Officially we are still unsure whether or not HSBC (NYSE:HBC) is under investigation over the LIBOR fixing scandal, but given its clout in banking industry it would be safe to assume that it would have been involved in some way or another.  For a system like that to work nearly everyone had to know about it or be involved intimately with it.  Let’s also not forget that HSBC has been under investigation by the U.S. Senate over suspicious money flows, and whether that constitutes money laundering.

In this environment of bank bailouts and scapegoating for the financial crisis it makes it difficult for many to separate our emotions from the numbers and for HSBC the numbers are still very good.  In fact HSBC remains the world's second-largest banking and financial services group and second-largest public company according to a composite measure by Forbes magazine in the world. They are a universal bank, organized into four business groups: Commercial Banking; Global Banking and Markets (investment banking); Retail Banking and Wealth Management (retail banking and consumer finance); and Global Private Banking.

HSBC posted a strong first quarter result this year. Profit before Taxes (PBT) for the quarter was $0.6 billion lower compared with Q1 2011 but operationally PBT increased by US$1.4bn, driven by increased revenues in Global Banking and Markets and Commercial Banking. Also Retail Banking and Wealth Management revenue increased in faster-growing regions. But, lurking on all of the major banks balance sheets is their gross exposure to European sovereign debt (and soon to be U.S. municipal debt, i.e. the bankruptcy of Stockton, CA). 

Greeks Bearing Gifts

If there is one lesson that Greece taught us it is that the notion of net exposure is a dubious one at best.  If the system is over-levered (which it is) to the point where in the case of default the counter-party to the insurance, i.e. the writer of the credit default swap, defaults, then net becomes gross and the whole company can be consumed in a very quick tidal wave of evaporating assets.

For Q1 2012 in Europe, they lost $997 million before taxes compared with a PBT of US$652m in Q1 2012. This was the result of higher adverse movements in credit spreads on the fair value of own debt of US$2.0bn in 1Q12 compared with US$397m in 1Q11. What accounting giveth one quarter it can taketh away the next.  Excluding this, PBT was US$1.0bn in 1Q12 which was 9.8% lower YoY as higher revenues were more than offset by an increase in operating expenses and loan impairment charges.

Don’t think it can happen?  Ask Lehman Brothers. 

As of 31st March 2012 total exposure to sovereign and agency debt of Greece, Ireland, Italy, Portugal and Spain was US $4.4 billion, down from US $4.7 billion on 31st December 2011. But, to reiterate, net exposure in this environment is a mirage.  In addition, they also contributed to the two tranches of the European Central Bank’s (‘ECB’) Long Term Refinancing Operation (‘LTRO’)  on December 2011 and again in February this year with €5.2bn (US$6.7bn) and €0.3bn (US$0.5bn) respectively.

JPMorgan (NYSE:JPM) is in a similar position with respect to the CIO trade that has cost them at least $9 Billion so far and by a number of people’s best guess is the last short left in the Silver pits. HSBC is a major position holder of gold on the COMEX.  With CDS spreads for all of the major banks higher now than they were to start the 2nd quarter this credit quality charge for both banks may be significant again.  In truth, it’s become a prime source of “earnings.”  The potential imposition of position limits may have a serious effect on the structure of that market; putting new upward pressure on the SPDR Gold Trust (AMEX:GLD). 

But, that said, their core Tier I capital adequacy ratio was a healthy 10.4%, nearly rivaling that of the best Singaporean banks.

Expansion Joints

But, back to the numbers, HSBC improved its cost efficiency ratio from 58.7% year over year to 55.5% in Q1 2012. This focus on cost efficiency reduced full time equivalent (‘FTE’) staff by 14,000 YoY and 3,500 quarter to quarter. Since May 2011, total annualized savings reached US$2.0bn.
HSBC completed its merger with Oman International Bank, with the newly-formed entity called HSBC Bank Oman; owning 51% and has injected additional capital from its internal funds into the new company.  Thanks in large part to the acquisitions like these; they now operate in 87 countries, often through subsidiaries with their own governance structures.  HSBC also entered into an agreement to acquire the onshore retail and commercial banking business of Lloyds Banking Group in the United Arab Emirates (‘UAE’).

The Asian Growth Numbers

As big as they are they are faring well in the world’s largest and fastest growing market, China; having outperformed any other foreign bank in the country. It has the largest branch network, with 162 outlets, as well as an array of stakes in Chinese financial firms worth $27 billion at the end of 2010.  It is the capital gains from their Chinese business that have partly offset the shrinking business in America and Europe They have a 19% stake in Bank of Communications, China’s fifth-biggest lender.

In Hong Kong, PBT increased by 21% to US$1.9bn compared with US$1.6bn in 1Q11, driven by higher net interest income from improved deposit spreads, and strong customer lending growth across the business in the first half of 2011. In the Rest of Asia-Pacific, PBT in 1Q12 increased by 24% compared with 1Q11 to US$2.0bn. Net interest income grew due to strong balance sheet growth in the region in 2011, supported by improved liability spreads and increasing commercial and individual account holdings across the region.  Business growth in both Mainland China and Malaysia was especially strong, boast a YoY profit increase for all segments of 43.5% and 31.7% respectively.  Hong Kong and now mainland China represent the HSBC’s stronghold as they continue to expand across Southeast Asia, where they are showing strong account growth in places like Malaysia, Singapore, Vietnam and Indonesia.

However, until there is some form of resolution in Europe and the U.S. to the swirling black hole of sovereign/municipal debt all the gains in Asia will be cancelled out, placing a strong drag on the stock price.  Their growth prospects in China and Asia are good and business is strong but Europe is still a concern until they can extricate themselves from the situation with both their reputation and balance sheet intact.