Thursday, July 23, 2015

Bank ROE's: Stuck at 10%

Morgan Stanley reported a 10% ROE last quarter and is giddy about it
Large global banks continue to waft through a maze of ways to achieve long-term earnings growth, even while they splash headlines of billions in profits and rebounding stock prices.  ROE is the way shareholders, bank boards and bank managers assess performance, and big banks can't get their returns-on-equity (ROE) to budge a bit.

There was once a time when big banks like Goldman Sachs and Morgan Stanley (when they were pure investment banks and broker/dealers) and the historically commercial banks like Bank of America and Citibank could generate returns above 13-15% or push returns toward 20% quarter after quarter. Those were the days when banks could do it all--lend money to small businesses, arrange mortgages, trade commodities, invent new derivatives, and operate like quasi-hedge funds. They took big risks (paying for those risks later during the financial crisis), but they could strive for high returns, ROE's that eclipsed 15% now and then.

Times have changed.  Laws have changed.  And regulators have been persistent in forcing banks to reduce the risks on their balance sheets and eliminate risk they take in hedge-fund-like trading and ensuring banks dare not use customer deposits to fund questionable balance-sheet positions or exotic activity.  Their biggest tools:  (a) Require banks to hold more and more (and more) capital and follow thousand-page rule books regulators devised (via Dodd-Frank legislation). (b) Take advantage of the discretion they have as rule-makers to increase the capital requirements when necessary.

The capital rules are tough, challenging, detailed, and sometimes hard to comprehend.  Give the big banks credit.  They whine, and they fret. Their CEO's and presidents craft long essays in financial reports explaining the difficulties in meeting requirements. But for the most part, they cooperate and comply.

More capital and less risk, however, mean lower ROE's and make it nearly impossible for senior bank managers to push ROE's toward, say, 12%.

Take the most recent quarter.  Big banks announced large amounts of earnings in the second quarter. JPMorgan Chase and Wells Fargo, for example, topped $5 billion each.  A better economic environment helps.  More confidence among their risk managers boosts loan volume and gets the loan machine churning again.  Investment-banking and asset-management fees have increased.  Bank administrators have squeezed out costs in just about every function, activity or process that exists.

In many cases, net revenues among banks are growing, but not in leaps and bounds. The increases are slight bumps upward--from net-interest income to fees.  Banks have become creative and obsessive about finding new fees to offset revenue declines from the trading they won't be permitted to do. Services they once performed for customers at their pleasure are now subject to lengthy fee lists.

Yet ROE's are merely satisfactory.  Bank managers and bank boards are realistic.  They hope to reach 12-13%, they dream of 15-17%, but they settle for 10-11%. Examine bank ROE's in the second quarter, 2015:

Wells Fargo, 12% (12% in 2014)
JPMorgan Chase, 11% (9% in 2014)
Morgan Stanley, 10%
Citigroup, 9%
Bank of America, 9% (including Merrill Lynch)
Goldman Sachs, 5% (after special legal charges, 11% otherwise)

They head into the second half of 2015 wishing they could have done better, but happy and giddy they generated percentages that hover about 10% because any number around and above 10% results from managing effectively dozens of factors--including regulators' persistent requests to add more capital to the ROE denominator.

They know they are fortunate, too, because much of the ROE they report resulted not from surges in revenue, but from successful cost-cutting campaigns.  JPMorgan Chase and Wells Fargo, for example, are banks of similar size; they have different strategies, scopes and businesses.  They overlap in some areas (credit cards, small-business banking, and mortgages, e.g.). Wells Fargo stays within U.S. boundaries and long ago elected not to immerse itself in derivatives and trading in the way JPMorgan does.

Both banks, however, have experienced respectable, but slow growth in net-interest income and overall fee income the past few years.  Both, especially JPMorgan Chase, won't be able rely on substantial income from trading bonds, equities and derivatives in the way they prefer.  For both, business is better, and it's growing, but in inches, not miles.

To boost profits in the way they have done in the past year or so, they have conducted rigorous, aggressive cost-cutting campaigns on top of being clever about where they can charge fees.  Cutting costs, rationalizing businesses, and improving efficiencies in processing, operations, and product delivery across the board have had a favorable impact on the bottom line. (Some of those cost reductions have been offset by substantial increases in expenses for risk management, legal and compliance, but not enough to cause earnings to suffer too much.)

Banks still must wrestle with ongoing challenges.  Bank of America clocked in at 9%, a solid output after it struggled with capital requirements, stress tests, and balance-sheet restructuring the past year. It pat itself on the back, yet still felt it necessary to shake up top management as it marched to the 2015's second half.

Managing a complex, globally entrenched financial institution is as tough as ever. Their balance sheets are constrained.  They must maintain billions  more in capital, atop the hundreds of billions in capital they already show on balance sheets. They must now prove to regulators they are liquid, showing substantial amounts of calculated cash or cash-like assets that can't be used to make loans.

They have restrictions on leverage, so onerous that some banks like JPMorgan Chase are turning away large corporate deposits--those same funding sources that banks since the beginning of time have salivated over.  (Many banks will accept the deposits, but will charge fees or penalties for doing so. Some hedge funds, for example, may be required to pay fees to deposit excess cash at some banks.)

For now, they confront questions like those that follow:

1)  How much more in costs can they wrench from large, complex organizations without jeopardizing service, risking operations and technology glitches, and losing employee talent in big numbers?

2)  From where will revenue growth come, if they can no longer rely on the occasional spikes like that from trading income, sometimes a result of trading in new, exotic products, often a result from proprietary activity?

3)  What will the bottom lines amount to once interest rates start to rise? What impact will rising rates have on earnings?

4) Is it worth the hassle and compliance complexity to maintain a trading business of any kind to gain incremental revenue?

These are mere snapshots of challenges just to get ROE to a 10% threshold.  And that might be why some banks, like Morgan Stanley, didn't lament reporting a 10% ROE.  They tooted their horns.

Tracy Williams

See also:

CFN:  Credit Suisse Makes a Big Move, 2015
CFN:  Banks and Stress Tests, 2015
CFN:  Wells Fargo Sticks to What It Does Best, 2014
CFN:  Citi:  Why Did Its CEO Resign? 2012
CFN: UBS Throws in the IB Flag, 2012
CFN:  JPMorgan's Regulatory Rant, 2012 
CFN:  Banks and Their Dreadful Downgrades, 2012
CFN:  Morgan Stanley:  Can It Please Analysts? 2012

Sunday, July 12, 2015

Greece, China and a Stressful Summer

Events in Greece and China have led to summertime uncertainty and worries
Just when we thought it was safe to settle in for a stress-free, event-free summer, we encounter unwanted turmoil corralling us from around the globe.  Summer should have afforded easy moments to let traders, investors, and bankers glide toward Labor Day.

But now here come forces from Greece, China and even from within U.S. markets that make us wonder whether the rest of summer will be disrupted by events oceans away.  What we fear most is whether what happens over there can have impact on what exists here. What over there will affect market performance, investor behavior, and overall economic outlook on these grounds?

Many observers argue that Greece defaulting on its debt obligations and China's stock markets entering into a quarter-length nose-dive are contained events that won't cause too much of a dent in U.S. capital markets.  We don't know for sure.  But most of us know how a tipping of a giant mortgage iceberg led to the financial crisis and Great Recession of the late 2000's.

Out of the blue in early July, an unexpected technology glitch caused a nearly four-hour shutdown at the New York Stock Exchange. That stressed markets for an afternoon, but spawned greater worries about who or what was responsible and when will that occur again. Market analysts reminded us that because brokers and traders can go elsewhere to conduct trading (thanks to updates in trading rules in the past decade), the shutdown didn't cause calamity or panic. Yet everybody now knows this can happen again, will likely recur, and will happen more frequently than we want to acknowledge.

So instead of taking it easy in the precious weeks up to Labor Day, we are obliged to keep an eye on world events and wonder how they much damage they will inflict on trading positions and investment portfolios. For bankers and corporate finance officers, we wonder what impact all this will have on deal flow, corporate transactions, and companies' willingness to invest in new projects and business growth over the next six months.

The financial turmoil in Greece is often explained and has been intricately analyzed.  A complex, befuddling scenario can be summarized:

a) Greece, a member of the Eurozone, didn't meet a recent required debt obligation (billion-dollar payments that were due) and wants to renegotiate terms with a creditors (which include the IMF and Europe's central bank) that are already fatigued from years of patience, fumbled negotiations, and little improvement in the country's economy or its willingness to take seriously a hefty debt burden.

b) Greece, meanwhile, also has other obligations, including substantial pension-related debt, accumulated after years of outlandish spending and effusive promises to government workers.

c)  While the country's economy stumbles and appears to have dim hopes of an impending recovery, Greece must fend off creditors, make choices about who should get paid or who won't, decide if it wants to continue to be a Eurozone team player, and employ expert negotiating tactics to get irritated creditors to back off and agree to a restructured debt arrangement.

No side in any multi-player game of debt-restructuring chess wants the worst outcome.  Hence, the mountain of debt must be restructured, payment schedules extended, terms redrawn, and tenors extended.  But how does this get done to the satisfaction of all?

Meanwhile, nobody definitively can show how the country's economy will rebound soon or define how a series of  defaults and continuing non-payments will affect the rest of the world.  Daunting uncertainty prevails.

In China, an equity marketplace still in adolescence is going through growing pains. The Chinese stock market has grown enormously and quickly, so much so that it is now second only to the U.S. in aggregate market valuation.  But unlike U.S. markets, Chinese institutions and investors, including individuals have helped spark the country's consumer boomm don't have the advantage of a history of precedents from which lessons can be learned about crises, rampant volatility, trends, and exuberant behavior. They are learning on the fly.

Stock investing in China had become a new, popular pastime. Individuals and institutions just becoming accustomed to buying shares in private companies and hoping for favorable windfalls had hopped onto the bandwagon of stock ownership.  Chinese markets welcomed the surge in new activity and new investors in the midst of a rocketing economy.

The inevitable equity bubble many projected has come to be.  Equity markets had soared above 75% in value in the last year or two. P/E ratios, the benchmarks that indicate what's a bubble or not, climbed to outrageously high levels, even soaring past P/E ratios of the irrational days of the 1990's Internet bubble here.  In the past month in China, markets have imploded by percentage points (30-40% and more) that would cause investing nightmares in the U.S.

Yet Chinese government bodies have assumed a curious, perhaps expected role in trying to prop up markets, reignite confidence and assuring all that things will be all right.  They have purchased shares or have arranged for loans to others to purchase shares to boost indices.  They, including Communist officials, have changed rules on the spot and show no restraints in intervening to keep a capitalistic-bred machine humming briskly. Anything possible, short of inviting invite foreign investors to come over and partake in trading in its markets. (For example, they have prohibited short-selling.)

The rest of the world is getting acquainted with Chinese equities, how they trade, who buys them, what explains volatility, and the meddlesome role of government entities that keep stock markets buoyant.

It's hard to compare U.S. and China equity markets. They operate by different rules and histories, although Chinese exchanges have observed U.S. markets and replicated some best practices (including triggers that halt trading when something seems awry).  U.S. companies have layers of ways to issue new equity (private placements, venture capital, private equity, small-business and large-company offerings, etc.). China continues to study what works and what it might adopt.

U.S. markets have strict laws for registering new securities, reporting requirements of issuing companies, and insider-trading prohibition. U.S. markets have a vast array of players from clearing firms to high-frequency traders and an assortment of hybrids and derivatives:  options, convertibles, equity swaps, e.g.  It's just a matter of time before China catches up and introduces its version of the same.

For now, Chinese players can work to straighten out the summer angst without the complexities of exotics.  The current woes are likely due to something U.S. players know well: irrational exuberance--market values that can't be explained by the underlying economics.

In the U.S., we watch both Greece and China, analyze, wonder and try to gauge impact.  In some ways, we are actually rooting for both to overcome their issues and solve their problems.  That results in stability for all and continued optimism in all world corners, because what's good over there keeps the markets humming over here, too. Like it or not, what happens in Shanghai can influence what happens on Wall Street or seep inside the computer servers that keep trading activity in the U.S. whizzing.

Yet back on these shore., the New York Stock Exchange's systems glitch reminds us that (a) we need to prepare for and brace for more frequent outages and technology mishaps, (b) it was a good idea after all to have changed rules in the early 2000's to permit more exchanges to exist to arrange trades for any or all stocks, and (c) now and then, there is still a benefit to stick with apparently antiquated trading models that require humans in trading robes to stand at Wall Street posts to ensure orderly markets will continue throughout a trading day.

Tracy Williams

See also:

CFN:  Alibaba and Its U.S. IPO, 2014
CFN:  Michael Lewis' Back-Door Move, 2014
CFN:  High-Frequency Trading:  What's Next? 2012
CFN:  Dark Days at Knight Trading, 2012
CFN:  Derivatives:  Making Sense of Where We Are, 2013

Monday, June 22, 2015

The Mid-Year Review in Finance

Time for a mid-year review in finance. Any surprises?
July is about to roll in, and that means, besides the start of a hot summer, a time to figure out how the year has fared at its half-way point.  In finance, have things turned out as expected, or have there been surprises, both pleasant and unsatisfying?

Much of early 2015 has been an ongoing and sometimes agonizing mulling over interest rates. Every analyst in all corners contends they will rise, but when, how soon, and what will be the immediate impact?   Market watchers, traders, banks, and economists have looked for clues from the Federal Reserve and speculated on how to be prepared.  Interest rates will rise, they argue, but, in fact, an upturn has been anticipated and discussed for years (since the early 2010's) and is now expected any day.

Now in late 2015, the probability seems certain. As a result, markets are occasionally jittery, corporations are winding up their rush to refinance long-term debt while there is an opportunity to tap cheap funding, and investment managers ponder what to do about massive portfolios with large bond positions (Reallocate and sell off now? Later? Be patient or act now?)  Others sense that misbehavior in markets and panic striking bankers, traders and corporate treasurers could lead to a mini-crisis of sorts. A rise in rates will increase borrowing costs to companies that want to grow, expand and/or invest. A rise could cause a sudden slowdown in the multi-year recovery.

The Federal Reserve is policing it all, and most market participants are ready to act.

Equity markets, to date in 2015, aren't soaring as they have done the past two years.  They haven't, however, collapsed. There are good days followed by sour days, much of the latter explained by interest-rate uncertainty, varying perspectives of a recovering economy, and interpretations of geo-political events.  Most indices are up for the year (just a little bit), and financial advisers continue to be confident in the long-term. They counsel keeping most assets in equities.  But it hasn't been unusual this year for 100-point drops in the Dow to be followed days later by 100-point rises, only to be followed by a similar drop the next week.

Even with some topsy-turvy market behavior, IPO's haven't evaporated. (Fitbit was the most recent highly touted offering.) With liberal new regulation permitting small companies to raise equity funding without cumbersome registration, new companies or old, small private companies have many options to go about doing it.

For many new ventures, the question these days is less about market timing (the best time to go public, based on equity-market behavior and demand for shares), but more about whether the new venture is willing to tolerate the unrelenting demands (reporting, shareholder expectations, growth projections, etc.) on a public company.

Think Uber. An IPO of Uber in the second half of 2015 would be popular, well-promoted, extensively analyzed, and likely successful. A 2015 Uber IPO would attract the same fanfare Alibaba's IPO did in 2014.  But Uber IPO this year is not in any bank's deal pipeline. Not yet. Uber management is steadfastly focused on strategy and exponential early-stage growth, instead of SEC registrations, road shows, quiet periods, and unstable earnings reported to new shareholders. Uber still has a few more countries to penetrate.

Bond markets are feeling some pain.  Investors and traders who maintain positions do so courageously. The expected increase in rates will reduce bond prices suddenly and could lead to earnings stumbles among traders and funds, even if they say they are prepared and hedged. New bank regulation has spurred banks, one by one, to reduce emphasis on fixed-income trading and market-making. The profit margins had become too slim, and the balance-sheet burden too great. The unintended consequence of bond-market restructuring is that these markets are now less liquid.  And what happens when rates rise and funds, dealers and traders want to sell? Big banks won't be accessible or helpful.

The year has featured a handful of notable M&A deals and corporate restructurings:  Charter Communications is acquiring TimeWarner and Verizon grabbed AOL, among others. GE caught may off guard by announcing it will sell off  GE Capital, even while the finance unit contributed substantial amounts of revenues and earnings to the consolidated GE organization.  This one was a decision based on long-term corporate strategy and long-term concerns about GE's balance sheet.  GE Capital is overwhelmingly profitable, but it also overwhelms GE's balance sheet and makes it subject to meddlesome surveillance and oversight by financial regulators. GE made the earth-shaking decision. It had to push a favorite child out the door. And in doing so, few have criticized its move.

Financial institutions (banks, asset managers, hedge funds, insurance companies, and broker/dealers) continue to cry for relief from the onslaught of what they contend is burdensome regulation.  In 2015, large non-bank financial institutions have done most of the crying, especially those that could be tapped with a label "SIFI"--strategically important financial institutions, a designation by regulators that subject non-bank organizations  (including insurance companies, finance companies, and investment funds) to bank-like regulation of balance sheets and capital requirements.  More than a few institutions (AIG and GE Capital come to mind) have hustled to craft rebuttals for why they shouldn't qualify.

Meanwhile, from quarter to quarter, the large, familiar global banks reorganize, restructure, consolidate, and rationalize everything under the institutional umbrella.  And in doing so, even some CEO's have been hustled out, as bank boards struggle to pinpoint the right overall strategy.  Deutsche, HSBC and Credit Suisse are big banks in 2015 that have replaced CEO's or announced a series of corporate overhauls. Other banks have endured stand-offs with equity analysts and politicians who argue the biggest banks are better valued and less risk if they broke themselves up into their natural parts. (JPMorgan Chase seems to be the bank defending most of the break-the-bank arguments.)

Every year, global banks contend with the scandal du jour.  Following years of litigation, write-offs and fines related to mortgage securities and LIBOR (interest-rate pegging), in 2015, the club of banks that dominated foreign-currency dealing for decades agreed to admit to wrongdoing in FX trading and pay big fines to regulators.  In the process, they had to open up closed doors about how this enormous marketplace has worked and how banks colluded to make it unfair to other participants (smaller counter-parties and dealers, corporate and institutional clients, etc.).  The big banks paid up hundreds of millions in fines, but their dominance in the trillion-dollar market continues.

In mid-June, JPMorgan Chase's heralded and consummate deal-maker Jimmy Lee died suddenly, and bankers and corporate clients around the country paid tribute to him. Some attribute the birth of the syndicated-loan market to him.  He didn't invent this financing market, but he is likely responsible for its boom in the 1990's. He was instrumental in turning it into a major financing machine, a viable, reliable funding vehicle for large companies that all of a sudden became just as important to the corporate treasurer and CFO as the corporate bond, high-yield and equity markets.

When companies needed billions and wanted it quickly, a bank syndicate could step up more quickly, more efficiently and more assuredly than if companies wanted to finance themselves via equities or bonds. At JPMorgan, the syndication machine was big, visible, effective, responsive, and successful. In due course, it became efficient, aggressive and comfortable with stomach-turning deal sizes. If a corporate CEO in the midst of an acquisition wanted confidence over a weekend that it could finance a bid in the billions, Lee's syndication army could arrange the financing by Sunday evening.

In turn, Lee made syndicate lending the centerpiece of investment banking activity and, in many ways, turned the organization of an investment bank upside down. At traditional investment banks, M&A and equity and bond underwriting are core activities.  At JPMorgan Chase (and later at other big banks), the syndication unit was the heart and core, around which competence in M&A, equities and bonds was built.

He was so successful in the machine he built that by the early 2000's,  investment banks that were once indifferent to corporate lending (Goldman Sachs, Morgan Stanley, e.g.) quickly developed lending operations to compete for and retain traditional investment-banking business (M&A, equities and bonds).

Mid-year always means a flood of new graduates, including MBA's, many of which continue to march into lucrative positions in finance, trading, investing and research.  In 2015, some big banks, knowing they now compete for talent that is distracted by more interesting or less-taxing opportunities in other industries, decided to raise base salaries for new analysts and some associates. This is an industry, remember, where if Goldman Sachs makes a human-resource move (hiring numbers, compensation levels, incentive payments, etc.), the rest of the industry watches and tries to follow, even if sometimes they lack the financial resources to do so. Hence, a bump-up base for many in entry positions.

Work-life issues, however, continue to surface.  Banks don't manage them well, even after they announce serially new initiatives and new rules to ease the physical toil of working on Wall Street. (Underneath the finance headlines this year, two analysts jumped to their deaths in apparent suicides after having reported to others how they suffered from working long hours.)

Is a crisis around the corner? That's the question that must be asked. Some will say the probability is low.  Some pinpoint signals (over-valued markets, under-capitalized banks, too much exuberance in new ventures, e.g.) and swear that a doomsday is on the horizon.

Others will say, despite probabilities, the more important question is whether the financial system (with new structures and new regulation and oversight) can exploit the millions of data points to detect tell-tale signs of the next crisis better and whether the system is better prepared for anything that can happen.

Tracy Williams

See also:

CFN:  Banks and the FX Scandal, 2014
CFN:  Banks and the Libor Crisis, 2012
CFN:  Verizon Rescues AOL, 2015
CFN:  Do Banks Have Enough Capital? 2015

Tuesday, June 2, 2015

Verizon rescues AOL

AOL gets Verizon as its new parent
The announcement seemed to come from nowhere, although without doubt, advisers, company boards and corporate strategists had mulled this over for a long time.  In early May, Verizon reported it planned to acquire AOL, the embattled Internet company, for $4.4 billion.  Many wondered what that was all about.

Why would Verizon bother? What is it acquiring? What does it hope to gain from the merger? And was it a bargain? Who gained more from the sale--Verizon or AOL shareholders?

In its public announcements, Verizon said this was an opportunity to expand into AOL's domain of display and mobile advertising. Underneath the headlines, some said Verizon gains access to millions of AOL consumers (viewers, clicks, and eyeballs), those who continue to pay monthly fees for membership and other services.  (This includes the tiny fraction that still dials up to reach the Internet.) Others have suggested Verizon also wanted to bring into its management fold AOL's aggressive, take-no-prisoners CEO Tim Armstrong.

What do the numbers suggest? Was the stand-alone AOL still capable of  double-digit growth and strong enough to face off against competitors, who've gotten bigger and better while AOL since its peak days with TimeWarner has stumbled and stalled?

First, AOL shareholders have gained considerable value since the announcement.  Its $40-ish stock price has now topped $50/share, mostly because of the "good news" from the merger announcement. AOL no longer wallows in uncertainty about whom it must pair with, as it has been for the past few years.  Until the Verizon announcement, there was faint talk about a merger between Yahoo and AOL, one that would permit two sluggishly performing companies desperate for a new vision to combine remnant strengths to create a more viable company.

Second, despite what many suggest, AOL is not an unprofitable, money-losing company, although earnings have nose-dived the past two years because of unusual expenses.  The company still shows revenue growth.  Sales (now above $2.5 billion/year) have grown three straight years--9% last year. Gross operating profits even eclipsed $1 billion last year.

Shareholders were rewarded with unspectacular 5% returns last year (ROE) and may have whined about the company's inability to keep up with the Googles and Facebooks. When the company's cards are in order (when it doesn't have unusual expense issues and strategic botches), it appears capable of cranking out $300-500 million in profits annually.  If all goes right.

Perhaps that's what Verizon might have seen when it surveyed AOL's performance.  Get unexpected costs and strategy in line, and Verizon will step in to boost earnings above $300 million and secure handsome returns for Verizon shareholders.

AOL's balance sheet is in tact. There are sufficient levels of cash resources and liquidity (enough to keep the company healthy).  There is a manageable, almost insignificant amount of debt.  The balance sheet is stable and appropriate for its business. Not much appears out of line.

Cash flow from operating activities (above $350 million) is also stable. The company has reinvested much of that cash into new activities and capital expenditures, the better to help sustain revenue growth in future periods.  It need not, also, use that cash to deal with a debt burden or even make dividend payments to shareholders.

Verizon might have made its financial decision to do the acquisition based on a few key factors:

1) AOL revenues have grown, and Verizon perceives it can help ensure growth will continue or will exceed recent percentage changes.

2) Verizon presumes it will be able to keep AOL costs controlled. It can help turn what is a modestly profitable company into one that is predictably profitable without hiccups and bad turns.

3) A few Verizon-led tweaks might turn the operation into a $350-400 million company (net income), generating cash flow annually of about $500-$550 million, much of which can be plowed back into the company and won't be necessary to pay down debt.

4) With earnings capability at that level (and with sustained earnings), Verizon could have reasoned that it is buying a $6 billion company for $4 billion and got a bargain. (The $6 billion might be a valuation based on consistent $400 million earnings.)

(Compare with Yahoo, which has been hampered by revenue declines and profit woes, although in the past year, all that has been offset by the good fortune of having had an investment stake in new-IPO Alibaba.)

In the end, with its own financial heft and with its own challenges to achieve growth and revenue diversity, Verizon rationalized that an investment in AOL was a no-brainer--no need to take on debt to accomplish the acquisition, no significant burden to finance it, and a tolerable amount of risk for a business that won't necessarily be an earnings drain.

This merger got a lot of publicity because of AOL's name, brand and important role in Internet history.  Verizon's $130 billion acquisition of Vodafone two years ago was a far bigger financial challenge (because it borrowed $49 billion).

Now with AOL, let's see what happens, let's see what role Armstrong will assume in the combined companies, and let's see how AOL is tweaked and changes for the better.

Tracy Williams

See also:

CFN:  Verizon Acquires Vodafone:  Big Numbers, Big Debt, 2013
CFN:  Alibaba's IPO in the U.S., 2014
CFN:  Twitter's Turn to Go Public, 2013

Saturday, May 16, 2015

Choosing Financial Services in 2015

About 100 new Consortium students will indicate an interest in finance in 2015
In two weeks, about 400 new candidates for the MBA degree will become Consortium students. They will swarm into Phoenix for the Consortium's 49th Orientation Program. The new students (most of whom are privileged to be full-tuition fellowship winners) will start at 18 Consortium schools around the country this fall, but will first have the opportunity to meet each other, meet corporate sponsors and be congratulated dozens of times about their admissions into both the Consortium and top business schools. (A few will actually earn summer-internship offers from corporate sponsors, even before they start school.)

About 100 or so will express an interest in financial services with plans to become corporate or investment bankers, private-equity investors, financial consultants, community bankers, operations managers, venture capitalists, researchers, hedge-fund traders, or asset managers.

Trends and recent numbers suggest that, despite intermittent times of volatility and uncertainty for those who choose financial services, there won't be any noticeable drop-off among the MBA students who check off finance when deciding a concentration in 2015.

Is there some cause for apprehension? Do they know what they embark upon? Are they hopeful for ample opportunities? And do they understand the constantly changing scenarios faced by banks, funds, broker/dealers, and an all others in the industry?

Do they understand the implications of working for  an institution that regulators might declare "systemically important"?  Will they realize the impact of regulatory advisories that force banks to boost their capital cushion? Will they comprehend how this might have some influence on what they do in finance or how much in bonus they are awarded?

They likely do to some extent, if only because to gain admission at schools like Michigan, Virginia, Cornell, or UCLA, they will have thought deeply about what they want to do with the MBA and they will have expressed effectively in applications what they plan to do in finance or financial services (or at least, hope to do in the current environment).

How should the current MBA in finance approach this scenario?

A consensus among many says that long gone are the days when a finance MBA from, say, Dartmouth, Cornell or Emory, any respected school, could gain an offer as a corporate -finance associate at Goldman Sachs or a similar position at Wells Fargo and expect to be there 20-30 years, rapidly and assuredly climbing rungs of steps toward a senior-vice-president or managing-director slot.  And be happy about that or be comfortable working within the same institution with its same culture for decades.

Students today are better off approaching careers in segments, in five-year spans, knowing that vast change will continue to overhaul the industry or reshape the way financial services are delivered or performed.  Once there was a time when the finance MBA joined the institution, remained enthusiastically loyal to it, and often (sometimes naively) counted on the institution to shepherd him through development, enriching assignments and lucrative rewards.

The MBA graduate today is better off asking herself what contributions can she make to a project, team or institutions over the next five years, based on her talents, experiences, and skills.  And while at it, she  must ask what can she do for herself to ensure she continues to learn, develop, and adapt to different business conditions.

Today, the trading desk that existed five years ago has been disbanded.  Some of the financial modeling that new associates toiled over in years past is now performed in India. And much of the processing of securities, funds, and foreign currencies is presided over by vast computer systems. With the snap of a finger, GE decided to cast aside GE Capital. Banks that had bulge-bracket presence in investment banking decide overnight they don't want to do as much i-banking anymore.

Deals will get done, services will be delivered, clients must be hand-held and schmoozed, and transactions will be processed.  However, technology, systems and data analytics will be supreme, critical factors.  The MBA graduate might find himself spending as much time implementing technology or interpreting reams of data and statistics as analyzing capital markets or reviewing the financing needs of a new company.

The MBA graduate might opt to disregard working for the familiar, established companies like Morgan Stanley, AIG, Schwab, or JPMorgan Chase and consider working in what is popularly called "fin-tech," or working for the hundreds of new companies in "financial technology" that have sprouted in recent years.

Those companies have goals to upset the status quo, fill gaps where big banks may have struggled with in recent years (e.g., making corporate or small-business loans).  The fin-tech companies are experimenting with innovative ways to deliver financial services (make payments, make loans to small and large businesses, raise capital for new ventures, make loans to consumers, or execute trades for dealers). Long-term viability for most of these new companies is still in doubt, yet some new  MBAs might prefer the adrenaline (and possible mammoth long-term pay-off) that comes from working in a new, industry-busting venture.

Regulation? Yes, financial reform and regulation, in whatever degrees of pressure they exist, will always be the gray cloud that hovers overhead, even if regulation isn't too onerous or too oppressive. It will always be the elephant in the atrium, sufficient enough to redirect banking business strategies or force banks to cede control of products and services to the upstart fin-techs. The push-pull between those factions who argue regulation has overwhelmed and those who argue regulation is feeble will continue.

The financial crisis is slipping into memory for some new MBAs.  For some new students, the debacles that were Bear Stearns and Lehman happened when they were departing high school.  It helps, nonetheless, for MBAs in finance to be aware that crises come and go and return.  Markets are booming and can bust.  Interest rates plunge, but also soar.  Borrowers bankrupt, and new ventures can wipe out private-equity values.  And unfortunately,  the lessons learned from a previous crisis are sometimes forgotten or dismissed.

New MBAs should still know that despite the plague of  uncertainty, rollicking markets, and banking institutions that must reorganize and restructure themselves every other year,  some truisms remain. Financial technical skills are still a must-have.  In the end, financial managers, risk managers, financial consultants, and corporate-finance bankers still must make big decisions on loans, equity portfolios, bond portfolios, balance sheets, and investments.

They still need to be adept at near-expert levels in accounting, corporate finance, and capital markets. They will still need to understand what drives stock markets, what constitutes a shrewd investment, what influences interest rates, when a company should issue new stock, or why some companies can handle debt burdens better than others.  Graham and Dodd forms of analysis never go out of style.

Tracy Williams

See also:

CFN:  Opportunities in 2015
CFN:  MBAs and Technical Skills in Finance, 2010
CFN:  MBAs Face a Complex Landscape in Finance, 2014
CFN:  The Finance Resume' and Recruiters, 2014
CFN:  New Opportunities in Financial Technology, 2014

Wednesday, April 29, 2015

Will Yahoo Ever Rebound?

Yahoo and its CEO Mayer must make pivotal decisions about the future, or else?
Marissa Mayer, Yahoo's CEO, gets much attention in the financial press, even if Yahoo's sluggish performance in recent years might not warrant it and if it appears that Yahoo is, well, such a 1990's phenomenon, as it lags in a race with behemoth Internet companies (Facebook, Google, e.g.). In this race, revenue scorecards are measured by and result from display advertising and searches. Mayer's Google pedigree explains some of the limelight.  She grew up there and rose to the top rungs. Instead of waiting another decade for the possibility of becoming a Google CEO, she grabbed the Yahoo opportunity.

Yahoo, the company and website, is still widely known, widely watched, and often criticized, while it has stumbled. With Mayer at the helm, it is more widely observed, as stock markets and equity analysts try to figure out whether she has the magic to turn the company around or at least craft a strategy to boost disappointing revenues.

Revenues, $5 billion in 2011, have slipped to $4.6 billion in 2014--an 8% decline from three years ago, while stalwart competitors in the industry continue to grow at astounding rates. Operating profits, above $600 million in 2011, have fallen to less than $250 million,  and imply paltry returns on equity (ROE, less than 5%). Operating profits in the quarter just ended, 2015, led to yet another frowning moment (an $87 million loss).

Yahoo is now 21 years old and chases after some of the same advertising streams as do Facebook, Google and Twitter.  Facebook revenues have now topped $12 billion/year. Mark Zuckerberg's social-media empire is already three times as large as Yahoo, although half its age. Twitter continues to gain ground, still hustling to convert tweets into advertising revenue growth that will erase a history of losses. Twitter is about a third the size of Yahoo (and it, too, reports a disappointing first quarter, 2015).

Lost momentum

Many analyze what happened at Yahoo, why the company lost momentum, why it doesn't attract eyeballs in growing numbers. Yahoo has content to lure viewers, and it has an old search engine. And it has a loyal core of users who prefer Yahoo as a gateway portal when they turn a desktop or laptop on. Others have examined how the company has tripped up from management issues, boardroom haggling and other disappointments.

More important nowadays, equity investors and business watchers want to know where does Yahoo go from here. Can it ever catapult itself to the frontlines of top global Internet companies?

In any analysis of this company, there is a wrinkle, an odd twist, but a fortunate one. While unlucky in many strategic steps the past decade, one strategy has worked miracles: Yahoo's decision to invest in Alibaba, the mammoth Chinese Internet shopping network that recently went public in the U.S. and competes in the same arenas of Amazon and eBay.

That stake has proven to be a lottery win and, in some ways, has rescued Yahoo's bottom line and allowed it to squeeze out respectable earnings (in the form of unusual income) and present a fair balance sheet with an improved capital base.

To be specific, in a year (2014) when revenues were flat and operating earnings fell, Yahoo reported net profits of $6 billion, because Alibaba's vaunted IPO let Yahoo report special gains last year above $10 billion, much of that attributed to its Alibaba stake and to Yahoo realizing some actual gain on its holdings.

When the company should be preparing to compete with the masters in the industry (and thwarting other threats in the industry), its financial results are dominated by Alibaba gains on the income statement and an enormous Alibaba stake on the balance sheet.  Yahoo has balance-sheet equity exceeding $35 billion, but most of that supports (or is rationalized by) its Alibaba asset.

What about that Alibaba investment?

Until it disposes all of that stake, Yahoo might well be a publicly traded investment fund, the fortunes of which are tied too closely to the stock price of Alibaba. Yahoo's market value, $42 billion, barely exceeds the value of its Alibaba holdings. Has the market discounted all other core activities in the company and is valuing mostly Alibaba on the balance sheet?

(In Feb., Mayer announced that the company hopes to spin off the stake and award it as a "dividend" to current Yahoo shareholders. When shareholders assume possession of that stake, they will also assume all tax liabilities related to selling the shares.)

Yahoo market values followed a pattern last year.  Its stock price anticipated the build-up to the Alibaba IPO, soaring from the mid-$30's to above $50/share at the IPO, but has since dropped to the mid-$40's, while the same market waits for management to come up with a credible plan for growth.

While Yahoo rediscovers or reinvents itself, the Alibaba gains and stake, in one way, offset risks of uncertainty and financial peril.  While operating profits have sagged, the Alibaba fortune allows it to boost its cash reserves (if it needs to) and gives its equity base a cushion against the modest amount of debt on its balance sheet (less than $1.5 billion).  Operating cash flow can't pay off that debt, but selling Alibaba shares for cash proceeds can resolve that problem, if necessary.

Mayer, however, must manage that Alibaba holding prudently, but also prove to shareholders that Yahoo in the long term is Yahoo (anchored by new strategies, new products, new services and desperate tactics to expand numbers of views and clicks) minus Alibaba.

Over the past year, Yahoo has become Yahoo plus Tumblr. A strategic move to purchase the blogger site is a modest move that will achieve modest results and have even more modest impact on helping to thrust the company back into the big leagues.

The next big strategic decision

So what can Mayer and team do?

1) More acquisitions?  It appears the company still wants to do tack-on acquisitions (like Tumblr).  Yahoo, for now, can't rely on cash reserves (from profits) to help finance blockbuster acquisitions. With sour earnings and no clear-cut direction, it wouldn't be easy to fund a new operation with new equity, especially if the target won't contribute to earnings right away.

The Alibaba gains (and new cash) from last year permit a little more debt capacity, but lenders or debt investors can't yet rationalize new loan exposure from operating cash flow. At least not right now. They would need to be asssured they'll have access to cash on the balance sheet, resulting from future Alibaba proceeds.

All that is to say that it might not be able to finance a blockbuster acquisition, if we assume that a target agrees to be acquired and the target will contribute to operating profits on Day 1.

2) A new product or service to shake up the industry? Not likely, at least not soon, because that  implies Yahoo has exceptional financial strength, ample funding resources and the ability to attract the industry's best technical talent. Yahoo continues to play catch-up on all three fronts.

It has, however, been able to hire content talent (in Yahoo news, finance, sports, etc.) on the premise that talent with experience from, say, the broadcasting networks and the New York Times will bring with them their viewers and readers.

2) Merge with another Internet company?  Random rumors have run about regarding a link-up with AOL.  How do you rationalize two strategically wandering companies with financial ailments of all kinds combining to form a stronger company? One plus one, in this case, might equal a half.

3) Sell out to Google?  Google, its giant neighbor in the Bay Area, could take over Yahoo with an eye-blink--if it chose to. But its corporate strategies aim far and wide. Google has other more ambitious dreams and plaguing issues (driver-less cars, European lawsuits, etc.).

4) Merge with a natural partner, Alibaba?  If this were a strategic possibility, it would have happened already. With different leaders and markets (and financial challenges), the two companies are headed in different directions. Yahoo is grateful for its great gains and must forge its own path.

The company is not headed into a bankrupt courthouse.  There is value in assorted ways. There is a balance sheet not too burdened with debt and with comfortable cash reserves.  It needs the right strategy (and product and service) to give the revenue line a swift kick upward.

Tracy Williams

See also:

CFN:  Alibaba's Highly Touted U.S. IPO, 2014
CFN:  Twitter's Turn to Do an IPO, 2013
CFN:  Facebook Stumbles Out of the IPO Gates, 2012
CFN:  What Does the market See in Amazon? 2014

Wednesday, April 8, 2015

Venture Capital After the Pao Lawsuit

Ellen Pao lost the lawsuit, but started a national conversation about the scarcity of women in venture capital
Something seems to have been overlooked in the wake of Ellen Pao's failed lawsuit against Kleiner Perkins, the powerful Silicon Valley venture-capital firm.

The discrimination court case received volumes of attention in the media, which not only reported the case and its verdict, but disseminated streams of statistics, stories and insider tales from witnesses. Those on the stand chronicled Pao's time at the firm and described the environment of working in the industry, making investments, supporting new ventures, and reaping millions.

A jury ruled in favor of Kleiner Perkins, but close observers of the case concluded it was a victory in some ways because the case was, in turn, a full-blown forum to determine who's to blame for the scarcity of women in senior venture-capital roles, while the industry enjoys one of its most blooming times.

Amid the discussion and debate, something was missing.  Women, reporters of the case pointed out often during the trial, often have less-significant roles in venture capital and private equity. Statistics show women comprise less than 10% (6% in recent surveys), of the principals, partners and directors at the major firms. However,  the recent discussion about the court case seldom got around to analyzing another truism in the industry--that there is also a blatant scarcity of other under-represented minorities who work at these same firms (namely, African-Americans and Latinos).

Or perhaps that fact goes without having to be stated prominently. A scarcity of women in this arena usually and automatically implies (like a corollary) there will be few Latinos and blacks sitting in the partners' rooms, making investments, leading deals, supporting entrepreneurs, and selecting the ideas that which will be afforded venture funding.

Beyond Pao's allegations of discrimination, the trial's transcript offered several recounts of what goes on inside a venture-capital outfit:  How do principals make decisions? How do they decide investments to fund or entrepreneurs to support? What skills are most important to succeed as a venture capitalist--relationship skills, people skills, technical knowledge, deal experience, negotiation skills or analytical skills? What does it take to become a partner, principal or director? And who decides?

Skills, skills, skills.  In most financial institutions (from global banks to boutiques and private firms), senior managers like to pronounce their organizations as meritocracies and say those with special skills and expertise will be promoted to the highest rungs. In venture capital, what are those special primary skills that help firms reap vast returns on investments, skills senior partners want to see before they promote associates to senior levels? As outsiders have asked often, why are there still so few women, many of whom likely possess or could certainly gain the same skills and expertise to become leaders in venture capital?

The trial, nonetheless, helped confirm what many already knew or what some don't want to always admit. Skills, knowledge and networks count for much.  But "some special magic" to hit venture-capital home runs is necessary. Luck is involved. Where does this "magic" come from, and why does it appear that a small group of men monopolize it?

The Necessary Skills

Successful venture-capital investing or identifying lucrative opportunities requires a combination of skills, external factors and good fortune at any of several stages of venture funding. Seed investing, incubator support, angel investing, early-round investing, mezzanine and debt funding, and private placements comprise the several rounds of funding activity before the new enterprise decides to issues equity shares to the public (or sell out to another company).  A venture-capital firm may step up to provide funding (and guidance, direction and management) at one or more of these stages.

Those who have outstanding track records (the big names in the industry, usually the names on the front door) will possess many skills and know how to capitalize quickly on opportunities and bonafide good ideas. Those who rise within the ranks of a firm will have proven to senior partners in some way they have the skills, capitalized on opportunities and deserve promotion. Or they were successful in conveying the importance of their contributions.

Some of the skills and factors can be assessed from quantitative measurements. At other times, it's what it is--a sometimes rash, subjective effort.

 a) Knowledge of the industry.

Shrewd venture investors must understand the industry, products, technology, and the requirements to start businesses in that industry and shape them into highly valued, stable, profitable organizations.

b) An understanding of risk tolerance.

Good investors understand risks in business and in investing and understand risks-vs.-rewards metrics (seeking ample rewards and being patient about reaping them for the risks they will absorb over the long term).

They understand their tolerance for degrees of risk and understand how to hedge, reduce or avoid certain risks.  Venture firms, by definition, take risks, but want to be prudent about them. For example, they reduce risks of investments by ensuring the companies they oversee are run by experienced operational managers, by managing costs efficiently, and by unveiling new services or products at the right time.

c)  A long-term vision.

Along with the entrepreneurs they finance, they, too, have a vision for where they see the product, company, and its markets in 2-5 years. If they don't have the vision yet, they devote time trying to develop or craft one, at least one that will eventually result in growing revenue streams.

d) Contacts and networks within the industry.

The best investors know who's who, what's what, and where's where. They cultivate relationships with successful entrepreneurs, other investors and institutions, experienced engineers and computer scientists, and big banks.  They know details of start-ups, technical planning, and product ideas. The conversations of what's next, what others are dreaming of, and what experts are thinking about flows through them. Or they ignite the conversations.

d) Financial analysis.

Financial analysis is often taken for granted.  But venture investors, like others who do well in investment management, have targets for how much they are willing to invest (over a set time period), what amount of return they expect and when they want it (a short- and long-term ROE), and what is a potential public-market value of the stake they hold. They can compute and rationalize the long-term value of an investment in public markets or in the eyes of a potential acquirer.

They are experts in the quantitative analysis of valuing companies, especially companies that have no profits, no track records, and often not yet a marketplace.

e) Experience and expertise in deals.

Doing deals involves structuring, innovation, pricing, negotiation, and execution.  Expertise in decision-making and deal structures usually follows from experience.  Expertise also implies apt timing--determining when to invest in early stages, when to do follow-up rounds of funding, when to take on other investors (both debt and equity), when to go public, and even when to sell out, if that is the right step.

f) Intuition and insight.

Venture capitalists do well, in part because they have intuition, special insight regarding the demand for a new product or service or an understanding of the customer base. They use insight to formulate a vision for what a company will be 5-10 years hence. They and the company founders will often have shared, common visions.  There is no unique way to call up or exploit insight, but insight exists because someone has competence in other areas (technical and product knowledge, broad networks, financial analysis, deal expertise, etc.).

Some say this is the "magic" or the "it" factor that some senior partners have and others don't, the knack for knowing what's right, what's next, or what will work.

Unfortunately, at least in the case of Pao and for others like her, evaluating an ability to have uncanny insight often requires subjective judgment.  It can be based on a past track record or it is inferred from experience. Most in the industry prefer not to call it for what it frequently entails:  good fortune, good luck, perfect timing.

g) Economic factors

Understanding the economic factors that affect a new company are critical.  The value of investments or the prospects for surging growth for a start-up can depend on pure economics: business cycles, product stages, interest rates, capital markets, consumer demand, and investors' behavior or liquidity.

Next Steps for the Industry?

The investment competencies above can be learned, experienced, shared, or attained (from advisers or mentors). So why should they be monopolized by small clubs of men in the Bay Area. Why aren't there more women, Latinos and blacks working at and rising to the top of Kleiner Perkins, Andreessen Horowitz, and Sequoia?

Do venture firms claim they can't find eager, well-prepared participants from under-represented groups who have most of the skills described above and a knack for taking advantage of opportunities?  Do they prefer not to be the first to bring them into these closed, private circles?  Are they unwilling to develop or nurture under-represented talent in the way they do for sons and daughters of classmates and fellow board members?

Or is this more an unconscious unwillingness to share the rewards from a booming, lucrative pie with groups other themselves? (High stakes imply closed circles?)

Some of the recent top firms are old-boy circles, circa 1998, circa 2005. Some (e.g., PayPal, Linkedin, and Netscape) are start-up entrepreneurs who reaped millions (billions?) in an early ventures, explored other side ventures, and eventually decided to establish themselves as managers of new venture-capital funds.  After stints managing new companies and sweating out an operation from dorm-room idea to billion-dollar IPO offering, they formed new firms to manage new wealth and to focus on selecting the newest new thing.

The circles of familiar faces invest in and support ideas and companies within tight spheres, share insights with each other and anoint the next generation of the best entrepreneurs to appear on the scene since Zuckerberg (Facebook) or Spiegel (Snapchat).

Most, including Ben Horowitz or many from Kleiner Perkins who were escorted to the witness stand, say the want to do their part. Some have tried, but are flummoxed by how to do it or distracted by typical business concerns.

The trial is over. The editorials and commentary have been written. The commitment to change (or at least do better) has been voiced. The discussion about what needs to be done has peaked.  Where do we go from here?

Will the industry take bold, sometimes brazen measures to ensure they open their doors and create more inviting environments for women, blacks and Latinos?  Or will it retreat back to the status quo after the publicity swooning around Pao wanes?

Tracy Williams

See also:

CFN:  Venture Capital Diversity Update, 2011
CFN:  Knocking Down Doors in Venture Capital, 2012
CFN:  Horowitz and His Latest Venture, 2014
CFN:  MBA's in Finance, 2015 Opportunities

Tuesday, March 24, 2015

Credit Suisse Makes a Big Move

Credit Suisse decided Tidjane Thiam was the right leader at a pivotal time.
These haven't been the best of times at Credit Suisse. The Zurich-based global bank is not on the verge of collapse. It doesn't appear on European regulators' endangered lists, but regulators abroad have expressed concern about possible inadequate amounts of capital on the balance sheet, capital it would need to endure tough times, whenever they return.

Regulators have concluded that the balance sheet is crammed with risky assets. And the bank has had to manage through legal investigations of U.S. citizens with Credit Suisse accounts evading taxes. (It recently paid a billion-dollar-plus settlement to resolve that issue, at least for now and at least for this side of the Atlantic).

In 2014, the bank recorded profits hovering about or above $2 billion for the second straight year. But its board of directors huddled and decided that might be inadequate. Last year's profits result in an almost-embarrassing 4.5% ROE, while other big global peers, competing on the same stage and wrestling with the same issues, fared much better or continue to show improvement. (Its cross-town rival, UBS, has gone through its own restructurings, but bounced back last year with earnings above $3 billion and returns on capital above 6%.)

This month, it paved the way for its CEO Brady Dougan, known for much of his career for a beaming track record in investment banking, to step down. Credit Suisse didn't replace him with a like-minded senior banker and hired someone in the mode of a strong business manager who must make tough decisions as soon as he slides his CEO seat.  Tidjane Thiam, who is from Cameroon and has an INSEAD MBA, becomes one of the few CEO's or Chairs of African- or African-American descent to lead a global financial institution. (Kenneth Chennault continues as CEO of American Express.)

Credit Suisse's choice is interesting. Thiam may not have been on any public short list of those expected to take over the bank, now or in the years to come. However, it's not a shocking appointment after you examine Thiam's track record, one that is consistent, broad, and filled with operational accomplishments.  He will arrive at Credit Suisse after having led Prudential, the British insurance company, not the one based in New Jersey.

Credit Suisse has decided it has arrived at a junction where it must make important operational and strategic decisions about the bank. Thiam, therefore, might have been the best person to make these decisions on Day 1 and consider how the bank should change course.  With little background in banking, but significant relevant experience in risk management and global operations, Thiam was likely chosen for proven skills in business management, including skills picked up also from his years at McKinsey, the consulting firm, and in government service.

The bank, too, may have decided that after Dougan, the experienced deal-maker, it needed business leaders from the schools of Warren Buffet and Jamie Dimon. Dimon, JPMorgan Chase's CEO the past decade, is always first to say he leads his bank as a "business manager," not a "banker." (In fact, Dimon--at least internally--refers to JPMorgan as "the company," not necessarily "the bank" or "the institution.")

Bankers close deals, advise clients, finance corporate activities, comfort clients and bring in new ones. Business managers manage operations, invest in new businesses, shut down poor-performing units, cut costs and obsess over cost efficiencies, balance-sheet strength, and returns on capital.

Global bank management at the senior levels has evolved into just that.  Bank management these days implies running complex organizations with tentacles in all corners of the work.  Senior leaders must make excruciatingly tough decisions about capital allocation, cybersecurity, regulation, risk management, business investment, technology efficiencies, and cost control. This means they don't devote as much time to do deals, trades, investment management, and client-schmoozing.

Credit Suisse, like many of its peers, is trying to decide what it will be, where it will be, and for whom. And while at it, it must decide how to boost so-so returns, reduce the risks on its trillion-dollar balance sheet, and decide what business lines should it emphasize and which ones to reduce or withdraw from. Just like all other global banks, some would say.  Except some banks, like Credit Suisse, UBS, and RBS must decide sooner than later. Citi, many will agree, made these strategic, balance-sheeting-paring decisions a few years ago and is experiencing brighter days.

Thiam still has weeks before he joins, but rumors and reports abound that he plans to reduce the bank's emphasis on investment banking (eliminate 3,000 IB jobs?), address the abundance of risks on the balance sheet, decide how much more in capital and resources to re-deploy for private banking, and consider how global it should be.

If investment banking fades a little into the background, the bank will have retreated from its celebrated roots cultivated by First Boston, the once large, prestigious U.S. investment bank Credit Suisse acquired in the 1990's. (First Boston had a long-time historical alliance with Credit Suisse. After it ran into difficulties during a spate of excessive deal-making and bridge loans in the 1990's, it sold out to the Swiss bank.)

What will be Thiam's directive from the board? How much time will it give him? Corporate, regulatory and balance-sheet issues will be hurled at Thiam the first day he arrives.  European regulators will pressure him to improve capital ratios. Investors, capital markets, and trading counter-parties will press for details of his strategy.

Investors so far have approved the selection. Share prices (based on ADR's, dominated in dollars) had fallen last year from $32/share to $20/share, while the market watched the bank confront many of these issues.  Thiam's announcement pushed the price up 25%. Even before he has settled onto the banking battlefield, investors surmise he'll remold and define the bank in the way it should be. Let's see what happens. But let's give him at least a year.

Tracy Williams

See also:

CFN: UBS Throws in the IB Flag, 2012
CFN:  Why Was Citi's CEO Asked to Resign? 2012
CFN:  Wells Fargo:  Sticking to What It Does Best, 2014
CFN: Can Morgan Stanley Ever Please Analysts? 2012
CFN:  What About Corporate Banking? 2010

Tuesday, March 17, 2015

When Does a Bank Have Enough Capital?

Bank of America received an "incomplete" on the latest stress test by the Federal Reserve
Global banking these days often means tending to "matters requiring immediate attention" and putting out fires ignited by the concerns of investors, clients and markets. It means senior managers scrambling up and down elevators in haste to prepare responses for regulators.

For the top 50 or so banks, this month's issue of the moment is the formidable "stress test." The Federal Reserve presides over a bank test to measure whether large financial institutions can survive worst-case scenarios without threatening the financial system and jeopardizing required payouts to depositors, trading counterparties, and long-term investors.

The tests are hypothetical, but regulators treat them as if the scenarios will occur, in the way we observed worst-case scenarios of all kinds during last decade's financial crisis. The tests are required by Dodd-Frank regulation and formally fall under the banner "Comprehensive Capital Analysis and Review," or "CCAR."

After the crisis, regulators around the globe concluded bank capital at sufficent amounts is the primary safeguard to protect the system when the next crisis occurs.  In finance, investors often proclaim "cash is king."  In bank regulation, regulators (and risk managers, too) exclaim "capital (as in capital cushion) is king."

It's all about capital, capital as a balance-sheet cushion to ensure that a bank enduring hard times or struggling through a volatile market will have enough of a capital base to permit the bank to meet all obligations to depositors, creditors, and other counterparties.

Capital as a Cushion

The principle of having "sufficient or adequate capital" is that balance-sheet or operating losses will be absorbed by shareholders. Banks with significant amounts of capital can tolerate a certain amount of losses. In worst-case scenarios, losses might be inevitable, but the best-capitalized institutions will survive and continue as ongoing institutions. Stress-test losses include projected losses from misbehaving capital markets, from mismanged operations, and from unforeseen events (even losses attributed to "tail events").  Most of all, test-givers want the bank to absorb these losses without having to resort to or rely on (or count on) support from regulators or the government.

Let's present a simple example. A bank, say, tallies its balance sheet and capital and computes them to be $15 billion and $1 billion, respectively.  Is the $1 billion an adequate amount of capital for both ongoing operations and for a worst-case, stressed scenario? It assesses the risk of each item on the balance sheet and evaluates its overall operating activity. All activities (on and off the balance sheet) are "risk-adjusted." (In "risk adjustments," $1 million in cash or U.S. Treasury securities has much less risk than $1 million in loans to a BB-rated oil-drilling company.)

All activities (on and off the balance sheet) are then "stressed," based on market and economic scenarios presented by regulators: Unforeseen events occur, interest rates move sharply, equity and commodity markets become volatile, bank borrowers default, depositors flee, and banks have no access to new funding or new capital. When quantified precisely, what is the maximum of losses in this scenario? And what impact do they have on the capital base and the bank's ability to survive without difficulty?

In our example, suppose the bank (with regulators looking over the bank's shoulders) computes the maximum worst-case loss total to be $300 million. That leaves $700 million in post-stressed capital. The tests help decide whether that amount is still a sufficient to anchor a risk-adjusted balance sheet. Regulators determine:

(a) whether this remnant $700 million capital is satisfactory (and "passes the test"),

(b) whether it's satistfactory, but too borderline, or

(c) whether it's not satisfactory and the bank has failed the test.

If regulators determine it's (b) or (c), then remedial action will be recommended or must be taken. That usually means the bank must reduce dividends or shareholder payouts (to ensure capital won't decline) or it must raise new equity over a defined timeframe.

Recent Stress Tests

The stress tests are exercises, but regulators take them seriously and publish the results widely. Therefore, stock markets, investors, and banks collectively take this seriously.  Markets react, investors might express concern by selling shares without thought, and banks pour resouces by the hundreds of millions to ensure they pass these tests and appear at the top of industry lists of the best-capitalized banks and the banks best prepared for a crisis. (Citi's CEO Michael Corbat last year even promised to resign if Citi failed a stress test in 2015. It passed; he won't have to resign, and it was reported Citi's trading floors applauded wildly.)

In the most recent test (Mar., 2015),  results show 28 of 31 banks passed the test, but not all in a blaze of glory.  The U.S. operating entities of Deustche Bank and Santander failed.  Bank of America received an "incomplete" grade, partly because regulators want more time to review the bank's plans to reduce capital with dividend payouts and share repurchases.

On most industry scorecards or league lists, Goldman Sachs roams near the top (the top of the most profitable banks, near the top of mergers-acquisition and equity-underwriting lists, etc.). For this round of stress tests, it appears in the bottom half (although with a passing assessment), despite its prowess in just about all banking activities it engages in. But its lukewarm stress-test outcome was enough to push down its stock price a notch or two in the past week.

Markets react because there are perceptions that banks (Goldman included) have more embedded risks than previously acknowledged, that banks are vulnerable and susceptible to sharp losses at any time, and that banks won't be able to pay the same attractive dividends many investors are accustomed to.

Banks, whether they are Bank of America or Citi, aren't shy with regulators and will challenge the test results, line by line, asset category by asset category. Banks don't want outsiders to meddle with their efforts to please shareholders with predictable dividend payouts. Regulators, nonetheless, usually have the last word. In the end, the test results (and trends in how banks perform on these tests) have enormous impact, not only on how markets and investors perceive banks, but in determining banks' long-term strategies and who they want and can be.

The Impact on Returns: Inside the CFO's Office

While regulators are obsessed with capital as a cushion, banks are obsessed and anxious about whether capital is allocated properly for various operations, businesses and balance sheets.  Capital must be abundant and in excess, but it must be assigned to bank operations precisely and aptly--more than just enough, but not too much.

If a bank's business requires too much capital (in the eyes of regulators), then banks won't be able to achieve high returns or won't be able to justify the risks that imply more capital. Some won't be able to raise the capital they need or will be restricted from paying dividends in order to reach optimal capital levels.

Peek inside a bank CFO's office, and watch the staff hold heated, vibrant discussions of bank capital, not just capital related to regulatory requirements, but capital related to risks, operations, funding strategies, and economics. They debate, analyze and compute: Do we have enough? How do we allocate? How do we meet regulatory requirements with ample excess? There are capital requirements defined by Basel III regulation, defined by Dodd-Frank, defined by European regulators, and defined by Federal Reserve edicts applicable to the largest banks.

CFO offices, along with colleagues in Risk Management, must also resolve the following:

a) How do we perform the complex calculations regulators require to determine whether we have enough and do so before deadlines? (Many big banks, like Citi, hire experienced senior financial managers to perform calculations and to ensure capital is adequate everyday, not just quarterly or for stress tests.) Do we cut dividends (and by how much)?

b) Do we cancel stock repurchases to improve capital ratios and present better test results?

c) Because of limited capital, how do we decide which businesses deserve it?

d) Should we "de-leverage" the balance sheet, sell off risky assets and trading positions, and shut down designated business lines and branches to improve our capital showing?

e) And perhaps most important: With all these capital requirements and the challenge to allocate precisely, how do we generate the returns investors expect (over 10%?) on this capital?

Some regulators, academics and others argue that capital requirements and capital stress tests at banks aren't strict enough and that banks have much leeway and too much time to comply. They seem to agree that if there had been tough capital requirements and other restrictions in the mid-2000's, Bear Stearns and Lehman might have survived. (They would have survived because with more capital and capital rising to prudent amounts, they would have been able absorb eventual losses or, with the same levels of capital, they would have not beeen able to take risks and assume leverage for the capital they had.)

What Do These Tests Involve?

The tests are complex, because bank balance sheets are complex, piled with trading assets, loans of all kinds, exotic derivatives and financial instruments fluctuating in value on the ledgers of subsidiaries around the world . The tests involve many definitions or "tiers" of capital and have spawned financing structures where some liabilities can turn into capital under certain conditions or behave or appear to be capital-like (e.g., convertible debt, subordinated debt).

The principles of a stress test are straightforward, as shown in the example above. The Federal Reserve examines the consolidated bank, while other regulators may examine the specific regulated bank entity.  The consolidated balance sheet of total assets is buttressed by a current amount capital. As described, those assets are "risk-adjusted"  (based on regulatory guidelines that are influenced by historical trends and internal bank calculations and interpretations of risk).

A "stress" scenario is summarized and quantified. "Stress" implies a nightmarish market or economic scenario similar to what we observed in crises past.  Tests try, also, to project distress that isn't projected, known or accounted for. "Stress," in these tests, implies losses--sudden losses and sustained losses over a time period. A stress scenario might entail a collapse in capital markets and increased probabilities of default in bank loans (including corporate loans, credit cards, and mortgages).

Specific ratios and standards determine whether capital as a percentage of total risk-adjusted assets is sufficient or inadequate. If tests indicate capital is borderline, then regulators will insist the bank adopt a capital strategy devised by regulators.  That strategy could prevent banks from paying dividends or repurchasing stock until capital levels reach more comfortable levels (accounting also for earnings and new injections).  Regulators, now more than ever, want to ensure banks have not just for rainy days, but for storms and the unknowable lightning strike.

Dividend restrictions frustrate bank managers and boards. Historically, banks like to please shareholders with dividends and occasional share buybacks. Investors in financial institutions buy these shares after they observe multi-year practices of stable (and sometimes increasing) dividend payouts and intermittent share repurchases.  And there emerges friction, when regulators present analysis that shows banks don't have enough capital, and banks respond with a financial argument to prove they are so well-capitalized they should have discretion to pay something to shareholders each quarter.

What Are the Long-term Implications?

The rules, the tests and the occasional confrontations between bankers and regulators have long-term impact:

1) Banks have become more precise and careful in computing capital requirements.

Just a decade or two ago, capital computations might have been done by a small team with files of spreadsheets. Capital computation and managing requirements now rely on technology systems, data feeds, and armies of bank professionals to monitor where a bank stands everyday. Computation is complex, too, because big banks measure assets in amounts that hover about a trillion, not in the billions of days gone by.

2)  For banks, capital-ratio computation and risk allocation have evolved into a science relying on data management, data quality and technology, as they attempt to use capital wisely and prudently (and profitably).

They ask difficult questions with no easy answers: How do we allocate and invest capital in such a way that

(a) operating needs are fulfilled (Capital acts as cushion, but it still must fund assets and bank activity),

(b) risks are managed,

(c) regulators are pleased, while

(d) investors get the return they wanted?

And how do we allocate and invest in a way such that there is still some excess to keep regulators satisfied and assured the bank can thrive in the toughest of times?

Banks look for precise answers and avoid estimates. The stakes are too high in Washington and on Wall Street.

3)  Banks won't hesitate to exit high-risk business lines that require too much capital, because of the detrimental impact on regulatory ratios and because of the near impossibility of achieving reasonable returns (ROE) (because of high capital requirements). 

Over the past five years, banks have withdrawn from businesses partly because of  new rules (e.g., Volcker rules that bar proprietary trading), but also because a business might require too much added capital for the same level of earnings.  For this reason, banks have shut down trading desks, withdrawn from some activities, pared back in areas that use too much balance sheet, avoided risks that can't be offset by reasonable rewards, and canceled privileges it once offered clients (e.g., overdraft lines).

Banks will continue to evaluate business sectors on this basis. In assessing business activity, the earnings and projected revenue growth might exist. But if risk calculations imply capital requirements could be too onerous, the bank will avoid expansion or might even withdraw altogether.

4) Bank finance managers must always have a long-term capital plan.

Many will say they have had capital plans for decades. Yet now the capital plan will be scrutinized and opined by regulators. Banks will, too, always need a realistic, detailed strategy for how to increase the capital base when it needs to, when it can increase dividiends, and when it is appropriate to conduct stock repurchases.

A long-term plan guides the bank on when dividends should be decreased, when it must issue new shares, borrow more in long-term debt markets, or sell large stakes to institutional investors (or Warren Buffet, who purchased his large stake in Goldman Sachs during the crisis).  In its waning days, without the benefit of a plan beforehand, Bear Stearns and Lehman rushed to find new investors to inject life and capital onto wiltering balance sheets. They looked abroad, they looked for advice, and they pleaded with their counterparties and creditors to be patient. These were the days before the U.S. Treasury decided to inject billions into banks once the crisis ballooned.

Bank CEO's and CFO's continue to have arduous tasks before them.  They set objectives to promise returns on investment to shareholders in the 10-12% range. Yet the denominator in this ROE ratio is elusive and spiraling upward. Just as they implement a strategy to boost revenues and earnings (the numerator), often accompanied by new risks, they must boost the capital cushion. The ROE returns, it seems, can't seem to budge upward.

Tracy Williams

See also:

CFN:  Basel III Becoming Real, 2013
CFN:  Keeping Up:  Basel III, 2013
CFN:  Big Banks and Dreadful Downgrades, 2012
CFN:  Wells Fargo:  Sticking to What It Does Best, 2014
CFN:  Why Did Citi's CEO Resign? 2012
CFN:  This Fall's Big-Bank Thorn:  FX, 2014
CFN:  JPMorgan's Refined Regulatory Strategy, 2014

Sunday, February 22, 2015

The Survey Says

GMAC shared the results this month of a global survey of MBA graduates 
GMAC is best known to MBA students and graduates for administering the GMAT, often a formidable hurdle when applicants decide to take two years off to immerse themselves in business school.  But the organization is more than a mere exam-process vehicle.  It is engaged, for example, in in-depth research in business education.

This month, it published the results of an extensive global survey to share what business-school graduates from around the world say they obtained from having earned an MBA degree.  What did they gain in terms of compensation, productive work experiences, and promotion paths toward the top? What were the most important skills they used in business experiences? What specific skills were important at various points in a long career?

Over 12,000 respondents replied to survey questions last fall.  They included MBA alumni from over 70 schools all over the globe, most of whom attended U.S. business schools, many in familiar two-year, full-time programs. Graduates from 1959-2014 were represented. Graduates in age from 25-75 were included. GMAC asked questions that encompass a multi-decade career and asked questions relevant to those just a year away from campus. It probed to determine whether business-school knowledge was more relevant in latter career stages than in the beginning. And it asked graduates whether or not certain courses are more important in senior corporate positions than in entry roles. 

Respondents attended a wide spectrum of business schools (which means a range of MBA experiences and curricula).  They included graduates of MBA executive programs, one-year programs, regional schools, and those brand-name elite schools with 3-5 times more applicants than spots for students (including Consortium schools).  The survey, hence, drew conclusions based on the input from, say, a septugenarian MBA graduate from a local business school in the 1960's, from 1990's graduates of prominent schools in Europe or from those who just stepped from the halls of, say, Dartmouth-Tuck or UCLA-Anderson a year or two ago.

But praise the organization's comprehensive efforts.  While the MBA evolves and adapts to the times, there is common ground for most MBA graduates. There are common experiences in school, common core courses, and a common immersion into factors (markets, finance, economics) that affect business performance.  The survey results suggest, for MBA's, there is long-term value. 

Survey Shortcomings?

Like all surveys, there are flaws or short-comings, even in the GMAC survey.  Graduates who are doing well professionally or have done well over many decades may be more eager to take the time to complete a long list of questions and share their stories of promise and good fortune and report their upward-sloping compensation ranges.  As well, measurements of "success," "accomplishment" or "senior management" benchmarks are often a function of personal experiences, values and objectives.

Furthermore, the good or bad fortune of graduates is influenced by other matters besides hard work, preparation, and business-school knowledge.  Notably, an indefinite number of factors unrelated to the MBA can explain "success," including the economy, an industry's product timeline, market timing and plain ole good luck, being in the right place at right time (or being at the right place, but in the wrong time, as many 2008-10 MBA graduates would attest). And even in 2015, bias, nepotism and old-school fraternal ties might come into play. 

Summarizing the Results

Yet like many surveys, there are some intriguing trends and worthwhile messages.  Some of them are highlighted here:

1.  The more senior they rise within an organization, the more likely MBA graduates will admit they use knowledge and skills obtained from business school. 

This suggests a notion many have stated all along--that MBA learning focuses on senior leadership, senior management, and global businesses. Business schools are often praised for teaching students to become sector leaders, business heads and chiefs of finance and marketing. 

But the same schools are often chastised for not reminding new graduates that the road toward the top will be long and hard, and years of dues-paying grunt work will likely precede end-of-career success at the top of the organization chart. 

Survey results show that as business-school graduates become more accomplished over time, they more readily acknowledged that the analytical and management skills they were exposed to as MBA students helped prepare them for current, senior roles.  A public-policy, real-estate or operations-research course might seem irrelevant to a first-year associate, but the head of Asia operations will more likely say exposure to those courses long ago helped. A second-year brand manager at a major consumer-products company may not appreciate her intermediate accounting course until she becomes a business-unit head responsible for a substantial balance sheet and bottom line. 

2.  Recent MBA graduates (more than older graduates), the survey suggests, say professional and alumni networks have helped propel their careers (win coveted job offers or get early promotions). 

Such sentiments might suggest the difficulties MBA graduates of the last decade have confronted, when financial crises, recessions, and massive restructuring across many industries meant graduates had to push beyond MBA credentials to find the best opportunities. Meanwhile, more experienced MBA alumni, established in their roles, may not need to rely as much on networks and contacts.

3.  The survey concludes that more experienced MBA graduates, especially those who have advanced to the highest rungs in organizations, are more likely to feel comfortable with taking risks in their careers.

They are more willing to embrace innovation and change, more willing to be pro-active in business strategy and more tolerant regarding risks of all kinds (financial risks, market risks, business risks and social risks). 

Many inferences can be drawn from the results, although not necessarily conclusively. Some will argue it's easier to take risks early in a career, when reputations have not yet been molded and when graduates have fewer family constraints and can start, stop and transition elsewhere without significant responsibility.  

But these survey results may imply: 

(a) Those who are the types who embrace and gravitate toward risk-taking, business execution, challenge and change are more likely to advance high in their industries, firms or companies. (They advanced because they were risk-taking.)

(b) Those who have reached those highest rungs also have the experience, confidence and financial resources to be able to take risks they may not have been able to when they were strivers still seeking to show competence. (The are risk-taking now because they have advanced.)

4.  For most of those who work in conventional corporate settings, there are few timeline short cuts to "C-suite" positions (CEO, CFO, chief marketing officer, chief information officer, chief risk officer, etc.). 

Survey results say it takes about 17 years of related work experience to reach the top of an organization, business unit or sector. The average age is 48, and the survey tells us something we already know well--that the officer in their C-suite slot is likely to be male.  

5.  Large numbers of MBA graduates today don't work for mega-corporations. They (about 12% of those surveyed) are entrepreneurs or are self-employed.  MBA entrepreneurs tended to be those in technology or products.  Those self-employed tended to be consultants. Vast amounts of the survey might have been irrelevant to them. The survey, nonetheless, allowed them to opine and reflect on their MBA degrees, as well.  

Many in this group describe themselves as being slightly less risk-taking than those in C-suite positions. 

That contrasts from popular notions that entrepreneurs and owners of their companies are those with unlimited courage, willing to tackle business and financial risks boldly.  Like others, they attribute parts of their success stories to business-school learning. They take risks, they acknowledged, but they are measured, calculated risks, especially because they are singularly responsible for employees and accountable to demanding lenders and investors (venture capitalists, banks, and funding backers who want a five-year payout).

6.  About 17% of survey respondents work in finance.

They survey shows that the oldest MBA alumni worked more prominently in finance (about 20% for graduates before 1990).  For later graduates, the global MBA workforce in finance has remained flat, notwithstanding the financial debacle of the late 2000's.

MBA graduates in greater numbers are  marching into technology and consulting (17% and 12%, respectively, over the last five years).  The most notable decline is the significant decrease in recent alumni (over the past five years) choosing government and non-profit positions. 

Those in finance, as expected, are working in financial centers around the world:  Singapore, Japan, New York, and London, e.g. 

7.  As alumni, what do MBA graduates want from their alma maters?  The survey shows they don't want to be harrassed too much about how much they aren't donating to their business schools.

Meanwhile, they prefer their schools offer alumni seminars in business strategy, business analysis, and data science.  They also want continuing access to career-development offices, alumni networking events, and more contact with professors on campus. 

Of the 12,000 graduates participating in the survey, about 70% graduated within the past 15 years and 70% are from the U.S.  About 69% were male, reflecting a surprisingly woeful lack of gender balance at the MBA level (and contributing to a scarcity of women who enter the pipeline from MBA associate to sector head).

Expanding the Survey?

The GMAC survey omitted many questions and topics it could have (or should have?) covered.  No doubt it needed to present a polished, easy-to-check-the-box list of questions, one for which there are discrete answers and which would not be time-consuming for survey-challenged executives. For the sake of efficiency, it avoided topics where responses are ambivalent or deserving far more than a multiple-choice selection.

The survey, for example, didn't provide breakdowns among some segments of alumni--women and under-represented minorities, for example, although there was ample categorization based on geographies and industries.

It would have been informative, for example, to review trends and signs of success among Latino graduates or to review the MBA skills women in senior roles saw as affording them a big advantage in pushing their careers. It could have provided hard data about trends among African-Americans in corporate hierarchies and compensation. And it could have confirmed whether the pipeline to senior leadership is dwindling or promising. 

The survey, too, didn't give alumni a chance to opine on the future of MBA education:  What should business schools focus on? How should courses be taught and in what format and timeline?  What should be in a first-year student's core? How much emphasis should schools put in online offerings, international experiences, operations and management topics, ethics, politics, and psychology?

GMAC is already doing research and sharing its finding on many of these topics.  The 2014 effort was likely about getting maximum participation from the largest number of respondents possible, from all over the world and from all ages and letting the data alone speak.