LEWITT $27.95 USA / $33.95 CAN W hile some semblance of stability has returned to the fi nancial markets, the economies on which these markets must ultimately depend remain structurally weak, and the path toward sustained growth will be diffi cult. In order to set the economy on a sounder path, we need to understand the sources of instability that caused the failure of the fi nancial system, rethink established ideas, and challenge the intellectual and moral authority of the institutions that control the world’s capital. The system is badly broken and we must fi gure out how to fi x it before it is too late. Written by respected portfolio manager and longtime investment professional Michael Lewitt, The Death of Capital looks at how, in recent years, the U.S. economy has increasingly been dominated by short-term speculation rather than productive investment, debt rather than equity, and short-term thinking rather than long-term planning. These disastrous trends, described here as “fi nancialization,” ignore the fact that capital is a highly unstable social process rather than a fi xed, historical object or category. As a result of our failure to understand the true nature of capital, we have developed a fi nancial and regulatory system that does exactly the opposite of what it should be doing—favoring obscurity over transparency and fomenting instability rather than a stable path to growth. In explaining where we have gone wrong, Lewitt pulls few punches in criticizing some of the counterproductive forces that have led to the death of capital— including Wall Street practices such as private equity and derivatives trading—which he views both as economically unproductive and morally bankrupt. Page by informative page, this timely guide: • Explores the most important aspects of capital and capitalism through the prism of four of the world’s great economic thinkers • Addresses “fi nancialization” and its consequences, such as a weaker U.S. dollar, the decline of American industries, and the loss of American economic and political hegemony • Examines how the legal system contributed to economic deterioration by privileging short-term profi tability above other important societal interests such as labor, the environment, and social welfare • Calls for politically controversial reforms such as stricter regulation of hedge funds and private equity fi rms, banning naked credit default swaps and off -balance sheet fi nancing vehicles, imposition of a Tax on Speculation, and principles-based reforms to improve systemic stability • And much more Filled with in-depth insights and practical advice, The Death of Capital is not just a play-by-play of the recent fi nancial crisis, but also an original and passionate analysis of the trends that led to it and how the fi nancial system can be reformed to avoid future crises. (CONTINUED FROM FRONT FLAP) (CONTINUED ON BACK FLAP) “In an era of books on the fi nancial crisis, this one is a signifi cant standout. Michael demonstrates a keen understanding of the factors that led to the fi nancial abuses of the past decade and equally importantly advances sound ideas for fi nancial reform. A very engaging and worthwhile read!” – LEON G. COOPERMAN, Chairman and CEO, Omega Advisors, Inc. “Michael Lewitt is a very thoughtful presenter of facts and conclusions in his regular market letter. He has identifi ed and clarifi ed the conditions [that] are impacting global capital markets. This book belongs on the reading list of every serious investor.” – DAVID KOTOK, cofounder, Cumberland Advisors, and coauthor, Invest in Europe Now! “Michael Lewitt describes how fi nancial technology became the tool that almost destroyed the very system it was designed to protect. This book is both passionate and logical.” – CHRISTOPHER WOOD, Equity Strategist, CLSA, Editor, Greed & Fear “Michael provides a serious, comprehensive study of the problems facing the United States and other countries and a synopsis of what created the intractable fi nancial problems.” – BILL KING, Editor, The King Report, and author, Wall Street Bull “An essential read for capitalists . . . which we all should be in America. This book highlights the often overlooked fact that the machinery of our system works on math and marketing.” – MARK STEVENS, CEO, MSCO-The Art and Science of Growing Businesses; author, Your Marketing Sucks “This is the right book at the right time by the right person. Combining a sophisticated understanding of markets and informed ethical criticism, Michael presents the most insightful analysis of the recent fi nancial crisis. The Death of Capital is required reading for anyone who wants to understand how the mistakes of the past will shape the future.” – MARK C. TAYLOR, Chair, Department of Religion, Columbia University “The Death of Capital is essential reading. It describes, in cogent and graceful prose, how it was all too predictable that the capitalist system—for all outward appearances at the peak of its power—would end up on life support. That achievement alone makes it a masterpiece in this era of those who claim the crisis was a ‘black swan’ or ‘1,000-year fl ood.’ Michael also sets out in stark and sometimes harsh terms the new policies he sees as necessary to save capital from capitalism.” – KATE WELLING, Editor, welling@weeden HOW CREATIVE POLICY CAN RESTORE STABILITY THEDEATHOFCAPITAL MICHAEL E. LEWITT is the President of Harch Capital Management, LLC and editor of the HCM Market Letter. He studied at Brown University, Yale University, and New York University School of Law. His writing has appeared in the New York Times, the New Republic, Trusts & Estates, and the Spanish newspaper El Mundo. JACKET DESIGN: PAUL M c CARTHY JACKET IMAGE: © ISTOCKPHOTO AUTHOR PHOTOGRAPH: © KEVIN MODICA PRAISE FOR THEDEATHOFCAPITAL AUTHOR OF THE HCM MARKET LETTER MICHAELE.LEWITT HOW CREATIVE POLICY CAN RESTORE STABILITY THEDEATHOFCAPITAL P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come iv P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come THE DEATH OF CAPITAL HOW CREATIVE POLICY CAN RESTORE STABILITY MICHAEL E. LEWITT John Wiley & Sons, Inc. i P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come Copyright C 2010 by Michael E. Lewitt. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. 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For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Lewitt, Michael E. The death of capital: how creative policy can restore stability/Michael E. Lewitt. p.cm. Includes bibliographical references and index. ISBN 978-0-470-46650-6 (cloth) 1. Capital. 2. Capitalism–United States. 3. Finance–United States. 4. Global Financial Crisis, 2008-2009. I. Title. HB501.L4125 2010 332 .041–dc22 2009049432 Printed in the United States of America. 10987654321 ii P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come To my family, who continually challenge me to try to make the world a better place iii P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come iv P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come CONTENTS Acknowledgments vii Introduction The 2008 Crisis—Tragedy or Farce? 1 Chapter 1 The Death of Capital 33 Chapter 2 Capital Ideas 49 Chapter 3 Empty Promises 85 Chapter 4 Financialization 103 Chapter 5 From Innovators to Undertakers 121 Chapter 6 Welcome to Jurassic Park 163 Chapter 7 The Road to Hell 195 Chapter 8 Finance after Armageddon 213 Conclusion “This Is Later” 255 Notes 259 v P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come vi CONTENTS Bibliography and Other Sources 279 About the Author 287 Index 289 P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come ACKNOWLEDGMENTS W hen I started writing The HCM Market Letter over 10 years ago, I had no idea whether anybody would be interested in what I had to say. But somehow the newsletter has assumed a life of its own, and I am very grateful for all of those who have taken the time to read it and send me encouragement to continue writing. I especially appreciate the criticism, for writing a monthly publication does not always leave sufficient time for other people to review my material prior to publication. The newsletter has become a collaboration between myself and my readers, and for that I am deeply appreciative. I have been strongly influenced by a number of financial writers and intellectuals in my writing. In particular, James Grant, editor of the indispensable Grant’s Interest Rate Observer, has extended me numerous kindnesses over the years and remains a true gentleman of the old school in a world that could use more of them. John Mauldin is another ex- tremely generous man who has exposed my work to a wider audience than I could have gained myself and continues to provide investors with more valuable information than virtually anybody else in the world today. Kate Welling has also been extremely generous by interviewing me and including my writings in her indispensable publication, welling@weeden. vii P1: OTE/PGN P2: OTE fm JWBT250-Lewitt February 22, 2010 13:26 Printer Name: Yet to Come viii ACKNOWLEDGMENTS I have also been strongly influenced by the example of Stephen Roach, whose weekly research is sorely missed as he continues on his Asian journey; Christopher Wood, who first made me believe in the power of contrary thinking and financial journalism with his great book Boom and Bust (New York: Atheneum, 1989); Mark C. Taylor, the chairman of the Religious Studies Department at Columbia University, author of the incredibly insightful Confidence Games: Money and Markets in a World without Redemption (Chicago: University of Chicago Press, 2004), wise man and, I hope, friend. Last but really first in my heart and mind, Arnold Weinstein, Edna and Richard Salomon Distinguished Professor of Comparative Literature at my alma mater, Brown University, and his wife Ann, who started teaching me more than 30 years ago about both life and literature have never stopped sharing their brilliance and humanity with me and their other students. In the business world, I have had the privilege of working with some giants. First and foremost, I must thank my partner Joseph Harch. I spent a lot of time in school, but I hadn’t really learned anything until I entered the “School of Harch” in 1988 as a newly varnished associate in Drexel Burnham Lambert, Inc.’s Corporate Finance Department in Beverly Hills, California. Joe became my mentor and has remained my mentor and one of my closest friends since then. Joe is an investment savant; ask him about something and you better bring your sleeping bag because he will speak to you with an enthusiasm and knowledge second to none for as long as you let him. It has been one of the great honors and thrills of my life to work beside him for almost 20 years, and there is no end in sight. I am also indebted to the team that Joe and I have worked with at Harch Capital Management, LLC, over the past two decades: Jeffrey Hill; James DiDonato; Gabriel “Buddy” Gengler; Adam Sternberg; Susan Crouse (who also helped tremendously with the preparation of this book); Mary Ide; James O’Neil; Vicky Zimmerman; Thomas Crawford; and Peter Ventry. G. Chris Andersen has also been an important teacher and friend to me over the years and remains one of the most original thinkers in the investment banking business. I would also like to thank Pedro J. Ramirez, the publisher of El Mundo, for offering me the opportunity to write for his newspaper. Pedro is a true citizen of the world, a scholar and a gentleman, and I am [...]... understanding the death of capital, however, there is one particular area of American jurisprudence that has been particularly damaging: the law governing fiduciary duty Over the past century, the U.S legal system has developed a body of law governing the conduct of fiduciaries that privileges the short-term economic interests of an individual company’s shareholders over the long-term, noneconomic interests of. .. profits While these firms were figuring out how to divide the spoils among their employees, they were overlooking the fact that their success was far less attributable to the intellectual and trading acumen of their about-to-be-overcompensated executives than their ability to take advantage of record low interest rates that the Introduction 7 government was forced to provide in order to ensure that the economy... and the creative greed of private bankers, trust promoters and the newly evolving investment banks created the perfect storm that shifted the production goals of American industry from goods and services to manufacturing and selling stock.4 The type of speculation that Professor Mitchell describes is endemic to the very capital structure of the American corporation “Waves of watered stock created by the. .. consideration One of the most pernicious consequences of the imposition of a narrow profit maximization motive on corporate boards of directors has been the flood of private equity transactions that consumed the public equity markets in the United States beginning in the 1980s and continued through the eve of the financial crisis The concept of maximizing value for shareholders was used by so-called corporate... calculated for decades to come The collapse of America’s financial markets was the outward sign of the potential beginning of the end of U.S global hegemony and was as much the consequence of good decisions made in the developing world as the United States’ own mistakes The crisis in financial markets demands that policy makers engage in a radical rethinking of the mantras of free market ideology that... became a national pastime in the U.S housing market in the first decade of the twenty-first century, and threatened to make a quick return to the American stock and credit markets in the wake of the 2008 crisis when investors began to bid up prices of stocks and bonds to extremely rich valuations after the markets hit their bottom in March 2009 Even in the immediate wake of the financial crisis, speculation... dramatically increased the instability of the financial system In The Death of Capital, financialization is understood as the process whereby the credit system makes increasing amounts of capital available for speculative rather than for productive economic activity Financialization is supported by lax regulation and a belief in the ability of the free market rather than government to make the correct choices... possible value for their stock (and the belief that the market for corporate control is the most effective way of delivering that result) The narrow reading of fiduciary duty that was adopted by U.S courts may seem to be consistent with the interests of traditional laissez-faire capitalism, but is, in fact, directly contrary to the teachings of Adam Smith and other theorists of capital, as the following... leverage ratios of some of the firms that failed from 12-to-1 to over 30-to-1 (meaning that a mere 3 percent drop in asset values could render them insolvent) This leverage was used to increase the profitability of these firms with little regard to the risks involved because the individuals managing these firms were compensated pursuant to asymmetric schemes whereby they not only profited greatly if their firms... the Nobel Prize and a free-market ideology that gained a blind following after the collapse of a Soviet system that was doomed to failure based on its own flaws, not as a result of any genius in the American economic system The second facilitator of financialization was the U.S legal system One could fill the Library of Congress with books describing the flaws in the U.S legal system For the purposes of . MODICA PRAISE FOR THEDEATHOFCAPITAL AUTHOR OF THE HCM MARKET LETTER MICHAELE .LEWITT HOW CREATIVE POLICY CAN RESTORE STABILITY THEDEATHOFCAPITAL P1: OTE/PGN P2: OTE fm JWBT250 -Lewitt February 22,. Editor, welling@weeden HOW CREATIVE POLICY CAN RESTORE STABILITY THEDEATHOFCAPITAL MICHAEL E. LEWITT is the President of Harch Capital Management, LLC and editor of the HCM Market Letter. He. site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Lewitt, Michael E. The death of capital: how creative policy can restore stability/ Michael E. Lewitt. p.cm. Includes bibliographical