Tuesday, September 8, 2009

Deleveraged banks are staying that way - for now

A recent BusinessWeek article by David Henry brought up an interesting point: have banks de-levered too much?
Barely a year after Lehman Brothers toppled under the weight of its own debt, Wall Street is calling for some players to load up again. Analysts say Goldman Sachs, Morgan Stanley, JPMorgan Chase, and other relatively healthy firms are holding too much capital—an overly cautious stance that's costing shareholders billions of dollars in profits.

Goldman's leverage for example dropped from low 20s last year to 14 currently. Other banks are now at similar leverage levels. But how exactly did banks de-leverage so much this quickly? Here are four components to the process:
1. Raising private and/or public (TARP) equity.
2. Asset sales: for example BofA selling China Construction Bank shares.
3. Retained fee income: fee income (and realized trading gains) that is not paid as dividend goes to equity.
4. Asset appreciation and interest income: this is the component that analysts want banks to build up to increase their leverage.

For those who are not familiar with how asset appreciation leads to lower leverage, consider an entity with $100 of assets and a $90 liabilities ($10 of book equity), producing a 10:1 leverage. If assets appreciate to $110, equity becomes $20 and the leverage drops to 5:1. Thus a 10% asset appreciation caused leverage to drop by 50%. It's the quickest way to de-leverage in a rising market, but the leverage will drop just as rapidly in a falling market (this is part of the procyclical nature of bank capitalization).

But there is a different way to think about banking shares. A stock of a leveraged company and in particular a bank can be thought of as a call option. The assets of a bank represent the option's underlying, and the amount of bank's liabilities is the strike price. The maximum of book value or zero is the intrinsic value of the option, and the the stock price is the option premium. That's why a company whose assets fall below liabilities has a positive stock value. The intrinsic value is zero, but the time value is still positive.

Last year when basks became extremely leveraged, their share price behaved like at-the-money call options, fluctuating wildly as their asset portfolios changed in value. What's interesting is that the leverage (for options it's sometimes called "gearing") is significantly higher for the at-the-money options than for the in-the-money ones. Gearing for options is usually defined as the option delta times the underlying price divided by the option premium. That is how much does one pay per unit of delta? The cheaper it is to get a dollar of delta exposure, the more gearing is in the option. The highest gearing is for the out-of-the money calls and it drops off rapidly as the option goes in-the-money (see chart below: gearing vs. book equity).

What the analysts are effectively saying to Goldman and other banks is they don't like deep-in-the-money options, and that's what some banking stocks have become. The reason they don't like deep in-the-money options is also why option traders don't like them: too much capital used and not enough up-side. Another way to put this is that the leverage is too low.

Of course banks are not ready to reload on leverage because of the hell they just went through. But more importantly they want to be "deep in-the-money" because they want to be prepared for what will come out of Washington on bank capitalization. Because maybe bank regulators will want the banks to stay "deep in-the-money". Clearly capped leverage lowers the amount of lending and is sure to limit the rally in financials. 20% expected growth for bank stocks will be a pipe dream without the leverage, but the slow growth may become the new reality of the US banking system.

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