HBOS - The bank that couldn't say no

From its Edinburgh corporate HQ, HBOS - formed in a 2001 merger of Halifax and Bank of Scotland and now owned by Lloyds - embarked on a slew of high-profile finance deals. Photo / Supplied

If you asked most New Zealanders how our country coped during the international banking meltdown of 2008, they'd probably mutter something about "bloody finance companies", and a recession that lasted longer than most.

But try telling a Brit or an American how much it hurt and you're likely to get your head bitten off.

One interesting outcome of the GFC - the Global Financial Crisis for those of you who have yet to get with the lingo - is that the old analogy about America sneezing and the rest of the world getting a cold is no longer heard with tedious regularity in this part of the planet.

This time, it was America that had a near-fatal brain haemorrhage, and the rest of the world got a headache (okay, so maybe a migraine if you're Icelandic or British or Greek).

In fact, only now are some public servants willing to admit that at the nadir of the crisis there were serious fears New Zealand might have been only days away from a run on our own banks.

It is also becoming evident New Zealand did not entirely escape the irrational exuberance that infected the banking sector worldwide as it became drunk on cheap debt.

While our main trading banks have emerged as relative heroes, compared to the zillion-dollar zeroes we are still reading about in the United States and Britain, the truth - as always - is somewhat more complex.

For a start, our big four trading banks - ASB Bank (owned by Commonwealth Bank of Australia), ANZ/National (owned by ANZ Australia), BNZ (owned by National Australia Bank) and Westpac (owned by Westpac in Australia) - are not the only big business lenders in this country.

As we are all now painfully aware, finance companies played a significant role in lending money to property developers and have also been a useful source of money for consumer finance. And some well-known overseas banks have also been prominent players here, such as BOS International, Barclays, and the Royal Bank of Scotland.

If you believe some in the industry, there are plenty of bank executives who are currently having difficulty hearing themselves think because of the distant clucking from all the corporate chickens finally coming home to roost.

While it would take a lift crammed full of people counting on their fingers to calculate the number of banks that have foundered as a result of the global financial crisis, it is interesting that Scotland has a particularly poor record, given the stereotype of the parsimonious Scot.

Although Northern Rock was the first bank to be bailed out by the British Government, HBOS and the Royal Bank of Scotland were not far behind.

HBOS was formed in 2001 when Halifax merged with the Bank of Scotland to create Britain's fifth-biggest bank, and its largest mortgage lender.

Founded in 1695, the Bank of Scotland didn't get grand ideas about international expansion until the 1970s, as profits began flowing from North Sea oil projects.

Its first overseas branch was in Texas and by 1987 it reached New Zealand, buying what was then known as Countrywide Bank (which it sold a decade later to Lloyds TSB).

In 1995, it bought BankWest from the Australian government and subsequently set up three other subsidiaries in Australia: consumer finance company Capital Finance, insurance company St Andrews and corporate financier BOS International.

BOS International quickly established itself as a specialist in leveraged buyouts and as a provider of property, project and infrastructure finance.

As Australia's big private equity funds began eyeing New Zealand companies, BOS International expanded across the Tasman, opening an office here in 2005. The following year, local spokesman Hugh Sykes was happy to talk to the Business Herald about many of the high-profile deals the company had helped to finance, including:

* $107 million to Infinity Investments Group to develop New Zealand's largest residential property project, the $1 billion Pegasus Town north of Christchurch.

* $350 million to IMF Westland to develop a shopping centre on 220ha of land at Tauriko in the Bay of Plenty.

* $300 million to enable Australian private equity firm Catalyst to buy Metropolitan Glass.

* $155 million for Cornerstone Group to buy a large block of Albany land from Malaysia's Neil Group.

* $30 million for Geneva Finance and about $75 million for Strategic Finance.

* Initial funds for Goldman Sachs JBWere and Quadrant Private Equity to buy clothing manufacturer and retailer Kathmandu.

At the height of the private equity boom, BOS International employed about a dozen people in New Zealand, who competed fiercely with other bankers to see who could dish out the most money to clients and notch up fat fees.

They were heady times. According to Companies Office records, BOS International's Australasian division made a pre-tax profit of A$108 million in 2005. The following year that almost doubled to A$199 million. By 2007 it nearly doubled again, to A$358 million.

A banking insider, who did not want to be named for fear it would jeopardise his career, says it was normal at the time for those in the industry to fly business class to meetings in Australia. He once flew to Sydney to meet a client for just half an hour.

"Half-way through the meeting, he said: 'I'm sorry I've got to go. I've got a plane to catch.' So I went back to the airport separately and I got on the plane, and there's this guy on the plane, flying to Auckland."

Naturally, there was a need to hold conferences at swanky Australian resorts. But sometimes the parties were closer to home.

"I remember going to a closing party for a deal and there were all these property developers who were drunk, and one guy was dancing on the table. I thought to myself: 'Oh no, this is just like '87."'

While he doesn't claim to have had any special foresight, or indeed any foresight at all, the banker proved to be spot on.

On September 15, 2008 Lehman Brothers imploded. More than two decades after the great sharemarket crash of 1987, the global financial crisis had arrived.

By 2008, BOS International had dished out almost A$20 billion worth of loans and commitments in Australia, and around A$2.2 billion in New Zealand. By the end of the year an alarming number were starting to go sour.

In 2007 it had A$47 million in impaired loans. By 2008, that rose to A$306 million. But much worse was to come. According to accounts recently filed with the Australian Securities and Investments Commission, in 2009 its impaired loans ballooned to A$1.2 billion and it recorded a pre-tax loss of A$827 million.

According to the insider, its parent company slammed the brakes on. However, its accounts show that at the end of December, it still had A$17 billion worth of loans and commitments in Australia, and A$2 billion in New Zealand.

On a scale from one to eight - with one being sovereign debt and eight being receivership or liquidation - BOS International has quite a few loans ranked five or worse, according to its latest accounts.

More than a third of its loans are in the property and construction sector. It is also a big lender to the transport, storage and communications industries, and to manufacturers. "Overseas residents" and "other services" are also significant.

The Australasian division has only been able to continue operating through support from its new parent, Lloyds, which was persuaded to buy HBOS two days after Lehman Brothers collapsed. A few weeks later, the British government had to pump around £37 billion (now $79 billion) into both Lloyds and the Royal Bank of Scotland to ensure they stayed afloat.

British taxpayers were understandably bewildered by the bailout and commentators have been caustic in their criticism of HBOS' lending practices.

Many claim the bank simply got greedy. Some say that instead of following the traditional model of a retail bank or building society, by taking in money from depositors and lending it back out to people it considered low risk, it seems to have decided to live a little more dangerously by investing almost half its money in private equity schemes and corporate finance deals.

Lord James, the company doctor who rescued the Millennium Dome in London and once tried to buy MG Rover, was quoted in the Times as saying the bank's loan book was "awful. It lent to anyone with a glass of whisky in his hand who was wearing a kilt".

In August, HBOS Australia changed its name to Lloyds International. But some things, it seems, don't change. According to its new website, Lloyds International has five core values, one of which is: "we stretch ourselves." That, say some local commentators, was precisely the problem in the first place.

David Tripe, who heads Massey University's Centre for Banking Studies, says there are plenty of banks that have a much worse reputation than BOS International.

Nevertheless, "there is an interesting question as to what on earth people in the Bank of Scotland thought they were doing with their risk management in this area, because it doesn't look good", he says. "Why did they think this was such attractive lending?"

In fact, HBOS is not registered as a bank in New Zealand or Australia, as it does not take deposits from the public here. In many respects it is just another finance company that managed to build a fairly lucrative niche for itself in a short space of time, without undergoing much public scrutiny.

"They really snuck in under everyone's radar in terms of the amount of business they built up to," says Tripe. "We didn't think of them particularly, and then we gradually realised they were doing a sizeable chunk of business in the New Zealand market."

Although the Reserve Bank now has oversight of non-bank deposit-takers, that only began in 2008 when it became obvious the public's confidence in New Zealand's entire financial system might be affected by the precariousness of so many finance companies.

In its latest financial stability report, in November, the central bank acknowledged the non-bank finance sector was continuing to face "ongoing challenges". However, it also noted the entire sector only accounted for 5 per cent of New Zealand's financial system.

The Reserve Bank declined to talk on the record about the issue, other than to say most countries did not prevent local borrowers turning to foreign banks for money, and this would be difficult to control even if it wanted to.

A spokesman said the central bank did not feel the need to look at the issue, as the amounts of borrowing being done by New Zealand-based businesses from overseas were "not significant".

"At the moment the New Zealand banks do account for the vast majority of the lending here."

Tripe isn't sure the Reserve Bank is right to be so sanguine. However, he agrees it is British taxpayers, and other Lloyds shareholders, who should be most concerned.

"To some extent, many of the people were busily digging holes for themselves, and BOS merely helped them out a bit. But if BOS hadn't lent to them, someone else probably would have. It's just a matter of who picks up Muggins' turn on this."

You could even argue the Lucky Country got even luckier because of HBOS' woes, says Tripe, as its problems eventually forced it to put two reasonable assets - BankWest and St Andrews - up for sale.

Both companies were snapped up by the Commonwealth Bank of Australia, now run by Ralph Norris. While HBOS recorded a loss on the sale of A$1.8 billion, Norris got "the bargain of the century", says Tripe.

But according to the insider, no one in the banking industry in either New Zealand or Australia is likely to be feeling too smug about the New Zealand loans that BOS International still has on its books.

The truth is that the main trading banks also lent money to many of the same people, he says.

"You've got to set the scene - it's boom time, everyone is lending to anyone. Everyone is credit-worthy; we haven't had a crisis for 20 years. It was the madness of the times. All the banks were competing to give these deals, and people were trying to get the fees. The private equity boom back then was just massive. They were out there paying $2.2 billion for Yellow Pages and companies like Independent Liquor were going for ridiculous prices.

"Most of those big deals, BOS was involved with all the other banks anyway, except for maybe one or two like Strategic Finance or Geneva. Pretty much everything else, they were in syndicated deals. All the private equity deals, everyone was in there."

Former Strategic Finance head Kerry Finnigan is adamant BOS International was not the only bank he dealt with.

"We sourced a lot of transactions which we got funded," he maintains. "We got them through ANZ and Westpac and BNZ and the like. We had a significant number also with BOS.

"The conclusion was drawn that we were too close to [BOS] as a result of the volume of transactions that we undertook with them, but that's not correct. There was a fair balance of funding done with other major trading banks, which seems to have been overlooked."

Finnigan insists BOS was not a reckless lender: "They're a normal bank and the process was pretty robust." Loans, he points out, had to be approved by its New Zealand managers, then its Australian managers and finally its British managers.

Queenstown-based developer Bob Robertson, who received more than $200 million from BOS to develop New Zealand's most ambitious residential development, Pegasus Town near Christchurch, has also previously defended the bank. In 2008 he told the Sunday Star-Times he found BOS "extremely easy" to deal with, as it took a different tack to local banks.

"They set you up to succeed by asking what you need, making sure you've got what you need and that you are not tight and that you can get there."

Another difference was the amount of research it did on a project and the amount of ongoing involvement once it was under way: "There's a lot more checking of the work and where the money's spent than with a New Zealand bank."

But according to British business journalist Ian Fraser, processes at the parent company were far from robust.

On his blog, Fraser says the bank seemed determined to win market share from its bigger rivals at almost any cost.

The Bank of Scotland was already considered an aggressive operator before it merged with Halifax, but after the merger sales dominated and its risk management and credit-checking processes struggled to keep pace with its rapid growth, he says.

Fraser believes its corporate division had a policy of lending to companies other banks would have recognised as insolvent, so it could book the customers' interest payments as profit - and avoid having to declare the losses associated with write-downs and bad debts.

"To cap it all off, the whole imprudent edifice was built on shaky foundations. The bank's short-term funding requirements were immense. Unlike the boards of better-managed banks like Santander and HSBC, HBOS' board were fully paid up subscribers to the illusion of unlimited equity. When this was revealed to be an illusion ... they were effectively scuppered."

According to locals, part of the problem for BOS in New Zealand was it was not familiar with the territory. Even amid the lending fever that seemed to grip the entire industry, some of the deals done by BOS seemed questionable at the time, says an insider.

At the height of the boom, even property developers managed to get loans for little more than 1 per cent above the bank bill rate, as banks and finance companies competed vigorously for their business.

"They say you should only lend money which you would lend yourself. But especially some of the deals done in Fiji, it was just like: 'I wouldn't do this myself."'

As for banks giving 100 per cent loans for residential property, which has traditionally been seen as very low risk, it didn't seem too over-the-top compared to what was happening overseas.

"We were probably only a couple of years away from 120 per cent home loans," he believes. But the bubble burst first.

The latest report from Ernst & Young on New Zealand's private equity and venture capital industry provides a handy perspective on what now appears to have been a couple of extraordinary years, even by the normal standards of the finance sector, which has a tumultuous history of booms and busts.

In Europe, the report notes, just €17.3 billion worth of deals were done last year - a 15-year low and only a fraction of the €170 billion of deals struck in 2007.

Venture Capital Association chair Franceska Banga says overall activity in New Zealand is back at the levels last seen in 2003 and 2004. "The billion dollar years of 2006 and 2007 stand out as abnormal aberrations," she says.

Banga acknowledges it is proving difficult to raise money for new funds in the current environment, and predicts a recovery could come too late for some fund managers. But on the bright side, around $177 million still changed hands last year in 108 deals, and at least two local funds, Maui Capital and Direct Capital, still have plenty of money to invest.

A spokesman for BOS International said yesterday that the bank "could say no and certainly did on a number of occasions.

"We are not Robinson Crusoe. We are in the pack. It's been tough for all and we've managed through.

"First quarter trading is according to plan and we are expecting conditions to improve throughout 2010. We are also confident that impairments have peaked, subject to no further economic deterioration. However, we still see some downside risk with commercial property."

The bank continued to have a significant presence in New Zealand, and continued to support its customers, he said.

Meanwhile, Lloyds announced last month it believed the worst was now behind it. It predicted it will return to profit this year, after two years of massive losses.

But some local players remain gloomy about the legacy of the boom years.

Kerry Finnigan believes it will be many years before the property sector recovers, and he is convinced that the finance company model of passing on funding from retail investors is gone for good.

And one major private equity player has been spending too much time reading essays by British historian Niall Ferguson, probably best known here for his wonderful TV series, The Ascent of Money.

Ferguson recently noted that contrary to popular belief, empires do not gradually crumble but often topple in a relatively short space of time, due to a lack of confidence in crucial institutions.

It has been calculated that over the next three years Australian and New Zealand companies will need to refinance somewhere between $200-300 billion that until now has been supplied by overseas banks. Indications are that at least some of those banks might be keen to retreat to their home markets.

Due to a flurry of rights issues in the past couple of years on both sides of the Tasman, it's unlikely many more companies will be able to go to their own shareholders to raise that kind of money, notes the private equity player. And because the corporate bond market in Australasia is not big enough, and there is very little institutional lending, options are limited, he suggests. Our local banks are also heavily dependent on international money markets.

The same person notes a recent survey that suggested nearly half of all CEOs in Australia and New Zealand have only been appointed in the past couple of years.

"If you're sitting on a corporate board right now, you're probably feeling like your shareholders have got very angry with you, your chief executive is new, you're feeling under pressure to revalue some of your assets, and you're a little bit uncertain how you are going to refinance some of your basic bank debt.

"So you're probably quite nervous, and probably what you have to consider is writing down some assets and selling them, because you get cash in for doing that. So it could be a time when corporates sell assets."

You might expect someone in private equity to say that. And you might also expect them to note that it is actually the peripheral players who are likely to get hurt the most.

But as the British and American governments have so clearly demonstrated, the lesson we seem to have learned from history is that many banks are indeed simply too big to be allowed to fail.

In New Zealand, many of our finance companies were allowed to founder, which has left many older people facing a miserable retirement. When it comes to big, bad corporate loans, the banks have little choice in the current environment but to persuade the company's shareholders to stump up more money, then pray that it all comes right eventually.

"People get very red-faced and jump up and down and say: 'You've got these huge leveraged entities - how unstable; how bad.' But what actually happens when they get stuck is that typically 30 or more per cent of the enterprise value disappears, and that's all paid for by the equity owners. The banks get to keep all their money and get control of the business and generally do very well," notes the private equity player.

"The worst case is the banks end up taking a massive haircut but end up controlling the asset. But what's much more likely is long drawn-out controlled workouts by banks where the equity owners lose their money and the banks do things they don't like to do, but which make a lot of sense."

And it is possible that if some foreign banks withdraw from Australia and New Zealand, others will take their place. There has been speculation in Australia, for example, that Asian investors are already circling in the hope of picking up some bargains.

As Reuters recently noted, the collapse of Australia's Babcock and Brown last year generated a trading blowout where buyers gorged themselves on most of the company's US$3.2 billion in debt. Most of the debt changed hands at less than 20c in the dollar as commercial bank lenders exited in a rush, sparking a trading frenzy.

If you believe Pacific Equity Partners, Independent Liquor has already managed to bounce back from the brink. Given the number of banks involved, all with different agendas, Yellow Pages has apparently got ugly, and there is speculation it might be put back on the market. Whether anyone would want to buy it - or more pertinently, at what price - remains to be seen.

At $2.2 billion, Yellow Pages was New Zealand's largest-ever leveraged buyout, and could yet be our own version of the takeover of tobacco and food giant RJR Nabisco, which spawned one of the world's best-selling business books, Barbarians at the Gate. BNZ, ANZ and Westpac are reported to have been part of the huge syndicate that funded the deal.

Some banks have apparently already written down their investment. But it is probably Yellow Pages shareholders - a pension fund for Canadian teachers and a Hong Kong investment fund - who will get hit hardest.

Banks, we should not forget, are usually first in the queue to get their money back, which is why so many of them have been seen as such good investments in the past.

The last couple of years might have been a bit hairy for their own shareholders, and for taxpayers who have bailed them out, but the same rules apply as for any investor: buyer beware.