Franco-Belgian bank Dexia became the first casualty of the sovereign debt crisis, after it was effectively nationalised by Belgium. Dexia shares were worth €22.50 each in early 2007, but had fallen to just 54c at one stage on Monday.
Dexia's plight throws an uncomfortable spotlight on many other, larger, European banks. Markets are now asking: are there any other Dexias out there? (Answer: lots mainly in Europe.) And are there any banks that are finally safe out there, given another couple of years of capital bolstering earnings? (Answer: a few mainly in America.) And where do the British banks sit on that scale? (Answer: somewhere in the middle.) We'll look at Dexia first, and see how the lessons from that bank apply to the rest.
Dexia had already received more than €6bn in capital in 2008 after Lehman Brothers collapsed and had, as the Financial Times put it, "long been among Europe's most vulnerable banks". The bank has €13bn in core tier 1 capital, but only €5bn of tangible common equity (TCE), the most conservative measure of loss-absorbing capital. These two sums should be very close to each other. If you see an inflated core tier 1 figure (the number the bank gives the regulator), that's a warning sign that it may be over-egging its soundness.
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This imprecise and inadequate capital position supported €316bn in loans to customers and €202bn in other, non-loan assets, according to the June 2011 balance sheet. The FT reports that a Dexia bad bank' will now be set up "to hold a portfolio of bonds worth up to €200bn". But only about €80bn of Dexia's non-loan assets are bonds: €66bn are others', including derivatives, and €48bn are interbanking assets. Banks hold a lot of each others' debt, often in the form of subordinated paper (in other words, debt that comes lower on the pecking order for repayment in the case of bankruptcy).
The trouble is, much like the supposedly risk-free sovereign debt in the bond portfolio, some of this subordinated paper is turning from being apparently very low risk into actually being rather high risk. Credit default swap (CDS) spreads are the insurance premium a bank would have to pay to insure a buyer of their bonds, and premiums have gone through the roof again (see chart below).
This is just one of the many danger points on Dexia's balance sheet. For example, the risk-weighted assets (RWA) figure measures how risky a bank's internal models reckon its assets are. It uses this figure to work out how much capital it should be holding against these assets. That means there's an incentive to keep this number as low as possible. Even though Dexia specialised in lending to municipals (cities and towns) and so had a reputation for good-quality assets, the fact that its RWA is only €127bn was another warning sign. That's less than half the total face value of loans and less than a quarter of total assets. Sure, maybe its loans really are ultra-low risk. But equally, it could be under-estimating the real risk.
That matters, because Dexia didn't have much room for error. Its TCE came in at less than 1% of total assets, so the bank was 100 times geared. Barclays is 35 times geared, Credit Suisse 43 times, Deutsche Bank 53 times and Crdit Agricole 67 times. By comparison, Citigroup and Wells Fargo, the least geared of the US banks, are only 14 times geared.
The European canary
But banks don't just fold because their equity is wiped out and they become insolvent. They can often disguise this for years. What normally seals a bank's fate is a bank run. This isn't just about depositors queuing up to get their money out. A less visible but just as devastating run can occur if banks lend more than they have in deposits, and make up the difference by borrowing from the wholesale capital markets. This difference is called a wholesale funding gap'. It was being frozen out of the wholesale markets that forced Northern Rock to fail.
Deposits at Dexia are only €125bn compared to €316bn of loans, leaving a wholesale funding gap of €191bn. As markets lost faith in the bank (the two-year CDS spread grew from just 2% in May to more than 10% by 28 September), this is what did for Dexia. Just as Northern Rock was the canary in Britain's coal mine, Dexia looks like being the first domino in Europe. Since 2007, Dexia had only made provisions of €0.2bn for loans going bad. That's 0.1% of total loans. A 10% loss rate assumption on loans (a best-case' scenario, as I explain in the box) implies €37bn to come, with perhaps another €3bn-€5bn of losses on non-loan assets. However, Dexia holds €3.5bn of Greek sovereign debt, €1.9bn of Portuguese and €15bn of Spanish debt, says the FT. An average 50% haircut on this lot alone would lift non-loan losses to €10bn.
To satisfy Basel II minimum capital requirements (which dictate how much capital a bank needs to hold against the loans it makes), Dexia had to hold just €5.7bn in common equity tier 1, the highest-grade capital. However, with a suspiciously low RWA figure, practically zero loan losses realised, more than €20bn exposure to peripheral sovereign debt, a giant wholesale funding gap, and a leverage ratio of 1% to back it all up, it's a wonder Dexia hadn't gone already. And that's the crux of the matter. If European markets are only now waking up to the likes of Dexia, who's next?
Liquidity or solvency crisis?
It depends on whether markets are more worried about liquidity or solvency. A liquidity crisis is when a bank can't get anyone to lend it money. A solvency crisis is when the loans a bank has made go bad and it needs more capital (equity) to absorb those losses. It's not easy to tell the difference between the two often funding dries up because a bank is facing solvency problems, as at Northern Rock. But the fact is that, while most European banks are vulnerable to being frozen out of the wholesale funding markets right now, if central banks were convinced that a bank with liquidity problems was otherwise solvent, it would be quite straightforward to keep it funded until markets unfroze.
That means the real bank killer is lack of capital (ie, potential insolvency caused by losses on securities, or bad loans equalling or exceeding capital). This is why, after any downturn, banks spread provisions for bad debts out over several years. They never let any one year's losses erode too much capital, to avoid starting a solvency crisis. The key measure of solvency risk is the capital ratio. The trouble is, banks are allowed to risk-weight their own assets, so the regulatory capital ratio is subject to complacent risk assumptions and conflicts of interest. That means the old-fashioned leverage ratio (pure TCE capital to total asset ratio) gives us the most honest steer.
Cumulatively, the five largest French and German banks today have core tier 1 capital amounting to just 2.4% of their assets. If Europe's leaders want to recapitalise the region's banks, these five alone would require €115bn to satisfy the minimum leverage ratio of 4% required in America for a bank to be adequately' capitalised. Barclays has a core tier 1 to asset ratio of 2.9% not a lot better than the big French or German banks. The Swiss pair of UBS and Credit Suisse are no better either, on 2.7%. Bringing up the rear, France's Crdit Agricole only has a ratio of 2.1% and Deutsche Bank has an almost unbelievably thin 1.8% loss-absorbing capital buffer.
Two more warning signs
There were at least two other warning signs from Dexia's balance sheet that we should watch out for in other banks. One was that it had done very little in terms of acknowledging bad debts, suggesting it had a lot more to do. Other banks that fall into this category include BNP Paribas, with cumulative loan loss provisions since 2007 of just 2.6% of total loans; Commerzbank on 2.4%; Deutsche Bank with just 1.8%; and the two Swiss banks with around 1% each. Compare that to HSBC, which has already achieved loan loss provisions of 8.1%. Or to Citigroup, where provisions on loans alone have topped $120bn an impressive 14.5% of peak outstanding loans.
Another warning sign was Dexia's suspiciously low RWA calculation, which we mentioned earlier. Others also look complacent on this count. Barclays's RWA figure, for example, is 26.5% of total assets. Even adjusted for derivatives, it is still just 36%. Worse, though, are UBS at 16.7%, Deutsche Bank on 17.3%, and Crdit Agricole on 23%. These very low numbers mean the banks in question believe their assets are very low risk. But as we've discovered the hard way, believing an asset to be very low risk doesn't always make it so. If such banks also sport very thin capital bases (as we've already noted above, these ones do), the margin for error becomes tiny.
More reason to avoid banks
What does all this mean? Well, if you put the numbers together and assume historically relevant loss rates for each bank before they're through to the other side of this crisis, then it looks like some may be unable to satisfy the very mild Basel III capital requirements, even by the delayed 2019 deadline. We're not saying that it's not safe to have your savings in any particular bank (assuming you stay below the £85,000 compensation scheme limit), as governments have made it pretty clear that they'll protect savers. However, investors in banks which may require more capital in the future may end up being diluted to the point where they incur serious losses.
So in general, we'd still be avoiding the sector. And on a broader note, the European banking sector as a whole looks the most vulnerable. The loan book totals at most continental European banks are at, or very near, peak levels, whereas America and Britain are now three years into bank balance-sheet repair, with all the pain from loan shrinkage that this implies.
There is a strong case to be made that Europe's banking crisis has yet to begin. If that is indeed the case, the euro is about to face a credit crunch that could dwarf the one seen in America, not least because European banking assets are a much larger proportion of GDP than they are in the US.
However, we wouldn't dismiss every bank out of hand. The other side of the coin is that, while European banks are just entering their tunnel, some British banks may be at least half-way through, and US banks, especially the large listed majors, look as though they are nearing the end of theirs. In fact, at least two banks, one American, one British, look like they may even be worth buying now.
The two banks to buy now
NB: James tipped these stocks on 14 October.
The essential problem with hidden losses on banks' balance sheets is that word hidden'. Even the banks themselves don't know how large eventual losses may turn out to be. It depends on the economy, other banks' willingness to lend to the buyers of collateral at foreclosure auctions, and on how accurate the bank's own in-house estimates of recovery rates prove to be.
However, these problems are common to all previous bank crises. Based on history, we can make some educated guesses.
Typical loan loss rates in a single country crisis, after all recoveries, end up being around 10%, so that's a good assumption to start with. Since this is a multi-country crisis, we'd expect a higher number. The worst-case scenario of modern times for a developed market was Japan at a 20% loan loss rate. So that can mark our upside cap.
Citigroup (US: C) in the US has already been forced to raise $100bn of supplementary capital ($45bn of which came from the taxpayer) to top up the $75bn in tangible common equity (TCE) it held at the start of the crisis in June 2007. This means that the bank has been able to crystallise $121bn in loan loss provisions, and a further $68bn in securities write-downs since 2007.
Given that, before bad debts and tax, it makes around $32bn a year, Citigroup's TCE capital position, even after all those losses, write-downs and provisions, is now a much more robust $142bn (it dipped as low as $29bn in the darkest days of late 2008 and early 2009). The loan loss rate has now hit 14.5%, halfway between typical' and worst-case (Japan).
There is work still to be done. But even if we assume Japanese-style loss rates of 20%, Citigroup satisfies Basel II capital requirements. Give it another year and Citigroup satisfies Basel III, a criteria most banks need until 2019 to pass, with almost $20bn to spare to cover any legal liabilities arising from the US securities backlash.
Yet even though Citigroup is almost impossible to kill now, the market cap is just $77bn. That's a 45% discount to TCE and a 56% discount to book. Pre-crisis, it traded at between two to three times book. So the longer-term upside is clear. If today's TCE of $142bn is eroded by another 5.5% loss rate on loans ($45bn), Citigroup would have endured the same punishment that set Japan's banks into a 20-year decline. Yet its capital would still be $100bn, rising at a rate of as much as $30bn a year all for today's price of $77bn. It is the first Western bank to come through the crisis and become an unqualified buy'.
No other Anglo Saxon or European bank can withstand such extreme assumptions and still survive. But the next best bank is our own HSBC (US: HBC). If we assume a 15% loan loss rate on its American loans, a 12% loss rate on British loans and a 3% loss rate on all other assets, HSBC could still satisfy the Basel II capital requirements. And within six months, HSBC could pass Basel III too, and by next summer would have $20bn to spare, which should cover the very worst-case scenario in terms of legal liabilities from Household, its American subprime lending acquisition.
Naturally, since Citigroup has already racked up a loss rate of 14.5% on its own loan book, a 15% loan loss rate assumption may prove too conservative. However, with a loss rate on peak loans of over 8% already paid for (RBS's loan loss rate is only 4.2% to date, for example) and $30bn a year in earnings before tax and bad debts, HSBC could theoretically absorb 3% bad debts a year out of earnings. So it is very unlikely that HSBC will need more external capital. Yet it still trades below book value. Rival Standard Chartered - a UK-listed but Asia-focused bank - trades on 1.3 times book, suggesting that HSBC is on a 25% discount to where it should be trading.
This article was originally published in MoneyWeek magazine issue number 559 on 14 October 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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