Washington Decoded

Greed Is All Right

Den of Thieves
By James B. Stewart
Simon & Schuster. 493 pp. $24.95

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By Max Holland

    If James Stewart's Den of Thieves (Simon & Schuster, 1991) is just half accurate, Wall Street’s mores and culture in the 1980s bore an amazing resemblance to the Mafia’s. As depicted by Stewart, Wall Street was a world unto itself greased by the exchange of favors. Money, power and sex defined status. Providing for one’s family was the ostensible excuse for any behavior, and only suckers played without an edge. Wall Street argot, as in “This company is going down” or “We’ll squeeze the board of directors,” bespoke violence, albeit of an economic kind. The universe outside was viewed with contempt, and Securities and Exchange Commission (SEC) lawyers (the cops on the beat) were fools too stupid to make it on the Street. Whenever the SEC mounted an investigation, Wall Street prized silence and loyalty above telling the truth. In practice, though, betrayal to save one’s own skin was commonplace. Den of Thieves reads like the script from director Martin Scorsese’s Goodfellas, with investment banker Martin Siegel in the role played by Ray Liotta.

    The great strength of this book lies in its use of SEC documents and federal court records, supplemented by interviews, to construct a story valuable, above all, for its coherence. Readers who closely followed newspaper accounts of the criminal misdeeds of Dennis Levine, Martin Siegel, Ivan Boesky and Michael Milken, the four main culprits in Den of Thieves, will still have their eyes opened by Stewart, a Pulitzer Prize-winning journalist with a law degree. Even the outstanding coverage of The Wall Street Journal, where Stewart is front-page editor, is no substitute for a sustained narrative that weaves together new information with half-forgotten facts. In particular, the means by which the government lawyers bring down “the Russian” (Boesky) and then Milken is crucial to understanding the whole sorry mess. Half the book is devoted to that grinding, slow-motion chase, most of which has never been reported, and it is the better half of the book.

    Few characters emerge with their reputations intact, fewer still with their reputations enhanced. Of the latter, the most prominent is Federal Judge Kimba Wood (a Reagan appointee, it must be pointed out), who sentenced Milken to ten years in prison precisely because he committed “only crimes that were unlikely to be detected.” Wood is to this scandal what John Sirica was to Watergate, a judge who restored some faith in the system, although Sirica had to work much harder and longer. Stewart’s other heroes are the SEC and Justice Department attorneys who persevered, finding resolve in the knowledge that they were, as one of them put it, “engaged in the single most important thing we would ever do in our lives.” Admirable characters outside the government are harder to find. Perhaps only Harvey Pitt acquitted himself well. Pitt, a former SEC general counsel who represented, among others, Ivan Boesky, managed to serve the interests of his clients and Justice at the same time.

That Milken emerges as the most malign individual among large cast of unsavory characters 1s no surprise. As late as 1986 Boesky seemed to have that mantle all to himself. In that year he defined the spirit of the eighties with his “greed is all right” commencement speech at Berkeley, not uncoincidentally marking Ronald  Reagan’s ultimate triumph over the campus that launched the Free Speech Movement. But Stewart rightly shows that Boesky, the arbitrageur, paled next to Milken, the junk bond king. It may have been a symbiotic relationship, but it was not equal. Boesky did Milken’s bidding, and so the decade ended with Milken as the embodiment of greed.

    I grew up in Los Angeles at roughly the same time as Milken, and I still find it hard to comprehend what a cheerleader from Birmingham High School (the Valley, no less) wrought. Start with Richard Nixon’s character flaws, add the zealotry and utter shamelessness of Oliver North, and the result might begin to approach Milken, an insecure, charismatic, obsessive accountant’s son who aimed to dominate the whole financial world. At some point Milken apparently decided that no big deal was going to be done without him, requiring him to seem unstoppable if not omnipotent. To this end he cheated his clients, his partners, his subordinates and his firm, Drexel Burnham Lambert. He tried to prevent publication of a book that dared criticize his junk bond empire. Once the SEC began to close in, Milken paid what amounted to hush money to try to keep his staff closemouthed. In all probability he destroyed evidence.

    Finally, in a last-ditch effort to stave off certain indictment, Milken underwrote an enormous public relations campaign calculated to neutralize public opinion, if not turn popular outrage into outright acclaim. Because any Manhattan jury was likely to include black Jurors, special efforts were made to propagandize the black community. Fortunately these did  not work, although Milken managed to enlist Jesse Jackson in this cynical exercise, yet another reminder that Jackson’s ego is larger than his politics.

    Milken’s lawyers were a true extension of their client. Edward Bennett Williams, the attorney hired by Milken immediately after Boesky pleaded guilty, sought to protect his client from indictment by keeping everyone at Drexel “inside the tent pissing out” instead of on each other. At no time did he ever attempt to get the truth from his client, unlike Harvey Pitt. In effect, it seems, Williams connived to obstruct justice.

    The tactics of Milken’s co-counsel, Arthur Liman, were even worse. When he became chief counsel to the Congressional committee investigating the Iran/contra scandal in 1987, Liman said his respect for the rule of law compelled him to put aside his lucrative corporate practice in order to perform a public service. But his defense of Milken suggests he has one set of legal ethics for government officials and another for wealthy private citizens.

  Just as Ollie North and Brendan Sullivan put North’s  interrogators on trial, Liman sought to make Milken’s critics and prosecutors the defendants. It was Liman who ordered that steps be taken to stop publication of Connie Bruck’s The Predators’ Ball “either through contacts” at Simon & Schuster “or in court.” It was Liman who suggested that Milken try his case in public by hiring Linda Robinson, a P.R. flack who proceeded to try to persuade America that Mike Milken was a “national treasure” instead of a national disgrace. After Williams died of cancer, full control of Milken’s defense fell to Liman, who clung to Williams’s scorched-earth tactics and continued to indulge Milken’s fantasies of complete innocence. When Drexel chairman Fred Joseph advocated a settlement with the SEC in a desperate effort to save the Drexel franchise, Liman accused him of “selling out” Milken, as if Drexel were an investment bank in Nazi Germany shedding itself of innocent Jewish partners. “That’s the first step towards concentration camps,” Liman told Joseph.

  Along with his sharply drawn portraits of right- and wrong-doers, Stewart sheds light on a neglected aspect of the frenzied eighties, namely, the care and feeding of the business press and other media by junk bond and takeover artists. But Stewart raises almost as many questions about the media as he answers. Martin Peretz, editor in chief of The New Republic, was a big investor in Boesky’s arbitrage fund. Did that fact have anything to do with the adulatory review of Boesky’s 1985 book, Merger Mania, that appeared in TNR? (One of Boesky’s assertions was that he never made any “undue profits.“) And why is it that none of the major networks, or PBS, ever put together a serious documentary about buyouts and junk bonds, a phenomenon that affected hundreds of thousands of jobs, pensions and benefits? Is it because "60 Minutes" producer Don Hewitt socializes with buyout artists like Henry Kravis, or because Kravis sits on the board of WNET, the PBS affiliate in New York?

    For all its power and value, Den of Thieves falls measurably short of the distinction some reviewers would give it: that it is the definitive book about Wall Street during the eighties. Stewart’s reportorial skills are considerable, but the book is stingy when it comes to going beyond a description of who-did-what to an interpretation of why things happened. The story begs, at many points, for Stewart to stop and paint the big analytic picture before he resumes his admittedly compelling narrative. He does so too infrequently. The underlying reasons for the eighties’ speculative boom are  inadequately discussed in three paragraphs on page eighty-three. The devolution of deal making over the decade is largely missing, along with significant nuances in the battles for corporate control. Even the October stock market crashes of 1987 and 1989 are treated almost as asides rather than events integral to the story. The sickening transformation of Wall Street from a collective means of financing the economy into a free-for-all looting of corporate America is never fully explained.

    A closely related drawback is Stewart’s focus on criminal activity: insider trading, the “parking” of stocks so as to conceal true ownership, and manipulation of share prices. This emphasis is understandable, given Stewart’s reliance on court documents that resulted in criminal convictions. But Wall Street in the eighties was not merely about illegality, though there was plenty of that. It was also about the utter collapse of business ethics, manipulation of the tax code by Wall Street’s best and brightest, who stole shareholders blind and then justified epic displays of avarice by claiming to maximize shareholder value. None of these activities are illegal, but they constitute more than half the depravity that was Wall Street during the Reagan years. Den of Thieves replicates, curiously enough, the self-centered world view of Wall Street. In fact, it seldom leaves the Street (Milken’s office in Beverly Hills notwithstanding). In his prologue, Stewart takes note of the big, consequential context, the corporations fatally crippled by criminal and unethical activity, the thousands of jobs lost to unserviceable debt, forced bankruptcies and depleted pension plans. But those consequences are only asserted, and never shown to be true in the same searing detail Stewart uses to reveal Boesky’s insider trading. The definitive book would show what happened to Rexene, or any one of hundreds of companies subjected to Milken-financed raids or buyouts.

    The exception to this parochialism is Stewart’s occasional reference to Washington, but he still does not tell enough about this aspect. Never mind the do-nothing Treasury Department and the cheer-leading by economists at the SEC, which was firmly in the grip of laissez-faire ideologues for most of the eighties. The non-response of   Congressional Democrats to Wall Street’s speculative orgy should have been an  important component of Den of Thieves. Stewart never mentions the Alliance for Capital Access, a lobbying front that Milken organized in 1985 with one purpose in mind: to beat back any attempt to rescind the tax deduction for interest on corporate debt. From 1985 through 1990 the alliance raised and spent $4.9 million lobbying Congress to protect the one deduction absolutely critical to Milken’s Ponzi scheme. Instead, Stewart merely tantalizes the reader with isolated facts, such as the $23,900 in campaign donations from Drexel that helped turn liberal Senator Timothy Wirth from a critic into a defender of junk bonds.

  All these gaps explain why Stewart concludes by proposing the most limited reforms imaginable, such as a statutory definition of insider trading (according to Stewart’s own book, Martin Siegel always knew when he was illegally sharing privileged information despite the vagueness of current law). The problems are much more fundamental. Basic issues of corporate governance and accountability need to be reopened and resolved if the corporate form of organization is going to benefit society and not just yield unconscionable rewards to a handful of bankers, lawyers and CEOs.

    Now that the eighties bubble has burst and Milken is in jail sans hairpiece until 1993 or thereabouts, it might seem like this story is mostly over. But recently Milken reduced Arthur Liman’s role in favor of that famed lawyer of last resort, Alan Dershowitz. Milken reportedly was inspired by Dershowitz’s success in the Claus von Bulow case, and there is speculation that, far from seeking a mere reduction in Milken’s sentence or defending Milken in $1 billion worth of pending civil suits, Dershowitz may try to withdraw his client’s guilty plea. The lawyer of last resort is using the tactic of last resort. Virtually all the negative characters in the book are Jewish, says Dershowitz, and gratuitously identified as such. To make his point, Dershowitz took out a $40,000 full-page ad in The New York Times attacking both Stewart’s book and the person who reviewed it in that paper (occasional Nation contributor Michael Thomas) as anti-Semitic. Stewart also says a private detective has been asking friend about his private attitude toward Jews. It is true that Stewart neglects the sociology of Wall Street, which would show the outsider status of Jews, not to mention other minorities. Seen in this context, the criminal behavior of Milken et al. was a kind of retributive assault on corporate citadels unfairly closed to them. That is what happens when people of great ability are treated dishonorably by those in power --they break the rules. But this lapse is not proof of any anti-Semitism on the part of Stewart, it’s just a shortcoming of the book.

    It may take a journalist with a novelist’s skills to write the definitive account of Wall Street during the eighties. Until then, read Stewart’s book.

    Postscript: Almost 16 years later, Wall Street is the same. Only the names have changed--and not all of them at that, viz., Henry Kravis.

       This book review first appeared in The Nation, 16 December 1991
                                  © 1991 by Max Holland

How to Kill a Company: Anatomy of a Leveraged Buyout

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By Max Holland
   

    Phil O’Reilly recognized that his company, Houdaille Industries, was taking a gamble when it underwent a leveraged buyout in 1979. A bad year or two could suck the Florida-based conglomerate into a whirlpool of debt. Ultimately, it might have to sell off its most attractive assets to satisfy creditors and buyout investors.

    But if nothing untoward happened, if Houdaille managed to service its debt, then O’Reilly knew that by 1984 a “pot of gold” awaited him and other equity investors. This is the moment when a private, leveraged company, having whittled its debt-to-equity ratio down to acceptable proportions, returns to the stock market. Equity investors then reap a huge reward, as much as 10 or 20 times their original investment.

  A buyout is a Faustian deal because it flouts a cardinal rule of management: Don’t bet the business. Houdaille’s executives did, and lost. Today Houdaille (pronounced WHO-dye) doesn’t exist anymore as an industrial manufacturer.

    The debate over the business wisdom of LBOs cannot be decided by the fate of one company. Buyout artists point out, and rightly so, that there are lots of “bad” deals to go along with the “good” ones. But interestingly, the investment bankers who engineered the Houdaille deal, Kohlberg, Kravis, Roberts & Co., tout it as a success despite the conglomerate’s demise.

    More disinterested observers might consider it an object lesson in what’s wrong with leveraged buyouts.

  Houdaille Industries, took its name from Maurice Houdaille, the Frenchman who invented recoilless artillery during World War I. After the war, a U.S. corporation bought the name and the rights to the rotary shock absorber Houdaille patented. By the 1930s, Houdaille Industries was one of the largest auto-parts subcontractors in Detroit and the premier U.S. manufacturer of shock absorbers. It was not unusual for a car owner to walk into a garage and ask for a new set of “Houdailles.”

    When national security warranted, Houdaille also manufactured more sophisticated products. During World War II, it participated in the Manhattan Project to develop the atomic bomb. But the modern era for Houdaille began in the mid-1950s, when it found itself being squeezed out as the number of automakers shrank and the survivors moved parts production in-house. To survive, Houdaille was forced to diversify. By the late 1960s, it had become a high-flying conglomerate, with interests in construction materials, industrial products, pumps and machine tools. In fact, its stable of machine tool companies made it one of the top U.S. builders of the “mother” machines which make all machines.

    In the winter of 1978, Houdaille common stock was selling for around $ 14.50 a share, well below the conglomerate’s book value. A depressed stock price was a familiar problem for Houdaille -- as for many other industrial conglomerates in the stagflation-prone ’70s. Houdaille had a more immediate problem as well: The conglomerate’s long-time CEO, Jerry Saltarelli, wanted to retire. But passing the baton, while keeping Houdaille independent, was not going to be easy. Speculators noticed that Houdaille was simultaneously debt-free and cash-rich, making it a likely takeover candidate. Funny things -- and heavy trading -- began to occur in Houdaille stock. The prospect of an unfriendly takeover worried Saltarelli. For his energetic lieutenant, Phil O’Reilly, it posed an even greater threat. Taking a leaf from his days as a star football lineman at Purdue, O’Reilly had worked long and hard to overcome every obstacle in the way of his becoming CEO. But now, on the verge of success, Houdaille stood to lose its independence.

    Just when there seemed to be no good solution, Houdaille’s financial advisers passed along a message from a then-obscure trio of bankers named Jerome Kohlberg, Henry Kravis and George Roberts. Kohlberg, Kravis, Roberts & Co. suggested that Houdaille could have its cake and eat it too. Saltarelli could liquidate his stake in Houdaille and keep it intact for his chosen successor. There would also be frosting on the cake for holdover management -- an opportunity to reap large profits in just a few years. All Houdaille had to do was undergo a leveraged buyout.

  At a meeting in Florida, KKR explained the deal. A small group of investors, primarily KKR and holdover Houdaille management, would acquire all the conglomerate’s public shares. The cash necessary for the buyout would be borrowed primarily from institutional investors, which would lend the money based on Houdaille’s assets. Saltarelli and O’Reilly were mystified by one thing. Where was Houdaille going to get all the cash to pay off the high-interest, or junk-bond, debt incurred as a result of the buyout? At this juncture KKR introduced the Houdaille executives to their silent but consenting partner in the deal: Uncle Sam.

    Stripped of all the complicating factors, KKR could offer an unheard-of $ 40 per share for Houdaille stock, leverage the company to the hilt and then cash in four or five years down the line -- all because of Uncle Sam’s largesse when it came to the redepreciation of capital assets and interest write-offs. In effect, a leveraged Houdaille would have to pay little, if any, corporate income tax for the life of the buyout. Thus, the same stream of corporate income would suddenly provide an extra 30-40 percent in cash, enabling Houdaille to service its massive debt -- courtesy of Uncle Sam. As Treasury Secretary Nicholas Brady observed some years later, “The substitution of [deductible] interest charges for [taxable] income is the mill in which the grist of takeover premiums is ground.” Or as buyout artists like to put it, the process “unlocks hidden value.”

  KKR hastened to add that managing for cash flow, rather than quarterly profits, would not be easy. But other managers had proved that it could be done. And if Houdaille executives could do it too, they would enjoy a financial windfall when the firm went back to the stock market in four or five years -- not to mention immediate profits from the $ 40 buyout and the hefty raises promised if the LBO was consummated. Phil O’Reilly, for one, was promised a raise from $ 110,000 to $ 200,000, exclusive of bonuses. Little wonder that wags on Wall Street soon took to calling LBOs the “kiss which turns the frog into a handsome prince.” In May 1979, Houdaille became the first large industrial corporation to undergo a leveraged buyout. The deal was a milestone. No corporation worth more than $ 100 million had ever been leveraged, and the Houdaille deal was worth $ 390 million. Wall Street immediately recognized that the financial rules were no longer the same. “The public documents on that deal were grabbed up by every firm on Wall Street,” one buyout artist, Frank Richardson, recalled several years later. “We all said, ’Holy mackerel, look at this!’”

    On the day that he finally assumed the top spot at Houdaille, Phil O’Reilly, a new millionaire, told The New York Times, “We’re looking forward to working with KKR. Their experience in finance coupled with our experience in manufacturing and marketing will make a very complementary group.” He indicated that Houdaille retained its appetite for growth through acquisition, but for the time being that aim had to take a back seat to a more pressing concern. “We’re highly leveraged right now, so our first goal is to pay off some of the debt.”

  A large chunk of Houdaille’s savings, $ 35 million, was immediately used to retire some debt. In addition, the new, privately-owned Houdaille liquidated the balance of its interests in construction materials, which had not been profitable since 1973. Another product line also underwent abrupt changes as automakers’ demand for chrome-plated bumpers -- which as recently as 1976 had accounted for more than half of Houdaille’s profits -- evaporated in 1980 as Detroit turned toward plastic bumpers.

    But the acquisition of John Crane in 1981, a company two-thirds the size of Houdaille, more than compensated for these divestitures. John Crane was an Illinois-based maker of mechanical seals used to prevent leaks around rotating parts and enjoyed more than 40 percent of the domestic market and 30 percent of the global market for seals. By any measure, the $ 204 million acquisition (via debt financing) was a business coup, putting the conglomerate exclusively in the business of manufacturing high value-added goods. Some two years after the buyout, Phil O’Reilly had every reason to be ecstatic. Houdaille had been able to restructure, and the pot of gold was within sight. But then the unexpected happened, or perhaps more accurately, the expected. For surely what makes running a business or corporation so invigorating is the almost constant need to cope with challenges, be they economic or technological. Normally, however, a corporation the size of Houdaille has a comfortable cushion -- its own equity -- to fall back on. It can suspend dividend payments if need be, or borrow against its equity if new investment is needed. But a leveraged company has only one option: service the debt, even if it means breaking up the company.

    The unexpected came in the form of a recession and foreign competition. Nothing like the deep 1981-1982 recession had been forecast when Houdaille underwent its LBO in 1979. As if that wasn’t enough, seemingly overnight Houdaille was also facing the specter of fierce competition in a business segment that was supposed to be a safe niche: machine tools. The Japanese were making startling inroads into the American market, long the almost exclusive preserve of U.S. builders like Houdaille.

    Two years after the buyout, Houdaille was caught in a triple bind of debt, recession and competition. The first was a given, and the second Houdaille could do nothing about. But O’Reilly believed that the last problem, foreign competition, might be amenable to a Washington cure. He hired a savvy lawyer, Richard Copaken, to press Houdaille’s case for import protection in Washington. But Copaken’s case did not adequately support Houdaille’s thesis: that Japan’s Ministry of International Trade and Industry had commanded a machine-tool cartel bent on carving up the U.S. market.

    After spending $ 1.5 million on the trade petition, O’Reilly was naturally bitter about losing. The stakes could not have been higher. The hemorrhaging of Houdaille’s machine-tool group, which typically accounted for about 25 percent of Houdaille’s revenues and profits, subverted the entire buyout because it pushed the pot of gold out of sight. Instead of shrinking as planned, Houdaille’s debt was actually increasing: from 107 percent of total capitalization in 1983 to nearly 113 percent in 1984, the year by which equity investors had been promised the pot of gold.

    In the always-revealing vernacular of Wall Street, the Houdaille buyout had become a “dog.” Yet Phil O’Reilly was still publicly praising leveraged buyouts. Among the joys cited by O’Reilly was that as CEO of a private company, answerable only to select institutional investors, he could “look out at a longer horizon.” After vigorous but vain attempts to find a buyer for its machine-tool group, Houdaille announced a “business restructuring program” in late 1985, thereby “reducing its interest expense and enhancing its future.” The divestiture was a complicated one. All told, seven divisions were split off from the conglomerate, including its entire machine-tool group. Phil O’Reilly blamed the Japanese, and then the Reagan administration, for the 2,200 highly-skilled, high-paying jobs that were lost as a result. But the real significance of Houdaille’s demise as a major machine-tool builder was that the Japanese were handed a still greater share of the U.S. and world markets in an industry that remains central to the health of any industrial economy.

    The restructuring greatly reduced Houdaille’s junk-bond debt, but investors clamored for more. Consequently, one year later Houdaille underwent another leveraged buyout, or what might be more accurately called a recapitalization. Its main purpose was to cash out those equity investors who wanted out of the deal after seven years. These investors, who paid $2.52 per share for their stock in 1979, received $11 per share.

    But “quieting the natives” came at a very high cost. Whereas the 1979 deal had been constructed with a pot of gold in mind, the recapitalization piled debt upon debt and put Houdaille on a precipice from which there was no escape, save dismemberment. Debt leverage soared from 103 percent to 152 percent of capitalization. Houdaille’s newly-issued junk bonds were rated CCC (a D rating means bankruptcy), and the conglomerate was forced to pay junk bondholders 13.875 percent interest at a time when interest rates were less than 10 percent. “Cash interest coverage and debt service coverage are very thin,” noted a Standard & Poor’s analyst in a report analyzing Houdaille’s new junk bonds. Little wonder that Houdaille’s rate of capital investment, as a percentage of revenues, was now less than half of the rate prior to the buyout.

    Less than a year after the recapitalization, Houdaille announced that Phil O’Reilly was retiring from active management, effective immediately. His abrupt departure caught industry observers by surprise. Few CEOs were more vigorous than O’Reilly, and at age 61 he was well short of normal retirement. No explanation was given out by Houdaille, but three weeks later, the shoe dropped. A British conglomerate, Tube Investments Group, announced that it was taking Houdaille over. TI intended to keep only one Houdaille division -- John Crane -- and dispose of the rest.

  Houdaille had passed into oblivion as an industrial manufacturer, a classic example of the consequences when debt is more profitable than equity, speculation more lucrative than enterprise. Ten years after the Houdaille LBO, the elaborate financial engineering pioneered in that deal has become commonplace, and LBOs are fundamentally restructuring corporate America. In the wake of KKR’s unprecedented $ 25-billion RJR Nabisco deal, Congress decided it was finally time to take a closer look at what Wall Street was up to.

    KKR promptly commissioned the accounting firm of Deloitte Haskins & Sells to prepare a study on LBOs. The 32-page report, naturally, extols the virtues of LBOs, or at least some of those engineered by KKR. More to the point, the last two pages describe the Houdaille success story. “All of the Houdaille ’constituents’ . . . fared well in the LBO,” says the report. Houdaille never fell behind on its debt service. And far from weakening the conglomerate, the LBO “improved management’s flexibility in dealing with the severe, rapid and adverse changes in the company’s operating environment.” As the result, “not only were all creditors paid in full . . . but superior returns were realized [emphasis in the original] by investors.”

    Postscript: Eighteen years later, leveraged buyout artists have redubbed themselves private equity investors, but they are still financial engineers  who engage in flipping companies like so many hamburgers.

     This article first appeared in The Washington Post, 23 April 1989
                             © 1989 by Max Holland

Senators Beat the Market with Insider Information

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By Max Holland
   

    The United States Senate is often called “the most exclusive club in Washington,” or exalted by its members as the “world’s greatest deliberative body.” But a new appellation may be in order: the world’s best investment club.

    According to a study conducted by four business professors, in any given year between 1993 and 1998, roughly 1/3 of all senators played the stock market, and those who did enjoyed an “abnormal” rate of return, meaning they out-performed the market. Senators consistently anticipated movements in stock prices: they often purchased stocks just before prices took off like a rocket, and revealed an uncanny ability to sell just when a stock was about to flatten out.

    For some perspective, the authors of the study (university professors Alan Ziobrowski from Georgia State; Ping Cheng from Florida Atlantic; James Boyd from Kent State; and Brigitte Ziobrowski from Augusta State) compared the senators’ performance with that of two groups. The first is the investing public: 66,465 randomly selected households in the United States that were studied in 2000. This group underperformed the market by approximately 1.4 percent annually from 1991 to 1996. The authors also compared the senators’ performance with a 2001 study of corporate insiders during the period 1975 to 1996. This group beat the market by about 6 percent annually—lending credence to the old Wall Street adage that you rarely go wrong if you buy and sell when the insiders do.

    Yet being a corporate insider, and presumably trading on the basis of privileged information, apparently pales next to being a senator. The Ziobrowski et al. study found that senators (including their spouses and dependents) outperformed the market by around 10 percent annually. “Nobody gets results like this in the financial world consistently and over the long term,” notes Professor Tom Ferguson, who studies money in politics at the University of Massachusetts-Boston. Any manager of a mutual fund, in fact, who regularly beats the market by as little as two percent annually is considered an investment genius.

    Since it cannot be a statistical fluke, the most plausible explanation for this achievement is that senators, by virtue of their powerful office, are made privy to such privileged information, and that some choose to capitalize on it. It’s unlikely that stock tips are being exchanged during whispered conversations in Capitol Hill cloakrooms, or that senators are the first to realize the economic repercussions of complicated legislation. Rather, senators’ acumen comes from being “embedded in social networks that provide them with access to valuable information,” as the professors put it. Think of it as the Martha Stewart scenario writ large.

    The study found no statistically significant difference between the abnormal returns earned by Democrats versus Republicans over the six-year period. Seniority, however, appeared to be a significant factor. Surprisingly, those with the least seniority (e.g., in their first six-year term) achieved higher abnormal returns than senators who had served at least two terms. This suggests that lucrative investments of other kinds may flow more easily to established senators who wield more power, say, committee chairmen.

    Mark Twain’s observation, first offered more than 100 years ago, seems pertinent. If your congressman comes back to your state to run for re-election and is not coming home a millionaire, noted Twain, “he is a fool and should be turned out of office.”

    To be sure, senators who trade are not doing anything illegal, or even unethical, according to the Senate’s internal standards. Stock trading on the basis of privileged information is not even addressed in the Senate’s Ethics Manual. Senators are prohibited from directly “cashing in” on legislation they work on; yet overall the rules governing their financial conduct are quite liberal. Senators are not required to “strip themselves of worldly goods” upon taking office, nor are they disqualified from voting on issues that generally affect their personal fortunes.

    Interpreting the ethics code is largely up to the members. At one end of the spectrum lies Richard Lugar (R-Indiana), a senator for 28 years, who decided when he entered politics in 1967 that holding individual stocks was incompatible with public service. Lugar invests only in diversified mutual funds, and each year releases a balance sheet of his assets and liabilities that goes well beyond what is legally required. At the other end is Ted Stevens, the senior Republican in the Senate who is also known as Alaska’s “senator for life,” having represented that state since 1969. Stevens invests in dozens of individual stocks, including telecommunications and technology companies that fall directly under the jurisdiction of the Commerce Committee, which he chairs.

    Because of the wide latitude allowed, sunlight is deemed the best disinfectant. Since 1978, senators have been required to disclose all their personal financial holdings (and those of their spouses and dependents) in an annual Financial Disclosure Report (FDR). This yearly exercise is considered the most effective mechanism for deterring gross conflicts of interest or egregious self-enrichment.

    The supposed transparency of the FDRs, however, is not all that it is cracked up to be. And this is the other troubling aspect exposed by the new study. The trading data available in the FDRs presented a host of problems. While some senators simply attached the monthly financial statements from their brokerage firms to the FDR, others provided only handwritten notations or abbreviations that the professors found impossible to decipher.

    More significantly, senators are only required to report their gains within eleven broad bands ($1,001 to $15,000, $15,001 to $50,000, and so forth), and so the exact amount of their profits cannot be measured. In order to perform their analysis, Ziobrowski and his fellow professors had to create imaginary portfolios that mimicked the buy-and-sell transactions the senators engaged in. While this methodology in no way invalidates the study’s key finding, it dulls the political point with respect to specific senators when a dollar amount cannot be attached.

    Indeed, the “banding problem,” as it’s known to money-in-politics cognoscenti, is a serious defect in the FDRs because it obscures almost as much as it reveals. One member of Congress, for instance, listed assets, in bands, that totaled somewhere between $813,000 and $1.7 million in 1996. This same member, nine years later, listed assets totaling somewhere between $2.4 million and $8.1 million. The gap between those numbers suggests two very different portraits: a member who is either simply a prudent investor, or someone who rivals Warren Buffett, albeit by exploiting, in all likelihood, the boundless perks available to elective officeholders. These opportunities encompass everything from getting in on the ground floor of initial public offerings of stock, to sweetheart real-estate deals. Ted Stevens once turned a $50,000 investment with an Anchorage real-estate developer into $1.03 million in seven years.

    Senators’ ability to time the stock market is one reason why at least 60 senators are worth at least $1 million now. As recently as 1994, only 28 senators had a net worth of that amount or more, and their salaries (currently $162,100) have not gone up fast enough in that 11-year period ($28,500) to account for this increased wealth.

    The Senate, of course, has always had its share of members unable to distinguish between their own personal fortunes and the nation’s. The late Robert Kerr (D-Oklahoma), the “uncrowned king of the Senate” in the 1950s, comes to mind. Born in a log cabin, but the wealthiest man in the Senate by far during his years of service, Kerr was infamous for privileging oil and gas interests, including his own company (Kerr-McGee), from his perch on the Finance Committee. Kerr believed doing business in the Senate was no different than doing business on the outside: Everything was predicated on a quid pro quo basis.

    Besides venal members, the Senate has always had its fair share of “empty suits,” senators whose main qualification is that they look or sound like Central Casting’s idea of a senator, as well as more than its share of ambitious politicians who regard the upper house primarily as a steppingstone. But what seems different now, and what makes these charming peccadilloes and real shortcomings harder to swallow, is that so few senators seem capable of, or committed to, fulfilling their responsibilities as public servants. Seldom in its history has the Senate seemed so removed from what the Founding Fathers envisioned: the place where the power of the executive branch and House could be checked, and the forum for “express[ing] sober second thought on national priorities,” as Lewis Gould put it in his recent history of the Senate, The Most Exclusive Club.

    The restraint of executive power has seldom been weaker. During the last decade, under Presidents Clinton and Bush, and without a declaration of war, the U.S. has bombed Serbia’s Slobodan Milosevic into submission; toppled the Taliban in Afghanistan; and instigated a war of choice to overthrow Iraq’s Saddam Hussein. Towards the end of the Vietnam War, the 1973 War Powers Act was put in place to check the commander-in-chief’s ability to commit American lives and treasure; the Senate spearheaded passage of the act. Although largely symbolic, it at least held out the promise of forcing meaningful debate over the issue of war. But nowadays the Senate is likely to give a transportation bill more thoughtful deliberation than a decision to commit American soldiers, as Leslie Gelb and Anne-Marie Slaughter noted in a November article in The Atlantic. Reportedly, only six senators read the classified intelligence estimate on Iraq before voting to authorize the use of force there.

    The weakness of the contemporary Senate is not only reflected in the absence of stirring debate on pivotal issues. It’s evident nearly every working day. It’s the rare senator who can ask extemporaneous questions of a witness before a committee. The impulse for serious investigating, which is time-consuming, hard work, is also all but dormant. Despite the stunning intelligence failure that preceded the war in Iraq, the Intelligence Committee has yet to explore the Bush administration’s misuse of the flawed estimates produced by the intelligence community. More recently, the Senate roused itself, at least temporarily, and blocked renewal of the Patriot Act. But that only occurred because, on the day of the vote, many senators apparently learned from reading The New York Times that President Bush had signed a secret and unprecedented order in 2002 authorizing the National Security Agency (NSA) to conduct warrant less intercepts and wiretaps domestically. Traditionally, the NSA has been highly restricted in its operations inside the United States.

    One has to go back to the Gilded Age to find a time when the Senate seemed of equal inconsequence. At that time, senators were widely criticized for being captive to moneyed interests and bent on self-enrichment. It was thought that these twin evils stemmed from the fact that senators were elected by state legislatures rather than by popular vote.

    Apparently not.

      This article first appeared in The Washington Spectator, 1 January 2006
                                                 © 2006 by Max Holland

Fantasy v. Reality in the Federal Budget

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By Max Holland

   
    In case you missed it—and the Bush administration was certainly hoping that you would—the federal government’s operating deficit for 2005 was $760 billion, or a whopping 138 percent higher than the much more widely reported budget deficit of $319 billion.

    The Bush administration hailed the lesser amount when it was announced last October by the Office of Management and Budget (OMB), largely because at a projected $319 billion, the budget deficit came in significantly lower than most estimates. But there was no fanfare when the Treasury Department reported the negative $760 billion net operating cost to Congress in mid-December—not so much as a press release. The Treasury’s figure, contained in the annual Financial Report of the United States Government, gives the lie to Bush’s contention that his fiscal policies pose no threat to the nation’s economic well-being and security.

    What is the difference between the budget deficit and the net operating figure? They describe virtually the same thing: the difference between what the government spends, and what it takes in, during a given fiscal year. But there is a world of difference in how they are calculated.

    The OMB’s budget deficit is based on simple cash accounting, a method appropriate to a business, oh, say, the size of a corner newsstand. In cash-based accounting, an expense is logged only when it’s actually paid. Under the more accurate system, called accrual-based accounting, expenses are recorded when a business becomes obligated to pay them; that reveals the long-term implications of current spending decisions. The necessity of taking into account future obligations is a major reason why under U.S. law every enterprise with more than $5 million in revenues is required to use accrual-based accounting, and also why David Walker, the U.S. comptroller general, notes that cash accounting paints a “potentially unrealistic and misleading picture of the federal government’s overall performance.”

    The government only began releasing an accrual-based budget figure in 1997, after it was mandated by an act of Congress. Getting the vast federal apparatus to abide by the buzz phrase “generally accepted accounting principles” was an enormous undertaking. It wasn’t until 2000, for example, that reliable figures for Social Security and Medicare could be incorporated into the annual Financial Report.

    When the Bush administration issued its first financial statement in early 2001, it reported a net operating surplus of $46 billion. Since then, there has been a flood tide of red ink. Every year the net operating cost has grown larger, exceeding the more widely known OMB figure by hundreds of billions of dollars. In 2005 alone, as noted, the difference was $441 billion ($319 billion versus $760 billion). Looking at it another way, from 2001 to 2005 Bush’s spending and tax policies resulted in budget deficits totaling $1.1 trillion, according to OMB’s calculations. The Treasury’s accrual-based figure is $2.9 trillion, or 164 percent larger.

    The lion’s share of this difference comes from a sober, accrual-based accounting of the long-term costs of the war in Iraq and the global war on terror. In the 2005 Financial Report, Treasury Secretary John Snow attributed the $441 billion increase over the OMB’s figure “principally to a $198 billion increase in Veterans Affairs’ actuarial costs,” including higher interest rates that will have to be paid because of mounting public indebtedness (from $5.7 trillion on the day Bush took office to more than $8.4 trillion today).

    Accrual accounting also paints a drastically different portrait of whether Bush’s deficits are shrinking or growing ever larger. When the OMB deficit shrank from $413 billion in 2004 to the lower-than-expected $319 billion in 2005, the Bush administration touted the reduction as proof that it was reining in government spending, and that it had been justified in pushing for tax cuts. Slashing taxes reinvigorated the economy, the administration said, resulting in increased revenues. But the accrual-based numbers tell a different story. From 2004 to 2005, the net-operating-cost deficit increased from $616 billion to the aforementioned $760 billion.

    The harsh truth of accrual-based accounting underscores just how reckless the administration is. Lyndon Johnson’s guns-and-butter policy during the Vietnam war looks almost prudent juxtaposed against Bush’s policy of fighting a major war while cutting taxes necessary to pay for it. Bush has deployed the fiscal equivalent of having an all-volunteer armed forces. Just as the absence of a draft diminishes widespread opposition to military adventures, sloughing off the cost of the Iraq war by citing unrealistic OMB budget numbers defers pressure on the administration. Americans aren’t bearing anything close to the economic burden that corresponds to the true cost of the war. Add in budget-busting costs from demographic trends starting in the next decade, and an economic meltdown is on the horizon.

    One of the members of Congress to take notice of this legerdemain has been Representative Allen Boyd, Jr. (D-Florida), a member of the Blue Dog Coalition, a group of 37 moderate-to-conservative Democrats. Boyd warns that “viewing the budget through rose-colored glasses” is “an unhealthy and damaging practice that will affect our economy, our standard of living, and ultimately, our national security.”

      This article first appeared in The Washington Spectator, 1 May 2006
                                              © 2006 by Max Holland

Bashing, Bullying, Blaming Japan, US Deals With a Deficit

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By Max Holland

 

    Journalistic predictions are risky. But here’s a sure thing. On or before May 30, the Bush administration will significantly heighten trade tensions with Japan and a congressionally-mandated report will be the catalyst.