Buttress bank tangible common equity
Whatever the results of the stress test are, increasing levels of tangible common equity (TCE) should be at the heart of the response. That implies painful and dilutive capital raisings to come, and not just for the banks being tested.
U.S. regulators will next week release information about the stress tests they are holding on 19 large banks. Expectations are that a substantial number will be forced to raise new capital and that some will be guided to converting existing preferred securities into plain old equity.
Tangible common equity, the bit that takes the first loss, is the foundation of banks’ capital structure and has been sadly eroded in recent years, worn away by losses and a preference for preferred securities and other types that count towards the Tier 1 regulatory measure of capitalisation.
The TARP money, in other words, has been aimed at the wrong part of the capital structure, probably at least in part as a tactic to stave off the nationalization question.
The problem is that ordinary shareholders know full well that the losses banks are now suffering could well swamp their economic interest, regardless of how much Tier 1 capital is above them to protect depositors and the public purse. This leaves banks with too little TCE vulnerable to a death spiral in their share prices.
For the 11 largest U.S. commercial banks the TCE on a regulatory basis equaled just 5.5 percent of risk weighted assets in the first quarter, down from more than 8 percent in 2007 and just below 10 percent in the late 1990s, according to Paul Miller at FBR Capital Markets, who realized well ahead of the government that the TARP plaster would not be enough. TCE as a percentage of Tier 1 is just 53 percent, against an average of 91 percent from 1991 to 2006.
He believes that TCE needs to return back to the 90 percent of Tier 1 capital range and at least 7 percent of risk weighted capital, or a leverage ratio of about 14-1.
This won’t be easy, or cheap and there are huge waves of losses yet to come. What is good for the banks in the stress test is good for the rest, and as Miller points out, there are plenty of regional banks with less TCE than they need.
Look for painful capital raisings and deleveraging to continue.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. —