Breaking the Law

I finally got around to reading some of the Emergency Economic Stabilization Act of 2008. I was a bit surprised - even a little impressed - by the level of specificity written into the bailout legislation. Yes, Congress did grant wide discretion to the Treasury Department. But the discretion was not boundless. The law does not give the executive branch of government the authority to spend $700 billion as it wishes; Timothy Geithner cannot go around buying whatever he wants. Rather, "The Secretary is authorized to establish the Troubled Asset Relief Program (or "TARP") to purchase . . . troubled assets from any financial institution on such terms and conditions as are determined by the Secretary, and in accordance with this Act . . ."

That may not sound like much, but in light of recent actions by Treasury, I would like to delve a little deeper into that straightforward instruction. Anyone who has taken a basic accounting class can tell you that an asset is something a company owns. It is worth something greater than zero. It can be a factory, a troubled mortgage bond or a patent. But it cannot be a liability. An asset cannot be something that will result in the company having less money in the future. (I apologize if this sounds obvious, but I promise I am going somewhere here.) When a company issues a share of stock, a preference share, or a bond, then a new liability is created. That LIABILITY is not an ASSET. Indeed, an asset is the opposite of a liability.

Ok, now take another look at the excerpt from the TARP law. It gave Treasury the authority to purchase assets. But not liabilities. So then how in the heck did we taxpayers end up spending billions of dollars on common shares and preference shares? The best answer I can come up with is that the Treasury Department decided it was above the law. I will refrain from expounding on the importance of democracy and adherence to the system of government outlined in the American Constitution. Suffice it to say that certain Treasury officials apparently believe they have more important concerns and that I respectfully disagree.

The law does contain a definition of the term "troubled assets." They are assets related to mortgages or "any other financial instrument." I'm sure the Treasury Department could find a lawyer to argue that therefore assets can be liabilities. However, even if that argument were to succeed, the Treasury would still be operating outside of the law because Congress specified how the Secretary must go about acquiring these assets (also know as liabilities to creative types). The Treasury is instructed that any publicly traded institution that sells assets to Treasury must also give the government a warrant or equity stake designed "to provide additional protection for the taxpayer against losses from sale of assets." In other words, the government must demand equity stakes as an additional compensation for buying troubled assets. But if the government is only buying equity stakes, then it would be impossible to receive any "additional protection" from equity stakes. It is therefore impossible to adhere to the law without the government acquiring more than just preferred shares or common stock. Any way you cut it, both former Treasury Secretary Hank Paulson and current Secretary Timothy Geithner broke the law by using TARP money to buy equity stakes instead of troubled assets.

The Asset Allocation Question

For years, many of the most trusted experts in personal finance have instructed American families to allocate their savings to a mix of stocks, bonds and money market instruments. The percentage that should be allocated to each sector, according to widely accepted theory, mostly depends on the investor's age, wealth, willingness to accept risk, and expected future income stream. But one factor has been conspicuously absent in the determination of investors' asset allocation decisions: valuations are not considered. If stocks are bubbly and bonds are cheap, the investor still funnels as much money into stocks as he would if the valuations were reversed. Two assumptions that underlie this approach to investing are that markets are generally efficient (meaning stock and bond prices are close to fairly valued given the amount of information available to the investing public) and that the average investor cannot beat the market.

Recent events have got me thinking a lot about this. This approach has wreaked havoc on the retirement savings of millions of Americans. So I took out a book I had not read since college: "A Random Walk Down Wall Street," by Princeton economist Berton Malkiel. The book is one of the most influential arguments for the efficient markets theory and the implications for personal investors. The basic message is that investors should not attempt to pick stocks or time the market.

Most of the research I have seen supporting the efficient markets theory (and the notion that the average investor cannot beat the market) focuses on the futility of stock-picking. "A Random Walk Down Wall Street" is no exception. It convincingly argues that people should not attempt to pick which stocks will go up and which will go down; they should just buy index funds with low fees. A small number of experts keep stock prices in line and earn profits doing so; but most people should not attempt to beat the market.

However, Malkiel only touches on the subject of asset allocation. Malkiel cites data showing that equity only mutual funds hold a larger percentage of their funds in cash (mutual funds almost always have a fraction of their funds in cash to meet liquidity requirements) at precisely the wrong times. He concludes that "mutual-fund managers have been incorrect in their allocation of assets into cash in essentially every market cycle during this period [1970-2002]." This is a weak argument. Equity only mutual fund managers are not in the business of allocating assets between equities and cash (and are often legally prohibited from investing significant amounts of money in bonds). They are in the business of buying stocks.

Consider the state of affairs in the United States. The vast majority of Americans and institutions invested a relatively fixed percentage of their savings into equities regardless of valuations. Despite the advice of people like Malkiel, a lot of that money is invested in funds with flexibility to pick stocks (as opposed to index funds). So, there are a lot of dollars out there chasing "cheap" stocks. Because so many people are chasing the same cheap stocks, it is very difficult to outperform the maket. But very few funds are able to sell stocks and buy bonds. Most of the money is literally stuck in the equity markets because investors believe they need to allocate some fixed percentage in stocks. There might just not be enough money out there that is actually managed by people with enough flexibility to keep stocks at fair levels relative to other asset classes.

I suspect that the very good research about the efficiency of the stock market has been wrongly applied to asset allocation in general. Although it may be difficult to pick which stocks are winners, it may be possible to intelligently allocate more or less money to certain sectors of the financial markets based on valuations like yields and P/E ratios. Much more research needs to be done on this point. But many studies have suggested that simple metrics like P/E and P/B ratios can be used to beat the market.

For years Americans have been instructed to invest with a blind faith in the ability of the stock market to turn money into more money when given a long enough time horizon. Recent events ought to at least trigger a serious academic reevaluation of the notion that Wall Street is able to keep the markets near their fair values. Perhaps it is time to rethink the philosophy of investing so much of our savings in the stock market regardless of fundamental valuations.

Equity Stakes

Speaking to a Congressional panel today, Treasury Secretary Geithner advanced the idea of converting the government's preferred equity stakes in banks into common equity. Preferred stock is actually more like debt than stock because companies pay a fixed coupon to holders of preferred shares. By converting preferred shares to common equity, the Treasury hopes to reduce the liabilities of troubled banks and thus improve their capital position. The media, along with many politicians, have correctly identified this as a risky idea. But most of the scrutiny has focused on the thorny issue of how the government can effectively control large ownership stakes in corporations. Fears of nationalization and government interference in private markets have been at the heart of the debate about converting government stakes to comon equity.

Such fears are valid. But they should not be the focus of the debate. First of all, the government already has control over bailout recipients. Many banks would be bankrupt without government assistance. If the government wants to interfere, it can already do so simply by threatening to cut off funding. So fears of nationalization or excessive government interference are moot. Second, and most importantly, the real problem is that common equity is much riskier than preferred equity. A preferred share must pay a fixed coupon to the investor unless the company suspends the dividend it pays to common shareholders. In other words, preferred share holders get paid before common equity holders. Preferred stock holders also fare better if bankruptcy occurs and the firm is liquidated. Congress and the media should be giving more attention to how the conversion would increase the government's probability of losing money. The Treasury has already put trillions of taxpayer dollars at risk to help banks. Converting preferred shares to common equity will exacerbate the problem.