immediate outflow of foreign-currency reserves, as local currency and other assets were exchanged into dollars to meet their collateral requirements. This would not only quicken the pace of the crisis, it would also deepen its impact by putting further downward pressure on the exchange rate and asset prices, thus
increasing the losses to the financial sector.
The mergers-and-acquisitions time bomb
In 2006, the dollar volume for merger and acquisition deals was $4 trillion, which was one-third of US GDP.
Mergers between corporations in theory create value by improving efficiency and synergy in an overcapacity economy. This is generally achieved by laying off redundant workers and executives to create a leaner merged company and by selling off non-core subsidiaries that could be run more profitably by others. Generally, mergers shrink production and business activities to improve profit margins and reduce competition. In other words, mergers squeeze financial value from downsizing the economy.
Acquisitions of public companies by private-equity firms are attempts to create value by taking public companies private on the theory that public companies are inherently inefficient because of regulations on corporate governance, such as the US Sarbine-Oxley Act. By taking public companies private, the new private owner can restructure the company with greater flexibility out of the public eye with less disclosure and can resell the restructured company for high profit within a relatively short time, usually to a public corporate buyer or through an IPO (initial public offering). The irony is that private-equity firms are now lining up to sell equity to the public, which is the equivalence of an anti-prostitution church running a cathouse.
These trends are by definition cyclical, depending of a fragile combination of abundant cheap money and low price of the target companies and an enabling tax structure. For example, one of causes of the 1987 crash, aside from the exchange-rate effects of the Plaza and Louvre Accords, was a threat by the US House of Representatives Ways and Means Committee to eliminate the tax deduction for interest expenses incurred in leveraged buyouts. Still another cause was the 1986 US Tax Act, which while sharply lowering marginal tax rates, nevertheless raised the capital-gains tax to 28% from 20% and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns and contributed significantly to the 1987 crash.
There were other factors, such as the effect of portfolio insurance on the futures market, etc. At present, the US federal tax authority, the Internal Revenue Service (IRS), allows carry fees earned by private-equity firms to be taxed at a 15% capital-gain rate rather than the 35% ordinary income-tax rate. A change in that ruling can do havoc to the private-equity sector.
The Wall Street Journal ran a report by William M Bulkeley on June 7 that the IRS shut a corporate-tax loophole two days after IBM used it on March 29 to avoid $1.6 billion in US taxes by structuring a $12.5 billion share buyback through a new subsidiary in the Netherlands. The IRS called the IBM maneuver a "triangular reorganization", in which the foreign unit spent $1 billion in cash and $11.5 billion in borrowed funds to buy 188.8 million shares, or 8% of outstanding, from a group of investment banks what had borrowed the shares from institutional investors.
The investment banks will buy share in the open market for returning the borrowed shared over the next nine months and IBM will make whole any losses to the investment banks if IBM share prices should rise. IBM intends to repay the loans with earnings from its foreign subsidiaries with tax rates averaging 22%, substantially below the average US rate of 40%, saving $1.6 billion.
The contradiction, aside from tax avoidance with no business purpose, is that the transaction gave IBM a reduced incentive to see its share rise in the open market until the $11.5 billion loans are repaid.
The PPI/CPI spread
Since 2003, the Producer Price Index (PPI) has risen by 16.4% in the US, while the Consumer Price Index (CPI) is only up 12.5%. This is caused by globalized trade through cross-border wage arbitrage keeping consumer prices down. CPI is heavily weighted toward import prices while PPI is weighted toward export prices. Import prices fall while export prices rise when the dollar rises against foreign currencies.
Even though exchange rate is only a part of the reasons for the US trade deficit, Congress has fixated on the idea of forcing China to revalue its currency upward against the dollar. But a falling dollar causes China's central bank to demand compensatory higher dollar interest rates for the US sovereign debt it buys, which in turn slows the US economy.
A higher short-term rate is important in its inflationary effect on CPI because it drives the rates for much of consumer credit, such as credit-card loans and auto loans, as well as adjustable home mortgages. The long 10-year bond rate drives fixed mortgage rates only at the time the mortgage is taken, but rising long-term rates will depress the price of outstanding long bonds to compensate for the gap in yields.
increasing the losses to the financial sector.
The mergers-and-acquisitions time bomb
In 2006, the dollar volume for merger and acquisition deals was $4 trillion, which was one-third of US GDP.
Mergers between corporations in theory create value by improving efficiency and synergy in an overcapacity economy. This is generally achieved by laying off redundant workers and executives to create a leaner merged company and by selling off non-core subsidiaries that could be run more profitably by others. Generally, mergers shrink production and business activities to improve profit margins and reduce competition. In other words, mergers squeeze financial value from downsizing the economy.
Acquisitions of public companies by private-equity firms are attempts to create value by taking public companies private on the theory that public companies are inherently inefficient because of regulations on corporate governance, such as the US Sarbine-Oxley Act. By taking public companies private, the new private owner can restructure the company with greater flexibility out of the public eye with less disclosure and can resell the restructured company for high profit within a relatively short time, usually to a public corporate buyer or through an IPO (initial public offering). The irony is that private-equity firms are now lining up to sell equity to the public, which is the equivalence of an anti-prostitution church running a cathouse.
These trends are by definition cyclical, depending of a fragile combination of abundant cheap money and low price of the target companies and an enabling tax structure. For example, one of causes of the 1987 crash, aside from the exchange-rate effects of the Plaza and Louvre Accords, was a threat by the US House of Representatives Ways and Means Committee to eliminate the tax deduction for interest expenses incurred in leveraged buyouts. Still another cause was the 1986 US Tax Act, which while sharply lowering marginal tax rates, nevertheless raised the capital-gains tax to 28% from 20% and left capital gains without the protection against inflated gains that indexing would have provided. This caused investors to sell equities to avoid negative net after-tax returns and contributed significantly to the 1987 crash.
There were other factors, such as the effect of portfolio insurance on the futures market, etc. At present, the US federal tax authority, the Internal Revenue Service (IRS), allows carry fees earned by private-equity firms to be taxed at a 15% capital-gain rate rather than the 35% ordinary income-tax rate. A change in that ruling can do havoc to the private-equity sector.
The Wall Street Journal ran a report by William M Bulkeley on June 7 that the IRS shut a corporate-tax loophole two days after IBM used it on March 29 to avoid $1.6 billion in US taxes by structuring a $12.5 billion share buyback through a new subsidiary in the Netherlands. The IRS called the IBM maneuver a "triangular reorganization", in which the foreign unit spent $1 billion in cash and $11.5 billion in borrowed funds to buy 188.8 million shares, or 8% of outstanding, from a group of investment banks what had borrowed the shares from institutional investors.
The investment banks will buy share in the open market for returning the borrowed shared over the next nine months and IBM will make whole any losses to the investment banks if IBM share prices should rise. IBM intends to repay the loans with earnings from its foreign subsidiaries with tax rates averaging 22%, substantially below the average US rate of 40%, saving $1.6 billion.
The contradiction, aside from tax avoidance with no business purpose, is that the transaction gave IBM a reduced incentive to see its share rise in the open market until the $11.5 billion loans are repaid.
The PPI/CPI spread
Since 2003, the Producer Price Index (PPI) has risen by 16.4% in the US, while the Consumer Price Index (CPI) is only up 12.5%. This is caused by globalized trade through cross-border wage arbitrage keeping consumer prices down. CPI is heavily weighted toward import prices while PPI is weighted toward export prices. Import prices fall while export prices rise when the dollar rises against foreign currencies.
Even though exchange rate is only a part of the reasons for the US trade deficit, Congress has fixated on the idea of forcing China to revalue its currency upward against the dollar. But a falling dollar causes China's central bank to demand compensatory higher dollar interest rates for the US sovereign debt it buys, which in turn slows the US economy.
A higher short-term rate is important in its inflationary effect on CPI because it drives the rates for much of consumer credit, such as credit-card loans and auto loans, as well as adjustable home mortgages. The long 10-year bond rate drives fixed mortgage rates only at the time the mortgage is taken, but rising long-term rates will depress the price of outstanding long bonds to compensate for the gap in yields.