A company is a legal entity and hence punishable by law… hence, one motivation for incorporating a company is so that the corporation can bear the brunt of mistakes made in its name. Absent that, if a company makes some misstep, all of its investors (owners) can be sued for the mishaps/misbehavior of the company itself and the extent of their liability or exposure is unlimited (they could lose their life savings). Once incorporated, however, the company itself is liable. Its owners/shareholders are not hold responsible. This is what the phrase “limited liability” refers to – it means that the owners/shareholders have limited liability for mistakes made (damage done) by the company itself. Note that the employees of the company (managers, directors) can be sued, even if it is incorporated.
- So what does the “limited” part mean? It means that shareholders are liable upto the value of their investment. So if I have 5 grand plugged into CostCo then I can lose that $5,000 but no more. My liability is limited to the size of my investment.
PROs/CONs of being public vs. being private
Private companies are typically owned by a small number of people; the distinguishing characteristic is that the general public cannot invest in them. Think of your local barber shop, salon, shoe repair shop, … By contrast a company is public if its stock is publicly traded. There are about 13,000 public companies in the US. The beauty of the stock market is that it lets “ordinary people” participate in the wealth and prosperity of public companies. And it lets those companies, in turn, finance their growth. You don’t have to work for Goldman Sachs to share in its success (and failure); you can just buy the stock.
- The vast majority of companies are private.
- The majority of employees work at public companies, however.
- PROs of being public (the opposite of each is a CON of being private)
- For investors, their investment is liquid – they can increase/decrease their holdings in the company at pretty much any time.
- For investors: Stock that is traded on a national securities exchange must be registered with the SEC, which requires periodic audits (by an independent auditor) of the company’s financial statements. Also, the company must disclose various events. In theory, this results in a good flow of information to the investor.
- CONs of being public (the opposite of each is a PRO of being private)
- Very high regulatory requirements (as imposed by the US gov’t): administrative, financial reporting, corporate governance
- E.g. Sarbanes Oxley (SOX) requires publicly traded companies to implement, doccument, and test controls which (are meant to) ensure proper and complete financial reporting “at all levels of the organization”
- Disclosure requirements (i.e. the company has to announce when it’s doing foo)
- Reporting requirements (the periodic audits)
- Corporate governance dictates
- Compliance costs (the consultants one must hire to do the SOX audits plus whatever costs lead up to that)
- Pressure and focus of consistently meeting quarterly earnings expectations (can foster short-term thinking/orientation)
Being registered with the SEC, etc.
The SEC exists to protect investors, effectively, by imposing requirements on companies that would offer securities for sale to those investors. For example, a company with SEC-registered securities must undergo periodic audits by an independent accountant and publish the audited financial statements. A company must register a class of securities (e.g. bonds, stock) with the SEC if: (1) the securities are “widely held” OR (2) the securities are traded on a national exchange (e.g. NYSE, Nasdaq, AMEX).
- The criteria for widely held is:
- If the company has significant assets (> $10MM),
- >= 300 shareholders for the given class of securities
- >=500 shareholders for the given class of securities
- Assets are measured as: total company assets for each of the last 3 fiscal years.
- ALL securities offered in the US must either be registered or quality for an exemption to the registration requirement.
What are the requirements for companies that have securities registered with the SEC? Their financial statements must be audited periodically and published. If any entity attempts to purchase >= 5% of a company’s shares, this must be disclosed. Also, if shareholder input is to be solicited on some matter (e.g. via a proxy vote), then this solicitation must be filed with the SEC first so that it can ensure that all required background/context is provided (“disclosure of all important facts concerning the issues on which holders are asked to vote”). Illegal insider trading == If someone possesses material non-public info about a company AND is required not to trade on it BUT does so anyway.
I’ve always wanted to learn about investing and money. So I’ve picked up a few books and will be working through them one-by-one. Typically the way I learn a new topic is to find a reliable, highly regarded source who has written an intro’ish tome for the topic. Then I just begin reading that book — stopping at any word or phrase or concept that I don’t completely understand and that isn’t completely explained in the book. Then I go on a side search to build up my understanding of not only that particular word or phrase but also any relevant context.
For example, I was on page 18 of Lynch’s book (Learn to Earn) when I encountered my first major need-to-detour. As I was reading about various public companies whose products we encounter every day, I began to think:
- What does it mean to go from public to private? What is the mechanism for this? Why might you do it?
And so for 1.5 days, I’ve been following that thread, just so that I can resume Lynch’s book on page 18, where I left off.
How does the Fed lower long-term interest rates?
- The Federal Reserve owns about $1.7T in US treasury securities (e.g. bonds issued by the federal government), which is about a trillion more than they owned before the quantitative easings of 2008 and 2010.
- When the Federal Reserve starts buying longer term US treasury securities, this obviously increases the demand for those securities.
- Note that US treasury securities include: Treasury Bills, Treasury Notes, Treasury Bonds. All of these are fixed income securities and so they yield some predetermined constant amount on some predetermined schedule.
- As demand for securities goes up, so does their price.
- And if the price of a fixed-income security goes up (say, from X to X+k) then its relative yield (yield amortized over the cost of the security) decreases.
- Say a given Treasury bond is going to pay $30 every 6 months for 30 years. If we buy that bond for $X then our yield per dollar invested (i.e. relative yield) will be higher than if we buy it for some amount >$X. Because the yield itself (the amount we’re earning) is fixed.
(($30 * 2 * 30)/$X) > (($30 * 2 * 30)/($X+k)).
What happens when long-term interest rates go down?
- The interest rates of many other securities (not issued by the federal government) are pegged to the Treasury interest rate. When Federal interest rates go down, then all such securities will have lower rates of return (since they will earn less interest than when the rates were higher).
- This will cause investors to seek other investment vehicles, which have higher rates of return, e.g. stocks. This will cause stock prices to rise, which will cause consumers’ stock portfolios to increase in value, which will make consumers feel wealthier and consequently spend more.
- This is called “the wealth effect”.
- Also, when long-term interest rates decrease, that means credit is cheaper, which encourages more borrowing and could encourage more hiring.
- This whole cascading effect is intended to stimulate the economy (by stimulating spending).
Other things the Fed might do to stimulate the economy
There are limitations to what can be accomplished by lowering interest rates. After all, if there aren’t credit-worthy borrowers (to take out the loans) or businesses willing to take advantage of low-cost loans (due to uncertainty about the future) then further lowering interest rates (by itself) is unlikely to produce stimulative effects.
- The Fed could also decrease the interest rate it pays to banks on the banks’ excess reserves. That might cause banks to look elsewhere (somewhere with higher returns) to park that money.
- Or if the Fed raises the target for inflation that might encourage folks to spend more now since their money will be worth less (relative to the cost of goods) later.
Some other notes
Interest rates of long-term treasuries are at historical lows (point: not much further to drop)
- The yield for a 10-year Treasury note:
- The yield for the 30-year U.S. Treasury bond:
* The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years. Source: Federal Reserve Board.
Source: Nearly Out of Tricks, Fed May Pare Longer Rates
What is it basically?
An “expansionary monetary policy”: that is, a policy that attempts to increase the size of the money supply, typically with the goal of lowering interest rates. Lower interest rates encourage (1) investors to look for higher yield places to park their money (e.g. riskier investments, such as stocks) and (2) borrowers to borrow (because money is so cheap). These twin side effects are intended to stimulate the economy.
As discussed elsewhere, the Fed controls some set of interest rates (e.g. the federal funds target rate); many other (private sector) interest rates are pegged to those controlled by the Fed. In particular, the US Prime Rate is typically (since 1994) three percentage points above the federal funds target rate. The US Prime Rate “is used by many banks to set rates on many consumer loan products, such as student loans, home equity lines of credit, car loans and credit cards.”
There are some interest rates, however, that are not directly related to the federal funds target rate (or are more loosely correlated) and so if the Fed wishes to lower these rates, they have to use different tactics. Applying quantitative easing – targeted toward purchasing private sector assets (e.g. bank bonds) – is one such technique.
How do you do it?
The central bank (e.g. the Federal Reserve) buys assets (e.g. US Treasury Securities) from the government or from the private sector (insurance companies, pension funds, banks, non-financial firms) by crediting the account of the seller (e.g. the private bank’s federal reserves account). In this way, the central bank didn’t literally print more money but it did in effect create money out of thin air by exercising its ability to credit one account without debiting another. Not only does this inject more money into the economy but it also frees up the seller to redeploy that capital elsewhere (for example, lending it to other institutions or to consumers).
- “The Bank can create new money electronically by increasing the balance on a reserve account. So when the Bank purchases an asset from a bank, for example, it simply credits that bank’s reserve account with the additional funds.” Source: The Bank of England: Quantitative Easing
- See also: Understanding The Federal Reserve Balance Sheet
- What’s a federal reserves account?
- Insert link here, when new section on federal reserves accounts is done.
- E.g. recent US quantitative easing
- In 2008, the Fed doubled its holdings of US Treasury securities – from approx $750B (in 2007) to approx $1.5T (in June 2011), now $1.7T.
- This included $600B in Mortgage Backed Securities (MBSs) (presumably from Freddie Mae and Fannie Mac). It also bought bank debt and treasury notes.
- In 2010, the Fed bought another $600B in Treasury Securities; this was referred to as QE2.
Why do you do it?
Lowering interest rates is one of the key tricks for stimulating the economy (as described here). If interest rates are already sufficiently low OR if lenders still don’t want to loan money, then central banks (e.g. the Fed) do QE in order to lower interest rates that are not otherwise under the control of the central bank (e.g. interest rates of securities that are not pegged to the rate of US Treasury securities).
- However, “economists [have] warned that quantitative easing may be of limited use when the problem is a lack of demand, rather than of liquidity — that consumers and businesses were uninterested in spending in the face of high unemployment no matter how much cheap money is around.” Source: Times Topics: Quantitative Easing
- “The cost of borrowing is not the problem,” said Paul Ashworth, chief United States economist at Capital Economics. “The problem is that there are not creditworthy borrowers, and that businesses don’t want to invest because they’re concerned about the economic outlook.” Source: Nearly Out of Tricks, Fed May Pare Longer Rates
Total US Debt
All told, the total US debt is about:
$55T ~= $16T (personal) + $21.4T (corporate) + $2.5T (state/loc) + $14.7T (nat’l gov’t)
- [$16T] Personal debt held by Americans
- [$13.56T] Mortgage debt (including non-residential mortgages)
- [$2.48T] Consumer debt (including car loans, credit card debt)
- [$21.4T] Corporate debt, including
- [$14.1T] The US financial sector debt
- [$7.3T] Non-financial business debt
- [$2.5T] State and local government debt
- [$14.7T] Federal government debt
Breakdown of the US national debt
The US national (federal government) debt is currently just under $14.7 trillion dollars (see also: The Debt to the Penny and Who Holds It). The amount of debt changes every year by the size of the budget deficit (increase!) or surplus (decrease!). The $14.7T is comprised of:
- [~$10.06T] Public debt: Securities issued by the federal government and held by the public (investors, the Federal Reserve, foreign, state, and local governments)
- [~$4.64T] Intragovernmental debt: Securities issued by the federal government which live in accounts administered by the government.
- What? Government account securities
- Federal Housing Administration
- Federal Savings and Loan Corporation’s Resolution Fund
- Federal Hospital Insurance Trust Fund (Medicare)
- Social Security Trust Fund
Not included in that $14.7T…
The national debt figure does not include:
- Fannie Mae and Freddie Mac obligations: together these accounted for about $5T in September 2008.
- Fannie Mae and Freddie Mac buy mortgages from lending institutions (such as your local bank) so that those institutions can be “freed up” to issue more mortgages or otherwise loan more money.
- But are these obligations actually guaranteed? No.
- Freddie Mac securities are not funded or protected by the US Government and they carry no government guarantee of being repaid.
- Freddie Mac states, “securities, including any interest, are not guaranteed by, and are not debts or obligations of, the United States or any agency or instrumentality of the United States other than Freddie Mac.”
- There is a widespread belief that Freddie Mac securities are backed by some sort of implied federal guarantee and a majority of investors believe that the government would prevent a disastrous default.
- Source: http://en.wikipedia.org/wiki/Freddie_Mac
- Guaranteed obligations:
- Unfunded obligations: Not included in the national debt are the obligations (under law) for payments the US government must make to Medicare, Medicaid, and Social Security.
- [$7.7T] Social Security
- [$38.2T] Medicare and Medicaid
- The cost of these programs far exceeds tax revenues for the next 75 years.
- The Medicare payouts already exceed the tax revenues intended to pay for Medicare. Similarly, social security payouts for a given year already exceed payroll taxes for that year.
- With the baby boomers nearing retirement (and redemption of their Social Security retirement payments), that these liabilities are unfunded looms large and imminent.
The below graph is over a shorter time horizon (than the above); note that this graph doesn’t include the spike in the 40s, which was related to WWII spending (I assume!). Also, this includes current and near-term debt-to-GDP ratios (inching toward 100%).
Over the years: international government debt versus GDP
How does the US debt-to-GDP ratio compare to that of other countries? (Lower is better!)