Month: March 2023

It’s Déjà vu All Over Again

Posted on by j.giglio

What’s telling about the Silicon Valley Bank collapse is that no one saw it coming.  When, on a visit to a London business school after the 2008-09 global financial crisis the late Queen Elizabeth asked why nobody saw it coming, no one had a clear answer.  Why, in a financial world crawling with regulators, did no one realize that subprime mortgages were toxic and on the brink of falling apart?

It looks like the regulators dropped their guard again.  Had they come to simply and blindly assume another set of false beliefs that ultra-low interest rates, designed to help tackle recession, were here to stay?

Entire business models were built on this assumption.  But then inflation returned and interest rates shot up.  And now we’re learning just how many banks bet the house on the idea that rates would never rise again.

Regulators closed Silicon Valley Bank, which catered to the tech industry for three decades, on March 10.  After an old-fashioned bank run, it did not have enough cash to pay its depositors.  It was the biggest bank to fail since the 2008-2009 financial crisis and the second biggest ever, after Washington Mutual fell in the wake of the collapse of investment bank Lehman Brothers, which nearly took down the global financial system.

During the COVID pandemic, Silicon Valley and other banks were raking in more deposits than they could lend out to borrowers.  In 2021, deposits at the bank doubled.

But they had to do something with all that money.  So they invested the excess in long-term ultra-safe U.S. treasury securities and mortgage bonds.  But rapid increases in interest rates in 2022 and 2023 caused the value of these securities to plunge.

The bank said it took a $1.8 billion hit on the sale of these securities and was unable to raise capital to offset the loss as their stock began to drop.  The bank’s client base, which included a lot of tech companies, exacerbated the problem.  Venture capital firms advised companies they invested in to pull their business from the bank.  This led to a growing number of the bank’s depositors to withdraw their money, too.  The investment losses, coupled with withdrawals, were so large that regulators had no choice but to step in and shut down the bank.

Despite being the 16th largest bank in the United States, Silicon Valley Bank was exempt from many stress- testing regulations other banks were compelled to follow.  It did its best to show it was one of the good guys.  Last year, for instance, it publicly committed $5 billion in “sustainable finance and carbon neutral operations to support a healthier planet.”

But how sustainable were the bank’s own finances?  It turns out its business model was hugely sensitive to interest rate hikes.  It had tied up its money in government bonds, which decrease in value as rates rise.

Here again the Queen’s question is relevant: Why did no one see it coming?  In this case, why was the bank so complacent in the year leading up to the crisis, when inflation was soaring?  And what other problems are lurking in the banking system as interest rates move back toward historical averages?

Silicon Valley Bank’s collapse highlights how blind regulators were to the scenarios that ultimately led to the bank’s demise—large and rapid increases in interest rates.  Do the Federal Reserve’s bank regulators not talk with or read about what their monetary brethren are doing?  Are the regulators fighting the last war, the last crisis?

More laws and regulations don’t always help if regulators are incompetent.  If they are, they should be terminated – along with the senior management at failed banks.

More on Stock Buybacks

Posted on by j.giglio

Few corporate policies have generated as much controversy in recent years as stock buybacks.  If excessive compensation for senior managers is the most criticized use of corporate funds, stock buybacks may well take second place.

But like most controversial capital allocation decision, the details of stock buybacks are complex and nuanced.

Buyback opponents argue that the practice overwhelmingly benefits top executives.  Conventional wisdom is that buybacks give executives the opportunity to manipulate the stock price and, as some have argued, “create a sugar high for the corporation.”

Proponents of stock buybacks point out that share repurchases give companies the flexibility to return excess cash to shareholders. Moreover, companies may believe its shares are undervalued and are confident in its growth, which would make repurchasing shares a smart move.

Companies have no obligation to complete announced share buybacks, nor do they have to say when they have halted buybacks. They just stop buying shares.

In a share repurchase, a company buys back some of its outstanding shares, typically at a price greater than the going rate for the stock.  The shares are then retired or held as treasury stock.

Although there are several ways for a company to buy back shares, doing so through an open market repurchase program is the most prevalent. There are three other stock repurchase methods. One is a fixed price tender offer where the company offers to repurchase a specified number of shares at a single specified price.

Another method is a Dutch auction, in which the price is set at the end of a tender process rather than at the beginning. The company offers a range of prices set above the current market rate at which it is willing to buy back shares.  Shareholders submit their proposals by stating the lowest price they would accept and the shares they are willing to sell. The Dutch auction tender offer is executed at the lowest price that allows the company to repurchase the shares.

Finally, a company may contact one or more large owners directly and offer to buy back its shares from them. The share purchase price, in this instance, includes a premium.

In the past, companies rarely repurchased shares in the open market because of potential liabilities related to price manipulation.  However, a 1982 SEC rule provides a “safe harbor” for U.S. listed companies to repurchase their shares without being subject to liability for manipulation under the Securities and Exchange Act of 1934. The rule proved to be the catalyst for increasing share repurchase activity in the United States.

Companies buy back stock for many different reasons.  In addition to senior management believing the company’s stock is undervalued, they may have more money than available investment opportunities.  There may also be instances in which managerial compensation incentives such as earning per share may influence the decision to repurchase shares.  Of course, this aspect of share repurchases is rarely mentioned by corporate executives and lends some credence to concerns expressed by opponents of share buybacks.

Lastly, share repurchases may be used to counter a hostile takeover or greenmail threats, where a corporate raider acquires a large stake in the company in the open market and then threatens a takeover. Companies may use share buy backs as a defensive action to reduce the possibility that a potential acquirer would get a controlling interest in the company.

Share buybacks, like any other capital allocation decisions, can be problematic when used to prop up the stock without regard for the value of the company, are poorly timed or serve to increase compensation for company insiders.  All this is in contrast to dividends that are carefully considered, and predictable.  A whole lot of things have to go just right for share buybacks to be done properly.

Chatter About Stock BuyBacks

Posted on by j.giglio

Before the 1980s, corporations rarely repurchased shares of their own stock.  But this year alone S&P 500 firms are buying back stock at double the pace of last year.  It is forecast that there will be at least $1 trillion in completed corporate stock buybacks by the end of the year.

All this despite a 1 percent tax included in the Inflation Reduction Act that went into effect on January 1 that is designed to slow stock buybacks.  Corporations that are awarded a piece of the $39 billion in grant money under the CHIPS and Science Act may also be barred from doing corporate stock buybacks.

Now the White House wants to further increase taxes on stock buybacks.  In his recent State of the Union address, President Biden said the tax should be much higher.  “Corporations ought to do the right thing.  That’s why I propose we quadruple the tax on corporate stock buybacks and encourage long-term investments.  They will still make considerable profit.”

That comment may have led the Oracle of Omaha, Warren Buffet, to weigh in on the hot button issue in the Berkshire Hathaway CEO’s annual letter to investors touting the benefits of repurchases: “When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).”

Still, Buffet included a caveat: he says buybacks make sense only if they are made at “value accretive prices,” i.e. when corporation don’t overpay.

Taking a step back, corporations have a number of ways to allocate capital:

  1. Make capital investments designed to grow their businesses. For example, buying new machinery or pouring more resources into research and product development;
  2. Acquire or merge with another company or business unit that the corporation believes could help grow its core business;
  3. Pay regular cash dividends to shareholders that tend to be more reliable than stock buybacks, an actual real return of cash to investors; and
  4. Use the money to repurchase their shares—a stock buyback automatically increases earning per share and has a stronger short-term impact with little, if any, tax consequences for shareholders.

As with many things in finance, the answer to whether stock buybacks are good for investors is “it depends.”

If a corporation sees its shares as undervalued and is flush with cash, a buyback could be a way to generate shareholder value.  A share buyback reduces the number of the corporation’s outstanding shares in the stock market and, theoretically, its share price should rise. Shareholders will own a bigger portion of the corporation and therefore a bigger portion of its earnings.

In theory, a corporation will pursue stock buybacks because they offer the best potential return for shareholders with relatively lower risk than other options for allocating capital.  When a corporation announces a stock buyback, it makes sense to ask if the firm believes its stock is cheap, or if there are other factors at play, such as senior management lining their own pockets in the case of a compensation incentive for executives based on stock price.

Also, investors are concerned if the stock buybacks are financed with debt, unlike dividends that are typically paid for out of cash flow, which makes the corporation’s balance sheet less resilient. Of course, it is a good sign if senior management is also buying company stock for themselves.

The tricky part in considering corporate stock buybacks is making sure senior executives are focused on sustainable long-term growth opportunities rather than increasing stock prices and engaging in share price manipulation while prioritizing the short-term.