Positive Economic Commentary
Did The Fed Unwittingly Aid And Abet The Growth In Executive Stock Options?
July 19, 2002
Everyone seems to be up in arms today about executive stock options. Do stock options distort reported corporate profits? Do stock options change the behavior of senior management so that short-run profits are maximized at the expense of longer-run profits? Do stock options encourage "infectious greed" to the extent that senior management knowingly "cooks the books" to enhance the value of their options? I don't know the answers to these questions. But, more fundamentally, the issue I want to address in this commentary is whether the Fed via its easy money policy of the late 'Nineties unwittingly aided and abetted the growth in executive stock options. In part, what motivated my interest in this subject was a November 1999 Federal Reserve Board Working Paper in the Finance and Economic Discussion Series (1999 #59) entitled "Share Repurchases and Employee Stock Options and their Implications for S&P 500 Share Retirements and Expected Returns," by J. Nellie Liang and Steven A. Sharpe (http://www.federalreserve.gov/pubs/feds/1999/199959/199959pap.pdf). I won't keep you in suspense. My answer to my headline question is, of course, "yes."
All else the same, when an executive stock option is exercised, it dilutes the corporation's per-share earnings because the number of shares outstanding increases. Thus, if this dilution is to be avoided, senior management must "retire" or buyback outstanding shares of the corporation's stock by the amount of the increase in outstanding shares resulting from the exercise of the stock options. The cash outlays for share buybacks are a "use" of the corporation's earnings just as are dividend payments. All else the same, the greater the amount of outlays for share buybacks, the lower are the corporation's retained earnings. And, again, all else the same, the lower are the corporation's retained earnings, the more it will need to borrow. Thus, the granting of stock options can lead to increased leverage of the corporation.
Liang and Sharpe examined the behavior of a sample of 144 corporations in the S&P 500 in these matters for the years 1994 through 1998. The authors calculated "payout" percentages for these corporations. A payout percentage is the sum of dollar amounts used to repurchase shares outstanding plus the dollar amount of dividends paid as a percentage of corporate profits. For the 144 corporations examined, the payout percentage rose from 56% in 1994 to 80% in 1998. So, in 1998, in the aggregate, these firms were using 80% of their profits to buy back shares of their outstanding stock and pay dividends to their stockholders. Liang and Sharpe found that in 1997 and 1998, these 144 firms "spent nearly 125 percent of their earnings on net investment outlays and stockholder payouts, suggesting that large corporations already have been borrowing or running down financial assets to finance stock repurchases." They went on to say "the recent pace of debt growth, if sustained implies a substantial increase in debt-to-asset ratios."
Let us examine some aggregate data for nonfinancial corporations. Chart 1 shows there were record dollar amounts of corporate stock that took early retirement, so to speak, in the late 1990s.
Chart 2 shows that corporations in the late 1990s were increasing there borrowing faster than they were increasing their capital spending. This is consistent with the Liang-Sharpe comment that corporations were borrowing not only to finance plant and equipment spending, but to finance stock repurchases, too.
And, finally, Chart 3 confirms the Liang-Sharpe view that that there would be in the late 1990s "a substantial increase in debt-to-asset ratios." In fact, this ratio reached a postwar high.
What does all this have to do with the Fed? It is clear from the Liang-Sharpe analysis that large-scale grants of executive stock options implies large scale borrowing by the granting corporations. This increased demand for credit would put upward pressure on the structure of interest rates. The increase in interest rates, if it were allowed to occur, would discourage share buyback borrowing and, thus, discourage large stock option grants to executives. But, because the Fed targets interest rates, the full upward pressure on rates would not occur unless the Fed raised its target rates commensurate with the increased demand for credit. But Chart 4 shows that the Fed kept its target fed funds rate almost constant from 1995 through 1999, when corporate stock buybacks and corporate borrowing were soaring. The way the Fed was able to hold the fed funds rate constant in the face of rising credit demand was to allow banks, thrifts, and money funds to create more money and credit, as evidenced by rapid growth in the M3 money supply in the late 1990s. Had the Fed been targeting and hitting some reasonable growth in some monetary aggregate, it would not have accommodated the increased demand for credit coming from stock buybacks. And had the Fed not accommodated that increased demand for credit, the onerous borrowing costs related to stock buybacks would have curtailed the granting of executive stock options.
It only goes to show you once again that money is the root of all evil!
Paul Kasriel
Senior Vice President & Director of Economic Research
The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
[an error occurred while processing this directive]