No Hair Of The Dog For Uk Banks

The Age

Saturday June 14, 2008

Julia May

The credit party is well and truly over, and the banks are nursing sore heads, writes Julia May from London.

AND next, the hangover.

The years of partying on cheap credit were always going to take their toll on Britain's banks, according to the increasingly gloomy governor of the Bank of England, Mervyn King.

"If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then, over time, the parties will become wilder and wilder," King told a British Banking Association conference this week. Innocent bystanders might lose their homes as a result, he warned.

King's acknowledgement that the central bank would take a more hands-off approach to the subprime crisis and casualties would worsen sent more shivers through the British market. And it reinforced the perception that the credit crunch is moving to its next stage in Britain.

Amid write-downs and rights issues by banks to shore up their balance sheets, rising borrowing costs are leading to more repossessions and, according to the Council of Mortgage Lenders, up to 30,000 home owners are facing the prospect of negative equity as house prices drop.

Britain - London particularly - has undergone a startling shift in just under a year. It has fallen off its pedestal as the financial centre of the world and site of an unprecedented housing and financial services boom. It now shares the spotlight with the US as the focus of a downturn and possibly, murmur the naysayers, a recession.

Much of the criticism is levelled at Britain's banks as they notch up losses, announce profit warnings and launch controversial rights issues, showing their balance sheets have been caught short by dried-up money markets, steep declines in asset prices and a slowing housing sector. Questions have followed about systemic and structural problems in the sector.

Bradford & Bingley, the lender whose bowler-hat logo used to be an apt representation of its conservatism, is the latest to flirt with disaster. B&B, which specialises in lending to landlords in the struggling buy-to-let market, attracted scathing criticism from shareholders after a rushed and apparently desperate revision of a rights issue it announced last month, which came a month after the bank denied it was considering a cash-call.

Its original proposal was to raise #300 million ($A625 million). But in the last week of May, management belatedly realised defaults on its loans had risen dramatically and it was set for a four-month loss. Its underwriters, UBS and Citigroup, felt they had grounds for changing the deal's terms.

B&B accepted a #179 million offer from TPG, the private equity group, for a 23% stake. B&B then replaced the previous rights issue with one aiming to raise #258 million. Investors, including institutions represented by the powerful Association of British Insurers, were incensed at the cut-price deal and claimed it breached a basic tenet of British corporate law - pre-emption rights, which give shareholders first option in any big equity restructure.

"As shareholders, we understand the importance of responding to a real threat of systemic risk in the financial markets," ABI investment affairs head Peter Montagnon said. "There is an urgent need for a proper understanding between the market and the authorities about what constitutes systemic risk."

He said the market was not convinced that the situation at B&B amounted to systemic risk, but he planted the suggestion of structural problems inherent in the risks that banks took to achieve growth, and which are being manifested in the institutions' response to the crisis.

Professor Charles Goodhart, the program director of regulation and financial stability at the London School of Economics, and a former member of the Bank of England's rate-setting Monetary Policy Committee, sees a link between B&B and three other beleaguered British banks: Northern Rock, which was nationalised in February after a subprime-related liquidity crisis, HBOS - the BankWest owner whose #4 billion rights issue is looking shaky, and Alliance & Leicester - which looks set to slip out of the FTSE 100 amid fears over its earnings and dividend.

Their link? All are former building societies that have demutualised and floated in the past decade.

During what King termed the credit party, the remaining 59 British building societies had to stay at home. A legal requirement to keep at least 50% of their funds in retail deposits from savers means they are not able to leverage as highly or to invest in the more creative asset classes that commercial banks have, making them appear less exciting during the past decade.

Goodhart said the problems facing Northern Rock, HBOS, Alliance & Leicester and B&B were exacerbated by a lack of management experience and an overeagerness to take risks, which was stoked by the lure of large bonuses.

Viral Acharya, a professor in banking at the London School of Business, also focuses on the four former building societies for their reliance on short-term debt markets to shore up their capital lines. Add to that business model a reliance on the British housing market - as all four have - and you'll find those that are suffering the most, he said, pointing to Northern Rock as a case in point.

The mortgage lender, which demutualised and floated in 1997, was heavily exposed to the wholesale credit markets, on-selling its loans to other banks and investors as bonds. But after losses caused by defaults by US home owners with poor credit history - in the so-called subprime mortgage market - debt markets dried up, leaving Northern Rock short of capital and unable to meet its liabilities. Following a highly-publicised run on the bank, the Bank of England lent it #25 billion and it was eventually taken under government control.

So came the moment to shine for those remaining, teetotalling building societies, to which many fleeing Northern Rock customers turned to deposit their savings. "Unexciting" is becoming perceived as "dependable" as they position themselves as protected from the problems that toppled Northern Rock.

"There is now a much greater level of public awareness about the funding strategies of plcs (listed companies)," said Adrian Coles, the director-general of the Building Societies Association. "This has seen many people turning to their local building society as a trusted brand, as a safe haven." But while they may have been shielded from the subprime problems, the housing slowdown in Britain bodes badly for building societies and commercial banks alike, Acharya says.

Britain's housing expansion was fuelled by interest rates at 40-year lows between 2001 and 2006. Residential property prices rose by 189% in the decade to October. This boom, while feeding growth, made the British economy and the mortgage lenders relying on it particularly vulnerable. "In hindsight, it's safe to say that it was a bubble and now you are seeing a significant price correction," Acharya said.

The Bank of England faces the difficulty of countering the combination of an apparent economic slowdown and inflation at 3%, a percentage point above the Monetary Policy Committee's target. The MPC was tipped this week to raise rates three times this year, bringing more gloom for home owners, prospective buyers and the lenders, which have tightened lending in the wake of the subprime debacle.

All this leads to questions about the future of the British banking sector. Some, such as Tim Sykes, a banking analyst at Execution, believe the end to cheap debt and the coming slowdown will create more consolidation in the sector - starting with what he calls "mercy killings" as banks seek to buy each other to revive their profit margins. Acharya does not think there will be consolidation, but believes business models will shift away from loan repackaging and short-term debt markets, and that ownership structures will change as private equity groups and sovereign wealth funds seek to capitalise on low stock prices.

Others are more optimistic. British stock-picker and head of investment at Fidelity, Anthony Bolton, emerged from the pack this week to say that an upswing for British banks may be imminent, and the lending squeeze presents margin-boosting opportunities for those with an injection of equity in their balance sheets - such as Royal Bank of Scotland, which successfully led the rights issue charge - to lend to property buyers who are seeking to capitalise on lower house prices. "The raising of fresh capital often marks the beginning of a recovery," he said.

Goodhart sees a recovery as a natural stage in the cycle: "(The banking system) is going through a rough time. But it will recover. It remains an essential part of any developed country's system."

© 2008 The Age

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