On the Unfair Treatment of Certain Common Equity Holders

Events of the past several months have been very disconcerting, particularly as it relates to the risks and rewards conveyed to common equity holders. It has become evident that due to political pressures, separate and apart from plain economics and market forces, that the returns to certain common equity holders have been subsidized to the detriment of other investors competing in an ostensibly free market. Further, many in the media and among the general public have viewed the sharp drops in certain issues to be "unfair" and due to "mismanagement" and "ganging up" by mean-spirited, money-hungry investors (read: hedge funds). In sum, the U.S. Government and its charges have willingly skewed free-market forces in the name of protecting the broader market. The problem is, the U.S. Government as well as many others are mixing up dampening systemic risk with protecting the interests of common stockholders. By mis-interpreting the essence of what it means to be a common stockholder, policy-makers run the risk of creating a set of problems far larger than those they are seemingly protecting against.

Investing in common stocks, particularly those of financial institutions, is akin to holding the "z-bond" - the residual - of a pool of mortgage-backed securities. It is a massively leveraged interest, one that rides extremely high when things go well and falls precipitously when things go poorly. This leverage is even more than what is appears on the balance sheet, where 30:1 is not an uncommon ratio of assets to equity, due to the prevalence of derivatives and other off-balance sheet exposures. Investors in such shares should know these facts, and understand the risks they are bearing. I didn't hear anybody complaining or read any stories about disgruntled investors when shares of BSC (Bear Stearns), FNM (Fannie Mae) and FRE (Freddie Mac) were top-ticking in the wake of low interest rates, calm markets and rising real estate prices. But when conditions turned, liquidity dried up and counterparties got scared, managements and investors started crying foul. Negative press. Coordinated short-selling by hedge funds. But why? Because losing money feels really, really bad. But this is part and parcel of being a common equity holder. An investor could have bought senior securities. They could have reduced risk by selling calls. They could have pared down their long positions when things started to sour. But all this is forgotten in the shell-shock of a rapidly falling share price. Deer in the headlights. Can't. Move. Can't. Sell. But sure can complain. And managements could have done a far better job financing their books. Liquidity cures a world of ills; it also lets you play another day. But by the time money is scarce and the price is dear, it is already too late. Bear Stearns found this out. But if you live in a highly leveraged world and don't provide for a rainy day, the inevitable downpour will wash you out. But in Bear Stearn's shareholder's case, they got precisely $10 per share too much for their common. They should have gotten zero. And that window dressing supported by the Fed and agreed to by JP Morgan sent the wrong message.

And the situation with Fannie Mae and Freddie Mac is even worse. Far worse. And might get much, much worse. In this case not only should common shareholders get zero, but certain subordinated investors might also deserve zero. But again, the U.S. Government has and will continue to pull strings to ensure that this doesn't come to pass. Why? Politics and other non-market oriented reasons. We, the U.S. taxpayer, will end up subsidizing these common stockholders and subordinated investors, and to what end? It will only further embolden managements of large institutions, thought of as "too big to fail," to take imprudent risks and swing for the fences. Because if things work out management and common stockholders get handsomely paid. And if they don't, management simply loses their jobs while common stock investors get some undeserved residual interest in the enterprise.

I don't fault our Government leaders from trying to ward off a massive systemic meltdown by providing credit to ensure the orderly disposition of obligations and maintenance of a functioning credit market. But no such obligation is owed to common equity holders. And every time policy-makers elect to bail out their interests, it lays the foundation for an even greater disaster down the road.