Brexit Has Left a Big Mess, but the City of London will be Fine.

By Roy C. Smith

For years successive UK governments have fought the EU to protect the freedom of the City’s financial markets. Now they won’t have to.

Yes, we know that the unexpected Brexit vote has thrown much into confusion, to be sorted out messily over an uncertain period of time, but the effects on the City after the smoke clears are likely to be more beneficial than not.

Indeed, the City has been around a lot longer than the EU, and its generally unregulated Euromarket, born in the 1960s, has evolved into the world’s largest capital market for global corporations, banks and governments, generating $4 trillion of new issues of debt and equity in 2015 as compared to less than $3 trillion in the USA.

Not much of this volume was British, of course; the markets have evolved to what and where they are because they have attracted others to use them. Over many generations, London, unlike any other European city, has learned to appreciate the value of low tax rates and a light regulatory touch that favors competitive free-market pricing of financial assets for issuers and investors from all over the world.

It has also accumulated a large financial talent pool with an accompanying infrastructure. London markets in securities, foreign exchange, commodities, and derivatives are hard wired into counterparts in New York, Toyko, Hong Kong and elsewhere to present a seamless, high-tech global trading environment in financial instruments of all kinds. These markets also serve as a hub for intra-European trading, where local European markets have benefitted by increasingly being integrated into the Euromarkets.

According to a recent McKinsey report, the global value of all outstanding securities in the world in 2015 was approximately $300 trillion, more than 3% of world GDP. The London-based markets account for a major chunk of this sum.

Since its beginning, the EU has been distrustful of the power of global financial markets, and since the 2008 crisis has attempted to impose significant limits on them. As the UK markets are the largest in Europe, they are the most affected by these ideas.

British governments have blocked or opted out of many of these efforts, but some still remain, in one form or another.

These include limits on bonuses paid to bankers, the European Banking Authority’s inclusion of British banks in its oversight and regulatory grasp, the applicability of a Financial Transaction Tax (which has been delayed, if not undone, with help from other EU member countries), and a proposal from the ECB to force clearing houses used by EU members to be located in continental Europe. Other such rules could be introduced in the future.

Being Out, of course, means not having to worry about these incursions any longer. But being Out also means the EU might enact other anti-market regulations that might require, as an extreme example, that EU issuers and investors only use EU regulated markets.  That would be a serious self-injuring mistake that likely would create ways around the rules, or encourage other member countries to object, but even so, British firms should still be able to participate in such transactions.  

That is because, as American firms have realized, under the Single Market Act, anyone can set up a subsidiary in the EU to do its business there with all EU membership benefits. Being outside the EU has not hurt US global capital market firms, which have a dominant share of the Euro market business. Though this may mean some legal reorganizing and shift of personnel to get passporting right, there is little reason for British firms to think they might not be able to adapt effective platforms to preserve their market shares.

In any case, it’s too early to worry. The UK has to serve official notice of its intention to withdraw, which may take several more months to do, and then there is a two-year negotiation period (which can be extended) during which competent officials try to reach a sensible agreement aligned with their own interests out of the public eye.

They will be negotiating just how Out Britain is to be. Out like Norway with special trading rights, or like Switzerland, which has bi-lateral trade deals with most EU countries. That kind of Out might not be so bad.

In the meantime, Britain is still In and will l be in for several more years.

The Brexit Shock

By Roy C. Smith

A year ago it was Greece that everyone thought might leave, or be tossed out of the European Union.  Grexit never happened, but today Brexit did through a 52-48 percent referendum vote (with an amazing 72% turnout) in which only Scotland and the London region supported remaining in the EU.

Pollsters said the sentiment had changed in recent weeks to favor remaining in the EU, and yesterday markets soared as investors treated themselves to an early victory celebration. But the polls were badly wrong. Markets collapsed on the news this morning.

Prime Minister David Cameron will resign sometime soon but no one knows who the next Conservative Party leader will be, as Cameron’s inner circle all supported remaining and are probably not eligible.  Boris Johnson, the maverick former Mayor of London, who broke with the Conservatives to support leaving, said the referendum provided Britain with a “glorious opportunity” to take control of its economy and its borders.

Donald Trump, visiting one of his golf courses in the UK at the time, agreed with Johnson said Britain had done the right thing.

Former Labour Party Prime Minister Tony Blair, who strongly supported remaining, said he though people believed the referendum offered an opportunity for a “protest vote,” when in fact it was instead a very important “decision vote.”  Referendums can be dangerous when voters get things confused.

Nicola Sturgeon, head of the Scottish Nationalist Party that lost a referendum vote in 2014 on leaving the UK, said a new Scottish vote would now be necessary.  The Scot Nats are the third largest political party in the UK.

Right wing politicians in several European countries claimed that referendum votes in their countries would likely follow the British example, causing elected leaders to worry about further defection among the (now) 27 remaining EU members. 

But out is out. Britain will now have to begin a two-year negotiation with the EU, under the never tested Article 50 for an orderly withdrawal. They will argue over future tariffs and market access. The EU doesn’t want to make it too easy, for fear others will follow the UK out the door, but they don’t want to make it too hard either because they still want the British economy linked to theirs.  But to do this the UK has to field a team of true-believing negotiators, and that may require another general election.

The economic argument for Brexit was that cut free of its obligations to the EU (social and economic policies more left than the UK would prefer), the UK could make its own laws and shape its own destiny and be better off.  But, leaving means that UK’s exports to the EU (44% of total exports) would be subject to tariffs and therefore more costly, and new investment in the country (especially by foreign companies) would likely fall off with diminished access to European markets.  A weaker pound (it fell 7.3% on the news) would balance some of this stuff, but whether Britain actually ends up better off will depend on how effectively it can change its own laws to boost its economy as the leavers expect it to do.

This will not be easy. Low growth and fears about job losses have driven economic policy in the UK, the EU and the US (the UK growth rate has averaged 2%, and unemployment 6.5% since 2010, but unemployment is now 5%). Many economists forecast a 3-4% recession as a result of the vote.

Or, as David Brady, a Stanford political scientist has said “no party, country or leader has discovered the path to achieve economic growth while mitigating the ills that go with it. “ It is a difficult time for tough-love market economics that threaten to make things worse in order for them to get better over the longer term.

There is also a lot of uncertainty over how the vote will affect the City of London, the longstanding financial center of the EU. There may be some job shifts to other European cities, but the talent and infrastructure of the London markets is likely to survive, and perhaps be made more competitive by its ability to escape the many EU rules it dislikes.

The politics of the thing, however, ultimately may be the more important issue for Britain. Leaving essentially is a repudiation of its old neighborhood, which clumsily or not has forged a historically unprecedented economic confederation of nations to provide economic prosperity and political security for a region of the world that had little of it for the first 50 years of the 20^th Century. Confederations are at best unwieldy and fragile alliances, but the EU, now with a pre-Brexit population of 507 million is the world’s largest economic marketplace (GDP of $18.5 trillion). The UK is Europe’s second largest economy (GDP of $2.9 trillion) and the second largest country by population (64 million).

For the EU to survive it has to strengthen itself as it grows and this requires the skillful attention of national political leaders from the largest countries. The UK has been an important dissenter (along with a few other countries that looked to the UK for leadership on certain issues) that has brought a market-oriented viewpoint to a group that definitely needed, but resisted it.

Now this voice will be absent, Britain’s influential role in Europe will be lost, and Great Britain may slip back to being Little England.     

Fifty Years of Extraordinary Change

By Roy C. Smith

Last week I attended the 50^th reunion of my class at Harvard Business School. There were 650 who graduated, 120 have died, and of the rest, 340 (including many wives) attended the reunion. There were only six women in our class. 

We were told that in 1966 about 6,000 MBA degrees were awarded in the US (almost none anywhere else) – now it’s about 200,000 in the US and a large number abroad. Most of the core courses of our day are still taught, but there are fewer of them and more electives.

We were trained to be managers of large manufacturing corporations (“masters of business administrator”), but by the time of our 25^th reunion, half the class identified themselves in a survey as being self-employed, working in small businesses or members of partnerships. Big business was not for them after all. 

Many of us were attracted to finance, which as an industry, probably changed more than any other during our 50 years.  Just as we were settling into our new careers (at an average starting salary of $11,000), the 1970s struck – the Dow Jones was the same in 1979 as it was in 1969, but the intervening years were plagued by inflation averaging nearly 8%. In 1971, the gold standard was abandoned; in 1973, the first oil crisis occurred; and in 1975 Wall Street was paralyzed by the forced introduction of negotiated commission rates. In 1979, the Volcker interest rate “shock” was engineered by the Fed to kill inflation  -- through this action led to the deep recession of 1981 and the S&L and Banking Crises of the 1980s.

So, for the first fifteen years or so, financial careers might have seemed pretty bleak, but out of all the difficulties of the 1970s came, a wave of innovations and a relaxation of competitive rigidities that enabled many financial firms to grow and prosper. Securitization, LBOs, junk bonds and derivatives were invented; new SEC rules such as shelf-registration allowed bankers to bid for business normally tied to “exclusive” relationships with other bankers.  The Eurobond market opened up and globalization of capital sources and investment opportunities abounded, especially in “emerging market” countries that previously had been considered as below the standards required to use capital markets.  

The world changed too. In 1979 Deng Xiaoping began China’s economic transformation; Margaret Thatcher brought “privatization” (of government owned businesses) and free-market policies to the UK. The EU was formed and the euro introduced, the Berlin Wall fell and the USSR voted itself out of business. First Japan, then China developed into Asian superpowers.

It wasn’t all easy – there were periodic financial crises along the way, but market economics prevailed and before we knew it, half the world’s population had bloodlessly changed their economic systems from ones oriented to socialist principles to capitalistic ones. And, the period from 1950 to the present became the longest uninterrupted time of peace and prosperity in Europe, North America, Russia, and China in modern history.

By 2016, global financial market capitalization was $300 trillion (over 3% of world GDP) and capable of generating market forces beyond the capability of any government to contain. In 1966, global market capitalization was well less than $1 trillion. In 2016, daily trading in foreign exchange was $5.3 trillion; in 1966 it was lass than $25 billion. In 2016 world trade was 33% of world GDP; in 1966 it was about 2%.

The daily volume of trading on the NY Stock Exchange was about 2 billion shares in 2016, up from 9 million in 1966; commissions had been reduced from about 1% of trade value to only 2-3 cents per share, but the NYSE’s share of trading in listed stocks fell to less than 20% as new technologies and trading platforms were introduced. 

Today, the cost of capital is largely determined by capital market activity; it is lower and more users have access to it than at any time in world history. Powerful economic linkages, and the extraordinary acceptance of markets (as judged by their use) despite some continuing political objections, leads us to believe that the system of market economics by which the world governs itself is here to stay.   

The firm I joined in 1966, Goldman Sachs, then had about 20 partners, with capital of about $20 million, and employed about 500 people. Fifty years later, Goldman’s public market capitalization is $62 billion and it employs 34,000. Still, the market value of the firm is about 3000 times greater than in 1966 but its headcount is only 85 times greater, which demonstrates the importance of computer and other technologies to all financial firms.

In 1966, Goldman Sachs had no foreign offices at all; today it has 61, 33 of which are in emerging market countries.

Despite all this growth in the industry, the fifteen largest US commercial and investment banks of 1966 have essentially disappeared – all but one (Goldman Sachs) have been acquired by other firms or failed, though some of the more prominent names have been retained. Today these thirty firms are boiled down into five – JP Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley, all buy Goldman the survivors of many large mergers that erased all traces of the cultures of the original firms.

The same thing happened in the City of London – for the same reasons. Globalization, deregulation and technology pushed all of the clearing banks, merchant banks, jobbers and brokers into mergers that consolidated the industry into just a few hands.

All in all, the world of global economics and financial services has been transformed far beyond anything we might have imagined in 1966. We are back into a bleak period, like the 1970s, with lots of reorganization and restructuring to come, but what the next fifty years in economics and finance is probably just has unpredictable as it was fifty years ago.

Growing Pains of Fintech

By Roy C. Smith

One of the hottest spots in finance today is innovation in various forms of financial services from computer-based technologies, which collectively we now call “Fintech.” From automated trading systems, to alternative payment platforms, to peer-to-peer lending, to “big data” management, the sector has blossomed with a few startup companies hitting it very big and everyone looking for the next one to do so.

The whole idea is that long established financial systems – banking and capital market trading with high fixed costs – can be disintermediated by applying high-speed information technology to extend services and lower the bid-ask spreads for financial transactions.

However, like the “Cleantech” industry that preceded it on the most-hyped list, Fintech has demonstrated over the last several months that while the underlying concept may be valid, execution at the corporate level can be very difficult.

Indeed, stock prices of Virtu (high speed trading), Square (payments), Lending Club (peer-to-peer lending), and Teradata (big data) have lost many billions of dollars of market capitalization in the past six months.  While Bitcoin’s “blockchain” distributed database has attracted a lot of attention recently, Bitcoin itself is still trading at only a third of its 2014 high.

Lending Club (LC) is the latest high flyer to fall, having now lost 83% of its market capitalization since the peer-to-peer lending concern went public in December 2014.  Some of the drop is attributable to the announcement last week of the forced resignation of its CEO, some irregularities related to a large loan sale and a federal investigation, but the stock price, after an initial IPO pop, had been declining for the past 16 months.

The peer-to-peer financial services model that bypasses banks (with their expensive capital and infrastructure and regulatory costs) is based on earning fee income rather than interest. Bloomberg estimated that the global peer-to-peer market was $77 billion in 2015; a 15x increase in three years.

LC was the largest peer-to-peer lender in terms of loans generated. Its revenues grew at an annually compounded rate of 240% from 2011 to 2015, when they reached $430 million. Though not yet profitable, LC went public in an IPO underwritten by Morgan Stanley, Goldman Sachs and Citigroup at a market capitalization of $8.5 billion.

LC’s business model is simple – it has developed an algorithm for assessing credit ratings online, and a platform for offering loans at appropriate interest rates to online investors. Because of its low costs, lack of regulation and effective technology, LC can offer borrowers rates lower than banks and provide investors with returns greater than money market or midterm bond funds.

Morgan Stanley was especially enthusiastic about peer-to-peer lending, estimating it would account for 10% of US personal and small business loans by 2020. In 2015 US credit card debt was $625 billion, retail credit (auto loans, etc.) $587 billion, and small business loans $600 billion – a total of $1.8 trillion.

But early on, LC realized that individuals and small business borrowers were not flocking to their website as they were expected to.

Perhaps retail investors didn’t trust the algorithm, or found the prospects of other people’s promissory notes too risky – banks were trained to make such decisions, not they.

As of December 2015, the LC marketplace had generated approximately $16 billion in loans since being launched in 2007. Of these, approximately $3.3 billion (21%) were acquired by retail investors, approximately $5.5 billion (34%) were invested in through securitized Trust Certificates bought by wealthy families, hedge funds or institutional investors, and $7.2 billion (45%) were sold as whole loans, mainly to institutional purchasers. 

In 2016 LC noted that institutions had purchased 56% of its loans, and that “a relatively small number of investors account for a large dollar amount of loans.” These investors, however, were no different from (or otherwise funded by) the banks and other financial intermediates that LC was supposed to be displacing. To the extent that the yields were attractive on the day they were shopping, they might invest; otherwise not.

Continuing rapid growth, upon which LC depended for its “unicorn” market capitalization, had to come from branching into the institutional field, which meant dealing in securitized products and whole loans, in which LC had little value to add.

After its experience with mortgage-backed securitizations, the market was cautious about what was in the package of loans being offered.

LC’s recent difficulties came from trying to sell deficient loans to Jeffries LLC that it would resell. Jeffries balked, and LC sold the loans elsewhere, but the breakdown of credit standards of the loans being originated was troublesome to the board. Its business model depended on investors trusting the quality of the loans being offered.

LC also planned to invest in Cirrix Capital, an investor in its loans, presumably as a way to boost sales.  This move may have been questionable in its own right, but couldn’t survive the fact that LC’s CEO had already invested without telling the board.

These events cast a shadow over the Fintech industry. This stuff takes time for users to trust it, and for service providers to prove themselves honest and reliable.  The industry may grow, but the startups in it are as risky as ever. The ones that may dominate the high ground in the future may not have been born yet.

Which may mean that the real Fintech industry will be going on inside the established players already well plugged into financial technology and the enormous IT budgets they require. Companies like Bloomberg, JP Morgan and Goldman Sachs are already identifying themselves as “tech companies” and are investing in (guess what) automated trading systems, alternative payment platforms, online lending, and “big data” management.

Darwinian Rules May Rescue Global Banks

By Roy C. Smith

First quarter results have raised questions again about whether the combination of structural and cyclical factors has ended the long reign of the global investment banks.  This seems to be the case for the weakest in the herd, but what about the strongest?

Most analysts agree that the two strongest among the top dozen banks are JP Morgan (JPM) and Goldman Sachs (GS), who ranked 1 and 2 in Dealogic’s 2015 investment banking revenues league table with 15% of all revenues between them. (They ranked 2 and 4, respectively, in 2005.) JPM is a diversified universal bank, with only about 18% of its $93 billion of revenues from investment banking and market operations; GS is the “purest play” in the industry with 81% of its $34 billion in revenues from investment banking fees, sales and trading and principal investing.

Darwin’s idea of the survival of the fittest did not rest on the fittest being the strongest – he claimed that the fittest would be those that adapted best to changes in their environment. The last five years have certainly demonstrated that a lot of environmental change is going on in the investment banking industry that will continue for some time.

As I have expressed many times in previous posts, the effect of these changes has most visibly appeared in returns on equity (ROE) being persistently less than the banks’ cost of equity capital. For the strongest, this differential is now relatively modest, but for the weakest the differential is in double-digit negative percentages. Within the industry, the ability to adapt this ratio into positive territory, more than anything, will determine fitness, and therefore survival.  

For some, adaptation may have to be quick and substantial, perhaps dramatic. But JPM and GS have avoided the dramatic for a steady, well-aimed series of small adjustments they hope will work best. The two firms are the only ones in their industry led by long experienced chief executives in place before the 2007-2008 crisis; both CEOs have laid out plans to re-engineer their firms rather than shake them up significantly.

Since 2010, JPM has parsed through its businesses and cut back on those made less profitable by regulatory change, and, accordingly total revenues have declined by 9%. At a time when many of its competitors are engaged in asset sales, layoffs and sharp cost cutting, JPM reduced headcount by only 2%, while increasing risk-weighed assets by 30%. It has also increased its compensation ratio (total compensation costs as a percent of net revenues) from 27% to 32%, and increased its annual technology and communications budget by 32% to a robust $6 billion. Even after these cost increases, JPM’s ratio of pretax operating profits to net revenues has increased by a third to 33% since 2010.  

JPM has been aided in its effort, some say, by its experience with the 2012 “London Whale” $6 billion trading mishap, which brought urgent attention to the importance of risk management and accountability for mistakes.  

GS had a similar “learning opportunity,” not from a trading loss but from bungled Congressional testimony related to the firm’s pre-crisis trading in mortgage bonds, and a consequent, poisonous “Vampire Squid” article in Rolling Stone that went viral in 2010. These public relations disasters seriously damaged the firm’s public reputation and helped inspire Bernie Sanders’ frequent attacks on the firm during his presidential campaign.

But, behind the scenes, GS has been adapting to its new environment steadily. As the most concentrated pure play in investment banking, it has had a lot of structural change to adjust to, and it has had to deal with cyclical factors more than others – its first quarter earnings per share were down 55% because of adverse market conditions, more than any of its major competitors.

Though GS’ 2015 revenues were 14% less than in 2010, risk-weighted assets increased by 22%, and headcount was up 3%. The firm is known for its profitability and high compensation, but its compensation ratio in 2015 had shrunk to 38%, well below the Wall Street historical norm of 50%. In 2015, however, GS reported ROE of only 7.4%; it was 11.4% in 2010.

GS’s most visible adaptation over the past five years is the reduction of its trading related businesses (Institutional Services, and Lending and Investment) to a combined 61% of net revenues from 75%, and in increasing its global reach. Fees from investment banking and investment management rose to 39% of net revenues from 25%, and more than 50% of the firm’s pre-tax earnings were from non-US sources in 2015.

GS prides itself in having transitioned into an information technology company (25% of its workforce). It relies on new technologies to enable it to “optimize” the firm’s balance sheet, manage risk, cope with all the new compliance and reporting requirements, and to capture the benefits of the on-line banking business it recently acquired from GE Capital.

GS also is proud of its unique, post-partnership culture in which a few hundred “Partner-Managing Directors” are paid based on how the whole firm performs, and another 2,000 or so Managing Directors who are rewarded for being culture carriers and enforcers throughout the various operational units of the firm.

However, for all their success in adapting to the future, both JPM and GS are lagging well behind where they want to be in terms of shareholder returns. Though JPM’s market capitalization is 39% greater now than in 2010, it is still $23 billion less than Wells Fargo’s, which is 30% smaller in terms of assets. JPM now trades at 104% of book value (WFC is at 150%), and in December 2015 had a ROE only 0.10% greater than its cost of equity capital (WFC’s was 5.70% greater).

GS has also done better than most, but not as well as JPM. Its present market capitalization is 20% less than in 2010, its stock price is now 92% of book value and its net return on equity after capital cost was -1.80% in December 2015.

Darwin never said it was easy. Adaptation to radically different environments takes time and is painful and uncertain. But someone has to emerge as the fittest, and capture the benefits of survival. JPM and GS are betting it will be them.

A Victory for Argentina

By Roy C. Smith

Argentina’s massively oversubscribed $16.5 billion bond issue last week reflected a surprising degree of confidence in the new government of Mauricio Macri, given the country’s considerable economic problems and those of its fallen-angel neighbor, Brazil.

It also demonstrated an unquenchable thirst for yield on the part of investors willing to grab at a 683 basis points spread over 10-year German bunds for a B3 rated bond by an issuer with a long history of defaults. 

Perhaps more important, however, is that it signaled the end of a difficult 15-year effort to restructure Argentine bonds that defaulted in 2001, and regain access to capital markets.

Argentina’s $82 billion default, the world’s largest, was a “can’t pay, won’t pay” event imposed by a floundering Argentine government, that was later led Nestor Kirchner, the country’s socialist Peronista party president elected in 2003 who was succeeded in 2007 by his wife, Christina Fernandez de Kirchner, and who died in 2010. The Peronistas have governed Argentina for the past 25 years.

The default was probably unavoidable, the economy was in free-fall and money was rushing out of the country. But the government chose a politically popular but highly confrontational approach to dealing with its creditors, eschewing any involvement by the IMF and ignoring demands of creditor committees.

Four years after the default, it offered a take-it-or-leave-it exchange of new bonds for old valued at $0.34 on the dollar. This was a value far less than other emerging market debt restructurings, and less than what most of the banks believed Argentina could manage to pay

To help persuade banks to accept the offer, the Argentine parliament passed a law making it illegal for the government to change the terms of the offer.

A 75% majority of the banks folded and took what they could get, writing off the rest.

But there were some holdouts that refused to exchange their debt, mainly hedge funds that had bought their positions from banks. So there was a second exchange offer made in 2010 that 66% of the holdouts representing $18 billion of claims accepted.

The die-hard hedge funds continued to resist, however, filing lawsuits seeking to block Argentine assets outside the country, including a naval training ship seized by creditors in 2012. When Argentina nonetheless sought to raise additional funds in the markets, the holdouts sued in New York and a judge ruled in 2015 that Argentina could not take on new debt until it paid off what was left of the old. 

In the end, despite mighty and heavy-handed efforts by Christina Fernandez to get around the courts, the game was lost. Her second term as president expired in 2015, and Macri replaced her.

Macri was heartily welcomed by politicians such as Barack Obama, and by investors. He made settling with holdout bondholders a priority, and decided to take advantage of the market’s good will to raise the new debt, with some of the proceeds going to repay the hedge funds.

The new bonds are issued under New York law and will be subject to future court rulings if the Argentine government seeks to interfere with bondholders’ rights in the future. 

But those rights are diluted by a “collective-action clause” (CAC) that will enable the government to change the maturity, interest rate and/or other terms of the bonds “with the consent of less than all of the holders.” If the designated percent of bondholders agree to the change in terms, then all bondholders are committed.

If the CAC covers exchange offers, issuers are able to avoid the headache of holdouts, which in Argentina’s case added ten years to the time it was able to re-enter capital markets after the first exchange offer.

Investors in emerging market debt know that governments are shielded by sovereign immunity that enables them to avoid direct legal remedies for default such as bankruptcy. They also may know that according to a Moody’s study of sovereign defaults from 1983-2010, that in any single year the default rate of Ba or B rated debt was about 4.0%, but over a 10-year period, the cumulative default rate for speculative-grade sovereign debt was 34%.

In other words, an investment in Argentina’s new 10-year bonds at 6.8% above the “risk-free rate” (i.e., the German bunds) would clear the Moody’s single year default rate expectation by 2.8%; but over 10-years the gain would not be enough to compensate for the cumulative 34% default rate.

Mr. Macri has got off to a good start, from a bondholder’s point of view. He devalued the country’s currency, moved to lower subsidies, laid off 20,000 unionized public service workers and imposed other austerities to help shore up the country’s finances.

But Argentina still has many challenges. Thousands of workers have already marched in protest of Macri’s proposals, and analysts expect the economy to shrink this year. The Inflation rate is currently over 30%.

Lots of unforeseen things can get in the way between a good start and a good finish to a bond issue.  If they do, the CAC will do away with both the opportunity and the pressure on the government represented by holdouts.  And Argentina’s go-it-alone, cram-down restructuring involving a 66% write-off in 2005 will be a tough precedent for it to resist in the future.

New Bank Leaders Face Limited Choices

By Roy C. Smith and Brad Hintz

Though none have announced their results yet, European capital market banks will surely experience a quartus horribilus. Total 1Q investment banking revenues are down 36% from the prior year, the lowest since 2009, led by sharp declines in M&A, high yield and IPO activity.

It also appears that trading revenues will be disappointing. Several US banks have discussed the challenging market conditions that have impacted market making and Jefferies, which serves as a harbinger of FICC performance, announced dismal trading performance in its first quarter.

2015 looked like a year that would signify the end of the post-crisis slump for the banks - mergers, equities, debt and LBOs all were firing away, and the beginning of the long awaited recovery of profits in the banking industry was foreseen. But, it was not to be. The oil glut rattled stock, debt and currency markets and recession fears forced unexpected credit write-downs.

The quarter’s results, however, mask mighty efforts being made by the big European banks to restructure themselves after years of dithering. Only three European banks will be among the top ten firms ranked by investment banking revenues. 

Eight years after the 2008 crisis most of them have become unviable relics drowning in a sea of tightened regulation and costly litigation, with little sense of what to do about it. But, by the end of 2015, all of the four largest Europeans had installed new management with no ties to past legacies and charged them with transitioning to a workable business model that could once again be attractive to investors.

Bailed out by a resentful Swiss government in 2008, UBS was the first to confront the need for major change, though it took four years to do so.  Sergio Ermotti, former Deputy CEO of Unicredit, was appointed CEO in 2011, and decided to reduce the investment banking business (and its related risk-weighted assets) to minimal levels, choosing instead to build a new, lower-growth but less volatile, dividend-paying business centered on wealth management. This was an easy call because its wealth management franchise was so vast, and it has paid off. In 2015 UBS reported ROE of 11.5%, its stock was trading at 1.1 times book value with a dividend yield of 3.6% that will increase further when the bank reaches its near-term goal of a 50% dividend payout. However, there was a high cost to Mr. Ermotti’s strategic move: UBS is no longer ranked among the top ten global investment bankers by revenues.

The three European banks that have clung to their investment banking market shares and revenue steam – Barclays, Deutsche Bank and Credit Suisse (ranking 6^th, 7^th and 8^th, respectively, by global revenues) remain in terrible shape, as they have been for most of the last eight years. ROEs were negative in 2015 for all of them, and today, on average, their stocks trade at a mere 43% of book value.

In July 2015, John Cryan, a former UBS finance chief, was appointed to replace Deutsche Bank’s ineffective co-CEOs. In October he announced a new “Strategy 2020” (that replaces a previous, but unaccomplished, “Plan 2015+”) that would rely on simplification, increased capitalization, less risk and better management. Risk-weighted assets (RWA) will be further reduced by 22% to  310 billion by 2020; capital and leverage ratios will be improved, some extraneous assets will be sold, and expenses and headcount will be cut further.  Eliminating dividends for two years will fund these efforts. Returns on tangible assets will rebound (it is hoped) to 10% by 2018 (about 8% of book value), which, however, is still less than Deutsche’s continuing cost of equity capital.  Deutsche Bank’s stock is down 27% since the new plan was announced – JP Morgan’s is essentially flat since then; UBS’ is down about 10%.

Tidjane Thiam, the former head of Prudential Insurance, became CEO of Credit Suisse in June 2015.  He also announced a plan in October similar to Cryan’s to trim hard and cut back, but stick to the old business model and protect profitable market share positions in investment banking.  Last month, however, Thiam announced a further tightening of the plan after the investment banking division blindsided him by adding assets to trading positions that then lost money.  RWA will be cut a further 20% along with 2,000 more jobs in the global markets unit. Despite bringing his miracle worker reputation to the bank, Thiam now seems to be in over his head. Credit Suisse’s stock price is down 37% since last October.

The most recent of the new CEOs is JP Morgan Chase veteran, Jes Staley, who took over at Barclays Bank in December. He too has announced a simplification, cost cutting and balance sheet trimming plan that would involve selling assets in Africa and shutting some non-essential business. His plan, however, also included halving the dividend for 2016 and 2017, and focuses on preparing Barclays for the ringfenced regime it will face in 2019. This, he demonstrated in a presentation to investors, will involve transitioning Barclays into two separately capitalized (and ultimately separable) businesses – a global investment bank, Barclays Corporate and International, with RWA of £195 billion, and a much smaller Barclays UK, with RWA of £70 billion. Even so, Barclays’ stock is also down 37% since October.

The three new CEOs have now all had early lessons on how hard it is to turn around a large underperforming European bank under present regulatory constraints and unsettled market conditions. It may be that balance sheet “optimization” won’t work any better for them than it did for their predecessors, who tried versions of it too.

Ultimately, there may be only two ways out. One is to convince regulators that important players in the global capital market system (there are some Americans too) will be sidelined indefinitely unless there is some relaxation of the capital adequacy, leverage, liquidity and other rules to allow market pricing to adjust to regulatory shifts. This may happen in time, but not soon. The only other way out is to split off the investment banking units into separate companies, which market conditions may make difficult, but not impossible, to do.

The new guys need to be brutally objective about their situations. If the renewed cut, squeeze and trim approach doesn’t work within a year or so, then the more drastic spin off approach may be all that is left.

 From: EFinancial News, March 31, 2016