Will Royal Bank of Scotland Continue to Pay Dividends on Its Preferreds?

Includes: PGF, RBS
by: Global Investing Editor

Several readers asked me whether the newly nationalized Royal Bank of Scotland (NYSE:RBS) will continue to pay dividends to owners of its non-cumulative preferred shares (and those of NatWest which it acquired).

My answer:

I do not know, but here is my best guess. the preferreds are a relatively minor part of the capital of the banks and are not currently being added to (like the common). So it is a free choice by the British PM Gordon Brown and and the Chancellor of the Exchequeur, Alisdair Darling, both of whom are Scots themselves, what they do about the biggest case, which is Royal Bank of Scotland. (Nat West is also RBS which acquired it before the mess hit.)

My guess is that they will not halt payment of interest on the preferred for a couple of reasons: 1) they were targetted at US retail investors, not speculative Britons like the recent buyers of RBS common; 2) the government wants eventually to sell the bank to the private sector again and does not want to hurt its standing too much; 3) this is a minor amount of money in fact; 4) it is linked to the dollar business RBS does, which is mostly wholesale, and cutting the payout would hurt the bank's global rep 5) the government's own shares are also preferreds which presumably means that preferred get preference which is what they normally get (I am not sure which preferreds are senior but in theory it is the ones we own) and 6) Britain would lose standing as an international bank centre if these payouts were halted.

They really don't want to wind up as Iceland on the Thames.

Another imponderable is news that the Dutch Parliament is looking into the acquisition by RBS of ABN-AmRo which triggered the meltdown at RBS and of course also hurt Dutch investors.

However, I have no deep insights into the souls of these Labourite Scots and I am just guessing. People can make stupid decisions based on a desire to control moral hazard, like the Paulson decision to let Lehman Brothers go bankrupt, which was a dreadful mistake.

That is why I say to buy the non-bailout bank preferred stocks too, which is Barclays (no UK govt. money taken or wanted, and a yield nearly as high).

There is a huge amount of speculative in- and out-flow into RBS and the other government assisted banks. There is risk with the preferreds but not in my view as much. I am buying these using limit orders, but am also keeping my fingers crossed. I will not comment on U.S. bank preferred stocks.

*Here is another view from an independent analyst at Datamonitor, Jonathan MacDonald, Lead Analyst writing on the British govt. bailout today: "damned if they do, damned if they don't". "It is not yet clear whether the move will prove successful as the current climate has no precedent' acknowledges MacDonald. "This is leading stakeholders to proceed with caution." He writes from London, edited intially by Datamonitor's Marie-Ange Nouroumby:

"The UK government has announced a 2nd wave of bail-out plans to help Britain's ailing banking sector start to lend again, only months after an initial multi-billion pound bail-out program. The first bail-out has seemingly failed to stimulate the financial markets and the economy in general, but the new plan has a greater potential to achieve its objectives.

"The new agenda consists of three steps: an insurance element, which guarantees bank loans for corporate and consumer debt; a mandate issued to state-owned Northern Rock to increase lending; and new powers for the Bank of England, allowing the institution to buy up to GBP50 bn in bank assets. In addition, the government is changing the terms of the initial bank bailout, which will allow banks such as RBS to convert the government's preference share holdings, which pay a 12% premium, into ordinary stock.

"Overall, this new plan is necessary. The taxpayers' money invested in the original program has clearly been used by the banks to cover bad debt provisions and shore up capital reserves, rather than to boost lending as the government originally intended.

"The banking industry and RBS in particular argued that the 12% premium demanded by the government in the form of preference shares has limited its ability to resume lending profitably. Given the cost of credit on the open market, this high percentage represents the 'slap on the wrist' that was dished out to the banks which sought government funds. However, this strategy backfired, as banks have not been able to provide credit while also repaying their government funding obligations.

"The new bail-out plan is better structured to kick-start lending. Rather than blindly covering banks' bad debts, the government plan provides insurance against any potential loss, with legal obligations for participating institutions to increase lending accordingly. The depths of these obligations are not yet known but, in theory, the new plan appears to be better thought out than the previous one.

"Critics have argued that the government is intervening too much, and question the unusual haste with which it has moved to plough billions into the financial industry 18 months ahead of the election deadline. However, one wonders whether this will actually be enough to finally quell the storm in the financial markets.

"Despite any reservations, however, an increase in credit will certainly assist many businesses currently struggling to find working capital, and will also provide a much-needed boost to the mortgage market. Furthermore, the government may find that its insurance is not called upon, leaving the taxpayer with a healthy shareholding in some blue chip financial stocks and little in the way of pure debt.

"With the government only insuring against losses as opposed to writing them off entirely, it may take quite some time for the industry to get to the bottom of the existing toxic asset pool, which may deter shareholders from reinvesting for a long time. The UK banking industry is now all but state-owned, and therefore should be promoting the best interests of consumers and the economy as a matter of priority."

Disclosure: I own 20 shares of RBS (calling card); 500 shares of RBS preferreds F and P, 200 shares of Nat West preferred; and am buying Barclays preferred if my limit orders go through.