by Perman, Ray
Internally it was also facing a problem. With a smaller volume of new business than budgeted and finer margins, retail would undershoot its profit target. Heavy pressure was put on Cummings and the corporate banking division to make up the slack. ‘We were forcing profit out of corporate to make up for the shortfall in retail,’ remembers one senior manager. ‘It was push and push in those last few years.’ Deals nearing completion were hurried through, bringing arrangement fees and interest payments, and Cummings’ policy of regularly taking equity in the companies to which it also lent through the Bank’s integrated finance unit now began to pay off. Over six years the equity portfolio produced profits of £2.4 billion. ‘It was our piggy bank, but by the end of 2007 it was starting to get empty.’ Dividends were taken and holdings were sold to realise profits. Uberior Investments, the subsidiary company which housed many of the Bank’s stakes, upped its level of sales to provide more cash for its parent, paying a dividend to HBOS of £290 million in 2006 and £280 million in the following year.
When the Bank reported its annual results for 2007, it revealed that for the first time corporate had passed retail in being the biggest contributor to the group’s earnings. Whereas profits from mortgages and personal lending had fallen by 13 per cent, profits from the corporate division had risen by 30 per cent. Even so, HBOS managed only a small increase in overall profits and Hornby’s reputation as the sector’s whizz-kid was tarnished. Although the Bank scrambled to recover its position by introducing new products and new incentives, analysts and investors wondered whether the housing market could ever again provide it with the fat profits it had been used to, and if it could not, how long the corporate division could go on expanding its loan book without dramatically increasing its bad debts.
Higgins paid the price of the bank’s loss of reputation. It was announced in August 2007 that he had ‘decided to move on’, but analysts were unanimous in their assessment that he had been forced out, a view reinforced by the revelation in the annual report that his basic salary of £655,000 had been topped up to £1.8 million by ‘further remuneration’. He had been with the Bank for little over a year but in total he had received more than £3 million in salary, bonus and allowances. Looking back, a member of the HBOS board decided: ‘Benny was a hero. He called it right on the mortgage market, but the executive and the rest of the board did not have the courage to back him.’
Higgins’ leaving was not the only change among the top management. Phil Hodkinson, who had been finance director since the retirement of Mike Ellis, announced that he was leaving to spend more time on charity work. He was only fifty. The two departures necessitated a reshuffle, with the extensive retail empire that Andy Hornby had once ruled being broken up and distributed to several directors. The surprise was the return of Mike Ellis to resume his former role as finance director. The market viewed his reappearance with puzzlement. He was a safe pair of hands, but what did his recall from retirement suggest for the future – that a firm hand might be needed to steady the ship?
A few months later Hornby scrapped the stretching market share goal that had driven the rapid growth of HBOS over the previous six years. ‘We will no longer set annual market share targets for net lending. Instead, we will make judgements on the trade-off between volume and margins on a month-by-month basis,’ he said. ‘Increased mortgage costs to consumers will inevitably lead to a slowdown in the mortgage market.’5 It was a significant statement for the man who had once been the arch-competitor and amounted to a tacit admission that the Higgins’ strategy may have been right.
There was good reason to be cautious. After a long period of cheap credit, interest rates were starting to rise, bringing financial pain to many people who had over-extended themselves and now found their monthly repayments climbing steeply. Northern Rock had been caught out when it failed to hedge against a rise in rates between the times when it approved fixed rate loans and the money actually being drawn down. The move was going to cost the Rock up to £200 million in lost income and forced the hitherto bullish bank to issue a profits warning. That was not enough to prevent it from continuing to chase new business or persuade its existing customers to stay by offering cut-throat deals to remortgage. ‘In two to three years the chances are that interest rates will not be rising and we can retain customers on better margins,’ said an ever-optimistic Applegarth. While HBOS’ share of the new market again fell to less than 10 per cent, Northern Rock took 19 per cent.
There were some warning signs coming from across the Atlantic. The phrase ‘sub-prime’ started to be heard for the first time, describing mortgages taken out by people who could not afford to repay them. Millions of these mortgages had been aggregated into large securitised loan packages, which were used as collateral for further borrowing. Now some people were starting to question whether these funds were actually worth what the banks which had issued them claimed they were worth. The investment bank Bear Sterns, not a well-known name in Britain outside the London financial community, but one with an 80-year history on Wall Street, had been forced to bail out two of its hedge funds to the tune of £1.6 billion. It was not a problem which many people believed would have much effect in the UK, but it was unsettling nonetheless.
HBOS was heavily exposed to the property market. At the end of 2007 it had £430 billion outstanding in loans to customers, more than half of it (£235 billion) in residential mortgages. Another £35 billion was lent to construction firms or commercial property companies and a further £8 billion to the hotel and retail trades. Home loans in Ireland and Australia added another £27 billion and lending to construction, property, hotels and retail in those countries and elsewhere another £24 billion. Add them all together and three-quarters of all lending was secured on land, bricks and mortar.
The board was not unduly alarmed. Nearly half the mortgage book had a loan-to-value ratio of 28 per cent – house prices would have to fall by more than three-quarters before the size of the loan was higher than the value of the property. Of the remainder, only 3.5 per cent was over 90 per cent. The asset cover was there, but what about the borrowers? Would they still be able to meet their repayments if there was a downturn? Here there was a worry. A quarter of all mortgages were classed as ‘specialist’, either buy-to-let or self-certified mortgages – over £60 billion.6
The UK housing market which had shown rises of 4–5 per cent a quarter at the height of the boom in 2004, had slowed considerably by 2007, but right up to the end of the summer prices had still been rising. The first fall in the October-December quarter was a little over 1 per cent, followed by a similar decline in the first quarter of 2008. A few doomsayers were claiming that prices could fall by 10 or 20 per cent, following similar plunges in the US, but there were plenty of people taking a more optimistic view. They included Martin Ellis, chief economist at HBOS, who told Money Marketing magazine, ‘A robust UK economy and the accompanying sound health of the labour market continue to provide strong underpinnings for the housing market . . . there is a fundamental supply and demand imbalance in the UK that simply does not exist in the US.’7
16
Ziggy’s stardust
In 1997 the rock singer David Bowie faced a problem. He wanted to buy back the ownership of songs he had recorded which were now owned by his manager – including his very successful 1972 concept album The Rise and Fall of Ziggy Stardust and the Spiders from Mars – but he did not have the cash to do it. A smart American banker called David Pullman came up with a solution. They would package all Bowie’s songs together and sell not the hits themselves, but the future royalties from them for ten years. It was one of the first asset-backed securitisation deals in the music industry and the singer received $55 million when the ‘Bowie Bond’ was bought by the Prudential Insurance Company of the US.1
The concept of selling a stream of future earnings was not new; in fact, Bank of Scotland had tried an early form of it in 1984 when it started to sell mortgages. The loans were grouped into portfolios and sol
d to a syndicate of banks, which took on the credit risk and received a proportion of the interest payments. The Bank kept the arrangement fees and the remaining interest.2 The experiment was deemed a success, but the Bank preferred to keep mortgages on its balance sheet and the idea was not repeated until the late 1990s when securitisation started to become fashionable. In the ten years after the Bowie Bond, securitisation issues multiplied exponentially, although in the housing rather than the rock-song market. By 2007 the amount outstanding was estimated at $10.24 trillion in the United States and $2.25 trillion in Europe. Like all new industries it threw up variants and sophistications, produced experts and specialists, inspired PhD theses and spawned its own jargon and initials. There were Asset Backed Securities (ABS), Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Collateralised Mortgage Obligations (CMOs), Collateralised Bond Obligations (CBOs), Special Purpose Vehicles (SPVs) and Special Investment Vehicles (SIVs), sometimes also called ‘conduits’.
For the banks there were two attractions to securitising their mortgages – liquidity and capital. They got their money back immediately (rather than waiting until the loans were redeemed) so they could lend it again; and, because the buyer of the securitisation issue took the risk, it did not have to be counted in the issuing bank’s balance sheet and therefore no regulatory capital had to be set aside to insure against default. This was truly William Paterson’s Philosopher’s Stone: the bank could go on indefinitely circulating the money and each time it went round, the bank could collect fees and interest.
In London there was no shortage of investment banks willing to help to structure and price issues and find buyers for them. The HBOS treasury department became very skilled at securitisation and its variant, covered bonds (similar, but the asset stays on the bank’s balance sheet). From the Bank’s formation it was routinely securitising £10 billion or more of mortgages a year and selling them on the market, where they were bought (of course) with more borrowed money. By 2007 HBOS had packaged and sold on £82 billion of mortgages in this way. To induce buyers to take on the risk, each issue had to be given a clean bill of health by the ratings agencies like Standard & Poors, Moody’s and Fitch. Since the vast majority of HBOS mortgages had been granted on low loan-to-value ratios, the Bank’s securitisations were given high ratings and it had no trouble in finding takers.
However sophisticated UK banks thought they might be, they lagged a long way behind the Americans. There the mortgage market boomed in the first years of the new century, fuelled by low interest rates, which brought cheap and abundant credit. Since ‘prime’ borrowers – people who could afford to meet the repayments on their loans – expected to pay low rates, banks and brokers turned to the ‘sub-primes’, people who in normal circumstances would have been considered too poor to buy their own homes, or were bad credit risks. In their millions they were induced to take out big mortgages and pay steep fees and high interest for the privilege. Securitisations of sub-prime mortgages were clearly higher risk than primes, so to get around this problem the banks turned to mathematics and portfolio theory: by packaging hundreds of thousands of these high-risk loans with others which were low-risk, it could be demonstrated that some of the risk would be diversified away.
As time went on the issues became more and more complex. They were sliced and diced, mixed and stirred until it was impossible to judge accurately what was inside them and what the real level of risk was. Everyone was involved in the market in one way or another, from small, shady regional banks and brokerages which ‘originated’ the mortgages (sold them to vulnerable and gullible people) to giant Wall Street investment banks which traded the securities. The market quickly became international, so that European banks would buy securities based on American mortgages and British banks would issue securities in the US. The money wheel might have gone on turning had the Federal Reserve Bank of the United States not decided to cool the overheating housing market by increasing interest rates. Poor people suddenly found their monthly repayments ballooning to levels they could not afford and began to default on their payments. Banks began to repossess their homes, but found that the more they repossessed, the lower house prices fell and the less security they had to back their bonds.
By 2007 the problem was starting to become acute. Some regional US banks went bust, hedge funds which had bought securitised bonds had to write them off as worthless and every bank began to examine its portfolio. HSBC, the international bank headquartered in London, had to swallow big write-downs at its American subsidiary, and French banks disclosed problems, but there was a feeling that it was a US problem and would not cross the Atlantic.
The nineteenth-century Prime Minister Lord Palmerston famously said that only three people had ever known the answer to the Schleswig-Holstein question: one was dead, another was mad, and the third was himself and he had forgotten. A similar situation had happened in the securitisation market. Packages of mortgages had become so complex that no one knew what was inside them – not the banks which had sold them, nor the banks which had bought them, nor the rating agencies which had given them their seal of approval. Since they did not know what they were buying, banks and investors decided not to buy anything at all. The securitisation market froze, so mortgages became harder to obtain, house prices tumbled further and the assets which backed the securities became worth less – and some eventually became worthless. But it went further than that. Americans, like Brits, had been saving less and spending more, so retail deposits were harder to come by for banks and they had been funding their lending from the wholesale markets, borrowing over years, months, weeks or days to match their obligations. Now this market froze too; if you could not gauge the value of an asset, how could you judge the creditworthiness of the bank which held it?
Banks and other investment institutions began to find it harder and more expensive to obtain the funds they needed, but those rumoured to be nearest to the edge of the precipice found that no one was willing to trust them with money for more than a few days and even then would charge them through the nose for it. Where once they would have laughed scornfully and gone elsewhere, now they had no choice. They had to take what was on offer or declare bankruptcy. The belief that this was an American problem did not last long. Finance was a global industry and US banks traded in European markets just as European banks did in the States.
At the end of August 2007, HBOS delivered a severe shock to its shareholders, which included the two million savers who had taken shares when Halifax demutualised. Many of the Bank’s 70,000 staff also took their bonuses in shares or were part of the Bank’s share-save scheme. Up until then they had assumed their Bank was not involved in the American mortgage market. Now, through a short statement to the Stock Exchange, they discovered that it was an investor in US home loans on a massive scale. The statement revealed that the Bank had been forced to provide credit for Grampian Funding, a Jersey-registered fund wholly owned by HBOS, which held $36 billion (£18 billion) of assets, $30 billion of which were invested in the US.
Grampian was not a recent invention; it had been formed by the Bank in 2002, but no word of it had ever appeared in the annual reports or statements to shareholders. To find any reference to it you had to obtain a copy of the report of HBOS Treasury Service plc, a subsidiary of the Bank. It was, however, no secret in the international securitisation market, where it had a conservative reputation, despite some lurid press reports. In 2003 the US newsletter Asset Backed Alert wrote about it. Under the heading: ‘HBOS Arbitrage Vehicle to Gorge on Bonds’, it wrote: ‘HBOS is laying the groundwork to become an even bigger buyer of asset-backed securities. The Edinburgh, Scotland, lender plans to fund the investment binge via its giant Grampian Funding commercial-paper conduit.’3
It was the latest in a line of funding ‘conduits’ used by the Bank’s treasury department, and took over from a fund named Pennine Funding, from which it acquired $11 billion of assets.
Grampian’s
business was arbitrage – exploiting the difference between the low interest rates it paid by borrowing short-term and the higher rates it could obtain by lending long-term, thus turning on its head the old banker’s rule ‘borrow long and lend short’. It was prepared to do this because the world had changed since Bank of Scotland experienced its first cash crisis 300 years before and in the twenty-first century the global inter-bank market had made the rule obsolete – or so everyone believed. The range of lenders was so wide – encompassing practically the whole developed world – and the pool of liquidity so deep – trillions of dollars – that there would always be someone, somewhere willing to lend. The worse that could happen to you was that the price would go up.
Grampian raised credit by issuing Asset Backed Commercial Paper, essentially borrowing over a short term, anything from 90 to 270 days. Investors were willing to take them because, although Grampian was a separate legal entity, it was consolidated into the HBOS balance sheet. Most of the time it would act as if it were a separate company, but if there ever came a crisis the Bank would stand behind it. With the money it raised, the conduit bought other securities, mostly packages of American mortgages which paid a good rate of interest. To protect itself Grampian only invested in Triple A-rated paper – the highest and safest rating – and that ruled out sub-prime (although it later revealed that it did have a very small amount, less than 1 per cent of its assets).
A year after its launch Grampian had become the largest conduit in Europe and the third largest in the world. Later it overtook the others to become the biggest player in this market. For five years it performed very well and the HBOS treasury team used its skill at buying and selling debt securities to generate hundreds of millions of pounds in profit for the Bank. But when the scale of the sub-prime scandal became known, the inter-bank market started to seize up. Despite its Triple A portfolio Grampian found the interest rates it was having to pay to borrow shooting up. To meet Grampian’s obligations HBOS had to lend it money. This was an embarrassing and costly exercise, but HBOS saw it as a temporary problem which would right itself once the market thawed. Andy Hornby and Mike Ellis issued reassuring statements saying that the Bank fully expected to get back the money it had advanced to Grampian and that it would have ‘no material impact’ on the Bank. By October 2007, the worst seemed to be over and the bank was able to issue a press release saying that the conduit was again self-funding.
