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What Is Value? Why Price Has Become an Unreliable Metric of ValueAll economies require social trust to work. While there are many reasons for the lack of confidence in the marketplace today, surely one of the most important is the unreliability of price as an indicator of value. A lot of people just don’t trust prices as reflecting the actual worth of a house or corporation, let alone the intangibles of social life or nature that we also value. This is symptomatic of the crisis of neoliberal economics and public policy. As I see it, there are a number of mutually reinforcing reasons for the waning confidence in the price system: 1. The market is too volatile so it’s hard to know if today’s price will be radically different tomorrow. In the face of great uncertainty about the future, a price seems arbitrary and unreliable, and not a well-vetted measure of long-term value. Price volatility is likely to persist for some time because – well, that’s a longer story that can’t be fully unpacked here. Suffice it to say that it will take a long time for countless companies, institutions and households to “de-leverage” their debt fueled by the bubble, and get prices back into a more realistic alignment with actual value. 2. Banks and big corporations can manipulate accounting practices so that prices will suit their needs. With massive bailouts now propping up entire sectors of the economy, it is no wonder that investors and taxpayers often don’t trust the stated market valuations of companies. When so many companies are being kept afloat, directly or indirectly, by taxpayers, it is hard to tell if stock prices truly reflect the honest verdict of a decentralized, transparent “free market.” And years of scams by Enron, Arthur Andersen, Worldcom and Bernie Madoff raise legitimate questions about the reliability of financial statements. It is a central tenet of market economics that price reflects the verdict of a marketplace that has assiduously considered all information and truck-and-bartered to determine a fair price. So why is the banking sector rejecting the sacred verdict of the marketplace? Historically, auditors have used a system called “mark-to-market” accounting to assign a price to financial instruments like mortgage-backed securities. The “fair value” is based upon current market prices or the prices of similar financial instruments, and provides investors with a credible way to make more informed decisions. Mark-to-market accounting has been part of the U.S. Generally Accepted Accounting Principles (GAAP) since the early 1990s, a set of protocols adopted by the Federal Accounting Standards Board (FASB), a private organization. (For more on mark-to-market valuation, see Wikipedia’s entry on the topic. A few weeks ago, however, the FASB changed its rules for mark-to-market accounting. While financial institutions will still have to mark transactions to market prices, they won’t have to use current market prices because of the presumed errors in today’s market. Instead, banks and other financial institutions will be able to make their own determinations of what they deem the value of the asset “really” is, according to the standards of an imagined, more stable future marketplace. So what happened to the sanctity of price as an arbiter of value and driver of markets? Whenever city governments “intervene” in the market to achieve social objectives or fairness, the Wall Street Journal howls about how “imposed” prices produce “market distortions” that discourage investment. But now, to achieve the social goal of “reassuring investors,” it’s okay for banks and other companies to override the market’s verdict on price! They are authorized to re-state (low) market valuations to reflect their own interests in a more attractive financial statement. Prices are chosen to reflect a bank’s self-serving notion of where the market “should be,” were markets operating “correctly.” Mind you, this sort of accounting legerdemain is supposed to reassure us and make us more willing to buy stocks. As one analyst put it, “The net impact [of the new FASB rules] could help boost bank earnings, reduce the need for capital injections (into banks by the government) and may help encourage participation” by private investors in government programs for selling toxic assets. In other words: let’s all acquiesce in this financial charade because it might help boost the economy. The chief U.S. economist at another investment firm, who obviously thinks that price ought to stand for something real, said that the FASB decision “allows financial institutions to use fictional valuations on many of their toxic assets” and further obscures their “true position.” All of this is of a piece with an April 16 column by economist Paul Krugman, who noted that the glowing quarterly profit statements that many banks and companies are announcing are fraught with dubious accounting methods. Not surprisingly, major stock-market investors are skeptical about the trustworthiness of reported quarterly earnings by banks. 3. There is another reason for flagging confidence in the price system: people are starting to realize that price is instrinsically unable to convey the full dimensions of value and risk. Once the government has to step in to guarantee a bank’s contractual obligations (lest it spiral out of control and bring down the entire economy), how do you incorporate that actual cost (borne by taxpayers) into the prices charged by banks? As things current stand, that cost has been a freebie – an off-the-books subsidy that is not reflected in prices. But this subterfuge only brings to mind the price system’s insistence that countless intangibles of social life and nature be treated as money. Historically, corporate America has been a big cheerleader for cost-benefit analysis as a key tool in regulation. All aspects of life are assigned a price tag so that we can determine if it is “worth it” to prevent workplace mutilations, fatal car crashes and carcinogenic exposures to babies. Before regulators can impose rules to prevent bodily harm or pollution, they are forced to assign a price tag to the cost of amputated limbs and clean air in the Grand Canyon. Despite the flim-flam methodologies for determining these prices, regulators are forced to treat these prices as meaningful indicators of value. Compliant economists have devised such analytic tools as “willingness to pay” as a proxy for a market price (“How much would you be willing to pay to avoid exposure to a carcinogen at work?”) – even though rich people have far greater willingness to pay than working stiffs who can barely pay their monthly bills. Economists have even developed such bogus disciplines as “hedonics” to assign prices to various aspects of human existence – so that a price could be plugged into a market calculus. Health and safety advocates have long known that the monetary sums used in cost-benefit analyses are intellectually indefensible. But the fiction proceeded apace because the neoliberal policy consensus was at its zenith. Now it is becoming abundantly clear that “price” is a highly malleable notion that can be crafted to suit the needs of powerful corporations. Don’t like the market valuation of your assets? Change the FASB mark-to-market guidelines. Don’t like the new EPA regs for your industry? Jigger the cost-benefit analysis to show that it isn’t “worth it” to curb toxic dumping. In short, the moral justification and practical machinery for setting trustworthy prices are in tatters. Value is a many-splendored thing that price can only express crudely and often not at all. 4. Finally, here’s the latest reason for flagging confidence in prices: The non-monetary “sharing economy” of the Internet – think open source software, Wikipedia, Flickr and social networking – is generating entirely new sorts of value that can never be accurately assigned a price. When people come together to collaborate online, they are producing huge pools of value that have nothing to do with cash or market exchange, and everything to do with collective value. Remarkably, this new arena of value-creation is frequently out-competing the market economy. Craigslist is out-competing newspapers and their classified ad sections. Wikipedia has out-performed Encyclopedia Britannica. People who share information through blogs or wikis or social networking sites are satisfying important needs without having to “consume” in the marketplace. Who needs a market when you can turn to an open access platform (Facebook) or a commons of shared interests (Wikitravel)? Here’s the bizarre thing: Even though the sharing economy is frequently out-competing the market economy, its workings generally remain inscrutable to market traditionalists. That’s because conventional economic metrics, especially price, are ontologically incapable of measuring socially created value. Can you express the value of your closest friendship in dollars? How do you assign value to collaborative, indivisible enterprises like Linux, the open-source operating system? (One analyst has estimated that the “Linux economy” generates some $36 billion in value each year, but this sum is probably as conjectural as the record industry’s estimates of the market value of pirated music — the point being that there IS NO ACTUAL MARKET in either case, so how can a realistic price be assigned?) Incidentally, the rising power of the sharing economy receives fascinating treatment in an essay by Adam Arvidsson, Crisis of Value and the Ethical Economy, on the P2P Foundation website. Highly recommended. Please don’t get me wrong: the price system is not going to go away any time soon. It often provides reasonably accurate signals about supply and demand. But the past seven months have illuminated a dirty little secret of the economics biz – that there are LOTS of things of great value that can never be reduced to a price, and that even the market system regularly fails to incorporate into prices the value of “exogenous variables” and long-term resources, such as the policies and institutions of government, the sustainability of the Earth’s atmosphere and other natural resources and the ethical norms that allow for trustworthy market activity. Market triumphalists have long acted as if the entire universe could be understood as a known or knowable system that need only concern itself with individual property rights, monetary valuations and markets. “There is no such thing as society,” Margaret Thatcher famously declared. Well, the real lesson of the moment is that price is just one tool among many other necessary ones; that the credibility of prices depends directly upon the social institutions and norms that support them; and that we must respect the intrinsic value and character of the commons. The market system is likely to remain volatile and unreliable so long as it fails to come to terms with its dependence upon these other realms of value. First step: the economics discipline must move beyond its fundamentalist creed and re-invent itself as a broader, more empirically based, socially sensitive field of inquiry. Is it that difficult to understand that value is not just about money, as represented by price, but about all sorts of ethical, humanistic, social and natural forms of wealth? What Good Are Economists Anyway? Why They Failed to Predict the Global Economic Crisis - And Why Their Help is Still Crucial to a RecoveryEconomists mostly failed to predict the worst economic crisis since the 1930s. Now they can't agree how to solve it. People are starting to wonder: What good are economists anyway? A commenter on a housing blog wrote recently that economists did a worse job of forecasting the housing market than either his father, who has no formal education, or his mother, who got up to second grade. "If you are an economist and did not see this coming, you should seriously reconsider the value of your education and maybe do something with a tangible value to society, like picking vegetables," he wrote on patrick.net. Take that, you pointy-headed failures! Go jump off a supply curve! To be fair, economists can't be expected to predict the future with any kind of exactitude. The world is simply too complicated for that. But collectively, they should be able to warn of dangers ahead. And when disaster strikes, they ought to know what to do. Indeed, people pay attention to economists at times like this precisely because of their bold claim that they know how to prevent the economy from sliding into a repeat of the Great Depression. But seven decades after the Depression, economists still haven't reached consensus on its lessons. The debate has only intensified in recent weeks. To fight the downturn, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Timothy F. Geithner, and National Economic Council Director Lawrence Summers are attempting an unprecedented combination of massive fiscal stimulus and extreme monetary policy. If it produces a sustained recovery—and there are some early signs of hope—they will look like heroes. For now, though, it's disturbing that they've had to resort to policy measures that in scale and scope are way outside what the economics profession had studied or even contemplated in recent years. The rap on economists, only somewhat exaggerated, is that they are overconfident, unrealistic, and political. They claim a precision that neither their raw material nor their skill warrants. Too many assume that people behave like the mythical homo economicus, who is hyperrational and omniscient. And they take sides in quarrels that freeze the progress of research. Those few who defy the conventional wisdom are ignored. Critics are scathing. Nassim Nicholas Taleb, the scholar of rare events who wrote Fooled by Randomness and The Black Swan, says: "We have to build a society that doesn't depend on forecasts by idiotic economists." Says Paul Wilmott, a quantitative finance expert: "Economists' models are just awful. They completely forget how important the human element is." In the face of such withering criticism, it's tempting to ignore the whole profession. But that won't do. For one thing, getting out of this mess and making sure it doesn't happen again will require the very best thinking of a generation. Macroeconomists—that is, those who specialize in business cycles and growth—have made important contributions. For example, research in the 1970s helped many countries eliminate chronic high inflation by highlighting the importance of having a strong, independent central bank. Even now, progress is being made. Scholars of all stripes are belatedly getting up to speed in modern finance. Because they are trained to think of financial markets as efficient, most economists weren't primed to spot the dangers posed by lax mortgage lending, overleveraged financial institutions, and impenetrably complex derivatives. "The time is absolutely right for new ideas to come in, much as they did in the 1930s and the 1970s," says Roger E.A. Farmer of the University of California at Los Angeles. Besides, even if you're suspicious of economists' value, they are impossible to ignore. Here's why: Every idea you can think of for coping with this crisis is based on some supposition about the way the world works. Whether you realize it or not, all of those suppositions come out of one school of economics or another. As the British economist John Maynard Keynes wrote: "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." So we had all better hope that the profession can get its act together. It won't be easy, because this crisis is rubbing salt in old wounds. It is reopening debates about one of the most contentious questions in macro, namely, the ability of government deficit spending (i.e., fiscal policy) to stimulate demand and get people back to work. In January the fight over fiscal policy broke out in public after then-President-elect Barack Obama made what probably seemed to him a safe claim, saying: "There is no disagreement that we need action by our government, a recovery plan that will help to jump-start the economy." Not long after, some 250 conservative economists, in an open letter published in major newspapers, wrote: "With all due respect Mr. President, that is not true." Middlebury College economist David C. Colander, who himself is suspicious of the stimulus package, says: "The debate is reasonable. What's unreasonable is that we're undertaking it at this time" rather than decades ago. Economists' worst sin is hubris. In the 1960s, free-market economist Milton Friedman persuaded virtually the entire profession that the Great Depression was caused by the Federal Reserve. That seemed to imply that better policy by the Fed, guided by economists, would prevent a recurrence. Bernanke, then a governor of the Federal Reserve, said as much in a 2002 speech for Friedman's 90th birthday that acknowledged the Fed's role in the Depression. He told Friedman: "You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Famous last words. Believing in the power of the Fed, economists mostly stopped researching the use of fiscal policy to fight recessions or depressions. What's more, recessions had become rarer and milder—the so-called Great Moderation. So who needed stimulus? Says New York University economist Xavier Gabaix: "Up until a year ago, you would look very old-fashioned if you were talking about optimal fiscal policy." Mainstream economists' adherence to orthodoxy was also apparent in their casual dismissal of worries about bubbles in housing and stocks. Former Fed Chairman Alan Greenspan denied that a national housing bubble was even possible, since housing was not a single national market. He also brushed off the dangers of Wall Street concoctions such as derivatives. Only last year did he concede he was wrong. In Senate testimony, he said he was shocked to have found a "flaw" in his ideology, adding: "I have been going for 40 years or more with very considerable evidence that it was working exceptionally well." Politics compounded the trouble. As a rough first cut, you can divide macroeconomists based on how concerned they are about economic instability. One group, in the tradition of Keynes, worries about self-perpetuating economic declines that leave the economy in a deep trough it can't escape. Members of this group say government needs to break downward spirals with the kinds of aggressive policies the U.S. is following now—cutting interest rates and raising government spending. The group includes Paul R. Krugman, the Princeton University economist and Nobel laureate; NYU's Nouriel Roubini, who was early in predicting a severe recession; and Yale University's Robert J. Shiller, who predicted the housing bust and the tech-stock bust. Other economists have more confidence that the economy is self-equilibrating. They believe low interest rates and heavy deficit spending will be ineffective while leaving the U.S. with a mountain of debt. Count Harvard's Robert Barro in this camp, along with Chicago's Robert E. Lucas Jr., Arizona State University's Edward C. Prescott, and the University of Minnesota's Patrick J. Kehoe and V. V. Chari. No surprise, the equilibrium school mainly leans Republican, and the interventionist school seems to be crawling with Democrats. Before this crisis, it seemed that economists might resolve their differences. The oft-combative Krugman, in the first edition of his textbook Macroeconomics in 2006, wrote that "the clean little secret of modern macroeconomics is how much consensus economists have reached over the past 70 years." The mood now is uglier. On the left, Krugman says: "This is really fairly shameful, that we should be wasting precious months as a profession retracing debates that were settled 70 years ago." On the right, John H. Cochrane of the University of Chicago dismisses those who advocate Keynesian stimulus, saying: "Professional economists, the guys I hang out with, are not reverting to ancient Keynesianism any more than physicists are going back to Aristotle when they can't understand how fast the universe is expanding." There are some middle-of-the-roaders, such as Columbia University's Michael Woodford, who argue that macroeconomists are converging on a methodology for asking questions. But even Woodford agrees that "recent debates don't particularly make the field look unified." The easiest criticism of macroeconomists is that nearly all failed to foresee the recession despite plenty of warning signs. In early September 2008, the median growth forecast for the fourth quarter was 0.2%, according to a survey by Blue Chip Economic Indicators. The actual outcome was a 6.3% annualized decline. The Fed didn't do any better. In July 2008, Fed officials projected unemployment in the fourth quarter of 2008 would end up between 5.5% and 5.8%. The actual number was 6.9%. Their projection for the fourth quarter of 2009, done at the same time, was for a range of 5.2% to 6.1%. Today, with unemployment at 8.5%, most forecasters expect the rate to be nearing double digits by the end of 2009. Now that fiscal policy is back on the table, economists are fighting over the size of the ripple effect—or "multiplier"—of increased government spending. Interventionist economists think multipliers are large when the economy is operating below capacity—and it certainly is now. According to a Fed report on Apr. 15, one-third of manufacturing's productive capacity is going unused, the biggest share on record back to 1948. Obama Administration officials believe that their fiscal policy is on the right track. The stimulus program "is putting a little more energy into the consumer," National Economic Council Director Summers told Maria Bartiromo. "Two months ago you couldn't find anything positive." Christina D. Romer, Obama's chief economic adviser and a historian of the Depression, said in March that "at some point, recovery will take on a life of its own." Until then, she said, government should watch closely "to make sure the private sector is back in the saddle" before easing off. Other economists say increased government spending may actually depress private employment. At a Council on Foreign Relations event on Mar. 30, Chicago's Lucas called the Administration's multiplier math "kind of schlock economics." The truth is, even backers of stimulus can't be sure it will work. As World War II ended, many economists worried that growth would lapse as military spending fell. Sewell Avery, the CEO of Montgomery Ward, was so anxious about a postwar depression that he refused to open new stores. Economists still aren't sure why he was wrong, so they can't say reliably whether fiscal stimulus will end this recession or just interrupt it. "Is it possible to engineer a durable recovery with fiscal expansion, or are you just buying time?" asks Krugman, who favors coupling stimulus with drastic action to fix the banks. What, then, is the way forward? Once this crisis is past, the next agenda for macroeconomists will be to help make the economy far more robust—enough to survive the blunders of politicians, bankers, and economists of the future. Taleb, the scholar of unpredictability, notes that nature achieves robustness through a redundancy that economists would consider wasteful: two hands, two eyes, etc. Blake LeBaron of Brandeis University suggests preventing huge crises by tolerating small disturbances, the way foresters use controlled burns to eliminate flammable underbrush. Perhaps out of the ashes of failure will emerge a better macroeconomics profession. The Capital well is Running Dry and Some Economies will WitherThe world is running out of capital. We cannot take it for granted that the global bond markets will prove deep enough to fund the $6 trillion or so needed for the Obama fiscal package, US-European bank bail-outs, and ballooning deficits almost everywhere. Unless this capital is forthcoming, a clutch of countries will prove unable to roll over their debts at a bearable cost. Those that cannot print money to tide them through, either because they no longer have a national currency (Ireland, Club Med), or because they borrowed abroad (East Europe), run the biggest risk of default. Traders already whisper that some governments are buying their own debt through proxies at bond auctions to keep up illusions – not to be confused with transparent buying by central banks under quantitative easing. This cannot continue for long. Commerzbank said every European bond auction is turning into an "event risk". Britain too finds itself some way down the AAA pecking order as it tries to sell £220bn of Gilts this year to irascible investors, astonished by 5pc deficits into the middle of the next decade. US hedge fund Hayman Advisers is betting on the biggest wave of state bankruptcies and restructurings since 1934. The worst profiles are almost all in Europe – the epicentre of leverage, and denial. As the IMF said last week, Europe's banks have written down 17pc of their losses – American banks have swallowed half. "We have spent a good part of six months combing through the world's sovereign balance sheets to understand how much leverage we are dealing with. The results are shocking," said Hayman's Kyle Bass. It looked easy for Western governments during the credit bubble, when China, Russia, emerging Asia, and petro-powers were accumulating $1.3 trillion a year in reserves, recycling this wealth back into US Treasuries and agency debt, or European bonds. The tap has been turned off. These countries have become net sellers. Central bank holdings have fallen by $248bn to $6.7 trillion over the last six months. The oil crash has forced both Russia and Venezuela to slash reserves by a third. China let slip last week that it would use more of its $40bn monthly surplus to shore up growth at home and invest in harder assets – perhaps mining companies. The National Institute for Economic and Social Research (NIESR) said last week that since UK debt topped 200pc of GDP after the Second World War, we can comfortably manage the debt-load in this debacle (80pc to 100pc). Variants of this argument are often made for the rest of the OECD club. But our world is nothing like the late 1940s, when large families were rearing the workforce that would master the debt. Today we face demographic retreat. West and East are both tipping into old-aged atrophy (though the US is in best shape, nota bene). Japan's $1.5 trillion state pension fund – the world's biggest – dropped a bombshell this month. It will start selling holdings of Japanese state bonds this year to cover a $40bn shortfall on its books. So how is the Ministry of Finance going to fund a sovereign debt expected to reach 200pc of GDP by 2010 – also the world's biggest – even assuming that Japan's industry recovers from its 38pc crash? Japan is the first country to face a shrinking workforce in absolute terms, crossing the dreaded line in 2005. Its army of pensioners is dipping into the collective coffers. Japan's savings rate has fallen from 14pc of GDP to 2pc since 1990. Such a fate looms for Germany, Italy, Korea, Eastern Europe, and eventually China as well. So where is the $6 trillion going to come from this year, and beyond? For now we must fall back on the Fed, the Bank of England, and fellow central banks, relying on QE (printing money) to pay for our schools, roads, and administration. It is necessary, alas, to stave off debt deflation. But it is also a slippery slope, as Fed hawks keep reminding their chairman Ben Bernanke. Threadneedle Street may soon have to double its dose to £150bn, increasing the Gilt load that must eventually be fed back onto the market. The longer this goes on, the bigger the headache later. The Fed is in much the same bind. One wonders if Mr Bernanke regrets saying so blithely that Washington can create unlimited dollars "at essentially no cost". Hayman Advisers says the default threat lies in the cocktail of spiralling public debt and the liabilities of banks – like RBS, Fortis, or Hypo Real – that are landing on sovereign ledger books. "The crux of the problem is not sub-prime, or Alt-A mortgage loans, or this or that bank. Governments around the world allowed their banking systems to grow unchecked, in some cases growing into an untenable liability for the host country," said Mr Bass. A disturbing number of states look like Iceland once you dig into the entrails, and most are in Europe where liabilities average 4.2 times GDP, compared with 2pc for the US. "There could be a cluster of defaults over the next three years, possibly sooner," he said. Research by former IMF chief economist Ken Rogoff and professor Carmen Reinhart found that spasms of default occur every couple of generations, each time shattering the illusions of bondholders. Half the world succumbed in the 1830s and again in the 1930s. The G20 deal to triple the IMF's Great bankruptcies change the world. Spain's defaults under Philip II ruined the Catholic banking dynasties of Italy and south Germany, shifting the locus of financial power to Amsterdam. Anglo-Dutch forces were able to halt the Counter-Reformation, free northern Europe from absolutism, and break into North America. Who knows what revolution may come from this crisis if it ever reaches defaults. My hunch is that it would expose Europe's deep fatigue – brutally so – reducing the Old World to a backwater. Whether US hegemony remains intact is an open question. I would bet on US-China condominium for a quarter century, or just G2 for short. IBM: Reflating the Corporate Bubble, GE-styleIBM just announced a $3b share-buyback and 10% increase to their dividend, despite a 10% decrease in Q1 revenue. Judging by moves like this, the concept of deleveraging doesn’t seem to have taken hold with many big companies. Unfortunately, it doesn’t look like financial wizardry is going away any time soon. Using Debt to fund Buybacks and Dividends It was just last October that IBM raised $4 billion from bond sales. They paid a fairly high price too, with yields ranging from 6.5% for the 5 year bond, to 8% for the 30 year bond (details here). Now they announce a $3 billion share repurchase, and a boost to the div? Layoffs Too? Official numbers are hard to find, but it appears that IBM has laid off up to 10,000 workers in North America this year. Public companies have a responsibility to shareholders to maximize ROI. At times that requires getting rid of some dead wood. But is it really prudent to lay off 10% of your U.S. workforce, while ramping up spending on share buybacks and dividends? That can’t be good for employee morale and loyalty. I can’t think of a better way to describe IBM’s strategy here than “jacking up the dividend, then doing a big ol’ share buyback to lure in longs and scare off shorts, resulting in a short-term pop in our stock. Yes, we have a bunch of liabilities that we should probably pay off first, but we’ll deal with that later“. Hmm, that doesn’t exactly roll off the tongue. Maybe if The Treasury Dept was in charge of naming it, they’d give us a catchy acronym like JUDDBSBLLSSRSTPOSYWHBLSPPOFBWWATL. Will the buybacks, layoffs, and dividends that IBM purchased be worth the cost? I’m skeptical to say the least. They may succeed in temporarily juicing the stock, which is what management wants to happen. That allows for bonuses and profitable option-redemptions. But will these moves be good for IBM 10 years down the road? I doubt it. Sketchy moves like this buyback should discourage investors from buying IBM. Wall St, however, was predictably impressed. The logic must have been along these lines, “yield good, money good, earnings good. buy ibm.” There are a just so many better companies to own than IBM, I don’t get it. Among other tech companies, I’d take AAPL over IBM any day, even at current valuations. The Flawed Rational of Share Buybacks Share buybacks are touted as a great way to return value to shareholders. They do increase earnings per-share, as the total # of outstanding shares decreases. In reality, buybacks are often just poorly-timed efforts to support a stock price. They’re also a distraction to management, who arguably have no business engaging in what is basically the day-trading of their own stock. Unfortunately, many boards of directors have the tendency of insta-approving reckless moves like this. I think of buybacks as debt-fueled orgies, which are usually accompanied by unsustainable dividends. Buybacks are the worse of the two. But borrowing money so you can pay it out in dividends is pretty bad too. GE is arguably the worst offender when it comes to this type of scheme. In their day, GE made IBM’s announcement today look miniscule. From 1994 to 2004, GE bought back 1.1 billion of their own shares, at a huge premium to their price today. At the same time, they piled up debt, taking advantage of their AAA rating. During the 10 year period up leading up to 2004, GE spent ~$75 billion on dividends and buybacks. Unfortunately I couldn’t find reliable information on how much they’ve spent since then. But I’m pretty sure it’s a staggering amount. This year alone, they were on track to pay out ~$13b in dividends, until they had to reluctantly slash the payout. Paying the tab The buybacks propped GE’s stock up for a while, and the dividends kept investors happy. But GE is now feeling the hangover from their binge. They currently have $504b in long-term debt, and seem reliant on the government’s generosity to roll-over their short-term paper. They have massive exposure to the commercial-real-estate market, credit cards, and other vulnerable pieces of our economy. It’s a shame that a great American institution like GE has been reduced to this. But it’ll be a much bigger shame if taxpayers end up footing the bill for their risky loans. Sorry about that, sometimes it’s hard to stop ranting about GE. Back to IBM’s balance sheet. It certainly isn’t as bad as GE’s, but it ain’t pretty either. The announcement today may give IBM shares a temporary boost and scare off potential shorts. But in the long run it will degrade their balance sheet further, and reinforce the cycle of debt. Here are some highlights from their Q1 2009 balance sheet: The last bullet-point is the most concerning. It gives IBM a Current Ratio of 1.18x, meaning their short-term liquidity situation isn’t great. In our current economic environment, why are they scraping by with minimal liquidity, while increasing the dividend and instituting a $3b share buyback? They could be putting that money towards paying off their substantial total debt of $30.9b. Instead, it seems they’ll keep re-financing and rolling debt over for eternity. Who knows, they might be forced to sell back those repurchased shares eventually (GE was forced to sell shares at a ~20 year low). Solutions? We are in serious need of a compensation system that actually rewards executives for long-term success, and removes conflicts like these from the system. I heard Lloyd Blankfein, Goldman’s CEO, on NPR the other day comparing executives like himself to pro-basketball players, “They get paid a lot too, we’re all just really awesome at our jobs” was essentially what he said. Is he serious?!?! First of all, I don’t recall the last time taxpayers bailed out failed NBA teams. And while Goldman may have avoided much of the damage from this collapse, they created more than their fair share, in my opinion. See this post for more on that topic… Investors and analysts need to start looking beyond PEs and dividends, and into the murky balance-sheets beneath. We’ve glossed over corporate balance sheets for too long (ie highly-leveraged REITS like GGP). This debt-mentality is pervasive throughout American society. And the longer we put off changing our behavior, the more painful it’s going to be. Just to be clear, I’m not saying IBM is a GE or GGP. But the strategy they’re using is simply not sustainable or efficient. And I think it’s crazy that investors apparently gave them a big thumbs up today, pushing the stock up 2% on a down day. Fed Is Said to Seek Capital for at Least Six BanksApril 29 (Bloomberg) -- At least six of the 19 largest U.S. banks require additional capital, according to preliminary results of government stress tests, people briefed on the matter said. While some of the lenders may need extra cash injections from the government, most of the capital is likely to come from converting preferred shares to common equity, the people said. The Federal Reserve is now hearing appeals from banks, including Citigroup Inc. and Bank of America Corp., that regulators have determined need more of a cushion against losses, they added. By pushing conversions, rather than federal assistance, the government would allow banks to shore themselves up without the political taint that has soured both Wall Street and Congress on the bailouts. The risk is that, along with diluting existing shareholders, the government action won’t seem strong enough. “The challenge that policy makers will confront is that more will be needed and it’s not clear they have the resources currently in place or the political capability to deliver more,” said David Greenlaw, the chief financial economist at Morgan Stanley, one of the 19 banks that are being tested, in New York. Final results of the tests are due to be released next week. The banking agencies overseeing the reviews and the Treasury are still debating how much of the information to disclose. Fed Chairman Ben S. Bernanke, Treasury Secretary Timothy Geithner and other regulators are scheduled to meet this week to discuss the tests. Options for Capital Geithner has said that banks can add capital by a variety of ways, including converting government-held preferred shares dating from capital injections made last year, raising private funds or getting more taxpayer cash. With regulators putting an emphasis on common equity in their stress tests, converting privately held preferred shares is another option. Firms that receive exceptional assistance could face stiffer government controls, including the firing of executives or board members, the Treasury chief has warned. Today, Kenneth Lewis, chief executive officer of Bank of America, faces a shareholder vote on whether he should be re- elected as the company’s chairman of the board. While Lewis has been at the helm, the bank has received $45 billion in government aid. ‘Out of Our Hands’ Scott Silvestri, a spokesman for Charlotte, North Carolina- based Bank of America, declined to comment on Lewis yesterday. Lewis said earlier this month that the firm “absolutely” doesn’t need more capital, while adding that the decision on whether to convert the U.S.’s previous investments into common equity is “now out of our hands.” Citigroup, in a statement, said the bank’s “regulatory capital base is strong, and we have previously announced our intention to conduct an exchange offer that will significantly improve our tangible common ratios.” Along with Bank of America and New York-based Citigroup, some regional banks are likely to need additional capital, analysts have said. SunTrust Banks Inc., KeyCorp, and Regions Financial Corp. are the banks that are most likely to require additional capital, according to an April 24 analysis by Morgan Stanley. Bank of America advanced 2.6 percent to $8.36 in German trading and Citigroup climbed 3.5 percent to $2.99. SunTrust slipped 0.2 percent to $13.69 in Germany. By taking the less onerous path of converting preferred shares, the Treasury is husbanding the diminishing resources from the $700 billion bailout passed by Congress last October. ‘Politically Constrained’ “Does that indicate that’s what the regulators actually believe, or is it that they felt politically constrained from doing much more than that?” said Douglas Elliott, a former investment banker who is now a fellow at the Brookings Institution in Washington. Geithner said April 21 that $109.6 billion of TARP funds remain, or $134.6 billion including expected repayments in the coming year. Lawmakers have warned repeatedly not to expect approval of any request for additional money. Some forecasts predict much greater losses are still on the horizon for the financial system. The International Monetary Fund calculates global losses tied to bad loans and securitized assets may reach $4.1 trillion next year. Geithner has said repeatedly that the “vast majority” of U.S. banks have more capital than regulatory guidelines indicate. The stress tests are designed to ensure that firms have enough reserves to weather a deeper economic downturn and sustain lending to consumers and businesses. ‘Thawing’ Markets He also said there are signs of “thawing” in credit markets and some indication that confidence is beginning to return. His remarks reflected an improvement in earnings in several lenders’ results for the first quarter, and a reduction in benchmark lending rates this month. Financial shares are poised for their first back-to-back monthly gain since September 2007. The Standard & Poor’s 500 Financials Index has climbed 18 percent this month, while still 73 percent below the high reached in May 2007. Finance ministers and central bankers who met in Washington last weekend singled out banks’ impaired balance sheets as the biggest threat to a sustainable recovery. Geithner has crafted a plan to finance purchases of as much as $1 trillion in distressed loans and securities. Germany has proposed removing $1.1 trillion in toxic assets. |
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