Capital Is King Once More In Banking

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This story features WESTPAC BANKING CORPORATION, and other companies.
For more info SHARE ANALYSIS: WBC
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The market was completely unsurprised yesterday when Westpac ((WBC)) announced a capital raising. There was, nevertheless, some surprise regarding the magnitude. Analysts had pencilled in $1-2bn so the $2.5bn institutional placement and upcoming $500m retail share purchase plan (for a total of $3bn) did evoke some whistles.

Westpac has followed in the footsteps of rivals ANZ Bank ((ANZ)) and National Australia Bank ((NAB)) in recent weeks in going to the market in order to shore up one’s balance sheet. Commonwealth Bank ((CBA)) was assumed by all analysts this morning to not be too far behind, and indeed as we speak CBA has announced a new stock placement to Merrill Lynch for the purpose of raising up to $750m. This will be used to redeem the PERLS II hybrid convertible issuance.

As we all know too well, banks in the US and UK in particular and across the globe in general have been imploding under the weight of their own leveraged debt, desperately seeking funds to survive. Some have gone the way of Lehman Bros and Washington Mutual, others have received government capital injections either once or, in the case of Citigroup, twice.

To put it in very simple terms, banks across the globe are suffering from a combination of debt asset value write-downs (to pretty much nothing in the case of mortgage-backed securities and the like) and increasing bad loans in the face of the credit/economic crisis. This puts them at risk of failing to satisfy central bank capital adequacy ratios, but in many cases at simple risk of insolvency.

Australian banks have not been immune to the fallout. The good news is that their exposure to toxic debt assets is minimal on a global scale, although a couple of banks have much greater exposure than others. The bad news is the bad debt problem is no different. There have been some high profile implosions – Centro, Allco, ABC etc – and clearly a growing number of smaller enterprise failures. Australian banks have thus also been hit with the need to improve their capital positions.

As we entered the credit crisis, Westpac was in the strongest position of the Big Five and CBA was simply big, while ANZ and NAB were overexposed and St George Bank’s days were numbered. We have recently seen ANZ and NAB go to the market for more capital but such a move may not have actually been necessary for Westpac’s survival, except that it had decided to takeover St George. In so doing, it quickly fell to the bottom of the pile on a capital basis given the extent of St George’s securitised borrowings and hybrid debt issues.

And that’s a lot to do with what Westpac’s bigger than expected capital raising is all about. The bank did top up its provisions a tad for the Allcos and friends, but there have been no new “names” biting the dust for a while and that bodes well. There was also $500m of “fair value adjustments” required once the intricacies of St George’s balance sheet were fully understood, which included differing accounting methods for such things as those old stalwarts “goodwill and intangibles”. St George also brings with it a chunk of hybrid convertible capital and the hybrid market is currently “closed”.

Aside from these necessities, the reality behind Westpac’s move is that eight has become the new seven.

Prior to the credit crisis, Westpac had a target range capital ratio of 6.75% to 7.75%. This implies that the bank felt comfortable in lending out its deposits and borrowings up to 12.9 times. But what the credit crisis has revealed – or should that be reinforced to a new generation? – is that such a small ratio is not sufficient to cover net risk, being the risk of those loans defaulting, and the risk of debt assets losing their value. It’s all about going back to basics after the orgy of lending that was life in the Roaring Noughties.

When ANZ and NAB issued new capital they took their respective capital ratios to 8.1% and 8.3%. In theory the Westpac raising takes its ratio to 8.32%, or the capacity to lend only 12 times. It doesn’t sound like much of a difference, but in the billion-dollar competitive world of prime banking every little basis point makes all the difference. This now makes Westpac top of the pops in the capital stakes, although Credit Suisse points out that if you exclude the inherited St George hybrid issues the ratio is only 8.01%. If the hybrid market is “closed”, meaning no one is buying, can such capital be considered Tier 1? Indeed, Westpac has itself noted that a lack of hybrid market forces the banks to go straight to equity capital – the ultimate Tier 1 capital.

But CS goes on to point out that if the hybrid market reopens, and St George’s hybrids are back in favour again, Westpac could actually boast a capital ratio of greater than 9%. It would be streets ahead of its rivals.

So the point is that capital raisings are not just about bad loans and write-downs. They are about an additional desire to bolster balance sheets in this Grave New World with more money “in the bank”. The Australian banks are all now looking at capital ratios in excess of 8% when previously they were only in excess of 7%, with St George even lower. That is all except CBA, who prior to today’s announcement was sitting on a capital ration of 7.6% and looking lonely. The $750m announced today will not be the end of it, one assumes.

It also surprised investors that Westpac should choose to issue so much new capital so shortly after providing an underwritten dividend reinvestment plan. By asking shareholders to reinvest their dividends (with a discount teaser) the bank is raising more capital in any other language. But the reality is the global economic situation has become much more dire since the DRP was flagged. All banks had moved swiftly earlier in the year to top up their balance sheets against the Allcos of the world and any more to come by seeking underwriters for their DRPs. But when things got really nasty in October, any market talk of the possibility banks would need to raise real capital turned to conviction that they would.

And here we are. The question is: Should investors be looking at this Westpac issue as a bad sign or a good one?

The answer form analysts is that it is all good, once you overcome the dilution of not just existing shareholder capital but of even the recent DRP capital. Westpac has now moved itself into a solid capital position and at $16.00 the shares are reasonable value. While the demand for credit in Australia has dropped sharply, foreign banks are heading for the hills. That leaves a bigger slice of the pie for the local banks to fight over, and you can’t go lending more money when you don’t have the capital to back it up.

Nevertheless, five of the ten brokers in the FNArena database are content to stick with only Hold ratings on Westpac, suggesting that while more capital is a good thing the risk of bad loan increases still remains. Credit Suisse goes as far as to maintain an Underperform rating on the basis that Westpac is commanding an undeserved premium valuation from the market over its peers. Macquarie, for one, disagrees with CS and suggests Westpac is worthy. Macquarie maintains an Outperform rating.

The average target in the database is now $20.00 after the brokers have adjusted for capital dilution. The anomaly among the bunch is that while CS sits at Underperform with a target of $17.00, the low marker is ABN Amro with a $16.13 target and a Hold rating. At last glance, Westpac is trading at $16.39. The high marker is currently UBS (Buy) at $24.00 but UBS has not reported this morning and thus will likely adjust for dilution.

Now it’s over to CBA to see just what else it might surprise the market with. It shouldn’t be too much of a surprise however, as the market already expects CBA to join the 8% club as soon as possible.

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