Wednesday, December 11, 2013

Abolishing the [financial] Pyramids

For thousands of years Jews have been celebrating Passover. Celebrating the liberation of our forefathers from slavery in Egypt, where many broke their backs building the Pyramids.  While ancient pyramids serve as archeological artifacts now days, new types of pyramids are still being built. Over the past decade, several “financial pyramids” have been erected in Israel, exploiting the fruits of labor of common people.  But this past week, the process of abolishing these pyramids achieved a few important milestones.

What are these ‘financial pyramids’, and why are they bad?

The process of constructing a financial pyramid typically starts with a small, often privately held company; let’s call it Private-Company. The owners of Private-Company raise capital by obtaining bank loans and issuing corporate bonds; the money is used to purchase a controlling interest (e.g. 51%) in another company: let’s call it Holding-Company. The Holding-Company turns around and raises capital again (via bank loans and corporate bonds) and purchases controlling interest in another company; one that manufactures goods or provides services; let’s call that company ‘Real-Company’.  
Slaving at the Pyramids

The Holding-Company can repeat the process multiple times: raise capital then purchase a controlling interest in yet another Real-Company. After a few iterations like that, you get a relatively small, Private-Company with controlling interest in one (or more) Holding-Companies, which in turn have controlling interest in multiple Real-Companies.

In a simple 3-layer pyramid, the Private-Company owns 51% of a Holding-Company who owns 51% of a Real-Company. The “beauty” of the scheme is that the Private-Company needs to invest barely ~25% of the Real-Company market value in order to fully control it. If you add more “layers” to the pyramid, the leverage becomes even greater. Keep in mind that ownership of such financial pyramids is obtained using ‘other people money’, through bank loans and corporate bonds. It is in fact a process where few individuals tap into common folk’s savings, and leverage it to gain broad financial control with minimum personal investment.  
So we have a few “smart individuals” (aka Tycoons) who use clever financial schemes to make a personal fortune. What’s wrong with that picture? It’s a free country, isn't it?

Well, there a bit more to it than just a few people making a buck. The holding companies are highly leveraged – they borrow heavily from banks and issue corporate bonds. Each holding company desperately needs “cash” in order to make payments on its debt.

To provide the holding company with much needed cash, the “real companies” under its control are “encouraged” to pay large dividends to their shareholders – which obviously include the holding company itself… High dividends force a manufacturing or service company to maximize its profits and minimize its expenses. A “dividend-centric” behavior leads the real company to “milk” every penny from its customers, while limiting investments in product or service improvements. These market “inefficiencies” lead to rising prices for manufactured goods and services. Doesn't sound so great for customers, does it? 

As the financial pyramids and their owners grow in strength, they seek political influence too. Passing the “right” laws and regulations to ban certain imports, or limit competition in certain markets can benefit the pyramids tremendously.  It was little surprise then to watch financial tycoons mingle with politicians and government regulators.

The “pyramid game” is highly slanted in favor of the tycoons: Common people deposit their hard earned money in banks, or pension funds. Those financial institutions use the deposits to either lend money to the pyramids, or buy corporate bonds issued by them. Either way, personal savings get funneled to the pyramids – which use it to grow even further. What follows is price increases and limited competition which raise the cost of living for common people.

I know, this is a rather simplistic description of some very convoluted financial schemes. But the principle holds true: Tycoons borrow money from the public; use it to build financial pyramids, who then exploit common people. Starts to sound similar to slaving at those good old pyramids…

Luckily, over the last couple of years the Israeli public became aware of this rigged game. Part of this awakening happened during the “social justice” protest that took place in 2011. Part happened because some tycoons overplayed their hands: they extended too far, or made poor investments which caused difficulties in paying the debt they took. Part happened because elected officials and government regulators realized that letting few tycoons exploit the rest of the nation may be bad politics after all.

Whatever the real cause is, the tide has turned. New legislation was signed this week which limits the structure and power of financial pyramids. As a result, some of the existing pyramids will have to be dismantled. Additionally, some debt holders (banks and bond holders) mustered the courage to call the shots and wrestle control from the hands of Tycoons.These are just the first steps in a national journey to stop such exploitation

Hopefully some important lessons have been learned. In the words of a great American president, Abraham Lincoln, who fought against other forms of slavery: You can fool all the people some of the time, and some of the people all the time, but you cannot fool all the people all the time.

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