by Perman, Ray
But it was not quite that easy. Grampian did not hold many sub-prime securities, but it had the next worst thing – Alt-A mortgages. These were loans issued to Americans who on paper at least had the wherewithal to repay, but included categories of borrower increasingly seen in the UK during the house-price boom years. There were borrowers of self-certified mortgages (called ‘liar loans’ in the US), those with poor credit histories, buy-to-let landlords and those borrowing on high loan-to-value ratios. HBOS tried to play down its exposure to these mortgages, but when its accounts for 2007 were published they showed that it had £7 billion at risk, plus billions more in other debt securities. Although it was not foreseen at the time, most of these investments eventually had to be written off.
Throughout the autumn of 2007 HBOS, along with most other banks, was finding it increasingly difficult and expensive to fund its own lending and pay off the money it had borrowed when loans fell due. ‘Spreads’, the extra interest payments lenders demanded to compensate for increased risk, increased by five times between June and September. Alongside its activities in Grampian and its securitisation issues, it had been an active issuer of covered bonds, another form of borrowing, but considered safer and more conservative than securitisations. HBOS used the bonds to lengthen the maturity of its borrowing and on occasion had issued 20-year covered bonds. Now that market too was seizing up. In September, HBOS managed to issue a new bond, but at a greatly increased price. In November, the covered bond market was briefly suspended because prices were rising so fast, making it even harder for banks to fund themselves. This was not a problem peculiar to HBOS; all mortgage lenders were suffering and some much more acutely.
Although the sub-prime scandal was a US phenomenon, 125 per cent loans, buy-to-let, self-certified mortgages and high multiples of salary had left many UK homeowners dangerously exposed to a rise in interest rates. Investors began to regard all mortgage banks with suspicion, but attention, inevitably, settled on one of the smallest and most aggressive, Northern Rock. Like HBOS, the Rock had fuelled its rapid expansion with borrowed money, but its situation was more serious. Whereas HBOS could cover around half of its lending from customer deposits, Northern Rock could only manage a quarter. It was dependent on borrowing from other banks in the wholesale market for 75 per cent of its funding, and when the markets froze in August 2007 it found itself with only enough cash to make it through to the end of the month and very little chance of getting any more.
Seeing the writing on the wall, the board of Northern Rock tried to find a bigger company willing to take them over. It opened talks with LloydsTSB, which was prepared to make an offer, but only if the Government would guarantee a £30 billion loan from the Bank of England, which was refused. An approach to the Royal Bank of Scotland also came to nothing.4 Rumours of the bank’s problems were now circulating widely and by September the share price had dived. The Bank of England was at first reluctant to intervene, with its Governor, Mervyn King, believing that the Rock had got itself into this situation by reckless and foolish lending. To bail it out would create a ‘moral hazard’ by encouraging other banks to believe that they could do anything they liked because the Bank of England would always be there to save them from their own stupidity. The stalemate dragged on for days until, with no private-sector solution in sight, King changed his mind and agreed to pump funds into Northern Rock, with the Bank of England acting as lender of last resort.
A statement was prepared, but before the news could be made public it leaked to the BBC and precipitated a run on the bank. Within three days savers queuing outside the bank’s branches, or besieging its call centres and website, had withdrawn £2 billion in deposits. Northern Rock eventually lost £10 billion – a third of its retail deposits. Ironically, HBOS was one of the beneficiaries, opening accounts for former customers of the Rock.
A public run on a bank – the first for a hundred years in the UK and virtually unthinkable in the modern world of close banking supervision and electronic payment systems – is every banker and policymaker’s worst nightmare. It is such a visceral image that the television pictures of orderly lines of ordinary people waiting to withdraw their savings flashed around the world, striking fear into the hearts of depositors everywhere who wondered whether their own savings were safe. Alistair Darling, Chancellor of the Exchequer, and Mervyn King were horrified as they watched the drama on screens in Lisbon where they were attending a meeting of the European Union’s economic and financial affairs council. They immediately cut short the meeting and flew back to London.5
Inside HBOS the television images sent a chill through the Bank. ‘It was a huge blow to us and a real confidence shaker,’ remembers one senior manager. Like the Rock, HBOS had been living with the consequences of the freezing of the market for weeks. Securitisations had stopped and other funding, where it could be obtained, was much more expensive. Lending had to be curtailed. It was outside the experience of even the most seasoned bankers. ‘Up until then we had always thought that you would always be able to fund a lending book. No one had ever seen a situation where you couldn’t. We couldn’t just withdraw from the mortgage market because we had deals in progress and in corporate some companies had facilities on which they were able to drawn down money. Also we were trying to secure our good, reliable clients.’
To end the run on Northern Rock, which had continued for four days, Alistair Darling announced that the Government would guarantee all deposits in the bank. The move worked in that the queues disappeared, but there were still questions over the Rock’s future. It was forced to borrow from the Bank of England at a punitive rate, which meant sustained losses and sent its share price plummeting. The guarantee only applied to Northern Rock, but there were other mortgage banks – Alliance & Leicester, Bradford & Bingley and HBOS – which were also struggling.
Central banks in the US, Canada and Europe had acted to pump money into the system to try to get the inter-bank market moving again, but with little effect. Those commercial banks which did have surplus cash were hoarding it to fund their own needs. In Britain the Bank of England was still hesitating to take more general action and the tripartite regulatory system – the Bank, the Treasury and the Financial Services Authority (FSA) – was proving ineffective, with each institution waiting for one of the others to take the lead. Senior bankers met the chairman and chief executive of the FSA, with Colin Matthew attending for HBOS, but were told that it was not able to put money into the wholesale market: that power lay with Mervyn King, who was still refusing to act. To the exasperation of the bank chief executives, when they met the Bank of England Governor one evening in mid-September he declined to talk about putting liquidity back into the market and lectured them on the danger of moral hazard instead.
The following morning he had a change of heart. The Bank of England announced that it would lend an initial £10 billion, with possibly more to come, against the security of packages of mortgages. In return, the Bank would charge a ‘penalty rate’ of interest. Those banks which took the money would make a loss, but they had no choice. The crisis was not over, but at least someone was now trying to do something about it.
HBOS reduced the cash flowing out of the business by closing down as much of its new business activity as it could. ‘We effectively pulled out of the SME [Small and Medium-sized Enterprises] market. The Royal Bank of Scotland was circulating internal emails to say that we had stopped lending and this was a good opportunity for them to step in,’ remembers one HBOS senior executive. Regular reports were going to Andy Hornby and Mike Ellis, who in turn briefed the board. Everyone knew the situation was serious, but until Northern Rock no one believed it might be terminal. ‘The feeling inside was that this was something we had to work through, sooner or later things would get back to normal – but they dragged on and on.’
17
The eye of the storm
By the beginning of 2008 the credit crunch was being seen as a global problem which needed to be fixed by government
leaders. Prime Minister Gordon Brown called a meeting of the heads of the G8 largest economies in the world to a summit in London. At a micro level Alistair Darling and a team from the Treasury were still trying to find a solution for Northern Rock, which was being kept on life support by regular transfusions of cash from the Bank of England. In February, with no private company willing to take it on without guarantees, they bowed to the inevitable and nationalised it, the first bank nationalisation since Labour had taken the Bank of England into public ownership in 1945. The crisis was still seen as largely confined to domestic mortgages and government efforts were concentrated on getting this market moving again. House prices were declining, but by a relatively small amount and most people believed this was a reverse which would correct itself within six months or a year, as it had done many times in past cycles.
The residential market was being hit, but the crisis did not yet seem to be serious in commercial property. In February Peter Cummings made a speech at an awards ceremony which would come back to haunt him, being quoted repeatedly in newspaper articles and in the House of Commons: ‘Some people look as though they are losing their nerve – beginning to panic, even – in today’s testing property environment. Not us.’1 At the time the speech was received positively; it was only later with hindsight that it was used as evidence of recklessness. Cummings was echoing the traditional Bank of Scotland policy of ‘staying at the table’, which had been restated by both his chairman and chief executive several times in HBOS annual reports. Losses on the commercial lending book still appeared manageable and Cummings intended to stand by his good customers until the market picked up again.
The Bank announced its financial figures for 2007 and although profits were down, the decline was a modest 4 per cent and the bank was still making over £5 billion in profit. The housing market was expected to be ‘flat’ in 2008, but the Bank said it was ‘well positioned to deliver good growth in shareholder value over the next few years’. Bad-debt provisions had been increased in the corporate banking division, but had actually fallen in residential mortgages, unsecured loans and credit card debts. The credit crunch was causing it some problems, but steps it had taken in recent years to lengthen and diversify its wholesale funding had paid off in the more turbulent credit markets of the second half of the previous year.
As a precautionary measure, the Bank had written down its investment in the US Alt-A mortgages by £227 million. This was more than the £180 million it had expected to have to provide when it had briefed investors at the end of 2007, but HBOS was confident it would eventually get the money back. The Bank was optimistic enough to increase the amount of cash it was paying to its shareholders and announced an 18 per cent rise in the dividend.2 Investors, however, were not convinced by the profit figures and the shares fell 5 per cent.
Despite the fall in profits, total pay and bonuses for the top directors went up. Andy Hornby received £1.9 million, up from £1.5 million, and Peter Cummings £2.6 million, up from £1.4 million – his rise including a cash incentive of £1.6 million reflecting the big boost in profits in the corporate banking division. Five executive directors earned more than £1 million and the part-time chairman, Lord Stevenson, saw his remuneration rise from £628,000 to £821,000. Generous though these payments were, they were not as high as they might have been. A long-term incentive plan did not pay out any cash because the target, beating the average total return to shareholders of the banking sector, had not been achieved. There was incredulity among shareholders when the Bank responded by halving the targets, but it brushed off criticism: ‘These targets are just as stretching as before, they simply recognise that earnings growth will be more modest,’ said the Bank’s spokesman.3 As an example of Orwellian doublespeak it was hard to beat.
Across the Atlantic the severity of the sub-prime crisis was brought home forcefully by the collapse of the investment bank Bear Sterns. A year previously its shares had been trading at over $130 each. A rescue package put together by the US Federal Reserve Bank and J. P. Morgan initially priced them at $2, but after threatened legal action from shareholders this was raised to $10.
In March rumours began to circulate that HBOS was having to seek emergency funding from the Bank of England. Within 20 minutes of the stock market opening one morning its shares plunged by 17 per cent. They had now lost half their value in a year. To stop a full-scale collapse, the Bank of England was forced to issue a strong denial that HBOS had sought a loan. The last time it had been forced to do that was in 1974 when NatWest was in danger of collapse from its property lending. The FSA warned traders against spreading untrue allegations. HBOS itself described the stories as malicious and Andy Hornby issued a statement saying they were ‘utterly unfounded’. There was a suspicion that ‘short sellers’, speculators who gamble on a share price falling by selling shares they do not own, were deliberately forcing the price down – a practice known in the City as ‘trash and cash’. An FSA investigation, which included listening to the taped telephone conversations of traders, found no evidence of criminal rumour-mongering, but did uncover some hedge funds with large ‘short positions’. They were placing big bets against HBOS, calculating that its share price had further to fall.
To show their faith in the business HBOS directors, led by Stevenson, Hornby and Cummings, spent £6 million buying more shares and the price began to rally, giving them a paper profit, but it was a false dawn. When the Bank published its annual report at the end of April it revealed that far from being able to shrug off the threat to its Alt-A mortgages, it was having to take serious pain. Hornby could not bring himself to use the word ‘losses’ so fell back on the accounting jargon by saying that a ‘negative fair value adjustment’ of £2.8 billion was being made to the Bank’s reserves. This, the Bank claimed, was not a loss, but a prudent accounting step. Mike Ellis, the finance director, said that in order for the securities backed by Alt-A mortgages to suffer an actual loss, six out of ten of the borrowers would have to default, and the loss on those loans would have to be more than 50 per cent. ‘We consider that a remote possibility,’ he said.
HBOS was being squeezed in a vice. As the housing and commercial property slow-downs in 2007 turned into a precipitous plunge in the spring and summer of 2008, lending covenants began to be breached. These were agreements between lender and borrower which specified, among other things, the level and frequency of repayments to be made and the loan-to-value ratio. A generation previously banks would have been able to fudge any breaches of covenants by tucking away problem loans into suspense accounts and trying to help the borrowers work through their difficulties. But new international accounting standards left no hiding place. Banks now had to write down loans and make provisions from their capital against default. Each time they did so their credit ratings suffered and they found it harder to obtain funding.
On 15 April Gordon Brown called bank chief executives to a meeting at 10 Downing Street where, almost unanimously, they demanded that more money be pumped into the inter-bank market. According to Brown most of the men present were suffering ‘quiet anxiety’, except for Andy Hornby, who sounded very worried.4 The unthinkable was happening, HBOS was running out of money.
The Government still had not appreciated the threat to the banks and was more worried about the mortgage freeze and the effect it would have on homebuyers, particularly young couples who were being denied a home of their own because they could not get loans. After stepping down from HBOS, Sir James Crosby had become a deputy chairman of the FSA – a poacher turned gamekeeper. Now Brown and Darling asked him to take on an additional role, investigating what measures could be taken to get the mortgage market moving again.
In May HBOS made a tentative return to the securitisation market, offering a package of home loans valued at £500 million. It was a timid toe-in-the-water compared to the £5 billion packages it had been used to issuing, but it was a success – it got its money, in fact it found so many lenders that it was able to up its target and
take in £750 million. What shocked investors was the price it was having to pay, which was a huge margin over the interest rates being charged in the inter-bank market and more than the cost of borrowing from the Bank of England, which was supposed to be charging a ‘penalty rate’. Some analysts saw the achievement of the issue as proof that the credit crunch was easing, others as evidence of the desperation of HBOS. A move that was seen as a confidence raiser, further sapped morale.
Liquidity – having enough cash – was not the only problem the Bank faced. It was also running short of capital, its cushion against losses. Since its share issue in 2002 HBOS had been steadily shrinking its capital, spending £2.5 billion of its surplus cash to buy back shares from its investors and cancel them. It had also steadily increased its annual dividend payouts. The effect of both had been to boost its share price and flatter its return on equity, but to reduce its capital. It was not the only bank in this position: the Royal Bank of Scotland and Barclays were also feeling the squeeze.
Since the early 1990s the capital that banks were required to hold against possible losses had been specified by an international agreement called the Basel Accord, after the Swiss city in which the regulators met. The rules were fairly crude and banks quickly found ways around them (moving assets off their balance sheets through securitisation, for example), so a modified system was introduced which became known as Basel II. The amount of capital a bank needed was to be calculated as a proportion of its total lending, but not all loans carried the same risk. Unsecured personal loans, for example, were much riskier than mortgages, where the bank had the security of a house to fall back on if the borrower defaulted. To allow for this, different types of lending were given different risk-weights and then added up to make a total of risk-weighted assets, on which the capital calculation was based.