KEY POINTS:
Time and again, big banks such as Citigroup argued that irrational and seized-up markets, not the woeful state of their balance sheets, were to blame for convulsing share prices.
For more than 18 months, the Government went along with that thinking. Instead of demanding that banks recognise their losses, overhaul operations and quickly raise equity from private sources, regulators bet a flood of money would unclog credit markets.
When that didn't work, the Government doled out billions of dollars to more than 100 banks through the Troubled Assets Relief Programme, again with few demands that banks take harsh medicine. That hasn't done the trick either.
The reason is pretty simple. This has never been a liquidity crisis. It's a capital crisis. Namely, investors don't think banks have enough of it, especially when it comes to tangible common equity (the value of shareholders' investment).
Citigroup is a dramatic example. Its tangible common equity was 2.41 per cent of tangible assets at the end of the third quarter. That was too low for investors' liking and below peers such as JPMorgan Chase and Wells Fargo.
This is one big reason why Citigroup is in such dire shape and may be on the verge of a breakup that could undo the behemoth created in 1998 by Sandy Weill's merger of Citigroup and Travelers.
In that sense, Citigroup should serve as a warning for other banks. It shows that further injections of money from the relief programme, as suggested in a speech by Federal Reserve chairman Ben Bernanke, won't placate investors. They want to see funding that bulks up common equity.
Investors also want banks to own up to their problems as quickly as possible. Again, Citigroup fell short in this regard, ignoring repeated investor calls, some going back four years, to shrink and refocus.
All this explains why bank stocks have again come under fire with shares in Citigroup and Bank of America declining more than 20 per cent over the past five trading days.
After all, if investors weren't concerned about capital, why run? Citigroup has access to the Fed's discount window as well as the ability to sell short-term debt that is backed by the Government.
In addition, the Government agreed in late November to absorb a portion of losses on as much as US$306 billion ($572 billion) of assets held by Citigroup. The Government has also pumped US$45 billion into the bank through the purchase of preferred stock.
For all that, the New York-based company is in crisis.
Investors don't believe the bank's numbers, or that it has the wherewithal to weather what many expect will be mounting losses on residential and commercial real estate holdings, as well as credit-card and auto-loan debt.
Analysts predict Citigroup will report a fourth-quarter net loss of about US$5.6 billion when it releases results next week, according to data compiled by Bloomberg.
While its planned brokerage joint venture with Morgan Stanley might generate about US$6 billion in new capital on paper, the deal highlights Citigroup's perilous state.
The company is selling part of a crown jewel so that it can write up the value of an asset on its balance sheet to make its capital look better. In the short term that will help offset losses. The price, though, is diminished earnings power.
Investors also see recent government capital injections as a mixed blessing. One day, banks will feel compelled to buy back the Government's preferred stock, especially if they don't want the 5 per cent dividend payment on much of it to ratchet up to 9 per cent. Future earnings will have to be diverted for those purchases.
Until then, earnings must go to pay the coupon. And while 5 per cent may seem low, it might become a headache if banks end up making 4.5 per cent, 30-year fixed-rate mortgages.
In the meantime, things may only get worse in 2009.
Analysts at Bernstein Research, for example, forecast that net charge-offs at US banks might peak at 2.7 per cent in the first half of 2010, well above an estimate of 1.66 per cent for the 2008 fourth quarter. Rising charge-offs deplete equity, the buffer that creditors require to keep lending a bank money so that it can make additional loans.
Many investors hope that banks will be able to earn their way out of this. But pre-provision earnings, or what banks earn before taking into account problem loans, may not be up to the task. These earnings could be dented by lower net interest margins and fee income.
Another worry: ratings-company downgrades of securities jumped in the fourth quarter of 2008 and might climb this year, according to a January 6 research report by Oppenheimer analyst
Meredith Whitney. Such downgrades typically require banks to hold more capital for these securities, reflecting the fact that the risk of loss has increased. That effectively lowers the amount of capital they have for regulatory purposes.
This means, according to Whitney, that even with all the relief money, "banks will once again have to raise fresh capital in 2009". They had better be quick about it, and raise common equity, if they want to avoid the kind of spiral that has shredded Citigroup. And until they do, there is little reason to own bank stocks, even at today's beaten-down levels.
- BLOOMBERG
