John Hemming's Web Log John's Reference Website
Saturday, October 18, 2008
  The UK Banking Rescue - Investment commentary
I want to have a more detailed look at the proposals for the UK banking rescue.

Firstly this is based upon the system used in Sweden. It was, in fact, the Liberal Democrats that proposed this first. The idea for the equity is that the government underwrites a rights issue. A rights issue is where people who already hold shares are allowed to buy more at a cheaper price than they originally bought.

If they decide not to put any more money in then the underwriter buys the shares. The underwriter charges a fee. In this case the underwriter is the government.

The question, of course, is the price of the rights issue. For RBS the current price is around 68p. It is difficult to find published figures as to the rights price, but a broker I know believes it is 65p.

The other thing the government is doing is putting in some subordinated debt. The point about such debt is that it is more secure than equity. In the UK they are charging a rate of 12% whereas in the US it is 5-6% (figures from newspapers).

Actually I think the UK approach is right. Taking RBS again this would involve the £5bn of debt getting £600m interest a year.

Firstly if you start with the RBS profit of £9bn (or so) that is not that much. Secondly, it encourages private sector finance to replace the government finance (actually almost immediately unless you believe that the company is going bust).

Look at it from the investors point of view. If you invest in these bonds at say 11% it pays better than even the Icelandic banks. Your only problem is if the bank goes bust, but it is clear that this won't happen. The interst charge is not actually that painful to the bank.

So we now have say £8bn of operating profit (apart from any exceptional losses).
This works out at about 90p per share.

So we now have the shares at 65p. The governent is going for a rights issue that could give 60% to the government. So that is 1 1/2 times 65p. Viz near enough £1.

So if you buy a share at 65p and pay £1 you have 90p of profit.

Realistically on a "going forwards" basis a bank should trade on a price earnings ratio of at least 10 which gives a price for this "share" of £9. So if you buy a share now and then pay the rights you get a share of £1.65 which is worth £9 (over time).

That's at the rights price. This gives a potential gain over time of more than 5 times.

That is why I would be surprised if the rights issue is not mainly taken up by private investors. I would also be surprised if private investors don't replace the government's planned debentures/preferntial shares/bonds (whatever you want to call them).

So. If that is the logic you would say why don't you put your money where your mouth is. Well, I have and mainly at 63p. Someone has to show confidence in the UK market. It matters to a lot of people mainly through pensions etc.

Peak Oil as an economic issue remains important. There will be a quite a few "exceptionals" as a result of property over valuation, but confidence should have been restored to the banking market at least.
 
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