black october 2008, insead

commentary from our finance profesor in Financial Times
Blaming share buy-backs for the crisis is like blaming a knife for a murderPublished: October 9 2008 03:00 | Last updated: October 9 2008 03:00From Prof Theo Vermaelen.Sir, With everyone searching for someone to blame for the current financial crisis, William Lazonick has apparently discovered a new culprit - share buy-backs (Everyone is paying the price for share buy-backs, September 26).Banks are blamed because they bought back a lot of stock rather than paying dividends. I fail to see how this would have made a difference: in both cases cash is paid out and financial leverage is increased. Moreover, companies are reluctant to cut dividends as dividend cuts are accompanied by very significant stock-price declines. Hence a dividend is perceived as a firm commitment while a buy-back is not. If banks had used their exces cash to increase their dividends rather than to buy back stock, they would have been in worse shape today. They would feel compelled not to lower their dividends, so more of them would follow surrealistic financial policies such as isuing equity to pay out dividends.Prof Lazonick argues that abundant stock options give [managers] an incentive to do buy-backs to boost stock prices even if this undermines long-term value. This statement is inconsistent with all the US-based empirical evidence on short-term and long-term consequences of buy-backs.On average, stock prices increase about 3 per cent around the announcement. Such a trivial increase can hardly be a motivation for destroying long-term value. In the long run, on average, stock prices experience significant positive abnormal returns, which is inconsistent with the manipulation story.It is also difficult to understand why such manipulation should be described as a measure of the grip that shareholder value ideology has on corporate America. Managers manipulating share prices to maximise their compensation is more consistent with the ideology of stakeholder value, where managers maximise their own interest at the expense of the stockholders.The empirical results hold on average and in the long run. Of course, the buy-back decisions of some companies, such as banks, in recent years can be criticised because a share buy-back is an investment as well as a capital structure decision. Companies should not buy back stock when their shares are overvalued or when the buy-back pushes the debt-equity ratio above the optimal level.So bankers who repurchased their own stock can be blamed for two mistakes. First, not valuing their asets and liabilities properly. Second, not fully understanding that increasing leverage increases the risk to the equity holders so that debt is not cheaper than equity. The last point was made by Merton Miller and Franco Modigliani 50 years ago. Although they received a Nobel prize for their contribution, I believe that this point has not really sunk in deeply enough among the banking community.Executing a succesful buy-back strategy requires strong valuation skills as well as understanding how capital structure affects both risk and return. Blaming buy-backs for the current financial crisis is like blaming the knife for the murder.Theo Vermaelen,Profesor of Finance,Insead,Fontainebleau,France

Ранее | Позже