If LLOY and RBS manage to drag out their “detailed discussions” with HM Treasury over the exact workings of the Asset Protection Scheme then with luck the UK economy will have recovered to a sufficient extent such that LLOY in particular will be able to avoid ever actually formally signing the documentation and entering the scheme.  LLOY stated in their H1 2009 results that they are ” working with HM Treasury to finalise the detailed terms and conditions and operational mechanics of the Group’s intended participation in the Government’s Asset Protection Scheme. The operation of the scheme and the impact on our business (and the consequential impact on our lending and the wider economy) is complex.  The Group expects to conclude these discussions and agree terms and conditions which are in the interests of shareholders”.

In their recent results LLOY were much more optimistic in their outlook than RBS.  LLOY currently have a Core Tier 1 capital ratio of 6.3% and if the economy recovers they could well generate enough operating earnings to cover future impairments (LLOY commented “impairments in the second half of 2009 are expected to be significantly lower than the first half with progressive reductions thereafter”) and thus survive the FSA’s stress test that Core Tier 1 capital may not fall below 4% over the cycle.  Formally entering the APS would effectively cap LLOY shares at 150 pence for the next few years.

RBS reported a Core Tier 1 capital ratio of 6.4% in their H1 2009 results but look unlikely to escape entering into the APS no matter how V-shaped an economic recovery anyone predicts (RBS commented the “APS is key to RBS’s short-term ability to withstand stressed scenarios, though important issues remain to be confirmed”).  Entering the APS would effectively cap RBS shares at 65 pence for the next few years.

From HMT’s viewpoint, not having to take on the liability of insuring 90% of £235 bln of LLOY future write-offs as well as £305.5 bln of RBS future write-offs is clearly a very desirable outcome so its suits HMT as well to allow the current “detailed APS negotiations” to drag on as long as the economy looks to be recovering.

Never formally enacting the APS would remove very large contingent liabilities from the Government’s balance sheet and the APS would have served its purpose by shoring up confidence in the UK banking sector when it was most needed at zero cost to the tax payer.  Such an outcome would be in the best interests of LLOY’s shareholders (with the Government being the largest shareholder) and would also cause a large jump in the LLOY share price which would present a window of opportunity for the Government to be able to sell some shares in LLOY at a profit for the taxpayer.  One way to play this is via a long LLOY/short RBS money-for-money pairs trade as RBS is not strong enough to get by without the APS.  If the banks give back part of their gains since March then LLOY and RBS should broadly track each other; but if LLOY do wriggle free of the APS then they will substantially outperfom RBS.  In the meantime do not expect an early end to the APS negotiations.

One deliberate side-effect of the Bank of England’s quantitative easing program is that their purchases of bonds will be financed by creating central bank reserves.  Literally the UK banks’ combined reserve accounts at the BoE will be credited with £75 bln (created with a wave of the BoE’s magic wand).  The BoE has decided to go down this path, hoping for the following result:

Lets follow the money (always a useful exercise).  A UK bank (lets assume LLOY as a proxy for the UK banking sector) buys £75 bln of bonds in the marketplace (the BoE has indicated this would comprise £50 bln in gilts and £25 bln in corporate bonds).  Assume further that the gilts are bought from institutional investors and the corporate bonds are newly issued by non-bank UK companies.  LLOY pays for these bonds by handing over its depositor’s cash : £50 bln to the institutions and £25 bln to the companies.  The UK companies have therefore just borrowed £25 bln of term money.  Institutional liquidity has just increased by £50 bln – they will want to reinvest this cash in either more gilts (bought from the Debt Management Office, thereby effectively monetising UK Government debt issuance) or corporate bonds or by buying equities.  Anyone still worried about how the DMO is going to sell the mountain of gilts it needs to shift this year can now rest easy.  However in reality LLOY is acting as an agent for the BoE and so LLOY sells the £75 bln of bonds to the BoE.  The BoE pays for these bonds by crediting LLOY’s reserve account with £75 bln.  The BoE pays the Bank Rate on these reserves (currently 0.5% p.a.) so it is going to make a profit on its holding of bonds.  But what about LLOY?  It is paying its depositors far more than the Bank Rate (Libor is still a shade under 2%) so it will take most of the £75 bln out of its reserve account, leverage it up to, say, £150 bln and lend this out to borrowers (10 year gilts at 3% would do nicely as they eat up little Tier 1 capital – there are £590 bln Gilts outstanding and the DMO is going to be selling new gilts like hot cakes!).  Then LLOY can afford to pay its depositors Libor on their £75 bln and still turn a profit.  In reality Libor is going to trend down towards the Bank Rate at the same time. Whether Gilts are over-valued is a question for the future (the view that Gilts offer return-free risk). In the meantime, has the DMO sold all its gilts yet?