Hubris: How HBOS Wrecked the Best Bank in Britain (24 page)

Thirty years on, the mortgage market had changed out of all recognition. Building societies had been deregulated by Mrs Thatcher’s government in 1986. Several of the largest societies had
turned themselves into banks and were competing hard for home loan business. The banks themselves had woken up to the fact that mortgages could be very profitable and new specialist lenders and
brokers had entered the market. The housing market looked like a one-way bet for both borrowers and lenders. There had been no serious setback in prices for years and from 2000 to 2007 average
prices more than doubled. Some areas of the country had seen even bigger rises. In contrast to the tortuous process I had to endure, borrowers were now almost having loans thrust upon them. Without
any evidence of saving, it was possible to get an advance of four, or even five times an applicant’s annual income
¹
and house prices
were rising so fast that some lenders were prepared to lend 100 per cent or even more of the value of a house, confident that inflation would restore the loan-to-value ratio to a sensible level.
Having to prove that you earned as much as you claimed was not always necessary; some banks offered self-certified mortgages where no evidence was required. Nor did having a bad credit record bar
you from getting a loan; several lenders specialised in taking on poor risks.

Halifax was the king of this market, with a dominant market share and an aggressive sales policy aimed at winning more new business each year, but former building societies like Abbey, Bradford
& Bingley and, especially, Northern Rock, were out to steal the crown.

Like Halifax, Northern Rock had its roots in the self-help and savings movement of the nineteenth century. Based in Newcastle, it
was an important local employer,
sponsored the football and rugby teams, and arts events. Through its charity, the Northern Rock Foundation, it supported community and social groups, especially those working with the
disadvantaged. After deregulation, it floated on the stock market and under a young, ambitious chief executive followed a strategy of aggressive growth. Adam Applegarth had a lot in common with
Andy Hornby. He was clever, joining Northern Rock as a graduate trainee after reading mathematics and economics at Durham University, had a rapid rise through the management ranks and had become
chief executive at the age of 39.

Northern Rock was a fraction of the size of Halifax and its market share of existing mortgages did not come close that of its larger rival, but in the fight for new business, it made most of the
running. It was heavily involved in the buy-to-let market, where ordinary people without experience or expertise in property letting or the assets to support heavy lending, were encouraged to buy
several houses with big mortgages in order to rent them out. It was one of the first lenders to offer 125 per cent mortgages, where an advance of 90–95 per cent of the value of a property was
topped up with a further 30–35 per cent as an unsecured personal loan. And it offered self-certified mortgages.

Much of this market was handled by brokers, who would guarantee to get you a loan. The magazine
Mortgage Strategy
estimated that nearly two-thirds of the £200 billion of new
mortgages being written by UK banks in 2006 was through brokers. There were some long-established and sound brokerage firms but the house-price bonanza had also attracted a lot of cowboys into the
market. A BBC investigation in 2004 found some recommending that applicants should lie about their income in order to get mortgages of five or six times earnings. It was not only brokers who were
exploiting the system. The BBC visited high-street branches of HBOS subsidiary Birmingham Midshires, where three out of three of the advisers the reporting team consulted offered self-certified
mortgages of around six times income for which the team would have had to have lied. One of these advisers boasted of getting a client a mortgage of around ten times income by inflating his salary
to over £100,000. The BBC estimated that up to 30 per cent of self-certified mortgages were obtained on fraudulent earnings figures.
²

My wife and I, having lied about our ‘furniture loan’, are in no position to criticise the young couples for whom exaggerating their
take-home pay was the
only way to get a foot on the housing escalator, which was accelerating prices much faster than salaries. Even at the start of the millennium the average cost of a home was more than three times
average earnings; by 2007 it was well over five times. But others had more pecuniary motives. Prices were rising so fast in some parts of the country that you could buy a house, hold it for a few
months and sell it at a profit, even allowing for professional fees and charges. The bigger the mortgage, the higher the value of the house you could buy and the larger the potential profit.

HBOS, through its Halifax, Bank of Scotland and Birmingham Midshires brands was into all parts of this market, topping up its plain vanilla repayment mortgages – which made up the vast
majority of its loan book – with ‘specialist’ offerings including buy-to-let, 125 per cent and self-certified loans, to the mute astonishment of some board members. The
Bank’s 125 per cent move was in response to the success of Northern Rock’s ‘Together’ mortgage, which had pulled in more than £8 billion of lending. HBOS also began to
introduce ‘affordability’ as a means of determining how much applicants could borrow, rather than a simple multiple of gross salary. This involved a detailed look at the actual amounts
coming into a home each month, versus the outgoings. In theory it was a more accurate measure of the level of repayment applicants could manage. In practice it often led to higher mortgage
borrowing. The demand seemed inexhaustible as consumers borrowed to improve their standards of living, not only by taking on mortgages, but also through unsecured personal loans and by buying goods
with credit cards. The average debt per household soared by a third during the boom years of 2003–2008 to stand at over 170 per cent of annual income.
³

After taking over as chief executive of HBOS in the summer of 2006, Andy Hornby set about expanding the Bank’s branch network in the south of England, spending £100 million to open
50 new branches in areas where it was relatively under-represented, such as inside the M25. He also announced a new push into the Irish mortgage market, through the Bank’s subsidiaries in the
republic. However, there were signs that the profit engine of retail banking, which had been one of the main motors of the rapid expansion of HBOS, was starting to falter. Even though economic
conditions were still relatively benign, bad debts had risen as consumers struggled to pay off loans – and the share of the new mortgage market was falling.
Retail had
increased its profits by only 8 per cent in the previous year, whereas corporate banking had risen by 21 per cent, helped by a fall in bad debts.
⁴

To fill his shoes as head of the retail banking division, Hornby recruited Benny Higgins from the Royal Bank of Scotland. Higgins was an outstandingly successful financial services manager, but
his colourful private life, leading to stories in the tabloid press, had cut short a career at Standard Life where he had been singled out as a future chief executive. George Mathewson had hired
him and he quickly rose to become head of the Royal Bank’s retail division. His move after nine years was a surprise, but watchers suggested that his chances of rising to the top job were
better at HBOS, even though he was a few years older than Hornby.

Higgins’ tenure at HBOS was to be brief and controversial. He fitted the mould of the bright and highly ambitious young managers who were now mostly running the Bank, but some of his
actions seemed to run contrary to the fast-growth ethos. He kept the Bank out of ‘equity release’, a fashionable innovation by some lenders by which home owners with low loan-to-value
ratios could borrow more on the security of the unmortgaged part of the value of their property. It was sold initially as a boon to retired people who wanted to stay in their own homes, but lacked
a big enough pension to be able to afford to do so. By remortgaging their houses they could obtain cash, which would only be repayable when the property was sold, possibly after their deaths. But
unscrupulous brokers and lenders soon turned it into yet another way to borrow for any purpose and people were taking out long-term loans on their homes to buy short-life goods like cars,
televisions or refrigerators or, worse, use the money for expensive holidays. Higgins refused to allow HBOS to follow, saying he saw the market as a mis-selling scandal waiting to happen. He also
responded to rising personal bad debt provisions by tightening up on credit card lending and wiping £1 billion off the limits of about 600,000 accounts.

But his boldest move was to respond to concerns over arrears in the housing sector by increasing the price of mortgages. HBOS was facing a problem of its own making, in that it had won huge
amounts of the new business in 2003 and 2004 by offering ultra-low-start mortgages which would ratchet up in price after an initial three or four years. Faced with a substantial increase in their
monthly payments, many customers were now looking to replace those loans with
new low-cost deals from other banks. Higgins persuaded Hornby that instead of trying to keep
these accounts by again undercutting the competition, HBOS should offer brokers an extra incentive to recommend staying with HBOS. By doing so, he argued, some of the heat would be taken out of the
mortgage market, profitability would be improved and competitors would follow suit.

They did not. Rival companies, led by Northern Rock and Barclays, redoubled their campaigns and snatched market share. HBOS had already lost ground, taking only 17 per cent of new home loans in
the previous year, against the 20+ per cent it had been used to getting. Now it saw its share halve to only 8 per cent. It was no longer king of the hill and had shown it was vulnerable to
aggressive competition. The stock market reacted badly and the Bank’s shares fell.

Internally it was also facing a problem. With a smaller volume of new business than budgeted and finer margins, retail would undershoot its profit target. Heavy pressure was put on Cummings and
the corporate banking division to make up the slack. ‘We were forcing profit out of corporate to make up for the shortfall in retail,’ remembers one senior manager. ‘It was push
and push in those last few years.’ Deals nearing completion were hurried through, bringing arrangement fees and interest payments, and Cummings’ policy of regularly taking equity in the
companies to which it also lent through the Bank’s integrated finance unit now began to pay off. Over six years the equity portfolio produced profits of £2.4 billion. ‘It was our
piggy bank, but by the end of 2007 it was starting to get empty.’ Dividends were taken and holdings were sold to realise profits. Uberior Investments, the subsidiary company which housed many
of the Bank’s stakes, upped its level of sales to provide more cash for its parent, paying a dividend to HBOS of £290 million in 2006 and £280 million in the following year.

When the Bank reported its annual results for 2007, it revealed that for the first time corporate had passed retail in being the biggest contributor to the group’s earnings. Whereas
profits from mortgages and personal lending had fallen by 13 per cent, profits from the corporate division had risen by 30 per cent. Even so, HBOS managed only a small increase in overall profits
and Hornby’s reputation as the sector’s whizz-kid was tarnished. Although the Bank scrambled to recover its position by introducing new products and new incentives,
analysts and investors wondered whether the housing market could ever again provide it with the fat profits it had been used to, and if it could not, how long the corporate division
could go on expanding its loan book without dramatically increasing its bad debts.

Higgins paid the price of the bank’s loss of reputation. It was announced in August 2007 that he had ‘decided to move on’, but analysts were unanimous in their assessment that
he had been forced out, a view reinforced by the revelation in the annual report that his basic salary of £655,000 had been topped up to £1.8 million by ‘further
remuneration’. He had been with the Bank for little over a year but in total he had received more than £3 million in salary, bonus and allowances. Looking back, a member of the HBOS
board decided: ‘Benny was a hero. He called it right on the mortgage market, but the executive and the rest of the board did not have the courage to back him.’

Higgins’ leaving was not the only change among the top management. Phil Hodkinson, who had been finance director since the retirement of Mike Ellis, announced that he was leaving to spend
more time on charity work. He was only fifty. The two departures necessitated a reshuffle, with the extensive retail empire that Andy Hornby had once ruled being broken up and distributed to
several directors. The surprise was the return of Mike Ellis to resume his former role as finance director. The market viewed his reappearance with puzzlement. He was a safe pair of hands, but what
did his recall from retirement suggest for the future – that a firm hand might be needed to steady the ship?

A few months later Hornby scrapped the stretching market share goal that had driven the rapid growth of HBOS over the previous six years. ‘We will no longer set annual market share targets
for net lending. Instead, we will make judgements on the trade-off between volume and margins on a month-by-month basis,’ he said. ‘Increased mortgage costs to consumers will inevitably
lead to a slowdown in the mortgage market.’
⁵
It was a significant statement for the man who had once been the arch-competitor and
amounted to a tacit admission that the Higgins’ strategy may have been right.

There was good reason to be cautious. After a long period of cheap credit, interest rates were starting to rise, bringing financial pain to many people who had over-extended themselves and now
found their monthly repayments climbing steeply. Northern Rock had been
caught out when it failed to hedge against a rise in rates between the times when it approved fixed
rate loans and the money actually being drawn down. The move was going to cost the Rock up to £200 million in lost income and forced the hitherto bullish bank to issue a profits warning. That
was not enough to prevent it from continuing to chase new business or persuade its existing customers to stay by offering cut-throat deals to remortgage. ‘In two to three years the chances
are that interest rates will not be rising and we can retain customers on better margins,’ said an ever-optimistic Applegarth. While HBOS’ share of the new market again fell to less
than 10 per cent, Northern Rock took 19 per cent.