Shareholders digest £18bn HBOS shock

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THOSE who thought the 'great credit crunch' was a phenomenon confined to overexcited New York traders and a few never-heard-of German banks have had a huge surprise close to home.

It came in a brief and tersely worded announcement from the Edinburgh-based bank HBOS to the Stock Exchange last Tuesday that it was extending credit to a vast in-house debt-finance fund called Grampian Funding.

Especially eyebrow-raising was the size of this Jersey-registered fund: a whopping $37bn (18bn).

Now, gigantic though it is, you will search in vain for any mention of Grampian in the 200-page HBOS annual report. There is no reference in the chairman or chief executive's statement, no section explaining its operations in the directors' report or any hint of its existence in the financial statement and balance sheet.

For the army of small HBOS shareholders, news that Grampian existed, never mind that it was the largest banking conduit in Europe and now needed financial assistance from its parent, came as a total shock, akin to discovering a face you thought you were familiar with had suddenly grown an enormous protrusion on the side of the head.

In the extraordinary market turbulence of recent weeks this exotic growth has suddenly appeared with all the sinister connotations of a malignant tumour. And 18bn for HBOS is some tumour. It represents 57% of the group's stock market capitalisation.

So what is Grampian? What is a credit conduit? How serious is the problem it has encountered? And what might be the wider implications for the banking system and the economy?

A credit conduit (pronounced "cond-wee") is a credit fund which makes money by borrowing short and lending long.

These funding mechanisms are usually run as a separate division and kept off a bank's balance sheet, thus freeing up resources for lending by the bank elsewhere. In the case of Grampian, its funds are on the HBOS balance sheet, though not labelled as such (representing, bank spokesmen are quick to point out, less than 3% of the group's 625bn balance sheet total).

Grampian relies for its funding on selling short-term Asset Backed Commercial Paper (ABP) and investing the proceeds in longer-term asset-backed instruments. In normal circumstances, dealings in these markets are routine, barely earning any financial press attention.

However, as the crisis in the huge American sub-prime mortgage market spread, with growing incidence of loan arrears and defaults, parts of the ABP market became exposed. And, as fear of this exposure spread, trading in this huge market began to be hit. The problem was made worse by the lack of transparency and uncertainty over which pieces of credit paper were (or were not) 'infected' by sub-prime debt.

In July, the credit ratings agencies Moody's and Standard & Poors downgraded their credit ratings on several hundred securities. Very soon, large quantities of ABPs came into question. The atmosphere became akin to that in a block of wealthy flats where a litigation lawyer has shouted up the stairwell and demanded to know who is liable for the water in the communal pipes. Such is the terror of the word 'liability' (never mind 'lawyer') that people quickly stop drinking the water and flushing the toilets. Result: a liquidity crisis certainly, but one more accurately described as 'dread-lock'.

By last week, analysts at Moody's were describing the liquidity situation in the asset-backed commercial paper market as "the tightest we have ever experienced".

Grampian insists that the quality of its ABP paper is extremely high, that in all but a few cases its credit paper is rated triple-A by Moody's and Standard & Poors. Its short-term paper is also accorded top rating status.

But, along with other conduits, Grampian found itself struggling to raise financing as investors questioned the validity of credit ratings across the board, and pension funds and insurance companies that normally buy its paper withdrew from the market.

This caused a major liquidity squeeze in ABP products. And the commercial paper markets were only willing to provide financing on an overnight basis - and at extremely high rates. Indeed, as the scare intensified, these overnight rates shot up. At this point, HBOS concluded it would be cheaper to fund Grampian by raising capital itself.

The terse statement last Tuesday said that Grampian will use facilities provided by HBOS "to repay maturing asset-backed commercial paper until such time as market pricing improves to a level acceptable to HBOS". In the fetid atmosphere of last week, and in the shadow of two German banks - Sachsen LB and IKB - struck down by problems with their credit conduits, here was an ominous sign that the crisis had spread to the heart of the UK banking system.

So what happens now? Lindsay Mackay, chief executive of Treasury Services at HBOS, is confident that the market will normalise within the next few weeks. And while the average maturity value of Grampian commercial paper is just 55 days, many of the debt maturities stretch out much longer, so there is no likelihood, even if market turbulence persisted, of HBOS having to find all 18bn in short order.

And, since last Tuesday, markets have begun to normalise, overnight money rates have come down and dealings have begun to resume in the ABP market, albeit in a highly apprehensive and jittery environment.

Grampian has estimated its exposure to US sub-prime debt at just 93m, or 0.5% of assets.

Central bank action has helped to ease the liquidity strain, while the move by the US Federal Reserve last week to cut the discount rate from 6.25% to 5.75% - effectively a cut in the penalty rate at which banks can lend direct from the Fed - has helped to steady nerves. It has also fuelled speculation that the Fed will cut the general Federal Funds rate on Tuesday, September 18, to help minimise the impact on the real economy.

Sceptics point out that to the extent that HBOS funds are directed to Grampian this cannot but have a squeeze effect on its lending operations elsewhere. This would be a 'conduit' by which the recent shocks in financial markets become shocks in the real economy, with restrictions in overall bank lending and a slowdown in business investment and expansion.

But, says Mackay: "These are the things we plan for in times of dislocation in the markets and we are prepared to take this in our stride."

Nevertheless, in view of this drama, HBOS shareholders will surely welcome at least some acknowledgement of Grampian's existence in the next voluminous set of report and accounts.