As millions of Americans now invest their investment portfolios in mutual funds, trillions of additional dollars are invested in the stock market, pushing up the prices of individual stocks. This causes many problems. As institutional investors such as mutual funds buy large blocks of stocks, their demand has the ability of increase the price of that stock. When they sell, they can bring the price of the stock down. More money creates a volatility in the market as the price of the stock is valued by demand, not the underlying strength of the company.
As more money is in the game, even larger problems are created as stockholders are increasingly concerned about short term earnings. Shareholders in the company are meant to insure the company makes good decisions, but officers of the corporations are paid off of quarterly and yearly results. Who is there to make sure companies make good long term decisions?
Over the last decade or two, revenue growth became more important than debt. Purchasing companies by large debt issues became the norm. Revenue become more important than earnings. And mergers and acquisitions became an easy way to grow larger and increase market share. Many companies came to believe diversification was the key to growth and they lost their focus.
Investment banks pushed initial public offerings to their preferred investors. Of the last 90 IPO's, only 1 has a share value that is higher today than when it was offered. In the meantime, billions were made by taking companies public. It doesn't make sense how a private company can create 500 million shares, release 10% of the shares for public sale, and suddenly have a market capitalization worth billions of dollars. The hype of marketing these initial public offerings are so powerful, but the reality is the company still needs to make money year in and year out. But in the last decade, too many of these offerings were just hype.
A single analyst for a ratings company or investment company can drop the market capitalization by billions of dollars. Simply lowering a rating from hold to sell by companies such as Moody's or JP Morgan can affect the price of the stock. Further, when large institutions begin to sell, the value of the stock is crushed.
Because of this, great pressure is placed on companies to "pad" their earnings statements. Enron became the poster child of creating separate subsidiaries to "hide" losses in order to meet earnings targets for Wall Street analysts.
I wish I could say this is an unusual tactic, but one has to look no further than to the Federal Budget. Social Security is held "off budget" but is included in the Congressional Budget Offices reporting of the federal budget deficitas seen here, in order to pad the books. As of this writing, Social Security taxes are approximately $200 billion more than is needed in the program. This money is transferred directly to the general budget, showing we have $200 billion more in revenue than we really do. So when you see that our budget deficit is $400 billion, it really is $600 billion.
Back to too much money in the stock market. I will be accused of simple minded thinking, but I really believe there is some strange thinking in our accounting standards and our financial markets that just don't make sense.
Let me explain it like this.
How much would you pay for a company that makes $100 per year? If it was guaranteed to make $1000 over 10 years, the amount you would pay would not be $1000, the sum of payments, because if you invested $1000 at 7% interest, and invested the monthly interest income, you would have $3000 after 10 years, so you wouldn't pay $1000 because you would have a better return just investing the money in 7% interest accounts.
It is for this reason, that if I have a company to sell to another private party, I am usually paid 7 times earnings.
But if you look at the stock market, stocks are trading at 30-50 times earnings. This just doesn't make sense. Further look at the dot.com bubble. We heard things like "earnings don't matter." Stocks were trading at hundreds of dollars per share on companies that didn't have income and didn't have a plan to ever make money.
Because there was so much money in the stock market, rational discussions of the value of companies have turned to irrationality. It was this warning that Alan Greenspan called "irrational exuberance." When underlying common sense is overtaken by rushes to make money, problems are sure to follow.
It is my belief the problem we are experiencing is caused by too much money in the system and overpricing stocks. Combine too much money, with the corporate mentality of building their quarterly earnings statements on accounting tricks in order to show investors paper earnings over actual sales and a real mess is created.
And this brings us to the financial crisis we are in. Fannie Mae claims to have made $6.3 billion in 2005, $4.0 billion in 2006 and lost $2 billion in 2007. The casual investor (or any investor, really) doesn't have any way of determining what the real value of this corporation really is. Fannie is really an insurance company. How much of the income they made was set aside to take care of future obligations related to insurance payments made to cover future crisis? Should that revenue be stated as earnings or simply reserves to be paid out at a later date? This is a complex question, but if you an executive and are paid on earnings, it is only common sense that executives would want to claim as much revenue as possible as earnings, thereby increasing the pay they received.
This is exactly what happened. Executives claimed as much revenue as they could as earnings, thus increasing their bonuses. When more money was needed in following years, they didn't have the appropriate amount of reserves to take care of their obligations. Suddenly, they were losing money by the billions. (on a side note, look at how much money Fannie paid in taxes. This isn't going to be there next year, along with many other financial businesses, and this will leave a huge void on tax reciepts--meaning more deficits)
I don't know how to fix this problem. But when people talk about greed, they are talking about Fannie Mae.
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