Originally posted by rajubhai55 flipping companies (buy companies, fire people get temporary rise in stock price and sell the company), flipping shares (high speed computerized trading, buy cheap by few cents and sell when it rises by few cents)
The thing about flipping companies: this activity is made possible by the massive tax loophole on debt issuance and carried interest.
How Uncle Sam Helped Mitt Romney Build His Fortune | Crooks and Liars Quote: As it turns out, the U.S. tax code doesn't merely allow Romney to pay a lower rate than many middle class families. Without the public subsidy that is the corporate debt interest deduction, there might not be a Bain Capital--or a private equity industry as we know it--at all.
Private equity owes its success in no small part to that uniquely American provision of the corporate tax code. The New York Times recently helped explain why:
Companies can finance investment from either debt or equity. Companies can finance investment from either debt or equity. But profit on an investment financed with equity -- stock issued by the company -- is taxed. In contrast, if the project is financed with debt, then only the profit after interest payments are made is taxed. This means debt-financed investments are cheaper than equity.
And not just a little cheaper. As the Treasury Department recently explained, "The effective corporate marginal tax rate on new equity-financed investment in equipment is 37 percent in the United States. At the same time, the effective marginal tax rate on the same investment made with debt financing is minus 60 percent--a gap of 97 percentage points." The result:
This creates a bias by corporations toward debt.
----
In January, The Economist explained how the perverse incentives work:
From 2004 to 2011 private-equity firms piled more debt onto their companies so they could take out $188 billion in dividends to pay themselves. The deals got bigger and bigger. The largest ever, in 2007, was the $44 billion purchase of TXU, an electricity company. The market worries the company will go under.
But though the private-equity people may have walked off with the loot, America's tax code was partly to blame, because it encourages this behaviour. The tax deductibility of interest payments on debt gives private-equity executives an incentive to pile extra debt onto the companies they buy, thereby risking the health of these firms for the sake of a tax benefit and the prospect of higher returns.
"Traditionally," Kosman noted in 2009, "cash-rich public companies have paid dividends to lure and reward investors." But private equity firms, he explained, stand this process on its head. "Fourteen of the largest American private equity firms had more than 40 percent of the North American companies they bought from 2002 until September 2006 pay them dividends, "Kosman pointed out, adding, "In thirty-two of the eighty-three case, 38 percent, they took money out in the first year." And the innovator behind the business model?
Mitt Romney was a pioneer of this strategy. His private equity firm, Bain Capital, was the first large PE firm to make a serious portion of its money not from selling its companies or listing them on the stock exchange, but rather by collecting distributions and dividends, which in this context is the exact opposite of reinvesting in a company. Bain Capital is notorious for failing to plow profits back into its businesses.
So much for candidate Mitt Romney's 2007 claim, "Don't forget that when companies earn profit, that money is supposed to be reinvested in growth."
Sorry to bring up Mitt again
But as we can see, the Bain model - and indeed a lot of the investment bank growth since the '90s - is created by US tax law. Imagine that, entire industries, the most capitalistic industries out there, exist due to tax subsidization!
As to the program trading, this is an inevitable result of open trading, the elimination of regulation aka price protection on commissions, and the improvement in computer technology. Where in the old days your broker could take big commissions and hide wide margins between bid and ask, these days both are paper thin. So the banks make it up on volume, as the old saying goes. There is a temptation to front run...
I agree with you that this type of trading doesn't actually add economic value - the claim is that high speed trading keeps the markets liquid, which is dubious at best. The purpose of this type of trading is to generate revenue for the equity floors of investment banks, pure and simple, and as such could be seen as an economic 'rent' on the system.