29 September 2008
Lloyds TSB’s chairman Sir Victor Blank believes he’s getting the bargain of the century with his HBOS acquisition. However, the catalogue of errors that brought HBOS to its knees means the Edinburgh-based lender is more likely to be a disastrous deal for Blank. Ian Fraser reports.
SIR VICTOR Blank and Eric Daniels, the chairman and chief executive of Lloyds TSB, are facing an almighty backlash in Scotland against their proposed takeover of Halifax Bank of Scotland.
Lloyds shareholders don’t appear to be too fond of it either. The 21% discount between the value of Lloyds’s offer and dwindling HBOS’s share price at Monday’s close tells us there’s a growing chance the terms of the deal will have to be reduced — or else that the deal will fail.
Unveiling the deal on Thursday September 18th, Blank and Daniels looked like the cats who had got the cream. They thought they would be getting their hands on the pride of Scottish banking, and one of the UK’s leading banks by size of ‘assets’, for a fraction of its intrinsic worth.
They were deluding themselves. Before the credit crunch intervened to reveal fundamental flaws in its business approach, HBOS was valued at £44 billion on the London stock market. However, by the time the unlikely duo of Englishman Blank and the American Daniels came riding to its rescue, its value had sunk to a mere £12bn.
Not only did the duo believe they were getting quality assets on the cheap; thanks to the extraordinary intervention of prime minister Gordon Brown, they would also have carte blanche to recreate the oligopoly in British banking (which ironically HBOS had sought to abolish when it was founded in September 2001). They also believed they would be able to create between £1 billion and £3 billion a year in so-called “synergy savings”.
Despite the disingenuous misinformation from the banks’ spin doctors, the merged bank will probably shut 1,000 branches and shed at least 30,000 to 40,000 jobs out of its 142,000 combined workforce.
The reasons that Blank and Daniels have clinched this extraordinary deal can be summarised as: cock-up, conspiracy and crisis.
Before getting into this, however, it is worth examining the claim from Scotland’s first minister Alex Salmond that it was the “spivs and speculators” of the City who brought the former Bank of Scotland to its knees. The first minister probably thought that having a non-Scottish scapegoat was politically expedient.
However, it is a wholly erroneous claim. According to Data Explorers only 2.75% to 2.96% of HBOS stock was “out on loan” on the critical days of 16th and 17th September 2008. The real spivs and speculators not short-sellers, but were the people on the bank’s board of directors and in its senior management team. They were led by the bank’s chairman Lord Dennis Stevenson (pictured above right) and chief executive Andy Hornby (left) who before joining Halifax in 1999 oversaw the George clothing range at Asda.
Over the past seven years, HBOS has been driven into a financial cul-de-sac by its management, largely as a result of their “pile ‘em high, sell ‘em cheap” approach to banking and the use of a rewards structure skewed towards the writing of loans, however crappy, rather than the gathering in of deposits.
Gordon McQueen, a former director of HBOS, confirmed flaws in the remuneration structure when I spoke to him on 25th September. He said that employees whose role was to grow the loan book were given lavish bonuses while those whose role was to grow deposits were given far less generous incentives (see Call to sack HBOS directors).
This was all part of the sales-driven culture that permeated the bank under Hornby, Crosby and Stevenson. Does anyone remember the unfortunate Glasgow and Paisley tellers who were punished for missing targets by having cauliflowers and cabbages left on their desks?
Peter Hahn, a former managing director at Citigroup who is now a fellow at the Cass Business School in London, said: “Bank bosses have been incentivised like tech bosses. If you’re a shareholder in Intel, you want the management to pull all the stops into developing the next chip because if they don’t and Samsung produces a better chip which captures the market, Intel could be bust. If it does go bust, it doesn’t effect anyone else. “The difference with a bank is a boss can say: ‘you want me to make more profits? No problem, I can just go out and buy more risk and deal with the problems later’.”
HBOS also appears to have fallen into the trap of believing its own marketing hype that UK property prices were on a permanent upward trajectory. This flawed assumption underpinned all the bank’s activities. One of the consequence was that it became perilously exposed to the UK property market. And it did so in a variety ways, including collateralised loans, direct lending to commercial property developers, private-equity-style loans to property-heavy buyout deals, equity stakes in property companies, mortgage lending etc — at a time when wiser heads knew the property bubble was about to burst.
The bank’s directors liked to pretend they were taking a prudent and responsible approach to the UK mortgage market. However they were, in truth, doing the exact opposite. For a start the bank has a history of actively encouraged purchasers of self-certification mortgages (liar loans) to lie about their salaries.
HBOS subsidiary Birmingham Midshires in October 2003 suspended three mortgage advisers after it investigated allegations that customers were encouraged to lie about their salaries on mortgage application forms — a criminal offence. Birmingham Midshires also suspended sales of self-certification mortgages. Other HBOS subsidiaries implicated in the scandal included the Bank of Scotland and The Mortgage Business. The saga can be seen on the BBC’s Money Programme [presented by Michael Robinson and first broadcast on 29 October 2003.
This episode is typical of HBOS cavalier approach to risk. Basically it was so obsessed about growing its balance sheet by flogging more and more loans that risk managers within the bank were ignored. At the half-year results in August 2007, CEO Andy Hornby blamed a sharp fall in the bank’s share of the UK mortgage market (HBOS’s share of new lending had slumped from circa 22% to 8%) on a flawed mortgage pricing strategy that was introduced by its former head of retail Benny Higgins the previous summer.
Hornby, formerly known as banking’s “wunderkind”, informed investors and journalists that the bank had decided in May 2007 to scrap the Higgins’s revised pricing strategy, which had been introduced in the hope of reducing “churn”. Speaking at the time Hornby said: “Having taken corrective action to our pricing strategy, the strength of the HBOS franchise has been demonstrated by the speed with which we have returned to our 15% to 20% net lending range in May and June.”
It was a final, desperate throw of the dice for Hornby; and probably one that sealed his and the bank’s fate.
The bank was already dangerously over-exposed to UK property. Now it wanted to become even more so. Given the repeated warnings from reputable organisations such as the International Monetary Fund and OECD that UK house prices were ripe for a correction, it was a giant punt.
HBOS’s activities in the shark-infested waters of commercial property and private-equity lending are no less bizarre. Once it got its hands on a larger balance sheet following the September 2001 merger of Halifax and Bank of Scotland, the bank seems to have thrown caution to the wind. To the wry amusement of better-managed banks, it became “aggressive” (the banking euphemism for cavalier) in its lending to property and retail buccaneers.
The corporate bank, led by the impressionable Peter Cummings, became the “poodle” of property and retail tycoons such as Sir Tom Hunter, Sir Philip Green, Sir David and Sir Frederick Barclay and Vincent and Robert Tchenguiz. Cummings seemed keen to pander to them and religiously attended their glizty parties.
Seemingly in their thrall, Cummings was eager to remain their lapdog. Also, I have been told, he jealously guarded control of the corporate banking side of the business. One source told me: “He controlled pretty much all the decisions in corporate. Everything had to have Peter’s approval.”
Even more bizarrely, the bank continued to buy into and fund the collapsing property sector (think Miller Group and Tulloch Homes) using its discredited “integrated” finance approach after the property bubble had burst. One of the scores of unanswered questions about HBOS is why it bankrolled the £925m purchase of the David Lloyd Leisure chain in August 2007, well after the credit and property bubbles had burst.
Bank of Scotland Corporate and London & Regional, a vehicle of the property billionaires Ian and Richard Livingstone, funded Next Generation Clubs’ acquisition of the tennis, gyms and leisure chain from the former brewers, Whitbread. Reports suggest that none of the debt advanced for this deal has been syndicated.
None of this exactly tallies with the content of BoS Corporate’s hubristic newsletter Deal Leader. It seems highly paradoxical now, but writing the foreword of the Spring 2008 edition, Cummings claimed: “The job of banks is to assess risk but, in the last 18-24 months, that’s a job many banks seem to have forgotten and have taken huge hits to their balance sheets as a result. We never forgot. Our decisive strength is assessing credit risk and – it’s part of the same tapestry – assessing people. We’re better at it. That’s the basis on which we back our partners as through-the-cycle lenders and investors.”
Sources claim that, while the “handshake banking” model that Cummings had learned from his mentor Gavin Masterton was all very well in a small country like Scotland, it became an accident-waiting-to-happen when translated onto the wider UK stage.
The bank’s biggest problem, however, was not one of naivete.
Its whole fragile edifice was built on the unstable foundation of short-term wholesale borrowings. This might have made sense while credit remained artificially cheap. But once the credit famine started – also in August 2007 – the flaws in HBOS’s model became immediately apparent.
Rather than admit the error of its ways and seek to reinvent the bank the board behaved like rabbits startled by the lights of an oncoming car and resorted to the Band-Aid of a £4bn rights issue. The inevitable result, especially given Hornby’s lack of candour over the real reasons for this year’s rights issue, was an accelerating loss of depositor confidence.
According to Alex Potter, an analyst at brokers Collins Stewart, by last week HBOS had £128bn in short-term borrowings which needed to be either be refinanced or repaid within three months. However, following the collapse of Lehman Brothers, investors had no appetite for lending to banks on the edge. At best, any moneys HBOS could have borrowed to fill this gap was going to be punitively expensive.
By way of comparison, the amount the beleaguered bank needed to rustle up by mid-December was four times the £33bn annual budget of the Scottish government.
Credit-default swaps, a form of financial trade based on the cost of insuring against the risk of HBOS defaulting on these payments, told their own story. At 3.25pm on Tuesday, September 16th, when HBOS was being buffeted about like a penny share in London trading, five-year senior credit default swaps on HBOS widened by 197.5 basis points to 512.5 basis points. This meant that the premium payable to insure £10 million of HBOS’ senior debt against default had risen to £512,500 a year.
It is perhaps also worth pointing out the role of mark-to-market accounting rules in all this. Had these so-called “fair value” rules applied in the mid-1980s, when Lloyds Bank and other UK banks were in trouble after lending excessive sums to less developed countries, many of the UK’s banks would have gone bust. Instead Lloyds and other banks were permitted by accountants and regulators to earn their way out of their respective holes over the course of the next seven years.
Wind the clock forward 20 years and attitudes among regulators and beancounters have hardened. Loans which could formerly be valued on a “held to maturity” basis now must be “marked-to-market”. Some commentators argue this is a root cause of the current liquidity crisis, suggesting it has set in motion the vicious spiral of bad debt provisioning, asset sales and capital raising that we’re still living through.
It was certainly a contributory factor. But, as this post seeks to explain, there were plenty of other things wrong with HBOS’s model and it was these which makes it seem more likely the bank was ultimately the author of its own demise rather than the victim of stricter accounting regulations or of short-sellers in the City.
By mid-September the bank’s prospects had become so bleak, given its dependence on rolling-over wholesale and securitised funding and the fact this had all but dried up following the Lehman collapse, that had Lloyds not been prepared to come to the rescue last week, the bank would almost certainly have faced either nationalisation or bankruptcy.
Lord Stevenson still seems to think he deserves to to receive £34,000 a week for leading HBOS into this pretty pass. In my view he should now do the honourable thing and fall on his sword and hand back his rewards for failure. The value destruction he has wrought has been worse than that of the disgraced peer and former HBOS director, Lord Simpson of Dunkeld, the man who broke Marconi.
The situation in which HBOS found itself meant that the Lloyds’s chairman Sir Victor Blank had UK prime minister Gordon Brown over a barrel. Brown was so terrified of having another Northern Rock-style situation — remember those queues of ‘panicked’ customers? — on his hands that he was prepared to contemplate anything. In the end he made the extraordinary (and possibly actionable) decision to waive competition law, as well as provide assurances that the Bank of England’s special liquidity scheme, which provides cheap loans to prop up banks, would be extended.
In exchange, Blank made certain promises to Gordon Brown, including that the merged bank would maintain lending levels to UK house buyers, continue to provide loans to first-time buyers (a farcical pledge given that the UK housing market has much further to fall) and to “preserve” jobs in Scotland. Presumably Glenrothes and his own Fife constituency were weighing heavily on Brown’s mind.
Whether or not these promises will be honoured is a moot point. The history of takeovers — including those of Distillers Company Limited in 1986 and indeed Lloyds’ own takeover of the Trustee Savings Bank a few years later — suggests they’re unlikely to be worth the paper they are written on.
Jonathan Pierce, a bank analyst at Credit Suisse, warns that Lloyds TSB will be making a disastrous error if it proceeds with the takeover of HBOS. He says: “Ultimately, the potential combine will be the biggest play on the UK housing market and economy in the sector. We identify at least £200 billion of risky assets within the business, more than five times the tangible equity.
“It also presents considerable pro-cyclicality risk – despite starting with the lowest equity-tier-one ratio in the sector with the highest contribution from embedded value. And the balance sheet de-leverage process will be expensive, and potentially leave the group with a higher proportion of riskier assets through adverse selection. Put simply, we see more risk of earnings-per-share downgrades and further capital issuance than at any other bank in the sector. We see a much better balance of risk and reward elsewhere.”
There also seems to have been a degree of small-minded Labour vindictiveness in the affair. Conspiracy theorists believe that Brown deliberately delayed introducing the short-selling ban and the enhanced liquidity package to ensure that HBOS was forced into the arms of his mates on the Lloyds board.
Apparently, there are senior figures in the Labour party who actually welcome the demise Scotland’s oldest bank. In their sick world view, the end of HBOS is something to be celebrated. To them, having one less bank in Scotland will weaken the economic arguments for independence and therefore strengthen the Unionist cause. It is hardly an attitude that will endear them to the Scottish electorate.
For another take on the HBOS disaster, read “Grimm reading: How the HBOS story is not one for bedtime” by Neil Collins, former City editor of the Daily Telegraph. Neil is also a director Finsbury Growth and Income Trust and Templeton Emerging Markets.