Elham Saeidinezhad, Author at

Is the Recent Buyback Spree Creating Liquidity Problems for the Dealers?

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”
― John Green, The Fault in Our Stars

By Elham Saeidinezhad | The anxieties about large financial corporations’ debt-funded payouts—aka “stock buybacks”—are reemerging a decade after the financial crisis. Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010. The root cause of most concerns is that stock buybacks do not contribute to the productive capacities of the firm. Indeed, these distributions to stockholders disrupt the growth dynamic that links the productivity and pay of the labor force. Besides, these payments that come on top of dividends could weaken the firms’ credit quality.

These analyses, however, fail to appreciate the cascade effect that will hurt the dealers’ liquidity positions due to higher stock prices. Understanding this side effect has become even more significant as the share of major financial corporations, including JPMorgan, is trading at records, and are getting very expensive. That high-class problem should concern dealers who are providing market liquidity for these stocks and establishing short positions in the process. Dealers charge a fee to handle trades between the buyers and sellers of securities. Higher stock prices make it more expensive for short selling dealers to settle the positions by repurchasing securities on the open market. If stocks become too high-priced, it might reduce dealers’ ability and willingness to provide market liquidity to the system. This chain of events that threatens the state of market liquidity is missing from the standard analysis of share buybacks.

At the very heart of the discussion about share buybacks lay the question of how companies should use their cash. In a buyback, a company uses its cash to buy its own existing shares and becomes the biggest demander of its own stock. Firms usually repurchase their own stocks when they have surplus cash flow or earnings, which exceed those needed to finance positive net present value investment opportunities. The primary beneficiaries of these operations are shareholders who receive extra cash payments on top of dividends. The critical feature of stock buybacks is that it can be a self-fulfilling prophecy for the stock price. Since each remaining share gets a more significant piece of the profit and value, the companies bid up the share values and boost their own stock prices. The artificially high stock prices can create liquidity and settlement problems for the dealers who are creating a market for the stocks and have established short positions in the process.

Short selling is used by market makers to provide market liquidity in response to unanticipated demand or to hedge the risk of a long position in the same security or a related security. On the settlement date, when the contract expires, the dealer must closeout—or settle—the position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market. If the prices become too high, they will not have enough capital to secure their short sales. At this point, whoever clears their trade will force them to liquidate. If they continue losing money, dealers face severe liquidity problems, and they may go bankrupt. The result would be an illiquid market. To sum up, in recent years, buybacks by public firms have become an essential technique for distributing earnings to shareholders. Not surprisingly, this trend has started a heated debate amongst the critiques. The problem, however, is that most analyses have failed to capture the effect of these operations on dealers’ market-making capacity, and the state of market liquidity when share prices become too high.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Is Transiting to SOFR Affecting Firms’ Survival and Liquidity Constraints?

“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.”
Margaret J. Wheatley

In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. This side effect might be one of the underlying causes of a challenge that the Fed is currently facing, which is understanding the turbulences in the repo market.

This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made. The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market. As a result, during this transition period, the price of these contracts swings daily, as the market perceives what the future value of alternative rate to be. In process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates. While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpectedly rise on their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on short-term funding market. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.

When it comes to sovereign debt, what is the real concern? Level or Liquidity?

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”
Adam Smith

By Elham Saeidinezhad | The anxieties around the European debt crisis (often also referred to as eurozone crisis) seem to be a thing of the past. Eurozone sovereigns have secured record-high order books for their new government bond issues. However, emerging balance-sheet constraints have limited the primary dealers’ ability to stay in the market and might support the view that sovereign bond liquidity is diminishing. The standard models of sovereign default identify the origins of a sovereign debt crisis to be bad “fundamentals,” such as high debt levels and expectations. These models ignore the critical features of market structures, such as liquidity and primary dealers, that underlie these fundamentals. Primary dealers – the banks appointed by national debt agencies to help them borrow from investors- act as market makers in government bond auctions. These primary dealers provide market liquidity and set the price of government bonds. Most recently, however, primary dealers are leaving Europe’s bond markets due to increased pressure on their balance-sheets. These exits could decrease sovereign bonds’ liquidity and increase the cost of borrowing for the governments. It can sow the seeds of the next financial crisis in the process. Put it differently, primary dealers’ decision to exit from this market might be acting as a warning sign of a new crisis in the making.

Standard economic theories emphasize the role of bad fundamentals such as high debt levels in creating expectations of government default and reaching to a bad-equilibrium. The sentiment is that the sovereign debt crisis is a self-fulfilling catastrophe in nature that is caused by market expectations of default on sovereign debt. In other words, governments can be subjected to the same dynamics of fickle expectations that create run on the banks and destabilize banks. This is particularly true when a government borrows from the capital market over whom it has relatively little influence. Mathematically, this implies that high debt levels lead to “multiple equilibria” in which the debt level might not be sustainable. Therefore, there will not be a crisis as long as the economy reaches a good equilibrium where no default is expected, and the interest rate is the risk-free rate. The problem with these models is that they put so much weight on the role of expectations and fundamentals while entirely abstract from specific market characteristics and constituencies such as market liquidity and dealers.

Primary dealers use their balance-sheets to determine bond prices and the cost of borrowing for the governments. In doing so, they create market liquidity for the bonds. Primary dealers buy government bonds directly from a government’s debt management office and help governments raise money from investors by pricing and selling debt. They typically are also entrusted with maintaining secondary trading activity, which entails holding some of those bonds on their balance sheets for a period. In Europe, several billion euros of European government bonds are sold every week to primary dealers through auctions, which they then sell on. However, tighter regulations, such as MiFID II, since the financial crisis has made primary dealing less profitable because of the extra capital that banks now must hold against possible losses. Also, the European Central Bank’s €2.6tn quantitative easing program has meant national central banks absorbed large volumes of debt and lowered the supply of the bonds. These factors lead the number of primary dealers in 11 EU countries to be the lowest since Afme began collecting data in 2006.

This decision by the dealers to exit the market can increase the cost of borrowing for the governments and decrease sovereign bonds’ liquidity. As a result, regardless of the type of equilibrium the economy is at, and what the debt level is, the dealers’ decision to leave the market could reduce governments’ capacity to repay or refinance their debt without the support of third parties like the European Central Bank (ECB) or the International Monetary Fund (IMF). Economics models that study the sovereign debt crisis abstracts from the role of primary dealers in government bonds. Therefore, it should hardly be surprising to see that these models would not be able to warn us about a future crisis that is rooted in the diminished liquidity in the sovereign debt market.