The Bank – now for the back story: HBOS’s toxic bonds

And there always is a back story. Suddenly we’re hearing about types of mortgage that have not been mentioned before. These are crafty little earners called ‘Alternative-A’ (or ‘Alt-A’) mortgage bonds. They represent debts secured against mortgages regarded as less safe than prime mortgages and issued without the range of checks prime mortgages have to satisfy. This puts them in between the low risk of prime mortgages and the high risk of sub-prime mortgages. So why should they be seen as so very toxic in the current situation?

There are two reasons for this. One is nothing to do with HBOS specifically. These mortgage bonds are known in the USA as ‘liar loans’. They don’t require borrowers to provide proof of income so those desperate to secure a loan can exaggerate to improve their chances. This may get them the loan they want but when the initial low interest rates set to attract them rise to market levels, they struggle with repayments. And this scenario does not even take general interest rate rises into consideration.

Defaults in Alt-A mortgages have quadrupled in he last twelve months – to a level five times higher than the default on prime mortgages. While sub-prime mortgages show a rather higher default rate, they represent half of the outstanding Alt-A mortgages which, by volume, are therefore far more dangerous.

The second reason Alt-As are seen as hugely dangerous has everything to do with HBOS. The bank has an exposure to Alt-A mortgage bonds of £6.6 billion, against its exposure to sub-prime mortgage bonds of just £90 million and a quite modest exposure of £2 billion to the safer prime mortgages. This is why shareholders were panicking to get out.

It has also emerged that HBOS has only written down its Alt-A bonds by 20% where the Royal Bank of Scotland (RBS) has written theirs down by 50%. What’s more, the now defunct Lehman Brothers bank had a 71% write-down on their Alt-A bonds – tellingly a more severe write down than they imposed on their sub-prime securities.

Maybe all of this explains why, when the Lloyds TSB takeover talks were leaked, a leading financial figure sent out to calm the horses was challenged by Kay Burley of Sky News with the proposition that ‘there’s no equity in HBOS’. His response was worrying. Flustered, he could only say he couldn’t agree with her on that.

You wonder why the loss of Barings Bank in 1995 with an £827 million loss from the unfortunate Nick Leeson’s gambling on futures was such a very big deal. It seems very pale beer these days.