Flogging the Black Horse: How Bad is it for Lloyds Shareholders?

CORRECTION (01:00 11/3): I made an assumption in this post (mentioned in section 5) that the Government would not have an entitlement to new ordinary shares at 38.43p each. In fact, they have stated that they DO have such an entitlement and intend to take it up. This point has been discussed on FT Alphaville, which notes that the minimum holding the Government will end up with in Lloyds is 62%, not the 51% I (and some others) arrived at. They will retain at least 43% of the ordinary shares, not the 26% I (and some others) arrived at, before the B shares are converted. I haven’t yet corrected this error in the text of this post. The discussion remains valid.

(10:00 11/3): Made corrections to some calculations in the text (in italics).

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It’s been incredibly frustrating over the last couple of days trying to determine exactly what the effect of the latest dodgy UK Government wheeze (its Asset Protection Scheme, APS) has been on the value of my modest Lloyds Group shareholding. On Sunday I complained, inter alia, about how the bank is being forced to lend not for business reasons, but because the UK Government seems to think this is a good idea. I have no idea whether or not such enforced lending will benefit the economy – it seems like just the latest fashionable economic thinking to me – but I presume that, if it turns out to be a big mistake, Brown, Darling and King will be disgraced and stripped of their pensions.

Nevertheless, I’m not too worried about the lending stipulation on Lloyds. After all, we’re a bank – that’s what we do!

I become a little more concerned (meaning my blood boils) when I read articles suggesting that the latest intervention – a “toxic asset” insurance scheme – may not in itself be entirely necessary (after all, we were told the UK banks were stress-tested last October – they are now just realising anticipated losses), but is being implemented in order to gain control of the banks in order to force them to implement ad hoc lending policies devised by politicians seeking re-election within 15 months.

I become very concerned (my blood curdles) when I subsequently discover that the UK Government appears to be making up the rules as it goes along, for example on capital adequacy, in order, it seems, to force the banks to participate in the APS, in order to force them to implement ad hoc government policies that may not be in their shareholders’ interests.

I am extremely concerned (blood clots block my veins) to read this morning that one of the few remaining independent UK banks – Barclays – may also be forced to become a tool of UK Government policy.

But none of the articles I’ve read clearly explain the precise impact on Lloyds shareholders. I’ve had to download a PDF from Lloyds own website. Sack the journos. And take away their pensions!

Let me try to explain the deal:

1. Cost for participation in the APS
I wrote on Sunday that this would be £10bn (plus a £25bn excess). I’m not sure where I got this figure – TV or radio speculation, probably – because news sources were quoting £15.6bn.

But neither figure is really correct. The £15.6bn is an entirely notional amount. It is intrinsic to the deal that this is paid in new Lloyds B shares:

“…carrying a dividend of the greater of 7 per cent per annum and 125 per cent of the dividend on ordinary shares.”

The B shares will cost 42p each, the approximate closing price last Friday, the last trading day before the announcement.

Now, call me naive, but even if we say that Lloyds shares are “worth” 42p, the B shares are worth somewhat more than my ordinary shares. They have first call on dividends (so in the worst case for ordinary shareholders could receive 2.94p each – 7% of the notional £15.6bn, i.e. £1.092bn! – in a year when ordinary shareholders receive nothing!).

But even if the ordinary dividend exceeds 2.94p * 1.25, i.e. 3.675p per share, the B shares will receive 1.25 times the ordinary share dividend.

It seems to me the B shares are worth north of 1.25 times the ordinary shares, that is, at least 52.5p each or £19.5bn in total.

But there’s a twist in the tail.

2. Conversion of B shares
The B shares can be converted into ordinary shares, but only at a cost of 115p, i.e. about 2.74 B shares would be converted into one ordinary.

Furthermore, the government must convert the B shares if the ordinary share price rises above 150p.

This would result in the government increasing its holding by at least an additional 12% of the bank (the figure depends on how many shares the Government already holds, since it dilutes its own existing holding by taking new shares) of Lloyds (see below for explanation), in terms of both economic and voting interest (but see below).

This is very curious, since, before conversion (strictly, if never converted), the B shares increase the economic interest of the Government in Lloyds by (at least) 3.42 (1.25 times 115 pence/42 pence) times as much, that is 41.07%!!! [Actually, the calculation is not quite so simple – perhaps its easier to say that before conversion the B shares number more than the ordinaries, and get a higher dividend per share, so on their own represent an economic interest of well over half the bank!! And the Government owns 43% of the ordinaries already, and could own as much as 65%. It’s total economic interest, i.e. share in dividends, before conversion of the B shares – which could be calculated exactly, maybe I will later – could be as much as around 90%].

Astonishing! As an ordinary shareholder, the Board of Lloyds will only be acting in my interests if it refuses to pay any dividends until the B shares have been converted into ordinaries. They will then have “merely” exchanged (approx.) 12% of the bank for the APS insurance. If the B shares are never converted, the insurance will have cost (approx.) 41% of the bank!!

3. APS insurance excess
I mentioned that the excess charge for the protected assets is £25bn. But this is on the assets after “historic impairments and writedowns”. So the cover is for £250bn of £260bn of loans. Maybe the excess should really be stated at £35bn, since it’s not clear that Lloyds would benefit were any individual loans that have been written down already to recover. This matters, as Lloyds has just declared a huge loss on the HBoS book. I understood at the time that this was done in order to get the bad news, or at least the worst of the bad news, out of the way.

If the £260bn of loans don’t make a further £25bn of losses, then Lloyds will have given the UK Government another 12% (or perhaps 41%) of the bank for nothing.

In fact, if the extra lending Lloyds is to undertake is given a value – say, several £bn – then, worst case, Lloyds will have given the Government 12% of the bank and several £bn, for nothing!!

4. Conversion of preference shares
I’m trying to be objective, here, so perhaps should cut out the exclamation marks and italic emphasis.

Even if Lloyds doesn’t lose another £25bn on the loan book, there is something in the deal for Lloyds shareholders. The Government is offering to underwrite a conversion of the 12% preference shares – albeit that these were outrageously expensive in the first place.

The £4bn of prefs are going to be converted at 38.43p per share, creating an additional 10.41bn shares.

There are currently about 16.34bn in circulation (calculated from Yahoo! data), so the new shares are 10.41/(16.34+10.41) or 38.92% of the increased pool of shares, or 63.71% of the shares already in circulation.

Now, if the shareholders end up with all these 10.41bn new shares, the Government’s existing 43% in the bank will be diluted down to only about 43/1.6371 or 26.27%.
[An alternative way of carrying out the same calculation is to note that, in this scenario, the Government would end up owning 7.03bn of a total 26.75bn shares, that is 7.03/26.75 or 26.28% of the shares – obviously small rounding errors are creeping in].
CORRECTION (10:00 11/3): This won’t happen, as the Treasury will take up its 43% or 4.48bn of these shares, maintaining its minimum holding at 43% or a total of 11.50bn shares (actually the Treasury has 43.5%, but forgive me if I don’t go back and correct this everywhere).

It’s quite possible that the shareholders will take up their entitlement to new shares at 38.43p, since the Lloyds share price at this very moment is somewhat higher at 48.8p (i.e. I could subscribe for my shares and sell them immediately at a 10.37p profit per share, but, of course, this will tend to lower the share price, so not everyone can do it).

On the other hand, if the Government as underwriter ends up with the new shares instead of its prefs, it will own (43% of 16.34 bn) + 10.41bn of the total 26.75bn shares in Lloyds, that is (7.03 + 10.41)/26.75 = 17.44/26.75 = 65.20% of the shares, as quoted in the Press.

5. Conversion of B shares revisited
As I mentioned above, if and when the Government converts its B shares to ordinary shares, it will increase its holding by at least an additional 12% of the share base.

As detailed in section 4, above, when it converts the B shares, the Government may have as many as 17.44bn shares out of the total share base of 26.75bn ordinary shares.

The £15.6bn of B shares will convert at 115p per share, that is, into 15.56/1.15 = 13.53bn new shares.

Treating the B shares separately after conversion, they give an economic interest of 13.53/(26.75 + 13.53), that is 33.59% of the bank.

Before conversion, the B shares receive dividends equivalent to at least 1.25*13.53*115/42 = 46.31bn shares, that is 46.31/(26.75 + 46.31) or 63.21% of the dividends.

But the B shares dilute the Government’s own ordinary share holding, so it’s also interesting to see their effect on the Government’s total holding after conversion.

If the shareholders subscribe to no new shares at 38.43p, the Government would end up owning (17.44 +13.53)bn of (26.75 + 13.53)bn ordinary shares, i.e. 30.97/40.28 or 76.89% of the bank as quoted in the Press.

Note that the Government’s voting rights are capped at 75%, which may explain why this number has sometimes been reported for the Government’s Lloyds’ share.

On the other hand, if the shareholders take up all their rights to the new ordinary shares being exchanged for the preference shares, then, after converting the B shares, the Government would only hold (7.03 + 13.53)bn of 40.28bn shares, that is, 51.04%.
CORRECTION (10:00 11/3): Since the Treasury will take up its 43% or 4.48bn of the preference replacement ordinary shares, as noted in section 4, its minimum eventual holding is in fact (11.50 +13.53)bn of 40.28bn shares, that is 62.14%.

Since this is a bare majority, I am ashamed to say that I am inclined to wonder whether the numbers have been stacked to ensure that the Government will always be capable of becoming a majority shareholder in Lloyds (since it can convert its B shares at will).
CORRECTION (10:00 11/3): OK, it’s not a “bare majority”, but I still wonder whether the whole process has been, in part, designed to ensure the Treasury gains a controlling stake in Lloyds.

I note, also, that that there appears to be no provision for Lloyds to pay for the APS by raising more than the £4bn needed to redeem the preference shares when it offers existing shareholders (and new investors) new shares at 38.43p. [On the other hand, I’ve assumed the Government will not participate in this share offer, even pro rata to its existing 43%, given that it is under-writing it anyway, and that the full £4bn worth of shares will be available to outside investors].
CORRECTION (10:00 11/3): I was in fact mistaken to make assumption indicated in the square brackets.

But, of course, if the numbers have been stacked, this would be tantamount to expropriating Lloyds’ shareholders assets – seizing them without adequate compensation – and of course that would be against the European Convention on Human Rights. And, of course, the Government is always careful to respect the rights of its citizens!

And, after all, according to Lloyds:

“HM Treasury has confirmed to the Board that its objective in increasing its potential holding of ordinary shares in the Group is to provide financial support. In the event that HM Treasury increases its ownership of the ordinary shares, it does not envisage any change to the constructive relationship it currently enjoys with the Board.”

So that’s all right, then.

After all, now that they’re in the position of having to sell the deal to shareholders, the Lloyds Board are not exactly free to speak their minds. I’m sure there’s nothing in the various stories that have appeared claiming they are unhappy.

Note: 22:23 10/3 Corrected an embarrassing slip in this post – the minimum B share dividend is 7% (2.94p), not 7p which appeared in a couple of places!