Today seems to be the day of banks praising each other with faint damns, what with James Gorman handing out copies of a Credit Suisse report lowering estimates for Morgan Stanley. Goldman equity research is also out with a mammoth and interesting note on French banks, which against this market backdrop actually manages to sound pretty chipper despite warning of increasing risks, reducing earnings estimates and downgrading Soc Gen from buy to neutral. They also think that French banks will need to improve capital ratios, but aren't sweating it too much. Here's how they think that goes:
In our view, delevering is the prime option. For share prices, the consequences are twofold:
- First, it would be less dilutive to earnings: simplistically, raising equity by cutting assets is raising equity on a multiple of 1x tangible book. Assuming that CT1 capital and tangible book value are broadly equal, trading at 0.5x TBV (the average for French banks) would be twice as dilutive as losing the earnings associated with delevered assets.
- Second, we believe reducing leverage and risk should benefit the cost of equity and therefore somewhat offset the impact of lower earnings on the share price. In our view, French banks’ valuations are penalized by their higher leverage. Reducing leverage would likely result in reduced wholesale funding needs and possibly tighten the gap between simple leverage and risk-based leverage (CT1 ratio).
There's even a handy chart (left axis seems to be EPS dilution, bottom is tangible book value multiple):
I was reminded of Barry Ritholtz's argument this morning that banks, by making their balance sheets increasingly opaque and hard for investors to value, have shot themselves in the foot with investors and are seeing their equity prices suffer. He's talking about US banks, but the same would apply to European banks that do little things like carry Greek debt at 100 (or 79) despite market evidence to the contrary.
At some obvious level Goldman's graph can't really be right - if it was, then banks should never trade below tangible book value because they could always just sell assets and pay down debt until they got their share price back to 1.0x tangible book. Or put another way if the banks could actually realize twice their market price by selling all of their assets, they should just do that then. If Soc Gen is worth twice as much to shareholders dead as alive, then it's destroying value by staying alive.
Of course that doesn't happen. The reason they trade below book value is mainly because investors don't believe that their assets are worth what they say they are, so they haircut the book value to get a safe trading level. You have to conclude that when a bank trades at 0.5x tangible book value there's something wrong either with its tangible book value or with its trading price. Or both. But in any case it's hard to imagine that the tangible book value is entirely right - there's more write-offs coming somewhere; the bank may not be worth 50% of what its books say but it's not worth 100% either.
So how does the deleveraging strategy work? You've got $1,000 in book value of assets and you sell $100 worth of them to pay down leverage. If you only get $90 for those assets, then you look pretty bad - if you can't sell your assets for the price you're carrying them on your books, then that throws the rest of your balance sheet into even more doubt.
If you do get $100 and pay down $100 worth of debt, then, great - you've confirmed that your valuations were right. On what you sold. You've provided no data on what you didn't sell. On the hypothesis that your equity investors - and not even short sellers any more! - know what they're doing valuing you at 0.5x book, then you've concentrated your business into the worst assets. Your multiple should go down, because your book value calculation has gotten even dodgier.
All sort of obvious stuff. But Goldman's suggested strategy for the French bank - delevering via asset sales is less dilutive than equity issuance! - suggests part of why kicking the can is so appealing for banks, and why investors are still so worried about them.