Credit Crunch Threatens U.S. Financial Sector's Equity

While already adding up to quite a lot, there may be more dislocation as the impacts and consequences for financial companies and investment funds unfolds over the next several months. Indeed, on present trends, it is likely that several large Wall Street financial institutions will be vulnerable to a downgrade by credit rating agencies, as the deteriorated credit environment and a change in regulations place substantial pressure on their liquidity and capitalization ratios.

When we calculate the numbers, using three set of assumptions (scenarios), our best guess is that the ratio of equity capital to total assets for a peer group of eight large Wall Street companies will be cut in half from their Q3 settings, taking them back to levels last seen in the early 1990s (see Figure 1). Beyond the inevitable change in credit profiles this would entail, such an environment places tremendous pressure on individual companies to change strategies, sell-off assets, and merge businesses with others.

Figure 1

"Mark-to-Market" Scenarios: Of course, the underlying problem is that declining values of low-quality mortgages issued by the large Wall Street financial houses has spread in influence to damage the value of higher quality securities. Some of the decline in value is a result of poor credit structures; while an additional amount is now due to poor market conditions. The banks and investment funds that own the degraded securities have needed to write down the lost value of the assets they own. As a result, the whole model of structured, securitized credit instruments is being re-evaluated by the markets and regulators.

However, one of the biggest operational problems facing the market these days relates to the difficulty of pricing these assets. It is very hard to discover their true market values in current market conditions, due in part to their complex and opaque nature; but also due to their being in a market that is thinly traded in the best of times, let alone during a buyer's strike period.

The financial institutions most active in the sub-prime mortgage-related market (MBS, CDOs, ABCP, SIV markets) are the largest banks. Table 1 summarizes key financial measures for these institutions, as publicly reported in the third-quarter 2007.

Table 1 – Financial Summary of Top Investment Banks in U.S., Q3 2007

Source: Thomson Financial, Global Insight Calculations

While it is difficult to predict the exact exposure of U.S. banks, and their balance sheets, to the current financial turmoil, we have devised a few scenarios to help gauge the potential size of the problem. The scenarios feature a few reasonable assumptions about the extent of the deterioration in the underlying assets, and about the transmission of the degraded values to financial company balance sheets:

1. What are the potential losses to equity from write-downs of credit securities such as CDOs, CLO, ABS, etc.?
2. What are the likely impacts stemming from the related halt in LBO financing for M&A?
3. Calculate the potential exposure of banks to new FASB accounting regulations for "Level 3" assets.

First, we created each of the three scenarios individually, to calculate their impact on a stand-alone basis. Next, we added all of the scenarios to calculate the joint impacts, if all their negative factors were to occur at the same time (a "perfect storm").

In the perfect storm case, it is likely the equity capital of U.S. Wall Street banks and investment will decline by half when measured as a percent of total assets. Furthermore, when we change the assumptions from being reasonable to being more extreme, then the tangible equity portion of total equity for several of the firms will be virtually wiped out.

Scenario 1: Potential losses from CDOs and mortgage-related securities?

In this scenario, we have added up all the losses on balance sheets that have already been announced by the firms in third-quarter 2007 and so far in the fourth quarter (Table 2). These investment banks were forced to write-down more than $30 billion of securities because of significantly reduced values in their holdings of CDs and other sub-prime related assets. This represents approximately 4% of the market capitalization of the combined peer group of companies.

Table 2 - Banks Announced Write-downs ($mill) in Q3 and So Far in Q4

The first assumption is that the total losses from degraded mortgages and CDOs are limited the amount that has already been announced to date. This is a somewhat generous assumption, as there are some analysts that believe further write-off will be needed in the future. The second assumption is that there will no material change in the amount of borrowing undertaken by the banks, and that they do not receive any new equity injections, which is a more stern assumption. Thus, the decreased value of assets on the balance sheet of banks causes a decline tangible equity.

In this scenario, the ratio of equity capital to total assets for the peer group composite falls from 5.35 to just over 5.0. In percent terms, this represents a 5.66% drop, with the declines for the different banks ranging between 1% and 22%.

Scenario 2: Potential losses in LBO markets

Banks serve as advisors for buyers and sellers in M&A deals, and they often use Leverage Buyout (LBO) to fund the strategies. However, since this past summer, there has been an abrupt change in available liquidity in the market for such deals, a reduction in investor demand for LBO loan risk. As a result, the public offering of many LBOs and the related leveraged loans have been postponed, restructured, or cancelled. The volume of completed M&A deals during the third quarter was recently estimated to be down by roughly 25%.

As a result, until they are sold to other investors, the banks’ balance sheets have become the home for many of the LBO loans. So, in this scenario we calculate the impact of banks having to absorb portions of the LBOs outstanding. The assumption driving this scenario is that 75% of all pending LBO deals, and 50% of completed ones, come back on the banks' balance sheet Source of the Data on Completed and Pending LBO Deals: Fitch Ratings .

The result of this scenario is a decrease in peer group average ratio of equity capital to total assets from 5.35 to 5.26, or a 1.66% drop, ranging among the companies from a 1.6% to 3.4% decline. This scenario has the smallest impact among the three on the solvency ratios, since the act of bringing the LBO financing onto their balance sheets means an increase in bank assets, even though they do not particularly want these assets on their books, and recognizing that the value of some of the LBO structures will also likely deteriorate in credit quality.

Scenario 3: Potential Change in Assets of the Banks due to the new FASB 157 Regulation.

In a master stroke of bad timing, and a clear manifestation of the law of unintended consequences, the accounting regulator Financial Accounting Standards Board (FASB) determined that new methods are needed to properly account for these securities. They issued a new rule to be implemented on November 15.

Essentially, Statement 157 requires a financial firm to divide its assets into three categories called Level 1, Level 2, and Level 3. Under FASB terminology, Level 1 means assets that can be marked-to-market, where an asset's worth is based on a real price, like a stock quote. Level 2 is mark-to-model, where the price of securities results from an estimate based on observable inputs, used when no regularly quoted prices are available. Level 3 values are based on unobservable inputs reflecting companies' own assumptions about the way assets would be priced, or related to their credit ratings.

Under previous regulations, banks were allowed to treat many of the CDO and other securitized assets as though they were Level 3, giving them great leeway in determining the drivers of security value. Now, however, a material portion of their assets will have to leave the Level 3 bucket, where they previously avoided using market prices to evaluate such assets. A significant portion of these financial assets will have to be valued using market prices or proxies of them, rather than using finance models and credit ratings.

At the same time that banks have to change the manner in which they value these securities, market conditions have deteriorated, making it more difficult to find reliable price quotes, and making it more likely that the discovered price is much lower that the prices used previously.

Table 3 – U.S. Bank's Level 3 Asset Holdings

Source: Nouriel Roubini's Global Economic Monitor, Global Insight Calculations

While the reasoning and intentions were well placed, the new FASB regulation will have the effect of causing many firms to downgrade to value of their assets. According to the Royal Bank of Scotland, U.S. banks and brokers will face as much as $100 billion of write-downs because of the new accounting rules, over and above the losses caused by the sub-prime mortgage credit slump. Table 3 summarizes the big banks holdings of Level 3 assets.

Under this scenario, we assume that 25% of Level 3 assets will be written down in fourth-quarter 2007 as a result of new regulation. This scenario has the largest impact among the three on the solvency ratios of banks. The ratio of equity capital to total assets for the peer group total in this scenario declines from 5.35 to 4.25. This translates into 20.46% decrease in the ratio, and with percent declines ranging from 3.7% to 63.9% for individual banks.

It is worth noting also the impact of this scenario is the most sensitive to the assumptions driving the scenario. We choose 25% as the amount of write-downs because it is a reasonable number given current market conditions.

However, if we assume instead a harsher write-down of 35% of Level 3 assets, this would lead to a reduction in the peer groups' ratio of equity capital to total assets from 5.35 to 1.51. In such a situation, at least one of the eight banks would flirt with liquidation, as its tangible equity capital to total assets ratio becomes negative. A more benign assumption of 15% of Level 3 write-downs still causes the ratio of equity to assets decline to 4.7 (Table 4).

Table 4 – Simulation Results of Scenario 3 Sensitivity Test for Peer Group Total

(Potential exposures to the new FASB 157 Regulation)

Perfect Storm Summary

What is the impact of all three scenarios happening at once, as in a perfect storm (Table 5)?

Clearly, the combination of these scenarios would cause significant financial damage to investment banks' equity positions. If the perfect storm takes place in the manner we have described, then the combined scenarios produce a substantial 27.5% decrease in the equity to assets ratio, from 5.35 to 3.88. Amongst the eight companies, the percent decline in this ratio ranges from 11% to a whopping 78%.

An even more severe decline is shown by the ratio of tangible equity to assets (a 47.56% drop). The ratio that uses tangible equity instead of total equity is typically viewed as a more accurate liquidity measure since it excludes the intangible assets that often contain no value during liquidation procedures.

Table 5– "Perfect Storm" Scenario Results for Peer Group Total

Such a decline in equity capital would bring their ratios down to levels not seen since 1990, during the recession, and S&L crises. If this were to occur, there will be great pressure for some of the companies to change strategies; possibly to sell assets, lend less, merge, or solicit additional (dilutive) equity injections.

What Else Could Happen?

There are a few other related factors that we have not included in this analysis. For example, we have not attempted to calculate any potential losses that might be required by write-downs of SIVs. Many of these SIVs are already in line for credit rating downgrades. In addition, several banks have already needed to give capital infusions to investment funds, operating under their umbrella, that have invested in the SIVs. There could be very large consequences indeed if the SIVs need to be brought onto the bank's balance sheets.

Also in the first scenario, we have assumed there will not be any further write-downs of structured products (e.g. CDOs). However, there are many analysts who believe there will be more write-downs required. Evidence for this is given by the continued declines in the ABX index, which tracks prices on mortgage pools.

Finally, we have not included any impacts on bank earnings that will come from having to put up more reserves against loan-losses, due to the deteriorating credit environment. If banks experience a hit to non-performing levels and bring that exposure to books, write-off of the principal on the loans brought on the balance sheet will follow. This would bring additional pressures on earning and thus higher probability of ratings cuts.

The scenarios we calculated, in combination with several of the other factors not included in the calculations, certainly highlight the potential for a prolonged period of impact on the finances of banks.