BBC NEWS | Business | Japan economy slides to recession

BBC NEWS | Business | Japan economy slides to recession

In my portfolio class we were recently discussing international investing and the benefits of diversification. This led to a brief discussion of the Japanese stock market. Few markets and economies have ever had such a long downward ride: from near 39,000 at the end of 1989 to about 11,600 currently.

Thus, today's news that the Japanese economy has slipped into its 4th recession in a decade came as only a small surprise.

A follow up to yesterday's Sarbanes-Oxley piece

Everyone obviously did not agree with yesterday's piece from Financial Engineering Today that suggested that the (net) costs of Sarbanes-Oxley may have been overstated. I am sure we will see more about the actual costs in the coming years, but I will admit that the costs can be far reaching and come from seemingly unexpected areas (but so too can be the benefits!).

For now we can say that for nearly all firms the actual costs of compliance have increased. What we can not yet see are the benefits.

Some of the higher costs include higher audit fees, and for some firms the costs include finding a new auditor. As if for evidence of this latter cost, the NY Times writes that many firms are being dropped by their auditors not for being problem clients, but because the auditors are merely too busy.

The New York Times > Business > Your Money > Sorry, the Auditor Said, but We Want a Divorce: "A growing number of companies are looking like unsuspecting spouses being left for trophy partners. That's because the top accounting and audit firms - PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte & Touche - are dropping their corporate clients in droves"

"The top auditing firms, collectively known as the Big Four, declined to say how much more the new law was costing their clients, though they all said it had sharply increased the amount of work they must do for clients, and the fees they charge. BDO Seidman, a so-called second-tier firm, says its fees have increased by 40 percent to 100 percent, if it agrees to retain the client at all"

The whole article is available here.

Sarbanes Oxley- SOX It To Them

This week's Financial Engineering Today newsletter has a great review and update on the Sarbanes-Oxley Corporate Responsibilty Act.
Sarbanes-Oxley- SOX It To Them

A few highlights:

• **"The stated objective of the act was “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws.” In plain English, the point of the law is to make companies more transparent and executives more accountable"
• **"The reaction of most chief executives, at least in private, was that the act was a knee-jerk reaction to the scandals, that the act was hastily drawn up without sufficient thought, that compliance to the requirements would be daunting "
• **"Despite these and other drawbacks, with compliance around the corner the sky has not fallen. While admittedly expensive to implement, examination of some of the claims CEOs have made about the cost of compliance leaves one scratching his head. One publicly traded company with $300,000 in earnings estimated that it would cost $250,000 "
• **There have been other "benefits" as well. For instance "Smart companies have used compliance as an opportunity to get a standardized financial reporting system in place across a company’s business units." While true to a degree, I have reservations with this since if there were these great benefits, firms would rationally adopt them with or without the law. (or at least in theory they would)
• **and finally, if transparency increases, so too should firm value.

The article is by Paul Schaafsma. Definitely worth your time!

Behind the Scenes at the FOMC: How the Federal Reserve Determines Monetary Policy

Want to see what the Fed does and how it does it? Fed Governor Susan Schmidt Bies gave a speech at the University of Tennessee Martin that gives us an very interesting look at the life as a Fed Governor and answers many of the questions you may have.

FRB: Speech, Bies--Behind the Scenes at the FOMC: How the Federal Reserve Determines Monetary Policy--February 7, 2005:

In her speech she "gives...an overview of the broad range of purposes and functions of the Federal Reserve System, as well as an insider's view of what happens behind the scenes at the FOMC."

A must for any Money and Banking student/teacher!

Oh and by the way, it is interesting too!!

What happened to the people at Drexel? Tie to MLB

On the 15th anniversary of Drexel's demise The New York Times has an interesting article on what happened to those who worked there.

You may have kept tabs on Milken:

"Michael R. Milken, the firm's legendary junk-bond trader, was indicted on 98 charges, including racketeering. He later pleaded guilty to six felony counts, paid $600 million in fines and restitution and served two years in prison." Mr. Milken, who has since survived cancer, established two major foundations devoted to cancer research and become a major investor in an education initiative, Knowledge Universe Inc."

But what about the others? Many of them landed on their feet and are doing very well.

"Interviews with more than two dozen former employees showed that, far from being embarrassed by their connection to Drexel, most retain an almost cultlike devotion to the firm and much of what it stood for. Few of them were crucial players in building Drexel's core franchise, junk bonds. And few of them were especially close to Milken."

Interesting! I had no idea of what happened to the rest of them at Drexel. I guess I should have--one now owns the Milwaukee Brewers!

Super Bowl Commercials

While I had posted this back in October, given the topic, it is worth re-running.

Paper is by Fehle, Tsyplakov, and Zdorovtsov

Short version: Super Bowl advertisers outperform the market by about a half a percentage point on Super Bowl Monday. This increase, which apparently is permanent, is concentrated in heavy advertisers and caused by buying activity by individual investors. This is consistent with a behavorial finance view of the world.

Longer version: Fehle, Tsyplakov, and Zdorovtsov study the stock price of firms that advertise during the Super Bowl. While overall there is no abnormal return, there is a positive abnormal return of slightly less than a half a percent for heavy advertisers. The stock price jump does not appear to be driven by either increased expected sales or enhanced liquidity.

To establish the mood and to tie this paper to behavioral finance, the authors begin by showing that previous research has shown that investor mood and attention, and not just financial variables, may influence stock prices. For example "Hirshleifer and Shumway (2003) document that the good mood associated with the weather...can still affect investor behavior."Once this link is established, the authors state that this same type of link can exist with Super Bowl advertising.

Again in their words:

"There are good reasons to believe that mood and attention effects on investorbehavior may exist as a result of advertising. Extensive marketing literature suggests that a person exposed to an affect-evoking advertisement about anyobject, tends to change his or her attitude toward a more favorableconsideration of the object. Thus, advertising promoting the company image maycreate a positive mood in the minds of investors and also potentially renderthem more optimistic in their evaluation of a company’s fundamentals. [footnotesremoved]"

The authors then set out to find this relationship. And sure enough they find it. For instance:

"While there do not appear to be significant abnormal returns for the overallsample on average, abnormal returns are greater for firms readily identifiablefrom the ad contents and increase in the number of ads employed....Forrecognizable companies with the number of ads greater than the sample mean oftwo, the event is followed by an average abnormal Monday return of 45 basispoints. Interestingly, the effect appears to be non-transitory in nature as the20-day post-event cumulative abnormal returns for this subset average 2%."

What might be more important is the finding that this increase in price is caused by buying concentrated in small buyers. This is interpreted as supportive of the view that investors, in particular small investors, are making decisions based on the ad and not on the underlying economics of the firm. This is understood to be consistent with a behavioral finance view of the world.

The authors correctly note that there are alternative explanations to these findings. For instance:

1. The ads are of higher than expected quality and high quality ads lead to more sales, and hence a higher stock price.
2. The ads reduce information costs and therefore lead to a more diffused shareholder base and higher liquidity.

These explanations are considered and then refuted. The easiest refutation is that if there is a response to information costs and liquidity stories, then the stock price should move on the announcement of the ads, and not on the Monday following the game.The authors comment on this:

"Given that Super Bowl ads are pre-announced, we expect that any positive or negative effect of the ad on sales is priced in before the Super Bowl. The only unexpected component of the sales effect could be due to the quality of the ad.However, there is no reason to believe that investors’ expectations of adquality should be biased and therefore we do not expect abnormal returns in thecross-section after ad quality is revealed."

What may be most interesting is the suggestion that the advertising firms know this relation exists and are running the ad as a means of raising stock prices. "...the decision to run a commercial can be viewed as a costly, endogenous and possibly strategic choice by firms that may aim to exploit investors’ misreaction. The potential for such strategic advertising suggests a possible link between behavioral finance and traditional corporate finance topics."

My view: “Getting noticed” is a factor in pricing. And yes one aspect of advertising is to get noticed. However, it is not a major determinant in asset pricing (the abnormal returns were less than ½ a percentage point). Given transaction costs (both information costs and trading costs), it is probably not worth it for investors to readjust their portfolios prior to when the advertisement actually runs. Additionally, this “getting noticed” is, as the authors suggest, arguably more important for smaller firms. This size story would also be consistent with the finding that the price jump is driven by small trades since larger trades would gravitate to larger firms.

That said, I am ALMOST convinced. This ALMOST is quite a concession from a market efficiency adherent and testament of a job well done by the authors. When I first read the abstract, I defensively thought of several explanations other than the behavioral finance story. But the authors addressed these arguments. So I am forced to admit that the behavioral finance angle is compelling.

The paper is available here

Greenspan on Adam Smith--February 6, 2005

Alan Greenspan gave a great tribute to Adam Smith! Fascinating!

FRB: Speech, Greenspan Adam Smith February 6, 2005 Some of the highlights:

"In the broad sweep of history, it is ideas that matter. Indeed, the world is ruled by little else. As John Maynard Keynes famously observed: "Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist....In his Wealth of Nations, Smith reached far beyond the insights of his predecessors to frame a global view of how market economies, just then emerging, worked. In so doing, he supported changes in societal organization that were to measurably enhance world standards of living."

Later Greenspan notes

"For most of recorded history, people appear to have acquiesced in, and in some ways embraced, a society that was static and predictable. A young twelfth-century vassal could look forward to tilling the same plot of his landlord's soil until disease, famine, natural disaster, or violence ended his life....Smith lived at a time when market forces were beginning to erode the rigidities of the remaining feudal and medieval practices and the mercantilism that followed them....For the first time, modern notions of political and economic freedom began to gain traction....gave rise to a vision of a society in which individuals guided by reason were free to choose their destinies unshackled from repressive restrictions and custom.

Adam Smith played a key role in the progression of this economic thought:

"In 1776, Smith produced one of the great achievements in human intellectual history: An Inquiry into the Nature and Causes of the Wealth of Nations. Most of Smith's free-market paradigm remains applicable to this day"

Great Stuff! I definitely recommend you read the whole speech!

The winner for best writer in the annual report category is .......

The winner for best writer in the annual report category is .......[Insert drumroll] Warren Buffett!!

While it may not have all of the excitement of the Grammys or the ESPYs, it is still quite the honor.

MSNBC - Billionaire Buffett gets an award for writing:

The National Commission on Writing for America’s Families, Schools, and Colleges is honoring Buffett for his "easy to undertand" annual reports.

"Buffett says he writes his annual report as though he were explaining Berkshire to a sister who has been away for a long time. Often the reports are sprinkled with humor."

Want to read them? The annual reports from 1995 to 2003 are available here.

Ralcorp Holdings, Inc. Announces a Variable Forward Contract on Ralcorp Stock by Chairman William P. Stiritz

Ralcorp Holdings, Inc. Announces a Variable Forward Contract on Ralcorp Stock by Chairman William P. Stiritz

What do you do when you are an insider and want to diversify your holdings but not sell your shares and give investors a bad signal? One alternative is to enter a Variable Forward contract. That is what William P. Stiritz, Ralcorp's Chairman.

"The VFC transaction provides the ability to benefit from future upside appreciation, up to an agreed upon amount, in the Company's share price over the next seven and a half years. The VFC also provides protection against declines in share value exceeding an agreed upon downside floor (set initially below the current market price) over the same period. Under certain circumstances, Mr. Stiritz can elect to retain the shares of Ralcorp stock involved in the VFC transaction, and settle the agreement with cash."

SSRN-Taxes and Financing Decisions by Jonathan Lewellen, Katharina Lewellen

SSRN-Taxes and Financing Decisions by Jonathan Lewellen, Katharina Lewellen

Next week in class we begin capital structure, so I simply could not pass up this article by Lewellen and Lewellen on capital structure and taxes.

Short Version: The authors show that internal equity has tax advantages. Moreover, "The trade-off between debt, retained earnings, and external equity depends critically on the tax basis of investors' shares relative to current price." Their paper suggest that much of what we thought we knew about capital structure, may not be quite right! "These predictions would all be contrary to the way trade-off theory is often interpreted"

Longer Version: The paper develops the consequences of Miller's 1977 paper that showed the tax benefits of debt are overstated when personal taxes are ignored. In their current paper, Lewellen and Lewellen (LL) build on this insight.

LL summarize the reson for their paper in a nice succient parapgraph:

"Our results follow from a simple observation whose importance for capital structure seems largelyunappreciated: when a firm distributes cash to shareholders, using either dividends or repurchases, thepayout triggers personal taxes that could otherwise be delayed. Thus, using internal cash for investment, rather than paying it out to equityholders, has a tax advantage – the deferral of personal taxes – thatpartially offsets the double-taxation costs of equity. An immediate implication is that internal equity is less costly than external equity for tax reasons."

Of course this is not new. Other have looked at this and have shown that external equity has some tax disadvantages, what is different in this paper is that looks not only at differing capital gains rates, but also is based in part on what the tax basis of the shares are to investors.

"Most clearly, our results show that the traditional view of debt and taxes, as exemplified by Miller (1977), is valid only when capital gains are taxed on accrual.... The main features of the
traditional view are (i) internal and external equity are assumed to be equivalent, and (ii) the tax cost of equity depends on the total taxation of equity relative to debt, (1 – τc)(1 – τe) – (1 – τi). The first statement is generally false and the second is, at best, incomplete (it misses the distinction between internal and external equity and it is unclear about τe)."

A consequence of this is that the tax advantages often get swept under the rug and we look elsewhere for explanations. As teh authors state:

"Thus, capital structure dynamics in these models are driven by agency problems and adjustment costs – the focus of the studies –not by a tax advantage of internal over external equity. The literature sometimes acknowledges that, because capital gains are not taxed until they are realized, the effective tax rate on capital gains is less than the statutory rate. But simply allowing for a low effective tax rate isn’t sufficient because it misses
the differential tax costs of internal and external equity."

So what does this all mean? Firms may have less of a reason to increase debt and a firm's capital structure is a function of not only firm characteristics, but also investor characteristics (such as effective tax rate).

And then the kicker! The model helps to explain the currrent problems we see with the trade-off theories:

"Indeed, our model suggests a kind of tax-induced pecking order, with debt and internal equity both preferred to external equity (the ordering of debt and internal equity is ambiguous and could change over time, for example, as a function of current leverage). Thus, our model might help explain two findings that have been described as ‘major failures’ of trade-off theory: (i) profitable firms seem to have too little leverage, and (ii) changes in debt largely absorb short-run variation in internal cash surpluses and deficits (e.g.,Shyam-Sunder and Myers, 1999; Fama and French, 2002)." (pp. 17-18)

Wow. I^3 (Informative, Important, and Interesting!)

Suggested Citation
Lewellen, Jonathan W. and Lewellen, Katharina, "Taxes and Financing Decisions" (October 2004). AFA 2005 Philadelphia Meetings Paper. http://ssrn.com/abstract=647847

Enron transcripts show unethical behavior for years

Money & Business:

"Enron Corp. was running scams to drive up the cost of power years before the 2000-01 West Coast energy crisis, according to audio transcripts and documents unveiled Thursday by a public utility north of Seattle."

"By November 1997, Enron apparently knew of loopholes in California's ill-advised deregulation plan, and by May 1998 - a month after the plan took effect - Enron was already falsifying transmission schedules to inflate prices, Snohomish County Public Utility District officials said Thursday as they unveiled new evidence at a news conference"

"The district is hoping to prove that an exorbitant contract it entered with Enron in January 2001, at the height of the crisis, should be considered fraudulent because of Enron's manipulation"

More from the NY Times

Michael Brennan on stock market

There is an early front-runner for top story in the next newsletter! What a great interview!

Kim Snider interviewed Michael Brennan on how the internet bubble happend. The interview discusses the various changes that had come about leading up to the bubble, agency costs, unrealistic expectations, and lessons we can learn from the bubble.

Great stuff!!! and you can even listen to it!

Several short news items of note

Three interesting finance related stories:

1. HoustonChronicle.com: "Last week...the National Association of Securities Dealers'.... board of governors approved a change in arbitration procedures that will let investors involved in a dispute request an explanation of why their claim was tossed....Under the current rules, arbitrators aren't required to explain their decisions."

2. What causes people to declare bankruptcy? Very often it is an illness. That is the finding of a study by Elizabeth Warren of Harvard Law School. From the Houston Chronicle: "Illness and medical bills now cause roughly half of all bankruptcies in the United States, more than a 23-fold increase since 1981, according to a new study." The skeptic in me questions a 23 fold jump in anything, but the fact that nearly half of all bankruptcies are caused by "illness and medical bills" is interesting and important. In a more recent study Warren also reports that "more than 90 percent of the families in bankruptcy qualify as middle class."

3. The NYSE was ordered (and complied) to release the details of Rochard Grasso's pay package. Grasso of course was forced out as a result of the pay package that was deemed excessive and as further evidence of poor governance at the NYSE. From the NY Times:

"The New York Stock Exchange on Wednesday released a previously confidential report detailing how former chairman Richard A. Grasso received his controversial $187.5 million pay package. The release came five days after a New York state judge ruled the contents of the 127-page report could not be shielded from the public by attorney-client privilege."

HoustonChronicle.com - Home equity used to finance Super Bowl trips

A home equity loan is when you use your house as collateral for your loan. This idea would be anathema for anyone who lived through the Great Depression. But now home equity loans are very common. So common in fact that some are even using them to pay for Super Bowl tickets:

HoustonChronicle.com - Home equity used to finance Super Bowl trips:

"Some Philadelphians are so desperate to get down to Jacksonville for the big game that they're borrowing against their homes to pay for the tickets....Mortgage bankers in Philadelphia and southern New Jersey say that Eagles fans have been inquiring about re- financing mortgages, or taking out home equity loans or home equity credit lines, to pay for what O'Donoghue calls "the chance of a lifetime." "

BTW : I was just putting the newsletter together (probably out today, maybe tomorrow) when I stumbled upon this. My guess is that today I will have severfal of these short "newsy" posts. This one might be useful for a money and banking class.