Lloyds rights issue may get banking moving again … but is it a sound investment?

By Ian Fraser

Published: Sunday Herald

Date: November 8th, 2009

Lloyds saddled with Howard; image courtesy of The Sun

The way some newspapers presented it, one might have thought that last Tuesday’s bank bail-out measures were a glorious victory.

Plucky British bankers and politicians had taken on Neelie Kroes and those meddling bureaucrats of Brussels and won, ensuring that great British institutions such as Royal Bank of Scotland and Lloyds Banking Group would be saved for the nation. The whole thing was topped off with some good old-fashioned propaganda about competition being reintroduced to the high street through the revival of names like Williams & Glyn’s and TSB.

That was certainly how Lloyds boss Eric Daniels and his army of well-rewarded advisers wanted us to see this mother of all capital raisings. For the past few weeks, Mr Daniels has been obsessed with extricating Lloyds – which was unwise enough to acquire the disastrous HBOS last September – from the government’s asset protection scheme.

To do this, he first had to persuade the government, the Financial Services Authority (FSA) and the Bank of England that his bank had sufficiently reformed itself that it could be trusted to raise money on the public markets in this way. And after talks with the tripartite authorities, Mr Daniels has convinced them to give Lloyds a clean (-ish) bill of health.

Lloyds’ largely private sector solution certainly has virtues. It enables the bank to sidestep the asset protection scheme, and therefore leaves the bank less susceptible to interference from the UK and EU governments and less prone to enforced disposals than zombie-esque RBS. It also means Lloyds should be able to return to full private ownership than its more damaged peer. For this, Mr Daniels deserves congratulation.

However, despite the presence of 19 investment banks as underwriters, there is no guarantee that Mr Daniels’s audacious “with one bound he was free” plan will win investor approval. Tuesday’s triumphalism was premature.

The £21 billion Lloyds is looking to raise is a truly fabulous sum – five and half times more than HBOS sought in its doomed rights issue last year. To put that into perspective, the sum Mr Daniels is looking to raise (which includes £13.5bn from stock market investors) is nearly as much as Lloyds’ entire £22bn stock market valuation. If Mr Daniels can make this baby fly, he will also have pulled off the largest rights issue in UK stock market history.

Some investors and analysts welcomed the plan, expecting that Lloyds will be able to extract much greater value from its HBOS deal than has been possible so far and reap big benefits from taking a commanding position in the UK savings and mortgage markets.

However, others are more sceptical. Having studied the 241-page prospectus, some investors might perceive little clarity on the bank’s near-term financial prospects.

Others may fear that bad and doubtful debts from the go-go HBOS years will haunt this financial feast like Banquo’s ghost.

HBOS’s disgraced head of corporate banking, Peter Cumming, had a penchant for lending crazy sums to favoured entrepreneurs in frothy sectors such as commercial property and housebuilding at the height of the boom. He also liked to use bank money to acquire hefty equity stakes in their businesses. Investors still don’t know where these toxic time bombs lie.

Lloyds’s finance director, Tim Tookey, told a UBS conference in New York on May 12 that £80bn of the £116bn of corporate lending advanced by Mr Cumming’s unit – a stunning 69% – was outside Lloyds TSB’s risk appetite. To be fair, however, the prospectus does warn investors about such loans, saying: “The potential for rising unemployment and further corporate insolvencies is expected to continue to put pressure on some lending portfolios in the short-term.”

The valuations put on some of equity stakes acquired by Mr Cummings may turn out to be wildly optimistic. Many were acquired at inflated prices, at a time when asset price bubbles were stretched to bursting point – or indeed already popping. At the very least investors have a right to greater clarity.

For example? HBOS paid £27 million for a 40% stake in the Inverness-based builder Tulloch Homes Group in April 2008. How are we know if an ll-judged investment like this has been sufficiently marked down on the Lloyds Banking Group balance sheet? When contacted on this matter, a Lloyds spokesman declined to comment.

The absence of up-to-date accounts for many of the bombed-out property firms and other joint-venture companies that comprise Lloyds’ hideously underperforming equity portfolio accentuates the risk that such assets will be over-valued in the Lloyds Banking Group accounts. At least the prospectus document recognises the risk here, warning investors that such valuations “could be further marked down”.

Then there’s the thorny issue of regulation and possible retribution for past errors. In the prospectus document, Lloyds acknowledges that the reinvented and more frightening FSA may inflict pain on the bottom line. The document says: “Regulatory reviews and investigations may result in enforcement actions and public ­sanction, which could expose the group to an increased risk of litigation.”

The document also warns that the outcomes of any regulatory review, proceeding or complaint against the group or the heritage HBOS group “could have a material adverse effect on the group’s operations and/or financial condition, especially to the extent the scope of any such proceedings expands beyond its original focus”.

Whether this relates to the current FSA inquiry into last year’s HBOS cash calls, or to the notorious BoS Corporate Reading scandal, in which former manager Lynden Scourfield lent up £500m to companies where the bank had installed the “turnaround consultants” Quayside Corporate Services, but yet many of the companies went bust and were unable to repay their loans, I don’t know. But if I was an investor, that uncertainty alone would predispose me to shun this rights issue.

There is no doubt however, that the British economy needs functioning banks. If putting further cash into this particular bank is only way that we can ensure we do have functioning banks, then one just hopes that other investors will be more charitable.

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