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Money Stuff: Banks Pretend 2020 Never Happened

April 16, 2020
Money Stuff
Bloomberg

Covenants, etc.

From an economic perspective I think what we'd all like is to forget that 2020 ever happened. That is easier said than done—if we froze all payments then people wouldn't have money to buy food, etc.—but there are a lot of gestures in that direction. For instance here's a story about maintenance covenants in revolving credit agreements:

Wall Street banks are lending billions of dollars to desperate companies these days, like hotelier Marriott International and concert producer Live Nation Entertainment.

Now, a host of those companies are turning around and asking the banks to waive or loosen financial markers that help ensure the debt will be paid back. And for the most part, the banks, from JPMorgan Chase & Co. to Wells Fargo & Co., are obliging them because they would otherwise risk triggering a wave of defaults that would swell their loan losses from the pandemic and eat into their capital.

"Borrowers are effectively asking lenders to forget 2020," said Valerie Potenza, head of high yield research at Xtract Research. "If lenders don't waive covenants, there are going to be defaults. And it's not just one borrower, it's many borrowers across many industries."

The waivers involve borrowing lines called revolving credit facilities, which companies typically obtain from banks and then draw down as needed. As the virus shuttered a broad swath of the economy, companies have drawn about $216 billion from the credit lines, according to data compiled by Bloomberg.

These loans typically include so-called covenants that require borrowers to maintain certain metrics, such as the ratio of debt to earnings. They usually kick in when a company has drawn down some 30% of the revolving loan.

But with earnings and cash flow drying up, these companies are sometimes unable to get anywhere near the financial tests. So the benchmarks have been effectively thrown out, suspended or rewritten to make it easier for them to avoid a technical default. In some cases, banks are allowing companies to use questionable accounting numbers for the new metrics.

In return for the reprieves, the lending banks often extract higher interest rates, additional fees or other concessions. 

Basically if you enforce all your maintenance covenants when all your clients have stopped getting revenue, then you will put all your clients into default, and they won't all pay you back, and you'll have to recognize a lot of losses right now. If you instead say "ahh forget about 2020 it's fine," then you won't have defaults, and you can sort of pretend that everything is fine, and maybe in 2021 their businesses will all come back and everything really will be fine, and anyway in the meantime you can charge them some extra fees. Makes sense.

Here's Live Nation Entertainment Inc.'s announcement of its credit-agreement amendment. Notice in particular its net leverage ratio covenant, the covenant that says that Live Nation has to have earnings before interest, taxes, depreciation and amortization equal to at least a certain set fraction of its net debt. The net leverage covenant is waived (replaced with a liquidity covenant) for this quarter and next quarter; for the fourth quarter of 2020 and the first two quarters of 2021, it will be calculated with a "substitution of consolidated EBITDA from the second and third quarters of 2020 with consolidated EBITDA from the second and third quarters of 2019, respectively." That is, when Live Nation calculates its earnings for 2020, for covenant purposes, it will delete the second and third quarters of 2020 and replace them with the second and third quarters of 2019. As far as Live Nation's banks are concerned, it will spend six months of 2020 in 2019. I wish I could do that! I think a lot of us would prefer to delete spring 2020 from our lives and replace it with reruns of spring 2019; it is nice that Live Nation's banks will let it do that.

Or here's a story about bank risk models, from Johannes Borgen. Banks plan for their financial risks using value-at-risk models, which use historical data about volatility to model how much money the bank might lose in any day. "There's a 99% chance that we won't lose more than $X in a day," is the basic output of that model. If you lose more than $X in a day, that is called a "backtesting exception," and if you have too many of those you get in trouble, because your model's prediction was wrong. From the Swiss financial regulator Finma:

Such an exception occurs if the loss incurred on a single day is greater than the loss indicated by the model (value-at-risk, 99% quantile). Above a certain number of exceptions an increasing supplement is added to the bank-specific multiplier, resulting in an immediate and substantial increase to the minimum capital requirements for market risks. The aim of this multiplier is to provide an incentive to rectify any shortcomings of the model.

If your model says that there's a 99% chance you won't lose more than $X in a day, and you lose $2X six days in a row, something is probably wrong with your model, and you should get in trouble. Except (arguably) that is not true now; now, when you lose $2X six days in a row, your model is fine, it is reality that is wrong. "Most exceptions today are not due to
shortcomings of the model, however, but due to the increase in volatility," says Finma. So the level of exceptions "will be frozen at the level of 1 February 2020 until 1 July 2020." If a Swiss bank lost more money than it expected between February and July, that doesn't count against its model. That's not the model's fault, that's the pandemic's fault, and we will all just agree to forget about it. Should the model have been prepared for the pandemic? Ehh that is a philosophical question that is beyond the scope of this column; my point is only that if your regulator or bank or counterparty or whoever will let you pretend that spring 2020 never happened, that is probably nice for you.

Everything is securities fraud

As broadly as possible:

  1. Basically every public company's revenue has collapsed due to a pandemic.
  2. So their stocks are all down.
  3. If a company didn't have a risk factor in its public filings saying "if there's a pandemic our revenue might go down," and if you bought its shares before the pandemic and held them through today, you might, if you worked really hard at it, manage to feel aggrieved. "Why didn't this company warn me about the risk that a pandemic would reduce its income," you might ask.

It is not much of a theory, really, but it is the theory behind "everything is securities fraud" I guess. "Everything bad that happens to a public company is also securities fraud," I often say, and while I mostly mean that about idiosyncratic problems I suppose it is also true about universal disasters. If something bad happens to every public company at once, then they've all committed securities fraud? Ugh I don't like it either, but I don't make the rules. Here is "Management Disclosure of Risk Factors and COVID-19" by Tim Loughran and Bill McDonald of Notre Dame:

Public companies in the United States are required to file annual reports (Form 10-K) that, among other things, disclose the risk factors that might negatively affect the price of their stock. The risk of a pandemic was well known before the current crisis and we now know the impact for shareholders is, for almost all companies, significant and negative. To what extent did managers forewarn their shareholders of this valuation risk? We examine all 10-K filings from 2018, well before any knowledge of the current pandemic, and find that less than 21% of the filings contain any reference to pandemic-related terms. Given management's presumably deep understanding of their business and general awareness that, for at least the past decade, pandemics have been identified as a significant global risk, it seems that this number should have been higher.

If you bought stock in 2018 and held until now, you can sue 79% of companies! Not legal advice.

Elsewhere here's a Bloomberg Businessweek story on "What Was Carnival Thinking," about how Carnival Corp. kept its cruise ships sailing as the pandemic gathered force. Here's how passengers on the Carnival Grand Princess reacted to a shelter-in-place order:

Laurie Miller was in the Da Vinci dining room eating chocolate peanut butter ice cream. "Oh my God," she remembers thinking. "This is real." Then she ordered more ice cream.

Other passengers ambled to the ship's stores and dining areas, too, to take advantage of the perks while they could. "Evvverrrybody went to the buffet," recalls 61-year-old Debbi Loftus, who was traveling with her parents. "I just thought, Oh, crap, the ukulele concert is going to be canceled."

Obviously Carnival "is facing multiple passenger lawsuits regarding its Covid-19 response."

Oops!

This is some of the most incredible dialogue I have ever read:

Margaret Brown, an all-member representative for CalPERS, posted on her Facebook page on Thursday that the board was never told about the elimination of one of two tail-hedge strategies, which are designed to protect portfolios against market crashes. And meeting minutes show that Brown asked CalPERS CIO Ben Meng about the strategy at the pension's March meeting. 

"Ben, can you tell me how our left-tail investments are performing?" Brown asked, according to the meeting minutes. "Are they performing the way we thought they would in this economic downturn?"  

In response, Meng said: "Yes, for any left-tail risk hedging strategy you're referring to, they should perform well in this kind of a down market, as they were exactly designed to do. And from what we know are most of these strategies are performing as anticipated." 

On Facebook, Brown pointed out that Meng failed to mention at the time that the pension had already unwound those positions. 

"The CIO was asked on March 18 how our tail risk strategies were performing. Mr. Meng's response omitted that he had abandoned the Universa hedge," she wrote, referring to a position run by Universa Investments. "The board must hold the CEO and CIO accountable and finally begin taking its fiduciary oversight role seriously."

CalPERS decided in October 2019 to eliminate the program because of its high cost and lack of scalability, Institutional Investor previously reported. The program could have paid out $1 billion in March.

Get it? In October 2019, the California Public Employees' Retirement System's investment managers decided to wind down their tail-risk hedging strategies, which they finished doing by January 2020. And then in March, as the world economy was sliding into collapse, Calpers had a board meeting, and a board member, quite sensibly, asked the chief investment officer "hey how's that tail-risk hedging strategy working out?" And he replied … "Yes, for any left-tail risk hedging strategy you're referring to, they should perform well in this kind of a down market, as they were exactly designed to do. And from what we know are most of these strategies are performing as anticipated." 

Reading the minutes, now, with hindsight, it is clear what he was saying: Uh, yeah, from what we read in the newspapers, it seems like tail-risk hedges are working right now, though we have no first-hand knowledge or hard data since we don't own any. But I take Brown's point that, at the time, it might have been nice for Meng to be a bit more explicit. "Just to be clear, tail-risk hedges are probably great right now but we don't own any," that sort of thing. I don't know that it would have mattered much—already too late!—but still.  

Some bribes

This week the U.S. Securities and Exchange Commission charged Asante Berko, a former executive director at Goldman Sachs Group Inc., "with orchestrating a bribery scheme to help a client to win a government contract to build and operate an electrical power plant in the Republic of Ghana." Disclosure, I used to work at Goldman, where I had the same rank as Berko,[1] and I never orchestrated international bribery schemes. Mostly I am impressed by Berko's energy and creativity; comparing him to my own investment banking career, he really seems to have been much more dedicated and creative in getting the deal done and helping the client succeed. With bribes, though, allegedly.

The story is that Berko's boss, a managing director at Goldman Sachs International, brought him in to help a Turkish energy company that was trying to build an electrical power plant in Ghana. His boss wanted "to advise and arrange financing for the Energy Company if the Energy Company was able to close such a deal," a good traditional investment banking activity. According to the SEC's complaint, Berko apparently thought, well, we will have a better chance of financing this deal if it actually happens, and it will have a better chance of actually happening if the energy company bribes the right officials. Berko was a Ghana expert, and he happened to know the right people ("a privately owned Ghanaian company that purports to provide consulting and other services for energy development projects in Ghana") to do the bribing, so he set up a meeting between the energy company, that intermediary/consulting/bribery company, and the relevant Ghanaian officials. They all got along, so they got to work developing the power project and, allegedly, bribing the officials.

I talk a lot around here about how, if you are doing bribes, you should not use cutesy euphemisms for the bribes, because that will look really bad if they eventually catch you, and I must say that these guys were mostly admirably matter-of-fact about things:

On April 19, 2015, the Intermediary Executive again urged Berko and the Energy Company CEO for the $500,000 in bribe money because "the intended recipient" - [Government Official 1] – "is on my case." The Intermediary Executive added: "I am going to part with [$250,000] to [Government Official 1] on the basis that I will receive the same in due course. This will represent part payment to him as discussed." The Intermediary Executive then pressed "to have the [$1.5 million] also here in Ghana no later than end of this week or early part of the following [week]" because "[a]s agreed, certain payments will be made on signing [of the Power Purchase Agreement] and I believe all will be covered if you follow the above guidelines." 

Good, yes. "Certain payments" to be made on signing. Neutral, nice. "Milestone payments" is another phrase they used, a good business-y term. On the other hand this seems bad:

On August 4, 2015, the Intermediary Executive emailed the Energy Company CEO requesting another $250,000. The Intermediary Executive implied that he intended to use all or part of this money to bribe Government Official 1, whom he noted "is also waiting for the 'holy rain' and would appreciate it sooner rather than later." The Intermediary Executive then forwarded this email to Berko, who responded: "Reply and copy me in saying adding Asante [Berko]. Gmail only!" Berko's instruction to use his personal email (Gmail) only served to remind his colleagues that his work email was monitored by his firm's compliance department.

No no no if you're like "we need to give a government official $250,000 for signing a contract," yes, sure, that is absolutely a bribe, but you can sort of brazen it out. "No that's not a bribe, we just needed to give him $250,000 for signing the contract. Milestone payment." But once you say "holy rain," or "Gmail only!" for that matter, anyone can tell that you are up to no good.

Also there was some delightfully detailed invoicing, for the bribes:

The Intermediary Executive then proceeded to justify the original invoice:

"[Government Utility Company employees] have so far received 120K, 100K from u and 20K from Asante [Berko]. Each inspector that visited Turkey was given 5K on top of the flight and accommodation. Total expenditure was over 45K."

"The [Ministry of Power] girls have been promised 30K in total . . . That's 10k each when we get [the Letter of Credit]. They have received 20k so far. These ladies are most vital to our communication and information acquisition."

"Parliament was all paid by Asante [Berko]. He actually added another 10k on his last visit as he had promised this to the guys. The whole 30k requested is due him. I know he paid more than that. (Approximately 46k that I know of!)."

"The power team was very receptive after I started agreeing payments with them. The payments were staggered and settled fully when we had a contract agreed. They were 8 in all … Average payment was only 3k! The important ones like [the Government Electricity Company] and the [Ministry of Power] received 5k."

[Government Power Grid Company] . . . . The number of times we have visited them and the number of engineers we have interacted with!! Each time they were sorted out to make sure we got the correct information and assistance. Why would even think 5k?"

I dunno, he makes a good case, those seem like bargains. Anyway Berko allegedly misled Goldman compliance about the bribery consultants, and he quit Goldman in late 2016, but "continued to assist the Energy Company in the Power Plant Project" after leaving. The energy company allegedly "paid Berko $2 million as compensation for arranging the bribery scheme." 

People are worried about bond market liquidity

If an exchange-traded fund of corporate bonds trades at a discount to the value of the underlying bonds, is the ETF price wrong (too low), or are the bond prices wrong (too high)? I feel like that's a pretty simple question to answer. If you want to buy or sell the ETF, you go to the stock market and put in an order and buy or sell the ETF in a fraction of a second. If you think the price is too low, you buy the ETF cheap. If you want to buy or sell the underlying bonds, there are a lot of them, and you have to call up your dealer and ask for a market on each of them, and the dealer may not want to transact in some of them because it doesn't have the risk appetite or balance sheet, and the bid/ask spread may be wide, and this sentence keeps getting longer and more boring until you lose interest in the transaction. In other words it makes sense that the bond prices would be wrong, because there are lots of bonds and transacting in them is relatively slow and complicated, while there are relatively few popular bond ETFs and transacting in them requires only pushing a button.

And so, when big bond ETFs started trading at big discounts to their net asset values last month, I and others wrote, yes, right, the ETFs are reflecting market reality (stuff is bad! credit has widened!), while the net asset values—just adding up the bond prices—were not reflecting reality because those prices were not moving in real time. 

Here is a Bank for International Settlements staff bulletin by Sirio Aramonte and Fernando Avalos making that point more rigorously:

Pronounced market stress in mid-March highlighted differences in how quickly ETF prices and NAVs incorporate information. Unlike mutual funds, whose assets are valued once a day, ETFs trade continuously, and their liquidity is supported by a variety of intermediaries. As a result, ETFs incorporate information in a more timely manner than the underlying bonds. Indeed, surprises in ETF prices explain future unexpected NAV and price dynamics much better than NAVs do, suggesting that information flows from prices to NAVs …

The NAV discounts that opened up in the corporate bond ETF market in mid-March 2020 highlighted that, especially in challenging times, ETF prices react to new information more quickly than NAVs do. Compared with the relative staleness of bond prices and NAVs, ETF prices can be useful tools for market monitoring and valuable inputs to risk management models that require up-to-date assessments, for instance trading book risk models. 

People are worried about circuit breakers

The basic idea of stock market circuit breakers is:

  1. Everything is normal, it's a quiet afternoon, the robots are trading stocks back and forth with each other.
  2. Some bad news comes out and people rush to sell stocks.
  3. The robots, who were trading unsupervised in a quiet afternoon market, are not prepared to buy all the stocks that people are selling.
  4. Prices crash.
  5. Everyone needs to take a 15-minute time-out so that the robots' bosses can come in and adjust their algorithms, and so that brokers can call up fundamental value investors and ask if they want to buy at the new lower prices.

It is a perfectly sensible theory but it has been tested in recent weeks, when what happened was more like:

  1. Terrible news comes out at night, or over the weekend, or investors examine their portfolios and search their souls overnight or over the weekend and decide to sell everything.
  2. Everyone shows up at the market at 9:30 on Monday morning ready to sell everything.
  3. Anyone who wants to show up to buy could also do that, in full knowledge of the bad news and of the likely discount on stock prices, but not a lot of people actually do.
  4. Prices crash.
  5. Everyone has to take a 15-minute time-out to twiddle their thumbs before they get back to selling.

It is a less productive pause than you'd like. No one is getting more time to react usefully to news; the news, and the reaction, all occurred before the market opened, and the pause is just sort of a waste of time. Anyway:

Financial heavyweights including Morgan Stanley, Citadel Securities and BlackRock Inc. are exploring potential changes to the U.S. stock market's circuit breakers after the rarely used mechanisms repeatedly halted trading last month.

Several members of the task force, according to the people familiar with the matter, suggested relaxing the circuit-breaker regime at the start of the day—between 9:30 a.m. and 9:45 a.m., for instance. Under such an approach, a drop greater than 7% would be required to halt trading during that period, the people said.

One idea was to allow the market to open down 7% but to halt trading if losses accelerated and the S&P 500 hit another threshold, such as 13%, they said. Some task-force participants questioned the need for having circuit breakers at all at the open, but others countered that it was important to retain some protections at 9:30 a.m., the people said. So far, the group hasn't come to a consensus on any changes.

Things happen

Banks Brace for Consumer Pain, but Wall Street Trading Arms Shine. Cash-rich Gulf funds hunt for bargains as asset prices plunge. Small-Business Aid Funds Run Dry as Program Fails to Reach Hardest Hit. Eight Weeks of Relief Is Not Enough for Small Firms Facing Failure. Debt-Laden Occidental Opts to Pay Buffett's Dividend in Shares. Adam Tooze: How coronavirus almost brought down the global financial system. Neel Kashkari: Big US banks should raise $200bn in capital now. Work-From-Home Veterans Have Had It With You Coronavirus Rookies. Golden stapler. Pizza Groundhog. 

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[1] Goldman uses the "vice president" title in the U.S. and "executive director" elsewhere, which means that I was mostly a VP but occasionally an ED on European and Asian deals. It always felt a bit like a promotion.
 

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