The banks referred to worse-than-expected deterioration in economic and financial market conditions in the fourth quarter, which led to greater losses and write-downs and û in the case of Royal Bank of Scotland (RBS) û a need for more government capital. But even more worryingly their statements drew attention, either explicitly or implicitly, to the fact that further losses in the months ahead will depend a lot on how financial markets behave and how the economic downturn is impacting the ability of companies to service their loans. The problem, it seems, is no longer confined to the valuation of subprime-linked assets (now commonly referred to as toxic assets), but of the risk that ordinary loans will turn problematic too.
RBS hit the nail on the head in its fourth quarter trading update on Monday with the following observation: ôSignificant uncertainties remain as to the path of both the world economy and markets. While more asset deterioration and significant credit losses seem certain, their extent and timing cannot be predicted.ö
The statement was echoed by MoodyÆs Investors Service as it downgraded RBSÆs long-term ratings to Aa3 from Aa1 and its bank financial strength rating to C- from B in the wake of the trading update. The ratings agency said the downgrades reflect its expectation of ôsignificant future losses beyond those indicated by the bank for 2008. These losses are likely to be driven by a combination of loans to lower-rated corporates as default rates rise, and commercial property exposures in the weakening markets of Ireland and the UK, as well as residential property and other consumer lending exposures in the US.ö The bank financial strength rating remains on review for a possible further downgrade.
Derek Chambers, an equity analyst with Standard & PoorÆs Equity Research, says the realisation that the problems in the financial sector are a lot bigger than just the losses on the structured products portfolios has only begun to sink in now. In fact, he argues that the collapse of the US subprime lending market was a symptom of the problem, rather than the cause. The cause, he says, was the large increase in leverage that was built up in the global financial system, which was difficult to see until the banking system began to crumble. Consequently, the potential losses for the credit providers should be seen not just in relation to the $1 trillion or so that has been lent for subprime-linked assets, but in relation to all financial assets in the global system, estimated at about $200 trillion or three times the global GDP.
ôCredit impairments will continue into 2009 and maybe beyond and that will make it difficult for banks to rebuild their capital bases from earnings,ö Chambers says.
RBS lost two-thirds of its market value during MondayÆs trading session as investors scrambled to rid their portfolios of its shares, although analysts say it wasnÆt primarily its gloomy outlook that spooked the market but the fact that its loan losses deteriorated more rapidly than expected in the fourth quarter and that the preference shares held by the UK government following an earlier bailout exercise, will be converted into ordinary shares. The latter will reduce RBSÆs annual dividend payments by ú600 million ($848 million), but will result in a 42% dilution of its existing share capital and likely see the government increase its stake from 58% to 70%.
RBS said it incurred significant credit impairment losses and credit market write-downs in the last few weeks of 2008 due to the ongoing dislocation in financial markets, significant uncertainties in credit conditions and the sharp deterioration in economic conditions. It estimated that it will report a full year 2008 attributable loss of between ú7 billion and ú8 billion before goodwill impairments and noted that the fourth quarter income in its global banking and markets division (GBM), which includes the investment bank, will be about ú3 billion lower than its expectations in early November.
Credit impairment losses are expected to be between ú6.5 billion and ú7 billion, of which ú3 billion can be attributed to GBM, and full-year credit market write-downs are estimated at ú8 billion, including ú1.9 billion of new write-downs in the fourth quarter. RBS added that it is currently reviewing the carrying value of goodwill and other purchased intangibles, but expects to take a charge ôin the region ofö ú15 billion to ú20 billion.
A credit analyst at Bank of America-Merrill Lynch said in a research note that he was ôsomewhat comforted (RBS) addressing the marketÆs concerns by taking a large goodwill writedown and booking further large losses on various (mainly credit market) exposures.ö However, he remains underweight RBS paper due to concerns about the weak outlook for the UK economy, which mean that we ômay not have seen the last of the bad news from this issuer.ö
Meanwhile, Deutsche Bank said it currently expects to post an after-tax loss in the region of Ç4.8 billion ($6.2 billion) û much worse than the market consensus - as market conditions have severely impacted the results of its sales and trading business, most notably within credit trading (including proprietary trading), equity derivatives and equities proprietary trading. The full-year loss is estimated at Ç3.9 billion. However, it added that it has reduced its exposure to leveraged loans and loan commitments from Ç11.9 billion at the end of the third quarter to below Eur1 billion at the end of the fourth quarter, and the value of its commercial real estate loans declined from Ç8.4 billion to under Ç3 billion in the same period.
Deutsche Bank chairman Josef Ackermann said in a statement that the bank was ôvery disappointedö with the fourth quarter result and noted that the difficult market environment had exposed some weaknesses in its platform, which it is addressing. This includes scaling back, or exiting, trading strategies that are most affected by the market turbulence.
Investor confidence was also rattled tis week by the UK governmentÆs announcement of a second bailout programme û a sure sign that the financial sector is in dire straits. Details of the package are to be released next month, but it will include the possibility for banks to buy government insurance against a decline in valuation of toxic assets. RBS immediately said that it would be one of the first banks to take advantage of this new insurance. On paper this should be positive for the banking system û as should the governmentÆs insistence that RBS must increase its lending to both SMEs and large UK companies by ú6 billion in return for its continued support. But the selloff in financial stocks this week suggests that investors remain sceptical as to whether these new measures will work, which is not too surprising since we have yet to see much positive impact from the first programme.
ôIn October, people were prepared to give [the first bailout package] a chance, but now sentiment is very fragile and people are beginning to feel that there is no early way out,ö says Simon Willis, a banking analyst with NCB Stockbrokers.
RBS may have seen a bigger share price decline than any other bank this week û it fell 70% on Monday and Tuesday to a low of 10.3 pence before rebounding 21.4% yesterday to a close of 12.5 pence û but it is far from the only one that is under pressure at the moment. In fact, the bank trading updates in combination with data supporting the notion of a prolonged recession, has led to intensified speculation that several banks, including HSBC, Barclays, and Deutsche Bank, may need to raise new capital.
Deutsche Bank has denied that this is the case, stressing that its tier 1 capital ratio is anticipated to be in line with its 10% target as of the end of 2008, while its core tier 1 ratio will be around 7%. Even so, its share price fell 29% in the five sessions after its fourth quarter update last Wednesday to a low of Ç17.05, before gaining 4.8% yesterday to a close of Ç17.88. HSBC has also been in the line of fire amid claims from analysts û and shareholder activist Knight Vinke (which owns stock in HSBC) û that it has a substantial and worsening capital shortfall and is poised to announce a substantial rights issue, perhaps as large as $30 billion.
HSBC issued a statement on Monday saying it has not sought capital support from the UK government and cannot envisage any circumstances where this would be necessary. However, investors remained doubtful and its London-listed shares lost 24% in the five days to Tuesday this week before bouncing 6.3% yesterday.
Barclays issued its own earnings guidance on Friday û likely in an attempt to halt the slide in its share price û saying that it expects to report a 2008 pre-tax profit well ahead of the market consensus of ú5.3 billion when it releases its full-year earnings on February 17. This would also be only slightly below its previous 2008 forecast of ú6.18 billion made at the end of October 2008. Investors proved hard to convince, however, and the stock has fallen sharply every day since last Monday, losing a combined 64%. Contrary to the other banking stocks, Barclays didnÆt rebound yesterday, but fell a further 9.3%.
Willis at NCB Stockbrokers says the market finds it hard to believe the upbeat numbers and says that the provisions made by Barclays so far are a lot lighter than for most of its peers. This has been possible because the bank has taken the approach of holding its toxic assets and leveraged loans to maturity and as a result believes that it should eventually be able to receive close to par value, rather than the distressed prices indicated by the market at present.
ôBarclays has a very similar business to RBS and thus they are being treated on a like-for-like basis. The market has finally decided that [Barclays] too will have to go to the UK government for capital,ö Willis says.
Meanwhile, across the Atlantic similar concerns about an additional need for capital has been hitting Bank of America this week, while Citi has been under pressure following the announcement that it plans to divide its businesses into one ôgood bankö and one ôbad bankö û with the intention of selling part of the bad bank assets. Both banks rebounded amid a relief rally on Wall Street Wednesday that was partly fuelled by short covering. BoA was also helped by regulatory reports showing that company insiders, including CEO Ken Lewis, had been buying company shares in size during the previous session.
Deutsche Bank will publish its fourth quarter and full-year 2008 results on February 5, while RBS's 2008 results are scheduled for February 26.
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