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Deal architect - rights issues: Mortgage lenders hunt around for recapitalization cash

With UK lenders RBS, HBOS and Bradford & Bingley in the market with rights issues totalling more than £16 billion ($31.5 billion) as Liquid Real Estate went to press, and intense speculation that Barclays Bank and others might soon follow suit in order to shore up their capital adequacy, recapitalization looks set to become the financial trend of the season for UK mortgage lending banks.

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“The problems facing the UK high street mortgage lending banks are a combination of domestic concerns – essentially the weakness in the UK housing market, which could lose as much as 14% in 2008 – and exposure to US problems, largely through structured credit,” says Hank Calenti, financial institutions analyst at RBC Capital Markets in London. “Basically, all the banks need to deleverage.”

The potential scale of the funding required is dramatic. Dresdner Kleinwort analyst James Irvine estimates that in addition to the £12 billion RBS is raising, the £4 billion targeted by HBOS and the £300 million cash call by Bradford & Bingley, unless Barclays Bank raises new funds it will have a tier 1 ratio of just 4.7% for the first half of 2008 although this will likely rise to 5.6% by the end of 2010.

Although Basle II regulations stipulate a minimum 4% tier 1 level, banks have usually aimed for a higher figure – often between 5% and 6%. As credit conditions have tightened, there has been a growing consensus that banks should aim for more than 6% in order to restore confidence in the system, and some commentators believe that 7% could be an appropriate figure.

In order to increase tier 1 capitalization above 6%, Dresdner Kleinwort estimates that Barclays requires up to £3 billion of new capital. However, the problems in accurately valuing the assets on Barclays’ books – and therefore assessing the scale of the problem – means that other analysts have calculated substantially different capital requirements.

Merrill Lynch says that Barclays needs to raise about £8.5 billion and Citi predicts a requirement of up to £12 billion, assuming that Barclays takes the opportunity to write down a further £8 billion. On May 15, Barclays said that its tier 1 ratio was just 5.1% – below its 5.25% target – and refused to rule out a rights issue, although it declined to announce a likely size or launch date.

One alternative to a rights issue for Barclays is a sale of new shares to a sovereign wealth fund or Asian banks. Specifically, it is thought that Barclays could be considering returning to China Development Bank, which bought 3.1% for about £1.7 billion last year, and the Singapore government’s state investment vehicle, Temasek, which bought 2.1% for about £1.1 billion at the same time.

Other banks thought to require funds in the medium term include Lloyds TSB, which is estimated by Merrill Lynch to need £2 billion in order to achieve a safe level of capitalization. On May 13, Alliance & Leicester ruled out a rights issue, noting that a £350 million lower tier 2 issue in April had restored its tier 1 ratio to 6.4%, while its total capital ratio was 11.7%.

RBC’s Calenti says that RBS and HBOS are likely to enjoy “a first mover advantage” in getting their rights issue in the market. “Ultimately, there is a limited amount of goodwill in the market and it might be that future rights issues from other banks will have to offer greater discounts in order to be successful,” he says. “HBOS, in particular, appears to have taken the opportunity to raise capital while it is available, despite not being in as precarious a situation as some of its peers.” HBOS is offering a 45% discount to its price before the rights issue announcement, RBS a 41.3% discount and Bradford and Bingley a 48% discount.

Nevertheless, there is no prospect of banks failing to get the funding they require. “Rights issues will likely be fully underwritten in any instance where there is doubt about take-up,” says Calenti. “And while raising new equity capital for recapitalization is always painful, shareholders also recognize that it is unavoidable.” Calenti says that investors, when considering rights issues, will “want to know that the banks have identified all their losses, are in a position to manage competently through the financial cycle and will be better positioned to benefit when the situations recovers”.

The UK government, which has linked bank recapitalizations and the Bank of England’s £50 billion scheme to swap some types of ABS, including RMBS, for government debt to a recovery in mortgage lending, is likely to be disappointed, according to Calenti. “Rights issue are certainly a good beginning to the process of restarting lending,” he says. “But more important is that banks become comfortable in lending to each other and that the RMBS market returns.”

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