Posts Tagged ‘Finance’

Capital Ratios of Financial Institutions

Thursday, August 14th, 2008

With the stocks of banks and investment banks imploding in 2008, there’s been much talk of capital ratios.  Regulators require banks to maintain minimum capital requirements.  The reason is to prevent them from failing due to overzealous lending during economic expansions that could result in financial setbacks when the economy turns down.  So just what are capital ratios?

In the United States, there are two primary capital ratios:  Tier 1 and Tier 2.  The Tier 1 capital ratio is the most important one, and that’s what I’ll focus on here.

The Tier 1 capital ratio consists of the ratios of the bank’s stockholders’ equity, preferred stock and retained earnings to its total risk-weighted assets.  Risk-weighted assets are calculated by putting each of the bank’s assets and off-balance sheet items into a basket and assigning a risk category to that basket.  Risk categories range from 0% to 100%.  If the overall risk is lower, then the bank is considered more stable for depositors and more conservative for investors.

The problem today is in determining both the valuation of and the risk relative to the assets.  Some, as I noted in my earlier posting on auction rate securities, are hard to value, but are less likely to default.  Others, such are a letter of credit, may be considerably riskier.  So actually determining the Tier 1 capital ratio involves art as well as science. Thus, bank stocks, which have fallen considerably this year, may still be overvalued.

Regulators use the Tier 1 capital ratio to segregate banks into five categories ranging from well-capitalized  to critically undercapitalized.

The Tier 2 capital ratio includes undisclosed reserves, general loss reserves, subordinated term debt, hybrid instruments, among other items.

Title 12 of the Code of Federal Regulations includes the regulations regarding minimum capital ratios.  A much more detailed compendium of what is included in bank capital ratios is available in Appendix A to Part 3.

Auction Rate Securities and How the Failure of One Market Can Snowball Into Other Markets

Thursday, July 31st, 2008

How can a failure in one market snowball and create failures in others?  Here’s a simplified example, in the case of auction rate securities (ARS).

Much has been written this year about the sudden illiquidity of the ARS market.  ARS are a product often used by companies to invest their excess cash.  The inability to properly value such securities led to problems because they need to be properly valued on a company’s balance sheet for financial reporting.  Additionally, when that cash was needed, reselling the ARS at what was their supposedly appropriate value was an issue, as they were trading at significant discounts because of market illiquidity.

An ARS is a debt security, most often a municipal or corporate bond, in which the interest rate is reset via a Dutch auction on each payment date.  Essentially, it is a long-term bond with a 20 or 30-year term, but with variable interest rate, so that it acts like short-term debt.  A Dutch auction, also known as a descending price auction, is the winning bid at which the lowest possible interest rate at which equilibrium occurs (equal numbers of buyers and sellers exist), such that all securities can be sold.  For ARS, the auctions to reset the interest rate usually are held every 7, 28 or 35 days.

In February, 2008, the market for ARS collapsed and more than 1,000 auctions failed.  This is because the ARS’ insurers were in financial difficulties because they previously had insured mortgage-backed securities that were now defaulting at higher rates.  Suddenly, the ARS were seen as riskier because the insurers backing them were less secure.  Although an auction may fail, the ARS’ rates do reset,  typically increasing to the maximum rate allowed for the issuer of that particular ARS.  Demand for the securities decreased.  The investment banks that make a market in these securities refused to act as bidders of last resort, which they previously had done.  Consequence:  the market for ARS froze.

Investment banks had pitched these securities as “cash or cash equivalents” to companies.  But cash and cash equivalents are considered liquid.  Suddenly, many companies which held ARS had to revalue their holdings, and some reclassified them as short-term investments.  These changes reduce cash holdings on the balance sheet.  In some cases, a company may technically default on its debt covenants based on the ratio of cash on its balance sheets.  Public companies with significant amounts of ARS as a percentage of cash could see a drop in their share prices.

Even if the issuer underlying a particular ARS is fine, the lack of liquidity and auction failure created problems for investors.  These problems, with began with the failure of mortgage-backed securities, spiraled into auction rate securities, affected companies’ balance sheets and perhaps, share prices.  This, simply put, is how the failure of one market can snowball into other markets.

A Management Flaw – and Financials Disasters That Shouldn’t Have Happened

Thursday, July 17th, 2008

One critical flaw that has hobbled and even killed companies is not managing growth.  Companies that don’t manage their growth produce unhappy customers, unhappy vendors, unhappy franchisees and sometimes, spectacular flame outs.  Why would a company put itself in this position?  Lots of reasons . . . attempting to grab market share, be the first into a new market and dominate a niche, management hubris or just plain greed.

Here’s an example of management hubris:  I interviewed for an executive position with a $700 million company that started growing extremely rapidly (It had doubled in the past 2 years.).  I spent 1.5 hours with their head of HR.  He told me, “We don’t have competition” and “I’d rather have someone do C+ work and get it done tomorrow than A work and get it done next week.”  Those sort of red flags say to me that when this company falls, it’s going to fall hard.

Two companies that should’ve been category killers, but ended up flaming out, are Boston Chicken (which changed its name to Boston Market) and Krispy Kreme Donuts.  Both had fanatics among customers and captivating products.  Both were loved by Wall Street.  In both cases, there was no dominant national chain in their niche, a la McDonalds in the hamburger category (KFC offered fried, not rotisserie, chicken.).  Both flamed out.

In Boston Market’s case, large loans fueled growth that occurred much too quickly.  Essentially, the company began to see itself as a financial, not food service, company, making money selling franchises instead of focusing on growing steadily and producing high quality meals.  The company failed to build a strong management team and had high executive turnover.  Food quality varied from unit to unit and even in individual units, depending on the time of day and number of customers.  Even its marketing strategy, with constant coupons, led to higher growth and lower margins.  Eventually, it filed for bankruptcy.

When Krispy Kreme opened in new areas, cars waited in long lines.  Although founded in 1937, its downturn came when it saw how lucrative franchising could be.  It sold its first franchise in 1995 and went public in 2000.  Its stock soared.  Yet it grew too rapidly without addressing a fundamental flaw:  stores that were too big – for selling just doughnuts – and cost too much to operate.  Some stores were too close together.  The company later began selling doughnuts to supermarkets, cannibalizing franchisees’ sales and flooding the market with product, lessening its cachet.  Franchisees paid high equipment and supply fees.  Ninety percent of sales were doughnuts, a much higher rate than competitors that diversified their offerings.  In other words, the company grew much too rapidly without first proving their franchise model.

On June 29, private equity firm MGL Asset Management Group LLC bid $7.25/share to take the company private.  But the company once traded at almost $50/share.

China and India Follow up – Investment and Economic Ramifications

Thursday, July 10th, 2008

A month ago, I wrote about the emergence of China and India in the world economy.  Their expansive growth, though, results in their being more greatly affected by global economic trends.  As Investor’s Business Daily notes in U.S. Slowdown Shows In Drop of China ETFs, lower consumer confidence and drops in spending among American consumers has hurt Chinese economic growth.  That’s because the U.S. is the largest export market for Chinese goods.

Technical analyst Michael Kahn, in his Barron’s column, What Happened to China and India?, states that both countries are in bear markets.  While the long-term fundamental stories are sound, there’s no technical reason to expect a recovery in the Shanghai “A” share index, the Bombay Sensex index or the iShares FTSE / Xinhua China 25 Index Fund (FXI) anytime soon.  The latter is a popular ETF that mirrors an index of the largest 25 Chinese mainland companies traded on the Hong Kong Stock exchange.  More information is available on the FTSE / Xinhua website.

Sam Walton’s 10 Rules for Success

Thursday, March 6th, 2008

In 1962, Sam Walton founded Wal-Mart. He built it into the largest retail company in the world. He had 10 rules for success….

Rule #1
Commit to your business. Believe in it more than anything else. If you love your work, you’ll be out there every day trying to do the best you can, and pretty soon everybody around will catch the passion from you – like a fever.

Rule #2
Share your profits with all your associates, and treat them as partners. In turn, they will treat you as a partner, and together you will all perform beyond your wildest expectations.

Rule #3
Motivate your partners. Money and ownership aren’t enough. Set high goals, encourage competition and then keep score. Make bets with outrageous payoffs.

Rule #4
Communicate everything you possibly can to your partners. The more they know, the more they’ll understand. The more they understand, the more they’ll care. Once they care, there’s no stopping them. Information is power, and the gain you get from empowering your associates more than offsets the risk of informing your competitors.

Rule #5
Appreciate everything your associates do for the business. Nothing else can quite substitute for a few well-chosen, well-timed, sincere words of praise. They’re absolutely free and worth a fortune.

Rule #6
Celebrate your success and find humour in your failures. Don’t take yourself so seriously. Loosen up and everyone around you will loosen up. Have fun and always show enthusiasm. When all else fails put on a costume and sing a silly song.

Rule #7
Listen to everyone in your company, and figure out ways to get them talking. The folks on the front line – the ones who actually talk to customers – are the only ones who really know what’s going on out there. You’d better find out what they know.

Rule #8
Exceed your customer’s expectations. If you do they’ll come back over and over. Give them what they want – and a little more. Let them know you appreciate them. Make good on all your mistakes, and don’t make excuses – apologize. Stand behind everything you do. ‘Satisfaction guaranteed’ will make all the difference.

Rule #9
Control your expenses better than your competition. This is where you can always find the competitive advantage. You can make a lot of mistakes and still recover if you run an efficient operation. Or you can be brilliant and still go out of business if you’re too inefficient.

Rule #10
Swim upstream. Go the other way. Ignore the conventional wisdom. If everybody is doing it one way, there’s a good chance you can find your niche by going exactly in the opposite direction.

Ask the VC

Thursday, February 14th, 2008

I get asked a loteven by experienced executiveshow much equity they should expect when negotiating to work for private companies. That’s all over the map and really depends on the company, the position, etc., but here’s a blog that tackles that subject and more: Ask the VC. It’s written by Brad Feld and Jason Mendelson, who are with Mobius Venture Capital and The Foundry Group.

This blog is worth checking out if you’re a small company planning to seek venture investment or even an entrepreneur trying to build a better private company. I like blogs with a lot of meat and little fat…and this is one of them.

Here’s one of those odd little twists that happen in life. Brad was the CTO of a company called AmeriData Technologies that was later acquired by General Electric. When I practiced law, I represented a venture firm that invested in AmeriData. I met the two founders of that company, but don’t recall meeting Brad.

An Overview of Credit Basics

Thursday, January 17th, 2008

Many people have little understanding of the fundamentals of using credit, even those who have good credit. If a basic finance course was mandatory in high school, American consumers would save billions of dollars by better managing their credit. That course is not mandatory, but I have written an article that will appear in First Time Homebuyer Magazine. Entitled An Overview of Credit Basics, it answers the following questions:

  • What is a credit report and how does it affect your loan?
  • What are credit scores?
  • How does ordering a credit report affect my score?
  • How can I establish credit?
  • How can I maintain my good credit?
  • How can I repair or improve my credit?
  • How can I correct errors in my credit report?