More Bank Failures are Coming

by Hans Wagner, TradingOnlineMarkets.com | September 16, 2008

To beat the market it pays to understand the fundamental factors that are holding investors attention. Last week-end The US government took control of the two Government Sponsored Enterprises Fannie Mae and Freddie Mac to keep them from failing. These two firms own or control more than 60% of all mortgages. Then everyone focused on the credit problems Lehman Brothers, Washington Mutual and AIG. It seems that every couple of weeks another financial institution takes center stage. On Thursday after the market closed Washington Mutual reported that their Capital was significantly above "well-capitalized" levels. Many investors expected resolution of Lehman Brothers to take place by Sunday September 14, 2008. Sunday Lehman’s management announced that that they would declare bankruptcy midnight. The question is how many more banks will become the center of investors’ attention?

Basics of Banking Capital Rules

Before I answer that question, it is helpful to understand what is a “well-capitalized” bank. Regulators measure the capital adequacy of banks using the following ratios:

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%

Basically, this means that a bank with $100 million in capital can lend $1 billion. Banks make most of their profit on the net interest margin which is the difference in the rate they receive on the loans they make and what they borrow (deposits, etc.) along with their cost of capital. If they pay 5% for their money and the lend it at 9% their net interest margin is 4%. For the $1 billion bank that is $40 million or a return of 40% on the $100 million in capital. That is the power of bank capital leverage. Of course they must pay for all their operating costs and cover loan losses.

Loan losses is where the real problem comes. Let’s say this same bank experienced a loss of $10 million. They still will have $30 million in net interest margin to cover operational expenses and profit. Now what if the losses are $40 million? Then the net interest margin will just cover the loan losses, meaning operational expenses would not be covered. I am ignoring bank fees, which is a growing way to generate revenue. Basically banks can make money as long as the loan losses are less than what they make in net interest margin.

When loan losses exceed their net interest margin, the downside of bank capital leverage comes into play. Should the bank above experience loan losses of $60 million, they would be unable to cover the loss with the money generated from the other loans. This means they must cover the loan loss with some of their capital. In this case the bank’s capital would be reduced by $20 million to $80 million.

Now the bank is faced with two choices. One is to reduce its loan portfolio to $800 million so it can stay within the limits of the capital ratios. This may require them to guarantee the loan in some form and or sell off their best performing assets. In short, it is likley to raise the risk of the bank’s portfolio. The other choice is to raise $20 million in equity to cover the loss in capital from the loan loss. An equity raise would dilute existing shareholders stake in the bank.

This is the situation many banks now face. The problem is the cost of capital is either very high or it is not available. Any firms willing to commit additional capital will look for ways to reduce their risk such as buying preferred which reduces their risk in case of a bankruptacy. The existing share holders are left holding an empty bag.

Of course the financial structure of banks is much more complicated that I have described here. Which is part of the problem. The complexity of the credits they have created makes it very difficult for anyone to understand the potential risk. Even the banks do not know the extent of the problem. Most analysts expect the problem to be larger than it is now.

Reported Losses

So far, there has been about $500 billion in write-downs and losses by investment and commercial banks. These firms have also raised about $350 billion in capital to help offset the losses. According the IMF, total losses will reach $1 trillion, meaning we are only half way through. I would not be surprised to see that number go higher.

So where are these losses occurring? Gary Shilling provides an investment newsletter that offers some interesting analysis through his company A. Gary Shilling & Co. The table below is from one of his recent letters where it shows the write-downs and capital raised by the larger banks in the world.

Citigroup tops the list in losses with $55.1 billion while raising $49.1 billion. Bear Stearns reported losses of $3.2 billion and it is now part of JPMorgan Chase in an orchestrated fire sale by the government. Lehman Brothers has reported losses of $10 billion and raised $13.9 billion in capital. Lehman has filed for bankruptacy.

Writedowns and Losses and Capital Raised

As these losses mount, it will be even more difficult for the banks to raise capital. Any new issues of capital will cost dearly, as no one wants to risk their money in a situation that looks inherently risky. Their other choice is to reduce the size of their portfolios by selling their assets. These sales tend to be at a loss as investors recognize they have an opportunity to make money if they can buy low. Further, as I have said in prior articles, the banks are curtailing their lending to they can get their capital ratios back in line. Many businesses will not be able to expand their operations, fund acquisitions, and buy new equipment, etc if they cannot borrow. It hurts the economy, especially when it is already weak. Moreover, we are only half way through the write-offs.

Future Failures

As of Tuesday morning September 16, 2008, Lehman Brothers has filed for bankruptcy. Lehman had been looking for a buyer but evidently could not find one.

The next Bank of America is buying Merrill Lynch. This was a surprise, as many believed Merrill raised sufficient capital and sold off many of its bad assets to shore up its balance sheet. They even sold their stake in Bloomberg, the financial information firm. This seems to imply that there was more bad news to come from Merrill and that the new CEO John Thain believed they could not survive. Bank of America is reported to be paying $29 per share. On Friday, Merrill closed at $17.05.

AIG the huge insurance firm is facing a liquidity problem and is asking the for a government bridge loan to help them get through the crisis. It looks like other banks are unwilling to step in and provide the necessary short-term financing. Yet these same firms will face additional problems if AIG goes in to bankruptcy as they have many interwoven agreements that would be difficult to unwind. I suspect these firms and AIG are playing a game of chicken with the government, I mean the US Taxpayer, caught in the middle.

Can it get worse? I believe the answer is yes. The Federal Deposit Insurance Corporation (FDIC) has 117 banks on its watch list. They also have $50 billion in their insurance fund with Indy Mac consuming about $20 billion. The pattern of losses will continue as foreclosures keep climbing. Next in line are commercial real estate loans that could be facing problems. A number of banks also hold preferred shares of Fannie Mae and/or Freddie Mac. With the government take over of these companies, the preferred shares are at risk. In fact, Wells Fargo and Pittsburgh National Bank have issued releases stating they will have to increase their loss reserve for the preferred shares they hold. I am not saying these banks will fail. Rather the losses will mount and more firms will face capital adequacy problems forcing them to raise capital, sell assets or seek a partner. The end is not here yet.

If you are interested in learning more about how to evaluate commercial and investment banks I suggest reading Financial Institutions, Markets, and Money by David S. Kidwell, David W. Blackwell, David A. Whidbee and Richard L Peterson. The best book I can find on financial institutions including how they work and analyzing their statements.

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling. One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas. Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

Bio As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/�

Contact Information

Hans Wagner | Colorado, USA | Email | Website