$Stock*Shop*Charts*News*Option$

[Tuff-Stuff]

Sub-prime disaster sours HSBC's Eastern promise
Last Updated: 12:24am GMT 02/03/2008Page 1 of 2

The British bank's loss-making American sub-prime portfolio is affecting its global performance and worrying investors, say Katherine Griffiths and Philip Aldrick

When HSBC alerted the world to problems in its subprime mortgage business in the United States in late November 2006, it was the first admission by a major bank that it had been stung by bad loans to lower income customers. Investors initially punished HSBC, but - as more sub-prime problems flowed from other major lenders in the US - the British bank was given grudging respect for being upfront about its difficulties.

The latest news and analysis from the banking sector
HSBC to hike dividend as crunch bites advertisement
As HSBC admitted that the picture was deteriorating and it had to issue its first ever profit warning in February last year, Mike Geoghegan, the bank's straight-talking chief executive, attempted to reassure investors by taking personal responsibility, saying: "I'm in the engine room driving the ship."

Geoghegan was careful to stress that sorting out the problems at the business, rebranded HSBC Finance from its original name of Household International, would take two or three years to sort out.

HSBC's shares have been the best performer among UK banks after Standard Chartered in the past year, with both benefiting from an explosion of growth in Asia.

However, the upbeat picture from the East at HSBC's results tomorrow is likely to be overshadowed by more grim findings in the West, centring on its US sub-prime portfolio.

Analysts are pencilling in a loss of more than $1bn (£503m) for just the three months to December????31 from HSBC Finance. They expect the bad debts to have spread from the most toxic areas, such as broker-originated business and mortgages known as "second lien " - which are taken out on top of an initial home loan and are the first to be hit if the house price falls - into more mainstream areas of subprime.

Abigail Webb, at Citigroup, said: "HSBC was ahead of the curve taking provisions. The question now is not whether they have to take further provisions, but how much. Loans are getting written off a lot quicker than they thought they would."

Investors are becoming impatient. Knight Vinke, the activist investor, built up a stake in HSBC last year and has been noisily pressing for change. It has a long list of criticisms, but top of its list is HSBC's huge exposure to sub-prime. HSBC Finance has a $180bn loan book and is among America's top 10 sub-prime lenders. In the five years since HSBC bought the business it has, at times, been a top three player.

Knight Vinke called on the bank in May 2007 to sell HSBC Finance and maintains that, had it done so at the time, it could have found a buyer and even netted a profit. Now anyone who wants to get rid of a sub-prime mortgage book would probably need to pay the buyer to take it off their hands.

One institutional shareholder says: "The Household deal falls into the category of deals everyone wishes hadn't been done. Had HSBC not bought Household, their share price would be a pound higher or so. The management realises this."

The shareholder is supportive of HSBC's management, but adds: "The board now has very little margin for error."

It was a different picture a few years ago. When Sir John Bond, HSBC's former executive chairman, announced in November 2002 that the bank was going to buy the Illinois-based Household, the market initially reacted with horror. The business was entirely in sub-prime loans, and had recently paid a $484m fine for predatory lending.

Bond assured the City that HSBC would impose its ethical standards. He added that buying a huge loans business that targeted poor Americans did not add to the bank's risk because it had an army of people with PhDs who were experts in "the actuarial likelihood of how people are going to behave".

Once investors had got used to the idea that HSBC - which positioned its brand as a quality bank, had suddenly become a large player in sub-prime - they came round. This was especially the case when the $15bn acquisition started to bring billions of dollars in annual profits. At the time the deal looked like it had been "a steal", Mike Trippitt, of Oriel Securities, said, and Bond was feted.

Stephen Green, successor to the enigmatic Bond, is in a far less comfortable position. It has turned out that the PhDs were not able to predict the danger areas, which has forced HSBC into having to write off billions of dollars of bad loans and for lost goodwill from the business.
Page 2

The bank has also had to pump cash into the US business and bring in new leadership, after making the embarrassing admission that its management in London had not realised that some parts of the US operation were being run in a rash way, driven by brokers who regar-ded commissions as their incentive.

Unable to sell the sub-prime business, HSBC is trying to cut its losses. It has quietly put its $40bn broker-led business, Mortgage Services, into run-off. Some would like HSBC to go further and to ring-fence the business in an attempt to further contain its losses.

HSBC would not comment on its plans, but it may try to come up with a structure to put a lid more firmly on its sub-prime exposure, which it could present at its annual shareholder meeting in May.

Some believe the bank has been punished too much over sub-prime. HSBC's market capitalisation of £91bn implies that the market is taking a negative value of £18bn for HSBC Finance, analysts believe. One says: "That implies HSBC Finance is never going to make money. I do not believe that is true. I think it will recover in a couple of years and then HSBC can sell it."

Supporters of HSBC believe there should be more focus on the fact that HSBC has had only a limited exposure to exotic investments such as special investment vehicles. They also fear that, because it is under attack from Knight Vinke, it might not repeat what it has done historically at difficult times in the economic cycle: pick up assets on the cheap.

Household was bought when it was in distress. In an early example of the wholesale funding problems that banks are now experiencing, Household was running out of cash and could not find new financial lifelines from institutional investors. It may not be the best example of the bank's bottom-fishing. But HSBC also bought its Mexican business, Bital, in 2002 in what is seen as a successful deal. HSBC also snapped up Losango, in Brazil, and Demir, in Turkey, during difficult times.

Alastair Ryan, at UBS, argues that HSBC's management also deserves praise for building up huge retail deposit bases. As well as having the largest share of its historic home market in Hong Kong, which is rapidly growing, "HSBC has built up a retail and small-business deposit base in other countries, which is unrivalled by any other bank", Ryan says.

The frustration of Knight Vinke, as well as other investors who prefer to remain below the radar for now, is that HSBC has had to plough a lot of its capital strength from its deposit base into propping up its sub-prime business, rather than fuelling growth in Asia at a time when the bank's businesses in the region have seen their best growth in a decade.

HSBC's Asian arm contributes 40per cent of the bank's earnings and management has said it wants to lift that figure up to 50 per cent.

There are questions over whether HSBC should not only get out of the US, but also other countries where it has presence, but lacks dominance. HSBC said on Friday that it is in exclusive talks to sell its regional branches in France for a possible €2bn to a local player, in what would be its biggest ever divestment of a business. It has said that other non-core businesses could be on the block.

However, some believe HSBC is at risk of going too far. One investor says: "The shares have fallen since January because of fears that there will be contagion from the US to Asia on sub-prime. But diversity is their advantage. You expect HSBC to outperform during a downturn and over the past year they have."

There remains a view that, as well as making some changes to its business, HSBC has got to shake up its culture. Often likened to a pseudo civil service, HSBC - the UK's largest bank - has historically had unusual practices such as having two possible candidates ready to replace any senior individual. The bank has got to admit more fresh blood from outside, shareholders and analysts believe.

Green is seen as other-worldly, but is gradually changing the board to include more independent directors. It is hoped that this should mean that, whatever strategic decisions HSBC makes in the future, they will be more robustly challenged by the board.


http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/02/cchsbc102.xml&page=2
Previous page12