De-leveraging redux

Yesterday, in a post entitled “De-leveraging,” I argued that credit writedowns and the resulting deleveraging are highly deflationary. This is the core of the problem with the global financial system. I want to expand a bit on that conversation.

Yesterday, I kept it simple to illustrate the problem with leverage and the need for companies to de-leverage. My discussion of gearing and leverage for financial institutions was a bit facile because I did not talk about tiered capital or FAS 157, which are two important concepts for understanding the fragility of the banking system.

Tiered Capital
Not all equity capital is the same. Some equity is better than others. Therefore bank regulators look at Tier 1 and Tier 2 capital ratios in addition to the overall level of gearing to asset capital adequacy levels of banks. Wikipedia says the following:

The Tier 1 capital ratio is the ratio of a bank’s core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country’s Central Bank). Most central banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.

So, what you basically see here is that regulators do not treat all equity the same, nor do they treat all assets the same. Tier 1 capital is better than Tier 2 capital and cash is better and more liquid than debentures, bonds or structured products. Therefore, what regulators see as the core capital ratio for banks is the ratio of Tier 1 capital to total risk-weighted assets.

Tier 2 capital is worth less than Tier 1. An example would be undisclosed reserves or revaluation reserves, where the bank holds assets which have appreciated considerably in the open market at book value on its balance sheet. These are unrealized gains that would accrue to the bank were the bank to sell those assets.

The problem with these reserves is that asset values rise and fall. Japanese banks had huge levels of undisclosed and revalued reserves in the 1980s and early 1990s. However, as land, property and stock market values fell, the Japanese banks looked increasingly undercapitalised. Their Tier 2 capital vanished. In many cases, reserves turned into unrealized losses.

Tier 2 capital can also includes some hybrid equity like convertible debentures as well as some subordinated term debt. But, on the whole Tier 2 capital is riskier than Tier 1.

Common capital ratios can be found below:

• Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6%
• Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-adjusted assets >=10%
• Leverage ratio = Tier 1 capital / Average total consolidated assets >=5%
• Common stockholders’ equity ratio = Common stockholders’ equity / Balance sheet assets

–Capital Requirements, Wikipedia

Listed below are the capital ratios in Citigroup at the end of 2003 [1].

(1) Tier 1 capital divided by adjusted average assets.

–Capital Requirements, Wikipedia

To be considered w
ell capitalised, a bank needs far more than just 6% Tier 1 capital.

ANZ, an Australian bank, has a good financial dictionary on its website that defines how the bankers’ bank, BIS, sees this.

Capital adequacy

A key principle in bank supervision which regards capital as the cornerstone of a bank’s strength. The Bank for International Settlements (BIS) devised a risk-weighted framework for bank capital adequacy which has been adopted in all OECD countries. Under these guidelines, banks must hold a minimum of 4 per cent of risk-weighted assets (ie, weighted for credit risk) as ‘core’ (Tier 1) capital and a ratio of total capital (Tiers 1 and 2) of no less than 8 per cent of risk-weighted assets. Tier 1 capital consists of paid-up ordinary shares, non-repayable share premium account, general reserves, retained earnings, non-cumulative irredeemable preference shares and minority interests in subsidiaries. Tier 2 or supplementary capital includes general provisions for doubtful debts (subject to a limit), asset revaluation reserves, cumulative irredeemable preference shares, mandatory convertible notes and similar capital instruments, perpetual subordinated debt and redeemable preference shares and term subordinated debt (up to a limit). Tier 1 capital must always exceed Tier 2. The BIS is proposing to adjust the minimum capital requirement to capture market risk.
–ANZ website, Financial Dictionary

Asset weighting
ANZ also defines how assets are weighted on a balance sheet to come up with the risk weighted asset denominator of capital adequacy ratios.

Risk-weighted assets

Assets which are weighted for credit risk according to a formula used by the Reserve Bank (and other OECD central banks which conform to the BIS’s capital adequacy guidelines). On and off-balance-sheet items are weighted for risk, with off-balance-sheet items converted to balance-sheet equivalents (using credit-conversion factors) before being allocated a risk weight. Risk weights are in five categories, from zero to 100 per cent. Those carrying a zero weight include notes and coins, gold matched by gold liabilities, balances with the Reserve Bank and commonwealth government securities with less than twelve months to maturity. Commonwealth government securities with more than twelve months to maturity carry a 10 per cent risk weighting, as do state government securities. Claims on other banks, Australian local governments and public-sector organisations, other than those with corporate status or which operate commercially, carry a 20 per cent risk weighting. Loans secured by a mortgage over residential property and with a loan-to-valuation of 80 per cent or less carry a 50 per cent risk weighting and loans to companies or individuals carry a 100 per cent risk weighting.

–ANZ website, Financial Dictionary

So, that rounds out the concept of capital ratios. What about FAS 157?

FAS 157
FASB (the Financial Accounting Standards Board) is the U.S. accounting group that delivers edicts that U.S. listed companies must follow in order to meet U.S. accounting standards under U.S. GAAP (Generally Accepted Accounting Principles). What they say goes in U.S. accounting. (This is the same group that roiled technology stocks when it issued an FAS123R to begin expensing employee stock options). They issue edict called
FAS numbers, which update accounting standards in the U.S. to new guidelines.

They issued an edict called FAS 157 that went into effect on 15 November 2007, that has major implicatins for how banks riskiness is viewed by investors. The day the edict went into effect of the edict, the Wall Street Journal described it like this:

Many investors, thanks to the banks’ early adoption of FAS 157, have already become pretty familiar with its disclosures based on what are called Level 1, 2, and 3 assets. These buckets are meant to show investors the amount of certainty that pertains to the valuation of a financial asset.

Level 1 is assets that have observable market prices. Think a stock traded on the NYSE. Level 2 assets don’t have an observable price, but they have inputs that are based on them. Think an interest-rate swap where its components are observable data points like the price of a 10-year Treasury bond.

Level 3 is for assets where one or more of those inputs don’t have observable prices. This is the bucket that has been described as a guesstimate, because it is reliant on management estimates. As things stand now, companies who haven’t early adopted FAS 157 don’t give this more detailed breakdown to investors. So, one result of FAS 157 is more information.

That has prompted investors to pay more attention to the way companies price hard-to-value Level 3 assets. In that sense, FAS 157 isn’t forcing companies to write down prices because of the current market turmoil. It is more a case that the new disclosures will cause investors, and regulators, to ask a lot more questions if it looks like a company isn’t taking adequate writedowns.

One other change is that FAS 157 makes it clearer that companies, if they have to value something using a model, have to think in terms of the value that would result if they were selling, or exiting, the position. In other words, they have to take current market pricing and conditions into account.

–Wall Street Journal, 15 Nov 2007

This edict is at the core off problems for financial institutions, particularly investment banks like Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch. These institutions have large amounts of Level 3 assets, meaning their balance sheets are rather opaque and subject to surprise massive writedowns when these market dislocations occur.

Conclusions
So, that’s the story of deleveraging in a nut shell. Financial institutions have either too little capital and risk credit downgrades like the ones we saw two days ago. Or they have way too much Level 3 assets on their balance sheet – risky, junky assets that are hard to value. Or both.

This is why you see financial institutions going cap in hand to Sovereign Wealth Funds for additional capital. This is why Bradford & Bingley was so distressed it needed to sell equity at a huge discount to TPG, the American buyout shop. This is why Bear Stearns went under and why Lehman Brothers is being scrutinised.

Finally, in a world of deleveraging — where banks are looking to dump Level 3 assets at any price and raise additional capital now — credit is hard to come by. And it is this credit crunch that is the worry. Credit crunches have an unpleasant way of becoming depressions.

Sources
Tier 1 Capital, Wikipedia
Tier 2 Capital, Wikipedia
Capital Requirements, Wikipedia
Citigroup financial statements, Citigroup website
Financial Dictionary: The Language of Money by Edna Carew, ANZ Bank website
Summary of Statement No. 157, FASB website
Level 3: An Investors’ Guide, WSJ, 2 June 2008
Goldman, Morgan Stanley Hit `Level 3′ Jackpot, Bloomberg News, 23 Apr 2008
Hardest-to-value assets escalate, WSJ, 15 Apr 2008
Swiss banking chief says banks need capital cushion, less debt amid credit crisis, IHT, 23 May 2008
City Focus: RBS rolls with the punches, This is Money UK, 29 February 2008
UK banks are cheap if you look ahead, Telegraph, 3 April 2008

See the Credit Crisis Timeline for a full list of writedowns by institution.