Sunday, November 30, 2008

Understanding “Tier 1″ capital ratios

(Dash Riprock at Option ARMageddon) With all the talk of bank failures and government involvement here on OptionARMageddon and throughout the media, I thought it made sense to explain a basic concept that investors and regulators use to measure solvency: how assets are “risk-weighted” in order to measure banks’ so-called “Tier 1 capital ratios.”

Rolfe (rightly) has been estimating the amount of leverage (and, by extension, a rough relative default probability) by looking at companies’ tangible assets relative to tangible equity. Again, Leverage = Assets/Equity.

Reiterating the basic definition of “tangible equity,” imagine that a company’s owner decided today that he was going out of business. He holds a going-out-of-business sale and sells everything—buildings, office equipment, any securities the company held, and so on. Once he has sold all his assets, he uses the proceeds to pay back all his lenders (bonds and loans), his senior equity holders (preferred shares) and, if he’s a financial, anyone who has given him money to hold or invest (depositors). Tangible equity is what’s left after the business has been liquidated and all its debtors paid off.

Unfortunately, it is not easy for the casual investor to find tangible equity figures. For starters, when it comes to banks, it’s nearly impossible to set the value of illiquid financial assets like CDOs. But another reason investors may have trouble finding tangible equity stats is that they are rarely reported.

There are a couple of reasons for this. The most cynical perhaps: If companies reported their true tangible equity, even more investors would run for the hills. The 280x tangible leverage that Rolfe calculated earlier for Citigroup is a pretty terrifying number. For an individual with $100,000 in assets to run that leverage ratio (let’s call her Cindy), she would need to borrow $27.9 million. Even the worst mortgage banker wasn’t handing that type of money out to borrowers, which is why you could imagine Citi investors weren’t totally comfortable with their position.

But the more accurate reason that banks don’t report leverage numbers like ‘tangible equity’ is because the balance sheet is only half the story. Let’s look at Cindy again: she has $100,000 of assets to start and is borrowing $27.9 million for a total of $28 million, and she is planning on investing that money in good faith, because she wants to pay her lenders back. So she is considering two business plans:

  1. Investing all $28 million into BBB-debt (rated Baa2/BBB by Moody’s/S&P)
  2. Investing $20 million into short term (less than 1-year) treasuries and $8 million in AAA-debt (rated Aaa/AAA by Moody’s/S&P)

Now in both cases Cindy has an assets-to-tangible-equity leverage ratio on her investments of 280x. But in case 1, the risk of loss on her investment is much, much higher than in the second. In fact, if Cindy can borrow at a rate around treasuries (maybe she locked in some great rates when the market was lending money to anyone and everyone) then case 2 might be an ok deal for everyone involved.

So how do you compare the relative risks of the two situations? You adjust the leverage for the relative risk of the portfolios. This is known as risk-weighting and became a key part of bank analysis after Basel I in 1992.

Instead of just looking at a leverage of 280x, regulators developed a different metric for measuring leverage called “Tier 1 risk-based capital ratio,” which considers the risk of the assets against the equity capital and cash reserves of the bank. The Tier 1 capital of a bank is its equity capital and cash reserves—in this case, the $100,000 that Cindy is putting up (there are actually several more steps involved in the calculation. You can see an out-of-date example here).

So in Cindy’s first situation, her investment grade bonds probably can be held at a 50% risk weighting. This means there is a substantial adjustment to her balance sheet for the regulatory capital calculation. The reasoning behind this is that the bonds are in fixed income securities, so they are safer than equity investments (which would be unadjusted).

In the second situation, the government securities can be held at a 0% risk weighting—since there is theoretically zero chance that the government can default on debt in its own currency (of course, there is always a chance, but forget that for now). The AAA rated debt would likely be held at a 20% risk weighting.

Using our two examples above, the calculation works roughly like this—please note the very slight difference in nomenclature has a HUGE impact on value:

  • Tier 1 leverage capital ratio (for both cases): $100,000 / $28,000,000 = 0.36%
    • Tier 1 risk-based capital ratio (BBB-debt): $100,000 / ($28,000,000 x 50%) = 0.71%
    • Tier 1 risk-based capital ratio (Government & other AAA-debt): $100,000 / ($20,000,000 x 0% + $8,000,000 x 20%) = 6.25%

In order to be considered “well-capitalized,” banks must maintain a Tier 1 Risk-Based Capital Ratio equal to or greater than 6 percent, and Tier 1 Leverage Capital Ratio equal to or greater than 5 percent. So in both cases, if Cindy were a bank, she would have an unacceptable leverage capital ratio. But in the second case she would have an acceptable risk-based capital ratio. Which one do you think she is going to publicize?

The issues with this, of course, are numerous. What happens if her AAA-debt gets downgraded to BBB or worse, to junk? Just by holding that debt, even if it doesn’t default, the bank may instantly fail capital adequacy regulations, causing investor flight and necessitating a government takeover. This was a real fear with AIG, whose debt was held by many banks worldwide. Given the amount of debt that AIG issued, continued downgrades could have taken down A LOT of banks that held AIG’s debt, even if AIG never defaulted.

You may hear a lot about Tier 1 capital in the coming months, it’s probably best to ignore it unless you are going to spend a lot of time digging through the bank’s filings with the federal reserve. You’re probably better off just checking Rolfe’s tangible equity calculations right here!

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