Wednesday, October 8, 2008

The bottom line on Commonwealth Bank’s balance sheet

Articles - Intelligent Investor
Almost everybody who owns shares in a large bank is taking the numbers on faith. Their complex financial statements preclude outside investors from gaining complete comfort.

In the investing world, taking matters on faith can be dangerous. This applies even to the most well-known and reassuring brands we come across in our daily lives. Americans, for example, were recently stunned by the collapse of Washington Mutual.

Before its demise, this 119-year old institution (which hadn’t actually been a mutual for 25 years) was the sixth-largest bank in the US. It is now (at least for the time being) the country’s biggest ever bank failure. A year ago investors were paying more than US$35 per share for it, implying a value of more than US$60bn. By way of comparison, Commonwealth Bank’s current market capitalisation is less than A$60bn.

This is part of the reason we’ve long advised conservative investors against having too much of their portfolios in the banks. These institutions are riskier than many people imagine, and too many investors have been burned over the past year by recognising risks only after they’ve flared up.

Highly leveraged beast

In this, the first of a two-part analysis, we’re going to sweep aside all the rhetoric and motherhood statements and put Commonwealth Bank’s balance sheet to the test. What we’ll show is that even this, the stodgiest of Australian financial institutions, is a highly leveraged financial beast which relies on a relatively thin $25.6bn slice of reported shareholders’ equity to support a towering mass of $487.6bn in assets.

This leverage ratio of more than 19:1 means that not a lot has to go wrong for Commonwealth before shareholders’ funds are put at serious risk. So we’re going to comb through the group’s assets to see where the danger might lie.

Before we start, though, we need to put this task in perspective. Commonwealth’s business and accounts are dominated by its Australian banking operations (encompassing more than 1,000 branches across the nation plus business and wholesale banking services). It also has life insurance, stockbroking and funds management arms, plus various international operations in New Zealand, Indonesia, Fiji and China.

Given this enormous scale and complexity, we must acknowledge the difficulty of analysing the resultant balance sheet. Any outside investor who says they fully understand the intricacies of Commonwealth Bank’s balance sheet is either a fool or a liar. So, in the course of our analysis we’ll have to take some liberties, make assumptions and, in parts, admit defeat. With that caveat, let’s jump to it.

CBA balance sheet (abridged) at 30 June 2008 ($m) Accounts Adjust. Adjusted value
ASSETS
Cash and liquids 7,736 7,736
Receivable from other fin. institutions 6,984 6,984
Trading assets (fair value) 21,676 (570) 21,106
Insurance assets (fair value) 20,650 (620) 20,031
Derivative assets 18,232 (2,188) 16,044
Loans, advances and other receivables 361,282 (3,183) 358,099
Property, plant & equipment 1,640 1,640
Intangible assets 8,258 (774) 7,484
Other assets 41,114 (600) 40,514
TOTAL ASSETS 487,572 479,638
TOTAL LIABILITIES 461,435 461,435
NET ASSETS 26,137 18,203
Minority interests (ASB perp. pref. shares) 518 518
SHAREHOLDERS' EQUITY 25,619 17,685
Shares on issue (m) 1,326 1,326
Book value per share ($) 19.32 13.34

You can see an abridged version of Commonwealth’s 30 June 2008 balance sheet in the table, and we’ll run through the assets line by line (we’ll assume the liabilities are correctly stated). The first couple of lines are pretty straightforward. Almost all the group’s $7.7bn in ‘cash and liquid assets’ and $7.0bn of ‘receivables due from other institutions’ are a regular part of the bank’s day-to-day cash management. Not a lot to worry about here.

Trading and insurance assets

Our first adjustment is required when we come to $21.7bn worth of ‘trading assets’. The terminology might sound somewhat ominous but an investigation of the relevant accounting note (number 10) shows there’s little reason for concern. These assets include fairly innocuous securities such as certificates of deposit ($13.1bn), medium term notes ($2.4bn), local and semi-government bonds ($1.5bn), federal and state government bonds ($1.4bn) plus $3.3bn of other assorted standard-looking financial fare (bills of exchange, commercial paper, floating rate notes, eurobonds and the like). The question is by how much we should adjust this figure, if at all, in our analysis.

My experience inside banks (though I’ve never worked for Commonwealth) tells me that it’s probably a good idea to give these numbers a bit of a ‘haircut’ for safety, especially given the current turbulent environment.

In a worst-case scenario, the issuers of some of those securities could fall on tough times and put Commonwealth’s money at risk. In the current environment, the medium term notes might be the main thing to worry about here – these are bonds issued by other banks as part of their regular funding programs. So we’ll leave the more prosaic securities alone but subtract a 10% margin of safety from the $2.4bn in medium term notes and $3.3bn of other securities. That means reducing the $21.7bn stated value by $0.6bn in round terms, leaving it at $21.1bn.

Insurance assets are the next cab off the rank, listed at $20.7bn. The accounting around these is complicated and somewhat confusing. Movements in the value of these assets are offset to a large extent by related liabilities.

There is a degree of risk for shareholders, though, if the investment future breaks somewhere south of the actuarial assumptions made. That being the case, let’s adjust these assets down by 3% to $20bn to allow a little breathing space.

Derivatives

Now we move on to a potentially explosive area, Commonwealth Bank’s $18.2bn of ‘derivative assets’. The sheer scale is noteworthy, with derivative assets representing fully 70% of the bank’s shareholders’ equity.

Note 11 to the accounts offers a mind-boggling summary of these instruments, which had a combined face value exceeding $1.4tr (that’s trillion, with a ‘t’), at 30 June. Of those, $2.6bn relate to derivative securities ‘held for hedging’. The lion’s share, $15.7bn (with a face value of almost $1.3tr), are designated under the purposes of ‘trading’ or ‘other’.

HORSE SENSE – Munger on derivatives

‘I think we’ve got plenty of scandals coming. A lot of rot has gotten in to the financial system – and of course, this recently caused vast unpleasantness. Someone at the Berkshire meeting asked me “What’s the next one?”, and I answered that my main candidate would be the derivative trading books of the world.

‘I think the accounting that’s been allowed by the accounting profession in the derivative books has been godawful. And I think the morals and intelligence of the people doing the trading has been godawful. And of course what’s really buried in those books is a very dangerous system with enormous clearance risks – and very optimistic assumptions which the accountants have allowed.’

Charlie Munger, Wesco annual meeting 2008.

The bank’s valuation policy on these securities is to use market quoted prices or broker/dealer prices where possible, which is standard practice across the industry. But that doesn’t make it conservative. As we’ve seen in recent months, derivative markets can change quickly (and sometimes dry up altogether).

In cases where it holds derivative securities that are not quoted, Commonwealth applies its own ‘valuation techniques based on market conditions and risks at Balance Sheet date’. That can be safely translated as ‘we make an educated guess’.

So what to do with $18.2bn of these assets? Realistically, we have to admit defeat. No one can know what dangers, if any, might lurk in a derivatives book with a face value running to 13 figures.

One could take the $18.2bn on faith. Or perhaps it should be severely discounted, especially given the current circumstances in world markets. But what if Commonwealth’s traders have made canny bets in these markets and are currently recording huge profits for shareholders (after extracting handsome bonuses, of course)?

We simply cannot know. But, for the sake of this analysis, we’re inclined to knock more than 10% off and call it $16bn. This is far from a worst-case scenario, though, and undertaking this part of the exercise highlights how much more dangerous National Australia Bank’s foreign currency options trading scandal could have been back in 2004 – the cost to NAB shareholders only ran into the hundreds of millions.

Loan book

Next we arrive at the biggest line on our abridged balance sheet, ‘Loans, advances and other receivables’ of $361.3bn. In the jargon, this is known as the ‘loan book’, and any meaningful analysis of Commonwealth rests heavily on the assumptions made about it.

The largest section of this segment is $215.7bn of mortgages (more than 86% of which are domestic). In a nightmare scenario, it’s possible to imagine there being losses in this portfolio. But overall the quality looks strong enough not to make any adjustments over and above the bank’s internal provisioning at this stage.

Of more potential concern is the $93.2bn of commercial and industrial loans. On this, we note an interesting slide deep within the presentation to analysts that went with the latest results. It showed the bank’s top 20 commercial exposures by credit rating.

We were alarmed to discover that three of Commonwealth’s seven largest commercial exposures are rated below investment grade. These three potentially shaky loans total around $2.5bn, though we can’t tell if they are secured exposures or not. Further down the list, another $600m sub-investment grade exposure was declared ($600m at a rating of BB+). It strikes us that there may be a few potential bombs in this section of the loan book.

Other areas where losses might materialise include credit cards ($8.1bn outstanding) and leasing ($4.8bn). In America, vehicle leasing companies are under serious pressure as funding costs have risen and the value of their security (vehicle resale values) has fallen. While the Australian banks are a different kettle of fish to the average American auto leasing company, we suspect there’s a degree of risk in this business.

Making adjustments to the loan book is difficult. For a start, the $361.3bn figure is net of $1.7bn in impairment charges already recognised by the bank. But we’d be inclined to anticipate some serious losses in the commercial portfolio.

These might arise from the bank’s exposure to the troubled New Zealand economy, or to the ailing property markets in New South Wales and certain sections of Queensland. That’s before considering the impact of any exposure to companies like A.B.C. Learning Centres or, perhaps, loans to precariously leveraged sectors like private equity, certain infrastructure funds or perhaps even hedge funds.

All things considered, we’re going to strip 3% off the $93.2bn commercial and industrial portfolio. We’re taking the same percentage off the credit card and leasing portfolios, which might be a little extreme but that allows us some leeway on the fact that we’ve let the mortgage book stand as is. All up, these adjustments will reduce the $361.3bn loan book by $3.2bn, taking it down to $358.1bn.

Other assets

We needn’t worry too much about the $1.6bn of property, plant and equipment – it’s all pretty standard stuff – but the next item down requires a little more scrutiny.

Commonwealth Bank carries almost $8.3bn of intangible assets on its books. Most of this ($6.7bn) is goodwill relating to its acquisition of Colonial back in June 2000. But there are some questionable items, such as computer software costs ($353m) and management fee rights ($311m), not to mention $110m listed under ‘Other’.

The auditors remain happy with the goodwill (which actually says something given the new tougher AIFRS accounting rules require annual ‘impairment testing’), so we’ll let that stand. But we can’t abide those capitalised software costs. We’ll also remove the ‘other’ and the ‘management fee rights’ just to be on the safe side. That brings our deductions to intangibles to almost $0.8bn.

With regard to the remaining $41.1bn of assets on the balance sheet, one point of interest is a $1.5bn asset relating to an overfunded defined-benefit superannuation scheme. We suspect some of that cushion has evaporated since 30 June. We’re going to adjust this pool of sundry assets down by $0.6bn, but prudence might suggest an even bigger markdown.

Adjusted total

After making all our deductions, we arrive at an adjusted total asset figure of $479.6bn. Subtracting the stated total liabilities of $461.4bn lands us at net assets of $18.2bn, from which we need to subtract $0.5bn of minority interests. Our final figure, then, for Commonwealth’s adjusted book value is $17.7bn, or $13.34 per share. That’s some way below the $25.6bn (or $19.31 per share) that anyone accepting the accountants’ version of reality would be working with.

As a rough cross-check, let’s compare our number with that arrived at by the bank’s regulator, the Australian Prudential Regulatory Authority (APRA). After making its own adjustments, APRA deemed Commonwealth’s ‘Fundamental tier one capital’ to be $23.8bn. This is the highest form of capital.

There are other forms of ‘residual tier one capital’ such as the PERLS income securities. Those securities might provide comfort for Commonwealth’s depositors and other creditors but we’re looking to APRA’s numbers for a guide to what ordinary shareholders might own, so we’ll exclude those.

The regulator then makes a number of hard-nosed deductions. These include all of Commonwealth’s goodwill, capitalised expenses, deferred tax and the superannuation plan surplus. It also applies discounts to a number of other assets, such as investments, and deducts a $587m safety buffer relating to the loan book (using more strenuous loss assumptions than the bank’s own boffins).

APRA’s ‘total tier one deductions’ come to $11.2bn. Subtracting these from the $23.8bn in ‘fundamental tier one capital’ leaves $12.6bn, or $9.50 per share. This is a rather austere assessment, but not a completely unreasonable one.

Gearing effect

You can see from APRA’s adjustments and from our own the effect of so much gearing – how relatively small adjustments to a bank’s asset base can translate into very large percentage adjustments to its shareholders’ equity, and hence to its intrinsic value.

Owning bank shares is not the same as owning Woolworths shares, for example. It would take quite a few years for Woolies to get into serious trouble, but a bank could easily manage it in weeks.

From our analysis, the major sources of danger for Commonwealth are its corporate lending portfolio and its huge derivatives book. In relation to the lending portfolio, it’s the banker’s age-old worst enemy – bad loans – that should cause shareholders to lose sleep. On the derivatives front, problems could range from rogue traders to insolvent counterparties or improperly hedged positions.

Summing up the situation, it’s clear that a few surprises, or a sharp economic downturn (leading to higher defaults) could see Commonwealth in need of a capital infusion. This is especially so given that its high dividend payout ratio allows little room for manoeuvre.

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