Mutual appreciation

22 March 2010 | By Christine Toner

Twelve months ago the building society sector was shaken to its core. Long revered as the safer, more conservative sibling of the banking industry the sector had seemingly weathered the credit crunch storm well. It had not got involved in the risky lending that was shaking the world economic structure and was faring OK through the crisis. Then on March 28 2009 it was announced that Scottish society Dunfermline was no longer viable.

The news sent shock waves around the sector. Yes, other societies had struggled somewhat in the past but these were small, local outfits snapped up by bigger contemporaries with little or no fuss and sometimes only the tiniest mention in the press.

This was different. Dunfermline was Scotland’s biggest society and the 12th biggest in the UK, it had assets of £3.3bn and the rumours of its demise had been bubbling below the surface of the industry for weeks.

Following the bailouts of the Royal Bank of Scotland and Lloyds Banking Group there was hope the government would come to the society’s rescue. Surely a 140 year old institution would not be left to crumble?

But the government made no bailout bid and eventually the branches, good loans and deposits were acquired by Nationwide Building Society, while the commercial lending business and poorer quality mortgages went to the Bank of England.

The collapse of the society showed that the sector was no longer safe and everyone was at risk of meeting the same fate.

So why are some societies still faring well while others, like Dunfermline, have failed? In recent weeks Coventry Building Society reported a pre-tax profit of £56.2m for 2009 compared with a £26.4m profit in 2008, while Leeds Building Society, the UK’s sixth largest mutual, reported a pre-tax profit of £31.7m for 2009, up from £20.3m in 2008.

Meanwhile, Nationwide has been doing so well it has been able to act as a knight in shining armour to smaller societies that are struggling, acquiring both Cheshire Building Society and Derbyshire Building Society in 2008 before taking on Dunfermline.

What is it that makes some societies prosper while others fall at the first hurdle? Let’s first look at how the collapse of Dunfermline came about.

Rumours that Dunfermline was in trouble began circulating early in 2009 but no formal statement was forthcoming for some time. In fact, it wasn’t until March 24 that Jim Willens, chief executive of Dunfermline, said the society would not be making any comment on speculation that it was seeking a bailout after seeing losses in the region of £26m.

“The articles are speculative,” said a message on the society’s website that morning. “Our results are due out in the next two weeks and we will not comment on them until that time. Meanwhile, our focus remains, as always, on looking after our members. Thank you for your continued support.”

The society had made a £2m profit in 2007 but it was understood the Financial Services Authority had been forced to step in and find a buyer after heavy losses.

A number of societies were believed to have been approached by the regulator but a deal had yet to be done.

Then on March 30 it was announced that Nationwide had taken on the collapsed society’s 34-branch retail network, its £1bn mortgage book and its £2.3bn deposit book. A statement from the Treasury at the time said that loan and mortgage customers could continue to contact Dunfermline in the usual way and should make their repayments as normal.

All of Dunfermline’s staff were transferred to Nationwide and its social housing portfolio was placed into a bridge bank wholly owned by the Bank.

It was claimed at the time that this would allow the Bank of England and the Treasury to determine the best outcome for this part of Dunfermline’s business while underlining the government’s commitment to maintaining the availability of lending to registered social landlords.

The government said it was talking to a number of players with a view to securing a long-term future for the social housing book, including the Scottish government. The deal excluded high risk assets that Dunfermline had on its books such as commercial loans and some residential loans including acquired residential mortgages and equity release loans.

At the time Graham Beale, chief executive of Nationwide, said this was good news for the members of Dunfermline .

“Nationwide is in a unique position - by virtue of its size and its financial strength - to provide support to Dunfermline, and we regard it as both responsible and beneficial from a commercial point of view to undertake this transaction,” he said at the time.

The problems being faced by Dunfermline caused uproar in the society sector and beyond.

On April 1 Mortgage Strategy’s sister title Lending Strategy reported that a Scottish MP had asked the Financial Services Compensation Scheme to repay the £7.2m levy it had imposed on struggling Dunfermline.

Willie Rennie, Liberal Democrat MP for Dunfermline and West Fife, appealed to the organisation amid reports that the society was on the brink of collapse. As part of the scheme the society had to pay the above to protect the first £50,000 of its savings.

But Rennie believed the sum was unfair.

“This is a huge sum for a society like Dunfermline,” he said at the time. “The FSCS levy penalises societies that are relatively safe.”

Rennie was adding his voice to a wider call from societies arguing that the amount they pay to the FSCS should depend on turnover rather than volume of savings held.

The near-collapse of Dunfermline was also cited as one of the reasons several societies had their credit ratings slashed by Moody’s. The societies vowed to challenge the agency over its judgment. The ratings agency hacked West Bromwich Building Society’s strength rating to E+ from Cand Chelsea Building Society’s to E+ from C.

Other societies downgraded included Britannia, Coventry, Nationwide, Newcastle, Norwich and Peterborough, Principality, Skipton and the Yorkshire.

The agency made the downgrades after stress-testing how mutuals would perform against a base case scenario of a 40% fall in house prices from the peak of the boom. It also stress-tested a more extreme scenario based on a 60% fall. And it seems the complaints were justified.

Moody’s seemed to be tarring all societies with the same brush when it emerged there was a vast difference between the way Dunfermline and other mutuals operated.

Unlike many other societies Dunfermline had got involved in a significant amount of specialist lending including in the commercial buy-to-let sector. It had also bought a bundle of self-cert mortgages from GMAC-RFC.

An article in the Guardian published the day after the ann-ouncement that Nationwide had rescued the ailing society questioned the regulator’s role.

“The FSA appears to have been wholly untroubled by the thought that Dunfermline, making profits of £5m to £6m a year, could pitch itself into commercial property lending, an area outside its core expertise, to the tune of £650m,” the article said. “The FSA needs to provide a proper explanation of what went wrong.”

Jeremy Hicks, senior corporate affairs manager for regional brands at Nationwide, says that while Dunfermline was a fundamentally sound business its diversification into commercial lending caused significant issues at a turbulent time for the financial services industry.

The Building Societies Act 1986 puts a statutory limit of 50% on wholesale funding for societies. Each firm’s board sets its own limit that is acknowledged and monitored by the FSA. Dunfermline adhered to this but it’s foray into unknown territory cost it dear.

“Where organisations take risks that go beyond the traditional model it is clear that they risk compromising their balance sheet in the way we have seen with Dunfermline,” says Hicks.

Tony Yorke, principal of Think Strategically, a consultancy advising societies and other financial services firms, believes mutuals should go back to their roots.

“That means returning to prudent ways and sticking to their knitting,” he says. “Societies that have stuck to what they know have done relatively well and kept out of trouble. Without exception, those that acted like quasi-banks have got into difficulties. They have either been forced to merge or been required to take exceptional action to minimise the problems they have been confronted with.”

Yorke says Dunfermline fell apart for two main reasons.

“It tried to be too clever and too greedy in markets it didn’t understand while lax regulatory supervision by the FSA meant any shortcomings - like lending £600m in commercial mortgages from a total book of £3bn - were not detected until it was too late,” he says.

“I’d like to think that the sector has learnt from these mistakes and put its house in order. Unfortunately, knowing what I do I can tell you this is not the case. The mistakes of recent years are still being carried out by a number of mutuals.”

According to industry consultant Mehrdad Yousefi there were several key risks facing the society.

“The risks were rapid expansion into commercial lending without adequate risk controls and insufficient capital,” he says. “It needed £60m additional capital to manage the likely loss exposures on commercial portfolio back in April 2009, the Treating Customers Fairly initiative, project management, its technology project, succession planning and fraud.”

“While the society’s commercial lending operation has been successful on the face of it, the portfolio has grown to a large enough size to warrant risk analysis across the portfolio rather than at individual exposure level.”

The FSA may have been criticised for not acting sooner in the case of Dunfermline but it has certainly been concentrating on the society sector since. It is introducing a Building Societies Sourcebook which is intended to help the sector learn from mistakes made in the past. The basic principle of the sourcebook is that more diversification demands a higher level of management skills, systems and controls.

But will the new guidelines be enough?

According to Yorke medium-sized organisations are facing the most difficulty.

“Large and small organisations either have the mass or the niche knowledge needed to survive,” he says. “Unfortunately, the jack-of-all-trades merchants are finding it tough going simply because they haven’t got a grip on their raison d’etre. Making a profit in traditional areas such as high street savings and prime residential loans is now a tough ask. In a short space of time we have seen prime retail savings become the most expensive type of savings account, while prime mortgages now deliver the lowest returns.”

Yorke says that many of the new products issued by middle tier players seem to reflect innovation for its own sake rather than being in support of a strategic vision.

“There’s no sign of any change in this situation at the moment,” he adds. “You only have to look at the best buy tables and see how many medium-sized players are regularly releasing market-leading deals to realise there is a serious squeeze on cash among a number of respected players.”

Yorke says the key for societies now is to stick to what they know best and he believes those at the top should be pushing this.

“The government should encourage all parties to stick to their knitting, and do it well,” he says. “Mutuals can play an important role in society provided they are allowed to represent the people who gave them legitimacy in the first place - the local communities in which they are embedded.”

Yorke says many societies have lost sight of why they are in business and who they serve.

“The government and the FSA have contributed to this situation,” he says. “Clear direction would be a big benefit for mutuals. If the Conservatives are elected at the general election the sector is likely to see greater clarity, which will be a good thing.”

He says that tinkering with regulation is only a partial fix and an inadequate solution to a wider situation that needs careful handling and an injection of long-term thinking.

“If mutuals seize the day and stop relying on the likes of the Building Societies Association to do their thinking 2010 could be the year the sector reinvents itself,” he says. “But unless there is some bold and decisive leadership at all levels - and more than one voice is heard - pressure will build on the sector and there will be yet more consolidation.”

Skipton Building Society is one of the mutuals that has fared well in the crisis, announcing pre-tax profits of £63.5m, up substantially on last year’s £22.5m.

David Cutter, group chief executive of Skipton, says its subsidiaries’ trading performances contributed substantial profits in 2009. As a result, Skipton has coped well in the past year.

But he adds that there’s no denying the fact that it’s a tough operating environment for the core society business while Bank base rate is languishing at 0.5%.

“It’s not for us to speculate about the specific circumstances experienced by other societies, which are bound to reflect their individual business plans and are a matter for their boards,” says Cutter.

“But a number of factors have made it harder for some to operate profitably. These could be structural issues with balance sheets such as excessive base rate tracker mortgages with no floors, or concerns about credit quality with commercial lending or buy-to-lets. But we’ve all been affected by the deadlock in the wholesale funding market and this has been exacerbated by ratings agency downgrades which have made it harder to access affordable funding.”

Cutter believes 2010 will continue to be difficult.

“This year will see hibernation in the sector,” he says. “I expect its size to continue to shrink while the base rate is so low. Meanwhile, any recovery in gross domestic product will be anaemic.”

So 12 months on from the Dunfermline crisis the society sector, like the rest of the financial services industry, is still facing an uphill battle.

ut the solidarity shown by mutuals in the face of trouble and the profits announced by many of the survivors are positive signs. This year may be one of hibernation but there’s no doubt the sector will return to flourish in the future as long as it adheres to its traditional values.

 

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