Bank Rights Offerings Reveal Need to Throw Good Money After Bad

By Elena Logutenkova and Elisa Martinuzzi

June 30 (Bloomberg) -- Merrill Lynch & Co. and UBS AG, fresh from raising a combined $47.3 billion after losses on subprime investments, are using their capital to help rivals find cash.

Merrill and UBS joined Goldman Sachs Group Inc. in arranging the 12.3 billion-pound ($24.4 billion) rights offering by Royal Bank of Scotland Group Plc, the biggest European share sale to existing investors. A 31 percent drop in RBS's stock price pushed the underwriters to within 20 pence of having to buy the shares.

``In the current environment, investing in financials is pretty much like throwing good money after bad,'' said Franz Wenzel, the Paris-based deputy director for investment strategy at Axa Investment Managers, which oversees about $830 billion. ``We have been looking at some banks, but it's still way too early to start buying.''

The inducement of as much as $107 million in fees from arranging rights offers helps explain why investment banks are risking their capital to help shore up the losses of rivals. Underwriters have booked more than $1 billion this year from the share sales, partly offsetting the 50 percent drop in income from managing initial public offerings. European financial firms have announced plans to raise $78.5 billion through rights offerings since January, exceeding the total raised by companies during all of 2007, according to data compiled by Bloomberg.

``We've lost many of our traditional sources of revenue,'' said John Crompton, the London-based head of European equity capital markets for Europe, Middle East and Africa at Merrill. ``Rights issues have been one of the most active contributors'' for underwriters this year, he said.

Rising Risk

The appeal of rights offerings may wane as financial stock prices drop -- the MSCI World Financials Index has declined 24 percent this year, the worst performance of the 10 industry groups in the index.

Morgan Stanley and Dresdner Kleinwort Group Ltd., the securities unit of Munich-based Allianz SE, may have to buy shares of Edinburgh-based HBOS Plc next month. The U.K.'s largest mortgage lender, which is in the midst of a 4.1 billion-pound share sale underwritten by the two banks, traded below the 275 pence offer price in London every day last week.

Bradford & Bingley Plc, Britain's biggest lender to landlords, cut the price of its 258 million-pound rights offer by 33 percent after the stock fell, exposing underwriters Citigroup Inc. and UBS to the risk of ending up with stock that other investors refuse to buy. Its share price fell 21 percent on June 27 to 63.25 pence, compared with the 55 pence offer price in the stock sale, scheduled to run from July 8 till Aug. 1.

`One-Legged Banks'

Royal Bank of Scotland fell to 219.5 pence in London trading on June 2, a week before the rights offer was concluded, from 381.09 pence at the start of the year. The underwriters had guaranteed to buy any shares not purchased at 200 pence.

``It's a slightly bizarre situation,'' said Andrew Lynch, who helps oversee about $3.5 billion in European equities at London-based Schroders Investment Management Ltd. ``The one- legged bank is supporting another one-legged bank.''

The fund raisings come as writedowns linked to subprime mortgage losses -- $399 billion since the start of last year -- triggered some of the worst collapses in banking history. JPMorgan Chase & Co. bought Bear Stearns Cos. for one-third of its market value after the New York-based securities firm faced bankruptcy in March. In the U.K., the government nationalized mortgage lender Northern Rock Plc in February after it had to be bailed out by the Bank of England.

New York-based Citigroup and UBS of Zurich have taken the largest writedowns and losses, data compiled by Bloomberg show. Citigroup raised more than $44 billion from investors, including the Abu Dhabi Investment Authority and the Government of Singapore Investment Corp., while Merrill got $17.9 billion.

UBS Rights Offer

UBS, which raised 16 billion Swiss francs ($15.7 billion) in a rights offering this month after $19 billion of first-quarter writedowns, was able to guarantee part of RBS's sale because its own issue was fully underwritten by investment banks led by New York-based Morgan Stanley and JPMorgan. UBS shares fell to as low as 7 percent above the rights-offer price during the subscription period.

James Renwick, a UBS vice chairman of investment banking in London, said capital problems at the Swiss bank haven't constrained its underwriting activities because risks are mitigated by setting offer prices at large discounts to the market, seeking bigger fees and finding sub-underwriters.

``The situation in the global banking market continues to be critical,'' Renwick said. ``As we move through this cycle, I think we're going to see people being slightly more cautious in their underwriting.''

So far, that hasn't always happened. While fees should have been rising to compensate for the greater risk, competition among underwriters in what has been the slowest start for IPOs in four years is bringing fees down.

Lower Fees

RBS paid underwriters fees of 1.75 percent, UBS paid about 1.65 percent and Paris-based Societe Generale SA about 1.5 percent for its 5.5 billion-euro deal. Banca Monte dei Paschi di Siena SpA, Italy's No. 3 bank, paid securities firms 1.2 percent for its 5 billion-euro rights offer in May. That compares with fees of 4.3 percent for Allianz's 4.4 billion-euro rights offer in April 2003.

``We asked 15 banks to submit proposals based on a very competitive set fee, and they were all interested,'' said Marco Morelli, deputy general manager of Siena, Italy-based Monte Paschi. The bank sold stock to help fund the takeover of Banca Antonveneta.

Paul Marsh, a professor of finance at London Business School and author of a study on fees charged in rights offers, likens underwriting to a put option. A company that hires underwriters buys a put option to place the stock with the investment banks if investors don't buy it. The value of the put depends on the stock's volatility and the duration, he said.

`Money for Old Rope'

``It comes as no surprise that banks want to underwrite rights offers,'' said Marsh, who analyzed about 1,000 rights offerings over four decades. ``Underwriting rights issues has been like money for old rope.''

With the volatility of European financial stocks at their highest level in five years, the underwriting of banks' share sales is riskier than in the past.

``Never before has such an amount been raised by one industry in such a short period of time,'' said Viswas Raghavan, the London-based head of international capital markets at JPMorgan, the largest U.S. bank by market value. That has caused greater stock swings, as investors become pickier about the companies they're willing to back, he said.

Underwriters may have also misjudged the risks involved in guaranteeing the deals, said Theo Vermaelen, a professor of finance at Insead business school near Paris.

``It's one of a few businesses that hasn't collapsed,'' Vermaelen said. ``Investment banks may have been overly optimistic in thinking that the stocks were undervalued.''

Sub-Underwriting

There are more rights offerings in Europe because regulations in most European countries oblige companies to offer existing shareholders new stock first so they can maintain a proportional stake in the company. Investors in the U.S. typically don't have such rights, bankers said.

Securities firms can reduce their underwriting risks by finding investors willing to buy part of the offering in a so- called sub-underwriting. In return, sub-underwriters get a cut of the overall fees.

Fees for sub-underwriting also are falling, and the gap between what firms get for underwriting and what investors receive for sub-underwriting is getting wider as banks seek to keep more for themselves, according to Marsh.

Typically, firms received fees of about 1.25 percent to sub- underwrite, Marsh said. Commissions offered to sub-underwrite RBS's stock offering were as low as 0.8 percent.

Risk and Reward

``Traditionally, banks wouldn't take the exposure unless they had a fairly good idea that they could obtain sub- underwriting,'' said Derek Chambers, a London-based analyst at Standard & Poor's Equity Research. ``In some of the recent rights offers, the banks arranging underwriting thought the discount was so wide they could afford to retain the risk and the reward.''

Investment banks may have no choice but to underwrite rights offers to help support customers in their own industry.

``Stepping away from these transactions when your clients are under pressure means that you get longer-term impact on the quality of your franchise,'' said Dirk Hoffmann-Becking, a London-based banking analyst at Sanford C. Bernstein & Co. ``You can't be a fair-weather underwriter, but when it rains you're not providing an umbrella.''

The number of rights offers from financial companies will probably continue to increase as European banks have only just started to shore up their balance sheets, according to analysts at Citigroup.

Sovereign Funds

``In an environment where banks have to deleverage quite sharply, they'll have to either shrink their balance sheet or come back to raise more money,'' said Lynch, the Schroders fund manager. ``I'd be very surprised if we didn't see any more banks coming to the market with more rights issues.''

Credit Agricole SA, which had the luxury of not having to ask investment banks to underwrite its 5.9 billion-euro offering, went to its regional banks instead.

``Our banks have more capital than the biggest investment banks,'' Credit Agricole Chief Executive Officer Georges Pauget said in an interview in Milan on June 20.

London-based Barclays Plc got sovereign wealth funds in Singapore, China and Qatar to guarantee its stock sale to help Britain's No. 4 bank raise 4.5 billion pounds last week.

Concern that rights offers may fail and damage financial companies' efforts to shore up their balance sheets prompted Britain's market regulator to demand disclosure of short selling during rights offers. That occurs when investors bet on declines of share prices by selling borrowed stock in the hope of repurchasing it later at a lower price.

Short Selling

The Financial Services Authority cited short sellers earlier this month for causing ``severe volatility in the shares of companies conducting rights issues.'' The new rules, introduced June 20, require disclosure of short positions of more than 0.25 percent of stock for companies selling new shares in rights offerings.

Even if the ability of hedge funds to short shares has been curtailed, the risks of underwriting aren't about to diminish.

``It used to be a pretty low-risk business,'' said Hoffmann- Becking of Sanford Bernstein. ``Now we see it actually can be risky. And though they got away this time around, we don't know what's going to happen next.''

To contact the reporters on this story: Elisa Martinuzzi in Milan at emartinuzzi@bloomberg.netElena Logutenkova in Zurich at elogutenkova@bloomberg.net