My Blog

October 3, 2007

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (3) By Michael Pettis

But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition.  On the contrary, it makes sense for state-controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders. 

 

As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions.  However the government’s position is not so simple.  In addition to its role as shareholder, the government has at least two other important roles.  First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness.  Second, it regulates the banks as part of its overall responsibility for the health of the banking system.

 

It turns out that both roles also involve optionality.  Creditors and regulators are effectively short put options on the asset value of the company because their exposure to increases in asset value is limited, while their exposure to declines is unlimited.  Because they have differing incentive structures, their objectives differ.  This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.

 

Because the government in its role as guarantor and regulator is effectively short a put option on the asset value of the bank, this creates a strong incentive to minimize volatility.  Lower volatility increases asset value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as asset value rises), while lower volatility always reduces time value. 

 

Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility.  In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits. 

 

What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders.  Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors.  China’s state-controlled banks are likely, in other words, to behave in ways which benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.

 

China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates.  But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways. 

 

The option framework makes two clear, and easily verifiable, predictions.  First, Chinese banks will almost certainly acquire assets and operations abroad because it is in the best interest of their regulator and primary shareholder that they do so.  Second, any Chinese bank that makes a relatively large acquisition abroad will see its share price fall significantly.  This may not happen immediately on the announcement of the acquisition – a surge of nationalist pride often causes the share prices to rise – but within days or weeks large institutional investors will dump shares until its price falls to reflect the reduction in time value.

 

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (2) By Michael Pettis

Over the past few months I have fielded many questions from foreign investors about the overseas acquisition plans of Chinese banks.  I have no inside information, but I think there are very good reasons to assume that Chinese banks will make acquisitions abroad.  The option framework, however, makes two powerful, and perhaps surprising, predictions about foreign acquisitions: first, that the acquisition of a foreign financial institution is likely to have a significantly negative impact on the banks’ share prices; and second, that the largest shareholder, because of its multiple roles, will have a strong incentive nonetheless to encourage foreign acquisitions.

 

There are many good reasons why a Chinese bank may want to acquire a foreign bank.  It may want to diversify its loan portfolio, to serve its Chinese customers abroad, to gain experience and technology, or simply to make a long-term bet in another market.  At the time of the acquisition, however, the main effect on the value of the bank’s share price will be the impact of diversification – a Chinese bank with operations in the US, for example, will have a more diversified loan portfolio and earnings stream than if it had nothing but Chinese operations.

 

Diversification reduces volatility, and so usually increases a company’s asset value (for finance geeks, this occurs largely because of the accompanying reduction in financial distress costs).  Since the intrinsic value in share prices consists of the difference between asset value and total liabilities, if asset value rises, the intrinsic value component of the share price must also rise – in other words, the excess of asset value over liabilities will rise.  Normally we would expect that this would cause the combined market value of the merged companies also to rise.

 

But this is not always the case.  A reduction in volatility may increase intrinsic value, but it always reduces time value (share prices always consist of more that just intrinsic value, and this excess is called time value). 

 

What actually happens to share prices depends on which effect is greater.  When the share price of the acquirer has high intrinsic value – i.e. the company is highly solvent and the value of its assets comfortably exceeds the value of its liabilities – it will typically have low time value, and the positive impact on intrinsic value will exceed the negative impact on time value.  This will cause the combined share price to rise. 

 

However when the share price of the acquirer has low intrinsic value and high time value – i.e. it is in a highly volatile business and has few real assets, like an internet company, or its liabilities approach or exceed its assets, like an insolvent bank – the impact of an increase in intrinsic value can be much less than the reduction in time value.  In that case an acquisition will cause the combined share price to drop.

 

This is true not just for insolvent banks but for any company whose share price consists mostly or wholly of time value.  For example when AOL and Time Warner announced in January 2000 that they would merge to create a media super-company, the first excited response of the stock market was to run up the combined value of the two firms by over 10%.  Within days, however, as investors began to understand the implications of the merger, market sentiment changed and the combined value of the two firms dropped to 5% below the pre-announcement levels – during a period in which the relevant market index rose nearly 10%.  Mergers involving start-up internet companies have almost always resulted in declining market prices for exactly this reason.

 

This also happens with bad banks.  When one of Mexico’s two largest banks acquired a largish California-based bank (I think it was in 1992 or 1993), the first reaction in the market was a surge in the bank’s stock price as proud Mexicans celebrated the success of Mexican banks, but within a week institutional investors began dumping shares as the implications sank in, and soon the value of the Mexican bank was well below its initial price, even as the Mexican stock market raced upwards.

 

For Chinese banks, like for internet startups or Mexican banks, any large acquisition will almost certainly result in a lower combined share price once the implications to investors are digested.  The negative impact on the Chinese bank’s time value will exceed the positive impact on its intrinsic value, or to put it another way, substantially more than 100% of the increase in asset value will go to the bank’s creditors, who benefit from more stable and diversified earnings.  Equity investors, unlike creditors, place a high value on Chinese banks precisely because China’s economic future is so uncertain.

 

Any reduction in the volatility around future expectations will reduce their value to equity investors.  Chinese banks currently have much higher price-to-book ratios than highly solvent global banks, and this high ratio reflects the high component of optionality (time value) in their share price.  By sharply reducing time value a large foreign acquisition will effectively drive the price-to-book ratio lower, and so reduce the combined market value of the two banks.

 

WED 3 OCT 2007

Should Chinese Banks Acquire Banks Abroad? (1) By Michael Pettis

In an article for the January/February 2007 issue of the Far Eastern Economic Review (“Buying into China’s Volatility”) I used an option framework to explain and predict the behavior of investors in China’s bank IPOs.  Chinese banks are, or are close to being, technically insolvent.  Share prices of insolvent or nearly insolvent banks consist almost entirely of what option traders call “time value”, with little to no “intrinsic value” (which is the excess of asset value over liabilities). 

 

Not all of my readers will agree that large Chinese banks are basically insolvent, but I am very skeptical that the published figures correctly state the extent of bad loans.  They almost certainly understate the extent of expected bad loans associated with the surge in new lending over the past three years.

 

The option framework predicts that in such a case investor perceptions of the quality of management or of levels of non-performing loans will have little to no impact on the share price performance of Chinese banks.  Instead share prices will primarily reflect investor perceptions of changes in China’s underlying economic volatility.  China’s banks are expensive, in other words, not because they are in good shape, but rather because there is so much future uncertainty about the Chinese economy, and it is increases in that uncertainty, not improvements in the quality of the banks, that are most likely to drive prices up.

 

This has happened in many countries undergoing reform besides China.  For example when Mexico’s 18 banks were privatized in 1991-92 as part of the massive economic and political reforms the country was undergoing (I was part of the team at credit Suisse First Boston that advised the government on the privatization), their purchase prices far exceeded even the most optimistic estimates provided by the advisors, the government, and the banking industry, which were largely based on discounting expected earnings. 

 

In fact, what investors were buying in Mexico was not the average expected outcome, but the fact that there was so much potential variation about the final outcome (which is another way to define time value).  After the privatization, prices continued soaring and I often heard wry comments from senior Mexican bankers about their valuations relative to the Citibanks of the world.  Of course those valuations didn’t last, and within the decade Mexican bank prices had collapsed to the point where they were nearly all acquired by foreign banks.  This is a fairly typical story during the 1990s.

 

Basically the thrust of my Far Eastern Economic Review article was to argue that China is like many other developing countries with weak banking sectors who are undergoing major economic reform.  Its banks will necessarily have very high valuations – indeed much higher than those of much more profitable banks in the developing world.  This is because countries undergoing significant economic reforms are likely to have highly uncertain outcomes. 

 

If it were possible to buy a call option on the underlying economy of a country experiencing massive reform, this option would be very valuable in the same way that any call option on a very volatile asset would be valuable.  Most of the value would consist of time value, which is mostly a reflection of uncertainty about the range of outcomes.

 

It turns out that a bankrupt or near-bankrupt bank is actually very similar to such an option.  Because the profitability of the banking sector is highly correlated with underlying growth, buying shares in a bank with very low intrinsic value (i.e. whose asset value is less than or barely exceeds its liabilities) allows investors to “buy” the country’s underlying volatility.  In my previous life as a Latin American bond trader, I can say that most of the region’s banks were in very poor shape during most of the 1990s, but nonetheless they had much higher valuations than their rich-country counterparts once it was clear that these countries were going to undergo major reform – and it is worth noting that while some cases of reform were very successful, others were not, which is the definition of a volatile range of outcomes.