In the article, The quarter-century buyback era draws to an end, I announced the demise of the dominant role of stock buybacks in the economy, although there has been no official death certificate and the body has not yet been found.

The buyback era began in 1982 when the US Securities and Exchange Commission promulgated Rule 10b-18, granting “safe harbor” to corporations that wished to use equity repurchases to boost market prices in order to give value to executive option schemes.

The justification given by the SEC, at the time, displayed a breath-taking irrational naiveté that demonstrated the government’s total lack of concern for the interests of small investors. Here is what they said when issuing Rule 10b-18 in 1982:

The Commission has recognized that issuer repurchase programs are seldom undertaken with improper intent, may frequently be of substantial economic benefit to investors, and, that, in any event, undue restriction of these programs is not in the interest of investors, issuers, or the marketplace. Issuers generally engage in repurchase programs for legitimate business reasons and any rule in this area must not be overly intrusive.

It should be noted that the Securities Exchange Act of 1934 includes broad general anti-fraud and anti-manipulative prohibitions meant to protect investors.

The SEC, in Rule 10b-18, without an Act of Congress, abrogated these investor safeguards, allowing corporations to fraudulently manipulate the price of their stock whenever they wished, barring investors from satisfaction in the courts and protecting corporate fraudsters from criminal prosecution.

Nevertheless, as the fraud unleashed by Rule 10b-18 robbed investors of trillions of dollars of value, the SEC continued to mouth pious platitudes about “protecting investors”, while most people, like the victims of Bernard Madoff, were happily unaware of what was going on.

How big was the buyback movement?

The impact of stock buybacks on the US economy can be measured from Federal Reserve Flow of Funds table F.102: Nonfarm, nonfinancial corporate business.

This table shows the net change of corporate financial assets and liabilities from one period to the next. The line item, Net equity issues, is expected to show a positive number, indicating that the corporation has issued more new shares than it has redeemed. However, since Rule 10b-18, net equity issues have generally been negative, reflecting the fact that US nonfarm, nonfinancial corporations have been buying back more stock than amounts raised through initial public offerings.

Total net buybacks of corporate equity from 1983 to 2008, according to Federal Reserve flow of funds table F.102, was $3.6 trillion.

However, we know that even in years with negative net new equity issues, there have been initial public offerings. The amount of these IPOs must be added back to the flow of funds figures to measure the size of the buyback phenomenon.

Also, there has been steady erosion of the value of the dollar since the Reagan years. To evaluate the impact of buybacks in terms of 2008 dollars, we must re-inflate the historic date in terms of today’s money.

Using Flow of funds table F.102, adjusted for inflation by the CPI index, and estimates of yearly IPOs (from Renaissance Capital data and Wolter Kluwer’s IPO Vital Signs ), we are able to put a value on the total amount of corporate buybacks since SEC Rule 10b-18, in 2008 dollars, at $5.77 trillion.

This is a very big number, even compared to the size of the Obama administration’s “stimulus” plans. It is more than 100 times the size of Bernard Madoff Ponzi scheme — and no one will go to jail.

Where the money came from and where it went

The mechanics of a stock buyback are quite simple. A company uses money that should belong proportionately to all shareholders, to buy back stock on a non-proportionate basis from a relatively few shareholders. Most stockholders get nothing from a corporate buyback, except the right to own part of a company with less cash.

As the SEC admitted, way back in 1982 when it issued Rule 10b-18, the purpose of buybacks is to manipulate the price of a stock upwards. This is good news for corporate executives who happen to be holding stock options (for which they paid nothing). It is also good news for mutual fund managers who earn fees based on the market value (not intrinsic value) of the portfolios they manage.

Over the years, the flow of funds accounts for corporate equities show a consistent pattern. As stock prices are forced up by ever increasing buybacks, individuals (mainly corporate option holders) have been selling into these rising markets, while other individuals (mainly small investors, lulled by SEC Total Return statistics and Morningstar “five star” ratings), have poured their life savings into mutual funds via 401(k) plans and IRAs.

One of the arguments advance by those advocating stock buybacks is that it is a more “tax efficient” way to pay dividends. Even if this were true (which it isn’t), these so-called dividends should at least come from corporate profits, not from depreciation reserves and bank loans.

Again, Federal Reserve flow of fund table F.102, shows how buybacks were financed over the years:

The graph shows that most of the time, buybacks have been funded not out of current profits, but by raiding depreciation reserves and borrowing from banks.

This misuse of corporate financial resources exploded to levels of over half a trillion dollars by 2007, leading directly to the crash in the stock market in 2008 when easy financing for buybacks could no longer be found.

What damage was done by the buyback movement?

Between the all time high in stock prices on October 9, 2007 and the low point on March 9, 2009, the market value of US equities, as measured by the Wilshire 5000 index, declined about 9 trillion dollars.

Since prices had been driven to the high point, not by high dividend rates or intrinsic value, but by the brute force of stock manipulation through equity buybacks — an upward pressure that, in the end, had come to rely upon bank financing which is no more — it seems clear enough that the bubble has burst and that equity prices, despite occasional rallies, will stay down for a long, long time.

This means that all those millions of small investors who believed piously in the Common Stock Legend and the goodness of the SEC, and who had been counting on the market value of their 401(k) plans, IRAs, retirement funds, and the validity of dollar-cost-averaging to get them through their “golden years”, will have to adjust their expectations downwards.

These are the first and saddest victims of the buyback fraud.

The imagined savings of these investors have been transferred securely into the pockets of the corporate executives by means of stock options. These executives are safe, thanks to SEC Rule 10b-18, from retribution or prosecution, although many of these people, also, were taken in by the fallacies of the buyback movement and foolishly reinvested their ill-gotten gains in the stock market.

Some small investors, indeed, were fortunate enough to have retired and cashed out most or all of their savings during the years 1983 to 2007, before the bubble burst. They are safe. (Many are even dead.)

But there is no “hope we can believe in” for those investors who held on too long.

The unemployed and future generations

In order to keep stock price moving ever higher, the buyback engineers were forced to drain ever more funds from corporate reserves — even resorting to borrowing.

This has left many companies without the reserves needed to get through the current recession, forcing companies into bankruptcy and mass layoffs.

College kids who voted for Barrack Obama will graduate into a world with many less job opportunities than they had expected, other than the chance to man a jack-hammer on a “shovel-ready project” and try to fend off the specter of inflation resulting from the administration’s undisciplined stimulus plans.

Although the immediate causes of the current crisis relate to the sub-prime mortgage scandal, the pain that most people will feel comes from the irretrievable decline in the value of their equity holdings and the dimmed prospects for future employment — both the results of irresponsible corporate behavior dating back to 1983 and the start of the buyback era.

The dividend factor explained

One of the reasons used to justify the buyback movement was the high tax on dividends, compared to capital gains. Indeed, in 1983, when SEC Rule 10b-18 was promulgated, Congressional Democrats, then as today, conspired to punish equity investors by double taxation of dividends.

The graph shows the high rate of corporate taxation when SEC Rule 10b-18 was issued. An effective rate of about 50% was reached in 1987. With a marginal tax rate as high as 70% of dividends, this meant that as much as 85% of corporate profits, if distributed fairly to stockholders, could be taken away by the federal government.

However, during the Reagan years, tax reforms were passed that, in time, gradually lowered the effective corporate tax rate, while the top rate on individual income was lowered from 70% to 50%.

Furthermore, in subsequent years, Congress passed measures allowing tax deferral on dividends received through 401(k) plans and IRAs, allowing dividends to be reinvested without taxation, and the fruits of this investment to be withdrawn, years later at what would normally be far lower tax rates.

By the time the buyback movement really got going, the excuse of tax efficiency was largely invalidated, especially for modest investors that made up most of the population.

However, buyback kept growing and growing — showing that the motive was not tax efficiency for most shareholders, but rather inappropriate exploitation of ordinary investors by corporate executives.

Who was to blame?

The damage caused by the buyback movement was due mainly to SEC Rule 10b-18, without which executives could not have had safe haven to exploit common shareholders.

Therefore, the list of culprits must be headed by every SEC commissioner who served since the time of Ronald Reagan. These people had the power and duty to protect investors from fraud and price manipulation, but instead not only looked the other way, but actively worked to facilitate the schemes.

Even the lax restrictions of Rule 10b-18 have been suspended to encourage price manipulation in down markets, such as the Crash of 1987, the Crisis of Nine-Eleven, and the Crash of 2008.

Now, the Commissioners of the SEC did not work without oversight, so we would have to put on our list of “bad guys”, every member of every Senate and House Committee that was set up to supervise the SEC, also going back to the time of Ronald Reagan.

After naming those directly responsible in government, the list gets too big to enumerate, taking in of course, corporate executives, academic consultants, fund managers, and stock-brokers.

But, in the final analysis, blame must be placed on the investors themselves, who, like the victims of the Bernard Madoff Ponzi scheme, just didn’t want to believe that it was unreasonable to think that their savings could be safely entrusted to the hope of selling them at a higher price to someone else, who had no obligation to buy, twenty or thirty years in the future.

How not to get taken again

I  hope that this article has managed to get you rather seriously pissed off, but that you haven’t thrown your computer out the window quite yet.

This lesson of the Great Buyback Scam is that you can’t trust either the government or your financial advisors to protect you. You must do this yourself.

This goes back to the very old rules, “Investigate before you invest” and “Do Your Own Research”. However, in today’s complicated market this is a daunting task.

I’ve fretted over this problem for a long, long time and finally concluded, 30 months ago, that a viable solution would be for serious investors to band together and engage in collaborative, open source research, using wiki methods.

This is a big, ambitious enterprise and you can help, even if you don’t think of yourself as a securities analyst or economist. The project is non-profit, but there are clear economic benefits for taking part.

Please click over to Capital Market Wiki and read further. We need you to join us.

This entry was posted on Tuesday, April 14th, 2009 at 12:45 pm and is filed under Capital Flow Analysis, Equities, Corporate Managers, Individual Investors, Government Officials, Fund Managers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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