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.
