Main Entry Page

Financial Market Regulation

By John Schroy, on May 3rd, 2010 |

Top-down analysis: excerpts

Here are entry points to articles about financial market regulation on this blog:

	Stock Buybacks: For over a generation, SEC Rule 10b-18 has given safe harbor to issuers wishing to manipulate stock prices upwards in order to give value to executive stock options. This has played a major role in the direction of equity prices and dividend policy, although many market participants are still unaware of the connection.
	US SEC: Comments on the role of the United States Securities and Exchange Commission on regulating issuers and protecting investors.
	Financial Market Regulators: Articles on financial market regulation in general.

Top-down analysis: list of articles

These essays are focused mainly on financial market regulation, the US SEC, and the regulation of stock buybacks.

Financial Market Regulator - Bank stress tests: aftermath and consequencesIn May 2009, the Obama administration divided some of America's largest banks into 'good banks' and 'bad banks'.This broke a long-standing practice of protecting the reputation of the US banking system. The Obama government seized TARP funds as an instrument of political power.Banks, large and small, are now eager to escape the trap of taking TARP funds, which will require them to raise $74.6 billion, either by selling equities on the market, or from profits.
Financial Market Regulator - Banks accept California IOUs for depositOn July 2, 2009, the Federal Reserve announced that it was aware that the State of California was issuing its own currency to pay its bills.This, of course, is consistent with the lack of fiscal discipline which is the hall mark of far left Californian politicians, of which Nancy Pelosi is a prime example.California has experience with nut-case economics, having been the home of the famous Emperor Norton who issued his own currency to pay his bills in the mid-19th century.
Financial Market Regulator - Dodd-Frank won't make better marketsUnfortunately, instead of a 'game-changing' confidence-inspiring reform, the Obama administration presented the United States with the Dodd-Frank Act — a legislative miscarriage that has the potential to hold back recovery and impair the position of New York as a world financial center for decades — unless repealed or drastically amended.
Financial Market Regulator - Is big bank complexity irreversible?The root problem with big banks today is organizational and product line complexity. Excessive complexity in banks can be traced to the reorganization of Citibank in 1956, under Walter Wriston, following the advice of McKinsey and Company.Under the McKinsey structure, banks were transformed into industrial-type marketing institutions with matrix organization by product line. Bank managers were paid to meet budgetary targets, rather than for being prudent bankers.
Financial Market Regulator - Mark-to-market nonsenseBanks, by their nature, are insolvent, requiring government guarantees of their liabilities to protect against bank runs. Over the last fifty years, the percentage of bank liabilities guaranteed by the government has fallen considerably, while banks, free from the shackles of the Glass-Steagall Act, have become increasingly complex.Mark-to-market rules do not provide useful information to either bank depositors or investors, but may increase bank capital requirements, reducing the capacity to lend in the midst of a recession.
Financial Market Regulator - Pension fund accounting rules tightenedFASB concept statement No. 5 represents a further slow tightening of the screws as to the way pension liabilities are reported — one step in a long, excruciating journey that has been underway for decades. This rule is expected to have an incremental negative impact on old, unionized companies, further decline in private defined-benefit plans, and higher state and local taxes.
Financial Market Regulator - Some banks are too complex to manageIt is no secret that Citicorp no longer earns the same respect in financial circles as in days of yore. The problem is excessive complexity. This article describes the simplicity of the Citibank operation in 1956 when the bank was the world's most powerful financial institution.It will not be easy, maybe not possible, for Citicorp to simplify operations and relearn the principles of sound banking.
Financial Market Regulator - Will your assets survive an atomic blast?Millions have brokerage accounts with SIPC protection and think this means they have government insurance of up to $500,000 on securities in custody with a broker-dealer, plus $100,000 on cash balances — similar to the FDIC guarantee on bank accounts.In this, millions of investors are mistaken.
Stock Buybacks - Accelerating to a buyback-option blowoutBy Q1 2006, stock repurchases by domestic non-financial corporations had multiplied to five times the level of 2000, the peak of the Great Bubble of the 1990s. With buybacks accelerating at an annual rate of 25% throughout 2005, and with net corporate profits after taxes increasing only 5.5% a year, it is now probable, if recent buyback-option trends persist, that by 2009 — the eve of retirement of the Baby Boomer generation — corporate stock buybacks will surpass net corporate profits after taxes.
Stock Buybacks - Business professor criticizes some buybacksThe Harvard Business Review (September 2006) featured a lead article by Professor Alfred Rappaport of Northwestern Univerity's Kellog Graduate School of Management that questioned stock buybacks at prices above intrinsic value.However, Professor Rappaport didn't object to buybacks below intrinsic value, as had Benjamin Graham, Warren Buffett's mentor and guru.
Stock Buybacks - Buyback bear rages: the worst is yet to comeOn September 17, 2007, Capital Flow Watch called the top of the Buyback Bubble, issuing a warning that stock prices might be in for a sharp fall. Throughout the last quarter of 2007, stock prices fell as funding for buybacks began to dry up, while executives rushed to exercise stock options before they were 'under water'.Equity sales by households are expected to continue, until executive options are 'under water' or until corporations run out of funding for stock buybacks, whichever is first.
Stock Buybacks - Buyback Bubble Pops! A long way downIt is always somewhat foolish to attempt to call the top of a bull market or the precise moment when a speculative bubble pops, but sometimes its better to be foolish than sorry.During the ides of July 2007, when the Dow Jones Industrial Average was gently massaging 14,000, signs appeared that air was finally beginning to leak out of the Great Buyback Bubble that has long characterized the US equity market.The headlines were about a liquidity crunch, sub-prime lending, and banking risk, but the buyback band kept on playing, as if these events were in some parallel universe.
Stock Buybacks - Buyback financing pushes up interest ratesMassive issuance of bonds by non-financial corporations, largely to finance an extraordinary level of stock buybacks, helped force bond interest rates upwards in Q1 2006. For years, the principal issuers of corporate bonds into the US market have been the financial sectors — mainly issuers of asset-backed securities raising funds for mortgages and consumer finance.The annualized rate of bond issuance by non-financial corporate business rose to $240.4 billion in Q1 2006, four times the issuance rate of 2005.
Stock Buybacks - Buyback news is an unreliable 'buy signal'Many investors have finally caught on that stock buybacks are a manipulative device used by company management to increase market levels and give value to stock options. Now, there are newsletters that inform short-term traders when companies announce equity repurchase programs. Buying on buyback news might have been a good idea ten years ago; it is certainly no longer a sure-fire, get-rich-quick formula.The flaw in the buy-on-buyback-notice scheme is market covariance.
Stock Buybacks - Buybacks + options + hedge fundsStock buyback programs are a legalized form of market manipulation, sanctioned under SEC Rule 10b-18 and that serve to drive up the price of a company's stock and to give false value to executive stock options — something that the SEC considers a "legitimate business reason" for rigging the market.However there is no safe harbor for insider trading.
Stock Buybacks - Buybacks slow innovation and job creationThe August 13, 2009 issue of Business Week published an article, "The Buyback Boondoggle — Companies spend lavishly on share repurchases, slowing innovation and job creation", by William Lazonick, a professor at the University of Massachusetts Lowell and director of the Center for Industrial Competitiveness.Because of the multi-trillion dollar scale of the enterprise, buybacks represent a fraud against the retirement plans of a whole generation on a scale that makes Bernie Madoff look like a piker.
Stock Buybacks - Can you sell stocks, and still have them?With prices falling after the market peaked in 2000 and with massive net sales of stocks indicated by the Federal Reserve flow of funds accounts, how can the percentage of assets represented by stocks still be about the same as in 1995?The apparent paradox of selling without reducing holdings can be explained by two common operations described in this article.
Stock Buybacks - Corporate Execs throw caution to the windAccording to Federal Reserve flow of funds accounts, a large portion of today's stock buybacks are financed by borrowing heavily and dipping into depreciation reserves. Even the slowest of minds should be able to grasp the fact that borrowing to finance buybacks results in interest costs that will reduce, not improve future profits.Corporate executives have thrown caution to the wind, touting buybacks as 'good for investors' without regard for the truth or laws against securities fraud.
Stock Buybacks - Execs pocket billions with Jobs Creation ActIn 2004, the US Congress passed the "American Jobs Creation Act" which allowed a US company to elect, for one taxable year, an 85% dividends-received deduction with respect to qualifying cash dividends from its foreign subsidiaries, when such dividends were in excess of a base period amount and were reinvested in the US pursuant to a 'domestic reinvestment plan'.Corporate executives took advantage of this tax break to fatten up their option pay, while cutting dividends to shareholders.
Stock Buybacks - Executives shun equities in their portfoliosA careful examination of the flow of fund accounts for 2005 suggests that probably not more than ten to twenty percent of proceeds from the exercise of stock options were channeled back into the stock market. In order for ordinary investors to benefit from the buyback option programs, they would have to sell 3.5% of their indirect holdings in equities and put the money elsewhere.Without doubt, such sudden 'rational behavior' would crash the stock market.

Stock Buybacks - Household stock sales outpace buybacksThe Federal Reserve national flow of funds accounts show that over the last five years, net sales of corporate equities by US households proceeded faster than corporations could match with buyback programs. The relative size and correlation between household stock sales and corporate equity buybacks indicates that most liquidations by individuals are related to executive option programs.From 2001 to 2005, net equity sales by households totaled $1,156 billion, which suggests that corporate profits transferred to option holders in half a decade may have been on the order of one trillion dollars.
Stock Buybacks - Is the Stock Buyback Era over?Stock buybacks failed to dominate the US equity market in the second quarter of 2009. Non-financial corporations were net issuers of equities for the first time in many years. Lack of corporate cash and a need to reduce leverage seem to be what's driving the market.However the SEC has not revoked Rule 10b-18 and stock buybacks still have a lot of support. Will stock buybacks return with better times?
Stock Buybacks - Legg Mason argues for stock buybacksLegg Mason, the giant asset management company that was recently sold off by Citigroup, issued a report on January 10, 2006 by Michael Mauboussin, Chief Investment Strategist, entitled, "Clear Thinking About Share Repurchases".The general tenor of the Legg Mason commentary seems to be favorable towards buybacks, especially extremely large buybacks that are aggressively pursued and that, presumably, are more effective in jacking up stock prices and making investment managers look good.
Stock Buybacks - Litigation threat for executive options?Trial lawyers are showing interest in the apparent conflict of interest when insiders use stockholders' money to buy back shares on the theory that they are undervalued, and at the same time are unloading their own shares.Legal action in this direction could threaten the equity market, given the importance of stock buybacks in keeping prices up.If stock buybacks were to cease, for any reason, the market could crash, which might wake the SEC from its slumbers.
Stock Buybacks - Moody's criticizes buyback financingAccording to the WSJ, a managing director of Moody's said, "We think issuing debt to repurchase stock or pay dividends is not a good idea — that doesn't strike us as conservative financial policy."In such operations, investors loan money to companies that transfer borrowed funds to shareholders who have no liability or interest in ever paying them back!
Stock Buybacks - Private-equity-buyback arbitrageThe distortion in equity prices caused by the stock buyback movement since 1982, presents an opportunity for long-term arbitrage by private equity players.By taking companies private, arbitrageurs can avoid the inconveniences of SEC oversight and the Sarbanes-Oxley Act, as well as the high costs of executive options supported by stock buybacks. This article discusses various ways the stock buyback movement might end.
Stock Buybacks - Stock buybacks and dividend equivalencyA basic principle of US security law is that material misstatements and omissions of fact in connection with the purchase and sale of any security are violations to be sanctioned.Corporations have argued that stock buybacks are equivalent to dividends. This article explains why this is not true and why suggesting buyback-dividend equivalency may constitute fraud.
Stock Buybacks - Stock buybacks are bad: Further evidenceA new research study by M.A. Gumport, published on the Social Sciences Research Network, shows that stock buybacks are not as good for investors as often touted.The report suggests that when dividends are favored over capital gains, the interests of long-term investors are better served.This is added evidence that stock buybacks are undesirable corporate behavior, despite the favorable opinion of many on Wall Street.
Stock Buybacks - Stock buybacks are still bad for investorsM. A. Gumport of MG Holdings has published the July 2010 edition of the Buyback Monitor, showing corporate stock profits for 275 firms over the period 2000-2010. Without buybacks, share prices for the group now would be at least 5.3% higher (nearly 10% higher after adjustment for foregone interest income).The lack of attention to protecting long-term investors against the massive fraud of stock buybacks is just one more sign that it will be some considerable time before the US works its way out of the present financial morass.
Stock Buybacks - Stock buybacks become less effectiveRepurchases of company stock, mostly under the safe harbor exemption from market manipulation provided by SEC Rule 10b-18, set an all time record of $366 billion (net) in 2005. This was 260% of levels in 2004 and 880% of buybacks in 2002.Despite extremely aggressive tactics of corporate management to manipulate stock prices upwards and give value to option and bonus plans, stock prices rose only about 3% in 2005, on average.
Stock Buybacks - Stock buybacks continue at record levelsNet share repurchases by nonfinancial nonfarm corporations ran at an annual rate of $554.8 billion, about the same level as in Q1 2006 and more than ten times the level of 2001 and five times the level of 2000, the peak of the Great Bubble. Amounts paid to exiting shareholders (including holders of executive options and short sellers) exceeded amounts paid equitably to all shareholders as regular dividends by 44%.
Stock Buybacks - Stock buybacks dry upSince 1982, US equities markets have been driven upwards by corporate stock buybacks. Federal Reserve flow of funds accounts showed corresponding sales of stocks by executives exercising options to take advantage of manipulated prices.The Crash of 2008 changed this pattern, driving equity prices down so that executive options were "below water". Companies reduced buybacks due to tight credit and the inability of executives to benefit in the depressed market.
Stock Buybacks - Stock buybacks financed by record borrowingDisbursement of corporate cash through dividends and stock buybacks totaled $1,073.5 billion in Q1 2006 (annualized). This massive distribution exceeded net profits after tax and was financed by selling bonds and mortgages. Reserves for depreciation were also used to finance buybacks and dividends.These disbursements were double annualized net corporate profits after tax of $509.5
Stock Buybacks - Stock buybacks refusing to die … live on!In Q1 2009, stock buybacks came back, driving up equity prices and sparking a rally by dominating a thin market.These equity repurchases were financed from depreciation reserves and bond issues.The return of financed buybacks in a recession indicates the lack of fiduciary responsibility of US corporate directors.
Stock Buybacks - Stock buybacks up fivefoldNet repurchases of equity by nonfinancial domestic corporations soared to an annual rate of $586.8 billion in Q1 2006 (a new record), pushing stock prices slightly higher. Domestic investors, through mutual funds, and foreign investors helped push prices upwards by buying equities.This frenzied buying was five times the buyback rate in 2000, the year the Great Bubble collapsed!
Stock Buybacks - Stock option price-rigging reportedIn a major article on March 18, 2006, the Wall Street Journal reported that the Securities and Exchange Commission was investigating the possibility that corporate executives were back-dating their stock options to achieve greater profits when these options were exercised.The article did not mention stock buybacks, nor the link between stock buybacks and the legalized price manipulation that is the key to giving value to executive options.
Stock Buybacks - Stock values and cash dividends witherWall Street ballyhoo and flim-flam to the contrary, the year 2005 closed-out half a decade of misery and pain for the average investor in US equities. Average cash dividend yields never surpassed 3.8% during the period, and most of this meager dribble, so grudgingly conceded by corporate boards, was consumed by taxes and management expenses of the open-end mutual funds.
Stock Buybacks - The Buyback Bubble is now official!The Federal Reserve flow of funds accounts have signaled that there is a massive disequilibrium in the US equity market for over a year. Most investors will pass through these days of madness, hardly appreciating the spectacle that surrounds them.However, I will step into the breach and make an unsolicited public service announcement:"The Great Buyback Bubble is now official! Look around you and behold!"
Stock Buybacks - The Stock Buyback Era evaluatedThe buyback era began in 1982 when the US Securities and Exchange Commission promulgated Rule 10b-18, granting "safe harbor" to corporations that wished to use equity repurchases to boost market prices in order to give value to executive option schemes. The total value of corporate buybacks since SEC Rule 10b-18, in 2008 dollars, is estimated at $5.77 trillion.Buybacks have been funded not only from profits, but by raiding depreciation reserves and borrowing from banks.
Stock Buybacks - The yin-yang that rules the marketStock buybacks and stock options are two dominant interlocked forces that have determined the direction of prices in the US equity market since 1982. Corporate management undertakes a stock-buyback program to manipulate the price of company stock upwards and benefits from this action by exercising executive stock options. Price increases caused by buybacks of one company reflect on the prices of stocks of other companies.

Stock Buybacks - Three-Card Monte and the Great EPS ScamThree-card Monte is a time-honored, street-corner con game the uses misdirection, sleight of hand, and shills to separate victims from their money. The Great EPS Scam is a similar con game, using Wall Street 'experts' as shills to distract investors with promises of "enhanced EPS", while corporate flim flam artists misdirect billions of shareholder money into their own pockets through the artifice of stock options.
Stock Buybacks - Track buybacks with 'Google Alerts'Google has come out with a new service called Google Alerts that is a great tool for tracking the madness of the US equity market. Sign up and enter the words 'stock buybacks' and each day your email will bring proof of the lack of market rationality. Googling for 'stock buybacks' now brings information that suggests that the 'Buyback Era' may be drawing to an end.
Stock Buybacks - Wall Street still loves stock buybacksThe webcast, This Week in the Boardroom, for February 25, 2010, discusses the issue of stock buybacks with Stephen Lamb, partner of Paul Weiss, a large international law firm prominent in the securities industry.Wall Street seems to have learned little from the Crash of 2008. The big law firms understand that the safe harbor provided by SEC Rule 10b-18 is still firmly in place; shareholders will continue to be defrauded by employee-directors with impunity.
Stock Buybacks - Warren Buffett attacks buyback schemesIn the 2005 Berkshire-Hathaway annual report, Warren Buffet points to the unethical aspects of the buyback-option schemes so common in the US stock market. He noted that "Too often, executive compensation in the US. is ridiculously out of line with performance. ... the deck is stacked against investors when it comes to the CEO’s pay. ... CEOs understand ... that every dime paid out in dividends reduces the value of all outstanding options"
Stock Buybacks - Why pension managers like stock buybacksThe sponsors of 'defined benefits' pension plans controlled, as of December 2004, about US $2.5 trillion in equities. Common stocks, even after the crash of 2000-2001, were substantially over-valued. In order for stock prices to reflect values that were customary before the advent of stock buybacks, prices would have to drop between 20% (earnings basis) and 50% (dividend yield basis).In the case of 'defined benefits' pension plans, this would represent a loss of between US$500 billion and US$1.2 trillion in market value of pension portfolios.
Stock Buybacks - WSJ exposes the 9/11 caperIn a major exposé of the misuse of executive options, the Wall Street Journal ran a front page article on July 15, 2006, reporting that as stocks sank after the the 9/11 attacks, scores of companies rushed to issue options to top officials. Some executives reaped millions.The SEC provided cover to this fraud, relaxing the already lax SEC Rule 10b-18. Executives were able to play on patriotic sentiment to personal advantage, diverting shareholder funds to their own pockets.
Stock Buybacks - WSJ mildly critical of stock buybacksOn June 12, 2006, the Wall Street Journal headlined, "Big companies put record sums into buybacks — repurchases aim to bolster shares but come at expense of investments in growth". For capital flow analysts, this is hardly news, but for the WSJ to acknowledge or even suggest that the practice may have negative connotations is news!
US SEC - Are investors being misled?Mutual funds are sold primarily on the basis of 'performance' measured by historical 'total return'.The famous Morningstar 'star' rating system is based on 'total return', in this case 'risk-adjusted total return' relative to funds of the same asset category.A general's stars are a clear indication of rank. People presume that 'five stars' are better than 'three stars', just as they presume that a 'five star general' is higher ranked than a 'three star general'.
US SEC - Does SEC Total Return protect investors?Millions of investors put money for retirement into mutual funds selected on the basis of "SEC total returns" and the name of the fund. This article explains how the SEC allows funds to use this misleading statistic to the detriment of investors' interest and to the benefit of fund managers.
US SEC - FASB fox guards investors' henhouseThe Financial Accounting Standards Board (FASB) is made up of seven members, six of whom are either ex-partners of major accounting firms or former high-ranking financial executives of their clients. Accounting practices and standards have a profound effect on capital flows, measured in hundreds of billions and even trillions of dollars. The interests of the issuers of securities are quite different from those of small investors who own these securities.
US SEC - How rating agencies contributed to the CrashThe Crash of 2008 revealed serious flaws in the rating agency system. The market had lost confidence in the major agencies because of the practice of selling ratings. Also, ratings had become a condition of default and agencies, to look good, rapidly downgraded issues just prior to default.Reform of this system is not simple, requiring an entirely new approach consistent with the complexity of today's market. Collaborative research with new Internet technology is a possible solution.
US SEC - How well does the SEC protect investors?One of the most entrenched principles of securities market supervision is ‘non-merit regulation’ — a guiding light of the Securities and Exchange Commission since its founding in 1934. The flaw in 'non-merit regulation' is that it assumes that investors will have the time, inclination, and intellectual capacity to study and evaluate the huge volume of 'material facts' now available under the securities laws of 1933 and 1934. Most US investors must rely upon third parties — fund managers or investment advisers — to study and evaluate information for them.But how much smarter are these 'advisers' than the people they advise?
US SEC - Problems with non-merit regulationThe regulatory principles of the United States Securities and Exchange Commission were established three-quarters of a century ago and have been copied by securities regulators throughout the world. However, the markets, technology, system complexity, and investor sophistication have all changed over this period. The SECs concept of non-merit regulation no longer adequately protects investors.
US SEC - Reforming the SECThe Crash of 2008 revealed weaknesses in the US SEC's ability to protect the public. SEC commissioners have more incentives to favor issuers and market institutions than ordinary investors.Appointed for five years, after serving many commissioners go back to work for market institutions.A commissioner that is too zealous in investor protection may be unemployed when his or her term expires.This article discusses possible solutions.
US SEC - SEC equates California IOUs to munisBy July 2009, the State of California, one of the world's larger economies, was unable to pay its bills, the result of profligate spending in the state legislature in Sacramento.Governor Schwarzenegger was forced to issue State IOU's to pay creditors.The US SEC went along with this, declaring this fiat money to be equivalent to municipal bonds. As usual, California leads the country. In this case, the precedent is not good.
US SEC - SEC probes back-dated optionsBack-dating of options is a side-show in the buyback-option programs that have defrauded investors for decades and that are the force supporting equities prices today. However, the SEC has not begun to investigate statements by executives that stock buybacks are beneficial for long-term investors or the link between stock-buybacks and insider trading.
US SEC - Traders violate First Law of RoboticsOn May 6, 2010, the Dow Jones Stock Index, at about 2:30 PM, fell almost one thousand points, before recovering when traders discovered that there was no real news justifying the crash in prices. The day will forever be know as 'Fat-Finger Thursday', in remembrance of the first inclination to blame the crash on supposed mistaken data entry by some trader, somewhere. Later, the authorities came out and declared that there was no "fat finger", but that the cause for the anomaly was unknown and under investigation.
US SEC - US SEC lets issuers play “Where’s Wally?”The US SEC allows issuers to hide required disclosure by perceptual tricks that remind one of the children's series, "Where's Wally?"These methods include burying warnings in a list of unlikely risks, incorporating facts 'by reference', loading documents with irrelevancies, and playing the 'each fact in the proper document' game.Capital Market Taxonomy provides ready-to-use check-lists that help analysts cut through dense disclosure documents.
US SEC - Why rating agencies overlook toxic assetsFailures of commercial rating services to do an adequate job have been widely recognized, in the wake of the Crash of 2008. Much of the criticism, however, has been directed to the conflicts of interests that are a characteristic of these services.This article discusses other weaknesses of commercial publishers of investment information, such as the industrial nature of their operations and their marketing focus on traders rather than long-term investors. The case of Auction Market Preferred Shares, which failed in 2008, is covered in detail.
US SEC - Why the SEC won’t catch the next MadoffThe US SEC was asleep at the switch in the case of Bernard Madoff. The SEC must follow the law, not commonsense. The SEC rule is, 'Wait until there is a victim. Then investigate'.Furthermore, SEC officials are not punished for dropping the ball. No one lost their pension for failing to warn investors of the Madoff scam. Thanks to the ACLU, the rights of criminals supersede the interests of investors.The myth-fantasy of an all-protective SEC puts millions of naive investors at risk.