Now that LLOY has wriggled free of the APS and RBS has had no option other than to enter APS, there is uncapped upside in LLOY shares whilst RBS shares still remain effectively capped at 65 pence (due to the terms of the B shares).

Both LLOY and RBS have now sufficiently strengthened their Core Tier 1 capital ratios (to 8.6% and 11.1% respectively) for the market’s focus of attention to turn to recovery possibilities.  RBS have forecast losses for each of the three years 2009, 2010 and 2011 which will eat into their Core Tier 1 capital (and 59 pence NAV) and these losses also imply that RBS will not even start to redeem their outstanding £25.5 bln B shares until 2012 (and then it will probably take RBS at least three years to fully redeem the B shares as they have to be redeemed with fully-taxed profits).  Hence RBS shares are effectively capped at 65 pence until the middle of the next decade because if RBS shares trade above 65 pence then the 7% B-share dividend falls away.  In this case HMT would logically want to convert its B-shares into ords and sell them in the market to realise a profit for the taxpayer.  But £25.5 bln B-shares convert into 51 billion ordinary shares (vs 56.35 bln currently outstanding) and ordinary shareholders will not want to get diluted in this way.  This is a real obstacle in the way of RBS shares progressing above 65 pence anytime over the next 5 years (it is also noteworthy that RBS CEO Stephen Hester’s full £9.6 mln compensation package depends on RBS shares getting to 70 pence).   The only way around the 65 pence cap is for RBS to somehow generate £25.5 bln in Core Tier 1 capital in order to be able to redeem the B shares but launching a rights issue is not the solution as this too will dilute ordinary shareholders (as would a debt-for-equity swap).  RBS may be able to make some money by buying back more of their own debt at a discount but this will only generate a small fraction of the £25.5 bln needed to clear the upside for RBS ordinary shares.  In the meantime RBS are not going bankrupt but RBS shares only become worth buying if they fall back towards their 10 pence low seen in January 2009.

Investors in RBS should switch into LLOY and take up their rights.  There will be plenty of opportunity to bank profits in LLOY and rotate back into RBS over the next 5 years.

As for the other major banks, HSBC are profitable and as a result their Core Tier 1 capital ratio is creeping higher (now 9.0%), but their 80% loan-to-deposit ratio is very conservative.  BARC have recently reported a Core Tier 1 ratio of 8.9% but they seem to be mutating into a global investment bank.  Assuming (for simplicity) the LLOY £13.5 bln rights issue is 1-for-1 at 50 pence, then LLOY post-rights NAV will be approximately 90 pence.  This gives an idea of where LLOY and RBS shares will eventually end up as over the long term bank shares seem to range between 50% and 300% of book value. 

Post Script (7 Dec 2009) : The actual terms of Lloyds’ rights issue were set at 1.34-for-1 at 37 pence.  This results in a Net Asset Value of approximately 73 pence per LLOY share after the rights issue is completed.

There has been much speculation about the prospect of Tesco competing strongly with the existing UK banks as it increases its finance footprint and starts to offer loans to its customers.  Tesco already has stores spread nationwide which could serve as a branch network to the millions of customers who already shop there each week. Last year Tesco also bought out RBS’ 50% stake in their Tesco Personal Finance joint venture which means TSCO now has roughly 6 million accounts and deposits of £4.5 bln.  Today Tesco announced a deal with Fortis whereby the latter will provide motor & household insurance underwriting and claims management with Tesco doing the retail pricing and marketing.

However if we follow the money then the prospect of Tesco crushing the existing UK banks by its entry into the banking market seems less fearsome.  The big question is where is Tesco going to get the money from which it would wish to lend out to its customers?  The Bank of England (which will once again resume its proper role as banking regulator if, as currently seems likely, the Conservatives win the next election) will not allow Tesco to fund its lending via the wholesale markets (this is the business model which got Northern Rock into trouble and the BoE will not allow it to happen again anytime soon), so TSCO is going to have to compete with the rest of the banks for its share of retail deposits.  These retail deposits are highly sought after at the moment as every bank (except HSBC with its loan-to-deposit ratio of 90%) is keenly trying to increase its retail deposits so as to shift their loan-to-deposit ratios down towards 100%.  This is the structural problem in the UK banking sector at the moment – there are not enough customer deposits to go around and so most banks will continue to shrink their loan books.

The implication is Tesco are going to struggle to quickly attract tens of billions of pounds sterling in retail deposits and therefore their capacity to extend loans to customers is going to be limited to how fast they can attract deposits.  As Tesco do not intend to run their banking subsidiary at a loss (and have little experience in assessing credit quality), they are going to grow their banking business relatively slowly.  Calm down dear, its only a supermarket trying its hand at banking.  This is nothing new as the Co-op has been in the banking business since 1872 and announced recently that its customer deposits increased 21% in the first half of 2009.

The other way for Tesco to fast-track its way into banking would be to buy Northern Rock off the UK Government.  However NRK holds deposits of £19.5 bln and has a mortgage book of £66.7 bln.  However although the TSCO-to-buy-NRK deal has been rumoured, Tesco would still face the same problem of how to attract sufficient deposits to pay off the billions which NRK still owes to the BoE.  Also NRK’s loan book is said to be of low quality and questions would arise as to whether Tesco is capable of assessing NRK’s outstanding loan book, as in order to get a deal done, a significant chunk of NRK’s mortgage book would remain with the Government.

The existing UK banks needn’t spend too much time worrying about serious competition from Tesco over the next decade.

Finally the market is acting like it believes LLOY has raised enough capital to see it through this recession.  LLOY shares have rallied since the announcement of its participation in the Government’s Asset Protection Scheme (entailing the issue by LLOY of £15.6 bln in B shares to HMT).  This rally has also been noteworthy in that it is also taking place against the backdrop of a £4 bln rights issue, underwritten by HMT at 38.43 pence (the same 8.5% discount to the prior close as has been used by HMT in underwriting all bank capital raising exercises since Oct 2008).

This indicates that investors believe this rights issue will be the last in the current series for LLOY and that HMT may not end up wearing the whole issue.  Technically a virtuous circle may push LLOY shares higher still as LLOY are currently cum-rights and therefore the further they rally, the more valuable the embedded rights become (especially as there is an over-subscription option).  LLOY gives a new meaning to a fortress-style balance sheet for a bank with a Core Tier 1 capital ratio of 14.5% (JP Morgan used to be described as running a fortress-style balance sheet with an 8% capital ratio).   LLOY management are also sure to know full well which of their assets are most likely to sour and it is these which will be placed into the Asset Protection Scheme.  Hence the higher 6% fee demanded by HMT to insure those assets (ameliorated by LLOY keeping its rights to tax losses).

RBS will have Core Tier 1 capital in excess of 12% after its latest £5 bln rights issue, £19 bln B share issue and participation in the Asset Protection Scheme.

HSBC must be feeling a bit left out.  Previously notable for being the best capitalised UK bank run by Scottish Sensible-types in Hong Kong and London, its recently announced £12.5 bln rights issue will bring its Core Tier 1 capital ratio up to 8.6% (from 7%).

In the end of course it will be the bank whose losses nibble through their capital rather than take great big bites out of their capital which ends up best capitalised once the bank sector as a whole starts making money again.  Only time will tell but BARC’s Fortress (Core Tier 1 capital of 6.7%) is looking more like a sandcastle at the moment and the tide is coming in…in good market conditions asset management companies usually change hands for around 2% of Assets Under Management but BARC will struggle to find a buyer willing to pay anywhere near £4.5 bln for its iShares subsidiary (with £226 bln AUM) in the current market conditions.

Post Script - 8 May 2009 : RBS announced its Core Tier 1 capital ratio will be 12.2% after its entry into the Asset Protection Scheme takes place.

With the changing of the US presidency, the market has been offered a new hope that Obama may be able to soften the depth of the current recession by helping the banks, getting stimulus legislation passed & generally making consumers feel better because they can feel optimistic about the future.  We have no idea whether Obama will be a good president or not, but the US people will naturally tend to hope for the best now that Bush has departed.

As ever in financial markets, this is all about confidence.  In the short term it doesn’t matter whether a US Bad Bank will make things better or not, merely the confidence that it will causes the financials to rally.  Whether the rally eventually holds depends upon how workable the scheme proves to be – there is no point killing the patient by buying dodgy assets off them at such a low price that the writedowns incurred bankrupt the bank.  This is the advantage of insuring suspect loans rather than buying them off the banks.

The evidence that the market is currently using confidence to price banks, rather than some form of expected p/e ratio, can be seen in the performance of BARC (in particular) over the past two weeks.  Its share price plunged over 20% in the last hour of trading a fortnight ago to close at 98p on Friday 16 Jan, below the prior 128p closing low of 20 Nov 2008.  This prompted the BARC Board to pre-announce 2008 earnings of £5.3 bln over the weekend.  The share price duly rallied when it opened the following Monday but this rally petered out quickly and within 2 hours the shares were back down at 100p; they then went on to halve during the rest of the week and closed at 51p on Friday 23 Jan.  The fact that the shares could not sustain a rally and fell to fresh lows after the company announced earnings were going to be better than expected was proof that the market was valuing BARC on confidence, not earnings prospects.  The BARC Board clearly had a re-think over the weekend and published an open letter, clearly spelling out the capacity of BARC to absorb future losses from bad debts without turning to anyone (shareholders, Middle East petro-dollars, the UK Government, etc.) to raise fresh equity capital, and clearly stating that BARC were talking to the Government about insuring some of their loans.  The UK Government’s proposal to provide insurance against dodgy bank assets was key in making the BARC statement believeable, and BARC have doubled in price back up to 100 this week.  The sting in the tail for BARC management is that buried in the detail of the Government’s announcement about providing insurance to banks is a statement about the Government requiring a say in remuneration policy…but I don’t think many people are going to shed a tear about Bob Diamond being paid less than 20 million this year.

 At least we can look at the 44th US President and hope he manages to instil some confidence.

Post Script:  During the week when bank share prices troughed (with BARC around 50p & RBS around 13p) Paulson & Co closed their short position in RBS.  Hats off to them for shorting high, riding the short down through two rights issues and not forgetting to close it near the bottom.