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This one is good! The Mystery of Capital

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The Mystery of Capital
The VC Tax Break
Focus On This: Merkley-Levin Did Not Get A Vote
The Mystery of Capital

Posted: 21 May 2010 09:05 AM PDT

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

The administration’s argument, as mentioned above, is that these kinds of rules should be negotiated internationally, not set by Congress, which is overly political. But as Bloomberg pointed out earlier this week, international negotiations are nothing if not political. And as Konczal highlighted, the administration is also taking the banks’ side in the international arena.

The Collins Amendment wants to make basic capital requirements simpler, with the option of adding more complex requirements on top (“shall serve as a floor for any capital requirements the agency may require”). Opponents want regulators to have as much discretion as possible. I think it’s important to have a simple floor, because discretion and complexity are just a way of fooling ourselves into thinking we can measure something that is inherently unmeasurable.

A while back, Steve Randy Waldman weighed in on bank capital requirements. He goes much further and deeper than Simon and I did in our article about capital requirements. “Bank capital cannot be measured,” he says. His point is both practical and epistemological.

On the practical side, look at Lehman: it was well capitalized on paper right before it collapsed, and then a few days later it had negative equity of at least $20 billion. (And it wasn’t because of some fire sale, Waldman explains.)

Here’s the epistemological side (the part I like the most):

“Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . . Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital.”

This is a point that I think is often lost. People talk about capital like levees to protect against a flood, but it’s like levees that you can’t see and measure, only guess at. Capital is probabilistic, so it’s only as dependable as your ability to assess those probabilities.

And, of course, with banks the errors always come out the same way — overstating capital:

“For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the ‘option value’ of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.”

And here’s Waldman’s conclusion: “We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.”

Ultimately, capital requirements alone are not the answer. But as long as we’re going to base our banking regulation on them, we should make them as resistant to definition error and measurement error as possible.





The VC Tax Break

Posted: 21 May 2010 07:47 AM PDT

By James Kwak

The House of Representatives is considering a bill that would change the tax treatment of venture capitalists’ income (and that of private equity fund managers as well). Currently, VCs typically are paid “2 and 20″ — that is, an annual fee of 2 percent of assets, plus 20 percent of profits. For example, let’s say a fund starts out with $200 million. Most of that money is invested by the fund’s limited partners — pension funds, endowments, insurance companies, the usual suspects. After ten years (roughly the average life of a VC fund), the investments made by the fund are now worth $400 million — a pretty humdrum return of 7 percent per year (before fees). The venture capitalists themselves will earn about $14 million ($200 million x 2% x 7 years)* plus $40 million (20% x ($400 million – $200 million)) equals $54 million. (Note that they earn that $40 million even for doing worse than the stock market’s long-term average return.) The limited partners get what’s left over after those fees. And before you start crying for the VCs, remember that a typical VC firm will have multiple VC funds going at once.

Right now, the $14 million is taxed as ordinary income, but the $40 million is taxed as capital gains — that is, at a tax rate of 15%. The bill would tax the $40 million as ordinary income (actually, 75% as ordinary income and 25% as capital gains), for an effective tax rate of about 35%.

The current tax treatment has never made sense to me. The lower rate on capital gains is supposed to provide an incentive for capital investment.** This is why, if you buy stock and sell it more than a year later, you pay tax on your gains at a lower rate. So clearly the actual investment returns on money invested in the VC fund should be treated as capital gains — but not the VCs’ 20 percent fee, since that’s compensation for fund management services, not returns on their investment. (VCs typically invest their own money in a fund, but it is only a small fraction of the whole, and no one is debating how that money should be treated.)

One argument I’ve heard is that the 20 percent comes out of the capital gains of the fund itself, so it should be treated as capital gains. But that’s nonsense. If the limited partners got to keep it, it would be capital gains. Once they pay it to the VCs, it becomes an investment expense for the limited partners and a performance bonus for the VCs.

Gerry Langeler, a venture capitalist, made a valiant effort to defend his tax break in the New York Times, but his arguments are so full of holes I wonder if even he believes them.

He starts off trying to equate the VCs’ 20 percent to the profit a homeowner makes on the sale of his house.

“If you buy a house and take out a mortgage, you usually put a small percentage down, with the bank carrying the balance. To keep the math simple, say the house costs $200,000 and you put down $20,000. Ten years later, if you sell the house for $300,000, you have a gain of $100,000 on that $20,000 investment. It is taxed as a capital gain because your capital was locked up for a prolonged time, there was a material risk of loss and the gain was not ‘guaranteed’ to you for just showing up every day, the way a salary is. You used the bank’s capital as leverage on your $20,000 investment, but that does not matter from a tax standpoint. Neither does the fact that you worked around the house over those 10 years to improve its value.

“Now, let’s compare that with carried interest in a venture capital partnership. We in the industry invest a small percentage of the total dollars in our partnerships, like the house purchase above, with our limited partners investing the rest. Our investments are locked up for prolonged periods of time, often five to 10 years before we see any return. There is a real, material risk of loss of capital. In fact, many venture funds in the bubble lost money, including partners’ capital. Like the house situation, our downside loss potential is ‘fixed’ by what we invested, while our upside is unbounded.

“We do a lot of work ‘around the house’ to help our start-up companies grow. Our investors get their return on the profits we make. For those investors that are taxpaying entities, they pay tax on the gain at capital gains rates, just as they would if they had invested in a home. No one is proposing to change that tax treatment.

“If there is a profit on the entire partnership, then and only then do we as managers of those partnerships get our carried interest — usually about 20 percent of the total profit. That carried interest is delivered in the form of stock in those start-ups, stock that has been held for 5 to 10 years. Unlike our salaries (rightly taxed as ordinary income), the carried interest is not guaranteed by our just showing up, and it is only delivered if a long-term gain in the form of capital is created.

“Carried interest in a partnership bears a striking resemblance to our personal ‘carried interest’ in our homes.”

This argument ignores the difference between equity and debt. When you buy a house, your mortgage is debt. You are in the first loss position. When a VC puts some of his own money in his fund, that’s equity; it’s on an equal footing with the limited partners’ money, and they share losses proportionally. Investment gains on that money — the VCs’ actual investment in the fund — are already treated as capital gains; it’s the 20 percent we’re talking about here. Saying that a VC is “leveraging up” his investment in his fund with LPs’ money is nonsense. If Gerry Langeler really wants to put in all the equity in his VC fund and borrow the rest from investors — well, good luck trying to find people who will lend 90 or 95 percent of the money in a VC fund. If that’s what he’s doing, he’s getting 100 percent of the profits after servicing his debt, not 20 percent; that’s what owning all the equity means.

More fundamentally, even if the return profile of carried interest has a resemblance to the return profile of buying a house, that doesn’t make it capital gains. The fact that there’s risk involved doesn’t make something capital gains; if that were the case, then banks could start paying long-term bonuses (based on multiple years’ work) and calling that capital gains. The fact that the upside is unlimited doesn’t make something capital gains; if that were the case, then sales commissions would be capital gains. The fact that there’s downside . . . wait, there is no downside. If the fund loses money, the VCs don’t make up 20 percent of the losses to the limited partners. Their downside is restricted to their direct investment in the fund.

The second argument attempts to equate VCs to founders.

“In another example, closer to home, say an entrepreneurial team starts a business and raises money from venture capitalists. Those entrepreneurs pay ordinary income taxes on their salary (of course), but any gains on their stock — generated by leveraging our money and our help, as well as their hard work — are taxed as capital gains.

“The powers in Washington say that one rationale for taxing venture capitalists’ carried interest as ordinary income is that this is a ‘fee for service’ situation. But how is that different from an entrepreneur’s founders stock? He or she is being compensated based on the wealth created by direct labor. If ours is now a fee for service, then so is that of the entrepreneur. Can you imagine the uproar about stifling company formation and job growth if Congress suddenly chose to double the tax on entrepreneurs in this country?”

Again, Langeler can’t tell the difference between a founder and an investor. To start off, what does it mean to say that founders are “leveraging our money”? The concept of leverage only applies to debt. VCs invest by buying convertible preferred shares, which are a form of equity, not debt.*** They are buying a share of the company, and they get all the upside on that share. That’s not leverage. Seen purely from the standpoint of the capital structure, VC investments dilute the founders. Granted, the company is getting something valuable — cash — in exchange for that dilution. But it’s giving up some of the upside. That’s the opposite of leverage.

And if Langeler doesn’t know how VCs’ carried interest is different from founder stock, he doesn’t know how his business works. It typically works like this. At time zero, the founders decide to start a company and do some work. At time one, which could be the next day, they actually create the company and they invest all of the capital. At this point, they own the whole thing. And they keep working. From that point forward, the founders are compensated for their labor through their salaries, which are taxed as ordinary income. (And in most cases, the founders either pay themselves no salary or a considerably below-market salary for several years.) Someday they may sell their founder stock for a large gain, but they got that stock because they owned the company to begin with.

At time two, the VC fund comes along and buys a piece of the company. As part of that deal, one of the VCs gets a seat on the board of directors. At that point, he has a fiduciary obligation to act in the best interests of all of the shareholders. Any work he does for the company is in that capacity. He is working for the investors in the company. The limited partners want this, because if they’re going to put their money in a company, they want someone they trust (the venture capitalist) watching over that company. So the VC on the board is acting directly as a fiduciary for the shareholders and indirectly as an agent of the limited partners. That is why the LPs are willing to pay him 20 percent of the profits. The fact that it’s 20 percent of profits, rather than an amount that’s fixed up front, makes it a bonus, and bonuses are always taxed as ordinary income; it doesn’t make it a capital gain.

The compensation for both the work Langeler does as a board member and the work the founders do as employees should be taxed as ordinary income. Langeler wants the compensation for his work as a board member to be taxed the same way as the appreciation on the founders’ initial ownership share in the company. That’s not apples and oranges; that’s apples and chartreuse.

Langeler continues:

“The gains of the limited partner investors in the stock owned by venture capital partnerships are taxed as capital gains. The gains by entrepreneurs on their stock holdings are taxed as capital gains. Under the new proposal, the only people taxed as ordinary income on the capital wealth created in that start-up would be the venture capital partners themselves.”

Um, right. That’s because the VC partners didn’t invest any of the capital.****

And it’s worse than that. The last sentence in that excerpt is an insult to anyone who ever worked at a startup company but who was not a founder. Many early stage employees contribute much, much more to the “capital wealth created in that start-up” than any VC. For Langeler, they don’t even exist.

(There’s a similar but better argument made by Bill Burnham a few years ago: that the 20 percent is compensation for the venture capitalist’s “sweat equity” for helping the company. But if you’re going to make that argument, I don’t see how you avoid acknowledging that founders also invest “sweat equity” beyond their actual capital contributions. Like the VCs, they own stock that everyone agrees should be treated as capital gains, and then they do some work. Why is the VCs’ work any different from the founders’ work? Especially when you consider that founders–and most early employees–are making considerably less than their opportunity costs, and hence their risk extends beyond their initial capital investments.)

There’s more, but I’ll stop there. Really, I have nothing against the VC industry. I regularly cite venture capital as one of the best parts of the financial system (and one that does not rely on anything that could be called “financial innovation”), my former company would not exist without VCs, and many of them are smart, hardworking people who have contributed greatly to the economy. Some VCs (well, one at least) are even in favor of the proposed tax change. The treatment of carried interest as capital gains is by no means the biggest problem with our tax code. I might be able to live with it if the argument were simply, “VCs are good, and this special perk is intended to provide an incentive for them to do what they do” (Daniel Shaviro thought about this line of argument, but wasn’t particularly impressed).

In short, I wouldn’t even have bothered with this post. Except that duty called.

* This isn’t quite right, because the $200 million is a capital commitment that gets drawn down, and the 2% fee is probably assessed on current asset value, not initial fund size, but this we’re not discussing this part of the fee here.

** I don’t actually this is a good idea to start with. The premise is that people are irrationally conservative when it comes to preservation of capital. and hence you have to provide an incentive for them to put their capital at risk. But even if you accept that premise, the better solution is allow full refundability of losses — meaning that you get to take a tax deduction for all of your capital losses. That solves the problem more directly, since it provides a benefit in the state of the world that people want to be protected against, and it is less distorting. In any case, the effect of the lower capital gains tax rate is to lower taxes for rich people, since they are the ones with capital gains. But for the purposes of this post, let’s just assume that capital gains are taxed at a lower rate than ordinary income.

*** Convertible preferred has debt-like features, but they only matter in a bad outcome (they give the VCs a disproportionate share of whatever value is left in the company). So from the founders’ perspective, a VC investment provides the downside of debt, but not the upside.

**** Again, you can debate whether labor should pay higher taxes than capital — my instinct is that it shouldn’t — but everyone, including Langeler, is taking that as a starting point for this debate.





Focus On This: Merkley-Levin Did Not Get A Vote

Posted: 21 May 2010 06:02 AM PDT

By Simon Johnson

After 9 months of hard fighting, yesterday financial reform came down to this: an amendment, proposed by Senators Jeff Merkley and Carl Levin that would have forced big banks to get rid of their speculative proprietary trading activities (i.e., a relatively strong version of the Volcker Rule.)

The amendment had picked up a great deal of support in recent weeks, partly because of unflagging support from Paul Volcker and partly because of the broader debate around the Brown-Kaufman amendment (which would have forced the biggest 6 banks to become smaller). Brown-Kaufman failed, 33-61, but it demonstrated that a growing number of senators were willing to confront the power of our biggest and worst banks.

Yet, at the end of the day, the Merkley-Levin amendment did not even get a vote. Why?

Partly this was because of procedural maneuvers. Merkley-Levin could only get a vote if another amendment, proposed by Senator Brownback (on exempting auto dealers from new consumer protection rules) got a vote. Late yesterday afternoon, Senator Brownback was persuaded, presumably by his Republican colleagues and by financial lobbyists, to withdraw his amendment.

Of course, Merkley-Levin was only in this awkward position because of an earlier lack of wholehearted support from the Democratic leadership – and from the White House. Again, the long reach of Wall Street was at work.

But the important point here is quite different. If Merkley-Levin did not have the votes, it was in the interest of the megabanks to have it come to the floor and be defeated. That would have been a clear victory for the status quo.

But Merkley-Levin had momentum and could potentially have passed – reflecting a big change of opinion within the Senate (and more broadly around the country). The big banks were forced into overdrive to stop it.

The Volcker Rule, in its weaker Dodd bill form (“do a study and think about implementing”), perhaps will survive the upcoming House-Senate conference – although, because this process likely will not be televised, all kinds of bad things may happen behind closed doors. Regulators may also take the Volcker Rule more seriously – but the most probable outcome is that the Fed and other officials will get a great deal of discretion regarding how to implement the principles, and they will completely fudge the issue.

Most importantly, everyone who wants to rein in the largest banks now has a much clearer idea of what to push for, what to campaign on, and for what purpose to raise money. This is the completely reasonable and responsible ask:

The Volcker Rule, as specifically proposed in the Merkley-Levin amendment
Constraints on the size and leverage of our largest banks, as proposed by the Brown-Kaufman amendment
When the mainstream consensus shifts in favor of these measures, or their functional equivalents, we will have finally begun the long process of reining in the dangerous economic and political power of our largest banks.