Banks still need bigger cushions (Q2 TCE update)

July 28, 2009

reuters-logoIt was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.


(Click table to enlarge in new window)

Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.

A nickel of equity for every dollar of assets is a pathetically small capital cushion.  And today, banks substitute federal guarantees for liquid capital.  Policymakers are afraid to remove the guarantees because they don’t want to precipitate another collapse. The financial system can’t stand on its own until its capital cushion is rebuilt.

Now consider the analyst comments on Goldman’s call: Bank of America Merrill Lynch analyst Guy Moszkowski asked how the firm plans to deploy “what looks like pretty significant excess…capital;” Oppenheimer analyst Chris Kotowski pronounced himself “stunned” by the increase in Goldman’s TCE.

To be sure, Goldman’s 5.7 percent ratio of TCE to tangible assets at the end of the second quarter surpassed rivals’. And it was up significantly from 4.6 percent in the the previous quarter. But how far have banking standards fallen that 6 cents against a dollar of assets is considered an excessively prudent cushion?

And other banks are in worse shape. Citigroup exited last quarter with a puny TCE ratio of 2.3 percent, which implies leverage of 43 to 1. That’s an improvement over 1.7 percent in the previous quarter, but it’s still awful.

The majority of the big banks are hovering between 4 percent and 5 percent, which implies leverage between 20x-25x. For the complete list of the top nine banks, see the chart above.

Thanks for the recent improvement go to Treasury Secretary Tim Geithner, whose stress tests forced the big banks to raise capital. But they haven’t raised enough. As unemployment rises, charge-offs on credit card and other consumer loan portfolios will accelerate. As property values stay depressed, impairments on mortgages and home equity loans will increase substantially.These losses will eat through banks’ small capital cushions quickly.

And Calyon analyst Mike Mayo expects the worst is yet to come. In a recent note to clients he said peak loan losses during the current cycle will “approach if not exceed peak loan losses during the Great Depression.” To deal with that, banks need to de-leverage. They need to take risk off their balance sheets. Mayo estimates they’re “just one-third complete” with this process.

In the meantime, banks are using various accounting gimmicks to hide leverage. For instance, Citigroup and JP Morgan Chase have $165 billion and $145 billion of off-balance sheet assets, respectively, that will have to come back on their balance sheets next year. Taking account of them now would reduce their TCE ratios by 8 percent and 7 percent, respectively. Bank of America has $470 billion of off-balance sheet assets, though they haven’t disclosed what will end up on the balance sheet.

A counterargument is that using TCE as the test for capital is excessively prudent, that regulatory measures like “Tier 1” are sufficient. But Tier 1 includes capital like preferred stock as equivalent to TCE. But it’s not because it isn’t in the first loss position of the capital structure. Banks that blew through this buffer last year saw their balance sheets disintegrate in a matter of hours.

FBR Capital Markets analyst Paul Miller argues that Tier 1 capital has been “polluted” by preferred stock offerings. At the end of the first quarter this year, TCE made up “just 53 percent of Tier 1 capital for the top 11 banks, down from an average of 91 percent” between 1991 and 2006. Afraid of diluting common shareholders, they sold preferred stock instead. In the end they gamed regulatory capital standards, substituting inferior capital for TCE.

The comments on Goldman’s call show that the pre-crisis mindsets have not changed. Less than a year from one of the greatest financial meltdowns in history, many analysts seem to think 17x leverage is “excessively” prudent. That is mind-boggling.


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But the USG has declared none of the gang of 19 will be allowed to fail (and besides their risks are all hedged) so why not gear up and increase earnings?

Posted by sangellone | Report as abusive

The banks are trying to get into the Goldman game again. They are buying CDOs at distressed prices, praying they don’t roll a ” 7-out ” !!

Forget about loans from now on.Beaten up real estate is the new game for speculation once again. Don’t have to touch a deed either. Oil speculation is passe’ due to that pesky demand problem. CFTC is sniffing around it anyway.

Posted by rayman in CA | Report as abusive

Uh, yeah. Banks need to be more prudent. That’s a good idea. The current system allows them to live off the public like a leach – only taking; never giving; spreading disease.

They got their bailouts (our tax money) – and they’re still charging over 20% on credit cards after a late payment. They get their bonuses whether business is good or bad. They didn’t see this 1,500 car pile-up? Same thing with AIG – didn’t ya hear about their new round of $235 million in bonuses? Google: “AIG $235″

This is what the End of America looks like.

But do you want to know what I really think?

This is more like the Federal Reserve trying to crash state budgets that are heavily based on property taxes – so they can extort what little is left of their sovereignty in exchange for emergency funds that their constituents originally paid as taxes!! Centralized planning from the Feds – and they said if only they had had more power to seize companies and their assets they could have averted all this. Sounds pretty Faustian.

Posted by Newspeak | Report as abusive

True free market economics will provide the proper incentive that the financial institutions need to self regulate. Proper incentive to self regulate is the key. As painful as it may be we need to go back to a free market system. To delay will only increase the pain at some point down the road.

Posted by A. Fisher | Report as abusive

1) Goldman is not a bank (anyone you know ever get a loan from them?) 2) They should never have been given BHC status 3) They will continue to be reckless with other peoples money until profit in doing so is removed 4) for a so-called bastion of capitalism they have received more bail-out $$ going back to LTC and beyond then any other institution 5) nice to have friends in high places – like the cabinet

Posted by georgetown | Report as abusive

“If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.”

why should they? They have been shown they will not be allowed to fail , so why not take on as much risk as possible?

Posted by Joe | Report as abusive

Indeed Joe. Indeed.

Posted by Rolfe Winkler | Report as abusive

Rolfe is right. Citi has already moved to shore up their TCE. Their public share exchange last week yielded over 60B bringing TCE to 100B and their current ration to 5.5% (over 9% tier 1 common). Will other banks follow suit? Will they be able?

Posted by Jim | Report as abusive