Hedge funds revisit Lloyds Bank, like Banquo’s ghost

Alasdair Macleod – 28 October 2009

Today, we read that hedge funds are shorting Lloyds Bank shares on the news that the bank is contemplating a rights issue of as much as £25bn. To the management they must be as Banqou’s ghost was to Macbeth.

Current trading conditions for the banks are at first sight benign. We are aware of the contraction in bank lending, which besides lowering related income is almost certain to trigger a rise in defaults over time in mortgages, and credit card loans. We are also aware that bankers bonus’s are up again on the back of strong investment banking business.

In Lloyds’ case, the acquisition of HBOS exposes it to commercial lending, much of which is fundamentally unsound. Against that, the £24.5bn of their mortgage backed securities have recovered some of their value in the market.

The interim statement for June 2009 carried the following health warning, which is worth reciting in full:

“There is a risk that market conditions deteriorate once more leading to a renewed contraction in wholesale funding sources. The key dependencies on successfully funding the Group’s balance sheet include the continued functioning of the money and capital markets at their current levels; the continued access of the Group to central bank and Government sponsored liquidity facilities; limited further deterioration in the Group’s credit ratings; and no significant or sudden withdrawal of deposits resulting in increased reliance on money markets or Government support schemes. In addition, a prolonged economic downturn in the UK may result in greater strain being placed upon the Group’s capital resources.”

Elsewhere, the management say they expect the UK economy to gently recover for the rest of this year and next. However, given that this view parrots the U K Treasury line (his master’s voice) perhaps we should pay more attention to the risk statement.

When considering the down-side, we should look at the capital in the business. The balance sheet total at end-June 2009 was £1,063bn, and the total equity was £35bn. From this, we need to subtract intangibles, which amount to £6.6bn leaving equity of £28.4bn. This is the margin that has to absorb the slings and arrows of outrageous fortune. We are not looking at this as bankers, who will tell you that Tier 1 capital is 6.3% but as insolvency practitioners.

Of course, not all the balance sheet total is risky, and we need to look at those elements that may be. The ones that should be isolated are as follows:

  • Trading and other mark-to-market assets at fair value of £133bn. A 21% fall would wipe out Lloyds’ capital.
  • Gross derivative positions of £52bn. Modest compared with some other banks, but carrying counterparty risk nonetheless.
  • Loans and advances to property companies of £82bn. Remember that commercial property is having a torrid time, HBOS was a crazy lender, and further write-downs are highly likely.
  • Mortgages and personal loans of £416bn. A 7% write-down would eliminate Lloyds’ capital.
  • Lloyds own mortgage securitisations on the books at £149bn, but with a nominal value of £171bn. Is a 13% discount enough?
  • Customer deposits total £429bn, less than half the balance sheet total. Lloyds is dependant on bond issues, commercial paper, the wholesale markets, cash and its own equity to finance the rest. Looks a little like Northern Rock in the good old days.

This can be summarised as an illustration of the risks inherent in high gearing. It is a far cry from the days when a prudent banker would lend less than his deposits “to keep something in reserve”. It is also a far cry from the days when a prudent banker wouldn’t lend more than ten times his own money.

Obviously, we must hope that Lloyds succeeds in its rights issue. But this exercise raises some fundamental points that can be applied to all banks. The first is the difference between regulatory capital requirements and a crude insolvency analysis. Stripping out intangibles, Lloyds is 37 times geared, but the bank shows core Tier1 capital at 6.3%. There is some regulatory drift involved, and in a world where insolvency has to be taken more seriously, this is cause for concern.

The second point derives from the first. The UK blew £1 trillion rescuing Lloyds et al first time round. What will be the cost on the second crisis?

Of course, the optimists who see asset prices continuing their recovery will argue such a crisis is unlikely. But they are ignoring the fact that today’s asset bubble comes from close to zero interest rates, they ignore the Japanese experience, and they ignore the experience of the 1930s, when 1.5% interest rates in America failed to stop 5,000 banks failing between 1930-33. This period spanned the Credit Anstalt crisis of 1931, and the banking panic of 1933, when there was widespread use of bank holidays to forestall bank suspensions.

So history suggests we are not clear of banking crises yet. Banquo’s ghost was an ominous premonition for Macbeth, as may be the return of hedge fund interest in the banks.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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