Despite some respite for the banks during trading on Monday, the latest note to clients from freshly-famous CIBC equity analyst Meredith Whitney is as bearish as ever.
Branching beyond her focused criticism of Citi last week, Whitney’s analysis sees further declines in banks’ shares on the back of damage to the sector’s risk-weighted assets and capital ratios. But it’s still Citi that features at the fore:
We continue to believe that Citi is at precariously low capital levels that will force the company to sell assets, raise capital, and cut its dividend. Our concern over C and the probability of its stock falling below $30 a share mounts by the day.
Again, it’s the rating agencies’ downgrades that are setting alarm bells ringing. Downgrades will have a “severe impact” on banks’ balance sheets says CIBC. Expect capital adequacy ratios to “be of critical focus in the fourth quarter.”
To put those rating agency downgrades into credit-crunch perspective, here’s a couple of graphs:
As is obvious, rating agencies went crazy in October. It is worrying then that, as Whitney says:
Almost all securities on balance sheet are 100% tied to such ratings. Tier 1 capital ratios will experience disturbing declines in the fourth quarter.
So how do those rating agency cuts translate?
Under the current FDIC rules, asset tranches are assigned risk weightings. AAA and AA get 20 per cent, A gets 50 per cent, BBB 100 per cent and BB 200 per cent, for example. Very basically then, an AAA rated MBS security worth $1bn, would carry a risk weight of 20 per cent – translating as $200m in capital. Imagine then, downgrading that AAA asset to BBB. The risk weight shoots to 100 per cent, and the capital requirement rockets to par value – $1bn. Understandably, the capital adequacy ratio would take a big hit. Under Basel II rules, which the big commercial banks have to comply with, the risk weightings are even more stringent.
All of the US banks, says Whitney, have been increasing the proportion of rating agency dependent assets on their balance sheets in recent years.
The situation is worst for Wachovia and Citi:
We believe the capital ratios of Citigroup and WB will be under the most pressure due to their recent acquisitions, capital markets-related write-downs and sluggish earnings growth due to higher credit costs. Further, C and WB’s Tier 1 ratios already stand more than 100 bps below most of their peers.
Both already have rather anaemic looking Tier 1′s:
We believe investors would be best served to avoid this group of large cap bank stocks as the “ring of fire” or virtuous interconnectedness plays out in what we expect to be lower earnings, lower capital ratios, lower ratings, and consequently still lower earnings.