Performance under pressure as US operations weaken

HSBC’s US operations have significant exposure to real estate, auto finance, credit cards, and other personal loans, and hence, would witness further deterioration in credit quality and delinquency ratios in the coming quarters. The bank’s performance in 2H 07 was negatively impacted by problems in its US business. Moreover, weakening consumer sentiment in the US is likely to trigger a spate of defaults in HSBC’s loan portfolio. Delinquency ratios continued to increase as the decline in home prices accelerated at a faster rate in 1Q 08, while the rising rates of unemployment and inflation hurt the borrower’s ability to repay loans.

HSBC Finance’s loan impairment charges surged 74% y-o-y to US$2.9 billion in 1Q 08, led by increase in impairment charges across its loan portfolio. The bank recorded an impairment charge of US$0.8 billion in the real estate secured portfolio, US$0.4 billion in credit card and private label, US$0.1 billion in motor vehicle finance, and US$0.1 billion in personal loans. HSBC Finance recorded a 48% decline in profit before tax to US$452 million on higher loss provisions. This fall was partially offset by fair value option income on market valuations of debt (which are likely to reverse in due course) and lower operating expenses.

With net receivables of US$142 billion, HSBC Finance’s operations mainly comprise its real estate secured portfolio worth US$86 billion, credit cards portfolio worth US$29 billion, and personal non credit cards portfolio of US$21 billion. Real estate secured loans consist of first lien worth US$70 billion and second lien worth US$16 billion. HSBC Finance had US$17.1 billion and US$18.5 billion in adjustable rate mortgage (ARM) loans in the Consumer Lending and Mortgage Services businesses, respectively, at the end of 1Q 08. The bank has been increasing provisions in its US operations in the last few quarters with the parent company being forced to infuse US$1.6 billion in capital. Considering the troubled loan portfolio and rising delinquencies, HSBC Finance has trimmed its loan portfolio 5.9% to US$151 billion in 1Q 08. Going forward, we expect delinquencies in the US operations to rise following a slowdown in US rebates after 2Q 08. Given the declining asset base and continued rise in defaults and delinquencies, our outlook for HSBC’s US operations is negative.

Macroeconomic woes in Asia to hamper credit growth

HSBC Holdings generates more than 50% of its earnings from Asia, led by Hong Kong, which contributes 30% to the profit before tax. Among other Asian economies, Mainland China, the Middle East, Singapore, India, and Malaysia together accounted for 21% of profits in 2007. Deteriorating macroeconomic conditions due to rising inflation caused by spiraling oil prices and the increasing risk of an economic slowdown could significantly affect HSBC’s operations in the region. Recently, oil hit an all-time high of over $145 a barrel, though it has corrected by about 25% as of the penning of this document, it is still up nearly 100% as compared to this time last year. With most of the major Asian economies importing the bulk of their oil requirements (and competing with more developed countries in the West), higher oil prices could further deteriorate the fiscal situation.

Hong Kong

HSBC Holdings’ Hong Kong operations have been an exception, recording a strong performance in FY 2007, driven by the expansion of its loan portfolio and healthy growth in net fee income. Net operating income surged 31.6% y-o-y and profit before tax grew 41.1% y-o-y. The economic and credit expansion, coupled with active financial markets, helped record strong growth in GDP. Hong Kong’s GDP grew 7.1% in 1Q 08; the economy had risen 6.4% in FY 2007. Domestic consumption continues to remain healthy, driven by a strong labor market, as the unemployment rate reached a 9-year low. In line with the decline in interest rates in the US, Hong Kong cut its benchmark interest rates to 3.75% in March 2008. The favorable economic factors, coupled with low lending rates, lifted HSBC’s performance in Hong Kong in FY 2007. Going forward, the two primary concerns for the economy are the slowdown in the US economy hurting export growth and rising oil and food prices fueled by inflation.

Hong Kong’s strong GDP growth was mainly driven by the services sector; net output in this sector rose 7.5% in real terms in 2007. The financial services sector grew at a double-digit rate throughout the year owing to increased financial market activities. In addition, the tourism sector recorded robust growth. Real estate (uh oh!) and business services also performed well due to an active property market and growth in general business. Strong domestic demand supported overall economic growth in 1Q 08. Consumption spending rose significantly helped by lower interest rates, buoyant labor market conditions, and rising incomes. Unemployment rate at 3.4% was near its 10-year low. Investment spending rebounded, led by increased building and construction activity.

However, consumer price inflation increased, averaging 4.6% in 1Q 08 led by a spike in food prices and private housing rentals. Also indicative of inflationary pressure were higher energy prices, gradual appreciation of the Renminbi, a weak US dollar, and escalating labor costs. High inflation levels pose a significant threat to the economy; increasing interest rates are likely to drive down demand and limit credit availability.

Hong Kong’s merchandise exports grew 9.1% in real terms in 1Q 08 compared to 6.6% in 4Q 07. Strong growth in exports to the European Union (EU) and the emerging markets in Asia helped offset sluggish demand in the US. Hong Kong’s exports to Mainland China increased 12.2% in 1Q 08.

However, the slowing US economy is a key cause for concern; exports to the US declined 5.9%, 6.6%, and 5.8% in the last three quarters. Growth in other advanced economies also is showing signs of deceleration. The International Monetary Fund (IMF) lowered its growth rate forecast for the US and global economies in 2008 to 0.5% and 3.7% from its January forecast of 1.5% and 4.1%, respectively. IMF cited worsening financial market conditions and the ongoing correction in the US housing market for the downgrade.

China

China is the second largest contributor to HSBC Holding’s profits in Asia. According to the Asian Development Bank (ADB), the country's economic growth is anticipated to slow down to 9.9% in 2008 and 9.7% in 2009, led by gradual appreciation of the yuan, tightening fiscal and monetary policies, and weakening external demand, especially from the US. As the Chinese government uses policy as a tool to control spiraling inflation and the effects of a slowdown in the US, we expect the country’s economy to cool down, going forward. Chinese exports grew at a slower pace in June 2008, rising 17.6%, as against the 28.1% growth recorded in the same year-earlier period. Moreover, the Purchasing Managers Index (providing an overview on Chinese manufacturing activity) declined to 53.3% in May 2008 from 59% in April 2008, indicating a relative slowdown in economic activity.

China recorded a GDP growth of 10.1% in 2Q 08 compared to 10.6% in 1Q 08. Tightening of the monetary policy toward the end of 2007 reduced the availability of credit, resulting in many SMEs in the coastal areas going bankrupt. Moreover, the appreciating Yuan as well as rising labor and raw material costs have started to negatively impact businesses in the region.

The Chinese yuan has risen approximately 16% against the US dollar since the country decided to do away with the dollar peg in July 2005. The yuan has appreciated more than 5.6% this year. Industrial output in Shenzhen, a manufacturing hub for exporters, declined 7% in the 1H 08, as the rising yuan led to a decline in exports. According to Shenzhen News Daily, between 300 and 400 foreign funded companies moved out or closed in the past six months. In addition, high energy consuming sectors, such as electric power, nonferrous metals, chemicals, iron and steel, building materials, and petroleum, felt the heat of rising oil prices and recorded output growth of 14.5% in 1H 08, almost 5.6% lower than that recorded in 1H 07.

In China, the consumer price index eased to 7.1% in June from 7.7% in May and 8.5% in April 2008, owing to the government's efforts to stabilize food supply. Rising crude oil prices are likely to drive inflation higher, going forward. However, crude oil cooled off from a high of US$146 a barrel to US$125 a barrel, providing a much-needed respite. The Producer Price Index (PPI) rose to a 3-year high of 8.8% in June as compared to 8.2% in May. Inflation, coupled with declining exports to the US, continues to pose a challenge to the Chinese economy.

India

The Indian economy is faced with the difficult task of controlling inflation, which has crossed the double-digit mark and reached a near 13-year high of approximately 12%. The Reserve Bank of India (RBI) continues to undertake corrective steps to tighten money supply by increasing interest rates and the cash reserve ratio. However, monetary tightening is likely to negatively impact the banking sector as the cost of borrowing increases. In its quarterly review on July 29, 2008, the RBI increased the repo rate by 50 basis points to 9.0% and cash reserve requirement by 25 basis points to 9.0%. The central bank’s move is likely to apply considerable pressure on HSBC’s margins. This hike is a signal to all banks that credit growth must be moderated to combat the rising inflation in the economy. The RBI also revised the GDP growth projections for India downward to around 8.0% for 2008–09.

In a recent development, Fitch Ratings cut India’s credit outlook to ‘Negative’ due to fears that rising inflation and the mounting burden of subsidies on oil as well as fertilizers will weaken government finances. Rising fiscal deficit also is a cause for concern. India reduced its fiscal deficit from 3.8% in 2006 to 3.17% in 2007, but significantly higher than that of many other world economies. According to Fitch, bonds issued to oil and fertilizer companies by the government would reach at least 2% of GDP this fiscal year, implying an underlying deficit of 6.5%. The government plans to provide INR946 billion (US$22 billion) to oil companies in the form of oil bonds to compensate them for selling fuel below cost; the government does not include this spending in its budget. In addition, plans to increase government salaries and waive farmer loans of US$17 billion are likely to worsen the government’s fiscal position.

The Indian market does not paint a pretty picture, having declined by approximately 40% since the beginning of the year. Moreover, the banking index has significantly underperformed the 30-share BSE Sensex. The banking sector was hit by rising interest rates and the government’s decision to waive farmer loans. Many banks in India are beginning to increase their loan loss provisions as defaults increase. ICICI Bank, India’s largest private sector bank, increased provisions by 43% y-o-y in its 1Q 09 results. The bank’s gross NPA has risen to 3.72% in 1Q 09 from 2.63% in 1Q 08. Considering the worsening macroeconomic outlook and higher defaults, the banking industry in India is likely to be under severe pressure in the coming quarters.

The Middle East

Most global economies are losing steam due to the credit crunch, rising inflation, and a slowdown in economic expansion. However, the entire Middle East region continues to benefit primarily from high oil prices, huge investments in infrastructure projects, and expansionary fiscal and monetary policies. Policymakers, however, are concerned by soaring inflation and currencies pegged to the sagging US dollar.

The UAE’s economy recorded a nominal GDP growth of 16.5% in 2007 and a real GDP growth of 7.4%. The construction, real estate, banking, and tourism sectors have been the main drivers of the strong growth in real GDP. However, inflation in the UAE has crossed the double-digit mark, exemplified and exacerbated by rising food prices and a housing shortage.

Increased net export earnings led by the rise in oil prices, strengthening housing rents (especially in the UAE), and falling interest rates are mainly responsible for fuelling inflation across the GCC region. The boom in commodity prices led by rising prices of raw materials, such as metals and agricultural products, and depreciation of the US dollar are the other contributing factors. The problem of inflation is further accentuated in the GCC region due to its necessity to reduce interest rates (in line with interest rate cuts by the US Federal Reserve), strong growth in money supply, and higher rents as housing demand outstrips supply.

In addition, GCC countries continue to increase their focus on infrastructure development as a strong financial position is stimulating private investments. According to MEED, GCC projects worth US$2 trillion have been announced as planned or are underway. Although GCC economies face severe inflationary pressure, high oil prices and strong infrastructure development are likely to drive growth in the region. We believe that a strong economy would add significantly to HSBC’s banking business. However, most GCC currencies are pegged to the US dollar. Hence, with the US likely to raise interest rates, the GCC would follow suit, impacting credit growth.

The United Kingdom (UK)

In the European region, HSBC Holding generates the majority of its profits from the UK (almost 67%), followed by France, Switzerland, Turkey, and Germany. Consumer confidence and property prices in the UK have fallen significantly year to date. Mounting pressure on asset quality in the bank’s UK loan portfolio is likely to result in higher provisioning in the coming quarters. HSBC (like many banks in the region) has raised mortgage rates resulting in lower credit consumption and related revenues, stalling the long property boom in the country. The Bank of England has kept the benchmark interest rate at 5% on concerns over accelerating inflation as the economy risks slipping into a recession.

UK's economy grew 0.2% in 2Q 08, the slowest rate since 2001 (the most recent recessionary period in the US). The unemployment rate has jumped the most in June 2008, as homebuilders and banks cut jobs, a trend similar to that seen during the last recession in 1992. The credit crunch situation, housing slump, and a sharp cutback in corporate spending are likely to result in the UK economy slipping into recession. Most banks in the UK are curbing lending following the collapse of the US subprime mortgage market, resulting in over US$469 billion in write-downs and losses. According to the British Bankers' Association, UK mortgage approvals slumped in June to the lowest level seen in the last decade. According to Jones Lang Lasalle, UK home prices would fall 7–9% in 2008 and 1–2% in 2009.

We believe these factors may result in increased defaults and delinquencies in its UK business, leading to higher losses for HSBC in the near-to-medium term.

HSBC — a major player in the credit derivatives market

HSBC is among the top six players in the US$62 trillion credit derivative market. We believe the delinquency cycle, which is just beginning to truly deteriorate, would result in increased corporate defaults in the near future. The CDS market is already troubled by monolines, which are counterparty to a large number of transactions, going bust - The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! and Reggie Middleton says the CDS market represents a "Clear and Present Danger"!. Moreover, due to the complex nature of the CDS market, it is yet to be seen as to who will ultimately be the worst hit if corporate defaults continue to rise.

HSBC has a US$1.6 billion net exposure toward derivative contracts entered directly with monoline insurers. According to the bank, notional exposure toward credit derivative contracts totaled up to US$1.89 trillion as of December 31, 2007. Credit derivative assets on HSBC’s balance sheet increased to US$25 billion in 2H 07 from US$4.4 billion in 1H 06. Considering the complexities in the credit derivatives market, we remain concerned as the unfolding of the CDS market story may seriously affect the bank’s financial health.

We have already covered the CDS market in detail in the Asset Securitization Series which talks about the potential losses that the financial markets could be subject to if a big counterparty fails.

Rising level of impaired loans depict rapidly deteriorating credit quality

HSBC has recorded a significant rise in impaired loans in the last few quarters as credit quality deteriorated. The bank’s impaired loans have risen by 33% to US$18.3 billion at the end of 2007, representing 1.8% of gross customer loans and advances. The growth in impaired loans was driven by rising defaults in North America and Latin America.

In North America, impaired loans grew 73% to US$8.4 billion as of December 31, 2007, mainly attributable to the consumer finance business in the US. In Latin America, impaired loans increased 30% to US$2.1 billion, primarily driven by the rise in credit card delinquencies in Mexico. While in Europe, France and Turkey witnessed a surge in default resulting in higher impaired loans.

The bank has significantly increased its impairment allowance in 2H 07 to 2.0% of gross loans as compared to 1.4% in 1H 06, mainly due to the increase in delinquencies in the personal lending business. Furthermore, the loan impairment charges as a percentage of operating income has surged to 24.9% in 2H 07 from 19.5% in 2H 06. The loans not impaired but past their due dates have increased by 25.1% to US$50 billion as of December 2007. HSBC’s renegotiated loans that would otherwise be past due or impaired increased to US$28 billion as of December 31, 2007 as compared to US$21 billion mainly attributable to US real estate assets as of December 31, 2007.

Key Assumptions

Net interest margin projected to contract

We expect the bank’s net interest margin to contract in the near term owing to the tight credit market conditions. Deposits are available at a cheaper rate currently. Going forward, rates are however likely to rise, led by rising inflation. We expect the credit crisis to limit credit growth. Moreover, HSBC will likely be less inclined to lend to riskier businesses, thereby impacting margins that stemmed from charging those businesses higher rates.

Loan growth could taper as crisis unfolds

a) Residential mortgage loans

We anticipate the growth in residential mortgage loans to decline in FY 2008 and continue to remain sluggish in FY 2009, in the aftermath of the worst housing crisis in the US that the world has seen since World War II. Banks would be more reluctant to lend in the mortgage space in the backdrop of the ongoing credit crisis and continued correction in housing prices. In both the US and the UK, housing prices continue to tumble and demand for housing has dropped at the same time that housing supply has skyrocketed and continues to increase with unsold inventory actually building in most areas. In this scenario, residential mortgage loans are likely to remain subdued in the coming quarters. Additionally, the rising interest rate scenario for mortgage loans is likely to negatively impact credit offtake in the near-to-medium term.

b) Other personal loans

The “other personal loans” business segment is also experiencing a significant rise in defaults. In the current scenario, we expect demand for loans in the personal finance space to contract in the near term. Rising delinquencies in the personal loan business and the deteriorating credit markets are likely to restrict growth in personal loans. In such turbulent times, we expect HSBC to tighten its lending standards.

c) Commercial, industrial, and international loans

Disbursement of commercial business loans witnessed robust demand. We anticipate loans in this segment to slow down in 2008, considering the ongoing credit crunch. However, if the economy begins to recover toward late 2009, we expect loan growth in this segment to report a strong uptrend. I anticipate a reversion to the mean in business bankruptcies, which has seen a marked downtick during the credit bubble led by the ability of businesses to “refinance” their way out of distress. With the bursting of this bubble, those companies whose operating cash flows cannot cover debt service will be forced to pay the piper. This particularly true in the US and the UK, and increasingly the case in the more prolific Asian countries as well.

d) Commercial real estate

We expect demand for commercial real estate loans to decrease as the global economy slows down. Moreover, considering the housing and real estate scenario in the US and Europe, HSBC’s loan book is likely to contract. Consequently, we expect the commercial real estate space to be severely affected, and hence, do not foresee this portfolio recovering in the near term.

Write-offs expected to rise as defaults increase in the UK market

Write-offs are projected to be driven by other personal loans as witnessed in 2H 07. Considering the rising default scenario, we expect the overall portfolio to be under greater pressure, going forward. In addition to other personal loans, residential and real estate is likely to witness higher write-offs in the coming quarters. HSBC’s impaired loans increased to 1.8% in 2H 07 from 1.5% in 1H 07.

Loan impairment charges to rise

HSBC increased its provisions in 2007 to 1.7% owing to the rise in defaults in its other personal loan business. Going forward, we believe the loss provisions to be 1.0% in 1H 08 and 0.9% in 2H 08. Due to deteriorating credit quality and higher defaults, the bank would be required to increase provisions.

As of March 31, 2008, 5.0% of mortgages in the US branch-based consumer lending business were two months or more overdue, compared to 4.2% as of December 31, 2007. The equivalent figures for the mortgage services business were 12.5% and 11.2%, respectively. This trend in rising delinquency ratios would result in higher provisioning in future.

Following are our assumptions on the write-offs from HSBC Holdings and the impairment charges on the bank’s loan portfolio.

Valuation

To value HSBC Holdings, we have used the Discounted Cash Flow (DCF), Price-to-Book Value (P/BV), Price-to-Earnings (P/E), and Price-to-Revenue (P/S) multiple methods. We have assigned a higher 40% weightage to the DCF valuation methodology and 20% each to P/BV, P/E, and P/S methodologies, respectively.

Weighted Average Fair Value

We have valued HSBC at US$48.78, representing a 40% downside from the current market price of US$81.40.

DCF Valuation

Based on our DCF valuation, we arrive at a fair value of US$48.45 for HSBC Holdings. Based on our cost of equity of 10.78%, we arrive at an equity value of US$112,661 million which translates into a fair value of US$48.45 per share.

Relative Valuation

Price/Book Value

We estimate HSBC Holdings’ book value at US$60 per ADR in FY 2009. Based on a P/BV multiple of 0.8x in line with the peer group average, HSBC Holdings is valued at US$50.9 per share.

Price/Earnings

We project HSBC Holdings’ earnings per ADR at US$7.05 in FY 2009. Based on a P/E multiple of 7.67x in line with the peer group average, HSBC Holdings is valued at US$54.11 per ADR.

Price/Revenues

We estimate HSBC Holdings’ revenue per ADR at US$34.0 in 2009. Based on a P/S multiple of 1.2x in line with the industry average, HSBC Holdings is valued at US$42.0 per share.

Next I will post the updates from H208 and a macro view of China. From then on, we will leave the world of pure finance and I will start publishing the next phase of my investment thesis, which I have been working on and attaining positions in over the last couple of months.