Friday’s news that Moody’s had downgraded Co-op Bank’s bonds to junk may be of quite some interest to Right Side readers. Last year, I wrote about the Co-op 5.55% perpetual bond. And until Friday, it had been performing very well indeed. But the body-blow from Moody’s knocked about a third off the price of all Co-op’s bonds.
As I’ll explain, by my reckoning this is a massive overreaction – and it gives us a great opportunity. And while I generally don’t like to question the markets, I do think in this case, it’s not so much that it’s got the wrong end of the stick, as it’s getting completely the wrong end of the tree.
Now, as it happens, I agree with everything in Moody’s analysis – I’ve been through it with a fine-tooth comb over the weekend. But the thing is, as correct as it may be, this report is totally irrelevant.
If you’ll allow me to explain why, you can judge for yourself whether or not the Co-op’s bonds now offer a very nice entry point for anyone willing and able to move quickly.
What Moody’s said
So that there’s no confusion, let me first make it clear that these bonds are nothing to do with any of the Co-op’s retail products you’ll find in store. These are bonds traded in the capital markets; markets where private investors seldom go. And for anyone with cash in the Co-op Bank – again, there’s no need to panic… just make sure you don’t leave anything more than £85,000 with any one financial institution.
Now over to Moody’s; they make three main points.
First, the bank faces significant losses from its portfolio of ‘non-core’ loans – these are essentially commercial real-estate loans. In 2009, the Co-op took over the Britannia building society. I think it’s fair to say the Co-op didn’t do its homework, and it turns out Britannia had made a lot of rather foolhardy loans in the commercial property sector.
Second, the bank hasn’t made enough provision for these souring loans. Basically, the bank has to make an assessment of how much money it may lose on these loans in the future, and begin to write off the value now.
Third, the bank isn’t generating enough money to be able to put things right itself. Now that the Co-op has dropped out of the bid to take on a whole batch of Lloyds branches, Moody’s can’t see them generating enough income to build up a balance sheet strong enough for incoming capital adequacy directives.
My response to this analysis is yes, yes, and yes. But then again, so what?
This is irrelevant
To understand why this analysis is irrelevant, we need to look at the Co-Op’s corporate structure. And here it is…
Now this chart is a little out of date. But it is very useful. Because to understand what’s going on at the Co-op, you need to understand the ownership structure.
The green boxes at the bottom are the financial businesses; note that the Co-op Bank is but one of these businesses. And just to confuse matters, all the financial businesses are owned by another holding company called “Co-operative Banking Group” (the orange box). And that ‘group’ is owned by the Co-op Group. And there’s a reasonable chance that you are a part owner. I mean, there are about eight million members of the Co-op and it runs everything from supermarkets to pharmacies and funeral parlours.
Right, so Moody’s is assessing the robustness of that green box at the bottom on the far right. What they’re saying is that the bank is likely to need some new capital in order to comply with regulatory demands. Further, they can’t see the banking group (remember, the orange box) as having the requisite finance.
Again, Moody’s are very, very likely to be right. But so bloody what? The point is, the ultimate owner, the Co-op Group, most certainly has a bucket-load of capital.
In fact, last year, the Co-op Group lost millions to the bank. Looking (as I have) at the 2012 report and accounts for the group, you’ll see that despite making what they call a “core profit” of £120m, the group lost nearly half a billion on the bank. Oops!
This is a rather sad indictment of mutually owned businesses. I mean, this kind of practice doesn’t go down well in a traditional shareholder democracy. As I’m sure you know, the architects of Lloyds’s dreadful merger with HBOS were made to walk the plank. And as for the Fred Goodwins of this world…
But for this mutual, no such venom. I bet most ‘members’ don’t even know they own this business. And I can’t imagine the annual report and accounts has had many downloads!
I’m sure the directors would much rather Moody’s went away and didn’t make such a fuss and draw attention to this rather sad tale.
The directors would much rather just fund the banking business from the central pot and forget all about the disastrous takeover of Britannia. Heck, the report and accounts says that profit isn’t really the main motivation for this business anyway.
And aside from that, the directors have actually been trying to put things right at the banking group. For a start, the life insurance side of the business (the first green box) is being sold. The general insurance arm (second green box) is up for sale too.
Together, these two sales should bring in enough money to keep the regulators happy. And if not, then the central group may have to put its hand in the members’ collective pocket again.
The bonds offer the brave a very attractive opportunity
Just to re-iterate, Moody’s is right. The bank risks having to seek external support. But ‘external’ support is very, very likely to come from the ultimate owner of the bank – the Co-op Group.
Now, though I make that bold statement, we have to remember that this is supposedly a democratic institution. That means, the ultimate decision rests with some eight million members. Neither I nor Moody’s can say with 100% certainty that the Co-op Group will continue to bail out the bank. And that’s all Moody’s is saying.
But let me put it to you that I am 99.9% sure that the group will not bust the bank.
It seems to me that this mutual is controlled by the board members. And in reality, there’s no established movement to control the board.
That means nobody has to own up to mistakes, and moreover, they can continue to leach money out of the profitable side of the business to prop up the loss-making side.
To say that this bank is weak and, on its own, lacks capital is as correct a statement as it is irrelevant.
Still, it does leave Co-op bonds trading at very attractive levels.
You’ve got to love Moody’s – triple-A ratings on securitised subprime mortgages, and now tarring our most venerable of mutuals with ‘junk’ status.
Before you go rushing in, please remember, this is only my opinion. Be aware that where there’s reward, there’s also risk. Visit the London Stock Exchange’s website if you want more details, see my Co-op bond article as to why I think it’s a good buy… and please don’t skip the risks I highlight at the end of that piece.
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