Annex 3: The Treasury Division
Introduction
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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