<p>The other shoe dropping<br/>While 2008 ushered in a financial-sector meltdown, 2009 will witness the<br/>fallout in the real economy. That means loan losses at the banks, and only<br/>some Taiwanese banks have the capital to weather the storm. Valuations<br/>have rebounded from trough levels but it is too early for a sustained<br/>recovery, particularly as the first wave of bad debts has yet to hit. Focus<br/>on the best franchises and stocks with balance sheets that provide<br/>resilience to losses. Chinatrust is our only remaining BUY.<br/>Positioned for a tough cycle<br/>􀂉 We forecast 4.4% new nonperforming loans (NPLs) as a percentage of total loans<br/>over the next two years versus 3.5-4.0% in the wake of the dot-com bust in 2001.<br/>􀂉 The economy is weaker but Taiwan is now better positioned to avoid credit losses.<br/>􀂉 Low system-wide loan growth, reduced corporate leverage, better management and<br/>a stronger property market all bode well for the economy.<br/>􀂉 Moreover, the government may intervene to prevent the largest defaults.<br/>Sensitivity to rising loan losses<br/>􀂉 While bank balance sheets are stronger than a decade ago, weaker pre-provision<br/>profits mean there is less of a cushion against loan losses.<br/>􀂉 We stress test the banks’ pre-provision profit and capital-adequacy levels.<br/>􀂉 Most banks can take 4-5% loan losses over the next two years without having to<br/>recapitalise, but some may then need new capital to expand.<br/>􀂉 Chinatrust, SinoPac, Yuanta, Fubon and First Financial unlikely to need new equity.<br/>Balance sheets at risk<br/>􀂉 Aggressive loan growth at the banks is a red flag for risk.<br/>􀂉 We also look at who is lending more to companies with weak Altman-Z scores.<br/>􀂉 US lending and corporate bonds are another area of concern.<br/>􀂉 First Financial and Chang Hwa have among the least risky profiles, while SinoPac<br/>and Chinatrust get flagged only for US lending.<br/>Too early for a sustained rally<br/>􀂉 Our forecasts assume big losses in 2009 and depressed earnings through 2010.<br/>􀂉 Low valuations reflect a grim outlook, but it is far too early to buy the sector.<br/>􀂉 We need the other shoe to drop on NPLs before thinking about a sustained shareprice<br/>recovery.<br/>􀂉 With the right combination of pre-provision operating profit (PPOP) and capital<br/>adequacy, Chinatrust is the most resilient to loan losses and is our only sector BUY.</p><p>Contents<br/>Executive summary ............................................................................ 3<br/>Positioned for a tough cycle ............................................................... 5<br/>Sensitivity to rising loan losses ........................................................ 25<br/>Balance sheets at risk ...................................................................... 37<br/>Too early for a sustained rally .......................................................... 58<br/>Appendices<br/>1: Company financials...........................................................................84<br/>2: Altman-Z data ...............................................................................109</p><p></p><p> <br/></p><p></p>