What’s next for mutuals?

A year after the credit crunch began, the announcement of The Derbyshire and The Cheshire\'s mergers with Nationwide has increased interest in building societies\' financial performance. Ironically, until these announcements, societies appeared to have weathered the storm comparatively well. By contrast, the impact of the turbulence in financial markets on banks in the past year is all too apparent, with profit warnings, rights issues and in one case, failure.

KPMG’s Building Societies Database report, published in September, shows that last year many societies had strong growth in profits and assets and had also controlled their costs well.

But does the rapidly deteriorating housing market and the competitive savings market portend another storm that will batter mortgage banks and societies harder?

The answer is at least in part, yes, with the prospects of a long drawn out credit crunch gradually increasing pressure on lending institutions.

There has been a great deal of comment about the effect of the deteriorating economy and housing market on mortgage banks and societies, with two issues in particular being raised:

  • The risk of deterioration in asset quality through rising arrears and rising losses on repossessions with consequent losses flowing through into the profit and loss account
  • The need for more capital as house prices fall as a consequence of models built to support the advanced approach to Basle II.

    But a much bigger issue for most building societies, and banks outside the big five, is the cost and relative scarcity of funding

    Asset quality

    The initial cause of financial turmoil among banks was not the quality of their own lending but their exposure to US sub-prime lending via asset-backed bonds held in treasuries. Societies typically have more conservative approaches to treasury management than banks and so, on the whole, suffered far less from write-downs in treasury asset values.

    With house prices on the slide and the economy showing signs of strain, the focus of attention is moving from treasury assets to balance sheet lending.

    Unlike the crisis of the early 1990s, societies’ commercial lending is so far showing only modest signs of strain and other than Nationwide, they have little exposure to unsecured lending and credit cards so attention is focused on residential mortgage lending.

    Societies’ prime residential and buy-to-let lending is showing little sign of stress. They report that their buy-to-let portfolios are performing better than residential prime lending, other than limited fraud problems.

    Unsurprisingly, the part of the mortgage market showing some strain is sub-prime lending, especially non-status high LTV lending. Such business has rarely been written by societies directly onto their own balance sheets but some have written it via subsidiaries and others have bought it in from specialist lenders.

    This leaves the majority of societies with mortgage assets in good shape, with probably only a handful having material exposure to potentially stressed lending.

    Basle II

    The Basle II accord, which has been implemented in the past 18 months, introduced a new level of sophistication to the way banks and building societies calculate the amount of capital they require. The emphasis is now on the modelling of how a lender’s credit portfolio will perform under stress and ensuring that there is sufficient capital to meet forecast credit losses that arise from stress scenarios. As house prices fall the amount of capital needed to cover stress scenarios rises, and the impact is particularly marked on institutions that adopt the advanced approach. The rising capital requirements flowing from Basle II coupled with the reductions in capital available due to sub-prime loss write-downs, has been partly behind the recent round of capital-raising by banks. Societies, being generally better capitalised than banks and not being exposed to large treasury losses, have not needed to raise fresh capital. But if house prices continue to fall, their Basle II models will project a rising need for capital, particularly where they have adopted the advanced approach.

    For many societies, a combination of high liquidity levels and a desire to protect capital ratios is likely to result in a focus on making the most of their re-sources by limiting or even shrinking asset growth, and by working hard to manage arrears and losses on repossessions. As a result, 2008 and probably 2009 will see the sector as a whole limit its share of new lending and see market share taken by banks. Basle II models are sensitive to the level of arrears and the size of losses that ultimately arise when homes are repossessed.

    Well managed societies are rapidly improving their collection processes and looking at how repossessed properties are managed and sold. Many of the hard learned lessons and skills about how to manage repossessed properties in the early 1990s are being relearned now.

    With the prospect of rising credit losses, they are also hunkering down to protect profitability, slowing or stopping discretionary spending and tightening belts all round.

    Cost-effective funding is the big constraint for most lenders, including building societies. The market price for one-year term funding, whether from other banks or the retail markets, is materially higher than the current league table rates for new mortgage lending, making new lending costly.

    The credit crunch and subsequent difficulty in raising long-term wholesale money have reignited interest in retail savings. The KPMG report shows societies have worked hard to cut wholesale funding, increase the maturity profile of what remains and boost liquidity.

    This has increased their need for retail savings at a time when banks, other than clearing banks, also want more retail savings. This has led to something of a bonanza for savers.

    Demand is especially strong for fixed term products such as bonds that help institutions push out the maturity profile of their funding, replacing longer term wholesale money that is unobtainable or highly expensive. The Bank of England’s Special Liquidity Scheme seems to have had little impact on demand for retail savings, in line with expectations when the scheme was announced, simply because most societies don’t have the infrastructure to access funding from that source.

    With funding costing more and the additional cost of carrying higher liquidity, societies’ margins are under pressure despite the rising price of new mortgage lending. The pressure has been increased by the rising popularity of base rate tracker mortgages in recent years, many of which pay less than LIBOR.

    The report predicts that continued margin pressure, combined with the prospect of limited or no balance sheet growth for this and next year, will in-crease pressure on profitability and encourage further cost reduction activity.

    Management under strain

    The rating agencies have reacted to the credit crunch by downgrading financial institutions and building societies have not escaped this trend, although all re-main well within investment grade.

    With asset quality being measured by arrears levels and profitability, the KPMG report shows that there is pressure on societies to manage arrears and keep costs under control.

    Against the background of credit rating agencies regularly reviewing performance, increased regulatory interest following Northern Rock’s failure and significant profit challenges from margins and credit losses, societies’ management is under considerable pressure.

    There are also significant operational challenges to manage. With mortgage sales, distribution and underwriting teams quiet and limited commercial lending activity there are painful decisions to be taken on capacity.

    In contrast, there is growing need for strong arrears management. Experience suggests those that grasp the nettle early will do well. Those that hesitate, hoping things will improve, are likely to find their situation deteriorating and possibly spiralling out of control.

    Looking ahead

    The KPMG report shows that the building society sector has emerged from the first round of the credit crunch in better shape than many banks, supported by generally good asset quality, limited exposure to US-originated mortgage-backed assets and a strong retail savings franchise.

    The recently announced mergers do nothing to change a fundamentally strong performance in the first round of the credit crunch.

    The second longer and slower round of the credit crunch is now underway, characterised by falling house prices and real incomes. This is combined with the continuing high cost and volatility of funding and market prices for new mortgage lending which are typically below the cost of funding.

    The evidence assembled by the report suggests that this round poses more problems for societies. Although slower and perhaps more predictable than the first, it gives management more opportunity to work through the issues. Belt tightening, timely action to redeploy resources from sales and underwriting to collections and recoveries and tight balance sheet management are the order of the day.

    As ever, it will be the quality of implementation rather than the cleverness of strategic thought that differentiates the winners from the losers. Strong, decisive and rigorous management will be the most important factor.

    As Adrian Coles, director-general of the Building Societies Association, says, “The forthcoming merger of HBOS with Lloyds TSB shows that the future doesn’t necessarily belong to the big battalions and what is important is strategy, impleLSmentation and management quality.”