Treasure Islands - Nicholas Shaxson [132]
One of his office’s functions was to take out cheap short-term loans and invest the proceeds in longer-term assets with higher rates of return. This is an easy way to make tax-free money—but it is dangerous too: You must “roll over” short-term loans every few days, replacing one loan with another. This is easy in the good times, but when lending dries up, as it did in 2007, you must still repay the short-term loans fast—but suddenly nobody will provide new loans to replace them. You can fall into default very quickly. This is exactly what brought down the British bank Northern Rock in 2007. Yet the Caymans regulator, Elmer said, took an extremist laissez-faire approach to these so-called maturity mismatches. “This is a short-term and long-term problem,” said Elmer. “From a regulatory point of view we couldn’t have done that in the UK or Switzerland. The Cayman Islands Monetary Authority (CIMA) should have picked that up.”
Elmer was involved in two CIMA audits. In the first one, he and his local CEO talked for an hour or so with a CIMA official. “The CIMA person said, ‘Is it the same as it used to be?’ The CEO said, ‘Yes, it is the same.’ The CIMA guy said, ‘No problem.’ The Cayman regulator knew our CEO well, and he knew he would tell him the truth. Personal relationships were key.” A subsequent, later audit was more extensive and lasted about a week. “You have to be very experienced in that sort of thing,” said Elmer. “Two junior auditors came in and made a lengthy report, which had little content. I went through those audits, and from a regulatory point of view, they were not sufficient at all.” No further action was taken.
“It was quite crucial for [our] group to use Cayman and BVI vehicles,” he said. “It boils down to three things: tax, regulatory, and legal advantages. You have a lot of freedom.”
This extreme freedom, turning the secrecy jurisdictions into hothouses for risky new banking products, contributed massively to the crisis of the world’s major economies.
The rise of debt in our economies has yet more offshore fathers. There is only space here briefly to sketch a few important ones.
In 2009 the IMF published a detailed report explaining how tax havens, combined with distortions in onshore tax systems, cranked up the global debt engine by encouraging firms to borrow rather than finance themselves out of equity.46 These effects, it said, “are pervasive, often large—and hard to justify given the potential impact on financial stability.” Amid all the noise from G20 leaders about tax havens in 2008 and 2009, the IMF concluded, this dangerous offshore aspect went entirely unnoticed.
The core principles the IMF outlined are simple. A corporation borrows money from offshore, then pays interest on that loan back to the offshore financing company. It then uses the old transfer pricing trick: the profits are offshore, where they avoid tax, and the costs (the interest payments) are onshore, where they are deducted against tax.
This simple trick is central to the business model of private equity companies. They will buy a company that someone has sweated for years to create, then load it up with debt, cutting the tax bill and magnifying the returns.
Leveraged buyouts—always involving offshore leverage—accelerated fast ahead of the crisis: The amount raised by private equity funds rose more than sixfold from 2003 to over $300 billion in 2007, by which time their share of all U.S. merger and acquisition activity had risen to 30 percent.47 Reports praise private equity companies for excellent “value creation.” Sometimes private equity companies do create real value. But this core feature of their business model is not value creation but value skimming. A big tax bill is slashed, the company’s shares or value rise, managers’ remunerations become engorged, and wealth is shifted away from taxpayers to wealthy managers and stockholders. Nowhere in any of this did anyone produce a better or cheaper widget.