The recent wave of bank failures returned asset liability management (ALM) to the spotlight.
Many correctly identified ALM breakdowns as causing their ultimate demise. Yet, ALM remains an underappreciated investment topic. It determines the fate of every company, not just the financially-oriented. Yet, few seem to fully appreciate how ALM missteps occur.
All financial crises and failures are rooted in ALM breakdowns. While assets garner the most attention, “L-side”-risks typically deal the mortal wounds. To be sure, asset quality can play a crucial role. However, its “unknowns” are generally appreciated. To quote (an expression attributed to) Mark Twain, “it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” With respect to ALM, the unknown liability unknowns get you.
It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
ALM pertains to business operations. It’s a financial lens applied to the physical management of people, plants, equipment, and all the other things required to run one. The ALM function ensures that cash inflows—generated by assets—cover cash outflows for liabilities; hence the moniker, ALM.
Cashflow is the lifeblood of business. Each must have enough to pay its bills when they come due. Rent, payroll, vendors, suppliers, creditors, and other company obligations generate expenses. Failure to pay fully and on time can force a company into bankruptcy. Thus, ALM plays a basic and vital function.
Financial firms generate the most attention with respect to ALM. Many correctly noted how its mismanagement directly caused the failures of Silicon Valley Bank, Signature Bank, Silvergate Bank, and even Credit Suisse. Each bank, for reasons outside the scope of this article, faced large deposit outflows. Unable to meet their cash demands, they became insolvent.
ALM breakdowns also caused the Global Financial Crisis (GFC) beginning in 2007. Some of the largest and most prestigious financial services firms failed to execute this basic business function leading to bankruptcies, forced takeovers, and controversial bailout policies like TARP and TALF. Those previously unaware of ALM’s importance learned it then.
Yet, for all the attention ALM garners, few seem to focus on its linchpin. Even today, assets get far too much attention. (Potential) liability risks go overlooked.
Asset risks are fairly straightforward. Companies generally understand their potential pitfalls. Financial firms, for example, assume levels of loss when underwriting investments. They expect some cash flow disruption from their assets, depending on each risk profile. Banks likely plan for higher losses in their personal loan portfolios than from their U.S. Treasury bill holdings. To be sure, projection accuracy can be poor. Thus, most companies budget conservatively, aiming for too much, rather than too little, cashflow. However, miscalculations and misfortunes occur, though rarely to catastrophic degrees. Most companies carry enough capital to cover unexpected losses from assets. Asset underwriting infrequently drives firms to bankruptcy, alone.
More commonly, firms fail due to unforeseen liability demands; specifically, when they unexpectedly increase and/or occur sooner than anticipated. When liability needs change, companies can face large bills for which they have not adequately planned. A bank run is a common example. Other catastrophic surprises include investment fund redemptions, changes in regulatory capital requirements, adverse legal judgements, interest rate adjustments, mass retirements, and policyholder deaths. Surprises sufficiently large can render firms insolvent.
While liability shortfalls can occur in concert with asset problems, like for the current slate of bank failures, they—alone—can cause bankruptcy. The GFC illustrated just this point. Then, rating agency downgrades of housing-related structured products caused many firms to fail, not realized investment losses. Many financial firms owned large quantities of highly-rated structured securities and credit default swaps; lots donned the highest credit ratings (such as AAA). These holdings’ various features protected investors from realizing losses. As a result, companies like American International Group, Inc. (AIG) borrowed against them. When Standard & Poor’s, Moody’s, and Fitch Ratings downgraded these securities, companies faced massive and unexpected margin calls which they could not meet. This was a common theme of the GFC.
The unrealized market valuation losses on AIGFP’s super senior credit default swap portfolio increased in 2008 compared to 2007 due to significant widening in credit spreads and the downgrades of RMBS and CDO securities by rating agencies in 2008 driven by the credit concerns resulting from U.S. residential mortgages and the severe liquidity crisis affecting the markets. In connection with the termination of $62.1 billion net notional amount of CDS transactions related to multi-sector CDOs purchased in the ML III transaction, AIG Financial Products Corp. paid $32.5 billion through the surrender of collateral previously posted … [Emphasis is mine.]
AIG’s 2008 10-K
Liability surprises drove two other life insurance companies, Lincoln Financial Group and The Hartford Financial Services Group, to accept bailout funds (TARP). The dramatic drop in interest rates caused book yields in some insurance products to fall below those guaranteed to policyholders. As a result, the insurers’ liabilities unexpectedly spiked. Suddenly short on capital, they turned to the government. Their capital needs also rose due to rating agency downgrades of investments, but to lesser degrees.
While surprise asset risks can wound a company, unplanned liabilities can kill. Thus, I pay less attention to asset-risk alarmists in times of stress. Instead, I scour companies’ financials for potential liability surprises.
Liability pitfalls aren’t exclusive to finance companies. Every type faces them. However, like lots of investment topics, only a proper definition of money illuminates this.
Money is a measurement concept. It translates real-life things into a quantified, common language of value (only). Everything can be conceived in money terms from real estate to labor. Money is the language of business like numbers are for mathematics. Commerce requires money.
Thus, it became evident to me that all businesses are carry trades. Equity- and debtholders finance purchases of people, plants, equipment, and materials needed to produce higher-value goods and services (accounted for as money). Successfully done, the initial capital outlay yields a profit. Profit quantifies the value created by measuring the difference between revenues generated from assets and their operating expenditures. It’s the spread between the cost of capital and the return on assets, just like for finance companies.
Thus, ALM is more than a financial company issue. It matters for all businesses. To be sure, liability surprises are more evident for financials due to their specific operating models (their raw materials are mostly monetary). Yet, non-financially oriented firms encounter liability pitfalls too. For example, more than 100 companies filed for bankruptcy due to hidden asbestos liabilities as adverse lawsuits created large, unforeseen capital needs. Environmental and tobacco-related health claims caused similar problems for some, while ballooning pension liabilities bankrupted other firms.
Even revenue shortfalls—the more evident driver of nonfinancial company failure—can be viewed through an ALM lens. General Motors Company’s (GM) 2009 bankruptcy can be framed as resulting from an insufficiently-flexible liability structure for its asset return volatility. GM’s fixed costs were too high relative to the level of sales (reliably) produced by its assets (i.e. cars and trucks). While few use ALM language to describe such causes of bankruptcy, the mismanagement of assets and liabilities are nonetheless to blame. Many investors understood GM’s sales variability at the time. Its liability risks were underappreciated, in my opinion.
ALM is a critical investment topic. While typically applied to financial companies, it affects every firm in every industry. While asset risks garner the most attention, unforeseen liabilities are most problematic.
Liability risks directly caused the recent round of bank failures. Deposit outflows exceeded their cash-raising abilities rendering each bank insolvent. Unplanned liabilities related to ratings downgrades and low interest rates pushed many large and prestigious financial firms out of business or into bailouts during the GFC. Adverse lawsuits, such as for asbestos, environmental, and tobacco injuries, and pension surprises bankrupted many nonfinancial firms too.
However, all bankruptcies can be viewed in ALM terms. Cash shortfalls result from mismanaging a firm’s asset capabilities and liability needs. Every business is a carry trade leveraging capital outlays for the prospect of profit.
Thus, in times of rising financial stress, I ignore those myopically focused on asset risks. Instead, I hunt for unknown liability in things that just might not be so.
Seth Levine is a professional, institutional investor focused on selecting high yield bond positions for a financial services company. He is also the creator of The Integrating Investor where he blogs about macroeconomic and investment strategy related themes. Seth holds a Bachelor of Science degree in Mechanical Engineering from Cornell University and is a CFA charterholder. You can learn more about Seth at www.integratinginvestor.com and follow him on Twitter at @SethLevine2. Please note that any opinions and views he expresses are solely his own and do not reflect those of his current or former employers.