Will the Big Banks need to raise equity?

[Buckeye]

Hello All,

 

I'd be interested to hear your opinions as to the validity of this Twitter string in which the poster claims that with the lowering of interest rates, leading to an increase in pension liabilities that the Big Banks should raise equity soon.

 

Thanks!

 

[elliott]

funny.

just yesterday, my DD process determined that I should not research Bank of America - one of the reasons being that its equity ratio is lower than what I ask of banks.

 

by the way, I may now be mixing banks so reader beware, but I think that in the 2019Q4 conference call, Bank of America indicated it felt it was more than adequately capitalized.

 

 

[ERICOPOLY]

Hello All,

 

I'd be interested to hear your opinions as to the validity of this Twitter string in which the poster claims that with the lowering of interest rates, leading to an increase in pension liabilities that the Big Banks should raise equity soon.

 

Thanks!

 

 

Her argument appears to be that Boeing is in trouble because (she argues) the AA bond yield is dropping. 

 

My question to her is, how much larger is the bond portfolio after accounting for the attendant capital gains that come hand in hand with dropping yields?

[Kaegi2011]

So I used to manage pension & assets for a F500, and the twitter thread is absolutely true.  A few things to think about (and to continue to use Boeing as the example):

 

1) PBGC's premiums have been going up as they lost a boatload of money last recession, and they understand the problems better to more efficiently price their premiums.  This means it's now more punitive to corporates if their plans are underfunded (it's a sliding scale).

2) I think she's being somewhat sensationalistic to use just the liability side of the equation.  It would give her more credibility to also talk more about the assets side.  So I looked at Boeing's latest 10k to see what assets they are invested in, and it looks like they're only about 50% in fixed income, which isn't great.  Given their minimal derivative exposure I'm going to make the assumption that they are not hedging their entire duration risk (you can effectively hedge the interest rate risk through derivatives and still participate in equities).  All this is to suggest that if you assume 50% of their assets hedge an effective $ amount of the liabilities, and the rest of the assets have performed in line with global equities, then their hole has increased pretty significantly since year end.

3) It's not only a balance sheet issue, but also a P&L and cash flow issue.  From a P&L perspective, in a world with 1.x% 30 year treasuries, they will need to justify how they reached their EROA assumption of 6.8%.  Auditors generally provide flexibility here so it's not black and white, but if rates persist the conversation next year may be more difficult.  Similarly on CF - they need to pay ~$5bn of cash per year for their pension and OPEB, yet they've contributed close to nothing over the past two years.  So now they're going to have to figure out where that cash will come from.  Do they sell equities (potentially selling at a "low") or fixed income (and lose the duration match if rates compress further)?  Looks like they have a decent amount of illiquid stuff too between HFs, PE, and RE.  All in the context of their 737 issues already pressuring their cash flows.

 

Now for a positive spin - the pension plans seem more or less closed since 2016, but OPEB is still accruing.  IN the context of their total liabilities at least the rate of liability growth from service cost is declining.

 

Now, if you care to learn more about how to think about pension plans, etc. the above should give you enough of a start.  But having said that, I think in the US, anytime someone can kick the can down the road, you should assume they will.  Pension problems are not new - not for corporates, not for munis, not for the federal govt.  Despite a decade of growth, our country's balance sheet now looks way worse, even though we knew the issues have been there all along (this is not a political dig at anyone - both Obama and Trump have ignored the issues).  So all of that is to say that I don't really think this matters unless a company really is insolvent and this is the issue that pushes them over the edge.  Outside of that, I think the equity market will not really focus on this unless it's just a huge problem.  BTW - I would bet that most wall st analysts can't really even explain how pensions work if you really probed...

 

 

[Kaegi2011]

 

Her argument appears to be that Boeing is in trouble because (she argues) the AA bond yield is dropping. 

 

My question to her is, how much larger is the bond portfolio after accounting for the attendant capital gains that come hand in hand with dropping yields?

 

THey have 61.7bn of assets at year end, with 49% in FI portfolio.  Assume they are using a liability driven investing model (LDI), you can basically assume that 30.2bn of the liabilities are fully covered by the FI portfolio.  Alternatively, they could be long duration using derivatives, etc., but given their derivatives exposure I'm not sure that's actually happening.  But let's say they are, you can assume more of their liabilities are covered.  So let's say 35bn of their liabilities are covered.  That leaves ~50bn of liabilities that's matched to equities/PE/RE/HF.  Assuming those 50bn of liabilities are now 10% higher, that's now a liability of 55bn.  On the asset side for risk assets, they've declined maybe 10% since beginning of the year in total?  So 30bn of assets are now 27bn.  So now they're in the hole for ~28bn vs. 21bn at beginning of year between pensions & OPEB. 

 

That's just quick math.  However, rates can go up just as quickly, so that's why these MTM exercises don't really move the needle.  Unless the company is going to not pay the pensioners this month/quarter/year, it's not really an issue that anyone focuses on.

[Jurgis]

Now, if you care to learn more about how to think about pension plans, etc. the above should give you enough of a start.  But having said that, I think in the US, anytime someone can kick the can down the road, you should assume they will.  Pension problems are not new - not for corporates, not for munis, not for the federal govt.  Despite a decade of growth, our country's balance sheet now looks way worse, even though we knew the issues have been there all along (this is not a political dig at anyone - both Obama and Trump have ignored the issues).  So all of that is to say that I don't really think this matters unless a company really is insolvent and this is the issue that pushes them over the edge.  Outside of that, I think the equity market will not really focus on this unless it's just a huge problem.  BTW - I would bet that most wall st analysts can't really even explain how pensions work if you really probed...

 

This pretty much.

[thepupil]

copying an older (Jan 2020) post on this with some additional data.

 

I don't think corporate pensions are a big issue because, for the most part, they've had years of bull market equity gains and for the most part behaved well and partially immunized them.

 

I don't love a lot of the businesses on this list to begin with, but I don't think it's pensions that will make them bad investments.

 

the twitter seems pretty alarmist. I agree with her estimate of duration of the liability based on boeing's 10-k

https://www.bamsec.com/filing/1292720000014?cik=12927

 

you can find details of boeing's pension on page 97. it is 49% fixed income and 30% equities, so it's not like the value of its $61  billion in assets is collapsing with the equity correction

 

Also, I would note, that it's not a coincidence that defense contractors run the biggest deficits. the federal government is responsible for a significant portion of pension costs:

 

https://fcw.com/articles/2012/02/10/federal-agencies-stuck-paying-for-federal-contractor-pensions-group-says.aspx

https://www.pionline.com/article/20130204/PRINT/302049981/defense-contractor-pension-assets-eyed

https://www.cagw.org/thewastewatcher/another-deficit-driver-contractor-pensions

 

 

https://www.investors.com/etfs-and-funds/sectors/sp500-ge-not-alone-25-companies-owe-trillion-pension-payments/

 

Largest 25 pension obligations collectively owe $1 trillion, and have a funding gap of $150 billion ($1 trillion of liabilities against $850 billion of assets)

 

Those 25 have a market cap of $3.5 trillion and $238 billion of EBIT, and $390 billion of EBITDA.

 

Most of these, their funding gap would add maybe half a turn or less to their leverage ratios. GE the data is wrong because they have negative EBITDA so it messes up the calculation.

 

For the companies that have the largest funding gaps as expressed in EBITDA, 4/4 of the top ones are defense contractors (Lockheed, Raytheon, Northrup, and Boeing). Many defense contractors utilize cost plus contracts that INCLUDE the cost of the pension benefits. The federal government is responsible for some portion of those folks pensions. Lockheed has the biggest funding gap, adding 1.3 turns to its leverage.

 

I recognize that the funding gap can really blow it if rates go down and stocks go down since that increases the liability and decreases the assets, but given the trend toward immunization, the very long term nature of funding a pension, and the low absolute numbers here as a percentage of these companies earnings power, I see very little risk in terms of corporate pensions.

 

Fear not the corporate pension "problem".

 

Let's say you think EBITDA is bullshit, so I'll use $240 billion of EBIT. I'll stress that down to $180 billion for fun. I'll increase the obligation by 20% and decrease the assets by 10%. then these collectively could get to 100% funded with just over 2 years of EBIT. And of course they don't have to do it like that.

 

Lockheed Martin                              -1.330194232

Raytheon                                    -1.161483702

Northrop Grumman                      -1.091703057

Boeing                                    -1.085029431

DuPont                                  -1.015721604

Delta Air Lines                      -0.745312682

United Parcel Service                -0.660816813

General Motors                          -0.634868058

Ford Motor                                  -0.538615238

Exelon                            -0.405309555

Exxon Mobil                    -0.328415521

Caterpillar                      -0.316484311

Pfizer                    -0.250183959

United Technologies      -0.227562352

3M                            -0.218516389

Johnson & Johnson      -0.181629476

Merck                        -0.117022936

AT&T                            -0.067857536

Verizon                    -0.04536176

Citigroup                    -0.03108909

Honeywell                  0.166219154

General Electric            1.852617649

International Business Machines  -0.521864315

[Guest eatliftinvestgolf]

I have trouble with the conclusion in the tweet being associated with the big banks and think the post is alarmist too. I agree that there is a pension assumption problem more broadly in the U.S.

 

I looked at most recent 10-Ks, to pull the U.S. pension plan assumptions for the four big banks in the U.S.  Where is the issue here?

 

For JPM, 3.3% discount rate on $17.1 BN year-end defined benefit pension obligation. 

For BAC, 3.32% discount rate on $15.4 BN year-end defined benefit pension obligation.

For C, 3.25% discount rate on $13.5 BN year-end defined benefit pension obligation.

For WFC, 3.21% discount rate on $11.7 BN year-end defined benefit pension obligation.

 

I think pension liabilities are a bigger reason to avoid low interest rate municipal debt in high tax states and some of the companies list above, than any reason to be concerned about the big banks... Would love to hear a counter argument.

[rb]

I have trouble with the conclusion in the tweet being associated with the big banks and think the post is alarmist too. I agree that there is a pension assumption problem more broadly in the U.S.

 

I looked at most recent 10-Ks, to pull the U.S. pension plan assumptions for the four big banks in the U.S.  Where is the issue here?

 

For JPM, 3.3% discount rate on $17.1 BN year-end defined benefit pension obligation. 

For BAC, 3.32% discount rate on $15.4 BN year-end defined benefit pension obligation.

For C, 3.25% discount rate on $13.5 BN year-end defined benefit pension obligation.

For WFC, 3.21% discount rate on $11.7 BN year-end defined benefit pension obligation.

 

I think pension liabilities are a bigger reason to avoid low interest rate municipal debt in high tax states and some of the companies list above, than any reason to be concerned about the big banks... Would love to hear a counter argument.

All of the above, and not only that.

 

JPM - over funded by 3.3 Bn

BAC - over funded by 4.9 Bn

WFC - under funded by 350 Mn

 

I would say that there is a zero chance that big banks have to raise equity due to actuarial changes with the pension plans.

 

Edit: Interesting how her tweets are supposedly about the big banks, but then she doesn't really talk about big banks.

[thepupil]

So I used to manage pension & assets for a F500, and the twitter thread is absolutely true.  A few things to think about (and to continue to use Boeing as the example):

 

1) PBGC's premiums have been going up as they lost a boatload of money last recession, and they understand the problems better to more efficiently price their premiums.  This means it's now more punitive to corporates if their plans are underfunded (it's a sliding scale).

2) I think she's being somewhat sensationalistic to use just the liability side of the equation.  It would give her more credibility to also talk more about the assets side.  So I looked at Boeing's latest 10k to see what assets they are invested in, and it looks like they're only about 50% in fixed income, which isn't great.  Given their minimal derivative exposure I'm going to make the assumption that they are not hedging their entire duration risk (you can effectively hedge the interest rate risk through derivatives and still participate in equities).  All this is to suggest that if you assume 50% of their assets hedge an effective $ amount of the liabilities, and the rest of the assets have performed in line with global equities, then their hole has increased pretty significantly since year end.

3) It's not only a balance sheet issue, but also a P&L and cash flow issue.  From a P&L perspective, in a world with 1.x% 30 year treasuries, they will need to justify how they reached their EROA assumption of 6.8%.  Auditors generally provide flexibility here so it's not black and white, but if rates persist the conversation next year may be more difficult.  Similarly on CF - they need to pay ~$5bn of cash per year for their pension and OPEB, yet they've contributed close to nothing over the past two years.  So now they're going to have to figure out where that cash will come from.  Do they sell equities (potentially selling at a "low") or fixed income (and lose the duration match if rates compress further)?  Looks like they have a decent amount of illiquid stuff too between HFs, PE, and RE.  All in the context of their 737 issues already pressuring their cash flows.

 

Now for a positive spin - the pension plans seem more or less closed since 2016, but OPEB is still accruing.  IN the context of their total liabilities at least the rate of liability growth from service cost is declining.

 

Now, if you care to learn more about how to think about pension plans, etc. the above should give you enough of a start.  But having said that, I think in the US, anytime someone can kick the can down the road, you should assume they will.  Pension problems are not new - not for corporates, not for munis, not for the federal govt.  Despite a decade of growth, our country's balance sheet now looks way worse, even though we knew the issues have been there all along (this is not a political dig at anyone - both Obama and Trump have ignored the issues).  So all of that is to say that I don't really think this matters unless a company really is insolvent and this is the issue that pushes them over the edge.  Outside of that, I think the equity market will not really focus on this unless it's just a huge problem.  BTW - I would bet that most wall st analysts can't really even explain how pensions work if you really probed...

 

interesting, I think we look at the same facts and come to a different conclusion. in the context of these companies' market caps and earnings power (both of which are fluid, but I'm assuming don't utterly collapse), a few billion a year of unplanned contributions to close the blow-out in the underfunded doesn't seem like a big problem to me.

 

I understand how the liability and pension return assumptions work and what falling rates does to that. But don't understand why you think this is a problem.

[Kaegi2011]

 

Also, I would note, that it's not a coincidence that defense contractors run the biggest deficits. the federal government is responsible for a significant portion of pension costs:

 

https://www.cagw.org/thewastewatcher/another-deficit-driver-contractor-pensions

 

This is fascinating stuff.  I had no idea this was happening.  Imagine going to a customer and asking them to pay for your costs & future pension costs!  You'd get laughed out of the room!

 

Thanks for sharing.  Learn something new every day.  :)

[CorpRaider]

I do generally try very hard to avoid companies with organized labor + defined benefit plans. 

 

What kind of longevity/benefit assumptions are we talking about here?  Couldn't covid-19 materially revise those downward for the boomers and older (i.e., pretty much everyone who will ever draw a pension).  By "raising equity" does one mean, "modestly reducing buybacks?"

[thepupil]

 

Also, I would note, that it's not a coincidence that defense contractors run the biggest deficits. the federal government is responsible for a significant portion of pension costs:

 

https://www.cagw.org/thewastewatcher/another-deficit-driver-contractor-pensions

 

This is fascinating stuff.  I had no idea this was happening.  Imagine going to a customer and asking them to pay for your costs & future pension costs!  You'd get laughed out of the room!

 

Thanks for sharing.  Learn something new every day.  :)

 

yep, a VIC write-up on LMT in 2011 taught me it.

https://www.valueinvestorsclub.com/idea/LOCKHEED_MARTIN_CORP/7341821351

(Geek's accounting note: we've adjusted the EBITDA/EBIT numbers to reflect the real-world economics of Lockheed's pension liabilities and expenses, which are, briefly, as follows: Since 85% of Lockheed revenue is generated by sales to the US government, approximately 85% of its pension expenses are also picked up by the US government. While that sounds fairly straightforward, the government's contract accounting standards (CAS) for pensions are different than corporate financial accounting standards (FAS). We'll spare you the details, but the important point is that while FAS may dictate that Lockheed book x as its pension expense in a particular year, the government will only reimburse pension expense as dictated by CAS, which is generally a totally different number. Over time, the two will converge, but in certain circumstances - such as when the plan assets get hammered by a severe equity market decline - FAS pension expense will be much higher than CAS pension expense for a while. These are mostly non-cash issues, and our analysis basically reflects only the CAS expense that Lockheed books and which is reimbursed by the government.)

 

I did what i could to verify this (googling around and talking to a few people) and it seemed legit, bought the stock for like 9x.

 

[Kaegi2011]

 

interesting, I think we look at the same facts and come to a different conclusion. in the context of these companies' market caps and earnings power (both of which are fluid, but I'm assuming don't utterly collapse), a few billion a year of unplanned contributions to close the blow-out in the underfunded doesn't seem like a big problem to me.

 

I understand how the liability and pension return assumptions work and what falling rates does to that. But don't understand why you think this is a problem.

 

Sorry if I was not clear.  For Boeing I used them as a continuation of the example as posted in the Twitter link, not trying to single them out or to suggest that they have a big issue.  Their 737 issues are far bigger (at least from afar, I know close to nothing about the company).

 

For the broader pension comment - I certainly agree that it's not a big problem for most corporates.  However, for govt entities I do think it's a reasonably sized issue, particularly the entitlement programs.  However, we start to get into politics about intergenerational wealth, which I don't think was the intent. 

 

So net net - I think we agree - market won't price securities on pensions until it's a huge problem, and for the most companies, it's not a huge problem. 

[thepupil]

 

interesting, I think we look at the same facts and come to a different conclusion. in the context of these companies' market caps and earnings power (both of which are fluid, but I'm assuming don't utterly collapse), a few billion a year of unplanned contributions to close the blow-out in the underfunded doesn't seem like a big problem to me.

 

I understand how the liability and pension return assumptions work and what falling rates does to that. But don't understand why you think this is a problem.

 

Sorry if I was not clear.  For Boeing I used them as a continuation of the example as posted in the Twitter link, not trying to single them out or to suggest that they have a big issue.  Their 737 issues are far bigger (at least from afar, I know close to nothing about the company).

 

For the broader pension comment - I certainly agree that it's not a big problem for most corporates.  However, for govt entities I do think it's a reasonably sized issue, particularly the entitlement programs.  However, we start to get into politics about intergenerational wealth, which I don't think was the intent. 

 

So net net - I think we agree - market won't price securities on pensions until it's a huge problem, and for the most companies, it's not a huge problem.

 

we do agree. I am an alarmist about government pensions/ entitlements. it is a problem at the local, state, and national level.

[Kaegi2011]

I do generally try very hard to avoid companies with organized labor + defined benefit plans. 

 

What kind of longevity/benefit assumptions are we talking about here?  Couldn't covid-19 materially revise those downward for the boomers and older (i.e., pretty much everyone who will ever draw a pension).  By "raising equity" does one mean, "modestly reducing buybacks?"

 

1) Not many companies now still have *open* DB plans.  What you see on balance sheets are legacy plans that companies have not sold off to insurance companies.  So I think it's important to distinguish between the two and one way to tell is to read the 10K and/or just look at their service cost for the latest year.  I don't think you want to throw out the baby with the bathwater.  Of course you may want to avoid organized labor period...

 

2) I think you'd need to have meaningful deaths related to COVID19 before it starts to be reflected in pensions, and I think that probability is very low.  ALso, remember that not all pensions are paid to the pensioner - it could be to a spouse as well depending on how the pensioner elected to receive their pension.  So I just don't think COVID / pension is an investible theme unless something dramatic happens.  And just as a counterpoint, someone may come up with a gene therapy to colve cancer, so the risk can go both ways. 

[Spekulatius]

IBM, GE and GM are much more likely to get into trouble than the big banks, due to the size of their total pension liabilities relative e to their earnings power and market cap.

Then the defense companies gave huge pension funds, but those are more or less indirectly funded fed by tax payers.

[thepupil]

I don't mean to make this a pension section 10-K reading contest (there are better ways to spend ones morning)...but Spek, why do you think IBM is a problem?

 

I don't know much about the company, but these numbers seem fine.

 

https://www.bamsec.com/filing/155837020001334?cik=51143

 

US Plans: $52 billion of assets, $50 billion liability, fully funded as of YE 2019

The Qualified PPP portfolio’s target allocation is 12 percent equity securities, 80 percent fixed-income securities, 4 percent real estate and 4 percent other investments.

 

Non US Plans: $40/$47 ($7  billion short)

The weighted-average target allocation for the non-U.S. plans is 20 percent equity securities, 71 percent fixed-income securities, 3 percent real estate and 6 percent other investments, which is consistent with the allocation decisions made by the company’s management.

 

[Buckeye]

Wow, thank you all so much for the amazing feedback.  The twitter post seemed a little sensationalist to me, but mostly because I didn't really understand the specifics.  Thank you again for your thoughtful and detailed responses!