Lloyds TSB ratings placed on negative watch by S&P

Standard & Poor's Ratings Services said that it placed its 'AA-/A-1+' long- and short-term counterparty credit ratings on Lloyds TSB Group PLC (Lloyds TSB) on CreditWatch with negative implications. At the same time, Standard & Poor's placed its 'AA' long-term counterparty credit rating on its subsidiary Lloyds TSB Bank PLC on CreditWatch with negative implications. Furthermore, the 'A-1+' short-term counterparty credit rating on Lloyds TSB Bank PLC was affirmed.
In addition, Standard & Poor's placed its 'A+/A-1' long- and short-term counterparty credit ratings on HBOS PLC, its 'AA-/A-1+' long- and short-term counterparty credit ratings on related entity Bank of Scotland PLC, and ratings on other wholly owned related entities on CreditWatch with developing implications. (For more information on the various insurance subsidiaries of the two groups, see "U.K.-Based Scottish Widows, Clerical Medical On Watch Dev; St. James's Place Outlook To Dev," published on Sept. 18, 2008, on RatingsDirect.)
At the same time, the outlook on HBOS' main Australian subsidiary Bank of Western Australia Ltd. was revised to developing from stable. In addition, the 'A+/A-1' long- and short-term counterparty credit ratings were affirmed.
We had previously downgraded HBOS PLC on Tuesday Sept. 16, 2008, citing concerns over its financial profile.
"These rating actions follow today's announcement of Lloyds TSB's agreed acquisition of HBOS. The CreditWatch placement on Lloyds TSB reflects our view that the transaction, although highly attractive in terms of market position, could lead to increased financial risks in the short to medium term," said Standard & Poor's credit analyst Nick Hill.
The offer is an all-share bid and values HBOS at approximately £12 billion, compared with Lloyds TSB's current market capitalization of approximately £16 billion. The merger announcement follows this week's dramatic movements in bank share prices and credit default swap spreads, affecting HBOS in particular. This led to intense speculation about its ability to fund itself, which threatened to become self fulfilling, and reportedly prompted political intervention to prevent the situation putting a strain on broader financial stability.
We view the proposed combination of Lloyds TSB and HBOS as offering considerable attractions from the point of view of the merged group's business position. In particular, the combined market shares in mortgages, retail deposits, current accounts, consumer credit, business banking, general insurance, and life insurance will provide the new group with a dominant position in financial services in the U.K., with shares of between one-quarter and one-third in most of these key products. Moreover, the combined branch network will comfortably be the nation's largest. Such a transaction would therefore normally be referred to the competition authorities, and indeed Lloyds TSB's proposed merger with the smaller Abbey National PLC (AA/Stable/A-1+) in 2001 was blocked on these grounds. In the current extraordinary environment, however, the U.K. government has proposed to wave such competition concerns in the interests of financial stability. The merger would also offer the potential for considerable in-market cost savings, which are likely to more than offset some attrition of revenue resulting from the overlapping businesses. Lloyds TSB estimates cost synergies at more than £1 billion by 2011, equivalent to over 10% of the combined cost base.
Set against this, we see some likely weakening in the group's financial position. We see Lloyds TSB's existing bank capital position as relatively weak on our measures, and pro forma capitalization is unlikely to be a rating strength. On a regulatory basis, the combined pro forma equity Tier 1 ratio would be 5.9%, weaker than either bank's current ratio. This is due to the crystallization of fair-value losses on various securities held in HBOS' conduits and treasury. Under available-for-sale accounting, the reductions in fair value on such assets are currently reversed under regulatory capital calculations, as well as Standard & Poor's own measures. Such capital dilution is likely to be partially offset by the intention to pay the final 2008 dividend in shares, and the future rebasing of the dividend payout ratio will aid capital retention and progression toward a 6%-7% core Tier 1 target ratio. Certain asset disposals could also provide additional capital, but are yet to be determined and are unlikely to be achievable in the short term given market conditions.
We also see Lloyds TSB's currently relatively strong asset quality as being diluted by HBOS' much larger balance sheet. In particular, we see additional risks stemming from HBOS' less favorable mortgage loan-to-value profile, higher exposure to weaker specialist borrowers, and its corporate investment portfolio–all areas where we see Lloyds TSB's existing stand-alone position as less vulnerable. Thus a portion of the combined U.K. mortgage book–a huge £345 billion–remains at risk from negative equity.
The challenge of reducing HBOS' wholesale funding requirement and lengthening its term profile–while more manageable in the context of the combined group–will remain considerable in the current environment. A pro forma loan-to-deposit ratio of about 160% is still higher than some peers, although combined short-term liquid assets of £80 billion together with substantial capacity to tap the Bank of England's (AAA/Stable/A-1+) Special Liquidity Scheme substantially mitigate funding risk, in our view.
While the combined group should be more diverse than either the existing Lloyds TSB or HBOS, the similarity in business models between the two organizations and geographic focus on the U.K. means the marginal benefit in terms of business mix is low.
Finally, the merger of such large and overlapping institutions introduces a material new element of risk in the integration of the institutions.
"We will resolve the CreditWatch placement on Lloyds TSB upon completion of the acquisition, which is expected to be in late 2008 or early 2009. Before then, we will meet Lloyds TSB's management to discuss in further detail its integration plan and the capital, funding, and asset quality prospects for the enlarged group. We will also discuss plans for business disposals and the role of certain rated subsidiaries within the enlarged group. If the ratings on Lloyds TSB are lowered upon completion, we do not currently expect it to be by more than one notch," added Mr. Hill.
The CreditWatch developing placement on HBOS reflects the possibility that the transaction may not proceed and if this unlikely scenario came to pass, we would then review whether the existing ratings on HBOS remain appropriate, in particular if there is renewed uncertainty over its funding position.
The developing outlook on HBOS' main Australian subsidiary, Bank of Western Australia Ltd. reflects the potential for a change in support or ownership resulting from the merger, which we do not expect to be resolved within the CreditWatch timeframe.