November 2009
SPROTT ASSET MANAGEMENT LP
Don’t Bank on the Banks
By: Eric Sprott & David Franklin
Without tempting fate, it is probably safe to assume that the world’s financial system will survive 2009. Governments across the world have done an excellent job convincing their constituents that the banking system had to be saved at almost any cost. Now that the banks are back from the brink, however, those governments are looking for some much-needed reparation. Bankers are being continually reminded of the sacrifices made and vast sums spent to save their jobs last year. Some are subtle reminders, others are more direct. Either way, the governments have unholstered their regulatory guns, and are pointing them directly at the banks that received the largest bailouts. Unpleasant regulatory changes are likely to be imposed soon, because if there’s one thing governments love to do, it’s creating new ways to regulate things - and last year’s financial crisis certainly warrants some serious attention in that area. A quick history lesson on US banking regulation is useful to understand recent reform proposals: the US government passed the famous Glass-Steagall Act in 1933 in response to the financial collapse of 1929. The Act established the Federal Deposit Insurance Corporation (FDIC) and included banking reforms which separated financial institutions by their function. Regular savings banks were granted full protection by the FDIC, while speculative ‘investment banks’ were left to survive on their own. Fast forward to 1999, when Congress passed the Financial Modernization Act which effectively repealed Glass-Steagall and allowed banks, insurance companies and investment houses to merge. This legislation gave birth to the huge financial companies like AIG and Citigroup that would become the centre of the 2008 financial crisis. Shortly after amending Glass-Steagall, Senator Byron L. Dorgan presciently remarked, “I think we will look back in ten years’ time and say we should not have done this, but we did because we forgot the lessons of the past, and that which is true in the 1930s is true in 2010.” Ten years later, Dorgan acknowledged what we found out the hard way last year - that “to fuse together the investment banking function with the FDIC banking function has proven to be a profound mistake.”1 With the 2008 meltdown seemingly behind us, it shouldn’t surprise you to learn that the US government is once again looking to reinstate regulation along the lines of Glass-Steagall. There are a number of high profile experts espousing Glass Steagall-like reforms. We refer to them as the “back to the future” school, because although varied in their versions of execution, they all centre around more separation between savings banks and riskier financial institutions like investment banks. This group is mostly made up of current and former central bankers who insist that the financial system should not let the banks use government guaranteed deposits for speculative gain. Current Governor of the Bank of England, Mervyn King, and President of the European Central Bank, Jean-Claude Trichet,
1 Sanati, Cyrus (November 12, 2009) “10 Years Later, Looking at Repeal of Glass-Steagall”. Retrieved on November 24, 2009 from: http://dealbook. blogs.nytimes.com/2009/11/12/10-years-later-looking-at-repeal-of-glass-steagall/
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as well as former Chairman of the Federal Reserve, Paul Volcker, support the broad separation of bank types according to their business focus. They argue that banks must fulfill their traditional role of providing a service to the real economy, as opposed to facilitating and enabling the financial speculation that led to last year’s meltdown. The other popular school of regulatory reform in the US centres on granting the US government broad authority to separate and financially inoculate failing institutions. We refer to this group as the “regulatory hammers”. The Obama administration’s version of this reform would grant the Federal Reserve authority to regulate and supervise all large non-bank financial institutions, and involves taking control and resolving their problems outside of the bankruptcy system (how convenient). Chairman of the Senate Banking Committee, Barney Frank, differs slightly in his approach and intends to regulate all financial firms as though they were already banks, while Senator Chris Dodd (D-Conn) proposes to regulate all companies that include financial activities “in whole or in part”. All of these proposals use broad language to describe the event that would trigger a bailout or enhanced supervision, and under all proposals the government would act as ultimate saviour, with the legal authority and obligation to rescue any institution that experiences difficulty. When you’re a politician with a regulatory hammer, every problem looks like a nail. In the UK, the verbal and legislative assaults on the banks have taken a harsher tone. While the governments are proposing tighter regulation, British Chancellor of the Exchequer, Alistair Darling, has gone a step further by actually blaming the shareholders of Britain’s failed and governmentrescued banks. “Their shareholders clearly didn’t ask the right questions,” he states. “They didn’t take their stewardship seriously.”2 In a similar vein, the European Commissioner for Competition has openly criticized the shareholders who allowed the Royal Bank of Scotland to triple its balance sheet from 2006 to 2008 into a size equivalent to that of the entire German economy.3 It is indeed embarrassing that shareholders and regulators failed to notice such egregious risks, and highlights the levels of complexity that banks were allowed to reach during the height of the credit bubble. While we appreciate the efforts of these politicians and central bankers, we are hard pressed to agree with many of their proposals as they completely fail to address the root of the problem. Regulation is needed, no doubt, but both the “regulatory hammer” and “back to the future” schools avoid the real culprit plaguing the financial system – leverage. Make no mistake – the financial crisis was always about leverage. Holding toxic assets isn’t life threatening in and of itself, but if you’re levered 100 to 1 (or more), they can suddenly become a serious problem. Amazingly, the regulators almost refuse to acknowledge leverage in any way, and in doing so, have wholly undermined the efficacy of their new proposals. As Paul Krugman recently stated, “The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system… that what we’re facing is the equivalent of a run on an essentially sound bank.” This is the crux of the problem in our view. As we have argued for so many years now – the banks are too highly levered to be “sound”, and until their leverage ratios are addressed, we will continue to face the risk of another financial failure. When the crisis was in full bloom last year, there was much talk of banks “de-leveraging” their balance sheets back down to more appropriate levels. Traditionally, banks would “de-lever” by selling portions of their loan portfolios to other banks, but in 2008 there were no buyers for financial assets at any price. Over the course of the last twelve months, however, many people have assumed that the banks were steadily improving their leverage levels from those of 2008. After all – the bank stocks have all rallied dramatically since March. They must be in better shape, right? Closer inspection reveals that they’ve achieved very little in the way of de-leveraging thus far, and
2 Griffiths, Peter. (November 13, 2009). “Darling Urges Bank Bonus Reform – Report” New York Times. Retrieved on November 24, 2009 from: http:// www.nytimes.com/reuters/2009/11/13/business/business-uk-britain-darling-banks.html 3 Wheatcroft, Patience. (November 13, 2009) “U.K.’s Darling Blasts Banks’ Investors” The Wall Street Journal. Retrieved November 24, 2009 from: http://online.wsj.com/article/SB10001424052748703683804574532041838908258.html?mod=googlenews_wsj
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have merely been propped up by various forms of government liquidity injections, guarantees, outright share purchases and support from existing shareholders. In order to better explain the leverage issue, we must first clarify how we calculate it as a metric. Leverage can be measured in many ways, but our preferred choice as equity investors is to look at how much ‘tangible common equity’ supports a bank’s ‘tangible assets’. It serves to remember that the concept of ‘equity’ simply represents what you’re left with when you subtract your liabilities from your assets. We remove ‘intangibles’, such as goodwill, from this calculation because they have no real value. You cannot buy goodwill and then sell it at a profit - and under a bank bankruptcy scenario, which we have seen so often over the past year, goodwill is worth nothing. What we are interested in calculating, therefore, is how many tangible assets are supported by one dollar of tangible common equity. This number gives us an indication of how levered a common equity investor in a bank stock is to changes in asset prices. The higher the leverage, the more exposure each dollar of common equity has to a change in asset prices, and the more risk you face as an investor. Applying our definition of leverage to the current system reveals the inherent weaknesses that still exist within it, and confirms why we question the value in bank stocks. In Chart A, we apply our leverage ratio to the top five Canadian banks, top ten US banks and select European and US banks
Chart A
Bank Equity Leverage Calculations
INSTITUTION Top 5 Canadian Banks5 Top 10 US Banks6 YEAR4 2007 2008 2009 2007 2008 2009 2007 Citigroup Inc 2008 2009 Royal Bank of Scotland 2007 2008 2009 2007 Dexia SA 2008 2009 TANGIBLE ASSETS
(billions)
TANGIBLE COMMON EQUITY
(billions)
LEVERAGE RATIO 32:1 37:1 31:1 26:1 35:1 20:1 37:1 64:1 17:1 574:1 61:1 48:1 50:1 377:1 116:1
$2,122 $2,529 $2,405 $6,936 $8,139 $8,261 $2,132 $1,897 $1,854 £1,791 £2,382 £1,843 € 602 € 649 € 590
$65 $68 $76 $270 $235 $422 $58 $30 $106 £3 £39 £38 € 12 €2 €5
Source: Bloomberg, Sprott Asset Management LP
4 For 2007 and 2008 we used the annual reporting period and for 2009 we used the most recent filing as of November 15, 2009. For Canadian Banks the annual reporting period ends in October 2007 and 2008. For US Banks, Royal Bank of Scotland and Dexia SA the annual reporting period ends in December 2007 and 2008. 5 We used the top 5 Canadian Banks by Tangible Assets as reported in each respective year. 6 We used the top 10 banks by Tangible Assets as reported in each respective year.
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that have been bailed out by their respective governments. We have used their ‘tangible assets’ as reported in their respective filings, with no interpretation for asset quality – an element worth noting for our more critical readers. You’ll notice that the average leverage ratio of the Canadian banking system is higher than that of the largest US banks in all periods we reviewed. It serves to note that each of the top ten US banks received common equity injections by both shareholders and the US government, thereby improving their respective leverage ratios. Looking at the Canadian system more closely, all five Canadian banks are levered at an average of 31:1, which is actually the lowest leverage ratio during the three years that we reviewed. This implies that if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would effectively be wiped out. Now, that doesn’t mean they would go bankrupt per se, but it does give us an indication of how little asset prices would have to decline in order to wipe out their tangible common equity. These leverage ratios worry us because they leave such a razor thin margin for error on the ‘tangible asset’ side of the leverage equation. We are always cautious about investing in companies that have zero or negative common equity - we’ve seen what happens to public companies that trade at those levels, General Motors being a good example. Acknowledging the leverage levels above, you may wonder how the Canadian banks escaped the 2008 meltdown unscathed. The answer is that they received significant assistance from the Canadian government. First, they received $65 billion in liquidity injections from the Insured Mortgage Purchase Program (IMPP), whereby Canada Mortgage and Housing (CMHC) purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.7 Next, the Bank of Canada provided them with an additional $45 billion in temporary liquidity facilities. Finally, a Canadian Bank (that shall remain nameless) also received assistance from the Canada Pension Plan (CPP) through the purchase of $4 billion in mortgages prior to the IMPP program, for a total government expenditure of $114 billion.8 For reference, the entire tangible common equity of the Canadian Banks in 2008 was $68 billion. Can you put two and two together? The Canadian government injected a sum through mortgage purchases worth more than the entire tangible common equity of the Canadian banking system! On top of that, the Bank of Canada provided more than 50% of the tangible common equity of the system in emergency liquidity facilities. Mark Carney, Governor of the Bank of Canada, acknowledged this, albeit in an indirect way: “Policy-makers had to do many unpalatable things to save the economy from the financial system – a financial system that begged for mercy.”9 In Chart A we provide leverage levels for a few select banks that deserve special mention in our leverage discussion. These three banks were all bailed out by their respective governments. We’d like to draw your attention to their leverage ratios, prior and post-bailout, to emphasize the importance of leverage over time. We’ll start with Citigroup, which was de facto nationalized by the US government when it received $25 billion from the TARP program, a massive US government guarantee on $306 billion in residential and commercial loans and a $27 billion cash injection for preferred shares. You can see the impact these bailouts had on Citigroup’s leverage ratio over the years, moving it from 37:1 in 2007, increasing to 64:1 at the end of 2008 and back down to 17:1 after the government cash injections. The 64 to 1 ratio required a government bailout. One wonders if 17 to 1 is an appropriate level for Citigroup, given their exposure to high risk assets.
7 Mark Carney “Reforming the Global Financial System” Montreal, Quebec (October 26, 2009) Retrieved on November 24, 2009 from: http://www. bankofcanada.ca/en/speeches/2009/sp261009.html 8 CPP Investment Board 2009 Annual Report. Page 32. Retrieved on November 24, 2009 from: http://www.cppib.ca/files/PDF/Annual_reports/ CPPIB_2009_Annual_Report_English.pdf 9 Mark Carney “Reforming the Global Financial System” Montreal, Quebec (October 26, 2009)
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The Royal Bank of Scotland makes Citigroup’s leverage look tame in comparison. Using our definition, we calculated an eye popping leverage ratio of 574:1 in 2007, implying that a mere 0.17% decrease in assets would have wiped out their tangible common equity. Is it any wonder then that the hiccup in the housing market blew them apart? RBS now holds the distinction as the world record holder for the largest bank bailout. The UK Government has earned a 70.3% shareholding in the bank after providing them with their second bailout in November 2009.10 In total, a whopping £53.5 billion has been injected into RBS by the British Government, which is now exposed to losses on £250 billion of RBS balance sheet assets.11 In return for the government support, RBS has agreed not to pay cash bonuses to any staff earning above £39,000 in 2009, and to defer executive bonuses until 2012. Although they’ve come down since 2007, RBS still maintains a very high leverage ratio. Hopefully two bailouts by the UK government will be enough. Our final example is Dexia. It was bailed out by three separate governments and its shareholders, receiving €6.4 billion in bailout money from France, Luxembourg and Belgium in September 2008. Dexia is the largest lender to local governments in France and Belgium. According to their latest financial filings, Dexia is operating at a leverage ratio of 116:1, which strikes us as very extreme in this environment. Again – at those leverage levels, the smallest asset decrease would wipe out all tangible common equity. That’s extremely risky for an institution as large as Dexia, and highlights the problems that still plague the global financial system. The examples above show that our leverage measurement is a good variable to review before making a common equity investment in a bank. The higher the leverage ratio, the greater the risk of losing your common equity. While we haven’t delved into the asset “quality” of any of these banks, we have been watching US bank failures for a market-based indication of the quality of their assets in a liquidation scenario. High profile examples include Colonial Bank, the largest US bank failure thus far in 2009, which had total assets of $25 billion and cost the FDIC $2.8 billion in losses - representing an 11% write-down on their assets. Also notable was Chicago’s Corus Bank, which cost the FDIC $1.7 billion on total assets of $7 billion - representing a 24% write-down. For Colonial, 10:1 leverage was too high, and in the case of Corus, a mere 4:1. Citing the most recent bank failures in the US, it would appear that most financial assets are still being written down by at least 10%. Although each bank is different and has its own specific asset allocation, this raises major cautionary flags for us, given that the banks listed above still utilize leverage ratios well above 20:1. For such a seemingly complicated industry, it surprises us that such a simple red flag continues to stump the regulators who oversee it. Given the discussion above, is it any wonder why we continue to see banks receive more government cash injections and asset guarantees? And is it any surprise that banks aren’t lending the cash they were given by the central banks? Of course it isn’t. The leverage in the banking system is still too high. Judging by recent comments by finance ministers and central bankers, it is clear to us that they have no plans to address leverage in their regulatory proposals, and until they do, we would advise that you invest in bank stocks with extreme caution. Don’t say you weren’t warned.
As we go to print, some recent news headlines have highlighted excessive leverage and its associated risks. We include select excerpts on the next page.
10 The Royal Bank of Scotland Group, Regulatory Story – Number 8308B07. Filed with The London Stock Exchange on November 3, 2009. Retrieved on November 24, 2009 from: http://www.londonstockexchange.com/exchange/prices-and-news/news/market-news/market-news-detail. html?announcementId=10257526 11 Winnett, Robert, and Edmund Conway and Harry Wallop (November 4, 2009). “Bank bail-out: every family shouldering £4,350 tax liability” Telegraph. Retrieved on November 24, 2009 from: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6496295/Bank-bail-outevery-family-shouldering-4350-tax-liability.html
November 2009
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China banks prepare to raise capital
Nov. 24, 2009 (FT). China’s bank are preparing to raise tens ofs billions of dollars in additiona capital to meet regulatory re-l quirements following an unprecedented expansion of new loans this year, according to people familiar with the matter. China’s 11 largest listed banks will have to raise at least Rmb300bn ($43bn) to meet more stringent capital adequacy requirements and maintain loan growth and business expansion, according to estimates from BNP Paribas. China’s banking regulator “is definitely aware of potential asset quality issues and is pushing for higher capital adequacy requirements to offset deterioration in asset quality”, according to Dorris Chen, an analyst with BNP Paribas. 14
Nov. 23 (Bloo mberg) -- Inter national Monetary Fund Managing Direc Dominique St tor rauss-Kahn sa id that about half of bank losses fro m the global financia l crisis have ye t to be revealed. “It is our view we are in the situation still where a lot of losses haven’t been dis closed,” StraussKahn said during qu estions at the Co nfederation of British Industry’s conf erence in London today 16 .
Strauss-Kahn Says Half of Bank Losses A Undisclosed re
Bank of England reveals £61.1bn spent propping up RBS and HBOS
The Bank of England today revealed for the first time that it spent £61.6bn propping up RBS and HBOS in the height of the global financial crisis last autumn. Governor Mervyn King detailed the emergency loans, which it made in its role as “lender of last resort” in a submission to the Treasury select committee.13
t Says CB’s Tricheure To E t It’s Prema isis Over Declare Cr ropean Central
Dominique Strauss-Kahn told the CBI annual conference of business leaders that another huge call on public fina nces by the financial services sector would not be tolerated by the “man in the street” and could even threaten democracy. “Most advanc ed economies will not accept any more [ba ilouts]...The political reaction will be very strong, putting some democracies at risk,” he told delegates.17
IMF warns second bailout would ‘threaten democracy’
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12 Evans-Pritchard, Ambrose. (November 24, 2009) “Most global banks are still unsafe, warns S&P” Telegraph. Retrieved on November 24, 2009 from: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6638922/Most-global-banks-are-still-unsafe-warns-SandP.html 13 Hopkins, Kathryn and Jill Treanor. (November 24, 2009) “Bank of England reveals secret £62bn loans used to prop up RBS and HBOS” Guardian. Retrieved on November 24, 2009 from: http://www.guardian.co.uk/business/2009/nov/24/bank-england-rbs-hbos-loans 14 Anderlini, Jamil. (November 24, 2009) “China banks prepare to raise capital” Financial Times. Retrieved on November 24, 2009 from: http://www. ft.com/cms/s/0/6f635a3a-d8f8-11de-99ce-00144feabdc0.html?nclick_check=1 15 (November 23, 2009) “ECB’s Trichet Says It’s Premature To Declare Crisis Over” RTT News. Retrieved on November 24, 2009 from: http://www. rttnews.com/ArticleView.aspx?Id=1138342&SMap=1 16 Hamilton, Scott and Sandrine Rastello. (November 23, 2009) “Strauss-Kahn Says Half of Bank Losses Are Undisclosed (Update1)” Bloomberg. Retrieved on November 24, 2009 from: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ay2MiTrFzQYI 17 Jameson, Angela and Elizabeth Judge. (November 23, 2009) “IMF warns second bailout would ‘threaten democracy’” Times Online. Retrieved on November 24, 2009 from: http://business.timesonline.co.uk/tol/business/economics/article6928147.ece
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