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.Victor Blank (pictured above) said that LBG's strength is its conservative, well-controlled, high quality, risk management that has now been extended to HBOS. The HBOS acquisition was part of a carefully conceived strategic plan, but the opportunity arose only out of HBOS's adversity. He said there are short term challenges but now the opportunity is before the bank to create substantial value in the enlarged group with its "extended earnings platform" and scope for revenue and cost synergies. There was no word about any job losses or branch closures and it is fair to assume that is not yet in plan. There are higher risk areas in HBOS but a number of core areas continue to perform well. Consequently LBG has a robust capital position and great prospects for performance gains after 2009.
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.Of this, about half (£80bn) has been cut-out and deemed the 'bad portfolio'. It is subject to intensive work-out and risk management. This involves £31bn in retail, £40bn in corporate (where £6bn write-down has happened) and £9bn in international, a total of £80bn. Three-quarters of HBOS's corporate lending was considered over-risky. by far the largest high risk category mainly because of exposure to property development including in Ireland.
It was also impressive to learn that on completion of the merger the new group hit the ground running; all group governance, especially in credit risk, and new group mission statements were in place on 19 January the first business day of the new group. Funding, market and credit risks had not been priced adequately by HBOS. That failure has now been rectified. But, this and other matters that can be gleaned from the accounts suggest to me, as clearly recognised by Lloyds accountants, that HBOS auditing was not up to the job! Despite efforts to rein in loans growth over the past year it is certain that the present write-down should never have had to happen. HBOS had expanded its balance sheet faster than its capital reserves should have allowed. Of course, much is always clearer in hindsight and that goes too for some of the Lloyds TSB accounting in the past such as its treatment of regulatory reserve and economic capital in deploying the long term funds of SWIP. There is much here in both looking back and in assessing the innovations going forward to exercise the best brains of the big 4 audit firms. They better make special studies of both RBS and LBG's 2008 reports, and then think seriously about what IFRS really means and whether they shot themselves in the foot somewhat before the Treasury committee when saying that their remit did not extend to risk assessments and capital ratios! It should have been quite clear to the auditors whether capital was being over-stretched or not?
The £10bn fair-value write-downs resulted from a top-down accounting exercise by Lloyds applying market-based credit default spreads across corporate and retail portfolios, including updating carrying values to reflect current interest rates. Hence the fair value discount is done by looking at the market value of the portfolios and is not an adding up of credit risk defaults and loan loss provisions. That is a separate bottom up impairment exercise per customer account and transaction level. Iam not sure, but this may be a world-first! What we have are a set of balance sheet accounts where huge [portfolios of hundreds of £billions are not valued by arithmetical addition of every account transaction according to whatever current risk values, but instead the total portfolios price by market prices as if they had all been securitised and offered for sale. That is very advanced practice, even avant-garde, while also most conservative, realistic and sensible. Most accounting proceeds by addition from the smallest ledger items aggregating progressively upwards. Here, instead, we have the accounting proceeding counter-intuitively, even contra-factually, with the fair-value market pricing using the harshest values of discredited and profoundly illiquid markets to price the balance sheet. I have to admit, despite being a proponent of the top-down approach, I am pleasantly stunned by the courage of this, however academically validated by the latest thinking in financial risk. Here is something that any of the big 4 audit firms will be challenged by possibly the ultimate in IFRS accounting standards logic.
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. What Lloyds has been doing therefore is a cleaning out of bad risk management, marking the loan portfolios to market and identifying the percentages of portfolios than need intensive care. This is comparable but different to how RBS placed over £300bn in a bad bank 'non-core' division. Lloyds similarly decided what is non-core, but less in business line terms, more in terms of what is outside Lloyd's conservative risk valuations and thereby created an equivalent 'bad bank' or 'worst-case' £80bn. That will reduce as the bottom-up assessments of each high risk account is managed.
So with £10bn write-down and worst case £80bn high risk to be managed in detail, the prospect going forward is that future losses for the year and through the worst of the recession should be relatively small and fit well within the bank's substantial capital reserves. These reserves can be topped up giving a further generous margin of safety by participating in the Government's Asset Protection Scheme.
Having said all those good things, it is clear that there are accounting standards issues in the bank's innovative top-down risk accounting and valuation standards to arrive at the formal results, whereby the results are based on an economic capital model and a global markets analysis. That is innovative, and good commonsense, but is bound to give the audit firms a serious hair-pulling headache. Some or a lot of the credit for this approach must go to the widely read white papers of my colleague John Angus Morrison (see www.union-legend.com who, with only modest assistance of myself showed several banks how to do their Pillar II economic capital model factor analysis). In the present part of the economic cycle, the uncertainties looking ahead even only quarter by quarter require a generous margin of safety error. This cannot be determined by looking at every account and transaction from the bottom up, but must accommodate judgements about the short to medium term, by looking at the big picture holistically and on a large portfolio basis.
CEO Eric Daniels and CFO Tim Tookey both spoke in terms that evidenced a strong and clear Economic Capital Model showing a lot of confidence about how well portfolio risks are controlled in their £1.1 trillion balance sheet (with 51% mortgages); there is plenty of working capital (60% deposits, 40% wholesale funding). There was a remarkable candour and openness that also bespeaks professional competence and confidence.
It will be fascinating to see how the restructuring and risk management provisions work out over the next two years. But, despite my disappointment at the loss of HBOS independence and how cheaply Lloyds has bought a bank with a net book value of £19bn (£13bn after write-down) I have to admit to being unusually very impressed with the LBG top management presentation of how they are professionally going about ensuring the solidity and future prospects of the UK's largest bank franchise.
It is important to recognise what reserve capital is. It is the buffer to absorb realised losses that has to be replenished whenever possible to retain at least 8% ratio to risk-weighted-assets. By 'assets' we mean exposure to risk of loss i.e. that part of loans and investments that is not covered by security such as collateral and guarantees. Out of over £1000bn in loans etc. the bank has £448.4 unsecured exposures. To provide for any possible losses based on long experience a capital reserve of at least 8% is needed and this must be the 'own capital' of the bank and not employed otherwise in the business of banking.
ReplyDeleteLBG Risk-weighted assets £bn
Credit risk = 448.4
Market & counterparty risk = 23.1
Operational risk = 27.0
Total risk-weighted assets = 498.5
This is typical of most banks. Half of loans and other exposures to financial risk is secured. Therefore, the
Risk asset ratios, after net negative impacts on Core tier 1 capital of £3.7bn (from est.fair value gain of £0.8bn, the bank's profit, and discounting of expected loss by £1.5bn, less est. write-off of HBOS assets-for-sale, hedging reserve and other adjustments of £6.0bn) gives:
Core tier 1 = £31.9bn = 6.4% RWA
Total Tier 1 (Regulatory capital) = £48.9bn = 9.8% RWA
Economic capital reserve (buffer) = £13.5bn
Total capital reserve £63.4bn = 12.5% RWA
There is some confidence here since £13.5bn was the approximate write-down credit and market losses of HBOS alone in 2008 although some £16bn was also identifiable by June '08. Assuming that 2009 could be as bad as 2008, but for all of LBG then an accounting loss of £20bn is feasible, but there is £22.4bn available to cover this before the minimum 8% reserve is breached. And over the medium term 40-50% of the accounting loss is very likely to be recoverable. It follows therefore that the Government will get its preference share coupon paid by LBG worth a few £bn. But, I strongly believe that LBG will deliver a better performance in 2009 notwithstanding the volatility of the year ahead and a few new economic lows before some upswing in the economy at year-end.
The performance as given by the accounts is also spring-loaded by the conservative top-down pricing of assets by the very bearish Credit default spreads market, which is also very international in character.
RBS and Lloyds have written off about £30bn (size of Scottish Government budget) onto their P/L. Some people are saying HBOS is to Lloyds TSB' what ABN AMRO is to RBS? I said on Sky News this is not so at all. I didn't spell that out - but the snwer is to do with HBOS being predominantly a traditional bank even if it is over-exposed to property. Clearly, however, if there was pressure to undo the LBG merger so as to fully nationalise HBOS and let Lloyds bounce up in share-value i.e. assuming the break-up value of LBG is higher than the NPV, and given that the two banks are not really merged in anything but name. Them why not nationalise HBOS and cut Lloyds free of this burden and let its share price will soar and let it rid itself of the government shareholding etc?
Well, in my view the chances of HBOS obtaining a brilliant and intelligent management of the calibre of LBG is small to zero.The 'two knights' and others could do a good job and HBOS systems are very good (albeit the old risk management was inadequate). But, I really believe HBOS is in the best hands, and i say that as someone who opposed the takeover - on various grounds. LBG's management are the best in the business for finding and restoring goodwill value.
BUT WHAT IS THIS GOODWILL ACCOUNTING?
Did the the two banks or any banks have that much goodwill recently to start with? What is the goodwill account. It is on the right hand side of the balance sheet and must have bank capital components on the left hand side. Goodwill items in other businesses are business value intangibles. In banks, goodwill is capital and must be solidly tangible in accounting terms, or otherwise why frighten everyone with these massive goodwill write-down-loss numbers in the negatively-bloated statutory P/L results?
In that respect the banks are being "bloody tangible" with their intangibles. Are these finger in the air judgemental fair-value corrections driven by a technological precision in accounting standards? The answer is somewhere between the two. The fact is that accounting technology and taxonomy are not up to the job of keeping pace with current developments in today's economic uncertainties with market values at the extreme end of the worst anyone could expect them to reach. Banks do not operate complete economic models and don't know how to precisely relate the economy to their business. So they must rely on intelligent use of indicators given by the markets. These are value indicators but not precise timing indicators. Assessing the shape of the credit and economic cycles is a matter of experience and historical analysis e.g. 10 months peak to trough and 60 months trough to peak. When Lloyds say they expect property values to fall another 15% in 2009 that is merely to get to the long run trend that all past property recessions have hit before starting to bounce back from. These benchmark assumptions given by past experience are reasonable and realistic to rely upon. For example the longest US post-WW2 recession has been 16 months and the official data suggests this one is already 14 months old, but now 20 months looks a better bet. The UK recession is 8 months old and may last therefore until the end of 2009.
Assessing the value of the bank's balance sheet by credit market prices and economic assumptions is I think the best that can be done. Without it the bank cannot assess how it is being pro- or anti-cyclical. Most people have forgotten, but the Swiss banks in the 1990s tried to remain pro-cyclical for a decade domestically and it severely hurt their performance when economic growth of the Swiss economy remained flat for so long.
LBG has erred on the conservative side, with write-downs that look to me much more as reflecting the safety margin including that of 25% insisted upon by the Bank of England for asset swaps at its liquidity window, and which will be repeated in its Asset Protection Scheme. From there it will be easier to supply the few tens of $billions of new lending that the Government quite rightly wants to see. Instead of simply recoiling from all lending like a scalded cat the bank will be judicious in restructuring from poorer to better quality lending and let the better quality grow faster than the poorer quality is being worked-out. If this means less exposure to property, hopefully there will be more exposure to industry. There will certainly be more lending exposure to the public sector.
1. The book values of net assets at the date of acquisition are considered a reasonable approximation to their fair values.
2. If a takeover is wholly owned then any goodwill is part of the whole group and need not be separately measured as attaching to any one part.
3. Goodwill is to be written off on a straight-line basis over a ten-year life. Negative goodwill is to be treated in accordance with IAS 22 Business Combinations=2 0/ FRS 10, Goodwill and Intangible Assets. Under IAS 22 the average remaining life of the depreciable non-monetary assets at the date of acquisition can be taken as four years. For the purposes of crediting any negative goodwill to realised profits under FRS 10, the average remaining life of the non-monetary assets can be taken as five years.
4. All depreciation / amortisation is on a straight-line basis.