Amid all the musings on the 10th anniversary of Lehman’s collapse, the story of American finance in many ways remains the same.
Michael J. Dell is said to be bringing Dell Computer back to the stock market, at a valuation several times higher than it went private.
Meanwhile, GE has been kicked out of the Dow Jones Industrial Index, after a sad saga of stock buybacks, financial manipulations and forced asset sales.
And Tesla, unable to meet its production targets except for an occasional week, still saw its stock price continue to defy gravity. It ended when Elon Musk became increasingly irrational in his – very public – communications.
All of these stories have a single theme: financial engineering, over the past two decades, has paid far better dividends to companies than actual engineering. For the health, especially of the US economy (as well as that of other Western economies), this needs to be reversed.
Dell as Poster Boy
Michael Dell is the poster child for the current boom in financial engineering. Having made a fortune the old-fashioned way by starting a PC distributor out of his college dorm room (although Dell Computer had always been more of a distribution and marketing success than an engineering one), he apparently decided that the size of the fortune – about $3.5 billion plus another $10 billion in outside investment – was insufficient.
In 2013, Dell privatized Dell Computer for $25 billion. He relied on the help of the private equity fund Silver Lake Technologies, in an operation criticized by Carl Icahn for having been carried out at too low a price.
At that time, Dell claimed that it wanted to reboot Dell for the cloud computing era. In fact, he did relatively little for the original PC company, but made another round of leveraged buyouts.
Dell bought storage maker EMC for $67 billion, acquiring a controlling stake in data center software company VMWare Inc. with it, and financing part of the purchase with the sale of stock. VMWare tracking.
The combined group is mostly in slow-growth tech sectors, so it didn’t add much value, although VMWare did well. Nevertheless, Dell is now proposing to make public an enterprise value of $120 billion.
It would buy out the VMWare tracking stock and end up with 72% of a tech conglomerate, worth $35 billion, ten times its original stake five years ago.
Nice work, if you can get it, but created almost entirely with financial juggling in five years, unlike the original 29-year-old work that Michael Dell undertook, which only created about a third of the wealth (since Dell’s outside investments likely came primarily from Dell Computer payments and stock sales).
Roots in the 1980s
The current wave of financial engineering began with the leveraged buyout boom of the 1980s. It really accelerated after the US Federal Reserve began keeping interest rates artificially low from 1995.
This strategy accelerated after 2009 as the Fed and other central banks kept interest rates at all-time highs for an unprecedented period.
During this time, there has not been much interest in true “engineering” economics. It has been very difficult, in the low productivity growth economy that the rich world has suffered since 2009, to build a great company based on real innovation and engineering skills.
With financiers like Silver Lake falling from the trees at every crossroads, it’s no surprise that financial engineering has dominated the real guy.
With money flowing into the financial markets for over twenty years now, there are now structural incentives to favor financial engineering over the real thing.
Hence the plethora of private equity and hedge funds. They all seek out financial engineering opportunities and somewhat disdain real engineering opportunities, not least because of the longer duration that the latter approach requires.
It is so much easier to fund rapid financial restructuring at the corporate level than to execute a long-term structural growth program. The fact that asset prices are high relative to earnings makes it relatively more profitable to manipulate assets rather than produce organic earnings growth.
There are a few legislative and regulatory solutions to the problem. One is to raise interest rates and keep them substantially positive in real terms for the next decade. This would collapse asset prices. It would also bankrupt all leveraged trading and hedge/private equity funds.
This would largely solve the problem of financial engineering, but at the cost of a lot of economic hardship across the economy. Back to the pre-1978 ban on buying back Treasury shares. This will reduce the indebtedness of large US corporations and eliminate the pernicious share buybacks that make the debt problem worse.
Taxing short-term stock option gains; this will make them unappealing to management.
One could also usefully eliminate the $1 million limit on the deductibility of non-incentive executive compensation. This is much less of a plutocratic suggestion than it sounds.
After all, this approach would incentivize companies to pay their top executives decent salaries for good work, with a lot less fictitious money on top of that. It would almost certainly also improve the quality of accounting reports, since management will no longer need to falsify accounts to achieve bogus bonus targets.
Only once we take effective legislative and regulatory action will we remove the incentives for financial engineering – and only then will the economies of the United States and the West return to full health.
It is ultimately also in the well-understood interest of the corporate elites. Clinging to the current practice of cleverly fabricated mechanisms of grotesque self-enrichment can only weaken the consensus for democracy and globalization even more than it already is.
The only thing protecting these elites – and the global economy – from the inevitable fallout for now is that the financial engineering games they play are not yet well understood by the general public.
We need to repeal SEC Rule 10B-18 and return to the pre-1982 position that companies repurchasing their shares in the market were deemed to engage in stock manipulation. In this way, much of the financial engineering and over-indebtedness would be eliminated.
Another crucial point: the dubious role of central banks – which claim to bolster the real economy with their injections of cash at a loss, while in reality serving the financial interests of the plutocrats – will come to haunt them before long.
Editor’s note: This article was originally published in the author’s journal “True Blue Will Never Stain” Blog.