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When rights go wrong

Never underestimate the banking industry’s ability to seek out the slickest
of banana skins. The global credit crisis has forced billions in write-downs and
triggered the need for several rounds of large capital increases. British banks
have been squeezed hard by the crunch over concerns about their exposure to the
housing market, write-downs on structured finance portfolios and pressure on
earnings.

The impact of the credit meltdown on the UK financial services industry has
worsened over the past quarter, as profitability plummeted at a record pace and
business volumes fell at the fastest rate in 17 years, according to the latest
Financial Services Survey from PricewaterhouseCoopers and the CBI.

The underlying problem is that banks are forced to writedown a lot of the
instruments they held with a view to buying securities, re-packaging them and
selling them at a profit. In many cases, while these assets were high yielding,
they were not as liquid as the banks believed them to be.

“The other side of the coin is the US sub-prime problem and quite a lot of
these instruments are exposed to this market,” says John Tattersall, a partner
at PwC. “The credit crunch for banks is about them having to write-down assets
that nobody wants to buy. The problem at the moment is one of deep uncertainty.”

Cap in hand
For the likes of heavily exposed banks such as Royal Bank of Scotland, HBOS and
Bradford & Bingley, the solution is to go begging bowl in hand to their
shareholders.

“The strategies we’ve seen reflect the starting points of the different
capital positions of each bank,” says Richard Barnes, credit analyst at Standard
& Poor’s. “RBS, having just completed the ABN-Amro acquisition, saw its
capital position as being more stretched than the others and this is reflected
in the scale of its [£12bn] rights issue.”

HBOS was next in line with a £4bn cash call, but the rights issue ran into
serious trouble when it was targeted by short-selling hedge funds. At one point
the bank’s shares plummeted 7% as investors took down-bets on the share price in
search of low-risk arbitrage profits.

Then came Bradford & Bingley with a 16-for-25 rights issue to raise
£300m. Two weeks later, the terms were revised to 19-for-25, but at a lower
share price. However, the restructured £258m cash call came with an additional
plan to sell a 23% stake to private equity firm Texas Pacific for £179m. This
triggered the most acrimonious fiasco the City has witnessed for years as the
influential Association of British Insurers raised a cry that the sale of such a
large stake to a single buyer breached sound corporate governance rules.
Confidence in the bank was further undermined with the simultaneous resignation
of CEO Steven Crawshaw, for health reasons.

In due course, B&B’s shares lost nearly one-third of their value. The FSA
took the unprecedented step of persuading Britain’s five biggest banks to
support a revised rescue capital-raising by underwriting £20m-worth of the
reworked £258m rights issue.

The waters were further muddied by outcries against last-minute re-pricing of
the banks’ rights issues, effectively letting underwriters off the hook. But as
PwC’s Tattersall points out, “People short rights issues, and if the situation
deteriorates during the course of the capital raising and share prices fall
below the rights price, the stock can end up with underwriters. This raises the
question of the extent to which it was caused by people shorting the stock or
whether the bank’s situation changed during the course of the rights issue.”

Companies are subject to those risks in a rights issue; in a direct placement
they are not. As a keen observer of its rivals’ woes, this is the course chosen
by Barclays, which announced a £4.5bn capital placement. Barclays sold £500m of
new equity to Sumitomo Mitsui Banking Corporation, while in a more controversial
move the Qatar Investment Authority will invest as much as £1.76bn and
Challenger Universal, a company representing the Qatar ruling family, will
backstop the placement with another £533m. This has sparked concern over what
may look like a foreign government trying to buy control of a major UK bank,
instead of an investment fund acting on strict transparent commercial
principles.

Most observers, however, believe that concern is misplaced. “These wealth
funds are not there as a tool of state policy,” says one analyst. “But there is
a lot of pressure to make these funds more transparent and that reflects some of
the concern in the market.”

For now, the difficulties most banks have had in getting their cash calls
away safely without leaving stock on the underwriters’ books recalls the recent
comment on Bloomberg that the banks are asking investors to throw good money
after bad.

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