Monday, June 19, 2017

Amazon's Latest Venture: Whole Foods

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Now what about Whole Foods?

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

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

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

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

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

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

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

Tracy Williams

See also:

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

Friday, June 16, 2017

Apple: Being Green

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tracy Williams

See also:

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

Wednesday, May 17, 2017

Second-guessing Snap

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

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

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

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

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

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

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

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

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

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

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

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

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

Tracy Williams

See also:

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

Friday, April 14, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

Uh-oh.

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

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

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

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

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

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

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

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

Banks might respond in many ways:

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

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

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

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

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

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

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

Tracy Williams

See also:

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



Monday, March 6, 2017

Snap Emerges from the IPO Gates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Is that possible?

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

Tracy Williams

See also:

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

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