Broke but never bust: The ECB and Swiss National Bank should be much more relaxed about losing money

 

CONTEMPORARY central banking is a strongbox of oddities. Deposits, which normally pay interest, can now incur a charge. Investments in government debt, which normally offer a return, give a negative yield. Faced with this weirdness central banks are trying to respect some cardinal rules of finance, with the Swiss National Bank (SNB) and the European Central Bank (ECB) taking steps to protect themselves from losses and ensure that their balance-sheets add up. The experience of several poorer places suggests they are wrong to do so.

In calm times central banking is simple and profitable. Central banks’ assets—mainly bonds issued by rich countries and blue-chip firms—pay a decent return. Their liabilities—deposits made by high-street banks and banknotes—cost them little or nothing. With this wedge between income and outgoings shareholders receive a dividend. The SNB paid dividends of SFr1 billion ($1.15 billion) to Switzerland’s federal and regional governments in 2012. The ECB’s 2013 payout—divvied up across the euro-area national central banks—was €1.4 billion ($1.9 billion).

The financial crisis changed the business. For one thing central banks are far bigger (see left-hand chart). Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs. The ECB, mindful of tight credit, has lent money to banks and bought corporate bonds. And on January 22nd, as The Economist went to press, it was expected to announce that it would start buying government debt.

The expansion would be greater but for worries about cashflow and capital. Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree. Worries that QE will lead to losses if struggling governments default on their debt have caused weeks of wrangling at the ECB, and may prevent it from buying Greek bonds.

From a narrow accounting perspective this caution seems prudent. With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

A helpful bias

The survival of threadbare central banks proves the theory. In the 1980s many emerging-market central banks faced sharply appreciating exchange rates and bought up dollars with newly created cash to cheapen their currencies. Since inflation was a worry they “sterilised” the purchases, mopping up the money by selling bonds to investors. With low-yielding assets (dollars) and high-cost liabilities (domestic-currency bonds) they locked in losses, as a 2008 paper* by Peter Stella and Ake Lonnberg of the IMF shows. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. After 20 years of losses Chile’s is in negative equity (see right-hand chart).

While none of these banks toppled, hawks have other fears. Like any firm, central banks face running costs. The urge to pay the bills could tempt them to print money rather than focus on inflation. Another worry, set out in a 2005 paper by John Dalton and Claudia Dziobek of the IMF, is that low capital could lead to a loss of independence. While negative capital doesn’t matter much it doesn’t look great; a central bank embarrassed by its capital deficiency might seek a capital injection from its finance ministry and be captured by boom-hungry politicians. In either case, capital erosion might mean a bias towards higher inflation.

There is some evidence for this. In a 2012 paper Gustavo Adler and Camilo Tovar of the IMF and Pedro Castro of the University of California, Berkeley, test the relationship between bank capital and interest-rate policy. Collecting data for 41 advanced and emerging economies between 2002 and 2011, they work out what a hypothetical central bank, behaving optimally, would do. They contrast this with the central bank’s choices and seek to explain why the two might diverge. They find that large deviations can be explained by a weak capital position. Flaky-looking central banks might lower interest rates by up to 72 basis points.

Doves should cheer this. Falling returns on government bonds mean central banks’ income will dwindle. Given their pumped-up balance-sheets, some losses are likely. None will fail, but a few might chase their losses by printing money and pushing rates down. In a world on the brink of deflation, bias towards a little more inflation would be no bad thing.

Source: http://www.economist.com/news/finance-and-economics/21640363-ecb-and-swiss-national-bank-should-be-much-more-relaxed-about-losing

The 2014 M&A Report

If one had to choose a single word to describe the M&A market in 2013, it would be disappointing, and indeed many market participants have used this very term. But the exasperated dealmakers have had little time to cry in their beer—they’ve been too busy. The M&A market took off like a rocket in 2014, fueled by the return of the megadeal (transactions with a value of more than $10 billion), which has been in hibernation for the last several years. The momentum of the first quarter carried into the second, setting up 2014 as a potential bellwether for the market’s longer-term evolution.

Megadeals capture the headlines, adding confidence to the market. At the same time, there is another, less publicized but no less significant, trend developing—one that should attract even greater interest in the boardroom. As we first noted two years ago, our research shows a continuing rise in divestitures as a powerful strategy for both unlocking value in today’s markets and improving performance by focusing on core operations. (See Plant and Prune: How M&A Can Grow Portfolio Value (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_plant_and_prune_m_and_a_2012/), BCG report, September 2012.) In 2013, divestitures represented almost half the total M&A market. Not all divestitures are created equal or produce equivalent results, however. The companion to this year’s M&A report—the tenth in our series highlighting major trends and their implications for companies—examines in depth the role of an active divestiture strategy in companies’ ongoing search for value.

2013: Hopes Unrealized; 2014: Hopes Heightened 

 

Is the long post-2008 M&A hangover finally coming to an end? Positive signs abound, for a change, starting with strong market activity. The Boston Consulting Group’s tenth annual assessment of crucial M&A trends, based on BCG’s global M&A database of almost 40,000 transactions since 1990, shows that following an anemic 2011 and a slow 2012, the M&A market stabilized in 2013, albeit at disappointing levels. It entered 2014 with a strong tailwind, including the announcement of roughly as many megadeals in the first six months as in the two previous years combined.

Multiple factors are fueling the resurgence. Continued low interest rates, the ample availability of capital, a less uncertain economic outlook, and high levels of M&A interest and financial capability on the part of both corporations and private-equity firms all bode well for the future. In addition, continuing a trend begun a few years ago, corporate divestitures are taking a growing share of the overall M&A market. (See Creating Shareholder Value with Divestitures (https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_creating_shareholder_value_divestitures/), BCG article, September 2014.)

After furrowing a deep trough in the years following 2008, the M&A market has at last recovered to the levels of 2005 and 2006. That said, most market participants saw 2013 as a disappointment. Overall deal volume declined by 6 percent and total deal value fell by 10 percent from 2012—despite credit remaining cheap, corporate profits continuing to rise, and generally strong performance by global equity markets. (See Exhibit 1.)

Multiple culprits can be identified. Most significantly, the much-awaited economic recovery failed to materialize, and neither employment levels nor consumer confidence improved as expected. GDP growth disappointed just about everywhere, especially in Europe, and many companies also held back from pursuing big or aggressive transactions owing to the continuing economic uncertainty. Deal volume and value fell in the financial-services and metals-and-mining sectors after heightened activity in the preceding years. Activity in Japan and a number of emerging markets, especially Brazil, Russia, and India, also declined. As is the case every year, several hundred transactions were announced but failed to reach consummation. The number of uncompleted deals was roughly equal in 2013 and 2012, but the total value of the withdrawn deals in 2013 was bigger as several large transactions were canceled, including the acquisition of 70 percent of Koninklijke KPN by América Móvil for $10 billion and the sale of BlackBerry to Fairfax Financial Holdings for $5 billion.
How quickly sentiments—and outlook—can change, however. The total value of first-half 2014 transactions jumped 62 percent over the value of transactions in the first six months of 2013. Megadeals accounted for more than 35 percent of total first-half 2014 deal value, including five deals worth more than $43 billion each—a level of activity not witnessed since before the financial crisis. These types of transactions not only boost the statistics, they also transform the confidence level of the market. Dealmakers who have been sitting on the sidelines, uncertain about financing, investor reaction, regulatory approvals, or other factors, see industry-altering transactions in the works and start to believe their deals can get done. Indeed, the hot pace continued into the second quarter, with AT&T’s acquisition of Directv, Apple’s acquisition of Beats Electronics, the $50 billion merger of cement makers Lafarge and Holcim, and the heated competition to acquire Alstom’s energy-equipment assets, which General Electric appears poised to win.

The overall economic outlook is the most positive in years, with U.S. GDP growth projected to approach 3 percent as we move into 2015, and growth expected to return to Europe, albeit slowly. Equity markets are holding up thus far, through the end of the second quarter. As always, there are risks that political or international events—in the Middle East and Ukraine, for example—could have a negative impact on the economy and thus on deal activity.

North America Leads the Comeback—Fueled by High Tech

 

The global M&A market is led by North America, whose share has been on the rise and reached 52 percent in the first half of 2014—up from 45 percent in 2010. While M&A activity stagnated or even decreased in most regions of the world, total deal value in the U.S. and Canada rose more than 5 percent per year over this period. The roaring tech sector has been a driving force, since the most prominent players in high-tech M&A are based in the U.S. (See Exhibit 2.)

Rather than following an overarching industry trend, many tech deals are rooted in individual company needs—Apple’s acquisition of Beats to rejuvenate its music business, for example. With the acquisitions of Oculus VR and Nest Labs, respectively, Facebook and Google are looking to stay at the cutting edge of technological advances with strong consumer applications, as innovations such as augmented reality and machine-to-machine communications begin to gain market traction. Priceline.com’s purchase of online restaurant-reservation service OpenTable (for $2.7 billion) promises the potential of cross-marketing to different digital consumer segments.

The rapid rise of mobile as the world’s dominant communications technology is spurring M&A activity in several spheres. Facebook’s acquisition of WhatsApp and Verizon’s $130 billion acquisition of Vodafone’s interest in Verizon Wireless show companies expanding, or consolidating control of, their share of mobile users. Microsoft is gaining control over mobile technology with its acquisition of Nokia’s device-and-service business.

Not all the tech activity is in North America. Dozens of deals have been announced involving European countries in late 2013 and the first half of 2014. However, since many of them represent smaller transactions, their overall impact on M&A markets has been less visible.
Outside the tech sector, so-called inversion deals are becoming an increasingly significant factor, particularly in the health care industry. U.S. companies are seeking acquisitions in Europe that make strategic sense and enable the acquirer to move its corporate domicile to Europe, where the company will benefit from more favorable tax treatment. In July, the Wall Street Journal estimated that almost a dozen such deals were pending, with a total value exceeding $100 billion.

Despite a rising number of transactions, capital markets continue to have difficulty deciphering the new business models of innovative tech companies and coming to grips with the seemingly outsize valuations that acquirers place on their targets, which often have limited track records and little or no earnings history. Memories of the bursting dot-com bubble in 2000 are still fairly fresh.

The February 2014 announcement of Facebook’s plan to acquire WhatsApp, a five-year-old cross-platform instant-messaging service with 55 employees, for $19 billion in cash and stock is a case in point—especially since WhatsApp had only recently completed a round of venture-capital funding that valued the company at $1.5 billion. Immediately after Facebook announced the acquisition, its share price dropped 5 percent because of skepticism over the deal and the company’s rationale. It took several days—and a concerted investor-outreach effort—for investors to understand the basis for the deal, both strategic and financial. The market ultimately awarded Facebook a cumulative abnormal return (CAR) of 1.1 percent. (CAR assesses a deal’s impact by measuring the total abnormal change in market value over a seven-day window centered on the transaction announcement date.) The market came to recognize that with WhatsApp’s more than 450 million mobile users and rapid user growth, Facebook was acquiring a potentially formidable competitor and strengthening its own mobile position at the same time. Perhaps most significantly, the price it was paying for WhatsApp was equal to $42 per mobile user—several times less than the value the market was placing on each mobile user of Facebook itself ($141) or its fellow social network, Twitter ($124). (See Exhibit 3.)

 
Will the Pace Pick Up?
 
Multiple factors—principal among them large cash reserves, bullish investors, and buoyant debt markets—point to a continued resurgence in deal activity.

Corporate cash reserves have been increasing since the financial crisis. Countless companies have used the downturn to strengthen their balance sheets and improve their performance, giving them a much-enhanced means of financing acquisitions. Corporate cash levels are at an all-time high—three times their level in 2000. Shareholders become restless with so much money sitting idly on the sidelines, and they will eventually demand that companies either put the money to work or distribute it to their owners through share buybacks or dividends, especially as the uncertainty in capital markets recedes. As economic conditions improve, investors are becoming far more receptive to companies making acquisitions so long as the deals are consistent with their strategy and, of course, the price is seen as reasonable. In BCG’s 2014 investor survey, the percentage of respondents favoring a more aggressive approach to M&A by companies almost tripled, from 23 percent to 60 percent, between 2012 and 2014. (See Exhibit 4.)

While activity among private-equity players has increased only slightly so far—the number of transactions rose 22 percent between 2012 and 2013, but the total value actually declined 3 percent—we do not see these firms remaining quiet for long. At a total of $431 billion, private-equity cash reserves are approaching their levels in 2008 and 2009, and these firms have their own investors to answer to. Moreover, debt financing is more readily available now than at any time in recent years. Leverage levels have returned to those of 2007 and 2008. (See Exhibit 5.) The average deal in 2013 included only 35 percent equity. “Covenant lite” loan activity in 2013 also smashed all records. The incidence of these loans, which generally do not involve any maintenance covenants, indicates growing investor appetite in the leveraged-loan market, making borrowing even more attractive for private-equity deals. We expect private-equity firms to become much more active in all kinds of transactions, with the exception of the largest megadeals, which are simply beyond their reach, if not their comfort zone.

Last but hardly far from least, current transaction valuations are still within long-term historical parameters. Valuation levels (as measured by the ratio of median acquisition enterprise value to EBITDA—EV/EBITDA) have been generally (if unevenly) rising since 2008, and they surpassed the historical average of 11.9 in the first half of 2014. Deal premiums (the amount by which the offer price exceeds the target company’s closing stock price one week before the original announcement date) approximated their historical average of 35.4 percent in 2013. One could thus argue that targets are not yet overvalued from a historical perspective—one more reason why deal activity among both corporate and private-equity players should continue to increase.

That said, it should also be noted that some industries are distinctly more active than others. Our analysis of deal volume (measured by transaction value) shows clear sector differences when long-term historical activity (from 1990 through 2010) is compared with deals done since 2011.
Energy, for example, saw a 4-percentage-point uptick in the current period, owing primarily to portfolio restructurings and consolidation, as well as to an increased focus on renewable energies following the Fukushima accident. Higher levels of activity in the health care sector (up 3 percentage points) are substantially the result of pharmaceutical companies acquiring new research pipelines as their own R&D programs produce fewer blockbusters and the patents covering older top-selling drugs expire. Changes in health care regulations in the U.S. and a difficult environment in Europe are also fueling consolidation in the sector. Companies in the industrial sector have been optimizing their portfolios as economies stabilize and return to growth. And, of course, high tech is highly active.
There is a clear impact of M&A intensity in “hot” industries: target companies are able to demand higher premiums from potential buyers. (See Exhibit 6.) Companies acquired in high tech and health care, for example, received average premiums of 36.5 percent and 37.3 percent, respectively, compared with premiums of only 29.9 percent in consumer and retail and 33.0 percent in financial services and real estate.

Timing is not everything in M&A, but it almost always is a critical factor and certainly an important consideration for both buyers and sellers during upswings in their industries.

Source: https://www.bcgperspectives.com/content/articles/mergers_acquisitions_divestitures_2014_m_a_report/

More Money Than They Know What to Do With

It is a $1 trillion game: Use It or Lose It.

The private equity world is sitting on that 13-figure sum. It’s what the industry calls dry powder. If they don’t spend their cash pile snapping up acquisitions soon, they may have to return it to their investors.
Nearly $200 billion from funds raised in 2007 and 2008 alone needs to be spent in the next 12 months or it must be given back.

Private equity executives, after spending the last several years largely on the sidelines amid the economic uncertainty — often proclaiming “patience” as an explanation — have begun to be anxious that they may need to go on a shopping spree. At least two major private equity firms, according to two executives involved in the discussions, have held internal strategy sessions in recent weeks about how to approach the looming deadline.

Some private equity firms have put the word out to Wall Street banks that they want to go “elephant hunting” — seeking big deals worth as much as $10 billion — and are willing to pay a special bounty for bringing them acquisition targets.

At least one firm has gone so far as to begin contemplating asking its investors, which include the nation’s largest pension funds, to extend the deadline for the money to be spent in return for certain concessions on fees. (Of course, they don’t return the fees that have been collected thus far).

“The clock is ticking loudly for these funds,” Hugh MacArthur, the head of Bain & Company’s private equity practice, wrote as the lead author of a report on the state of the industry.

So the race is on.

But, of course, there is a problem: “Burning off the aging dry powder will likely result in too much capital chasing too few deals throughout 2012,” according to Mr. MacArthur.

That means it is possible we could see a series of bad deals with even worse returns.

Already, private equity firms have been quietly spending lots of cash. In the third quarter alone, private equity firms in the United States burned through $45 billion, up from $17.1 billion in the previous quarter, according to Capital IQ, which tracks deals data. Carlyle Group, which had its initial public offering in May, has been the busiest firm this year: it has done 11 deals worth almost $12 billion.

Acquisition prices are also likely to balloon because of “lots of firms bidding for the same obvious deals,” Alastair Gibbons, a senior partner at Bridgepoint Capital, told Triago, a fund-raising services firm that publishes a widely read quarterly newsletter. “Since there is near record dry powder globally, it’s entirely plausible that we’ll see increasingly overcrowded bidding processes.”

Richard Peterson, an analyst for S&P Capital IQ’s Global Markets Intelligence group, said that private equity firms are already paying multiples of Ebitda — earnings before interest, taxes, depreciation and amortization — of 10.6 this year, up from 10.3 last year. It’s worth remembering that many of the most successful deals in the private equity industry were bought for six to eight times Ebitda, he said.

He noted, however, that since firms were able to borrow at unheard-of low rates today “it may give them more confidence to pay a little bit more.”

Perhaps in a sign of desperation, many private equity firms have been increasingly engaged in a game of “hot potato” with one firm selling a business to another — known as a secondary deal. Mr. Peterson said that at the current pace, the industry was expected to spend a record-breaking $22.3 billion this year simply buying companies from each other rather than buying businesses from the public markets or from private owners outside the private equity industry.

Mr. Peterson also raised a question that is often being whispered about but rarely said aloud: “A lot of these firms are publicly traded now. So to what degree are the transactions being driven by earnings objectives?”
Many of the big private equity firms — Apollo Group, Kohlberg Kravis Roberts, Blackstone Group and Carlyle Group, among them — are public. And for the first time, it is possible that the interests of the public shareholders could diverge from the interests of the investors in the buyout funds, at least in the short term.
If the private equity firms don’t spend the money that they have already raised, it is unlikely they will be able to raise even more in coming years. And increasingly, the private equity firms have become dependent on the management fees not just to keep the lights on but to expand their businesses into other areas, in part to diversify, which has been part of the pitch to public investors. The biggest firms have become asset gatherers.

“In a nutshell, 95 percent of funds would be affected and see a big drop in fee income based on not investing all of the committed capital,” according to Tim Friedman, director of North America for Preqin, which tracks private equity fund-raising and deals. He said that he did not expect firms to do deals simply “for the sake of it,” but he also cautioned that the firms were “under a lot of pressure.”

So keep an eye out for megadeal headlines — and whether they command the same prices when the companies are sold.

Source: http://dealbook.nytimes.com/2012/10/01/more-money-than-they-know-what-to-do-with/

Don’t expect economic boost from cash-rich companies

Growth in the developed world will continue in 2012 to be hostage to the deleveraging process that is required to address the huge debts that piled up during the credit bubble. Yet the pattern is distributed unevenly across economies. In the US non-financial corporate sector, to take a striking case in point, the balance sheet recession has long been over. Profit margins are at record levels thanks to savage labour shedding and companies are awash with cash.

A similar accumulation of cash has occurred in Europe, though without comparable shrinkage in the workforce. Bin Jiang and Tim Koller of McKinsey estimate that European and US companies hold about $2tn of surplus cash, defined as the amount outstanding over and above operating cash, which is deemed to be two per cent of revenue. The question is how these cash balances will be deployed.

Ideally, companies should be investing, which would have the benign effect in current account deficit countries such as the UK and US of helping to rebalance the economy away from domestic consumption and public spending, and to jog them out of the habit of underinvesting relative to Germany, France and Japan. Yet this seems unlikely to happen. The effect of the recent credit bubble has been to bring forward many corporate spending decisions. This bunching of investment has been further exacerbated by the Obama administration’s investment tax breaks, now coming to an end. So it is a racing certainty that investment will fall sharply in the first half of the year in the US.

In Europe, meantime, the troubles of the eurozone banking system mean that a strong precautionary motive is at work. Many industrialists are hanging on to cash that earns very little interest because they fear that banks may be unable to finance their working capital requirements. The likelihood of recession in the eurozone likewise damps animal spirits.

Historically, profit margins have tended to revert to the mean, so excess cash may anyway dwindle. I suspect, too, that the English-speaking countries may be moving to a new, low-investment paradigm and not merely because, as in the case of the UK, they have a service sector bias. The practice of rewarding executives increasingly with equity is imposing a far greater focus on short-term measures of performance. Academic evidence in the US has, for example, shown that a high proportion of chief financial officers admits to a willingness to sacrifice economic value to meet short-term earnings targets. The current record profit margins and exceptionally high unemployment reflect that ruthless focus.

The capital market culture of these countries also has a strong emphasis on merger and acquisition activity which, from a managerial perspective, substitutes the thrill of the chase for the hard slog of managing operating businesses and investing in fixed capital. Business becomes transactional at the expense of relationships and performance is seen in narrowly financial terms. Far too many of the deals fail in economic terms, partly because stock options and rewards for failure give managers a huge incentive to bet the ranch.

That brings us to the most likely outlet for all that corporate cash. Much of it will go into share buy-backs, which are relatively painless for managers since, unlike dividends, they entail no continuing commitment to pay. Part of this activity will be arbitrage because corporate bond yields for many companies are now below the yields on equity.

This carries an interesting echo of the Japanese experience in the bubble of the 1980s. As the stock market soared, big corporations turned increasingly to financial engineering, using leverage to boost short-term earnings through speculation. That all ended in tears and a painful deleveraging process.

Charles Kindleberger, the economic historian, speculated that a shift in emphasis from production to consumption and a preoccupation with financial manipulation might be symptoms of national decline. That is hard to prove. Financial sophistication is arguably a natural accompaniment of advanced forms of capitalism.

Moreover, it is a mistake to consider investment as inherently virtuous. Japanese corporations have over-invested for decades and consequently shown poor returns on capital. Much the same is now happening in China, where investment is running at close to half gross domestic product. This is hugely wasteful and causes big distortions in global as well as domestic markets.

Yet it remains the case that the increasingly financial focus of anglophone business is not doing much for the ultimate shareholders, who are chiefly pension beneficiaries. The supposed alignment between the interests of managers and beneficiaries on the basis of stock options and other equity incentives is a fiction. Perhaps the poor equity returns of the past decade partly reflect that fact.

Source: http://www.ft.com/intl/cms/s/0/d7ff64c2-361f-11e1-9f98-00144feabdc0.html#axzz1iUVbDoKd

Bank funding: The dash for cash

USUALLY it is banks that put customers under a microscope before lending them a penny. But in Europe banks are the ones now facing scrutiny before investors, companies and savers will lend them any cash. Faced with an investor strike, banks are putting a halt to new loans and selling or pawning all they can. Unless the investor strike lifts soon, Europe risks a credit crunch. At worst, there may even be bank runs and failures.

In one sense, a slow bank run is already taking place in the market for bank bonds, which in happier times provide the long-term and stable funding that allows bank regulators to sleep peacefully at night. Since July these markets have frozen up almost completely for European banks. Bond issuance has plunged (see chart) and has shifted towards secured bonds, which are backed by assets that investors can grab if the bank defaults.

David Lyon of Barclays Capital, an investment bank, reckons that just €17 billion ($24 billion) in unsecured European bank bonds have been sold since the end of June, compared with €120 billion in the same period a year earlier. “In the context of the requirement, this is a paltry amount of funding,” he says.

The run on European bank-funding markets in some respects mirrors the one taking place in some government-bond markets. This is to be expected given the links between banks and governments. During the 2008 crisis, governments propped up their banks. Now, governments are leaning on banks to keep buying their bonds. As a result even the strongest banks from peripheral euro-area countries such as Spain or Italy (where yields on an auction of three-year government bonds surged to an unsustainable 7.9% on November 29th) are finding it hard to borrow from investors.

Yet the bond-buyers’ strike afflicting banks is more worrying than the sovereign one. No banks are regarded as havens in the way that British and German government bonds provide a refuge for investors. Even strong banks in “core” euro-area countries are being frozen out of markets.

A second vital source of funding is borrowing through short-term interbank markets or tapping money markets. Both of these are also drying up. American money-market funds, which were a big source of dollars for the European banking system, have reduced loans by more than 40% over the past six months.

Banks are reluctant to lend to one another except for the shortest possible time, usually overnight. “Every night for the past few months [chief financial officers of big banks] have been getting reports saying they are short of a few billion,” says one banker. “They take the phones and start calling all the other banks to ask if they can borrow €100m here and some there.”

For now, this is keeping the system ticking over, partly because a bank lending money overnight knows it may have to ask for the favour to be returned next week. Euro-area central banks are also leaning heavily on their biggest banks to keep supporting the smallest with interbank loans.

An area of particular vulnerability, the “nightmare scenario” in the words of one banker, is that the trickle of deposits leaking from banks in peripheral countries turns into a full-flood bank run. The risk that savers will lose faith in banks seems remote for now. Yet it is not unthinkable. Greek depositors have been shifting their money for the past year. Savers in Italy and Spain now appear to be starting to do the same. And large corporations, which are able to shift deposits easily, are seeking relative safety, either with large banks in core countries or further afield.

Tighten belts and brace yourself

Max Warburton, an analyst at BernsteinResearch, notes that German carmakers are now buying German government bunds or are quietly moving their money directly to the European Central Bank (many of them already have banking licences because they provide car loans). “We don’t believe they are at the stage of buying gold…but perhaps it’s not far off,” he wrote in a recent report.

Banks are responding by desperately hoarding the cash they have, selling assets and slowing new lending. The most recent survey of credit conditions in the euro area shows a sharp tightening in September. The effects are being felt far more widely than in the euro area. In central and eastern Europe borrowers fret about regulatory changes that are encouraging banks in Sweden and Austria to cut their cross-border exposures. In Asia, too, the withdrawal of European banks is likely to drive up borrowing costs and restrict the availability of credit, according to analysts at Morgan Stanley, an investment bank.

Yet unless funding markets reopen, even aggressive deleveraging by banks will probably not allow them to shrink their balance sheets quickly enough.

This suggests a need for more action by central banks. On November 30th a group of central banks introduced new measures to ease a shortage of dollars in the banking system (see article). That will ease the pressure, but banks also need help raising longer-term debt. The ECB currently offers one-year loans, but these give little comfort to banks, which generally lend to their clients for longer periods and are reluctant to write new loans unless they can find matching funding. Another option could be for governments to guarantee bank debt, but strained national accounts probably rule this out.

Inaction could be disastrous. The longer banks are unable to raise funding, the greater the chance that one may fail. As one banker ominously puts it: “you are getting further along the train tracks towards the buffers.”

Source: http://www.economist.com/node/21541019

Backlash from Netflix Buybacks

It is not Netflix's fault that investors priced its shares for perfection. But the Internet video company is to blame for managing its own balance sheet for the same flawless performance.

The former high-flier announced Monday night it had sold $200 million in new shares at $70 each and another $200 million in bonds convertible to stock at $85.80. Just months ago, the stock traded above $300. It is now at $72.



Netflix could easily have avoided this. The company has spent over $1 billion on share repurchases since 2007, leaving it with just $366 million in cash and $200 million in debt at the end of the third quarter. During that time, executives including chief executive Reed Hastings have been selling shares.

In buying back shares, Netflix failed to build a cash cushion against any slowdown in its heady growth rate. With expectations for healthy subscriber additions stretching into the future, the company locked into big contracts for streaming content. Since the start of 2011, the company has more than tripled such commitments to a whopping $3.5 billion, of which $2.9 billion is due in the next three years.

But everything changed this summer after the company raised prices and began bleeding subscribers. The company has not indicated subscriber losses have stopped and said it expects to lose money next year. Netflix has also said it expects free cash flow to lag net income over the next several quarters. In the year through September, the company's free cash flow was a modest $204 million, while buybacks totaled $200 million.

Unfortunately, dilutive stock and convertible issues have become Netflix's best option for raising cash to cover the potential outflows. The company sold $200 million in eight-year bonds in 2009, but those have a yield of about 7.3%, according to MarketAxess. So issuing more debt would mean large coupon payments. The newly-issued convertible doesn't include regular interest payments and won't mature until 2018.

What Netflix desperately needs is for streaming subscriber growth to resume. That should boost margins and cash flow, even though a portion of the content costs rise with viewership, because much of it was purchased for a fixed price. And if subscriptions improve, content owners could yet ask for higher fees in future deals, making a cash cushion crucial.

The lesson for growth companies is that buybacks can be risky—not just in large amounts, but at high prices. Netflix paid an average price of $45 a share for stock repurchased since 2007, below the current level of $72. But many of the recent purchases were at multiples of that price. If Netflix had refrained from aggressive buybacks until the business model was relatively steady, inevitable bumps in the road would have been much easier to ride out.

Source: http://online.wsj.com/article/SB10001424052970203710704577054431537105996.html?mod=WSJ_Heard_LEFTSecondNews

Banks in Italy Find an Unusual Liquidity Lifeline

LONDON — The London Stock Exchange is becoming the lender of last resort for many banks in Italy as concerns over the country’s debt levels squeeze liquidity out of the Italian financial market.

With cash increasingly hard to come by, Italy’s banks are turning to CC&G, the exchange’s Italian clearinghouse, for short-term lending. That includes some of the country’s largest financial institutions, including Unicredit and Mediobanca, according to a person close to the situation.

While just two banks received short-term capital from CC&G in 2009, that number has now risen to 15 — half of them Italian and the rest European financial institutions that trade in the country.

Under terms of the deals, the clearinghouse, which acts as a middleman to guarantee trades between financial parties, is offering money to both Italian and European banks with a presence in Italy for up to three days.

The money, which comes from collateral that traders must put up to complete financial transactions, is deposited with the banks to cover shortfalls in liquidity. CC&G earns a profit by charging banks interest on the money that they borrow.

Previously, banks had used the so-called repo market, where banks lend capital to each other on a short-term basis, to meet their financing requirements. But fears about Italy’s ability to repay its debts has pushed up borrowing costs and reduced the ability of banks to access that market.

A spokesman for the exchange said the company was in close discussions with the Italian central bank about any potential problems in the country’s financial sector, and used stringent risk management to decide whether to give banks access to capital.

CC&G also doesn’t technically lend money to banks, but instead deposits the cash with them on a short-term basis. Under Italian law, this distinction makes CC&G a depositor with the banks, and places it ahead of other creditors looking to get their money back if any financial institution should fail.

The legal distinction may still leave CC&G exposed if a lender defaults. And analysts question the sustainability of lending to struggling banks. That’s particularly true as the collateral offered to institutions as short-term financing is often provided by the same bank’s separate trading operations.

Paul Rowady, senior analyst at financial consultancy TABB Group in Chicago, said the global squeeze on liquidity was forcing institutions to look elsewhere, including to clearinghouses, to meet their short-term financing commitments.

He added that central clearing parties might feel secure in lending to banks because it was on a short-term basis and they were eager for extra revenue.

“Financial entities are making money in new and different ways,” he said. “Just because times are bad doesn’t mean they’re not looking for profits.”

And Italy’s turmoil has been good business for the London Stock Exchange. According to the exchange, CC&G reported a 209 percent jump in income to £54.3 million, or $83.6 million, during the first half of the year, compared with the same period in 2010.

The Italian business now represents 14 percent of the exchange’s overall income, compared with just 5 percent in the first half of 2010.

Source: http://dealbook.nytimes.com/2011/11/17/banks-in-italy-find-an-unusual-liquidity-lifeline/

As Economy Goes, So Go Takeovers, Even as Bargains Abound

he merger market is like a pack of lemmings. If the economy is good , the takeover market will follow, but when times are bad, the market stalls.

For the moment, there are still mega-deals, like Kinder Morgan’s $21.1 billion acquisition of the El Paso Corporation, and takeover activity is up. The volume of global mergers and acquisitions was up 22 percent, to $2.748 trillion, for the last 12 months ending in August from the period a year ago, according to Thomson Reuters. The increase in deal volume was driven in part by a threefold increase in hostile offers and strong company balance sheets.

Yet many major economies in the world are growing sluggishly, if at all. The negative economic outlook is likely to counteract some otherwise strong drivers for deal-making.

The International Monetary Fund estimates growth for advanced economies at just 1.6 percent this year and only 1.9 percent in 2012, compared with a historical average of about 3 percent. In the United States, unemployment remains stubbornly high, and 2011 G.D.P. growth was recently estimated by a National Association for Business Economics poll of economists to be about 1.57 percent.

The European sovereign debt crisis has worsened the economic growth problem. And the uncertainty over how far the crisis will spread in Europe is bound to drive down takeover volume.

Then there is the stock market. In a presentation last week at the Penn State M&A Institute, Jane Wheeler, a senior managing director at Evercore Partners, noted that since 1985, takeover volume had grown in only two years when the Standard & Poor’s 500-stock index had declined.

So we have the lemmings problem again. Takeover volume follows the stock market, and the market is down. Its recovery is fragile given the negative trends.

Also weighing on the merger market are signs that the Obama administration is stepping up antitrust enforcement. Last year, the federal government made a second request for information, an indication of an in-depth investigation of a transaction, in 4.1 percent of deals, compared with 2.5 percent in the last year of the Bush administration, according to a joint report submitted to Congress by the Federal Trade Commission and Department of Justice.

Mergers are also being challenged more often, and antitrust enforcement appears to be becoming even more aggressive in recent months. Although Continental and United Airlines cleared antitrust review by the Obama administration in August 2010, the federal government is suing to stop AT&T’s acquisition of T-Mobile USA after effectively blocking Nasdaq’s bid to acquire NYSE Euronext and Avis’s effort to acquire Dollar Thrifty.

All this spells a decline in takeover volume. Deal makers do not want to take undue risks, and fear of uncertainty and a downturn is real even beyond the heightened regulatory scrutiny.

Yet there remain some forces that should be putting wind in deal makers’ sails.

The takeover market’s pattern of following equity prices is counterintuitive. When stocks are down, valuations are low and takeovers should make the most sense from a value perspective. Right now, price-earnings multiples are about 15 times earnings, compared, according to Standard & Poor’s, with a historical average approaching 20 times earnings. One would think companies would be rushing to scoop up low-priced assets.

This is particularly true since credit is easy, at least for some. The high-yield market is choppy at best, but good companies can borrow at incredibly low rates for long periods. The Norfolk Southern Corporation, for example, priced a $400 million 100-year bond with a yield of 6 percent.

Even beyond credit there is cash, and companies have plenty of it. Standard & Poor’s estimates that American companies have more than $2 trillion of cash on their balance sheets. Although much of it is held abroad as companies wait for the federal government to lower the dividend tax on the repatriation of cash, certainly hundreds of millions of dollars can be spent domestically.

Private equity firms are also sitting on big cash hoards. Globally, private equity still has almost $1 trillion in dry powder, according to a study by Bain. Leveraged buyouts currently average a mix of about 40 percent equity and 60 percent debt. Private equity therefore has enough firepower for more than $2 trillion in buyouts.

So where are they? The industry remains notably hesitant to make deals. Only 6.5 percent of global M.& A. transactions through the first nine months of 2011 were private equity acquisitions, according to Dealogic.

While it is hard to know what in particular is holding private equity back, they too are most likely following the economic cycle, afraid to invest in a volatile, potentially down market.

Must-do deals will still happen, like the El Paso acquisition, which Kinder Morgan’s chairman and chief executive, Richard D. Kinder, called a “once-in-a-lifetime transaction.”

Yet the overall trend is that of M.&A. rushing toward a cliff. Companies that might have pulled the trigger on an acquisition will instead spend their cash on dividends and stock buybacks.

Sure, some brave companies will take a plunge and try to acquire at a lower value. And the slowdown in initial public offerings may also spur takeover activity.

These are likely to be small blips. For the next few months, investment bankers are going to have a hard year as they try to point to the positive factors in the market to sell deals. But they are going to be running against those lemmings.

Source: http://dealbook.nytimes.com/2011/10/18/as-economy-goes-so-go-takeovers-even-as-bargains-abound/