Turkey of the week: bank with little upside, and plenty of downside

By Paul Hill Nov 13, 2009

Paul Hill

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The big news last week was Lloyds' announcement that it would raise £13.5bn via a deeply discounted rights issue. That should lift its core tier 1 capital ratio (CTCR – defined on page 48) from 6.3% to 8.6%, as well as freeing the bank from the government's Asset Protection Scheme (APS).

Lloyds will also issue £7.5bn of 'contingent bonds' that would automatically convert into shares should the CTCR drop below 5%. However, the question remains of whether its 2.8 million retail investors would be wise to take up their rights.

After buying HBOS back in September 2008, Lloyds is now the country's largest bank. It has a loan book of £683bn, supported by net tangible assets of £25.2bn (worth 92p per share).

CEO Eric Daniels, who master-minded the acquisition, clearly believes the worst is over – he points out that asset write-downs slowed in the third quarter. He also sees UK GDP growing by 1.8% in 2010 and no further falls in commercial or residential property values. He thinks Lloyds can deliver "high single-digit income growth by the end of 2011", and even pay a dividend in 2012.

If he's right, I would value the stock at one times net tangible assets, which, after adjusting for the £2.5bn after-tax APS break fee, gives a pre-rights value of about 84p a share – pretty much in line with today's level.

Lloyds Bank (LSE: LLOY), rated a BUY by Oriel Securities

But I am not as confident. Record low interest rates and £200bn of quantitative easing have not only inflated property and debt markets, but also artificially protected default rates. When the recent stimulus is withdrawn (late 2010 looks likely), asset valuations will plummet again. And worse still, some of Lloyds' numbers are grim.

For instance, at the interims in August, £71bn (or 20.4%) of Lloyds' mortgages were in negative equity (where a loan exceeds the value of a property). If house prices fall by another 10%, £51bn more will be added to that total, with £21bn relating to risky buy-to-let properties.

Further, once the general election is out of the way, politicians will be forced to slash public spending – that will push up unemployment and delinquency rates. And these cut-backs will occur just as all the major lenders are shedding debt, or "deleveraging", perhaps to the tune of £800bn over the next five years. Such a massive loss of credit will surely tip the country back into recession, and torpedo Lloyds' insolvency ratios once more.

I think Lloyds will incur at least another £40bn of write-offs over the next two years – taking its pre-rights net tangible assets down to 50p per share. So, with the stock offering little upside but plenty of downside, it's time to get out. The rights issue is to be priced on 24 November, with the board indicating a level of about 30p per new share.

Recommendation: SELL at 89p

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

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