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by Tom Sieber

The banking sector has been through a seismic change in 2007/08 – for a number of years a relatively boring part of the stock market, what wouldn’t it give to be boring now?

The initial financial earthquake caused by the run on Northern Rock has been overshadowed by aftershocks that are more damaging to the industry because their impact has been that much more widespread.

If the impact had only been felt at the epicentre (Northern Rock) then the industry might have been able to convince itself and others that it was a disturbing aberration and bore no relation to the rest of the sector. In some ways this would not have been an entirely unjustified observation. The model that had offered the Rock such massive and rapid growth was like fool’s gold – any prolonged shortage of liquidity was likely to cause huge, and as it turned out, insurmountable problems. But history tells us this was far from an end to the banking crisis – caused by greed and now prolonged by fear.

Will there be a return to normality after we have emerged from the current crisis and would that be desirable even if it were possible?

As Merrill Lynch’s John Paul Crutchley observes: ‘The UK banks effectively became leveraged junkies, which helped fuel the credit bubble. They were heavily reliant on wholesale funding to ensure continuing growth. We may see a return to a more normal environment but not the very easy environment we were seeing 18 months ago – and that is probably a good thing.’

Crutchley is right that the banks needed to adopt a more realistic attitude to risk but the pendulum has now swung too far the other way and they have been left increasingly unwilling to lend to us or each other.

The first thing that must happen if that issue is to be addressed is for confidence to be restored to the market.

Crutchley gives a useful explanation of what is required for even a measure of credibility to return. First, he says, the banks need to repair their balance sheets and raise capital; only then can an investor judge them on their merits. He says: ‘At that point you can ask the question: “Have they got a good business model that stands up to scrutiny?’’’

Confusion continues

The balance sheet and capital raising issues are only belatedly being addressed. The most recent results season in February and March, which was expected to lend some clarity, in fact did nothing of the sort. Banks were bullish, in many cases hiking their dividends in a display that was clearly intended to bolster confidence. In the event such bravado was made to look foolish and nearly all the UK banks are now looking to recapitalise – with varying degrees of success, the target being to get their tier 1 capital ratios, a key measure of capital adequacy, up to a level sufficient to restore confidence. Royal Bank of Scotland for example is targeting a ratio of more than 6% (the current level being around 4.5%). The story so far is that to be big is a major advantage. A simplistic comparison between RBS, which got its rights issue away without too much difficulty and Bradford & Bingley, which was forced to scrap its initial attempt at a cash call, is telling. It suggests that Barclays, assuming it takes this route, should ultimately be successful – and that Alliance & Leicester may struggle. For other reasons HBOS may face difficulties getting its rights issue away.

For, while RBS is dominated by big institutional shareholders, who have plenty of cash and who will tend to support management in most such cases, HBOS has two million private shareholders, the biggest non-institutional shareholder base in the UK. These may be less willing to unquestioningly take up their rights.

Banks have also sought other ways of raising capital with RBS seeking to sell its insurance division – which includes Direct Line and Churchill – for around £7 billion.

Exceptions to the rule

Not all banks are under this pressure; two names have been absent from this discussion until now – Standard Chartered and HSBC. Neither is likely to have to extend its cap to shareholders to shore up its capital base. With both seeing their balance sheets in better shape than competitors thanks, in the former’s case, to exposure to emerging markets and in the case of the latter due both to a similar exposure and to its sheer size. This does not mean either is immune to an economic slowdown but it does mean both are more resilient in present circumstances than their peers.

UK-focused Lloyds TSB also looks unlikely to have to fundraise, thanks to its more conservative approach over the past few years.

Lending, despite the efforts made to repair balance sheets, remains an issue for the sector. Cuts in the base interest rate are yet to feed through to the level of lending between the banks or the commercial rates being offered to consumers. Three month Libor – the most widely used measure of interbank lending – stood, at the time of writing, at 5.95% still some way ahead of the benchmark rate of 5%. With Bank of England Governor Mervyn King being forced to send letters of explanation to Number 10 for the rate of inflation, it is unlikely that it will be persuaded to cut that figure again in the near future – having brought rates down since the turn of the year.

New era

Against this backdrop it is hard to believe things can ever be the same as they were 18 months ago – dangerous as that is to assume. A big part of the way the banks did business prior to the credit crunch was through packaging debt – also a key cause of the crisis itself, with banks no longer able to identify the toxic sub-prime mortgages.

Nevertheless Hichens Harrison analyst Magnus Mathewson believes that for the sector to get back on track one of the banks must complete a securitisation on decent terms. Securitisation involves pooling and repackaging cashflow-producing financial assets into securities that are then sold to investors. Facilities such as this helped banks such as Northern Rock to grow at such a stratospheric rate.

He says: ‘You can’t really call the worst as being over until one of the banks has got a big securitisation away.’

Interestingly the chairman of HSBC Stephen Green would not agree. He told the British Bankers’ Association’s annual conference last week that banks need to leave behind their reliance on wholesale funding and securitisation and concentrate on retail deposits – suggesting there would be no return to the model of the past five years and instead a resurgence of the ‘good old-fashioned stuff.’

Problems compunded

Will there be many customers who have the funds to start saving, though? The banks are not immune to what is happening in the UK macro environment and the signs here aren’t particularly good. In a sense the lenders have nobody to blame but themselves. Pulling the carpet of easy credit out from under the feet of their customers has accelerated and accentuated a downturn in the housing market. This, combined with the looming threat of recession, suggests the problems that originated in the financial sector – now seeping into the real economy – will come home to roost for many banks.

Panmure Gordon’s Sandy Chen says: ‘We think there is the risk that as negative equity in the UK gathers pace, arrears rise, and credit ratings fall, there could be a sharp uptick in write-downs.’

Is this already priced in though – many stocks in the sector are now at 15 or 20-year lows – in some cases they have halved or more since the highs of last year – surely the worst-case scenario has already been factored in by the market.

It would be tempting to think so but, just when you imagine the clouds shrouding the sector may be dispersing, another issue emerges to put the pressure back on. The latest is the fate of the monoline insurers. Although signposted some time ago, the decision by the debt ratings agencies to downgrade MBIA and Ambac could still have a significant impact. According to Chen this has not already been priced in. His analysis suggests both RBS and Barclays, which have the most monoline exposure, may face writedowns of around £2 billion – which would not be easily absorbed by either in the current climate. In reality we must accept there are still, to paraphrase Donald Rumsfield, ‘too many unknown unknowns’ too have any great confidence in the sector at present.

Key indicators

The economics:

• Three month Libor

• Interest rates

• Rate of inflation

• Mortgage market

• Tier 1 Capital ratios

• Weighting of sector on FTSE

Sector facts & figures

Number of companies: 13

(Main market): 10

(Aim): 3

Sector PE: 9.1

Prospective yield: 7.5%

TOP ANALYSTS

John-Paul Crutchley – Merrill Lynch

Another viewpoint

Having been on both sides of the fence is a an advantage as an analyst according to Merrill Lynch’s John-Paul Crutchley. He joined Merrill Lynch in July 2000 from Dresdner Kleinwort, where he was also responsible for UK banking research.

Prior to moving into the investment banking industry in 1998, though, John-Paul worked for Barclays, which he joined as a graduate trainee in 1988. ‘Having worked on both sides gives you a bit of an advantage – in that you have a better understanding of how a bank operates and how management thinks. Also, having worked in the industry in some capacity for

20 years I’ve seen a fair number of different cycles.’

Even with the benefit of that experience and the level of perspective that it brings, Crutchley believes that the current crisis, particularly in terms of the share price reaction, is ‘up there with the worst of them’.

He stresses though that once banks such as RBS, Barclays and Lloyds address their most pressing concerns they should be alright. He is less positive on HBOS which, he says, has ‘fundamental problems’ and adds that both Alliance & Leicester and Bradford & Bingley are ‘dead in the water’ in the current climate.

In terms of making sense of the fall-out from the credit crunch he believes there are different ways in which an analyst can be effective. ‘Some analysts are good stock-pickers, others are more number junkies and some are more focused on strategy and management – I would probably put myself in that category.’

Sandy Chen – Panmure Gordon

The bear

Sandy Chen is in demand at the moment, his bearish take on most of the UK banks having been all but vindicated in the past few months.

And the bad news for them is that he hasn’t changed his mind. He says: ‘Quite a few investors have been asking: ‘Is this the bottom (of the market)?’ This is not the bottom.

‘What is interesting is that until now everything has been very US-focused. What we expect now is a deterioration in the UK macro environment.’

Chen has experience of the effects of a sudden market downturn, having sought his fortunes in the tech sector during the dot.com boom – ‘lousy timing,’ he concedes. But, having worked as an analyst for Credit Suisse First Boston in the late 1990s, ‘came crawling back to the banking sector’ and joined Panmure two years ago.

He believes the current crisis is ‘bigger in scale and actually in scope’ than any other event he has witnessed in the 14 years since he first began looking at the sector. ‘I think comparisons with the early 1990s and the mid-1970s crises in the UK are apt,’ he adds.

Unsurprisingly he also thinks that a good analyst needs a ‘healthy dose of cynicism.’

‘I don’t think it is rocket science,’ he says. ‘It is a demanding business, though, and you have to keep abreast of so much... particularly in the past year, with some quite challenging new stuff to learn about – such as CDOs and SIVs.’

Magnus Mathewson – Hichens Harrison

The natural

Banking is in the blood of Magnus Mathewson – analyst at Aim-listed broker Hichens Harrison: his father, Sir George Mathewson, was chief executive and later chairman of Royal Bank of Scotland, and helped to turn a provincial Scottish bank into one of the world’s leading banking brands. This led Mathewson to look outside the UK, to avoid charges of nepotism. ‘Ideally I’d like to live and work in Edinburgh but the name just casts too much of a shadow.’ Mathewson has worked at Investec, Credit Lyonnais and Banco Santander and has covered the sector for the best part of a decade.

He believes at least part of the blame for the current crisis can be laid at the door of UK policy makers, observing prime minister Gordon Brown was ‘being mendacious in the extreme’ when he said that there would be no return to boom and bust, and if Mervyn King had looked at the Northern Rock crisis ‘less like a fundamentalist and more like a businessman we might not be in as bad a situation as we’re in.’

Mathewson believes the sector’s fortunes will improve. ‘Banks currently represent 14% of the FTSE and it shouldn’t ever be that low,’ he says.

A good analyst, Mathewson observes, needs ‘to get enough right not to look stupid’. ‘In retrospect we were completely wrong on Barclays and RBS – we should have sold the whole sector,’ he says. ‘But we were closer to the mark with Bradford & Bingley, Alliance & Leicester and HBOS.’

BEST BUYS

HSBC – HOLD

Toughing it out

It has the right exposure the right size and the right profile to see out a period in which the entire industry been put under a great deal of pressure.

It does of course have exposure to the US mortgage market after the ill-timed purchase of the sub-prime lender Household International in 2003. The board is still being attacked by activist investor Knight Vinke for its running of the bank, but has been able to shield itself from the worst of the criticism thanks to the excellent performance of its emerging markets’ businesses. As an indication, in its most recent update to the market last month HSBC was able to report that profits for the first quarter were up on last year – not a claim that will be made by many other European banks. In response Alex Potter at Collins Stewart observed: ‘HSBC remains a safe haven and core holding.’

The company does look to be facing defeat in its attempt to break into the Korean banking market. A £3 billion bid for Korea Exchange Bank being derailed by regulators.

Many now believe that the bank will look further afield in Asia, where it is likely to get more for its money. Reports suggest that the group may take a stake in BankThai in Thailand, further augmenting the group’s emerging markets footprint.

Royal Bank of Scotland – HOLD

Life after that rights issue

Clearly one of the key concerns with the bank was that its capital position had been strained by the acquisition of ABN Amro, so successfully getting the largest rights issue in UK corporate history off the ground could mark a turning point.

According to Tom Rayner at Citigroup, the reward for a successful rights issue may just be an increase in the share price. Rayner believes RBS’s valuation is now ‘compelling’. ‘A key issue is the progress of the £12 billion rights issue,’ he says ‘It is possible that a high subscription rate could be taken as a positive signal for the share price by reducing potential overhang.’ Adding that ‘book value’, essentially the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated, is likely to prove more resilient than at some of its peers.

Also, the successful cash call means it is already well on the way to addressing capital issues – something that is yet to be dealt with by most of the sector.

When the company updated the market last week it was able to meet expectations – despite conceding earnings would be held back by the impact of the global credit crunch – and, if it can continue to do that then, it should prove worth holding. As Sir Fred Goodwin, the bank’s CEO, observed: ‘There is still more bad news than good news, but we’re not looking at the end of the world.’

Standard Chartered – HOLD

Emerging market play

An oddity, it doesn’t really fit with the rest of the major banks in the sector and is all the better for it. Standard Chartered is a pure play on the emerging markets, which are propping up HSBC, and as a result it is an isolated growth story at present.

As an indication of its confidence, the company is planning to bring in 10,000 new employees this year, and CEO Peter Sands has said he believes the economies of India, China, Singapore, Indonesia and economies in Africa and the Middle East will continue to grow despite the volatility in the financial markets. Reports suggest the bank may even be considering a listing on the Indian stock exchange, as a route to chasing more deals there.

The bank has zero exposure to the increasingly embattled UK consumer or direct exposure to US sub-prime – and what credit crunch related write-downs there have been pale into insignificance compared with what has been seen among the rest of the banks.

Its valuation may look a bit toppy but is probably justified given its position as a safety raft in the current economic storm. Also, while it may look expensive in comparison with other UK banks, when set against more natural peers in key markets such as Hong Kong and Singapore it is relatively cheap.

STEER CLEAR

Alliance & Leicester – AVOID

Lack of size matters

Small is bad in the new post-credit crunch world, and Alliance & Leicester is pretty small in relative terms – and is facing the prospect of imminent demotion from the FTSE 100.

For the smaller banks the cost of funding is a real issue. The lack of available wholesale funding has forced the group to borrow from investment banks at higher interest than it was used to paying, squeezing its margins and limiting loan growth.

The balance sheet is under some pressure after last month’s unexpectedly large write-downs of £192 million Though the bank had said – categorically – that it would maintain the 2008 dividend at 2007 levels, there has been some hasty backtracking since, and management now says it is ‘too early to call’.

While a rights issue hasn’t been ruled out, it appears that a cut in the dividend is favoured as a way of shoring up the balance sheet.

At present, building societies turned banks such as Alliance & Leicester, with their reliance on the mortgage market and wholesale funding, are unlikely to find any measure of success. It is obviously looking to snare savers, but offering a rate of 8.5% smacks of desperation. Put simply, it must attempt to steer a course through the current maelstrom and hope that there is a return to the kind of normality in which it flourished before. For now, though, it is difficult to identify a reason to remain in the stock.

Bradford & Bingley – AVOID

The issue of rights going wrong

Given that, like Northern ‘Crock’, Bradford & ‘Bungle’ has been given its own derisive moniker it should hardly be a surprise that we see it as one to get rid of. It would be tempting to say it had reached rock bottom, as it is worth around 15% of what it was a year ago but, with current uncertainty, exposure to the kind of problems B&B faces is not reassuring – not least as the company has serious credibility issues, having strenuously denied planning a rights issue only weeks before it was announced – at least most of its peers left their options open.

Observers even questioned the effect of the action. James Invine of Dresdner Kleinwort noted: ‘Management claims that the extra capital strength will help the group’s funding and deposit efforts. But we wouldn’t expect any meaningful impact and so have not factored in any revenue improvement beyond the interest on the cash raised.’

Then there was the debacle of the cash call itself. It was forced to cut the rights issue’s price (from 82p a share to 55p) and amount to be raised (to £258 million from £300 million). B&B also announced the sale of a 23% stake, at 55p a share or £179 million, to US private equity group Texas Pacific Group.

HBOS – AVOID

An intractable problem

The proposed rights issue will tackle capital issues that have plagued the bank and affected sentiment but they won’t change a fundamentally flawed model.

Also, with the shares crashing through the 275p pricing, the bank will face an almost impossible job persuading its retail shareholder base, proportionally the largest in the sector, to take up their rights; although the bank has confirmed its cash call is fully underwritten and moved to reassure investors, saying trading is in line with expectations.

The problem is HBOS has been too reliant on wholesale funding to fuel growth – a market now closed to it – so the balance sheet may improve but growth will be constrained. The bank has admitted as much, with chief exec Andrew Hornby saying: ‘We are planning on the basis that scale securitisation markets will not reopen this year and we’ll have to wait until well into 2009 for the world to turn back to what people might term sensible normality.’

As the UK’s leading mortgage lender it is the most exposed to the housing downturn. With thousands predicted to go into negative equity and house prices in decline bad debt-associated write-downs are possible.

RISING STAR

Banks’s Manx ray of light

Conister’s enterprising CEO is deftly steering the group into a promising new market

Identifying a rising star among the banks is not easy. First, they are dominated by a few established names that have been around for some time. Second, the prospect of finding a ‘good news’ story at the moment is particularly weak.

So we had to cast our net wider for a candidate. Still, we would not necessarily have expected to find one on the Isle of Man. Indeed, when a consortium first took over a small independent bank on the island two years ago it would have taken an optimist to expect big things – but that is what Arron Banks, aptly named CEO of Conister Financial Group, is promising now.

Banks, who has a successful career in insurance behind him, cuts a confident figure and strongly believes in the story he is selling. Previously chief exec of Group Direct, he started in insurance in 1987, mainly at director level, with Lloyds, Haven (NU) and Motorcycle Direct, which he co-founded.

Conister has two divisions – the prepaid cards business Transend, launched in 2006, and the original licensed bank Conister Trust – which can trace its history back to 1935 and which listed on the junior market in 1995. In H1 2006, an additional £5.4 million of equity capital was raised to fund the development of the group and strengthen its balance sheet, supplemented by a £7.1 million equity injection in November 2007 to develop the prepaid cards division.

In the short term much excitement is tied up with this side of the business. Simply put a prepaid card is a debit card without an associated bank account – customers load money on to the card which can then be used to withdraw cash from ATMs and make online and point-of-sale payments.

Conister is targeting a potentially massive market in prepaid cards and has already issued more than 28,000 cards and become the first company approved to issue MasterCard prepaid cards for online gaming.

This area has dominated the group’s spending since its launch, with recent final results revealing an outlay of £2.47 million last year. The signs are this investment will be worth it. Banks, who took over Conister in April, explains cards have perhaps most potential among foreign workers, who until now have had to rely on money transfers to get funds home.

He also points out that the major banks are not particularly interested in the prepaid card market because it would be cannibalising their own business. Also Transend’s margins are likely to be better than some of its competitors because it has a banking licence, so can issue its own cards. Most other operators have to go through third parties which can be expensive.

Of the rest of the sector at present, Banks observes it ‘has gone into meltdown’ – and he is bullish about Conister Trust’s prospects. The bank can point to the fact that it has zero exposure to the UK mortgage market or the complex financial instruments clogging the balance sheets of our better-known financial institutions. Most of this traditional business is financial products for private cars, business vehicles, domestic furniture and electrical equipment. Personal loans are a growing part of the Manx business and are available for things such as holidays, weddings, or home improvements.

Diversification

More recently, the banking division has diversified into the insurance premium finance market and treasury management for high-net-worth clients. While Royal Bank of Scotland has conducted a £12 billion rights issue to get its Tier 1 capital ratio above 6%, Conister’s currently stands at 26%. ‘The sector... is in complete disarray,’ Banks adds, ‘whereas we are focusing on just a few core objectives. We will look to do more and more deals to build the business and I think there will be opportunities for us.’

A wealthy shareholder base is prepared to support the growth of the business. Chairman James Mellon is an entrepreneur who has established several companies around the globe and holds directorships with several investment companies. Fund manager Helvetica, which invested in the company last year, has strong links with the state of Qatar and the group says it’s ‘support, network and expertise will be invaluable in our future.’

All these factors promise a rapid rise in fortunes for Conister and its CEO.

30 second Conister Financial

• Conister Trust established in 1935. Expanded Conister Financial Group incorporated in 2006 and prepaid cards division Transend launched later that year.

• Originally floated on Aim in 1995.

• Market valuation of £38 million.

• Transend has 28,000 prepaid cards currently in circulation.

• Intends to focus on high net worth clients.

CHARTING THE SECTOR

Bank a bargain

As the banking sector continues to come in for a kicking, the technicals suggest the decline is levelling off

by Simon Griffin

The chart of the banking sector paints a telling tale. As a sector, it has all but returned to levels that it was moving through when Tony Blair and New Labour first took office in 1997. Though growth of almost 82% was seen between 2003 and 2007, interestingly, though the sector continued in an uptrend until February 2007, it had started to underperform against the wider market, as measured by the FTSE 100, as early as February 2005. This relative underperformance continued and the more recent sell off has seen a loss of some 40% of value which represents a continuing relative underperformance of 35%.

From a technical perspective, a case can be made that the decline could just be about to plateau. This is because we are now resting on a previous support level that has terminated significant declines on at least three other occasions in the last 11 years.

Indeed, if anything the behaviour of the index in broad terms suggests a large sideways trading range with this afore mentioned support representing the base of the range. If this level holds up then it could prove to have been a great level at which to have bought into the banks, at least for the adventurous.

Either way, it gives a level below which a protective stop on any such trade would necessarily be triggered or indeed where the last semblance of any bullishness will leave the market and further significant losses would then be expected. What happens in the next few weeks will be key.

Royal Bank of Scotland (RBS)

BUY - 237p

TARGET - 346p

STOP LOSS - 210p

The shares has suffered the double whammy of the fallout from the sub-prime lending fiasco and the ABN Amro takeover. With the market in a negative stance toward banks in general, the logic of paying what RBS did for ABN has further depressed the shares. The drop has been dramatic, with the shares losing some 65% of their value in a little over 12 months.

That is a massive loss, equivalent to approximately £71 billion of market capitalisation and puts the £12 billion rights issue in perspective somewhat. Despite this, there are signs that might bring hope to the beleaguered bulls.

We can see that the the share price has now tested support from the spike low that occurred February 2000 when an adjusted close of 216p was seen. The market does have a memory and it will recall that a sharp bounce from this level was seen, are we seeing history repeating itself? The argument is given further weight by the evident volume spike that accompanied the test this time. Such spikes on sharp drops suggest capitulation, a necessary pre-condition to the ending of a down trend. Buying for the bounce might seem risky, however, a genuine move and close below 216p would be the ‘get out quick’ signal so risk is actually contained.

Bank Of Georgia (BGEO)

BUY - $26.50

TARGET - $35.60

STOP LOSS - $24.80

The best known bank servicing the Republic of Georgia and the Ukraine, is the Bank of Georgia and no doubt as these economies grow, so will the banks that service them.

As can be seen, the LSE-listed shares (actually global depository receipts), which floated in November 2006, were initially a huge investment success racing up to $44 and in the process more than doubling in eight months. Then the market turned and an equally pronounced down trend set in that saw the shares halve in value over the following nine months.

Moving to the current position we can see some interesting features on the chart. Firstly, the low towards the end of April was accompanied by an exceptionally high volume spike, this should invariably sound warning bells that a change is imminent. So far the upside has remained shy of the 200-day average and a break above this would be seen as highly positive.

Nevertheless, with our new bull trend in place and the luxury of a close stop just below the line, congestion and the 50-day average at $25, we favour a move above the recent high and likely coincidence of the 200-day average at $29 with gains to focus on $35.60 in the coming months.