On the Unfair Treatment of Certain Common Equity Holders
Events of the past several months have been very disconcerting, particularly as it relates to the risks and rewards conveyed to common equity holders. It has become evident that due to political pressures, separate and apart from plain economics and market forces, that the returns to certain common equity holders have been subsidized to the detriment of other investors competing in an ostensibly free market. Further, many in the media and among the general public have viewed the sharp drops in certain issues to be “unfair” and due to “mismanagement” and “ganging up” by mean-spirited, money-hungry investors (read: hedge funds). In sum, the U.S. Government and its charges have willingly skewed free-market forces in the name of protecting the broader market. The problem is, the U.S. Government as well as many others are mixing up dampening systemic risk with protecting the interests of common stockholders. By mis-interpreting the essence of what it means to be a common stockholder, policy-makers run the risk of creating a set of problems far larger than those they are seemingly protecting against.
Investing in common stocks, particularly those of financial institutions, is akin to holding the “z-bond” - the residual - of a pool of mortgage-backed securities. It is a massively leveraged interest, one that rides extremely high when things go well and falls precipitously when things go poorly. This leverage is even more than what is appears on the balance sheet, where 30:1 is not an uncommon ratio of assets to equity, due to the prevalence of derivatives and other off-balance sheet exposures. Investors in such shares should know these facts, and understand the risks they are bearing. I didn’t hear anybody complaining or read any stories about disgruntled investors when shares of BSC (Bear Stearns), FNM (Fannie Mae) and FRE (Freddie Mac) were top-ticking in the wake of low interest rates, calm markets and rising real estate prices. But when conditions turned, liquidity dried up and counterparties got scared, managements and investors started crying foul. Negative press. Coordinated short-selling by hedge funds. But why? Because losing money feels really, really bad. But this is part and parcel of being a common equity holder. An investor could have bought senior securities. They could have reduced risk by selling calls. They could have pared down their long positions when things started to sour. But all this is forgotten in the shell-shock of a rapidly falling share price. Deer in the headlights. Can’t. Move. Can’t. Sell. But sure can complain. And managements could have done a far better job financing their books. Liquidity cures a world of ills; it also lets you play another day. But by the time money is scarce and the price is dear, it is already too late. Bear Stearns found this out. But if you live in a highly leveraged world and don’t provide for a rainy day, the inevitable downpour will wash you out. But in Bear Stearn’s shareholder’s case, they got precisely $10 per share too much for their common. They should have gotten zero. And that window dressing supported by the Fed and agreed to by JP Morgan sent the wrong message.
And the situation with Fannie Mae and Freddie Mac is even worse. Far worse. And might get much, much worse. In this case not only should common shareholders get zero, but certain subordinated investors might also deserve zero. But again, the U.S. Government has and will continue to pull strings to ensure that this doesn’t come to pass. Why? Politics and other non-market oriented reasons. We, the U.S. taxpayer, will end up subsidizing these common stockholders and subordinated investors, and to what end? It will only further embolden managements of large institutions, thought of as “too big to fail,” to take imprudent risks and swing for the fences. Because if things work out management and common stockholders get handsomely paid. And if they don’t, management simply loses their jobs while common stock investors get some undeserved residual interest in the enterprise.
I don’t fault our Government leaders from trying to ward off a massive systemic meltdown by providing credit to ensure the orderly disposition of obligations and maintenance of a functioning credit market. But no such obligation is owed to common equity holders. And every time policy-makers elect to bail out their interests, it lays the foundation for an even greater disaster down the road.
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COMMENT:
AUTHOR: Greg Battle
EMAIL: gbattle@gmail.com
URL: http://gbattle.tumblr.com
DATE: 08/20/2008 11:48:43 AM
I’m glad you finally wrote about this “unfair” treatment Roger. It sickens me to think that my tax dollars are subsidizing BSC investor losses. I might feel less sick if they restricted BSC management and employees from the bailout as frankly, they had that direct control over the outcome. Why can’t companies fail anymore? Who is covering the losses of pensions invested in HF’s who correctly saw BSC as a terminal short (and I know of a few)? What kind of margin of safety analysis can be done for companies that are “too big to fail” ie. auto-taxpayer bailout prospects? The fear and reality of failure is a good a thing.
[insert slamming of table here]
i call bullsh*t.
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COMMENT:
AUTHOR: wcw
EMAIL: wcw@bignose.org
DATE: 08/20/2008 05:18:25 PM
While I like your piece, I don’t like your throwaway about call-selling. Selling a call, covered or uncovered, is a short option position. A short option position does not to my mind, ceteris paribus, lower risk. Just because it generates an income doesn’t make it a T-bill.
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COMMENT:
AUTHOR: niklas
EMAIL: kryptiskt@gmail.com
URL:
DATE: 08/20/2008 05:44:42 PM
Equity holders aren’t the problem. They tend to accept that they have a risky asset. It really wouldn’t matter if they were thrown a bone or not, they have lost most of their money already. Of course they should be wiped out anyway, but the moral hazard is elsewhere.
The problem is all the trillions of dollars (and euros) that are chasing the fantasy of riskfree investment, stumbling from one stupid AAA-rated financial innovation to another.
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COMMENT:
AUTHOR: James Cullen
EMAIL: cullenjh@bc.edu
URL: http://collegeanalysts.com
DATE: 08/20/2008 06:25:31 PM
This needed to be said - great work getting it out there with a cogent, rational argument. Some of the stocks that have gone under in the last year or so should have been in the negatives; the owners were lucky stocks stop at zero… but there is still enormous resistence to actually wiping out a large financial, so I find it hard to believe anyone higher on the totem pole at Fannie/Freddie will get zero - though should something like that happen, I bet it accelerates the process of bottoming.
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COMMENT:
AUTHOR: Roger
EMAIL: roger@informationarbitrage.com
URL: http://www.informationarbitrage.com
DATE: 08/20/2008 07:27:16 PM
wcw, it wasn’t a throw-away comment. Selling a call reduces the delta of a long stock position therefore, by definition, reducing risk. Period. My comment has nothing to do with generating income.
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COMMENT:
AUTHOR: Alan
EMAIL: alan@tradememe.com
DATE: 08/22/2008 08:03:38 AM
It’s always a question of lesser of two evils. Hopefully, procedures will be established so that such situation never arise again.
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COMMENT:
AUTHOR: nigelh
EMAIL: nigelhharvey@gmail.com
URL:
DATE: 08/23/2008 04:54:39 AM
All agreed … but the devil is in the detail of your final paragraph on trying to ward off systemic risk. eg surely the calculation was bribing Bear’s shareholders to lie down vs arguing for years in courts once the horse had already bolted. Of course they’ll be running out of ammo and then what? Use US force to grab someone else’s?
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2 years ago
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