Uncharted Territory

October 31, 2009

The Grandmother Of All Stealth Taxes

Filed under: Credit crisis, Economics, Media, Moral hazard, Rights issues — Tim Joslin @ 9:19 am

As the nights were drawing in this time last year I detailed how the UK’s “bailout” of the banks is in fact the Mother Of All Stealth Taxes. Well, I underestimated the greed of our politicians.

In March this year the government had obviously not yet done a good enough job of convincing the world’s speculators that the UK financial system was safe. They therefore proposed an insurance scheme in case Lloyds’ losses on specific assets (some £260bn worth, mostly commercial property and mostly acquired when Lloyds took over HBoS) amounted to more than £25bn. For this insurance scheme Lloyds would be required to pay a notional amount of £15.6bn in shares as I described at the time.

I say the amount is notional, because no-one knows what the shares would have been worth in the future. Presumably existing shareholders think the shares are worth more than their current price or they would sell them. Furthermore, the price of the shares granted for the insurance scheme was set when the bank was in difficulty. Since pre-emption rights of existing shareholders (i.e. their right to buy shares on the same terms as the new investment in the bank) were not respected we have no way of knowing how many would have bought shares on the same terms as the UK’s Treasury was offering.

Since Lloyds would have to incur losses of £(25+15.6) = £40bn or so before it even broke even on the deal, their executives started looking into ways to make themselves strong enough to insure themselves against these potential losses. The situation is not straightforward, but Lloyds’ management must have considered that they could manage the assets to incur less than £40bn in losses.

Lloyds now believes it can raise enough money by selling new shares to existing shareholders and issuing some bonds (mandatorily convertible to shares in certain circumstances, I gather) to insure itself, which is, after all, a large part of what banks do.

But as is being widely reported, the Government is demanding a £2.5bn break fee. This has no logical justification whatsoever.

The febrile media reaction to the banks is typified by Dan Roberts in the Guardian. His commentary begins:

“Another day, another few billion pounds of our money is on its way to cheer up Britain’s banks. Today it was the turn of Lloyds to stick its hand out – indicating it wants an estimated £5bn to support its latest restructuring wheeze.”

and which descends into complete incoherence by the end:

“All in all, it’s like taking out house insurance during a fire, refusing to pay for it once the fire is out and sending the insurance company a bill for a new sprinkler system. The real irony is that behind all the complexity, the APS and this associated exit strategy boil down to something very recognisable to bankers by now: a credit derivative, the most toxic yet invented.”

In actual fact a capital raising by Lloyds is a welcome simplification of what looked like becoming a labyrinthinely complex relationship with the UK government. It’s not the role of the taxpayer to guarantee the dodgy property loans Lloyds inherited when it took over HBoS – when, we shouldn’t forget, the bank’s executives were denied the right to conduct thorough due diligence on behalf of Lloyds’ shareholders – so Lloyds raising capital itself so that it is strong enough to bear the potential losses of the assets now on its books represents a return to normality which pundits like Roberts should be welcoming.

What Roberts seems to object to is the government’s participation in the rights issue. But this is what happens when you’re a shareholder. The government will be better off compared to underwriting the losses on a £250bn dodgy loan portfolio. The cost to the Treasury of keeping its/our shareholding to 43% will be around £5bn whereas they could otherwise have had to pay out, we have to assume, perhaps somewhere around £25bn in insurance in return for increasing their holding in Lloyds from 43% to 62% according to calculations done back in March. Let’s be generous and assume ~20% of Lloyds raises £15bn when the taxpayers’ stake is eventually sold (valuing the whole bank at £75bn). Even then the taxpayer is at least £25bn – £5bn – £15bn = £5bn better off under the rights issue plan than writing the APS insurance, assuming £25bn losses, after excess.

The reader may ask why a deal being done at all. The answer is that obviously Lloyds’ management think they can keep losses somewhat lower, but the Treasury surely has to take a more cautious view – note that because of moral hazard, the level of losses could depend on whether or not they’re insured by the Treasury! Since the sensational news has just come through this morning that RBS is to exit the scheme as well, I suspect that all involved – particularly in government – have realised that the scheme is in fact unworkable. It distorts the two banks’ incentives so much that it is impossible for them to do their job of managing the bad debts.

But what of this £2.5bn fee? There are two sorts of justification. One is that the government “saved” Lloyds by proposing the APS. But if the government had done nothing either the whole banking system would have collapsed in March or the banks would have faced down the short-selling speculators and recovered (as Barclays did, its shares having risen 6-fold since then). I would have thought it was part of the normal responsibility of government paid for by all our taxes, not an optional extra, to ensure the existence of an orderly banking system.

Then there is the financial justification. Roberts suggests in his fire insurance analogy that:

“The catch here is that we haven’t been paid yet for providing this insurance when it was needed most (ie, during the crisis) and are having to haggle to get the premium paid retrospectively.”

For what the government deserves another £2.5bn (making them at least £7.5bn better off than before this latest deal) is not exactly clear. The point is the insurance scheme had a £25bn excess and was to run for 5 years, so Roberts’ fire insurance analogy is inappropriate – the insurance policy would have had to pay out nothing for at least the first couple of years. Logically, if there’s going to be a fee of this kind it should be offset against losses and writedowns to date against a scaled-back excess of ~£5bn, i.e. a fifth of £25bn, since about one of the 5 years will have passed since what I understand to be the baseline for the insurance policy of last December by the time the Lloyds fund-raising is complete. Furthermore, the FT this morning provides details of RBS’s losses to date on assets that would have entered the APS. I don’t know where such data for Lloyds could be found, but they are likely to be comparable. RBS has already absorbed losses of £23bn! Even if we take a figure of £15bn for Lloyds, then the loss after the excess is £10bn. The government pays 90%, so owe Lloyds £9bn. Fine. We’ll offset the £2.5bn against that amount!

The £2.5bn break fee is just an opportunistic tax, ultimately falling largely on UK pension funds. There’s no financial justification for this amount.

Lloyds shareholders are likely to be understandably aggrieved that the fee is much higher than the figure of £1-1.5bn that has been touted in the media for some time now. There has to be the suspicion that the government’s negotiators have ramped the price at the last minute. If so, this reeks – I would have thought government had a duty of fairness.

With another £13bn from a rights issue, Lloyds shares are in total worth around £40bn, tops, right now, so £2.5bn represents an arbitrary tax of at least (2.5/40)*100 = 6.25%. There is still an upside, but it’s not looking stellar. I gave a guesstimate earlier that, with a fair wind, Lloyds may eventually be worth £75bn or about double the value shares are currently trading at. But this might not be for 5-10 years. A lot of investors are going to consider that they can much more easily double their money in a “global return to growth” scenario by investing it in emerging markets – where the political risks these days seem no worse – instead of in the UK. Does the government want that to happen? Especially as they may want to sell a lot of bank shares in a few years!

I have owned Lloyds shares since I worked for the bank in the early 1990s. When I was given a few shares as part of my remuneration, I certainly wasn’t warned that the government would levy arbitrary taxes whenever the country’s finances hit a patch of turbulence.

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1 Comment »

  1. […] need it, but it sticks in the craw that so much disappears in transaction costs (and in this case, a windfall tax in all but name). Especially when I’m not going to get any dividends for another 2 years! Possibly related […]

    Pingback by Lloyds Rights Issue complexity: Um, why don’t we just change the rules? « Uncharted Territory — November 4, 2009 @ 8:49 am


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