Hubris: How HBOS Wrecked the Best Bank in Britain (21 page)

But beneath the surface rivalries in the senior management had been building. James Crosby was still not 50, at the height of his powers and by taking his foot off the accelerator pedal had
started to be accepted by the City as an effective manager who could deliver sustainable growth for his investors. Mark Tucker, who had been seen by many as a potential next chief executive of the
group, announced in June 2005 that he was leaving after a year to go back to Prudential as its head. The remaining two possible candidates who might eventually succeed Crosby offered a clear
choice. George Mitchell, at 55, had nearly 40 years of solid banking experience behind him and had worked in almost every department of the Bank. Personable, but usually undemonstrative in public,
he was viewed by those who thought he should be the heir apparent as the safe bet, a practical banker who could consolidate the gains the group had made.

Andy Hornby was almost the exact opposite. Still only 38, he had achieved academic brilliance at Oxford and Harvard, whereas
Mitchell had joined the bank straight from
school. Hornby’s only banking experience had been in the six years he had been at Halifax/HBOS and then only in the personal banking market. Mitchell’s post-school education –
studying for the certificate of the Institute of Bankers in Scotland – had been narrowly focused on one industry, banking. Hornby’s postgraduate education at the world’s foremost
business school (where he had passed out first from 800 students) had taught him that management was a generic skill which could be applied in any industry. At HBOS, he had used techniques he
picked up in retailing such as weekly sales and service updates.

He was described in glowing terms by the managers he had worked for in the supermarket group Asda. Alan Leighton, Hornby’s former boss, said: ‘He has brought a lot of Asda stuff into
HBOS. He is focused and I know spends a lot of time in the branches talking to people about what is going on and is very good at strategy. As well as being super-bright, he is also likeable.’
City analysts were even more complimentary. One said: ‘His overall record in the retail business has been exemplary.’ Another described him as a ‘superstar’.
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With verdicts like these, it was a surprise to find that Hornby had spent only three years at Asda, his previous jobs being at the Boston Consulting
Group and Blue Circle Cement.

Hornby – young, dynamic, energetic, successful and likeable – was the board’s favourite, but some of the former Bank of Scotland directors worried about his lack of all-round
banking experience and knowledge. They suggested to Lord Stevenson and James Crosby that Hornby should be made chief executive of Bankwest, the group’s Australian subsidiary. In a few years
in a smaller institution and a more benign competitive environment he would encounter a broad range of typical banking problems and be able to return with more experience and enough time still to
become one of the youngest chief executives in the UK. The suggestion was rejected without discussion.

In June 2005, Hornby was named Chief Operating Officer – number two in the hierarchy. As well as retail banking he would have overall charge of the insurance and investment division. With
this addition he would be responsible for 60 per cent of the group’s profit. He was the clear successor to James Crosby, although the chief executive made it clear no change was imminent
– he had no intention of stepping down. ‘There is no vacancy at the top. I am
49 . . . but it’s my job to be thinking about these issues of succession and
senior management capability is one of my core responsibilities.’

George Mitchell, the rejected candidate, resigned, although officially he was described as retiring. In the annual report Lord Stevenson said he would be remembered as a powerful advocate of
HBOS and a superb business builder. You had to look at the small-print notes on page 81 to find that special financial arrangements were being made for his leaving. There was to be no termination
payment, but since Mitchell was leaving ten months short of the 40 years service which would give him his maximum pension, the group was paying £198,000 to make up the shortfall. The pension
would be based on his final salary and in the previous year he had received £595,000 topped up with a further half million in bonus and incentives. A salary review in the year he left
increased his base salary to £610,000.

To replace Mike Ellis, Phil Hodkinson moved from heading insurance and investment to be finance director and, to replace George Mitchell, Peter Cummings was appointed head of corporate banking
and joined the board. He had been with the Bank for 32 years and was not only a capable deputy to Mitchell, but a supremely talented deal-maker, yet some board members had doubts about the
appointment. ‘Peter was a very able executive,’ said one, ‘but he wasn’t director material. He couldn’t see the big picture.’

According to Crosby, the bank was now ‘firing on all cylinders’, but there were lingering doubts that it could keep up the pace of its expansion over the past three years. Profits
had doubled and costs had been cut but could this be sustained? Non-performing loans – mortgages on which the borrowers could not meet their interest payments – had risen, not by much,
but enough to raise questions. There was also concern about the creditworthiness of some unsecured personal lending HBOS had made. Six months later, when it reported its half-year results for 2005,
the bank did its best to quell fears over its bad debt levels which, although they were up by a quarter, were more or less steady as a percentage of the total loan book, which had also risen by 25
per cent. Deep in the small print some analysts discovered a deterioration in the quality of some personal loans, overdrafts and credit cards, but the market as a whole did not seem worried and the
share price rose.

At the beginning of 2006 the HBOS share price hit a record high. The group seemed to have shaken off the doubts about its ability to
keep growing and James Crosby was the
toast of the City. At exactly that point he announced he was leaving. It was a shock inside and out of the company. He was not being poached to step into another big job, he was not nearing
retirement, being still short of his 50th birthday and only a few months previously he had denied that he was stepping down. His decision, which had been discussed with Lord Stevenson, was known to
only a few members of the board. Andy Hornby was to be the new chief executive.

Prophetically, the
Financial Times
commented: ‘Barring a complete change in HBOS’s fortunes in the coming year, [Crosby] is likely to be remembered as the chief executive
who walked away from his job long before anyone asked him to leave. “Sustained business success is about an orderly transition from one generation to the next,” he says. The next few
years will determine whether or not that transition has been a success.’
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Give me enough debt and I’ll move the world

As any school science pupil ought to know, Archimedes, who discovered the lever laws famously said: ‘Give me a place to stand, and I will move the earth.’ In the
twenty-first century, debt had taken the place of levers in doing the heavy lifting, but there was still a belief that anything could be shifted provided there was enough borrowed money. I will try
to illustrate the power of the debt lever with a simplified example from my own experience.

In the 1990s I was a director of a company which bought the
Glasgow Herald
newspaper group from the conglomerate Lonrho for £80 million. Four years later the company was sold for
£120 million. Simple arithmetic would suggest the profit was £40 million, or 50 per cent of the original investment – not a bad return in such a short time and certainly much more
than would be earned by putting the money on deposit. But that ignores the power of leverage.

Most of the original £80 million purchase price was borrowed. Shareholders – in this case a venture capital company and the management team – only provided £5 million.
All the rest – £75 million – was borrowed from banks. The company traded profitably during its four years, but all its earnings went to pay interest on the debt and investment in
the company, shareholders took nothing out. When the firm was sold, banks received their £75 million back, plus a further £10 million in fees and charges – a good return for them
considering they had been paid interest each year and much more than they would have received under normal commercial lending terms.

This left £35 million of profit to be divided among the shareholders – who had only put up £5 million. Their return was therefore seven times their initial stake, or 700 per
cent – the magnifying power of the debt lever.

That burden of debt (more than the annual sales of the company) would not usually be considered for a trading business. A management team would be mad to take it on and a
bank would be daft to lend it to them. Banks were willing to lend in this case because the company had a long trading history and they could see that it was capable of generating enough cash to pay
the interest, even if the economy turned down (which it did). They charged well above the normal rate for commercial lending and extracted fees on top of that. They would not have been willing to
put up the money for a long period, but it was always part of the plan to sell the company within five years to pay off the debt. There are a number of complications I have ignored but the basic
principle remains the same. By leveraging its small amount of equity with a large amount of debt, the shareholders were able to greatly increase their reward.

Archimedes’ ambition would have been commonplace in the world of corporate leverage. Bank of Scotland was one of the first banks into this market, using the skills it had learned in the
1970s lending to oil field developers to assess the cash flows of a diverse range of businesses. Predicting the amount of money a business could reliably generate was an essential part in reducing
the risk for a bank and followed the old banking rule of ‘look at the borrower, not the asset’. The bank would study the market for the company’s products to see how that might
affect cash coming in, and would assess the management team to make sure they had the skills and experience to run the company successfully.

The first management buyouts (or MBOs in the jargon) were like our purchase of the newspaper company. In the 1980s and 1990s large conglomerates were selling off basic businesses, often to their
managements. Banks were keen to finance these deals because the companies to which they were lending usually had long track records and the people leading the buyouts were usually the same
managements who had been running the company previously. They already knew the business and the market and, freed from the control and costs of the conglomerate, they could make the company grow.
These were good deals for the banks because they could lend large sums of money at high rates of interest and charge fancy fees. Always implicit was that the debt would be repaid after a few years
when the company was sold or floated on the stock market. The bank could then take back its money and start the whole process again, earning more fees and more interest.

The first MBOs were small, in the tens of millions of pounds; then they grew to hundreds of millions, then finally billions. Eventually conglomerates had broken
themselves up and there were no more left to sell off subsidiaries so MBOs became less common, but the power of leverage had been discovered and seemed as immutable as the laws of mechanics. Debt
in large quantities began to be used in any big transaction – acquiring another company, for example. MBOs became LBOs – leveraged buyouts – and the provision of debt acquired a
series of euphemisms, such as ‘structured finance’ and ‘integrated finance’. Bank of Scotland, still operating under its own name even though it was part of HBOS, was an
acknowledged leader and its specialist teams based in London or Edinburgh were respected and sought after. Each deal they did added to their stock of knowledge and enhanced their reputation.

The merger with Halifax had given the Bank of Scotland corporate team a lot more clout in the market, but it was still not in the top league. Major multinational companies were unlikely to
choose HBOS as their primary banker because it could not offer the full range of services that the Big Four banks could provide. It had only a limited international network and in other specialisms
such as treasury and investment banking it was a small player. So it had relatively little of the regular bread-and-butter income that servicing large corporate customers brought to its bigger
rivals. HBOS was dependent on one-off transactions for much of its earnings. Although it could take part in financing the very largest corporations, it was unlikely ever to be able to lead these
deals and would be a junior partner. It preferred instead to create a niche for itself in servicing medium-sized businesses and entrepreneurs who were ambitious to grow. These were inherently more
risky than the very largest businesses but the bank prided itself on its ability to appraise risk and by leading deals it was able to earn arrangement fees.

Because it had relatively little regular income, the corporate team had to position itself to be ready to participate in or lead deals and it became very good at seeking out areas of the economy
where there were opportunities to provide debt. These included not only corporate acquisitions and buyouts, but energy, finance to housing associations to build homes and to /files/12/22/44/f122244/public/private
partnerships to build schools and hospitals.

The corporate department also expanded abroad. Building on the
Bank of Scotland network of offices in North America and the Far East, its Bankwest subsidiary in Australia
and its growing presence in Ireland, it added offices in European capitals. It also broadened its range of products. Traditionally banks had provided only ‘senior debt’ – so
called because if a company had to be wound up, it was the senior debt providers who would be paid out first and therefore had the best chance of getting their money back. Now it was also providing
‘mezzanine’ finance – called that because it ranked between the ‘top floor’ of the senior debt and the ‘ground floor’ of the equity providers (the
shareholders) who would be paid out last and were taking the most risk of losing their money. Mezzanine was more risky than senior debt, but was more profitable. Banks could charge a higher rate of
interest on mezzanine and often also received a ‘kicker’ – a success fee at the end of a transaction, or a small shareholding in the company.