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| In a banner year for trading, Goldman Sachs could generate over $12 billion from trading net revenues |
Global finance is treading water while managing a global pandemic. Surviving better than expected. After an initial period of shocking disbelief, banks and businesses are now operating in markets, doing business, selling product, issuing debt, and engaging in trading in capital markets. It's as if we have entered a phase of a "CoVid-normal"--a scenario described by players assuming the threat of CoVid-19 will be here for at least another 18 months.
Economic and government statistics lament increases in unemployment and decline in GDP. (In the U.S., unemployment hovers about 8-10% and GDP is expected to decline 5% in 2020.) But business activity, banking transactions and trading markets hum along. There has been financial carnage everywhere--bankruptcies, shutdowns, and massive restructuring. But most participants, while struggling and recovering, have adapted.
Banks Are Surviving Well
Banks across the U.S. have survived well after initial speculation of massive loan defaults, operating losses and severe capital erosion. Most medium- to large-size banks have managed through this crisis, where in that last crisis, financial institutions were pummeled.
Banks had to boost loan-loss reserves to prepare for the long-term impact of the pandemic. They also had to increase loan-loss reserves to respond to new accounting rules--"CECL"--that require them to project loan losses far more conservatively.
CECL--"Current Expected Credit Loss" increased loan-loss reserves in the first quarter for publicly traded U.S. banks. At the same time, banks were forced to add to reserves to deal with CoVid-related deteriorating quality in their loan portfolios. Wells Fargo, through June, increased its loss reserves from $9-19 billion in the first half, 2020. Citi increased its reserves from $12-21 billion.
In 2020, banks are anchored by stronger balance sheets, less leverage, and tiers and tiers of additional capital. U.S. Dodd-Frank and Basel III requirements boosted the capital cushion they all needed to get through this unexpected scenario.
No one anywhere envisioned a pandemic in 2020 (at least on the massive, global scale we've endured). Hence, banks have been able to build reserves while still maintaining excess capital (and still paying dividends). Increases in reserves subtract from earnings and capital. But large capital cushions (because of regulation) help banks to absorb these modest hits.
Bank stock prices plummeted and have been volatile all year, even as banks have proven to be strong enough to endure 2020. Bank supervisors are less worried about share values, because they assess a bank's "book capital" more closely than "market values." Investors may dislike the fact that U.S. regulators have prohibited bank moves they normally enjoy in good years: stock buybacks and dividend growth. Early in 2020, U.S. bank regulators stopped buyback programs and prohibited increases in dividend payouts.
The Federal Reserve rolled out the results of its stress test in June, the exercise applied to the top 34 bank entities operating in the U.S. That stress test was based on a "severely adverse" scenario, quite similar to the scenario we are living through in 2020. But its stress test presumes what we are enduring now will continue for about two years more.
The test and the Federal Reserve's models attempt to predict worst-case losses at banks and check whether they can continue to be "well-capitalized" by regulatory standards. Most banks passed this test adequately. Projected losses were computed to reach enormous levels--about $47 billion in loan losses at Wells Fargo, for example. But large banks among the peer group that includes Wells Fargo each maintain equity capital near $200 billion.
In this current crisis, JPMorgan Chase has now eclipsed $3 trillion in assets, almost $2 trillion in deposits. The atmosphere is far less gloomy among the top-tier ("too big too fail"?) banks than it had been in late 2008.
The Federal Reserve gets the last word, as usual. In the midst of 2020 it altered capital-requirement rules by tying minimum-capital requirements, in part, to how banks fared in its test. (It has now implemented a new, incremental "capital stress-test" buffer.) Stumble in the stress test; then you are required to hold incrementally more capital.
For banks, third-quarter numbers are about to be reported, and there aren't signs of trouble. If there have been notable increases in loan defaults and losses, they should have been be accounted for and projected in the first and second quarters during the re-calculations of loan-loss reserves.
While this has been a year of caution for banks on the lending side, banks all over the country (and in all sizes) have had to manage responsibilities in booking loans under the under the U.S. Government's PPP and U.S. Cares Act programs. Some argue banks have encountered operational risks (processing and cybersecurity risks) in these programs, rather than funding and credit risks.
Banks everywhere have whispered this has been a money-losing operation (low spreads, high operating costs), even as the program has had favorite impact and the Government accepts credit risk. Otherwise, banks are having a banner year for big banks on two fronts: (a) deposit taking and (b) trading.
Retail and corporate depositors are comfortable with the soundness of banks (along with FDIC insurance), have increased deposits substantially, and have permitted banks to accumulate cash that helped support PPP lending, corporate loan growth and increases in investment securities portfolios. (JPMorgan announced it had booked over $25 billion in U.S. Cares Act loans.)
All the activity, flurry of trading, and volatility in capital markets mean big trading banks have massive opportunities to make money with such volume. Trading at big banks is practically a function of volume and volatility. (The big banks engage in trading and rely significantly on trading to contribute to total net revenues. Beyond the top 10 banks, few banks engage in trading (market-making) across all risk classes.)
Markets move, investors want to switch out of and into other asset classes, and banks make money doing the trades. In the first half, 2020, JPMorgan generated $5.3 billion in trading gains; Goldman Sachs is on a pace to generate more than $12 billion in trading for the year.
As the Federal Reserve pushed down interest rates to near-record levels, the move encouraged bankers to nudge their corporate clients to issue long-term debt raise cash for uncertain business activity, of course, but also to take advantage of low funding costs. From quarter to quarter, some banks have racked up enormous feeds to help corporates issue record levels of bonds.
Corporates: A Different Story
Among corporates, the story must be told in tiers, different chapters. The big have gotten bigger and stronger. The vulnerable have disintegrated or disappeared. The middle of the pack, while floundering, are managing to endure while hoping for better days if and when post-pandemic days arrive.
Market observers everywhere have tried to explain the surprising performance of stock markets. In the year that everybody wants to forget, equity indices are up.
But remember, stock indices reflect the outlook and current performance of large and mid-size corporates, not the thousands of smaller and middle-market businesses that have struggled or collapsed in the pandemic. There certainly has been a large roll call of well-known, large bankruptcies, but almost all were names that were
(a) in industries that were about to disappear or were in transformation before 2020,
(b) were poorly managed or bet on dubious growth strategies, or
(c) were simply too enormously highly leveraged after having been blinded by near-record low interest rates.
After a first-half roll call featuring Hertz, Neimann Marcus, J.Crew, Brooks Brothers, and JCPenney, who's next? Is a Macy's filing just around the corner? There has seldom been a time when a bankruptcy filing was less of a stigma.
Otherwise, the corporate story in 2020 is mostly an industry story: Vulnerable industries, dying industries, thriving industries, industries exploiting the current environment, and industries that will do fine regardless of a pandemic's impact.
Beyond the industry story, it becomes a story of balance sheets, cash on hand and capital structure. What companies are suffering for having too much debt, despite the low cost of debt? What companies prepared well for worst cases and stockpiled cash on the balance sheet and managed tolerable amounts amounts of debt?
Beyond the balance-sheet story, it might be a management story: How are current business leaders adjusting, changing tunes, tweaking operations, and managing a workforce for the next 18 months?
Just check stock markets, and we see how well the familiar tech names are doing or at least see the favorable impression investors have for them (Apple, Google/Alphabet, Amazon, Facebook, etc.). There are notable stories of companies reporting exploding revenues because of the pandemic (Zoom, Netflix, e.g.). But the corporate space is dotted with names that six months into the pandemic will see no bright horizons for a long time (airlines, travel and entertainment companies, hotels, etc.).
A recent issue of the Economist identified another segment: Zombies, non-investment-grade companies that have avoided bankruptcy, but are proceeding aimlessly, showing few signs of growth, but operating at bare bones just enough to remain solvent.
The pandemic kick-started debt markets and spawned companies' renewed love affair with leverage. Banks saw companies with revolving-credit lines borrow almost to their limits. Everywhere, from General Motors to middle-market borrowers, companies that hardly used these lines in the past tapped them to prepare for the worst. Meanwhile, after the Federal Reserve clipped rates to near zero, many of the same companies decided to reduce some of the R/C loan outstandings by issuing new public debt at enticing near-zero rates. Investment banks salivated at the opportunity to help them.
Bank lending appears to have leveled off since then, and third-quarter bank balance sheets might show a slight decline in loan totals. Bank loans at JPMorgan Chase topped $1 trillion in March-2020, but fell to $979 billion in the second quarter. Bank of America also touched $1 trillion in gross loans this year, but will likely report less than $990 billion in the third quarter.
All in all, debt and equity investors appear to have combed through the markets and identified winners and losers. And perhaps hangers-on (Zombies).
Beyond the periodic spikes in equity volatility for corporate names in public secondary markets, there is the new-issue market--IPOs. The IPO hasn't disappeared in 2020. After a crash of equity indices in March and after a period of digesting what hit everybody in the first quarter, the IPO market re-emerged. New companies and their investment banks decided to march ahead and stay the course in plans to go public.
The New York Times reported the third quarter, 2020, was the busiest IPO quarter in 20 years (81 new offerings). That includes a recent and closely watched Palantir Technologies deal. Bankers and executives Airbnb and DoorDash have queued and are preparing for the next wave of equity offerings. Major investment banks (the JPMorgans, the Citis, Morgan Stanleys and Goldmans) are enjoying exceptional years trading securities and derivatives, as well as issuing new debt and new equity.
(A new trend, "direct listings," has surfaced, which could hurt banks' roles in IPO. This approach, popular in Silicon Valley, permits companies to go public without the underwriting roles (and the related enormous underwriting fees) of major investment banks. For the past 15 years, tech-savvy companies have been exploring ways to circumvent the traditional IPO-underwriting process when going public. Banks still must assist in the early due-diligence and SEC registration process.)
In late 2019, this kind of confidence and flurry of banking activity would have been projected and highly expected. In late March, 2020, this confidence disappeared, but had re-emerged cautiously by September.
Don't Forget CLO Markets
One market niche shouldn't be forgotten: CLOs, or Collateralized Loan Obligations, securitized structures backed by portfolios of non-investment-grade corporate loans.
Contemplate what those loans could be. When structured, they include B+-rated secured loans under the premise that these corporate borrowers, while generating uncertain cash flows from operations, can still meet debt-servicing requirements. Investors like the high credit spreads on the loans and the fact the loans are senior and secured. They take risks, but the risk-taking is "tranched," because CLOs issue securities rated from AAA to B.
As long as these non-investment-grade names names are surviving and as long as the collateral is evident and valued (and legally perfected), investors in CLO tranches and securities can enjoy reasonable returns, sometimes slightly better than if they invested in AAA-to-B bonds elsewhere.
But in 2020, non-investment-grade names, almost by definition, have struggled. Some slipped quickly into default and bankruptcy. Others are similarly vulnerable.
Could there be increasing levels of risks for the investors, traders, and risk-takers who have bought these bonds? A CLO portfolio with 100-percent in B-rated corporate loans in September, 2020, might have 10% in C-rated loans or a sprinkling of defaulted loans in the portfolio. CLOs, remember, are structured such that investors who take risks are tiered ("tranched"). Lower-tranched, equity-residual investors or BBB-rated tranches will absorb losses on the portfolio sooner than the AAA-tranched investors.)
Yet a portfolio of CLO loans will certainly not be performing as strongly as the same portfolio a year ago. What do the data say?
In normal years, the default rates of a portfolio of CLO loans might average about 3%. That won't be the case in 2020, where default rates, in some deals, could top 10%, if they haven't already. Before the pandemic, industry analysts indicated about 11% of CLO portfolios included loans classified as "negative watch" by regulators. That, too, has increased substantially as 2020 runs its course.
Industry analysts focus on the percentage of the portfolio rated CCC+ or below. When the CLO is initially structured, the portfolio might include a small amount of CCC loans (about 5-6% when first structured) Over the life of the CLO, investors, traders and analysts track trends in CCC and below. Debt rated CCC or below, of course, will have significantly higher default probabilities, which will have impact on pricing and desirability of CLO securities.
CLO investors are protected, too, by diversity in the portfolio. A typical U.S. CLO may have as many as 250 loans in the basket, helping to reduce concentration by names, but not necessarily by industry. There is also the risk of "correlation"--that independent loans in the portfolio may be subject to default correlation. (They default unfortunately all at the same time.) Because so many different names and industries are vulnerable to the pandemic, correlation risks are real.
Three Months to Go
The year is not over. And the impact of 2020 apparently will carry over into 2021. Expect markets to continue to be volatile. Expect interest rates to continue to remain low. Expect banks to remain in solid shape, notwithstanding their disappointing share prices and the quarterly upward blips in loan-loss reserves. Expect another round of announced bankruptcies of household names. Expect the expected.
Tracy Williams
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