With all the formulas for calculating bank capital, one — the tangible common equity ratio — is now front and center among the people who size up banks for a living.
Analysts take common equity and strip away intangibles such as goodwill, servicing rights, or deferred tax assets, then feel they have the purest measure of a bank's ability to survive.
"It's the key issue now because it's the front line of defense for losses," said Gerard Cassidy, an analyst at Royal Bank of Canada's RBC Capital Markets Corp. "Bank losses are rising due to the recession, so companies that have low tangible common equity ratios will have less of a cushion to combat losses."
The list of companies with tangible common equity below 5% as a share of tangible assets now includes Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Wells Fargo & Co., PNC Financial Services Group Inc., and M&T Bank Corp.
All are well-capitalized in regulators' eyes, with Tier 1 capital ratios above 10%, though this is in many cases because the company sold preferred shares to the Treasury Department as part of its Capital Purchase Program.
Tier 1 includes common and preferred equity, as well as subordinated debt, but common equity has the first exposure to credit losses. Debtholders and preferred shareholders get repaid before common equity holders. Then banks deduct credit losses from retained earnings and account for it on the equity section of their balance sheets by reducing tangible common equity.
"When a company reports a credit loss, common equity gets hit first, and so common shareholders have to absorb the earnings loss" as dividends are trimmed or eliminated altogether, said Albert Savastano, an analyst at Fox-Pitt Kelton Cochran Caronia Waller. "There's also a fear that banks will continue to push those losses down," further eroding the balance sheet "and then they could go bankrupt."
B of A, which last week cut its dividend to a penny, from 32 cents, after huge fourth-quarter losses, said in its earnings conference call that its tangible common ratio was about 2.83%.
"While we feel very comfortable it is adequate, that is one of the areas we have to focus on to build, and that is … why the dividend reduction will help rebuild that," the Charlotte company's chief financial officer, Joe Price, said in the call.
But Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. Inc. on Tuesday wrote in separate notes that he is concerned about B of A's ratio, as well as about Wells Fargo's pro forma 3.6% ratio (the company is to report fourth-quarter results Jan. 28).
Both companies' losses will probably be worsened this year by their recent purchases of companies with troubled asset portfolios, B of A's Merrill Lynch & Co. deal and Wells Fargo's Wachovia purchase, Mr. Miller said.
B of A's ratio "is just too low in our opinion, particularly for a company with questionable near-term profitability and credit costs," he wrote. "The bottom line is" that B of A "is undercapitalized in our opinion."
Wells Fargo spokeswoman Julia Tunis said in an interview that the company "doesn't comment on analysts' notes or speculations."
Citi does not publish its tangible capital equity ratio, but Jason Goldberg, an analyst at Barclays Capital, estimated it at 1.5%.
In the company's earnings conference call, Citi's chief financial officer, Gary L. Crittenden, said its ratio could potentially benefit when the company gets about $6.5 billion from its joint venture deal with Morgan Stanley for the Smith Barney brokerage unit and about $7.5 billion from the conversion of preferred stock owned by Abu Dhabi's sovereign wealth fund into common shares.
To offset declines in this ratio, analysts said, banks should cut dividends, as B of A did, and raise common equity, though this would be expensive and dilute existing shareholders.
New investors may be turned off if banks cut dividends, but Theodore Kovaleff, the president of Information Sources Group in New York, said that investors would ante up "if the price is right."
Collyn Bement Gilbert, an analyst at Stifel, Nicolaus & Co. Inc., is particularly concerned about the ratios at PNC and M&T — both recent acquirers. PNC's deal for the troubled National City Corp. in Cleveland closed Dec. 31, and the $65.3 billion-asset M&T struck a deal last month to buy the $6.4 billion-asset Provident Bankshares Corp. in Baltimore, a bank that has also posted high losses.
On Wednesday the $145.6 billion-asset PNC reported preliminary results, saying that, due to widening credit losses, it expects its tangible common equity ratio to be in the range of 2.5% to 3%. However, since it has a "well diversified, high-quality" securities portfolio, its ratio should be about 4%, excluding the "accumulated other comprehensive loss."
Because it has a Tier 1 ratio of 9.5% to 10%, PNC said it would not raise capital, either through the government or through a common stock offering. Moreover, its board on Jan. 8 declared a 66-cent quarterly dividend, in line with previous payouts.
PNC is scheduled to report fourth-quarter results on Feb. 3. M&T reported Thursday that its ratio was 4.59% at Dec. 31 but that the Provident deal is likely to cut it to 4.4.%.
In an interview Thursday, M&T's chief financial officer, Rene Jones, noted that the bank earned twice as much as it paid out in dividends last year. "So as long as we do that, it's not very logical to do a capital raise and dilute existing shareholders," he said. "We'll manage our way through the credit cycle by earning more money."
Adam Barkstrom, an analyst at Sterne, Agee & Leach Inc., said that the $26 billion-asset Colonial Bancgroup Inc. in Montgomery, Ala., has a pro forma tangible common equity ratio of 5.1% for the fourth quarter. However, due to continuing losses in its home builder portfolio, the ratio would probably fall below 4% in subsequent quarters, he said, so he was uncertain whether the troubled company will be able to find a buyer.
"Right now, the marks Colonial would have to take on their books are so large," he said, "it would negatively impact the tangible common equity ratios of any buyer."
Mr. Savastano said that if banks cannot find willing investors for additional common stock, then the government may have to step in again to backstop further credit losses, or find some other way to keep banks solvent — including converting the preferred shares of banks it currently owns into common shares.
But this would bring its own set of issues, as the government would then have voting rights.
In First Horizon National Corp.'s earnings conference call last Friday, D. Bryan Jordan, chief executive of the $31 billion-asset Memphis company said that it was trying to preserve its tangible common equity ratio, which was 7.3% at Dec. 31, mainly by shrinking its balance sheet.
"We expect the balance sheet to come down close to another couple billion dollars in the course of 2009," Mr. Jordan said. "I think that ratio being strong and growing is a good thing, and so clearly we want to keep it north of the 7% ratio, and we expect it to move toward 7.5% to 8% as we continue to reduce the size of that balance sheet."