Incentivize constructive equity instead of hazardous debt

By J. Morton Davis

When purchasing a business, real estate or shares of stock, buyers often invest little of their own funds and borrow as much as they can to maximize returns. If the investment is successful, they multiply the amount they earn on the appreciated asset, as they are rewarded not only on the minimal equity investments they made, but on the amount they were able to invest as a consequence of the much larger amount they borrowed.
If the investment turns bad, then the investor only loses the small amount he actually invested and the lender is stuck with the loss. This kind of default, when it happens in individual cases, only hurts the limited parties involved. But when there are many incidences, borrowing and leverage can unleash economic breakdown and disaster, as we saw in 2008.
Yet, perversely, government policy provides incentives for borrowing and excessive leverage by treating interest on debt as tax deductible. And the leverage that emanates from such borrowing significantly magnifies risk — or more accurately, debt magnifies the consequences of a decline and increases the defaults.
In the event of any disappointing or unexpected negative occurrence, it makes the eventual triggering of defaults and insolvency to both the borrower and the lender more likely. Debt can adversely affect the stability and health of the economy — as is now clearly evident from the bursting of the housing bubble and the overwhelming mortgage defaults that ensued — at a potentially immense cost to taxpayers.
Operating with too much debt and far too little equity, the banks and other financial institutions did immense harm to the country and its economy. As a direct result, the banks themselves became insolvent because their holdings decreased in value to where their entire 5 percent to 8 percent equity and even more was wiped out. If the stimulative TARP program did not rescue them (together with the fact that they were permitted to avoid writing down their holdings to their actual market value), almost all of the “too big to fail” banks and financial institutions would have been history. Astonishingly, Bear Stearns and Lehman Brothers were so leveraged it’s questionable that they even held 2 percent of their own equity relative to their enormous holdings. In other words, they were borrowing almost 100 percent.
In an effort to prevent the recurrence of such dangerous economic practices, the Dodd-Frank financial reform law would require that these” too big to fail” financial institutions maintain capital ratios of 13 percent or more. Had these financial institutions had such minimum capital (and I believe that amount is still hardly anywhere near enough), the debacle that unfolded could have been avoided.
Shockingly, these very same institutions are aggressively lobbying against the introduction of any safety measures because, it appears, they would like to continue operating on a capital shoestring so they can maximize the return on their invested equity. They insist it’s not a good time to hamper the economy.
Greedily, these institutions prefer to continue to enhance return on invested equity capital by enjoying the maximum leveraging through debt, while demonstrating indifference to the enormous economic damage this behavior has inflicted already and could do again, if left unchecked. They like it when it is heads they win, and tails the taxpayers lose.
Obviously, in light of the existing tax system, which favors debt over equity, the policy is unwise and encourages practices that expose the economy to collapse. The banks and institutions pushing for the repeal of Dodd-Frank are, after all, the very same activists that successfully pushed for the elimination of the Glass-Steagall Act that worked so beneficially ever since the Great Depression, as it kept traditional banking safer by keeping it separate from far riskier trading and investment activities.
Glass-Steagall’s repeal contributed to the current financial mess. Freed from the regulations and restrictions of Glass-Steagall, banks increased their risk and inflated the bubble, triggering the crash and almost leading to their own demise.
While debt prudently incurred can be useful, it should not get special favors in tax law. It’s hardly worthy of being favorably incentivized by our tax laws.
Wouldn’t it make far more sense, and be far safer and healthier for the financial system, to incentivize equity investments and, to the maximum extent possible, minimize debt? Instead of interest on debt being tax deductible, dividends should receive that preference. The more equity a bank, corporation, private business or individual has put up, the less chance there is of forced insolvency. In fact, if equity constituted the entire capitalization of every investment on every balance sheet, insolvencies — and the overwhelming disastrous fallouts that emanate from such adversities — would all but disappear.
Were that the case, the catastrophic housing bubble could never have come to pass, nor would the banks, nor indeed the entire U.S. financial system, have been placed in jeopardy. There would have been no need for TARP or the other gigantic government expenditures to save the “too big to fail,” or the resultant excruciating crash.

Source:
http://thehill.com/opinion/op-ed/190363-incentivize-constructive-equity-instead-of-hazardous-debt

A tiny fee that could generate billions in deficit reduction

By: J. Morton Davis

Introducing a one-cent fee on every share of stock and every commodity contract traded and a 10-cent fee on each $1,000 bond traded would be a simple and painless way to increase government revenue and reduce our nation’s menacing deficits and debt.
Such miniscule fees would not cause any real investor or trader harm or much inconvenience, but it could generate many billions of dollars. In 2010, these fees would have generated $47.63 billion.

Many traders, banks and investment trading desks would fight this tooth and nail because Wall Street has evolved into a kind of Las Vegas casino where enormous volumes are traded for profits of even a fraction of a penny per trade. The introduction of such fees would undoubtedly cut the volume of trading. But even if it dropped by as much as 50 percent, which is highly unlikely, it would still generate $24 billion annually.
Even a fee of two or three cents a share would hardly be onerous and would double or triple the amount of revenue generated. Historically, the spread between the bid and asked prices for any security was far greater than it is today, and thus generally far more costly than the small fee I am proposing.
For years prior to the elimination of fixed fees in the early 1970s, the stock market functioned smoothly and effectively for investors despite the fact that the fixed commissions were much higher — approximately $1 per share for a $30 stock whether you bought 100 shares or 100,000 shares — and it was charged both at the time of purchase and of sale. So, the miniscule fee I am proposing should not be burdensome.
To those who suggest such trading fees or taxes would be unfairly discriminatory, it should be pointed out that far more burdensome taxes are paid by others, including those at the bottom of the economic ladder, on such everyday essentials as gasoline, restaurant food, shoes, clothing, text books and so on. So it’s unpersuasive, indeed unscrupulous, to say it would be terribly unfair to impose a small fee on financial transactions.
In contrast to the high-frequency instant traders, real investors such as individuals, pension funds, mutual funds and insurance companies would be almost totally unaffected.
And we should not be sidetracked by suggestions that such a fee would stanch liquidity. Hundreds of millions of shares trading every hour does not evidence liquidity — it merely confirms that what was once a real and respected marketplace to facilitate real investments has become instead a financial casino. The bulk of transactions are not by investors but by computers that trade automatically based on algorithmic formulas that can pick up hundreds of millions of dollars by front-running other less mathematically-sophisticated investors.
The nation’s four largest banks made this plain when they announced that they had experienced not a single down day in the first 61 days of trading last year. Not even the most successful genuine trader in history ever achieved such results.
Many experts believe that high-speed computerized trading has spun out of control, is what caused the “flash crash” on May 6, 2010, and frightens and destroys the confidence of the really constructive and critical long-term investors who provide financing for American corporations.
This explosion of high-speed computerized trading does indeed serve to make trading less costly, but that only serves to create frenzied stock market activity that has very little to do with facilitating the raising of the productive investment funds, which is the foremost objective of a well-functioning capitalist securities market.
The most powerful players would strenuously resist the infinitesimal fee I am proposing. But, while it’s useful to do all that we can to strengthen our banks and financial system through enhanced profitability, that’s not a good reason not to introduce this fee. Helping banks play a more productive role in the recovery of the economy is an important goal. But it does not override the need to do what is best for the economy and the country as a whole.
Let’s enact this immensely beneficial fee. It could prove to be one of the most successful, least painful, revenue generators ever implemented.