The Minotaur's Handmaidens Part A: Mergers and take overs, Hedging and Leverage

The last post presented the Global Minotaur as a peculiar, yet powerful, Global Surplus Recycling Mechanism (GSRM). Now, I move on to a discussion of the various submechanisms by which the US twin deficits managed to attract financing from the capital surpluses of the rest of the world so that this strange GSRM could operate effectively for at least 25 years. I call these mechanisms ‘The Minotaur’s Handmaidens’. Today I look at two of these mechanisms/handmaidens: (a) Take overs, mergers and acquisitions, and (b) Hedging and leveraging. Tomorrow I shall complete this discussion with two more such mechanisms: The Wal-Mart business model and Wall Street’s newfangled capacity to print its own (toxic) money.

Introduction: The world in the grips of Minotaur Envy

On the run up to the Crash of 2008, almost everyone sang from the same song sheet in praise of the American economy. European policy makers in Brussels, their Japanese counterparts in Tokyo, Italian ex-communists, Eastern European born-again neo-rightists, academic economists; they all cast a lustful gaze across the great oceans and toward the land of the free, convinced that the United States was the model to be urgently and unequivocally emulated.

Whole forests were pulped to produce the policy papers heralding yet another ‘new era’. One where American-style unregulated labour and financial markets promised new vistas of prosperity, spreading with the élan of Hollywood’s latest blockbuster from Paris to Moscow, from Amsterdam to Athens, from Yokohama to Shanghai.

Ireland, and even Britain, were held up as pioneers on this modern road to Damascus. The proverbial pot of gold was sought at the end of the Anglo-celtic rainbow, somewhere between a Wal Mart store and a Wall Street bankers’ club, between the City of London and an East End building site on which armies of Eastern European gastarbeiter were building new apartments for the platoons of up and coming City workers.

Every card carrying member of the global commentariat was on the same wavelength, convinced that they lived in an age of some Great Moderation. Depressingly few seemed willing to notice that the reality was quite the opposite. For under the semblance of temperance, the world economy’s natural balance was being ravaged by a terrifying Global Minotaur whose presence few were willing to acknowledge.

Unable to come to terms with their Minotaur Envy, the elites pretended there was no beast in the room. Their pretence was so powerful that they hypnotised themselves into believing that, yes, it was possible for everyone (Europe, Japan, China, India etc.) to achieve the same success as the United States had (since the mid-1970s) simply by adopting the American model. As if in a bid to provide yet another testimony to the human capacity for wishful thinking, hordes of otherwise bright people lulled themselves into a remarkable fantasy: That it was possible for all major capitalist centres around the world to attract, at once, a massive net flow of capital (in the region of three to five billion dollars per working day, which was the sum that the Global Minotaur had managed during its golden years); that it was feasible for all major capitalist centres not only to breed their own Minotaurs but also to cajole the rest of the world into nourishing them.

Meanwhile, the Global Minotaur was hollowing out the American economy at the same time that it was strengthening its bottom line. To this purpose, it benefitted from the enthusiastic and loyal service of a series of handmaidens. Wall Street was, naturally, the most obedient. But there were others: Corporations like Wal-Mart were creating a new business model that added to the rivers of cash while politicians and economists were providing the institutional and ‘scientific’ cover that made the whole enterprise appear legitimate, even enlightened. In this chapter I focus on these handmaidens.

Takeover fever: Wall Street creates metaphysical values

In a typical year before the Crash of 2008, even before the crazed frenzy of the 2006-8 period), the Minotaur was devouring more than 70% of global capital outflows. Japan and Germany were the primary source until the early naughties. From around 2003, China stepped in as the greatest contributor. Mountains of cash shifted from all over the world to Wall Street and from there to US corporations and households in the form of equity and loans.

The massive capital inflows, together with the increases in corporate profitability mentioned in the last chapter, caused a great wave of mergers and acquisitions that, naturally, produced even more residuals for Wall Street operators. Indeed, the 1990s and 2000s saw a manic drive toward ‘consolidation’; a euphemism for one conglomerate purchasing, or merging with, another. The purchase of car makers like Daewoo, Saab and Volvo by Ford and General Motors was just the tip of the iceberg. Two periods in the history of capitalism stand out as the pinnacles of merger and acquisition frenzy: The first decade of the 20th century, when men like Edison and Ford built empires, and the twenty years that preceded 2008. It is not a coincidence that both periods led to a catastrophic event, 1929 and 2008.

Reading the 1999 Economic Report of the President, we come across the following lines: “Measured relative to the size of the economy, only the spate of trust formations at the turn of the century comes close to the current level of merger activity, with the value of mergers and acquisitions in the United States in 1998 alone exceeding 1.6 trillion dollars. Corporate mergers and acquisitions grew at a rate of almost 50 percent per year in every year but one between 1992 and 1998. Globally, more than two trillion dollars worth of mergers were announced in the first three quarters of 1999. The leading sectors in this merger wave have been in high technology, media, telecommunications, and finance but mega-mergers are also occurring in basic manufacturing.”

Both ‘consolidation’ waves (of the 1900s and the 1990s) had momentous consequences on Wall Street, effectively multiplying by a considerable factor the capital flows that the banks and other financial institutions were handling. However, the 1990s version was more explosive because of the effects of two new phenomena: The Minotaur-induced capital flight toward America and the way in which the so-called New Economy, predominantly the prospects for e’ commerce, mesmerised investors.

Wishful Thinking: How mergers and acquisitions created fictitious value[1]

Suppose there are two companies selling widgets: Goodwidget is the traditional manufacturer with 25 years of a track record behind it and E’widget an upstart that has been going for only a year and is selling widgets through the Internet (unlike Goodwidget which still relies on its traditional network of outlets). Suppose further that the following statistics capture the fundamentals of the two companies:

Goodwidget (25 years old):

  • Earnings (E) = $500 million per year
  • Growth = 10% annually for the previous twenty five years
  • Stock market capitalisation (K) = $5 billion
  • K/E = 10:1

E’widget (1 year old):

  • Earnings (E) = $200 million last year
  • Projected e’sales share in the years time = 10% of an  estimated) $1 trillion market = $100 billion
  • Stock market capitalisation (K) = $10 billion
  • K/E = 50:1

A prudent person might imagine that Goodwidget is probably a safer investment. However, that thought was routinely dismissed as faddy-daddy, backward looking and insufficiently tuned into E’widget‘s bright future. So, here is how Wall Street thought: Suppose E’widget were to utilise its superior stock market value or capitalisation (K)  to buy Goodwidget. What would the value of the merged company be? Should we just add up the two companies’ capitalisations ($10 billion plus $5 billion = $15 billion)? No, that would be too timid. Instead, Wall Street did something cleverer. It added the earnings of the two companies ($700 million + $200 million = $900 million) and multiplied it with E’widget‘s capitalisation to earnings ratio. This small piece of arithmetic yielded a fabulous number: 50:1 times $900 million = 45 billion!

Thus, the new merged company was valued at $30 billion more than the sum of the capitalisations of the two merged companies (a sudden leap of 300%). Needless to say, the fees and commissions of the Wall Street institutions that saw the merger through was analogous to the marvellous big figure they had miraculously arrived at.

In 1998 Germany’s flagship vehicle maker, Daimler Benz, was lured to the United States where it attempted, successfully, to take over Chrysler, the third largest American auto-maker. The price the German company paid for Chrysler sounded exorbitant, $36 billion, but, at the time, it seemed like a good price in view of Wall Street’s valuation of the merged company that amounted to a whopping $130 billion!

Motivated by the psychological exuberance caused by the Minotaur-induced capital inflows, Wall Street’s valuations were stratospheric. When internet company AOL (America On Line) used its inflated Wall Street capitalisation to purchase time-honoured TimeWarner, a new company was formed with $350 billion capitalisation. While AOL produced only 30% of the merged company’s profit stream, it ended up owning 55% of the new firm. These valuations were nothing more than bubbles waiting to burst. And burst they did, just before the Crash of 2008. In 2007, DaimlerChrysler broke up with Daimler selling Chrysler for a sad $500 million (taking a ‘haircut’ of $15.5 billion, compared to the price it had paid for it in 1998, the lost interest not included). Similarly with AOL-TimeWarner. By 2007 its Wall Street capitalisation was revised down from $350 billion to… $29 billion. The break up left both companies reeling.

On the other side of the Atlantic, in the other Anglo-Celtic economy that the Europeans so much admired before 2008, in Britain, a similar game was unfolding at the City of London. In 1976, just before the Minotaur took its first wobbly steps, the households with the top 10% of marketable wealth (not including housing) controlled 57% of income. In 2003 they controlled 71%. Mrs Thatcher’s government prided itself for having introduced what she called an entrepreneurial culture, a shareowners’ democracy. But did she? If we take the British households in the lower 50% income bracket and look at the proportion of the nation’s speculative capital that they owned and controlled, in 1976 that percentage was 12%. In 2003 it had dropped to 1%. By contrast, the top 1% of the income distribution increased its control over speculative capital from 18% in 1976 to 34% in 2003.

The City of London, attached every so firmly to Wall Street, could not but emulate the spirit of financialisation that first emerged in the United States in response to the large capital inflows from the rest of the world. Two concrete examples illustrate well the change in the logic of economic power during the time of the Minotaur: Debenhams and the Royal Bank of Scotland. Debenhams, the retail and department store chain, was bought in 2003 by a group of investors. The new owners sold most of the company’s fixed assets, pocketed a cool £1 billion and re-sold it at a time of exuberant expectations at more or less the same price that they had paid. The institutional funds that bought Debenhams ended up with massive losses.

Even more spectacularly, in October 2007 the Royal Bank of Scotland (RBS) put in a winning bid of more than €70 billion for ABN-Amro. By the following April, it was clear that RBS had overstretched itself and tried to raise money to plug holes exposed by the purchase of ABN-Amro. By July 2008 the parts of the merged company that were associated with ABN-Amro were nationalised by the governments of Holland, Belgium and Luxembourg. By the following October, the British government had stepped in to salvage RBS. The cost to the British taxpayer? A gallant £50 billion.

In short, the Global Minotaur created capital flows that propelled Wall Street’s gains from mergers and acquisitions (and, by osmosis, the City of London) to the financial stratosphere. In what seemed to many, wrongly of course, like a never-ending virtuous circle, these capital flows reinforced the Minotaur, as they satiated the twin US deficits in its belly. And it was not just the mergers and acquisitions flows that became entangled in a mutually reinforcing relationship with the Global Minotaur. Two other capital streams were part and parcel of the same dynamic: The profits of firms adopting the Wal-Mart extractive model and the debts of the average American for whom borrowed money was the only means of not falling completely out of touch with the American Dream.

Hedging and leverage

Before the Global Minotaur had wilfully disintegrated the world economy (to recall Paul Volcker’s sensational phrase circa 1978), derivatives were cuddly ‘creatures’ that actually helped hard working farmers find a modicum of safety in a viciously uncertain world. The Chicago Commodities Exchange (originally known as the Chicago Butter and Egg Board) allowed long suffering farmers the opportunity to sell today their next year’s harvest at fixed prices, thus affording them a degree of predictability.

Like all benign instruments that can turn malignant as they grow bigger and sharper, derivatives evolved into the Minotaur‘s grossest handmaiden. At first, they gave us hedging. Suppose that you want to buy an asset (e.g. a portrait, a house or a pack of shares) currently worth $1 million. However bullish your expectations about its future price, you are worried that it may drop in value. So, prudence urges you to buy some insurance; a get-me-out-of-here option to sell at, say, $800 thousand whenever you want (within a certain time frame). Like any form of insurance, if disaster does not strike (i.e. actual price never falls below $800 thousand), the insurance policy will have proven a waste of money. But if, say, the shares shed 40% of their value, you are covered for half of that loss.

Hedging has been with us for a long time. But it was the Global Minotaur that gave it a wholly new role, and a terrible reputation after 2008. At a time when the capital flows into Wall Street made its golden boys and girls feel invincible masters and mistresses of the universe, it became common for options to be used for exactly the opposite purposes than hedging. So, instead of purchasing an option to sell shares (as an insurance in case the shares that they were buying depreciated in value), the smart set bought options for buying even more! Thus, they bought their $1 million shares and on top of that they spent another $100 thousand on an option to buy another $1 million (at the current price). If the shares went up by, say, 40% that would net them a $400 thousand gain from the $1 million shares plus a further $400 thousand from the $100 thousand option. A total profit of $700 thousand.

At that point, the seriously optimistic had a radical thought: Why not buy only options? Why bother with shares at all? For if they were to spend their $1.1 million only on an option to buy these shares (as opposed to $1 million on the shares and $100 thousand on the option), and the shares went up again by 40%, their profit would be a stunning $4.4 million. And this is what became known as leverage: A form of borrowing money to bet big time which increases the stakes of the bet monumentally. Alas, from 1980 onwards, prudence was for wimps. The Minotaur was generating capital inflows that in turn guaranteed a rising tide in Wall Street that submerged the last islets of caution left.

From then onwards, people ‘in the know’ flocked to buy new financial ‘products’ and ‘innovations’. There was of course no such thing. These ‘innovative’ contraptions were just new ways of creating leverage; a fancy term for good old debt. On this matter, the best line belongs, yet again, to Paul Volcker. After the Crash of 2008, Wall Street’s bosses went into damage-control mode, desperately trying to stem the popular demand for stringent regulation of their institutions. Their argument, predictably, was that too much regulation would stem ‘financial innovation’ with dire consequences for economic growth; a little like the mafia warning against law enforcement because of its deflationary consequences.

In a plush conference setting, on a cold December 2009 New York night, all the big Wall Street institutional players were assembled to hear Paul Volcker address them. Attendance was high because President Obama had entrusted him with the planning of the new regulatory framework for the banks. Volcker lost no time before lashing out with the words: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth; one shred of evidence.” A hapless banker retorted that the financial sector in the United States had increased its share of value-added from 2% to 6.5%. Volcker responded with a killer question: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid?” To finish him off, he added: “The only financial innovation I recall in my long career was the invention of the ATM.”

The combination of options to buy, hedging and leveraging is such risky business that, had it been a pharmaceutical, it would have never in a million years secured FDA approval in the United States. This is, by now, well understood. Much less understood is the fact that, without the Global Minotaur guaranteeing a steady torrent of capital into the United States (often via London), these practices would never have taken off as a systemic practice. Not even in Wall Street…

Tomorrow we turn to the Wal-Mart business model and Wall Street’s toxic money. 


[1] This example comes from John Lanchester’s London Review of Books article ‘It’s Over’, 28th May 2009 issue.


2 Comments

  • Derivatives De-demonised.

    In the beginning of my career (1991) I worked as a FX trader here in Athens. The environment back then was highly regulated by BOG and FX was the only trading “opportunity” for banks in Greece. With no secondary market there was no interest rate curve beyond the 3 months. What a good times…
    So I joined the shiny circle of dealers trying to make a better living (read bonus) from putting bets all-day on whether USD/DEM or USD/GRD would go up or down. It doesn’t take a genius to understand that this (like any other form of proprietary trading) is a zero-sum game. Advocates of free-trading would argue that liquidity is a prerequisite for fair-pricing of the financial instruments.

    True but at what cost? How the fine tuning of an FX-rate justifies a trading volume 10 to 30 times larger than the real market size. Be careful: I only refer to plain FX trading, no derivatives no financial engineering. How a better exchange rate for say an exporter by .1% or less is compared to the huge cost of the banking sector in sustaining proprietary trading salaries and technological infrastructure? What is the long-term effect in that exporter’s real economic life from the increase of the systematic risk that interbank trading creates? Financial sector has a uniqueness: most of its activity is carried out horizontally inside the sector boarders due to proprietary trading and leveraging. Yet the effects of the unavoidable bad twist of things is impossible to be contained within.

    Prop trading the main cause of financial troubles. Derivatives and leveraging only magnify the effects.

    Golden boys or yuppies are just young people (like I used to be) that are promised the world if their bets win, while what they risk is their job (in the worst case scenario) if their bets drown their employer. With a couple of good years on the floor you can stop worrying about your future anyway…

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