Wealth Shift: The Decline of Ethics in America
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Lesson #6 – Bankruptcy-proofing 101

If you look at the actions of the big boys, you can quickly learn how to bankruptcy-proof yourself. Bankruptcy-proofing isn’t about staying out of bankruptcy. It’s about getting through it better off than you were before you went through it. The bankruptcy laws in many states are very lenient. Several states allow you to keep your house (unlimited value), cars and other personal property (some limits), retirement benefits, etc.

The big boys have also figured out that if your debt is in a separate “legal entity” from yourself, the company can be the one to go through “restructuring” while you personally emerge unscathed. (Isn’t that nice? Everyone else goes “bankrupt”, Big Boys merely “restructure”.)

Real estate professionals are particularly adroit at this “game”.

In the mid-1980s, I was the tax compliance manager for the Trammell Crow Company for two of its regions. As such, I was in the position to learn the way in which Trammell Crow partners bankruptcy-proof themselves through a perfectly legitimate technique called “over-borrowing”. (This technique is not specific to Trammell Crow Company all real estate professionals use it.) The way “over-borrowing” works is as follows:

1) Form a partnership with a 1% Subchapter S general partner (wholly owned by you) and a 99% limited partner (a teacher’s retirement fund is always good).

2) Have the limited partner contribute enough capital so you can go and borrow money on a construction line of credit to build a commercial building.

3) Build the building.

4) Lease it fully.

5) Go back to the bank and refinance the building based on a new appraisal, which, instead of being based on what the building cost to build, will now be based on the payments the building can cash-flow now that it’s fully-leased up.

6) Take the money you get from the new loan, pay off your construction loan, and then distribute the rest out to the general partner, as its “fee” for putting the deal together and managing the construction.

7) Once the over-borrowed funds are in the hands of the Subchapter S general partner, further distribute the money out to yourself and the other shareholders of the Subchapter S general partner. Encourage the shareholders to use their distributions to buy (for cash) the biggest house they can find in a bankruptcy-friendly state.

8) In your capacity as general partner, grant yourself a lucrative management contract to oversee the daily ongoing operations of the building

I am not trying to pick on Trammell Crow, here. “Over-borrowing” is the way real estate professionals make their living, and I don’t begrudge them a reasonable amount of that. What does concern me about “over-borrowing”, is that real estate professionals often get too greedy with what they are willing to over-borrow.

Instead of setting a reasonable fee from the start, real estate professionals have allowed it to evolve into a “whatever the market will bear” concept. Real estate professionals allow their friendliest lender, rather than logic and longevity, to set the amount of over-borrow the general partner will take from the partnership as its fee. If a lender will give a 90% loan-to-value, then everybody jumps up and down and thinks that’s great. It matters very little whether the building can continue to cash flow the debt if the economy takes a turn for the worse, or a major tenant leaves, or whatever. It matters very little if a 70% loan-to-value would have had a much lower interest rate and been easier for the building to cash flow. All that matters is that the general partner gets its fee. And that is Wealth Shift.

In the mid-1980s, after the Tax Reform Act of 1986, a lot of real estate loans went into default. Many of the commercial buildings financed this way went into foreclosure, which meant that the poor little limited partners lost all their investment in the partnership. Unfortunately a lot of these partners were pension funds for teachers and others – people who couldn’t really afford to lose their life savings this way.

We admire our real estate tycoons like Donald Trump for their conspicuous consumption. But we don’t really understand where all that wealth comes from. Although Donald Trump has never been personally bankrupt (of course not, he’s an overborrower extraordinaire), many of the real estate ventures he participated in leveraging up and taking fees from have done so.

The problem is not that people like Donald Trump take a fee for doing what they do. The problem is that they take too big a fee for the long-term health of the entities they have both created and encouraged other people to invest in/lend money to.

The sad state of affairs in this country is that any Joe Blow with fairly decent credit could do something similar and get away with it the same way that real estate professionals do. Even with stricter bankruptcy laws, anyone with half a brain can “overborrow” and Wealth Shift cash to himself.

Here’s how it could be done (assuming Joe lives in a bankruptcy-friendly state):

1) Joe Blow, a debt-free apartment dweller making $60,000 per year, goes out and systematically applies for as many credit cards as he can.

2) Joe Blow uses every card a little bit for a year or two, paying them off monthly until such time as he is able to engender enough trust to get the credit card companies to all raise his cash advance limits to significant amounts.

3) In one fell swoop, Joe Blow maxes out his credit card cash advances, using the proceeds to buy the biggest house he can pay cash for.

4) Joe Blow then uses the rest of his credit lines to buy a car, furniture, electronics, and other personal property up to the maximum limits of his state. He then blows the rest on things like travel and entertainment.

5) Joe continues to make the minimum payments on his card for one year (or whatever the fraud look-back period in his state is).

6) Joe stops paying his credit cards. Now Joe can decide. He can either a) ignore his creditors entirely and hope they will all figure out he is judgment-proof and write his debt off, or b) he can declare formal bankruptcy under the Super-Chapter 13 rules.

This example is not to say that there are a bunch of Joes out there actually implementing this plan. Mostly Joe is just out there slowly maxing out his credit cards over time in the weary effort to make ends meet. The purpose of this example not to give Joe a road map, but rather to demonstrate just how clever Joe could be, should he ever become disillusioned enough, or unethical enough, or proactive enough to do it.

Joe would certainly be able to find plenty of justification for doing so. All he’d have to say to himself would be, “Hey, if the laws and the banks are going to keep letting the big boys borrow a bunch of money and then walk away, why not me? I only want a couple hundred thousand. They’ve defaulted on billions.”

I am not with Joe. I don’t think that banks and laws should bear all the responsibility for preventing people from taking advantage of the system. I’m with J.P. Morgan. It is character, and character alone, that makes a person creditworthy. It is character, and character alone, that is going to save this country.

Executive Summary: Just because there are not laws in place to prevent you from doing something doesn’t mean you should go ahead and do it. Appropriate compensation for a job well done is fine -raiding is not. If you have found loopholes in the law that allow you to manipulate they system for your own benefit, don’t automatically assume that there are not loopholes out there that will let the Average Joes in this country do the same. In the end, it is not regulations that are going prevent people from Wealth Shifting money from financial institutions to themselves. It is character. (And if you think the new bankruptcy laws are going to stop bankruptcy in this country, you need to do a little research on the “Super Chapter 13” rules, and learn that a complete walk-away by any other name still smells sweet to a bloodless turnip.)


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