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____________ Review____________ Vol. 67, No. 10 December 1985 5 The Farm Credit Crisis: Will It Hurt the W hole Economy? 16 M ergers and Takeovers— The Value o f Predators’ Inform ation 29 New Seasonal Factors for the Adjusted M onetary Base T h e Review is pu b lis h e d 10 tim es p e r y e a r by th e R esearch a n d Public In fo rm a tio n D e p a rtm e n t o f th e F e d e ra l Reserve B ank o f St. Louis. Single-copv subscriptions a re available to th e p u b lic f r e e o f charge. M a il requests f o r subscriptions, back issues, o r address changes to: Research a n d Public In fo rm a tio n D e p a rtm e n t, F e d e ra l Reserve Bank o f St. Louis, P.O. Box 442, St. Louis, M is s o u ri 63166. T he views expressed a re those o f th e in d iv id u a l au th ors a n d do n o t necessarily re fle c t o ffic ia l positions o f th e F e d e ra l Reserve B ank o f St. Louis o r th e F ed eral Reserve System. A rtic le s h e re in m ay be re p rin te d p ro v id e d th e source is c re d ite d . Please p ro v id e th e Bank's R esearch a n d Public In fo rm a tio n D e p a rtm e n t w ith a copy o f re p rin te d m ate ria l. Federal Reserve Bank of St. Louis Review December 1985 In This Issue . . . Some prominent economists and consulting firms have argued recently that financial problems in the agricultural sector may slow real growth and increase unemployment in the econom y as a whole. The likelihood o f such spillover effects from the farm econom y to the aggregate econom y is the subject o f “The Farm Credit Crisis: Will It Hurt the Whole Economy?" by Michael T. Belongia and R. Alton Gilbert. Whether farm loan losses w ill harm aggregate econom ic activity is quite important since, to a large extent, greater federal aid to farmers and their lenders is being justified by some legislators on this basis. Belongia and Gilbert examine the effects o f farmers’ financial problems on general econom ic activity in several wavs. Looking at data since 1981, when farm sector loan problems began to arise, they do not find the kinds of effects described in studies that project advei-se effects on the econom y from farm financial problems. They then review data for the 1920s when a similar financial crisis was concentrated in the farm sector. This earlier episode also fails to reveal any strong links between losses on farm loans and general econom ic activity. Overall, Belongia and Gilbert conclude there is little historical evidence to support the assertion that farm loan losses imperil aggregate econom ic activity. In the second article o f this issue, "Mergers and Takeovers — The Value o f Predators’ Information,’’ Mack Ott and G. J. Santoni discuss the recent increase in corporate takeover activity and examine a number o f criticisms that have been leveled at this m ethod o f changing corporate ownership. Instability in financial markets and the misdirection o f corporate planning to short-term goals have been attributed to corporate takeovers. Takeovers also have been criticized for stripping management, labor and owners o f career, livelihood and wealth. The authors’ conclusions contrast sharply with those critical o f the recent wave of takeovers. Ott and Santoni find that both theory and evidence suggest that takeovers are expected to produce a more efficient use o f the targeted firm ’s assets and that the firm ’s owners generally benefit through a rise in the value o f their ownership shares. As with any econom ic change, third-party effects probably exist. The third-party effects most frequently advanced by the critics, however — negative em ployment effects, higher interest rates or neglect o f long-term plan ning — do not seem to be caused by merger and takeover activity. Weekly values o f the adjusted m onetaiy base have been more variable since the adoption of contemporaneous reserve requirements in February 1984 than before this change. This increase in weekly variability reflects problems w ith the sea sonal adjustment o f the m onetaiy base series. In the final article in this Review, “ N ew Seasonal Factors for the Adjusted Monetary Base,” R. Alton Gilbert de scribes a m ethod o f adjusting the monetary base for its new seasonal patterns under contemporaneous reserve requirements and compares the new series that derived using the previous seasonal adjustment procedure. Gilbert’s evidence indicates that applying the new seasonal factors substantially reduces the shortrun variability in the adjusted monetary base since February 1984. 3 The Farm Credit Crisis: Will It Hurt the Whole Economy? Michael T. Belongia and II. Alton Gilbert C k^^O M E economists estimate that 5 percent or more of all farms currently in business will go into bank ruptcy in 1986, and that one farm in seven w ill fail within the next four years.' A recent study bv two agricultural economists estimates that farm lenders may write off as much as $50 billion in bad farm debt over the next four years, with S20 billion cited as the "most probable" loss estimate.2 Such projections o f losses on farm loans may be high. Nevertheless, actual losses to date already have been large enough to cause a substantial increase in the failure rate among agricultural banks. Accounting for 22 percent o f bank failures between 1981 and 1983, agricultural banks have made up about two-thirds of all failed banks since July 1984; 62 agricultural banks failed during 1985.' Moreover, the Farm Credit System, a group o f federally sponsored agencies that lends to farmers, announced this fall that it w ill need direct assistance from the federal government to stay in operation.' Ordinarily, the failure o f some farmers and some farm lenders need not attract more attention than we currently pay to the thousands o f business firms that fail each year.'’ For several reasons, however, the cur rent farm debt situation has attracted special atten tion. First, projections o f large losses concentrated in agriculture have created concern about the econom ic health o f the entire industry. Moreover, the farm credit crisis has developed at a time when loan losses of commercial banks already are relatively high. Finally, the apparent vulnerability o f the banking system to the farm credit crisis has increased public concern about the continued \iabilitv o f many banks that have been heavily comm itted to agricultural lending. Some economists further believe that problems in the farm sector will spill over into the rest o f the economy, causing slower econom ic growth and low er employment. One recent study suggested that bank failures resulting from losses on farm loans could cause investors to view investments in all privately issued securities as more risky." Consequently, inter est rates on all privately issued securities could rise relative to the interest rates on U.S. Treasuiy securities, causing a slowing in econom ic growth. This article discusses reasons for thinking that this effect either will not occur or w ill be relatively insignificant and/or short-lived. Michael T. Belongia is a senior economist and R. Alton Gilbert is an assistant vice president at the Federal Reserve Bank of St. Louis. Laura A. Prives provided research assistance. ’Schink and Urbanchuk (1985), Drabenstott and Duncan (1985), and 'The Farm Slide" (1985). 5From 1979 through 1984, an average of 20,000 business firms failed each year. U.S. Department of Commerce (1985). 2Schink and Urbanchuk. 6Schink and Urbanchuk. In particular, the Wharton study indicates wider spreads between the commercial paper rate and the threemonth Treasury bill rate. A related study by Chase Econometrics (1985) deals with the more narrow question of a default by the Farm Credit System on its bonds. Its study shows even more substan tial spillover effects, with private debt interest rates rising by 300400 basis points over rates on government debt. Agricultural banks are identified as those with a ratio of farm loans to total loans above the national average for all commercial banks. This average is currently 17 percent. 4Karrand McCoy (1985). For a discussion of the financial condition of farm lenders, see Belongia and Carraro (1985). 5 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C hart 1 Farm Land Values and Farm Debt If the failure o f large numbers o f farms affects both interest rates and general econom ic activity adversely, then assisting the agricultural sector o f the econom y may make sense over and above the usual rationale based on the social benefits o f maintaining the family farm. The magnitude o f federal aid necessary to keep farm lenders viable, however, has been estimated to be in the “multi-billions” o f dollars for the Farm Credit System alone. In light o f current efforts to reduce the federal budget deficit, it seems prudent to assess the likelihood that the current financial problems o f the farm sector wall affect the w hole econom y adversely. This article analyzes the influences o f the current farm credit crisis on the econom y in two wavs. The first approach examines the performance o f financial markets and the econom y in recent years. Since the financial trouble o f fanners became widespread after the average price o f farmland started declining in 1981, we might expect to observe some adverse effects on the econom y already. The second approach examines Digitized for 6 FRASER the effects o f the farm financial crisis o f the 1920s on the econom ic activity o f that period. THE ORIGIN AND EFFECTS OF THE CURRENT FARM CREDIT CRISIS Today ’s farm crisis developed as a result o f the rapid increases in the prices o f farmland in the 1970s through 1981 and the subsequent declines in land prices since then. The 1970s and early 1980s w ere years o f rapid inflation. From 1972 through 1981, the GNP deflator rose at an 8.1 percent average annual rate while the CPI rose at a 9 percent average rate. The price o f farmland rose even more rapidly: the average price o f an acre o f farm real estate rose at a 14.4 percent annual rate from 1972 through 1981. Chart 1 indicates that total farm debt rose in step with the rise in the prices o f farmland. Movements in 'Between 1972 and 1981, the price of farmland increased at an average annual rate of 14.4 percent, while, over the same period, total farm debt increased at a 13.5 percent average annual rate. DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS C h a rt 2 Farm Land Values a n d Prices Received by Farmers land prices and farm debt over this period were closely related for two reasons: First, many farmers w ho bought land w hile land prices w ere rising bor rowed heavilv to finance their purchases. Second, the rising land prices enabled farmers to pledge their land as collateral for general purpose loans. Unfortunately for farmers, prices o f farm com m odi ties did not rise as fast as farmland prices (chart 2). From 1972 through 1981, an index o f prices received by farmers on all farm products rose at an 8.1 percent rate, equal to the general inflation rate. Furthermore, most o f the rise in the index o f farm prices over these years was concentrated in 1973-74 and 1978-79. Prices received by farmers have not risen as rapidly as the GNP deflator since 1979. Thus, during the years o f rapid inflation, the price o f farmland rose substantially faster than the prices received by farmers for their output. The general rate o f inflation slowed sharply after 1981, making farmland ownership less valuable as an inflation hedge. In addition, the price o f farm output relative to nonfarm prices has declined bv 1.8 percent since 1981. For many farmers w ho borrowed heavily during the period o f rapid increases in the price o f farmland, prices received for farm products have not been high enough to cover their operating expenses and meet their loan payments. Consequently, farm lenders have begun incurring losses on the loans on which farmers have defaulted, and the protection of collateral for farm lenders has been eroded by falling farmland prices. Only A Minority7o f Farmers Have Financial Problems The data in table 1 show that the "farm credit crisis" is concentrated primarily among a minority o f the family-size commercial farms, which have annual 7 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 Table 1 Distribution of Family-Size Commercial Farms by Their Ratio of Debt to Assets, January 1985 Nature of financial condition Ratio of debt to assets Percentage of farms Percentage of debt of all family-size commercial farms Technically insolvent Over 100% 6.3% 14.5% Extreme financial problems 70 to 100% 7.4 17.3 Serious financial problems 40 to 70% 20.0 40.3 No apparent financial problems Under 40% 66.3 27.9 NOTE: Family-size commercial farms are identified as those with annual sales of farm output between $50,000 and $500,000. Source: U.S. Department of Agriculture (1985). sales o f farm output between $50,000 and $500,000.” About two-thirds o f the familv-size commercial farms have ratios o f debt to assets below 40 percent; the USDA considers these farms to have no apparent financial problems. Moreover, these farms account for less than 30 percent o f the debt held by medium-size farms. In contrast, about 14 percent o f familv-size commercial farms have debt-to-assets ratios o f 70 per cent or higher, and these account for over 30 percent o f the debt. In total, about one-third o f familv-size 8Farms with less than $50,000 in annual sales tend to be part-time operations for the farmers; for these farms, there are nonfarm sources of income available to meet the debt payments. In contrast, many of the farms with annual sales over $500,000 are specialty operations, like cattle feedlots and poultry farms, which have oper ated profitably with high debt-to-assets ratios for many years. Farms with relatively large annual sales tend to be more profitable than smaller farms. Only 1 percent of all farms have sales in excess of $500,000 but they account for more than 60 percent of farm income. In contrast, the group of farms with less than $40,000 in annual sales actually shows a loss equal to 6.5 percent of farm income. In comparing farms that sell between $40,000 and $500,000 of product annually with those selling more than $500,000, the larger farms have an income-to-equity ratio of 16.5 and an income-to-debt ratio of 28.6 vs. figures of 3.3 and 11.9, respectively, for the smaller category of commercial-size farms. For more detail on holdings of farm debt by size of farm and alternative estimates of the number of farms in serious financial trouble, see Bullock (1985). Digitized for 8 FRASER commercial farms hold more than 70 percent o f this farm category’s debt and have debt-to-assets ratios that indicate some financial stress. It is this minority o f farmers — and their lenders — w ho account for the problem debt. Has the Farm Credit Problem Affected the Economy in Recent Years? The spread between the interest rates on com m er cial paper and Treasury bills — one measure o f the spread between interest rates on private and public debt — appears to reflect a risk premium on privately issued debt. Of the years covered in chart 3, the spread was largest from 1980 through 1982, essentially one continuous period o f econom ic recession.'1This rate spread also w idened for a few months around the time o f the financial crisis at the Continental Illinois Na tional Bank in May 1984, perhaps reflecting investors' concern about the possible consequences o f failure bv Continental Illinois. There is little evidence, however, that the growing farm credit crisis since 1981 has had adverse effects on the economy. Real econom ic activity has been rising since late 1982. Moreover, the spread between the commercial paper rate and the Treasury bill rate gen erally has n a rro w e d following the sharp rise in the failure rate among agricultural banks that began in the second half o f 1984 (chart 31. In fact, since mid-1984, the spread between interest rates on private and pub lic debt instruments o f similar maturity has been as low as at any period since 1978. Thus, w hile this rate spread reflects a risk premium, the risk premium does not appear to be significantly correlated with prob lems in agriculture as suggested by studies warning of a general financial crisis. ECONOMIC EFFECTS OF THE FARM FINANCIAL CRISIS IN THE 1920s Since history frequently repeats itself, w e may learn something by looking back to similar problems in an earlier era. The agricultural sector o f the U.S. econom y experienced a financial crisis during the 1920s that was similar in many respects to farmers’ and farm lenders’ current financial problems. To make this ex perience relevant for an analysis o f the 1980s, w e first 9The average spread between 1975 and 1980 was 52 basis points. This widened to an average of 140 basis points between 1980 and 1982. Since the beginning of 1983, the average commercial paperTreasury bill rate spread has been 40 basis points, with a high of 95 basis points in June 1984 and a low of 7 basis points in July and August 1983. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C h a rt 3 Short-Term Interest Rates must examine some o f the important similarities and differences between the farm crises o f the 1920s and 1980s. U.S. Agriculture before World War I Agriculture accounted for much larger shares of employment and output in the U.S. econom y before World War I than in the 1980s.1" In 1900, for example, about 41 percent o f total em ployment was in the farm sector. The share o f the labor force on farms was declining, falling to just under 30 percent by 1913. In contrast, the farm sector accounted for only 3 percent o f civilian employment in 1981, the year ot the recent peak in farmland prices. During the five years ending in 1901, the dollar value o f farm output accounted for 23.5 percent o f gross ’“Data used in this discussion are taken from the U.S. Department of Commerce (1975). private domestic product. Bv the five years ending in 1921, that percentage declined to 14.5 percent. In contrast, farm output accounted for about 3 percent of gross private domestic product in 1981. These con trasts suggest that adverse developm ents in the farm sector should have had larger effects on the econom y before World War I than in the 1980s. The farm sector was the major export sector o f the U.S. econom y before the war, with farm exports ac counting for 65 percent o f the dollar value o f all U.S. exports in 1901. That share o f total exports declined gradually to 46 percent in 1913, but rose again to 48 percent in 1920. In 1981, agricultural products ac counted for 18.6 percent o f U.S. merchandise exports. The Growing Importance o f Credit fo r Agriculture Several developm ents made the availability o f credit more important for farmers by the late 1800s than it 9 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 Table 2 Farm Mortgage Debt and Its Distribution Among Lenders: 1910-29 Percentage held by Year Total debt (millions of dollars) 1910 1913 1915 1918 1920 1925 1929 $3,207 4,347 4,990 6,536 8,448 9,912 9,756 Federal Land Banks 0.6% 3.5 9.3 12.1 Jointstock land banks * 0.7% 4.5 6.7 Life insurance companies Commercial banks 12.0% 12.7 13.4 14.6 11.5 19.6 21.9 12.7% 15.5 15.0 15.4 14.3 12.1 10.7 Individua and others 75.3% 71.8 71.6 69.3 70.0 54.5 48.5 ‘ Less than 0.1 percent. Source: U.S. Department of Commerce (1975). had been earlier in U.S. histoiy. In the early 1800s, homesteaders could obtain land and becom e farmers relatively cheaply; bv the late 1800s, new farmers had to buy land from other landowners. Farming also became more capital-intensive as specialized machin ery and buildings m ade farm operations more efficient. maturities made farmers more vulnerable to foreclo sure by creditors. Although a farmer experiencing temporary financial distress ordinarily might be able to meet the payments on an outstanding mortgage loan, lenders might not renew the mortgage loan if it matured w hile a farmer was having a financial problem. Prior to W orld War I, farm mortgage credit was available from commercial banks, life insurance com panies, individuals, and others (table 2). The category o f "individuals and others,” which accounted for 75 percent o f farm mortgage credit in 1910, included the farm mortgage loan companies that began operating in the late 1800s. Mortgage loan companies generally w ere funded by investors in the eastern states. These companies em ployed agents w ho w orked in farm communities, accepted mortgage loan applications from farmers and transmitted the loan applications to the mortgage companies for approval." Farmers turned their complaints about the terms o f credit available to them into an important political issue by the early 1900s. Political initiatives by farmers resulted in the passage o f the Federal Farm Loan Act of 1916, which established the Farm Credit Banks under the ownership and supervision o f the federal govern ment. That act also facilitated the developm ent o f joint-stock land banks, which were privately ow ned and managed firms that operated under the supervi sion o f the federal government. These two categories o f federally supervised lending institutions made most o f their farm mortgage loans with maturities o f 33 to 35 years.'4 Table 2 indicates that the Federal Land Banks and the joint-stock land banks did not becom e major farm lenders until the 1920s. Most farm mortgage loans had maturities o f three to five years.'- Maturities o f farm mortgage loans tended to be shortest at commercial banks; about half o f these loans had maturities o f one year or less.1:1Shorter loan "Eichengreen (1984) and Olsen (1925). t2Farmers did not like the terms on which mortgage credit was made available to them. They considered the interest rates on farm mortgage loans to be too high. Many farmers also considered the maturity of farm mortgage loans to be too short. See Eichengreen, Higgs (1971), and Stock (1984). ,3Olsen, pp. 208-19. Digitized for 10FRASER World War I and the Farm Financial Crisis o f the 1920s The farm financial crisis o f the 1920s resulted from the response o f the U.S. agricultural sector to the disruption to agricultural production that occurred in Western Europe during W orld War I. The nations o f '“Olsen, p. 215. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C h a rt 4 N o m in a l V a l u e of Farm Exports Western Europe increased their agricultural imports to replace lost production. This caused the dollar value o f U.S. farm exports to rise sharply during the war and shortly thereafter (chart 4). Prices o f farm products and farmland rose sharply during these pe riods in response to the increase in foreign demand for U.S. farm products. Farmers borrowed substantially during the war to buy land that was rising rapidly in value and to spend more on non-land inputs to expand production. Farm mortgage debt increased from $4.7 billion on Januaiy 1, 1914, to $10.2 billion on Januaiy 1, 1921. Non-realestate farm loans at commercial banks rose from $1.6 billion to $3.9 billion over the same period. U.S. farm exports declined after the war, as farms in Western Europe resumed production (chart 4). The decline in export demand for U.S. farm products con tributed to a reduction in farm prices relative to prices of industrial commodities. This ratio o f farm to non farm prices peaked in 1920, then declined sharply in 1921 (chart 51. The average price o f farmland contin ued to rise through 1920, then declined in each subse quent year through 1928 (chart 6). Declines in the prices o f farm output and the value o f farmland drove many farmers into bankruptcy and many agricultural banks into failure. From 1921 to 1929, an average o f 635 banks failed per year, com pared with an average o f 88 bank failures per vear over the previous 20 years. Charts 5 and 6 compare the declines in prices of farm comm odities and land in the 1920s with those of the 1980s. These comparisons show declines much more severe than what has been obseived so far in the 1980s. First, the relative price o f farm output declined more in the 1920s than in the 1980s (chart 51. Second, there were sharper declines in farmland prices, the collateral base for farm debt, after 1920 than after 1981 (chart 6). Other things equal, these declines would hav e had much greater effects on the ability o f farmers to secure new short-term debt or sustain old debt in 11 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C h a rt 5 Trends in R elative Farm Prices in the 1920s and 1980s N O T E : T he r a t io s p lo t t e d a r e th e G N P d e f la t o r f o r fa r m p r o d u c t s r e la t iv e to th e G N P d e f l a t o r f o r in d u s t r ia l (n o n fa rm ) c o m m o d itie s . R e la tiv e p r ic e r a tio s a r e s e t e q u a l to 1 .0 in 1 9 2 0 a n d 1981. D a t a f o r 1 9 8 5 a re p r e lim in a r y . Chart 6 Prices o f F a r m R e a l E s ta te p e r A c r e R e l a t i v e to P e a k Prices in 1 9 2 0 a n d 1981 Digitized for12 FRASER FEDERAL RESERVE BANK OF ST. LOUIS the 1920s. Finally, with shorter maturities on most o f the farm mortgage credit in the 1920s, the declines in farm prices and land values made farmers more vul nerable to foreclosure then than now. Economic Adjustments to the Farm Financial Crisis o f the 1920s: Implications f o r the 1980s? As noted previously, agriculture’s larger share o f total output in the 1920s implies that problems in the farm sector would have had larger adverse effects on GNP and employment in the 1920s than in the 1980s. Yet the 1920s w ere years o f general econom ic prosper ity. Real GNP rose tit a 4.2 percent annual rate from 1920 through 1929, up from an average o f 3 percent annual growth over the prior 20 years. The number of persons em ployed grew at a ) .8 percent rate from 1920 through 1929, about the same rate as over the prior 20 years. Although general econom ic growth might have been even stronger without agriculture’s problems, the actual econom ic performance certainly meets or exceeds most historical norms. Declines in the prices o f farm output and farmland in the 1920s also had relatively small effects on eco nomic activity in the farm sector. Although farm out put fell sharply in 1921, the index o f overall farm output had regained its previous peak by 1925. Farm output rose at a 1.4 percent annual rate from 1925 through 1929, while real GNP rose at a 3.2 percent rate. Total employment in the farm sector essentially was unchanged in the 1920s; the growth o f employment occurred in the nonfarm sector. How could such a severe deflation in the farm sec tor, with widespread farm bankruptcies, have such small effects on farm output? The answer involves the process o f bankruptcy in our capitalistic econom ic system. When farmers go bankrupt, their land and equipment do not go out o f production; these re sources instead are sold to other farmers at reduced prices. It is the low er prices that make it profitable for other farmers to buy the land and equipment even though prices for farm output are lower. Thus, through the process o f bankruptcy, farm assets are repriced to levels low enough to make their continued use profitable for farmers. Finally, if higher bank failure rates cause an increase in risk premiums on privately issued debt, this effect also should have been stronger in the 1920s than in the 1980s, especially since federal deposit insurance did not exist then. Despite the large number o f bank failures during the 1920s, however, the spread be DECEMBER 1985 tween the commercial paper rate and the yield on short-term Treasuiy securities did not w iden during that decade (chart 71.' Thus, the financial distress in the agricultural sector o f the econom y did not seem to produce an increase in risk premiums on privately issued debt. Individual Bank Failures vs. the Liquidity o f the Banking System The prim aiy reason that the bank failures had such little influence on overall econom ic activity in the 1920s was that the m oney supply grew fast enough to support growth in econom ic activity and to forestall liquidity problems in the banking system as a whole. Deposits in the many failed banks w ere sim ply trans ferred to solvent banks, with no overall reduction in the money stock. Because the quantity o f money is closely related to aggregate spending and econom ic activity, the growth in the m oney stock facilitated growth in overall econom ic activity (chart 8). Although the m oney supply dropped sharply in 1921, during a recession after W orld War I, M l (demand deposits plus currencvl rose at about a 3 percent annual rate from June 1921 through June 1929. This increase facili tated the econom ic growth that occurred over that period, in sharp contrast to the beginning o f the Great Depression (1930-331, which saw the money stock decline at an 11 percent annual rate (chart 81."' CONCLUSIONS Many farmers with high ratios o f debt to assets will go bankrupt unless they receive large government subsidies. Some economists have warned that rising farm bankruptcies w ill cause the failure o f many farm banks and possibly the Farm Credit System. Others even have suggested that farm loan losses are likely to produce a genuine financial crisis unless federal aid is provided. The evidence presented in this article does not support the argument that the farm financial crisis will adversely affect the entire economy. The financial problems o f many farmers have becom e serious since 1981 primarily because the average price o f farmland has declined. The financial problems o f farmers, how ever, have not increased the relative interest rates on ,5The average spread in the 1920s was 127 basis points. The lowest and highest average spreads were 73 basis points in 1928 and 231 basis points in 1920. ,6For a detailed analysis of how declines in the money stock were related to the Great Depression, see Friedman and Schwartz (1963). 13 FEDERAL RESERVE BANK OF ST. LOUIS C h a rt 7 Short-Term Interest Rates C hart 8 Changes in Gross National Product and the M oney Stock Digitized for 14FRASER DECEMBER 1985 DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS all privately issued debt or slowed the growth o f total output. Evidence from the 1920s, a period o f similar crisis in the farm sector, indicates that the farm finan cial crisis of that decade also had no adverse effects on the interest rates on privately issued debt or on overall econom ic growth. If w e want to rationalize govern ment support for farmers with high debt-to-assets ratios, such support should be sought on other grounds. REFERENCES Belongia, Michael T., and Kenneth C. Carraro. “The Status of Farm Lenders: An Assessment of Eighth District and National Trends,” this Review (October 1985), pp. 17-27. Bullock, J. Bruce. "Farm Credit Situation: Implications for Agricul tural Policy,” FAPRI #4-85, (Food and Agricultural Policy Re search Institute, March 1985). Chase Econometrics. “ Economic Impacts of a Farm Credit System Default,” report to the Farm Credit Council, October 1985. American Economic Review (December 1984), pp. 995-1015. "The Farm Slide.” Christian Science Monitor, August 20, 1985. Friedman, Milton, and Anna J. Schwartz. A Monetary History of the United States, 1867-1960 (Princeton University Press, 1963). Higgs, Robert. The Transformation of the American Economy, 18651914 (John Wiley and Sons, 1971). Karr, Albert R., and Charles F. McCoy. "Farm Credit Will Need Massive U.S. Aid in 18 to 24 Months, Chief Regulator Says,” Wall Street Journal, September 6,1985. Olsen, Nils A. et al. “ Farm Credit, Farm Insurance, and Farm Taxation," Agriculture Yearbook 1924, (U.S. Department of Agri culture, 1925), pp. 185-284. Schink, George R., and John M. Urbanchuk. “ Economy-Wide Im pacts of Agricultural Sector Loan Losses," Wharton Econometric Forecasting Associates, July 1985. Stock, James H. “ Real Estate Mortgages, Foreclosures, and the Midwestern Agrarian Unrest, 1865-1920,” Journal of Economic History (March 1984), pp. 89-105. U.S. Department of Agriculture, Economic Research Service. The Current Financial Condition of Farmers and Farm Lenders, Agricul tural Information Bulletin No. 490, March 1985. Drabenstott, Mark, and Marvin Duncan. “ Agriculture s Bleak Out look,” New York Times, August 14,1985. U.S. Department of Commerce, Bureau of the Census. Statistical Abstract of the United States (U.S. Government Printing Office, 1985). Eichengreen, Barry. ________ _ “ Mortgage Interest Rates in the Populist Era,” Historical Statistics of the United States (GPO, 1975). 15 Mergers and Takeovers—The Value of Predators’ Information Mack Ott and G. J. Santoni I f $150 is the p ro p e r “free m arket" value o f a share o f CBS, isn't there something fundamentally wrong with a svstem that values a share at barely half that unless some buccaneer com es along? — Michael Kinsley <4 k^^KEPTICISM about the efficiency ol capital mar kets causes people to be uneasy about corporate mer gers and acquisitions.1In many cases corporate take overs have been criticized for stripping management, labor and owners o f career, livelihood and wealths Even the jargon that is used to describe this method of changing corporate ownership is notable for its value laden terms (see "The Language o f Corporate Take overs” on opposite page). It creates the; impression, perhaps deliberately so, o f innocence on the part of the target — e.g., maiden, defense, white knight — and evil on the part o f the buyer — e.g., raider, stripper, pirate. Why is all o f this brouhaha being raised now? Is the rate or size o f corporate takeovers much larger in the 1980s than in the past and, if so, why? Are takeovers harmful — to the efficient operation o f targeted firms, Mack Ott and G. J. Santoni are senior economists at the Federal Reserve Bank of St. Louis. James C. Poletti provided research assistance. 'Kinsley's statement contrasts with the conventional view of econo mists and financial analysts that stock markets are "efficient” in the sense that asset prices reflect all publicly available information. Changes in individual asset prices, therefore, are caused by changes in information. See, Fama, Fisher, Jensen and Roll (1969); Jensen (1983), (1984); and Jensen and Ruback (1983). 2See Grossman (1985), Lipton (1985), Saddler (1985), Sloan (1985), Werner (1985); for examples of legislative or regulatory proposals, see Rep. Leach on ‘Talking Takeovers" (1985), Domenici (1985), Rohatyn (1985) and Martin (1985). Digitized for 16FRASER to stockholders’ wealth, or to third parties? This article addresses each o f these questions. MERGERS AND ACQUISITIONS — AN HISTORICAL PERSPECTIVE Economic historians identity three major merger waves from 1893 to 1970:1 ill 1893-1904 — horizontal mergers for monopoly fol lowing the Sherman Antitrust Act of 1890, which outlawed collusion, but not mergers; ended bv the Supreme Court's Northern I'rust decision in 1904 which "made it clear that this avenue to monopoly was also closed by the antitrust laws."' 121 1926-30 — horizontal mergers resulting in oligopo lies in which a few large firms dominated an indus try; ended by collapse o f securities markets associ ated with the Depression. 13) mid-1950s-1970 — conglomerate mergers in which corporations diversified their activities through mergers; driven by the Celler-Kefauver Merger Act 11950) which “had a strongly adverse effect upon horizontal mergers” and the financial theory of diversification; the merger wave ended in 1970 with the decline in the stock market, which eroded the equity base for the leveraged purchases.' 3Simic (1984), pp. 2-3; Greer (1980), pp. 142^16. “Stigler (1968), p. 100. 6Stigler, p. 270. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 The Language of Corporate Takeovers Crown Jewel: The most valued asset held bv an acquisition target; divestiture o f this asset is fre quently a sufficient defense to dissuade takeover. Fair Price Amendment: Requires super majority approval o f non-uniform, or two-tier, takeover bids not approved by the board o f directors; can be avoided by a uniform bid for less than all outstand ing shares (subject to prorationing under federal law if the offer is oversubscribed). Going Private: The purchase o f publicly owned stock o f a com pany by the existing or another competing management group; the company is delisted and public trading in the stock ceases. Golden Parachutes: The provisions in the em ployment contracts o f top-level managers that pro vide for severance pay or other compensation should they lose their job as a result o f a takeover. Greenmail: The premium paid by a targeted company to a raider in exchange for his shares of the targeted company. Leveraged Buyout: The purchase o f publicly ow ned stock o f a com pany by the existing manage ment with a portion o f the purchase price financed by outside investors; the company is delisted and public trading in the stock ceases. Lockup Defense: Gives a friendly party (see White Knight) the right to purchase assets o f firm, in particular the crown jewel, thus dissuading a takeover attempt. Maiden: A term sometimes used to refer to the company at which the takeover is directed (targetI. Poison Pill: Gives stockholders other than those involved in a hostile takeover the right to purchase securities at a very favorable price in the event o f a takeover. Proxy Contest: The solicitation o f stockholder votes generally for the purpose o f electing a slate of directors in competition with the current direc tors. Raider: The person(s) or corporation attempting the takeover. Shark Repellants: Antitakeover corporate char ter amendments such as staggered terms for direc tors, super-majoritv requirement for approving merger, or mandate that bidders pay the same price for all shares in a buyout. Standstill Agreement: A contract in which a raider or firm agrees to limit its holdings in the target firm and not attempt a takeover. Stripper: A successful raider who, once the tar get is acquired, sells off some o f the assets o f the target company. Target: The com pany at which the takeover at tempt is directed. Targeted Repurchase: A repurchase o f comm on stock from an individual holder or a tender repur chase that excludes an individual holder; the former is the most frequent form o f greenmail, while the latter is a com m on defensive tactic. Tender offer: An offer made directly to share holders to buy some or all o f their shares for a specified price during a specified time. Two-Tier Offer: A takeover offer that provides a cash price for sufficient shares to obtain control of the corporation, then a low er non-cash (securities) price for the remaining shares. White Knight: A m erger partner solicited by management o f a target w ho offers an alternative merger plan to that offered by the raider which protects the target com pany from the attempted takeover. 17 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C h a rt 1 M e r g e r a n d A cq uisitio n A c tiv ity Relative value of mergers and acquisitions Rate per ----- 1----- ------ 1----- ------1------------1----- ------1----- ------1----- ------1----- ------1------------1----- ------1----- 1965 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 o 1984 S o u rc e s : W .T . G rim m a n d C o m p a n y a n d U.S. S e c u ritie s a n d E x c h a n g e C o m m issio n . Q R a tio o f th e d o lla r v a lu e o f t o t a l m e rg e rs a n d a c q u is itio n s to th e to ta l d o lla r va lu e o f c o m m o n a n d p r e fe r re d s to ck o f a ll p u b lic ly tr a d e d d o m e s tic firm s . [2 R a tio o f th e d o lla r v a lu e o f m e rg e rs a n d a c q u is itio n s o f p u b lic ly tr a d e d firm s to th e to ta l v a lu e o f c o m m o n a n d p r e fe r re d sto ck o f a ll p u b lic ly tr a d e d d o m e s tic firm s . Some have suggested a fourth major wave in the 1980s, perhaps beginning at the end o f the 1970s.BYet, as can be seen in chart 1, the overall rate o f U.S. mergers and acquisitions per 10,000 firms peaked in 1969 at 25. From 1969 to 1975, it declined to slightly less than 10 and has remained there. can be seen, it follows the pattern o f total mergers. Consequently, w hile this latest m erger wave is not as widespread as was the conglomerate m erger wave in terms o f the rate per 10,000 firms, it is notable for the number o f veiy large transactions. An alternative measure o f m erger and acquisition activity is its share as a percentage o f the total value of comm on and preferred stock listed on U.S. exchanges. While this measure also declined sharply at the end of the 1960s, after a trough in 1975, it increased from less than 2 percent to nearly 8 percent in 1984.7For the four years o f available data, chart 1 also shows the mergers of listed firms in relation to the value o f listed stock; as DEREGULATION AND THE CURRENT MERGER WAVE There are basically two explanations that econo mists and other analysts have offered for the current wave o f mergers: (1) the removal o f the U.S. Justice Department's antitrust rules against vertical mergers in 1982 and the relaxing o f rules against horizontal mergers in 1984; (21 the deregulation o f specific indus tries since 1978“ 6Simic, p. 3; Jensen (1984), p. 109. T h e figures for the first half of 1985 imply a similar rate for 1985; see Acquisition/Divestiture Weekly, p. 2095. Digitized for 18FRASER aCouncil of Economic Advisers (1985), pp. 192-95. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 Antitrust Industry-Specific Deregulation1:1 In 1982, the U.S. Justice Department repealed re strictions against vertical mergers, that is, between suppliers and customers. Summarizing this policy, Assistant Attorney General William F. Baxter asserted that “mergers are never troublesome except insofar as they give rise to horizontal problems.”'1 In the same year, constraints on horizontal mergers — mergers between competitors — also were relaxed. Beginning in the late 1970s, a sequence o f changes loosened restrictions in a number o f industries. The Natural Gas Policy Act o f 1978 lessened restrictions on the setting o f well-head gas prices and set in motion their phaseout for most natural gas by 1984; crude oil prices w ere deregulated by an executive order in 1981. Nonetheless, the standard measure o f concentra tion by which the Justice Department assessed the m onopoly pow er in potential mergers continued to be criticized bv economists as inefficiently restrictive: But while horizontal mergers have the clearest anti competitive potential, there are also potential ef ficiency gains from such mergers that the; new anti merger policy may sacrifice. In addition to the obvious possibility of complementarities in production and distribution, managers in the same industiy may have a comparative advantage at identifying mismanaged firms. Bv foreclosing these managers from the market for corporate control, an anti-horizontal merger policy may impair efficient allocation of managerial talent and, perhaps more importantly, weaken significantly the incentive of incumbent managers to maximize the value o f their firms."’ Consistent with view, the Justice Department fur ther relaxed its restrictions on horizontal mergers in June 1984. The Department’s new test for anticom petitive effects takes into account the market shares of all significant competitors, including foreign sellers." Moreover, the new guidelines consider merger-related efficiencies as a positive criterion that may counterbal ance a rise in market concentration. Finally, the new guidelines “permit failing divisions to be sold to direct competitors if the units face liquidation in the near future and a non com petitive acquirer can’t be found. ” ‘- 9Quoted in Stillman (1983), p. 225. '“Stillman, p. 226. "This new test employs the Herfindahl-Hirschman Index of market concentration which is calculated by summing the squares of the individual market shares of all of the firms (domestic and foreign) included in the market. Unlike the four-firm concentration ratio previously used, the new test reflects both the distribution of the market shares of the top four firms and the composition of the market outside these firms. ,2Simic, p. 125. In addition, he notes that divestitures have amounted to between one-third and one-half of corporate acquisitions during the last 10 years (p. 78). Thus, the relaxed antitrust policy has led to greater specialization, a movement exactly opposite to the conglom erate merger wave of the 1960s; see Toy (1985). The Depository Institutions Deregulation and M on etary Control Act o f 1980 and the D epositoiy Institu tions Act o f 1982 made banking and finance more competitive. These acts deregulated interest rates on deposits and allowed thrifts to offer checking ac counts, m oney market accounts and consumer loans. In addition, decisions by the Com ptroller o f the Cur rency (1982) and Federal Reserve Board (19831 permit banks to engage in some insurance activities and to own discount security brokerages. Finally, the Su preme Court has upheld the constitutionality o f re gional interstate banking pacts, which permit com bi nations o f banks in m em ber states. The transportation industry was changed more fun damentally by deregulation than any industrial group beginning with the Airline Deregulation Act o f 1978. Deregulation o f railroad, trucking and household movers follow ed in 1980. These acts reduced entry restrictions in these industries and made it easier to change prices and routes. Beginning in 1982, a sequence of Federal Communi cations Com m ission decisions eased ownership transfers in the broadcasting industiy. In addition, rules w ere relaxed on children’s programming in 1983 and public service or local programming in 1984. Tim e and frequency restrictions on commercials w ere elim inated in 1984. In Decem ber o f that year, the comm is sion replaced its 7—7—7 rule with a 12-12-12 rule — allowing a single corporation to ow n as many as 12 TV, 12 FM, and 12 AM stations as long as the combined audience reached is less than 25 percent o f all televi sion viewers and radio listeners. Mergers and Acquisitions, 1981—84 The 1985 E con o m ic R e p o rt o f the P resident points out that "these recently deregulated industries [bank- 13Details on these deregulatory acts and decisions are contained in the following sources: for the oil and gas industry, Executive Order 12287 (1981), pp. B1-B2; for banking and financial services, Gottron (1981), vol. V, pp. 261-65, also Fischer, et al (1985) and Garcia (1983); for the insurance and insurance agency industries, Felgran (1985), pp. 34-49; for the transportation industry, Gottron, vol. V, pp. 311-13, 331-34, 336-39; for the broadcasting industry, Wilke, et al (1985) and Saddler. 19 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 Table 1 Value of Merger and Acquisition Transactions by Industry, 1981-84 (dollar figures in millions) Industry 1981 1982 1983 1984 1981-84 Oil and Gas Banking, Finance and Real Estate Insurance Food Processing Conglomerate Mining and Minerals Retail Transportation Leisure and Entertainment Broadcasting Other $22,921.6 $ 9,165.5 $12,075.8 $ 42,981.8 $ 87,144.7 4,204.4 7,862.5 3,800.0 809.4 10,850.6 1,844.4 475.3 2,150.4 1,060.1 26,638.9 5,605.3 5,717.8 3,075.2 3,973.6 355.2 1,948.1 1,074.4 1,082.1 787.2 20,970.1 13,628.3 2,966.1 1,163.6 2,745.1 2,946.2 1,489.0 5,254.6 1,797.4 3,747.1 25,267.3 5,846.3 3,005.9 7,094.8 6,982.9 346.7 6,673.2 1,251.8 2,580.7 1,917.9 43,541.7 29,284.3 19,552.3 15,133.6 14,511.0 14,498.7 11,954.7 8,056.1 7,610.6 7,512.3 116,418.0 Total $82,617.6 $53,754.5 $73,080.5 $122,223.7 $331,676.3 Percent of total 26.3% 8.8 5.9 4.6 4.4 4.4 3.6 2.4 2.3 2.3 35.1 Cumulative percentage 26.3% 35.1 41.0 45.6 49.9 54.3 57.9 60.3 62.6 64.9 100.0 100.0% SOURCE: Simic, Tomislava, ed. Mergerstat Review, (W.T. Grim and Company, 1984), p. 41. ing, finance, insurance, transportation, brokerage and investment] accounted for about 25 percent o f all merger and acquisition activity between 1981 and 1983.” " Table 1 shows that deregulated industries continued to dominate the merger and acquisition totals through 1984. Moreover, divestiture sales bv conglomerates reflect a general move away from diver sification and toward specialization, a consequence of relaxed antitrust constraints.13 Thus, eight o f the 10 industrial groupings in table 1 reflect some form o f deregulation. During 1981-84, these industries ac counted for 58.2 percent o f the value o f all reported mergers and acquisitions. OBJECTIONS TO MERGERS AND ACQUISITIONS The recent objections to corporate mergers and acquisitions encompass three fundamental com plaints. Some have claimed that mergers are “totally nonproductive.” "' Others have claimed that stock “ Council of Economic Advisers (1985), pp. 194-95. I5ln particular, sales of divisions by conglomerate corporations first rose to prominence in 1982, then doubled in 1984, the two years of significant antitrust changes discussed above. For more detail re garding the divestiture side of recent mergers and acquisitions, see Toy: also Council of Economic Advisers, p. 195. ,6Lipton; see also Werner, and Sloan. Jensen (1984) quotes the New York investment banker Felix Rohatyn as asserting: “ All this frenzy may be good for investment bankers now, but it’s not good for the country or investment bankers in the long run.” Digitized for 20FRASER holders are harmed.17 Still others have argued that there are significant third-partv effects — such as employment losses, higher interest rates or reduced research activity."* Are Mergers and Takeovers Unproductive? Mergers and takeovers are simply a change in the corporation's ownership. Because these transactions are voluntary, they occur only if the buyer and the seller expect to profit from the transaction. The buyer believes that the firm ’s assets can be used to generate a greater return than they are producing under the current owners. Consequently, the buyer w ill offer to ,7For examples, see Lipton, Minard (1985), p. 41, and Sloan, p. 137. Sloan provides evidence that purports to show that a target’s share holders are often better off when takeovers are unsuccessful (p. 139): We studied 39 cases in which companies successfully re sisted hostile tenders. In 17 cases, the value of the target’s stock at year-end 1984 exceeded what a shareholder would have if the offer had succeeded and the proceeds had been reinvested in the S&P’s 500 Index. (Where a company de feated one offer but was later bought, our calculations run through the acquisition date.) However, if the corporations that were taken over in subsequent attempts (28 of the 39) are excluded from the analysis, the average annual yield to stockholders of the 11 resisting corporations was negative, - 3.2 percent. ’“See Lipton and "Talking Takeovers." DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS purchase the firm at a price high enough to induce the current owners to sell (the seller's reservation price), but low enough not to exceed the expected value of the firm to the buyer under his ownership (the buyer’s reservation price).1'1 Buyers and sellers value the firm differently (have different reseivation prices) because they have differ ent expectations about the stream o f earnings that can be produced with the corporate assets. In part, these expectations depend upon the information that peo ple have about current opportunities as well as forth coming events that w ill affect the demand for the corporations’ product or its cost o f production. Such information is neither uniformly distributed across individuals nor w eighted with the same subjec tive likelihood about its validity or usefulness. Conse quently, people will have different reseivation prices for the same firm. In fact, if everyone had the same reseivation price, there w ould be no inducement to trade. Thus, information is the key to understanding mer ger or takeover activity.-" In some cases, this informa tion may concern the “crown jewel,” that is, a particu lar asset o f the firm that the bidder believes could be em ployed more profitably in some other use. The bidder may plan to gain control o f the firm and strip off (liquidate! the asset.'1On the other hand, this infor- 19A reservation price is the capitalized value of the future stream of earnings that the buyer (seller) expects the firm to generate. Gener ally, the capitalized value of an expected future receipt is calculated by dividing the expected future receipt by the discount factor (1 + r)\ where r is the m a rk e t an n u a l ra te o f in te re s t a n d t is th e n u m b e r of years in the future until the income will be received. In the case of an asset that generates a stream of receipts, summing all such dis counted future receipts gives the present value of the asset, V: V = Sl + __5?__ + __— (1 + r) (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 If the annual receipt is expected to be constant and perpetual, the above equation reduces to V = s/r. “ Indeed, Kinsley quotes James Tobin as offering this explanation: “Takeover mania is testimony to the failure of the market on this fundamental-valuation criterion. . . .Takeovers serve a useful func tion if they bring prices closer to fundamental values.” The market price in an efficient market incorporates all publicly available (and some private) information; Tobin s indictment notwithstanding, the market's nonincorporation of all private information (prior to some one revealing it) cannot be classified as failure. 21For example, Crown Zellerbach’s timber holdings appeared to be the "jewel” in James Goldsmith s plan for the firm. In the case of Trans World Airlines, it was the PARS reservation system and the overseas air routes. mation may be a plan to reduce the firm's cost of production or to change its product line.” Capitalizing on the bidder’s information requires a plan to reorganize the corporation. Only in this way can the bidder obtain the expected increase in the value o f the firm. In essence, the bidder’s information can be thought o f as a way to make the firm more productive or efficient.’ 1The increase in productivity or efficiency can arise from one o f three sources. First, the reorganization may permit greater output from the existing resources with no change in output prices. Second, the reorganization may exploit a change in regulatory constraints in the form o f pro duction or permitted market share. Third, the reor ganization may permit a greater value o f output be cause the current management has not responded appropriately to a change in relative prices. Each o f these is discussed more formally in the appendix. Whichever the source, the fact that the bidder offers to purchase the firm at a price attractive to the current owners can be explained by an increase in the target firm’s profitability under the planned reorganization. Moreover, bv observing the movements of stock prices during and after takeover attempts, the hypothesis of expected increased profitability under reorganization can be tested. If it is valid, there should be significant differences between the price movements of firms that are taken over and those that successfully resist takeovers. Table 2 is a summary o f a number o f individual studies that examine the effect o f takeovers on stock prices. The data are abnormal percentage changes in stock prices for both targets and bidders involved in corporate takeovers. Abnormal changes are those that exceed general movements in stock prices. The data are broken dow n by the type o f takeover technique em ployed (tender offer, merger, proxy contest) and by the success o f the takeover attempt. The individual studies summarized differ in terms o f the period overw hich the returns are measured. For “ An example of reduced production cost is Carl Icahn’s renegotiation of TWA’s labor contracts. It is estimated that, had these renegoti ated contracts been in place during the past year, TWA would have reported a $70 million profit rather than a $56 million loss; see Burrough and Zieman (1985). 23The analysis in this paper assumes that the rise in the value is not due to obtaining monopoly power through merger. All mergers of publicly traded corporations are subject to Justice Department re view to determine possible anticompetitive effects; mergers found to imply anticompetitive conditions are either enjoined or the corpora tions are compelled to divest those subsidiaries resulting in the anticompetitive condition. Conversely, research into recent mergers blocked by the Justice Department suggests that, if anything, anti trust review has been too strict, not too lax; see Stillman. 21 DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS Table 2 Abnormal Percentage Stock Price Changes Associated with Attempted Corporate Takeovers_______________________ Takeover technique Successful Target Unsuccessful Bidders Target Bidders Tender offers 30% 4% -3 % -1 % Mergers 20 0 -3 -5 8 N.A. Proxy contests 8 N.A. SOURCE: Jensen, Michael, and Richard S. Ruback, Journal of Financial Economics, (April 1983), pp. 7-8. NOTE: Abnormal price changes are price changes adjusted to eliminate the effects of marketwide price changes. successful tender offers, the period was roughly one month before to one month after the offer. For suc cessful mergers, the price change was measured from about one month before the offer to the offer date. For unsuccessful takeovers, the measurement period runs from about one month before the offer through the announcement that the offer had been terminated. The data indicate a statistically significant increase in the stock prices o f targets when the takeover was successful.’ 4 The above discussion suggests that the rise in capital value can be explained bv an increase in the firm ’s future stream of profits that investors expect to result from its reorganization by the bidder. Rudelv stated, the rise in value is not simply the result of a speculative craze induced by the knowledge that an outside bidder is attempting to gain control o f the firm. The latter explanation is lurking in Kinsley's critique. Fortunately, there is some evidence that helps dis criminate between the two alternative explanations. First, in a proxy contest, there is no outside bidder to start a "speculative” snowball. Rather, a proxy contest is an internal takeover attempt by some o f the existing stockholders. An alternative slate o f directors is pro posed and its proponents attempt to oust the existing board. Yet successful proxy contests result in a statisti- 24Each of the individual studies summarized in table 2 found statisti cally significant positive abnormal returns. See Jensen and Ruback (1983), pp. 7-16. Furthermore, Bradley, Desai, and Kim (1983), one of the studies summarized in table 2, conduct a detailed study of unsuccessful tender offers, segmented into those targets that did and did not receive offers during the subsequent five years. They found that the cumulative average abnormal return for the targets that received subsequent offers is 57.19% (t = 10.39). In contrast, the average abnormal return over the same period for targets that did not receive subsequent offers Is an insignificant -3 .5 3 % (t= -0 .3 6 ): this return includes the announcement effects. 22 callv significant abnormal return for the firm (see table 2)5' Second, in contrast to unsuccessful merger’s and tender offers, which leave the stock prices o f targets statistically unchanged, unsuccessful proxy contests result in statistically significant positive abnormal returns. These contrasting results are important because they illuminate the role played by information in changing the stock price. In the case of an outside takeover attempt, the bidder has eveiy incentive to keep his special information or reorganization plan secret so that he may acquire the stock cheaply. Con sequently, if the target is not taken over (either initially or in subsequent attempts), the price o f the stock returns to its original level since other investors have learned nothing in the process (see footnote 24). In contrast, in a proxy contest, the cost to the instigators of revealing their special information is lower. Since they own substantial shares o f the firm they are less likely to be concerned about acquiring additional shares and revealing their plan may aid in obtaining support from other stockholders. Thus, the special information is more likely to be revealed in proxy contests, and it is this information that raises the firm's present value even though the contest may not have succeeded in ousting the existing board. Are Stockholders Harmed by Mergers and Takeovers? The evidence reviewed above shows that the values o f target firms rise in takeover attempts, im plying that owners o f targeted firms experience wealth gains in the event of a successful takeover. On these grounds, it 25See Jensen and Ruback, p. 8. DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS is difficult tu claim, as some have, that existing owners are harmed by successful takeovers. N or does it ap pear to be the case that the owners o f targeted firms are harmed bv unsuccessful takeovers (the small nega tive abnormal returns earned by targets in unsuccess ful tender offers and mergers are not statistically sig nificant). Targets o f unsuccessful proxy contests earn significantly positive abnormal returns. While this evi dence is inconsistent with shareholder harm, some have criticized takeovers on other grounds. These are considered below. Two-tier offers. Since mergers and takeover at tempts are aimed at acquiring corporate control, the bidder frequently offers a higher price, in cash, for shares necessaiy to obtain a majority holding, then a low er price, in securities, for the remaining shares. Some allege that this two-tier offer is an attempt to frighten shareholders into tendering their shares rather than holding on for a possibly higher-valued offer later. Yet, even if this w ere true, the value o f the stock w ill rise relative to its pre-takeover level so the issue is the distribution o f the gain among sharehold ers, not o f harm.-1. Management Self-Interest and Golden Para chutes. Management w ill seek the highest bid for the firm's shares if their wealth depends heavily on this effort. Generally this is the case; most o f top manage m ent’s compensation is in equity terms, not cash salaiy.-7 Moreover, the so-called golden parachute ^Council of Economic Advisers (1985), pp. 204-05: In addition, two-tier tender offers can be desirable for target stockholders and managements. SEC data show that two-tier offers are used in friendly takeovers about as often as they are used in hostile takeover attempts. There are at least two reasons that target stockholders could prefer a two-tier bid. If a two-tier offer is properly structured, target stockholders who accept securities in the back end of the transaction may be able to defer tax due on the appreciated value of their shares. In addition, the acquirer may find that it is easier to finance the transaction by issuing securities for the back end than by borrowing funds from banks or through other financing mech anisms. If these savings induce the bidder to offer a higher blended premium, then the two-tier offer can also be beneficial for the target s stockholders. 27Lewellen (1971) found that after-tax executive compensation for large U.S. manufacturing firms for both chief executives and the top five executives was primarily from (1) stock-based remuneration, (2) dividend income, and (3) capital gains, with (4) fixed dollar remuner ation being relatively minor in comparison. In particular, over the period 1954-63 the average annual ratio of [(1) + (2) + (3)]/(4) ranged from 2.123 to 7.973 for chief executives and from 1.753 to 8.669 for the top five executives in large U.S. manufacturing corpo rations (Lewellen, pp. 89-90). Moreover, these executives, on aver age, had large stock holdings in their own corporations — $341,437 to $3,033,896 during 1954-63 — and were not active sellers (Lewel len, p. 79). may be thought o f as a guarantee that management will be rewarded for obtaining a high bid (one that is acceptable to the owners). Its purpose is to assure that management will not im pede the auction. Corporate Charter Changes — Shark Repellants. If takeover attempts w ere harmful to shareholder in terests, changes in corporate charters that make take overs more difficult should raise the share prices of firms passing these amendments. A recent study by the Securities and Exchange Commission, however, finds a statistically significant 3.0 percent decline in the average price o f 162 corporations passing certain kinds o f antitakeover amendments.® Hole o f Institutions and Other Fiduciaries. A final piece o f evidence suggesting that takeovers do not harm shareholders is the voting behavior o f institu tional holders and other trustees. The SEC study just cited found that “ institutional stockholdings are lower on average for firms proposing the most harmful amendments.” That is, the institutional holdings of stock w ere smaller in corporations proposing anti takeover restrictions than in corporations that had not proposed such restrictions.-'1 Recently, administrator’s o f pension fund invest ments have begun to favor rather than oppose the auction process entailed in a takeover attempt. In particular, California’s state treasurer, Jesse Unruh, has formed a Council o f Institutional Investors (CII) to combat antitakeover abuses, which he views as depriv ing the institutional funds o f profitable opportuni ties."1As CII co-chairman Harrison Goldin, N ew York Citv comptroller, put it, “Should Mr. Pickens, Mr. Icahn, the Bass brothers or others care to hold an open auction for anv o f the stocks held by my pension funds, I would not want to restrain them.”" Furthermore, fiduciaries opposing takeover bids have been held liable for the loss o f stock value: . . . a judge ruled that trustees who helped Grumman Corp. frustrate a takeover hid bv LTV Corp. in 1981 ^Jarrell, Poulsen, and Davidson (1985). The study distinguishes between “fair price amendments" (requiring super majority share holder approval in the case of a two-tier offer) and other shark repellants — classified boards, authorization of blank-check pre ferred stock, and super majority amendments for approval of any merger or tender offer regardless of whether it is a two-tier offer. The fair price amendments had no effect on stock prices while the others lowered stock prices significantly. 29Jarrell, Poulsen, and Davidson (1985), pp. 44-46. “ Smith (1984). 3,Makin (1985), p. 212. 23 DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS were personally liable for damages because they didn't act in the best interests of family beneficiaries for whom they held Grumman stock in trust.“ Third-Party Effects Critics o f the recent wave o f mergers and takeovers frequently allege that they have “third-party’’ effects that damage the economy, individuals or regions in ways not measured bv changes in corporate value or stockholder returns.'1To a certain extent, this is true but such costs typically accompany innovations: For example, innovations that increase standards of living in the long run initially produce changes that reduce the welfare of some individuals, at least in the short run. The development of efficient truck and air transport harmed the railroads and their workers; the rise of television hurt the radio industiv. New and more efficient production, distribution, or organiza tional technology often imposes similar short-term costs. The adoption of new technologies following take overs enhances the overall real standard of living but reduces the wealth of those individuals with large investments in older technologies. Not surprisingly, such individuals and companies, their unions, com munities, and political representatives will lobby to limit or prohibit takeovers that might result in new technologies. When successful, such politics reduce the nation’s standard of living and its standing in international competition." Labor Displacement. The argument that em ploy ment is low ered by mergers and takeovers appears to be based on the belief that plant closings and consoli dations inevitablv follow and that labor demand must therefore decline.1' However, if output expands as a result o f the reorganization, wages as well as the number o f jobs may increase. Even when employment cutbacks are associated with mergers and takeovers, such effects apparently have been overcom e by other forces: Payroll em ployment growth during the current expansion has been at a 3.68 percent rate (November 1982-October 1985) compared with a 3.39 percent rate “ Stewart and Waldholz (1985), p. 13. 33The “ lost jobs” argument has been raised by Rep. Leach; in “ Talk ing Takeovers” ; the "financial destabilizing” argument by Rohatyn (1985), Domenici, Lipton, and President Hartley of Unocal Corp in Minard (1985); the “ shortened planning horizon” by Lipton (1985), Hartley, and Leach. MJensen (1984), p. 114. 35ln some cases, wage, salary and benefit schedules exceeding labor productivity may be the cause of low corporate value. The potential for reorganization through a takeover and an increase in efficiency would then entail either a reduction in wages or a reduction in labor use. In the TWA takeover, it was the former (see footnote 22); in the AMF takeover by Minstar Corp., it was the latter. See Ehrlich (1985). 24 during econ om ic period."1 expansions over the 1970-81 Adverse Effects on Capital Markets. One allegation frequently made about the impact o f takeovers on capital markets is that the extra demand for credit to finance takeovers raises interest rates and crowds out productive investment. This critique is specious. Takeovers and mergers are productive lin that asset values rise I. Any crowding out that occurs is o f less productive investment. Moreover, the funds obtained bv the bidders are transferred to the sellers who can reinvest them. Consequently, there is no reason to expect interest rates to change.17 Neglect o f Long-Term Planning. Several critics have argued that takeover threats force management to concentrate on projects that raise earnings in the near term at the cost o f long-range planning, in particular, research and development. For example, the chair man o f Carter-Hawlev-Hale department stores said that takeover activity causes management to "take the short-term view and to neglect what builds long-term values.”1 "1This implies a serious inefficiency in capital markets, since capital values are expected future re turns discounted to the present. This short-term focus is said to be im posed by institutional shareholders w ho view current earnings as more important than capital appreciation; evi dence, however, demonstrates the opposite. Jarrell and Lehn o f the SEC found that institutional investors tended to prefer higher rather than low er research and investment expenditures. More to the point, they found that, o f the 217 firms that w ere takeover targets during 1981-84, 160 reported that research and devel opment expenditures were “ not material," w hile the remaining 57 had research and developm ent expendi ture rates less than half the averages in their respective industries. Finally, Jarrell and Lehn also found significant an nouncement effects attending new research and de velopment projects: Our study examined the net-of-market stock price reaction to 62 Wall Street Journal announcements “ Payroll employment growth rates during each of the preceding economic expansions of the 1970-81 period were as follows: 3.48 percent during November 1970-November 1973; 3.62 percent dur ing March 1975-January 1980; 2.00 percent during July 1980-July 1981. 37See Martin, p. 2. “ Work and Peterson (1985), p. 51; see also Drucker (1984), Lipton, Rohatyn, and Sloan. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 between 1973-1983 that firms were embarking on new R&.D projects. These tests show that, on average, the stock prices of these firms increased (1% to 2%) in the period immediately following the publication of these stones.-"1 Thus, the market appears to reward rather than pun ish the long-term view; takeovers are most frequent in firms that have ignored the long term. As Joseph observes: "If you take the best-run companies, they typically make long-term commitments, and they sell at decent multiples. IBM is not a target. ITT is a target, because it hasn't managed its businesses veiy well. So ITT is complaining that it can't plan long term because o f the sharks.” 1" Drucker, Peter F. “ Taming the Corporate Takeover," Wall Street Journal, October 30, 1984. Ehrlich, Elizabeth. "Behind the AMF Takeover: From Highflier to Sitting Duck,” Business Week (August 12, 1985), p. 50-51. Executive Order 12287, 1981, United States Code, Congressional and Administration News. Fama, Eugene F., Larry Fisher, Michael C. Jensen, and Richard Roll. “The Adjustment of Stock Prices to New Information,” Inter national Economic Review (1969, No. 10), pp. 1-21. Felgran, Steven D. “ Banks As Insurance Agencies: Legal Con straints and Competitive Advances,” New England Economic Re view (September/October 1985), pp. 34-49. Fischer, Thomas G., William H. Gram, George G. Kaufman, and Larry R. Mote. “The Securities Activities of Commercial Banks: A Legal and Economic Analysis,” Federal Reserve Bank of Chicago, Staff Memoranda S M -85-2,1985. Garcia, Gilian. “ Financial Deregulation: Historical Perspective and Impact of the Garn-St Germain Depository Institutions Act of 1982," Federal Reserve Bank of Chicago, Staff Study 83-2,1983. CONCLUSION We have examined three criticisms o f corporate takeovers: II that mergers and takeovers are unpro ductive, 2) that stockholders are harmed, 3) that third parties are harmed. Both theory and evidence suggest that resource values rise and, consequently, stock holders generally benefit from takeover activity. Both are consistent with the proposition that takeovers are expected to result in a more efficient use o f the target’s assets. As with anv econom ic change, third-partv ef fects probably exist. Negative em ployment effects, higher interest rates or neglect o f long-term planning, however, do not seem to be caused by m erger and takeover activity. These potential third-party effects do not appear to be important and do not establish a case for additional constraints on corporate ownership transfers. Since takeovers contribute to the efficient working o f capital markets, policy or legislative initia tives to im pede takeovers should bear the burden of proving the harm they propose to ameliorate. Greer, Douglas F. Industrial Organization and Public Policy (MacMillan Publishing Co., 1980). Grossman, Harry I. 1985. Letter to Editor, Wall Street Journal, April 14, Grotton, Martha V. Congress and the Nation (Congressional Quar terly, Inc., 1981), vol. 5. Hirshleifer, Jack. 1976. Price Theory and Applications (Prentice Hall) Jarrell, Gregg, and Kenneth Lehn. “Takeovers Don't Crimp LongTerm Planning,” Wall Street Journal, May 1, 1985. Jarrell, Gregg, Annette Poulsen, and Lynn Davidson. “ Shark Repellants and Stock Prices: The Effects of Antitakeover Amendments Since 1980,” Office of the Chief Economist, Securities and Ex change Commission, July 1985. Jensen, Michael C., ed. "Symposium on the Market for Corporate Control: The Scientific Evidence,” Journal of Financial Economics (April 1983). ________ _ "Takeover: Folklore vs. Science,” Harvard Business Review (November-December 1984), pp. 109-21. Jensen, Michael C. and Richard S. Ruback. “ The Market for Corpo rate Control: The Scientific Evidence,” Journal of Financial Eco nomics (April 1983), pp. 5-50. Kinsley, Michael. “You Won’t Find An Efficient Market on Wall Street,” Wall Street Journal, July 18, 1985. REFERENCES Quality Services, Lewellen, Wilbur G. The Ownership Income of Management (Co lumbia University Press, 1971). Bradley, Michael, Anand Desai, and E. Han Kim. "The Rationale Behind Interfirm Tender Offers: Information or Synergy?” Journal of Financial Economics (April 1983), pp. 183-206. Lipton, Martin. "Takeover Abuses Mortgage the Future," Wall Street Journal, May 4, 1985. The Acquisition and Divestiture Weekly Report. October 7, 1985. Burrough, Brian, and Mark Zieman. “ Investor Icahn Lifts TWA Stake to 40.6% And Is Said to Be Purchasing More Shares," Wall Street Journal, August 7,1985. Council of Economic Advisers. Economic Report of the President (U.S. Government Printing Office, 1985), chapter 6. Domenici, Pete V. "Fools and Their Takeover Bonds," Wall Street Journal, May 14, 1985. Makin, Claire. “ Is the Takeover Game Becoming Too One-Sided?", Institutional Investor (May 1985), pp. 207-22. Martin, Preston. Statement to Subcommittee on Oversight and Se lect Revenue Measures of U.S. House Ways and Means Commit tee, April 16, 1985, (B.I.S. Press Review, No. 88). Minard, Lawrence. “ Millions for Defense NotOne Cent for Tribute," Forbes (April 8, 1985), pp. 40-46. Rohatyn, Felix G. “Junk Bonds and Other Securities Swill,” Wall Street Journal, April 18,1985. 39Jarrell and Lehn (1985). “ Sloan, p. 139. Saddler, Jeanne. “ Storer Dissidents’ Bid for Board Control Clears Hurdle in 3 -2 Decision by FCC,” Wall Street Journal, December 4, 1985. 25 FEDERAL RESERVE BANK OF ST. LOUIS Simic, Tomislava, ed. pany, 1984). DECEMBER 1985 Mergerstat Review (W.T. Grimm and Com “Talking Takeovers.” McNeil-Lehrer News Hour, Transcript 2518 (May 22, 1985), pp. 3-8. "Why Is No One Safe?” Forbes (March 11,1985), pp. Toy, Stewart. “ Splitting Up, the Other Side of Merger Mania," Busi ness Week (July 1, 1985), pp. 50-55. Smith, Randall. “ California Official Moves to Organize Pension Funds to Combat Greenmail,” Wall Street Journal, July 26, 1984. U.S. Securities and Exchange Commission. Fiftieth Annual Report, 1984 (GPO, 1984), p. 112. Stewart, James B., and Michael Waldholz. "How Richardson-Vicks Fell Prey to Takeovers Despite Family’s Grip,” Wall Street Journal, October 30,1985. Werner, Jesse. Sloan, Allen. 134-40. Letter to Editor, Wall Street Journal, April 16,1985. The Organization of Industry (Richard D. Irwin, Wilke, John, Mark N. Vamos, and Mark Maremont. “ Has the FCC Gone Too Far?” Business Week (August 5, 1985), pp. 48-54. Stillman, Robert. “ Examining Antitrust Policy Towards Horizontal Mergers," Journal of Financial Economics (April 1983), pp. 225-40. Work, Clemens P., and Sarah Peterson. “The Raider Barons: Boon or Bane for Business?” U.S. News and World Report (April 8, 1985), pp. 51-54. Stigler, George J. Inc., 1968). APPENDIX Bidder's Information; Productive Capacity, and Stock Values There are three distinct cases in which the bidder’s plan for reorganizing the corporation — based on the bidder’s information — could in crease the value o f the corporation. These cases are: 1) using the corporation’s physical capital more productively; 2) changing production techniques to reflect a change in regulatory constraints; 3) changing the output mix to one more profitable given changes in relative output prices. In each o f the three cases, the corporation is assumed to produce two goods, X and Y, with a concave production function continuously differ entiable in the two factors capital (K) and labor (L). Capital, which is e x 100 percent equity-financed and (1-e) X 100 percent debt-financed, is assumed to be fixed, but some capital, K„, may be idle; labor is variable. Factor use is determ ined by wages, inter est and product prices. The corporation is assumed to be a price taker in both factor and output mar kets.1Thus, (1) Q = IX,Y] = F (K,L) (2) K = Kx + Kv + K„ dx = wdY = wdx = j^ ’ dL ~ Px’ dL _ Pv’ dK “ Pv dK = _L P,‘ These factor-use equations, (3), for labor in X and Y or capital in X and Y production im ply 14, dV _ _ dX [\ and, com bined with the fixed capital stock 12), allow us to represent the corporation’s efficient produc tion choice as in figure A l . The relationship shown is concave with respect to the origin. While our assumptions do not rule out a linear or convex relationship, these latter two configurations would imply corner solutions (the firm concentrates on one product). Most large corporations are multi product producers im plying a concave production frontier. The relative price line tangent at E„ is also the isovalue line whose X-axis intercept X„ multiplied by Pxgives the value of output at E„, PxX„. At point E„, production is [X0, Y„] and corporate econom ic profit (5) tt„ = PVY„ -I- I\X„ - WL, - rK 'The analysis ignores quirks in the tax code that may play a role in some takeovers. A uniform corporate income tax, however, has no qualitative effect on the results. Digitized for26 FRASER = PxX0 - WL„ - rK. Note that it., may be positive, zero or negative. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 F ig u r e A 2 F ig u r e A1 The corporation's equity is just K - (1-e) K = eK, (101 V , = ^ + eK; r and the shareholders receive earnings, dividends plus retained earnings, (7) s0 = tt0 + reK. (8) V 0 = -° = — H- e K . r A corporation with negative takeover. tt„ is a candidate for For a more detailed presentation, see Hirshleifer (1976), chapter 7, and appendix A3. AI. Bidder’s Information: Reorganize Production to Increase Output The reorganization increases the corporation's capacity to produce X relative to Y as shown in figure A2. The output mix shifts from [X„,Y„] to [X„Y,] entailing a decline in Y production. Corporate eco nomic profit rises from -rr0in (5) to tt„ (9) Tt, = P,Y, + PVX, - WL, - r K = PNX, - WL, - rK, from (5), (8), (9) and (10) this is an increase o f (11)AV = This implies a value (VI for the corporation o f r and corporate value from V„ to V„ -iP sIX,-X„) - W (L, —L„)], which by (3) and the assumption o f concavity must be positive. All. Bidder’s Information: Change Output Mix in Response to Deregulation As shown in figure A3, deregulation — whether on input use or output mix — changes the produc tion function from F„(K,L) to F(K,L). That is, instead o f being kinked at E„, the function is now smooth as the regulatoiy constraint is lifted. The adjustment from E„ to E, results from the same logic as in AI. Also, the rise in value is formally as in (11). AIII. Bidder’s Information: Change in Output Mix in Response to Change in Relative Output Prices As shown in figure A4, a change in relative output 27 FEDERAL RESERVE BANK OF ST. LOUIS Figure A 3 prices, where X rises in value relative to Y, should induce a shift in production and corporate organi zation from E„ to E,. The adjustment from E„ to E, follows the same logic as in AI and corporate value again rises according to 111). Note that this com par ison is o f production mixes a fte r the price change. Thus, the value o f output at E„ is not as large as E, 28 DECEMBER 1985 Figure A 4 under the new prices; the value at E„ at the old prices was greater than at E, at the old prices. Consequently, the rise in corporate value in reor ganizing from E„ to E, is due to E„ not being a maximal value mix under the new prices and by existing management’s failure to recognize it. New Seasonal Factors for the Adjusted Monetary Base R. Alton Gilbert T HE February 1984 adoption ot contemporaneous reserve requirements (CRR), which changed the tim ing between deposit liabilities and required reserves, has altered the seasonal patterns in the adjusted m on etary base (AMB).1Weekly variability in the AMB has been substantially higher since that date, which sug gests that seasonal factors based on past data do not reflect the seasonal patterns in the AMB under CRR.This article describes a new m ethod o f deriving sea sonal factors for the AMB that reflects the timing o f reserve accounting under CRR.;i requirements bv the Federal Reserve.4 RAM is the difference between the reserves that w ould be required (given current deposit liabilities) if the base period’s reserve requirements were in effect and the reserves that are actually required given cur rent reserve requirements. Adding RAM to the source base produces a series that shows what the source base w ould have been in each period if reserve re quirement ratios had been those o f the base period/' This procedure converts the impact o f reserve require ment changes into equivalent changes in the source base, holding reserve requirements constant." THE CALCULATION OF THE ADJUSTED MONETARY BASE The AMB is designed to be a single measure o f all Federal Reserve actions, including changes in reserve requirements, that influence the m oney stock. It is equal to the source base plus a reserve adjustment magnitude (RAM) that accounts for changes in reserve ft. Alton Gilbert is an assistant vice president at the Federal Reserve Bank of St. Louis. Paul G. Christopher provided research assistance. 1A general description of CRR appears in Gilbert and Trebing (1982). 2The average absolute value of weekly changes in the AMB from January 1982 through January 1984 was $492 million. This mea sure of weekly variability was $1,723 million for the period February 1984 through December 1985, more than three times larger than in the earlier period. 3An earlier paper by Farley (1984) presents a different method of deriving seasonal factors that reflect the timing of reserve account ing under CRR. 4The following articles describe and explain the AMB in greater detail: Gilbert (1980,1983 and 1984) and Tatom (1980). 5The source base equals the reserve balances of depository institu tions with Federal Reserve Banks, which excludes their required clearing balances and balances held to compensate for float, plus total currency in circulation, whether held by depository institutions or the public. It is derived from the combined balance sheets of the Federal Reserve Banks and the U.S. Treasury. 6The base period for calculating RAM is January 1976 through August 1980. Base period reserve requirements are the average reserve requirements over that period for two categories of deposit liabilities: transaction deposits and total time and savings deposits. For member banks, the average required reserve ratio was 12.664 percent on transaction deposits and 3.1964 percent on total time and savings deposits. For nonmember institutions, base period reserve requirements were zero, since they were not subject to reserve requirements of the Federal Reserve in the base period. Thus, RAM is calculated as the current transaction deposits of member banks multiplied by 0.12664, plus the current total time and savings deposits of member banks multiplied by 0.031964, minus the current required reserves of all depository institutions. 29 FEDERAL RESERVE BANK OF ST. LOUIS Under the Prior System o f Lagged Reserve Requirements Calculation o f the AMB under lagged reserve re quirements ILRR) is illustrated in equations 1 through 3. Definitions o f the terms in these equations are presented in table 1. Equation 1 shows how RAM is calculated for each reserve maintenance period under LRR. (II RAM, = BRTR (TR, l4l + BRTS (TS,_U) - RR, The source base is equal to total currency outstand ing (that held by the public and in the vaults of depositoiy institutions) plus the reserve balances o f depositoiy institutions. Under LRR, the items that could be used to meet required reserves in the current mainte nance period w ere reserve balances held in the cur rent period (RB,) plus vault cash held in the week ending 14 days earlier (V, l4). This sum is thus equal to required reserves (RR,) plus excess reserves (E,). Conse quently, the source base can be expressed as shown in equation 2. 12) SB, = CP, + V, + RB, = CP, + V, + RR, + E, - V, ,, Thus, the AMB under LRR is shown in equation 3. (3) AMB, = SB, + RAM, = CP, + E, + V ,-V ,,, + BRTR (TR,..,.,) + BRTS (TS,_,4) Under the Current System o f Contemporaneous Reserve Requirements (C R R ) The reserve maintenance periods, during which average reserves must equal or exceed required re serves, have been lengthened under CRR to two-week periods ending every other Wednesday. Required re serves on transaction deposits for the current twoweek maintenance period are based on daily average transaction deposits for the 14-day period ending two days before the end o f the current maintenance pe riod. In contrast, required reserves on time and sav ings deposits are based on daily average deposits over a 14-day period ending 30 days before the end o f the current maintenance period. The assets o f depositoiy institutions that count toward m eeting their reserves in the current maintenance period are their reserve balances in the current maintenance period plus aver age vault cash over the 14-day period ending 30 days before the end o f the current maintenance period. Equation 4 illustrates the calculation o f the AMB un der CRR. 30 DECEMBER 1985 Table 1 Definitions of Terms Used in Specifying the Adjusted Monetary Base___________ SB, — the source base over the maintenance period ending on day t RAM, — reserve adjustment magnitude for the maintenance period ending on day t BRTR — base period required reserve ratio on the transaction deposits of member banks TR,-,* — transaction deposits of member banks in the week ending 14 days before day t BRTS — base period required reserve ratio on the time and savings deposits of member banks TSM4 — time and savings deposits of member banks in the week ending 14 days before day t RR, — required reserves of all depository institutions in the maintenance period ending on day t RB, — balances of depository institutions in their reserve accounts at Federal Reserve Banks in the mainte nance period ending on day t V, — vault cash of depository institutions in the mainte nance period ending on day t V,_,4 — vault cash of depository institutions in the week ending 14 days before the end of the current maintenance period. E, — excess reserves in the maintenance period ending on day t; prior to the imposition of reserve requirements of the Federal Reserve on all depository institutions in 1980, it includes the vault cash of nonmember institu tions, held in the week ending 14 days earlier CP, — currency held by the public in the maintenance period ending on day t TR ,- 2 — transaction deposits of member banks over the 14 days ending two days before the end of the current maintenance period TSM0 — time and savings deposits of member banks over the 14 days ending 30 days before the end of the current maintenance period V,_3q — vault cash over the 14 days ending 30 days before the end of the current maintenance period (4) AMB, = SB, + RAM, = CP, + E, + V, - V, -I- BRTR (TR,.,) + BRTS (TS, „,) EFFECTS OF CRR ON SEASONAL PATTERNS IN THE AMB If the seasonal patterns o f transaction deposits and time and savings deposits are not changed by the FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 C h a rt 1 S e a s o n a lly A d ju s te d M o n e t a r y Base Old and Revised Series Billions of dollars Billions of dollars 1984 1985 NOTE: The o ld s erie s is w e e k ly ; the re vise d series is b iw e e k ly , c o v e rin g re se rve m a in te n a n c e p e rio d s . switch from LRR to CRR, seasonal movements in the AMB will be different under CRR. For example, an increase in transaction deposits w ill lead to a rise in the AMB about two weeks earlier' under CRR than under LRR. In contrast, a rise in time and savings deposits w ill lead to a rise in the AMB about tw o weeks later under CRR than under LRR. Through 1985, seasonal factors for the AMB were derived by applying the X - ll seasonal adjustment program to past AMB data, the bulk of which were for the period prior to February 1984.7 Thus, these data are generally inappropriate in calculating seasonal factors for the period since February 1984. Alternative seasonal factors for the period since February 1984, however, can be derived by a simple procedure. The procedure requires the calculation of a counterfactual AMB series for several years prior to February 1984 that reflects what the AMB’s seasonal patterns w ould have been if CRR had been in effect T h e weekly seasonal factors for the AMB are derived from a version of the X-11 program that has been modified by the staff of the Federal Reserve Board to derive weekly seasonal factors from monthly seasonal factors. during the earlier period. The counterfactual AMB series is derived by adding to the AMB (as calculated before February 1984) the adjustments necessary to convert the timing of reserve accounting to that under CRR. Equation 5 shows how this counterfactual AMB series is derived. N ote that equation 5 reduces directly to equation 4 when components with opposite signs are cancelled. 15) AMB, = CP, + E, + (V,-V,_14) + BRTR ITR, l4) + BRTSITS, ,,) + <V,_,4-V,_3„I + BRTR (TR,_, - TR, + BRTS (TS,_ „, - TS, ,,) The counterfactual AMB series for periods prior to February 1984 is calculated as shown in equation 5, with one modification. The modification involves an adjustment for the change in the timing o f reserve accounting on vault cash (V ,,, - V, ,,,). The term V,_14is for weeks ending on Wednesdays, whereas V , i s for weeks ending on Mondays. The time series currently maintained on weekly vault cash is for weeks ending on Mondays, which is available back to 1975. An ap proximation to (V,_14—V,_.„,) in equation 5 is derived as (V, ,6- V , u s i n g data on the vault cash o f all com m er cial banks from 1975. The counterfactual series on the 31 DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS C h a rt 2 M l M u lt ip lie r Old and Revised Series Ratio 2.68 Ratio 2.68 2.64 2.60 2.56 2.52 F M A M J J A S O N D J 1984 F M A M J J A S 1985 N OTE: The o ld s erie s is w e e k ly ; the re vise d series is b iw e e k ly , c o v e rin g re se rve m a in te n a n c e p e rio d s AMB does not include an adjustment for the change in the timing o f reserve accounting for vault cash in the years 1969 through 1974. The counterfactual AMB se ries for several years prior to Februaiy 1984 is com bined with the AMB as calculated since Februaiy 1984. Seasonal factors are derived from this series and ap plied to the AMB, not seasonally adjusted, since Feb ruary 1984“ Much o f the increase in short-run variability in the AMB since Februaiy 1984 is elim inated by using sea sonal factors based on the counterfactual series. Fur thermore, AMB data for the two-week reserve mainte- 8The counterfactual observations for the AMB in periods prior to February 1984 are calculated for weekly periods. For the purpose of calculating seasonal factors, observations on the AMB since Febru ary 1984 are calculated for each week (seven-day periods ending on Wednesdays), by adding the source base for the week to the biweekly observation for RAM that includes that week. The X-11 program is used to derive weekly seasonal factors from this weekly series. The weekly seasonal factors are used for calculating the biweekly observations for the AMB, seasonally adjusted, since February 1984. Data on the transaction deposits and on time and savings de posits of member banks are available for weeks ending on Mondays since 1979. Data from 1979 through 1985 provide enough weekly 32 nance periods are less variable than in the weekly data. Chart 1 shows the difference between weekly data on the AMB as published through 1985 and the biweekly series with the n e w seasonal factors based on the counterfactual method. Chart 2 presents a similar contrast between the alternative M l multipli ers. Table 2 indicates a low er incidence o f large changes with the alternative seasonals, especially for the biweekly series. CONCLUSIONS The weekly adjusted monetary base has been more variable since the Federal Reserve adopted contem po raneous reserve requirements in Februaiy 1984. The increase in its weekly variability appears to reflect problems with estimating the seasonal patterns in the AMB using data prior to Februaiy 1984. N ew seasonal observations for the calculation of the weekly seasonals, but monthly data are needed over a longer period to get meaningful results from the X -1 1 program. Monthly average observations for the counterfactual series on the AMB for the years 1969 through 1978 are derived by using data on deposits for weeks ending on Wednesdays as approximations for observations on deposits for weeks ending on Mondays. FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 Table 2 Incidence of Large Changes in the Adjusted Monetary Base Series with Two Sets of Seasonal Factors Weekly Series (98 periods) Biweekly Series (48 periods) Percentage of periods in which the absolute value of the changes exceeded: With old seasonal factors With revised seasonal factors With old seasonal factors With revised seasonal factors $1 billion 2 billion 3 billion 64.3% 35.7 14.3 48.9% 23.4 7.1 75.0% 25.0 10.4 14.6% 2.1 0 factors have been derived from a counterfactual AMB series designed to reflect the timing o f reserve ac counting under CRR. Short-run variability in the AMB is reduced substantially by averaging the AMB over the two-week reserve maintenance periods in effect since February 1984 and by using seasonal facial’s derived from the counterfactual AMB series. Gilbert, R. Alton. “Calculating the Adjusted Monetary Base under Contemporaneous Reserve Requirements," this Review (Febru ary 1984), pp. 27-32. REFERENCES ________ , and Michael E. Trebing. “The New System of Contem poraneous Reserve Requirements,” this Review (December 1982), pp. 3-7. Farley, Dennis E. “Alternative Measures of the Monetary Base," paper presented at the Federal Reserve System Committee on Financial Analysis meeting, Federal Reserve Bank of Kansas City, October 15,1984. _________“ Two Measures of Reserves: Why Are They Different?” this Review (June/July 1983), pp. 16-25. _________“ Revision of the St. Louis Federal Reserve's Adjusted Monetary Base,’1this Review (December 1980), pp. 3-10. Tatom, John A. “ Issues in Measuring an Adjusted Monetary Base,” this Review (December 1980), pp. 11-29. 33 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1985 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW INDEX 1985 JANUARY JUNE/JULY Michael T. Belongia and G. J. Santoni, “Cash Flow or Present Value: What’s Lurking Behind That Hedge?” Keith M. Carlson, “Controlling Federal Outlays: Trends and Proposals” Ronald A. Ratti, “A Descriptive Analysis of Economic Indicators” G. J. Santoni, “The Monetary Control Act, Reserve Taxes and the Stock Prices of Commercial Banks” FEBRUARY R. Alton Gilbert, “ Recent Changes in Handling Bank Failures and Their Effects on the Banking Industry” John A. Tatom, “ Federal Income Tax Reform in 1985: Indexation” Dallas S. Batten and Daniel L. Thornton, “Are Weighted Monetary Aggregates Better Than Simple-Sum M1 ?” R. Alton Gilbert, “Operating Procedures for Conducting Monetary Policy” AUGUST/SEPTEMBER Dallas S. Batten and Daniel L. Thornton, “The Discount Rate, Interest Rates and Foreign Exchange Rates: An Analysis with Daily Data” Dallas S. Batten and Mack Ott, “The President’s Pro posed Corporate Tax Reforms: A Move Toward Tax Neutrality” MARCH Michael T. Belongia, “ Factors Behind the Rise and Fall of Farmland Prices: A Preliminary Assessment” R. Alton Gilbert and Mack Ott, “Why the Big Rise in Business Loans at Banks Last Year?” Richard G. Sheehan, “Weekly Money Announcements: New Information and Its Effects” Daniel L. Thornton, “ Money Demand Dynamics: Some New Evidence” OCTOBER Richard G. Sheehan, “The Federal Reserve Reaction Function: Does Debt Growth Influence Monetary Policy?” APRIL G. J. Santoni, “Local Area Labor Statistics—A Phantom Army of the Unemployed?” John A. Tatom, “Two Views of the Effects of Government Budget Deficits in the 1980s” Michael T. Belongia and Kenneth C. Carraro, “The Sta tus of Farm Lenders: An Assessment of Eighth District and National Trends” NOVEMBER R. W. Hafer, “The FOMC in 1983-84: Setting Policy in an Uncertain World” Michael T. Belongia and Courtenay C. Stone, “Would Lower Federal Deficits Increase U.S. Farm Exports?” MAY Keith M. Carlson, “ Monthly Economic Indicators: A Closer Look at the Coincident Index" A. Steven Holland, “ Rational Expectations and the Ef fects of Monetary Policy: A Guide for the Uninitiated” DECEMBER R. Alton Gilbert, Courtenay C. Stone and Michael E. Trebing, “The New Bank Capital Adequacy Standards” Michael T. Belongia and R. Alton Gilbert, “The Farm Credit Crisis: Will It Hurt the Whole Economy?” R. \N. Hafer, “ Monetary Stabilization Policy: Evidence from Money Demand Forecasts” Mack Ott and G. J. Santoni, “ Mergers and Takeovers— The Value of Predators’ Information” Dallas S. Batten and R. W. Hafer, “ Money, Income and Currency Substitution: Evidence from Three Countries” R. Alton Gilbert, “ New Seasonal Factors for the Adjusted Monetary Base” 35
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