Eh up lad, it’s retro time. Back in the good old days of the 1929 American depression Laurel and Hardy, a couple of guys in bowler hats, had us in stitches with their zany capers (no, I wasn’t alive then, I saw the repeats on BBC2). The new boys on the block are a couple called Bradford & Bingley and their equally daft pranks have had the City in stitches.

On Monday these guys stunned stockmarkets when they issued a profit warning just 9 days after they’d said everything was OK. But the real ground breaking announcement was that they were revising the terms of the recently announced rights issue.

Now, a renegotiated rights issue is as rare as Gazza without a drink, so it’s worth having a closer look at what a rights issue is and why it all went Pete Tong.

What’s A Rights Issue?
It’s a polite way of asking shareholders for more dosh. It’s polite because there are other ways of raising money (issuing corporate bonds or selling shares to an individual ‘benefactor’), but this way gives shareholders the chance to be involved.

A rights issue is a way in which a company can raise money by selling new shares. These shares are offered to existing shareholders in proportion to their current shareholding, but at a much cheaper price than the current market price.

“Wa hey!” says you, “I thought there was no such thing as a free lunch; this looks pretty close to me.”

‘fraid not pal. I’ll save the full maths lesson for another day, but trust me on this. Freebies from the City are usually limited to pens, mouse mats and stress balls. Although you get these shares ‘on the cheap’ those nasty guys in the City will adjust (mark down) the price of your existing shares to take account of all this, a sort of robbing you to pay you.

If you take up the rights your holding will remain the same in percentage terms. But here’s the rub; if you don’t take up your rights, your original investment will be worth less, though you can sell the rights to make up some, or all, of the loss. Not so wonderful now then.

Rights issues can be launched from a position of strength; a company doing well might need further capital to fund a new venture, expansion or a strategic takeover. Alternatively, companies also launch rights issues from a position of weakness, for example, if it needs extra funds after suffering losses or a deterioration in its balance sheet. Unfortunately the banking sector falls into the second category. For a bit of background check out my earlier piece on rights issues.

Underwriters-the ones closest to a free lunch
When the company bosses decide to ask its shareholders to have a whip round, they’ll phone the investment banker that took them to the sport at Leopard’s Town/ Twickenham/ St Andrews and ask him to set the ball rolling.

The investment banker gets on well with all the top institutional shareholders (who also get taken to Leopard’s Town/ Twickenham/ St Andrews). He and his team will then play investment poker with shareholders to arrive at the best price they can sell the new shares at. He needs to judge the appetite for the extra shares, and balance the highest price he can sell the rights at with the risk that he might be left with unwanted shares if the price is too high.

The Investment bank will underwrite the rights issue. In normal language that means they’ll guarantee that the company will receive full payment for all the shares; they’ll buy any shares not wanted by existing shareholders. And for doing this they’ll get paid an astronomical multiple of the Leopard’s Town/ Twickenham/ St Andrews ticket price.

But here’s the clever bit; the investment bank doesn’t want the risk of holding unwanted shares. So they offer the underwriting commitment to other organisations in exchange for a part of their massive fee. In the good times this is a real gravy train; it’s money for old rope as rights issues are priced to go. But once in a while the underwriters have to earn their fees and take the unwanted shares.

What Happened To The Men In Bowler Hats?
Back in April the whole market was buzzing with news of a Bradford & Bingley rights issue, they needed cash to ease their funding problems. But Laurel & Hardy denied they were planning any such thing. However, in May the Royal Bank of Scotland and HBOS broke the ice by announcing rights issues. Then guess what? Bradford & Bingley also announced plans for a rights issue, offering shareholders 16 new shares for every 25 held, at a price of 82p.

Now here’s the real slapstick. On Monday (Just two weeks after the announcement), Laurel & Hardy had to tear up their original plan and make a revised offer of 19 new shares for every 25 held, at the lower price of 55p. This was despite the fact that the underwriters were obliged to buy the shares at 82p.

Bradford & Bingley announced that rising arrears in the bank’s mortgage book had caused it to make a loss of £8 million in the first four months of the year. The Chief Executive was retiring, due to ill health, and the terms of the impending rights issue had been revised. Oh, and a US private equity firm was going to take a 23% stake in the bank at rock bottom prices.

Word on the street was that the underwriters, Citigroup and UBS, were already pretty nervous and looking at the small print for a way out. The dramatic change in Bradford & Bingley’s earnings in such a short space of time could have provided them with a ‘change of conditions’ get-out clause. Rather than fight the underwriters Bradford & Bingley offered to change the terms of the issue.

TPG (formerly Texas Pacific Group), the US private equity firm, had already been sniffing around Bradford & Bingley in April, around the time of the original rights issue rumours. It looks as though they were sent packing but, smelling blood, decided to return with a new offer. This time they came away with a potential 23% stake in the bank (subject to shareholders’ approval) at the knock-down price of 55p a share.

I’m not sure whether Bradford & Bingley wanted to sell 23% to TPG at that level, or if they were pressured into it by their worried underwriters. But once they had offered shares to TPG at 55p they were duty bound to offer the rights at the same level. Monday morning saw the shares collapse 23%, ending the day not far off the revised rights price. There were plenty of pretty fed-up shareholders, especially as TPG want to provide two board members. “Will they really be acting in the best interests of all shareholders?” was the question asked. Some were more optimistic, saying that TPG’s actions suggested they saw value in the bank at that level, which was a sort of vote of confidence.

What About The Other Banks?
As things stand HBOS and RBS are the names in the frame. There was a lot of market chatter about hedge funds smashing the RBS price, trying to get a re-pricing of the RBS rights issue. D-Day is Friday and it looks as though it’ll survive on the existing terms. But HBOS is a different kettle of fish. Its business exposure to the UK mortgage market, particularly Buy To Lets, is much closer to B&B, leaving it vulnerable to all sorts of monkey business ahead of the rights take up in July

Also in the UK, Barclays is playing a dangerous game of bluff. Its capital ratios scream out for a rights issue, but the company line is that they’re not desperate and they’re looking at several ways of raising capital.

Irish banks were also caught up in the B&B turbulence this week; Anglo Irish shares fell by 7% on Tuesday, whilst Bank of Ireland’s were smashed for 11%. There’s speculation that Irish banks might also have to raise capital, but bosses at Bank of Ireland and Anglo Irish have dismissed this. Just like Bradford & Bingley did in April!

And in the US the potential demand for more capital is mind-boggling. Each new release of earnings seems to be accompanied by a need for more capital. On Wednesday the Financial Times revealed the Armageddon scenario of a change in accounting rules forcing $5,000 billion of assets back onto US banks’ books . This could lead to a whole post box of begging letters, desperate for new funds.

And to finish off, Laurel & Hardy received a custard pie in the face from Cattles Holdings. Cattles is one step up from the door-step loan shark, its business is lending to sub-prime borrowers. But the group successfully raised £209 million from a rights issue to allow it to gain a full banking license.

Conclusion
Dictum Meum Pactum (My Word Is My Bond). Before lawyers were invented and Americans ran the City this worked really well. But beneath the comic capers of the Bradford & Bingley board, there’s a nasty smell of the underwriters bottling it. The talk is that they were prepared to jump ship, and yet they they’ll still receive their £37m fee, even though the risk has been reduced. The whole purpose of paying the sum equivalent of the GDP of Wales to these people is for the certainty that, come rain or shine, the company gets its money.

This is a massive point; it’s almost unprecedented for a rights issue to fail, or have the terms revised to avoid such an event. The potential amount of capital still to be raised by banks will be a big enough test for the sector. But if a rights issue were allowed to fail the result would be more catastrophic than another series of Big Brother.