Tangible Common Equity: How Much Is Enough? 18 comments
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Suddenly, everyone is interested in the amount of tangible common equity (”TCE”) invested in banks. Oddly, no one seems to know how much TCE is enough, despite TCE being the primary and most important element in determining the adequacy of bank capitalization. Of course, history provides a guide to what is enough TCE - and right now banks don’t have enough. Only a massive amount of public and private bank investment will fill in the existing capital hole, which explains the falling stock prices of many banks and financial institutions.
What is “tangible common equity” and how is it measured?
Banking regulators started focusing on the low level of TCE at large banks right after Tim Geithner became Treasury Secretary. Adequacy of TCE is measured by the TCE ratio, which is the amount of TCE divided by amount of tangible assets. Banks with higher TCE ratios are better capitalized and have a lower risk of failure than banks with lower ratios.
TCE is different than common equity because TCE is reduced by the amount of intangible assets owned by a bank. Intangible assets are things like goodwill and tax benefits from net operating loss carry forwards. These assets don’t produce income and don’t have a cash equivalent value. Moreover, intangible assets can’t support banking operations or cover losses. Even worse, intangible assets have a childlike “pretend” quality to them; one minute everyone pretends intangible assets are there and then the next minute reality sets in and they disappear.
Regulators focus on “common equity,” and not all forms of capital because only common equity can be depended upon in a tough pinch. Other forms of capital are “Almost Common Equity” and include preferred stock and subordinated debt. Almost Common Equity investors are fair weather friends; they are just like best friends when things are good but when things don’t go well they stop pretending. Preferred stock and subordinated debt investors think that they are going to get paid back and earn a fixed yield through interest and dividend payments and eventual repayment of principal. When things aren’t going well most Almost Common Equity investors turn into creditors and demand their cash back. Only common stockholders expect to stick it out through thick and thin.
How much is enough? The 1980s experience
Since Geithner mentioned the stress test, media pundits have been arguing about how much TCE is enough. Many “experts” say that a 4% or 5% TCE ratio is good enough. Well…I don’t think so.
When I was a young lawyer in the early 1980s, I remember S&L CEOs telling me that a 4% to 5% TCE ratio was good enough for them. Within a few years every CEO who said that 20 to 1 leverage was a good idea (that is what 5% TCE ratio means) had been ejected from the industry and their institution seized. Some of those CEOs were in jail.
More recent data on TCE from 1995
But the 1980s was a tough time in American finance and was a long time ago. After all, it was before the internet, derivative securities and securitization. To today’s young Turks, 1984 is ancient economic history and before some people working on Wall Street and in banking were born. So, maybe my memory of ancient history needs to be updated with a more current example of adequate levels of TCE for safe and sound banking operations.
I think the amount of TCE that banks had in the mid-1990s is a benchmark that current market participants can identify with and accept. After all, by 1995 the internet had been invented, most of the Republican leaders who are in the news today were in the news then, and securitization was an accepted form of financing.
Below is a chart comparing the amount of TCE that a select group of banks had at the end of 2008 and at the end of 1995. The reason I selected the below banks is because I was able to talk a friend at an investment bank to pull the information for me and this is what he found (thanks Brent!). The sample isn’t random and lacks the sampling purity of an academic exercise. But I know enough about statistics to know that the uniformity of the results make it statistically significant and important.
Tangible Common Equity / Tangible Assets (%) | ||||||||
| Company | 1995 | 2008 | ||||||
| Bank of America Corporation | 6.1 | 3.1 | ||||||
| Bank of New York Mellon Corporation | 8.3 | 1.6 | ||||||
| BB&T Corporation | 8.1 | 4.8 | ||||||
| Citigroup Inc. | 6.3 | 1.8 | ||||||
| JPMorgan Chase & Co. | 5.4 | 3.9 | ||||||
| PNC Financial Services Group, Inc. | 6.6 | 3.6 | ||||||
| State Street Corporation | 5.9 | 2.7 | ||||||
| U.S. Bancorp | 6.4 | 3.2 | ||||||
| Wells Fargo & Company | 5.6 | 2.4 | ||||||
| Median | 6.3 | 3.1 | ||||||
| Source: SNL Financial | ||||||||
| PNC Financial Services Group is as of 9/30/08 | ||||||||
| Citigroup, Inc was CITICORP in 1995 | ||||||||
So, how much TCE is enough?
It’s a lot more than the banks currently have and probably more than in 1995. Banks need more TCE today because they are riskier companies now than they were 13 years ago. Off balance sheet liabilities, credit default swaps and stupid decisions of the last 8 years didn’t exist in 1995 and need TCE. The capital hole in the banking system to restore TCE levels to those that existed in 1995 is in the hundreds of billions and even more is required to cover the new liabilities of today’s banking system.
Sophisticated investors understand the magnitude of the capital hole and know that this problem is causing bank stocks to tank. And, sophisticated investors also understand that until large banks get their house in order, corporate earnings will be anemic (at best). The reason the stock market has been diving isn’t because of Obama’s budget proposals, it is because his administration is shining a bright light on bank capital ratios and their capital inadequacy.
It took years of neglect for bank capital ratios to drop as far as they did and it will take several years for banks to repair their balance sheets. Obama didn’t make this problem, but we are lucky that his administration is trying to figure out how to fix it.
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and you didnt mention pre-provision, pre-tax earnings...which are really the first buffer to absorb losses, before your much hyped TCE...some banks in fact have higher pre-prov pre-tax earnings than TCE...but I guess either you are not smart enough to figure that out, or it wouldnt be as helpful for the short position you probably have...
Why pre-tax? Do you think debt will get paid before salaries? I mean seriously, where did you attend school?
Please explain how a declining stock price has any effect on tangible common equity (which is assets-intangibles-lia... A lower stock price makes it more difficult to raise additional common equity but has no effect on existing TCE.
Fortunately, the Fed came to the rescue guaranteeing these assets and preventing banks from eating it or many customers would be destitute. Still, customers persist to be ignorant of their susceptibility by keeping their bank funds in non-FDIC insured accounts paying .2% higher interest at Citibank and other banks. Hopefully, they will realize their risk and move them into safer FDIC insured CDs etc. before one of these banks really goes under.
The sad thing is in any case, the taxpayer is liable to be paying for the bank's foray into the highly leveraged brokerage business with or without the depositors sharing in the pain. All banks should be allowed to offer is FDIC insured accounts because when they eat it, the government and FDIC invariably ends up with the check.
Not being an expert on banks, I've never figured out why preferred stock shouldn't count as capital. Sure, they have a higher claim than common stock, but that doesn't make it debt. Anyone have a good reason for this?
I'm also mildly curious how the banks with large branch networks compare with the internet banks. It seems like all of the branches would create a large base of tangible assets that would not be comparable to those of internet banks.
Usually I don't respond to comments but this is an exception.
I am intimately aware of how bank preferred stock works.
A short primer is in order for those that have commented.
First, much of the preferred stock is "trust preferred stock" which is a hybrid. It is a form of tax deductable preferred stock that grants hybrid creditors rights to preferred shareholders.
Second, the vast majority of the rest of preferred stock is term perferred stock that has a fixed redemption date to it. Just like a bond it carries principal and interest payments requirments (although often it is a bullet principal payment). You may recall that TARP preferred stock is this type.
There is a third type of preferred stock which is prepetual preferred stock and I think this is what you are referring to in your comments. However, this is the most expensive type of preferred stock that is issued and over the life of the preferred stock the dividends equal many times the outstanding principal amount of the preferred stock. Because it was the most expensive type of preferred stock to issue it is the least issued. However, you are correct in saying that it is the closest to common equtiy (even if it still isn't common equity).
And, there are limits as to how much preferred stock can count in capital ratios because just like ice cream, a little is good but too much is bad. So, there are limits to how much preferred can count as Tier 1. Also, as you know preferred stock that is within 7 years of its redemption date has reduced availability to count as Tier 1.
Other forms of "capital" that banks are counting as capital includes holding company debt which of course if just plain old debt.
The reason that preferred stock can't count in unlimited amounts as capital is that preferred shareholders have the expectation that there will be dividends and most often principal payments. That is a form of decapitalizing banks and bank holding companies. If preferred stock agreements aren't honors the holders have rights (often not creditors rights but rights just the same) to change the course of the bank that has issued the preferred stock and get paid back or get the dividends paid. Banks are, therefore, loath not to honor the preferred stock requirments.
Recent experiences with institutions going bankrupt or failing and preferred stock not being honored is no different than other types of investment not being honored (i.e., unsecured debt). The issue with preferred stock isn't when the bank is broke but when the bank is in the process of going broke. Banks decapitalize all of the time to make preferred stock payments right up to the date of seizure which makes preferred stock, as a practical matter, similar to debt.
Preferred stock is equity but it isn't the same a common. Regulators know this, preferred shareholders should know it and banks certainly know it.
Pretending that preferred stock and sub debt are like common equity is the type of thinking that got the US and world into the current crisis. For 100+ years everyone knew that preferred stock wasn't the same as common equity. Suddenly in the last 5 years everyone thought that it was the same as common equity and guess what happened to the banking system in the last 5 years? Investors need to unlearn all of the great lessons of the last decade and remember the basics of finance, accounting and, in the case of banks, what makes a safe and sound bank.
As an aside, I apologize for any spelling errors in the above. Without spell check I tend to have a lot of typos.
I agree with your premise that banks are woefully under-capitalized and need some serious reform.
Would you be in favor of a requirement that made banks have a certain minimum of permanent equity capital, and not rely on so much debt which as you say, always wants to get paid and exit the corporation once the weather turns cloudy?
And perhaps we should also have certain restrictions on the types of 'securities' and investments the banks can invest in, like in the old days. What happened to good old fashioned lending?
I see the current banking crisis as largely being a serious breakdown in regulatory standards, as well as executive stupidity, malfeasance, and the pursuit of bonuses based on phantom derivative profits, rather than sound banking. The past 10 years or so have been an episode in banking nonsense.
Finally, if you could comment on the conversion of what used to be "investment banks" to regular banks, which is what Paulson rammed through in desperation to save Goldman and Morgan Stanley. I consider that an outrageous move that simply puts the taxpayer at further risk down the road - the last thing I want is for GS or MS to take time deposits so that they have capital to invest in the next wave of dotcoms or Countrywides.
What do you think?
I am in favor of all of your suggestions. The converstion of Morgan and Goldman were desperation measures. Now the Fed needs to regulate them as bank holding companies and make sure that they have adequate amounts of equity and are safe and sound. I don't see a lot of evidence of that happening but then again I can't prove that it isn't happening behind closed doors. Being a bank holding company and getting Federal help has benefits but there are responsibilities as well and the Fed should be making sure that these institutions hold up their end of the bargain.
As for ratios requiring permenant capital, shockingly there are some but for some reason on a holding company level no one seems to care (not the markets, not the regulators, not the media).
I am a reasonably frequent guest on FOX and Bloomberg and for months in 2008 only talked about TCE (and was either ignored or made fun of). But, by when analyizing banks and whether or not they are risky everyone should start by looking at TCE ratios. Those ratios don't say whether or not there is a good business, whether or not they are making money, or whether or not one should invest, but the TCE ratio is a good proxy for balance sheet risk. If everyone starts with TCE they will find that they are able to predict what happens to the banks almost as well as Meridith Whitney.
As an aside and in respose to another comment, risk weighted assets are important but it still all starts with TCE ratios. As an example, assume a bank is totally core deposit funded and only buys Treasuries (i.e., no funding or credit risk). The bank still needs to have adequate TCE because of market risk (yes, off the run Treasuries have some market risk) and interest rate risk (the interest rate risk can be high if the Treasuries are Treasury strips, high coupon or low coupon and even on the run Treasuries have interest rate risk). Same with Freddie/Fannie pass throughs - lots of market and interest rate risk. And, the bank has operating risk, i.e., the risk that managment makes a mistake and doesn't hedge market risk or interest rate risk well or has a law suit or other problem. All of these risks require TCE. Running a bank on 20 to 1 leverage makes no sense to me even if the bank has 0% credit risk.
And, for the people reading this blog and accused me of trying to dump the stocks because I am short, I have neither a long or short position in the banks. For a lot of reasons relating to my employment and my wife's employment I don't own individual stocks and only own mutual funds that are generic in nature. And, I don't expect nasty comments from anyone on the fact that I am prohibited from owning stocks yet commented and wrote an article. The chart was meant to be "industry generic" not particularly company specific.
I feel the best approach is to test bank capital from three ratio perspectives: TCE/TA, Tier 1, and, importantly, the so-called "Texas Ratio"----NPAs(Non Performing Assets + 90 day Past Dues/TCE + Reserves). In other words, my concern is our current obsession with TCE as a singular marker which really doesn't take into consideration any metrics which reflect the quality of assets, how much has been reserved against those assets; as well as earnings, "intangibles" which in fact have a market, and quality of counterparties the bank is engaged with. Bottom line, if the bank is not really a candidate for liquidation---say a USB, WFC, JPM, or BAC, look at it as a going concern as well as a liquidation candidate which it probably isn't.
You say above that preferred holder "have rights ... to get dividends paid." I've not seen a single preferred prospectus summary that doesn't explicitly say that the issuer has the right to suspend dividends for a period not exceeding 20 quarters. That's 5 years without legal recourse.
As bad as a plain pref. div. suspension would be, it would also be an effective way to preserve cash. And it could be done in two stages depending on desperateness; traditional preferred 1st and trust pref. 2nd.
I cannot see how the Geithner/Citi arm-twisting deal is an improvement. Actually, it seems to be much worse. I think the last week has shown that this deal has done nothing to increase confidence at Citi, but it has successfully blown up over a trillion $ of preferred market value worldwide.