Post QE – The Fed and the Banks

I thought this article by Bloomberg provided a clear and simplified explanation why the Fed or the central bank in US is in a deadlock and unable to adjust the US economy easily.

1. During the period of Quantitative Easing to stimulate the economy, the Fed bought back US Treasuries/Government Bonds (The US Government sold it to the banks when issuing it) and mortgage back securities(MBS) from the Banks.
2. The Fed pays the banks in the form of credits from the Reserves.
3. This cause the banks to have “excess reserves”. When the Fed tries to implement a contractionary monetary policy by selling US Treasuries, the banks do not have problems buying new US Treasuries without borrowing more money. They can use the excess reserves to pay for it.
4. Thus, the regular monetary policy of the Fed to sell Treasuries and reduce money flow in the economy is not working.
5. The banks can continue to hold the “excess reserves” because the Fed pays interest to the banks. It would only be profitable if they can lend out the money at a higher interest rate than the “excess reserves” interest rate.
6. On the other hand, the Fed is also getting interest from all the treasuries and MBS it bought from the banks. But all these interest it gets are going back to the banks for holding the “excess reserves”. The interest could have help to reduce the yearly deficits in the reserves.

The gist of it is…. the Fed is in quite a deadlock on how to reduce these excess reserves and the cost of paying the banks. What would be the right rate of treasury issuance to ensure that it will not be too “massive and disruptive to the economy”?


Fixed Income

Fixed Income Debt

Looking beyond the IPO stage, as the company is listed, a more sophisticated capital raising takes place. There are various instruments that are created beyond a pure loan from banks – bonds. Bonds have evolved beyond a plain vanilla and straight instrument of a regular interval payment and principal payback at maturity. Structurers in investment banks have been creatively structuring new instruments that serves different risk appetites and ways to value a debt instrument. As the demand for capital grow by corporates, the debt instruments issued have to be attractive as well and makes sense for the issuer and the bond holders. Reasons could pertain towards cost of financing instruments and attract enough demand from investors.

Some of the common structures include:

  1. Foreign currency bonds typically called Eurobonds, are issued by corporates to finance projects in the foreign currencies. Depending on the currencies, the bonds have been named such as Samurai Bonds (JPY), Kangaroo Bonds (AUD), Dim Sum Bonds (CNY), etc.
  2. Convertible bonds are issued with an option to convert debt to equity when it hits a price cap. Thus, having this option typically lowers the cost of financing the debt as investors are buying the value of converting to stocks when the company is valued well on the stock market.
  3. Floating rate bonds are typically issued by corporates because they deemed that it would have a lower cost of financing if they deemed that interest rates will fall over time. The buy side investors will have to weigh out the interest rate environment in its decision to have an “axe” on these bonds.

US Treasuries are instruments used by the US government. There are different uses of these instruments depending on the economic policy. It can be used to fund government projects such as infrastructure development and military operations or as a monetary policy instrument. Most recently in the 2008 financial crisis, the term quantitative easing has been mentioned a lot. This is a practice of debt issuance by the government and immediate buy back by the government from an open market. In the case of US, the US Treasury issued the debt through the auction market that the primary dealers purchase and were bought back from the open market by the Federal Reserves to hold the US Treasuries. The primary dealers funds their purchase through deposits issued by the bank. The sellers to the FED are typically the Primary Dealers with spare inventories and secondary market owners such as hedge funds, mutual funds and other investment firms.  Through these action, the government wants to create a multiplier effect as the primary dealers would have higher capital at a lower cost to issue out more loans as a broker. (“On-the-run” treasuries are typically the most recently issued and most liquid bonds. They are the most actively traded on the market. The treasury actives curve, I25, is the benchmark to how corporate bonds are priced and valued against.)

Similar to the launch of an IPO, the investment banks also have to underwrite and service the issuer to sell these bonds. Roadshows will be conducted to gather interest in buying these bonds. One of the key players to valuing the bonds are the rating agencies. Rating of the companies and subsequently the bonds will determine the credit quality of these bonds. This is essential for bonds to be band under “Investment Grade” or “Junk”. “Junk” bonds will typically be deemed as high risk and high chances of default in coupon payment and principal at maturity. Because of the poorer financials of the company, the cost of issuing debt is also higher. Junk bonds are usually issued with higher coupon to ensure it is competitive and more attractive than Investment Grade bonds.

On a daily basis, the sell side bond salesman sends out “runs” to their clients on the buy side. “Runs” includes the daily inventory and price that the bond salesman has on his list. These prices are important especially for bonds that are illiquid and do not have active prices on electronic. The buy side players who received these runs would typically communicate over email, an instant messaging chat or phone to make the purchase. Once a price is struck, a buy or sell ticket can be sent from either party to confirm the deal. For the more liquid and actively traded bonds, the sell side banks could price them electronically to ensure efficiency and speed. Another mechanism is the Request for Quote (RFQ) process where the buyside player can request quotes from multiple dealers. Given the scrutinies from the 2008 financial crisis, regulators are pushing towards an RFQ process to ensure that the buy side players have transparency in trading at the best price.

The financial market is undergoing changes every time and more so in the post-2008 financial crisis. Dodd-Frank, Volcker Rule and the Basel III are names of new regulations that are in the midst of implementation and changing the way how the securities are being traded and valued. The cost of issuing and trading bonds have increase with changes in capital requirements and regulatory reporting is required. In addition to this, the state of the leading economies have shaken since the global oil glut and restructuring of China’s economy. The environment is not the best for corporates to issue new debt for many reasons relating to cost and self-sustainability.

(Obviously, this is brief and the complexity of the products and relationships of the players is huge. I’ll recollect my thoughts again and add more information over time. I hope this gives a quick overview of the products and the market.)



IPO and Stocks

IPO and Stocks

Moving past private equity funding, most companies would see the option of taking their company public through IPO to raise a larger amount of capital that is beyond the limit of private equity funding. At such stage, Many startups and founders see this as an opportunity to exit from their companies by putting their shares up.

On the surface, the general media loves to mention that it’s an exit for the founders. They will hype the potential networth of the founders once an IPO take place. However, they typically fail to stress the main reasons why a company is preparing an IPO. It’s fundamental for anyone who wants to participate in investing to know what is the reason the company is requiring these money and how are they planning to allocate their capital. As a rational stock investor, one should shield these noise and identify the true value of a company in comparison with the value overblown by the hype.

When a company plans to launch an IPO, they would have to work with an investment bank to prepare the prospectus for filing an IPO. These investment banks service companies as underwriters and gets a cut when companies goes to IPO. The lead underwriter that prepares the books of the company is also called the “book runner”. The IPO is a huge process requiring the underwriter to prepare the books and ensure that they are attractive for investment. The accounting firms have to ensure that the books are audited. The lawyers have to ensure that the legal terms to selling the stocks are acceptable. In addition to these, the executives of the company launching the IPO will work with the investment banks to participate in a road show to draw interest in their IPO. The key is to ensure that there are strong interest from the buy side in acquisition of the stocks that the company is releasing. The company have to “sell” their vision why an IPO has to take place and how can the value of these stock will grow with this new capital.

Listing company’s stock onto the exchange is one of the key mechanics of capitalism. It is a stage where companies have to be transparent on their business and operations to raise capital from the public. Companies can choose to sell more stocks after listing or raise capital through other forms of debt instruments such as loans and bonds.