Monday, May 11, 2009

Reich Is Wrong

The staggering nonsense written of late about preferred stock is an object lesson in just how out of touch most commentators are with the basics of economics and finance, even top credentialed economists and commentators.

The essence of preferred stock should have been learned in Finance 101. In some cases, it clearly was not.

Case in point: Robert Reich (pictured). Reich is professor of public policy at the University of California at Berkeley, was secretary of labor during the Clinton administration. Yet, his confusion about preferred stock is simply astounding. He thinks it is debt, or possibly doesn't realize that is what the government has been buying from banks.

Reich writes of the latest Treasury plan to swap preferred stock for common:

The Treasury will simply swap debt for equity -- turning what the banks owe the government into shares of stock in the banks...Much of the money we originally gave Wall Street took the form of senior debt. We were preferred creditors, meaning that in the event of bankruptcy (or some form of it) we’d get repaid first. But as shareholders, we’d get nothing.

The government didn't get "preferred debt" ( an odd term to begin with, used sparingly in the world of finance). The government received preferred stock, and it is the preferred stock that banks are converting to common.

Preferred stock is different from debt in that it generally never is required to be paid back(though it generally can be paid back). Debt always has a maturity date. Secondly, payments made on debt are interest payments which must be paid on stated payment dates, or the debt issuer is in default. Preferred stock does not pay interest. It pays out a dividend. If the issuer of the preferred does not pay out the dividend, the issuer is not in default. The dividend is only paid out by the board of directors if it is deemed a sound decision to do so.

Reich is clearly clueless here. This may explain why you get some bizarre policy prescriptions from this guy. He doesn't get basic stuff that an average college sophomore should get.

Another faux pas, made by others, surrounding the preferred stock conversion to common is that this will help the cash flow of banks.

But, again, a preferred stock does not pay interest, it pays a dividend. If a payment of a preferred dividend would do so much damage to cash flow as to significantly weaken a bank balance sheet where the possibility of a bank continuing to operate as a going concern were a possibility, then the board of directors would have no obligation to declare the dividend on the preferred be paid. Indeed, it would be a breach by the board of their fiduciary responsibility to declare such a dividend.

Anyone promoting this cash flow benefit of the conversion from preferred to common, just doesn't get the subtleties of preferred stock versus debt.

If these guys can't get the differences between common stock, preferred stock and debt, I don't hold out much hope for their getting business cycle theory. No wonder these crises repeat themselves, with the same errors being made by group after group of officials, even at cabinet level, who don't understand the basics.


  1. OK I'm glad you said this, because I was thinking I was taking crazy pills when everyone kept referring to it as a "debt for equity swap."

    I think I'm on crazy pills a lot, nowadays.

  2. This explains why the government so easily violated absolute priority and gave the majority of (the alleged) value of Chrysler to the unsecured UAW over the 1st Lien Term Loan debt held by investors.