Should you be taking up your entitlements to extra bank shares?  We will use RBS as an example here but the same logic applies to LLOY and HBOS.  An important advantage a private investor has over institutions is that they can take a multi-year view as opposed to worrying about how their performance will look at the next quarter-end.  This analysis is very broad-brush and simplifies much, but then who said investing had to be overly complex.  To rehash a Warren Buffet quote – “If it takes more than elementary maths to understand then don’t bother investing”.  The UK Government decided recently that in order to boost confidence in all UK banks, they should have much higher Core Tier 1 capital ratios than the prevailing 6%-ish levels and that in order for the banks to raise the necessary capital in a hurry the Government would provide the extra capital, if necessary. 

There were approximately 16.5 bln RBS shares outstanding before the UK Government agreed to underwrite a £20 bln capital raising.

£15 bln will be raised by issuing roughly 22.9 bln new shares at 65.50 pence.  The other £5 bln comes from preference shares issued to the UK Government.  Assume that in the next few years, once RBS has made its write-offs and the dust has settled, it gets back to making the £10 bln p.a. that it made in 2006/7 (higher net interest margins will help this profits rebound).  Assume further that it makes a 10% pre-tax return on the £20 bln of new capital it has just raised.  Tax those £12 bln of earnings at 28% and subtract preference dividends of £600 mln (12% on £5bln).  You end up with EPS of 20 pence on 39.4 bln shares.  Bank shares on prospective P/E ratios of approximately 3x are worth tucking in the bottom drawer…take up your entitlements (or buy the shares in the market if they are trading below the subscription price).

This describes the situation whereby a share price gets attracted towards at a particular level at which there are lots of options struck which are shortly due to expire.

A good example is RBS in its current capital raising which is set at 65.50 pence (the “Strike price”).  The UK Government has agreed to buy any shares that are not bought by other investors.  Shareholders are entitled to buy shares at the strike price (their “entitlement”) and have to pay for them on 25 Nov 2008 (the “pay date”).  This creates a situation where an investor who fully intends to subscribe for their entitlement can buy those shares in the market before the pay date if the share price falls below the strike price (RBS shares have often dipped below 65.50 pence since their capital raising was announced on 13 Oct 2008).  If RBS shares then rally above the strike price, the investor can sell the shares they bought lower down, safe in the knowledge that they can take up their entitlement and replace them at the strike price.  This process can be performed ad infinitum until the option expires on the pay date.

In reality what happens is that RBS shares trade very close to (get “pinned to”) the strike price, especially as we get the nearer the pay date, so as to prevent these ‘risk-free’ profits being extracted from the market by investors who fully intend to take up their entitlements.  The pinning situation disappears after pay date and a support/resistance level is left at the strike price in its place.  Pinning happens less often in traditional rights issues because many big market participants are already on the hook to purchase stock having already underwritten the rights issue.  In the current RBS example this is not the case because the Government has underwritten the stock placement.