Michael C. Hill - Cannibal Capitalism - How Big Business and The Feds Are Ruining America.docx

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Library of Congress Cataloging-in-Publication Data:

Hill, Michael, 1971-

Cannibal capitalism : how big business and the feds are ruining America / Michael Hill.

p. cm.

Includes bibliographical references and index.

ISBN 978-1-118-17531-6 (hardback); ISBN 978-1-118-19775-2 (ebk); ISBN 978-1-118-19776-9 (ebk); ISBN 978-1-118-19777-6 (ebk)

1. Income distribution—United States. 2. Industries—United States. 3. Capitalism—United States. 4. Right and left (Political science) 5. United States—Economic conditions—21st century. I. Title.

HC110.I5H55 2011

330.973—dc23

2011039742

Introduction

There I was, sitting in bankruptcy court. It was all gone. It was over. Why? Why me? What did I do wrong? How was I going to take care of my family? My wife was six months pregnant with our second child, a little sister for our two-year-old daughter. Why did I put their futures at risk? How didn’t I see it coming? I was all in. Everything I had was on the line, but it was all tied up in the “safe” haven of real estate. Everyone said the real estate market only slows, not stops. It was considered more stable than gold. In fact, land is the only property called “real,” and yet there I was. The whole thing had collapsed. They called it a subprime crisis, but the whole economy was in crisis.

By 2008, the whole thing had failed. “Dog eat dog world” is just a figure of speech, until you are the one being cannibalized. It was as if the whole country had turned on itself economically; instead of growing through the pain, the pain caused a cannibalization of engines of growth in the economy. Small businesses like mine that produce tangible goods and services and employ regular people were sacrificed, while paper traders who amass vast wealth through the exchange of abstractions derived from the real economy were propped up as too big to fail. It was a panic—a panic initiated by the greatest fear of the super-rich—the fear that they might become a little less rich. For those a little lower on the totem pole, the fear was based on the near reality of losing everything.

Just a year earlier, I had won a Custom Builder of the Year award for the Greater Washington Metropolitan region, and my company was valued by an investment bank at $47 million. My homes were featured in magazines, and I was rubbing shoulders with celebrities. We were engaged with a venture capital fund to take the business nationwide and ultimately go public with a stock offering. I thought I’d realized my dream, but it all blew up in my face. Sales froze and I was stuck holding over $10 million worth of real estate that was “underwater,” as they say.

I had to retrace my steps. I had to understand the market forces that drove my success, or the illusion of it, as well as its collapse—not just for me, but for everyone caught up in this economy. The old distinctions we once safely made between Wall Street and Main Street have proved to be fallacious. Our money may come from the banks, but the value of that money comes from the real economy of Main Street. When a business fails, they may say, “You win some, you lose some,” but what is a game for some is life and livelihood for so many more. The forces that drive wealth creation and destruction, the flow of capital up and down the socioeconomic ladder, and even the trading of financial instruments that no one understands, govern our lives in ways not easily perceived.

I pored over census data, market trends, economic theories and reports, and book after book of analysis of the economy. In the course of my studies, I turned myself into a sort of blue-collar economist, not academically trained in theory, but well practiced in real-world economics and the art of business. I am a career entrepreneur. I have skills in a variety of highly technical areas and very broad work experience. I’ve held jobs ranging from janitorial services to research assistant in a solid-state physics lab, but my life has been business. To understand my predicament, you have to understand my background.

My father is a rocket scientist, as turgid as that may sound. This is significant only insofar as the end of his career shaped my view of work, money, and career. He had long dreamed of working for NASA, and that dream came true. He worked on the space shuttle before the time of its first launch. It meant everything to him—perhaps too much. He gave himself fully to the space program, and in the end, it cost him his family. Now, there are many details that I won’t describe here, but in short, when he faced the life-changing choice between career and family, he chose career.

Ironically, a short while after my parents divorced, the space program suffered wide-ranging budget cuts, and he was laid off. He played by the rules and got a good education and a good job, but ultimately, his dream was empty. The illusion shattered. If being a rocket scientist—the well-worn cliché for any intellectual challenge—is a guarantee of nothing, then what is? I became determined to chart a distinct course. I would not live my life that way.

Think about it—my father’s education and diligence led to a dead end, while college dropouts like Microsoft’s Bill Gates and Oracle’s Larry Ellison number among the richest men in the world. To me, it’s strong evidence that something is very wrong with what we are all generally taught. “Go to school, get good grades, pick a career, get a degree, put your money in a bank, work hard for job security, buy a house, and retire to a warm place.” It’s standard fare, but it doesn’t really work, at least not anymore. Feeding people that garbage may maintain the status quo, but it doesn’t meet the ambitions of overachievers, and it hasn’t led the national economy to a brighter future.

The axioms of success sounded hollow to me. The school system has gone to pot. Careers hardly ever last a lifetime. Banks rarely pay more than the lowest recent inflation rate in interest even on certified deposits, which of course means that your savings constantly shrink in value. There is no such thing as job security. And now even your house, the most significant investment regular people ever make, may not be worth what you paid for it. If you are fortunate enough to have home equity, then vultures hover ready to give you a reverse mortgage.1

No, I was going to find another way. I gave up my earlier goal of pursuing a career in science like my father. Instead of completing an MD-PhD double doctorate, I redirected my training from physics to a degree in medical applications. I worked for a short while in a hospital, but maintained a constant lookout for my first major business venture. I found that the combination of high turnover, 24/7 shifts, vacations, and sick leave makes the entire medical services industry utterly dependent on temporary workers. So I quit my job and started a medical temp service. In short order, I was providing nurses, X-ray techs, and medical assistants to doctors’ offices, clinics, and hospitals throughout the mid-Atlantic. I sold out of that business while it was still on the rise.

But I didn’t let go of that vine without a firm grip on a new one. Just in time for the PC revolution, I started an IT consulting and training company. It was a natural fit. I had been programming computers since I was ten years old. Remember, my father is a scientist, and there were always computers around the house. In almost no time, I racked up all of the certifications needed to maintain credibility and acquire contracts. This company also grew and flourished until the dot-com crash.

Just before the dot-com crash, the hot thing to do was day trade. A number of online brokerages were bringing the stock market to the masses. Day traders take advantage of online access and cheap fees to rapidly buy and sell publicly traded stocks. I was only too eager to diversify my wealth-building path and join this revolution. For a while, people were making a killing . . . for a while. The dot-com crash affected me on two fronts (both as an investor and as a proprietor of a technology company), and ever since, the market has been anything but a sure thing. All of this made it clear to me and many others that a safer investment vehicle was needed. So, where did I and so many other, far bigger fish turn? It was to real estate.

I played it safer than just real estate. I invested almost exclusively in waterfront property. In fact, I bought waterfront property on the Potomac River in the vicinity of the national capital, Washington, DC. Then I searched for builders to help me develop my land. I was repeatedly disappointed by the offerings of the field. The real estate development industry suffered from an embarrassment of riches. Billion-dollar companies were building cracker boxes and selling them for a fortune because there were no alternatives for homebuyers. Now, don’t misunderstand, there was competition, but all of the players were building the same junk. You’ve no doubt seen it yourself: community after community on vast tracts of land consisting of the same house over and over again, irrespective of the name on the street sign at the corner. Real estate developers only really compete over location, not product. I realized every entrepreneur’s dream: I found a vacant niche in a multibillion-dollar business.

It was 2001, and the business of new-home construction was dominated by high-volume, low-quality production developers—as it still is today. The builders had been constantly lowering the expectations and standards of new homebuyers with respect to quality, while increasing the size and superficial amenities of their two or three homogenous designs. Individuality was lost in the home-building business, far from the days of building one unique home at a time. The exception to this ubiquity was principally found among a few ultra-elite design-build firms for the “money is no object” consumer.

The divergence of these two market segments had opened a gap; a class of consumer was being ignored, one that could afford more and wanted more than the cookie-cutter product, but that couldn’t afford the custom products currently available. The only companies that were targeting this market segment were just giving them bigger cookie cutters. I was determined to give this market what it really wanted—custom homes at a cookie-cutter price.

On one hand, you can’t argue with the simple economic advantage of mass production of a uniform product, but there is always a better way. With my background in information technology, I was certain that technology could be used to normalize the costs of building distinct houses, so I could produce them at a price competitive with the typical cookie-cutter home. I also knew that, given the choice, people would choose individuality. I knew this in my heart, but I had to prove it.

For the next five years, I devoted myself to developing systems and procedures to build entire communities of new homes without ever duplicating the same house design, and to do it at or less than the cost of the competition. Despite being what we call a mature industry, the inefficiencies in even the “best” building businesses were shocking to me. The industry was bloated, paper-oriented, and totally stuck in the systems of the baby-boom era, despite the fact that so much of the work is brainwork that lends itself to automation and efficiency improvements. Not only was my theory going to be proved correct, it would be easier than I’d at first believed. Easier or not, in order to obtain significant expansion capital from private equity investors, I would have to demonstrate five years of financial proof of my concept and impressive growth.

The five-year financial history of my creation began in 2002. If you do the math and you haven’t been under a rock with respect to what has happened to the housing and credit market, you already know where this is going. Nevertheless, before the crash, my concept did work, and it worked better with each successive year. We grew at an average annual rate of 317 percent and had gross profit margins exceeding 50 percent. Our banks loved us, our customers loved us, and Wall Street was next.

At the end of 2006, we thought we were moving into the big league. As we were taken on by a reputable investment bank, my company was ramping up to go national. We were holding (actually, trying to sell) about $10 million in real estate, and for the first time, we detected that something was wrong. I had heard rumblings that the hot real estate market was cooling off, so I dropped the prices of the homes I was trying to sell, but the adjustment was too late.

Our cash flow slowly dried up as sales went cold, and I mean stone cold. Months went by and there were no sales—none. Halfway through 2007, a couple other local builders went under. We needed our funding and time was running out. I was covering payroll and other business expenses out of my personal funds. I was overextending myself because I never stopped seeing light at the end of the tunnel. But a sad reality of business is that it is hardest to get financing when you need it the most. The credit was drying up. It was as if we were a microcosmic preview of what the U.S. economy would experience in 2008.

Even so, I still hadn’t fully come to grips with reality. Our projected financial reports still looked great, but those were based on sales that weren’t happening. We were hemorrhaging all of our cash, but I still believed. I had no choice. Investors and bankers always want to know how much “skin in the game” you have, but I was far beyond skin. Everything I had from all of my previous business pursuits was now tied up in this business. I believed completely in my business plan (frankly, I still do), and so I was “all in,” as poker players say.

In the meantime, I was pushing every investment resource that I could. We had passed through due diligence with an investment fund and thought we were just waiting for a check, but when we missed a milestone in our projections because of no sales, they pulled the plug.

We still could have made it, but we needed a sale. Months more went by and still no sales. Fear in business is much the same as fear in the animal kingdom. An animal stricken with fear either runs or attacks—the classic fight-or-flight response. Our vendors and subcontractors were beginning to show this kind of response. Hearing rumors of our financial instability, some stopped showing up to work for us. Material suppliers cut credit lines, and before long, our production operations ground to a halt. It was apparent to all that there was blood in the water. With that, the attacks began.

The only thing that could change our course toward destruction was a sale, but by this point we were solidly in the worst housing crisis to grip the country since the Great Depression. Why was this happening? I had heard of subprime lending, but how did it become so pervasive?

I responded as I’d been trained my whole life to respond. Although I didn’t follow my father’s footsteps, I was raised to be a scientist. Questions demand analysis. Every action has a cause. I was going to get to the bottom of this, hopefully in time to save my company and my economic life.

I remembered a conversation that I had with a mortgage banker from California. It was years earlier. He was describing to me a variety of loan programs that he wanted to sell my customers. These loan products have since become infamous, including interest-only mortgages, option adjustable-rate mortgages (ARMs), and other creative loans to reduce monthly payments. He explained that homes were so expensive in California that these loans had become very popular. In fact, many higher-priced markets in California were utterly dependant on these loan products. I hadn’t given much thought to what he had said until the end of 2007, when these were the very loans blamed for the collapse occurring in the mortgage system.

These mortgages were in play far more than anyone realized. Even some of my customers had used them. From my perspective as a homebuilder, the old adage seemed to apply; I didn’t want to look a gift horse in the mouth. To some extent, I wondered how people could afford homes at such rising prices, including the homes I was selling, but hey, if the check is good, the check is good.

Nonetheless, the reality is that the median home prices in most of the major regional markets were and still are two to three times the nationwide median home price, but the same has not been true of income. What if that California banker’s statement were true about the broader market? What if a substantial percentage of the housing commerce that had been taking place for those last few years had been based on these loans, now toxic and universally viewed as blight on the economy?

I wondered what metrics are used to track and compare income to home prices. You always hear about Case-Shiller and the sales reports from the National Association of Realtors (NAR) and the National Association of Homebuilders (NAHB), but these don’t match consumer buying power to home prices. Analysis of these numbers alone assumes that everything else remains static, but things were no longer static. Approaching the issues of housing supply and forecasting a turnaround without considering the buying power of the market would be futile. Fortunately, when I dug deeper I discovered that there is a much more telling index that gets very little attention. It is the Housing Affordability Index (HAI).

The HAI is the standard established by the NAR to gauge the financial ability of consumers to buy a home. A reading of 100 means a family earning the national median family income (reported by the Census Bureau) can qualify for a mortgage on a typical median-priced, existing, single-family home, assuming a 20 percent down payment. An index above 100 signifies that a family earning the median income more than qualifies, and conversely an index be...

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Michael C. Hill - Cannibal Capitalism - How Big Business and The Feds Are Ruining America.docx

Part One: What’s Wrong with This Picture?

Part Two: How Did We Get Here?

Part Three: Where Are We Going?

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