Hubris: How HBOS Wrecked the Best Bank in Britain

by Perman, Ray

  HBOS was now increasing its concentration on property and property-related sectors and starting to initiate deals and put together consortia to bid for companies. In 2004 it even bought its own headquarters when investors including Tom Hunter’s West Coast Capital, Prestbury Investment Holdings and Bank of Scotland Corporate paid £150 million for 33 Old Broad Street, London, the meeting place of the HBOS board and offices of HBOS Group Treasury Services, and the insurance and investment subsidiaries Clerical Medical and Insight Investment. It also lent money and took venture stakes in property transactions led by David Murray, the owner of Glasgow Rangers Football Club and head of a metals business.

  But much bigger deals were to come. In 2006, after a contested battle, HBOS corporate bought McCarthy & Stone, Britain’s largest builder of retirement homes, for £1.1 billion in partnership with Hunter, the Reubens and Vincent Tchenguiz. As before, HBOS provided the debt and took part of the equity. By now it was also initiating deals, finding the targets and putting together entrepreneurs to front the bids. Shortly after the McCarthy & Stone purchase, Hunter and HBOS acquired the house builder Crest Nicholson for £660 million. There were also big purchases in hotels – a joint venture with Saudi Billionaire Prince Alwaleed bin Talal to buy the Savoy for £220 million and £750 million to buy the de Vere group with a party of eight investors.

  The corporate loan book was increasing at an extraordinary rate and outstripping the growth of other banks. In the City some eyebrows were being raised at the speed and scale of HBOS corporate’s deal-making, but Cummings calmed fears by describing the Bank’s ‘aggressive sell-down policy’ to pass some of the debt on to other banks. In the 18 months leading up to October 2006 it had originated 14 per cent more deals, but was only holding on to 8 per cent more of them. On one deal, he added, the bank had sold 90 per cent of its exposure.8 ‘German and Irish banks were falling over themselves to buy loans from us,’ remembers one manager, ‘we had no difficulty in selling down.’

  As its reach extended, the corporate division opened an office in Mayfair, separate from the rest of the business. It began promoting itself in European capitals, holding receptions in the Louvre for a thousand French business people and Stockholm’s maritime museum for businessmen in Sweden, where it financed a hostile bid for Capio, a Swedish healthcare group. In 2006 HBOS topped the list of debt providers to European buyouts, with 11 deals in the previous six months. The specialist buyout bank 3i came second.

  At the beginning of HBOS’s life corporate banking was very much the junior partner. It lent £35 billion, only a quarter of the total provided by the retail business, mainly in mortgages. It provided over £500 million in profit to the group, but that was dwarfed by the £1.4 billion earned by the retail business and lagged behind the £770 million earned in insurance and investment. The British economy was in the doldrums in 2002, but corporate banking still managed to grow its lending by a third. As the economy rebounded in 2003 it pushed its lending up to £50 billion and its profit by 21 per cent to £826 million. In time business banking was folded into corporate and the combined division overtook insurance and investment as the second largest contributor to group profits. By 2004 profits topped £1 billion and by 2007 it was making more than £2.3 billion and had passed the retail bank as the group’s largest profit earner.

  The total amount lent to customers also rose dramatically, from £35 billion in 2001, to £78 billion in 2004 and £109 billion in 2007.

  A lot of the growth was coming from the property sector, which accounted for more than a third of all lending. Ideally a bank would want to match its lending to the profile of the whole economy, but as Bank of Scotland was dependent on corporate transactions it was pulled into those activities where most deals were being done. The Bank’s risk assessors looked into the problem: ‘It was something we were aware of, and we would have liked to redress the balance, but we did not see any need for immediate panic. It was an issue we would get to over time.’ The Bank reviewed its portfolio and satisfied itself that it was well diversified between activities – property investment, construction, house building, housing associations, office and factory development. It was not over-exposed to those areas which had been prone to overheating in the past – particularly the London office market. Also its lending was covered by prudent covenants, which specified conservative loan-to-value ratios and strong cash flow from rents. Bad debt provisions were low. The market was past its trough and there was no cause to be concerned.

  The first years of the new century seemed a good time to invest in property. Prices had been depressed by slow growth in the economy but interest rates were coming down from their peak. Commercial property, long the Cinderella of the sector, was seen by some investment analysts as due for a rerating and in residential property Britain still suffered from a housing shortage which should continue to support price increases. Over the four years from the low point in the market in 2003, commercial property prices rose by over 40 per cent. HBOS rode the boom, lending to property developers and taking part in developments itself as a joint venture partner. It was not alone. According to Bank of England figures, banks lent an extra £80 billion to commercial property companies during this period, taking the sector’s proportion of total lending to an all-time high.9

  There was no fear of an economic slowdown; in fact the HBOS corporate department prided itself on its counter-cyclical strategy, lending more when prices were low and the competition was backing off, lending less when prices rose and competition intensified.10

  15

  As safe as houses

  My wife and I got our first mortgage from the Halifax Building Society in 1976. It was not an easy or a pleasant process. Apart from a few local authorities, building societies were the only source of home loans at that time and they were strictly regulated. The Bank of England turned the mortgage tap on and off to prevent overheating in the housing market, but even when the money was flowing it was not a simple matter to borrow; you first had to negotiate a moral and financial obstacle course.

  There was no point in even asking for a mortgage unless you could demonstrate a habit of thrift, which you did by opening a savings account and making regular deposits. Only when you had done this for a period of months, or even years, could you get an interview with the branch manager, who was usually a daunting authority figure. I was working for the Financial Times and my solicitor advised that I play to the vanity of the local Halifax manager by asking for his views on the economic outlook before broaching the subject of our application for a mortgage. The ploy worked and he agreed to lend us the money, but that was the beginning rather than the end of the process. The society would lend a maximum of two-and-a-half times my income, plus half my wife’s income. They would not take my word for how much I earned; I had to produce my three most recent payslips and even then the branch wrote to my employer to seek written assurance that I was in a permanent job. My wife was a freelance writer, so to prove her income they demanded her latest tax assessment from the Inland Revenue.

  The society would only advance up to 85 per cent of the value of the house – the value being determined by a surveyor appointed by them, reporting to them, but paid for by us. The survey came up with a figure which was less than the price at which our solicitor thought we would have to pay to get the house, so to make up the difference we had to resort to subterfuge. My wife told her bank that we had already bought a home and obtained a loan ‘to buy furniture’. This had to be hidden from the building society because any suggestion that we were borrowing to provide the deposit would have led to the immediate withdrawal of the offer. The survey also caused another problem. The house was 100 years old and did not have a damp-proof course and the Halifax decided that until we got one, they would withhold one third of the total loan. This was a severe blow. We were already stretched to our financial limit – we could not afford to bridge the gap and pay for the work to be done. We resigned ourselves to losing the house but were saved by an unsolicited temp
orary loan from my wife’s great-aunt.

  Thirty years on, the mortgage market had changed out of all recognition. Building societies had been deregulated by Mrs Thatcher’s government in 1986. Several of the largest societies had turned themselves into banks and were competing hard for home loan business. The banks themselves had woken up to the fact that mortgages could be very profitable and new specialist lenders and brokers had entered the market. The housing market looked like a one-way bet for both borrowers and lenders. There had been no serious setback in prices for years and from 2000 to 2007 average prices more than doubled. Some areas of the country had seen even bigger rises. In contrast to the tortuous process I had to endure, borrowers were now almost having loans thrust upon them. Without any evidence of saving, it was possible to get an advance of four, or even five times an applicant’s annual income1 and house prices were rising so fast that some lenders were prepared to lend 100 per cent or even more of the value of a house, confident that inflation would restore the loan-to-value ratio to a sensible level. Having to prove that you earned as much as you claimed was not always necessary; some banks offered self-certified mortgages where no evidence was required. Nor did having a bad credit record bar you from getting a loan; several lenders specialised in taking on poor risks.

  Halifax was the king of this market, with a dominant market share and an aggressive sales policy aimed at winning more new business each year, but former building societies like Abbey, Bradford & Bingley and, especially, Northern Rock, were out to steal the crown.

  Like Halifax, Northern Rock had its roots in the self-help and savings movement of the nineteenth century. Based in Newcastle, it was an important local employer, sponsored the football and rugby teams, and arts events. Through its charity, the Northern Rock Foundation, it supported community and social groups, especially those working with the disadvantaged. After deregulation, it floated on the stock market and under a young, ambitious chief executive followed a strategy of aggressive growth. Adam Applegarth had a lot in common with Andy Hornby. He was clever, joining Northern Rock as a graduate trainee after reading mathematics and economics at Durham University, had a rapid rise through the management ranks and had become chief executive at the age of 39.

  Northern Rock was a fraction of the size of Halifax and its market share of existing mortgages did not come close that of its larger rival, but in the fight for new business, it made most of the running. It was heavily involved in the buy-to-let market, where ordinary people without experience or expertise in property letting or the assets to support heavy lending, were encouraged to buy several houses with big mortgages in order to rent them out. It was one of the first lenders to offer 125 per cent mortgages, where an advance of 90–95 per cent of the value of a property was topped up with a further 30–35 per cent as an unsecured personal loan. And it offered self-certified mortgages.

  Much of this market was handled by brokers, who would guarantee to get you a loan. The magazine Mortgage Strategy estimated that nearly two-thirds of the £200 billion of new mortgages being written by UK banks in 2006 was through brokers. There were some long-established and sound brokerage firms but the house-price bonanza had also attracted a lot of cowboys into the market. A BBC investigation in 2004 found some recommending that applicants should lie about their income in order to get mortgages of five or six times earnings. It was not only brokers who were exploiting the system. The BBC visited high-street branches of HBOS subsidiary Birmingham Midshires, where three out of three of the advisers the reporting team consulted offered self-certified mortgages of around six times income for which the team would have had to have lied. One of these advisers boasted of getting a client a mortgage of around ten times income by inflating his salary to over £100,000. The BBC estimated that up to 30 per cent of self-certified mortgages were obtained on fraudulent earnings figures.2

  My wife and I, having lied about our ‘furniture loan’, are in no position to criticise the young couples for whom exaggerating their take-home pay was the only way to get a foot on the housing escalator, which was accelerating prices much faster than salaries. Even at the start of the millennium the average cost of a home was more than three times average earnings; by 2007 it was well over five times. But others had more pecuniary motives. Prices were rising so fast in some parts of the country that you could buy a house, hold it for a few months and sell it at a profit, even allowing for professional fees and charges. The bigger the mortgage, the higher the value of the house you could buy and the larger the potential profit.

  HBOS, through its Halifax, Bank of Scotland and Birmingham Midshires brands was into all parts of this market, topping up its plain vanilla repayment mortgages – which made up the vast majority of its loan book – with ‘specialist’ offerings including buy-to-let, 125 per cent and self-certified loans, to the mute astonishment of some board members. The Bank’s 125 per cent move was in response to the success of Northern Rock’s ‘Together’ mortgage, which had pulled in more than £8 billion of lending. HBOS also began to introduce ‘affordability’ as a means of determining how much applicants could borrow, rather than a simple multiple of gross salary. This involved a detailed look at the actual amounts coming into a home each month, versus the outgoings. In theory it was a more accurate measure of the level of repayment applicants could manage. In practice it often led to higher mortgage borrowing. The demand seemed inexhaustible as consumers borrowed to improve their standards of living, not only by taking on mortgages, but also through unsecured personal loans and by buying goods with credit cards. The average debt per household soared by a third during the boom years of 2003–2008 to stand at over 170 per cent of annual income.3

  After taking over as chief executive of HBOS in the summer of 2006, Andy Hornby set about expanding the Bank’s branch network in the south of England, spending £100 million to open 50 new branches in areas where it was relatively under-represented, such as inside the M25. He also announced a new push into the Irish mortgage market, through the Bank’s subsidiaries in the republic. However, there were signs that the profit engine of retail banking, which had been one of the main motors of the rapid expansion of HBOS, was starting to falter. Even though economic conditions were still relatively benign, bad debts had risen as consumers struggled to pay off loans – and the share of the new mortgage market was falling. Retail had increased its profits by only 8 per cent in the previous year, whereas corporate banking had risen by 21 per cent, helped by a fall in bad debts.4

  To fill his shoes as head of the retail banking division, Hornby recruited Benny Higgins from the Royal Bank of Scotland. Higgins was an outstandingly successful financial services manager, but his colourful private life, leading to stories in the tabloid press, had cut short a career at Standard Life where he had been singled out as a future chief executive. George Mathewson had hired him and he quickly rose to become head of the Royal Bank’s retail division. His move after nine years was a surprise, but watchers suggested that his chances of rising to the top job were better at HBOS, even though he was a few years older than Hornby.

  Higgins’ tenure at HBOS was to be brief and controversial. He fitted the mould of the bright and highly ambitious young managers who were now mostly running the Bank, but some of his actions seemed to run contrary to the fast-growth ethos. He kept the Bank out of ‘equity release’, a fashionable innovation by some lenders by which home owners with low loan-to-value ratios could borrow more on the security of the unmortgaged part of the value of their property. It was sold initially as a boon to retired people who wanted to stay in their own homes, but lacked a big enough pension to be able to afford to do so. By remortgaging their houses they could obtain cash, which would only be repayable when the property was sold, possibly after their deaths. But unscrupulous brokers and lenders soon turned it into yet another way to borrow for any purpose and people were taking out long-term loans on their homes to buy short-life goods like cars, televisions or refrigerators or, worse, use the money for expensiv
e holidays. Higgins refused to allow HBOS to follow, saying he saw the market as a mis-selling scandal waiting to happen. He also responded to rising personal bad debt provisions by tightening up on credit card lending and wiping £1 billion off the limits of about 600,000 accounts.

  But his boldest move was to respond to concerns over arrears in the housing sector by increasing the price of mortgages. HBOS was facing a problem of its own making, in that it had won huge amounts of the new business in 2003 and 2004 by offering ultra-low-start mortgages which would ratchet up in price after an initial three or four years. Faced with a substantial increase in their monthly payments, many customers were now looking to replace those loans with new low-cost deals from other banks. Higgins persuaded Hornby that instead of trying to keep these accounts by again undercutting the competition, HBOS should offer brokers an extra incentive to recommend staying with HBOS. By doing so, he argued, some of the heat would be taken out of the mortgage market, profitability would be improved and competitors would follow suit.

  They did not. Rival companies, led by Northern Rock and Barclays, redoubled their campaigns and snatched market share. HBOS had already lost ground, taking only 17 per cent of new home loans in the previous year, against the 20+ per cent it had been used to getting. Now it saw its share halve to only 8 per cent. It was no longer king of the hill and had shown it was vulnerable to aggressive competition. The stock market reacted badly and the Bank’s shares fell.