The Capital Crunch Spreads

Capital levels are tumbling at major banks and brokeragesnot just Citigroupwhich could crimp earnings and economic growth

After Charles Prince III resigned as chief executive (, 11/5/07) of Citigroup (C), the first question that analysts asked on a conference call to discuss the move wasn't about Prince's decision to step down, the interim CEO, or the hunt for a permanent successor. Never mind the leadership issues. Instead, analysts began the call on Nov. 5 by asking Chairman Robert Rubin and Chief Financial Officer Gary Crittenden about the financial giant's capital. "How do you feel about where the tangible equity ratio is?" said analyst Glenn Schorr of UBS (UBS). "It seems like an alarming number."

Rubin and Crittenden assured everyone on the call that things would be fine and that Citi's capital would be built back up. But the emphasis the issue received highlights a growing problem at Citi and in the banking industry as a whole. Citi's tangible capital is 2.8% of assets, about half the industry average of 5% (, 11/107), according to Meredith Whitney, a bank analyst with CIBC World Markets (CM). And Citi's not alone. Banks and brokerages across the U.S. are taking writedowns to reflect the falling value of subprime debt and leveraged loans used in buyouts, and they've whacked away at the capital on their balance sheets in the process.

Dangerously Low Reserves

Capital ratios across the sector are now at their lowest level in 20 years, according to analyst Mike Mayo, of Deutsche Bank (DB). The ratio of reserves to loans for major banks and brokerages is 1.2%, the lowest level since 1983 and well below the historic average of 1.73%, according to Mayo. Banks would have to reduce earnings by 20% to set aside enough cash to bring their reserves back up to the average, Mayo says. The ratio of tangible equity to assets is the lowest since 1986.

It's a serious problem for banks, and potentially for the economy. "This reduces financial flexibility for share buybacks, dividends, cash acquisitions, and balance sheet growth," Mayo warns.

Capital ratios are an abstract way of capturing a very important idea. Capital is the money banks use to generate earnings, by making loans or other activities. If capital falls as a percentage of loans or assets, banks are put in a bind. They have less room to make loans to consumers and businesses, which can reduce earnings and the pace of economic growth.

Financial Institutions Post Huge Losses

Citi, Merrill Lynch (MER), and Bear Stearns (BSC) have been particularly hard hit by the credit crunch (, 9/17/07). Merrill has taken an $8.4 billion writedown (, 10/29/07), and more could be on the way.

Citi has taken a $6.5 billion writedown for the third quarter, and expects an $8 billion to $11 billion writedown for the fourth. Credit-card company Capital One Financial (COF) said on Nov. 7 that it expects to take a writedown of about $5 billion for all of 2008. Washington Mutual (WM) has said it will take $2.7 billion to $2.9 billion in writedowns because of falling home values. Lehman Brothers (LEH) analyst Bruce Harding said Nov. 5 that he expects Washington Mutual to take $3.8 billion in writedowns for 2008, and that the company's dividend could be at risk if writedowns exceed $5 billion.

Citi Claims Robust Profitability

Whitney, of CIBC, has predicted that Citi will have to boost its capital ratios by cutting its dividend or selling higher-quality assets, such as credit cards and real estate. She estimates it will take years to rebuild its capital ratios without those steps. Citi says it doesn't plan to reduce its dividend and that it can restore its ratios by mid-2008, just on the strength of its business growth. "We…have very strong capital-generation capability as a result of the normal ongoing profitability of the company," said CFO Crittenden during the Nov. 5 call with analysts. Citi also plans to raise capital by offering shares in Nikko, a Japanese bank it is acquiring.

Investors are skeptical, though. Mayo says bank earnings will be depressed by 10% to 25% over the course of two to three years, while banks repair their capital structures. The big variable is how bad the real estate and leveraged loan markets turn out to be. If the economy and the mortgage markets take another turn for the worse, the banks could be forced to take additional write-offs. That would damage their capital ratios and limit their growth even further.

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