What does Bradford & Bingley’s £300m rights issue mean for banks?

B&B is the latest UK bank to whip out the begging bowl. Its business model worked fine when house prices were rising - but this is no longer the case...

Bradford & Bingley (BB) has become the latest UK bank to whip out the begging bowl, but don't expect it to be the last.

Following large rights issues from Royal Bank of Scotland and HBoS last month, the Yorkshire-based bank said today that it would sell around £300m of new shares to shareholders in order to shore up its balance sheet.

It's quite a turnaround for the former building society, which only last month said that a rights issue was not on the agenda, indignantly denying press reports that such a move was on the cards. But then, that was before sector giants RBS and HBoS broke the ice, allowing a minnow like B&B to announce a rights issue without panicking its depositors.

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The group will issue 16 new shares for every 25 in existence, priced at 82p a share, a 48% discount to Tuesday's closing price of 158.75p. Its interim dividend will now be paid in shares, though its full-year dividend is still planned to be paid in cash. B&B says the fundraising would raise its Core Tier 1 capital ratio to 9.2%. This sounds comparatively high for the sector, but the FT points out that this level is "needed to give comfort to investors given the bank's specialism in troublesome niches such as buy-to-let and self-cert mortgages."

The fund raising comes as little surprise, despite the earlier denials. In common with other banks, B&B invested in the dodgy assets behind the credit crunch. And the value of those assets fell £13 million in April at B&B, on top of £262 million in earlier losses. Given that B&B is having trouble raising money from more traditional sources, i.e. bank deposits, it's had no option but to go to the market for capital. And it probably won't be the last in the sector.

"With RBS, HBOS and B&B having announced rights (issues), we can no longer discount A&L, Barclays and even Lloyds following suit," analysts at KBW said in a note. Which then raises a question over the sustainability of business models at B&B and banks like it such as Alliance & Leicester.

Alliance & Leicester, like B&B, has been heavily reliant on the housing market, on which it's piggybacked for growth in recent years. As house prices went up, they offered more and more mortgage products to customers. That's no longer the case, and an increase in the number of mortgages going into arrears bodes ill for this part of the business.

Already, A&L is pulling mortgage products from the shelves and hiking interest rates for anyone who doesn't at the very least have a 25% deposit at hand. Indeed, gross lending of £649m in the first four months of 2008 is 34% lower than the same period in 2007, A&L said yesterday.

Hence, the boost in interest the bank is offering to current account holders, with headline grabbing best offers on the High Street (6.5% AER and 12% on current accounts). Yet net customer deposits have fallen 4% at the bank, says James Ferguson, an economist at Pali. What's more, "as a further sign of the deteriorating quality and increased fragility of the business, the net interest margin last year was the lowest for a decade at 1.16%", Ferguson adds. The net interest margin is the difference between the interest banks pay to savers and creditors and the interest it charges borrowers.

To make matters worse, A&L believe it will drop to 1% this year. Ouch. And as they're cutting back mortgage lending and can't seem to raise the money needed from deposit accounts, it looks like a rights issue could be the only option to shore up its capital base.

So where to for A&L and B&B from here? Only last month, JP Morgan analyst Carla Antunes da Silva argued that Alliance & Leicester's and Bradford & Bingley's business models were unsustainable as they would not be able to fund their various products from the wholesale markets. The only option therefore, was for the government to "encourage' some of these smaller/weaker banks to look for strategic partners in order to avoid getting into this type of situation (because the need to raise capital for many of these banks is likely to be simply a question of time)."

A&L and B&B's business model, like Northern Rock's, worked fine when house prices were going up and people were hungry for mortgages. This is no longer the case. Expect both to merge with other banks, or more likely get acquired by a bigger one.

Jody Clarke

Jody studied at the University of Limerick and she has been a senior writer for MoneyWeek for more than 15 years. Jody is experienced in interviewing, for example in her time she has dug into the lives of an ex-M15 agent and quirky business owners who have made millions. Jody’s other areas of expertise include advice on funds, stocks and house prices.