'An accident waiting to happen': The failure of HBOS - Parliamentary Commission on Banking Standards Contents

Annex 3: The Treasury Division


1. HBOS's Treasury Division had three objectives, which were (in order of priority): managing the Group funding and liquidity position; providing treasury products and services to Group customers; and generating profits as a profit centre in its own right.[317] We examine Group funding and liquidity in the next annex of this Report. In this annex, we consider the effects of the asset portfolio the Treasury Division built up.

The Division's changing asset portfolio

2. As noted above, profit generation in its own right was the third and least important of the Treasury Division's functions, and several witnesses emphasised the Division's conservative approach. In 2001, 99 per cent of the Treasury Division's assets were rated A or better, and 86 per cent were AAA.[318] At the end of 2006, the proportion rated A or above remained above 99 per cent.[319] The Division closed its proprietary interest rate trading activities in 2005.[320]

3. The Division originally established a structured investment portfolio to manage the excess capital within Halifax,[321] and the HBOS Group maintained a large liquidity portfolio as deliberate protection against the size of its wholesale funding.[322] The Division had £18 billion of structured credit assets which were from Halifax and which predated the merger. The Division increased this to some £40 billion by the end of 2008, and had another £40 billion in a combination of government bonds and bank paper.[323]

4. By 2004, the Treasury Division had developed a strategy to diversify the portfolio of liquid assets from what was regarded as an over-reliance on government bonds and bank certificates of deposit (CDs):

    Alternatives were being developed to build new pockets of liquidity; to develop new products - for example, in Credit Derivatives - that would have superior returns and liquidity characteristics; to lower the cost of high quality liquid assets; and to leverage expertise to create income.[324]

Consequently, the Treasury Division held significant portfolio of debt securities at the end of 2007, as summarised in the following table.

5. The Division's US residential mortgage backed securities (RMBS) portfolio included £7.1 billion in Alt-A backed loans. The investments included £5.1 billion in exposure to monoline insurers in the form of negative basis trades and guarantees.[325] The Division held an increasingly significant portion of its assets via conduits. The most significant of these was Grampian.[326] Grampian had a balance sheet of £19 billion (ie 23 per cent of the Division's debt securities holdings at the end of 2007), all of which was held in asset backed securities (ABS) (ie 44 per cent of the Division's ABS holdings).[327]

6. Philip Hodkinson, Group Finance Director from 2005 to 2007, claimed that, because the Treasury Division arranged UK mortgage securitisations, it had "a good level of expertise in the ABS market."[328] Indeed, in sourcing assets, the Treasury Division always made its own decisions, rather than relying on external credit ratings.[329]

7. The diversification of the liquidity portfolio resulted in the increase in the structured investment portfolio. Although this was still viewed by the Group as low risk, the Executive Committee understood that the risks were increasing.[330] However, outside Treasury, HBOS senior management, including the Board relied on external ratings in its assessment of risk, rather than an understanding of the instruments themselves. Jo Dawson, group risk director in 2006 and subsequently a Board member said that she "would not have known what an Alt-A security was" and that the Treasury Division was given a mandate to invest in a particular credit rating.[331]

The Division's losses

8. The Treasury Division took £7.2 billion of profit and loss account charges against its assets between 2008 and 2011. In 2008, Treasury incurred £3.95 billion of 'market dislocation losses' on its investments, as a result of the financial crisis, comprising £1.4 billion of impairments and £2.5 billion of negative fair value adjustments. The losses resulted in an overall pre-tax loss of £3.6 billion for the Treasury Division in 2008. The bank also took £4 billion of negative fair value reserves direct to equity.[332] In the 2009-11 period a further £1.3 billion of impairments were charged against Treasury assets classified as loans and receivables and a total of £1.9 billion of the negative fair value reserves against available for sale assets were taken through the profit and loss account.

317   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 60. Asset Management was not material to the group's financial results, still less its failure and therefore this annex deals exclusively with Treasury activities. Back

318   HBOS, 2001 Annual Report and Accounts: The New Force, p 32 Back

319   HBOS, 2006 Annual Report and Accounts: Our strategy has five key elements to create value, p 73 Back

320   B Ev w 242 Back

321   B Ev w 385 - 386 Back

322   BQ 472 Back

323   BQq 440, 472, 580 , 593  Back

324   B Ev w 385 Back

325   This total comprised £2.8 billion through negative basis trades and £2.3 billion in 'wraps' on other bonds. HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., pp 63-64 Back

326   Grampian was established in 2003, with an initial targeted size of $6 billion, as the then existing conduit, Pennine, had reached its maximum size of $12 billion (B Ev w 277 - 278). Grampian later replaced Pennine. Grampian sought to fund its investments by raising funds on the wholesale markets, notably in commercial paper. After the beginning of the financial crisis, in common with many other similar vehicles, Grampian became unable to fund itself from third party sources at acceptable rates and was forced to rely on the Group (HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 67). Back

327   HBOS, 2007 Annual Report and Accounts: Delivering our strategy..., p 63 Back

328   B Ev w 232 Back

329   BQ 590 Back

330   B Ev w 302 Back

331   BQq 270-271 Back

332   HBOS, 2008 Annual Report and Accounts, pp 11, 44 Back

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Prepared 5 April 2013