Canadian and British banks find access to capital markets

Since Lehman Brothers declared bankruptcy in September, the capital markets have been all but shut to large banks globally. Investors were spooked by the evisceration at Lehman, Washington Mutual and Wachovia to name but a few cases of near total losses. As a result, many banks have been forced to go cap in hand to the government for a bailout in order to bolster their balance sheets. Apparently, a thawing could be in the offing as more and more banks are selling shares to investors. The latest two are HSBC and CIBC.

In HSBC’s case, it has been hotly debated whether HSBC actually has a strong balance sheet ever since Morgan Stanley called this into question.

Is HSBC’s $17.7 billion rights issue a sign of weakness or of strength?

THERE are two radically different tales doing the rounds about HSBC, Europe’s biggest lender by market value. The first says that HSBC, deep down, is still an emerging-markets operation run by rugged types who disdain the sorcery of modern finance. Under the temporary grip of an evil spell in 2003 they bought Household, an American consumer-credit firm that then haemorrhaged losses. On March 2nd they snapped out of it. HSBC’s chairman acknowledged that it was “an acquisition we wish we had not undertaken”, wrote off its cost and promised to run down its book of dodgy loans. Having opened its heart, HSBC felt able to lower its dividend and raise its core tier-one capital ratio to 8.5%, above those of JPMorgan Chase (6.4%) and Santander (7.2%), two more of the Western world’s biggest banks also vying for the title of the safest one.

Against this there is a horror story. It says that HSBC’s definition of capital excludes mark-to-market losses on asset-backed securities (ABS). Furthermore, particularly demanding critics say that it also excludes mark-to-market losses on its loan book. Like almost all banks, HSBC carries these at book value and impairs as customers default. However, include both these items and the core tier-one ratio would drop to just 2%. Treating loan books on the same basis, JPMorgan would be at 5% and many other banks would be insolvent.

This would suggest that HSBC is in fact poorly capitalised, and needs to raise even more equity. The alternative, advocated by, among others, Knight Vinke, an activist investor, would be to cut loose Household, which HSBC does not legally guarantee and which accounts for just over half of the additional mark-to-market losses. Household’s credit spreads are much higher than HSBC’s, suggesting that investors think this is possible, despite HSBC’s verbal assurances to the contrary.

Which story is right? Given the risk of litigation, the reputational hit and the fact that HSBC has itself loaned Household some $13.5 billion, its mark-to-market loss would have to get a lot worse before HSBC was prepared to let it default. And like many banks, HSBC argues that there is at least some chance mark-to-market losses overstate the ultimate impairments it will face. The ABS loss has been very volatile, doubling in six months and stands at ten times HSBC’s “stress test” estimate of the probable hit. The mark-to-market loss on Household’s loan book is double what optimistic analysts think the likely ultimate impairment will be.

Pleading that fair-value accounting is cruel is hardly unique, but what makes HSBC’s position more credible than most is that it has the capacity to wait and see. Its funding position is excellent with deposits exceeding loans, reducing its dependence on wholesale markets. And the core business continues to generate lots of pre-provision earnings. If spread out over several years, the bank could absorb the hit from Household implied by the mark to-market valuation without damaging its capital.

Indeed the real moral of the tale is different. Compared with other banks HSBC is protected by its big deposit base and its profitability. It looks therefore as if investors will back the rights issue. Others do not have even that comfort.

Edward here. The HSBC story demonstrates the murkiness infecting the global banking system, because even the best of institutions must be doubted until zombie banks are liquidated or restructured.

I remember I had a very negative reaction to the Household International deal when it was announced. Here was a top tier bank buying into sub-prime; it seemed like a total mismatch.  And this deal has blown up in HSBC’s face.  After all, HSBC started the whole daisy chain of writedowns because of Household way back in February of 2007.  How do we know more isn’t lurking underneath?  That is the problem with not clearing away the bad assets — everyone comes under suspicion.  If the like of JPMorgan Chase and HSBC are called into question, no large financial institution can be considered safe. This is bad for the proper functioning of credit markets.

CIBC presents another case altogether. The Canadian banking system is considered the best in the world as Marshall Auerback likes to remind me. Nevertheless, a bubble in housing and a downdraft from the U.S., Canada’s largest trading partner are bound to have a deleterious effect on Canadian banks’ balance sheets. CIBC, one of the smallest of the big five Canadian banks, has decided to act.

Canadian Imperial Bank of Commerce (CM.TO) said it will issue C$1.6 billion of Tier 1 notes through its CIBC Capital Trust unit in a move to bolster its capital ratios and balance sheet strength.

The bank said the offering includes an issue of C$1.3 billion of Tier 1 notes with a 9.976 percent yield until June 30, 2019, and C$300 million of Tier 1 notes with a 10.25 percent yield until June 30, 2039. Both notes are due June 30, 2108.

CIBC, which was hardest hit by the credit crisis among Canadian banks, said the proceeds will be used for general corporate purposes and are expected to qualify as Tier 1 capital. A bank’s Tier 1 ratio is considered a key measure of its financial strength.

Canada’s banks, which have been ranked as the world’s soundest as the global financial crisis ravages their international peers, have nevertheless been shoring up their balance sheets by issuing preferred and common shares.

With this and other recent financing, the bank’s pro-forma Tier 1 capital ratio at Jan. 31, 2009 would be about 11.5 percent, CIBC said.

The regulator of Canada’s financial institutions requires domestic banks to have a Tier 1 capital ratio of at least 7 percent, but the average is around 9.5 percent.

We could be seeing a potential return to the capital markets for global financial institutions if these deals go well. Certainly, the likes of Citigroup are probably not getting capital from anyone but the U.S. government. However, we should hope stronger institutions do find alternative funding sources available.

Sources
HSBC’s rights issue, Household chores – The Economist
CIBC to issue C$1.6 bln of Tier 1 notes – Reuters
HSBC may need $30 billion: Morgan Stanley – Reuters

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