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Yet Another Huge Bank Failure in the USA

Jan 13, 2009
Economic Reality

Up until last year, CitiGroup was the largest bank in the USA and in the top 3 globally.  Now Citigroup is breaking itself up as it desperately tries to avoid total collapse:

  • Citi is selling its Smith Barney brokerage and investment business to Morgan Stanley so that it can raise $2.7 B in emergency cash.  Citigroup is selling 51% of Smith Barney now followed potentially by another $2.5 B to follow within 5 years if Morgan Stanley decides to expand its ownership of Smith Barney.
  • Citi is also jettisoning 1/3 of its loan book by spinning off $600 B in bad “assets” into a seperate “bad bank” that can be further broken-up and sold off to the US government and other high-risk junkyard investors.

To put the size of this spin-off in a Canadian perspective, the resulting “bad bank” will have 50% more “assets” than the total assets of the Bank of Montreal and slightly more “assets” than the TD Bank.

The $1.2 T magnitude of the 2009 US economic bailout is approximately equal to the size of the entire Canadian GDP.  According to Statistics Canada, the Canadian economy is dependant on exports for 45% of this GDP and 76% of those exports are based on trade with the USA.  However, Canada’s trade surplus is currently plumeting with November 2008 exports running at 50% less than September’s export volume. 

The worst of the fallout has still to hit the Canadian economy and ultimately Canadian banks.  Given the rate of erosion of exports, this will likely occur within 90 days if the balance of trade dips negative.  

In the last 6 months, the largest (Citigroup) and thrid largest (Wachovia) banks in the USA have crumbled – anyone who thinks that the Canadian banking industry is immune to these issues is simply not in touch with reality.

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Is The Bank of Montreal About To Fail?

Dec 24, 2008
Economic Reality

Danger Signals

On December 15, the Bank of Montreal successfully issued a round of new common and preferred shares to raise $1 Billion in shareholder equity.  This pushed the BMO’s Tier 1 ratio to 10.4%.

However, to sell this equity the BMO had to price the common shares at a 9.5% yield!  Danger Signal #1 is a yield that is significantly above the rate that investment grade securities are priced.  For example, Enbridge is priced to yield 3.8%, Transcanada Pipelines at 4.4%, Manulife at 5.5%.

Danger Signal #2 is that other peer banks have yields that are priced considerably lower.  For example, the Royal Bank is priced to yield 5.8%, TD is at 6%, Scotiabank at 6.5%, CIBC at 7.3%.  They average 6.4% , or 1/3 lower than the BMO.

Danger Signal #3 is that the total BMO market capitalization ($14.9 B) is now less than shareholder equity ($17.9 B).  In other words, the BMO is worth less than the amount that shareholders invested in it and regardless of the high Tier 1 ratio, the Bank is worth considerably less than its Tier 1 equity.

When this happened to Wachovia in July 2008, the bank failed in Sept.  When Wachovia failed, its total shareholder equity was $73 B – almost 5x that of BMO.   Wachovia failed quickly – within 90 days.  On Oct 28, the BMO’s market capitalization was $33 B.  Today the BMO is worth half that amount.

BMO's Bad Assets

According to the BMO’s 2008 Financial Report, the BMO is carrying about $8.7 B in bad assets – fully half of its market capitalization:

  • Bad loans total $3.7 B.  Of significant concern is that $2 B of this amount is so-called “formation of new impaired loans” – i.e. was suddenly added in 2008 alone.  Half of these new impaired loans are attributable to losses in the manufacturing sector and in US real estate.
  • Collateralized debt and loan obligations total $4.5 B.  Most of this is hedged with other banks which is great in theory as long as there is no counter-party risk.  However, in October inter-bank lending actually dried up due to fear of counter-party risk!
  • Subprime mortgages and asset backed securities total another $0.5 B.

The BMO also has $99 B in off-balance sheet credit loaned to its clients.  If only 10% of these default, then the total bad loans of the bank will double.  Remember Enron?

The final straw that broke Wachovia’s back was when bad debts equalled more than the paid in equity of the bank.  When that happens, the bank is insolvent.  The BMO is halfway there!  If its market capitalization falls by another half in another month, or if 10% of its off-balance-sheet lending defaults, or if some combination of these two events occur, the First Canadian Bank will be history.

Other CDN Banks

A quick health test of the other Candian banks shows that they are in much better shape than the BMO:

  • Royal Bank has a
    • market cap of $45.5 B which is almost 2x shareholder equity at $24.4 B.
    • yield of 5.5% which is below the peer group average for Canadian banks
  • Scotiabank has a
    • market cap of $29 B which is 1.5x shareholder equity at $18.8 B
    • yield of 6.5% which is roughly equal to the peer group average
  • CIBC has a
    • market cap of $18.5 B which is 1.3x shareholder equity at 13.8 B
    • yield of 7.3% which is above the peer group average (suggesting risk)
  • TD has a
    • market cap of $33.4 B which is slightly more than shareholder equity at $31.6 B
    • yield of 6% which is below the peer group average.

 

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Could Canadian Banks Vapourize As Fast As Wachovia?

Oct 28, 2008
Economic Reality, Political Reality

Yes!

Wachovia
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.

Canadian Banks

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.

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