by Perman, Ray
The new regime made some startling changes. It did end the distinction between on- and off-balance sheet lending, closing one loophole, but it also reduced the risk-weight applied to residential and commercial mortgages from 50 per cent to 35 per cent. There had been strong lobbying from the banks that they were being forced to hold too much capital, which was reducing their profits. Like the old system, Basel II relied heavily on the assessment of risk associated with individual securities made by the ratings agencies. The different weights of risk corresponded to different investment ratings. Two types of asset were given zero risk-weightings (i.e. they were seen as carrying no risk at all). These were lending to governments or central banks, and securities classified by the ratings agencies as AA- up to Triple A, the highest grade.
Banks were given a choice of ways to calculate their risk-weighted assets. They could choose from a menu of risk-weights provided by the Basel committee (using 35 per cent for mortgages, for example). This was known as the ‘Foundation’ method. Or they could calculate their own risk-weights, known as the ‘Advanced Internal Ratings-Based’ method, or Advanced IRB for short. To do this banks had to get the consent of their own country regulator (the FSA in Britain) by demonstrating that they had the skills and knowledge to be able to perform the complex calculations necessary. Most British banks opted for the Foundation method, but some, including HBOS and Barclays, applied to be allowed to calculate their own risks. HBOS had a large risk-management department employing over 100 people and headed by Peter Hickman, the Group Risk Director. It also had elaborate procedures for the ways in which it assessed and calculated risk. The explanation of these and a description of the governance process by which risks were sanctioned took up 19 pages of its 2007 annual report. It was confident it could calculate risk accurately and at the beginning of 2008 the FSA announced that HBOS had been granted Advanced IRB status.
Mike Ellis, the finance director, sought to reassure investors that HBOS was taking a very conservative approach. ‘Maintaining strong capital ratios is a given at HBOS and we will not compromise in this regard,’ he told a conference. ‘One of the key tenets of liquidity management is not to take unacceptable credit risks, accepting that you cannot eliminate entirely credit risk, and we are very confident regarding the credit quality of our portfolio.’5
It has been argued that HBOS under-calculated the risks it faced, but subsequent analysis has suggested that the bank did take a conservative view and could have reduced its capital requirement by choosing the Foundation method.6 If HBOS, like the Royal Bank and other banks which failed, had ended up with too little capital, it was a basic problem with the Basel system, rather than the internal calculation.
Faced with sclerosis in the inter-bank lending market and increasing losses on their Triple A-rated mortgage securities, banks in America and Europe were being forced to go back to their shareholders to ask for more cash. In the UK Bradford & Bingley had been first with a call for a modest £400 million, but the issue had turned into a fiasco as the bank was forced to announce a profits warning, a debt downgrade and the retirement through illness of its chief executive before the money could be gathered. The Royal Bank of Scotland came next, seeking to raise a massive £12 billion in new capital and promising to raise £8 billion more by selling off businesses. These were moves which it said would make it one of the safest banks in Europe.
It was a foregone conclusion that HBOS would have to follow suit. It announced that it was asking shareholders to give it £4 billion, but a mark of its concern about its predicament was the price at which it was offering new stock. Its share price, which had once topped £11, had dropped to less than £5 before the announcement. Now it was offering new shares at £2.75 – a 45 per cent discount. It looked like a fire sale and did nothing to bolster the confidence of shareholders.
As a further move to conserve money, the dividend was being cut and half of it would be paid by issuing new shares to shareholders rather than cash. Hornby tried to portray the issue as one of good management, rather than desperation. ‘It is a prudent step change in our capital strength and our target ratios. We need to be prepared for all macroeconomic events. Banks that do not have strong capital ratios will find it harder,’ he said.7 But no one was convinced.
In June the Bank published its rights issue prospectus, and again tried to put an optimistic gloss on what were depressing facts for shareholders. Specialist mortgages – buy-to-let and self-certified – accounted for a quarter of the £250 billion mortgage book and over 3 per cent of these were already in arrears – they had missed their mortgage repayments for three months or more. The figure did not include repossessed houses, so the real picture may have been worse. Overall the Bank had £5 billion-worth of souring home loans. In the commercial market HBOS had lent more than £4 billion to house-builders, who were facing a crunch of their own as homes they had completed failed to find buyers. Corporate banking’s ‘nest egg’ equity stakes in this sector had been valued at £200 million, but half of that had now had to be written off.
To make matters worse the ratings agency Standard & Poors reduced the bank’s credit watch status from ‘stable’ to ‘negative’.
Investor confidence was severely shaken by the revelations. The share price had fallen since the announcement and had briefly dipped below the rights issue price. If it kept falling the share issue was bound to fail: why would shareholders pay £2.75 for new shares when they could buy existing ones cheaper on the stock market? To guard against this HBOS had spent £160 million on underwriting fees with financial institutions, which would guarantee to buy any shares that were not wanted by HBOS shareholders. ‘Our rights issue is fully underwritten, it’s on track and we’re going to get it completed and get back to normal life,’ said Hornby.8 He probably believed a return to normal was possible, but if so he was in a shrinking minority.
The rights issue in July was the biggest flop since the stock market crash of 1987. Less than 9 per cent of the shares were bought by HBOS shareholders, leaving the underwriters to take over 90 per cent. As the price fell even further they were left with an immediate paper loss. Small shareholders were angry that the Bank had bought back shares between 2005 and 2007 at prices from £8.55 to £10.70, yet now it was trying to sell new ones at £2.75. There were calls for Andy Hornby to resign, but they went unheeded in the boardroom.
The Royal Bank of Scotland and Barclays had fared little better with their rights issues. To Gordon Brown the lesson was clear: ‘I interpreted this as meaning that the markets did not believe that HBOS had come clean on its toxic assets and future write-offs. At the same time the RBS share price was at 197.6p, while its rights price was at 200p, and the Qataris had been left with most of the Barclays issue as there was only a 20 per cent take-up. The whole market was simply walking away. They did not believe the banks; neither did I.’9
18
Apocalypse now
At the special meeting in Edinburgh to approve the rights issue, chairman Lord Stevenson told shareholders: ‘Armageddon may happen, and we should be prepared for it, and we are.’ Armageddon came three months later and no one was prepared for it.
The events leading up to the final collapse took place in New York. On 7 September the US Government announced it was taking the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, usually known as Fannie Mae and Freddy Mac, into public ownership. This was a huge step for a right-wing Republican administration led by President George W. Bush, which could not bring itself to call it nationalisation, preferring the term ‘conservatorship’. The two companies were essentially mortgage wholesalers and had been wrecked by the sub-prime disaster, losing £14 billion in a year. Their bailout would eventually cost the US taxpayer more than $150 billion.
A few days later Lehman Brothers, one of the elite group of Wall Street investment banks, disclosed that it had lost $3.9 billion on mortgage debt in the previous three months alone. There were now severe doubts over the futu
re of even the largest banks and these were reinforced when Bank of America, under strong pressure from the US Government, rescued Merrill Lynch, one of Lehman’s competitors, which had lost $20 billion in a year. Through late September the future of Lehman hung in the balance as politicians and regulators on both sides of the Atlantic tried to find a way to save it. Barclays showed interest in acquiring it, but the US Government would not guarantee Lehman’s losses and Alistair Darling refused to suspend UK company law to let a deal go through without it first being put to Barclays shareholders. The decision to allow Lehman to go bust destroyed any remaining confidence left in mortgage banks on both sides of the ocean. Five thousand Lehman employees in London lost their jobs.
On 15 September, a day the newspapers called ‘Black Monday’, ‘Meltdown Monday’ or ‘Panic Monday’, the FTSE 100 share index tumbled 200 points and HBOS shares went into freefall. The Financial Times described a macabre prediction game in progress: who will be next? The market had already decided: it would be HBOS.
The plight of the Bank had been watched closely by the UK Government throughout the summer. The company’s half-year results, revealed at the end of July, showed profits halved after a loss of £1 billion on its investments, a further £2 billion write-off to its reserves and bad debts up again. To save liquidity the dividend was being cut and would be paid by issuing new shares, rather than in cash. Andy Hornby also announced that the Bank was putting some of its best subsidiaries up for sale: Bankwest in Australia, the insurance company Clerical Medical and the fund manager Insight Investment. Alistair Darling was sceptical about its future: ‘There was a whiff of death surrounding the whole operation. Two once solid institutions, the Halifax Building Society and the Bank of Scotland, were heading for the rocks.’1 HBOS posed a massive problem for the Government. They had not yet found a permanent solution to Northern Rock’s difficulties, but HBOS was much bigger – any collapse would destroy the savings of 20 million people and create havoc in the banking system. The FSA was already searching for options and the Treasury began to work on a contingency plan.
Worries focused on HBOS’ capital and liquidity. A further big fall in the value of its reserves following a massive write-off in 2007 suggested that its capital was progressively crumbling away and with it the bank’s capacity to absorb losses. It was also running short of cash. Hornby had tried to play down suggestions that HBOS was having problems raising money on the inter-bank market, but to add to its woes the credit rating agency Standard & Poors downgraded HBOS one notch from AA- to A+, increasing the costs it had to pay to borrow.
It was about this time that I attended the dinner where my neighbour gave me the shocking news that he had withdrawn £20 million to put it in a safer place.3
In fact a massive run on the Bank was in full swing, but it was practically unseen by the general public. Unlike Northern Rock a year earlier, there were no queues outside branches and no television pictures to alarm bankers and politicians, but by electronic transfer, telephoned instructions and face-to-face withdrawals HBOS was haemorrhaging cash as its depositors lost faith. An estimated £30 billion was withdrawn by individuals and companies within a few weeks – a death blow.
On the other side of the balance sheet money was not coming back as quickly as it had done. As the economy turned down, householders could not sell their homes, so they were not moving and paying off their mortgages. Credit card debt was not being paid off as quickly. Companies were taking longer to reduce their borrowings and were unable to refinance deals with other banks. Many of those firms which had over-borrowed in the days of low interest rates and high economic growth were now in trouble. HBOS corporate teams were fighting fires all over the country. McCarthy & Stone, bought by HBOS and Tom Hunter in 2006 for £1.2 billion, was struggling to refinance its £800 million debt. Crest Nicholson was trying to get banks to exchange half of the £1 billion they were owed for shares in the company. Retail chain JJB Sports and property groups Kandahar and Kenmore had breached their lending covenants. The secondary market was also drying up. Recent deals were remaining on the books of HBOS as other British and foreign banks which once would have snapped up portions of HBOS Corporate’s loans withdrew from the market, meaning that the whole debt remained with HBOS.
In Bank of Scotland’s LIBOR4 department staff were trying to complete a routine transaction: ‘We were trying to transfer £100 million to another syndicate bank. It was the sort of thing we liked to get done at the start of the morning, but at the end of the day we got a call asking “Where’s the money?” We checked everything over and couldn’t find anything wrong – the money had left us. The following day it still hadn’t arrived – I thought to myself: “Someone in treasury hasn’t pressed the right button; they’re going to get in trouble for this.” But that wasn’t the problem; the money never arrived, we just didn’t have the funds.’
To keep the bank afloat, Alistair Darling had to authorise the Bank of England to make exceptional loans to HBOS and other troubled banks, including the Royal Bank and Bradford & Bingley. In view of the severe fall in the HBOS share price caused by the false rumour six months before, the arrangement had to be kept secret from the market, but in confidence Darling told John McFall MP, chairman of the House of Commons Treasury Select Committee. The full extent of the loans did not become known for a year, when Mervyn King told MPs that, acting in its capacity as lender of last resort, the Bank of England had lent £62 billion to the troubled banks2. Over a third went to HBOS, which, with Darling’s approval, was also borrowing $18 billion from the US Federal Reserve through Bank of Scotland’s American branch.3
Darling estimated that HBOS was having to borrow £16 billion overnight, every night, just to keep going.4 The figure may have been an over-estimate, but the timescale was not. The market had become very short-term. After the collapse of Lehman every bank wanted to conserve as much cash as possible, so lending for 24 hours was as long as they were prepared to let it out of their sight. HBOS had borrowed £278 billion on the wholesale money markets, 60 per cent of this for periods of less than a year. In the next 12 months it would have to refinance £164 billion as its loans fell due and had to be repaid, yet it was living from day to day. The strain on the treasury department was immense, but it remained calm and professional and took each day as it came.
The atmosphere was much more tense in the group’s City executive suite. Andy Hornby was feeling the stress of the constant pressure and uncertainty. Until then, in the words of one of his close colleagues, he had led a charmed life. Whatever he had done at school, at Oxford, at Harvard, in his first jobs in Blue Circle, Asda and Halifax, he had excelled. He had been the youngest, the cleverest, the highest achiever. Any setbacks he had encountered had been minor and, with his willingness to listen, learn and work hard, he had won people over and put any difficulties behind him. But this time his problems were of a different order of magnitude. He was having to react hourly to events that he not only could not control, but that he could not understand. His easy likeability was being replaced by irritability, and the lack of sleep and continual worry were showing on his face.
HBOS could not survive on its own. After Northern Rock, Brown and Darling were reluctant to nationalise another bank, so a private-sector solution seemed the neatest answer. Of the possible candidates as acquirer, LloydsTSB was the obvious first choice. It was conservatively run, with a strong balance sheet (dependent on the wholesale markets for only 25 per cent of its funding) and had come through the sub-prime crisis largely unscathed. It also had the most to gain. A takeover of HBOS would give it coverage in the North of England and Scotland, where it was weak, and provide scope to make massive cost reductions by cutting out duplication in back office functions and the branch networks. The HBOS board had often considered a merger between the two banks at strategy planning sessions, but the obstacle in the way had always been the Competition Commission. A combined bank would have a dominant market share in mortgages, personal savings and current a
ccounts that would never be allowed in normal times. But these were not normal times.
Hornby knew the LloydsTSB chairman, Sir Victor Blank, well because they both served on the board of Home Retail Group, the Argos and Homebase retailer. He had also encountered Eric Daniels, Lloyds’ chief executive, many times at bank meetings. Daniels, known as the ‘Quiet American’ in the City because of his unAmerican love of understatement, was a career banker. He had served with Citibank in Latin America and met his wife in Panama, where they still had a house with views from the Atlantic to the Pacific. He spent three years in London in the late 1980s running Citi’s private bank during a previous property crash. He joined Lloyds in 2001 as head of retail and moved into the top job two years later. According to The Guardian: ‘With his slow American drawl, Daniels is the perfect foil to the bank’s go-getting chairman, Sir Victor Blank. Although he admits to a love of “over-wrought” Italian opera, Daniels is not a man given to histrionics. He even smokes with an air of quiet contemplation – leading journalists to describe him as the Marlboro man . . . When asked last month [August 2008] whether he would do any more deals he replied: “Don’t hold your breath. I don’t buy a pair of shoes just because they are cheap.” ’5
