Stock Buy Backs Like Mortgage Backed Securities Bubble of 2008

   Stock buybacks remind me of the mortgage backed securities bubble of 2008 where banks sold packages of loans to other banks, creating a debt and real estate bubble. One bank would create poor quality loans, get an inflated rating from a ratings agency, package the loans into securities and then sell them to another bank, where the seller alleged they were investment grade bonds. The new owner of the loans could then tell regulators that the bank owned securities were rated “AAA” by ratings agencies, thus passing a bank regulator exam when instead they should not have passed the exam. This fueled the 1997-2007 housing bubble, and created the illusion of economic growth and stability when instead it was making thinks less stable.
In the case of stock buy backs what happens is a company buys back its own shares which makes the stock price go up because it increases earnings per share. Then the newly enriched shareholders sell their higher priced stock and use the cash to buy other stocks. So if two companies do this then windfall profit funds from stock buy backs done by company A get spent by investors (unduly influenced by the rise in share prices) on buying shares of company B and vice versa (since buy backs often happen every quarter then the possibility exists that one company’s buy backs simply recirculate into the secondary market for shares of another company and then back to the company that originally started the buy back), thus creating a bubble-making feedback loop that wouldn’t exist if these were privately held companies.
A stock buy back does do damage to a company because valuable cash that should be saved for emergencies is instead disbursed out of the company. The capitalist system can be ruthless and put an over-leveraged company into bankruptcy during a recession if they lack emergency cash. The only defense is to hoard cash and liquid investment grade bonds and to avoid getting into excessive debt. When a recession comes the banks won’t lend, so only those who have saved their cash will be able to use cash to buy assets when they are on sale in a recession, or use the cash to fight off of surprise problems. The contingent risk of being caught without an adequate supply of cash, or marketable securities, during a recession, is an unforgiveable risk that can damage or kill a company. It is like driving a jeep, off road, in the desert without adequate fuel. During recessions companies in some industries can’t qualify for a loan, may have their bank line of credit suddenly cut off, and would have to sell stock at fire sale prices to raise cash.  

     Currently there is a massive overhang of corporate BBB rated bonds caused by borrowing for the purpose of doing stock buy backs. The risk to the issuing companies and to the economy is that the BBB rating of these bonds could suddenly slip down one notch to BB which is a junk bond rating. Then the company would find it had to pay more to borrow or wouldn’t be able to borrow. These bonds would drop in price, causing harm to bond investors, resulting in the bond market cutting off credit to other weak borderline quality borrowers, possibly triggering a recession caused by lack of liquidity.
Stock buy backs used to be illegal (unless a special waiver was issued by SEC) before 1982; we ought to return to those rules.

   Investors need independent financial advice about the risks of being fooled by stock buy backs.

2018-12-28T17:13:57+00:00December 28th, 2018|mayflowercapital blog|Comments Off on Stock Buy Backs Like Mortgage Backed Securities Bubble of 2008

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.