Wealth Shift: The Decline of Ethics in America
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Lesson #5 – Leverage It Up

In ancient Egypt, grain was stored in huge granaries as a precaution against famine. The Egyptians knew that prosperity was cyclical in nature, and would never have left their granaries empty once the famine was over.

Modern societies also have release valves for periods of economic downturn, the single most effective of which is the ability to loosen credit to stimulate the economy. However, unlike the Egyptians, we have not been disciplined enough to pay down our debts during periods of economic prosperity. Instead we have just borrowed more and more, creating an Everest of debt. We are fast approaching the point of no return -the point at which we can no longer turn back to base camp before the storm sets in.

Take a look at the following chart. You will see what I am talking about. We can barely afford the annual interest on our national debt, much less repayments of principal.

We think we are so clever because we have found a way to make our lenders take most of the risk. But leverage is a dangerous toy for the big boys to play with, and an even more dangerous toy in the hands of an Average Joe. Leverage is a perfect example of the old adage: Just because you can do a thing, doesn’t mean you should. “How to max out your credit” is not a lesson we should really want anyone to learn, much less an unethical Wealth Shifter. Yet we think we are so much smarter than the Average Joe.

He’s not capable of learning the debt practices we are engaging in, right?

Oh, how I wish that were true, but the sub-prime fiasco in this country has already proved that it’s not. (Nor does it represent the entirety of the problem.)

J. P. Morgan understood how important ethics are in the leverage game. When asked what he thought commercial credit was based primarily on -money or property -he responded that the first thing an extension of credit should always be based on is character. He knew, and so should we all, that the most important thing in determining whether to lend someone money is whether they have the character to pay you back, come hell or high water. The single biggest problem with the vast majority of debt today is that it has been lent on a shoestring and assumes that the borrowers involved have character, when in fact they have none.

Michael Milken was one of the first people to open the floodgates on debt. Since then, many, many people have followed his lead to the long-term detriment of this country. It is amazing to me how Milken’s tactics have been recast in light of short-term results. Now virtually everyone sees Milken’s ideas on leverage as having been a positive thing for our economy. People look at the results of what Milken “accomplished” as though he created an absolute rule about the power of leverage. They fail to look at the fact that there were reasons why Milken’s plan may have worked then, but may not continue to work now.

In the mid-1970s, when Milken first decided to put his efforts toward creating a large market for speculative high-yield (aka “junk”) bonds, credit was still being advanced cautiously. The country, most companies, and most people had very little debt, relative to today. The debt spigot may have been trickling, but it had not yet been opened full-blast.

Not so once Milken got involved. Soon any company with an ounce of idea could find an underwriter to help get it financed. Despite being indicted on 98 counts of racketeering and fraud, plea-bargaining it down to 6, serving time in jail, and being barred from Wall Street forever, people who are short-sighted in their analyses have decided that Milken’s strategies were actually brilliant. We were just too dumb at the time to realize it.

Milken’s Biography According to Milken

Starting in 1969, when he joined the firm that would become Drexel Burnham Lambert, Milken helped finance thousands of companies. By 1976, the financial theories he developed in the 1960s had been proven in the world’s markets and are now considered mainstream. The Economist said his financial innovations “are credited with fueling much of America’s rampant economic growth by enabling companies with bright ideas to get the money they need to develop them.” His use of equity-based securities, bonds, and hybrids to build the right capital structure for his clients helped to create millions of jobs, leading a Time bureau chief to write in 1997, “Milken was right in almost every sense.” A Wall Street Journal editorial referred to “Mr. Milken’s contribution to the explosive economic growth experienced in the last 20 years.” Canada’s Globe and Mail called it “one of the greatest achievements of modern capitalism.”

Milken used more than 50 different types of securities in some dozen asset classes to help finance corporate growth for his clients and adapt their capital-structure needs to changing market conditions. In his book “How the Markets Really Work” (Crown, Mew York, 2002), former Harvard Business Review editor Joel Kurtzman wrote: “Milken’s real contribution was far greater than simply to sell portfolios of bonds. His real contribution was to get investors to understand that the stock and bond markets were not really separate markets. Milken created a tremendous pool of liquidity and guided its use with surgical precision. He did it in a way that took an often bloated and ailing American economy and made it lean, mean and resilient. Much of the strength of the economy today – including its ability to rebound in times of adversity – is due to the way people using Milken’s financing vehicles remade ailing companies or put their entrepreneurial zeal to work.”

His most important work was financing entrepreneurs who had good ideas for building companies that became engines of job creation. Based on his studies during the 1960s and his practical experience in the 1970s, Milken was determined to focus, first on cash flow rather than reported earnings; and second, to consider human capital part of the balance sheet. He played this out by backing such pioneers as Bill McGowan (telecommunications), Ted Turner (cable television), Craig McCaw (cellular telephones), Steve Wynn (resorts), Len Riggio (book retailing), and Bob Toll (homebuilding) among many other leaders of the 3,000+ companies he financed. They earned Milken’s respect and backing because they had greater vision than the sclerotic, risk-averse managers who had always counted on banks for financing. When the banks ran into problems in the 1970s and turned off the capital spigot, Milken stepped forward and made capital available for thousands of dynamic, growing companies that created jobs and shareholder value. This was an epic decision that helped make the U.S. economy the envy of the world in the last quarter of the 20th century. A 2008 New York Times article said, “Mr. Milken helped create a new generation of companies and an entirely new way to finance nascent ideas that have helped fuel the global economy.”

Milken and his colleagues created what is today a major part of the structure of global finance based on their innovations in the 1970s. These innovations – now taken for granted and taught in every business school – powered job growth in America for a quarter century and are now moving around the world through the efforts of the Milken institute.

Snort. Not short on ego, is he? But look, all self-aggrandizing aside, nobody’s arguing the power of leverage. No question, if you infuse a huge amount of cash into any financial system, you are going to see results. And if you are infusing a lot of cash into a financial system at the same time that huge strides are being made in innovation, you are going to be able to catch a massive wave of potential profit.

But I have a question for Mike Milken and his minions:

What if, instead of ushering in a new period of prolonged prosperity capable of continuing to fuel itself, we merely shot off all our firecrackers at once? What if a slower, more judicious, pace would have been a better course for us all?

It’s awfully hard to say, having already committed to one course of action, what another might have been, but I think perhaps a longer-term perspective may just change our minds about the “rightness” of all this leverage. And the reason may simply be because we are not taking the trouble to pay it back.

Had Milken’s debt ideologies not found fertile ground in high-tech start-up companies of the Information Revolution, but, instead, merely funded the status quo, undoubtedly the story would have turned out quite differently. Perhaps Milken was about more than just facilitating the process of throwing a bunch of bucks against the wall and seeing which ones bounced back with interest and/or dividends and capital gains attached. Perhaps he saw an endless stream of innovation that would result in the cash flows of American companies being able to stay ahead of their next loan payment forever.

But surely Milken knows that cash flow funded by debt, and debt alone, is all about finding the next greater fool. If the company you loan money to (or invested in) can’t ever turn enough profit to pay you back, then you and all the other fools who lent it money (or bought its stock) will be the ones to go down with the ship. Only the executives with their banked salaries and cashed-out options will be able to escape unscathed.

Surely Milken understands that prosperity is cyclical. Or maybe he doesn’t. But even he has to admit that he doesn’t know it’s not. No economy in the history of mankind has ever expanded forever with no period of contraction whatsoever. And I will bet that Milken understands (even though he has been unwilling to say it publicly) that you’d be an idiot to bet the entire company on the proposition that you can go and blow, ad infinitum, fully-levered to the hilt. Debt is a lot like a hot potato. It’s something you don’t want to get caught with when the economy takes a turn for the worse. When tough times hit you want to be in a position to borrow, not default.

Like riches, the wise way to handle debt is neither to have none at all, nor have nothing but, but to have just the right amount. (This goes for convertible debt, too.) Debt in moderate amounts can do amazing things. If you can borrow at 5% and earn 20%, then you can net 15% for yourself. And this is a good thing. But if you are borrowing at 5% and losing 20%, you’ll be out of business shortly. (Unless you are some kind of debt wizard who can continuously find a greater fool than the last guy who lent you money.)

When faced with the opportunity to leverage your balance sheet, it is tempting not to go overboard - especially when “The Street” is pressuring you to increase profitability quarter upon quarter. But it is important to remember that the circumstances that drove your decision-making yesterday are not going to be the same as the ones that will drive your decision-making tomorrow. Michael Milken’s truth about leverage is not a universal truth. It is a truth that worked at that pinpoint in time and under those very specific circumstances. And if you doubt the veracity of this statement remember this:

1) The average life expectancy for a Fortune 500-type company is between 40 and 50 years.

2) A full 1/3 of the companies listed in the 1970 Fortune 500 had vanished by 1973.

3) The average life expectancy for newly created companies is less than 10 years.

In his book, The Living Company: Habits for Survival in a Turbulent Business Environment, Arie De Geus discusses an unpublished study commissioned by the Royal Dutch Shell Group in which two Shell planners and two outside business school professors drew the following conclusions from studying the habits of 40 different extremely long-lived (100+ years) companies.

1) Long-lived companies are sensitive to their environment, remaining in continuously harmony with the world around them (think The Biltmore Company and S. C. Johnson and Son)

2) Long-lived companies are cohesive, with a strong sense of identity – no matter how widely diversified they are, employees feel part of one culture. Managers are promoted from within the company and universally consider themselves stewards of the longstanding enterprise

3) Long-lived companies are tolerant of activities on the margin – outliers, experimenters, and eccentrics – within the boundaries of the cohesive firm – which keep stretching their understanding of possibilities

4) Long-lived companies are conservative in their financing. They understand that borrowing money is borrowing against future earnings. For that reason, they are frugal and do not risk capital gratuitously. They understand the value of having spare cash. Having spare cash gives them flexibility and independence to pursue options their competitors cannot without first having to convince third-party financiers of their attractiveness.

Gosh, put that way it seems so intuitive, doesn’t it? But a conservative approach to debt is not what this country, its companies, and its people have been practicing for the past 30 years. Instead, we have used debt indiscriminately. We have thrown money at everything we could think of with very little consideration of the long-term value of the expenditures being made.

It is not unusual today for a company with no profit, and no plan to be profitable for several years, to be able to raise a billion dollars of capital to play with. Furthermore, it is not unusual for the executives of companies to structure the company’s debt specifically to be able to cash out and live the high-life themselves. Because the value of an executive’s stock options is not based on generating corporate revenues (the performance of the company), but, instead, is based strictly on share price, executives are often able to cash out on the strength of the optimism engendered by nothing more than the company’s “story” and pass on the own risk straight to the company’s lenders, shareholders, and employees (as we have discussed before).

It is important that we remember that operating a company that is maxed out on debt is very much like going Mach 10 on the salt flats in Utah. It’s an adrenaline rush for a while, but sooner or later you are going to run out of either fuel or salt flat. And then what? Running a company is not an extreme sport - it’s a responsibility.

It seems that people want to take the credit for developing a certain kind of financial product, but not the responsibility for what happens after that product is unleashed on society. Instead, as we have discussed before, they want to blame someone else. They say they are not responsible for predicting the downturn of the economy, or the way someone else has misused the product for a purpose not originally intended, or for the fact that the product is so incredibly sophisticated that the ultimate user can’t even begin to understand the delayed implications of it when he first signs the contract. These financial gurus are disingenuous at best if they think these arguments hold water.

Going back to Angelo Mozilo, the Countrywide Financial Corp. CEO. Mozilo got caught passing the responsibility buck by a customer, Daniel Bailey, Jr., who on May 21, 2008, received a reply from Mozilo to a blanket e-mail that Bailey had sent out to 20 different Countrywide e-mail addresses. Bailey’s e-mail was a plea for a modification of the terms of his adjustable-rate loan based on his representation that he didn’t fully understand the terms of his loan, was wrongly told he could refinance his home after a year, and was on the verge of losing his house.

Mozilo’s response (obviously intended for someone other than Bailey) was “This is unbelievable. Most of these letters now have the same wording. Obviously they are being counseled by some other person or on the Internet. Disgusting.” An observation of this comment posted on loanworkout.org said Mozilo’s e-mail was “a perfect example of the ‘help’ people can expect to receive when they contact their lenders.”

So, what lessons are we learning from the big boys about debt? Well, if you ask me, quite a few. In the first place we are learning to set up significant lines of credit for ourselves. We are learning that lenders don’t really watch the people they lend money to very closely, or ask too many questions about how you are planning to repay them, either. Creditworthiness is determined at a pinpoint in time, and isn’t revisited until a borrower actually goes into default. We are learning that you can get credit cards even if you have no income -as long as it looks like you may make something, someday. According to a 2006 study by Nellie Mae, a leading provider of educational loans, the average graduate school student carries total outstanding credit card balances of $8,612. The majority surveyed (67%) said they took out their first credit card as an undergraduate.

We’re learning you can’t get blood from a turnip. Bankruptcy filings are at an all-time high in this country, in spite of the recent bankruptcy reform laws.

According to Visa USA and MasterCard International, in 2006 there were already 984,000,000 Visa and MasterCard debit and credit cards in circulation. Many people carry multiple cards. According to the Experian National Service Index, 1 in 10 consumers have more than 10 credit cards and the average number is 4. Credit card holders have access to an average combined credit line of $19,000, according to myfico.com. American Bankers Association and the Federal Reserve says 15% of credit card holders have total card balances of $10,000 or more, and 1 in 6 families only pay the minimums. Consumers have learned quite handily that credit makes a good release valve when earnings are insufficient. The only question is how many people actually can (or even intend to) pay those credit card companies back.

When home prices went up from 2001 to 2006, people were encouraged by lenders to cash out the equity in their houses and pay off their credit card debts with the proceeds. The lenders, who were looking for a way to make their unsecured credit more secure, advertised the positive benefits of lower, tax-deductible interest. The borrowers, who were looking for a way to live better now, saw this as a good deal. If a lender could talk a borrower into an adjustable rate mortgage, so much the better for the lender. Senior citizens were also encouraged to “live better now” and take out reverse mortgages on their homes. As a result of all this “equity financing”, mortgage debt in this country now exceeds $10 trillion dollars.

The National Debt Clock shows our National debt (in 2009) to be rapidly approaching the $10.5 trillion dollar mark. That’s over $35,000 for every person in the country. If you have a family of 4, this means your family’s share is $140,000. Can you pay up? Could you ever? If Bill Gates and Warren Buffett both gave up their entire net worth to the government, it would only pay 0.5% of the National debt. Their combined net worth couldn’t pay the interest on the National Debt for three months. No wonder they are giving so much of their wealth to a charitable foundation. Far better a charity than a sinkhole.

According to the Federal Reserve, total credit card debt in this U. S. reached $904 billion in June, 2007 – 18 times the then-net worth of Bill Gates. Underwater on our homes, our gas-guzzling SUVs, and our credit cards, many of us are technically insolvent.

With a median household income in the U.S. of $43,200, I have to wonder whether the average person thinks it’s even possible to get out of debt in this country. And when you think a thing is impossible, you tend not to work very hard to make it happen.

Executive Summary: Thanks to the lessons in debt that this country has learned from its financial leaders, the only thing standing between us and the bankruptcy court is our honor – our character. But since Wealth Shift has done such a fine job on that, it’s no wonder people are deciding to go ahead and max out their credit cards in one wild Wealth Shiftathon before the credit card companies catch on and take away our cards altogether. If it’s only a matter of time before this country goes bankrupt, why not go ahead and get while the getting’s still good? It’s a self-fulfilling prophecy – one that’s already coming true.


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