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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Joined: 2007-01-23

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. 

B24's picture
B24
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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. 

B24's picture
B24
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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.

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. 

B24's picture
B24
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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

troll's picture
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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

babbling looney's picture
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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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