by Tim Langeman 2233 words (17 min read)
Before the coronavirus, a false narrative arose that the economy was healthy, as measured by:
- growth in the stock market and a
- reduction in the unemployment rate ..
when in fact this facade was only made possible with an increasing mountain of debt and low interest rates.
But there is more to the economy than the stock market and unemployment rate. The bond market is larger and “smarter” than the stock market. When assessing the pre-coronavirus economy, one must also take into account the stagnant profits1 corporations disguised by borrowing in the bond market to fund purchases of their own stock, artificially inflating the stock market.
Like an Injured Athlete taking Pain Killers
The US economy was like a professional football player who had been “playing hurt” for many years.
The economy used debt, like the football player uses pain killers. The debt masks the economy’s problems2 and allows it to perform at a higher level than otherwise would have been possible had pain-killers not dampened the brain’s ability to perceive reality. But unfortunately an economy is not like an athlete in that it can’t retire at the end of a 15-year career.
Featuring: The Seven Dwarfs
The story I’m about to tell is intended to illustrate how corporations borrowed money and then used that money to buy their own stock, inflating the stock price.3 In finance jargon this is called “leveraged stock buybacks”.4 Corporations have used stock buybacks as a major strategy to boost their share price but many corporations didn’t have enough profits to buy back their stock because the overall level of (pre-tax) corporate profits has been flat since 2012.5. While some companies may have been able to legitimately afford to buy their own stock with real profits, over 50% of those buybacks were done using borrowed money.
In fact, if you look at who had been the buyer of most of the stock purchases in 2018 and 2019, it had mostly been the companies themselves purchasing their own stocks, not pension funds, individuals, or hedge funds.
I illustrate how this market manipulation works using a fairy tale featuring the seven dwarfs and their mining company “7 Dwarfs Mining, Inc.” Early in the story the dwarfs seemed to have discovered a easy way of making money until an unforeseen emergency struck and disrupted their carefully laid plans.
It is commonly known that emergencies reveal.
This story illustrates what emergencies can conceal.
The Founding Members:
- Sleepy, and
Assets # of Shares Yearly Profit Profit per Share Debt $7 million 7 $700,000 $100,000 $0
Going Into Debt to Hide Flat Growth
One year, Grumpy decided he was unhappy in the mining business. Perhaps this was due to his sour attitude, or perhaps he was feeling blue because the mine’s profits had not increased at all in the previous 6 years.9 Grumpy decided to sell his share in the mining company, but there were not a lot of other dwarfs that wanted to buy out his stake at the price of $1 million.
The other 6 dwarfs in the company wanted to continue in the business but they didn’t have the cash to buy out Grumpy, so they decided to borrow the $1 million from the bond market. Interest rates were low in the Forest Kingdom because the economy hadn’t fully recovered from the previous debt-fueled financial crisis a dozen years prior.10 The kingdom’s treasury secretary’s belief that low-interest rates stimulate growth was also a factor in setting the interest-rate climate.11 This easy lending environment allowed the dwarfs to succeed in borrowing $1 million at an interest rate of 3% per year.
The Dwarfs’ Epiphany: Earnings per Share
After Grumpy exited the company, the 6 remaining dwarfs renamed their business: “6 Dwarfs Mining, Inc“. The total value of the company (market cap)12 was still $7 million and they split the same $700,000 profit six ways instead of seven. This resulted in profits of $116,666/share, a 16.7% increase over the prior year. Grumpy sulked for the next year and a half about missing out on the share price increase his exit had created, but Dopey reminded him that it was his own idea to leave. 🙁
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 m $0 Post-Grumpy Exit $7 m 7/6 $700,000 $116,667 13 16.7% $6 m $1 m
Upon learning of this increase in EPS (Earnings Per Share), the 6 remaining dwarfs were elated! By taking on debt to buy out Grumpy’s stake, they managed to reduce their number of shares, thereby achieving their first share price increase in 6 years! Things were looking up! **
** “Earnings per Share” were up even though the Dwarf’s equity in the company was down.14
Setting Dopey’s Debt Plan in Motion
Bashful was known to wear his heart on his sleeve, especially if he had romantic feelings for someone.15 So the next year, after Bashful’s most recent crush departed the village, Dopey encouraged a lovestruck Bashful to retire from the company and follow his sweetheart to the neighboring Mountain Kingdom to the North. Dopey wanted to reduce that number of shareholders in the mining company because he had learned the benefits of having fewer shareholders from Grumpy’s exit, even if that comes at the expense of having more debt. He calculated that splitting $7 million five ways would result in a share price of $1.4 million per share. This would be a 40% increase over the original $1 million share price, although the company’s profit was still the same $700,000 per year. Once again, the dwarfs went to the bond market and used borrowed money — an additional $1 million dollars — to buy out one of their fellow dwarf’s share.
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 m $0 Post-Grumpy Exit $7 m 7/6 $700,000 $116,667 16.7% $6 m $1 m Post-Bashful Exit $7 m 7/5 $700,000 $140,000 16 40% $5 m $2 m
After the successful payoff, Dopey said to Doc: “Wow, this debt thing is really an easy win. A few years ago we were struggling with plans to make efficiency improvements to the mines but that would have required us to invest some of our profits into new machinery, research and development, and employee training. Instead, I only needed to identify the key to Bashful’s heart and use some accounting wizardry17 to increase our share price the “easy way” — with more debt.”
Following the Plan
Dopey had a reputation for harebrained plans, but he knew that Sleepy’s drowsiness was no reason to doubt his intelligence or acumen.18 Dopey concluded that the two things that would most motivate Sleepy to sell his share were the attraction of sleeping in until noon and a bonus of $100,000, so he struck up a conversation with Sleepy on these two themes when the two had a private moment together. The next year, Sleepy was enjoying a restful retirement in the tropics and the mining company had one fewer shareholder.
The pattern continued again the following year with Happy given a $150,000 bonus contingent on his retirement, causing the share price to rise to $2,333,333 (a 133% increase). All the remaining dwarfs were extremely happy at this turn of events, as was Happy himself. 🙂 Dopey took out a loan to buy a red Ferrari with the vanity license plate “Debt King” in anticipation of his upcoming buyout. Yet, at the same time, the company’s total profit remained the same $700,000 per year it had been originally before Grumpy exited.19
Exit Market Cap Leverage Ratio Yearly Profit Profit per Share % Profit Increase
Equity Debt Original 7 Dwarfs $7 m 7/7 $700,000 $100,000 – $7 $0 m Post-Grump Exit $7 m 7/6 $700,000 $116,667 16.7% $6 m $1 m Post-Bashful Exit $7 m 7/5 $700,000 $140,000 40% $5 m $2 m Post-Sleepy Exit $7 m 7/4 $700,000 $175,000 75% $4 m $3 m Post-Happy Exit $7 m 7/3 $700,000 $233,333 20 133% $3 m $4 m
(Note: These figures are simplified. They do not include reinvesting profits or interest charges on the debt.)
A Declining Credit Rating
One of the unnoticed consequences of Dopey’s plan was that the mining company’s credit rating began to deteriorate as the company borrowed money in the bond market. The company was effectively agreeing to devote some of its future revenue (i.e. paying interest on the additional debt in the future) in exchange for a higher earnings per share today. Before Grumpy exited, the company had a AAA credit rating, but as Bashful, Sleepy, and Happy’s shares were bought out, the company’s credit rating fell to AA, then A and now stood at BBB, the lowest investment grade.21
Dopey was warned that if the company was assessed another credit downgrade the company would fall to a non-investment grade status (often referred to as “junk” bond status22). Were that to happen, pension funds and many investors would no longer be legally permitted to own the company’s debt and the interest rate the dwarfs would have to pay would spike higher. Dopey calculated that there was a higher risk to the company’s finances in the coming years, but he figured that would be Doc and Sneezy’s problem, not his, because he, Dopey, planned to be the next dwarf to exit. After Dopey left the company his financial interests would be separate from the mining company and he would not longer care if the company should happen to suffer losses.
The number of shares now stood at 3, with Dopey, Doc, and Sneezy remaining, when something unforeseen happened — a sickness called Rapidico took hold in the neighboring kingdom of Achin. As the illness reached the cities of the Dwarfs’ Forest Kingdom the advisors to the kindom’s Queen — Queen Elizabeth II’s23 privy council24 — recommended that the kingdom go into lockdown to prevent the spread of the disease.
A lockdown seemed like a radical idea, and one that the queen deferred to individual provinces.25 As other provinces of the kingdom went into lockdown, Dopey, Sneezy, and Doc were dismissive and continued business as usual at 3 Dwarfs Mining, Inc.
A month and a half later, an outbreak of Rapidico took place at 3 Dwarfs Mining, Inc., set off by an asymptomatic Sneezy. Dopey later recalled, “Sneezy is always sneezing; I didn’t think nothing of it.” But the tight quarters of the mine proved to be fertile ground for the contagion to spread and many mine workers were infected. True to his name, Doc threw himself into the job of treating the afflicted dwarfs and heroically saved countless lives, but the mine’s production ground to a halt nonetheless. Other businesses were similarly affected and the queen was forced to move beyond her earlier deference to provincial autonomy and call for a strict quarantine.26
The Divided Kingdom
Because the Forest Kingdom was so fractious and the forest creatures so impatient, financially vulnerable, and headstrong, not all parts of the kingdom followed the queen’s orders closely. This disunity among the provinces resulted in stubborn pockets of disease in the lagging parts of the kingdom which hampered the economic recovery.27
The length of the quarantine caused heavy losses to the 3 Dwarfs Mining, Inc., requiring them to borrow more money. Of the original $7 million that the company had started with, the 3 Dwarfs Mining Inc had only $3,638,841 equity left ($9,846,549 assets – 6,207,708 debt)28 because they had borrowed in the bond market to buy out the shares of Grumpy, Bashful, Sleepy, and Happy, resulting in a debt of $6,207,708.29
The Risk and Reward of a High Leverage Ratio
Companies can choose how much risk they want to take to accelerate growth (Risk vs Reward). The use of debt is a key contributor to the speed at which a company can grow but it also increases the risk that the company will falter should an unforeseen risk arise.
In this particular case, the leverage ratio30 I’m comparing is the ratio of market cap31 to debt. Notice how the Leverage ratio increases as the number of shares (or equity) decrease. Reducing the equity, in this case, increases the leverage ratio (7/2 = 3.5), which increases the profit per share.
Notice how the profit per share increases as the leverage ratio increases.
Exit Market Cap Leverage Ratio Leverage Profit per Share Original 7 Dwarfs $7 million 7/7 1.0 $100,000 Post-Grump Exit $7 million 7/6 1.17 $116,667 Post-Bashful Exit $7 million 7/5 1.4 $140,000 Post-Sleepy Exit $7 million 7/4 1.75 $175,000 Post-Happy Exit $7 million 7/3 2.33 $233,333 Planned Dopey Exit $7 million 7/2 3.532 $350,000
Note: This chart has been simplified33
When Dopey planned to exit, the share price would have risen from $1 million to $3.5 million on the leverage ratio alone. A more complex calculation that reinvests profits each year would have the original $1 million share price to rise to $4,923,274, not including a bonus of $200,000, which would leave Dopey with a total exit package of $5.1 million dollars!34
When things are going well, leverage has the effect of multiplying a company’s earnings per share by the leverage ratio. But when an unforeseen tragedy hits, it leaves companies with less of a cushion to ride out a storm.
The “Debt Bomb” Goes Undiscovered
There had been a concern before the Rapidico virus hit, that a large number of Forest Kingdom companies had also been following Dopey-like plans to increase their share price the easy way — through financialization — that is “financial engineering” that inflates share price but does nothing to improve labor productivity. In the 7 Dwarfs Mining Company, profit growth is assumed to be zero, but EPS (earnings per share) still goes up anyway because the number of shares goes down. The shareholders retain ownership in the company, but often with higher levels of debt.
Resetting the “Debt Bomb”
The result is a potential “debt bomb”35 36 where a buildup of debt can threaten the whole economy. The companies contributing to this “debt bomb” report share price growth, but this “growth” is artificial because total profits are flat and earnings per share growth is only made possible by taking on more debt. When the debt bomb explodes (or pops like a bubble) it threatens to spill over into the broader economy, threatening the whole country, not just the borrowers. 37
The Rapidico crisis had given the government the opportunity to blame some of the kingdom’s problems, which had been years in the making, on the Rapidico virus and the country of Achin, even though a significant part of the financial problems were the fault of the kingdom’s systemic dysfunction. Had the kingdom not already experienced a financial crisis a dozen years prior, and had there not been such low interest rates, the Dwarfs would not have taken on so much debt, leaving their mining company financially vulnerable in a time of crisis. Had the Rapidico crisis not happened, such debt dysfunction was bound to lead to another recession anyway and leave the kingdom to grapple with questions about the authenticity of the prior decade’s growth.
Debt for Productive Purposes?
When some of the queen’s more intellectually self-critical advisors speculated that it would have been better had the Forest Kingdom’s companies invested the money they borrowed into productive assets rather than share buybacks, others replied that too few workers could afford to buy38 what the companies would have produced.3940
Sweeping it Under the Rug?
A lone advisor commented that the prior 6-8 years of flat profits41 during supposed “good times” boded poorly for future growth prospects. “When was the last time we’ve generated substantial growth without a lot of debt and the creation of another artificial bubble?”, said the deputy finance minister. Many advisors agreed with her, but were hesitant to break the bad news to the public. Nevertheless, all agreed that the queen’s legacy depended upon her taking steps to prevent such a debt bomb from re-emerging and requiring yet another bailout. You might be able to afford this bailout, but we haven’t done anything to pay down the debt from the previous financial crisis and we certainly can’t afford to make bailouts the norm. Next time, her advisors said, you won’t have the Rapidico virus to blame for the bailout and you won’t be able to sweep all that debt under the rug.
Will the Dopey Financial Plans Stay Concealed?
“I know we’ve got to face our problems,” said the queen,42 but a financial crisis is no time to address deep weaknesses within the economy. Calling attention to the country’s debt dysfunction will only erode consumer confidence when we need it most. Besides, many of the Debt-Dopies are particularly crafty and hire former members of parliament as their lobbyists! Another bailout is inevitable. It is better for me to let the “Debt Dopies” 43 remain concealed by the wider bailout for now, encourage optimism about the economy’s revival, and let someone else deal with the problem later.”
To repeat my opening statement:
It is commonly known that emergencies reveal.
This story illustrates what emergencies can conceal.
by Tim Langeman
Perhaps you have ideas on how this story could be improved. I welcome your suggestions.
I also welcome suggestions about who you think would be interested reading about and collaborating on this issue.
This is a very simplified example of financialization involving only debt and share buybacks at large corporations. More complicated cases can involve some profit growth, executive compensation, and cost-cutting. This story is not about small businesses. It has been simplified to a case of only 7 shareholders for illustrative purposes.
- Had you heard how much many USA large corporations’ credit ratings declined in the years before the coronavirus crisis started in early 2020 and that much of their debt was rated just above “junk” status at that time?44 45 NPR’s Planet Money has an accessible and entertaining story on why Credit ratings declined. It was this 9-minute podcast story which inspired me to do the research for this piece.
- Did you know that most of the stock purchases made before the crisis were NOT made by pensions, individuals, foreign investors, or hedge funds, but by the companies themselves?
- Did you know that over half of companies’ stock buybacks were funded with debt?
- Why do you think many large corporations chose to borrow money to buy back their stock rather than invest it for productive purposes between 2012 and 2020? Here’s some possibilities to start with:
- Too much regulation to make investment profitable?
- Taxes too high?
- Too much political uncertainty?
- Customers already have what they need?
- Customers too maxed out to afford to buy more?
- The company has a mature market position- there is little room to grow. Better to draw down on the company’s credit rating (“mortgage the company”) and redirect the money to other companies with better opportunities?
- Executives don’t want to take a risk on long-term innovation and growth when low-interest rates make significant short-term debt-driven share price increase a low-risk choice?
- Perverse incentives reward executives for hitting bonus targets in any way they choose, even if their choices are contrary to the long-term interests of the company?
- How would you feel if it turns out that, contrary to conventional wisdom, corporate profits (before taxes) had been flat from roughly 2012 – 2020 and stock prices were inflated with debt?4647
- What other political or economic things are being revealed or concealed by the coronavirus?
- Financialization is profit margin growth without labor productivity growth. (by Ben Hunt)
- Texas Instruments: a poster child for financialization, the Obama/Trump Zeitgeist: an unparalleled transfer of wealth to the managerial class (by Ben Hunt)
- 9 Questions about the Finance System: Was the Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020) (by Tim Langeman)
See Linked Spreadsheet for Details of Dopey’s Financial Plan.
(Improve my numbers: download Excel version, tweak and Email me.)
Social Capital CEO Chamath Palihapitiya’s case against stock buybacks, dividends
More that is Concealed:
Federal Reserve enters new territory with support for risky debt
Programme to support ‘junk’ bonds aims to soften blows from coronavirus and downgrades
.. The Federal Reserve has jolted credit markets by expanding the scope of its support measures, announcing plans to buy debt issued by riskier companies in a radical addition to its crisis-fighting toolkit.
.. Under the programme, the central bank will buy corporate bonds that were rated triple B minus or above — the threshold for a company’s debt to be considered investment-grade — on March 22. That still includes bonds from recently downgraded companies such as Ford, known as “fallen angels” when they lose their coveted investment-grade ratings.
Read More: Financial Times (British)
Obscure Section of CARES Act Provides $195 billion for Wealthy
.. the $2.2 trillion CARES Act passed by Congress last month contains deep within its 800 pages two barely-noticeable tax clauses that only benefit rich Americans, perhaps including the president.
.. The astronomical cost only became evident a day after CARES was signed into law, when the nonpartisan congressional Joint Committee on Taxation (JCT) published an analysis of the provisions. The committee’s latest findings show that four of five millionaires will pocket an average of $1.6 million more this year alone thanks to the stimulus bill. This of course dwarfs the $1,200 one-time checks average Americans will receive.
In total the tax clauses will cost taxpayers more than the funding allotted in the CARES Act to all hospitals throughout the US, and more than the relief provided to all state and local governments, according to the JCT analysis. Together, they are the costliest elements of the relief package.
Read More: Quartz
Echoes of 2008: They Mistook leverage for genius
Steve Eisman (of Michael Lewis’s book and Movie “The Big Short“)
Steve Eisman: Quantitative Easing was a failure: it didn’t get corporations to borrow and invest. Rather, they borrowed and bought up their own stock. They didn’t really invest in the economy.
In other words, they increased their profits by increasing their debt (leverage) ratio.
(the interview is from 2017)
People “levered themselves” (ie took out loans that increased their debt-equity ratio)
Steve Eisman: They made money because they increased their leverage (debt ratio) and they mistook their leverage for genius (12:19)
This work is licensed under a Creative Commons Attribution 4.0 International License.
(Most images created by others)
You might wonder why this Federal Reserve chart looks different than upward sloping graphs you are used to. The first reason is because this graph uses pre-tax figures that do not include the boost that corporate tax cuts gave to the stock market. The other reason is that this graph is based upon total profits, rather than earnings per share. In the rest of this article you will learn how corporate debt artificially inflated earnings per share .↩
The fallout from of the prior 2008 financial crisis was not delt with. The government bailed out the system and assumed the debt. Most Americans’ wages had stagnated and healthcare and education expenses have gone up dramatically. In order to compensate for week customer demand, companies had begun to borrow money and buy back their own stock. Even with a deficit of $1 trillion/year, pre-coronavirus, the economy grew at a rate of 2.1% and was projected to fall to 1.6% in by 2024.↩
Now with the coronavirus crisis, the federal reserve is buying some of that debt, as well as allowing corporations to issue additional debt at artificial prices.↩
Pre-tax Corporate profits peaked in 2014 and have been roughly flat since 2012. The perception of growth is mostly due to the additional debt (share buybacks) and the 2017 tax cuts (federal government debt).↩
The value of all the stock is equal to the value of all the company’s assets minus its liabilities.
( total stock shares = number of shares x share price) ↩
I picked round numbers for this. If you want to help me improve the numbers, see the excel doc in the footer and edit it.↩
In Place of the Finances of the 7 Dwarfs Mining, Inc., I’ve inserted a Graph above referring to US Corporate Profits before Taxes, as reported by the St. Louis Federal Reserve. Read more about the chart and about “Financial Engineering” that turns this flat graph into a growing one. ↩
While the level of consumer debt was reduced, corporate and government debt went up.↩
How different would rates have been if the government had not pushed for a late-cycle stimulus and not resisted advice to raise interest rates?↩
7/6 = 1.67↩
“Equity” is the what the shareholders own after all the bills (including debt) have been paid. It is the value of assets minus liabilities. The additional debt they took on to buy out Grumpy’s share is a liability.↩
Disney Fandom: “Aside from his coyness, Bashful also appears to be romantic. He adores the idea of true love, and when Snow White decides to share a story with the dwarfs, Bashful joyfully suggests a love story, which she obliges to.”↩
7/5 = 1.40↩
Investopedia.com: financial engineering is the use of mathematical techniques to solve financial problems. .. Although financial engineering has revolutionized the financial markets, it played a role in the 2008 financial crisis. As the number of defaults on subprime mortgage payments increased, more credit events were triggered. Credit Default Swap (CDS) issuers, that is banks, could not make the payments on these swaps since the defaults were happening almost at the same time. ↩
Disney Fandom: “However, in spite of spending most of his time nearly falling asleep, Sleepy is apparently the most observant and logical of the seven dwarfs, whether he knows it or not. He was the only dwarf to make the assumption that the Evil Queen may be attacking Snow White at the cottage when the forest animals frantically interrupted the dwarfs’ mine work.”↩
This is a simplified version of the finances that doesn’t include interest or profit reinvestment. I was concerned that adding them at this point would take away from the broader point.↩
7/3 = 2.33↩
Prior to the coronavirus, roughly half of all corporate debt was rated BBB , which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.↩
“Junk” bonds are often referred to as “high yield” bonds. “High yield” sounds nicer and it accurately conveys that these bonds have a higher yield (or interest rate) as compensation for the extra risk the lender takes.↩
I am deliberately using the British System as a way to distance the reader from drawing favorable or unfavorable inferences onto current American officials. This story is really about the dwarfs (and especially large corporate businesses) and the way they relied on debt to raise their share price.↩
The Privy Council of the Forest Kingdom is a formal body of advisers to the Sovereign. Its membership mainly comprises senior politicians who are current or former members of either the House of Commons or the House of Lords. ↩
Provinces are like states in the American context. The head of a province is the Premier.↩
Yes, I know in the British system the Queen would leave this governance to the prime minister but I figure an audience of Americans don’t understand the British system and this version is simpler to explain while taking the spotlight off of particular American politicians.↩
In some parts of the kingdom the quarantine was applied multiple times to respond to re-occurrences.↩
“Equity” denotes how much their company is worth — how much remains for the shareholders after everyone else is paid.↩
One might think the debt would be (4 x $1 million)= $4 million. But the actual cost of buying out each share increased as the share price increase: $1 million + $1.28 million + $1.67 million + $2.35 million + bonuses. ↩
For simplicity, I’m using a leverage ratio which uses marketcap/debt. A more common ratio is debt/equity.↩
value of all shares, which is the share price multiplie by the number of shares↩
Leverage = 7/2 = 3.5↩
- I’m assuming a constant total profit of $7 million to simplify this example
- I’m not including reinvesting profits or deducting interest paid on the debt
See spreadsheet at the bottom of this page↩
A debt bomb is a situation where a default on a large accumulation of debt can produce major negative consequences not only for the borrower but for many other market participants. That is to say, other people’s debts can harm you even if you were not over-indebted yourself.↩
.There is more than one type of debt bomb. Banks can become debt bombs. Countries can become debt bombs due to public debt. This is a simplified example of a small business as a metaphor for an entire country.↩
Low-interest rates make it easier to have more debt and to create “debt bombs”.↩
40% of Americans can not afford a $400 emergency. Why should companies invest in increased capacity when consumers’ wages have been stagnant for decades and therefore can’t afford to purchase more products and services? ↩
One can argue that share buybacks are a good way for established companies with limited opportunities to redirect money to shareholders, but does this also apply when companies don’t have the cash but decide to take on extra debt for this purpose?↩
I’ve heard that leveraged stock buybacks can be thought of as “refinancing,” but refinancing only changes the interest rate of existing debt. These seem more like talking on additional debt for the purpose of converting equity to debt. The average homeowner can think of this like taking out a second or third mortgage on a house. You’re taking on more debt. If the debt doesn’t have a productive purpose it is likely to be problematic. ↩
My goal is to focus on the debt and the circumstances why it was incurred, rather than to focus on Trump (in the American context) or any particular politician, which is why I cast Queen Elizabeth II in the role of queen.↩
When I talk about large corporations, I’m not talking about small businesses of less than 1,000 employees. The 7 Dwarfs were used as an illustration to make the situation easier to understand, but I don’t mean to include small businesses in this analysis at all.↩
Roughly half of all corporate debt is rated BBB, which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.↩
Another factor that contributed to corporate share price growth was tax cuts which were “paid for” with additional growth in the national debt.↩
I don’t know how much money David Geffen will personally get from this bill. I use his yacht as a symbol of the wealth that isolates rich people from the typical citizen and curries favor with the politicians that write, vote for, and sign the bailout packages.↩
wipe out over three years yeah speaking
of kind of bad situations we are not at
the end so we don’t have complete
clarity of the hindsight but there’s
been a lot of what I’ll just call bad
behavior in the market that led to a lot
of this so whether it’s the
over-leveraged of corporations or even
hedge funds at the key talks right at
one point a lot of the debt fueled
buybacks the CEO departure is kind of at
the top all of these things what’s your
take at this point in time right so
we’re kind of going into this situation
we’re not out of it but like how do you
view a lot of that be
right now so I got it I got an email
this morning actually from my prime
broker so hedge funds were at 99 to a
hundredth percentile of their historical
max leverage literally February 20th and
now we’re at you know the 20th to 30th
percentile historically so you know we
were probably at 7 or 8 turns of
leverage and now we’re probably down to
one and a half to two or three I think
that this next go-around you’re going to
have to realize government will have to
realize that in 2008 all they did was
allow financial institutions to pass the
buck they were able to take the leverage
off balance sheet and when you subtract
out debt as a function of GDP for many
years now we have had negative GDP so we
were not growing in the absence of
people issuing debt and most of that
debt unfortunately was not towards R&D
but it was towards things that
superficially propped up stock prices
which really only benefited a handful of
people and I do think we have to
restrain people from being able to do
that in the future I don’t think it
makes a lot of sense and I don’t think
it adds a lot of value and I think that
it’s not that it was obviously
responsible for the coronavirus but I do
think that when you look at how much
devastation we are encountering and when
we do the final tally on the amount of
buyback oh sorry the amount of bailouts
we need the bailouts are directly
correlated to how stupidly run and badly
run these companies were you know why is
it that California is legally mandated
and you’ll say oh because it’s a
nonprofit but legally mandated to have a
rainy day fund but a company isn’t and
then the company is the first one to
knock on the door of the government and
we’re just waiting for the next shoe to
drop or California Mississippi Alabama
Louisiana to all do the same thing and I
would much rather see the money go to
the states and the cities in an in an
then the money go to a private company I
think that those private companies
should be wiped out the equity should be
wiped out and they should need to
restart it’s one thing I’m a hundred
percent in alignment with you on this
but the part that I don’t understand is
how do you continue to benefit from the
elements of capitalism if you take out
the risk moving forward it everyone
knows I can quote unquote take this like
fake risk and if anything goes wrong I
can just run to the government and get a
bailout you changed the dynamic of what
happens and I actually think you
incentivize even more bad behavior right
it’s almost like there was bad behavior
and then there was no punishment for it
and therefore you just encouraged that
to continue you know when we get out of
this thing well I it depends on what you
view capitalism as I think if you view
capitalism as a game of risk I think
you’re right I’ve always viewed
capitalism as money becomes a fulcrum
instrument for change what do you want
to see in the world okay
money is your lubricant you decide and
the person with more money or the person
who’s willing to put more money into
something and who can be more clever
basically has the opportunity to win so
I I think it’s a game that puts
ingenuity and money at the forefront
that’s what to me that’s what capitalism
is and so when companies are doing
things that are fundamentally not
advancing that forward they should
disqualify themselves from them being
able to run to the government so it
would be a different thing entirely if
all the airlines had invested let’s just
say 96% of free cash flow dollars on
supersonic flight failed and then came
to the government and said look I took a
big bet on the future to help advance
humanity it didn’t work and I need a
bailout I would be the first one to say
okay but when 96% of free cash flow
dollars go back to buying back shares
and then you basically claim the same
thing I think you should be punished and
punished financially so you know you you
you took the money that you had you
refused it you refused to multiply it by
a good smart bet on the future and I
think that there should be consequences
yeah I don’t disagree with you at all
last question for you
been incredible kind with your time here
if you were the president over the next
what’s your playbook so president Shamus
got full control can do whatever was it
within the presidential powers what’s
your playbook to kind of weather the
storm and get us out of this
I would first stand up every single
voting site that we would use in the
and I would schedule every single man
woman and child to come through all of
those testing facilities and I would
basically deploy a rapid test to figure
out whether they had coronavirus in that
moment okay and families could come you
know 10 minutes apart so that you could
get back into your car and go etc etc in
step number one if you didn’t have
Corona so you weren’t shedding the RNA
in that moment you go to a second and
you get administered a finger prick
and you get tested for the antibodies
and within 15 or 20 minutes and you’re
held in an isolation
you know booth area where you you know
you’re on Instagram and when you’re done
you’re given a wristband and that
wristband basically says one of three
things well if you had tested positive
you get a red band you go home and you
isolate if you test negative and you
have the antibodies you get a green one
and if you test negative and you how
don’t have the antibodies maybe you get
a blue one green and blue are allowed to
go back to work right away red self
isolates you contact trace etcetera etc
that’s sort of the frontline of getting
the economy back to work and you have
some combination of the National Guard
and sort of like a whole infrastructure
then separately I think you introduced a
massive massive massive infrastructure
bill that starts to drive the
of the supply chain back in
to the United States and part of that is
incentives and part of that is
government spending and it has to cut
across many categories from you know
semiconductors in silicon all the way to
clean energy to actual physical
infrastructure like you know bridges and
and tunnels and roads and in that what I
think you’re mandating is a certain
percentage of things to be made
domestically in the United States and
you start to get people back to work so
the short term path I think is to kind
of baseline the disease and get the
people who are allowed to be working
back into a green zone of every city
every town where people with these green
and blue bands are allowed inside and
the red banded people have to stay and
quarantine themselves so that we can
start to restart this economy and then
longer-term is an infrastructure build
that basically resets incentives towards
resiliency towards inefficiency away
from efficiency I think that’s a pretty
solid plan I’m shot I’m actually shocked
that some of this hasn’t been instituted
already the lack of testing just blows
my mind I mean the stats I saw on
Saturday 895 thousand people I think
I’ve been tested at a 330 million in the
United States I think the other
reckoning that we have to do maybe just
to finish on this is that we’ve
politicized things that should never
have been politicized health should not
be politicized you know the problem is
that starting with Obamacare health
became something that was about the
Democrats versus the Republicans and you
can see how that’s sort of like you know
flowed into things like the FDA and the
CDC and history will tell what they
could have done better history will tell
what the w-h-o should have done
but I think what we can see is that
there are many points along the
evolution of this disease where logic
and open-mindedness and iteration ran
into bureaucracy and bureaucracy one and
I think that’s probably the most
generous way of describing it and we
need to figure out
where there are almost constitutional
level provisions you know you have the
right to bear arms great what about the
right to basically not you know not die
in a preventable scenario what does that
mean for how these organizations should
run you know we at a very basic level
have told the healthcare infrastructure
that we must do no harm and I think it’s
time to say look with 8 billion people
in the world and a 90 trillion dollar
economy that supports those eight eight
eight billion people do no harm doesn’t
work anymore it doesn’t scale we need to
do our best and there’s a lot of rules
that could change in a scenario where
you embrace do your best and I think
that that that has to happen but the
failures of the political infrastructure
and the healthcare infrastructure to use
bureaucracy as the thing that that
drives decision making I think is also
the a domino that has to fall after this
and we need to revisit because it’s a
you know we’ve we’ve done a lot of
unnecessary damage to ourselves and some
of this some of these self-inflicted
injuries we should figure out how to
prevent for the next time because it’s
gonna come again yeah I think we’re
living in incredibly uncertain in
chaotic times and you know one just
thank you for your time today but uh too
is uh think I speak for a lot of people
in that we’d love to see you go public
and kind of be along for the journey so
you’re doing an incredible job and I
just appreciate you uh
kind of going out there and sticking
your neck out there frankly because a
lot of people who they they’re gonna all
be the armchair quarterbacks right okay
two three years from now like I said I
told you that we should have done X or Y
but right now they’re they’re kind of
quiet so we’ll see how it plays out well
I really appreciate the fact that you
had me on and I just want to say that I
think you’ve been a really good person
in being out there in this moment the
reality is like in moments like this you
need people to be coalescing opinions
and I think that you’ve done that that’s
a really important service because it
allows people to get to ground truth so
I just want to say thank you for doing
thanks for including me
no problem at all all right sir well
thank you a teacher
all the best talk to you soon right bye
An orgy of borrowing, speculation and euphoria has left the markets on the verge of catastrophe
Financial markets have experienced the fastest ever crash over the past few weeks. Even during the dotcom bust and the Lehman crisis, stocks did not fall this quickly. In less than a month, we have seen major indices fall almost 30%, and stocks in sectors such as oil and travel down by 80%. We are experiencing terrifying daily declines not seen since the 1929 stock market crash that preceded the Great Depression.
We are at a watershed moment: the coronavirus Covid-19 is a catalyst fast bringing many long simmering problems to the boil. It is exposing the creaking financial systems around us and it will change the way economies function. Economic and financial pundits, however, have been focusing almost exclusively on the short-term effects of coronavirus and so are missing the much bigger themes at play.
Epidemiologists tell us that when it comes to the virus, we are looking at a once in a century event. It is highly contagious and highly lethal. Experts are not comparing Covid-19 to SARS or Swine Flu, but to the Spanish influenza of 1918 that killed between 50 and 100 million people worldwide.
We do not have good data on what the stock market did during the 1918 flu, but we do know that it led to a severe recession. The connection between influenza and recessions is well documented. Going as far back as the Russian flu in 1889-90, the Spanish flu in 1918, the Asian flu in 1957-58 and the Hong Kong flu of 1968-69 — they all led to recessions. This one will be no different.
But this recession will not only be driven by the economic loss of able-bodied workers, it will be helped along too by the steps political leaders take to avoid the spread of the coronavirus. In medicine, the immune system’s response can often be worse than the disease. When the body goes into septic shock, the immune system overreacts, releasing what doctors refer to as a cytokine flood, which can reduce blood to vital organs and lead to death. Sepsis is common and kills more than 10 million people a year. Today, the political reaction to Covid-19 is causing something akin to a septic shock to the global economy.
The recession is likely to be very sharp and but brief. Recessions are self-regulating. De-stocking of shelves and warehouses leads to re-stocking. Collapsing low interest rates and oil prices eventually spur spending and borrowing. Government spending and central bank easing eventually feed through to the real economy. While there will be massive panic and bankruptcies today, there is little doubt that markets will be better in a year, and certainly will be in two to three years,
But the structural changes to how our economy operates, however, will be felt for decades to come. And this is in large part because we didn’t learn the lessons of the last crash.
Over the years since the 2008 crisis, central banks have been trying to stamp out every single small fire that flares up (the European crisis in 2011-12, the Chinese slowdown in 2015-16, the slowdown last year); but suppressing volatility and risk only creates bigger fires. Risk is like energy and cannot be destroyed. It can only be transformed.
Forest fires are a useful analogy. California has infrequent, devastating forest fires; the Mexican state of Baja California has many small frequent fires and almost no major catastrophic fires. Both states have a similar climate and vegetation, yet they have vastly different outcomes. That’s because when there are very few small fires, underbrush grows, vegetation increases and creates greater kindling for the next fire. Suppressing small risks only makes them emerge eventually as very big ones.
In politics and economics, massive change events tend to happen not in orderly sequences, but in sudden spasms, like the Arab Spring, or the collapse of the Eastern Bloc. Watching events unfold is often like watching sand grains pile slowly on top of one another until a final, random grain causes the entire pile to collapse. People knew the Arab countries were fragile and that the Eastern Bloc might eventually fall, but predicting which grain of sand would do it precipitate either was impossible.
Physicists call these transitions critical thresholds. Critical thresholds are everywhere in nature. Water at moderate temperatures is disorganised and free-flowing, yet at a given critical value, it has an abrupt transition to a solid. It’s the same with the sandpile: one grain too many can trigger collapse — but which one?
In 1987 Per Bak, Chao Tang, and Kurt Wiesenfeld found that while sandpiles may be individually unpredictable, they all behave the same way. The critical finding of their experiments was that the distribution of sand avalanches obeys a mathematical power law: The frequency of avalanches is inversely proportional to their size. Much like forest fires, the less frequent they are, the more catastrophic they are.
It’s the same with financial markets and the economy. We will experience years of quiet, interrupted by sudden avalanche. Years of slowly adding grains of sand can end abruptly — to our great surprise. Today in financial markets, many unsustainable trends have been building, and the coronavirus is merely the grain of sand that has tipped the sandpile.
It would be controversial to say that the stock market reaction to the coronavirus would not have been very big had we not been in the middle of an orgy of borrowing, speculation and euphoria. Of course, stocks would have fallen with coronavirus headlines, but it is unlikely they would have crashed the way they did without those exacerbating factors. Furthermore, without enormous underlying imbalances of high corporate debt, the prospect of poor sales would not have driven so many stocks to the verge of collapse.
This aspect of the current crisis has so far gone unreported. But not unmentioned. A few weeks before the crash, Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s longtime business partner, issued a dire warning, “I think there are lots of troubles coming,” he said at the Los Angeles-based Daily Journal annual shareholders meeting. “There’s too much wretched excess.”
Speculative euphoria was at record highs. As Sir John Templeton once said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” Investors were all on the same side of the boat, and it capsized, as happens in market crashes.
- Investors were buying a record amount of call options, or bets on stock prices rising further. According to SentimenTrader, by early February, “We’ve never seen this level of speculation before. Not even close.”
- Asset managers were betting in record quantities on stock futures, which are instruments to bet on underlying indices. Positioning in S&P futures hit a new high as of February 11.
- Hedge fund borrowing to buy stocks was at a 24-month high. They were highly confident markets would keep rising.
It was not a coincidence that there was such euphoria. Retail brokerages had announced over the past few months that they were eliminating all commissions on trading activity. Buying and selling stocks was suddenly “free”. It was like pouring truckloads of kerosene on a blaze. At Charles Schwab, daily average trading revenue exploded 74% after the change.
In scenes reminiscent of the dotcom boom, stocks were doubling overnight. Virgin Galactic Holdings, with no revenue, was worth over $6 billion dollars. Tesla, which has never made money selling cars, had a market capitalisation greater than any other car manufacturer. Its stock price quadrupled in less than three months. The market was so stretched that it would have crashed due to its own absurdity — with or without coronavirus.
The source of this “free” trading came from high frequency trading firms that are supposed to act as market makers, executing buys and sells for clients. Except that they are not really disinterested middlemen; they are running their own trading strategies to make money off retail investors. They execute the order flow of so called mom and pop investors and profit from these “dumb money” retail traders, in the words of Reuters.
The brokerages which sell retail orders receive hundreds of millions of dollars in return from the market makers. This means that, essentially the market makers are bribing the brokerages to profit from retail traders. For example, E*Trade received $188 million for selling its customer order flow last year, while TD Ameritrade made $135 million in the fourth quarter alone. The market makers are willing to pay so much because they almost never lose money — they trade fast and know where the market is going.
As Warren Buffet once said, “As they say in poker, ‘If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.’” Retail is the patsy.
Ken Griffin is the owner of Citadel Securities the biggest market-making firm, and his business is so profitable that he has gone on one of the greatest property buying sprees of all time. In 2015 Griffin paid $60 million for multiple condo units in Miami. He paid a U.S.-record $239.96 million penthouse in New York City, a $122 million mansion in London, and over $250 million in Palm Beach properties. Market making against “dumb money” is a fabulous business.
As the mania deflated in late February, though, mom and pop were abandoned. As the crash started, market makers pulled back and provided less liquidity. Retail investors were left high and dry. It is no wonder prices fell so quickly.
The high frequency market makers have since been pleading for more capital, and rumors swirl that many are experiencing financial difficulties. The illusion of benign market makers looking after retail investors has vanished.
There are echoes here of the old problems from the Lehman crisis; but they have mutated into different forms. During the Lehman crisis, mortgage bonds were pooled together, and insurance companies and pension funds bought them. Today, retail investors have been buying popular funds known as Exchange Traded Funds (ETFs). These are easy to trade and cheap, but they have a fundamental problem. While ETFs have simple tickers like HYG, JNK, LQD that the average retail broker can trade on their screen, they are really holding hundreds of individual bonds inside of them that the investor is unaware of. These bonds are not easy to trade at a moment’s notice and are highly illiquid. But while the ETFs rose slowly and steadily, and investors poured more money in, lulled by a false sense of security.
While the ETF shares trade daily by the second, the underlying bonds are not easy to trade on their own. In the old days, insurers and pension funds bought these bonds, put them away in a drawer and never traded them. Today, though, investors expect instant liquidity from an illiquid investment. Liquidity mismatches are as old as banking itself (deposits and cash are highly liquid, while mortgages and loans are often completely illiquid); the problems of ETFs have been known all along, and the outcome has been inevitable.
As the coronavirus panic spread, the ETFs started trading at big discounts to the underlying value of the baskets of bonds. Markets are broken, and the gap is a sign of how illiquid the underlying holdings really are.
But these ETFs should never have been allowed in the first place. In the words of Christopher Wood, an investment strategist at Jefferies, “they commoditise equity and bond investing in an insidious way which ultimately creates a dangerous illusion of liquidity. True, ETFs are cheap. But so is fast food.”
While ETFs may appear technical and unrelated to the broader problems in markets, they share the same underlying problem. We have had the illusion of safety and liquidity for some time, and it is the coronavirus that has exposed the gaping holes in financial markets.
The coronavirus won’t kill companies. But it will expose their bloated, overleveraged balance sheets. Corporate debt in companies has never been higher and has now reached a record 47% of GDP.
Rather than encouraging moderation, central bankers and policy makers have been reloading the all you can eat buffet and persuading everyone to come back for third and fourth plates. The European Central Bank and the Bank of Japan have been buying corporate bonds, and central banks have kept funding at zero rates, which has encouraged a massive increase in indebtedness over the past decade.
Central bankers have long promoted high corporate leverage because they see it as a way to stimulate demand. Even now, many economists see no problems on the horizon. In the New York Times, Nicolas Veron, a senior fellow at the Peterson Institute for International Economics in Washington, was openly mocking anyone advocating prudence, “The prophets of doom who thought that more debt was more risk have generally been wrong for the last 12 years.” Like most central bankers for the past decade, he argued, “More debt has enabled more growth, and even if you have a bit more volatility, it’s still net positive for the economy.”
But while debt has encouraged growth, it has also introduced much greater financial fragility, and so the growth is fundamentally unsound. We are now finding out that less debt, rather than lower rates is better for financial stability.
The global economy has gone mad
According to FactSet, 17% of the world’s 45,000 public companies haven’t generated enough cash to cover interest costs for at least the past three years. Debt has been used to finance more debt in a Ponzi fashion. The Bank for International Settlements looked at similar economic measures globally and found that the proportion of zombie companies — companies that earn too little even to make interest payments on their debt, and survive only by issuing new debt — is now higher than 12%, up from 4% in the mid 1990s.
Entire industries are zombies. The most indebted and bankruptcy prone industry has been the shale oil industry. In the last five years, over 200 oil producers filed for bankruptcy. We will see dozens if not hundreds more bankruptcies in the coming year. They were all moribund with oil at $50 dollars; they’re now guaranteed to go bust with oil at $30.
Only now, belatedly, are groups like the IMF waking up to the scale of the problem. In a recent report they warned that central banks have encouraged companies to pursue “financial risk-taking” and gorging on debt. “Corporate leverage can also amplify shocks, as corporate deleveraging could lead to depressed investment and higher unemployment, and corporate defaults could trigger losses and curb lending by banks,” the IMF wrote.
According to the IMF, a downturn only half as bad as 2008 would put $19 trillion of debt—nearly 40% of the corporate borrowing in major countries—at risk of default. The economic consequences would be horrific.
Corporate debt has doubled in the decade since the financial crisis, non-financial companies now owe a record $9.6 trillion in the United States. Globally, companies have issued $13 trillion in bonds. Much of the debt is Chinese, and their companies will struggle to repay any of it given the lockdown and the breakdown in supply chains.
We have not even begun to see the full extent of the corporate bond market meltdown. One little discussed problem is that a large proportion of the debt is “junk”, i.e. lowly rated. An astonishing $3.6 trillion in bonds are rated “BBB”, which is only one rating above junk. These borderline bonds account for 54% of investment-grade corporate bonds, up from 30% in 2008. When recessions happen, these will be downgraded and fall into junk category. Many funds that cannot own junk bonds will become forced sellers. We will see an absolute carnage of forced selling when the downgrades happen. Again, the illusion of safety and liquidity will be exposed by the coronavirus.
The average family is encouraged to save money for a rainy day, in case they are fired, or they face hardship. Saving some money is considered prudent. It’s quite different for business. Companies pocket the profits in the good years and ask Uncle Sam to bail them out in the bad years. Heads shareholders win, tails the taxpayer loses.
Industry can’t be blamed for not expecting an act of God or force majeure, but in the past 30 years we have seen two Gulf Wars, 9/11, SARS, MERS, Swine Flu, the Great Financial Crisis, etc. Saving for a rainy day should only be expected in cyclically sensitive industries.
But rather than do that, companies have been engaging in a rather more reckless strategy: borrowing to buyback shares. This may boost their Return on Equity (ROE), but it is not remotely prudent and makes their companies highly vulnerable. Borrowing to prop up their own shares means they have less on hand when hard times come.
According to Barons, “Stock buybacks within the S&P 500 index totaled an estimated $729 billion in 2019, down from a record $806 billion in 2018.”
And then along came coronavirus.
Of those industries that are now seeking a bailout, none has saved for a rainy day. Boeing, the poster boy of financial engineering and little real engineering, bought back over $100 billion worth of stock over the past few years. Today it is asking the government for a backstop to its borrowing.
According to Bloomberg, since 2010, the big US airlines have spent 96% of their free cash flow on stock buybacks. Today, they’re asking US taxpayers for $25 billion.
Airline CEOs have been handsomely paid while not saving for a rainy day. Delta Airline’s CEO Ed Bastian made the most, earning nearly $15 million in total compensation. American CEO Doug Parker $12 million, while United CEO Oscar Munoz earned total compensation last year of $10.5 million.
Corporate buyback culture is financial engineering not value creation
The cruise liners were little different. Over the past decade, Carnival Cruises paid $9.2 billion dollars in dividends to its billionaire owners and bought back $6.7 billion of shares. Royal Caribbean, which is a smaller company, paid out $2.7 billion in dividends and $1.6 billion in buybacks. And the smallest cruise liner Norwegian Cruise Line spent $1.3 billion on share buybacks.
For years, the cruise lines have triumphally proclaimed massive dividends and buybacks. For example, Carnival proudly announced in 2018. “In just three years, we have doubled our quarterly dividend and invested $3.5 billion in Carnival stock.”
Cruise lines have no real claim to any bailout. They pay no taxes due to a legal loophole, and all their vessels fly the flags of Liberia, Panama and the Marshall Islands. Furthermore, their owners tend to be billionaires with more than enough financial wherewithal to recapitalise their own businesses. Their shareholders are not among the 1%. They’re among the 0.01% of richest people in the world. In the worst-case scenario, the US has a highly efficient bankruptcy process. Bondholders of today become shareholders of tomorrow, and the companies can have a fresh start. Bondholders would only be more than happy to own the equity of these companies.
Banks, too, will inevitably be asking for bailouts before this is over. Banks have among the most aggressive stock buyback programs of any industry, with some repurchasing a staggering 10% of their outstanding shares annually. The eight biggest banks have announced they will suspend their share buybacks for the next two quarters due to the COVID-19 pandemic on the global economy. In 2019, the top eight banks bought back $108 billion of their own stock.
If any good can come of the current crisis, perhaps it is exposing the irresponsibility of share buybacks and lack of prudence of most companies.
Monetary policy was one of the mechanisms employed in response to the last crisis, in the hope its effects would trickle down to the unwashed masses. Central banks bought vast amounts of treasuries and mortgage bonds to tighten financial spreads for banks and borrowers, but none of it went directly to households. It was all intermediated by the financial system and those who had access to capital.
The absurdity of the policy was perfectly illustrated recently in Europe. The European Central Bank has been busy buying bonds, and recently it bought bonds from LVMH, the luxury conglomerate owned by the world’s richest man Bernard Jean Étienne Arnault. The bonds had a negative yield, meaning that the ECB was paying LVMH to borrow. LVMH used the ECBs money to buy Tiffany.
If rates are now so low that billionaires are being paid to borrow, monetary policy has reached the limits of its usefulness.
Investors own stocks because their bond portfolios have acted like a hedge. Whenever stocks have fallen, bonds have gone up. In every downturn since the 1980s, central banks have cut rates, but most government bonds now have close to zero yields.
Extremely low interest rates and high valuations mean that any small change in interest rates will make portfolios much more volatile. If interest rates were to rise even slightly, they would vaporise many bond and stock portfolios. The margin of safety in bonds and stocks has diminished rapidly as rates have approached zero.
The world is now upside down. Many investors now buy stocks for current income and buy bonds to trade given how volatile they have become. Things cannot hold.
What do high frequency market making, share buybacks and high corporate debt have in common? They are supposedly tools to make trading, growth and returns on capital more efficient and cheaper, yet they have made the system more fragile and less resilient. Perhaps returns on capital and cheapness of market orders and ETFs are less important than stability and anti-fragility, i.e. designing systems that are robust in the face of stress.
We have seen the fragility in supply chains in the recent crisis.When the coronavirus struck in China, suddenly companies everywhere found out that outsourcing all their manufacturing and even medicines and face masks to China might be a problem.
Manufacturing has become less robust, more fragile, even if the returns on capital are better for those companies that outsource everything to China in pursuit of share buybacks.
The lessons of history are instructive. Although planting a single, genetically uniform crop might be more efficient and increase yields in the short run, low genetic diversity increases the risk of losing it all if a new pest is introduced or rainfall levels drop.
Have we been played by China?
The Irish Potato Famine is one such cautionary tale of the danger of monocultures, or only growing one crop. The potato first arrived in Ireland in 1588, and by the 1800s, the Irish had used it to solve the problem of feeding a growing population. They planted the “lumper” potato variety. All of these potatoes were genetically identical to one another, and it was vulnerable to the pathogen Phytophthora infestans. Because Ireland was so dependent on the potato, one in eight Irish people died of starvation in three years during the Irish potato famine of the 1840s.
The lessons from nature are dire. In the 1920s, the Gros Michel banana was almost wiped out by a fungus known as Fusarium cubense, and banana shortages became a growing problem. The widespread planting of a single corn variety contributed to the loss of over a billion dollars worth of corn in 1970, when a fungus hit the US crop. In the 1980s, dependence upon a single type of grapevine root forced California grape growers to replant approximately two million acres of vines when the pest phylloxera attacked.
Today, China is manufacturing’s monoculture.
Against this dangerous backdrop of volatility and uncertainty, the coronavirus will now achieve the impossible. For the past few years, two ideas have floated around on the political fringes of the Left, but they have been dead on arrival. No one has seriously thought they might become government policy. Today, the Left and Right in the United States and Europe are embracing them.
Andrew Yang, a former tech executive from New York, ran a quixotic, obscure presidential campaign in the United States based on the idea that every citizen should receive a Universal Basic Income (UBI). He advocated a “Freedom Dividend”. This would be a form of universal basic income that would provide a monthly stipend of $1,000 for all Americans between the ages of 18 and 64.
Today, Trump, Pelosi, Romney and others are fully backing Yang’s idea. Respected think tanks such Brookings and Chatham House have advocated UBI. But once it is implemented, there will be no going back. Handouts will start small and grow.
The other big idea has come from Stephanie Kelton, who advised Bernie Sanders and advocates for Modern Monetary Theory (MMT). Kelton argues that in any country with its own currency, budget deficits don’t matter unless they cause inflation. The government can pay for what it needs by simply printing more money — no reason to borrow by issuing bonds. Helicopter money.
Could free cash fix the economy?
Her ideas were widely criticised across the Left and Right, ranging from Paul Krugman to Warren Buffett to Federal Reserve Chairman Jay Powell.
Yet today, the two ideas have come together. There are no atheists in foxholes. Even libertarians on Twitter are now calling for government intervention. Investors and politicians of all stripes are calling for UBI financed by MMT money issuing.
This is an epochal turning point, a great reset. The coronavirus is the grain of sand that will cause the avalanche.
For once the taboo of printing money to pay citizens is broken, we can never go back. Governments will spend money with few constraints, aided by central banks. It’s a strategy that has not worked well in emerging markets, and it did not work well in the 1970s — which has conveniently been forgotten.
Undoubtedly, the government must compensate citizens from mandatory curfews and quarantines. The short-term impacts of the lockdowns must be mitigated, but temporary policies must not become permanent political expedients.
That’s why the danger is not today or even a year from now, it’s five to ten years away, when the crisis has past, along with the reason for UBI and monetary easing. What politican will be disciplined enough to stop spending? What central banker will raise rates when it is unpopular to do so?
Today we are reaping the whirlwind of the last financial crisis. Rather than pursue lower leverage, less debt and more robust institutions and more responsible corporate behaviour, investors and companies instead learned that they would be bailed out in a crisis.
Central banks became enamored of their own success as fire fighters, and they have busily been trying to put out fires by
- encouraging reckless behaviour,
- prizing low volatility above a robust financial system,
- viewing “risk management” as preferring no financial corrections ever.
They should accept that sometimes putting out every single fire creates greater conflagrations. They should be humbler about the extent and limits of their power.
It looks like they’re about to learn the hard way.
American corporations are spending trillions of dollars to repurchase their own stock. The practice is enriching CEOs—at the expense of everyone else.
n the early 1980s, a group of menacing outsiders arrived at the gates of American corporations. The “raiders,” as these outsiders were called, were crude in method and purpose. After buying up controlling shares in a corporation, they aimed to extract a quick profit by dethroning its “underperforming” CEO and selling off its assets. Managers—many of whom, to be fair, had grown complacent—rushed to protect their institutions, crafting new defensive measures and lodging appeals in state courts. In the end, the raiders were driven off and their moneyman, Michael Milken, was thrown in prison. Thus ended a colorful chapter in American business history.
Or so it seemed. Today, another effort is under way to raid corporate assets at the expense of employees, investors, and taxpayers. But this time, the attack isn’t coming from the outside. It’s coming from inside the citadel, perpetrated by the very chieftains who are supposed to protect the place. And it’s happening under the most innocuous of names: stock buybacks.
You’ve seen the phrase. It glazes the eyes, numbs the soul, makes you wonder what’s for dinner. The practice sounds deeply normal, like the regularly scheduled maintenance on your car.
It is anything but normal. Before the 1980s, corporations rarely repurchased shares of their own stock. When they started to, it was typically a defensive move intended to fend off raiders, who were drawn to cash piles on a company’s balance sheet. By contrast, according to Federal Reserve data compiled by Goldman Sachs, over the past nine years, corporations have put more money into their own stocks—an astonishing $3.8 trillion—than every other type of investor (individuals, mutual funds, pension funds, foreign investors) combined.
Corporations describe the practice as an efficient way to return money to shareholders. By reducing the number of shares outstanding in the market, a buyback lifts the price of each remaining share. But that spike is often short-lived: A study by the research firm Fortuna Advisors found that, five years out, the stocks of companies that engaged in heavy buybacks performed worse for shareholders than the stocks of companies that didn’t.
One class of shareholder, however, has benefited greatly from the temporary price jumps: the managers who initiate buybacks and are privy to their exact scope and timing. Last year, SEC Commissioner Robert Jackson Jr. instructed his staff to “take a look at how buybacks affect how much skin executives keep in the game.” This analysis revealed that in the eight days following a buyback announcement, executives on average sold five times as much stock as they had on an ordinary day. “Thus,” Jackson said, “executives personally capture the benefit of the short-term stock-price pop created by the buyback announcement.”
This extractive behavior has rightly been decried for worsening income inequality. Some politicians on the left—Bernie Sanders, Elizabeth Warren, Chuck Schumer—have lately gotten around to opposing buybacks on these grounds. But even the staunchest free-market capitalist should be concerned, too. The proliferation of stock buybacks is more than just another way of feathering executives’ nests. By systematically draining capital from America’s public companies, the habit threatens the competitive prospects of American industry—and corrupts the underpinnings of corporate capitalism itself.
The rise of the stock buyback began during the heyday of corporate raiders. In the early 1980s, an economist named Michael C. Jensen presented a paper titled “Reflections on the Corporation as a Social Invention.” It attacked the conception of corporations that had prevailed since roughly the 1920s—that they existed to serve a variety of constituencies, including employees, customers, stockholders, and even the public interest. Instead, Jensen asserted a new ideology that would become known as “shareholder value.” Corporate managers had one job, and one job alone: to increase the short-term share price of the firm.
The philosophy had immediate appeal to the raiders, who used it to give their depredations a fig leaf of legitimacy. And though the raiders were eventually turned back, the idea of shareholder value proved harder to dispel. To ward off hostile takeovers, boards started firing CEOs who didn’t deliver near-term stock-price gains. The rolling of a few big heads—including General Motors’ Robert Stempel in 1992 and IBM’s John Akers in 1993—drove home the point to CEOs: They had better start thinking about shareholder value.
If their conversion to the enemy faith was at first grudging, CEOs soon found a reason to love it. One of the main tenets of shareholder value is that managers’ interests should be aligned with shareholders’ interests. To accomplish this goal, boards began granting CEOs large blocks of company stock and stock options.
The shift in compensation was intended to encourage CEOs to maximize returns for shareholders. In practice, something else happened. The rise of stock incentives coincided with a loosening of SEC rules governing stock buybacks. Three times before (in 1967, ’70, and ’73), the agency had considered such a rule change, and each time it had deemed the dangers of insider “market manipulation” too great. It relented just before CEOs began acquiring ever greater portfolios of their own corporate stock, making such manipulation that much more tantalizing.
Too tantalizing for CEOs to resist. Today, the abuse of stock buybacks is so widespread that naming abusers is a bit like singling out snowflakes for ruining the driveway. But somebody needs to be called out.
So take Craig Menear, the chairman and CEO of Home Depot. On a conference call with investors in February 2018, he and his team mentioned their “plan to repurchase approximately $4 billion of outstanding shares during the year.” The next day, he sold 113,687 shares, netting $18 million.* The following day, he was granted 38,689 new shares, and promptly unloaded 24,286 shares for a profit of $4.5 million. Though Menear’s stated compensation in SEC filings was $11.4 million for 2018, stock sales helped him earn an additional $30 million for the year.
By contrast, the median worker pay at Home Depot is $23,000 a year. If the money spent on buybacks had been used to boost salaries, the Roosevelt Institute and the National Employment Law Project calculated, each worker would have made an additional $18,000 a year. But buybacks are more than just unfair. They’re myopic. Amazon (which hasn’t repurchased a share in seven years) is presently making the sort of investments in people, technology, and products that could eventually make Home Depot irrelevant. When that happens, Home Depot will probably wish it hadn’t spent all those billions to buy back 35 percent of its shares. “When you’ve got a mature company, when everything seems to be going smoothly, that’s the exact moment you need to start worrying Jeff Bezos is going to start eating your lunch,” the shareholder activist Nell Minow told me.
Then there’s Merck. The pharmaceutical company was a paragon of corporate excellence through the second half of the 20th century. “Medicine is for people, not for profits,” George Merck II declared on the cover of Time in 1952. “And if we have remembered that, the profits have never failed to appear.” In the late 1980s, then-CEO Roy Vagelos, rather than sit on a drug that could cure river blindness in Africa but that no one could pay for, persuaded his board of directors to manufacture and distribute the drug for free—which, as Vagelos later noted in his memoir, cost the company more than $200 million. More recently, Merck has been using its massive earnings (its net income for 2018 was $6.2 billion) to repurchase shares of its own stock. A study by the economists William Lazonick and Öner Tulum showed that from 2008 to 2017 the company distributed 133 percent of its profits, through buybacks and dividends, to shareholders—including CEO Kenneth Frazier, who has sold $54.8 million in stock since last July. How is this sustainable? “It’s not,” Lazonick says. Merck insists it must keep drug prices high to fund new research. In 2018, the company spent $10 billion on R&D—and $14 billion on share repurchases and dividends.
Finally, consider the executives at Applied Materials, a maker of semiconductor-manufacturing equipment. As is the case at many companies, its CEO receives incentive pay based on certain metrics. One is earnings per share, or EPS, a widely used barometer of corporate performance. Normally, EPS is lifted by improving earnings. But EPS can be easily manipulated through a stock buyback, which simply reduces the denominator—the number of outstanding shares. At Applied Materials, earnings declined 3.5 percent last year. Yet the company still managed to eke out EPS growth of 1.9 percent. How? In part, by taking more than 10 percent of its shares off the market via buybacks. That move helped executives unlock more incentive compensation—which, these days, usually comes in the form of stock or stock options.
Corporations offer a variety of justifications for the practice of repurchasing stock. One is that buybacks are a more “flexible” way of returning money to shareholders than dividends, which (it’s true) once raised are very hard to reduce. Another argument: Some companies just make more money than they can possibly put to good use. This likewise has a smidgen of truth. Apple may not have $1 billion worth of good bets to make or companies it wants to acquire. Though, if this were the real reason companies are repurchasing stock, it would imply that biotechnology, banking, and big retail—sectors that hold some of the biggest practitioners of buybacks—are nearing a dead end, idea-wise. CEOs will also sometimes make the case that their stock is undervalued, and that repurchases represent an opportunity to buy low. But in reality, notes Fortuna’s Gregory Milano, companies tend to buy their stock high, when they’re flush with cash. The 10th year of a bull market is hardly a time for bargain-hunting.
Capitalism takes many forms. But the variant that propelled America through the 20th century was, at its heart, a means of pooling resources toward a common endeavor, whether that was building railroads, developing new drugs, or making microwave ovens. There used to be a healthy debate about which of their stakeholders corporations ought to serve—employees, stockholders, customers—and in what order. But no one, not even Michael Jensen, ever suggested that a corporation should exist solely to serve the interests of the people entrusted to run it.
Many early stock certificates bore an image—a factory, a car, a canal—representing the purpose of the corporation that issued them. It was a reminder that the financial instrument was being put to productive use. Corporations that plow their profits into buybacks would be hard-pressed to put an image on their stock certificate today, other than, perhaps, the visage of their CEO.