shsawant379@gmail.com

The post below is a collective view of 5 posts that I wrote on Linked In during my motor biking adventure in Arunachal Pradesh, India in early April 2026. It gives an aggregated picture of the scale of the 5 Hyperscalers.

Post 1 of a 5 part series. INTRODUCTION.

Some rituals deserve to be repeated!

Same time last year, my buddies and I rode Royal Enfield Meteors and Himalayans past glaciers and under vast skies in picturesque Ladakh. This year the road leads us to breathtaking Tawang in Arunachal Pradesh, among snow-capped peaks and alpine lakes.

And just as the mountains have their seasons, so do Markets! Same time last year, markets were rocked by Liberation Day events. This time, it is the slow-burning tensions in the Middle East.

My riding philosophy doubles as my investing mantra – Keep Calm and Carry On!

Over the next 7 days, I will post 4 articles and one best photograph from the road.

What will I write about?

Over the past decade and a half, US equity markets have turned increasingly concentrated in a handful of stocks. Different acronyms have been the flavour of the season at different times – FANG, FAANG and Mag 7.

Today, Nvidia may be the dazzling protagonist of the greatest equity markets story of our time. But the heart of the matter — the engine, the infrastructure, the nervous system — belongs to five hyperscalers: Oracle, Microsoft, Alphabet, Meta and Amazon. The OMAMA.

Over the next 4 articles, I will summarize the aggregate mind numbing scale of OMAMA and well as summarize some simple key takeaways and points to watch out.

Five Companies. One Planet. Too Big to Fail?

Stay Tuned. And Vroom….

Post 2 of a 5 part series. AGGREGATE REVENUES OF OMAMA.

FY 2025 combined Total Revenue of OMAMA = $1.66Tn

At $1.66 trillion, OMAMA’s combined revenues exceed the GDP of all but 15 countries on earth — in other words, this single group of five companies out-earns the entire economy of over 180 nations.

The market expects an average revenue growth rate of 15% over the next 2 years i.e. Revenues of $1.9Tn and $2.2 Tn in 2026 and 2027. The $540 billion in incremental revenue that OMAMA is expected to add over the next two years is larger than the entire GDP of Singapore or Thailand or Bangladesh.

The key component to understand is that out of the $1.66Tn, roughly $350Bn is Cloud related revenue – which basically needs to grow at 25%-40% rates in the short to medium term.

This massive growth in Total Revenues is fundamentally a bet that AI will structurally increase global demand for compute, software, and advertising efficiency, with hyperscalers capturing that through both infrastructure and application-layer monetization.

It is key to understand the AI related revenue drivers for each of the 5 hyperscalers.

– Microsoft’s growth depends both on monetizing AI at the application layer (Copilot and enterprise software) and on capturing the increase in global compute demand through Azure.

– Alphabet’s growth depends on using AI to defend and enhance its core advertising and search economics, while also capturing increase in global compute through Google Cloud.

– Amazon’s growth depends on capturing increasing global compute demand through AWS, while embedding AI across its commerce and logistics ecosystem to drive efficiency and incremental monetization.

– Meta Platforms’ growth depends on using AI to increase user engagement and advertising yield across its platforms, thereby expanding revenue per user.

– Oracle Corporation’s growth depends on serving concentrated, large-scale AI and cloud workloads through its infrastructure offerings, while leveraging its enterprise database and applications footprint to anchor demand, with a more capacity-driven model that is highly sensitive to utilization and customer concentration.

In the next post, we will look at the aggregate mountain of Debt in OMAMA.

Photo Info – Sela Pass. 13,700 Ft. Tawang’s lifeline connecting it to the rest of India. Renowned for its stunning snow-covered scenery and the frozen Sela Lake (in the background)

Post 3 of a 5 part series. AGGREGATE DEBT OF OMAMA.

Across OMAMA, headline leverage metrics remain superficially benign despite a meaningful step-up in capital expenditures.

Total Debt has more than doubled at these 5 hyperscalers – from ~$200bn in 2023 to ~$300bn in 2025 and ~$420bn in early 2026! That is roughly equal to the entire GDP of South Africa – a country of more than 60 mn people!

Measured against operating cash flow, which has grown from ~$360bn to ~$580bn over the same period, leverage appears modest at ~0.5-0.6x Debt-to-Operating cash flow. On the surface, this suggests ample debt servicing capacity and balance sheet resilience. However, this framing understates the true economic burden.

First, Operating cash flow is not Free cash flow. A substantial portion of OCF must be reinvested into capex to support AI-driven infrastructure buildouts, at least in the next 2-3 years.

Share buybacks and dividends further constrain financial flexibility. (It would be a negative signal if these companies slashed dividends or share buybacks). As a result, the cash truly available for servicing incremental debt is materially lower.

Second, and more importantly, traditional on-balance sheet debt only captures part of the financing picture. Hyperscalers are increasingly funding capacity expansion through long-duration lease commitments—particularly build-to-suit data center arrangements—which function as debt-like obligations but are either underrepresented or entirely absent from current balance sheets.

These lease commitments: Require fixed, multi-year payments, Are often contracted well ahead of asset delivery, Will progressively convert into recognized liabilities over time

Taken together, this creates a growing pool of “forward-deployed leverage”—obligations that are economically real but only partially reflected in reported debt metrics today.

Oracle is the standout risk in the group. With $135Bn of total debt and expected FY 26 Operating cash flow of $28Bn, it is heavily dependent on rapid growth in revenues which in turn is dependent on Open AI’s fortunes.

Interestingly, this is still not the complete picture. In the next post, I will elaborate more on these Leases! Specifically, what you see on the balance sheet in the form of Leases is the tip of the iceberg, with a major amount below the surface of the sea!

Photo Info : Tawang, Arunachal Pradesh. 10,000 Ft. 0 Deg. Birthplace of a Dalai Lama. Yak Butter – Not just food, its culture. A Giant Buddha statue. Epicenter of the 1962 Sino India War. Strategically important – just like OMAMA!

Post 4 of a 5 part series. AGGREGATE LEASES OF OMAMA.

Lease accounting governs how companies recognize and disclose leases on their financial statements. The most significant recent change came with IFRS 16 (Internationally) and ASC 842 (US), both of which took effect for most companies in 2019, replacing the old IAS 17 and ASC 840 standards respectively. The core change was the elimination of the “operating lease” off-balance-sheet treatment. Under the new rules, lessees must now recognize virtually all leases on the balance sheet as a right-of-use (ROU) asset and a corresponding lease liability, making previously hidden obligations visible to investors. The practical impact was significant: companies in asset-heavy, lease-intensive industries like retail, airlines, and logistics saw their balance sheets inflate considerably, affecting metrics like debt ratios, EBITDA, and return on assets.

Lease liabilities (on the balance sheet) across OMAMA have risen sharply, from ~$69bn in 2023 to ~$165bn in 2024 and ~$212bn in 2025!

This increase should be viewed alongside the concurrent rise in on-balance sheet debt—from ~$200bn in 2023 to ~$420bn in early 2026!

However, even this combined view remains incomplete!

A much larger pipeline of obligations sits off-balance sheet in the form of leases not yet commenced, which have expanded dramatically—from roughly $100bn in 2023 to an estimated ~$680bn by early 2026! This is the number that will eventually reflect on the liabilities side of the Hyperscalers balance sheet, albeit a discounted to present value number.

These represent contracted, long-duration commitments for future capacity that have not yet been capitalized, but will progressively convert into recognized lease liabilities as underlying assets are delivered.

Once again, this dynamic is most pronounced for Oracle Corporation. Oracle’s on-balance sheet debt is already high at $90 Bn (May 2025) and reported lease liabilities are ~$15bn range, but more importantly, its Lease liabilities for leases not commenced as of Feb 2026 have increased to a whopping $261Bn! Relative to Oracle’s current ~$60bn revenue base (or even taking into account $88Bn expected FY 2027 revenue) and materially lower operating cash flow compared to hyperscaler peers, this implies a much higher ratio of forward, fixed commitments to cash-generating capacity, increasing sensitivity to capacity utilization and execution risk!

In the next and final post, we will examine aggregate capex across OMAMA!

Photo Info : Bhutan Gate. Entry to a land that prioritizes Gross National Happiness (GNH) over Gross Domestic Product (GDP) to guide development, focusing on holistic well-being, environmental sustainability, and cultural preservation rather than mere economic output.

Post 5 of a 5 part series. AGGREGATE CAPEX OF OMAMA.

Capital expenditures across OMAMA have accelerated sharply, rising from ~$150bn in 23 to ~$223bn in 24 and ~$375bn in 25, with projections pointing to a step-up to ~$640bn in 2026.

Until now, this expansion has remained broadly supported by operating cash flow, which increased from ~$360bn in 23 to ~$470bn in 24 and ~$580bn in 25. However, the funding dynamics are getting increasingly difficult. At $700Bn of projected 2026 Operating cash flow, projected capex roughly equals operating cash flow, leaving limited internally generated cash to fund other uses.

But these hyperscalers also need to demonstrate consistent dividends and share buybacks. In 2025, OMAMA returned roughly ~$150bn through dividends and share repurchases. For instance – share repurchases are needed simply to offset the massive dilution from monstrous SBC pay packages. With operating cash flow increasingly committed to infrastructure investment, these distributions—and any incremental flexibility—would need to be funded through existing balance sheet cash or additional external financing.

Once again, Oracle remains a standout risk. Expected FY26 Operating cash flow of $28Bn. But it needs to spend over $50Bn each year in Capex over the next 2-3 years. Post the February bond issuance, cash on hand sits at $38Bn and the Company plans to raise equity of another $20Bn. The numbers make $5Bn of historical dividends somewhat unsustainable!

Across these five articles, one thing should be impossible to miss — the scale of OMAMA is not just large. It is system-defining. We are, for the first time, witnessing the emergence of corporations so large, so interconnected, and so deeply embedded in global digital infrastructure that the language of systemic risk — once reserved for banks — is beginning to feel appropriate. Too Big to Fail is no longer just a Wall Street phrase.

It is little surprise, then, that OpenAI’s CFO Sarah Friar had floated the idea of a federal backstop — essentially a government guarantee — for investments in AI chips and data centres. When a private sector executive starts speaking the language of sovereign guarantees, you know the numbers have entered stratosphere.

And beneath all of this lies a question that the market has not yet fully answered: can AI revenues — consumer and enterprise combined — actually grow fast enough to justify what is already being spent? The capex is real. The returns are still, largely, a promise!

Final Picture from the road trip – Investing in current markets be like the photo below….

www.thecreditbalance.com

Due diligence / Financial journalism is an adrenaline rush.

Private credit is the flavour of the day. And Jamie Dimon’s recent comment about cockroaches in the alternative finance space has added fuel to fire.

For the past few months, I have been combing through regulatory filings of private credit lenders to understand the underlying exposures of these lenders. Below is one illustrative story on Blue Owl Capital Corporation. Caveat: There isn’t sufficient evidence to call this a cockroach. This very well might be a truly performing asset. I will let the reader be the judge of that. Moreover, please don’t look for contagion risks in this article. The amounts involved are relatively small. But it is a great example of the depth of financial diligence needed in the investing world.

Blue Owl is one of the largest private credit players in the world. Blue Owl Capital Corporation is a traded BDC, listed on the NYSE under the ticker OBDC. A Business Development Company (BDC) is a type of closed end investment fund that provides financing to middle market companies. 

2018 – Loan Origination

In June 2018, Platinum Equity, via an SPV called Swipe Acquisition Corporation (“Swipe”), acquired PLI Card Marketing Solutions (“PLI”), a provider of gift, loyalty and membership card marketing solutions, including card production, personalization, fulfilment, direct mail and print services.

The acquisition announcement also said – PLI is also the world’s largest manufacturer of hotel keycards and is the exclusive keycard vendor to some of the industry’s largest brands, including Hilton, Marriott and Hyatt. In 2017, the company produced approximately 1.6 billion gift, loyalty and hotel cards across all segments. Financial terms of the acquisition were not disclosed.

Immediately after the acquisition the buyers alleged that the sellers had concealed the loss of a major customer (First Data / Amazon business) that materially reduced revenue. Court filings show that the Buyer initially offered ~$210 million; after due diligence and revisions the purchase price was reduced to $195 million.

The acquisition was funded by a First Lien Senior Secured Term Loan of ~$112mn priced at L+7.5% with an initial maturity date of 29th Jun 2024 and a Delayed Draw Term Loan (possibly with a commitment amount of $13mn) with an initial maturity of 30 Sep 2019.

In Q4 2018, OBDC lent another $50mn to Swipe with the same maturity date of 29th Jun 2024. The interest rate was stepped up to L+7.75%. This loan possibly might have been to fund another acquisition. Platinum equity, as a part of its bolt on strategy, acquired Harvard Card Systems (through PLI), a leader in the card printing and gift card manufacturing industry.

2020 – Loan wite down, restructuring and debt-to-equity swap

The Covid pandemic started gaining steam in 1Q 2020. OBDC wrote down $11.5mn of the Swipe Loan. OBDC then wrote down another $15.7mn in Q2 2020 and a further $29.7mn in Q3 2020. Cumulatively it wrote down ~$57mn of the original ~$160mn exposure. OBDC also disclosed in its Q3 2020 filing that it added Swipe to non-accrual status and was in the final stages of debt restructuring and becoming the controlling shareholder, presumably via a debt to equity swap.

OBDC completed the restructuring and became an majority equity owner (87%) of PLI (and accordingly Swipe) in Q4 2020. In summary, $100mn of the outstanding loans at fair value was converted to $50mn of loans to Swipe and $50mn of equity in PLI. OBDC also offered a new Delayed Draw Term Loan commitment of $18mn to Swipe.

2021 – Maturity extension

By the end of Q4 2021, the DDTL exposure had increased from $2.6mn in Q4 2020 to $10.8mn in Q4 2021. More importantly, the DDTL maturity date was changed from 31 Dec 2021 to 31 Dec 2022. Total exposure stood at $61mn.

2022 – Loan exposure increases, maturity extended and equity investment is written up

By the end of Q4 2022, the DDTL exposure had increased from $10.8mn in Q4 2021 to $14.7mn in Q4 2022. The loan maturity date was once again changed from 31 Dec 2022 to 31 May 2023. Total exposure stood at $64mn. More importantly, OBDC chose to write up its equity investment in PLI from $50mn to $98mn. It is key to note that this unrealized gain in valuation also goes into the Income Statement for the year. In fact, this $50mn write up in OBDC’s equity investment in PLI helped shield OBDC’s earnings for the year from what otherwise would have been an even sharper decline. OBDC EPS decreased to 1.18 per share in 2022 from 1.59 per share in 2021. Excluding the $50mn of PLI equity write up, OBDC EPS would have been $1.06.

2024 – Sharp increase in Loan exposure and maturity extended again

2023 was relatively uneventful for OBDC on its Swipe exposure. However, by the end of Q4 2024 the debt to Swipe ballooned from $62mn in Q4 2023 to $107mn. OBDC provided a new First Lien Senior Secured Term Loan of $36mn with a maturity date of 30 Nov 2027 at an interest cost of S+5.0% (i.e. lower than the previous loans which were at S+8.0%).  

The table below shows the gross exposure, amortized cost and fair value of the Swipe loans recorded in OBDCs books at the end of some key quarters and each year from the initiation of the loan in 2018.

The table below shows the Fair Value of the Swipe exposure (both equity and loan), including write ups and write downs recorded in OBDCs financial accounts at the end of some key quarters and each year from the initiation of the loan in 2018. The table also show interest and dividends earned each year by OBDC.

Summary takeaways

• Given the original acquisition story involved a legal dispute around misrepresentation by the sellers to Platinum Equity, this probably was a botched up deal to begin with. Little surprise that Platinum Equity seems to have handed over the keys to Blue Owl in less than a year since acquisition.

• OBDC’s original loan exposure stood at ~$160mn at the outset in 2018. As of 2024, that exposure stands at ~$200mn. There seems to have been no repayment since the original loan date of June 2018. Moreover, the maturity dates have been extended more than a few times. Given the history, I would be inclined to believe the maturity would be once again extended when we come closer to that date in November 2027!

• Total interest earned in the 5 years from 2020 till 2024 is cumulatively a solid $31mn. Most likely, this is not a PIK instrument. i.e. OBDC probably received cash interest on its loans.  However, over the same 5 years new loans of ~$50mn have been provided further to Swipe. The interest seems to be funded simply from new loans extended by OBDC to Swipe.

• Post the debt restructuring in 2020, $50mn of loans were converted to equity. Over the past 5 years, that equity value has been written up by another $50mn to a current fair value of $100mn. While there might be some rationale behind the write up, it seems hard to fathom an equity write up when the interest on existing loans seems to be funded by new loans from the same lender.

• Once again, just to be adequately clear, I am not suggesting that OBDCs $200mn exposure to PLI in the form of equity and loans is clearly and deeply underwater. There simply isn’t enough data to prove so or otherwise. But there in lies the problem – Opacity. Bank regulations require risk managers to be more prudent on marking loans to market. They provide clear rules around the definitions for non-performing exposures and forebearance. In private credit, we simply cannot ascertain if the “mark-to-model” represents a true, fair and current valuation of the underlying asset!

If you are interested in analysis like the above, you can reach me at info@thecreditbalance.com or shsawant379@gmail.com

Happy Reading and as always Happy Investing !

Not meant to be Investment Advice. Do your own research!

Shashank Sawant

www.thecreditbalance.com

Inflation has been the centre of attention for most of the past 4 years. However, focus is now shifting to the other side of the Fed mandate – Unemployment. Over the past few months, we have had some notable weakening in the employment picture.

• Monthly jobs added has fallen substantially with the latest NFP August figure coming in at a mere 22K jobs

• Job openings have fallen consistently in 2025

• Continuing unemployment claims have risen especially sharply in recent months, an indication of the difficulty of finding full time employment after losing current jobs

Jobs data tends to be confusing. I wrote about it here. Firstly, the initial numbers that the market receives is based on surveys conducted by the Bureau of Labor Statistics. Response rates to these surveys have collapsed since the start of the pandemic posing and valid question about the accuracy of the data. Second, the data gets revised multiple times during the year in line with various processes of the BLS. Lastly, with the Trump administration’s firing of the BLS Commissioner, politicization of the BLS casts a further shadow on the reliability of this key data.

I have previously written about the jobs methodology

Understanding the Non-Farm Payroll Data

Understanding the Non Farm Payroll Data (Part 2)

Given the importance of this single data point, understanding the jobs data and its revision methodologies is imperative.

The monthly jobs data (NFP), that we are all familiar with, is benchmarked to comprehensive counts of employment in March every year. These comprehensive counts are derived from State unemployment insurance tax records that nearly all employers are required to file and hence this data is more accurate (“QCEW” data).

Since the benchmarking exercise results are released only a year later (i.e. we will receive updated benchmarked figures for March 2025 only in March 2026), the BLS also provides a preliminary benchmark estimate in August / September. On Tuesday 9^th Sep 2025, the BLS published its preliminary benchmark revision for March 2025. Market participants were keenly awaiting this release, especially in light of recent weak jobs numbers. The preliminary benchmark estimate showed job creation in the 12 months through March 2025 was overstated by 900K! While this undoubtedly is a large revision, it is prudent to step back and understand a few factors.

Firstly, don’t fall in to fear mongering. We have seen this story play out before.

In August 2024, the BLS’ preliminary benchmark revision estimated that total jobs for the year ended March 2024 might have been lower by 818K. Headlines like the below serve to set the cat amongst the pigeons. Chair Powell also acknowledged then that the FOMC has considered reports that recent jobs numbers may be “artificially high”. When the final benchmarking exercise was published in March 2025, the figure was revised lower to around 580K jobs. Nonetheless, the key point to note was that the Fed had cut rates by 50 basis points in September 2024 on the back of a weakening job market, only for the jobs data to spring back up again and the S&P 500 making new highs.

The QCEW data itself gets revised up to 3 times. Below graph shows the impact of these revisions. The Blue line in the graph below is the impact on jobs from the initial values derived from the QCEW data. And the Orange line shows the impact on jobs from the revised values from the QCEW data. As you can see, the Blue line almost always over estimates the downward impact of the QCEW data. In summary, the preliminary number of 911K will likely be revised to a lower number in March 2026 upon completion of the final benchmarking exercise.

Just like 2024, we have seen this story in 2023 as well. See Bloomberg article below from August 2023.

There is no doubt that the job market has been slowing down. The revisions are the highest since 2009. See chart below.

But we are currently in a no-hire, no-fire economy. Despite slowing job numbers, there is little data as of now to support the case for an oncoming recession trainwreck and inflation still remains high and above the Fed’s target. Goods inflation, in certain categories which are import dependent, has increased recently. Services inflation, which was declining up until December 2024, has flatlined – but at a higher than pre-pandemic level. Lastly, Core Services Ex Housing inflation has picked up pace in the past 4 months.

Inflation expectations, both survey measures and market based metrics are still very elevated. 5 year and 10 year inflation breakevens’ are substantially above where they were a year back.

The economy is undoubtedly weakening. But it is the quantum and pace of the weakening that matters.

Given the jobs vs inflation dynamics, I had mentioned the below strategies in September 2024. I still believe both to remain effective in the immediate short and medium term, with an additional third point below.

• Don’t time the market and sell out of all positions. Staying invested has worked.
• Buying insurance in the form of puts is a costly strategy. Even with the low implied volatility, selling covered calls and strangles has generated better yield and also reduces cost overtime, partially mitigating a downside scenario.
• Long term yields will likely stay higher with increasing fiscal burdens and  higher inflation expectations. Any pull back in long term yields is an opportunity to sell into the rally or actively short long term treasuries

Needless to say, I will be watching and analysing data closely. If you are interested in analysis like the above, you can reach me at info@thecreditbalance.com or shsawant379@gmail.com

Happy Reading and as always Happy Investing !

Not meant to be Investment Advice. Do your own research!

Shashank Sawant

www.thecreditbalance.com

Never say Never!

Such a cliché. But yet so true. One of key reasons finance and markets are so incredibly interesting is that you never know what to expect and which way will markets turn!

We have had a hot CPI yesterday. We just got a hot PPI today. Normally, that would have set the cat amongst the pigeons and Treasuries would have sold off and yields jumped higher. Instead, we are seeing the bond market rallying and yields more than 8 basis points down!

There are 2 points I want to highlight via this short note.

First, yess I agree Tariffs have the potential to be inflationary. So far though, for all the President Trump verbal threats, the only actionable item we have seen is 10% duties on China. The rest has so far transpired to be a negotiating tool. However, admittedly, we cannot speculate on whether new tariffs will see the light of the day or whether they will remain a negotiating tool. But, instead we can make informed bets based on historical episodes and prior data. For instance, see below for a 2019 NBER working paper by Gita Gopinath analysing passthrough of the 2018 US tariffs.

https://www.nber.org/system/files/working_papers/w26396/w26396.pdf

Conclusion: In summary, amongst others, one of the conclusions of the paper was that while there was some passthrough of tariffs to final consumers, retail margins also fell since Retailers absorbed some of the cost increases due to the tariffs. Needless to say, no two periods are alike and we might see a greater inflationary impact of tariffs this time around. But then again, there wasn’t a DOGE then which was slashing US government expenditure either!

Second, lets look at Shelter inflation again. Shelter inflation rose 0.4% in January, the same as the previous month. The Index for Owners Equivalent Rent increased 0.3% in January, once again the same as the previous month. While there was no improvement in the monthly figures for these 2 critical components, they did not significantly deteriorate either. There seems a good chance that we will get a resumption in the downward trajectory of these CPI components in the coming months.

Why do I believe so?

The BLS recently introduced a New Tenant Rent Index series. This new Index measures the price renters would face if they changed housing units every period. The shelter component of the CPI measures the change in all rents, including new leases, renewals and rents in the middle of a lease. That makes the New Tenant Rent Index a better indicator of current rental prices. The latest release showed the New Tenant Index was 2.4% lower over the year and 5% from the prior quarter! The picture below speaks a thousand words!

Undoubtedly, the lag between current rental price inflation and the CPI has been longer than anyone expected. However, those relationships have now started to reflect in Core CPI measures!

Bonds have a place in everyone’s portfolio. Now is as good a time as any!

If you are interested in analysis like the above, you can reach me at info@thecreditbalance.com or shsawant379@gmail.com

Happy Reading and as always Happy Investing !

Not meant to be Investment Advice. Do your own research!

Shashank Sawant

www.thecreditbalance.com

Inflation has been the centre of attention for most of the past 3 years. However, the focus is now shifting to the other side of the Fed mandate – Unemployment

The Fed has cut by 50 bps. And, similar to the recent past, market participants are evenly divided between whether this is a bearish signal or the reignition of the risk assets rocket.

Jobs data tends to be confusing. I wrote about it here https://thecreditbalance.com/understanding-the-non-farm-payroll-data/.

Given the importance of this single data point, understanding the jobs data and its revision methodologies is imperative.

The monthly jobs data (NFP), that we are all familiar with, is benchmarked to comprehensive counts of employment in March every year. These comprehensive counts are derived from State unemployment insurance tax records that nearly all employers are required to file and hence this data is more accurate (“QCEW” data).

One of the most important developments in August 2024 was the BLS announcement of its preliminary estimate of the annual benchmark revision. Simply put, the BLS said that total jobs for the year ended March 2024 might have been lower by 818K. Headlines like the below serve to set the cat amongst the pigeons.

Chair Powell also acknowledged that the FOMC has considered reports that recent jobs numbers may be “artificially high”.

But are we reading too much into this data point?

Firstly, even with the benchmark exercise, 2.1mn total jobs were created in the year ended March 2023 (instead of 2.9mn). That, by itself, is a sizeable number – translates to 175K jobs each month. The level of job creation is still higher compared to pre-pandemic levels.  

Second, no one seems to be noting the fact that the QCEW data itself gets revised up to 3 times. Below graph shows the impact of these revisions. The Blue line is the impact on jobs from the initial values derived from the QCEW data. And the Orange line shows the impact on jobs from the revised values from the QCEW data. As you can see, the Blue line almost always over estimates the downward impact of the QCEW data. In summary, subsequent revisions to QCEW might show that the loss of 818K jobs is actually a lower number!

Just to refresh memory, we have heard this story before (exactly a year back). See Bloomberg article below from August 2023.

Outside of slowing job numbers, there is little data as of now to support the case for an oncoming recession trainwreck.

Oil is ~10% up in the past 2 weeks.

5 year and 10 year inflation breakevens’ are up ~10% in the past 2 weeks.

Inflation is undoubtedly lower compared to 2022. But it is not at the 2% level yet. Shelter inflation is still running at about 5%. And most importantly, Core Service ex-housing has mostly been flat on a y-o-y basis for the 12-15 months.

The economy is undoubtedly weakening. But it is the quantum and pace of the weakening that matters.

Given the above, from an investing standpoint, a few strategies have helped in 2024.

• Don’t time the market and sell out of all positions. Staying invested has worked.
• Buying insurance in the form of puts is a costly strategy. Even with the low implied volatility, selling covered calls and strangles has generated better yield and also reduces cost overtime, partially mitigating a downside scenario.

Needless to say, I will be watching and analysing data closely. If you are interested in analysis like the above, you can reach me at info@thecreditbalance.com or shsawant379@gmail.com

Happy Reading and as always Happy Investing !

Not meant to be Investment Advice. Do your own research!

Shashank Sawant

www.thecreditbalance.com

Time to take a break from Macro and write something different. Every year I take a weeklong trip with my teenage daughter doing something different. Last year we hiked a summit in the Himalayas. This year we walked the beautiful hills of Kodaikanal in the southern Indian state of Tamil Nadu.

I used my spare time to read a book – Money Games by Weijian Shan. And it was worth every minute! The book is a detailed account of Newbridge Capital’s acquisition of Korea First Bank post the 1997 Asian Financial Crisis. Below is a simple summary. The note is structured as a Table – One row as Key Learning (in the grey box) and the next row as the corresponding anecdote in the context of the book and the actual transaction (in the white box).

Since time eternity, the core reason of financial / banking crisis has been the same. Excessive leverage, perverse incentives and unsound credit decisions.

During the rapid industrialization of the sixties and seventies, the Korean government chose “winner” industries and companies to bestow favours on (the Chaebols). Banks lent unbridled to these companies with the assumption that the government will come to the rescue of these strategically important companies if they get into trouble. The Asian Financial Crisis put this assumption to the test.  

External borrowings are always a double edged sword. Used wisely, lower interest rates and tapping overseas savings when domestic savings are insufficient, result in accelerated economic growth rates. Used excessively and unwisely, the short term nature of some of these debt flows can cause instability and result in an accelerated economic downdrift due to the pro-cyclical nature of these debt flows.

The World Bank has pointed out that if Korea had relied only on domestic savings, its economic growth rate which was 8.2% between 1962 and 1982, would have been only 4.9%. At the end of 1997, as foreign creditors pulled back on lending, Korea experienced a severe liquidity crisis.  

Capital is hard to raise! But it is always available for the really good deals.

Prior to this transaction, Newbridge’s first fund had raised $100mn in capital. Newbridge Fund II ($400mn) was in the process of being raised. Yet, at the first meeting with the Korean bank regulator (which was effectively the Seller), the author felt confident enough to state “Capital is no constraint for us” when asked if they had the financial wherewithal to consummate a transaction as large as KFB.  

In Mergers and & Acquisitions price is undoubtedly a critical factor, but often times the transaction boils down to considerations far greater than the price of the target asset.

In the immediate aftermath of the 1997 crisis, the Korean government had already poured 1.5 Tn Won into the 2 troubled banks, Korea First Bank and Seoul Bank and was expected to inject much more as more loans soured. Tax payers money was obviously at stake. The Newbridge proposal gave the Korean government 49% economic ownership and hence potential upside once the crisis has passed and the bank turns around. The deal structure gave the Korean government the opportunity to partake in an upside scenario and hence help sell this deal to the general public.  

“Signalling” is a very powerful construct in finance. Often times “signalling” can have the desired effect without actually having to transact to achieve the same objective. For example, if the RBA states that it will hold its 3 year bond yield at 0.25%, it might not even have to transact much in the open market to hold that level. Speculators might be put off just by the “signalling” effect.

Newbridge signed an initial MoU with the Korean government to purchase KFB in December 1998. On January 1, 1999 S&P revised its outlook on Korea to “positive” and indicated a possible upgrade of its credit rating. Amongst the reasons it cited was the KFB MoU. S&P even cited the MoU as an indicator of the government’s willingness to undertake structural reforms. In a similar example, the author states that international reaction and the stock market’s reaction to Newbridge signing a binding Terms of Investment on KFB was positive. Korea Exchange Bank went up 12% on the first day post announcement and bank stocks in general were up 3%.    

Transactions involving the bureaucracy will inevitably be games of patience. The key is to understand underlying motivations of behaviour.

A large portion of the book is a detailed description of the negotiation process with the Korean bank regulator which had been entrusted the task of selling the 2 erstwhile jewels of the country – KFB and Seoul Bank. Selling the banks was necessary, not only because it was required as a part of the IMF bailout, but also because bringing in new foreign investors would revitalize the strategy and operations of the bank and reform some of the old banking and accounting practices that, to some extent, had led to the crisis in the first place. At the same time, situations like these are politically volatile and ultimately the government and government officials are answerable to the public.  

Marking loans to market involves a ton of subjectivity. As a result, it is hard to gauge the quality of a bank’s loan book by just looking at its financial statements and notes to accounts. (Needless to say, the reforms to banking regulations in the past 25 years have significantly whittled down this subjectivity)

Prior to the 1997 crisis, Korean accounting practices were rather loose on the criteria to mark loans to their market value. As long as the borrowers paid their interest obligations, the loans would be classified as normal – irrespective of the capability of the borrower to meet future payment obligations. During the transaction negotiations, the Korean regulators insisted on applying this outdated accounting practice. Even though they also had an eye on overall reforms to move to forward looking accounting practices more in line with international standards.  

Loan syndication is a very attractive business for banks. In the ideal scenario, a bank can underwrite a risky but well-structured deal and sell down its exposure to zero. And in the process, earn significant fees and some interest on the exposure held prior to selling the loan to other investors. However, banking history is littered with examples of syndications gone wrong for a variety of reasons.

In November 2000, Citibank underwrote an 800 Bn Won loan to Hynix. KFB joined the syndicate for 100 Bn Won, even though it was full up on the Single Borrower Limit to Hynix. The semi-conductor market collapsed in 2001 and the price of DRAM chips fell 90% in 2001. KFB was left stuck with its Hynix exposures and ultimately took $200mn in losses, almost wiping out the previous year’s profit. The CEO accepted responsibility and resigned.  

In most situations, full disclosure and transparency is always viewed positively by investors. This is becoming increasingly relevant in private equity as investor participation is broadening and even the retail investor is getting more closely involved in this asset class.  

As a non-public company KFB would not have to publish its annual reports. However, at the request of the Korean regulatory authorities, Newbridge retained KFB’s status as a publicly listed company even though there were no public shareholders and the share were no longer traded. Since the bank had been nationalized using taxpayers’ money, the regulators wanted to ensure full transparency. And most importantly, Newbridge obliged.  

Diversification or minimizing Concentration lies at the heart of almost everything from investor portfolios to bank business strategy. However, it can sometimes be a double edged sword as Goldman has figured recently with its foray into consumer banking or the way Standard Chartered Bank figured with KFB post its acquisition in 2004.  

KFB, prior to 1997, was primarily a corporate bank. That strategy had also resulted in concentrated lending exposures to a few large chaebols. Under Newbridge, KFB pursued an aggressive consumer banking growth strategy to transform KFB into a bank with a balanced exposure. By 2002, Korea was experiencing a boom in consumer credit. The total number of credit cards issued in Korea – that had a population of 38mn over the age of 14 – reached 105mn in 2002 ! Years later, the consumer banking exposures would pose significant challenges for SCB to manage.  

Outbidding competition to buy a company is not reason enough to celebrate. A deal is successful only upon generating actual cash profit – either by a successful exit or organically during ownership.

Newbridge acquired KFB in December 1999 and would finally conclude its sale to SCB in December 2004 – after having successfully transformed the bank, improved risk management practices and having ridden the wave of Korea’s emergence out of the 1997 crisis. Together with the Korean government, Newbridge had invested 1 Tn Won or $900mn in KFB and finally sold it to SCB for 3.4 Tn Won or $3.3Bn.    

Due diligence is the holy grail of any Investing, Lending or M&A transaction and sometimes it is prudent to simply pass on opportunities rather than compromise on the depth of diligence for lack of time or simply because the opportunity is being pursued by many suitors in a bidding war.

Newbridge began active sales conversations for KFB in September 2004, primarily with HSBC – which was the most likely suitor for most of the time up until KFB was sold in December 2004. It was only on November 10^th, 2004 that SCB entered into formal conversations with Newbridge on KFB and before 2 months were over, the transaction had concluded! Did SCB really do adequate diligence on KFB or got simply pressured into buying it because it was fearful of losing it to HSBC? While KFB was a successful deal for Newbridge, it would go on to pose many more challenges for SCB. KFB’s large footprint in retail banking from the aggressive growth strategy pursued during the Newbridge days, its personnel severance liabilities and many such other issues would go on be nightmares for SCB for many years to come.  

And finally, Buy when others are fearful. And wait patiently and bide your time when FOMO is in full swing.

Newbridge undoubtedly made a sweet deal on KFB. However, the key point to note is that it was willing to risk it when most foreign investors were running for the exits. By the end of 1997, Korea was on the verge of default. Money was fleeing the country, forex reserves were down to just $9Bn – 2 weeks worth of outflows, the stock market had plunged 49% and the Korean Won had depreciated 65% against the dollar. In this backdrop, the author provides a statement by David Bonderman, Chairman of TPG in response to the author’s interest in pursuing the KFB deal : “The history of life is that well protected failed bank deals are an excellent way to make money if you can buy them at the bottom of the cycle”.     And, just to tie this back into our current world of financial investments, I wonder if this is the best time to buy risk assets??  

Below is a long term graph of S&P500 Historical LTM Price Earnings Multiple

Money Games by Weijian Shan is a gripping narrative of Newbridge’s acquisition of Korea First Bank in the aftermath of the 1997 Asian Financial Crisis.

It provides an end-to-end narrative from Newbridge’s initial expression of interest to acquire KFB, the incredibly long and frustrating negotiation with the regulatory and government authorities prior to completing the acquisition, the turnaround of the bank and finally its sale to SCB after a bidding war with HSBC.

Happy Reading and as always Happy Investing !

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Last year, Bloomberg launched a new brand campaign. “Context changes everything”. I liked this tag line.

If you are a risk assets investor, you cannot invest without first placing the treasury market into context.

Let’s start with some numbers to contextualize the market we are going to talk about.

World GDP : ~US$96 Tn

Global Equity Market Cap : ~US$109 Tn

Global Bonds Outstanding : ~US$130 Tn

US Total Fixed Income Outstanding : ~US$52 Tn

US Equity Market Capitalization : ~US$50 Tn

And finally….

US Treasuries Outstanding : ~US$26 Tn

The US Treasury market, as we know, forms the basis of pricing literally every single asset in the world.

In the note below, I will talk about 2 key current aspects of the US Treasury and Money Markets. The first concerns demand for long dated US Treasuries and the second is about the state of money market.

Point Number 1 : Demand for Long dated US Treasuries

Coupon auction sizes:

The Auction size for 10 year Treasury notes has been progressively increased from US$32bn in January 2023 to US$42bn in Feb 2024. Similarly, auction size for 30 year Treasury bonds has been increased from US$18bn to US$25bn during the same period.

Key Takeaway: Coupon auction sizes have been steadily increasing to meet the funding requirements stemming from big fiscal deficits..

Coupon Auction Performance:

Generally speaking, auction performance for long dated treasuries has been relatively weak in recent times.

This week the Treasury auctioned US$67bn of 10 year and 30 year bonds. In contrast to recent trends, auction performance on these long dated securities was nothing short of stellar. For instance, Primary dealers had to take up only ~14% of the 10 year note auction, which was comparatively lower than recent auctions. And the tail on the 30 year bond was a sizeable negative 2 basis points !

Key Takeaway: While overall auction performance has been weaker than expected, it’s been far from alarming. And the latest $67bn auctioned this week had quite a stellar outcome…

Throwback to an article I wrote in early 2022 when there were initial rumblings on who would buy all this upcoming treasury issuance deluge.

$3–4.5Tn net Trsy issuance over next 3 yrs! Who will buy this debt?

Point Number 2 : Adequacy of Liquidity in the Financial System

Let’s look at the other end of the market now. Liquidity in money markets.

Rate Hikes Over; Excess Liquidity Soaked :

The consensus expectation is that rates hikes are a thing of the past. Even the Fed believes so. Money market fund managers have been pulling money out from the Reverse Repo and either buying Treasury Bills or investing into the Repo market.

The Reverse Repo balance is seen as a gauge of excess reserves in the financial system and hence indicative of liquidity conditions. The monumental build of $2.5 Tn in the Reverse Repo has come down to $550bn now. This brings the LCLOR or “Lowest Comfortable Level of Reserves” (i.e. minimum amount of Reserves needed for smooth functioning of the US banking system) into sharp focus.

Key Takeaway: The huge build up in the RRP was viewed as excess liquidity in the financial system that was not required. It is down substantially due to rates peaking, quantitative tightening and a deluge of bill issuance. But now no one knows what is the right point at which to stop…

SOFR Spikes, History Repeats?

The best indicator of adequacy of reserves is the cost of short term money in money markets. Below are 3 graphs that show year end SOFR rates. But before we get there – a quick line to provide context. During fiscal year end, Banks, which are both borrowers and lenders in the money market complex, get more conservative to “manage” balance sheet ratios and tend to “conserve cash”. i.e. reduce the amount of lending activity in the repo market.

The first graph is during year end 2021. This was when Quantitative Easing was in full effect and the system was flooded with reserves. With ample reserves, there was no undue spike up in repo rates.

The second is during 2018. This was the time that the Fed was engaging in its first Quantitative Tightening exercise. Note the SOFR spike in December.

The third is the latest during 2023 year end. Quantitative Tightening is in full swing. History is repeating itself?

The sharp spikes in December 2023 in SOFR have not gone unnoticed and the Fed is bound to take due note of these spikes. The reason why the 2018 and 2023 graphs are key is because of what happened subsequently in 2019. Post the “Repo Madness” of September 2019 when repo rates spikes and liquidity dried up, the Fed essentially had to halt its quantitative tightening and inject liquidity back into the system!

Key Takeaway: With the RRP coming down rapidly and rates still high, either a liquidity squeeze event is around the corner or the Fed might halt QT soon. It is also key to note that the Fed seems divided on whether to wait till the RRP comes down all the way to zero or stop QT much before that.

Summary:

The US Treasury market is the centre of our modern financial universe. Any ripples originating from the centre can be felt in faraway corners of the investing pond. Given the dynamics at the short end of the curve, that ripple seems around the corner. On the other hand, the US$ and the US economy still remain the cornerstone of the world. TINA at its best! While there is a ton of valid concern around fiscal largesse, long dated US treasuries will still be the go-to haven when “things” hit the ceiling!

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

It might have flown quietly under the radar, but this was an eventful week in Treasury Markets – marked by the auction results turning out to be a fairly non-event. That’s an Oxymoron for you!

But more than the week, it has been the past 3-month correlation between movements in treasury yields and equity market performance which, for me, has been the star event of the year.  

Lets do a recap. Risk assets or S&P500 (or mostly the Magnificent 7) were doing quite well up until 31^st July. That when the US Treasury announced its refunding plans for Q3 and Q4 of 2023. In simple terms, the Refunding Plans are the mechanism through which the US Treasury tells the market how much it intends to borrow and what format it intends to borrow in (bills vs bonds).

I had written about this in early August highlighting the substantial increase in marketable borrowing plans of the US Treasury as well as the increase in coupon auction sizes. Link here (or go to the Posts section on my Linked in Profile): https://www.linkedin.com/posts/shashank-sawant-459a06_home-activity-7092916022877306880-uzwH?utm_source=share&utm_medium=member_desktop

In immediate response to the treasury refunding announcement, long bond yields rose higher and the S&P500 experienced an equally swift fall.

The US Treasury announced its latest borrowing plans on October 30^th and November 1^st.

It surprised markets by announcing a lesser than expected borrowing quantum for Q4 2023 and also increased coupon auction sizes by lesser than expected. The marketable treasuries borrowing estimate for the 4^th quarter of 2023 was revised down from US$852bn to US$776bn. And coupon auction sizes for auctions in the months of November 2023 through January 2024 were also lower than expected. Specifically, auction sizes for the 3 year, 10 year and 30 year bonds to be auctioned in the month of November were lower than expected by US$2bn.

Once again in immediate response long bond yields fell sharply and the S&P500 experienced an equally swift rise back up again.

Given this backdrop, the key event to watch out for in the week of 6^th November was the performance of the 3 year, 10 year and 30 year treasury auctions. And thankfully, it turned out to be relatively non-eventful. Auction performance across the 3 year and the 10 year was relatively benign, while the 30 year auctions results were quite disappointing last night. The weak auction, coupled with a hawkish speech from Jerome Powell which suggested that the Fed may not be done hiking, sent bond yields higher again and risk assets lower.

The table below summarizes the auctions results this week.

*The comparison and colour grading is against an average figure of the last 6 auctions in that tenor.

In general, demand at the longer end is likely to continue to be tepid. That will cause a lot of volatility especially in the 20 and 30 year tenors (Opportunity or Risk for the TLT ETF enthusiasts!!).

What should I watch out for next?

The next event to watch out for is the October US CPI release on Nov 14, 2023. The first point to note is that the base effect is favourable in October 2023. M-o-M CPI had increased 0.5% in October 2022.

Secondly, given this base effect and the recent drop in energy prices, it is likely that we will see a fall in headline y-o-y inflation. A drop in core inflation will probably cause long bond yields to dip further slightly and will be positive for risk assets. Yet, it is equally important to consider other factors that will have a large bearing on the markets into the year end viz. government shutdown risks, seasonal trends, tax loss harvesting and larger coupon auctions into the next 2 months. In summary, both bond and stock markets seem poised for range bound activity – which makes certain option strategies like selling strangles or covered calls the ideal trades to perform. That is if you still want to generate some income instead of heading out to the mountains, beach or the bar in the holiday season!

Happy Diwali.

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Information overload is a pitfall of the digital era we live in. A ton of apparent topics get covered in mainstream financial media. The interesting bit is to explore and educate on lesser discussed issues.

Alan Greenspan, the 13^th Chair of the Federal Reserve, served five terms from 1987 to 2006. He is best known for having presided over the “Great Moderation”, a period from the mid 1980s to the GFC of 2007, characterized by relatively stable inflation and solid economic growth. The term “Greenspan Put” a cornerstone at the intersection of monetary policy and financial markets is another of his legacies. Also, one of his key achievements, is said to be the “Soft Landing” navigated in the US economy in the mid 1990s.

Have a look at the charts below.

The first chart show US labour productivity through the 1990s. The second shows US labour productivity from right before the pandemic till date. The question to ask ourselves is will the productivity boom experienced by the US economy from mid 1995 till the end of that decade (marked in red) repeat itself in the next few years to come?

Why does that matter? Read on..

US Labour Productivity 1991 to 2000

US Labour Productivity 2019 to Q3 2023

The monetary policy tightening cycle of 1994-95 is remembered as probably the only instance in recent history when the Fed achieved a soft landing. After a brief recession (caused by the Gulf war), the US economy witnessed 2-3 years of stellar GDP growth in the early nineties.

GDP Growth up until the monetary tightening cycle of 1994

Inflation concerns from a booming economy led to Greenspan initiating 7 back-to-back rate hikes starting from February 1994.

Rate Hikes starting 1994

The last of these rate hikes took place in February 1995. By the first quarter of 1995 there was some slowdown in economic growth, but far from unequivocal clear signals of a significantly slowing economy or rapid disinflationary indicators. Yet, Greenspan initiated a series of rate cuts. Starting from July 1995, the Fed cut rates 3 times by a cumulative 75 basis points into the start of 1996.

Rate cuts starting mid 1995

Up until May 1995 inflation was still running at a solid 3.0%. The US economy continued to record robust growth. Yet Greenspan saw what no one else did. The upcoming productivity expansion.

Relationship between Productivity, Inflation and Wages:

Now, let me shift gears a bit and explain the relationship between Productivity, Inflation and Nominal wage gains. Wage growth can be said to equal productivity growth plus inflation. All other things being equal, if productivity grows at 1.5% and nominal wages grow at 4.5%, that can likely mean an average realized inflation of around 3%. Explained in another way, productivity improvements lead to a higher output for the same hours of labour worked. Higher output per hour of labour gives companies and businesses the ability to raise wages without crimping profit margins or eroding competitiveness. This fuels a virtuous cycle of economic growth and wage gains. But the low unit labour costs on the back of continuous productivity gain keep inflationary pressures low. This is precisely what occurred in the late nineties.

Labour productivity improved substantially as foreseen by Greenspan..

Wages gained through the period…

And yet inflation remained fairly benign through most of the late nineties…

The productivity change of approximately 2.1% was significantly greater than the 1.4% and 1.6% seen in the previous two cycles of the seventies and the eighties.

The productivity boom and economic growth also translated commensurately into company earnings and consequently equity market performance. (Needless to say there were a ton of other factors which influenced that period’s equity performance including the famous “irrational exuberance” of the late nineties)

Does History Rhyme?

There has been ample amount of literature that attempts to explain the post 1995 productivity acceleration. Some of the key points to note are –

• Investments in Information Technology caused an increase in labour productivity throughout the economy. The semi-conductor industry experienced rapid innovation with better performing chips and shorter gestation periods for node innovation. The emergence of the internet further contributed to a demand boom for personal computers

• High or increasing competitive intensity resulted in the spread of innovation. For instance, in general merchandise retailing, Walmart’s success forced competitors to improve operations. Pharmaceutical wholesalers responded to competition from large retailers by automating distribution centers.

• Another key aspect of the post 1995 productivity boom was that the US experienced a much larger increase in productivity compared to the rest of the world.

• Low inflation itself created competitive pressures which forced businesses to spur productivity growth (although there is a circularity in this argument)

While the intent of the note is not to dive into the absolute specifics of the post 1995 productivity spike, it would be remiss to not draw some parallels to the current trends in the world. While AI might be an over-hyped and often abused term, it hard to miss daily narratives of simple improvements to personal and corporate lives – ranging from work from home to virtual meetings to digital assistants to electric vehicles to driverless cars to lightning speed 5G connections to gene editing to tele-medicine to 3D printing. The list is almost endless.

Summary:

So what’s the summary? The BLS released US labour productivity data on 2^nd Nov 2023. The report showed non-farm business sector labour productivity increased a substantial 4.7% in the 3^rd quarter of 2023. Productivity has been improving since Q3 2022. If we continue to see an above trend improvement in productivity, wage increases at 4.0 – 4.5% can be sustained without causing a wage price spiral. The almost elusive “Soft Landing” will have actually materialized then! There are a ton of other factors to consider including the role of relative leverage in the economy, which is significantly higher now compared to the late nineties and can potentially have devastating effects on the economy and risk assets. Similarly, it is also key to consider fiscal dominance given budget deficits of 6-8%. Nonetheless, it is equally key to keep an eye on productivity trends. Like the cliché says, history does not repeat itself but it often rhymes.

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com

Two banking behemoths. Two different years. Two divergent equity returns. One common underlying reason.

There is no denying the fact that JP Morgan and Bank of America are in a league of their own. By their sheer size, scale and market dominance, they have a systemically important place in the financial system that is probably unparalleled in history.

Today we examine how their paths have differed over the past 3 years post the pandemic – all mostly attributable to one underlying reason.

First, here is a look at their comparative share price performance over 3 periods:

Full year 2021 – BAC : 48% , JPM : 26%

January through November 2022 – BAC : -18% , JPM : -16%

December 2022 till Oct 6 2023 – BAC : -29% , JPM : +5%

Borrow from Peter and Lend to Paul:

The business of banking, even though some folks might make it seem like fancy financial engineering, is a surprisingly simple one – Maturity Transformation. Borrow short and Lend long. And the summary in this case is that Bank of America decided to allocate a larger portion of their asset base to the “lend long” bucket than JP Morgan did. The result – JPM now has more flexibility to take advantage of increasing rates than it closest competitor BAC.

Lets dig a bit deeper.

BAC – Make hay while the sun shines

The first chart shows the trajectory of the two competitors’ asset deployment strategy over the past 5 years. BAC undertook a clear strategy to allocate a large percentage to investment securities compared to reserves (funds held at the Federal Reserve) and deposits at other banks. More specifically a larger chunk was allocated to Agency Mortgage backed Securities for the incremental spread over comparable maturity treasuries. It was good till it lasted in 2021 and BAC stock returns out-performed JPM by a mile. That was until the Fed embarked on the fastest rate hike in recent history. In simple terms, that means a larger portion of BAC balance sheet is locked up in these low yielding assets. Given the massive duration on these securities, any sales to free up balance sheet capacity entails crystallizing a significant loss.

JPM – Deposit taker of the last resort?

Second, and a bit surprisingly, BAC recent deposit trends look weaker than JPM. To comprehend the full landscape, one must understand that it is non-interest bearing deposits which matter most to a bank’s economic performance. A bank can mop up money with a high paying CD. But that’s hardly of any economic use in today’s rate and economic environment. While BAC is “home’ bank to many US blue chip corporations (OPAC liabilities) and a dominant retail franchise, the stark contrast to JPM in the loss of non-interest bearing deposits is unmistakable. Most of the drop in deposits for BAC seems to be attributable to its Consumer Banking and Wealth Management franchise. Conversely, deposits for JPM Consumer Banking and Wealth Management seem to be holding much better.

NIM-ble footed JPM

In summary, balance sheet flexibility due to a lower share of long duration fixed rate investments and the stronger deposit performance is enabling JPM to have a clear differentiation in Net Interest Margin and consequently Net Interest Income – a key driver of bank profitability.

Quarterly focus vs Long term strategy

The capitalist world can be unforgiving. For a period of time rates were very low in the immediate aftermath of a severe pandemic. Even the most distinguished of finance leaders were suggesting transitory inflation. After all we had lived through more than a decade of sub 2% inflation. It was in this environment that JPM still chose to take a different path than its closest competitor and hold more reserves at the Fed compared to investment securities. At every earnings release during 2021, JPM was asked the same question – why not sweat the asset book more by investing more in government treasuries and agency securities.  Here’s an example below from the 3Q 2021 investor call. The pressure must have been intense all through 2021 and into 2022. But patience has its rewards – which are now manifesting in JPM stock returns in 2023.

Question

Quote

Hey, guys. Was hoping to follow up on the capacity to deploy liquidity. And I guess just to kind of lean in a little bit, if we look at the growth in deposits, I know some of them are kind of considered noncore, but take out the loan growth and the growth in securities book since COVID, you’ve got about an extra $500 billion of deposits. And how much of that do you think can be deployed into securities, and understanding that you expect loan growth to pick up so that will go to some, but is there a way to size that $500 billion capacity in terms of buying securities?

Unquote

Answer

Quote

Yeah, so I think there’s a lot of factors that play into what the deployment decision is in any given moment. Obviously, as you said, loan growth, but also, we always make these decisions on the long-term economic basis, not for the purpose of generating short-term NII. And so when you do that, you have to think about capital volatility, drawdowns, and frankly, whether or not you see value. And that, if anything, is probably the biggest single factor right now.…So we’re always – we always try to be long-term economically motivated there considering all the scenarios, considering risk management, considering the convexity of the balance sheet, and looking at value and being tactical there. So that’s really how I would think about that.

Unquote

Who says Accountants are not Creative

Lastly, a short note on accounting jugglery as well. Investment securities generally are classified as Held to Maturity or Available for Sale. In the case of the former, the bank does not mark-to-market investment losses on the securities i.e. they are carried at amortized cost on the bank’s books. On the other hand, investment securities held in the Available for Sale book, need to be measured at fair value with any losses accounted for in the Bank’s Equity (via Other Comprehensive Income). It does not take a genius to figure that in an environment of steeply rising rates, it makes sense to transfer securities from Available for Sale to Held to Maturity, so that any further reductions in fair market value do not result in more hits to bank equity. The below paper at the University of Chicago suggests that cumulatively Banks in the US reclassified more than $900bn securities from AFS to HTM during 2022 (https://bfi.uchicago.edu/insight/research-summary/bank-fragility-and-reclassification-of-securities-into-htm/). It is difficult to pin point precise numbers since many Banks do not specifically disclose reclassification in quarterly results (I could find JPM disclosures on quantum of reclassified securities from AFS to HTM. But not for BAC). But the below graph does provide a representative (even though not comprehensive) idea of the difference in reclassification strategies adopted by BAC and JPM.

Earnings Yearnings

Bank earnings kick off next week. As of June 2023, BAC had gross unrealized losses of $105.7 billion on its Held to Maturity debt securities. Moreover, given the relatively benign or even favourable rates movement in the previous 3 quarters (4Q 2022, 1Q 2023 and 2Q 2023), the impact of mark-to-market losses on the AFS investment portfolio was benign (and mostly positive). The monster rates rally in Q3 2023 will have a negative impact on OCI and consequently Equity (that assumes no offset from derivatives).

Just to clarify, the above analysis does not infer that BAC is in any form of solvency risk. In fact, far from it. There would be hundreds of other banks which would face trouble before things get so bad as to merit a question over BAC. But it does explain a substantial portion of the divergence in stock returns over the past years!

Not meant to be Investment Advice. Do your own research. Happy investing!

Shashank Sawant

www.thecreditbalance.com