Friday, December 15, 2017

Glancing Back Ten Years

Columbia University hosted a conference in Dec., 2017, to assess financial markets 10 years after the crisis
Ten years ago, rumblings of a financial crisis had begun to boil.  The darkest days were still ahead.  Bear Stearns, AIG Financial Products, Lehman Brothers, Countrywide, and Washington Mutual continued to stoke the mortgage-products machinery of mortgages, mortgage securities, and mortgage derivatives.  Although erratically, many were still making money.

There were hints of the nightmare that would overtake 2008-09.  In 2007, there had been unexplained standstills in certain credit markets. Short-term debt almost ground to a halt. Financial institutions, all of a sudden, couldn't roll over short-term funding or commercial paper.  Many thought markets would eventually correct themselves, one-time losses would revert to profits, and small, insignificant players would disappear quietly without impact. The financial system in 2007 would resolve these uncertainties and tolerable mortgage losses as 2008 approached. After a mid-2007 collapse of an obscure Bear Stearns mortgage fund, market players would get over it.

Ten years later, we know what happened in 2008. And in 2009-10.

We know who disappeared, who collapsed, who was forced to be acquired, and who threatened to put the global financial system on its knees. And today we recoil over the memory of a Great Recession, billions in losses, mortgage penalties and fines, and the avalanche of regulation that followed. New regulation was supposed to present solutions to avert or soften the blow of the next crisis.

Columbia University, in early Dec., 2017, held a "Ten Years After" banking and finance conference on campus and invited industry leaders, bankers, academics, regulators, and long-ago participants to review what happened and decide whether industry solutions are appropriate. Conference participants were tasked to try to predict when the next crisis along similar scales will occur and what will be the financial product or circumstance that triggers it.

The guest list of panelists and speakers included Nobel laureate economics professor Joseph Stiglitz and former U.S. Congressman Barney Frank--yes, the Frank, as in Dodd-Frank legislation, for whom vast amounts of post-crisis bank regulation is named. 

Former U.S. Treasury Secretary Jacob Lew appeared, as well as Columbia Law professor John Coffee, Jr., Columbia Business School dean Glenn Hubbard, and Stephen Cutler, JPMorgan Chase's chief legal officer during the years of the crisis and thereafter. Standard Chartered Bank CEO Bill Winters, who spent the crisis years as an Investment Bank head at JPMorgan, piped in via teleconference and proved his in-depth familiarity with the minutiae of bank regulation and its impact on banks like the one he runs.

Other academics (in business, economics, and law) also weighed in, sharing summaries of research they've conducted and papers they've written that explain what went wrong, why it went wrong, and why things may go wrong again.

Because the format permitted panel discussion and audience participation, the banter was formal and informal, lively and freeform.  Congressman Frank sparred with JPMorgan's Cutler, as they debated heartily on whether bank regulation today is suffocating, complex, and stifling or is inadequate and insufficient.

There were other highlights from two-day sequence of presentations of analysis of what happened and speculation of what market phenomenon around the corner will start the next crisis.

The Volcker Rule, the prohibition of proprietary trading at U.S. banks, was vetted often. Will it be tweaked, changed, updated, or simply reaffirmed?  U.S. banks say they are disadvantaged.  Winters in London said European banks suffer in some ways, too, because they are on the "receiving end" in not being able to trade reliably with U.S. banks, who can only rationalize some trading activity if it's tied to customer flow.

Many who are now accustomed to the rule's restrictions on trading say they just wish it were less complex, more simplified. Proving to the Federal Reserve that a securities or derivatives trade was done for the benefit of an institutional client is one of the most difficult tasks big banks face today.

Basel III is the governing regulation by which financial systems and governments around the world choose to abide. Dodd-Frank legislation in the U.S. legitimizes Basel III in the U.S. and then, of course, tightens up many of the requirements and offers an array of other rules (like Volcker and periodic stress tests). 

Has Basel III worked, does it continue to work, and where do we go from here?  Panelists pondered next steps, discussed, debated and offered data and research. A Basel IV is inevitable, the next step in bank supervisors trying to fend off the unforeseeable or trying desperately to ensure banks are prepared for the next round of financial turmoil.  Basel IV might also be, as Winters suggested, efforts to "roll back" to more consistent methods of calculating capital requirements or simplify the models big banks must use.

While the conference was going on, Bitcoin prices were soaring, providing a backdrop and a suggestion the next crisis could be triggered by boundless enthusiasm over cryptocurrencies.  During the same week, the Chicago Mercantile Exchange was about to introduce a new futures contract tied to Bitcoin prices. Investors (or speculators) can now leverage themselves in betting on the direction of Bitcoin. (They only need to put up a calculated margin on a total notional bet.)

Panelists preferred to focus instead on Bitcoin technology, Blockchain distributed ledger technology.  Many banks, while dismissing the euphoria of surging Bitcoin prices, have embraced the technology--its transparency, its record-keeping, its ability to process and confirm transaction without days of delay by a central intermediary. Over time, it can and will work in securities processing, trade settlement, funds settlement, and other bank operations activity.

In his point-counterpoint with Frank, JPMorgan's Cutler highlighted the complexities of big banks seeking to comply with a thousand pages of Dodd-Frank rules, some in place, some still to come.  He said JPMorgan responds to seven different regulators in operating a mortgage business.  In the aftermath of its "London Whale" trading loss (where its investment office lost over $4 billion trading credit-default swaps), Cutler said JPMorgan had to respond to five or six different regulatory enforcement arms, each independent from the other.

However, big banks themselves are frustratingly complicated, too.  Their organization charts are large, wieldy, interconnected, and difficult to comprehend--a messy maze. A panelist showed that  the "GSIBs" (Globally systemically important banks, as identified by central banks) average over $1.6 trillion in assets and each manage over 1,400 subsidiaries.  Dodd-Frank's "Living Wills Rule" (Recovery and Resolution Plan) requires banks must show how those countless subsidiaries would unwind net assets and businesses in a stress scenario or liquidation.  JPMorgan's Cutler admitted the exercise pushes banks to rationalize some of those subsidiaries. At JPMorgan, there are only about 50 subsidiaries "that matter," he said.

Frank agreed in the U.S., there ought to be some consolidation of regulatory bodies.  Why do both the SEC and CFTC exist? Why are they separate? Why can't they consolidate?   Understanding how inertia overtakes the U.S. Congress, Frank explained how East Coast-West Coast Congressional interests are wedded to the SEC, while "fly over" agricultural interests are tied to the CFTC.  A bill to merge the two is not likely in the works.

Panelists agreed the SEC's expertise is financial disclosure and consumer protection--less so around quantifying and managing market and systemic risks. They also pondered what would have been the outcome if the Federal Reserve had been the primary supervisor behind Bear Stearns and Lehman.  How would the Federal Reserve have managed the demise of these two institutions? (Frank and Cutler couldn't agree on whether the Dept. of Treasury in 2008 "forced" JPMorgan or "pressured" JPMorgan to acquire Bear Stearns, even as both had a ring-side seat of the monumental transaction.)

Across the board, with Frank in the room, the consensus was Dodd-Frank in the U.S. won't be abolished. It will likely be smoothed over a bit.  For example, rules will likely be relaxed for smaller banks, who shouldn't be subject to convoluted rules related to stress testing, liquidity coverage, and financial modeling. And perhaps there will be an easing of rules for regional banks and custody banks. Mid-size banks already have enough on their hands in managing anti-money laundering, "Know Your Customer" rules, and the Patriot Act.

Law professor Coffee was insistent the next blind side could be related to incentive compensation, the giant bonuses big banks paid top bankers during the crisis and in the 10 years since.  He presented data, trends and arguments to show that banks, for the most part, have dismissed what Dodd-Frank attempted to regulate in bonus payouts.

Coffee worries about systemic risk and banks and supervisors' capability of managing this risk.  He said the interests and objectives of bank shareholders are not in sync with supervisors' objectives to manage systemic risks.

Coffee's Law School colleague Mark Roe presented an analysis of the current U.S. tax-law proposal. What impact will a planned reduction in corporate tax rates (from 35% to 20%) have on banks?  Roe's study estimates banks will have 3% more equity capital, suggesting banks will be that much better capitalized to absorb risks (if a new crisis unfurls).  He didn't address the likelihood, however, that banks would just as eagerly pay that "extra capital" out in higher dividends or stock buybacks (catering to stockholders' interests).

New tax legislation could limit the amount of interest expense that's deductible from taxable income. Roe says that could increase the cost of debt and, therefore, decrease the appetite to issue debt. A higher cost of debt might encourage banks to issue or retain more equity. (The Federal Reserve's new "TLAC" rules for large banks will still require them to issue a minimum amount of long-term debt.)

Roe contemplates financial engineers will step in to introduce ways to respond to new tax rates and tax rules in the way of new derivatives or securitizations. Count on it.

While the crisis of 10 years back has been sliced, diced, reinterpreted, and analyzed to points of exhaustion, no panelist pinpoints when, where and why the next crisis will occur. Not many bothered to guess. 

But most agree bank regulation, as complex and difficult as it is, might help banks be better prepared.

Tracy Williams

See also:

CFN: A Spike in Bank Stocks? 2017
CFN:  Is Volcker Hurting Market Liquidity? 2017
CFN:  Will Dodd-Frank Be Dismantled? 2017
CFN:  The Impact of MiFID 2, 2017

Tuesday, December 5, 2017

A Spike in Bank Stocks?

U.S. bank stocks have enjoyed a smooth, upward ride in recent weeks. What explains the rise?
Take a look at how bank stocks have soared in recent weeks:  Share prices at JPMorgan have climbed 10% since early November, 8% at PNC Financial, 8% at Regions, 9% at Citi, and even 8% at Wells Fargo, the big bank that has had its share of reputational and off-balance-sheet issues the past year and a half. Bank of America shares have inched up almost 2%. 

What spurs such a spike in share prices? And is this spike subject to a later freefall after the market has deciphered and digested the bundle of financial news that has caused the spike in the first place? Or have market values risen to a new plateau?

Equity analysts often compare market values to book values (MV/BV) and try to determine how much a bank's market value (from share prices) exceed book value (net assets on the balance sheet).  The more confident investors feel about the strength of the bank's balance sheet, the way the bank manages an array of credit and market risks, and the "sustainability" and "predictability" of earnings, the higher the market value (relative to book value).

The same group of banks above (except for Citi) now show MV/BV ratio in a 1.2-1.4 range.  Investors appear comfortable that banks are measuring and managing risks and will be able to generate a predictable level of satisfactory earnings. (Citi continues to lag in this metric, but it, too, has seen upturns in overall market value in the past year.)

Consider how just a short time ago (a year ago? two years ago?) banks barely reached beyond MV/BV=1, and many showed MV/BV less than 1.  When the ratio falls shy of 1, equity analysts will rationalize shareholders are better off if banks break themselves up and sell of divisions, sectors, and subsidiaries.  (Buy the shares at 80; sell the various assets at book value at 100, and reap gains.)

What explains the rise?

<1 a="" ago="" analysts="" and="" at="" bank="" banks="" better="" book="" broken="" but="" chorus="" consolidated.="" cried="" discount="" divisions="" equity="" feed="" in="" into="" is="" it="" less="" might="" more="" nbsp="" of="" off="" or="" outcry="" p="" pieces.="" separated="" shareholders="" shares="" so.="" sold="" some="" spurred="" still="" suggesting="" than="" that="" the="" this="" to="" trading="" two="" up="" value="" was="" way="" were="" who="" worth="" years="">Some say favorable tax treatment (under the proposed U.S. legislation) explains rises in value.  If banks pay less in taxes, then they certainly will have more cash available to increase dividend payouts and buy back stock.  Citi and Bank of America reported over $6 billion in tax provisions last year; JPMorgan, over $9 billion. Bank stock investors lust after the predictable flow of bank dividends, and any hints that dividends will continue to rise will certainly boost share prices today.

This undermines some of the purpose of updated tax legislation, where politicians contend companies will use tax savings to reinvest in company operations.  At banks, the presumption is that banks will retain the extra earnings to boost capital that will permit banks to increase loan portfolios.  There is no guarantee.  Banks may just as likely use the extra earnings to deliver gifts to shareholders (dividends, stock buy-backs).

Projected easing of tough bank regulation is also speculated. Bank industry leaders continue to argue that regulation straps them. (Some say new regulation strangles them, curtailing growth and discouraging innovation and expansion.)  Dodd-Frank won't disappear, but it could be tweaked in ways that permit banks to boost loan growth and engage more comfortably in certain types of securities and derivatives trading.  If so, share investors contemplate this might boost returns on capital and, therefore, share prices.

Achieving ideal returns on capital continue to be a challenge for banks. Regulation imposes capital requirements on most bank activities and operations. Reaching a 12-13% is challenge. Few banks have returns that eclipse that mark.  Even fewer have returns that exceed 15%.  (And this includes all banks--big and small, global and community). 

Bank investors appear to understand returns will likely hover in the 10-12% range and are comfortable with that as long as returns are stable and predictable (while risks are managed) and as long as returns are sufficient enough to pay dividends and conduct occasional stock buy-backs.  No rational, reasonable investor can expect bank performance to result in ROE> 20% year after year.

U.S. banks, in the aftermath of the financial crisis and complex bank regulation, seem by now to have adjusted to the new normal.  Making sure they are comfortably above all requirements, benchmarks and standards is a regular operating activity at banks.  Share investors may have acknowledged that by 2017, banks have adjusted well to compliance, requirements, and stress tests, even if they wish some of the rules could be loosened or would just go away. 

In 2017, U.S. banks fared well in the Federal Reserve's stress tests, a regulatory-administered examination that assesses whether a bank can survive a prolonged period of downtown and macro-economic stress.  Banks subject to the test geared up, invested in people and systems, and reorganized their balance sheets to ensure enough capital anchored balance sheets to pass these tests--despite their complaints they didn't get to see the Federal Reserve's inhouse models used to conduct the tests.

Stock investors would likely be concerned about unexpected risks in banks.  Much of that is borne in trading and investment banking.  Related revenues and earnings are volatile.  But many big banks have offset these activities with revenue generators (asset management, consumer banking, service businesses, e.g.) with predictable streams of income.  Some big banks (JPMorgan Chase, Bank of America, e.g.) still look for trading and investment-banking home runs, but they won't be saddled too much if those activities are dormant in certain periods.

Banks also continue to do a better job simplifying the disclosure of complex activities in earnings and on the balance sheet (including loan portfolios, trading risks, hedging programs, etc.).  Some investors might actually understand most pages in 200 pages of 10-K disclosure.  Risks--including credit, market, liquidity and operational risks--are thoroughly explained. Even risks related to collateral, reputation, and documentation are addressed. 

Banks, as well, have been better about loss reserves on the loan portfolio.  Loss reserves should equal to expected losses from a range of loans--consumer to corporate, secured and unsecured, domestic and abroad. If the bank observes signs of vulnerability or weakness in the portfolio, they appear to plan and reserve for losses more quickly and more conservatively. Where could there be weaknesses in current portfolios?  Perhaps some banks have excess concentrations in energy loans, real estate loans, or loans originated in vulnerable countries.  Perhaps banks are reconsidering loans extended to companies in other sectors (retail companies, technology companies, etc.). 

The fin-tech sector, including new-venture companies that for the past few years have threatened to blow up traditional banking, still poses as a challenge to conventional banks.  They operate slightly beyond the supervisory eye of regulators. (They don't take deposits. At least not yet.) Many banks have begun to respond to the challenge, rather than dismiss or neglect the important role of that sector.  Some banks have decided to establish partnerships, providing capital and access to customers (something fin-tech companies crave and need). 

Stock investors are likely comfortable that banks are developing reasonable strategies to whatever goes on at or whatever will come from fin-tech companies. 

With any sector of stocks, there's always something that looms that could threatened to cause values to plummet.  The great unknown. The uncertain, unplanned-for event. The threat that appears from the darkness.  Analysts try to predict what could be the firestorm that tears apart a bank's sturdy, sound balance sheet.

What could that be?  Insufficient cybersecurity risks? A global recession that sets upon the global economy from yet another house of cards (one incident leading to another to another until the economy is wrecked)?

For now, at least until yearend, some bank shareholders will say, let's enjoy this bundle of riches for the moment.

Tracy Williams

Friday, October 13, 2017

What's the Fuss at P&G?

Shareholder activist Nelson Peltz made P&G his next move.  Round one has ended.
Old reliable blue-chipper, Procter & Gamble, is seldom in the financial headlines--unless it's being praised for being a good corporate citizen in its Ohio home state or unless it announces expansion into a new region in the world or names a new CEO.

P&G has grabbed headlines in recent days.  A shareholder activist has made moves to "shake up the company."  Nelson Peltz, the activist acting on behalf of his Trian fund, wants to reorganize the company to improve results and shareholder returns and made bids to try to get a spot on the board.  He and his fund own about $3.5 billion of the stock and launched formal proxy efforts.

The activist says he doesn't want to oust current management and replace with his own appointees, nor he does he claim to have devised revolutionary strategies and product ideas.  He wants to reorganize in a way to permit outsiders to understand performance better and hold managers accountable. 

Although not the same, it appears similar to how Google reorganized itself into the Alphabet holding company and separated out the search-engine business from other innovative or different activities, at least to permit investors to dissect each business activity carefully. Business activities are not bundled into single operations, and managers and investors know for sure what's growing, what's profitable, and what's worth investing in for the long haul.

P&G hasn't ignored Peltz's pressure and responded with vigor, reaching early-round triumph in the recent proxy move.

But what is it about P&G's performance the past decade that irks him and stirs such activism? Sometimes it's not about specific performance, but specific performance compared to others in the industry. Sometimes it's about a reorganization to figure out what's profitable and what's not, and what should, therefore, be sold off or shut down.

In the consumer-goods industry, that will likely mean they measuring P&G's share performance against the likes of Colgate-Palmolive and Kimberly Clark.

Needless to say, with all the commotion about business reorganization and board seats, the stock price has jerked around a bit the past several days. By most measures, share price (now hovering about $91-92/share) has increased steadily since it experienced brief dark moments in late 2015 (when the broader market was in a downswing).  The stock's price-earnings (P/E) ratio ranges between 24-25 range. In some circles, investors might suggest it's over-valued. Activists will contend it's not where it could be.

The company, like others in consumer goods and products, has reached levels of stagnation.  Revenues haven't grown over the past several years; in fact, they have declined. Profits, therefore, have remained flat.

What had been a $74 billion-revenues company will not likely eclipse $65 billion in revenues this year.  Facing markets in very mature product lines and encountering tough competition wherever it turns, the company has worked to cut costs to maintain profits and to generate returns investors want to see in a bustling economy. The company appears to have done well to reduce costs across the board, which explains why operating profits are flat when revenues are down.

Returns on capital deployed (book capital) have climbed above 20%. The company is resorting to financial maneuvering like other mature companies in a similar scenario.  Revenues are flat, because product offerings are mature and global expansion has peaked. Hence, to achieve reasonable returns on capital, companies like P&G focus on (a) cost control or cost curtailment and (b) rewarding shareholders with big dividends and share repurchases. They also resort to reducing overall funding costs by substituting cheap debt for expensive equity. 

Returns on capital rise, and share prices could actually climb (because of dividends and the certainty of cash flow generated from old products year after year after year).  Share prices inch upward, but they may not soar.  Activists take big stakes and then insist they have the right strategies to help the share price surge.

Debt at P&G now totals a manageable $31 billion (including short- and long-term debt).  Operating cash flow of about $9-10 billion annually (even after accounting for capital expenditures), as well as cash reserves of about $10 billion on the balance sheet, can handle the debt burden. Ratings agencies award it a AA- rating, stellar by most standards.

Now compare with Colgate-Palmolive, a peer, where shares trade at a higher multiple (28 P/E) and which might have benefitted from recent market "concerns" about P&G, as its own stock has climbed almost 5% in the last week.

The numbers show CP wrestles with similar issues. The company is about a quarter the size of P&G and has also experienced steady declines in revenues. Like P& G, it has boosted profits from aggressive cost-cutting.  It, too, keeps shareholders happy with consistent dividends and share buybacks, but hasn't had to increase debt to supplement operating cash flow (about $3 billion annually).

(CP has a market value at 10/13/17 of $66 billion, based entirely from predictable cash flows and the value of many brands. It has less-than-zero book equity.)

P&G, by comparison, is an elephant, a healthy one, but perhaps one that is walking uphill. Peltz might have launched his haunting of P&G by habit.  He, his fund and other investment vehicles have habitually invested in large, mature consumer-products or consumer-goods  companies.  In past years, they have had stakes (and pursued activist strategies) at PepsiCo, Mondelez, Kraft Foods, and Wendy's.  (He might best be known for stir-ups at DuPont two years ago.)

After an unsuccessful proxy effort, Peltz was shoved back to the sidelines.  But the ball is in P&G's court, as it had announced it has its own well-crafted plan to determine a way grow an old, graying enterprise.

Tracy Williams

See also:

CFN: PepsiCo's CEO on the Hot Seat? 2015
CFN: Is Shake Shack Worth a Half-Billion? 2015
CFN: Radio Shack's Doomsday, 2015
CFN:  What Happened at JCPenney? 2013
CFN: Why Is Dell Going Private? 2013
CFN:  Alibaba's U.S. IPO, 2014
CFN:  Twitter's Turn to Go Public, 2013

Monday, September 4, 2017

Is Volcker Hurting Market Liquidity?

Paul Volcker, former chairman of the Federal Reserve, proposed the Volcker Rules.  Have they reduced liquidity in capital markets?

The Volcker Rule. That's the infamous rule adopted after the financial crisis that prohibited banks (deposit-taking financial institutions) from engaging in proprietary trading, trading for their own accounts, or adopting trading styles that mimicked some of the most risk-seeking hedge funds.

The Volcker Rule, an appendage of Dodd-Frank U.S. legislation in 2010-11, was supposed to ensure banks, big and small, would focus on the basics of banking and would never use customer deposits to support exotic trading positions.

Banks can engage in trading of securities (equities, options, swaps, corporate bonds, commodities, futures, etc.), but it must be done on behalf of customers. Any equity security that sits on a bank's balance sheet must be tied to customer-related trading, as if the security is inventory on a shelf, up for sale.  A bank can buy and hold, as long as it expects to sell a short time later to a customer. While it holds, it can report and enjoy the related trading profits. 

The onus is on banks to prove to regulators that trading positions exist to accommodate customers--and not to profit from their own views of whether a market is headed up or down. Volcker rules stipulate the bank must show securities and derivatives on the balance sheet (and positions off the balance sheet) have "customer demand." They most show proof there are customers who may come along and purchase what resides on the bank's balance sheet. More technically, banks must quantify "reasonably estimated near-term demand," known better among compliance officers as "Rent-D."

Banks have responded to the Volcker Rule by scaling back trading activities, reducing positions, and refocusing capital-markets strategies.  This has also meant withdrawal from several markets and downsizing balance sheets--responses, some say, that are exactly what regulators wished. Such withdrawals and wind-downs meant banks reduced trading positions by tens of billions, as well as winced as they watched trading profits wither away.

Large banks, having absorbed the regulatory punches, re-engineered and pressed on by adopting strategies that suited them.  Among the large banks, trading revenues continue to be substantial:  JPMorgan Chase and Bank of America (Merrill Lynch) reported $12 billion and $7 billion, respectively, in trading profits in 2017.  JPMorgan still reports over $400 billion in trading-related assets in June, 2017, even while complying with Volcker and rationalizing many trading desks.

But there is another big picture that bothers some market players:  As banks have had to withdraw and restrict trading assets and trading risks, has regulation reduced liquidity in certain markets?

Because banks agonize over Volcker compliance, has that hurt liquidity, volume and activity in certain markets?  In many fixed-income and derivatives markets, participants and investors could always count on big banks to act as dealers and counterparties--ready to make markets or take positions to accommodate their own trading schemes. And for sure, they had the capital and balance-sheet heft to take positions. A hedge fund or an insurance company always knew a big bank might be interested in assets they wanted to get rid of.

Diminished liquidity in securities and derivatives markets can have significant impact on costs, prices, and values.  Transaction costs rise; bid-ask spreads on financial instruments widen, and often traders, investors and dealers can't establish a true value of a security or a derivative.  In many ways, illiquidity leads to further reductions in liquidity.

The prevailing notion is that while the Volcker Rule has forced reductions in market risks at banks, liquidity in certain markets has dwindled. 

Or has it? Has Volcker really had that kind of impact? Are markets less liquid, or has the nexus of liquidity shifted away from many banks to a handful of core banks and a swath of other dealers, trading systems, hedge funds, and financial institutions. 

This year, the Securities & Exchange Commission decided it wouldn't guess at impact on liquidity; it would measure impact.  With the support of the U.S. Congress, it tasked its own Department of Economic and Risk Analysis to determine the truth.  In August, in a 300-plus-page report, it published its findings--which concludes on its first-page executive summary that the Volcker Rule has had no material impact on liquidity in most fixed-income and derivative markets.

The report examined both primary-issuance activity (underwritings and IPO's) and secondary markets (dealers, traders, investors, etc.).

In IPO and new-issue activity, it concluded Volcker impact has been "mixed."  Activity has fluctuated the last few years, but not because of Volcker restrictions. 

In corporate bonds, where many suspected there might be the most significant declines in liquidity, SEC examined market-makers, dealers, and electronic markets. It concluded banks' capital commitments to such activities had declined, but liquidity hasn't changed materially, and there has been negligible change in transactions costs and volumes. 

It examined complex bonds:  convertibles, putables, redeemables, and those with sinking funds.  It examined credit-default-swaps sales (CDS), derivatives that can be sold by dealers and traders to achieve the same economic position (and risk) of owning a corporate bond.  The SEC concluded there was no material impact on liquidity, reporting that banks' withdrawal from some of these activities has been offset increased activity from hedge funds.  And brisk activity in CDS has helped ensure corporate credit risks (reflected in bond and CDS prices) are priced fairly and up to date.

In structured products, the SEC studied activity in asset-backed securities of all kinds, particularly those tied to mortgages (RMBS, e.g.). Similarly, it examined activity, volumes, bid-ask spreads, transaction costs, and participant numbers.  It looked at "young bonds" (newer issuers) vs. "old bonds" (bonds issued long ago).  Its conclusions were the same:  not much impact on liquidity, it reported.

The SEC also looked at private markets.  That would include private placements of various kinds (financings subject to Regulation D, 144A, "JOBS" Act (for small issues), and popular crowdfunding processes in recent years).  Same conclusion. No noticeable, meaningful impact on liquidity.

Attempting to cover all grounds, it addressed stress scenarios.  Liquidity may be brisk in normal times, but, as market players know well, liquidity can dry up swiftly in distress.  Banks, traders, and dealers disappear because they can't absorb the risks of loss, want to avoid the uncertainty, and can't get true prices of assets or positions.  The SEC report concludes the Volcker Rule won't exacerbate how market players react in stress cases.  It observed some dealers will, in fact, sell assets to make room for customer purchases. 

So the 300-page, well-documented analysis will likely be used to rebut arguments from factions who believe the Volcker Rule must be watered down to permit banks to replenish market liquidity.

Banks and other proponents to abolish much of the Volcker Rule may have difficulty in finding flaws in the SEC analysis. They may now focus on other favorite tactics: (a) Volcker's ambiguity in what is defined as a proprietary trade and (b) the time-consuming, costly efforts banks expend to prove compliance in the rule in the first place.

Tracy Williams

See also:

CFN:  Volcker Rule: Point of No Return, 2013
CFN:  Volcker Rule: Here It Comes, 2011
CFN:  Volckerized, 2010

Thursday, August 10, 2017

MiFID 2: Do We Know the Real Impact?

MiFID 2 are trading-related rules in Europe, but will have impact on global activity and participants everywhere.
More than those from other industries, financial institutions (banks, broker/dealers, investment firms, etc.) are accustomed to addressing the burden of regulation and assessing the short- and long-term impact. Many, however, will pout about the detrimental effect on income in blogs, annual reports and earnings calls, but they adjust. And they invest in people, systems and data management to do whatever they can to comply.

Sometimes, too, they procrastinate in preparing for or adjusting to changing rules.  Or they aren't sure of the real impact until deadlines and target dates loom. Take MiFID. Or what's technically called MiFID II (say, "MIF-fid").  Amidst the rumblings of normal mid-summer trading and banking activity now come scattered howls from banks and trading firms who must comply with MiFID II before the next big deadline, January 1, 2018. 

As that deadline approaches, banks, broker/dealers, trading firms of all kinds (high-frequency traders, algorithmic traders, alternative trading systems, inter-dealer brokers, exchanges, clearing firms, etc.) and even small investment advisers have begun to emit a big, collective "uh-oh," as they've begun to realize the new rules written in Europe might present bigger-than-expected obstacles in day-to-day trading activities. 

What is MiFID II anyway?

Markets in Financial Instruments Directive, Part 2. (Part 1 was implemented in 2007.)

MiFID, in sum, is the European Union's version of securities and derivatives trading rules in the ways such rules are written in the U.S. by such regulators as the SEC, CFTC, and the Federal Reserve (and codified by such legislation as the Dodd-Frank Act). 

During and after the crisis, the European Commission (along with the European Securities and Markets Authority) rewrote trading rules with a primary goal of ensuring that markets would be liquid and transparent and that investors would be protected and treated fairly.  In the aftermath of the crisis, a second version was necessary. And as expected, trading and investment rules are not summarized in a short, easy-to-read Word document.

In 2017, moreover, trading, dealing, and investing are activities that are as global as ever. Financial institutions have a footprint in most banking, securities and derivatives markets around the world.  Investors today buy, sell or trade securities and derivatives wherever there are opportunities. Bankers, dealers, traders, and investors step across national boundaries to find the best price, the best rate, the best counterparty, the best arbitrage, and the best trading ideas.  Funds, capital, securities and claims flow at all hours to all places.

Regulators in the U.S., Japan, Europe, and the U.K. and elsewhere play catch-up swiftly to ensure markets are fair, losses (yes, they are inevitable) will be manageable, and the less-than-sophisticated or uninformed participants are not taken advantage of.

MiFID II applies to securities and derivatives activities, which implies trading, dealing, and investing--from the trillion-dollar institutions to the recent college graduate buying a mutual fund. Comb through the hundreds of pages of rules (Level 1, Level 2, Level 3). The goals are simple, the rules are frighteningly detailed and complex, and the potential impact on global markets is what is causing some institutions and market watchers to squirm out loud.

The basic goals are worth praising:  investor protection, pre-trade transparency (best price, best execution), post-trade transparency (price reporting), execution on approved exchanges and venues (favoring those within Europe), cost-efficient research, and awareness of what's being traded and with whom. 

But MiFID has tossed a few knuckle balls in the process. For example, if an investing firm wants to purchase shares of an equity security, then new regulation requires that its broker/dealer funnel the trade to the exchange or venue offering best execution (with low transaction cost) and best stock price (lowest share price), as long as the venue is within the EU or the trading counterparty is in a foreign market with rules and regulation similar to those outlined in MiFID (called "equivalence" in regulatory nomenclature). 

What if the foreign market, which trades the same security at the best price, doesn't have equivalent rules?  Within MiFID, investor protection supersedes best price or best execution.  What if the ineligible trading counterparty is a well-known dealer in the U.S.? In this scenario, it loses trading volume and, therefore, trading revenue.  Now multiply that by millions of shares daily. Lost flow, lost business.

In securities research, MiFID will require investors know the specific cost of research they get from broker/dealers (or sell-side firms).  Conventionally, investors (including individuals and asset managers) pay for research from the commissions they pay broker/dealers when they funnel trades to that firm. To protect investors, MiFID wants them understand the real cost of research they are receiving and pay for it directly. 

Sell-side firms must alter how they present and distribute research and expect to engage in pricing wars with each other. To date, firms seldom, if ever, separated out or disclosed publicly how they quantified the costs of investment research.  In 2018, they must do this for investors based in Europe or investors based elsewhere who transact with institutions based in Europe. 

MiFID II does its best to cover all aspects of securities and derivatives trading.  It addresses issues and risks of "dark pools"--where large institutions match buyers and sellers of securities in-house beyond public markets (at the request of both parties).  It doesn't outlaw such activity, but wants to limit its prominence and impact.  It wants to avert the possibility that for some stocks, most of the trading could occur in dark, non-transparent venues. Those who preside over such trading pools must register as "systematic internalizers" and report trading data and prices in ways they weren't required do so in the past.

High-frequency traders, that segment of trading firms that rationalizes trades with exquisite algorithms and quick-trigger technical prowess, will be tolerated, but MiFID will require they disclose their general trading strategies to permit market players to understand their roles.

MiFID understands how investing and trading occurs in an expansive global arena, but is forcing players in the arena outside of Europe to implement rules consistently with those in the EU.  Hence, there has been focus on "equivalence."  If two firms engage in interest-rate swap trading and if one operates or resides in Europe, where can the two parties clear and settle the trade? Bank regulation (Basel III) may require it be cleared and settled by an approved counterparty. MiFID regulation may require it be cleared at a venue with MiFID-approved rules.  Does that mean the traders must overlook settling the trade at the Chicago Mercantile Exchange, where costs and efficiencies could be more attractive?

Beyond the howls and whining, most large, active financial institutions (from banks to small dealers and registered advisers) are familiar with the post-crisis landscape:  They recognize what new regulation is trying to resolve, complain resolutely, critique sharply, and weigh the impact. They lobby for easing some line items in rules, hire the right personnel, and invest in systems and data accumulation. They make the proper disclosures, reorganize, procrastinate, reshape business models, adjust, and then proceed.

And then of course, they might wait for MiFID III, where they hope regulators will try to ease the burden and simplify.

Tracy Williams

See also:

Monday, June 19, 2017

Amazon's Latest Venture: Whole Foods

Amazon won't have issues raising $13 billion to acquire Whole Foods
Amazon, arguably the best example of where 21st-century big business is headed, never fails to catch markets and industries off guard. As part of CEO Jeffrey Bezos-inspired corporate strategy of taking dare-devil leaps in many different directions in many products, the company surprised, but didn't surprise when it announced its June, 2017, $13 billion acquisition of Whole Foods, the popular food chain saddled with more than a few frustrated shareholders.

Amazon may have been pondering such a move for a long time and then pounced on the opportunity when the $13 billion price tag was too enticing a value.

Industry strategists and business futurists have already begun to imagine what Amazon will do with Whole Foods and how it will revolutionize how food is marketed, sold and delivered in the U.S. and, perhaps eventually, around the world.

By tradition, Amazon takes big steps, makes acquisitions, starts new activities and ventures and examines them over long periods.  It admits failure and doesn't tolerate short-term scorecards to measure what they do. It won't care how markets assess the Whole Foods acquisition in, say, October or November or even a year from now. Right now, the acquisition is about developing a business model with little regard (for now) for expenses.

If the acquisition is consummated (barring counteroffers from other suitors and prohibitions from regulators), industry watchers will unleash unending analysis on the Amazon-Whole Foods marriage. 

On the finance side (balance sheets, capital, returns, shareholder value, cash flows, debt levels, etc.), how is the transaction rationalized or justified? How might have performance and financial strength at both companies led to the two parties coming together? How will Amazon structure and finance the deal?

For those who follow Amazon shares, the company is a long-term growth story. Earnings have always fluctuated.  Losses occurred intermittently, although performance has improved the past two years.  On the other hand, revenues surge year after year. The Bezos approach to corporate management is growth first (measured by new businesses and stunning increases in revenues) and pay attention to earnings later. Stock markets have bought the growth story. Why else would its Price-to-Earnings (P/E) ratio exceed 180x, when values are hardly influenced by promises of dividend streams and smooth income statements. (Amazon still doesn't pay dividends.)

The growth story is indeed extraordinary.  Revenues will approach or exceed $140 billion this year, almost doubling those of 2013.  Earnings, which until 2016, were a succession of losses and gains from quarter to quarter, will likely approach $3 billion this year. That puts it on a pace to generate balance-sheet returns of a 14% (before Whole Foods' numbers are tacked on).

Notwithstanding volatile earnings in the past, Amazon has always been adept at generating handsome amounts of operating cash flow, thanks in part to shrewd, efficient management of current operations (inventories, supply chains, etc.).  But operating cash flow from recent periods ($16 billion last year, is not enough to pay for Whole Foods. Operating cash flow is already used to support and grow existing businesses. 

Remember, the company, even as old as it is, doesn't pay a dividend.  All operating cash flow is reinvested into its many businesses (and new ventures). 

The company enjoys the advantages of debt (low costs, leveraged returns), but in moderate doses.  Debt has financed growing levels of assets and new ventures. Debt isn't used (as with other companies its size) to fund stock repurchases and subsidize dividend payouts, because the company has never elected to reward its owners that way.  (Rewards come in increased stock values based on, yes, assumptions and expectations of long-term growth.)

Investment bankers will have already advised Amazon on how it will fund its purchase of Whole Foods.  The company has about $20 billion in cash reserves, but won't exhaust most of that to acquire Whole Foods. Also, it won't likely issue new equity (because it hasn't done so in years and because it won't risk diluting current share values).

Including capitalized leases, Amazon's debt level exceeds $15 billion, and based on sustainable operating cash flows of about $16 billion (excluding contributions from Whole Foods), Amazon may have "room" to increase debt another $10 billion or so before ratings agencies and credit markets get worried.  Because of such "room," for the total amount it needs to acquire Whole Foods, it could borrow some of the $13 billion and use some balance-sheet cash for the rest and then fine-tune these proportions, depending on market conditions and reviews from of ratings agencies and shareholders. Amazon may not likely want debt to rise too far above $20-22 billion. And it may not likely want cash reserves to dip below, say, $15-18 billion.

This, of course, assumes Whole Foods will operate at least at breakeven and won't be a financial and cash-flow drain on Amazon, as the two companies integrate and try to figure out that magic model for how groceries will be sold and delivered in the 21st century.

Now what about Whole Foods?

Company management has been subject to analysis and criticism, mostly because performance has been flat the past several years for many reasons.  Revenues hover about $15 billion, and earnings exemplify that flatness (simmering within a range of $507-579 million annually the past four years).  Whole Foods is viable and sound, and balance-sheet (book-value) returns on equity are satisfactory (about 15%). But shareholders are displeased.  There didn't appear to be a thrilling investment upside in the years to come. Whole Foods' numbers would suggest the company is operating on a treadmill--not stumbling and falling, not really going anywhere.

Shareholders might have benefitted from stock-repurchase and dividend-payout programs, as part of an effort to make them happy.  In 2016, the company, which had operated with negligible debt levels, took on about $1 billion in new debt, partly to finance stock repurchases (to help boost sagging stock prices).

Whole Foods has tweaked its business model (fresh, organic, premium-priced food), but the numbers suggest it hasn't made eye-opening investments or stepped beyond its niche.  It's a $15 billion (revenue) company that seemed stuck at $15 billion. 

Amazon's finance team won't have an eye on cash reserves on Whole Foods' balance sheet (It keeps cash at low levels), but will like that Whole Foods doesn't bring hefty amounts of debt to Amazon.  That permits Amazon to rationalize incremental debt to acquire Whole Foods. 

In effect, Whole Foods won't be a financial drain on Amazon while the latter conducts its experiments on what to do with it (and how, of course, to keep the likes of Walmart at bay). Whole Foods shareholders will miss the modest dividend payments, but will certainly have gained value by selling out.

Some will ask whether Amazon could have paid less for Whole Foods. In another year, it might have.  In 2017, Amazon is buying stable cash flows, an operating structure, a brand, a customer base, and some infrastructure. 

But it is also paying for not having to start this new experiment from scratch.

Tracy Williams

See also:

CFN:  What Does the Market See in Amazon? 2014
CFN:  What Happened at J.C.Penney? 2013
CFN:  Why Is Dell Going Private? 2013
CFN:  Yahoo Tosses in the Towel, 2016
CFN:   Alibaba's IPO, 2014

Friday, June 16, 2017

Apple: Being Green

By pledging to invest in energy projects, Apple is, in effect, getting into the energy business.
With the assistance of big banks Goldman Sachs, Merrill Lynch, and JPMorgan Chase, in early June, Apple, the iPhone giant, borrowed $1 billion, payable in 10 years.

That should not have been a notable news item.  The company now has about $99 billion in debt and abundant resources from cash flows and cash sitting in accounts around the globe to be able to manage the new billion and all other debt.

Financial analysts often try to sniff out how much cash the company has.  Is it $65 billion it has on hand on U.S. balance sheets, or does it have over $200 billion in cash-like assets squired away on balance sheets off-shore and in far-flung subsidiaries--cash it apparently maintains outside the purview of U.S. tax collectors? Which is it?

In its post-Jobs era, the company borrows substantially and does so for familiar corporate-finance reasons (pay down other debt, pay dividends, invest in new projects, buy back stock, etc.).

This new offering has a special purpose and proves Apple is gradually getting into the renewable-energy and conservation businesses.  The new offering is being called a "green bond" and adds to an existing green bond on its books ($1.5 billion). Hence, it has $2.5 billion in "green bond" liabilities.

Bond proceeds will be directed to an Apple-managed fund, which has been and will continue to make investments in wind farms and solar plants, renewable energy, and projects related to energy efficiency and reductions in carbon emissions. It is advancing its initiative to not only ensure that its supply chain and whole organization are run on sustainable energy, but also to invest in other projects, as well.

In other words, it's taking a lead in becoming a behind-the-scenes energy company.  That's similar to the fact that, in 2017, all large companies, whether they are in consumer goods or financial services, are now, in essence, technology companies in various degrees.

Sooner or later, most large companies operating in all kinds of industries will have evolved into energy companies, as they make decisions and investments about how energy is sourced and used within their operations.

Apple didn't hide that this new green bond is timely, coming in the wake of the White House's withdrawal from the Paris climate and emissions initiatives this spring.  Apple and other large companies have decided to provide energy and climate-concerns leadership, if the U.S. Government lags.

In effect, Apple, via its fund, will become a merchant bank for energy projects. It assumes a role, where other banks might still be reluctant or shy, because of inherent risks or no guarantee of sufficient returns. It will have borrowed $2.5 billion-plus, invest in an internally managed fund, and support projects based on criteria to keep the "green" label attached to the bond. It also hopes to invest prudently.  While Apple has the right spirit and mind, it won't be giving away the funds and would expect to generate reasonable returns in whatever forms of investment it takes on (equity, debt, notes, loans, etc.)  Shareholders will hold Apple to that standard. 

Could Apple do more? Yes, it has the resources.  Yet it likely wants to set the model and encourage other companies to do the same.  Should it do more?  Some will argue Apple should be applauded, but should continue to focus on what it does best or focus on the next generation of Apple products.  Some will access whether shareholders will be disadvantaged. (Some Apple shareholders will say they themselves can choose to invest in energy projects or companies with special expertise and focus on energy.)

With the new debt and the mountain of existing debt, no one questions Apple's debt burden.  The company continues to generate gobs of cash everyday, although trends over the past year showed declining levels.  The company generated about $65 billion in operating cash flow last year (new cash beyond what already existed on the balance sheet), although most of that ($41 billion) was generously returned to shareholders (dividends and stock buy-backs). 

It continues its strategy of holding on to the $200-billion-plus in cash on the balance sheet and tapping new debt to support ongoing investments, capital expenditures and operating cash flow to reward stock investors. It has decided there is no value yet in reducing the overseas cash reserves, especially in an environment where debt costs are still low and where it can borrow easily with its Aa1 credit rating. (Note Apple does not have a AAA rating.)

After years of avoiding debt financing, the company is accustomed to it.  Debt levels have risen from $16-99 billion in just four years. With such increases, the company's book equity ($134 billion) and market value ($745 billion) have soared, too, over the years. Analysts and some observers might be concerned (as they should be) about recent declines in revenues, earnings and cash in fiscal-year 2016.  (Revenues fell 8%, and earnings dropped 15%.) Stock values have been satisfactory, despite the declines, as shareholders seem confident the company will figure its next steps (or new products or variations of old products) to spur growth.

Now in the energy business with its energy-related fund (and emboldened by high standards and expectations for itself and all companies), Apple, we can bet, won't likely share in-depth details about its energy portfolio (amounts, returns, performance, risks, concerns, shortfalls, etc.) on an ongoing basis, and it may not even have lofty objectives regarding investment returns. It may, in fact, be trying to do its part when it appears Washington is taking a back seat.

Tracy Williams

See also:

CFN:  Apple's stash of cash, Buffet's investment in Apple, 2012-2016
CFN:  Apple With All That Cash, 2013

Wednesday, May 17, 2017

Second-guessing Snap

Did Snap decide to go public too quickly? Are its bankers and board regretful, after share-price declines and a recent large loss?
Just weeks ago, Snap, the corporate parent of the popular Snapchat application, issued new shares to the public in a bang. Investors hustled to get a piece of the new IPO and imagined stock values that would eventually soar in they way they do for Facebook, Apple and Google.

Snap shared a past with these and other big tech giants in that they were started by twenty-something wonders, brought fascinating products and service to the market, struggled with early losses, struggled in early days to get the business bustling, and managed the demands of venture capitalists.

Snap made the decision last year to go public and "actualize" theoretical values of the company. In the process it would raise some cash to put on the balance sheet and decide how best to grow the company and face off against Facebook's Instagram. In doing so, bankers prayed this might spur momentum in a lackluster IPO market and might encourage Silicon Valley unicorns Uber and AirBnB to rush to market.

Just weeks later and just after reporting a blockbuster loss in its first reporting period after the IPO, Snap leaders and board members might be second-guessing themselves.  In the recent quarter, it announced a $2.2 billion loss that sent its stock value in a downward swoon (25%) and caused many to wonder if it would have been better off to delay the offering. (If it had delayed, the loss would not have been publicly acknowledged. It would have, however, likely been the subject of speculation the company continues not to make money.)

The announcement of the loss caused its stock price to sink from $23/share to $18/share in a blink. At May 17, the stock was valued at $19/share. Unlike the mildly botched IPO offering at Facebook, when shares dropped partly because of share-distribution mechanics with Nasdaq, Snap's price decline reflects true market sentiments.

As a public company, it must disclose and explain the loss and then gear the market up for how it will perform in the next quarter. And the quarter after that. And on and on.

How is the loss explained? That it lost money is not news. Snap, the quarterly reports show, loses about $100-200 million every three months.  This loss was ten times more than usual. The company explained most of the expenses in the recent quarter are one-time charges and promises the losses will settle back to usual levels.  But will investors feel comfortable enough with such assertions to jump back into the stock? Some hedge funds, reports say, have short positions in the stock.

In the most recent quarter, the company reports over $1.4 billion in sales and administrative expenses and about $800 million in essential research-and-development expenses in its battle with Instagram and practically all other firms that generate revenues mostly from digital advertising.  Most of these expenses were accrued, so the company didn't necessarily use up all the cash it received in the public offering. It still holds onto about $990 million in cash reserves and will collect another $160 million in the period to come from receivables.

Hence, the company is  not yet desperately cash-strapped--at least not in the short term. It also has no debt and pays no dividend, which means it isn't under pressure to generate high levels of cash flow to meet demands from lenders, debt investors and shareholders.  Shareholders, if they aren't already, will wonder about long-term prospects and growth. Will the losses ever transition into earnings, and how long can they tolerate that?  Snap reminds investors earnings won't be positive anytime soon.

Wouldn't the company have been better off remaining private? (Is this the question for the moment its leaders and bankers have pondered?)  Going public permitted it to raise cash and reward founders and employees.  Going public also might have forced the company instill financial discipline and deliver a plan toward profitability to the public.

But going public forces it to explain lagging performance and rationalize to frustrated shareholders why they "aren't there yet" and devote more time to investor constituencies, less time to product strategy. It permits the flocks of equity analysts to scrutinize every line on the income statement and balance sheet and second-guess strategy, forecasts, financial condition and intrinsic market value. Every quarter, co-founders Spiegel & Murphy must delivery a public message about Snap operations--good or bad.

As a public company with no earnings expected for quarters (years?) to come, does it still have "value"? Expert tech investors will argue it does.  Earnings and cash flow contribute to value, but so do accounts, views, usage and resident technology (which Snap has, although growth has slowed and the competition is strong).  With all the recent bad news regarding performance and expected growth, the company's market value totals $24 billion--about 20 times the value of an old company like the retailer J.C. Penney.

It's a good bet Snap's loss, for the most part, encouraged AirBnB and Uber, private companies on everybody's watch list for the next big IPO, to hang back and remain private for a while.

Tracy Williams

See also:

CFN:  Facebook's Stumbling IPO, 2012
CFN: Twitter Takes an IPO Turn, 2013

Friday, April 14, 2017

Who is "Cecil"? What is "Cecil"?

As if they didn't have dozens of other issues to resolve, financial institutions must now incorporate new CECL rules when determining expected losses on credit portfolios.
In sports, commentators analyze "on field" activity and "off field" issues.  The game is played with veracity and intensity on the court, on the diamond, and in arenas. Yet off-field issues abound in levels as low as Little League all the way to the Olympics and the NBA.

In banking and finance, commentators and senior managers in financial institutions analyze both on-field and off-field issues. On the field, industry participants and observers wonder where fin-tech will take us and worry about the threats of "shadow banking" and cyber thieves. They explore opportunities to increase loan portfolios, trade securities, or invest in companies.  Off the field, they fret about the burdens of regulation and the future of Dodd-Frank and wonder how to reshape strategies to make money without liberties they enjoyed just a decade ago.

(In his latest message to shareholders--and for all purposes, to the entire financial community, JPMorgan Chase CEO Jamie Dimon used his annual forum to complain about how burdens and inconsistencies of bank regulation distract from his bank's efforts to grow, expand and be an engine booster in the economy. This year, however, he delineated specific examples (liquidity, capital, and leverage ratios) and called for immediate action to simply difficult rules.)

Financial institutions are encountering yet another off-field issue, and as 2020 approaches, they whisper and talk among themselves about its possible impact on earnings and precious capital calculations. It's called, informally, "Cecil."

Cecil stands for "Current Expected Credit Loss," or CECL, or "Cecil." It's not a Basel III, BIS or Dodd-Frank regulatory requirement, although bank supervisors happily endorse its purpose. It's a new accounting standard.

Financial institutions (banks, mortgage companies, finance companies, etc.) book loan assets, or assets with varying degrees of credit exposures and risks.  They may be leases, credit-card receivables, mortgages, or long-term loans to a Fortune 500 company. They may be corporate bonds held to maturity. They also project losses on the portfolio or anticipate defaults on delinquent, high-risk or non-performing assets.

Hence, for a $100 million portfolio of loans, accountants (with regulators in the background) guide lenders on how much they should reserve for losses:  loan-loss allowances, loan-loss provisions, etc. This total is not always based actual losses or actual charge-offs, but on "expected losses." Actual charge-off histories and losses figure in the determination, but reserve amounts are supposed to be a forward-looking calculation.

Banks determine these reserves or allowances in various ways, often prudently, carefully, and based on outlook in various markets.  But they do so inconsistently.  The reserves are subtracted from earnings and capital.  Traditionally banks don't want to make them too high or too low.

A year ago, financial institutions were examining their corporate loan portfolios for oil-and-gas exposures as plummeting energy prices jeopardized the payout of loans to related companies.  Across the board, because expected losses on these assets were increasing (because of troubles in the industry), banks increased their reserves.  Each bank decided what would be appropriate and did so under the auspices of accountants, regulators, competitors, counterparties, and shareholders. In such analysis, banks target the borrowers that would be candidates for losses:  vulnerable borrowers, borrowers on watch lists, borrowers in declining industries, etc.

Financial institutions spend substantial amounts of time discussing and analyzing what reserves should encompass or are meant to be. Should they be subtractions from delinquent loans, restructured loans, and loans that are candidates for charge-offs?  Should they take into account the probabilities of default or credit deterioration of even the best, investment-grade portfolios? And to what extent should loan recovery (the amounts that can be recouped after a loan defaults, typically because of collateral, seniority, hedges or guarantees) be incorporated?

Now comes Cecil to ensure this practice (a) is implemented more consistently across all financial institutions (not just banks), (b) proceeds with similar assumptions, and (c) examines the possible or expected losses for the entire life of the loan that is booked (not just for one year or two years).

What worries banks is "Cecil" may highlight where they may have been under-stating expected losses or allowances and may require them to increase loss provisions substantially.  As well, credit provisions (and annual allowances for customer default) will likely increase from year to year, become a much larger cost than usual, and diminish bank profit growth and capital build-up.


Big banks (like Citi, JPMorgan Chase and Bank of America) already take credit provisions on loan portfolios of $1-2 billion annually (higher in 2016 as they grappled with struggling energy exposure). Within those same portfolios, they have reserves for losses that can top $10 billion, a direct subtraction from gross loan portfolios.

Cecil rules will require banks (in 2020 and beyond) to calculate expected losses based on the entire life of a loan, not loss expectations over a shorter time frame.  The rules also apply to corporate securities that are held to maturity.

If Wells Fargo, PNC, Goldman Sachs or Regions books a $25 million, ten-year loan to a corporate client, then it must determine an expected loss based on 10 years, not one or two years. How much could Wells Fargo be expected to lose over a 10-year loan life? Under most scenarios, the expected loss over 10 years would be significantly higher than an expected loss over a year or two, if only because the elapse of time presents many scenarios for the borrower to default.

Basel III and Dodd-Frank require related calculations, but differ in two ways:  (a) Regulators require banks to determine losses over a one-year time frame, and (b) they want banks to hold capital (not apply provisions against earnings or allowances for default under loan assets) for unexpected losses.  They want banks to have capital to absorb the risks for the worst-case scenario over a much shorter period.

Just like Basel III rules, Cecil rules may have impact on the volume, content and riskiness of the loans banks decide to book in short- and long-terms.

Risk analysts define expected loss to be the product of probability of default x loss-given-default x exposure at default.  In the 10-year loan example, the probability of default is much higher over 10 years than over one year, because (a) default statistics show this to be true and (b) there are ample opportunities in 10 years for borrowers' creditworthiness to decline and market conditions to deteriorate. Banks can reduce expected losses by requiring exposures to be shorter in terms or requesting good collateral for even stronger borrowers.

Financial institutions still have about two more years to adopt approaches and a loan strategy.  They are doing this already as they determine concurrently the amounts of capital necessary for Basel III purposes.

Nonetheless, where it's now an imposing challenge for banks to achieve superb returns on equity (ROE) (say, above 12%), it could get harder.  For the same level of risks and business activity, Cecil could reduce ROE by a percentage point or two.

Banks might respond in many ways:

a) Focus on investment-grade borrowers and require collateral or some degree of support in ways they may not have required it before.

b) Reduce portfolio exposure with non-investment-grade borrowers, new ventures, or borrowers with little track record or operating in industries with no history.

c) Reduce exposures for longer tenors and focus on shorter-term funding arrangements.

d) Focus on products with revolving exposures (revolving credits) rather than long-term commitments.

e) Continue to sell off or securitize loan exposures beyond a certain threshold.

In other words, reduce the tolerance for risk, when there will, otherwise, be an immediate impact on earnings and returns.

For analysts, Cecil will make it easier to compare banks' loss provisions as apples to apples. For bank supervisors, it will be an additional tool to reduce the likelihood of another financial crisis.  But for banks, it will be another variable to manage precisely in what they perceive might be a vain effort to construct the almost-perfect balance sheet.

Tracy Williams

See also:

CFN: Wells Fargo's 2016 Woes, 2016
CFN:  The Essence of Corporate Banking, 2010
CFN:  Bank ROE's: Stuck at 10%, 2015

Monday, March 6, 2017

Snap Emerges from the IPO Gates

Snap proved again new tech ventures can achieve billions in market value without earnings. At least not yet.
Snap, the company responsible for Millennials' infatuation with an image-disappearing network and the parent of Snapchat, exploded from the public-stock starting blocks in March in what might be the most anticipated IPO of the past few years. Arguably this is the most talked-about debut of a company going public since Alibaba's U.S. arrival in 2014. 

Snap, like other tech darlings, is a young company, born in dorm rooms and frat houses at Stanford. It has made a splash among the young set and has regularly added features to its product line to hang on to the short attention spans of its audience.  Like other tech darlings contemplating public offerings, it passed the Unicorn test ($1 billion in private-company valuation), fended off larger companies interested in the product, talent, and users (Facebook), and followed the IPO timetable scripted by its New York bankers.

(Morgan Stanley and Goldman Sachs acted as lead banks on the underwriting.)

Like other tech darlings before and after an IPO, Snap disclosed performance to the financial world for the first time. No surprise.  The company has had growth surges that would cause any venture capitalist to swoon and has amassed over 100 million average daily users.  Like many tech darlings, the company doesn't make money. And in its IPO prospectus, it suggested it won't make a dime at least for a few more years.

So how does the company (and its club of bankers who helped set its IPO share price) rationalize being valued in public markets at an amount above $25 billion ($32 billion as of Mar. 6)?

How does a company founded and run by twenty-somethings, reporting a string of start-up losses, justify a market valuation that exceeds older companies with decades of track records (and earnings)?  Compare Snap's $32 billion market value with well-established companies like Nike ($90 billion in market value), Target ($30 bil), Goodyear ($9 bil), General Mills ($35 bil), or HP ($29 bil).     .
What do the numbers suggest?  Where will the numbers go? What could happen to that vaunted valuation?

No doubt Snap wanted to avoid the first-day-of-trading snafus Facebook experienced in 2012, when it went public under the auspices of the Nasdaq exchange.  The first-week, mechanical mix-ups in Facebook's IPO offset some of the joys of Facebook finally becoming a public company.  Snap elected to list with the New York Stock Exchange. 

Highly publicized IPO's, especially those where there is strong, popular demand for the new stock, are usually accompanied by the first-day bump in price, or sometimes spiking surge. Snap's shares experienced a 44% increase in price the first day. That often leads to the inevitable response from market watchers who wonder how the investment bankers might have under-priced the deal.  That 44% price increase represents an amount not received in proceeds by Snap, the issuer of new shares. Snap raised $3.4 billion in cash from the IPO. A 44% increase implies it could have raised $4.9 billion. 

Investment bankers often explain first-week spikes are typical in IPO's and are often followed by dips, where the shares settle back into a price range reflected by the initial offering price. 

Keep in mind Snap is a company that didn't exist six years ago (or perhaps it did so in dreamy debates among Stanford students in a dining hall).  And it reported $515 million in losses for 2016.

Market valuations are based mostly on promises and expectations of revenues, earnings, and cash flows over an extended period.  Snap's $32 billion valuation, therefore, should reflect investors' confidence that revenues will soon top $1 billion and glide toward the tens of billions and earnings will eventually flip and turn into a flood of profits and cash flows. 

Can Snap get to $1 billion in revenues quickly enough? Investors who bought and will hold the stock likely think so. The company reported $165 million in recent quarterly revenues, a total that puts it on a pace to eclipse $600 million in revenues in 2017. 

Some may opine otherwise. In this digital-advertising sphere, revenues are tied closely to user numbers:  views, users, clicks, daily volume, etc.  The fundamental question will be whether it can continue growth in usage in the way it presided over it the past few years.  How many more potential users are there around the world? Or what fascinating image technique (or filters or trickery) can the company devise to (a) keep current volumes and (b) attract the tens of millions who haven't bothered to try the app? How will competitors siphon off some of that potential growth? And will Snap try to achieve it via acquisitions or partnerships with others?

Right now, Snap has significant costs, which explains much why it is losing money. That's not a surprise for companies only a few years old.  New companies incur the expenses necessary to build a market or create demand for the product.  Once product demand (or product awareness or product popularity) is established, the company can strike out certain promotional and brand-awareness expenses.  (It reports $290 million in annual sales and administrative costs, for example.)

Snap also had $185 million in research-and-development costs in 2016. For new technology companies, that's not a surprise. Technology is the beacon that leads to the features that attract the users, which generate the revenues. For many technology companies, however, R&D expense doesn't eventually disappear; it remains steady, as the company must continue to grow, adapt, evolve or die, as they say.

Last year's loss translated into an operating cash-flow deficit of $615 million.  Companies, of course, are supposed to generate cash-flow surpluses for their stakeholders, and they can't bleed cash indefinitely. With the $3.4 billion in new cash (from the IPO) and $1 billion it already has on the balance sheet, it can bear another two or three years of big losses without new funding.

The company has no long-term debt. That helps when it is not generating positive cash flow: No worries about generating steady, predictable streams of cash from operations to meet interest payments.  It also has little need to borrow in substantial amounts to fund huge investments in plant and property.  As a new public company, nonetheless, once a quarter it will need to explain performance thoroughly and present optimistic projections for how profits will come about eventually.

With over $4 billion in cash after the IPO, it has a buffer to get it through periods of losses and has a source to make small acquisitions (not big, notable ones), if it thinks that's necessary to compete with, say, Facebook's Instagram, Google's own image ventures, and any other upstart.

Investors will give it a cushion of about three years of losses and cash-draining operations before they get antsy or even uptight (in the way investors of no-profits-yet Twitter have become).  A $25-30 billion valuation tolerates losses in early years, but means an avalanche of profits in the billions are on the horizon.  In a rudimentary (and crudely computed) way, a $25 billion valuation means the company is expected to generate operating cash flows within five years of at least $1 billion/year (that's profits, not revenues), remain on that plateau and grow from there at a rate of at least 2-3 percent/year. 

Is that possible?

Or will Millennials have moved on to the next new thing?

Tracy Williams

See also:

CFN:  Alibaba's IPO, 2014-15
CFN:  Facebook's IPO: What Went Wrong? 2012
CFN:  Facebook's IPO: The Lucky Underwriters, 2012
CFN:  Twitter's Turn to Go Public, 2013