Today I heard that the US Federal Reserve is accepting stock as payment on loans to banks [1]. I am still not able to understand the reasoning behind this change of policy.
First of all, a single share of stock in a company is a share in that company's DEBT. It's not ownership in anything, it's not a guarantee of pay back, nothing. It's just a share of debt that the company thinks will be worth more than the strike price at some time in the future. That is, if you choose to purchase stock on the long. The difference in the stock price at sale versus purchase is the interest rate on that debt.
If I am the Federal Reserve and I am LOANING money to a company, then I have leverage on that company in terms of DEBT. This is the same thing that happens when a consumer gets a loan on a car or house. Yet, in the Federal Reserve situation, there is no collateral, so this is UNSECURED DEBT.
When the company issues stock, it is releasing debt in micro amounts so as to amortize the cost of the debt across multiple sources of capital. In that way, the individual leverage over the company for that debt is small and therefore lower financial risk to the company. The financial risk to the stock holder is much higher because they have nearly zero leverage over the company.
So when a company pays the Federal Reserve in stock, it is really paying for a debt using another debt vehicle. This is exactly the same as a consumer paying their home mortgage using their credit card. Sound familiar? This is the type of behavior that got many sub-prime mortgage holders into trouble, and is a common problem in the sub-prime credit market.
Now that the Federal Reserve has stock, the company that has issued the stock can sell off its assets and fold itself, thereby releasing itself of having to pay off that obligation to the Federal Reserve. This happens quite often when an encumbered company can no longer operate with profitability.
Who will ultimately have to pay back the loan for these banks? The US tax payer. By saturating the economy with junk debt backed by a leverage vehicle, e.g. stock, the Federal Reserve is contributing to increasing inflation. This works opposite to the efforts of the Federal Reserve, which has been struggling to find a blance in the economy to control inflation.
I find it hard to believe that Treasury Secretary Hank Paulson is okay with this strategy. Not only is the US Treasury capitalizing junk debt, but it's authorizing the Federal Reserve to increase inflation and prolong the inevitable crash of several bad banking companies.
Inevitably, consumers who pay their debts with more debt will file for bankruptcy. This will also happen with the US Treasury when it is holding $50 Billion US Dollars in junk stock that has zero par value.
If I were Michael Milken, I would be seriously angry with the Judicial system. He was indicated and convicted of fraudulent junk bond dealing in the 80s. The junk bonds that he was selling are no different than the low value stock being used to pay back cash loans by these banks.
This is yet another prime example of Ben Bernanke's lack-luster chairmanship of the Federal Reserve. I don't have to be a Professor of Economics to understand bad debt, junk bonds, and over-leveraged finance. The banks that are struggling right now need to find their own fix for the trouble they are in.
Just look at Merrill-Lynch and Bank of America [2]. These banks got it right. The heads of the banks figured out their own financial problems, fixed themselves, and immediately got on top of their problem. Why can't the rest of these enumbered banks do the same?
Ben Bernanke needs to leave the Federal Reserve. He's too parochial in his view of the greater economy that is the USA. We need someone who has more real-world finance experience. Someone who doesn't sit on economic theory as his basis for policy. Economic theory is what got us into this problem in the first place with CDOs.
[1] CNBC News Article on the Federal Reserve decision
[2] CNBC News On Merrill-Lynch and Bank of America
First of all, a single share of stock in a company is a share in that company's DEBT. It's not ownership in anything, it's not a guarantee of pay back, nothing. It's just a share of debt that the company thinks will be worth more than the strike price at some time in the future. That is, if you choose to purchase stock on the long. The difference in the stock price at sale versus purchase is the interest rate on that debt.
If I am the Federal Reserve and I am LOANING money to a company, then I have leverage on that company in terms of DEBT. This is the same thing that happens when a consumer gets a loan on a car or house. Yet, in the Federal Reserve situation, there is no collateral, so this is UNSECURED DEBT.
When the company issues stock, it is releasing debt in micro amounts so as to amortize the cost of the debt across multiple sources of capital. In that way, the individual leverage over the company for that debt is small and therefore lower financial risk to the company. The financial risk to the stock holder is much higher because they have nearly zero leverage over the company.
So when a company pays the Federal Reserve in stock, it is really paying for a debt using another debt vehicle. This is exactly the same as a consumer paying their home mortgage using their credit card. Sound familiar? This is the type of behavior that got many sub-prime mortgage holders into trouble, and is a common problem in the sub-prime credit market.
Now that the Federal Reserve has stock, the company that has issued the stock can sell off its assets and fold itself, thereby releasing itself of having to pay off that obligation to the Federal Reserve. This happens quite often when an encumbered company can no longer operate with profitability.
Who will ultimately have to pay back the loan for these banks? The US tax payer. By saturating the economy with junk debt backed by a leverage vehicle, e.g. stock, the Federal Reserve is contributing to increasing inflation. This works opposite to the efforts of the Federal Reserve, which has been struggling to find a blance in the economy to control inflation.
I find it hard to believe that Treasury Secretary Hank Paulson is okay with this strategy. Not only is the US Treasury capitalizing junk debt, but it's authorizing the Federal Reserve to increase inflation and prolong the inevitable crash of several bad banking companies.
Inevitably, consumers who pay their debts with more debt will file for bankruptcy. This will also happen with the US Treasury when it is holding $50 Billion US Dollars in junk stock that has zero par value.
If I were Michael Milken, I would be seriously angry with the Judicial system. He was indicated and convicted of fraudulent junk bond dealing in the 80s. The junk bonds that he was selling are no different than the low value stock being used to pay back cash loans by these banks.
This is yet another prime example of Ben Bernanke's lack-luster chairmanship of the Federal Reserve. I don't have to be a Professor of Economics to understand bad debt, junk bonds, and over-leveraged finance. The banks that are struggling right now need to find their own fix for the trouble they are in.
Just look at Merrill-Lynch and Bank of America [2]. These banks got it right. The heads of the banks figured out their own financial problems, fixed themselves, and immediately got on top of their problem. Why can't the rest of these enumbered banks do the same?
Ben Bernanke needs to leave the Federal Reserve. He's too parochial in his view of the greater economy that is the USA. We need someone who has more real-world finance experience. Someone who doesn't sit on economic theory as his basis for policy. Economic theory is what got us into this problem in the first place with CDOs.
[1] CNBC News Article on the Federal Reserve decision
[2] CNBC News On Merrill-Lynch and Bank of America