Inflation, Interest, and the Fed

Interest rates play a crucial role in the economy, influencing savings, investment, consumption and overall growth.  Central banks around the world cut benchmark interest rates sharply following the 2007-09 financial meltdown that  tanked the global financial system. In many cases, the nominal interest rate was cut to zero, close to zero or even negative territory.

It was thought that these aggressively low interest rates helped stimulate economic activity, although there remain uncertainties about the side effects and risks. 

Distressed, or “Zombie,” companies feasted on cheap credit. These firms tied up resources that could have been better allocated to more productive and efficient businesses, hindering overall economic growth.

For example, companies such as Bed Bath & Beyond earned just enough money to continue operating, but were unable to pay off their debts as interest rates rose.  As rates have risen, many of the loans banks made to these firms have turned out to be stinkers, as borrowers miss payments or default. 

Indeed, cheap credit, by way of low interest rates, was allowed to persist for an improbable 14 years – much too long in the minds of many analysts.  What was initially seen as a blessing turned out to be a curse. 

When continued for too long, cheap credit effectively inspires excessive borrowing – some of it speculative.  And bubbles do eventually burst. 

A lot has happened since the 2007-09 financial crisis. Recently, inflation has returned with a vengeance.  The Federal Reserve and other central bankers are trying to stop surging prices by raising short-term interest rates, which is not necessarily a boom for the stock market or the economy.

Rising interest rates help control demand for credit, soften growth of the money supply and therefore help control demand.  In theory, higher mortgage rates may slow housing price inflation and help make property more affordable over time. 

Others argue that today’s rate hikes threaten to push up tomorrow’s housing costs amid high prices for materials and loans.  This creates a threat of future housing shortages that could lead to more inflation.

High interest rates prevent a misallocation of capital goosing the price of the riskiest assets in the shares casino.  Then there are investment projects, often vanity projects, that only proceed because of cheap capital. 

As interest rates rise, they incentivize savings in contrast to the recent near-zero interest rates that made savers – including many retirees – feel like fools.  

Finally, high interest rates give central banks room to cut interest rates in the event of a negative external shock. In sum, they act as a deterrent to excessive borrowing and spending, curbing inflationary pressure and preventing the formation of bubbles.

But higher interest rates also bring with them the risk of significant slowdowns in consumption.  They might choke off much needed business investment in new home building and renewable energy capacity, for example. 

Rising interest rates may cause the dollar to appreciate, making exports less competitive and leading to an export slowdown and perhaps a worsening trade deficit.

Higher interest rates certainly make government debt more expensive, sending debt costs soaring and eating up a bigger share of public budgets.

Finally, higher interest rates might lead to a broad-based economic slowdown that could hit stock prices, pension fund assets, and dividend incomes.

In recent months, inflation has been as persistent as gravity.  A cold dish of truth is that it is unclear when prices will moderate.  The Fed took a break from raising interest rates at its June meeting after a string of 10 consecutive rate hikes in just over a year. Still, the benchmark rate could go a bit higher in the near future.  

The Fed is taking some time to assess the effects of its prior rate hikes on inflation and the overall economy, as well as the impact of other economic activity – namely the collapse of three banks this spring.  Improvisation is clearly the order of the day.

The Future of Roadway Pricing

The need to find a better way of managing public roads in metropolitan areas is painfully apparent to many Americans each morning when they drive to work.

It is easy to conclude that the U.S. has made a series of wrong-headed choices about how to finance its all-important metropolitan roadway systems.  The results of these mistakes are ubiquitous and take several forms.

We have insufficient roadway capacity where it is most needed, as evidenced by severe traffic congestion on many critical roadway links in important metropolitan regions during increasingly long portions of the day.

We are chronically unable to build new roadway capacity to keep up with demand, to the point that blindly chanting “we can’t build our way out of congestion” too often replaces serious discussion of how to overcome obvious capacity shortfalls.

We insist on “saving money” in government operating budgets by reducing needed roadway maintenance, which causes roads to wear out faster and reduces long-term capacity.

To move beyond these mistakes, transportation policy makers must recognize the potential of recent technological breakthroughs that enable effective, market-oriented roadway financing systems that can dramatically improve how the U.S. manages, maintains, and pays for existing metropolitan roadway systems.

In simple terms, technology can now allow access to metropolitan roadway capacity through the same kind of marketplace mechanism traditionally used to distribute access to a host of private sector goods and services.

We can charge motorists directly for access to each roadway in a metropolitan area without requiring them to stop or slow down. Prices can be based on the distance they travel on that roadway and can be differentiated based on the “popularity” of each route as measured by the number of vehicles per hour traveling on them.

Prices can also be differentiated based on vehicle type, so trucks and other heavy vehicles that cause more wear and tear on pavement pay higher prices than small vehicles that cause less wear. Charges can be adjusted frequently to reflect changes in the number of vehicles traveling on a roadway.

Frequent price adjustments can also be used to guarantee motorists a certain minimum average speed on a particular route. Charges can be raised or lowered to maintain a target maximum number of vehicles on the roadway.

Intelligent use of these new technologies narrows the often considerable gap between a roadway system’s theoretical capacity and its functional capacity by using the classic economic principle of using price to control the demand for scarce resources.  It also results in better service for all roadway customers in a metropolitan area.

Note the term “customers.”  A customer is a willing buyer of what you have to sell at the price you are charging. What makes someone a willing buyer is a personal judgment about whether the value they are getting is greater than the price charged.

Suppose a driver can use two different lanes to reach their destination.  One lane charges a price per mile but promises an average speed of 60 mph.  The other charges nothing, but moves at less than 10 mph.  If the driver is on their way to an important business meeting and can’t afford to be late, they may decide that the value of time saved by using the priced lane is greater than the cost.  But if they are simply making a discretionary trip to the mall, they may opt to use the fee one and put up with the additional travel time.

Put simply, roadway pricing lets you create value for drivers by offering them shorter travel times for high-priority trips.  Drivers determine the priority of their trips, making personal judgments about which are the most important and how much they are willing to pay to reach their destinations faster.

Using price to distribute travel demand rationally at and raise resources for roadway maintenance?   Now that would be something to write home about.

Playing Let’s Pretend

One definition of intellectual dishonesty is the practice of ignoring reality when it interferes with what you want to believe about the way the world works.  The bipartisan deal President Biden signed on June 3, after months of political brinkmanship to raise the debt limit for two years and increase the amount of money the federal government can borrow, is an example.

Cynics might be forgiven for insisting there is a great deal to be said for intellectual dishonesty in American society.  They would remind us that the body politic is much more likely to enjoy an adequate supply of the public goods and services that are so vital to the national welfare if Americans can convince themselves that “someone else” is paying for them.

Whenever we admit to ourselves that the cost is coming out of our pockets, we inevitably try to cut corners or do things on the cheap, and ultimately deprive ourselves of much that is really needed.

Many Americans would argue that government has played a major role in this national con game since the early days of the republic.  By cleverly manipulating things like tax rates, deductions, and public accounting practices, the government has made it easy for Americans to persuade themselves that “the other guy” is paying most of the bill for the things we need.  All of which has helped make the United States great—in the sense of becoming the world’s most ostensibly successful national economy for the moment.

The national debt has soared, nearly tripling since 2009, forcing the U.S. Treasury Department to borrow more to pay for government spending.  The legislative curb on this borrowing is known as the debt ceiling.  When Treasury spends the maximum amount authorized under the ceiling, Congress must vote to suspend or raise the limit on borrowing.

The latest deal includes caps on federal spending, additional work requirements for food stamps and welfare, and reforms to build energy projects more quickly.  But the caps would not actually reduce spending.  The end game is to make it grow more slowly, say more slowly than the rate of inflation.

Divided government is never pretty.  But if you are of a Panglossian persuasion, you will rejoice that this deal enables both sides to claim a win of sorts.

Neither wants to be responsible for a catastrophe, so each pretends it is a win-win deal. Republicans can say they cut spending since spending will grow more slowly than it might have otherwise. Democrats can argue that they prevented actual cuts.  In theory, everyone wins and politicians insist they conducted themselves in an intellectually honest fashion.

But the American public, not elected officials and government bureaucrats, is to blame for this.  They insist on receiving more from government than they’re willing to pay for, and they don’t ask any serious questions about the charades and fiscal shenanigans necessary to sustain the illusion of a free lunch.

The U.S. is up to its neck in debt – $31.4 trillion as of January 2023.  Since it cannot increase its income in the short term, it needs to exchange new debt for old debt, leaving no choice but to raise the debt ceiling to avoid global economic chaos.  The annual federal deficit has averaged nearly $1 trillion since 2001, meaning government spends that much more money than it receives in taxes and other revenue.

To make up the difference, the government has to borrow to finance payments that Congress has already authorized. Even with the debt limit raised, the best way to repay the debt is to figure out how to revive the economy.

Good government types and fiscal moralists may be outraged by these shell games and urge Americans to stop acting like children.  But Americans have a long and pragmatic tradition of believing that fiscal morality, like religion and the law, is great as long as it doesn’t get in the way of anything really important.

Pay Me Now or Pay Me Later

Maintenance is often seen as the stepchild of infrastructure.  It easily slips from public notice in the face of more glamorous new construction.

Yet delayed or poorly executed maintenance can add billions of dollars to the private and public costs of infrastructure.  In addition, deferred maintenance hastens the need to replace assets by years, if not decades.  Many urban transit systems are testament to the high cost of inadequate maintenance.

Infrastructure spending has traditionally been divided into two categories: capital and operations and maintenance.  But such a breakdown can be misleading and is too simplistic to serve as a basis for allocating resources.  A more useful approach would be to think along functional lines. So capital spending can be split into new capacity and rehabilitation and operations and maintenance divided into its two components:

  •      New Capacity—expenditures for the engineering design or construction of new facilities or for plant and equipment that significantly expand existing capacity.
  •      Rehabilitation—capital-intensive activities that extend the useful life of a facility more than two years.
  •      Maintenance—expenditures on routine schedules to repair or maintain the good working order of existing facilities, plant, equipment, or rolling stock that neither adds new system capacity nor extends the life of facilities beyond two years.
  •      Operations—expenditures incurred on a routine basis for labor, utilities, engineering, and other overhead activities that support the day-to-day delivery of services.

For certain, a rigorous breakout of spending into each category is difficult.  It is particularly easy to confuse maintenance and rehabilitation.  For example, the two-year criterion used to differentiate between them is somewhat arbitrary.  The key is that “pure” maintenance focuses on short-term improvements (filling potholes) while rehabilitation has a longer-term impact.

Similarly, rehabilitation work and new capacity are often combined.  A road may be resurfaced at the same time that additional lanes are added.  Maintenance and operations also overlap.

In many ways, these four activities represent a continuum that, taken as a whole, could be called lifecycle costing.  In other words, inattention to one aspect increases the cost of all the others.  Finding the most cost-effective combination of spending, as opposed to focusing exclusively on building things, is one of the keys to effective infrastructure management.

Proper maintenance of infrastructure assets is important for two reasons.  First, there is a direct link between the quality of current services and the performance of the nation’s infrastructure.  Second, public perceptions of the overall quality of infrastructure services depend on good routine maintenance.

Just to be clear, lack of maintenance spending impacts long-term infrastructure costs.  Effective maintenance reduces rehabilitation costs and/or delays the time when such spending is required.

Although maintenance spending plays an important role in lifecycle costing, it is not always an obvious part of the infrastructure decision-making process.  This can result in maintenance being ignored or afforded neither adequate attention nor funding.

Since local governments own and operate most infrastructure assets, they also bear the heaviest financial burden for maintaining those assets.  Yet local governments do not always possess the financial resources or have the institutional flexibility to implement innovative maintenance programs. Consequently, they must be the main focus of efforts to ensure adequate maintenance.

Maintenance of infrastructure assets is surely not a politically compelling category of public spending. That adds to the dilemma of getting it properly funded.

Putting maintenance on par with other categories of infrastructure investment is not a simple matter, especially given the temptation to defer maintenance when the much higher costs it causes would likely hit on somebody else’s watch. That explains why elected officials all too often put the politics of new construction ahead of maintaining existing infrastructure.

The Feds Recent Rate Hike

So, things really are different this time.  The Federal Reserve Bank decided to raise its Federal Funds Rate on May 3 by a quarter-point, to 5.00-5.25 percent, in spite of a banking crisis that has seen three large banks fail in the space of six weeks, with remarkably little spillover into the economy at large. The misery mostly limited to shareholders in the banks concerned.   This is where rates sat before the financial crisis hit in 2008.

This recent rate hike has caused plenty of controversy as fears grow that further hikes risk tipping the economy into recession.  The inflation rate sat at 5 percent on the year in March, but core inflation (which excludes fuel and food) slightly increased in March, up to 5.6 percent. So, the Fed raised rates once again, in an effort to get price hikes under control, reiterating their focus on dragging inflation back down to earth even if it means tipping the economy into recession.

It should be noted that unemployment fell to 3.4 percent last month, matching the lowest reading since 1969.  So far, historically high inflation, slowed economic growth, increasing interest rates and banking turmoil has not cracked the still hot labor market.

For the past two decades, this sort of thing didn’t happen.  Under the unwritten laws of the “Greenspan put”, the Fed could be relied upon to provide some form of stimulus at the first sign of financial trouble.  It began with the collapse of the hedge fund Long Term Capital Management in 1998, when the Fed put together a $3.6 billion bailout funded by a consortium of banks, and it carried on long after former Fed chair Alan Greenspan himself had departed the scene.

Greenspan argued with monotony that “free markets are inherently self-regulating”, (like foxes are inherently the best guardians of chickens).  If markets wobbled, if banks got into a spot of trouble, an interest rate cut, or quantitative easing was never far behind.  He took the Fed in a direction quite different from the previous ruling guideline expressed by William McChesney Martin, Fed Chairman from 1951 to 1970, who’s famous for supposedly having said: “The Fed’s job is to take the punch bowl away just when the party’s going good”.  Or words to that effect.

Investors formed an expectation that the Fed would always help.  It was an Alice in Wonderland world where bad economic news often became good—good because investors calculated that the Fed would respond with a stimulus package.  By such means, the country ended up with the bubble economy of the past 20 years.

But this time around, the Fed has failed to oblige.  True, until the collapse of the Silicon Valley Bank, the Fed had been expected to raise rates by half a percentage point compared with the quarter point increase announced May 3.  But by raising rates at all the Fed has signaled that yes, it really did mean it when it said it was going to tackle inflation.  Not even falling US inflation has persuaded the Fed to take a break from its tightening program.  The Fed officials have said they want to see sustained evidence that inflation is moving toward their 2 percent goal.

The Fed finds itself in a tricky situation, having failed to act on price rises early on, so now they are playing catch up.  They were too late to the game to keep prices under control—having suffered a hit to credibility, have had to keep hiking rates, putting a damper on economic growth.  The Fed is clearly hoping this is the end of the line.

It softened its language in its statement after the May 3 hike, no longer preparing investors for further rate hikes, but rather noting that a myriad of factors—including economic growth—would feature in the “extent to which additional policy firming may be appropriate”.  In other words, interest rates may still rise, but it is by no means certain.  Ergo, only a naïve or ignorant person who say the worst if over.

Monetary Mischief

The past two and a half years have been extraordinary.  The unnerving combination of a global pandemic exacerbated by energy scarcity, supply chain disruptions, the return of inflation,  rising multipolar geopolitical tensions, and a new monetary era have people wondering what certainties are left. Still, in times of rapid change, it’s nice to know that some things stay the same.

Take The Federal Reserve for an example.  The Fed does not learn from its mistakes.  The Fed lost control of the money supply, causing inflation to soar.  In the two years following the March 2020 COVID-induced recession, the Fed allowed the broad money supply to expand by a staggering 40%.

It did so by keeping its policy rate at its zero-lower bound and increasing the size of its balance sheet by almost $5 trillion through its aggressive purchases of Treasury bonds and mortgage-backed securities.

In 2021, not hemming and hawing, the Fed kept assuring the American public that the inflation they were experiencing was a transitory phenomenon.  The Fed lost much credibility by failing to acknowledge inflation was surging back in 2021 and it is not obvious it has rebuilt its reputation.  This despite warnings that the explosion in money supply growth would take the country back to the inflation of the 1970s.

Not to forget, the Fed effectively pursued a policy of zilch interest rates or free money for 14 years since the 2008 financial crisis.  Individuals and institutions happily adapted to a universe in which money was practically free.  They forgot that free money turns out to be expensive. By failing to return the price of credit to something normal the Fed was fueling greater risk taking.

A sign of an intelligent mind is learning from one’s mistakes.  This is not the case with the Fed. The technocrats, the boffins, and the cognitive elites didn’t know what they were doing. Worse than not knowing what they were doing, Americans suffered big declines in disposable incomes over long period as a result of their policy choices. The economy did not deliver to the great majority of Americans the sort of life they wanted and hoped for.

People bought houses they could only afford with tiny interest payments, companies borrowed to buy back their own shares, investors borrowed to buy stock in a can’t lose stock market, and politicians ran up national debts whose servicing was only possible if interest rates remained negligible forever, putting the country on an unsustainable fiscal trajectory.

Then in 2022, the wise men at the Fed started raising interest rates at the fastest pace in half a century: 500 basis points in pursuit of lower inflation.  That is a lot to cram through the economy in a year and something just might break. And it did.  March madness was the appropriate tag line applied to last month’s scare provoked by the collapse of three U.S. banks as a result of rate hikes poor management, and the abject failure of regulators.

Of course, none of this would have been necessary had the Fed started tightening monetary policy a year earlier. The inflation was not transitory. It’s a bitter solace to savers that they can earn a meager say, 4.5 percent interest on their savings only now that, inflation being so high, that their funds on an inflation adjusted basis are still losing value and adding to the cost of living crisis for the ordinary American.

Ushering back in a new era of cheap money is by no means a requirement but would be a tempting one at that given how addicted to mass spending everyone has become.  But that if the Fed has learned anything would have serious repercussions.

Looking forward it may well be that in God’s newly automated earth, AI will offer a precious escape from the problem of setting interest rates, avoiding the friction and stress and politics which accompanies developing monetary policy.  Just as the intelligent ChatGPT is churning out poetry better than Milton,  surely this new technology can design, plan, and execute monetary policy in the future.   They are becoming quite good at that.

The Next Banking Crisis

When markets are in a “seek and destroy” mode, like the last dragon in Game of Thrones, it’s fruitless to guess where they might attack next in search of weaklings. But their next focus, alongside the impact of fast-rising interest rates on bond portfolios, may be commercial property and commercial real estate loans.

Concerns about a commercial office space crash have followed the collapse of Silicon Valley Bank, Signature Bank, and the regional banking crisis that began in early March. Federal Reserve officials have stressed that the collapse of these two banks had nothing to do with commercial real estate.

So often used for investment purposes, higher interest rates are making the commercial office property sector far less enticing.  Fast increases in the Federal Reserve Bank’s benchmark interest rate have led to significant shifts in customer behavior.  Institutional investors are shunning real estate for higher yields at lower risk on government bonds.

Fragility in parts of the banking system has not stopped the Federal Reserve from pushing up interest rates to subdue stubbornly high inflation.  The Fed recently voted to raise the benchmark borrowing rate by a quarter of a percentage point, the ninth increase over the past year.  That brought the fed funds rate to a target range of 4.75-5 percent, its highest level since late 2007. Another part of the motivation to raise rates might be to show—rather than simply tell—that the central bank has faith in the banking sector.

As property deals become more expensive to finance, the appetite for them wanes, which means fewer projects being built. Across, the sector, the Green Street Commercial Property Price Index is down 15 percent in a year, with the biggest drops in urban office real estate, where space stands empty as working from home takes permanent hold and people predict the death of the office.

U.S. office occupancy rates are between 40 and 60 percent of pre-COVID levels, according to the real estate firm JLL. Further, almost a quarter of the mortgages on office building must be refinanced in 2023, according to Mortgage Bankers’ Association data, which will bring higher interest rates.

COVID changed everything when employees were forced to work from home.  While some companies have pushed for a return to the office, others have adapted to the change and are allowing their workers to stay remote.  That is a bad sign for office owners.  As leases come up for renewal, many companies that have embraced work from home as the new normal will opt to terminate the leases.  That leaves some banks, especially regional ones, facing losses on real estate loans.

Consider that commercial real estate is a highly leveraged asset.  When mortgages on these properties mature and owners have to refinance, interest costs increase and adversely impact cash flow. Higher interest rates and more vacancies also decrease the value of some office buildings.  Indeed, some bank commercial office real estate loans may be threatened.

This is especially concerning for smaller banks, due to larger exposure as a percentage of their assets. For example, before its collapse, Signature Bank had the 10th-largest commercial real estate book in the United States. Another bank in the news, First Republic, had the ninth-largest loan portfolio in the same market.

According to Fitch Ratings “the office sector faces asset quality deterioration, putting smaller banks at risk.” It may turn out that the pretense that Silicon Valley Bank was a one-off is finished.

In 1992, Warren Buffet coined the phrase: “It’s only when the tide goes out that you learn who’s been swimming naked.” Now that the flood of cheap money has drained away and interest rates are on the rise, there may be more unpleasant revelations.

It’s unclear what the market dragon’s breath may scorch next.  But the next banking calamity may be commercial office real estate

It’s Déjà vu All Over Again

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

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

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.