From Time to Time, Banks Produce Worthy Pieces of Research.

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Last month was the case of Credit Suisse that perfectly predicted the current shortage of liquidity that forced three massive interventions of the FED in the last three days.

The Treasury will issue over $800 billion in net new debt and increase its cash balances at the Fed by $200 billion by the end of the year. The augmented supply pushes funding under stress.

Supply came at a very bad time, while companies are cashing in for their tax payments.

Dealer inventories are at a record. Given the curve inversion, supply is having a big impact on the front-end of the curve.

The Fed appears to sense these mounting pressures and that’s why is no longer tapering.

But cutting taper short by about $60 billion is a drop compared to $800 billion – a nice gesture, but not a solution. Solutions like asset purchases (“mini-QEs”) or a standing repo facility are unlikely to be ready any time soon as they take time to design, test and communicate – and fiscal dominance starts “tomorrow”. That’s why O/N repos are under stress.

Absent a technical bazooka, stresses will leave one option left: more rate cuts. Cuts that are aggressive enough to re-steepen the Treasury curve such that dealer inventories can clear and inventories don’t drive funding market stresses.

We never had this much Treasury supply during a curve inversion on top of record inventories with leverage constraints. The Fed has her hands tied up.

More aggressive cuts are an easier “sell” politically and optically than outright asset purchases in an environment of record Treasury issuance. Nevertheless, the FED is divided: the last cut came with only 7 members in favour out of 10.

Dealer inventories are the actual problem. Banks funding dealer inventories is the private solution, but that private solution has a huge limit: intraday liquidity.

The public solution for that is the Fed’s balance sheet. Let’s expand it again adding a permanent repo facility. But it is not so easy to set it up, and here we are.

Rate cuts must be aggressive enough to re-steepen the curve so that dealer inventories can clear .

Cuts must be deep enough that would incentivize real-money investors to lend long, not short and that would enable carry traders to borrow short and lend long again.

How many cuts are needed to keep funding stresses at bay?

Certainly more than the last shy move that left all these problems still on the table.

The plumbing are no longer able to let the enormous volume of water pass. But it seems that nobody cares about the plumbing: not the Treasury that has inundated the market with paper neither the FED.

The flattening of the last two days is a message from the plumber: I need more!

The curious case of WeWork

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WeWork represents the tip of the iceberg of a severe dichotomy between private and public markets. In a sort of reedition of “Barbarians at the Gates”, big houses, like Softbank, pushed by large sovereign and pension funds, are running an opaque business that melts down when it reaches the new ultra-transparent reality of the public markets.
The IPOs of Uber, Lyft, Snapchat and the coming quotations of AirBnB and WeWork are no longer exceptions, but they are becoming a worrying rule in the market.
Never before we have seen companies that rushed toward an IPO with bigger pre-IPO losses than WeWork and Uber.
The old age of private equity was full of fulgid examples of organic growth, pre and post IPOs. Companies went public presenting realistic scenarios of growth and, many times, innovative processes able to set high entry barriers, essential to justify valuations and guidance.
Unicorns are changing the paradigm. Uber and Lyft shares have plunged 29% and 48% from their respective peaks since their IPOs and the new approach of earlier investors and CEOs is today to actually rip off shareholders with obscene pre-IPO deals on preferential liquidity.

But the WeWork case goes beyond anything we saw before, like RBR Nabisco did in the ‘80s.
As private company, WeWork was “valued” at $47 billion. No financial statements are available but this sort of magic comes out from closed-door negotiations whose purpose can only be to beef up expectations.
Recently, the IPO valuation had fallen to as low as $10 billion.
In its SEC-filing, WeWork shows a company that made 1.8 bio in revenues in 2018 and had 1.9 bio of net losses. Revenues doubled between 2017 and 2018 but so did expenses as well.
Both WeWork and Uber have a lot in common, in terms of losses and cash-burn business models. In addition, gargantuan stock-based compensation costs and low entry-barriers.

Where does WeWork spend so much money?

Fixing up office properties. Office properties: the most cyclical commodity in the world.

In its filing WeWork writes:
“We have a history of losses and, especially if we continue to grow at an accelerated rate, we may be unable to achieve profitability at a company level (as determined in accordance with GAAP) for the foreseeable future.”


To create excitement, they actually wrote in the report that they expect revenue opportunities of $3 trillion. Literally. In other words, France’s GDP. How they came up with that number tells you a lot about their sickness. They have WeWork facilities in 111 cities and they plan to open offices in other 169 cities. They estimate a potential member population of approximately 255 million people. They multiply that number by the average revenue per WeWork membership and you’ve got $1.6 trillion.
With a bit of hocus-pocus, referred to the average occupancy cost of an employee they reach $3.0 trillion in revenues. What is produced in France in one year.
Apparently, they also plan to inundate members with adverts to increase revenues.
Yet, we have very little information, or none, about its financials. Good for us that in April 2018 they issued a note due in May 2025 that now trades at 91.25 cents on the dollar. To get a meager B+ from S&P they had to publish their stunning figures on net losses.
These losses of nearly $2 billion in 2018 are operating losses, and not investments in new office projects. After the company leases office space and decks it out, it takes up to 18 months to fill the space, and during that time, the space produces lots of expenses but revenues start out at zero and grow only gradually until the space is filled. That’s what they call: the price of expansion.

But then there is a lot of churn, as “members” might not need that desk for all that long, and WeWork has to work furiously to find new “members” to rent those desks, and that involves a lot of expenses as well.

Ok. They burn tons of money. What about the investors?

Its biggest investor is Japanese conglomerate Softbank. In January, Softbank agreed to a $2 billion deal of which only $1 billion was new funding. But that was down from an initially hyped $16 billion deal with $6 billion in new funding. Previously, WeWork had signed $4 billion in deals with Softbank, a $1 billion convertible note and a $3 billion warrant.

But WeWork is just one example.

Lyft lost shy of 1 billion in 2018, Uber loses about $800 million a quarter.
Slack share price is in freefall, while the company lost $360 million in a single quarter, from $32 million last year. Snapchat also is in the billion club in terms of yearly losses.
Only Pinterest, for the time being, seems to be an exception to the new burning-money rule. Operating losses are contained (once IPO expenses are netted out).

And from the land of Private Equity, that’s it folks… for now.

Why the Tearing System Introduced by the ECB Is so Important

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Graph 1: Annual Cost on Banks’ Excess Reserves Held at the ECB

Graph 1: Annual Cost on Banks’ Excess Reserves Held at the ECB

On September 12,  the ECB decided a 10 basis point rate cut to -0.5%. But even more importantly, they introduced a tiering system, where the exempt tier will be remunerated at 0% and applies to the minimum reserve times six. Both the multiplier and the interest rate can be changed over time. This is a massive relief for the banking sector.

Currently, the European banking system keeps 178 bio in reserves with the central bank. Although the central bank moved down the interest rate on deposits from -0.4% to 0.5%, the reality is that it allows banks to keep money at 0% up to six times the minimum reserve. It means that the European banking system may move between 300 and 500 bio into 0% yielding deposits, moving the money away from negative-yielding securities. Think of it: the new QE is only 20 bio per month (expected 30 bio) and the banks will be incentivized to sell core-European assets: Germany, France and Dutch Treasuries (See Graph 1).

It comes with no surprise that the Governor of the Bank of France joined Weidmann and Knot in opposing this decision. The Governing Council of the ECB seems to be more divided than ever.  However, Draghi said during the Conference Call that there was consensus and no vote. A common procedure for the ECB, when most of the Governors are united. But half of the economy of the Eurozone was apparently against it (See Graph 2).

A divided Council combined with the expected selling pressure on Govies had significant impacts on financial assets: Government yields went up, EUR was stronger, equity mixed and Financials positive in Spain, Portugal and Italy.

Graph 2: Governors from the Heartland of the Euro Opposed the Resumption of QE

Graph 2: Governors from the Heartland of the Euro Opposed the Resumption of QE

Regarding the Tearing System:

The Bank of Japan applies a tiering system since January 2016.

The Japanese version of pain relief involves breaking up banks’ deposits into three tiers — one with a positive rate, one at zero and one that is negative.

In Switzerland, the Swiss National Bank is using negative rates to prevent an appreciation of the Swiss Franc. It operates a two-level system, with amounts equal to 20 times a bank’s minimum reserves exempt from any charge. Above that level, an annualized rate of 0.75% is levied on the deposits held at the central bank.
The new European QE is just a placebo, it has very little substance. In reality, the banking system will do much less to support Government bonds. All in all, a zero-sum game.