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The Waning of Finance Print E-mail
by Martin Hutchinson    Mon, Feb 27, 2012, 03:57 PM

Wall Street’s 2010 results were disappointing and the howls of banker anguish over shrunken bonuses have reverberated through the better Manhattan restaurants, bars and clubs. The rise in financial services’ share of the economy, seemingly so inexorable, has at least paused. Is this merely a blip, or is it the beginning of a reversal, in which financial services returns to its historically modest position in our economic life, and other forms of wealth creation take its place?

The increasing share of financial services in GDP has been inexorable since World War II. Taking the “finance and insurance” sector of the national accounts as a benchmark, its share of GDP rose from 2.4% of GDP in 1947 (the first year available) to a local peak of 4.3% of GDP in 1972. Then it was flat for a few years, surged during the 1980s to 6.0% of GDP in 1987 and surged again in the 1990s to a peak of 8.2% in 2001. That later peak was not surpassed during the housing finance boom of the mid-2000s, surprisingly, but was finally topped in 2010, in which the sector represented 8.5% of GDP. Thus the surge in financial services activity is consistent and long-term, nearly quadrupling as a share of GDP over the last 63 years.

At first sight, that makes it appear as though financial services’ growth is an inexorable feature of a modern economy. However if you go back further, recognizing that GDP figures before 1947 are not very accurate (the concept was only invented in 1934) you will see a further surge in financial services, from a low of about 1.5% of GDP in 1880 to a peak around 6% of GDP in 1929 – followed by a catastrophic drop during the Depression and World War II.

The 1930s decline in financial services income is not surprising. Stock brokerage and investment management, which had been becoming major businesses by 1929, were decimated by the downturn. The Glass-Steagall Act, separating commercial from investment banking, may have been useful safety legislation, but it resulted in the de-capitalization of brokerage and underwriting businesses, leading to a dearth in public debt and stock issues in the late 1930s such as had not been seen since before the Civil War.  Home mortgage lending, conducted in the 1920s without government guarantees, but on unsound principles of 10-year maturities and inadequate amortization, was equally decimated by the decline in house prices. Deposit banking was badly damaged by the disappearance of one third of U.S. banks in 1932-33.

Only insurance remained a stable and reliable financial services product, and seems likely to have maintained its share of GDP, more or less. However the decline in other financial services was not just a product of poor markets (thought it was to an extent a cause of them) but represented a reorientation of the U.S. economy away from finance – egged on by populist politicians who found it easier to blame the Great Depression on finance rather than on their own errors.

It has to be said therefore that Barack Obama has so far failed where FDR succeeded, in that finance has not yet declined as a share of U.S. GDP. That may however be about to change. (Incidentally, the massive Wall Street contributions to Obama’s 2008 campaign surely represent in its purest form the adage, supposedly coined by Lenin, that capitalists will sell you the rope with which to hang them!)

Once the current period of artificially low interest rates ends, its stimulus to asset prices and leverage will also end. At that point, many of the products and services that have pushed up finance’s salience will become unprofitable.

One such product that has already declined from its peak is securitization. In its initial incarnation, securitization seemed a useful way to remove excess home mortgage assets from bank balance sheets and transfer them to investors who would welcome this new low-risk asset class. The business was greatly facilitated by the availability of quasi- government guarantees from Fannie Mae and Freddie Mac. However after the subprime debacle it became clear that securitization could be used by unscrupulous operators to originate mortgage loans that should never have been made.

Today, much of the demand for securitized products comes from mortgage REITs, leveraged up the eyeballs and gambling on the spread between short-term and long-term rates. Once that spread disappears, there will be a gigantic glut of this paper on the market as the mortgage REIT losses wipe out their capital bases. The home mortgage market will be disrupted, and will operate only at considerably higher interest rates in relation to Treasuries. Finance’s intermediation profits will be correspondingly diminished, or wiped out altogether. Fannie Mae and Freddie Mac will report losses so large that they may prompt even a spineless Congress to put those useless behemoths out of business.

The derivatives sector is largely responsible for the financial services growth of the last three decades. One of the changes that have boosted derivatives’ salience has been the practice by industrial companies to treat their finance departments as profit centers, thereby encouraging speculative game playing by finance staff claiming to “hedge” exposures. As innumerable investors can attest, the principal effect of such hedging is to make financial statements completely impenetrable, so that hedged oil companies, for example declare huge profits when prices fall, the reverse of their economic reality. A little shareholder pressure and reformed corporate governance should eliminate much of this activity.

While it seems likely that interest rate swaps, currency swaps and their associated options will remain a modest part of the financier’s toolkit, the same cannot be said of their eldritch cousin credit default swaps. The principles of the Life Assurance Act of 1774, which forbade taking out policies on unrelated lives and then arranging accidents, must be applied to this market, so that counterparties cannot take large naked short positions on credit. The legal and payment uncertainties surrounding these instruments in any case make them almost pure gambling contracts. There will doubtless be another financial crash shortly, in which CDS are heavily implicated; it is to be hoped that regulators don’t neglect this area after the next crash as they did after the last one.

Fast trading, whereby institutions position their machines at the stock exchange in order to get earlier information of trading flows, on the basis of which they trade, is pure rent-seeking and a form of insider trading. The various Tobin tax proposals being mooted, while they may do other damage, should at least cut off this illicit source of financial services revenue.

Hedge funds and private equity funds have been major beneficiaries of loose money, attracting institutional capital by promising superior investment returns unlinked to the conventional equity market. It should already be clear, and is becoming increasingly so to the dumbest state pension fund and even to the Harvard endowment, that both these claims are untrue. In the long run, the returns of hedge funds and private equity funds are not superior, especially net of their excessive fees. Second, those returns are highly correlated to the stock market, since they depend crucially on the readily available and excessively cheap money on which all bubbles are built.

Finally, in Europe especially, financial services companies have sought to be universal dumpsters for government debt. While the pre-2008 belief that government debt was risk-free was nonsense, in general financial services entities (unlike some unleveraged global manufacturing companies) are not better credit risks than the governments under which they operate. Hence it makes no sense for them to hold government debt, other than as part of their underwriting function. They have been encouraged to do so by the spuriously steep yield curves of recent years, which have encouraged them to invest in long-term paper, while funding it in the short-term market. Like the unfortunate First Pennsylvania Bank in 1980, some of them will pay the ultimate price for this folly, while others will merely suffer large losses and be forced to sell off operations and fire staff in order to survive.

However, the principal factor cutting back financial services’ share of the economy is the tsunami of regulation that has been and is being imposed on the industry as a result of the 2008 crash. This also happened in the 1930s: the SEC and the Glass-Steagall Act deflated financial services inordinately, doing great economic damage thereby. It is now clear that the damage from Dodd-Frank’s 848 pages arises not from the Act itself, which was fairly anodyne and missed many of the better legitimate targets among the industry’s bad practices, but the regulations it encouraged, which contain a large multiple of the complexities of the Act itself. Much of the financial services industry will be engaged in battling those regulators every inch of the way, while other parts of its business will be severely hampered by the rules they produce.

There are thus three factors cutting back financial services’ share of the economy. First, there is a natural reaction against the excesses of recent decades, in which some of their more egregious business practices will no longer work and will be abandoned. Second, an end to the current excessively loose monetary policy will result in a dampening of speculation and a reduction (much of it the hard way, through bankruptcy) in systemic leverage. Finally, the surge of regulation through Dodd-Frank and the equivalent EU regulations will itself dampen activity in the sector, forbidding some practices and making others uneconomic. Just as deregulation from the 1970s encouraged the growth of the financial services sector so new regulations, imposed ineptly, will cut it back as they did in the 1930s.

The financial services sector may not fall back to the 2.4% of GDP it represented in 1947, but it could easily fall back to the 4% or so of GDP it represented in the 1970s, about half the current size in terms of the overall economy. The moral is thus clear: don’t put too much money in bank stocks, and above all, don’t waste the lives of your intelligent offspring by encouraging them to enter this currently overblown sector, prone to parasitism in bull markets.

(Originally appeared in The Bear's Lair.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site—and co-author with Professor Kevin Dowd of “Alchemists of Loss” (Wiley – 2010). Both now available on, “Great Conservatives” only in a Kindle edition, “Alchemists of Loss” in both Kindle and print editions.


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Pay Up and Like It! Print E-mail
by James Reza    Mon, Feb 27, 2012, 03:54 PM

Genesis 1-26: And he said: Let us make man to our image and likeness: and let him have dominion over the fishes of the sea, and the fowls of the air, and the beasts, and the whole earth, and every creeping creature that moveth upon the earth.

Boy, God sure made it plain and clear that man is more important to Him than trees, dirt, birds, seals, and all things Environmental Wackos (a person(s) who is/are regarded as crazy, eccentric or mad), along with President Obama tend to pay homage to.  The world and what one finds in it are more important to environmentalists than the needs of mankind.  It seems to me that they worship the things and creatures of the world than what is better to improve and ensure the well being of humans.  I’ll never forget some years ago when some wacko woman lived in a tree to protect it from being cut down.  She despised the harvesting of trees and was protesting so tree loggers would stop cutting down trees without realizing that the wood from the trees is most often used to build homes and other wood related products to better serve humans.  The foolish woman didn’t realize that as trees are cut down, new ones are replanted to replenish the forest.  And forest fires caused by lightning destroy millions of trees yearly. Is this woman going to try to stop lightning from striking forests?

In another incident a baby seal that was saved in the Exxon Valdez oil spill that occurred in Alaska in 1989 was released back into the ocean with much news coverage and fanfare to the delight of environmentalists.  As the TV cameras covered the release of the seal, the happy atmosphere of the crowd sudden turned into horror.  As the seal swam out into the ocean a killer whale plucked the seal, tossed into the air and had itself a great meal.  Now folks you just can’t make that up!

I guess you can say that those of my generation (40s, 50s, 60s) were indeed environmental wackos and didn’t even know it.  “Why James?” some might ask.  My dad never owned a car.  Thus, mom and I walked weekly to go buy groceries.  I was the gopher of the house and daily I had to go buy bread and milk.  Thus, we didn’t spend one nickel on gas.  When mom and I walked to the store we’d returned our empty soda and milk bottles, otherwise mom would be charge for the cost of new milk and soda bottles.  Stores back then would return the empty bottles to their respective plant to be washed, sterilized and refilled.  Now folks that is what you call recycling!  Dad never owned a gas-powered lawn more.  He’d cut the yard with a push mower.  Again, he didn’t use any gas nor did he pollute the air. Mom, along with my wife for years hung the wash on a clothesline.  I didn’t buy my wife a dryer until I had to battle it out with a bunch of women on a rainy weekend as I tried to dry my daughter’s diapers in the 70s.  Also, my sis and I walked to school until we graduated in 1956.

Today, Americans are spoiled.  Most households have a dryer/washer, freezers, ac/heat units, 2 to 5 TVs, 2 cars or more in the garage.  Kids in school today are picked up by a school bus or driven to school by car. Heaven forbid that they would have to walk to school or have to wait for a city bus like most of us did in the 50s.  For some reason I can’t envision women today walking to the grocery store like mom and I did. Most, I suspect, as I do, drive to the store, work, post office, bank, etc.  With all the comforts most of us enjoy we have to shell out more of our hard earned money on water, electricity, natural gas and for the last 3 years under the Obama Administration, gas for our vehicles.  When Obama took office in 2008 gas was a little over $1.80 a gallon.  Today, it is $3.65 here in Fort Worth and many states are reporting over $5 a gallon.  “Why so James?” some might ask.  My friends, Obama, and his environmental wacko friends, hate fossil fuels (oil, petroleum, coal, etc.).  Obama has been quoted as wishing gas would creep up so Americans would embrace electric cars like the Chevy Volt, which by the way has been a total disaster!  Throughout July of last year, a whopping 125 Chevy Volts were sold ($46,000 per car).  The sticker price for electric cars is astronomical, as car shoppers would actually save money purchasing a Mercedes-Benz over a Chevy Volt.  Car buyers are simply not ready to drop $40,000 for a smaller, slower, and less attractive vehicle at twice the expense.  And, as per car analysts, electric cars are not cheap to operate; they cost more to operate than gas engine cars.

I find it comical that this past Sunday Senator Schumer stated in a letter to Secretary of State Hillary Clinton to urge the Saudi government to increase production to full capacity of 12.5 million barrels per day to make up for lost Iranian oil.  “What’s so funny about that James?” some might wonder.  Folks, just recently President Obama stated that Republicans only solution to lower gas prices is to drill, drill, and drill.  And here you have Senator Schumer begging Saudi Arabia to drill to lower the price of gas while President Obama wants us to be less dependent on foreign oil.  Something here just doesn’t make sense.

When President George W. Bush was president and gas rose over $3 dollars a gallon Democrats and the media blasted the president saying he was in bed with oil producers.  After President Bush opened up drilling in the East and West Coasts the barrel of oil went down to 38 dollars lowering significantly the price of gas at the pump.  Meanwhile Obama has stopped the Keystone Pipeline from being built even though his union buddies want it, which by the way will create millions of jobs.  However, Obama serves at the altar of the environmentalists.

I hope that poor people and those on Welfare who love Obama are enjoying the high price of gas and remind them that there’s no free gas at the pump for them. They, like the rest of us, have to pay up and like it


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Remembering Washington Print E-mail
by Wes Riddle    Mon, Feb 20, 2012, 09:20 AM

The First President George Washington was born 22 February, albeit we’ll observe his Birthday on Monday the 20th this year.  The day will serve to round out a nice long weekend for many folks, welcome time off during the hardest month of winter.  Federal employees too will enjoy the day: time to enjoy with family and friends; time to rest or catch up on projects around the house.  The average citizen will enjoy the day the same way, and only hope most Government employees pause long enough to remember the man whom the nation honors with its respite. 


Historians now openly talk about the way America has left her Constitution behind.  Certainly there is a cumulative case to be drawn, probably starting with the War Between the States.  Most accounts of government growth and the accretion of power in Washington , D.C. , prominently involve the Progressive Era, and of course the New Deal.  Damage was done and also accumulated, but it was not until sometime after World War II when lawmakers actually stopped consulting the Founding Document, when public debates waned concerning the Constitution’s relevant meaning to contemporary public policy.  Since the 1950s the Government simply uses political mandate to do whatever the Government wants to do. 


Regulations and taxes pile up on people in the name of the People, imposed however by Government through a kind of modern virtual representation, which the Colonists utterly rejected of Great Britain .  Just as the Constitution no longer acts as a parameter on what the Government does, neither can it be said of George Washington that he still informs young people and adults of what constitutes the ideal masculine character or responsible republican citizenship.  Washington was a preeminent role model for these things until the middle of the Twentieth Century, when the study of biography receded in education and pop celebrity displaced historic heroes.   


Washington might have been King but he chose elective office instead, and then he chose to leave that office after just two terms.  He had more than the good judgment to quit while he was ahead!  He indeed knew what was most important in his own life: his home Mount Vernon ; family and personal obligations; fellowship with friends; reflection, and the study of Scripture.  He also knew the nature of power and the temptations attendant to power.  He knew the crucial impact that leadership can have, but he valued civil liberties and freedom in society much more.  Freedom had been the object of the Revolution, not dynasty or empire. 


Washington was esteemed a very wise man, but he eschewed the power to impose his wisdom on everyone else.  Washington esteemed the prerogative inherent to liberty, as something more important than either physical wellbeing or scientific certainty in a particular.  People run their own lives, some successfully and some not—but it is after all the peoples’ lives and theirs to run.  Various environments might be comparatively cruel or limited, chimerical or privileged.  An asteroid might hit the earth someday, and the sky is always falling or liable to fall to the Chicken Littles amongst us.  Still, families are natural institutions that govern even before the Government does.  Government didn’t give a person life or sanction the marriage between the man and woman who had the baby.  Indeed, the Church never asked nor asks permission to marry two people.  The legal conventions are not always the same as religious ones, albeit for most of our history they have overlapped almost completely, mainly because of the approach to Government the Founders, George Washington included, took. 


It bears repeating: It is the peoples’ lives—and so it should be their private choices that govern in nearly all particulars that pertain.  This is true whether the individuals choose wisely or not, whether they are wrong or right; and whether they are brilliant or certifiably stupid, handicapped or studs.  Individuals possess a prerogative to live according to their lights, regardless and irrespective of circumstances so long as they do not harm anyone else!  Individuals possess natural rights according to natural law, and Government must have a compelling interest to intervene and mess with things.  If Government does intervene, it does so by exception; further, it should be at the level of the State where a person lives and for some good reason, i.e., to protect others or to promote the general welfare, not necessarily the convenience of society.  States are dual sovereign political entities alongside the Federal Government in the construct of Washington ’s Constitution and ours. 


Imagine: Washington ’s Constitution, the Founding Document in light of his and the Founders’ worldview—a Restoration of the Republic.  This is how I shall be remembering Washington , and how Government better start remembering if I read the Tea Party through to its logical potential conclusion.  Remembering Washington means a dedication to the future and to a very similar project to that which he faced in his day.  As freemen and freewomen we must choose to remember him and the Revolution, as well as the Constitution, which was its crowning achievement.  Heroes did and do exist.  Sometimes they are celebrities, but most of the time they are people proud to call themselves American, men and women of character and uncompromising determination to be free—free to dream and succeed, free to dream and fail on their own terms and God’s.  Government is not God.  The Constitution as amended, is not subject to the whim of the President or the Congress, not today anymore than it was in Washington ’s day.  It is not subject either to the Supreme Court, in terms of decisions it has made based upon unconstitutional precedents entered in, which break the moral compact and implicit structure of federalism upon which our Union is entirely based.  Government has made carrion of the so-called “living” Constitution and given us a Dead Constitution Walking.  Political Revolution is in the air, or should we say brewing


Wesley Allen Riddle is a retired military officer with degrees and honors from West Point and Oxford .  Widely published in the academic and opinion press, he serves as State Director of the Republican Freedom Coalition (RFC) and is currently running for U.S. Congress (TX-District 25) in the Republican Primary.  He is also author of two books, Horse Sense for the New Millennium (2011), and The Nexus of Faith and Freedom (2012).  Both books are available on-line at and from fine bookstores everywhere. Email:  This e-mail address is being protected from spam bots, you need JavaScript enabled to view it .


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Lawyers and Some Unusual Moonlighting Print E-mail
by John Browning    Wed, Feb 15, 2012, 09:40 AM

I have a confession to make.  I don’t eat, sleep, and breathe the practice of law.  In what passes for spare time, I teach, I write articles and books, and I lecture.  But every now and then, my gaze drifts over to that Mexican wrestling mask I brought back from a trip to Cancún, and I think “What if . . . ?”  Could I battle it out in courtrooms by day, and by night enter a wrestling ring as “El Abogado Luchando” (The Fighting Lawyer) in the lucha libre?  Okay; actually, I don’t have that pipe dream.  But Chicago lawyer Tom Benno does, and he’s actually turned his dream into reality.


To casual observers, the 57 year-old Benno is your typical suburban Chicago trial lawyer.  But a couple of years ago, the former high school wrestler and longtime wrestling fan had an itch he wanted to scratch.  He learned of Carlos Robles, a real estate agent/wrestling promoter who was running an independent wrestling league, GALLI—Gladiator Aztecs Lucha Libre International—patterned after the “lucha libre” Mexican wrestling, complete with capes, masks, and fast-paced athletic moves.  Benno and Robles became business partners, and the league started taking on some of the characteristics of American professional wrestling, featuring heroes and villains and storylines.  Shortly after Benno got involved on the business end and provided legal advice, another idea struck him—why not wrestle as well?


Benno began training—losing 40 pounds, building a wrestling ring behind his wood-paneled law office and perfecting his moves.  Equally important, he developed his wrestling alter ego: “Apocalypto,” a character who “plays the mediator, staying neither good nor bad, leaving audiences uncertain.”  Befitting this new persona, Benno-as-Apocalypto wears a mask with one side depicting a grin, and the other a frown.  Apocalypto made his wrestling debut last November, entering the ring at the Addison Park Community Rec Center to the Darth Vader “Imperial March” from Star Wars.  After some flying leaps off the turnbuckle, and a few more well-choreographed moves, Apocalypto had his first “victory.”


Friends and family have been mostly supportive of Benno’s masked moonlighting.  While his wife Terri appreciates the fact that he has an outlet that’s gotten him into better shape—she says “there are worse things he could be doing than wrestling”—she is not completely sold on “Apocalypto.”  She says “I know Tom is a lone ranger and he doesn’t fit into boxes too well . . . . I guess I just hoped this whole thing would be a like a fleeting fancy.  Except obviously, it’s really not.”  Benno himself knows that, at 57, his days in the wrestling ring are numbered.  But he’s thoroughly enjoying it while he can, and even finds similarities between his profession and his avocation.  Practicing law and wrestling, he says, both require you to “be dramatic, have presence and be spontaneous and always think on your feet.”


Tom Benno is not the only lawyer who moonlights by slamming into people.  Amy Dinn is a 36 year-old civil litigator by day with the Gardere Wynne Sewell law firm’s Houston office.  But at night, she becomes “The Prosecutor,” competing with a roller derby team in Houston.  Dinn competes in 3–4 games a month at the local and national level.  Dinn notes that “The roller derby of today is not the same as it was in the Seventies.  It is an empowering sport for female athletes.  It’s also a sisterhood.”  It’s also a painful one; the 5’10” Dinn works out at least 3 times a week, in addition to 3–4 team practices each week that can last up to 3 hours, and she’s endured reconstructive knee surgery and back surgery.  Dinn says that co-workers were surprised at first about her unusual hobby, but that the physical demands of it made keeping her roller derby competition impossible.  “The first time you get hurt the cat’s out of the bag at work.  I come in bruised or walking funny and co-workers ask questions.”  Like Tom Benno, Amy Dinn also observes that her chosen sport has much in common with her day job.  “Litigation is a high-stress profession,” Dinn notes.  “Sometimes you have to be aggressive and stand your ground on your position.”


Young lawyer Emeka Onyejekwe took a less painful path to moonlighting and, eventually, a career change.  The attorney seemingly had everything he wanted after graduating from NYU School of Law in 2006, taking a job as an associate with one of the most prestigious law firms in the country.  But something was missing; Onyejekwe had a deep, abiding interest in music since the age of 8, and had even been in a band during college.  After toiling less than a year in the legal trenches, the lawyer embarked upon a different path.  He became hip hop artist “Mekka Don”—“the Legal Hustler.”  “Mekka Don” proclaims “Music is my calling.  God spoke to me and I listened.”


And, really, isn’t that what it’s all about?  A law degree affords a person many opportunities, but sometimes it’s just not enough.  So, even if you don’t quit your day job, you don’t have to abandon your passion—whether it’s wrestling, roller derby, rapping, or even writing.  I’m sure John Grisham doesn’t regret following his dreams after long days at the courthouse.

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Occupy the C-Suite! Print E-mail
by Martin Hutchinson    Tue, Feb 14, 2012, 07:30 PM

Probably the biggest single lesson of the last few years outside monetary policy has been that the contract between top management and shareholders is broken. Top management rewards itself with ever more grandiose bonuses and option payments, while shareholders are fobbed off, not with dividends which have value, but with “share repurchases” which do not. It is truly time for shareholders to “Occupy the C-suite” (of high corporate officials who are determined to be chiefs) and demand fair treatment

Dividends are the key to sound corporate governance. They are also the solidest and most transparent method of providing shareholders with a return on their money. The solid dividend stocks of yesteryear provided the best investments of all for individual investors, because their dividends tended to increase with inflation, unlike bond coupons. Those about to retire could do no better than buy solid dividend stocks. The stocks’ fluctuation in price was of no consequence, provided the dividend continued to be paid reliably, with occasional adjustment for inflation.

This comfortable world was disrupted by the arrival of Modern Finance, in particular the Modigliani/Miller Theorem. Prior to its arrival, finance executives had calculated a company’s debt capacity by examining the worst possible recession, then ensuring that the company’s debt service (including principal repayments) would be covered by a comfortable margin during that recession. Debt was known to be cheaper than equity, but the dangers of loading up with debt had been only too clearly demonstrated during the Great Depression, at a time when bankruptcy often meant liquidation.

The Modigliani/Miller Theorem changed all this by postulating that a company’s cost of capital did not vary with its capital structure. Then the fact that debt interest was tax-deductible while equity dividends were not made leverage economically attractive. The 1978 Bankruptcy Act, allowing corporate management to stay in control (and keep getting paid) during a bankruptcy, further removed the barriers to leverage, since it now seemed that bankruptcy had cost primarily for the creditors, and not for the company itself or its management. Shareholders lost out in bankruptcy of course, but if the company was leveraged enough, their economic loss was minor and they had been paid for the risk involved. The leveraged buyout boom of the 1980s and subsequently and over-expansionary monetary policies from 1995 exacerbated the trends to leverage, short-termism, management control and speculative corporate finance.

A substantial role in this unpleasant long-term trend has been played by a further development, the replacement of dividends by stock repurchases. According to their propagandists, stock repurchases are as beneficial to shareholders as dividends, but more tax-efficient. Instead of getting returns in highly-taxed (until 2003) dividends, shareholders would make their money through capital gains, which would not be taxed at all until the shares were sold, and then only at capital gains rates.

As a replacement for dividends, stock repurchases are very unsatisfactory. For one thing, unless the company conducts a (rare) formal tender offer individual shareholders do not actually get their stock repurchased; the repurchases occur between the company and large brokers and institutional investors. Further, while stock repurchases increase nominal earnings per share, if they are carried out at prices above the company’s net asset value they dilute its net asset value per share. Thus whereas individual investors get their fair share of $100 million paid out by the company in dividends, they get nothing like their fair share of $100 billion in stock repurchases above net asset value, since the asset backing for their shares shrinks by proportionately more than the share count.

The opposite is of course true for managers whose remuneration is partly or wholly in the form of stock options. Dividends are unattractive to such management, because they reduce the share price and the value of their options. Conversely, stock repurchases both increase the value of the shares into which their options can be exercised, and ensure that the issue of shares through their options is not in itself dilutive. In extreme (but quite frequent) cases companies match stock purchases to generous options grants, without paying cash dividends. In such cases, management gradually takes control of the company, whose asset base is hollowed out by repeated stock purchases at a premium to net asset value, leverage increases ad infinitum and individual shareholders get nothing until the company maybe goes bankrupt in the next downturn, wiping out their stake altogether.

It does not help that stock buybacks are generally laughably mistimed. Modern management, obsessed by budgets, almost always fails to spot downturns in its business and the economy generally, while assuming that periods of prosperity will continue ad infinitum and indeed improve (as their budgeting process forces them to assume). Consequently, in innumerable cases (think of Netflix last year) stock repurchases are made at grossly inflated prices, intensifying the bubble in a particular stock, and are then halted after the business and the stock have turned down and management discovers there’s no money left. Worse still are the cases, frequent in 2008-09, in which stock repurchases at inflated prices are succeeded by an emergency stock issue in a bear market, as the company is found to have inadequate funding for the recession.

Now Finnov, a research collaboration sponsored by the European Union, has proposed banning stock repurchases. The group points out that such repurchases were banned in many European countries before 1996, being considered a manipulation of the market. In Europe as in the U.S. such programs have proliferated, rising in London from a value of $2.6 billion in 2000 to $14.7 billion in 2008. Finnov makes the same points as above relating to value destruction and destabilization of companies.

In the United States, we can at least take away the tax advantage of share repurchases over dividends. Dividends should be made fully tax-deductible at the corporate level, and fully taxable at the individual level, thus removing their double taxation. By doing this, much of the political salience of the “Buffett rule” would be removed, since rich people’s dividends would be taxable at income tax rates above 30%, while in reality suffering less overall tax than now. Egregious under-taxation of millionaires would then be confined to capital gains tax and to loopholes such as the charitable contributions deduction and the “carried interest” under-taxation of private equity returns.

This would give shareholders more incentive to demand dividends from managements, but the British experience of 2000-08 shows this may not be enough – in Britain the “Advance Corporation Tax” system achieves much of the effect of dividend tax-deductibility, albeit at the cost of horrendous tax complexity. Management’s incentive to engage in share repurchases could be further reduced by allowing stock option exercise prices to be adjusted for dividends paid, with appropriate tax payments by their beneficiaries when they did so. While the EU’s proposed prohibition against stock repurchases may be too draconian, they should at least be restricted to formal tender offers open to all shareholders, so that individuals can participate properly.

Overall, we must return to a financial system in which companies are built for the long term, and investors’ ideal retirement portfolio consists of shares in substantial companies, paying 5-6% dividends. The current system, in which the retired are supposed to invest in bonds with pathetically low interest rates, or speculate short-term in the stock market, buying and selling like day-traders in the hope of capturing capital gains, is far too demanding of individual investors and turns the market into a casino.

In a well-ordered financial system, the majority of shares are owned by individuals, whether in taxable accounts or through their retirement accounts. Those shares provide primarily a steady and increasing flow of dividends, suitable for investors seeking income in retirement. There are a number of changes needed for this to happen, from cutting back the estate tax (so that company founders have an incentive to keep the company in their families) to restoring monetary policies that encourage saving and depress stock prices (thereby increasing yield and reducing volatility).  Recent changes in accounting standards need to be reversed, so that “mark to market” accounting of derivative positions and balance sheets and creative goodwill accounting are not allowed to distort financial statements beyond the comprehension of anyone without an advanced degree in finance. But the most direct means of moving towards this objective is simple: removing the double taxation of dividends and ensuring that management avoids stock repurchases except through formal tender offers open to all shareholders.

Shareholder capitalism is the most effective mechanism for wealth creation known to man. Managerial capitalism offers no such advantage.

There are no guarantees that dividend paying stocks will continue to pay dividends.  In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks. 

(Originally appeared in The Bear's Lair.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site–and co-author with Professor Kevin Dowd of “Alchemists of Loss” (Wiley – 2010). Both now available on, “Great Conservatives” only in a Kindle edition, “Alchemists of Loss” in both Kindle and print editions.


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