On Wednesday we mentioned that the finalised terms of the UK government’s Asset Protection Scheme would be crucial for the future of Lloyds Banking Group.
Recall that under the initial terms of the APS deal, released in March, Lloyds will absorb the first £25bn of any losses, after which the government will absorb 90 per cent of the remaining losses, with Lloyds on the hook for the remaining 10 per cent. The trade-off is that Lloyds has to pay a participation fee, make additional lending commitments and promises on renumeration, and endure further dilution of its shares.
On Wednesday, the bank announced £13.9bn worth of impairments on bad debt, alongside a £4bn proforma first-half loss. About three quarters of the £13.9bn charges, however, were on assets designated for the APS, the bank assured its investors — presumably implying that those losses were somehow mitigated (they won’t be as the bank has to absorb the first £25bn of its losses). In any case, Deutsche Bank has a bit more detail on the implications of the APS in a research note.
From DB’s Jason Napier:
The fact that LBG did not publish 1H09 pro-forma capital ratios including the impact of the APS got us to thinking about whether an improved LBG share price and global economy which has turned the corner might present viable alternatives for the company. Though management wouldn’t be drawn today on exactly how much of the planned £25bn APS first loss would be consumed by the £13bn 1H09 loan loss charge, broad disclosures suggest around £10bn of the first loss piece has been consumed already.
Figure 8 [below, click to enlarge] shows that on our forecasts, loans designated for the APS could generate as much as £32bn of APS loan losses by 2011 — saving the company £6bn in loan losses (LBG would bear 10% of the losses over £25bn). However, this overstates the usefulness of the APS as a buffer as we’d expect the proportion of loan losses captured in the APS to fall over time as the number of unexpected defaults (which we’d primarily expect to see housed in the ex-APS book) rises.However, given the overall cost of the APS (£15.6bn insurance premium, funded by issuance of 13bn shares at 115p bearing an initial 7% coupon) it bears considering whether LBG should look at reducing the extent of its participation in the scheme or perhaps self-insure via bolstering its capital ratios independent of government. Figure 9 shows how if we exclude the capital benefits of the APS (£194bn off RWAs, £15.6bn onto capital) the stated core tier 1 ratio of the group progresses, troughing at 4.7% in 2010.
What Deutsche’s implying then, is that, given things appear to be getting better economically, Lloyds could attempt to bypass the share dilution, financial and regulatory costs associated with the APS and go straight to the market to raise its own capital. How much capital will be needed is harder to define — but the sense from Deutsche is that including the APS, in its current form, results in a rather higher-than-needed Core Tier 1 capital ratio of 13.2 per cent.
Here’s Deutsche’s conclusion:
Overall therefore our forecasts include participation in the APS, finalised in early 4Q09, as our base case, but we remain alive to the possibility that LBG may now be in a stronger position to consider alternatives which may reduce future EPS dilution relative to the original APS proposal announced on 8 March when LBG was at 42p and the FTSE 100 was at 3530.
Related links:
Laughing Lloyds – FT Alphaville
Asset Protection Agency hires ‘grey panther’ – Telegraph
No asset protection for Lloyds – FT Alphaville