Steve Saville of www.speculative-investor.com recently published an article to which he appended the following note:
"Many people believe that debt defaults cause the supply of money to shrink, but this is not so. A debt default will probably reduce the wealth of the person/company making the loan, but if the loan originally resulted in new money being created -- for example, a loan made by a commercial bank to finance the purchase of a home -- then that money will have been spent by the debtor and will remain within the economy following the loan default. Of course, if the customers of a lender default on their loans then the ability and/or desire of that lender to make additional loans may be hampered. It is therefore possible for debt defaults to bring about a reduction in the future rate of money supply growth, but debt defaults do not directly affect the existing supply of money."
(Emphasis mine).
This is a meme that I have come across on many message boards, but this is the first time I have seen it offered by a (self-appointed) analyst. The question is: "is it true?"
Let's follow through the logic.
1) A bank is established with, say $1m of capital.
2) It acquires $9m of deposits for a total of $10m of equity and liabilities.
3) The bank makes $10m of loans, say, 100 loans of $100k each.
4) The borrowers spend the money in the economy.
5) One of the $100k borrowers defaults, without paying any principle or interest.
So the money made it out of the bank and into the economy where it is trapped and can never be destroyed (according to Saville) right? Not so fast.
Let's liquidate the bank and see what we have. We sell off the loan portfolio at book for $9.9m. We use $9m to pay off our depositors. We use the remaining $900k to pay off the equity holders - $100k less than they provided to capitalize the bank.
It's clear that the $100k loan default has resulted in the destruction of $100k originally used to capitalize the bank. That's a wash, a one for one destruction of the money created through the loan.
My mental model of credit created cash is like a matter ($) - antimatter (debt) pair. They can exist seperately for a time (dictated by the terms of the loan), but ultimately the anti-matter will seek out an exact equal amount of matter to destroy. The money originally loaned into existence is either paid back or the capital backing the loan is consumed.
Naturally we can make this model more complete: What about the interest, what if we can't sell the loans at face value, what if the defaults exceed the banks capital, what if the FDIC bails out the depositers, etc, etc. It's the same in every case: someone's capital gets destroyed in equal amount to the default. If your analysis seems to leave money trapped in the economy you are not thinking hard enough (it's like the first law of thermodynamics).
I like Steve Saville's work as a well argued counterpoint to hardcore deflationists, but he is wrong on this point, defaults are deflationary.
Stock Buybacks
Here's a simple topic that is surrounded by myths and mis-conceptions: Stock buy-backs increase stock prices.
This is one of those ideas that contains some truth, but not for the reasons put forward, here are some of the variations you will see:
1. Stock buy-backs reduce the number of shares outstanding increasing earnings per share. To maintain constant PE the price must go up.
2. It shows a company's confidence in the future: they are investing in their own stock.
3. The company believes its stock is undervalued and will soon rise so they are buying it.
and so on.
First, let's address the mechanics of the situation. What is a company worth? Well, on the asset side of the balance sheet it has it's profit-making activities (V) plus any spare cash or liquid investments (C). On the liabilities side it has its debt (D). What is the stock worth in aggregate? S = V + C - D. Notice I am not invoking any valuation method to derive the value of the going concern, simply showing how it figures into the aggregate shareholders' equity.
So when a company pays a dividend or buys back stock it is using C, the cash (or liquid assets) it has over and above what it needs to fund day-to-day operations. With a dividend the effect is easy to see: C decreases so S decreases by an equal amount - this is why the ex-div price is equal to the share price less the dividend per share.
For the share buy-back it is a little more complex. Let's say there are N shares, trading at price P. Let's also agree that the company is going to spend all of its spare cash, C, on the buyback. So it buys back n = C/P shares. What is the stockholders net worth now? The original value of the company less the cash used = S - C = V-D. How many shares are left outstanding? N-n. What should their price be? Pnew = (V-D)/(N-n). Substitute n = C/P and you will see Pnew = P. So all other things being equal, the share price should not change.
How are the two events similar or different? Before the event we have a shareholders who own a company which owns productive assets worth V, cash worth C and owes debt of D. In the case of the dividend payment, after the event we have shareholder who own a company with assets worth V and debt of D, and the shareholders in total have cash of C - the cash has been transferred to the shareholders but their ownership of the company is worth less. In the case of the stock buy-back we have a reduced number of shareholders who own a company with assets worth V and debt of D, and the ex-shareholders who own total cash of C. Notice that the overall net worth of each of the players does not change, only the form of that net worth (a claim on cash and assets vs direct ownership of cash or assets).
The nice thing these days is that the tax consequences are the same for dividends and buy-backs.
So, going back to the points at the beginning of this post.
1. The PE of a company completing a stock buy-back doesn't stay constant. This is because by distributing all the cash, the leverage and hence the risk of the shareholders' investment increases, thus the PE decreases.
2. The idea of a company "investing" in their own stock is a fallacy. A company cannot invest in its own stock, it is meaningless to pay dividends to itself. It is meaningless for a company to buy its own stock, hold it and later sell it for a "profit". Most corporations have authorized but unissued stock that could serve the same purpose without using any cash for the buy-back in the first place. Any company telling you they are doing a stock buy-back to "invest" in their own stock is blowing smoke.
3. Same as above. If management believes their stock is undervalued then they should dig into their own pockets and buy with their own money. They should also do a better job communicating with the market. Neither of these activities uses the shareholders' money.
So why do corporations love to announce stock buy-backs rather than pay a dividend? My guess is that it is self-dealing on the part of management: Markets are not efficient in the short term, so any company buying its stock over a short time frame is going to drive up the stock price, people know this and try to ride it adding to momentum; once you have momentum running it feeds on itself. The bulk of senior management compensation is tied to options and stock grants which naturally do exceedingly well during these run-ups providing insiders with excellent compensation opportunities. When prices drop back down again, they can grant themselves a whole new batch of options at low strike prices. Wash. Rinse. Repeat.
As a final comment, note that as a result of the temporary run-up in stock price caused by a buy-back (or even the announcement of same) the company pays a temporarily inflated price for its shares and thus ends up buying less shares back than if markets were efficient. The remaining shareholders end up with less of the company than they might otherwise. So, distributing money to shareholders via buy-backs seems less efficient than via dividends.
This is one of those ideas that contains some truth, but not for the reasons put forward, here are some of the variations you will see:
1. Stock buy-backs reduce the number of shares outstanding increasing earnings per share. To maintain constant PE the price must go up.
2. It shows a company's confidence in the future: they are investing in their own stock.
3. The company believes its stock is undervalued and will soon rise so they are buying it.
and so on.
First, let's address the mechanics of the situation. What is a company worth? Well, on the asset side of the balance sheet it has it's profit-making activities (V) plus any spare cash or liquid investments (C). On the liabilities side it has its debt (D). What is the stock worth in aggregate? S = V + C - D. Notice I am not invoking any valuation method to derive the value of the going concern, simply showing how it figures into the aggregate shareholders' equity.
So when a company pays a dividend or buys back stock it is using C, the cash (or liquid assets) it has over and above what it needs to fund day-to-day operations. With a dividend the effect is easy to see: C decreases so S decreases by an equal amount - this is why the ex-div price is equal to the share price less the dividend per share.
For the share buy-back it is a little more complex. Let's say there are N shares, trading at price P. Let's also agree that the company is going to spend all of its spare cash, C, on the buyback. So it buys back n = C/P shares. What is the stockholders net worth now? The original value of the company less the cash used = S - C = V-D. How many shares are left outstanding? N-n. What should their price be? Pnew = (V-D)/(N-n). Substitute n = C/P and you will see Pnew = P. So all other things being equal, the share price should not change.
How are the two events similar or different? Before the event we have a shareholders who own a company which owns productive assets worth V, cash worth C and owes debt of D. In the case of the dividend payment, after the event we have shareholder who own a company with assets worth V and debt of D, and the shareholders in total have cash of C - the cash has been transferred to the shareholders but their ownership of the company is worth less. In the case of the stock buy-back we have a reduced number of shareholders who own a company with assets worth V and debt of D, and the ex-shareholders who own total cash of C. Notice that the overall net worth of each of the players does not change, only the form of that net worth (a claim on cash and assets vs direct ownership of cash or assets).
The nice thing these days is that the tax consequences are the same for dividends and buy-backs.
So, going back to the points at the beginning of this post.
1. The PE of a company completing a stock buy-back doesn't stay constant. This is because by distributing all the cash, the leverage and hence the risk of the shareholders' investment increases, thus the PE decreases.
2. The idea of a company "investing" in their own stock is a fallacy. A company cannot invest in its own stock, it is meaningless to pay dividends to itself. It is meaningless for a company to buy its own stock, hold it and later sell it for a "profit". Most corporations have authorized but unissued stock that could serve the same purpose without using any cash for the buy-back in the first place. Any company telling you they are doing a stock buy-back to "invest" in their own stock is blowing smoke.
3. Same as above. If management believes their stock is undervalued then they should dig into their own pockets and buy with their own money. They should also do a better job communicating with the market. Neither of these activities uses the shareholders' money.
So why do corporations love to announce stock buy-backs rather than pay a dividend? My guess is that it is self-dealing on the part of management: Markets are not efficient in the short term, so any company buying its stock over a short time frame is going to drive up the stock price, people know this and try to ride it adding to momentum; once you have momentum running it feeds on itself. The bulk of senior management compensation is tied to options and stock grants which naturally do exceedingly well during these run-ups providing insiders with excellent compensation opportunities. When prices drop back down again, they can grant themselves a whole new batch of options at low strike prices. Wash. Rinse. Repeat.
As a final comment, note that as a result of the temporary run-up in stock price caused by a buy-back (or even the announcement of same) the company pays a temporarily inflated price for its shares and thus ends up buying less shares back than if markets were efficient. The remaining shareholders end up with less of the company than they might otherwise. So, distributing money to shareholders via buy-backs seems less efficient than via dividends.
First Words
I have been following various economic and investment-oriented blogs for a couple years. I have learned a lot.
However, I often come across ideas that don't seem to make sense to me. There are two possible reasons: I just don't get it, or the idea itself isn't right.
In the hopes of helping me understand these ideas and, in the process, help others, I thought I would comment on them and see what feedback I get so I can figure out which of the two reasons seems to be applicable.
Many of the ideas I am talking about have achieved the status of memes. They are commonly held beliefs, trotted out without question or critical analysis, and it seems to me to be a good thing to challenge some of these memes to see if they really hold up.
I hope to be able to put these ideas into any one of four categories:
1. The idea is, in fact, correct and stands up to scrutiny.
2. The idea is simply and demonstrably wrong.
3. The idea contains a kernal of truth but is not operative to the extent its proponents claim.
4. The idea is correct but not for the reasons usually put forth.
My general approach to any kind of debate or discussion is to try to dig right down to the fundamental set of ideas that ultimately are a matter of opinion i.e. to find what is at the core of the disagreement. Then at least one can say: if you believe "a" then you should conclude "x", if you believe "b" then you should conclude "y". And no-one can say "a" or "b" is correct since they are a matter of speculation about the future and the actions of parties over which one has no control.
Perhaps an example might help here. I have been greatly fascinated by the inflation / deflation debate. It seems to me the whole debate comes down to: If you believe the Fed is controlled by politicians, and you believe politicians pander to the majority, then you will conclude that the Fed will inflate until our currency collapses in a hyperinflationary super-nova. If you believe the Fed will act to preserve the dollar and protect creditors (i.e. the banking community) then you must conclude the Fed will be unable to prevent a deflationary credit collapse and a severe recession (possibly even a second depression).
So, for now, anyone can comment, there are no rules. I will correct my posts for grammar / spelling as needed; if I make edits that materially change the content I will highlight those edits. I would welcome suggestions for topics (economic or investment related) to tackle.
Talk to you all soon.
However, I often come across ideas that don't seem to make sense to me. There are two possible reasons: I just don't get it, or the idea itself isn't right.
In the hopes of helping me understand these ideas and, in the process, help others, I thought I would comment on them and see what feedback I get so I can figure out which of the two reasons seems to be applicable.
Many of the ideas I am talking about have achieved the status of memes. They are commonly held beliefs, trotted out without question or critical analysis, and it seems to me to be a good thing to challenge some of these memes to see if they really hold up.
I hope to be able to put these ideas into any one of four categories:
1. The idea is, in fact, correct and stands up to scrutiny.
2. The idea is simply and demonstrably wrong.
3. The idea contains a kernal of truth but is not operative to the extent its proponents claim.
4. The idea is correct but not for the reasons usually put forth.
My general approach to any kind of debate or discussion is to try to dig right down to the fundamental set of ideas that ultimately are a matter of opinion i.e. to find what is at the core of the disagreement. Then at least one can say: if you believe "a" then you should conclude "x", if you believe "b" then you should conclude "y". And no-one can say "a" or "b" is correct since they are a matter of speculation about the future and the actions of parties over which one has no control.
Perhaps an example might help here. I have been greatly fascinated by the inflation / deflation debate. It seems to me the whole debate comes down to: If you believe the Fed is controlled by politicians, and you believe politicians pander to the majority, then you will conclude that the Fed will inflate until our currency collapses in a hyperinflationary super-nova. If you believe the Fed will act to preserve the dollar and protect creditors (i.e. the banking community) then you must conclude the Fed will be unable to prevent a deflationary credit collapse and a severe recession (possibly even a second depression).
So, for now, anyone can comment, there are no rules. I will correct my posts for grammar / spelling as needed; if I make edits that materially change the content I will highlight those edits. I would welcome suggestions for topics (economic or investment related) to tackle.
Talk to you all soon.
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