Margin Call: Historic recurrence of financial crises

“It's just money; it's made up. Pieces of paper with pictures on it so we don't have to kill each other just to get something to eat. It's not wrong. And it's certainly no different today than it’s ever been. 1637, 1797, 1819, 37, 57, 84, 1901, 07, 29, 1937, 1974, 1987, […], 92, 97, 2000 and whatever we want to call this. It's all just the same thing over and over; we can't help ourselves. And you and I can't control it or stop it, or even slow it, or even ever-so-slightly alter it.” (Irons, 2011, 01:36:50)

Back in 2011, roughly 4 years after the outbreak of the great recession, director J. C. Chandor and his team released one of the most interesting movies about the financial crisis by taking a different perspective on the crash. Margin Call, as the movie is titled, shows the happenings inside a fictional investment bank during the last 24 hours before the financial collapse. In summary, everything starts with the junior risk management analyst Peter Sullivan (Zachary Quinto) whose financial models show that the firm’s mortgage-backed securities, financial instruments that pool securitized mortgages, were valued incorrectly. He predicts that a 25% depreciation of those products would be enough to force the bank into insolvency whereupon the executive staff meets immediately to discuss how to handle the situation.

This is the point where Margin Call manages to stick out of the list of historical examinations of the 2007 financial crisis: It tries to focus on the personal reasons, thoughts and fears of the people behind the desks instead of analysing technical details like who really could be blamed for the existence of collateralized debt obligations. It is indisputable that many personal mistakes in form of unethical behaviour were made on sides of the bankers in the years before the crash and the list of unscrupulous activities reaches from excessive greed to misleading investors. Although, it is a fact that great parts of the emotionalized public debate on the topic failed to take into consideration that bankers are not part of a vicious sect that plans on how to rob the society’s wealth but just human beings that got the same fears and burdens like everyone else. However, one of the major differences between those 2 groups is the circumstance that senior bankers work in positions where any kind of action can have severe systemic impact on the globalized world and whenever at the same time, regulations fail to keep bad incentives in check, people tend to exploit the system if they have no other motives to not do so.

Therefore, one could argue that the solution is simple: Regulate the financial markets! But taking into consideration the quote at the beginning of this blog, why were people in history not been able to control the markets if regulation was the answer? Proponents of regulation will state that the regulative measures and activities that have been used in the past were not efficient enough, so they call for higher influence and funding of regulative authorities. On the contrary, opponents will highlight the failures of regulative activities in the past and point to idealistic liberal theories of self-regulation due to market efficiency.

Looking at those controversies from a non-institutional shareholder point of view, investors have no other choice than to admit that they just can not know if politicians and regulators can keep our financial ecosystem stable. This is surely not an academical approach at all, but it might make sense on a personal level as regulatory jurisdiction is also often way too complex for regular investors to understand and analyse. However, as soon as they admit that the system we live in is not perfect and vulnerable to crises, shareholders can start taking measures to prepare and protect themselves. Examples would be portfolio diversification in form of buying stocks that historically performed above average in recessions like utility, energy or pharma companies, investments in stocks that pay historically stable and constant dividends or insurances that grant the investor safe income in times of crisis.

Finally, I think that academic research in the field of regulation leads us to efficient markets closer every day. Although, it would be naive to think that we are even close to a “perfect” and infallible market system. Margin Call shows us certain reasons for this fallibility on a human and psychological level and as an investor, I should learn the lessons of this and integrate them into my investment strategy every day.

Bibliography

Barnum, A. O., Benaroya, M., Quinto, Z., Dodson, N., Moosa, C., Jenckes, J. (Producers), Chandor, J. C. (Director), & Irons, J. J. (Performer). (2011). Margin Call [Movie]. United States: Before the Door Pictures. Retrieved from https://learningonscreen.ac.uk/

Share buybacks: The other side of the medal

Figure 1. Buybacks are the new dividend. Reprinted from 
Financial Times, by R. Henderson, 2019, https://www.ft.com

Following the trend of the last 10 years, share buybacks remain on track to be the highest ever as companies are spending an incredible amount of over $200 billion per quarter on the corporate pay-out programs in 2019 (FT). Even though the massive payments appear to be a sign of a prosperous economy, at first sight, there seems to be another side of the medal. On 30^th July, CNN Business publishes an article called “Stock buybacks are reaching dangerous levels”, on 10^th September 2019, the Forbes magazine titles: “The Stock Buyback Disaster (And 3 Exceptions)”. This list of articles could be continued way further, and Investors ask themselves why certain academics and experts are so concerned about share repurchases which were always believed to be a positive market signal.

In order to evaluate and understand the recent media coverage, investors must understand the basics of stock buybacks. Companies have 3 ways to deal with earning profits namely reinvesting them into the firm in the form of buying new assets or paying higher wages, paying dividends to shareholders or lastly, buying shares back. Latter implies that the bought back stocks are taken from the market, decreasing the outstanding number of shares and therefore increasing the Earnings per Share as the denominator falls while the numerator stays constant. Further benefits are the already mentioned signalling because markets interpret the repurchases as believes of undervaluation, as well as observable short-term share price appreciations due to supply shocks.

In 2014, William Lazonick publishes a controversial paper stating that not tendered share buybacks are one of the major reasons why the cumulative change in per hour productivity rose significantly faster than the cumulative annual change in real per hour wages since the 1970s. The economist provides several points of critique on share buybacks which I will discuss in the following.

Figure 2. Where did the money from productivity increases go? Reprinted
from "Profits without Prosperity" by W. Lazonick, 2014, Harvard Business
Review, 92(9),  46-55

Firstly, the academic highlights that stock repurchases are positively correlated with stock prices (See Figure 2) when looking at historical data. Therefore, executives do not buy shares when they are undervalued because this would imply that buybacks are the highest in recessions. This argument doubts one common justification of buybacks but as long as markets interpret them factually as positive signals and companies are not forced to offer low price stocks in recession, the implications of this data proven refutation are not apparent to me.

Secondly, the article emphasizes that repurchases do not have any tax advantages in the US. Due to the Bush tax cuts in 2003, so-called “Qualified Dividends”, which are dividends paid by a US corporation if the stocks are owned longer than 60 days (90 for preferred stocks), are taxed at the capital gains tax rate. Therefore, one of the main arguments of buyback proponents is completely invalid and even a major conclusion of Grullon’s & Michaely’s (2002) paper, namely that taxes do matter when comparing dividends with repurchases, must be reconsidered. Surely, one could argue that the concept of qualified dividends is not universally applicable as it only exists in certain countries (for example in Germany where dividends are taxed at the same rate as capital gains), nevertheless, it has to be considered as economies like those two have a significant impact on global markets. Taking this knowledge into consideration, I further ask myself why companies are not taking advantage of the tax implications of qualified dividends as they create a strong incentive to hold the shares for a longer period.

Lastly, Lazonick gives an alternative explanation for the excessive amounts of buybacks in recent years: The fact that most of the modern-day CEOs receive a significant amount of their salary in the form of stock-based pay. Simplified, this means that they receive higher bonuses if the company succeeds to reach the threshold of certain ratios like Earning per Share. As we know that share repurchases artificially increase EPS through the decrease of the outstanding shares, this method would help the executives to reach their required targets and increase their salary without having any impact on the financial stability of their companies. The data supports his theory as the CEOs of the 10 largest repurchasers between 2003 and 2012 received an average of $168 million each in compensation during the same period while stock-based payments accounted for over 50% of those salaries. Interestingly, only 3 of those 10 companies have outperformed the S&P 500 during this period. Basically, Lazonick severely accuses all executives who participated in the enormous buyback programs of the last years of corruption if they intentionally put their own monetary interest before the company’s and shareholder’s one. This whole line of reasoning may present the strongest argument for dividends over repurchases as both may be substitutable in forms of pay-outs to the shareholders, but the latter creates strong incentives for excessive underinvestment as managers may favour short-term salary appreciations over long-term corporate growth.

In summary, there are several points provided that strongly question the amounts of share buybacks during the last decades. By his taxation argument, the economist scrutinizes the often-stated advantage of buybacks over dividends, but he is never directly criticising the usage of buybacks over dividends, rather the massive underinvestment of firms in their assets. Although, his claims indirectly state an advantage of dividends over buybacks in terms of preventing underinvestment as the latter create undesirable incentives.

Having discussed several aspects of modern shareholder pay-out policy, I now realise once again how easy it is to form and take over commonly shared opinions without questioning them. Especially when your university provides you papers and PowerPoint slides with accepted theories, I tend to forget that there are still many prestigious academics who share a completely different point of view on the same controversial topic. Although I am not overwhelmed by Lazonick’s paper as he only criticises share repurchases but does not give any data or evidence on the effect of dividends on underinvestment in pre-buy back times and how it got worse or not, it is still a recommendable paper more than worth a read for every finance interested student, academic or investor.

Bibliography

Grullon, G., & Michaely, R. (2002). Dividends, Share Repurchases, and the Substitution Hypothesis. The Journal of Finance, 57(4), 1649-1684.

Lazonick, W. (2014). Profits without Prosperity. Harvard Business Review, 92(9), 46-55.

Leveraged buyouts and the effect of capital structure on the shareholder value

Only 5 days ago, on 5^th November 2019, the Financial Times reported about meetings between the $55 billion market valued global drugstore Walgreen Boots Alliance and several private equity groups. According to the magazine, both parties evaluate a possible $70 billion leveraged buyout (LBO), constituting the largest take-private deal ever in history. Immediately after Bloomberg’s and Reuters’ media coverage of the rumours, Walgreen’s share price rose 4 percent on the New York Stock Exchange implying that investors would support the potential takeover strongly.

Figure 1. Walgreen Boots Alliance's share price development.
Reprinted from Yahoo Finance, https://finance.yahoo.com/

How is this instant value appreciation explainable in the context that Walgreen’s share price fell almost 25 percent (Bloomberg) since last year? And even more striking, why do markets have no concerns about bankruptcy due to the arising debt obligations when modern capital structure theories suggest the disadvantages of such capital restructuring?

Before going deeper into detail, I want to shortly summarize and explain the basics of Private Equity (PE) firms and their way of investing and operating. Generally, PE companies can be viewed as the fund managers, so-called General Partners, of private equity funds which are financed by institutional investors and high net-worth individuals, the so-called Limited Partners. The main goal of the private equity managers is to acquire controlling positions by engaging in buyouts of publicly listed companies in order to take on operational roles in the firms and maximize their value. By listing, merging or selling the restructured companies afterwards, the fund managers and their limited partners receive their return if they were successful. Going deeper into detail, one way to achieve the aim of delisting the public equity of the targets are the already mentioned leveraged buyouts. LBO’s are highly geared company acquisitions characterized by the fact that the raised debt is not backed by the PE firm but only by the target’s future cash flows. The purpose of this way of structured financing is the high return on equity that can be achieved according to our understanding of the capital structure and the impact of high debt on the equity cost of capital.

With that kind of knowledge, we can partly explain the share appreciation of Walgreen. Firstly, the rumours about the buyout directly imply that the target should be currently undervalued, that it can be restructured to be more profitable in the long-term and that it should be financially stable enough in terms of future free cash flow to repay all occurring debt obligations. Furthermore, there is strong academic evidence for the positive impact of leveraged buyouts on shareholder value and future financial performance. Exemplars in favour of this kind of view are Bull (1989), giving proof for superior post-buyout performance in comparison to pre-buyout performance and Torabzadeh & Bertin (1987), stating that companies acquired in LBO’s from 1982 to 1985 made statistically significant economic gains posterior the corporate restructuring. We see that PE firms are taking advantage of the implications of capital structure theory by buying strategically suitable targets in combination with the increased return on equity in order to increase shareholder value.

Although all the mentioned benefits, there is also justifiable criticism when it comes to highly indebted company acquisitions, especially such oversized mega deals like the Walgreen one. Concerning the biggest risk namely the rising probability of bankruptcy due to the high gearing, we should look at the current largest LBO ever. In 2007, a syndicate of 3 PE firms took control over the Texan power company TXU corp. for $31.8 billion (Reuters) at a point of depressed valuation with the expectation of rising of gas prices. 7 years later in 2014, TXU declared insolvency, collapsing under the obligations of more than $40 billion (Bloomberg) in debt. This is exemplary demonstrating the risk that comes along with higher return on equity demands and is in accordance with modern capital structure trade-off theory that suggests not to lever up to such excessive levels (Kraus & Litzenberger, 1973).

In conclusion, it might seem like investors are too enthusiastically focused on the upsides of the potential takeover. Since the pharma giant is going through tough times as newly digital businesses in the healthcare sector like online prescription companies are flooding the market, the shareholders might have desperately waited for a managerial turnover without critically questioning the full background of the deal. Furthermore, subjective criticism could also be the arguable managerial abilities of a few non-specialist private equity bankers to fix Walgreen’s weakened business model.

Having discussed the possible takeover, I realized how present and important modern financial capital structure theories are in daily business. One the one hand, the theories can be used to elucidate the cornerstone of investment strategies like leveraged buyouts, on the other hand, models like the trade-off theory are furthermore able to give explanations for the limitations and risks that come along with certain capital structures (Kraus & Litzenberger, 1973).

Bibliography

Bull, I. (1989). Financial Performance of Leveraged Buyouts: An Empirical Analysis. Journal of Business Venturing, 4(4), 263-279.

Fontanella-Khan, J., Vandevelde, M., Kuchler, H., & Massoudi, A. (2019). Walgreens Boots Alliance Explores $70bn Buyout. Financial Times. Retrieved from https://www.ft.com/

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Torabzadeh, K. M., & Bertin, W. J. (1987). Leveraged Buyouts and Shareholder Returns. The Journal of Financial Research, 10(4), 313-319.

The story of LTCM: Can we blame financial models for market crashes?

“If you are out to describe the truth, leave elegance to the tailor.” – Albert Einstein

Since hundreds of years, academics in the field of the philosophy of science among the globe discuss on the trade-off between simplicity and detailedness of theoretical models and mathematical equations. Theories on this question date back to middle ages like the famous law of parsimony, also called Occam’s razor, stating that the most obvious and simplest solution is mostly the correct one and therefore, theoretical models should be kept as straightforward as possible. On the other hand, many scientists, like Einstein in my entrance quote, oppose this kind of view and are convinced that the truth is way too complex and therefore mostly not possible to be described in efficient and simple formulas (Ironically this is coming from the man who delivered the mathematical proof for “e=mc²”, maybe the most known and elegant equation in the world).

Especially relating to modern financial theory, commonly used and accepted models among academics and professionals like the capital asset pricing model (CAPM) that build the cornerstone of finance as an econometric exercise (Dempsey, 2013) are under severe critique of being oversimplified and not applicable at all. Arguments that underpin this critique highlight false CAPM assumptions like observable market inefficiencies.  Besides CAPM, one of the most popular but also heavily criticised and furthermore Nobel Prize winning financial theories is known as the Black-Scholes Model (BS). Published in 1973 by Fischer Black, Myron Scholes and Robert Merton, the three economists claimed to have found a way to value option prices correctly and therefore creating the possibility to eliminate risk completely by using dynamical hedging strategies. Nonetheless, also Black and Scholes elegant equation was constrained by several key assumptions creating the same trade-off problem between parsimony and detailedness.

I asked myself several times during my studies of quantitative finance and economics: Are there any real-life consequences of the application of models with insufficient assumptions? Or is it enough that the people and the markets unitary believe in them, creating self-fulfilling prophecies. One case in history might indicate where the boundaries of financial modelling are and how these insufficiencies could affect everyone, being way worse than CAPM and poorly calculated benchmarks for managers or inappropriate discount factors (Dempsey, 2013).

The instance refers to the already mentioned Myron Scholes and Robert Merton. In 1994, years after their publication of the Black-Scholes Model, the 2 academics and a Hedge Fund manager named John Meriwether decided to operate on the global markets on their own and founded Long-Term Capital Management (LTCM). Within a few months, the team raised 3 billion dollars (Barbu, 1999) as investors were almost proud to give their money to 3 of the most popular luminaries in finance. The fund managers invested mainly in options in the field of Fixed-Income Arbitrage by applying the same dynamical hedging approach they used in their model.  In the following 3 years, LTCM generated an exorbitant return after costs between 30% and 40% per year (Barbu, 1999) and it seemed like the impossible had happened namely that science had cracked the code of the financial markets by using mathematics.  

Figure 1. $1000 investment in LTCM . Reprinted from
Wikipedia, by R. Lowenstein, 2000, https://en.wikipedia.org/

Although, it came different as the Russian financial crisis of 1998 hit the global markets completely unexpected. Investors all over the world reallocated their capital in the safest way possible, mainly in securities like US Treasury Bills. The consequences were an increase in the spread between interest rate swap derivatives and their underlying Treasury Bonds – the exact opposite way to LTCM’s investments. The hedge fund began to lose hundreds of millions every day till their liabilities reached an unimaginable amount of $1.25 (Barbu, 1999) trillion causing the possibility of a collapse of the global financial markets.

Lastly, the markets did not crash as the USA organised the biggest bail out of history prior to the 2007 financial crisis, nonetheless, the story of LTCM raised many questions concerning the reasons how one single company could create a systemic risk of this scale and what role the financial models like Black-Scholes played in this context.

A main implication of the simplicity of models like BS and CAPM is the common usage among finance professionals. One could say that this is a good thing because not applicable models are worthless in real life. On the other hand, models that are followed by everyone and finally turn out to be wrong lead to much greater downturns as everyone is betting on the wrong horse. The major problem that occurs when people criticise the utilisation of financial and econometrical models is in my opinion the lack of alternatives. I doubt if it would be truly socially desirable if we could force traders to stop listening to academics and let them invest only because of their gut feelings and instincts. Moreover, the dystopian idea of stopping academics research in order to prevent investors from using their ideas would be even worse, leading to a complete standstill of human and social development. Whereas what we need instead of thoughtless criticism of mathematics is the efficient regulation of markets through legislation to prevent excessive risk-taking, illegal exploitation of asymmetric information distributions and all the other cases where markets fail to regulate on their own.

Having analysed the downfall of Long-Term Capital Management, a company that could not even be managed by 2 of the greatest minds in modern economics, makes me even look more critical on financial theories like CAPM and their assumptions. Professors all over the world teach about the models’ limitations, but the excessive usage of them makes the students, me included, often forget about the obvious imperfections. Although, I am in the opinion that academic models are an important cornerstone for modern investment management, as long as they are not applied thoughtless and get steadily falsified and improved as academics gain more and more knowledge every day.

Bibliography

Barbu, G. (Director). (1999). Horizon – The Midas Formula [Motion Picture]. United Kindom: BBC. Retrieved from https://learningonscreen.ac.uk/

Dempsey, M. (2013). The Capital Asset Pricing Model (CAPM): The History of a Failed Revolutionary Idea in Finance? Abacus, 49, 7-23. Retrieved from https://onlinelibrary.wiley.com