The American Way

Ten days ago, bowing to the demands of a frantic Administration, the pleadings of desperate Wall Street moguls, and the weight of a plunging stock market, Congress passed a bill (which the President signed into law almost before the final "aye" vote was cast) authorizing the Secretary of the Treasury to purchase $700 billion worth of toxic (translation: almost worthless) securities from undercapitalized commercial and investment banks -- but only after larding it up with $150 billion in pork-barrel spending and corporate tax breaks -- all this on top of the $1 trillion obligation already assumed by the federal government in nationalizing Freddie Mac and Fannie Mae and in throwing lifelines to Bear Stearns and AIG.

But, not to worry. Our schizophrenic Secretary, after selling his bailout plan to a wary Congress and a skeptical public as a matter of utmost urgency, has abruptly changed course. He now proposes to buy commercial paper from credit-starved corporations and invest taxpayer money in struggling banks. No wonder the financial markets are spooked.

Meanwhile, like crazed fiddlers in a burning city, our esteemed Presidential aspirants, Messers. McCain and Obama, dance along the campaign trial, blithely promising their weary audiences a panacea of tax cuts, universal health insurance, regulatory reform, and comprehensive energy strategies -- all of which are estimated to cost anywhere from three to five trillion dollars over the next five years. Do I detect a disconnect here?

Maybe not.

Because, while much has been made of the crushing tax burden being imposed on the irate taxpayer because of the Treasury's extraordinary measures, nowhere have I read or heard of any one actually being required to pay more. In fact, after the anticipatory discomfort dissipates and a proper anesthetic is applied, these copious dollar hemorrhages feel as harmless as a root canal.

Perhaps a little suffering would be instructive. I have a suggestion which, I believe, would either end bailouts forever or launch a second American Revolution. With total federal tax revenues -- from personal and corporate income taxes, social security taxes, and excise taxes -- in the $2 trillion range (a number I derive from subtracting a $4oo billion deficit from a $2.4 trillion budget), a new $1 trillion federal obligation represents a fifty per cent increase in required income; to pay for that, the IRS should simply apply a surcharge to each taxpayer equal to fifty per cent of his current tax bill. Or, since annual U.S. gasoline consumption is about 150 billion gallons, how about a $6.50 per gallon assessment? Yes, my friends, as John McCain would say, the masses would storm the barricades. And they would hardly be pacified by spreading the payments over five years; a twenty per cent surcharge, or $1.30 bump at the pump, would be no more palatable.

But, instead of entertaining such a foolish (but, in my view, quite reasonable) proposal, because it would shake the very foundations of American civilization, low taxes and cheap gasoline, our gritless politicians will no doubt turn a blind eye to any semblance of fiscal responsibility and resort to their perennial method of financing deficits -- the sum total of which is now $10 trillion. They will borrow the money, and keep borrowing until either our credit runs out or the escalating digits overwhelm even them, at which point they will inflate the currency by printing more, and usher in an insidious hidden tax by the back door.

It's the American Way. The taxpayer complains without feeling any pain. The government gets the money at minimal interest rates. And the banks get to dump their worthless paper in return for an infusion of capital, costing them nothing more than a little "lipstick": a handful of warrants and some cosmetic restrictions on CEO compensation. It's like getting something for nothing, which seems appropriate, since that's how all the players earned their roles in this tragicomedy to start with.

It was a combustible combination: government pressure to make home ownership more accessible and more affordable to low-income (minority) citizens mixed with the profits inherent in financing such ownership, profits produced by loan origination, by higher interest rates, by the packaging of these loans with others of better quality into less risky marketable securities, and by the buying and selling of these securities in huge quantities at tiny spreads. The match to ignite the firestorm was readily at hand: lowered underwriting standards for home mortgages to subprime (less credit worthy) and prime (more credit worthy) borrowers.

As a result, former renters got a home, and current homeowners got roomfuls of cash via refinancing or home equity lines of credit, for almost nothing: no down payment and low introductory teaser rates scheduled to reset in the distant future, when their homes would have increased in value (and were thus solid bank collateral) and their rising incomes would easily enable them to make their higher monthly payments. After all, this was America, where prosperity knew no boundaries.

It amuses me how eager so many sanctimonious sophisticates are to cast aspersion upon these folks for merely accepting what some ambitious loan officer handed to them on a silver platter, even if it turned out to be a turkey they couldn't afford. There are many people in this world (or should I say America) who know how to live within their means, but there are just as many who don't, and quite a few who do know how but prefer not to. In our stores, we sell home furnishings, appliances, and electronics on credit. Can we blame the customer if we compromise our criteria and allow him to take home a brand new fifty-inch plasma television with no down payment and a credit history that indicates that he is unlikely to pay for it? Of course, a lender who is looking at collateral he knows will depreciate rather than at collateral he expects will appreciate tends to be more rational.

No less magical than the crystallization of homes out of thin air were the bountiful profits generated by the trade in mortgage-backed securities. Borrowing at interest rates kept artificially low by our own monetary policy makers, Fed Chairmen Greenspan and Bernanke, operating under a dangerously unbalanced ratio of one dollar of capital for every thirty dollars of debt, the institutions engaged in this financial sleight of hand were making money in the literal sense of the word, manufacturing it out of the most ethereal of raw materials.

And when they had extracted every last dollar of profit from the mortgage game, they invented a new one, based on derivatives. These credit default swaps had no intrinsic value in and of themselves, but, when layered on top of the mortgages and other debt instruments they were written to insure, possessed the power to multiply profits exponentially. By calling them swaps instead of insurance, their purveyors cleverly avoided any reserve requirements or regulatory oversight, grounding them in a nothingness even a layman can appreciate. While the actual number remains as elusive as it is incomprehensible, a reported $30 trillion worth of these "nuclear weapons of financial mass destruction," to quote Warren Buffett, is floating around in cyberspace.

Eventually, as Reverend Jeremiah Wright would say, "The chickens came home to roost." Homeowners -- occupants would be a more accurate term -- and securities traders were rudely awakened to what they surely knew but had just forgotten. Their pyramid of wealth did indeed have a foundation. Its name was leverage, and suddenly it turned on them, from an indispensable ally into an implacable foe.

According to Niall Ferguson, writing in Time Online, October 2, 2008, over the past thirty years households and financial institutions have accumulated tremendous levels of debt, now unsustainable due to a frightening reversal of fortune: the assets they bought with the money they borrowed have declined in value.

In the case of households, debt rose from about 50 per cent of GDP in 1980 to a peak of 100 per cent in 2006. Much of the increase was used to invest in residential real estate, the price of which has been falling since the housing bubble burst in 2007. In June home prices in twenty cities were down 16 per cent compared to last year.

"Banks and other financial institutions are in an even worse position . . . By 2007 the financial sector's debt was equivalent to 116 per cent of GDP, compared with a mere 21 per cent in 1980. And the assets the banks loaded up on have fallen even further in value than the average home -- by as much as 55 per cent in the case of BBB-rated mortgage-backed securities."

For a person whose business loans and borrows money, I've never understood leverage.

My customers probably don't understand it either. After they purchase their home furnishings, appliances, or electronics at one of Schewel Furniture Company's fifty stores and finance it by making monthly payments for up to twenty-four months at an APR of 24.9 per cent, I suspect that nine out of ten have no idea that they are borrowing money. Because SFC carries the account itself rather than a bank or finance company, they believe that they are simply paying for their sofa, bedroom suite, or refrigerator over a period of time -- and are happy to enjoy the use of it along the way. Applying a type of leverage they do understand, when service is necessary, they find it quite useful to be making those payments to the same entity that sold them the product.

Accounts receivable, the money owed to the company by its customers, is a two-edged sword. Increased non-cash sales and extended contract terms will drive up accounts receivable -- and yield higher interest income. On the other hand, these same factors will reduce cash flow and require the company to borrow money to finance its operations. Wall Streeters would find this a laughable non-choice, since the cost of the money will be considerably less than the 24.9 per cent interest rate charged to customers.

Which is one reason why a venture capitalist firm was willing to fork over an ungodly amount of borrowed money twenty-two years ago to purchase 51 per cent of Schewel Furniture Company -- an amount equal to twice its book value and almost seven times its earnings before interest (of which there was none), depreciation, and taxes. While its owners -- my father, brother, sister, and I, who owned fifty per cent, and our cousins, who owned the other fifty per cent -- would experience instant wealth creation, become cash-rich overnight, and retain the opportunity to participate in its future growth, the company would be saddled with an unwieldy burden of debt that could endanger its survival if economic conditions should deteriorate.

The company's owners had always been debt-averse. In fact, during their eighty-year history of financing customer purchases, they had borrowed money only once: to buy out a third partner in the late 1950's. Now a lucrative offer was on the table, and a decision had to be made. Debt financing was the American Way, but was it our way?

Actually, the issue was not whether to borrow; it was how much to borrow. No member of our cousin's family was interested in the business, and the only one who had ever worked there had semi-retired from it eight years earlier when he had been elected to the Virginia State Senate. With dollar signs dancing in their heads, they were ready to cash out.

For my father, my brother, and myself, the story was different. Schewel Furniture Company was our identity, our lifelong career, and a labor of love. We were as invested in its continued viability as we were enamored of all that liquidity, and we were reluctant to surrender control of the company to an outsider, no matter how deep his pockets. (Or maybe we were just too noble for our own good.) What began as an auction to the highest bidder degenerated into a bitter negotiation process, fraught with emotional turmoil; my father had recently been diagnosed with terminal cancer, and I was in the throes of a divorce.

Our former partners became our adversaries, and filled the air with vague threats if this deal were not consummated by the end of the year, three weeks away, when capital gains rates were set to increase. Finally, the active owners, my father, my brother, and I, agreed to puchase our cousins' stock for an amount equal to fifty per cent of the outsider's offer, plus a twenty per cent premium for some future earnings, a concession they flushed out of us in the heat of the moment, attributable, I believe, to my clumsy naivete, my lack of financial expertise, and my stubborn fixation on forcing them out. As a result, they received almost two-and-a-half times the book value of their stock and eight times pre-tax earnings, exorbitant multiples even in that high-flying era.

Nevertheless, my father proudly maintained that the day he owned all of Schewel Furniture Company was the happiest of his life. Of course, since he knew he had only two years to live, he had no qualms about bequeathing his children a mountain of debt.

A local banker made the loan, declaring ominously: "Now, Marc, you do know that one day you will have to pay this back."

Since I was as debt-averse as my forbears and had never been initiated in the wily machinations of Wall Street, I had every good intention of doing so.

I guess one's tolerance for debt is a function of his temperament. For the optimist, the glass is always half-full, and the asset which he has purchased with borrowed money -- a house, a business, a mortgage-backed security -- is an opportunity to enjoy the fruits of its appreciation. For the pessimist, the glass is always half-empty, and that asset is an encumbrance bearing a huge cost.

To counteract my own innate pessimism, I recalled the sage advice of an old friend: "The man who has no faith in the future of America -- or in the future of his investments -- will never be successful." Fine words, to be sure, and undeniable, yet hard to stomach during a twenty-five per cent bear market.

Those outside investors with the big check were willing to leverage Schewel Furniture Company up to its eyeballs not only because they had confidence in its continued growth and profitability, but also because their goal in five to ten years was to resell the company for considerably more than they had borrowed. But if it's the American Way to use other people's money as much and as often as possible, it's also the American Way to live the dream of owning your own business and to preserve it for the next generation. Which is why my father, my siblings, and I shunned our ardent suitors and put our names -- and our futures -- on the dotted line.

While the company's newly-acquired debt was a necessary means to an end, your pessimistic chronicler struggled daily to look beyond the added interest cost, the uncomfortable bank covenants, and the prickly notion that the owners did not have complete control of their destiny. I learned a hard lesson about the installment credit business.

The investment banker who had brought us that outlandish offer, and then skillfully run interference between the two warring families, had painted for me a rosy picture. While profits would no doubt be reduced by interest costs, the company would still be generating enough cash every year to pay down some of its bank debt. What he conveniently failed to explain was that if the business experienced any growth, which it did, those profits would be reinvested internally to fund increased accounts receivable and inventory. The company ended up borrowing even more, much to my chagrin.

My steady comptroller reassured me that debt service was just another cost of doing business. My high-rolling director of credit operations reminded me that we were arbitraging our interest rates. A keen observer of the human condition philosophized: "A man's wealth is measured by how much he owes." But I never fully accepted the transformative power of leverage until I realized that the bankers standing at my door one sunny day were there not to padlock it but to loan me more money.

Emulating millions of fellow citizens, thousands of other businessmen, and an engorged federal government, I enlisted as a willing foot soldier in this army of borrowers, or at least adopted their devil-may-care attitude. Like the freckle-faced juvenile adorning the front page of my generation's favorite magazine, my internal refrain became, "What, me worry?" It's only money -- and not even that. It's merely a long-term liability entry on a financial statement.

Ironically enough, about the time I reconciled myself to the American Way of finance, about ten years ago, Schewel Furniture Company began to pay off its debt -- thanks to good collection practices, a slight uptick in the number of customers paying by cash or credit card, and a generous fire insurance settlement. Today it owes only about twenty per cent of the amount it borrowed in its 1986 recapitalization and is weathering the current economic malaise with a strong balance sheet.

Other businesses, financial institutions, and households have not been so fortunate. Under pressure from a decline in the value of their assets, principally residential real estate and mortgage-backed securities, they have been forced into a massive deleveraging.

It's a vicious downward spiral that feeds on itself, writes Mr. Ferguson. "When families and banks tip into bankruptcy, more assets get dumped on the market, driving prices down further and necessitating more deleveraging." A pessimist might say that, "This process has so much momentum that even $700 billion in taxpayers' money may not suffice to stop it."

Then again, a pessimist -- who knows he can't get something for nothing -- would never have allowed himself to get into such a predicament in the first place.