Paper Profits.

Neal St. Anthony reports on a recent decision by the Star Tribune's parent Avista Capital Partners not to make a quarterly interest payment to its second-tier debt holders.

George Singer, a veteran bankruptcy attorney with Lindquist & Venum who is not connected to the Star Tribune, said Avista's decision to withhold payment to the junior debt holders likely was made with the approval or encouragement of the senior lenders who would get paid first in a bankruptcy. The senior debt has traded among banks for as little as 56 cents on the dollar while the second-tier debt has traded for as little as a dime on the dollar.

Also, junior creditors often exchange their debt for equity through a financial restructuring.

"The banks say: 'Don't make any payments to subordinate debt holders.'" Singer said.

Notice it's the banks telling Avista to pay them, but hold back on paying others. That's today's wealth creation, where banks specialize in restructuring debt rather than growing businesses and funding innovation.

There's the economy in a nutshell. Today's financial industry — which is a major industrial sector, lobbyist and problem child — is all too often about leveraging debt and laying off risk on the suckers — whether they're workers, local governments or junior debt holders. It's not about investing in the fundamental business, but figuring out ways to divert profits to pay off increasingly untenable layers of debt until one owner finds the next more ruthless or gullible one.

I'm reminded of a recent interview with economist Michael Hudson, who said:

Our tax laws have shaped the marketplace to favor the debt-financed buying and selling of real estate, stocks and bonds rather than new direct investment. Advocates of this financialization of saving and investment depict it as a viable mode of wealth creation, but the effect is simply to de-industrialize the United States. And this is the tragedy of our economy today.

...

As the debt overhead grows exponentially, it siphons off more and more money from being spent on production and consumption. For the financial sector, this is applauded as being the miracle of compound interest. The volume of loans keeps on growing by purely mathematical principles, without much regard for the economy's ability (or inability) to generate a large enough surplus to pay.

More and more wages, corporate profits and tax revenues have to be earmarked to pay creditors. These creditors then turn around and lend out their flow of debt service to yet new borrowers. This involves finding more and more risky markets, while the debt becomes heavier and heavier.  

To pay the carrying charges on these debts, wage earners cut back consumption while debt-wracked companies cut back on new capital investment, research and development. State, local and federal governments also pay interest on their deficits by cutting back on spending to maintain infrastructure or improve services. These cutbacks shrink the domestic market, leading to lower investment and hiring.

All this is applauded as the magic of the marketplace in allocating resources. But it's the financial sector that is doing the applauding, not industry.

 

Comments

[leftymn]

Excellent post Charlie. I would argue that since the early 1980's this has been the guiding force of finance as taught in the nation's business schools, so we have 2 generations of wise guys who have perfected the art of leverage and cutting up risk into small pieces while enriching themselves. This is essentially a legalized Ponzi scheme, and now the greatest fools are holding the ugly remnants in the USA and Global economies.

When it is sanctioned by the government as in the past 20+ years, it is called crony capitalism too.

[Charlie Quimby]

Yes, Bush may get the credit for this economy, but it started before him.

[Jeff Dege]

"Our tax laws have shaped the marketplace to favor the debt-financed buying and selling of real estate, stocks and bonds rather than new direct investment"

And what is it in our tax laws that are shaping the marketplace in this way?

Two things: Taxes on capital gains and double taxation of dividends.

Have you suddenly become a supporter of eliminating either?

[Charlie Quimby]

Jeff,
The real issue is not the capital gains tax, but the effect of the tax in relation to other ways to make money. Leveraging debt is more profitable than building industrial capital or investing in new knowledge.

Personally, I'd rather see corporate taxes lowered and all personal income treated the same. But the smart kids on Wall Street would probably still find their loopholes and their lobbyists would get them enacted.