Bank distress worries return to haunt UK

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Investors had been hoping the days of huge writedowns on toxic US subprime mortgage assets were largely over for UK banks.

So suggestions that the dramatic writedowns taken by Merrill Lynch, the US investment bank, could cause further pain for British banks has been greeted with concern in the market.

Merrill was forced to sell $6.7bn (£3.4bn) of collateralised debt obligations for 22 cents in the dollar. On Tuesday, UK bank shares were hit as analysts tried to digest the implications for those with large structured credit portfolios.

Many of the fears centred around Barclays, whose shares fell by as much as 10 per cent before recovering to close down 4 per cent. Royal Bank of Scotland fell 3 per cent and HBOS 5 per cent.

In the past year, Barclays has written off just £1.7bn on the value of complex debt securities stuck on its balance sheet, a fraction of the writedowns taken by rivals. By contrast, RBS has been far more aggressive and has already written down £5.9bn of assets, including 48 per cent of its high grade CDOs.

Some analysts remain nervous about Barclays’ total exposure. For example, they have questioned whether it might need writedowns in areas such as its leveraged loan portfolio, where markdowns of £190m are less than 3 per cent of its net exposure of £7.3bn.

James Eden, a banks analyst at BNP Exane, says: “Many do not believe that the level of writedowns taken by Barclays is adequate, notwithstanding the company’s constant and extremely robust defence of its methodology and approach.”

Barclays credit market exposures
Dec 31 2007 (£bn)Mar 31 2008 (£bn)
ABS CDO Super Senior4.673.98
Other US subprime5.044.24
Monoline insurers1.342.78
Commercial mortgages12.4012.62
Leveraged finance7.377.35
Source: company

Barclays has a portfolio of assets including £4bn of ABS CDOs, which repackage slices of other securitisations such as mortgage-backed bonds. These were subject to a £495m writedown in the first quarter.

Other analysts contest that it is almost impossible to read across from Merrill to Barclays or RBS.

They point out that many of the CDOs disposed of by Merrill were written relatively recently – after 2005 when the market was far more racy. By contrast, 70 per cent of the CDOs held by Barclays were written before 2005 when the market was more conservative.

And even in CDOs that were written more recently, the portfolios contain assets of differing compositions and asset quality. Barclays has always made the point that risk is not generic and all banks do not have identical books of assets and therefore do not have to write them down in an identical way.

Indeed, the persistent questions about the valuations of complex debt securities on Barclays’ balance sheet have exasperated its executives.

Barclays pointed out at the time of its £4.5bn placing last month that its proposed new Asian and Middle Eastern investors performed extensive due diligence on the bank’s exposures as did the investment banks that sponsored the prospectus.

But as the UK bank reporting season gets under way with Lloyds TSB on Wednesday, it is clear it will take very little to unnerve investors – particularly if there are further unexpected big writedowns.

Shareholders are already concerned that a UK recession would cause a huge spike in bad debts and prompt banks to raise yet more capital.

Although four of the country’s biggest banks, including RBS, HBOS and Barclays, have raised about £21bn to repair battered balance sheets through rights issues and placings, analysts are questioning whether this is enough.

“The first phase of the writedowns on structured products may be nearing its end and there may be a period of calm,” says Bruno Paulson at Bernstein Research.

“The real threat comes from the second half of the storm: a potential recession in the UK hitting earnings from 2009.”

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