Financial Engineering Backfires
Something that happened just before the prior two market crashes, and the recessions that accompanied them, including the Great Recession, is happening again: the boom in financial engineering is starting to backfire against the companies doing it.
Their credit ratings are getting slashed, and their borrowing costs are therefore rising, even while they need newly borrowed money to buy back even more shares to keep the charade going. Until the music stops.
Downgrades ascribed to “shareholder compensation,” as Moody’s calls share buybacks and dividends, have been soaring, according to John Lonski, Chief Economist at Moody’s Capital Markets Research. The moving 12-month sum of Moody’s credit rating downgrades of US companies, jumped from 32 in March 2015, to 48 in December 2015, and to 61 in March 2016, nearly doubling within a year.
The last time the number of downgrades attributed to financial engineering reached 61 was in early 2007. It would hit its peak of 79 in mid- 2007, a few months before the beginning of the Great Recession in Q4 2007. At the time, stocks were on the verge of commencing their epic crash.
And there’s a reason for the link.
Companies buying back their own shares, often with borrowed money, are a big force in pushing up stock prices. Unlike other buyers, whether humans or algorithms, corporations are trying to be the high bidder. Their goal is not to buy low and sell high. Their goal is to push up their share prices. In this ingenious manner, they have become the relentless and dumb bid with near limitless means (borrowed money) – exactly what a stock market needs in order to soar beyond all reason.
Buying back shares also helps prop up stocks because it reduces the number of shares outstanding or at least it reduces the dilution that existing shareholders experience when companies award their executives and employees stock-based compensation or when companies buy other companies by issuing new shares. By reducing the share count, buy backs increase earnings per share, and particularly ex-bad-items earnings per share, which is the metric Wall Street analysts and corporate chieftains want everyone to look at.
Share buybacks have some big advantages: they are not accounted for as an “expense” on the income statement though they suck up huge amounts of mostly borrowed cash. So from an income point-of-view, share buybacks are free. But from a cash and leverage point-of-view, they’re very expensive.
When a company borrows money to buy back its own shares, the borrowed money doesn’t get invested in productive activities that would help service that debt in the future. All the company ends up with is a pile of additional debt that might cause all sorts of havoc when the multi-year credit boom – the “credit cycle,” as it’s called – ends. And that is now happening.
There is another element. According to Moody’s, upgrades attributed to common equity capital infusions are plunging. These include IPOs if they raise cash and lower debt for the company, and thus do the opposite of share buybacks (but many IPOs just raise capital for the investors exiting their deal). The moving 12-month sum of these upgrades peaked in the current cycle in September 2010 at 48. For the 12-month span ended in March, it plunged to just 14.
In the cycle before the Great Recession, the moving 12-month sum of upgrades attributed to equity infusions fell to 31 in December 2007.
Both – the soaring downgrades attributed to financial engineering and the plunging upgrades attributed to common equity capital infusions – speak volumes. Moody’s:
The climb by shareholder compensation downgrades suggests corporations are increasingly compelled to take extraordinary measures in order to support equity prices. When companies are willing to return capital to shareholders even at the cost of a credit rating downgrade, managements implicitly admit to the difficulty of achieving a satisfactory return from business assets.
Similarly, the much diminished incidence of upgrades from infusions of common equity capital reflects the now high cost of equity capital that stems from the more uncertain outlook for profits at this late stage of the business cycle.
And the gap between the 61 downgrades attributed to financial engineering and the 14 upgrades attributed to common equity capital infusions – at 47 – is now the highest since mid-2007, when it peaked at 49. Just after that, things began to unravel.
A similar gap built up just before the 2000 recession, but on a smaller scale.
This metric doesn’t cause markets to unravel. But it shows how late in the boom cycle we are today. It shows that the costs of financial engineering are starting to gnaw on stock prices. As at the end of the prior two cycles, companies see this too. Eventually, they curtail their share buybacks, or they’re forced by the credit markets to abandon them altogether. And when that relentless and dumb bid weakens, it pulls a big prop out from under the stock market.
The Fed heard the screaming from Wall Street earlier this year about the chaos in the markets, and it brushed rate hikes off the table. What ensued was a marvelous rally all around, particularly in bonds. But Moody’s pours some cold water over it. Read… OK, I Get it, this Junk-Bond Miracle-Rally Is Doomed