Building societies not blameless in banking

crisis
After the trouble at those nasty big banks with their horrid lending practices, lax regulation
and overpaid executives, you might imagine your savings are better off in those cuddly little
building societies.

Not so fast. Though they may have escaped headlines about multi-billion pound government
rescues and giant pension payoffs to failed executives, building societies have not covered
themselves with glory in the financial crisis.

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Not so clean or clever, then

Even though they are owned by customers and not shareholders, many of these mutual
groups exhibited the same poor lending practices as their bigger banking brothers.

The problem loans may be in millions not billions, but then so are the resources building
societies have available to deal with them. Ironically, they have also been hit hard by the
industry-wide government levy designed to clean up after the financial crisis.

Annual results from the largest building society, Nationwide, reflect the pressures. Profits
halved to £393 million from £781 million a year ago and the society warned that the pressure
on returns was expected to continue throughout the current year.

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Financial casualties abound

Several societies have already reported losses in 2008, something that is normally extremely
rare in this supposedly staid and predictable sector.

Chelsea Building Society lost £39.3 million, Newcastle £35.7 million, National Counties £8
million, Stroud & Swindon £3.4 million, Chesham £2.6 million, Darlington £2.5 million and
Chorley & District £1.9 million.

Profits plunged by between 85% and 94% at the country's second largest building society,
Britannia (which is now being bought by the Co-op) and at Vernon, Nottingham, Skipton,
Yorkshire and Buckinghamshire building societies.

Building societies say most of their problems are down to Icelandic deposit issues and the
millions they now have to pay into the Financial Services Compensation Scheme.

This is levied across the banking industry on deposit size, yet the building societies have
benefited far less from government schemes, such as state underwriting of bonds, designed to
assist troubled banks. Nationwide alone said it had to put aside £241 million this year for the
FSCS, accounting for more than half the drop in profits.
"History will record 2008 as a year of fundamental change to banks and financial institutions
across the world. Nationwide has remained strong in the midst of all this turbulence and has
been the only major UK banking institution not to raise capital or seek access to government-
sponsored capital enhancing schemes," said Nationwide chief executive Graham Beale.

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More than nice words

"We need to find a fairer mechanism for funding the compensation scheme," Building
Societies Association chairman John Goodfellow told the association's annual meeting last
week.

"The time for only nice words by the authorities about mutuals is over. We need to see action,
support and a desire to build a better future," he said.

Whatever the reasons, pressure remains on this dwindling band of mutuals. A few societies,
such as Derbyshire, Cheshire, Catholic and Barnsley have already disappeared since the
credit crunch began, taken over by stronger rivals or in one case, Dunfermline, jointly
rescued by the government and Nationwide.

Many more are likely to merge because of the combination of cash lost in Icelandic deposits,
mortgage losses caused by the recession and incautious lending and an inability to pass new
stress tests being conducted by the Financial Services Authority.

But there are much more damaging worries to be laid at the doors of the mutuals themselves.
Over the quality and oversight of loans made to homeowners, particularly in buy-to-let loans
for amateur landlords, high loan-to-value mortgages and self-certification loans which require
no proof of income.

Particular problems arose when building societies stepped away from what were once their
core lending areas:

 West Bromwich Building Society has been hit hard by losses on its commercial loan
book and now needs rescuing by a stronger suitor. Despite this, it was seeking
deposits for a savings account which would have been larger than the £50,000
covered by the Financial Services Compensation Scheme, according to the Times.

 Darlington Building Society has been hit by losses at its own upmarket flat builder
Darlington Homes.

 Britannia Building Society, the second largest society before being merged with Co-
operative Financial Services, quadrupled its loss provisions from £14 million to £57.8
million mainly because of losses at its Platform unit which deals with sub-prime
borrowers.

 Melton Mowbray Building Society made losses because of problems at its Praxis
subsidiary which bought in mortgages originated by a panel of 20 brokers. Martin
Reason, chairman of the society, was still so confident of this business model which
relied entirely on the judgment of others that he promised at that time of the Praxis
 acquisition in October 2007: “Brokers can be assured that all pipeline applications and
fees will be honoured.”

Pass the buck, quick

Many building societies, Like Melton Mowbray, accepted mortgages which had been sold by
third parties, which is precisely how the US sub-prime crisis began. There is clearly much
less restraint in lending money by a broker who passes on a loan than there is by a lender who
will have to deal with any long-term consequences of default.

Last year the biggest 45 building societies quintupled their reserves against bad debts, from
£51 million to £254 million. Expect worse this year, as unemployment continues to rise and
house prices continue to fall.

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Downgrade and perhaps worse to come

On Friday, credit rating agency Fitch downgraded the ratings of Chelsea, Newcastle,
Principality, West Bromwich and Yorkshire building societies. Skipton Building Society was
put on negative watch, which means that though the rating is unchanged for now, the next
change is likely to be downward.

"Fitch's concerns are concentrated on higher-risk lending by societies, which includes buy-to-
let, self-certification, adverse, purchased loans and commercial mortgages," said Matthew
Taylor, senior director of Fitch's Financial Institutions team.

Damaged financial reputation

Credit ratings allow traders to assess the prospects of default in an institution or even a
country. Downgrades make raising fresh cash through bonds more expensive for the issuer.

When Moody's, another credit rating agency, downgraded several building societies in April,
Treasury minister Paul Myners raised eyebrows by criticising the agency for "lacking
appreciation of the funding and capital basis of building societies".

It may well be that Fitch appreciates rather better than the minister where weakness lies.
Though it can be said that agencies were not tough enough on banks early in the credit
crunch, Myners' incautious remark now they are being tougher does not sit well with his duty
to help ensure that the financial sector is strong enough to regain savers' confidence.

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Same motives, same response

Looking at these troubles, it is obvious that mutuals have come a long way from their
financial and community roots. They have become driven by internal revenue targets, growth
strategies and all the same management incentive paraphernalia as their stock-market listed
rivals. They are in the same market for executive talent too.

So it isn't surprising they grasped at the same areas for growth and competed with the banks
to get it. So when banks went after sub-prime, high loan-to-value, buy-to-let and commercial
lending in pursuit of profit (however short-term those profits turned out to be) the supposedly
staid mutuals followed them in, with the same consequences.
The lesson remains that just because the staff in Cuddletown & Huggington Building Society
greet you by name instead of directing you to dial a faceless call centre doesn't necessarily
mean that it wasn't up to the same financial shenanigans as banks.

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