DBRS Comments on Lloyds’ Alternative to the Government’s APS and 3Q 2009 Results, Ratings at A (high), Trend Negative

DBRS has today commented that its ratings of Lloyds Banking Group plc (Lloyds or the Group) and related entities, including the Group’s Issuer and Long-Term Debt Rating of A (high), are unaffected by the Group’s announcement of an alternative to the U.K. Government’s Asset Protection Scheme (APS) and the release of the Group’s 3Q 2009 Interim Management Statement. The trend on all non-HM Treasury guaranteed long-term debt remains Negative. The trend on all Short-Term Debt ratings and the HM Treasury guaranteed debt remains Stable.

Today’s comment follows Lloyds’ announcement that it has reached an agreement with HM Treasury regarding an alternative to participating in the APS. The Group’s proposal is to affect a GBP 21.0 billion capital raise through a combination of a rights offering and an exchange offer. The rights issue is estimated to raise GBP 13.0 billion, net of expenses, with the U.K. Government taking up GBP 5.7 billion, maintaining 43% ownership in Lloyds. Additionally, Lloyds intends to generate at least GBP 7.5 billion of core Tier 1 capital through the Exchange Offer of non-core Tier 1 notes for new lower Tier 2 capital qualifying bonds, Enhanced Capital Notes (ECNs). The new ECNs will convert to ordinary shares of the Group, should the Group’s consolidated core Tier 1 capital ratio decline below 5%. DBRS notes at 30 June 2009, Lloyds’ core Tier 1 capital ratio was 6.3% and subsequent to the proposed capital raise the pro-forma ratio would be significantly strengthened to 8.6%.

DBRS views Lloyds’ decision to forego the APS and move forward on this capital raising exercise as positive. Although Lloyds will be required to pay HM Treasury a pre-tax GBP 2.5 billion fee for the benefit of the implicit guarantee received since the APS announcement, the Group avoids paying the GBP 15.6 billion APS participation fee. Further, DBRS sees the alternative proposal as having little impact to the overall franchise given the divesture requirements from the E.U. for receipt of State Aid could have been far more draconian. Nonetheless, Lloyds will be impacted by the required divesture of the Cheltenham & Gloucester branches (but not the brand), Lloyds TSB Scotland branches (but not the brand), the TSB brand, the approximately 200 Lloyds branches in England and Wales, and the online retail bank, Intelligent Finance. Although the required divestitures will reduce market share in certain businesses and geographic regions, the Lloyds franchise and overall market shares remain very strong. Moreover, in DBRS’s view, the added benefit of the resulting strengthened capital position and the protection added by the ECN’s will help mitigate any potential weakening of capital generation. As such, DBRS views the overall impact to the franchise as very manageable.

Lloyds’ revenue performance during Q3 2009 continues to improve in line with that experienced in H1 2009. Further, net interest margin (NIM) has stabilised, albeit at reduced levels due to the lower interest rate environment. NIM continues to benefit from ongoing asset repricing which helped offset low deposit margins and higher funding costs. Reduced economic activity in the U.K. continues to constrain overall lending demand, resulting in unsecured balances largely flat to H1 2009 and mortgage lending at subdued levels. Lastly, results are buoyed by Lloyds’ strong cost control management, which continues to produce solid results with costs 2% lower year-to-date compared to a year ago. DBRS views the continued solid results as illustrating the resiliency of Lloyds’ underlying earnings generation ability and further evidence of Lloyds’ strong franchise, both of which are key factors underpinning the rating. Notwithstanding, DBRS notes that the Group expects to report a loss before tax for the full year 2009, excluding the impact of the GBP 11.2 billion credit relating negative goodwill related to the HBOS acquisition.

While the Group has indicated that impairments for the half year are trending lower than the sizeable levels experienced in H1 2009, DBRS remains cautious towards credit performance given the current point in the cycle. Continuing elevated levels of unemployment and the outlook for a protracted recovery are likely to weigh on household and business income pressuring their ability to service debt. Further, the decision to not participate in the APS removes a degree of loss protection from elevated levels of impairments; however, the proposed capital measures discussed above significantly increase loss absorption capacity. DBRS still views managing elevated credit costs, most notably within the HBOS legacy portfolio, as Lloyds’ chief challenge.

The trend remains Negative, reflecting DBRS’ view that, while there continues to be indications of a degree of stabilisation in the U.K. economy and housing prices, the operating environment in the U.K. will likely remain challenging over the near-term. Unemployment is expected to remain elevated which will result in continued pressure on U.K. households and businesses, thereby impacting credit costs. Loan demand will likely remain subdued, given the lower economic activity, whilst deposit margins and net interest margins will likely remain pressured owed to the overall competitive environment and the expectation of an extended period of low base rates. While the trend remains Negative, DBRS continues to look for indications of a sustained improvement in the operating environment, which in conjunction with improved financial performance, may lead to a revision of the trend to Stable. Progress in achieving a level of profitability is essential for rating stability.

Note:
All figures are in GBP unless otherwise noted.

The applicable methodology, Analytical Background and Methodology for European Bank Ratings, Second Edition, can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.