Lloyds Buys HBOS: Good Deal or Bad?

It is fascinating to see HBOS be acquired by Lloyds (LYG), which is only half its size! In my humble opinion, the British government might have played a key role in this deal to avoid another Northern Rock (NHRKF.PK)-like nationalization. However, I'm not sure whether this is a smart move or not.

• Lloyds has total assets of £367.8 billion and net tangible equity of £8.54 billion. Leverage of 43 to 1.
• HBOS has total assets of £681.4 billion and net tangible equity of £18.32 billion. Leverage of 37 to 1.

These two institutions are as leveraged as one can be. How much can a much-leveraged, yet smaller bank help a larger one, i.e. can Lloyds "rescue" HBOS?

Interestingly, when Lehman (LEH) filed for Chapter 11, it had a leverage of 32 to 1. And, Bear Stearns (BSC) had a leverage of 33 to 1 when it was bailed out by JPMorgan Chase (JPM). Even Morgan Stanley (MS) with 25 to 1 leverage is potentially merging or selling to Wachovia (WB) or another willing buyer.

The Lloyds-HBOS deal doesn't look like a good deal to me. It might solve a temporary liquidity crisis for HBOS, but if residential mortgage defaults start climbing, which I believe they will, then, Mr. Gordon Brown, might have to think about bailing out Lloyds-HBOS at some later date ...

If HBOS needed a bailout, it would need a larger, better capitalized bank, i.e HSBC (HBC). Of course, the government is worried about monopoly, etc., etc. Unless government wants to nationalize HBOS, it really should have let bigger banks like HBSC step in. Bear Stearns was successfully taken over by JPMorgan Chase as JPMorgan is significantly bigger and has a "fortress balance sheet".

Any thoughts?

Disclosure: No position in any of the above mentioned banks

Comments

[Rohit Joshi:]

The problem here isn't the leverage. The problem is the confidence in the leverage! Clearly market had list confidence in HBOS' assets (its risque' mortgageportfolio). And once the wholesale market paniced and media picked it up, it was only a matter of hours that the retail depositors would start panicing. A bank facing a classic "run" cannot be saved.

Hence the government had to prempt this by forcing a merger not so much to lend support to the balance sheet but more to lend support to the brand name. This done it has extended its lending window till January to accept all sorts of (dodgy) mortgages. Thus wholesale funding is still available. The move was primarily to stem the tide and retain the much larger retail source of funds.

Thoughts?

2008 Sep 18 10:47 AM

[Rohit Joshi:]

The problem here isn't the leverage. The problem is the confidence in the leverage! Clearly market had lost confidence in HBOS' assets (its risqué' mortgage portfolio). And once the wholesale market panicked and media picked it up, it was only a matter of hours that the retail depositors would start panicking. A bank facing a classic "run" cannot be saved.

Hence the government had to prempt this by forcing a merger not so much to lend support to the balance sheet but more to lend support to the brand name. This done it has extended its lending window till January to accept all sorts of (dodgy) mortgages. Thus wholesale funding is still available. The move was primarily to stem the tide and retain the much larger retail source of funds.

Thoughts?

2008 Sep 18 10:54 AM

[venividivici:]

I think a lot of this is going on and it is based on the principle that if you tie two lead ballons together then the combined entity will soar. And maybe it will work if they can simply overcome the laws of physics or in this case the laws of accounting.

2008 Sep 18 10:58 AM

[Lilliana:]

LLoyds is getting this merger at a gift price along with the UK Goverment approval. and sanction ( Which they coulnd get with Abbey, that eventually went to Santander/Spain)
Knowledge and Experience is worth far more than obscure numbers on leverage ...Lloyds has been in finance and banking for about 261 years and in our opinion, knows what it is doing when it merges with HBOS
Lloyds are pros and know exactly what is going on in the market and the world.
It is strongly stated that a large China bank is taking a heavy stake in Lloyds...what a combination , ....onwards and upwards.....
Alpha.....Call back in two years on the value of Lloyds.

2008 Sep 18 12:37 PM

[Nick Hill:]

The lead balloons analogy is wide of the mark.Think of both banks as being hot air balloons carrying too much sand. With the deal they can dump a lot of sand (ie people/branches/costs) without complaint from the authoriies. The end result might still be a crash, but of the options available it was the best one for both. The idea that HSBC might buy HBOS just because it is big and could afford it doesnt stack up.

2008 Sep 18 12:40 PM

[Jeff Cross:]

The leverage ratios presented in the article are not comparable to US accounting. They include all off balance sheet financing, which US firms do not if (as is the case for LYG) they do not include residual risk for the firms. Taking out the on balance sheet securitizations for LYG (which do include some counter party risk, which, I understand, the UK government has now quietly assumed for both banks if the deal closes - this may not be the actual fact, it's not officially disclosed) and making a few other comparability adjustments the LYG tangible leverage ratio is about 12 to 1 (similar to JPM on the same basis). I don't know what the US comparable ratio is for HBOS (LN) but it's a lot less than 37. We should also note that on a common shareholder tangible equity basis the exchange ratio works out to LYG paying 39 cents on the dollar for HBOS's tangible equity (this is based on equating LYG and HBOS tangible equity). We should contrast this 0.39 ratio to banks normally trading at 2 to 5 times tangible common equity (though we see a number of banks trading below 1.0 today in the US). It might also be worth noting that both these banks were profitable in the first half even after write downs and mark to market charges, unlike the bulk of US banks.

2008 Sep 18 12:57 PM

[E Nuff Sed:]

Jeff Cross is correct that UK and US banks are not directly comparable. UK is a oligopolist market, where a few super banks dominate the market. LYG with its strong deposit base will balance out HBOS's exposure to the whole sale market.

Lloyd's CEO Eric Daniels said that immediately after the deal — which is expected to complete early next year the bank would have core tier 1 capital ratio, the measure most used by analysts for balance sheet strength, of 5.9%. That is marginally below its target of a ratio of between 6% and 7%, and less than the 6.2% it reported at the halfyear stage. At its half-year stage HBOS's core tier 1 ratio was even better at 6.5%.

LYG is cutting its dividend to preserve capital ratio's but if the UK housing market continues to plummet it may be forced to raise more capital at below book value.

2008 Sep 27 03:11 PM

[E Nuff Sed:]

The merged bank will be Britain's biggest mortgage lender and current account provider with a near-30% market share in both. It will be the largest life assurer, too. The pricing power this gives CEO Eric Daniels' new behemoth is quite extraordinary. I can't think of any other bank in any other major industrial economy holding such a large market share. I think if the markets do not go to hell in a hand basket LYG ADR's could be a triple to ($60) while the down side (assuming dilution) is probably $10. Best is to hold for now and see how the next few months play out.

2008 Sep 27 06:19 PM

[Menachem Be...:]

We now know the truth about the merger. And that management was not honest when it reported results only six weeks ago. Lloyds common shareholders will receive NO DIVIDENDS FOR AT LEAST 5 YEARS!!!
Maybe longer. The UK government however gets a 12% p.a. dividend on its " preference " shares.
THE MERGER IS A DISASTER. SHAREHOLDERS MUST VOTE NO!!!!!

2008 Oct 13 10:54 AM