Friday, October 9, 2009

BusinessWeek, just put my subscription on hold

Cooper's article again lacked any whiff of rational thought and underlying facts to support his thesis but an even more egregious article was penned by Ben Levishon and Mark Scott. (Editor's note: don't click the link to the article unless you want some cheesy advertisement to queue up and start playing. WTF is that?) I imagine the penning of this article took place after a long three martini afternoon at the Delmonico.

I won't bore you with the details of the article but here is the handy dandy chart (which I had to re-create because they don't include it in their online article version. Seriously, WTF?)

Notice damage, pay extra, fewer choices, cost rising.

Notice now: may affect, may ..., could rise

So based on something they overheard while watching a monkey wrestling match at Delmonico even then they could not bring themselves to state that these reforms will actually affect any pricing. "I don't know what we are yelling about... Loud Noises!!"

They did find a partner whose firm represents JP Morgan Chase, ABN Amoro, Barclay's and BNP Paribas to state "it won't make it any easier for companies and investors to dig out of the recession." So they quickly put that in their sub-head on their collateral damage chart, except the editor made them add the caveat "may."

The authors then pen this gem "Credit Default Swaps - blew up, prompting huge loses at insurer American International Group and other companies. The reforms are meant to prevent another disaster." The thing is though, they did not blow up, in fact CDS's were the only market actively trading during the entire crisis. What did happen was that AIG posted no collateral for the CDS trades they initiated. They "wrote" these contracts meaning they would take in premium periodically over the life of the contract and if the underlying security defaulted then they would have to pay out.

Well some of their contracts triggered and then they need to pay those claims out. Then their counterparties demanded that they start posting collateral for CDS they underwrote. This created a $180 billion dollar hole in AIG's balance sheet almost over night. It was not the instrument!! It was that unlike contracts that trade at the CME, the Merc, NYMEX where you have to post collateral when contracts go against you, there was no action you could take against AIG until it was too late, thus the run on the company.

The authors continue "Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south." Well, we already talked about that above. Their argued flaw is actually the enhancement that will prevent AIG-type companies from blowing up!!! Avoiding collateral charges because of their AAA ratings is not reasonable. This idea ensures that counterparty exposures can be nipped in the bud when companies bet wrongly in the derivative markets.

So there goes one of the boys arguments.

"The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized."

The regulators are treading lightly. They want safety for the financial system, but also not to deter consenting adults from making contracts. The hope is to move CDS contracts to the exchanges where there are more safeguards. Thus far, regulators only want to move standardized contracts to the exchanges. Tailored CDS solutions will still be allowed if that is what a client needs. However, it will be out in the open and very transparent that companies will take on a huge counterparty risk if it chooses a non-exchange traded contract.

Another one bites the dust and now for the nail in the coffin.

Here is the real reason the shills are heading their masters' calls. From Satyajit Das "Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity. The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible."

From the article, "In light of the changes, financial firms are pulling back on some commodity offerings for small investors...Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area."

This is probably a sane idea as well from Barclays. There is a must read article from David Merkel about investors in Commodity ETFs are being snookered.

Here is the money quote for those short on time. "One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple. “Buy the front month futures contract, and roll to the second month contract before the front month expires.” Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy. So, what do the other investors do? They take the opposite side of the trade early, in order to make it more expensive to do the roll. Buy the second month contract, and short the first. As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract. What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market."

Too bad, so sad. No real problem there accept small investors may be better protected from ETFs that do not work as advertised.

Oh no the dread of all publishers who publish an honest-to-god hold-in-your-hand periodical, there is only two paragraphs left!!!!

High-Frequency Trading

"The technique [high-frequency trading] has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled."

The Daily Show With Jon StewartMon - Thurs 11p / 10c
Cash Cow - High-Frequency Trading
Daily Show
Full Episodes
Political HumorRon Paul Interview

Well that was fun but seriously HFT is not a bad thing. It's much worse.

Commissions have gone down for trading. The spread may have lessened as Professor Lo points out. However, someone is paying for the spread and it is the retail investors. Now, back in the old days there was a market maker and he took the spread. He has now been pushed aside by the HFT supercomputers since they both perform the same function. However, investors and traders were willing to pay the spread to the market maker for liquidity. So when you bought the market maker sold; if you sold he bought. With the HFT there is no guarantee or onus of guaranteeing liquidity. If the bots do not want to play no one can make them. Thus, liquidity can be withdrawn from the system overnight and liquid positions may not be based on the, relatively [may be this is a mixed metaphor], solid pillar the trader believes them to be. There is a lot of information at this website.

So all in all not bad for BW, they missed on all three accounts.

Analysis, analysis everywhere but not a drop of think

So I stopped by my favorite, well one of my favorite, spots on the Internet. The S&P500 estimates website and was pleasantly surprised that it now had a spot on revenues. As an aside I am also working on a retail sales spreadsheet but the slog is slow, this is to show how pricing power is declining. So let me put up what S&P has on revenues.

Click to enlarge.
Below their data set I just wanted to see the data expressed in a level with the beginning of September 2008 as 1. Thus, Revenues at this point are 39.02% below where they were at this time last year.

Then I took a stab at valuing the index based upon expected earnings both operating (excludes write-offs and write-downs) and reported earnings. I used the Baa Corp Bond Yield as the discount rate. For the exit year I used both a P/E of 15 and also a straight line growth of 5% with inflation running at 3%. Here is what I found.

So what is going on in the market looks rational. Based on my crude estimates the index could be overvalued by over 25% or it could be dead on. Bulls versus bears and all that jazz. But this where I draw back to my first chart with revenues. That is, cost cutting can only do so much to hold on to earnings. Are there any other risks to earnings besides the micro factors affecting the companies that collectively make up the index? Then I remembered this chart from Credit Suisse

I first saw this from John Mauldin years ago. Now astute viewers may argue that this is not a big problem. They will reason that it says Option Adjustable Rate and since rates have fallen since these mortgages were underwritten that this will actually be a boon to homeowners. Well, yes and no. It is true that mortgage rates have lowered and when they "reset" it will be to lower rates. However, a portion of these are "recasting." Recast means that the person who took the mortgage took a interest only option, or a "pick-a-pay, " which means that even if the rate is resetting lower because the person will now be responsible for principal as well interest will see their payment jump, sometimes double or triple what they have been paying. This is because the principal has never been actually touched by the monthly mortgage payment or in some cases it has actually grown because of negative amortization. So the proportion of these loans will be key.

Click to enlarge

Basically it states that "Of the $189 billion securitized Option ARM loans outstanding, 88% have yet to experience a recast event ... Of these loans that have not yet recast, 94% have utilized the minimum monthly payment to allow their loans to negatively amortize." I'll outsource to my favorite chihuahua "Ren: ...he's DEAD! DEAD YOU EEDIOT! YOU KNOW WHAT DEAD IS? JUST LIKE WE'LL BE IF WE DON'T GET OUT OF 'ERE!"

Now let's have a look at that chart again.

The coming crisis will be about as a big as the subprime crisis. However, because the economy will be a lot weaker than it was when subprime hit this could portend a double dip recession where we take out the March lows before we finally have cleansed the system. I am not suggesting guns and bottled water but gold... it may finally be the time where gold as a store of value takes center stage in your investment portfolio.

Wednesday, October 7, 2009

Debt-Market Paralysis Deepens Credit Drought

Good to see MSM media covering a topic I covered over a month ago.

So I'll do a reprint plus add in my nifty chart of the financial system.

This is similar to Paul Krugman's chart found here.

Here is the re-post in italics. Below I will add some notes from the NY Times post.

I was on the Federal Reserve website checking out the major holders of debt in the United States historically. Both charts that I created show basically the same data. The first though shows the difference in the amount of debt over time, though it is nominal terms not real terms. The second just illustrates more lucidly the amount allocated to each type of provider. There were no data from earlier, but we can generalize that the banking system in the Great Depression looked a lot more like the 1943 data than the 2003's data points.

So it is obvious that the financial system has evolved, not in the Victorian sense that evolution necessarily means for the better, just that it has mutated. Securitized pools which do not exist in the data until the end of the 1980's come to make up over 30% of debt extended in its halycon days of 2003. A securitized pool is a pool of debt instruments for instance mortgages, or credit card debt, or automobile debt, or just general loans. These are sold to investors, usually pension funds, mutual funds, etc. The idea is that these instruments should be safe but yield more than comparable government bonds or AAA corporate bonds. These pools also allow the end borrower to borrow more cheaply than had investors not bid up the price they would pay for these structures.

The reason to make the distinction between the two eras or even to look back at how the debt market has evolved is that the response of the players should be different as well. When a bank in the 1920s and 1930s funded itself via deposits and then constructed a loan portfolio of assets it was subject to a risk of concentration. The first part of the concentration risk was that since there was no FDIC the deposits were not insured, so if all the people of the town came asking for their money at the same time there would not be enough cash in the vault to meet their claims. The second risk that stems from the first, was that if the financial system was in dire enough shape for people to be asking for their cash deposits back it meant that the economic system was in arrears as well with unemployment sure to follow. Thus, the loan portfolio (mortgages, small business loans) concentrated in the area in which the bank was would probably not pay back all the cash flows it was expected to generate. These are the reasons that the social safety net was constructed with unemployment insurance and deposit insurance.

So, what can be expected of the banks to do now? Well, banks will keep on doing what they have been doing. Making loans where it is profitable to do so and winding down bad loans. It is instead the securitized pools that worry me. Some of those pools were brought back onto the originating banks balance sheets, which then ties up their regulatory capital, thus decreasing their lending. Now a securitized deal cannot even be done without a guarantee from the Federal Government backing it. If we lop off the 25% of debt structure of the United States it will be hard to recover back to normal and "normal earnings and revenues." It's what PIMCO has been saying for awhile now that a new normal may be in store.

I echo thoughts from Mr Krugman. When you have a business model that relies upon investors who then rely upon rating agencies there has to be a lot of trust. When a bank makes a loan either student, credit card, mortgage, it knows its customer, or at least tries to understand it. When the loan is extended through securitization the role of the bank know falls upon the investors. Since there are multitudes of underlying mortgages or loans that make up the pool the investors rely upon the originator to have made honest assessments and to diversify the holdings. Secondly, the investor relied upon the rating agencies to act as a safeguard in reviewing these same pools to ensure they were well diversified and that they were actual assets to back up the loans. During the boom neither of these ideas were true for the banks or the rating agencies. Of course, this market is now dead.

Now as I see it there is a two fold crisis. On the one hand there is no trust, so no one wishes to lend. [The decrease in securities lending and also bank lending] On the second hand no one wishes to borrow either. People do not want to borrow to purchase a home that may continue to lose value. They do not want to borrow to obtain a MBA that will have no job offer at the end of their two year commitment. There has to be an outside stimulus of aggregate demand to shift resources from the defunct housing market to the now unemployment dole to the next engine of growth.

In my state of mind, the weakening dollar is a good thing. It will stimulate export growth and also retard imports. It will make the creation of renewable energy devices, fresh water desalinization created here rather than China. It will be our next bubble to invest in!!!

Tuesday, October 6, 2009

Private Equity, my version of the neverending story

Nobody likes Private Equity, never have and never will. The hedge funds hate them because they make similar amounts but their structure prevents investor runs on the funds, unlike the ones that occur to a hedge fund. The i-bankers hate them because they have more freedom and make more money than they do. The regulators hate them because they operate outside their grasp. People hate them because the tippy-top make more money than Peru in a given year and almost everyone in the industry, at minimum, makes more than 3x what a median American household makes. For these reasons, and many, many more PE tries to keep a low profile. However, if you want to do the research you can find out about them their deal history, their portfolio companies, and anything else you might ponder. Dartmouth's Tuck School of Business has a dedicated unit writing up case studies and training talent for these firms. Of course, Harvard, Stanford and Chicago train plenty of MBAs who end up in PE, either by starting a firm or joining one. Still, the only thing that ends up in main stream media are the giant takeovers and the blow ups, which represent a very small and an even smaller proportion of the deals done.

The latest missive continues the trend of large takeovers and blow ups to again portray the industry in poor light. To help, I will refute some of the misunderstandings and bring about the industry in lay terms.

Imagine a house. Now imagine you want to buy that house. If you are unlike Bill Gates, you will more than likely require financing. Now the current owner's financing may be completely different from your idea of what an ideal capital structure may be. The mortgage may have already been paid off, or they may only own 25% equity if the had recently purchased it. This does not matter because you will pay them the agreed sales price and then can institute your own capital structure. For instance, once the sales agreement is negotiated stating you would pay 100,000 for the house. If it was the latter situation (25% equity), 75,000 would go to pay down the mortgage lender and 25,000 of equity would go to the former owners. Now your financing may be something like 50% cash and 50% mortgage from your local bank. The bank lends you money because it knows if you do not pay than it can reclaim the house from you, that is the mortgage is collateralized.

Most LBOs are like mortgages where the new owners put down 20% equity and borrow the last 80% from banks, or shadow banks (sophisticated debt investors) using the assets of the firm as collateral. After the mortgage is paid down, does not have to be all the way, you can sell it. The purchaser (PE firm) will make money in several ways: the equity appreciation (less debt in the capital structure), multiple expansion ( the next buyer will pay you more than you paid for the home.) That's basically all there is to private equity. Just like a 68% of Americans have done when purchasing their home, Private equity firms use collateralized loans.

Of course just like Americans found out, PE firms' portfolio companies can still end up underwater trying to live the American dream.

1st let me flesh out an idea about how the cycle of a portfolio company works. Ever see the movie Ronin. Well, Robert DeNiro's character never walked into a place he couldn't get out of. That's exactly how PE firms think. From day one they are thinking about the exit. (plenty of good work here.) Basically, there are a few ways PE firms will end their involvement with one of their portfolio companies.
  • Merger with a public company, including a reverse merger where the public entity merges into the private entity
  • Acquisition, this can be from a conglomerate, a competitor, or to another PE firm
  • IPO, sell the shares to the public
  • private placement, where a few large institutions purchase the company or a portion of it
So instead of this paragraph sounding ominous "... as part of an agreement by its current owners to sell the company — the seventh time it has been sold in a little more than two decades — all after being owned for short periods by a parade of different investment groups, known as private equity firms, which try to buy undervalued companies, mostly with borrowed money." You can see that this is just one of the ways that a PE firm exits. It just so happens that each time it was to a financial buyer instead of a strategic purchase from a firm like Sealy or Tempurpedic.

The article then speaks about dividend recapitalization. Here I can agree with the article's thrust that this action is a very dangerous game to play. However, the General Partner of the PE firm, may be at a time where his investors are looking for a return. What this action does is bring money back immediately to the LPs (investors of the PE firm) but also gives them a call option should the firm continue to shed its debt with its operational cash flow. The new debt though has to be sold to someone and that entity or entities may require some agreements, or covenants, that restrict the flexibility of the firm. This is, as the article insinuates, akin to taking out a second mortgage. Plus, as in the case of Simmons, the company can become over-levered in an economic environment that is unfavorable thus tipping the portfolio company into bankruptcy. With no recourse to follow back up to the PE firm, this leaves a bad taste in the mouths of all the people mentioned in paragraph one.

As always, the financial intermediaries will make money as long as transactions are going on. So of course investment banks made money as underwriters of debt and of IPOs. Articles like these love to point this out when the company fails but the i-banks also make money when these firms succeed as well.

The rest of the article could be about any firm, any where in the current economic environment. The cheap debt era ended, consumers have cut back and employees who were looking for a lifetime commitment are in the best of cases receiving a severance on their way out the door.

From the article, "because they pile debt onto the companies they buy, the firms free up their own cash, allowing them to make additional investments and increase their potential profits."

This is in so many ways wrong. The PE firms do not hold cash, they hold commitments from their limited partners (LPs/investors.) When they find a firm to purchase they hold a capital call and the LPs are supposed to provide the cash necessary to support the capital structure the GP (general partner) thinks is best suited for the targeted firm given its micro- and macro-economic environment. So never will a PE firm pony up 100% of the cash to buy a firm, just to then lard it down with debt, given the new acquisition its best shot but just playing the coin flip of heads I win, tails you lose. Intense projections, which are corroborated by the retained management, are devised. The capital structure is tested for revenue drops and unexpected shocks. The management is encouraged by the PE firm because they will also have a stake in the new capital structure along with the PE firm. So everyone works together to make the most amount of money for the equity holders of the new firm.

As I stated above there are a few ways in which to make money in the PE process, the two already mentioned because they fell in with the house analogy are debt repayment and multiple expansion. The third however is the generation of cash flow. The PE firm's staff are highly trained management, process innovators, former industry titans and financiers who know how to change a business model from one that may putter along into a well oiled machine. The business model has to be that way to ensure enough leeway to make bond coupon payments from the debt the company has taken on.

Any cash taken out of the portfolio company is returned to the partners of the PE firm, either the General or the Limited Partners according to their agreement and how far along they are in the agreement. If this is the first cash generating investment it would more than likely all be going to the LPs. If it was the last 80% would go to the LPs and 20% to the GP. None of this money is used to make new investments.

The remaining piece of the article tends to hone on the two points, the dividend recapitalization and the fall of Simmons market & thus the company. I would point out one more thing, the dividend recap was oversubscribed. The investors buying this "home equity loan" knew what it was being used for and thought with all the cheap debt and the solid business model that Simmons could handle it and be able to pay them back. Unfortunately they were wrong. The human interest portion of the article while touching and sad as Schumpterian creative destruction takes hold, shows how the executives were trying to save the company. Whereas the employee remarks there were no more Christmas parties, I say, well that means that the factory can make payroll for the next week instead.

Did THL error, yes. Did employees suffer, yes. Is this what THL predicted or wanted as an outcome? No. That they may have gleaned their principal back is not what their LPs want. In fact when they raise their next fund the LPs will remember that in this investment they were returned their principal and not a return on the principal. The fact is at the end of the day the bondholders (including the ones who lent the "second mortgage,") will try to make a new go of it. The only thing changing will be the owners of the company. I predict that consumers will still be enjoying Simmons mattresses years from now.

“How Economists Are Missing Another One,” or Not

The worst thing I have ever read. It completely lacks an understanding of savings, investment and how the capital markets work. It does include enough facts that it seems plausible but I am still baffled as to how this was printed at The Big Picture at 10:18 AM 10/6/2009.

First, I would like to state that yes shares are traded on the secondary market and that people or corporations buying these shares are not really inserting new capital into a company unless they are buying an IPO or a seasoned offering. The reason this is done is to buy portions of current and future earnings that will be ultimately be returned to the shareholders through dividends, stock repurchases by the company or selling it to another entity who wishes to diversify their holdings and have a claim on the company’s earnings.

The “quelle horror” of total return versus dividends is because there is a tax benefit for shareholders in that dividends are taxed as ordinary income in the year received. However, when the corporation buys backs it shares and thus concentrates the earnings to the surviving shareholders; the shareholder can either choose to sell some of his holdings back to the company for income or hold on and be taxed later on. The taxation all depends on the shareholder’s preference. This is why total return is a better mark than dividends.

The argument that companies can create money is ridiculous. The Federal Reserve is the only entity that can create money using the banking system multiplier and open market purchases. There are newer tools but I won’t bore you with them now. This bold statement is made but then later on in the essay the author then decides that it isn’t really creating money it is shifting money from savers to investors, which is exactly the raison d’etre of the financial system. I would liken this to being angry with the sun because it basks us with sunlight every morning.

The paper fortune that you describe Bill Gates has is because each of those shares he has includes a claim of the near monopoly pricing and therefore earnings of Microsoft. If everyone traded in their laptop for an iPhone than guess what; those shares would drop in value not because they were worthless to begin with but because the future earnings of Microsoft would be in peril. Thus, the incendiary remark that it is a legal form of counterfeiting is placed in there only to excite the automatons. The whole piece reeks of this economic populism. For instance, “Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.” While it may be true that entrepreneurs are benefiting by selling shares in their enterprises to the common man, they are not doing so without giving the common man a claim against any and all future income that the corporation may receive.

I cannot even fathom how the author comes up with the idea, let alone the evidence, that “These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition.” If the “hulk” of the company was in such a “weakened” position than who would purchase it? This assumes that the i-bankers underwriting the IPOs are snake oil salesman and that this is done with the tacit agreement from the SEC. Both of these statements may still be true, however, at the end of the day the buyer of these IPO shares has to have done due diligence and expects to earn a return not a bankruptcy.

Here is a report by a Harvard and Chicago professor about the job loss at private equity firms.

If no time read the article by Andrew Sorkin of the Times describing that paper and its results here.

Both find little evidence that private equity firms do more firings than is necessary to clear dead wood than any other firm. “[Portfolio companies] compared with those public companies with similar junk debt ratings, buyout [portfolio] companies defaulted at half the rate.” Tends to show that PE firms are more adept at managing a fiscal crisis than their public counter-parties. I will agree that the behemoth pe firms can have their incentive structured skewed to earn management fees and transaction advisory fees, ahem KKR, but the majority of funds and the GPs only make money once it has been all returned to the LPs. (indeed the carried interest doesn’t start until the principal and the management fees are returned.)

After that section though I have no quips with the analysis. The boomers turning from buyers to sellers is a valid argument, especially in the face of the liquidity crisis cum solvency crisis of the past few years. If on a whole investor’s risk appetites switch to shorter duration investments for income generation or just in cash or cash-like equivalents than yes the stock market could tank as there would be more supply than demand. But markets have a funny way of clearing. So if investors preferences do change to more income producing investments, I believe stock buybacks might be accelerated to decrease the supply of stock shares outstanding. Alternatively, the government may change its rules, as it is want do when a large portion of voters now need dividends, having capital gains and dividends receive the same tax treatment. This in turn would shift CFOs to go back to offering dividends with its excess cash instead of share buybacks, which would make the author happy?

Finally, I should think in concurrence with the author that baby boomers who planned on having twenty plus years of retirement may instead be more realistic and work later on into life, thus, decreasing the amount of time in which they have to live off of their investments.

I apologize for being so shrill to begin with, but there is some good analysis in this piece, it’s just that there is a ton of rhetoric contained in this piece that has been refuted.

I am re-posting this below because now I cannot find this anywhere on the internet. Here is a screen grab from my RSS feeder.

Thornton Parker is the author of “What If Boomers Can’t Retire? How to Build Real Security, Not Phantom Wealth” and has worked for the Department of Commerce and the Executive Office of the President. He focuses on retirement plans and investing in stocks to solve the ongoing Social Security problem. He defines phantom wealth as “the returns from corporate stocks that are based on market prices” as opposed to real wealth that is based on “work, earnings, and solid accomplishments, instead of just hopes.”


Paul Krugman explained, in “How Did Economists Get It So Wrong” (The New York Times Magazine, September 6, 2009) how economists’ oversimplifying assumptions and models led to the present crisis by hiding important realities of the financial system and the real economy. He also described differences between the “salt water” economists at universities along the Atlantic and Pacific coasts and the “fresh water” economists of the Middle West, particularly the University of Chicago.

Today’s crisis grew out of problems on the credit and consumption sides of the economy. This essay builds on Krugman’s article and explains why problems on the equity and production sides, that few economists, political leaders, or corporate executives seem to understand or are willing to admit, are likely to cause another crisis.

Most salt water economists agree that creating jobs on Main Street is important. That will require extensive private sector investments, but the term “investment” has several meanings that can hide the different ways that stocks can affect jobs, wealth distribution, and the economy. The differences stem from three aspects of stock investments; types of investment, investors’ objectives, and stock flows.

Types of stock investments

Stock investments are productive or parasitic. The line between them can be fuzzy sometimes, but the differences are usually clear. Productive investments, which are called direct investments when made in other countries, provide capital to start and expand businesses in the real economy. They pay for the things, knowledge, and services that a company needs to operate. Young companies that are intended to become large need productive investments that usually come from the founders, their friends and families, and early stage investors such as angels and venture capitalists who take active interests. Because investments in these young companies involve many risks and are hard to liquidate, the companies depend on stock and rarely borrow very much. If they are successful, they may raise more productive capital from an initial public offering (IPO) and maybe from secondary offerings. If they continue to grow and establish a credit record, they may borrow money for productive investments, but equity capital is required for most early stage development.

In contrast, most stock purchases by individuals and institutional investors are parasitic investments because the buyers just want their money to grow. They are not interested in who gets their money or how it is used. They may buy stock of specific companies or they may buy shares of mutual and exchange traded funds that in turn buy companies’ stock. In any case, their money goes to the former stockholders, not to the companies. These are parasitic investments because they contribute little to the companies but piggy-back the productive investments that others have already made. And as will be discussed, they may be harmful and lead to eliminating rather than creating Main Street jobs.

Investors’ objectives

Five primary reasons for obtaining stock are for control of a company; to receive current income from its operations; for price gains; to store future purchasing power; and to create money. Company founders typically believe they know best how to manage their new enterprise, so they take large blocks of stock before the IPO in order to retain control. Similarly, outsiders who want to influence or take over a company may buy large amounts of its stock on secondary markets.

Income from dividends used to be a major reason to buy stock for the long term, but in the early 1980s, emphasis shifted to “total returns” which were dominated by price gains. S&P 500 Stock Index data show that 1981 was the last year after 1925 when the sum of all dividends paid was greater than the gains. The shift was profitable for Wall Street and coincided with the emergence of 401(k) retirement plans which emphasized growing portfolio values. Now, most stock purchases are for short term gains.

Retirement plans are the dominant stock buyers today, and their purpose is to build future purchasing power. But the plans have hurt Main Street and have fatal flaws which will be discussed below.

Finally, despite the general understanding that companies issue stock to raise money, their main reason is literally to create a form of money.

Stock flows

Individual and institutional investors buy most of their stock on the New York Stock Exchange, the NASDAQ and other secondary markets. Only small amounts of stock are bought directly from companies through public offerings. My analyses of Federal Reserve Flow of Funds Data indicate that after companies have their IPOs, most of their shares come to secondary markets when insiders sell them. This will be discussed below because it has major wealth distribution and other effects that few people understand, economists ignore, and those who benefit try to keep from being discussed.

Creating money with stocks

The reckless expansion of credit that led to over-consumption and the housing bubble has been widely discussed, but comparable mistakes with stock are being ignored. Creating money is the best place to start applying the three aspects of stock investments listed above (types of investment, investors’ objectives, and stock flows) to show how stocks can affect jobs, wealth distribution, and the economy.

It is natural for the founders of a company to want to keep control of their baby, so they can easily justify taking large blocks of stock before the IPO. Right after the IPO, however, all shares are treated as being worth the market price and if the founders took enough, their paper fortunes can make them rich in a day. Most recent fortunes have been made by (figuratively) printing stock certificates and passing them as money in what amounts to a legal form of counterfeiting. Few economists or public officials have recognized how this process expands the money supply while reducing the national savings rate, and almost no data are published to track it. Entrepreneurs need incentives to take risks, but there are serious questions about how large the incentives should be and how they should be taxed.

Insiders convert their paper fortunes into cash by selling the stock. Aggregate data for this are scarce, but it is how most stocks come into the market. The efficient-market hypothesis (EMH) does not consider how insiders drip feed stock into the market, pacing the sales to maximize their returns while not overly depressing the market.

Bill Gates, the richest person in the world, is the extreme example of this. He took 45% of the Microsoft stock before the company went public in 1986 and has been selling ever since. During the first eight months of 2009, he sold 60 million shares for a total of $1.2 billion. He more than recovered his investment from his first sale during the IPO, so all of his receipts are profit and are now taxed as capital gains at 15%. He still had 713 million shares as of August 18, 2009, which at the average price he received this year is a paper fortune of more than $14.7 billion. Like many other companies, a primary goal of Microsoft is to create personal fortunes using its stock, and at one time there were an estimated 10,000 “Microsoft millionaires.”

Retirement plans

Retirement plans exist to provide earnings streams to retirees. After 1982, Wall Street began promoting stocks as retirement investments by emphasizing their “total returns” which are driven by stock price growth more than dividend payments. Largely as a result of this change, stock prices were inflated in terms of their price-to-dividends and price-to-earnings ratios until the market peak in early 2000. Today, retirement plans of all types own nearly two thirds of the publicly-held stock traded on U.S. markets, but three important points are being overlooked.

First, as retirement plans bought stocks, almost no one asked where the stocks were coming from and where the retirement savings were going; or to put it another way, if stocks were such good long term investments, who was selling them and why? The answer, which few people including economists and political leaders seem to know, is that insiders like Bill Gates and his associates sold most of the stocks that the plans bought in order to convert their paper fortunes into cash. Despite Wall Street claims, retirement plans invest little in companies. Instead, the plans buy stock that insiders sell, thus transferring middle class savings to the richest people in the country and increasing the wealth gap.

The second point is that except for small amounts that some pension plans put into venture capital funds, nearly all stock investments by retirement plans are parasitic. As money flows in to plan managers who are expected to make it grow, they buy stocks and pass the pressure for growth on to companies. The companies respond by cutting costs, downsizing, outsourcing, laying off domestic employees, abandoning communities, promoting globalization, and going global themselves, all to inflate stock prices.

A recent example of these harmful effects grew out of the search for higher returns by pension systems. When stock prices stopped rising, they turned to “alternative investments,” including miss-named private equity funds which are actually leveraged buy-out operations. These LBO outfits acquire a company with strong assets including cash but low stock prices; sell some of the assets; close down operations and eliminate jobs to cut costs; extract the cash with dividends; borrow large amounts to pay for the process; and sell the companies back on the market in a weakened condition. The LBO outfits and pension plans are the winners, while companies, their employees, and their communities are the obvious losers. Less obvious are the companies that have learned not to look healthy enough to attract LBO attention.

The net effect of retirement plans’ buying insiders’ stock and parasitic investing has been to shrink both the production side of the economy and the middle class. The shrinkage was partly hidden while borrowing financed the housing bubble and excess consumption. Now, the country is trying to end the recession and create jobs, but the production side of the economy is crippled. Rebuilding it will require massive productive investments in companies and even new industries to create jobs that will be harder to export. People are being advised to save more for their retirements, but almost none of their savings that will be handled by retirement plans or Wall Street will become available for the productive, equity investments that will be needed to create jobs.

The third overlooked point about stock-based retirement plans that is until their stocks are sold, their portfolio values are just phantom wealth that can simply vanish, as it has done twice in the past ten years. Whether or not the plans can be successful will be determined by the demand for stocks and supply offered for sale when boomers want to retire. This leads to the fundamental flaws in stock-based retirement plans.

Retirement plan flaws can lead to another crisis

One of the worst things that could happen in the near future would be for stock prices to return to their former heights because that would restore confidence in stock-based retirement plans. These plans have eight fundamental flaws.

  1. They are built on a stocks-for-retirement cycle. Most baby boomers are in the front, or buying half of the cycle, and to receive retirement incomes, they will have to shift to selling their stocks for substantial gains in the back half. This makes the cycle a national Ponzi scheme because returns to early investors (boomers) must come from money paid in by later investors (younger workers), not from companies as dividends.
  2. When boomers gradually shift from buying stocks to selling them, the primary domestic buyers will have to be the younger workers that some believe will not be able to sustain Social Security in its present form. Stock-based plans and Social Security are joined at the hip by the same demographics—if stock based plans can work, there will be no Social Security problem, but if Social Security can’t work, neither can the stock-based plans. Despite urgings to boomers to save more and buy stock, their plans will be determined as much by the saving and stock-buying habits of younger workers as by the boomers’ own actions.
  3. There has been a symbiosis between corporate insiders and boomers’ retirement plans. The plans wanted the insiders’ stocks and the insiders wanted the boomers’ money. As the boomers’ plans shift from buying to selling, the relationship will end and they will have to compete with insiders who will still be selling. This will add more downward pressure to stock prices in what may become a sustained bear market.
  4. Boomers are told to plan to stretch their stock sales over many years, but if there is a serious bear market, some of them may decide to get out quickly and save what they can. This, of course, would feed the bear.
  5. Boomers’ retirement plans that will have to sell stock suffer from the fallacy of composition; while some might be able to build and store future purchasing power individually, all of them can not do it collectively. Retirement income cannot be stored for a whole generation. It is a flow that can only come from other flows like employee and company earnings, which is why there appears to be a Social Security problem.
  6. If there were an accepted due diligence analysis or feasibility study that explains how the boomers’ stocks-for-retirement cycle can be expected to work, Wall Street would quote it like a mantra. But there is no such document, so when asked, Wall Street changes the subject.
  7. The plans are based on the same mistake of anticipating ever higher asset prices that led to the housing bubble. There is no accepted explanation of how stock prices can increase more than the economy grows for several generations, but this must happen for younger workers to pay adequate prices for the boomers’ stocks and then sell them at a profit to pay for their own retirements.
  8. In a 2002 paper titled “Demography and the Long-Run Predictability of the Stock Market,” John Geanakoplos of Yale and two salt water associates from the West Coast explained that there has been a close relationship between stock prices as represented by price-earnings ratios and the ratio of young and old adults in the population. They predict a long bear market when boomers switch to selling.

The termination of thousands of company pension plans and the sorry shape of many state and local plans are evidence of these flaws. Any one of these flaws should be enough to make economists, corporate and government officials, and Wall Street question boomers’ plans before they all fail. But instead of asking questions, they avoid them.

What’s left?

Like fractals, the picture is similar at any level of detail. Few boomers have saved nearly enough to hope to retire for many years; despite Wall Street predictions, their stock-based retirement plans have done little for the past ten years; their savings in houses have declined; and ultimately the stock portion of their retirement plans are likely to fail as many pension plans are failing now. Many boomers will have to work more years than previous generations.

Governments typically approach employment problems with training programs, but unless jobs are created, training will be useless. Massive, productive investments must be made in new industries to create the middle class jobs with adequate pay and benefits that boomers, those who lost their jobs in the recession, and younger workers coming into the labor force will need. But these are just the kinds of investments and jobs that institutional investors, including retirement plans, have been forcing companies to avoid or eliminate. Further, Wall Street is devoted almost entirely to helping wealthy people speculate with parasitic investments and is not equipped to provide the equity capital needed to make the productive investments.

Today, attention is being paid to problems on the credit and consumption sides of the economy, but regardless of when the recession formally ends, America’s recovery and long range prosperity will be limited by problems on the equity and production sides. These problems will be harder to fix than the ones being considered now because they are more subtle; few people understand them; the fixes will require far more complex changes to the financial system; governments have reached their borrowing limits; and Wall Street will deny them and may delay action until it is too late to avoid a another crisis

But problems on Main Street, which Wall Street helped to create and many economists are missing, will not just go away and it is impossible to explain how the economy can regain its strength unless it is based on a strong Main Street.