Banks will have to raise new capital in 2009, as a sharp increase in credit-rating downgrades on mortgage-related securities will lead to further stresses on bank capital, according to top banking analyst Meredith Whitney at Oppenheimer Equity Research.
"From July 2007 to date, over $5 tn worth of securities have been downgraded, but our concern here is that the pace of downgrades has only accelerated through 2008," the Oppenheimer analyst wrote in a research note.
As a result, "capital ratios will be meaningfully lower in the fourth quarter (of 2008) versus post TARP pro forma levels," she added.
In describing what Whitney calls the banks' "Ring of Fire," the analyst explains: "When a security is downgraded, a higher level of capital is required by banks to be held against that security."
We've flagged this problem to you already, see blog “The Coming Bank Writedowns.”
The problem of downgrades aggravating bank capital needs is getting worse.
In the fourth quarter, over $2.3 tn of securities were downgraded, or over two and a half times the amount of the prior quarter and almost the entire amount of securities downgraded between the third quarter of 2007 and the third quarter of 2008.
Calling it "the single most important report we published in 2007," in which Whitney first sounded the alarms about this problem, Whitney says there is an "overwhelming but unappreciated relationship between rating agencies and regulators in determining the bank capital requirements."
Since the summer of 2007, Wall Street has been hammered by a sharp pullback in debt markets, which began with mortgage woes and escalated into a credit crisis, slowing economic activity around the world.
The problem Whitney has identified is adding fuel to the fire.
Fourth Quarter Writedowns Coming
Aside from the estimated $44 bn in writedowns and provisions in the fourth quarter Whitney expects for the group of 10 bank stocks under her coverage, and earnings pressure related to "chronic negative operating leverage," Whitney also expects "capital strains to become apparent from ratings change pressures."
Whitney estimates that Bank of America, Citigroup and JPMorgan Chase will be hit with a total of $13.7 bn in writedowns on certain risk exposures in the fourth quarter.
Citigroup will be hurt the most, with $8.8 bn in estimated writedowns, JPMorgan Chase next with $3.4 bn and Bank of America at $1.3 bn in estimated writedowns.
The $13.7 bn is about 21% of the TARP money the three have raised.
Goldman Sachs and Morgan Stanley have already posted fourth quarter writedowns in excess of $13 bn.
Banks will have to raise more capital in 2009.
Growing Loan Reserves Sting
Putting pressure on capital demands, JPMorgan Chase (JPM) will have the largest increase in fourth-quarter 2008 credit loss provisions at $6.2 bn, up 145% from $2.5 bn in the year-earlier period, Whitney said.
Whitney estimates Bank of America (BAC) will have to book a fourth-quarter credit loss provision of $6.7 bn, up 103% from $3.3 bn a year earlier.
Citigroup's provision for the period will be $7.9 bn, up 8% from a year earlier, while Wells Fargo (WFC) will need $4.4 bn, up 69% from a year earlier, the analyst said.
Into the Ring of Fire
"Investors have little faith in rated securities and thus buyers' appetite is dismally low, and, as these assets continue to de-rate/de-value, bank capital ratios seem increasingly built on sand," Whitney says.
In the first "Ring of Fire" report in 2007, Whitney predicted Tier 1 ratios would fall far more dramatically than expected in the fourth quarter and that there would be broad demand for bank recapitalizations.
That is what happened--with no let-up in sight in 2009.
Whitney has maintained her cautious stance on the group.
Downgrades Parallel Capital Infusions
The upward trend of the credit rating downgrades correlates closely with that of the banks' capital infusions, Whitney notes.
During the fourth quarter of 2008, the sharp spike in credit rating downgrades correlates closely with the $85 bn of non- TARP capital raised.
"Since the third quarter of 2007, the correlation has been undeniable," Whitney notes.
The Bear Stearns Hedge Fund Collapse
The collapse of the two Bear Stearns hedge funds back in June-July 2007 sent shock waves through the credit markets and corresponded with the first series of downgrades by the rating agencies, Whitney says.
"While July 2007 seemed traumatic to the credit markets with over $16 bn in securities downgraded, things were only poised to get worse," her report says.
"In fact, downgrade activity shot up to $43.9 bn in August 2007 (more than two and a half times that in July-2007) and $107 bn in October 2007 (nearly two and a half times that in August 2007), although that seems like a mere drop in the bucket as compared to the past months' activity," Whitney says.
Downgrades Hit a Zenith
"The credit rating downgrades were the highest in fourth quarter of 2008 with an aggregate $2.4 tn or monthly downgrades in excess of $740 bn per month," Whitney notes.
In fact, the credit rating downgrade volume on U.S. mortgage related securities was two and a half times greater than the prior quarter, Whitney says, with December alone seeing downgrades of over $880 bn.
The average monthly downgrades in the fourth quarter represent more than seven times the levels seen in October 2007, Whitney says.
The months during the fourth quarter were the most disruptive months for the debt market in terms of selling pressure from credit ratings, Whitney adds.
Since the fourth quarter of 2007, the 10 financial institutions under Whitney's coverage have raised $390 bn of capital.
In the fourth quarter of 2008, the financials have raised over $195 bn of capital, of which $110 bn was from the Treasury's TARP program, Whitney notes.
Citigroup has raised the most capital since the third quarter of 2007, $113.8 bn, followed by Bank of America with $55.7 bn and JPMorgan Chase, $44.7 bn.
Although Merrill Lynch raised $29.9 bn, it has the highest level of writedowns at $48.5 bn since the third quarter of 2007, Whitney says, followed by Citigroup's $48.1 bn.
Bank of America, which has acquired Merrill, has taken $11.1 bn in writedowns, and JPMorgan Chase, which bought Bear Stearns, has taken $9.9 bn in writedowns, Whitney estimates.
Since the third quarter of 2007, the banks and brokers under Whitney's coverage incurred over $223 bn in writedowns on risk exposures related to assets such as residential mortgages, commercial real estate, leverage loans, and financial guarantors.
New Rule Changes Hurt Even More
What's more, due to new accounting rule changes going into effect late this year, banks will have to post an additional $25 bn in loss reserves over the next 12 months, Whitney estimates.
The proposed accounting rule changes set to go into effect for quarters after November 2009 will force the banks to put back onto their balance sheets securities now held in off-balance sheet entities, which will further force banks to hold onto more capital against these assets.
Translation: Expect even more capital raises. And demands on TARP.
The New Accounting Rules Slam Banks
Citigroup has approximately $1.14 tn in off-balance sheet assets, Whitney estimates. The analyst figures that JPMorgan's exposure is approximately $735.2 bn, and Bank of America's is approximately $73 bn.
Under the new accounting rules, many off-balance sheet vehicles will no longer exist.
But not all of these sums will have to come back onto the balance sheets. The rules are complicated, but according to Whitney's read of them, the potential amount coming back on to Citi's balance sheet is $253 bn.
As for JPMorgan, it has approximately $735.2 bn in off-balance sheet vehicles, but the potential sums stuck back on JP's balance sheet could be at least $218.5 bn, Whitney says.
As for Bank of America'st $73 bn in off-balance sheet vehicles, it's unclear how much BofA would have to put back on its balance sheet, Whitney says.