Credit Suisse Is Bearish On Chinese Banks13 October, 2011, 3:06. Posted by Zarathustra
I have been in a minority who think that investing in Chinese banks’ shares now is a very bad idea as there is a big risk, in my view, that the equity capital of banks can be wiped out after bad loans surge as a consequence of the lending spree. The large scale of local government debts, and now the underground banking system, should be sources of worry, as, say, 10%, of those loans turning bad can be sufficient to wipe out much, if not all, of the equity.
Credit Suisse came out with an excellent report which has laid out the bearish argument on Chinese banks with great detail, which, I think, has get to some of the very important points of banks’ valuation (a bit late to turn really very bearish, but the arguments are spot on). Sanjay Jain and his team actually believe that non-performing loans (NPLs) ratio can get to 8.0-12.0% in the years to come. And in that case, NPLs would represent 65-100% of banks’ equity. That means at their base case scenario, equities of some banks can be wiped out COMPLETELY by NPLs.
And this is how they come to the 8-12% NPLs ratio:
Local government loans are about one fifth of loan book, but are expected to contribute about half of the potential NPLs.
About 55% of the loans are considered to be more risky, including local government, real estate, manufacturing and SMEs. They contribute more than 80% of the potential impairment.
Real estate exposure is estimated to be double of the direct exposure. However, it would be even higher if we include the collateral that is used as security for 42% of loans.
Among the off-balance sheet items, trust loans are believed to be the safest, while entrusted loans are considered the most risky.
The impairment in off-balance sheet items is likely to be ahead of the assumptions here, but for the purposes of liability on banks, we have a conservative estimate.
Potential NPLs work out to 65–102% of the banking system loans. The number is similar for individual banks
Under the higher end of the base case assumption of NPL ratio (with 60% loss ratio), the the impairment as a percentage of banking system equity capital would be 61.4%. In the most pessimistic case (NPL ratio of 17%), 85.9% of the banking system equity will be wiped out in 2011.
They also believe that while Chinese banks are very attractive at current P/B ratios (which are pretty much hitting post-Lehman lows), they believe the 2012 earnings could be wiped out as credit losses are expected to increase, and beyond that point, the book value will also be hurt. In that scenario, Chinese banks are not at all attractive. Thus they reduce their target prices based on lower profits and book values based on impairment charges, lower net interest margins, weaker fee income, and higher cost of equity due to higher Beta.
These reasons have been spot on. Just as I repeated my very bearish view on Chinese banks 2 days ago:
First of all, bank’s cost of equity capital will become very high as beta of the share rises (i.e. volatility will rise). Second, stock price will become depressed because the equity capital is getting closer to be wiped out. Third, as cost of equity rose, it is harder to get the private sector to recapitalise the banks. In that case, the state would have to stand behind the banks.