Loss of trust

By Ian Fraser

Published: Signet Magazine

Date: July 16th, 2012 (minor edits March 28th, 2013)

Scottish banking was once renowned for prudential management. Today the association is rather different. Financial journalist Ian Fraser gives his view of events behind the collapse of RBS and HBOS and calls for a Leveson-style inquiry. PDF version of this article (pp 7-10)

A few weeks after the bailouts of Royal Bank of Scotland and Halifax Bank of Scotland in October 2008, prime minister Gordon Brown told BBC’s The Politics Show that: “What’s happened is we’ve had a banking crisis which started in America … This is an international crisis that has not been generated in Britain.” Brown wasn’t the only politician to be in denial about the causes of the UK banking crisis. In an interview the previous month, as HBOS was being acquired by Lloyds TSB, Scotland’s first minister Alex Salmond accused “a bunch of short-selling spivs and speculators in the financial markets” for causing the Edinburgh-based bank’s narrowly averted collapse.

With the benefit of hindsight, such claims were ludicrous. For RBS and HBOS were not laid low by short-sellers or events beyond their control in the United States (although these may have played a part in tipping them over the edge); they failed because of the stupidity, hubris, self-delusion and greed of their management. In a report published last December, even the Financial Services Authority blamed the Edinburgh-based bank’s collapse on factors including the “significant weaknesses in Royal Bank of Scotland’s capital position”, “over-reliance on risky short-term wholesale funding” and “concerns and uncertainties about RBS’s underlying asset quality.” But the regulator added that “the multiple poor decisions that RBS made suggest that there are likely to have been underlying deficiencies in RBS management, governance and culture which made it prone to make poor decisions.”

This is edging towards the truth. Put another way, one could say that Sir James Crosby (chief executive of HBOS from September 2001 to June 2006), his successor Andy Hornby (chief executive of HBOS from July 2006 to October 2008), and Fred Goodwin (chief executive of Royal Bank of Scotland from March 2000 to October 2008) were so obsessed with growing their banks’ balance sheets, with the pursuit of quixotic yardsticks like return on equity – and by extension enhancing their own earning-power and status – and so delusional about economics, they clean forgot the fundamentals of banking.

Alarm bells ought to have rung out long before the October 2008 implosions. For example, when the Royal Bank of Scotland splashed out $10.5 billion on Charter One in May 2004, RBS didn’t seem to mind that the Ohio-based bank’s balance sheet was stuffed with a form of subprime lending. By December 2007, Charter One had $9.3bn of ‘home equity lines of credit’, known as Helocs, and $11bn of mortgages secured by second liens on its books. But unlike HSBC with its $14bn Household Finance Corporation deal, Goodwin refused to acknowledge he had been sold a pup. Even once the credit crisis was in full swing he failed to admit that any of Charter One’s loans were impaired. “So where is RBS on all this?” asked John Hempton of Bronte Capital Management in May 2008. “Answer: delusional. They have taken no charges and all the goodwill from the Charter One acquisition, which remains on RBS’s balance sheet unimpaired.”

Hubris was already starting to get the better of Goodwin. He splashed out £18m on private jet, £5.3m on the conversion of a St Andrew Square town house, £350m on a campus-style headquarters at Gogarburn and $400m on a US headquarters with the world’s second largest trading floor. Black Mercedes S600s with peaked-hatted chauffeurs were on call 24/7 wherever he went. He indulged himself with a permanent suite in the Savoy hotel, complete with personal valet to look after his clothes. He recruited his boyhood heroes Sir Jackie Stewart and Jack Nicklaus as £4m-a-year “ambassadors” for the bank, had fresh fruit flown daily from Paris and deluxe pies hand delivered by favourite pie-makers Yorkes of Dundee at all times of day and night. He also became so obsessed with interior décor at the bank’s global network of offices that he is said to have ripped out acres of brand new, thick-pile carpet if it was the wrong shade.

By 2005, investors were becoming a little concerned that Goodwin might have his priorities wrong. Around the time that one investment analyst accused him of being “a megalomaniac” who was more interested in scale than shareholder value, the RBS board commissioned PR firm Brunswick to check whether this view was widely shared. It turned out it was. But the board shied away from sacking Goodwin, opting instead to hobble him by banning further acquisitions.

To escape from M&A ‘cold turkey’, Goodwin dashed headlong into areas he did not really understand, sowing the seeds of the bank’s collapse two years later. He gave RBS’s investment banking arm, led by Johnny Cameron and Brian Crowe, its head. The unit went hell for leather into the US structured finance market, as well as the leveraged-buyout and commercial property markets in the UK and Europe, but at the worst possible point of the economic cycle.

RBS Greenwich Capital, the bank’s Connecticut-based structured finance arm, became one of the leading players in collateralized debt obligations (which basically meant it “structured” or “engineered” teetering piles of debt built based on a foundation layer of subprime loans issued to US consumers with little propensity to pay them back), first as a manufacturer/distributor and then as a hoarder. RBS leapt up the league tables of CDO underwriters becoming a top five player alongside players like such cautious institutions as Bear Stearns and Lehman Brothers, with CDO volumes increasing 134% in 2006 alone.

By mid-2007, other Wall Street players recognised the CDO market was what derivatives expert Janet Tavakoli has described as a “fraud to cover up a fraud” and sought to “derisk” their portfolios, which meant selling as much as they could, as fast as they could, to easily duped European banks. But RBS preferred to cling on to the fiction that its portfolio of “super-senior tranches” of CDOs was largely unimpaired, so it held onto these tranches in the vain belief that the credit crisis a mere ‘blip’ and valuations would recover.

The FSA, otherwise known as the ‘Fundamentally Supine Authority’ puts these sorts of things down to “poor decisions” and a “bias towards optimism”. The Americans see it rather differently. In a 111-page lawsuit filed last September, the Federal Housing Finance Agency, an arm of the US government that took out a criminal action against RBS Greenwich Capital and RBS for ‘hoodwinking’ Fannie Mae and Freddie Mac by selling them $30.4 billion of misdescribed residential mortgage-backed securities (RMBS). Sometimes the “owner occupancy data was materially false”, claimed the FHFA, adding that RBS also “furnished appraisals that they understood were inaccurate and that they knew bore no reasonable relationships to the actual value of the underlying properties”. The FHFA also accuses RBS of “systematic disregard of their own underwriting guidelines”. The case, which RBS is determined to fight, is scheduled for 2014.

Seemingly motivated by a playground desire to avoid RBS being leapfrogged by Barclays, Goodwin then doubled up on RBS’s exposure to the most toxic parts of the financial markets by paying €71bn for the Dutch bank ABN Amro in a three-way bid with Belgian and Spanish banks. The deal was completed four months after the credit crisis had erupted but Goodwin failed to adjust the price. This deal basically destroyed RBS’s already dangerously over-stretched balance sheet, and meant RBS’s wholesale funders shied away, refusing to roll over loans, given their knowledge of the further nasties that lurked on ABN Amro’s balance sheet (after all many of them had parked them there). For RBS, by now the largest and most toxic bank in the world with a $3 trillion balance sheet was being kept alive thanks to some £100 billion of secret, emergency loans from the US Federal Reserve and Bank of England.

Then, in what must be one of the most shareholder unfriendly diktats in history, FSA chief executive Hector Sants forced Goodwin to tap his shareholders for more cash through a rights issue. Goodwin and the rest of the RBS board, together with advisers Merrill Lynch, Goldman Sachs and UBS persuaded investors to chuck a further £12bn into the RBS money pit. The money was obtained under false pretences and almost entirely lost. Hundreds and possibly thousands of former NatWest and RBS staff who took out loans to buy shares in the rights issues have been cleaned out financially as a result and having sacked them, RBS is now evicting some of them from their homes.

There are people I know who describe this rights issue as the “crime of the century”. But according to the FSA, Goodwin and his co-directors were not responsible for any corporate governance failures. They just made a few bad decisions.

Given this clear regulatory failure, the RBOS Shareholders Action Group – comprising more than 8,000 retail and institutional investors – is filling the vacuum and on March 12th pushed the green light on a £3bn legal action against Goodwin, his co-directors Sir Tom McKillop and Johnny Cameron and the bank itself. The action group is being represented by Bird & Bird and a team of QCs. Proceedings are expected to start in London’s High Court in or after June 2012.

Of course it is wrong to lay all the blame for what happened at HBOS and RBS on the banks’ respective chief executives. Every major decision was rubber-stamped by non-executive directors, voted on by seemingly somnambulant institutional investors and pored over by legal and other advisers such as the ‘magic circle’ firms Allen & Overy and Linklaters. But this corporate governance superstructure, despite syphoning out hundreds of millions of pounds in fees, failed utterly.

The ‘tripartite’ regulatory framework introduced by Gordon Brown in 1997 was if anything worse. The Bank of England, FSA and Treasury sat idly by while the likes of Goodwin leveraged their banks as much as 70 times (there is also strong evidence to suggest that the FSA was complicit in helping the banks bury some of their more virulent frauds and misdeeds).

And where were the auditors in all this? Shouldn’t they, at least, have recognized that RBS’s and HBOS’s capital positions were dangerously weak, leverage was out of control, and “assets” less solid than made out? Of course they should. But they too failed utterly.

In keeping with Deloitte’s ‘embedded’ approach at RBS, KPMG failed to raise any red flags about HBOS, despite fanciful valuations given to most of its corporate “assets” and a series of alleged frauds and misdeeds in its corporate lending arm (some of which are the subject of one of the UK’s largest ever fraud inquiries, led by Thames Valley Police and the Serious Organised Crime Agency). Yet despite the seeming inability of Deloitte and KPMG to detect that anything was awry at RBS and HBOS the Financial Reporting Council, where ex-RBS director Sir Steve Robson remains a director despite his part in RBS’s downfall, does not seem to have any current intention of probing either Deloitte’s or KPMG’s bank audits.

Five years into the banking crisis, the banking world remains very much in denial and a long way from recovery. There is a patchwork of yet-to-be-implemented reforms including ‘ring-fencing’ from the Independent Commission on Banking, higher capital and liquidity requirements from the Basel Committee and ‘bail-ins’ from the European Union. But the proposed reforms ignore the elephant in banking’s room – that the banking industry has become, and to a large extent remains, an ethics-free zone. Both before and after the crisis it has few qualms with treating customers, depositors and shareholders with contempt, and basically considers itself to be ‘above the law’.

This is why I and others including the Telegraph’s assistant editor Jeremy Warner, former Labour spin doctor Alistair Campbell, and “HBOS whistleblower” Paul Moore believe that it is still not too late for a wide-ranging, independent and unbiased, Leveson-style public inquiry into banks and their role in the crisis. The proposed inquiry would scrutinize all the parties involved in this sorry episode, including bankers, institutional investors, brokers, credit rating agencies, accountants, other professional advisers, the FSA, the Treasury and the Bank of England. David Cameron and George Osborne made calls for just such an inquiry in November and December 2008, when they were in opposition. Now they’re in Downing Street, they seem to have gone cold. But they need to rediscover their nerve. Without such an inquiry, it seems unlikely that banks and financial institutions will ever regain our trust.

Note: an edited version of this article was the cover story in the July 2012 issue of Signet Magazine [PDF], the magazine of the Society of Writers to Her Majesty’s Signet. The article was written in May 2012 before much was known about the leading role of both RBS and HBOS/Lloyds Banking Group in Libor rigging scandal. This only became apparent on June 27th, 2012 when Barclays was fined $453 million by regulators in the US and UK. 

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