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Foreign Exchange

FX comment: Lloyds and RBS convertible gilts – ingenious or ingenuous?

Last weekend’s Sunday Times revealed an idea the government is apparently considering to divest itself of its £70 billion stake in Lloyds and RBS: convertible gilts.

Merrill Lynch, among many others, thinks it’s a good idea. I’m not sure I do. As I understand it, the instrument is effectively just a gilt with an out-of-the-money call on Lloyds or RBS attached. Presumably the optionality will be embedded at fair value. But, if it is, what is the attraction?

Merrill Lynch, which predicted that the Lloyds share price could more than double over the next two years, said: “It provides a bridge for income and pension funds to buy into the equity of the part-state-owned banks prior to the ordinary dividends being resumed, we think by 2013. As natural buyers of bank equity this is clearly very important.” Maybe I’m missing the point but why not simply buy the shares?

Of course it is possible that the option will be priced under fair value to make the issue more attractive. But that would bring accusations of a fire sale and put the holdings of existing investors under pressure.

And, of course, it’s not as if there isn’t already a supply of long-dated calls: courtesy employees’ deferred bonuses.

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