END OF THE CHARADE

HSBC HOLDINGS

When it comes to HSBC, the Street cannot come up with enough disingenuous excuses for the Thomas J. Monaco groups glaring problems notably at the subsidiary level. In our view, HSBC has not made TOM@FORENSICASIA.COM the necessary adjustments during the quantitative easing reprieve. Rather, it has allowed Andrew Haskins legacy problems to linger as new ones in emerging markets gather pace. The result has been ANDREW@FORENSICASIA.COM extreme earnings overstatement, causing HSBC to become one of the largest practitioners of capital forbearance globally. This charade appears to be ending, given how few earnings levers remain besides selling off core elements of the franchise and the stringencies of Basel III compliance. We expect EPS pressures and dilution from capital increases to be high. A dividend cut may even be on the cards. SELL. SIGNIFICANT ASSET RISK AND EXTREME CAPITAL NEEDS HSBC Holdings (5 HK; HSBC or the Group) has overstated assets at the major subsidiary level to the tune of US$63.6bn-US$92.3bn, by our calculation, amounting to between five and seven years of results. Given this unaccounted-for level of balance sheet risk and the enormous increase in the Groups Basel III/CRD IV capital requirements, we believe HSBC needs to raise between US$58bn and US$111bn in capital (depending on the implementation of a counter-cyclical buffer), representing 32-61% of current stated equity. Given how much new equity HSBC appears to need, a dividend cut or suspension is quite plausible. 12%-15% CORE ROE TARGET IS PURE FALLACY It is a wonder how Group management can say to shareholders with a straight face that HSBC will achieve perennial operating ROEs of 12-15%. Here are our problems with Group CEO Stuart Gullivers target: (a) the numerous franchise disposals and accounting change should cause the Groups 2012 mainland Chinese 15.1% bottom-line contribution to decline by 39% in US$ terms; (b) HSBCs emerging market franchises are not faring well either, since not only has HSBC failed to take advantage of QE judiciously, allowing many of its legacy developed market problems to linger, but newly created ones in emerging markets are now building up; (c) if we are correct, the Group is likely to raise substantial capital and/or hive off parts of its core franchise; (d) we think HSBC faces up to US$10bn of additional legal and regulatory penalties; (e) high reliance (52% of pre-tax income) on low-quality and volatile trading seems unsustainable. INITIATING COVERAGE WITH A SELL RATING We formally launch coverage of HSBC with a Sell rating and set a price target of HK$63 per share, implying 25% downside. At face value, HSBCs shares trade on a P/BV of 1.6x and a consensus P/E of 10.6x. HSBC also trades on a P/TBV of 1.4x. If our analysis is correct, HSBC now trades on a P/ATBV (adjusted tangible book value) ratio of 2.3x. Our price target implies a P/ATBV of 1.7x. FIGURE 1: HSBC GROUP: HISTORICAL DATA AND CONSENSUS FORECASTS YEAR TO DEC (US$ M)
Pre-Provision Oper. Profit Net Profit Core Oper. Earnings (COE) P/E P/COE P/BV P/TBV Yield
SOURCE: FORENSIC ASIA, BLOOMBERG

2009
38,033 5,565 10,031 33.8 18.8 1.59 1.92 3.0%

2010
30,817 12,890 10,631 14.0 17.1 1.25 1.53 3.5%

2011
26,574 16,224 8,799 8.2 15.5 0.87 1.05 5.4%

2012
18,379 13,454 2,873 14.1 65.3 1.12 1.31 4.3%

2013E
20,104 17,001 11,545 12.4 18.2 1.55 1.40 4.4%

2014E
12,544 9,408 9,408 22.4 22.4 1.50 1.34 3.6%

2015E
13,171 9,878 9,878 21.3 21.3 1.44 1.30 3.7%

COMPANY REPORT // NUMBER 14

14 January 2014
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC HOLDINGS END OF THE CHARADE

Founded in Hong Kong and Shanghai in 1865 and now headquartered in London, HSBC Holdings plc is one of the worlds largest financial institutions. Its international network comprises around 8,000 offices in 88 countries and territories in Europe, Asia-Pacific, the Americas, the Middle East, and Africa.

Description

Investment Summary

Over the past year we have published a series of reports on the major subsidiaries and regional franchises of HSBC Holdings plc (5 HK; HSBC or the Group), repeatedly expressing our concern about overstated earnings, inadequately capitalised balance sheets, legal and regulatory problems, and related issues. The present report puts all our work together into a comprehensive opinion about the Group as a whole. In summary, we are initiating coverage on the shares of with a Sell rating and are setting a price target of HK$63.00 a share which implies 25% downside potential. European investors consider HSBC as a well-capitalised growth story versus a peer group of perceived weaker British banks, while Asian investors see it as the industry stalwart which represents 14.6% of the Hang Seng Index. While correct assessments, we believe that a better understanding of the Groups overall risks would be more beneficial to shareholders.

This report puts together all our previous work on the HSBC Groups subsidiaries; we nor formally launch coverage of the HSBC with a Sell rating

When it comes to HSBC, in our view the Street seemingly cannot apologise or come up with Im sorry just doesnt cut it enough excuses for an endless level of managerial mistakes, such as a series of disastrous any more acquisitions (1997-2004) and a welter of one-time negative items. We think HSBCs balance sheet has been problematic for years, and management faces a very tough challenge to steer this ship out of troubled waters. The Groups financial performance relies heavily on cost cutting, shedding underperforming businesses, and reducing legacy-problem assets. Whilst this is a sensible strategy, HSBC will also be stretched to achieve organic growth and core ROE targets of 12-15% during the current weaker economic environment. This environmental economic weakness must be taken in the context of the Groups imprudent levels of capital forbearance which, in our view, have exacerbated earnings overstatements. The stringencies of Basel III compliance requirements coupled with asset valuation concerns lead We think HSBC needs capital us to conclude that HSBCs stated capital ratios are substantially weaker than the Group would of US$111bn by 2019 all else being equal have investors believe. The level of questionable assets on the Groups balance sheet amounts to US$63.6bn-US$92.3bn, by our calculation, and represents 34.7-50.4% of its stated equity at 1H13 and between 4.7 and 6.8 years of results. The 2019 Basel III milestone implies a cumulative capital need for HSBC of between US$58.3bn and US$110.6bn (32.9-60.6% of current stated equity), by our calculation. Unfortunately, the bulk of this new capital is likely to come from dilutive equity issuances and the possible liquidation of its core franchises. None of this is positive for operating EPS, nor for core ROEs, and there is a real possibility that the dividend will be cut or temporarily suspended. HSBC remains in the spotlight even after a half decade of being mired in legal and regulatory HSBCs legal problems are problems. Management continues to warn of uncertainty, as it sets aside more provisions. Given just the icing on the cake the Groups repeated involvement in legally questionable and objectionable actions, we think its legal and regulatory problems should actually be perceived by investors as arising from normal business activities rather than as one-time items. In addition to headline risk for its share price, we estimate HSBC to have a minimum of US$10bn in additional litigation risk.

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HSBC HOLDINGS END OF THE CHARADE

Significant asset risk and extreme capital needs

We believe that detoxification of the HSBC Group will be a painful process. Below, we highlight our top concern about HSBC, namely asset overstatement which is likely to necessitate huge new capital raising. BALANCE SHEET BLACK HOLE In our opinion, the Quantitative Easing (QE) miracle (lower interest rates causing asset reflation) has prolonged the inevitability of marking down risk globally. In fact, however, even before the Global Financial Crisis (GFC), HSBC was notoriously deliberate in recognising its on and off balance sheet risk as it hid behind accounting and regulatory guidelines allowing the bank to resist addressing its fundamental problems straight away. Today, the Group is in even more of a quandary as post-QE blues have added to HSBCs legacy-problem assets. Applying moderate stress tests to the Groups major subsidiary balance sheets (90.4% of consolidated assets), we find that the cumulative level of questionable assets ranges between US$63.6bn and US$92.3bn, and perhaps higher. Questionable balance sheet line items include: loan loss reserves, accrued interest receivable, deferred tax assets, defined benefit pension plans, Level 3 assets, and intangibles. Our identified black-hole figure also highlights how much HSBC has distorted stated core profits and thereby stated ROEs. If our analysis is correct, then this level of questionable assets represents between 4.7 and 6.8 years of post-tax results. Even if we are only half correct in our assessment this is still an enormous earnings overstatement. FIGURE 2: HSBC HOLDINGS: IMPACT ON CAPITAL OF ASSET OVERSTATEMENTS ASSET OVERSTATEMENTS (US$ M)
Hongkong Bank Group HSBC UK HSBC France HSBC Europe HSBC USA HSBC Latin America HSBC Middle East Total for All Subsidiaries
SOURCE: FORENSIC ASIA

If you ignore problems, they dont go away; we estimate aggregate questionable assets at US$64bn-US$92bn, or between five and seven years of profits

LOW-END ESTIMATE

15,158 16,671 2,579 19,250 21,800 4,500 2,850 63,558

HIGH-END ESTIMATE

26,328 33,423 3,340 36,763 23,000 4,500 2,911 93,502

MAJOR RECAPITALISATION ALMOST CERTAIN HSBCs stated Tier 1 capital ratio amounts to 12.8% at 1H 2013 well above the rest of our identified peer group average as seen in Figure 3 below. In fact, the Groups tangible common equity (TCE) ratio is also well above average at 4.7%. While having stated capital ratios well above peer averages is all well and good, HSBCs stated capital ratios would appear to be nothing more than a mirage if our analysis is correct. Coupled with the new risk management stringencies set forth under Basel III, we find that the Group will need to raise an extraordinary level of new capital.

More than a finger is needed to plug the hole in this dike: we estimate US$58bnUS$111bn in new capital will be needed by 2019

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HSBC HOLDINGS END OF THE CHARADE FIGURE 3: HSBC HOLDINGS PEERS CAPITAL RATIOS COMPANY 2010
Bank of America Barclays BBVA Citigroup HSBC Holdings J.P. Morgan & Co. Lloyds Banking Royal Bank of Scotland Santander Standard Chartered Average 11.2% 13.5% 10.5% 12.9% 12.1% 12.1% 11.6% 12.9% 13.1% 14.0% 12.4%

TIER 1 CAPITAL RATIO 2011 2012

12.4% 12.9% 10.3% 13.6% 11.5% 12.3% 12.5% 13.0% 13.6% 13.7% 12.6% 12.9% 13.2% 10.8% 14.1% 13.4% 12.6% 13.8% 12.4% 13.1% 13.4% 13.0%

1H 2013
12.2% 13.5% 11.3% 13.2% 13.6% 11.6% 14.2% 13.3% 12.0% 13.0% 12.8%

TANGIBLE COMMON EQUITY RATIO 2010 2011 2012 1H 2013

5.9% 2.9% 5.1% 6.9% 4.7% 5.6% 4.1% 4.2% 4.0% 6.1% 5.0% 6.5% 3.0% 5.0% 7.9% 5.0% 5.6% 4.2% 4.0% 4.0% 5.8% 5.1% 6.6% 2.9% 5.2% 8.5% 5.4% 6.3% 4.3% 4.2% 3.8% 6.1% 5.3% 6.9% 2.8% 6.0% 8.7% 5.6% 6.2% 4.5% 4.6% 4.0% 6.0% 5.5%

SOURCE: BLOOMBERG, FORENSIC ASIA

The European Commissions Capital Requirements Directive IV (CRD IV) is implementing the Basel III framework throughout the EU via a single rulebook. Although CRD IV final rules have been published, there remains substantial uncertainty over what the final capital requirements will be, given member-state discretion. Nonetheless, as seen in Figure 4 below, these new regulations will be phased in through January 1, 2019 which gives us a pretty good sense as to what HSBCs minimum capital ratios would look like. FIGURE 4: HSBC HOLDINGS CRD IV/BASEL III CAPITAL INCREASE TIMELINE MINIMUM CAPITAL RATIOS
Common Equity Tier 1 (CET1) Ratio Additional Tier 1 Capital Tier 1 Capital Ratio Capital Countercyclical Buffer Capital Conservation Buffer G-SIFI Buffer - HSBC Specific Minimum Tier 1 Capital Ratio With Cumulative Buffers Tier 2 Capital Ratio Total Capital Ratio Minimum Total Capital Ratio With Cumulative Buffers Leverage Ratio
SOURCE: KPMG, FORENSIC ASIA

2013
3.5% 1.0% 4.5% 0.0% 0.0% 0.0% 4.5% 3.5% 8.0% 8.0% 3.0%

2014
4.0% 1.5% 5.5% 0.0% 0.0% 0.0% 5.5% 2.5% 8.0% 8.0% 3.0%

2015
4.5% 1.5% 6.0% 0.0% 0.0% 0.0% 6.0% 2.0% 8.0% 8.0% 3.0%

2016
4.5% 1.5% 6.0% 0.625% 0.625% 2.5% 9.75% 2.0% 8.0% 11.8% 3.0%

2017
4.5% 1.5% 6.0% 1.25% 1.25% 2.5% 11.0% 2.0% 8.0% 13.0% 3.0%

2018
4.5% 1.5% 6.0% 1.875% 1.875% 2.5% 12.3% 2.0% 8.0% 14.3% 3.0%

2019
4.5% 1.5% 6.0% 2.5% 2.5% 2.5% 13.5% 2.0% 8.0% 15.5% 3.0%

CRD IV defines capital, new capital conservation and counter-cyclical buffers, a minimum leverage ratio, counterparty risk and liquidity requirements, and buffers for global systemically important banks (G-SIFI). Under the regulatory guidelines, the minimum required Common Equity Tier 1 (CET 1) capital ratio will be gradually raised from 3.5% of risk-weighted assets (RWA) in 2013 to 4.5% in 2019, while the minimum total capital ratio will remain at 8.0%. However, the minimum Tier 1 capital ratio will increase from 4.5% to 6.0% over that timeframe. The cumulative capital buffers over time would appear to grow as high as 7.5% (enormous by any stretch) but it remains unclear whether the Prudential Regulatory Authority (PRA) in the UK will require British banks to implement a counter-cyclical capital buffer. JP Morgan & Co. (JPM US, Not Rated) and HSBC have been identified by the international Financial Stability Board (FSB) as the only two banks that must hold the highest level (an additional 2.5% of RWA) of G-SIFI capital
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HSBC HOLDINGS END OF THE CHARADE from 2016 due to their size and reach. CRD IV also introduces a minimum 3.0% leverage ratio (CET 1 divided by non-RWA) which the European Commission likely will make binding by 2018. Additionally, Basel III introduces several higher risk-weightings making capital compliance that much more difficult under this new regime. We analyse HSBCs capital needs in three stages: (a) assessment of balance sheet risk by major subsidiary; (b) 2016 capital requirements; and (c) 2019 capital requirements. In Figure 5 and Figure 6 below, we apply stress testing to HSBCs balance sheet for asset values and the new CRD IV capital stringencies after asset growth, earnings, and dividends for the 1H13-2018 period. By 2019, among the Groups major subsidiaries we calculate only Hongkong Bank Group and HSBC Middle East will remain above the minimum guidelines. FIGURE 5: HSBC HOLDINGS CAPITAL RATIOS UNDER ASSET STRESS AND BASEL III/CRD IV (PART 1) COMPANY
Hongkong Bank Group HSBC Europe HSBC UK HSBC France HSBC USA HSBC Latin America HSBC Middle East HSBC Holdings
SOURCE: HSBC, FORENSIC ASIA

By 2019, among the Groups major subsidiaries we calculate only Hongkong Bank Group and HSBC Middle East will remain above the minimum guidelines

1H 2013 STATED RATIOS

CET 1 n/a 11.1% n/a n/a n/a n/a n/a 10.1% Tier 1 13.7% 12.0% 11.8% 13.3% 17.7% n/a 11.3% 13.6% Leverage 8.2% 3.7% 4.1% 2.3% 10.5% n/a 10.5% 4.7% CET 1 n/a 5.4% n/a n/a n/a n/a n/a 9.8%

ADJUSTED 2013 RATIOS

Tier 1 8.6% 6.0% 5.8% 7.2% 3.3% n/a 4.6% 8.2% Leverage 4.9% 1.1% 1.1% 1.1% 3.3% n/a 5.3% 3.4%

FIGURE 6: HSBC HOLDINGS CAPITAL RATIOS UNDER ASSET STRESS AND BASEL III/CRD IV (PART 2) COMPANY
Hongkong Bank Group HSBC Europe HSBC UK HSBC France HSBC USA HSBC Latin America HSBC Middle East HSBC Holdings
SOURCE: HSBC, FORENSIC ASIA

ADJUSTED 2016 RATIOS

CET 1 n/a 5.3% n/a n/a n/a n/a n/a 5.8% Tier 1 9.0% 7.2% 5.9% 7.0% 3.9% n/a 5.7% 8.4% Leverage 4.3% 1.8% 1.1% 1.1% 3.5% n/a 5.1% 3.5% CET 1 n/a 4.9% n/a n/a n/a n/a n/a 5.8%

ADJUSTED 2019 RATIOS

Tier 1 10.3% 6.5% 5.5% 6.0% 4.7% n/a 7.6% 8.1% Leverage 4.1% 1.6% 1.1% 0.9% 3.6% n/a 5.9% 3.4%

We analyse HSBCs need for capital in three stages. As noted in Figure 7 and Figure 8, Stage 1 would suggest that HSBCs capital-starved subsidiaries plus the holding company would cumulatively require the Group to raise US$45.1bn in order to comply with current capital minimums plus a 50bps cushion by year-end 2013. This sum grows to US$67.8bn in Stage 2 in 2016 as capital buffers start kicking in. Stage 3, in 2019, would suggest that the Groups aggregate capital requirements could grow to between US$58.3bn and US$110.6bn without accounting for litigation risk. In our view, this is likely as HSBC is considering raising between US$15bn and US$20bn in Basel III/Tier 1 compliant bonds and a partial listing of HSBC Bank plc (UK retail). Re-capitalisation of HSBC UK (US$35.5bn), HSBC France (US$10.4bn), and HSBC Latin America (US$4.5bn) looks to be on the cards, in our view.

We believe the Groups aggregate capital requirements could grow to between US$58.3bn and US$110.6bn without accounting for litigation risk

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HSBC HOLDINGS END OF THE CHARADE FIGURE 7: HSBC HOLDINGS: THREE STAGES OF CAPITAL REQUIREMENTS (PART 1) CAPITAL NEEDS (US$ M)
Hongkong Bank Group HSBC UK HSBC France HSBC Europe HSBC USA HSBC Latin America HSBC Middle East Aggregate Subsidiaries Holding Company Total Capital Requirements
SOURCE: FORENSIC ASIA

YEAR-END 2013
CET 1 Tier 1 3,971 3,971 Leverage 26,980 7,426 34,434 4,500 38,934 2,210 Total 26,980 7,426 34,434 3,971 4,500 42,905 2,210 45,115 CET 1 19,945 -

1 JANUARY, 2016
Tier 1 4,292 426 4,718 Leverage 30,126 8,494 38,619 4,500 43,119 Total 30,126 8,494 38,619 4,292 4,500 426 47,838 19,945 67,782

FIGURE 8: HSBC HOLDINGS: THREE STAGES OF CAPITAL REQUIREMENTS (PART 2) CAPITAL NEEDS (US$ M)
Hongkong Bank Group HSBC UK HSBC France HSBC Europe HSBC USA HSBC Latin America HSBC Middle East Aggregate Subsidiaries Holding Company Total Capital Requirements
SOURCE: FORENSIC ASIA

1 JANUARY, 2019
CET 1 -` 100,909 Tier 1 3,533 3,533 Leverage 35,525 10,421 45,945 -4500 50,445 35,525 Total 35,525 10,421 45,945 3,533 4,500 53,978 100,909 100,909 35,525

LIQUIDITY BUFFER A FLUID SITUATION CRD IV introduced two liquidity buffers: the Liquidity Coverage Requirement (LCR) which is intended to improve the short-term liquidity (monthly) resilience of commercial banks; and the Net Stable Funding Requirement (NSFR) which is intended to ensure that commercial banks have an acceptable amount of stable funding to support assets over the medium term. Commercial banks are expected to maintain an LCR of at least 100%. The timetable will be: 60% by 2015, 70% by 2016, 80%in 2017, and 100% in 2018. The NSFR will be introduced from 2018. How the PRA liquidity regime will change upon the specification of the LCR is still uncertain, but it has decided not to exempt UK institutions from this new liquidity regime. As it stands currently, a significant level of interpretation is required to calculate an LCR. Under HSBCs interpretation, it should come as no surprise that management believes that the overall Group and major subsidiaries are already compliant with the final rules for 2018. Under our analysis, however, all major subsidiaries would pass the 2018 100% LCR test except for HSBC France which comes in at 91.7% with HSBC Middle East marginally making the grade.

Under our analysis, all HSBCs major subsidiaries would pass the 2018 100% liquidity coverage requirement test except for HSBC France

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HSBC HOLDINGS END OF THE CHARADE

HSBC Group management has a very lofty ROE target of 12-15% on a go-forward basis, and in our view has essentially pulled on every earnings lever known to man in order to get there. The Groups financial performance relies on cost cutting, shedding underperforming businesses (it sold twelve businesses in 2013), and reducing legacy-problem assets. Whilst this is a sensible strategy, HSBC will find it very challenging to achieve organic operating earnings growth in a deteriorating economic environment. The combination of asset disposals (15.1% of pre-tax operating results) and the unsustainability of low-quality trading gains (52.1% of pre-tax operating earnings) makes attaining even the 1H13 ROE level of 9.0% quite a challenge. Below we outline our major problems with Group CEO Stuart Gullivers targets: DIVORCING CHINA IS COMING AT A PRICE In addition to the new Basel III requirements of 100% capital against non-controlling financial institution stakes, financial-sector problems in mainland China have been prompting an exit from this market by some of the worlds largest financial institutions including: Goldman Sachs (GS US, Not Rated)/ICBC (1398 HK, Not Rated); Bank of America (BAC US, Not Rated); China Construction Bank (939 HK, Not Rated); and Zurich Insurance (ZURN VX, Not Rated), and New China Life (1336 HK, Not Rated). HSBC is now playing catch-up. So far, it has sold its entire 9.9% stake in Ping An Insurance (2318 HK, Sell) 1, given up its right to own up to 40% of Bank of Communications (3328 HK, Not Rated), refused to participate in Industrial Banks (601166 CH, Not Rated) 2 capital call, and more recently announced the sale of its 8% stake in Bank of Shanghai. As can be seen below in Figure 9, the asset disposals and accounting change in mainland China represented 15.1% of HSBCs pre-tax results. Whether additional disposals actually occur, negative fundamental pressures suggest a medium-term earnings downside risk.3 FIGURE 9: HSBC HOLDINGS MAINLAND CHINESE PRE-TAX CONTRIBUTION (US$ M) HSBC MAINLAND 2012 % CHINA % H/KONG % HSBC 2014 CHINA OPERATION BANK
Ping An Insurance Bank of Communications Industrial Bank Bank of Shanghai HSBC Life Insurance JV Contribution Other Total HSBC Mainland China Hongkong Bank Group HSBC Holdings 763 1,670 670 86 25 681 3,895 13,044 10,068 19.6% 42.9% 17.2% 2.2% 0.6% 17.5% 100.0% -5.8% 12.8% 5.1% 0.7% 0.2% 5.2% 29.9% 7.6% 16.6% 6.7% 0.9% 0.2% 6.8% 38.7% 0 1,754 0 0 30 700 2,484 14,088 25,691

12-15% core ROE target is pure fallacy

HSBC is running for the Himalayas, exiting China and leaving behind 15.1% in pretax profit

% CHINA % H/KONG BANK

0.0% 70.6% 0.0% 0.0% 1.2% 28.2% 100.0% 0.0% 12.4% 0.0% 0.0% 0.2% 5.0% 17.6% -

% HSBC
0.0% 6.8% 0.0% 0.0% 0.1% 2.7% 9.7%

SOURCE: HSBC; KPMG; FORENSIC ASIA

See Ping An Insurance Squaring Up For a Fall coverage initiation report dated June 7, 2013 for more detail. See Hang Seng Bank Tomfoolery coverage initiation report dated March 4, 2013 for more detail. 3 See HSBC Mainland China Divorcing China report dated July 4, 2013 for more detail.
1 2

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HSBC HOLDINGS END OF THE CHARADE OTHER BOTTOM-LINE CHALLENGES SEEN THROUGHOUT THE FRANCHISE Other bottom-line challenges by market include: a) Hong Kong (32.2% of pre-tax operating results) sowing mortgage growth & NIM pressures: Mortgage-market controls are negatively affecting loan growth in Hong Kong. The Hong Kong Monetary Authority (HKMA) and the local government have severely tightened the mortgage-lending screws. Mortgage loan growth has decelerated to 4.7% on an annualised basis in 1H13 as a result down from 11.5% in 2012. The NIM outlook is also less certain given rising deposit costs, less loan pricing power, and the prepayment of mortgage and syndicated loans; b) Developed Markets (32.2% of pre-tax operating results) trying to get these houses in order: Asset values remain remarkably overstated in the bulk of the developed markets six years after the GFC. Sets of results in both markets were helped by on-off items in 1H 2013. In Europe there were lower cost of redress charges, while in North America the franchises results were helped by a large gain on the sale of its New York State retail operation. From an operating perspective, European results were aided by lower operating expenses and lower quality trading gains which were up 5.8x since 2H 2012 due to positive movements on foreign exchange debt hedges the latter being unsustainable. Although lending margins were higher, net interest income remained flat HoH. HSBC has been aggressively trying to reduce its exposure to the American market after the fiasco of the acquisition of the Household consumer finance company. Assets have been reduced another US$4.2bn or 2.1% for the year through 1H 2013. The latest asset disposal was a large leveraged loan portfolio with others on the way. As in Europe, North America benefited from a positive mark-up of its debt of US$505m, due to improving credit spreads. That said, the North American net interest margin (NIM) continues its decline down 5bps to 1.30% in 1H 2013. North America is also experiencing lower fee revenues following the sale of its retail branches in New York State; and c) Emerging Markets (32.2% of pre-tax operating results) asset gains mask lower operating results: HSBC has been shedding assets in emerging markets namely in mainland China and Panama. Coupled with the retreat on its accounting treatment of Industrial Bank, we calculate that emerging market pre-tax income will decline by 18.2% in 2014. In addition to the groups scaling-back of operations in various Asia-Pacific markets, other bottom-line pressures persist in the region. The Asia-Pacific NIM has declined 15bps to 2.05%, while net interest income growth has decelerated to 2.1% annualised down from the 10.5% posted for all of 2012. HSBC Latin America (HLA) is experiencing negative loan growth, deteriorating credit quality, and weaker NIMs. HMEs asset mix is shifting toward lower-yielding securities. Costs at HLA are high with Brazils efficiency ratio and overhead to average earning asset ratio coming in at 60.5% and 5.95%, respectively, while Mexicos were 66.8% and 4.96%. HSBC reports its financial results in US$, and these weaker currencies and higher rates have cumulatively caused US$ translated earnings at the Group level to decline 8% during 1H 2013, and increased mark-to-market risk in subsidiary securities portfolios.

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HSBC HOLDINGS END OF THE CHARADE CREDIT RISK REMAINS HIGH Credit quality remains weak in the Group, while deterioration has become quite noticeable at the franchise level especially in emerging markets. According to HSBC, problem loans amounted to US$83.9bn at 1H 2013 although they declined US$6.1bn (6.8%) since year-end 2012. On a total loan basis, as seen in Figure 10 below, problem loans amount to a whopping 7.06% despite being down 66bps HoH. With emerging markets turning for the worse, we do not anticipate much improvement in credit quality from now on. Credit improvement unfortunately is not as strong as management would like investors to believe, as net new NPLs are only down 1.9% over the past six months. We also note that the Groups 30 to 89 day overdue loans have been tracking in the mid-30bps of loans outstanding for the last couple of years without much improvement. In terms of new credit weakness, we are seeing a breakdown in Brazil, Mexico, Dubai, and Asia-Pacific where 45% of the new NPL growth is concentrated. We comment on credit issues by market in greater detail below: (a) HSBC Europe: by our calculation, 13.5% of HSBC Europes overall loan portfolio is dedicated lending to the French financial sector. The weak French financial sectors reliance on wholesale funding is quite problematic. 6.5% of HSBC Europes loan portfolio, we calculate, is dedicated to British commercial real estate, whose value in some instances is down by more than 50% since 2007. 3.5% of HSBC Europes loan book, by our calculation, is exposed to undisclosed and problematic areas within the Eurozone; (b) HSBC USA: Despite the elevated NPL and 30 to 89 day past due levels at HSBC North America, more worrisome is the enormous level of troubled debt restructurings (TDRs) which are not disclosed as NPLs but count as performing loans according to the new terms of the restructuring. According to HSBC North Americas regulatory filings, TDRs amount to US$13.7bn or 13.9% of total loans an eye-popping 2.1x the size of stated NPLs at 1H13; (c) Hongkong Bank: Hongkong Bank generally has a very clean loan portfolio. It is important to note that more than 57% of HSBC's Asian exposure is in Hong Kong where 29% of the risk is concentrated in mortgages where loan-to-value ratios are 32% on average. Its largest concentration of direct lending 23.1% is in mainland China. As such, given the difficulties in the market, our confidence in Asia-Pacific is not nearly as high as with Hong Kong. Other emerging Asian markets, such as India, Malaysia, and Singapore cause some concern as well given the growth and currency issues. Indias political situation is even more of a concern. (d) HSBC Latin America: A recent shift in government housing under the new Mexican president has sought to end construction of housing estates in suburban and rural areas. This is a substantial business model change for Mexicos largest homebuilders which have built huge housing stock on the outskirts of the cities, to which we believe that HSBC Mexico has a US$.1.3bn exposure (equivalent to 9.2% of its loan book). 29.1% of lending by HSBC Brazil is done to financial institutions a country which has actually allowed bank failures over the last couple of years. As there is a presidential election in 2014, President Dilma Rouseff has disregarded prudence with respect to a housing bubble by stoking demand on a price surge allowing the unemployment insurance fund to subsidise borrowers; and (e) HSBC Middle East: Credit quality at HSBC Middle East is incredibly weak, and has been so since 2H 2009. By our calculation, NPLs amount to a franchise-worst 16% of total loans. In 1H 2013, we witnessed a significant and initial negative turn in credit quality the first in four
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HSBC HOLDINGS END OF THE CHARADE years. The annualised 52% HoH increase in net new NPLs in 1H13 (versus 8.6% for all of 2012) heightens our concern. By country, risk is increasing as well. Insufficient policy reform has allowed Dubai to go back to its old tricks with another string of irresponsible projects. Crude-oilreliant Oman has invested significantly in infrastructure, but a stubbornly high unemployment rate remains a problem. Rapid growth in Qatars CRE sector is fast resembling old Dubai with a 20% office vacancy rate. FIGURE 10: HSBC HOLDINGS: PROBLEM LOAN BREAKDOWN CREDIT QUALITY
30-89 Days Past Due Problem Loans Past Due But Not Impaired Substandard Impaired - Current Impaired - Not Current Renegotiated Loans as % of Performing Problem Loans/Total Loans
SOURCE: HSBC, FORENSIC ASIA

IH 2012
0.36% 0.01% 2.30% 1.12% 3.48% 1.29% 8.19%

2012
0.38% 0.02% 2.06% 1.22% 3.32% 1.10% 7.72%

1H 2013
0.32% 0.01% 1.91% 1.02% 3.21% 0.90% 7.06%

VERY QUESTIONABLE RESERVE COVERAGE HSBCs ability to absorb losses from its current and future problem loan portfolio is quite limited, in our view. On a traditional loan-loss reserve to total loan basis, HSBCs coverage looks strong at 1.31%. However, on a reserve to problem-loan basis, HSBC coverage is a concern at 18.9%. The loan-loss reserve coverage becomes even more precarious when if one considers the continued high annualised level of net charge-offs (NCOs) at HSBC of 0.74% in 1H13, and the 87.3% provision/NCO coverage. This level of reserve bleeding has allowed for reserve coverage of problem loans to decline from a fairly robust 99.7% in 2008. Excluding off-balance-sheet risk, we find that on a Group level HSBCs loan-loss reserve is light by US$20.9bn or 134% of the current loan loss reserve. This shortfall represents 11.4% of stated capital at 1H13. However, when we look at reserve coverage in greater detail on an aggregate subsidiary basis this loan-loss reserve shortfall amounts to US$31.7bn 51.7% higher than the Group shortfall. If HSBC were to provide for this amount against problem loans, reserve cover of problem loans would be a substantially more adequate 43.5% which is not even close to the coverage prior to the GFC. . LEGAL AND REGULATORY ISSUES NOWHERE NEAR SETTLED HSBC continues to be in the spotlight even after a half of a decade of being mired in legal and regulatory problems. It continues to warn of more uncertainty, as it sets aside more provisions. Considering HSBC's blatant failure to implement anti-money laundering controls and wilful flouting of US sanctions, among many other issues discussed in detail below, the Group nearly put itself out of business, in our view. Incidentally, we did not dream up the harsh terms blatant failure and wilful flouting. We are citing the former US Assistant Attorney General, Lanny Breuer, who used them last December when the US Justice Department announced that HSBC would not be criminally prosecuted (see, for, example, the article HSBC, too big to jail, is the new poster child for US two-tiered justice system in the Guardian newspaper on 12 December, 2013 (see HTTP://WWW.THEGUARDIAN.COM/COMMENTISFREE/2012/DEC/12/HSBC-PROSECUTION-FINEMONEY-LAUNDERING). These blatant failures appear to have been prevalent globally for HSBC. Indeed, so widespread were legally questionable activities within HSBC that one wonders whether investors should not treat provisions against legal and regulatory risk as normal business costs rather than one-time

HSBCs ability to absorb losses from its current and future problem loan portfolio is quite limited

HSBC Groups cavalier attitude to legal and regulatory issues nearly put it out of business, in our view

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HSBC HOLDINGS END OF THE CHARADE items. It is worth noting why HSBC did not face criminal prosecution in the US. Lanny Breuer really put HSBCs egregious behaviour into perspective when he made clear that had the US authorities decided to press criminal charges, HSBC would almost certainly have lost its banking licence in the US, the future of the institution would have been under threat, and the entire banking system would have been destabilised (see the same Guardian article cited above). Although the Group seemingly received a free pass in the US, the cost of additional scrutiny and tougher regulation globally are added burdens for HSBC. Indeed, the threat of further litigation still looms quite large. Considering its own legal costs, losing legal battles, and the possibility of additional fines in the future, we conservatively estimate a minimum of another US$10bn in litigation risk. While the magnitude of potential lawsuits is difficult to estimate with any certainty in value or timing, it is fair to say that HSBC is mired in legal issues which in many instances could dwarf the regulatory fines it has incurred so far: (a) Payment protection insurance (PPI) the UKs form of kabarai: The UK has its own form of Japanese kabarai (the term used to refer to the excessive interest rates formerly charged by Japanese consumer finance companies). In Japan, excessive interest payments on consumer debt were legislated to be repaid provided the proper claims were made a process which has been ongoing since December 2006. While payment protection insurance (PPI) in the UK is certainly different from Japanese kabarai claims, we fear the ultimate repayment tail will be just as long as in Japan. PPI covers borrowing repayments if the policyholder is unable to meet them in certain situations (accident, illness or redundancy). Unfortunately, the FSA has found that these polices were widely mis-sold and that many policyholders who purchased them may be able to claim a refund provided the proper physical claim filing is made. Claims are likely to rise further given the outbound mailing from banks to all PPI customers. Comments from the Financial Ombudsman Service (FOS) indicate that around 5 million PPI claims have been made thus far versus a total of 35 million PPI policies sold by UK banks implying a very kabarailike tail to resolve this issue. Specifically, in the case of HSBC Bank plc, nearly US$1.8bn (US$1.2bn in disbursements) appears to have been set aside for this particular redress issue amounting to about 15 months of coverage based on the current level of incoming claims; (b) LIBOR-fixing scandal: Most interest rates are pegged to LIBOR, as hundreds of trillions of The LIBOR fixing scandal US$ in financial products are tied to this rate. The LIBOR-fixing scandal was a series of could be problematic for years to come. fraudulent actions that arose when it was discovered that banks were falsely inflating or deflating their rates in order to profit from trades, or to give the impression that they were more creditworthy than they actually were and to influence the price of trades. Under the scheme, 16 of the largest global banks would submit to an independent London-based LIBOR panel the interest rates that they would charge other banks to borrow. The LIBOR panel would dismiss the four highest and the four lowest rates, averaging the remainder in order to create that day's LIBOR rates. That the LIBOR panel only used the middle eight interest rates suggests how difficult it would be to artificially influence interest rates. Essentially, the largest global banks colluded to fix the price of money. In June 2012, multiple criminal settlements (a mere 290m) by Barclays Bank (BARC.LN, Not Rated) revealed significant fraud and collusion by member banks (including HSBC Bank plc) connected to the LIBOR submissions. HSBC Bank plc has set aside a modest amount of reserves to cover litigation risks in the UK over its participation in the LIBOR scandal. We
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HSBC is mired in legal and regulatory issues which could lead to fines dwarfing those it has incurred so far

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HSBC HOLDINGS END OF THE CHARADE believe that there exists further downside risk related to LIBOR fixing from potential civil litigation and upcoming settlements with regulators in other jurisdictions; (c) Swap mis-selling: Around 40,000 interest-rate hedging products (IRHPs) were sold to small businesses since 2001. Initially the original deals were created for bank customers to swap variable interest-rates loans for fixed rates if interest rates rose. In recent years, interest rates have fallen to record low levels, leaving businesses with an excessive cost of funding. In many cases, fees were also egregious if businesses wanted to exit the contract. In a pilot study, the Financial Services Authority (FSA) found that in a sample that 90% of IHRPs sold to unsophisticated customers had broken at least one rule. On January 31, 2013, the FSA has identified four banks (including, you guessed it, HSBC Bank plc) which were guilty of mis-selling and directed each to calculate compensation for tens of thousands of small businesses which were mis-sold complex insurance deals. There is a lack of clarity on what the full redress looks like, but redress should aim to put customers back in the same position that they would have been in had the regulatory breach not occurred. UK banks have made 0.7bn in provisions, while HSBC Bank plc has provided 0.4bn. While it is very difficult to estimate the eventual cost related to this issue, it has been suggested that the cost of potential redress for IHRP mis-selling could be comparable to PPI. There have been no significant disbursements as yet for HSBC Bank plc; (d) Offshore account scandal in Jersey: HSBC Bank plc has opened accounts in Jersey, in Who is not from Jersey? the Channel Islands, which, in some instances, apparently aided certain of its customers in money laundering and tax evasion in the UK. HSBC is now apparently being investigated by HM Revenue and Customs after a whistle-blower handed it the names, addresses and balances of every person that has an account with it in Jersey. According to press reports, a total of 699m is being held in 4,388 Jersey accounts. Like the United States, the UK is stepping-up its efforts to uncover the identities of those individuals who avoid taxes. Jersey's Financial Services Commission is likely to probe anti-money laundering systems and controls at HSBC as well. It is widely anticipated that HSBC Bank plc will face fines of up to 1bn over the affair; (e) Currency manipulation: HSBC has confirmed that it is cooperating with Britain's Financial Conduct Authority, which is leading an investigation into the US$5.3tn per day foreign exchange market that has spread to include regulators in the US, Asia and Switzerland; (f) Mexican hat dance: Mexican branches of HSBC had become so well-known to drug traffickers as a place to launder proceeds from illicit drug sales that the bank designed special boxes to cope with the large quantities of cash. Between 2006-10, the Sinaloa drug cartel in Mexico and the Norte del Valle cartel in Colombia moved more than US$881m in proceeds through HSBCs US unit. In total, the banks US and Mexican units failed to monitor more than US$670bn in wire transfers and more than US$9.4bn in purchases of US dollars from HSBC Mexico. HSBC was too slow to put anti-moneylaundering systems in place that were up to modern standards. This substantially hurt its reputation and resulted in a US$1.9bn fine in the US likely with further fallout; (g) Argentine problem: In stark contrast to the US, the Argentine government has been much more combative with the British bank. The Argentine Government has accused HSBC
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HSBC HOLDINGS END OF THE CHARADE Argentina of facilitating money laundering to the tune of US$120m. It has also accused the bank of aiding client tax evasion, allowing three companies (Mas Distribuidora SA, Recaudaciones y Servicios del Sur SRL and Red de Multiservicios) to use falsified receipts to justify the issuance of checks whose amounts were deposited under a generic tax identification number. HSBC Argentina failed to inform the AFIP (Administracin Federal de Ingresos Pblicos) tax agency about the 2007 issue. Already, HSBC Argentina has been fined US$1m for failing to the report money laundering, and if Argentina's courts apply further penalties to HSBC Argentina, someone at the bank could face a criminal trial; (h) New York AG headache: The State of New Yorks Attorney General is suing HSBC Bank New York State is even getting USA and HSBC Mortgage, for failing to set timely foreclosure settlement conferences as in on the act required by state law. According to the law, mortgage lenders who foreclose on residential home owners must request court-supervised intervention and attend a settlement conference on a possible loan modification within 60 days. There are about 25,000 foreclosure cases state-wide which have languished for months because lenders have delayed filing the papers that would trigger a conference while continuing to assess interest, fees and penalties. The lawsuit would require HSBC to waive those later charges; (i) The John Doe summons: With a normal summons, the Internal Revenue Service (IRS) seeks information about a specific taxpayer whose identity it knows. A John Doe summons allows the IRS to get the names of all taxpayers in a certain group. In 2008, the John Doe summons was allowed to be used by the Internal Revenue Service (IRS) to sue UBS (UBSN.VX, Not Rated) for information about US taxpayers using Swiss accounts. UBS was fined US$780m. The IRS ultimately roped in HSBC, among many other banks, to produce data on undisclosed accounts at Bank of N.T. Butterfield & Son (NTB.BH, Not Rated) in the Bahamas, Barbados, the Cayman Islands, Guernsey, Hong Kong, Malta, Switzerland, and the UK. HSBC has made an extra provision in its private bank to cover a US investigation into US citizens with bank accounts in Switzerland; and (j) Household name: A class-action against the Household subsidiary in the US was initiated in August 2002, claiming Household and three of its former top executives made false and misleading statements about the business to artificially inflate its stock price, and used predatory lending practices to boost sales. A jury in Chicago found in favour of the plaintiff in May 2009 but HSBC appealed against the decision. HSBC estimated that it could be hit for damages and interest ranging from an insignificant amount to US$3.5bn, depending on the outcome of its appeal. How to value an organisation that has substantial assets in three continents becomes the multiple billion dollar question that we try to discern, as we compare and contrast several valuation methodologies and comparables for the shares of HSBC. Given the capital struggles that HSBC is about to embark upon and asset values that seem stretched, we feel the best way to measure HSBC is on an historical P/TBV multiple versus its liquidation value rather than an on earnings basis. Given the high likelihood that HSBC will have to raise between US$58-US$111bn, we believe the value of the shares should be closer to HK$63.00 per share. We explain our reasoning below. On a core earnings/core ROE basis. At the current price of HK$83.90 per share, we find the banks valuation to be stretched at 10.5x and 9.4x consensus 2014 and 2015 EPS estimates of
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Valuation

13

HSBC HOLDINGS END OF THE CHARADE US$1.03 per share and US$1.15 per share, respectively. On this basis, HSBC would achieve a core ROE and earnings growth of 10.3% and 10.4%, respectively. Given the deliberate reduction in mainland Chinese pre-tax profit, the sale of the Panama operation, weaker fundamentals across the board, low quality earnings reliance, and huge potential capital raise/core franchise disposal, consensus forecasts appear quite optimistic nearly 25-30% above an achievable level between 2013 and 2015, in our view. Our core ROE figures look closer to 8.1%-8.3%. This, we believe, is a clear sign of a downward earnings multiple re-valuation. On this basis, we find that the shares of HSBC would be worth HK$68.00 per share representing 15.4% negative return on investment (post-dividend). Blue Chip Asian regional bank. Given the companys call letters of HSBC which previously stood for Hongkong & Shanghai Banking Corporation, comparing HSBC to the other Asian regional banks is generally the first and most obvious way to evaluate this institution from a valuation perspective. On a P/E basis, HSBC is trading at a 27% discount to its five-year historical average, and a 5.0% discount relative to the Asian regional banking sector. However, if our 2014 EPS forecast is correct then the shares are actually trading at a 41.0% premium to its historical P/E band implying a price target of HK$51.30 per share. Relative to the Asian regional banks, our 2014 EPS forecast implies an 82% P/E premium to its historical average. Liquidation analyses. Under a liquidation scenario for HSBC, we derive a price target of HK$63.00 Shares are trading at 1.7x per share. After deducting the below mentioned items from capital adjusting for the loan-loss adjusted TBV not exactly cheap! reserve shortfall of US$2.7bn, we add back the earnings after dividends, arriving at a book value of HSBC after liquidation. We then divide the book value after liquidation by the fully diluted shares outstanding at 1H 20113 to arrive at a tangible book value of HK$37.26 per share after liquidation. Finally, we apply the average price to a tangible book value multiple of 1.7x for the past five years of HSBC and arrive at a fair share price of HK$63.00 per share.

Final note

For easy reference, over the following pages, please see the front pages of our earlier reports on the major subsidiaries and regional franchises of the HSBC Group.

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14

HONGKONG BANK
CROWN JEWEL LOSING LUSTRE
Hongkong Bank is HSBC Holdings founding member, and the dominant banking franchise in Hong Kong. The Groups crown jewel has unfortunately been losing its lustre, as Hong Kong and Asia-Pacific top-line pressures are mounting, while credit quality is showing signs of weakness in both segments. The disposal of its Ping An Insurance stake and the accounting reclassification of Industrial Bank have likely reduced Hongkong Banks 2014 operating results by 13%. Hongkong Bank too, like the other HSBC subsidiaries, has also taken advantage of capital forbearance to the tune of US$10bn-US$24bn. Coupled with our identified risks at its sister companies, HSBCs aggregate level of over-stated earnings (or balance sheet hole) appears to range between US$65bn-US$79bn, i.e. 31-38% of market capitalisation. TOP-LINE PRESSURE SEEN THROUGHOUT ASIA Hongkong & Shanghai Banking Corp. (Hongkong Bank) is HSBC Holdings (5.HK, Not Rated; HSBC or the Group) founding member, and the dominant banking franchise in Hong Kong. Hong Kong (58% of Hongkong Banks pre-tax operating earnings) and Asia-Pacific are feeling substantial negative revenue pressures. Loan growth (especially Hong Kong mortgages) is decelerating, margins remain under pressure, while trading revenues appear to be weakening. Foreign exchange translation risk outside of Hong Kong remains problematic, while the disposal of various sub-optimal parts of the franchise is severely limiting Hongkong Banks cause. AGGRESSIVELY REDUCING MAINLAND CHINA CONTRIBUTION As discussed in detail in our HSBC Mainland China report1, mainland China accounts for 24% of Hongkong Banks operating revenues. However, the organisation is aggressively paring back its mainland Chinese revenues and exposure. The first to go was Ping An Insurance2, (2318 HK, Sell), which accounted for 4.5% of mainland Chinese operating revenues in 2012. The organisation changed its accounting treatment of Industrial Bank (601166.CH, Not Rated)3, which will reduce the mainland Chinese contribution by another 8.9%. There have been rumblings about jettisoning other parts of its mainland Chinese businesses too. ROBBING PETER TO PAY PAUL HSBC has missed a golden opportunity to reinforce Hongkong Banks Asia-Pacific balance sheet. Instead, the gains from Ping An Insurance and Industrial Bank were delivered upstream as dividends to the parent company. This is hardly the first time that HSBC has used the Hongkong Bank franchise to support its faltering sister companies, and masks decades of managerial mistakes. Hongkong Bank, like its sister companies, is substantially overstating earnings in our estimation, suggesting that the needs of its sister companies are even more substantial. Our estimated level of earnings overstatement at Hongkong Bank ranges between US$10bn and US$24bn (16%-34% of stated equity). However, this level of capital forbearance has substantially boosted HSBCs post-GFC bottom line.
Thomas J. Monaco +852 2843 9423
TOM@FORENSICASIA.COM

Andrew Haskins +852 2843 9433

ANDREW@FORENSICASIA.COM

1 2

See HSBC Mainland China Divorcing China report dated July 4, 2013 for more detail. See Ping An Insurance Squaring Up For a Fall coverage initiation report dated June 7, 2013 for more detail. 3 See Hang Seng Bank Tomfoolery coverage initiation report dated March 4, 2013 for more detail.

COMPANY REPORT
18 December 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC MAINLAND CHINA

DIVORCING CHINA
Several years ago it would have been unheard of for global banks to dispose of major Thomas J. Monaco mainland China financial assets. But with economic problems in China rising and most major TOM@FORENSICASIA.COM western banks needing to shore up domestic capital shortfalls, perception has changed. Gillem Tulloch Divestitures of foreign stakes in local franchises are accelerating. Following this trend, HSBC GILLEM@FORENSICASIA.COM Holdings sold its entire 9.9% stake in Ping An Insurance earlier this year, and could well sell all remaining assets. Whether or not the group is successful, deteriorating economic fundamentals in China are likely to weigh on group results. THE CHINA MIRACLE IS OVER We think 2nd tier banks, which account for half of system-wide deposits, are on the verge of a US S&L-type crisis where a lack of bank liquidity will exacerbate a credit meltdown. The latest action by the Peoples Bank of China (PBoC), which targets wealth management vehicle funding with higher Shanghai interbank (SHIBOR) rates, only increases our concerns. ACT NOW, YOULL NEVER SEE THESE PRICES AGAIN It seems that mainland China is no longer so important to the worlds financial community. After several high-profile exits by western financial institutions (eg Goldman Sachs/ICBC, Bank of America/China Construction Bank), HSBC is finally playing catch-up. So far, it has sold its entire 9.9% stake in Ping An Insurance (2318.HK, Sell), given up its right to own up to 40% of Bank of Communication (3328.HK, Not Rated) and failed to take part in Industrial Banks (601166.CH, Not Rated) recent capital call. We expect several other asset sales if the bank can find buyers. HSBCS OPERATING RESULTS TO BE HIT HARD BY COSTLY SPLIT This mainland Chinese divorce (like everyone elses) will come at a high price. In 2012, the mainland accounted for 31% of group pre-tax profits of which the recently divested Ping An Insurance accounted for 51%. Further disposals could see this segments pre-tax profits fall yet another 38% compared to 2012. As such, the groups ROE target of 12%-15% is optimistic. Whether additional disposals actually occur, negative fundamental pressures suggest mediumterm earnings downside risk.
Mainland China Contribution to HSBC Group Pre-Tax Profits (%)

COMPANY REPORT
4 July 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HANG SENG BANK

SELL: TOMFOOLERY
You can fool some of the people all of the time, and all of the people some of the time, but Thomas J. Monaco you cannot fool all of the people all of the time. Hang Seng Banks tomfoolery of attempting to TOM@FORENSICASIA.COM juice earnings in a down market with an initial accounting misclassification of Industrial Bank Gillem Tulloch is being unwound whether the accountants are pushing for it, or the future constraints of GILLEM@FORENSICASIA.COM Basel III. The end result will be lower earnings and equity values, the creation of credibility gap, and what will likely wind up in the total disposal of its stake likely at a loss from its current marked-to-market position given the lack of buyers and the brewing storm in the 2nd tier mainland Chinese banking sector. This situation is likely to be painful for shareholders and HSBC. INDUSTRIAL BANK ACCOUNTING CHANGE TO WEIGH ON FUTURE RESULTS Hang Seng Banks initial and questionable accounting of Industrial Bank has enabled it to achieve earnings CAGRs of 10% since it was acquired. Not only will the accounting reclassification cause a 28.6% reduction in operating earnings, but we find that equity capital will decline as the Industrial Bank marked-to market (MTM) gain of HK$10.4bn likely will be more than offset by the reversal of Industrial Banks attributable earnings. As a result, we now question the validity of Hang Seng Bank even retaining this sub-optimal holding. POTENTIAL FOR DIVIDEND CUT Hang Seng Bank currently has the highest dividend yield among peers; this may not hold. Hang Seng Banks capital is under pressure especially if it retains its stake in Industrial Bank. Given both a flat absolute dividend since 2008, the lack of participation in several Industrial Bank secondary offerings, the lowest leverage and tangible leverage ratios in our coverage universe, and Basel III pressures for minority stakeholders of financial institutions, Hang Seng Bank appears to have serious capital constraints. Hang Seng Bank would be wise to cut its dividend, especially since it appears to pay out more in cash than it earns on a normalized basis. INITIATING COVERAGE WITH A SELL RATING We are initiating coverage on the shares of Hang Seng Bank with a Sell recommendation, and are establishing a price target of HK$100 per share-which intimates downside of 21%. In addition to questionable overall capital, we also dislike the shares of Hang Seng Bank for its earnings destruction from the Industrial Bank misclassification, the misperception that Hang Seng Bank is a superior franchise to its Hong Kong peers, fundamental pressures on the legacy franchise, and of course its excessive valuation.
Consolidated Financial Forecasts:
Year to Dec NII (HK$m) Core Profit (HK$m) Net profit (HK$m) EPS (HK$) Core EPS (HK$) PE (x) Core PE (x) Price/Book (x) Core ROE (%) Dividend Yield (%) 10A 14,300 14,030 14,917 7.80 7.34 16.4 17.4 3.50 21.9 4.1 11A 15,736 15,876 16,680 8.72 8.30 10.6 11.1 2.24 21.3 5.6 12E 16,577 18,693 18,093 9.46 9.29 12.5 12.8 3.50 26.1 4.4 13E 17,200 12,708 23,534 12.09 6.65 10.4 19.0 3.50 19.5 4.1 14E 18,100 15,288 15,288 8.00 8.00 15.8 15.8 3.45 18.0 4.1

COMPANY REPORT
4 March 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC EUROPE
BLEEDING LIKE AN SIV
Investors particularly those in Asia are going to ask the question, Is HSBC Holdings plc Thomas J. Monaco (5.HK) really maximizing shareholder value by lugging around two awful developed market TOM@FORENSICASIA.COM franchises in Western Europe which consistently underperform this, even prior to the Gillem Tulloch increasingly hostile regulatory environment? These franchises have negative return on GILLEM@FORENSICASIA.COM invested capital even in the best of times and, given our review of HSBC Europe, we continue to expect negative returns. Between the SIV-like capital that each European franchise possesses versus their level of assets and their level of capital forbearance, the Group when we take HSBC North America into account looks to need equity capital to the tune of US$44bn-56bn or 23-29% of its market cap even before we take into account the cost of redress litigation. Why the Group didnt accept a bailout on behalf of HSBC Bank plc (UK operation) from the Crown when it was offered during the heat of the GFC still remains a mystery. MORE THAN MEETS THE EYE IN THE UNITED KINGDOM Like nearly everywhere else in the developed markets, HSBC seems determined to not provide against the level of risk on its balance sheet. Were this not bad enough, the Prudential Regulation Authority (PRA) is looking to bring forward some of the 2019 Basel III rules while the Financial Policy Committee (FPC) recently suggested that sector capital levels are misleading. We tend to agree with the FPC in at least one instance HSBC UK. Given the noise on HSBC UKs balance sheet, we find that its Tier 1 capital ratio would decline from 10.7% to 5.6%, while its leverage ratio would fall from a stated 4.20% to 1.29% both below the anticipated Basel III minimums. FRENCH FRIED Not only was this one of the Groups most bizarre acquisitions at the time as it clearly did not fit within the HSBC framework, but this entity potentially could be right up there with the Groups infamous Household International transaction in the US given both its 62% loan exposure to the French financial sector (in reality already on its knees), and 16% exposure to the euro zone. Before making any adjustments to HSBC Frances balance sheet, this subsidiary begins with only 2.13% of equity against assets. In our view, it is only a matter of time before the Group either significantly re-caps this entity, sells it at a massive loss, or shuts it down altogether. THE MESS OF REDRESS HSBC UK is now mired in legal issues which in many instances could dwarf its regulatory fines, in our view. Some of the problems that HSBC UK is contending with include scandals surrounding Payment Protection Insurance, LIBOR fixing, swap mis-selling, and issues with offshore accounts in Jersey. All of which have made HSBC UK the poster child for everything that is wrong with the British banking system, even if there are many contenders to this title.

COMPANY REPORT
22 April 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC NORTH AMERICA

WELL CAPITALISED MIRAGE
By our calculations, HSBC North America has US$22bn of questionable assets which if Thomas J. Monaco provisioned for properly could easily result in its Tier 1 capital ratio declining from 17.2% to TOM@FORENSICASIA.COM just 1.8%, or even less. Only an extraordinary amount of capital forbearance has allowed its Gillem Tulloch North American division to report profits. HSBC Holdings targeted 12-15% ROE looks very GILLEM@FORENSICASIA.COM vulnerable when this is taken into consideration. The potential for write-downs could translate into nearly 16 months of earnings for HSBC Holdings, and have a negative 12.6% impact on BVPS. CHALLENGING ENVIRONMENT LEADS US TO QUESTION AMERICAN ASSET VALUES The level of questionable assets, by our calculation, at HSBC North America amounts to US$21.8bn having the highest level of problem loans at 22.0%, the weakest reserve cover at 22.4%, nearly the highest percentage of deferred tax assets, and a large concentration of Level 3 securities. CAPITAL FORBEARANCE NOT LOST ON HSBC NORTH AMERICA HSBC North America has the most capital at risk by a wide margin of the largest American retail banks, in our view. By our calculation, HSBC North Americas adjusted Tier 1 capital ratio could very easily decline from 17.16% to 1.81% - more so if we consider the likely potential negative impact of the recent Congressional, legal and regulatory inquiries. Frankly, it would not surprise us to see HSBC Holdings Plc (5.HK) significantly re-cap the American financial holding company or even sell the local franchise outright at a significant loss. HIGH RELEVANCE TO HSBC HOLDINGS HSBC North America represents about 12.5% of HSBC Holdings assets and negative 8.4% of the overall bottom-line at 1H12, which is not insignificant to HSBC Holdings. In fact, we find that extraordinary level of capital forbearance in the US has allowed the London company to post earnings whereby losses would have likely ensued. We find that HSBC Holdings stated ROE target of 12%-15% is very vulnerable as losses at HSBC North America could likely weigh on the entire operation. The potential for write-downs could translate into nearly 16 months of earnings for HSBC Holdings, and have a negative 12.6% impact on BVPS.Body content in style

COMPANY REPORT
8 February 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC LATIN AMERICA

HACIENDA HEADACHE
Between 1997 and 2006, HSBC Holdings (5 HK, Not Rated) was one of the more aggressive Thomas J .Monaco acquirers of problem bank assets across Latin America. Today, HSBC Latin America (HLA) is TOM@FORENSICASIA.COM the problem asset. Credit quality has taken a substantial turn for the worse in its largest Gillem Tulloch markets, Mexico and Brazil; loan growth is negative, net interest margins are under pressure GILLEM@FORENSICASIA.COM while inflation and labour unrest are leading to cost pressures. Local currency weakness is lowering US$ denominated earnings at the Group level, whilst troubling local credit quality, and is causing negative mark-to-market (MTM) pressures on capital and earnings. With a loss of earnings firepower at HLA, HSBC Mainland China, and HSBC Middle East, we continue to question the Groups ability to meet its lofty performance targets. We estimate HLA is underprovided for by US$4.5bn, taking the Groups black hole to US$55bn (so far), 27% of market capitalisationand this is before we turn our analysis to Hong Kong. HACIENDA HEADACHE IN MEXICO Problem loans at HSBC Latin America (HLA) are on the rise. In Mexico, which accounts for 31% of loans outstanding, the presidents 180-degree turn on housing policy has led to significant debt restructuring at local homebuilders and residential mortgage uncertainty. Previously, homebuilders were allowed to develop in suburban and rural areas but the new administration prefers vertical housing blocks in urban centres. This is forcing homebuilder write-downs of current land/housing stock and weaker home valuations and sales. This has created a problem for residential mortgage lenders which account for 12% of HSBCs Mexican loan portfolio. AND A FEIJOADA OF CREDIT PROBLEMS IN BRAZIL In Brazil, which accounts for 59% of loans outstanding, weak international commodity markets have contributed to a weak economy. Whilst private sector banks have pulled back their lending, state controlled banks have picked up the slack, thereby keeping asset prices and inflation artificially buoyant. In an increasingly stagflationary environment, the Brazilian Real (BRL) has weakened nearly 20% since the beginning of the year. Should the government slow loan growth, credit deterioration will further accelerate from 2012s net new problem loan growth level of 43%. F/X TRANSLATION RISK REMAINS A RECURRING THEME In 2013, the BRL real has weakened nearly 20% versus the US$, while the Mexican peso (MXN) declined 10%. Both factors have caused US$ translated earnings at HLA and the Group to decline 12% and 2%, respectively. Given the threat of QE tapering, slowing US import demand, and continued weakness in commodity markets, further currency weakness is expected. EARNINGS MELTDOWN CONTINUES WHILE QUESTIONABLE ASSET VALUES RISE HLA has become increasingly immaterial to Group earnings, accounting for 11.5% pre-tax profits in 2012, falling to just 3.3% in 1H13. Combined with HSBC Mainland China and HSBC Middle East, these three divisions will see earnings drop by 25% YoY in 2013. Furthermore, our analysis has found HLA to be under-provided by US$4.5bn and when including shortfalls at HSBC North America and HSBC Europe takes the total group level under-provisioning to US$55bn, 27% of Group market capitalisation.
Reports in the HSBC series so far: HSBC NORTH AMERICA: WELL CAPITALIZED MIRAGE HSBC EUROPE: BLEEDING LIKE AN SIV HSBC GROUP: DIVORCING CHINA

COMPANY REPORT
27 November 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC MIDDLE EAST

SAND TRAP
Although smaller than the Groups other major subsidiaries, HSBC Middle East (HME) has Thomas J. Monaco significantly over-earned by exploiting various low-quality earnings levers which may not be TOM@FORENSICASIA.COM available going forward. Still, this is the primary reason that the overall Group has achieved Gillem Tulloch its only modest performance objectives, and its China1 exit makes meeting future targets GILLEM@FORENSICASIA.COM more difficult. Like Europe2 and the USA3, HME has an enormous level of credit risk which has not been properly provisioned for. The credit quality improvement seen in local Gulf Cooperation Council (GCC) markets from lower rates has now reversed, and due to regulatory arbitrage HMEs larger GCC entities now lack capital to the tune of US$3.0bn, limiting the Group from meaningfully exploiting it further. NOT MANY MORE EARNINGS LEVERS LEFT FOR THE GROUP TO PULL ON HME over-earned to the tune of US$1bn in 2012, by our calculation, reporting a profit of US$606m whereas a loss closer to US$400m would have been more prudent. This level of over-earning accounts for 6.0% of overall Group profits. Having negative loan loss provisions with incredibly weak reserve coverage when the credit cycle has deteriorated is imprudent. Meanwhile, lowquality trading revenues dominate results. Declining F/X and commodity volatility suggest that this revenue line will continue to be less robust going forward. Coupled with Net Interest Margin (NIM) compression and weak loan growth, both HME and HSBC are likely to struggle to meet performance targets. Without HMEs earnings levers, HSBC would more likely have reported core ROEs of 7.9% versus stated core ROEs of 8.4%. FRANCHISE-WORST CREDIT QUALITY Credit quality at HME is weak, and has been since 2H09. By our calculation, Non-Performing Loans (NPLs) amounted to a franchise-worst 16% of total loans end-1H13. In 1H13 HOH, we witnessed a significant negative turn in credit quality the first in four years. The annualised 52% HOH increase in net new NPLs in 1H13 (versus 8.6% for all of 2012) heightens our concern. Economic fundamentals are deteriorating as well. Insufficient policy reform has allowed Dubai to splurge on another round of irresponsible projects. Crude oil-reliant Oman has invested significantly in infrastructure, but a stubbornly high unemployment rate remains a problem. Rapid growth in Qatars Commercial Real Estate (CRE) sector fast resembles the Dubai of old with a 20% office vacancy rate. ADDING MORE WOOD TO THE PILE Weakening loan loss reserve cover, a lack of capital in its local entities, Level 3 assets, etc., lead us to conclude that the stated capital ratios do not tell the entire story. Not nearly as egregious as in Europe or USA, the level of capital forbearance at HME is still fairly significant. At a minimum, we find that the level of questionable assets on HMEs balance sheet amounts to US$3.0bn. However, a large re-cap of HME (unlike Europe and USA) is likely not on the cards because the regulators seem willing to turn a blind eye.

1 2

See HSBC MAINLAND CHINA DIVORCING CHINA report dated July 4, 2013 for more detail. See HSBC EUROPE BLEEDING LIKE AN SIV, report dated April 23, 2013 for more detail. 3 See HSBC NORTH AMERICA WELL CAPITALIZED MIRAGE report dated February 28, 2013 for more detail.

COMPANY REPORT
14 November 2013
Regulated by the SECURITIES AND FUTURES COMMISSION of Hong Kong

HSBC HOLDINGS END OF THE CHARADE

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