Investors Can't Bank on Capital

by Dollars and Sense

Interesting commentary from Bloomberg; hat-tip to Larry P.

Commentary by David Reilly (Bloomberg)

Jan. 28—Sheila Bair shouldn't try to jawbone these markets.

The head of the Federal Deposit Insurance Corp. declared during a television interview last week that "98 percent of all banks are well capitalized."

Technically, she is right, since regulatory capital is different from shareholder equity. Still, that's a nuance lost on most of the public and one that doesn't adequately reflect just how bad things are at banks.

Even as Bair was speaking, debate was brewing in government circles over the possibility of having to nationalize banks. It doesn't get much bleaker than that.

Bair needed to reflect in her comments more of a sense that all isn't well, even if in language that didn't panic investors or cause a bank run.

That may sound like semantics. It isn't.

In July 2008, then-Treasury Secretary Henry Paulson and other government officials reassured the public that Fannie Mae and Freddie Mac had adequate regulatory capital.

Plenty of mom-and-pop investors took those declarations to heart and held onto their stock in the mortgage giants. About six weeks later, those same investors got whacked when Paulson placed Fannie and Freddie under government control.

Even if the outcome isn't as grim this time around, Bair's talk of banks being well-capitalized runs the risk of lulling investors. She may also have underscored what many investors consider to be the inadequacy of capital measures and the need for changes to these measures.

Capital Overstatement

Consider Tier 1 ratios, a key regulatory measure of a bank's financial strength that compares Tier 1 capital to so-called risk-weighted assets. Banks must have a Tier 1 ratio of 4 percent to be adequately capitalized and a ratio of 6 percent to be considered well-capitalized.

At the end of last year, Citigroup Inc. had a Tier 1 ratio of 11.8 percent and Bank of America Corp.'s was 9.15 percent. Yet both have needed huge amounts of government support.

Why doesn't this distress show up in the Tier 1 ratios? Because Tier 1 capital can contain what investors now consider fluff.

"The definition of capital for the banking world has been confused over the last 20 years as the government regulatory bodies have counted various long-term funding sources as capital," Paul Miller, a bank analyst at Friedman, Billings, Ramsey & Co., wrote in a Dec. 3 research report.

Debt in Disguise

Preferred stock is an example. Normally preferred stock wouldn't be such a concern since it is typically only a small portion of a bank's total equity.

At the end of 2007, for example, Citi didn't have any preferred stock outstanding. That's no longer the case.

The government has taken $52 billion of preferred stock in Citigroup. This is more than two times the bank's tangible common equity and about three times its market capitalization.

That is troubling because the government preferred, while offering a lifeline, isn't capital in the traditional sense. The dividend on the preferred increases after five years, meaning banks that received this assistance will eventually have to buy out the government. That makes the government preferred more akin to debt.

"That's the problem. It's a loan and they're calling it Tier 1, but the market doesn't think it's Tier 1," said Chris Senyek, tax and accounting analyst at research firm ISI Group. "They couldn't issue five-year paper to private investors and get that to be counted as Tier 1 capital."

Deferred Assets

Besides preferred stock, banks also count in their Tier 1 capital certain hybrid securities that have equity-like characteristics but actually are debt.

These accounted for $18.4 billion of BofA's $100.3 billion in Tier 1 capital at the end of the third quarter, the last period for which a detailed breakdown of regulatory capital is available.

Losses on certain holdings, mostly mortgage-backed securities, that banks claim are temporary are excluded from Tier 1 capital. That has a flattering effect; Citigroup in the third quarter excluded $6.2 billion of such losses.

Banks can also get credit in Tier 1 capital for a portion of what are called deferred-tax assets. These could one day be used as a tax offset. Their usefulness is far from certain, though, given banks' greatly reduced profitability. This makes these a pretty airy asset.

All of this can leave Tier 1 measures looking fatter than metrics based on tangible common equity. No surprise, then, that investors are giving up on regulatory capital and turning to this measure, which takes common shareholder equity and subtracts goodwill and other intangible assets.

Running Lean

On that basis, many banks look a lot worse than their Tier 1 ratios suggest. According to an investment presentation made by Citi yesterday, a group of nine large banks (Citi included) had average tangible common equity ratios of 2.1 percent versus average Tier 1 ratios of 10.2 percent.

Even worse, the 8.1 percentage-point difference between the two rates compares with a spread of just 5.3 percentage points in 2006, according to Citi.

Those aren't the kind of figures that leave investors feeling warm and fuzzy about big banks, no matter what the FDIC's chairwoman says.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

Labels: Bank of America, banking system, capitalization, Citigroup, FDIC, Sheila Bair

 

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1/29/2009 11:10:00 AM