In 2006, Wachovia had a market capitalization of $88 B USD and was the 3rd largest US bank. By July 2008 this sank to $33 B even though shareholder equity was $75B and Tier 1 capital ratio was 8%. In other words the market valued Wachovia at 50 cents for every dollar invested by Wachovia’s shareholders.
By end of Sept Wachovia was kaput and was forced to sell its banking operations to Citigroup for $2B. Citigroup paid Wachovia’s shareholders less than 3 cents for every dollar they had invested into Wachovia’s Tier 1 capital. That’s a destruction of $73 B in shareholder equity in under 2 years. Even with the subsequent higher offer from Wells Fargo, Wachovia’s shareholders realized less than 30 cents on the dollar.
Wachovia’s downfall was triggered by a bad acquisition of Golden West’s mortgage business that resulted in Wachovia holding $122 B in crazy mortgages. Although Wachovia had almost $1 Trillion in “assets” it really only had $75 B of invested capital to cover $122 B in suspect loans. Ooops.
The market cap of Wachovia was less than the shareholder equity and was a clear signal from the markets that the majority of those loans were bad.
Meanwhile the largest bank in Canada is the Royal Bank of Canada with a current market cap of $63 B and also has a “solid” Tier 1 capital ratio of 8%. Total shareholder equity is only $29 B. So far the market is expressing confidence in the “asset” quality of the bank since the market cap is greater than total shareholder equity by about 2:1.
In theory, the top 3 banks in Canada could vanish as fast as Wachovia since their total shareholder equity combined is less than the $73 B destroyed in the Wachovia collapse. The risk currently appears low as the smallest of the Canadian banks by market cap is the Bank of Montreal with a market cap of $33 B and total shareholder equity of $18 B. Not quite 2:1 but not bad – even though the BMO’s tier 1 ratio is 9.9% (stronger than RBC).
So far so good, but let’s bear in mind that a top rated capital ratio of 10% means that the bank is still 90% leveraged! As long as deposits exist to cover this leverage, and as long as the depositors are willing to trust the bank with those deposits, the bank will be strong.
The key leading indicators of bank stability are deposit ratio and shareholder equity to market cap. If these are insufficient – watch out!
Tier 1 Capital Explained
The Tier 1 capital ratio is the total amount of “assets” managed by the bank divided by the amount of money actually invested by shareholders in the bank plus the cumulative retained earnings made by the bank. A ratio of more than 6% is considered good by international banking standards and a ratio of 8% or higher is considered “excellant”.
Since banks loan money, the debt owed to them is considered an “asset” even though in the real world it is actually a liability from the perspective of the borrower. Since it is no fun to only lend money you actually have, even though your savings deposited into the bank are actually liabilities owed by the bank to you, banks also count them as “assets” because they are used to provide the funds for the loans made.
Banks are allowed by law to lend up to 25x more than what is actually invested into the bank. If the Tier 1 ratio is 8%, then the banks actually owe 12.5x more money than is actually invested.