Structured Finance: Securitizations Principles

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

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

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

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

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

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

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

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

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

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

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

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

Securitizations : the basics

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

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

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

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

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

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

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

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

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

The portfolio and the risks accompanying it

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

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

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

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

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

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

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

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

Tracy Williams

And Now for 2021...

Despite the pandemic and global concerns from politics to public health, 2020 wasn't a bad year in financial markets and for financial institutions. What's on the plate in 2021?

Why bother to even forecast events for 2021 in the global financial community after all that occurred in 2021? 

A year ago, CoVid-19 was a slight blurb in the news, a vague, remote threat. Not many, if anybody, anticipated the avalanche of unfavorable events in 2020. 

Yet strangely by the end of the year of such vast tumult, equity markets had a bustling, favorable year. In a year when the GDP of almost all sovereigns (except China) reported declines in economic activity, big banks around the globe survived and even made reasonable amounts of money. Many U.S. banks were able to get through the year without having to cut dividends in the way regulators seek for them to do in economic downturns. (Within days, many of the top five big U.S. banks will report annual net earnings exceeding $10 billion each.)

Markets, although volatile in upsetting ways at certain times, functioned. Recall during the financial crisis of 2008-09 there were days when the global financial system was in jeopardy, days when some market sectors stopped function (commercial paper, e.g.).  

In 2020, debt markets (loans, bonds) were active, as many companies increased borrowings in response to a global recession (the better to have cash reserves now than to scramble for them later). Investment bankers, while mostly working at home, hustled to execute crammed deals calendars.

In a year where it might have been hard to rationalize or predict any kind of favorable activity, IPOs and M&A activity resumed brisk paces after earlier in the year bankers paused to survey and worry about the oncoming the financial landscape. 

So now what's on the table for 2021--beyond the expected transition in Washington and continued efforts from government and corporate leaders to do all possible to flip the trends in global economies?

Bank Loan Portfolios and Borrower Defaults

Banks survived 2020 partly because they had ample capital as cushion for losses, as prescribed by mid-2000s regulation.  They braced for the worst and boosted loan-loss reserves early on and reviewed portfolios carefully for vulnerabilities. 

Losses occurred in portfolios, but banks weren't blind-sided. In the U.S., most banks will report decent 2020 earnings and many didn't reduce portfolios; they increased lending. Some of that, of course, is related to their support of government programs. Some of that is related to corporate borrowers' increasing outstandings under revolving facilities. By late 2020, because public debt markets hummed along, many corporate borrowers would eventually refinance bank debt in an active bond market with low interest rates. Such was a funding game plan observed among medium-to-large corporate borrowersin the U.S. and in other developed countries. 

Banks will continue the same march in 2021: Prepare for losses, maintain reserves and please regulators with ample capital. 

Banks, too, benefitted from being able to modify loan terms, permitting borrowers to defer principal due or agree to other loan-forbearance arrangements. All that means is for some struggling borrowers, instead of defaults and charge-offs, borrowers' payments are postponed, delayed or appended to the end of the maturity dates. That helps banks maintain loan-portfolio quality (or at least reduce charge-offs). 

While corporate loans increased during the year, while consumer borrowing was stagnant. The demand for the latter decline, as individuals avoided spending or weren't employed long enough to engage in pre-2020-like spending. Credit-card receivables at many U.S. banks declined--partly as banks managed these unsecured risks, partly because borrowers had lesser need to use the lines (for travel, at restaurants, e.g.) than in previous years. 

In 2021, loan portfolios will likely grow modestly as the whole world digs out from the abyss of a pandemic-ridden 2020, but banks will still be cautious, aware that the old normal still won't return at least until late 2021 or early 2022.

Low Interest Rates

Once the pandemic struck and proved to be around for the long haul, central bankers everywhere leaped to respond to retrigger economic activity. 

In the U.S., that means the Federal Reserve Bank. Around the world, that ordinarily implies other countries and central banks will have closely watched the behavior and actions of the Fed and will attempt to adopt something similar. 

The Fed reduced interest rates to near historic lows from short-term to long-term across the yield curve.  A reignition of economic activity (measured by GDP trends) would require low borrowing costs.  Rates across the spectrum (U.S. Treasuries, investment- and non-investment-grade corporate (Libor, e.g.), mortgage rates, etc.) plummeted and have remained low since March.

Corporate borrowers swarm toward low interest rates and sometimes borrow even when they don't need to. In 2020, some of the borrowing is rationalized by a contingency plan to boost cash reserves in an economic downturn:  Borrow now when you can, put the cash in reserves, and prepare for worst-case scenarios when business revenues disappear, but tend to expected and unexpected operating costs . 

Before 2020, some large corporates had begun to reduce leverage (pay down debt and reduce the burden), while anticipating rate increases.  Corporate debt sprouted by late March and has leveled off since then. Demand for debt increased, but it certainly helped that banks and debt markets (investors) accommodated them. (Many large U.S. corporates reached borrowing peaks in June, but have reduced marginally since then.)

In 2021, most experts and market watchers expect the current low-rate environment will continue at least through early 2022. While familiar, large behemoth companies (Amazon, e.g.) are healthy and strong, the overall economy (in the U.S. and around the globe) still needs time to bounce back. Borrowings peaked last year, but large corporates don't intend to seek to reduce leverage substantially as part of 2021 financial planning. 

Equity Markets

In strange ways, while the world was turning upside down, stock markets glided to a happy end by the end of the year. But the churning and tumbling along the way were sometimes unbearable.  Market analysts and traders measure volatility based on statistical "standard deviations" and a familiar "VIX" index in the futures markets.  

Yet in the end, because all stock indices increased with above-satisfactory returns, we simply reaffirmed what we knew all along--that equity markets are not true gauges of domestic and global economies. They reflect what they are supposed to do--market values in the top companies that appear in that index. Some of those top companies (Amazon, Microsoft, Alphabet, et. al. proved to be pandemic-proof.)

One new company appears in the S&P index for the first time in 2021: Tesla, one of the year's most dazzling stocks. A year ago, its share price hovered around $110/share. By the end of 2020, its share price had topped $800/share. A few analysts attribute some of that bump to buying pressure from funds that needed to purchase shares to replicate an S&P basket.  

However, the gains have been enormous and, to some, unexplainable for a company that has a choppy financial past, a mountain of debt, an erratic CEO and fierce challenges in managing production costs. 

To its credit, indeed, the company will report its best earnings year ever, much of that because of its ability to control costs while boosting revenues by at least 15%.

While a global economy imploded in 2020 and while many are comfortable about an eventual recovery in late 2021, predicting the stock markets in 2021 is still difficult.

The IPO market stopped, stalled, and restarted in 2020.  Companies intending to go public all along during the year eventually did.  (There were reportedly over 400 IPOs in the U.S., one of the best years since the dot-com era.) Not many shelved plans to issue new stock because of the pandemic. And if they did, the pandemic wasn't entirely the blame. AirBnB, DoorDash and Palintir were the most prominent names to go public. 

The controversy in the recent spate off IPOs may not be that some companies issued new shares before they should have, but that some companies fall under the category of "SPACs," the special-purpose acquisition companies that are business shells with no business purpose other than to acquire private companies that might have considered going public in the future. (They are also called "blank check" companies.) In the fourth quarter, every other IPO announcement appeared to be from an SPAC. 

SPACs will garner more attention in 2021, partly because of the large influx of them, partly because it's considered a fad in finance in the current era, and partly because regulators wonder whether it's a scheme for private companies to circumvent the more burdensome routine of going public. 

Mergers and Acquisitions

In the early weeks of the pandemic, M&A activity stalled, as expected. But by the second half, companies resumed the momentum of executing business strategy via mergers and acquisitions. That's what companies do, especially large ones and despite industry statistics that show most mergers ultimately should never have been done. 

In the U.S., the year started off with Morgan Stanley's announced acquisition of E*Trade. During the year Salesforce bought Slack,  and Uber bought Postmates. Nothing transformative, not much seizing front-page headlines, but still a steady flow of tack-on acquisitions, as companies sought to diversify into other businesses or expand into other industries. 

If it weren't a blockbuster year, it wasn't because of lack of financing. Large companies, by late 2020, had access to financing markets (debt and equity) and might have even been encouraged by low interest rates. Companies, too, have been focused on preserving cash flow and wrestling with the uncertainties of the pandemic. In 2021, they may consider eyeing targets that might be under-valued and worthy of taking risk of acquiring. 

As all know, investment banks' livelihoods depend on deal flow from IPO and M&A activity (as well as debt underwriting and other corporate-advisory services). The banner years in IPOs and M&A contributed to exceptional years for the big banks and to the frustrations of those wonder why bankers profit so much when much of the country and world suffers.  

The top banks are an oligarchy at the top and generated fees in the billions. They will all report increases in related fees by at least 20%. The names are the same from year to year. The order switches up slightly: JPMorgan, Goldman Sachs, Bank of America, Morgan Stanley, Citigroup and Credit Suisse. For this group of six, companies and other financial institutions paid over $40 billion in fees (in aggregate) to help them go public, acquire other companies and/or raise money in bond and loan markets. 

Bank Regulation

After the last monumental crisis, bank regulators around the world rolled out tiers of regulation (Basel III, Dodd-Frank, European Union directives, MiFiD II, etc.). The rules were tightened (almost too severely by some bankers' accounts) and have eased or tweaked since 2010. In the U.S., the Federal Reserve and the OCC have revised, rethought, and rewritten rules routinely, mostly to ease the burden on bank compliance officers. (In the U.S., stress-test rules were loosened, certain Basel III requirements were lifted for banks with assets under certain thresholds, and regulators worked out ways for small banks to have simple capital requirements.)

However, some of the same tough rules senior banks complain about (liquidity, capital adequacy, loan-loss provisions, leverage, operational risks, trading restrictions, etc.) might explain why many banks survived 2020 without much more than a hiccup. 

Banks will begin to report 2020 earnings in the weeks to come. Few bank leaders will deliver sour results, although many in the U.S. will quietly pout about how responsibilities to provide loans in the U.S. under the U.S. CARES Act loaded up their balance sheets with low-earning assets and resulted in scattered operational nightmares.  

They certainly whined about how stock markets were unkind to bank shares. But in recent weeks, for many bank stocks, valuations have rebounded as if the pandemic never happened. 

U.S. banks must continue to adapt to new U.S. GAAP rules related to how they compute expected losses (loan-loss allowances) on their respective loan portfolios. The new U.S. "CECL" rules are conservative and forced the larger banks to increase reserves (and lower earnings just a little bit) in 2020. Those adjustments occurred in the first quarter, just when the same banks were preparing for CoViD battle.  In most years, CECL would have grabbed financial headlines to explain the first-quarter earnings downturn, but CoViD supplanted all references to that. 

Trading Activities: Financial Institutions

In the days to come, when top banks and financial institutions report 2020 fiscal results, one remarkable line upsurge will show in income generated from trading activities--including trading fixed-income securities, equities, derivatives, commodities and currencies.  

U.S. bank traders (by rules from Basel, Dodd-Frank, and Volcker rules) are market-makers, and market-makers dine on volatility and volume. It doesn't matter about market movement and trends, as long as there is volume. And throughout 2020, there were concern, panic, uncertainty, desperation, and later optimism and hope. All that is a recipe for success among market-making traders who buy, sell, hedge, anticipate flow, and maintain "inventory." They interface with counterparties and customers who want to dump assets, buy where there is opportunity, and/or just hedge a variety of unbearable risks. 

The activity leads to trading gains (mark-ups, price appreciation, bid-ask spreads, commissions, more customer flow, more volume, etc.). Right from the beginning of the pandemic, large banks feasted. Bank of America, for example, will likely report over $11 billion in trading gains; so will JPMorgan Chase. Goldman Sachs, from which about 40-45% of its 2020 operating income will come from trading, could reach $14 billion. 

If anything, bank traders may lament the stability and higher degree of market certainty 2021 could bring. Stability and certainty decrease the likelihood that investors, funds, and other managers will want to churn their portfolios, hedge certain risks or reallocate among asset classes. Lesser volume. Lesser trading income. 

Because of bank regulation, smaller banks avoid the trading arena. But there are unmanageable or intolerable amounts of market risks (risks the larger banks can adroitly manage). There are also market-related capital requirements, technology investments, and the burdens of complying with the Volcker rules (which dictate how banks can conduct trading activities and which are more difficult to follow than a flight plan to the moon). 

Cryptocurrencies: Are We There Yet?

Cryptocurrencies (most notably, Bitcoin) have become household words now and aren't considered as bizarre and arcane as when they bolted onto the financial scene a few years ago. Everybody knows at least a little about cryptocurrencies, even if most stay as far as possible from them.

Cryptocurrencies continue to try to find a niche, a purpose, and a home in the above-ground financial system. By 2020, major financial institutions have at least taken a "here to stay" approach, even if they haven't figured the best business rationale for them.

Many financial institutions, on the other hand, have explored the system behind cryptocurrencies:  Its vaunted distributed-ledger technology (DLT), the accounting and computer-processing behind cryptocurrencies, often referred to as "blockchain." Big banks like JPMorgan and Goldman have done research to figure how the system (not necessarily a cryptocurrency) can be used to replace inefficiencies in bank processes like the settling of securities, the funding in overnight repo (inter-bank) funding markets, and the steps involved in export-import financing (including bank letters of credit). These projects continue, and some will eventually be successful in leading to expected efficiencies and cost-reductions.

Now back to cryptocurrencies themselves. We are now where the negative stigma associated with being involved in this financial space is slowly erasing. 

In 2021, in fact, securities regulators could approve the set-up and issuance of Bitcoin ETFs, shares traded in public markets that invest in Bitcoin. That will permit almost anybody with a brokerage account to gain access to the coin and participate in the wild rides of Bitcoin volatility.  (A Bitcoin that was value a $10,600 in October reached $36,000 in January, 2021.)

Corporate Bankruptcies

The list of corporate bankruptcies in 2020 was long. It included familiar names (J.C. Penney, Modell's, Pier 1, Gold's Gym, Niemann Marcus, J. Crew, Borden and Hertz Global); it included names from the energy industry (Chesapeake Energy) and a flock of companies in already-vulnerable industries (retail, entertainment, hospitality, etc.). The airlines (except for LatAm and Avianca) tripped up, experienced existential moments, but somehow survived.

The stigma of a bankruptcy announcement was erased. In fact, many customers, investors, and business leaders have grown numbed to the regular announcements of filings. 

In 2020-21, a bankruptcy filing is just as much influenced by private-equity and hedge-fund creditors, as much as corporate banks. In current times, they play an enormous role in pushing companies to file and preferring not to restructure or provide leeway for debt that is due. They may not be chasing debt payments, but chasing underlying infrastructure assets or control of the enterprise. They have more aggressive agenda and different objectives than banks, which often prefer to work something out, avoid liquidation or escape the laborious bankruptcy proceedings.

Many bankrupt names in 2020 had already struggled with faulty business models, outdated products, excessive debt and diminished customer demand. The pandemic pushed them off the cliff. Others were companies where revenues and cash flow disappeared overnight. 

In a rebounding 2021, the frequency and magnitude of borrower defaults and bankruptcies may slow or decline. But other companies, running out of cash and seeing a pandemic rebound will be slower than hoped, will file in the months to come. 

CoVid-19 was a hurricane to businesses big and small, but it forced everybody to adapt to different habits, ways of life, processes, and workstyles as 2021 gets under way. That forces businesses and industries to adapt and change. Some are doing so; some won't be able to do so. 

Tracy Williams

See also:

CFN: Corporate Bankruptcy Season, 2020

CFN: Are Corporate Borrowers Prepared? 2020

CFN: M&A and CoViD, 2020

CFN: What Is the Banks' CECL Requirement? 2017

CFN:  Morgan Stanley's Sneaky Acqusitiion of E*Trade, 2020

CFN:  Banking 101 and Corporate Financial Analysis, 2020

CFN:  BitCoin Mania, Again, 2018

Morgan Stanley's Sneaky E*Trade Move

In a combination of marquee names, Morgan Stanley announced it will acquire E*Trade 

Yearend has come and gone. Markets have resumed intermittent volatility.  Deals that might have been on the table last fall are ready for roll-out with fanfare. In mid-February, Morgan Stanley stealthily announced a major acquisition for the financial industry to ponder.  The vaunted investment bank, now a global financial institution under the auspices of bank regulators, reported it will buy E*Trade, the broker/dealer firm that launched an online revolution in the late 1990s. It will pay $13 billion (in Morgan Stanley stock) to E*Trade's shareholders in a deal that will close in late 2020. 

By 2020, E*Trade had evolved into more than a discount broker offering stocks online. Recall the height of the explosive dot-com era of the late 1990s. E*Trade vaulted the gates to become one of the first to sell stocks and bonds to individuals on the Internet. It did so (as it does today) with the help of eye-catching advertising.  What appears to be as a routine as the sun shining today was something revolutionary at the time. E*Trade eventually grew into a large financial institution, offering a multitude of products and owning bank entities.  

For years, Morgan Stanley and E*Trade seemed headed in different directions. One rested on the prestige of its investment banking and trading units.  The other appealed to individuals, day-traders and novice investors.  In recent years, as Morgan Stanley has emphasized its asset management business to generate badly desired revenue growth, parts of Morgan Stanley was inevitably headed into E*Trade's direction. 

Not many would have speculated Morgan Stanley had its eyes on E*Trade, although many might have wondered what would have been the response by other institutions after Charles Schwab had announced its own major deal weeks before.  Schwab agreed to acquire a peer firm, TD Ameritrade, for $26 billion. And soon afterward, Franklin Resources agreed to acquire Legg Mason for $4.5 billion. 

Morgan Stanley-E*Trade is different. The two institutions, although they competed and had parallel business activities, weren't considered peers.  Morgan Stanley is often regarded in the league of Goldman Sachs, Citigroup, Bank of America, and JPMorgan Chase. All five have global investment banking and trading operations, but all five highly value their asset management and consumer businesses more and more. (Yes, even Goldman.) All five are now regulated bank holding companies, carefully watched by banking regulators and painstakingly attuned to regulatory restrictions.  

E*Trade, too, is engaged in banking and wealth management, but targeting individuals and a customer segment that don't overlap with Morgan Stanley's.  It launched itself as a premier online, cheap-commissions broker (when others were just experimenting with it) and expanded its businesses over time. Squeezing an asterisk within its name was not an accident, but a way to spawn attention when other online brokers had pranced onto the scene. 

By the mid-2000s, it, too, had a commercial banking operation to complement all the online-trading activity. It competed vigorously with Edward Jones, Ameritrade (before its TD merger), Scottrade, and Schwab. 

By the end of 2019, Morgan Stanley (especially after periodic tumbles during the crisis) had become a major financial institution with about $900 billion in assets, $80 billion in book capital, and an $8 billion net-income earnings stream (and an admirable 10% return on book equity).  E*Trade had grown its balance sheet to $60 billion, its capital base to about $7 billion, and earnings hovering close to $1 billion. Returns on book equity were approaching 14%, quite laudable for financial institutions in 2018-19. 

Yet in this large pocket of the financial-services industry, it's often not about balance-sheet assets and equity, but just as much about "assets under management." How can and how would each continue to attract customer assets or convince customers to bring all their financial assets into their fold? 

Assets under management ("AUM") generate stable, predictable streams of fees. And they don't require balance-sheet usage and funding. Probably more important, they don't require substantial amounts of regulatory capital (based on market and credit risks). For Morgan Stanley and E*Trade, the new deal will permit the combined firms' AUM to levels above $3 trillion. (AUM includes assets in custody, assets channeled into funds of all kinds, and assets being managed passive and actively.)

Hence, their market values (the precious stock values their respective shareholders care much about) can only grow if AUM grows.  For the large bank institutions and non-bank institutions (like BlackRock, $6 trillion AUM), competition for assets is fierce, and organic AUM growth has stabilized. So why not combine two separate institutions to achieve a leap in growth?

Over the past year, the stock price of E*Trade's dividend-paying shares has bounced around often between $45-60/share. The Morgan announcement has given E*Trade shares a slight bump ($53/share). The Schwab-TD Ameritrade announcement had pushed it downward, as the market wondered about E*Trade's next step.  

Meanwhile, Morgan Stanley's share price has zoomed upward (to its current $52/share) over the past year in the same way its peers' prices have increased, as large banks have benefitted from improved earnings, stronger balance sheets, dividend increases and diverse business lines.  Yet Morgan still likely felt it needed a boost, an E*Trade-triggered boost. 

Over the past year, after Schwab and some firms announced they would reduce trade commissions to zero or near zero, everybody had to react lest they lose AUM.  As commission fees dip toward zero, companies still have to recoup revenues somewhere if only to cover operating costs and generate a profit.  As much as advertising and promotion announce firms are allowing "free" trades, nothing in the end is all that free.  

If brokerage fees slip toward nothing, firms will recover these revenues in other ways:  other banking products and asset-management and custody fees. The more assets they accumulate, the more they can digest free trading and the more likely they can offer the same customers a suite of other products (perhaps home mortgages, credit cards, loans to purchase securities on margin, loans secured by assets in the portfolio, and auto loans).

Now that the Morgan-E*Trade 2020 deal has been reported, details and approvals must come. Regulators must approve the marriage, although there are few signs that suggest--at least initially--they won't.  Like all major deals, while some applaud the merger, others will ask questions about how the two will make this work. 

1.  How will Morgan Stanley integrate the businesses, legal entities, personnel, management and operations of E*Trade? 

2.  How will Morgan Stanley incorporate the brand of E*Trade? Will it manage E*Trade as a separate investment, a wholly-owned independent subsidiary? 

Often acquirers permit their targets to operate independently until they implement a plan to rationalize and combine business lines. The E*Trade name won't disappear soon, but history suggests acquirers sometimes acquire a brand and then eventually retire it. (Remember Smith Barney and Dean Witter?)

3.  How will Morgan Stanley rationalize product offerings and pricing to existing groups of Morgan Stanley and E*Trade customers?

4.  What operating "platforms" will be used to manage assets, conduct and settle trades, hold securities in custody, and ensure that pricing and services are consistent for both Morgan Stanley and E*Trade customers?

5.  Will regulators express concern and delay approval of the deal? 

The process will take time, but approvals will likely come.  There are no monopolistic, unfair-competition implications.  Morgan Stanley's capital base, risk management groups, and overall balance sheet will be able to shoulder risks, balance sheet, and term debt from E*Trade. E*Trade's relatively modest size won't make Morgan Stanley, already considered a firm "too big to fail" (or "globally significantly important bank"), that much more of an even bigger bank to fail. E*Trade plus Morgan Stanley will become a bank that is still smaller, in many respects, than JPMorgan Chase or Bank of America.

6. How will Morgan Stanley effect the purchase? 

It will issue stock to E*Trade shareholders (stock-for-stock transaction). There is risk the deal dilutes Morgan Stanley's share for existing shareholders (reduces earnings per share), but armies of operations managers will seek to rationalize cost-cutting and redundant roles. 

7. Now what will all others do?  

Other financial institutions won't sit still. Often the marketplace and shareholders prompt institutions to prepare and deliver a response. What will Bank of America, Goldman Sachs, and JPMorgan Chase do?  Do they observe from the sideline, or do they work with advisers to consider the right strategic next step? Are there more deals expected down the road?

Tracy Williams 

See also:

CFN:  Morgan Stanley: Can It Please Analysts? 2012

CFN:  Today's "Bulge Brackets" 2013

CFN:  Bank ROEs Are Stuck at 10 Percent, 2015

WeWork: What Happened? Why?

Earlier this year, the company was a unicorn darling ready for a $50 billion IPO. By late 2019, its solvency is now in question.

Just a few months ago, the company was a darling unicorn, the stock of which was coveted by many. It was about to unveil itself to the world of public markets with a lavish IPO.  At that time, market watchers and equity analysts debated its market value. How much could it fetch in value in public markets? $40 billion? $60 billion? Maybe $70 billion?

Bankers lined up to participate in every way:  Lend money to its revered founder and CEO.  Arrange debt funding for its operations. Sell the IPO to salivating prospective investors.  Lead and underwrite the IPO with fanfare and pats on the back for all.

In one short period this summer through early fall, a giddy market anticipated its public offering; just a few weeks afterward, investors backed off, began to question the value of shares, pondered how the stock would perform in a projected recession, and wondered about the sanity and focus of its CEO. Investors, too, got uncomfortable with the CEO requesting to retain too much voting power. All of a sudden, there appeared to be no predictable timeline for when the company would ever make money.

What is this company that zoomed to start-up and investment-banking heights in early 2019 and is now being regarded by some as near insolvent, fighting for its life in late 2019?

WeWork. (Or We Company, as the holding company that would issue the new stock is called.)

What happened? How could this have happened? What role did banks play in helping to hoist the company to its loft financial heights? What role did they play in thrusting it toward a decline and arguably a questionable existence?

A turning point likely occurred when prudent, common-sense-approach prospective investors took note that other similarly prominent IPOs in the last few years (Uber, notably), which had blazing IPO launches, offered no reasonable timeline for when they will begin to make money.  Investors grew anxious when outlandish payments were intended to the CEO (Adam Neumann) and when they learned more about conflicts of interest between the company and the CEO's interests and outside holdings. All the projected earnings growth that was supposed to follow the company's large start-up and expansion-related losses, all of a sudden, had little expectation of occurring on schedule.

Prospective WeWork investors and the market that would follow its stock became uncomfortable about any management-flavored forecast for when the company would begin to make money.  Value in a company (or WeWork's pre-IPO assessment of $47 billions) is often based on the company generating long-term, sustainable, and achievable earnings and earnings growth. If the $47 billion were based on the company becoming long-term profitable in five years, investors and doubters began to reason that it would be much longer (maybe 7-10 years). If ever. If that long, surely the company couldn't be worth $47 billion today.

Bankers (from the big, notable investment banks), of course, ride a capital markets wave and momentum.  If the timing is right, they push the company toward a pubic offering:  Do it now before uncertainty sets in--uncertainty perhaps spurred by continuing uncertainty regarding China-related tariffs or the 2020 presidential election.  Do it now before investors become disenchanted with technology-branded young companies or prefer another attractive industry. (Bankers, almost without saying, are motivated by fees, including the tens of millions it would have earned from a public sale of We stock.)

Bankers, however, must do due diligence, investigate the validity of numbers, pore through accounting reports, and project performance, although they do so couched with guarded language and warnings that markets and environment change often and alter valuations frequently. But in their initial $40-billion-plus assessment of the company, they, too, may have been blinded by the charisma and style of CEO-founder Adam Neumann and believed with conviction his projections of unrealistic revenue growth from the company's global presence.

Neumann marketed a new business model, or a nuanced business model of something as old as the commercial real estate business.  He allowed the market to treat We as a "technology" play. As fast as it could, WeWork would enter into long-term lease obligations to control properties or consider borrowing long-term debt to purchase buildings. These obligations would be paid out from sublease income (cash flow rental payments from tenants).  Sublet rates, of course, would be determined from supply-demand dynamics and should be more than sufficient meet debt and long-term lease obligations and leave enough cash flow left for employee bonuses and earnings for investors.

The tweaked model is that the subleases (a) would be in small pieces (leases to entrepreneurs, small businesses, or even individuals) and (b) could be over shorter terms. Hence, the leases could turn over  frequently. Inevitably, there will be times when the space would be vacant (generating no cash flow to pay down debt or lease obligations to larger landlords).  While cash outflows (for lease and debt obligations) were fairly fixed and projectable, cash inflow would be uncertain, often volatile and unpredictable.

WeWork and Neuman convinced bankers and its primary pre-IPO investor SoftBank the working world had changed permanently: There would always be sufficient demand from businesses and individuals for this unique, different kind of work space. Workers from different business enterprises would be comfortable and even exciting about sharing work space. They argued this new, evolving working world would lead to surging, predictable cash inflows.

Bankers and SoftBank perceived that to sublease space to a new working generation, the company would need to (a) secure space, (b) build a brand, (c) promote a hip 21st-century culture of working and sharing space, (d) convince investors and lenders that cash flow will rush in, and (e) explain how demand for such novel, progressive work spaces would soar over time.

But what happens when an economy heads downward and entrepreneurs and businesses elect not to renew leases because they no longer anticipate similar business activity or choose another way of managing work space? What happens when entrepreneurs and small businesses cut costs by not renewing leases. The space becomes vacant and cash flows disappear likely more quickly than conventional real estate models.

Until late this summer, bankers and SoftBank rode the hyped model, prepared to lend the group $6 billion and to lead a well-publicized IPO.  Bankers eagerly arranged the debt piece, although they structured it to tie it to the offering of IPO shares to ensure there was a meaningful "capital cushion" below the debt they would offer. They also wanted to make sure there would be, at least for now, lots of cash sitting on the balance sheet at the start of the loan. At least interest would be paid on the debt outstanding for the foreseeable future.

Analysts, banks and investors (pre-IPO) presumed that cash proceeds from an IPO and from the debt (in billions of dollars) could help the company endure operating cash-flow deficits until operating-cash-flow-surpluses appeared. The company, they reasoned, was propped up and ready to endure a year or two without earnings.

But almost overnight, many realized that cash (from banks and the IPO) could disappear more rapidly than projected and no one had a good sense for when profits would appear. That cash might not permit it to survive more than a year or so.

Just like that, a company once prepared to ring stock-exchange bells to celebrate a vaunted IPO was now being dissected for possible insolvency.  The question was no longer whether or not the company's post-IPO share price could grow steadily, but whether the company could meet current obligations to debt holders, lessors, and employees, whether the company could slip into bankruptcy in a matter of months.

Many bankers, instead of reprimanding themselves for trying to push out a stock which today might have about a tenth of the value at which they were willing to promote it, may be praising themselves for having avoided a possible IPO disaster of an IPO and called it off.

The mission at WeWork these days is not about company promotion, creating happy work environments and boosting shareholder value. At least not this year (or next?). The objective now is about survival and getting through this uncertain, tough period.  Founder Neumann has been cast aside and pushed out (for reasons related to and beyond the IPO).  SoftBank has invested new cash to ensure the company can get through the next year or so (and to respond to ongoing concerns about the company's solvency). (SoftBank has even regrouped inhouse and is determined to learn lessons from this episode, announcing recently new standards for investments and company governance.)

The banks are also prepared to provide debt financing--likely at much tougher terms, restrictions and covenants than they might have required earlier this year. They all get to buy time to figure out how to massage what had been a glamorous business strategy and how to plan for more patient, realistic business growth.

New managers, new strategies and a realistic assessment of its marketplace could get it right. And its dreamers and founders, in the long term, could be spot on about the changing nature of work spaces and work environments. Time will tell.

Perhaps the company will have learned a lesson about how much better it is if they present themselves to the public with a much more precise timetable toward profitability.

Tracy Williams

See also:

CFN:  Snapchat and Its IPO, 2017
CFN:  LinkedIn Sells Itself, 2016
CFN:  Twitter's Turn to Do an IPO, 2013
CFN:  Facebook's Rough IPO Start, 2012
CFN: Is Uber Ready for an IPO? 2018
CFN:  Even Shake Shack Goes Public, 2015
CFN:  Alibaba's U.S. IPO, 2014

Bitcoin Mania, Again

Activity and values of Bitcoins and cryptocurrencies continues to rise in unexplained ways. In 2018, where do we go from here?

To invest or not to invest. To buy or not to buy. Is it for real? Is it here to stay?

Bitcoin. Cryptocurrencies.

The mania reached peaks in 2017.  An "investment" in Bitcoin a few years ago of about $1,000 reached values exceeding $18,000 as we approached the Christmas holidays, 2017. Swoons of volatility and uncertainty pushed that back to $13,000-plus and sparked greater discussion about digital currencies, blockchains, and the distributed-ledger technology that runs Bitcoin (and other digital currencies like Ethereum and Ripple).

Confusion still abounds. What explains 2017's surge in Bitcoin? What explains value? How should it be quantified? What is its purpose? Why are investors and traders willing to take such risks?

Regulators, bank supervisors, and government officials are huddling in conferences trying to determine what their roles should be.  They watch, share views, analyze public data, observe the euphoria among some traders, but haven't taken action (beyond some overseers in a few countries)--partly because they aren't sure how they are empowered to do so.

Questions continue--in the media, in academic discussions, in financial columns and among traders, investors, technologists, politicians, regulators, and bank leaders. What does it actually mean to own Bitcoin?  Is this flippant speculation? Does it represent real value? Does a catastrophe of some kind lie on the horizon? Could mishaps on a Bitcoin exchange trigger defaults and extreme events in the larger, global financial system? Will Bitcoin volatility trigger global systemic risks?

Rational traders approach the market as if value is based on not Bitcoin's purpose or usefulness today, but on prospects that it may have significant purpose and usefulness tomorrow--in periods to come.  That purpose would be tied to the value of Bitcoin as

(a) a way of making payments (consumer and corporate, anywhere in the world),
(b) a storage of economic or investment value,
(b) a safe haven from unstable global currencies (a "flight to quality"), and
(c) a way of operating within a transparent system without intermediation or intervention by a central government or central bank.

Hence, Bitcoin's value (or the value of any meaningful cryptocurrency) is a function of those factors and the probability the coin or the system will achieve those goals.

But some traders aren't interested in such factors and merely want to speculate and take advantage of what ultimately is a speculative trading game.

In reality, combinations of both types of traders are involved in the market. The two factions have influence on the daily fluctuations in Bitcoin prices.  Speculators are risk-seeking and will gamble to achieve high returns. Investor-traders who perceive there is a long-term purpose for Bitcoin and other digital currencies assess long-term value.  They acknowledge uncertainty in achieving those long-term objectives in the way there are uncertainties in any risky investment.

In the current marketplace, however, speculators might be out-numbering rational investor-traders.

Instances of fraud abound and have been reported, and institutions and entrepreneurs devise ways to open up markets to new participants to invest directly (via a Bitcoin wallet) or invest indirectly (via exchanges). In the U.S., the Bitcoin ETF (exchange-traded fun) doesn't exist. At least not yet. An ETF offering must win approval of securities regulators, who will certainly take their time to determine whether it's a suitable investment from all classes of investors.

In a recent step toward legitimacy, in late 2017, commodity and futures exchanges announced they would unveil a new Bitcoin futures contract, an instrument that permits investors and traders to maintain a leveraged stake in Bitcoin values--a way to trade (or speculate in?) Bitcoin without having to enter into the blockchain system and owning the digital coin directly. A trader comfortable with uncertainty and volatility now has an opportunity to speculate with financial leverage. The trader doesn't have to buy the entire Bitcoin amount, but merely put up a margin deposit (financial leverage).

The Chicago Mercantile Exchange launched its product in December. To do so, it had to do preliminary value analysis and assess worst-case scenarios. (Exchanges and clearinghouses do this on an ongoing basis for each of the trading products they offer.)  It had to measure and quantify price volatility and set up rules.

In doing so, it also had to establish and quantify "initial margin" (an amount the investor must put up in cash-equivalent margin to account for the maximum (short-term) loss the investor will experience within a defined time period). Unfortunately the CME has had to establish these margin requirements based on a limited number of years of trading data and without experience or scenarios of what could happen to Bitcoin values in extreme cases or "black swan" events. (It likely increased its worst-case calculations to account for the limited years of trading data.)

The CME is aware it is facilitating trading of all kinds in Bitcoin values and prices (investing, betting, gambling, speculating). It's also aware it will attract the most speculative of Bitcoin speculators because of the advantages of "leverage" in purchasing financial futures. And it will lure traders who will try to profit from the disparities in Bitcoin market prices and Bitcoin futures prices (arbitrage or basis trading).

The exchange/clearinghouse has established an initial margin of about 40-50% of the face value of a Bitcoin contract.  Hence, to purchase a Bitcoin contract (for March settlement) at $13,000, the investor must deposit, say, $6,500.

If the price doubles, the investor makes $26,000- $6,500 (=19,500, or 300% of the deposit amount). If the price declines by half (as it likely could in this market), the investor loses everything (or 100%). Speculators might consider this trading opportunity a trade from heaven, notwithstanding the real possibility of losing all of the up-front deposit.

The exchange, of course, will have done significant due diligence to determine if the investor (operating through a registered broker/dealer) is financially qualified and capable of taking such risks. In reality, it's likely the trader would have also have other trading positions and assets (where gains elsewhere can offset Bitcoin-futures losses) (cross-product margining).

In the past year, government supervisors have begun to weigh in and render opinions. It's about time. Except in some places (like South Korea recently), no specific law or ruling has been enforced in the U.S., but they have begun to suggest where there could be problems or how they might act in certain circumstances. They have identified flaws in cryptocurrency systems and exchanges. They have called for protections for uninformed consumers or under-capitalized investors, and they have diagnosed whether cryptocurrencies are currencies or financial instruments and securities.

And there is the ICO.

On other fronts, government regulators are addressing this Bitcoin offshoot--initial coin offerings, where companies seek to raise funds by issuing new digital coins, specific to the company, similar to the way young companies issue new shares to the public to finance operations.  Several ICO's have been done.

Now regulators are catching up. A primary questions looms over this activity: Is this a way for companies to finance the business without approval by securities regulators and without having to be subject to the same scrutiny and due diligence the SEC in the U.S. requires?

In early 2017 and in December, the SEC issued statements acknowledging that, to date, it has not approved any cryptocurrency or any ICO.  Period.

It has reminded investors that if any person or institution who invests in a digital coin via an ICO and if there is expectation of a share of ownership or economic value from the earnings from the issuing company, the ICO offering might be deemed to be security under U.S. securities laws.

The SEC stated summarily:  "(While) there are cryptocurrencies that do not appear to be securities, simply calling something a currency or a currency-based product does not mean that it is not a security."

The SEC's detailed notices suggest it acknowledges Bitcoins and the growing number of cryptocurrencies are here to stay. It joins a growing number of financial leaders and organizations that admit crypto-currencies, blockchains, and distributed-ledger technologies could refashion the global financial system in the way derivatives and securitizations vaulted into the middle of the financial world in the 1990's.

Acknowledging "We can't beat this, so let's wrap ourselves around the risks and do so quickly," the SEC, to its credit, offered a handy list of questions investors should to ask themselves when they decide to join this marketplace. They include such questions related to proper due diligence of the sponsor, use of proceeds, financial statements of sponsors, timely trading data, openness of the blockchain, threats of cybersecurity, and legal rights of investors.

Blockchains and distributed-ledger technology, no doubt, are here to stay. Many industry participants see the best value in Bitcoins from the underlying technology and system--a record-keeping system free of a central moderator or intermediary and transparent to all players, and one that crosses borders easily.  Hence, many institutions are supporting enterprises to exploit the technology for purposes of securities clearance and settlement and other conventional financial transactions.

On the other hand, crypocurrencies are here to stay unless some catastrophic collapse in values or some blatant fraud leads to a debilitating financial crisis. Industry leaders cringe about systemic risk: The risk that unexplained, unexpected volatility would lead to mammoth market losses, which could lead to credit risks, credit losses and the bankruptcy of significant participants, which could lead to losses among financial institutions and banks that interacted with or funded the bankrupt players, which could lead to a global standstill, which could lead to....

Such extreme events would likely halt popularity and expansion, but for a short time. Remember, derivatives, securitizations, mortgage securities and junk bonds spawned financial crises of various kinds years ago, but after periods of inactivity (and after new rules), they all reappeared.

See also:

CFN: Bitcoins: Embrace or Beware? 2014
CFN:  Flash Boys: Slowing Down High-frequency Traders, 2014
CFN: MiFid 2: Do We Know the Real Impact? 2017
CFN:  Making Sense of Derivatives, 2013
CFN:  High-frequency Trading, 2012

U.S. Stocks: Winners and Losers

U.S. stock indices rose 20% and higher in 2017. Who were some of the winners and losers?What will happen in 2018?

A year ago, just on the heels of a glowing year in equity markets, investors and traders were optimistic, but geared up for volatility and possible corrections in 2017.

A year later, equity market players (investors, analysts, traders, and bankers) are patting themselves on the back and feeling fortunate.  The markets survived and even thrived during Trump-triggered political volatility. It was a good year. Most stock indices were up around 20%, some higher.  Arguably, the biggest winners are investors who parked funds in mutual-fund indices and ETF's, avoiding higher management fees to reach such lofty returns.

With the Dow eclipsing 25,000 in early January and some momentum carrying over, will 2018 be even better?

A year later, pundits and columnists do what they always do. They contemplate whether a correction is ahead and a long-run bull market will be derailed. They assess the short-term favorable impact of the latest U.S. tax legislation.  They ponder the impact of large companies with billions in cash residing in foreign balance sheets repatriated back into U.S. operations.  They decipher patterns in consumer spending, consumer and corporate debt levels, and hidden messages from Federal Reserve Board governors.

And then they dare to predict boldly where we might go from here.  The market, meanwhile, follows its own course.

A quick look back.

What companies and sectors were winners and losers? What explains a momentous surge or an inexplicable decline when the market in general is trending upward? Let's examine a sample.

Among S&P 500 sectors, tech, healthcare, pharmaceutical, banking and industrial stock portfolios all exceeded 20% returns.  Consumer, retail and real estate sectors lagged, although they experienced gains.  Energy stocks, as a sector, had losing returns, even as oil and commodity prices bounced back from 2015-16 lows. (All, of course, depends on how a sector is defined and what stocks are included in a vast array of energy-related companies.)

Across all industries, there were some real winners, where gains exceeded 40% and share prices vaulted to new highs because of new corporate strategies, new markets, and well-planned expansion and because of the continuing phenomenon of "the internet of things" and plain ole luck.

The computer-chip maker Nvidia saw its shares increase by 85% in 2017 (and the rise continues in 2018). It benefits from growing markets in gaming and artificial intelligence.  With P-E ratios above 50, investors have expectations of continued growth in sales and earnings.  The $8 billion-revenues company is expanding quarter after quarter and generating over a billion in annual cash flow to add to a balance sheet with mounds of cash (over $5 billion) and a modest amount of debt.

PayPal is a fin-tech stock that also surged in 2018 (88% increase).  It has gone through transitions and iterations (mergers, spin-offs, etc.) and now stands alone.  Like Nvidia, investors are paying for grand expectations of growth. At PayPal, investors perceive monetary payments will become more digital, and such electronic wallet payments will no longer be an experiment or a technology fashion.

Like Nvidia, PayPay's P-E (price-earnings) ratios exceed 50 and reflect educated guesses the company will continue to grow. Income in recent years has fluctuated and in 2017 was flat from quarter to quarter (generating satisfactory 10-11% returns on book equity).  The company appears to have adopted an Amazon corporate strategy of focusing on revenue growth, managing costs reasonably, but not allowing rigorous cost control to keep it from growing as rapidly as it wants to. 

Revenues are approaching $13 billion annually.  The company operates with almost no debt, lots of invested cash, and a strong equity cushion. Some observe PayPal is a financial institution; others classify it as a technology company. Many see it as a combination-- a major participant in financial technology with years of a track record and a realistic strategy.

For those who endured tough times with the company, Freeport McMoRan, the global copper-mining company, was a 2017 winner. Its shares increased 46%.  Just a year or two ago, with commodity and copper prices imploding, the company was a financial mess.  Losses were rampant, revenues plummeted (with declining copper prices), and a mountain of debt couldn't be managed. Ratings agencies and creditors worried. And it had to confront political turmoil and labor strife in its mines in Indonesia.

The company went through significant restructuring. It redefined its businesses, shed some operations, sold assets to raise cash, and has managed to get the debt burden under control ($20 billion in debt has declined to less than $13 billion).  It helps, too, prices for copper and gold (two of its mined products) have rebounded. 

At Freeport, investors and traders aren't necessarily buying long-term sustainable growth, as much as they are rewarding a company for having solved operating problems, dealt with debt, and, of course, taking advantage in upswings in mineral prices.

Even in a winning year in equity markets, there are losers--companies and industry sectors that are struggling, where products and prospects are dim, cash is disappearing and corporate strategy is confusing or questionable.  That applies to much of the retail industry (think Sears, JCPenney, Macy's, The Gap, etc.), where companies coast to coast are near panic trying to respond to online-shopping trends.

Sears and JCPenney are attempting every trick in the retailing book to stuff the flow of losses, although both will likely report 2017 fiscal losses. Share prices have declined in the last few years, but occasionally bounce up and down as investors evaluate whether company managers have restructured adequately or have adopted the miracle strategy that will turn their fortunes around.

Macy's encounters the same, but it still makes money. In 2017, Macy's shares declined 30%. The company continued to address falling revenues, dwindling cash flow, and debt.  Shutting down stores is a short-term solution. New marketing strategies, supposedly a long-term solution, haven't worked as well as hoped.  Investors and traders aren't sure what's next for the company or any old brick-and-mortar retail company.  At least Macy's is reporting earnings (barely) (about $300 million in 2017 (estimated) on a precipitous drop in revenues (about 6% return on book equity).

Macy's management is fortunate it's not confronting what Sear's and JCPenney are facing today:  another year of high-probability losses in 2018, cash disappearing from the balance sheet, and futures even more uncertain than that at Macy's.

Under Armour, the upstart sneaker and athletic-apparel company, suffered a 50% decline in stock value and might have been a victim of excess enthusiasm in a company thought to be able to gnaw at Nike's market share.

Until this year, the company had been performing well--double-digit percentage revenue growth, steady earnings improvement, and good returns.  In 2017, growth was stunted, and quarterly earnings were erratic.  Had the company reached a peak? Had it run out of clever ways to attack Nike's stranglehold of the marketplace?  And has the industry saturated? 

In recent days, Under Armour's share values have recovered in small amounts. Traders may have soured on the company during the year, but may have corrected their pessimism.

It's January, and observations about equity portfolios are as varied as the industries that comprise the S&P 500.  Optimists point to economic metrics, employment figures, companies' optimism and companies with billions of cash searching for creative ways to invest in the long term. Pessimists remind all that bubbles burst and we've been down these euphoric paths many times before.

Tracy Williams

See also:

CFN:  The Recent Spike in Bank Stocks, 2017
CFN: Shareholder Activism at P&G, 2017
CFN:  Amazon and Whole Foods, 2017
CFN:  What Happened at JCPenney? 2013
CFN: Second-Guessing Snap, 2017