Special focus: Banking 2008 and beyond
Bank valuations are at 10-year lows, while capital injections from private equity firms and sovereign wealth funds are drying up. In order to shore up balance sheets and return shareholder value, will they be forced to sell the crown jewels, or should they change their business models? Helen Avery reports.
IN A SURVEY by Allen and Overy of chief executives of FTSE 350 and Fortune 500 companies in the summer of 2007, 21% of financial firms said they expected demerger activity in their sector before the end of June this year. Only in the technology, media and telecoms sector did chief executives foresee greater demerger activity. Demergers seemed the likely route as large financial conglomerates were faced with having to improve their balance sheets. A decade of merger activity had led to inefficiencies at the firms, and streamlining to unlock value seemed certain. Buyers were thought to be plentiful – those that survived the sub-prime storm undamaged would be keen to seize opportunities for cheap acquisitions.
Yet the wait for demergers continues. Bank stocks have plummeted. Keefe, Bruyette Woods’ large-cap bank index was down more than 33% over the 12-month period up to August 15. Its capital markets index was down almost 24%. As comparison, the S&P 500 was down about 9%. Capital injections from sovereign wealth funds have dried up, having lost around 50% of their investments in firms such as Citi, Merrill Lynch and UBS. Capital-raising in the public markets has been exhausted. How else can these banks shore up their balance sheets if not through starting to sell off parts of their businesses? It can only be a matter of time.
As yet, divestitures have been few and far between. The large banks so far have limited themselves to asset sales and sales of small businesses, or controlling interests, rather than selling off or spinning off entire business lines such as investment banking, wealth management, retail banking or asset management. Merrill Lynch followed several other large financial players by getting out of insurance with the sale of its life insurance business last year to Dutch insurer Aegon for $1.3 billion. It also sold its middle-market commercial finance business to GE Capital, and this year has announced the sale of its 20% ownership in Bloomberg and its controlling interest in Financial Data Services. Citi, which ditched its insurance business back in 2005, has this year sold off Citistreet, its benefit servicing business with State Street, to ING, and its German retail banking operation. Bank of America sold its prime brokerage business to BNP Paribas.
RBS is also expected to sell off small parts of its business. Plans to sell its UK car insurer subsidiary, DirectLine, have been shelved but its ABN Amro units in Australia and New Zealand seem to be on the block, as, possibly, is its Spanish insurance joint venture. Barclays announced the sale of its insurance unit to Swiss Re in August.
It makes sense, says one analyst. "Something has to give and it is going to be the non-core smaller business lines and stakes that go first."
There is still, however, a lack of strong bids in the market that is hindering even small divestitures and spin-offs. Allianz searched for a buyer for its banking unit, Dresdner, before making a deal with Commerzbank. Continued volatility in the financial sector had lowered the value of Dresdner’s securities unit, Dresdner Kleinwort, which posted a loss in August for the fourth consecutive quarter.
It’s hardly surprising that there is a lack of buyers in general, says a UK-based investor. "People keep suggesting that banks in a stronger position, like HSBC, should buy up some of the ailing banks in the UK, but that strategy is absurd. Let the weak banks go bust, and then go after their customers. It’s much better to let your competition fail than to use precious equity at the moment to buy them out. Some will find buyers, but I expect two or three will go bust."
The problem with asset sales
If buyers of business lines seem scarce, there are at least willing buyers of problem assets. In May, UBS sold $22 billion of primarily US sub-prime and Alt-A US residential mortgage-backed securities to investment manager Blackrock for $15 billion.
But they may not be enough for the most beleaguered banks. In September Lehman Brothers announced plans to sell a majority stake in its asset management arm and spin off its poorly performing commercial real estate assets, having already offloaded about $6 billion in assets to hedge fund R3 Capital Partners.
But the markets didn’t buy into Lehman’s plans and, within a week, the 158-year-old US broker-dealer was forced to file for Chapter 11 bankruptcy protection. That said, its asset management business and parts of the investment bank will end up in the hands of new owners once the work-out is completed.
In August, Merrill Lynch announced the sale of $30.6 billion of US CDOs to Lone Star funds for an average price of 22 cents on the dollar. It can be assumed that problem asset sales have occurred at all the banks but have been kept out of the public eye.
Selling these assets at a steep discount is certainly painful in the short term. Along with other capital-raising measures taken in August, Merrill Lynch says the Lone Star deal will result in a $5.7 billion write-down in the second quarter. So is it worth it? In Merrill’s case it only kept the firm alive until the demise of Lehman Brothers showed it was next in the firing line, and Merrill’s board sought to maximize what was left of shareholder value with a sale of the entire business to Bank of America.
Asset sales do not result in the big uptick in share price that a demerger would provide. The main advantage appears to be assuaging investor concerns. Both Merrill Lynch and UBS were praised at the time of the sales for addressing their problem assets swiftly and for attempting to clean up their balance sheets. But some analysts question whether they are merely pulling the wool over investors’ eyes. UBS financed 75% of the $15 billion sale to Blackrock, so essentially is on the hook for $11.25 billion. "The risks of the assets were not really transferred off the bank’s books. Would UBS normally offer a loan of this type with these terms for sub-prime assets in this environment? I doubt it," says Reggie Middleton, a private institutional investor and blogger. Merrill Lynch similarly financed 75% of its Lone Star transaction. As Michael Lewitt, president of Hegemony Capital Management, puts it: "This means that Lone Star is on the hook for the first $1.7 billion of losses, and then Merrill Lynch will eat any losses beyond that. In other words, another $0.05 drop in the value of these securities would leave Merrill Lynch back on the hook for more losses. Either this will prove to be one of the most desperate transactions done in the annals of the current credit crisis, or John Thain knows something the rest of us don’t want to know about the real value of the toxic waste he just sold to Lone Star." And Lehman Brothers was a major stakeholder in R3, putting it also "on the hook" if the assets deteriorated further.