Getting Comfortable With Share Buy-Backs

Large companies like Meta attempt to please shareholders with substantial dividend payouts and share buy-backs

What is this about corporate stock buy-backs? Why do they occur? Why do some of the loudest shareholders push for both dividends and occasional repurchases of shares? Some of the best known global companies and even some not as known occasionally plan buy-backs. Some buy back shares routinely. 

They go into the marketplace and use excess cash reserves to buy back their own shares. They do so at discretion. The cash could have been used to invest in new businesses or to pay down debt. 

Sometimes they do it if managers perceive their share values are under-valued. Buying back shares will likely provide a short-term upturn in the stock price (as supply of shares declines). The evidence shows the occasional "boost" to share value once a repurchase is announced. Companies that pay consistent and growing dividends get a boost in share value. Shareholders see greater value of cash in their hands of shareholders than in cash sitting idle of a balance sheet.

Thriving, well-established companies (even many banks and large financial institutions) report growing earnings and operational cash flows. As cash builds on the balance sheet, they face potential pressure from active shareholders, who inquire: "At what point do you give that cash to us?" 

Old corporate finance texts contend shareholders have an expected return on investment (cost of equity).

If the company has excess cash, instead of allowing the company to maintain it in reserves or even hold it in a foreign subsidiary (often the case), shareholders argue if the company can't or doesn't reinvest at a required rate of return, then the cash should be returned to shareholders. They, in turn, can find other channels or opportunities to invest at the expected return. 

But insteady of sending out cash already on the balance sheet, what happens if management elects to go out into debt markets and borrow substantial amounts and use that cash to conduct buy-backs (or pay increasing amounts of dividends)? How does management justify leverage for that purpose? Why would shareholders encourage more debt for this specific purpose?

Note the substantial buy-backs some prominent companies engaged in over the past several years:  Merck bought back over $17 billion in shares from 2017-19, some of it financed by borrowing in low-rate markets during the period. 

PepsiCo repurchased $18 billion in shares from 2017-20, similarly funded in part by low-rate debt. Coca-Cola, PepsiCo's long-time competition, bought backs shares, also at substantial levels. As rates started to rise in 2022, the same companies reduced their buy-back programs to avoid using more expensive debt to fund this activity.

 

With plausible scenarios of rates falling in late 2024, buy-back popularity has resumed. In 2024, Meta announced a $50 billion buy-back and new plans to pay dividends for the first time. In little time, its stock price leaped 14% just from the announcement.

Such buy-backs for these and other large familiar companies, in many cases, helped to increase share values for mature companies with large slices of their product markets, but low growth in revenues and earnings. Higher leverage and fewer shares outstanding kept stock prices from plummeting when there are few signs of growth. The stock price holds tight even when expectations for revenue growth fall below 5% per annum. 

When prospects for growth dim and threaten to undermine the intrinsic value of the shares traded, a buy-back program might be able to keep share prices from sliding.

Merck and PepsiCo have long been regarded as mature, low-growth companies. Perhaps Meta has joined the mature-company club that includes older companies with their best days of soaring revenue growth behind them. Meta retains market share, continues to be predictably profitable, but growth rates are not what they had been 15 years ago, and shareholders covet the cash resting on the balance sheet. 

If a company's performance, operating cash flow, and prospects for growth are excellent, steady and vivid, then the increased leverage might be rationalized comfortably. What, however, if performance is erratic or the company is headed into risky, recessionary scenarios? How would excess leverage justified? 

(In the world of private companies, management-owners might consider "dividend recaps," or dividend recapitalizations, where the company borrows in debt markets and uses the proceeds not for growth and expansion, but to reward private owners with dividends that may not have been paid before and may not be justifiable from earnings. Private owners (sometimes founders) argue this is a way to monetize the efforts they expended to found a company or manage an operation.)

When it comes to shareholder expectations, banks address the same. When banks have exceptional earnings and start to accumulate excess capital (excess beyond what regulators require), they, too, seek to give it back: increase dividends or conduct buy-backs. 

For banks, the story takes a different turn during periods of uncertainty or distress. Regulators around the globe reserve the right to intervene and discourage banks from conducting buy-backs. During the financial crisis and during the early months of the pandemic, 2020, bank supervisors (including the Federal Reserve) swiftly adopted rules (at least for a defined period) to suspend or cancel buy-back programs. Bank regulators, of course, focus on financial institutions having more than adequate amounts of equity to absorb losses during stress and avert the likelihood of deposit run-offs. 

Lenders and debt investors who fund these corporate rewards or maneuvers must get comfortable with such use of cash. Investment-grade companies have power to convince debt markets that increased leverage won't harm performance (and undermine the ability of the company to meet debt requirements). Yet leverage will increase. The Debt/EBITDA ratio might rise--almost, in certain cases, to levels that suggest greater risks or non-investment-grade considerations. 

Some may contend buy-back programs and using leverage to boost returns and share price are forms of "financial engineering."  Unless the company is a regulated financial institution (including also broker/dealers and insurance companies), markets and investors become the factions that "regulate" whether such activities harm creditworthiness or financial condition.  

If the company is a public company, could it also be considering doing the buy-back to take it private? Or does management or a private fund want to gain complete control of the enterprise (something that happened at Dell Computer in 2013).

In some cases, companies conduct buy-backs if they don't pay dividends or if they prefer shareholders not get accustomed to regular dividend payouts. They still want to be responsive to shareholders who request immmediate rewards. The technology firm Synopsys in Silicon Valley has done just that in recent years.

Its performance has been excellent and consistent (stable returns on capital, steady revenue growth leading to steady earnings increases), but the company has not paid dividends. Earnings pile up in cash reserves, which help fund many small acquisitions that complement current business strategy.  

Synopsys revenues will likely top $6 billion this year, and earnings have begun to exceed $1 billion annually. Its shareholders have pushed for "rewards" in some way (to help boost share values), and the company has obliged by paying out over $2.5 billion for share buy-backs the past three years. 

Tracy Williams

See also

Financial Analysis: Back of the Envelope, 2020

When Dividend Payouts Cease, 2021

A Spike in Bank Stocks? 2017

Musk's New Venture: Twitter-Tesla Tango, 2022

Apple: Being Green, 2017

Big Banks' Big Year, 2019

Basel "Endgame": Agonizing, Inevitable

PNC Financial, headquartered in Pittsburgh, must brace itself for Basel "Endgame" and more restrictive regulatory requirements

Bank regulation (for big banks, small banks, community banks, and those banks "too big to fail) is always an ongoing thorn for those who lead banks. Most understand why regulation exists (e.g., protect consumer deposits, ensure adequate liquidity, corral banks' appetite for taking too much risk in lending and trading, and put handcuffs on banks that might jeopardize the existence of a financial system). 

Yet the "thorn" for bank leaders (CEOs, particularly, who must (a) understand the arcane rules and (b) ensure their banks remain comfortably in compliance) is that the rules change frequently. Most of the time, they get more complex and onerous. Some senior bankers complain that some rules are irrelevant, don't properly address the risks they aim for, or duplicate other rules. They express their concerns in annual-report presentations, in occasional comments to the media, and to shareholders in quarterly earnings discussions.

Now comes Basel "Endgame," a U.S. proposal of rules, led by U.S. bank regulators, that will increase requirements and make them more complex for banks with assets exceeding $100 billion. Until now, U.S. bank regulators imposed complicated rules, but conveniently simplified them for smaller banks--for banks with assets less than $700 billion and especially for community banks (less than $1 billion in assets). 

Basel "Endgame" is the U.S. version of a larger initiative globally. Basel, Switzerland, is the home of the global committee that provides guidance on banking regulation around the world. In the 1970s, sovereign leaders felt it necessary for banks across the world to be governed by a consistent set of rules. Over the decades, there had been Basel I, II, and III (for a moment, there was Basel 2.5 in the wake of the financial crisis). For the past few years, there was constant banter about when Basel IV would follow. 

Whenever there is a new banking crisis, one like the crisis we observed in liquidity and funding risks a year ago (the one that led to the disappearance of Silicon Valley and Credit Suisse), you can bet regulators huddle to figure what new regulation is necessary to prevent the next banking-system scare. After a series of bank failures, regulators, politicians and and business-school professors follow with "lessons learned." Lessons learned sometimes are reframed into another round of new rules for financial institutions.

In this case of 2023, the rapid disappearance of reputable banks (because of liquidity issues and deposit run-offs) and the concerns other banks would follow a similar route to insolvency spurred bank supervisors to get going with another round of restrictive regulatory requirements. Last year's first-quarter crisis (First Republic and Signature banks disappeared, too) led to a frightening period about confidence in bank deposits and a market guessing game of what other smaller banks were subject to the same liquidity pressures. 

Basel "Endgame" (or Basel "Finalization," which is what it is called in Switzerland) doesn't merely address the risks of lack of liquidity and raging deposit run-offs. It's across the board. 

In its basic form, bank regulation is generally categorized by risk forms and by whether the bank is properly managing each of those risk forms:  credit risk, market risk, operational risk, and liquidity risk. The first three conventionally require the bank to maintain a minimum amount of what is called loss-absorption capital. (Many investors and risk analysts are familiar with the tiers of capital banks have to comply with: Tier 1, Tier 2, T-LAC, etc.)

Regulators insist shareholders and subordinated-debt investors absorb bank losses before deposits are at risk. That makes sense. They are enjoy the upside of returns when the bank does well. They should suffer first when the bank stumbles through losses. 

Liquidity regulation generally requires the bank to have access to cash reserves to meet obligations or deposit withdrawals on any day. 

The thousands of pages of Basel III and, in the U.S., Dodd-Frank specify what is required and how banks should compute those requirements. 

So while the liquidity-risk upheavals in 2023 spurred bank supervisors to review requirements to ensure those events won't recur anytime soon, it becomes an opportunity to review just about everything. 

Basel "Endgame" toughens requirements in all risk forms. More important, where before, the most strenuous regulation applied to the largest U.S. banks (with assets above $700 billion and for those considered "too big to fail" (Globally Significantly Important Banks, GSIBs), "Endgame" requirements encompass more banks (banks with assets above $100 billion). 

"Endgame" is currently going through a request-for-comments period, and banks haven't hesitated to express points of view. (The rules would not be fully implemented for another four years.) Many such viewpoints are predictable and common: "Bank regulation discourages us from investing and supporting the community." "Bank regulation is too complex and difficult to compute." "Bank regulation gives non-banks too many advantages in financial markets." "Bank regulation requires unusual costs and investments to comply." 

Basel "Finalization" (from the BIS-Switzerland) had hoped to simplify the calculation of some requirements (credit-risk capital and operational-risk capital, e.g.), while still toughening and increasing capital requirements for similar levels of exposure or activity. 

(One example is the calculation of a capital charge for "CVA" (Credit Valuation Adjustment), the requirement that banks account for the expected loss from credit risks with their derivatives-trading counterparties. CVA computing may hardly be relevant to small- and medium-size banks, but it would be an obsession at Morgan Stanley and Goldman Sachs, because of the gigantic size of their derivatives trading books. If Morgan Stanley does interest-rate swaps (derivative) with JPMorgan, it has capital requirements to protect itself if JPMorgan deteriorates or if it fails. Today, the amounts computed cannot be done on the back of a napkin.)

Around the U.S. and across the globe over the past two years, with interest rates surging, bank investment portfolios, filled with fixed-income bonds of all kinds, suffered substantial market losses. All banks of all sizes, anywhere, have investment portfolios. They take deposits and invest excess cash into bonds, often government bonds or government-backed bonds. Bond values plummeted sharply in 2022-23, and bank losses in their portfolios have exceeded record levels. The question is how does the bank report the losses--at all times or only when they sell the bonds. That depends. 

In the U.S., unless the bank had assets above $700 billion, the unrealized losses in those portfolios (applicable to bonds not yet sold) were are not subtracted from bank equity capital. 

Basel "Endgame" wants to put an end to that. The losses on investment portfolios (those classified "available for sale") will reduce capital and make it harder for banks to show they have excess capital, if the bank has assets above $100 billion. 

Basel "Endgame," while at it, will force banks not subject to such rules to compute capital requirements for operational risks (the risks of loss from technology, systems, processes, misconduct and cybersecurity) and to include off-balance-sheet risks in maximum-leverage requirements ("supplementary leverage" ratios). 

Basel III (the non-U.S. version) always stipulated banks should have capital requirements for operational risks. In the U.S., to date, such a requirement is only applicable to the largest banks. With thousands of branches and assets exceeding $1 trillion and with activities in just about all imaginable types of bank activity, they have obvious operational risks (the risks of power outages, employee misconduct, systems failure, cybersecurity threats, etc.). 

It's conceivable going forward a bank with $98 billion in assets might decide to refrain from growth, if only not to be subject to the more restrictive regulatory rules. Many familiar U.S. banks toe the line with assets near $100 billion. A bank considering an acquisition or expansion or planning for loan and deposit growth must now assess the impact of new rules on capital requirements and ongoing capital compliance. (For example, Alabama-based bank Regions Financial has assets totaling about $160 billion. Rules not applicable before would apply going forward.)

In all, some industry analysts and bankers have estimated under the "Endgame" rules, bank capital requirements will increase by more than 15%. 

Implementing new rules is not as easy as it appears, especially for large banks. Just tweak the formulae and models that determine what's required, some legislators and supervisors might say. Bankers know to change rules is also to change a business and risk-management mindset--which might be the intent of bank supervisors. 

The same banks typically address required capital on an ongoing basis at all levels, for all risks, and for all entities. It's a necessary and routine part of managing the bank, managing the balance sheet, reviewing risks and transactions, reviewing new products and business activity. Bank strategic decisions are made following careful analysis of "allocated capital" and "returns on the same allocated capital." All new deals, new loan portfolios, new products, new investments and new trades are all subject to a capital-allocation review. A loan that could be rationalized before "Endgame," because capital required is less and return on capital is more, may not make sense going forward. A derivatives trade that was economically feasible before might be deemed unprofitable going forward. 

In some ways, Basel "Endgame" drafters pat themselves on the back for trying to simplify some rules (like capital required for the risks operational losses), even while imposing slightly requirements for similar levels of risk. 

The debates, disagreements and pleas to reduce the regulatory burden have begun. They have been and will be well-defined and passionately explained. Yet in the end, what we've observed the past 15 years or so, bank supervisors usually get most of what they unveil in a new round of rule-making. 

Tracy Williams

See also:

JPMorgan Acquires a Failing First Republic, 2023

Silicon Valley's Liquidity and Deposit-Runoff Nightmare, 2023

Banks Subject to the Federal Reserve Stress Test, 2020

Dodd-Frank Dismantled? 2017

Recovery and Resolution: "Living Wills," 2016

When Does a Bank Have Enough Capital? 2015

And Then First Republic....

JPMorgan Chase will now have the privilege of serving First Republic's private-banking client base

Just a few weeks ago, market watchers, regulators and risk managers were paranoid about the state of the banking system. Topics related to liquidity risk, deposit run-offs and stable funding roamed financial headlines. We wondered whether there was contagion in financial markets and in the financial system. If there is a stress in one part of the arena, does it imply or lead to stress everywhere?

In just a span of a few weeks, names like Credit Suisse and Silicon Valley Bank disappeared forever. Credit Suisse had been the formidable international bank that absorbed the once-formidable, prestigious investment bank First Boston. Silicon Valley had been the regional bank that found a niche on the West Coast and had begun sprout and establish an untouchable perch among venture capitalists and tech-firm CFOs.

And then there was First Republic. 

Some of the first-half, 2023, panic about the health of bank balance sheets has dimmed. Markets and degrees of mania pummel long-standing financial institutions. And then markets move on.

The problem with contagion is that customer mania leads to run-offs, which leads markets to panic in their determination to figure out who's next: What other institutions are suffering from the same risks? Mania transfers to the other banks. Markets react first and ponder the ramifications or root causes later. 

JPMorgan in early May pounced on the opportunity to take over First Republic in the same way it seized Bear Stearns in 2008. In the midst of that crisis back then, the bank also acquired a failing Washington Mutual. It absorbed both large financial institutions and would later admit there were reams of lessons it learned from such swift takeovers, risks they learned about after acquisitions had been consummated. 

In 2023, its acquisition was similarly swift, but it claims its due diligence was much more thorough. In one public document, it says 800 personnel were devoted to examining the bank's loan portfolios, balance sheet, client lists, etc., as they were determined to find hidden risks. But it helped overall that the FDIC agreed to guarantee 80% of the loan exposure. 

That makes due diligence that much easier. Such a government-related guarantee also reduces the capital required to support its bringing in a loan portfolio that exceeds $100 billion. 

It's fair to conclude JPMorgan cared little about the First Republic "brand" or expertise of its senior leaders. It wanted clients, accounts, deposits and branches in areas where it has near-invisible presence today--especially valuable private-banking clients and accounts. 

Nonetheless, First Republic's demise was a little bit trickier than Silicon Valley's. Both, of course, suffered because of rampant, rash run-offs from depositors. But the scares might have resulted from different causes. 

At Silicon Valley, a concentrated group of tech-company and venture-capital fund depositors were alarmed by the mounting losses in the bank's fixed-income investment portfolio. The losses, of course, were caused by steady increases in interest rates throughout 2022. When a handful of depositors requested withdrawals that led to realized losses in the portfolio, other depositors in a near panic sought to do the same. 

At First Republic, a large, but conventional bank focusing on private-wealth clients had amassed large portfolios in real-estate and mortgage loans--when interest rates were hovering near record lows. As interest rates crept upward, funding costs steadily increased. Therefore, net-interest spreads and net-interest earned declined. A new mortgage over 10 years ago might have earned 8%; by 2020-21, a new mortgage earned less than 3%. In 2022, deposits matured and had to be refinanced at higher rates. 

All banks faced the same net-interest-spread challenge in the same way all banks faced the decline in values in their respective fixed-income investment portfolios. But the impact of such risks proved more harmful to Silicon Value and First Republic than most other institutions--partly because of the concentration of customer base and the lack of diversity in business activities. First Republic shareholders were haunted by the steady deterioration in performance, leading depositors and fund-providers concerned about its solvency in the long term. 

Larger banks facing low net-interest spreads, during the years of 2015-2021, could offset such declines with ancillary businesses: investment banking, principal trading, cash-management services, and asset management. 

Larger banks, too, would likely have much better expertise and competence using complex derivatives to minimize the losses in their portfolios in fixed-income investments. Imagine almost any bank, besides the derivatives powerhouses of Goldman Sachs or JPMorgan Chase, considering such interest-rate derivatives as "swaptions" or "deferred interest-rate swaps." 

In the end, as soon as it could, JPMorgan Chase announced to valued First Republic private-banking clients that they had become JPMorgan clients, and the First Republic name and brand would immediately become sequestered into latest chapters of finance history books. 

Along with the names of Bear Stearns, Lehman, Drexel, and Washington Mutual. 

Tracy Williams

See also: 

The Sudden Falls of Silicon Valley Bank, 2023

Turmoil at Deutsche Bank, 2016

Wells Fargo's Woes, 2016

"Where Was the Risk Management Group?" 2012

MF Global's Sudden Demise, 2011

Knight Capital's Darkest Day, 2012

Financial Rumbles in Silicon Valley

Silicon Valley Bank is already relegated to the finance history books as a case of liquidity and funding mismanagement

Out of the blue in 2023 came the hearty rumbles from Silicon Valley. The shocks rippled around the globe and perhaps led to grave concern about the health of banks and the financial system from here to Switzerland. 

We all know and have heard about the demise of Silicon Valley Bank. We have, too, observed the countless critiques, observations and accounts of what happened. And we have watched the "blame game": What happened? Why? Was there incompetence among those responsible for managing liquidity risk and short-term funding at the bank?

There has arguably been as much analysis and second-guessing and finger-pointing in regards to Silicon Valley Bank as there were the number of people who were familiar with the bank before the FDIC stormed into Northern California. 

Silicon Valley Bank risk managers, in effect, under-estimated the risk of maintaining a concentrated deposit base (corporate deposits from technology companies and the venture capital funds and investors of many of those same companies). It mis-read the behavior of such depositors and overlooked the scenario that many of them would choose to withdraw funds en masse in a short time frame. It also mis-calculated the probability that it would need to sell off long-term U.S. Treasury (and Federal agency) bonds to meet such run-offs. 

It invested in such fixed-income bonds in the first place, because (most of the time) long-term bonds generate a higher yield (and higher earnings) than do shorter-term bonds. They intended to hold the bonds until maturity. The urgency to purchase such bonds was explained by a decade or so of low interest rates. Banks feel compelled to invest funds to achieve the highest returns on assets, whether the assets are consumer loans, corporate loans or investments in securities. 

With its surge in deposits (mostly from corporates, almost negligibly from consumers), it couldn't increase loans at the same pace. All that idle cash had to be invested somewhere. The bank was lured by the relatively higher yields on longer-term bonds. 

Students of fixed-income markets know--and Silicon Valley Bank risk managers probably knew--that when interest rates rise, as they have done so steadily the past year or so, the market value of such long-term fixed-rate bonds decline. 

The amount of the decline is a function of the maturity of the bonds. More specific, bond analysts, traders and investors compute the "(modified) duration" of such bonds, which more specifically suggest precisely how much the values of such bonds can decline if rates rise. 

"Modified duration" is not the same as the maturity of a bond, but it is a function of it. A 10-year U.S. Treasury bond paying a 2% coupon interest rate will have a duration of about 8.8. That implies that if interest rates rise by 100 basis points (1%), then the bond will lose about 8.8% in value.

Silicon Valley risk managers likely were aware of these basic bond principles. However, they naively presumed they would never be forced to sell long-term maturities suddenly and without warning.  They never addressed the scenario that it could lose over $2 billion and be forced to realize such losses after a sale of bonds.  

Banks around the world have experienced the same--banks from Citigroup and JPMorgan Chase to community banks in the neighborhood. Massive amounts of their similar investment portfolios in fixed-income securities have also been clobbered in value. 

Larger banks with more experience and competence in derivatives markets may have successfully hedged against interest-rate rises. (Some had reported booked "deferred interest-rate swaps" or "interest-rate swaptions," where losses in investment portfolios could be offset by marked-to-market gains in related derivatives activities.)

Regulators are aware of the same risks and examine banks closely to see if they understand the same risks and are managing them properly. For banks smaller than the top-tier systemically important banks (like the Goldmans and JPMorgans), losses in an investment portfolio are not deducted from capital until the bank has sold the investments or realized the losses in earnings. In some sense, the banks are granted earnings and capital relief under the premise that banks are investing idle funds and plan to hold them in these securities for long periods. They are not speculating and trading. The longer they hold the investments, the more likely they would recoup their unrealized losses. 

Unlike banks in the same regulatory segment (size) as Silicon Value Bank, the larger "globally systemically important banks" are required to deduct those losses in value in capital totals, especially the capital that counts as a regulatory cushion. And larger banks (those with assets that exceed $700 billion in assets) are subject to much greater scrutiny and liquidity requirements than those that fall below. Larger banks, too, as many have learned the past month, are subject to rigorous stress tests administered by the Federal Reserve. 

(The Federal Reserve's stress tests for 2023, naturally, will include a more rigorous test for deposit run-offs than it has done in previous years.)

Liquidity risk managers at Silicon Valley (or more formally, those who lead a bank's "Asset-Liability Committee") deserve the criticism they are receiving. But what happened at SVB could easily have happened at dozens (if not hundreds) of other banks in the U.S. SVB managers likely quantified the risks. Some report or some model would have showed that if interest rates rise by 100 basis points, then 10-year Government bonds would decline by 8% or more in market value. Regulators look for such models and report. 

SVB's big bet--the gamble that large corporate depositors would not likely withdraw funds all at once and they would not need to sell investments so quickly--went awry. 

The stories have also been well chronicled about the bank's concentration of deposits. Despite the legends of tales of retail depositors lining up to withdrawn funds from a bank rumored to be failing, most banks enjoy the "stickiness" of retail deposits. Large, familiar investment banks like Wells Fargo and Bank of America value small deposits when managing liquidity risks. (They may not like the operating costs and administrative attention sometimes required to maintain them.) History shows retail depositors are much less likely to run-off or run away if it appears a bank is in rapid decline. 

Of course, retail depositors are comforted by deposit insurance (the FDIC in the U.S., up to $250,000). And many consumers have administrative inertia when it comes to making large withdrawals and closing accounts--the time and expense involved in withdrawing all banking services from one bank and searching for another institution. 

Regulators examine historical run-offs based on past stress scenarios and observe empirically how classes of depositors behave during those periods. The Financial Crisis of 2008-09 is a best example. During this period when many were doubting the survival of the U.S. financial system, run-offs from retail depositors were insubstantial compared to massive run-offs from corporate and financial-institution depositors, many of which are have exposures far above FDIC guarantees. 

New Basel III and U.S. Dodd-Frank rules attempted to address these scenarios and penalize banks with substantial non-retail deposit bases. But those same rules were lightened years later and weren't applicable to Silicon Valley Bank.

Even with the awareness or knowledge that non-retail deposits would be unpredictable and whimsical, the bank doubled-down on its concentration of large deposits from the corporate motors that run Silicon Valley: technology companies, venture-capital firms, tech entrepreneurs and venture-capital partners. 

The story has been rehashed, re-told and reviewed non-stop about the "death spiral" that occurred when the bank began to sell investments it never intended and planned to sell at losses that began to approach billions. A "death spiral" starts when such an incestuous financial world (usually institutions that provide funding to other institutions) shares tales about the probable demise of a bank (or broker/dealer or hedge fund). That the demise may be, in fact, imminent is not as important as no lender wants to be caught with losses when there was an opportunity to get out. 

The sudden, unplanned run-offs force the bank to sell assets at losses to accommodate withdrawals. More withdrawals lead to further withdrawals and asset sales at a loss to meet payouts. 

For this bank, the circle of tech-company and venture-capital deposits pass the word among themselves until the bank ultimately becomes illiquid while sliding toward insolvency. The FDIC intervenes, the spiraling stops, but the game ends for the bank. 

The best-run banks would have prepared for such scenarios, even if the probability of occurrence is remote or near zero. Those banks have elaborate contingency plans and conduct stress scenarios that outline steps to take when depositors start to behave in such fashion. Such a contingency plan would ordinarily have been requested and reviewed by regulators. 

Silicon Valley likely had such a plan, if only because regulators would have requested to review it. The plan likely made pertinent assumptions about unexpected run-offs, but might have confidently assumed that the tech industry will embrace and support it during periods of stress. The bank might, too, have conducted stress tests covering the scenario that occurred (rising interest rates, devalued bonds, realized bond losses resulting from selling bonds it had not intended to do so). 

Could the bank have hedged against the losses that accumulated in the investment portfolio? It could have, but market risk managers there (if they had such) expected never to be forced to sell this portion of the securities portfolio. The investments were classified as "held to maturity" (by accounting and regulatory standards). If bonds issued by the U.S. Government or Federal agencies are indeed held to maturity, we ordinarily presume there is no market or credit risk. There would be no losses at maturity date. 

SVB could have still hedged against losses, if they were in what they thought was a worst-case scenario where they would be forced the sell the securities. Those hedges might include such products as interest-rate hedges (using such products as interest-rate swaps, Treasury futures, interest-rate swaptions, or deferred swaps). If properly constructed, such trades would offset the losses from being forced to sell long-term investments. 

Silicon Valley may have considered such hedges, but may have thought it didn't need to do so or didn't want to go through the administrative chores of managing the hedges or meeting ongoing requirements (fees, costs, margins, collateral, etc.) while maintaining hedges. 

When a U.S. bank and the FDIC intervenes, as it did with Silicon Valley, pundits and media observers exclaim how the Government has "bailed out" depositors or how taxpayers saved depositors and lenders to the bank. In practice, the FDIC is a Government organization and is an important regulator (standing alongside the OCC, the Federal Reserve and state examiners, but it effectively is an insurance company. Banks pay premiums for the privilege of having depositors "bailed out" when they falter. 

Long ago, the FDIC charged banks based on deposit levels. The percentage fee would change from year to year. The FDIC, at the beginning of the year, would announce whether fund resources were rising or sagging and levy fees based on such resources. In some years, if the FDIC felt it was fully funded, the fee would go to zero. Whatever the fee was, banks sometimes found ways to pass that cost to customers--even large corporates with deposits > $100,000 (at that time). They do that quietly and sometimes embed it in other fees. Some large depositors would try to negotiate that away.

Eventually the FDIC changed to a risk-based assessment. It charged the fee based on the riskiness of the assets of the bank; hence, all banks don't pay the same rate. 

Nonetheless, when the FDIC has determined that a bank is failing, it first tries to liquidate net assets of the bank before it taps into its own fund. Often it can do that successfully. Equity shareholders ("loss-absorption" capital is how regulators regard the capital base) get wiped out, but debt-holders and depositors have some meaningful recovery.

We all know now that in the Silicon Valley case, the FDIC intervened quickly in the way it does so conventionally. But after a few days, it decided to guarantee not only deposits below $250, 000, but deposits above that mark, as well. That might have sparked much of the banter of a Government bailout. 

It took this step to stabilize financial markets and the global financial system and minimize the contagion that seemed to spark run-offs at other similar banks around the country and the world during that week. 

After Silicon Valley imploded, markets panicked and wondered which bank could be next. Markets presume (sometimes rationally, often times irrationally) that factors that led to Silicon Valley's demise will also lead to failure elsewhere. In just days, there were rumblings that swamped First Republic Bank and Charles Schwab in the U.S. and Credit Suisse and Deutsche Bank abroad. 

Credit Suisse had already been labelled a troubled bank, not because of liquidity-risk mismanagement, but because of embarrassments and stumbles in its investment bank (including losses related to exposures to Archegos, the failed hedge fund). Yet asset losses of any kind can certainly lead to liquidity and funding challenges, as we observed with Silicon Valley Bank. 

UBS, days later, bought out Credit Suisse (at the urging of Swiss regulators) at a bargain-basement price, which reminded many of the swift sale of Bear Stearns to JPMorgan Chase in 2008 (at the urging of the U.S. Treasury). 

Over the past few weeks, regulators have mapped out and resolved what will happen at Silicon Valley. After its announcement to guarantee all deposits, the FDIC began the work-out of the bank's net assets. An East Coast financial institution agreed to purchase large amounts of the balance sheet, which includes much of the loan portfolio and depositors who remain. Shareholder value is erased, while the FDIC reduces the likelihood that it would need to tap its own funds to make depositors hold. Other assets are up for sale, too.

Before this type of resolution was unveiled, those with large, uninsured deposits had begun to speculate whether they could sell their stakes to distress investors eyeing a trading opportunity if there is still a possibility of recovery at a failed borrower. 

Hence, an existing lender or depositor with more than $250,000 of SVB exposure might be willing to sell that exposure to a third party at a discount. The buyer, of course, will assess how much recovery the FDIC could achieve as it goes through resolution. (Would the FDIC permit such transactions or sales?) A corporate depositor with, say, $2 million in SVB deposits would consider selling that deposit to a third party at, say, 25% discount. The third party might deduce that the ultimate loss is, say, 10%, instead of 25%. These potential transactions disappeared when the FDIC announced it would guarantee all deposits. 

In the end, in just a matter of three or four months, a brand-name bank that had carved out a special niche among technology companies and venture capitalists and that had exhibited astonishing growth in recent years has already been relegated to the finance history books, one of the prominent cases of failed liquidity risk and funding mismanagement. It joins the chapter that describes the mishaps and demise of Bear Stearns, Lehman Brothers, Long Term Capital and Washington Mutual. 

Tracy Williams 

See also:

Dodd-Frank Dismantled, 2017

Regulators Are Easing Up on Stress Tests, 2019

Deutsche Bank: Turmoil and Concern, 2016

Where Was the Risk Management Group, 2011

When Does a Bank Have Enough Capital? 2015

What Are Living Wills at Big Banks? 2016

FTX: What Could've Been, What Won't Be

For much of the past year or two, FTX, the new cryptocurrency exchange birthed by Samuel Bankman-Fried, existed on the periphery of crypto mania. Word seeped around quickly about the enormous value of the new company and the billions amassed by Bankman-Fried (who was widely known as "SBF"). Whispers and estimates of his net worth suggested he had over $5 billion. Or $10 billion? Or 15 billion? 

How was this "worth" culled or computed? What was it based on? As it turns out, his worth was based scraps of paper, elaborate Excel spreadsheets, and far-flung estimates of values of tokens and currencies. The organization, presenting itself as a financial exchange, was eventually funded by investments from venture funds, pension funds, and other private equity funds. It now appears they flocked to the enterprise without bothering to engage in conventional due diligence. They trusted SBF, bought into the storyline, and would wait patiently to reap vast returns. 

SBF had aspired to be crypto-world's statesman, a leader who would perfect the business model of cryptocurrencies and continue as an ambassador a world not yet completely convinced of the purpose and raison d'etre of crypto. 

The new billionaire spread the word, name and brand of crypto investing and trading. In a short period, "FTX," the name and brand, was implanted and spotted around the country--on the floor of an NBA arena (in Miami), on the field at a college stadium (UC-Berkeley), and on the front jackets of baseball umpires. Many of us knew what FTX was engaged in (crypto-something), and many knew it all might have involved speculative investing, although most didn't know exactly what FTX was up to.

By late November, almost everybody following financial markets knew FTX blew up and disappeared in a matter of days. The scrutiny the now-bankrupt company and its confusing web of affiliates are receiving in the financial media is exponentially greater than what it received throughout its existence. Mainstream news organizations are combing through 2022's version of "house of cards" to piece together the financial story. 

Meanwhile, the legal system and bankruptcy court will figure out how to resolve billions in losses, billions in liabilities and claims and how billions in firm value disappeared overnight. There have been several comparisons to Lehman, Enron, and Madoff. 

Stay In Your Lane

If FTX had stayed in its lane or remained as a functioning exchange, it may have survived. But it drifted from what it publicly said it would be. Examiners are trying to determine what propelled it to go beyond its purpose. Was FTX taking advantage of the inability of regulators to bring the group of companies into their domains and corral activities? Did FTX observe a gold-mine opportunity and try to exploit crypto markets to its advantage? Was it desperate to recoup losses in its affiliates, including the hedge fund Alameda?

As a proper exchange, it would not be taking market positions of any kind and be subject to asset (cryptocurrency) volatility. Exchanges provide access to markets or sometimes make markets, but essentially insulate themselves from market and credit risk--market risks arising from the assets traded, credit risks from from participants. Exchanges have defined roles: price discovery, price disclosure, access to markets, trade confirmation, and clearance and settlement (associated with after-the-trade activities). 

More often, exchanges and their related "clearing houses" are typically more concerned about credit risk--the risk that participants and members will not make payments on what is due or will not deliver assets (securities, e.g.) when they are due. They manage the credit risk accordingly. Sometimes that might involve participants themselves contributing to a "default fund" to absorb worst-case credit risks 

Exchanges and clearinghouses project conservatively what customer/participant losses could be and require participants to post "up front" margin (cash or government securities) in anticipation of worst-case scenarios. Markets can be wildly volatile (as they have been in 2022), and customers and broker/dealers may be subject to unusual gains and losses. But a proper exchange manages this risk without subjecting itself to the same unusual gains and losses. 

FTX billed itself as a futures exchange for cryptocurrencies (Bitcoin, e.g.). It, too, could require participants to contribute a "margin" or up-front cash. In this case, participants are not buying or selling Microsoft stock or pork-belly futures. They are getting into a position tied to cryptocurrency values. An exchange such as FTX would earn a transaction or brokerage fee. The sum of such fees should be the primary source of revenue for the exchange. (It can earn additional fees from selling data, prices and other services.) 

How It Presented Itself

As a futures exchange, participants would buy into a position by placing a margin amount, a fraction of the total price of the position. Participants sell a position and also place margin to cover potential losses. Gains and losses related to the trading positions are added or subtracted to the deposits participants initially put up.)

As a securities exchange, participants buy a position by purchasing the entire amount (or at broker/dealer, participants can borrow from the broker/dealer to purchase the entire amount)).

Outside of crypto trading and investing, exchanges fall somewhere within the grasps of securities, derivatives and banking regulation--no matter where around the globe. In the U.S., that would be the SEC, the CFTC, or even in 2022, the Federal Reserve, which seeks to rationalize getting involved to manage "systemic risk" in the financial system. 

Regulators want to see the exchange runs a fair market with fair access to participants (brokers, market-makers, and moms and pops), and updated prices. Regulators will also want to ensure the exchange or trading platform has minimum amounts of capital--"operating capital" and "loss-absorption capital." Just as important, regulators seek to protect deposits from participants, members and customers (sometimes called 'initial margin" or "customer payables" or "customer credits"). 

Regulators don't want exchanges and clearinghouses to use customer funds for no other reason than to manage customer-related risks. Hence, the deposits should be funneled into low-risks investments or activities (cash, government securities, investment-grade securities, e.g.).

Even if it operated beyond the purview of financial regulation, FTX would have still wanted to ensure participants their idle deposits were protected. Participants can take risks and be subject to losses. But participants' funds (if not being used to support trading activity) would be safe. 

What the world of investigators are now unraveling is a story of improper use of customer funds. Participants deposited funds to engage in trading. FTX used idle customer funds to fund activity that we now see was extraordinarily risky. 

If FTX had been regulated (and that presumes the current crop of regulators would have gotten around to approving and permitting a crypto-exchange to exist in the first place), the customer funds deposited at FTX would have:

a) Been required to be invested in cash, cash reserves/bank deposits, or liquid securities rated investment grade (typically, U.S. Government securities), 

b) Not been permitted to be used to fund proprietary trading elsewhere within the exchange or trading platform,

c) Not been permitted to be used to make loans to other unaffiliated third parties or counterparties, and

d) Not been permitted to be used to fund furniture, fixtures, and equipment (or luxury penthouses in the Bahamas, as it now appears FTX might have done). 

Because it wasn't a regulated exchange (and because venture investors seemed careless or indifferent in bothering to probe), customer deposits could be used for whatever purpose FTX and SBF it chose. In this case, customer deposits had grown beyond $8 billion. 

What It Really Wanted to Be

Now we know, FTX used such customer funds to venture into areas it had no business stepping into or connect with affiliates and activities that had to do with acting as an exchange. The exchange, it now appears, ran a hedge fund, lending business and private-equity investment fund on the side. 

(Sounds familiar. Bernard Madoff, well known from the mid-2000s scandal, ran a prestigious, legitimate broker/dealer, but presided over a Ponzi-scheme hedge fund on the side. Customers of the regulated Madoff broker/dealer wouldn't lose money, because of strict broker/dealer rules. Customers of the hedge fund. Well, the tale is now a prominent chapter in financial history books.)

As a pure exchange and with an avalanche of volume (for which it could charge transaction fees), the FTX business model alone could likely be profitable or could get to profitability over a defined, projected timeframe. The market value of the entity (based on future flows of earnings), however, likely may not yet have eclipsed $1 billion. SBF, the billionaire, might have been SBF, the multi-millionaire. (Today's market value of the CME Group, parent company of the Chicago Mercantile Exchange, totals about $62 billion.)

As investigators and journalists unravel a messy pile-up of spreadsheets and SBF's tendency to create dozens (or hundreds?) of subsidiaries, affiliates, and entities on a whim, it turns out customer funds turned out to be FTX's bank to fund and support risk ventures beyond a basic exchange.

Customer funds funded loans to Alameda, the affiliate hedge fund.  Customer funds funded investments in other vehicles, other ventures, and any purpose SBF had in mind at the moment. 

The "exchange" also created, we know now, its own cryptocurrency ("coin" or "token") and manipulated its value by playing supply-demand games. And it used the same tokens to lend to Alameda, and Alameda used the same to pledge as collateral to get more funding. Examiners now reason that Alameda, the crypto hedge fund, had amassed debt and trading losses and likely tapped FTX for support. In effect, the SBF's trading venture desperately required support from SBF's exchange. The left hand seeks aid from the right hand. The right hand snatches funds belonging to customers to do so. 

Unraveling, investigations, legal recourse, and bankruptcy proceedings could take years. In the end, all involved may conclude FTX wasn't the core operation. The hedge fund might have been the core entity, and the exchange was the funding vehicle. 

Many will likely wait for the book and movie to understand what happened. Media outlets report Michael Lewis, arguably the finance industry's best storyteller of trends, scandal, characters, and unexplainable financial products, has already begun to prepare of draft of this story. 

Tracy Williams 

See also: 

CFN: Bitcoin Mania Again, 2018

CFN: Bitcoins--Embrace or Beware? 2014

CFN:  Wall Street's Flash Boys, 2014

CFN: High-Frequency Trading, 2014

CFN: Dark Days at Knight Capital, 2012

CFN: JPMorgan and Its $6 Billion Trading Loss, 2012

CFN: What is Really a Derivative? 2012

Musk's New Venture: Twitter-Tesla Tango

Everybody is weighing in on Musk's latest venture, Twitter, but banks and debt investors eagerly supported the deal

Just five months into 2022, can we already select Elon Musk's recent successful $45 billion bid to acquire Twitter as the "Deal of the Year"--not because of size, not because of its expected leverage, but because it's Elon Musk, it's Twitter, and everybody has an opinion about both. 

In some ways, the deal was unpredictable, because, yes, not many knew a year or two ago Musk might have been eyeing the company, although he surely had a dominating and controversial presence on the platform. 

The swiftness in which the deal (still not yet consummated, but unlikely to be slowed down by government regulators) got done proves how rapidly banks, markets and boards of directors can move to reach an objective. (Documentation in this deals permits opt-outs if required steps are not taken before yearend.)

While many in the media (and on Twitter itself!) are expressing views on what Musk will do to the platform, what will Musk (along with other private-equity investors who might join him) acquire?

The company had earnings losses in 2021, a disappointing year after the company had begun to show a promising and upward bottom line. The loss in 2021 still needs to be reckoned with and understood. (From 2013-17, it recorded a string of  net losses, often attributed to its being in start-up mode. During that period, it also went public in 2013 via an IPO and was blessed with billions in cash reserves to help cushion operating losses.)

In 2022, Musk and crew are purchasing an enterprise that generates about $500-900 million in annual operating cash flow (before investments and capital expenditures). And they present the case they can stir up the magic that will boost earnings to where they can be. As a private company, it will be able to spur growth as its own pace and without being second-guessed each quarter by a broader market. 

The company had its best years in 2018-19, topping $1 billion in each year in earnings, and operating cash flow also topped $1billion and the company could finance growth, investments, acquisitions, and capital expenditures without increasing debt much. Before Musk's involvement, Twitter debt had reached a manageable $5 billion, much of it related to lease obligations. 

Results have been puzzling since then. Revenues continue to grow quickly (even at last year's 35% pace), but expenses and unusual costs seemed to have spiraled upward. For example, litigation-related expenses and other unusual items topped $700 million last year. 

Until the acquistion announcement, debt was not yet a burden, partly because the company has maintained cash reserves of at least $6 billion on its books since 2016. Some of the cash on the balance sheet was gathered from IPO proceeds, and it has remained there in part because shareholders haven't demanded dividends in great numbers and they haven't often pressed for big buy-backs. 

The new Musk-led buyout will layer tiers of debt on the operation and put pressure on the business to generate the consistent cash flow to service levels of debt that could exceed $15 billion in the new private entity. 

Musk-led enterprises aren't afraid of debt. Tesla continues to operate with debt totals above $20 billion, although cash flow there has reached stratospheric proportions (almost $12 billion in 2021--before capital expenditures--amidst revenue growth that has quintupled the past four years. Revenues ($53 billion last year) could stall in growth as all other automakers dip into electric-vehicle (EV) waters. Yet despite recent declines in Tesla shares (related to the debt financing in the Twitter deal), Tesla reported one of its best quarters ever in 2022's first three months. 

Twitter, on the other hand, is a different beast--different business model, different kinds of competition, different relationships with its stakeholders (customers, users, shareholders), less capital-intensive. It doesn't need to address labor issues and concerns about raw materials and battery production or tend to risks related to production, assembly lines, and supply availability of silicon chips.   

In a classic leveraged-buyout approach, banks lined up eagerly to provide the financing (about $25 billion in total). Musk and his small troop of other equity investors will invest another $20 billion in equity. When all the documentation is signed and the deal finally closes, there will be a new consolidated balance sheet that will feature at least $13-15 billion in debt and perhaps as much as $35 billion-plus in "goodwill," the accounting intangible that shows how much the group paid above the book value of current Twitter. 

The deal is complex, but not unusual. Musk will sell Tesla stock to come up with $20 (and consider raising some of that total from private-equity-fund friends). Musk will separately borrow $12-13 billion from a Morgan Stanley-led bank group and pledge more than $20 billion in Tesla stock to collateralize the loan. A newly formed parent company will be capitalized by those Musk contributions and then will gain funding from additional debt of $12-13 billion. The total fundraising will be sufficient to purchase the net assets of Twitter. 

Bankers likely got comfortable (and did so quickly) for their various fund-providing roles because of the bundles of cash sitting on the balance sheet already and because of the pledge of notably liquid, but volatile collateral--some of Musk's Tesla stock holdings. As a highly leveraged transaction, investors and banks providing debt at the new parent company will seek the typical safeguards, protections and security interests (collateral on just about all assets available for pledging, covenant restrictions on new debt, minimum cash flow to ensure interest is paid on time, limitations on dividends and buy-backs, etc.).  

Debt investors and bank are relying on (or praying for!) steady growth in Twitter operating cash flow, and the expectation Twitter's new owners are not seeking dividend payouts and share-buys (at least not early on).  

Banks will rely, therefore, on the performance of two businesses: Twitter and Tesla. While Tesla shares have grown remarkably the past few years (by almost 8-times in value the past three years), its values can be unbearably volatile. (The beta of the stock--one mesaure of volatility--exceeds 2.00). 

Two unrelated businesses will become connected. If Twitter's performance declines, that increases banks' reliance on Tesla stock, which boosts the probability that banks could seize and sell down substantial holdings.  

The deal still comes down to what are Musk and team purchasing: The brand? Expected growth? Growth spurred by a novel strategy? An ability to manage unexplained costs? Access to Twitter accounts? Operating cash flows?

The company's core business revolves around generating advertising revenue. That business grew 41% last year, yet (a) the company still reported losses after expenses, (b) it generated negative operating cash flow after investments and capital expenditures and (c) it encounters fierce competition from the other digital-advertising behemoths (Facebook, Google, e.g.). 

A balance sheet with debt that required it to pay only $51 million in interest expense will transform into one where interest costs (above $400 milion?) could carve out as much as half of operating cash flow. 

The media have focused on Musk caring less about the deal's financials (the revenue streams, growth rates, expenses, debt levels and cash flow) and more on Musk's agenda to use Twitter as a platform for non-financial strategies (unrestricted free speech, e.g.). Notwithstanding the non-financial objectives, investors (lenders, bond-holders, and private-equity funds) seek performance to service the debt or to build value. 

The excess leverage on the new balance sheet (consolidated) requires cash flow and won't tolerate periods of reinvention or business-model remodeling. So while Musk tends to the non-financial goals, the new organization must tend to conventional leveraged-buyout mandates: cost-cutting, cost-savings (via labor layoffs), operational efficiencies, core revenue growth, quarterly interest payments, and long strategy sessions to come up with ideas to generate consistent cash flow today. 

Tracy Williams 

See also: 

CFN:  Twitter's Turn to Do an IPO, 2013

CFN: Facebook's IPO: What Went Wrong? 2012

CFN: Evaluating Debt Ratios, 2015

CFN: Will Yahoo Ever Rebound? 2015

CFN:  Analysis of Corporate Debt, 2021

The Netflix Story in 2022

Netflix's revenues grew 19% in 2021, but has its grip on the top spot in the entertainment-streaming market loosened? Is the company now less burdened by debt (now at $15 billion)?

By all standards, Netflix is a household name, a brand known to the population around the world. Company strategy has pushed its streaming services to every corner of the globe. The model has been successful, and the stay-at-home days of the pandemic helped spur subscriptions.

The company recently announced 2021 results, and headlines splashed across the financial media about its praiseworthy 19% growth in revenues ($29.7 billion in total)--aided continually by pandemic-era demand for streaming services and the steady upbeat in subscriptions in global markets. (Subscriptions now exceed 220 million.)

Stock investors didn't celebrate too much, as its share price has slid down a roller coaster in recent weeks. But does that reflect investors' concerns about the Netflix momentum easing up, or did that reflect traders expressing a greater concern about equity valuations everywhere?

In many ways, Netflix once again is at a pivotal point, a junction. The revenue growth rate is its lowest reported in the past nine years, the lowest since it long ago veered away from DVDs in the mail and hammered out its streaming strategy. 

The alarm among investors or debt analysts has not always been a slowdown in growth. The company generated $5 billion in earnings and enough cash flow to ease some of the concerns about its mounting debt.  Netflix's story, at least among debt-holders and ratings agencies, had been its steady habit of tapping debt markets to support the development of new content. New content, subscribers know well, is necessary to feed the growth and at least maintain a tight grip on old subscribers. 

New content (programs, movies, documentaries, etc.) helps it maintain the old accounts, but permits it to attract new subscribers in the U.S. and regions and cultures around the world. But new content must be financed. Over the past eight years, the company's financial managers funded over $25 billion in new content (production costs, talent and acquisition costs, etc.) mostly from long-term debt (now hovering about $15 billion). 

It has shirked issuing new equity to accomplish the same. Contrast with Tesla--although in a different industry, which issued $20 billion in new stock in 2020 to support its aggressive strategy to construct the infrastructure and production lines to manufacture more electric vehicles. (Netflix doesn't pay a dividend and hasn't hinted at doing so yet.)

At Netflix for years, because there had been earnings, there has been operating cash flow, but not enough to support all of its new-content goals. And after the stock markets helped spark a surge in its share price, the company has been reluctant to issue new equity to support such growth--the better to not dilute share value. 

Furthermore, during a near-euphoria period of low interest rates and enthusiastic debt markets, the company had little trouble finding willing institutions, investors and banks to provide funds. Ratings agencies assigned non-investment-grade ratings to Netflix bonds, but investors snapped up the issues and traded them as if they were investment-grade.

Over the past two years, the steady increase in earnings (and operating cash flow) has permitted the company to slow down adding more debt. The boost in cash flows led one rating agency to upgrade the company to a BBB rating in 2021.

Netflix is now producing new content at a rate of  at least $5 billion annually, an amount it likely has determined is necessary to keep subscriptions growing. By 2021, the company announced and then proved it could fund much of the new development mostly from operating cash flow. 

Yet debt still has to be managed, refinanced, or paid down. There is still the $15 billion it must address, when some of that matures in years to come. The company will likely seek to refinance whatever might be due during that time. 

Debt levels are often measured by the common Debt/EBITDA ratio--which has fallen from above 7.0 down to about 2.4 today. EBITDA, a performan metric based on pre-tax earnings, doesn't account for cash required to support new content. After accounting for new-content expenditures, there isn't much cash remaining (even in 2021) to pay down debt. Hence, the company will continue to rely on debt markets refinancing whatever is due in upcoming years. 

The biggest worry--a concern expressed by stock markets the past month--is whether it revenue growth rate can reach what it experienced the past eight years (an average 27%/year)--especially as every other entertainment enterprise under sun has entered the streaming industry.  They have offered every attraction or pricing discount to streer subscribers away from Netflix. The wars began a few years ago, but haven't peaked. 

Its business model comes down to subscription memberships, retentions and additions. Sounds simple, but many of its strategies, financial planning, and growth prospects revolve around that basic mission: How does Netflix gain subscriptions, keep them, and grow them?

Think about the typical subscriber today--who may be a milennial perched on a sofa in Northern California or a retired baby-boomer in North Carolina or, more and more, a resident of Brazil in search of a diversion. The subscriber today is a sophisticated consumer, who performs scientific-like analysis to figure out the right price to pay for a monthly subscription, a critical factor in this industry, a crucial factor the company faces as it confronts competition and stagnant growth.

Now think about the competition (Disney and Amazon always come to mind), which also has developed sophisticated algorithms to determine correct pricing and gauge what subscribers want to watch.  Inevitably, the solution Netflix has adopted is to increase that subscriber base by developing attractive, alluring content at a pace of about $5 billion annually--while daring to increase monthly prices.  It expects its entertainment specialists will know better than Disney what subscribers want to see, spending as much as possible to ensure high quality.

Proclaiming the necessary and requirement to develop new content is one thing. Another factor is deciding what kind of content to develop for an audience in every region in the world with disparate, local tastes. Arthouse movies? Bollywood? Korean film? Sci-fi? What do subscribers in India prefer to see vs. what subscribers in Argentina or Korea want to see?

CoViD propelled subscription growth in 2020, but CoViD worries curtailed production. Who could make movies when the world was on lockdown? Content spending fell 84% from $5 billion-plus to less than $1 billion. Otherwise, the company would have been making movies if it could have. 

After 2020, the company resumed development back above $5 billion, all while ratings agencies and debt investors have watched the mountainous level of debt. Netflix promised cash flows would catch up and become the primary source of funding. And they have. Sort of. 

Operating cash flow, now above $6 billion, can finance new content. But can that amount continue to grow or at least be generated consistently. The company is no longer the "only game in town." 

The company will not likely reduce debt substantially (by, say, a half), because (a) it won't be able to do so, (b) it may not need to do so now since much of it is due years from now, and (c) investors and lenders will be comfortable with debt at a now-constant level, an amount that can likely be refinanced years from now when due.

On the other hand, as interest rates creep upwards, company finance managers may consider reducing some debt to manage interest payments--which topped $750 million last year and could rise even more as rates rise.

Disney, Hulu, Amazon, Peacock (with the "+" appended to many of their names) and a list as long as high as the moon are now streaming and threatening the company's stronghold on the market. In recent days, even ViacomCBS decided to change its name to Paramount, partly to emphasize its newly adopted streaming strategies.  

That might be the major factor causing 2022's share-price plunge. Its value had approached $700/share in late 2021 and has not dipped by almost a half (down below $370/share), partly because of investors' wariness in the company repeating past growth rates, partly because of the current global sell-off in equity markets. Debt investors and ratings agencies today assess the operating cash flows are in better shape. Equity investors, at least this quarter, assess the 24% annual growth in revenues might be a thing of the past. 

 Tracy Williams

See also:

CFN: Netflix Manages a Mighty Debt Load, 2018

CFN: Expectations, Insights for 2022

CFN:  Updates in Analyzing Corporate Debt, 2021

Expectations, Insights for 2022

The year 2021 was marked by mania in SPACs and cryptocurrencies and by widespread concern about inflation. Yet volatile equity markets finished up in admirable fashion.

The year 2021 will likely not deserve a whole chapter in finance history books--as perhaps 1998, 2008, and 2020 did. For bankers, traders, investors, regulators, and corporate financial managers, it was still eventful. An evolving year, some might say, with new fads, trends, and tendencies.  A transitioning year, as markets, countries and economies continued to ward off the impact of CoViD 19 and all its variants. In 2021, think pandemic, Zoom, return to work, and recovery.  And in 2021, think also SPACS, crypto-everything, market volatility and interest-rate obsessing. 

Investors, traders and bankers will spend the new year content about the year behind us because markets progressed upward, deals flowed steadily, and regulators basically watched for now. 

As always, the year produced new jargon ("meme stocks" and "DeFi"), new products and flaming fads (SPACS, e.g.). Finance types enjoy crafting new language to spout and new things to sell, although what's new is often a variation of something already old. "SPACS" have been around for years, but the hoopla surrounding them in early 2021 was as if they had been newly discovered New Year's Eve a year ago. 

Jargon introduced a few years ago took off in 2021. One example is "ESG," although it is embedded in financial discourse mostly for good reason. A term that was hardly bantered about 15 years ago is spouted everyday and all the time. While it is imperative environmental, social and governance challenges be addressed and corporates and banks be held accountable, the term encompasses hundreds, if not thousands, of topics: investments, capital expenditures, business models, strategy, operations, accounting standards, disclosures, reporting, stakeholder objectives, etc. 

By late autumn, 2021, financial markets had become consumed by two variables: (a) another wave (the Omicron variant) of CoVid just as when most thought the pandemic was slowly disappearing and (b) clear signs of inflation. All of a sudden, the economy and markets returned to specific computations of the Consumer Price Index and watched the calculation rise above 2% for the first time in generations. 

Inflation Watch

The inflation focus was not only on the metric, but on the strategic steps and timetable of the Federal Reserve Bank. Is the inflation we observe and compute something temporary? Is it for real? Will it rise and continue into 2022? Economics and market strategests opined and debated. What will be its impact? And what will the Federal Reserve do? 

As the monthly computations of the CPI index inched higher, we acknowledged the presence of inflation and reviewed the impact on corporate operations, consumer spending, economic recovery, interest rates and the value of bond portfolios. "Fed watch" had become more than an occasional investor activity, but almost an obsession. The Federal Reserve has since announced tentative steps to increase interest rates in 2021. And away we go, assessing the influence of higher rates on economic recovery, GDP output, bond investments, bond positions, corporate borrowing rates, mortgage rates, and banks' bottom lines. 

Often markets react negatively not necessarily to higher interest rates, but to greater amounts of uncertainty. The prospect of high interest rates in 2021 hasn't caused equity markets to sink as some would think, because we know what's coming. 

SPACs

The hoopla surrounding SPACS ("Special Purpose Acquisition Company") has dimmed since it peaked in early 2021. A year or so ago, just as teens flocked from one phenomenon to another (from Snap to Tic-Toc), older adults swarmed toward what's hip in finance, even if they aren't professionals in business and finance. NBA all-stars, pop musicians and former politicians, all of a sudden, wanted to join what sounded like an extravaganza. 

SPACs are rationalized and advertised as a financial maneuver for private companies to go public without the lengthy process of doing an initial public offering, which requires a lengthy process to gain government approval. It also involves significant disclosure of performance and balance sheet and a detailed discussion of operational and legal risks (all those things that could go wrong and upend the value of the solicited investment). 

By late 2020 and early 2021, it had seemingly become a legal "get rich" scheme available to those in the right financial, business, social and entertainment circles. Many hurred to join "sponsorships," where the real money could be made with little initial investment and, for some, without much of a time commitment or even intimate knowledge of the structure. 

In theory, sponsors are supposed to examine opportunities to acquire the right private business based on the cash already provided by SPAC investors. For their toil (research, analysis, valuation, negotiation, and structuring), they would be rewarded with substantial returns (often shares allocated to them). 

Over the past two years, SPAC activity explains a sizeable chunk of the exponential upturn in IPO activity the past two years.  (By design, SPACs become public companies upon their birth and can do so without the lengthy, aforementioned SEC approval process. There is not much to analyze in a SPAC at formation, because there is no business operation. Only a pile of cash reserves looking for a target.)

Few, if anybody, are arguing SPACs should be closely, tightly regulated. Many just wonder whether the euphoria around the product could implode like the collapses we saw in junk bonds (the 1990s), dot-com public offerings (the 2000s), and mortgage-backed securities (the 2000s). A worst-case scenario involves the formation of SPACs, the timetable SPACs adhere to while searching for a target, and the plausible scenario where (with time running out) sponsors force the SPAC to acquire an under-performing, under-investigated, or even illegal business operation. 

Crypto-Mania

Perhaps the greatest uncertainty is the specific picture of finance in 10 years (or even five!), as cryptocurrencies  dominate the landscape. The fuss over cryptocurrencies is not just about the coins themselves, but also the related technology (often referred to as "distributed ledger technology" or the blockchain). 

Until the last year or two, cryptocurrency investing, trading, and payments had been a niche segment, mostly spurred by curiosity or participants' being enamored with Bitcoin's creator's mission to establish a currency not controlled by governments. Over the past few years, cryptocurrency mania has exploded because of profit opportunities--multimillionairs and billionaires being minted overnight. There are widely reported disclosures of Bitcoin traders, miners (market-makers), and investors who have accumulated massive amounts of digital wealth.

In finance, when the prospects of immediately attainable wealth increase, the herds flock to the segment and to reap gains before the masses get involved. 

The year 2021 was a pivotal point in cryptocurrency finance, perhaps a take-off point. It is no longer a mystical niche. It has stepped into the mainstream and attracted enormous amounts of capital, talent, and offshoot business models. There had been the core cryptocurrencies (Bitcoin, Ethereum, etc.). Nowadays there are opportunities in cryptocurrency exchanges, cryptocurrency futures at the major exchanges, and futures at the less-than-major exchanges (FTX.com, e.g.).

The investor, the trader or even the asset manager (who must now at least contemplate crypto as an asset class on behalf of clients) have multitudes of ways to "get in on the game." Buy the Bitcoin outright. Purchase assets at an exchange. Purchase futures contracts at government-approved exchange. Purchase futures contracts at an unregulated exchange. 

There is the offshoot to the offshoot: "DeFi," which stands for "Decentralized finance," but refers to the creation of a financial system based on cryptocurrencies. Within that system, participants not only can make payments in cryptocurrencies, but can borrow and lend to others. A company or institution can borrow in crypto, lend in crypto, or accept payments in crypto. 

This world claims any transaction that can be accomplished by the dollar or euro should eventually be accomplished by Bitcoin. The same world envisions corporate borrowers seeking to expand their business financing operations with another, perhaps better, more efficient alternative--borrowing in crypto markets and negotiating, executing and settling the transaction on an efficient blockchain. 

The new firm NYDIG is typical of new crypto ventures. It seeks to plug itself into many traditional areas of personal and institutional finance--but with a Bitcoin wrinkle. Insurance, investments, brokerage, and loan products--all involving Bitcoin. 

The big banks (JPMorgan Chase and Goldman Sachs, e.g.) that once avoided cryptocurrencies (because they had not figured out how to manage the legal and market risks related to this kind of non-government-sanctioned product) are now cautiously embracing the domain. 

Large banks applaud creativity in finance as a way to fend off competition and grow net revenues. In cryptocurrencies, heretofore they have treaded carefully if only because they had not yet addressed the unquantifiable levels of market risk, operational risk, and legal/regulatory risks. They had not yet figured how to sell the activity to shareholders, clients, depositors, and regulators 

Just like other business revolutions in the past (most notably, the Internet itself), ideas flourish today. Time will tell how such ideas will come to fruition and work themselves out. Finance history suggests ideas become more defined and concrete after some experimentation fails and results in colossal losses and a short-term threat to the financial system.  

Yet still in finance, creativity rules. The intent is that creativity spawns new products, and new products (without the influx of competition) lead to might returns. Over the past year in crypto, creators organized trading in digital images--now better known as "non-fungible tokens," or NFTs. Who knows where this is headed, although many are betting the barn that investments in computer images will be purposeful and fruitful. 

Because of the opportunities to make mind-boggling amounts of money, this expanding world of DeFi, crypto and Blockchains has begun to attract talent and expertise. The Stanford or MIT doctorate in computer science might be less interested in working for Google or Intel, less interested in working for Morgan Stanley or Goldman Sachs, more interested in linking up with a crypto operation. 

Meme Stocks, Short Sales, and Equity Swaps

From year to year, there always appears to be a trade, transaction or deal that defines the time or period. Often in such transaction, somebody makes huge amounts of money. A counterparty or the other side loses its entire capital base and becomes insolvent overnight. The next day, it liquidates or files for bankruptcy. The financial media scrambles to describe, explain and understand the trade. Critics and pundits point fingers.

In 2021, a pheneomenon, eventually described as trading in "meme" stocks, surged. A few years ago, the phrase "meme stock" would have meant nothing. Today, it describes equity trading where values are driven up artificially based on Internet banter, often uninformed and unexplained. GameStop, the gaming company, was arguably the "meme stock" of the year. 

GameStop's business model, on paper at least, appears to be something from the 1990s. Its prospects for revenue growth are suspect and uncertain. Yet random discussions gain momentum on the Internet; home-bound day-traders and basement-room analysts convince themselves the stock has intrinsic value and share their fleeting points of view in social media. 

This leads to buying pressures, and the stock price takes off. On the other side exists a hedge fund that has analyzed the prospects for low growth and few profit opportunities. It decides to put on a short-sale trade to profit from the decline in share value. (It must borrow the same stock from a financial institution and then sells it at the unjustiable high price with hopes of repurchasing it later at the rationalized lower price.) The meme brigade, however, has whipped up momentum to push the price to irrational levels. The hedge fund experiences unimaginable losses and eventually has its capital wiped out. 

The subplot to the GameStop tale involved the broker/dealer Robinhood, which couldn't handle the flood of volume of requested purchases of GameStop stock and which was required to halt brokering of such trades by its clearing counterparty (DTCC). The hedge-fund losses, the halt in trading in the stock, and the shut down by the broker/dealer provided many lessons to contemplate and learn in the basics of equity trading. 

The other notable trade that led to hundreds of millions in trading losses revolved around ViacomCBS stock. The hedge fund Archegos accumulated outsize positions in the stock. Archegos projected an upsurge in growth at the company and decided to bet the ranch. It do so via actual purchases of the stock and via derivatives with participating trading banks ("total-return swaps"). Notwithstanding Archegos' analysis and view, ViacomCBS could be a stock where the company's growth prospects are uncertain. Its business model, for many, like GameStop, appears dated. 

In early 2021, after its stock value had peaked, the ensuing plunge caused huge losses and insolvency for the fund. Yet the complexity of the derivatives also led to losses for the banks on the other side of the trades (Credit Suisse, MUFG, et.al.). 

The banks' derivatives positions required Archegos to pay them the losses Archegos accrued. As its capital imploded, there were no profits to pay banks for the gains they were entitled to. Archegos owed the banks cash in billions; the banks had to report losses on the receivables due to them.  For finance risk managers, this would be another lesson to address: How did the banks have that much confidence that Archegos could make these payments on losses? How could the banks have permitted the fund to accumulate these large positions (the same questions risk managers ask crisis after crisis)? (The lesson learned falls within the banking world's area of "counterparty derivatives credit risk.")

Fin-Techs

For much of the past decade, global finance has embraced financial technology in the same ways technology has wrapped itself around every other industry in the world. But early on, technology experts grasped for a role in finance. Should it be in consumer finance, lending, payments, market analysis, securities trading and settlement, and financial reporting.

The answer is all of the above, although it appears the public generally thinks apps for home lending and consumer payments when it sees references to "fin-tech." 

And within fin-tech, traditional players continue to figure out their roles--as partners? As investors? As competition? As researchers and developers? The answer again is all of the above. Large banks hire as many as specialists in technology today as they do for roles in banking, research and analysis. Technology is arguably embedded in every single process, delivery of service, product development, data aggregation, financial disclosure, and financial research and analysis. 

For a few years, boutique fin-tech firms believed they could supplant the role of traditional banking. In some ways, they can, but not necessarily because of their technology expertise or advantages. Often their advantages are related to less regulation and fewer capital and leverage requirements. But some fin-tech firms in some areas (including payments and lending) acknowledge they need banks as partners because they need banks' balance sheets and banks' experience in managing market and credit risks.  

Fin-tech is here forever. In fact, like the Internet two decades ago, there is no longer a debate over the role and purpose of fin-tech. The latest wrinkle, obviously, involves cryptocurrencies and Blockchains. 

Corporate Debt: Bonds, Loans, and Credit Spreads

In 2022, corporate debt markets might take differents turn because of expectations of interest rates will rise. That market includes bank lending, corporate bonds, private placements, mezzanine finance, convertible bonds, and high-yield debt. 

Examine this from the office of the CFO, as interest rates creep upward during the year. Corporate CFOs must contemplate whether to pay down some debt or defer some offerings as rates rise. History suggests investment-grade companies tend to ease down debt levels when rates increase incrementally.  For all the operating cash they generate, in a low-rate environment, they often consider stock buybacks and increases in dividend payments. With higher interest rates, the amended strategy is to consider de-leveraging the balance sheet. For banks, that could lead to lower levels of debt offerings--something debt markets have already begun to experience in the early days of 2022. 

Debt activity, nonetheless, is also influenced by corporate business strategy for expansion and growth. If the company plans an acquisition or major capital expenditure, it may make more sense to finance it with more debt than new equity issuances, since, in theory, the cost of debt is almost always cheaper than the cost of equity. And CFOs, along with CEOs, are always concerned about the equity-value dilution (lower earnings-per-share metrics) when they contemplate issuing new stock. 

In higher-yielding debt markets and leveraged finance, activity might be a function of other factor, too:  credit spreads (investors' views of the risks of issuers) and deal-making activity.  The continuing upturn in deal mergers, acquisitions, takeovers, and buy-outs influences non-investment grade debt markets.  M&A transactions must be financed. Low interest rates encourage debt financing. But the possibility of improved credit ratings and credit perceptions do, too. 

Deal-making surged in 2021, and signs don't show deal flow declining significantly in the periods to come. 

On the investors' side, activity for many years has been spurred by buyers chasing credit spreads.  With low U.S. Treasury rates, investors scout out for non-investment-grade issues (those rated BB+ and below) that deliver higher returns and appear not likely to default in the medium term.  

Bond theory, for example, might suggest some BB-rated-and-below names should result in bond yields of, say, 5.0-6.00%. But in practice, fixed-income investors who won't settle for 1.5-1.6% yields from Government bonds will tolerate higher risks, assume some well-known names (Tesla, Netflix, e.g.) won't default, and will bid up bond prices or bid down credit spreads. 

For much of 2021, credit spreads on non-investment grade portfolios gradually declined because investors "chase spreads" and because the worst days of the pandemic disappeared. Credit spreads for high-yield issues in late autum hovered in the 300-320 basis-points range (based on S&P and ICE BofA portfolios) had been on a steady, downward trends since Mar., 2020. 

Stocks: Upward Surge or Downward Correction?

Equity markets are a constant guessing game. Who knew back in Mar., 2020 the S&P indice would rise 27% in 2021? Some even suggested it would take years for stock prices to recover after they plummeted 20%-plus in the first quarter of the pandemic in 2020.

By the end of 2021, the sentiment among many watchers was there is little chance for share values to replicate 2021 and investors should watch for sultry returns in 2022. Many said the same a year ago. 

That's not to say 2021 was a smooth ride. Throughout, markets churned and fluctuated. They peaked in late summer, they dove downward in early fall, they rose and fell again in late fall, and they eased to a rising trend by yearend. (And they have choppy in the early days of Jan., 2022.) While projecting where the Dow index (or other major indices around the world) is almost a fruitless exercise, projections of intermittent volatility might be more accurate. 

Financial markets, of course, have an index to track expectations of volatility, and the bravest traders try to profit from such an index (the VIX index). That index, keep in mind, is not an index of current or historical volatility, but a gauge that measures how much traders think stocks will fluctuate going forward over the ensuing year.

That index, now at about 17.0, peaked at about 30.0 in early December.  Even the index that attempts to project volatility is similarly volatile. At 17.0, the VIX index implies there is 16% chance the portfolio of S&P stocks will fall about 17% in 2021. Yet the same index also implies there is a similar probability the portfolio will rise about 17%, too. 

Mergers and Acquisitions

The 2021 numbers are out and tell us bankers had a feast at the deal table last year with $5.63 trillion in consummated M&A deals around the globe ($2.61 trillion in the U.S.). The familiar names led league tables (Goldman Sachs, JPMorgan Chase, et.al.). Private-equity buy-outs account for almost a fifth of global totals. 

M&A activity is spurred by many factors. That might even include a company's CEO becoming so uninspired by current business strategy that the CEO initiates an acquisition at least to represent to board members and shareholders that management is doing something as markets evolve. 

In the periods as the pandemic spread around the globe, corporate strategies and buy-out companies surveyed the market to see if there were bargain-basement companies up for sale. Stronger companies with predictable cash flow, not impaired too much by the recession and with mounds of cash sitting on balance sheets, explored where they could pick-up discounted companies or companies with market values damaged by pandemic confusion. Private-equity firms combed through the marketplace with similar intent. 

Low interest rates also spark M&A activity. In 2020, rates declined to historical lows. Cheap debt financing makes it easy to expedite even some of the most complex takeovers. Occasionally a merger is rationalized by strategy, synergies and effective integration, but financing costs are too high or the increased leverage brings a frown to credit rating agencies. 

The M&A momentum should continue in 2022, even as rates creep up as scheduled.  

Investment and corporate bankers, corporate CEOs and CFOs, and even investors and traders in certain segments are all not frowing too much. 

Tracy Williams 

See also: 

CFN: M&A Amid CoVid, 2020

CFN: Understanding the "Fear Index," the CBOE VIX, 2018

CFN: Market Volatility: Can You Stand It? 2011

CFN:  Corporate Debt:  Analysis, Topics, 2021

CFN:  Corporate Bankruptcy Season, 2020

CFN:  Falling in Love With SPACs, 2021