Hubris: How HBOS Wrecked the Best Bank in Britain (26 page)

But it was not quite that easy. Grampian did not hold many sub-prime securities, but it had the next worst thing – Alt-A mortgages. These were loans issued to Americans who on paper at
least had the wherewithal to repay, but included categories of borrower increasingly seen in the UK during the house-price boom years. There were borrowers of self-certified mortgages (called
‘liar loans’ in the US), those with poor credit histories, buy-to-let landlords and those borrowing on high loan-to-value ratios. HBOS tried to play down its exposure to these
mortgages, but when its accounts for 2007 were published they showed that it had £7 billion at risk, plus billions more in other debt securities. Although it was not foreseen at the time,
most of these investments eventually had to be written off.

Throughout the autumn of 2007 HBOS, along with most other banks, was finding it increasingly difficult and expensive to fund its own lending and pay off the money it had borrowed when loans fell
due. ‘Spreads’, the extra interest payments lenders demanded to compensate for increased risk, increased by five times between June and September. Alongside its activities in Grampian
and its securitisation issues, it had been an active issuer of covered bonds, another form of borrowing, but considered safer and more conservative than securitisations. HBOS used the bonds to
lengthen the maturity of its borrowing and on occasion had issued 20-year covered bonds. Now that market too was seizing up. In September, HBOS managed to issue a new bond, but at a greatly
increased price. In November, the covered bond market was briefly suspended because prices were rising so fast, making it even harder for banks to fund themselves. This was not a problem peculiar
to HBOS; all mortgage lenders were suffering and some much more acutely.

Although the sub-prime scandal was a US phenomenon, 125 per cent loans, buy-to-let, self-certified mortgages and high multiples of salary had left many UK homeowners dangerously exposed to a
rise in interest rates. Investors began to regard all mortgage banks with suspicion, but attention, inevitably, settled on one of the smallest and most aggressive, Northern Rock. Like HBOS, the
Rock had fuelled its
rapid expansion with borrowed money, but its situation was more serious. Whereas HBOS could cover around half of its lending from customer deposits,
Northern Rock could only manage a quarter. It was dependent on borrowing from other banks in the wholesale market for 75 per cent of its funding, and when the markets froze in August 2007 it found
itself with only enough cash to make it through to the end of the month and very little chance of getting any more.

Seeing the writing on the wall, the board of Northern Rock tried to find a bigger company willing to take them over. It opened talks with LloydsTSB, which was prepared to make an offer, but only
if the Government would guarantee a £30 billion loan from the Bank of England, which was refused. An approach to the Royal Bank of Scotland also came to nothing.
⁴
Rumours of the bank’s problems were now circulating widely and by September the share price had dived. The Bank of England was at first reluctant to
intervene, with its Governor, Mervyn King, believing that the Rock had got itself into this situation by reckless and foolish lending. To bail it out would create a ‘moral hazard’ by
encouraging other banks to believe that they could do anything they liked because the Bank of England would always be there to save them from their own stupidity. The stalemate dragged on for days
until, with no private-sector solution in sight, King changed his mind and agreed to pump funds into Northern Rock, with the Bank of England acting as lender of last resort.

A statement was prepared, but before the news could be made public it leaked to the BBC and precipitated a run on the bank. Within three days savers queuing outside the bank’s branches, or
besieging its call centres and website, had withdrawn £2 billion in deposits. Northern Rock eventually lost £10 billion – a third of its retail deposits. Ironically, HBOS was one
of the beneficiaries, opening accounts for former customers of the Rock.

A public run on a bank – the first for a hundred years in the UK and virtually unthinkable in the modern world of close banking supervision and electronic payment systems – is every
banker and policymaker’s worst nightmare. It is such a visceral image that the television pictures of orderly lines of ordinary people waiting to withdraw their savings flashed around the
world, striking fear into the hearts of depositors everywhere who wondered whether their own savings were safe. Alistair Darling, Chancellor of the Exchequer, and Mervyn King were horrified as they
watched the drama on screens in
Lisbon where they were attending a meeting of the European Union’s economic and financial affairs council. They immediately cut short
the meeting and flew back to London.
⁵

Inside HBOS the television images sent a chill through the Bank. ‘It was a huge blow to us and a real confidence shaker,’ remembers one senior manager. Like the Rock, HBOS had been
living with the consequences of the freezing of the market for weeks. Securitisations had stopped and other funding, where it could be obtained, was much more expensive. Lending had to be
curtailed. It was outside the experience of even the most seasoned bankers. ‘Up until then we had always thought that you would always be able to fund a lending book. No one had ever seen a
situation where you couldn’t. We couldn’t just withdraw from the mortgage market because we had deals in progress and in corporate some companies had facilities on which they were able
to drawn down money. Also we were trying to secure our good, reliable clients.’

To end the run on Northern Rock, which had continued for four days, Alistair Darling announced that the Government would guarantee all deposits in the bank. The move worked in that the queues
disappeared, but there were still questions over the Rock’s future. It was forced to borrow from the Bank of England at a punitive rate, which meant sustained losses and sent its share price
plummeting. The guarantee only applied to Northern Rock, but there were other mortgage banks – Alliance & Leicester, Bradford & Bingley and HBOS – which were also
struggling.

Central banks in the US, Canada and Europe had acted to pump money into the system to try to get the inter-bank market moving again, but with little effect. Those commercial banks which did have
surplus cash were hoarding it to fund their own needs. In Britain the Bank of England was still hesitating to take more general action and the tripartite regulatory system – the Bank, the
Treasury and the Financial Services Authority (FSA) – was proving ineffective, with each institution waiting for one of the others to take the lead. Senior bankers met the chairman and chief
executive of the FSA, with Colin Matthew attending for HBOS, but were told that it was not able to put money into the wholesale market: that power lay with Mervyn King, who was still refusing to
act. To the exasperation of the bank chief executives, when they met the Bank of England Governor one evening in mid-September he declined to talk about putting liquidity
back into the market and lectured them on the danger of moral hazard instead.

The following morning he had a change of heart. The Bank of England announced that it would lend an initial £10 billion, with possibly more to come, against the security of packages of
mortgages. In return, the Bank would charge a ‘penalty rate’ of interest. Those banks which took the money would make a loss, but they had no choice. The crisis was not over, but at
least someone was now trying to do something about it.

HBOS reduced the cash flowing out of the business by closing down as much of its new business activity as it could. ‘We effectively pulled out of the SME [Small and Medium-sized
Enterprises] market. The Royal Bank of Scotland was circulating internal emails to say that we had stopped lending and this was a good opportunity for them to step in,’ remembers one HBOS
senior executive. Regular reports were going to Andy Hornby and Mike Ellis, who in turn briefed the board. Everyone knew the situation was serious, but until Northern Rock no one believed it might
be terminal. ‘The feeling inside was that this was something we had to work through, sooner or later things would get back to normal – but they dragged on and on.’

The eye of the storm

By the beginning of 2008 the credit crunch was being seen as a global problem which needed to be fixed by government leaders. Prime Minister Gordon Brown called a meeting of
the heads of the G8 largest economies in the world to a summit in London. At a micro level Alistair Darling and a team from the Treasury were still trying to find a solution for Northern Rock,
which was being kept on life support by regular transfusions of cash from the Bank of England. In February, with no private company willing to take it on without guarantees, they bowed to the
inevitable and nationalised it, the first bank nationalisation since Labour had taken the Bank of England into public ownership in 1945. The crisis was still seen as largely confined to domestic
mortgages and government efforts were concentrated on getting this market moving again. House prices were declining, but by a relatively small amount and most people believed this was a reverse
which would correct itself within six months or a year, as it had done many times in past cycles.

The residential market was being hit, but the crisis did not yet seem to be serious in commercial property. In February Peter Cummings made a speech at an awards ceremony which would come back
to haunt him, being quoted repeatedly in newspaper articles and in the House of Commons: ‘Some people look as though they are losing their nerve – beginning to panic, even – in
today’s testing property environment. Not us.’
¹
At the time the speech was received positively; it was only later with
hindsight that it was used as evidence of recklessness. Cummings was echoing the traditional Bank of Scotland policy of ‘staying at the table’, which had been restated by both his
chairman and chief executive several times in HBOS annual reports. Losses on the commercial lending book still appeared manageable and Cummings intended to stand by his good customers until the
market picked up again.

The Bank announced its financial figures for 2007 and although profits were down, the decline was a modest 4 per cent and the bank was still making over £5 billion
in profit. The housing market was expected to be ‘flat’ in 2008, but the Bank said it was ‘well positioned to deliver good growth in shareholder value over the next few
years’. Bad-debt provisions had been increased in the corporate banking division, but had actually fallen in residential mortgages, unsecured loans and credit card debts. The credit crunch
was causing it some problems, but steps it had taken in recent years to lengthen and diversify its wholesale funding had paid off in the more turbulent credit markets of the second half of the
previous year.

As a precautionary measure, the Bank had written down its investment in the US Alt-A mortgages by £227 million. This was more than the £180 million it had expected to have to provide
when it had briefed investors at the end of 2007, but HBOS was confident it would eventually get the money back. The Bank was optimistic enough to increase the amount of cash it was paying to its
shareholders and announced an 18 per cent rise in the dividend.
²
Investors, however, were not convinced by the profit figures and the
shares fell 5 per cent.

Despite the fall in profits, total pay and bonuses for the top directors went up. Andy Hornby received £1.9 million, up from £1.5 million, and Peter Cummings £2.6 million, up
from £1.4 million – his rise including a cash incentive of £1.6 million reflecting the big boost in profits in the corporate banking division. Five executive directors earned more
than £1 million and the part-time chairman, Lord Stevenson, saw his remuneration rise from £628,000 to £821,000. Generous though these payments were, they were not as high as they
might have been. A long-term incentive plan did not pay out any cash because the target, beating the average total return to shareholders of the banking sector, had not been achieved. There was
incredulity among shareholders when the Bank responded by halving the targets, but it brushed off criticism: ‘These targets are just as stretching as before, they simply recognise that
earnings growth will be more modest,’ said the Bank’s spokesman.
³
As an example of Orwellian doublespeak it was hard to
beat.

Across the Atlantic the severity of the sub-prime crisis was brought home forcefully by the collapse of the investment bank Bear Sterns. A year previously its shares had been trading at over
$130 each. A rescue
package put together by the US Federal Reserve Bank and J. P. Morgan initially priced them at $2, but after threatened legal action from shareholders
this was raised to $10.

In March rumours began to circulate that HBOS was having to seek emergency funding from the Bank of England. Within 20 minutes of the stock market opening one morning its shares plunged by 17
per cent. They had now lost half their value in a year. To stop a full-scale collapse, the Bank of England was forced to issue a strong denial that HBOS had sought a loan. The last time it had been
forced to do that was in 1974 when NatWest was in danger of collapse from its property lending. The FSA warned traders against spreading untrue allegations. HBOS itself described the stories as
malicious and Andy Hornby issued a statement saying they were ‘utterly unfounded’. There was a suspicion that ‘short sellers’, speculators who gamble on a share price
falling by selling shares they do not own, were deliberately forcing the price down – a practice known in the City as ‘trash and cash’. An FSA investigation, which included
listening to the taped telephone conversations of traders, found no evidence of criminal rumour-mongering, but did uncover some hedge funds with large ‘short positions’. They were
placing big bets against HBOS, calculating that its share price had further to fall.