The Financial Sector

Private Equity (PE) firms are the pinnacle of financialization. So, we will spend some time going into more depth about their activities.

Most PE firms operate under an entirely extractive business model, solely focused on extracting as much money as possible in the shortest time possible. They achieve this predominantly through use of other people’s money—borrowed funds – and asset stripping.  “These facts of short-term, high-risk, and low-consequence ownership explain why private equity firms’ efforts to make companies profitable often prove disastrous for everyone except the private equity firms themselves.”⁵

Brendan Ballou lists the strategies employed by PE firms:

• Acquire a company and take it private.⁶
• Debt- burden the acquired company with debt that it must repay from its operating funds.
• Leasebacks involve selling assets and then leasing them back to the acquired company. PE firms gains value from the assets, while the acquired firm is further burdened with lease payments.
• Dividend Recaps: Allocate a portion of the borrowed funds to pay a dividend to the private equity firm (PE) owner. For instance, utilizing borrowed money, Blackstone extracted $200 million from Apria Health in 2020.
• Operational Changes: Layoffs, Price Increases, and Quality Reductions
• Strategic Bankruptcies
• Tax Avoidance
• Legal structures were created to protect PE from liabilities and responsibilities.
• Perverse incentives for managers of acquired companies

Here is a brief description of the PE model in action. A fund of money is raised from private investors, pension funds, endowments, wealthy individuals, sovereign wealth funds, and others. Companies are targeted for acquisition, typically with substantial amounts of borrowed money to meet the acquisition price. Once acquired, additional debt can be added alongside a rigorous cost-cutting regime to drive down operating costs. Reductions in staffing and benefits (including pensions) are typical. This strategy supports the significantly increased costs of repaying the debt. It is not uncommon for the fixed assets of the acquired company to be sold off. This is a preferred strategy for retail companies. In these cases, the PE firm retains the proceeds from selling the retail store’s real estate while further burdening the retail operation with the costs of leasing the space back from the new owner. Acquired companies are generally sold off within five years.

PE funds generate revenue through the well-known 2 + 20 fee structure. Each year, the PE firm collects 2% of the investors' committed capital and receives 20% of the profits from transactions. Additionally, the managers of the PE firm benefit from favorable federal income tax breaks through the carried interest deduction.⁷

A study of 484 companies acquired by private equity (PE) firms revealed a 20% bankruptcy rate, in contrast to a 2% rate for a control sample.⁹ “In 1996, about 8,000 firms were listed in the U.S. stock market. Since then, the national economy has grown by nearly $20 trillion. The population has increased by 70 million people. And yet, today, the number of American public companies stands at fewer than 4,000.”  PE is making large parts of the economy invisible to public scrutiny through this privatization.

Risks of various kinds are an inevitable part of life. Car accidents, house fires, and untimely deaths are some of the dangers we all face. The insurance industry offers policies designed to mitigate the costs incurred when one of these risks affects us. This form of wagering is beneficial. We agree to pay a fee for the insurance policy, which serves as our wager. Insurance companies possess extensive knowledge of the probability of insured events occurring and the required amounts for wagers and payments based on those statistics. It's important to note that in the case of insurance for these types of risks, one side of the wager has a real stake in the subject matter. They own homes, personal belongings, cars, and so forth. Similarly, when farmers hedge against crop failures or price volatility, they have personal stakes in the outcome.

In the case of financial derivatives, neither party has a genuine interest in the subject of the derivative bet. A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, currency, or interest rate, and is often referred to simply as the "underlying."¹⁰ A derivative is essentially a wager on the future value of an asset at a specified point in time. In fact, in many derivative products, the claimed values are so complex and varied that it is likely no one can truly claim to understand what is at hand.¹¹  Neither party involved in a derivative contract needs to actually possess the asset in question. This is no different from gambling on the outcome of a sports event. The notional value of derivatives in the global financial markets was $632 trillion (6,320 billion) in June 2022. This exists in a world with an approximate global GDP of $97 trillion.

Anglo-American common law has grappled with the moral and practical problems of gambling. As Lynn Stout has pointed out:

"As already noted, gambling by its nature is a rent-seeking¹² activity that redistributes existing wealth rather than creating new wealth. When rent-seeking exhausts valuable resources, such as time, money, or human ingenuity, the zero-sum game becomes a negative-sum game, reducing net social welfare. Thus, common law judges condemned the use of derivative contracts to speculate on market events because they "promote no legitimate trade" and "discourage the disposition to engage in steady business or labor." This nineteenth-century concern finds its modern echo in the fear that, by the end of the twentieth century, many of America's brightest and most productive scientists and mathematicians were being lured to Wall Street to squander their talents on earning private profits for investment banks and hedge funds at other traders' expense."¹³

"Financial derivatives, in particular, are bets between parties that one will pay the other a sum determined by what happens in the future to some underlying financial phenomenon, such as an asset price, interest rate, currency exchange ratio, or credit rating. This is exactly why derivatives are called derivatives. The value of a derivative agreement is "derived" from the performance of the underlying financial phenomenon, just as the value of a betting ticket at the racetrack is "derived" from the performance of a horse in a race."¹⁴

Before the passage of the Commodity Futures Modernization Act in 1999 under President Clinton, derivatives and most other financial products resembling bets were restricted to private exchanges that ensured discipline among participants and limited public exposure to speculation. For an entertaining exploration of this world, watch the movie Trading Places.

Here, we have speculation on a breathtaking scale. In 2022, international trade in merchandise, services, and digital services amounted to $35.92 trillion. In April 2022, turnover in global foreign exchange markets reached $7.5 trillion per day.¹⁵ Annualized, this equates to $1,620 trillion in foreign exchange trading, which supports the actual world trade in goods and services of $35.62 trillion. This results in a total foreign exchange turnover of over 46 times the real-world trade volume.

Forty-five percent of that activity was “inter-dealer,” meaning banks betting against each other on the direction of exchange rates and not supporting actual transactions needed to settle accounts between buyers and sellers of tangible goods and services. Some will attempt to explain that some of this activity involves hedging and risk management to mitigate the risks associated with the fluctuations of exchange rates. Others describe this activity as increasing the market's liquidity, ensuring that there are enough buyers and sellers available. However, it stretches credulity to claim that this can account for a turnover that is 46 times greater than what is necessary to sustain genuine transactions between buyers and sellers of tangible goods and services.