This practice is not new. Barnet and Muller documented it in Global Reach, nearly forty years ago. The current financial crisis is responsible for renewed interest in transfer pricing, because governments are desperately seeking to increase tax revenues. The New York Times reports that “the charity Christian Aid, which is concerned with the effect [of transfer pricing] on developing countries, estimated that governments lose $160 billion a year when companies working across borders misapply the rules” (NYT, Jan. 4, 2010). According to Bloomberg news “Transfer pricing lets companies such as Forest, Oracle Corp., Eli Lilly & Co. and Pfizer Inc., legally avoid some income taxes by converting sales in one country to profits in another — on paper only, and often in places where they have few employees or actual sales” (bloomberg.com, May 13, 2010).

Disputes over transfer pricing are symptomatic of intensifying conflict between national governments and global companies. Indeed, these disputes reflect a struggle for economic and political dominance. Just as kings gained the upper hand over landed aristocracies with the progress of industrialization in the early modern period, global firms are gaining political power at the expense of existing national governments. The reasons are similar: kings won out because wealth shifted from possessors of land to possessors of factories; multinationals will eventually win the game because wealth is shifting from static resources to dynamic resources, i.e., wealth is becoming increasingly global in scope. The shift in power will be a slow process; governments are not yet toothless tigers, and can fight back against the multinationals. But the ultimate outcome is not in doubt – a new political economy resembling the pre-modern feudal system is in the making (see Virtual Organization, chapter 8).

One of the great ironies in history is the inability of entrenched power to anticipate basic change in the conditions of economic and political life. The Bourbon kings’ proverbial failure to forget and their inability to learn led to the French Revolution in which at least one of them lost a head. The Maginot Line, erected by the French to deter German aggression after World War I, has become symbolic of the failure to anticipate altered conditions of warfare. French strategic military thinking in the 1920s was guided by the experience of the static confrontations of massed forces characteristic of the First World War, and failed utterly to take account of the innovations in mobile, lightning warfare perfected by the Germans in the period between the world wars.

Contemporary governments are making the same kinds of fatal errors in dealing with global companies. Based on past experience, governments are trying to control the activities of multinationals through fiscal and monetary policy. But these companies are more agile and innovative than governments and are able to circumvent control measures. Occasionally they are excessively clever and carry things too far as did Enron by using virtual organization to obfuscate their financial condition. Such excesses bring down the wrath of government on particular firms but do not alter the basic shift of power to global business.

Transfer pricing is a powerful element in a global company’s bag of tricks, and like sophisticated financial instruments it can be modified to overcome restrictions that governments might impose. The current furor triggered by the recent precipitous decline in government revenues will run its course and transfer pricing will continue to serve the interests of global business.

Like the character Howard Beale in the 1976 movie “Network”, Mr. Katz says in effect “I’m as mad as hell, and I’m not going to take this anymore!” Maybe his efforts will spawn a movement that goads Congress into enacting legislation that curtails the abuses of debt farming.

“The bill collectors, when they call, make you feel like the only option you have is to lay down and play dead. That’s not true,” said Mr. Katz said, who does not charge for his advice. “Nothing validates this more than getting a check.”

Call this movement revenge of the (alleged) deadbeats. Even as collectors try to recoup debts from millions of Americans struggling to pay their bills, a small but growing number of lawyers and consumers are fighting back against what they describe as harassment, unscrupulous practices — and, most important to their litigiousness, violations of the Fair Debt Collection Practices Act.

from NYTimes 4/23/2010, by Andrew Martin

If, for example, ABC Farmers, Inc. pays as much as twenty cents on the dollar, the firm will make a gross profit of 20% by collecting on two out five of the outstanding bills. The more ABC collects, the greater its profit. Expenses are quite modest since all that is needed for this debt collection business is a computer for producing and emailing statements, a phone for calling ‘customers’ and a bank account for accepting payments. Also helpful is the tenacity of a pitbull in the collecting process.

This type of ‘farming’ is reminiscent of tax farming in the Roman Empire. An ancient tax farmer made an advance payment to the state in exchange for the privilege of collecting taxes within a given territory. The more the taxes collected, the more the profit. Once the ‘contract’ was let, the state effectively washed its hands of the matter. Much the same conditions hold for debt collection today.

It is not in the interests of the modern debt collectors to try to determine how much, if anything at all, is actually owed on a particular account. A bill included in the portfolio purchased by ABC, for example, might be for a debt that was cleared through a legal bankruptcy proceeding. The interest of ABC is to try to collect regardless of the disposition of the debt. It costs little to send threatening letters, and if the alleged debtor eventually succumbs to all the badgering, ABC adds a bit more to its coffers.

Potential for abuse grows as obligations to pay are detached from the original transactions in which they were incurred. A company selling a product or service has some incentive to treat its customers fairly, if only to promote return business. The owner of an abstract debt obligation has no such incentive. Cynical practices are rewarded since people sometimes pay off balances that are not due simply to escape further harassment.

Companies sell accounts receivable for far less than the face value of the accounts because they believe the return on investment in pursuing delinquent accounts is not worth the cost. Possibly this policy helps the company’s bottom line in the short term, but it does not help to stimulate customer loyalty and has the long term social cost of reducing trust in the economic and political system.

Overhauling and strengthening regulatory oversight of financial markets is a sensible step, but not enough to prevent a recurrence of the frenzied pursuit of profit that precipitated the crisis. Not all mortgage lenders succumbed to the lure of higher profits through securitization of loan portfolios.

Many local and regional banks, for example, continued doing business as of old. They held to the traditional policy of making prudent loans to qualified borrowers in their communities, and keeping on their books the mortgages they issued to home buyers. Such policy acts as a brake on greed by underscoring the lender’s interest in making sure potential borrowers can repay their mortgage loans; it also reinforces prudent behavior on the part of realtors and appraisers because the lender needs a realistic assessment of the market value of a house as collateral for a loan. Moreover, by insisting on documenting income sources, traditional policy reinforces the honest behavior of borrowers.

The essence of traditional policy is a direct connection between lender and borrower. When that connection is broken by securitizing mortgage assets, the incentive for actors in real estate and financial services to act prudently and ethically is substantially weakened.

A marketable security based on mortgage assets is an abstract financial instrument that carries no information about borrower and lender. An investor who purchases such a security is concerned only about its current price, potential for future price appreciation, and the dividends it pays. There is no direct relationship in the financial marketplace between borrower and investor or between lender and investor.

The parties to a real estate transaction are related to each other only by the formal roles they play in the transaction; the informal relationships that are essential to reinforcing appropriate behavior in any group are entirely absent. So, it is not surprising that predatory and abusive lending practices had become widespread, and that lenders were less than eager to meet with financially strapped borrowers to resolve problems.

The set of relationships defined by a real estate transaction has come to resemble a virtual team in which the members are place markers for required roles. Each role – agent, broker, lender, and borrower – can be played by one individual today and another tomorrow. Ideally a virtual team shares a common purpose. The parties to a real estate transaction may or may not have a common purpose. Be that as it may, even if there were a shared goal, it would be extremely difficult to ensure that each member of a virtual team contributes to that goal to the best of his or her ability, since personal relationships are weak or non-existent.

If transactions in the financial marketplace continue to reflect the kind of disconnection prevalent among the individual and institutional actors in the real estate bubble, the absence of effective mechanisms of social control evident in virtual teams will inevitably facilitate new crises in the future.

The process of purchasing a house consists of a long chain of transactions starting with a ‘meeting of the minds’ of buyer and seller, usually mediated by a real estate agent representing the seller. Once an agreement has been reached, the buyer must arrange financing. Here is where the trouble starts.

Let’s say the buyer uses the services of a mortgage broker to find a bank or other lender willing to issue a mortgage on the house. Having no responsibility for the future behavior of the buyer, and receiving a fee for its services, the mortgage broker’s interest is to place as many mortgages as possible. Real estate agents and property appraisers have a similar interest. Both work on fees or commissions based on sales, so their aim is to generate as many sales as possible.

In the ‘old’ days – before the housing bubble of the past decade – the bank or mortgage company issuing a mortgage on a given property would generally hold the paper until the debt was discharged. This relationship between home buyer and lender changed as mortgages were bundled into pools of financial assets to be securitized and sold. With securitization the lenders’ interests became aligned with those of realtors, appraisers and mortgage brokers.

Commercial banks and other mortgage originators realized they could increase their profits through securitization. By using pools of mortgages as assets for new classes of securities, and selling these securities to investors, additional funds could be made available for yet more lending. Investment banks entered at the end of the chain to package, underwrite and sell the mortgage-based securities to investors.

None of the actors in this chain was overly concerned about the borrower’s ability to repay a loan. Borrowers’ equity increases when house prices rise. Under these conditions even subprime borrowers could cope with adjustable rate mortgage resets by using the additional equity to refinance their loans. Alas, all good things must come to an end, and house prices cannot rise forever. When prices ceased to rise, and adjustable rate mortgages reset higher, many subprime borrowers could neither make their payments nor refinance their loans.

Mortgage holders started a wave of foreclosures that eventually depressed house prices by increasing the inventory of houses on the market. The wave of defaults and foreclosures led to price declines for mortgage backed securities, and suddenly major financial institutions had to take write downs on billions of dollars worth of securities on their balance sheets. This led to the collapse of major financial institutions and necessitated intervention by the Federal government.

A vast amount of ink has already been spilled on this issue, so why retell the story here? Missing from the picture painted by the media is the underlying cause of the debacle. No doubt greedy and unscrupulous lenders, real estate agents, property appraisers, mortgage brokers, commercial and investment bankers and rating agencies, together with irresponsible borrowers are the villains of the piece. But greed and irresponsibility have always been with us and these human traits are not likely to disappear any time soon. It is necessary to identify the greedy, unscrupulous and irresponsible parties, but such identification is not sufficient to prevent a recurrence of similar behavior in the future.

To be continued in Part 2 …