Structured Finance: Securitizations Principles

Many blamed the debacle and near crushing collapse of financial markets during the financial crisis of 2007-09 on the financial industry's addiction to securitization. Many know securitizations as an alphabet soup of finance. Special-purpose vehicles are set up by asset managers, some of which are banks; others might be other financial institutions. The same SPV entities issue bonds that have been best known by their acronyms or initials: CMOs, CMBSs, CLOs, CDOs, MBS, CBOs, etc. 

These SPVs bought loans of all kinds (mortgages, auto loans, commercial real estate loans, credit card receivables, and more). They funded such purchases by issuing tranches of bonds. Banks, other financial institutions, bond funds and broker/dealers bought the bonds. They held them or traded them or made markets in them.

In the euphoria of financial markets and frantic activity before 2008, their arrangers or investment banks (Lehman Brothers and Bear Stearns immediately come to mind) set up the SPVs, arranged and issued the bonds, collected their fees, and proceeded to set up other SPVs (partly to continue to collect more fees). 

To issue such bonds and get investors comfortable, SPV asset manager must arrange for rating agencies to rate the bonds, typically in tranches from AAA down to B. A AAA investor could invest in mortgage markets, earn reasonable returns without owning mortgages. Banks that originate the loans had a place to park them and allow the process to originate more. By selling into SPV structures, banks could transfer the credit risks to other parties and could generate liquidity or cash to deploy as they prefer. 

In the glory years before 2008, many institutions had swooned toward securitizations "on steroids." There were plain-vanila securitizations, but also re-securitizations (securitizing the BBB tranches of structured finance, or "CDO-squared"). There were securitizations of credit insurance (index-tranche credit-default swaps). There were institutions, like AIG, that sold credit insurance on securitized bonds. The objective might not have been (by mid-2007) to transfer risk or structure properly managed portfolios of loans into highly rated securities, but to find a reason to create yet another SPV (to earn more asset-management fees).  

A problem arising from the crisis was the notion that an SPV could buy any form of credit asset (corporate loan, home loan, consumer loan, receivable, etc.) and use models to create investment-grade bonds (AAA, AA, e.g.). By 2007, non-investment-grade loans were used to create AAA bonds. Second-lien home mortgages and mortgages for which the borrowers had frighteningly low credit scores or needed only to make interest payments for a long term were funneled into structures funded by AAA or AA bonds. As long as the ratings were maintained at investment-grade levels, investor classes would be interested in purchasing these bonds or comfortable holding them. 

By mid-2007, the structures began to collapse. Borrowers in many asset classes couldn't pay as promised or couldn't pay with the levels of confidence asset managers and rating agencies projected. As borrowers defaulted, as SPVs collapsed, and as structured bonds defaulted, the financial crisis ensued.

In the years since, securitization and structured finance didn't disappear into finance history books. Regulators and bank supervisors didn't prohibit such structures or some of the practices and privileges of banks. Securitizations (the creation of AAA or AA bonds from loan portfolios of all kinds) continue today--but with a flock of new rules, restrictions and (for banks) capital requirements. 

Long lists exist today of what banks can and cannot do. Rating agencies are required to be more transparent and more conservative in determining how a AAA bond can fund a portfolio of BB corporate loans. And some banks, asset managers and institutions continue to be creative about the kinds of loans, leases or receivables that can be securitized (data-center leases, e.g.).

For data centers, the so-called SPV is de facto a data center that owns computer infrastructure (servers) and leases the assets to uses (including perhaps "hyperscalers" such as, say, Nvidia or Meta. The SPV's balance sheet will report net lease receivables. Lease income is netted for related data-center costs (cooling and power costs, e.g.). The net lease receivables are funded by the securities rated and issued. 

Yet occasionally, even since the financial crisis and the slate of corrective action taken by regulators, problems, a collapse or a unsettling event occurs. In the fall, 2025, financial markets and risk managers watched the failure of auto-dealer and lender TriColor, an institution that made auto loans to an uncreditworthy borrowing segment, sold some of them into temporary SPVs (called "warehouses"), which sold some of those into final SPV, which would issue long-term bonds to fund the purchase of the auto loans. 

As the auto loans began to default en masse (not a surprise for many), all related structures imploded, too. And lenders or investors to such SPVs are absorbing massive losses, while the original TriColor stumbled into the bankruptcy. As with the crisis of 2008, lessons are now being charted and culled with hopes that future crises in securitizations will be averted. 

Securitizations : the basics

Let's return to the basics. Debt (including loans, receivables, or leases) is purchased by the SPV and included in the SPV’s loan portfolio. An asset manager is responsible for identifying the assets to place into the SPV. The SPV may purchase loans from many originators (often other banks), but it requires funding to support such purchases.

Securitizations, therefore, mean the SPV has elected to issue tranches of bonds to fund the loan portfolio. To get investors comfortable, the SPV (or its asset manager) will seek credit ratings from the rating agencies. Asset managers seek to get the maximum amount funding from AAA-rated issued bonds, partly because AAA-rated bonds are easier to sell to the public and AAA-bonds imply cheap funding. Indeed, the SPV (like any financial institution) seeks to generate wide net-interest-earned spreads by keeping funding costs as low as possible and to permit equity holders (or "residuals," as they are sometimes called) to generate high returns. 

The types of loans or credit assets (or exposures) that are securitized may include home mortgages, credit-card receivables, auto loans, commercial real estate loans, corporate non-investment-grade loans, small-company loans, or export receivables. But assets can also range from equipment leases to royalties earned from holding music licenses. In recent periods, asset managers are interested in securitizing the lease payments tied to data centers. (Data-center companies lease the equipment to technology companies. Hence, imagine the demand or opportunity to create securities backed by lease payments on computer infrastructure that supports the rapid growth in AI.)

CLO structures purchase non-investment-grade loans (BB+ and lower) and have become as a sector the largest lending group in leveraged finance in the U.S. (and in other develped markets, too). CLOs fall within the broader segment of "private credit" because such public-like bonds fund the private loans and because most CLO structures are now managed by the stalwarts of private credit, names like Blackstone, KKR, Apollo and Ares.

Banks may not be permitted to structure and manage CLO SPVs (a regulatory fallout from the financial crisis), but are interested in investing in CLO bonds (A-rated or better), mostly because some of the highly rated issues are liquid and because the yields are often better than the returns from investing other A-rated-or-better bonds (including U.S. Government bonds). 

CMBS structures purchase commercial real-estate loans, often buying from well-established corporate real-estate banks. They purchase by "property types"--office space, multifamily housing, warehouses, etc. 

RMBS SPVs include family home mortgages and have been structured in countless ways, including portfolios with sub-prime loans and payouts to investors in "sequential" or "non-sequential" ways. "Private label" SPVs refer to structures that would not involve the federal agencies purchasing the mortgages or guaranteeing the debt in such SPV structures. 

In both CMBS and RMBS structures, many banks may originate the mortgages, sell them into these structures, but will happily agree to service them (collect the principal and interest from the underlying mortgages), of course for a fee throughout the long life of such mortgages. 

Credit-card structures are sometimes called "flow" structures because receivables run off, but run back on, too, because of the revolving natures of credit-card exposures. The SPVs account for the well known "minimum monthly payment" for credit cards in projecting the cash inflows. 

The portfolio and the risks accompanying it

The “loan portfolio” in a securitized structure is funded by the SPV issuing securities (bonds). The SPV may also have a small equity investment or “residual” (funded in part by the asset manager).  In many cases, to make the bonds more attractive or to conduct analysis on behalf of the bondholder, the SPV will likely need to call upon rating agencies to rate the top tranches of bonds (AAA, AA, A, BBB). It might be possible to sell tranches without ratings, but investors require an expert third party to analyze the extreme risks in the portfolio. 

To rate the tranches accurately, rating agencies use models to quantify portfolio risks, credit-risk deterioration, and worst-case scenarios. Portfolio models focus on expected loss and maximum probable loss in the portfolio. The projection of loss considers many factors and variables—including macro scenarios, correlation risks, concentration risks by loan type or region, recovery rates after loan defaults, etc.  Bond-holders among the highest tranches are collateralized by the loans in the portfolio. (The loans themselves are secured (commercial real estate, e.g.) or unsecured (credit-card receivables). 

Based on the outcome the models, the rating agency determines the amount of collateral cushion required to maintain a tranche rating (AAA, AA, A, BBB, etc.). This is referred to as “over collateralization.” For the most part, the AAA tranche will be collateralized by all assets in the portfolio. The over-collateralization amount is effectively the maximum loss on the SPV's balance sheet before the AAA tranche must absorb a default or loss. In many structures, the AAA loss cushion migh range from 25-35%. (The structure could lose 25% of total assets (from massive defaults in the portfolio) before the AAA investor risks not receiving interest and principal payments. 

Rating agencies perform the detailed stress tests, the scenario testing, sensitivity analysis and and loss analysis. They identify risks in the portfolio and outline the waterfall of payouts to investors (the receipt of principal and interest payments from the portfolio to fund the interest expense and principal payments to the bondholders (“waterfall”)).  The SPV’s asset manager manages defaults, cash-flow deficiencies, and other signs of deterioration in the portfolio.

The process of securitizing loans includes a period of warehousing, where a special SPV is set up to hold assets before they are sold to the final SPV that issues rated bonds. The warehouse SPV typically relies on short-term bank financing to hold the loans or “ramp up.” It was in warehouses where banks found trouble and a deluge of defaults in the Tri-Color case. Defaulting auto loans in the warehouse cannot be sold to the final SPV; hence, banks funding those warehouses absorbed losses. 

As straightforward as the structuring and process might appear, there have been collapses, crises and over-zealous asset managers and sometimes the failure of rating agencies to compute an adequate maximum probable loss. There are lessons learned for investors, participants, bank regulation and even rating agencies. Lessons learned led to new procedures and evolving structures in securitization and may have resulted in limiting the roles of banks.

Emerging markets around the world have have observed the advantages and disadvantages of securitizations and, of course, might benefit from lessons learned. They may see opportunities to expand in securitizations—partly to permit banks to transfer risk to accepting third parties or to sell off assets for liquidity purposes to be able to fund new loans.  

Emerging markets, as part of implementation or growth, will likely have adopted many of the lessons learned as they establish rules, procedures and what kinds of institutions can perform in various roles.  Sovereign governments and/or central banks set rules and expected practices for securitizations.  They also provide the legal framework to permit banks to sell loans to third parties and allow for the formation of SPVs.

Tracy Williams

Analyzing Health Insurance Companies

Health insurance companies have been a focus of attention frequently over the past year for several reasons. How do investors, lenders and ratings agencies analyze these complex organizations?

For many reasons, health insurance companies have roamed news headlines often the past year. There have been single events, there has been outcry from consumers (about coverage and costs), and there have been political debates about the the government's role in facilitating care related to Medicaid/Medicare programs. 

By mid-2025, UnitedHealth eased out its CEO because of an upcoming downturn in performance. Health insurers everywhere are contemplating payouts and claims related to Medicaid and Medicare Advantage programs. CVS decided to withdraw from providing insurance in the marketplace under Obamacare ("ACA") and plans to close hundreds of stores. Shareholders are showing angst by dumping shares, especially vivid from sharp declines in value at UnitedHealth. For the most part, the big names in health insurance are profitable. They reports billions annually. Profits are not growing as expected. 

For all the attention it has received, UnitedHealth still reported net profits above $6 billion in the first quarter, 2025. 

Health insurers, for the most part, are consolidated corporate organizations, mandated to provide benefits to shareholders without taking advantage of consumers and within constraints outlined by government regulators.

Consumers become irritated when they observe large insurers accumulating billions in profits. Shareholders require a return and hope company managers can boost "shareholder value." Shareholder value comes when profit margins widen and when revenue growth soars. Profits grow when costs are managed (or claims paid on insurance are limited and operations are managed efficiently); profits grow, too, when premiums increase--either from volume of customers or from the price of insurance.

Shareholders, bank lenders and bond investors help fund the activities of insurers, which goes beyond mere medical insurance and includes additional activities like providing actual health services or managing retail stores (CVS, e.g.). While consumers seek care and insurance and want assurance that exorbitant medical costs will be covered, shareholders and other stakeholders look for a predictable flow of earnings, operating cash flows and returns.

The insurance model is influenced by many categories of risk—including underwriting and claims-paying risks (medical costs), pricing risks related to the premiums received from customers, investment risks in a portfolio of securities, and operating risks related to business operations. Risks evolve over time, and companies seek to expect them, measure them, and manage or contain them.

Analytic approaches

To analyze a health insurance company requires an understanding and analysis of balance sheets, earnings statements and operating cash flows. It also involves understanding the essentials of insurance-related accounting and financial reporting. There is insurance accounting subject to IFRS and GAAP standards, but there is also insurance accounting for statutory purposes (accounting standards used by insurance regulators). Just like bank and broker/dealer regulators, insurance regulators (under the supervision of the NAIC in the U.S.) prefer to examine conservative, stress-scenario balance sheets and earnings.

The financial information is interpreted and analzyed as a basis for quantifying risks and forming conclusions about financial condition. Shareholders, beyond earnings growth, look for  the prospects of a steady dividend and occasional share buybacks. Lenders and debt investors look for assurance that debt interest and principal can be repaid or the debt can be comfortably refinanced (or debt can be refinanced with no difficulty). Insurance regulators are more concerned about the insurance company's ability to make payments on claims. For health insurers, that would be medical and drug costs of all kinds.

Debt investors may rely on the analysis and interpretations of ratings agencies, which provide ratings, updates and perspectives on the bonds issued by insurance companies. They also provide ratings on the ability of the same company to pay out claims for the benefit of policyholders ("financial strength" ratings).

In 2025, health insurance companies in the U.S. must address widespread public and consumer concern about high price of coverage and the uncertainty in whether the company will actually provide coverage or pay on a claim. (Some argue the "denial of claims" is an inherent part of the business model. Insurance companies maximize earnins on the underwriting side by boosting premiums and managing operatingcosts, but also by effectively minimizing the amounts of claims paid.)

There are also ongoing consumer worries about government regulation and legislation related to Medicare/Medicaid, trade policies, drug prices, rising healthcare costs, costs related to medical devices, and more. In 2025, there are GLP-1 (obesity and diabetes-related) drugs; insurance companies grapple with strategies related to coverage (premium pricing, expected medical costs).

The income statements and balance sheet of a health-insurance company are similar to other insurance companies, subject in similar accounting rules and principles. IFRS and U.S. GAAP accounting standards may differ in presenting financial information. Insurance accounting focuses especially on the accounting for the risks and expected amounts of  claims during the current period and over a defined time period. Life insurers must account for a potential payout that may occur decades from now, is not known and can only be estimated. Health insurers have expected medical-cost payouts over a current period, but may have expected payouts over a certain time. Accountants require insurers to quantify these payouts (amounts paid and amounts expected to be paid out) and report them as liabilities and expenses on the income statement. 

Compared to other insurance companies, the products health insurance companies offer and the risks they assume will differ from other insurance groups (P&C insurance, life insurance, e.g). In all cases, by convention, insurance companies are paid for the risks they accept by generating premiums and seek to increase earnings and bolster returns for shareholders from growth in premiums. All insurance companies want to ensure their premiums received cover their expected and actual payouts (as well as operating costs). 

In all cases, they must measure and project the payments they make on claims. The projection of payments is based on historical data, but other factors as well (demographics, use of insurance, regions, government regulation, etc.). 

Most insurance companies supplement the underwriting businesses with other sources of income. Life insurers offer retirement services and asset management; some in the past have ventured into securities brokerage. Health insurance companies, like CVS, manage a well-known retail (drug) store operation. UnitedHealth Group provides medical insurance, but also offers health services. Hence, it provides insurance for customers who might be serviced by a medical center it also controls. It might provide drug coverage for a customer who purchases the drugs at a pharmaceutical network it runs. 

All insurance companies address the challenge in determining how to price premiums and how to ensure they adequately cover medical costs in current periods and over extended timeframes. Premiums often do cover medical costs and operating costs, which explains why many well-known insurers are consistently profitable. But health premium pricing is often restrained by competitive factors and by regulation. Government bodies and regulations seek to ensure premiums are fairly priced. 

If the company provides coverage, for example, for those who fall within U.S. Medicare and Medicaid programs, U.S. regulators might cap premiums to put a limit on the profit margin the company might generate.   

Like all companies with shareholders, management adopts and implements strategies (by products, risks, regions, e.g.) based on the ability to be profitable and ensure a proper return to shareholders. Like all, shareholders seek not mere profits, but value from profit growth and the possibility of consistently and sometimes increasing dividends. 

Like all insurance companies, health insurers attempt to grow premiums earned, understanding there will be risks and predictable payouts of claims ("costs" on the income statement). Unfortunately, for the policy holder, the textbook insurance model recognizes profit growth if claims are denied or if claims are paid out at amounts less than expected. 

Expected medical costs are especially difficult to model and forecast. The related costs are difficult to quantify, sometimes appear irrational and unexplainable (to consumers), and just seem to soar uncontrollably from period to period.

On the other hand, across all sectors, insurance companies must also prepare for and manage the risks of unexpected risks or extraordinary loss or costs.

Investment portfolio risks

The insurance business model includes an investment portfolio. This applies, too, for health-insurance companies. Premiums are generated and funneled into a portfolio of securities and other investments, where they can generate returns until investments are liquidated to meet claims. Hence, many insurance companies of all kinds supplement insurance operations with investment income. Often the income includes coupon interest received from bond investments. Insurance investments may also include equity securities, loans, mortgages, and other classes of assets--subject to scrutiny from regulators. 

However, investments are subject to liquidity and market risks, which are managed by the company and reviewed by analysts.

Insurance companies invest most of the funds into high-quality fixed-income bonds. However, when interest rates rise, as they have done in recent years, the values of those bonds fall. Hence, many insurance companies have suffered bond-related losses and have had to develop strategies regarding reducing related holdings. 

Even if performance is satisfactory or good (returns are above expectations), they must ensure investments are liquid—can be easily sold when cash reserves are necessary to meet claims obligations.

The analysis of the investment portfolio includes an analysis of worst-case market scenarios (worst-case losses) and analysis of liquidity under stress.

Just as with banks, regulators intervene to ensure the company doesn't take too much investment risk. While most insurance companies invest in somewhat "safe" assets (government securities, municipal bonds, investment-grade corporates), others are willing to take risk: investments in higher-returning securities that will supplement the earnings from the insurance side of the business. Or investment returns could offset the losses from the  insurance-underwriting operation. 

Health insurers often supplement the insurance activities with ancillary business activities, such as providing health services (not just insurance) or selling pharmaceuticals (not just drug insurance). They tend not to rely as much on the returns from an investment portfolio as other insurance companies (especially life insurers).  But those other businesses come with their own risks, including risks operating inefficiencies and decline in customer demand for the services. 

Regulation

Like many other financial institutions (including banks and broker/dealers), insurance companies are highly regulated. Regulators and supervisors seek to ensure that customers are protected against significant, unexpected losses. (In the U.S., states separately regulate the insurance industry, but states have agreed to implement regulation consistently across the country via the National Association of Insurance Commissioners (NAIC).) 

Insurance companies project loss and payouts, based on expected-loss models, based on historical payouts and demographics and regions. Regulators step in to determine what would be unexpected loss losses far beyond what a company might have forecasted. For P&C insurers, that would be classifed as "catastrophic" losses, exceptional losses when there are hurricanes or California wildfires. For health insurers, that might be losses that occurred during the pandemic of 2020. Few health-insurance models in 2021 would likely have accounted for the widespread medical costs because of CoVid. 

In insurance, regulators still want to ensure the company has means and resources to pay those expected losses---claims and meet other operating liabilities on an ongoing basis. Similar to banks and broker/dealers, unexpected losses should be absorbed by shareholders. In essence, in the way bank supervisors want to protect depositors, insurance regulators want to protect policy-holders. 

Therefore, based on balance-sheet information and other off-balance-sheet risks, regulatory capital is based on a computation of unexpected losses from underwriting risks, investment risks, interest-rate risks, operations risks and other factors. “Unexpected loss” is determined by regulatory assumptions and methodology. Insurance regulators revise financial information and require more conservative approaches in presenting a balance sheet and income statement (statutory accounting principles).

Shareholders, therefore, are supposed to absorb the unusual losses, not the policy-holder (and not any supplier, vendor, or senior lender, for that matter).   Insurance companies are expected to maintain capital in excess of minimum requirements. In the U.S., insurance companies are regulated by each state. An alliance of state regulators (“NAIC”) permits insurance regulation to be consistent across states.

In practice, insurance companies will be organized by holding companies owning several insurance subsidiaries. Each insurance subsidiary would be subject to regulatory requirements.

Rating agencies, including Fitch Ratings, often use their own internal models to determine appropriate amounts of capital to absorb worst-case losses. (Fitch uses a “PRISM” model.)

Financial analysis

The financial analysis of an insurance company often blends approaches in analysis of a financial institution (capital adequacy; investment portfolios and sufficient liquidity to meet claims payments) with an analysis of a corporate enterprise (consistent operating cash flow to meet long-term debt obligations).

Insurance companies use long-term debt to support infrastructure, fixed assets, expansion, growth and acquisitions. (Life insurers may use debt to leverage the investment portfolio to enhance returns.)

The analysis entails the analysis of revenue growth, cost control, operating efficiencies, and returns on invested capital. Most revenues are generated from net premiums. Health insurance companies may also generate revenues from other sources: health services, products, pharmaceuticals, etc. The non-insurance business activities, essential to supplementing insurance revenues, can vary, based on corporate strategies. Large companies may have substantial stakes in companies that act as pharmaceutical intermediaries, "pharmaceutical benefit managers" (PBMs) who decide how and where to distribute drugs manufactured by drug companies. 

For non-life insurers, profitability is also measured by “combined ratios” that measure whether premiums can cover claims, reserves and operating expenses comfortably. Operating losses may occur because claims are higher than expected or operating expenses have risen substantially.  Ideally, to generate returns that please sharesholders, company management may target a "return on invested capital" to exceed, say, 13%. And to reach 13%, it may strive to maintain a "combine" ratio of less than 90% (10% implying pre-tax margin). 

The investment portfolio should generate returns that supplement underwriting earnings or offset underwriting-related losses. But the portfolio itself is subject to market risks that can result in losses that might eliminate underwriting profits. No matter the efforts to invest in "safe" assets, market risks exist, as many insurers observed in 2023-24 as rising interest rates led to billions in losses in "safe" U.S. Government securities or investment-grade corporate bonds. 

Life insurers are not generally assessed based on the same combined ratio; therefore, returns from the investment portfolio are critical to overall profitability. That might lead some insurers to take on more risk to achieve higher returns. Life insures must still generate necessary income (usually interest income from fixed-income portfolios) to keep up with growing levels of liabilities (future payouts to beneficiaries of life insurance, e.g.). 

Because investment income is necessary to boost profitability, life insurers might even use long-term debt to "leverage" the portfolio, achieving higher returns relative to the capital invested in the enterprise.

In recent years, prospective investment funds and other institutions have observed "value" in a life insurance's asset-liability structure. The company's balance sheet is viewed as an "investment vehicle": a large investment portfolio counterbalanced by  the expected payouts to beneficiaries. They compute the "embedded value" of the life-insurance portfolio, accounting also for the premiums that will be continued to be paid over a long term. (Embedded value = (present value) premiums earned each year + expected annual returns in the investment portfolio - accrued interest on benefits liabilities and policyholder deposits - beneficiary payouts.) 

Such funds or institutions will acquire a life insurer or the net assets related to embedded value, not to become life-insurance operators, but to get access to the portfolio and to have the ability to reallocate assets in the portfolio based on market opportunities. 

For all insurance companies, in the analysis of debt, analysts review the purpose of debt and assess whether leverage is too high based on metrics and based on whether cash flows are adequate to cover related obligations (especially interest expense). In general, most companies will seek to refinance long-term debt at maturity.

Cash flows from operations (after payment of claims and infrastructure expenditures) will be funneled into the investment portfolio, but may also be used to fund growth and expansion and reward shareholders via dividends or share buybacks.

At such point, as with the assessment of corporates, the assessment of an insurer becomes an observation and projection of cash flows. For public companies, it too becomes of an assessment of what is the best and most prudent use of operating cash flow: reinvest in the operation, maintain cash reserves for emergency purposes, pay out the cash as rewards to shareholders (dividends and buybacks). 

Tracy Williams 

See also:

Valuing banks and financial institutions, 2024

Financial rumbles in Silicon Valley, 2023

Corporate debt analysis: updates and topics, 2021

Financial analysis: back of the envelope, 2020

Corporate debt analysis, 2020

Valuing Banks and Financial Institutions

In recent periods, Bank of America's share price is trading 1.29 times its book value. 

Bank analysts and equity analysts, those involved in performing valuings of the share ownership of a financial institution, must often determine the right model or the right methodoloy to use. Often the value of the equity of a corporate balance sheet, at least the intrinsic or market value, is based on an assessment (or valuation) of the company's earnings or free cash flows (the widely acknowledged discounted-cash-flows approach). The analyst presumes the business is an ongoing concern and that cash flows can be projected and generated into perpetuity. 

There can be other ways to value the firm (liquidation value, for example), but the conventional corporate-finance approach equates shareholder value with the value of future cash flows to which owners are entitled. 

Those familiar with "discounted cash-flow" approaches to valuing companies know the historical methodology, which requires projections of operating cash flows (or free cash flows) into infinity or at least to a terminal date. And it requires determining the "cost of equity," the return required by rational shareholders relative to the returns they could receive from investing in high-grade sovereign bonds and taking into account "beta," a factor that compares the company with current equity-market returns (and volatility). The business-school textbooks refer to this as the "Capital Asset Pricing Model," or "Cap-M."

A primary challenge in this approach is tackling the challenge of projecting cash flows into an indefinite future and valuing the same cash flows. How best should an analyst project cash flows for an enterprise ten years from now? Twenty years from now?  (Valuation analysts "solve" that problem partly by assuming that a company has a "terminal value," about five years from the point of projecting cash flows. They then attempt to value the business at that point.)

Equity analysts, in turn, might seek to determine whether this approach is relevant for financial institutions, or for the most part, banks. 

Often financial institutions or entities that have financial assets on their balance sheets will be subject to a different type of valuation analysis--less of a future-cash-flows approach and more related to the values of the net assets on the balance sheet.  That would be within the category of a "relative-value" approach by observing current market-related metrics for a select group of institutions to determine the value of a specific company or institution. 

That's not to say the discounted-cash-flow approach is ignored or disregarded in the analysis of banks, broker/dealers, funds, or insurance companies. 

One common approach is a MV/BV-multiple approach.  The focus of valuing a financial institution is based on relative value based on common or expected ratios of  MV/BV (market value to book value). The book value is commonly based on "net assets," or "assets minus liabilities."

We could indeed show the discounted cash flow approach is applicable, because shareholders desire earnings and cash-flow growth for rewards.  Financial institutions generate earnings and, in various ways, generate new cash flows. Shareholders ultimately desire cash returns, whether they are received regularly (via dividends, for example) or generated when they liquidate the investment (when they sell their holdings). 

Therefore, it wouldn't be a chore approach the valuation based on cash generated from business activity.  The discount rate (expected return rate) has impact on the equity valuation. 

Yet the discount rate (tied to prevailing interest rates) also impact on the value of assets on the balance sheet of a financial institution. If the discount rate rises, cash-flow valuations fall. But similarly, if interest rates rise, the values of many of the financial assets on the balance sheet fall, too (fixed-income bonds in the investment portfolio, most notably). 

In general, a financial institution ought to be at least as worth its book value. Accountants, more now than ever in updated accounting standards, attempt to present the balance sheet of a financial institution based on the "fair value" (or something like market value) of the assets and liabilities on the balance sheet. We, too, must note that for financial institutions, there can also be the changing fair value of liabilities: "short sales," derivatives payable, e.g.

But we may consider factors that explain how and why its market value can exceed the book value (liquidation value). For valuation purposes, book value doesn't include funding sources (preferred stock, subordinated debt., e.g.) that would be considered "Tier 1 or Tier 2 capital" for the purpose of bank regulation. Book value would be equivalent to common shareholder's equity reported on the balance sheet. 

While book value is based in part on the value of net assets on the balance (assets minus liabilities), most of those assets are financial assets (investments, trading positions, loans, loans held for sale, derivatives receivable, e.g.). As mentioned, many of those financial assets are already valued (investments, trading positions, securities owned, etc.) at market value (based on fair-value accounting). For some financial assets (commercial and corporate loans), financial institutions may be permitted to account for them based on "cost," if they asset is "held to maturity." Most loans on bank's balance sheet are reported in such matter. Otherwise, the book value should reflect closely to the market value. 

Often we want MV/BV > 1.0, and we need to understand and explain when MV/BV < 1.0. Bank equity analysts like the benchmark of the financial institution's MV/BV >  2.0.  We explore factors that explain why the firm could be worth more than its book value. Some of the financial assets might be over-valued, some might be reported based on cost and not fair value or market value (loans and some investments in bonds, if they are held to maturity).  

However, if the financial institution has substantial businesses and services that are not directly linked to the balance sheet (advisory businesses, asset management businesses, other services), those factors can increase MV relative to book value. They provide revenues or fees that are in addition to the value we see on the balance sheet. Those cash flows have value that help push the MV/BV above 1.0. 

Large banks, therefore, with substantial investment-banking activities are expected to have MV/BV > 1.0 and approaching 2.0.

In November-2024, note the MV/BV ratios for some prominent financial institutions (mostly large universal banks with substantial fee-based revenue sources): 

CITIGROUP: 0.67

BANK OF AMERICA: 1.29

GOLDMAN SACHS: 1.77

MORGAN STANLEY: 2.28

JPMORGAN CHASE: 2.11

REGIONS: 1.41

PNC: 1.48

USBANCORP: 1.61

THE TRAVELERS: 2.08

In some cases, we see MV/BV < 1.0.  Often analysts and observers will argue that if the market value is less than book value, the institution's owners are better off if it is sold in parts (selling parts of the balance sheet or selling the subsidiaries or business units) than if it remains consolidated. The market may be "perceiving" or assessing that the institution combined is riskier than if the integral parts are sold off and operate separately.

For years, analysts argued the same about Citigroup. They suggested the market right-size-valued assets on the balance sheet (loans, investments, trading positions) for valid reasons. There is more risk on the balance sheet than what is implied on the accounting statements. That risk is reflected in the market value. Perhaps the market sensed the assets on the balance sheet would later be subject to write-offs or write-downs that accountants (and regulators) have not yet accounted for. 

Even as of mid-November, 2024, Citigroup continues to be valued less than book value, although its CEO Jane Fraser has worked aggressively to improve its balance sheet and shed assets and operations that were vulnerable or non-profitable, especially in its international businesses. Performance has improved over the past year, and the balance sheet is indeed stronger. Market participants may be looking for an extended track record of performance. 

For the institutions above, JPMorgan and Morgan Stanley have market values exceeding 2.0. That might be explained not just by having "cleaner" balance sheets, but also by the substantial income sources (and cash flows) from advisory businesses. Both institutions are prominent in investment banking and asset management activities. Asset management cash flows generated consistently for years to come would certainly enhance their market values. Those expected cash flows have value. 

For the past eight years, JPMorgan has generated at least $15 billion in asset-management revenues, cash flows that aren't recognizable on the balance sheet and cash flows that are highly considered in shareholder valuation. For the past 11years, JPMorgan has generated at least $6 billion in investment-banking fees, also considered in shareholder valuation. 

Goldman Sachs may be penalized, in part, because of risks and losses in its bungled effort to grow its consumer businesses. Consumer loans still reside on its balance sheet, and all potential losses from that segment may not have been flushed through. Trading income also contributes more to net revenues at Goldman (over 30% annually) than for all of its peer. Markets may account for the expected volatility in trading income and the difficulty in keeping trading income stable and predictable over the long term.  (Trading income at Goldman, meanwhile, has been at least $10 billion annually the past five fiscal years.)

In valuing an institution based on MV/BV multiples, we would normally compute the range for many similar financial institutions to determine at least (as of the moment) how the market is valuing an institution's balance sheet and the possibility of non-balance-sheet activities. And then we would determine what the right multiple to use for the specific institution we are analyzing. 

Now as for insurance companies, we might consider a cash-flow approach, but also examine the MV/BV approach because a substantial amount of the assets of an insurance company are funnelled into investments and marketable securities of which much will likely be accounted for at fair value. Accountants also require (at least for life insurance companies) that future liabilities (benefits to policy-holders) be adjusted regularly to be reported at fair value. 

The insurance business model is certainly a cash-flow business--cash inflows from premium payments and cash outflows to pay claims. (Accountants (especially IFRS accounting) are pushing to show the value of such cash flows on the balance sheet.) At the same time, the insurer's balance sheet can flucutuate daily because of market volatility in the investment portfolio. 

In the examples above, The Travelers, an insurance company, reports MV/BV = 2.08--a multiple that reflects the risks and values of an $80 billion investment portfolio, but also incorporating the high-probability future cash flows from its property-and-casualty business.

Valuation professionals will review all possible approaches before selecting what they consider they correct value of an institution. (Investment banks present that in a "football field" grid to show all possible values for a business or institution.) That means examining relative values, MV/BV, discounted cash flows, dividend models, liquidation values, and more. 

There is no one approach, but in the end, there might be favored approaches. 

Tracy Williams 

See also:

Basel III Endgame, Feb-2024

JPMorgan Acquires a Failing First Republic, June-2023

Financial Rumbles in Silicon Valley, April-2023

Deutsche Bank: Turmoil and Concern, October-2016

Dimon at JPMorgan Prepares for a New Crisis, April-2020

Easing up on Bank Stress Tests, March-2019

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