Monday, May 23, 2016

Taking a Bite Out of Apple

Warren Buffett likely gave a nod of approval before Berkshire decided to invest $1 billion in Apple

To the surprise of many who figured Buffett and his Berkshire Hathaway investment company always steer far from investments that sound and smell “technology,” the group announced in May it would invest $1 billion in Apple stock. 

In the days before the announcement, Apple’s stock had tumbled a bit following what it deemed a lackluster first-quarter performance (a slight decline in revenues for a company that had hardly experienced bad-news earnings the past decade). In the moments after the announcement, its stock price bounced upward. A Buffett stock-purchase gesture will do that for you. 

Some analysts responded in the media this signaled a step toward retirement for Buffett, now 85--a hint that he is allowing others to lead the company’s investment decisions and that might have spurred the decision behind the Apple stake.

On the other hand, no matter how many detect Buffett is permitting others to make investment decisions, a billion-dollar investment in Apple or Coca Cola or any major company likely required Buffett’s nod of approval. The next generation of decision-makers at Berkshire will likely have sought Buffett’s input and sign-off. He might have not have come up with the idea or might not have immersed himself in the research that usually accompanies a Berkshire stake. Others performed the analysis and industry research and presented a legitimate case to invest; Buffett, no doubt, okayed it.

What did they see, as they researched and reached a decision that must have conformed to the company’s decades-long investment principles? The  principles form the backbone of investments in companies that will show consistent, stable and sustainable performance for a long time. 

Buffett and his Omaha crew for ages have preached investments in

(a) businesses they know and understand and businesses with readily understood operating models,

(b) industries that will be important for a long time to a large buying market, 

(c) companies that have groomed leaders to be astute, shrewd business managers, 

(d) companies that hit certain measurable objectives: good, stable returns on equity (book value), most notably, 

(e) companies that have “intrinsic” values that far exceed the values calculated by emotion-swamped and flighty short-term shareholders, 

(f) companies that have cost control and exhibit some signs of growth (after a modest amount of tweaking by the same experienced management team), 

(g) companies that may occasionally experience downturns or slumps, but will be granted time to recover and even soar.

And yes, companies that pay steady dividends from predictable streams of cash flow, aren’t burdened with too much debt and aren’t daring to venture into non-core, exotic activities or activities that appear to be CEO “hobbies.” 

Does Apple qualify? What could have swayed them, beyond Apple’s decades-long performance of stunning levels of operating cash flow? 

Take a peek. 

a) Market values that fall shy over “intrinsic” values, even if Apple hasn’t yet unveiled the next gadget of the decade.

Apple now has a market value that now exceeds $510 billion, even after the stock price cascaded downward from above $130/share to the mid-90’s today. Berkshire analysts may have concluded after a slight downturn in earnings (“down” to $10 billion in the first quarter), equity markets might have over-reacted. Has the market been too concerned about Apple's product line, uncertainties about an Apple watch product and slippage in revenues warrant declining values? 

A recent P-E ratio computed to 10, for a company operating in a still-growing industry where normal P-E’s range above 15. A P-E ratio hovering about 10 suggests markets aren’t willing to give value to uncertain levels of growth. 

The Omaha team may have concluded the market is under-estimating future growth. They are confident Apple management (under Tim Cook, as CEO) can still crank out operating cash flows continually in a $10-15 billion range each quarter. 

b) Cash reserves, which rest visibly on its balance sheet. 

Apple still sits on billions in cash, even if in recent years, the company has elected to reward shareholders with dividends and not hoard it all. Beyond dividend pay-outs and stock repurchases, it still has about $40 billion to “play with”—for new investments, new projects, an occasional acquisition. (Another $30-40 billion resides in operating units overseas and unconsolidated subsidiaries, targets for many who claim the company keeps that cash there to avoid tax obligations.)

A few years ago, shareholder activists protested that some of the cash reserves should be siphoned off to equity-holders in the form of dividends, if only to boost an already astounding ROE’s (returns on equity). 

Apple complied, started paying dividends for the first time and instituted a stock-buy program. It replenished much of the stockpile from new cash from operations and from proceeds of new debt. (Apple continues to pay out about 15% of operating cash flow in dividends.) 

Activists pushed for stock buy-backs, too, and begged for a capital structure that welcomed cheap debt, less equity. A little financial engineering, so to speak. Apple has obliged and has conducted occasional stock repurchases the past three years or so. 

c) Operating cash flow 

Even if it claims it experienced a “bad” first quarter (unsuitable for its standards), the company is still generating sustainable (predictable) cash flow (after capital expenditures) from operations of about $15 billion a quarter, over $60 billion a year, reliable streams that get Berkshire analysts excited.

Berkshire analysts could have concluded that operating cash flow won’t surge to $80 billion a year soon, but the market may be under-valuing a company that will likely continue to generate at least $40-50 billion cash from profits, even in the toughest years. 

d) Book-value returns. 

Buffett has often said they assess performance based on a company’s ability to generate earnings on book value. Apple produced an ROE of 44% last year (31% last quarter). Getting comfortable with low-cost debt (as it has done the past few years) has enhanced returns. High profit margins (22% ROS) on products peddled to consumer public has helped. (Remember, iPhones have $500-plus price tags affixed to them.)

Buffet is attached to companies with operations that result in returns (ROE) that exceed expectations and cost-of-capital requirements. 

In the end, the team of analysts concluded sustainable cash flows and sound returns on capital offset the label of Apple being a “technology” company. They crunched the numbers and felt comfortable the right management is in place for a long time. And Cook and his corps of product creators will develop new products that will keep piles of cash flooding its doorsteps. 

Buffett and team are less worried about whether Apple’s watch didn’t usurp the iPhone in popularity, not too concerned because one or two quarters fell short of fabulous earnings in previous years. They may have beamed they could swoon in and grab a piece of a $500 billion company they think—with cash flows and predictable streams and a business culture that finds a way of producing the next new thing—is really worth $600-700 billion. 

Tracy Williams

See also:

Thursday, April 21, 2016

What's This About "Living Wills"?

Bank regulators, including the FDIC, gave failing grades to some well-known banks in the recent "living wills" test

U.S. financial regulators delivered another blow toward big banks in mid-April, 2016. Some analysts and equity markets considered it a benign one because bank stock prices hardly budged.  It provided easy fodder, however, for the bands of critics (including a presidential candidate or two) who wage arguments that big banks must be broken up.

This time the FDIC and Federal Reserve announced its list of banks that didn't pass its latest test to assure the public that tax-payer funds won't bail out the next Lehman or Bear Stearns. A slate of banks (including JPMorgan Chase, Bank of America, Wells Fargo, and State Street) failed the "Living Wills" test.

This requirement is not arbitrary or recent. Dodd-Frank, the U.S. legislation that spells out much of bank regulation after 2010, permits regulators to establish rules that require big banks (especially the ones deemed "too big too fail") to show how they will wind down their vast operations in the event of extreme distress (at or near bankruptcy) without putting us through what the globe endured in 2008.

In other words, if a bank like JPMorgan or Wells Fargo in control of over $2 trillion in assets in all parts of the globe is in jeopardy of going out of business (perhaps because of mounting loan losses, extraordinary asset concentration, gigantic trading losses, insufficient capital, or fraud), can it manage an orderly liquidation of the business? Can it do it without hurting depositors and causing wreckage in capital markets?

And can it do so without the U.S. Government having to intervene? Can it do it without the Government feeling obliged to inject new capital to keep markets at peace and avoid jeopardizing the existence of the financial system? Can that orderly process occur with only shareholders (and maybe subordinated debt-holders) bearing the inevitable billions in losses?

In 2015, regulators requested banks to complete this  exercise.  After assessing the "living wills," they would decide which banks passed or failed--regardless of how well those banks are performing today or how well the banks meet current regulatory requirements for capital, leverage and liquidity.

The banks got their report cards recently, and they accepted their wrist slaps in stride, suffered a little embarrassment and promised to redesign their respective liquidation plans.  They must present improved presentations of  "living wills," and they are taking this seriously.

Why did JPMorgan, a bank cushioned with over $200 billion in book capital, fail this test?

How could the big behemoth, with $20 billion-plus annual profits and with its hands entangled in about every form of financial transaction that exists, have not passed?  JPMorgan management is blaming technicalities.  And it might have a case (although that won't convince regulators to change their grade).

Regulators examined a hypothetical scenario where the bank's credit ratings have been downgraded to near-default status (or the ratings have been withdrawn) and where the bank's parent company is in or on the verge of bankruptcy. They argued a JPMorgan liquidation process, as catastrophic as that seems, has short falls that require immediate attention. The bank has the rest of this year to redo the will. A catastrophic-sounding wind down, regulators insist, must have minimal impact on the rest of the financial system.

In reality, if JPMorgan is about to implode and if rumors of bankruptcy abound and even if its problems and woes are isolated, it's likely other big institutions will be fumbling (or failing) because of similar issues.  Big banks have similar businesses,  strategies, balance-sheet content, and ways of managing risks. They often interface, compete, or aggressively manage markets in similar ways. Paraphrased, they often copy each other, if only to compete and grow. If JPMorgan is going down, then it's likely Goldman Sachs and Citi are suffering similar financial anxiety.

The goal of a "living will" is to ensure an orderly, safe liquidation that follows a regulatory-approved "playbook."  The implied goal is to assure all of us the financial system won't suffer a repeat of 2008.

Explaining in clear communication, regulators directed JPMorgan to clean up lingering issues with liquidity management, complex legal structures, and derivatives exposures.  To their credit, they outlined the problems in layman's detail.

Bank overseers say the bank's liquidity plan has weaknesses.  The bank has vast amounts of cash reserves (to meet short-term obligations), but the bank is over confident its ability to summon up cash that might be trapped in subsidiaries, particularly regulated entities.  Regulators want the bank to assume that parent cash deposited at a major subsidiary might become "ring-fenced," trapped overseas, blocked by other rule-makers or encumbered by third parties, unable to be funneled back to the parent.

They also remark the bank's parent entity presides over a sometimes inexplicably complex legal structure, one that would with certainly impede an orderly liquidation. They recommend the bank consider aligning legal entities with business activities.  No doubt regulators are aware big financial institutions create hundreds of legal entities, often to separate regulated activity from non-regulated activity, sometimes to extract exotic, difficult-to-value assets from trading units that seek a high-grade credit rating.

Regulators also want to see a better plan for recapitalizing some of those entities, if and when necessary. And they are pushing for a stronger outline for how it would wind down billions in derivatives exposures.

The strikes above result partly from the bank's size (cash reserves residing on balance sheets around the world, vast numbers of unexplained legal entities, and exposures in nearly every kind of derivative that is traded).  That explains why it can be harder for JPMorgan to pass a "living will" test than it would be for a   domestic, medium-size bank, even one that isn't growing or is barely profitable.

However, it's a strike, and it's a new era. The bank's legal staff, compliance officers and financial managers will hastily respond and resubmit a stronger liquidation plan, even if the probability of a such a bankruptcy is low and unimaginable.

Tracy Williams

See also:

CFN:  Banks and their Energy Loans and Losses, 2013
CFN:  JPMorgan's Regulatory Rant, 2012
CFN: Credit Suisse Makes a Big Move, 2015

Monday, March 28, 2016

Best Work Places: Financial Institutions?

Why aren't financial institutions on this list in greater numbers?
Fortune magazine just published another list.  Lists sell print copies.  They attract views and readers online.  Starting with the Fortune 500, Fortune's lists--from top global companies to its power and diversity lists--get the attention its editors crave.  Lists spur dialogue and discussion. They at least encourage the larger population to talk about the subject, even if many disagree lists are subjective.

Lists can be disconcerting and controversial, especially the criteria on which most lists are made.  Criteria are often too subjective and permit list-makers to exploit statistics, data, numbers and surveys in the way they might want lists to appear.  Fortune's 500 list, it happens, might be one of the least-subjective lists around.  They are based on public company's disclosed, audited sales totals.

(BusinessWeek's and USNews' lists of top business schools are subjective and can change significantly by tweaking one variable among many in a list of criteria. Such lists can be helpful, but should viewed with caution. Should business-publication editors get to decide what business school is "better" than another one?)

Fortune's latest list is its list for the best companies to work for.  Remember, this is not a "500" list. Companies appear based on a set of subjective criteria, surveys, interviews, and evidence of perks, special benefits, and hear-say.

The net worth, market values or profitability of companies is not a primary factor, although some of the "best companies" on this list attract top talent because they have proven results and strong financial performance.  Vice versa, strong companies are able to invest in perks and benefits to attract top talent and keep the talent for years because of such benefits.

The usual names appear at the top of this year's list:  Google/Alphabet, Salesforce, KPMG, EY, Pricewaterhouse, IKEA, Whole Foods, and Deloitte. Even GoDaddy, Mars (Candy), and the Cheesecake Factory made the list. (Many, in fact, are Consortium sponsors.)

But what about financial institutions:  banks, broker/dealers, asset managers, insurance companies, hedge funds, mutual-funds companies, securities exchanges, etc.?  Do they appear on the list? If not, why? And how has this trend changed in recent years?

First, let's check Fortune's criteria, at least the way the publication organized and presented the criteria in 2016. Remember, this isn't a list that measures size, bottom-line metrics or a company's ability to generate tens of billions in sales, although many on the list are big and generate returns that keep investors smug and satisfied.

Happy, talented employees contribute to strong performance, no doubt. And employees are generally happy when companies eagerly provide perks, nurture sane work environments, and maintain common sense about employees' own lifestyles and family constraints. Fortune's criteria revolve around just that:  benefits, rewards, and attractions that help retain employees for the long term.  They include childcare, sabbatical privileges, flexible workdays, healthcare, and exercise gyms.

What financial institutions appeared on the list?  Some names are familiar. American Express, for example, no matter recent performance issues it has had to deal with, is still a favorite place for employees--thanks, still, to the leadership of its CEO Kenneth Chenault.

A few are scattered on the list--some insurance companies (Nationwide, e.g.) and a handful of banks and regional broker/dealers (CapitalOne, Edward Jones, American Express, Robert Baird, e.g.). Goldman Sachs doesn't  make the top 50.  Major banks or institutions such as Citi, Blackstone, JPMorgan Chase, and Morgan Stanley aren't listed at all.

Why don't financial institutions appear on these lists in large numbers?

There might be some an assortment of reasons.  Large size and unwieldy organization structures might be factors.  The volatile, unpredictable nature of financial markets could be a contributing factor, too.  That many financial institutions are the results of a series of clunky mergers shouldn't be minimized.  But let's try to tackle a few common reasons:

1)  Regulatory requirements and related priorities. 

Financial institutions are deeply immersed in a complex web of financial regulation.  Compliance is difficult, laborious, expensive, and critical.  As much as they are attentive to financial performance (shareholder returns, revenue growth and cost-cutting), they are wading through thousands of pages of new regulation and playing catch-up even when they catch up.  (Bank regulation continues to evolve and expand each year since the crisis.)

Meeting capital, shedding trading desks, reducing leverage, and passing stress tests with top grades become priorities. Gifting employees with free perks and caring about work-life balance issues get thrust into the back seat.

2)  Still haunted by the financial crisis.

The financial crisis has receded into financial history, but financial institutions today take business steps and adopt strategy with one foot pointed ahead and the other anchored down by debilitating risks that caused a near collapse in the financial system.

Banks, hedge funds and broker/dealers are not necessarily risk-adverse at all hours of the clock. But they operate in anxiety, pushing buttons to ensure they don't slip back into a setting where all markets are slamming their balance sheets, capital bases and earnings reports. Nor do they want to make an errant, rash decision that might result in hundreds of millions in litigation years from now.

3)  Less able to attract the best talent.

In recent years with a surge in interest in technology, entrepreneurship, and new business models, financial institutions may no longer be the most desirable destination for undergraduates and for those with professional degrees (JD, MBA, e.g.).

Banks know that and have worked hard to redefine the experiences and growth paths in their institutions. Some are "creating" interesting roles to attract not only those who adore capital markets and investment management, but those interested in computer science, engineering, and international relations.

It's a tough sell. Some interested in financial services may turn first to opportunities in "fin-tech," or financial-technology start-ups and related new ventures.

4)  Fewer benefits, perks and special attractions.

Financial institutions are bogged down with capital requirements that increase every year (as rules are amended to ensure they can stand down the next crisis).  They are steadfastly focused on containing or cutting costs to reach profitability objectives.  The best way to achieve an ROE that pleases shareholders, when revenue growth is limited, is to wage aggressive cost-cutting campaigns, the kinds of campaigns that cut into the core of a business operation. If abolishing tuition reimbursements for employees helps cut costs, then so it goes.

Large banks have cut their costs or managed them well in recent years.  The expense numbers prove it, and the profit margins in recent years show it. (Just this month, Credit Suisse announced bold efforts to cut cuts even more.)  But what gives and what goes away?  Employee benefits, employee perks, long-term or contractual compensation, and many of the factors that might help put banks on best-work-place lists.

5)  An industry still in flux.

The industry of financial services is evolving quickly.  Regulators are concerned about institutions being "too big to fail" and have imposed restrictions on activities like proprietary trading and on balance-sheet leverage.  Smaller start-up companies, not yet constrained by regulation, have begun to tread on bank territory to provide payments and lending services. Securities exchanges have sprouted all over the place electronically.

What financial institutions from banks and broker/dealers to exchanges and futures dealers could do years ago might be prohibited or limited today.  What they could do years ago might make little economic sense today. How they do things (processing securities and making payments, e.g.) is changing rapidly.

Uncertainty in some industries can present opportunities.  Uncertainty in financial services presents opportunities, as well, but can also discourage talent, if the talent is unsure what the role of large financial institutions in 10 years will be.

6)  Fluctuating, unpredictable patterns in compensation.

Compared to many industries, financial services continues to pay well, especially in areas like investment banking, investment management, research, private equity, and hedge funds (when they are doing well).  The old guard might complain that the era of star bankers and stratospheric, guaranteed compensation is over, but head-shaking compensation packages still exist.

Sometimes, however, compensation--no matter how lucrative--varies significantly from year to year and is too often be based on subjective criteria. The best employee is not always assured of being paid fairly or commensurately.

7)  Working under a constant threat of lay-offs, reductions, and firings.

Within the industry, there have been precedent and patterns since the financial crisis.  Financial professionals no longer join the industry confident they can spend 20 years or more doing well on the job and be handsomely rewarded and aptly promoted. The days of such comfort are gone.

Companies, banks and firms in financial services nowadays make critical decisions on businesses, geographies, products, balance sheets, and profitability. Unfortunately people are affected. That has led to a work environment, unlike decades before, where employees say they work under a cloud that "this day could be the last."

Staff reductions and dismissals exist in all industries.  Yet the aura of "the last day" and ongoing efforts by employees to look for omens (little signs that lay-off-related announcements are looming) persist often in financial services, because of what has occurred regularly in the past decade.

8)  Lack of attention to professional and management development.

The industry does an outstanding job in providing experience and expertise to junior staff about products, markets, clients, services, and systems.

The industry focuses first on "closing the deal," "booking the best trade" or "providing the most lucrative advice" and ensuring that everybody involved is equipped with market information, data, or financial models.

The industry, however, falls short in helping develop new professionals to become shrewd, compassionate managers of businesses, sectors, and people. And much of that is due to fierce, ironclad attention toward the market place and to regulatory compliance, while professional development is overlooked as a priority.

9) The hours.

Stories about "the hours" working in a financial institution are legendary:  the so-called 100-hour work weeks, the sudden demands from higher ups to cancel weekend plans, the Sunday-afternoon conference calls, beach vacations spent in front of a laptop, etc.

Long hours exist in other industries, too. Management consultants, computer programmers, and entrepreneurs work similar hours and have the same level of demands. Those who work for banks, hedge funds, and private-equity boutiques don't complain as much about the long hours as much as they screech about the lack of control over the hours they work.  Few who choose the industry mind the deals, transactions, trading, and research they do.  Many enjoy the thrill of the deal, trade, client closing or investment find. Yet many will say the uncertainties and sometimes the whims of supervisors or clients are too hard to tolerate.

Let's not lampoon the industry without highlighting its attractions and explaining why, despite all, thousands of graduates swarm toward Wall Street or its regional equivalents every year.

Why would or should a financial institution appear on the list?

1) Technical innovation and changes in the industry.

For good or bad and despite demands and clamors from regulatory authorities, the industry is in the midst of constant change.  Technology helps drive that. Entrepreneurs and a new-venture spirit contribute.  The impact of technology over the past 15 years has been extraordinary. The way securities are traded and cleared is swift, efficient and less cumbersome (although some say more improvements are necessary).  They way payments (institutional and retail) are made are similarly swift and smooth. Loans (including small-business and student-related credit) have hopped this electronic, swift-approval bandwagon.

Such constant innovation, much of which has helped to spur growth and cost-efficiencies and much of which has sparked the formation of new companies or partnerships with big institutions, can attract talent into the industry.  The computer expert who might have fled to Silicon Valley to join an interesting new venture might choose to accept Goldman Sachs' offer to build a trading model that might reduce the market risks of billions of dollars of derivatives.

2)  Capital resources: breadth and size

Critics from all over argue loudly financial institutions (banks and insurance companies) should not get too big. With their lists of who's too big and who's not, regulators worry, as well. Substantial size leads to significant systemic risks and "contagion" within the system. We've heard these argument lines regularly since the crisis, and many offer valid points, while regulators obsess in what else they can do.

Capital resources and size, however, typically mean big institutions can take on big, bold projects and make big investments that can have important impact.  Big institutions can also preside over big transactions and deals (loans, underwritings, trades, etc.) or operate across the globe if they choose to do so.

The ability to capitalize on size, scale and resources can be attractions to those who like to work on headline transactions, big deals, or financings that have widespread impact.  Size and resources in the industry make it easier to get things done in capital markets or with clients with operations around the world. The MBA finance graduate, newly arrived from Dartmouth-Tuck, can work on a $5 billion equity offering on the first day on the job or help arrange the merger of two large pharmaceutical companies the next week.

3)  International presence.

Large financial institutions have a global footprint. They operate just about in every major locale, where there exist vibrant capital markets or bustling business activity, where there exists a groomed financial system.  This often means banks, insurance companies, and asset managers will station themselves in New York, Chicago, San Francisco, London, Paris, Brazil, Tokyo, and Singapore at the blink of an eye.

Opportunities to work around the world amidst different culture and environments or having an impact on emerging markets are attractions to talented, diverse employees.

4)  Compensation benchmarks

Even if it is volatile and unpredictable and even if it comes with fewer other perks and special privileges, compensation within the industry is still more than satisfactory. In certain institutions or financial-sector niches, opportunities to increase rewards (via stock and incentive plans or investments) continue to be favorable industry attributes.

5)  And, yes, the thrill of financial and capital markets

In the end, the industry will always be attractive to those who understand the significant, varied contributions of financial companies (as traders, as intermediaries, as market-makers, as advisers, as researchers, as asset managers, and as innovators of new financial instruments).

Financial markets can be a thrill to follow, to dissect, to analyze and explain. Financial instruments offer vast amounts of funds sources that spur investments in new products, industries and regions.

And those who are enamored will be willing to step in to do the analysis, do the trade, do the investment, do the research, nurture the client, help the customer, and close the transaction.

Tracy Williams

See also:
CFN:  Summertime, Summer Internships, 2010
CFN:  Work-life Balance:  The Discussions Continue, 2014
CFN:  Delicate Balance:  Long Hours and Personal Lives, 2010
CFN:  Finance:  Still a Popular Destination? 2014
CFN:  Is I-Banking Still Hot? 2011CFN:  Diversity:  Black Enterprise's Top 40, 2009
CFN:  Diversity Top 50, 2012
CFN:  Fortune's Best Places, 2013
CFN:  Affinity Groups in the Work Place, 2011

Sunday, March 20, 2016

Banks: Energy Losses Now, Not Later

Some big banks have decided to take their expected losses in energy loans now

In recent weeks, oil prices have inched upward, and seldom have markets and investors felt good about that.

After the precipitous, steady slip in prices over the past year, the oil-and-gas industry drooped toward turmoil, and banks braced themselves at the start of 2016 for a rough year of loan losses from lending to hundreds of companies that have ties in some way to slumping prices of oil.

Once prices dipped below $30/barrel and companies started to disclose sour results and whined that losses could continue through the year and perhaps into the next, bank shareholders and analysts began to react. They tapped their calculators and ran their computer models to determine how many billions banks will lose in the next few years.

Many dumped bank shares and pushed prices downward. JPMorgan Chase share prices in the mid-60's had slid suddenly into the mid-50's, at least until the market could learn the gory details about what's vulnerable in their portfolios of energy loans.  Pessimistic equity markets in the midst of a wild, volatile first quarter could easily have inferred that billions in bank loan losses will be sufficient to trigger the next Great Recession. 

In the past month, banks, likely with some urging from regulators, jumped ahead of the guessing games and decided to compute their expected losses. 

(For banks, "expected losses" are a function of probabilities of default, which in the industry certainly rise when prices are declining. They are also a function of recovery rates after default.  Factors such as collateral, third-party support, guarantees, loan tenor and loan seniority increase the likelihood of recovery.)

With Wells Fargo and JPMorgan taking the lead, big banks have decided to

(a) report details of the total amount of loans they have in the energy sector,

(b) act conservatively and reserve for possible losses at amounts far more than they actually expect to lose and

(c) remind market watchers of the huge capital bases they now maintain (thanks, in part, to new regulation) to act as a comfortable cushion against actual losses in the years to come.

They counted up their energy-related exposures, including those to companies that supply the industry and build its equipment and even including amounts that have not yet been borrowed under committed revolving-credit arrangements.  They tallied the amounts that have collateral.  And they declared they are taking the bulk of expected losses now. 

JPMorgan increased energy-related loan losses by $500 million; Wells Fargo took  provisions of $1 billion.  (The biggest banks are reporting total exposures in the tens of billions, not the hundreds of billions.)

They helped prove such conservative gestures won't damage the viability of big banks with capital bases that exceed $150 billion (as both JPMorgan and Wells Fargo possess).  Energy-industry exposures still comprise less than 10% of all loan exposures. The expected losses are still less than 10% of total bank equity capital.

Regulators, for sure, likely applauded these moves or might have coerced banks to do the same if they banks had sat still. Post-crisis regulators are intimately involved and influencing behavior.  They frightened many big banks last year with their exhaustive, comprehensive stress tests and weren't reluctant to report who passed, who failed, and who received an incomplete assessment. This year, regulators could choose to crunch numbers and come back to report which banks they believe couldn't pass a new stress test tied to a prolonged slump in oil prices.

The loan-loss gestures of JPMorgan and Wells Fargo, however, are isolated and don't necessarily account for what has haunted banks to no end in the past decade:  correlation.  What happens in one loan sector (in one industry) might cause horrors in other sectors.  Problems in the oil industry might lead to problems in other industries--equipment manufacturing, transportation, or even consumer products in the long term. (To its credit, in its compilation of oil-industry exposures, Wells Fargo even reports consumer loans to employees in the industry.)

The exercise is far from over. Banks will continue to watch and worry about oil-and-gas exposures and review portfolios almost daily. Many will have already initiated steps to reduce risks in other ways: 

a) hedging by purchasing credit-default swaps (before they become too expensive),

b) arranging to reduce loan outstandings while they can,

c) cancelling lines of credit where they can legally, selling loans to other institutions that have the risk appetite or like the loan returns (given the high risks), 

d) requesting more collateral,

e) renegotiating terms, and

f) postponing new business at least until oil prices to trickle back up to a certain level.

Some are revamping energy-banking units to focus, as well, on other energy projects and related companies--sustainable and green energy, wind and solar projects, natural gas, etc.

The most experienced bankers understand how the oil industry is intermittently volatile and how booms, busts and oil cycles occur with near certainty. 

Tracy Williams

See also:

CFN: The Collapse of Oil Prices: Painful for Banks? 2016
CFN:  Banks' ROE's:  Stuck at 10%?
CFN: When Does a Bank Have Enough Capital? 2015
CFN: Credit Suissie's Big Move, 2015

Wednesday, February 10, 2016

Who Calls the Shots in Silicon Valley?

Of all the board members of the top 150 Silicon Valley public companies, 87% are male.
Silicon Valley, some will argue, has grabbed the heart of American commerce.  It's the unabashed global seat of technical innovation and creativity. Other regions in the country and around the world wish they could replicate at least a small portion of its entrepreneurial successes and its contributions to value in global markets and consumer satisfaction.

It's the home base of companies like Facebook, Apple, HP, Oracle, Alphabet/Google, Intel, Dropbox, Salesforce and eBay.  It's where the next new things are dreamed, groomed and designed.

But the Valley has fallen flat on its face when it comes to diversity.  And to its credit, it knows it.

The statistics tell the story, and so do casual glimpses of its board rooms, its venture financiers, and its popular tech-crunch conferences, where technology good-'ol-boys hang out, trade industry stories, and promote glistening new products.

Lonergan Partners, an executive-search and talent firm based in the Bay Area, recently presented its findings from a research project to determine who's who in Silicon Valley and who runs all the shows that make Silicon Valley soar. It focused on board membership at major Silicon Valley companies, what it calls the "Silicon Valley 150." With help from nearby Stanford Business School, it compiled statistics, summarized its findings, and made careful attempts to draw conclusions.

Its findings reaffirmed what most already suspected, what most had already observed.

The SV150, a moniker to rival the S&P 500 or Fortune 500, includes the top 150 publicly traded companies headquartered in Silicon Valley. It includes many companies with familiar names that went public within the past decade (Facebook, Twitter, LinkedIn, e.g.). It includes, also, companies that helped give birth to the region as a technology center of the universe (HP, e.g.).

It includes companies in assorted industries: IT, Internet, semiconductor, biotechnology, clean technology and consumer products.

It doesn't include recent start-ups and the dozens of companies classified as "unicorns," private companies that have been valued at $1 billion or more, but haven't yet decided to leap across the private-public divide into IPO land.

Apparently it would have included the best-known unicorns (Uber and AirBnB come to mind), if it could.  But for survey and research purposes, Lonergan wanted reliable, updated data, information that can more easily be obtained from public companies or at least from their annual reports and public filings (information public companies can't hide or camouflage).

It also doesn't include much of the finance sector, the venture capitalists who surround the industry prominently with promises of rounds of funding and who set the agenda for which companies will have the best chances to thrust themselves toward billion-dollar market valuations.

Nonetheless, the reliable results from a data pool of 150 public companies are informative and meaningful.  By examining the make-up and membership of the boards of directors of these companies, it could determine, based on data and not hearsay or hunches,

a) Who are the people who run the big Silicon Valley companies?

b) Who are the people who have influence at many companies in an industry?

c) What are the backgrounds, experiences and education of people who run these companies?

d) Are women represented in board rooms and in senior-management positions in meaningful numbers?

e) Are there board members in significant numbers from under-represented minority groups?

What did it find? And did it recommend solutions and next steps for an industry that sells products and services to the masses around the globes, but for which its core of leaders tend to be a cozy neighborhood of well-connected men?

Men run the show, for certain--as founders, as visionaries who get their projects funded, as private investors, as senior engineers and designers, as founder-CEO's, and as board members.

The SV150 tally shows an astounding number of male board members.  That's not shocking; the numbers reinforce what we already knew.

Of the 1,156 board members of the top 150 companies, 87% (as of August, 2015) are male, who at an average age of 59 are not as young as fables suggest and who tend to have had established business and board experience (about 7 years of board involvement). Board chairs are 97% male.

Not surprisingly, board memberships are interlocking, where members are typically selected from those already established within the network.  About 20% of the board members serve on other SV150 boards.

Over a quarter of the boards (42 or 28%) have no women.  How much does Silicon Valley trail all other top global companies? The Valley's 13% women board composition lags the S&P 500 (19%).

Well, what about new, young companies, more recently founded and perhaps more likely to be conscientious and progressive about board representation.  Lonergan research shows for companies that have gone public within the past five years, only 12% of board composition are women. Hardly any different from older, established companies.

The results aren't too sour. Some companies deserve applause.  Google, Symantec, Netflix and Cisco are among the nine companies with at least three women board members. The number of women CEO's is now up to eight.

Researchers tried to compile trends and numbers for minorities. They acknowledged challenges because they couldn't determine with certainty who fell into which groups, because they were not relying on (and likely couldn't rely) on companies self-reporting information by race and ethnicity.

As best as possible, they were able to conclude that among total employees, minorities (blacks, Latinos, and Asians) account for about 35% of the total.  Among board members, minorities comprised only 5%, most of whom were Asians (South and Pacific Asians).

The lists of reasons why the numbers are abysmal in 2016 are long and have been analyzed relentlessly. Solutions aren't always implemented well or aren't prioritized. Technology companies, especially those struggling to remain solvent or respond to pressing demands from venture investors, dance around or neglect the topic. Often they just aren't motivated to ensure leadership is as diverse as the users of their products.

The usual "excuses" include a scarcity of women and minorities in the "pipeline" for leadership roles and the low numbers of women and non-Asian minorities interested in or pursuing engineering. The real reasons are often tied to a lack of urgency or emphasis on the issues and tied to the tendency for busy people to appoint whom they know or hang around with or hire those with degrees or experiences they share.

Hewlitt-Packard is one company deserving a pat on the back, even if financial analysts have criticized the company's financial performance almost non-stop the past decade. In the midst of making a strategic decision to split up a company whose founders are often called pioneers of the Valley, HP announced the two new companies would have a set number of women and minority directors.  And it came through.

That it already had a woman CEO (Meg Whitman) might have been why it took bold, immediate steps.  The company now exists as two independent public companies (HP and HPE), but their boards now include at least three African-American women:  Pam Carter, a former Cummins executive, Stacey Mobley of DuPont, and Stacy Brown-Philpot, the COO of TaskRabbit.

In a club whose members can likely be counted on one hand (and maybe half of another), black board members among the 150 include James Bell at Apple and Robin Washington and Colin Powell at Salesforce.  Hector Garcia-Molina at Oracle is the only confirmed Mexican-born board member in a state where Latinos are at least 38% of the population (20% of the Bay Area).

Take a look at Facebook, whose hundreds of millions of daily users include huge numbers of women, blacks, Latinos and Asians.  Its board is small (only eight members).  Its membership includes, besides CEO Mark Zuckerman and COO Sheryl Sandberg, a predictable small club of Silicon Valley legends, (Marc Andreesen, Reed Hastings, and Peter Thiel).

If one reason for the lack of women and under-represented minorities in senior roles or positions in Silicon Valley is the tendency to appoint those who share the same degrees and schools, statistics prove it.  Over 20% of SV150 board members have a degree of some kind from Stanford.

There is indeed a core of favorite schools from which companies hire to populate the pipelines that eventually lead to appointments as senior managers and board members.  The Lonergan research showed that most board members and company senior managers (CEO's, CFO's, COO's) were graduates of just a handful of top schools:  Stanford, Harvard, Princeton, Berkeley, Yale and Michigan (undergraduate) and Stanford, Harvard, Berkeley, Penn, UCLA, Carnegie Mellon, and Cornell (graduate, including MBA's and including degrees from Consortium schools).

(Consortium business schools in California include USC-Marshall, UC-Berkeley-Haas, and UCLA-Anderson.)

Over 50% of the 150 women board members have an MBA, most from the list of top, favored schools.

The Valley has a long way to go. A long, long way.

Statistical research helps because it shows trends (and progress, where it might exist) and confirms notions we already have had.

However laudable such findings and research may be, they don't offer solutions or a game plan that would force board leaders and senior managers (including the clubs of founders, visionaries, and highly networked, well-contacted people that decide what's next in the Valley) to act now instead of "when the time is right."

Tracy Williams

See also:

CFN:  Venture Capital and the Pao Lawsuit, 2015
CFN:  Harvard Business School and Gender Diversity, 2013
CFN:  Horowitz and His Latest Venture, 2014
CFN:  Venture Capital Diversity Update, 2011
CFN:  Sally Krawchek's Pivot Move, 2014
CFN:  Muriel Siebert, Wall Street Pioneer, 2013
CFN:  Knocking Down Doors in Venture Capital, 2012

Monday, February 1, 2016

Collapsing Oil Prices: Painful for Banks?

Will the steep drop in oil prices haunt banks and their loan portfolios?
Last August, we endured the pain of wild swings in equity markets.  At that time, we blamed it on China, its boiled-over economy and its government's desperation to find quick solutions via currency manipulation and temporary shut-downs in the market.

In early 2016, we are enduring pain again, but from a different source:  the continuing collapse of oil prices.  How can this be?

Economists in years past have tried to show that slight, steady declines in oil prices can prompt slight, steady boosts in GNP.  A decline in the price of oil barrels is supposed to be kind-hearted to consumers, airlines, manufacturers, and auto-makers. A decline in the price of fuel and energy should bring joy to consumers and manufacturers, helping to boost confidence in capital markets and encourage consumers to get out and about and companies to invest and grow.

This time, however, markets are in disarray. The decline in prices is producing a far different effect, an impact that has sent shudders among stock investors before the new year can even get off its feet.  The woes of depressed oil prices have caused problems (and declining revenues and losses to be reported in the periods to come) for countless participants in the energy sector--from exploration companies and drillers to oil traders and powerful, big-name companies. (We'll see for sure in the weeks to come as big oil companies, announcing 2015 earnings, report substantial earnings declines.)

How steeply have prices declined?

Just two years ago, oil prices hovered about $100/barrel. This month, they slipped below $27/barrel. And yet world supply continues to increase in ways that puzzle many market watchers, which suggests the likelihood that prices will continue to fall.

Market analysts are examining the phenomenon in countless ways--global and regional supply, global and regional demand, U.S. energy policy and strategy, the impact of natural gas, the impact of fracking,  Middle Eastern politics and geographic tension, OPEC's intentions, OPEC's bluffs, and now Iran gaining the privilege of entering the world market.

In finance, what impact will depressed prices have on financial institutions--the banks that provide funding for exploration and drilling, the hedge funds that trade energy stocks and derivatives, the dealers that trade the bonds of energy companies, and the fund companies that bundle energy stocks into ETF's?

Inevitably it won't necessarily be positive. Negative impact at financial institutions implies loan losses, trading losses, and balance sheets bulging with concentrated, unhedged risks.

Banks do significant business with companies in this industry sector. They lend money, arrange financing, syndicate loans, provide advice and underwrite stocks and bonds for big oil companies like Exxon and Chevron and for companies involved in exploration, drilling, refining, and distribution. They also make markets in bonds, securities, and commercial paper issued by companies in the sector.

Until Dodd-Frank came along and until Volcker Rules became a reality, some banks dared to leap into the industry to become not arrangers or financiers, but "players," institutions that made markets in commodities like oil (and other energy components) and traded for their own accounts, speculating like hedge funds and buying and owning refineries.

New regulation has either prohibited banks from continuing down these paths or discouraged them by imposing onerous capital requirements.

Banks and other financial institutions continue to do significant business with the sector.  Take JPMorgan Chase, for example. In a corporate loan portfolio that totaled about $204 billion in Dec., 2014, about 9% is extended to oil and gas companies, companies now confronting a market where the price of one of the primary products they sell has declined 75% over the past 18 months, contributing to devastating impact on revenues and earnings.

At the end of 2014, JPMorgan's total credit exposure to the industry was reported at $19.2 billion, a total that includes loans outstanding, loan commitments, letters of credit, and derivatives activity. No doubt risk managers at the bank, along with the regulators camped within, have huddled to devise a risk strategy to address the risk of losses from doing business with this sector.  That likely means having to decide the right amount in loan reductions, loan sales, hedges, and loan-loss provisions in earnings. And it will possibly mean prohibiting overall loan growth for now.

In fact, when the bank announced its record-breaking 2015 earnings (over $24 billion), it cautioned investors that it had already begun to account for loan losses to energy companies. (It increased loan-loss provisions to its oil-and-gas sector in the fourth quarter.) And perhaps more will come.

Overall, the unfavorable aspects of depressed oil prices on banks can fall in the following categories:

1.  Loan portfolios

Banks with significant concentration of loan and credit risks to the sector are likely addressing concentration risks right now and getting set to identify non-performing loans and reserves for potential losses and allocate more capital for unexpected losses.  Bankers are also deciding how best to hedge (which credit-default swaps to purchase) and are sitting through many "portfolio reviews" to determine where else they might be most vulnerable.

Regulators, this time around, are hovering in the background to ensure banks are calculating expected and unexpected losses and allocating more capital for sector risks.

2.  Client relationships

Banks have significant client relationships with big energy companies.  Many relationships date back decades (even during the times of other energy-industry crises).  Some banks have files and cases of lessons learned that go back to industry troubles in the early 1970's and the early 1980's.  Bad loans during those periods led to the outright demise of big-name banks (Remember Continental Illinois?).

Long-term relationships must be managed tenderly, carefully. Client CFO's and senior managers, for some reason, tend not to forget how their banks treated them when they endured difficult periods. The same client for which the bank knocked down lobby doors to win a lead-underwriting role may now be one for which the bank must decide whether to reduce loan outstandings or demand more collateral and to postpone a debt offering.

3.  Corporate-bond yields

Banks and funds make markets and trade in corporate bonds, including those issued by energy companies.  All of a sudden, because risks loom indefinitely, bond yields are rising to account for the increased possibility of default by oil and gas companies.  A bond trading in the 90's and rated single-A by a major rating agency could suddenly trade in the 80's after a ratings downgrade to BB-.

If the bonds are already in a trading portfolio, higher yields imply bond-trading losses, unless the banks have hedged against these potential losses already.

4.  Energy-related derivatives, credit-default swaps

This includes many kinds of financial instruments:  oil futures, oil forwards, other energy-related futures and forwards, related derivatives traded and settled on exchanges and markets around the globe, often on behalf of energy-related companies or other speculators and hedgers.

This might include, too, credit-default-swap contracts and indices related to participants in the industry, for which hedgers and speculators may want to protect themselves against the possibility of a default by a company (or companies) in the sector or want to speculate that a company is about go beyond a cliff's edge.

Banks have limited roles in dealing and trading nowadays, but they are still smack in the middle of activity, standing in between trades, arranging each side, making markets for client-investors, clearing trades, and more. In these times, they'll want to ensure they are not handling trades for counter-parties that are over-exposed to the industry or simply don't know what they are doing in this sector.

5.  Commodity prices

There are oil prices and related volatility. There are also prices for other energy products that might have some correlation with or that might be influenced by oil-price fluctuation:  natural gas, ethanol, coal, and electricity, e.g.

Banks, traders and hedge funds are likely examining the impact of oil-price declines on these and other commodities, too, as they examine their trading portfolios, as well as the clients and counter-parties that have significant exposure to the other commodities.

6.  Clients that do business with energy companies

One sector overlooked in examining current risks is that which includes the companies that may not be energy-related, except they sell products (tools, real estate, drilling equipment, raw materials, etc.) to oil and gas companies.  These companies could be vulnerable, too.  And banks and financial institutions that do business with them will incur more risk, as well, if oil-related companies can't buy supplies in similar numbers from them anymore.

Hence, as they conduct their reviews of risks and vulnerability, banks will try to identify borrowers that fall in this group.

As we go through this unique, different type of "crisis" (a mini-crisis, we hope), hedge funds, because they aren't regulated, will take their lumps (as they have been doing so the past year or two). Equity investors in the sector will have a rocky road for a while.

As for banks?  Regulators, meanwhile, will intrude and are hopeful the strenuous capital requirements and risk-management rules they've imposed since the days Lehman collapsed will protect banks if large numbers of energy-related borrowers default, disappear, or collapse.

The new year is not yet 60 days old, but already financial institutions have a big risk item to manage in ways regulators hope they will do so with prudence, without much ado, and with no risk of banks failing.

Tracy Williams

Friday, January 15, 2016

The Fin-Tech Revolution

New fin-tech companies have sprouted by the hundreds and promote speed, cost efficiency, and information flow in financial services.

Financial technology is a bona fide industry sector in finance. Most people involved in banking and financial services refer to the sector as "fin-tech." (Some say, "FinTech.")

Fin-tech, however, encompasses much. It depends on who's describing the industry, talking about it or making observations.

We first heard widespread use of the term in the late 1990's, early 2000's, when securities and trading transactions drifted online, during an awakening when institutions realized that paper and telephone trading of securities or transferring of funds could be accomplished quite efficiently with computers communicating with each other.

Even back then, Bloomberg terminals were planted on most trading desks, and funds could be transferred electronically around the globe. But the industry was not yet sure how the Internet and other forms of technology could drastically improve the delivery of financial services.

Today, there is no boundary for what fin-tech refers to. In general, fin-tech describes a reorientation or new delivery of financial services, taking full advantage of technology and Internet connections. That can apply to any aspect of finance--from retail payments to the settlement of securities, from lending platforms to stock-trading matching engines, from corporate-finance modeling to corporate-finance advice, from wealth management to information gathering in capital markets.

That means just about anything beyond the conventional way of performing transactions and delivering services, as long as the new technology offers blinding speed, cost efficiency, and the neat assemblage of massive amounts of data.

A few years go, mention " fin-tech," and industry observers would think institutions trading securities online and institutions exploiting computer power to engage in algorithmic, high-frequency trading or organizations creating electronic markets to match buyers and sellers of securities, currencies, derivatives and commodities.

Today, fin-tech now means, also, payments, brokerage, and asset management for institutions and individuals.

The fin-tech phenomenon has resulted in the sprouting of hundreds of new companies, recent start-ups and young firms hustling to fill gaps in finance, occasionally threatening the domain of big banks.  They include companies with colorful names like PayPal, Square, Stripe, Wealthfront, Betterment, SoFi, CommonBond, ThinkNum, DataFox, and Axial.

(They include companies organized by Consortium alumni, like MyFinancialAnswers, founded by Virginia-Darden graduate Ben Pitts. There is even an boutique investment bank, FT Partners (as in "Financial Technology Partners"), based in San Francisco, solely focused on fin-tech deals.)

Many big banks, like JPMorgan Chase, Goldman Sachs and Citi, are aware they no longer compete just with each other and assorted funds, but also compete with well-funded enterprises with the best ideas about how to lend money, trade and settle securities, facilitate payments, and analyze markets--swiftly and cheaply and often without substantial capital deployment.

Over a decade and a half ago, JPMorgan established "LabMorgan" as an incubator for new ideas in fin-tech and helped birth new companies that went on to become leaders in selling services to quantify market and credit risks, trade credit derivatives and corporate bonds, and settle foreign currencies.

In the past year, JPMorgan's CEO Jamie Dimon mentioned in financial reports that his bank must now confront the competition of fin-tech start-ups that threaten to swipe swaths of market share in consumer banking, securities services or corporate finance.  In recent months, the bank established a working partnership with one outfit to facilitate to small business loans.

Fin-tech companies can be subdivided into the following categories:

Processing and information 

Robo-investing is now a popular sub-sector of fin-tech under the investments category. Bands of financial entrepreneurs have determined there are cheaper and scientific ways to help people invest, manage assets over a long term. They devised unbiased formulas to help investors to allocate funds among stocks, bonds and mutual funds. They argue that young investors will not pay exorbitant fees to financial advisers at large, reputable firms, when they can use surveys and algorithms to make the same selections at minimal costs (or at no cost, in some cases).

Examples of fin-tech firms include the following firms. Often, their employee rolls include computer specialists, data scientists, quantitative finance graduates, and finance portfolio theorists.

In robo-investing, ETF's tend to be the favorite investment, the better to minimize costs in all possible ways.  Investors sleep at night, aware that computer models update market statistics and assess performance and risk. They feed algorithms that redistribute funds among the classes of assets that include stocks, bonds, mutual funds, cash, commodities, and currencies. They allocate to minimize tax obligations, country risks or industry risks.

Wealthfront, a favorite among Silicon Valley professionals, claims to use behavior finance, machine learning and data science to strike the right allocation balance for investors.  It helps to have Burton Malkiel and Charles Ellis, legendary names in portfolio finance and investment banking, as advisers to give the firm credibility and to complement the core of Stanford MBA's on staff.  It helps, too, to have some of Silicon Valley's best known venture capitalists as backers.

The firm is now four years old and has amassed $2 billion in assets. Portfolios less than $10,000 pay no fees, an attractive lure for twenty-somethings, who are accustomed to DIY methodology and interfaces with computer screens.  The average client portfolio totals about $91,000.

On the East Coast, a competing firm is Betterment, based in Manhattan, a year older than Wealthfront and flocked with Columbia MBA's.  It, too, claims to offer algorithms that rebalance portfolios continually into about 12 asset classes (most of them ETF's), favoring "modern portfolio theory" (or more specifically a "Black-Litterman model," an updated version of finance that manages investment risks with a steady plan to diversify and rebalance).  It has accumulated $2.5 billion in assets.

The above firms, as investment-adviser companies, are not broker/dealers or stock-picking or stock-transacting firms.  Robinhood, a New York firm, falls in that category. It was founded by Stanford graduates who migrated to New York to work at big banks, but were outraged by high commissions on stock trades.  They devised a broker/dealer business model to use technology to reduce costs to virtually nothing and facilitate free trades. (Revenues will come from free use of customer balances and margin lending.)

They hope to upend the world of retail brokerage in the way the discount brokers (e.g., Charles Schwab) did a generation ago.  Operating in the fin-tech sector, the firm sells single stocks without hiring a house full of human brokers and consultants.  Andressen Horowitz, the venture capitalists, believes in the model enough to have invested with the firm.

At another end of the fin-tech spectrum exists Digital Asset Holdings (or "DA"), now run by former JPMorgan Chase executive Blythe Masters, best known for contributing to a core group there that created the credit-derivatives market.

While observing the explosion in popularity in the Bitcoin currency market the past two years, DA reasoned the technology and transaction logic behind Bitcoins could be useful in other markets.  DA's founders and computer programmers, with Masters now aboard , are researching ways to restructure the nuts, bolts, pipes and plumbing of traditional trading and settling of securities, currencies and derivatives by replicating the best of what happens in the Bitcoin marketplace.

DA claims when one bank agrees to sell a large corporate loan to another bank, it shouldn't take hours 2-3 weeks of negotiating documents and finalizing trade terms before the trade is settled. Technology should reduce such a trade to an immediate settlement after two parties consummate a transaction.

The Bitcoin market is decentralized, uses "distributed ledger technology," is an open data base, and boasts about being transparent, open-sourced, and, in some ways, democratic.  That market is not policed by government regulators, which presents issues for countless observers and potential participants. That market is also often volatile and unpredictable, although not necessarily because of its structure. (See CFN-Bitcoins.)

DA argues that, notwithstanding the volatility of the value of the Bitcoin market, the efficiencies of Bitcoin settlement can be transported into the trading, settling and risk management of corporate loans, foreign currencies, U.S. government repos, and derivatives.  While they present their case to institutions, they are in a fund-raising phase ($35-40 million), hoping to get investor and institutional support for a model that could diminish the roles of major organizations already involved in trading and securities clearance.

How about a fin-tech firm that takes advantage of social media?  Dataminr, a start-up formed by Yale graduates, does just that.  Aware that hedge funds, banks and traders are constantly hunting down information, news and data that will have impact on their portfolios or trading strategies, they determined it would be invaluable if all the updatesthat emanate from Twitter could be organized into "actionable signals."

Instead of traders sifting through mountains of Twitter feeds, Dataminr (for a fee) organizes Twitter feeds into useful streams related to mergers, acquisitions, energy, and specific companies.

If, therefore, bankers and traders have all this useful, organized information, expedited by Dataminr, what trading strategies should they adopt to take advantage of it?  Along comes another fin-tech outfit, SumZero, which was formed as an "investment community" of hedge-fund traders, asset managers, and private-equity investors to share ideas, research, concepts and thoughts about trading opportunities (for a fee, of course, and at different access levels).

It's ingrained in traders not to share investment strategies or trading positions they contemplate, but the site is popular and has attracted thousands of members, partly under the principle of reciprocity--that to find new strategies, you have to share your own.  A recent trading strategy on the site explained how traders can put on a Yahoo position (longs and shorts), tied to the likelihood the company will be split, the likelihood that it will have substantial tax liabilities related to its Alibaba investments, and the likelihood that it could be acquired.

The above companies are just a handful in scattered world of fin-tech, which now has tentacles in every sub-sector, every financial market.  The sample above hardly touched the bulge in fin-tech efforts in retail payments (mobile payments, online payments, etc.), consumer lending or small-business finance.

This snippet proves, nonetheless, how small technology-oriented enterprises are quietly and busily overhauling the industry in the way AirBnB and Uber are transplanting the travel and transportation industries.  Not only are these new companies changing the industry, mostly for the better, some are luring away the talent that otherwise might have opted for multi-decade careers at established firms.

And the big-name institutions know it.

Tracy Williams

See also:

CFN:  Bitcoins:  Embrace or Beware? 2014
CFN:  Financial Technology:  New Opportunities, 2014
CFN:  High-Frequency Trading:  What's Next?  2012
CFN:  Opportunities and Outlook, 2016

Monday, December 28, 2015

Opportunities and Outlook, 2016

Where are the best opportunities in finance for MBA graduates in 2016 and beyond?
Opportunities in finance ebb and flow, surge and subside, as most MBA graduates (and older, experienced alumni!) in finance know well.

Capital markets, economic trends, regulatory whims and winds, and the make-up of financial institutions will dictate how many and who will get hired from business-school campuses each year and how many and who will be able to transition from one sector in the industry to another, when they wish to do so. 

The year 2015 wasn't a disaster by anybody's measurement, although there were periods of head-turning turbulence (at least in August and at least in equity markets). Market watchers obsessed over China's economy, China's currency, and energy prices for most of the year. Optimists were happy investment portfolios didn't collapse. Pessimists were bothered that we didn't experience the upswings we observed in the year or two before. 

The economy improved by inches, and markets and finance managers waited the whole year for interest rates to make a microscopic upward budge, thanks to the Federal Reserve daring to make its first move. 

In corporate finance, deals proliferated, and, depending on the measuring stick, the year reached unprecedented levels in mergers, acquisitions, and restructurings.  The favorite deal du jour was the spin-off, the split-up, as company after company explored whether shareholders (HP, Yahoo, e.g.) were better off with simpler organization structures and less-diverse revenue streams.  (Pfizer announced its merger with Allergan and then announced that the two, when combined, will spin-off certain units. Hence, a merger begets a spin-off.)

Markets, transactions, politics, and corporate strategies down the road set the stage for whether opportunities exist for MBA graduates in the short term.  Let's explore by sector.

Let's also apply an informed, unscientific rating on the general outlook in each for opportunities to establish a thriving career:

What are the chances that a solid MBA finance graduate from a top (including Consortium) business school will encounter favorable opportunities in a particular sector in 2016-17?

Corporate treasury:  STABLE/POSITIVE

Opportunities in financial management, corporate treasury, and corporate finance depend on the corporate industry. In the current economy, where we are now long beyond the early stages of recovery, companies continue to grow, expand, and invest, sometimes not at the urgency that economists covet.  But these are not recessionary days. As long as companies grow and invest, they must finance activity, manage capital structures, issue debt and/or equity, and manage business investments and flows of funds. 

That ensures opportunities in financial management, financial analysis, and corporate treasury. It also means companies can develop future CFO's across all business lines. 

Investment banking: STABLE

The year 2015 was a blazing year in global mergers and acquisitions, while the year might have been lukewarm in other investment-banking-related activities (debt issuance, equity offerings, etc.).  

Investment-banking opportunities always present themselves in a whimsy--soaring one year; negative, cold and repulsive in another.  Activity by industry group will vary, as well.  When technology groups might be bustling, more staid groups like industrials, manufacturing and automotive might lag. Other groups like healthcare, financial institutions, or diversified will have deal flow and activity (as they did in 2015), mostly because those industries are restructuring or in immediate need of equity capital. 

In 2015, energy groups might be at a standstill or in "work-out" mode, as banks determine whether energy-related companies can manage through debt obligations in the current low-price environment. 

Market-timing and interest rates are also important factors that influence whether banks will hire more analysts and associates. 

Debt financing of all kinds (loans, bonds, notes, and private placements) flourished in years of low interests. Companies took advantage record low rates to refinance old, high-rate debt or invest in new projects with low cost of capital.  When interest rates rise, debt financing might pause or stay flat. 

The big names in banking tweak their hiring numbers from season to season, if not from year to year. Meanwhile, boutique firms (Moelis, Greenhill, Evercore, e.g.) continue to sprout. They start up, win headlines by slipping in the back door to advise on gigantic transactions, and don't go away. Some have been successful enough to increase their banker rolls steadily and expand into other cities, as they prepare for their own public offerings.  

As long as top bankers at "bulge bracket" banks (Goldman Sachs, Morgan Stanley, e.g.) feel the need to escape the bureaucracy, politics and regulatory burden at large institutions or decide they will enjoy the craft without being tethered to a large organization, boutique firms will appear, and some will survive and do fine.  

Private banking and private wealth management:  POSITIVE

Banks' best response to increased capital requirements (and to lesser returns on equity (ROE) is to expand in businesses that don't require enormous balance-sheet usage.  Private banking and wealth management are favorite go-to strategies. 

Banks don't deploy too much of their own balance sheets when they chase after clients to park their wealth in private-banking units.  The challenge, of course, is to keep others' assets under management (AUM) growing. 

In the last decade or so, banks (and financial-management start-ups that claim they can do better than banks) have hired aggressively in private wealth management.  New professionals, nonetheless, are usually required to hit the pavement promptly to help build assets.  

Corporate banking:  STABLE

In the 1990's and early 2000's, thanks to the generous regulation of the time, large banks rushed to reinvent themselves as investment banks. Many (JPMorgan Chase, Citi, e.g.) completed the transformation, but shifted some corporate-banking basics (corporate lending, cash-management services, payments, custody services, etc.) to the sidelines.  

After the financial crisis, large banks re-emphasized corporate banking, even if these activities pile up assets (loans) on the balance sheet.  They have renewed appreciation of the benefits of relationship banking, low-risk lending, and non-lending services, especially for mid-sized companies that can grow into prosperous global companies.

Opportunities exist in these areas, often for those with experience in specific bank functions (lending, cash management, securities processing, e.g.) and for those with both experience and deep corporate relationships. 

Sales and trading:  NEGATIVE

These are times when banks' large, football-field-size trading rooms are just as likely to be vacant or half-empty, as they are to be jammed with boisterous traders and blinking monitors. 

Regulation has pummeled this sector, and most banks except for a few (like JPMorgan and Goldman Sachs) have reduced emphasis substantially.  The new Volcker Rules (which prohibit proprietary trading), new limits on bank leverage, and increased capital requirements have made it near impossible for banks to rationalize large trading desks (in equities, fixed-income, and derivatives).  A few will forge ahead and make an effort.  Many others won't bother. 

Banks are permitted to facilitate "flow" or "customer-related" trading, but unless they are blessed with continually high volume, they have determined, too, it's not worth the pain to sift through trading to decide what's permissible (customer-related) and what's not (proprietary). 

Trading and capital-markets desks still exist at all banks (for foreign currencies, funds movement, repo markets and government securities and for some derivatives activity (interest-rate swaps, credit-default swaps, e.g.)). But the numbers are down, and the prospects for growth almost non-existent. 

Risk management:  POSITIVE

Risk management in financial institutions beefed up substantially after the crisis.  The function is well-integrated in bank organizations. Prudent risk management up and down the organization chart and in all business lines was a lesson well learned after the crisis. Moreover, bank regulation now requires banks to have an enhanced risk-management culture and rigorous risk-management discipline.  

Risk management nowadays encompasses several forms of risk:  credit risk, market risk, operations risk, legal and documentation risk, and even reputation and headline risks.  Financial institutions seek expertise, experience and talent in all these areas. They seek, too, expertise in managing all forms at once ("enterprise risk").  

Banks typically look for experienced people and have done poorly in explaining and promoting these roles when they recruit on campus.  Yet the needs exist, and opportunities abound. 

Asset management:  POSITIVE

Just like private banking and private wealth management, financial institutions continue to emphasize this segment.  (Asset management sometimes includes private banking and private wealth management and usually includes corporate and institutional clients and mutual-funds activities.)  

The impact of regulation hasn't been too harsh, and banks can still earn high returns.  Banks continue to push to accumulate and grow assets under management--fee-based businesses that don't require much balance-sheet usage. 

Competition is fierce among financial institutions.  But that hasn't dampened the aggressive efforts of most of them to compete for assets, charge reasonably for fees and generate satisfactory returns for shareholders.

Investment research:  STABLE

Research applies to institutional equities and fixed-income ("sell side") for broker/dealers and may apply to the same ("buy side") for asset managers.  

The sector on the "sell side" underwent a massive overhaul in the early 2000's to eradicate conflicts of interest and too-cozy relationships with investment bankers (after related scandals of the era). Compensation models and incentives for analysts have changed, too. 

Research has now grown more comfortably into its new, mandated role. Analysts seem to understand clearly what they can and can't do, whom they should and shouldn't speak to. Opportunities exist based on corporate industries, asset classes, and institutions' willingness to promote the value of research.  

Research (on both sides: "sell" and "buy") performs an invaluable service.  Analysts not only attempt to determine proper values of stocks and bonds, but they digest, interpret and explain the vast amounts of information that influence the performance of companies in an industry.  

Venture capital:  POSITIVE

Venture capital is trendy in this era, especially the funds and firms that hover about Silicon Valley, all searching to invest in the next new thing.  

Opportunities would appear to be positive in selected segments and regions. The environment is optimistic, no matter the scuttlebutt about a "technology bubble" or over-valued "unicorns." Investors are eager to find and finance new business ideas and new companies in new industries.

But opportunities are fleeting. They exist, but are hard to find, difficult to ferret. There are few recruiting schedules or broadly announced openings. Connections, special industry expertise, and years of experience open doors to the elite VC firms (Kleiner Perkins, General Catalyst, Sequoia, et. al.).   

Opportunities, however, might exist at non-traditional venture-funding organizations, those that finance or "incubate" businesses with small scope and rely on various crowd-oriented financing. 

Private equity:  STABLE

The industry is dotted across the country (and globe). There are big, known firms like KKR, Blackstone, and Silverlake.  There are industry-niche firms like Vista.  

Macroeconomics, investor appetite, and general business conditions often influence opportunities and the decisions firms make to close down old funds and start new funds. PE firms prefer stable, businesses with proven management. 

Firms may specialize in a certain industry or, like a Blackstone, will traverse the landscape to find any stable business with predictable results (fast-foods, railroads, real estate, merchandising, e.g.).   When the economy blooms, PE firms invest, grow, and watch for easy-to-project returns on capital. When the economy sours, they sweat and tend to the large debt loads they mounted to gain control of the companies they acquire.

The brand-name firms (like Carlyle or Blackstone) have begun to seek analytical help by approaching campuses and establishing relationships at favorite schools.

Smaller PE firms will avoid campus recruiting and traditionally pick the pockets of big banks in numbers larger than banks and head-hunters care to admit. (One of the biggest headaches of investment banks is responding to the onslaught of PE firms making offers to young bankers who've gained just enough experience to be invaluable to outsiders.)

Hedge funds: NEGATIVE

The past two years have been a nightmare for most hedge funds.  Performance has lagged most equity benchmarks.  Hedge funds compete among themselves, but also compete with the proliferation of ETF's and other investment vehicles. "Crowds" of trading funds chase a handful of trading strategies, no matter how complex they are. Often the results are paltry or undistinguished when compared to what investors might reap from channeling funds into a low-cost, simple S&P index. 

Fund managers have had to redeem cash to investors, in 2015 upset with losses or embarrassing returns. Others have shut down funds or implemented new trading strategies.  

Opportunities may exist in pockets at a few established funds (Citadel?), but the industry is focused on bouncing back and convincing armies of investors that it still makes sense to pay high fees for specialized, professional management. 

Compliance and regulation:  POSITIVE

Knock on the door of just about any regulated financial institutions (banks, broker/dealers, insurance companies, and fund companies), and watch them roll out lists of jobs they need to fill in regulatory compliance.

Regulatory reform resulted in thousands of pages of new regulation.  Banks need people to interpret rules, accumulate related data, and ensure compliance. They need people to price assets, perform calculations, and preside over stress tests.  They need people who understand new rules for leverage, liquidity, capital, systemic risk, and money-laundering.  And they want people who will be attentive to the regulatory agenda, not prone to distractions, and who will want to stick around. 

Despite such needs, financial institutions haven't done well to explain these roles to candidates or promote them as desirable careers.  Often they prefer those who have some legal or compliance experience or who are comfortable being off the front-lines, away from doing deals and mingling with clients. 

Raise your hand, express interest and commitment, show that you can learn a lot about a dozen or so banking functions quickly, and the institutions will swoon.

Community banking:  STABLE

Regional banks, those that survived, have recovered after the mortgage woes of the crisis. They rebounded and restructured. Many have recommitted to community banking via on-line transactions and branch relationships.  

They, too, encounter strenuous capital requirements, but are figuring out a way to reap sufficient returns from plain-vanilla banking:  deposit-taking, consumer and small-business loans, mortgages, and perhaps credit cards.  

Business is still fiercely competitive, especially as new non-bank, financial-technology firms have discovered ways to attract customers with low fees and Internet connections. Banks, however, are not in a holding pattern as they fight off the competition. 

Community development:  STABLE

Banks are subject to regulation to support communities and are audited for compliance.  Most try to engage in their respective communities meaningfully. 

Financial technology:  POSITIVE

Financial technology (or "fin-tech") has grown significantly over the past 15 years and expanded into broad areas of finance. 

Think Internet, and think of various ways to exploit technology for the benefit of investors, retail customers, or corporate clients.  Think of various ways for investors to find opportunities via an Internet community, retail customers to do transactions (payments, loans, etc.) cheaply via a mobile device, or corporate clients to discover potential merger partners from an algorithmic match-making process.  

Fin-tech now encompasses all facets of finance. The number of companies that have organized, formed, and sold their services to a global market has exploded. Some (like PayPay, e.g.) will become household names. Others will disappear.  Shake-out is inevitable. 

Opportunities will exist in the years to come, but in unconventional ways.  Many will prefer to recruit as if they are the start-ups they indeed are.  Many will prefer those experienced in finance, financial transactions, and capital markets.  

Electronic markets:  STABLE

This includes electronic exchanges; trade-matching engines; markets in equities, fixed-income, derivatives, municipals, and currencies, and the controversial sub-sector of high-frequency traders. 

Since the late 1990's, the presence of electronic markets has increased steadily, although growth might have plateaued. (There are now nearly a dozen electronic stock exchanges under the auspices of the SEC.) 

Electronic markets evolve, too, under the wary eyes of regulators and other industry participants. Some electronic markets are match-makers or pure brokers. Some see themselves as "liquidity providers" or "liquidity-takers."  Others are involved in trade-processing, trade-settlement or trade-netting.  Others are involved in pricing and quoting services.  

Almost all try to persuade markets (and their investors) they perform services to improve liquidity, efficiency and fairness in markets. Some critics say high-frequency traders inhibit market efficiency and fairness.  

Opportunities will exist, but may not be easy to find.  They may exist best for those with technology skills and an uncanny understanding of how markets work and function.  

Tracy Williams

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