Free Hubris: How HBOS Wrecked the Best Bank in Britain by Ray Perman, Alistair Darling Page B

the risk of running out of cash. If there was a shortfall in customer deposits,
Treasury had to make up the deficiency as cheaply and effectively as possible by borrowing on the wholesale market. It also bought and sold currencies on behalf of the Bank’s customers. What
it was not there to do was take unnecessary risks – which the Bank’s board regarded as gambling – even if this meant it might miss out on profitable opportunities.
    There was one fashion, however, which it did not shun. The Bank’s entry into the mortgage market at the end of the 1970s had been a great success. There was an increasing demand from
couples to own their own homes and the Conservative Government, headed by Margaret Thatcher, encouraged the trend and offered a tax incentive which made mortgage interest payments more attractive
than paying rent. By 1984 home loans made up 10 per cent of the Bank’s lending 3 and its advertising campaigns were producing more leads
than it could handle. This was low-risk business. Borrowers knew that they could lose their homes if they failed to meet the repayments and would tighten their belts elsewhere rather than default
on the monthly mortgage. The Bank carefully screened applicants to satisfy itself that they had steady incomes and could meet the repayments even if the economy turned down. It also took security
over the house, or over an endowment life assurance policy. Besides the loan, there were other gains for the Bank: it insisted that mortgage customers open a currentaccount
to channel their monthly payments and tried to sell them insurance, on which it earned a commission. The loans themselves were very profitable: the Bank not only charged a premium on the interest
rate, but a set-up and administration fee as well. The problem was that home lending was growing much faster than the Bank could attract deposits. It wanted to do more, but how was it to find the
money to lend?
    The answer was to sell the loans on to someone else, a process now known as ‘securitisation’. The Bank formed syndicates with other banks and they parcelled up thousands of mortgages
together. They now represented a very large amount of lending, which was being repaid in regular and predictable instalments. The risk was low, partly because the Bank had taken care to vet the
borrowers, but also partly because of the diversification effect of this huge portfolio which was spread over different parts of the UK, different ages and types of homes and borrowers, whose
occupations and incomes were different. It was very unlikely that many of them would default at the same time. These packaged mortgages could be sold to life assurance and pension companies which
had cash to invest and needed predictable, reliable incomes to meet monthly pension payments.
    The Bank kept the fees it had charged to borrowers and took a small share of the interest payments to cover the cost of continuing to administer the loans, collect the repayments and process any
early redemption of loans when borrowers moved house. It also kept the risk and undertook to buy back any outstanding loans at the end of seven years.
    Borrowers were oblivious to any of this. As far as they were concerned, their loans were with Bank of Scotland, to whom they continued to make their repayments and to whom they addressed any
queries. But with the money it received from selling the mortgages, the Bank was able to make new loans, collecting set-up fees and a margin on the interest payments each time. As long as the
demand was there it could carry on doing this indefinitely.
    Had he been able to see 300 years into the future, William Paterson would have approved; this was near to his ideal of a bank benefiting from interest on money it was creating out of nothing.
Some of the Bank’s board, however, did not approve.
    ‘Who were these mortgages being passed on to and what responsibility did we have?’ one director remembers wondering. ‘We askedthese