Tax Amnesty Is For SuckersFor supersmart finance guys, every debt is an opportunity for securitization.
By Michael Silverstein
I have this friend I'll call "Gerard." He's made a lot of money running with the Wall Street crowd over the years, and he's never reluctant to talk about his successes. He's also fond of bragging about how he's gotten out of paying his taxes, which struck me as kind of dumb until I realized that, for people like Gerard, all aspects of financial life are played according to a different set of rules.
My enlightenment came after I heard the city of Philadelphia was offering a tax amnesty. Since Gerard has lived here a long time and boasted that he never bothered paying the Business Privilege Tax - and since the city had threatened to come down on tax evaders who don't take advantage of the amnesty like a ton of cheesesteaks - I figured Gerard was in deep Cheez Whiz.
Foolish me.
"Your problem, Mike," he said over coffee and danish, smiling benignly as he chewed, "is you don't recognize opportunity when it comes along."
"How can owing a huge amount of back taxes be an opportunity?" I asked.
He laughed. "Nothing is expensive if someone else foots the bill. I got investors to pay this freight."
"That's crazy," I replied.
He laughed harder. "Yeah, like a fox. All I had to do was securitize the debt; turn it into a CDO - that's a collateralized debt obligation, for folks like yourself. I owed Philly taxes for a bunch of years. I packaged these yearly debts as a kind of bond, and I got a broker-dealer to peddle it for me."
I was astounded.
"What kind of securities dealer would peddle this?" I asked.
"One whose traders like their commissions," Gerard said. "The commission on this baby was very, very attractive. On top of that, it had a great rating."
"Not possible," I said.
He laughed still harder. "Who do you think pays for ratings? The people who buy financial instruments?" Gerard loved that word - instrument - because it made him feel like a heart surgeon when he used it, he once told me.
"The issuer of these instruments pays for the ratings," he continued. "I'm the issuer here - the client who has to be accommodated - and I was backed up by calls from traders wanting my deal's generous commission."
"All right," I said. "So you could sell it. But who would buy it?"
There was a twinkle in Gerard's eye now. "Reputable seller, good rating, and I threw in a generous coupon. It couldn't miss. You only get a pittance in coupon interest from government and top corporate debt these days, because the Fed is keeping national interest rates low to help pump up the economy. Searching for a decent return makes investors willing to buy almost anything.
"And of course," he added, "the first investors never get stuck on deals like this, even if they tank."
"Why not?" I asked, my head spinning.
"Because they swap the debt, Mike. What's wrong with you? Haven't you ever heard of swaps - where, for a fee, some party agrees to pay up if a debt instrument" - he sure loved that word - "defaults?"
"So these swappers are the ones who get stuck when you default - which, no offense, I expect you to?"
"Don't be silly, Mike. The swappers buy their own insurance for defaults. So it's passed along. That's the game all the big boys play."
I nodded. "So the last swapper holds the bag, right?"
Gerard stared in disbelief at my lack of financial sophistication. "The last swapper, Mike, is almost always a party that needs a tax loss from a default, so the savings are almost always larger than what that party has to pay to cover the defaulted debt.
"This country has a complicated tax system, in case you haven't noticed," he continued. "Profit, loss - it's all in the bookkeeping."
I finally understood. Even if Uncle Sam doesn't get hit directly, as with the AIG bailout, he gets hit indirectly with less tax revenue down the road. Sam's the one who ends up sitting on the floor in this game of financial musical chairs.
"But at least," I said to Gerard, "at least the city is going to get its money from your deal."
He looked at me with pity. "No, Mike. The proceeds of this deal, which I took the time and trouble to organize, all go to me. I plan to spend the money on an island I know where bill-collecting is a capital offense."
"Look, kid," Gerard added, "taxes are for dummies, and the markets only work for the people who know how to play them. And for that insight," he concluded, standing up to leave and offering one more important life lesson, "you're paying for breakfast."
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Michael Silverstein is a Philadelphia writer who invented the preceding conversation.
He can be reached at mike@wallstreetpoet.com
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Published June 25th
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