Loopholes, People Who Love Loopholes

America is the official “Home of the Loophole.” Whenever any new tax law or regulation comes out, a bevy of accountants and lawyers, all still very well compensated even in meltdown-land, pour over every word and nuance to see how they can “tax plan” their way to minimize taxes for clients. The more complicated the issues, the more these experts get paid (we pay ‘em more than engineers!), and the richer you are, the more you can plan your way out of liability. It’s called tax “avoidance,” because “evasion” could get you jail time, although these days, it does seem like a good place to meet high-level politicians and high-roller financiers.

OK, I laugh when I hear folks in Hong Kong, where the highest tax rate on earned income is 16%, trying to figure out structures to avoid even that figure, but in terms of job-creation, there’s nothing like having expertise about how to avoid a government regulation or statute that gets in the way of making money. When salary caps were being discussed for top executives at bailed-out financial institutions, the loophole experts were busy defining what an “executive” was that might be impacted.

When Obama’s bailout $787 billion bill was passed earlier this year, Senator Chris Dodd, at the urging of the Department of the Treasury, introduced an intentional loophole to let top financial players continue to sip at the bonus/compensation trough of “more than you will ever need” slop. The government figured that they would need a lot of Wall Street money to go along with federal subsidies to get the job done, so why alienate the necessary residents of the hog farm?

The loopholes and exemptions from regulation are a driving force behind oh-so-many business efforts. When the SEC took the cap off how much debt the largest financial institutions could borrow based on equity, on April 28, 2004, they created a very specific and intended loophole that only impacted Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. It seems that these companies, that could borrow money very, very cheaply, were allowed to pursue what they saw as humongous profit potential in buying mortgage-backed securities and credit default swaps (lovely derivatives) with yields significantly in excess of the cost of borrowed funds. These companies didn’t want some lousy government rule that limited how much they could borrow, based on how much equity they had, get in the way of profits.

Boy did the big five listed above lobby hard to get that result. The SEC, although initially skeptical (good instinct), ultimately bought into the argument that the institutional CEOs made (including then-Goldman CEO, Henry Paulson): these banks were just too big to fail. Look at that list again. Notice how three out of the five companies died or were “merged by force of government action” into other financial institutions? Bear and Lehman went out owing well over 30 times their equity. Hedge funds were already exempt from any serious regulation, and for most of the private equity world (most of which entities were not public), borrowing to the hilt was the only way you would ever buy and restructure a company (but the debt would be relegated only to the company being purchased).

And even when the government knew about the problem – in 2004 the FBI warned the government that the mortgage industry was awash in liar’s loans (where applicants were encouraged to present fictitious earnings information to qualify for subprime loans that the above companies so desperately wanted to buy), and SEC was told by some insiders that they should take a closer look at Bernie Madoff – it preferred not to rock the boat. After all, these financial institutions must know what they were doing. And hey, the credit rating agencies were rating all these subprime derivatives as “A,” so they must be okay. Never mind that the credit rating agencies were being selected and paid by the issuers of the debt derivatives.

So as the Obama administration courts Wall Street to participate in investment funds targeting auction-priced toxic (er, excuse me, legacy) assets, it is also joining forces with the G-20 nations to create an entirely new, ground-up rebuild, regulatory structure intended to curb over-borrowing at virtually every level, implement government regulation of the large private investment structures (like hedge funds and private equity), create transparency and accountability across all kinds of tradable instruments (read: mostly derivatives), make credit ratings real, and curb executive compensation abuse (forcing performance criteria into the analysis).

So it comes down to a pretty basic question. How do you impose seriously unwanted regulations on an industry that you are begging to help bail the country out of its misery? Can you really expect those folks to give up the penthouse in Manhattan and the homes in Palm Beach and the Hamptons ?

There is this heartening news reported in the Aprtil 10^th New York Times: “On the Upper East Side of Manhattan, where the financial industry’s collapse has compressed many a household budget, Dr. Marc Goldstein says he has been performing more vasectomies than usual over the last five months… ‘I’ve been in practice for 30 years, and I’ve never seen a spike [sic] like this,’ Dr. Goldstein said. ‘Many of my clients work in finance and say they feel anxious about the expense of an added child.’” Hmmmmm….. Maybe the financial industry is beginning to self-regulate.

I’m Peter Dekom, and maybe I worry just a little too much.