Now It's Twitter's Turn

Now it's Twitter's turn. It hesitated for the past year or so. This week (Oct., 2013) it bravely stepped into IPO waters, taking the first big step by sharing publicly its SEC filing and letting the financial world see its bottom line.

Twitter's hesitation, like all companies contemplating issuing stock to the public for the first time, results from trying to determine the optimal moment to sell stock in equity markets. That's often tied to market interest in the stock issue, supply and demand for the stock, and general equity-market trends.

Its hesitation may have also resulted from other factors: (a) its being shy about letting the world pore through its true financial performance and (b) its desires to avoid the IPO debacle Facebook experienced last year at Nasdaq with Morgan Stanley as the lead underwriter.

Twitter through the years has had to wrestle, too, with management and organizational issues. Some of those problems have been resolved, and the company has moved on to capitalize on its soaring popularity around the world.  In the filing, Twitter reports 218 million users on average each month this year, up 44% from a year ago.  Not quite Facebook numbers, but sufficient growth to get prospective investors interested and excited. Twitter might argue that the value or meaningfulness of ongoing usage is different than account activity in, say, Facebook or Linkedin. Hence, it's not how many use the site, it could argue as it sells new stock, but who uses it and how it's used. 

Because of the planned IPO, Evan Williams and Jack Dorsey, Twitter founders, can now calculate more accurately their fortunes (over $400 million each). A handful of venture investors will have a nice payday, as well.

Twitter in the filing divulged what many thought was the case. It continues to have losses with no signs those losses will turn into profits in the short term.  Investors in its stock, therefore, will bet that the company will continue to experience stellar growth in users, will find even more effective ways to generate advertising revenues, and will eventually turn losses into steady, growing profits by keeping costs under control.

The company will raise $1 billion in the IPO offering.  Investment bankers advising Twitter have suggested the company today has an implied market value of about $10 billion. How then does the company have such value, the corporate-finance novice asks, when the company reports losses with no expectations of profit in the short term?  SEC documents indicate the company lost $79 million last year and $69 million in 2013 to date.

Investors who will buy the stock are assuming profits are on the horizon. They will come because there are still vast opportunities to grow the number of users, grab more advertising dollars, and, therefore, increase total revenues substantially. They will buy the stock based on expectations, not based on history.

For now, investors and those who assess the value of the firm will value the company based on a reasonable estimate of growth prospects and based on refined projections of users and revenues. Revenues for the six months, 2013, doubled from the previous year, Twitter reports, while number of users continues to grow.

Investors and advising banks have Facebook and Linkedin as convenient benchmarks:  They study and compare current market values of those companies' stocks, their numbers of users, the activity in the millions of accounts and the level of sales and sales growth.  Investors will, too, assume the company, now under the guidance of CEO Dick Costolo, will invest in whatever technology is necessary from year to year to keep the engines going.

Twitter has few competitor threats. No other social network is about to topple it in doing what it does best in those 140 characters. But Twitter, along with Google, Facebook, and Linkedin, all chase after the same pool of advertising dollars. Companies seeking to advertise digitally must decide where they can get the biggest Internet bang without particular regard to the specific roles social networks play.

Goldman Sachs, winners of the investment-banking shoving match, will be the lead underwriter and will be assisted on the front lines by Morgan Stanley and JPMorgan.  The challenge they have as advisers, besides setting precisely the price of a single share, is to form a view of markets in the face of October's U.S. Government shut-down and recent equity-market uncertainty. But that's why they will be paid tens of millions of fees. They must step up and make such decisions and, especially after last year's rough launch, avoid a 2012 Facebook near-catastrophe.

Tracy Williams

See also:

CFN:  Facebook:  The Lucky Underwriters, 2012
CFN: Facebook Stock:  What's Going Wrong? 2012
CFN:  Did Goldman Overpay for its Facebook Stake? 2011

Who's Betting on Blackberry?

Worth a $4 billion gamble?

Among other deal announcements in Sept., 2013, an investing group from Canada has decided to bet on Blackberry, the tech company that was all the rage from the late 1990's until the iPhone shoved it off the scene in the mid-2000's.

People still use Blackberry (yep, some still do!), and many companies support employee usage, partly because of an efficient messaging system. Yet with rapidly deteriorating market share and with its feeble efforts to catch up with what other smartphones offer (and with mounting losses), who would want to buy the company?

A Canadian private-equity company has jumped in to take the gamble and assume the risk. It sees some value other market investors and the consuming public at large don't--up to about $4.7 billion worth. It has agreed to a buy-out to purchase shares it doesn't already own. 

In recent weeks, Blackberry's CEO has announced large losses, lay-offs and a new strategy focusing primarily on institutional relationships (selling the product and service to companies, not individuals).

Blackberry's prospective owners, Fairfax Financial, must see some virtue in this strategy. And they get to observe the strategy in execution out of the public's eye (as a private company).  No more need to earnings conference calls to disappointed investors to explain why market share dipped a few more percentage points.

For now, Blackberry and its new owners must digest some big losses.  The company just announced a quarterly loss of nearly $1 billion--mostly write-offs of Blackberry product that never could sell and never will in an environment when other companies take bigger leads in the smartphone race.

But the new owners also see billions in cash that still reside on Blackberry's balance sheet and tens of billions in value from patents and other intangibles. For all its troubles, the company has a balance sheet that's surprisingly sturdy--over $2 billion in cash and negligible amounts of debt. (Somebody in its finance office deserves a pat on the back for that.)

The new owners haven't articulated publicly an acquisition strategy (what they plan to do when they control the company). They may think that Blackberry's prospects deserve one more desperate effort. And the deal was struck such that they could change their minds without much penalty.

Over time, if all doesn't go well, they can always sell off valuable parts of the balance sheet, seize whatever cash that remains, and sell what was once a top-of-the-heap brand name.

Time will tell, and the new owners will probably give a go for the next year and a half. The clock starts now.

Tracy Williams

Fighting the Gender Fight at HBS

The pot is stirring at Harvard Business School

Harvard Business School made the front page of the New York Times last weekend.  It wasn't because one of its alumni is perched atop a Fortune 500 company or another announced a blockbuster merger with another mega-company.  It wasn't because one of its alumni is waging a ferocious shareholder campaign to take over a multinational company. And it wasn't because one of its alumni is the announced head of McKinsey, Goldman or Booz Allen.

It was because its dean and staff are fighting a fierce fight to change the culture of the school and make it more accepting of the growing number of women on campus. According to the article, women now comprise 40% of the students in the business school. But the culture still remains entrenched in male dominance--in case-study groups, in classroom discussions, in the assembling of secret societies ("Section X," one is supposedly called), and in seizing the highest-compensation opportunities after graduation (especially in private equity, venture capital, investment banking and consulting). The article points out how males at the school are better at "touching the money," finding easier pathways to lucrative job offers.

Harvard, in the article, is applauded for recent successes and progress. It highlights the efforts of Dean Nitin Nohria and his team of administrators, who want to spawn an environment where women can thrive. And they want to change attitudes and increase the number of women faculty.

In business school, class participation, the art of leading discussion and presenting ideas and arguments, can comprise much of the final grade in a course.  In many Harvard courses, participation, as subjective as it is assessed, can be as much as 50% of the final grade.  Harvard administrators want to change how professors assign participation grades, because aggressive, outspoken males in class--honed by aggressive styles from stints in banking and trading--dominate class discussions, outshine others, and dismiss input of females in class.  Harvard wants to change the classroom dialogue and the benchmarks by which students are evaluated.  They are even recommending women to attend sessions on how to raise their hands (highly, visibly and confidently) in class.

This revolution of sorts, a punishment of old, male conventions and traditions at Harvard, has been welcomed by many, but has caused uneasiness, discomfort in others. The Harvard administrators press on, aware that right now the impact is cast only on campus and that the current group of students are part of a grand experiment.

Frances Frei, one of the deans on staff in the business school, is the face of many of the changes, the one who has decided progress is possible by making "unapologetic" (her favorite word) moves and making things uncomfortable for the old guard.

The article highlights what most have speculated about HBS for years--that the experience of attending the school involves intense immersion inside the classroom, in case groups, and, perhaps most important, outside the classroom in networks, social interactions, and after-hours gatherings. Social success, social connections and even social match-making, it seems, count as much, if not more than, aptitude inside the classroom--in finance, marketing, accounting, and operations management.  Some students worry more about social dynamics than about basic principles of valuing a corporation.

That might be disconcerting to some, especially to those who deem themselves unconnected, disadvantaged, or without means or ties to the business elite. That might be fresh air to those with connections, special ties, and less of a knack for dissecting financial statements, cash flows, and volatile currencies.

That's not the way it should be, asserts HBS's current leadership. And the leadership has decided it will change the ways of the school even if it means making unpopular decisions, some of which have rankled many who knew Harvard better as a two-year fraternity for the sons of the elite.

Will HBS succeed? Will the experiment work? Or will it work on campus, but its impact will simmer once its 900 graduates march off to a resistant real world?

Harvard staffers are operating on an old premise for overhauling a culture. Making changes sometimes means inflicting discomfort and pain. Old ways, old patterns and old prejudices against women must be smashed, not just gingerly dealt with. Taking bold steps requires stirring the pot.  Not only is Harvard guiding female students on how to raise their hands in class, but it is monitoring the tone and flavor of discussion in class and evaluating professors on grade participation. It is even setting strict rules on the costumes women might wear or the parts they play at theme parties or end-of-year follies.

Harvard deans understand that changing Harvard won't mean sudden changes in hiring practices and the work environment at private-equity firms, venture capital firms, banks, trading floors and consulting firms. They hope for some eventual trickle-over impact.  They know what they do at Harvard will be watched and replicated at some business schools--at least those schools that have harbored similar cultures of marginalizing women. They know, too, that graduates today will one day become decision-makers, business chiefs and industry leaders in due course and could be influenced by values they adopted in school.

Has Harvard (not a Consortium school), however, addressed similar issues and a similar feeling of disenfranchisement among under-represented minorities on its Boston campus? Maybe not. Or not as vocally. Some among under-represented minority groups will avow they, too, sometimes feel excluded from social groups or closed, social societies on campus or feel uncomfortable raising their hands and presenting their views in classes filled with boisterous former investment bankers on the front row.

Harvard, or at least this group of deans running the business school these days, hopes that a plan that helps resolve gender issues is a plan that crosses boundaries and creates a culture that is a comfortable, conducive setting, so that everybody can thrive--not just brash former M&A bankers taking a two-year break from Wall Street. 

Tracy Williams

See also:

CFN:  Venture capital and Diversity, 2011
CFN: MBA Diversity:  A Constant Effort to Catch Up, 2012

Muriel Siebert: Wall Street Pioneer

Siebert: A career of firsts

Many people on Wall Street who knew Muriel Siebert well called her "Mickie."  Other people who interacted with her or conducted business with her firm knew about the Chihuahua dog that always tagged along. The dog even shared her office and sometimes interrupted meetings, often scrambling around the office craving attention. Visitors wouldn't dare complain.

On the Street, everybody familiar with her knew about her long career of firsts--the first woman to become a member of the New York Stock Exchange, the first woman to become New York State's top banking regulator, one of the first to found her own brokerage firm, and arguably the first icon in the securities industry for all the women who've followed behind.

They knew, too, about her dogged, determined ways, her bold, sometimes brash manner in speaking up on behalf of women. She thrived in one of the most recalcitrant environments, where men ruled the industry as if it were a college fraternity. From the moment she decided to make a living selling stocks and bonds, she battled old-boys clubs that blatantly disregarded pleas from women and minorities who wanted to crack the core.

Siebert, who died this month at 84 in New York, rubbed Wall Street men the wrong way--not because she wanted to, but she might have felt she had to. She spoke her mind and fussed about gestures and traditions that offended women. (The story is told often about the big ado she made about getting a women's room near the New York Stock Exchange dining room.) The doors she knocked down opened slightly, but only after relentless pounding. In later years, she never hesitated to toot her horn, recount her accomplishments, and remind all within earshot that we were only at the 20-yard-line in a 100-yard dash.

(The sprint for fairness and opportunity continues. Amidst announcements of her death come reports in late August that Merrill Lynch, now part of Bank of America, is settling a long-running lawsuit with black brokers in its retail network for amounts over $150 million.)

After gaining the stock-exchange membership in 1967, she set out on her own, choosing not to tackle the manly bureaucracies at the major brokerage houses of that time (the Paine Webbers, Merrill Lynches, and E.F. Huttons), if those houses would even offer her employment opportunity. She established her own small brokerage firm, eventually reorganizing it as a "discount brokerage house," where she peddled stocks at discount commissions--not bothering to expand into other securities businesses (corporate finance and trading), preferring to stick to what she knew best.

For years, her brokerage firm Muriel Siebert & Co. (and its incarnations through the years) operated within that niche, fortunate to survive in a tough industry, going head to head with bigger, more-capitalized firms that featured, of course, armies of old-school, male brokers. Over time, she eventually took the firm public (Siebert Financial Corp.) and ventured into philanthropy to give back and support other women following her path.

Nonetheless, not many know how she clamored and pushed for progress in other ways.  Late in her career, she formed ties with Napoleon Brandford and Suzanne Shank, senior African-American bankers in municipal finance.  When she decided to expand into municipal finance in 1996, her firm invested in a new affiliate partnership, Siebert, Brandford & Shank, now one of the top minority-owned banks in municipal finance. With more capital, they could win more business and rise higher in underwriting syndicates and tables.  She exploited their connections and experiences in municipal finance, while they took advantage of new capital and the "Siebert" brand.

Siebert fought, struggled and pouted until the end--likely still perturbed by slow progress across all sectors of brokerage and banking in big banks, in hedge funds, in small regional brokerages, and at asset-management companies.

Goldman Sachs this year announced a new slate of partners and managing directors--bankers, traders, and managers at the top echelon, the ones who run business units, make decisions about strategy and expansion, and the ones who reap the most in compensation. Only 14% of the new partners (managing directors with large ownership stakes) were women; only 23% of the new managing directors (those without promised large stakes) were women.  At Morgan Stanley, only 17% of new managing directors were women.

Siebert would not have been satisfied, would have been puzzled about such numbers in 2013, and in Siebert-like fashion might have picked up a phone and scolded the CEOs of those firms or might have whispered her disappointment sternly in a corner at Wall Street charity dinner.

Over 45 years, Siebert "leaned in" and pinched a few nerves, ruffled the cuffs of many securities-industry leaders, and griped about unfair practices and unfavorable opportunities for women. Like many pioneers, she worried less about being liked, worried more about progress.

Tracy Williams

See also:

CFN:  Making Demands on Diversity, 2013
CFN:  Getting Pushed Back, While Leaning In, 2013
CFN:  MBA Diversity: A Constant Effort to Catch Up, 2012
CFN:  Making Markets in Her Home Country, 2009

August: No Time for Doldrums

Market events mean no time for rest?

If history repeats itself or if tradition rules, then the waning days of summer in finance and markets should be marked by doldrums, inactive markets and dreading Labor Day.

But once again August has thrown a soft curve ball--with market volatility, big institutions confronting legal issues, and a band of activist shareholders causing havoc in boardrooms. Nothing that has caused market nightmare, but enough to cause a little upheaval in what should be dull days before mid-September.  The Augusts of 2011-12, recall, were upended by disgusting debates in U.S. Congress about government deficits and debt. 

The tale of the "Whale" and the $6 billion in trading losses at JPMorgan from 2012, events we thought had faded from everybody's attention, plopped up again when government regulators and law-enforcement officials decided to place criminal charges against some banks officials for hiding information about the losses and acting in deceitful ways.  The irony is the "Whale" himself, the JPMorgan trader in London who presided over the disastrous trading positions, is not a target.  JPMorgan likely suspected some action of this kind would occur, but it didn't expect the whole matter would resurface in late-summer business headlines, forcing the bank once again to rehash, review and remember the whole dreadful episode.

William Ackman, the tenacious shareholder activist whose bold charges and boardroom moves attract constant media attention, raised his surrender flag this month with J.C. Penney.  Ackman and his Pershing Square Capital fund were instrumental in implanting Apple-groomed CEO Ron Johnson, who was supposed refashion JCP into the retail-industry version of Apple-like merchandising. The Ackman-backed experiment failed miserably, the JCP CEO resigned, and Ackman became a pariah in that boardroom.  He gave up in August, resigned from (or was shoved off) the board, and resumed his shareholder fights elsewhere--at Herbalife. 

Ackman has charged that company (Herbalife) in running a Ponzi scheme in selling its product, and various sides have taken up the debate:  Is Herbalife a legitimate company, a reasonable growth investment? Or is it administering a fraudulent marketing scheme? The skirmish continues.

Commodity activities have plagued big banks Goldman Sachs and JPMorgan this summer, and unexplained volatility is not the reason.  Business reporters (first at the New York Times) discovered questionable practices by Goldman in aluminum markets, where Goldman receives fees for warehousing aluminum before final sales to end-users. Goldman is alleged to conduct a practice of delaying the transport of aluminum by transferring it from warehouse bin to bin for no apparent reason except to prolong fee collection.

The wreckage of mortgages and assembling mortgage securities won't go away for many top banks. This summer, Bank of America, still being knocked over for acquiring Countrywide in the midst of the crisis, is wrestling with legal accusations and possible settlements--in the tens and hundreds of millions. 

Elsewhere, regulators accused JPMorgan for deceptive pricing behavior in West Coast electricity markets.  Energy regulators accused the bank of unfair mark-ups in electricity prices in related trading activity.  JPMorgan and regulators agreed to a settlement, but the entire episode was enough to spur the bank to move quickly, reorganize and rethink its commodities-trading business. It opted to withdraw from physical-commodities businesses--businesses it had inherited from Bear Stearns.

After a remarkable first-seven months run, equity markets have begun to rumble and shudder, mostly because market-moving investors prefer to pay much attention to hidden messages coming from the Federal Reserve.  Every hint that the Fed plans to stop purchasing bonds that will keep interest rates low leads to gyrations in stock markets. That's the way the markets move these days.

And while it was transforming itself into a model citizen for regulators, JPMorgan was pummeled once again when the SEC announced it was investigating the bank for nepotism, hiring sons and daughters of well-connected Chinese executives and government officials.  No doubt senior bankers in CEO Jamie Dimon's circle are puzzled about a finance-industry practice that has taken place since, well, stock-market traders consummated transactions around a tree in downtown, 19th-century Manhattan.

Perhaps these days, it's all  the new normal--abetted by the Internet, technology, immediate access to market updates and everybody's ability to reach out to anybody anytime.  There might have been a time when all bankers, traders, compliance officers, deal-doers, and research analysts escaped en masse in August.  But nowadays regulators and enforcement officials don't take a break.  High-frequency traders and hedge-fund managers don't let up in summer.  Shareholder activists don't ease the pressure, and board rooms, CFOs, and investment-managers don't have the luxury of summertime doldrums anymore. 

Tracy Williams

See also:

CFN:  Delicate work-life balance, 2010
CFN:  Market volatility: Can you stand it? 2011
 

Derivatives: Making Sense of Where We Are

The world of derivatives is in a purgatory state--a prolonged holding pattern until regulators finally finish new rules that will govern how they will be sold, traded, valued, cleared and reported. Regulators and financial institutions in the industry have dragged their feet in annoying, painstaking ways. What will eventually happen to how they will be traded?  How will be big banks respond? What will they do? When will the industry decide?

How will banks compensate for the billions in revenues that could evaporate when the derivatives playing field is re-landscaped?

The stories have  been told often over the years how derivatives markets have surged and soared, how derivatives have become a market of trillions (measured by the "notional" or face value of the derivatives traded globally).  The credit-default-swaps market is said to be over $25 trillion. (That would be "notional" face value, not actual market value or market outstandings.)

The story is also told often about how derivatives markets are opaque, sometimes illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths that dictate pricing spreads, trading procedures, collateral requirements and who gets to join the inner circle of dealers.

WHAT REALLY IS A "DERIVATIVE"?

"Derivatives" is a financial term that today encompasses a wide range of financial activity. The term was rarely used before the mid-1980s, although some forms of derivatives have existed for as long as there have been viable trading markets.  In current times, a derivative might include almost any financial instrument that is influenced by market risks and credit risks, but is not a director investment into a corporate entity.  In other words, it encompasses all that is not an equity investment, a plain-vanilla bond, or a loan. 

Derivatives, by convention, include options of all kinds (puts, calls and collars), convertible bonds (and other "hybrid" instruments), interest-rate swaps, credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps, and currency swaps.  They include futures trading--those traded on

exchanges and those traded "over the counter."

Frequently, derivatives will include forward foreign-exchange transactions.  For most in finance, the term will include mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.

Derivatives creators adore acronyms, complexity, quantitative analytics and the lure of something new and different.  Derivatives managers enjoy the open-round gush of profits.  Financial theorists and financial engineers embrace whiteboards of equations and calculus that try to define the behavior of these instruments.

Derivatives, the term, captures just about any complicated instrument that doesn't sound like a stock, bond or loan.  The finance media define derivatives as financial instruments "the value of which are based on other securities and instruments"--a catch-all phrase that often doesn't explain exactly what they are or how they perform in live markets.

THE APPROACH OF BIG BANKS AND DEALERS

Here is how large banks and hedge funds that have dominated prominent segments of the market define and approach derivatives--at least until now, while the global business model for trading derivatives is under threat:

1.   The first institution to conceive, create, build a model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."

2.  The first few firms, usually large banks, that leap into the arena of a new derivative product determine the profit dynamics--how profit margins and spreads are determined, how positions are valued, and how prices are reported. Therefore, they become the core of large dealers that dominate the new market at the outset.  They will behave in ways to ensure they maintain control of the market--especially the lucrative pricing spreads.

3.  The large dealers who control the market decide when and how to open it up to new clients and counter-parties.  This permits the new market to grow, boosts liquidity, and spawns a large number of "end-users," who often use the derivative for risk-management or hedging purposes.

4.  The large dealers and their inner circle will design the marketplace such that the growing number of "end-users" (corporations, manufacturers, small funds, and individuals) must arrange trades by going to one of the large dealers.

5.  Large dealers, banks and hedge funds are able to maintain control of markets (and profits) because of advantages in capital resources, systems and technology, and information.  They can survey, see, comprehend and act upon all the activity that occurs around them.

6.  Large dealers, because they control pricing, spreads, and profits, have little incentive to change the status quo, except to increase activity and liquidity and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).

7.  Once they understand the new product and market behavior, speculators abound and will pounce on any opportunity to take advantage of market abnormalities or inefficiencies. They will likely be specialized hedge funds and funds that house "quant-jocks," but they may also (at least in the past) be the proprietary trading units of large banks and dealers.

8.  Large dealers, because they control the market, can determine the price reported among themselves, prices reported to other interested end-users, and prices reported to the public.

9. Large dealers determine, as they see fit or with guidance from regulators, how the transactions are "cleared" (settled, paid for, or consummated formally) and how they protect themselves from "default risk" by setting rules for how end-users participate (for example, by pledging collateral or requiring they meet certain capital standards).

Large banks and dealers claim they haven't managed these markets ruthlessly. They argue there has been sufficient self-policing and adequate oversight from regulators and industry-related organizations.  (ISDA, for example, is an industry association that continues to set common standards for trading, documentation, reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)

Then came the financial crisis.

Then came the public's charges that improper selling and trading of derivatives explains why the crisis unfurled and infected much of the global economy. 

Then came Dodd-Frank legislation and regulation.  Dodd-Frank was a comforting anecdote to the crisis. It had the right themes and provided outlines to make markets safe. But Dodd-Frank didn't stipulate tough  deadlines. 

Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how derivatives markets should be overhauled.  They have been tardy, however, in writing the thousands of rules, line by line, that will redesign markets from front to end.  Because derivatives are amorphous financial instruments and don't fall easily into categories, regulators fuss among themselves about which body should have the most oversight.  The debates among the SEC, the CFTC, the securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of the reason for delays.  The Federal Reserve, FDIC, FHFA, and OCC have opinions, too.  An alphabet smorgasbord of sometimes conflicting input.

In  spirit, regulators seek to require most commonly traded derivatives be bought, sold, traded and reported on a major exchange with pricing and dealer transparency rules.  Commonly traded derivatives must be cleared and settled (all post-trade operations) via an approved, recognized arrangement, usually funnelled through large well-capitalized banks and overseen by established clearinghouses.

Regulators knew, too, large dealers and banks weren't going to sit still and let millions/billions in profits wither away. Until banks figured out a way to re-engineer their business models to generate profits while strapped by new rules, they would stall the implementation of regulation and continue to squeak out profits. Or they would retreat to their finance labs to craft other ways of making money from derivatives dealing.

WHAT'S ON THE HORIZON?

Where are we now? Where do we go from here? Will reforms do what they are intended to do--reduce risks in the system, reduce the likelihood that trading won't implode into market nightmares, and prepare institutions for the next crisis?

1.  Banks are rebuilding their derivatives-trading desks, reorienting them toward customer activity and customer flow and allocating proper amounts of capital to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.

2.  But big banks won't go away sheepishly.  Revenues from derivatives soared until the late 2000s. They will continue to eke out profits until the economics and capital requirements dictate that old models make no sense.  The biggest and best dealers (including Goldman Sachs and JPMorgan) will develop new, different business models to generate profits. 

3. Massive regulation, oversight and public concern will discourage banks and hedge funds from creating new derivative products--at least not as rapidly as the 1990s and early 2000s, when new products flew off the shelves.  Not long ago, large banks seemed to roll out a fancy new acronym for a new product every other quarter, always a moment of pride for them and for the quantitative experts they had hired to think them up.

4.  Regulators, in an effort to come to a conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding to some of their unrelenting lobbying efforts.

5.   "Pain vanilla" activity (basic swaps, basic forwards, will thrive, even with thinner profit margins. The big banks will compensate with volume and take advantage of other banks exit derivatives activities.

It will have been a long haul, and it won't be over soon. Derivatives markets are huge, impactful, and complex.  This story still has many chapters remaining.

Tracy Williams

See also: 

CFN: Cliffs, Reform and Recovery, 2013

CFN:  Libor in Crisis, 2012

CFN:  High-frequency Trading: What's Next? 2012

CFN:  The Big Short and Credit-Default Swaps, 2010

CFN:  MF Global:  Too Small to Save, 2011

Basel III: Becoming Real

For those who work in or work with financial institutions, it's nearly impossible to avoid discussions of financial regulation.  It's everywhere.  It can be the drudgery of banking, deal-making, trading, lending, and investing.  But in an environment that is hustling to rid itself of the stark memory of the financial crisis, it's inescapable. 

Financial regulation, Dodd-Frank and Basel III are hot summer topics this year, because it's time for the deliberation to stop and for the rules to become real.  Large banks, such as Bank of America, Goldman Sachs, and Citigroup, have sprinted tirelessly to get ahead of the 900-plus pages of Basel III regulation-- rules drafted by the Basel Committee on Bank Supervision, which includes 27 nations, and intended to have more meat than the rather languid rules of Basel II and Basel 2.5.

Basel III regulation consumes the minds of CEOs and global heads of legal, risk, and compliance.  Trying to gain a fierce grip around the Basel III monster requires resolve, patience, an obsession to detail and resources to hire people and invest in infrastructure to keep up with everything.

The essence of 900 pages of guidelines and rules is that capital is king, that enormous of amounts of bank capital act as a safe financial cushion in times of crisis, whether the crisis is caused by in-house failures or by system-wide troubles.  Basel III details explain the calculations banks must make to determine the precise amount of capital they must maintain for the level of business (measured by the level of assets--assets on and off the balance sheet) they are engaged in.  

To avert confusion of what is an asset and what comprises capital and to discourage banks from using financial tricks to circumvent the rules, Basel III painstakingly defines "assets" and "capital." It also permits other regulatory bodies (such as the Federal Reserve) to define assets and capital further and add their own pages to the existing rules. In other words, the Federal Reserve can choose to make the requirements tougher, as it did in early July.

Capital requirements differ for different kinds of banks, for banks of various sizes, and for large banks (like JPMorgan Chase, Wells Fargo, or Bank of America) that have what many say is extraordinary impact on the global financial system.

This month, the Federal Reserve took bold steps in the Basel III roll-out by tweaking the leverage rules, causing bank CEOs and compliance officers to squirm even more. The Federal Reserve proposed stricter leverage limits:  No matter how risk-averse a bank's balance sheet can be, the Federal Reserve proposes that the largest banks (those with assets exceeding $700 billion) must maintain $6 capital for $100 of assets, implying a maximum leverage (total assets-to-capital ratio) of 16-to-1.  (Basel III is more lenient at $3 capital/$100 assets, permitting leverage to rise about 30-to-1.)

What irks banks most nowadays are (a) the vast amounts of resources, time, and people they must deploy to comprehend and keep ahead of the rules and (b) the uncertainty of what's to come from further rules imposed by the Federal Reserve and other regulators. What has frustrated banks the past few years, until they begin to accept it as a matter of the way things are in the new world of banking, was the impact of increased capital requirements and reduced leverage on banks' returns on equity.  More capital and lower leverage, quite simply, imply lower ROEs.

Outside the offices of senior bank managers, what does Basel III mean to everybody else--bank shareholders, finance professionals, bank clients, and finance students pondering careers in banking?

1.  If there is another tumultuous financial crisis, most banks complying with Basel III will be better able to endure it.  Governments won't likely need to inject billions in new capital to give the banking system a spark.

2.  If one large major bank struggles and implodes, its collapse won't likely cause system-wide turmoil, won't threaten the global financial system, or won't cause hundreds of its counter-parties and clients to tumble with it.

3.  Regulators and market-watchers might forecast better which large banks are vulnerable and could be threats to cause damage to the financial system. They may be able to diagnose a sickness in the system before it causes a global plague.

4.  Banks, not able to exploit leverage and constrained by rules from taking exorbitant risks, must settle for returns on capital in the 10-15% range, if they even manage themselves efficiently and maintain large market shares.  Days of regular 20%-plus returns will be almost impossible to achieve. With relative higher amounts of capital on the balance sheet, they won't be able to use debt to get boosts in ROEs.

5.  Economists and business leaders appreciate concerns about risks, weak balance sheets, and burdensome leverage and debt levels.  Some fear, however, good banks might become too strapped by rules and will become less willing to take prudent risks--risks that include lending to corporations, small businesses and start-ups that provide swift thrusts to a lagging economy. 

Others fear an irony.  Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.

6. Banks will hire and might be willing to pay a premium for expertise in compliance, reporting, risk management, and systems.  Complex regulation will require experts to interpret rules, gather data, calculate requirements and report to regulators--in real time, all the time, for the rest of time.

Banks would have preferred to hire new people for revenue-generating businesses or deploy capital for new businesses and expansion. But they have accepted they must build stronger compliance and risk-management structures and show shareholders, regulators and politicians they are taking new regulation seriously. (In 2012, JPMorgan Chase reported it would take 3,000 employees and nearly $3 billion in costs to comply with new, ongoing regulation--over 14,000 different rules from all forms of regulation, not just Basel III rules.)

6.  Senior bank managers will spend more time acting as arbiters among business units scrambling for a precious piece of the bank's balance sheet.  There will be more defined rules for capital allocation:  Who will get to use increments of capital for business purposes? And who will be able to maximize the amounts allocated to them?

7.  Banks will obsess over their capital numbers.  They must develop strategies for how to comply with rules today and in 2018-19, when most rules take effect.  Should they  issue more equity in large amounts now to increase capital and proudly show excess amounts before rules are in effect? Should they maintain excess amounts to show markets, shareholders and regulators they are flush with capital, amply above requirements?  Or should they not raise capital, but choose to scale down businesses, assets and risks, based on current levels of capital? 

8.  Bank boards, sector leaders, subsidiary heads and senior managers will knock themselves out, figuring out how to squeeze more return from the balance sheet, how to nudge ROE upward one more percentage point. They face monstrous challenges to do so without increasing risk levels and credit exposures, without the privilege of growing assets any way they could in years gone by. Solutions to this problem won't come easily.

Basel III has rumbled into town. Many rules go into effect in 2014. It's a reality, no longer an academic concept or a discussion paper in volumes by professorial types in Europe. Banks knew these days were coming and have been preparing them, but they still know it will be a constant, everyday struggle to tame the impact of 900 pages of guidelines.

Tracy Williams

See also:

CFN:  Basel III and Capital Cushion, 2010

CFN: 2013 Outlook:  Reforms and Recovery