Share repurchases and the Great Deleveraging

The Economist writes in “From buy-backs to sell-backs” that the slowdown or reversal of share repurchases is an ominous harbinger for stock markets.

The article seems to miss the central reason for the change: the cost of risky debt was historically, monumentally low before August 2007, leading everyone (corporations, individuals and governments) to increase their debt/equity ratio.

The academic model cited in the article, with tax effects, argues for a 100% debt, zero equity structure. In the real world, this is usually moderated by a nonlinear increase in the cost of debt as the debt/equity ratio increases: lenders simply won’t go that high. But just how high they may be willing to go is a moving target. Before last summer, lenders were eager, so many public companies dutifully issued debt and bought back stock, increasing firm value by increasing debt/equity ratio, as in the academic model.

Suddenly in August, the price of risky debt skyrocketed, dramatically reducing the optimal debt/equity ratio. Companies are frantically trying to delever in response.

The best CFOs recognized all along that the cost of risky debt, and the cash flow available to service it, change through time. As a result, the true optimal debt level was much lower than implied by the prevailing cost of capital during the go-go years of 2005-2007.

The article also mentions rights issues by banks. These are a related matter, but not in the way implied. Banks were on the other side of the leverage table before 2007, providing the aforementioned monumentally cheap risky loans. The results of this are well known, and banks need to rescue their now impaired balance sheets. Few will lend to them, so one of their only financing options is to issue stock. A rights issue is the least expensive way to do so.

The really ominous harbinger for stock markets is neither the slowdown in buybacks, nor the increase in rights issues, but rather the underlying reason for both: inability to borrow. This cannot be resolved until the root cause of the credit crunch — a crisis of confidence in credit rating agencies — is corrected. This problem lays outside the realm of monetary policy, and thus cannot be fixed by the central banks.

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