British Banks Face Two Problems

Exposure to toxic U.S. subprime debt coupled with pressure from Britain's own real estate downturn spells trouble for British banks

Every day brings more bad news about the global financial-services sector. It's no surprise, then, that market watchers are waiting with bated breath for Britain's largest banks to announce their 2007 results over the next two weeks. The country's top five institutions—HSBC (HBC), Royal Bank of Scotland (RBS), Halifax Bank of Scotland (HBOS.L), Barclays (BCS), and Lloyds TSB (LYG)—all are in the firing line as investors fear additional subprime-related writedowns that could further weaken balance sheets and depress share prices.

The outlook isn't encouraging. For Britain's globe-straddling money center banks, such as HSBC and RBS, further losses from complex securitized products are expected across the board. At the same time, more domestically oriented banks such as Lloyds TSB and HBOS are feeling pressure from a deteriorating British real estate market and worsening consumer debt that could squeeze them just as forecasts predict an economic downturn.

Earnings Season Reveals Subprime Losses

Barclays kicked off earnings season Feb. 19, announcing $3.1 billion in writedowns. But investors were relieved the damage wasn't worse, and the bank's pretax profits of $7.08 billion, though down slightly, were in line with the market's subdued expectations.

Other losses tied to the subprime mess are likely to follow. "This is definitely the end of the beginning, not the beginning of the end [for bank writedowns]," says Pete Hahn, fellow at City University's Cass Business School and a former managing director at Citigroup (C). "We're entering an undefined time where holes in the financial infrastructure are becoming visible."

HSBC, which unveils its 2007 results on Mar. 3, is expected to post losses of more than $1 billion related to exposure to U.S. subprime assets. That may pale in comparison to the cumulative $18 billion in writedowns announced Jan. 30 (, 1/30/08) by Swiss giant UBS (UBS), but underlying problems could still hit HSBC in the long run.

According to London-based securities firm NCB, 31% of HSBC's global loan book is focused on U.S. residential mortgages and corporate finance. With these sectors already coming under significant pressure, the analysts say in a report that further problems could "pose a meaningful threat to substantial losses."

RBS, too, faces significant exposure. Banking analysts at Credit Suisse (CS), for example, reckon RBS has a combined $31.3 billion in its collateralized debt obligation (CDO) and leveraged finance portfolios, but only 3% of the value has been written down so far, so there may be more to come.

Ironically, RBS's hard-won battle to take over Dutch bank ABN Amro (ABN) may have exacerbated its exposure to U.S. securitized financial products. In a December trading update, the Edinburgh-based bank, which announces its 2007 results on Feb. 28, said it was taking a $587 million loss from the newly acquired ABN assets on top of its own $1.8 billion writedown. Now analysts expect further losses, particularly from a downturn in commercial real estate mortgages that constituted 6% of the bank's pretax profits in 2006.

To be sure, such problems aren't limited to British banks. On Feb. 20, France's BNP Paribas (BNPP.PA) wrote down $1.3 billion in subprime losses on a 32% drop in fourth-quarter, pretax profits, to $2.3 billion. Rival Société Générale (SOGN.PA) on Feb. 21 reported $3.8 billion in subprime losses, which, when added to the $7.1 billion in writedowns from rogue trader Jérôme Kerviel (, 2/21/08), resulted in a $4.9 billion net loss for the fourth quarter of 2007.

Domestic Liabilities

Britain's more domestically focused banks, such as HBOS and Lloyds TSB, face a different set of concerns. While they have far less exposure to U.S. subprime assets, they face homegrown concerns over stagnating real estate and levels of consumer debt at all-time highs. Indeed, on Feb. 20, British mortgage lender Alliance & Leicester (ALLL.L) shocked the market with a 29% annual profit decline and downbeat 2008 outlook (, 2/20/08), prompting a nearly 7% swoon in its already battered stock.

According to analysts at JPMorgan Chase (JPM), HBOS, which announces its 2007 results on Feb. 27 and already unveiled writedowns of $352 million, is particularly exposed to British commercial real estate. Property prices fell 12% in 2007 and are expected to drop a further 15% this year. That will have a significant impact on the bank, as more than 42% of its corporate loan book is dedicated to the construction and property sectors.

As for Lloyds TSB, which reports its 2007 results on Feb. 22, limited exposure to toxic securitized assets is offset by a significant presence in the real estate and unsecured lending markets that could leave the bank vulnerable if Britain's economic growth trails off. Credit Suisse analysts reckon, though, that Lloyds' strong revenue growth from corporate lending—estimated to have increased 16% year-over-year in 2007—will help the bank see off the worst of the current financial instability.

With each bank facing different but interrelated problems, the key question is how any further losses will affect their overall 2007 results. Estimates vary, but the consensus shows Britain's top five institutions matching or slightly underperforming last year's earnings. Strong performance in the first half of 2007, as well as continued lending to the corporate sector may carry the day over second-half losses in riskier investments.

Yet as the financial markets gear up for further bloodletting, the prospects for British banks are anything but rosy. For jittery investors, the upcoming results announcements will offer a glimpse at how bad things could get.

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