Monday, November 17, 2008

Lloyds TSB + Halifax Bank of Scotland?

Senior bank officers these days are a haggard, hang-dog guilt-ridden looking bunch, often shunned at dinner parties and blanked at the club, late home every night, working weekends, enduring weeks, months, of relearning old skills such as spreadsheeting and how to make one's own assessments now that it is dangerous to delegate strategic capital adequacy matters to the hired help. Thus, be assured that the leaders of Lloyds TSB and HBOS, for example, are very much on the bridge of their banking (listed) ships examining the instruments and taking measurements, a taxing experience. How does one value a bank today? There is no one way, only a triangulation of approximations. Looking back and trying to see ahead it is reasonable to assume that banks are losing capacity to write new business and support existing exposures, so much so that the combination of Lloyds TSB and HBOS, if it goes through, may during this recession shrink to a size not much more than the present size of HBOS alone and shrink more than they both would if they remained separate competing entities! This may be factored into the very low share values and P/E ratios.
There is excessive fear among share investors attaching to mortgage assets that only to AI Hedge funds are now looking like solid high profit investment opportunities, the main reason for the share value difference between Lloyds TSB and HBOS that is the inverse of the sizes of their respective balance sheets. And yet, it is not clear why HBOS should be so devalued by its mortgage book. The loan to value ratio of HBOS's mortgages are 10% lower than those of Lloyds TSB, and by end of 3Q '08 loan defaults remained low for both banks and even as these grow dramatically should be manageable. Mortgages are at least backed by bricks and mortar in an economy that still evidences a severe housing shortage. What is more to be feared are the knock-on effects once actual (not yet registered) unemployment rises (expected to double) and this time among the highly indebted South East white-collar professionals. When Halifax and Bank of Scotland merged (merger of equals) to form HBOS this made a lot of sense given that BOS had been financing the bulk of H's mortgage book for years. There is now we learn at least £10bn of loan recently agreed between Lloyds TSB and HBOS as part of their boards agreeing to the takeover, but there would have to be a lot of other outstanding finance between them that could be internalised to justify the new combined mega-bank, which is not justified by the estimated £1.5bn in annual cost savings (by 2011) since this is likely to be less than the costs of merging in the short to medium term (where the costs of new core banking systems will be singularly large and potentially risky) and certainly not in the public interest to have one bank accounting for 30% of UK domestic bank loans. Additionally, there is much to be said for Scotland's economic benefit in retaining the independence of HBOS and having it fully headquartered in Scotland. (It is instructive to re-read Walter Scott's Malachi Malagrowther letters in 1826 - see comment). This morning I received the following opinion by email.Men love in haste, Byron’s Don Juan noted, but detest at leisure. Shareholders might long for Halifax Bank of Scotland to dump Lloyds TSB and for Barclays to ditch its high-maintenance Gulf sheikhs but worry the alternatives are worse. Institutions have no plan to reject the measly terms on which HBOS is being plundered by Lloyds. Whether they have the stomach for a real fight with Barclays’ boss John Varley at next week’s vote on his plans to raise £7bn from expensive private sources rather than the government is to be seen. Barclays and HBOS have alienated investors by being slippery, disingenuously suggesting, for example, that the government might refuse to make public cash available if they were to return to it with their begging bowls and that any money offered would come on worse terms than those Barclays spurned in October. Thus shareholders must accept the deals on the table or risk being diluted to oblivion when the government imposes higher capital requirements on costlier terms. (A view that I take to be much exaggeratd since there has to be a floor beyond which further dilution is too incredible and in any case the higher capital reserves are what all banks have to find and wih Government help are so doing). Dennis Stevenson, HBOS’s chairman, wrote in the bank’s last annual report: “In times of uncertainty, communication is vital and transparency is essential.” The bank has lately delivered little of either. Only on Friday did it belatedly reveal critical information it has had since October 11 – namely that the government would require HBOS to raise £12bn if it remained a standalone entity, barely more than the £11.5bn the Financial Services Authority says it needs to merge with Lloyds. The Treasury believes its refusal to disclose the terms on which it might now fund either bank is tactically smart for a government keen to ration public funds. It is mistaken. There is a strong public policy argument against creating an anti-competitive superbank in Lloyds Banking Group and for helping Barclays out of the costly hole it has dug for itself in the sands of the Middle East. Both should be given access to public funds on the same terms offered to other UK banks.
It is a delightful oddity of the credit crunch crisis to read similar views daily firmly stated yet leading to no tangible conclusions, merely subjective opinion. My own view, not a subjective one, is that former Royal Bank of Scotland CEO Sir George Mathewson and Sir Peter Burt, former chief executive of Bank of Scotland, quite rightly have written to shareholders and gone public with a firm view supported by The Scotsman and other newspapers (as a perfectly proper challenge to which no clear answer has yet been received) that HBOS shareholders are being bounced into a mispriced takeover when there is no reason to suppose HBOS with Government investment (temporary) cannot survive and competition among UK banks maintained.
My analysis, which I shall report more about later, is that HBOS has a sound balance sheet worth twice as much at twice the size of Lloyds TSB despite Lloyds TSB being priced in the stock market as worth double HBOS.
The FT has written that major investors view the two knights' challenge to the takeover with derision, but cannot supply any tangible facts to support this wholly negative view of, even plain insults to, Mathewson and Burt. At the weekend we learned that UK Treasury officials are considering offering pension funds and other City investors the chance to buy the Government's £9bn lucrative preference shares in the clearing banks (RBS, HBOS and Lloyds) to reduce the public cost of its bailout plan (report by The Times. This would represent a U-turn on the anti-cyclical conditions attaching to SARP, the Government's £37bn bailout of the 3 banks, which together represent over half of UK domestic banking. The preference shares pay 12% a year. The idea of allowing fund managers to buy some, if not all, of the preference shares, is ostensibly to encourage them to also to buy more of the banks' ordinary shares. Under the original plan, the government took the preference shares, leaving ordinary shareholders with stock that paid little or no cash or shares dividend in the short term so long as the preference shares were outstanding. Government now appears to recognise this as unfair or draconian. It does not follow however, why fund managers would buy ordinary shares whether or not the superiority of the preference shares is reduced. This might be another blow to Barclays deal with Gulf sovereign investors. It might also be a bribe to ensure the Lloyds TSB HBOS takeover is voted through? Worst of all, it might mean the Government is retreating from insisting that banks maintain 2007 levels of mortgage and small business loans to domestic UK borrowers?
If a bribe it is not the only one. Last week we learned that Lloyds TSB secretly provided financial support to HBOS through a £10bn loan facility, in a covert agreement between the two banks. HBOS also agreed a £11.5 bn capital injection backed by the government on the condition that it proceeds with the Lloyds takeover. If it stays independent it will need to raise additional capital, but this need has recently been estimated at currently only about £500m.
Burt and Methewson say “The takeover by Lloyds is not in the public interest, and it is not in shareholders’ interests ...This is a business that under normal circumstances would make a lot of money. To cast it all away for a mess of potage does not seem to be in the public interest.” (There was also an initiative mounted by James Spowart to lead an alternative takeover, but he has had to gove up on this.) The two knights are campaigning to win support from 10% of HBOS investors to vote down the deal when HBOS shareholders meet on 12th December to vote for or against the Lloyds TSB offer. Shareholders' scepticism has to be based on not beleiving the published accounts, that they fully disclose toxic exposures, and anxiety about the impact on P/L of recession. Mathewson and Burt would have to be able to evidence more certainty about why such fears are exaggerated and for that they would need access for a team of analysts to HBOS books. But, as yet, they do not qualify for such access. I agree with the two knights errand that Lloyds has “fared little better” than HBOS in the financial crisis and HBOS shareholders are at least entitled to a larger share of the new company. This is a valid view based on both banks' last reported figures even if neither bank's quarterly results are fully transparent as to their credit crunch and economic recession risk exposures. As for future insolvency or share value dilution, at present it looks as if each bank's share values might rise on the takeover/merger not proceeding. Above all, it is unclear why competition rules should be ignored and HBOS lose its independence if Government can bail out the banks and ensure their survival through the crisis. One reason may be that a foreign bank taking over either Lloyds TSB or HBOS is as unwelcome to London as HBOS's loss of independence is unwelcome to Edinburgh?
There is a site for those questioning the HBOS takeover by Lloyds TSB. (See: and comment 2 below. The FT have reported a speech by Chancellor Darling ( that is interpreted as a rebuff to Mathewson and Burt in their attempt to keep HBOS independent, but I do not see the logic of the FT's interpretation being so definite in practise.

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