Marry in haste, repent at leisure

Lloyds TSB and HBOS: a match made in heaven or the marriage from hell? FST editor Huw Thomas investigates.

“We will do whatever is necessary to maintain the stability of the financial system”
-Alistair Darling, UK Chancellor

On 19 January 2009 the UK financial industry bore witness to one of the biggest events of an already incident-packed few years. The marriage of Lloyds TSB and HBOS was supposed to be the wedding of the century, creating Britain’s biggest financial company and protecting the taxpayer from excessive bailout losses. Lloyds Banking Group, as the new union was dubbed, was to be Britain’s new superbank, a financial powerhouse strong enough to ride out the downturn. But the honeymoon period for Lloyds Banking Group ended all too quickly. Less than a month after the merger was completed the new organisation was forced to admit losses of £10 billion in HBOS that meant the Scottish lender was worth significantly less than the £12.2 Billion Lloyds paid for it.

Considering that cost efficiencies allowing the new financial entity to save £1.5 bullion a year by 2011 were a key factor in the merger, discovering that it was much further in the hole than previously thought has come as quite a shock. But should we really be that surprised? For a deal of this size and complexity you would generally expect a considerable period to elapse between the announcement and completion. For Lloyds and HBOS, it was just four months. The fear that insufficient due diligence was leaving the then very strong Lloyds TSB exposed to some fatal holes in HBOS’ accounts was addressed by Lloyds Chief Executive Eric Daniels at the November 2008 meeting called to persuade shareholders of the wisdom of the takeover. He stated that ‘5000 man hours’ hade been spent picking through HBOS’ books. Taken in isolation, this seems pretty impressive. However Daniels’ later admission to the House of Commons Treasury Committee that, had time been available, Lloyds would have completed three to five times as much due diligence suggests that expedience trumped responsibility in this case.

“I believe everything is out there as far as HBOS is concerned. They've made three or four statements over the course of last year explaining exactly what their financial position is.” Lloyds Chairman Sir Victor Blank, January 2009

“Since its 12 December 2008 trading update, HBOS's 2008 trading has been further impacted by increasingly difficult market conditions, an acceleration in the deterioration of credit quality and falls in estimated asset values. The Group expects HBOS to report an underlying loss before tax of some £8.5 billion for the year ended 31 December 2008.” HBOS results statement, February 2009

So why did the deal go ahead? What pressures forced through a move that, even to the casual observer, now seems terrifically misguided? A key factor has to be the state of the UK banking system in the weeks leading up to the deal. It has since come to light that total collapse was a very real possibility, and was only averted by the narrowest of margins. Lord Paul Myners, the Financial Services Secretary to the Treasury, is reported as saying “There were two or three hours when things felt very bad, nervous and fragile,' Major depositors were trying to withdraw from a number of large banks.” In such a climate of fear it is understandable that the necessity to do something overrode a little of the caution the might usually be expected.

From the perspective of the Lloyds TSB’s leadership, snapping up HBOS and becoming the leading financial institution in the country makes a great amount of sense. Despite its troubles, the group had traditionally been a good franchise with plenty of solid business. Between 2004 and 2006 it produced a net income of between 14 and 16 billion pounds. Though it is unlikely that it would produce comparable returns in the near future, it remained an acquisition with plenty of potential. The uncertainty sloshing around the economy provided the perfect opportunity. In more stable financial times the deal would almost certainly never be approved as a result of competition restrictions. In the midst of the meltdown, the Government turned matchmaker and coughed up a £17 billion dowry to ensure that it went through.

"We will do whatever is necessary to maintain the stability of the financial system." UK Chancellor Alistair Darling, February 2009

“The Government enabled the merger to take place, by including a new condition in competition legislation, which allowed financial stability to be a factor. That was enabling — but it didn’t oblige the merger to take place.” City Minister Lord Myners, March 2009

The Government’s role in the affair is one that warrants particular scrutiny. Long known to be opposed to further consolidation that would leave the UK with only four major high-street banks, the UK’s financial leadership underwent a dramatic change of heart. Not only did the Government suspend any objections, it participated in the negotiations to make the deal a reality.

In fact, the whole process of the merger was about as far from business as usual as it was possible to be. “Generally you go through and announce these things in principle, but then there is the due diligence process,” Says McDowall. “What normally happens with the consideration is so much is up front and then there's amount held back because things might come out of the woodwork. Some of this might be held for a year or a year and a half before it's handed over finally, because clearly some of the issues don't surface or the risks and so on don't crystallize. What really surprises me about this is that it appears that it was virtually done on the spot and that the due diligence, if I can put it like that, was speedy.”

This has led to speculation that the state exerted pressure to accelerate the process. Due to a heavy veil of secrecy, it is unlikely that the exact nature of the discussions that took place will be known for quite a while. However, it doesn’t require too big a leap to picture the scenario of Government dropping its objection to excessive bank consolidation on the understanding that any deal be done immediately. While the Government, and even Prime Minister Gordon Brown, was originally keen to talk up its involvement in making the Lloyds HBOS deal a reality, the tone has changed since the extent of the new company’s problems have emerged. It is insisted that, rather than pushing the deal, all Downing Street did was provide the conditions to allow it to happen. Nonetheless, a strong feeling remains that, if the Lloyds HBOS union was indeed a shotgun wedding, then Government was at least one of the parties with its hands on a weapon.

“Economies and markets are by nature cyclical, and if you set a prudent policy it gives you much better consistency and much less volatility. At some point I think there will be recognition that those kind of values are worth something.” Lloyds Chief Executive Eric Daniels, March 2008

“It looks increasingly as if Lloyds is being dragged under by the dead weight of HBOS.” Liberal Democrat treasury spokesman Vince Cable, February 2009

But regardless of who’s responsible, there remains the question of what the creation of Lloyds Banking Group was meant to achieve. “If the merger hadn't taken place, then almost certainly we would have had to have nationalised HBOS: the taxpayer would have taken all the losses and HBOS would probably have to have been broken up.” These were the words of a senior Government source when asked about state involvement in the plan. While it is true that Lloyds’ intervention prevented a conventional nationalisation of HBOS, the current situation doesn’t look that different from nationalisation anyway. Following the initial bailout of Lloyds Banking Group the Government was left with a 43.3 percent stake in the new company. As a result of the Group’s participation in the Government asset protection scheme a new set of fees for toxic debt were imposed which effectively increase the state’s stake to more than 70 percent. In all but name, Lloyds Banking Group is already nationalised.

“The opportunity to acquire HBOS was considered against our other strategic options, and before deciding to proceed the Board considered a number of alternatives…after a thorough review, the Board decided that the HBOS acquisition would offer the highest value strategy for our shareholders.” This was the reasoning stated by Lloyds for going ahead with the merger in its 2008 results but, it is extremely hard to see where this value might now come from. Prior to the takeover Lloyds shares were trading at 275p. At time of writing they hover around 100p. While in the past being described as ‘boring’ might not have been particularly desirable, in the current interesting times, a little less excitement is just what everyone needs. What is clear is that Lloyds has traded stability and independence for uncertainty and external interference.

While this is a nationalisation at arms length, administered through the newly created entity UK Financial Investments plc, it is nationalisation nonetheless. As with any shareholder led enterprise, the biggest group tends to get its own way. This raises certain questions about the exact nature of Government involvement in Lloyds Banking Group and those other institutions that have fallen under the control of UKFI.  “Inevitably, you can't avoid there being some political influence,” says Bob McDowall. “This could come as pressure to lend to small and medium corporates or other things that could be described as gesture politics. That will always be so because at the end of the day they're accountable to the Government and the taxpayer. It's not a question of subterfuge, it's a stark reality.”

But now that we’re already going down the road, what happens next for Lloyds Banking Group and other institutions that are under Government control? First of all, UKFI needs to establish a clear plan for the future, one that satisfies a number of different requirements. “It does need to set out a route map for what it's going to do,” says McDowall. “Whether it wants to privatize as soon as possible or whether it wants to hang on and get more value for the taxpayer, there's a whole host of permutations. But it does need to quickly set out its roadmap. Unfortunately, it’s not just a financial roadmap, it's a political roadmap as well, because you can't divorce the two.”

As for the specific case of Lloyds Banking Group, the debate is not yet over. The Group already expects to post a loss for 2009 and with the economic outlook as it is, any chance of improvement is uncertain even after that. The restrictions likely to be placed on the organisation by its Government masters will also limit any ambitions of expansion until its debts to the taxpayer are cleared. While rivals like Barclays and HSBC have rejected bailout money and are consequently free seek their fortunes in international markets, Lloyds is going to be kept on a very short leash. This reality has led to calls for the Lloyds HBOS merger to be unpicked before it goes any further. The process remains in its early days, so it might not be too late to reverse it. Lloyds could revert to the solid, if unspectacular, performer it has been for so many years while the unfortunate HBOS could be absorbed by the Government in much the same way as Northern Rock has. Might it not be better for everyone to preserve one functioning institution at the expense of another, rather than to allow the continued existence of one much larger failure?

However, so much effort and political capital has been spent on the Lloyds Banking Group story, it seems unlikely that such a step backwards will be countenanced. This is a position that all concerned may come to regret. No one wants to admit their marriage isn’t working, but this is one case where an annulment might well be preferable to a complete breakdown.

The money pit
Key dates in bailout Britain

18 February 2008 – Northern Rock
Months after the first run on the troubled lender, the Government steps in. It is the first such nationalisation since the 1970’s.

29 September 2008 – Bradford & Bingley
The Treasury stumps up more than £40 billion for the building society’s failing mortgage book. Spanish giant Santander steps in to take over the remaining branches and deposits.

13 October - RBS, HBOS and Lloyds TSB
A further £37 billion is pumped in to avoid the UK banking system from imploding. RBS receives £20 billion while Lloyds and HBOS get the remainder. The Government takes equity stakes in all three banks.

UK Financial Investments Ltd. (UKFI) has been set up to manage the Government’s shareholdings in faltering British financial institutions. Run by a small group of ex-bankers, officials and other business professionals, its aim is to protect the taxpayer’s investment while remaining at arms length from central Government. Though it remains to be seen what the UKFI’s long-term approach will be, it has already stated its intention to oppose Royal Bank of Scotland’s plan to award full pensions to Sir Fred Goodwin and Johnny Cameron after the role they played in the institutions collapse. While arguments can be made that this makes good financial sense, punishing bankers is also a populist move frequently touted by Government. Only time will tell if the UKFI is really independent of political influence.