Monday, March 2, 2009

Return Democracy to the Capital Markets

There has been a lot of rhetoric lately labeling the bailouts as socialism. I think the debate on both sides is really a lot of noise by people who are not thinking. What is true (and easily demonstrated) is the slow decline of democracy in America's public capital markets. And there are some very obvious and easy fixes to the problem.

In a recent public presentation, I asked how many attendees if given some money with the requirement to invest in stocks would buy GM stock right now. I then asked if given some shares of GM, how many would keep the shares instead of changing to another stock. Nobody raised their hands. I then pointed out that anyone participating in retirement plans and investing in US stock funds are likely buying or holding GM stock. The voting mechanism has disappeared. Investors subrogated their rights to various types of organizations believing outside expertise is more likely to achieve their financial goals even considering the added cost. The past 18 months have most capital market participants questioning this premise. While much could be said and debated as to the past, I want to focus on the solution(s) for those willing to accept my theory.
1. Allow people complete freedom to allocate their capital.
  • The largest capital asset for the majority of the U.S. is retirement plans. Almost all retirement plans have very few selections of investments. The legal requirement from the DOL is something like 4 obviously different fund choices. But what if I want US stocks, but not GM and the fund owns GM? In many plans I cannot rollover any investments unless I leave the company or retire. I have just moved from democracy over my capital to socialism.
  • Even more, I am an owner of GM, Citigroup, and AIG. I don't want to be, but every US citizen is. I will not invest in any financial company that has more than 200 branches or 1,000 staff. But I guess what happens with my capital is not my choice.
  • What if I no longer want to own financial assets? I see a good value on a home, but all my long-term savings is in a retirement plan that I would have to pay a penalty or taxes to get out. Some IRA custodians will allow real estate, but IRS rules require an appraisal every year for valuation purposes. The actual value of my IRA to the IRS (who takes taxes) is really quite irrelevant unless I am taking money out or putting money in (or 70.5 and required to take money out). The public will begin to demand this, but not before it is too late I am afraid. For those around my neck of the woods, First State Bank in Middlebury used to allow property inside an IRA and may still.
  • What if I want to invest in a friend's start-up company? Unregistered securities are the most difficult thing to get in a retirement plan or IRA. The IRS is concerned that people will abuse the tax-deferral benefit, by sheltering more money that legally allowed (in theory making excess contributions using undervalued assets). Make a more onerous tax structure, or only allow a ratio of unregistered holdings, or require assets be invested in marketable assets for the first 2 years. There could be numerous solutions besides socialism if people think.
2. For a successful return to democratic capital markets honest information and immediate feedback (positive and negative) to the decision maker is necessary. Because a person can change their vote daily in publicly traded markets, real transparency must exist. Two easy fixes:
  • Change the incentive ratio for companies to buy back stock instead of pay dividends. To get a dollar after tax into a shareholder's pocket costs about $2. Giving that shareholder a $1 greater representative ownership of the company by buying back stock costs about $0.80. But if every company had been paying the majority of their earnings out in more tax efficient dividends except Enron who retained all their fake earnings, not as many people would have been inclined to invest with them. Astute investors would have questioned if a dividend check for all those fake earnings would bounce (as we now know it would have).
  • Allow investors taking on real risk to experience the penalty for that risk when it doesn't work out. Risk premium is defined as the expected return in excess of the risk free rate for a given asset. In changing market climates the metric is used to determine investors' consensus appetite for risk. Some market participants rolled the dice for excess return taking on extra risk (i.e. commensurate increase in overly negative outcomes compared to those in safe assets like treasuries or CD's). Nothing unnerves me more than knowing the safe investors who never had the potential big payoff are now having to experience the negative outcomes.