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Bond of the Week: 11 July 2014
Co-op Bank – revisited
    

It is almost a year since the morally superior Co-op Bank, feted by right and left as the way forward for banking in the 21st century, departed company with its Chairman. Selected for the job as the right sort of person, perhaps with his absence of banking experience seen as a virtue, the Methodist Minister was not up to the job, *for a fuller description of his “CV” you can see this extract from Wikipedia.


So how has it been for the bank since they were de-Flowered? Previously they were a bank owned by a mutual (never a mutual directly) now they are a bank owned by hedge funds and various other private sector investors. The Co-op Group is down to a 20.22% shareholding.

Here are some numbers. There are 451,456,510 shares outstanding. The current share price, quoted off exchange, is £2.80-£3.00 and that gives a market cap of £1.31bn at the mid-price. Apparently a committee is being established at the moment to discuss the timing and method of gaining a listing. Originally it had been thought this would be obtained in 2014 – now it seems likely it will not be until the second half of 2015. The listing might come either in the form of an IPO (if sufficient existing holders wish to get out) or a placing. The unlisted shares trade in Crest for those who might be interested.

At the end of 2013 the total equity in the bank was £1.777bn. The £263million promised by the Group is not included as it could only be counted once the money had turned up; it has since arrived. It is expected that there will be a further loss in 2014 (and possibly an additional but diminishing loss in 2015). I was also told that very approximately it would be fair to assume that the 2014 loss will equate to the contribution from the Group. Therefore the year end 2014 equity figure would be similar to the year end 2013 number. But in addition there has been a rights issue for £400 million completed in May. All told the total prospective equity at the end 2014 is in the region of £2.18bn. That means the shares are trading on a multiple of 0.6X book. Here are some comparisons from the major high street banks. Barclays 0.68x 7% ROE, Lloyds 1.25x 10% ROE, RBS 0.6x 1.7% ROE, HSBC1.05x 10% ROE.

What is management’s plan for the bank? As with other bank restructurings they have a core and a non-core book. The non-core book to be phased out consists firstly of large corporate lending (not a problem but not profitable) and commercial real estate lending which was a Britannia Building Society inheritance. This has generated losses as the lending was made to a hodge-podge of borrowers, mainly in the North West, and by a group of people who “didn’t know what they were doing”. However, a rising tide raises many wrecks and unsurprisingly the commercial loan book is starting to show some signs of improvement.  The second leg of the non-core book to be wound down is the mortgage product Optimum. This consisted of buy-to let and self-certified mortgages. I was told the Co-op’s experience was typical to what other banks have experienced with such books. Arrears in buy-to let mortgages, contrary to initial expectations at the beginning of the financial crisis, have been low. However, it is calculated that 80% of borrowers are trapped. Either they are unable to refinance the amount borrowed or else they cannot improve upon or equal the rate of interest they are currently paying. Also to be noted is that the great majority of such mortgages are interest only and I think the bulk will have matured within ten to fifteen years. Self-certified mortgages have produced arrears and losses (this is a typical experience in line with other banks) and are a greater problem than buy to let mortgages. Finally Co-op is winding down housing association lending (safe but with no margin) and private unsecured loans (profitable but an area they no longer want to be involved with).

The non-core book has shrunk from £14.5bn at end 2012 to £12.5bn at end 2013 and is expected to be £11bn  by the end of 2014. From then onwards, however, there is likely to be a long tail as the Optimum book of £7bn runs off slowly because of a lack of incentive for borrowers to re-finance. A parallel is with the Bradford and Bingley buy to let mortgage book which has low arrears figures but also a much slower run off rate than the Northern Rock Asset Management residential mortgage book. I was told that Co-op would like to sell off parts of the mortgage books in order to speed up restructuring but they could not afford to do so (unlike Lloyds and RBS which have had huge amounts of tax payers’ cash injected into them which means they could speed up their restructuring) at a loss. Any sale for the Co-op Bank has to be near par value.

The core book is £17.5bn of which £15.5bn are standard mortgages, £1.1bn is unsecured lending and £0.8bn is lending to small businesses. The core book shrank last year as all new lending had to be suspended during the crisis. However, new lending has now resumed although, like an industrial complex, it takes time to crank up the lending machine after a shut down. The target is for the bank to have low double digit returns (i.e. 11-12%) on equity by 2018. Also encouragingly is that the core book already has a respectable-to-good net interest margin of 1.81%. That compares with a just negative margin or -0.03% for the non-core book recorded in 2013. In part the non-core book margin has been affected by arrears, costs of specialist management of the book and restructuring etc as well as low actual margin. I was told the priority for the bank was the extraction of capital, not income production, from the closed books.

But of what relevance is all this to bond holders? Most readers, who still have a position in Co-op, even though they will have started with retail bonds issued by the banking entity, will now have the Co-op Group 11% 2025. The Group and Bank have now truly diverged and I think it clear that the Bank, which has shareholders to turn to if they need further cash plus a clear plan to return to profitability, is now a better credit than the Group. This is the first thing to take note of. How much better the Bank is than the Group is unclear because of the still murky situation of the Group even if they have now accepted Lord Myners’ reform proposals.

Co-op Bank does have one outstanding unrated Lower Tier 2 issue, the £206million Co-op 11% 2023. It may be offered in the 124% region to yield 7.5% but liquidity is poor. I think on a value basis this bond is cheap if it can be bought around 124 and provided it can be placed in a tax efficient vehicle (ISA, SIPP or a Ltd company) because of its very large price premium. Denominations are £10. In addition I was told that Co-op have said that before 2018 there is likely to be a new Lower Tier 2 or possibly even a Hybrid deal. The intimation is that this will be sooner (I don’t necessarily mean this year) rather than later both to take advantage of low credit spreads and also because regulatory forbearance on capital ratios may not wait until the bank has returned to profit. I believe a raise of £200 million has been pencilled in for 2015 and a further raise of £200million for 2017. Unfortunately any new issue will be an institutional deal (£100,000 minimums) but it may be that a new issue could re-price the Co-op 11% 2023.

This is a bond not an equity column. However, it is always an idea to keep ones eye open for an angle. The equity may be worth mulling over (I have made no decision) as a recovery play. It is also possible that there will eventually be a favourable price response when the equity gets listed. I would add a caveat here that there may be issues for some stockbrokers with trading an unlisted equity.

Conclusion. There isn’t one today. This piece is really to keep you informed about what has gone on since Co-op Bank was splashed all over the front pages. The bank is not out of the woods yet but they are making progress. Core Tier 1 equity was 7.2% at end 2013 and would have been 9.8% if the £400 million rights issue had been included.  The PRA requirement is for 7% core capital and 4 ½% under stress, but in practice the regulator will want a reasonable margin over this, especially for a loss making bank. At present Co-op is benefitting from forbearance from the PRA and that is likely to continue until the bank can demonstrate a clear return to profitability as well, of course, that the bank continues to meet required capital and liquidity ratios. That is not to say that neither the existing bond (attractive yield for a recovering credit) nor the equity (recovery play) do not have points of interest. I have done a back of an envelope calculation on the equity. If the bank meets its restructuring target and has a 12% return on equity in four years’ time and if banks with such a ROE trade on a similar book value as today that would imply the shares should trade at 1.1x. On that basis, to go from 0.6x to 1.1x suggests very roughly a total return of 16%. I think fair but not compelling. Given, in the unlikely event that more capital were to be required, there are shareholders to be turned to, I would think the bond represents the better investment route. I emphasise though that I am not an equity analyst and as a recovery story there remain a lot of unknowns when it comes to putting a correct valuation on the shares. 


Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

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