I doubt I'm the first to associate our credit crunch crisis with the internationally much loved Alice in Wonderland. This time the association sprang to mind over Loyds Banking Group's pre-announcement for annual 2008 impairments and write-downs for HBOS that drove the bank's share price down to briefly wipe out almost the total value of HBOS within the new group; bye bye to stock market value of a banking giant with over £600bn ($1 trillion) of mostly traditional conventional banking assets!
Assurances from No.10 on Monday helped stem some of the panic down-draught on shares in Lloyds Banking Group when its price fell off the cliff just after lunch on the instant the interim trading statement was out.
I spoke about this on camera and to microphones and got quoted in some of the press saying basically “hang on, where's the surprise, we knew this months ago?!”. Peter Burt, ex-CEO of BoS and Chairman of HBOS said publicly the exact same. But, no-one else! The markets and the media wanted to be shocked, wanted the drama! And that was predictable and therefore how LBG handled its press release was a PR disaster, a suicide note evidencing media incompetence.
ON RESULTSThe Queen: It's a poor sort of memory that only works backward.
Government and the Bank of England are doing a great job; they are on the job every day; never asleep at the wheel. Why should Government need to furnish reassurance when the banks could and should do this themselves? How could this have been handled better by LBG? The bank should have inserted the words “as we forecast”, “as expected”, “impairments contain expected recoveries over the medium term” or suchlike or any other sensible words of confidence and assurance including no need for further capitalisation injections etc. which is only in line with previous working capital statements.
ON STATEMENTS TO THE MARKETMarch Hare: …Then you should say what you mean.
Alice: I do; at least - at least I mean what I say -- that's the same thing, you know.
Hatter: Not the same thing a bit! Why, you might just as well say that, 'I see what I eat' is the same as 'I eat what I see'!
March Hare: You might just as well say, that "I like what I get" is the same thing as "I get what I like"!
The Dormouse: You might just as well say, that "I breathe when I sleep" is the same thing as "I sleep when I breathe"!Given that we are only days away from publication of the Annual General Reports of Accounts for 2008 (for both Lloyds TSB and HBOS to the end of December 2008 that merged in January 2009) the interim trading statement could have focused on trading and wholesale funding first and foremost to show underlying profitability and succesfully refinancing of the funding gaps, and only after that mention some write-downs and impairment or loan loss provisions totalling about £10bn are deemed 'conservatively' sensible to reflect current markets and cost of funding, Bank of England SLS swaps, or whatever etc. bla bla. Was the Corporate Book the right focus or is it a proxy for write-downs by the Bank of England at the SLS?
VOLATILITYThe Caterpillar: What size do you want to be?
Alice: Oh, I'm not particular as to size, only one doesn't like changing so often, you know.The media asked daft questions in their 'concerned' coverage e.g. “serious questions remain about whether the bank – product of a merger between the conservatively managed Lloyds TSB and comparatively reckless HBOS – will need to raise more money this year, an eventuality that could force the government to lift its stake-holding above 50 per cent” (FT). This is daft because anyone pretending to have some expertise should know that banks are selling assets via SIVs to the Bank of England and can either apply those funds to capital reserves or to refinancing the funding gap, and given that it is public knowledge that £185bn in t-bills were provided, plus £250bn guarantees, plus £57bn capital by BoE and HMT out of £500bn so far authorised. Therefore, there is no basis for inviting alarmist questions threatening shareholders. Citigroup and other bank analysts have merely marked LBG as a 'hold' from a 'buy' and Moody's and S&P have notched it down a bit – that does not indicate the experts think further share dilutions leading to nationalisation are necessary.
LENDER OF LAST RESORTThe Queen: Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!The No.10 spokesman offered a qualified statement that nationalisation is not being “actively” considered . The handling of last Friday’s profit warning from HBOS reignited that fear and that “toxic assets” (for which no accounts have substantiated the fear) “sitting on HBOS’s balance sheet” (er, not on the published B/S so where is it?) “threaten to 'poison' Lloyds” - this is rumour-mongering from a most reputable FT that should be reproved by the FSA – but where is the FSA- it's reviewing itself and asking whether all the paperwork of plans, intentions and guidelines it produces is being matched by sufficiently forthright action on the ground?
News organs are not the only alarmists. Moody’s, on Monday, down-graded Lloyds because of the high level of “troubled and higher risk exposures within HBOS”, which says nothing really but sounds profound and is merely knee-jerk responding to the news. The FT and others were opining, “What was most shocking about the HBOS figures last week was the speed of deterioration in its corporate loan book”, but why when the corporate loan-book is £116bn and a 4-8% impairment is only what is sensibly to be expected, subject to my caveat that the write-downs maybe are not exactly in Corporate? And the 'losses' (impairments) are only up £3.3bn from the end of June, in fact only a doubling of the first half result.
LBG might have imagined that following RBS's £28bn announcement the markets could take £10-11bn in its stride, if so foolish thinking, given that it took no time for all and sundry to claim this a UK bank's largest loss ever! LBG said it was applying its own stricter more conservative valuation approach – but that is just an insult to HBOS and not its job; the results to end of December 2008 are HBOS responsibility. LBG only formed on the 16th of January!
While dismissing fear of nationalisation, LBG said it is well capitalised with Tier 1 capital ratio – a key measure of capital strength – of 6-6.5%, within an acceptable regulatory range. That is just ignorant eyewash. What matters more is Tier 2 plus economic capital buffers to know what the total capital reserve ratio is to the bank's net assets (RWA). bank analysts love to step up and grab a headline, so Ian Gordon, analyst at Exane BNP Paribas, said: “The market’s reaction to Friday’s profit warning is factoring in a sense of inevitability that Lloyds will be forced to raise fresh capital.” He knows no more than anyone reading the newspapers. There is a poverty of circularity of opinions between news and analysts, especially when neither have any special insight and both just want column inches. Tom Rayner at Citigroup said LBG might have to raise £11.2bn in equity to get through the downturn. His previous estimate was £3bn. Where does this come from - £3bn plus £8bn to reflect the current net loss for 2008, but that is surely a most simplistic assumption about the range of means available to banks to shore up their reserve capital. He is assuming all the loss is on Tier 1 and at the expense of shareholder capital – why – to be alarmist too of course, join the media circus.
ON TOXIC ASSETSThe Cat: By-the-bye, what became of the baby? I'd nearly forgotten to ask.
Alice: It turned into a pig.
The Cat: I thought it would. When Eric Daniels, LBG CEO, said last week that the due diligence on HBOS was less than it might have been, was he seeking further government guarantees, sympathy, pity, to evidence the risks he took to please No.10 and No.11? He told the Treasury Committee he'd expended 5,000 man-weeks on due diligence – strikes me that's more than enough, but this had the effect of suggesting he too was surprised that losses are higher than expected, even though he himself had predicted a £10bn write-down in November. Then it turns out he is surprised about an extra £1.3bn! We are talking here about £1,3bn more out of over £600bn in HBOS assets!
This is also a matter of judgement. If there is no such possible write-down than this (and in fact maybe a lot more in either HBOS or Lloyd TSB accounts depending on many ways of looking at these matters) then, if follows, the merged banks must have the world's most amazingly sophisticated risk accounting systems with Swiss Watch precision and the very latest state-of-the-art general ledgers and have nailed IFRS7 to every umpteenth decimal place – they haven't and won't for years –
ON TRUTH-TELLING BY BANKSAlice: But I'm NOT a serpent, I tell you! I'm a -- I'm a --
The Pigeon: Well! WHAT are you? I can see you're trying to invent something!
Alice: I -- I'm a little girl.
The Pigeon: A likely story indeed! I've seen a good many little girls in my time, but never ONE with such a neck as that! No, no! You're a serpent; and there's no use denying it. I suppose you'll be telling me next that you never tasted an egg!The anxiety-making goes on. FT and other papers reported, “One of its top five investors was reported to be angry and thinking of pursuing legal action, “'the feelings against the group are building up a head of steam. Confidence in the management has evaporated'. Many shareholders questioned the merger, particularly those who had bought the stock because of its reputation as a bank that was managed in a conservative way. One top 20 shareholder said: 'Everyone told them they shouldn’t do it and they did. It puts the board under a lot of pressure. It is the chairman who is seen to have orchestrated the deal. On paper it should have been a fantastic deal. I think [the management] will survive but they have a lot of explaining to do.' According to these investors, the Lloyds board assured them it was a once-in-a-lifetime opportunity to merge the group that they could not afford to pass up. 'Now it is clear,' says another major shareholder, 'the directors rushed at it – not understanding how the world had changed.'”
ON REMUNERATIONMarch Hare: Have some wine.
(Alice looked all round the table, but there was nothing on it but tea.)
Alice: I don't see any wine.
March Hare: There isn't any.
Alice: Then it wasn't very civil of you to offer it.
March Hare: It wasn't very civil of you to sit down without being invited. This is silly. The institutional shareholders voted for the takeover. They have perfectly good analyses of their own. Some of them are looking to do deals to buys part of the group. Some have been lending stock and shorting the shares. All knew that write-downs are inevitable and much of losses will be recoverable. They must understand banking in an economic downturn and be able to take the longer medium term view and look forward to return of the good times – that the Bank of England Inflation report suggests could be sooner than later! If the institutions are worried it may be that they fear the Government via its 43% alone, and definitely if this rises above 50%, will start determining the bank's strategy including what is sold off and how this is sold off! The Government is already dictating some strategy e.g. lending levels, and determining bonus remuneration. Where is the surprise in that?
ON ASSET GROWTH AND CAPITAL RESERVESThe Dormouse: You've got no right to grow here.
Alice: Don't talk nonsense. You know you're growing too.
The Dormouse: Yes, but I grow at a reasonable pace, not in that ridiculous fashion.“In the fullness of time, it still may turn out to have been a good deal,” says one shareholder. If not, the board will not be able to say it was not warned. “We suspect that genuine deterioration in the property focused loan book at HBOS is the key driver,” this investor wrote to clients. Absurd! The bank's property exposure is known. It may be higher than others, but property is central to all banking and the bank's ratios are not bad. When recovery comes all this exposure suddenly looks positive, 'bricks and mortar' after all, must be better than £100s of billions in net derivatives and maybe better sadly than unsecured lending, manufacturing loans or god forbid professional services lending? I do get the distinct feeling that pre-crunch habits of how to look at matters in what is a system-wide problem and recession have totally failed to get real and understand changed cyclical circumstances. As I have said before this is a phase we are going through and “this too will pass!”
ON LONG TERM OUTLOOKAlice: Would you tell me, please, which way I ought to go from here?
The Cat: That depends a good deal on where you want to get to
Alice: I don't much care where.
The Cat: Then it doesn't much matter which way you go.
Alice: …so long as I get somewhere.
The Cat: Oh, you're sure to do that, if only you walk long enough.What we are seeing are far too many commentators insisting on taking the short term view when of all times when it could be reasonable to do so this is so definitely not it! other such media remarks that reflect short term myopia include phrases like, “corporate ... a big headache for Lloyds”, for which one could read any other asset class from private equity to credit cards, “fear UK recession is worse than expected”, (um, when was that when it was expected, sometime so last year?) and “ losses in (1, 2,3,4...n ) division continue to accelerate”, “unemployment rises”, “consumers default on (anything, mortgages, credit cards, car loans)”, “limited choices in capital raising” (er, no, why we have governments and central banks), “government preference shares could be converted into equity giving the state a majority stake” (and why would that be a good move when share values continue to evaporate?), “a value-destructive U-turn”, “plug the capital gap” (but reserve capital is a cushion not a hard rock) , “if it does not raise capital, this will stretch its core equity tier one ratios” (what about Tier 2 and Economic Capital?).
Panmure Gordon estimates LBG's pre-tax loss could hit £10.7bn in 2009 and not including any negative goodwill could turn that loss into bringing the core equity Tier one ratio down to 3.9%, below the 4% level expected by the FSA” (even if true, which it's not, hardly merits even a 'so what?'). Panmure says profits in 2010 and 2011 would nudge the core equity Tier one ratio up above 4%, arguing that as such “we don’t expect this would force a full nationalisation”. Hmm, frankly this is just the most absurd finger-in-the-air forecasts about £1 trillion assets and a host of business non-core assets that might be sold!
The FT at least comments that there are some big unknowns. It also wonders if capital pressures would be eased by a possible relaxation of the Basel II rules, being considered by financial regulators. “Basel II usually means banks have to hold more capital against loans if, for example, house prices fall” (er, no, not when average LtV is 47%!) and anyway if the bank is nationalised Basel II regulations no longer apply! “If regulators gave more latitude, it would ease capital pressure on the banks” (there is latitude to be counter-cyclical, and do we really want banks to be less prudential?).
ON STRESS TESTINGAlice: I didn't know that Cheshire cats always grinned; in fact, I didn't know that cats could grin.
The Duchess: You don't know much; and that's a fact. Lloyds lost its long-held Aaa credit rating from Moody’s ratings saying it worries about HBOS losses putting extra pressure on the LBG share price. What is the model for that whereby a bank that has already lost 80-90% of its share price still has Aaa until just now? The ratings model is driven by profit and other ratios, not the share price. Below Aaa it is merely at the top end of where most reputable banks are. One is reminded of the Queen of Hearts in Alice in Wonderland, “The Queen had only one way of settling all difficulties, great or small. 'Off with his head!' she said, without even looking round.”
The ratings agency said integrating a group the size of HBOS “during a major market downturn may prove problematic and will be a substantial challenge for the management team” adding, “The downgrades reflect the high level of troubled and higher-risk exposures within HBOS, which Moody’s considers will weaken the profitability and capital adequacy of the overall group,” but also that LBG could weather £16bn of impairment charges and losses to stay at its current rating level.
The main problem is that banks have not calculated how to forecast themselves over the credit and economic cycle in such a way as to show the markets what is reasonable to expect before recovery and what will be restored once recovery arrives, despite all the vast data we have and experience over many such cycles? It does no good to make verbal assurances only. Banker have no credit left for that. They have to substantiate their forward-looking estimates. This is what Basel II Pillar III requires. It is the law.
WRITE-DOWN LOSSESThe Duchess: You're thinking about something, my dear, and that makes you forget to talk. I can't tell you just now what the moral of that is, but I shall remember it in a bit.
Alice: Perhaps it hasn't one.
The Duchess: Tut, tut, child! Everything's got a moral, if only you can find it. It has been said time without number that the cure to the present crisis must involve more transparency. UK financial sector like other financial sectors including most vitally that of the USA are (to use an FT analogy) sailing as if in a thick fog with foghorns sounding off in all directions and occasional sailors calling out the fathom depths. Investors have repeatedly struck icebergs (so says the FT), such as, “last week, analysts were stunned by the scale of HBOS’s losses – £10bn in 2008” (nonsense, they just pretended to be shocked), adding “although the UK government has plans for clearing the gloom in the medium term, it must do something so the system can function in the meantime.
The UK needs a robust banking system; it is vital for the broader economy” and the piece goes on to cite “a plan to deal with the toxic assets”, “an insurance scheme”, a “bad bank” etc. But, as all must know the issue is funding banks' 'funding gaps' and that is what central banks are doing, and doing so quite well, and therefore with deposits rising somewhat, all else is in hand. But, matters are not helped in the BoE and HMT insist on keeping stumm about how much assets are swapped and to whom (2009 Banking Bill regarding working capital for banks) may not report until October and reserves the right not to report even then?
MARKET TRANSPARENCYThe Duchess: Be what you would seem to be -- or, if you'd like it put more simply -- Never imagine yourself not to be otherwise than what it might appear to others that what you were or might have been was not otherwise than what you had been would have appeared to them to be otherwise.
Alice: I think I should understand that better, if I had it written down: but I can't quite follow it as you say it.The FT worries, “Funders must not fear their investments are imperilled by their banks extending new lines of credit to customers. Otherwise, institutions will have incentives to be overcautious”. What is happening is that private wholesale funding sources for the clearing banks are being sidelined and effectively shut out by their own fears and this profitable money market is being nationalised and the profits (from off-budget finance) gained by taxpayers (on budget). The UK government, and those of other big countries, has pledged that it will not allow British banks to fail or renege on their bondholders. So if private sector funders are holding out for wide spreads or don't trust government assurances and guarantees, they only have themselves to blame for losing this market.
The FT suggests however, “having made this commitment in communiqués and speeches, however, the government should formalise it, pledging to recapitalise any bank whose capital ratio falls below a specified floor”. The necessity and logic of this escapes me?
The FT is right to say, “banks are not enjoying the benefits in terms of confidence that this Treasury support merits. If the public is to absorb bank risk, the banks should not be eyed with suspicion. The UK Treasury has more power to make such promises than most finance ministries. It must be careful to keep an eye on the vast risks it is taking on from the UK’s skeleton crew of bankers in overseas markets.” Actually the skeleton crew is in UKFI, who will oversee the biggest commercial banking holding company on the planet! But, as a government agency normal rules and laws no longer apply, and today I read that HM Treasury now wants urgently to employ 70 "redundant" bankers and economists, so that's alright then.
So Lloyds Banking Group has written off over £10 billions in goodwill and assets plus some loan impairments mostly from HBOS. But, the LBG results presentation is a superb banking study in what I call Goodwill Hunting.
Eric Daniels (pictured) was forthright, confident, thoughtful and impressive in saying that HBOS central group management was not strong enough to manage its total business. That is as fierce a condemnation as we are likely to hear outside of Scottish newspaper columns and Treasury Committee hearings. Lloyds has gone about their goodwill hunting with determination and innovation. The major loan portfolios were assessed first for what meets Lloyds risk appetite standards. This found over a quarter of HBOS assets or £165bn is higher risk lower quality than Lloyds TSB would have tolerated.
Tim Tookey, CFO, gave a workmanlike but also confident performance even when he found page 11 missing from his presentation. He answered questions well and suggested to me that he knows the whole bank. My one gripe would be the lack of anything much about wholesale markets trading and investment and none of my fellow bankers asked the platform about that either? The reports themselves do give considerably more detail about funding than is usual and indeed more comprehensive information that has been usual for either bank previously. 
