Should you buy into banks’ rights issues?
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Normally, if you want to raise some money, you call up your bank. Now, apparently, it’s the other way round. Two weeks ago Royal Bank of Scotland (RBS) asked its shareholders for a cool £12bn in Europe's biggest ever rights issue, then last week HBOS (HBOS) rattled the tin for an additional £4bn. And more cash calls could soon be on the way.
What’s going on? Don’t lenders have oodles of money after seemingly declaring records profits year after year?
Well no, actually. Things haven’t gone quite so well in the banking parlours recently. Heavy-duty hits from the US sub-prime mortgage train wreck have hit both balance sheets and revenue accounts, necessitating financial rebuilding. The money markets are still under strain as evidenced by LIBOR – the London interbank offered rates at which banks lend to each other – where the 3-month level is holding more than 0.75% higher than official base rates, showing just how nervous bankers are right now. And with capital ratios under pressure and needing a boost, what better option than scurrying round to the shareholders to ask for a bit of extra cash?
The concept has already found favour with Bank of England Governor Mervyn King, who has already endorsed the theory of bank rights issues, and expects to see others in the near future. So for the two above-mentioned lenders, the timing is probably as good as it could be, and they have at least managed to gain pole position in the cash raising queue.
Here are the details: Royal Bank of Scotland has just admitted a further write-down of £5.9bn and is offering 11 new shares for every 18 existing shares at an issue price of 200p each. Based on the stock price of 365p at Friday’s close, that equates to a current discount of 45%, and a 34% discount to the theoretical ‘ex-rights' price of 302.5p.
HBOS has unveiled a £2.8bn asset mark-down and is offering 2 new shares for every 5 existing shares at 275p. Again, this is a deeply discounted issue. At the current price of 495.5p, the new shares are also being made available at discounts of 45% currently and 36% compared with the theoretical ‘ex-rights’ price of 432.5p.
Shouldn’t the banks be sharing the pain by cutting payouts? Sounds sensible, but they do have to be careful. Don’t forget the source of that rights issue cash. Bank managements don’t want to be biting the hand that feeds them. That said, RBS has already set the trend with the promise of an unspecified dividend cut for the current year while HBOS will also be reducing its payout ratio to 40% from 46%.
So much for the banks…what about their investors? Shareholders are now faced with big decisions about whether to commit further capital to a sector that has underperformed the FTSE All-Share index by almost 21% over the last twelve months. It’s tempting to believe that all the bad news is now discounted within bank share prices and that this salvo of rights issues could signal the low point.
That might be a dangerous assumption. Back to the Bank of England, widely reported recently to have pronounced that the worst of the banking crisis is now behind us. Not quite correct - what the Bank actually said was that perhaps markets have fearfully over-reacted, but that the days of loose credit availability are unlikely to return. And also that for those previously identified “areas of vulnerability” within the economy – commercial property, leveraged businesses and highly indebted households - default risk has increased.
Despite the entirely predictable expression of confidence by current managements in both themselves and the future, there is almost certainly more bad news in the pipeline, as the UK follows the US in experiencing a potential housing market meltdown. What’s more, the banking sector’s less-than-stellar near-term track record hardly provides much future encouragement. RBS in particular has made several recent errors, including the top dollar €72bn paid by its consortium for ABN Amro last year. And ratings monitor Moody's recently suggested that a combination of concerns over volatile capital markets, the size of the write-downs, the ABN Amro integration and more UK economic risk may force a downgrading of the bank's debt.
The likelihood now is that further sizeable amounts of money will be sought by indigent lenders, and therefore plenty more shares will be sluicing around for investors to absorb. That in itself is a recipe for lower stock prices.
For those who do think the credit crisis is nearly over, taking up the rights offers makes a lot of sense. But if a shareholder doesn't want to invest any fresh cash, he or she can sell the new 'nil paid' shares, i.e. after they have been created in 'ex-rights' form but before they have to be paid for. Of course, selling the ‘nil paid’ new shares significantly dilutes that shareholder’s remaining interest in the company. For those who remain cautious about the banking sector, that probably represents the best plan of action.
For more details on the specific rights issues, click here: A short guide to the RBS and HBoS rights issues
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