Between the Lines: Societies face their own problems over lending

Published on Thursday 2 April 2009 21:45

BOTH the Scottish and UK governments have been pinning the blame for the downfall of the Dunfermline Building Society on its managers. It is certainly true they made big mistakes. But this leads to the assumption that what went wrong was unique to the Dunfermline. It wasn't and isn't – building societies have a big problem and there may be more casualties before the sector gets on to a steadier footing.

Our natural inclination in Scotland is to focus on Scottish institutions and not worry too much about what is happening to others elsewhere in Britain. But a fairly startling fact is that, including the Dunfermline, a tenth of the 59 societies that existed at the start of 2008 have undergone enforced mergers because they have hit trouble.

The problems of the now disappeared societies have been varied – money locked up in failed Icelandic banks (the Barnsley, Cheshire), not making enough money (the Catholic, Scarborough), too much subprime lending (Derbyshire), and foolish commercial property lending (Dunfermline). Others have had narrow escapes – the Newcastle and the Chelsea both recently announced big losses.

All of these societies cannot have had bad managers. Yet neither should they be running into trouble like this. In the business of attracting savings, building societies have two competitive edges.

First, because they are mutuals – owned by customers – they do not have to pay dividends to shareholders. On some calculations, this means they should have a 35 per cent cost advantage over banks.

Second, they have a reputation, based on their long history in the communities which they serve and strong relationships with customers, for being safe places to keep money. This has been a big advantage; since the credit crunch began in August 2007, the sector has enjoyed a net gain in deposits of 22.6 billion, compared to a net inflow of 12.9bn in the same length of time prior to August 2007.

As societies depend on savings deposits to conduct their mortgage lending, and, unlike the banks, only to a very limited extent on the frozen wholesale money markets, the building societies ought to be buzzing successes just now. But clearly they are not.

The problem in fact pre-dates the credit crunch. In times when wholesale money was cheap and apparently available in limitless quantities, the competition to lend it out in mortgages was ferocious. That's why you could get loans which were 100 per cent and more of the value of property they were secured against, and at incredibly cheap rates.

It seems that, in this trading environment, despite the societies' much-vaunted competitive edge, they struggled to lend both competitively and profitably. And although societies do not need profits to pay shareholder dividends, they do need profits in order to build up the stock of capital that all financial institutions need in order to meet any unexpected losses.

Faced with a sharply narrowing profit margin on residential mortgages, which has to be not less than three-quarters of their lending business, quite a few societies struck out in riskier directions with the remaining quarter where they hoped to make better profits.

This was where all the societies listed at the beginning of this article, and not just the Dunfermline, came unstuck when the boom in cheap credit came to an end. The glued-up Icelandic deposits, not that the Dunfermline (as far as anyone yet knows) indulged in them, were also a similar but illusory route to quick profits.

Those that have survived are not out of the woods yet. The financial crisis has landed them with the headache of paying big levies into the Financial Services Compensation Scheme so that depositors in the failed Bradford & Bingley and the UK arms of Icelandic banks get their money back. That cost the Dunfermline 7.2 million in 2008, rather more than its usual profits.

And like the banks, the building societies also have to increase their capital stock to improve their stability. Since profits are hard to come by, that means raising money by issuing a form of bond, which is expensive.

This means that building societies are ill-equipped to compete in the present market. The banks, especially the part-nationalised ones, are under heavy government pressure to increase their mortgage lending, so much so that banks are generally offering both cheaper mortgages and better rates for savers than are building societies.

In these highly adverse market conditions, it is hard to see how the Dunfermline, even if it had been bailed out and kept independent by the government, could have prospered.

Even the best society managers are going to find business extremely tough for the next few years. And one conclusion looks inescapable – that the societies, including the Nationwide, will have to find ways of making drastic cost cuts, which means that a lot of jobs will go.

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