Nov. 4 (Bloomberg) -- Royal Bank of Scotland Group Plc, waiting to take up the U.K.'s biggest bailout, abandoned its full- year profit forecast as credit losses worsened and bad loans rose.

The Edinburgh-based bank took 1.4 billion pounds ($2.2 billion) of markdowns before accounting adjustments in the third quarter and warned that fourth-quarter credit losses probably will be higher. RBS also wrote down 1 billion pounds in October against assets tied to Lehman Brothers Holdings Inc. and Icelandic banks, Finance Director Guy Whittaker said.

Chief Executive Officer Stephen Hester said the latest charges, coming on top of 5.9 billion pounds in the first half, show the bank has too much risk and may have a full-year loss. The ``global financial crisis'' has triggered rising loans defaults in the U.K., U.S. and Asia, the bank said in a statement. The U.K. will own as much as 60 percent of RBS unless investors buy some of the 20 billion pounds of stock it plans to sell later this year.

``It doesn't look good in the fourth quarter, and we would expect that as we go into next year, impairments will rise,'' said Julian Chillingworth, chief investment officer at Rathbone Brothers Plc, who helps manage $21 billion including RBS stock. ``Like a large oil tanker, it is difficult to turn around.''

RBS closed unchanged at 65.2 pence in London trading, just below its offering price of 65.5 pence for 15 billion pounds of ordinary shares. Investors have little incentive to buy shares in the U.K.'s biggest rights offering unless RBS stock rises.

Treasury Fees

RBS will pay the U.K. Treasury a commission of about 1.5 percent as underwriter on the offering, or 225 million pounds. Merrill Lynch & Co. and UBS AG are joint financial advisers to RBS and joint book-runners and sponsors.

The company also plans to sell 5 billion pounds of preferred shares that pay the government 12 percent interest. The U.K. rescue package, which also covers Lloyds TSB Group Plc and HBOS Plc, restricts dividend payments and executive compensation until the preferred shares are repaid.

RBS's goal is to repay the preferred shares and resume dividend payouts in 2010, Hester told reporters today. The bank will pay all adviser fees and costs related to the sale of preferred shares.

The bank's capital has been eroded by hedging contracts in the securities unit that have expired or been terminated by counterparties including Lehman Brothers, the New York-based securities firm that filed for bankruptcy in September. There is ``relatively high'' likelihood that RBS will post charges on loan defaults related to hedge funds, Whittaker also told analysts.

Credit Defaults

RBS bought 20 billion pounds of credit-default protection from so-called credit derivative product companies. The bank has a fair-value exposure based on market prices of 2.6 billion pounds, Whittaker said.

As defaults rise, credit derivative product companies ``may come under increasing pressure,'' said Sandy Chen, a London-based analyst at Panmure Gordon & Co., who has a ``sell'' rating on RBS.

``A significant deterioration in credit quality is one of the major challenges,'' Chen said. ``We feel comfortable with our expectation that RBS will book a full-year loss.''

RBS may post a loss of 228 million pounds for the full year, according to the average estimate of seven analysts surveyed by Bloomberg. That compares with net income of 7.3 billion pounds last year. Operating profit before tax and writedowns fell 8 percent during the nine months ended Sept. 30.

Goodwill

RBS may also write down goodwill associated with acquisitions in the U.S., as well as units acquired from Amsterdam-based ABN Amro Holding NV, Whittaker said.

Goodwin, who announced Sept. 13 that he's stepping down, spent almost $90 billion on takeovers since he became CEO in 2000. He paid 14.3 billion euros ($19.3 billion) for part of ABN Amro, eroding the bank's capital and contributing to a third of its first-half writedowns.

Loans in danger of defaulting rose across all divisions in the first nine months, RBS said. They represented 1.7 percent of total loans as of Sept. 30, up from 1.5 percent at June 30. Impairments in retail and commercial loans in the U.S. rose ``sharply'' in the third quarter, and defaults also rose in the U.K. and Asia, the bank said. Commercial real estate impairments will also jump, Whittaker said.

Hester, who replaces Fred Goodwin, 50, as CEO later this month, has instructed all the bank's units to provide him with business plans and said he will complete a review by the end of 2009. He will update investors by February about which assets he may sell.

Trading Business

RBS may sell some of its trading businesses including a majority stake in a Sempra Energy unit which it bought this year as well its Asia consumer banking units and Cleveland-based Charter One Financial Inc., the U.S. bank it bought for $10.3 billion in 2004, said Mike Trippitt, a London-based analyst at Oriel Securities Ltd. in London.

Hester, 47, may set up a so-called bad bank to separate off the lender's damaged assets and restore confidence in its main businesses, said Sandy Chen, a London-based analyst at Panmure Gordon & Co.

Barclays Plc, the U.K.'s third-largest bank, is trying to stay clear of Prime Minister Gordon Brown's plan to pump 37 billion pounds of new capital into the country's banks to jumpstart lending. The London-based bank agreed to sell almost 7 billion pounds of securities paying as much as 14 percent interest to investors including funds in Qatar and Abu Dhabi to meet the U.K.'s new capital requirements, it said Oct. 31.

New Accounting

RBS said it used new accounting to reduce third-quarter writedowns by 1.2 billion pounds. It follows Frankfurt-based Deutsche Bank AG and London-based Lloyds TSB Group Plc in using new accounting rules to limit writedowns in the last half of the year. The London-based International Accounting Standards Board decided Oct. 13 to allow European banks to avoid marking certain securities and loans to market from July 1.

RBS's credit losses were also mitigated by 2 billion pounds of gains on its own debt, which will be eliminated in the fourth quarter, Whittaker said.

``Once you reverse out the gains and the adjustment, the real figure for the writedowns is about 3.5 billion pounds,'' said Trippitt. RBS will post about 5 billion pounds in credit losses in the second half, Trippitt estimates.

The bank is reducing the size of its securities unit to reduce its capital needs and mitigate further credit losses. It planned to reduce trading assets by 60 billion pounds in October.

Alex Potter, a London-based analyst at Collins Stewart, lowered his rating on RBS to ``hold'' from a ``trading buy'' because ``capital levels appear lower, the outlook is weaker and the dividend flow is more distant than peers.''

The bank will hold a shareholder meeting Nov. 20 to approve it capital raising plans.

To contact the reporter on this story: Ben Livesey in London blivesey@bloomberg.netJon Menon in London at jmenon1@bloomberg.net

Last Updated: November 4, 2008 13:55 EST