And Then First Republic....

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

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

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

And then there was First Republic. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tracy Williams

See also: 

The Sudden Falls of Silicon Valley Bank, 2023

Turmoil at Deutsche Bank, 2016

Wells Fargo's Woes, 2016

"Where Was the Risk Management Group?" 2012

MF Global's Sudden Demise, 2011

Knight Capital's Darkest Day, 2012

Financial Rumbles in Silicon Valley

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tracy Williams 

See also:

Dodd-Frank Dismantled, 2017

Regulators Are Easing Up on Stress Tests, 2019

Deutsche Bank: Turmoil and Concern, 2016

Where Was the Risk Management Group, 2011

When Does a Bank Have Enough Capital? 2015

What Are Living Wills at Big Banks? 2016

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

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

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

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

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

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

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

Stay In Your Lane

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

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

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

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

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

How It Presented Itself

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

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

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

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

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

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

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

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

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

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

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

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

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

What It Really Wanted to Be

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

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

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

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

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

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

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

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

Tracy Williams 

See also: 

CFN: Bitcoin Mania Again, 2018

CFN: Bitcoins--Embrace or Beware? 2014

CFN:  Wall Street's Flash Boys, 2014

CFN: High-Frequency Trading, 2014

CFN: Dark Days at Knight Capital, 2012

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

CFN: What is Really a Derivative? 2012

Archegos: What Went Wrong?

Earlier in 2021, the hedge fund Archegos held large positions in ViacomCBS stock and eventually took losses in billions that led to losses at big banks. How did that happen?

You would think hedge funds and the banks that provide funding and services to them will have learned lessons from the past. One of the most impactful implosions of a hedge fund was the 1998 demise of Long Term Capital, now a notable chapter in financial-markets history. Books were written about its surprising collapse.

But too often the lessons from that time are forgotten. That episode (Long Term Capital) and its sudden exit, after it had attracted some of Wall Street's best traders and two Nobel Prize laureates, got immediate attention from the Federal Reserve. As a regulator of bank holding companies, the Federal Reserve Bank (New York) found a way to squeeze into of that late-summer, 1998, chaos to orchestrate a wind-down to avert systemic risks on markets. Finance historians explain the Federal Reserve's role, a pivotal moment for how it intervened in a segment of the financial system not clearly under its supervision.

What goes around seems to come around.  In finance, history is often lost within a generation or so. Lessons are written. Bits and pieces of regulation are implemented. Since then, hedge funds are not regulated financial institutions, but those of a certain size must report their balance sheets and positions to bank supervisors.  And after the financial crisis of 2008-09, big banks were forced to withdraw from this sector as traders and investors.  

Years later, while still permitted to determine themselves how much leverage they desire or capital they must maintain, hedge funds still take on as much risk as they prefer. They remain glued to trading strategies that work well when designed in conference rooms with the help of models, computations, and napkin scribblings over lunch, until they don't work and they lead to losses measured by millions and then billions. 

In some ways, if the Federal Reserve or the SEC doesn't formally regulate the hedge fund, then its bankers could.  If the fund is too highly leveraged, has too much concentration in trading positions, or appears not to have ample amounts of capital cushion, then the bank (or broker/dealer or another fund) can choose not to do business with it. But of course, it loses the opportunity to make millions while supporting the fund's operations. 

In 2021, a hedge fund few knew much about found its way to the front pages. Bill Hwang's Achegos was widely known in hedge-fund circles, partly because of his esteemed role at Tiger Management, run by hedge-fund legend Julian Robertson. 

Like many funds, Archegos amassed huge positions, misunderstood or mis-calculated the risks in the postions, took sudden losses that wiped out much of its capital base and caused its funding and counterparty banks to take losses. Another chapter in hedge-fund history, but one where many participants involved might have ignored Long Term Capital lessons. 

Compare Archegos to AIG, the giant insurance company. Back in 2008, it, too, had amassed substantial trading positions tied to a collapsing mortgage market. It had sold "credit default swaps" on mortgage securities and anticipated it would suck in the the CDS premiums indefinitely--a seemingly easy business to manage as long as there was no foreseable, formidable collapse in mortgage markets. 

By late 2007, the unforeseable occurred. It accumulated losses in billions (marked-to-market trading losses) and owed the same to counterparties (including Goldman, UBS, JPMorgan, and others). But in this case, the U.S. Government intervened conveniently and recapitalized AIG and permitted the new structure to pay out counterparties. Shareholders were pummeled, management was escorted away, but a restructured AIG exists today. 

Archegos was not big enough, important enough or critical enough to warrant Government supervisors to step in with bail-outs (something even less likely to occur in 2021, especially for non-banks). Its counterparties on the gigantic trades had to take losses exceeding hundreds of millions, topping a billion in one or two casses.  

Banks hurt when hedge funds collapse because hedge funds rely on banks to support their trading activities in the way. They need banks for 

(a) funding (secured loans) their positions,

(b) executing trades on their behalf (prime brokerage), 

(c) custody for holding securities on their behalf, 

(d) derivatives counterparties to help in hedging or using the same to gain a "synthetic" position, 

(e) currency sales and trading, if trades involve foreign markets, 

(f) futures and commodities brokerage if they seek positions in futures markets, 

(g) securities lending, when they need to source securities to borrow to effect "short sales," and 

(g) cash-management services if fund transfers are necessary. The list could be longer. 

Long Term Capital even had syndicated bank revolving-credit facilities in place to ensure funding over an extended period of time. If overnight and short-term funding markets disappeared, it could tap into the committed bank credit line. 

Since 1998, many banks regrouped and reassessed their strategies involving hedge funds as a client base, implemented strict risk policies, and required more safeguards. In that respect, banks "regulated" hedge funds and had become selective in choosing which funds to maintain relationships (or "onboard") and which funds to avoid. 

The industry is still formallly unregulated (or at best, extremely lightly supervised), but important enough to banks because of the revenue opportunities. When banks engage in business with hedge funds, it becomes a risk-vs.reward analysis. The rewards can be mammoth, but the risks are too often hard to measure. 

The industry continues to have hiccups intermittently since Long Term Capital--e.g., Amaranth, a natural gas trader. The 2008 Madoff scandal-collapse fits into this timeline somewhere, too. An electricity trader in Europe caused a temporary shut-down in 2018 at a derivatives clearinghouse at Nasdaq. 

In 2021, the bold, brazen Archegos fund decided to accumulate positions in ViacomCBS stock (among other equities), but not at modest amounts.  It sought positions by

(a) purchasing the stock outright in public markets and 

(b) creating "synthetic" positions via derivatives markets. 

In the case (b), that might mean purchasing call options or selling put options, but also might involve something called "total-return swaps," a derivative that is not new and permits funds to accrue gains without buying the underlying stock. 

Whether Archegos sought positions via (a) or (b), it needed a counterparty and/or a willing bank. 

The bank will be lured by hefty fees, but will have (or should have done) analysis and homework of the hedge fund itself (track record, earnings performance, trading expertise, balance-sheet leverage, capital adequacy, in-house risk management, etc.). The bank will have (or should have) analyzed the market risks related to the trading positions hedge funds are putting on. The bank might have required the fund to compute what is called the "VaR" of the trading position (or computed it itself) ("Value at Risk," a modelled computation of what the worst loss would be on the position with 95-99% confidence over a 1-10-day period.) 

It appears Archegos (or Hwang, essentially) had overwhelming confidence that the price of ViacomCBS shares (and other names) would increase sharply over a defined period of time. That confidence might have been advanced by any number of factors: the media industry, company management, its adapting or evolving business model, certainty in future cash flows, expectations that it might combine with other media companies, etc. 

Whatever the reason, the hedge fund wanted to capitalize on the likely prospects of future price appreciation. Just like many funds wedded to their notions or models, they chose not to take a modest or disciplined approach. They chose to bet the house and amplify returns via balance-sheet leverage: A 20% increase in the underlying stock could lead to a 40%-plus return for investors if it borrowed most of the funds to get into the positions. 

Borrowing, of course, requires cooperating banks. And banks get comfortable by requiring the fund to pledge the underlying stock as collateral (with a reasonable, conservative cushion, or requiring the collateral to be, say, twice the amount of the loan outstandings).  

Banks, too, would provide the funding at their discretion, meaning they offer the loan on an overnight or roll-over basis. The fund can borrow as long as there is sufficient collateral (ViacomCBS stock, in this case) or as long as banks are comfortable with the fund and exposure. Once they sense excessive risk or trouble (or see signs the fund's positions are spiraling out of control and resulting in mammoth losses), they can choose to call the loan. Often the request to call the loan and require payback is too late, history reminds us. The losses will have occurred as soon as the bank has valued the underlying collateral.

Along the way, banks, of course, earn an interest spread on the loan, which is a lesser reward than the risks attached to the exposure. But they gain all those other ancillary rewards from executing trades, acting as brokers and holding securities in custody on behalf of the fund (as described above). 

Banks, however, individually and collectively, will have a limit in how much funding they are comfortable in providing.  If a hedge fund like Archegos wants to increase its position (or gain more leverage in the position) and if banks have capped their tolerance for loan exposure, then the fund seeks other (synthetic) ways to achieve the position. 

And that's where the "total return swap" comes in play. 

In this case, Archegos enters into contracts with banks (or other funds) where it will pay counterparties an interest rate (say, quarterly) applied to a notional amount (say, $100 million). It will receive the percentage change in price of the underlying stock (reference asset) from the banks. If over six months, the stock rises by 12%, then Archegos pays the banks a rate pegged to Libor, and the banks pay Archegos 12% (times $100 million).  

This permits Archegos to enjoy the gains of increases in ViacomCBS stock without owning it. 

Always there's a hitch.  If ViacomCBS stock falls in value, then Archegos must pay the Libor-pegged interest and the amount of the stock decline. 

In its case, earlier this year, as the stock plummeted after it surged in late 2020. Earlier this year, the stock had reached $97/share; in recent days, it has been valued at $41/share (a 58% decline). 

Each bank that engages with the fund (via lending or transacting via the derivative) won't necessarily know what other banks are doing. From day to day, banks can only guess at the total positions the fund has in one stock. From quarter to quarter, it may have leverage enough to require quarterly summaries and updates. 

Banks and dealers that enter into the swap often have another counterparty on the other side. That means if they are receiving a Libor-based rate from Archego, they are paying something similar to another counterparty (in a dealer's role). It also means that if Archegos owes the banks the sum of Libor plus the amount of price depreciation, the banks owe something similar to the other side.  Dealing banks must pay out what they receive from Archegos.

So as the price plummets, Archegos is losing significant amounts, enough to wipe out liquidity and capital on its balance sheet. The banks don't receive their cash payments from Archegos and must absorb the losses to make payments to the mirrored side of the trade. Unless a government steps in to bail out Archegos, which in 2021 won't happen. 

The banks (including Credit Suisse, Morgan Stanley, Nomura, MUFG and others) had to absorb such losses from the trades and from loans they provided for Archegos, if they did do so.

As usual, not soon after, questions about apt risk management are hurled everywhere. How could Archegos have accumulated such positions? 

Or better phrased, how was it permitted to accumulate such positions, because to do so required funding and trades with participating banks? How could both banks and the fund have under-estimated the volatility of the stock (and other equities, as well)? 

It is likely the fund and bank risk models didn't account for the substantial increase in ViacomCBS stock volatility (sudden, sharp rise, followed by sudden, sudden fall). The fund and its counterparties might have presumed the so-called "VaR" of these positions (including ViacomCBS) was modest, predictable. Maximum losses were tolerable, acceptable.  Up until mid-2020, that might have been the case. Share prices had not been too volatile the previous few years. 

But even so, notwithstanding the surge in volatility, a bank counterparty would still have relied on the health, balance sheet, and capital adequacy of the fund to ensure its solvency in even the most volatile of markets. Hence, a strong, sturdy fund should be able to withstand losses from one issue or position of just about any amount, if it is not too highly leveraged, has sufficient liquidity (cash) on the balance sheet, and has a large capital cushion. 

Archegos might have had a sterling track record and a known-among-funds reputation for its leader to do well.  It, too, might have been a significant revenue-generator for banks involved. It may not have had, however, a strong balance sheet, stable earnings performance, lots of cash sitting on that balance sheet, and ample capital. 

In such case, its stakeholders (including banks and counterparties) might have presumed too much that

 (a) he who has had bountiful success and has shown competence in reaping big rewards while taking big risks would not allow his fund to risk its entire capital base, 

(b) the worst cases imaginable as it relates to the stocks in the positions could happen, but won't happen, and

 (c) if the models (and data reporting volatility and risks) say the probabiity of worst-case massive losses is close to infinitesimal, then proceed.

What history keeps telling us is that while operating beyond the grips of regulators, hedge fund managers know big losses have occurred (They read the headlines and histoy books) and might still occur (They run models and scrutinize volatility), but this time or the next time, it's always:  "We've got this."

Tracy Williams

See also:

CFN:  Market Volatility: Can You Stand It? 2011

CFN: Toning Down High-Frequency Traders, 2014

CFN: Dark Days at Knight Capital, 2012

CFN: JPMorgan's "London Whale" Losses, 2012

CFN: How Will Stephen Cohen's Saga End? 2013

CFN: Quant Funds Go Searching for the Truth, 2010

CFN:  Is the Volcker Rule Hurting Market Liquidity? 2017

Corporate Bankruptcy Season

(In late May, 2020 and with over $20 billion in debt, Hertz resorted to Chapter 11 bankruptcy to reorganize its business, improve its capital structure and buy time during the pandemic.)

Start the roll call. As we roll deeper into the CoViD-blamed recession, every other day a familiar corporate name announces it has filed for bankruptcy.

In May, J.C. Penney Company and Hertz Global filed. Others in 2020 include Neimann Marcus and J.C. Crew.  Market watchers and bond investors try to project who's next by providing drive-by analysis or injecting opinion into capital markets (via rising yields in corporate bonds and increases in "credit spreads" in credit derivatives). Airlines LatAm and Avianca have filed.

Bloomberg reports at least 98 global companies with debt of at least $50 million have filed for bankruptcy in the first five months of 2020. Other familiar American filings include Dean & Deluca, Borden Dairy, Modell's, Pier 1, and Gold's Gym. There can no longer be a stigma of failure when a company submits papers for Chapter 11.

Some bankrupt names are victims of the pandemic. Their business models are based on social contact and constant interaction among humans. They might have been thriving businesses until revenues evaporated suddenly after February.  Other bankrupt names (Pier 1, Modell's, e.g.) were vulnerable all along, barely surviving businesses that had been candidates for insolvency for a long time. A coronavirus scenarios merely thrust it off the cliff.

Take the rental-car agency Hertz. CoViD-19 has ravaged its business, because people aren't traveling on business or for pleasure. In mid-May, it missed a payment on debt due and requested extensions from its banks and a restructuring of the loan, an extension in some way. By late May after having asked its CEO to resign, it resorted to a formal Chapter 11 filing.

For others, it wasn't about CoViD-19; it was about changing tides within the industry. Either companies were evolving or they had begun a slow crawl toward the end of existence. Before March, a long list of names in the retail and consumer products industry were candidates for bankruptcy. They include the familiar department-store names, brick-and-mortar businesses that hadn't quite embraced Internet shopping. This industry has been embattled for a long time. Some companies casually glanced at the explosive surge of online shopping in the past decade without bothering to embrace it or compete.

Its woes are blamed, too, on their reluctance to embrace a different way for consumers to purchase goods. Some in the industry tried to transition into online sales, but did so too late.  Even Sears had embarked upon an online strategy, but its early hesitance led to the downfall of a company deeply embedded in American business history. That company filed for bankruptcy two years ago.

Other retail-industry companies were able to survive as barely break-even enterprises, scrounging for ways to come up with a miracle that might boost annual sales at least by 5-10 percent annually.  They might been able to squeeze a year or two of solvency or sell themselves to an optimistic private-equity firm--until CoViD appeared.

Rating agencies have tried to project default rates among non-investment grades after the beginning of the pandemic.  Default rates reported range from 8-14%, depending on the industry or country. That doesn't imply14% of corporates rated BB+ or lower will end up in bankruptcy.  But they become candidates.  Defaults initially lead to efforts by both parties to restructure or extend debt due. Many lenders and investors seek to resolve an initial problem before bankruptcy becomes a final resort.

Watch closely, too, WeWork.  Its near collapse in 2019 after it had prepared for a celebrated IPO was well chronicled.  A faulty business structure and fragile balance sheet put it on the precipice of insolvency.  It will continue to struggle throughout 2020-21.

JC Penney's Woes

JC Penney was certainly one of those names.  Others like Macy's or The Gap might be candidates further along.

JCPenney  is a name that could have managed survival before CoViD-19, despite its stumbles in updating business models and strategies the past decade. Unlike other retail companies, for the past eight years, it has managed to hang onto sales at $11-12 billion annually.  Business wasn't growing, but it wasn't disappearing in sharp down-steps. (By comparison, annual revenues at Sears fell by 60% in the last five years before its filing for bankruptcy.)

JCPenney suffered accounting losses, but when a company is struggling to survive, it's less about GAAP income and more about actual cash inflow. (Many companies, as we've observed the past decade, present GAAP results, but switch quickly to non-GAAP presentations of performance to show cash flows and often to show the best of themselves in whatever manner possible.  Accountants permit these non-GAAP reports of performance, as long as the company explicitly states the adjusted earnings don't meet conventional standards.)

For the past five years, the company consistently generated operating cash over $400 million each year. Much of that cash each year was deployed to fund capital expenditures, often cash outlays to maintain or upgrade old stores.  It sold other investments to gain cash to pay down some debt.  But debt still totaled over $3.5 billion at the start of this year.

The company had little room for error and held onto an embarrassingly low amount of cash reserves for a company operating across the country (less than $400 million). With a small amount of cash on hand, CoViD-19 was the misfortune it couldn't afford to encounter. Its $12 billion-revenue business probably won't top $6 billion in 2020, while fixed store costs will remain the same until they can sell properties that will be shut down. The $400 million in operating cash flow of last year will more likely become $400 million in cash deficit in 2020.

While the evaporation of business activity in March-April, 2020, will be the blame for many insolvencies, highly leveraged balance sheets will have been the symptom that pushed them into the courtroom.  JCPenney might have been able to conserve about $100 million in cash annually if it had about half the amount of debt it had by the end of 2019.

Bankruptcy (the Chapter 11 version) is about devising a plan for how it will proceed (and how it will generate cash flow to appease creditors).  Because revenues won't grow anytime soon, the company will shut down stores to reduce fixed costs and consider selling related assets. It had done so in the past, but not in the aggressive way it must do so now.

In May, it announced it will sell 30% of its stores over the next two years.  Selling stores reduces fixed costs, but it subtracts off substantial amounts in revenues. It also wants to present a polished plan to emphasize online sales, activity that had heretofore contributed modest amounts to total revenues.  Sears, nonetheless, in its waning years before bankruptcy had tried a similar path and made similar promises.

How to Remain Solvent?

The retail industry won't be the only industry to get pummeled in these times.  Businesses in such industries as hospitality, entertainment, travel and airlines are similarly vulnerable.  In the first wave, companies that were already struggling with low cash flow or tenuous business models will seek bankruptcy protection.

A second wave could follow for companies that had been sturdy and relatively strong before the crisis. Because they had sufficient cash reserves and manageable debt levels, they can survive a short-term downturn.  Eventually cash runs out more quickly than revenues recover to pre-crisis levels.

Companies that exhibit the following will have the best chance of remaining solvent and staying away from bankruptcy:

a) Cash on hand and operating leverage.  Companies with adequate cash reserves to manage operating expenses with negative growth in revenues over a 6-12-month period put themselves on good footing.  Many large companies have stockpiles of cash, although they may have been earmarked for other activities. Unencumbered cash is always a short-term solution at least until an economy starts to rebound. (In early 2020, Tesla entered the crisis with over $6 billion in unencumbered cash. Goodyear Tire has about $4 billion if the availability under a committed revolving-credit facility is included. Netflix has over $5 billion.)

With the cash on hand, they can meet operating expenses comfortably if they have manageable levels of fixed and variable costs and relatively low cost structures. Companies are in better shape if fixed costs are relatively low (vs. total costs) and if variable costs can disappear as rapidly as declining revenues.

b) Low leverage.  Companies with insignificant amounts of debt can avoid insolvency.  Bankruptcy is technically a way for borrowers to manage the demands of creditors. Low leverage reduces the amount of cash payouts to creditors and the likelihood creditors will push for default resolution.  Leverage is measured in so many ways:  Debt/Ebitda, Debt/Equity, Debt/Operating-Cash-Flow, Free-Cash-Flow/Current-Debt-Payments.

In early 2020, ratings agencies and investment analysts were reporting Debt/Ebitda ratios rising slightly, but below 6 for leveraged-finance transactions.

In 2019, by these ratio standards, JCPenney had high leverage: Debt/Ebitda > 6, Debt/Equity = 4, Debt/Operating-Cash-Flow = 8.  In 2020, those metrics were only going to worst and worst, as cash flow deteriorates.

c) Debt refinancing and debt tenors.  In good times, investment-grade companies expect to pay down expiring debt by refinancing the debt.  In good times, non-investment-grade companies also expect to refinance most debt. (Netflix, a non-investment-grade name, has $15 billion in debt and typically plans to roll it over when due and use operating cash flow to continue to finance its growth spurt.)

In bad tines, non-investment-grade companies must plan for expiring debt not to roll over and must show they can pay down what's due.

If the principal on the debt is due in more than two years to come, struggling companies can breathe more easily by paying interest and hoping for eventual revenue upturns. JCPenney, for example, always managed a way to pay annual interest of about $300 million in the last few years--before the pandemic.

The "refinancing wall," thus, determines the level of problems a highly leveraged company can have: What amount of long-term debt is due within the next 12-24 months? (Investment-grade name Merck has $22 billion in debt, about $8 billion due in the next three years.)

d) Revenue decline.  How quickly will revenues decrease--slowly, gradually, rapidly?  Airlines, hotels and certain entertainment companies observed their sales erase overnight--in large percentage chunks.

For companies in other industries, revenues are slipping away slowly as the impact of recession affects their customer bases. Customers with long-term sales contracts or operating in low-risk industries might not experience revenue implosion immediately. Some companies with diversified revenue sources may suffer a less dramatic drop-off in sales.

Other companies took a sharp turn in repurposed the business or product in the interim to meet pandemic-related demand for other services.  Uber has begun to focus on UberEats.  Some manufacturers reengineered product lines to become makers of hand sanitizer, protection equipment, etc.

Hertz Global Files for Chapter 11

Hertz's suffering was caused by a global lockdown on travel--whether for business or pleasure. Yet excessively high leverage shoved it into bankruptcy court. The company had increased its debt burden by 2019 to over $20 billion (including obligations on operating leases). Almost all of that debt funds its fleet of vehicles around the world. (Debt/Equity at March 30 computed to an overwhelming 13.7. Its Debt/Ebitda was not a meaningful ratio because of recent operating losses.)

Hertz's operating model is built around ensuring vehicles are in use frequently, rented out to customers for the maximum amount of time.  Utilization of vehicles before CoViD-19 had been above 70%; in late March, utilization was sliding to 60%. By May, utilization may have fallen below 50%. Even as the pandemic wanes and travel increases gradually, the company can't expect utilization to rise back above 70% in 2020 and early 2021.

(Hertz also operates via franchises, which too will have suffered similar decline in activity.)

Cash is also generated from selling an aged fleet of cars. Cash flow from that source (normally about $2 billion/quarter) will also deplete in the short term.

Before it filed, Hertz did what many large companies did to prepare for the onslaught of the coronavirus:  It drew down on bank-led revolving-credit facilities. That permitted Hertz to confront a CoViD-19 environment with other $1 billion in cash. But that amount can't offset the substantial operating deficits it expects in the coming months.

The company has some favorable factors: (a) It has a globally known brand, which provides in multiple ways, and (b) it has the ability to bounce back quickly when people are comfortable traveling again.  Hence, it is in a waiting game and hopes creditors can wait, too.  Can it keep costs to a minimum until revenues return perhaps to near 2019 levels? When will revenues return--2021, 2022? Can utilization approach 70% again? And when will that be?

Advisory Firms

In bankruptcy and insolvency scenarios, banks play many roles.  They are lenders and creditors who line up to stake their claims on the borrower's assets.  They are also fund-providers, providing debtor-in-possession financing (often working-capital funding), a short-term source as the company and court work through the process. Or as investment banks, they may be advisers, assisting the borrower in identifying cash sources and restructuring the business and the balance sheet.

Many advisers are boutique firms, not likely to have been lenders and counterparties to the borrower and able to act independently.  Some advisers are firms that specialize entirely in restructuring and bankruptcies (Alix Partners, Alvarez and Marsand, e.g.).

Other advisers are investment banks with reputable positions in mergers, acquisitions, and underwriting. In down times, they switch tunes to focus on restructuring by devoting more resources and pitching related services.

Lazard has a prominent restructuring group. Fees from this activity will offset the expected decline in merger advisory and underwriting.  In its latest annual report, not anticipating the major downturn at that time, it described how it represents the borrower or the creditors. The practice is divided into before bankruptcy advisory work and after bankruptcy advisory.

In periods of distress and before filing, Lazard will determine current debt capacity of the company and then advise how best to restructure its balance sheet while working with bankers and investors.  In bankruptcy, Lazard advises the company on reorganization planning and strategy. That could include the issue and structure of new securities. The firm generated $1.1 billion in investment banking fees last year, but it doesn't disclose what portion of that is derived from the restructuring and bankruptcy business.

Other boutiques, such as Evercore and Moelis, also push the restructuring business to the front when companies scramble to keep businesses solvent before filing.  Moelis, in fact, will assist Hertz. It's not unusual that senior bankers who step into these roles are former bankruptcy attorneys.

Tracy Williams

CFN: Radio Shack Files for Bankruptcy, 2015
CFN: Yahoo Tosses in the Towel, 2016
CFN:  MF Global: Too Small to Save, 2011
CFN:  Are Corporate Borrowers Prepared for CoVID-19 Scenarios? 2020
CFN:  WeWork: What Happened and Why? 2019

Dimon Prepares for a New Crisis, 2020

Just after his heart surgery, JPMorgan Chase's CEO Jamie Dimon still prepared a COVID-19-impact letter to shareholders in 2020

Even while recovering from unexpected heart surgery, because of the onslaught of COVID-19, JPMorgan Chase CEO Jamie Dimon likely tore up a previously drafted annual letter to shareholders he wrote in, say, February.

Whatever he was about to say about the bank's 2019 performance, its capital base, its liquidity, its loan portfolio, and its plans to grow despite competition and political winds, he decided to start from scratch. Or at least it seemed so in the letter widely distributed in the financial community this week.

He had hoped to boast about the bank's banner year, generating $34 billion in earnings and boosting returns on book capital to levels above 13%. (Reductions in tax rates from 2017-18 still help.  The bank paid about $6 billion less in taxes than if it had generated the same in 2017.)

The balance sheet now totals almost $2.7 trillion in assets--including over $900 billion in loans and over $400 billion in trading securities and derivatives. A book capital base of over $260 billion anchors the balance sheet.

The letter he writes annually is often a message to the industry, widely read and closely digested. This spring's note, that final version, was a blueprint game plan for how the bank will survive and thrive in a coronavirus-blamed economic crisis. This letter hardly took Dimon time to craft. He has well-thought-out and well-reasoned opinions and is comfortable sharing them.

As a bank leader, he pushes for growth in earnings, increased market shares and global expansion.

But unlike many bank leaders, he is a consummate risk manager, a worry-wart who foresees the worst case and grasps the issues that can have detrimental impact on a colossal bank. That explains his non-stop reference to the bank's "fortress balance sheet."

In the 2020 letter, Dimon states he had intended to present the bank's strategy to respond to competition. JPMorgan competitors include the obvious top-tier banks Citigroup, HSBC, Credit Suisse, Bank of America, Wells Fargo, Goldman Sachs and Morgan Sachs. But the bank operates in many markets and has dozens of businesses; hence, competitors include large regional banks (Regions, PNC, USBancorp, et. al.), specialty banks (BNY Mellon, State Street), broker/dealers (Raymond James, Scottrade), asset managers (BlackRock),

Otherwise, some of the fiercest competition comes from non-bank financial institutions and financial-technology companies ("fin-tech") with technology advantages or access to certain markets JPMorgan covets--the PayPals, the Wealthfronts, etc. For 2020, Dimon was set to present JPMorgan's fluid, ready-to-go strategy, propelled by the bank's size, capital base, risk management experiences, systems expertise and breadth of product offerings.

With the current crisis, he needed to show JPMorgan's posture and planned interaction with consumer and corporate customers, its engaged role in capital markets, and (just as important) its willingness to use its balance sheet and take reasonable risks to support customers. (About 180,000 of its global employees are working from home--including investment bankers, traders, risk managers, relationship managers, systems personnel, community bankers, etc.)

He acknowledges what many expected.  The bank's loan portfolio will increase sharply over the next month or so, because large corporates are drawing down on revolving-credit commitments (about $50 billion) and small business loans have increased by $1 billion since February. And for those businesses that can decipher Federal guidelines that offer funding under the stimulus legislation, community businesses will increase borrowings.

Dimon promises JPMorgan Chase risk managers will focus on vulnerable corporate industries.  Exposures to these industries at the bank are large, but can be managed.  The bank's $950 billion loan portfolio tends to be 50-50 consumer and corporate. The number pushes beyond $1.5 trillion, if commitments and credit-card lines are added.  Committed revolving-credit funding and consumer credit lines could be used beyond normal levels as 2020 unfurls.

The recent loan increases suggest the bank's actual loan outstandings might exceed $1 trillion  at least for a short period, while it works aggressively to reduce exposures in vulnerable industries. About 11% of its corporate loan exposure is in the lackluster consumer-products and retail-industry sector, 4% in oil and gas, 17% in commercial real estate.

In consumer lending, the bank has over $380 billion outstandings in mortgages and credit cards.

Loan portfolios (outstandings and commitments) at the bank are also managed by country risk and currency risk. (The bank has about $19 billion in China-related exposures, about $42 billion in Brexit-burdened U.K.)

Concurrently the bank will focus on vulnerable small businesses across the U.S., where operating cash flows are dwindling quickly and where cash reserves had already been small. At the outset of this crisis, the bank, like many banks around the country, wants to start by promising to support small businesses (via funding, transactions, cash management, etc.), although it will protect itself from widespread losses, undisciplined business strategy, and irrational risk decisions.

JPMorgan has climbed to the top of most investment-banking tables (underwriting, advisory, mergers and acquisitions, etc.), but this business is uncertain and volatile. (It generates $7.5 billion in annual fees at the bank.) That's the nature of the segment.

Dimon notes the industry had one of its best-performing quarters in the first quarter in investment-grade corporate-bond issues.  That might be a result of (a) corporate CFOs taking advantage of low interest rates, (b) a slate deals that might have been postponed in late 2019 and put on the 2020 schedule, and (c) corporate borrowers rushing to close deals and increase funding before public debt markets close their doors later in the year. A wise CFO is a CFO who concludes the company must secure the funding now because it may not be able to get access to it later--especially with interest rates at near-record low levels.

Mindful of the mounds of litigation and penalty payouts it paid to government bodies and civil suit plaintiffs after the last crisis, Dimon mentions the bank will help clients, but wants to minimize litigation risk. At the least, this implies inhouse lawyers will closely advise bankers welling products and making promises to clients. Products that appeared so lucrative and riskless in the early 2000s (subprime mortgage securities, mutual funds, exotic derivatives, e.g.) led to billions in penalties and settlements in the post-crisis years.

Regulation has been a favorite target in Dimon shareholder letters the past decade.  In 2020, he tosses another dart at global and U.S. bank regulation:  "While a lot of the rules were constructive and made the financial system stronger, we are now seeing the impact of poorly constructed, poorly calibrated and poorly organized rulemaking," he wrote.

This time he reminds readers that onerous liquidity requirements (Basel III) could limit the bank's efforts to provide new loans to consumer and business customers who desperate need funding in the months to come. Financial reports for Dec., 2019, show bank regulation requires JPMorgan Chase must hold cash reserves of $469 billion (to meet unexpected run-offs and withdrawals of deposits and other short-term funding). To comply, the bank maintained $545 billion in "High Quality Liquid Assets," much of which, Dimon has long argued, should be funneled into the loan portfolio to meet cross-the-globe demand.

Yet the so-called tough regulatory rules explain, in many ways, why the bank and most of its peers, should withstand the worst of what's to come.  Dimon highlights the stress tests the Federal Reserve conducts on the bank's balance sheet and the stress tests the bank performs for itself.  Such tests suggest the bank could survive about $30 billion in an assortment of losses over the next 12-24 months.

Footnotes in the 2019 annual report state the bank's board had authorized bank management to buy back shares at its discretion up to $15 billion until June, 2020. As times improved the last decade and after periods of building up capital bases to ensure compliance with new regulation, banks around the country had begun to reward shareholders with higher dividends and stock buybacks.

As a crisis becomes hard reality, banks must reset priorities and strengthen balance sheets that could be crushed by loan losses and market hits.  Dimon's note says the bank will suspend buybacks for now, although it hopes to maintain its attractive dividend.  The bank's internal analysis and stress testing suggest the bank will continue paying stock dividends unless Tier 1 capital (which includes tangible equity and preferred stock) falls below $170 billion.  That was based on regulators and the bank's stress test for an "extremely adverse" scenario.

At Dec., 2019, JPMorgan reported $214 billion in Tier 1 capital (and had continued to show increasingly higher capital ratios for all forms of capital requirements).  Capital ratios are the highest they have ever been over the past decade and give credence to Dimon's frequent reference to the bank having a "fortress balance sheet."

As for regulation, he has a suggestion for when this crisis slips into history: He recommends regulators review the extent to which banks were prepared: "After the crisis subsides (and it will), our country should thoroughly review all aspects of our preparedness and response." And maybe regulators can update rules and requirements that might not have been necessary in the worst of cases. 

Tracy Williams

See also:

CFN:  Dimon's Regulatory Rant, 2012
CFN: The State of the Industry from JPMorgan, 2011
CFN: Letters to Shareholders at Financial Institutions, 2010
CFN:  Is $13 Billion a Lot of Money for JPMorgan, 2013
CFN:  JPMorgan Chase's Refined Regulatory Strategy, 2014
CFN:  What Will Dimon Do? 2013
CFN:  JPMorgan's London Whale Losses, 2012
CFN:  Big Banks' Big Year, 2019

Are Corporate Borrowers Prepared?

General Motors announced it will borrow under its $15 billion in bank revolving-credit arrangements

In the midst of the COVID-19 crisis, corporate borrowers--big and small--must brace themselves for a prolonged downturn. Are they prepared? Are they projecting significant declines in business activity and revenues, which will lead to operating cash-flow deficits for many--whether the company is Macy's, Microsoft or a neighborhood grocer?

What impact will an economic and business downturn have on the ability of companies to manage debt on the balance sheet, both short- and long-term?

Few companies, if any, projected what we are experiencing today.  Most companies go through exercises to project worst-case scenarios and recessionary environments. Most companies expect businesses and the economy to ease into a downturn. Few companies expect a downturn to appear from nowhere and have immediate impact on revenues, earnings and cash flows.

For COVID-19, regulators and lawmakers stepped immediately. In the U.S., the new CARES Act is supposed to present short-term relief by providing funding to companies in designated industries and companies of a certain size (if they request it).

For the most part, companies are on their own to manage the months to come.

As the previous financial crisis (2008-09) receded into history, a growing global economy helped companies improve revenues and earnings until 2019. Part of this growth is attributed to central-bank-sponsored low interest rates from the late 2010s until today.  Low interest rates, during those years, encouraged big companies to finance investments and capital expenditures via long-term debt.  Low interest rates also encouraged companies to reengineer their balance sheets by using some of the new debt to fund rewards (dividends and share buybacks) to shareholders.

By late 2019 before the current crisis, large companies all over (and the investors, analysts and rating agencies who observe their financial performance) had become tolerant of excess amounts of term debt. Stable, predictable earnings could manage these highly leveraged balance sheets. Excess balance-sheet cash could get companies through occasional, but sufferable downturns.

Some companies had begun to reduce debt in 2019 after an upturn in interest rates in late 2018.  Yet corporate balance sheets continued to be highly leveraged by most standards when the calendar turned to 2020.

High leverage is measured often by Debt/Equity and Debt/Ebitda metrics. Analysts may use other metrics:  Debt/Total Capital, Debt/Operating-Cash-Flow, Net-Debt/Ebitda, Total Liabilities/Equity, Debt-Service-Coverage Ratio, etc.  It is also measured by companies' trends in long-term debt outstanding.  Many companies more than doubled long-term debt in the past decade.

Tesla, for example, has $12 billion in debt (Debt/Equity=5). Companies like Merck, Coca-Cola and PepsiCo report debt obligations each above $20 billion. Companies in vulnerable industries like J.C. Penney and Goodyear must manage debt of about $4-5 billion, as they proceed through precarious times. Debt at Netflix, now at $15 billion, increased $13 billion in just five years.

The New York Times reports aggregate U.S. corporate debt totals about $6 trillion.  Not all is due in 2020, but companies must at least generate cash to pay interest and current portions this year. (About $178 billion is due this year. In "good" years, much of that can be refinanced.)

Lenders include banks, syndicated arrangements among banks, bond investors, and the growing number of non-bank lenders (hedge funds, ETFs, insurance companies, and CLOs). 

Companies in some industries are more vulnerable than others.  They are not hard to find, and they have already been prominently identified:  transportation (airlines included), hospitality and travel, energy, etc. Revenues are declining swiftly. Healthy earnings will become losses within the next quarter or so. 

All companies seek to meet obligations (principal and interest) from operating cash flows.  Investment-grade companies often manage principal obligations by refinancing them when due, because they can. When operating cash flows decline or disappear and become deficits, companies must retrieve Plan B, tapping other sources like cash stockpiled on the balance sheets, proceeds from selling off non-strategic businesses and other assets. Some will hope their lenders can agree to a restructuring of debt (by extending tenor, reducing rates, or altering amortization schedules).

(When it endured a down period a few years ago, the mining company Freeport McMoRan managed to reduce long-term debt by selling assets and investments, generating about $2-3 billion in cash.)

In the U.S. in anticipation of a prolonged downturn, the Federal Government's CARES Act attempts to help small and large businesses and will provide funding, investments and guarantees to companies in identified segments and industries. Such support will come with restrictions (including caps on compensation to executives and prohibitions on dividend and buyback payments), restrictions that airlines, hotels and other affected industries can bear until business improves.

In the months to come, where are corporate borrowers vulnerable? How could they have prepared for unforeseen, worst-case scenarios?  What companies will thrive? What companies will risk default, bankruptcy or non-existence?

Debt analysts and ratings agencies have already begun to track deterioration.  Moody's predicts default rates for non-investment-grade issues will top 10% by the end of 2020 (vs. 13% in 2009). Even before the current crisis, S&P had already begun to downgrade a larger-than-usual number of corporate names.

As expected, investors have observed "credit spreads" on traded corporate bonds increased sharply the past month. Higher credit spreads imply investors expect a higher probability of default (and higher expectations that investors should be rewarded for the risks they are taking on).

Earnings and Cash Flows

Few companies will be insulated. (Yes, some are reported to be thriving and are experiencing immediate upturns in performance--Zoom, Walmart, et.al.) A drastic decline in the U.S. and global economy will have impact on revenues.  Companies with high-fixed-cost structures, low operating margins, and without the ability to reduce variable costs quickly will begin to report earnings (and deficit cash flows).

Companies with diverse business lines and industry sectors may survive better. Companies operating in "consumer discretionary" segments will see immediate decline in performance.

Companies with substantial amounts of cash on the balance sheet will be able to endure and continue to operate until the new year, as they meet expenses and other obligations.

Many large companies benefitted from tax reductions in 2017-18, which boosted earnings and helped to contribute to stockpiles of cash on many balance sheets.  Tesla above, despite erratic performance over the years, has $6.2 billion in cash; Twitter has $6.3 billion in cash and a modest amount of debt ($2.5 billion).  PepsiCo reports over $10 billion in cash. Some of the cash companies report is earmarked or pledged (for capital projects or specific creditors). Some of the cash exists in overseas subsidiaries or in regulated industries.

Synopsys, a Silicon Valley-based technology company that has long avoided debt, has over $700 million in cash with less than $120 million in debt.  It has long-term contracts with clients to ensure revenues will not sink suddenly.

Netflix has over $5 billion in balance-sheet cash, much of that likely already earmarked for new content development. (Monthly subscription payments arrive at Netflix routinely, generating new cash. Much of that, however, must be used to manage its existing $15 billion debt.)

Other companies are cash-strapped.  Lackluster performance has not contributed sufficient cash flows to keep cash on hand.  J.C.Penney has a string of operating losses the past eight years. That's not a surprise, given its retail-industry business models. It struggles with less than $500 million cash (and $4 billion in debt) and few signs its $12 billion annual revenues will turn upward again.

Liquidity and Working Capital Management

An examination of cash on hand for corporates leads to an assessment of overall liquidity. Companies plan for long-term growth, but they also plan for next week, next month and next quarter to meet current obligations. An assessment of liquidity requires an examination of the company's working-capital needs and operating cycle, or what others call "cash-conversion cycle" or "asset-conversion cycle."

Liquidity includes cash; it also includes access to cash from committed bank funding. And it must account for other assets and funding sources that can convert to cash quickly. Financial institutions are governed by regulation to ensure they are always sufficiently liquid. Corporate borrowers rely on discipline and shrewd financial management to ensure they are liquid and operations are performing smoothly. (They may also be held in check by the banks that provide ongoing funding and may require borrowers to meet liquidity benchmarks.)

Beyond the cash on the balance sheet, most companies will have bank credit lines they use to gain liquidity or to meet current obligations.  Many will have already arranged committed revolving-credit facilities from banks (including bank syndications).  The largest companies rely on cheaper commercial-paper funding, but will still have "back-up" revolving-credit lines from banks.

(History suggests if a ratings-agency downgrades commercial paper, short-term investors will disappear quickly. Companies prepare for this scenario by routinely arranging back-up facilities for a certain percentage of CP outstandings.)

In the early days of this crisis, CFOs and corporate treasurers quickly drew down on "revolvers"

(a) to ensure they had cash reserves if and when other cash flows and funding sources disappear and

(b) to ensure they can borrow today when they may not be able to do in quarters to come (especially if a breach in "financial covenants" prohibits them from borrowing or if a bank is unable to fund commitments reliably).

(In extreme stress, some banks may look for both covenant breaches and legal loopholes to avoid providing funds to a rapidly deteriorating borrower.)

An airline today might still be eligible to draw down on a bank line this week, but could be ineligible when it reports first-quarter earnings in a few weeks.  Banks could expect to see some large companies, which never bothered to use their credit lines and arranged them only as "dry powder," borrow in billions this month, if they haven't done so already.

By the end of March, General Motors had planned to draw down on its $15 billion revolver. Macy's, struggling for years with its increasingly antiquated retail model, drew down its $1.5 billion line. McDonald's announced it will borrow $1 billion under arrangements.

(It is not unusual for the largest companies to have revolving facilities totaling $5-10 billion with arrangements in the U.S. and in other countries/currencies and with availability often at the parent company, which uses the funds at its discretion within the company's global structure.)

Companies must also watch for unusual delinquencies and defaults on accounts receivable, an asset item many presume is a cash-equivalent. For example, a company with receivables normally collected within 45-60 days might observe longer periods to collect the cash (60-90 days). Higher-than-normal delinquents and defaults reduce liquidity.

With declining amounts of business activity, inventory may not turn over as quickly or may take longer periods before sale (and eventual conversion to cash).  A company in a vulnerable industry, for example, might have observed inventory being sold within 45-60 days now requiring over 90 days to be turned over.

Delinquent receivables and longer "days on hand" for inventory (longer periods before sale) also require longer periods of working-capital funding. Inventory that resides on the balance sheet too long require longer periods of short-term funding (and higher interest expenses).

Companies must also detect problems or challenges on the supply side:  Have suppliers become concerned about their customers and begun to alter terms for payment (putting pressure on companies to meet accounts payables more quickly)?  Are suppliers themselves experiencing problems in delivering raw materials or inventory? Are they, too, hampered by liquidity issues or inability to maintain funding to support their own balance sheets?

Companies that manage efficiently operations, working capital, working capital funding, and the cash-conversion cycle and understand the risks of each step in the operating process are the ones best-equipped to manage costs and cash flows through difficult periods.

Unfortunately some banks will choose to walk away, having concluded the risks of continuing to provide short-term funding for companies in decline are too much to bear. Companies often will have planned for such contingencies and often will have lined up enough banks, such that if one or more disappear, there will still be a core of supporting banks.

Fixed Assets, Planned Investments 

Companies often start a year with lists of planned investments and projects, which result in planned capital expenditures.  From year to year, companies must invest in plant, property, and equipment to maintain or restore the fixed assets that anchor business operations.  Fixed assets deteriorate (and depreciate in value). They will also have determined the projected revenues and returns from those expenditure/investments and the manner in which they will fund them.

Companies make capital expenditures and investments for various reasons, besides maintenance and restoration.

They also invest in

(a) operating efficiencies and technology that result in improved business processes and lower operating costs and

(b) business growth and expansion that lead to growth in revenues, earnings, and eventually "enterprise value" (or the market value of the business).

In an economic decline or emergency scenario, they will focus on current operations and efficiencies. Plans for long-term expansion and growth might be tabled for now, and certain projects may be postponed, new investments deferred.

Capital expenditures, therefore, won't disappear; they must be rationalized and purposeful.

Funding Sources: Long-Term-Debt

The same investments and capital expenditures described above require funding.  Companies will have already adopted a funding strategy for 2020 for these purposes:

(a) Operating cash flows,
(b) debt,
(c) equity, or
(d) combinations of debt and equity.

In a stress environment, operating cash flows may dwindle or cash will be reserved for funding short-term operations if the business generates losses.

Too much uncertainty will limit access to equity markets--public and private. Debt markets may be available, if transactions are structured to reduce risks for banks and investors.  This might entail higher credit spreads, more collateral pledged, and tougher financial covenants.

In the U.S., as mentioned above, anticipating the needs of corporates, the Federal Government (via the CARES Act and other legislation that could follow) has stepped up with plans and ideas. From day to day, the Federal Reserve explores how best to fund businesses (big and small) directly or indirectly.

Because companies have begun to use revolving credits at higher levels than normal, bank loans will have increased in the first quarter, 2020. But they will increase up to a certain point. Regulatory oversight and specific rules will increase bank capital required to support increased loan portfolios. Bank risk managers will also set bank-wide limits on total credit exposure--by industry, by country, by currency.  (Accounting requirements related to increased loan-loss-reserves ("CECL") come into effect in 2020 and may discourage banks from increasing long portfolios, too.)

Some banks have already urged clients to consider other debt markets, notably public debt markets.

Companies with declining cash flows are at risk. The same companies with sturdy balance sheets,  longer tenors on debt obligations, and minimal amounts of scheduled payments (refinancing risks), sheets within the next five years can buy time.

How long, nonetheless, will public debt markets remain accessible to large corporates? At what point will investors avoid corporate issuers, even if issuers promise higher yields to compensate for growing risks? One of the first signs of trouble in the mid-2000s was when in mid-late 2007 some corporate issuers had difficulty rolling over commercial paper (short-term debt) and difficulty proceeding with plans to sell bonds to the public (long-term debt).

Debt markets can shut down, at least temporarily.  Will companies, therefore, rush to issue new debt this spring while they can? Will issuers need to provide enticements--higher yields, warrants, convertibility, better pricing and terms once the environment improves?

Debt markets can be divided in many ways:

(a) short-term vs. long-term,
(b) public vs. private,
(c) investment-grade vs. non-investment grade,
(d) U.S. issues vs. Non-U.S. issues,
(e) amortizations vs. balloon payments,
(f) secured vs. unsecured, and
(g) senior vs. subordinated

Issuers will consider whether a new debt offering (a) refinances old debt or (b) increases total debt outstanding on the balance sheet.

Companies, advised by CFOs and investment banks, will decide when to issue, how much, and on what terms. In the current environment, they will need to structure issues to get lenders and investors comfortable with pricing and risk mitigation. In the best of times in negotiating terms, corporate borrowers (particularly investment-grade issuers) have advantages in negotiations and gain lower pricing, lower fees, and the best of terms ("covenant lite" transactions, e.g.).

In deteriorating scenarios, lenders and investors will have an edge and will look for protection and ways to reduce risks:  better collateral, stronger liens, longer lists of financial covenants, higher pricing, senior ranking and positions, intercreditor agreements, etc. Credit spreads have increased substantially in recent weeks--especially in non-investment-grade markets. BBB-rated issues are approaching 500-bp spreads; B-rated issues approaching 1,000-bp spreads.

In the months to come, debt markets may not shut down entirely as much as banks and investors will influence terms in ways they have lost advantages in recent years.

Financial covenants, which benchmark expected performance, may increase in number, permitting revolving-credit banks a legal excuse to rescind funding commitments if borrowers slide rapidly toward insolvency. The wave of "covenant lite" deals should ebb.

Capital Structure

Will companies suffer for having reengineered capital structures in the late 2010s, where they reduced equity (via share buybacks) and took on larger debt burdens--to take advantage of low interest rates and because they (and the marketplace) were confident they could generate stable cash flows indefinitely? Reengineered balance sheets also helped boost stock values, as earnings per share and returns on capital increased.

In 2020, well-capitalized balance sheets will relieve companies of pressure to generate steady streams of cash flow to pay principal and interest on large amounts of debt.  A company can always choose not to reduce or not pay out dividends.  It can always cancel share buyback programs. A failure to pay principal and interest on debt and the collective unwillingness of debt-holders to restructure obligations could lead to insolvency or bankruptcy.

The balance sheets of the 2010s were crafted based on optimistic, continuing streams of operating cash flow--and low interest rates. Not all companies piled on debt, paid high dividends, and bought back stock.  Some operated consistently on a hunch the worst case was always one quarter away.

For companies with substantial debt, are there ways they can repair unstable balance sheets and brace themselves for stress?

Issuing new equity is a solution, but an impractical one--whether in private or public markets today. There still may exist a private-equity fund willing to buy a large stake in a company whose market values are unfairly or excessively under-valued, a company that will thrive when signs point to an economic upturn.

Companies will consider working with commercial and investment banks to extend debt maturities and provide banks and investors comfort with collateral and opportunities to gain rewards on an upside (convertibility, warrants).

In the months to come, expect companies and their banks (including commercial and investment banks) to be in constant dialogue.  (Some boutique investment banks (Lazard, e.g.) have experienced restructuring units.) Many banks and their risk management squads have vast amounts of experience in crises. Banks know, too, that corporate managers remember and later reward the banks that shepherded them through tough periods.

Rating Agencies

Rating agencies (S&P, Moody's and Fitch) have begun to issue negative outlooks. They had begun to increase downgrades earlier in the year. Downgrades were outpacing upgrades.

After the debacle of the crisis in 2008-09 and regulators' perception of the their contributions to that crisis, ratings agencies are poised to be better prepared this time. Regulatory activities are supervised by the SEC in the U.S. For a few years after the last crisis, regulators and financial-services industry mulled over the role, responsibilities and compensation methodology of rating agencies.

In this crisis, rating agencies won't adjust and revise ratings (name by name) irrationally or inexplicably. Or too rapidly. Wise, attuned investors know credit spreads (and yields) increase far more swiftly than ratings agencies elect to downgrade.

An A-rated borrower's credit spreads on bond issues will change the same day the market digests more bad news about the company.  The rating-agency downgrade requires a more deliberate, objective process, but a process that likely will occur more rapidly and carefully than years ago.

Vulnerable Industries

Banks and debt and equity investors quickly began to identify the industry pockets of risks around the globe.  Equity investors respond, of course, from day to day. Bond and derivatives traders respond similarly with higher yields and credit spreads in bond issues and credit-default-swaps pricing. Traders also respond by declining to step up to make markets in certain products. Liquidity evaporates, signaling concern and uncertainty.

In the assessment of corporate industries, survivors and "thrivers" are on one list.  (In March, companies like Zoom and Clorox appeared to be candidates to survive in the months to come.) Vulnerables and Red Flags are on another list.

Corporate industries most vulnerable (on many lists by bank analysts, equity analysts, and ratings agencies) include "consumer discretionary" industries (hotel, restaurant, airlines, in-person entertainment, and travel).  Other vulnerable industries include oil-and-gas, automotive, auto supply, banks and insurance.

Industries less vulnerable include utilities, household products, software, healthcare technology, food and staples, wireless telecommunications, and biotechnology. The good news is this list is not too short.

Vulnerable industries will include companies that may experience red flags and problems described above. Well-capitalized, efficiently operated, and cash-rich companies in these industries will have the best chances of enduring tougher periods.

Collateralized Loan Obligations (CLOs)

One market segment worth casting an eye on is CLOs, which issue tranches of rated debt securities, the proceeds for which are used to purchase bank loans.  This special securitization structure has permitted non-bank financial institutions to participate in loan markets, giving them opportunities to buy secured corporate debt and buy it in baskets.

They buy tranches of debt backed by a pool of bank loans. A typical feature is the basket includes almost entirely collateralized BB-rated loans, which pay higher interest rates.  Nonetheless, in 2020, this a vulnerable segment with high probabilities of default in stable environments and even higher in stress scenarios. There is always the likelihood that BB-rated companies slip toward CCC ratings or "jump to default."

CLOs are structured by asset managers working with ratings agencies.  The current scenario will likely put their structuring models to test.  The structures benefit from loans being senior in ranking and being collateralized.  CLO senior-tranche debt can be rated AAA, because of excess collateral assigned to that exposure and because of an adequate amount of "residual" or equity capital beneath it. The models, which have been updated to incorporate lessons learned from 2008-09, include stress tests that should have incorporated a 2020 scenario. The model determines the amount of "residual equity" cushion and is based on worst-case scenarios.

If the CLO market perceives BB-rated loans will deteriorate and default at higher levels than projected, then watch for CLO debt to decline in value, CLO debt to become more illiquid and harder to sell, and AAA-rated CLO securities to be downgraded.

Tracy Williams

See also:

CFN: The Burden of Corporate Debt, 2015
CFN:  Netflix and Its Mounting Debt Burden, 2018
CFN:  Banking 101: Corporate Borrowers, 2020
CFN:  Updating Financial Models, 2015
CFN:  Apple With All That Cash, 2013
CFN:  What About Corporate Banking? 2010
CFN: Big Company Woes: GE, Sears and Tesla, 2018