Why did bank shares rise after bad news?

By This Is Money
Updated: 07:35 EDT, 10 March 2009

Why did Royal Bank of Scotland's share price increase by more than 20% after announcing the biggest losses in UK corporate history on 26 February? D.O., Cardiff

On the up: How come bank shares rise after a crisis?

Spencer Winfield at stockbroker Charles Stanley replies: Warren Buffett, arguably the most famous US fund manager, once said that to be a good investor 'one should be fearful when all around you are greedy and greedy when all around are fearful'.

It is presumably with this sentiment in mind that some investors started acquiring Royal Bank of Scotland (RBS) shares after its results on Thursday 26 February.

Rightly or wrongly, these investors took the view that RBS shares were already trading at rock bottom levels in anticipation of the losses it announced.

I believe that for the majority of buyers, their investment decision was a reaction to the announcement that RBS had ring-fenced £325bn worth of it's 'toxic debt' into a Government insurance plan and that the bank is now, in fact, only liable to pay the first 10% of the losses on this pool, effectively cutting its liability to the first £32bn.

In addition, the board of RBS have, one would imagine, 'thrown the kitchen sink' in with the results to get all the bad news out of the way.

This is usually the case when a new management team takes over a troubled business. They tend to make sure all the bad news is in the public domain at the first opportunity. This, of course. avoids any risk of their being blamed at a later stage for errors made by their predecessors and it also gives them a lower starting point for comparison against any progress they make in subsequent years.

A further factor to consider is that it is widely accepted in the market that the Government does not wish to fully nationalise any of the major clearing banks if it can avoid it.

Finally, when a share price begins to move higher on this kind of news there can be a certain degree of herd mentality, where those considering whether or not they should acquire shares are dragged in as they see the price moving higher and become concerned they will miss the opportunity.

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The ring-fencing of the debt has effectively made the RBS potentially viable again, although this comes at a huge potential risk and expense to the taxpayer. This has encouraged what will in the future be viewed as either crazy speculators or astute investors (depending on the final outcome) to acquire the shares in the hope the bank will survive the present crisis and rally in due course.

While the present financial outlook is undoubtedly worse than that seen back in the 1973/74 stock market crash, there once again we saw a clearing bank in trouble. On that occasion it was National Westminster Bank (NatWest) that was on the brink of collapse as the market plummeted.

At the time, NatWest shares were trading below their nominal value and it looked as though the bank was likely to fail.

As we now know, the bank survived and the shares subsequently recovered and anyone who had been brave enough to buy the stock and hold on to it made spectacular profits. NatWest was, somewhat interestingly, acquired by RBS in the early Nineties shortly after another banking fiasco brought about by irresponsible mortgage lending. How history continues to repeat itself!

With the ring-fencing of the 'toxic debt', the Government's stance on complete nationalisation and the proverbial kitchen sink having been thrown at the accounts, some investors clearly felt this was the turning point for the bank. This led to a weight of buying immediately after the figures pushing the shares significantly higher.

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I'm afraid it is often the case that the difference between a brilliant investment decision and a disastrous one is a very fine line and while many of us will be wise in hindsight some investors took the view on the 26th that these factors had tilted the scales in favour of RBS surviving.

Some of the more speculative among those who bought the shares last month may be a little more familiar with my final quote than that from Mr Buffett, above.

On this occasion the words of wisdom come from arguably the UK's best known market trader - I need not tell you his name: 'He who dares wins, Rodders, He who dares wins'.

While this is a little less sophisticated than Mr Buffett's observation, the underlying thread is still the same and it is this mindset that led to RBS's share price being marked higher in the aftermath of its figures.