RBS’s Decision To Buy Risky U.S. Mortgage Portfolio Raises Eyebrows

The Royal Bank of Scotland Group (NYSE:RBS) doesn’t seem to have learned a lesson yet after being brought back from the brink at the peak of the global economic downturn of 2008 through a multi-billion pound cash infusion by the U.K. government. After all, given that the single biggest reason for its near-insolvency in 2008 was its huge exposure to high-risk mortgages, one would expect the global banking group to stay away from them at least until it finds a way to rid itself of the government’s 81% stake.

But in a move that raises eyebrows, the bank went ahead and purchased a portfolio of 4,000 U.S. mortgages at an auction by the U.S. Department of Housing and Urban Development (HUD) last month. ^[1] And while RBS sees value in this portfolio of poorly performing mortgages which it won for less than half their unpaid principal balance, one cannot miss the irony here – the taxpayers’ money that was pumped in to clean up a mess created by risky mortgages is now being used to add similar mortgages to the bank’s balance sheet.

We maintain a $11 price estimate for RBS’s stock, which is at a premium of nearly 25% to current market prices. A large part of this difference can be attributed to the weak sentiments towards European banks in the wake of Cyprus’s contentious bailout plan and continuing economic weakness in the region.

See our full analysis for RBS’s stock

No Doubt, RBS Is Going Through A Difficult Phase…

RBS has been struggling to keep its numbers out of the red since the recession of 2008. While the bank has done well to address a large number of issues pertaining to its business model, the increased pressure from the U.K. government which is a majority shareholder in the banking group, tighter regulatory norms and the continued slowdown in Europe have made it difficult for RBS to churn out revenues close to record levels seen prior to 2008.

Most notably, the U.K.government has directed the banking group to curtail its investment banking operations to a large extent and has also forced it to focus on its operations in the U.K.

… But Taking On Additional Risks When It Is Already Bogged Down Just Doesn’t Seem Right

RBS’s decision to acquire the mortgage portfolio from the HUD stands out because it seems to go against quite a few things it is trying to set in order. Firstly, the portfolio of 4,000 poor performing mortgages represent an unwarranted risk – the 54% discount they came at notwithstanding. And secondly, this goes against the U.K. government’s diktat for RBS to focus on its U.K. retail business.

Given the growing demand for high-yielding investment options around the globe, RBS will most likely look to securitize the mortgages and sell them off over the coming months. And it might very well be successful in doing so. But should the banking group really get into that cycle again – especially when it was severely impacted from it just a few years ago and is yet to recover from the setback?

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1. RBS Is Back Into Poorly Performing Mortgages, The Wall Street Journal, Apr 17 2013 [↩]