Wednesday, May 04, 2005

I got Mail.

Thought I'd post a response, so all three of you can see that I can write a cohesive thought:

On March 29, TC wrote:
"One could... argue that the higher taxation of dividends has the net effect of being a social insurance cost on dividend earning stock investments."

This idea you have that a tax can be akin to an insurance premium to pay for a sort of social insurance policy is interesting. Perhaps we can think of an example that would be more clear-cut though, because the dividend tax as insurance premium analogy doesn't seem to work for the examples you listed. You cite as examples the S&L bailout and Long Term Capital Management. The problem is that neither of these is an example of a corporation being bailed out by the government. The Savings and Loan institutions were required to pay deposit insurance premia to federal regulators (the now defunct FSLIC) in exchange for deposit insurance. As is still the case today, the money deposited in a bank is insured by the federal government for up to $100,000. If you happen to have $200,000 that you would like insured by the federal
government, then you should deposit $100,000 with one bank and deposit the other $100,000 in a different bank. In any case, if the deposit insurance fund is insufficient to meet banks' insurance claims, then tax revenues are used to "bail out" the remaining bank liabilities (deposits), as they were in the 1980s; the taxpayer is tagged as the "lender of last resort" due to the structure of bank regulation. (By the way, in the 1980s all banks paid the same deposit insurance premium, perhaps encouraging some of the riskier banks to take on excessive risk as there was no penalty for doing so. Since 1990, deposit insurance premia have been tied to the riskiness of a bank's asset portfolio.) Because of deposit insurance and due to the fact that banks are the most heavily regulated businesses in the U.S., stockholders, depositors and other stakeholders have less of an incentive to monitor banks than they would ordinary corporations. Banks are sometimes bailed out for
fear of the damage that bank failure would cause to the local economy if the bank is deemed "too big to fail."
LTCM I believe was a partnership, not a corporation, and never paid a dividend. And it wasn't bailed out by the federal government. Alan Greenspan may have played a part in the negotiations between LTCM and its creditors, but there was no "bail out" from the Fed. The problem with LTCM was that it failed to take into account the high kurtosis of asset price deviations (the distributions of asset price changes have "fat tails" compared to Gaussian distributions). A lot of things had to go wrong at the same time, but then, as anyone who has played blackjack knows, the chances
of losing ten hands in a row are higher in reality than on paper. For the most part, corporations are usually allowed to fail and are very rarely bailed out. In the recent past, our federal government did not lift a finger to bail out such large companies as WorldCom and Enron. Granted, there were social costs to these bankruptcies; the employees and retirees of Enron were particularly hurt due to the fact that corporations are required to manage their employees' pension funds and health-care benefits. These pensions should have been diversified but were not. The government is footing the bill for the litigation involving Andrew Fastow (Enron CFO), Jeffrey Skilling and a number of other senior executives of troubled
companies - I'm not sure if this qualifies as the kind of "social insurance" policy you were referring to though.
I agree with you that dividend taxation is not the only relevant factor or necessarily even a dominant feature in explaining the "tech bubble," but it certainly did contribute to a lack of dividend paying stocks and hence to the excessive decline in stock prices. Those stocks that do not pay dividends had on average a much larger decrease in value than those stocks which do pay dividends. It is troubling to me that investors did seem to ignore "fundamentals" for a period of time in the 1990s as you say; investors exhibited what the Federal Reserve called "irrational exuberance."
As I recall, at that time people would use arguments like, "It's a new world with new technologies and higher growth rates. One should not expect the future to look like the past. Valuation models need to adapt." Most economic models and asset valuation models are based on an assumption that market participants are rational. Democratic governance is likewise based on a similar assumption. It troubles me a great deal when such assumptions are apparently unsubstantiated (ex post).
There seem to be plenty of social innovations that provide a mix of both beneficial and detrimental incentives. For example, car insurance is considered a good thing that any rational person would want to have. However, it could be argued that the existence of car insurance has the net effect of increasing the number of car accidents because part of the risk involved in driving is borne by the insurance company. One could for example make the argument that, if car insurance policies did not exist, then people would drive more carefully. Similarly, if our bank deposits were not insured by the FDIC, we all would pay more attention to our banks' activities. So these things frequently have both positive and negative consequences. The positives outweigh the negatives in the things that we keep, one would hope.
I found it particularly interesting that you brought up the Orange County bankruptcy because it just so happens that the Financial Markets and Institutions class that I currently teach is covering repurchase agreements right now, which is the financial contract that was "blamed" for the bankruptcy. What happened, as I understand it, is as follows: Robert Citron had been repeatedly reelected as Treasurer of Orange County
because he had produced average annual returns of 9% on a fund containing the reserve money of the municipalities (school districts, transportation authorities, etc.) located in Orange County. Mr. Citron achieved this by means of a strategy using repurchase agreements and leverage. For example, in 1994 the fund purchased Treasury notes with the yield of 4.61%. These were financed using six-month repurchase agreements (repos) at 3.31%. A repurchase agreement (repo) is a fully collateralized loan in which the collateral consists of marketable securities. As repo rates rose with the increase in the general level of interest rates, the positive spread between
financing and investment rates declined and eventually turned negative. That is, the cost of borrowing exceeded the return from investment at some point in 1994. In December 1994, when the fund declared bankruptcy, the repo rate had risen to 6.75% p.a., resulting in a negative spread of 2.14% p.a. on this transaction.
Sadly, this transaction was not alone. Citron leveraged a $7.4 billion investment fund into a $14 billion portfolio using repo transactions (by buying Treasury securities and using them as collateral to borrow money to buy more securities). As long as interest rates stayed low or fell, the strategy was profitable. It seemed like a winning investment strategy, but Mr. Citron did not recognize the interest rate risk exposure in his strategy. When interest rates moved up, the losses in market value of the securities used as collateral for these repo transactions accumulated. Upon hearing of Orange County's bankruptcy filing (triggered by a missed $200 million payment on a repo transaction), most repo counterparties quickly sold their collateral, thereby recouping their principal. An exception was Merrill Lynch, which was Orange County's adviser and largest counterparty. Merrill held onto its over $1 billion of repo collateral even as other repo counterparties liquidated their holdings. Merrill's efforts to avoid the unraveling of Orange County's portfolio
didn't help though. In January 1995, Orange County filed a $3 billion lawsuit accusing Merrill of "wantonly and callously" selling highly risky securities to the municipal fund in violation of state and federal laws.
It just makes me wonder whether our elected officials should maybe take some finance courses. There are many other examples of financial disaster caused, at least in part, by misunderstanding the risks involved (LTCM, the Malaysia meltdown, Enron, Barings Bank, etc.). Often times, long term risks are exacerbated because the focus is on minimizing short term risks. I would agree with you that the assumption of rationality may be contentious.
- dw


Blogger Tim said...

DW, email me!

4 right wing wackos

10:47 PM  

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