Hard times for our mutual friends

Published on Saturday 5 December 2009 13:12

AT THE annual lunch of the Building Societies Association (BSA) in London last month, chairman Graham Beale said: "The traditional values of building societies revolve around putting the customer first."

If only more of his members had listened, the beleaguered sector may not have been facing the trouble it is today since it has been those which exhibited bank-like ambition that have been wounded most deeply.

Last week, the troubled Chelsea Building Society was taken over by the bigger, more conservative Yorkshire. The Chelsea's 66 million losses in 2008 and the first half of 2009 were caused by a double whammy of deposits from failed Icelandic banks and a big exposure to buy-to-let fraud.

Dunfermline BS, which had more than 800m of high-risk loans and assets, admitted to losses of 24m and the government was forced to underwrite its merger with Nationwide (of which Beale is chief executive) with 1.6 billion.

Risky buy-to-let wheezes, commercial property, corporate and sub-prime lending may have been good earners in the old days of cheap debt, but they were never a comfortable fit for the humble building societies.

Insiders are fond of pointing out that, while the crisis may have forced the sector to reveal its skeletons, only Dunfermline needed government intervention, unlike RBS, HBOS et al.

"The mutual model has proved its resilience," says Adrian Coles, BSA chief executive.

But the problems facing the sector are significant. Even its traditional means of making money are down, with no new net mortgage lending and no net increase in deposits to speak of in the past year.

While there is some evidence of a flight to perceived safety among fed-up bank customers, big depositors and local authorities have pulled out more than half the money on deposit with building societies in the past year and a half. The Office for National Statistics figures show that councils had 12.7bn on deposit with mutuals in July 2008, and only 5.6bn in July 2009. With historically low base rates of 0.5 per cent in danger of persisting, margins are wafer thin.

Then there is the issue of big payments to the Financial Services Compensation Scheme which are, according to Coles, "a bit of an annoyance". Last year, the Scottish Building Society (SBS), a small but prudent mutual with assets of 300m, paid 250,000 to the scheme to buck-up "less prudent" institutions. Nationwide, the biggest society, paid 250m.

Payments are based on the amount of retail deposits – the majority of building societies' funds – so it is easy to see why the societies argue they are being unfairly treated. David Chalmers, chairman of the SBS said: "In operating a prudent funding model as opposed to that of many banks, (SBS] has to pay proportionately far more toward the FSCS levy, in some cases nearly three times as much. While this is legal, it is simply not fair."

These are just some of the reasons why there is widespread belief the sector is due for further consolidation.

Since the financial crisis began, Nationwide has sucked up Derbyshire, Cheshire, Portman and the Dunfermline, making it the sector's 300lb gorilla, representing 55 per cent of building society assets.

The merger of Yorkshire and Chelsea – which took in the Catholic last December – creates the UK's third largest mutual behind the merged Britannia and the Co-op.

At least five to seven more mergers are expected.

"Would I envisage 50 societies in five years' time? Absolutely not," says Matthew Lindsay-Clark, a director with corporate finance boutique Lexicon Partners

, who led the deal with bondholders that allowed the Chelsea-Yorkshire merger to go through.

Chelsea's bondholders were asked to write off half the 200m debt and accept the remaining 100m in a "contingent capital" instrument that converts into a form of equity if the mutual hits trouble, boosting its core tier one ratio. Lloyds did a similar deal last month.

Lexicon also handled the West Bromwich deal earlier this year, which was hours away from a government bailout after reporting losses of 48.8m in March, with bondholders also trading outstanding subordinated debt of 182.5m for "profit-participating deferred shares" (PPDS).

In the years of demutualisation in the late 1980s and 1990s, many former big societies converted to banks – starting with Abbey National in 1989, through to Alliance & Leicester, Halifax and Northern Rock in 1997, and lastly Bradford & Bingley in 2000.

The ones who remain mutual turned to the bond markets, raising capital through permanent interest bearing shares (PIBs) and subordinate debt to fund growth. This gave them less bang for their bucks than counterparts who went private, but then building societies were never supposed to take over the world.

But there are fears that the Financial Services Authority (FSA), having created new hybrid instruments for the sector, will kill the PIBs market. Instead the sector will be limited to relying on the "good old fashioned" members' capital and the new hybrid bonds – but access will be limited to only the biggest building societies.

"You will find a lot scrutiny by investors as to what societies are actually doing. Historically, everyone had assumed it was a low risk instrument and that proved not to be the case," says Lindsay-Clark.

Coles admits the invention of PPDS has "conceivably damaged the PIBs market", but he remains hopeful the FSA will stay on side regarding PIBs. "We are arguing with them about that," says Coles.

He welcomes the "inventiveness" of the new capital raising instruments but admits retained earnings will continue to be difficult, and this will result in smaller balance sheets.

"If your balance sheet is falling then your capital ratio will go up," he says. "Many will fall this year. The banks as well."

Lindsay-Clark has his doubts investors will remain as interested in new issues of PPDS.

"That is the $64,000 question. At the moment people have jaundiced views of financial institutions for good reason. If the yield is attractive enough people will put money in. But pricing those instruments is difficult – no-one knows the risks. We would argue it is low-risk but everyone has a different view on it."

What is clear that only the largest societies will be made welcome by bond investors. Nationwide is seen to be the "acid test" for the industry. Beale has admitted there is "some mileage" in the concept, having raised almost 4bn in unsecured and mortgage-backed funding this year, but he is in no rush to be a guinea pig.

"There isn't an immediate need for us to do that but it is an interesting concept. It represents opportunities," a Nationwide spokesman said.

Although building societies face a grim few years, Coles is hopeful. "It is not close down time by any means. Building societies can hibernate

, wait two or three years then come out as the market turns up."