

Why do companies actually use buybacks?

In theory, corporations should have a distinct advantage over the rest of the market when buying back shares. After all, executives know their industry, the company’s challenges, and their strategic plans better than anyone else. This should enable them to buy their stock when it’s cheap and not when it’s overvalued.

But most companies carry out buybacks for reasons that have nothing to do with maximizing shareholder value. Pressure to hit short-term earnings targets and executive compensation plans often incentivize the wrong metrics which often push companies to buy back stock when it’s most expensive and the money could be better used elsewhere. This is what the Harvard Business Review calls “The Overvaluation Trap.” Data shows that companies buy back more stock during booms and sell them during market crashes. In this way, less like the knowledgeable executives and more like panicky and underperforming investors.

untitled

This 2016 Forbes graph of GE stock buybacks and its valuation. You can see that instead taking the traditional investor advice of “buy low, sell high,” they actually have bought high and sold low. As a result, their stock has lost value.

A graph from Forbes shows this value-destroying behavior for General Electric by comparing between the amount of money spent buying back shares and the price to economic book value, a measure of growth expectations embedded in the stock price. As this graph illustrates, GE bought back an incredible $12.3 billion worth of stock in 2007, just before the market crashed. At the start of the bull market in 2009, the company sold off $600 million worth of its own stock. Throughout the last decade, you can see a high correlation between how expensive GE’s stock is versus current cash flows and how much stock the company buys back. Overall, in the last decade, GE bought back $44 billion of its own shares (17% of its market cap). Yet, its stock fell by 15% over that same time. By inefficiently utilizing valuable capital to buy back stock at inflated prices, GE destroyed value for long-term shareholders. When a company’s equity is overvalued, its executives have to scramble to justify that expensive price. One way to do that is by artificially boosting the EPS through share buybacks. As this Forbes graph above shows, GE does this effectively as the company managed to hit or beat EPS in 15 out of past 16 quarters.

575f22fe910584145c8c891c-960-1150

Business Insider’s graph on IBM also shows how buybacks might make the EPS look good as the number of outstanding shares drops. Despite that the net income has fallen, which isn’t a good sign in most businesses.

Another case is IBM who spent $4.6 billion in 2015 and $125 billion in the decade prior as of 2016. According to a Business Insider graph, from 2010 to 2015, its total share count was down by about a fifth while earnings per share rose 15%. Yet, in that same period, IBM’s actual income went down 11% as sales fell, too. As a result, IBM has lost about $50 billion in market value since 2013, or about 30%.

ceo-pay

Since executive pay is often tied to stock compensation, top Wall Street execs have often been pressured to do buybacks to increase their coffers. Even if it makes no strategic financial sense. It’s part of a phenomenon called greed. This is a Bloomberg graph of IBM’s CEO compensation.

Also, many companies have executive compensation packages incentivizing excessive share buybacks, either directly or indirectly. In GE’s case, a percentage of its bonuses depends on the company returning a certain amount of cash to shareholders. In 2014, executives had to make sure combined dividends and buybacks hit at least $10 billion to get their full bonus, even if that decision made no strategic sense. But it makes perfect sense in regards to greed. Because when share prices go up, CEOs reap a bonanza so the value of their pay also rises in what amounts to a retroactive and off the books pay increase on top of their already humongous compensation packages. As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are squandering most of their companies’ profits for their own prosperity. The Academic-Industry Network’s William Lazonick told The American Prospect, “All of those trillions of dollars flowing out of companies are being used to build the war chests of hedge-fund activists for further buybacks or [giving them more] money to play around with on derivatives. When you connect the dots, it’s part of bigger process. This is really a long-run problem that helps to explain concentration of income at top because it’s getting made off the stock market.

Other companies incentivize share buybacks through emphasizing metrics that can be easily manipulated and have little impact on shareholder value. For example, Cisco executives are judge in part on their ability to grow adjusting operating income, adjusted EPS, and operating cash flow. That term “adjusted” is crucial since Cisco uses metrics for judging executive performance exclude share-based compensation. Meaning that executives can pay employees (and themselves) with stock instead of cash, buy back shares to offset dilution, and increase these adjusted metrics to improve real operating performance. In 2015, Cisco bought back 155 million shares. But after effects of employee stock compensation, it only reduced the total outstanding shares by 38 million. So all those buybacks are just trickery executives use to boost their own bonuses.

And it’s not just GE, IBM, and Cisco. According to FactSet data by Andrew Birstingal, the performance of companies engaging in buybacks has been disappointing. “In the past year, companies repurchasing shares saw an excess weighted cumulative return of -1.9% relative to the benchmark, while companies not repurchasing shares saw a return of 9.8% relative to the benchmark,” he said in 2016. On a three-year horizon, those companies buying back shares ended up with a -2.9% return against 11.5% gain for those not buying back stock. A study found that companies completing buybacks outperformed their benchmark before 2001. Yet, those who completed buybacks between 2002 and 2006 didn’t generate better returns since that time than those who didn’t. Based on this research, buybacks aren’t helping share prices in either short- or long-term.

However, the cost of buybacks doesn’t just come from overpriced stock losses, but also from missed opportunities to invest growth and innovation. Over the past decade, AT&T bought back $50 billion in stock which could’ve been used to improve its wireless network quality and catch up with Verizon which doesn’t buy back stock. All those buybacks didn’t keep AT&T from underperforming versus Verizon and the broader market. We tend to think of buybacks as a sign of success proving a company has plenty of cash to throw around. In reality, they amount to admission of failure for a company buying back stock signals the market that it lacks profitable investment opportunities.

So what’s the deal with stock buybacks and the economy?

StockTax4

Stock buybacks don’t give any incentives for companies to use profits in improving their enterprise and raising workers’ wages. The frequency of buybacks have led to increased economic inequality and more money going to the 1%.

Before the Security and Exchange Commission loosened regulations that gave companies an ability to repurchase stock without facing charges of stock manipulation and a shift toward stock-based compensation toward top executives, corporate money flowed through the broader economy in the form of higher wages or increased investments in plants and equipment. But today, these stock buybacks drain millions of dollars of windfall profits out of the real economy and into a paper-asset bubble. This inflates share prices while producing nothing of tangible value. Corporate managers have always been pressured to grow earnings per share, but where once the only option was the hard work of actually growing earnings by selling better products and services, they can now simply manipulate their EPS by reducing the number of outstanding shares. As a result, it has become a gigantic game of “keep away” with CEOs and shareholders tossing a $700 billion ball back and forth over American workers, whose wages as a share of GDP have fallen in almost exact proportion to profits’ raise. Since buybacks give firms no incentives to share their profits with the workers who truly invest in these companies, pouring their lives into them each day for pay increases and stable opportunities. Or the taxpayers who have an interest in whether a corporation that uses government funding can turn a profit that allow it to pay taxes. As the Academic-Industry Network’s William Lazonick told The American Prospect, “The issue is what are they not doing when they do stock buybacks. What they’re not doing is keeping people employed longer, paying them more, and giving them more benefits. There’s a direct connection between the decline of those norms and the rise of buybacks and the legitimized ideology of ‘Shareholder First.’” Over the last decade, 94% of company profits have gone to shareholders through buybacks and dividends.

This practice isn’t just unfair to Americans, but also to individual harmful to both companies and the American economy. A 40-year obsession with “shareholder value maximization” stock buybacks and excessive dividends have reduced business investment and boosted inequality. Now almost all firms carry out investment through retained earnings. Thus, diverting cash flow to stock buybacks has inevitably resulted in lower rates of business investment. And since the 1980s, corporations have bought back more equity than they’ve issued, representing a net negative equity flow. In other words, shareholders aren’t providing capital to the corporate sector like they should. They’re extracting it. Meanwhile the shift to stock-based compensation helped drive the 1%’s rise by inflating the ratio of CEO-to-worker compensation from 20 to 1 in 1965 to 300 to 1 today. Labor’s steady falling share of GDP has depressed consumer demand, resulting in slower economic growth. It’s mathematically impossible to make the public- and private- sector investments necessary to sustain America’s global economic competitiveness while flushing away 4% of its GDP year after year. If the US is to achieve growth distributing income equitably and providing stable employment, government and business must take steps bringing stock buybacks and executive pay under control. The nation’s economic health depends on it.

What should be done about stock buybacks?

The federal government must reorient its policies from promoting personal enrichment to enhancing national growth. Such policies should limit stock buybacks and raise the marginal rate on dividends while providing real incentives to boost R&D investment, worker training, and business expansion.

According to a 2014 Harvard Business Review, a good first step would be an extensive SEC study of the possible damage that open market buybacks have done to capital formation, industrial corporations, and the US economy over the past 3 decades. For instance, during the amount of stock taken out of the market has exceeded the amount issued in almost every year. From 2004-2013, this net withdrawal averaged $316 billion a year. Overall, the stock market isn’t functioning as a funding source for corporate investment.

Another measure we need to do is reining in stock-based pay which should be very limited. Many studies have shown that large companies usually use the same set of consultants to benchmark executive compensation and that each consultant recommends that the client pay its CEO well above average (which is what CEOs want to hear). Thus, compensation inevitably ratchets up over time. They also show that even declines in stock price increase executive pay. So when a company’s stock price falls, the board stuff even more options and stock awards into top executives’ packages, claiming that it must ensure they won’t jump ship and will do whatever necessary to get the stock price up. A 1991 SEC decision allowing top executives to keep gains from immediately selling stock acquired from options only reinforces their overriding personal interest to boost stock prices. Because corporations aren’t required to disclose daily buyback activity, it gives executives the opportunity to trade to trade undetected on inside information about when buybacks are in progress. The SEC at least should stop allowing executives to sell stock immediately after options are exercised. And incentive compensation should be subject to performance criteria reflecting investment in innovative capabilities, not stock performance.

But more importantly, we must transform boards determining other executive compensation. Boards are currently dominated by other CEOs with strong bias toward ratifying higher pay packages for years. When approving enormous distributions to shareholders and stock-based pay for top executives, these executives believe they’re acting in shareholders’ interests. And that’s a big part of the problem. The vast majority of shareholders are simply investors in outstanding shares who can easily sell their stock when they want to lock up gains or minimize losses. Since taxpayers and workers are the people truly investing in the productive capabilities of corporations, they need to have seats on boards of directors. Their representatives would have the insights and incentives to ensure that executives allocate resources to investments in capabilities most likely to generate innovations and value.

If business leaders want to maintain broad support for business, they must acknowledge that a corporation’s purpose isn’t to enrich the few, but to benefit many. Once America’s CEOs refocus on growing their companies over their share prices, shareholder value will take care of itself and all Americans will share in the economy’s benefits. The corporate allocation process is America’s source of economic security or insecurity whether its people like it or not. If Americans want an economy in which corporate profits result in its shared prosperity, the buyback and executive compensation binges will have to end. Sure executives will complain like whiny babies. But the best executives might actual get satisfaction being paid a reasonable salary allocating resources in ways sustaining the enterprise, providing higher standards of living to the workers who make it succeed, and produce tax revenues for the governments providing it with crucial perks.

Advertisements

The Vultures of Wall Street

lead_960

For the United States in 2017, the economy is growing, unemployment is low, and consumer confidence is at a decade-long high. Though this would normally create a retail boom, more chains are filing for bankruptcy and rated distressed than at the height of the Great Recession. Cities across the country are facing 6,800 store closings which has become known as the retail apocalypse. This year 19 retail companies have declared bankruptcy including Radio Shack, The Limited, Payless, and Toys “R” Us. Naturally people like to point at Amazon but e-commerce sales in the second quarter only hit 8.9% of sales. So it’s not like these stores are necessarily hurting for business despite declining sales. Besides, most of the retailers already have online stores.

RetailApocalypse-NEW

Here’s a chart on the stores closing due to the retail apocalypse. Though we often blame Amazon for this and declining sales, the real cause for this is far more insidious than you can even imagine.

However, the real reason why so many companies are sick has little to do with technological disruption. Rather with debt and a predatory financial scheme. Over the past decade, private equity firms bought numerous chain stores and loaded them up with unsustainable debt payments as part of their business strategy. Billions of dollars of this debt comes due within the next few years. As Bloomberg wrote in a recent article, “If today is considered a retail apocalypse, then what’s coming next could truly be scary.” The retail sector has already lost hundred thousand jobs from October 2016 to April 2017. In the following June, 1,000 stores closed within a week. And it will only get worse. This year only $100 million in retail debt came due this year. But there will be $1.9 billion next year and $5 billion on average due between 2019-2025. This threatens retail sales and cashiers who make up 6% of the entire US workforce and a total of 8 million jobs. And since these workers aren’t confined to any one region, the entire country will share their pain. In the Pittsburgh area where I live, 26.8% of retail loans are delinquent. States like Michigan, Illinois, West Virginia, and Ohio are among the hardest hit where retail employment has declined over the last decade and those will likely spread. Meanwhile, any states like Florida, Arkansas, and Nevada have overly relied on retail for job growth and will feel more pain as the fallout deepens. States like Alabama, Louisiana, New Hampshire, Mississippi, and South Carolina have the highest concentration of cashiers. As the debt comes due, expect more displaced low-income workers, shrinking local tax bases, and investor losses on stocks, bonds, and real estate.

141224123845-stats-on-sears-thumb-1024x576

The tragedy of Sears is a major example of how private equity can be so insidious. Once a retail bastion, it’s now facing bankruptcy thanks to overbearing debt and mismanagement by hedge fund manager Eddie Lampert.

The most famous example of this is Sears which is now closing hundreds of stores and facing bankruptcy. Once a bastion in America’s consumer-based economy, it has been run to the ground by none other than hedge-fund king Eddie Lampert. A former Yale roommate of Treasury Secretary Steve Mnuchin, arranged the Sears-Kmart merger and immediately started shifting revenue to shareholders. In addition, he spent $6 billion on stock buybacks to reward investors and raise the share price. More importantly, Lampert personally lent billions to Sears Kmart which increased its corporate debt. As its in-store sales lagged, Sears sold off major assets like its Craftsman brand tools and Land’s End outdoor equipment to pay for the loans. He also split ownership of 266 Sears and Kmart buildings into a real estate investment firm called Seritage. Last year, Sears and Kmart stores paid $200 million in rent on these properties they once owned which ate up its operating revenue. Even as Sears’ very existence is in question, Lampert will likely come out ahead. He’s enjoyed fees from all the lending to Sears and he’ll recoup more money in any restructuring even if Sears has to sell off inventory to do it. As Seritage’s shareholder, Lambert’s hedge funds can profit from higher rents charged to new retail outlets moving into shuttered Sears and Kmart locations. In fact just this year, a Kmart near where I lived and used to shop closed down and I knew some people who worked there.

59386dd56e410.image

This is a Kmart store in Rostraver Township, Pennsylvania that’s near where I live. On June 7, 2017, it was announced this store was closing. I’ve shopped at this place on many occasions and knew some of the people who worked there. Kind of a shame. I’ve also heard that the Kmart in Mount Pleasant Township closed earlier this year as well. Kind of a shame.

Sears’s mismanagement reflects an ongoing pattern of private equity takeover artists benefitting from crippling the companies they purchase. Golden Gate Capital and Blum Capital, the 2 firms behind Payless, paid them $700 million in dividends in 2012 and 2013 on the company’s back. Payless filed for bankruptcy this year and closed 400 stores. Toys “R” Us filed for bankruptcy in September unable to sustain between $400-$500 million in annual interest payments on $5.2 billion long-term debt. Private equity firms, including Bain Capital and longtime firm Kohlberg Kravis Roberts, stripped out nearly $2 billion in cash as debt levels rose. And Toy “R” Us’s profitability was increasing when it filed for Chapter 11 since sales in the toy sector had been rising annually by 5% over the past 5 years.

Toys R US To Close 87 Stores

Toys “R” Us wasn’t among the worst casualties in the retail apocalypse. But its filing for bankruptcy in September came as a shock because its profitability had increased and its business was mostly stable. However, the real reason was that the toy store chain was overburdened with debt to private equity firms that bought it out in 2005.

What you see is a robbery in progress. Private equity firms borrow massively to buy companies and use corporate cash reserves to pay themselves back. Workers contributing the value to the business see nothing but the possible job cut since companies usually cut staff to service the debt. When the company collapses under the borrowing weight, all workers lose their jobs even when sales are up. Though troubled retailers have billions of borrowings on their balanced sheets like Sears, sustaining that load will only become more difficult even for healthy chains like Toys “R” Us. Private equity firms defend that their business model returns companies to fiscal health thanks to superior management. But this isn’t what we see in the retail apocalypse. Retail firms typically roll over debt to buy time and avoid bankruptcy. However, interest rates have increased since the last set of buyouts several years ago, making that prospect more expensive. Now these overleveraged companies are finding it difficult for anyone to agree to refinance. As a result, delinquent payments on shopping centers and other commercial real estate have spiked as high as one quarter of all loans in some parts of the country.

retailjobs-768x666

This is a map from Bloomberg showing the concentration of retail jobs all over the country from 2016. Due to private equity overleveraging, the retail apocalypse will only get worse as debts come due. This could mean millions of Americans losing their jobs.

Yet, private equity firms don’t receive a lot of attention which is why I devised this handy FAQ for you to look at. If there is a reason we should care about private equity firms, is that they play a huge role in our economy. Though not all PE firms aren’t predatory finance schemes, many are. And the fact they’re less regulated than banks only exacerbates matters when these vulture capitalists put a company under. Predatory financial schemes hurt everyone. They kill jobs and businesses as well as ruin communities and whole economies. As of 2012, private equity firms own companies employing about 1 out of 10 Americans. This makes them hugely important since they’re basically America’s biggest employers. If you work for a PE-owned company, you might stand a chance of losing your job within the next few years. Now I’m not a fan of corporate America and have the criticized the retail industry for mistreating their workers on shit wages, unpredictable schedules, and anti-union activities. But I understand the retail industry does play a key role in the US economy. Even a shit job like cashier is a job nonetheless. And people rely on these jobs to support their families. Thus, I believe we need to understand what these private equity firms do and how many of them can be a business’s best friend or its worst nightmare. So here is a handy FAQ for reference. Besides, since millions of Americans will lose their jobs over private equity activities, they should know the truth as to why.

What is a private equity firm?

elderd-land-gimv-8-638

This is a diagram of a private equity firm business model. Though I suppose more of an advertisement since it seems to create a positive image.

A private equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through an array of loosely affiliated investment strategies. Usually described as a financial sponsor, each firm takes a bunch of money for a private equity fund and buys up these companies. They do this by usually matching rich people and institutions with more money than they know what to do with to middle market companies who need access to a steady flow of cash. First, the equity firm buys the company through an auction. Second, the firm then increases the company’s value whether through upgrading its accounting system, a procurement process and information technology, or laying off workers and closing unprofitable operations. In return, the private equity firm will receive a periodic management fee and a 20% share in the profits earned. With their investors, private equity firms will acquire a controlling or substantial minority position in a company and then look to maximize that investment’s value. And they generally receive a return on their investment through one or more of the following (if they’re lucky):

Initial Public Offering (IPO)- company’s shares are offered to the public, typically providing a partial immediate realization to the financial sponsor and public market into which it can later sell additional shares. Through his process, a privately held company transforms into a public one. IPOs are usually used by companies to raise the expansion of capital, possibly to monetize investments of early private investors, and become publicly traded enterprises. Companies selling shares are never required to repay its capital to public investors who pass money between each other afterwards. Although an IPO offers many advantages, there also significant disadvantages such as the costs usually associated with the process and the requirement to disclose information that could provide helpful information to competitors. Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertake an IPO with assistance from an investment firm acting in the capacity of an underwriter. Since underwriters provide several services like help with correctly assessing share value and establishing a public market for shares.

Merger and Acquisition (M&A)- one company is sold for either cash or shares in another. As an aspect of strategic management, M&A can allow enterprises to grow, shrink, and change the nature of their business or competitive position. From a legal perspective, a merger is a legal consolidation of 2 entities into one. Whereas, an acquisition occurs when one entity takes ownership of another entity’s stock, equity interests, or assets. From a commercial and economic point of view, both types of transactions generally result in consolidation of assets and liabilities under one entity and the distinction is less clear. A transaction legally structured as an acquisition may lead to placing one party’s business under the other party’s shareholders’ indirect ownership. At the same time, a transaction legally structured as a merger may give each party’s shareholders partial ownership and control of the combined enterprise. This deal may be euphemistically called a “merger of equals” if both CEOs agree that joining together is in the best interest of both of their companies. Meanwhile, when the deal is unfriendly (like when a target company’s management opposes the deal), it might simply be seen as an “acquisition.”

Recapitalization- cash is distributed to the shareholders (in this case the financial sponsor) and its private equity funds from a company’s cash flow or raising debt or other securities to fund the transaction. As a type of corporate reorganization involving substantial change in a company’s capital structure which may be motivated for a number of reasons. Usually, the large part of equity is replaced with debt. In more complicated transactions, mezzanine financing and other hybrid securities are involved.

pegcc_infographic_051512b1-882x1024

As you can see from this infographic, private equity is widespread. As you can see, they’re a major presence in the US economy. Of course, the industries they invest most into are consumer and information technology, which should surprise anyone.

But we should understand that often the effort to fix up the company fails and bankruptcy is the outcome. So while the rewards are great so are the risks. Back in 2012, The Wall Street Journal did an analysis of the 77 businesses Bain Capital invested during former Governor Mitt Romney’s tenure. It found that 22% either filed for bankruptcy or shut down within 8 years of Bain’s investment. Even several companies that initially provided Bain with huge profits later ran into trouble. Of the 10 deals producing more than 70% of Bain’s gains, 4 eventually filed for bankruptcy. But the companies that succeeded were hugely profitable as the Journal concluded that Bain turned $1.1 billion into $2.5 billion in gains in the 77 deals.

So they’re like hedge funds?
Not exactly. Private equity firms characteristically make longer-hold investments in target industry sectors or specific investment areas where they know a lot about. They also take on operational roles to manage risk and achieve growth through long-term investments. Private equity firms and investment funds shouldn’t be mistaken for hedge fund firms which typically make shorter-term investments in securities and other more liquid assets within an industry sector but with less direct influence and control over a specific company’s operations. And hedge fund firms usually bet on both the up and down sides of a business or an industry sector’s financial health.

What is a private equity fund?

Private_Equity_Fund_Diagram

This is a diagram of a generic private equity fund. The private equity firm acts as the general partner while the limited partner investors usually supply the cash for the investments.

Private equity funds usually have a general partner (GP) raising capital from cash-rich institutional investors like pension plans, universities, insurance companies, foundations, endowments, and high-net-worth individuals investing as limited partners (LPs) in the fund. Before buying the company, the GP (who makes all the fund’s decisions), devises a plan for how much debt to use, how the company’s cash flow will be used to service the debt, and how the PE firm will exit at a profit. The private equity firm typically has very little of its own money at risk, only investing 2% or less in the fund while the LPs put up 98% of the equity. But it claims 20% of any gains from these companies’ subsequent sale. Among the terms set forth in the limited partnership are the following:

1a93380

Though I’ve already shown a private equity fund’s basic structure, here’s a more detailed chart. You can see the kinds of partners who invest as well as the strategies used.

Term of the Partnership- usually a fixed-life investment vehicle that’s 10 years plus some number of extensions.

Management Fees- annual payments made by investors in the fund to its manager to pay for the private equity firm’s investment operations (usually 1% or 2% of the committed capital to the fund).

Distribution Waterfall- the process in which the returned capital will be distributed to the investor and allocated between the Limited and General Partner. This waterfall includes the preferred return, which is the minimum rate of return (e.g. 8%) which must be achieved before the GP can receive any carried interest, which is the profit share paid to the GP above the preferred return (e.g. 20%).

Transfer of an Interest in the Fund- Private equity funds aren’t intended to be transferred or traded. Though they can be transferred to another investor but such transfer must receive the fund manager’s consent and is at the GP’s discretion.

Restrictions on the General Partner- the fund’s manager has significant discretion to make investments and control the fund’s affairs. However, the LPA does have certain restrictions and controls and is often limited in the type, size, or geographic focus of investments permitted, and how long the GP can make new ones.

Can you describe each private equity firm investment strategy?
Certainly. Here are some in depth descriptions of some major strategies. Though they’re not the only kind of ways private equity firms invests.

Leveraged_Buyout_Diagram

The main investment strategy private equity firms uses is the leverage buyout. This involves buying a company with a combination of equity and debt and using its cash flow as collateral. In fact, it’s usually on the company to pay back the debts. This practice has been prone to plenty of overleveraging and abuse like in the case with Sears.

Leverage Buyout (LBO)- a financial transaction in which a company is purchased with a combination of equity and debt so its cash flow is the collateral used to secure and repay the borrowed money. Since the debt costs less than capital and equity, it serves to reduce the acquisition’s overall financing costs. After all debt costs less than capital and equity because interest payments reduce corporate income tax liability while dividend payments don’t. So the reduced financing costs allows greater gains to accrue to the equity, and as a result, the debt acts as a lever to increase the equity’s returns. Though usually employed when a financial sponsor acquires a company, many corporate transactions are usually funded by bank debt which can also represent an LBO. It could take many forms like management buyout (MBO), management buy-in (MBI), along with secondary and tertiary buyout among others. It can occur in growth situations, restructuring situations, and insolvencies. Though LBOs mostly occur in private companies, they can be employed with public companies, too (in a so-called PtP transaction-Public to Private). As financial sponsors increase their returns by employing a very high leverage (like a high ratio of debt to equity), they’re incentivized to employ as much debt as possible to finance an acquisition. In many cases, this can lead to “over-leveraging” in companies in which they don’t generate enough cash to pay their debt, leading to insolvency or to debt-to-equity swaps in which the equity owners lose control over their business to the lenders. This is the main strategy most private equity firms use and typically finance a buyout of a company with 30% equity and 70% debt. Private equity funds use the acquired company’s assets as collateral and put the burden of repayment on the company itself.

Startup_Financing_Cycle

This is a diagram illustrating how start-up companies are typically financed. First, the new firm seeks out “seed capital” and funding from “angel investors” and accelerators. Then if it can survive the “valley of death” (when the start up’s trying to develop on a “shoestring” budget), the firm can seek venture capital financing.

Venture Capital (VC)- a form if financing provided by firms or funds to small, early-stage, emerging funds either seen as highly profitable or potentially so. VCs invest in these early-stage companies in exchange for a return or an ownership stake in those they invest in. They take on the risk of financing risky startups in hopes that some of the firms they support will eventually succeed. The typical VC investment occurs after an initial “seed funding” round also called the Series A Round. A VC will provide this financing in the interest of generating a return through an eventual “exit” event such as the company selling shares to the public for the first time in an IPO or through its merger or acquisition (a.k.a. “trade sale”). In addition to angel investing, equity crowdfunding, and other seed funding options, VC is attractive for new companies with limited operating histories that are too small to raise capital in the public markets and haven’t reached the point where they could secure a bank loan or complete a debt offering. In exchange for the high risk that VCs assume by investing in smaller and early stage companies, they usually get significant control over their decisions along with a portion of their ownership (and consequently value). They also often provide strategic advice to the firm’s executives on its business model and marketing strategies. Additionally, VC is also a way in which the private and public sectors can build an institution that systematically creates business networks for the new firms and industries so they could progress and develop. The VC institution helps identify promising new firms and provide them with finance, technical, expertise, mentoring, marketing “know how,” and business models. Once integrated into the business network, these firms are more likely to succeed as they become “nodes” in the search networks for designing and building products in their domain. However, VC decisions are often biased as well as exhibit an instance of overconfidence and illusion of control like entrepreneurial decisions in general.

Growth Capital- a private equity investment (usually minority investment), in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets, or finance a significant acquisition without a change or control of the business. Companies seeking growth capital will often do so to finance a transformational event in their lifecycle. Unlike VC-funded companies, growth capital companies usually able to make a profit but can’t generate sufficient cash to fund major expansions, acquisitions, or other investments. Because of this lack of scale, these companies generally can find few alternative conduits to secure capital for growth. Thus, access to growth equity can be critical to pursuing necessary facility expansion, sales and marketing initiatives, equipment purchases, and new product development. Growth capital can also be used to affect a restructuring of a company’s balance sheet, particularly to reduce the amount of leverage (or debt). Growth capital is often structured as the preferred equity, though certain investors use various hybrid securities including a contractual return (like interest payments) in addition to an ownership interest in the company. Often, companies seeking that growth capital investments aren’t good candidates to borrow additional debt, either because of the stability of the company’s earnings or existing debt levels.

Mezzanine Financing- any subordinated debt or preferred equity instrument representing a claim on the company’s assets that’s senior only to that of common shares. It can be structured as either debt (usually an unsecured or subordinate note) or preferred stock. It’s often a more expensive financing source for a company than secured or senior debt. The higher cost of capital associated with mezzanine financing is due to it being unsecured, subordinated (or junior) obligation in a company’s capital structure. Should that company default or go bankrupt, mezzanine financing is only paid after all senior obligations are satisfied. Additionally, since it’s usually a private placement, mezzanine financing is often used by smaller companies and may involve greater leverage levels than issues in the high-yield market which involve additional risk. But in compensation for the increased risk, a mezzanine debt holder requires a higher return for their investment than a more senior debt holder.

Distressed Securities- securities over companies or government entities experiencing financial or operational distress, default, or are under bankruptcy. As far as debt securities, this is called distressed debt. Purchasing or holding distressed debt creates significant risk due to the possibility that bankruptcy may render such securities worthless (zero recovery). Deliberate investment in distressed securities as a strategy while potentially lucrative is significantly risky as the security may become worthless. Doing so requires significant levels of resources and expertise to analyze each instrument and assess its position in an insurer’s capital structure along with the likelihood of ultimate recovery. Distressed securities tend to trade at a substantial discounts to their intrinsic or par value and are considered below investment grade. This usually limits the number of potential investors to large institutional investors like hedge funds, private equity firms, and investment banks.

Why would anyone invest in a private equity fund?

Private-Equity-Investors-1

Though private equity has earned a reputation as corporate saboteurs outside Wall Street, this kind of investment is quite popular among investors. As you can tell from these stats, the notion of private equity won’t go away soon.

Private equity funds are illiquid and managed by active investors. Those familiar with common index funds such as those of ordinary investors might hold in their investment portfolios might lead you to believe a private equity fund investment is foolish. But private equity funds do have a number of good advantages.

1. Taking companies private is incredibly profitable- When a private equity firm takes a company private from the public market, it has 100% of the ownership and thus can claim all its profits and control all capital allocation. Thus private equity firms have unlimited control over what goes on in the company unlike public equity investors. So they could claim all cash flows in the company.

2. Equity returns in short time frames- It wouldn’t be wise to invest in a portfolio of 100% stock if you’ll need the money within the next 5-7 years. Yet, since private equity firms take companies private, they reap the full ownership benefits (profits) and then resell the companies within 5-7 years in the future. During this time period, private equity investors receive equity-like returns in a time period that would only be safe for fixed-income investments.

3. Leverage- Private equity funds take money from investors and then leverage it with bank loans and bond issues from their newly acquired companies to boost returns for their investors. If a private equity firm takes a company private at 10x earnings of 10% per year, it can do very well for its limited partners by leveraging those earnings with cheap debt. It’s kind of like buying real estate, which when leveraged with bank loans, can be an excellent one.

4. Exits- Private equity funds are designed to exist only for a period of spanning less than a decade. When the fund reaches the end of its designed life, it “exits” its holding by selling them. A common exit is to sell a private equity position to a competing firm or to list private companies on the public markets through an IPO.

Why would a company seek private equity financing?

private_equity

Here’s a cycle of private equity financing from a firm’s site. Though this seems more catered to investors and has a rather positive spin on it.

Private equity financing provides several advantages to companies such as the following.

1. Active involvement- Unlike other funding options, private equity firms are much more hands on and will help a company reevaluate every aspect of their business to see how it can maximize its value. Having experienced professionals in a business can also result in major improvements.

2. Incentives- Private equity firms need a business to succeed since they borrow a lot of money to make their investments and have to pay that back and generate a return for their investors. Individual partners in private equity firms often have their own money invested as well and make additional money from performance fees if they make a profit. So they have strong incentive to increase a company’s value.

3. Large amounts of funding- Private equity can provide larger amounts of money than other options since deals are usually measured in hundreds of millions of dollars. This kind of money can have a massive impact on a company.

4. High Returns- Combinations of major funding, expertise, and incentives can be very powerful on companies. According to a 2012 study by the Boston Consulting Group, more than 2/3 of private equity deals resulted in the company’s annual profits grow by at least 20% while nearly half of the deals generated a profit growth of over 50% a year or more.

5. Patient Investors- Since private equity firms invest in a company to make it more valuable within a number of years before selling to a buyer appreciating the lasting value created, their investors are less concerned with short-term performance targets though they do have their eyes on the prize. Sometimes such firms are also known to offer private equity back office services to other firms or companies needing them for investments.

What are the disadvantages of private equity financing?
At the same time, private equity financing come with an array of disadvantages such as the following.

1. Dilution/Loss of Ownership Stake- Other funding options let the owner still stay in control of the company despite the investment’s costs. A company may receive much more money with private equity, but the owner has to give up a large share of the business. Private equity firms often demand a majority stake and sometimes leave the owner with little or nothing in ownership. It’s a bigger trade and one many business owners balk at.

2. Loss of Management Control- Beyond money, a business owner can lose direct control of their company. The private equity firm would want to be actively involved which can be a good thing. But it can mean losing control of basic elements in the business like setting strategy, hiring and firing employees, and choosing the management team. Since the private equity firm’s stake is usually higher, the loss of control is much greater. This is especially true when it comes to the private equity firm’s “exit strategy” which might involve selling the business outright or other options that don’t form part of the owner’s plans. Then there’s the fact that private equity decision-making has been shown to suffer from cognitive bias such as illusion of control and overconfidence.

3. Different Definitions of Value- Private equity firms exist to invest in companies, make them more valuable, and sell their stakes in large profits. Mostly this can be good for the companies involved since any business owner would want to create more value. But a private equity firm’s definition of value is very specific and limited since it’s focused on a business’s financial value on a particular date about 5 years after the initial investment when the firm sells its stake and books a profit. Business owners, by contrast have a much broader definition of value with a longer-term outlook and more concern for relationships with employees and customers as well as reputation. Such difference can lead to clashes.

4. Eligibility- Private equity firms look for particular types of companies to invest in which have to be large enough to support those major investments and offer potential for large profits in a relatively short time frame. This means that a company must have very strong growth potential or it’s in financial difficulties and is currently undervalued. A business that can’t offer investors a lucrative investment within 5 years will struggle to attract interest from private equity firms.

5. Debt Accumulation- Private equity firms use significant amounts of debt to perform deals in financial markets. This can significantly damage not only the company who has to pay for the debt but also to investors and financial markets as well. Not to mention, they charge their companies a bunch of hidden fees. They also make the companies sell their real estate and pay a higher rent to remain on the property, too.

6. Lack of Transparency- Though oversight on private equity firms has increased since 2008, they’re still less regulated than more traditional forms of financing. Private equity also adheres to some practices that alarm politicians. One tactic is a fee-waiver conversion which intentionally directs a greater amount of an investor’s capital away from higher-taxed fees and into a more favorably taxed category.
So what’s with the vulture capitalist reputation?

venture capitalism

Though not all private equity firms are vulture capitalists, there are plenty of large firms that have acquired such reputation. One of these was Mitt Romney’s Bain Capital as you can see on this cartoon chart.

Private equity firms are notorious for making money for their investors without regard to stakeholders in the business. In most cases, private equity firms acquire the kinds of companies that are already in poor financial health, lack a competitive environment, or have poor managers. They want to acquire companies cheap and that means buying companies they believe have more value than Wall Street is willing to realize. Sometimes this means buying companies everyone knows will go out of business. Sometimes a private equity fund performs as advertised using reasonable amounts of debt and providing access to management and expertise and financial resources. This usually involved smaller companies with few assets that can be mortgaged but many opportunities for operational improvements.

kosman_paperback_launch

This is Joshua Kosman. In 2009, he wrote a book called The Buyout of America arguing that private equity firms are terrible and will cause the next credit crisis. In his intro he writes, “I believe the record shows that PE firms hurt their businesses competitively, limit their growth, cut jobs without reinvesting the savings, do not even generate good returns for their investors, and are about to cause the Next Great Credit Crisis. Leadership is needed to rally opposition to close the tax loopholes that make this very damaging activity possible.” So far this year’s retail apocalypse is proving him right.

However, the reality is that private equity firms almost always buy larger and profitable companies that already have modern management systems in place as well as substantial assets that can be mortgaged. Here, private equity firms use debt and financial engineering strategies to extract resources from healthy companies. This earns them a reputation for using strategies that critics say play out more as “vulture capitalism”- a phrase that some people use to describe the process where investors make enormous profits while needlessly laying off workers. Private equity investors may increase their investment in companies they own by replacing senior management, reducing the workforce, selling off assets, and essentially gutting the company for profit. A private equity firm could buy a sizeable company, load it up with debt, and then take the money out. After improving their short-term earnings through cuts, it can borrow money and pay itself a dividend. In good times, it can collect a disproportionate share of the investment returns. But this can set up that company for failure and financial vulnerability. If the debt can’t be repaid, the company, its workers, and its creditors bear the costs. Yet, even when a company fails, a private equity firm still makes money. For instance, from 1987-1995, 22% of the money Bain Capital invested in funds raised went to companies that eventually went bankrupt. But Bain made $578 million, comprising of the bulk of these companies’ profits. Under Mitt Romney, 4 of Bain’s 10 biggest investments ended up bankrupt yet the firm still made a killing. Today, it’s no surprise that private equity activity’s often said to focus on short-term profits over a company’s long term health.

But do they improve businesses? According to author Josh Kosman, that may not be so. Out of the 25 biggest buyouts in the 1990s, 52% of those companies ended up bankrupt. Among the 10 biggest, private equity improved only one of the businesses. In 3 cases, the results were mixed while the other 6 companies would’ve been better off had the private equity firm not acquired them. A report from Moody’s back in 2012 showed that in the 40 biggest leveraged buyouts that took place from 2005-2008, these companies saw a revenue increase by 4% while their strategic peers saw profits rise by 14%.

Another criticism is that studying private equity returns is relatively difficult since private equity funds don’t disclose performance data. As these firms invest in private companies, it’s difficult to examine the underlying investments. Comparing private equity to public equity performance is challenging because private equity fund investments are drawn and returned over time as investments are made and subsequently realized. Commentators have argued that a standard methodology is needed to present an accurate picture of performance, to make individual private equity funds comparable and so the asset class as a whole can be matched against public markets and other types of investment. There’s also a claim that private equity firms manipulate data to present themselves as strong performers, making it even more essential to standardize the industry. It’s even worse that private equity firms aren’t as regulated as banks.

Can you describe some shady private equity firm financial engineering practices?

the-retail-apocalypse-is-being-fueled-by-private-equity-firms-adding-to-debt-loads

Here’s a chart on the rates in which private equity firms have stripped assets on retailers. Much of this took place in the mid-2010s. Through junk bonds and leveraged loans to fund special dividends to PE owners, retail stores have lost billions in their assets. What a shame.

Certainly. After a buyout, private equity firms often engage in financial engineering that further compromise their portfolio companies. They might have companies take out loans at junk bond rates and use the proceeds to pay themselves and their investors a dividend. They might split a real estate rich company into an operating company and a property company. They then sell off the real estate and repay investors while the operating company must lease back the property and pay the (often inflated) rent. As you can see, this is what Eddie Lampert did to Sears. They may require their companies to pay monitoring fees to the PE firm for unspecified services. Paying these fees reduces the companies’ liquidity cushion and puts them at risk.

What happens to portfolio companies and workers?

kkr1

Here is a list of companies private equity firm KKR owns. Some of the these brands you might recognized, especially Toys “R” Us which filed for bankruptcy.

In these situations, financial engineering results are predictable. In bad economic times, these companies’ high debt levels (especially in cyclical industries) make them seriously vulnerable to default and bankruptcy. According to one economic study, roughly a quarter of highly leveraged companies defaulted on their debts during the last recession. Though the financial crisis officially ended in 2009, bankruptcies among PE-owned companies continued through 2015. In 2007, a PE consortium acquired Energy Future Holdings which defaulted with $35.8 million in debt in 2014. In 2006, a PE acquired the Las Vegas-based Caesar Entertainment whose long-term debt more than doubled by mid-2007. In 2015, it declared bankruptcy putting over 30,000 union workers at risk. Rigorous econometric studies back these job loss cases. One study found that through 2005, PE-owned establishments had significantly lower employment and wages post buyout than comparable publicly-traded companies. Though PE-owned establishments experienced higher wages and employment growth than their counterparts in their buyout year. But employment rates at PE-owned companies were 3-6.7% lower after 2 years and 6% lower after 5 years.

What happens to the Limited Partner investors?

NewTycoons1

Here’s another chart detailing which companies private equity owns. Many of these will surprise you. But some of them won’t.

Private equity fund performance depends importantly on how investment returns are measured. Private equity firms use the “internal rate of return” (IRR). Finance economists use the “public market equivalent” which compares returns in PE investments from comparable stock market ones. Recent academic studies find that buyout funds don’t deliver outsized returns to investors. Despite industry claims, private equity funds haven’t beaten the stock market since 2006. A recent study indicates a downward trend in PE performance finding that the median PE fund outperformed the S&P 500 by 1.75% in the 1990s and by 1.5% in the 2000s. Private equity returns also need adjustment for PE investments’ greater riskiness. Industry analysts and most investors assume that private equity fund returns should exceed stock market returns by 3%. More than half of US PE funds have failed to meet that standard over the past 25 years. Average PE returns are upwardly skewed by top quartile funds’ outperformance. But recent research shows it’s no longer possible to predicts which funds will outperform the stock market. GPs with top quartile funds have about a 25-cent chance that their next fund will do the same. Same goes for GPs with bottom quartile funds.

What should the US do about private equity firms?
We must hold our politicians responsible for the looming retail apocalypse. After all, our tax code privileges debt by making corporate interest payments tax-deductible. Private equity firms that gut companies and walk away receive tax subsidies to pull it off. This incentivizes them to borrow even more to run the game again. Even more importantly, we need to look at these asset-stripping schemes with more skepticism. The Securities and Exchange Commission can and should police these designed-to-fail corporate bonds resulting from these leveraged buyouts. The SEC should also go after banks underwriting these deals and earning fees off of companies’ misery.

The House Republican tax bill proposed a cap on deductibility on interest payments over 30% of a company’s earnings. The Senate bill defines earnings in such a way to reduce that cap even further. This should discourage some debt-fueled buyouts which private equity firms don’t like. However, the GOP tax plan exempts real estate companies which leaves a gaping loophole. This could help private equity firms that split their business’s operating side from the property side like Sears did. And enable them to put all the borrowing onto the property side and keep deducting the interest. Not to mention, most of the Republican tax bill is a piece of shit that punishes most Americans who don’t own a yacht. So I wouldn’t advocate the Republican tax plan to crack down on private equity anytime soon.

Nevertheless, don’t expect that Donald Trump will do anything about and we shouldn’t be surprised. The Trump administration will likely continue aiding wealthy financiers through regulatory neglect since those people are their donors. Recently, Comptroller of Currency Keith Noreika broke with a years-long crackdown on high-risk corporate lending, signaling that these private equity firms should issue more debt. It’s a shame we don’t have regulators willing to protect workers, investors, and the economy. Because private equity is accelerating a decline that will affect millions in every major city. To do nothing is to let it continue.

The Legal Loan Sharks Among Us: The Matter of Payday Loans

 

paydayloans-debt-trap.jpg

A loan shark is a person or body offering loans at extremely high interest rates. When we hear the term, we usually think about gangsters who lend money to people but enforce repayment through methods like blackmail and threats of violence. However, what you may not know is that while loan sharks are mostly seen as figures in the criminal underworld and organized, they’re not always seen as crooks linked to the mob, especially in the world of small time and salary lending. Historically, it wasn’t unusual for many moneylenders to skirt between legal and extralegal activity. In late 19th century America, the unprofitability and negative societal perception of small loans paved the way for a slew of lenders offering loans at profitable but at illegally high interest rates under a veneer of legality and preyed upon a borrower’s ignorance of the law. The 1920s and 1930s saw a rise of loan sharks who targeted high risk borrowers and small businesses either in dire straits or ill repute as well as enforced repayment through threats of violence. Sometimes these loan sharks were affiliated organized crime but they never had such monopoly. Today our non-standard lenders consist of subprime loans which led to a global financial crisis and payday lending which are both legal. But both are rather exploitative and prey upon those who can’t qualify for standard loans on mainstream sources. Yet, it’s the payday loans that generally don’t receive the attention they should since they’ve come under tremendous scrutiny as a predatory enterprise and must be stopped. Here I provide a small cheat sheet for explanation.

midwestpaydayloan

It’s likely you may see a lot of payday loan ads like this. A payday loan is a small unsecured loan that’s typically due on the borrower’s payday. However, they tend to have an reputation of high interest rates.

What is a payday loan?

A payday loan is a small short-term unsecured loan that’s typically due on the borrower’s payday. They usually range from $100-$1,500 and are often due 30 days or less. A payday loan relies on the consumer having previous payroll and employment records. In a payday loan, a borrower gives the lender access to their checking account or writes a check for the full balance that the lender has an option to deposit when the loan comes due. Other loan features can vary. Though payday loans are often structured to be paid off in one lump sum payment, interest only payments known as “renewals” or “rollovers” aren’t unusual. In some cases, payday loans may be structured so they’re repayable in installments over a longer period of time. Payday loans usually include a finance that may range from $10-$30 for every $100 borrowed or the check’s percentage value.

legality_of_payday_loans_in_the_united_states_by_state

While payday loans are legal under federal law, state laws may vary. My home state of Pennsylvania is one of the states that prohibits them outright as you can see from the map.

Are payday loans legal in the United States?

At the federal level, yes and payday lenders are subject to regulation by the Consumer Financial Protection Bureau as well as the Federal Trade Commission along with the Truth in Lending Act that requires them to disclose their finance charges. And there are special protections for military servicemen through the Military Lending Act. However legislation regarding payday loans varies widely between different states. As of 2017, payday lending is legal in 27 states, legal with restrictions in 9, and banned in 14 including my home state of Pennsylvania.

How did payday loans come to be?

The history of payday loans can be dated as far as the early 1900s with some small lenders participating in salary purchases, buying a worker’s salary at less than its value days before the scheduled payday in order to avoid usury laws. Loan sharks and the mafia also had their own payday loan schemes starting from the 1920s. In the 1930s, check cashers cashed post-dated checks for a daily fee until the check was negotiated at a later date and began offering payday loan services in the early 1990s. When banking deregulation caused small community banks to go out of business in the late 1980s which, the payday loan industry sprang up in order to fill the void in the microcredit supply at expensive rates. From there, the industry grew from less than 500 storefronts to over 22,000 and a total size of $46 billion. The number has grown even higher over the years that by 2008, payday loan stores nationwide outnumbered Starbucks shops and McDonald’s restaurants. There are also major banks that offer payday loans as well as companies that offer them online. Deregulation also caused states to roll back usury caps and allow lenders to restructure their loans to avoid them after federal laws were changed.

What do I need to qualify for a payday loan?

According to the CFPB, payday lenders generally require you to have an active checking account, provide proof of income from a job or another source, show valid identification, and be at least 18 years old. Some may have additional criteria like minimum time at your current job or a minimum income to qualify for a certain amount.

payday_loan_rollovers_allowed_by_state

Like payday loans themselves, rollovers and renewals on payday loans also have varying legality among the states. However, they’re usually more or less regulated except in Kansas, Utah, and Nevada.

What does it mean to renew or rollover a payday loan?

According to the CFPB, “Generally, renewing or rolling over a payday loan means you pay a fee to delay paying back the loan. This fee does not reduce the amount you owe. If you roll over the loan multiple times, it’s possible to pay several hundred dollars in fees and still owe the amount you borrowed. For example, if you roll over a $300 loan with a $45 fee three times before fully repaying the loan, you will pay four $45 fees, or $180, and you will still owe the $300. So, in that example, you would pay back a total of $480.” Some payday lenders give borrowers this option if they can’t afford to make the payment when it’s due. Nevertheless, this practice is legal in only 14 states and most of them place limits on this save Nevada, Utah, and Kansas.

payday-loans-3

Despite what ads may tell you, most payday loan users are low income workers who usually take them out for recurring expenses over the course of months. This is partly why a lot of users have trouble paying them off.

Who uses payday loans?

According to a Pew study, “Most payday loan borrowers [in the United States] are white, female, and are 25 to 44 years old. However, after controlling for other characteristics, there are five groups that have higher odds of having used a payday loan: those without a four-year college degree; home renters; African Americans; those earning below $40,000 annually; and those who are separated or divorced.” Recent immigrants, Hispanics, and single parents also were more likely to use payday loans. And most borrowers use payday loans to cover ordinary living expenses over the course of months, not unexpected emergencies over the course of weeks (contrary to what the industry states in its ads). So it’s not unusual for borrowers to use more than one. The average borrower is indebted about 5 months a year. In 2013, 12 million people took out payday loans each year.

tumblr_inline_n8k2vmqcco1s27oyr

Payday lenders may claim to help people in tight spots. But they ensure employees to make tough times last forever thanks to obscenely high interest rates that may be impossible for some to pay off.

So why do payday loans have a shady reputation?

Payday lenders are notorious for their predatory lending practices of exorbitant higher fees and interest rates than traditional loans that don’t encourage savings or asset accumulation. According to the CFPB, “The cost of the loan (finance charge) may range from $10 to $30 for every $100 borrowed. A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400%. By comparison, APRs on credit cards can range from about 12 percent to 30 percent.” If that loan’s not paid on time, then the total cost will be much larger than expected $404.56 within 20 weeks or $2,862.22 within 48. The Pew study states that the average payday loan borrower took out 8 loans of $375 each and paid interest of $520 across the loans within a year.

Payday loans are usually marketed towards low-income households because they often can’t provide collateral in order to obtain a low interest loan or lack access to a traditional bank deposit account. Families who use payday loans are disproportionately black or Hispanic, recent immigrants, and/or under-educated since these individuals are least able to secure normal lower-interest-rate forms of credit. The payday loan industry takes advantage of the fact that most of their borrowers don’t know how to calculate their loan’s APR and don’t realize they’re being charged rates up to 390% interest annually. Those higher interest rates are likely to send borrowers into a debt spiral where they must constantly renew. And according to the Center for Responsible Lending, almost of half of payday loan borrowers will default within the first two years. Taking out payday loans also increases the possibility of economic difficulties that make it hard to pay the rent, mortgage, and utility bills. Such difficulties can also lead to homelessness as well as delays in medical and dental care along with the ability to purchase drugs. Since payday lending operations charge higher interest-rates than traditional banks, they have the effect of depleting assets in low-income communities. A consumer advocacy group called the Insight Center reported that payday lending cost the US $774 million a year in 2013.

Payday lenders have also made effective use of the sovereign status of Native American reservations, often forming partnerships with members of a tribe to offer loans over the internet which evade state law. While some tribal lenders are operated by Native Americans, there’s also evidence many are simply a creation of so-called “rent-a-tribe” schemes where a non-Native company sets up operations on tribal lands. The FTC also monitors these lenders as well. And the fact the Military Lending Act imposes a 36% rate cap on tax refund loans and certain payday and auto title loans made to active duty armed forces and their covered dependents as well as prohibits certain terms in such loans illustrates that the payday loan industry has targeted military servicemen.

1-u718_w0wokjhazkw6hrjqg

Payday loans are often a debt trap since they target people who can least afford to pay them back. And such debt may lead borrowers to take in more payday loans ensuring a vicious cycle to continue.

How are payday loans a debt trap?

A debt trapped is defined as “a situation in which a debt is difficult or impossible to repay, typically because high interest payments prevent repayment of the principal.” According to the Center for Responsible Lending, 76% of the total volume of payday loans are due to loan churning, where loans are taken out within two weeks of a previous loan. The center states that the devotion of 25-50% of the borrower’s paychecks leaves most borrowers with inadequate funds, compelling them to take new payday loans immediately. And they will continue to pay high percentages to float the loan across longer time periods, effectively placing them in a financial hole.

How do payday loans affect the economy?

Payday loans actually hurt the economy. Though they’re designed to provide consumers with emergency liquidity (despite being normally used to meet normal recurring obligations), payday loans divert money away from consumer spending and towards paying interest rates which can range from 200-500%. In 2011, payday loans cost the US $774 million in consumer spending, $169 million in 56,230 bankruptcies, and 14,000 jobs. States that have outlawed payday lending have lower rates of bankruptcy, a smaller volume of complaints regarding collection tactics, and the development of new lending services from banks to credit unions.

How long does it take to pay off a payday loan?

Borrowers typically have payday loan debt for much longer than the loan’s advertised two-week period, averaging about 200 days. Though most borrowers do know when they’ll pay them off and about 60% of them pay off their loans within two weeks of the days they predict.

default-payday-loan1

Payday lenders can be quite ruthless when it comes to collecting the debts. On some occasions, payday lenders have threatened borrowers with legal action that has led to a small percentage serving jail time.

How do payday lenders collect on loans?

Under federal law, a payday lender can use only the same industry standard collection practices used to collect other debts specifically standards listed under the Fair Debt Collection Practices Act (FDCPA). The FDCPA forbids debt collectors from using abusive, unfair, and deceptive practices to collect from debtors. Such practices include calling before 8 o’clock in the morning or after 9 o’clock at night, or calling debtors at work. In many cases, borrowers write a post-dated check to the lender and if they don’t have enough money in their account by the check’s date, it will bounce. When that happens, payday lenders will usually attempt to collect on the consumer’s obligation first by simply requesting payment. If internal collection fails, some payday lenders may outsource the debt collection or sell that debt to a third party. Yet, a small percentage of payday lenders have in the past threatened delinquent borrowers with criminal prosecution for check fraud which is illegal in many jurisdictions. But over a third of states in 2011 allowed late borrowers to be jailed despite the fact that debtor’s prisons have been federally outlawed since 1833.

Then there’s the matter with Texas, which prohibits payday lenders from suing a borrower for theft if the check is post-dated. But lenders get their customers to write checks for the day the loan is given knowing that they’d bounce since the borrowers didn’t have any money. If the borrower fails to pay on the due date, the lender sues them for writing a hot check. Sometimes they can file criminal complaints. This has led Texas courts and prosecutors becoming de facto collections agencies that warn borrowers they could face arrest, criminal charges, jail time, and fines. On top of debts owed, district attorneys charge additional fees. Borrowers have been jailed for owing as little as $200 and most of them who failed to pay had lost their jobs or had their hours reduced at work.

alternatives-to-payday-loans-_hoyes-542x1024

There are several alternatives to payday loans whether it means borrowing money from work or from friends or taking money from a credit union. However, if you need some fast cash before your next payday, it’s better to pay a late fee on your bills than take a payday loan. Because payday loans are nothing but high interest debt traps.

Are there any alternatives to payday lending?

Yes, there are. Credit union loans have lower interest but more stringent terms that take longer to gain approval, employee access to earned but unpaid wages, pawnbrokers, credit payment plans, paycheck cash advances from employers (“advance on salary”), auto pawn loans, bank overdraft protection, cash advances from credit cards, emergency community assistance plans, small consumer loans, installment loans and direct loans from family or friends. Those who own a car can go with an auto title loan which uses the equity of the vehicle as the credit instead of payment history and employment history. You can also take advantage overdraft protection at your bank, establish a line of credit from an FDIC-approved lender. However, if you should consider taking payday loans, always consider the alternatives or at least try to avoid taking them. So if you need to pay your bills before payday, a late fee might be cheaper than a payday loan finance charge.

1j

Yes, payday loans work like that. So remember, if you’re a low income worker in need of money, don’t be embarrassed to ask for help from a friend or employer. Chances are they’d probably not put you through financial hell like the predatory payday loan business. I mean such

Money Is Not Speech: Why We Must Get Rid of Citizens United

220px-adbusters_flag1

As it’s become apparent that the 2016 US presidential election campaigns are in full swing, I would like to devote a post to the issue of campaign finance. As 2016 draws upon us, we should expect to see more political ads in the media featuring candidates asking us to cast their votes. Now discussing campaign campaign finance may not be as interesting as other issues the media and the populace like to talk about. But in our day in age, it’s apparent that money has a profound influence in political policy in the United States. Wait a minute, money has a profound influence in pretty much everything. It’s just money has a higher influence in politics than most walks of life. While political candidates may act like prima donnas now and then, we need to note that it’s through elections that we choose our government leaders. Whoever’s in government usually shapes social policy. And social policies affect our lives in more ways that we’d like to admit. So yes, money does play a crucial role in politics, especially when it pertains to who’s giving it.

Yes, elections are decided by voters. But if you want to run for office, you will need to promote yourself and convince voters to go for you. That costs money. So this is where campaign financing comes in.

Yes, elections are decided by voters. But if you want to run for office, you will need to promote yourself and convince voters to go for you. That costs money. So this is where campaign financing, fundraising, and donations come in.

But aren’t elections decided by votes? Absolutely. And doesn’t everyone have only one vote? Sure. However, if you want to run for elected office, you need to promote yourself as a candidate in your constituency. To do that, you need to tell voters who you are and why they should choose you some time before the election actually takes place. In our mass media culture, it’s best you start early. Now candidates promote themselves in a variety of different ways like personal appearances, endorsements, and advertising through signs, mailings, social media, newspapers, radio, television, the works. All that costs money. So how will get it? From anyone willing to give it to you which is the reason why candidates hold fundraisers as well as have mass mailings to solicit donations.

This chart shows who received the most campaign funds in the 2010 midterm elections. Since donors tend to have some relationship with elected officials, it's no surprise that most donations go to incumbents. And it's no wonder that incumbents usually win. Even in Congress which has a 90% reelection rate.

This chart shows who received the most campaign funds in the 2010 midterm elections. Since donors tend to have some relationship with elected officials, it’s no surprise that most donations go to incumbents. And it’s no wonder that incumbents usually win. Even in Congress which has a 90% reelection rate.

However, although every US voter is equal in electoral value, they are not all equal financially nor as willing to give money to a political candidate. In fact, more than 90% voters don’t since well, they either can’t afford to or don’t have much interest to. Giving money to a political candidate isn’t like giving to a church, charity, PBS station, non-profit, college, or cultural establishment. You aren’t giving money because you have an affinity for it or want to do something good. No, people give money to political candidates because they want them to win so they can put forth social policy that they want. Still, even among those who contribute to political campaigns, most will contribute no more than $200, while some will donate hundreds or thousands. If you’re a political candidate, chances are you’re going to actively seek political donations from the entities who contribute the most campaign cash. In 2010, small donors only contributed to 13% to congressional candidate funds (which doesn’t include PACs that make up 23%). Large donors contributed to 48% of campaign donations. But here’s the thing, most big money donors won’t just hand you a large chunk of cash right off the bat. No, for before they give you the money, they want to know where you stand on the issues and what you’d be willing to do for their interests. And you’ll have to curry to their good graces by promising them that you will do everything you can to please them once elected. If you think it’s a form of bribery, you’re probably right. Yet, as far as I know it’s perfectly legal. Nevertheless, the more big money donations you have, the more you can spend on campaign advertising. And the more you can spend on advertising, the more likely people will vote for you. So everything’s fine, right?

Here's an infographic on the 2012 presidential election between Barack Obama and Mitt Romney showing where the money came from in their campaigns. However, while Romney managed to raise more money, Obama still won reelection.

Here’s an infographic on the 2012 presidential election between Barack Obama and Mitt Romney showing where the money came from in their campaigns. However, while Romney managed to raise more money, Obama still won reelection.

Well, not really. While government officials are elected to represent the people and fulfill campaign promises, we all know all too well that it’s not exactly the case. Yes, candidates make promises on the trail to get them to vote for you. But that doesn’t mean all will be fulfilled, given the realities of the political landscape. But since these rich donors give money to these candidates, then they believe in the issues they stand for, right? Actually it depends on the contributor. Sure there are donors who do contribute money to those who share their views or party affiliation. But there are plenty of other donors who just want to gain political influence and will contribute to any candidates regardless of party or issue stance (even in the same race). All they care about is having friendly access the candidate so they could support measures they want, even if their wishes contradict the campaign promises and party platform. They may even contribute money because you oppose their interests and just want you to keep quiet. Hell, they don’t care if their wishes works against the candidate’s conscience or their constituents. And sometimes not even the laws. Of course, while this may put some politicians in a dilemma, many tend to follow the wishes of these big contributors to keep their cash flowing. After all, they need the money for reelection and don’t want the other guy to have more influence and capital than them. But do these political money deals benefit the American people?

During the 2010 elections, the biggest sources of campaign funds came from large individual donations consisting of 48%. Small donations from individuals only consisted of 13% of funds. PACs contributed 23%.

During the 2010 elections, the biggest sources of campaign funds came from large individual donations consisting of 48%. Small donations from individuals only consisted of 13% of funds. PACs contributed 23%.

Actually no. The fact that politicians are more likely to listen to large donors than their constituents suggests that there’s something very wrong in our political system. Yes, people elect their government officials but since they depend on campaign contributions to promote themselves, they usually tend to side with their backers who tend to have their very own lobbyists. After all, most incumbents usually get reelected so those voters aren’t going anywhere. Besides, the biggest incumbent supporters are usually long term donors they’ve had a relationship with every election year. To them, giving is a way of life and a cost of doing business all for the sake of having access to a politician, which leads to more power and influence on policy. But some of these donors can be fickle and might shift their money to the politicians in the majority party whenever the balance of power changes. And it doesn’t help that the fundraising never stops since an successful US Congressional campaign costs $1.4 million on average. But US Congressmen are elected every 2 years so it’s a rather short time window. And US Senate campaigns cost more than 6 times as much. But as money becomes more important in politics, the politicians seem more like a lackey to their rich overlords than the constituents who they’re supposed to represent. This leads to most of the American people having a considerable less political influence in politics, less access to lawmakers, and less of a chance of having their interests heard. More often than not, they become nothing but mere pawns who tend to cast their vote against candidates who may not represent their best interests for various reasons. But it’s mostly because they either know the guy, party line, or that they have no other choice. Thus, as big donors tend to have more access to politicians, American citizens lose out.

While the Federal Election Commission is supposed to oversee campaign regulations, it was designed as an ineffective organization from day one. The fact our system can't create agencies without congressional approval kind of explains why. Because  Congressman have to be elected.

While the Federal Election Commission is supposed to oversee campaign regulations, it was designed as an ineffective organization from day one. The fact our system can’t create agencies without congressional approval kind of explains why. Because Congressman have to be elected.

But don’t they have rules and regulations on campaign finance? We have a Federal Election Commission (FEC) that’s supposed to enforce and oversee campaign finance laws, it’s notoriously ineffective. However, as an organization that’s supposed to monitor lawmaker behavior, it’s no surprise that it was designed this way even if it was created in response to Watergate. And being the elected politicians they were, lawmakers made sure that the campaign watchdog would have a very tight leash and interfere as little in their campaigns as possible. I mean they set the FEC up as a 6 member body so no ruling can go into effect without a 4 vote majority. This is often impossible since the FEC is evenly split with 3 Republican as well as 3 Democratic commissioners, each nominated by their respective parties. Tie votes are often commonplace on some of the most important campaign finance issues which make the system riddled with loopholes. Because of this, the agency often takes years to resolve complaints and political operatives have learned that they can live on the edge of the law with little fear or interference from the FEC. And judging by the political culture these days, I’m sure the people behind the FEC knew what they were doing.

In 2010, the Supreme Court ruled in favor of Citizens United which stated since money is speech, then corporations and unions should contribute as much as they want to political campaigns. Unfortunately, not everyone has money and such notions basically keep many Americans from having a political voice. And it's apparent that most Americans don't like it.

In 2010, the Supreme Court ruled in favor of Citizens United which stated since money is speech, then corporations and unions should contribute as much as they want to political campaigns. Unfortunately, not everyone has money and such notions basically keep many Americans from having a political voice. And it’s apparent that most Americans don’t like it.

Still, despite it’s reputation, the FEC is quite effective with improving disclosure for campaign contributions for the most part. But even this has its limitations. And then there’s the matter with the Citizens United Supreme Court case in 2010, which did away with many campaign finance laws already on the books as well as opened up unlimited spending by corporations, unions, and other independent groups. This led to the 2010 elections seeing an unprecedented flood of outside money flowing into congressional races all over the country. Tens of millions of dollars came from secret donors whose identities will never be known. Much of this campaign spending goes to funding political advertisements to elect (or defeat) candidates running for office. However, the money in question can only be used for independent expenditures (not direct contributions to the candidates’ campaigns). And whatever ads are produced can’t be coordinated with the candidates. Of course, it’s no small stretch to say that such measures aren’t always enforced. Thus, rich donors didn’t particularly give a shit since they want to contribute as much money as they want with little or no consequence. However, they didn’t win when it came to disclosing political contributions on account that their right to privacy isn’t as important as the public’s right to know who’s funding who if amount is over $200. The Supreme Court has also said that disclosing campaign contributions is the best way to guard against political corruption. Of course, this brings me to the outside political organizations created to raise campaign funds for elections:

This is the logo for a realtors' political action committee or PAC. It's supposed to pool contributions from members to contribute to political purposes. According to federal law, an organization becomes a PAC when it receives or spends more than $2,600.

This is the logo for a realtors’ political action committee or PAC. It’s supposed to pool contributions from members to contribute to political purposes. According to federal law, an organization becomes a PAC when it receives or spends more than $2,600.

PAC (political action committee)- an organization designed to specifically pool campaign contributions from members to donate for political purposes whether it’s to campaigns for or against a candidates, ballot initiatives, or legislation. According to the Federal Election Campaign Act (FECA), at the US federal level, an organization becomes a PAC when it receives or spends more than $2,600 for the purpose of influencing a federal election. As for state level, the money pertaining to state elections in PAC designation varies. There are many types depending on political purposes and how each one spends their money. Still, you’d see at least one in almost every type of political advocacy organization you could think of. However, PACs have to follow certain criteria which includes:

  1. Though corporations and labor unions may sponsor a PAC as well as provide financial support through administration and fundraising, they can’t contribute through their own treasuries.
  2. Union-affiliated PACs may only solicit contributions from members.
  3. Independent PACs may solicit contributions from the general public and must pay their own costs from those funds.
  4. Federal multi-candidate PACs may contribute to candidates as follows:
  • $5,000 to a candidate committee for each election (primary and general elections count as separate elections)
  • $15,000 to a political party per year
  • $5,000 to another PAC per year
  • PACs may makes unlimited expenditures independently of a candidate or political party

The types of PACs consist of the following:

This is the United Steelworkers PAC which is an example of a connected PAC. These are sponsored by corporations and unions. These can only raise money from a

This is the United Steelworkers PAC which is an example of a connected PAC. These are sponsored by corporations and unions. These can only raise money from a “restricted class” of donors though the entities can pay for the administrative costs and fundraisers. For instance since the United Steelworkers is a union, it can only receive money from its own members.

Connected PACs- designated as “separate segregated fund” (SSF), these are sponsored by labor unions and corporations. These PACs may only raise money from a “restricted class” generally consisting of managers and shareholders for corporations and members for unions and other interest groups. Sponsor may not contribute to the PAC directly but can absorb costs of administrative operations and soliciting contributions. As of 2009, there were 1,598 registered corporate PACs, 272 related to labor unions, and 995 to trade organizations.

This Free Enterprise PAC from Idaho is an example of a non-connected PAC, used by politicians, parties, and ideology groups. Unlike connected PACs, they must pay their administrative expenses through donations but may accept funds by anybody. It's one of the fastest growing categories in campaign finance.

This Free Enterprise PAC from Idaho is an example of a non-connected PAC, used by politicians, parties, and ideology groups. Unlike connected PACs, they must pay their administrative expenses through donations but may accept funds by anybody. It’s one of the fastest growing categories in campaign finance.

Non-Connected PACs- basically financially independent PACs that must pay for its own administrative expenses with contributions it raises. May be financially supported by an organization but such expenditures are considered PAC money which are subject to the dollar limits and other requirements of FECA. May accept funds from any individual, connected PAC, or organization. Used by members of Congress, political leaders, ideology, and single-issue groups. As of 2009, there were 1,594 registered, the fastest growing category.

Now this is CAPAC which is a PAC for Asian and Pacific Islander Americans in Congress. This is an example of a leadership PAC sponsored by political parties and elected officials. Now these can't be used to fund an official's own campaign but they can fund other expenses.

Now this is CAPAC which is a PAC for Asian and Pacific Islander Americans in Congress. This is an example of a leadership PAC sponsored by political parties and elected officials. Now these can’t be used to fund an official’s own campaign but they can fund other expenses.

Leadership PACs- non-connected PACs sponsored by elected officials and political parties with independent expenditures, which isn’t limited (as long as it isn’t coordinated with the other candidate). Nor can they be used to support the official’s own campaign. Set up since elected officials and political parties can’t give more than the federal limit directly to candidates. Can fund travel, administrative expenses, consultants, polling, and other non-campaign expenses. Used by dominant parties to capture seats from other parties. Between 2008 to 2009, these have raised more than $47 million.

Of course, this is Stephen Colbert's Super PAC, which started appearing after the Citizens United ruling. Now these may not contribute or coordinate directly to candidates or campaigns. But there is no legal limit on contributions it can receive. As of August 2012, these have raised over $349 million with 60% from just 100 donors.

Of course, this is Stephen Colbert’s Super PAC, which started appearing after the Citizens United ruling. Now these may not contribute or coordinate directly to candidates or campaigns. But there is no legal limit on contributions it can receive. As of August 2012, these have raised over $349 million with 60% from just 100 donors.

Super PACs- Citizens United gave rise to this new kind of PAC designated as “independent-expenditure only committees,” because they may not make contributions to campaigns or parties directly but can generate any political spending independently of the campaigns. Unlike other PACs, there is no legal limit on funds they can raise from individuals, corporations, unions and other groups, provided they are operated correctly. As of August 2012, 797 of these have raised $349 million, with 60% of that money coming from just 100 donors, according to the Center of Responsive Politics. Also, Stephen Colbert started his own Super PAC for his show to inform his viewers how it’s done (but he donated all the money he raised to charity).

Aside from the PACs, there are some other organizations and entities also known to raise money for political campaigns as I list below:

Crossroads GPS is one of many 501(c)(4)s that have appeared after the Citizens United ruling. Considered

Crossroads GPS is one of many 501(c)(4)s that have appeared after the Citizens United ruling. Considered “social welfare” organizations under the IRS, they can only use 49.9% of their contributions for political purposes. Can accept unlimited contributions as well as aren’t required to disclose their donors. In 2012, Crossroads GPS and Americans for Prosperity raised more money into the presidential campaigns than all of the Super PACs combined.

501(c)(4) Organizations- defined by the IRS as “social welfare” non-profit and tax-exempt organizations but may also participate in political campaigns and elections. That is, as long as its “primary purpose” it promoting social welfare and not political advocacy (50.1% of their spending efforts much go to “social welfare” activities or “promoting in some way the common good and general welfare of the people of the community.”) Like Super PACs they can accept unlimited amounts of money from corporations, unions, or other interest groups. However, they are not required to disclose spending on their political activity or information on their donors unless they give for the express purpose of political advocacy. Traditionally these have been civic leagues promoting social welfare or local associations of employees with limited memberships to a designated company or a municipality or neighborhood. And often these net earnings went exclusively to charitable, educational, or recreational purposes. Groups like Planned Parenthood, the National Rifle Association, the NAACP, the National Organization for Marriage, the Sierra Club, and the League of Conservation Voters have been active in lobbying and have long held 501(c)(4) status before 2010. Citizens United has seen a dramatic rise of these organizations that contributed to a sharp increase in outside campaign spending from undisclosed sources from a bit more than 1% ($700,000) in 2006 to 44% ($1.27 million) in 2010. In 2012, that number was more than $308 million. And as far as we know much of this anonymous donor money went to Republican organizations and candidates since it helped topple the Democrats in Congress that year. And as of August 2012, two of the biggest 501(c)(4) organizations (Crossroads GPS and Americans for Prosperity) put more money into the presidential campaign than all the Super PACs combined, according to Pro Publica. However, these two groups were much less successful in that year’s presidential election (because Obama still won). Along with Super PACs, it’s also said that these organizations tend to coordinate among themselves and each other. Nevertheless, almost every advocacy organization has one. Also, Stephen Colbert talked about these on his show as well.

MoveOn.org is a famous example of a 527 organization. These are tax-exempt and not regulated under federal and state election laws. Mostly because they don't

MoveOn.org is a famous example of a 527 organization. These are tax-exempt and not regulated under federal and state election laws. Mostly because they don’t “expressly advise” whether to elect or defeat a candidate or party (officially). Can receive unlimited donations from anyone and there are no limits. However, they are required to file with the IRS and report independent expenditures.

527 Organizations- tax-exempt organizations which aren’t regulated under state and federal campaign finance laws because they do not “expressly advocate” the election or defeat of a particular candidate or party. When operated within the law, there are no limits on contributions to these groups or restrictions on who may contribute. Nor are they subject to spending limits either. However, they must register with the IRS, disclose their donors, and file periodic reports of contributions and expenditures.

Political Parties- while they may do more than just raise campaign cash, national and state party committees may contribute funds directly to candidates and make additional “coordinated expenditures” for their nominees in general elections. But these are subject to FECA limits. However, national party committees may make unlimited “independent expenditures” to support or oppose federal candidates. Nevertheless, since 2002, national party committees have been prohibited from accepting any funds outside FECA limits.

Here's an infographic on the bundler contributions in the presidential elections. These are individuals who raise money from other contributions and present the sum to the campaign.  However, while disclosing them isn't required, they are likely to be appointed to posts in presidential administrations.

Here’s an infographic on the bundler contributions in the presidential elections. These are individuals who raise money from other contributions and present the sum to the campaign. However, while disclosing them isn’t required, they are likely to be appointed to posts in presidential administrations.

Bundlers- actually these are individuals who can gather contributions from many individuals in an organization or community and present that sum to the campaign. They’re often recognized with honorary titles and sometimes exclusive events featuring the candidate. It has evolved into a more structured form in the 2000s and we know that all high profile candidates use them. However, there’s currently no law requiring disclosure of campaign bundlers as long as they’re not active, federally registered lobbyists. Nevertheless, the amount raised by bundlers has grown significantly with each election year with average contributions to winning presidential candidates reaching $186.5 million in 2012. We should also note that bundlers are more likely to be appointed to administration posts. In the Obama administration, it’s apparent that 80% of those collecting over $500,000 took key administration posts. George W. Bush appointed about 200 bundlers to posts in his administration.

I know writing about this campaign finance stuff might seem boring and meaningless to you in our political process. But it’s not. In fact, knowing about such organizations can explain how campaign donations for elections shapes the political landscape. Besides, noting how campaign finance works tends to explain a lot about what’s going on in this country. The rise in political activity pertaining to 501(c)(4)s was what led to the IRS scandal in 2013 as employees tried to create ways to weed out organizations that applied for 501(c)(4) status for being overly political. Their methods might not have been specifically appropriate but you really couldn’t blame the IRS for suspecting certain applicants of being overly political, particularly if they support conservative or Tea Party policies. This is especially the case if the recent 501(c)(4)s like Karl Rove’s Crossroads GPS and the Koch Brothers’ Americans Prosperity which many people seem to believe as having little to do with promoting the social welfare whatsoever. Following the money in Washington also explains other recent events as well. Powerful healthcare lobbies help explain why it was so difficult for Democrats to pass the Affordable Care Act despite a Democratic presidential administration and significant control of both congressional houses. The significant influence of the Koch Brothers and industry on Washington help explain the pervasive influence of climate change denial among Republican politicians and why so many polluters shift clean up costs to taxpayers during environmental disasters. And the NRA’s influence helps explain why no gun control legislation has ever been passed in either congressional house, despite the prevalence of mass shootings in recent years.

Open Secrets.org has this diagram of how much campaign cash each sector contributes between 1990-2010. The fact the financial sector contributes the most money offers a great explanation why almost no one involved in the Wall Street collapse in 2008 was prosecuted.

Open Secrets.org has this diagram of how much campaign cash each sector contributes between 1990-2010. The fact the financial sector contributes the most money offers a great explanation why almost no one involved in the Wall Street collapse in 2008 was prosecuted.

But what the nature of campaign finance really helps explain is the relationship between Washington and Wall Street. The fact that the financial sector tends to be the largest contributor to federal office candidates and parties explains why the federal government has been so reluctant to prosecute Wall Street after the 2008 recession. It helps explain why many Republicans have vociferously opposed raising taxes and instilling regulation but supported bailouts. Yet, the financial sector also contributes money to Democrats which doesn’t make passing financial reform on Capitol Hill any easier. Just so you know, the financial sector contributed $468.8 million to federal campaigns and candidates in 2008 alone (80% more than in 2006) and has spent more on K Street lobbying than any other sector. As of 2014, the financial sector has spent nearly $500 on lobbying as well reports 855 clients and 2,358 lobbyists. Thus, it’s a very powerful influence in Washington as well as a very corrupting one. Wall Street’s dubious practices basically led to an economic collapse and recession in 2008 as well as put so many people in financial ruin, possibly for the rest of their lives. But because of the financial sector’s hold on Washington, the federal government walks a fine line between its obligation to the general public and the desires of powerful backers many of them committed actions that should’ve put them in jail.

This is an infographic from the Center for Media and Democracy explaining how ALEC works. Now it calls itself a nonprofit and nonpartisan organization. However, it's really a business friendly conservative bill mill. Let's just say, even if you disagree with my politics, this is a very powerful lobby whose activities should concern you.

This is an infographic from the Center for Media and Democracy explaining how ALEC works. Now it calls itself a nonprofit and nonpartisan organization. However, it’s really a business friendly conservative bill mill. Let’s just say, even if you disagree with my politics, this is a very powerful lobby whose activities should concern you.

Still, while this post appears to focus on the nature of campaign finance in Washington, the corrupting influence of the political money culture doesn’t just affect the federal government alone. State governments have their officials supported by the same kind individuals and organizations with the same agendas and in very much the same way. Of course, what’s different at the state level is voters can elect more people to office like high court justices and cabinet positions. However, there’s a special nonprofit organization founded in the 1970s called the American Legislative Exchange Council (ALEC) consisting of state legislators and private sector representatives. Now according to ProPublica, ALEC is said to produce model legislation that is heavily influenced by big business and industry as well as “works to advance the fundamental principles of free-market enterprise, limited government, and federalism at the state level through a nonpartisan public-private partnership of America’s state legislators, members of the private sector and the general public.” Each year almost 1,000 bills based on ALEC’s “model” legislation are introduced in state houses across the country of which about 200 become law. Now these ALEC sponsored bills advocate a wide range of measures like reducing corporate regulation and taxation, combating illegal immigration, loosening environmental regulations, preventing Medicaid expansions and other state-related Obamacare policies, reducing pensions for public employees, retaining the minimum wage, privatizing prisons as well as enacting harsh sentencing laws, deregulating the telecom industry, privatizing public education, tightening voter identification rules, weakening labor unions, and promoting gun rights. It also acts as a networking tool among Republican state legislators, allowing them to research conservative policies implemented in other states. Not to mention, it’s funded almost exclusively by big business.As of 2013, ALEC’s membership consists of 1,810 state legislators representing nearly a quarter of legislative seats in the US as well as 300 corporate, foundation, and private-sector members.

Now this is a rough diagram explaining how ALEC works and its appeal among corporations and politicians. Now ALEC helps give each entity what they want on an expense paid vacations and parties. Corporations get legislation tailored to their interests and access to politicians. And politicians gain access to campaign funds and private sector jobs.

Now this is a rough diagram explaining how ALEC works and its appeal among corporations and politicians. Now ALEC helps give each entity what they want on an expense paid vacations and parties. Corporations get legislation tailored to their interests and access to politicians. And politicians gain access to campaign funds and private sector jobs.

Now it’s very simple to explain why politicians and private entities would want to join this organization if you know a anything about campaign finance. ALEC allows state legislators to be acquainted with potential campaign backers while it helps corporations gain access to and form long term relationships with politicians.They also hold meetings on all expense paid trips in cities across the country that are said to resemble vacations (sometimes funded by taxpayer money by the way). Another way to explain its appeal was how it helps draft model bills through task forces during their meetings. Public and private sector members make up each of their task forces with the later typically being corporate or think tank representatives (who have veto power over drafted model bills). These task forces generate model bills that members can customize an introduce for debate in their own state houses after being approved by their board of directors who comprise of all legislators. In your 2016 Republican lineup, ALEC-related contributions have gone to Marco Rubio, Bobby Jindal, John Kasich, Lindsey Graham, Rick Perry, and Scott Walker as well as held some considerable influence in Chris Christie’s gubernatorial administration in New Jersey. Nevertheless, it’s a hugely influential lobbying organization in the states which it has always denied to keep its tax-exempt status. Yet, what it does can be seen by most Americans as nothing but the very definition of lobbying. But media scrutiny has grown after being publicized by liberal groups and news outlets like The New York Times and Bloomberg Businessweek since 2011 and for a good reason.

As a conservative bill mill, ALEC produces model bills through the collaboration between state legislators, right wing special interests, and corporations. So far, it's apparent that ALEC's model bills have done absolutely nothing to benefit the public. In fact, they've impacted a considerable degree of harm.

As a conservative bill mill, ALEC produces model bills through the collaboration between state legislators, right wing special interests, and corporations. So far, it’s apparent that ALEC’s model bills have done absolutely nothing to benefit the public. In fact, they’ve impacted a considerable degree of harm.

However, while I might pick on ALEC for supporting measures I think hurt this country, I think all Americans should be very concerned about this organization regardless of their politics. Because if their politics doesn’t trouble you, its conduct should since this conservative bill mill is well known for its lack of transparency. Since the 2000s many news organizations have found that ALEC hasn’t been friendly to reporters much and usually doesn’t grant interviews. They may open policy seminars to reporters and other nonmembers but they will receive public conference agendas that don’t include names of presenters, the lists of legislative and private-sector board chairs, or the meetings’ corporate sponsors. Task-force meetings and bill-drafting sessions are held behind closed doors mostly taking place at high end hotels in American cities, which resulted in reporters being turned away. ALEC doesn’t disclose membership lists or the origins of its model bills. Instead lawmakers generally propose ALEC-drafted bills without disclosing authorship as an newspaper found out in 2012 after analyzing 100 bills proposed by the Christie administration in New Jersey.

Besides being a conservative bill mill producing

Besides being a conservative bill mill producing “model legislation” for state lawmakers to pass into law, ALEC’s reputation for lack of transparency should also concern you. Such activities are undemocratic as well as possibly unconstitutional. Sure ALEC may give corporations a voice and a vote, but it also goes to great lengths to deny a say to anyone who potentially disagrees with them. All it cares about is promoting its own agenda.

Now it’s one thing for businesses to lobby for business friendly legislation drafted in the state house committee. But a lobbying organization drafting model bills behind closed doors for lawmakers to introduce and adopt them without disclosure seems like a violation of the democratic process, if not then the US Constitution. In fact, I’m not sure if the idea of a political organization drafting a model bill in secrecy is even legal or ethical, especially if it promotes legislation benefiting big business at the public expense. It also excludes not just Democratic legislators but also the American people from having a say in drafting legislation, which ALEC puts in highly partisan politicians and private sector hands. And in many ways, I see ALEC’s methods of secrecy as as a way for corporations and politicians to put their legislative ideas forward and avoid public scrutiny by opposing forces like liberals, the media, or the American public. But while public scrutiny can be annoying and disruptive, it’s an essential component in our democracy which should never by taken away even by some private and right-wing lobbying organization. While ALEC claims that their organization is supposed to give corporations a voice and a vote, they also want to make sure to deny a voice to anyone who potentially disagrees with them. It also shows that this organization only cares about enacting its own agenda and would do so through any means necessary. It doesn’t care whether its proposed legislation works at the public interest’s expense to enhance corporate profits. Not only that, but this organization has existed for over 40 years and prior to 2011, almost nobody knew it existed outside its membership until investigative reporters blew the whistle on it. And as of 2015, there are still people who’ve never heard of this organization. Now people have talked about certain shadow government organizations as the stuff of conspiracy theories such as the Illuminati. But ALEC is a real organization that functions exactly like one that reflects the relationship between money and politics at its worst. However, thanks to investigative reporting exposing the organization, ALEC has become a toxic brand as well as experienced an exodus of politicians and corporations.

In recent years, the influence of money in politics has made elections much more expensive. This chart shows the increase shows the rising costs of beating an incumbent in Congress. Really disturbing, I know.

In recent years, the influence of money in politics has made elections much more expensive. This chart shows the increase shows the rising costs of beating an incumbent in Congress. Really disturbing, I know.

Now I understand that American campaigns will always be tied to money and special interests to a certain extent even if I may not always like it. However, we need to understand that corporations are not people and money isn’t speech. Nor should political access and influence be a pay to play field. Yes, money buys influence and influence buys votes. But sometimes political money games prevent a substantial number of citizens from having a political voice in their governments all because they don’t contribute thousands of dollars to their representatives. And I mean at the state and federal level. Sure I know that liberals aren’t above these political shenanigans either as I’m well aware of it. But we have to understand that most big money contributors are more likely to support Republican policies, especially since most campaign donations come from big business. And since 2010, those who’ve benefited from Citizens United and its impact have been Republican politicians. Besides, as far as I know, the Democratic Party doesn’t have its own shadow government organization generating model bills for them. Or at least one as powerful or influential as ALEC. Thus, my focus on contributions and lobbies in Republican campaigns is based on more than my liberal political biases here. But the growing influence of money in politics hasn’t been good to our democracy its created a system where incumbents almost always win, the races are not even competitive, politicians are at the mercy of big donors and their lobbyists, and a significant chunk of Americans feeling like they don’t matter in the political system.

Since incumbents usually have more connections to donors and name recognition, this makes it difficult for anyone to challenge them. This chart shows how most 2010 congressional races usually have one candidate outspending their opponents 10 to 1.

Since incumbents usually have more connections to donors and name recognition, this makes it difficult for anyone to challenge them. This chart shows how most 2010 congressional races usually have one candidate outspending their opponents more than 10 to 1.

Now I know politicians don’t want to implement campaign finance reform since it hurts their self-interests. But since money tends to talk, we need regulations to keep those with the big money at bay. Or else such influence might make us wonder whether our political representatives work for the voters who elected them or the donors who bankroll them that consist of a wealthy few. Yes, I know that some people don’t like regulations they think infringes on their rights. But regulations also protect the rights of those who may otherwise be sidelined by the rich and powerful special interests. And powerful special interests care more about themselves and don’t care if the public has to suffer for policies they want passed. Besides, we want our elections to be fair while big money tends to offset the balance, especially in races involving incumbents who have access to considerable financial resources. Our country was founded on freedom of the people, by the people, and for the people with a government to promote the general welfare and secure the blessings of liberty, for ourselves and posterity. And if we want that, we need to acknowledge and do what we can to keep big money from undermining these ideals. Yes, I know that money is necessary for everything, but it doesn’t have to be the bottom line in politics or how representatives conduct their business. We can start with overturning Citizens United so we can set limits on campaign spending by corporations because we need to.

To learn more:

OpenSecrets.org: The Center for Responsive Politics OpenSecrets.org: Money in Politics — See Who’s Giving & Who’s Getting

ALEC Exposed from the Center for Media and Democracy ALEC Exposed

Why We Can’t End the Fed

Marriner_S._Eccles_Federal_Reserve_Board_Building

I haven’t written on anything political on this blog for a long time but I think a post on the Federal Reserve is a worthy topic of discussion since it’s not much understood even if what I have to say isn’t what people want to hear. I know this isn’t a favorite institution among Americans who sometimes think that it’s corrupt or doesn’t have much transparency. Some like to think that it’s been involved in a lot of conspiracies such as the Kennedy assassination (which it certainly wasn’t, nor has the CIA). Many view the Fed There are libertarians like Ron Paul and his son Rand who want to end the Fed thinking that it’s unconstitutional and that there’s no need for such system since they believe the economy could regulate itself on its own (I’ll get to this later). Then you have people in the Occupy movement who think that the Federal Reserve exists as a private corporation with too much power in the federal government and only serves the interests of large corporations led by people with too much power and too much money already (it’s actually an amalgamation of a government agency-corporation but with 12 privately owned district banks, yet all profits and central authority belongs to the federal government). However, while many of the anti-Fed movement don’t realize (or ignore) is that the Federal Reserve plays an essential role in the American economy which most Americans take for granted. And while it’s not a perfect system or one a lot of people like, we need to understand that to abolish the Federal Reserve would be absolutely insane.

Now you don’t have to be a financial genius to know that abolishing the Federal Reserve would be a catastrophically stupid idea. In the United States the Federal Reserve functions as a central bank to manage the nation’s money supply through monetary policy, deter bank panics, providing financial services for the government as well as private banks (particularly as a lender of last resort),  strike a balance between privatization and government involvement, and create a stable economic environment for businesses, investors, and consumers alike. All these are extremely important for a national economy as well as in our daily lives. Still, while many do blame the Fed for the country’s economic woes, many don’t understand that if the Fed wasn’t around in the first place, the US would’ve been in much worse economic shape than it has been since its creation in 1913. Yet, even Founding Father Alexander Hamilton knew that establishing a centralized national bank was necessary to stabilize and improve the nation’s credit as well as to improve handling of the US government’s financial business. While this idea was controversial for years (even in his own time), history would later vindicate Hamilton’s views on finance, particularly that of a centralized national bank and the Federal Reserve is living proof of this from its inception to its 100 year existence.

When it comes to understanding why we need the Federal Reserve, we need to remember that the Fed was created in 1913 after the US had spent 76 years without a central bank (giving us a good window into what would happen if we actually ended the Fed.) Now unlike what many free-market libertarians would want you to believe and Ron Paul’s gold standard nostalgia,  these weren’t great economic times to be honest. Of course, the reason why the US went through a period with no centralized banking system during this time had to do with a few factors. For one, the First and Second Banks of the United States were privately owned (and had foreigners share in the profits), shared only 20% of the nation’s currency supply while state banks accounted for the rest, and ran on 20 year charters which both expired before they could be renewed (all based on Hamilton’s ideas by the way save for the expiring bit). Nevertheless, the fatal flaw with Hamilton’s central banking system was that it provided a way for business interest and greed to usurp power from the federal government and common citizens. Second, a lot of Americans didn’t like a centralized banking system which they saw as undemocratic, corrupt, and favoring the interests of big business. They particularly distrusted centralized financial authority which undermined both banks, which was particularly personified in Andre Jackson who was more than happy to help the Second Bank of the United States along its demise in 1836 even to the point of vetoing congressional attempts to renew its charter to usher an era of laissez faire economics and de-centralized American banking. Unfortunately financial anarchy didn’t go so well.

Of course, running a country without a central bank empowered to issue paper money led to more than a few problems, well, more like large systematic financial fuck ups between 1837 and 1913. During this time the dollar supply was tied to private banks’ holdings and government bonds, which would’ve been fine if the need for dollars was fixed over time. Unfortunately it wasn’t the case. Since there was no central, government-backed bank able to create money on demand, the American banking couldn’t provide it nor was there a for a bank’s money supply to adjust with demand either. When people would try to withdraw more money from one bank that it had available, the bank would fail leading to other people trying to withdraw their funds from other banks. Such activities would create a vicious cycle later snowballing into widespread bank failures and contraction of lending across the economy resulting in economic depression. This happened every few years. Another reason for bank failures being so common before 1913 was the tendency of huge fluctuations in the money supply. Often the US economy would alternate between too much money in circulation and not enough causing all sorts of economic chaos.

The American banking system was particularly unstable during the Free Banking Era between 1837 and 1862 when banks had no federal oversight whatsoever. During this time, banks were short lived with an average lifespan of 5 years with half of them would failing (due to fraud, incompetence, or bad economic conditions) and a third going out of business because they couldn’t redeem their notes. You also have a practice called wildcat banking in which many banks would issue nearly worthless currency backed by questionable security (like bonds or mortgages) since the institution’s real value would often be lower than its face value. Some bank currency was more valuable than others depending on the bank you received the banknote and the quality of its assets, your state’s banking regulations, the quality of your state’s bonds if your state required such banknotes to be backed by them, and the likelihood of fraud. Not only that, but there was no transparency at all so you couldn’t tell whether your neighborhood bank’s assets were wildcat money. And if that weren’t enough, you had to deal with the fact that there were over 30,000 different currencies floating around in the United States at this period, which could be issued by almost anyone even drug stores and steakhouses. A lot of problems also stemmed from this including the fact that some currencies were worth more than others whether backed by silver, gold, or government bonds. Then you have the Panic of 1837 that caused a major recession that lasted until the mid-1840s, eight states either wholly or partially unable to pay their debts, and 343 of the nation’s 850 banks closing their doors resulting in a shock from which the system of state banks would never recover.

The National Bank Era of 1863-1913 was not much better. Though it did establish a uniform US banking policy, established a series of national banks with higher standards than many state ones,  created a national currency, and basically helped put an end to the wildcat banking practices. National banks were required to use government issued bills and back them with US government issued bonds as well as accept each other’s currency at par value. The federal government’s 1865 issue of a 10% tax on state bank bills would not only give rise to a uniform national currency by forcing all non-federal issued currency out of circulation but also the creation of checking accounts by the state banks which became the primary source for most banks’ revenue by the 1880s. Yet, despite the reforms, a lot of problems still remained. For one, while the US finally had a uniform currency, it was required to be backed up by treasuries. When such treasuries fluctuated in value, banks had to either recall loans or borrow from other banks or clearinghouses. Second the banking system of the National Bank Era created seasonal liquidity spikes particularly in rural areas during planting season when demand for funds was the highest. When the combined liquidity demands were too big, the bank would again have to find a lender of last resort to borrow from so it could pay its depositors and escape from financial ruin. Unfortunately, the responsibility would usually fall to other banks and financial institutions yet they weren’t always willing to bail out a troubled entity since doing so could put them in financial risk. This led to a string of financial panics which caused serious economic damage. Because there was a chance that you wouldn’t be able to access your bank account during an economic meltdown, Americans didn’t have much faith in their banking system.

The worst of the financial meltdowns to occur during the National Bank Era that helped facilitate the creation of the Federal Reserve was the series of events that helped lead to the Panic of 1907, the period’s worst. Now there are a variety of factors that contributed to this financial crisis that happened to converge all it once. It all began with the devastating San Francisco Earthquake of April 1906 not only developing an urgent need for cash to fund the recovery efforts and contributing to market instability but also made the survivors unable to access their cash for weeks mainly because it had been locked in bank vaults so hot from broken gas line fires that opening them would’ve caused their money to burst into flames. Not only that, 1906 was also a bumper year for crops which brewed a possible economic boom so companies nationwide wanted more cash to invest in new ventures like rebuilding San Francisco. Both of these events made dollar demand uncommonly high at a time when the money supply couldn’t increase much resulting in rising interest rates and withdrawals. Before long, the high number of withdrawals would soon put banks across the country on the brink of failure. In October of 1907, a copper miner turned banker F. Augustus Heinze and his stockbroker brother Otto tried to take over the United Copper Company’s market by buying up its shares. They failed and United Copper’s stock price tumbled causing investors to rush to pull any deposits out of any bank even remotely associated to F. Augustus Heinze. Banks and financial institutions began to fail, particularly the huge Knickerbocker Trust Company, the third largest trust in New York, which had its depositors withdrawing $8 million of its funds in less than 3 hours. Knickerbocker’s failure led banks and financial institutions nationwide to hoard their cash unwilling to lend to other banks, especially in New York. Though undisputed Wall Street king J. P. Morgan managed to bail out some of the troubled banks due to his immense wealth and his ability to get rich guys and bankers to do what he wished, he was unable to solve the systemic failures of the US finance system caused the crisis in the first place.  The Panic of 1907 would spark one of the worst recessions in US history as well as similar crises in much of the world as well as would lead to the creation of the Federal Reserve four years later.

Of course, the Federal Reserve doesn’t prevent bank panics it just serves as a better tool to deal with them as a lender of last resort as well as regulating money supply. Thanks to the Fed, the United States has experienced fewer major financial panics and the money supply is mostly under control with huge fluctuations being few and far between. Because of the Federal Reserve, the United States has become a much more stable economy which has helped create a better climate for capitalist enterprise than any US banking system has ever had in its existence. Sure the Federal Reserve isn’t a perfect institution and has problems that need corrected. Yet,  we need to understand that when the US tried to do without centralized banking, the economy was much less stable and much more unpredictable while banks weren’t always places you could put your money in. No American wants to live at the time when they’d have to worry whether their bank ran out of money, loan their money to someone else who didn’t pay them back, or issued currency notes of questionable value. Nor do Americans want to live at a time of dramatic fluctuations in the money supply either or frequent bank panics and financial meltdowns. Sure there have been accusations that the Fed serves the interests of wealthy bankers and corporations but it also serves in the best interests of all Americans by making sure that the public retained confidence in the nation’s money and where it’s held. It also helps keep our economy system moving and minimize financial disturbances threatening economic stability. Our ancestors in the 19th century didn’t have such system nor did they have as much trust in the American financial system as we do nowadays. While there were plenty of financial institution running to Washington for bailouts during the 2008 meltdown, there were very few Americans running to the banks to withdraw their life savings before they ran out of money. Thus, while the Federal Reserve may have its flaws and critics, at least it’s a viable system that has worked quite well in its 100 year existence playing a crucial role in the US economy and performing services the American people just can’t live without. So perhaps when people talk about possibly ending the Fed, you might want to remind them that our financial system before the Federal Reserve was much worse and much less accountable. Nevertheless, to say that the Fed does more harm than good is simply not the case at all.