The Great Deformation (106 page)

It thus happened that after twenty years in the financial bubble, prospering as an investment banker and private equity investor, albeit at a much more modest scale than Mitt Romney, I had become as oblivious to the dangers of leveraged speculation as most of Wall Street. Having been the scourge of debt in the public sector, however, my lassitude on the matter was especially telling.

Indeed, it was only after my own crash landing on the shoals of excessive leverage that I came to recognize the Great Deformation. Like most baby boomers playing hard inside the bubble, I simply had not noticed the financial landscape morphing ever deeper into a debt-fueled casino of speculation and rent seeking.

In fact, if you were aggressively engaged inside the financial bubble the music never really stopped. After brief pauses in 1987, 1998, and 2000–2002, the deal-making machinery came roaring back stronger each time; the availability of high-yield debt and other forms of high-risk capital became more abundant and less demanding; and the benchmark interest rate drifted steadily lower, meaning that the valuation of financial assets was lifted ever higher.

As seen in
chapters 14
through
26
, everything financial got bigger: the size the mortgage market, the girth of Wall Street balance sheets, the magnitude of M&A takeover volumes, the scale of stock buybacks, the AUM of the hedge fund sector, the size of LBOs, and the extent of funds invested in private equity and other alternative asset classes. In short order, financial growth got totally out of synch with the possibilities for growth of real output and wealth.

Thus, even a healthy and balanced free market economy can grow at perhaps 3 percent per year on a sustained basis, or 35 percent in a decade, or 3X in half a century. But as the financial bubble expanded, gains on leveraged deals and various classes of stocks and risk assets frequently grew by 5X, 10X or even 50X in just a few years. The Bain Capital cases cited above were not that unusual.

Most wave riders, including myself, didn't see the disconnect between the modest economic advance during the bubble years and the massive financial advance. A combination of factors including the end of the cold war, the technology and Internet revolutions, the stunning rise of China and East Asia, and the roaring stock markets produced a suspension of disbelief. To see that the Greenspan prosperity was actually a giant, relentlessly inflating financial bubble you had to be thrown off your ride and gain some alternative perspective from being sprawled out on the terrain below.

I was afforded exactly that experience in the spring of 2005 when the largest LBO in my equity fund blew up in bankruptcy, and not just an ordinary one. The company called Collins & Aikman was a supplier to Detroit of automotive interior components such as instrument panels, door panels, and molded floor carpets and was heavily leveraged, with debt at nearly 6X EBITDA. When Ford and General Motors were downgraded to non-investment grade status in May, debt covenants were triggered throughout my company's capital structure and supplier trade credit dried up rapidly.

Collins & Aikman's scramble into bankruptcy was considered unseemly at the time, but it proved to be only a prelude to the eventual unwinding of the entire automotive house of cards in the industry's fiery crash in the fall of 2008. In fact, as detailed in
chapter 30
, the auto industry had become a
daisy chain of debt during the bubble era and that was truly insensible: the auto industry was among the most cyclically violent sectors of the economy, but by the second Greenspan bubble nearly every link in the supply chain, from the giant GM to tiny auto fabric mills, was freighted down with debt, including massive unfunded retirement and medical obligations.

Nevertheless, Collins & Aikman was among the first to splatter and the shock of it caused the company's board to demand my resignation as CEO, even though I had personally organized the company from a series of M&A deals, had raised its tottering layers of debt, had worked without pay as CEO for nearly two years to salvage it, and was the majority shareholder through my private equity fund. Whether the board acted correctly or not, the bankruptcy filing and my abrupt departure generated a swirl of controversy and scapegoating in Detroit.

It also attracted the attention of the aforementioned prosecutor, an assistant US Attorney (AUSA) in the southern district of New York named Helen Cantwell, who had just come off the drug and murder beat and was apparently hunting for bigger game in the arena of white-collar crime. In short order, AUSA Cantwell, who had never previously led a business case, filed an indictment charging me with violation of an accounting standard that I had never heard of.

It had to do with accounting for supplier rebates, which at the time were a common practice in Detroit. The auto industry's pricing structure was then collapsing under the weight of massive excess capacity funded with way too much debt. Desperate suppliers therefore were offering customers large cash rebates from their lists prices in order to retain business volume and the cash flow to meet their debt service.

Collins & Aikman had paid millions to GM and the other OEMs every quarter to keep them alive, and had in turn put the screws to its own suppliers for cash rebates against their invoice prices. Sensibly, my company had booked the massive outflow of cash rebates to the OEMs each quarter as a current-period expense, and the rebate payments from suppliers as current-period income.

This was the practice and pattern of the entire auto industry's supply chain as it descended into the fires of deflation and insolvency. As we struggled to pay the company's crushing debt, it never occurred to me that this symmetrical and industrywide practice was not kosher.

Blessed with no training or experience in business, accounting, finance, and the tottering auto sector, the big-game-hunting AUSA found this to be a violation of a pending accounting standard called EITF 02-16. The block letters meant that it was an “emerging” rather than a settled standard and that the profession was still divided, but Cantwell was certain that Collins
& Aikman's rebate accounting practices were criminal violations ordered by me.

Put in mind of what Samuel Johnson once said about the gallows, I found that a criminal indictment did, indeed, concentrate my mind. At least it did so long enough to prove to the top US attorney that in 15 million pages of discovery there was not a shred of evidence that anyone at Collins & Aikman had violated EITF 02-16 or even heard of it.

By then Cantwell had already fled the courthouse for a berth in a top-drawer white-collar defense firm for good reason: she had brought a groundless indictment that now had to be withdrawn by the mighty Southern District of New York. When the charges were withdrawn, the case was also dropped against eight other employees of my company whose lives, needless to say, had been ruined by a badge-toting prosecutor trying to leapfrog up a legal career path. Needless to say, the case also attracted the usual quota of class action lawsuits and piling on by the SEC. All of these cases were settled for $7 million in nuisance money without any trial or any denial or admission of wrongdoing in any of the venues involved.

Yet during a multiyear battle to prove there was nothing wrong with Collins & Aikman's accounting, I had extensive occasion to delve into every nook and cranny of its balance sheet and other financial statements and come face to face with the debt monster I had created in this case, and had been doing in the LBO business as a general practice for years.

Stated simply, the company had no shock absorbers because every imaginable asset had been hocked and every dime of even quasi-discretionary expense had been cut. Thus, all of the receivables had been sold to GE Capital or to “fast pay” lenders who discounted future payments from shipments to the Big Three. Nearly all of the equipment including multimillion-dollar plastic molding machines in eighty worldwide manufacturing plants had been sold for cash and leased back, creating mandatory rental payments just like regular debt. Trade credit from suppliers had been pushed to the breaking point, and the balance sheet itself was freighted down with several different bank revolvers, a half dozen flavors of junk bonds, tax-exempt economic development bonds, and other debt exotica.

And yet Collins & Aikman was typical, if not conservative. It had started out as an M&A roll-up of interior component suppliers in 2001 with leverage at 3.8X EBITDA, a ratio which was exceedingly modest by the standards of the LBO blow-off phase in 2006–2007. But the problem was that as the auto industry's deflationary crisis intensified, the whole supply chain descended into an orgy of price cutting and for an overpowering reason: the fixed cost of debt service was so great that any business that
produced “variable contribution” to debt service was the object of ferocious competition, even if the return on plant capital and corporate overhead was negative.

As price cutting intensified in this manner, cost cutting followed right behind. Auto companies all the way up the chain to and including GM were literally throwing their future down the drain in order to generate cash in the present period, and head-count reduction was the go-to angle of first resort. In the case of Collins & Aikman, we had started with 32,000 employers and were down to 20,000 or so based on the same $4 billion annual volume of business when the crash finally came.

I had actually moved into the CEO suite in Detroit in order to be expense-cutter-in-chief because I thought I knew how to do it and my fund had hundreds of millions invested in the company. What I learned was that one day at a time, the debt monster can cause rational executives to devour their own enterprise.

We started by getting rid of long-term expenses like marketing, R&D, new business development, information services, and human resource people, and then any and every frill including employee cafeterias, lawn care services, and weekend heating. Yet as the pricing and revenue deflated, even that wasn't enough and so soon pensions were slashed, 401k matching was eliminated, bonuses were terminated, employee health-care cost sharing was drastically increased, cell phones were curtailed and expense accounts cut to the bone, and much more.

But the debt kept rising and pricing and cash flow kept falling. So then it got really serious. The sales force was gutted, the company's well-regarded engineering ranks were drastically pruned, assistant plant managers were eliminated, and more than half of all executives making more than $100,000 per year were terminated and their jobs assigned to those who remained. By April 2005, the company had been picked to the bones and was an accident waiting to happen. In short order it did.

In my early days in the LBO business I had taken to speech making about the wondrous efficiency and productivity-generating powers of debt. During most of the years at Blackstone and my own fund I went to quarterly board meetings and harassed managers about the need to cut more and “restructure” faster. In the final days at Collins & Aikman I had become a desperate ax wielder, red in financial tooth and claw from sacrifices made to the monster of debt.

Only in exile did I see that Collins & Aikman was not simply a one-off accident or case of bad timing, but that it was an economic deformation that would never have occurred on the free market. Its mountains of debt and off-balance sheet leverage had been raised right in the heart of Wall
Street via syndications led by JPMorgan, Credit Suisse, Deutsche Bank, GE Capital, and many more. They had been able to distribute this toxic paper to hundreds of banks, CLOs, high-yield mutual funds, pension managers, insurance companies, and just plain speculators because in the world of bubble finance economic risk was badly underpriced and high-yield paper was drastically overowned.

In the end, upward of $100 billion of losses were absorbed by investors in auto sector equities and debt when the house of cards collapsed in the bankruptcy of every major Detroit company save for Ford and Johnson Controls. This should have been the lesson of a lifetime, a thundering wake-up call that cheap debt, the Greenspan-Bernanke Put, the huge tax bias for debt, and capital gains are a mortal threat to free market capitalism. They generate behaviors which ultimately destroy enterprises and wealth, even as speculators like myself, Mitt Romney, and the rest of the LBO kings and hedge fund complex extract windfall rents along the way.

But the canaries which fluttered briefly in the mine shaft in September 2008 just dropped dead. That's all. As will be seen in
chapter 30
, the auto industry was on fire with speculative windfall gains within months of the horrid bailout of GM and the Fed's shift to all-out money printing in March 2009. So the Truman Show of bubble finance has entered yet another season. After the failed election of 2012 and the conservative party's embrace of a standard-bearer who was actually a member of the cast, there is nothing to stop the final triumph of crony capitalism.

Sundown now comes to America because sound money, free markets, and fiscal rectitude have no champions in the political arena. The very antithesis of bubble finance, they are anathema to the Wall Street machinery of speculation and rent seeking which insouciantly demands more debt and more money printing to keep the fatal game going.

CHAPTER 28

 

T
HE BLACKBERRY PANIC OF 2008 WAS INDUCED BY TWO MEN, BEN
Bernanke and Hank Paulson, who were in the wrong high office at the worst possible time. Bernanke, like Greenspan, was weak and no match for the furies that came screaming out of the canyons of Wall Street when the great financial bubble, decades in the making, violently exploded during the Lehman failure. Paulson, in fact, was one of the furies and single-handedly neutered the GOP for its final capitulation to fiscal folly.