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Bond of the Week: 14 May 2014

Manchester Building Society PIBS

    

Manchester Building Society PIBS: SELL

No matter how obscure the issue, I have traded practically all the PIBs and ex-PIBs listed on the LSE; but never the two Manchester Building Society issues. They have always been both too illiquid (ie no meaningful supply available) and never a bargain. Through the depths of the financial crisis the returns were nothing like those available for much better known names. For example the low of the 8% issue was around 80p, while I bought various Lloyds and RBS issues at prices in the 20s and on a couple of occasions in the teens (in 2009). Until now I have never gave the Mancunian PIBS a second thought. Then it was pointed out to me that they had had rather unsavoury results.

Much has changed since my first visit to the nightmare post-apocalyptic urban wasteland of early 80s Manchester; driving around Mad Max style in a broken down car it was cool but not thriving. The city has since come on leaps and bounds. The CEO of Bruntwood PLC which owns 20% of the commercial centre of Manchester told me the place was happening and the bars were heaving. The backdrop to the mortgage market in the North West is therefore fine.

Although with a headquarters in and named after Britain’s second city, the Manchester is only the 19th largest building society in the Uk; in size it is not much more than a village building society. I expect this is because, being founded in 1922, it was a latecomer to the mutual movement. Talking of villages I note that a certain Manchester Village (where that pillar of mutual rectitude, the Rev Flowers, might be found [he who was fined £400 for supplying to young men; by non-serendipitous fate exactly the same sum I was charged by Camden Council to tow away my car for a slight misunderstanding with the parking permit]) is but 5 minutes away. Through the swing doors at 125 Portland Street and then left and left again and you are in Canal Street.  Anyway enough of all that; as the Rev might say; let’s get down to business. Here are Manchester Building Society’s two lines of stock.

Issuer:                              Manchester BS                         Manchester BS
Size:                                £5mil                                        £10 million
Coupon:                            8%                                           8%
Sedol:                               0877505                                   B0712W1
Maturity:                           None                                        None
Call:                                 None                                        April 2030
Mid-Price:                         117.50                                      102
Yield:                                6.8%                                        6.62%

For the year to December 2013 Manchester reported a loss of £1.6 million (operating profit of £7.6 million but impairments of £8.7 million).  At the same time they have restated their 2012 results to show a loss of £3.1 million (operating loss of £1.9 million and impairments of £0.9 million). This increases the Society’s previous loss by £0.8million. I have not previously looked at the Mancunian Society’s results but in the 2012 annual report they also took the opportunity to restate their prior year results.  The 2011 results were restated in 2012 to show a £21.9 million (!) loss because of a “change in accounting treatment and fair value adjustments”. Unfortunately any further investigation was stymied as the 2012 results are the earliest shown on the Society’s website. Therefore I cannot see the 2011 annual report and am unable to see whether, in turn, the 2010 results were restated. I assume by now the accountants will have got their act together (in August 2013 the PRA announced Grant Thornton, the auditors, were to be investigated about the 2012 results), and therefore there will be no further major restatements.

The actual losses reported seem relatively small.  But do not forget Manchester Building Society’s balance sheet is, as banks/ building societies go, tiny (£646 million as at December 2013) and their numbers should be seen in percentage terms.  As a percentage of assets (0.2% of the balance sheet) the 2013 loss would be the same as Lloyds loosing £2.1 billion. Manchester Building Society’s 2011 results would have been the equivalent of Lloyds losing an eye watering £21.88bn. Just to remind you, Lloyd’s worst ever loss, reported for 2011, was “only” £3.5bn and Lloyds has shareholders and the government to turn to. It also appears there is a trend of losses and a trend in this case would not be your friend. Will Manchester continue to eek out impairment over years to come? Frequently bank boards have found this the best way to deal with bad loans; too much honesty all at once would mean curtains. I note West Bromwich, a much bigger society and one that went very close to the edge of the financial precipice, has made 5 consecutive years of losses and counting. Indeed in their case it appears loss making has become so entrenched that the Chief Executive in the most recent Interim Statement began “The West Brom once again delivered an improvement in financial performance” before going on to explain they had lost money again; for the fifth year (albeit less money than usual).

To return to Manchester: where has all their money gone? I spoke to the Financial Director who was most helpful, and I thank him for that. The annual report mentions that there had been problems in Spain. He explained that they had made equity release loans to ex-patriots living in Spain and this book accounted for £7 million out of £8.7 million of impairments despite the Spanish book being only £40million. The way the equity release mortgages work is that someone, generally a pensioner, would take out a loan, to release equity, on a Spanish home and the interest would roll up compounding over time. The loan (with accumulated interest) would only become repayable either upon the sale of the house or when the householder, perhaps wearied by the state of the Spanish property market, journeyed again – this time to the far side banks of the Jordan.

The Financial Director pointed out to me that because none (his words) of these loans had fallen due there had been no actual losses. Perhaps that failed 1990s soap “Eldorado” set in an expat village on the Costa del Sol should have been named “Shangri-La”  since the Grim Reaper has yet to pay a call on any indebted sun-tanned Mancunian pensioners. That is as it may be but I take it that none can be taken to read as very few. [Note there is no redemption provision in the mortgages because of a fall in valuation]. How the land lies, with any individual mortgage, for the Society will not be known for certain until either the mortgage or mortgager is redeemed (sorry, enough!, that is the last of those jokes).

There are no arrears as yet on this book just provisions arrived at by using a complicated mathematical valuation tool. Small inputs to estimates of Spanish property inflation can produce large output changes as to what the realised losses might be. The fact that nothing has been realised to date, nothing crystalised, neither the income from the mortgages nor any capital losses at redemption, makes this book particularly frightening. Also don't forget this; the income of the book accrues and compounds on the balance sheet. If we assume the average interest rate charged is 5% then the size of the book grows by £2 million pounds per annum. Meanwhile Manchester Building Society has been de-leveraging the other assets on their balance sheet and de-leveraging fast. Total assets have fallen by nearly 25% from £850 million in 2011 to £646 million as at Dec 2013.  Without continual provisioning the Spanish book could turn out to be a monster – an ever growing book of potentially problem assets against an ever shrinking total balance sheet.

Of course I haven't mentioned the Spanish Property market and maybe I don’t need to as readers will be well aware of what has been going on. Suffice it to say that in the sort of areas where ex-pats may have bought houses, prices have fallen by around 50% and it is predicted the market will not bottom until 2015. Also be aware, when deciding on how much to lend, Manchester will not have been relying on static prices to make the figures work but property inflation. I fear the money lent in Spain has gone mainly down the drain.

The operating profit of £7.6 million (on the size of balance sheet) looks very healthy. Although no figure is published I make that a net interest margin of 1.18% which is very high for a building society. Many societies had very lean net interest margins at 0.5% and sometimes lower (Kent Reliance even managed a negative margin at one stage) although overall these margins are creeping up with the new economic reality. I asked if this sort of net interest margin was likely to continue and the Finance Director said it was. The margin is a result of the blended average of lending and of course our old friend the Spanish equity release book makes an appearance here again because it is these equity release mortgages that pay the really juicy returns (except of course they don’t pay). I am not sure how it is worked out but it may be that while the provisions on the book are taken in one place, the accrued income is rolled up in another part where there have been no impairments, so the more they provision the higher the interest margin on the remaining book. I emphasise I do not know this to be the case –I just speculate.

As to future profitability a lot will depend on whether they can start lending again as new mortgages post the financial crisis pay higher margins than old mortgages. I was told that they were indeed lending again and had made 70 new advances last year. I am not sure 70 advances a year makes for much of a going concern. That is the sort of number Old Mother MacPhee of the Moss Side sub branch could process on her own in a year. With 3,750 existing borrowers it is not replacing the redeeming mortgages. The FD did say, however, that they had enough capital to continue to write new mortgages.
 
Is the Society well capitalised? Manchester, along with other small financial institutions, does not produce ratios (Core Tier 1 e.t.c.) but just a total figure. As at Dec 2013 they had capital of £23.2 million. I make that a leverage ratio of 3.6%. The capital is made out of the 2 PIB issues, a PPDS issue and retained earnings. Under Basel III the £15 million PIBS ceases to count as equity from 2014 at 20% for the first year and 10% per annum thereafter. In fact the 8% PIB has already been reclassified in its entirety as a liability in the balance sheet, because of its interest payment clause, and consequently no longer contributes to equity. By 2023 equity provided by the PIBs will have entirely gone. There is one £18 million PPDS (Profit Participation Deferred Shares) which was placed in April 2012 at the time the horrendous 2011 loss was announced. What is a PPDS? It is a form of equity capital for building societies (now probably superceded by CCDS following the Nationwide 10.25% issue) that was invented by West Bromwich (who has the only other issue I have ever come across) at the time they were peering over the precipice. To cut a long story short the institutional subordinated bond holders at the time were forced into switching their bonds for the revolutionary PPDS issue. The PPDS gets written down following a loss and pays out a percentage of the profits of the society when there is a profit (post writing up the shares to par): in the case of West Brom 25% in the case of Manchester 30%.  I asked if there was any publicly available documentation for the PPDS. There is not. I asked who the buyers were and was told the issue was privately listed (?) and would not trade and it was confidential who the buyer(s) were. It is quite clear to me that the buyer can only have been a rescuer -a building society has no shareholders - and therefore can only have come from the building society movement. Step forward the Nationwide or a consortium led by them. You will see why I am so certain it was a rescue job by moving on to the next paragraph.

Are you sitting comfortably? Are you ready for a real horror show?  Brace yourselves. The remaining item under capital is retained earnings. In December 2013 retained earnings were minus £4.1 million. Given that building societies never pay out capital as they have no shareholders that means that in the 92 years of their existence they have cumulatively lost money. All that hard work over many generations, all that compounding up of profit and capital gone; all for nothing. Just to be certain I checked this with the FD and he confirmed this to be the case. Therefore of what does the capital of the society consist? Ignoring the PIBS which are rapidly running off as capital instruments, the entire capital base of the society relies upon an emergency issue (terms not released) made in 2012 to an unknown buyer. That is not a (financial) house built on rock.

I think at this stage it might make sense to see these figures in tabulated form:

                               Dec 2013      Dec 2012                 Dec 2011

Total Assets             646 mil          777mil                       850mil (before restatement 878 mil)
Borrowers                 3,750            5,700
P&L                         (1.6mil)         (3.1mil)                     (21.9mil)
Capital
Retained earnings     (4.1mil)          3.6mil                        9.7mil (before restatement 38.4mil)
PPDS                      17.5mil             -                                                                            
PIBS                        9.8mil            9.8mil (8% excluded)  14.8mil      

Total capital              23.2mil          13.4mil                      24.5mil (before restatement 53.2mil)

Note: 1) I have used restated 2012 figures. 2) The 6.75% PIB, after 20% exclusion in 2014, should only contribute 7.8mil of equity in Dec 2014 and shrink by approximately 1mil p.a. thereafter. 3)  18mil PPDS were issued but already 0.5mil has been written off (contribution of 30% towards the 2013 loss). Could write down of PPDS trigger non-payment of PIB coupons (especially the 6.75% which contributes equity)? West Brom does not pay out on the PIBS unless it pays out on the PPDS. No PIBS payment has been made for several years.

To date the PIBs have always paid their coupons. Were they not to pay the prices would come crashing down (West Brom’s PIB which does not currently pay a coupon trades at a price of 20%). Quite fairly the FD said that as capital instruments coupons are voted upon by the board of directors and therefore forward looking statements about paying them would be wrong as they would be for any other institution. The coupons are payable for both issues in April and October. The 2013 results came out after the payment of the April coupon had been made so you will not know until October if the 2013 results will effect payment. My guess is you will be OK as the PIBs coupons were paid last year after the disastrous restatement of the 2011 results.  However, I think we should cast our eyes over the relevant coupon payment clauses.

The Manchester 8% PIB (the older issue) states:  “3) Interest in respect of the PIBS shall not be paid or credited for any Interest Period if the Board is of the opinion that:

(a) there has been a failure by the Society to satisfy the second criterion of prudent management … and such failure is then continuing; or

(b) the payment or crediting of the interest or, as the case may be, the payment or crediting in full of the interest would cause or contribute to such a failure by the Society.”

The 6.75% PIB gives less protection and states that the coupon is not payable if the Society is not in compliance with capital adequacy requirements or if the Society just decides not to pay the coupon (ie carte blanche). However, Manchester does say they do not intend to avail themselves of this second ption and this clause is only in there to comply with current regulatory requirements (in 2005).

With all the information available, although I am not suggesting there will be (but I am not poo-pooing  the idea there won’t be)  an imminent non-payment of coupons or a default, there can only be one recommendation on these bonds: sell and sell at anywhere near today’s market prices. With poor liquidity, very small issue sizes and perhaps no-one paying attention to this article (all set against the backdrop of the great search for yield) the PIB prices may continue to trade at what I think are wildly unrealistic levels. I can only make a recommendation on value or, to put it another way, the trade-off between risk and reward. There is a very real risk that losses continue (it can get habit forming) or that in the process of further write downs the Manchester gets swallower by a larger society. In that case you are not only at the mercy of the continued goodwill of the board of directors (which has so far been forthcoming). You might also find the regulator decides to intervene or that any “rescue” takeover requires some pain to be taken by the PIB holders (this has happened before). It is very difficult to say where these PIBs should trade (a double digit yield for a start). Should coupon payments get suspended they are likely to stay suspended. The best example of a non-paying PIB is West Brom and that would mean an 80% fall in price.
 
Conclusion: Although retail bonds, few readers will own the two PIBs as they are only £15 million in size. Therefore this piece has no direct relevance to you if that is the case. However, it serves as a very good illustration of what can go wrong with a small institution that is not on the radar of either institutional investors or the press. I also think it makes a very interesting case study.

Manchester Building Society has been perfectly correct in the financial announcements it has made. It is just no one was listening, no one cared, no one could be bothered. I am not a forensic accountant and I write this piece as a form of journalism, but in looking at Manchester Building Society it seems quite clear there has been a huge unreported financial disaster. So far the PIB holders have escaped but that does not necessarily mean that will always be the case. Someone should warn them of the risk they are unknowingly taking and I hope this piece will do that. 

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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