Description

Investment Overview

We recommend establishing a LONG position in RBS’s Tier 1 Securities, specifically, the 5.9% Series E and 6.08% Series G.  We believe there is 80-105% upside over the next 12-18 months.

They are listed under the Bloomberg ticker symbols RBS 5.9 Pfd and RBS 6.08 Pfd.

Note: these are $25.00 par securities.  All price references below are shown both in actual dollar terms ($25.00) and as % of par (100).  Example: $25.00 / 100.

These securities currently trade at distressed levels of ~$11.00 / 45% of par.   This represents a 13.5% current yield once coupons are turned back on.

The coupons on these securities are discretionary and currently turned off.  In conjunction with RBS’s agreement to accept state aid from the UK government in 2008, the European Commission required RBS to turn off all discretionary coupons on hybrid securities for a period of two years beginning April 30, 2010.  Those coupons will be turned back on at the end of April 2012.  However, the Series E and Series G coupons were not turned off until April 1, 2011, and as a result, will not be turned back on until April 2013.  Note: the coupons are non-cumulative, so no accrual for missed payments.

We think that once RBS turns on the coupons for the initial moratorium securities, the Series E & G will trade up to $15.00-17.50 / 60-70, levels reached in May 2011.  This represents 50% upside from current levels over a six month investment horizon.

We think that once the coupons for the E’s and G’s themselves are turned on in April 2013, they could trade to $20.00 / 80, representing ~80% upside over a ~15 month investment horizon.  A price of $20.00 / 80 would still imply a current yield of 7.5%.

Downside supported by potential LME (liability management exercise, i.e. swaps for cash at premium to current levels but discount to par)

- If current distressed valuations persist, RBS is likely to conduct a liability management exercise to retire these securities at a premium to current trading levels and book a gain

While we believe that the UK may slide back into recession in 2012, we think that RBS is sufficiently well capitalized to weather the storm:

- Core Tier 1 Ratio of 10.0% at Sept 30, 2011 (11.3% incl the UK govt support agreement)

- Near-zero sovereign peripheral (GIIPS) exposure: £1.1bn on £50bn Core Tier 1 capital

- No need to raise additional equity capital

- Non-core Irish book has already been written down dramatically -- 40% cumulative provisions on gross loan book (again for non-core Irish assets)

- The UK Government owns ~83% of RBS equity, mitigating the risk of an impairment of junior securities in any subsequent restructuring

We believe this investment opportunity exists because the coupons have been turned off and subordinated paper of European banks is the last place most investors want to be right now.

Business Description

The Royal Bank of Scotland Group is one of the four large UK banks

- Key stats:

• £1,607 billion in total assets (that’s £1.6 trillion, i.e. too big too fail)
• £512bn in risk-weighted assets
• £50bn in Core Tier 1 capital (10% CT1 ratio)
• Only £1bn peripheral sovereign exposure (GIIPS), mostly Greek paper already marked at 37

The “Core” business consists of:

UK Retail

• £50bn in risk-weighted assets, £2bn in operating profit in 2011E
• Almost exclusively a residential mortgage book with 57% LTV

UK Corporate

• £75bn in RWA, £1.5bn in 2011E operating profit
• Danger is a large CRE book (£30bn gross loans)

Wealth Management

• £13bn in RWA, £300mm in 2011E operating profit
• Solid business; £30bn AUM

Global Transaction Services

• £19bn in RWA, £750mm in operating profit
• Very steady, high ROE business

Ulster Bank (Irish bank)

• £34bn RWA, will lose £1bn in 2011
• Mostly a residential mortgage book with 72% LTV (£21bn loan book)
• Rest of portfolio is CRE (£5bn) and Corporate (£8bn)

US Retail & Commercial

• £57bn in RWA, £450mm in 2011E operating profit
• Book is commercial lending (£22bn), home equity lending (a bit scary at £15bn) and residential mortgage lending (£6bn)

Global Banking & Market (investment bank)

• Though still profitable, this business has a very low ROE and weak business mix
• RBS will dramatically shrink this business over the next few years

The “Non-Core” book is RBS’s bad bank

- RBS has been shrinking this book aggressively, down to £87bn in Q3 2011 from £160bn two years ago

- ~1/3 of the loan book is property & construction

RBS Insurance

- Plans to sell this business by 2013

Key Risks

- UK economic slowdown

• We think recession is likely; severity TBD by outcome of Euro sovereign crisis

- Ireland exposure

• £50bn gross loan book (core + non-core); £41bn net loan book
• Non-Core book has been heavily provisioned already
• Core book is mostly mortgages…still a heavy exposure to Irish economy

- Eurozone break-up

• There is concern in the market that if peripheral countries exit Eurozone, resulting currency depreciation will wipe-out any bank exposure to those countries
• In Ireland, RBS has local deposits that significantly reduces its net asset exposure in the periphery
  • Note: Irelandis the only peripheral economy where RBS has a local bank
• That said, if the Eurozone breaks up, this and every other security issued by European banks will trade down

- Shipping book

• RBS has a ~£14bn shipping book that has very little provisions in place
• We are concerned about the shipping portfolios of RBS and other European banks given capacity glut for these assets and resulting price declines

- Additional regulatory burdens (see below)

Regulatory Considerations

RBS faces a litany of new regulations that will pressure ROE;  most of these however require RBS to hold more capital -- a credit positive

- Basel III

• Basel III will require banks to hold more capital and meet additional liquidity requirements
• Negative for equity holders, positive for creditors

- G-Sifi

• RBS has been designated a Global Systematically Important Financial Institution and will have to meet additional capital requirements above and beyond Basel III; net credit positive

- UK Bank levy

• 2011 will be the first year RBS is charged the new UK bank levy; latest disclosure indicates an expected annual charge of £330mm

- Rink-fencing

• UK ICB report recommends ring-fencing retail bank assets from investment banking activities
• It’s still too early to understand if / how these recommendations will be implemented but in theory a net negative for credit backed by the investment banking assets only

Key Business Trends

- Key business trends are negative almost across the board

- NIM compression driven by both lower rate environment and higher funding costs

- Additional revenue pressure from deleveraging and falling loan demand

- Elevated provisions in core-book likely to persist given economic outlook inUKandEurope

- Subdued market activity affecting all trading related businesses

- More stringent regulatory environment requiring higher capital, higher liquidity reserves and higher taxes

- In spite of all these headwinds, RBS should generate greater than £2bn of net income in 2012 and pre-provision income of greater than £8bn

• i.e. RBS can weather £16bn of further impairments over 2012 and 2013 without depleting its capital base

Senior Management

- Stephen Hester CEO

• Appointed in November 2008; has been leading the restructuring of RBS
• Have never met; appears to be well-regarded and provides sense of accountability

- Bruce van Saun CFO

• Appointed in October 2009
• Long career on Wall St.   Have not met.  No view.

Risk / Reward

- Once coupons get turned back on, we conservatively estimate these securities will trade for at least ~7.5% yield resulting in a price of $20.00 / 80

• 100% upside from current levels to April 2013 coupon announcement

- Once coupons get turned back on for the initial moratorium securities, that should serve as a significant catalyst for these securities and could cause them to return to pre-sell off levels of $15.00-17.50 / 60-70 (50% upside)

- A par recovery via redemption is a possibility, as these securities do not qualify for Core Tier 1 capital treatment under Basel III

• However, at current trading levels LME is more likely as an intermediate step

- On a fundamental basis, downside from current levels would occur if RBS is forced to take additional state aid, extending the moratorium on coupons for perhaps an additional two years. 

• We think this is highly unlikely but could be mitigated by LME -- supporting security prices and allowing RBS to record a book gain / boost Core Tier 1 capital.

- On a technical basis, if the Eurozone crisis deteriorated significantly, we would not be surprised if these securities re-traced October lows.  We are long-term holders of this paper and would be buyers in that situation.

Other Notes

- These are perpetual securities with no maturity date and 2012 call dates (though non-callable until coupon moratorium is lifted)

- The Series E and Series G were originally issued by ABN AMRO, subsequently acquired by RBS and now exist under the RBS subsidiary RBS N.V.

- These notes do not have a guarantee from RBS parent, merely a letter of support

- Furthermore, RBS has been in the process of moving ~3/4 of the assets of this entity to RBS Plc

- Although it may appear as though RBS is stripping assets from an entity of which is does not provide a guarantee, RBS IR has explicitly told us they do not intend to leave holders of these securities in the cold

- RBS NV assets consist mostly of investment banking divisions, which are about to undergo a massive restructuring -- RBS is looking to sell or close many of these units

- Regardless of what course of action RBS takes with respect to the i-bank, we believe RBS will do right by the Series E & G holders and that any restructuring of the business could be a catalyst for a positive credit event in these securities

- Lastly, note that these are USD issues: no need to worry about hedging foreign currency

Variant Perception

- We believe management will turn the coupons back on

• Current trading levels suggest investor skepticism

- We believe RBS is sufficiently well-capitalized to withstand a further deterioration in European economic outlook

- While we are very concerned about the Eurozone sovereign crisis, we believe the monetary union will survive for the foreseeable future (with the possible exceptions of Greece and perhaps even Portugal)

Catalyst