Monday, March 6, 2017

Snap Emerges from the IPO Gates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is that possible?

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

Tracy Williams

See also:

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

Tuesday, February 7, 2017

Dodd-Frank Dismantled?

Under Review:  Will Dodd-Frank be dismantled or just tweaked?
Two weeks into his presidency, Donald Trump has already threatened to dismantle Dodd-Frank financial regulation. During the campaign, he hinted at granting regulatory relief to a variety of participants in the financial industry, but didn't offer details or specify which rules and requirements would be altered or abolished.

Less than a month into his term, he has initiated efforts to shake up bank regulation and Dodd-Frank requirements, pushing us back toward an era that pre-dates the days of the financial crisis. 

This is the same regulation enacted and signed into law in 2010 as the anchor around which banks would reform and restructure to (a) reduce the likelihood of another near collapse of the financial system and (b) to ensure banks are strong, healthy and sturdy enough to endure a crisis when it occurs again.  (It also includes protection for consumers when they engage with financial institutions and when they purchase bank products.)

The Trump administration, much to the quiet happiness of some bankers, wants to eliminate or revise some of the new rules.  This would come after years of banks conforming to new rules, arranging to increase capital in large chunks, reduce leverage and reconstitute the risk content of their balance sheets.  This would come, too, after banks invested in systems and personnel to comply with hundreds and hundreds of new rules.

So can Dodd-Frank be completely dismantled and done away with? Or will the administration selectively choose rules to keep and rules that will be eliminated? Or will it  substitute with a different, more bank-friendly law? If rules are adjusted, changed or eliminated, which ones are likely to be altered?

We can assume not much will change in the short term. Because Dodd-Frank supporters will be able to argue the post-crisis benefits to the banking system and because banks are already adapting quickly to the new environment, there will be fierce debate. (Consumer-finance advocate Sen. Elizabeth Warren will be at the front line.  Senior Federal Reserve Bank officials--past and present--will have much to say.)

The substance or essence of Dodd-Frank won't be eliminated.  Banks and bank regulators around the world have agreed to comply with the basics of bank regulation defined by the Bank of International Settlements and outlined in what we all know as Basel II and III.  Dodd-Frank formalizes and reinforced U.S. banks' compliance global regulation.

Basel III regulation outlines capital requirements for banks of all sizes to absorb credit, market and operational risks.  Basel III also set standards for liquidity and leverage.  But the BIS and Basel III permit member countries to adapt rules to their respective systems and tighten them up, if they choose to do so.

Dodd-Frank, as expected, toughened many of the same requirements, imposed new restrictions, and added other rules and stress tests. It empowered regulatory agencies to set other rules, as necessary, and fill in the minutiae.  (Other countries have done the same.  Europe's Dodd-Frank might be what is called "MiFID," or Markets in Financial Instruments Directive.)

The biggest banks have the toughest requirements, subject to Basel III, Dodd-Frank and Federal Reserve guidelines.  Throughout the post-crisis era, regulators have worried about the impact of big- bank failures on the financial system.  That concern has been a guiding light in writing new rules.  With stringent capital and liquidity requirements, let's reduce to tiny probabilities the likelihood that big banks will fail.  And if they do, let's minimize the impact on everybody else.

The familiar names (from Bank of America to Wells Fargo) have had little difficulty in complying with every aspect of new regulation--except for the occasional failing of a stress test. Perhaps the greatest direct impact of regulation is banks being forced to do business with much more capital and much less leverage (leading to lackluster to modest returns of equity).

In corporate and investment banking and in trading, what rules are candidates for change and how they might change?

Minimum capital requirements.  Basel III requirements for capital for credit, market and operational risks are specifically defined.  Rules vary based on how large and how systemically important financial institutions are.

Bigger banks, especially those with foreign operations and complex organizations and complex product offerings, calculate requirements based on advanced, statistical models.  Banks deemed "too big to fail" (determined from definitions of size, not based on perceptions of big) have higher minimum-capital ratios (based on "GSIB" designations and regulatory discretions about how much more capital they should have). 

An amended Dodd-Frank might tamper with the definitions of "too big to fail," might increase the minimum size of banks subject to advanced calculations of risk capital, might ease the burden of requirements to maintain significant capital for operational purposes, and might be lenient about what forms of debt can be included in the many definitions of capital.

Liquidity requirements.  U.S. regulations amended Basel III requirements for liquidity requirements (the amount of cash and cash-equivalents banks must hold in anticipation of meeting obligations over the next 30 days). They made them more onerous for big banks. Cash-equivalent definitions are stricter (Is a CMO considered a cash-equivalent?), and big banks must comply with liquidity metrics everyday, not monthly. 

Banks are complying with current rules and will boast quarterly how liquid they are.  But they would enjoy filling those liquidity pools with assets Dodd-Frank-related rules limit (lower-rated corporate bonds?).   A revised Dodd-Frank might ease the daily requirements and permit a broader range of financial instruments to be included in the pool of cash-like assets. Banks will prefer to meet these requirements more and more with assets that generate a return of some kind.

LeverageU.S. rules (beyond Basel III) pummeled banks in limiting leverage.  Basel III rules limited the size of bank's balance sheets, relative to capital, regardless of risk levels.  Banks can "de-risk" balance sheets and, therefore, reduce capital requirements.  Yet Basel III's leverage rules still require a minimum level of capital.  Dodd-Frank rules led to U.S. banks calculating a tougher "supplementary" leverage ratio, which includes certain off-balance-sheet activities.

A revised Dodd-Frank might eliminate the supplementary leverage or ease the burden of requirements.

Volcker Rule.  This rule prohibits proprietary (hedge-fund-like) trading at banks.  Banks can engage in sales and trading, but the activity must expedite customer activity.  All trading must be tied to customer flows.  Banks can hold corporate bonds and equities, as long as they are eventually sold to customers.  Banks, especially institutions with large trading desks and a recent history of occasional surges in trading profits, have responded in various ways.  Many have reduced emphasis on trading, shed desks, and focused on fewer asset classes. Others have aimed to increase market share, while committed to making money from customer flow. 

For banks still with big trading aspirations and large trading positions, the rule is difficult to comply with.  Banks must prove to regulators trades on the books exist to meet customer demand or customer expectations.  While those trades sit on the books, they can be subject to market losses, but can be privileged with market gains.  Whatever is on the books, regulators want to see them eventually off-loaded to customers.

Traders at some banks crave for the days of trading at free will.  Many other banks just wish there were easier ways to comply. In the wake of Trump's announcement, there have already been rumblings that the rule might be repealed, modified or eased, although it may be one facet of Dodd-Frank most difficult to overturn.  In the eyes of many, undisciplined trading and mismanaged market risks rank among the handful of causes of the mid-2000's crisis. And regulators won't easily allow banks that accept consumer deposits in one part of the organization to engage in hedge-fund-like activity in another part. 

CCAR.   This refers to the annual stress tests banks conduct (better known as "See-Car").  Banks are handed business and operations scenarios that reflect worst-case situations and extreme scenarios.  They must then compute the maximum they will lose in these scenarios and then show they are still in compliance of capital requirements.  Failing a test is often a public-relations embarrassment and will lead to reprimands from regulators to reduce risks or boost capital. 

The tests are comprehensive exercises and give regulators more beef in their arguments that banks need more capital.  To pass the tests, banks now realize they must take them seriously and devote time, attention and resources to do them thoroughly.  Most banks have built the exercises into the ordinary course of business. They conduct them routinely for themselves. 

Dodd-Frank opponents won't disagree with the purpose of stress tests.  They may propose tests overseen by the Federal Reserve be conducted less frequently (biennially?) and pass-fail grades be applied less harshly. 

Living Wills (Recovery and Resolution).  This Dodd-Frank exercise is a liquidation scenario. Regulators want banks to show how they would liquidate operations in a stress scenario without jeopardizing the financial system. When first implemented, banks might have taken for granted how easy it would be to pass. But large banks are labyrinthine structures with a complex network of holding companies, operating entities, regulated entities, minority interests, joint ventures, special-purpose structures, and deposit-taking operations. 

Unwinding these structures is far more difficult than they initially presented in the exercise. It involves legal structures, legal issues, foreign operations, dividends upstreamed, intercompany transactions unwound, securities up for sale, loan portfolios reduced, cash funneled from subsidiaries abroad and siphoned up to the holding company. Not quite on board with the fundamental purpose of the exercise, some banks have not fared well in the exercise.  After receiving unsatisfactory grades, they now do. 

But if Dodd-Frank is amended, they would hope for relief in the frequency of compliance and in scenario assumptions. 

Derivatives Trading. U.S. and global bank regulation, after the crisis, tightened up requirements for where basic derivatives (plain-vanilla interest-rate swaps, credit-default swaps, e.g.) are traded. Regulators seek to push much of the high-volume trading from over-the-counter (OTC) markets to exchanges and central counterparties, trades that would be transparent to most of the market and would be settled by approved settlement organizations. 

The transition from OTC to exchanges and central counterparties has proceeded in deliberate fashion (not necessarily the fault of banks), but new regulation works to their advantage.  Related credit and market risks are reduced and, therefore, risk-capital requirements. 

A revised Dodd-Frank will not likely abolish these requirements, but could push for more swift approval of derivatives exchanges and settlement organizations. 

TLAC.  Dodd-Frank allowed the Federal Reserve to add another layer of long-term capital requirements. Regulators worry about banks' reliance on unstable funding sources.  They are concerned, too, about how extreme risks will erase much of the capital cushion and jeopardize the claims of depositors.  Hence, last year they introduced "TLAC" (or Tee-Lac) requirements to increase the amount of "loss-absorbing capital" on the balance sheet.  TLAC includes equity capital, preferred shares, subordinated debt and senior, unsecured debt.  TLAC, regulators hope, should offset unstable short-term funding and unstable deposits. 

Banks are complying and will do so without difficulty, as long as they have investment-grade ratings.  But bank CFO's have accepted that long-term stable funding means higher costs of funding (and lower earnings, compared to income statements long years ago).  Some might argue that higher liquidity requirements should ease the

Dodd-Frank revisions might support the concept and purpose of TLAC, but could reduce the actual requirement.

Stay tuned.  The debate will eventually heat up. Often it won't be easy to follow or understand. But even the slightest changes could have substantial impact on bank capital levels, balance sheets, performance, business operations, and risk levels in the system.

Tracy Williams

See also:

CFN:  TLAC to the Rescue, 2017
CFN:  Basel III, 2013
CFN:  JPMorgan's Regulatory Rant, 2012


Friday, January 6, 2017

The Latest M&A Rankings

The old Merrill Lynch franchise helps keep Bank of America in the top 5 in global mergers and acquisitions.
Investment-banking league tables--those lists that report who led banks in deals in a given quarter or year--appear to be a relic from the sporadic soaring periods of deal-making in the 1980's through mid-2000's.  The lists conjure images of the old Lucite trophies bankers used to collect on their desks after a deal closed and client companies paid their large fees.

The acrylic, translucent plaques, crowded on window sills of junior and senior bankers, seem to have faded as favorite industry props (partly because corporate clients and their bankers don't want to bicker over who should shoulder the celebratory expense).  However, league tables still appear quarterly.

And they still count for much.

At the least, they show which banks are the most prominent or most successful at attracting big corporate clients, winning big mandates, and getting deals done in all sizes and complexities (crossing borders, too).

The tables and lists are compiled for many banking products and activities--from syndicated loans to equity IPO's and corporate- and municipal-bond offerings. But the most widely reported and widely analyzed table is that for mergers and acquisitions, that most consummate of all investment-banking activity.

M&A is not a casual corporate event, although some companies (like pharmaceutical company Valeant in 2015 or GE in times of yore) acquired others as frequently as the weather changes.  M&A can transform a company significantly by changing its strategy, its organization, its people, and its size. M&A involves undeterminable synergy risk, the risk that what appeared idea on the spreadsheet of a Morgan Stanley associate doesn't make sense when operating units combine as one.

M&A, in some big investment banks, is a centerpiece of relationships with large corporations, because (a) the bank speaks directly to the client company's board, CEO and CFO and gets immediate feedback, (b) the bank earns millions in fees, if a deal is successful, and (c) the bank doesn't need to use up its balance sheet, unless it chooses to finance an acquisition (as many banks do). 

As for (c), if the bank doesn't finance the acquisition, the bank minimizes credit and market risks, although it must tend to reputation risk. (Reputation risk might range from the embarrassment of not being to manage an announced deal or the criticism it might get from arranging an vitriolic, unfriendly takeover.) Because of (c), boutique banks, such as Evercore or Greenhill, can compete head to head with the might of Goldman Sachs or JPMorgan Chase.

In 2016, merger league tables hardly budged. Those we expect to be at the top remained at the top. In a year of over $3.6 trillion in global deals (a total that doesn't even eclipse the industry's best year ever in 2015), the leaders of the pack are Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America Merrill and Citi.  (Thomson Reuters tallied the latest rankings.)

The old Merrill Lynch franchise still thrives at Bank of America, at least on the merger front.  Banks that have threatened for the past 2-3 years to downsize investment banking (Credit Suisse, Barclays, UBS, and Deutsche) still remain locked down in the top 10.  In fact, the ranking of UBS, a bank that announced a notable departure from investment banking, improved, as it remains a leader in Asia.

In this banking sector, boutiques don't take a back seat to their bigger brethren, even if they don't bring billions in financing commitments to the deal table to finance major mergers.  Evercore, Lazard, Centerview and Perella Weinberg are in the top 15. 

For which corporate industries are these banks arranging expensive link-ups?

Headlines would suggest banks swarming the globe making deals in technology and Internet industries. That's true in the number of deals, if not the size of deals. Recall in 2016 the announcements of Microsoft acquiring LinkedIn and Verizon taking over Yahoo. 

There were much commentary and discussion about pharmaceutical firms contemplating acquisitions or grabbing smaller companies.  But league-table statistics report the greatest dollar volume of transactions were done in oil-and-gas, chemicals, and power/utility industries.

Merger activity is driven by a confluence of factors:  shake-out and consolidation in specific industries, cheap sources of financing, surplus cash sitting on companies' balance sheets, economic outlook, regulators' interpretation of antitrust laws, tax considerations, shareholders' demands for better returns, and the aggressive efforts of investment banks.  The years 2015-16 were ablaze, but the second best deal year was 2007, the eve of the financial crisis.

Activity in league tables show evidence of banks generating millions in fees.  Deals they lead and participate in sometimes grab almost the same attention at some big banks as credit-card advertising.  When Microsoft acquired LinkedIn, industry analysts provided immediate critique of the deal, but were curious to know who orchestrated the deal and who helped set the price tag (and who would be entitled to receive the lucrative fees). 

Investment banks also show off league tables to win new deal mandates.  They do so to prove competence and ability to manage complex transactions around the world.  Every presentation by a bank to a company's board to outline why the company should wed itself to a competitor includes an M&A top 10 or top 20.

For the biggest banks, merger fees lead to prestige, while CFO's salivate that deals require minimal balance-sheet usage and insubstantial regulatory capital.  Still, at JPMorgan, Citi and Bank of America, merger fees contribute less than 8 percent of total net revenues, reminders that big financial institutions still make the bulk of their earnings from lending to large companies, not always from advising them acquisitions.

Meanwhile, for the boutiques, the merger business is their lifeblood.

Tracy Williams

See also:

CFN:  UBS De-emphasizes Investment Banking, 2012
CFN:  Credit Suisse and Its New CEO, 2015
CFN:  Merger Mania: Boom Times? 2013
CFN:  Can Morgan Stanley Please Analysts? 2012



Monday, December 19, 2016

Wells Fargo's 2016 Woes

Wells Fargo is still big, profitable and well-capitalized, but 2016 had a rough ending.
Board members and senior managers likely can't wait for 2016 to go away at Wells Fargo.

Heretofore, the bank had been often described as the best-managed, the best-run bank among the top global banks. Whenever someone published a list of big banks with the highest ROE's (to measure returns on capital and general performance), Wells Fargo with its 12% returns over the past few years roamed the top. Whenever someone published the credit ratings of big banks, Wells Fargo with its AA-ish rating roamed the top.

Part of its industry respect, its reputation for shrewd management and its results were due to its escaping financial-crisis debacles of trading losses, insufficient capital, and mortgage-securities wipe-outs. It wasn't plundered by billions in mortgage settlements to government bodies.  Part of it was its business model--expansive in all corners of the country, fairly basic:  accept deposits and use them primarily to fund a large, varied, diverse portfolio of consumer and corporate loans.  Sprinkle in a little global activity and a representative investment-banking unit.

Furthermore, its success was because it resisted (somewhat) the temptation to propel itself to the top among major investment banks (mergers, acquisitions, and underwriting) and major securities and trading dealers. It participated in these arenas, but it didn't aspire to compete head-on with Goldman Sachs or Deutsche Bank. 

Then came the retail-bank scandal in late 2016, which smashed the bank's reputation almost to bits and led to the ouster of its CEO John Stumpf in October.  The scandal, as everybody knows, is tied to the bank's strategy to sell phantom bank accounts and other unnecessary services to thousands of retail customers. The bank paid a government penalty, dismissed lower-level employees involved, and continues to address the fall-out from these disclosures.

Such scandalous retail practice was likely its way of responding to pressures to sustain performance. Banks nowadays boost their returns not from highly leveraged, moderately risky loan and trading portfolios.  The strategy calls for controlling costs and generating fee income, steps that have negligible capital requirements and balance-sheet impact.

Now just as it felt it was rescuing itself from the reputation blues, the year winds down and the Federal Reserve and FDIC announced the bank had failed its most recent "living will" test (Recovery and Resolution regulation).  That's the regulatory exercise regulators command banks take seriously, although it addresses a hypothetical scenario. The Dodd-Frank-related requirement stipulates banks must show how they would unwind their businesses and liquidate their balance sheets in stress without being a detriment to the financial system. 

JPMorgan Chase led the short list of banks that fell short on this test last year.  At Wells Fargo, at a time when the bank desperately needs to assure retail and corporate accounts its culture is evolving and convince everybody in sight it has cleansed itself of the scandal, a bank regulator slaps its wrist with a failing grade.  For the second time.

With ample capital (almost $200 billion in equity), strong risk management, and a footprint in households and corporates coast to coast, the bank is in no danger of failing.  It has a net-revenue base of over $80 billion.  Its net earnings top $20 billion annually.

It may likely suffer a hiccup or two in income over the next few quarters, as it addresses lingering issues from the scandal.  (Some customers will likely review their relationships or choose not to funnel similar amounts of business.  They, too, must respond to stakeholders about their ties to the bank.) But Wells Fargo's balance sheet is sturdy, and the franchise entrenched. 

Regulators suggest the bank should take more than a passing interest in trying to pass the "living will" test. They insist if the bank's financial condition is, in fact, declining quickly, if it needed to unwind, dis-aggregate or sell off assets to pay down depositors, lenders and debt-holders, all it should do is click on the "game plan."  The "game plan" should be detailed, thorough and include all funds flows and entities on the organization chart.

In the same way it criticized JPMorgan last year, regulators have one specific issue, among others. It claims Wells Fargo isn't showing adequately how it would funnel cash from affiliates or subsidiaries to the holding company to pay down debt-holders. 

That process is less smooth than JPMorgan and Wells Fargo have assumed in these exercises.  That shouldn't be a surprise, since big banks preside over complex, intertwined organizations. Cash or cash-equivalent liquidity residing on a balance sheet in a subsidiary in Singapore shouldn't be counted on immediately to be a source to pay down a debt obligation for the parent company in New York or San Francisco.

Or the $100 million in Singapore might take weeks or months to snake its way legally to New York through a labyrinth of legal companies and tax obligations. And the amount might dwindle to $50-75 million on the way.

"Living will" tests and other stress tests are exams banks like JPMorgan and Wells Fargo with extraordinary amounts of capital and liquidity should be able to pass, as long as they give them proper attention and devote resources (personnel, technology, etc.).  This time, Wells Fargo's "wrist slap" penalty is a restriction on the bank expanding internationally or investing in non-bank activities--something the bank can accept without complaint.  A greater penalty is for its senior management and shareholders to see the bank's name soaring across the financial media in negative headlines.

Whether it's JPMorgan, Wells Fargo or RBS (which failed a stress test recently), a failing grade results in an "uh-oh" moment, a realization that regulators are, in fact, taking these tests seriously, so "we had better give this priority" beyond delegating the tasks to a team of junior associates.

Tracy Williams

See also:

CFN:  Explaining Living Wills, 2016
CFN:  Wells Fargo Sticks to What It Does Best, 2014
CFN:  Another Round of Bank Stress Tests, 2016
CFN:  When Does a Bank Have Enough Capital? 2015
CFN:  The Essence of Corporate Banking, 2010
CFN:  JPMorgan:  Is $13 Billion a Lot of Money? 2013
CFN:  JPMorgan's Dimon's Regulatory Rant, 2012

Sunday, December 18, 2016

Tee-Lac to the Rescue


Federal Reserve Bank of New York:  The Fed will administer the TLAC requirement that big banks should have a minimum amount of long-term debt, as well as capital. 

Up and down the elevators at big banks in the U.S. these days, there is prominent discussion going on among those who worry most about balance sheets, bank capital and regulation. Listen in, and they might be debating the impact of a new regulatory requirement--above and beyond the thousands of other pages of bank regulation unleashed by Basel III and Dodd-Frank.  "TLAC" is what they're talking about. It's referred to as "Tee-Lac," and it stands for "Total Loss-Absorbing Capacity (or Capital, in some circles)."

For the past couple of years, bank financial managers and risk managers have been pondering it, whispering about it, analyzing it, and attempting to understand it.  Regulators have been promising it was on the way.

It's finally here, at least in the early stages.  The Federal Reserve affirmed its TLAC plan in December.

The largest banks will try to prove quickly they are in compliance. In the back corridors, some will fret that while it makes big banks stronger and much better able to endure stress or extreme scenarios, it is yet another threat to banks' dwindling returns on equity (ROE).

Increases in capital and reductions in leverage (as required by post-crisis regulation) snip at ROE. With all its promise that it leads to a stronger financial system and makes for sturdier bank balance sheets, TLAC could also gnaw away at ROE.

TLAC is supposed to ensure banks have ample amounts of long-term and stable funding sources, especially vital when the biggest of banks now sport balance sheets flirting with $2 trillion levels. Bank CFO's wince, because the requirement will increase the cost of funding, on average. Cheaper, but less-stable, less-reliable short-term debt must be replaced by more expensive, but more stable long-term debt.

TLAC will be measured as the sum of (a) equity capital, (b) subordinated debt and (c) unsecured term debt. Regulators will want to see required contributions in each category. (Effectively banks will have capital requirements related to the following: "CET1," Tier 1, Tier 2, leverage, supplementary leverage, and now TLAC.)

Banks will be required to substitute some of those fleeting, unpredictable funds sources (like deposits from hedge funds) with long-term debt to add to the mounting amounts of capital requirements described above.  Think "run on the bank," or the regulators' efforts to introduce a metric (or requirement) to minimize the scenarios where worried, panicking short-lenders or depositors run away from what they perceive as a financial house burning down.  Or viewed differently, short-term lenders and institutional depositors won't flee too quickly if they know there are several layers (and tens of billions) of a capital cushion resting beneath them.

Many may call it "TLAC."  Many others, including regulators themselves, are calling it "bail-in" capital, as opposed to regulators in the last crisis bailing out banks.

Bail-in basically means bank supervisors or the U.S. Government won't be pressed to bail out banks in a financial fire because (a) they don't want to, (b) much of the new regulation is designed with just that in mind and (c) they will have required the layers of long-term capital to absorb all the losses first. If the TLAC requirement is sufficiently high, even tens of billions of losses couldn't threaten the viability of the bank, threaten the claims of depositors and secured lenders, or (in sum) increase the likelihood of a Government bail-out.

Call this, if you will, the "memories of Lehman" rule.  Regulators and analysts reason that if Lehman had more liquidity and if it had more equity capital and long-term debt to supplant its reliance on worried secured lenders, it might have been able to survive the crisis of 2008, despite mortgage-securities mismanagement and mortgage losses. That's a big "if," given Lehman's shortcomings in managing risks and its balance sheet and its outsize ambitions.  In the midst of market panic in mid-2008, Lehman reached a point where it couldn't buy the patience of institutional short-term lenders, who with growing amounts of complex, illiquid mortgage securities as collateral were clamoring to get out.

As for TLAC, banks deemed to be "systemically important" (SIFI and G-SIB are other terms used to describe the club of banks considered "too big to fail) must comply. Peer banks in Europe will have similar rules.  The amount of TLAC a bank is required to have will be tied directly to the riskiness of its balance sheet ("risk-weighted assets" (RWA) come to mind) and to the size of its balance sheet (leverage rules come to mind).  The more market and credit risk embedded in its businesses and its balance sheet, the more TLAC. The larger the balance sheet, the more TLAC.

Bank supervisors argue TLAC will give big banks more than a greater loss cushion. It will be the saving grace for banks in stress periods, when they can worry less about which class of depositors or short-term lenders is unwilling to provide funding and which might be responding to rumors of insolvency and are desperate to flee the apparent maelstrom. With TLAC, a bank can be somewhat indifferent to whether hedge-fund depositors, bank depositors, corporate depositors, or commercial-paper investors want to stick with them in volatile times.  (Retail depositors tend to remain loyal, if only because they know FDIC insurance hovers above their accounts.)

And the more TLAC, remember, the more likely regulators will not feel obliged to tap the U.S. Treasury to save the bank in order to save the global financial system. Recall the tumultuous times of 2008-09 when the Federal Reserve and the U.S. Treasury developed game plans on the fly to decide whom to bail out and whom to allow to slide into bankruptcy.

On any balance sheet, corporate or financial institution, more long-term debt offsetting declines in short-term debt means higher interest costs.  With TLAC, net-interest spreads, which banks painstakingly manage, could decline, as a result.

The familiar top banks we think of when we think "too big to fail" already have substantial long-term debt and pay substantially more interest on it than they do on deposits and overnight funding.  JPMorgan Chase, for example, has almost $300 billion in long-term debt for which it pays over three-times more in interest than in short-term funding. (Bank of America and Citigroup each has over $200 billion in long-term debt to help meet TLAC compliance.)

It's a new banking world.  The big banks have begun to realize what they really knew all along--that the cost of strengthening their balance sheets and helping them endure the next crisis is shedding several points in their returns for shareholders.

Tracy Williams

See also:

CFN:  Basel III in Summary, 2013
CFN:  Are Bank ROE's Stuck at 10 Percent? 2015
CFN:  Credit Suisse Makes a Big Move, 2015
CFN:  UBS Throws in the IB Flag, 2012

Friday, November 18, 2016

That Coveted Goldman Partnership

Goldman recently announced its 2016 class of "partners." Is the title still one of the most coveted goals on Wall Street?
Every other year in even years, mid-autumn becomes hush-hush time around the corridors at Goldman Sachs.  That's when the big bank announces its new slate of partners.

A partnership at Goldman has long been a treasured milestone, the culm
ination of a decade or two of hard work and internal accomplishments--at hours of commitment that most workers can't fathom.

Is it still coveted reward? Do prestige, power, and mounds of wealth accompany the promotion in the way it often did through much of the firm's history?

The New York Times reported the recent announcement and elected to focus on the percentage of women in this year's class and assess in any trends.  Of the 84 named, 19 (or 23 percent) were women. Trends show improvement in the numbers, although the increases trickle upward; they don't surge upward. No information was disclosed about under-represented minorities.

Like most banks (commercial, corporate and investment banks), senior bankers are granted the title managing director. At Goldman, a subset of managing directors have partnership privileges.  They are not partners in the company, because Goldman is not a partnership (although it was decades ago).  Managing director-partner is a privileged title.  Those who hold the title are granted, however, a large percentage of shares.

For this new partnership roster, is Goldman the same firm as it was when partners numbered less than a couple of hundred (not the 500-plus today) and when it focused much of its activity on mergers, acquisitions, underwriting and a modest amount of trading?  Is a partnership there still a stepping stone toward the top of Goldman's hierarchy or (as has been in the past) a pathway to a senior, powerful government post?

What is the true Goldman today?

It's now formally classified as a bank holding company, subject to the same supervision and oversight that its new group of peers (like JPMorgan Chase and Citi) must adapt to everyday. It still maintains predictable leads in the league tables that investment bankers care much about (mergers, acquisitions, IPO's, bond underwriting, etc.). And it appears to have a side-table seat and the ears of board members involved in the merger transactions that keep getting bigger and bigger as years go by.

Yet because it's a big bank (a "systemically important" one, in fact) and because it chooses to remain aggressively at the frontlines of sales and trading, it has to confront issues and challenges that JPMorgan and Citi do, issues and challenges its IB boutique peers (Evercore, Moellis, Greenhill, Lazard, e.g.) aren't bothered with.

Addressing many of those issues and challenges often means boosting capital, reducing leverage, stockpiling liquidity, and worrying excessively about stable funding--all while sending its armies of M&A and advisory bankers around the world to advise on the biggest companies on what they should do and how they should finance what they should do.

Peek at recent numbers.

Investment banking is for which Goldman is best known--the merger deal valued in the tens of billions, the advice its teams present to CEO's and board members to buy out another company or defend itself from unwanted suitor, the financing packages they assemble to permit Company A to acquire Company B with debt levels that might cause the unacquainted to faint, and the timetables they lay out to shepherd a Silicon Valley unicorn through its IPO.

The numbers, however, show Goldman--despite restraints from regulators--is still a trading powerhouse.  Trading has been slowed down, even hand-cuffed. Yet Goldman continues to push in that direction, seizing roles and market share where other banks have stepped back. Trading activity (from trading and commissions revenues) contributes about half of all net revenues at the bank. Investment-banking fees, by comparison, comprise less than a quarter.

Still, some would argue the IB tail wags the trading dog. IB polishes the Goldman name and brand.

Critics have lately cited the bank's lagging returns on equity, especially compared to some of its peers. Check the best measurement of ongoing performance:  returns on (book) equity (ROE), the returns the bank generates on behalf of its owners, including the hundreds of partners who run the firm.  ROE for the past two years hovers about 7-8% (including 2016 results)--returns that lag some banks (JPMorgan Chase and Wells Fargo, e.g.) and returns that shove it into a pack of mediocrity.
.
All big banks struggle to generate decent returns nowadays. Regulators insist on greater and greater levels of capital and also limit leverage and the size of balance sheets.  Furthermore, the Volcker Rule (which prohibits proprietary trading) puts constraints on what Goldman can do well: trade all classes of securities, derivatives and options in most venues and in many countries and manage related risks.

In 2016, the bank is on a pace to generate about $13 billion in trading revenues.  Imagine how much more it could generate if it weren't hampered by the Volcker Rule or didn't have to adhere too closely to capital requirements and leverage limits.

Critics would argue, of course, that restrictions keep Goldman from taking on extraordinary risks that lead to billions in losses. By comparison, Goldman takes on about the same level of trading and derivatives risks (measured by the common market-risk metric "value at risk") as JPMorgan Chase and Citi, but has about a third the amount of capital.  (Goldman could rebut and show it doesn't have the same level of loan and credit risks as JPMorgan and Citi.)

Investment-banking fees (the fees it generates from the Wall Street Journal headline-splashing deals) comprises only 21% of 2016 net revenues for the firm. For decades, the firm has been an elite institution in corporate finance and advisory, and it will continue to attract the talent (and pay the talent) to ensure that it will also be. The brand alone will help keep Goldman in the top 5 in most league tables (barring any embarrassing scandal). But IB fees fluctuate. They rise, fall, come and go, based in part on corporate balance sheets, company shareholders' desperation to grow, and confidence in the economy.

Since the crisis, Goldman is supervised by the Federal Reserve. It is no longer a pure investment bank and broker/dealer. The bank holding company presides over bank, broker/dealer, and asset-management operations.  It can choose to take deposits and make corporate and consumer loans in the way Wells Fargo does.  But it hardly emphasizes loan-making. The loan books of Bank of America, Citi, and JPMorgan Chase are about 20-times greater. (The lending it does is focused almost entirely on corporates, real estate and wealthy individuals and is likely done to accommodate treasured clients on a special-needs basis.)

No need to be sympathetic toward the firm.  Despite less-than-stellar results (or results that might pale in comparison to some of the glory days before the Federal Reserve imposed the new set of rules), the firm will still press on. 

ROE's will touch and occasionally exceed 10%. Risks will be measured and managed.  It will get the first call from corporate clients when they set out to do the biggest deals. It will attract its share of the best talent from top business schools.  Partners will be selected and be compensated at jaw-dropping levels. 

Let's make sure it doesn't forget to include a fair number of women and under-represented minorities at that table.

Tracy Williams

See also:

CFN: How Does Goldman Do It? 2010
CFN: Did Goldman Overpay for its Facebook Stake? 2011
CFN:  Volckerized, 2010
CFN:  Goldman and Work-Life Balance, 2013
CFN:  Goldman and the Greg Smith Letter, 2012

Friday, October 7, 2016

Deutsche: Why the Turmoil and Concern?

Is Deutsche Bank the next Lehman? Shouldn't new rules avert the next Lehman-like crisis?
For a moment or so, some wondered whether we were headed down another 2008-like path, as if investors, traders, and lenders in capital markets are resigned to a recurrence of the financial crisis. This time, it's not Lehman, Bear Stearns, Washington Mutual or Countrywide.

Deutsche Bank is the target this month, the subject of widespread concern about which large financial institution could be the next to fail--even after politicians and regulators had imposed new rules, stress tests and capital requirements to minimize another Lehman-like implosion.

What explains this concern?

Much of it followed the U.S. Government's announcement that it intends to fine the bank $14 billion for mortgage-crisis improprieties.  Can a bank with equity capital of about $70 billion absorb such a substantial payout? Does it have enough leverage to negotiate a much-lower settlement? These are similar to the big penalty payments other big banks have paid in the wake of the problems mortgage securities contributed to the mid-2000's crisis.

Now there is anxiety about the bank's health. Some gauge it might not be able to manage fine payouts or at least convince the Government to reduce the penalty and settle for something less.

In the world of financial institutions, concern about the solvency of an important player, counterparty or market participant often leads to anxiety and often unsubstantiated rumors that could be true or may not be.  For the institutions that trade with it, lend it money, deposit funds  or clear and process its securities, they prefer not to be caught off guard.  They flee.  And when they flee en masse, the institution singled out struggles to survive.  When the run is on, days of survival can be counted. They end up getting acquired or winding down.

But Deutsche Bank, a Germany-based powerhouse tightly interwoven into the global financial system and in such size that the numbers are unthinkably large?

In the years since the crisis, legislators and regulators implemented layers of rules to eliminate the occurrence of another Lehman, to reduce the likelihood of runs on banks, and minimize the impact of unexpected market and credit losses. As if the current rules aren't enough, more rules are in draft and will come later.  Think capital requirements, liquidity rules, stable-funding requirements, long-term-funding requirements, stress tests and orderly-wind-down scenario runs--all to ensure big institutions like, yes, Deutsche will survive every conceivable banking scenario.

So why are respectable hedge funds and other large institutions running scared, pulling funds out, canceling securities-trading arrangements, and withdrawing? Why is its stock price plummeting?

Wouldn't the capital and leverage ratios have hinted at certain risks? Wasn't the bank (or at least its U.S. operations) required to pass tests related to market, liquidity and credit risks and smooth liquidations?

And wouldn't regulators, who normally park themselves on floors of big banks for extended periods, not be aware of specific risks that could jeopardize the bank's existence?

What do the numbers suggest?

They tell part of the story. The bank meets most the standard regulatory requirements, but in some instances, barely.

In 2016, the bank is not losing money. But with returns on equity (ROE) less than 2% this year, it's not making enough money to justify the enormous risks the bank takes and the leverage it uses to support risk-taking activity. Some shareholders are justified in dumping shares (on that basis).

The bank conducts an array of activities with a $2 trillion of assets on the balance sheet (and similar amounts off balance sheet). Yet it does so with about a third of the amount equity capital as some of its U.S. peers (JPMorgan Chase, Citi, Bank of America, e.g.), which have similar-size balance sheets with different risk content. 

A glance at the details of the balance sheets shows a bank less involved in deposit-taking and loan-making and more involved operating a large derivatives-market-making machine.  Its loan book is almost half the size of peers (including Chase, Citi and also-under-watch Wells Fargo).  Its derivatives activities, at least what appears on the balance sheet, exceeds some peers by almost 10 times. 

In essence, annual reports and public statements may tell the story of one kind of bank. The financials suggest a bank with an ironclad strategy to generate profits and returns from seizing the role of market-making in derivatives (swaps of all kinds, currencies, options, forwards, futures, etc.). While capital has dipped in recent periods (partly because of losses last year), derivatives activity explains as much as a third of its balance sheet.  Earnings from the same haven't contributed in the same proportions, as bank profits still rely on net-interest from lending and other areas to overcome mediocre results on the trading side.

So wouldn't a bank with such leverage, with significant trading risks, and flat levels of capital have trouble meeting regulators' strenuous requirements for minimum capital and maximum leverage?

It should, but it doesn't.  The bank follows the rules and benefits from some of the relief the rules permit (hedging, collateral, netting agreements with counterparties, e.g.), which soften some of the blow of hefty balance-sheet leverage.  It appears to have taken baby steps to increase long-term stable funding (steady increases in long-term debt to offset reliance on short-term, fickle funding), something regulators are encouraging.

The irony is the bank could arrange to pay out $14 billion and still be just above minimum capital requirements and meet most regulatory tests (likely coming in right on the button for leverage tests). (Some equity analysts argue the maximum it can pay out without threat to solvency is about $4 billion.

The reality, nonetheless, is that it would thereafter have no more room for error--no room for further losses, no room to increase the balance sheet or risk levels. It would be a bank that survives, complies with rules, but forced to wrestle with whether or not its role as a global bank with a too-big-to-fail trading role is the right strategy for the years ahead.

The solution?  Big boosts in capital (and all the funding sources that get counted as "bank capital").

Tracy Williams

See also:

CFN:  MF Global:  Too Small to Save, 2011
CFN:  Dark Days at Knight Capital, 2012
CFN:  Basel III Becoming Real, 2013
CFN:  Jefferies: Comfortable in its Niche, 2012

Monday, September 12, 2016

Checking In: Opportunity Outlook, 2016

For new MBA students, time to review where opportunities are prominent in financial services.
This is the season when Consortium MBA students in finance, old and new, return to campus.

Some, the first-years, are gleeful, excited and anxious about the new days ahead, new courses, new contacts, and new relationships with professors, deans and career advisers.  Some, second-years, are still hopeful that summer internships, including the celebrated networking receptions and occasional work on deals, will turn into offers any day now.

Both groups, whether they head back to campus at Darden, Tuck, Ross, Marshall or Haas, know they need to allot the right amounts of time to make career and employment decisions.  Corporate-finance case work is important, and so are finance-club duties and public-policy presentations. But trying to decide where to go by next summer is crucial, too.

As we head toward the latter days of 2016, let's update where the state of opportunities among sectors of finance.  Let's peek and highlight where banks, funds and financial institutions have elected to expand (or not), grow (or not) or support (or not). 

Opportunities, in general, seem bright, if only because capital markets, while occasionally volatile and uncertain, are stable these days, notwithstanding ongoing uncertainty about where interest rates are headed.  Market experts know well that with a finger snap, markets can misbehave, volatility can surge and financial institutions will retreat and tighten up as quickly as winter will inevitably approach.

This follows reviews and assessments from late, 2015, and early, 2016.

Corporate treasury:  STABLE/POSITIVE

If companies are growing, expanding and investing in new businesses, then such growth or new assets must be funded. New cash generated from growing business operations must be managed or reinvested.  Hence, corporate-treasury and finance functions (at non-financial institutions) are active, tapping into resourceful ways to finance the business and reduce financing costs or assisting senior managers in deciding how best to deploy cash on hand.
 
Many big companies (the familiar Fortune 500 names, for example) continue to try eke out higher returns and bolster stock prices by taking advantage of cheap debt and continuing to repurchase stock.  That keeps corporate-finance types busy, too. 

Many other big companies choose to hoard millions/billions in cash, taking precious time to decide the right investment opportunity (if they choose not to buy back stock to boost market values).  That keeps them busy, too. Other finance managers are actively involved in hedging balance sheets and earnings against interest-rate spikes or unforeseen currency movement (similar to "Brexit" fluctuations, e.g.).

Investment banking: STABLE

Investment bankers are in satisfactory moods these days.  Deals are in the pipeline, mergers and acquisitions continue to bloom, and these might be good times to spark up the IPO engine.  Big companies continue to issue cheap debt and buy back stock--under the guidance of bankers.  Other companies are always on the prowl for the next right acquisition--also guided by bankers.  A technology bubble burst was projected by naysayers earlier this year, but it hasn't happened yet. Technology bankers, however, haven't been successful in convincing many familiar "unicorns" (Uber, AirBnB, e.g.) to go public.

With banking, a lot depends on the sector:  healthcare, consumer goods, real estate, energy, financial institutions, diversified, industrials, technology, media, pharmaceuticals, etc. For much of 2016, energy has been the untouchable (oil and gas exploration, most notably), but activity in many ways is still brisk in pharmaceuticals and some technology segments. 

Boutique firms continue to form, sprout, spread and make an impact. And companies, large and small, won't hesitate to be advised by small outfits still unpacking boxes in a new Park Avenue office.  

The big I-banking names, however, continue to push hard in banking, because investment-banking fees are more valuable than ever--fees from advising, underwriting, committing, processing, managing, arranging, and syndicating.  The big names (including Goldman, Morgan Stanley, Citi, Bank of America, and JPMorgan) haven't curtailed their investment-banking strategies.

Some foreign banks (Deutsche Bank, Credit Suisse, e.g.) are having second thoughts, as they seem to do every other year.  Other names (like Wells Fargo and other foreign-based banks) start, stop and resume in the sector, but still command respect in certain niches. Barclays this year, with many prominent hires in the senior ranks, appears to be regrouping to prepare to compete fiercely with the big names.
  
Private banking and private wealth management:  POSITIVE

For more than a decade, financial institutions have adored wealth management as a business line, partly because of the stable, predictable fee-income streams and partly because the related activities come with manageable risks and manageable balance-sheet requirements. This, along with other asset-management businesses, has been a targeted growth area.

Results have been satisfactory at most banks, and growth might not have soared as they had hoped. But it's still a preferred area, as banks prefer to grow in sectors where capital requirements aren't onerous and where balance-sheet impact is tolerable. 

Competition, however, is fierce--and not necessarily from other large institutions. Robo-advisers have surfaced and claim to provide the same banking, wealth management and asset management services for much lower costs. Financial institutions now fend them off or try to convince clients they aren't better off retreating toward algorithmic-driven online advisers. The robo-segment will likely seize younger clients and those just starting to build wealth. Banks must decide a strategy of how to react: Compete or form partnerships. 

Corporate banking:  STABLE/POSITIVE

Regulators like it when banks go back to basics--deposit-taking and loan-making. With more and more restrictions and with banks' hands tied in knots, corporate banking appears more attractive than banks' pre-crisis efforts to engage in the exotic in those go-go years.  Banks appreciate the corporate relationships and more stable net-interest-earned revenues that come with corporate banking.

Boosting this business helps boost revenues and potential transactions in investment banking. The two go hand in hand now.  In fact, many big banks combine the sectors. It's more common to see the sectors named "Corporate and Investment Banking."  The banking group that can issue the bonds on behalf of a big company will likely be the same group that can arrange a billion-dollar syndicated loan.

Corporate banking, nonetheless, comes with big risks.  Some of the biggest losses banks have absorbed over many decades have resulted from bad risk management or aggressive corporate lending in certain industries. 

Thus, while they beef  up corporate-banking units, they must concomitantly beef up risk management and suffer the headaches (and capital requirements) that come with big loans to big companies.

Sales and trading:  NEGATIVE

The outlook for those interested in working on trading desks is negative, but that doesn't imply there aren't opportunities to sell and trade securities, derivatives and currencies profitably. As long as there are thriving capital markets, there are opportunities to trade for gains.

But financial institutions continue to review and rationalize sales-and-trading businesses. Senior managers are still determining what their roles should be and what the right business model will be. Some institutions are deciding whether computers and machines can substitute for the roles of humans on trading desks consummating large equity or bond sales/trades with other institutions.

Regulation has restricted what they can do or how they can do it. Profit opportunities are fewer.  Dodd-Frank's Volcker Rule (which prohibits proprietary trading at banks) is in place. Some banks have scaled back; other big banks continue to hold big positions (to facilitate customer flow), while they struggle to ensure compliance with new rules.  Some determined banks have found ways to be profitable, but most banks aren't seeking to expand these areas aggressively. Hiring occurs, but not in the way it did before 2008.

Risk management:  POSITIVE

Risk management opportunities continue to grow, even if banks have not figured out the best ways to recruit talented MBA's in finance into these areas.  For the most part, risk management has become a complex responsibility. At major financial institutions, it is now sub-divided into several areas:  market risk, liquidity risk, credit risk, operations risk and now even such areas as reputation risk and enterprise risk.

Many financial institutions seek what they need in mid-level and senior roles by convincing bankers and traders to assume risk positions. Some banks have tried hiring junior risk managers and developing them through the years, as they take on more responsibility. 

Risk management, like it or now, now encompasses regulatory compliance. The new rules have become voluminous, arcane and difficult and are often tied to how a financial institution quantifies and manages risks.  The best risk managers are now expected to understand new regulation, as well as understand clients, borrowers, counterparties, markets, financial modeling and analysis, and (more and more) advanced levels of statistics.

Banks have always encountered the fact that few colleges and business schools offer courses in financial risk management, if only to give students an idea of what risk management is all about. So when they recruit, they must convince prospects of the importance of such roles (and of course pay them as if they would pay bankers and traders).

Yet year after year, most institutions are desperate to find the right people to fill critical roles.

Asset management:  POSITIVE

Like private wealth management, asset management is a targeted growth area. Financial institutions (including banks and some insurance companies) scramble to accumulate investors' assets (ranging from individuals to institutions and mutual funds) and charge fees for holding and investing them, based on criteria.

The arena is crowded and now includes the aforementioned robo-advisers.  Because it's crowded, institutions must offer competitive pricing or offer a bundle of services under a price sheet. Robo-advisers claim they can provide much of the service bundle at much lower cost.

Like private wealth management, banks are attracted to asset management's minimal regulation:  Not much capital is required to appease the Federal Reserve when managing a billion dollars. The fees and a tolerable amount of regulation keep some banks pushing harder to expand and grow, although performance has reached a plateau in recent years.

Investment research:  STABLE

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

After years of trying to fix the business model of equity and bond research (after scandals during the dot-com-bubble era), the industry seems to have settled into something that works for many institutions.  Debt investors still examine credit ratings from ratings agencies. Equity investors and traders still seek guidance on company stocks and embrace the research and valuations researchers offer. Those researchers are still paid from the commissions their firms generate from equity-trading activity. And many investment managers will still do some credit and equity research themselves.

While an MBA in finance is an advantage, many institutions like what the CFA adds.

Venture capital:  POSITIVE

At the start of 2016, many suspected we might be on the brink of a technology bubble, a bubble that could burst the apparently inflated stock values of new companies and burst the enthusiasm of venture-capital companies supporting any start-up that has a heart beat.

But the bubble hasn't burst yet. The industry proceeds, however, with both caution and optimism. 

For opportunities for MBA's, the challenge is always the same even when the going is good:  Finding a way to get through the front doors of a closed-off, clubby world.

Private equity:  STABLE/POSITIVE

Private equity differs from venture capital in one important way. Both industry segments invest in and manage operations in private companies. Venture-capital firms focus on the unknown--new company, new managers, a vision, new products or services, almost no track record.  Private-equity firms focus on the known--often old companies, experienced managers, old products and services, a withering brand, long track records, and often a worn-out vision. 

Venture-capital firms determine a business model and find new ways to generate revenues and cash flow.  Private-equity firms often invest in companies with sound revenue streams, but focus on streamlining operations, reducing costs efficiently, and exploring new markets or channels.  At some point, when timing is right and after companies are spruced up, they consider selling those old companies back into the public markets.

There is an argument that private-equity firms thrive when equity markets are down, the better for them to discover and buy under-valued companies. There is another argument that private-equity firms thrive when equity markets soar, the better for them to consider selling refurbished companies back to the public market.

When business is brisk and opportunities exist, private-equity firms are always stalking banks and business schools to find the hordes who will do the complex finance models to determine when to buy and when to sell.

Hedge funds: NEGATIVE

Might these be the worst of times for hedge funds?

Hedge funds have experienced horrible returns and times the past two years. Many have shut down, closed shop, and returned money to disappointed investors. Some updated statistics show as much as 15-20% in redemptions, partly reflecting dismal performance when other market indicators are doing well, partly reflecting frustrations at investors paying fund managers the proverbial 2-and-20 fees (2% asset fees and 20% of fund profits) for almost embarrassing outcomes.

These would also include activist-shareholder funds, funds that do less frequent trading and are more involved in building equity stakes in notable companies to drive a new financial strategy (merge, acquire, expand, change business model, pay more in dividends, reward shareholders better, reconstruct board membership, conduct stock buy-back campaigns, etc.).  Some have had satisfactory results; some, too, have had weak returns. Others have just merely withdrawn their relentless efforts to force the new strategy.

Many hedge funds, therefore, aren't opening their doors widely to new candidates fresh from business school.

Compliance and regulation:  POSITIVE

Dodd-Frank has been in force for more than a half-decade. Financial institutions continue to do all they can to understand, interpret, analyze and comply with the thousands of pages (yes, thousands) of new rules.  Many rules under Dodd-Frank and Basel III are still in formation, still in draft form.  So banks must be ready to comply with regulation that has still not been written in entirety.  Or they must work harder to improve the metrics that show they have excess levels of whatever is required--capital, liquidity, stable funding, cash reserves, etc.  They must survive complex annual stress tests and prove their demise (even if it won't happen soon) won't damage the financial system.

Compliance and regulation are now beastly tasks that require attention, investments (for systems), and expertise (in the rules, in statistical analysis, or in organization structures).  And they must be explained to bankers and traders in a way to help them understand the impact on their businesses and their dwindling returns on capital.

They must prove (based on new quantitative tests of their roles in the financial system) they aren't "too big to fail" or suffer the onerous regulatory requirements that come with being global, colossal institutions.

Many large institutions will admit they don't have sufficient enough people who willingly and eagerly want to be involved in ongoing compliance. Those doors are as wide open as any door in a bank is these days.

Financial technology:  POSITIVE

If there's a hot sector for the times, it's financial technology--or fin-tech. The time is ripe where the worlds of technology, new ventures, and financial services are locking hands to create something new, or at least "disrupt" the traditional ways of providing financial services, advice and funding. 

Fin-tech presents innumerable opportunities. While the trends are upward and show promise, the sector is too broad and too unpredictable to pinpoint how young professionals can best take advantage of opportunities.  Fin-tech includes electronic payments, small-business lending and robo-advising in wealth management, but it may also include mergers and acquisition, investment research, and financial reporting.

Companies have formed everywhere, not just in Silicon Valley or on Wall Street.  Companies have been started by computer experts and former bankers and traders.

A few themes are emerging:  Big institutions have taken notice and are responding with their own strategies (and investments or partnerships). As with most new ventures, not all fin-tech businesses and models will survive.  Many won't be able to expand in scale.  Others will make mistakes not in technology, but market strategy or risk management.  Most will require time to perfect a business model (how to provide financial services, funding, or advice profitably).

But all that won't diminish opportunity in the early days of what might be called a financial revolution of sorts.

Tracy Williams

See also:


Tuesday, August 2, 2016

Yahoo Tosses in the Towel

It's been about two years since Yahoo board members and CEO Marissa Mayer huddled among themselves time and again to decide what to do with the company. Few companies, including many of its competitors all along the Silicon Valley corridor, have endured as many volatile ups and downs in its two-decade history. Yahoo's earnings, revenues and its strategic direction have bounced around like balls in an aimless path.

Mayer was hired from Google to become the CEO who would devise the strategic, pick the people, make the acquisitions, and develop the products that would thrust the company into the elites among technology companies that depend on digital advertising.  Mayer was supposed to push Yahoo to seize once again its top perch among Internet "portal" companies.
Somewhere along the way, Yahoo stepped into a blockbuster of good fortune from having invested in Alibaba, the big Chinese company that combines the best of PayPal, eBay and Amazon and issued its equity over here.  Yet Yahoo stumbled a few times. It picked itself up, stumbled again, and reached a point of not being sure what that best next step should be--except to separate the company into its Alibaba parts and its website parts and let another big company, with resources enough to take risks with it, decide what that next strategy should be.

Verizon has decided to purchase the non-Alibaba parts of Yahoo for a mere $4.8 billion. (Yahoo could have sold itself to Microsoft years ago for nearly 10-times that amount.) Verizon decided to find a partner for AOL, which Verizon acquired within the past year.  Put AOL and Yahoo together, take advantage of their millions of subscribers and tens of millions of clicks, coordinate the content they both pour through websites, reduce duplicate expenses, and make gobs of money from digital advertising.

Yahoo was not on the verge of bankruptcy or insolvency. Revenues have been flat, and earnings exist, although losses are occasional.  Mayer staged many acquisitions (Tumblr, for example), but none could help boost revenues much beyond $4 billion/year. Alibaba brought a fortune--tens of billions in unusual earnings and needed cash reserves.  It also brought bothersome levels of tax headaches.  Yahoo had modest levels of debt (to help its acquisition binge and to develop content), but dwindling cash flow meant it had little room to borrow more.

Markets, disappointed and signaling frustration in slipping stock prices, pushed Meyer and the Yahoo board toward a final move. The market, in fact, had valued Yahoo, minus its Alibaba asset, at negative values.

Mayer's rise to a top post Silicon Valley was meteoric, rapid, and not unexpected (from those who had knew her work at Google).  As a woman CEO not yet 45, she was watched, observed, and perhaps over-analyzed. Every quarterly earnings announcement (or quarterly misstep) and every large-scale, over-priced acquisition were headlined, heralded, or overly analyzed. When the desired revenue growth never appeared, her strategies were second-guessed. It's unfortunate the Verizon acquisition reduces women CEO's in Silicon Valley by one--a worrisome number in a corporate sector where women CEO's can tallied by less than two hands.

No matter what Mayer attempted, the company couldn't rocket itself to where it wanted to be, even if it head years of a head start before the Googles and Facebooks were household names.  Sales were stagnant at below $5 billion. No matter what it acquired, developed, and created, operating revenues (excluding anything related to Alibaba) never topped that $5 billion lid. Earnings and cash flow were erratic (They were losses and deficits last year).  The company spent and spent (development, administrative, and traffic-acquisition expenses), but revenue growth didn't accompany the spending sprees. Debt levels were moderate (less than $2 billion), but would have become a difficult burden if losses continued.

In the eyes of a potential acquirer, Yahoo offered some form of equity value, measured not by growing flows of operating cash, but from the metrics that technology companies with digital-advertising business crave:  subscribers, views, and clicks from a predictable core.

Just as it reasoned with AOL, Verizon likely rationalized that $4 billion and change is not an outrageous price to pay for a company that attracts enough eyeballs daily to generate a base level of $4 billion in revenues. It also likely concluded it could erase much of the billions in Yahoo expenses within a year and eliminate its debt without a flinch. Verizon may quickly turn something that is lackluster breakeven operation into something cash-flow positive. 

The challenges, however, will be (a) how to increase revenues to justify the acquisition, (b) how to mesh Yahoo's operation with that of AOL, which had its own set of financial woes, and (c) how to respond to regulators who might all of a sudden express concern about Verizon amassing enormous amounts of customer information from its combined Verizon-AOL-Yahoo data bases in its efforts to sell the most-targeted form of digital ads.

Tracy Williams

See also: 

CFN:  Verion Acquires Vodafone, 2013
CFN: Why is Dell Going Private? 2013
CFN:  Verizon Rescues AOL, 2015
CFN:  Will Yahoo Ever Rebound? 2015
CFN:  Who Calls the Shots in Silicon Valley? 2016

Friday, July 15, 2016

Who Attracts the Best Talent?

Financial institutions are scarce on LinkedIn's new talent-attraction list, but Goldman Sachs slips in at no. 27 on its U.S. list
Which companies around the globe attract the best and the brightest?  Where do the most talented want to work?  What are the coveted places for those who are select their employers, before employers select them?

LinkedIn used its stockpile of data from over 400 million users and took a stab at creating a list. It used data analytics and data science. It tapped intuition and made assumptions (many of them). Here's one:  Companies that attract the best talent are companies that get the most job requests in LinkedIn or garner the most attention in LinkedIn updates or communications. 

In early July, it presented the results of the project, its first such effort. Its data and models produced a ranking of top companies or financial institutions it contends are successful in attracting the best talent. Some of the familiar names (Apple, Google, Amazon, Facebook, e.g.) led the top of the list.  Financial institutions were few in number, and there might be reasons.

Be mindful that a broad survey or analysis of the kind LinkedIn led could lead to possible false impressions or misrepresentations. (What is the real definition of "talent"? Aren't many talented people recruited without their making inquiries in LinkedIn?)

Yet the final list included names we would expect in 2016, names of companies that pay well, that have ambitious plans to grow and make a societal difference, that offer pleasing perks, and that present interesting problems for smart people to find solutions in their first few days on the new job.

Up front, LinkedIn needed to define top talent and best talent.  It then assembled a set of assumptions to define what it means to attract talent.   Are the companies at the top of its list attracting employees who sported the highest GPA's, who performed beyond expectations during internships, who have in-depth levels of skills in technical areas, and who have demonstrated qualitative skills (drive, energy, work ethic, leadership, etc.) in previous work assignments? Are they MBA's from top business schools, those who lead class discussions in investment analysis or chair the finance club?  Are they mostly computer science whizzes from elite engineering schools?

There's a global list and a U.S. list. Apple, Salesforce, Facebook, Google, Amazon, Microsoft, Uber, Unilever, and Coca-Cola and Oracle appear on both lists.  In the U.S. compilation, you see Uber, Stryker, Netflix, Under Armour and Tesla. Are we not surprised? Don't talented people want to work at companies making a mark or sitting on the cusp of extraordinary growth? (Many of the companies on the global list are Consortium sponsors.)  Few financial institutions appear on the list, and we might be able to rationalize why.

LinkedIn explains the criteria clearly, even if many will argue about the flaws (as there are in just about all lists published and promoted widely).  LinkedIn has access to voluminous data--from companies, recruiters, employees, industry leaders, potential hires, students, etc.  It culled the data, deciphered trends, clicks and activity from its users, put together a set of rules and used results to present a list.

Its premise for talent-attraction is based on (a) reach and clicks (how well known the company and its brand are) (b) engagement and interaction (how often LinkedIn users connect with the company in some form), (c) job interest (how often LinkedIn users explore or seek employment at the company), and (d) staying power (how long do employees remain at the company).

Some filtering of data must have been necessary, because those who lack required skills or talent are also clicking and exploring and pursuing job opportunities at many of the same companies.  And often the best are discovered and tapped in other ways or through other channels.  They need not spend much time completing job applications discovered from an exploratory moment in LinkedIn. But LinkedIn asserts, if thousands are exploring employment opportunities at Google, then Google's chances of hiring the best increase.

Now what about financial institutions?  Why don't they crowd or dominate the list in the way they might have in the 1990's or mid-2000's, when art-history and music majors expressed interest in gaining a spot in an investment-banking class at, say, Credit Suisse or Lehman Brothers?

Why are Goldman Sachs (no. 27 on the U.S. list ) and Morgan Stanley (no. 40 on the U.S. list ) the only two large financial institutions on the list?  Do financial-service companies (banks, funds, institutions, insurance companies, and asset managers) not attract top talent annually from undergraduate and business schools or from other industries?  Are this generation's brightest choosing careers mostly in technology, new ventures or less-bureaucratic and less-hierarchal organizations?  And are work-life-balance issues factors?

What implications can we make from LinkedIn's efforts to highlight the paths that talented people take in pursuing opportunities or employment?

1) Investment banking might still be a lure.

Goldman and Morgan appear on the list, partly because of the continuing attraction of investment banking.  They are no longer "pure investment banks." (They are officially bank holding companies.) But in some circles, they are considered major investment banks before they are labeled commercial banks.

Wells Fargo, Citi, or JPMorgan Chase with similar brands and, in some cases, strong financial results might easily have supplanted Goldman and Morgan.  With Goldman and Morgan Stanley, there is the apparent direct tie (and heritage) to investment banking, where compensation packages are still lucrative and deals, transactions and trading still cause surges of adrenaline.

2)  The steady transformation of financial services (including the impact of regulation) can be daunting.

With new regulation keeping banks strapped in many ways, talented people might be restricted from being creative, expanding on bold ideas, and coming up with new products.  Regulated financial institutions have restrained balance sheets and thousands of pages of new rules to adhere to. 

3)  The survey, with some flaws, could still have omitted some institutions or miscalculated "talent attraction."

Let's consider that banks such as Wells Fargo, hedge funds such as Bridgewater and Citadel and private equity firms such as KKR, Carlyle and Blackstone indeed attract the financially talented.  How do they not appear on the lists? In some cases, they aren't household brands (one of the criteria). In other ways, they identify talent in stealth ways and hire in limited numbers.  And they may have a limited presence in LinkedIn.

4) The fintech revolution might, in fact, even its early unproven stages, be enticing talent that might otherwise have gone to work at Charles Schwab or Bank of America.

New companies that fit the mold of "fintech" didn't ease onto the lists. A few notable ones (Square) did. Others might show up on lists in the years to come. SoFi is a prominent example. But the wave has come and is far from peaking. They have affected talent retention at banks, which are suffering anxiety trying to determine a counter-strategy:  Beat them or join them or invest in them?

An MBA graduate (of a Consortium school?) with a concentration in finance and an extensive background in computer science is just as likely to want to explore working for a transformative, business-model-breaking fintech company as she would want to start out as an associate in project finance at Deustche Bank.

So the list is out, slowly slipping onto the digital screens of young professionals (and those more experienced).  It will likely be an annual LinkedIn roll-out, and no doubt it'll polish and update the criteria next year.

One special note:  Microsoft, which just announced its planned acquisition of LinkedIn, appears on the list.  LinkedIn list organizers unabashedly said they will keep the new parent on the list this year. For now, at least.

Tracy Williams

CFN:  The Fintech Revolution, 2016
CFN:  Financial Technology and Opportunities, 2014
CFN:  Bitcoins:  Embrace or Beware, 2014
CFN:  High-Frequency Trading:  What's Next? 2014
CFN:  Fortune's Best Places to Work, 2016