13th August 2009
Surprisingly good news from UK banks
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Welcome to this week's edition of Events Trader. In this issue we will analyze and discuss the results for RBS and Lloyds and I will tip a few more Tier1 securities that still offer decent returns over the long term.
I still believe these securities have one of the best risk/reward profiles around, and unless we have a second banking crisis - a very unlikely event in my view - they offer some great returns.
Lloyds better than expected
Lloyds reported a pro forma loss of £4bn for the six-month period ending 30th June 2009. This included asset write-down hits ("impairment charges") of £13.4bn. But strip these out and the bank made an operating profit.
However these results from Lloyds were blurred somewhat by a £11.2bn "negative goodwill gain associated with the purchase of HBOS" which pushed the reported pre-tax earnings to £6bn. But investors can take some comfort from the fact that no major new threats emerged from the latest press release.
More positively, the chairman stated that future impairment charges should fall as the economy improves. This news was enough to spark a rally in the shares.
Lloyds might even try to raise £15bn of shares to avoid using the asset protection scheme set up by the government. If such a rights issue goes ahead which is far from certain it would not be great for existing shareholders who would face having their holdings diluted if they don't take up their rights. However it could be pretty good news for the holders of Tier1 capital. That's because with additional equity capital the bank will be less risky.
RBS off the critical list?
RBS reported a net loss of £1.04bn for the 6 months ending on the 30th June 2009, disappointing the markets, which had expected a profit of £1.1bn. Worse, non-performing and problem loans have tripled to £31bn or 5.1% of the loan book.
Among the more positive news was the fact that the bank reduced the size of its asset impairments from £2.2trn to £1.6trn. Another positive was that 70% of the losses came from part of the bank that are earmarked for disposal. But the best news of all was the £6.3bn of operating profit boost from favourable conditions in the investment banking unit that allowed the bank to set aside £7.5bn in write downs.
These results still confirm that RBS is the sickest of the big UK banks, but also that it is not in a critical condition anymore. The new CEO Stephen Hester - forecast two more lean years, but providing we do not enter a second dip of the same magnitude as the recent one the bank should be able to survive and more important continue to pay the coupon on the tier1 bonds.
One area to watch with RBS is the fact that, unlike Lloyds, it has a lot more exposure in commercial and wholesale banking. At the peak of the market RBS was also one of the more enthusiastic financiers of leveraged (debt-financed) buyouts - for example it had exposure to Lyondell Basel, a bankrupt chemical company plus Yell and Seat Paine Gale, two highly leveraged providers of yellow pages directory. This could come back to haunt it if the economy stagnates.
All in all these results from two of our biggest banks were not as bad as people feared. Two points in particular are worth emphasising. The first is that most of the impairments in Lloyds and RBS were related to loans that will be covered by the asset protection scheme implemented by the UK government. Under this scheme the banks will be responsible for the first 10% of any loss with the rest being borne by the UK government. This means that no further write-downs should be necessary on these problem loans going forward.
The second point is it looks as though the banks will be able to earn their way out of this crisis. All banks (with the exception of RBS) reported operating profit gains before write-downs. That means that unless the economy sinks further, more government capital injections should be avoided.
A useful accounting trick
Do you know what happens when a company issues a bond that subsequently plummets in value to a fraction of its face value and is then bought back by the same company?
Let's suppose that a bank issues £100m in bonds. Accounting rules require it to record a liability for the amount of the bond in issue on the balance sheet and cash for the same amount on the asset side.
Even if the bonds then drops in price to lets say 20% of face value, the bank may still carry the same £100m liability on the balance sheet whilst the bonds are in issue.
However should the bank decide to buy it back at 20% of face value, or £20m, those same accounting principles allow it to cancel the £100m liability for an outlay of £20m and book a profit of £80m. Seem strange?
Well actually many people do the opposite every day - they buy things for say £10, sell them later for £15 and book a profit of £5. This is just the reverse - the bank sells debt for £100, buys it backs later for £20 and it books the £80 in profit.
This accounting trick has a major implication for the bank: the profit that is generated counts towards core tier 1 capital. Meanwhile the original Tier 1 bonds being bought back would only have counted as non-core tier 1 capital and are regarded by regulators as a weaker form of loss absorbing buffer.
So this little trick allows the banks not only boost their bottom line but also replace a weak form of Tier 1 capital with a stronger type.
This accounting trick has also a major impact for investors - for as long as these tier 1 securities trade at a sizeable discount to their face value, banks will have an interest in buying them back and cancelling them. This should support the price of these instruments or even push them higher for holders. And in nearly all the results published this week by the major UK banks, you could find a reference to some profit booked by the bank while repurchasing these type of instruments.
Investment opportunities
Remember that these securities are senior to common equity, meaning that before your tier 1 stock takes any losses all the ordinary shareholders (including the government) will have to be wiped out. However in the event of a nationalization of an insolvent bank, this Tier 1 will bear significant losses and could be wiped out as well.
There are hundreds of Tier 1 issued by various banks, and the right one will depend on your personal circumstances and the time horizon for your investment. Some large bid offer spreads mean I would advise people to hold them until maturity. I include an indicative list of some of the more interesting ones issued by UK banks, available to download here.
All of these Tier 1 can be purchased through any major online broker and have minimum size of £1000. It's best to check the latest best price on Bloomberg or Reuters before dealing as prices are quoted by a number of different banks. This way you will ensure that your broker tries to deal with the bank displaying the best quote.
You should be able to deal at that price for sizes of £10,000 or more, but sometimes for smaller sizes a bank will quote a price that can be 2 or 3 points higher. Do not worry, as even with the higher price they are still a good investment.
Also please refer to my earlier piece on Tier 1 securities (Issue 2) as it includes some more information on this.
As usual I welcome your feedback on eventstrader@f-s-p.co.uk.
Riccardo Marzi
Events Trader
Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.
Figures are calculated using the closing mid-prices on the date on which shares are first recommended. All gains are gross, and returns will be affected by dividend payments, dealing costs and taxes. Past performance and forecasts are not reliable indicators of future results.
Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Editors or contributors may have an interest in shares recommended.
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