Friday, December 20, 2013

Looking Back at 2013

An informal glance of the year just past
Years from now, a finance historian or a research analyst looking back at 2013 won't have a clever moniker for the notable financial events of the year.  The year was eventful, but may not even deserve a whole chapter in finance history.

And perhaps that's a good thing. It wasn't like 1987, 1994, 1998, 2008, years that conjure memories of crises, crashes, volatility, and uncertainty.

The year 2013 was not one of turmoil.  Markets behaved well. We saw equity upswings of the likes of the mid-2000's and mid-1990's, even while old hands suggested a bubble is near and we shouldn't get accustomed to double-digit percentage stock-market increases.

The fury and hoopla over BitCoins, that arcane, macabre digital currency, didn't rise to the surface until late 2013.  That, in fact, could be the bubble that bursts in 2014, and let's hope that damage won't cause debilitating financial ripples around the world.

The year 2013 featured big deals, badgering shareholder activists, headline court cases, and a few notable IPO's. One common theme prevailed, nonetheless:  financial regulation.  Regulators, politicians, and lawyers bickered about what to do, how harsh they should be, and when they plan to roll out new rules promised from Dodd-Frank legislation, now going back several years ago.

New regulation, they argued, must be at least a little painful to make up for late-2000s financial sins. But the unveiling of a new era of restraint and a new playing field has taken a long time. Basel III, Volcker rules and new rules governing derivatives and equity trading have trickled out slowly, to the pleasure of many banks still squeezing out profits from privileges about to go away.

Dodd-Frank, Volcker and Basel III are not favorite topics among bankers, but they are inevitable.  Banks paid lobbyists and waged campaigns to push back, but they know they aren't winning this tug-of-war and have begun to adapt. Compliance officers, lawyers, and business managers are combing through hundreds, thousands of pages of rules, guidelines, and capital and liquidity requirements, as they prepare for a wave of requirements set for 2014-15. Not fun, fancy tasks, but this is the new normal for the late 2010's.

Civil suits, criminal charges and legal indictments were abundant all year long, as federal prosecutors followed a determined agenda to punish those involved in insider trading.  A legal blitz on insider trading kept the mystical, aloof hedge fund SAC Capital on the front pages for much of the year--right until now, as prosecutors one by one investigate and/or indict various members of Stephen Cohen's trading circle. 

Shareholder activists charged out front and waged fierce campaigns, taking some of their battles to the front lines of the media. They pushed to get Apple to pay dividends, pushed to reshape and remake JCPenney, and battled over the legitimacy of Herbalife products--anything to boost corporate values, oust disagreeable management, wrest some value from out-dated business models, or cause fuss in equity markets. Names like Icahn, Ackerman, Einhorn and others--stubborn and persistent and sometimes irate--kept themselves busy chasing after corporate boards.

The public got used to JPMorgan Chase's billions--not quarterly profits, but a series of regulatory or legal settlements, pay-outs, charge-offs, and reserves.  A billion here, a billion there, until we saw a climatic $13 billion mortgage-related settlement that caused the public to gasp until it learned that the bank will still report handsome profits in 2013, still wields a heavy hand in banking, and its CEO  Jamie Dimon's job is not at all in jeopardy. (Recall the past springtime when a shareholder petition requested Dimon give up his chairmanship. Dimon and team, breathlessly but with confidence, waited out what was supposed to have been a close vote.)

Apple, Inc. continued to muddle over what to do with its billions in cash--billions on its balance sheet with a reluctance to reward shareholders. Investor activist Carl Icahn applied pressure, and others proposed innovative financial devices to pay shareholders. During the year, Apple relented, deciding to share the wealth via dividends with shareholders and then testing debt markets by borrowing $17 billion in a deal done mostly to show markets it could manage a debt transaction and debt payments.  Meanwhile, the company continues to amass billions more in cash from normal operations.

Twitter's IPO, in many financial circles, will be cast as the year's deal of the year. Nothing fancy about the transaction. And nothing unusual about it, even if Twitter has yet to show meaningful operating profits and long-term growth rates are uncertain (Will the fad run its course?).  Yet the deal was widely discussed and eagerly bought, if only because it signaled a comeback of sorts in the new-issue market or it proved that an IPO with high expectations can burst through starting gates without market turmoil or mechanical difficulty (like the Facebook IPO).

Other deals made headlines, too, contributing to a summer surge that flirted with bankers, who might have thought the M&A glory days had returned.  In one deal, Verizon borrowed a whopping $49 billion to make an even-more-whopping $130 billion acquisition of the portion of Verizon Wireless it didn't own. But as the fall quarter approached, banks realized corporate CEO's and strategists still harbor economic anxiety and are hesitant about making too many acquisitions too quickly.

During the year, we began to observe the slow death watch of Blackberry.  Losses continue, employees have been let go, and management--those who remain--has run out of ideas and imagination about products.  A Canadian private-equity firm had a long-running bet that things would turn around. During the year, it contemplated stepping up the bet to acquire the portions of the company it didn't own. Near the end of the year, it, too, had begun to change its mind about Blackberry.  The company stumbles, gets on its feet every few months when it announces what it perceives as a novel product offering or a strategy geared to corporates, but then it trips again.

Michael Dell had grand dreams of taking his computer company Dell private, where he could seize control of the company's strategy without the withering distractions of shareholders, research analysts, and whimsical stock prices.  Dell, however, didn't realize he had to ward off shareholder activists and prolong the process by addressing apparent conflicts of interest (with him leading both the public company and the private buy-out).

Goldman Sachs didn't make it through the year without headlines, no matter how much it preferred. It had a sideline seat in the civil trial of one of its employees (Fabrice Tourre), the one singled out as instrumental in structuring the large mortgage securities/derivative transaction that permitted hedge-fund investor John Paulson to earn billions. Goldman wasn't an accused party, but for Goldman, the trial caused headaches and reputation blemishes.

Outside courtrooms, Goldman made news when former employee Greg Smith's published his long-awaited book about why he left Goldman.  The book was widely awaited and carefully reviewed and read, although the author didn't stir up as much trouble as some might have hoped. Nor did he offer more than an insider's account of his decade working and watching Goldman drift slightly away from its firm principle of treating clients as kings and queens.

Banks, once every five or ten years, try to do something revolutionary to change the pressure-cooker culture of banking. In the past, they allowed for permissive dress codes (business casual, as it came to be) and tried to be tender-hearted about late nights and all-nighters in the workplace.  Goldman took a big step in 2013 when it announced it would forbid junior bankers (analysts) from working Saturdays t to instill a more civil, comfortable work environment.  The move was praised and appreciated, although skeptics know how little this might be enforced or how the new standard might be forgotten in the months to come. But Goldman is praised for daring to show empathy.

Cheryl Sandberg, Facebook's COO, published her  book Lean In and presented pages of advice of how women can aspire to senior roles in business and how women can confront difficult business settings with a more aggressive stance or posture. No book in business in 2013 was more talked about, tossed about, and debated than Sandberg's tome. Women on both sides of the argument of the effectiveness of leaning in weighed in. But was her book applicable to all groups under-represented in business?

An eventful year, but one that didn't leave the blood boiling or cause business and finance leaders to sink into an abyss of anxiety. With bits of the recession and crisis still haunting and reminding all how bad things can be, companies and capital markets proceed into 2014 with degrees of confidence. But they cling to appropriate amounts of worry, wondering if a devastating market blow looms over the horizon.

Tracy Williams

Friday, December 6, 2013

Volcker Rule: Point of No Return

Volcker's rules: Any day now
Three years have elapsed since regulators proposed new regulation to restrict proprietary trading at banks (more specifically, depositary financial institutions).  Three years of discussion, debate, rule-writing and re-writing, dissension, lobbying, and procrastination. 

And now the new rule, better known as the Volcker Rule and named for former Federal Reserve chairman Paul Volcker, who first proposed limits on bank trading during the crisis, has reached a point of no return.  Regulators--the SEC, FDIC, OCC, CFTC and the Federal Reserve--have promised to sign off before mid-December.

Banks aren't surprised. They aren't caught off guard. They knew an old era of gun-slinging, wild, volatile, frantic, but overwhelmingly profitable proprietary trading at the major banks was coming to an end.  While regulators and their lawyers sequestered themselves for years to write hundreds and hundreds of pages of rules, banks tried to push back and soften the blow. But they knew they wouldn't win much of this tuggle, although they poured resources and time into the effort.  They had already begun to scale down prop-trading activity. 

New rules will prohibit outright proprietary trading (trading for banks' own accounts using their own capital), but will permit trading for clients, trading for hedging purposes and limited hedge-fund activity. And therein lies profound complexity.   

Regulators have spent the past three years trying to define all possible scenarios of client trading, hedging, and hedge funds with such fine-tooth clarity that banks won't be able to exploit loopholes in the way they can do adeptly and profitably to their advantage--and, in the eyes of regulators, at the expense of clients and individual customers.  Regulators, worried about how banks can exploit omissions in the rules, have tried to cover every base in hundreds of rules-making pages. 

Despite regulators' attempts at clarity, banks now prepare for the burdens and chores to remain in compliance.  Banks know well that trades that look like, feel like and were booked as client trades might evolve into prohibited proprietary trading.  New rules will allow "inventory" (securities and derivatives on banks' balance sheets) to exist on banks' balance sheets as items on a shelf to sell to clients.  But Volcker rules might define inventory exceeding a certain level or inventory maintained for more than a certain number of days as illegitimate "proprietary activity" (and determine it to be out of bounds). 

Banks that choose to remain prominent in sales and trading will need to invest in an army of compliance personnel and significant amounts of infrastructure to ensure they stay within client-trading or hedge-trading boundaries. A nightmare for some banks. An onerous cost of doing business at others. 

Volcker proponents say the new rules will reduce the likelihood of another round of "Whale Trading" losses at places like JPMorgan Chase, which lost over $4 billion from credit-derivatives trades in 2012. Critics and JPMorgan argued that "Whale-related" trades would have been permitted by Volcker rules. (JPMorgan launched the first phase of these trades for hedging purposes--to hedge credit risks in its large loan portfolio. But the trades piled on top of each other and the massive positions turned into something very "proprietary.")

Now big banks across the U.S. must decide (and have decided) whether (a) to stay in the game of securities and derivatives trading and eke out profits from client-driven flows or (b) to retreat, withdraw or just get out.

The bulge-brackets, such as Goldman Sachs, JPMorgan, and Morgan Stanley, are fully invested, have been adapting to a Volcker world. The big banks have resigned themselves to declines in trading revenues as much as 10% (25% at Goldman, one analyst contends). They hope to turn their once-magnanimous trading desks into humming, full-throttle plays on volume and flows.  Their desks have been reorganized and restructured.  They've shuffled talent, shut down some desks, invested in automated trading systems, and allowed many traders to seek employment at hedge funds.

Other banks have withdrawn and expect to engage in a token amount of trading at modest levels and minimal volumes--all client-related or tied to risk-management hedges.

In 2014 and beyond, critics, proponents, and regulators will watch banks closely.  Some say liquidity in certain sectors of capital markets will diminish, because large well-capitalized banks won't be able to buy, sell, and hold in large amounts of securities in the way they could before.  Some (municipalities, for example) say rates on bonds may increase because of diminished liquidity, because banks will nudge margins up to account for lack of liquidity, and because banks won't be to rationalize holding any inventory. 

(Imagine scenarios where banks can rationalize economically holding large amounts of securities/derivatives in inventory even for eventual client sales, but will choose not to build up inventory for clients to avoid the risk of penalties of not complying with Volcker restrictions.) 

Some say the best talent for managing trading volumes, risks, portfolios and positions will no longer reside at banks. Some say new rules will discourage financial innovation, because banks often trade and make markets in new products in large volumes to generate interest and liquidity. (Banks don't push new trading products if the profit dynamics don't make sense.)

Yet others contend we won't see those periodic billion-dollar trading losses because banks' "prop desks took a view" of the market or tried to guess interest-rate trends, commodity prices, or economic indices in their efforts to make gobs of money from proprietary positions.

At least for a while in 2014, banks will routinely convene troops of lawyers, traders and compliance officers to figure out this new world. It won't be easy. What happens if a bank amasses a position with intents to sell to a client, but the client decides not to pursue the trade? Will a regulator slap the bank's wrist right then and there? What happens if the bank purchases certain derivatives to hedge a portfolio, but volatile markets abruptly change the hedged position into an huge, unhedged derivatives position?   

Somebody within the banks' troops will be required to spend all-nighters trying to determine the  section in the hundreds of rules pages that cover these scenarios.

Tracy Williams