November 2009

SPROTT ASSET MANAGEMENT LP

Don’t Bank on the Banks

By: Eric Sprott & David Franklin

Without tempting fate, it is probably safe to assume that the world’s financial system will survive
2009. Governments across the world have done an excellent job convincing their constituents
that the banking system had to be saved at almost any cost. Now that the banks are back from
the brink, however, those governments are looking for some much-needed reparation. Bankers
are being continually reminded of the sacrifices made and vast sums spent to save their jobs last
year. Some are subtle reminders, others are more direct. Either way, the governments have un-
holstered their regulatory guns, and are pointing them directly at the banks that received the largest
bailouts. Unpleasant regulatory changes are likely to be imposed soon, because if there’s one thing
governments love to do, it’s creating new ways to regulate things - and last year’s financial crisis
certainly warrants some serious attention in that area.

A quick history lesson on US banking regulation is useful to understand recent reform proposals: the
US government passed the famous Glass-Steagall Act in 1933 in response to the financial collapse
of 1929. The Act established the Federal Deposit Insurance Corporation (FDIC) and included banking
reforms which separated financial institutions by their function. Regular savings banks were granted
full protection by the FDIC, while speculative ‘investment banks’ were left to survive on their own.

Fast forward to 1999, when Congress passed the Financial Modernization Act which effectively
repealed Glass-Steagall and allowed banks, insurance companies and investment houses to merge.
This legislation gave birth to the huge financial companies like AIG and Citigroup that would become
the centre of the 2008 financial crisis. Shortly after amending Glass-Steagall, Senator Byron L.
Dorgan presciently remarked, “I think we will look back in ten years’ time and say we should not have
done this, but we did because we forgot the lessons of the past, and that which is true in the 1930s is
true in 2010.” Ten years later, Dorgan acknowledged what we found out the hard way last year - that
“to fuse together the investment banking function with the FDIC banking function has proven to be a
profound mistake.”1

With the 2008 meltdown seemingly behind us, it shouldn’t surprise you to learn that the US government
is once again looking to reinstate regulation along the lines of Glass-Steagall. There are a number
of high profile experts espousing Glass Steagall-like reforms. We refer to them as the “back to the
future” school, because although varied in their versions of execution, they all centre around more
separation between savings banks and riskier financial institutions like investment banks. This group
is mostly made up of current and former central bankers who insist that the financial system should
not let the banks use government guaranteed deposits for speculative gain. Current Governor of the
Bank of England, Mervyn King, and President of the European Central Bank, Jean-Claude Trichet,

1 Sanati, Cyrus (November 12, 2009) “10 Years Later, Looking at Repeal of Glass-Steagall”. Retrieved on November 24, 2009 from: http://dealbook.
blogs.nytimes.com/2009/11/12/10-years-later-looking-at-repeal-of-glass-steagall/

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November 2009

as well as former Chairman of the Federal Reserve, Paul Volcker, support the broad separation of
bank types according to their business focus. They argue that banks must fulfill their traditional
role of providing a service to the real economy, as opposed to facilitating and enabling the financial
speculation that led to last year’s meltdown.

The other popular school of regulatory reform in the US centres on granting the US government
broad authority to separate and financially inoculate failing institutions. We refer to this group as the
“regulatory hammers”. The Obama administration’s version of this reform would grant the Federal
Reserve authority to regulate and supervise all large non-bank financial institutions, and involves
taking control and resolving their problems outside of the bankruptcy system (how convenient).
Chairman of the Senate Banking Committee, Barney Frank, differs slightly in his approach and
intends to regulate all financial firms as though they were already banks, while Senator Chris Dodd
(D-Conn) proposes to regulate all companies that include financial activities “in whole or in part”.
All of these proposals use broad language to describe the event that would trigger a bailout or
enhanced supervision, and under all proposals the government would act as ultimate saviour, with
the legal authority and obligation to rescue any institution that experiences difficulty. When you’re
a politician with a regulatory hammer, every problem looks like a nail.

In the UK, the verbal and legislative assaults on the banks have taken a harsher tone. While the
governments are proposing tighter regulation, British Chancellor of the Exchequer, Alistair Darling,
has gone a step further by actually blaming the shareholders of Britain’s failed and government-
rescued banks. “Their shareholders clearly didn’t ask the right questions,” he states. “They didn’t
take their stewardship seriously.”2 In a similar vein, the European Commissioner for Competition
has openly criticized the shareholders who allowed the Royal Bank of Scotland to triple its balance
sheet from 2006 to 2008 into a size equivalent to that of the entire German economy.3 It is indeed
embarrassing that shareholders and regulators failed to notice such egregious risks, and highlights
the levels of complexity that banks were allowed to reach during the height of the credit bubble.

While we appreciate the efforts of these politicians and central bankers, we are hard pressed to
agree with many of their proposals as they completely fail to address the root of the problem.
Regulation is needed, no doubt, but both the “regulatory hammer” and “back to the future” schools
avoid the real culprit plaguing the financial system – leverage. Make no mistake – the financial crisis
was always about leverage. Holding toxic assets isn’t life threatening in and of itself, but if you’re
levered 100 to 1 (or more), they can suddenly become a serious problem. Amazingly, the regulators
almost refuse to acknowledge leverage in any way, and in doing so, have wholly undermined the
efficacy of their new proposals. As Paul Krugman recently stated, “The Obama administration is
now completely wedded to the idea that there’s nothing fundamentally wrong with the financial
system… that what we’re facing is the equivalent of a run on an essentially sound bank.” This is
the crux of the problem in our view. As we have argued for so many years now – the banks are too
highly levered to be “sound”, and until their leverage ratios are addressed, we will continue to face
the risk of another financial failure.

When the crisis was in full bloom last year, there was much talk of banks “de-leveraging” their
balance sheets back down to more appropriate levels. Traditionally, banks would “de-lever” by
selling portions of their loan portfolios to other banks, but in 2008 there were no buyers for financial
assets at any price. Over the course of the last twelve months, however, many people have
assumed that the banks were steadily improving their leverage levels from those of 2008. After
all – the bank stocks have all rallied dramatically since March. They must be in better shape, right?
Closer inspection reveals that they’ve achieved very little in the way of de-leveraging thus far, and

2 Griffiths, Peter. (November 13, 2009). “Darling Urges Bank Bonus Reform – Report” New York Times. Retrieved on November 24, 2009 from: http://
www.nytimes.com/reuters/2009/11/13/business/business-uk-britain-darling-banks.html
3 Wheatcroft, Patience. (November 13, 2009) “U.K.’s Darling Blasts Banks’ Investors” The Wall Street Journal. Retrieved November 24, 2009 from:
http://online.wsj.com/article/SB10001424052748703683804574532041838908258.html?mod=googlenews_wsj

2
November 2009

have merely been propped up by various forms of government liquidity injections, guarantees, out-
right share purchases and support from existing shareholders.

In order to better explain the leverage issue, we must first clarify how we calculate it as a metric.
Leverage can be measured in many ways, but our preferred choice as equity investors is to look at
how much ‘tangible common equity’ supports a bank’s ‘tangible assets’. It serves to remember that
the concept of ‘equity’ simply represents what you’re left with when you subtract your liabilities from
your assets. We remove ‘intangibles’, such as goodwill, from this calculation because they have no
real value. You cannot buy goodwill and then sell it at a profit - and under a bank bankruptcy scenario,
which we have seen so often over the past year, goodwill is worth nothing. What we are interested in
calculating, therefore, is how many tangible assets are supported by one dollar of tangible common
equity. This number gives us an indication of how levered a common equity investor in a bank stock is
to changes in asset prices. The higher the leverage, the more exposure each dollar of common equity
has to a change in asset prices, and the more risk you face as an investor.

Applying our definition of leverage to the current system reveals the inherent weaknesses that still
exist within it, and confirms why we question the value in bank stocks. In Chart A, we apply our
leverage ratio to the top five Canadian banks, top ten US banks and select European and US banks
Chart A

Bank Equity Leverage Calculations

TANGIBLE
INSTITUTION YEAR4 TANGIBLE ASSETS LEVERAGE RATIO
(billions) COMMON EQUITY
(billions)

2007 $2,122 $65 32:1

Top 5
Canadian 2008 $2,529 $68 37:1
Banks5
2009 $2,405 $76 31:1
2007 $6,936 $270 26:1
Top 10
2008 $8,139 $235 35:1
US Banks6
2009 $8,261 $422 20:1
2007 $2,132 $58 37:1
Citigroup Inc 2008 $1,897 $30 64:1
2009 $1,854 $106 17:1
2007 £1,791 £3 574:1
Royal Bank
2008 £2,382 £39 61:1
of Scotland
2009 £1,843 £38 48:1
2007 € 602 € 12 50:1
Dexia SA 2008 € 649 €2 377:1
2009 € 590 €5 116:1
Source: Bloomberg, Sprott Asset Management LP

4 For 2007 and 2008 we used the annual reporting period and for 2009 we used the most recent filing as of November 15, 2009. For Canadian Banks
the annual reporting period ends in October 2007 and 2008. For US Banks, Royal Bank of Scotland and Dexia SA the annual reporting period ends
in December 2007 and 2008.
5 We used the top 5 Canadian Banks by Tangible Assets as reported in each respective year.
6 We used the top 10 banks by Tangible Assets as reported in each respective year.
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November 2009

that have been bailed out by their respective governments. We have used their ‘tangible assets’ as
reported in their respective filings, with no interpretation for asset quality – an element worth noting
for our more critical readers.

You’ll notice that the average leverage ratio of the Canadian banking system is higher than that of
the largest US banks in all periods we reviewed. It serves to note that each of the top ten US banks
received common equity injections by both shareholders and the US government, thereby improving
their respective leverage ratios.

Looking at the Canadian system more closely, all five Canadian banks are levered at an average of
31:1, which is actually the lowest leverage ratio during the three years that we reviewed. This implies
that if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would
effectively be wiped out. Now, that doesn’t mean they would go bankrupt per se, but it does give us an
indication of how little asset prices would have to decline in order to wipe out their tangible common
equity. These leverage ratios worry us because they leave such a razor thin margin for error on the
‘tangible asset’ side of the leverage equation. We are always cautious about investing in companies
that have zero or negative common equity - we’ve seen what happens to public companies that trade
at those levels, General Motors being a good example.

Acknowledging the leverage levels above, you may wonder how the Canadian banks escaped
the 2008 meltdown unscathed. The answer is that they received significant assistance from the
Canadian government. First, they received $65 billion in liquidity injections from the Insured
Mortgage Purchase Program (IMPP), whereby Canada Mortgage and Housing (CMHC) purchased
insured mortgages from Canadian banks to provide additional liquidity on the asset side of their
balance sheets.7 Next, the Bank of Canada provided them with an additional $45 billion in temporary
liquidity facilities. Finally, a Canadian Bank (that shall remain nameless) also received assistance
from the Canada Pension Plan (CPP) through the purchase of $4 billion in mortgages prior to
the IMPP program, for a total government expenditure of $114 billion.8 For reference, the entire
tangible common equity of the Canadian Banks in 2008 was $68 billion. Can you put two and two
together? The Canadian government injected a sum through mortgage purchases worth more than
the entire tangible common equity of the Canadian banking system! On top of that, the Bank of
Canada provided more than 50% of the tangible common equity of the system in emergency liquidity
facilities. Mark Carney, Governor of the Bank of Canada, acknowledged this, albeit in an indirect
way: “Policy-makers had to do many unpalatable things to save the economy from the financial
system – a financial system that begged for mercy.”9

In Chart A we provide leverage levels for a few select banks that deserve special mention in our
leverage discussion. These three banks were all bailed out by their respective governments. We’d
like to draw your attention to their leverage ratios, prior and post-bailout, to emphasize the importance
of leverage over time.

We’ll start with Citigroup, which was de facto nationalized by the US government when it received $25
billion from the TARP program, a massive US government guarantee on $306 billion in residential and
commercial loans and a $27 billion cash injection for preferred shares. You can see the impact these
bailouts had on Citigroup’s leverage ratio over the years, moving it from 37:1 in 2007, increasing to
64:1 at the end of 2008 and back down to 17:1 after the government cash injections. The 64 to 1 ratio
required a government bailout. One wonders if 17 to 1 is an appropriate level for Citigroup, given their
exposure to high risk assets.

7 Mark Carney “Reforming the Global Financial System” Montreal, Quebec (October 26, 2009) Retrieved on November 24, 2009 from: http://www.
bankofcanada.ca/en/speeches/2009/sp261009.html
8 CPP Investment Board 2009 Annual Report. Page 32. Retrieved on November 24, 2009 from: http://www.cppib.ca/files/PDF/Annual_reports/
CPPIB_2009_Annual_Report_English.pdf
9 Mark Carney “Reforming the Global Financial System” Montreal, Quebec (October 26, 2009)
4
November 2009

The Royal Bank of Scotland makes Citigroup’s leverage look tame in comparison. Using our definition,
we calculated an eye popping leverage ratio of 574:1 in 2007, implying that a mere 0.17% decrease
in assets would have wiped out their tangible common equity. Is it any wonder then that the hiccup
in the housing market blew them apart? RBS now holds the distinction as the world record holder
for the largest bank bailout. The UK Government has earned a 70.3% shareholding in the bank after
providing them with their second bailout in November 2009.10 In total, a whopping £53.5 billion has
been injected into RBS by the British Government, which is now exposed to losses on £250 billion of
RBS balance sheet assets.11 In return for the government support, RBS has agreed not to pay cash
bonuses to any staff earning above £39,000 in 2009, and to defer executive bonuses until 2012.
Although they’ve come down since 2007, RBS still maintains a very high leverage ratio. Hopefully two
bailouts by the UK government will be enough.

Our final example is Dexia. It was bailed out by three separate governments and its shareholders,
receiving €6.4 billion in bailout money from France, Luxembourg and Belgium in September 2008.
Dexia is the largest lender to local governments in France and Belgium. According to their latest
financial filings, Dexia is operating at a leverage ratio of 116:1, which strikes us as very extreme in
this environment. Again – at those leverage levels, the smallest asset decrease would wipe out all
tangible common equity. That’s extremely risky for an institution as large as Dexia, and highlights the
problems that still plague the global financial system.

The examples above show that our leverage measurement is a good variable to review before
making a common equity investment in a bank. The higher the leverage ratio, the greater the risk of
losing your common equity. While we haven’t delved into the asset “quality” of any of these banks, we
have been watching US bank failures for a market-based indication of the quality of their assets in a
liquidation scenario. High profile examples include Colonial Bank, the largest US bank failure thus far
in 2009, which had total assets of $25 billion and cost the FDIC $2.8 billion in losses - representing an
11% write-down on their assets. Also notable was Chicago’s Corus Bank, which cost the FDIC $1.7
billion on total assets of $7 billion - representing a 24% write-down. For Colonial, 10:1 leverage was
too high, and in the case of Corus, a mere 4:1. Citing the most recent bank failures in the US, it would
appear that most financial assets are still being written down by at least 10%. Although each bank is
different and has its own specific asset allocation, this raises major cautionary flags for us, given that
the banks listed above still utilize leverage ratios well above 20:1. For such a seemingly complicated
industry, it surprises us that such a simple red flag continues to stump the regulators who oversee it.

Given the discussion above, is it any wonder why we continue to see banks receive more government
cash injections and asset guarantees? And is it any surprise that banks aren’t lending the cash they
were given by the central banks? Of course it isn’t. The leverage in the banking system is still too
high. Judging by recent comments by finance ministers and central bankers, it is clear to us that they
have no plans to address leverage in their regulatory proposals, and until they do, we would advise
that you invest in bank stocks with extreme caution. Don’t say you weren’t warned.

As we go to print, some recent news headlines have highlighted excessive leverage and its associated
risks. We include select excerpts on the next page.

10 The Royal Bank of Scotland Group, Regulatory Story – Number 8308B07. Filed with The London Stock Exchange on November 3, 2009.
Retrieved on November 24, 2009 from: http://www.londonstockexchange.com/exchange/prices-and-news/news/market-news/market-news-detail.
html?announcementId=10257526
11 Winnett, Robert, and Edmund Conway and Harry Wallop (November 4, 2009). “Bank bail-out: every family shouldering £4,350 tax liability”
Telegraph. Retrieved on November 24, 2009 from: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6496295/Bank-bail-out-
every-family-shouldering-4350-tax-liability.html
November 2009

anks Strauss-Kahn
Most global b , China banks Says Half of
are still unsafe Bank Losses A
warns S&P prepare to Undisclosed re
Standard & Po
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big banks - Nov. 24, 2009 (FT). China’s bank rauss-Kahn sa tor
d investment ex are preparing to raise tens ofs id that
cover trading an
about half of
do w ng ra de s bank losses fro
further billions of dollars in additiona global financia m the
posure, risking l crisis have ye
18 m on th s un less they capital to meet regulatory re-l revealed. “It is t to be
over the next - our view we are
beef up their de quirements following an unprec- in the situation still
move swiftly to ba nk in Japan, edented expansion of new loans haven’t been dis
where a lot of
losses
y sin gl e closed,” Strauss-
fences. Ever ly this year, according to people said during qu Kahn
y, Spain, and Ita estions at the Co
the US, German 45 gl ob al familiar with the matter. China’s ation of British nfeder-
P’s list of 11 largest listed banks will have Industry’s conf
included in S& sa fe ty level
in London today 16
.
erence
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lenders fails th d
cy’s risk-adjuste ($43bn) to meet more stringent
under the agen M os t fall woe- capital adequacy requirements
ra tio .
capital (RA12C) and maintain loan growth and
fully short. business expansion, according
to estimates from BNP Paribas.
China’s banking regulator “is
definitely aware of potential as-
set quality issues and is pushing
C B ’s T r i c h et Says
for higher capital adequacy re- E t ure To
quirements to offset deteriora-
It ’s P r e m a
Bank of England tion in asset quality”, according
to Dorris Chen, an analyst with
c l a r e C r i s is Over
reveals £61.1bn spent BNP Paribas. 14 De ropean
Central
s) - Eu richet
(RTTNew nt Jean Claude T
propping up RBS and o n M
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Bank Pre day that it was st
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re the glo
HBOS mature to d e c la
r, while h
e offered
re a ssur-
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IMF warns c ri si s o v e w e ll p re
was
the ECB nal mea-
The Bank of England today revealed for ance that u n conventio
to unwin
d it s ely man-
second bailout
the first time that it spent £61.6bn prop- d ti m
ping up RBS and HBOS in the height of s in a g radual an l premature
sure is stil
f today, it over,”
the global financial crisis last autumn. ner. “As o e financial crisis
Governor Mervyn King detailed the
emergency loans, which it made in its role
would ‘threaten to
he sa
d e c la
id .
re
“ B
th
u
e a
t when th be no con-
p p ro priate
should
as “lender of last resort” in a submission
to the Treasury select committee.13
democracy’ time com
cern a b o u
es, there
t th e E C B’s determ
15
ination

y to exit.”
Dominique Strauss-Kahn and abilit
told the CBI annual
conference of business
leaders that another
huge call on public fina
nces by the financial
services sector would not
be tolerated by the
“man in the street” and
could even threaten
democracy. “Most advanc
ed economies will
not accept any more [ba
ilouts]...The political
reaction will be very
strong, putting some
democracies at risk,” he
told delegates.17

12 Evans-Pritchard, Ambrose. (November 24, 2009) “Most global banks are still unsafe, warns S&P” Telegraph. Retrieved on November 24, 2009 from:
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6638922/Most-global-banks-are-still-unsafe-warns-SandP.html
13 Hopkins, Kathryn and Jill Treanor. (November 24, 2009) “Bank of England reveals secret £62bn loans used to prop up RBS and HBOS” Guardian.
Retrieved on November 24, 2009 from: http://www.guardian.co.uk/business/2009/nov/24/bank-england-rbs-hbos-loans
14 Anderlini, Jamil. (November 24, 2009) “China banks prepare to raise capital” Financial Times. Retrieved on November 24, 2009 from: http://www.
ft.com/cms/s/0/6f635a3a-d8f8-11de-99ce-00144feabdc0.html?nclick_check=1
15 (November 23, 2009) “ECB’s Trichet Says It’s Premature To Declare Crisis Over” RTT News. Retrieved on November 24, 2009 from: http://www.
rttnews.com/ArticleView.aspx?Id=1138342&SMap=1
16 Hamilton, Scott and Sandrine Rastello. (November 23, 2009) “Strauss-Kahn Says Half of Bank Losses Are Undisclosed (Update1)” Bloomberg.
Retrieved on November 24, 2009 from: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ay2MiTrFzQYI
17 Jameson, Angela and Elizabeth Judge. (November 23, 2009) “IMF warns second bailout would ‘threaten democracy’” Times Online. Retrieved on
November 24, 2009 from: http://business.timesonline.co.uk/tol/business/economics/article6928147.ece
6
Sprott Asset Management LP
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