BANKS' PROPERTY LOSSES - NEXT YEAR "SO LAST YEAR"

With banks looking dirt cheap in the collapsed bull market, what to do with a £100m investment sum for investing in their cheap as chips shares? Well I could buy 0.5% of the new Lloyds Banking Group (LBG). Not enough for a seat at the top table, but more substantial than one thousandth of HSBC, which might leverage something like an office supply contract if I had an office supplies company to hand? I might be better picking up 0.4% of RBS and look for a premium when, if ever sometime soon, it's maybe taken over? The Irish banks, however, appear to offer surprisingly good opportunities just now, not least with a rising Euro/£ rate. The three big Irish banks together are only worth two thirds of HBOS or a seventh of LBG or an eighth of RBS. [Though, by comparison, the UK's global local bank HSBC is king of all it surveys; HSBC could buy any number of banks that not long ago were considered substantial, even predatory, not Christmas bargain sales!] Just look at Anglo-irish bank's shares. I could buy 40% and not have to be passed by the regulator or offer to stump up a lot of funding so long as I don't try to run the bank and am happy to have my share diluted by the next round of capital raising. The bank's got revenues of €5.6bn and net revenue of over €600m, two and a half times its share price! Sure, it's massively exposed to property, but the bank says the credit worthiness of its nborrowers and the loan conditions are above reproach? Something must be wrong though, but what? It may be the 120% ratio of debt to capital, but its cash flow performance looks comfortable? trouble is there is an oily brylcream smell about property lenders, and anyway they have ample deposits from me already that I'm sufficiently concerned about despite the Government guarantee - what if they have a rogue element or an operational risk event? How about Bank of Ireland? Growing revenues of €12.6bn and net revenue of €1.7bn, 75% above the share value; can't lose, got to be a great winner in my portfolio? The stock market is crackpot stupid! Then too there is Allied Irish Bank. Revenue is up in 2008 from €9bn to €11bn and net revenue of nearly €2bn, also more than the share price. What has happened to the Irish miracle economy's banks? They are profitable, in fact returning 50% to over 100% return on equity! Yet, their share values are totally floored. I suppose there is money to be repaid to Government and share issues, but still how cheap has a bank got to be to attract savvy investors? Can shares fall any more than Allied Irish Bank €1.74bn (down 88% this year), Bank of Ireland €1bn (down 91%, and Anglo-Irish Bank €273m (down 97%). If I did invest I'd have to consider the rights issues that might dilute dividends per share (and possible dividend blocking conditions) and then share values diluted by over half, but still very substantial ratios would be left. I cannot see why they are so cheap. Defaults are 1-1.5%, similar, very low given the anxieties about property exposure, slightly below 1.5% at HBOS. I suppose defaults will rise sharply, but they would have to be stratospheric before I'd worry about my stake. 100% of deposits and bondholders are government guaranteed. Some worry whether Government could afford to bail out a major bank collapse? Maybe the problem is the scale of Irish bank lending to the size of the economy? But the banks have adequate reserves, fully in line with the EU's CRD regulatory recommendations, loan-books performing well at this stage of the recession, and a Government about to pump €10bn into the Irish big three plus no.4, Irish Life & Permanent. Are the banks just the victims of short-selling or can anyone seriously have reason to fear any of the banks collapsing absolutely or, in that shock event, the Government unable to pick up the pieces? Maybe the answer lies in Belgium. If the Rubicon is being crossed from banking as usual to complete restructuring it is surely there, and in massive political and economic crisis if BNP Paribas do buy Fortis Belgium and also if it does not buy Fortis Belgium? Fortis, once briefly the biggest bank in Benelux, now dismembered and sicker than a dead parrot. €1bn was lost to Madoff, the bank's in purgatory, and the Belgian parts and some subsidiaries agreed to be bought by France's biggest bank BNP Paribas. Fortis shareholders rejected the appointment of a new chairman on Tuesday during a stormy meeting, at which they lined up to harangue the board after its partial nationalisation. 5,000 investors voted against installing – and loudly booed – Etienne Davignon, the Belgian businessman and former diplomat, as chairman. They rejected re-appointment of two other board members and kept the present board in place for now. There's activism, unlike the supine well managed votes at Lloyds TSB and HBOS recently. Its banking and insurance businesses in the Netherlands are nationalised and the Belgian parts agreed to be sold to BNPP, along with rights to the Fortis name and logo. Jan-Michiel Hessels, vice-chair, argued Fortis had been unlucky in the timing of the ABN Amro deal not mistaken. “The world changed fundamentally in the last 18 months,” he said as shareholders booed, jeered and shouted. “What has not changed is our conviction that the acquisition of ABN Amro was, strategically, a good choice, even with what we know today.” The meeting in Brussels was more emotional than one in Utrecht for Dutch shareholders the day before. Both meetings voted against re-appointing Mr Hessels and Philippe Bodson. For comparison of where its share value is compared to its peers, see how low a €104bn revenue (2007 revenue) bank has sunk. The revenues shown are 2007, share capital is current and employment (in thousands) is 2007. If the sale to BNPP proceeds the remnant will consist of of the group’s international insurance and majority stake in an ABS vehicle holding €10.4bn of structured credits (before a 57% writedown). Trading in shares at €2.15bn was suspended by the Belgian regulator for lack of sufficient details of its new structure, plus problems with its legacy risk accounting. It will get €14.4bn in cash from sale and nationalisation of assets, a net cash position of €10.5bn after funding the securitisations (that it owns 66% of, government 24% and BNPP 10%), exceeding its €9.4bn of debt obligations i.e. not bankrupt. The securitised assets (much of it US subprime) will be funded with €7.4bn in debt and €3bn in equity. The €10.4bn investment will be marked down 57% of face value. In this case, unlike HBOS, court action has however resulted in a delay to the BNPP takeover by 65 days over objections to BNPP taking the bank's reserves even though what these are currently worth is guesswork. Fortis has big question marks over its financial and risk accounting and needs severe auditing. Rarely can a bank's logo have looked so appropriate. The Government is doing all it can to unlock the legal obstacle to proceeding with selling the bank and itself then becoming the biggest single shareholder in BNPP. But, BNPP itself is suddenly not a happy ship, and not just because of €500m lost with Madoff. €800m losses in securities investment trading and 800 sackings plus doubts surfacing about the operational risks and costs of taking over and integrating Fortis, combined with falling assets and deserting customers the longer the Fortis takeover is delayed, are all worrying factors. Fortis is not over-exposed to property, but does have exposures to other sectors that are currently retrenching just a smuch or more. If BNPP back out of the deal, the Belgian Government has a major headache to recover the bank and see it not just solvent but operationally sound? One of the ironies of property exposures (including US subprime assets with about 10% defaults though paying 8-12% coupon) is that a more sober analysis should see the longer term upside. This is the redemption of the Irish banks, despite over 30% property price falls and 60%+ property exposures, plus the cash-flow problems of property (residential especially) may prove to be relatively stronger loan-quality through the downturn compared to other business segments like corporate debt (if much of it also property-related, developers and construction, and many insolvencies!) Bank shares have fallen steepest for property-exposed banks like the Irish or in the UK HBOS. But, next year, even if there is another 10% property price fall, that perception as corporate defaults take centre stage, may appear outdated, just "so last year"! But that is just the brave view. I shall refer to Irish pundit David Williams for a description of the problem, a similar if lesser problem that is considered to best HBOS and why it needed Lloyds TSB takeover and could not have been saved if in an independent Scotland - though I continue to doubt this prognosis, it seems genuinely a severe anxiety in the Republic of Ireland. McWilliams says of the Irish banking problem, "we now do not have the financial firepower to help ourselves. This should make each and every one of us angry because monumental economic mismanagement and national hubris brought Ireland to the brink. One of the first things we need to get right is to acknowledge the extent of our difficulties. The epicentre of our crisis is the banking system and the legacy of the huge property bubble, which has burst. Apart from this, we have a robust economy with good people and a reasonable chance of getting our act together. However, the banks are contaminating us and need to be quarantined. There are two quite different problems facing the banks and, make no mistake about it, these problems — which threaten to overwhelm the rest of us — are entirely the responsibility of appalling management. We need to understand that our banking system is bankrupt... without the Government guarantee, Irish banks would run out of money in 90 days. The second thing ... no-one (share investors) wants them, because professional investors and others expect much greater bad loans to emerge in Ireland than anything we have come close to admitting. The rest of the world expects the Irish Bear Sterns to be announced any day where a bank is sold for practically nothing to stave off collapse. But who would buy such a thing?" "The crux is that the Irish banking system faces two disasters ... first disaster is a funding disaster where the average loan to deposit ratio of Irish banks is between 150 and 160pc (implying large dependency on wholesale interbank funding). For the likes of Irish Life & Permanent it is a ludicrously reckless 260pc! This ratio means that for every €160 the Irish banks lent out, they only had €100 in deposits. So they borrowed €60 from the wholesale money markets — which are now shut. As long as the money markets are shut, the banks are being kept on a life-support machine by the State’s guarantee. The strategy to borrow for growth was implemented by the managements of our banks who — amazingly — are still drawing hefty salaries. Without the State guarantee, the banks, which have been consistently downgraded to close to “junk status”, would have to pay so much for funding that they would go under gradually". In fact Ireland has the benefit of experiencing recession early compared to the rest of the Euro zone. It gets pulled down and up again by the US and UK while able to also rely on EU fiscal and monetary stimuli if there are any of sufficient strength. The Irish economy went into recession six months after the USA (normal irish response) and time will show this coincided with UK recession also. The irish picture is this one. Gradually sounds not to bad for me if in the interim the economy recovers? Also, I'm mindful that some EU countries are in as bad or worse straits e.g. Greece. McWilliams continues more starkly, however, "Even with the guarantee, the banks will have to get the loans to deposits ratios down to somewhere around 80-100pc... “deleveraging” ...by increasing deposits and reducing lending. This contraction of credit will have a monumental knock-on effect on the second big problem for the banks: bad loans. At the moment, Irish banks are telling half-truths about their bad loans, and given that the management of Ireland’s banks have got nothing right in the past two years, there is no point believing them now. To get a better idea ... examine the experience of other countries. Switzerland and Sweden both suffered a banking crisis following a property bust in the early 1990s. In both cases the banks had to write off close to 8pc of their loan book. This was traumatic and the banks lost fortunes, but they recovered... Irish loan book is over €400bn, a similar writedown (means)... about €33bn. This figure dwarfs the €10bn recapitalisation fund and deleveraging guarantees enormous falls in asset prices and concomitant rises in bad debts. So, no-one wants our banks because they are full of bad loans. Banks and investors are afraid to buy because of what they might find. How do we solve this conundrum? One idea is to divide our banks into good and bad banks. We could set up one or two bad banks, which would be “financial skips” into which we throw all our bad loans. These could then be restructured and traded by the State, using specialist, restructuring experts. The huge land banks, sites and commercial developments that are now worthless could be traded at, let’s say, 20 cent in the euro. As the economy recovers, these discounted prices would rise. (Many years ago I traded defaulted Brady Bonds of emerging countries on the same basis and the market worked.)This would have two positive effects. First, it would get all the crud off the balance sheets of the good banks, allowing them to borrow and restart lending to small and medium-sized enterprises. The second positive is that it would allow some liquidity to return to the market for land, not for speculation but to end the uncertainty, which will otherwise cripple the Irish economy for years. The idea of “bad” banks has the added positive of allowing those who have the skills to restructure debts to do their job, while those with the skills to lend and get the system going can do their job. Next year is not going to be pretty but we have to think around corners to see things straight." This is more or less what has been done in the case of Fortis, but the result is the break-up of the bank and some national loss of a commanding height of the Belgian economy. The irish Government is keen not to lose either of its two main banks to foreign ownership. The persisting crisis is one of interbank funding. But, it is not only a problem for Ireland. McWilliams in his prognosis does not address what might be organised at the EU-level. But he is right to emphasise that more funding is required than more reserve capital buffer. He emphasises future losses to cover what might be 8% loan loss. That is the level I also expect, but a level that will be typical across Europe and the USA (half of which should be recoverable medium term). The more immediate problem is liquidity. Bank of Ireland alone needs to roll-over about €30bn in the next year. Banks may be reluctant to lend new money but should be pressed to renew existing facilities for each other. All depends too on not just how well US, UK and EU actions to jump-start interbank lending succeeds, but how quickly. The Irish Government may not have the €70bn or so resources to provide new funding to the banks itself. But, it has borrowing capacity sufficient (and in conjuncion with the ECB which envisages providing more of a central intermediating role in interbank money markets) to guarantee or provide long term loan guarantee to cover the high LIBOR spread that Irish banks would otherwise have to pay and find uneconomic to do so in the short term. There are however some competition rules governing this that require Commission approval. It may be no coincidence that at this uncertain time for the Irish economy and its awareness of resource constraints that the Government is also being pressed to re-run the Lisbon Treaty vote on whatever basis would gain a yes-vote, even if this requires unique concessions that othetr countries might envy?There is more potentially at stake than just the cash-flow solvency of the banks, and the immediate crisis of the Irish economy. Commission policy wonks clearly believe this is a psychological moment to re-invite the Irish voters express a communitaire majority and overturn two previous no votes, even for a treaty little changed from what was rejected by the Irish twice before.
Analysts also suspect the ECB will outline new plans to kick-start interbank lending by pushing banks out of hoarding cash at its own overnight deposit facility. But banks' borrowing requirements are not overnight but 3-month money. One of the options is cutting the interest rate that banks get from the ECB when they deposit with it. "Re-widening the standing facility band has been openly discussed by some ECB Council members," (analysts at Dresdner Kleinwort). "Such an approach could force banks to start lending excess reserves to other market players again. But, this is a severely unbalanced market between lenders and borrowers and hence it is a dubious belief that the lending margins would significantly contract. The Irish banks are merely a few of many in a long queue, and not the first choice among lenders. The question is whether the time is right at the moment to push the banks?" (euro zone economist Rainer Guntermann). Policy makers are split on timing. There are a host of short term measures in train to provide European substance to the G20 statement of November including a wide range of measures to improve financial stability. There is also a €200bn counter-cyclical spending boost envisaged and €30bn Commission expenditure brought forward, but unlikely to have much immediate impact.
ECB Governing Council member Ewald Nowotny backed the idea of lower ECB deposit rates in a recent interview with Reuters. But Bundesbank chief Axel Weber said on Wednesday that it could also create problems. Aurelio Maccario at UniCredit said there was a good chance the ECB would announce the change although it may also wait until its first meeting of 2009 - January 15. Back in October the ECB made a string of changes to its lending operations in an attempt to restore confidence after the collapse of Lehman Brothers. The last two quarters of 2008 are expected to be negative growth for the Euro Zone, though I suspect 2009 will actually prove to be positive growth.
The October moves included guaranteeing banks as much money as they wanted at a fixed flat rate. At the time the ECB said the changes would stay in place until Jan. 20 at least, but also stressed that they were only supposed to be a temporary measure. There was some resentment at the time about the amount of claim that irish banks immediately made on this liquidity boost. "The next (central) rate setting meeting is Jan 15th... but why not give banks a bit more visibility and say either these are definitely temporary measures, or on the other hand that they will stay in place until some later date?" (Guntermann).
Money market problems remain at the heart of the current financial crisis and policymakers say that they are blunting the effectiveness of cuts in official interest rates. Others say that monetary measures alone are ineffective. ECB President Jean-Claude Trichet has been hammering home the importance of the bank's recent 175 basis points worth of rate cuts feeding through to money market rates so that banks, businesses and consumers feel the benefit. Policymakers also appear to be warming to the idea of an ECB-guaranteed clearing house as one way of getting banks to lend between themselves again. Though it cn only be a vague hope without firm direction. ECB Vice President Lucas Papademos said on Monday it was an idea worth studying but analysts think it unlikely the ECB will come up with any firm plans fast? "If you listen to the comments and speeches we have had over the past couple of days, further action (to restart money markets) at some point will happen, but we have no indication that anything will happen tomorrow" (Dirk Schumacher, economist, Goldman Sachs). Guntermann also ruled out that the bank would announce plans to follow the U.S. Federal Reserve with proposals for quantitative easing measures. "I'm not excited about any announcement about buying other assets like government bonds or commercial paper although they could clarify in theory what they could do."

A parcel o’ rogues plus Mandy: How HBOS was lost

Article from today's Sunday Herald Newspaper - BUSINESS COMMENT: By Robert McDowell
WHEN THE Belgian bank Fortis was taken over in October, board members could not appear in public without risking violent abuse, such was the blow to national pride of the bank's collapse. Should it be different for our banks? Friday's demise of HBOS is a profound blow to Scotland's national economic pride and the political fallout will remain active for a long time yet.
If, in the final act of this drama, the Merger Action Group (MAG) had won referral of the merger to the Competition Commission (CC), as the Office of Fair Trading (OFT) recommended, the takeover would have been prevented. But after losing the case last Wednesday, MAG gracefully declined to appeal.
Rank-and-file staff of both HBOS and LLoyds won't share their boards' satisfaction with Friday's result. Possibly more than 20,000 will lose their jobs, north and south of the Border. Not a very material consideration, if you agree with the business secretary the noble Baron Mandelson of Hartlepool, who, without fear or favour, weighed in the balance competition law and banking stability.
Or did he? Let us re-create the day - October 30 - when Mandelson weighed in the balance the fate of a 300-year-old Scottish bank. Outside his Whitehall window thousands of "No Pay Day" protesters were calling for an end to the gap between men and women's wages. His Lordship had just returned from a four-day trip to Russia (politically embarrassing given his Corfu connections). On that day Russia moved 2000 troops into South Ossetia, unsettling timing for the Baron, considering he had just returned from cultivating East-West relations.
As his diary also required him to speak alongside Chancellor Darling and European Investment Bank president Philippe Maystadt at London's Guildhall, urging banks to honour loan commitments to small firms, can we conclude that his mind was not fully on the HBOS merger?
Evidence given to last week's tribunal by a Mr Saunders, a civil servant, stated: "On the afternoon of October 30, the Secretary of State met with officials to discuss the advice and submissions he had received and to reach a decision. At our request, officials from HM Treasury were also present in case he had any specific further questions about the evidence of the Tripartite Authorities relating to the implications of the merger for financial stability. Having satisfied himself that all the evidence and options had been fully examined, the Secretary of State reached the decision, in line with our recommendation and on the basis of the arguments set out in the submission dated October 28, 2008, not to refer the merger to the Competition Commission."
There was much to consider, but I suspect that the meeting on such a busy day was kept snappy. Saunders doesn't say if the minister asked any "specific questions".
MAG argued last week that the law strictly obliged Mandelson to reach a decision "with an open mind", and that this was impossible when the chancellor and prime minister had, in repeated statements to the media, firmly committed the government to not referring the merger. To do so would have scuppered the merger.
As noted in the panel's conclusions: "The evidence is, therefore, all one-way and there is simply no basis for the allegation that the issue of the continuing need for the merger was not properly considered by the decision-maker." But how was it that "all the evidence and options had been fully examined" if, as seems reasonable to speculate, no detailed counter-arguments were explained to Mandelson that day?
The key question is: was the minister "fettered"? Prima facie, he was. His bosses had already publicly decided the issue. There were also the "tying" conditions in the takeover bid or merger agreement.
And, having enacted a change to the law days earlier, and only receiving one-sided advice in the context of vague fears for future financial market stability, where was he allowed latitude "to examine all the evidence and options"? The answer is: nowhere.
Imagine the media derision should Mandelson have performed a U-turn and referred the merger to the CC. It is scarcely conceivable that he could have contradicted and embarrassed his political colleagues who had rushed through legislation the week before.
The MAG judgement is about "lawfulness", not "correctness". But, for the noble Baron's decision to be lawful it absolutely must be "unfettered". The sublime manner in which the judges concluded he was "unfettered" is sheer legal escapology.
How can anyone seriously imagine the secretary of state's decision had not already been made for him by others? If the Baron was not mentally "fettered", he was surely corralled up a one-way street.
To many, the fate of the Bank of Scotland will be just another addition to the butcher's bill of the credit crunch. But in Scotland it cuts to the heart of what our small nation is all about.
On HBOS's former headquarters on the Mound stands the gilded figure of Victory. The hollow statue, was cast in spelter (a form of impure zinc) exactly 200 years ago, at a time of new prosperity and pride in Scotland, coinciding with the epochal visit of King George IV.
Thatvisit was hosted by Sir Walter Scott, who later defended the Scottish banks against Bank of England encroachment. He appealed ingeniously to the binding clause in the Treaty of Union whereby no decision by Westminster affecting private interests is binding on the people of Scotland unless it is demonstrably to their benefit. Where was Sir Walter, a true Scot, when we needed him?

LLOYDS AND HBOS MERGER NIGHTMARE?

WHAT HAPPENS NEXT?
Lloyds TSB was preparing to run a fine-tooth comb over HBOS’s assets last night, having finally secured the shareholder approval. This thrusts Chris Wiscarson into the spotlight as the man in charge of integrating the two banks. Next week those in charge of merging individual divisions will be named. Martin Akers, head of wholesale banking at Lloyds TSB, is likely to be among bankers managing the integration of its corporate assets. Mr Wiscarson, the former head of IT and operations at Lloyds TSB, has been in the post since October, but will now begin his work in earnest. Together with HBOS's Philip Gore-Randall, the chief operating officer, Mr Wiscarson will preside over the creation of Lloyds Banking Group, which will become an instant colossus in British high street lending. Lloyds Banking Group, due formally to come into being on January 19, will become the third-largest bank by market value, behind HSBC and Royal Bank of Scotland, about 3,000 branches and a total staff of 143,000,28 per cent of the mortgage lending market, 30 per cent of Britain’s current account business and 23 per cent of its savings market. Alex Potter, an analyst at Collins Stewart who has been a vocal critic of the merger, said that HBOS’s surging bad corporate debts would have a material effect on the newly formed Lloyds Banking Group and urged investors to avoid the banking sector.
The now all-too-likely merger of Lloyds TSB and HBOS is at risk of becoming a nightmare for both banks at a time when there are nightmares a plenty in the markets and the economy. We are not talking the equivalent of RBOS’s bridge too far in out competing Barclays for ABN AMRO, but some of that is not wide of the mark. One difference is that HBOS is pathetically cheap relative to its true value even in current markets of somewhere north of 5 times its current share price, and even then that only starts to exceed book value.
Lloyds TSB’s best tactic would be to do the least in the short term to integrate the two banks. Far better, not to threaten massive jobs cuts as a consequence and just focus on selling off non-core parts of the empire that are valuable standalone businesses These would include the mortgage and lease finance firms that would usefully reduce headcount anyway but without involuntary redundancies. The irony is, however that the morale and cultural integrity, the human capital, of a business is more important to its value and viability at this time than at any other time.
HBOS needs to be somewhat cheap, however, if any bank is to buy it and merge or integrate it. That is because this is a time for Joseph Schumpeter's 'creative destruction'. It will be two steps back for one step forward for at least two years. Why? Lloyds TSB expects to integrate HBOS and achieve 'synergies'. At the same time the whole of each bank has to be shrink-washed, assets run-down and a new economic capital model created as a condition of redeeming the Government's over 43% shareholding. That’s a tall order for the banks as independent entities, to integrate them in parallel is on anyone’s measure to easy task, fraught with concern.
Lloyds is already planning what to writedown and sell-off. The senior executives are now talking to potential buyers, even before the deal is finally certain; that is standard practice. You may expect a flurry of sales announcements as soon as the merger is complete in mid-January when HBOS shares are delisted. I imagine, for example, that Intelligent Finance is on the shop counter. I expect Lloyds can recover most of its bid cost quickly and will have bought a substantial bank for nothing! The next problem is preserving its value and whether or not that is a hostage to fortune.
Looking at the evidence of the past on similar corporate actions, assuming they are a good guide, I can envisage HBOS as a study of what to do right over three centuries and how to lose it all in next to no time. There were three major errors:
1. The ousting of James Crosby (some say by a ‘palace coup’) when, after merging Halifax with BoS, he wanted lower mortgage exposure. Andy Hornby did not. This was a battle between an experienced banker and the hubris of inexperience. One does have to blame the rest of the board for this too.
2. The handling of the capital raising in June/July this year was a disaster, both by the bank and by the underwriters, both incompetent in my view. The same teaming-up repeated similar errors a few months later. Frankly, unbelievable.
3. The handling of media relations by senior managers when the banks figures were doubted regarding defaults and toxic debt, and even worse when the bank became the easiest of prey for short-sellers, was not so much bungled as missing in action.
Except for these matters, HBOS is a truly excellent bank, with great systems compared to its benchmark peers. Left to survive by itself it should do so well or no worse than others, probably better than the new merged group if it tries immediately to begin integrating both banks.
HBOS has moved over £400m of PFI assets off balance sheet. It has sold some non-banking holdings and WestBank in Australia. There is much more can be sold.
HBOS staff may expect to bear the brunt of 20-40,000 job losses and must be fearful and angry. What are the risks when merging with a bank in distress, when staff are less than enthusiastic?
Lloyds will use as its template Royal Bank of Scotland’s integration of the operations of NatWest a decade ago in a technology wonder project led by IBM. The cost (external not internal) was in the region of £3 billions. Cost savings, or the hoped-for 'synergies', are expected to be worth £1.5bn a year. But it will take several years to get there. HBOS systems are much superior to Lloyds, but Lloyds has the whip hand in this merger. Lloyds general ledger core accounting is reputedly a 30 year old model long past replacement date. Remember, Lloyds Group is itself an un-integrated collection of individual brands. Only days ago, a 4 year old project to modernize financial reporting across the bank was cancelled half way through. This does not bode well. The software failed because the complexity bewildered the analysts.
HBOS had problems integrating with Halifax, but these were mild. This was a merger of equals (financially) and much effort was expended to cherry pick the best of the respective systems. Anyway the two banks had so many complementarities that integrating into a single contiguous system across all business units was thankfully not worth doing. The merger made excellent sense for both banks not least because Bank of Scotland had been financing Halifax’s mortgage book for years.
Deloitte, the audit and consulting firm, emailed me recently about bank mergers to say, "...All those dreams of capturing synergies through higher revenues and lower costs may turn to dust if you don’t incorporate information technology (IT) into the integration process from start to finish. By failing to invite IT to the party, companies may overpay for an acquisition and suffer buyer’s remorse down the road. And once the transaction is completed, IT still has a crucial role to play in whether the expected synergies actually deliver on the promise of the deal. Here’s the bottom line: Integration without IT is no integration at all".
As is commonly recognized by the experts in this arena, Banking is Information Technology nowadays, has been for years; front and back office; retail or wholesale; if you don’t recognize that your head is in the sand!
Synergies, if narrowly cost-ratio determined, are illusory anyway in my bitter experience - they are demanded by stock market analysts as a fig-leaf. The analysts want to be sold the “value-proposition” of "why buy?", when the real why buy is simply bigger market share. But, when two big players merge in markets, where these players trade directly with each other, the merger wipes out a large slice of the markets' in depth liquidity.
And this also happens in domestic traditional banking. A lot of assets are borrowings by households and businesses merely to re-cycle other loans with other lenders. So when LTSB and HBOS merge they make UK domestic banking volume smaller. They reduce the velocity of money by default. The 'velocity of capital' in the UK economy will fall significantly, and do so when already falling too much anyway as a consequence of credit crunch and recession. Mergers in such conditions will find expected gains prove illusory, a mirage in a the desert.
Mergers & Acquisitions projects all too readily assume integration is worthwhile. What the investment bankers forget is that company cultures (internal brand value, procedures & processes are very delicate) are destroyed and a new one has to be created, two steps back for one step forward. Recall the cull at IBM Greenock in the mid 90s. Something like that will happen now to the intellectual capital of Scottish banking, pulled south, over the border.
It is like taking two different fine Swiss watches to bits and trying to build a new one with parts from each; it cannot be done. So what happens - entirely new systems need to be bought, tailored, legacy data populated, tested and rested many times, rolled out, training,and more training, bug-fixing, always new bugs appearing - an endless cycle of improvement and replacement that should take 18 months but takes 5 years, by which time half of all is outdated and needs renewing again! It would be far better is to maintain the banks as separately operating entities under a holding company. And then only judiciously integrate them, beginning at the top before moving down layer by layer and only when business cases are convincing and change absolutely necessary. Cultural change needs time. Banks are not watches; they are people businesses with quirky and highly-elaborated information systems that are very complicated and obscurely tailored. No way can be everything be changed simultaneously. That will only overwhelm management resources and exhaust the skills of the bank and of the marketplace. Some people use the analogy of merging two rail networks running on different railway gauges; HBOS with 23 million accounts, Lloyds TSB with 15 million. It is even more impossible than that! My advice: forget root & branch integration synergies and stick to what matters, which are risk management and financial accounting plus sale of non-core businesses and other assets.
HBOS has already agreed sales of BankWest and St.Andrew’s wealth management, both in Australia to Commonwealth Bank of Australia for £1.2 billion at 20% below book value having earlier rejected a £2 billion offer (Herald, 8 Oct). HBOS still has Capital Finance Australia Ltd, BOS International (Australia) Ltd and HBOS's Australian Treasury operations. Some more HBOS goods potentially in the new Lloyds Banking Group’s January sales shop window.
St James Place plc., an investment bank and life assurer, majority-owned by HBOS, worth over £900m (current market capitalisation), it has only lost one third of its December 2007 value, and still trading at over twice book value when HBOS is a fraction of book value, is a jewel in the 2009 sales, potentially, anyone with sense will be climbing over the next guy to get at it!
Birmingham Midshires (BM) with roots dating back to 1849. It is an amalgam of 50 building societies including the Midshires and Birmingham & Bridgwater Building Societies. It is Birmingham’s largest private employer and won the accolade of Best Savings Account Provider for the second year running. BM employs over 2,000 and manages assets in excess of £10 billion.
Intelligent Finance the online bank and mortgage provider (launched in 2000) had at one time assets of £16 billion and about a million customer accounts, employing over 2,000. Today it is somewhat mothballed insofar as it became more fully integrated into HBOS with much of its development stopped in August, therefore possibly a prime candidate for selling on?
LEX is the UK’s leading vehicle contract hire business. Formed in 1959, bought by HBOS in 2006, it has a fleet of a quarter of a million vehicles and 20,000 business customers. It has won a host of awards and probably net revenue of circa £90m?
Clerical Medical, health and liability insurance and investment funds (founded in 1913 and bought by Halifax in 1996) it has about £17 billions in assets and employs about 2,500. It is integral to HBOS where Funds for all HBOS’s insurance business are managed by Insight Investment Management (another HBOS Group subsidiary). Property investments are managed by Invista Real Estate Management (a company spun out of Insight in September 2006). This is Edinburgh’s Asset Management community taking another pounding.
Other companies in the HBOS empire include First Alternative, car insurance, eSure car, travel and home insurance, TMB, The Mortgage Business for mortgage intermediaries, and Colley’s, the largest home valuation and surveying business in the UK, Freeway, car finance, and in July HBOS may have sought to auction Hill Hire, its commercial vehicle lease hire company with 21,000 vehicles and 17 depots, for £300m?
A big question, of course, concerns HBOS’s special purpose vehicle, Grampian Funding Ltd, set up in Jersey to manage the first and biggest securitization (covered bond) issue in Europe at a time when other countries had facilitating legislation for covered bonds, but not the UK, which turned a convenient blind eye. It was £28bn of securitized assets and is now a ‘fair value’ of about £19.6bn off balance sheet, funded by £7bn from internal HBOS resources, which is much more than the ‘fire-sale’ price for the whole of HBOS? Some say this is the reef that holed the ship!

Sunday Herald 14th December, Edinburgh’s Intelligent Finance said to be in shop window By John Phelps
POTENTIAL BIDDERS are standing by for a fire sale of prime financial assets in January when Lloyds TSB boss Eric Daniels gets his feet under the table after Friday's takeover of HBOS.It is understood that he has already received inquiries about the group's near 60% stake in wealth management group St James's Place and its holding in Clerical Medical. Analysts say he is also keen to offload HBOS's internet-based Intelligent Finance subsidiary. "Any and all of these are certainly potential candidates for sale, especially Clerical Medical in my view," said Ian Gordon at Exane BNP Paribas. "However, I'm not particularly convinced Intelligent Finance would have too many willing buyers."
The dismemberment of the Scottish group could also include its portfolio of dozens of shareholdings in its Integrated Finance division, which accounts for some £4.5 billion of loans. This operation - which includes stakes in David Lloyd Leisure, Café Nero, social-housing group Keepmoat and cranes operator Ainscough - has been a big profits earner for the group, but has suffered from its exposure to property and building groups. It is understood that investment-banking group NM Rothschild has been taken on by Lloyds TSB to advise on its options but may be held back by the reluctance of any buyers to take on inherited debt as well as equity holdings.
The anticipated asset sale will be watched with some trepidation by staff at Intelligent Finance's headquarters in Edinburgh Park. They have already suffered from cutbacks after a decision to stop giving out conventional mortgages and to offer only offset home loans in which customers open savings accounts. And the writing could also be on the wall for fellow HBOS mortgage specialist, BM Solutions. Concerns have already been expressed by former HBOS director Alan Cleary, who believes the Lloyds TSB directors plan to focus on the Bank of Scotland and Halifax brands, together with their own Cheltenham & Gloucester."Lloyds will find some Halifax brands toxic, and they will disappear," he predicted in a recent interview.
Other leading experts question whether even Cheltenham & Gloucester could be safe from a fresh appraisal of the group's mortgage business if Lloyds TSB is prepared to share the pain of rationalisation moves after the merger is completed. While brokers believe that the sales of the Clerical Medical business and St James's Place could be the first off the block, some analysts believe that they will do little to meet the group's strategic plans. "Daniels will be delighted to receive the cash and the sales will be warmly received by investors," commented one broker. "But his prime focus will be on improving the banking loans-to-deposit ratio of the combined operations and any moves on the Integrated Finance division would be far more significant."
Buyers would be likely to insist on bargain prices in current conditions, although it is believed that HBOS has already written off the value of a number of its equity stakes to ease potential sales to trade buyers with adequate financial backing.
Hopes of an early sale of financial assets, though have risen since entrepreneur Clive Cowdrey raised £500 million of finance for his reborn Resolution group with the specific aim of seeking bargain buys in the sector. His backers have been told they might have to find up to another £5bn to fund deals that puts both St James's Place and Clerical Medical comfortably within reach while still leaving him with enough firepower to pull off bigger transactions.Former Standard Life director Trevor Matthews at Friends Provident is also believed to have shown an interest in St James's Place, although analysts believe that his own company could fall victim to Resolution's growth ambitions.Private equity groups, such as CVC and the Dutch Rabobank, are also said to be keen to step up their presence in the UK market place.On Friday, HBOS shareholders overwhelmingly agreed a takeover deal with Lloyds TSB at a meeting in Birmingham. Lloyds shareholders had backed the deal in November, and HBOS shareholders had been widely expected to follow suit. Earlier that day HBOS shares fell almost 23% as the bank said it was operating in "increasingly difficult market conditions" and that bad debts were rising. Lloyds fell almost 18% and Royal Bank of Scotland lost 15% on fears that the sector shared HBOS's problems.