Depression vs. Today Story

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snaggletooth's picture
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This story is for BondGuy since he likes stories.  It'll be the short version because I have a meeting in 20 min.
The regulators have warned the major firms in the last few days against spreading rumors which may have caused a run on Bear Stearns and may have hurt Lehman and others.
It's odd how rumors start.  Back in the beginning of the crash in 1929, Joe Kennedy, Sr. would go to very high class restaurants and would talk very loudly so people could overhear him.  He would say how poorly a company was doing, whether it was or not, and these prominent businessmen would tell their people what Joe Kennedy was saying, so they went and dumped their stock in a panic.  All the while, Kennedy was actually shorting the stock...
 
How did Kennedy avoid losing his fortune in the crash?  He was in a taxi and the taxi driver had no idea who Kennedy was, but proceeded to give him stock advice on "can't miss" stocks.  Kennedy arrived back at his office and thought for a moment, "If the cab driver is giving me advice to buy, it is most definitely time to sell". 
 
Another example of how when everyone tells you to sell, it might be time to buy.

Borker Boy's picture
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Interesting story, and pardon me for my limited knowledge about how the markets really work.
I'm unclear as to how a "run on" a company can bring them down. Obviously, this term refers to people frantically selling their stock and driving the price to nothing. However, my understanding is that the company only receives money from the sale of its shares at the IPO--or during subsequent offerings.
 
1. How does a run on a company drive it into bankruptcy?
2. Why is it so important that a company increase its stock price?

Trapper SS's picture
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Borker Boy wrote:
Interesting story, and pardon me for my limited knowledge about how the markets really work.
I'm unclear as to how a "run on" a company can bring them down. Obviously, this term refers to people frantically selling their stock and driving the price to nothing. However, my understanding is that the company only receives money from the sale of its shares at the IPO--or during subsequent offerings.
 
1. How does a run on a company drive it into bankruptcy?
2. Why is it so important that a company increase its stock price?
 
A couple years ago, I would've felt fine having over 100k in a WaMu account.  Now I wouldn't be. 
 
The problem with rumors isn't just that it pushes down the stock price, but it makes the big depositors nervous about keeping the big coin with them.  A bank run is when people pull out deposits very quickly, causing the bank to run out of liquidity since they only need to keep 10% of deposits they take in.  If a bank loses too many deposits, it'll need to come up with more capital somehow.  Usually it's through issuing new debt or equity.  End result is a drop in their stock price. 

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Company stock is used as currency for leverage.  Look at it this way....if you owned a rental property that you bought for $250,000, and had a mortgage of $125,000 on it, let's say you wanted to further leverage your property to buy another property.  Well, at current market value, you could take out, let's say, another $75,000 in equity to put towards another proeprty.  If the RE market tanked and your property was now worth $100,000 (extreme example), you are upside down and have no additional leverage.
 
Although this is a very BASIC example, it can apply to the equity markets.
 
In addition, one of the things you are currently seeing is not so much the stock price affecting the company, but the net capital of a company affecting the stock price (when you write down assets from your books, your company is technically worth less, therefore the stock price follows).
 
Also, reduced company market values become takeover opportunities (i.e. Bear, Lehman, Yahoo, etc.).  No company wants to be bought involuntarily.
 
In a "normal" market, a company will not be driven into bankruptcy because of it's stock price.  Theoretically, the floor of the stock price should be somewhere around it's book value or "breakup" value.  However, when the underlying assets are questioned, or cannot be reasonably appraised (i.e. CDO market, Enron, etc.), then the "market" cannot place a vlue on it's assets.  The company may then be forced to liquidate depreciated assets to come up with additional capital, or, as you mentioned, issue additional equity (not usually preferred, since it further dilutes existing shares).  The other options is borrowing, but that becomes difficult and costly when your only collateral is questionable assets (i.e. CDO's).
 
Or you can do what Merrill just did, and loan money to a buyout firm to purchase your own discounted assets with a put option (see "off balance sheet accounting" for clarity).  This was one of Enron's mastermind ideas a few years back. 

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Trapper SS wrote:Borker Boy wrote:
Interesting story, and pardon me for my limited knowledge about how the markets really work.
I'm unclear as to how a "run on" a company can bring them down. Obviously, this term refers to people frantically selling their stock and driving the price to nothing. However, my understanding is that the company only receives money from the sale of its shares at the IPO--or during subsequent offerings.
 
1. How does a run on a company drive it into bankruptcy?
2. Why is it so important that a company increase its stock price?
 
A couple years ago, I would've felt fine having over 100k in a WaMu account.  Now I wouldn't be. 
 
The problem with rumors isn't just that it pushes down the stock price, but it makes the big depositors nervous about keeping the big coin with them.  A bank run is when people pull out deposits very quickly, causing the bank to run out of liquidity since they only need to keep 10% of deposits they take in.  If a bank loses too many deposits, it'll need to come up with more capital somehow.  Usually it's through issuing new debt or equity.  End result is a drop in their stock price. 
 
This is correct when you are just referring to banks.  But they can't always issue new debt, since they have to follow a net capital rule.

Anonymous's picture
Anonymous

Borker Boy wrote:
Interesting story, and pardon me for my limited knowledge about how the markets really work.
I'm unclear as to how a "run on" a company can bring them down. Obviously, this term refers to people frantically selling their stock and driving the price to nothing. However, my understanding is that the company only receives money from the sale of its shares at the IPO--or during subsequent offerings.
 
1. How does a run on a company drive it into bankruptcy?
2. Why is it so important that a company increase its stock price?
 
Trapper did a reasonable job on #1.  Most people don't realize this, but our banking system essentially "creates" money.  In that, they don't actually have your deposits on hand (only 10% or so as dictated by the Fed) - they lend most of your deposits out (i.e. how they make loans).  In fact, if everyone in the country tried to withdraw even 30 or 40% of their deposits from their bank(s), our entire financial system would collapse.  They just don't have it on hand - strike that, technically most of that money doesn't even exist for them to have on hand.  So, when people get concerned that a particular financial institution is in trouble and going to go bust, they run to the bank to withdraw their money - and basically the bank (like IndyMac) says, "Ah fuck, we don't have enough money to cover these withdrawals" - and the FDIC doesn't like that at all...so you know what they do then.
 
2.  B24's description of stock is pretty flawed - although, I'm sure that's partially because he tried to explain  it in as few words as possible.
 
By selling stock, companies are trying to raise capital to pay for expansion.  MOST companies raise money, overwhelmingly, by the use of debt (bonds, bank loans, etc.), selling stock is a very, very, small portion of "financing" for most companies.
 
However, companies generally own a sizeable amount of their own stock (Treasury stock, etc.).  They also buy and sell their own stock in the open markets when they a) need money, or b) think it is over or undervalued.
 
The most important reason that a company is concerned about its stock price is this:  the sole purpose, by law, of a public company, is to maximize shareholder wealth.  That's it, in a nutshell.  It makes sense, if you think about it - the Board of Directors watches over management, to ensure they are doing a good job of maximizing shareholder wealth.  If management is not doing a good job, the board can remove them and find someone else to do a better job.  This should make sense - as an equity owner of a company, your GOAL is to make the most money as possible.  It would be no different if you were a small business.  Heck, it's no different as an FA.  Your goal, is to make as much money as possible.  You don't buy stock (ownership) in a company for it to clean up the environment, or helps AIDS victims in Africa...you buy stock in a company, to make F'n money. 
 
Stock PRICE is determined very simply by this:  The Net Present Value of ALL future dividends.  Granted, that "formula" is modified for the real world because some companies don't currently pay dividends.  Stock volatility, in theory, should be only due to differing opinions (of market participants) about how much those future dividends should be, and/or appropriate discount rate, AND expansion into new markets/projects/businesses that aren't currently accounted for in the current stock price (or if it becomes apparent that the company will not participate in certain markets/projects, that were previously priced into the stock - this would cause the price to fall). 
 
In any case, this is a topic you can't accurately cover in less than 100 pages in any real depth.
 
The main point is - it's important to keep stock price high because the people that own the stock...own the company.  If you (as management) don't get the stock price to rise (or if you let it fall) over a period of time, the owners of the company are going to get pissed and fire you, and find someone that CAN get the stock price to rise (and i.e. increase shareholder wealth). 
 
There are other reasons, as mentioned (such as stock option incentives, being delisted from certain exchanges if your price falls to low, etc.), but that's the main one.

Anonymous's picture
Anonymous

A simple way to relate to maximizing shareholder wealth:

 
You decide to go indy as an FA, so you borrow some money from the bank to buy your office and get started.  You decide that with a little more capital, you could really do some bad ass seminars in a really wealthy area and reach a market you haven't currently tapped...but the bank won't lend you anymore money because you don't have the assets for collateral.  So what do you do?  You find an equity investor in your practice.  They give you $XXX,XXX in exchange for a 30% ownership in your practice...
 
Now, assuming you don't know this person (as public companies don't "know' their shareholders)...what is their reason for buying a 30% share in your practice?  To make MONEY; and ONLY to make MONEY.  He doesn't care if you help people on this forum; or if you donate your time to the local YMCA; he cares that in exchange for his investment in your company, you either a) Pay him dividends, or b) build up the worth of your practice so that his 30% share of your company is worth more than what he paid, so he can sell his 30% share and make money from his investment. 
 
Not only make a couple bucks, remember, he is going to compare his investment in your practice to his other investment options.  If he could buy a 5% CD at the bank, FDIC insured, by investing in your practice, and taking risk, you best be sure to earn him more than 5% on his money, or you are going to get fired.  In fact, you better earn similar returns as your peers (other practices), or else you are going to be fired as well.
 
That's it.  Plain and simple.
 
Now with a public company, there are 1,000's of investors, not just 1 guy with a 30% share (duh), but you get the point. 

Anonymous's picture
Anonymous

A simple description of how banking works:

 
You go to the bank and deposit $100.  The Fed requires that the bank keeps 10% of that deposit in it's coffers, to satisfy your withdrawal needs (ATM, checks, etc.).
 
The next day, the bank lends the lendable $90 to me to build a house.  Of course, I don't deposit that money, but I pay my homebuilder with that money.
 
My homebuilder then deposits $90 in his bank.  Of course, that bank has to keep 10% of that money on hand for withdrawal needs of its customers. 
 
So the next day, it loans out the loanable portion of that deposit, or $81, to Joe Smith, to buy a car.
 
Joe Smith, of course, doesn't deposit the money, but he pays it to his car dealer, who then deposits the money in their bank...
 
Now lets take a timeout here:
 
You deposited your $100 in a bank, and you SEE $100 in your account.  HOWEVER, your bank really only has $10 available to give to you if you want it back...they loaned the rest out to me to build my house!
 
Now, my homebuilder deposited his $90 (that I gave him to build my house) in his bank...he SEES $90 in his account, BUT the bank really only has $9 on hand to back that up if he wants it...they lent the rest out ($81) to Joe Smith to buy a car! 
 
I was going to go further with this example, but I think you get the point...what if EVERYONE at the bank goes and asks for their money at one time?  Well, it's pretty clear the bank is screwed.  So when people get scared that their bank is going out of business (because of making bad loans), they will go get their money out (for obvious reasons)...but when everyone starts asking for their money - uh oh! 
 
I gotta go to an appointment now anyway.  Hope that helps.

Trapper SS's picture
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Kudos for the in depth explanation, ice.  I remember the first time I read about how the banking system's reserve requirements worked.  I couldn't believe how fragile our banking system really is.  Thats why 'faith' in the banking system is so important for the general public

babbling looney's picture
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Not really Ice.  The bank is required to keep a certain percentage (reserve ratio) of it's total deposits in reserve.  The money you took out and the money your contracter put in cancel each other out. 

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ICE,
Sorry you don't like me explanation. Unfortunately, it is accurate. And Borker was not asking about banks specifically. he was asking about companies in general. There is a big difference between a "run on the bank" and a run on a companies stock price. A run on the bank is fairly straight forward. Anyone with a college degree can understand that.

I would argue that a company's stock price is not the net present value of future dividends. It is the discounted net present value of future EARNINGS. Big difference. No company will ever pay out all profits in the form of dividends (even REITS). So dividends are not really a factor (it's like valuing an LLC based on cash distributions - it's irrelevant - only earnings are important). History of dividends will play a part in the value (discount rate) placed on those earnings (earnings multiple or "PE ratio"), since dividends are cash, and are more valuable than paper profits (since profits can be manipulated, dividends cannot). Bu in reality, businesses are valued purely on earnings, and perceived continuity and growth of those earnings in the future. For example, I may pay 2X earnings for a restaurant, since those earnings are sort of shaky, but may pay 5X earnings for a CPA practice. Companies like GE experience multiples in the teens or 20's because their earnings are more of a "sure thing" in the future. Growth firms can have huge multiples because of preceived growth of earnings. In real estate, there are multiple valuation methods - cap rates, NOI, and simple payback period ratios. Cap rates fluctuate based on interest rates and other market conditions.

Sooooo, as companies write down what were thought to be income producing assets (i.e. CDO's), the stock price gets hammered, since those assets no longer produce earnings (in theory). When companies sell off assets, their stock price may or may NOT go down. It depends on what they plan to do with the cash.

Trapper SS's picture
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babbling looney wrote:Not really Ice.  The bank is required to keep a certain percentage (reserve ratio) of it's total deposits in reserve.  The money you took out and the money your contracter put in cancel each other out.  That's assuming the contractor deals with the same bank

Anonymous's picture
Anonymous

Babs - No, that's incorrect.  If the reserve requirement is 10%, there is roughly 10x as much money in cirrculation than actually exists or is available all at one time if everyone tried to withdraw it.  Do the math (or Google it), you'll see.  That's the beauty and the beast of our banking system, all at once.
 
B24 - I'm sorry, but you are also wrong (re: stock price).  You and I are both saying the exact  same thing, but technically speaking, you are incorrect.  Your stock price is based on NPV of all future dividends, into perpetuity. 
 
Reason being - non-employee owners of a company (i.e. stock holders) can only actually get their hands on company earnings, via dividends.  A stock that doesn't pay dividends, and never, ever, forever would pay a dividend, would be theoretically worthless.   You would have a piece of paper, that would entitle you to a very, very small piece of a company, that will never be liquidated for book value (because the valuation formula assumes perpetuity, and you can't liquidate a company 100 years from now, but still value its earnings in perpetuity), and will also never, ever pay you a dime of earnings.  And that, my friend, would be worthless. 
 
Seems like splitting hairs, but that's how it is.  Also, I didn't say I "didn't like your post."  I said it had a few flaws, which it does.  For the record, I did like it for the most part.
 
Also, look it up if you like.  Actually, that's how market participants are SUPPOSED to price a stock - but we all know they don't - so it really doesn't happen that way in real life. 

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troll's picture
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joedabrkr wrote: iceco1d wrote:Babs - No, that's incorrect.  If the reserve requirement is 10%, there is roughly 10x as much money in cirrculation than actually exists or is available all at one time if everyone tried to withdraw it.  Do the math (or Google it), you'll see.  That's the beauty and the beast of our banking system, all at once.
 
B24 - I'm sorry, but you are also wrong (re: stock price).  You and I are both saying the exact  same thing, but technically speaking, you are incorrect.  Your stock price is based on NPV of all future dividends, into perpetuity.  Also, look it up if you like.  Actually, that's how market participants are SUPPOSED to price a stock - but we all know they don't - so it really doesn't happen that way in real life.  Actually both of you are wrong.  A stock's price is determined solely by supply and demand.  Everything else is merely theory.
 
sounds like some new age voodoo Joe

Anonymous's picture
Anonymous

iceco1d wrote:Babs - No, that's incorrect.  If the reserve requirement is 10%, there is roughly 10x as much money in cirrculation than actually exists or is available all at one time if everyone tried to withdraw it.  Do the math (or Google it), you'll see.  That's the beauty and the beast of our banking system, all at once.
 
B24 - I'm sorry, but you are also wrong (re: stock price).  You and I are both saying the exact  same thing, but technically speaking, you are incorrect.  Your stock price is based on NPV of all future dividends, into perpetuity. 
 
Reason being - non-employee owners of a company (i.e. stock holders) can only actually get their hands on company earnings, via dividends.  A stock that doesn't pay dividends, and never, ever, forever would pay a dividend, would be theoretically worthless.   You would have a piece of paper, that would entitle you to a very, very small piece of a company, that will never be liquidated for book value (because the valuation formula assumes perpetuity, and you can't liquidate a company 100 years from now, but still value its earnings in perpetuity), and will also never, ever pay you a dime of earnings.  And that, my friend, would be worthless. 
 
Seems like splitting hairs, but that's how it is.  Also, I didn't say I "didn't like your post."  I said it had a few flaws, which it does.  For the record, I did like it for the most part.
 
Also, look it up if you like.  Actually, that's how market participants are SUPPOSED to price a stock - but we all know they don't - so it really doesn't happen that way in real life
 
I hate to quote myself...but wtf?  I didn't think I had to post the obvious part (actually it's supply & demand). 

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Babs - No, that's incorrect.  If the reserve requirement is 10%, there is roughly 10x as much money in cirrculation than actually exists or is available all at one time if everyone tried to withdraw it.  Do the math (or Google it), you'll see.  That's the beauty and the beast of our banking system, all at once.
 
I'm not disagreeing with you on that.  There is more money on the books (bank accounts, CDs etc) than there is real money circulating.  I was in banking before I became an investment advisor so I'm very well aware of how banks calculate their reserve requirements and lend out the remaining money.    
 
I used to tell people that there really wasn't a pile of cash in the vault with a flag on top of it with their name on it.   If a customer wanted to make a big withdrawal in cash, in addition to the CTR, we would have to tell them that they would have to wait because we would have to order the cash from the Federal Reserve and have it delivered.  So I know you are correct in that a run on the bank by a lot of small depositors would be extremely stressful and could even cause the institution to collapse.
 
That's assuming the contractor deals with the same bank
 
No.  The money is gone from the demand deposits of one bank and their  minimum reserve ratio amount for "vault cash"  or an amount on deposit in reserves at the Fed Bank, is therefore lowered because they have less deposits. The money is now on deposit in another bank and their reserve amount is therefore raised. Well managed banks rarely reserve at just the minimum ratio because they could be out of compliance with large deposit swings from month to month. They usually have a buffer and if they need more cash so they can have more to lend out, they offer better rate CD's to draw in more deposits from other institutions.
 
How often the financial institution reports to the Feds on their reserves depends on the institution.  I'm not sure here because I wasn't involved in the reporting, but I believe that smaller institutions, like a local regional bank, report more frequently than the big boys who have much larger deposits and therefore reserves. 
The banking reserve requirements are a ratio based on the total demand deposits for all institutions.  Unless the Fed creates more cash and puts it into the system or people pull the cash out and put it under their matresses, the amount of reserves is approximately the same amount (with some fluxuation because of the reporting requirements) no matter which bank the money is in.
 

babbling looney's picture
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There is more money on the books (bank accounts, CDs etc) than there is real money circulating.
 

By that I mean if the bank has 10 Billion in demand deposits and has lent out 90% of it, there exists more money on the books of the bank than there is in reality.  Confused yet?

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