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.

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.