Through all historical periods of inflation, assets inflate first, then consumer prices inflate and then, eventually (if ever), wages inflate. When assets inflate but wages stay stagnant, investing in markets becomes more inaccessible to everyday people, but the rich get richer as stocks rocket to the moon. When consumer prices go up but wages stay stagnant, the least wealthy suffer the most. The dollars they’ve saved up little by little buy them fewer goods and services.
Inflation isn’t a way to take from the rich and give to the poor, it’s quite the opposite. Inflation makes rich people richer through asset inflation, and makes poor people poorer through consumer price inflation.
So, What Actually Happened In The 1970s?
Bringing this back to the example Chamath initially brought up: the 1970s, aka, Stagflation.
Consumer price inflation spiked up to 20 percent annually in the ’70s for two reasons. First, geopolitical events related to the oil crisis caused a supply shock. Second, we abandoned the gold standard and established the fiat standard, which gave central banks around the world the ability to create unlimited amounts of money, causing inflation.
Inflation was high, and wealth inequality was relatively low, but the former didn’t cause the latter, and even if it did, it certainly wasn’t a good thing. The reason wealth inequality was low was because everybody was having a tough time. The ’70s had one of the highest rates of unemployment in recent history, and prices rose significantly while growth and wages stayed stagnant (stagnation + inflation = stagflation).
To combat this, former chair of the Federal Reserve Paul Volcker raised interest rates to 20 percent at the end of the decade, sending the country into a recession. Equity prices went down as treasury yields rose, and most people who owned stocks suffered. And everyday folks, out of jobs with little in savings, suffered far more as their money had less value and purchasing power.
Stagflation was a miserable time for most Americans. To imply that both wealthy and poor people suffering is good because they’re somewhat equal is preposterous. Perhaps Chamath knows all of this, and chooses to misinform his 1.4 million followers? Given Chamath’s exposure to both bitcoin and his heavy involvement in U.S. equities, both of which would benefit from inflation, this could make sense. Regardless of his motives, Chamath’s comments on inflation and wealth inequality are wrong. Inflation causes wealth inequality. Well… what now?
Over the past decade, Chamath Palihapitiya has solidified himself as one of the greatest investors. Chamath’s vision goes beyond his investing skills, as he plans to build the next Berkshire Hathaway with a slightly different approach. In this video, I cover how Chamath is overtaking Warren Buffett with Berkshire Hathaway 2.0.
Chamath Palihapitiya, the CEO of Social Capital and chairman of Virgin Galactic, talks about a wide range of issues, including Bitcoin, COVID, civil unrest, and broad economic trends and forecasts. We discuss:
- Whether his economic forecasts have shifted throughout COVID
- Why he believes a debt crisis will occur
- How he views the success of BTC as a hedge against the ruling class
- How the economic pendulum will swing back toward consumers
- Why he doesn’t mind if big corporations and hedge funds get wiped out
- Whether he subscribes to the thesis that Bitcoin is uncorrelated
- Why the pandemic has not spurred institutional adoption of crypto
- Why he sees no merit in Ethereum
- How the economy will become more decentralized in the future and whether blockchain will be a part of it
- Why he prefers SPACs over ICOs
- Why he started capital as a service
- Why he believes the government should bust up large corporations
by Tim Langeman 2233 words (17 min read)
Before the coronavirus, a false narrative arose that the economy was healthy, as measured by:
- growth in the stock market and a
- reduction in the unemployment rate
when in fact the recovery from the 2008 financial crisis was weak and the facade of strength was masked by low-interest rates which enabled governments, corporations, and individuals to achieve the illusion of prosperity through increased borrowing.1
But there is more to the economy than the stock market and unemployment rate. The bond market is larger and “smarter” than the stock market. When assessing the pre-coronavirus economy, one must also take into account the stagnant profits2 corporations disguised by borrowing in the bond market to fund purchases of their own stock, artificially inflating the stock market.
Like an Injured Athlete taking Pain Killers
The US economy was like a professional football player who had been “playing hurt” for many years.
The economy used debt like the football player uses pain killers. The debt masked the economy’s problems3 and allow it to perform at a higher level than otherwise would have been possible had pain-killers not dampened the brain’s ability to perceive reality. But unfortunately, an economy is not like an athlete in that it can’t retire at the end of a 15-year career.
Featuring: The Seven Dwarfs
The story I’m about to tell is intended to illustrate how corporations borrowed money and then used that money to buy their own stock, inflating the stock price.4 In finance jargon, this is called “leveraged stock buybacks”.5 Corporations have used stock buybacks as a major strategy to boost their share price but many corporations didn’t have enough profits to buy back their stock because the overall level of (pre-tax) corporate profits has been flat since 2012.6. While some companies may have been able to legitimately afford to buy their own stock with real profits, over 50% of those buybacks were done using borrowed money.
In fact, if you look at who had been the buyer of most of the stock purchases in 2018 and 2019, it had mostly been the companies themselves purchasing their own stock, not pension funds, individuals, or hedge funds.
I illustrate how this market manipulation works using a fairy tale featuring the seven dwarfs and their mining company “7 Dwarfs Mining, Inc.” Early in the story, the dwarfs seemed to have discovered an easy way of making money until an unforeseen emergency struck and disrupted their carefully laid plans.
It is commonly known that emergencies reveal.
This story illustrates what emergencies can conceal.
The Founding Members:
- Sleepy, and
Assets # of Shares Yearly Profit Profit per Share Debt $7 million 7 $700,000 $100,000 $0
Going Into Debt to Hide Flat Growth
One year, Grumpy decided he was unhappy in the mining business. Perhaps this was due to his sour attitude, or perhaps he was feeling blue because the mine’s profits had not increased at all in the previous 6 years.10 Grumpy decided to sell his share in the mining company, but there were not a lot of other dwarfs that wanted to buy out his stake at the price of $1 million.
The other 6 dwarfs in the company wanted to continue in the business but they didn’t have the cash to buy out Grumpy, so they decided to borrow the $1 million from the bond market. Interest rates were low in the Forest Kingdom because the economy hadn’t fully recovered from the previous debt-fueled financial crisis a dozen years prior.11 The kingdom’s treasury secretary’s belief that low-interest rates stimulate growth was also a factor in setting the interest-rate climate.12 This easy lending environment allowed the dwarfs to succeed in borrowing $1 million at an interest rate of 3% per year.
The Dwarfs’ Epiphany: Earnings per Share
After Grumpy exited the company, the 6 remaining dwarfs renamed their business: “6 Dwarfs Mining, Inc“. The total value of the company (market cap)13 was still $7 million and they split the same $700,000 profit six ways instead of seven. This resulted in profits of $116,666/share, a 16.7% increase over the prior year. Grumpy sulked for the next year and a half about missing out on the share price increase his exit had created, but Dopey reminded him that it was his own idea to leave. 🙁
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 m $0 Post-Grumpy Exit $7 m 7/6 $700,000 $116,667 14 16.7% $6 m $1 m
Upon learning of this increase in EPS (Earnings Per Share), the 6 remaining dwarfs were elated! By taking on debt to buy out Grumpy’s stake, they managed to reduce their number of shares, thereby achieving their first share price increase in 6 years! Things were looking up! **
** “Earnings per Share” were up even though the Dwarf’s equity in the company was down.15
Setting Dopey’s Debt Plan in Motion
Bashful was known to wear his heart on his sleeve, especially if he had romantic feelings for someone.16 So the next year, after Bashful’s most recent crush departed the village, Dopey encouraged a lovestruck Bashful to retire from the company and follow his sweetheart to the neighboring Mountain Kingdom to the North. Dopey wanted to reduce that number of shareholders in the mining company because he had learned the benefits of having fewer shareholders from Grumpy’s exit, even if that comes at the expense of having more debt. He calculated that splitting $7 million five ways would result in a share price of $1.4 million per share. This would be a 40% increase over the original $1 million share price, although the company’s profit was still the same $700,000 per year. Once again, the dwarfs went to the bond market and used borrowed money — an additional $1 million dollars — to buy out one of their fellow dwarf’s share.
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 m $0 Post-Grumpy Exit $7 m 7/6 $700,000 $116,667 16.7% $6 m $1 m Post-Bashful Exit $7 m 7/5 $700,000 $140,000 17 40% $5 m $2 m
After the successful payoff, Dopey said to Doc: “Wow, this debt thing is really an easy win. A few years ago we were struggling with plans to make efficiency improvements to the mines but that would have required us to invest some of our profits into new machinery, research and development, and employee training. Instead, I only needed to identify the key to Bashful’s heart and use some accounting wizardry18 to increase our share price the “easy way” — with more debt.”
Following the Plan
Dopey had a reputation for harebrained plans, but he knew that Sleepy’s drowsiness was no reason to doubt his intelligence or acumen.19 Dopey concluded that the two things that would most motivate Sleepy to sell his share were the attraction of sleeping in until noon and a bonus of $100,000, so he struck up a conversation with Sleepy on these two themes when the two had a private moment together. The next year, Sleepy was enjoying a restful retirement in the tropics and the mining company had one fewer shareholder.
The pattern continued again the following year with Happy given a $150,000 bonus contingent on his retirement, causing the share price to rise to $2,333,333 (a 133% increase). All the remaining dwarfs were extremely happy at this turn of events, as was Happy himself. 🙂 Dopey took out a loan to buy a red Ferrari with the vanity license plate “Debt King” in anticipation of his upcoming buyout. Yet, at the same time, the company’s total profit remained the same $700,000 per year it had been originally before Grumpy exited.20
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 $0 m Post-Grump Exit $7 m 7/6 $700,000 $116,667 16.7% $6 m $1 m Post-Bashful Exit $7 m 7/5 $700,000 $140,000 40% $5 m $2 m Post-Sleepy Exit $7 m 7/4 $700,000 $175,000 75% $4 m $3 m Post-Happy Exit $7 m 7/3 $700,000 $233,333 21 133% $3 m $4 m
(Note: These figures are simplified. They do not include reinvesting profits or interest charges on the debt.)
A Declining Credit Rating
One of the unnoticed consequences of Dopey’s plan was that the mining company’s credit rating began to deteriorate as the company borrowed money in the bond market. The company was effectively agreeing to devote some of its future revenue (i.e. paying interest on the additional debt in the future) in exchange for a higher earnings per share today. Before Grumpy exited, the company had a AAA credit rating, but as Bashful, Sleepy, and Happy’s shares were bought out, the company’s credit rating fell to AA, then A and now stood at BBB, the lowest investment grade.22
Dopey was warned that if the company was assessed another credit downgrade the company would fall to a non-investment grade status (often referred to as “junk” bond status23). Were that to happen, pension funds and many investors would no longer be legally permitted to own the company’s debt and the interest rate the dwarfs would have to pay would spike higher. Dopey calculated that there was a higher risk to the company’s finances in the coming years, but he figured that would be Doc and Sneezy’s problem, not his, because he, Dopey, planned to be the next dwarf to exit. After Dopey left the company his financial interests would be separate from the mining company and he would not longer care if the company should happen to suffer losses.
The number of shares now stood at 3, with Dopey, Doc, and Sneezy remaining, when something unforeseen happened — a sickness called Rapidico took hold in the neighboring kingdom of Achin. As the illness reached the cities of the Dwarfs’ Forest Kingdom the advisors to the kingdom’s Queen — Queen Elizabeth II’s24 privy council25 — recommended that the kingdom go into lockdown to prevent the spread of the disease.
A lockdown seemed like a radical idea and one that the queen deferred to individual provinces.26 As other provinces of the kingdom went into lockdown, Dopey, Sneezy, and Doc were dismissive and continued business as usual at 3 Dwarfs Mining, Inc.
A month and a half later, an outbreak of Rapidico took place at 3 Dwarfs Mining, Inc., set off by an asymptomatic Sneezy. Dopey later recalled, “Sneezy is always sneezing; I didn’t think nothing of it.” But the tight quarters of the mine proved to be fertile ground for the contagion to spread and many mine workers were infected. True to his name, Doc threw himself into the job of treating the afflicted dwarfs and heroically saved countless lives, but the mine’s production ground to a halt nonetheless. Other businesses were similarly affected and the queen was forced to move beyond her earlier deference to provincial autonomy and call for a strict quarantine.27
The Divided Kingdom
Because the Forest Kingdom was so fractious and the forest creatures so impatient, financially vulnerable, and headstrong, not all parts of the kingdom followed the queen’s orders closely. This disunity among the provinces resulted in stubborn pockets of disease in the lagging parts of the kingdom which hampered the economic recovery.28
The length of the quarantine caused heavy losses to the 3 Dwarfs Mining, Inc., requiring them to borrow more money. Of the original $7 million that the company had started with, the 3 Dwarfs Mining Inc had only $3,638,841 equity left ($9,846,549 assets – 6,207,708 debt)29 because they had borrowed in the bond market to buy out the shares of Grumpy, Bashful, Sleepy, and Happy, resulting in a debt of $6,207,708.30
The Risk and Reward of a High Leverage Ratio
Companies can choose how much risk they want to take to accelerate growth (Risk vs Reward). The use of debt is a key contributor to the speed at which a company can grow but it also increases the risk that the company will falter should an unforeseen risk arise.
In this particular case, the leverage ratio31 I’m comparing is the ratio of market cap32 to debt. Notice how the Leverage ratio increases as the number of shares (or equity) decrease. Reducing the equity, in this case, increases the leverage ratio (7/2 = 3.5), which increases the profit per share.
Notice how the profit per share increases as the leverage ratio increases.
Exit Market Cap Leverage Ratio Leverage Profit per Share Original 7 Dwarfs $7 million 7/7 1.0 $100,000 Post-Grump Exit $7 million 7/6 1.17 $116,667 Post-Bashful Exit $7 million 7/5 1.4 $140,000 Post-Sleepy Exit $7 million 7/4 1.75 $175,000 Post-Happy Exit $7 million 7/3 2.33 $233,333 Planned Dopey Exit $7 million 7/2 3.533 $350,000
Note: This chart has been simplified34
When Dopey planned to exit, the share price would have risen from $1 million to $3.5 million on the leverage ratio alone. A more complex calculation that reinvests profits each year would have the original $1 million share price to rise to $4,923,274, not including a bonus of $200,000, which would leave Dopey with a total exit package of $5.1 million dollars!35
When things are going well, leverage has the effect of multiplying a company’s earnings per share by the leverage ratio. But when an unforeseen tragedy hits, it leaves companies with less of a cushion to ride out a storm.
The “Debt Bomb” Goes Undiscovered
There had been a concern before the Rapidico virus hit, that a large number of Forest Kingdom companies had also been following Dopey-like plans to increase their share price the easy way — through financialization — that is “financial engineering” that inflates share price but does nothing to improve labor productivity. In the 7 Dwarfs Mining Company, the profit doesn’t grow at all, but EPS (earnings per share) still goes up anyway because the number of shares goes down. The shareholders retain ownership in the company, but often with higher levels of debt.
Resetting the “Debt Bomb”
The result is a potential “debt bomb”36 37 where a buildup of debt can threaten the whole economy. The companies contributing to this “debt bomb” report share price growth, but this “growth” is artificial because total profits are flat and earnings per share growth are only made possible by taking on more debt. When the debt bomb explodes (or pops like a bubble) it threatens to spill over into the broader economy, threatening the whole country, not just the borrowers. 38
The Rapidico crisis had given the government the opportunity to blame some of the kingdom’s problems, which had been years in the making, on the Rapidico virus and the country of Achin, even though a significant part of the financial problems were the fault of the kingdom’s systemic dysfunction. Had the kingdom not already experienced a financial crisis a dozen years prior, and had there not been such low interest-rates, the Dwarfs would not have taken on so much debt, leaving their mining company financially vulnerable in a time of crisis. Had the Rapidico crisis not happened, such debt dysfunction was bound to lead to another recession anyway and leave the kingdom to grapple with questions about the authenticity of the prior decade’s growth.
Debt for Productive Purposes?
When some of the queen’s more intellectually self-critical advisors speculated that it would have been better had the Forest Kingdom’s companies invested the money they borrowed into productive assets rather than share buybacks, others replied that too few workers could afford to buy39 what the companies would have produced.4041
Sweeping it Under the Rug?
A lone advisor commented that the prior 6-8 years of flat profits42 during supposed “good times” boded poorly for future growth prospects. “When was the last time we’ve generated substantial growth without a lot of debt and the creation of another artificial bubble?”43, said the deputy finance minister. Many advisors agreed with her, but were hesitant to break the bad news to the public. Nevertheless, all agreed that the queen’s legacy depended upon her taking steps to prevent such a debt bomb from re-emerging and requiring yet another bailout. You might be able to afford this bailout, but we haven’t done anything to pay down the debt from the previous financial crisis and we certainly can’t afford to make bailouts the norm. Next time, her advisors said, you won’t have the Rapidico virus to blame for the bailout and you won’t be able to sweep all that debt under the rug.
Will the Dopey Financial Plans Stay Concealed?
“I know great nations face their problems, rather than distract the public with diversions,” said the queen,44 but a financial crisis is no time to address deep weaknesses within the economy. Calling attention to the country’s debt dysfunction will only erode consumer confidence when we need it most. Besides, many of the Debt-Dopies are particularly crafty and hire former members of parliament as their lobbyists! Another bailout is inevitable. It is better for me to let the “Debt Dopies” 45 remain concealed by the wider bailout, for now, encourage optimism about the economy’s revival, and let someone else deal with the problem later.”
To repeat my opening statement:
It is commonly known that emergencies reveal.
This story illustrates what emergencies can conceal.
by Tim Langeman
Perhaps you have ideas on how this story could be improved. I welcome your suggestions.
I also welcome suggestions about who you think would be interested reading about and collaborating on this issue.
This is a very simplified example of financialization involving only debt and share buybacks at large corporations. More complicated cases can involve some profit growth, executive compensation, and cost-cutting. This story is not about small businesses. It has been simplified to a case of only 7 shareholders for illustrative purposes.
- Had you heard how much many USA large corporations’ credit ratings declined in the years before the coronavirus crisis started in early 2020 and that much of their debt was rated just above “junk” status at that time?46 47 NPR’s Planet Money has an accessible and entertaining story on why Credit ratings declined. It was this 9-minute podcast story that inspired me to do the research for this piece.
- Did you know that most of the stock purchases made before the crisis were NOT made by pensions, individuals, foreign investors, or hedge funds, but by the companies themselves?
- Did you know that over half of companies’ stock buybacks were funded with debt?
- Why do you think many large corporations chose to borrow money to buy back their stock rather than invest it for productive purposes between 2012 and 2020? Here are some possibilities to start with:
- Too much regulation to make investment profitable?
- Are taxes too high?
- Too much political uncertainty?
- Do customers already have what they need?
- Customers too maxed out to afford to buy more?
- The company has a mature market position- there is little room to grow. Better to draw down on the company’s credit rating (“mortgage the company”) and redirect the money to other companies with better opportunities?
- Executives don’t want to take a risk on long-term innovation and growth when low-interest rates make significant short-term debt-driven share price increase a low-risk choice?
- Perverse incentives reward executives for hitting bonus targets in any way they choose, even if their choices are contrary to the long-term interests of the company?
- How would you feel if it turns out that, contrary to conventional wisdom, corporate profits (before taxes) had been flat from roughly 2012 – 2020 and stock prices were inflated with debt?4849
- What other political or economic things are being revealed or concealed by the coronavirus?
- Financialization is profit margin growth without labor productivity growth. (by Ben Hunt)
- Texas Instruments: a poster child for financialization, the Obama/Trump Zeitgeist: an unparalleled transfer of wealth to the managerial class (by Ben Hunt)
- 9 Questions about the Finance System: Was the Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020) (by Tim Langeman)
See Linked Spreadsheet for Details of Dopey’s Financial Plan.
(Improve my numbers: download Excel version, tweak and Email me.)
Social Capital CEO Chamath Palihapitiya’s case against stock buybacks, dividends
More that is Concealed:
Federal Reserve enters new territory with support for risky debt
Programme to support ‘junk’ bonds aims to soften blows from coronavirus and downgrades
.. The Federal Reserve has jolted credit markets by expanding the scope of its support measures, announcing plans to buy debt issued by riskier companies in a radical addition to its crisis-fighting toolkit.
.. Under the programme, the central bank will buy corporate bonds that were rated triple B minus or above — the threshold for a company’s debt to be considered investment-grade — on March 22. That still includes bonds from recently downgraded companies such as Ford, known as “fallen angels” when they lose their coveted investment-grade ratings.
Read More: Financial Times (British)
Obscure Section of CARES Act Provides $195 billion for Wealthy
.. the $2.2 trillion CARES Act passed by Congress last month contains deep within its 800 pages two barely-noticeable tax clauses that only benefit rich Americans, perhaps including the president.
.. The astronomical cost only became evident a day after CARES was signed into law, when the nonpartisan congressional Joint Committee on Taxation (JCT) published an analysis of the provisions. The committee’s latest findings show that four of five millionaires will pocket an average of $1.6 million more this year alone thanks to the stimulus bill. This of course dwarfs the $1,200 one-time checks average Americans will receive.
In total the tax clauses will cost taxpayers more than the funding allotted in the CARES Act to all hospitals throughout the US, and more than the relief provided to all state and local governments, according to the JCT analysis. Together, they are the costliest elements of the relief package.
Read More: Quartz
Echoes of 2008: They Mistook leverage for genius
Steve Eisman (of Michael Lewis’s book and Movie “The Big Short“)
Steve Eisman: Quantitative Easing was a failure: it didn’t get corporations to borrow and invest. Rather, they borrowed and bought up their own stock. They didn’t really invest in the economy.
In other words, they increased their profits by increasing their debt (leverage) ratio.
(the interview is from 2017)
People “levered themselves” (ie took out loans that increased their debt-equity ratio)
Steve Eisman: They made money because they increased their leverage (debt ratio) and they mistook their leverage for genius (12:19)
This work is licensed under a Creative Commons Attribution 4.0 International License.
(Most images created by others)
Finance-types refer to borrowing as “leverage” because, like a ‘lever’, it amplifies your effort.↩
You might wonder why this Federal Reserve chart looks different than upward sloping graphs you are used to. The first reason is that this graph uses pre-tax figures that do not include the boost that corporate tax cuts gave to the stock market. The other reason is that this graph is based on total profits, rather than earnings per share. In the rest of this article, you will learn how corporate debt artificially inflated earnings per share.↩
The fallout from the prior 2008 financial crisis was not dealt with. The government bailed out the system and assumed the debt. Most Americans’ wages had stagnated and healthcare and education expenses have gone up dramatically. In order to compensate for week customer demand, companies had begun to borrow money and buy back their own stock. Even with a deficit of $1 trillion/year, pre-coronavirus, the economy grew at a rate of 2.1% and was projected to fall to 1.6% by 2024.↩
Now with the coronavirus crisis, the federal reserve is buying some of that debt, as well as allowing corporations to issue additional debt at artificial prices.↩
Pre-tax Corporate profits peaked in 2014 and have been roughly flat since 2012. The perception of growth is mostly due to the additional debt (share buybacks) and the 2017 tax cuts (federal government debt).↩
The value of all the stock is equal to the value of all the company’s assets minus its liabilities.
( total stock shares = number of shares x share price) ↩
I picked round numbers for this. If you want to help me improve the numbers, see the excel doc in the footer and edit it.↩
In Place of the Finances of the 7 Dwarfs Mining, Inc., I’ve inserted a Graph above referring to US Corporate Profits before Taxes, as reported by the St. Louis Federal Reserve. Read more about the chart and about “Financial Engineering” that turns this flat graph into a growing one. ↩
While the level of consumer debt was reduced, corporate and government debt went up.↩
How different would rates have been if the government had not pushed for a late-cycle stimulus and not resisted advice to raise interest rates?↩
7/6 = 1.67↩
“Equity” is what the shareholders own after all the bills (including debt) have been paid. It is the value of assets minus liabilities. The additional debt they took on to buy out Grumpy’s share is a liability.↩
Disney Fandom: “Aside from his coyness, Bashful also appears to be romantic. He adores the idea of true love, and when Snow White decides to share a story with the dwarfs, Bashful joyfully suggests a love story, which she obliges to.”↩
7/5 = 1.40↩
Investopedia.com: financial engineering is the use of mathematical techniques to solve financial problems. .. Although financial engineering has revolutionized the financial markets, it played a role in the 2008 financial crisis. As the number of defaults on subprime mortgage payments increased, more credit events were triggered. Credit Default Swap (CDS) issuers, that is banks, could not make the payments on these swaps since the defaults were happening almost at the same time. ↩
Disney Fandom: “However, in spite of spending most of his time nearly falling asleep, Sleepy is apparently the most observant and logical of the seven dwarfs, whether he knows it or not. He was the only dwarf to make the assumption that the Evil Queen may be attacking Snow White at the cottage when the forest animals frantically interrupted the dwarfs’ mine work.”↩
This is a simplified version of the finances that doesn’t include interest or profit reinvestment. I was concerned that adding them at this point would take away from the broader point.↩
7/3 = 2.33↩
Prior to the coronavirus, roughly half of all corporate debt was rated BBB, which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.↩
“Junk” bonds are often referred to as “high yield” bonds. “High yield” sounds nicer and it accurately conveys that these bonds have a higher yield (or interest rate) as compensation for the extra risk the lender takes.↩
I am deliberately using the British System as a way to distance the reader from drawing favorable or unfavorable inferences onto current American officials. This story is really about the dwarfs (and especially large corporate businesses) and the way they relied on debt to raise their share price.↩
The Privy Council of the Forest Kingdom is a formal body of advisers to the Sovereign. Its membership mainly comprises senior politicians who are current or former members of either the House of Commons or the House of Lords. ↩
Provinces are like states in the American context. The head of a province is the Premier.↩
Yes, I know in the British system the Queen would leave this governance to the prime minister but I figure an audience of Americans don’t understand the British system and this version is simpler to explain while taking the spotlight off of particular American politicians.↩
In some parts of the kingdom the quarantine was applied multiple times to respond to re-occurrences.↩
“Equity” denotes how much their company is worth — how much remains for the shareholders after everyone else is paid.↩
One might think the debt would be (4 x $1 million)= $4 million. But the actual cost of buying out each share increased as the share price increase: $1 million + $1.28 million + $1.67 million + $2.35 million + bonuses. ↩
For simplicity, I’m using a leverage ratio that uses market cap/debt. A more common ratio is debt/equity.↩
value of all shares, which is the share price multiplied by the number of shares↩
Leverage = 7/2 = 3.5↩
- I’m assuming a constant total profit of $7 million to simplify this example
- I’m not including reinvesting profits or deducting interest paid on the debt
See spreadsheet at the bottom of this page↩
A debt bomb is a situation where a default on a large accumulation of debt can produce major negative consequences not only for the borrower but for many other market participants. That is to say, other people’s debts can harm you even if you were not over-indebted yourself.↩
.There is more than one type of debt bomb. Banks can become debt bombs. Countries can become debt bombs due to public debt. This is a simplified example of a small business as a metaphor for an entire country.↩
Low-interest rates make it easier to have more debt and to create “debt bombs”.↩
40% of Americans can not afford a $400 emergency. Why should companies invest in increased capacity when consumers’ wages have been stagnant for decades and therefore can’t afford to purchase more products and services? ↩
One can argue that share buybacks are a good way for established companies with limited opportunities to redirect money to shareholders, but does this also apply when companies don’t have the cash but decide to take on extra debt for this purpose?↩
I’ve heard that leveraged stock buybacks can be thought of as “refinancing,” but refinancing only changes the interest rate of existing debt. These seem more like talking on additional debt for the purpose of converting equity to debt. The average homeowner can think of this as taking out a second or third mortgage on a house. You’re taking on more debt. If the debt doesn’t have a productive purpose it is likely to be problematic. ↩
The satirical website “The Onion” provided prescient commentary in 2008 when they published an article titled “Recession-Plagued Nation Demands New Bubble To Invest In”↩
My goal is to focus on the debt and the circumstances why it was incurred, rather than to focus on Trump (in the American context) or any particular politician, which is why I cast Queen Elizabeth II in the role of queen.↩
When I talk about large corporations, I’m not talking about small businesses of less than 1,000 employees. The 7 Dwarfs were used as an illustration to make the situation easier to understand, but I don’t mean to include small businesses in this analysis at all.↩
Roughly half of all corporate debt is rated BBB, which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.↩
Another factor that contributed to corporate share price growth was tax cuts which were “paid for” with additional growth in the national debt.↩
I don’t know how much money David Geffen will personally get from this bill. I use his yacht as a symbol of the wealth that isolates rich people from the typical citizen and curries favor with the politicians that write, vote for, and sign the bailout packages.↩
wipe out over three years yeah speaking
of kind of bad situations we are not at
the end so we don’t have complete
clarity of the hindsight but there’s
been a lot of what I’ll just call bad
behavior in the market that led to a lot
of this so whether it’s the
over-leveraged of corporations or even
hedge funds at the key talks right at
one point a lot of the debt fueled
buybacks the CEO departure is kind of at
the top all of these things what’s your
take at this point in time right so
we’re kind of going into this situation
we’re not out of it but like how do you
view a lot of that be
right now so I got it I got an email
this morning actually from my prime
broker so hedge funds were at 99 to a
hundredth percentile of their historical
max leverage literally February 20th and
now we’re at you know the 20th to 30th
percentile historically so you know we
were probably at 7 or 8 turns of
leverage and now we’re probably down to
one and a half to two or three I think
that this next go-around you’re going to
have to realize government will have to
realize that in 2008 all they did was
allow financial institutions to pass the
buck they were able to take the leverage
off balance sheet and when you subtract
out debt as a function of GDP for many
years now we have had negative GDP so we
were not growing in the absence of
people issuing debt and most of that
debt unfortunately was not towards R&D
but it was towards things that
superficially propped up stock prices
which really only benefited a handful of
people and I do think we have to
restrain people from being able to do
that in the future I don’t think it
makes a lot of sense and I don’t think
it adds a lot of value and I think that
it’s not that it was obviously
responsible for the coronavirus but I do
think that when you look at how much
devastation we are encountering and when
we do the final tally on the amount of
buyback oh sorry the amount of bailouts
we need the bailouts are directly
correlated to how stupidly run and badly
run these companies were you know why is
it that California is legally mandated
and you’ll say oh because it’s a
nonprofit but legally mandated to have a
rainy day fund but a company isn’t and
then the company is the first one to
knock on the door of the government and
we’re just waiting for the next shoe to
drop or California Mississippi Alabama
Louisiana to all do the same thing and I
would much rather see the money go to
the states and the cities in an in an
then the money go to a private company I
think that those private companies
should be wiped out the equity should be
wiped out and they should need to
restart it’s one thing I’m a hundred
percent in alignment with you on this
but the part that I don’t understand is
how do you continue to benefit from the
elements of capitalism if you take out
the risk moving forward it everyone
knows I can quote unquote take this like
fake risk and if anything goes wrong I
can just run to the government and get a
bailout you changed the dynamic of what
happens and I actually think you
incentivize even more bad behavior right
it’s almost like there was bad behavior
and then there was no punishment for it
and therefore you just encouraged that
to continue you know when we get out of
this thing well I it depends on what you
view capitalism as I think if you view
capitalism as a game of risk I think
you’re right I’ve always viewed
capitalism as money becomes a fulcrum
instrument for change what do you want
to see in the world okay
money is your lubricant you decide and
the person with more money or the person
who’s willing to put more money into
something and who can be more clever
basically has the opportunity to win so
I I think it’s a game that puts
ingenuity and money at the forefront
that’s what to me that’s what capitalism
is and so when companies are doing
things that are fundamentally not
advancing that forward they should
disqualify themselves from them being
able to run to the government so it
would be a different thing entirely if
all the airlines had invested let’s just
say 96% of free cash flow dollars on
supersonic flight failed and then came
to the government and said look I took a
big bet on the future to help advance
humanity it didn’t work and I need a
bailout I would be the first one to say
okay but when 96% of free cash flow
dollars go back to buying back shares
and then you basically claim the same
thing I think you should be punished and
punished financially so you know you you
you took the money that you had you
refused it you refused to multiply it by
a good smart bet on the future and I
think that there should be consequences
yeah I don’t disagree with you at all
last question for you
been incredible kind with your time here
if you were the president over the next
what’s your playbook so president Shamus
got full control can do whatever was it
within the presidential powers what’s
your playbook to kind of weather the
storm and get us out of this
I would first stand up every single
voting site that we would use in the
and I would schedule every single man
woman and child to come through all of
those testing facilities and I would
basically deploy a rapid test to figure
out whether they had coronavirus in that
moment okay and families could come you
know 10 minutes apart so that you could
get back into your car and go etc etc in
step number one if you didn’t have
Corona so you weren’t shedding the RNA
in that moment you go to a second and
you get administered a finger prick
and you get tested for the antibodies
and within 15 or 20 minutes and you’re
held in an isolation
you know booth area where you you know
you’re on Instagram and when you’re done
you’re given a wristband and that
wristband basically says one of three
things well if you had tested positive
you get a red band you go home and you
isolate if you test negative and you
have the antibodies you get a green one
and if you test negative and you how
don’t have the antibodies maybe you get
a blue one green and blue are allowed to
go back to work right away red self
isolates you contact trace etcetera etc
that’s sort of the frontline of getting
the economy back to work and you have
some combination of the National Guard
and sort of like a whole infrastructure
then separately I think you introduced a
massive massive massive infrastructure
bill that starts to drive the
of the supply chain back in
to the United States and part of that is
incentives and part of that is
government spending and it has to cut
across many categories from you know
semiconductors in silicon all the way to
clean energy to actual physical
infrastructure like you know bridges and
and tunnels and roads and in that what I
think you’re mandating is a certain
percentage of things to be made
domestically in the United States and
you start to get people back to work so
the short term path I think is to kind
of baseline the disease and get the
people who are allowed to be working
back into a green zone of every city
every town where people with these green
and blue bands are allowed inside and
the red banded people have to stay and
quarantine themselves so that we can
start to restart this economy and then
longer-term is an infrastructure build
that basically resets incentives towards
resiliency towards inefficiency away
from efficiency I think that’s a pretty
solid plan I’m shot I’m actually shocked
that some of this hasn’t been instituted
already the lack of testing just blows
my mind I mean the stats I saw on
Saturday 895 thousand people I think
I’ve been tested at a 330 million in the
United States I think the other
reckoning that we have to do maybe just
to finish on this is that we’ve
politicized things that should never
have been politicized health should not
be politicized you know the problem is
that starting with Obamacare health
became something that was about the
Democrats versus the Republicans and you
can see how that’s sort of like you know
flowed into things like the FDA and the
CDC and history will tell what they
could have done better history will tell
what the w-h-o should have done
but I think what we can see is that
there are many points along the
evolution of this disease where logic
and open-mindedness and iteration ran
into bureaucracy and bureaucracy one and
I think that’s probably the most
generous way of describing it and we
need to figure out
where there are almost constitutional
level provisions you know you have the
right to bear arms great what about the
right to basically not you know not die
in a preventable scenario what does that
mean for how these organizations should
run you know we at a very basic level
have told the healthcare infrastructure
that we must do no harm and I think it’s
time to say look with 8 billion people
in the world and a 90 trillion dollar
economy that supports those eight eight
eight billion people do no harm doesn’t
work anymore it doesn’t scale we need to
do our best and there’s a lot of rules
that could change in a scenario where
you embrace do your best and I think
that that that has to happen but the
failures of the political infrastructure
and the healthcare infrastructure to use
bureaucracy as the thing that that
drives decision making I think is also
the a domino that has to fall after this
and we need to revisit because it’s a
you know we’ve we’ve done a lot of
unnecessary damage to ourselves and some
of this some of these self-inflicted
injuries we should figure out how to
prevent for the next time because it’s
gonna come again yeah I think we’re
living in incredibly uncertain in
chaotic times and you know one just
thank you for your time today but uh too
is uh think I speak for a lot of people
in that we’d love to see you go public
and kind of be along for the journey so
you’re doing an incredible job and I
just appreciate you uh
kind of going out there and sticking
your neck out there frankly because a
lot of people who they they’re gonna all
be the armchair quarterbacks right okay
two three years from now like I said I
told you that we should have done X or Y
but right now they’re they’re kind of
quiet so we’ll see how it plays out well
I really appreciate the fact that you
had me on and I just want to say that I
think you’ve been a really good person
in being out there in this moment the
reality is like in moments like this you
need people to be coalescing opinions
and I think that you’ve done that that’s
a really important service because it
allows people to get to ground truth so
I just want to say thank you for doing
thanks for including me
no problem at all all right sir well
thank you a teacher
all the best talk to you soon right bye
During his View From The Top talk, Chamath Palihapitiya, founder and CEO of Social Capital, discussed how money is an instrument of change which should be used to make the world a better place. “Money drives the world for better or for worse. Money is going to be made and allocated – you have a moral imperative to get it and then use it to make a difference.“