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The impending rights issues for HBOS and RBS are a stark warning to jump ship now

by Simon Keane

Now is the time to cut your losses on banking groups HBOS and Royal Bank of Scotland, and quickly. Both are asking investors to put more cash on the table, their begging bowl of choice – the rights issue. For investors, this will just be throwing good money after bad.

Don’t be fooled into thinking that doing nothing is an option either. Should you keep your stake but fail to actively participate in the rights issues you will lose out heavily. The dilutionary impact of the new shares that will flood on to the market is almost certainly going to drive the share prices of these two banks down, by as much as 12% or more from current levels. Only by taking up the offer, or getting out altogether now, can existing investors protect themselves.

Worse, this is not the end of the write downs and fund raisings. It is time for a line to be drawn in the sand.

Damage limitation

No one really knows yet the full extent of the damage done to the world’s financial system by a decade of reckless lending. It could take years to become fully apparent, and until then banks are likely to remain dog investments with their own perculiar fleas.

There are still many investors with their heads in the sand, denying the full scale of this latest market calamity, sitting side by side with the banking industry’s boards of directors, not to mention a raft of City professionals, including analysts, fund managers and press commentators, who for the past three months have been saying banks on yields of 8%-plus are a buying opportunity too good to miss.

Banks won’t cut their dividends, they harked, only for RBS and HBOS to do precisely that in the past couple of weeks. Perhaps many were bamboozled by boardroom-speak. HBOS told the market as recently as March that it remained strongly capitalised, suggesting that its directors were unwilling or unable to fully comprehend the scale of events.

This is a board that wants to have its cake and eat it – it condemns rumour-mongers who trade off stories of a funding emergency yet fails to keep investors in the loop regarding its true state of financial affairs.

RBS chief executive Fred Goodwin is perhaps in more denial over the state of the banking crisis than most. His constant reassurances that RBS remained in rude financial health has been markedly undermined by his subsequent unveiling of the UK’s largest ever rights issue to a largely unsuspecting market.

Quite incredibly, the market seems to be going along with the idea that Goodwin is the man to get RBS out of the very mess he steered it into in the first place. There were mutterings that he would have to resign, having only a year ago paid a massively inflated price to get his hands on ABN Amro, whose own exposure to bad debts is causing double the pain for RBS investors now.

Swallowing the party line

Is the market really buying the line that Goodwin is too important to lose? Only a couple of weeks ago the fund managers were making an incredible racket about Stuart Rose combining the chief executive and chairman role at Marks & Spencer – so why haven’t they got anything to say about Goodwin?

The fact is RBS is too big a mistake to admit. As the UK’s second biggest bank by market value, behind only HSBC, it will be in most fund managers’ portfolios. To admit they got this one so badly wrong is too much to stomach. So many of the big investors will sheepishly subscribe to the rights issue while in fact they should be getting out now – it is nothing more than a face-saving exercise at their members’ expense.

The rights issues proposed by HBOS and RBS are likely to drive down the value of their shares by 12% from today’s levels. That is not an issue if you subscribe to the rights issue as, by paying a discounted price for your allocation of new shares, in effect you are reducing the average price paid for the whole holding. But this means now is the time to sell before this technical share price correction kicks in.

The dilutionary impact of issuing new stock on the share price can be crudely estimated. RBS is is offering investors 11 shares for every existing 18. Prior to the rights issue’s announcement the shares were trading at 372.5p, so the value of a holding of 18 shares was £67.05. The option is to take up 11 more shares at 200p, so the value of those additional shares is £22. At the end of the process investors will be left with 29 shares worth £89.05, or 307.07p each.

The fallout

All else being equal, then RBS’ shares have about 12% to fall from their current 350.25p before the impact of the rights issue is factored in. As mid May’s EGM date approaches (the point the rights issue will get approval from investors and become a certainty), RBS shares are likely to start inching downwards. A similar analysis, which is by no means perfect as it only takes account of the impact of the new cash on the balance sheet rather than the impact on earnings per share, would have HBOS falling to 432.68p, down 12% on today’s 491.25p.

RBS and HBOS are going to be the stock market’s dog shares for a good time yet. The true extent of the bad debts out there, and the implications of them, will not become apparent for another year or more so it promises to be a bumpy old ride, since without being able to fully quantify the repercussions, who knows what lies in wait for banks’ earnings. Now is the time to come to terms with the fact that this has been an almighty disaster for everyone, a truly terrible investment, and supporting these rights issues will only serve to compound that error.