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.