...Archive for October 2008

Share buybacks and uninformed investors

Today I was reading Felix

[F]or many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream — one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late 70s and early 80s, the S&P 500’s dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price.

And then Mish

How many billions of dollars did GE [whose stock currently trades for about $18] waste buying shares back over the years at $40 or greater? $35 or greater? $25 or greater? $20 or greater? Think of where GE might be if it used the money to pay down debts rather than buy shares at absurd prices.

I see that GE is paying a dividend of 6.6% while borrowing money from taxpayers to fund operations. How long can that dividend last?

If you take an introductory finance class, you will learn that firms can return cash to their shareholders in two ways. They can issue dividends, or they can use the same money to buy-up shares from shareholders. Fundamentally, you will learn, these two approaches are equivalent: With a dividend, all investors receive some cash, but the stock they hold loses value. In a buyback some investors sell shares and receive cash, leaving investors who hold their stock with a less “diluted” claim on the assets of the firm, making the payout equitable to all shareholders.

To clarify, suppose there is a firm whose sole asset is $1,000,000 in cash and two shareholders. The firm could pay a dividend of $500,000, giving $250,000 in cash to each shareholder. Alternatively, the firm could buy out one of the shareholders, paying $500,000. In the first case, both shareholders end up with $250,000K worth of stock and $250,000 in cash. In the second case, one shareholders ends up holding $500K in cash while the other shareholder holds stock worth $500K. In financial terms, everyone gets a fair deal either way.

However, conventional wisdom has it that share buy-backs offer important advantages that may make them superior to dividends payments:

  • Preferential tax treatment — Investors are more lightly taxed with buybacks, especially if dividends are taxed more heavily than capital gains. With buybacks, those who sell are taxed only on net gains (a smaller amount than the cash actually received, and perhaps at a lower capital gains rate), while those who don’t sell are not taxed at all until they sell sometime in the indefinite future.

  • Flexible reinvestment with low tax and transaction costs — With a dividend, people who want to stay invested in a firm have to accept and pay taxes on the dividend, and then incur transaction costs to reinvest the proceeds back in the firm. With a buy-out, investors who want to stay invested very efficiently do nothing, while those who want cash can sell into the buyback.

  • Cash-management flexibility for the firm — For whatever reason, firms are expected to keep dividend payments stable and increasing over time, even though business profits and cash needs may be very volatile. Firms that cut regular dividends are often punished by the market. Discretionary stock buyback programs allow firms to return cash to shareholders when business conditions permit and withhold payouts as cash needs grow while maintaining a smooth and stable dividend policy.

All of this would be well and good in a world with perfectly efficient markets, no asymmetric information, and investors whose portfolio preferences are continuously enforced.

But consider an uncertain world in which firms are frequently mispriced, and where many investors have limited attention and rebalance their portfolios only infrequently. (Among this latter group would be buy-and-hold investors who hold a fixed portfolio and either consume the dividends or reinvest them pro rata in a broad portfolio rather than in the issuing firm directly.) In this more realistic world, share repurchases benefit informed and flexible investors at the expense of their less informed or more rigid partners, while dividend payments reduce the ability of informed investors to profit at the expense of other investors.

Let’s first consider the case where some investors know a firm’s stock to be overpriced. Informed investors are more likely to sell into overpriced buyouts, extracting cash from firms at the inflated share price while concentrating the burden of future write-downs on long-term, less-informed investors. A dividend, on the other hand, would return cash equitably to all investors, automatically disinvesting slower investors from the overpriced stock, and forcing informed investors to share in losses. Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm’s poor prospects, and cause the share price to fall before they can exit. (That’s how information is supposed to get impounded into markets prices!) With or without the buyback program, investors in an overpriced firm must suffer the cost of a downgrade, but the cash disbursal policy affects the distribution of the losses. Returning cash via buybacks lets the informed shift losses to the uninformed, while the same cash distribution via dividends reduces the eventual cost to slow investors and forces informed investors to share more of the pain.

With an underpriced firm, the difference is less stark. Only ill-informed or liquidity constrained investors sell their shares into a buyback, concentrating future gains in the hands of both informed investors and slow buy-and-hold investors. So although informed investors do gain, the gains are more broadly shared: “slow money” as well as “smart money” benefits, the losers are ill-informed investors or random people who need cash. When an underpriced firm issues dividends, all investors are partially disinvested from a firm whose shares are destined to appreciate. But active, informed investors are likely to reinvest, potentially informing the market and provoking a revaluation towards fair value that benefits all investors. If the market adjusts quickly to the reinvestment flow, informed investors may not be able repurchase very much stock at all from less informed investors before the price adjusts, leaving the revaluation gains broadly shared among all investors rather than captured mostly by the informed.

An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don’t repurchase stock than if they invest in firms that don’t pay substantial dividends but use stock buybacks to “return cash”.

This line of thinking opens up interesting questions about for whom a firm is to be managed. The party line is that firms should be managed for the benefit of shareholders. Even if that is true, for which shareholders should it be managed? One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors, and create incentives for management to buyback overpriced shares even though in some sense this is bad for “the firm”. (There are lots of anecdotes about hedge funds and other activist investors lobbying successfully for share repurchases by firms that turned out to be overpriced.)

Even if one imposes a fiduciary obligation on management to treat all shareholders equally, it’s not clear that management is betraying its trust by working to inflate share prices and creating opportunities for the savvy to cash out. Even if the strategy harms future earning streams, it creates a valuable option that is ex ante available to all shareholders, and the option value of a firm is a real and often substantial component of its worth. If markets are not efficient, it’s quite possible that maximizing current shareholder value is inconsistent with maximizing discounted infinite horizon profit streams, which leads one to question whether current shareholder value is a very useful metric of firm value from a social welfare perspective.

I sing the praises of financial innovation

A few weeks ago, Dani Rodrik issued a challenge:

[A]dvocates [of financial innovation] owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

I will give Dr. Rodrik some of what he wants, that is, examples. But first, I have a nit to pick. In citing last year’s would-have-beens, Rodrik has offered up the textbook marker of an anti-innovation.

…have allowed millions of people to purchase homes that they would not have been able to afford otherwise.

Any claim that a financial innovation has achieved a concrete, positive end is a sure sign of disaster, or (in the unfortunate lingo of economics) a distortion. The purpose of a financial system is to solve a collective optimization problem whose solution we cannot guess a priori. If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply. More generally, one cannot judge a financial system by any particular outcome, because all financial systems make mistakes, and the mistakes always look good while they last. We judge financial systems by the performance of the economies they guide over time.

Rodrik has asked for examples of good innovations. Here are a few on my list:

  • Exchange-traded funds
  • The growth of venture capital and angel investing
  • The democratization of access to financial information (e.g. Yahoo! finance)
  • The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

No list of good innovations is complete without a list of bad innovations. Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I’d place them directly in the “good” column.) But there are many, many more bad innovations that we have yet to come to terms with:

  • 401-K plans with limited investment menus
  • The conventional wisdom that long-term savings ought by default be placed in passive stock funds
  • The conflation of ordinary saving and financial return seeking
  • The tolerance, advocacy, and subsidy of financial leverage throughout the economy
  • The move towards large-scale, delegated, and professionalized of money management
  • The growth of investment vehicles accessible primarily or solely to professional and institutional investors

How do I distinguish the good innovations from the bad? I cannot do what Dani Rodrik asks, and point to concrete good outcomes, and I have no studies to show that economies with tools I prefer outperform those without. In engineering fields, one develops and chooses innovations not by virtue of historical experience, but by application of a theoretical toolkit that prescribes what would work if it were tried. Of course, eventually historical experience either vindicates or discredits the theory, but I have a theoretical view, and I claim that it has not been discredited. Here are a few principles:

  1. Financial systems are means of aggregating diverse, decentralized information into patterns of capital creation in the real world. Financial innovation ought to be judged by how capably they facilitate this information transmission. By this criteria, “opaque” financial instruments — these include everything from complex tranches of CDOs to certificates of deposit at your local bank — are presumptively bad. If an investor does not know and actively choose to bear the risk of the real projects she is investing in, then she is introducing noise into the allocation decision. On a sufficiently large-scale, this noise will lead to allocative errors and widespread catastrophe with probability one.

    Good innovations:

    • Are transparent, investors can understand what they are investing in.
    • Are expressive, that is they increase the range of widely dispersed information that investors can impound into an investment decision.
    • Are compartmentalized, the parties upon whom the costs and benefits of the investment decision fall are well-defined, and these parties accept and are capable of bearing the risks they have chosen without external support.
  2. Savers should not be investors, that is they should not be underwriting the execution of projects about which they have no opinion and whose risks they are unwilling to bear. Savers’ sole legitimate goal is to transmit their current wealth into the future with the minimum loss possible. (Savers who want to earn a real return must become investors, that is they must perform informational work and bear risk.) Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production). This is a tragedy both for savers (baby-boomers who are losing their retirements ought to have been able to “buy forward” their housing, food, transportation, etc. years ago), and for the economy as a whole, because information about future consumption is lost, and we have no reason to believe that the salesmen who pawn off “savings products” are qualified to make outsized contributions to the allocation decision.

  3. A primary goal of a financial system is to allocate and minimize the burden of economic risk. That has two implications:

    • To the maximum degree possible, the financial system ought not introduce risks that are not inherent to the real projects it is underwriting. In particular, financial systems should be designed to minimize what I’ll call “secondary counterparty risk” — the risk that an intermediary will fail to pay a claim that is not made explicitly contingent by the terms of the investment contract. Secondary counterparty risk is tacit, it is opaque (since human enterprises are never perfectly transparent and inter-relationships are complicated, we can never know a counterparty’s capacity to pay), and the informational problem of evaluating and quantifying it grows exponentially with the size and complexity of financial intermediation. So, financial intermediation ought be kept as “thin” and simple as possible. Having vast numbers of intermediaries bound into unstructured and unknowable networks by virtue of idiosyncratic bilateral claims is obviously dumb.

    • The risks inherent to real economic projects, which include ordinary investment risk and “primary” counterparty risk (you lend to an enterprise that fails, as opposed to the failure of a financial intermediary), should be very clearly allocated, and financial markets should not make it easy for risk-bearers to escape the consequences of their risks by ex post transfers in overly “liquid” markets. As much as possible, investors should be able to choose the level of risk they bear, and should plan to reap the fruit or accept the costs those choices in a very straightforward manner.

Some miscellaneous comments:

  • Complexity is much more often a marker of snake-oil than of quality in a financial instrument. “Sophisticated” investors are almost always predators or fools. The real-world informational problems investors face — what is it that should be done? how ought our resources be deployed? — are challenging enough. Creating structures that cannot be understood except by applying complex models that may or may not adequately capture the behavior of the instrument is just idiocy, a mish-mash of quant hubris and pseudoscientific salesmanship.

  • There is no inherent tension between financial innovation and regulation in designing a financial system. Some regulation compels and encourages useful innovation. For example, if as an outcome of the current crisis, banks find their leverage tightly constrained, it may be necessary for a new ecosystem of investment funds to arise to meet the needs of investors who otherwise would have lent to banks and enterprises that previously relied on bank financing. That is, a “local venture capital” boom might arise as a direct consequence of bank regulation. Further, much good regulation is itself a form of financial innovation. Centrally-cleared, collateralized derivatives exchanges are incredibly clever devices, whose function and regulation are intimately intertwined. Good regulation does not take the form of minions of the state saying “no! non! nyet!” to hearty capitalists. Good regulation involves the clever definition of market structures to which participants are naturally drawn because they function well. Regulation itself can be a form of financial innovation, as in “cap-and-trade” pollution control schemes, Warren Buffet’s import-certificate proposal, or congestion-pricing of trades in financial markets.

So, this has been a sprawling brain-dump, rather than a clear-headed vindication of the proposition “financial innovation can be good”. Despite the deficiencies of the essay, I strongly believe that transitioning from our current, very broken, financial system to something better will require a great deal of innovation, along with regulation. We should think of the financial system as an integrated system, and work creatively to improve both its private-sector and public-sector components. We should be humble, and careful, and introduce big changes incrementally where possible. We should try to bear in mind the social purpose of a financial system, and use that as a yardstick against which to evaluate new ideas. But we must make big changes, and it will not be enough to tell people what they cannot do. We want a financial system that is safe and simple, but also expressive and dynamic and capable of taking large, well-considered risks. We will have to invent to get what we want. The stakes could not be higher.

Crocodile tears and the LIBOR-OIS spread

OK. So, stock markets are, like, tanking.

But the new conventional wisdom has it that stock markets aren’t really where the action is. To gauge how the crisis is unfolding, we are told, we should pay attention to credit indicators, particularly indicators that compare the cost of interbank lending to the cost of “risk-free” government borrowing, such as the TED spread.

Felix Salmon has done a nice job of pointing out the flaw in these indicators: Banks don’t actually have to borrow at the elevated interbank rates, as long as central banks are willing to lend directly at much lower rates. So, it’s unclear whether interbank borrowing rates like LIBOR are meaningful as measures of interbank counterparty risk. As Felix notes:

Libor is an indicative rate: it’s the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks’ cost of funds in the real world, where the interbank markets are becoming increasingly dried-up and unhelpful.

What is very clear is that LIBOR serves as the basis of many thousands of private sector contracts, and that the banking system as a whole is a net receiver of LIBOR-indexed funds. To the degree that LIBOR does not reflect banks effective cost of funds, an elevated rate can be viewed as a hidden tax of the nonfinacial sector by banks. Rather than reflecting the banking system’s pain, a high LIBOR might indicate banks’ ability to leverage their collective insolvency to charge higher rates on nonfinacial firms without complaint.

The oddest duck in the credit indicator menagerie is the LIBOR-OIS spread. That’s a measure of the difference between what banks claim they have to pay to borrow from one another and what the market actually expects they would pay, if they adopted a strategy of borrowing overnight from, err, one another in the Federal Funds market. Both legs of the LIBOR-OIS spread represent unsecured interbank lending, so it’s not obvious how this measure captures counterparty risk. It does, to a degree, because counterparties of a bank rolling overnight loans can choose not to renew the credit, should bad news strike, while a bank that extended a term loan at 1-month or 3-month LIBOR can do nothing but watch the fall. In a sense, LIBOR-OIS can be viewed as the price of an option to call a loan, to the degree that LIBOR accurately reflects the cost of interbank term financing.

But since US banks can borrow from the Fed’s discount window at the Federal Funds rate + 25 basis points, while adjustable rate loans from banks are often indexed to LIBOR, a simpler way to think of the LIBOR-OIS spread is as a measure of the difference between the cost to banks of central bank money and rate they charge on private loans. Put this way, it is hard to understand why banks are upset that this indicator is elevated.

If this seems overly cynical, it’s worth considering what happened to a LIBOR predecessor, the Prime Rate during the last US banking crisis.

The Bernanke conundrum

Why did Ben Bernanke, widely respected among economists as both a scholar and gentleman, support a rescue plan that very few of his colleagues considered “first-best” or even “second-best”? While there was no firm consensus among economists about precisely what ought to have been done, a plan based on no-strings-attached purchases of difficult-to-value assets by taxpayers was particularly surprising. Here’s Greg Mankiw being politely puzzled. Paul Davidson quotes correspondence with Chris Carroll, in which the Hopkins economist admits he wants to

spur Bernanke to try to provide his own views… My suspicion …is that he [Bernanke] thinks buying the toxic assets is a bad idea …. I think Bernanke believed all along that a recapitalization was the only effective thing that could be done, but he could not persuade Paulson of that.

Cynics can easily find reasons for Secretary Paulson to have favored the original TARP proposal. But why did Dr. Bernanke play along?

Here’s a possibility: Sometime in the middle of September, the Fed hit its balance sheet constraint. Dr. Bernanke could not have provided liquidity on the scale he thought necessary to support the financial system without injecting unsterilized new cash into the banking system and potentially sparking inflation or a run on the dollar. At that moment, the U.S. Federal Reserve lost its independence entirely. In order to pursue the policy its technocrats thought best, it required large-scale funding from the US Treasury. Dr. Bernanke had to negotiate with Secretary Paulson, whose nickname “The Hammer” is not a tribute to his love of carpentry. A deal was struck, and the Supplementary Financing Program was born.

Undoubtedly, inside both the Fed and the Treasury, a variety of options were considered on how to intervene as credit conditions continued to deteriorate. Perhaps the Treasury settled upon the TARP approach, while the Fed might have preferred something different. Perhaps the Fed had to give a little to get a little. Perhaps that’s why the Paulson Plan emerged as what Greg Mankiw terms the “new Washington consensus”.

The Fed has now regained some of its independence. The “stabilization act” included a clause that gives the Fed authority to pay interest on bank deposits, which permits the central bank to partially sterilize cash injections without having to sell securities from its much depleted portfolio.

But in mid-September, events were spiraling, and the Fed was cornered. Even a gentleman and a scholar might have decided that acceding to a proposal that could do little immediate harm and might do some good was better than having his hands tied and watching the banking collapse he was born to prevent unfold before his tired eyes.

Update History:
  • 11-Oct-2008, 11:15 p.m. EDT: Added a missing “his” to the concluding sentence.