Neil Dwane comments on the Bank of England’s debt market plan and Royal Bank of Scotland’s (RBS) rights issue
“A Faustian bargain has clearly been struck in the USA and the UK. No more forced bankrupt takeovers or nationalisations and nearly all the liquidity you need, but existing shareholders must suffer through dilutive rights issues and dividend cuts.
“Since last summer, we have lived with the triple axes of deleveraging, constraints on capital after the boom of balance sheet expansion, and a liquidity crisis. Slowly politicians, regulators and now banks are prepared to face the necessary solutions. Deleveraging must occur and keep occurring as most financials are ludicrously leveraged. However, the markets need an orderly process; hence we now see more use of mark-to-myth Level 3 assets in the USA and a common recognition that the ABX and ITRAXX indices are overreflecting the level of ultimate bad debts. Constraints on capital remain powerful and after many burnt fingers at several of the sovereign wealth funds, management now realise that there is not a quick fix and that the old uber-leveraged balance sheet model needs more capital. To facilitate both objectives, the markets need liquidity, something that the ECB recognised on day 1 but which the US Federal Reserve and yesterday the Bank of England reacted to, as well.
“Why now? Well, as we know in the USA housing has already fallen over 10% and looks set to fall further whilst the signs are now emerging in the UK that mortgage problems are affecting the UK housing market after all. Will these new Bank of England policies help? Well, yes they will eventually but mainly because the UK banks were one of the largest borrowers from the global money markets and as confidence in the UK and sterling has fallen, so has the banking industry’s ability to source funds to lend on; obviously, what is being lent is more costly, so prices to end consumers are rising, which will also undermine the UK consumer who is already paying record %s of after-tax income on home interest related costs. In the USA, the failure of Bear Stearns has saved the other investment banks, but little has saved the housing market yet. We expect further falls in housing and in consumer spending.
“What have we learnt from the announcement of a massive RBS rights issue? That this is an entire company Board in denial, who six weeks ago raised the final dividend! Nothing has changed. Their financial situation was dire then and it is indeed dire today. Provisions have been taken which do look prudent in most areas, but why back a management who should have been anticipating much of this, relentlessly pursued a now utterly stupid acquisition and is now seeking to sell the best capital returning parts (insurance) to fund a recently acquired mediocre bank. Oh and not to forget cutting the dividend and paying it in scrip shares. Indeed, if a real recession hits the USA and the UK, they have not raised enough new capital...and there has been no management change.
“Where we go from here is clear. The banking crisis is now producing real economic pain and lower interest rates must play a part in alleviating this. Many consumers will be forced to save more as credit is constrained and many will be unable to access credit. The right lending standards will have been reapplied before the mythical days of securitisation. Governments and regulators will demand greater oversight and by RBS's admission, new capital will earn lower returns. The plight of the industry also remains closely tied to the value of the collateral. For most of us that is our homes. If the UK follows the USA into a retrenchment of property values, then further bad debts will accrue to the banks as in any normal cyclical downturn. Consumers in the West have benefited from the disinflation exported from China and Asia, but with food and commodity prices strong, this process is at an end.
“Many banks, both pre or post refinancing, are yielding 7% to 9% and at one and a half times book value, this seems cheap, but so did Barclays in 1992. Thus it is our judgement at RCM that there is no rush into bank shares nor property shares as the real economic slowdown is still unfolding and many more rescue rights issues are on their way. However, there are attractive financials that offer exposure to growing economies and underbanked economies of Eastern Europe and Asia, like Standard Chartered and the Prudential.”
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