The MasterBlog: Credit Crunch: It's just getting started...
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Monday, November 5, 2007

Credit Crunch: It's just getting started...

The Banks
Credit Crunch: More To Come
Liz Moyer, 11.02.07, 6:00 AM ET

Thursday brought new signs that Wall Street faces a fresh round of wrenching asset write-downs and the need to shore up shrinking capital levels. That sent markets into a tailspin, with the Dow Jones industrial average plunging 362 points. Financial stocks as a group fell 5%. So much for the Fed.
The main culprit: Citigroup. Its shares fell more than 7% at one point, after an analyst said Citi needed to raise $30 billion in capital, possibly by cutting its dividend, and raised concerns about the firm's bloated balance sheet.
The note by Meredith Whitney of CIBC World Markets supports the argument that banks are maintaining inadequate capital levels given the risks they are assuming on their trading books, particularly in their out-sized exposures to the credit derivatives that have gone haywire in the recent market tumult.
Citigroup's total capital ratio at the end of the third quarter was 10.1%, just above the 10% minimum regulators like to see to consider a bank "well capitalized." Its leverage ratio was 4.1%, down from 5.22% at the beginning of 2006 and below the 5% regulatory definition of well-capitalized.
More to the point, Whitney says, Citi's tangible capital ratio of 2.8% is well below the 4.7% average of banks of similar size, the result of a flurry of acquisitions over the last two years that bulked up its assets by 35%.
Citi faces a fourth quarter filled with uncertainty about the value of its remaining mortgage-derivative holdings, related short-term debt conduits and the possibility of further deterioration in consumer credit quality. This "would only exacerbate our thesis of capital pressures," Whitney said in her research note.
Some think Citi and other banks need even more capital. Twice as much, in fact. "The biggest mistake banks made was committing so many of their resources to structured finance," said Christopher Whalen, managing director of Institutional Risk Metrics, which advises firms on risk management.
When bond markets froze up in August and September, it became impossible for Wall Street to put a value on billions of securities on their books. That doesn't even speak to the assets they have off balance sheets that potentially might have to come back on.
Goldman Sachs classified $72 billion of assets, 15.6% of its trading inventory, as "level 3" in the third quarter, which means it couldn't come up with any way to price them using market data. Morgan Stanley has 15% of its trading assets in the level 3 category, Bear Stearns 12.6% and Lehman 12.3%, according to research by Sanford Bernstein.
Merrill Lynch, which wrote down more than $8 billion of assets in the third quarter, has yet to disclose its level 3 numbers, but they are certain to increase substantially over the second quarter, said Bernstein analyst Brad Hintz. Ditto for Citi.
Merrill still has $15 billion of collateralized debt obligations on its books, which is not good, according to Hintz. "We do not believe Merrill will be able to offload these assets in the near future," he wrote in a research note. "With virtually no available liquidity in this market, these assets will likely face negative pricing pressure as the supply of these assets will likely outpace demand."
The fact that ratings agencies keep reconsidering their ratings on the credit derivatives themselves isn't helping. This week, Standard & Poor's added another $20 billion worth of mortgage-related CDOs to its negative-credit watch list.
Further write-downs from CDOs and subprime holdings at Merrill could knock as much as 33% off its estimated fourth-quarter book value, figures Hintz of Sanford Bernstein.
The Federal Reserve has been trying to ease the credit crisis by pumping money into the banking system, adding another $41 billion on Thursday through its open-market operations. It encouraged further direct borrowing by lowering its discount rate for banks another 25 points on Wednesday, to 5%. (It also lowered the more important Fed funds rate, to 4.5%.
Still, the bad news keeps pouring out. Credit Suisse said third-quarter profits of $1.1 billion were off 31%, dragged down by leveraged loan exposures that it couldn't sell off during the quarter. At least Credit Suisse didn't surprise analysts the way Merrill Lynch did.
Regulators view banks as well capitalized if they maintain leverage ratios at or above 5% and total capital at or above 10%. Citigroup, in the third quarter, had a leverage ratio of 4.1% and total capital of 10.7%, down from 11.8% in January 2006. Tangible capital, which measures the ratio of tangible equity to tangible assets, is at 2.8%, where most banks are closer to 5%.
Problem is, Citigroup's balance sheet has ballooned in assets, bloated by more than $26 billion worth of acquisitions since last year and the return of off-balance-sheet assets brought back on since the summer's credit crunch.
A so-called "superfund" designed to alleviate the pressure on certain off-balance-sheet investment conduits (Citi has among the biggest individual exposures, at $80 billion to $100 billion) organized by Citi, JPMorgan Chase and Bank of America, seems to be struggling to get off the ground.
Citi could raise capital levels by selling assets or relying on earnings to rebuild capital, but any move it makes is likely to take a dent out of its share price.
The company wouldn't comment, and some other analysts said they thought a dividend cut would be an extreme step. Certainly, it's never a great sign when a bank--the stalwart of an income investor's portfolio--cuts its dividend. Widows and orphans beware.

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