Ladenburg Thalmann analyst Richard Bove is taking the contrarian view to FBR Capital’s $10 trillion-bailout note yesterday.
Recall, FBR saying that US financials need at least a $1 trillion capital injection to restore confidence to the banking system and improve liquidity. The argument wasn’t really about how much capital the financial system needs but what kind. FBR were lobbying for tangible common equity as opposed to the preferred stock contained in the $700bn Tarp.
Remember that tangible common equity is how shareholders look at what they own once assets and liabilities are netted out and intangibles like goodwill are excluded. It’s different from Tier 1 capital — which includes preferred stock and intangibles like deferred tax assets, and tends to be what regulators look at when examining a bank’s capital adequacy.
Here’s Bove on why tangible common equity isn’t needed:
Among the many reasons now being given for selling bank stocks is the belief that banks need meaningful injections of tangible common equity. This is another theory that gives me difficulty. There seems to be no discernable reason why tangible common equity is a relevant indicator of anything other than market participants think it should be.
From a theoretical standpoint one might argue that the return on intangibles is zero. Therefore if one invests a large amount of equity in an area of zero returns two developments will occur:
• First, the return on equity will plummet; and
• Second, the secular growth rate of the firm will decline.
The problem with this theoretical construct is that there is no empirical evidence that it is true. Note the tables on the next few pages. They show:
• The ratio of intangibles to assets and to common equity,
• Compared to the return on average common equity before extraordinary items,
• For all banks and thrifts with more than $20 billion in assets
• For the 3rd quarter of 2008 and the full years 2007 and 2006.
It is immediately evident from these tables that there is no relationship between the return on average common equity and the level of intangibles at each of these institutions. The reason for this is clear. Businesses like money management, data processing/business services, deposit gathering, and mortgage servicing have high returns on equity relative to the core business of lending. In normal times this is also true of capital markets activities.
When a bank acquires one of these businesses it picks up two things:
• A great deal of intangibles, and
• A much higher ROCE.
The comeback to this argument is that in liquidation tangible common equity is very important. Not so. If a bank is to be liquidated and its businesses sold off, those businesses associated with the intangibles are likely to bring a much higher price than the businesses backed by tangible assets. The bank will go under because the tangible assets fail not because of issues associated with the businesses that brought the intangibles.
From our understanding, the problem with the US financial system is one of solvency (and leverage). Financial intuitions are under-funded and over-leveraged — they need more capital to support their deteriorating balance sheets. Tangible common equity, again, as we understand it, is the first line of capital to take losses. Here’s Rolfe Winkler, from Option Armageddon, on the subject as it relates to Citi:
There are plenty of slides talking about “Tier 1 Capital” and such. I never understood those ratios and don’t think they’ll be worth much in a panic situation as banks lose access to hard funding sources like consumer deposits. Using Citi’s Tier 1 Capital ratio of 10.4% would imply a leverage ratio of 100/10.4 = 9.6x.
But we know from the cases of Fannie and Freddie that regulatory capital ratios are very squishy. Back out worthless assets from the bank’s equity calculation and the denominator may be halved.
In Fannie’s case, you had $2.5 trillion of assets versus ~$45 billion of “capital,” which implied a leverage ratio over 50x. And yet that “capital” figure included at least $21 billion of deferred tax assets that Fannie wrote down to $0 in the most recent quarter…
The reality is, intangible assets like deferred tax assets should NOT be included when calculating leverage ratios. Excluding those meant Fannie had a leverage ratio of 100:1! When assets are 100x larger than equity, it takes only a tiny reduction in assets to reduce equity to zero. And with house prices likely to fall more than 30% nationally, asset values are falling more than just a little. This is why Fannie has already said they’ll need more than the $100 billion promised by Treasury.
Leverage ratios are important because they tell you how much money is in reserve to cover losses. That’s why you shouldn’t include faux assets like intangibles, deferred tax assets and goodwill. These things are worthless in a bankruptcy court. They can’t be used to pay off a company’s debts.
This is of course polar opposite to what Bove’s saying above. We’d tend to side with the latter argument on this on — in the current environment intangibles are becoming ever more, err, intangible. How much goodwill would a bank really be able to net in today’s market? In fact, we hear they’re giving them away for free with toasters.
Wanted: $10,000,000,000,000 to bailout the financial system – FT Alphaville
Citi’s leverage – Option Armageddon