Is the UK banking sector effectively bust? You would think so, listening to some of the gloomier prognoses around the City. Share prices tell a similar story. Shares in Bradford & Bingley – which last week was forced to restructure its rescue rights issue for a third time after US private-equity firm TPG pulled out of a deal to buy 23% of the mortgage lender – are down 90% so far this year and now trade at around 50% of book value. HBOS, also in the middle of a rights issue, has seen its shares fall more than 70% to 0.6% book value. These valuations only make sense if you assume that the UK is heading for financial Armageddon and multiple bank failures.
There are certainly people around who think this is exactly what lies in store. The bears’ case is fairly straightforward. They worry the banks do not have enough capital to absorb losses heading their way as a result of the housing market crash and likely recession – and they can’t see where the banks can now turn for more capital. To put this problem in perspective, the International Monetary Fund estimates global losses as a result of the subprime crisis could total $1trn. So far, the banking sector has raised about $300bn of fresh equity. Add in about $250bn of bank profits this year, and that still leaves a $550bn shortfall – and that is just to plug existing losses. If the banking system is to start to grow lending again to get the economy moving, it may need to raise even more.
Most obvious external sources of fresh capital have been exhausted. Sovereign wealth funds bailed out Western banks last year, but their investments are now so deep underwater they aren’t up for doing so again. Private equity was also once touted as the banking system’s saviour as it has access to pools of long-term money. But that theory took a knock this week when TPG walked away from B&B.
Finally, banks have tried to recapitalise via rights issues. But with every UK bank now trading below its rights price, investors are refusing to stump up the money. B&B is only going to be able to undertake its latest restructured rights issue thanks to some ferocious arm-twisting by the Financial Services Authority – hardly surprising when you consider B&B has a market capitalisation of £200m but is trying to raise £400m.
The problem is that if banks cannot raise sufficient capital from outside sources, they will be forced to raise it from their own operations. One way is to try flogging assets or spinning off businesses. But that only works if they can sell the assets at decent prices, which looks impossible right now. Another way is to scrap dividends, which arguably banks should have done already. But banks will be loath to upset their shareholders particularly when they need capital.
The banks could also try to raise capital by running down their existing loan books and not writing new business. The snag here is that borrowers aren’t repaying their loans as fast as expected because they can’t refinance, so the banks are stuck with low margin, increasingly risky business, which means profits are likely to start falling. And investors are increasingly spooked that, while it may make sense for individual banks to cut back their new lending, if everybody does it, it could trigger a nasty economic spiral, leading to even greater losses. Given the lack of alternatives, government-led bail-outs may be the only option – in which case, shareholders are likely to get screwed, as Northern Rock shareholders have already found.
Amidst all this gloom, is there any bull case for buying UK banks? Well, there are certainly a few brave investors who think so – and it’s fair to say, they include some smart hedge fund managers. Their argument is that there is very little chance of these banks going bankrupt. The Bank of England has put in place a Special Liquidity Scheme, which should prevent a repeat of Northern Rock. They also argue that most UK banks have better-quality loan books, lower mortgage loan-to-value ratios and – post the latest capital raisings – more than enough capital to survive a recession. They argue that the banks are still profitable and that these profits should absorb future losses, keeping capital ratios high. Finally, they claim that despite the doom and gloom, the economy is fundamentally in better shape than it was in 1990-1992 – the last time banks had to raise new capital: interest rates are low and likely to stay that way and unemployment is not yet rising.
If these bulls are right, some banks are cheap. It’s possible that share prices at many banks have been driven down by trading shenanigans by hedge funds around their rights issues. Certainly any bank that avoids bankruptcy ought, over time, eventually to trade at least at book value. For the very brave – and very patient – that could signal buying opportunities at B&B (LON:BB), HBOS (LON:HBOS), RBS (LON:RBS) and possibly Barclays. The snag is that, thanks to opaque accounting practices, it is very hard for outsiders to know what their loan books are really worth. Much as I admire the bulls I am inclined to be neither brave nor patient.
• Simon Nixon is executive editor of Breakingviews.com.