Stress Tests and Stock Buybacks

Bear with me. I’m going someplace here, I swear.

The US Government, just 11 years after Nancy Pelosi became the best contortionist in the world in keeping the Congressional Budget Office’s 10-year cost estimate of Obamacare under a trillion dollars, has just passed a TWO trillion dollar economic bailout package.

Woo Hoo!

As a fiscal conservative, I am a bit sanguine about the entire matter. This is probably due to age; I turned 65 this year, and one of the benefits of impending retirement is that you can look at your government doing silly things, and realize that if they’re determined to go to hell, you no longer have to go with them.

However, in the run-up to the bill’s passage, there was (expectedly) a record amount of demagoguery that I thought was worth discussing, in that we seem to have an increasing segment of the voting population who has no effing idea how public corporations do what they do, and WHY they do what they do, regarding their fiscal responsibility to their shareholders.

So, here goes.

Businesses, whether large or small, public or private, all have the same goal: to make a profit. The small business is owned by a person who pays a mortgage just like everyone else; and in the vast majority of the cases, they earn more than the average white collar worker does, but not tremendously more. The entrepreneur who owns a couple of Subway franchises is not lighting cigars with hundred dollar bills.

A small number of businesses, perhaps a few thousand of the 1.7 MILLION corporations in the US, make a LOT of profit, to the point that the owner or the corporate executive IS able to light cigars with hundred dollar bills. If the corporation is private, they’re living large; but if the corporation is publicly held, all that profit is actually owned by shareholders, not the founder or the CEO. (Remember that point — — we’ll come back to it later.)

And that’s where the management of profit gets interesting.

So, we have this small number of public corporations where a LOT of profit is being made. The first thing that people tend not to realize that even in corporations where a LOT of profit is being generated, the corporation doesn’t keep a lot of cash laying around; if they have to cease operations because of, say, a pandemic……they’re out of business in 30 days, unless they lay off most of their employees, AND/OR their lienholders cut them some slack……. AND/OR they get some money from the government that allows them to keep some or all of their employees on the rolls.

The fact that corporations don’t keep money around came to front-and-center this week, and became grist for the demogogic mill. BECAUSE (the demagogues said) they WASTED ALL THAT MONEY ON STOCK BUYBACKS SO THEIR FAT CAT FRIENDS COULD GET RICH, AND NOW THEY WANT A BAILOUT!!!!!!

There is so much stupidity in that sentence it will take me awhile to distill it. Let’s start with WHY the corporations don’t keep a lot of money around.

Corporations don’t keep a lot of cash around, simply put, because that money doesn’t belong to them; it belongs to, like everything the corporation has, the shareholders. (There are a couple of other reasons they don’t want to keep cash around, but let’s not digress.) The bottom line is that if the shareholders see that their corporation is spooling up cash*, they get annoyed, and start demanding that cash be given to them. Then, IF the Board of Directors doesn’t give it to them straightaway, they vote out the Board and demand the CEO be fired.

  • *Note: These general principles do not apply to high growth companies in the tech or biopharma industries, as well as a few others. Such companies are rare, and are exceptions to these principles, to some extent. So don’t comment with a “but..but…but…AMAZON!!!!!”; they’re one of a very small number of corporations who literally can’t figure out what to do with all their profits.

So, the Boards and the CEO, in a very logical move of self-preservation, gives the shareholder’s money back to them. But, HOW do they give it back to them? There are two primary ways:

  1. Dividends. Dividends are the most straightforward way, and most efficient. However, despite this, the shareholders don’t always WANT dividends, or at least don’t want too much of them. Why is that, you ask? Because dividends are immediately taxable. So, the majority of shareholders want their cash back in a different, more tax manageable way, known as……..
  2. ……STOCK BUYBACKS. Stock buybacks decrease the number shares in circulation, thus decreasing supply, and thereby give money back to the shareholders by driving up the value of their stock. Stock buybacks are less efficient than dividends, because there are other variables that affect the stock price, but buybacks have the advantage of giving the shareholder CONTROL over his or her tax liability, because stock profits are not taxed until the shares are sold.

So, with all that in mind, let’s put to rest (at least) this one part of the demogogery that accompanied the debate:

Stock Buybacks are NOT an example of irresponsible corporate management engaged in for no other reason than to make the rich richer. They are enacted to drive up share prices because the shareholders will not permit the spooling up of cash, AND because the way the tax code is written makes higher stock prices more desirable than dividends**.

  • **It’s worth mentioning here that if the tax code were changed to make dividends nontaxable, then the shareholders would want dividends a lot more than they would want buybacks. This would make the stock markets more efficient and a lot healthier…..but there is a strong political contingent in the U.S. that (weirdly) assumes that only the rich benefit from dividends, and therefore oppose this sort of change.

Now, let’s move on to this “Fat Cat” nonsense:

It is incorrect to refer to shareholders as “fat cats” or to think of stock buybacks and dividends as something that benefits only “the rich”. Certainly there are rich people that benefit from them, and benefit greatly. But the entities that are usually the largest shareholders in corporation are rarely individuals like Warren Buffet or the Carl Icahn; the largest shareholders are usually public pension funds (which return all their profits to public sector retirees like teachers and police); and mutual fund companies (who return their profits to the (mostly) non rich that hold them in their 401Ks***. Therefore, if you regulate stock buybacks and dividends, what happens is that the rich get annoyed (and find other ways to get richer) but you impoverish those trying to save for a decent retirement, AND you vastly increase the risk of needing to bail out public pension funds at a later date.

  • ***Logically, then, if it genuinely bothers you that the rich get richer through buybacks and dividends……the fix is NOT to mess mess with the corporation’s ability to buy back stock or pay dividends — that hurts too many people on Main Street. The fix to THAT problem is just to tax the rich more.

So, I’ve now answered the question as to why bailouts are necessary — — because corporations, for good reasons, don’t keep a lot of operating capital around. Hope that helps. However, it now begs another question — is there a better way to do all this? Could we avoid having to bail out corporations in the next time of crisis?

The answer is YES.

After the events of 2008, which required massive banking bailouts, the Fed instituted a system of regulations requiring what are known as “stress tests”. A banking “stress test” is the application of a crisis model developed by the Fed to the bank’s balance sheet. In other words, it’s the Fed asking the bank “IF this set of circumstances stressing the financial system occurred….would your bank have enough cash on hand to survive it?”

Or, put another way: “Do you have enough cash around to bail YOURSELF out if need be, and not have to depend on us?”. This is perhaps a better way to say it, because it expresses the Fed’s objective.

Notice that the banks are not screaming for bailouts during this pandemic crisis, right now, largely because of these post 2008 stress-test regulations. So one must ask: Should there be stress tests for large, strategic corporations also? Or, maybe, just a federal requirement that every corporation must keep on hand enough operating capital to run their business for 30 days, assuming no profits are coming in, without laying off any employees?

Food for thought.

I have a lot more to say about the 2T bailout deal, and (Inshallah) will write three more articles about it:

  1. Why a 500B loan facility is not a “slush fund”, (And why you want it to exist, even if it is.)
  2. Does the bailout bill make us socialist? (And why it doesn’t matter if it does or not.)
  3. And…..eh, there was something else, but my train of though derailed. I’ll update this list when it comes to me.

Written by

Data Driven Econophile. Muslim, USA born. Been “woke” 2x: 1st, when I realized the world isn’t fair; 2nd, when I realized the “woke” people are full of shit.

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