True cost of toxic assets

To help clean up British financials, the government has launched an Asset Protection Scheme to secure banks from bad debts from past loans. But just how much will this cost the taxpayer, asks Abigail Montrose, and is it enough?

British banks are in a real mess. In recent weeks, the core banks have recorded breath­­taking losses and the government was forced to step in again to help bail them out. The latest attempt is using its Asset Protection Scheme, which enables banks to insure themselves against potential losses from past loans.

While the government has made it clear it will not allow British banks to go to the wall, the cost of shoring them up has resulted in further state ownership. The question now is how much more is needed and how much will insuring the banks’ toxic assets cost the taxpayer?

With so much uncertainty, it is little wonder investors are steering clear of financials. But finding safe havens in the British financials sector has not been easy for some time, although there are some bright spots.

Many non-life insurers have avoided the worst of the meltdown and several other financials are once again being eyed with interest. Among financials funds, those which concentrated on these areas and kept significant cash holdings, were least hard hit. For example, Jupiter Financial Opportunities posted an impressive 4.6% rise over 12 months to February 23, thanks to having about a third of its assets in cash.

Banks make up the lion’s share of the British financials sector and were worst affected. During 2008 it became clear that British banks were more overleveraged than thought. Just 18 months ago it would have seemed fantastic to think of the government stepping in to rescue the banking system.

In the past 12 months we saw Northern Rock and Bradford & Bingley nationalised and HBOS taken over by Lloyds. The government now owns at least 75% of Royal Bank of Scotland (RBS) and Lloyds is more than 50% state-owned. Bank share prices have collapsed, with Barclays, Lloyds and RBS down by up to 90% on the year, depending on which day you look.

Uncertainty is rife. There is uncertainty about the underlying value of the banks’ assets and about the ability of customers to service their debts. Confidence has collapsed and fund managers have sharply reduced their exposure to Britain’s core banks.

Lloyds TSB was not so long ago an attractive proposition says Chris White, director of UK income funds at Threadneedle. But he decided to pull out when it announced its takeover of HBOS. “At the start of 2008 we wanted to be in strong UK banks such as HSBC, Lloyds and Standard Chartered. But we reduced our exposure to Lloyds over the year because we were concerned over its capital ratio. The final straw was when it took over HBOS and took on its mortgage book, which was of poor quality. About 25% of its book was in buy-to-let and self-certified mortgages,” he says.

The government has ploughed billions into the ba­nking system to help with liquidity and strengthen the banks’ balance sheets. The concern now is how much further nationalisation will go, says Tim Gibbens, a global financials analyst at Alliance Trust.

“If macroeconomic conditions continue to deteriorate at the current rates, nationalisation may be the only option and this would wipe out any value for equity holders,” he says.

Richard Hunter, the head of UK equities at stockbroker Hargreaves Lansdown echoes this view. “Until the nationalisation issue is put to bed, and until dividends are resumed, the market view is that there is little reason to be buying bank shares at the current time,” he says.

HSBC and Standard Chartered, sometimes called the Asian banks, have fared better than the core British banks. However, their share prices have also been hard hit, says John Yakas, the manager of the Hiscox European Financial and Hiscox Insurance Portfolio funds.

Yakas says: “We have held on to HSBC and Standard Chartered because, although these have UK businesses, they are also driven by other issues. They have significantly out­performed the rest of the sector. The appeal of Standard Chartered, and to a lesser degree HSBC, is that you
can buy into a balance sheet that is much less geared up than Barclays or Lloyds. You have to remember that in terms of their finances, a lot of Asian countries are in much better shape to boost growth.”

To help improve its balance sheet, HSBC has announced a £12.5 billion rights issue. Rather than going cap-in-hand to the government for money, it hopes to raise cash from its British shareholders by offering just over five billion shares at 254p each, which is 48% lower than its closing price of 491.25p on February 27.

Ian Henderson, the manager of the JP Morgan Global Financials fund, is looking overseas for value in banks. He has reduced his weighting in British banks over the year from 20% to 12%, and has just 2% of this in Lloyds and Barclays and nothing in RBS. But he has kept his exposure to HSBC, Standard Chartered, Chinese banks and other emerging market banks.

“The difference is that in the emerging world the loan-to-deposits ratio of most banks is less than one. Whereas in the UK it has been 170. This means the deposit base for these banks has been sufficient to fund the lending practices of the banks, so they have not had to go to the interbank market,” he says.

Life insurers have also been badly hit, although not as much as banks. The main concern is their solvency ratios. These are the regulated amounts of capital insurers must have to back their businesses. As these insurers are heavily-invested in equities and bonds, their fortunes are closely aligned with the stockmarket.

But just how badly they have been affected is hard to tell because they are opaque, making it hard to get a clear picture of what their underlying business is like, says Threadneedle’s White. “You have to take a view on the underlying quality of their investments based on their books. We know they hold bonds and equities, but we’re not sure which, or the types, or how they will perform,” he says.

Concerns over solvency ratios, coupled with worries over whether insurers will be able to pay their dividends, has resulted in fund managers reducing their holdings in these stocks. In the year to February 25, 2009, the FTSE All-Share Life Insurance index fell 52%. In stark contrast, the FTSE All-Share Non-Life Insurance index managed to chalk up a 1% gain.

The non-life insurance sector was one of the few safe havens throughout the financial crisis. These stocks are more defensive and have enjoyed a better pricing environment. They also have better balance sheets because they have lower exposure to equity markets. These insurers cannot risk investing in complex financial instruments as they always need funds readily available to pay claims quickly.

The demise of AIG has also helped some Lloyds insurers and, along with the Hurricane Ike disaster, this had led to a huge supply shock in terms of capital in the non-life sector, says James Lowen, the manager of JO Hambro Capital Management’s Equity Income fund. His portfolio has more than 30% of its assets in financials, with most of his overweighting in non-life insurers.

“Pricing is going through the roof. This is the only sector this year which will see an increase in its return on equity and that’s why these stocks are moving aggressively higher. They outperformed by 35% last year and will continue to do well this year,” he predicts.

“All the non-life companies we’ve got, basically the Lloyds insurers and Royal Sun Alliance, have vanilla balance sheets and are free of all the issues affecting the banking sector and the toxic assets that have affected the equivalent insurance sector in the US.”

Despite the increasing popularity of this sub-sector, Lowen remains confident there is money to be made. He points to the asset bases of these stocks, which are dollar-denominated and says the dollar has basically offset the re-rating of the equity performance, so they are still cheap.

“If you look at Amlin, Hiscox or Omega, the dollar sterling trough has favoured the asset bases of these companies. The price-to-book, which is the key valuation measure here, has not moved higher. If you were to look at the price-to-book of these Lloyds insurers over the last 20 years, they are still near their lowest point,” he says.

Non-life insurers also benefit from being more easily understandable than life insurers, says Jonathan Fieldsend, the manager of the Elite EEA UK Financials fund. “The Lloyds insurers have the simplest balance sheets. For example, if there’s a hurricane and some ships sink, the only question is how much will it cost. Whereas life insurers have complex actuarials and reserves, which may be from 100 years ago or more” he says.

Real estate is another area attracting attention. A lot of the quoted property sector looks quite distressed and there have been a number of defensive rights issues from the likes of Hammerson and British Land to bolster balance sheets.

The sector has fallen a long way and opportunities are starting to appear, says White. He points out that the sector is sometimes regarded as a bond proxy because when corporate bonds do well, it does well. “I like corporate bonds at the moment because interest rates are low at 1% and 10-year gilt yields are at 4%. So if you can pick up high-quality properties on yields at 7%, 8% or higher, then that looks reasonably attractive,” he says.

Lowen is also looking at property. He expects commercial property prices to continue falling this year, but where firms have been fund raising via rights issues, the risk of a covenant breach or a balance sheet problem is eradicated.
“If you build in a 15% to 20% fall in prices this year post fundraising, they will still be trading at a significant
discount. Because of Reits [real-estate investment trusts] legislation all of these stocks have to pay out 90% of their income in dividends, so dividend yields on stocks such as British Land, which recently had its rights issue,
is 7.5%.

“So if you have a balance sheet made secure even on a worse-case scenario of a 20% fall, a material discount trough NAV [net asset value] and you have an ongoing dividend of 7.5%, that starts to look quite an attractive investment case,” he says.

An added attraction with British Land is that it has debt facilities fixed for 10 years, which means it will be able to buy property while the market is cheap, says Lowen.
Other financials are also attracting attention. Lowen bought into Henderson at the start of February when the stock was priced at 55p and yielding 10%. Since then the company has acquired New Star and announced a 15% cut in its cost base. This should result in a significant upgrade, he says.

He also likes Provident Financial, which is a doorstep lender with a 65% market share. Two years ago Lehman Brothers tried to compete with Provident, but following the demise of Lehmans, Provident now has no competition. The stock is riding high, prompting Lowen to take profits.
Other financial companies with interesting valuations and offering good dividends include mutual insurer and loss adjuster Charles Taylor, investment manager Brewin Dolphin, fund managers Aberdeen and the buy-to-let mortgage specialist Paragon, says Fieldsend.

“There are many firms paying good dividends that are not under any pressure to cut them. If you look on an earnings basis, you can find lots of companies that are on six, seven or eight times earnings,” he says.

The outlook for financials remains uncertain. Banks will be the big concern but, with the recent reporting round over, we should have a clearer picture says Fieldsend.“We are now in a reasonably good position to know the extent of the damage, where the problems are and how big they are. We also know the government is doing its best to make sure the banks don’t fail,” he says.

While things may get worse before they get better, no one doubts the need for a strong banking system.

“Lloyds and RBS have been wiped out and their reserves devastated by what’s gone on. But if you walk down the high street, you will still see a NatWest or a Lloyds and they will take your deposits and lend money, so there’s a business there. Our call is to see through the noise caused by the problems of reckless lending in various parts of the banking sector and work out what we think the core banks are worth,” says Fieldsend.

The newsflow is mostly negative. But there are those who think the tide is turning. For example, Lansdowne Partners, one of Britain’s largest and most successful hedge funds, recently told its investors it now believes the British banking sector is undervalued. It has cashed in its short-selling position on Barclays, which it is thought to have made £100m on in the past two years, and no longer has a negative view on the bank.

As the year progresses, the situation should become clearer, but until there is some stability in the economy, it will be a bumpy ride. So has the stockmarket reached rock bottom yet? No one knows, but there is a belief that we could hit the nadir in the middle of the year, with recovery being priced in at the start of next year. An improvement in the stockmarket is likely to flag a recovery in the economy.

British banking crisis timeline

February 17 – Northern Rock is nationalised.

April 22 – Royal Bank of Scotland (RBS) announces a £12 billion rights issue. It also reveals a write-down of £5.9 billion on the value of its investments between April and June – the largest write-down for a British bank.

June 25 – Barclays unveils a £4.5 billion share issue.

August 29 – Bradford & Bingley posts losses of £26.7m for the first half of 2008.

September 17 – Lloyds TSB agrees to take over Britain’s largest mortgage lender HBOS, after a run on HBOS’s shares. The £12 billion all-share deal is facilitated by the government and means the Lloyds banking group will hold about one-third of Britain’s savings and mortgage market.

September 29 – Bradford & Bingley nationalised. The Treasury is to take over its £50 billion mortgage book and the rest of the business is sold to Santander.

October 8 – The government releases details of a rescue plan for the banking system worth at least £50 billion.

October 13 – The state pumps £37 billion into RBS, Lloyds TSB and HBOS in return for equity in each of the banks.

November 28 – The government increases its stake in RBS to 58%, following the rejection of its share offer by shareholders.

January 19 – A second bank rescue plan is launched by the government. One of the provisions is to offer banks insurance against toxic asset losses and guarantee their debts via the Asset Protection Scheme.

February 9 – Barclays reports pre-tax profits of £6.08 billion for 2008, which is 14% down on the previous year.

February 26 – RBS is to insure £325 billion of its toxic assets in the Asset Protection Scheme. This follows news that RBS made losses of £24.1 billion for 2008, the largest annual loss in British corporate history. RBS is to receive a capital injection of £25.5 billion from the government, taking its stake in the bank to a potential 95% if it converts these B shares into ordinary shares.

February 27 – The Lloyds banking group reveals pre-tax losses of £10.8 billion in 2008 for HBOS, which it merged with in January. Meanwhile, Lloyds TSB profits plunged 80% in 2008 to £807m. Lloyds is in talks with the Treasury about insuring its toxic assets with the new Asset Protection Scheme.

March 2 – HSBC announces a £12.5 billion rights issue in Britain to help shore up its balance sheet. The cash call accompanies news that the bank saw its pre-tax profits in 2008 fall 62% on the previous year to £6.5 billion.

Asset protection scheme

The Asset Protection Scheme is a government insurance scheme designed to clean up the balance sheets of banks.

Operation Broom, as it is also known, enables banks to insure their most risky loans against potential losses. The government hopes the scheme will restore confidence in the banking sector as it removes uncertainty about potential losses from these toxic assets. It also aims to increase liquidity as participating banks must make a legal commitment to raise their lending.

The scheme was first announced on January 19 and is open to all big British banks and British subsidiaries of foreign banks. Royal Bank of Scotland (RBS) was the first bank to sign up on February 26, following news of its record-breaking £24.1 billion losses last year.
The terms negotiated between RBS and the Treasury seem generous.

RBS has insured £325 billion of its toxic assets over its lifetime for a fee of £6.5 billion in non-voting equity, which equates to just 2%. If the loans go bad, RBS pays the first £19.5 billion of losses and after that the government will cover 90% of the remaining loss and RBS 10%.

As well as the 2% fee, RBS will not offset its losses against tax, which effectively raises the cost of the scheme to 4%. RBS has also agreed to increase its lending by £25 billion.

This deal reduces the likelihood of the bank being nationalised, says Richard Hunter, the head of UK equities at stockbrokers Hargreaves Lansdown. “The risk of RBS being nationalised has now receded following the government’s latest cash injection and its decision to insure RBS’s toxic assets,” he says.

The Asset Protection Scheme also allows RBS to allocate lower risk weightings to its most toxic loans, which eases pressure on its capital ratios.

At the time of writing, Lloyds is in talks with the Treasury about joining the scheme and Barclays is expected to follow suit, once it sees the deal brokered by Lloyds.

Performance of financials