The Uptick Rule

Barring unforeseen calamity or luck, I plan on being a lawyer and generally like rules.  They give me some range within which I can act, and more importantly, require a client to pay for the services of someone like me.  To that extent I'm generally in favor of rules, I'm in favor of the uptick rule.

But has the elimination of the uptick rule really been a factor in this financial mess?  Or, in the words of President Bartlett, does Wall Street believe in the phrase "post hoc, ergo propteur hoc (after it; therefore, because of it)."  The phrase essentially relates to a confusion of causation, and I think that may be what's going on here. 

The uptick rule requires someone that is shorting a stock (after having borrwed it) to sell the stock at a price immediately higher than the last sale price.  That is, if you want to short GE, and it last traded at $9, you'd have to sell the borrowed stock at $9.01.  That's my impression of the uptick rule at least.  I say this because while Wall Street and CNBC and Jim Cramer have been railing against the elimination of the uptick rule and saying how it is the cause of our financial crisis, no one has explained what it is (except Wikipedia).

What you'll hear on CNBC:

Correlation:  The SEC eliminated the uptick rule in July of 07. 

Causation:  Look at what has happened since

Notably, the SEC suspended the uptick rule in July of 04, and in the six month period following the suspension. the Dow rose about 300 points.  Nothing incredible, but nothing shabby.  If the elimination fo the uptick rule caused all this insanity, why didn't we see insanity back then?  Just more proof that you should vote for President Bartlett for reelection.

My Crystal Ball and the GE Proxy

For a couple of sad, sad months, I was a shareholder of General Electric.  I bought it intiitally to hold for a day because I thought it was oversold, but I ended up holding it for over a month.  I was right on the day and wrong on the month.  If I learned anything, it was not to make a trade into an investment.

The stock ended up being a huge disappointment - its value plummeted and I didn't have the moxy to sell.  I knew the stock was going to continue to go down; I knew I was going to lose money but I didn't want to realize the loss.  Finally, I realized that I was trading emotionally and bit the bullet.  I lost more money on my GE holding than I've ever lost on any other trade.  I learned 2 things:

1)  Don't be emotional.  Realize your loss and shut up.  The loss is already there so stop pretending like it's not

2) Never make a trade into an investment.

The story is just beginning though, because I just got GE's proxy statment in the mail.  I had the shares on the date necessary such that I get a vote (or 251) at GE's annual shareholder meeting. I was looking at the proxy statement earlier today, and you won't believe what I read!  A precatory shareholder proposal suggesting that dividends not be paid out to GE executives on unvested stock.  That's exactly what I wrote about 1.2 weeks ago!  It was made my a pension fund.  Here's the text of the proposal:

"RESOLVED, that the shareowners request that the Board of Directors of General Electric (“Company”) adopt a policy that the Company will no longer pay dividends or equivalent payments to senior executives of the Company for shares they do not own."

Two important things to note:

1)  Jeffery Immelt, CEO of GE, does not get dividend payments on restricted stock he owns.  He gets dividends only when that stock becomes unrestricted (I don't know if the dividends accumulate while the stock is restricted and are paid when the restrictions lapse).  Anyway, this isn't the case for the other executives.  Note in the text of the statement of support that Intel and MSFT don't pay dividends for unvested stock.

2)  The company recommends I vote against the proposal. 

This is awesome!  I can't believe an issue I spotted ended up being on the proxy statement just a week later. 

Here is a portio of the statement of support:

In response to this proposal in the 2007 Proxy Statement, the proxy statement declared that Mr. Immelt, starting in
September 2006, would only accumulate dividend equivalents if he earns the shares, and that payments would be
made (without interest) upon full ownership. However, for other senior executives, it stated that the goal of providing
“dividend equivalent payments is to mirror the income generation associated with stock ownership” and asserted that
the current practice was “competitive.”
In our opinion, the limited change in Company policy for Mr. Immelt is insufficient. For the CEO, it continues to
undermine the principle of pay for performance because payment is made on shares that are not owned. For other top
officers, there has been no change in the practice of awarding dividends or dividend equivalents on shares not owned.
According to the Wall Street Journal report noted above, several leading companies, such as Intel and Microsoft,
“never pay dividends” before full ownership rights have been earned. If the Management Development and
Compensation Committee believes that current executives are underpaid in the absence of “phantom dividends” or
dividend equivalent payments, we believe it should increase other components in compensation packages.
In our view, contingent pay should be truly contingent. We agree with Paul Hodgson at the Corporate Library, who
has stated that dividends on performance shares are “stealth compensation.”
We urge shareholders to vote for this proposal.

I can't wait to vote my proxy!

Don't make a trade into an investment.

This is the best advice I've ever read/received/heard.  More on this later...

Excessive Short-Termism

Much has been made recently of the short-term outlook that seems to have plagued the management of America's financial companies.  The CEO's and risk-management officials at these companies, the argument goes, focused only on short-term revenues in earnings; consequently, they lost sight of the severe, and sometimes systemic, risks that their institutions were facing.  To a large extent, this is true; Wall Street is focused on earnings - earnings per share, earnings quarter over quarter, earnings year over year.  But to what extent is this focus on earnings a result of management compensation structure and the Internal Revenue Code?

I think we're all aware that CEO's (especially of financial institutions) get low base salaries and are compensated through the use of stock options that vest after some period of time.  This is in part due to the IRC which restricts the amount of money a corporation can deduct from its earnings for base compensation to its CEO.  That is, if you pay a CEO $5 million in base compensation each year, you are not allowed to deduct that entire amount from earnings when determining your gross income (you're only allowed to deduct 500k or $1 million, I don't remember which).  Looking at this from a public policy perspective, this provision is intended to align CEO and shareholder interests.  Since the CEO will be compensated less in base salary and more through stock options as a result of this IRC provision, the CEO will have a personal, financial incentive to see the stock price rise. 

But let's take a look at this in terms of a dividend/stock repurchase/retained earnings perspective for a second.  The CEO's compensation will largely be through stock options that vest after a number of years (lets say 3 years).  Until then, his base salary is likely to be the same (either $500k or $1 million depending on what the IRC says), lets say $1 million.  Most of his salary is coming through stock options that vest over a period of time and have a strike price of $X, $X being what the company's stock is trading at today. 

Now what really matters, and what I'm going at, is how dividends are paid out to investors and management during the 3 year period during which the CEO's restricted stock option vests.  If the CEO decides that dividends are appropriate while his options haven't vested, what happens to his share of the dividends?  I assume that they are not distributed to him since he does not have any actual shares of the company's stock.  If he gets no dividend even though everyone else does, the CEO has no incentive to declare dividends.  In fact, he has a disincentive to declare a dividend; when his options do vest, the company will have less money than before. 

Ironically, the CEO has an incentive to either preserve the cash in the corporate till until his options vest (keep in mind that he is getting options every year, so all of his options have never vested until he leaves his position), or do attempt to use the money to increase the share price of the company's stock.  He would not want to preserve the cash in the company's bank account because it would make his company ripe for a takeover and because his options never vest until he leaves; he always has an incentive to not distribute the money.  Instead, his best option to spend the money, perhaps unwisely, to increase share price.  Thus, does compensation structure actually incentivize the CEO to waste money at the expense of shareholders?  Is his personal interest in increasing share price so dominant that he will corporate squander money rather than dividend it out?  How are we incentivizing him to make good decisions with retained earnings?

Now all of this depends on how dividends are distributed to those with restricted options, and to the extent that I'm wrong about my assumption, this entire article is useless.  But I've been mulling this idea around for a few days in my head, and I needed to get down on paper.

TCE v. T1CR

Whats the difference between tangible common equity and Tier 1 capital ratio?  My real question is, what's Tier 1 Capital Ratio?