A Leading Indicator: Corporate Stock Buy-Backs

I must admit to being wrong.  I believed that the big cash buildup at corporations would be used to fuel a mergers and acquisitions binge.  I thought that the economic recovery was strong enough that the “better off” corporations would “pick off” all the low-hanging fruit offered by the companies that were not in a very good position coming out of the Great Recession. 

I argued that this behavior would not accelerate economic recovery because the restructuring taking place would result in consolidations and debt reductions that would just make industry more productive somewhere down the line but add very little to economic growth and lower unemployment in the present.

Merger activity has been fairly high this past year but not as great as I thought it would be.    

Where I was wrong…was in the strength of the recovery.  The economic recovery is not strong enough to propel the M&A binge I expected. 

So, what are the cash accumulations and the low borrowing rates leading to? 

Corporations buying back their own stock.

“US companies are on pace to announce buy-backs of more than $500 billion worth of shares this year, according to stock research firm Birinyi Associates, the third biggest year on record.” (http://www.ft.com/intl/cms/s/0/546f97ec-1231-11e1-9d4d-00144feabdc0.html#axzz1fwprkyNi)

The message is that the economy is not recovering sufficiently to warrant more acquisitions and the stock markets have not been robust enough to provide higher valuations for market shares, so, the companies with the cash or with access to the cash are buying back their stock at prices they believe to be ridiculously low. 

This can have some consequences for firms.  For example, Safeway, Inc., sold $800 million in bonds last week and, the same day, management disclosed that it was buying back $1 billion worth of its own common shares. 

The rating agency, Fitch Ratings, immediately dropped the company’s credit rating by one notch to triple B minus. 

A similar thing happened to Amgen and Lowe’s.  Last month, Amgen sold $6 billion worth of bonds to buy back its stock early in November…and Moody’s Investors Service cut Amgen’s bond rating by one notch while Fitch cut its rating by two notches.  Lowe’s sold bonds in November to buy back stock, which resulted in downgrades by Moody’s and Standard & Poor’s. 

That is, the debt issue followed by the stock buy back increased the financial leverage of these companies and hence make their debt riskier.

Stock buy backs, however, do not increase economic growth!

What is happening?

Long-term interest rates in the United States are being kept down by the actions of the Federal Reserve and the flight of money from Europe seeking a “safe haven” in United State Treasury bonds.  The Fed wants to get the economy going again and has said it will keep rates at historically low levels for another two years or so.  And, “with corporate bonds benchmarked to US Treasuries, whose yields have fallen to historic lows amid strong demand for havens, borrowing costs fro investment grade companies have also fallen.”

So what do we have…low economic growth and credit growth that exceeds the “productive” needs of the corporations. 

In essence this is a picture of credit inflation.  To be sure, we are not seeing the creation of credit raising consumer or wholesale prices at this stage…but, when credit expansion exceeds the real growth rate of the economic sector that the funds are going into we get a “dislocation” that can lead to problems in the future.

That is why, to me, the acceleration of corporate stock buy-backs in this instance seems to me to be a leading indicator of dislocations in the economy that will have to be dealt with at a later time.

“Although bondholders generally do not like these transactions (issuing bonds to buy back stock) because of the risk they pose to companies’ credit ratings, most of the groups buying back shares this year with debt have not seen too much fall-out from the bond markets or from credit rating agencies.”

This is always the case.  Those that move first and move rapidly get the most benefits from their actions.  Only later, when many others attempt the same thing, do markets…and credit rating agencies…move more…or produce greater “fall-out.”

“The deals, then, are likely to continue so long as investors keep buying bonds and pressuring rates.”

And, as the Fed works to keep interest rates so low.

The concern about corporate stock buy-backs being a leading indicator?

If economic growth does not pick up a greater speed (http://seekingalpha.com/article/312223-the-focus-should-be-on-underemployment-not-unemployment) and if the Fed continues to maintain the excess reserves it has pumped into the banking system and keep interest as low as it has promised to do, then we need to be aware of where the dislocations are forming in the economy. 

And, be assured, if this credit inflation begins to show up in some places…it will also begin to show up in other places as time passes.  That is, fault lines are created in the economy much as Raghuram Rajan has described in his award winning book called “Fault Lines: How Hidden Fractures Still Threaten the World Economy.”  And, fault lines make everything more fragile.   

Some Banks Are Stretching For Risk

According to Matt Wirz in his article “Banks Apply Lever to Cash Positions” in the Wall Street Journal, this morning (http://professional.wsj.com/article/SB10001424053111904103404576559100934308730.html?mod=ITP_moneyandinvesting_1&mg=reno-secaucus-wsj) some commercial banks, generally the larger ones, are stretching for higher yields by taking on more risk.

I have recently discussed this problem in several posts (http://seekingalpha.com/article/292286-will-bernanke-policy-destroy-credit-creation-bill-gross-is-worried-it-will, and http://seekingalpha.com/article/292446-will-bernanke-policy-destroy-credit-creation) and how it is related to the current policy of the Federal Reserve to keep interest rates at such low levels for the next two years.  Basically, commercial banks cannot earn the interest spreads they need with the term structure of interest rates being so flat.  And, any effort to achieve an even flatter yield curve through an “interest rate twist” policy will just exacerbate the situation.

With the term structure so flat, what is a bank to do? 

Rely on fees?

For an answer to this question see my recent post (http://seekingalpha.com/article/293657-bankers-expect-weak-profit-performance-in-the-future). Given the recent volatility in financial markets, larger banks are experiencing substantial shortfalls in trading and investment banking activity which is resulting in much lower fee income than in the past year or two.   New regulations are also resulting in lower fee income.

So with other sources of income shrinking, some banks are turning to higher risk loans in order to gain higher returns to “goose up” earnings.

According to Wirz, “Much of the lending is taking the form of so-called leveraged loans.  They are floating-rate loans made to companies with ‘junk’ or non-investment grade credit ratings, and typically used to finance buyout deals or refinance existing debt.”

In August, for example, leveraged loans totaled $36 billion, a small monthly amount for this year, yet the junk bond market and the IPO market only produced $2 billion combined. 

Wirz states, “there are signs that the risk in this line of lending is rising.  The large leveraged buyouts that banks arranged in the first seven months of the year carried 14 percent more leverage than those underwritten in the same period of 2010…That puts leverage on current deals on par with those financed in 2006, but below 2007 levels.”

Another type of risky loan, called pro-rata loans, is made to “stronger companies with junk ratings—typically rated BB—to boost interest earned…” This type of loan, through July of this year, is already up 16 percent from all of 2010.

Do we have here a case of the “law of unintended consequences”?  The Federal Reserve, in its fear that it will not do enough to prevent a double-dip recession, may be creating an environment that will result in outcomes that, over the longer-haul, may not be what it would like.

It is a good thing to get banks lending again and to get the economy expanding.  However, the loans that are being discussed in the above-mentioned article are not going to economy expanding business investment.  There are plenty of articles elsewhere that indicate there is not a robust amount of demand for loans on the part of businesses, especially those that deal with small- and medium-sized banks.  And, many small- and medium-sized banks are not that anxious to make more “new” loans, given the state of their balance sheets. 

Do we want banks to be making risk-stretching loans for the purpose of financing buy-out deals or refinancing existing debt?  

Historically, we see that this is not the way that the economy usually achieves more rapid economic growth.  Historically, additional risk taking is connected with periods of credit inflation.  Much of what the Federal Reserve has done in recent years, especially the execution of QE2, can be classified under the title of credit inflation. 

And, credit inflation is what we have experienced for the past fifty years!

The consequences of this credit inflation?

Higher rates of under-employment, unused manufacturing capacity, greater income inequality, a busted housing system, and sagging morale. 

Credit inflation does not result in improving productivity but instead results in speculation and bubbles.  As we have gone through the past fifty years, this is exactly what we have gotten…slower economic growth…and more financial innovation and risk exposure. 

Seeing commercial banks beginning to stretch for risk at this stage of the economic recovery is, to say the least, a little disconcerting. 

Monetary Targets: The Latest Take

The morning papers contain articles on the newly released paper on monetary policy by James Bullard, the President of the Federal Reserve Bank of St. Louis. The basic thrust of the paper is that the Fed’s efforts to keep interest rates so low and for “an extended period” of time may eventually backfire and result in a Japan-like dilemma of stagnation and price deflation.

The “appropriate tool” in the present situation, Bullard contends, is the use of “quantitative easing.” More specifically, he argues that the Federal Reserve needs to be willing to buy longer-term Treasury issues to expand the amount of Federal Reserve Credit outstanding in spite of the fact that there are more than $1.0 trillion in excess reserves currently in the banking system.

The problem, as Bullard sees it, is a policy dilemma that results from the fact that nominal interest rates include a factor to account for inflationary expectations and that current Federal Reserve operating procedures rely on some form of what is called “the Taylor Rule” to set target interest rates. Bullard contends in his paper (which can be accessed through this article: http://blogs.wsj.com/economics/2010/07/29/feds-bullard-raises-policy-concerns/) that using the Taylor Rule can result in one of two “steady state” outcomes, one with higher interest rates yet more inflation, and the other with low interest rates and outright deflation.

The latter “steady state” position is what the Japanese have experienced. The former is where the United States has been operating. The fear is that by continuing the Federal Reserve policy of keeping its target interest rate close to zero for “an extended period” the United States will migrate from where it is now into the situation more similar to that of the Japanese.

This is why Bullard suggests that the Fed may need to focus more on “quantitative easing” going forward.

The concept of “quantitative easing” was originated early on in the financial crisis that accompanied the Great Recession. When nominal interest rates approached zero, the Federal Reserve (and the Bank of England) argued that it needed to continue to provide more reserves for the banking system (print more money electronically) even though it could not drive nominal interest rates below zero.

Quantitative monetary policy procedures went out-of-fashion in the late 1980s. Paul Volcker had used quantitative measures in the late 1970s and early 1980s to “frame” his efforts to combat the inflation being experienced at the time. However, by the late 1980s, policy makers began to lose confidence in quantitative measures for policy purposes because the various monetary measures that were used did not provide consistent information, at least to those making policy at the time.

As a consequence, policy makers relied more and more on interest rate targets and this is when the Taylor Rule came into usage. Many claim that by adhering to this rule, even implicitly, resulted in a period of relative claim in financial markets and the economy now referred to as “the Great Moderation.”

One reason given for the disenchantment with quantitative monetary measures is that so much reliance has been placed on mathematical modeling within the Fed: monetary measures just did not lend themselves to such a formal process. Hence, quantitative targets were not easy to produce and actual results were even harder to explain because of the divergent movements of the different measures.

We can observe this kind of behavior over the past two years in many of the monetary measures.
For example, if one looks at the behavior of the narrow measure of the money stock, M1, relative to the behavior of a broader measure of the money stock, M2, from 2008 through the present, one can get different signals. In the first six months of 2008, the year-over-year growth of the M1 measure was close to zero. The year-over-year growth rate of M2 was around 6%.

As the financial crisis hit and progressed in the fall of 2008, the rate of growth of the M1 money stock increased dramatically whereas that of the M2 money stock rose only modestly. In the first quarter of 2009 the M1 money stock was growing, year-over-year, at around 17%; the M2 measure had peaked in the fourth quarter of 2008 at about 10% and was beginning to decline.

Furthermore, the behavior of other monetary aggregates seemed all out of line with these money stock measures: Total Reserves in the first quarter of 2009 were increasing, year-over-year, at about 1,850%; the Monetary Base rose by about 110%, year-over-year.

How do you explain these differences? Econometric models couldn’t do it.

Two basic things were happening. First, as the financial crisis progressed, people took more and more money out of less liquid asset holdings and began putting the funds in currency or very liquid bank deposits. Although the M2 measure rose during this time period, most of its increase was coming in the M1 component.

Second, the Federal Reserve was pumping unprecedented amounts of reserves into the financial system. These funds did not go into bank lending so as to expand the money stock: the banks just held onto the money. In August 2008, excess reserves in the banking system totaled less than $2.0 billion. In the first quarter of 2009 excess reserves averaged over $800 billion.

How can you mathematically model these kinds of behavior?

And, the problems of interpretation continue. Money stock growth has dropped off. In the second quarter of 2010 the year-over-year rate of growth of M1 was just under 6.0% while the rate of growth of M2 was less than 2.0%. The non-M1 component of M2 was growing well under 1.0%. People were still putting money into transaction balances and not in savings staying as liquid as they could. The rates of growth in both Total Reserves and the Monetary Base fell dramatically through 2010 yet excess reserves in the banking system averaged more than $1.0 trillion. Banks, too, were acting very conservatively by not lending and keeping as liquid as they could.

The point of this discussion is that the Federal Reserve needs to focus a lot more on the quantitative monetary measures than they have in recent history. But, the understanding of what is going on over shorter periods of time requires institutional understanding within a historical context and not just formal mathematical modeling. The consideration of monetary variables is important for setting and conducting monetary policy!

It is still true that over the longer run, important things like inflation/deflation are still “everywhere and in every time” a monetary phenomenon. Interest rates don’t correlate over the longer run.

Bullard is arguing for a greater focus on the monetary aggregates. By buying Treasury securities in a “quantitative easing” the Fed will be expanding the monetary base. Why would you want to expand the monetary base? Because commercial banks are not lending and if the economy is going to show more life going forward, bank lending is going to have to increase and the money stock measures are going to have to start growing faster again.

Milton Friedman argued that in the 1929-1933 period, the M2 money stock measure declined by one-third. However, the monetary base rose modestly. Freidman criticized the Fed for letting the money stock measure fall. To him, the Fed needed to provide more base money to get the banks’ lending again so that the money stock would grow. Is Bullard saying we are in the same type of situation Friedman described?

Federal Reserve Exit Watch: Part 6

Debate seems to be picking up about the Federal Reserve exiting its current policy stance. Last week Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, and Charles Plosser, President of the Federal Reserve Bank of Philadelphia, spoke last week of the forthcoming need to wind down the Fed’s position. Hoenig said that the Fed should end its purchase program of mortgage-backed securities and Plosser talked about the recovery being sustainable even as existing fiscal and monetary stimulus programs recede.

Still, economists are pessimistic about when the Fed will begin to raise its target for the Federal Funds rate. The effective Federal Funds rate in recent months has averaged about 12 basis points. Bloomberg News conducted a survey of economists’ expectations and the median forecast was for the target rate to remain unchanged through September 2010 and then rise by a half of a point in December 2010.

Since the Federal Reserve finally realized in 2008 that there was a financial crisis and began to combat the unfolding chaos, the basic policy of the Fed has been to throw whatever it can at the wall so that a sufficient amount of what is thrown will stick so that a financial collapse can be avoided.

Can people who devised such a policy really be expected to move its target rate up until it is far past the time that a rise is needed? And, the Fed will then face a situation in which rising interest rates will put many holders of Treasury securities and mortgage-backed bonds underwater and the question will then be, “Can the Fed afford to raise interest rates too swiftly because of all the losses it will create?”

Right now, the Fed is subsidizing the profits of the large banks (and not the small- and medium-sized banks) by its interest rate policy (of course, the Obama administration has threatened to tax away a good deal of the profits). It is just amazing the contradictions in monetary and fiscal policy that are coming out of Washington, D. C. these days. Confusion reigns!

It is no wonder that businesses and banks don’t want to do much of anything these days. They don’t know what the economic policy and regulatory environment will be in three years, let alone three months.

Anyway, the Federal Reserve continues to add reserve balances to the banking system. In the past 13-week period ending Wednesday, January 13, 2010, the Fed has added about $84 billion in reserves to the banking system.

Remember in August 2008 when the total reserves of the whole banking system were only about $44 billion!

Of this $84 billion, $62 billion was put into the banking system in the latest 4-week period.

The major contributor to this increase was security purchases by the Federal Reserve in the open market. In the latest 4-week period, the Fed added almost $71 billion to its securities portfolio bringing the total new purchases for the last 13 weeks up to $233 billion.

A large portion of this increase went to offset the decline in several of the special facilities set up to handle the financial crisis. For example, the amount of funds supplied the banking system through the Term Auction Credit facility fell by about $80 billion over the 13-week period, by $10 billion over the last 4 weeks.

The swap facility with foreign central banks also continued to decline dramatically, falling by almost $38 billion in the latest 13-week period and by about $9 billion in the last four weeks.

In total, it appears as if the funds supplied the banking system through special financial crisis facilities fell by $42 billion over the past 13 weeks and by only $2 billion over the last two.

Thus, the Federal Reserve continues to let these special facilities wind down, replacing them in the banking system through open market purchases.

In terms of preparing for the Fed’s exit, there has recently been trading in reverse repurchase agreements with dealers, but there was no “practice” activity in the past four weeks presumably because of the seasonal Thanksgiving/Christmas churning in the banking system.

As of Wednesday, January 13, 2010, the Federal Reserve held $969 billion in mortgage-backed securities in its portfolio. The central bank has authorized purchases of up to $1.25 trillion going into March of this year. As mentioned earlier, there seems to be substantial debate within the Fed as to whether or not this program should reach the maximum total. We shall see.

The Fed now holds $777 billion in Treasury securities and $161 in the securities of Federal Agencies.

So, the Fed Exit watch continues. So far, the Federal Reserve has honored the path that it started out on: purchasing securities to add to its portfolio thereby replacing the funds draining away from the special facilities created to combat the financial crisis.

Obviously, the real test has not begun. Within the next month or two, if the recovery continues, the Fed is going to come under more and more pressure to start raising its target rate of interest. Until then, big banks will continue to arbitrage the Treasury market and the carry trade will continue to prosper. This behavior is based on the assumption that the Fed is not going to let short term rates rise for a while.

When this assumption is broken, expectations will have to be reset and there will be a re-adjustment in the financial markets as investors exit their arbitrage positions.

What the Fed does then remains to be seen.

However, by maintaining its current policy stance, if the economy doesn’t recover or goes into a double dip recession, the Federal Reserve cannot be accused of aborting the upswing by raising its target interest rate too soon.

Obama to Tackle Deficit--Next Year!

“This has been the year of coping with the economic mess. Next year will be the year of coping with the deficit mess that follows the economic mess.”
So says Wall Street Journal writer Gerald Seib. (See “Obama Lays Plans to Tackle Deficit,” http://online.wsj.com/article/SB125599128538995091.html#mod=todays_us_page_one.) “The timing is tricky” because next year is an election year, but Obama is going to do it! Yes we can!

The strategy is a two pronged attack with another strong initiative in the wings. The first go at it will be at the president’s State of the Union address. That’s in January.

Following right after there will be the president’s budget proposals. That will be in February.

Then, well, let’s put together a task force—say eight Democrats and eight Republicans and let them address “the nation’s long-term fiscal imbalances.”

Yes, the Obama administration has things under control.

And, the world goes on.

The value of the dollar has declined by about 13% since January 20, 2009. It is possible that it could decline another 5% to 10% over the next six months or so.

Over the last thirty-eight years, since August of 1971, participants in international financial markets have failed to trust governments that ran up huge budget deficits. The general attitude has been that governments that cause their debt to increase substantially through loose or irresponsible budgets will eventually end up having their central bank monetize large portions of their debt.

In the face of such behavior, investors have sold the currencies of these countries until some appropriate response has been forthcoming from the governments running the deficits. More than a few countries have experienced this consequence of their budgeting largesse. Concern has even been expressed about how a group of “unknown bankers” could have such an influence over sovereign nations. (See for example the book “The Vandals’ Crown: How Rebel Currency Traders Overthrew the World’s Central Banks” by Gregory Millman.)

But, the United States government ran massive deficits earlier in this decade and the Federal Reserve supported such debt with extremely low interest rates while it allowed asset bubbles to run their course. During this time period the value of the United States dollar declined by about 40%.

The situation since January 20 has several characteristics in common with this period: large deficits supported by the Federal Reserve with extremely low interest rates. And, as mentioned above the value of the United States dollar has declined by about 13% since that time.

Talk about a strong dollar is a joke at this time. Talk about getting the deficit under control is approaching the same seriousness.

Let’s face it, Obama owns the deficit now.

As is usual in economics, people and markets have a short memory. The past is the past. The current administration has been in office nine months now. It is a “full term” pregnancy! The child, the current deficit and subsequent problems, belong to Obama.

Markets will not wait for additional speeches, even a State of the Union speech. Daily, there is more and more talk about the inability of the Obama administration to make decisions, to act. It only talks and promises.

People and markets don’t want a task force to address “the nation’s long term fiscal imbalances.” How long will that take? Six months, twelve months, or longer?

The markets need some substance. As far as I can see there is no indication that any “substance” is going to be forthcoming soon. Thus, the dollar will remain weak because what reason is there to buy it?