HSBC covers US failure with ambitious rights issue

HSBC is trying to turn the tables on its critics with a bold £12.5 billion ($17.7 billion) rights issue (net of expenses) and plans to close its loss-making consumer finance unit in the US. The fresh funds will strengthen its capitalisation and enable it to win market share from its weakened multinational rivals, the bank claims, while closing the consumer finance operation will stop the flow of losses once and for all.  

Investors were not impressed, however, and its share price hit a 52-week low during London trading on Monday. At the end of the session the bank had lost 18.8% of its market value and closed at 399 pence.  

That is not just because the fully underwritten rights issue will raise the equivalent of 25% of HSBC's market cap. The bank also announced net earnings of just $5.73 billion for 2008, compared to consensus estimates of $13.5 billion. However, the striking drop was primarily due to the company unexpectedly deciding to take the complete $10 billion charge on goodwill for the consumer finance unit HSBC Financing Corporation (HSBCFC), which it bought for $15 billion in 2003, rather than spreading it over two years.

Apart from HSBCFC, the bank unveiled encouraging operating figures, which showed that it was growing its business across the world at a time when most of its rivals were being propped up by government handouts. (HSBC has so far refused any public funds.) HSBC executives took credit for not suffering heavy losses in the UK (unlike the other domestic banks) and CFO Douglas Flint said that by "calling the top of the bubble in 2006" HSBC made $3.7 billion in the UK in 2008 -- a 23% decline year-on-year.

The plan with regard to HSBCFC is to run off most of the existing loans and close the branch network. Around $100 billion in mortgages, secure consumer lending, vehicle finance and unsecured personal credit will be affected, but not credit cards and private labels, which amount to around $46 billion. Group CEO Mike Geoghegan admitted that he had misread the speed of the increase in unemployment in the US, which has a massive impact on consumer lending.  

Outside the US, HSBC was profitable in all geographic areas, although down from the mostly record levels of 2007. The top line, net operating income, increased to $81.7 billion in 2008 from $78.9 billion a year earlier. HSBC made $12 billion pre-tax in Asia, $2 billion in Latin America, and $10.9 billion in Europe, for a total of $24.9 billion. North America generated losses of $5 billion excluding goodwill impairment, and another $10.6 billion including impairments.

Globally, personal financial services (PFS) lost money because of the US operations. But commercial banking, global banking and markets, and private banking were all profitable pre-impairment, generating a combined $19.9 billion before tax. After factoring in the $10.6 billion goodwill impairment in the US, HSBC announced a 62% decline in profits before tax to $9.3 billion.

One-off gains and losses, apart from goodwill, comprised the sale of its regional French bank network for $2.2 billion, $1 billion against the Madoff fraud, a gain of $6.6 billion on its own debt, and trading write-downs of $5.4 billion in global banking and markets. Global banking and markets is HSBC's investment banking division under Stuart Gulliver, which has focused on financing its clients rather than behaving like the high-risk, high leverage, principal investing-driven bulge bracket banks in the US.

The fully pre-emptive five-for-12 rights issue at 254 pence ($3.81) per share will "increase HSBC's signature financial strength", raise its core equity tier-1 capital ratio to 8.5%, and provide the bank with the means for organic or inorganic growth in markets deserted by its multinational rivals. In what looks like an implicit recognition that Basel II has essentially completely failed to protect the health of the banking system, HSBC said in a statement to the Hong Kong stock exchange that under current circumstances, markets and regulators are looking for signs of financial strength beyond the traditional ones.

"We don't need this capital," says chairman Stephen Green in an HSBC earnings video message, "but it further strengthens our capital in exceptionally volatile times, and enables us to invest in fast-growing markets and grow our risk-weighted assets." HSBC would not give a ratio for common tangible equity to assets less goodwill, which is increasingly seen as the new quasi-regulatory hurdle in the US.

The rights issue, which will account for 41.7% of the existing issued share capital, is subject to shareholders' approval at a general meeting on March 19. It will be fully underwritten by Goldman Sachs, J.P. Morgan and others, including BNP Paribas, Credit Suisse and RBS Hoare Govett as co-bookrunners. Goldman Sachs, JPMorgan Cazenove and HSBC Bank are acting as joint global co-ordinators and joint bookrunners.

The issue price of 254 pence -- HK$28 for shareholders in Hong Kong -- represents a 36.3% discount to yesterday's closing price in London, a 47.5% discount to Friday's close after adjusting for the fact that the rights share will not be eligible for the fourth interim dividend, and a 39% discount to the theoretical ex-rights price (based on the adjusted Friday close).

HSBC is not withdrawing from all its activities in the US, where it also has a banking network. Green says he envisages the bank serving customers who are connected across the world. Prime examples in the US would be Hispanic customers, since HSBC has a network in the Latin America, and Americans with interests in China.

HSBC also points out that it has increased its customer loans and advances by 9% compared to a 16% increase in customer accounts. It has a strong advances-to-deposit ratio of 83.6%, down slightly from last year. In other words, its deposits are larger than its customer advances.

By withdrawing from HSBCFC, HSBC is agreeing with activist investors Knight Vinke that the acquisition was a mistake. Knight Vinke has been demanding an extreme solution to the HSBCFC problem, namely that HSBC walk away from its US bonds, which HSBC has firmly refused to do. In a written statement on Monday, Knight Vinke expressed its discontent at the likelihood of HSBC using the proceeds of the rights issue to plug the hole in the US. At a press conference in London on Monday, the management denied this, and pointed out that HSBC is a profitable business which will generate sufficient capital to pay for the runoff in its US portfolios.

Provisioning is unlikely to be over yet, though. A question mark hangs over the $56.2 billion (although with reserves of $18.7 billion against them) of 'available for sale' asset-backed securities. These are marked -to-market but not reported on the income statement until they are sold. HSBC also announced that 2% of its $427 billion in trading assets are 'level 3', meaning that they are impossible to value at market prices.

Until recently, HSBC has played an elegant and effective game in defending its brand and its franchise. However, the argument that HSBC will become the supreme cross-continental bank as rivals like Citi break up or shrink back to within their borders sounds unconvincing. These days, it's not just banks that are shrinking- - so is the whole superstructure of globalisation, including record levels of trade, which was created by unprecedented prosperity. In Tokyo, Hong Kong and Beijing, expats are being retrenched. And local firms aren't taking up the slack -- they are staying within their borders and nurturing their capital instead. Yet it's precisely these cosmopolitan and highly paid people that HSBC needs to tap. It may indeed take market share, but the question is whether that market will be worth anything.