The Dangers of US Style Financial Engineering

Amidst all the reflections on the 10th anniversary of the Lehman collapse, the story in U.S. 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 that at which it went private.

Meanwhile, GE has been thrown out of the Dow Jones Industrial Index, after a sorry saga of share buybacks, financial manipulation and forced asset sales.

And Tesla, unable to meet its production goals except for the occasional week, still saw its share price continue to defy gravity. That ended when Elon Musk became ever more irrational in his – very public – communications.

All these stories have a single theme: Financial engineering, for the last two decades, has paid much better dividends for corporations than actual engineering. For the health especially of the U.S. economy (as well as that of other Western economies), this needs to be reversed.

Dell as a poster boy

Michael Dell is the poster boy for the current financial engineering boom. Having made a fortune the old-fashioned way from starting a PC marketer in his college dorm room (though Dell Computer was always more of a distribution and marketing rather than engineering success), he apparently decided that the size of the fortune – about $3.5 billion plus another $10 billion in outside investments – was insufficient.

In 2013, Dell took Dell Computer private for $25 billion. He relied on the help of the private equity fund Silver Lake Technologies, in a deal that was criticized by Carl Icahn for being carried out at too low a price.

At that time, Dell claimed that he wanted to reboot Dell for the cloud computing era. In fact, he has done relatively little for the original PC company, but has carried out a further series of leveraged buyouts.

Dell bought the storage maker EMC for $67 billon, acquiring with it a controlling interest in the data storage center software company VMWare Inc., and funding part of the purchase with the sale of a VMWare tracking stock.

The combined group is mostly in slow-growing sectors of tech, so has not added much value, although VMWare has done well. Nevertheless, Dell is now proposing to go public on an enterprise value of $120 billion.

He would be buying back the VMWare tracking stock and ending up with 72% of a tech conglomerate, worth $35 billion, or ten times his 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 slog Michael Dell had undertaken, all of which created only around a third as much wealth (since Dell’s outside investments presumably came mostly from Dell Computer payouts and stock sales).

Roots in the 1980s

The current spate of financial engineering began with the leveraged buyout boom in the 1980s. It really accelerated after the U.S. Federal Reserve began keeping interest rates artificially low from 1995 onward.

This strategy accelerated after 2009, as the Fed and other central banks have kept interest rates at unprecedentedly low levels for an unprecedentedly prolonged period.

Meanwhile, there has not been much of interest going on in the real “engineering” economy. It has been very difficult in the low-productivity-growth economy that the rich world has suffered since 2009 to build a major company based on real innovation and engineering skills.

With financiers such as Silver Lake falling out of the trees at every crossroads, it is unsurprising that financial engineering has dominated the real kind.

Structural incentives

With money having been showered on financial markets for more than twenty years now, there are now structural incentives to favor financial engineering over the real kind.

Hence the plethora of private equity and hedge funds. They all seek financial engineering opportunities and somewhat disdain real engineering opportunities, not least because of their longer time frame the latter approach requires.

It is so much easier to finance a quick-buck financial restructuring at the company level than execute a program of long-term structural growth. The fact that asset prices are high in relation to earnings makes it relatively more profitable to manipulate assets rather than to produce organic earnings growth.

There are a few legislative and regulatory fixes for the problem. One of them is to raise interest rates and keep them soundly positive in real terms for the next decade. This would collapse asset prices. It would also put all the leveraged operations and hedge/private equity funds out of business.

That would solve the financial engineering problem to a large extent, albeit at the cost of a lot of economic pain throughout the economy. Return to the pre-1978 prohibition on buying back Treasury stock. This will reduce the leverage in major U.S. corporations and eliminate the pernicious stock buybacks that worsen the leverage problem.

Tax stock option gains as short-term; that will make them unattractive for management.

One could also usefully eliminate the limit of $1 million on deductibility of non-incentive compensation to top management. That is far less a plutocratic suggestion as it first appears.

After all, this approach would incentivize companies to paying its top executives decent salaries for a good job, with much less funny money on top. Doing this would almost certainly also improve the quality of accounting reports, since management will no longer need to fudge the accounts to achieve spurious bonus targets.

Conclusion

Only once we take effective legislative and regulatory action do we remove the incentives for financial engineering – and only then will the United States and Western economies return to full health.

This is ultimately also in the well-understood interest of corporate elites. Clinging to the current practice of skillfully manufactured mechanisms of grotesque self-enrichment is bound to hollow out the consensus for democracy and globalization even more than it already is.

The only thing that protects these elites – and the global economy – from the inevitable fallout for now is that the financial engineering games they play are not yet properly understood by the public at large.

We need to repeal SEC rule 10B-18 and return to the pre-1982 position, whereby companies re-purchasing their stock in the market were deemed to be engaging in share manipulation. That way, much financial engineering and over-leverage would be eliminated.

One more crucial point: The dubious role of central banks – who pretend to strengthen the real economy with their loose money injections, while in reality serving the financial self-interests of the plutocrats – will come to haunt them before long.

Editor’s Note: This article was originally published in the author’s “True Blue Will Never Stain” blog.