Plastic profits approach meltdown

Few lines of US bank business have proved as profitable or as seemingly failure-proof as consumer lending through credit cards. After all, what other loans carry interest rates close to 20% and a 50% return on equity? Bankers all wanted to get a piece of the action. As a result, there are 7,000 US bank card issuers. Over the past two years these have mailed out an astonishing 5 billion card offers ­ many of them “pre-approved”­ to college and high-school students, as well as to the unemployed. Now credit card profitability has been almost halved and might even vanish altogether.

In many cases, bankers have brought the problems on themselves. The US economy may be in a recovery phase, but the boom in credit card lending over the past two years has led to a 15-year high in delinquencies and rising bankruptcies. The banks’ second quarter earnings figures indicate that loss ratios of credit card portfolios had risen by an average 40 basis points (bp) during the quarter, notes bank analyst George Salem of Gerard Klauer Mattison in New York.

“Credit cards will clearly be the most troubled loan category for US banks in 1996 and 1997,” Salem wrote in an prescient report published in June. In the past, the credit card business boasted an average 300bp return on assets (ROA). Since the second quarter rise in charge-offs, Salem estimates ROA is down to 160bp and is likely to deteriorate further. The veteran banking analyst, who has a reputation for sounding alarm bells long before other analysts and even regulators take notice, says “the profit will collapse” if there is a recession.

The report has attracted the attention of the regulators and Salem believes these may ask the banks to assign more capital or reserves to cover card risk, particularly for bank loans that have been securitized and are off balance sheet but still carry residual risk for the issuers. Banks currently reserve few, if any, funds for losses there.

Among the major banks most vulnerable to a downturn in profitability are Citicorp, which Salem calculates earned 30% of its total income from net credit card receipts in 1995, First Chicago, which earned 27%, Chase Manhattan Bank (19%) and Bank of New York (18%).

Regulators have also begun to speak out. In a speech to the New York State Bankers Association in June, comptroller of the currency Eugene Ludwig stated that the credit card issue was a “real problem that neither regulators nor the banking industry can ignore”. He noted that Federal Reserve data showed card debt rising at an alarming 20% annual rate in April, three times faster than income growth.

However, Federal Reserve chairman Alan Greenspan played down the risks in response to a question after his semi-annual speech on the economy before the Senate banking committee last month. He argued that interest rates on cards are still sufficiently high to cover large losses and that the Fed’s loan-officer surveys indicate that banks are beginning to rein back on marketing. But the extent to which this is a response to the debt build-up is questionable. Analysts acknowledge that, as the escalating bankruptcies seem to indicate, the market may be saturated. Salem’s research concluded that, on average, every American between the ages of 18 and 64 was offered about $130,000 in credit lines during the two-year marketing blitz.

Greenspan’s sanguine view echoes those of the bankers. A Citicorp spokesman noted that while costs and charge-offs were up during the second quarter, growth in the US portion of the portfolio has slowed ­ to 12%. The leading credit card issuer reported that credit losses in the US rose by $55 million and the loss ratio rose to 4.99% during the quarter, up from 4.38% in the first quarter. In line with Greenspan, Citicorp argues that the rates charged for its cards are high enough so that there is “a lot of room for bankrupties”.

But Salem argues it’s precisely this philosophy that has created problems. “You’re heating up the risk,” he says. Moreover, high rates are being charged to those with the least capacity to pay. Salem found that card usage by lower-income families (incomes under $25,000) has almost doubled over the past decade, while it has been flat for those with incomes of between $25,000 and $50,000. In families with incomes above $50,000, card usage has declined. Bankruptcy lawyers interviewed by Salem attributed the rise in bankruptcies to excessive card debt, often amounting to between 50% and 150% of annual income. His research indicates that bankruptcy filings are likely to increase by 31% this year. Yet his survey of bankers shows that many lenders fail to verify or even ask for employment status or annual income. One banker, claimed this was “‘too expensive to verify”.

Why worry about underwriting when you can securitize your loans and, at least theoretically, turn the loans over to investors? Few have done this more aggressively than Citicorp, which has securitized 62% of its $42 billion credit card portfolio. Salem believes this makes it particularly vulnerable to questions about the adequacy of reserves for these loans.

Securitization is a murky area that could cause banks unforeseen problems. For accounting purposes and so that securities can gain an AAA rating, the securities are considered a sale. But critics have argued that securitization is merely an off balance sheet financing that enables banks to avoid posting capital for the loans and to finance credit cards at lower rates of interest, by virtue of the AAA rating offered through third party financial guarantees. Salem argues that securitization is the “glue that has prevented credit card profitability from deteriorating sooner”, and thinks a decline in securitization that is bound to follow rising credit card delinquencies will “adversely affect capital adequacy and costs of funds for the banks”.

As the rating agencies see it, whether securitized cards belong to the bank or investors is a question of semantics. “The securitization is a temporary transfer of risk,” notes Ed Bankole, a securitization analyst at Moody’s Investors Service. Adds Standard & Poor’s bank analyst Tanya Azarchs: “Securitization does not wind up off-loading a lot of the business risk of managing these accounts or the credit risk.” Citicorp, however, insists that the ultimate risk lies with the investor. But, admits the Citi spokesman, “he’s clearly got a lot of things to enhance the credit”.

When card receivables are securitized, the bank still manages the individual account: it can increase the credit limit, change the interest rate and so on. The pool of securities, known as a master trust, is a complicated structure that is constantly being replenished by new loans, so that its outstanding level remains stable. Likewise, to keep paying investors, charge-offs must be compensated for with new loans.

For example, according to Citicorp, its master trust had a total yield of 18.6% in June. But the weighted average coupon investors received was only 6.57%. The trust had a net principal loss of 5.82% in June and paid fees to the bank of 0.79% for total expenses of 13.18%. The bank’s spokesman says Citi does not set aside reserves to cover losses in its securitized portfolio. But the excess cash of 5.5% is the “investor’s protection”, he explains. The excess cash is recorded on the bank’s statement as fee income. Should the trust have to use some of that cash to pay for additional charge-offs, there would be a charge against income. “For this trust to go under water, the losses would in effect have to double,” he argues.

Citi’s yield of 18.6% is above the industry average, making it relatively immune to major problems. Azarchs says that the trusts, which control $162 billion of securitized credit card loans, now have an average 16% yield, compared with 19% two years ago, since competition between issuers is lowering rates charged to consumers. But that also lowers the margin for error. The greatest problems are likely to surface at monolines (banking institutions whose sole business is credit cards), which securitize about 80% of receipts and have been the most aggressive in cutting rates. But analysts say it is hard to predict the effect that their woes would have on the rest of the industry.

Bankers are trying to put the matter in the best light, many arguing that the second quarter’s increase in charge-offs was the peak. But Azarchs doesn’t think the second quarter was “much reassurance”. She notes that charge-off levels are currently around 5.5% for seasoned portfolios (most charge-offs don’t occur until the borrower has had the card for at least two years), which was the same level experienced during the 1991 recession. “And,” she says, “we haven’t got a recession.” Michelle Celarier

INTERNATIONAL EQUITY

Honesty is the best policy

Investors in British Energy, holding company for the UK’s nuclear power generators, suffered a nasty surprise at the climax of the company’s privatization in July. Just hours after the retail offer for shares had closed over-subscribed, the company announced that two of its eight sites had been completely shut down for safety inspections.

The company had long scheduled routine inspections at Hinkley Point in south-west England and Hunterston in Scotland. One of the two sister reactors at each site was due to be closed. On July 4, a tiny crack was found in a steam pipe at Hinckley and, following advice from engineers, the company’s safety committee decided late on July 9, the eve of closure for the retail offer, to shut down the other two reactors for inspection.

That news was not made public for another 12 hours while a board meeting was convened, and a statement drafted and circulated to armies of investment bankers, lawyers and public relations advisers working for the company and for the UK Department of Trade and Industry. By the time the BBC broadcast the news on the afternoon of July 10, the retail offer had been closed for two hours.

The affair reminded some investors of the second sale of stock in the UK’s conventional power generators, National Power and PowerGen, in 1995, when an aggressive announcement by electricity regulator Stephen Littlechild, on the day after the deal closed, hammered the share price.

Amir Eilon, co-head of equity capital markets at BZW, a global coordinator on both deals, dismisses the comparison: “The Littlechild announcement raised the possibility of a real change in the operating environment for the regional electricity companies (RECs) and got investors worried about possible knock-on effects for the generators. By contrast, these shut-downs did not indicate any change. They show what the business of British Energy is all about. This company operates middle-aged kit which it regularly closes down, inspects, repairs and gets running again.”

At the board meeting on Wednesday morning, bankers had had to decide whether or not the closures were a significant enough event to require a rewriting of the share sale prospectus. They decided they did not.

Nevertheless a tumbling US stock market and nervous UK share traders undermined the British Energy issue. Partly-paid shares fell quickly from 105p to 89p on massive turnover in a wave of selling which hit the deal in the first 20 minutes of trading. BZW traces this to three sources: two institutions sold out; a number of retail brokers began selling immediately on behalf of small investors hoping to stag the deal; and, most overwhelmingly, London-based market-makers, worried about the direction of the UK market, used the liquidity of the new issue to set up short positions.

BZW stepped back from this plummeting market. But in the following days its efforts at stabilization looked more successful. By the end of July, partly-paid shares had recovered to 99p in a volatile, generally weak UK stock market. Eilon says: “The price is now 1% to 2% off the UK market since the time of the float, and no institution will worry about that. As for those who hoped to make a quick killing ­ that’s not what privatizations should be all about.”

Rival bankers say institutions received higher allocations of British Energy shares than they really wanted or expected, and this contributed to frantic early trading. In most successful privatizations, stock is scarce and institutions inflate their orders, expecting to receive no more than 40% of what they request. In this case, they received fuller allocations and then sold out. Eilon says that some institutional orders evaporated late in the bookbuilding due to market volatility and news of the reactor shut-downs. For those who remained, allocations varied widely, depending on the global coordinator’s view of the quality of investors. “Some received zero, some 25% of their orders, some took 75% plus,” says Eilon. “There was very little cutting and running in the after-market.”

BZW had already priced the deal at 203p fully paid, the bottom of its indicated range of between 200p and 230p. This reflected a variety of investor concerns, including the scale of future liabilities for decommissioning reactors, reprocessing spent fuel and disposing of waste. It’s a complicated company to value, with operating cash flow perhaps more important than reported earnings.

Because of its high fixed costs, British Energy will only be a good investment if it can increase its output by either extending the operational life of its power stations or reducing the number of unscheduled shut-downs. The company has increased its stations’ available generating time from 52% in 1991 to 71% in 1996.

So the unscheduled closures, though a fact of life for British Energy, marked a poor start to life as a privatized company.

Still, the unscheduled inspections turned up nothing unpleasant. The safety record at British Energy is good. The International Atomic Energy Agency uses a scale of 1 to 7 for nuclear events: 1 signifies an anomaly; 5 a serious accident with off-site risks (as at Three Mile Island in 1979); and 7 a major accident (as at Chernobyl). Since 1990, British Energy has only reached level 2 (incident) on three occasions.

A spokesperson for British Energy says that the decision to close the reactors at such a critical moment in the share offer shows the company’s regard for safety and its openness with the public. “It would have been easier to sit on it. But if we had, that might really have rebounded on us later.” Nice to know they considered all the options. Peter Lee

INTERNATIONAL BONDS

Angry boycott mars triumphant bond issue

On July 11 Crédit Lyonnais, with Merrill Lynch and Morgan Stanley, launched a Ffr40 billion bond for special-purpose vehicle Cyber-Val 07-96, the largest ever bond issue in the international capital markets. Despite the size ­ equivalent of $7.74 billion ­ the bonds sold out by launch.

But jubilation threatened to turn to dismay as an acrimonious row broke out over allocations of bonds. Three French banks ­ Banque Nationale de Paris, Caisse des Dépôts et de Consignations and Société Générale ­ boycotted the issue, citing meagre allocations of just 1% of the issue each. While the syndication policy was the sticking point, the ire sprang from wider concerns, including the role of state aid to Crédit Lyonnais and the prominent role played by two US houses.

The Cyber-Val transaction still marks a considerable achievement. Employing the technology of securitization, it parcelled up part of a loan made at the end of last year by Crédit Lyonnais to the Etablissement Public de Financement et Restructuration, a quasi-governmental body charged with managing the sell-down of soured assets from the troubled French bank. The trick: to harness the zero capital adequacy risk weighting of the loan to create an attractive asset that could be marketed to external investors and thereby free up liquidity for Crédit Lyonnais.

That loan ­ originally Ffr145 billion but amortized down to Ffr118 billion by the time of the launch ­ had been advanced as part of the 1995 restructuring agreement between Crédit Lyonnais and the French government: a crucial element was that the loan was made at just 85% of the TME overnight money market rate ­ well below Crédit Lyonnais’ blended cost of funding ­ in exchange for government participation in the restructuring.

Selling off part of the loan meant carving it into two separate tranches ­ a Ffr40 billion A loan with market coupon rates to back the Cyber-Val bonds and a B tranche with rates adjusted downwards to arrive at an over-all rate equivalent to 85% of the TME rate. The Crédit Lyonnais securitization team had to convince the French Trésor that these terms would not invite objection from the EU’s competition authorities, who had agreed to the original restructuring.

The B loan effectively remained on the balance sheet of Crédit Lyonnais; but selling the A tranche through the Cyber-Val vehicle allowed it to free up Ffr40 billion of cash, so it was important the overall transaction was not seen to give undue competitive advantage to the bank.

Despite being below market rate of interest, the underlying loan was always going to prove attractive raw material for a securitization ­ the quasi-governmental nature of the borrower allowed the bonds to be constructed with a triple-A rating from Moody’s and Standard & Poor’s. By the time of the issue’s launch, the bonds had already received a zero-risk weighting from France and Luxembourg, and a 10% weighting in the UK.

Carving the cash flow from the underlying loan to fashion a capital market superstructure on top of the loans then became the key to the transaction. The bonds were divided into four tranches, ranging in maturity from one to five years. The five-year tranche was twice the size of the others ­ at Ffr16 billion rather than Ffr8 billion ­ but with half of that amount paid down early in year four. “It was important to avoid cannibalization of the investor base,” says Michael Dee, head of syndicate at Morgan Stanley in London. The deal’s lead managers had judged that buyers would be wooed first by the near-cash nature of the one-year tranche and the juicy yields on the five-year bonds. Only then would attention turn to the intermediate classes.

During marketing in the week immediately preceding the July 11 launch, demand did in fact build broadly as expected, although the relative sluggishness of the intermediate tranches led to the hiking of their price by 1 basis point over the indicated price range. That was sufficient to ensure the deal was fully sold by the deal’s official launch.

Domestic buyers dominated at the shorter end of the maturity spectrum; overseas investors were more tempted at the longer end.

Merrill Lynch and Morgan Stanley had already been chosen to add distribution clout; the domestic banks’ relatively junior role in such a potentially lucrative transaction rankled all the more. “We were invited in for a very small amount ­ only 1% ­ and that was not really serious,” says Philippe Guyot, head of new issues at Caisse des Dépôts. “One per cent was a ridiculous amount,” agrees the syndicate head at another of the French banks that turned down the deal.

In domestic syndications, the main French banks typically receive between 5% and 10% each of the issue to sell. But Crédit Lyonnais and its two co-leads said that the deal was too large to syndicate in the traditional manner and that it was in any event a securitization, which had never been sold in France with a conventional syndicate.

“We recognize that this operation was quite special,” responds Caisse des Dépôts’ Guyot. “We understand that the syndication could be more like a Eurobond syndication than a domestic one ­ we have no problem with that ­ but even in a Eurobond, you are not invited in for just 1%.” Syndicate officials at all three absentee banks privately indicate that allocations of 3% ­ maybe even 2% ­ would have been enough to tempt them in.

Syndicate members estimate that fees on each 1% of bonds sold at the re-offer could have garnered between Ffr250,000 and Ffr360,000. “We wanted more paper and we wanted more fees,” says one official. That was something they were entitled to, they argue. “The primary market is based on reciprocity,” says Guyot, pointing out that French banks had continued to include Lyonnais in syndicates throughout its troubles. For the private banks the background of state aid for the troubled Lyonnais will have added to the rancour. Mark Johnson

The way we calculate equity figures for German banks led to some confusion. We have always included profit participation certificates, Genußscheine,in our calculations; had we excluded them, Dresdner Bank would have come second in the rankings and Commerzbank third. Eurastar, which analyzed the data, will canvass German banks to gauge their opinion on this, and next year’s rankings will reflect the outcome.

As a result of a mistake on our part, several banks were left out of the Top 200 rankings, despite appearing in their country lists. These banks were Republic New York Corp, with a shareholders’ equity of $3.0 billion, putting it in 132nd place, CERA Bank of Belgium, ranking at 188 with $2.0 billion, and five German banks: Bayerische Vereinsbank, with $8.0 billion in 45th; Bayerische Landesbank ($5.8 billion, 67th), Staatsbank Berlin ($5.0 billion, 82nd), Berliner Handels- und Frankfurter Bank ($2.3 billion, 178th) and Hamburgische Wohnungsbaukredit ($2.0 billion, 190th).

Below are seven banks whose 1995 figures arrived late or which we published with slight inaccuracies.