ICICI is parading the fact that Moody's is rating its UK subsidiary at Baa1.
Two things strike me; a) it's Moody's, the same outfit that had Kaupthing at Baa3 until as recently as October 8th and b) the rating is higher than Moody's FC rating for the Indian parent.
So it looks like the Baa1 rating includes some support from a higher rated entity - presumably the UK government. But did anyone see ICICI UK Ltd on HMG's "chosen few" list of 7 banks and 1 building society?
And the other rating agencies - both have ICICI India at BBB-/stable, with an A3 short-term rating. Furthermore, bank strength ratings are in the order of C and C-; these are weak for a bank.
So thanks to Moody's JDA (joint default assessment) scheme, which gives the UK branch a better rating (neither Fitch or S&P rate the UK entity and why would ICICI buy an extra rating if it's lower?), the management are trying to imply that all is well. For some reason, ICICI Ltd in Singapore does not get any uplift and is Baa2 according to Moody's but that is probably down to the Moody's JDA black box expectation of support from MAS.
The move to seek reaffirmations of the ICICI ratings from Moody's and S&P over the weekend is an unusual move and almost certainly requested by the company. The hurriedness is reflected in the S&P statement referring to "Bakerie" rather than the Bakrie group.
In conclusion, things may be well with ICICI India but there is no guarantee for the UK subsidiary. Things may well be well for the UK subsidiary too, although it does seem to have been more exposed to the shenanigans of international derivatives than the Parent in India.
What is not so good is management's apparent misunderstanding of ratings and structural sub-ordination and the implications this has for the advice management is giving to the world at large about its relative credit standing.
Monday 13 October 2008
Wednesday 8 October 2008
Gordon Brown should copy HKMA
Given that the equity market is the most liquid, the most talked about and a key element in economic Lead Indicators, why doesn't HMG buy bank shares?
It can then make proper representation as a shareholder in the control of the business and can profit from its involvement.
Given that it is giving liquidity through the Bank of England, some equity upside is not too much to ask.
Unlike Mr Buffet, HMG should buy from the market and not take options on future performance. Furthermore, the preference share route is best avoided; these do not provide a cushion to a bank's equity price, but act as a penal charge on income. In the current environment of liability guarantees, the cushion to unsecured creditors afforded by the preference shares is simply not needed.
The common equity purchase plus judicious involvement in any rights issues or placings represent the best spur for confidence and allow the market to see the floor. All those investors now holding cash can then take a view.
In purchasing the equity, the trading criteria should be specific; e.g. it will be a potential buyer of bank shares if the price to book is say less than 0.35x and a potential seller if the price to book is over 0.65x. It will never sell more than 5% of its holding or 1% of the shares outstanding in the bank in any one day, and so on.
Does it work? Ask the Hong Kong Monetary Authority if their $15bn of share purchases on the Hong Kong stockmarket, over two weeks in August 1998, worked. I think it did, and they subsquently made a good profit. Perhaps there's some gecko lurking somewhere in Gordon waiting to emerge.
It can then make proper representation as a shareholder in the control of the business and can profit from its involvement.
Given that it is giving liquidity through the Bank of England, some equity upside is not too much to ask.
Unlike Mr Buffet, HMG should buy from the market and not take options on future performance. Furthermore, the preference share route is best avoided; these do not provide a cushion to a bank's equity price, but act as a penal charge on income. In the current environment of liability guarantees, the cushion to unsecured creditors afforded by the preference shares is simply not needed.
The common equity purchase plus judicious involvement in any rights issues or placings represent the best spur for confidence and allow the market to see the floor. All those investors now holding cash can then take a view.
In purchasing the equity, the trading criteria should be specific; e.g. it will be a potential buyer of bank shares if the price to book is say less than 0.35x and a potential seller if the price to book is over 0.65x. It will never sell more than 5% of its holding or 1% of the shares outstanding in the bank in any one day, and so on.
Does it work? Ask the Hong Kong Monetary Authority if their $15bn of share purchases on the Hong Kong stockmarket, over two weeks in August 1998, worked. I think it did, and they subsquently made a good profit. Perhaps there's some gecko lurking somewhere in Gordon waiting to emerge.
Wednesday 1 October 2008
Debt for Equity - not liabilities to governments
There is a concern that banks have stopped lending. Is this because there are no solid borrowers or is it because lenders have lost faith as a result of arbitary changes to property rights and bankruptcy laws?
Banks will not advance money if they no longer see the equity of the borrower taking the first hit. If there is no first hit to be taken, then the banks must assume that they are pari passu with equity holders.
The main problem facing markets is that banks are facing immediate heavy losses arising from derivative financial contracts. Banks balance sheets are not designed for catastrophic losses of equity, but they can absorb up to 10% to 15% total losses on their loan book over say 5 years. This is equivalent to a 50% to 66% recovery on a bad loan book equivalent to 30% of the total loan book. Banks with non-performing assets = 10% of total assets will struggle. If the ratio reaches 20%, the bank will most likely fail.
For example, assume a typical bank with common equity of 6% of assets and a pre-tax, pre-provision ROA of 3.5%. If in any one year 15% of the loan book is non-performing then ppROA will fall to say 3%. Provisions and losses at 33% of these NPA reduce overall ROA to 0% and eat into equity to the value of 2% of assets, reducing equity to 4% of assets. The bank has an equity issue of say 1 new share for every one held but as the Price to Book Value will be <<1.0x, say 0.5x, the equity base only recovers to where it was before, at 6% assets.
If the same happens the following year, then shareholders will once again need to chuck money at the bank equivalent to 2% of the asset base until the problem eases.
But if I don't recover 67cents on the dollar and/or if the NPA ratio is higher, then the equity will be depleted by much more than 2% of the asset base. In addition, the ppROA will be adversely impacted by funding costs and the price to book ratio, ahead of the new share issue, will be even more bleak.
The forthcoming settlement of AIG, Fannie & Freddie, and Lehman CDS contracts means that we will get some market clearing prices on the bad assets. Then buyers and suppliers of capital will magically reappear because the calculations outlined above can be done with more certainty.
However, bank recapitalisation also requires time. As alluded to above, banks take the hits year by year and that is because the work out of loans or recovery of collateral are also time consuming processes. Furthermore, as these bad loans were "held to maturity" assets, and thus valued with some discretion, the banks had a chance to blend internally generated capital and external equity injections to restore the bank to rude health.
By contrast, the upcoming CDS auctions could be traumatic as we are trying to estimate in a few days the recovery value of the assets and the liabilities of four intertwined businesses. This is before the people now controlling the failed entities have barely started work on assessing the real assets of the businesses.
Unfortunately there is massively more value in the CDS being settled by auction than there is in the real assets of the business. Maybe 10x more derivatives traded than underlying assets, maybe much more. Mispricing the CDS values by 5cents on the dollar is equivalent to being 50% wrong on the value of the real assets.
But unfortunately the market price established will need to be used by the banks and this will almost certainly throw up some permanent impairments to their "held to maturity" loans. The chance for banks to smooth their way back to profits will have disappeared.
There seem to be three routes forward assuming banks remain in the private sector;
i) BIS and/or Fed relax the banks' capital criteria,
ii) another major overhaul of mark to market accounting is required or
iii) creditors take equity.
The purest route forward to offset the instant value destruction derived from the CDS auction would seem to be the creation of instant equity. In other words, there must be a mechanism for the instant swap of debt for equity.
But such changes cannot happen if governments have guaranteed all non-consumer deposits and liabilities, or if indeed the government has already split the balance sheet up.
As noted earlier, banks, in effect, already believe that they are no better off than equity holders which is why they are not lending. However, it is not the uncertainty of the credit market that makes holding equity unattractive but the unpredictability of government actions with respect to any holder of a bank liability.
At least with another bank's equity in their pockets, a bank then owns (albeit a very large amount) a homogeneous, transparently-priced security for which there is a liquid market - as long as the government doesn't interfere.
And finally, the conflict between going concern principles and fair value accounting can, in my view, best be resolved if liabilities are valued at the higher of par or market value. (Pension liabilities should be discounted at long-term government bond yields). There would need to be a balancing quasi-financial asset, but at least the ridiculous state of affairs where a struggling bank can show an enhanced equity valuation because the market discount to par of its own capital instruments are credited to equity, would disappear.
Invexit
Banks will not advance money if they no longer see the equity of the borrower taking the first hit. If there is no first hit to be taken, then the banks must assume that they are pari passu with equity holders.
The main problem facing markets is that banks are facing immediate heavy losses arising from derivative financial contracts. Banks balance sheets are not designed for catastrophic losses of equity, but they can absorb up to 10% to 15% total losses on their loan book over say 5 years. This is equivalent to a 50% to 66% recovery on a bad loan book equivalent to 30% of the total loan book. Banks with non-performing assets = 10% of total assets will struggle. If the ratio reaches 20%, the bank will most likely fail.
For example, assume a typical bank with common equity of 6% of assets and a pre-tax, pre-provision ROA of 3.5%. If in any one year 15% of the loan book is non-performing then ppROA will fall to say 3%. Provisions and losses at 33% of these NPA reduce overall ROA to 0% and eat into equity to the value of 2% of assets, reducing equity to 4% of assets. The bank has an equity issue of say 1 new share for every one held but as the Price to Book Value will be <<1.0x, say 0.5x, the equity base only recovers to where it was before, at 6% assets.
If the same happens the following year, then shareholders will once again need to chuck money at the bank equivalent to 2% of the asset base until the problem eases.
But if I don't recover 67cents on the dollar and/or if the NPA ratio is higher, then the equity will be depleted by much more than 2% of the asset base. In addition, the ppROA will be adversely impacted by funding costs and the price to book ratio, ahead of the new share issue, will be even more bleak.
The forthcoming settlement of AIG, Fannie & Freddie, and Lehman CDS contracts means that we will get some market clearing prices on the bad assets. Then buyers and suppliers of capital will magically reappear because the calculations outlined above can be done with more certainty.
However, bank recapitalisation also requires time. As alluded to above, banks take the hits year by year and that is because the work out of loans or recovery of collateral are also time consuming processes. Furthermore, as these bad loans were "held to maturity" assets, and thus valued with some discretion, the banks had a chance to blend internally generated capital and external equity injections to restore the bank to rude health.
By contrast, the upcoming CDS auctions could be traumatic as we are trying to estimate in a few days the recovery value of the assets and the liabilities of four intertwined businesses. This is before the people now controlling the failed entities have barely started work on assessing the real assets of the businesses.
Unfortunately there is massively more value in the CDS being settled by auction than there is in the real assets of the business. Maybe 10x more derivatives traded than underlying assets, maybe much more. Mispricing the CDS values by 5cents on the dollar is equivalent to being 50% wrong on the value of the real assets.
But unfortunately the market price established will need to be used by the banks and this will almost certainly throw up some permanent impairments to their "held to maturity" loans. The chance for banks to smooth their way back to profits will have disappeared.
There seem to be three routes forward assuming banks remain in the private sector;
i) BIS and/or Fed relax the banks' capital criteria,
ii) another major overhaul of mark to market accounting is required or
iii) creditors take equity.
The purest route forward to offset the instant value destruction derived from the CDS auction would seem to be the creation of instant equity. In other words, there must be a mechanism for the instant swap of debt for equity.
But such changes cannot happen if governments have guaranteed all non-consumer deposits and liabilities, or if indeed the government has already split the balance sheet up.
As noted earlier, banks, in effect, already believe that they are no better off than equity holders which is why they are not lending. However, it is not the uncertainty of the credit market that makes holding equity unattractive but the unpredictability of government actions with respect to any holder of a bank liability.
At least with another bank's equity in their pockets, a bank then owns (albeit a very large amount) a homogeneous, transparently-priced security for which there is a liquid market - as long as the government doesn't interfere.
And finally, the conflict between going concern principles and fair value accounting can, in my view, best be resolved if liabilities are valued at the higher of par or market value. (Pension liabilities should be discounted at long-term government bond yields). There would need to be a balancing quasi-financial asset, but at least the ridiculous state of affairs where a struggling bank can show an enhanced equity valuation because the market discount to par of its own capital instruments are credited to equity, would disappear.
Invexit
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