Dividends and Stock Prices

I've been writing about finance on a regular basis since 2000, yet it took me until this week to get clear in my own mind the significance of the questions: do stock prices fall in value in response to a  forthcoming dividend payment? and its related question: if so, why? There is a lot of material about which I am still very naive, I concede.

If I had been asked, I might have remembered some long-distant lesson about two guys whose names each begin with the letter "M," and the notion that dividend policy, in an efficient market, is neutral as to the value of a stock. So I would have denied that any move at all could be predicted with any degree of confidence.

That may still be the "right answer," but I now believe I understand that there is a controversy here, and why.  Figuring it out involved wrestling with vocabulary and chronology. My understanding is that the usual process is this: a company will say that it will pay dividends this quarter, and it will set a "record date" in the near future, and a "payment date" about a week after that. The payments will go out to everyone who owns the company's stock -- who is a "holder of record," as of the record date.  Hence the term.

But to make things more complicated, two days before the record date comes what is called the ex-dividend date. This exists because it can take a couple of days for a stock transaction to settle: for the necessary paperwork to get done between the time somebody shouts "sold" on a trading floor on your behalf and the time you are in deed a owner of record. Thus, before the ex-dividend date the stock was trading "with the dividend," -- part of what you were purchasing in buying it was the expectationof that dividend. On and after that date, the stock is trading "ex" the dividend. 

Intuitively, then, one would expect stocks to increase in value at the time of the announcement and drop in value again on the ex-dividend date. As of the announcement, the stock carries with it the promise of a near-immediate cash rebate, whereas after the ex-dividend day, the stock no longer carries the expectation of a cash payment that it had carried the day before.  Why, then, wouldn't it be worth a bit more after the one development and a but less after the other?

But the money doesn't come out of nowhere. The market at the time of the announcement understands that by these cash payments the company will be depriving itself of that amount of cash, and losing the opportunity to re-invest it in something productive. Further (and this was the key to the Miller-Modigliani argument to which I alluded above) the market is indifferent between an increase in the value of the stock by one dollar on the one hand and the pay-off of $1 as a dividend on the other. So these announcements don't seem to produce any increase in value.

There is an arbitrage argument for the irrelevance of the ex-dividend date, too. After the declaration date, everyone in the market knows when the dividend will be paid, and when the ex-dividend date arrives. If this situation were sufficient to create a price drop, then a lot of speculators would rush in a short sell the stock in the days leading up to the ex-dividend day, betting on that price drop. Their short sales would cause the price to fall earlier than that date, perhaps as soon as the day after the announcement. The date itself, then, would be an irrelevance.

The situation is complicated by the issue of taxation. Dividends are taxed more than are capital gains, a fact that may make some investors and traders less willing to buy a stock that has announced a dividend in that run-up to the ex-dividend day than they would otherwise be, and might thus reduce the extent of the drop, if any, on that day.

Theories notwithstanding, there is evidence that there is a decline ceteris paribus on or around the ex-dividend date.

Is the decline equal to the full value of the dividend to be paid, perhaps with some modification for tax considerations?  That is another question, and not one I yet want to try to tackle.

The Mortgage Interest Deduction

I'm no expert on the history of taxation, just someone who fumbles through his own form every April. But it is my understanding that prior to 1986, an interest payment on ANY personal loan was deductible.

That year there was a desire to raise revenues, in a way that wouldn't raise the marginal tax RATE, because supply-sider doctrine focuses on whether the tax rate is going up or down rather than on the question of whether a given taxpayer owes more to the IRS this year than he did last. So in 1986 Congress passed and Reagan signed a bill that removed the interest deduction from any loan. With the important exception of home mortages.

That exception was preserved on the theory that encouraging home ownership is a good thing. Apparently a non-controversial bipartisan notion in the US.

Obama's new budget limits the range of households that can take such a deduction, cutting it off at $250,000.

There is a lot that might be said about this subject. I saw a very interesting letter in the Wall Street Journal in late February. Richard P. Urfer, a fellow from Morristown NJ, wrote that the elimination of interest deductibility for everything except mortgages encouraged the misllocation of capital into housing. He also writes about a tax change [also in 1986?] that allowed tax free profits up to $500,000 on the sale of a primary residence (every two years).

These changes, says Urfer, transformed the home market into "a municipal bond-type investment vehicle." And everybody crowded in, although other sparks were necessary to turn this dry wood into the present conflagration.

Does Urfer's analysis sound plausible to you, dear readers?

At any rate, leaving my own anarchistic views out of account and thinking "within the box" of the current US political system in its broad outlines, I'll say this: there may be a case for abolishing the mortgage interest deduction altogether, completing the work that was begun in 1986. But there is no good case for creating a cut-off line at $250,000.

This is especially obvious if we agree that Urfer is right. If the exception made for mortgage interest in 1986 helped direct speculation into houses, then preserving taht exception but narrowing its scope with an arbitrary income limit won't do anything to prevent another go-round of this sort of boom and bust. All it means is that McMansions won't be part of the next go-round.

It may just mean that the next time there is a housing bubble it will be more intensely focused on middle and lower income housing than the last time. That's an improvement?

What if I were allowed to deduct the interest on payments I made to credit card companies if and only if I had incurred my debts to those companies in order to raise cash to gamble in a casino? The "gaming" industry would love this idea were it politically palatable at all. Would it be a wise policy?

If somehow we found ourselves in that situation and wanted to reform our way out of it, would it make sennse to keep the deduction, but put a household-income ceiling on it?

Three Questions for Senator Clinton

I'm on the list for press releases from the two remaining Presidential candidates in the Democratic Party.

Why am I not on Senator McCain's list, too? Because my presence on any of these lists dates back to last October, when Congress was debating the issue of the taxation of "carried interest" on private equity funds. This is a matter of grave concern for my usual audience, so I contacted the Democratic candidates about it.

There was no "carried interest" story on the Republican side, I assure you.

Anyway: I am on the lists, and on Friday I received an e-mail statement from Hillary Clinton's press office on the new unemployment numbers.

The statement was by-the-book, but I decided: what the hack? why don't I write back. I don't really expect an answer, but I'll share with you the questions:

I'm curious about the matters below that concern: Clinton campaign economic/financial policy. I'd love to have an on-the-record quote from the candidate about these matters.

1. Glass-Steagal. Does Senator Clinton believe, as Senator Obama suggested recently, that the repeal of the Glass-Steagal distinctions between investment and commercial banks was part of the road to our present troubles? If so, did she use her influence within the administration of President Clinton to raise warning flags at the time, or has the problem only subsequently become clear?

2. Yesterday morning, one of the Banking Committee Senators asked Mr. Bernanke: How big does an institution have to be to be 'too big to fail'? I'd appreciate the Senator's views on that. If no institution is too big to fail, then sometimes the right thing for a President to do (invoking the imagery of a certain television ad) would be to let the phone ring, wouldn't it? Why should the CEO of Bear Stearns, or someone in a similar position, expect to be able to reach anybody in the White House at 3 AM?

3. A more minor point, involving personnel issues, but one in which I think our readership will be interested: Would Robert Rubin likely play an important part in the economic/financial policy of a new Clinton administration?

I'd very much appreciate it if you could get back to me on these points. Thanks.

Capital Gains

What is a "capital gain"? and why is it taxed at a rate lower than than of ordinary income?

The textbook answer to the first of those questions: a capital gain is the amount by which proceeds from the sale of an asset exceed the original cost.

Further, there is at least one obvious and intuitive reason for treating capital gains differently. The income from the sale of an asset that a taxpayer has held for several years realizes the accretion of value over each of those years, whereas his/her salary, wages, tips etc.(paradigms of "ordinary income") represent the return on labor expended in the taxable year involved. This means that if the income from the sale of a house were taxed as ordinary income the year of the sale, the homeowner would experience an enormous hit that year. This is called the "bunching effect," i.e. taxable events from several years bunched into the year of realization. That, in turn, would freeze up assets -- everyone would become afraid to sell anything valuable for fear of the tax hit -- with disastrous economic effect.

So far, so good. But there are also short-term intra-year capital gains. Why aren't they taxed as ordinary income? Suppose I bought a house in February 2006 for purpose of flipping it. Did so in April 2006. Why shouldn't my profit be treated as ordinary income? The best argument against doing so is that there would still be a "lock-in effect" even without any bunching. We (policy makers or others putting ourselves in their shoes) want people to be able to flip house, because they contribute to the liquidity of the marketplace -- to the ease with which non-speculators too can find something to buy or sell when the time is right.

But the intuitive appeal of that argument is weaker, it would seem, than the appeal of the bunching argument for longer-term investments.

And since we're thinking about it ... there might be better ways of dealing with the "bunching effect" in the case of long term investments too. Conceivably, the accretion of value to my house could be taxed each year as it happens, so that the final sale would have no or only a very slight significance for tax purposes. (Yes, there would be obvious practical difficulties there.)

Aside from the bunching and lock-in effects, the only significant remaining argument for differential treatment of capital gains is this: taxing such gains discourages investment or (what is the same) discourages savings, encouraging immediate consumption and indebtedness.

Does it, though? The late Milton Friedman always used to maintain that fiscal policy is much less efficacious at shaping behavior than policy-makers flatter themselves it is. I wonder about this one.

Also, there seem to be a number of areas defined by law as "capital gains" arbitrarily, or simply as a response to lobbying power and cronyism, where the definition isn't warranted by any of these arguments. But more of that another time perhaps.