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Sprott November Commentary: Massive Bank Leverage Is Still A Ticking Timebomb
Eric Sprott concludes simply that nothing has changed, with the neutron bomb just waiting a Dubai-type event for everything to go back to Lehman levels:
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 have merely been propped up by various forms of government liquidity injections, guarantees, out-right share purchases and support from existing shareholders.
Some of the most prominent landmines just waiting to be tripped on:
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.
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.
And since nobody cares about any facts anymore with the Fed backing up each and every form of risk, in perpetuity, from here to the Persian gulf, here is a reminder of what leverage is:
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.
h/t Joel
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goddammit *it-always-sunny-in-Philadelphia*
Cheeky! You bastard, where have you been? Hope you're OK? They were saying you were kidnapped by aliens but I kept on insisting you ARE an alien.
Hope all is well my friend. :>)
jail
http://www.youtube.com/watch?v=nwX-aZixthM
serious question: with leverage so scrotum-tighteningly high, how does on reduce it other than through collapse?
This. And nothing else.
Only few moves you can make with fractional reserve. Let it collapse a bit put it back together. Massively inflate it to correct. As it runs the banking system just gets more and more levered until its too dangerous to let people take thier deposits out. It creates a mountain out of a molehill and either you make the hyperbole a super duper real thing or fudge it down to something thats not so distorted that it doesn't make everyone scratch thier heads too much.
Problem is that each time it happens you give people the eyes to see it. And you can't put them back into the illusion box. More and more people knowing the true value of everything causes either more corruption or more revolt.
Dear Mr. Bank Holding Company, please put the mark-to-market leverage ratio in the center of the first 10-Q page in huge letters.
Thanks.
From the article, Leverage ratio: how much ‘tangible common equity’ supports a bank’s ‘tangible assets’.
No problem, all I have to do is find out the current market asset price and off-balance sheet risk exposure to the BHC 'tangible assets'. Perhaps easier after the first of the year when hopefully FASB rules reflect reality.
OK so we are we at.
The FED MBS buy ending in the first quarter 2010 (at least thats what they said), and it has been proposed that the leverage ratio is still too high to withstand any further decline in base asset prices (residential and commercial RE).
FHA + home buyer credit, seen as the new subprime, also ending in mid 2010. Obvious effort to influence real estate prices through government backed cheap credit.
It is clear that the FEDs present era of non-systemic risk bank aid will be reactionary. That is, no additional action taken unless there is a significant event of some sort.
OK so what will break first?
Which BHC of significant size bites it first, and runs again to mama FED? What will the FED do?
Mark Beck
Cash and cash equivalents.
illiquid mortgage backed securities.
illiquid credit card debt.
illiquid commercial ventures.
illiquid commercial paper.
These are cash equivelants to the financial industry. Only problem is that if they put them in conversion motion the value of everything implodes into a black hole. So they have to hang on to them until such time as psychology can match the illusion of value. When dot com equity toilet paper became a cash equivelant people should have known that bad cash creates worse equivalents.
Yup, those bank failures, one would presume, are really about those individual banks who aren't "big enough" - or diabolical enough, or cagey enough, to know how to roll over their unpayables --- after all, that is the reason behind credit derivatives trading (along with the primary reason of ultra-leveraging).
And the rest continue to use those bailout funds - from a variety of sources now - for stock market (and other market) arbitrage, commodities speculation -- in other words, to continue rolling over their unpayables.
And the beat goes on.......
Sprott is long, long, LONG gold and wants to convince you the world is coming to an end. That's exactly what he told me when I met him back in 2003. Smart guy but I see he hasn't changed his tune.
Leo: so if I invested say $10k in one of his gold funds back in 2003 how would I be doing today? (I suspect not so great http://www.sprott.com/Docs/Performance/gold.pdf)
Separately did you notice that the Caisse has some exposure to Dubai? and to think I always associated La Belle Province and sun destinations with exotic locals such as Hollywood FL.
I think the world as we knew it in 2003 has pretty much ended.
indeed. However, that doesnt make him incorrect. In late 2006 he wrote the inciteful if not groudbreaking piece called "Too Much Finance" and about 3 montths later the entire Cdn financial sector (to say nothing about the U) declined by about 60%. He was correct then and I think could be correct now.
Trying to see how that observation is anything other than great foresight on his part.
And speaking of leverage, if governments have weak hands and need to refinance at the expense of bank customers, how will assets (loans, securities) perform ? And by implication, how solid are blocks of tangible equity if these assets could gap down ?
Bank leverage should be hitting all-time lows considering this plight of the public sector.
Leo,
He is no "stopped clock", but rather, "spot on"!!
Well, leverage is leverage. Maybe Sprott's calculations are wrong, or maybe they're not. It seems like leverage north of 20:1 (and in some cases a lot more than 20:1) would qualify as "risky" no matter who does the analysis. And, these are ratios using lots of assets that have make-believe values. We shouldn't worry about this because we have a helicopter force that can fly day and night in all kinds of weather.
Sprott made huge returns back in 2001 by going short technology/ long gold. He's very smart and when he has conviction, he goes for it. But he has also suffered huge drawdowns because he's basically directional and vulnerable in good years when markets hum along. I'd be curious to see how he performs in 2009 and more importantly 2010 and beyond.
Technical analysis suggests this bear market rally is topping out and the Dollar will rally.
http://www.zerohedge.com/forum/market-outlook-0
yo
email me
show me what you have.
i have a few interesting charts as well
jamesbrrando@gmail.com