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Where are the jobs? For many companies, overseas


In this Feb. 17,2009, file photo, an engine technician works on a vessel engine at Caterpillar in northern Germany.
By Heribert Proepper, AP file


AP [via http://www.salon.com/news/feature/2010/12/28/us_overseas_hiring/index.html ]

By Pallavi Gogoi, AP Business Writer
December 28, 2010

Corporate profits are up. Stock prices are up. So why isn't anyone hiring?

Actually, many American companies are — just maybe not in your town. They're hiring overseas, where sales are surging and the pipeline of orders is fat.

More than half of the 15,000 people that Caterpillar has hired this year were outside the U.S. UPS (UPS) is also hiring at a faster clip overseas. For both companies, sales in international markets are growing at least twice as fast as domestically.

The trend helps explain why unemployment remains high in the United States, edging up to 9.8% last month, even though companies are performing well: All but 4% of the top 500 U.S. corporations reported profits this year, and the stock market is close to its highest point since the 2008 financial meltdown.

But the jobs are going elsewhere. The Economic Policy Institute [ http://www.epi.org/ ], a Washington think tank, says American companies have created 1.4 million jobs overseas this year, compared with less than 1 million in the U.S. The additional 1.4 million jobs would have lowered the U.S. unemployment rate to 8.9%, says Robert Scott, the institute's senior international economist.

"There's a huge difference between what is good for American companies versus what is good for the American economy," says Scott.

American jobs have been moving overseas for more than two decades. In recent years, though, those jobs have become more sophisticated — think semiconductors and software, not toys and clothes.

And now many of the products being made overseas aren't coming back to the United States. Demand has grown dramatically this year in emerging markets like India, China and Brazil.

Meanwhile, consumer demand in the U.S. has been subdued. Despite a strong holiday shopping season, Americans are still spending 3% less than before the recession on essential items like clothing and more than 10% less on jewelry, furniture, electronics, and big appliances, according to MasterCard's SpendingPulse.

"Companies will go where there are fast-growing markets and big profits," says Jeffrey Sachs, globalization expert and economist at Columbia University. "What's changed is that companies today are getting top talent in emerging economies, and the U.S. has to really watch out."

With the future looking brighter overseas, companies are building there, too. Caterpillar (CAT), maker of the signature yellow bulldozers and tractors, has invested in three new plants in China in just the last two months to design and manufacture equipment. The decision is based on demand: Asia-Pacific sales soared 38% in the first nine months of the year, compared with 16% in the U.S. Caterpillar stock is up 65% this year.

"There is a shift in economic power that's going on and will continue. China just became the world's second-largest economy," says David Wyss, chief economist at Standard & Poor's, who notes that half of the revenue for companies in the S&P 500 in the last couple of years has come from outside the U.S.

Take the example of DuPont, which wowed the world in 1938 with nylon stockings. Known as one of the most innovative American companies of the 20th century, DuPont (DD) now sells less than a third of its products in the U.S. In the first nine months of this year, sales to the Asia-Pacific region grew 50%, triple the U.S. rate. Its stock is up 47% this year.

DuPont's work force reflects the shift in its growth: In a presentation on emerging markets, the company said its number of employees in the U.S. shrank 9% between January 2005 and October 2009. In the same period, its work force grew 54% in the Asia-Pacific countries.

"We are a global player out to succeed in any geography where we participate in," says Thomas Connelly, chief innovation officer at DuPont. "We want our resources close to where our customers are, to tailor products to their needs."

While most of DuPont's research labs are still stateside, Connelly says he's impressed with the company's overseas talent. The company opened a large research facility in Hyderabad, India, in 2008.

A key factor behind this runaway international growth is the rise of the middle class in these emerging countries. By 2015, for the first time, the number of consumers in Asia's middle class will equal those in Europe and North America combined.

"All of the growth over the next 10 years is happening in Asia," says Homi Kharas, a senior fellow at the Brookings Institute and formerly the World Bank's chief economist for East Asia and the Pacific.

Coca-Cola CEO Muhtar Kent often points out that a billion consumers will enter the middle class during the coming decade, mostly in Africa, China and India. He is aggressively targeting those markets. Of Coke's (KO) 93,000 global employees, less than 13% were in the U.S. in 2009, down from 19% five years ago.

The company would not say how many U.S. hires it has made in 2010. But its latest investments are overseas, including $240 million for three bottling plants in Inner Mongolia as part of a three-year, $2 billion investment in China. The three plants will create 2,000 jobs in the area. In September, Coca-Cola pledged $1 billion to the Philippines over five years.

The strategy isn't restricted to just the largest American companies. Entrepreneurs, whether in technology, retail or in manufacturing, today hire globally from the start.

Consider Vast.com, which powers the search engines of sites like Yahoo Travel and Aol Autos. The company was founded in 2005 with employees based in San Francisco and Serbia.

Harvard Business School Dean Nitin Nohria worries that the trend could be dangerous. In an article [ http://hbr.org/2010/11/column-wealth-and-jobs-the-broken-link/ar/1 , via http://hbr.org/search/nohria?Ns=publication_date|1 (next below)] in the November issue of the Harvard Business Review, he says that if U.S. businesses keep prospering while Americans are struggling, business leaders will lose legitimacy in society. He exhorted business leaders to find a way to link growth with job creation at home.

Other economists, like Columbia University's Sachs, say multinational corporations have no choice, especially now that the quality of the global work force has improved. Sachs points out that the U.S. is falling in most global rankings for higher education while others are rising.

"We are not fulfilling the educational needs of our young people," says Sachs. "In a globalized world, there are serious consequences to that."

Copyright 2010 The Associated Press

http://www.usatoday.com/money/economy/2010-12-28-jobs-overseas_N.htm [also at e.g. http://www.salon.com/news/feature/2010/12/28/us_overseas_hiring/index.html and http://www.huffingtonpost.com/2010/12/28/job-market-booming-overseas_n_801839.html ]

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Wealth and Jobs: The Broken Link

by Nitin Nohria
Harvard Business Review
November 2010

For most of the 20th century, a symbiotic link existed between value creation and job creation. When businesses prospered, employment expanded and communities thrived. This virtuous circle was good for business and good for society.

But now the relationship between value creation and job creation is more tenuous. In the United States, for example, the corporate sector—judging from most companies’ earnings reports—is doing well, yet people are struggling to find work. Perhaps job creation will catch up with value creation, as confidence grows in the future of the economy. But what if this is a symptom of a deeper structural issue?

Two factors that once supported the link between business growth and job growth have fundamentally changed. Businesses in the 20th century were both more industrial and more local than they are today. To grow, an industrial firm had to expand mass production and mass distribution. An increase in the demand for products, whether cars, washing machines, or TV sets, eventually created additional jobs on the assembly line and in the supply and distribution chain.

These jobs were local, and over time they became well-paying middle-class jobs. As a result, in the U.S. for most of the 20th century the rise of business coincided with the rise of the middle class, creating confidence in the system and establishing the American Century.

Fast forward to today. When Google, Facebook, or another of the amazing companies that exemplify the new American economy doubles in size, it doesn’t multiply jobs the way fast-growing industrial firms once did. A hedge fund trading billions of dollars needs far fewer people than would a traditional bank handling similar sums. And often new jobs are going to a few skilled, highly paid knowledge workers rather than to many middle-class workers.

Moreover, business is no longer local. Decent production capability is distributed more widely in the world and can be developed more quickly, further weakening the link between business growth and local job growth. This is the Global Century, in which jobs ignore borders and move quickly to lower-cost regions.

To be sure, both these changes benefit society overall, enabling prosperity for far more people around the globe. The rise of a middle class in India and China ultimately produces many new customers for the likes of Google and Facebook. But these benefits will be realized in the long run. To people worried about finding jobs now, the short run is all that matters—and politicians looking to get elected have no choice but to respond to those short-term concerns.

The stakes are high. I don’t have the answers, though government policies and business practices that promote innovation, entrepreneurship, and the formation of skilled human capital seem essential. Executives and politicians must find new ways to link value creation and job creation. If they don’t, business leaders will continue to lose legitimacy in society, especially if they keep prospering while people around them are struggling. Instead of a virtuous circle, the relationship between business and society will become a vicious circle.

When society is angry at business, the risk that governments will enforce overreaching regulation is real. Moreover, that anger distances citizens from the source of answers to many of our most urgent issues. None of the major problems confronting the globe today—sustainability, health care, poverty, financial-system repair—can be solved unless business plays a significant role. But to do that, business must restore its stature and help to address the anxiety about job creation.

Copyright © 2010 Harvard Business School Publishing Corporation

Nitin Nohria is the dean of Harvard Business School.

http://hbr.org/2010/11/column-wealth-and-jobs-the-broken-link/ar/1 with comments]


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How Superstars’ Pay Stifles Everyone Else


In sports as in business, pay has soared at the very top of the scale. Last season, the soccer superstar Cristiano Ronaldo, right, made about 15 times as much as Pelé did in 1960, adjusted for inflation.
Left, Agence France-Presse; right, Pierre-Philippe Marcou/Agence France-Presse - Getty Images


President Franklin D. Roosevelt signed the Glass-Steagall law in the 1930s to separate commercial banking from investment banking. Standing from left are Senator Carter Glass, Senator Duncan Fletcher, Henry Morgenthau Jr. of the Treasury, Jesse Jones and Representative Henry Steagall.
Associated Press



Published: December 25, 2010

This article was adapted from “The Price of Everything: Solving the Mystery of Why We Pay What We Do,” by Eduardo Porter, an editorial writer for The New York Times. The book, to be published on Jan. 4 by Portfolio, examines how pricing affects all of our choices.

*

IN 1990, the Kansas City Royals had the heftiest payroll in Major League Baseball: almost $24 million. A typical player for the New York Yankees, which had some of the most expensive players in the game at the time, earned less than $450,000.

Last season, the Yankees spent $206 million on players, more than five times the payroll of the Royals 20 years ago, even after accounting for inflation. The Yankees’ median salary was $5.5 million, seven times the 1990 figure, inflation-adjusted.

What is most striking is how the Yankees have outstripped the rest of the league. Two decades ago. the Royals’ payroll was about three times as big as that of the Chicago White Sox, the cheapest major-league team at the time. Last season, the Yankees spent about six times as much as the Pittsburgh Pirates, who had the most inexpensive roster.

Baseball aficionados might conclude that all of this points to some pernicious new trend in the market for top players. But this is not specific to baseball, or even to sport. Consider the market for pop music. In 1982, the top 1 percent of pop stars, in terms of pay, raked in 26 percent of concert ticket revenue. In 2003, that top percentage of stars — names like Justin Timberlake, Christina Aguilera or 50 Cent — was taking 56 percent of the concert pie.

The phenomenon is not even specific to the United States. Pelé, from Brazil, the greatest soccer player of all time, made his World Cup debut in Sweden in 1958, when he was only 17. He became an instant star, coveted by every team on the planet. By 1960, his team, Santos, reportedly paid him $150,000 a year — about $1.1 million in today’s money. But these days, that would amount to middling pay. The top-paid player of the 2009-10 season, the Portuguese forward Cristiano Ronaldo, made $17 million playing for the Spanish team Real Madrid.

Of course, the inflated rewards of performers at the very top have to do with specific changes in the underlying economics of entertainment. People have more disposable income to spend on entertainment. Corporate sponsorships, virtually non-existent in the age of Pelé, account today for a large share of performers’ income. In 2009, the highest-earning soccer player was the English midfielder David Beckham, who made $33 million from endorsements on top of a $7 million salary from the Los Angeles Galaxy and AC Milan.

But broader forces are also at play. Nearly 30 years ago, Sherwin Rosen, an economist from the University of Chicago, proposed an elegant theory to explain the general pattern. In an article entitled “The Economics of Superstars [ http://www.jstor.org/pss/1803469 ],” he argued that technological changes would allow the best performers in a given field to serve a bigger market and thus reap a greater share of its revenue. But this would also reduce the spoils available to the less gifted in the business.

The reasoning fits smoothly into the income dynamics of the music industry, which has been shaken by many technological disruptions since the 1980s. First, MTV put music on television. Then Napster took it to the Internet. Apple allowed fans to buy single songs and take them with them. Each of these breakthroughs allowed the very top acts to reach a larger fan base, and thus command a larger audience and a bigger share of concert revenue.

Superstar effects apply, too, to European soccer, which is beamed around the world on cable and satellite TV. In 2009, the top 20 soccer teams reaped revenue of 3.9 billion euros, more than 25 percent of the combined revenue of all the teams in European leagues.

Pelé was not held back by the quality of his game, but by his relatively small revenue base. He might be the greatest of all time, but few people could pay to experience his greatness. In 1958, there were about 350,000 television sets in Brazil. The first television satellite, Telstar I, wasn’t launched until July 1962, too late for his World Cup debut.

By contrast, the 2010 FIFA World Cup in South Africa, in which Ronaldo played for Portugal, was broadcast in more than 200 countries, to an aggregate audience of over 25 billion. Some 700 million people watched the final alone. Ronaldo is not better then Pelé. He makes more money because his talent is broadcast to more people.

*

IF one loosens slightly the role played by technological progress, Dr. Rosen’s framework also does a pretty good job explaining the evolution of executive pay. In 1977, an elite chief executive working at one of America’s top 100 companies earned about 50 times the wage of its average worker. Three decades later, the nation’s best-paid C.E.O.’s made about 1,100 times the pay of a worker on the production line.

This has separated the megarich from the merely very rich. A study of pay in the 1970s found that executives in the top 10 percent made about twice as much as those in the middle of the pack. By the early 2000s, the top suits made more than four times the pay of the executives in the middle.

Top C.E.O.’s are not pop stars. But the pay for the most sought-after executives has risen for similar reasons. As corporations have increased in size, management decisions at the top have become that much more important, measured in terms of profits or losses. Top American companies have much higher sales and profits than they did 20 years ago. Banks and funds have more assets.

With so much more at stake, it has become that much more important for companies to put at the helm the “best” executive or banker or fund manager they can find. This has set off furious competition for top managerial talent, pushing the prices of top-rated managers way above the pay of those in the tier just below them. Two economists at New York University, Xavier Gabaix and Augustin Landier, published a study [ http://papers.ssrn.com/sol3/papers.cfm?abstract_id=890829 ] in 2006 estimating that the sixfold rise in the pay of chief executives in the United States over the last quarter century or so was attributable entirely to the sixfold rise in the market size of large American companies.

And therein lies a big problem for American capitalism.

*

CAPITALISM relies on inequality. Like differences in other prices, pay disparities steer resources — in this case, people — to where they would be most productively employed.

Despite the great danger and cost of crossing the border illegally into the United States, hundreds of thousands of the hardest-working Mexicans are drawn by the relative prosperity they can achieve north of the border — where the average income of a Mexican-American household is more than $33,000, almost five times that of a family in Mexico.

In poor economies, fast economic growth increases inequality as some workers profit from new opportunities and others do not. The share of national income accruing to the top 1 percent of the Chinese population more than doubled from 1986 to 2003. Inequality spurs economic growth by providing incentives for people to accumulate human capital and become more productive. It pulls the best and brightest into the most lucrative lines of work, where the most profitable companies hire them.

Yet the increasingly outsize rewards accruing to the nation’s elite clutch of superstars threaten to gum up this incentive mechanism. If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side.

Inequality has been found to turn people off. A recent experiment conducted with workers at the University of California found that those who earned less than the typical wage for their pay unit and occupation became measurably less satisfied with their jobs, and more likely to look for another one if they found out the pay of their peers. Other experiments have found that winner-take-all games tend to elicit much less player effort — and more cheating — than those in which rewards are distributed more smoothly according to performance.

Ultimately, the question is this: How much inequality is necessary? It is true that the nation grew quite fast as inequality soared over the last three decades. Since 1980, the country’s gross domestic product per person has increased about 69 percent, even as the share of income accruing to the richest 1 percent of the population jumped to 36 percent from 22 percent. But the economy grew even faster — 83 percent per capita — from 1951 to 1980, when inequality declined when measured as the share of national income going to the very top of the population.

One study concluded that each percentage-point increase in the share of national income channeled to the top 10 percent of Americans since 1960 led to an increase of 0.12 percentage points in the annual rate of economic growth — hardly an enormous boost. The cost for this tonic seems to be a drastic decline in Americans’ economic mobility. Since 1980, the weekly wage of the average worker on the factory floor has increased little more than 3 percent, after inflation.

The United States is the rich country with the most skewed income distribution. According to the Organization for Economic Cooperation and Development [ http://www.oecd.org/document/53/0,3746,en_2649_33933_41460917_1_1_1_1,00.html ], the average earnings of the richest 10 percent of Americans are 16 times those for the 10 percent at the bottom of the pile. That compares with a multiple of 8 in Britain and 5 in Sweden.

Not coincidentally, Americans are less economically mobile than people in other developed countries. There is a 42 percent chance that the son of an American man in the bottom fifth of the income distribution will be stuck in the same economic slot. The equivalent odds for a British man are 30 percent, and 25 percent for a Swede.

*

NONE of this even begins to account for the damage caused by the superstar dynamics that shape the pay of American bankers.

Remember the ’80s? Gordon Gekko first sashayed across the silver screen. Ivan Boesky was jailed for insider trading. Michael Milken peddled junk bonds. In 1987, financial firms amassed a little less than a fifth of the profits of all American corporations. Wall Street bonuses totaled $2.6 billion — about $15,600 for each man and woman working there.

Yet by current standards, this era of legendary greed appears like a moment of uncommon restraint. In 2007, as the financial bubble built upon the American housing market reached its peak, financial companies accounted for a full third of the profits of the nation’s private sector. Wall Street bonuses hit a record $32.9 billion, or $177,000 a worker.

Just as technology gave pop stars a bigger fan base that could buy their CDs, download their singles and snap up their concert tickets, the combination of information technology and deregulation gave bankers an unprecedented opportunity to reap huge rewards. Investors piled into the top-rated funds that generated the highest returns. Rewards flowed in abundance to the most “productive” financiers, those that took the bigger risks and generated the biggest profits.

Finance wasn’t always so richly paid. Financiers had a great time in the early decades of the 20th century: from 1909 to the mid-1930s, they typically made about 50 percent to 60 percent more than workers in other industries. But the stock market collapse of 1929 and the Great Depression changed all that. In 1934, corporate profits in the financial sector shrank to $236 million, one-eighth what they were five years earlier. Wages followed. From 1950 through about 1980, bankers and insurers made only 10 percent more than workers outside of finance, on average.

This ebb and flow of compensation mimics the waxing and waning of restrictions governing finance. A century ago, there were virtually no regulations to restrain banks’ creativity and speculative urges. They could invest where they wanted, deploy depositors’ money as they saw fit. But after the Great Depression, President Franklin D. Roosevelt set up a plethora of restrictions to avoid a repeat of the financial bubble that burst in 1929.

Interstate banking had been limited since 1927. In 1933, the Glass-Steagall Act forbade commercial banks and investment banks from getting into each other’s business — separating deposit taking and lending from playing the markets. Interest-rate ceilings were also imposed that year. The move to regulate bankers continued in 1959 under President Dwight D. Eisenhower, who forbade mixing banks with insurance companies.

Barred from applying the full extent of their wits toward maximizing their incomes, many of the nation’s best and brightest who had flocked to make money in banking left for other industries.

Then, in the 1980s, the Reagan administration unleashed a surge of deregulation. By 1999, the Glass-Steagall Act lay repealed. Banks could commingle with insurance companies at will. Ceilings on interest rates vanished. Banks could open branches anywhere. Unsurprisingly, the most highly educated returned to banking and finance. By 2005, the share of workers in the finance industry with a college education exceeded that of other industries by nearly 20 percentage points. By 2006, pay in the financial sector was again 70 percent higher than wages elsewhere in the private sector. A third of the 2009 Princeton graduates who got jobs after graduation went into finance; 6.3 percent took jobs in government.

Then the financial industry blew up, taking out a good chunk of the world economy.

Finance will not be tamed by tweaking the way bankers are paid. But bankers’ pay could be structured to discourage wanton risk taking. Similarly, superstar effects are not the sole cause of the stagnant incomes of regular Joes. But the piling of rewards on our superstars is encouraging a race to the top that, if left unabated, could leave very little to strive for in its wake.

*

Copyright 2010 The New York Times Company

http://www.nytimes.com/2010/12/26/business/26excerpt.html [ http://www.nytimes.com/2010/12/26/business/26excerpt.html?pagewanted=all ]

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Dodging Repatriation Tax Lets U.S. Companies Bring Home Cash


John Chambers, chief executive officer of Cisco Systems Inc.
Photographer: Joshua Roberts/Bloomberg

Video:
Dec. 15 (Bloomberg) -- Motorola Inc. co-Chief Executive Officer Greg Brown, and CEOs James McNerney of Boeing Inc., Scott Davis of United Parcel Service Inc. and David Cote of Honeywell International Inc. comment on today's meeting with President Barack Obama about the economy. Obama said his meeting with 20 company executives brought “progress” in efforts to accelerate the U.S. economic recovery. (Source: Bloomberg)
http://www.bloomberg.com/video/65312594/ [embedded]

By Jesse Drucker - Dec 28, 2010 11:01 PM CT

At the White House on Dec. 15, business executives asked President Obama for a tax holiday that would help them tap more than $1 trillion of offshore earnings, much of it sitting in island tax havens.

The money -- including hundreds of billions in profits that U.S. companies attribute to overseas subsidiaries to avoid taxes -- is supposed to be taxed at up to 35 percent when it’s brought home, or “repatriated.” Executives including John T. Chambers of Cisco Systems Inc. say a tax break would return a flood of cash and boost the economy.

What nobody’s saying publicly is that U.S. multinationals are already finding legal ways to avoid that tax. Over the years, they’ve brought cash home, tax-free, employing strategies with nicknames worthy of 1970s conspiracy thrillers -- including “the Killer B” and “the Deadly D.”

Merck & Co Inc., the second-largest drugmaker in the U.S., last year brought more than $9 billion from abroad without paying any U.S. tax to help finance its acquisition of Schering-Plough Corp., securities filings show. Merck is also appealing a federal judge’s 2009 finding that Schering-Plough owed taxes on $690 million it had earlier brought home from overseas tax-free.

The largest drugmaker, Pfizer Inc., imported more than $30 billion from offshore in connection with its acquisition of Wyeth last year, while taking steps to minimize the tax hit on its publicly reported profit.

Disclosures in Switzerland and Delaware by Eli Lilly & Co. show the Indianapolis-based pharmaceutical company carried out many of the steps for a tax-free importation of foreign cash after its roughly $6 billion purchase of ImClone Systems Inc. in 2008.

‘Trivially Small Taxes’

“Sophisticated U.S. companies are routinely repatriating hundreds of billions of dollars in foreign earnings and paying trivially small U.S. taxes on those repatriations,” said Edward D. Kleinbard, a law professor at the University of Southern California in Los Angeles. “They devote enormous resources first to moving income to tax havens, and then to bringing those profits back to the U.S. at the lowest possible tax cost.”

With the exception of the Schering-Plough case, no authority has accused Merck or Pfizer or Lilly of paying less tax than they should have. While corporations have no obligation to pay any more than the legal minimum, “the question is what should that minimum be?” said Kleinbard, a former corporate tax attorney at Cleary Gottlieb Steen & Hamilton LLP and former chief of staff at the congressional Joint Committee on Taxation [ http://www.jct.gov/ ].

U.S. companies overall use various repatriation strategies to avoid about $25 billion a year in federal income taxes, he said.

‘Best of Worlds’

“The current U.S. international tax system is the best of all worlds for U.S. multinationals,” said David S. Miller, a partner at Cadwalader, Wickersham & Taft LLP in New York. That’s because the companies can defer federal income taxes by shifting profits into low-tax jurisdictions abroad, and then use foreign tax credits to shelter those earnings from U.S. tax when they repatriate them, he said.

They’re aided by a cadre of attorneys, accountants and investment bankers in the tax-planning industry -- such as a panel of KPMG LLP tax advisers who held forth in a chilly hotel ballroom at a Philadelphia conference last month. There, they discussed a series of techniques for multinationals to return cash from overseas while avoiding or deferring the taxes.

KPMG tax advisers Kevin Glenn and Tom Zollo used slides to describe several methods. One diagram resembled a schematic from the Manhattan Project [ http://www.atomicarchive.com/History/mp/p2s4_image.shtml ]. Another strategy would require certain “bells and whistles” to convince regulators of an actual non-tax business purpose, Glenn explained.

Cat and Mouse

Such maneuvers reflect a decades-long cat-and-mouse game. As regulators and lawmakers tighten the rules, companies seek new, legal methods for getting around them. One of the techniques the KPMG advisers discussed was in response to loophole-closers Congress passed in August to address a projected $1.4 trillion federal budget deficit. The changes will make it harder for companies to manipulate the credits they get for taxes paid overseas.

“Some of the best minds in the country are spent all day, every day, wheedling nickels and dimes out of the tax system,” said H. David Rosenbloom, an attorney at Caplin & Drysdale in Washington, D.C., and director of the international tax program at New York University’s school of law.

Chambers, Cisco’s chief executive officer, brought up a repatriation break during the White House meeting, according to a person familiar with the discussion. It could reprise a 2004 tax holiday that allowed multinationals to return profits to the U.S. at a tax rate of 5.25 percent. U.S. corporations brought home $362 billion, with $312 billion qualifying for the relief, according to the Internal Revenue Service.

Short-Term Fix

Such a move “is a short-term fix to a long-term problem, which is the uncompetitive U.S. tax structure,” said Cisco spokeswoman Jennifer Greeson Dunn. The San Jose, California-based company reported $31.6 billion of undistributed foreign earnings, on which it had paid no U.S. taxes, as of July 31.

President Obama, who campaigned in part against companies’ use of offshore havens to avoid U.S. taxes, asked Treasury Secretary Timothy F. Geithner to follow up on the issue with business leaders, according to a White House official who asked not to be identified because the discussions were private.

The argument that a new tax break for offshore earnings would generate a domestic stimulus “holds no water at all,” said Joel B. Slemrod, an economics professor at the University of Michigan’s school of business and former senior tax economist for President Reagan’s Council of Economic Advisers. U.S. companies are already sitting on a record pile of cash -- $1.9 trillion in liquid assets, according to Federal Reserve data.

‘Cash Hoards’

“The fact that they have these cash hoards suggests that investment is not being constrained by lack of cash,” Slemrod said.

U.S. multinationals boost earnings by shifting income out of the country via transfer pricing, a system that allows them to allocate costs to subsidiaries in high-tax countries and profits [ http://www.bloomberg.com/news/2010-05-13/exporting-profits-imports-u-s-tax-reductions-for-pfizer-lilly-oracle.html ] to tax havens. Google Inc., for example, cut its taxes by $3.1 billion in the last three years by moving most of the income it attributed overseas ultimately to Bermuda, Bloomberg News reported in October.

The tax benefits from such profit shifting can have a greater impact on share price than boosting sales or cutting other expenses, since the reduced rate goes straight to the bottom line, said John P. Kennedy, a partner at Deloitte Tax LLP, speaking at the conference in Philadelphia Nov. 3.

Boosting Share Prices

For a hypothetical company that has 1,000 shares outstanding, has pretax income of $5,000 and trades at 20 times earnings, cutting just 2 percentage points off the rate could drive the share price up $2, Kennedy said.

“You may think two bucks isn’t much, but when you’re the CFO and she has 100,000 options, that’s pretty interesting,” he said. He cited large pharmaceutical and biotech companies, including Merck, Amgen Inc. and Eli Lilly, which have reported effective income tax rates at least 10 percentage points below the statutory 35 percent rate.

The bottom line: The effective tax rate “is, and will continue to be, the metric that is used to judge your performance,” he told the audience of corporate tax accountants and attorneys.

U.S. drugmakers shift profits overseas far in excess of actual sales there. In 2008, large U.S. pharmaceutical companies reported about four-fifths of their pre-tax income abroad, up from about a third in 1997, according to a March article in the journal Tax Notes by Martin A. Sullivan, a contributing editor and former U.S. Treasury Department tax economist. Their actual foreign sales grew more slowly, to 52 percent from 38 percent.

Stranded Cash

Deloitte’s Kennedy warned that booking large portions of income overseas can mean “you are going to strand so much cash offshore that your business chokes.” That’s because the foreign profits cannot be used for such purposes as building domestic factories without triggering federal tax. Overall, U.S. companies reported more than $1 trillion in such “indefinitely reinvested earnings” offshore at the end of 2009, according to data compiled by Bloomberg.

Last year, Merck, based in Whitehouse Station, New Jersey, tapped its offshore cash, tax-free, to pay for just over half the cash portion of its $51 billion merger with Schering-Plough, according to company filings.

At the deal’s closing, Merck’s foreign subsidiaries lent $9.4 billion to a pair of Schering-Plough Dutch units. Then the Dutch companies used those funds to repay a pre-existing loan from their U.S. parent, securities filings show. The $9.4 billion ended up with Schering-Plough shareholders as part of the cash owed under the merger, according to the company’s disclosure.

No Tax Hit

Bottom line: Merck used its overseas cash to pay the former Schering-Plough shareholders -- with no U.S. tax hit. In considering whether companies owe taxes in such cases, the IRS often asks whether payments from an offshore unit constitute a dividend, which would be taxable.

In Merck’s case, it arguably could be, said Robert Willens, who runs an independent firm that advises investors on tax issues.

“Merck was obligated to pay Schering-Plough shareholders and they tapped into the funds of their overseas subsidiaries to do it,” he said. “You’d have to be concerned about a constructive dividend there.”

Merck objected to any characterization of the payment as a dividend. “We don’t think the characterization is accurate and we remain confident with our tax position,” said Steven Campanini, a company spokesman.

On Appeal

In the Schering-Plough case decided last year, the drugmaker brought home $690 million tax-free as a result of assigning its rights to income from a complex interest-rate swap to a foreign subsidiary in the 1990s. A judge found the company “failed to establish a genuine purpose for the transactions other than tax avoidance” and said Schering-Plough was not entitled to $473 million in back taxes in dispute. Merck is appealing the judgment.

Even when companies pay large tax bills to import their foreign profits, they find ways to minimize the impact on the earnings they show investors. Last year, New York-based Pfizer repatriated more than $30 billion from offshore to help pay for its $64 billion purchase of Wyeth, according to company disclosures and a person familiar with the transaction.

The acquisition created a so-called deferred tax liability on Pfizer’s balance sheet of about $25 billion, according to securities filings, in part to allow for an anticipated tax hit on the earnings that would be repatriated.

Impact Wiped Out

While bringing home more than $30 billion helped generate a $10 billion tax obligation, Pfizer was able to draw down $10 billion of its new deferred liability through its income statement. Doing so wiped out the tax impact of the repatriation on its earnings reported to shareholders.

So while the company paid a real tax bill to the U.S. government stemming from the repatriation, that tax payment had limited impact on its publicly reported profits.

Pfizer made use of a legal accounting quirk that allowed it to set up the deferred liability on its balance sheet, but reverse part of that liability through its income statement, said Edmund Outslay, a professor of tax accounting at Michigan State University.

“Had Pfizer repatriated these earnings independently of the purchase of Wyeth, it would have incurred a huge tax charge” on its income statement, Outslay said. “So through the magic of purchase accounting, you create an opportunity to bring this money home while mitigating its impact on your effective tax rate.”

Effective Tax Rate

Pfizer spokeswoman Joan Campion said the $10 billion tax hit was indeed erased on the income statement because of the accounting treatment, but noted that the company’s effective tax rate rose in 2009 in part because Wyeth’s overseas profits were repatriated to help finance the deal.

Other strategies based on acquisitions have achieved nickname status among corporate tax advisers.

The “Killer B” maneuver is named for section 368(a)(1)(B) of the Internal Revenue Code [ http://www.irs.gov/taxpros/article/0,,id=98137,00.html ], which deals with tax-free reorganizations. A U.S. company using the technique would sell its shares to an offshore subsidiary, bringing cash back to the U.S. tax-free. The offshore unit could then use the stock to make an acquisition. In 2006, the IRS issued a notice aimed at shutting down the maneuver.

Using a Variation

International Business Machines Corp. used a variation on the technique in May 2007, with an offshore unit purchasing the shares from a trio of banks, according to a company securities filing. That permutation wasn’t covered by the IRS in 2006. Two days after IBM’s disclosure, the agency announced plans for additional rule changes addressing stock sales to subsidiaries from shareholders as well as directly from parent companies.

The “Deadly D,” also named for a section of tax law, allows a U.S. company to attach the high tax basis in a newly acquired company to one of its existing foreign units. In some cases, doing so enables the U.S. parent to pull cash from the subsidiary up to the amount of the recent purchase price tax-free. The Obama administration has proposed changing the provision that enables the maneuver.

Lilly closed on its purchase of ImClone in November 2008. The next month, the newly acquired company converted to an LLC and Lilly transferred the investment to its main Swiss subsidiary, Eli Lilly SA, according to disclosures in Switzerland and Delaware. The transfer was in exchange for a $5.8 billion note payable to the U.S. parent company due at the end of 2011.

Extracting Earnings

Willens, the independent tax adviser, said the steps indicated a likely D reorganization, or another method “to extract earnings from overseas without tax consequences -- of course.” Lilly had no comment beyond its filings, said David P. Lewis, the company’s vice president for global taxes.

The KPMG panel discussion in Philadelphia, called “Global Cash Tax Management Plans and Repatriation Planning,” dissected other techniques, including one that took six slides to explain. It works like this:

Soon after a U.S. multinational has purchased another U.S. company, the new unit promises to pay the parent a large amount of cash pursuant to a note agreement. Since both parties are U.S. companies, there is no tax bill for the parent under current U.S. law.

Then the new acquisition converts to a foreign company. So when the payment pursuant to the note is made, it comes from overseas. That means the foreign cash is treated as a nontaxable payment under the note, instead of a taxable dividend.

Going Offshore

The newly converted foreign subsidiary could access the multinational’s existing offshore cash by borrowing from a foreign sister unit, said Glenn, the KPMG tax partner. He and Zollo were joined by colleague Frank Mattei, as well as Don Whitt, a Pfizer tax official.

“This basic transaction is something that at least a couple of taxpayers have done, and I know a number of others have evaluated,” Glenn said. The strategy’s name follows the alphabetic tradition of Bs and Ds. It’s called “the Outbound F.”

*

Attachment: KPMG Excerpt
http://media.bloomberg.com/bb/avfile/rBccIXSBXDm0

Attachment: Tax Notes Article
http://media.bloomberg.com/bb/avfile/r9q62nPCrCiw

*

To contact the reporter on this story: Jesse Drucker in New York at [e-mail].

To contact the editor responsible for this story: Gary Putka at [e-mail].

©2010 BLOOMBERG L.P.

http://www.bloomberg.com/news/2010-12-29/dodging-repatriation-tax-lets-u-s-companies-bring-home-cash.html


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Corporations Don't Do Bad Things, People Do!

By Dave Johnson
December 20, 2010 - 8:54pm ET

Are there "good" companies and "bad" companies? No, there are just companies, and companies don't have moral characteristics any more than a chair does. Here is something to understand about the things companies "do." If we LET a company "do" something, all companies HAVE TO do it. The misunderstanding of deregulation is that anything that CAN be done WILL be done. Anything.

E. J. Dionne Jr., in Even progressives need CEOs [ http://www.washingtonpost.com/wp-dyn/content/article/2010/12/19/AR2010121903017.html ] writes that it is,

... important to recognize that there is no single business class or corporate model. Obama doesn't need to coddle CEOs so they will say warm things about him at parties in the Hamptons. He should figure out which parts of the private sector share an interest in reducing the dreadful inequalities that have metastasized over nearly four decades and in creating an economy that produces well-paying jobs.

[. . .] Government policies, no matter how often we use the words "free enterprise," through design or inadvertence, inevitably affect the private economy. Why not choose policies that specifically encourage sectors that create good jobs for Americans?

The piece is well-worth reading because it points out that there are plenty of great business leaders who want to help the country address our problems and do better for our people. Mostly we hear today about the worst kind of self-interested, greed-driven business leaders because those seem to be the ones calling the shots for our economy and our political system. This is because we let the them get away with being the worst, so they rise to the top.

We need strong regulations and tough laws so the good CEOs can do the right thing, and still remain competitive.

Corporations Are A Good Idea

Last year in Why I Am Pro-Corporate [ http://www.ourfuture.org/blog-entry/2009073128/why-i-am-pro-corporate ], I wrote about why corporations are a good thing

The things that the corporate legal structure enables people to do are good for society. This is why We, the People decided to enact the laws that created corporations. If we want to be able to accomplish things on a large scale, like build a railroad or airports and airplanes or skyscrapers – or solar power plants to replace coal power plants – we want to enable people to more easily raise the necessary capital and amass the resources needed to get the job done. The legal structure of the corporate form of a business accomplishes this.

Corporations are just an idea. They are just a bundle of contracts. They don't do things, people do.

Do Companies "Do"? Do They "Want"?

It is the business leaders, not the companies, who make decisions and want things and do things. Companies are just things that don't "want" any more than they "do." They don't "think." They don't "decide." They don't "respond." Sentient entities want and do. It is the people who make decisions want and do things. Companies are not sentient entities any more than chairs are. And how we think about this affects the conclusions we reach.

One reason we apply these characteristics to companies is because they want us to. ("They want." There I go do it, too.) When the people who do marketing for companies (is that better?) try to make us think about companies this way, it is called "branding." They try to make us believe that a company is somehow a sentient entity because then we can think they "are good or bad" and therefore form emotional attachments that cause us to be influenced into buying their products. This is really just a manipulation and a distraction but it affects our brains. It is so important to realize that we are dealing with individual people who run companies because then we can think clearly about how to deal with the problems that they cause.

We have to understand the system, and what we are dealing with. We are dealing with people who run companies, not with companies. You can't be "pro-business" or "anti-business" because business just is. But you can require that people do the right thing.

We Need Very Strong Regulations And Tough Laws

When we complain about Wal-Mart "doing" something we are misunderstanding the system. The people who run Wal-Mart will do what we don’t stop them from doing. They have to. They don't necessarily want to. (Though some do.) That is what the system is. We set down rules, and they follow the rules. If something is not against a rule, then they don't just do whatever it is, they have to. And if they do something that is against the rules but we let them get away with it, then they will continue and others will start doing that, too.

Here is why: If Wal-Mart doesn’t then (the executives who run) Target or KMart or another company will, and then Target or KMart will have a competitive advantage, and after a while we’ll all be complaining about Target or KMart instead because Wal-Mart won’t be in the picture. They have to do everything we let them do. That is how the system works, and that is why we have to have strong regulations and tough law.

Instead of complaining about the things the business leaders do, we have to make strong regulations and tough laws to stop them and we have to enforce them. Period. We, the People have to use government “interference” and use force and that is our job and our responsibility to each other and to all of the business leaders who want to do the right thing.

It Is Not Fair To The Good, Responsible Leaders Not To

Let's say you are running Wal-Mart and you want to pay people more and want to provide good benefits. But the law does not require you to. If you do these things anyway, and your competitor doesn't, you are putting your company at a disadvantage, and you are risking the livelihood of everyone in the company. Think about the conflict and pressure that creates in good people who want to do good things. They can't do good things unless we make all the businesses do good things.

Companies are forced by competitive pressure to do the things other companies do, whether they "want" to or not. There isn’t really a middle ground. Our system of competition forces companies to do everything they can get away with, and they will do that, and the only thing that will stop them is We, the People actually stopping them.

So don't complain about things companies are doing, and certainly don't blame the companies. What do you have to do is change the rules. It just isn't fair to good people who want to do good things to do anything else. We have been letting good people down by listening to and doing the bidding of the likes of the Chamber of Commerce and the others who are fronts for the worst among the business community, who are working to corrupt our business environment and our politics.

Most Business Leaders Are Good People

Almost all corporate leaders are good, responsible and well-intentioned. For this reason they want and need clear rules that let them operate their companies responsibly. This is why listening to the greedheads who are always complaining about government and regulations is such a mistake. Most business leaders want to do the right thing and good, strong regulations and laws that are enforced let them do that. The deregulation and lack of enforcement that we see all around us today forces them to do wrong things in the name of staying competitive.

When you initially deregulate, good corporate leaders will try to be responsible and they will have every intent of doing so. They will live up to their promises. But along will come other corporate leaders who just want to make money for their companies,and more to the point, for themselves. They will do whatever we let them do to accomplish that. They will push up to and a bit beyond the exact wording of what they think they can get away with. The “good” CEOs will be at a disadvantage and will be forced to do the same.

Clear And Strong Regulations

When I ran a company I had a rule for agreements – get everything on paper and signed because the people talking about things today on both sides might get in a car wreck, or move to another company or forget or whatever and all that is left is the agreement and not the intent of the agreement. Similarly, we need to clearly lay out every little part of what can and cannot be done because that is what people will do in the end.

Business leaders want and need a clear playing field with rules that are strong enough to enable them to do the right thing and remain competitive. Let's help them out.

Copyright 2010 Campaign for America's Future/Institute for America's Future (emphasis in original)

http://www.ourfuture.org/blog-entry/2010125120/corporations-dont-do-bad-things-people-do [also at http://www.huffingtonpost.com/dave-johnson/corporations-dont-do-bad_b_800604.html (with comments)]

and see (items linked in):

http://investorshub.advfn.com/boards/read_msg.aspx?message_id=52862196 (and preceding)

http://investorshub.advfn.com/boards/read_msg.aspx?message_id=53736967 and preceding and following

http://investorshub.advfn.com/boards/read_msg.aspx?message_id=54119408 and preceding and following


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Out of Lehman's Ashes Wall Street Gets Most of What It Wants


Sachs CEO Lloyd Blankfein and his top deputies are in line to collect more than $100 million in delayed 2007 bonuses.
Photographer: Chris Kleponis/Bloomberg

Video:
Dec. 28 (Bloomberg) -- Bloomberg's Christine Harper discusses lobbying efforts and influence exerted by Wall Street’s biggest banks over government regulations. Harper speaks with Pimm Fox on Bloomberg Television's "Surveillance Midday." (Source: Bloomberg)
http://www.bloomberg.com/video/65552898/ [embedded]

By Christine Harper - Dec 27, 2010 11:01 PM CT

Wall Street’s biggest banks, whose missteps caused a global financial crisis and economic slowdown two years ago, were more agile when it came to countering the political and regulatory response.

The U.S. government, promising to make the system safer, buckled under many of the financial industry’s protests. Lawmakers spurned changes that would wall off deposit-taking banks from riskier trading. They declined to limit the size of lenders or ban any form of derivatives. Higher capital and liquidity requirements agreed to by regulators worldwide have been delayed for years to aid economic recovery.

“We continue to listen to the same people whose errors in judgment were central to the problem,” said John Reed, 71, a former co-chief executive officer of Citigroup Inc., who estimated only 25 percent of needed changes have been enacted. “I’m astounded because we basically dropped the world’s biggest economy because of an error in bank management.”

The last two years have been the best ever for combined investment-banking and trading revenue at Bank of America Corp., JPMorgan Chase & Co., Citigroup, Goldman Sachs Group Inc. and Morgan Stanley, according to data compiled by Bloomberg. Goldman Sachs CEO Lloyd Blankfein, 56, and his top deputies are in line to collect more than $100 million in delayed 2007 bonuses -- six months after paying $550 million to settle a fraud lawsuit related to the firm’s behavior that year. Citigroup, the bank that needed more taxpayer support than any other, has a balance sheet 14 percent bigger than it was four years ago.

Army of Lobbyists

Wall Street’s army of lobbyists and its history of contributions to politicians weren’t the only keys to success, lawmakers, academics and industry executives said. The financial system’s complexity gave bankers an advantage in controlling the narrative and dismissing the ideas of would-be reformers as infeasible or dangerous. A revolving door between government and banking offices contributed to a mind-set that what’s good for Wall Street is good for Main Street.

To make their case, bankers and lobbyists characterized proposed regulations as stifling innovation, competitiveness and economic growth. They said the industry had learned its lessons and that firms were adopting changes voluntarily to be more transparent and accountable. Successful companies shouldn’t be punished for the sins of those that failed, they said.

“It is important to look beyond the rhetoric and ask the tough questions about underlying structural changes that promote responsible reforms and stability to our financial system, yet support the ability of financial firms to innovate and serve the needs of families and employers,” Timothy Ryan, CEO of the Securities Industry and Financial Markets Association [ http://www.sifma.org/ ], an industry lobbying group, wrote in a Feb. 5 op-ed piece [ http://www.washingtonpost.com/wp-dyn/content/article/2010/02/04/AR2010020403621.html ] for the Washington Post.

‘Culture of Greed’

That argument resonated with lawmakers under pressure to boost a fragile economy and bring down an unemployment rate that has hovered near 10 percent since August 2009, its highest level in more than a quarter of a century.

“The big financial industry has convinced a lot of people, particularly in Congress and on the regulatory side, that they bring value to the economy with new instruments and new approaches,” said Byron Dorgan, a Democratic senator from North Dakota who is retiring this year. “Anybody who wants to do things that seem aggressive is called a radical populist.”

U.S. President Barack Obama was elected in 2008, weeks after Lehman Brothers Holdings Inc. collapsed in the largest bankruptcy and the Federal Reserve and government provided unprecedented support to insurance company American International Group Inc. as well as nine of the largest banks. Obama, who raised $15 million on Wall Street, promised that his administration would “crack down on the culture of greed and scheming” that he said led to the financial crisis.

Geithner, Summers

While Obama vowed to change the system, he filled his economic team with people who helped create it.

Timothy F. Geithner, 49, who had been responsible for overseeing banks including Citigroup while president of the Federal Reserve Bank of New York, became Treasury secretary and named a former Goldman Sachs lobbyist as his chief of staff. Lawrence H. Summers, 56, who is stepping down as Obama’s National Economic Council director, opposed derivatives regulation and supported the 1999 repeal of the Depression-era Glass-Steagall Act, which separated commercial and investment banking, when he served as deputy Treasury secretary and Treasury secretary in President Bill Clinton’s administration.

‘Free Pass’

“It was very clear by February 2009 that the banks were going to get a free pass,” said Simon Johnson, a former chief economist for the International Monetary Fund who is now a professor at the Massachusetts Institute of Technology’s Sloan School of Management [ http://mitsloan.mit.edu/ ]. “You could see from the hiring of Tim Geithner and from the messages that he and his team were putting out that this was going to go very badly.”

Even when changes were advocated by people who couldn’t be characterized as radical populists, their ideas were dismissed as unrealistic, misinformed, advancing ulterior motives or damaging to U.S. competitiveness.

Such tactics helped bat back suggestions from billionaire hedge fund manager George Soros and Berkshire Hathaway Inc. Vice Chairman Charles Munger that regulators ban purchases of so-called naked credit-default swaps -- contracts that allow speculators to profit if a debt issuer defaults.

Geithner was an early opponent of any such ban, arguing at a March 2009 House Financial Services Committee hearing that it wasn’t necessary and wouldn’t help.

“It’s too hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome,” he said.

‘Unbelievably Complicated’

Dorgan, 68, who offered an amendment to the Dodd-Frank bill that would have banned such swaps and who wrote a 1994 article [ http://www.washingtonmonthly.com/features/1994/199410.dorgan.html (below)] for Washington Monthly warning about the dangers posed by over-the-counter derivatives, said supporters in Congress backed down because they didn’t get pressure from their constituents.

“The debate that’s necessary on these subjects is a debate that is so unbelievably complicated that the larger financial institutions have always controlled the narrative,” Dorgan said. “Even things that were fairly mild were contested as anti-business and going to injure and ruin the economy.”

Instead Dodd-Frank gave regulators at the Commodity Futures Trading Commission and the Securities and Exchange Commission the responsibility of writing rules governing the $583 trillion market in over-the-counter derivatives. The law, named after Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, requires that most derivatives be traded on third-party clearinghouses and regulated exchanges.

Private Swaps

The CFTC withdrew a proposed rule on Dec. 9 after at least one commissioner, Scott O’Malia, a former aide to Republican Senator Mitch McConnell, objected. The rule would have required dealers of private swaps to quote prices to all market users before trades could be executed on an electronic system. A new version, approved Dec. 16, will save dealers billions of dollars, according to Moody’s Investors Service, because they will be able to limit price information to select participants.

An amendment requiring banks to spin out their swaps-dealing operations into separately capitalized units, so they wouldn’t have access to government backstops, made it into the Dodd-Frank bill. It was diluted at the end to exempt interest-rate and foreign-exchange contracts that make up more than 90 percent of the derivatives held by U.S. banks.

Banks were also allowed to trade derivatives used to hedge their own risks and given up to two years to trade other types of derivatives, such as credit-default swaps that aren’t standard enough to be cleared through a central counterparty.

Too Big

A suggestion that banks deemed too big to fail should be broken up or made small enough to fail -- an idea backed by former Federal Reserve Chairman Alan Greenspan, Bank of England Governor Mervyn King and hedge-fund manager David Einhorn -- also failed to win support from U.S. policy makers, as bank executives argued that size alone didn’t make a company risky and that it could be essential for banks to compete.

Jamie Dimon, JPMorgan’s CEO, said in a January 2010 interview that most of the financial firms that collapsed during the crisis were narrowly focused investment banks, insurers, mortgage brokers or thrifts, not big integrated conglomerates.

“A lot of companies are big because they’re required to be big because of economies of scale,” he said.

Glass-Steagall

The closest the Obama administration came to trying to limit the size of banks was in January, when the president proposed levying a fee on financial firms with assets of more than $50 billion. The idea was never adopted by Congress. Instead, it supported Geithner’s plan for a so-called resolution authority that would give regulators the ability to manage an orderly wind-down of a large financial company. Critics say the authority is unlikely to work in practice because regulators won’t have power over a bank’s international operations.

“The resolution authority as drawn up by Dodd-Frank does not apply to the megabanks and doesn’t apply to JPMorgan Chase, nor can it because that authority only applies to U.S. domestic financial entities,” said MIT’s Johnson, a Bloomberg contributor. “If anything, it’s gotten worse because we have fewer big banks. The ones that remain are undoubtedly too big to fail.”

Even before Obama took office in January 2009, former Federal Reserve Chairman Paul A. Volcker, an economic adviser to the president-elect, was calling for clear distinctions between banks that take deposits and make loans and those that engage in riskier capital markets businesses. The recommendation, a modern version of Glass-Steagall, was put forward in a report by the Group of 30, an organization of current and former central bankers, financial ministers, economists and financiers whose board Volcker chairs.

Volcker Rule

Reed, the former Citigroup co-CEO, and David Komansky, a former CEO of Merrill Lynch & Co., were among those who said publicly that they regretted having played a role in overturning Glass-Steagall. Both of their former companies were crippled by investments in mortgage-linked securities during the crisis, and Merrill was sold to Bank of America in a hastily reached agreement the same weekend Lehman Brothers went bankrupt.

“We have to think of the original reasons why Glass-Steagall was brought down in the first place, and that is the U.S. banks were competing with large, universal banks around the world,” Goldman Sachs CEO Blankfein said in a March 2009 interview with Bloomberg Television. “So I don’t think we’d turn the clock back.”

The idea was left out of Geithner’s original financial regulation proposals and didn’t gain much support until January, after a Republican upset a Democrat in a Massachusetts senate race. Obama and his economic team, including Volcker, then announced they were supporting a so-called Volcker rule that would ban proprietary trading at regulated banks and prohibit them from owning hedge funds and private equity funds.

Proprietary Trading

E. Gerald Corrigan, a former New York Fed president who worked under Volcker at the Fed and is now a managing director at Goldman Sachs, told a Senate hearing that banks shouldn’t be prevented from owning and sponsoring hedge funds or private equity funds because they promote “best industry practice.” He urged a distinction between proprietary trading and “market making” for clients or hedging related to such market making.

In the final version of Dodd-Frank, the Volcker rule ended up looking much more like the Corrigan rule. Banks were allowed to own or sponsor hedge funds and private equity funds and even to invest in them as long as their holdings didn’t account for more than 3 percent of the bank’s capital or 3 percent of the fund’s capital.

The ban on proprietary trading exempted dealing in government and agency securities. Regulators were charged with deciding what other types of trading would be considered proprietary and which would be deemed market-making.

Volcker was disappointed with the final version, according to a person with knowledge of his views.

Dodd-Frank

Goldman Sachs Chief Financial Officer David Viniar, who told analysts in January that “pure walled-off proprietary trading” accounted for about 10 percent of the firm’s revenue, said in October that the company had closed one such business and was waiting to see if the rules would require other changes.

While the Dodd-Frank Act is the most sweeping financial legislation in decades, creating a consumer-protection office for financial products and a council of regulators charged with monitoring systemic risk, it won’t fundamentally change a U.S. banking system dominated by six companies with a combined $9.4 trillion of assets, MIT’s Johnson said.

‘Falls Short’

The law won’t prevent lenders with federally guaranteed deposits from gambling in the derivatives markets, though it will place restrictions on some types of contracts and require more transparent trading and central clearing. It does little to solve the danger posed by leveraged firms reliant on fickle markets for funding.

“It’s not my point to say that the legislation enacted is worthless,” said Dorgan. “It requires more transparency and disclosure and a series of things that are useful, even though it falls short of what I think should have been done.”

The Treasury Department takes a more positive view. The law “fundamentally changes the landscape of our financial regulatory system for the better,” said Steven Adamske, a Treasury spokesman, in an e-mailed statement.

“The Obama administration and Secretary Geithner fought hard to enact a tough set of reforms that reins in excessive risk on Wall Street, protects the economic security of American families on Main Street, and makes certain taxpayers are never again put on the hook for the reckless acts of a few irresponsible firms,” Adamske said. “It also creates a safer, more transparent derivatives market through comprehensive reform, bans risky pay practices, and it puts in place the strongest consumer protections in history.”

2,300 Reasons

The biggest financial companies increased their spending on lobbying in the first nine months of 2010 as they sought to influence the legislative outcome, according to Senate records. JPMorgan’s advocacy spending grew 35 percent, to $5.8 million from $4.3 million, while Goldman Sachs’s jumped 71 percent to $3.6 million.

Banks had “2,300 pages worth of reasons” for spending, said Scott Talbott, a lobbyist at the Financial Services Roundtable, which represents the largest lenders and insurance firms, referring to the size of the Dodd-Frank bill. “The issues on Capitol Hill required more attention.”

‘Always There’

Spending during 2010 probably played only a small role in the ability of financial companies and trade groups to influence legislators, according to Anthony J. Nownes [ http://web.utk.edu/~anownes/ ], a political science professor at the University of Tennessee in Knoxville whose books on the role of lobbyists include “Total Lobbying: What Lobbyists Want (and How They Try to Get It)” (Cambridge University Press).

“The idea that they stepped up their activity has some truth, but the larger truth is that they always spend a lot of money and this was no exception,” Nownes said. “They’re always there, their viewpoints are always heard and it is a cumulative effect -- they’ve been saying the same things for years and years and years.”

Even as they were spending more on lobbying, the largest U.S. banks cut their political giving for the 2010 elections. Of the 10 biggest financial firms, only Goldman Sachs, MetLife Inc. and the U.S. subsidiary of Deutsche Bank AG spent more from their political action committees during the 2009-2010 election cycle than they did in 2007-2008, according to Federal Election Commission filings.

Talbott said the decrease was partly because of the economic slump, and also because some members of Congress refused to take donations from banks that received federal funds during the crisis.

Orszag, Lubke

The financial industry is adept at hiring people with experience in Congress and government, which gives it an edge in understanding the best tactics to use, Nownes said. This month Citigroup recruited former Obama administration budget director Peter Orszag as a vice chairman in its global banking business, and Goldman Sachs hired Theo Lubke from the New York Fed, where he oversaw efforts to make the derivatives market safer.

Research shows that lawmakers are more susceptible to lobbying on issues that are complex, technical or economic, which benefits the banks, Nownes said.

“This certainly was a huge advantage for them, especially in designing some of the more intricate details of this piece of legislation,” he said. “The more technical and complex, the bigger the informational advantage they have.”

Tax on Bonuses

Even in areas that weren’t technical, such as bonuses, the financial industry was able to resist tough regulation.

With polls showing strong popular support for limits on pay, former British Prime Minister Gordon Brown pressed for a tax on banker bonuses and one on financial transactions to deter speculative trading.

Obama didn’t go that far. Instead, the administration appointed Washington lawyer Kenneth Feinberg to review pay for the 100 top executives at firms receiving “exceptional assistance” from the Troubled Asset Relief Program. Feinberg ordered cuts at Bank of America, Citigroup and AIG, as well as at two bankrupt car companies and their finance divisions.

The administration, while opposing any pay caps, urged regulators to require changes that would better align compensation with risk, such as paying bonuses in restricted stock. Several banks responded by raising bankers’ salaries. So far this year, five Wall Street banks -- Bank of America, JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley -- have set aside more than $91 billion for salaries and bonuses.

Money ‘Paralyzes’

In early 2010, Virginia Senator James Webb and California Senator Barbara Boxer, both Democrats, proposed an amendment to a jobs bill that would have imposed a 50 percent tax on any bonuses above $400,000 collected in 2009 by executives at banks that received at least $5 billion in TARP funds.

The U.S. Chamber of Commerce, which opposed the tax, urged senators to reject the idea because it “would likely hamper efforts to resolve the ongoing financial crisis, restore economic growth, spur job creation and is likely unconstitutional.” The bill never made it to a vote.

“Neither party wanted to touch that issue,” Webb said at the Washington Ideas Forum [ http://webb.senate.gov/newsroom/interviewtranscripts/04-05-2010-01.cfm ] on Oct. 1. “Quite frankly, the way that money affects the political process sometimes paralyzes us from doing what we should do.”

In a Bloomberg News National Poll conducted Dec. 4 through Dec. 7, 71 percent of Americans said big bonuses should be banned this year at Wall Street firms that took taxpayer bailouts, and 17 percent said bonuses above $400,000 should be subject to a one-time 50 percent tax. Only 7 percent of the respondents said they consider bonuses a reflection of Wall Street’s return to health and an appropriate incentive.

Protecting Stockholders

Reed, the former Citigroup executive, said he didn’t understand why lawmakers gave so much credit to arguments made by financial-industry participants whose job it is to put the interests of their shareholders above any concern for the safety of the financial system.

“I’m surprised that the people in Washington think that the stockholders are the people that they should protect,” Reed said. “It would seem to me that the people who should be protected are the overall banking system and the many, many, many companies that depend on it.”

To contact the reporter on this story: Christine Harper in New York at [e-mail]

To contact the editor responsible for this story: David Scheer at [e-mail].

©2010 BLOOMBERG L.P.

http://www.bloomberg.com/news/2010-12-28/out-of-lehman-s-ashes-wall-street-gets-what-it-wants-as-government-obliges.html


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Very Risky Business

If we don’t watch out, a new kind of Wall Street gambling—exotic derivatives trading—could shake the market and put the taxpayers on the line for another bailout.

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Watch Senator Dorgan's remarks 15 years after this article was published, at the October 15, 2009 Washington Monthly/New America event "Risky Business: Why We Must Re-Regulate Finance."

http://www.youtube.com/watch?v=0hh8EubXDV0 [embedded]

*

By Senator Byron L. Dorgan
Washington Monthly, October 1994

Last spring, when the stock market took its hair-raising ride, in one corner of Wall Street there was more than the usual anxiety. In fact, there was stockbrokers-looking-for-upper-floor-windows kind of fright. In April, clients of the giant Bankers Trust New York Inc.—including Procter & Gamble—took multimillion dollar losses on a kind of trading most Americans had never even heard of, called "derivatives." A rumor went around the Street: Maybe something truly sinister was brewing. Maybe this was a ... derivatives collapse.

The spring market panic hit just as the March issue of Fortune—hardly a carping business critic—cast a dark pall over derivatives, which are complicated futures contracts based on mathematical formulas. Fortune called them an "enormous, pervasive, and controversial financial force." The magazine added: "Most chillingly, derivatives hold the possibility of systemic risk—the danger that these contracts might directly or indirectly cause some localized or particularized trouble in the financial markets to spread uncontrollably."

The headline on the Fortune cover was "The Risk That Just Won't Go Away," shown over a pool of alligators. With that staring back at brokers and investors from their coffee tables, the sudden dip in the Dow and the story of Bankers Trust made people think, Hey, we really need to get a grip on this. But the dip turned out to be a blip, and the crisis passed out of the news. In typical fashion, the media moved on to other matters, content that where there's no immediate crisis, there can be no fire.

Yet, this "false alarm" could turn out to be a harbinger of a real financial conflagration—one that would make us nostalgic for the days of the $500 billion savings-and-loan collapse. In August, The Wall Street Journal declared that derivatives were now a $35 trillion—that's right, trillion— worldwide market. The U.S. share is estimated at $16 trillion, which is four times the nation's economic output. And the Journal estimates that since 1993 there have been $6.4 billion lost in the derivatives game—$6.4 billion that could have opened businesses and created jobs. Derivatives are no doubt widespread: An Investment Company Institute survey found that 475 mutual funds with net assets of $350 billion recently held derivatives; about two-thirds of those assets were in short-term bond funds sold to average investors. And here's the real kicker: Because the key players are federally insured banks, every taxpayer in the country is on the line.

So what is this thing called a derivative? Bankers and speculators maintain it's just hedging, a perfectly normal practice to manage risk. Farmers hedge, so do banks and businesses. So what's the big deal? Derivatives have become much more than managing risk. They have begun, in some cases, to look like a financial casino where the decisions are wagering decisions, not business ones. Derivatives may well be the most complicated financial device ever—contracts based on mathematical formulas, involving multiple and interwoven bets on currency and interest rates in an ever-expanding galaxy of permutation. Of course, what individual investors knowingly do with their own money is their own business. But when financial institutions are setting up what amount to keno pits in their lobbies, it's something that should concern all of us.

Let me explain by example. One form of derivative—the most simple—is a futures contract, which is the traditional device for a company to lock in a price for materials at a future time. Say a company that manufactures film—Company X—needs to buy silver every year and wants to guard against rising silver prices. So in 1994 it enters into a contract with a mining company to pay the going 1994 rate in 1995. This is a risk for X if silver prices tumble, because they will be required to pay the higher price. But if prices rise, X wins because it will be able to buy the silver for less than the 1995 market price. Of course, speculators can buy and sell such commodities contracts with no intention of actually obtaining the commodity, hence gambling on the fluctuation of prices. But this kind of traditional futures trading takes place on organized exchanges that are well-regulated and well-understood.

The troubling derivative deals are much different. They take the basic futures idea a quantum leap further into a netherworld of high finance. Let's take a simple example. Say Company X is under an obligation to sell film in Japan next year. Assume further that the company's analysts believe the value of the yen will fall against the dollar. The analysts would like to protect against the risk that silver and yen prices may fluctuate over the course of the year, thus hedging their original hedge. The company can't go to an exchange in Chicago and get that precise deal, so it gets on the telephone to its bankers and suggests that the bank write a customized contract that is based on the delivery price of silver in yen, not in dollars. This is called an "over-the-counter," or OTC, transaction, since it does not take place on an organized exchange.

The new speculative twist is much, much riskier for both Company X and the bank. It doubles the stakes: now, instead of betting just on the price of silver, it is also wagering on the value of the yen. Why would X do this? Because doubling the bet may hedge their risk in both the silver and yen markets. Why the yen? Because its analysts, in consultation with the bankers, used complex mathematical models and probability charts to decide the yen bet was a good gamble.

If the analysts were right about the yen, of course, it all works out. But if they were wrong about the yen, and wrong about the silver, too, the result would be like having two lead weights slide to one end of a see-saw.

Unlike a traditional future, moreover, these exotic derivatives are almost impossible to sell if one of the two bets goes south. They are especially tailored to X's needs, and are therefore unattractive to other buyers.

And that's a simple example. Currency fluctuations are just the beginning. Interest rate gambles are common, too, and in this volatile year have led to many of the big losses, including the $700 million that Piper Jaffray, the respected Minneapolis firm, lost on behalf of clients that included small city governments and the local symphony association. Piper Jaffray had decided on the basis of obscure mathematical formulas that interest rates would not rise. Unfortunately, the formula didn't anticipate the Federal Reserve Board's rate hikes this year.

More trouble comes from exotic new derivatives called "swaps." Say Company A has borrowed money at a floating interest rate but is worried that rates might rise. It wants to lock in the rates at the lower level. So it calls a derivatives dealer—often a major bank—to find another company, call it B, which is willing to bet that the floating rates will be more favorable than the set rate. A swap results: Company A will pay a fixed rate of interest to Company B, which will pay a floating market rate to Company A. The risk to Company A is that rates will fall but A will be obligated to pay the higher, fixed rate. The risk to Company B is that B will end up paying higher rates than the fixed rate it receives from A. If you had trouble following that, then you are starting to get the idea. And all of this can be done without anyone even knowing, since such transactions can be done "off book"—effectively concealing them from stockholders and employees. Procter & Gamble bought a floating rate deal like this from Bankers Trust, losing a reported $157 million in the process.

There has been a steady flow of such losses in past months. The reports of recent derivatives disasters could be the first trickles of water through a rickety dam: Askin Capital Management, in New York, lost $600 million; Kidder Peabody, $350 million; CS First Boston Inc., $40 million. Such debacles have led some leading Wall Street sages—Gerald Corrigan, the former president of the New York Federal Reserve; Felix Rohatyn, the investment banker; and Henry Kaufman, the bond guru, among others—to warn that derivatives are out of control. These men are not given to impetuous overstatement where finance is concerned. Nobody would care if these were just a few Donald Trumps taking a hit at a respectable financial casino.

But the truly scary thing is how losses like these could spread through the entire banking system. Suppose X, our film company, had entered into a swap with a New York bank. That bank in turn might then enter an offsetting contract with another bank which in turn might continue to pass along that risk on and on and on, perhaps using exchange-traded futures. So now a default by X could create a domino effect: X could not pay its bank, and its bank therefore couldn't make the payments on its offsetting contract, and so on until the chain of losses enters the exchange, where the originally esoteric bet can hurt real businesses. This is not mere fantasy. According to the Brady Report on the causes of 1987's Black Monday 508-point fall, the problem was worsened by automatic computer programs that kept ordering traders to sell stock index futures—which are, in essence, derivatives.

Making matters still worse is the concentration of big derivatives dealers. The General Accounting Office found this year that much of the big OTC derivatives dealing is concentrated among 15 major U.S. dealers—including federally insured banks—that are extensively linked to one another and to exchange-traded markets. The top seven domestic bank OTC dealers accounted for more than 90 percent of total bank derivatives action, and the top five U.S. securities firms accounted for 87 percent of all such activity in securities in the country. Add in the always-more-volatile foreign markets (tied to about $4 trillion of the U.S.'s $16 trillion) and we're talking real money.

"This combination of global involvement, concentration, and linkages," warns Charles Bowsher, the head of the GAO, "means that the sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole."

If this seems a remote possibility, don't forget that financial implosions nearly always seem that way—before they happen. This kind has has happened before, albeit on a smaller scale. The S&Ls are the most notorious example, of course, but there are others. The failure of the Bank of New England, in 1991, cost taxpayers $1.2 billion, and the bank had a $30 billion portfolio of derivatives that had to be painstakingly unwound to avoid, in the words of the GAO, "market disruptions." And the feds have had to clean up non-banking financial messes as well. In 1990, when Drexel Burnham Lambert failed, the government had to insure payments that flowed between Drexel's sundry creditors and debtors to avoid a chain reaction. With a $35 trillion derivatives market, a crash would make these precursors look Lilliputian.

All that stands between the public and a financial disaster of this sort is the guardians of the banking system in Washington. Regrettably, they are outgunned by the derivatives dealers in several ways. For one, there are fewer examiners than dealers, and many examiners are young and inexperienced. Worse, exotic derivatives—the stuff the big boys are doing—just don't fit within the existing scheme of federal finance regulation. It's a little like asking traffic cops to stop the nation's computer crime.

Perhaps it seems that none of this concerns you directly, but in this spooky new financial world, there are basically three ways you could lose.

• You have money in a money market fund or a mutual fund. This is the scariest and most immediate prospect for most Americans. It's entirely possible—in fact, it's all too likely—that you wouldn't know whether your fund had money at risk. Two-thirds of the assets held by tax-exempt U.S. money market funds, which were created to give the small investor access to high rates of return, are now covered by derivatives. BankAmerica recently had to pump $67.9 million into its Pacific Horizon money market funds to make up for derivatives losses. As for mutual fund losses, ask Mound, Minnesota. When the public officials of the Minneapolis suburb wanted to tuck $2.5 million away to pay for new water meters and sewers, it chose an eminently respectable, reputedly conservative Piper Jaffray mutual fund that invests in U.S. government securities. But as The Wall Street Journal reported this summer, Mound lost $500,000 because Piper Jaffray was playing a derivatives game with the town's money, betting that interest rates would fall. Leaders of Moorhead, Minnesota, can tell you a similar story.

• A private investment goes bad. If you are a stockholder in a company that's trading in derivatives, and the bets turn out badly, the stock is going to take a hit. In one of the biggest cases so far, the German firm Metallgesellschaft, a mining, metals, and industrial company, took what may be a $2 billion loss on derivatives. One of the company's U.S. subsidiaries, MG Corp., which owns an oil refinery, bet on oil prices and lost badly. Several divisions of the company have had to be sold, and 7,500 out of 46,000 employees were laid off.

• Government takes a hit—either directly or indirectly—through bank losses in derivatives. Mound's local taxpayers lost money; in Orange County, California, taxpayers had to meet a $140 million collateral call when some derivatives speculations started going bad. This is not the best use of the taxpayers' money. The federal government, too, is quietly but rapidly getting into the game. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation use exotic derivatives, as does Sallie Mae. And because these are federally chartered corporations, the possibility of the federal government getting stuck with clean-up costs is great.

Bank shots

In the peculiar market of recent years, successful exotic derivatives have been a miracle drug for bank balance sheets, not to mention the dealers who are shovelling in millions. It's not surprising, then, that these banks and dealers are resisting reform. What is surprising is that the Office of the Comptroller of the Currency (OCC) and the Federal Reserve agree, too, that legislative reform is unnecessary. "As far as the Federal Reserve Board is concerned," Chairman Alan Greenspan testified in May, "we believe that we are ahead of the curve on this issue as best one can get." Why would Greenspan, in light of the mounting evidence, soft-peddle the problem? Partly, it's the old story. Because the Federal Reserve, like other banking regulators, tends to think more like the people it is supposed to be watchdogging—in this case, the banks and the larger financial community—than they think like the rest of us. And in fact, in the case of the Federal Reserve, it is the industry it is supposed to oversee: The members of the Federal Reserve are bankers.

This does not augur well. Just a few years ago, the S&L crisis began with a trickle of bad news, a few seemingly unrelated belly-flops. A chorus of operators, experts, and federal regulators assured the public and Congress that nothing was substantially amiss.

Certainly the industry understands the parallel—enough, at least, to try to convince Congress that the parallel doesn't exist. The International Swaps and Derivatives Association, a trade group of the most exotic operators, recently hired one of the top Washington lobbying firms to make their case. And although some members of Congress are awake to the derivatives problem, it takes more than that to reach a critical mass.

That's where the press comes in—or should. But except for a few pieces, the national press has been cowed by the complexity of the subject. Instead of inquisitive reporting, we get reports of assurances from Greenspan and others. Part of the reason is that, as with the S&Ls, the disasters so far seem local: Piper Jaffray is a Minnesota story, etc. Back in the mid-eighties, when thrifts were beginning to collapse, it seemed as if it were a Texas story one day, a California story the next—never a national story. With the huge exception of The Wall Street Journal (and even it is more specialized a publication than, say, The New York Times or The Washington Post), a story like the S&Ls or derivatives only makes it off the business pages after disaster strikes and it's too late to rally public attention to reform.

Another reason is that much of this story lies in the pedestrian precincts of the regulatory culture. "It's a case where the government is outgunned and outmanned," says a senior GAO official. "One or two people at the top of the agencies are really knowledgeable, but I don't know how deep the talent goes. And at the big banks, you're going to have talent all the way down." At the Fed and the OCC, there are about 3,000 examiners but hardly any of them monitor derivatives. That task falls to small teams of about 10 to 15 examiners who go into major banks like Citicorp and are expected to track deals that the banks need up to 100 different analysts and traders to put together.

Dollars and sense

House Banking Chairman Henry Gonzalez wants to strengthen reporting requirements for derivatives trading—a sound step, but alone this keeps federal taxpayers in the line of fire. I think I have a better, cleaner idea. I have introduced S. 2123 in the U.S. Senate, which would prohibit banks and other federally insured institutions from playing roulette in the derivatives market. If an institution has deposits insured by the federal government, it should not be involved in trading risky derivatives. Of course, what investors do with their own money is their own business. (And of course, dealers must be required to tell their customers when derivatives are involved; in the Piper Jaffray debacle, customers did not understand what was happening.) But what banks do with money insured by the taxpayers is another matter entirely.

The classic purpose of deposit insurance, one of the enduring legacies of the New Deal, is to encourage saving and create a pool of capital to build homes and businesses and jobs. Deposit insurance is not supposed to underwrite airy speculation on Wall Street, and my bill will stop that.

Banks will argue that derivatives are good since they hedge risks they take by loaning money to real people. But my proposal would not affect traditional, conservative forms of hedging. And banks, so long as they created pools of betting money outside their federally insured deposits, could gamble to their hearts' content. But not with our money.

Byron Dorgan is a Democratic senator from North Dakota.

Copyright © 1994, 2009 Washington Monthly (emphasis in original)

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