Saturday, November 22, 2014

How Stock Options Inflate Payout Ratios

Imagine a firm with a price to book ratio of 1, worth $100 million, with $100 million in revenues, 10% profit margin ($10 million per year) and a 50% payout ratio.  Each year, owners receive $5 in dividends, and the firm reinvests $5 million, so that the following year, the firm is worth $105 million, etc.

Now, imagine that the firm replaces $1 million of cash wages with $1 million worth of stock options.  Let's say that, on average, when those options are exercised, employees receive $5 million worth of stock, but only pay $4 million for it.  And, let's assume the firm has a policy of purchasing the shares on the open market when those options are exercised.  So, in a typical year, the firm will repurchase $5 million dollars worth of shares in order to distribute stock to employees through the stock option program.

Note, the firm still has $100 million in revenues, $10 million in profit ($11 million in profit from operating cash flows minus $1 million in GAAP expense from the stock options), and $5 million in dividends.  And they still reinvest $5 million into the business ($11 million in profit from operating cash flows, minus $5 million dividends, minus $5 million in buybacks, plus $4 million from employee option exercises).

But, now, they have a 100% payout ratio instead of a 50% payout ratio - just by replacing 1% of market cap. with stock options in lieu of cash wages.  But true profit and profit retention remain unchanged.

PS.  I use the antidilution stock buyback here for consistency in the example, but the options cause the gross payout ratio to be inflated regardless of the buyback policy.  When the option is exercised, the firm receives cash equal to the strike price of the optioned shares.  This is a capital inflow from the employee.  The exercise of the options mean that, ipso facto, the firm had higher capital inflows than would be inferred from gross capital distributions.
Firm with all cash wages
Firm with Stock Options
Cash Profit
$10
$11
Options Expense
$0
$1
Net Profit
$10
$10
Less: Dividends
$5
$5
Less Buybacks
$0
$5
Operating Retained Cash
$5
$0
Add Stock Sales
$0
$4
Add back Option Accrual
$0
$1
Total Retained Cash
$5
$5
 
 
 
Total Gross Distributions
50%
100%
Total Net Distributions
50%
50%

Thursday, November 20, 2014

Not a good sign

While the employment market has been strong, credit has been showing weakness after initially showing strength when QE3 first started tapering.  Part of the problem, in my opinion, is that the Fed didn't commit to a full recovery in household real estate equity, relative to mortgage debt.  That, in addition to pro-cyclical regulatory sentiment, has put a stranglehold on real estate credit markets.  The recent decline in cash buyers may be related to the end of QE monetary accommodation.

So, my question is, is momentum in labor and production strong enough to keep markets growing while real estate markets continue to present a liquidity problem.

The first graph here shows Commercial and Industrial Loans and Closed End Residential Real Estate Loans since before the recession.  We can see here how both seemed to accelerate at the beginning of the QE3 taper.

But, the second graph is a close up view of recent weekly changes.  Closed End Residential Real Estate has not only flattened.  It is clearly declining and is now back to levels not seen since March.  And C&I Loans look like they may be leveling off also.

The FHFA has announced plans to lighten up on some regulations of securitized mortgages.  But the loans shown in the graph are loans owned by the banks.  The path we are seeing here is not a positive scenario.  And, 5 year inflation expectations from TIPS is still down around 1.4%.

On the bright side, inflation seems to have firmed up in the last couple of months.  I have been watching CPI less Food, Energy, and Shelter.  It has rebounded after going into negative territory in July and August.

Wednesday, November 19, 2014

Higher Education Subsidies are extremely regressive

From Twitter:

Bryan Caplan, who is working on a new book about education that should be very interesting, has also commented on this issue a lot.  I would take it even further that Garett.

1) As he mentions, students who don't attend college see lower wages because they lack the credentials that are more widely distributed.

2) For students who are incentivized to go to college, but don't graduate, the subsidy will be associated with immediate missed wages and work experience, and more debt from the portion of their education expenses that was not subsidized.

3) The only students truly subsidized are the students who do graduate.  And, they will tend to have higher lifetime earnings than the students who are net losers from the subsidies.

See Caplan's post, linked above, regarding graduation rates.

Further, there is no market failure here.  There are huge private resources devoted to distributing scholarships by need and merit.  The students that Caplan would encourage to attend college have many private options.  The effect of public funds on opportunities for students is likely harmful for many reasons.

1) It leads to increased tuitions over time.

2) It introduces student selection criteria into the marketplace of grants, loans, and subsidies that are likely to be less reliable than the existing private selection processes.

3) The additional students selected into college attendance because of public subsidies will end up taking some of the private funding sources that could have been used by students who would have graduated.  According to Caplan's data in the link, among all but the highest quartile of high school graduates, as measured by math scores, about 40% of high school graduates attend but do not graduate from college.


There is a lot of concern, across the political spectrum, for the high level of publicly subsidized student loans.  High default rates are definitive evidence of the lack of reliability in student selection among these subsidies and loans.  This is a case where the effect of public spending on national welfare could very likely be negative.  The spending hurts us, not least of which those of us who can least afford it.  We should stop it.

Tuesday, November 18, 2014

From the "We are the 100%" file: Sticky Wages and Sticky Fed Funds Rate

Scott Sumner has a great post at econlog.  The words were flowing from my penny pencil today, so I thought I'd copy & paste a comment I left there.  But, I encourage you to read Scott's post.

---------------

Great post.
I think this is related to another illusion - that rising wages are inflationary. If Fed policy is sticky, then it will be pro-cyclical, and Fed policy will lead to inflation when a strong economy leads to rising real wages and interest rates.
The illusion is bolstered by the cognitive illusion of narrative thinking, where we imagine that employers and employees are in a negotiating battle and that rising wages are a result of employees having a stronger hand in negotiations.
But, rising wages aren't associated with falling profits.
But, this also is related to an illusion. Since profits are not sticky, they are the first measure to fall when a correction comes. When they begin to fall, it will naturally happen at the cyclical high point of wage growth and profit. So, if one is inclined toward believing the negotiating narrative, the empirical evidence will seem clear as a bell. Don't you see? Whenever real wages are growing at their highest, profits fall.
The narrative says that when a worker has readily available other options, he can go to his supervisor and demand a raise. This is why rising wages are associated with low unemployment.
But, the negotiation is a red herring. The real effect in that picture is that the worker has other opportunities, and that they are willing and able to move out of their current job into a job that captures more of their productive potential. It's the movement that creates the rising wage, not the negotiation. And, this is obvious in the JOLTS data.
This and a thousand other effects where frictions that keep labor from flowing freely to its best use are what keep real wage growth down when unemployment is high. Everybody is better off without the frictions. So, we see high real interest rates, high profits, and growing real wages together. The correlation of these sources of income is so overwhelming through business cycles, it's incredible that it is so universally misunderstood.
This is why it is so infuriating to me to see the "1% vs. 99%" rhetoric and the "corporations love to see high unemployment" rhetoric. Humanity has a special ability to use divisiveness in the service of ignorance. This is a case where the unifying truth is right in front of our noses, and so many people just aren't going to accept it.

Mass Transit

Tyler Cowen linked to a story about some new bullet trains in Japan that will travel almost as fast as airplanes.

A commenter at Tyler's post pointed out that the Japanese rail system is run by private firms.  Here is a Wikipedia page about them.

Seoul also has a very nice subway system which is operated privately.

By far the largest mass transit system in the United States is also largely run by private, competitive firms - Southwest, United, Delta, etc.

It's a sad commentary on the present condition of our electorate and our governance that mass transit is generally explicitly assumed to be public, even though we all utilize private mass transit frequently.  How strange is it that in the United States - the supposed beacon of laissez-faire sensibilities, the international leader of disruptive and innovative technological industries - we can't even seem to imagine the private funding and operation of industries and institutions where such has been the case for decades in many parts of the developed world?

Monday, November 17, 2014

Fun stuff from other blogs

1)  The first recorded evidence of "trickle down" economics. (HT: Tyler)



2)  A great post on the ethics of trading for third parties. (HT: Tyler)  It's hard to excerpt.  He walks through a series of days where a client asks you to buy oranges at the market price.


3)  Timothy Taylor has some interesting figures on incomes.

Here is a table he posts.  As he points out, much of the difference between the lowest quintile and the second quintile is that the second quintile gets more government transfers.  (In fact, the middle quintile gets the most transfers.)This points to one of the difficulties of using these numbers to arrive at summaries of income distribution.  Many of the lowest quintile households are retired, students, or are households with very volatile incomes.  The second quintile might, in some ways, be more indicative of marginally working class households.

Here is a graph I did that shows the make-up of different income levels by age.  While the bottom quintile certainly contains some of the most vulnerable families, statistically it seems that some work would need to be done to separate the single young male living with his parents because he is an unemployed construction worker from the 85 year old widow in the nursing home and the grad student who will start making $150,000 when they are in their 30s.

Here is a graph from Taylor.  There are a number of narratives we could build here.

1) The incomes of the 1% have outpaced everyone else.

2) The incomes of the top 1% and the bottom 20% are highly correlated.

3) All the gains since 2009 have gone to the top 1%.

Different parts of the elephant....

I do wonder, though, if that correlation between the top and bottom is a product of the unsystematic nature of the residents of the bottom quintile at any given time.  Maybe the correlation is a product of the temporary movements into and out of the quintile from households with volatile incomes.

Friday, November 14, 2014

Interesting Article on Non-Emotional Investing

CFA Institute Magazine printed an interview with C. Thomas Howard, director of Athena Investment Services.  He has an extreme style of investment, meant to eliminate all emotional biases.  Some of his ideas are definitely outside the mainstream.  He makes a good argument that the Prudent Man Rule, and even modern portfolio theory itself, are, in some ways, the institutionalization of emotion-driven investing, so that even our ethical and academic frameworks are damaging to optimal investing.

I think he makes some great points, and has some challenging ideas about how to invest wisely.

In the end, the problem comes down to the fact that optimal investing is hopelessly bound up with uncertainty on many levels.  We can never cleanly separate temporary and permanent changes, losses from mistaken tactics and losses from volatility, etc.  So, while the best long term investment needs to be unconcerned with volatility, there will always be the possibility, at the nadir of volatility that is likely to be mean-reverting, that it is actually only the beginning of the consequences of a very poor or very unlucky position.  That includes tactics as broad as having a diversified exposure to the global productive economy.  And, that problem is multiplied many times over when your portfolio is under the management of a 3rd party.

Even when a portfolio does well, it can be for reasons that are unclear.  For instance, the Athena Pure portfolio has gained an average annual return of 25% over 12 years. Howard attributes this to his non-emotional, behavioral finance approach.  But, it just so happens that part of his theory regarding this approach is that he prefers firms with high levels of debt and large dividends.  How much of his gains have come from behavioral finance insights, and how much has come from the happenstance that this profile might do very well in a context of falling interest rates?  (I haven't researched the fund's holdings.)

Here is the link (pdf).  An interesting article, with food for thought, and several good ideas, in any case.

Thursday, November 13, 2014

September JOLTS come in strong

September JOLTS confirm recent strength in employment.  Hires and quits jumped and job openings remained strong.  Taken together, openings and quits suggest a labor market similar to mid-2005, when the unemployment rate was at about 5%.  Recent strength in both of these measures suggests to me that the approx. 0.8% of the unemployed who are very long term unemployed (VLTUE) are not aggressively involved in the labor market.  The strong trends in quits and openings makes me more confident that the slow decline in VLTUE will continue and also that recent trends in regular unemployment declines will continue.  We might see the current pace of a monthly drop of 0.1% or more continue for a few more months before the trend flattens out.
 
After the June employment report, I argued that quits and openings pointed to an unemployment rate just about where we were at the time (6.1%), once adjustments were made for demographic comparisons and the remaining inflation in the unemployment rate stemming from VLTUE.  Since then, the unemployment rate has dropped 0.3% and momentum in hires, quits, and openings confirm the strength of that drop.

Wednesday, November 12, 2014

Monetary Offset applies to Asset Values, too

The conflation of asset prices with inflation has led to very damaging confusion.  Much of the discussion of this point seems to build on the idea that either open market operations (OMO) from the Fed bid up treasury bond prices or that the cash infusion is somehow funneled persistently into asset markets, as opposed to consumption.

While there are some (arguable, in scale, persistence, and effect) ways in which OMO might create short term jumps in some asset prices, is there any theory that lays out how dovish monetary policy could create persistent inflation of asset prices relative to consumption prices?

Here is a graph of household real estate values and mortgage levels, as a proportion of GDP.  Note that, while there was some rise in mortgage levels, relative to incomes, total real estate values were expanding much more quickly in the 2000s.

The next graph shows the leverage of household real estate (mortgages / market values).  Leverage had increased in the late 1980's and early 1990's.  But, this was coincident with declining relative home values.  (I have speculated that these patterns are consistent with the idea that real estate serves as a means of consumption smoothing in economies with high levels of human capital, and that we should have expected the baby boomer demographic to lead to higher mortgage levels in the 1990's, and then higher real estate prices in the 2000's that were mostly in the form of equity gains.)

So, there was no net leveraging during the entire period of the subprime loan buildup.  Leverage didn't create the housing boom.  The sudden rise of leverage was the result of the collapse of asset values.

The next graph shows the YOY change in nominal levels of real estate values, mortgages, and net equity.  Again, we can see here that, for most of the housing boom, real estate market values were rising much faster than mortgage levels were.  So much faster that for much of the bubble, households were gaining about $2 in equity for every dollar of mortgage funding.

Here is a sign of the problems caused by the subprime boom, though.  Initially, because of low interest rates, mortgage debt service remained fairly stable, even though mortgage levels were climbing along with home values.  When short term rates started to rise in 2004, debt service ratios began to climb fairly steeply.  Previously, debt servicing ratios had not been so responsive to short term rate movements.

So, by early 2006 home prices had topped out and mortgage debt service levels had reached the highs of the previous cycle and were steeply rising.  No crisis had come yet, and leverage levels were still where they had been for 10 years.  And, already by this time, the yield curve had inverted.  The Fed Funds Rate would remain higher than the 10 year treasury rate until February 2008 - a full 20 months.

I want to keep all of this in mind as we look at the next graph.  During the housing boom, until 2006, presumably, there was a net increase in aggregate demand as a result of credit creation.  On the other hand, some of these activities reflect household savings.  The balance of these factors would play out through inflation and NGDP.

If loose monetary policy was creating home price increases, we would expect to see something like the late 1970's, where everything is moving together - inflation at 5-10%, currency growing at 10% per year, NGDP growing at 10%+ per year, and houses going up along with everything else.

A target-based monetary authority, whether targeting inflation or NGDP, would automatically offset demand coming from asset price movements.  In the 2000s, NGDP and inflation were both well within their 20 year bands of normal (relatively low) growth levels.  If homes were acting like ATM's, flooding the economy with cash, then why wasn't NGDP high?  If NGDP doesn't look high because it didn't account for the high cost of housing, how can this be the case when mortgage debt servicing was stable until after rates were hiked?  If mortgage debt service was only low because the Fed was artificially pushing down rates for years on end, then why was currency in circulation growing at less than 5% per year?  How does the Fed push down rates without pushing currency into the economy?


In fact, the very low growth in currency in circulation suggests that the Fed was, indeed, offsetting any effects.  They wouldn't have to do it explicitly.  Their inflation target would cause them to do it implicitly.

And, I wonder, maybe this was the problem.  The Fed had only been implicitly offsetting the demand effects of the housing boom.  When their offset became too strong, and home values started to collapse, the offset became explicit.  Now, the consensus was that the collapse had been a long time in coming and was probably something the economy needed to see.  In fact, those high home prices must have been a product of loose policy that was showing up in home values instead of inflation.  Now that the idea was explicit, the Fed simply continued with their explicit policy of not offsetting the demand effects of the housing market.  From February 2007 to September 2008, YOY growth in currency-in-circulation remained under 2.5% while home prices fell by nearly 10%.

But, don't blame the Fed.  How much flack would they have taken if in 2009 inflation was at 4%, homes were up another 20% instead of down, if subprime teaser loans had been reset at low rates, and if bankers were sitting on high profits?  Now, they are largely seen as heroes, and if there is one complaint against them it is that they didn't let the banks suffer enough.  In the counterfactual, where many working class households would still be in their homes, sitting on some home equity, and unemployment may never have topped 7%, would the Fed be seen as heroes?  Or would the country be divided between many on the left complaining that the Fed was feeding inequality by boosting asset prices and many on the right complaining about the coming day of reckoning and malinvestment?  We wouldn't let them explicitly offset the housing bust.

Yet, take out housing, and there is nothing in that data that comes close to implying monetary excess in the 2000s.  And the one thing about housing that is completely outside the historical norm is the devastating collapse of 2007-2012.

Will we always be fighting this deep human tendency to distrust abundance?  This is not a partisan issue, which is why it is such a problem.  It spans the political spectrum.  For some time, speculators (buyers and lenders) were cashing in on an asset boom.  Speculation isn't an admirable way to gain treasure.  We aren't going to purposefully create destruction, of course.  But, if losses have to be taken, well, we kind of had it coming, didn't we?  OWS fans and Austrian business cycle proponents may speak different languages, but they are really part of an ecumenical movement from our shared source of human intuition.  Is there a more universal human intuition than the idea that the gods are serving us our comeuppance?  How do we know it was a bubble?  Well, just look how bad the bust was.

"All asset bubbles come from carnal greed which is in speculators and bankers insatiable" is only a slight paraphrase.


PS. Matt Taibbi at Rolling Stone introduced us to Alayne Fleischmann.
Her decision to go into finance surprised those closest to her, as she had always had more idealistic ambitions. "I helped lead a group that wrote briefs to the Human Rights Chamber for those affected by ethnic cleansing in Bosnia-Herzegovina," she says. "My whole life prior to moving into securities law was human rights work."
But she had student loans to pay off, and so when Wall Street came knocking, that was that.
Clearly, she is not one of them.  And, he notes:
Back in 2006, as a deal manager at the gigantic bank, Fleischmann first witnessed, then tried to stop, what she describes as "massive criminal securities fraud" in the bank's mortgage operations. (emphasis mine)

I don't mention this to cast doubt on Ms. Fleischmann.  I don't think anyone would be surprised to find out that there were a lot of people scrambling to cover their backsides, frequently in unscrupulous ways, and that the large banks have tentacles in the regulatory agencies.  That timing is interesting, though.  When she first witnessed securities fraud, the Fed Funds rate was solidly at 5.25% and 10 year treasuries were bobbling around 4.75%.

Saturday, November 8, 2014

Scott Sumner shares my input on Monetary Offset

Scott Sumner argues that since the monetary authority is the last mover in targeting the nominal economy, fiscal cyclical policy is mostly neutered.  If the Fed is targeting a certain nominal production level or inflation level and the government institutes fiscal policy intended to increase nominal economic activity, then the Fed will offset that policy in order to remain on target.  If the Fed wouldn't offset fiscal policy stimulus, then the question is why wasn't the Fed creating more stimulus to begin with?  The zero lower bound isn't a reason.  I have found that the Fed has been able to influence forward inflation and interest rate expectations at the zero lower bound.  Here is a recent study coming to the same conclusion.

At any rate, Scott has posted some comments I made about the issue.  Click on the link for the full story.  The short version is that we can see monetary offset in the Fed transcript from September 2008.

In fact, I suspect that, on a policy like Emergency Unemployment Insurance (which was first implemented in this cycle by President Bush in June 2008), the modelers at the Fed probably model the policy as stimulative.  So, there is a double whammy effect of monetary offset.  Someone like Janet Yellen sits down at the FOMC meeting and she looks at the models from the Fed quantitative staff, which reflect perceived additional fiscal stimulus, and thinks, "Hey, things aren't so bad.  We don't have to be as accommodative as I thought."  Then, bringing her own intuition to the meeting, she notes that the unemployment rate is probably overstated because of the recently instituted emergency unemployment insurance.  We would normally expect rising unemployment to be disinflationary, but since it is likely exaggerated by the effects from EUI, we can kind of figure that the labor market is doing better than the unemployment rate would suggest.

So, EUI might cause Fed modelers to point to a more hawkish policy and then the FOMC adds their own additional hawkish twist.

In actuality, Janet Yellen was right that EUI probably caused higher unemployment, but this probably called for more dovish policy.

Here is a fiscal policy that could be contractionary, but that leads to an exaggerated monetary offset that is also contractionary.