Banking Sector Report28th February 2008Anthony Grech,Research Analyst,IG Index

ObjectiveThe aim of this report is to provide the reader with an understanding of the factors that are causing share prices in the banking sector to fall, identify whether this trend is likely to remain, and suggest trading strategies to fit the environment.

This paper begins by introducing the sub-prime crisis and its impact on the banking sector. The following sections identify major write-downs and unearth catastrophes and concerns surrounding the sector. This should provide the reader with a better understanding of the negative share price performance and explain why fundamental data is starting to appear attractive. In the final section, I gather analysts’ opinions and attempt to conclude whether it is a good time to be going long or short on shares in the banking sector.

*No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does soentirely at their own risk. The research does not have regard to the specific investment objectives, financial situation and needs of anyspecific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independenceof investment research and as such is considered to be a marketing communication. Although we are not specifically constrained fromdealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. We are authorisedand regulated by the Financial Services Authority (FSA No: 195355).

IG Index plc Banking Sector Report 01

Sub-Prime Crisis: The Impact on the Banking SectorHas the sector finally reached a bottom: Is it a good time to be going long or short on shares in the banking sector?*

28th February 2008Anthony Grech, Research Analyst, IG Index

Introduction to the sub-prime crisisThe sub-prime market consists of individuals with impaired credit scores who are only eligible for mortgages with higher interest repayments to compensate for the elevated level of default risk. During 2002 to 2004, US federal fund interest rates were at historically low levels (as seen in the chart below), and individuals with impaired credit ratings were able to gain access to sub-prime mortgages which were directed toward residential properties. This helped boost the price of certain US properties and allowed borrowers to extract equity from their homes. As a result, debt continued to pile on without due consideration being given to the impact of higher interest rates.

At the same time, banks pooled the income streams from individuals making repayments on credit (including sub-prime mortgages) and repackaged them into complex asset-backed securities (ABS). Financial institutions then sold these complex securities to investors for a profit. This practice was feasible at the time (between 2002 and 2004) because federal fund rates were abnormally low (in a historical context).

Toward the end of 2004, the Federal Reserve (and later the Bank of England) started to tighten monetary policy in an attempt to control inflationary pressures. At this point, sub-prime mortgage holders started to feel the pain of higher interest rates and borrowers who were unable to meet their monthly repayments eventually defaulted. According to year end data released by RealtyTrac, an online real estate marketer, between 2006 and 2007, the number of US homes receiving default notices rose by 75%[1]. The Council of Mortgage Lenders in the UK estimated that 14,000 properties were repossessed in the first six months of 2007, a 30% surge from the previous period [2].

The increase in defaults dealt a direct blow to the banking sector because the income streams funding these complex ABS products were significantly reduced and they were no longer generating the returns that were initially expected. As a result, banks and investors started to quickly sell off these products which drove

their value down. As the problem worsened, nobody wanted to acquire ABS products and the secondary market, which financial institutions used to benchmark the value of these securities, dried up. This left banks with inventories of complex ABS securities that were difficult to value and contributed to a sector-wide write-down spree.

Banks resorted to proprietary computer-based models and tracked ABX indices (asset backed indices compiled by Markit) in an attempt to derive valuations. These indices are calculated from a portfolio of actively traded derivatives. Since the value is being derived from an actively traded (liquid) market, it is supposed to be more accurate than the computer-based system. A decline in the ABX Index is meant to represent falling values in asset backed securities and forces banks to incur write-downs on their holdings of these securities.

The fact that there was a shift in the method of calculating ABS securities raised concerns over the possibility of miscalculations in their value, questioned the validity of write-downs experienced so far, and fuelled worries of larger future write-downs.

The mark-downs experienced up until now have deteriorated banking sector earnings, dented balance sheets and forced some banks to seek liquidity from outside investors. The size of the write-downs and the share price reactions will be shown in the following section.

Major write-downs in the banking sectorThe banking sector experienced a series of sub-prime linked write-downs which severely damaged earnings during 2007. According to data compiled by Bloomberg, the collapse of the US sub-prime mortgage market has led to approximately $146 billion of losses and markdowns at securities firms and banks since the beginning of 2007. Merrill Lynch and Citigroup were among the worst casualties of the sub-prime crisis, followed by UBS. So far, these three banks recorded a staggering $65.3 billion in sub-prime related write-downs and credit losses, almost half the value (45%) of all the write-offs in the industry so far. A recent G7 meeting indicated that credit crunch related losses could reach $400 billion; that’s a further $254 billion than currently experienced, which is almost twice the size of write-downs incurred to date [3].

Merrill Lynch, the world’s largest brokerage firm, posted a fourth quarter loss of nearly $10 billion after experiencing a quarterly write-down of $16 billion. The company’s 2007 full-year net loss amounted to a staggering $7.8 billion as opposed to a 2006 net profit of $7.5 billion. This made 2007 one of the worst years for the firm since it was founded. In order to replenish its liquidity, Merrill Lynch had to seek help from Mizuho Financial Group, Korean Investment Corporation, Temasek Holdings and the Kuwait Investment Authority which, in aggregate, contributed over $11 billion to help the company’s depleted balance sheet.

[1] World Socialist Website (30 January 2008): ‘US home foreclosures rise by75% in 2007’

[2] BBC NEWS (3 August 2007): ‘Home repossessions rise by 30%’

[3] The Press Association: ‘Banks fighting to secure cash’

IG Index plc Banking Sector Report 0228th February 2008

Anthony Grech, Research Analyst, IG Index

Citigroup’s 2007 fourth quarter was equally alarming. The largest US bank reported a fourth quarter loss of $9.83 billion, after surging home loan defaults pressured the bank into writing down $18.1 billion. This depleted the company’s 2007 full-year net income to $3.62 billion, down 83% from the previous year. The company slashed its dividend by 41% from $0.54 to $0.32 per share in order to retain capital, and like Merrill Lynch, sought to raise funds externally. $20 billion was invested by: The Government of Singapore Investment Corporation, Kuwait Investment Authority, Prince Alwaleed bin Talal (one of Citi’s largest shareholders), and former chief executive Sandy Weill. Citigroup reported that, as of 31 December 2007, it still had a total of $37.3 billion in direct sub-prime mortgage exposure, down from $54.6 billion three months before.

UBS, the largest bank in Switzerland and once known for its conservative lending and investment policies, announced that it expects a record fourth quarter loss of $11.45 billion and a lower 2007 full year net profit of $4.03 billion, after suffering from severe sub-prime related write-downs of $18.4 billion in 2007. UBS also mentioned that it still had around $29 billion in sub-prime holdings.

IG Index plc Banking Sector Report 0328th February 2008

Anthony Grech, Research Analyst, IG Index

Concerns & share price performance The occurrence of large write-downs across the banking sector has drained liquidity and dented earnings. It has fuelled greater uncertainty about the future which has led banks to tighten lending, even among each other. This, in turn, has driven short-term interbank loan costs higher and depressed liquidity in the banking sector, which eventually contributed to the Northern Rock debacle.

Societe Generale recently incurred a €4.9 billion trading loss, after a series of large concealed trades were executed by Jerome Kerviel. Although the problems at Societe Generale and Northern Rock are fundamentally different, it has raised concerns on the risk management procedures being implemented in the banking sector. Why were these banks unable to avoid their problems? Will there be any further surprises?

Credit rating agencies are pointing to an extensive downgrade spree across the bond insurance sector (also referred to as ‘monoline’ insurance). These monoline insurers guarantee around $2.4 trillion worth of bonds and there are growing doubts over their ability to cover losses on complex asset-backed securities. If monoline insurers are downgraded, their guarantees could become worthless and banks could be forced into further multi-billion dollar write-downs. MBIA and Ambac Financial Group, the world’s largest bond insurers, have already reported a combined loss of $5.5 billion in their fourth quarter and are currently in danger of losing their AAA credit ratings.

Meredith Whitney, an analyst at Oppenheimer & Co, believes that bond insurance downgrades may force banks to write down $70 billion [4]. On 25 January, analysts at Barclays Capital stated that banks own $820 billion of securities guaranteed by bond insurers and that they would need to raise another $143 billion should credit rating firms start downgrading monolines [5]. The question is, what’s going to happen? How far will bond insurers be downgraded? Will write-downs be larger or smaller than already experienced so far? When will write-down season end?

The uncertainty as to the way in which the value of asset-backed securities is being derived, and the massive write-offs experienced so far, also cast doubt on the quality of reported earnings in the banking sector. The FBI has also become involved and, at the time of writing, was investigating 14 companies over possible accounting fraud and insider trading violations. Will any discrepancies be unearthed?

The problems mentioned in the previous paragraphs are a major worry and have caused many investors to sell their holdings in banking sector shares. The chart shows the share price performance of five banks from 30 January 2007 to 30 January 2008.

During this period, the share price of Merrill Lynch fell by 40% from $92.76 to $56.09 while the value of Citigroup’s shares halved from $54.27 to $27.88. The shares of HSBC Holdings (-19%), Morgan Stanley (-40%), Bear Sterns (-46%) and UBS (-32%) all suffered a beating during this one-year period.

Analyst opinions and fundamentalsThe share price declines varied across equities in the banking sector with some banks losing half their value during 30 January 2007 to 30 January 2008. At this juncture, some analysts are starting to believe that certain banking sector equities have fallen too much and that it’s a good time to be buying. On the other hand, there are analysts who are of the opinion that the banking sector may continue to fall further. These mixed opinions are a product of the uncertainty that has typified this phenomenon. The following section identifies analysts’ opinions:

Madeleine Hofmann, senior banking analyst at Julius Baer,believes the worst is now over for UBS. She said, ‘I’m not rulingout further write-downs, but it’s safe to say that the worst isnow behind them [UBS]. I’m expecting things to get betterfrom now on.’ [6].

William De Vijlder, chief investments officer at FortisInvestments, believes that banking shares are on the brink ofrecovery, after taking a beating over the past few months. MrDe Vijlder said, ‘Despite what the market currently anticipates,we think that financial stocks could start to bounce back eventhough the US housing slump continues.’ [7].

On 31 January, brokers at Fox-Pitt Kelton upgraded SocieteGenerale from ‘in line’ to ‘outperform,’ on hopes of a takeover.Mark Sartori, head of European equities at Fox Pitt Kelton,stated, ‘The market has now priced in SocGen’s problemsso you get the M&A [Mergers and Acquisitions] option on thecheap.’ [8].

[4] Bloomberg News (5 February 2008): ‘MBIA’s AAA Rating Placed Back Under Reviewby Fitch (Update2)’

[5] BBC News (25 January 2008): ‘Banks may need an extra $143bn’

[6] Bloomberg (30 January 2008): ‘UBS Reports Record Loss After $14 BillionWritedown (Update7)’

[7] Reuters News (7 December 2007): ‘ Banking shares poised to recover - Fortis’

[8] Financial Times (31 January 2008): ‘UBS writedown put pressure on banks’

IG Index plc Banking Sector Report 0428th February 2008

Anthony Grech, Research Analyst, IG Index

On the other hand, Franz Wenzel, a strategist at AXA InvestmentManagers, is of the opinion that there is still some downsideremaining to the sector. He said, ‘2007 has been a horrible yearfor the banks and the sector is not out of the woods yet.Currently, banks are trading at a price-to-book ratio of 1.4, andthe historical average has been 1.1 to 1.2.’ [9].

During an interview on 5 February 2008, Piet Viljoen, an assetmanager at Regarding Capital Management in South Africa,stated, ‘Banks are probably fair value if one looks at the price-tobook ratio, which is something we look at. They are notextremely low. They are quite a bit lower than they used to be,but they are not at historically low levels. So we still wouldn’tbe getting on the aggressive side of the buying activity there.’ [10].

Dresdner Kleinwort wrote, ‘We expect to see larger writedowns than already announced, with Barclays and RBS most atrisk. 2008 looks set to be a tough year. ‘ [11].

The analyst’s opinions make reference to price-to-book ratios, which compares the company’s market value to its net asset value (total assets less total liabilities).

At this point, it is important to understand that the price-to-book ratio does not directly provide any information on the ability of the firm to generate profits or cash for shareholders. It is a relationship between market value and accounting value. A bank with a higher price-to-book ratio than a peer implies that investors expect the company to create greater value from a specific set of assets, everything else being equal.

In practice, analysts value equities using a number of multiples and financial modelling techniques, and the price-to-book ratio is one of the ratios used when determining the ‘attractiveness’ of a bank’s value. Research does prove that the price-to-book ratio is a valid valuation model [12] and as seen in the previous section, fund managers frequently benchmark a bank’s price-to-book ratio against its rivals when referring to the value of a bank.

A bank trading with a higher price-to-book ratio (relative to its rivals) indicates that investors are willing to pay a premium to acquire shares that they expect will provide larger returns. However, value investors (individuals who aim at acquiring undervalued shares) would consider banks that have lower price-to-book ratios than the sector to be attractive. However, this has to be considered within context; although a lower price-to-book ratio could mean that the stock is undervalued, it could also indicate that there is something fundamentally wrong with the company.

For more information see Appendix on final page

Conclusion: long or short on the banking sector?The financial services industry is constantly innovating and creating new products in an attempt to produce exceptional returns to investors. When ABS products were created, they were initially considered to be attractive products to hold in a portfolio. However, when economic pressures escalated and sub-prime mortgage owners defaulted, they became difficult to value and caused banks to incur major write-downs which threatened to derail the financial services industry and slow down the global economy.

The information gathered in the previous sections makes it reasonable to expect further write-downs and more negative revelations for 2008. This means that we may expect further pressures on banking sector shares. However, in my opinion, the sector’s downside may be limited because major banking sector shares may already price in the negative news. Some of the analysts mentioned in the previous section were also of the opinion that banking sector shares were starting to fall close to their fair values from a fundamental analysis perspective.

As a result, banking sector shares may start to attract more support as they fall from current levels, and this would ultimately limit the sector’s downside. In my opinion, most of the bad news regarding the sub-prime crisis and write-downs should be out of the banking system by the third or fourth quarters of 2008 and this could help the sector reverse its downward direction. However, this scenario is more probable if the problems in the monoline insurance industry are successfully resolved.

If shares in the sector continue to fall and become fundamentally cheaper, then it is not impossible to foresee some M&A activity in the sector. Although the weakness of the credit markets and the conservative aura now attached to the sector make it highly improbable that leveraged buyouts will take place, certain banks with strong balance sheets may consider this period as an opportunity to acquire valuable assets.

The turbulence seen in the financial services industry has not deterred billionaires Warren Buffett and JC Flowers from buying shares in the financial services industry. They recently bought shares in European insurers which have fallen close to their book value and have minimal sub-prime exposure. Warren Buffett acquired a 3% stake in Swiss Reinsurance, the world’s biggest reinsurer, while JC Flowers bought a 2.7% share in Friends Provident. Buffett has an enviable and celebrated track record; according to a study conducted by the American University and University of Nevada, his purchases during the last three decades delivered approximately twice the return of the Standard and Poor’s 500 Index (circa 24.6% return) [13].

Speculators may consider shorting the banking sector, since market consensus points to the possibility of further write-

IG Index plc Banking Sector Report 05

[9] Reuters News ( 30 January 2008): ‘European stocks drop ahead of Fed, UBS sags’

[10] Money Web (5 February 2008)

[11] Bloomberg (28 January 2008): ‘Stocks Fall in Europe, Asia, U.S. Futures Drop;Total Declines’

[12] Price to Book Ratio as a Valuation Model: An Empirical Investigation (June 1996)

[13] Bloomberg (30 January 2008): ‘UBS Reports Record Loss After $14 BillionWritedown (Update7)’

28th February 2008Anthony Grech, Research Analyst, IG Index

downs and negative news being unearthed in the short term. They may also consider adopting a trading strategy which incorporates going short of banking sector shares which are trading at higher price-to-book ratios than their peers. However, short and long strategies must be considered carefully and within context, because shares in the sector currently appear to be trading more on sentiment and could be above or below their peers’ price-to-book ratio for a reason.

Alternatively, traders may look at financial sector companies that benefit from increased market volatility and which may have had their share price beaten down by panic selling.

Whatever strategy is chosen, traders must be careful; there is a lot of volatility out there and it is very difficult to foresee exactly when the write-down season will end or when intra-day sentiment will change.

Sources The Press Association (11 February 2008): ‘Banks fighting to

secure cash’ http://ukpress.google.comarticleALeqM5jHIimIOZEyoKdakcguRzeqwNSIiw

Money Web (5 February 2008): ‘Piet Viljoen: Mark commentator,RE: CM’ http://www.moneyweb.co.za/mw/view mw/en/page55?oid=190300&sn=Detail

Bloomberg (1 February 2008): ‘Goldman Says Banks May Face$60 Billion in Write downs (Update2)’ http://www.bloombergcom/apps/news?pid=newsa chive&sid=aMvnGoBjkjXc

Bloomberg (31 January 2008): ‘Sub-prime Bank Losses Reach$146 Billion as Europe Joins: Table’ http://www.bloomberg.comapps/news?pid=newsarchive&sid=a0T7r3uZwt4

Accountancy Age (31 January 2008): ‘UBS announces furtherwrite-down - £9bn to date’ http://www.accountancyage.comaccountancyagenews/2208482/ubs-announces-write

New York Times (31 January 2008): ‘In Europe, Questions OverContinuing Write-Downs’ http://www.nytimes.com/2008/01/31/businessworldbusiness/31ubshtml?ref=business

Bloomberg (31 January 2008): ‘Sub prime, CDO Bank LossesMay Exceed $265 Billion’ http://www.bloomberg.comappsnewspid=newsarchive&sid=auotjOehBWQ

Bloomberg (31 January 2008): ‘Corporate Bond Risk Rises onS&P’s $534 Billion Sub-prime Review’ http:/www.bloombergcomappsnews?pid=newsarchive&sid=aqdGsJAkpHA

Financial Times (31 January 2008): ‘UBS writedown put pressureon banks’ http:/www.ft.com/cms/s/0/d8b8768c-cf9f11dc-854a0000779fd2ac.html

WSWS (30 January 2008): ‘US home foreclosures rise by 75% in2007’ http:/www.wsws.org/articles/2008/jan2008home-j30shtml

Financial Times (30 January 2008): ‘Are bank stocks cheap?’http://www.ft.com/cms/s/1/aa07ef1c-cf17-11dc854a0000779fd2ac.html

International Herald Tribune (30 January 2008): ‘UBS sub-primelosses deepen’ http://www.iht.com/articlesreuters/2008/01/30business/OUKBS-UKUBS-RESULTS.php

Bloomberg (30 January 2008): ‘UBS Reports Record Loss After$14 Billion Writedown (Update7)’www.bloomberg.com.auappsnews?pid=20601087&sidaD1jWGtde750&refer=home

International Herald Tribune (30 January 2008): ‘Mountingconcerns over write downs at European banks’ http://wwwihtcom/articles/2008/01/30/businessubs.php?page=2

Bloomberg (30 January 2008): ‘Banks May Write-down $70Billion, Oppenheimer Says (Update3)’ http://www.bloombergcom/apps/news?pid=newsarchive&sid=lkvneXe4JiQ

Bloomberg (30 January 2008): ‘BNP Paribas Profit Falls 42% onCredit Market Slump (Update5)’ http://www.bloomberg.comapps/news?pid=newsachive&sid=aeaIo00Ovx7M

Reuters (30 January 2008): ‘European stocks drop ahead ofFed, UBS sags’ http://www.reuters.com/articleeurMktRpt/idUSL3056410520080130

Bloomberg (28 January 2008): ‘Stocks Fall in Europe, Asia, U.S.Futures Drop; Total Declines’ http://www.bloomberg.com/apps/news?pid=20601087&sid=a18qgY57hjo&refer=home

Market Watch (25 January 2008): ‘Banks may need $143 billionin fresh capital If bond-insurer ratings are cut deeply, banks’capital will be tested: study’ http://www.marketwatch.comnewsstory/banks-may-need-new-capital/storyaspx?guid=%7B9663E5EE-9A01-4A82AA4F-8B7CA9D24C8A%7D

BBC News (25 January 2008): ‘Banks may need an extra $143bn’http://news.bbc.co.uk/2/hi/business/7209839.stm

Bloomberg (24 January 2008): ‘Barclays Sees U.S. as‘Opportunity,’ says Diamond (Update1)’ http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aMVSBCb.KY

Bloomberg (22 January 2008): ‘Wachovia Net Falls 98% onMortgage-Linked Write-downs (Update5)’http://www.bloomberg.com/apps/news?pid=newsachive&sid=ablegQr0QGMU

TimesOnline (18 January 2008): ‘Merrill Lynch reports record$9.8 billion 4Q loss’ http://business.timesonline.co.uktol/business/industry_sectors/banking and_finance/article3207432.ece

Bloomberg (17 January 2008): ‘Merrill Posts Record Loss on$16.7 Billion Write-down (Update6)’ http://www.bloomberg.com/appsnews?pid=newsarchive&sid=agM1TeRH9E4

IG Index plc Banking Sector Report 0628th February 2008

Anthony Grech, Research Analyst, IG Index

Merrill Lynch Website (17 January 2008): ‘Merrill Lynch ReportsFull-Year 2007 NetLoss From Continuing Operations of $8.6Billion’ http://www.ml.com/index.asp?id7695_7696_8149_88278_88282_88436

Citigroup Website (15 January 2008): ‘Citi Reports FourthQuarter Net Loss of $9.83 Billion, Loss Per Share of $1.99’http://www.citigroup.com/citigrouppress/2008/080115a.htm

Charlotte Observer (10 January 2008): ‘How low can bankstocks go?’ http:/www.charlotte.com/businessstory/439799html

UBS Website (10 December 2007): ‘UBS Pre-announces Full-Yearand Fourth-Quarter 2007 Results’ http:/financialservicesinc.ubs.com/wealthUBSPre-announcement2007.html

Reuters (7 December 2007): ‘Banking shares poised to recover –Fortis’ http:/www.reuters.com/article/managerViewsidUSCAS73088620071207

Financial Times (24 November 2007): ‘What’s the sub-primedamage?’ http:/www.ft.com/cms/s/0/3ca7bbc0-8af511dc-95f7-0000779fd2ac.html

iStockAnalyst (19 November 2007): ‘Buffett on the move’ http://www.istockanalyst.com/article/viewarticleaspx?articleid=1011837

BBC News (3 August 2007): ‘Home repossessions rise by 30%’ http://newsbbc.co.uk/1/hi/business/6929361.stm

Surendra P Agrawal et al “Price to Book Ratio as a Valuation Model: An Empirical Investigation” (June 1996) http://www.iifedu/data/fi/journal/Fi102/FI102Art5.pdf

Appendix

IG Index plc Banking Sector Report 0728th February 2008

Anthony Grech, Research Analyst, IG Index