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.