Oversea-Chinese Banking Corp ? Lion Capital Management Ltd, partly owned by OCBC, will manage $500m of collateralised debt obligations backed by corporate bonds held by Standard Chartered, according to Fitch Ratings. The issuer will be One George CDO Pte, Fitch said in a statement. Corporate bonds rated investment grade make up 87% of the portfolio, with the rest rated below investment grade, Fitch said. The CDOs will mature in 2017, the rating company said.

FSM - Growing Profits In The Local Banks

Some of the world's major banks have been delivering a slew of bad news recently. One after another, many of them have announced losses from their positions in investments exposed to the US sub-prime mortgages. Home-loan defaults in the US have caused a plunge in the mortgage-backed and related bonds, costing the world's largest financial institutions more than US$30 billion in writedowns and bad debts. Table 1 shows a list of charges which some of the major banks have declared for the third quarter of this year. Currently, lingering concerns about how the US finance sector would perform in the months to come, still plague the markets.

Table 1: List of Charges (Writedowns + Provisions) Incurred By The Major Banks

Source: Fundsupermart.com compilations

Provisions For Losses

Many investors would have read in the papers that the major banks have already made provisions for their potential losses related to the sub-prime. A provision for losses is usually made when the timing and amount of the losses are uncertain. For instance, when banks extend loans to the borrowers, experience would usually give them a clue that some of these may eventually become bad debts. The largest uncertainty would be to identify which of these would go bad, when will they go bad, and how much would they be able to recover from the borrower? To assume a prudent stance, so as not to run into the risks of overstating profit, banks would usually provide for these losses ? setting aside a small percentage of the total sum of these loans, and charging them against their profits. In such an exercise, and during this period of heightened volatility in the credit markets, some banks might have made larger sums of provisions than necessary. When the CDOs they hold mature and the number of defaults turns out to be less than estimated, some of these banks may then realize they have over-provided for their losses, and would thus write some of these provisions back into their profits.

How Did Singapore Banks Fare In 3Q2007?

All of the three local banks reported healthy increases in 3Q2007 earnings despite incurring provisions and mark-to-market losses for their investments in CDOs with exposure to the US sub-prime mortgages. DBS Bank Ltd was the first of the trio to report its 3Q2007 earnings on 26 October. Its net profit was up 17% year-on-year. UOB Ltd's 3Q2007 earnings increased 8.2%, while earnings for OCBC in the same period jumped 22%, compared to the same period a year ago. The banks' total earnings in the third quarter grew 13% from a year ago. The growth was broad-based with higher interest income and higher non-interest income, such as fees and commissions. The former was led by high loan growth and the improvement in net interest margin, while the latter was due to other businesses such as stockbroking, investment banking, loan syndication and wealth management.

DBS Bank Ltd Charged S$112 Million For Potential Sub-prime Losses

DBS Bank Ltd has exposure to S$2.36 billion of CDOs with S$275 million of the CDOs exposed to US sub-prime assets. Investors should note that not all CDOs are exposed to US sub-prime mortgage market. CDOs are backed by assets which could be corporate loans, high-grade mortgages, sub-prime mortgages, car loans, among others. While none of these has defaulted, DBS Bank Ltd has charged S$43 million to its profit and loss statement for the potential losses. Another S$27 million worth of cumulative general allowance was also reclassified as provisions for the CDOs exposed to the US sub-prime mortgages. In addition, there were mark-to-market losses of S$42 million charged to its net trading income related to the CDOs held by Red Orchid Secured Assets (ROSA).

UOB Ltd Charged S$66 Million For Potential Sub-prime Losses

The group's total CDO investments of S$388 million are low, compared to DBS Bank Ltd's. Similar to DBS, none of the CDOs held by UOB Ltd as investments has defaulted. UOB has made an additional S$20 million worth of provision for their potential losses and there were also mark-to-market losses of S$46 million. Amongst the three local banks, UOB has the least exposure to the CDOs.


OCBC Charged S$221 Million For Potential Sub-prime Losses

OCBC's total CDO exposure amounted to S$641 million, with S$270 million exposed to the US sub-prime mortgages. There were no reported defaults as of 30 September. OCBC's provisions for potential losses due to their sub-prime exposure in their CDOs holdings were more aggressive than the other two banks, setting aside S$221 million. This was an 82% loss of value for their CDOs exposed to the US sub-prime mortgages.

As explained previously, when the investments are held to maturity with zero or less-than-estimated defaults, some of these provisions for losses could be recovered.

Less Woes For The Local Banks

Investors are concerned that the third-quarter writedowns from the major banks may not be the last of what they might hear. UBS, for instance, have warned of additional potential writedowns, and Citigroup has disclosed on 4 November that their exposure to US sub-prime mortgages as of 30 September was at US$55 billion ? a figure much higher than its previous assessment of US$13 billion. There may be additional US$11 billion worth of writedowns resulting from their sub-prime mortgage losses, on top of a US$6.5 billion writedown in the last quarter.

Our local banks' exposure to the sub-prime mortgages, as a percentage to their total assets, is low. Also, the Tier-One capital ratio for the local banks ranges from 9.2% to 11.9% ? much better than most of the US banks. Tier-One capital is capital that is available to absorb losses without being obliged to cease trading. As such, a high Tier-One capital ratio is important to various stakeholders such as the investors, depositors, among others, as it gives them greater confidence in the banks' ability to stay solvent. An example of Tier-One capital is the ordinary share capital of the bank.

Table 2. Tier-One Capital Ratios of Various Banks

Source: Fundsupermart.com compilations
 

Conclusion

Our local banks remain well-capitalized despite their recent provisions for the potential losses in their CDO investments exposed to the US sub-prime mortgages. With corporate loans and housing loans picking up, their bread-and-butter business of interest income should bring in another good year of positive earnings growth. As such, we remain optimistic about the Singapore equity market.

Gross loans expanded to S$68.0b (+14.5%yoy, +4.1%qoq), driven by higher building and construction loans (S$11.9b, +33.6%yoy, +5.8%qoq) and housing loans (S$18.6b, +2.7%yoy, +3.0%qoq). Cost to income was higher at 40.8% due to higher staff costs (+38.0%yoy, +6.9% qoq) and other operating expenses (+28.3%yoy, + 2.6% qoq).

The bank made an astonishing S$221m allowance for its S$270m ABS CDOs using third party valuation model, but was offset by a S$82m write back in allowances for loans and S$101m for properties and other assets.

NPLs fell 8% to S$1.48b while the NPL ratio improved to 2.1% from 2.4% last quarter. Total cumulative allowances amounted to 107.2% of NPLs as compared to 104.0% last quarter. CAR ratio dipped to 12.8% (3Q06: 15.8%, 2Q07: 14.6%) with Tier 1 declining to 11.9% (3Q06: 12.9%, 1Q07: 12.5%) as the amount of risk weighted assets increased.

ROE slipped to 11.5% (3Q06: 12.3%, 2Q07: 15.4%) while ROA decreased to 1.33% (3Q06: 1.43%, 2Q07: 1.71%) as equity was boosted from MTM gain of S$1.02b due to Bank of Ningbo?s increased market valuation. Diluted EPS decreased to S$0.53 (3Q06: S$0.47, 2Q07: S$0.65) while net book value increased to S$4.72 (3Q06: S$3.90, 2Q07: S$4.39) over the year.

We believe OCBC has taken a kitchen sink approach in providing allowance for 82% of the ABS CDOs and thus we should not expect any more allowance in the coming quarters. Taking the CDOs issue aside, growth in core earnings remains commendable. Therefore, we maintain OCBC?s target price to S$10.90, 2 x FY08 NAV based on our Gordon growth model. Maintain BUY.