The rights escape for Lloyds

August 10, 2009

Margaret DoylePeter Thal LarsenTalk about hitting the ground running. Even though he doesn’t formally take charge until next month Win Bischoff, chairman-designate of Lloyds, is reported to be pressing for the bank to raise up to 15 billion pounds through a rights issue and to scale back its participation in the government’s Asset Protection Scheme (APS).

His intentions are to be applauded. But regaining some independence will not come cheap for Lloyds shareholders, and substantial government support will still be needed.

The world has changed since the APS was launched on March 8. It prevented the collapse of the UK banking system, while stopping short of full nationalisation.

At the time, Lloyds agreed to submit assets worth 260 billion pounds — a quarter of its entire loan book — into the scheme. After absorbing the first 25 billion pounds of write-downs on the loans, the government would absorb 90 percent of any further losses.

The fee was 15.6 billion pounds, in the form of ‘B’ shares convertible into ordinary shares at 115 pence. Lloyds shares were around 42 pence at the time, so the terms were extremely generous to the bank.

The crisis passed, and Lloyds shares have more than doubled. Five months on, the bank has a better handle on the losses in its loan book, particularly the disastrous HBOS portfolio which accounted for 80 percent of its 13.4 billion of write-downs in the first half.

Lloyds with St Pauls in backgroundHaving taken what peers consider to be a conservative view of provisions (i.e. a lot), Eric Daniels, Lloyds chief executive, went so far as to predict last week that bad debt charges had peaked.

Meanwhile, the APS has morphed into a bureaucratic monster as the government attempts to review the individual loans. The bank wants to put the worst cases into the APS, which was designed to deal with only the average.

Today, Lloyds could credibly argue that, at more than 40 billion pounds, the all-in cost of the scheme (first loss plus premium) is greater than the losses it is likely to suffer on its legacy loan book.

However, to scrap the scheme altogether needs fresh capital on a scale which the markets will not provide, even in today’s improving climate. The problem is simply too big to be solved at a stroke, while maintaining the capital ratios at the high level demanded by regulators.

Lloyds could not raise the cash it needs to abandon the APS altogether; even a 15 billion pounds fundraising — larger than HSBC’s record offering from earlier this year — would not solve the problem. But a big rights issue could allow it to scale back its participation in the APS.

The government could underwrite the issue, and effectively dictate terms to ensure that its shareholding did not rise too far for comfort. This would allow Bischoff and Daniels to argue that the plan reduces the government’s ongoing involvement in the running of the bank and reduces the possibility of it taking fuller control by the conversion of the new B shares.

A reduced APS could enable Lloyds to negotiate less punitive terms from EU competition commissioner Neelie Kroes in return for receiving state aid.

As Daniels acknowledged last week, Lloyds would still benefit from government support that caps future losses. The government would also receive some compensation for its support to date – without which Lloyds would have failed months ago.

Even so, if Lloyds can persuade shareholders to take on some of the risk that is currently borne by the government, Sir Win could notch up his first victory before he even takes the reins.

(Additional reporting by Peter Thal Larsen; Photo: Reuters/Stefan Wermuth)

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