As the share price goes, so goes the company

Citigroup's share price has plunged over the past week, from an already abysmal $10 to about $4. This gives it a market capitalization of $20 Billion, for a bank with $2 trillion in assets. This same behavior precipitated the takeover of Bear Stearns, Fannie/Freddie, and as I've written about before, in the UK.

Bloomberg has an article speculating on the takeover of Citi by the federal government:

The U.S. government may step in to rescue Citigroup Inc. after a crisis in confidence erased half the bank’s stock-market value in three days, according to investors and analysts.

The only possible justification for this would be Citi becoming insolvent. If any company is too big to fail, it's the the ginormous financial behemeth which is Citigroup.

But what the hell does the share price have to do with anything? Really? The only problem is if they don't have enough capital on hand to cover immediate obligations. As a fractional reserve bank they're vulnerable to bank runs, even if they're solvent (in theory). The shareholders would get wiped out, so if people were worried about Citi going under it would make sense to sell.

It doesn't work the other way, though. If the market thinks Citi is insolvent, so everybody sells their shares, that doesn't affect the capital they have on hand to meet liabilities. At all. A drop in share price could trigger other things, like creditors recalling loans, which would affect the capital ratio, but the share price itself is not something the government should care about.

Error rating: 7. MARKETS FLUCTUATE

-Enginerd

Market manipulation shouldn't be government policy

The weekends over, and that means the latest in the wave of world government clusterfucks rescue plans is being announced. The UK is partially nationalizing the Royal Bank of Scotland and HBOS. I can understand why that might be necessary (too big to fail, systemic risk, yada yada) but the justification given is the dumbest thing I've ever heard:

The Government was forced to take bigger stakes in the banks than it originally intended because of a dramatic slump in banks’ share prices last week. It also increased the amount of money it demanded the banks raise in an attempt to rebuild shattered confidence in the financial system.

That's stupid. Their share price is irrelevant. Look at their damn books, and see how solvent the bank is. Remember when people cared about assets and liabilities? A run on a banks deposits is reason for a bailout; a run on their stock most certainly is not. It gets better:

Mervyn King, the Bank of England Governor, has reportedly told the banks to ask for more than they need, meaning their capital position would be strengthened sufficiently to absorb shocks and a long recession

Take the money now, and because somebody might ask questions later. If we don't give "emergency" loans, disbursed over a period of days, people might actually be able to consider the consequences of our actions. Oy.

Error rating: 7. MARKETS FLUCTUATE

-Enginerd

Short-sellers, speculators, and other bogey men

Assuming you spend lots of time on the intartubes (like I do), the SEC ban on short-selling financial stocks is old news:

The U.S. Securities and Exchange Commission took what it called "emergency action" Friday and temporarily banned investors from short-selling 799 financial companies.

The temporary ban, aimed at helping restore falling stock prices that have shattered confidence in the financial markets, takes effect immediately.

You may recall that they did this a few months ago. It bounced the stock market, in particular the financials, or maybe that was the FRE/FNM bailout. Who knows. Anyway, this particular market intervention appears to be having the same effect. The S&P 500 is up 98 points (8.5%) over the past two days. Again, that could also be the governments plan to take the losses themselves.

People always get this backwards. When a bubble inflates, it's seen as the economy growing, new wealth being created everybody winning. That's a lie. When it bursts, people complain that wealth is being destroyed. That's also a lie. It never existed in the first place. And they also blame short sellers and speculators, cause hey, everybody knows that profiting off the misfortune of others makes you evil. That's why everybody hates doctors.

Short sellers make markets more liquid, and more efficient. Naked shorting is a different story (and should be banned altogether), but there's nothing wrong with regular short selling. This is especially heinous because only financial stocks are being propped up, artificially inflating their values. It won't help them raise equity, because investors won't pay artificially inflated prices.

Error rating: 3. I know you mean well, but you're hurting in the long run. Plus, the people in charge of the economy are supposed to understand economics.

-Enginerd

No, stock buybacks are not a scam

I normally agree with the angry rants posted at lewrockwell.com, so I was surprised at the most recent article entitled Stock Buybacks are a Scam, by Eric Englund. The gist of his argument is summarized thusly: a bunch of large financial institutions underwent major buybacks over the past 6 years*, and now all of their stocks are tanking. Therefore, stock buybacks are bad for shareholders. Stated that way, it sounds stupid, to anyone who remembers that correlation does not necessarily equal causation.

He makes other points, such as that if buybacks are so good for companies, shouldn't management execute them when times are so tough? But of course that would be stupid, because during tough times a company should watch it's balance sheet and hold on to cash for dear life. Therefore, stock buybacks are always evil. This type of paranoid ranting bothers me, because it distracts from more deserving paranoid rants.

When a company earns money, it has 2 basic choices: re-invest to grow the company, or distribute the earnings to shareholders (or maybe employees). In order to distribute the earnings, the company can just pay the money out in cash as a dividend, or repurchase shares to drive up the price and value of remaining outstanding shares. Prior to the Bush tax cuts, the latter choice was clearly optimal because dividends were taxed at a much higher rate than capital gains; nowadays they're usually taxed at the same rate, so the choice is less clear.

The basic idea of a stock buyback is that a company believes its shares are undervalued, and thus shareholder value can be increased by buying shares. The understand this, lets say that the shares were exactly correctly priced at 1 share = present value future earnings. Buying 1 share at $100/share doesn't gain or lose the company anything, it pays $100 for $100 of future earnings. If the shares were undervalued, say at $90, then the company pays $90 for $100 of earnings. Of course, the company is only likely to be undervalued during "tough times", so management needs to make sure they have enough working capital (as always), but any surplus should be invested as profitably as possible.

Seems like a good idea to me. The act of the buyback will drive up the share price, benefiting current shareholders. Englunds argument about weakening the balance sheet is true of any business activity which requires capital, also known as any business activity. Still, buybacks are only a good idea if shares are undervalued, and the capital used could not be reinvested more profitably somewhere else.

Englund closes with a story told by Buffett (how could anybody disagree with Buffett?), about a CEO who uses share buybacks to drive up the share price and hide the declining earnings of the company. This is a valid concern, but Buffett's point relates to executive compensation, and gave an example of a CEO making a killing even though the company's earnings declined, because the CEO drove up the share price through buybacks.

This is an example of how stock buybacks can be used to hide declining performance. Most investors only care about a companys' share price. As long as it goes up, they're happy. A company which spends all of its' earnings on buybacks to drive up the price is not growing, and what investors are losing is opportunity. This is a real cost, and an investor should not be happy about a CEO sacrificing opportunities for long-term growth to create short-term stock gains.

A buyback is intended to transfer earnings from shareholders, and that's exactly what it does. Dividends do the same thing, but I'd be surprised if anybody would call massive dividends a scam. Usually the opposite is claimed, since payout ratios have been decreasing over time. They're ways to return earnings to shareholders. Obviously, management needs to strike a balance between retaining earnings for growth and paying out earnings to shareholders.

Yes, buybacks can be used to cover up declining earnings, and as such, they can be used to mislead shareholders. That doesn't make them bad in general, just like hammers aren't inherently evil because you can use them to kill people. They're a tool, simple as that.

Error rating: 3. The entire argument is based on 7 companies which are going through hell right now, assuming correlation equals causation, generalizing from 7 companies all in a single industry to the entire stock market, and mis-interpreting an example from Buffett. On second thought, all that together adds up to a 4.

-Enginerd

* He gives figures for J.P. Morgan, Citigroup, Lehman, Merill Lynch, Morgan Stanley, Wachovia, and Washington Mutual