Credit Suisse Buries China's Banks
Wonder why China just bailed out its banks, preemptively, on Monday? Here's why. In a report issued by Credit Suisse's Sanjay Jain, the China strategist, who joins such now infamous skeptics as Bank of Countrywide Lynch's David Cui, has revised his base case Non Performing Loan ratio forecast from 4.5%-5.0% to 8.0%-12.0%: a unprecedented doubling in cumulative losses. Why unprecedented? Because as he explains, this could "would work out to 65–100% of banks’ equity." Crickets? Yes, Credit Suisse just singlehandedly said the equity value of the entire Chinese banking system is between 66% and 100% overvalued (with a downside case of $0.00). So for those putting two and two together, on one hand we have the four horsemen of the Chinese apocalypse, already presented visually before by Bank of America, consisting of i) a surge in underground lending, ii) a property downturn, iii) bad bank debt and iv) and "hot money" outflows, and on the other we have the vicious loop of what this means in terms of a central planning reaction. Simply said look for China to scramble to undo all the signals that it had been trying to spark while it was fighting with the Fed-inspired inflation bubble. Only problem is that like in the US and Europe, finding the Goldilocks point where all 4 are in equilibrium will be next to impossible, especially if investors in the country's banks realize the equity they hold is worthless and scramble to get the hell out of Dalian. Then the fears over a parliamentary vote in Slovakia will seem like a pleasant walk in the park.
Summary from Credit Suisse:
How bad could things get?
A view on China’s banks is completely a call on the potential impairment. Hence, we attempt here to dig deeper into the various sources of credit risk, both on- and off-balance sheet. Real estate, manufacturing, local government and SMEs are the four main sources of risk. They account for about 55% of the loan book, in our view, and are expected to contribute more than 80% of potential NPLs. We revise our overall NPL ratio forecast to 8.0–12.0% (from 4.5–5.0% earlier) of loans in the next few years, and NPLs would work out to 65–100% of banks’ equity. Still, we note that this is at best an estimate, and the impairment range could vary, depending on the economic growth and backdrop.
Assuming a loss ratio of 60%, typically the case in many banking crises, the potential loss on the revised NPL range would be 40–60% of the equity in the banking system. At the individual bank level, we recognise the differences (ABC and Minsheng have the highest real estate exposure, BOC and CITIC have grown real estate the fastest, Minsheng has lent the most to small enterprises and has the highest exposure to real estate and local government, etc.). However, we believe they are operating in the same environment and the margin of error would not be significant if we apply the 8–12% NPL range. The results are largely similar, with potential loss being 40–60% of their equity.
What is the market pricing in?
Using the Gordon Growth Model and current P/B, we estimate the market-implied ROE for each bank. Then we back-calculate the market-implied credit cost, which works out to 170–180 bp annually. This corresponds to incremental NPLs of 3.0% of loans every year.
Introducing price-to-adjusted book
How to value banks when we cannot rely upon the earnings and, possibly, even the book value? If we apply our base case range of 8–12% NPL ratio, the price-to-adjusted book would work out to 1.6–2.1x using consensus profits for 2012E. As a corollary, every 1% NPL ratio jump would shave off roughly one-fifth of the profits, and NPL ratio rising beyond 5% would wipe out the consensus-projected profits for 2012E.
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