Are Chinese banks massaging their losses?

Posted by Tracy Alloway on Dec 18 09:53.

Ratings agencies aren’t generally known for expressing negative views, but Fitch has really done a number on Chinese banks in its annual review on the sector, currently making headlines around the world.

The basic idea is that while Chinese banks appear largely unscathed from the credit crisis there are things going on beneath the surface of Chinese finances.

For instance, the asset quality of the country’s banks:

For more than a year, Fitch has been voicing concern about the asset quality outlook for banks in China. But rather than worsening, the asset quality figures reported by most Chinese banks have actually been improving in 2009 . . .

Fitch has emphasized all along that asset quality deterioration is a medium‐term issue for banks in China because of the extended time it can take for loans to be recognized as impaired due to widespread rolling‐over of delinquent credits and the bullet‐oriented structure of most corporate lending. This is not to be overlooked, as one could argue that many of the flaws in the global financial system might still be hidden today if banks in the US had been more lenient in classifying delinquent mortgages.

Ouch.

In fact, if you dig deeper into the numbers, Fitch says, there was basically CNY450bn ($66bn) missing in non-performing (NPLs) and special mention (SM) loans in 2008.

China’s listed banks began disclosing the downward rate of migration within their five-tier loan classification brackets in 2009. It’s basically the rate that loans are deteriorating. And as Fitch notes, “at first glance, some of the ratios are surprisingly high given how little movement there is each period in the balances of NPLs, SM loans and charge-offs.”

For instance, in 2008 listed Chinese banks reported an average migration rate of normal loans to NPL or Sm status of 3.7 per cent. According to Fitch’s calculations, that would imply about CNY500bn of combined new NPLs and SM loans in 2008 — but the reported amount of NPLs and SM loans adjusted for charge-offs rose by only CNY50bn. What happened to that other CNY450bn?

Are Chinese banks, in FT Alphaville parlance, err, massaging their losses?

Here’s what Fitch suggests:

• The migration ratios currently reported by many banks appear to be systematically overstated owing to deficiencies in the mathematical formulas underlying the ratios; and
• even taking into account this overstatement, it would appear that a substantially greater amount of loans are migrating to SM and NPL status each period than changes in the balances of NPLs or SM loans would indicate. This means that a large number of existing NPLs and SM loans must either be moving upward in the classification, or getting repaid or disposed of to offset this downward movement.

That might not sound too bad, but bear in mind the discrepancy effectively means the migration numbers currently reported by Chinese banks can’t be relied upon, and are pretty much useless when it comes to comparing one bank’s migration rate against another’s.

And on the second point — the mysterious movements in loans — there’s a much bigger issue at play:

Over the past two years, the most disconcerting trend Fitch has observed in China’s banking sector is the growing prominence of unreported loan transactions. In a special report in September 2008, the agency highlighted one type of this activity, which is the sale and re‐packaging of loans into wealth management products that are then sold on to investors. Since that time, Fitch has noticed the growing popularity of another type of transaction, which is the outright sale of loans to other financial institutions. In both instances, the vast majority of activity is not recorded by Chinese banks on‐ or off‐balancesheet, and therefore is invisible to investors and analysts.

The idea here is that repackaging or selling off these loans allows China’s banks to free up space to extend new loans and keep up with the state’s rather rigorous lending quotas.

The banks themselves say such transactions aren’t an issue, since the credit risk is totally transferred to the buyer — hence why they don’t disclose them in their financial reports. But Fitch worries that the banks could still be “reputationally liable” for losses on the loans. They note that:

Indeed, in the very few instances of default on loans underlying wealth management products to date, Chinese banks either have stepped in and completely covered investor losses, or are engaged in heated legal disputes.

While Fitch has major concerns about the transparency of this activity, it recognizes that to some extent it is a natural outgrowth of a rapidly developing financial system, where capacity to extend new credit is facilitated by active securitization markets. However, China is in the awkward position of having reached the point where greater securitization could be helpful precisely at a time when the reputation of all securitization activity has suffered a major blow. Nevertheless, allowing such activity to continue in an unregulated manner with extremely poor disclosure could lead to substantial hidden contingent liabilities, and is one of the major factors weighing on the Individual Ratings of Chinese banks.

Maybe not massaging their losses then, but certainly (potentially) their liabilities.

The whole report is really worth reading.

Related links:
Chinese capital likely more strained, Fitch says – Bloomberg
Tidying up after China’s lending binge – WSJ

[Outlook 2010] Saxo's outrageous predictions for 2010

Posted by Izabella Kaminska on Dec 17 09:50.

Every year Saxo Bank comes out with a list of 10 outrageous predictions for the year ahead.

Previous predictions from the bank have included Ron Paul being elected US president, crude crashing to $25 per barrel and Chinese growth hitting zero.

Without further ado then, we present Saxo’s latest outrageous predictions for 2010:

1)Bunds yields will fall to 2.25%
Deflationary forces and excessive monetary policy will lower the yield on Bunds and other sovereign fixed income when the government fixed income traders refuse to buy into the “growth story” that is being told by the stock market. We believe that the German 10-Year Government Bond could be forced from 122.6 to 133.3 by the end of 2010 in a general flight to quality.

2) VIX will fall to 14
The markets are showing the same kind of complacency towards risk as they were in 2005-06. Although the VIX has been trading lower since October 2008, this could bring the VIX down from 22.32 to 14 as trading ranges narrow and implied options volatility declines.

3) CNY (China Yuan Renminbi) will be devalued by 5% vs. USD The efforts of Chinese authorities to stem the credit growth and avoid bad loans, combined with the creation of several growth bubbles could ultimately reveal the Chinese investment-driven growth as being deficient. The massive, Chinese spare capacity and the economic backdrop could be a deciding factor in devaluing the CNY vs. the USD.

4) Gold will fall to $870 in 2010 but will rise to $1500 in 2014
A general strengthening of the USD could break the back of the recent speculative element in gold. Although we are long term bullish on gold (believing it will reach $1500 within five years), this trade seems to have become too easy and too widespread to pay out in the shorter term. A serious correction towards the $870 level could shake out the speculative community while keeping the metal in a longer term uptrend.

5) USDJPY to reach 110
Although the downturn in the USD is rooted in irresponsible fiscal and monetary policies, we believe that the USD could snap back at some point in 2010 because the USD carry trade has been too easy and too obvious for too long. At the same time, the JPY is not reflecting economic reality in Japan, which is struggling with a huge debt burden and ageing population.

6)Angry American public to form third party in the US
The anti-incumbent mood is approaching 1994 and 2006 levels as a result of bail-outs and general disapproval of both the big parties. A demand for real change among American voters could propel a third new party to become a deciding factor in the 2010 elections.

7) The US Social Security Trust Fund will go bust
This is not so much an outrageous claim as an actuarial and mathematical certainty. The outrageous part is that social security taxes and contributions have been squandered for so long. 2010 will be the first year where outlays for the non-existing trust fund will have to be part-financed by the federal government’s General Fund. I.e. the budget trick, in reality a “fund” without funds, will be visible for the first time. Part of the social security outlays will have to be financed by higher taxes, more borrowing or more printing.

8)The price of sugar will drop one third
Despite a recent spike in prices caused by Indian drought and above average rainfall in Brazil, the forward curve already indicates considerable downside beyond 2011 so a return to more normal weather conditions in 2010 would make sugar one of the less inspiring commodities. Furthermore, the higher price of ethanol (which is correlated to the demand for sugar) has made both Brazil and the US lower the ethanol content of gasoline by five percentage points, consequently lowering the demand for sugar.

9) TSE Small Index will rise by 50%
Small cap firms have been underperforming the Nikkei, but their fundamentals indicate this is a “bargain index” compared with its large-cap peer. With a price/book ratio of only 0.77 and only about 12% of the index consisting of financials, we know no other index this cheap. Positive GDP figures in 2010 could very well make this index a surprise to the upside.

10) US trade balance will turn positive for first time in 34 years
Last time the US trade balance was positive was briefly in 1975 after a large drop in the USD following the aftermath of the oil crisis. The USD has now become cheap enough again to stimulate US exports and punish imports. The trade balance has already improved somewhat but change takes time and once it has momentum we would not rule out a positive US trade balance for one or more months of 2010.

To compare and contrast with how they fared before click here.

Article Series - Outlook 2010

1. The deluge begins
2. Deutsche Bank ponders all things sovereign
3. Goldman sees 2010 as 'exciting, with risks!'
4. Goldman Sachs up 12-mth gold forecast to $1350/toz
5. JPM targets 20% gain for Euro equities
6. Thundering Herd bullish on Euro equities
7. How will analysts fare?
8. Moody's sees sovereign states a-suffering
9. 10 surprises from UBS
10. Chasing the rally into the New Year
11. Saxo's outrageous predictions for 2010
12. Ten tweets from Wilmot

All hail the Basel banking regime change

Posted by Tracy Alloway on Dec 17 13:17.

For it is — after much speculation and hand-wringing — here.

And here’s the summary of what the Basel Committee on Banking Supervision, which sets the supervisory standards for many of the world’s banks, is suggesting to strengthen the sector:

First, the quality, consistency, and transparency of the capital base will be raised. This will ensure that large, internationally active banks are in a better position to absorb losses on both a going concern and gone concern basis. For example, under the current Basel Committee standard, banks could hold as little as 2% common equity to risk-based assets, before the application of key regulatory adjustments.

Second, the risk coverage of the capital framework will be strengthened. In addition to the trading book and securitisation reforms announced in July 2009, the Committee is proposing to strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos, and securities financing activities. These enhancements will strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the next through the derivatives and financing channel. The strengthened counterparty capital requirements also will increase incentives to move OTC derivative exposures to central counterparties and exchanges.

Third, the Committee will introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. This will help contain the build up of excessive leverage in the banking system, introduce additional safeguards against attempts to game the risk based requirements, and help address model risk. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for any remaining differences in accounting. The ratio will be calibrated so that it serves as a credible supplementary measure to the riskbased requirements, taking into account the forthcoming changes to the Basel II framework.

Fourth, the Committee is introducing a series of measures to promote the build up of capital buffers in good times that can be drawn upon in periods of stress. A countercyclical capital framework will contribute to a more stable banking system, which will help dampen, instead of amplify, economic and financial shocks. In addition, the Committee is promoting more forward looking provisioning based on expected losses, which captures actual losses more transparently and is also less procyclical than the current “incurred loss” provisioning model.

Fifth, the Committee is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. The framework also includes a common set of monitoring metrics to assist supervisors in identifying and analysing liquidity risk trends at both the bank and system wide level. These standards and monitoring metrics complement the Committee’s Principles for Sound Liquidity Risk Management and Supervision issued in September 2008.

The full Basel paper is available here, and the liquidity supplement is here.

And the market reaction for selected banks:

Related links:
Bank capital rules face overhaul – FT
A Basel breather heard ’round the world – FT Alphaville
A Basel round-up for bonus-bugged bankers – FT Alphaville
Counting the costs of more bank capital – FT Alphaville

How the IRS sort-of-saved Citi

Posted by Tracy Alloway on Dec 17 13:35.

Who says the IRS isn’t, umm, understanding?

The US tax authority exempted the Citigroup, and some other bailed-out companies, from rules which would otherwise have led to the troubled bank losing $38bn worth of tax credits.

Citi had planned to repay the US government’s Tarp stake, and under IRS regulation, companies that encounter a change in ownership lose these tax credits. The rule is designed, according to the IRS, to prevent profitable companies from buying loss-making ones to evade taxes.

The rule-change has nevertheless raised eyebrows. From the Washington Post on Wednesday:

The federal government quietly agreed to forgo billions of dollars in potential tax payments from Citigroup as part of the deal announced this week to wean the company from the massive taxpayer bailout that helped it survive the financial crisis.

The Internal Revenue Service on Friday issued an exception to long-standing tax rules for the benefit of Citigroup and a few other companies partially owned by the government. As a result, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells its stake to private investors.

The “quietly agreed to forgo billions of dollars in potential tax payments” is a bit of a red herring, bit it has sparked quite a bit of outrage from the Washington Post’s taxpaying readers (all available for perusal on the paper’s dot.comments blog).

The issue here is that these tax credits — Deferred Tax Assets (DTAs) — make up a significant proportion of Citi’s capital. Yanking them because of a change in ownership, one caused by the bank repaying the Tarp no less, would have defeated the purpose of them paying back the Tarp in the first place, and probably ended up costing the US taxpayer more US taxpayer in terms of lost Tarp monies and potential support costs.

Reuters columnist Rolfe Winkler, who’s been following the Citi capital debate for some time now, posted a good illustration of the problem:

To be sure, there’s a degree of moral hazard involved here. The US government has just changed the rules to reflect very specific circumstances, with the effect of, as one Republican staffer put it “[inflating] the returns that they’re showing from the Tarp.”

The market’s not stupid, however. It knows Citi still has problems — notably it could still lose some of its DTAs if there’s a regulatory crackdown, or if the bank’s future profitability is less than expected. That’s one of the reasons DTAs make such shoddy capital — they’re only really useful when a bank is making (enough) money.

In any case, Citi’s Tarp repayment fittingly fell through on Wednesday after investors demanded a lower price ($3.15) for the stock than the government paid ($3.25) when it acquired its stake.

Related links:
Citigroup’s share sale under fire – FT
What’s up with Citigroup? – The Baseline Scenario
The rise of deferred tax assets in Japan – University of Chicago paper (via SSRN)

Dubai is worth more than you think

Posted by Izabella Kaminska on Dec 17 14:39.

That is, Dubai EFS crude — rather than the emirate itself — is worth more than you think.

As Morgan Stanley highlighted in its commodity outlook for 2010, Dubai crude, which historically traded at a discount to Brent crude due to its heavier and sour quality, has managed to trade at a premium to Brent on several occasions in 2009.

Here’s the chart:

The investment bank predicts this will happen with even more consistency in 2010, as light-heavy spreads stay narrow and Asian refinery capacity continues to ratchet higher against lower US and European refinery throughput.

As they explain:

The IEA is expecting Asian crude demand to eclipse North American in early 2010, we see no reason to disagree with this forecast. Not only is the volume of Asian refinery capacity increasing rapidly — we count almost 1 mmb/d of incremental CDU capacity coming on line in Asia in 2010 — but the high complexity of the new refineries is also quickly eroding Brent’s quality premium.

And here’s a chart showing just how impressive that surge in Asian refining has been this year:

Related links:
Nothing bullish in crude – FT Alphaville
Not just a refinery, a super refinery – FT Alphaville
Why refinery shutdowns matter - FT Alphaville

Digesting the Basel reforms

Posted by Paul Murphy on Dec 17 18:17.

The latest Basel proposals for the banking sector were released on Thursday, and they are not going down well.

Here’s a snap summary from the banks team at Credit Suisse:

The Basel Committee has published its latest thoughts on capital and liquidity. We are still digesting the main implications of this, but at first read it looks pretty punitive on the sector. In particular, the new definitions of common equity tier 1 appear to take a very hardline with the majority of deferred tax assets, insurance equity capital, excess expected losses, unrealised debt losses, minority interests and pension fund liabilities being deducted. Other supervisory deductions will get a 1250% risk weight on these proposals. The calculation of counterparty credit risk also seems to be changing markedly. The liquidity document seems less surprising with the broad thrust being an increase in Government bond holdings and a reduction in short-term wholesale funding which we have written about extensively before.

Overall, we believe this is negative for the European banks sector. Timeline for implementation isn’t until 2012, with grandfathering arrangements thereafter, but the market is likely to look through this and penalise banks which rely heavily on DTA, pension fund add backs, and financial subsidiary capital in our view.

For individual banks, we need to do more work, but our first read is that UK banks, in particular LBG and RBS look substantially exposed (see our research pre-empting this two weeks ago). But this will affect most European banks as well. For example, the French banks have 6-22% of equity tier 1 capital from minorities. Consider also that Credit Agricole and Natixis are potentially exposed due to the listed entity owning 20-25% of their own retail networks with the associated deduction 50% from tier 1 and tier 2 – the rules might not apply here but could create uncertainties until decisions are made in 2010. Another example is Dexia with an equity tier one ratio at 10.8% but below 5% if the €8.8bn of unrealised negative AFS currently not deducted is applied to tier 1. Other regions, like Scandinavia and Italy are arguably less exposed given tier 1 definitions are already prudently struck.

Of course, these are still proposals and there’s a lot of detail still to emerge. There might also be national discretions, although the aim of this in part seems to be to remove those. One need only look at the Australian banks, several of which would report equity tier 1 ratios 200bps higher were they to adopt UK FSA standards. But generally speaking, the definitions are tightening up for all. Of course, the BIS might apply relatively low equity tier 1 minima, in line with tighter definitions. The question then is whether the market would accept lower headline numbers, or still push for relatively high (e.g. 8-10%) ratios on the new definitions. At the very least, the BIS’ starting point seems to be a relatively hardline approach to new capital and liquidity definitions – and hence we would view this negatively for the sector as a whole.

The real sticking point here seems to be changes to the definition of Tier 1 equity. Minority interests no longer apply, unrealised losses (and gains) must be taken into account, the use of deferred tax assets is largely ruled out and there are stringent new rules proposed for the related treatment of pension fund deficits. In short, banks’ core equity is going to have to get a lot purer.

Also, at the Tier 2 level, it looks like banks will be kissing goodbye to the upper and lower divisions.

There are some very complex changes to the treatment of counterparty risk, including the charming concept of “wrong way” risk, and also alterations to calculations like the probability of default, which in future will include the important caveat: in a downturn.

Meanwhile, on the liquidity front, the proposed framework here is broadly as expected, with banks being required to hold significantly more government bonds on their books.

Here’s some more from Credit Suisse:

1. Liquidity coverage ratio. This new regulatory ratio aims to ensure adequate liquidity in the event of another market disclocation. It is meant to require a bank to maintain an adequate level of “unencumbered, high quality assets that can be converted into cash to meet its liquidity needs for a 30 day time horizon under an acute liquidity stress scenario”. The ratio is defined as:

· (stock of high quality liquid assets) / (net cash outflows over a 30 day time period), with a minimum of 100%.

With high quality liquid assets including Government bonds and covered bonds. This isn’t a major surprise and is effectively a similar definition to central bank eligible collateral pre-crisis. More surprising though is the regulator’s assessment of an extreme stress scenario:

· 7.5% of “stable” retail and small business deposits go in the first 30 days;
· 15% of “less stable”deposits, high net worth (uninsured) deposits and internet deposits;
· 25% of wholesale funding with a maturity of less than 30 days supplied by large corporate customers as part of an operational payments services float;
· 75% of wholesale funding < 30 days from large corporate customers other than as part of payment systems float;
· 100% of interbank funding with a maturity of less than 30 days.

2. Net stable funding ratio. This new regulatory ratio aims to “promote more medium and long-term funding of the assets and activities of banking organisations”. It is defined as:

· (available amount of stable funding) / (required amount of stable funding) with a minimum of 100%

The numerator of this ratio is roughly equivalent to “core funding”, as defined in the Reserve Bank of New Zealand regulations and in our recent note “More important than Tier One?”, 27 November. It is calculated using a weighting schedule as below:

· 100% of total tier 1 and tier 2 capital and preferred stock
· 100% of liabilities with a contractual maturity >1yr
· 85% of “stable” retail and small business deposits with maturity <1yr
· 70% of “less stable” retail and small business with maturity <1yr
· 50% of large corporate deposits with maturity <1>

plus

· 10% of all undrawn committed credit lines and overdraft facilities
· And a percentage of guarantees, uncommitted credit lines, letters of credit, potential money market mutual fund repurchase obligations etc, at local regulator’s discretion.

The denominator is calculated as a weighted sum of the asset side of the balance sheet:

· 0% weighting – cash, securities with a remaining maturity <1yr, interbank loans with a maturity <1 yr, securities held with an offsetting reverse repo
· 5% weighting – unpledged high-quality liquid securities (similar definition to central bank eligible collateral)
· 20% weighting – corporate bonds and covered bonds with a proven record of liquidity (ie, no major increases in repo haircut in the last 10 years)
· 50% weighting – other corporate bonds, gold, equities, loans to corporates with a maturity less than one year
· 85% weighting – retail loans with a maturity less than one year
· 100% weighting – all loans with maturity > one year, all other assets

All in all, the view seems to be that this is a tad more aggressive than forecast. According to back of an envelope calculations by Credit Suisse, the European banking sector as a whole will have an aggregate funding requirement of €1,100bn.

Credit Suisse says that is broadly as expected, but it still sounds like an awfully large amount of money.

Related links:
Bank capital rules face overhaul – FT
Strengthening the resilience of the banking sector – BIS
International framework for liquidity risk measurement, standards and monitoring – BIS

US ’shadow housing inventory’ at 1.7m, CoreLogic says

Posted by Stacy-Marie Ishmael on Dec 17 20:39.

The “shadow” housing inventory in the US rose to 1.7m units in the third quarter of 2009, according to estimates by FirstAmerican CoreLogic, a provider of real estate data.

The data provider defines this pending housing supply, which stood at 1.1m in the same period a year ago, as:

real estate owned (REO) by banks and mortgage companies, as a result of foreclosures and other actions, such as deeds in lieu, as well as real estate that is at least 90 days delinquent.

This shadow inventory is not traditionally included in official measures of unsold inventory, which, as the Wall Street Journal pointed out, makes the exact level of supply in the US housing market “impossible to pin down”.

According to the WSJ, recent estimates by BarCap suggested banks and mortgage investors had 639,000 foreclosed homes for sale across the US:

That’s equivalent to more than 10% of expected U.S. home sales this year. The bank-owned homes are largely concentrated in Florida, California, Arizona and Nevada.

The estimate by FirstAmerican CoreLogic is even more aggressive (emphasis ours):

At the current sales rate, the pending supply is 3.3 months, up from 2.4 months a year ago. The months’ supply measures how quickly the inventory will run off given the current sales rate.

• The visible supply of unsold inventory was 3.8 million units in September 2009, down from 4.7 million a year earlier. The visible inventory measures the unsold inventory of new and existing homes that are currently on the market. The visible months’ supply fell to 7.8 months in September 2009, down from 10.1 months a year earlier.
• The total unsold inventory (which combines the visible and pending supply) was 5.5 million units in September 2009, down from 5.7 million a year ago. The total months’ supply was 11.1 months, down from 12.7 a year earlier. This indicates that while the visible months’ supply has decreased and is beginning to approach more normal levels, adding in the pending supply reveals there is still quite a bit of inventory that will impact the housing market for the next few years, especially in the context of the current increase in home sales, which is in part due to artificially low interest rates and the homebuyer tax credit.

FirstAmerican CoreLogic chart of Visible vs Pending Months' Supply

FirstAmerican CoreLogic chart of Months' Supply Pending Inventory Detail

Related links:
Shadow inventory threatens U.S. housing recovery – Globe and Mail
Housing Won’t Collapse in 2010, says Radar Logic – HousingWire
Goldman says US gov’t boosted home prices by 5% – FT Alphaville
Very Hamp-ered – FT Alphaville