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Carson Block misfires on bearish Standard Chartered bet

The famed hedge fund short-seller Carson Block's bet against Standard Chartered - citing deteriorating loan quality evidenced by a $1 billion loan to the chairman of Bumi - significantly overstates the risks on the emerging market-focused bank’s balance sheet.

Standard Chartered not only views itself as a bridge between the east and west but, unlike some of its peers, also manages to deliver on this much-vaunted macroeconomic promise in headline profit terms. The UK-based, emerging market-focused bank routinely generates an underlying 15% return on tangible equity, while analysts expect it to grow over the next few years at around 10% on a tangible-equity basis.

This structural growth story underscores the organic growth of capital formation in emerging markets – thanks to their catch-up potential – and the bank’s leading cash management business, which serves to complement its corporate advisory business. Nevertheless, there are plenty of EM-focused banks, such as Standard Bank, that have failed, in recent years, to deliver a decent return on equity thanks to a high cost base. As a result, with Standard Chartered trading at a premium to its book value, markets clearly have faith in the bank’s growth prospects – apparently boosted by its decent risk management, say analysts.

Against this backdrop, analysts were taken aback after Carson Block, the China bear, famed short-seller and head of hedge-fund Muddy Waters, said in mid-May that “deteriorating loan quality” makes Standard Chartered a prime target for a bearish punt, expressed by shorting its five-year CDS. Block cites the fact that in 2011 Standard Chartered lent $1 billion to PT Borneo Lumbung Energi & Metal to fund the acquisition of a 23.8% stake in coal producer Bumi from PT Bakri & Brothers, in a five-year deal the bank hasn’t fully syndicated down, leaving close to $800 million on its own books, according to some estimates.

 Block; Source: Reuters

Block’s views can’t be dismissed out of hand; his reports from 2010 triggered $7 billion of losses for Chinese firms over two years, according to Bloomberg, and claimed the scalp of the management at Sino-Forest, a Hong Kong- and Toronto-listed tree plantation operator, found to have inflated its asset values.

Asset-quality deterioration – which the bank has already acknowledged and is priced into Standard Chartered credit spreads relative to European banks – is the nature of business in EM. But Block suggests something more sinister. He described the $1 billion loan as a “very messy situation”, underscoring risk-management concerns and material risks in the bank’s exposures. “We think the market misunderstands the amount of risk that’s presently in the book,” he said at a conference in Las Vegas on May 10.

Old news

Really? The market has been aware of the loan for years. Asked about the loan in an interview with Euromoney last year, Michael Rees, head of wholesale banking at Standard Chartered, said: “We are very comfortable with the $1 billion loan – it’s well secured, it’s well priced. The only reason we would need to sell it down would be because under the new leadership and management there will be a lot more business for us to do with Bumi and we need to keep our limits open to do all the other deals that are now coming our way.”

Peter Kay, head of leveraged finance syndication at the time of the loan, left the bank in October 2012. The loan disbursement was not “exactly pristine”, notes Matthew Phan, Asia Pacific analyst at CreditSights, citing the “out-sized proportion of the share financing loan relative to the pre-existing balance sheet”, and the fact that Standard Chartered “went ahead with the loan despite being unable to find partners for the syndication, and that the bank decided to take such a large loan onto its own balance sheet”.

Phan adds in a research note: “We think SCB made a mistake with the BORN loan as it had been growing its mining book very rapidly over the last few years, though from a small base – mining loans were $15 billion at FY12, up from $6 billion at FY09, with the bank adding about $3 billion per year. In this context, the existence of another bad loan – Block cites a $30 million loan to Far East Energy Corp – is not a good sign.” On the latter, however, Phan notes the “loan is tiny and practically negligible relative to SCB’s overall book”.

He adds: “At this point, we are prepared to give the bank the benefit of the doubt. We would regard these credit decisions as mistakes that have been recognized, rather than a sign of an aggressive risk-taking culture across the group.”

In sum, if the Bumi loan goes sour, it won’t sink the bank – the nominal sum amounts to around 10% of annual operating profit.

Although Standard Chartered lost its innocence in 2008, after taking a $116 million loss on its structured investment vehicle, Whistlejacket, it boasted little exposure to the structured credit market, unlike its besieged global peers. What’s more, the Iran scandal – as damaging as it was to the bank’s reputation – cost $667 million in penalties to US regulators, but that only just offset the underlying increase in operating profits. In sum, Standard Chartered is not structurally exposed to risky bets that will challenge its pre-provision profitability, liquidity and capital levels, the CreditSights analyst concludes.

Nevertheless, Block’s call could be indicative of a growing trend: hedge funds casting Standard Chartered as proxy for a China slowdown, meaning the beta of the credit with China GDP could intensify in the coming years. In any case, there are plenty of opportunities to short China risk, with, for example, HSBC and commodity producers also structurally exposed. If Block is talking up his book to gain a tactical advantage in the event of poor economic growth in China, the shorting of Standard Chartered should be seen as relating to “global factors, rather than those specific to SCB and the equity and credit of many other companies and banks throughout Asia-Pacific would be affected by the same factors”, Pan concludes.

What’s more, according to Société Générale, Standard Chartered remains one of the few big global banks with more customer deposits than loans to non-financial companies, and managed last year to boost its fully loaded Basle III core tier 1 ratio to 10.7%, ahead of its peers. In other words, the bank has excess capital relative to the regulatory requirement. In the context of gross over-capitalization, it’s not hard to imagine the Standard Chartered risk-committee encountering shareholder pressure to deploy this excess capital by expanding its loan book.