Don't bank on the divi

SCRUTINEER

HBOS

573p -1.5p

RBS

370p +1.75p

AN INTERESTING note from Lehman Brothers explains why the broker remains bearish towards Royal Bank of Scotland and HBOS in the banking sector.

One of the reasons is that the two banks are "the most geared to UK corporate sector loan quality and particularly to the two key areas of commercial property and buyout finance".

HBOS, the Bank of Scotland/Halifax group, has £40bn of property and construction loans, equivalent to 220 per cent of its market capitalisation.

RBS's exposure in this area was £56bn at the end of 2007, says Lehman, which is 175 per cent of its market value.

In the uncertainty facing the UK economy following the subprime crash in the US, these exposures are not a plus, the broker persuasively argues.

It adds that another weakness for HBOS is that 59 per cent of its wholesale funding matures within one year, hardly reassuring given the vertiginous Libor rates at which banks are currently lending to each other.

Meanwhile, RBS's costly victory in acquisition battle for parts of ABN Amro has left it highly leveraged as well as having some of the biggest US exposure of any UK bank.

Robert Law, Lehman's MD for equity research for European banks, also sees UK banks as being in a quandary about launching rights issues or initiating asset sales to try and de-leverage balance sheets.

Law said yesterday: "I do think they (the banks] will look at shedding assets ahead of raising equity. But the amounts the UK banks can raise through asset sales are relatively limited.

"It would be incremental to their balance sheets rather than transformational."

Having said that, Lehman believes that if a big UK bank does launch a big rights issue – if only to cover subprime-linked writedowns – there will be considerable peer group pressure for others to do the same.

Whatever way you look at it, UK banks look to be facing their toughest ride since the early 1990s recession.

Against the current nervous backdrop, Lehman argues that, in terms of stock valuation, balance sheets will be more important than profitability. That is quite a sobering thought.

One of the first things to go in this climate may be previously generous increases in banks' dividends.

Few people expect the divis to be actually cut, but average current expectations of increases of 12 per cent this year look pretty optimistic given the almost daily bad news coming out of the sector.

Jon Peace, executive director for European banks at Lehman, said: "It is anathema for them to cut the dividend.

"But we think dividend growth expectations will get chopped right back."

The gloom continues.

THERE are few true mergers of equals. A dominant culture usually emerges from one side.

This is even more transparently obvious when the company being taken over, as in banking group Bear Stearns, faced going to the wall otherwise.

From an internal memo, it now looks like all but five of the 26 top jobs in the "merged" company's investment banking division following JPMorgan Chase's takeover of the distressed bank will go to JPMorgan people.

Given that Bear's staff held lots of shares in the group, when it was bought for a song in March the foot soldiers lost not only their jobs but also a lot of their personal paper wealth.

Some of the highest rollers, however, might have hoped the pain of seeing their stock worth virtually nothing would be softened by at least finding a berth in the new ship. No way José, as the Americans say. No sentiment, and little surprise. It is the way of Wall Street.

SAY what you like about Luqman Arnold, and many do, but he gets around.

He was ejected from UBS after a clash with the soon-to-be-ousted chairman Marcel Ospel. With colleague Stephen Hester he then turned around a distressed Abbey National before flogging it to Banco Santander of Spain.

And his Olivant vehicle only recently unsuccessfully tried to parachute management into Northern Rock in return for a minority stake.

Now Arnold is turning his attention to UBS again, demanding a shake-up and divestment of its investment banking operation to leave it focused on wealth management. He says Olivant's 0.7 per cent stake in the bank is meant to make money, not for revenge for old slights.

With Arnold around, banking is not boring, it's a carousel.