Employee earnings are set to decline sharply in the investment banking division of RBS.  Future bonuses to be paid in subordinated debt spread over the following 3 years.  Subordinated debt is currently about as popular as a bad smell in a lift.  Hence its even more of a pay cut to be allocated a bonus in sub debt at par when other subordinated bank debt is trading at a big discount to par in the marketplace.  Sub debt has the same downside as equity but no upside as its limited to par. 

Yesterday the Government agreed to pay RBS par for £19 bln of convertible preference shares, which are even further down the capital structure than sub debt.  Technically the RBS B shares are Convertible Non-Cumulative 7% Preference Shares, issued on a 108% conversion premium and automatically callable at 130%; coincidentally the 65 pence call trigger is the same price as the second rights issue of 2008.

RBS will be aiming to buy back the B shares from future retained earnings.  Having 38 bln new shares created is not in the best interests of minority RBS shareholders – so don’t expect RBS shares to trade above 65 pence until all the B shares have been bought back.  RBS would also benefit from buying back subordinated debt in the market if they could buy it back below 50%.  Below this level the profits from cancelling the debt would exceed the Core Tier 1 capital spent on the buyback.  This would therefore be neutral from a Core Tier 1 capital perspective and would also wipe out future coupon payments.  Buying back below 33% would even be neutral from a normal Tier 1 capital perspective.  There are will be even fewer buyers of perpetual subordinated bank debt once they realise that none of this debt will be called until RBS has spent £19 bln of future retained earnings on buying back B shares.

Back to those pressured employees.  We are at the start of a structural change in pay in the marketplace.  More of the company earnings will be retained by shareholders.  This marks the end of the 48% compensation payout ratio.  Will they all leave and go work somewhere else in today’s global marketplace?  A few individuals may leave, especially those whom are already independently wealthy, but for the rest I doubt it as there is nowhere else to go.

In the very long run investment banking will go back to private partnerships as these are the best way of risking capital – when its the partners’ money they pay attention to the risk.  Not quite the same as hedge funds as partnerships are not creaming off 2% of their investors’ money every year come rain or shine.  Boutiques offering corporate finance advice will be set up first as these require little start-up capital.  Risk-taking partnerships will start small and build up their capital by retaining earnings – this will take much longer but at least these partnerships will not bring an economy to its knees if they go bust.

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).

The UK Government’s objective is not to acquire significant stakes in LLOY, HBOS and RBS.  Their objective is to restore market confidence in UK banks by addressing three inter-related areas which have come under the harsh spotlight of the market’s scrutiny.  These areas are :

1.  Do the banks have enough physical cash (or access to such cash) so as to be able to carry on conducting business?

2.  Will the banks be able to refinance their debts when they fall due?

3.  Do the banks have enough capital to be able to withstand likely losses and still remain in business?

The expansion of the Special Liquidity Scheme and the establishment of a Discount window at the Bank of England fully addresses point 1.  The provision of a Government guarantee for their debts provides confidence in a positive answer to point 2.  Point 3 is addressed by the Government underwriting the capital-raising issues announced on 13 October 2008.  There is clearly a hope that given that the banks now have a future, investors will step up to the plate and subscribe for most of the ordinary shares to be issued which will leave the Government with small stakes in the banks which will be sold off in the future (perhaps they will even be bought back by the banks themselves as they will likely be flush with capital in a few years time).  RBS and the enlarged-LLOY are both planning to buy back the Preference shares during 2009 so as to be able to resume paying cash dividends.

A lack of investor confidence that the banks will survive has been the focus of attention.  With this week’s 150bp rate cut by the BoE (such a decisive move is to be applauded), the BoE is well on the way to creating a steeply-positive yield curve which will enable the banks to make lots of profits (against which they can recognise their losses).  The Government has re-engineered confidence in the banks.  It is all over bar the shouting.