Chancellor George Osborne’s stated intent to extricate the UK government from owning RBS and the departure of its CEO Stephen Hester sparked a sell-off of its bonds. Osborne’s plans to separate the financial institution into ‘good’ and ‘bad’ banks raises the risk that RBS’ bonds could be transferred to the bad bank to unburden the good entity. However, the chancellor’s aim to split RBS looks hard to reconcile with his aim of selling off the government’s stake in the bank. And even if Osborne does force a split, it would be difficult to migrate bondholders into the weaker entity without resorting to aggressive legislation that would undermine confidence in the rest of the UK banking sector, suggesting the sell-off looks overdone, according to buysiders and analysts.
The principal motivation to split up RBS is to accelerate its return to private ownership and in the process get the best value for money for taxpayers while maximizing the lenders ability to support the economy.
The chancellor’s plan to hive off RBS’ toxic assets (primarily commercial real estate and Irish loans) into a separate entity or ‘bad’ bank to be run down over time as a means to re-privatize the institution encountered a wave of fierce criticism in the market, including from Hester.
The proposal flies in the face with Osborne’s comments that there would be “no more taxpayer capital into RBS as part of the process”, as most bad bank set-ups usually involve full nationalization as a first step. Transferring impaired assets at market value would crystallize losses for RBS, while transferring them at book value would expose the government to losses in the bad bank, and only nationalization squares this circular problem.
The government’s 81% stake in the lender (through UKFI) was meant to give the state “arm’s length” managerial duties, but the Treasury has meddled much deeper, which has weighed on RBS’ commercial strategy. The PCBS (Parliamentary Commission on Banking Standards) report of 12 June notes “the current arrangements therefore cannot continue.”
But creating a bad bank is unlikely to comply with either one of these stated objectives, buysiders and analysts say. The PCBS itself does not appear fully convinced either about splitting RBS and highlights several challenges to creating a bad bank.
The key obstacle to selling assets to a government-owned bad bank would be getting the threshold level of shareholder consent, which is 50% for unrelated equity holders (i.e. not including UKFI). Shareholders would only agree if the deal is beneficial for them.
RBS’ GBP 53bn in non-core assets alone as of 1Q13 would need to be funded one way or another from the Treasury, imposing a burden on its accounts. The bank has reduced its non-core assets significantly from GBP 258bn in 2008 so the case for establishing a ‘bad’ bank has diminished substantially with the status quo no longer an impediment to lending to UK business.
Moreover, a significant portion of these non-core exposures are of good credit quality, one analyst notes. And even though the size of its non-core assets could swell to GBP 130bn after including additional loans and assets, it would still be less than 10% of RBS’ balance sheet and unlikely to need restructuring, he added. “The non-core run-down rate has been impressive and on track to continue in a similar fashion so the need for setting up a separate entity is not there.”
Since any bad bank (rather than an internal separation of non-core assets) would require state aid, there would be a series of lengthy negotiations with EC competition authorities in Brussels, analyst noted.
“This would have a material impact as it would restrict dividends and serve only to extend the time majority shareholders, that is, taxpayers, receive their return on investment,” he said. “It doesn’t make any sense.”
A dividend restriction would most likely trigger a coupon block.
Timing is another issue that plays against splitting the bank. The time taken to implement a separation given the operational, legal and valuation complexities along with getting shareholder consent would mean Osborne would be unable to return RBS to the private sector anytime soon.
Bonds not going anywhere
But even if the government does stick to its guns and pushes through the split, it will be unlikely to move its senior and subordinated debt into a bad bank, the buysiders and analysts said.
Under FSMA 2000 legislation bondholders are protected, implying they cannot be left in a bad bank with the government exiting its equity investment in RBS, the second analyst said. “[But] politics is in the driver’s seat with any decision not going to be made purely on economic grounds meaning sub debt could be materially impacted.”
The rationale for targeting parent-entity debt (RBS Group) is that it is likely to house the non-core bank as it is easier to attach to another entity while the operating company (RBS PLC) will be the resultant good bank.
“We view a transfer of sub debt into a bad bank as a very low probability event,” one buysider said. “The capital position is not great but nor is it significantly bad enough to warrant imposing losses on creditors. It is also difficult to imagine subs getting burned without equity guys taking a hit. Meanwhile, forcing losses on shareholders at this stage would risk delaying privatization, unraveling the restructuring achievements over the last few years and destroying the reputation of RBS.”
“We’ve been in and out of the name, namely the Tier 1 5.25% and 5.5% Euro perpetual, which have moved up recently but would still be adding risk at these levels,” said a second buysider.
The RBS Group (RBOS) 5.25% NC 13s are quoted at 66/68 to yield 8.21%/7.96%, up from the lows of 61.9 on 24 June but still inside the mid-70s the level the debt traded at throughout most of the year, according to Markit. The 5.5% NC 13s are indicated at 67/68 with an 8.4% YTM, up from the 63 level last Monday. The 6.467% fixed-floating perpetual regulatory tier one securities are quoted at 62/64, down from a high of 75 in May.
Alternatively, for more risk-averse investors looking for shorter-dated debt with non-discretionary coupon flows, the 4.625% 21 LT2 NC 16s at a cash price of 90 offer a yield of 6.5% but an 8% yield-to-call, the analysts note.
To leverage up returns, selling sub CDS protection would also be an attractive position, noted a third analyst and the first buysider.
“With sub debt CDS written on the operating company and not on group issued debt, apportioning parent-company sub debt to a bad bank would not trigger a CDS credit event. Neither do the contract terms dictate precisely that such an event would constitute a trigger,” the third analyst said.
RBS has the biggest capital deficit among its UK peers at GBP 13.6bn (61%) out of the GBP 22.2bn total shortfall. The figure is slightly lower than the provisional estimate released earlier this year of GBP 25bn, according to the PRA’s capital shortfall results released last month. The bank needs to raise GBP 3.2bn to reach the year-end 7% PRA target, but is on course to meet this and has a track record of over-delivering on its targets. RBS is set to achieve this by trimming its balance sheet, downsizing its Markets division, running down risk in its non-core assets (RWA reduction), carrying out small planned EU divestments as well potential liability management exercises (LMEs). RBS’ core loan-to-deposit ratio stands at 90%, well below its worst point of 154% (in FY08) and has a net stable funding ratio (NSFR) of 119%. Liquidity is running at 3.5x wholesale funding.