FYI | Mar 17 2008
By Greg Peel
James Turk is an international banking specialist who directs most of his attention to the gold and silver markets. But in the light of the Bear Stearns collapse, Turk has decided to have a closer look at US banks.
As questions arose last week, notes Turk, about the quality of Bear Stearns’ US$395bn of assets carried on only US$12bn of equity, its customers and other brokers became unwilling to accept the counterparty risk that arises with transacting with Bear, while its lenders began worrying about repayment. Given that extent of leverage, it only takes a small decline in asset value to significantly erode the firm’s equity base.
Bear is now gone, for the paltry sum of of around US$236m. But even though the 85-year old company was America’s fifth largest investment bank, when you stack it up against the big US commercial banks it is merely a small fish. (Perhaps not the whale GaveKal has been anticipating). Unlike investment banks, which engage mostly in broking and dealing in capital markets, commercial banks are deposit and loan centres for the individual citizens and businesses of America’s 300 million population. As such they are protected by the central bank lender of the last resort facility, which in turn requires the banks to maintain a certain level of capital adequacy. JP Morgan Chase, buyer of Bear, is America’s second largest commercial bank, and it also has an investment banking business. The largest is Citibank, part of Citigroup. Citigroup also has an investment banking business.
Citibank nearly went under in 1991 (mirroring Westpac’s experience in Australia) following on from the ’87 crash, the junk bond/leveraged buyout boom, and the Savings & Loans crisis and a commercial real estate crash. It was then saved by Saudi Prince Al-Waleed bin Talal via an investment of US$590m. Turk suggests total losses in the financial system back then were about US$100bn. The numbers touted this time around are in the range of US$500-600bn. Around US$140bn has been written off to date. The London Daily Telegraph noted, following the US$200bn made available to investment banks by the Fed last Friday, in a long line of liquidity injections (or bail-outs by any other name), that “as the bail-outs are getting bigger, then clearly the problems causing them are getting bigger”.
In which case size does not matter. The same problems which beset Bear Stearns are currently besetting every financial institution, including Citibank. But commercial banks enjoy certain advantages. As well as that Fed support, they have a Harry Potter-style “cloak of invisibility”. While investment banks are required to mark their assets to market – the process which has forced all the write-downs – commercial banks are not. The argument in support is that loans on commercial bank books, such as mortgages, are not packaged up as tradeable securities. Instead they are held to maturity, in which case it matters not what value they may hold before that time. Nor are they beholden to ratings agency credit downgrades on corporates. Commercial banks can make up their own minds on what a loan to a company is worth.
Commercial banks do own tradeable securities, but these can be transferred into investment portfolios if they are not performing, again making them effectively disappear until maturity. But while this cloak might have its reasons, it doesn’t hide the fact commercial banks still operate with a good deal of leverage.
Turk notes Citibank’s leverage, measured as total liabilities divided by stockholders’ equity, has increased each quarter from December 2005 to December 2007 – from 12.3x to 18.2x. This implies equity as a percentage of liabilities has declined in this period from 8.1% to 5.5%. However Citibank, like all banks, has intangible assets and goodwill forming part of its equity. These have also increased since 2005. Intangible assets and goodwill are worthless in a crisis, so removing these from the equation increases leverage to 41.6x.
(Clearly Bear Stearns is an example here of valueless intangible assets, given the brand name of the venerable 85-year old firm was effectively assigned a negative valuation as the company sold for less than the value of its premises. However, one might note the recent Westpac swoop on RAMS Home Loans, where the bank paid up to acquire the lender’s brand name and distribution network. The latter case suggests intangible assets are not always valueless.)
On this basis Citibank’s ratio of equity to tangible assets is 2.3%. Given the cloak of invisibility, it’s impossible to determine the quality of those assets, but we do know that their value need only fall 2.3% before Citi is technically insolvent, even if it is still liquid and trading.
So what are the assets potentially worth?
Bear Stearns’ total of Level 3 assets (derivatives the value of which are unknown except for a best guess given they rarely trade, eg CDOs) was US$28bn. According to the US Comptroller of Currency, Citi is a counterparty to derivatives positions with a notional value of US$34 trillion. Turk is not taking this number as gospel, employing the use of the editors’ “(sic)” in his missive. This is understandable, as it is a fairly rubbery figure. The notional value of derivatives can be skewed by extreme leverage and risk open-endedness. And a number like US$34trn evokes a fantasy land of Monopoly money. Let’s just say Citi’s total exposure is a BIG number.
JP Morgan has warned that Wall Street is facing a “systematic margin call” on subprime mortgage securities alone of US$325bn. Citibank accounts for 10% of the capital of all US banks so taking US$32.5bn off Citi’s capital would leave just US$17.2bn of tangible capital. This is before we start talking about calls on all the other now distressed securities. Turk notes Citi has already taken a credit-related loss of US$20bn in the second half of 2007, and in theory the first half of 2008 will only be worse. And banks do not perform well in recessions.
To reduce its leverage back to its December 2005 levels Citi would either have to raise US$46.9bn, meaning double it, or sell US$384.1bn of assets, Turk calculates. It can’t sell assets because this would knock down security valuations further and thus erode it’s own capital again, so it would be self-destructive. As to raising US$47bn, how could that be achieved in this current market?
For a conclusion, Turk turns to a statement made by David Rubenstein, co-founder of the private equity firm Carlyle Group. The Bear Stearns fiasco stole the financial headlines from last week’s news of the collapse of Carlyle Capital, a securities investment hedge fund managed by the Group. Carlyle Capital defaulted on its loans to Citi, among others.
“This is the tip of the iceberg. People are looking at our situation and saying, ‘There but for the grace of God go I’. There are others out there hanging on by their fingernails.”