Hubris: How HBOS Wrecked the Best Bank in Britain (27 page)

To show their faith in the business HBOS directors, led by Stevenson, Hornby and Cummings, spent £6 million buying more shares and the price began to rally, giving them a paper profit, but
it was a false dawn. When the Bank published its annual report at the end of April it revealed that far from being able to shrug off the threat to its Alt-A mortgages, it was having to take serious
pain. Hornby could not bring himself to use the word ‘losses’ so fell back on the accounting jargon by saying that a ‘negative fair value adjustment’ of £2.8 billion
was being made to the Bank’s reserves. This, the Bank claimed, was not a loss, but a prudent accounting step. Mike Ellis, the finance director, said that in order for the securities backed by
Alt-A mortgages to suffer an actual loss, six out of ten of the borrowers would have to default, and the loss on those loans would have to be more than 50 per cent. ‘We consider that a remote
possibility,’ he said.

HBOS was being squeezed in a vice. As the housing and commercial property slow-downs in 2007 turned into a precipitous plunge in the spring and summer of 2008, lending covenants began to be
breached. These were agreements between lender and borrower which specified, among other things, the level and frequency of repayments to be made and the loan-to-value
ratio. A generation previously banks would have been able to fudge any breaches of covenants by tucking away problem loans into suspense accounts and trying to help the borrowers work through their
difficulties. But new international accounting standards left no hiding place. Banks now had to write down loans and make provisions from their capital against default. Each time they did so their
credit ratings suffered and they found it harder to obtain funding.

On 15 April Gordon Brown called bank chief executives to a meeting at 10 Downing Street where, almost unanimously, they demanded that more money be pumped into the inter-bank market. According
to Brown most of the men present were suffering ‘quiet anxiety’, except for Andy Hornby, who sounded very worried.
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The
unthinkable was happening, HBOS was running out of money.

The Government still had not appreciated the threat to the banks and was more worried about the mortgage freeze and the effect it would have on homebuyers, particularly young couples who were
being denied a home of their own because they could not get loans. After stepping down from HBOS, Sir James Crosby had become a deputy chairman of the FSA – a poacher turned gamekeeper. Now
Brown and Darling asked him to take on an additional role, investigating what measures could be taken to get the mortgage market moving again.

In May HBOS made a tentative return to the securitisation market, offering a package of home loans valued at £500 million. It was a timid toe-in-the-water compared to the £5 billion
packages it had been used to issuing, but it was a success – it got its money, in fact it found so many lenders that it was able to up its target and take in £750 million. What shocked
investors was the price it was having to pay, which was a huge margin over the interest rates being charged in the inter-bank market and more than the cost of borrowing from the Bank of England,
which was supposed to be charging a ‘penalty rate’. Some analysts saw the achievement of the issue as proof that the credit crunch was easing, others as evidence of the desperation of
HBOS. A move that was seen as a confidence raiser, further sapped morale.

Liquidity – having enough cash – was not the only problem the
Bank faced. It was also running short of capital, its cushion against losses. Since its share
issue in 2002 HBOS had been steadily shrinking its capital, spending £2.5 billion of its surplus cash to buy back shares from its investors and cancel them. It had also steadily increased its
annual dividend payouts. The effect of both had been to boost its share price and flatter its return on equity, but to reduce its capital. It was not the only bank in this position: the Royal Bank
of Scotland and Barclays were also feeling the squeeze.

Since the early 1990s the capital that banks were required to hold against possible losses had been specified by an international agreement called the Basel Accord, after the Swiss city in which
the regulators met. The rules were fairly crude and banks quickly found ways around them (moving assets off their balance sheets through securitisation, for example), so a modified system was
introduced which became known as Basel II. The amount of capital a bank needed was to be calculated as a proportion of its total lending, but not all loans carried the same risk. Unsecured personal
loans, for example, were much riskier than mortgages, where the bank had the security of a house to fall back on if the borrower defaulted. To allow for this, different types of lending were given
different risk-weights and then added up to make a total of risk-weighted assets, on which the capital calculation was based.

The new regime made some startling changes. It did end the distinction between on- and off-balance sheet lending, closing one loophole, but it also reduced the risk-weight applied to residential
and commercial mortgages from 50 per cent to 35 per cent. There had been strong lobbying from the banks that they were being forced to hold too much capital, which was reducing their profits. Like
the old system, Basel II relied heavily on the assessment of risk associated with individual securities made by the ratings agencies. The different weights of risk corresponded to different
investment ratings. Two types of asset were given zero risk-weightings (i.e. they were seen as carrying no risk at all). These were lending to governments or central banks, and securities
classified by the ratings agencies as AA- up to Triple A, the highest grade.

Banks were given a choice of ways to calculate their risk-weighted assets. They could choose from a menu of risk-weights provided by the Basel committee (using 35 per cent for mortgages, for
example). This was known as the ‘Foundation’ method. Or they could calculate
their own risk-weights, known as the ‘Advanced Internal Ratings-Based’
method, or Advanced IRB for short. To do this banks had to get the consent of their own country regulator (the FSA in Britain) by demonstrating that they had the skills and knowledge to be able to
perform the complex calculations necessary. Most British banks opted for the Foundation method, but some, including HBOS and Barclays, applied to be allowed to calculate their own risks. HBOS had a
large risk-management department employing over 100 people and headed by Peter Hickman, the Group Risk Director. It also had elaborate procedures for the ways in which it assessed and calculated
risk. The explanation of these and a description of the governance process by which risks were sanctioned took up 19 pages of its 2007 annual report. It was confident it could calculate risk
accurately and at the beginning of 2008 the FSA announced that HBOS had been granted Advanced IRB status.

Mike Ellis, the finance director, sought to reassure investors that HBOS was taking a very conservative approach. ‘Maintaining strong capital ratios is a given at HBOS and we will not
compromise in this regard,’ he told a conference. ‘One of the key tenets of liquidity management is not to take unacceptable credit risks, accepting that you cannot eliminate entirely
credit risk, and we are very confident regarding the credit quality of our portfolio.’
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It has been argued that HBOS under-calculated the risks it faced, but subsequent analysis has suggested that the bank did take a conservative view and could have reduced its capital requirement
by choosing the Foundation method.
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If HBOS, like the Royal Bank and other banks which failed, had ended up with too little capital, it was
a basic problem with the Basel system, rather than the internal calculation.

Faced with sclerosis in the inter-bank lending market and increasing losses on their Triple A-rated mortgage securities, banks in America and Europe were being forced to go back to their
shareholders to ask for more cash. In the UK Bradford & Bingley had been first with a call for a modest £400 million, but the issue had turned into a fiasco as the bank was forced to
announce a profits warning, a debt downgrade and the retirement through illness of its chief executive before the money could be gathered. The Royal Bank of Scotland came next, seeking to raise a
massive £12 billion in new capital and promising to raise £8 billion more by selling off
businesses. These were moves which it said would make it one of the
safest banks in Europe.

It was a foregone conclusion that HBOS would have to follow suit. It announced that it was asking shareholders to give it £4 billion, but a mark of its concern about its predicament was
the price at which it was offering new stock. Its share price, which had once topped £11, had dropped to less than £5 before the announcement. Now it was offering new shares at
£2.75 – a 45 per cent discount. It looked like a fire sale and did nothing to bolster the confidence of shareholders.

As a further move to conserve money, the dividend was being cut and half of it would be paid by issuing new shares to shareholders rather than cash. Hornby tried to portray the issue as one of
good management, rather than desperation. ‘It is a prudent step change in our capital strength and our target ratios. We need to be prepared for all macroeconomic events. Banks that do not
have strong capital ratios will find it harder,’ he said.
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But no one was convinced.

In June the Bank published its rights issue prospectus, and again tried to put an optimistic gloss on what were depressing facts for shareholders. Specialist mortgages – buy-to-let and
self-certified – accounted for a quarter of the £250 billion mortgage book and over 3 per cent of these were already in arrears – they had missed their mortgage repayments for
three months or more. The figure did not include repossessed houses, so the real picture may have been worse. Overall the Bank had £5 billion-worth of souring home loans. In the commercial
market HBOS had lent more than £4 billion to house-builders, who were facing a crunch of their own as homes they had completed failed to find buyers. Corporate banking’s ‘nest
egg’ equity stakes in this sector had been valued at £200 million, but half of that had now had to be written off.

To make matters worse the ratings agency Standard & Poors reduced the bank’s credit watch status from ‘stable’ to ‘negative’.

Investor confidence was severely shaken by the revelations. The share price had fallen since the announcement and had briefly dipped below the rights issue price. If it kept falling the share
issue was bound to fail: why would shareholders pay £2.75 for new shares when they could buy existing ones cheaper on the stock market? To guard against this HBOS had spent £160 million
on underwriting fees with financial institutions, which would guarantee to buy any shares that were not wanted by HBOS shareholders. ‘Our rights issue is fully
underwritten, it’s on track and we’re going to get it completed and get back to normal life,’ said Hornby.
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He probably believed a return to normal was possible, but if so he was in a shrinking minority.

The rights issue in July was the biggest flop since the stock market crash of 1987. Less than 9 per cent of the shares were bought by HBOS shareholders, leaving the underwriters to take over 90
per cent. As the price fell even further they were left with an immediate paper loss. Small shareholders were angry that the Bank had bought back shares between 2005 and 2007 at prices from
£8.55 to £10.70, yet now it was trying to sell new ones at £2.75. There were calls for Andy Hornby to resign, but they went unheeded in the boardroom.

The Royal Bank of Scotland and Barclays had fared little better with their rights issues. To Gordon Brown the lesson was clear: ‘I interpreted this as meaning that the markets did not
believe that HBOS had come clean on its toxic assets and future write-offs. At the same time the RBS share price was at 197.6p, while its rights price was at 200p, and the Qataris had been left
with most of the Barclays issue as there was only a 20 per cent take-up. The whole market was simply walking away. They did not believe the banks; neither did I.’
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Apocalypse now

At the special meeting in Edinburgh to approve the rights issue, chairman Lord Stevenson told shareholders: ‘Armageddon may happen, and we should be prepared for it, and
we are.’ Armageddon came three months later and no one was prepared for it.

The events leading up to the final collapse took place in New York. On 7 September the US Government announced it was taking the Federal National Mortgage Association and the Federal Home Loan
Mortgage Corporation, usually known as Fannie Mae and Freddy Mac, into public ownership. This was a huge step for a right-wing Republican administration led by President George W. Bush, which could
not bring itself to call it nationalisation, preferring the term ‘conservatorship’. The two companies were essentially mortgage wholesalers and had been wrecked by the sub-prime
disaster, losing £14 billion in a year. Their bailout would eventually cost the US taxpayer more than $150 billion.

A few days later Lehman Brothers, one of the elite group of Wall Street investment banks, disclosed that it had lost $3.9 billion on mortgage debt in the previous three months alone. There were
now severe doubts over the future of even the largest banks and these were reinforced when Bank of America, under strong pressure from the US Government, rescued Merrill Lynch, one of
Lehman’s competitors, which had lost $20 billion in a year. Through late September the future of Lehman hung in the balance as politicians and regulators on both sides of the Atlantic tried
to find a way to save it. Barclays showed interest in acquiring it, but the US Government would not guarantee Lehman’s losses and Alistair Darling refused to suspend UK company law to let a
deal go through without it first being put to Barclays shareholders. The decision to allow Lehman to go bust destroyed any remaining confidence left in mortgage banks on both sides of the ocean.
Five thousand Lehman employees in London lost their jobs.