Financial, Real Estate, Stock Markets Trends and Current Affairs

Feeble performance in Hong Kong an unpleasant surprise

HSBC’s weak performance in Hong Kong, one of its largest markets, was a jolt from the blue. The bank’s Hong Kong operations recorded an 8% decline in operating profit due to sluggish growth compounded by a 20% increase in costs. However, Hang Seng Bank posted a 17% increase in operating profit on account of healthy growth in net interest income. Profit from Hong Kong operations (excluding Hang Seng Bank) decreased 19% y-o-y. The decline in Hong Kong Inter Bank Offer Rate (Hibor) in 1H 08 also negatively impacted the bank’s performance. HSBC’s net interest income expanded 7%, while its expenses increased 20% y-o-y, resulting in a sharp increase in the cost income ratio.

Other factors that adversely affected the bank’s performance in Hong Kong included a US$296 million decline in the valuation of strategic investments (in India and Vietnam), contracting yields and increased costs. Also, higher losses in the non-operating business (US$725 million in 1H 08 compared to US$186 million in 1H 07) proved to be a drag on the overall profitability in the Hong Kong region.

Bleak outlook for Asian operations despite good performance

HSBC’s Asian operations (excluding Hong Kong) recorded strong growth in earnings mainly due to robust expansion across geographies. The main growth driver, the Global Banking and Markets business, accounted for 70% of the increase in earnings. However, considering the decline in investment banking activity and reduction in trading due to the global slowdown, earnings from this business are likely to be unsustainable. The recent spike in inflation coupled with the anticipated slowdown in growth across Asian economies is expected to result in a rise in non-performing loans. The worsening macro economic scenario could also dent the growth in commercial and personal banking activities. So far, the bank’s performance has been primarily driven by the significant growth in emerging economies such as China, India and the Middle East. However, as the economic slowdown tightens it grip on Asia and as growth in the banking industry decelerates, credit expansion may take a hit, going forward.

US operations continue to experience a difficult operating environment

HSBC, which became the biggest subprime mortgage lender in the US after buying Household International Inc. for US$15.5 billion in 2003, continued to suffer losses in its US operations due to the ongoing decline in the housing market. HSBC’s pre-tax losses in North America stood at US$2.9 billion in 1H 08 as against a pre-tax profit of US$2.4 billion in 1H 07. The bank has already reduced the number of its branches in the US by 10% to 900 and indicated that it will divest its vehicle finance operation worth US$13 billion. HSBC continues to reduce its mortgage services portfolio. The Personal Financial Services and Global Banking and Markets businesses recorded significant losses owing to continued weakness in the housing market and worsening credit market conditions. The Personal Financial Services business recorded a pre-tax loss of US$2.1 billion as loan impairment charges increased 88% due to deteriorating credit quality in the US. The Global Banking and Markets business registered a loss of US$1.6 billion in 1H 08 due to tight credit markets. HSBC recorded goodwill impairment charges of US$527 million in its North America Personal Financial Services business.

The number of delinquencies is likely to continue to increase as the unemployment rate rises, while the auto finance business is expected to face bigger problems in the light of the closure of auto finance activities and decline in the residual value of these assets. Residual values are falling at a brisk pace as reflected by the writedowns by auto majors such as General Motors, and Ford Motors. Moreover, benefits from tax rebates provided by the US government are likely to fade away in 2H 08. This factor could also result in higher delinquencies in the coming quarters.

The deterioration in credit quality is spreading to good quality prime assets, as indicated by the rise in impairment charges at HSBC USA, which deals mainly in prime and commercial loans. HSBC USA’s loan impairment charges increased to US$1.1 billion in 1H 08 from US$469 million in 1H 07. With a loan portfolio of US$91 billion, this subsidiary is likely to witness higher impairment charges in future if the markets worsen.

European operations fare better despite UK slowdown

HSBC performed well in Europe despite slowdown in the UK. The net operating income after loan impairment charges increased 12% y-o-y to US$13.4 billion. Loan impairment charges remained flat as asset quality continued to be healthy despite the worsening UK housing market and sluggish economic growth in Europe. However, going forward, as the economy witnesses a slowdown, the asset quality is likely to decline, resulting in higher impairment charges. I am bearish on both the UK and the EU in general.

Increase in loan impairment charges

The bank’s loan impairment charges have risen significantly in the last year due to the worsening credit scenario and deteriorating housing market. Loan impairment charges increased 58% y-o-y but decreased 8% h-o-h. North America continued to lead the way as credit cost rose to US$7.2 billion in 1H 08 but was lower than that in 2H 07. Delinquencies increased to 8.3% in 2Q 08 from 7.9% in 1Q 08. Net charge-offs in the US rose sharply to 7.43% in 2Q 08 from 4.96% in 4Q 07 and 6.43% in 1Q 08. Second lien mortgage charge-offs also increased to 33.5% from 17.4% over the same period in the US. HSBC USA’s non-performing loans increased 9% q-o-q.

The asset quality remained healthy in Europe, despite the popular belief that charges would rise on account of the deteriorating UK market. Decrease in non-performing loans and impairment charges in Europe helped the bank to maintain its overall asset quality and report lower charges. However, the credit quality in the UK market is likely to deteriorate as macro economic conditions continue to worsen. In Latin America, particularly Mexico, HSBC’s non-performing loans increased 25% h-o-h, while its impairment charges rose 27% due to the deterioration in credit quality.

HSBC wrote down US$3.9 billion in 1H 08 across several asset categories, including buyout loans, asset-backed securities (ABS) and bond insurance. The figure is significantly higher than the $2.1 billion writedowns in 1H 07. The bank wrote down US$1.0 billion toward subprime mortgage assets, US$1.4 billion toward non-subprime trading assets, US$1.2 billion toward monoline exposure and US$0.3 billion toward leveraged loans. The bank has written down more than $10.5 billion and has now taken approximately $15.4 billion of provisions in the past 15 months against the subprime mortgages. The rise in writedown toward monoline (financial guarantor) exposure raises concerns as HSBC is among the top players in the CDS market.

Disclosure of HSBC’s structured credit exposure warrants caution

HSBC provided disclosure on exposure toward problem asset classes in its 1H 08 results. The carrying value of exposure to ABS, trading loans held for securitization and leverage finance declined to US$117 billion on June 30, 2008, from US$135 billion on December 31, 2007. Approximately US$25 billion of the structured credit exposure is toward ALT-A/subprime assets, which account for 22% of the exposure. The bank’s Available for Sale (AFS) reserve on asset-backed securities increased to US$6.1 billion in 1H 08 from US$2.2 billion in 2H 07.

HSBC has incurred impairment losses totaling US$55 million; this represents a meager 0.85% of total AFS reserve. We expect losses to rise significantly if market conditions and asset values deteriorate. We believe the bank will be required to make higher impairment charges related to AFS reserve on ABS in future.

The rise in the fair value of AFS reserve on ABS worth US$6.1 billion reflects the deterioration in the quality of ABS. In our opinion, this rise in the AFS reserve would be passed on to the P&L account in the coming quarters.

SIVs: Structured Investment Vehicles, SICs: Securities Investment Conduits

Monoline exposure

HSBC‘s notional exposure toward monolines in derivative transactions declined from US$15.4 billion in 2H 07 to US$14.5 billion in 1H 08. The monolines as counterparties could be a problem for HSBC in the event of any of the financial guarantors going bust. The notional exposure shows the potential dependence on financial guarantors in case of underlying assets depreciating in value. The increased likelihood of monolines filing for bankruptcy would seriously dent HSBC’s books. The bank wrote down US$1.2 billion toward monolines in 1H 08 after incurring a US$0.3 billion charge in 2H 07. The net exposure after credit risk adjustments increased to US$1.28 billion in 1H 08 from US$1.20 billon in 2H 07. This reflects the direct exposure of HSBC’s derivative transactions to monoline insurers.

HSBC has extended liquidity facilities totaling US$158 million to monoline insurers; of this, US$23 million was drawn as of June 30, 2008.

SIV and conduit assets

Assets held by Structured Investment Vehicles (SIVs) and new conduits and consolidated on HSBC’s balance sheet declined by US$11 billion from that at the end of 2007 to US$29 billion in 1H 08, primarily as assets were either sold or run off. HSBC has established new asset-backed conduits – Mazarin and Barion. Total assets decreased from US$33.3 billion in 2H 07 to US$23.4 billion in 1H 08 mainly due to exchanges against capital notes, amortization, and recoveries. HSBC also established the asset-backed conduit Malachite in 1H 08. Total assets fell from US$7.4 billion in December 2007 to US$5.9 billion on June 30, 2008.

HSBC’s maximum exposure toward SIVs and conduits declined from US$86.9 billion in December 2007 to US$73.9 billion in June 2008.