A year ago, CoVid-19 was a slight blurb in the news, a vague, remote threat. Not many, if anybody, anticipated the avalanche of unfavorable events in 2020.
Yet strangely by the end of the year of such vast tumult, equity markets had a bustling, favorable year. In a year when the GDP of almost all sovereigns (except China) reported declines in economic activity, big banks around the globe survived and even made reasonable amounts of money. Many U.S. banks were able to get through the year without having to cut dividends in the way regulators seek for them to do in economic downturns. (Within days, many of the top five big U.S. banks will report annual net earnings exceeding $10 billion each.)
Markets, although volatile in upsetting ways at certain times, functioned. Recall during the financial crisis of 2008-09 there were days when the global financial system was in jeopardy, days when some market sectors stopped function (commercial paper, e.g.).
In 2020, debt markets (loans, bonds) were active, as many companies increased borrowings in response to a global recession (the better to have cash reserves now than to scramble for them later). Investment bankers, while mostly working at home, hustled to execute crammed deals calendars.
In a year where it might have been hard to rationalize or predict any kind of favorable activity, IPOs and M&A activity resumed brisk paces after earlier in the year bankers paused to survey and worry about the oncoming the financial landscape.
So now what's on the table for 2021--beyond the expected transition in Washington and continued efforts from government and corporate leaders to do all possible to flip the trends in global economies?
Bank Loan Portfolios and Borrower Defaults
Banks survived 2020 partly because they had ample capital as cushion for losses, as prescribed by mid-2000s regulation. They braced for the worst and boosted loan-loss reserves early on and reviewed portfolios carefully for vulnerabilities.
Losses occurred in portfolios, but banks weren't blind-sided. In the U.S., most banks will report decent 2020 earnings and many didn't reduce portfolios; they increased lending. Some of that, of course, is related to their support of government programs. Some of that is related to corporate borrowers' increasing outstandings under revolving facilities. By late 2020, because public debt markets hummed along, many corporate borrowers would eventually refinance bank debt in an active bond market with low interest rates. Such was a funding game plan observed among medium-to-large corporate borrowersin the U.S. and in other developed countries.
Banks will continue the same march in 2021: Prepare for losses, maintain reserves and please regulators with ample capital.
Banks, too, benefitted from being able to modify loan terms, permitting borrowers to defer principal due or agree to other loan-forbearance arrangements. All that means is for some struggling borrowers, instead of defaults and charge-offs, borrowers' payments are postponed, delayed or appended to the end of the maturity dates. That helps banks maintain loan-portfolio quality (or at least reduce charge-offs).
While corporate loans increased during the year, while consumer borrowing was stagnant. The demand for the latter decline, as individuals avoided spending or weren't employed long enough to engage in pre-2020-like spending. Credit-card receivables at many U.S. banks declined--partly as banks managed these unsecured risks, partly because borrowers had lesser need to use the lines (for travel, at restaurants, e.g.) than in previous years.
In 2021, loan portfolios will likely grow modestly as the whole world digs out from the abyss of a pandemic-ridden 2020, but banks will still be cautious, aware that the old normal still won't return at least until late 2021 or early 2022.
Low Interest Rates
Once the pandemic struck and proved to be around for the long haul, central bankers everywhere leaped to respond to retrigger economic activity.
In the U.S., that means the Federal Reserve Bank. Around the world, that ordinarily implies other countries and central banks will have closely watched the behavior and actions of the Fed and will attempt to adopt something similar.
The Fed reduced interest rates to near historic lows from short-term to long-term across the yield curve. A reignition of economic activity (measured by GDP trends) would require low borrowing costs. Rates across the spectrum (U.S. Treasuries, investment- and non-investment-grade corporate (Libor, e.g.), mortgage rates, etc.) plummeted and have remained low since March.
Corporate borrowers swarm toward low interest rates and sometimes borrow even when they don't need to. In 2020, some of the borrowing is rationalized by a contingency plan to boost cash reserves in an economic downturn: Borrow now when you can, put the cash in reserves, and prepare for worst-case scenarios when business revenues disappear, but tend to expected and unexpected operating costs .
Before 2020, some large corporates had begun to reduce leverage (pay down debt and reduce the burden), while anticipating rate increases. Corporate debt sprouted by late March and has leveled off since then. Demand for debt increased, but it certainly helped that banks and debt markets (investors) accommodated them. (Many large U.S. corporates reached borrowing peaks in June, but have reduced marginally since then.)
In 2021, most experts and market watchers expect the current low-rate environment will continue at least through early 2022. While familiar, large behemoth companies (Amazon, e.g.) are healthy and strong, the overall economy (in the U.S. and around the globe) still needs time to bounce back. Borrowings peaked last year, but large corporates don't intend to seek to reduce leverage substantially as part of 2021 financial planning.
Equity Markets
In strange ways, while the world was turning upside down, stock markets glided to a happy end by the end of the year. But the churning and tumbling along the way were sometimes unbearable. Market analysts and traders measure volatility based on statistical "standard deviations" and a familiar "VIX" index in the futures markets.
Yet in the end, because all stock indices increased with above-satisfactory returns, we simply reaffirmed what we knew all along--that equity markets are not true gauges of domestic and global economies. They reflect what they are supposed to do--market values in the top companies that appear in that index. Some of those top companies (Amazon, Microsoft, Alphabet, et. al. proved to be pandemic-proof.)
One new company appears in the S&P index for the first time in 2021: Tesla, one of the year's most dazzling stocks. A year ago, its share price hovered around $110/share. By the end of 2020, its share price had topped $800/share. A few analysts attribute some of that bump to buying pressure from funds that needed to purchase shares to replicate an S&P basket.
However, the gains have been enormous and, to some, unexplainable for a company that has a choppy financial past, a mountain of debt, an erratic CEO and fierce challenges in managing production costs.
To its credit, indeed, the company will report its best earnings year ever, much of that because of its ability to control costs while boosting revenues by at least 15%.
While a global economy imploded in 2020 and while many are comfortable about an eventual recovery in late 2021, predicting the stock markets in 2021 is still difficult.
The IPO market stopped, stalled, and restarted in 2020. Companies intending to go public all along during the year eventually did. (There were reportedly over 400 IPOs in the U.S., one of the best years since the dot-com era.) Not many shelved plans to issue new stock because of the pandemic. And if they did, the pandemic wasn't entirely the blame. AirBnB, DoorDash and Palintir were the most prominent names to go public.
The controversy in the recent spate off IPOs may not be that some companies issued new shares before they should have, but that some companies fall under the category of "SPACs," the special-purpose acquisition companies that are business shells with no business purpose other than to acquire private companies that might have considered going public in the future. (They are also called "blank check" companies.) In the fourth quarter, every other IPO announcement appeared to be from an SPAC.
SPACs will garner more attention in 2021, partly because of the large influx of them, partly because it's considered a fad in finance in the current era, and partly because regulators wonder whether it's a scheme for private companies to circumvent the more burdensome routine of going public.
Mergers and Acquisitions
In the early weeks of the pandemic, M&A activity stalled, as expected. But by the second half, companies resumed the momentum of executing business strategy via mergers and acquisitions. That's what companies do, especially large ones and despite industry statistics that show most mergers ultimately should never have been done.
In the U.S., the year started off with Morgan Stanley's announced acquisition of E*Trade. During the year Salesforce bought Slack, and Uber bought Postmates. Nothing transformative, not much seizing front-page headlines, but still a steady flow of tack-on acquisitions, as companies sought to diversify into other businesses or expand into other industries.
If it weren't a blockbuster year, it wasn't because of lack of financing. Large companies, by late 2020, had access to financing markets (debt and equity) and might have even been encouraged by low interest rates. Companies, too, have been focused on preserving cash flow and wrestling with the uncertainties of the pandemic. In 2021, they may consider eyeing targets that might be under-valued and worthy of taking risk of acquiring.
As all know, investment banks' livelihoods depend on deal flow from IPO and M&A activity (as well as debt underwriting and other corporate-advisory services). The banner years in IPOs and M&A contributed to exceptional years for the big banks and to the frustrations of those wonder why bankers profit so much when much of the country and world suffers.
The top banks are an oligarchy at the top and generated fees in the billions. They will all report increases in related fees by at least 20%. The names are the same from year to year. The order switches up slightly: JPMorgan, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup and Credit Suisse. For this group of six, companies and other financial institutions paid over $40 billion in fees (in aggregate) to help them go public, acquire other companies and/or raise money in bond and loan markets.
Bank Regulation
After the last monumental crisis, bank regulators around the world rolled out tiers of regulation (Basel III, Dodd-Frank, European Union directives, MiFiD II, etc.). The rules were tightened (almost too severely by some bankers' accounts) and have eased or tweaked since 2010. In the U.S., the Federal Reserve and the OCC have revised, rethought, and rewritten rules routinely, mostly to ease the burden on bank compliance officers. (In the U.S., stress-test rules were loosened, certain Basel III requirements were lifted for banks with assets under certain thresholds, and regulators worked out ways for small banks to have simple capital requirements.)
However, some of the same tough rules senior banks complain about (liquidity, capital adequacy, loan-loss provisions, leverage, operational risks, trading restrictions, etc.) might explain why many banks survived 2020 without much more than a hiccup.
Banks will begin to report 2020 earnings in the weeks to come. Few bank leaders will deliver sour results, although many in the U.S. will quietly pout about how responsibilities to provide loans in the U.S. under the U.S. CARES Act loaded up their balance sheets with low-earning assets and resulted in scattered operational nightmares.
They certainly whined about how stock markets were unkind to bank shares. But in recent weeks, for many bank stocks, valuations have rebounded as if the pandemic never happened.
U.S. banks must continue to adapt to new U.S. GAAP rules related to how they compute expected losses (loan-loss allowances) on their respective loan portfolios. The new U.S. "CECL" rules are conservative and forced the larger banks to increase reserves (and lower earnings just a little bit) in 2020. Those adjustments occurred in the first quarter, just when the same banks were preparing for CoViD battle. In most years, CECL would have grabbed financial headlines to explain the first-quarter earnings downturn, but CoViD supplanted all references to that.
Trading Activities: Financial Institutions
In the days to come, when top banks and financial institutions report 2020 fiscal results, one remarkable line upsurge will show in income generated from trading activities--including trading fixed-income securities, equities, derivatives, commodities and currencies.
U.S. bank traders (by rules from Basel, Dodd-Frank, and Volcker rules) are market-makers, and market-makers dine on volatility and volume. It doesn't matter about market movement and trends, as long as there is volume. And throughout 2020, there were concern, panic, uncertainty, desperation, and later optimism and hope. All that is a recipe for success among market-making traders who buy, sell, hedge, anticipate flow, and maintain "inventory." They interface with counterparties and customers who want to dump assets, buy where there is opportunity, and/or just hedge a variety of unbearable risks.
The activity leads to trading gains (mark-ups, price appreciation, bid-ask spreads, commissions, more customer flow, more volume, etc.). Right from the beginning of the pandemic, large banks feasted. Bank of America, for example, will likely report over $11 billion in trading gains; so will JPMorgan Chase. Goldman Sachs, from which about 40-45% of its 2020 operating income will come from trading, could reach $14 billion.
If anything, bank traders may lament the stability and higher degree of market certainty 2021 could bring. Stability and certainty decrease the likelihood that investors, funds, and other managers will want to churn their portfolios, hedge certain risks or reallocate among asset classes. Lesser volume. Lesser trading income.
Because of bank regulation, smaller banks avoid the trading arena. But there are unmanageable or intolerable amounts of market risks (risks the larger banks can adroitly manage). There are also market-related capital requirements, technology investments, and the burdens of complying with the Volcker rules (which dictate how banks can conduct trading activities and which are more difficult to follow than a flight plan to the moon).
Cryptocurrencies: Are We There Yet?
Cryptocurrencies (most notably, Bitcoin) have become household words now and aren't considered as bizarre and arcane as when they bolted onto the financial scene a few years ago. Everybody knows at least a little about cryptocurrencies, even if most stay as far as possible from them.
Cryptocurrencies continue to try to find a niche, a purpose, and a home in the above-ground financial system. By 2020, major financial institutions have at least taken a "here to stay" approach, even if they haven't figured the best business rationale for them.
Many financial institutions, on the other hand, have explored the system behind cryptocurrencies: Its vaunted distributed-ledger technology (DLT), the accounting and computer-processing behind cryptocurrencies, often referred to as "blockchain." Big banks like JPMorgan and Goldman have done research to figure how the system (not necessarily a cryptocurrency) can be used to replace inefficiencies in bank processes like the settling of securities, the funding in overnight repo (inter-bank) funding markets, and the steps involved in export-import financing (including bank letters of credit). These projects continue, and some will eventually be successful in leading to expected efficiencies and cost-reductions.
Now back to cryptocurrencies themselves. We are now where the negative stigma associated with being involved in this financial space is slowly erasing.
In 2021, in fact, securities regulators could approve the set-up and issuance of Bitcoin ETFs, shares traded in public markets that invest in Bitcoin. That will permit almost anybody with a brokerage account to gain access to the coin and participate in the wild rides of Bitcoin volatility. (A Bitcoin that was value a $10,600 in October reached $36,000 in January, 2021.)
Corporate Bankruptcies
The list of corporate bankruptcies in 2020 was long. It included familiar names (J.C. Penney, Modell's, Pier 1, Gold's Gym, Niemann Marcus, J. Crew, Borden and Hertz Global); it included names from the energy industry (Chesapeake Energy) and a flock of companies in already-vulnerable industries (retail, entertainment, hospitality, etc.). The airlines (except for LatAm and Avianca) tripped up, experienced existential moments, but somehow survived.
The stigma of a bankruptcy announcement was erased. In fact, many customers, investors, and business leaders have grown numbed to the regular announcements of filings.
In 2020-21, a bankruptcy filing is just as much influenced by private-equity and hedge-fund creditors, as much as corporate banks. In current times, they play an enormous role in pushing companies to file and preferring not to restructure or provide leeway for debt that is due. They may not be chasing debt payments, but chasing underlying infrastructure assets or control of the enterprise. They have more aggressive agenda and different objectives than banks, which often prefer to work something out, avoid liquidation or escape the laborious bankruptcy proceedings.
Many bankrupt names in 2020 had already struggled with faulty business models, outdated products, excessive debt and diminished customer demand. The pandemic pushed them off the cliff. Others were companies where revenues and cash flow disappeared overnight.
In a rebounding 2021, the frequency and magnitude of borrower defaults and bankruptcies may slow or decline. But other companies, running out of cash and seeing a pandemic rebound will be slower than hoped, will file in the months to come.
CoVid-19 was a hurricane to businesses big and small, but it forced everybody to adapt to different habits, ways of life, processes, and workstyles as 2021 gets under way. That forces businesses and industries to adapt and change. Some are doing so; some won't be able to do so.
Tracy Williams
See also:
CFN: Corporate Bankruptcy Season, 2020
CFN: Are Corporate Borrowers Prepared? 2020
CFN: What Is the Banks' CECL Requirement? 2017
CFN: Morgan Stanley's Sneaky Acqusitiion of E*Trade, 2020
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