Editor's Note: Please click here for Part 1 and here For Part 2.

In 2007, equity markets fell out of love with financial institutions, especially those with large investment banking operations. 2008 saw something of reconciliation - the bigger the write-off, the bigger the dividend cut, the bigger the capital raising, perversely the greater the investor buying interest. There are reasons for caution.

The asset quality of major banks remains uncertain. Svein Andresen, secretary general of the Financial Stability Forum, which is made up of global regulators and central bankers, recently told a conference of bankers in Cannes: “We are now 10 months through this crisis and some of the major banks have yet to make disclosure in [crucial] areas.”

Despite significant writedowns, sub-prime assets remain vulnerable. There are substantial differences in valuations (see Exhibit 1: Values (%) of CDO Super Senior Tranches). Lack of detailed disclosure about valuations compounds the uncertainty.

Other assets - consumer credit, SME loans, corporate lending and high yield loans - all look vulnerable as the real economy slows. Banks have increased provisions but it is not clear whether they will be adequate.

Bank balance sheets have changed significantly. Traditional commercial bank assets consisted primarily of loans and high quality securities. Traditional investment bank assets consisted of government securities and the inventory of trading securities.

In recent years, asset credit quality has deteriorated. High quality borrowers have dis-intermediated the banks financing directly from investors. Banks also hold lower quality assets to boost returns.

Bank balance sheets also now hold investments – private equity stakes, principal investments, hedge fund equity, different slices of risk in structured finance transaction and derivatives (of varying degrees of complexity). Sometimes, the assets don’t appear on balance sheet being held in complex off-balance sheet structures with various components of risk being retained by the bank.

Under U.S. accounting rules, asset must be classified into:
 

• Level 1 (Mark-To-Market) - liquid assets or instruments that are actively traded.
• Level 2 (Mark-To-Model) - instruments that cannot be priced based on trade prices but are valued using observable inputs.
• Level 3 (Mark-To-Make Believe or Mark-to-Myself) - the asset or liability cannot be priced using observable inputs and requires the use of modeling techniques and substantially subjective assumptions.

Asset quality uncertainty can be gauged by looking at bank’s Level 3 assets (Exhibit 2: Analysis of Level 3 Assets).

In the first quarter of 2008, the position deteriorated. For example, Merrill Lynch’s (MER) Level 3 assets increased to U.S. $69.86 billion as of March 28 from $41.45 billion on December 28 (an increase of 69%), equivalent to over 225% of capital.

There are several areas of concern. Banks have benefited from hedging transactions (some of these are difficult to value Level 3 transactions). The exact nature of the hedges is not disclosed. The value of the hedge is based on models and estimates. The lack of disclosure around the value of the hedges, their nature and hedge counterparties make it difficult to gauge whether they will be effective in reducing losses.

A further area of concern is the practice of “circular asset sales.” Banks have sold risky assets where the seller has provided the buyer with favourable terms. Banks have sold leveraged loans on the basis that the bank lends the buyers 75-80% of the price at below market rates. Sellers have given undertakings that if future asset sales are at lower prices than that paid by the buyer then the seller will compensate the purchaser. These provisions have allowed banks to sell assets at prices that avoid the need to further mark down its positions.

This creates uncertainty about the value of bank assets. Further write-downs in asset values cannot be discounted.

Banks require re-capitalization. The capital required is in excess of $300-500 billion (15-25% of total global bank capital) to cover losses. Capital is also needed for assets returning onto their balance sheet (as the vehicles of the “shadow banking system” are unwound). This capital is required to restore bank balance sheets. Additional capital will be needed to support future growth.

Banks have raised a significant amount of capital but face increasing competition. Insurers, including the monolines, and the government sponsored enterprises (Fannie Mae (FNM) and Freddie Mac (FRE)) also need re-capitalization. This may limit availability and increase the already high cost of capital for banks.

Availability of capital, high cost of new capital and dilution of earnings will impinge upon future performance.

Part 4 can be found here.