As I set out to describe the “dots” that need connecting, the first dot is the one that determines where the wealth (aggregate retained income) of the nation goes.
Commerce, employment and capital markets trading are all mass effects with millions of independent agents choosing what they think will benefit them at the time they make the choice. By their nature, these choices nearly always have people choosing “both sides of the trade” for each transaction. The simplistic truth that for every buyer there’s a seller expresses this fact quite nicely.
My question is: How does policy affect the eventual outcome?
When I learned a surprising historical fact partway through my Wall Street career, I saw very clearly how seemingly minor policy differentials work over time to move wealth from Group A to Group B.
That historical fact was the distribution of property ownership in the former Confederacy in the latter part of the 19th century.
You might guess that the former plantation owners had succeeded in getting their control of the land back. Or you might think that ‘carpetbaggers’ had come and bought up all the property with their Yankee dollars after the monetary system of the South had collapsed. You might even think that post-war redistribution by the Federal government had given the old south a broad ownership base from the famous “40 acres and a mule” laws.
You’d be wrong. By the end of the 1880’s, the largest landowners in the south were Met Life, Prudential, and the other northern insurance companies.
How did this happen? Simple. Insurance companies could invest tax-free in what were otherwise taxable investments. Over time, the randomness of decision-making ensured that whatever group had the lowest cost of ownership (tax rate) would end up owning everything.
The result of this astonishing concentration of wealth was the imposition of a tax, usually at a state level, on the surplus at insurance companies. It was a small tax (just a few percent), but sufficient to halt and reverse the trend that threatened to make the USA into the USI (United States of Insurance).
I found out about all this when my team landed a securitization deal for Prudential Insurance, at the time the second largest insurer in America. Despite catcalls from structuring and banking teams at other firms, our deal collateralized by low-interest loans that policyholders had taken against the cash value of their insurance policies was an enormous benefit for Prudential, worth hundreds of millions of dollars over time.
How could that be? We were using loans that only paid 5% annual interest and selling bonds that yielded as high as 8% to 9% to finance them. More than one report in the industry press repeated claims by our investment banking competitors that the deal was “uneconomic.”
Here’s why the deal made sense: Prudential got to sell billions of dollars of policyholder loans to the trust that issued the bonds, removing those loans at full face value from the surplus that was being taxed at nearly 4% per annum at the time. Prudential got more than 30 years’ worth of tax savings, plus the income from reinvesting the cash from the bond sale (about 60% of the face value of the loans) into higher-yielding investments.
The net present value of the transaction to Prudential Insurance policyholders was hundreds of millions of dollars, making it worth the two years of complexity we slogged through to structure the deal, and the tens of millions in legal fees, etc. that they paid.
The eye-opening lesson for me was that even a few percentage points of legal tax avoidance or modified tax policy could shift the wealth of a nation over time.
In coming posts, we’ll explore how tax policy shifted our entire economy from the wealth-gathering mode that followed World War II into a cash-out refi economy that subsidized those who extracted the accrued savings.
We went from a nation that had rewarded working for a living and running profitable businesses until the 1980’s to a nation that had tax policies rewarding junk bond financiers for their Leveraged Buy-Outs with far lower tax bills than their ‘fuddy duddy’ competitors who ran prudent businesses that carried little or no debt and believed in saving for a rainy day.
The grand experiment in “supply-side” economics created a system that rewarded companies that gave out tax-advantaged stock options in lieu of salaries, that sold their factories and equipment to special purpose companies and leased back those same buildings and machines.
Pensions that promised a living income after retirement were liquidated by corporate raiders, and employees were given the option of buying stock market lottery tickets (401Ks) instead.
The residential mortgage market debt explosion was only the last act in a 30-year play that made borrowing the preferred method to get spending money.