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will help firm up the in-scope value on which the where there are potentially circa 50-60 branches within ......
Treasury Select Committee - Project Verde Advisory work carried out by KPMG, JP Morgan and Deloitte - Document Index 18 November 2013 Date 18/09/2008 05/11/2008 18/12/2008 23/12/2008 23/12/2008 July 2009 19/01/2009 12/11/2008 12/11/2008 19/01/2009 20/01/2009 06/01/2009
Document Description Page number KPMG - Engagement letter KPMG - 'Project Vintage - Synergy assessment report' KPMG - 'Project Vintage - Draft due diligence report' KPMG - 'Project Vintage - Capital projections report' KPMG - 'Project Vintage - Fair value adjustments: accounting, tax and capital implications' KPMG - 'Project Vintage phase II - Fair value adjustments & Accounting policy alignment review' JP Morgan - Engagement letter JP Morgan - 'Project Vintage - Approach to valuation and terms' JP Morgan - 'Project Vintage - Implications for dividend' JP Morgan - Fairness opinion JP Morgan - Project Vintage Board paper Deloitte - 'Project Vintage - Final report to Co-operative Financial Services Limited' (includes engagement letter)
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Project Vintage Synergy Assessment Report 5 November 2008 ADVISORY
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KPMG LLP Financial Services Advisory One, Canada Square 8th Floor Canary Wharf London E14 5AG
Tel +44 (0) 7711 448778 Fax +44 (0) 207 311 5882
Private & Confidential Mr D. Parkhouse Managing Director Retail Division Cooperative Financial Services Miller Street Manchester M60 0AL
In addition to the executive summary, this report is structured around three sections which provide our assessment of: 1. The financial model used to calculate the synergies 2. Cost synergies 3. Revenue Synergies.
Mr M. Ellison Group Head of Strategy & Planning Britannia Building Society Britannia House Cheadle Road Leek Staffordshire ST13 5RG
This update is confidential and is released to you on the basis that it is not to be copied, referred to or disclosed, in whole or in part, without our prior written consent, save as permitted in our Engagement Letter. In accordance with that letter, you may disclose our draft status update to your legal and other professional advisers in order to seek advice in relation to our work for you, provided that when doing so you inform them that, to the fullest extent permitted by law, we accept no responsibility or liability to them in connection with our draft report and our work for you.
5 November 2008
Yours sincerely
Dear Dick and Martin, Project Vintage We have been engaged jointly by Claret and Burgundy to review the synergies and integration costs associated with Project Vintage. This update has been prepared on the basis of fieldwork carried out up to 5 November 2008 and supersedes our previous report dated 27th October 2008. KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative.
Partner KPMG LLP
Registered in England No OC301540 Registered office: 8 Salisbury Square, London EC4Y 8BB
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Scope of work performed from 8 September to 5 November 2008 We have reviewed the work which the joint team from Claret and Burgundy have undertaken to assess the potential cost and revenue synergies. With regard to the cost
synergies V2 has been derived by applying some high level adjustments to reflect feedback received from various sources (including ourselves) on the do ability of individual cost hypotheses which had been used to construct cost synergies in V1 base case. The high level adjustments have yet to be traced back in to the individual cost hypothesis. Hence our report is structured around our review of the individual cost hypothesis in V1 base case and the impact of the high level adjustments. In addition, we have completed our review of V2 revenue synergies and potential dis-synergies. The joint team have looked at circa. 45 cost synergies in V1 and circa. 8 revenue synergies. We have assessed each individual synergy against appropriate benchmarks
and our experience of other situations and classified each as being either: undemanding, achievable or challenging in nature with regard to the realising the stated value in year 5 and the profile over which the benefits are phased over time. Areas where we have performed further work since our draft of 27 October 2008 Review and testing of underlying cost modelling and the reconciliation of in-scope costs to the 2008 budget data Update of the transparency and accuracy of cost assumptions following receipt of an updated assumptions paper Update of revenue synergies including clarification of the current levels of profitability of core banking, savings and mortgage products Review of the negative impact of price harmonisation on revenue synergies Update to Executive summary to reflect key findings resulting.
Limitations of scope We draw your attention to the significant limitations in the scope of our work. We have conducted our work off site from the premises of Claret or Burgundy with a
significant proportion of our review being conducted as a desk based review based on specified documents on a data site and weekly meetings with the joint team. Supporting work papers have not been available in all instances and we have asked and received verbal clarification on many points. We have not physically checked the information and verbal clarification we have received to underlying data and Management Information which we would expect to exist within each organisation. These restrictions have had a corresponding impact on the nature of comments we have been able to make on the financial information available We have not yet had access to information in respect of certain key areas and accordingly are unable to express a view on these areas: −
Potential revenue synergies or dis-synergies associated with Insurance manufacturing
−
Capital which is available and required to support revenue cross sales synergies
−
Implementation costs fro the integration: we have seen some provisional information and discussed this in an initial meeting on 3 November but are aware that this data is currently being reviewed by management and it will be released to us for review in the near future
Synergies are calculated by reference to changes in the performance over a five year period against the respective 2008 Budgets line items for Claret and Burgundy. We
have not reviewed the construction of these budgets but have not assessed the potential impact of either (a) adverse actual trading performance (cost and revenue) against the 2008 Budget or (b) any adjustments which should be reforecast in to the Budgets as a result of the recent significant changes in the economic environment. Overall, there is clearly a risk of synergies being overstated in later years if the underlying 2008 Budgets and projections for Claret and Burgundy are materially out of line from when they were produced We do not accept responsibility for such information which remains the responsibility of management. We have satisfied ourselves, so far as possible, that the
information presented in our report is consistent with other information which was made available to us in the course of our work in accordance with the terms of our engagement letter. We have not, however, sought to establish the reliability of the sources by reference to other evidence This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents The contacts at KPMG in connection with this report are: Michael Robinson Financial Services Advisory Partner, KPMG LLP London Tel: +44 (0) 7711 448778 Fax: +44 (0) 207 311 5882
[email protected]
Executive summary Cost model review Reconciliation to 2008 budget
Keith Cowley Financial Services Advisory Senior Manager, KPMG LLP London
Review of in-scope costs
Tel: +44 (0) 7917 174047 Fax: +44 (0) 207 311 5882
Cost synergies
Review of ratio of costs
[email protected]
V1 base case overview V1 base case V2 low case IS cost synergies
Revenue synergies Revenue synergy values and risks Cross sell volumes Margin dis-synergy
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Executive summary
Our review has been based on two sets of information: −
V1 base case: 1 October 2008 subsequently updated on 29 October 2008. Note : updated figures have been used below and in the reconciliation
−
V2 low case: 27 October 2008. This case is lower in early years but higher in later years principally due to management reducing the profile of benefits profile for many of the cost saving hypothesis which we would classify as demanding in V1 plus the inclusion of £10m synergies which are attributable to IS but where not included V1
In our view we believe that the £61m of cost synergies in V1 are undemanding in aggregate. However, 69% of these savings are attributable to a reduction in Head Office functions which relates to a reduction of 24% of the related in scope. This contrasts with the relatively undemanding level of reduction in processing and customer which are targeting only 3-4% reduction of in-scope costs
The V2 low case incorporates much of our and other stakeholders’ feedback on V1 and seeks to de-risk synergies in years 1 and 2 which are lower and the balance of synergies is now less weighted towards head office in year 5 (i.e. 50% of overall value). We see opportunities (e.g. within the channels and savings operations) which could be set at the start of integration planning which could help further reduce the overall mix of the source of cost synergies from being heavily attributable to Head Office.
Movement of in-scope cost base V1 Base Case (£m)
25%
Head office
696
Total synergies
V2 Low Case (£m) 696
9%
176
24%
Year 5 (£m)
NB: Not same scale
% reduction
% reduction
10%
635
Increase / decrease £m
626 176
20%
134
+9
141
38%
36%
Processing
100%
266
Customer
Overall mix and nature of value created from cost synergies relative to in-scope cost base
254
70
35 3%
266
9%
257
100%
61 50%
42
242
-7 69%
Year 5 pre synergy in scope costs
4%
244
Year 5 post synergy V1 £61m
4%
254
Year 5 pre synergy in scope costs
243
Year 5 Post synergy V2 low £70m
15%
9
16%
10
+1
V1
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34%
11
16%
+15
V2 Low
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Executive summary Review of cost model and underlying data used to calculate cost synergies
The process which was used to develop the financial model to underpin the estimation of cost synergies is based on extracting c.40,000 rows of data from Claret’s and Burgundy’s 2008 Budget data with each row in the model being mapped to a hypothesis for a synergy or being classified as out of scope for the merger of Claret and Burgundy. Due to the size of the manual process which has been undertaken there is some potential risk of error in how the underlying data has been tagged and aggregated to form the in scope cost base
We conducted three tests to test against a risk of material misstatement: 1. A reconciliation of total costs to 2008 budget to in scope costs (to identify reconciling items and their treatment) 2. A review of values and line item descriptions per model to hypotheses (to assess accuracy of mapping) 3. A review of the ratio of Claret to Burgundy costs (to give and indication of completeness and accuracy of costs).
Our principal findings from this review have highlighted:
A reconciliation of hypotheses to the model has been performed. There are reconciling items, many of which relate to the identification of service and support cost from data outside the model. The joint team has done significant work and has produced separate reconciliations of service and support cost but further work is planned either using third party data outside the model (e.g. procurement data) or through detailed analysis of service and support (flag 12) in the model itself. The service and support reconciliation is used to derive an estimate of in-scope costs on which a 10% synergy is assumed. The review will help firm up the in-scope value on which the procurement synergy is based. The value of the synergy is £4m in V1 and £6.8m in V2 (the latter is 10% of cost synergies of c.£70m in V2)
The review of mapping identified instances where costs have been mapped into head office hypotheses which relate to areas that may be considered out of scope (e.g. WMS, Platform for Burgundy, and GI and Life and Savings for Claret). These costs totalled £24.1m in the head office functions reviewed (Finance staff cost, Marketing spend, HR Staff cost, Training all costs). Management from both Claret and Burgundy decided to include these cost items so that cost reduction items in these areas could be realised at the same time as integration synergies. In respect of Finance, Burgundy has confirmed that synergies can be obtained from consolidating WMS, Platform and B finance functions but that this synergy is already assumed in the non-Vintage baseline and accordingly should be treated as out of scope for Vintage. A potential adjustment of c.£0.5m has been identified. With regard to Marketing V2 synergy a decision has been made within the team to reverse out some of the synergies in Year 1-4 to reflect the challenging nature of reducing GI and L&S marketing spend. In Year 5 a benefit (based upon current spend mix) of £3.6m has been included which is attributable to a 20% reduction of the overall GI and L&S marketing spend.
Three hypotheses (footprint, branch premises, leadership) were reviewed which appeared to have show significant differences between the cost respective structures between Claret and Burgundy. In all cases our analysis indicates that Claret costs are materially higher than Burgundy on a per unit basis. There are many valid reasons why this difference may exist however we have not tried to determine the underlying reason e.g. is it due to mapping of costs (e.g. incomplete mapping of Burgundy costs or inclusion of depreciation in Claret property costs) or whether this is a reflection of structural difference between current operations such as Claret Branches are full service centres and senior management in Claret are responsible for managing a broader business and hence this will effect the roles/compensation for senior staff
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Executive summary Cost synergies
Management have set out to estimate the level of cost savings based on identifying a set of potential integration activities which have a low degree of risk and complexity. Subject to any potential inaccuracies arising from the model, the overall cost synergies in V1 of £60.8m in year 5 represent 9% of the in scope 2008 cost base of £696m. In aggregate this level of cost saving is in our opinion undemanding.
Synergies in V1 relating to reduction in staff costs represents approx two thirds of all synergies in year 5 i.e. c£40m and c.800-900 FTE’s
Cost synergies are significantly weighted towards reductions in Head Office cost (£41.7m in year 5 for V1) and this is the key driver of synergies and how value is created in the transaction. These synergies account for approx. two thirds of all cost synergies within the V1 Base case. Overall the cost synergies from Head office represent 24% of the attributable in scope costs and in aggregate are in line with what we would expect from a transaction of this nature. If the deemed in scope cost base is adjusted for the £24.1m of costs which may not relate to directly overlapping cost within Claret and Burgundy (see comment on page 5) then the impact would be that the cost synergies from Head office would represent 28% of the V1 base case in scope cost base and in our opinion this value would start to become demanding for management to realise.
Synergies from Customer processes (Channels and Operations) are £9.8m in year 5 in V1 and represent only 4% of the associated in scope 2008 costs. This is due to a relatively small amounts of people being removed from Branches (50 FTE’s in V1) and minimal reductions in contact centres and operations. These are clearly undemanding as there are opportunities to further rationalise Channels and Operations e.g. close overlapping branches where there are potentially circa 50-60 branches within half a mile
Synergies from reducing costs in the Processing areas of £10.3m in year 5 in V1 equate to only 3% of the associated in scope costs and are undemanding primarily because V1 does not include any estimate for potential synergies being realised from IS where there is circa £100m of in scope costs.
Within V1 there are 7 cost saving hypothesis (totally £18.8m) which we would assess as demanding against appropriate benchmarks. In constructing V2 Cost : Low Case, management have : 1. Significantly lowered the synergies associated with 4 out of the 7 demanding cost hypothesis as these relate to control functions (Credit Risk, Debt
Management, internal Audit and Treasury) which total £3.7 m within V1 Base case to reflect the need for high degree of service/oversight 2. Reduce the benefit attributable from downsizing the Leadership and other staff in year 1 by £11.8m to reflect the overall effort required for
integration and running the business in the initial period post completion 3. Included a £10m (year 5) benefit attributable to rationalising in scope IS costs. Whilst some of the underlying hypothesis to make savings from IS
look challenging, management have only taken in to account for V2 two thirds (i.e. £10m) of their provisional £15m overall target. Like all estimates for IS at the initiation stage of a project these values are subject to a higher degree of uncertainty until detailed design is undertaken
A potential reduction of £2.2m of finance in scope costs has been identified through the review of the model. The current £1.9m target cost saving now equates to 27% of the in scope cost base which together with the fact that this is a control function which will face many demands on its service levels post completion, we would now classify this as demanding, particularly in the early years
In summary, V2 cost synergies management have factored in mitigating actions to ensure that in all but two of the cost savings hypothesis the cost saving values and profile are either undemanding or achievable. The two areas which remain in our view demanding are (1) the £3.8 m attributable to a 40% reduction in Sales support staff and (2) £1.9m saving attributable to a 27% reduction in the Finance Function, after reducing for out of scope cost. Clearly a proportion of these benefits can be readily seen as being achievable in their own right, therefore, there is probably circa. £2-3m (£0.5m Finance, c.£2m Sales support) of cost synergies out of the total of £70m which are potentially demanding to realise with there being a large number of cost saving hypothesis (e.g. channels) which remain undemanding which management could seek to realise compensating level of benefits. This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Executive summary Revenue synergies: cross sell
Revenue dis synergies
Cross sell synergies of £18 m in year 5 have been reviewed against the underlying assumptions for new business volumes, annual attrition rate and average contribution per product −
Volumes appear undemanding with respect to current accounts and credit cards. In particular, consumers value access to a branch network before they purchase a current account. Burgundy’s branch network is more than double the size of Claret’s current branch network and should provide an opportunity to increase penetration of cross selling in to Burgundy customers. The revenue synergies for current accounts represents only a 3% penetration of Burgundy’s customer base in year 5 which is low compared to other mortgage lenders who have introduced competitively priced current accounts
−
Annual attrition rates vary between 15-21% across products which may be low depending on the profile of the term of the products e.g. 2 year versus 5 year mortgages. Overall the aggregate figures appear reasonable
−
Average contribution per product has been derived from Claret’s product profitability models with values for savings and mortgages reduced to be prudent. These values are blended averages over a product life cycle as represented in the strategic plan. We are aware that in the current trading environment these levels of contribution are not being realised by Burgundy. We believe, Management have chosen to evaluate this downside risk in an overlay to the overall business case rather than to factor it in to this particular synergy benefit. In addition, the average contribution for the core banking bundle would benefit from further work to separate out the underlying value for the current account, loan and credit card products e.g. the blended value of circa. £115 is higher than what would normally be attributable to a stand alone current account but dependant on the price and term of a loan this may be representative
There are other potential sources of revenue synergies which have yet to be incorporated e.g. cross-sell of GI Home being the principal one
Management has calculated the potential maximum revenue synergy exposure at c.£40m each year. This covers three product groups that are similar in nature but with different pricing: Instant access (c.£32m), Child accounts and Cash ISAs (c.£10m between the two)
Management however expect to be able to take actions to reduce the revenue dis-synergy down to £8m in year 1, £5m in year 2, £2m in year 3, and 0 in years 4 onwards in respect of Child accounts and Cash ISAs
No provision has been made for the c.£32m margin at risk on instant access products on the basis that a closed book approach will be adopted and because these customers are already being paid a non price leading rate that they will have a low rate of attrition arising from decisions to manage margin. Burgundy have stated that their experience from managing a similar risk in their acquisition of the Bristol & West savings book resulted in a 3% (c.£1m) impact. We understand the above rationale, but still believe in today’s environment where the media has a high degree of interest and ability to inform customers about how banks are managing their margins that there is still a real possibility of further down side risk to that contained in the business case and would recommend that as a minimum this risk is at least factored in an overall overlay of risks and opportunities for the business case.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents The contacts at KPMG in connection with this report are: Michael Robinson Financial Services Advisory Partner, KPMG LLP London Tel: +44 (0) 7711 448778 Fax: +44 (0) 207 311 5882
[email protected]
Executive summary Cost model review Reconciliation to 2008 budget
Keith Cowley Financial Services Advisory Senior Manager, KPMG LLP London
Review of in-scope costs
Tel: +44 (0) 7917 174047 Fax: +44 (0) 207 311 5882
Cost synergies
Review of ratio of costs
[email protected]
V1 base case overview V1 base case V2 low case IS cost synergies
Revenue synergies Revenue synergy values and risks Cross sell volumes Margin dis-synergy
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Cost model review Overview The modeling process has involved mapping Burgundy and Claret data into a common data set. This has then been manually mapped to each hypothesis. Decisions have been made on out of scope items. The process could be
A relatively complex and manual modelling process has been undertaken by the joint team to establish in-scope costs for each cost
hypothesis. This has involved mapping c.40,000 cost categories to either a specific hypotheses or one of the out of scope categories We have identified three principle risks associated with the process, together with tests to assess the level of risk of error
Risk
Test
Outcome
1. That the model does not reflect the underlying costs of the businesses and that costs are not correctly mapped
Reconcile total costs to 2008 budgets, to model, and to in scope costs on hypotheses spreadsheet
See page 10
2. Costs mapped to individual hypotheses are not accurate
Review value and component descriptions to assess accuracy
See page 11
3. Costs mapped to individual hypotheses are not complete
Review ratio of burgundy to claret costs for reasonableness and consistency
See page 12
prone to error so we have reviewed the model from three perspectives
In the 2009 to 2012 projections which have been reflected on the next page we have not assessed the impact of any economic factors
including inflation. We have not reviewed any of the assumptions underpinning the strategic plan projections. If inflation is not included in either of the Burgundy or Claret figures this could have an impact on synergies as these have been currently driven off 2008 (non inflated) combined cost base
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Cost model review Reconciliation to 2008 budget £M
£M
2008 Budget
2009 Plan
2010 Plan
2011 Plan
Total costs
905
Claret
581
603
610
628
624 Latest 2009 strategy plans
Less projects
(70)
Burgundy
250
217
217
217
217 2008 strategy plans
which relate to the
2008 budget
835
Total
831
820
827
827
841
identification of service
Less Burgundy depreciation
(31)
Movement %
-1.3%
-0.5%
1.7
1.2 % inc / Dec on 2008
and support cost from
Per cost model
804
A reconciliation of hypotheses to model has been performed. There are reconciling items many of
data outside the model.
Our of scope: Flag 0
The joint team has done
Net amount in hypotheses not in model:
significant work and has
29b: TE (outsourcing) cost
1.2
34: ATM
1.5
4: Leadership
3.8
continuing to investigate
5: Governance
2.4
further.
7: PR
0.8
8: Membership
0.5
produced reconciliations of service and support cost. The joint team is
The review will help firm
(12.1)
24: Legal
which the procurement
42: Process improvement
1.0
synergy of 10% is based.
10: IS
4.5
26: Sales support
2.0
14.1
17: Footprint
0.4
Net amount in model not in hypotheses:
A meeting is planned on 6
21: Fees
(0.2)
November to investigate further.
Synergies have been driven off 2008 costs not 2009-12 plan
However as plan shows minimal movement this should not be a material problem (note Claret increases, Burgundy decreases)
Burgundy decrease not costed but synergies will be prudent if it is not implemented
Flag 0 adjustments (out of scope)
(61.7)
Staff out of scope
(3.8)
Service and support oos
(4.9)
Occupancy oos
39.3
We understand these costs are principally GI including contact centre
IS recharge add back
The total of these costs is part of the projects costs above
19.0
Change recharge add back
The total of these costs is part of the projects costs above
(12.1)
Total flag 0
Model adjustments have not been verified but are principally to strip out insurance service and support costs
This item requires further work and should be viewed alongside the £63.3m in the V1 model (29/10/08) which equates to the £68m in the V1 model of 01/10/08
Flag 12 service and support adjustments
is £4m in V1 and £6.8m in V2.
Source: Steve Whitehorn
£M
up the in-scope value on
The value of this synergy
2012 Plan
12: Service contracts 33: Payments Other Total per hypotheses
(128.0)
£M (11.6)
GI
(9.5)
GI claims
(9.9)
Investments
(35.4)
Life and savings
(0.8)
(24.0)
Payments
1.1
(37.6)
Not identified
(128.0)
Total flag 12
696.2 Source: 29/10/08 V1 Model, KPMG analysis
Source: Steve Whitehorn, KPMG analysis
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Cost model review Review of value and nature of in scope costs The value of costs shown
The value of in scope costs in the hypotheses spreadsheet was reviewed against the model. In addition the descriptions of components in the model were reviewed for reasonableness against the hypotheses description
in the model matched those on the synergy hypotheses sheet but
Hypotheses number
Description
In scope cost base
Does model output value match hypotheses spreadsheet (yes, no)
Does model description match hypotheses (yes, uncertain, no)
Comments
1
Finance, burgundy, staff cost
£5.1m
Yes
No includes out of scope Platform and WMS
Burgundy costs includes finance costs for out of scope functions which reduce synergy (e.g. WMS £1.2m, Platform £1.0m) by 20% of this amount. Martin Ellison has confirmed that synergies should not be claimed in respect of these values as consolidation of finance functions already part of non-Vintage baseline. Adjustment £0.44m (20% synergy of £2.2m out of scope costs above)
1
Finance, claret, staff costs
£4.1m
Yes
Yes
N/A
6b
Marketing spend
£39.4m
Yes
Yes but includes GI and L&S
Claret cost appears to include £14.5m of GI and £3.1m of L&S marketing. Louise Fowler has indicated that these costs should be in scope but synergy has been toned down in early years of V2 to reflect potentially demanding position. KPMG position adjusted in V2 to Achievable from Undemanding to reflect Management statement
19
HR – Total staff cost
movements were noted between V1 1st and 29th October versions A review of descriptions identified costs for areas thought to be out of scope of £24.1m. We understand that with the exception of Finance, management have made a deliberate policy of leaving these costs in scope so that cost reduction can be pursued in these areas. A pragmatic reduction has been made in Marketing V2 synergies in years 1-4 to reflect the potential
£16.6m V1 01/10/08
No
£15.4m V1 29/10/08
Yes
Yes but includes Platform and WMS
Burgundy costs include c.£1.4m of Platform and WMS which may limit synergies. Management made a deliberate decision to leave in scope. A Burgundy Platform and WMS synergy of c. £0.5m is assumed within the total HR synergy of £5m which is itself relatively undemanding
£16.4m V1 01/10/08
No
Yes but includes GI
£14.7m V1 29/10/08
Yes
Claret costs include £2.9 tagged as GI. Management have made deliberate decision to leave in scope. A GI training synergy of c.£0.5m (15% x £2.9m) is assumed within the total training synergy of £2.5m, which is in itself relatively undemanding.
challenge of achieving these insurance synergies. The reduction in Finance synergy is c.£0.44m
20
Training all costs
reflecting synergies already in Burgundy nonVintage baseline
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Treasury Select Committee - Project Verde
Private & confidential
Cost model review Review of ratio of costs A review of non-branch
The objective is to see whether the ratio of costs between the two enterprises appears reasonable by reference to each other, and detailed data in the model.
occupancy reveals a surprisingly high ratio of 6.7:1 for Claret to Burgundy. The synergy percentage assumed in
Hypotheses number
Description
Burgundy value £m
Claret value £m
17
Footprint non FTE (occupancy non branch)
6.2
41.4
28b
Branch network occupancy
19.6
12.3
1.6
Uncertain
Burgundy has 254 branches (prior to Dec 2008 closures) and Claret has 89, a ratio of 2.85:1 Average cost per branch for Claret is virtually double that of Burgundy (£138k vs £77k)
4
Leadership
10.6
20.2
1.9
Yes
Claret has 152 FTEs vs burgundy 109 FTEs. Average salary of £133k vs £97k probably within tolerance
respect of this hypothesis
Ratio largest to smallest 6.7
Appears reasonable
Comments
Uncertain
Burgundy costs only appear to include Leek Claret costs include £23.6m for “synergy” division – unclear as to what this is and where it should be included
is low and hence corresponding risk is low Similarly Claret costs per branch are twice as high as Burgundy which may indicate a different approach to mapping costs Claret leadership costs are also 30% higher but within reasonable tolerance. We understand that this may be because of different levels being mapped in this hypothesis
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Treasury Select Committee - Project Verde
Private & confidential
Contents The contacts at KPMG in connection with this report are: Michael Robinson Financial Services Advisory Partner, KPMG LLP London Tel: +44 (0) 7711 448778 Fax: +44 (0) 207 311 5882
[email protected]
Executive summary Cost model review Reconciliation to 2008 budget
Keith Cowley Financial Services Advisory Senior Manager, KPMG LLP London
Review of in-scope costs
Tel: +44 (0) 7917 174047 Fax: +44 (0) 207 311 5882
Cost synergies
Review of ratio of costs
[email protected]
V1 base case overview V1 base case V2 low case IS cost synergies
Revenue synergies Revenue synergy values and risks Cross sell volumes Margin dis-synergy
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case overview Synergy value £m
V1 base case synergies have been produced and categorised between:
Description
Year 5 cost base £m
Synergy / inscope cost base
Synergy / total synergies ratio
Page Reference
9.8
254
4%
16%
15-16
41.7
41.7
176
24%
69%
17-19
7.7
9.3
9.3
266
3%
15%
20-21
57.6
60.8
60.8
696
9%
100%
1
2
3
4
5
1.6
5.3
9.8
9.8
Head office
27.3
36.4
40.1
Processing
5.9
7.5
34.8
49.2
customer (e.g. channel and operations), head
Customer
office, and processing (e.g. IS, procurement, facilities) Overall cost synergies of 9% are not demanding but
Base case total
Source: V1 cost model, years 1-5 synergies per 1 October 2008 version and cost base updated to latest view
the mix of synergies is weighted towards head office functions and this is
the key driver of value in the proposed transaction, accounting for two thirds of all cost synergies within
the V1 base case Comments in this section
Two thirds of value is coming from head office synergies. As a whole these are achievable subject to: −
Mix: It may be desirable to lower reductions in control functions (e.g. Debt Management) and substitute these from other areas (e.g. Training)
−
Phasing: Year 1 and 2 phasing may be challenging in some instances (e.g. reduction in leadership roles assumed from day 1)
Customer incorporates channels and operations and appears undemanding at 3.5% of in-scope cost base. This figure is small because: −
Relatively small amounts of people are taken out of branches (50 FTEs) and many of these are added back in V2
−
Contact centres and operations also have small reductions
−
Included in the in scope costs are Claret field sales staff (arguably out of scope)
reflect an assessment of transparency, accuracy
Processing is undemanding principally because it excludes IS synergies, which are added as part of V2 low case at £10m in year 5. However other undemanding areas include:
and reasonableness of
−
Non branch occupancy saving at 6% of costs
synergy assumed. They do
−
Procurement savings at 10% of spend: our non-IS procurement benchmark suggests 22% achievable
not incorporate views in
−
However sales support reductions at 40% appear challenging and out of line with relative small reductions in channels
the preceding section in respect of potentially out
FTE savings account for approximately two thirds of all synergies (£40m). There are expected to be c.800 FTE reductions at c.£50k average salary, the majority of people being from Head office / enterprise functions, hence the average salary being higher than for the businesses as a whole (£33k average)
A separate piece of work on branch synergies has been performed but the findings are not incorporated in either the V1 base case or the V2 low case
of scope costs or other uncertainties. The V2 low case slide reflects our holistic view of synergies
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: customer (channel and operations) (1) Customer includes the principal customer facing functions, including branch, contact centre and operations. Reductions are overall very modest reflecting the minimal product overlap, and therefore limited customer contact and operational synergies. There are however 60 branches overlapping each other out of a combined total of 334. The saving currently assumed is 2.4% for FTEs and 5% for occupancy; this appears modest against the 18% overlap. Other channels and mortgage processing provide cost reduction opportunities, which although not strict synergies, may be desirable if realigning the cost base to a specific cost income target
Synergy Number
11
27
28
28b
25
29
29b
30
Description
Contact centre: Sales and Service (includes Complaints, excludes Claret Mortgages) Partnership: Staff cost and other associated with Affinity Marketing Relationship Mgt
Year 5 Synergy Value £m
Undemanding
4.2% saving on £57.2m post EP year 3. Current climate suggests lending sales (mortgages, loans, cards) below capacity and so contact likely to be reduced. Saving indicated could be achieved through attrition
Yes – 5% quoted is of Claret FTEs only or £48.8m cost hence £2.4m
Undemanding
10% reduction of a combined team of 47 FTEs looks undemanding. Key question is how much relationship management is being delivered in current market (e.g. mortgage broker relationship mgrs)? Recent benchmark of 25% reduction
Yes – applies to both FTE and non FTEs
Undemanding
Only 2.4% saving on £61.3m. Assumes 1 manager per branch leave at £30k each. Latest analysis suggest c.50 branch closures reasonable volume assumption, but potential to save 2-6 FTEs per branch out not just 1. Phasing in year 2 would assume closures in that year.
Yes
Undemanding
50 branch closures out of a combined 257 + 89 branches - 9 already planned closures is c.15% saving not 5% assumed. Upper case 18%
Yes
Achievable
There are challenges to moving Burgundy to a Claret insurance model the assumed saving of zero is prudent and reasonable given these challenges.
Yes – 0% because issue parked at moment
Achievable
Assumes 50% cost reduction in Claret FTEs or 27% reduction in combined FTEs. Current limited Claret sales volumes for 2008 suggest this is reasonable
Yes- 27% reduction in combined
Achievable
IT savings manually de-duplicated out of IS savings
Yes
Undemanding
No reduction assumed. However recent Lean analysis of savings function identified 25% base case reduction and 40% stretch
Yes
0.4
1.5
Branch Network Occupancy
1.6
0
Mortgage FTE: Staff costs non FTE customer service
2.0
Mortgage systems: 3rd party processing costs via Teito Enator
0.6
Savings FTE: Savings processing
Base assumption transparent and accurately applied?
2.4
Branch Network FTE: 50 Branch managers (£30k each) overlap
AXA Advisors: Amalgamate into Claret
Rationale for Assessment
KPMG Assessment
0
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: customer (channel and operations) (2) We are seeing examples in the industry of investment in savings operations and
Synergy Number
Description
Year 5 Synergy Value £m
KPMG Assessment
Base assumption transparent and accurately applied?
Rationale for Assessment
debt management functions so would not expect reductions in these
3
areas
34
Challenging
Only 5% savings but current economic environment driving increased indebtedness and competitors are growing functions rather than contracting them
Yes
Achievable
Only 25 FTE involved in Claret (none identified in Burgundy); any saving would be minimal (assumed at zero)
Yes – 0%
Achievable
Minimal savings of 1% shown. Burgundy has few ATMs an few scale economies so reasonable. ATM network may need to be grown (implementation costs)
Yes
Achievable
Claret’s function is over four times the size of Burgundy so minimal duplication . Reduction amounts to 5% of total cost or c.30% of Burgundy cost
Yes- FTE and non-FTE
0.4
ATM - FTE
ATM investment in the Burgundy network may be
Debt Management: Staff Costs for collections and recovery activity for personal debtors
0
desirable to support current account cross sales
ATM – 3rd party costs 34b
0.4
Customer synergies amount to £9.8m or 16% of total cost synergies. Total customer costs are £254m and so synergies represent only 4% of this figure
40
Commercial Lending: FTE costs associated with corporate relationship management / lending / administration
0.6
TOTAL CUSTOMER SYNERGIES
9.8
0.1 rounding
Source: V1 Cost Model 1 October 2008 per data site
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: head office / enterprise management (1) Head office synergies amount to £41.7m or 68% of total cost synergies.
Synergy Number
Total head office costs are
Year 5 Synergy Value £m
Leadership: Elimination of 40% of Top 3 tiers
£176m and so synergies represent 24% of this
Description
4
KPMG Assessment Challenging
Immediate Day 1 delivery of 40% reduction does not appear achievable without pre-deal Organisational Design and consultation 40% reduction takes out more cost than Burgundy’s current cost by £1.3m p.a.
Yes
Achievable
A 20% reduction by year 4 may be stretching for a control function but the slow build to this figure suggests achievable. This assessment becomes Challenging if out of scope costs removed (see p11/22)
Yes
Challenging
The current environment is likely to increase the focus on credit risk rather than reducing it. Some synergies may be possible but 20% appears challenging
Yes
Achievable
We understand that not all Claret costs are mapped but that saving relates to Burgundy costs which have been mapped. 80% reduction in Burgundy only cost assumed
Yes
Achievable
Reductions in FTE of 30% do not look unreasonable but this is subject to further validation
Yes
Achievable
Reduction of spend of 20% also does not look unreasonable but this is subject to further validation and the need to obtain detail by product, type of spend, whether committed, and in line with strategy.
Yes
Achievable
Need more detail but financial PR 40% reduction should be achievable
Yes
Achievable
No in-scope costs or FTEs shown for Claret, so only 40% of Burgundy’s reduced.
Yes
Undemanding
Assumptions to be confirmed – no year 5 benefit but non-material year 3 benefit in numbers
Not Applicable
11.9
figure Leadership synergies appear challenging in year
Finance: FTEs 1
1.9
1 (full benefit claimed) In the current environment we are generally not
Credit Risk: FTEs 0.9
2
seeing significant reductions in control functions (e.g. credit risk,
5
finance, operational risk, internal audit). It is in this context that we have noted
6
some reductions as challenging. It is also probable that the volume
Governance: All costs related to AGMS and Board Meetings Marketing FTE
2.1
2.4
Marketing spend 7.9
6b
of work (e.g. for internal audit) will not reduce and so reductions may not be
7
PR: FTEs
0.4
Base assumption transparent and accurately applied?
Rationale for Assessment
achievable. 43
8
Internal Comms: FTEs
Membership
0.2
0
Source: V1 Cost Model 1 October 2008 per data site This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: head office / enterprise management (2) HR and Training may provide opportunities for
Synergy Number
Description
further reductions to offset any reductions in synergies from of control
9
Strategy and Planning: FTEs
Year 5 Synergy Value £m
KPMG Assessment
synergies could be
Procurement: FTEs 16
Rationale for Assessment
Achievable
A 40% reduction appears achievable. However given the level of change it may be desirable to retain a higher proportion of people with these skills
Yes
Achievable
It is realistic to keep 70% of Burgundy function (as assumed) as there will be substantial procurement activity to pursue post transaction
Yes
Undemanding
The combined function has 247 FTEs at an average cost of £67k each £15.6m total). A 30% reduction has been assumed; benchmark is 40+% synergy and mix saving should also be possible. Taking Mercer benchmark of 1:66 this implies a further £1m saving. Stretch 1:100
Yes
Undemanding
The combined function has 168 FTEs at an average cost of £74k each (£12.5m total). A 15% reduction is assumed. This looks undemanding against a recent benchmark of 1:108 staff for a Retail Bank which would imply a further saving of c.40 FTEs
Yes
Achievable
The 30% saving assumed is £0.4m more than the current level of Burgundy spend of £1m. However it is believed that not all Burgundy data has been found hence management are comfortable with £1.4m benefit
Further fees to be identified to complete transparency assessment
Achievable
10% saving of Claret staff appears realistic (Burgundy staff have not been separately identified but believed to reside in Marketing and Finance)
Yes – 10%
Challenging
The 20% saving represents the equivalent of the elimination of the Burgundy function. It is probable that this team has skills not within Claret and therefore the reduction assumed would represent a cut into Claret existing skills
Yes
Undemanding
0% reduction in FTEs and 10% in external spend. Level of duplication probably higher than net 7.5% reduction
Yes
0.9
functions. Our benchmarks suggest these
Base assumption transparent and accurately applied?
0.2
materially increased. This HR: FTE
will depend however upon the support model offered
19
5.0
and expected degree of self service and online Training: FTEs and external costs
support provided. 20
21
22
Fees: Mandatory membership of industry bodies (APACS, BBA etc) Product Management: FTEs
2.5
1.4
0.3
Treasury: FTEs 23
24
1.6
Legal: FTEs and external spend
1.2
Source: V1 Cost Model 1 October 2008 per data site This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: head office / enterprise management (3) No costs or assumptions have been assumed yet for complaints functions, but
Synergy Number
Description
Year 5 Synergy Value £m
KPMG Assessment
Base assumption transparent and accurately applied?
Rationale for Assessment
these are likely to be material in size and offer
24.1
Fraud Ops: FTEs
0
Achievable
Nil reduction appears prudent. Some saving may be achievable in latter years
Yes
Achievable
Nil reduction appears prudent. Some saving may be achievable in latter years
Yes
Challenging
20% reductions in Internal Audit (equivalent to Burgundy’s current function) may not be achievable from Day 1. The level of reduction may also be challenging given an increased focus on controls and risk management
Yes
Challenging
20% reductions in Operational Risk (equivalent to Burgundy’s current function) may not be achievable from Day 1. The level of reduction may also be challenging given an increased focus on risk management
Yes
Achievable
Given the level of change the combined organisation will go through a nil reduction is not unreasonable
Yes
Achievable
No synergy has been assumed for GI manufacture as the model is not yet clear. Nil saving is reasonable
Yes
Undemanding
Costs not yet identified but functions are likely to be material in size and there should be peak balancing and cross-skill opportunities to gain in excess of the 10% reduction estimated
Not Applicable
potential for longer term savings
24.2
Compliance: FTEs
0
Internal Audit: FTEs 24.3
0.5
Operational Risk: FTEs 24.4
0.6
42
Process Improvement: FTEs associated
35
Product Management GI: FTE saving assumed re Claret manufacturing Burgundy GI
44
Complaints: FTEs not ‘payouts’
TOTAL HEAD OFFICE SYNERGIES
0
0
0
0.2 Rounding
41.7
Source: V1 Cost Model 1 October 2008 per data site
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: processing and occupancy (1) Processing and occupancy synergies
Synergy Number
Year 5 Synergy Value £m
Description
amount to £10.3m or 17% of total cost synergies. Total processing and occupancy costs are
10 13 14
IS: FTEs Data Centre / Disaster Recovery Support Applications
0
32
Image Processing: leverage Burgundy image processing into Claret
0
£266m and so synergies represent 3% of this figure. This figure however currently excludes IS synergies which are added back in version 2 low case
12
Service contracts: All 3rd party supplier spend excluding marketing, IS, etc
KPMG Assessment
Rationale for Assessment
Undemanding
IT savings not yet identified in Version 1. Added in version 2a and assessed later in this pack. Undemanding pending inclusion
Not Applicable
Undemanding
Claret mailing costs not yet identified so not possible to identify synergy at this stage. Undemanding pending inclusion
Not Applicable
Undemanding
10% reduction assumed from Day 1. KPMG savings with other Retail banks has been c.22% across non-IS categories. Level of saving will depend on category spend and how recently negotiations have taken place. Spend categories would be targeted in groups over time and the Day 1 assumption may not be realistic
Assumption changed to £4m manually prior to final V1 submission. See detail of risk on reconciliation page [x]
Achievable
Significant change planned so nil reduction appears reasonable
Yes
Challenging
A 40% reduction appears challenging given that the scale of sales channels is only showing modest reduction and that increased, and in early years, somewhat manual cross selling is envisaged. Managing MI may require significant manual processes. A recent cost reduction benchmark achieved c.25% reduction
Yes
Achievable
Progressive build to 15% reduction in year 5 appears achievable. [3rd party payments pending]
Yes
Undemanding
The size of mail operations is driven by the number of buildings served and new business and back book operations volume. A 6% reduction in footprint has been assumed (see over) but recent Lean analysis of a similar function identified 30% savings. Current cost base is £2.2m.
Yes No Assumption
4.0
which adds £10m of synergies
18
26
33
45
Change: FTEs associated with project and programme delivery including testing Sales Support: FTEs associated with central support to all delivery channels, e.g. Sales planning, MI, help lines Payments: FTEs associated with fulfilment of customer payments Mailing Operations: Burgundy FTEs associated with mail processing
Base assumption transparent and accurately applied?
0
3.8
0.6
0
Source: V1 Cost Model 1 October 2008 per data site adjusted for flag 12 - £1m deduction to reflect late change in business case This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V1 base case: processing and occupancy (2) Synergy Number
17
Year 5 Synergy Value £m
Description
Occupancy – FTEs and non branch occupancy cost
TOTAL PROCESSING AND OCCUPANCY SYNERGIES
KPMG Assessment Undemanding
0.9
Rationale for Assessment
Non-FTE savings of £0.3m are only 0.6% of £47.8m and FTE savings of £0.6m are 25% of FTE costs of £2.4m. The version 1 initial case assumes 7.2% of FTEs will leave (excluding branch and IS). Hence the non-FTE saving at 0.6% is undemanding relative to headcount reduction of c.7%
Base assumption transparent and accurately applied? Yes
0 rounding 9.3
Source: V1 Cost Model 1 October 2008 per data site adjusted for flag 12 - £1m deduction to reflect late change in business case
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
V2 low case Synergy value £m
V2 low case includes various adjustments to the
Updated KPMG Assessment
Rationale for Assessment
10.9
Achievable
Synergies reduced from £11.9m for all years to reflect 6 months delay to the level 3 FTE savings and £1m reduction pa
6.0
6.0
Achievable
Synergies reduced to 5% in years 1-3 and 15% in years 4-5. See p11 for rationale for change and KPMG assessment
6.8
6.8
6.8
Uncertain
Further work needs to be performed to validate the in-scope cost base, but we are comfortable with the 10% assumption
1.4
1.4
3.8
3.8
Challenging
No adjustment to V1 base case. See comments in respect of synergy number 26. Does not reflect reductions in channels
0
3.5
3.5
3.5
3.5
Achievable
No adjustment to V1 base case. See comments in respect of synergy number 5 and 21 (21 updated since 271008 draft)
Training (staff + suppliers)
2.5
2.5
2.5
2.5
2.5
Undemanding
No adjustment to V1 base case. See comments in respect of synergy number 20 and scope found per p11
HR (staff)
0.8
1.7
3.3
5.0
5.0
Undemanding
No adjustment to V1 base case. See comments in respect of synergy number 19 and scope found per p11
Branch (staff + Occupancy)
0
0.2
0.2
1.8
3.6
Undemanding
Already undemanding synergies reduced further in early years. Separate analysis suggests £10m+ p.a. may be achievable
Mortgages (staff + systems)
0
2.3
2.6
2.6
2.6
Achievable
No adjustment to V1 base case. See comments in respect of synergy number 29 and 29b
0.8
1.6
2.4
2.4
2.4
Achievable
No adjustment to V1 base case. See comments in respect of synergy number 6
0
0
0.0
2.4
2.4
Undemanding
Slight adjustment to V1 base case (year 3 synergy deleted to align to EP). See comments in respect of synergy number 11
Finance (staff)
0.5
0.9
1.4
1.9
1.9
Challenging
No adjustments to V1 base case but £2.2m of costs found to be potentially out of scope, and c.27% saving now assumed
IS savings
0.8
2.9
7.2
10
10
Achievable
Added in V2. Appears reasonable – See appendix IS synergies
Cost avoidance
2.5
2.5
2.4
2.4
2.4
Achievable
Not reviewed but includes Burgundy internet development in years 1,2 and Claret 3rd site costs for years 3-5
0
5.2
5
6
6
Mix: See notes
Includes all other synergies (see comments preceding) plus adjusting staff costs to half year savings in year 1. Note that this includes many ‘undemanding’ Customer functions
24
45
52
68
70
Description
1
2
3
4
5
Leadership (top 3 tiers: staff)
6.8
10.9
10.9
10.9
Marketing (suppliers)
2.0
2.0
2.0
Service Contracts (suppliers)
6.8
6.8
Sales Support (staff + suppliers)
0
Governance and Fees (suppliers)
base case (some up, some down) which overall increase the year 5 synergy to £70m, principally due to the inclusion of £10m of IS synergies not included in V1. The other key adjustment is the re-phasing of various synergies such that the aggregate figure in years 1 and 2 is reduced from the £34m and £49m assumed in V1 V2 incorporates feedback from selected stakeholders and this has not been exhaustive nor
Marketing (staff) Contact centre (staff)
has it been subject to challenge. However our overall view is that the more prudent phasing of V2 is more achievable and the inclusion of IS benefits at £10m appears achievable based upon our
Others (sub £1m pa opportunities)
analysis.
Source: V2 Cost Model 27 October 2008 per Matt Atkin draft business case V2 Low case totals
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Treasury Select Committee - Project Verde
Private & confidential
Cost synergies
IS cost synergies overview General
Cost synergies
The proposed benefits & project costs have been created during four hours only of direct meetings between Claret and Burgundy IT representatives, followed by four hours of discussion with KPMG.
It cannot therefore be stated whether the list is complete, and in every instance, there is a recommendation for further work to be performed in order to increase the confidence level over transparency and accuracy. It is noted that this approach taken by Claret and Burgundy is as per the brief provided and it is fully recognised the additional work to be performed.
We also note that on some occasions the format of the information provided to us by Claret and Burgundy differed and it may be that there are inconsistencies between the two sets of data. This risk may have been reduced by Claret and Burgundy having applied a number of approaches that provided similar results but further work could be performed to ensure consistency.
Overall however, through discussions with KPMG, the stated benefits would appear “achievable” to “challenging” on a line by line basis, and we would consider £5m reduction in aggregate annualised benefits to make the overall value of £10m savings in year 5 achievable.
The savings are primarily concerned with the operations (personnel & infrastructure) and some assumed level of application integration whish is appropriate, however no benefits stated are currently wholly dependant upon the implementation of EP (though some e.g. Fineos to Finacle assume a migration based upon the EP licensing model and related TAM). No savings are reliant upon Magellan.
Many of the savings are based upon staff costs. KPMG has expressed concern that these haven’t been validated and requires clarification of comparable roles and responsibilities in both organisations. On a few occasions it was agreed that we may not be comparing like to like. When implementation costs are considered in due course it is important that FTE savings estimates are reflected as appropriate within people implementation costs
Any saving based upon licence fee, requires further evidence and review to ensure it has been accurately applied and is transparent.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Cost synergies IS cost synergies (1) Synergy Number
Description
Year 5 Synergy Value
KPMG Assessment
Rationale for Assessment
Base assumption transparent and accurately applied?
Ops1
£1,254,098 Unix dc & technical staff Annualised saving Rationalise headcount of from 2011 similar sized functions, with rationalised application architecture and efficiency benefits.
Achievable but more work
Assumptions include rationalisation of back office systems – HR / Finance etc., and 4 to 2 data centres, but not EP or Magellan. Based upon 50% head count reduction appears reasonable by 2011.
Yes – based on headcount costs (to be confirmed) & documented assumptions.
Ops2
Unix & dc licence Rationalised technical architecture, headcount and improved supplier leverage.
£800,000 Annualised saving from 2011
Undemanding but more work
Large discrepancy between organisations (Claret costs 4x higher), but dependant upon contract until 2011. Following 2011, savings could be higher and potential for earlier savings.
Unclear – limited view of potential savings, further work required to validate contract possibilities & post contract savings as well as further understanding of what has been included for some of the cost in Claret.
Ops3
Service desk Bring desk together and locate in Leek.
£487,500 Annualised saving from 2011
Achievable but more work
Based on saving 10x heads out of 38 appears reasonable.
Yes, based on headcount costs, but which need to be further validated. Work required on headcount totals to ensure like for like.
Ops 4
LAN/WAN – staff £150,000 Significant rationalisation Annualised saving enabled, using in-house from 2011 model.
Achievable but more work
Replication of work, remove 3 of the 4 heads from the smaller team appears reasonable.
Yes, based on headcount costs, but which need to be further validated. Work required on headcount totals to ensure like for like.
Ops 5
WAN Re-negotiation and redesign.
£1,340,000 Annualised saving from 2011
Achievable but more work
Assumption of 20% reduction appears reasonable on renegotiation .Unclear – the20% could be recovered anyway in the of large contract.. higher cost of Claret annual WAN costs with BT, may not be a Vintage benefit..
Ops 6
Voice Call costs reduction.
£300,000 Annualised saving from 2011
Achievable but more work
As above.
Ops 7
Desktop Utilising Burgundy lower cost in-house model.
£3,270,000 Annualised saving from 2011
Challenging but more work
More work to be done on assessing difference between the Unclear – until further work completed. We understand models. The lower Burgundy costs could be related to difference in this has commenced. desktop requirements (PC vs. green screen etc.), branch network, and therefore invalid.
As above.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Cost synergies IS cost synergies (2) Synergy Description Number
Ops 8
Ops 9
Ops 10
Ops 11
Ops 12
Year 5 Synergy Value
KPMG Assessment
Rationale for Assessment
Base assumption transparent and accurately applied?
Licence management £84,231 Rationalise headcount of Annualised saving similar operations. from 2010.
Achievable but more work
Appropriate rationalisation of headcount from 13 to 10.
Yes, based on headcount costs, but which need to be further validated. Work required on headcount totals to ensure like for like.
Intel Support Savings by utilising Claret's outsourced model .
Achievable but more work
Savings appear achievable but further validation required on comparing the two models.
Unclear – further work required.
Challenging but more work. Claret use of contractors and project implementation mandate means costs are more.
May not be comparing like for like. Claret cost of £1.4m may be artificially high as includes contractors / project staff.
Unclear – further work required and need to compare like to like.
£433,000 Annualised saving from 2010.
Challenging but more work
Requires further clarification on where the 4x head savings reside. Unclear – further work required..
£2,000,000 Data centre rationalisation Annualised saving to be confirmed (includes from 2011. avoided cost), includes DR rationalisation.
Challenging but more work
Saving appears high, requires further investigation as no information behind this figure.
Unclear – further work required..
NEW: 3rd party audit / assurance services reduction for combined entity.
Achievable
New saving identified by KPMG based upon reduction in certification, audit and assurance fees for combined company, includes ISO, ITIL, VOCALINK etc.
Estimate provided by KPMG based upon understand of Claret and sector generally.
£280,000 Annualised saving from 2010.
Information Security £578,903 Significant rationalisation Annualised saving achievable because of from 2010. duplicate activities. Costs cheaper in Leek.
IS Management Rationalisation of management of IS.
£100k Annualised saving from 2011.
Ops 13
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Cost synergies IS cost synergies (3) Synergy Number
Description
Year 5 Synergy Value
KPMG Assessment
Rationale for Assessment
Base assumption transparent and accurately applied?
ECM - workflow
£600,000 Annualised saving from 2010.
Achievable but more work
Decommissioning of one Document management system appears Yes, but reliant upon validating figures from existing reasonable. Support contract can be ended, but migration would contract, decision on the primary solution, as well as EP require further scoping and assessment. strategy and plans becoming clear.
Apps2
Fineos replace Fineos with Finacle CRM.
£1,000,000 Annualised saving from 2010.
Achievable but more work
Support contract of £1m can be ended, but assumes migration to EP, hence more work required on TAM & priorities to meet business requirements.
Apps3
TE – Claret £500k Migrate to Burgundy TE Annualised saving and decommission Claret from 2010.
Undemanding but more work
Support contract stated as £1.2m per year can be ended, so Yes, but reliant upon validating figures from existing potentially undemanding. Relies on TAM and priorities hence more contract. work required.
Challenging – but more work
May be high, as assumes 100% saving from Burgundy system.
Apps4
HR £200k Migrate to Claret system. Annualised saving from 2011.
Apps5
Financial £350k Migrate to Claret system. Annualised saving from 2011.
Achievable but more work
Assumption of 3 staff at 35k pa plus £250k of licence fees appears Yes, based on headcount costs, but which need to be reasonable. further validated. Work required on headcount totals to ensure like for like.
Apps6
Midas Migrate to Burgundy system.
£500k Annualised saving from 2011.
Undemanding but more work
Potential avoidance of one-off £7m Claret project, for £5m Unclear, further detail of project and license costs migration could provide further savings, but further work needed on required.. TAM and priorities.
Apps7
Complaints Migrate to Burgundy system.
£200k Annualised saving from 2010.
Achievable but more work
Based upon a migration and removal of license fee, but further work needed on TAM and priorities.
Apps1
Yes, but reliant upon validating figures from existing contract as well as EP strategy and plans becoming clear.
Yes, but reliant upon validating figures from existing contract.
Yes, but reliant upon validating figures from upon existing contract.
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Cost synergies IS cost synergies (4) Synergy Description Number
Apps8
Apps9
Apps10
Year 5 Synergy Value
KPMG Assessment
Rationale for Assessment
Base assumption transparent and accurately applied?
£175k Membership – Decommission after 2009 Annualised saving member payment. from 2010.
Achievable but more work
All stated costs can be removed following 2009, appears valid as no remaining requirement – based upon 5x staff.
Yes, if head-count costs are validated. Membership notification of merger will involve expenditure in 2009.
MI/OI Merge to Claret MI
£280k Annualised saving from 2011.
Challenging but more work
Assumes all stated costs can be removed following 2009 – based upon 8x staff, which may not be realistic. Further work to understand TAM and priorities.
Yes, if head-count costs are validated and realised.
Intranet Single Intranet
£175k Annualised saving from 2011.
Achievable but more work
Based upon saving the full contingent of 5x Burgundy staff. More work required to determine if this is a priority project and if within the HR budget..
Yes, if head-count costs are validated and realised.
Total gross IS cost synergies
£15m
Less adjustment per Overview
(£5m)
Adjusted IS cost synergies per V2 low case
£10m
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents The contacts at KPMG in connection with this report are: Michael Robinson Financial Services Advisory Partner, KPMG LLP London Tel: +44 (0) 7711 448778 Fax: +44 (0) 207 311 5882
[email protected]
Executive summary Cost model review Reconciliation to 2008 budget
Keith Cowley Financial Services Advisory Senior Manager, KPMG LLP London
Review of in-scope costs
Tel: +44 (0) 7917 174047 Fax: +44 (0) 207 311 5882
Cost synergies
Review of ratio of costs
[email protected]
V1 base case overview V1 base case V2 low case IS cost synergies
Revenue synergies Revenue synergy values and risks Cross sell volumes Margin dis-synergy
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Revenue synergies
Revenue synergy value and risks Synergy value £m
Quantified revenue synergies are principally
Description
Average Contribution per account pa.
Annual Attrition rate
8.1
£115
20%
3.2
4.2
£50
15%
3.3
4.9
6.1
£100
21%
1.4
0.7
0.1
(0.4)
Not reviewed
Not reviewed
6.2
9.6
13.8
18.0
1
2
3
4
5
Core banking bundle (current accounts, loans, credit cards)
1.0
2.3
3.6
5.6
Savings
0.2
0.9
2.0
Mortgages
0.4
1.6
Other (GI Motor & Credit card and loan book purchase)
2.4
Base case total revenue synergies
4.0
driven from increasing cross sales of products into the respective customer bases. These amount to £18m in year 5. Negative synergies relating to pricing harmonisation have been estimated at c.£8m in year 1 falling to £5m and then
Source: V2 Revenue Model 22 October 2008 per data site
£2m in years 2 and 3. In our view there is still
potential downside risk Non-material synergies are also assumed from the
Cross sell synergies have been reviewed in respect of volumes (page 30 overleaf), average value (contribution) per product, and attrition rate: −
The core banking bundle may need to be separated to see the value per product, but the attrition rate assumed and average value do not look materially unreasonable (current accounts may be lower, but loans depending on cross sells, higher)
−
Savings and mortgages also appear reasonable although mortgage profitability will depend on the details of pricing, including fees, margin and exit penalties. We also note that Burgundy is currently not achieving these levels of contribution on either its mortgage or savings products. A view needs to be taken as to whether management expect profitability to return to long term average soon, if not then it may be prudent to assume a lower average contribution, particularly in early years
purchase of unsecured personal lending books (hence negative synergy in ‘Other’)
GI Motor synergies are relatively immaterial (rise to £0.4m) so have not been reviewed; similarly the assumption about the profitability of the potential purchase of the back book has not been reviewed
The risk of negative synergy resulting from harmonisation of savings products has been quantified and is outlined on page 31. The negative synergy assumed is £8m in year 1, £5m in year 2 and £2m in year 3 and zero thereafter
There are a number of negative synergies that may impact and have not as yet been quantified. Work has started but we have not seen the results as yet in terms of:
Insurance manufacturing has been assumed as neutral and further work needs to be performed to quantify any positive or negative impact
−
Insurance Manufacturing synergy (selling Claret products through Burgundy instead of existing arrangements). Currently assumed neutral but risk that this model is difficult to implement effectively and may in the short term adversely impact morale and performance of AXA staff
−
The general level of disruption and change in management focus may cause a dip in sales performance as the transaction is settling down. This could be caused through a combination of customer and staff confusion and disruption. Mitigating against this however is the fact that currently few customer facing channels or operations are being materially affected
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Revenue synergies
Cross sell volumes Cross sales are based upon selling core banking products (current
Synergy Number
Description
Year 5 penetration % / of which book
KPMG Assessment
Rationale for Assessment
Base assumption transparent and accurately applied?
accounts, loans, credit cards) into Burgundy’s customer base (hence penetration of savings
1
Current accounts: Penetration of B savings account base to rise from 0% to 3% by year 5
Undemanding
Burgundy has no current accounts and increase to 3% penetration of savings accounts by year 5 looks undemanding against a benchmark of 32% (equivalent to Claret cross holding). However realising this synergy and gaining profitable accounts will be dependent upon the attractiveness of the proposition - i.e. competitors currently offering 8% headline rates
Yes
Achievable
Synergy assumed of 3% penetration of Burgundy savings book in line with Savings benchmark, but both are lower than Claret benchmark probably reflecting sales off current accounts. An increase in current account cross sales could be reflected in an increase in loan sales
Yes
Undemanding
Synergy assumed of 2% penetration of Burgundy savings book looks undemanding relative to Savings benchmark benchmark of 8%, but both are lower than Claret benchmark probably reflecting sales off current accounts. An increase in current account cross sales could be reflected in an increase in cards sales.
Yes
Achievable
Synergy assumed of 10% penetration of Claret current account base look in line with Big 4 Banks benchmark of 9% and undemanding compared to Mortgage banks benchmark of 15-19%. There may be additional upside selling mortgage into Burgundy savings base as the current penetration of 3.6% is low compared to 10% benchmark
Yes
Challenging
Claret existing penetration of current accounts of 39% is in line with existing benchmarks - taking this up a further 10% appears challenging. However the type of account and average balance relative to Burgundy needs to be confirmed. Further work required to confirm
Yes
3% / Savings
book comparison) and mortgages and loans into Claret’s current account customer base.
2
Loans: Penetration of B savings account base to rise from 1% to 3% by year 5
3% / Savings
Penetration rates have been compared to industry standards. The low current account penetration stands out as
3
Credit Cards: Penetration of B savings account base to rise from 1% to 2% by year 5
2% / Savings
an area of opportunity as this is generally seen as the core relationship product to sell other
4
products. Achieving
Mortgages: Penetration of current account base to rise from 3% to 10% by year 5
10% / Current Accounts
increased penetration is however reliant upon other factors, including the competitiveness of the offer and enabling the
5
Savings: Penetration of current account base to rise from 40% to 50% by year 5
49% / Current Accounts
Burgundy branch network for servicing capabilities
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Revenue synergies
Margin dis-synergy The negative synergy
Management has identified a potential revenue dis-synergy in respect of harmonising pricing on certain overlapping categories within the savings product range. There are three overlapping categories
associated with pricing harmonisation of overlapping products that
Margin at risk £m
Year 1
need to remain open book is £8m, £5m and £2m in years 1, 2 and 3 respectively
Dis-synergy provided
Category description Instant Access
Year 2
Year 3
32
0
0
0
10
8
5
2
42
8
5
2
Child savings Cash ISA
We note that there is risk in these figures value and
Total
duration (the dis-synergy could extend past year 3). The risk is both of margin erosion and customer attrition In addition no provision has been made against instant access accounts. There is a possibility of further downside risk.
Source: Mark Chizlett, Burgundy, DRAFT margin at risk subject to confirmation
Management has calculated the potential maximum revenue synergy exposure at c.£40m each year. This covers three product groups that
are similar in nature but with different pricing: Instant access (c.£32m), Child accounts and Cash ISAs (c.£10m between the two) Management however expect to be able to take actions to reduce the revenue dis-synergy down to £8m in year 1, £5m in year 2, £2m in year
3, and 0 in years 4 onwards in respect of Child accounts and Cash ISAs No provision has been made for the c.£32m margin at risk on instant access products on the basis that a closed book approach will be
adopted and because these customers are already being paid a non price leading rate that they will have a low rate of attrition arising from decisions to manage margin. Burgundy have stated that their experience from managing a similar risk in their acquisition of the Bristol & West savings book resulted in a 3% (c.£1m) impact. We understand the above rationale, but still believe in today’s environment where the media has a high degree of interest and ability to inform customers about how banks are managing their margins that there is still a real possibility of further down side risk to that contained in the business case
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TRANSACTION SERVICES
Project Vintage DRAFT Due diligence report For presentation to the CFS Risk Management and Group Audit Committees 18 December 2008 ADVISORY
Page 56
Treasury Select Committee - Project Verde
KPMG LLP Transaction Services 1 The Embankment Neville Street LEEDS LS1 4DW
Private & confidential
Tel +44 (0) 113 231 3000 Fax +44 (0) 113 231 3186
Private & Confidential The Directors Cooperative Financial Services 4th Floor Miller Street Manchester M60 0AL
We draw your attention to the Important notice included on the following page Within the draft findings below we have identified where work is still incomplete
18 December 2008
We shall be pleased to receive your observations on our draft report Our draft report is confidential and is released to you on the basis that it is not to be copied, referred to or disclosed, in whole or in part, without our prior written consent, save as permitted in our Engagement Letter. In accordance with that letter, you may disclose our draft report to your legal and other professional advisers in order to seek advice in relation to our work for you, provided that when doing so you inform them that, to the fullest extent permitted by law, we accept no responsibility or liability to them in connection with our draft report and our work for you
Dear Ladies and Gentlemen Project Vintage As requested, we enclose a copy of our draft report on Project Vintage dated 18 December 2008. We understand that your purpose in requesting a draft report at this stage is to enable you to give preliminary consideration to the findings available to date with regard to the key issues identified by you in relation to the transaction. You will note that we have not received sufficient information to address all areas of our scope and as such this report represents a status update of our findings to date. In accordance with our engagement letter dated 18 September and the variation letters dated 23 October and 17 November 2008, you have agreed that our final written report shall take precedence over this draft, and that no reliance will be placed by you on any draft report other than at your own risk
Yours faithfully
KPMG LLP
This draft status update has been prepared on the basis of fieldwork carried out up to 18 December 2008. You will be aware that we have not yet completed the work required to enable us to report in accordance with the terms of reference set out in our Engagement Letter. You should, therefore, bear in mind when considering the draft report that the information contained within it and our preliminary conclusions based thereon may alter or be refined as our work progresses
KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative
Registered in England No OC301540 Registered office: 8 Salisbury Square, London EC4Y 8BB
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Important notice z
Our work commenced on 4 August 2008 and this report reflects our fieldwork up to 18 December 2008. You will be aware that we have not yet completed the work required to enable us to report in accordance with the terms of reference set out in our engagement letter dated 18 September 2008 and variation letters dated 23 October and 17 November 2008. You should, therefore, bear in mind when considering the draft report that the information contained within it and our preliminary conclusions based thereon may alter or be refined as our work progresses
z
This engagement is not an assurance engagement conducted in accordance with any generally accepted assurance standards and consequently no assurance opinion is expressed
z
Our report makes reference to ‘KPMG Analysis’; this indicates only that we have (where specified) undertaken certain analytical activities on the underlying data to arrive at the information presented; we do not accept responsibility for the underlying data
z
The numerical data presented in our report has been imported from Excel spreadsheets and may include minor rounding differences as a consequence
z
The contents of our report have not been reviewed in detail by the directors of Burgundy to confirm the factual accuracy of the report
z
We accept no responsibility or liability for the findings or reports of legal and other professional advisers even though we have referred to their findings and/or reports in our report
z
The prospective financial information set out within our report has been prepared by Burgundy; we do not accept responsibility for such information. We must emphasise that the realisation of the prospective financial information is dependent on the continuing validity of the assumptions on which it is based. The assumptions will need to be reviewed and revised to reflect any changes in trading patterns, cost structures or the direction of the business as they emerge. We accept no responsibility for the realisation of the prospective financial information. Actual results are likely to be different from those shown in the prospective financial information because events and circumstances frequently do not occur as expected, and the differences may be material
z
The analysis of ‘adjusted’ earnings is for indicative purposes only. We have sought to illustrate the effect on earnings of adjusting for those items identified in the course of our work that may be considered to be 'non-recurring' or 'exceptional' or otherwise unrepresentative of the trend in earnings using criteria established by Claret. However the selection and quantification of such adjustments is necessarily judgmental. Because there is no authoritative literature or common standard with respect to the calculation of ‘adjusted’ earnings, there is no basis to state whether all appropriate and comparable adjustments have been made. In addition, while the adjustments may indeed relate to items which are 'non-recurring' or 'exceptional' or otherwise unrepresentative of the trend, it is possible that earnings for future periods may be affected by such items, which may be different from the historical items
Limitations of scope z
We draw your attention to the significant limitations in the scope of our work. We have had no access to the premises of Burgundy. Access to the audit files has not been granted at this stage. Management information available has been restricted to specified documents in a data room and supporting work papers have not be available in all instances. These restrictions have had a corresponding impact on the nature of comments we have been able to make on the financial information available
z
We do not accept responsibility for such information which remains the responsibility of management. We have satisfied ourselves, so far as possible, that the information presented in our report is consistent with other information which was made available to us in the course of our work in accordance with the terms of our engagement letter. We have not, however, sought to establish the reliability of the sources by reference to other evidence
z
In preparing this update, our only source of information has been the information contained in the Burgundy data room and various meetings with Burgundy management between 12 August and 18 December 2008
z
Information provided in the Burgundy data room has not been sufficient to address all areas of our scope. This report focuses on a number of key issues identified in discussion with you and reflects the information with which we have been provided and discussions we have held as noted above. We have also highlighted within this report recommendations for subsequent phases of work should further information be made available
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Private & confidential
Glossary of terms ABS
Asset Backed Security
HY2
Period from 1 July to 31 December
AFS
Available For Sale
HMRC
HM Customs and Revenue
AHL
Amber Homeloans Limited
HPI
House price index
ALCO
Asset and Liability Committee
IBNR
Incurred But Not Reported impairment
BCIG
Burgundy Capital Investments Group
ICAAP
Internal Capital Adequacy Assessment Process
BI
Burgundy International
ICG
Individual Capital Guidance
BMR
Burgundy Member Reward
IFRS
International Financial Reporting Standards
BTL
Buy-to-Let
LGD
Loss given default
BTS
Burgundy Treasury Services
LIBOR
London Inter Bank Offered Rate
CDS
Credit Default SWAP
LTV
Loan to Value
CII
Consumer Indebtedness Index (Experian product)
MBS
Mortgage backed security
EIR
Effective Interest Rate
MI
Management information
EL
Expected loss
MIG
Mortgage Indemnity Guarantee
ERC
Early Redemption Charge
MTN
Medium Term Note
FTB
First time buyer
NIM
Net Interest Margin
FSA
Financial Services Authority
PD
Probability of default
FSCS
Financial Services Compensation Scheme
PIBS
Permanent interest bearing shares
FSD
Forced Sale Discount
RPI
Retail Price Index
FRN
Floating Rate Notes
SIV
Special Investment Vehicle
FY06, FY07, FY08
Financial year ended 31 December 2006, 2007 and 2008
SLS
Special Liquidity Scheme
GCC
Group Credit Committee
SREP
Supervisory review and evaluation process
GEB
Guaranteed Equity Bond
SVR
Standard Variable Rate
GEN PRU
General Prudential Sourcebook
TOMS
Tax scheme in relation to Foreign Exchange Translation
GIC
Guaranteed Investment Contract
UTD
Up to date
HY1
Period from 1 January to 30 June
WMS
Western Mortgage Services
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Private & confidential
Contents The contacts at KPMG in connection with this report are: Andrew Walker Financial Sector Group Partner, KPMG LLP Leeds Tel: +44 113 231 3913 Fax: +44 113 231 3139
[email protected]
Kieran Cooper Financial Sector Group Senior Manager KPMG LLP Leeds Tel: +44 113 231 3972 Fax: +44 113 231 3139
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity
[email protected]
z Securitisation
Andrew Nelson Transaction Services Associate Director KPMG LLP Manchester
z Accounting policies
Tel: +44 161 246 4640 Fax: +44 161 838 4096
z Adjusted earnings
[email protected]
Katie Clinton Financial Sector Group Senior Manager KPMG LLP Manchester
z Taxation
z Pensions z Capital
Appendices
Tel: +44 161 246 4480 Fax: +44 161 838 4040
[email protected]
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Private & confidential
Executive summary
Introduction Scope of work z
This report summarises the findings of Phase 1 of due diligence. Phase 1 of due diligence focused on ten key areas, which were considered by Claret to be the areas of highest risk. The key findings in each area are summarised over the following pages of the executive summary
z
Claret and Burgundy senior management agreed that Phase 1 of due diligence (in both directions) would draw upon information readily available in each business. As a result, certain scope items in connection with lower risk areas, or in respect of which information is not readily available, have been deferred to Phase 2. These items are outlined in Appendix 1. It is anticipated that Phase 2 of due diligence will be completed following approval by the respective Burgundy and Claret boards, most likely in early 2009
Interaction of workstreams z
We have been engaged to perform work with Claret in three different workstreams of Project Vintage. Our responsibilities, together with an explanation of how and when we will report under each workstream, are summarised below Area
Focus
Status
Due diligence
z
Focus on ten key areas of due diligence under Phase 1
z Phase 1 complete and findings summarised in this report which
Synergies
z
Review of projected revenue and cost synergies and comment on ‘achievability’
z Findings have been summarised in a separate report, dated 5
Transaction structuring
z
Acquisition assistance, with a focus on deal structure, tax implications, accounting and fair value of assets and liabilities, and commenting on combined capital projections
z Principal output will be to comment on combined capital
includes responses to questions raised by the CFS RMC on 31 October 2008 and the Combined Claret/Group ARC on 3 November 2008. Where issues have been identified, these are summarised on page 10 and are being rolled forward into combined Vintage capital projections, which ultimately will form part of the business case for Vintage November 2008
projections, specifically to address approach, key assumptions, key uncertainties and sensitivities. This is anticipated to be completed following agreement of revised capital projections, expected to be completed 19 December 2008 z We have not been requested, at this stage, to perform any further attestation work on the business case for Project Vintage
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
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Executive summary
Headlines (1)
Commercial lending quality
z
One of the key mitigants to a rising impairment charge in Burgundy is Illius, which acquires repossessed properties for rental. The planned volumes of properties in Illius are 800 by the end of 2008 (with a value of approximately £100 million), which represents 90% of the Group’s planned repossessions. This introduces a significant new economic risk in the form of maintaining rental income in difficult markets, the carrying value of the properties and possible legal / regulatory risk in the light of the Government’s emerging view on limiting repossession volumes
z
Analysis of data tapes for the Leek Finance 18 and 19 securitisation vehicles has corroborated the management information produced by Burgundy, particularly in connection with its ‘problem cohorts’ of lending originated in H2 06 and H1 07
z
The fraud case reporting by Burgundy on the residential landlord portfolio identifies five lending cases on which estimated losses are £9.7 million, against which no provision has been booked
z
Burgundy has exposures to Woolworths as underlying tenants which total £16.4 million. A further exposure of £4.3 million exists in a property which is 1/3 let by MFI. Management has included a £4.8 million provision for these exposures
z
No other arrears are being experienced in either the housing association or pure commercial lending portfolios as at 31 October 2008
700 600 500 400 300 200 100
Member Business
Source:
BTS
Sep-08
Jul-08
Aug-08
Jun-08
May-08
Apr-08
Platform
Arrears reporting underlying data
Composition of comm ercial book £ billion Loa ns secured on commercial property Loa ns to Regi stered So cial Landlords (RSLS) Loa ns secured on residential property Source:
HY08
FY07
FY06
2.2 0.8 0.7 3.7
2.1 1.0 0.7 3.8
1.6 1.2 0.4 3.2
Burgundy 2008 Interim Results / 2007 Annual Report
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Page 62
Mar-08
Jan-08
Feb-08
Dec-07
Oct-07
0 Nov-07
The forecast charge for the full FY08 remains at £75 million as management believes it will benefit from further changes in methodology, further benefits from Illius and enhancing the effectiveness of collections. In the light of declining house prices and continuing increases in arrears in parts of the portfolio, we consider that the charge may be understated. Burgundy’s forecast charge for FY09 is still being considered by Burgundy, but could also be in the region of £75 million. This will be equally, if not more challenging, as many of the 2008 adjustments are not sustainable
Arrears movements July 2007 to July 2008
Sep-07
z
In common with the industry, arrears and losses in specialist lending have been on an increasing trend. The impairment charge for HY108 was £40 million, which was stated after the benefit of changes in impairment methodology and assumptions totalling £18 million (reducing the impairment charge). We understand the further charge for July to October of this year was £18 million (reduced since September due to a £4 million credit in October) bringing the YTD charge to £58 million. The run rate of the monthly charge before management actions is approximately £10 million per month
Jul-07
z
Aug-07
Residential mortgage credit quality
Jun-07
Comment
Residential Mortgage Arrears £'m
Area
6
Treasury Select Committee - Project Verde
Private & confidential
Executive summary
Headlines (2) Area
Comment
Liquidity book
z At 30 September 2008, Burgundy had a liquidity base totalling £9.3 billion, which is designated as available for
sale assets. The majority of the portfolio (98%) is either A rated or higher. Of the £140 million in BBB rated assets, none are considered impaired by Burgundy, and this remained the case as at 23 October 2008
z The fair value adjustments on the AFS book at 30 November 2008 amounted to £648 million (30 June 2008:
£139 million). The majority of the deficit arises on the ABS/MBS portfolio, on which the largest fair value adjustments are in respect of holdings issued by Granite (Northern Rock’s securitisation vehicles)
z Management is in the process of discussing with the auditors the possibility of transferring a number of the
AFS assets to loans and receivables and restating at a mark-to-model value. If agreed, this would be done at their fair value as at 1 July 2008
z Burgundy management has identified high risk wholesale counterparty exposures to Lehmans, IKB, Kaupthing
and Mazarin & Barion of £130 million, as set out opposite. The recoveries on these assets are highly uncertain, but we would currently suggest an additional provision of £40 million, reflecting the best evidence of possible recoveries at this stage. This has been reflected in the capital projections and Claret management are considering the IKB position further
High risk liquidity / banking exposures
£m
Burgundy proposed provision
Gross
Leh mans IKB K aupthing Mazarin & Barion Source:
90 25 10 5 130
Claret view
45 5 2 52
80 9 4 93
Counterparty exposures report September 2008
z Detailed analysis on the performance of the mortgage backed securities has identified 21 positions with a
nominal value of £244.0 million and a MTM value of £188.4 million, for which there is a high risk of some impairment. Claret management has calculated a potential impairment provision of £65 million on these assets
Liquidity and funding
z At 30 September 2008 the profile of Burgundy’s balance sheet was such that non-securitised mortgages were
88% funded by retail deposits
z Over 2008 the Group has become increasingly reliant on repo and SLS funding in replacement of longer term
commercial paper funding. The liquidity book at 30 September 2008 of £9.7 billion comprises ‘genuine’ liquid balances, (CDs, Gilts and cash) of £6.8 billion (70%) and less liquid balances (primarily ABS/MBS) of £2.9 billion (30%)
z Short-term funding roll-over rates are reducing; however, this is partly through strategic choice as opposed to
being all market related. A small number of counterparties were lost as a result of the downgrading earlier in the year; predominantly small parties with the exception of L&G and Morley (together £350 million). The rollover rate at 30 September 2008 was 84%
z Burgundy performs regular stress testing of liquidity, with focus on the severe firm specific scenario in which
both wholesale and retail funding lines are reduced, redemptions are slowed, wholesale funding rollovers are reduced and there is a one-notch credit rating downgrade. The testing shows that Burgundy retains positive liquidity headroom after management actions to curtail new lending
z Within the warehouse line agreements, step up rates of between 75-100 bps exist where the funding lines are
termed out. Additionally, triggers exist so that if the credit rating of Burgundy were to fall to BBB or below, the GIC accounts would need to be held externally
z In the event of a further one notch downgrade of credit rating, Burgundy management believes that funding
rollover rates would be reduced further, and has quantified this impact to be in the region of £150-200 million of unsecured and a further £250-500 million of repo over a 12 month period
Balance sheet assets and liabilities (December 2007 & June 2008) 100%
£1.1
£1.0
£2.1 £0.5
80%
£9.2
£10.2
£9.4
£11.9
70% £4.3
60% £4.7 50% 40% £25.1
£25.5 30%
£19.2
£17.6 20% 10% 0% FY07 assets
FY07 liabilities
H12008 assets
H12008 liabilities
M o rtgages
Liquid assets
Other assets
Retail funds
No teho lder funds
Who lesale funds
Other
Capital & reserves
Source:
Annual Financial Statements December 2007; Half year announcement June 2008
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Page 63
£2.0 £0.4
90%
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Treasury Select Committee - Project Verde
Private & confidential
Executive summary
Headlines (3) Area
Comment
Securitisation
z
Over the history of the programme, Burgundy has issued £9.25 billion equivalent under the public Leek transactions of which £3.4 billion remains securitised (excluding Leek 20 which was used for the SLS programme)
z
Credit enhancement to protect investors is provided through a combination of subordinated note classes, a reserve fund requirement and excess spread earned within the structures. The capital required to be held against the structures is capped at the level of the first loss reserves (£130 million); however, we note that this is further reduced, to £42 million, as a result of the Dovedale structures
z
z
Accounting policies
Taxation
Issue name
There is a significant amount of headroom between the current loss levels in each vehicle and the first loss recoveries. In the worst instance (Leek 19), the reserve fund is 5 times higher than the cumulative losses experienced to August 2008 The investor reports at 31 August 2008, in which cumulative losses are reported for each securitisation vehicle suggests that losses are increasing by 0.08% of the book per month in the worst instance, Leek 19. At that rate, it would take 31 months until the reserve fund is exhausted, even after the excess spread is exhausted
Outstanding note amount £ equivalent
Reserve fund as % of outstanding amount
Cumulative losses since issue (% original balance)
Leek Finance 11
44
19.35%
0.04%
Leek Finance 12
88
17.56%
0.17%
Leek Finance 14
194
11.46%
0.14%
Leek Finance 15
335
7.42%
0.25%
Leek Finance 16
416
4.99%
0.34%
Leek Finance 17
723
3.83%
0.34%
Leek Finance 18
843
3.20%
0.38%
Leek Finance 19
753
2.38%
0.48%
3,396
z
However, arrears in the later vehicles examined by us (Leek Finance 18 and 19) are increasing rapidly (30% between August and October) which suggests that these vehicles are most at risk of utilising their credit enhancement
z
The offering circulars made available contain no significant triggers within the securitisation vehicles
z
The Leek 19 portfolio was downgraded in December due to the increasing arrears in the portfolio
z
With the exception of GEBs there are no significant accounting policy differences between Burgundy and Claret. However, there are a number of subjective accounting estimates which may differ with those of Claret. These include impairment provisioning, the accounting for investment properties and amortisation of goodwill and intangible assets
z
Further information is required from Burgundy on the GEBs accounting treatment to fully understand the potential impact of this treatment. Based on information available to us, we believe that the GEBs adjustment of £8 million in HY108 is not acceptable. This benefit is projected to grow to £15 million for FY08; however, we note that this would be a timing adjustment only and all benefit would accrue over the medium term if Claret’s accounting policy was adopted
z
At the half year 2008, Burgundy held provisions of £32.3 million for tax uncertainties relating to transfer pricing and foreign exchange planning. Based on our high level assessment, there is a risk that these provisions are understated by £10.9 million (which included un-provided interest estimated at £8.3 million in relation to the foreign exchange planning
z
With the exception of the above items, there do not appear to be any material open issues
z
The accounts include deferred tax assets of £15.3 million which could be lost on completion of Project Vintage. This comprises £9.5 million in relation to trading losses which, under the current legislative framework, would be extinguished when Burgundy Society ceases to exist and £4.8 million in relation to IFRS transitional adjustments which would be a loss of the final period for Burgundy Society – this loss could also be extinguished if it cannot be utilised
B urgundy ass ess m ent of ris k expos ure - ha lf y ear £'m Forex pla nning (TO M S ) Tra nsfer pric ing enquiry
12.1
E s tima ted ta x expo sures
40.9
W eig h tin g 95%
A m ou n ts p ro vid ed - P rov is ions in indiv i dua l entites - P rov is ion on cons olida tion U n-prov ide d ex pos ure o n Burgundy a s se ss m ent Ad d: Additiona l 5% pro vision on TO M S Ad d: Intere st on un paid tax re TO M S (ne t of ta x relief) U n -p r ovid ed exp o s ur e S o u rce :
50%
P ro vis io n 27.4 6.1 33.4
(26.8 ) (5.5 ) 1.1 1.4 8.3 10.9
H a lf y e ar m e m or an du m to B u rg u n d y a ud it co m m ittee a n d K P M G a na ly sis
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M ax 28.8
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Treasury Select Committee - Project Verde
Private & confidential
Executive summary
Headlines (4) Area
Comment
Adjusted earnings
z The most significant adjustments relate to one-off profits recognised in H108 (£25.1 million)
and subjective reductions in the impairment provision (£18.0 million). Burgundy has also benefitted from a change in accounting estimates in relation to GEBs of £8.0 million. Potential additional exposures relate to further deteriorations in the housing market increasing the impairment charge
z In aggregate, adjustments to reported operating profit would create an adjusted loss, although
some elements of these are subjective in nature
z Some of the earnings adjustments, most significantly, the change in accounting policy on GEBs
will have a further impact in H208
z We note that any changes in the accounting policy of GEBS is only a change in timing of
recognition of income (and is therefore neutral over the medium term) and that improvements realised due to Illius would be continuing, assuming the scheme continues to work
z In addition to the adjusted earnings noted opposite, Claret management has estimated the
potential impact of further SLS interest costs and FSCS costs going forward. These total £25 million and £22 million post tax respectively in both FY08 and FY09. As the final impact of these has not yet been calculated by Burgundy management, they have not been included in the adjusted earnings table opposite
Pensions
Adjusted earnings £'m Reported operating profit One-off profits: Gain on VocaLink shares Basis book swap rip-ups Sale of gilts Profit on sale of fixed assets Total one off items Adjusted profit after one-off items Total impairment adjustments Total income adjustments Total EIR/provision adjustments Adjusted operating profit/(loss)
FY07 114.6
HY108 50.1
(4.0) (4.0) 110.6 (15.0) (4.8) (10.0) 80.2
(3.0) (14.1) (4.0) (4.0) (25.1) 25.0 (25.9) (14.2) (5.0) (20.1)
z The valuation of the Burgundy defined benefit scheme (“DB scheme”) as at 5 April 2008 disclosed an ongoing funding deficit of £28 million. Burgundy has agreed to
clear the ongoing deficit with a single lump sum payment of £28 million before the end of 2008. In addition, Burgundy has agreed to pay around £8.5 million a year to the DB scheme in respect of future service benefits
z The overall ongoing (cash funding) valuation basis adopted in April 2008 is generally reasonable although the salary growth assumption of price inflation less 0.5%
p.a. is unusually low. Burgundy is obliged to fund the impact of higher salary increases should they be granted in the future
z At 31 December 2007, the IAS19 disclosures revealed a Funded status of £58 million for the DB scheme although this was reduced to £45 million after allowing for
the impact of the surplus cap under IAS19 and the impact of £4 million of unfunded pension liabilities
z At 30 September 2008, we estimate that the ongoing funding deficit of £28 million has increased to around £67 million, using consistent assumptions. Moving to
the funding assumptions adopted for Claret’s defined benefit scheme would result in a funding deficit of £148 million
z At 30 September 2008, we estimate that the IAS19 balance sheet position would show a surplus of £71 million before the application of any surplus cap. Moving to
the accounting assumptions adopted for Claret’s defined benefit scheme would result in a surplus of £19 million
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Treasury Select Committee - Project Verde
Private & confidential
Executive summary
Headlines (5) Area
Comment
Capital
z The FSA conducted a SREP on Burgundy in August 2008. Key findings were that the ICG will
be at least 130.5% of pillar 1 requirement plus £164 million, an increase of approximately £30 million over the interim ICG. The FSA raised significant issues in the areas of capital planning, credit concentration risk, subordination of building society depositors, interest rate risk in the banking book and business risk
z Burgundy’s most recent capital headroom at 31 August 2008 was £258 million. Outside of the
combined capital work, which is subject to separate due diligence reporting, the latest formal projection of capital headroom at 31 December 2008 was £199 million on the consolidated basis (£53 million lower on the solo basis). Management has also confirmed that current capital burn rate is £15 million per month
Burgundy capital surplus
Capital requirement Capital resources Surplus
Actual
Actual
Forecast
31-Dec-07 1193
30-Jun-08 1304
31-Dec-08 1482
1656 463
1646 342
1681 199
z As work continues on the capital forecasting, it is likely that the opening position of FY09
capital will change
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Treasury Select Committee - Project Verde
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Executive summary
Summary of differences A number of differences
Due diligence findings
have been noted as part of the KPMG due diligence process. Those that have not been reflected in the capital planning total £137.8 million of additional expense with a resultant impact on capital
£ million O pening balance Tax provi sions Residential impairment MBS / ABS impairment FSCS costs S LS interest costs Total adjustments Closing balance Source:
FY08
FY09
Closing re serves 1,109.0 (10.3) (25.0) (65.0) (35.0)
PBT 47.1 (25 .0) (20 .0)
Base case 693.9 (7.4 ) (36.0) (46.8) (39.6)
Moderate stress 662.6 (7.4) (36.0) (46.8) (39.6)
(2.5) (137.8) 971.2
(30 .0) (75 .0) (27 .9)
(23.4) (153.2) 540.7
(23.4) (153.2) 509.3
Capital headroom (FY09)
6
KPMG analysis
Adjustments following due diligence findings (continued)
Previous issues now adjusted for z
We understand that the suggested provisions relating to the Lehman's and Icelandic Bank exposures have now been fully reflected in the combined capital planning along with the de-recognition of the pension asset in the available capital
z
Capital adjustments have been tax effected (i.e. netted down)
5. Following the nationalisation of Bradford & Bingley and the collapse of
Icelandic banks and London & Scottish Bank, all UK deposit takers are required to pay an element of the interest and capital on loans of circa £20.0 billion to the Financial Services Compensation Scheme (‘FSCS’). The FSCS are using the level of retail deposits to determine how much each entity must pay. Based on current expectations in the market, we believe that Burgundy’s element of this could be as high as £35.0 million in FY08 and at least £20 million per annum for Fy09 to FY11. There is also the potential risk to Burgundy’s share of the capital on these loans
Adjustments following due diligence findings z
Note 1 2 3 4 5
Differences in the treatment and quantum of certain assets and liabilities have come about as part of the due diligence process. These have been captured here to show what impact they would have on the FY09 income statement and capital position (both base case and moderate stress) of Burgundy
6. In the projections, it is assumed that a further £1.5 billion of SLS funding is
received. No additional interest cost has been accounted for on this funding. Claret management believe this would be in the region of £30.0 million per annum
1. The FY09 income statements and capital projections have been used as
z
There are three additional areas that have not been considered as part of the transaction to date, due to their timing, which will need to be considered in the strategic plans going forward;
2. Following the receipt of additional information on taxation, we have
-
The impact of a low base rate environment has not been considered within the Strategic Plan Light. This could have a material impact on the margin assumed within the plan and leave the current plan looking optimistic
-
The impact of government schemes of mortgage assistance to those in difficulties has also not been considered to date. This would be likely to impact the level of possessions going forward and would impact on income and losses
-
Finally, the FSA consultation paper on liquidity has not yet been considered which would significantly impact the funding basis of the combined entity going forward if the plans were to be approved
Burgundy management have stated that none of these issues would be reflected in the FY08 statutory accounts
reduced our estimate of the additional tax provisions we believe are needed to £10.3 million. This consists of increasing the TOMS provision to 100% (from 95%) and including an element of fines and late payment interest
3. We believe the residential impairment provision is understated by circa
£25.0 million in FY08 and again in FY09
4. Following a detailed analysis of the MBS and ABS portfolio, we
highlighted a number of assets which could show signs of impairment. Claret management has reviewed our work and determined that they believe an impairment provision of £65.0 million is needed against these assets
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Executive summary
Continuing economic impact
4.0
z
The main areas that Burgundy management has been requested to look at are;
-
The impact on any caps in the difference between SVR and base rate within the mortgage products;
2.0
-
Any floors in the level of rates payable on the savings accounts; and
1.0
-
A more general view of the impact on the overall margin of the business
0.0
z
As more information is released by Burgundy, we will analyse it and report in subsequent papers
Dec-08
Oct-08
Nov-08
Sep-08
Aug-08
3.0
Jul-08
the due diligence process
5.0
Jun-08
to be quantified as part of
6.0
Apr-08
considerations that need
7.0
May-08
Many financial institutions are currently working to try and model what the effect of a low base rate environment will have on their business, and with few examples to draw from across the world which mirror the current UK environment, this is proving difficult
Feb-08
z
Mar-08
Since the last report, there have been further reductions in the Bank of England base rate to its lowest point in recent history
Jan-08
z
Dec-07
of uncertainty and further
Bank of England base rate November 2007 to December 2008
Nov-07
continues to lead to areas
Low base rate environment
Percent
The market turmoil
Recent Government actions z
The Government had made a number of announcements over the past month in an attempt to ‘kick-start’ the economy and prevent excessive possessions
z
In November, the Government announced a scheme whereby they will guarantee amounts of interest on people whose mortgages are in arrears for up to two years. The detail of this guarantee is yet to be seen; however, it appears that the Government will enforce the guarantee where a member of the household has suffered a loss or reduction in income which is preventing them from making their mortgage payments
z
This could have the impact of delaying the time to possession and also will have adverse consequences for banks as they will need to fund these nonperforming assets, and the increased capital they will require if these remain classified as ‘non-performing’ for capital purposes
z
In December, the FSA released its consultation paper on liquidity. This discusses the possibility of regulated banks and building societies being required to maintain a certain amount of funding (up to 25%) direct from the government
z
The idea behind this is to prevent the issues faced by Northern Rock, and to a lesser degree by Bradford & Bingley, where the disappearance of the securitisation market and falling retail deposits put significant pressure on the banks to fund their operations
z
Neither of these scenarios have been modelled by Burgundy as yet
Source:
Bank of England web site
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Treasury Select Committee - Project Verde
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Treasury Select Committee - Project Verde
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Overview of business
Group structure There are two key
Group structure
elements of the Burgundy
z
The Burgundy Group comprises Member Business and Burgundy Capital Investment Group (‘BCIG’). Burgundy is owned by the 2.9 million customers who have Member Business savings or mortgages
z
The Member Business consists primarily of deposit taking and secured lending activities typical of a traditional building society. As a mutual, the Member Business is not run to maximise profits – it generates only the profit needed to maintain financial strength and invest in the business
z
BCIG is a portfolio of specialist businesses in which Burgundy has invested members’ capital over the years. The BCIG companies – BTS, Platform and WMS – are run to maximise returns which are shared with members through the Burgundy Member Reward scheme (‘BMR’)
z
The BCIG businesses have grown significantly over the last few years, expanding Burgundy’s presence in markets such as intermediary lending, third-party mortgage servicing, securitisation and commercial lending. Over the last five years the BCIG businesses have generated almost £230 million in cash payments to the members of Burgundy
Group: a traditional building society run in the interests of its members and a separate profit centre business (BCIG) which has sought to maximise returns to members through the
Burgundy Group
BMR The activities of BCIG are more exposed to fluctuations in the macroeconomic environment than traditional building societies, which makes the long term reported
Member Business Activities z
Deposit taking and secured lending
profitability of the
Key revenue streams
Burgundy Group open to
z
Interest income
potential significant
z
Insurance commission
volatility
z
Mortgage fees
Treasury
BCIG
Activities z
Group Funding Platform
BTS
Key revenue streams z
Interest income (wholesale)
z
Profit on sale of capital assets
Activities z
Funding of BCIG businesses
Key revenue streams
Activities z
Intermediary and commercial lending
Key revenue streams
z
Interest income
z
Interest income
z
Asset sale profits
z
Mortgage fees
WMS Activities z
Mortgage servicing
Key revenue streams z
Servicing fees from BTS asset acquisitions and external parties
BMR payment to members Source:
2008 Interim Results announcement
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Overview of business
Products and customers Out of the top five Building Societies, Burgundy has the highest exposure to specialist lending
Treasury Services & WMS
Mortgages z
Fixed rate
z
Time deposits
z
Flexible
z
Call accounts
z
Offset
z
z
Tracker
z
Buy to let
Funding programmes (MTN’s, securitisation and commercial paper)
Unsecured lending
z
z
Portfolio sales and purchases
z
Commercial lending
z
Servicing of mortgage portfolios
Value proposition z Remaining mutual and acting in
the membership’s best interest
z Being financially strong z Being ethical, socially responsible
and a model of compliance
z Being a great place to work, grow
and develop
z Rewarding members through the
loyalty scheme; and
z Maintaining an extensive branch
network
Customers
Savings
z
Prime borrowers (Society)
z
Near prime borrowers (conforming)
z
Subprime borrowers (Nonconforming)
Savings bands
z
Residential landlords (Buy-to-let)
Investments
z
Commercial borrowers
z
Retail and wholesale investors
z
Easy access savings
z
Regular savings
z
Notice accounts
z
ISA’s
z z
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Overview of business
Key drivers of financial performance, identified risks and opportunities Division
Member Business
Current position and key drivers of financial performance
z
Operated on a member basis, not to maximise profit
z
Operated as a profit centre to generate dividend income for the BMR
z
Reported operating profit H108 £42.2 million (FY07: £25.1 million)
z
Reported operating profit H108 £7.9 million (FY07: £89.5 million)
z
Decline in adjusted net interest margins (before GEB and EIR model adjustments) over H108 driven by increased cost of retail funding
z
Platform margin has been impacted by a change in product mix away from higher margin products and the impact of new lending criteria
z
Benefited from high redemption levels increasing fee income during FY07 and a good quality loan book with low historical levels of impairment
z
Commercial income restricted due to cessation of new lending
z
BTS has benefited from the premium of LIBOR over base rate during H108 and the success of fixed rate swaps
z
Maintain Platform business through economic downturn and grow WMS offering
z
Avoid commercial lending until market conditions improve
z
Hold assets in BTS until market has recovered
Strategic plans
Key opportunities
Key risks
BCIG
z
Key drivers are the quality of the loan book, activity and value of the residential housing market and overhead cost of maintaining branch network
z
Increase lending criteria to maximise quality of loan book, maximise retail deposit levels and target a nil net cash outflow position in FY08
z
Maintain liquidity and capital position
z
Focus on cost reduction and brand awareness
Ï
Large and stable member base
Ï
Platform has a strong market franchise and experienced staff
Ï
Established branch and distribution network which has been recently refurbished
Ï
Ï
Brand investment across FY07 and FY08 through TV advertising
Restricted lending criteria and arrears management processes may help restrict exposure to future impairment levels
Ï
Impact of government schemes on mortgage arrears
Ï
Focus on loss recoveries
Ï
Good experience in securitisations
Ï
Lower forced sale discounts as a result of the Illius scheme
Ð
Lower redemption volume potentially restricting levels of fee income
Ð
Ð
Increased funding costs in a competitive retail deposit market in order to maintain liquidity, and due to entry into SLS
The sustainability of Platform given economic downturn and increasingly competitive market
Ð
Asset sales market not open to BTS
Ð
Long term risk to savings margins as higher margin products are replaced by lower margins
Ð
Increasing arrears and exposure to further impairment as a result of HPI deflation and changing nature of Platform book (i.e. Longer life)
Ð
IT systems due for upgrade which could result in significant capital expenditure
Ð
Ð
Increasing arrears
Exposure to mortgage fraud, especially within the residential investment Commercial book
Ð
Reducing capital headroom
Ð
WMS appears to require infrastructure investment in order to grow as expected
Losses on wholesale assets, potential risk of “secondary” exposures
Ð
Quality of asset purchases, in particular GMAC acquisitions
Ð
Profitability has been increased through the upfront recognition of profit on GEBs and other one-off adjustments
Ð
Ð
Impact of low base rate environment
Increased arrears and rating agency downgrades may put at risk early amortisation of securitisation vehicles (in particular Leek 18 and 19) and require replacement funding at higher costs
Ð
Impact of FSA’s CP on liquidity
Ð
The premium of LIBOR over base rate is not expected to continue in the long term which may result in increased hedging cost exposure
Ð
Impact of FSCS costs
Ð
Risk on rental income in Illius investment properties
Ð
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Private & confidential
Overview of business
Key issues summary Overview z
We note in the table below the 10 key areas that have been the focus of the Phase I due diligence exercise as agreed with Claret management
z
The table shows what the key issues have been in each of those areas, and the impact they could have on earnings, capital and liquidity. We also suggest where further work would be recommended as part of a Phase II to fully understand the position pre-completion
We outline below the key risks we have addressed as a priority in phase one, together with further areas of focus to pursue in phase two Area
Issues
Impairment
z
z
z
asset mix, arrears profile, capital usage, impairment methodology, key assumptions, Illius, payment arrangements, credit policies
Quality of commercial loan book −
Securitisation
top ten exposures, watch list
Structure and associated risks −
overview, credit enhancement, first loss, impact on capital
Wholesale
z
Risks associated with the fair value of the AFS book, ratings profiles
Funding/liquidity
z
Understanding of available facilities −
Accounting policies
z
Adjusted earnings
z
Taxation
9
9
Liquidity
impact of the application of subjective accounting policies
Impact of one-offs, accounting policies and key risks to earnings
Significant tax exposures
Recommendations for focus in phase 2
n/a
z
Get further information on roll-out rates, migration of PDs and LGDs by product/security type to understand the key drivers of future loss and possible scenarios
n/a
z
In depth review of weak counterparties - watch list as number of new cases shows sign of increase
9
z
Extent to which deferred consideration has already been extracted from vehicles
n/a
z
Update on wholesale exposures
z
Responses to FSA SREP letter of 29 August 2008
z
Understand mitigating actions assumed in liability stress testing
n/a
z
Clarification of approach to GEBs
n/a
z
Impact of aligning impairment calculation to Claret policies
z
Impact on FY08 outturn and FY09 forecast
z
Detailed information is required to comment on Burgundy’s tax status
z
Further focus on the adequacy of the tax provision in respect of TOMS
n/a
maturity analysis, stress testing
Consistency of policies with Claret −
z
Capital
Adequacy of impairment provisions −
Commercial
Earnings
n/a
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Private & confidential
Overview of business
Key issues summary We outline below the key risks we have addressed as a priority in phase one, together with further areas of focus to pursue in phase two Area
Issues
Pensions
z
z
Appropriateness of Burgundy’s funding and accounting assumptions compared to Claret’s assumptions, in particular the unusually optimistic low salary assumption
Capital
Liquidity
n/a
Capital requirements for pensions −
Capital
Earnings
Consider the additional capital requirement under GENPRU 1.2.82. Now that the deficit will have grown since 5 April 2008
z
Impact on Claret defined benefit plan
z
Capital treatment of pensions surplus (£71 million error at 30 September 2008)
z
Understanding current position and headroom −
n/a
key risks and subjectivities, sensitivities
Recommendations for focus in phase 2 z
Consider Burgundy and Claret Trustees’ reaction
z
Confirm treatment of pensions for capital adequacy purposes (to be confirmed with the FSA)
z
Consider mitigation strategies for DB scheme risk and volatility
z
Confirm treatment of sex equalisation reserve
z
Clarify capital treatment with FSA of pensions surplus under GEN PRU
z
Understand further key drivers of capital resources
z
In collaboration with Burgundy, address various capital forecast scenarios
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Private & confidential
Key financials
Financial summary and key ratios In line with the market and
Key financial summary
its peers, Burgundy
Year ended 31 December
demonstrated healthy
Total assets (£’m)
growth during the five year period to FY06 Since the onset of market difficulties, however, growth slowed considerably in FY08 to date
Group FY03
Group FY04
Group FY05
Group FY06
Group FY07
Group FY08
20,929
25,219
32,433
35,149
36,827
35,269
Profit/(loss) after tax (£’m)
65.3
70.2
51.2
57.0
49.3
36.2
Profit/(loss) after tax as a % of mean total assets (%)
0.33
0.30
0.18
0.17
0.14
0.10
Management expenses as a % of mean total assets (%)
0.86
0.78
0.73
0.82
0.74
0.71
Cost/income ratio (%)
53.62
55.73
61.92
67.01
67.40
61.43
Liquid assets (%)
31.08
31.37
40.30
40.55
34.78
31.8
Free capital including supplementary capital (%)
6.92
7.02
6.02
6.18
5.93
n/a
Supplementary capital as a % of free capital (%)
26.93
37.37
49.78
50.52
49.68
n/a
Deposits (%)
42.10
44.49
40.30
38.01
40.19
49.16
1,581.1
1,382.3
(119.2)
1,171.7
1,296.3
305.8
88.89
91.97
88.94
91.23
89.85
91.69
Deposits increase/ (decrease) over year (£’m) Loans fully secured on residential property (%) Source:
KPMG Building Societies Database 2003-08
Overview z
Burgundy is the second largest building society in the United Kingdom, ranking only behind Nationwide Building Society
z
Burgundy operates through a branch network of 254 branches. It also operates via a joint venture company, Mutual Plus, a branch sharing arrangement with Yorkshire Building Society, which operates a further 134 branches. Burgundy’s branch network increased significantly in 2006 following the acquisition of the Bristol & West branch network, which comprised 97 branches, 850,000 customers and deposits of £4.5 billion
z
Burgundy’s strategic priorities in the present market conditions are as follows (in order of priority): 1. Liquidity 2. Capital / profit 3. Key themes: −
cost reduction
−
leadership
−
brand
4. Growth
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Overview of business
Market position In 2007, Burgundy ranked
Market positioning in the Building Society sector
12 in the UK market in terms of mortgage balances outstanding and 13 in relation to gross mortgage lending
Group total Group asset assets £’bn growth %
Name Burgundy Average of Peer Group Societies’ Claret Bank plc Note: Source:
Rank (out of 21)
Group profit for year £m
Group profit change %
Rank (out of 20)
Group cost/ income ratio
Rank (out of 21)
4.8
21
44.9
(13.51)
15
0.87%
15
67.6%
12
n/a
16.7
n/a
n/a
(3.81)
n/a
0.98%
n/a
64.4%
n/a
13.1
2.4
n/a
49.1
(34.6)
n/a
2.59%
n/a
64.8%
n/a
Based on top 21 societies by asset ranking KPMG Building Societies Database 2008
Market position Liquid Rank assets (out of ratio (%) 21)
z
In 2007, Burgundy ranked 12 in the market in terms of mortgage balances outstanding with £23.4 billion of loans representing a 2.0% market share. In comparison, Claret ranked 30 with £3.3 billion of mortgage balances outstanding
z
In terms of gross mortgage lending, Burgundy ranked 13 in 2007 (in comparison to 31 in 2006) with total advances of £6.2 billion representing an estimated market share of 0.3%
Gross Rank Free Rank capital (out of capital (out (%) 21) (%) of 21)
Burgundy
34.80%
1
7.00%
7 5.90%
7
Average of Peer Group societies
23.98%
n/a
6.63%
n/a 5.86%
n/a
KPMG Building Societies Database 2008 and Claret Bank plc statutory accounts 2007
Strategic priorities z
Burgundy has reported that its key strategic priorities in the current market circumstances, that is key areas of strategic focus are liquidity and capital
z
The table opposite shows Burgundy’s reported liquidity and capital ratios compared with the Societies peer group average for 2007 and those Societies who have declared results for HY108
HY108 comparison Liquid assets ratio Gross capital Free capital % % % Burgundy
27.0
6.0
5.3
Skipton
27.1
7.9
5.3
Principality
23.4
7.8
n/a
Source:
Group NIM/mean assets
36.8
FY07 comparison
Source:
Rank (out of 21)
Half year announcements
Market positioning of the Building Society sector z
The tables on FY07 show extracts from the KPMG publication “Building Societies Database 2008” which is based on reported results for 2007. Claret Bank has also been added for comparison purposes
z
Burgundy’s total assets growth was the weakest in its peer group in 2007. This is however in line with its reported strategic priorities
z
Of greater significance is the reducing trend of group profits (ranked 15th) in 2007, which has continued into 2008. Of the four societies which have reported results for the six months ended June 2008, Burgundy’s profit change compared with the same period in 2007 was ranked 15th. Claret’s profit change from HY108 versus HY107 was (34.6)%
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Private & confidential
Key financials
Income statement Reported operating profit
Income statement
Summary income statement
has declined from £81.4 million in HY107 to £50.1 million in HY108, driven by increased impairment charges associated with Platform’s residential
£'m Income
HY107
HY207
FY07
HY108
Interest receiveable Interest payable
986.0 (826.0)
1,110.5 (955.7)
2,096.5 (1,781.7)
1,064.8 (896.3)
160.0 35.4
154.8 33.9
Net interest income Fee and commission income
mortgage book
Fee and commission expense Net fee and commission income Other operating income
Exposure to the housing
Expenditure
market, volume declines and lower early
(3.3) 32.1 18.0
Administrative expenditure Depreciation and amortisation Impairment: losses
at Platform pose a
Operating profit Share of post tax profits from joint ventures Profit before tax and BMR
significant risk to BCIG ‘s
Source:
redemption charge income
(4.7) 29.2 2.3
314.8 69.3 (8.0) 61.3 20.3
168.5 30.5
210.1
186.3
396.4
213.2
(122.3) (16.1) (14.7)
(236.6) (31.2) (14.0)
(108.3) (14.4) (40.4)
81.4 0.3 81.7
33.2 0.3 33.5
114.6 0.6 115.2
50.1 0.4 50.5
73.4
(75.0)
94.0
z
As a result in HY108 the Member Business contributed 84% of operating profit against 33% in HY107. The £15.3 million increase was principally due to margin increases, however the movement is before adjusting for non recurring items and accounting adjustments, which are significant (see adjusted earnings sections for detail)
z
Net fee and commission income represents mortgage fees, lending fees and insurance income including GEB income
z
Other income is driven by gains achieved on derivative instruments. Other income in HY207 also includes impairment charges associated with an investment in the Cullinan SIV
1.1.8.2 Interim announcement H108, 2007 Statutory Accounts
60.0
Divisional operating profit
50.0
90.0
40.0
80.0 70.0 60.0
comparison to HY107,
50.0 £'m
increased in HY108 in
30.0
26.9
20.0 £'m
Member Business
40.0 30.0
driven by a number of
20.0
non-recurring items and
10.0
accounting adjustments
BCIG’s profitability has in past years been key to funding the BMR (in FY07 this was £45.9 million). However, significantly reduced profitability from this division has been experienced in HY207 and HY108, due to significant increases in impairment charges, declining business volumes, lower early redemption charges (ERC), and lower income from asset sales
BCIG operating profit by the business
Operating profit within the
although this has been
z
(241.8)
future profitability and the future funding of the BMR
HY108 operating income is 1.5% higher than the corresponding period in HY107, although a number of non-recurring positive adjustments have helped increase Membership income as highlighted in the adjusted earnings section of this report
337.4
(6.3) 24.2 20.5
(114.3) (15.1) 0.7
z FY08 (re-forecast)
35.0 7.9
-
(1.8 )
(10.0 )
(analysed further within
HY107
adjusted earnings)
BCIG
Source:
42.2
54.5
HY207
HY108
Membership
Member Business operating profit shows a loss in HY207 due to the allocation of Treasury contribution for the purposes of statutory reporting. The management accounts reflect £20.7 million operating profit for Member Business before this adjustment
15.9 3.9 13.3
0. 7 1 4.
2.0 3.2 3.9
15.5
10.0
18.5
13.6
-
(1. 4 )
(1.0 )
19. 2
(10.0 )
(26. 2 )
(20.0 ) (30.0 ) (40.0 ) HY107
HY207
HY108
Losses within Platform have been the key driver of BCIG performance
Commercial Lending
BTS
WMS
BCIG Central and provision adjustments
Platform Note: Source:
Chart excludes impact of Burgundy International and IoM as from April 2008 these are analysed within the membership results within the Board reports 1.1.5.2 BCIG Managing Director Board reports
1.1.8.2 Interim announcement H108, 2007 Statutory Accounts
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Key financials
Balance sheet In HY108 Burgundy has experienced a reversal of historic growth in its residential mortgage book, which has resulted in loans to customers falling to £25.1 billion at 30 June 2008 There are £259 million of unrealised losses at 31 August 2008 on AFS securities that will potentially crystallise at acquisition (30 June 2008: £134 million) Retail deposit balances have been maintained at 2007 levels, and significant warehouse funding has been drawn down from other banks so as to mitigate liquidity risk resulting from the decline in securitisation activity post credit crunch
Assets
Summary Balance Sheet £'m
As at 31st December 2006 2007
As at 30th
z
Loans and advances (‘L&A’) to banks reduced by £0.5 billion in 2007 as lending has been funded partially by the wind down in liquid funds acquired from the Bristol & West branch network and savings business
z
The growth achieved in 2007 on L&A to customers (residential mortgage balances) was driven by a £1.1 billion mortgage book purchase from GMAC (by BTS), and £0.6 billion growth on both the Commercial and Member Business lines. This growth has been aided by increased customer retention as a result of lower redemptions in HY207
z
Trends established in FY07 have continued into HY108, as restricted lending criteria (in response to the macro-economic environment) have reduced Platform’s residential mortgage book from £6.5 billion at 31 December 2007 to £6.1 billion at 30 June 2008
z
The AFS balance has declined between December 2006 and June 2008 as a result of Burgundy managing down its Balance Sheet, planned MBS reductions that arose from the Bristol & West acquisition, and fair value falls in AFS assets as a result of the credit crunch
z
The retirement benefit scheme has moved from a liability of £44 million at December 2006 to an asset of £41 million at June 2008. However, an actuarial review is currently in progress, with initial indications suggesting a potential actuarial deficit on the scheme of £28 million at 5 April 2008 which had increased to £67 million by 30 September 2008
June 2008
Assets Loans and advances to banks and the BoE Loans and advances to customers Investment securities - available-for-sale Fair value adjustments for hedged risk Derivative financial instruments Goodwill and intangible assets Property, plant and equipment Deferred tax assets Prepayments, accrued income and other assets Retirement benefit asset Total assets Liabilities
2,557 23,129 8,653 (35) 374 241 83 29 118 35,149
2,037 25,480 8,178 76 441 238 84 8 241 45 36,827
2,222 25,091 7,026 (129) 600 235 81 6 97 42 35,269
Retirement benefit obligation Shares Deposits from banks Other deposits Debt securities in issue Derivative financial instruments Accruals and deferred income Other liabilities and taxes Subordinated liabilities Subscribed capital Provisions for liabilities and charges Total liabilities
44 17,138 884 2,571 11,888 329 147 128 562 302 18 34,009
17,568 5,058 3,583 7,945 335 184 93 561 304 8 35,639
17,583 5,349 3,240 6,646 202 190 70 546 296 6 34,128
General reserve Available-for-sale reserve Cash flow hedging reserve Total equity and liabilities
1,143 (1) (2) 35,149
1,255 (68) 1 36,827
1,286 (139) (6) 35,269
Source:
Equity and Liabilities z
Retail deposits (‘shares’) have been maintained at 2007 levels, despite the decline in assets, as Burgundy manages its liquidity and funding profile
z
The decline in securitisation activity associated with the credit crunch has resulted in the debt security balances declining by £5.3 billion over the last 18 months, with Burgundy drawing down £4.5 billion warehouse funding from other banks (‘deposits from banks’) and £0.6 billion of time deposits (‘other deposits’) to manage its liquidity
z
AFS unrealised losses are recognised through the AFS reserve, and will potentially crystallise on acquisition
1.1.2 Statutory accounts FY07, 1.1.8.2 Interim announcement HY108
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Private & confidential
Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendixes
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Private & confidential
Residential mortgage lending
Overview of mortgage asset mix (1) The asset mix has
Overview of lending mix at 30 June 2008
remained relatively stable
Residential Landlord
in the period from FY06 to
Asset mix overview
Housing Association
z
Commercial investment
FY08 and is forecast to
Burgundy’s mortgage assets can be split into three distinct groups as follows: -
Member Business – this consists of the mortgage lending completed by the Society. This is all considered to be prime lending
-
BCIG (Platform & BTS) – this includes the riskier elements of lending i.e. Non-conforming, self-certified and BTL businesses. There is also an element of prime lending completed through BCIG
-
Commercial – the commercial book consists of pure commercial lending, larger scale residential landlord business and housing association business
remain so up until the end Self cert
of FY08
Prime
The capital required on the riskier business (i.e. that
BTL
carried out within BCIG
Mortgage assets by type
residential and Non-conforming
commercial) is greater than the traditional Member prime lending business
Note: Source:
£bn Member business BCIG (Platform & BTS) Commercial Total
Intermediary Intermediary prime (Member) prime (Platform)
Supporting data presented in Appendix 1 Presentation for rating agencies final June 2008
FY07 11.1 10.7 3.7 25.5
FY06 10.5 9.5 3.2 23.2
z
The asset mix has remained relatively stable in the period from FY06 to FY08 and is forecast to remain so up until the end of FY08
z
The only notable change is the slight fall in commercial assets due to Burgundy effectively withdrawing from this sector at the end of FY07 due to the riskier nature of this lending in an economic downturn
z
13% of the book (for absolute figures see appendix 1) consists of nonconforming assets, an area of higher risk lending that Claret does not currently participate in
z
Further detail of the Commercial portfolio can be seen in the next section of the report
Relative capital requirement Housing Association Prime Residential Landlord
HY108 11.3 10.0 3.8 25.1
Intermediary prime (Platform)
Commercial investment
Capital usage z Self cert
As can be seen by the comparison opposite, the levels of capital required for higher risk lending are significantly higher than that for the Member Business, prime lending portfolio
Non-conforming BTL Member Business Note: Source:
Platform & BTS
Commercial
Supporting data presented in Appendix 1 Presentation for rating agencies final June 2008
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Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Overview of mortgage asset mix (2)
70% 50%
and Leek 19 securitisation
40%
vehicles (most recent), the
30%
detailed analysis of which
20% 10%
the LTV profile is
0 - 75% Source:
> 75%
> 80%
> 85%
Jun-08
falling HPI environment,
May-08
As would be expected in a
deteriorating
z
As can be seen from the chart opposite, the stock LTV has been deteriorating slightly since the start of the year despite the tightening of criteria earlier in the year
z
Whilst the level of 90% LTV + new lending gradually reduced, the other high LTV band new lending remained consistent. This coupled with higher LTV borrowers being unable to mortgage away has led to the deteriorating stock position as a percentage of the whole book
z
As at 30 June 2008, the indexed LTV showed 86.0% of stock balances were below 85%
0% FY05
can be seen overleaf
Monthly monitoring of the LTV mix by the Credit Committee, by both stock position and new lending started in February 2008. Historic data for FY05, FY06 and FY07 year ends were also supplied
60%
provided for the Leek 18
Apr-08
Detailed data tapes were
80%
Mar-08
the mortgage book.
z
90%
Feb-08
received limited data on
100%
FY07
diligence, we have
LTV mix
Residential stock LTV FY05 to June 2008
FY06
During phase 1 of due
Other areas z
A full, detailed breakdown of the loan portfolio has not been received in Phase I of the project albeit this has been provided for the Leek 18 and Leek 19 securitisation vehicles. This, coupled with the developing nature of MI in this area, has prevented us from completing a full analysis of the asset mix
z
In more recent MI, management has stated that they are seeing deterioration in the book due to payment shock of borrowers moving from fixed to SVR interest rates
z
Detailed forecasts of reversionary rates to fully assess the potential size of this issue can be completed in Phase II when data tapes of the full loan portfolio can be provided
z
Of the portfolio, data has been provided showing the split between interest only and repayment on the platform and BTS books as shown opposite
z
As can be seen, there are relatively high levels of interest only lending, which reduces the effect of natural reduction in LTV’s due to repayment of capital on a regular basis
> 90%
Credit Committee Arrears and Losses Reports January 2008 to July 2008
Interest only stock (Platform and BTS) 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0%
Leek 18 and Leek 19
0.0% Platform
BTS
Buy to let
BTS
Self cert Interest only
Source:
Platform
Platform
BTS
Non-conform ing
Repayment
z
Detailed data tapes have been provided for the Leek 18 and Leek 19 portfolios by Burgundy
z
Analysis of these portfolios can be seen at the end of the residential mortgage lending section of this report
Interest only stock
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Credit policies and criteria changes Recognising a
Credit criteria comparison Pre-August 2007
deterioration in the Platform portfolio and market in general, management has introduced a number of
Maximum LTV
95%
85%
90%
£750,000
1,000,000
Self certified maximum LTV
85%
75%
80%
Buy-to-let maximum LTV
90%
75%
75%
110%
125%
125%
Minimum rental cover
since February 2007 to
FTB for BTL loans
restrict the level of arrears
Non-continuing BTL
in the portfolio These changes appear to bring Burgundy closer to Claret’s current position
Claret
£1,000,000
Maximum loan size
credit criteria changes
and bad debt experienced
Current
Conforming
Allowed
Not allowed
n/a
Available
Not available
n/a
Maximum almost prime LTV
85%
80%
n/a
Maximum minor adverse LTV
95%
80%
n/a
Maximum light adverse LTV
95%
80%
n/a
Maximum new build LTV
85%
75%
n/a
£1,000,000
£750,000
n/a
110%
125%
n/a
Available
Not available
n/a
Non-conforming
Maximum loan size Minimum rental cover Medium and heavy adverse products
Claret does not offer nonconforming products
General Income assessment Source:
Income multiples
Affordability Mix of income multiples and affordability
Presentation for rating agencies final June 2008, Claret’s Mortgage policy summary and Claret’s summary changes 2007 to mid 2008
Criteria changes z
Lending in the second half of FY06 and first half of FY07 expanded due to the level of new entrants into the market which had led to many businesses loosening credit criteria and tightening their margins
z
As management became aware of increasing arrears levels in this population of lending (as early as February 2007) they began to reign in the credit criteria, particularly in the heavy adverse areas, to effectively remove themselves from the market
z
Management continued to tighten the criteria, particularly in early FY08, as the credit crisis developed
z
The main changes focus around the tightening of the LTVs offered in the various products as management believes that this is the main driver of whether or not a loan will go into arrears (and subsequently default)
z
All BTS acquisitions made have followed the Platform credit criteria in force at the time of acquisition. However, it may not be appropriate to assume that the level of credit risk in these books is consistent with BCIG lending as lower levels of due diligence were carried out in the early acquisitions than the 100% due diligence carried out in the FY08 acquisitions
Comparison with Claret z
The table above highlights the relative credit policy positions between Claret and Burgundy, which shows that Burgundy has moved closer to Claret’s current position
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Residential mortgage lending
Arrears (1) rising across the whole
100
Member Business
of these initiatives Source:
Sep-08
Aug-08
Jul-08
Jun-08
Apr-08
Mar-08
BTS
May-08
assess the relative success
Feb-08
Jun-07
is currently too early to
Jan-08
0
going forward; however, it
Dec-07
z
As can be seen opposite, arrears levels have been rising across the whole portfolio, as has been seen in the market as a whole
The key risk areas identified by the tree diagrams have shown variable arrears performance over recent months z Management has introduced a number of measures to try and contain the arrears deterioration including: − moving arrears management resource from the performing Member Business book to the Platform and BTS arrears of the business
Platform
Arrears reporting underlying data
new arrears management systems are being developed and are due to be implemented imminently
−
working hours have been changed to ensure that resource is available at the right time of day for making contact with customers
16%
reviews of the purchased portfolios are being completed to ensure all warranty cases are picked up and sent back to the originating organisation prior to warranties expiring Restructuring of accounts
14%
z
20% 18%
12% %
−
−
Key high risk lending cohorts with > 90 days arrears
10%
-
8% 6% 4%
June Notes: Source:
July
Commercial residential lending
BTS nonconforming
0%
Platform new build flats
2% Platform nonconforming
and reduce arrears levels
As the loan portfolio has come under greater arrears pressure, the GCC has developed reporting and management information, using detailed tree diagrams, to help better understand the key risk arrears in the portfolio (included in a appendix 2 to this report)
z
200
Oct-07
number of actions to try
z
300
Nov-07
Management has taken a
400
Sep-07
lending
The performance of the loan portfolio is monitored on a monthly basis by the Group Credit Committee (‘GCC’)
500
Platform first time buyers
risk BCIG residential
600
Aug-07
increases seen in higher
z 700 Residential Mortgage Arrears £'m
portfolio, with the largest
Overview
Arrears movements July 2007 to September 2008
Jul-07
Arrears levels have been
No comparative Platform non conforming June data provided
All areas relate to assets of 85% LTV and greater Arrears and losses monthly M2 report end June 2008 and end July 2008
Another way in which management is taking action to reduce possession cases is through the restructuring of accounts. These now take two forms as follows Arrangements – this is where the monthly payment is reduced and the term of the loan extended. Nevertheless, interest is being serviced and principal repaid. Following a six month period of payment under arrangement, the account will be reclassified as no longer in arrears. Management has recognised a benefit of £5.0 million from this scheme in HY108 as explained later in this report
-
Concessions – this is where Burgundy allow a lower payment to be made on an account; however, the debt continues to increase. These are only allowed for shorter periods of time and the accounts cannot be taken back out of arrears. This is not currently practised, but is under consideration for late 2008
z
Management is yet to decide how to treat the concessions cases in terms of arrears and provisioning
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Residential mortgage lending
Arrears (2) Arrears in the prime
Arrears trends FY08 YTD
member book and the commercial lending book, have remained stable, but are increasing in all other areas The arrears profile of the Burgundy group is worse than others in the building
Prime (Member) Prime (BCIG) Non Conforming Conforming Commercial Lending Total book Source:
December FY07 Total No % >3 No
June FY08 Total No % >3 No
July FY08 Total No % >3 No
August FY08 Total No % >3 No
September FY08 Total No % >3 No
145,898 9,677 34,524 44,871 469 235,439
146,070 9,257 32,759 42,221 457 230,764
145,192 9,153 32,490 41,585 453 228,873
144,148 9,090 32,197 41,510 452 227,397
143,475 9,018 31,784 40,983 453 225,713
0.3% 1.7% 5.3% 1.2% 1.1% 1.2%
379 162 1,833 539 5 2,918
0.3% 2.8% 7.4% 2.2% 2.6% 1.8%
486 256 2,412 926 12 4,092
Losses and Arrears Report May 2008 to August 2008
The arrears profile of Platform is also relatively
z
predominantly due to the higher proportion of subprime lending
poor compared to peer groups in specialist lending
499 259 2,519 969 9 4,255
0.3% 3.0% 8.4% 2.5% 1.1% 2.0%
481 269 2,689 1,031 5 4,475
0.3% 3.5% 8.8% 2.8% 0.9% 2.1%
461 290 2,926 1,154 4 4,835
Arrears comparison to Bradford & Bingley
Recent trends z As can be seen in the table above, the most recent trends in arrears continue to show a deterioration in the loan books across all of Burgundy’s lending z To determine if the arrears being seen are typical of similar asset portfolios, public data has been obtained on Bradford & Bingley loan portfolios to allow a comparison of the buy to let and self certified elements of the portfolio though we note that this comparison cannot be conclusive because of inconsistencies in the makeup of the ‘other’ category for both lenders
society sector
0.3% 2.8% 7.8% 2.3% 2.0% 1.9%
When considering the Platform side of the business against other sub-prime lenders in the market, Platform is again performing relatively badly compared with other lenders
z
Further benchmarking against the Building Society sector can be seen overleaf
Jun-08
Mvmt (bps)
B uy-to-let
1.30%
2.28%
98
S elf certified
2.74%
3.85%
111
O ther
2.55%
3.64%
109
O verall
1.85%
2.87%
102
B uy-to-let*
1.01%
1.84%
83
S elf certified*
1.46%
2.67%
121
O ther
4.50%
6.30%
180
O verall
2.80%
4.30%
150
Burgundy (excl member)
Whilst the buy to let and self certified books look slightly better within Burgundy (very similar if GMAC acquired assets are stripped out of the Bradford & Bingley arrears rates), the non-conforming book (£3.5 billion) has a significant impact on arrears
z
Dec-07 Bra dford & Bingley
Sub-prime > 3 months arrears (by balance) Burgundy (Platform) Lender 1 Lender 2 Lender 3 Lender 4 Lender 5 Lender 6 Lender 7 Lender 8
31-Dec-07 5.21% 1.98% 3.72% 1.85% Unavailable 2.29% 6.81% 9.13% 2.90%
30-Jun-08 5.51% 2.89% 4.43% 2.87% 4.22%* Unavailable 8.46% 11.63% 5.80%
Note:
( * ) Accounts UTD and < 1.25% in arrears (**) Accounts > 1.25% in arrears (A) All ratios are as at 31 Dec except for 2 lenders (March 2008) (B) Data not provided in this form Source: Bradford & Bingley Investor reports, Building Societies Database and financial statements This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Residential mortgage lending
Arrears benchmarking Burgundy’s arrears are
Arrears experience across the building society sector FY06 and FY07
higher than most in the
2007 Nationwide
top 10 building societies reflecting the high proportion of specialist lending in the Group compared with other societies
Group UTD 97.93%
< 3 months 1.71%
> 3 months 0.35%
Building Society benchmarking
> 12 months 0.04%
Possessions 0.02%
Britannia
92.22%
5.90%
1.88%
Note B
Note B
Yorkshire Coventry
98.06%* 94.87%
Note B 4.58%
1.85%** 0.49%
Note B Note B
0.09% 0.07%
96.50% 97.07%
1.20% 2.28%
2.23% 0.55%
Note B 0.03%
0.07% 0.10%
Chelsea Skipton West Bromwich
96.17%
2.42%
1.10%
0.04%
0.32%
Leeds Derbyshire
96.00% Note B
3.24% Note B
0.66% Note B
0.01% 0.06%
0.10% 0.06%
Principality
96.2%
2.9%
0.8%
0.2%
0.1%
2006 Nationwide
98.05%
1.68%
0.28%
0.03%
0.01%
Britannia Yorkshire
94.29% 98.70*%
4.22% Note B
1.49% 1.25%**
Note B Note B
Note B 0.05%
Coventry Chelsea
95.33% 96.68%
4.23% 0.99%
0.40% 2.28%
Note B Note B
0.04% 0.05%
Skipton West Bromwich
97.61% 97.35%
1.86% 1.99%
0.44% 0.54%
0.02% 0.04%
0.09% 0.12%
Leeds
96.31%
3.14%
0.47%
0.01%
0.08%
Note B 96.9%
Note B 2.6%
Note B 0.4%
Note B 0.0%
Note B 0.1%
Derbyshire Principality
z
The arrears profile of Burgundy is worse than others in the building society sector predominantly due to the size of its higher risk, sub-prime lending
z
Other societies do have sub-prime operations (such as Skipton through its subsidiary AHL); however, the proportion of sub-prime versus prime leads to the overall arrears being higher in Burgundy
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Residential mortgage lending
Residential lending provisioning methodology and assumptions The provisioning methodology is used by
Provisioning methodology Burgundy provides for individually impaired loans (defined as those which are 1p or more in arrears) and also on an incurred but not reported (‘IBNR’) or collective basis
z
Whilst the source of data and the IT systems used for calculating provisions for Member Services and BCIG differ, the underlying methodology remains consistent
z
In HY108 Burgundy changed its policy on the treatment of accounts in 130 days arrears. These are no longer taken into the impairment calculation (consistent with others in the industry) but are still subject to the IBNR calculation. The impact on provisions was minimal (£1.5 million)
Burgundy to calculate ‘underlying’ impairment, but it is reduced by a number of management adjustments, is in line with others in the industry There have, also been a
z
number of changes to the provisioning methodology,
z
which have resulted in a release of provisions of £20 million, £11 million of which was due to the change in the point at
In HY208, Burgundy has adjusted its definition of arrears to 3 months from 1 month. The impact of this is expected to be an £11 million release of the provisions in FY08 Two further changes to the impairment methodology are to be made for FY08, being a change in the definition of impaired but not reported (‘IBNR’) accounts (benefit of £2 million) and a new approach to calculation of expected losses of sale (benefit of £7 million)
Impaired loans z
A loan requires an impairment to be recognised where the net discounted cash flow of loan is less than the period end balance on the account. Where this is the case, the probabilities of that case moving to default and through to possession are determined on past experience
z
Net sale proceeds are then determined by the following calculation:
which an account is deemed to be impaired
IBNR
z
−
z
the most recent valuation is indexed using Halifax HPI adjusted for assumed house price movements during the period to sale. Management has assumed HPI falls in 2008 and 2009 of 7% and 5% respectively although the 2008 HPI projected fall was increased to 13% in October 2008, which increases the provision by £18 million
−
a forced sale discount is applied based on experience over the last 12 months of 26%, noting that the FSD for the most recent three months is approximately 1% higher. The FSD has been adjusted to 17% for those properties expected to be purchased by Illius (90% of repossessions)
−
associated possession and sale costs are taken off
−
recoveries under the MIG policy are allowed for
z
The IBNR element of the provision takes into account customers who are not yet in arrears but are experiencing financial difficulty
z
All accounts are updated monthly using the Experian Consumer Indebtedness Index (CII), and where indications of financial distress are identified, the above provisioning methodology is applied
z
As discussed above, the definition of IBNR is to change in HY208
Key provisioning assumptions Area Assumption Time to default/sale Time to default 8.6 months Time to sale 21.7 months Probability of default Society 10.4% BTS 18.9% to 58.0% Platform 25.5% to 77.3% Probability of possession Society 8.3% to 43.4% BTS 4.5% to 27.2% Platform 5.6% to 29.0% Forced sale discount Society 19.6% BTS 22.6% Platform 25.2% HPI 2008 13% reduction 2009 Source:
5% reduction
KPMG comment Based on historic experience but will be likely to incrase
Probabilities change based on LTV band as would be expected
Based on 12 month average which includes a period of lower deterioration compared to recent experience
Revised recently
Group Finance Director’s Report – 16 July Board Meeting and Group Policy: Loan Impairment Provisions
The difference between this calculation and the loan amount at the date of sale is then taken as a provision
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Illius scheme To date the Illius scheme has had a positive impact on the bad debt write-off and balance sheet provisions of £60 million
Illius – overview of the scheme z The Illius property management scheme is a scheme whereby Burgundy repossession cases are purchased by a separate legal entity within the Group and managed as an investment property until property values recover z
and management expects to recognise a further £6 million benefit in HY208 We believe the HPI assumptions and the achievement of the
z
appropriate rental income are the key risks to the success of the scheme
The Board has currently approved financing of £70.0 million for the initial pilot of Illius, made up of £50 million secured financing, a £13.5 million inter-company loan and £6.5 million of equity. It is anticipated that the pilot is to be extended, such that approximately 90% of repossessed properties will be acquired by Illius. This equates to some 800 properties by the end of 2008. It should be noted that management’s previous forecasts were 50% of properties and 1,000 properties, which suggests that fewer properties are planned to hit repossession in FY08. We are investigating why this is the case The business case also assumes costs for fees, stamp duty, revenue repairs etc of 2.85% of purchase price. The immediate benefit to Burgundy is a reduction in the FSD which has a direct impact on the losses recognised through the profit and loss account. This occurs as the rental income multiple leads to a higher valuation being attached to the individual properties, therefore leading to a positive crystallisation of the losses position
z
Currently, FSDs on Illius purchased properties are 17% compared to 26% in the rest of the portfolio in HY108. The latest indications from management (and the assumption built into the provisioning models) is that the effect of Illius will be to push average FSDs in Platform down from 25.2% to 22.5% and in BTS from 22.6% to 21.3%
z
To date this has had a positive impact on the bad debt write-off and balance sheet provisions of £6 million and management expects to recognise a further £6 million benefit in H2 FY08 based on the October reforecasts
Key risks to the scheme z The key risks involved with the Illius scheme include: − the normal risks associated with the setting up of a new business venture − the reputational and financial risk associated with potential future claims against Burgundy for unfairly profiting from repossessed properties bought at under value now − − − − − z
Source:
FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 109 265 383 478 553 612 659 693 719 737 Illius Board presentation
If any of these risks were to materialise then the forecast benefits from the scheme could be eroded Illius position E nd Octobe r position Lettings secured Completions O ffers accepted O utstanding offers made P roperties und er assessment P roperties available for purchase Source:
z
Illius property value forecast £m
acquiring inappropriate properties that are not rentable acquiring properties at an inappropriate value not achieving the rental income or re-sale value needed to meet the business plan rental voids higher than planned whether the FSD on the repossessed properties not acquired by Illius increases if they prove to be lower quality properties
Arrears and losses pack for October
Based on updated information received on 23 October 2008, we understand 30 lettings have been secured. Management’s expectation is that properties should be let by about two months following repossession. Because of this time lag, Burgundy expects approximately 300 of the 841 properties expected to be acquired in FY08 to be let by the end of 2008
Burgundy management has informed us that repossessing properties is a last resort option for the Group. No impact on this policy is anticipated as a result of the Government’s recent stance on repossession z As Illius will only take effect following a repossession, this is not expected to have any impact on the Group’s stance to repossession z
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Residential mortgage lending
Further management actions and outturn Whilst management’s
Underlying impairment
forecast charge for the full
£'m Reported HY108 Impairment charge Benefits reducing impairment charge
FY08 remains at £75 million, in light of declining house prices and continuing increases in arrears in parts of the portfolio, we consider the forecast charge is challenging The provision would be higher by approximately
Further management actions HY108 40.4
Arrangements Illius property company
z
Beyond the Illius scheme and the management actions as arrears, management have also set up a loss recovery unit
z
This unit has been set up to review all loss cases where warranties may allow them to be put back to the originator (for instance with purchased loan portfolios) and also review all loss cases for potential recovery through personal covenants
z
An assumption has been made in the provisioning that 5% of losses will be recovered through personal covenants. This amount has not been discounted; however, management have informed us that the Loss Recoveries Unit is expected to exceed the original projections used in the provisioning
z
The Group has also reduced sales costs, which is expected to have a positive impact of £6 million for FY08
z
The Group has also implemented other management actions, including new products to mitigate payment shock, warranty claims on acquired mortgages and more pre-arrears contact with customers
5.0 6.0
Loss recovery unit Total benefits
7.0 18.0
Other Forecasting risk provisions Potential provision on commercial loan (Panchoo) Change in accounting policy for 1-30 days arrears Total other Underlying impairment Source:
4.4 2.0 1.5 7.9 66.3
KPMG analysis
£20 million, without the benefit of the policy changes in HY208
Summary of changes to June forecast loss provisions charge in calculation of the revised forecast
Outturn position FY08 £m
The impairment charge for HY108 was £40 million, which was stated after the benefit of changes in impairment methodology and benefits totalling £18 million. We understand the further charge for July to September of this year was £22 million bringing the YTD charge to £62 million
z
Management’s forecast charge for FY08 remains at £75 million as management believes it will benefit from further changes in methodology as described opposite, further benefits from Illius and enhancing the effectiveness of collections
z
In light of declining house prices and continuing increases in arrears in parts of the portfolio, we consider the forecast charge is challenging
75
June forecast Improvem ents to provisioning approach Updated assumptions within the provisioning model
(2)
Changes to impairment and IBNR definition Decrease due to new approach to calculating expected losses on sale Update on management actions Update on the impact of flexible arrangements actions
(13) (7) -
Reduction due to impact of extending Illius Update on the impact of loss recoveries
(6) -
Reduction due to renegotiation of sales costs on repossessed properties Worsening economic conditions Increase on forecast arrears volumes
(6)
Increase in forecast due to higher decline in HPI from -7% to -13% Increase in commercial provision forecast Revised forecast credit loss provisions charge
18 2 75
Source:
z
14
Burgundy 2008 Group Credit Losses Forecast
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Fraud Burgundy’s fraud losses
Fraud losses by portfolio
are most prevalent in Platform and BTS as would be expected. These have shown an increasing trend since 2006 as seen across the industry
Year identified Member book 200 8 P latform/BTS 200 6 200 7 200 8 O ther 200 7 200 8 Source:
Estimated loss
Provision
Actual losses
£'0 00
£'000
£'000
Number of cases 1
-
-
-
51 179
666 4,369
1,589 5,814
1,401 4,409
255
4,943
8,414
5,009
6 27
150 503
57
171 125
Burgundy fraud loss analysis 20 November 2008
Fraud losses z
Burgundy’s fraud losses are most prevalent in Platform and BTS as would be expected. These have shown an increasing trend since 2006 as seen across the industry
z
The analysis suggests that the provision adequately covers the estimated fraud losses
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Impact of sensitivities Burgundy has quantified the impact of sensitivities for judgemental areas in
Forecast element
Area of judgement
Potential impact
Changes to IBNR and impairment definitions
Burgundy's proposed changes are more predictive of losses If Burgundy decide to take a more conservative approach our forecast and in line with industry practice but have yet to be approved would increase by £7-13m. by the auditors
New approach to calculating expected losses on sale
Burgundy are proposing to use a more accurate valuation of Burgundy do not anticipate any challenge to this proposal from the properties in possession to remove the need for a deflation auditors but if Burgundy decide not to proceed with this approach the factor applied to valuations until time of sale forecast would increase by up to £7m.
Arrears volumes
Forecast of future volumes of arrears and speed at which arrears cases deteriorate
A variation of 5% in arrears levels from the forecast would change arrears by £4m.
House Price deflation
House prices decline by more than the current forecast projection
Each 1% variation in the House Price Inflation forecast changes the provisions forecast by £3m
Forced sale discount
The forecast level of the forced sale discount in the A change in the forced sale discount of 5% would lead to a change in remaining months does not reflect the experience in the last the forecast provision of £18m 12 months
Arrangements
Borrowers agreeing arrangements and keeping to them vary Each 10% change in borrowers keeping to their arrangement changes from the forecast the full year provision charge by £1.2m
Illius
Prices paid by Illius deliver a different expected forced sale benefit than expected
Each 1% variance in the forced sale discount on properties purchased by Illius changes the provisions charge by £1m
Illius
Illius acquires a lower percentage of properties than forecast
Each 5% reduction in the percentage of properties acquired by Illius reduces the benefit to the provisions charge by £0.9m
Warranty claims
Burgundy may be able to make further warranty claims on assets we have purchased and conversely may receive claims from buyers of Platform’s mortgage books.
The forecast includes all advised claims against us (impact in 2008 £0.5m) and our best estimate of successful claims Burgundy will be able to make in 2008 (estimate £1.6m)
provisions
Source:
Burgundy 2008 Group Credit Losses Forecast
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Leek 18 and Leek 19 mortgage asset mix (1) Balance outstanding
Balance outstanding at 31 October – Leek 18
At 31 October 2008,
200.0
Balance outstanding
2,600
Leek 18 and 19 portfolios
180.0
Account volume
2,400
totaled £1.4 billion,
160.0
approximately 6% of the
140.0
1,800
total residential mortgage
120.0
1,600
2,200 2,000
1,400
100.0
1,200
80.0
1,000
performed on data tapes
60.0
800
of mortgage assets in Leek
40.0
18 and 19, principally to
20.0
Further analysis has been
600 400 < £50k
z
whether the
Source:
information already Burgundy on ‘problem
200.0
cohorts ‘ is reasonable
180.0
and complete
suggests that the
£m's
if the arrears level and pace of deterioration
£100k£150k
£150k£200k
£200k£250k
£250k£500k
£500k£1m
> £1m
Balance outstanding
z
At 31 October 2008 the Leek 18 portfolio comprised 5,988 loans with a balance outstanding of £715.0 million. The number of accounts in the pool has reduced by 1,189 since 31 March 2008 and the balance outstanding has reduced by £142.5 million (17%)
z
At 31 October 2008 the Leek 19 portfolio comprised 5,404 loans with a balance outstanding of £683.0 million. The number of accounts in the pool has reduced by 439 since 31 March 2008 and the balance outstanding has reduced by £53.5 million (7%)
z
The average loan balances for the Leek 18 and 19 portfolios at 31 October 2008 are £119.4k and £126.4k respectively. This compares to the latest CML index which shows the average loan size of £123.0k
z
Across the two pools there are 10 loans which have balances outstanding of £750k+. At 31 October 2008 two of these loans are in arrears, both loans are less than three months in arrears
z
Mortgage lenders throughout the market including Burgundy have tightened their lending criteria through 2007 and 2008 and higher risk customers may find it harder to secure a new mortgage deal
Account volume
2, 000
Portfolio analysis
1, 800
160.0
1, 600
140.0
1, 400
120.0
1, 200
100.0
1, 000
credit enhancement in
80.0
800
the securitisation
60.0
600
vehicles will be utilised
40.0
400
20.0
200
-
z
The following section gives an analysis of the mortgage assets held within the Leek 18 and Leek 19 portfolios from the data tapes supplied by Burgundy management
z
The analysis firstly covers the split of the book into key features such as LTV, product, balance outstanding and then overlays this analysis against the arrears profile within the portfolios
z
Analysis of data tapes for the Leek Finance 18 and 19 securitisation vehicles has corroborated the management information produced by Burgundy, particularly in connection with its ‘problem cohorts’ of lending originated in H2 06 and H1 07
< £50k
Source:
The mix of balances outstanding by remaining loan size within the two pools is similar with the majority of loans having a balance outstanding of £50k-£150k at 31 October 2008
Leek 18 data tape
Number of accounts
z
£50k£100k
Balance outstanding at 31 October – Leek 19
provided to us by
z
200
-
assess:
Number of accounts
assets
£m's
mortgages balances in the
£50k£100k
£100k£150k
£150k£200k
£200k£250k
£250k£500k
£500k£1m
> £1m
Leek 19 data tape
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35
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (2) Balance outstanding by date of origination
in the Leek 18 portfolio were originated in 2005/06 The majority of loans in
Balance outstanding by date of origination
450
z
The majority of loans in Leek 18 were written in 2005/06. The majority of loans in the Leek 19 portfolio were originated in 2006
400
z
The loans remaining in the Leek 18 portfolio were written in the period between H2 04 and H2 08. 85.9% of loans by balance outstanding were originated in the 12 month period from 1 July 2005
z
Within the Leek 19 portfolio, 97.8% of the loans remaining on the portfolio were written in the period from H1 05 to H2 08. The remaining 2.2% of loans were written in 2002
z
80.6% of the loans in the Leek 19 portfolio by balance outstanding were written in H2 2006, 97.5% of the loans were written in 2006
z
As can be seen by the graphic, the majority of the loans were written in the period from H2 05 to Q4 06. When considering this against the performance of the portfolio as a whole, the H2 06 and H1 07 vintage is the worst performing of all the lending
350
the Leek 19 portfolio were originated in 2006
300
£m's
250 200 150 100 50
Leek 18 Source:
H1 08
H1 07
Q3 06
Q1 06
H1 05
H1 04
H1 03
0 H1 02
The majority of the loans
Leek 19
Leek 18 and Leek 19 data tapes
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 92
36
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (3) Lending within the two
Overview of pools by product type
Portfolio mix overview – Product type
100%
z
The asset mix for each of the pools principally comprises buy to let, self cert and subprime mortgages
z
The asset mix is broadly similar to the overall asset mix for specialist lending, in Appendix 2
z
The Leek 19 pool also contains a small number of sub prime buy to let and prime accounts, these represent 2.6% of the pool at 31 October 2008
z
The movement in the mix of the pools between the two periods suggests that the attrition rate of the self cert and sub prime accounts across the pools is considerably higher than that of the buy to let loans which has driven the change in the mix in the portfolios between the two dates
pools comprises buy to let,
90%
self cert and subprime
80%
mortgages. The Leek 19
70%
portfolio also includes a
60%
small proportion of prime
50%
accounts
40%
The asset mix is broadly similar to the overall asset mix for specialist lending
30% 20% 10% 0%
in Appendix 2 The geographical mix of
Leek 18 - M ar 08 B uy to let Source:
Leek 18 - Oct 08 Leek 19 - M ar 08 Leek 19 - Oct 08 P rime Self Cert Sub prime Sub prime B TL
Leek 18 and Leek 19 data tapes
the portfolios is also similar, both portfolios
Overview of pools by geographic region
Portfolio mix overview – Geographic region
exhibit a concentration of
100%
z
lending in Greater London
90%
The regional mix of accounts for each of the pools is spread across the United Kingdom with a concentration of accounts in Greater London and the Southeast. 46.8% of the Leek 18 and 49.6% of the Leek 19 pools comprise accounts from these these two regions
z
The Q3 2008 House Price Index data issued by HBOS plc shows that the annual fall in house prices in Greater London and the South East was 16.5% and 12.4% compared to a UK average of 12.4%
z
This suggests that Burgundy has a high level of exposure to geographic regions which are currently experiencing high levels of house price deflation
z
The mix of accounts across the two periods is broadly static
and the South East
80% 70% 60% 50% 40% 30% 20% 10% 0% Leek 18 M ar 08 East A nglia No rth Sco tland Wales
Source:
Leek 18 Oct 08 East M idlands No rth West So uth East West M idlands
Leek 19 M ar 08
Leek 19 Oct 08
Greater Lo ndo n No rthern Ireland So uth West Yo rkshire and Humberside
Leek 18 and Leek 19 data tapes
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 93
37
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (4) At 31 March 2008 the majority of accounts were on a fixed rate but this proportion reduced by 31
Overview of pools by product rate
70% 60% 50%
discount and Libor linked
40%
products
30%
Customers who move
20%
from a fixed rate deal to
10%
has recently been a cut in the base rate, this has not
z
At 31 October 2008 the mix has changed and the proportion of customers on fixed rate products in the Leek 18 and Leek 19 pools has fallen to 41.0% and 40.5% respectively
z
The reduction in the value of accounts on fixed rate loans is considerably higher than the balance attrition seen within the two pools in the six month period to 31 October 2008. This suggests that the fixed interest term has ended for a proportion of the accounts and these have migrated onto the base and LIBOR products as would be expected
z
When the agreed term of a borrowers mortgage ends the customer will usually move onto to the lender’s Standard Variable Rate (SVR) which is likely to be higher than the rate applicable in their lock in period. This can lead to a sharp increase, or ‘payment shock’, in the amount of the borrowers monthly repayment which may in turn lead to an increase in arrears
z
Customers on fixed rate mortgages are likely to experience the greatest payment shock when the term of their mortgage ends. Borrowers would historically have been able to obtain a new mortgage deal at a rate below SVR to reduce their payments; however, under current market conditions many borrowers are finding it harder to secure a new mortgage at the end of the initial lock in period
z
If this trend continues then the proportion of mortgages which are on base rate linked products is likely to continue to increase as fixed and tracker product terms come to an end within the pools
0% Leek 18 - M ar 08
payment shock if the SVR the fixed rate. Whilst there
The majority of accounts in the Leek 18 and Leek 19 pools were on a fixed rate product at the 31 March 2008 (67.9% and 54.9% respectively by balance outstanding)
80%
migrated onto base
is considerably higher than
z
90%
October 2008 as borrowers
SVR may experience
Portfolio mix overview – Product rate
100%
Leek 18 - Oct 08 B ase
Source:
B ase disco unt
Leek 19 - M ar 08 Fixed
Libo r
Leek 19 - Oct 08
Libo r disco unt
Leek 18 and Leek 19 data tapes
Overview of pools by reversion date 100%
yet been passed onto
90%
borrowers by Burgundy
80%
The majority of accounts
70%
have either reverted, or
60%
will revert prior to the end
50%
of 2009
40%
Portfolio mix overview – Reversion rate
30% 20% 10% 0% Leek 18 - Oct 08 Q4 2008
Source:
2009
Leek 19 - Oct 08 2010
2011
2012
A lready reverted
Leek 18 and Leek 19 data tapes
z
The reversion date for the majority of the accounts in both pools has either occurred, or will occur in prior to the end of 2009
z
54.0% of the balances outstanding in the Leek 18 pool and 50.4% of those in the Leek 19 pool have a reversion date in the period to 31 December 2009. The UK base rate stands at 3.0% following a 1.5% cut in November 2008 but this cut may not have been reflected by Burgundy in the interest rate applied to its base rate products. As a result, those customers who revert to this rate in 2009 may still experience some payment shock, unless UK base rate falls further or there is a cap on the difference between base rate and SVR included in Burgundy’s terms and conditions
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 94
38
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (5) The majority of accounts are secured on terraced or semi detached houses though significant volumes are also secured on flats
Overview of pools by nature of security
Portfolio mix overview – Nature of security
100%
z
The asset mix of the two portfolios is similar with the majority of the portfolio comprising terraced houses but also with significant volumes of semi-detached and flat/maisonette properties
z
All of the accounts in the Leek 18 and Leek 19 portfolios are secured on properties which were built in or before 2006. Properties built in 2006 make up 2.7% of the Leek 18 portfolio and 6.8% of the Leek 19 portfolio. 12.0% of the properties in the Leek 18 and 12.7% of properties in the Leek 19 portfolio were built prior to 2000
z
At 31 October 2008 301 (5.0%) accounts from the Leek 18 portfolio were secured on flats/maisonettes built in 2005/06, the balance outstanding on these was £46.7m (6.5%). 283 (5.2%) accounts in the Leek 19 portfolio were built on flats/maisonettes built in this period, the balance outstanding on these was £43.5m (6.4%)
z
This is in line with the GCC management information summarised in Appendix 2
z
We note that no build date was provided for five of the properties across the two portfolios
z
The asset mix of the two portfolios remains broadly unchanged across the six month period to 31 October 2008 though we note that the proportion of flat/maisonettes within the Leek 18 property increased by 2.0% in the period with a similar decrease seen in the proportion of detached properties
90% 80% 70% 60% 50%
All of the properties used
40%
as security in the Leek 18
30%
and 19 portfolios were
20%
built in, or prior to, 2006
10%
The majority of accounts
0% Leek 18 M ar 08
in each portfolio have an LTV of 85-100% at their
B ungalo w
Source:
Leek 18 Oct 08
Detached ho use
Flat/maiso nette
Leek 19 M ar 08 Semi-detached ho use
Leek 19 M ar 08 Terraced ho use
Leek 18 and Leek 19 data tapes
last valuation date 65 accounts in the Leek 18 and 89 accounts in the
Overview of pools by LTV banding (on last valuation)
Portfolio mix overview – LTV banding (on last valuation)
100%
Leek 19 portfolio have an LTV of over 100% at 31
80%
z
The majority of accounts in each of the portfolios have an LTV of 85-100% at 31 October 2008 (Leek 18: 49.8%; Leek 19: 54.2%)
z
Within the Leek 18 portfolio 51.3% of accounts by account balance have an LTV of over 85%. The balance outstanding on these 2,712 accounts at 31 October 2008 is £361.9 million. 65 accounts have an LTV of over 100%, the arrears position of these accounts is considered within the arrears section of this report
z
Within the Leek 19 portfolio 56.6% of accounts have an LTV of over 85% by account balance. The balance outstanding on these 2,684 accounts at 31 October 2008 is £383.9 million. 89 of these accounts have an LTV of over 100%
z
The proportion of accounts with an LTV greater than 85% is significantly higher than the blended average of 35% across the whole portfolio, which would be expected given the more recent nature of this lending
z
The LTV data is based on the most recent valuation performed, no adjustment has been made for HPI movements since the date of the valuations. Valuation dates range from September 2004 to October 2008 for the Leek 19 portfolio and from August 2001 to September 2008 for the Leek 19 accounts
z
97.2% of the valuations undertaken on the Leek 18 properties occurred in 2005/06, 91.7% of the valuations undertaken for the Leek 19 portfolio occurred in this period
October 2007 60%
40%
20%
0% Leek 18 Oct 08 0-25% Source:
25-50%
50-75%
Leek 19 Oct 08 75-85%
85-100%
100+
Leek 18 and Leek 19 data tapes
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 95
39
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (6) We have adjusted the valuations used in the LTV calculations to reflect HPI movements since the date of the valuation
Indexed and stressed LTV – Leek 18 31 Oct 08
Indexed LTV
100%
80%
z
We have adjusted the latest valuations provided by Burgundy to reflect the movements in the house price index in the period since their last valuation. In doing this we have used the Halifax house price index
z
The average LTV of the indexed Leek 18 portfolio at 31 Oct 2008 is 74.6%, a reduction on the un-indexed average of 78.3% at the same date. The reduction is evident in the LTV mix of the portfolio which shows an increase in the proportion of accounts with an LTV of 50-75% which is matched by a reduction in the proportion of accounts with and LTV of 85%+
z
The average LTV of the indexed Leek 19 portfolio at 31 October 2008 is 77.6%, a slight reduction on the LTV of the un-indexed portfolio of 79.5% at the same date
z
30 accounts within the Leek 18 and 33 within the Leek 19 portfolio have an LTV of over 100% using the indexed LTVs
60%
The average LTVs (using indexed valuations) of the
40%
Leek 18 and Leek 19 portfolios are 74.6% and
20%
77.6% respectively. This is a reduction on the un-
0% Latest valuation
indexed LTV for both portfolios
0-25%
25-50%
Indexed valuation
50-75%
75-85%
Indexed valuation10% haircut 85-100%
100-125%
Applying a 10% haircut to
Source:
the indexed valuation of
Indexed and stressed LTV – Leek 19 31 Oct 08
the Leek 18 and 19 portfolios increases the average LTVs to 82.9% and 86.2% respectively
Indexed valuation30% haircut 125-150%
Stressed LTV
150%+ z
We have also stressed the indexed LTVs of the Leek 18 and Leek 19 portfolios, applying a ‘haircut’ of 10% and 30% to the indexed LTV at 31 October 2008
z
Under the 10% stress test the average LTV of the Leek 18 portfolio increases to 82.9% and the Leek 19 to 86.2%. Under the 10% stress scenario 436 accounts (7.3% of the portfolio) within the Leek 18 portfolio and 1,205 (22.2%) of the Leek 19 portfolio would have an LTV of over 100%
z
Under the 30% stress test the average LTVs of the Leek 18 and Leek 19 portfolios are 106.6% and 110.8% respectively
z
Assuming a forced sale discount of 25% (2008 actual, up to introduction of Illius), in a base case 77% would be in ‘negative’ equity, which rises to 86% and 96% in the 10% and 30% stress scenario’s respectively
Leek 18 and Leek 19 data tapes
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Latest valuation
0-25% Source:
25-50%
Indexed valuation
50-75%
75-85
Indexed valuation10% haircut 85-100
100-125%
Indexed valuation30% haircut 125-150%
150%+
Leek 18 and Leek 19 data tapes
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 96
40
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (7) At 31 October 2008 20% of Leek 18 and Leek 19 accounts were classed as non-performing (i.e. one month in arrears)
Portfolio split by performing and non-performing accounts
Performing and non-performing accounts
100%
z
At 31 October 2008 1,198 (20.0%) of accounts in the Leek 18 portfolio and 1,094 (20.2%) of those in the Leek 19 portfolio were in arrears
z
Both portfolios have worsened from their arrears positions at 31 March 2008 when 14.0% (1,007 accounts) and 15.9% (931 accounts) of accounts were in arrears in the Leek 18 and Leek 19 portfolios respectively
z
A high level extrapolation of the data provided suggests that the arrears balance of the Leek 18 and Leek 19 portfolios at 31 October 2008 was £2.7 million. This is 0.38% and 0.39% of the balance outstanding on the two portfolios at this date
z
An increase in the volume of accounts in arrears is being seen throughout the market with larger increase being seen in riskier lending portfolios
z
The blended three months plus arrears ratio of 8.6% compares with 5.7% for Platform and 4.8% for BTS as shown in the GCC management information in Appendix 2. The higher rate is explained by the more recent nature of this lending
90% 80% 70% 60%
This proportion had
50%
increased from the
40%
position at 31 March 2008
30%
when 14% of Leek 18 and
20%
15.9% of Leek 19 accounts
10%
were classed as non-
0% Leek 18 - M ar 08
Leek 18 - Oct 08
performing
Up to date Source:
At 31 October 2008 8.6% of the Leek 18 and Leek 19 portfolios were three or more months in arrears
Leek 19 - M ar 08
Leek 19 - Oct 08
in arrears
Leek 18 and Leek 19 data tapes
Non performing accounts split by age of arrears
Arrears ageing
100%
z
At 31 March 2008 36.5% of accounts which were in arrears in the Leek 18 portfolio and 37.8% of those in the Leek 19 portfolio were three or more months in arrears. At 31 October 2008 this proportion increased to 43.16% and 42.9% across the Leek 18 and Leek 19 portfolios
z
For accounts in arrears, over the six month period to 31 October 2008, the average arrears age increased from 3.4 to 4.0 months for the Leek 18 pool and from 3.7 to 4.1 months for the Leek 19 pool
z
At 31 October 2008, the average arrears age for accounts which are three or more months in arrears was 7.4 months for the Leek 18 portfolio and 7.8 months for Leek 19. These averages are broadly unchanged from the position at 31 March 2008 (Leek 18: 7.1 months; Leek 19: 7.6 months)
z
74 accounts within the Leek 18 portfolio and 85 accounts within the Leek 19 portfolio were 12 or more months in arrears at 31 October 2008 with an outstanding balance of £11.9 million and £16.0 million respectively
90% 80%
The average age of an
70%
account in arrears has
60%
increased in the six
50%
months since 31 March
40%
2008 from 3.4 to 4.0
30%
months for the Leek 18
20%
portfolio and 3.7 to 4.1
10%
months for the Leek 19
0% Leek 18 - M ar 08
pool
Source:
Leek 18 - Oct 08
0-1m o nths
1-2 m o nths
2-3 m o nths
6-12 m o nths
12 -24 m o nths
24+ m o nths
Leek 19 - M ar 08 3-4 m o nths
Leek 19 - Oct 08 4-6 m o nths
Leek 18 and Leek 19 data tapes
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 97
41
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (8) Accounts three or more months in arrears split by product rate – Leek 18
Accounts in arrears by product rate – Leek 18
100%
accounts in arrears which
3.1%
z
90%
9.7%
are on a LIBOR linked
80%
The graph opposite considers the split of accounts, by their product rate, which are three or more months in arrears at 31 March and 31 October 2008 and also the mix of the total portfolio at these dates
product rate is
70%
z
disproportionately higher
60%
than the mix of these
At 31 March 2008 the largest proportion of accounts three or more months in arrears are on a fixed rate product (63.0%) which is broadly in line with the mix of the portfolio
50%
products within the
z
40%
portfolio for both the Leek
30%
At 31 March 2008 9.7% of the total portfolio balance comprised products with a LIBOR rate but 18.2% of accounts three or more months in arrears at this date arose on these products
18 and Leek 19 pools
20%
z
At 31 October 2008 the proportion of accounts three or more months in arrears on a LIBOR rate increased to 41.6% whilst the mix of these accounts within the total book increased to just 21.2%
The proportion of
The proportion of accounts in arrears which
six month period to 31 October 2008
18.2%
21.2%
4.3%
41.6%
43.3%
69.7% 63.0%
30.6% 5.6% 3.1% 7.3% 10.2%
Leek 18 M ar bo o k B ase
20.5%
6.8%
0%
Source:
26.6%
6%
10%
are on a LIBOR linked rate has also increased in the
6.0%
3.4%
Leek 18 M ar A rrears
B ase disco unt
Fixed
Libo r
Leek 18 Oct bo o k
Leek 18 Oct A rrears
Libo r disco unt
Leek 18 data tape
Accounts three or more months in arrears split by product rate – Leek 19
Accounts in arrears by product rate – Leek 19
100%
5.4%
z
90%
8.8%
The mix by product rate of accounts that are three or more months in arrears within the Leek 19 portfolio is similar to that of Leek 18
z
At 31 October 2008, 38.2% of accounts that are three or more months in arrears are on fixed rate products however these products make up 41.6% of the total pool
z
Accounts with a LIBOR rate make up 15.8% of the total pool at 31 October 2008, however, 27.7% of accounts three or more months in areas are on these products
z
Within the Leek 19 pool the LIBOR discount products exhibit a similar trend to the LIBOR products. 11.5% of accounts three or more months in arrears are on a discounted LIBOR rate but these products only comprise 5.4% of the total pool
z
This suggests that accounts within the portfolio with a LIBOR or discount LIBOR rate may have a higher propensity for entering arrears than the rest of the portfolio
5.4% 16.5%
80%
11.5%
15.8%
14.2%
27.7%
70% 60%
54.4%
41.5%
50% 50.9%
38.2%
40% 30% 20%
20.4% 25.0%
13.0% 14.5%
10% 0%
6.5%
4.0%
To tal po rtfo lio - M ar 08
A cco unts in arrears M ar 08
B ase Source:
16.9%
B ase disco unt
Fixed
To tal po rtfo lio - Oct 08 Libo r
9.6%
A cco unts in arrears Oct 08
Libo r disco unt
Leek 19 data tape
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 98
42
Treasury Select Committee - Project Verde
Private & confidential
Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (9) The majority of accounts which are in arrears are sub prime in nature
Accounts in arrears split by product type – Leek 18
Accounts in arrears by product rate
100%
z
At 31 March 2008 68.8% (253 accounts) of the accounts which are three or more months in arrears are sub-prime. At this date 42.5% (3,050 accounts) of the total mortgage pool comprises sub-prime accounts which indicates that there is a higher propensity for these accounts to enter arrears, this is in line with our expectations
z
The arrears performance of the self cert and sub prime accounts has worsened in the six month period to 31 October 2008 whilst a slight improvement has been seen in the buy to let accounts. At 31 October 2008 there were 336 sub prime accounts three or more months in arrears, total sub prime accounts in the pool at this date numbered 2,376
z
At 31 October 2008 the proportion of self cert accounts three or more months in arrears had increased to 16.4% from 13.9% (85 accounts from 51 accounts) at 31 March 2008 whilst the proportion of self cert accounts in the total portfolio had reduced to 18.1% from 20.5% (1,083 from 1,471 accounts)
z
The arrears performance of the buy to let portfolio has improved slightly in the period relative to the change in the proportion of buy to let accounts within the total pool
90% 80%
A slight reduction in the
70%
proportion of accounts in
60%
arrears on sub prime products is seen in the six months to 31 October 2008 driven by an increase
50%
65.0%
68.8%
18.1%
20.5%
40% 30%
16.4%
13.9%
in the proportion of
20%
arrears cases on buy to let
10%
accounts and self cert
39.6%
42.5%
42.3%
37.0%
18.6%
17.4%
0% To tal po rtfo lio M ar 08
accounts Source:
A cco unts in arrears M ar 08
To tal po rtfo lio Oct 08
B uy to let
Sub prime
Self cert
A cco unts in arrears Oct 08
Leek 18 data tape
Accounts in arrears split by product type – Leek 19 100%
Accounts in arrears by product rate
90% 80%
40.2%
38.8%
70% 67.4%
71.3%
60% 50% 40%
20.3%
20.0%
2.2%
2.2%
30% 38.7%
1.1%
37.0%
10%
As with the Leek 18 portfolio, the majority of accounts which are three or more months in arrears are sub-prime
z
There are indications that the performance of accounts in the other portfolios has worsened in the six month period to 31 October 2008. At 31 October 2008 the proportion of accounts which are three or more months in arrears across the prime, buy to let and self cert products has increased from 28.4% at 31 March 2008 to 32.4% at 31 October 2008 (100 accounts to 152 accounts)
9.8%
8.8%
20%
z
1.7% 20.9%
18.5%
0% To tal po rtfo lio M ar 08
A cco unts in arrears M ar 08 B uy to let
Source:
P rime
To tal po rtfo lio Oct 08
Self cert
A cco unts in arrears Oct 08
Sub prime
Leek 19 data tape
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Residential mortgage lending
Leek 18 and Leek 19 mortgage asset mix (10) 57.0% of accounts within the Leek 18 portfolio
Balances outstanding split by LTV and arrears status – Leek 18 Oct 08 100%
which are in arrears have
90%
an LTV of 85-100%, 1.4%
80%
have an LTV of over 100% 62.9% of the accounts in arrears within the Leek 19
At 31 October 2008 1,198 accounts in the Leek 18 and 1,094 accounts in the Leek 19 portfolios were in arrears
z
Within the Leek 18 portfolio 57.0% of the accounts in arrears (by balance outstanding) have an LTV of 85-100% at 31 October 2008 and within the Leek 19 portfolio 62.9% of accounts in arrears have an LTV in this range
z
1.4% of accounts by balance outstanding in the Leek 18 and 2.3% of accounts in the Leek 19 portfolio have an LTV of over 100%, the balance outstanding on these loans at 31 October 2008 is £10.2 million and £15.4 million respectively
z
As previously noted, the account LTVs provided by Burgundy are based on the most recent valuation, no indexing has been performed to adjust for movements in property values since the date of the valuation
60% 50% 40% 30% 20%
85-100% and 2.3% have an
10% 0% 0-30
30-50
50-75
These LTVs are prior to
75-85
85-100
100+
LTV %
any adjustment for indexing
z
70%
portfolio have an LTV of LTV of over 100%
Arrears status and LTV
UTD Source:
>0-3 months
3-6 months
6-12 months
12-24 months
24+ months
Leek 18 data tape
Balances outstanding split by LTV and arrears status – Leek 19 Oct 08 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 0-30
30-50
50-75
75-85
85-100
100+
LTV % UTD Source:
>0-3 months
3-6 months
6-12 months
12-24 months
24+ months
Leek 19 data tape
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendixes
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Commercial lending
Asset mix and impairment Overview
Whilst the pure
Composition of commercial book
commercial and housing
£bn Loans secured on commercial property Loans to Registered Social Landlords (RSLS) Loans secured on residential property
association lending has no arrears or provisioning, the residential landlord
Source:
shows some sign of
HY08 2.2 0.8 0.7 3.7
FY07 2.1 1 0.7 3.8
FY06 1.6 1.2 0.4 3.2
Burgundy 2008 Interim Results / 2007 Annual Report
Top ten commercial exposures
distress
Rank 1 2 3 4
Tenant Government National Westminster Bank Public Limited Company DSBG Retail Limited National Car Parks Limited
5 6 7 8 9
Tesco Stores Limited J Sainsbury plc PricewaterhouseCoopers LLP The Prudential Assurance Company Limited B&Q plc
Balance (£m) 112.9 71.2 65.8 47.4
% of total book 9% 6% 5% 4%
46.8 44.9 44.7 35.9 35.6
4% 3% 3% 3% 3%
30.0 71.2
2% 42%
10 Hilton Hotels Corporation Total Source:
z
The commercial lending team of BCIG was established in 1989 and is currently made up of 43 people managing total assets of £3.7 billion
z
The lending is predominantly in the UK and consists of ‘pure’ commercial lending, residential landlord and housing association as shown in the table opposite
z
We understand that the tenants of loan agreements are structured so as to not exceed the minimum guaranteed lease terms
Commercial (£2.2 billion: 59%) z
The top ten exposures in the commercial book (as at July 2008) can be seen in the table opposite
z
None of the commercial book loans are in arrears and therefore no provisions have been made against this book
z
Management review the portfolio on a regular basis and compile a watch list (utilising and traffic light system) as detailed below:
Red z
A key tenant is entered into administration, receivership or liquidation
−
When serious concern regarding a tenant is raised with real potential for individual company default or a concern that the tenant will fail
Amber
300. 0
z
250. 0 200. 0 150. 0
Ongoing concern regarding tenant performance that may lead to tenant failure usually highlighted by one of the following: −
Poor financial performance e.g. Losses reported, deterioration in profits or deterioration in Net Worth
−
Concerns relating to strategic factors which could potentially lead to losses and then default or tenant failure
Green
100. 0
z
50. 0
Red
Arrears and Losses Report July 2008
Amber
Green
Jul-08
Jun-08
May-08
Apr-08
Mar-08
Feb-08
Jan-08
Dec-07
Nov-07
Oct-07
Sep-07
£ million
−
BCL tenant exposures
Commercial lending watch list – value of cases on list
Source:
Usually one of the following
z
Usually one of the following −
Concerns are raised in relation to a tenant usually following a downturn in performance although not necessarily resulting in losses
−
Concerns regarding the sector in which a tenant operates
−
When a tenant has previously been experiencing difficulties and is now in the recovery stage
The graphic opposite shows the level of corporate accounts on the watch list from September 2007 to July 2008. As can be seen the level of accounts on the list has been increasing over that period, a trend seen elsewhere in the industry
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Commercial lending
Asset mix and impairment (2) In two cases where loans are in possession, no impairment has been taken as management has assumed that the properties will be taken
Name
No of properties
Amount outstanding Detail
Sanderston
68
£5,540,673
Properties in South East 2 properties still to be sold
1.27
72
£6,549,388
Properties in Lincolnshire 4 sales still to complete
3.98
Panchoo
100
£6,254,000
Properties in North West Planned to retain and manage properties Possible under-provision by £2 million
1.17
McGuiness
31
£12,000,000
New build properties in Woolwich Planned to retain and manage properties Properties valued at £9 million, leaving an exposure of £2.9 million
2.92
Grace
tbc
tbc
Properties from the three Grace transactions have been sold in auction generating a loss of £0.65m
Ibrahim
tbc
tbc
Receivers recently appointed who are taking action to gain control of the rental income
We believe that additional provisions of at least £9.7 these accounts Burgundy has exposure to Woolworths totaling £16.4
Provision £ million
Brentwood
into the Illius scheme
million are necessary for
Residential landlords (£0.7 billion: 19%)
Residential landlord outstanding fraud/receiver cases
Source:
-
0.40
z
The residential landlords book consists of BTL properties where individuals or companies have ten or more properties
z
There are nine fraud cases in the residential landlord book
z
As at the end of August 2008, four of the loans are in the hands of receivers, as detailed in the table opposite, with a further five cases in arrears where no provision has been made. A further two loans have been placed in the hands of receivers as at the end of September 2008
z
As can be seen from the table opposite, one of the management actions taken to reduce arrears and bad debt losses has been to manage residential properties going into possession through the Illius scheme. Further detail on this scheme can be seen earlier in the report
z
No further data on the five arrears cases has been provided by Burgundy to date
Housing association (£0.8 billion: 22%) z
Fraud loss report received 20 November 2008
million and a further £4.3 million exposure to MFI. Currently, provisions of £4.8 million are in place for these exposures
Exposure to Woolworths
Woolworths and MFI exposures Deal name Woolworths
Property type
% of rent
z
Following the administration of Woolworths on 28 November, Burgundy management has provided details of the exposures they had within the commercial portfolio to the company. These can be seen in the table opposite
z
The largest of the exposures is a £12.7 million loan to Keyscrest Property Holdings Limited which is secured on a distribution centre 100% let to Woolworths Group Plc
z
Burgundy management has calculated a provision for these exposures using a similar methodology to that used in the residential mortgage portfolio. This results in a provision of £4.2 million
Loan (£)
Lan dmaster Properties Denstar Luxury Properties P rimrose / Primetone Luxury Properties
Retail (multiple Retail (single Retail (single Retail (multiple Retail (single
unit) unit) unit) unit) unit)
2.5% 25.5% 42.7% 3.3% 57.3%
651,363 348,151 785,413 901,657 1,052,435
K eyscrest Property Holdi ngs
Storage/distri bution
100.0%
12,695,621 16,434,640
MFI P eerstand
Retail (multiple unit)
31.8%
4,277,361 20,712,001
Source:
Management has confirmed to us that the housing association book has no arrears and is considered very low risk. At this stage no further detail has been provided about this lending
Burgundy information
Exposures to MFI z
Burgundy have one exposure to MFI as detailed opposite
z
As with Woolworths, Burgundy management has applied a provision of £550k on this loan
z
Further work is being carried out on these exposures and the Top 40 commercial loans to determine if any additional provisions are required
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Available for sale assets
Available for sale asset mix The AFS loss reserves have moved from £139 million in June 2008 to £259 million in August 2008
AFS assets by type and rating (June 2008) 10.0 9.0
£ billion
CD's Gilts FRN
£2.8
6.0
As can be seen in the charts opposite, the majority of the liquid asset book is in “vanilla” instruments of a high grade
z
Management has informed us that the assets in grade BBB of £140 million have been reviewed for impairment and all were considered un-impaired
z
The Cullinan SIV was further impaired at the half year by £0.75 million (in addition to the £1.6 million taken in FY07) bring the net exposure to £2.65 million. The valuation is higher than that used by Claret (who we understand have provided the asset down to 20%), but is in line with the net asset valuations by HSBC of the Mazarin and Barion components of 22% and 34% respectively
Reverse repo
£4. 2
ABS/MBS
£0.2
5.0
Deposits
4.0
BBB
£3.2
A
3.0
of assets which may have become impaired due to the recent market turmoil.
AA
2.0
£3. 6
1.0
AAA
Available for sale loss reserves z
The fair value adjustments on the AFS book at 30 November 2008 amounted to £648 million (30 June 2008: £139 million). This is based on current market prices for the instruments and would reverse where instruments were held to maturity and did not default
z
The reversionary profile of the AFS losses can be seen in the chart opposite and shows that circa 23% of losses per year would reverse (from FY09) were none of the assets to default
z
A detailed review of the assets has been completed which identified a number of assets that could be at risk of permanent impairment. These include Lehmans, IKB, Kaupthing, Mazarin & Barion which have exposures of approximately £130m
£1.8
0.0 Asset type Source:
Asset rating
Half year announcement June 2008
Reversion timing of AFS fair value adjustments 30.0% 25.0%
Underlying performance Percentage
Additionally, we have identified a further 21 MBS positions with a nominal value of £244.0 million and a MTM value of £188.2 million on which we consider the risk of some impairment to be high, on which Claret has calculated a provision of £65 million would be needed
£1. 2
£0.3
7.0
z £0. 2
£0.9
8.0
Whilst the majority of the AFS portfolio consists of high quality “vanilla” assets, there are a number
With the exception of the Lehmans exposure of £90 million, management believe this is not the case, however, we have found evidence of other impaired loans with a carrying value of £40 million
Available for sale asset mix
20.0%
z
15.0% 10.0%
Following receipt of more detailed information on the MBS and ABS portfolio, further analysis has been carried out on the higher risk assets to help management determine where permanent impairment may occur. This analysis is shown on the following pages
5.0% 0.0% FY08 FRN's Source:
FY09
FY10 MBS / ABS
FY11
FY12 +
MBS / ABS (BTS)
AFS reserves detail
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Available for sale assets
Wholesale counterparty exposures Burgundy management has identified high risk
Wholesale counterparty exposures z
wholesale counterparty exposures to Lehmans,
Burgundy management has identified high risk wholesale counterparty exposures to Lehmans, IKB, Kaupthing and Mazarin & Barion of £130 million. Analysis is set out below:
High risk liquidity / banking exposures
IKB, Kaupthing and Mazarin & Barion of £130 million
£m
Gross
Leh mans IKB K aupthing Mazarin & Barion
Source:
90 25 10 5 130
Burgundy proposed provision 45 5 2 52
Claret view 80 9 4 93
Counterparty exposures report September 2008
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Available for sale assets
Mortgage and asset backed securities (1) Using publically available information, we have analysed the performance of the underlying assets of
Introduction z
Further analysis of the underlying performance of the riskier AFS assets has been performed
z
To complete this work, we have segmented the AFS assets into those that contain the highest inherent risk and hence the lowest current market values, namely the MBS and ABS assets. These have been further segmented to concentrate our work on where the higher risk of loss exists. In the case of the MBS and ABS, as agreed with Claret management, we have focused on the following areas;
80 of the higher risk MBS/ABS assets In total, these account for £613 million of the MBS/ABS book, which is 19% of the total MBS/ABS portfolio
z
-
Any asset where the MTM adjustment has reduced the assets volume to below 70% of the original book value;
-
MBS’s with assets originated by Northern Rock (Granite);
-
MBS’s with assets originated by Bradford and Bingley (Aire Valley); and
-
All other MBS/ABS with Fitch origination grades (or equivalent) of ‘A’ or below
In total, this has led to us analysing 80 AFS assets with a nominal book value of £613 million and MTM value of £492 million
Method of analysis z
Our analysis has been based on publically available information on the individual securitisation vehicles or their master trusts
z
The data supplied by each varies and therefore, the analysis completed is not uniform across each of the identified high risk areas
z
Typically, information available has included;
z
-
rating on issuance;
-
most recent rating;
-
rating outlook;
-
certain data on the credit enhancement within the vehicle; and in certain instances
-
arrears and losses data
Our analysis uses this information to highlight where the key indications of impairment exist within the selected assets
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Available for sale assets
Mortgage and asset backed securities (2) Within the population of MBS with a fair value of less than 70%, key risks of some impairment loss lie
Overview of population
MTM Asset value of 70% or less z
z
Individual securities of note
and Newgate securities,
z
RMAC securities
million and a fair value of
z
z
z
The arrears on the underlying assets are 7.3% and the credit enhancement within the vehicle is below that at origination and currently required (£4.95 million compared to £5.78 million). The securities, however, retain their original grading of A and AA with a stable outlook Given the significant MTM losses being experienced on these securities, poor performance of the underlying assets and credit enhancement is below target, we would recommend management considers impairing these assets as part of the fair value exercise.
Resloc UK z
Resloc UK is Morgan Stanley’s securitisation programme and Burgundy hold three securities within this population ranging from A to AA in rating (face value £22.0 million; MTM £12.0 million)
z
The MTM losses range from 35% to 55% and whilst the arrears are currently 4.1%, the credit enhancement across all three securities is higher than at inception
z
Brunel is the Bank of Ireland’s securitisation programme and Burgundy hold four securities in Brunel RMS within this population which are all BBB rated with a face value of £10.5 million (MTM £5.1 million) Arrears on this vehicle are low at 1.0% and the credit enhancement above that at inception (2.5% compared to 1.5%)
z
Newgate is the securitisation programme for Mortgages Plc (a subsidiary of Merrill Lynch) for which we have not been able to find any data The one security in this population has a face value of £4.3 million with a 50.8% MTM discount leaving a MTM value of £2.1 million
Various securitisation reports
z
1st Flexible and Paragon are both securitisation programmes run by Paragon. Burgundy hold 6 securities across these two vehicles within this population with a face value of £19.9 million and MTM value of £12.8 million (blended MTM of 64.3%)
z
Limited data is available on the 1st Flexible securities, however, the data that is available shows very low arrears levels and credit enhancements higher than inception and in line with latest required
z
The low MTM values on these securities could be linked to market sentiment surrounding the large US investment banks
Residential Mortgages Securities (RMS) z
RMS is the securitisation programme of Kensington Mortgages plc
z
Burgundy hold two securities in RMS in this population with a face value of £4.0 million and MTM value of £2.2 million (55%) both of which are ‘A’ rated with a stable outlook
z
Whilst the credit enhancement on these securities is above that at inception (10.1% compared to 6.5%), the arrears are high at 23.1%. This, and the general market sentiment surrounding Kensington Mortgages, is believed to have driven down the MTM value
Arkle z
Arkle is the securitisation programme of Lloyds TSB and Burgundy holds one security in Arkle in this population
z
Whilst this is BBB rated and has MTM losses of 30.7% (£5.0 million to £1.5 million), the underlying arrears in the vehicle are good at 0.6% and credit enhancement is at required levels
Newgate Funding z
6 1
1st Flexible / Paragon
Brunel z
2 10
BBB No data on rating Source:
Two securities with a face value of £13.3 million and MTM reductions of 52.1% and 78.1% are held within this population. They relate to mortgages originated by GMAC
19 £79,045,636 £42,365,182 (46.4%)
AA A
The securities in this population relate to 9 different securitisation programmes, each of which is considered in more detail below
nominal value of £21.6 £9.0 million
Total face value Total MTM value Average MTM loss
Full details of the securities can be seen in Appendix 4 which includes the originator (the entity that originally lent to the borrower)
within the RMAC, RMS which collectively have a
Number of securties
Excluding the Granite securities, which are covered overleaf, there are 19 securities with a MTM value of 70% or below. These total £79.0 million (£42.4 million MTM value)
Overall z
Within this population, whilst all assets could be impaired to a lesser or greater degree, the key risks lie within the RMAC, RMS and Newgate securities, which collectively have a nominal value of £21.6 million and a fair value of £9.0 million
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Available for sale assets
Mortgage and asset backed securities (3) Burgundy has an exposure to Granite notes of £379.5
Granite securities z
million of these notes, we consider that the notes issued in H2 06 and H1 07, which have a nominal
z
value of £141.6 million and a fair value of £113.3
loss
Data was available by individual securitisation up until 2005; however, following that date, data is pooled for to the overall master trust agreement covering all of the securitisations
z
As can be seen in the table opposite, the largest MTM losses are experienced on the BBB securities as would be expected. In all cases, these securities currently have a credit enhancement of 1.65% compared to a required enhancement of 2.22%. This is the case for all securities issued after 2004. This means that the first loss reserves and other credit enhancement tools are not up to the levels that are required
It has been reported in the press this morning (21 November) that Northern Rock has decided not to continue supporting the Granite programme and that it will now go into run-off. This could lead to
z
All securities pre 2005 have credit enhancements in line with that required and six show a positive outlook on their rating
z
Full details of the securities can be seen in Appendix 5
Overview of securities purchased z
Since 2003, £54.7 billion of Granite securities have been issued to the market of which Burgundy has purchased £408.3 million (75 bps). Full details of the securities issued and purchased by series can be seen in Appendix 6
z
The relative proportions of credit rating of the securities can be seen in the graph opposite which shows that, proportionately to securities issues, Burgundy have taken a higher relative proportion of more junior notes
z
Of the £408.3 million purchased, £141.6 million relate to securities issued in H2 06 and H1 07. Given the flow of securitisations performed by Granite at this time, it is likely that these underlying mortgage assets would have been predominantly written around this time, at which time the market competition was at its most aggressive point
longer pay-off periods and increased risk of loss to lower tier note holders. We will give a verbal update to the Committee on this issue as more
In total Burgundy holds 31 Granite securities which total £ 379.5 million (£319.3 million MTM value). These range from BBB to AAA in credit rating and are experiencing MTM losses of between 1.4% to 65.4%
z
million represent a high risk of some impairment
Given the nationalisation of Northern Rock earlier in the year and continued deterioration in the economic environment since that time, the securities in the market originated by Granite (Northern Rock’s securitisation programme) have seen significant losses. As such, analysis of all the Granite securities was considered appropriate
details will come to light over the next few days z
Similar to Burgundy’s own experience, we would expect the highest losses to emerge from these more recent issues. Therefore, we conclude that these notes, with a book value of £141.6 million and a fair value of £113.3 million represent a high risk of impairment
Overview of Granite portfolios by year Number 3
2003
Value 19,282,245
MTM 18,980,887
2004
9
71,175,393
64,243,957
(9.7%)
2005
6
60,439,167
54,264,077
(10.2%)
2006
6
162,000,000
134,197,250
(17.2%)
2007
7
66,577,080
47,642,161
(28.4%)
Total
31
£379,473,886
£319,328,332
(15.8%)
MTM 264,202,282 26,624,189 15,723,300 12,778,561 £319,328,332
MTM loss (12.6%) (17.6%) (26.9%) (45.6%) (15.8%)
Source:
AFS reserves detail
Overview of Granite portfolios by grade Number 14 8 3 6 31
AAA AA A BBB Total Source:
Value 302,151,968 32,318,838 21,500,000 23,503,080 £379,473,886
AFS reserves detail
Granite securities and Burgundy’s portfolio mix 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
3.5%
3.1% 2.5%
90.9%
Issued by Granite
A notes Source:
12.8% 7.3% 6.3%
B notes
73.6%
Mix of Burgundy portfolio
M Notes
C Notes
Granite Master Trust and AFS reserves detail
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MTM loss (1.6%)
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Available for sale assets
Mortgage and asset backed securities (4) From the population of other low rated securities,
Aire Valley securities z
including Aire Valley, the securities at highest risk of some impairment are Clydesdale, Permanent, Paragon, Bank of Ireland and the ‘A’ rated Alliance
z
The security was rated BBB on issuance and remains at this rating with a stable outlook
z
The arrears in the underlying portfolio are at 2.64% below that disclosed in June across their whole portfolio of 2.87%
z
The latest credit enhancement with the vehicle (and for these rates) is at the required rate
and Leicester and Lloyds TSB securities. These have nominal value of £80.8 million and a fair value of £65.9 million
Burgundy hold one security issued by Aire Valley (the securitisation programme of Bradford and Bingley plc) with an original value of £1.6 million and MTM value of £1.3 million (15.3% MTM reduction). Full details can be seen in Appendix 7
Other lower rated securities z
We note that following the decision by Northern Rock
Excluding the Aire Valley security detailed above, there are a further 14 ‘BBB’ rated securities and 14 ‘A’ rated securities totalling £36.9 million (MTM £31.3 million) and £114.0 million (MTM £96.3 million) respectively
to allow Granite to go into
BBB securities
run-off, there is a risk that
z
other lenders will do the same, with commentators naming Bradford & Bingley as the most likely
z
to follow suit
The BBB securities are detailed in the table opposite. As can be seen, all of the securities underlying assets have low arrears, credit enhancement in line with requirement and have rating outlooks of stable The MTM movements on these securities do not suggest significant negative sentiment in the market (in comparison with certain securities) with the exception of Clydesdale (where we have little data) and Permanent
z
Within the ‘A’ rated securities (as detailed opposite) little data has been found on Paragon, Clydesdale and Bank of Ireland
z
Of the remaining securities, two (Alliance and Leicester and Lloyds TSB) have credit enhancements below the required level
Remaining BBB rated securities Credit enhancement A bbey National Clyde sdale Bank HBOS P ermanent Llo yds TSB A rran Residential A lliance & Leiceste r Source:
Face value 12,358,240 5,000,000 10,947,765 2,372,655
MTM 11,117,977 3,649,500 9,849,124 1,682,687
Arrears 0.76 no data 1.07 1.07
requirement 1.68 1.50 2.26 1.86
current 1.68 no data 2.26 1.86
3,000,000 1,977,213 1,250,000 36,905,873
2,520,000 1,588,295 873,750 31,281,333
0.63 4.78 0.22
1.65 1.65 1.65
1.65 1.65 1.65
MTM
Arrears
19,600,000
15,407,560
0.63
4.45
1.77
4,000,000
3,517,200
4.78
100.00
100.00
Securitisation reports and AFS reserves detail
Remaining A rated securities Credit enhancement Face value Llo yds TSB A rran Residential
requirement
current
Royal Bank of Scotland
11,000,000
9,212,500
4.05
100.00
100.00
B ank of Ireland
17,000,000
12,821,400
no data
no data
no data
P aragon
8,840,223
8,000,402
7.13
no data
no data
A lliance & Leiceste r
4,000,000
3,055,600
0.22
3.40
3.63
A lliance & Leiceste r
16,000,000
14,656,000
0.22
9.25
9.21
A bbey National
16,800,000
15,453,460
0.76
4.55
4.57
4.80
no data
no data
5.09
Clyde sdale Bank
8,000,000
6,619,200
no data
HBOS
8,719,348
7,601,077
1.07
113,959,571
96,344,399
Source:
Securitisation reports and AFS reserves detail
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Treasury Select Committee - Project Verde
Private & confidential
Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Balance sheet funding The balance sheet is
Balance sheet assets and liabilities (December 2007 & June 2008) 100%
£1.1
funded via retail funds,
£1.0
£2.1 £0.5
£2.0 £0.4
Retail funds z
These comprise deposits from individual retail customers. Burgundy do not have current accounts
z
Maturity analysis of retail deposits as at 8 October 2008 is set out below, although we have noted that the balance of £nil in the 0-8 day bucket is incorrect (most of Burgundy’s deposits are instant access)
securitisation and
90%
wholesale funding
80%
Broadly speaking, the
70%
Noteholder funds
60%
z
The noteholder funds comprise funding via Burgundy’s securitisation structures (Leek 11 to 19) and also funding obtained via the Government’s Special Liquidity Scheme (SLS). The amounts are broadly split £3.1 billion to £1.2 billion respectively
z
Further detail around the Securitisation structures can be seen later in the report
retail funds and
£9.2
£10.2
£9.4
£11.9
£4.3 £4.7
securitisation match off
50%
against the mortgage
40%
assets with wholesale
£25.5
funding matching off
Wholesale funds
£25.1
30%
£19.2
£17.6
against the liquid assets
z
Wholesale funds include the MTN programme, PIBS and subordinated debt as well as shorter term funding from counterparties such as local government, fund managers, pension schemes and lines from other financial institutions
z
Burgundy also have warehouse lines (via their Meerbrook facilities) totalling £1.2 billion of which £580 million is currently drawn down
z
A small number of counterparties were lost as a result of the downgrading earlier in the year; predominantly small parties with the exception of L&G (£300 million) and Morley (£50 million). The cumulative rollover rate of funding declined from 93% to 87% after the down grade. Whilst numbers of counterparties reduced, the overall balances remained stable. The rollover rate at 30 September 2008 has reduced further to 84%
z
Management have informed us that the consequences of a further downgrade would be as follows
-
As seen previously, certain counterparties would be expected not to roll over their funding lines. Treasury management believe this would be possible to replace but just at a higher cost. Management’s estimates of the value of wholesale flight are £150-200 million of unsecured and a further £250-500 million of repo over a 12 month period;
-
If the grading were to fall to BBB or below, the GIC account associated with the Meerbrook warehouse funding lines would have to be held externally. Given the warehouse lines are renegotiated on an annual basis, there could be a risk that these lines were withdrawn. Where the lines have already been drawn, these amounts are guaranteed; however, a step-up rate of interest would be applied (which is 75 to 100 bps above the current drawn margin); and
-
Management are not aware of any other significant triggers that would be breached albeit they could exist in agreements such as repos etc
z
Further detail on the wholesale funding can be seen overleaf
20% 10% 0% FY07 assets
Source:
FY07 liabilities
H12008 assets
H12008 liabilities
M o rtgages
Liquid assets
Other assets
Retail funds
No teho lder funds
Who lesale funds
Other
Capital & reserves
Annual Financial Statements December 2007; Half year announcement June 2008
Maturity analysis of retail deposits
Deposit balances £m Up to 8 days 8 days - 1 month 1 month - 3 months 3 months - 6 months 6 months - 12 months
11,766 1,748 708 3,439
1 year - 2 years
633
2 years - 3 years
369
3 years - 4 years
238
4 years - 5 years
466
> 5 years Total Source:
2 19,369
Burgundy Maturity Profile 8 October 2008
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Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Retail funding (1) Of total accounts of
Comparison of Burgundy and Claret retail deposit portfolios z
We have performed high level analysis on data provided by Burgundy and Claret to assess the extent of ‘overlap’ of retail deposit customers across the two portfolios
4,517,511, we have
z
Our analysis sought to ‘match’ those individuals considered to be customers of both entities based on commonality of gender, age and full postcode
identified 4,178,302
z
Findings are summarised below:
accounts with balances of
BURGUNDY
£22.3 billion where retail deposit investors do not appear to overlap. 253,390 accounts indicate evidence of crossover; balances on these accounts total £1.76 billion
Note
CLARET
Bal £
No
Bal £
No
Assumed to be standalone
No valid postcode present
1
23,961
80,369,158
45,480
169,758,182
No matching postcode for other entity (1)
2
976,000
6,075,805,593
518,841
1,905,899,059
Single "M" or "F" with age matched across entities
3
124,951
1,147,690,500
124,951
589,269,138
Cross entity matches
Single "M" or "F" with age not matched across entities
4
1,358,936
9,451,819,492
846,937
3,575,180,418
Definitely standalone
No matching postcode for other entity (2)
5
310,562
728,781,724
53,461
193,776,486
Definitely standalone
Multiple "M" or "F" with age matched across entities
6
1,741
19,562,077
1,741
6,543,096
Cross entity matches
Multiple "M" or "F" with age not matched across entities
7
25,129
179,622,040
25,704
111,341,666
Definitely standalone
No matching postcode for other entity (3)
8
3,815
18,650,109
72
381,037
Definitely standalone
Single "U" with age matched across entities
9
3
8,994
3
20,860
Cross entity matches
Definitely standalone
Single "U" with age not matched across entities
10
250
1,237,010
11,769
25,874,278
Definitely standalone
No matching postcode for other entity (4)
11
25,203
64,959,785
136
681,723
Definitely standalone
No matching postcode for other entity (5)
12
20,804
4,811,807
683
1,503,337
Definitely standalone
Remainder
13
11005
9,190,627
5373
12,952,691
2,882,360
17,782,508,916
1,635,151
6,593,181,972
Total number of custom ers Source:
Assumed to be standalone
Burgundy maturity profile 8 October 2008
Note 1: No matching can be performed since no valid postcode is present - must assume that these customers are all standalone Note 2: Having eliminated items in 1 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - all customers with these postcodes are definitely standalone Note 3: Having eliminated items in 1 and 2 above, identify matches between Burgundy and Claret where PC, age and gender (where "M" or "F") are present and agree, and there is only 1 record at the PC for each entity - assume that these relate to the same person Note 4: Having eliminated items in 1 to 3 above, identify items where PC, age and gender (where "M" or "F") are present and agree, but only occur in Burgundy and not Claret, and vice versa nd there is only 1 record at the PC for each entity - all customers with these postcodes are definitely standalone Note 5: Having eliminated items in 1 to 4 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - all customers with these postcodes are definitely standalone Note 6: Having eliminated items in 1 to 5 above, identify matches between Burgundy and Claret where PC, age and gender (where "M" or "F") are present and agree, and there is more than 1 record at the PC for each entity, but the same number of records for each entity - assume that these relate to the same person Note 7: Having eliminated items in 1 to 6 above, identify items where PC, age and gender (where "M" or "F") are present and agree, but only occur in Burgundy and not Claret, and vice versa and there is more than 1 record at the PC for each entity - all customers with these postcodes are definitely standalone Note 8: Having eliminated items in 1 to 7 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - all customers with these postcodes are definitely standalone Note 9: Having eliminated items in 1 to 8 above, identify matches between Burgundy and Claret where PC, age and gender (where "U") are present and agree, and there is only 1 record at the PC for each entity assume that these relate to the same person Note 10: Having eliminated items in 1 to 9 above, identify items where PC, age and gender (where "U") are present and agree, but only occur in Burgundy and not Claret, and vice versa – all customers with these postcodes are definitely standalone Note 11: Having eliminated items in 1 to 10 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - these are definitely standalone Note 12: Having eliminated items in 1 to 11 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - all customers with these postcodes are definitely standalone Note 13: Postcodes agree but insufficient other detail to positively match - must assume that these customers are all standalone This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Retail funding (2) Following on from the comparison of the retail
Comparison of Burgundy and Claret members z
Following on from the comparison of the retail deposit portfolios, comparison of the members of Claret has been completed using the same methodology. The results are summarised below:
deposit portfolios,
BURGUNDY
comparison of the members of Claret has been completed using the same methodology
CLARET
Note
No
No
Insuffici ent details to match No matching postcode for other entity P ostcode, age and gender match ed across entities (same number of customers within postcode for each entity) No match on postcode, age and gender for other entity P ostcode, age and gender match ed across entities (different nu mber of customers within postcode for each entity)
1 2 3 4 5
4 46,089 9 12,905 1 30,006 1,3 65,210 19,925
665,469 1,244,448 130,006 1,270,427 19,925
S tandalones Total number of customers
5
8,225 2,8 82,360
13,594 Definitely standalone 3,343,869
A ssumed to be standalone Definitely standalone Cross entity matches Definitely standalone Cross entity matches
Note 1: No matching can be performed since no valid postcode is present or no age is present – must assume that these customers are all stand alone Note 2: Having eliminated items in 1 above, identify postcodes which occur in Burgundy and not Claret, and vice versa - all customers with these postcodes are definitely standalone Note 3: Having eliminated items in 1 and 2 above, identify matches between Burgandy and Claret where PC, age and gender are present and agree, and there are the same number of records at the PC for each entity - assume that these correlate to the same persons Note 4: Having eliminated items in 1 to 3 above, identify items where PC, age and gender are present, but the combination only occurs in Burgundy and not Claret, and vice versa Note 5: Having eliminated items in 1 to 4 above, identify matches between Burgandy and Claret where PC, age and gender are present and agree, but the number of records at the PC for each entity differs. Assume that these correlate across the entities as follows: where number of records in Burgundy exceeds number of records in Claret match Burgundy records to the available Claret records on ‘first come, first served’ basis assume remaining unmatched Burgundy records are stand alone where number of records in Claret exceeds number of records in Burgundy match Claret records to the available Burgundy records giving priority first to Claret records with Payout-CFS flag, then to Claret records with Payout flag, then to other Claret records assume remaining unmatched Claret records are stand alone
z
Additionally, where cross entity matches have definitely been identified, these have been split by account balance. The results are summarised below;
Cross entity matches by balance No Aged under 18 Balance < £500 Balance >= £500 Aged 18 and over Balance < £100 Balance >= £100 and < £2,500 Balance >= £2,500 Total
Balances (£)
125 95 220
12,662 350,066 362,729
31,792 46,581 71,338 149,711 149,931
497,862 35,210,199 1,373,277,621 1,408,985,681 1,409,348,410
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Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Wholesale funding As with the market, Burgundy’s access to term funding has been severely limited; as a result it has
z
The wholesale funding liabilities are made up of a number of different liabilities as detailed below
z
Burgundy also has a US$3,500,000,000 commercial paper programme in place
z
Burgundy is considering taking support from the UK Government credit guarantee scheme. Term funding up to three years will be made available under agreed conditions. Initial investigations are that the cost to Burgundy would be in the region of Libor + 220 for 1 to 3 year funding
z
These are debt securities with a maturity of 1 to 364 days and are not listed on any stock exchange
entered the Bank of England’s SLS and has increased its reliance on term funding
Commercial paper
Overview
PIBS summary
Permanent Interest Bearing Shares (PIBS) z
PIBS take their legal form from the Building Societies Act and are deeply Issued subordinated debt instruments which pay high interest and are permanent Permanent in nature. These are treated as Tier 1 capital for regulatory purposes due Callable to them having significant ‘equity’ like features
z
Burgundy have two tranches of PIBS, the details of which can be seen opposite
Interest step up
z
Given the unprecedented turmoil in the financial markets, Burgundy PIBs have recently been subject to volatility. From a price of 117p (yield 11%) at the beginning of September, the shares fell sharply down to a price of 70p (approx 17%) during early October
Source:
£110m PIBS
£200m PIBS
1992 Yes No
2005 Yes 10 years after issue and every 6 months thereafter
No, interest fixed at 13% Step up 10 year and 3 months in perpetuity after issue at LIBOR +205bps
Detailed paper on PIBS
Subordinated debt summary
Subordinated debt z
The subordinated debt is listed on the London stock exchange via the Euro Medium Term Note Programme (EMTN) detailed below
z
This debt is subordinated to all wholesale funding with exception of the PIBS. Further details can be seen in the table opposite
EMTN’s
Issue date
Currency
value
value
date
Maturity
18-May-06 28-May-02
Euro GBP
300 150
200 150
18-May-11 None
18-May-16 28-Mar-33
02-Mar-04
GBP
200
200
02-Dec-19
02-Dec-24
Source:
z
Burgundy has a US$6,500,000,000 EMTN programme in place which allows it to issue listed debt to the market (but there is currently no market)
z
Each time a new issue is made under the programme, terms are agreed at that time
z
There are also three other term note programmes in place as follows: −
Australian dollar $1,000,000,000 short term and medium term note programme
−
French €3,000,000,000 Certificats de Dépôt programme; and
−
Short term promissory notes
Detailed paper on subordinated debt
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Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Wholesale funding Burgundy has committed funding lines in place with its main relationship
Warehouse funding Drawings z
banks, RBS and JPM, to ensure contingency funding for Platform originations. Burgundy has not budgeted for any securitisations to be transacted other than in
z
Where a drawn facility is not renegotiated and the drawings become a 25 year term advance as detailed above, a step-up rate of between 75 to 100 bps is charged above the drawing margin noted opposite
z
Burgundy has no obligation to fund any Meerbrook facility other than for the subordinated loan provided at the inception of the scheme. The exception to this is the Meerbrook 4 facility, guaranteed by Burgundy, which is repayable by Meerbrook or Burgundy after seven years
respect of Leek 20 for the Bank of England Special
Burgundy’s existing warehouse facilities operate on an identical basis in respect of notice period and term extensions should a lender wish to withdraw their support. In summary, at not less than 60 days prior to the 364 day termination date, Burgundy may approach the lender to gain an indication of whether or not the lender intends to provide a new facility. Not less than 10 days prior to the termination date, if such a notice has not been received, Meerbrook companies are permitted to draw a term advance for a period of 25 years for the entire facility. In this way there is no liquidity risk to Meerbrook
Liquidity Scheme
Warehouse financing capital requirements z
z
Burgundy has committed funding lines in place with its main relationship banks, RBS and JPM, to ensure contingency funding for Platform originations which are funded through normal Burgundy group resources. In summary Burgundy currently has four committed warehouse facilities in place with additional uncommitted lines of £450 million to fund third party acquisitions Burgundy’s strategy is there to ensure that there is an alignment of interest on securitisation and funding with the key banks
z
Burgundy acquired £1.2 billion of mortgage loans from a third party at the end of September 2007. Burgundy funded approximately £600 million from the uncommitted warehouse lines from Meerbrook 2 with JPMorgan and the remaining funding from general Burgundy resources
z
Burgundy renewed the Meerbrook 3 warehouse facility in December 2007 and refinanced the £226 million of loans from August 2007
z
Burgundy refinanced the £600 million borrowings under the Meerbrook 2 facility into a new scheme, Meerbrook 4. Additionally, this facility receives the benefit of a guarantee from Burgundy
Current position is summarised as follows: Meerbrook 1 (Remains Undrawn)
Meerbrook 2 Meerbrook 3 - Meerbrook 4 (Remains (Part Drawn) (Fully Drawn) Undrawn)
Capital Treatment
OFF BALANCE SHEET
OFF BALANCE SHEET
Committed Lines (£m)
400
400
500
600
Uncommitted Lines (£m)
150
300
-
-
Lender
RBS
JPM
RBS/JPM
JPM
Term
364 day revolving 364 day revolving
364 day revolving
364 day revolving
Burgundy has not budgeted for any securitisations to be transacted other than in respect of Leek 20 for the Bank of England Special Liquidity Scheme. If the market permitted, Burgundy may consider bringing a securitisation on a traditional or private/bilateral basis. Should the markets allow for an alternative transaction or Covered Bond to be created from the existing mortgages in warehouse facilities or from other on balance sheet mortgages, this is not expected to have a significant impact on capital as these will again be on balance sheet
Drawing on warehouse lines and recent activity z
Burgundy sold £226 million of loans to the Meerbrook 3 warehouse company in August 2007. Following this, RBS and JPM funded £226 million of cash to Burgundy
25 years
25 years
25 years
7 years
Renewal
May-08
Sep-08
Dec-08
Mar-09
Drawing Margin
20 bpts
75 bpts
75 bpts
75 bpts
Subordinated Loans Tranche A Tranche B
Tranche C
£8.6m
£24m
£30m
(not deducted)
(not deducted)
(not deducted)
£35.73
£5m
£58.38m
(not deducted) £0.25m expense loan (deducted)
(not deducted) £1.76m discount reserve top up (not deducted)
(not deducted)
(not deducted)
£0.5m
£153.2m (MAS 5 loans not deducted)
expense loan (deducted)
£1.3m Tranche D
£0m
£2.4m
n.a
expense loan
£0.85m n.a
(not deducted)
discount reserve (not deducted) £0.3m (deducted)
Tranche E
n.a
n.a
n.a
Current Drawings
Nil
Nil
£226m
(MB2 refinance + £150m MAS5)
Funding Treatment
Securitisation
Securitisation
Securitisation
Wholesale
£738m
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ON BALANCE SHEET
Repayment
Forecast usage z
ON BALANCE SHEET
60
Treasury Select Committee - Project Verde
Private & confidential
Funding and liquidity
Liquidity mismatch Burgundy has a significant
Balance sheet assets and liabilities maturity
mismatch in the 8 days to
Overview z
The chart opposite shows the mismatch between the Treasury liquid assets and the wholesale funding
z
As can be seen, there is a mismatch in the first eight days with a positive balance. This is then offset by the large liability maturities in the eight days to three months time brackets and does not even out again until the one to two years brackets
z
The significant asset balances in the five years plus bracket relate to the MBS and ABS asset maturities
3,100
12 months, with liquid assets falling short of wholesale funding in that
2,100
time bracket
£ million
1,100
100
(900)
( 1,900)
Source:
MMR reserves
Bank deposits
CDs
Reverse repo
FRNs
Gilts
MB S/ABS
Issued C Ds
Time deposits
Repo
EMTN
Sub debt
ZCP
PIBS
> 5 years
4 - 5 years
3 - 4 years
2 - 3 years
1 - 2 years
6 - 12 months
3 - 6 months
1 - 3 months
8 days - 1 month
> 8 days
( 2,900)
Management asset and liability maturity analysis
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Treasury Select Committee - Project Verde
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Funding and liquidity
Liquidity stress testing Liquidity stress testing is
Wholesale funding and liquidity stress assumptions
completed on a two weekly basis with a paper being submitted to the
Current Member 12% Platform 22% BTS 41% Commercial 7% Member 84% Platform 51% BTS 92% Commercial 78%
Moderate Member 12% Platform 17% BTS 36% Commercial 2% All existing apps honoured and BCIG halve lending
Firm specific Severe Member 2% Platform 12% BTS 31% Commercial 0% All existing apps honoured and new lending ceases
Credit agencies ratings
S&P downgraded to
Short term rating
Downgraded to BAA1
downgrade by S&P,
by any one of the major
Retail flows
A-2/term £463 million inflows over 12 months
Prepayment assumptions
ALCO on a monthly basis Funding roll rates of 93%
Conversions
in June have reduced to 87% in September, equivalent to £600 million of funding. This is due to market conditions and management action to reduce the balance sheet Management currently
Wholesale funding
Extreme Same as severe
Market wide Moderate Severe Same as current Same as current
All existing apps honoured and new lending ceases
Same as current
Same as current
Data not available
Data not available
Data not available
Moody's & Fitch rating agencies £213 million inflows over £2.4bn outflows over 90 £3.4bn outflows over 90 Same as current 12 months days days
Burgundy specific, severe
Bank deposits
65% rollover over 12 41% rollover over 12 months months At maturity At maturity
At maturity
Same as current
Same as current
stress scenario at the 90
CDs and Gilts
Realisable day one
Realisable day one
Realisable day one
Realisable day one
Same as current
Same as current
FRNs and MBSs
At maturity
At maturity
At maturity
At maturity
Same as current
Same as current
focuses more on the
day level given the current funding environment, which as at the August ALCO, showed a positive position of £974 million We note that this was analysed prior to the Burgundy downgrade
Source:
22% rollover over 12 months At maturity
Same as severe
Same as current
Same as moderate Same as severe
July 2008 ALCO
Liquidity stress testing z Liquidity stress testing is completed on a two weekly basis with a paper being submitted to the ALCO on a monthly basis z Given the current environment management assessed the market conditions as D (weak) and current liquidity as C (slightly weak) out of a scale of A to E z The liquidity stress testing looks at five different scenarios, as detailed above, including three Burgundy specific scenarios and two market wide scenarios z The assumptions used in the scenario testing have been based on the experience following the last downgrade, actual mortgage redemption behaviour and actual roll rates on funding. The assumptions are generally less stringent than those applied by Claret z Rollover rates have been falling in the last twelve months as a consequence of the markets and management action to reduce the balance sheet. Rates of 93% in June have reduced to 87% in September, equivalent to £600 million of funding, following the ratings downgrade
The results at the > 12 month stress show the following available liquidity: − £3.5 billion under the current scenario − £1.4 billion under the moderate stress − £0.8 billion under the severe stress z Management currently focuses more on the Burgundy specific, severe stress scenario at the 90 day level given the current funding environment, which as at the July ALCO, showed liquidity headroom of £974 million z The eight day retail deposits inflow/outflow are as follows − Current conditions £21 million (0.1%) inflow − Moderate firm stress £30 million (0.2%) outflow − Severe firm stress, £(1,497) million (8.5%) outflow z All the above tests assume management action of a reduction in lending although we have not yet seen by how much z
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Funding and liquidity
Interest rate sensitivity gap and hedging Burgundy monitors
Interest rate sensitivity gap
interest rate sensitivity to
Term
Yield Net asset/ (net curv e liability)
parallel shifts in the yield
Sensitivity to Policy limit +1bp
Running P/L
0-1 years 1-2 years
% 5.86 5.35
£m 209 (256)
(24,463) 20,113
+/-£75,000 +/-£75,000
+ve -ve
2-3 3-4 4-5 5-6 6-7 7-8
5.24 5.21 5.18 5.13 5.09 5.05
(213) (18) 128 (57) (22) (29)
30,280 (2,723) (52,290) 26,073 10,800 18,406
+/-£75,000 +/-£75,000 +/-£75,000 +/-£75,000 +/-£75,000 +/-£75,000
-ve -ve +ve -ve -ve -ve
5.01 4.98 4.69
31 5 (32)
(22,056) (4,713) 25,853 25,280
+/-£75,000 +/-£75,000 +/-£75,000
+ve +ve -ve
years years years years years years
8-9 years 9-10 years 10 years + Total Source:
August 2008 ALCO
z
At 30 June 2008, Burgundy had a relatively high level of interest rate sensitivity in the 0-1 year and 1-2 year brackets, albeit still within limits. The latest ALCO shows that this sensitivity as fallen in 0-2 year brackets but further volatility has been introduced in the medium term markets
z
As can be seen in the table opposite, Burgundy spread their nonsensitive internal rate of return (‘IRR’) out to 10 years
z
We note that when interest rate hedges are taken out against pipeline products, Burgundy recognise the SWAP and the pipeline, thus distorting their IRR until the pipeline products are taken up. This could have a significant impact on the reported IRR
z
Based on the August gap position, the recent increases in LIBOR would have been income generative
Hedging z
Burgundy currently run both fair value and cash flow hedges against their balance sheet exposures
z
We are expecting to have more detailed information from Burgundy management to consider hedging strategy
z
Management has informed us that they have not experienced any significant hedge ineffectiveness since introducing IFRS
z
After the designated hedges and the other ‘natural’ hedges of the balance sheet, management have confirmed that only two small areas of fair value risk remain unhedged including:
Interest rate sensitivity gap 300
6.00
200
5.80 5.60
100
5.40 0
5.20
-100
−
circa £80 million of unhedged RPI linked savings accounts
−
an insignificant book of mortgage assets with floors and caps
5.00
Net asset/ (net liability)
10 years +
9-10 years
8-9 years
7-8 years
6-7 years
5-6 years
4-5 years
3-4 years
4.60
2-3 years
-300
1-2 years
4.80
0-1 years
-200
Source:
%
£ million
curve
Interest rate sensitivity
Yield curve
August 2008 ALCO
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Securitisation
Overview of Leek securitisation programmes The Leek programme provides a key component of Burgundy’s funding and at 30 June represents 30% of total wholesale funding and 14% of total funding at 30 June 2008 Whilst the securitisation programme is designed to be bankruptcy remote
The Burgundy and related Dovedale programmes are a complex series of structured funding transactions, with extensive detailed documentation and legal agreements associated with each of the individual issues. This report seeks only to summarise certain key aspects to provide an understanding of the main areas of risk associated with the programme based on the limited data which has been made available to us and does not represent an extensive consideration of the detailed documentation relating to the programmes Key features z Burgundy established the Leek programme in 1996 and has issued 18 public residential mortgage backed securitisations through the separate entities Leek Finance 1 -19 (no Leek Finance 13), with two further issuing entities Leek Finance 20 and 21 established to issue securities under the Bank of England Special Liquidity Scheme z Over the history of the programme, Burgundy has issued £9.25 billion equivalent under the public Leek transactions. The security in the structures comes from Platform and BTS books. A number of the earlier securitisation transactions have already matured and been called such that no outstanding notes remain in issue, with remaining collateral from these previous deals put into later transactions z At 31 August 2008 the transactions with notes still outstanding are summarised below:
from Burgundy it remains exposed to and interested in the performance of the securitised assets through
Issue name
Issue date
Issue amount £ million equivalent
Outstanding note amount £ equivalent
Leek Finance 11 Leek Finance 12
Deferred consideration paid in 2007 and in 2006 £k
Oct 2003
375
65
896
3,573
Mar 2004
704
92
5,662
15,932
Leek Finance 14
Oct 2004
1,046
211
9,792
18,406
its various roles and
Leek Finance 15
Apr 2005
1,080
410
9,996
6,565
interests in the structure
Leek Finance 16
Oct 2005
961
492
13,111
611
For this reason, in
Leek Finance 17
Apr 2006
1,168
750
1,256
nil
Leek Finance 18
Oct 2006
1,048
881
nil
nil
Leek Finance 19
Apr 2007
833
738
nil
nil
7,215
3,639
Burgundy’s group financial statements, the securitised mortgages remain on balance sheet
z
Burgundy made subordinated loans to the structures to provide the required reserve funds on start up (known as the ‘first loss reserves’) and, subject to the impact of Dovedale, it remains effectively at risk for these potential amounts should the performance of the programmes not generate the required income to meet the required payments for scheme expenses, bond interest and principal payments (see further details below)
z
Burgundy receives interest from the excess spread earned in the structure in the period (provided sufficient is earned); and at final maturity of the structure these subordinated loans would be repaid from the reserve fund balances. The right to any remaining excess spread remains and is paid to Burgundy as deferred consideration. The table above sets out the deferred consideration that has recently been extracted from the structures which have not yet reached maturity, however we have been unable to determine the extent of any deferred consideration earned from those fully matured programmes)
z
Burgundy has traditionally been the Guaranteed Investment Contract (‘GIC’) account provider to the programme, though the extent of this activity has recently been restricted due to the ratings downgrade of Burgundy
z
Burgundy also retains other involvement in the structure through its administration and servicing of the securitised loans by WMS
z
Interest rate swap arrangements hedge the risk that arises between the interest rates charged on the mortgages (SVR and fixed) and those paid on the notes (linked to LIBOR and other interbank rates) – these SWAP arrangements are provided by external, third party banking counterparties
and the recording of income, costs and losses is not affected by the existence of securitisations until reserve funds are fully expired
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Securitisation
Overview of Leek securitisation programmes Reserve funds exist within the structures which provide credit support in the event that losses should arise
Credit enhancement structures z Credit enhancement to protect investors within the structures is provided through a combination of subordinated note classes, a reserve fund requirement and excess spread earned within the structures. Any excess spread within the structures and the reserve funds exist to absorb any losses and meet requirements to pay interest before any loan or note holders would be impacted. The transactions are constructed such that losses are intended to be absorbed within and through this credit enhancement structure z
In the worst instance (Leek 17) provisions would have until it equates to the reserve fund. The position is more prudent when cumulative losses are considered; however, we draw your attention to the later developments outlined at the end of this section
Excess Spread
The reserve funds do not amortise over the life of the programme and any unconsumed amounts will only be available for release or repayment of loans as the programmes mature and all other priority obligations and notes have been repaid
z
Substantial reserve fund balances have been accumulated within the various structures. The position of the reserve funds at issue, and their levels at 31 August 2008 are summarised below
z
The June board sub-committee minutes state that: − provisions already made should be sufficient to cover losses incurred − it is unlikely there will be any need to draw on reserve funds during the remainder of 2008 − the possibility of a draw on reserves being made in 2009 would require quarterly losses to exceed £2.5 million, compared to current running rates of approximately £1.5 million
to increase by 3.5 times
Losses
−
Reserve Fund
BB notes BBB notes A notes AA notes
The investor reports at 31 August 2008, in which cumulative losses are reported for each securitisation vehicle suggests that losses are increasing by 0.08% of the book per month in the worst instance, Leek 19. At that rate, it would take 31 months until the reserve fund is exhausted, and that is only after excess spread has been exhausted
Issue name
Issue amount £ million equivalent
Outstanding note amount £ equivalent
Reserve fund at closing
Reserve fund as % of initial amount
Leek Finance 11
375
44
5.3
Leek Finance 12
704
88
9.4
Leek Finance 14
1,046
194
Leek Finance 15
1,080
Leek Finance 16
961
Leek Finance 17 Leek Finance 18 Leek Finance 19
AAA notes
Reserve fund at 31 August
Reserve fund as % of outstanding amount
Provisions as % of outstanding amount
Cumulative losses since issue (% original balance)
Possessions %
1.42%
8.4
19.35%
0.62%
0.04%
1.29%
3.70%
1.33%
15.4
17.56%
1.91%
0.17%
1.39%
10.56%
17.6
1.68%
22.3
11.46%
1.46%
0.14%
2.82%
9.17%
335
18.7
1.73%
24.8
7.42%
1.37%
0.25%
2.39%
8.92%
416
14.8
1.54%
20.8
4.99%
1.27%
0.34%
2.74%
9.76%
1,168
723
23.4
2.00%
27.7
3.83%
1.10%
0.34%
2.20%
7.26%
1,048
843
23.3
2.22%
26.9
3.20%
0.75%
0.38%
1.81%
6.87%
2.15%
17.9
2.38%
0.38%
0.48%
2.80%
6.16%
833
753
17.9
7,215
3,396
130.4
Three months+ arrears %
164.2
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Securitisation
Illustrative Leek 19 transaction structure diagram The typical Leek securitisation structure is
Burgundy Building Society
shown here (in this case
Buy Back Guarantee
Leek 19). The structure also shows the Guarantee of Administration and Buy Back Guarantee
relationship with the Meerbrook warehouse vehicles
WMS (Sub Administrator) Beneficial Sale of PFL Mortgages
Correspondent Lenders
Platform Funding Limited Originator, Administrator and Legal Owner)
Beneficial Sale of PFL Mortgages
Administration and Servicing Guaranteed by Burgundy
Meerbrook Finance Number Three Limited (a warehouse vehicle) Beneficial Sale of PFL Mortgages
Trustee
Security
Liquidity Facility
Sub-Loan Leek Finance Number Nineteen PLC (Issuer)
Principal & Interest on Class A1, Class A2, Class M, Class B, Class C and Class D notes
Noteholders
Expenses Loan
GIC Agreements and GIC Guarantee Interest Rate Swaps and Basis Swaps
Cross Currency Swaps
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Securitisation
Simplified Leek payment distribution summary The operation of the securitisation accounts is conducted on a quarterly cycle Make up liquidity shortfalls in place
Further details on the
Make good any losses of principal suffered (e.g. Previous reserve draws)
requirements in connection with the operation of the accounts Principal receipts
will be contained in the cash management legal
Income:
Fund any mandatory partial redemption requirements (e.g. In pay down situation)
agreements, to which we have not yet had access
Mortgage interest and fee income Specified reserves Income under a swap arrangement Income arising form GIC accounts
Residual / surplus income distribution
Application / payment process
Allocation / calculation process
Interest receipts
Issuer expenses and costs Interest payments on bonds
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Deferred consideration
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Securitisation
Dovedale structure The Dovedale structure has effectively transferred
The Role of Dovedale z
a portion of Burgundy’s risk exposure in the Leek reserve funds associated with the transaction
z
The extent to which loss coverage is provided through Dovedale will only become clear as the
z
underlying Leek transactions reach maturity and loss
z
experience has crystallised
z
The Dovedale transaction is structured to enable Burgundy to sell on a share of its exposure to the reserve funds held in certain Leek Issues to other investors. This gives protection to Burgundy’s risk exposure and provides capital relief. The remainder of the reserve fund is the first loss portion which is retained by Burgundy Dovedale is a funded synthetic securitisation transaction. In effect Burgundy buys credit protection from Dovedale on a portion of a portfolio of Leek reserve funds (the Leek issues 10 – 17, totalling £119 million at 21 August 2008) in exchange for a premium under a credit default swap. The reserve funds for these issues remain outstanding until each issue is redeemed Dovedale funds its obligations under the credit default swap by issuing credit linked notes into the capital markets. Burgundy pays Dovedale a premium for the credit default swap and this, together with interest earned, is used to fund payments on the Dovedale notes Dovedale issue notes initially with a principal balance equal to a portion of the amount held in the Leek reserve funds at the issue date, for which Burgundy is seeking to buy protection, an amount equal to approximately £100 million at issue on July 2006, and now standing at approximately £88 million at 30 June 2008 Payments would be made to Burgundy by Dovedale, to offset losses incurred in the transaction pools referenced by the credit default swaps, when a defined 'Credit Event' occurs – effectively when there is a shortfall on the reserve funds greater than a specified threshold amount
z
Dovedale notes are profiled to the final legal maturity of the Leek notes and the weighted average lives assume Leek call all notes at their respective step up and call date
z
With regards to the residual counterparty risk associated with the Dovedale structure, the obligations of Dovedale Finance under the credit default swap were matched by Dovedale putting cash on deposit with Burgundy. The cash was raised through the issuance of bonds to third party investors. As such, the Burgundy’s exposure to Dovedale is cash collateralised by Dovedale’s deposit with Burgundy
BURGUNDY BUILDING SOCIETY (CDS Counterparty)
CDS Counterparty payments
DOVEDALE FINANCE
Notes
No.1 PLC
Interest payments (Quarterly)
Class A1 £2,500,000
Class A2 £14,000,000
Reference Pool Issuer CDS payments (if any)
Net proceeds
(Quarterly)
(Closing date)
GBP Funds
Interest income
Deposit Cash deposit With Account Bank
EUR Principal and Interest
Currency Swap Counterparty
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NOTEHOLDERS
Class B1 £4,000,000
Class B2 £47,500,000
Class C1 £14,500,000
Class C2 £55,500,000
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Securitisation
Key risks associated with the Leek securitisation programme Under normal circumstances, notes will
z
We have not yet been provided or had access to details of the specific triggers applicable within the Leek structures and all the transaction documentation in which these may be contained
z
However, within typical securitisation structures, a range of triggers are generally in place which are intended to come into effect prior to any event of actual default on a note, which are designed to provide additional credit support within the structure. Breaching of these may not in themselves directly lead immediately to early repayment of the notes or impact on the funding, depending on their severity and the degree to which they can be remedied. The matters considered further below are not an exhaustive description of the full range of criteria and their potential impact, merely a summary of the principal types of trigger events and other criteria breaches which are key to understanding the risks associated with any programme
be paid down through a controlled amortisation payment profile from cash flows generated from the pool of mortgage assets
Key risks – Triggers and other criteria
held in the structure
Asset triggers
z
An asset trigger event may occur if sufficient losses associated with the mortgage assets were to arise to such an extent that a deficiency in principal arises to the account of the senior note holders. This situation would only arise if the extent of losses in the structure was very severe and could not be met by the credit enhancements in place in the structure: excess spread, reserve funds and junior note holders. In such circumstances, principal would be repaid pro-rata and all notes outstanding become pass through. We have not been able to confirm if such a trigger exists within the Leek structures, nor have we been able to ascertain the loss experience to date. The information we have seen suggests such a level of losses is not anticipated (see reserve funds above), and Burgundy management has confirmed this
Non asset triggers
z
A non asset trigger might typically occur in the event of insolvency – this trigger should be a remote consideration in normal circumstances, but could result in the requirement for Leek to transfer the administration and servicing of the portfolios to another service provider
Ratings criteria
z
A complex range of rating triggers typically apply within securitisation structures which can significantly impact on the structure - in the Leek transactions, the implications of the recent downgrade have included the requirement to limit the extent of the GIC account which can be held to 20%, and the transfer of the remaining proportion of the GIC accounts to another financial institution
Non call of issues
z
At the step and call date (the maturity date expected within the structure) Leek has the option to repurchase the outstanding loan notes, which it has always taken. If not called, interest rates increase on the notes in question, and notes may move to a pay through payment mechanism; with draws made on made on reserve funds and excess spread to pay down notes in specified orders of priority
However, if certain criteria are not met and triggers are breached, then the payment profile may change to a 'pass-through' mechanism which will accelerate and change payment priorities within the structure in favour of the senior bond holders Under such circumstances the principal payments through to Burgundy will
z
The information we have seen does not suggest any arrears triggers or requirements within the structures, other than a restriction on acquiring further advances into the structured portfolios if interest arrears exceed 3% of total gross interest. We have seen no evidence of the extent of interest arrears levels and whether this currently creates any restrictions on the Leek structures, or the implications on pool performance were this situation to arise
z
There is no substitution risk in the portfolios, as per the offering circulars
be deferred as its subordinated loan and any deferred consideration rank further down the priority order for payment
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Securitisation
Capital approach and losses For accounting purposes, the securitisation structures remain on balance sheet and in effect the securitisation cash flows are dealt with as memorandum accounts, with no impact on the group accounts other than where the structure could not repay the subordinated loan and the first loss exposure of Burgundy is called upon treated as ‘off balance z For regulatory capital purposes, however, it is recognised that the structure provides effective risk transfer and accordingly it is treated as ‘off balance sheet’. sheet’ for regulatory Under this approach, Burgundy is required to make a deduction from capital equal to the value of the subordinated loans made to the Leek entities to fund the capital purposes – where it initial reserve fund requirements. The deduction from capital is capped however such that Burgundy is in no worse a position that it would have been had the securitisation been treated as on balance sheet. Under an ‘on balance sheet approach’, the Pillar 1 capital requirements would be the ‘KIRB’ calculated capital is deemed effective requirements – based on risk weighted assets and expected losses on the portfolio. If required, a further Pillar 2 component would be applied were this to be transfer of risk has been considered necessary z The deduction from capital is then further limited in respect of Leek for the protection obtained under the Dovedale structure which achieves the transfer on achieved under the the first loss piece of the transaction covered by the structures Leek 11-17 structure z The required capital calculation approach can therefore be summarised as: The Leek programme is
z
The deduction from capital which would otherwise be required has been restricted by the Dovedale
Approach
structure – which has achieved further risk
Determine if ‘on’ or ‘off’ balance sheet capital treatment appropriate – based on effective risk transfer under structures
Quantify deduction from capital – first loss exposure (i.e. Subordinated loans), but capped at KIRB calculated amount if lower
Assess impact of risk transfer of first loss exposures under Dovedale structure – for Leek 10-17- and reduce the capital deduction for this amount
Resultant deduction from capital in respect of securitisation structures
Off balance sheet approach
Subordinated loans – approximately £130 million at 30 June 2008 (less than KIRB)
Dove risk transfer – approximately £88 million at 30 June 2008
Capital deduction required in respect of net approximately £42 million at 30 June 2008
transfer of the first loss exposure retained by Burgundy in the relevant
How Burgundy has applied this approach
Leek programmes to which it is referenced
Accounting loss exposures z
Burgundy continues to book impairment losses as if no securitisation structures exist (as, for the purposes of accounting, derecognition of the mortgage loans has not occurred), until the first loss reserve is exhausted. Beyond the net first loss exposure, further losses will be trapped within the securitisation structures, in effect to be borne by the remaining note tranches, in specified priority orders from junior notes through to more senior ones. There is still headroom until the first loss reserve is expired, as shown above
z
Should the programmes not perform in the manner anticipated, the potential exposures to Burgundy follow a similar rationale and are as follows: −
‘loss’ of income arising from the ultimate deferred considerations excess spread which would otherwise be anticipated to be generated – we have not seen any quantification of these potential forecast amounts to be received from the securitisation structures but there appears to be approximately £34 million reserve fund balances in excess of the minimum required amounts within the existing structures
−
crystallisation of the potential first loss exposure – in effect through non recovery of subordinated loans. This is avoided to the extent that the Dovedale structure will kick in to cover those losses relation to the referenced Leek programmes estimated at approximately £88 million at 30 June 2008
−
until the first loss reserve is used, the continuing impairment charges against securitised loans will continue to be capital consumptive
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Securitisation
Recent downgrade of Leek 19 On 8 December Moody’s downgraded the Leek 19 securitisation vehicle due to the increasing losses
Overview z
Leek 19, the most recent of the external securitisation vehicles was downgraded by Moody’s on 8 December 2008
z
The reason for the downgrade was the increasing losses being experienced in the portfolio of mortgages backing the securitisation vehicle increasing to a point above that originally envisaged by the rating agencies in their original assessment of the vehicle
z
The impact of such a downgrade on Burgundy is limited due to the degree of separation built into the securitisation vehicle from its inception. The vehicle is completely stand alone from Burgundy and there is no requirement for Burgundy to inject further capital or substitute any assets into the vehicle
being experienced in the portfolio of mortgages backing the vehicle
Supporting the vehicle z
If management chose, they could decide to put additional support into the structure via the first loss reserve of by suspending the removal of any excess spread; however, this could have financial consequences for the Society in the following way;
-
Financial impact – naturally, there would be a financial impact on Burgundy if they were to put additional support into the vehicle;
-
Capital – the capital treatment of the vehicles is only allowed as they are considered to be completely stand alone from the Society. Were Burgundy to decide to support the vehicle, this could lead the capital advantages experienced from such a structure being lost and increasing the capital required within Burgundy
z
If the capital treatment were to be removed, it would be difficult at this stage to determine the exact impact on the required capital. Claret management has calculated the potential impact under the base case scenario by showing the difference between the capital requirement based on agreed risk weights (as if the mortgage assets were on balance sheet) and the capital treatment afforded by the securitisation structure. This leads to an advantage of circa £162 million under the securitisation structures (as at August 2008)
Allowing the loan note holders to experience default z
If Burgundy were to continue to allow the vehicle to experience losses and stand alone from the Society then there is an associated moral hazard risk. The reputational risk incurred could lead to the following negative actions;
-
Wholesale funding - wholesale funders may assume the quality of asset in the vehicles is similar to that on the balance sheet and therefore loss of wholesale funding could be experienced;
-
Retail flight – if the event were to come to the attention of the general public, the association could also lead to an amount of retail flight as well;
-
Credit rating - this type of event would also put pressure on the rating agencies to look harder at the core originator rating and therefore could indirectly lead to negative outlook / downgrade in the originating entity;
-
FSA – it could also lead to additional pressure from the FSA, again due to a perception that balance sheet assets are similar to those in the securitisation;
-
Covered bonds / other wholesale structures – finally, this could lead to flight in the market not just from general banking lines but from ability to successfully complete future wholesale funding structures
z
Not stepping in could be reputationally damaging, however, there is precedent (within the market of large Banks which could have been supported being set free into rapid amortisation e.g., Northern Rock)
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Accounting policies
Burgundy accounting policies (1) The application of
Issue
Key findings
Impairment calculations
z
KPMG comment and next steps
accounting policies in relation to impairment, goodwill, intangible assets, GEBs, investment properties and hedging
When assessing impairment of its assets, Burgundy considers whether there is objective evidence of impairment. In making this assessment, the following evidence is considered: −
late or missed repayments of principal or interest
−
other evidence that borrowers are experiencing financial difficulties, or
−
national or local economic conditions that indicate an increased likelihood that borrowers will default
have been commented on opposite Impairment charges are
z
In the FY08 interim period there have been a number of changes in estimates in impairment calculations discussed in the FY08 interim audit report to the audit committee. These changes relate to for example recoveries, accounts in the early stage of delinquency and flexible arrangements. The effect of the changes in estimation approach reduce the level of provision required
z
The accounting policy does not differ to Claret, however the assumptions used do differ, and these are considered in more detail in the impairments section above
z
There is an existing balance for goodwill on Burgundy’s 31 December 2007 balance sheet of £157.9 million in respect of Platform and Bristol & West deposit book/branch network
subject to significant levels of judgment which may differ from Claret’s view Burgundy has concluded that no impairment is required in relation to goodwill although this is
Goodwill
reliant on the ongoing profitability of the Member
z
Business and Platform
It is noted by the Burgundy Finance Director in a board report that "The high level of integration of Bristol & West into the Member Business means it was not possible to identify separately its trade and contribution but it was noted that due to the continued strong performance of the core Member Business there were no indicators of impairment“
z
Burgundy management has conducted an impairment review of goodwill, and has concluded that no impairment is necessary given the projected profit for the Member Business and Platform
z
The accounting policy is consistent with that of Claret
z
The accounting policy as stated appears consistent with IFRS
z
There is significant judgement within the estimation of provisions and there have been a number of changes in those estimates. Changes in estimates are not adjusted retrospectively
Next steps for Phase 2 z
Confirm, within the detailed impairment model, the evidence used to justify the changes in estimates on impairments made and confirm whether the judgements appear reasonable based on the Claret view
z
The accounting policy appears consistent with IFRS
z
Where businesses are integrated the goodwill can be tested as part of a larger cash generating unit including existing assets of Burgundy
z
It should be noted that on acquisition the existing goodwill of Burgundy will have no fair value, and will effectively be subsumed within the goodwill on the acquisition of Burgundy
z
Goodwill is currently deducted from Burgundy’s capital resources
Next steps for Phase 2 z
Confirm how the impairment testing was carried out and seek information on the headroom within impairment tests
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Accounting policies
Burgundy accounting policies (2) Further information is required to conclude fully on the application of accounting policies in
Issue
Key findings
Guaranteed equity bond (GEB’s)
z
The guaranteed equity bond is reflected as a liability and measured at fair value through profit and loss. Other financial liabilities of Burgundy are measured at amortised cost
z
The justification for measurement at fair value through profit and loss is that this measurement removes an inconsistency due to the bond being commercially hedged with swaps. If measured at amortised cost changes in the swap value would impact earnings but changes in the bond value would not be recognised. Please note that hedge accounting is not used for GEBs and the related swaps
relation to GEBs which we believe to be inappropriate
z
Intangible assets
KPMG comment and next steps
In FY08 the accounting policy for GEBs was changed. Previously payments received on entering into the swaps were incorporated into the effective yield on the GEB and spread over the life of the GEB. From FY08 payments received are recognised immediately on entering into the swap. The justification appears to be that the embedded derivative element of the swap was previously not recognised and that the receipt on the swap provides evidence of the fair value of this element of the GEB
z
This change of approach to recognition has not been recognised as a change in accounting policy on the grounds that both the GEB and the swap continue to be recognised at fair value through profit and loss
z
Claret use an accounting policy more consistent with Burgundy prior to its change of policy. However it should also be noted that Claret do not use the same hedging instruments as Burgundy and therefore do not receive premiums on entering into the swaps and therefore the accounting may not be directly comparable
z
Burgundy capitalises the cost of internally generated software as an intangible asset amortised over seven years
z
Claret accounting policy is consistent with Burgundy however, the judgement and estimates used may differ
z
The accounting policy stated for GEBs and the related swaps is consistent with IFRS and it is acceptable to hold financial liabilities at fair value through profit and loss to remove a measurement inconsistency
z
The GEBs do contain an embedded derivative which should be fair valued along with the rest of the instrument if the policy is to recognise at fair value through profit and loss. The change in policy therefore may be acceptable however, it should be considered that usually the consideration given at initial recognition reflects fair value of financial assets and liabilities and going against that is unusual
Next steps for Phase 2 z
Careful consideration needs to be given to the justification for the change and the terms of the swap should be investigated to confirm that they do match with the GEB terms and justify changing the fair value of the GEB
z
To complete this, access to the detailed terms and conditions of the swap is needed
z
This policy is consistent with IFRS however it involves judgement on which costs to capitalise and materiality. An amortisation period of seven years for systems is longer than the period used by many companies however, does not seem excessive
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Accounting policies
Burgundy accounting policies (3) There do not appear to be
Issue
Key findings
KPMG comment and next steps
Investment properties
z
The FY08 interim audit report indicates that Burgundy have set up a new company to hold and rent out repossessed property, Illius
z
Currently Burgundy have not determined an accounting policy for investment properties and Claret do not hold investment properties
significant issues in relation to the accounting treatment of hedge accounting
z
The accounting treatment for investment properties
If it is held as an investment property IFRS allows the property to be measured at fair value with gains and losses in profit and loss, or alternatively allows the properties to be held at cost less depreciation. The more common policy for companies holding investment property is to recognise at fair value with gains and losses recognised in profit and loss
is yet to be determined by
Next steps for Phase 2
Burgundy
z
Claret should consider what their policy will be towards these properties and assess the potential future impact on earnings
z
Whilst the accounting policies appear consistent with IFRS there may be differences in the hedge accounting approach the Burgundy and Claret adopt which would have an impact on earnings
z
In particular, Burgundy has made significant use of basis swap hedges, which have had a key impact on reported earnings
Hedge accounting
z
Burgundy use derivative instruments and in some case apply hedge accounting whilst in other cases derivative instruments are not recognised using hedge accounting
z
The policies stated for derivatives appear in accordance with IFRS however, the circumstances where hedge accounting is used can be a matter of judgement
z
Burgundy uses different hedge accounting strategies and the accounting policies appear consistent with Claret
Next steps for Phase 2 z
Determine the detailed policies that Burgundy have towards hedge accounting and the situations and instruments for which it is used. Claret will then need to determine whether their policies align with those of Burgundy
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Taxation
Overall tax compliance summary In FY07 there are
Summary of tax creditor movements
significant movements
£'m
FY05
FY06
FY07
Opening balance Profit and loss account:
25.0
29.0
38.3
Current year Prior periods Tax paid Movement through cashflow hedging reserve Movement through available for sale reserve Other unreconciled difference Closing creditor
18.3 (1.5) (12.8)
22.2 2.2 (12.6) (1.0) (1.6) 0.1 38.3
17.7 (1.2) (24.0) 1.2 (20.9) 11.1
taken to equity in the financial statements that affect taxable profits – this needs to be taken into account when considering forecast taxable profits
Source:
29.0
Burgundy group accounts
Tax provision per accounts z
In FY07, there is a significant reduction in the corporation tax creditor arising from losses taken to equity on assets available for sale. The losses arising have been utilised to reduce taxable profits across the group to £nil
z
The remaining tax creditor is composed of a number of provisions for tax uncertainties, net of tax paid on account for FY07 (which is potentially repayable due to the losses mentioned above)
Next steps for Phase 2 z
No detailed information has been provided to date in relation to VAT nor to tax compliance status generally
Consideration will also need to be given to how future expected movements through equity (e.g. On assets available for sale) may affect Burgundy’s taxable profit profile and its ability to shelter bonus payments in FY08 to FY10 Basis of information z
z
All comments in relation to taxation are based on high level information provided and follow up discussions with Burgundy management and Burgundy’s advisers
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Taxation
Provision for known tax exposures The current tax balance
Current tax balance - 31 December 2007
includes provisions for
£'m Provision for forex planning (TOMS)
exposures related to foreign exchange planning
Transfer pricing enquiry
and transfer pricing
Provision for known exposures Additional provision in consolidated accounts
The total provisions were
Group relief / tax refunds due Closinng corporation tax creditor
£29.1 million at the end of FY07 and £32.3 million at the end of June 2008 (both
Source:
of additional provision held at group level) Assuming that Burgundy
Amounts provided - Provisions in individual entites
settlement at 50% of the exposure on transfer pricing, we estimate that the group is currently
9.2
9.2
23.6
23.6 5.5
(53.6) (30.0)
(18.0) 11.1
Burgundy assessment of risk exposure - half year £'m Forex planning (TOMS)
in full and agrees a
Group 14.4
In fo rmation provided by Burg undy and analysis of Burg undy gr oup audit committee presentati on
figures include £5.5 million
is required to settle TOMS
Society 14.4
Max 28.8
Weighting 95%
Transfer pricing enquiry
12.1
50%
Estimated tax exposures
40.9
Provision 27.4 6.1 33.4
(26.8)
- Provision on consolidation
(5.5)
Un-provided exposure on Burgundy assessment Add: Additional 5% provision on TOMS
1.1 1.4
Add: Interest on unpaid tax re TOMS (net of tax relief) Un-provided exposure Source:
8.3 10.9
Half year memor an dum to Burgun dy audit co mmittee an d KPMG analysis
under-provided by £10.9
Deferred tax liability / (asset) - 31 December 2007
million
£'m Accelerated tax depreciation
The deferred tax provision
Pensions and other post retirement benefits
12.6
12.6
in Burgundy Society is net
Allowances for losses on loans and advances Capital gains
(5.9) 1.5
(7.1) 1.7
which could be lost on
Tax losses carried forward Other temporary differences
(9.5) (1.4)
(9.8) (11.4)
completion of Project
Sub-total per accounts
2.6
(7.6)
Vintage
Adjust for tax losses which may expire on completion Adjust for IFRS transitional adjustments
9.5 5.8
9.5 5.8
Adjusted deferred tax liability on a fair value basis
17.9
7.7
of assets of £15.3 million
Source:
Society 5.3
FY07 gr oup accoun ts and KPM G an alysis
Group 6.4
Tax provisions z There are no material provisions in the accounts for tax, other than corporation tax and deferred tax z The key open issues are in relation to TOMS and transfer pricing z Burgundy has calculated its provisions based on a risk-weighted approach. During the current year, Burgundy has re-assessed the risk weighting applied to the two key exposures, increasing the provision in relation to TOMS to 95% of the maximum potential liability (excluding any penalties or interest) and reducing the exposure in relation to transfer pricing to 50% of the maximum potential liability (which includes interest but not penalties) z The overall provision increase in relation to these items in the period is £3.2 million. This has not been charged to the income and expense account, rather existing provisions which were found to be surplus have not been released z There is an additional provision of £5.5 million which arises only on consolidation. If this is added to the existing provisions, there is a shortfall of £1.1 million between the provision and Burgundy’s probability weighted estimate of the overall exposure z Assuming full provision is made for the TOMS exposure and the transfer pricing enquiry can be settled at 50% of the potential exposure, taking into account interest on late paid tax, we estimate the under-provision as at 30 June 2006 at £10.9 million – see opposite z No specific provision has been made for other exposures (see current compliance status summary) Deferred tax z The closing deferred tax asset in the group accounts includes tax losses of £9.8 million. The amount recognised in Burgundy Society is £9.5 million but if Burgundy Society’s surplus losses are not utilised prior to completion of the transaction, they will no longer be available to carry forward z As at the end of FY07, tax relief of £20.6m (gross) in respect of adjustments arising on transition to IFRS remains deferred in Burgundy Society. This amount is being spread over 10 years and any remaining amount is expected to crystallise in full on completion of the transaction as a loss of the final period for Burgundy Society – this loss cannot be carried forward into the enlarged Society and will need to be fully utilised in the final period z Adjusting for both of the above items, the revised deferred tax liabilities are £17.9 million for Burgundy Society and £7.7 million for Burgundy Group
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Taxation
Tax return / HMRC enquiry status There are a number of outstanding returns but they are all still within the
Status of tax returns z
Management was not aware of any overdue returns for any taxes
z
A number of corporation tax returns for FY07 remain outstanding (approximately 25%) and management has agreed with HMRC an extension of the normal filing deadline to 31 January 2009 – this is on account of key staff absence due to sickness
extended filing deadline agreed with HMRC The key exposures are in relation to TOMS and transfer pricing Both issues are likely to
z
The following tax returns remain open:
z
All returns – the statutory enquiry windows remain open (and some returns have yet to be submitted) Burgundy Society – returns subject to HMRC enquiry
several years and
Open enquiry issues
significant provisions have
TOMS (foreign exchange planning)
been made
z
During FY02 Burgundy Society implemented planning which resulted in an additional tax deduction of £95.6 million (tax saving of £28.8 million)
There are sundry other
z
There has been follow up correspondence with HMRC and significant documentation has been provided by Burgundy. No discussion of technical issues has taken place and we understand that a similar approach has been taken with other businesses which have implemented the planning
open issues which are subject to correspondence with HMRC. Burgundy is z
can be resolved with minimal (if any) Based on our discussions
z
However, there would be interest to pay on any late-paid tax
Transfer pricing z
There are on-going enquiries into the interest rate that ought to be charged on the balance with Burgundy International, the group’s offshore deposit taker
z
The group has historically levied interest at 3 month LIBOR plus 30 basis points, and HMRC considers that LIBID should be used. The maximum tax exposure to the end of FY07, including interest but excluding penalties, was estimated at £12.1 million
z
Burgundy has provided all of the requested information to HMRC and the enquiries remain open. As this is an issue which is common across the industry, HMRC expects to proceed with a test case to determine the issue and the timescale for resolution of the enquiry remains uncertain
z
At present, Burgundy has provided for 50% of the maximum potential liability. Since the question to be determined is an economic one, it is possible that the issue will be decided at a rate somewhere between HMRC’s proposal of LIBID and Burgundy’s current rate, and a provision of 50% of the maximum exposure does not appear unreasonable
FY01-FY05 z
adjustment to the returns.
If this is the case, it may be possible to avoid any tax-related penalty on technical grounds since it is arguable that the penalty provisions applying to FY02 do not allow for penalties where the company itself is not taxpaying
FY06 and FY07
remain unresolved for
confident that these issues
z
z
with Burgundy, this appears reasonable
z
HMRC is currently litigating a similar planning scheme implemented by Prudential Plc. The case has been heard by both the Special Commissioners and the High Court, with both hearings decided in favour of HMRC Whilst Burgundy believes there are distinguishing factors between its case and that of Prudential, we consider that there is a high risk that HMRC could be successful if they were to litigate Burgundy’s case and accordingly a significant provision would be required – we understand other affected business have made full provision. Therefore we believe that the 95% risk rating should remain as a minimum at the year end FY08 and arguably should be increased to 100%
Other open issues z
HMRC has challenged a claim for tax relief for £1.7 million of expenditure on refurbishment of former Bristol and West branches on the grounds that the assets had not been used in the business (HMRC has asserted that the branches were not re-opened following the refurbishment, but Burgundy disputes this)
z
HMRC has challenged a claim for relief of £3.4 million in respect of unmatched derivative losses taken to reserves. Burgundy contends that as the losses were not matched with any profits (they were intended to hedge products that were not ultimately sold) it is not necessary to apply the hedging rules and a deduction should be available under basic principles
z
We have not seen underlying documentation but provided the facts are as stated by Burgundy, there would appear to be good grounds for claiming relief for each of the above items
We have not seen detailed computations or documents relating to the planning but it may be the case that it has only served to increase the losses that would otherwise have been incurred by Burgundy Society
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Taxation
Other tax matters £15.1 million was returned to the UK group from the Guernsey captive by way of a share buy back.
z
Burgundy’s key overseas operations are the deposit taker and the Guernsey-based captive
z
The captive is treated as a controlled foreign company and pays dividends so as to satisfy an acceptable distribution policy. The broad impact of this is that 10% of the captive’s annual profits remain outside the scope of UK taxation (and they are not taxed in Guernsey). It appears that no deferred tax has been provided on unremitted profits, which is in accordance with IAS 12. The overseas structures saved tax of £2.4 million in FY07)
There is a small risk that a capital gain could arise in FY07 in this respect (although we understand
VAT
Overseas entities
z
there are surplus tax losses in that period)
Captive share buy-back
issues in relation to VAT
z
£15.1 million was returned to the UK group via a share buy back in FY07. Burgundy has treated this amount as non-taxable on the grounds that any gain element should qualify for the substantial shareholdings exemption (“SSE”)
z
The availability of SSE is not beyond doubt since the captive earns significant income from investments and HMRC might seek to argue it is non-trading
z
However, the investment income has only arisen as the regulator has refused permission to make an early return of funds to the UK and there is therefore no investment intention in retaining the funds in the captive
Some minor compliance errors were noted during HMRC’s ISA audit and a small settlement was agreed
z
The group has not reached agreement with HMRC over a partial exemption method for VAT recovery, but we understand that the amounts at stake are not material (the current recovery rate is less than 1% and the group incurs limited overheads which are subject to VAT)
z
Management is not aware of any material issues arising from recent inspections
z
In FY05 the group made a disclosure to HMRC of an arrangement which it was considered might carry the hallmarks of avoidance. The group had used a subsidiary company, outside the VAT group, to construct a new head office in the early 1990s. The group opted to tax the property and recovered VAT in connection with its construction. VAT was charged on annual rent to the Society, with minimal VAT recovery in the Society
z
In FY01, a new lease was entered into at an annual rental of £620,000. The new lease is not subject to VAT and accordingly there is no loss of VAT on rental payments, resulting in an annual saving of approximately £92,000 – the impact on VAT recovery in the property holding company is negligible
z
HMRC has not queried these arrangements and provided the fact pattern supports the technical analysis we would not expect a successful challenge to arise
HMRC has not raised any enquiries into transfer pricing with the captive but as 90% of its profits are currently taxed the additional tax that might be raised through a successful challenge to transfer pricing is likely to be immaterial
There are no material open or payroll taxes
z
In the event that SSE is not available, the share buy-back is likely to be seen as a part disposal of the overall shareholding in the captive and as a result a gain could arise. We are unable to quantify this but we note that there are surplus tax losses in FY07 in Burgundy Society which could shelter the gain (and since there is a risk that these losses would be lost on completion of the transaction, any utilisation might not result in an overall tax loss to the group)
Payroll taxes z
The group sent a detailed report to HMRC in January 2008. A small settlement (£12,000) arose and a further exposure of £10,000 is expected to be disclosed on a separate issue before the end of the calendar year
ISAs z
HMRC carried out an audit into the tax treatment of ISAs and a settlement of £147,000 was agreed in March 2008 in relation to sundry compliance failures – new procedures have been implemented to prevent recurrence
Group reorganisations z
Subject to the outcome of discussions with HMRC, there is a risk that tax charges could arise on any assets transferred by Burgundy Society to subsidiary entities. Management was not aware of any such transfers but we recommend that this is considered in more detail in phase II if HMRC will not agree to exempt any such transfers from the charging provisions that could apply on completion of the transaction
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Adjusted earnings
Adjusted earnings The most significant adjustments relate to oneoff profits recognised in HY108 (£25.1 million) and subjective reductions in the impairment provision (£18.0 million) Burgundy has also benefitted from a change in accounting estimates in relation to GEBs of £8.5 million
Adjusted earnings £'m Reported operating profit One-off profits: Gain on VocaLink shares Basis book swap rip-ups Sale of gilts Profit on sale of fixed assets Total one off items Adjusted profit after one-off items Impairment assumptions: Arrangements Loss recovery benefit
FY07 114.6
(4.0) (4.0) 110.6
(3.0) (14.1) (4.0) (4.0) (25.1) 25.0
(15.0) (15.0)
(5.0) £5 million benefit taken in HY108 based on management expectations. Further benefit expected in HY208 (7.0) Assessed on case by case basis. £7 million recognised in comparison to expected benefit of £11.6 million £6 million benefit taken based on 50% of expected benefit. Little track record to date. Further benefit expected (6.0) in HY208 (18.0) Accounting estimate changed in H108 resulting in one-off benefit of £1.5 million. Further benefit expected in (1.5) HY208 (2.0) Potential loss in relation to "Panchoo" case. Not provided as property taken to balance sheet to rent out (4.4) Provisions released on basis of "more sophisticated" arrears models leading to one-off releases (25.9)
Illius Total benefits 1-30 days impairment change
Potential additional exposure relates to further deteriorations in the housing market increasing the impairment charge In aggregate, adjustments to reported operating profit would create an adjusted loss, although some elements of these are subjective in nature
Potential loss on Commercial lending Release of forecasting risk provisions Total impairment adjustments Income: GEB change in accounting policy Member business other income Benefit of LIBOR premium over base Total income adjustments EIR/provision adjustments Platform EIR models changed Fixed rate product EIR models changed Release of warranty claims General provision release Total EIR/provision adjustments Adjusted operating profit/(loss) Source:
HY108 Description 50.1 One-off profit on revaluation of VocaLink shares One-off profit on basis book swap rip-ups in HY108 One-off profit on sale of gilts in HY108 Primarily sale and leaseback of branch properties
(4.8)
(8.5) Change in accounting treatment resulted in one-off earnings impact, only sustainable if current volumes continue Release of provisions to Member Business fee income (5.7) Benefit enjoyed in BTS, potentially unsustainable (14.2)
(10.0) (10.0) 80.2
(3.6) Lower redemptions in Platform indicate full year adjustment of £7.2 million in FY08. Only half taken at HY108 (1.1) One-off benefit resulting from spreading of discount not consistent with market approach (0.3) Provision created in relation to warranty claims from purchasers of mortgage books no longer deemed necessary Endowment misselling provision no longer deemed necessary creating one-off earnings impact (5.0) (20.1)
(4.8)
KPMG analysis, Burgundy audit committee meeting 12 August 2008, PwC auditor management report FY07 and HY108
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Adjusted earnings
Adjusted earnings Burgundy management has not yet adjusted their forecast outturn for the
Reconciliation of YTD08 and HY08 budgeted profit to actual / reforecast profit z
Burgundy’s reconciliation of budgeted to actual / forecast PBT for the year to September and FY08 is set out below:
Reconciliation of YTD08 and HY 08 budgeted profit to actual/reforecast profit
impact of additional SLS
YTD 08
funding and impact of the FSCS costs being levied on all entities with a depositing taking FSA permission. These have been estimated by Claret management to cost £25 million and £22 million
£m 100
GEB income - accounting method Core MB Bonds/ISA pricing
11.4 -8.1
15.2 -14.3
Profit on gilts & basis book swaps Platform ERC remodelling/mix
14.6 -9.6
9.7 -15.8
Interest rate impact Other
18.3 -4.9 21.7
26.8 0.8 22.4
Costs Marketing costs
2.9
2.8
IS costs - lower staff/higher recharges MB - projects/excpetional costs
1.6 1
1.8 1.5
-0.8 1
3
3.4 9.1
2.7 11.8
-29.3 -23.8
-22.8 -41
5.2 12.8 2.3
3.9 16.5 3.2
-32.8 -2
-40.2 -6
58.4
94
Budgeted profit before tax andBMR Incom e
respectively (post tax) As the final numbers have not been confirmed by Burgundy management,
FY08
£m 60.4
we have not included
Platform - higher restructuring costs WMS - recruitment control
them in the reconciliation
Other
opposite Loan loss provisions PHL/BTS higher arrears/possessions HPI decline Commercial Lending Management action Other Total movement Actual profit before tax and BMR Source:
Burgundy Monthly Performance Report, September 2008
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Pensions
Funding position – current position The valuation of the DB
Background
funding deficit of £28
z Burgundy operates a defined benefit (DB) pension scheme which is closed to new entrants but has around 1,350 members currently accruing benefits, and a defined contribution (DC) scheme which is open to new members and has around 2,100 active members. This report focuses on the DB scheme, which is the main area of risk for Burgundy
million
Results of the 5 April 2008 valuation of the DB scheme
scheme as at 5 April 2008 disclosed an ongoing
Burgundy has agreed to clear this deficit with a single lump sum. In addition, Burgundy has agreed to pay around £8.5 million a year to the DB scheme in respect of future benefit accrual The DB scheme was overfunded on statutory PPF assumptions, but had a significant buy-out
z
Summary of results of the actuarial valuation as at 5 April 2008 Ongoing Funding basis “PPF” basis £m - Active members 159 n/a - Deferred pensioners 140 n/a - Current pensioners 118 n/a - Sex equalisation reserve 5 n/a Total Liabilities 422 345 Total Assets 394 394 Surplus / (Deficit) (28) 49 Funding level (%) 93% 114% Source:
The overall ongoing (cash funding) valuation basis adopted in 2008 was generally reasonable
Buyout basis n/a n/a n/a n/a 558 394 (164) 71%
Mercer draft actuarial valuation as at 5 April 2008
z
We have reviewed the main assumptions used and have the following comments (with strong assumptions resulting in a higher assessed deficit):
Summary of main assumptions for the 2008 ongoing valuation Strength Comment 1.75% additional return Pre-retirement MID-STRENGTH above Government Bond 6.15% p.a discount rate yields Based on swap yields and Post-retirement 4.5% p.a STRONG similar to Government discount rate Bond yields Equals the difference between the yields on Government fixed-interest and index-linked bonds Price inflation 3.45% p.a WEAK less an allowance of 0.15% for “inflation-risk premium” incorporated in index-linked bond yields Equals price inflation less Salary inflation 2.95% p.a VERY WEAK * 0.5%
z
Burgundy has agreed with the Trustees of the DB scheme to remove the ongoing deficit by a single lump sum payment of £28 million
Pension increases – RPI (min 3%, max 5%)
3.75% p.a
MID to STRONG*
Equals price inflation plus 0.3%
z
In addition, Burgundy will contribute 23% of pensionable salaries (or around £8.5 million p.a.) towards the future cost of benefits, expenses and life assurance
Pension increases – RPI (min 0%, max 5%)
3.45% p.a
MID to STRONG*
Equals price inflation
deficit of around £164 million
The following table set outs the results of the 5 April 2008 actuarial valuation of the DB scheme
Commentary on 2008 funding assumption - Ongoing cash funding basis
Description of funding bases z
Ongoing: the basis recommended by the Scheme Actuary to determine the rate of contributions to be paid by the Company
z
Pension Protection Fund (“PPF”): the Government introduced the PPF in April 2005 to ensure pension scheme members receive a minimum level of benefit if a scheme sponsor becomes insolvent. If the trustees were to seek assistance from the PPF, then a valuation under Section 143 of the Pensions Act 2004 would need to be carried out. This would then determine whether the scheme had sufficient funds to pay at least PPF levels of compensation and whether the PPF should assume responsibility for the scheme
although the salary inflation assumption of price inflation less 0.5% is unusually optimistic z
Buy-out: the assessed cost of securing all liabilities by the purchase of immediate and deferred annuities with an insurance company. This amount is only relevant where a scheme is being wound up in this way
Post retirement mortality (pensioners and non-pensioners)
PA92 (Year of In line with current Birth) Medium (prudent) mortality Cohort, plus a MID to STRONG expectations and allows minimum for future improvements improvement in mortality underpin of 1% p.a
* relative to the price inflation assumption
z
The overall ongoing (cash funding) valuation basis adopted in 2008 was generally reasonable
z
However, the salary inflation assumption (price inflation less 0.5%) is unusually low. This is much lower than the salary inflation assumption of price inflation plus 1.5% assumed for the Claret DB scheme
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Pensions
Accounting position and updated positions At 31 December 2007, the IAS19 disclosures revealed a Funded status of £58 million which resulted in a net asset of £45 million in the balance sheet At 30 September 2008, we estimate that the ongoing funding deficit of £28 million has increased to around £67 million on a consistent basis Moving to the funding assumptions consistent with those adopted for Claret’s DB scheme would result in a funding deficit of £148 million at 30 September 2008 At 30 September 2008, we estimate that the IAS19 balance sheet position would show a surplus of £71 million Moving to the accounting assumptions consistent with those adopted for Claret’s DB scheme would result in a surplus of £19 million
Accounting position as at 31 December 2007 z
Burgundy reports DB Scheme pension costs under IAS19. The balance sheet positions and P&L charges as at 31 December 2007 and 2006 are as follows:
IAS19 position of DB Scheme as at 31 December 2007 31 December 2007 Balance Sheet £m Assets 408 Liabilities (350) Funded status 58 Funding level (%) 117% Impact of IAS19 surplus cap (9) Unfunded obligations (4) Net asset / (liability) in the balance sheet 45 12 months to Profit & Loss charges £m 31 December 2007 Employer service cost 7.7 Interest cost 21.0 Expected return on assets (23.4) Total P&L charge 5.3 Group (Society) DC contributions over year 3.6 (2.9) Assumptions Discount rate 5.8% Salary increase 3.3% Mortality PA92(YoB) MC
31 December 2006
365 (405) (40) 90% (4) (44) 12 months to 31 December 2006 7.7 19.3 (20.3) 6.7 3.2 (2.3)
Estimated funding and IAS19 funded status position as at 30 September 2008
Assets
z
367
367
367
(515)
(296)
(348)
Funded status surplus/(deficit)
(67)
(148)
71
19
Funding level (%)
85%
71%
124%
105%
Pre-retirement discount rate
6.15%
5.2%
7.05%
6.9%
Post-retirement discount rate
4.5%
4.7%
7.05%
6.9%
3.45%
3.65%
3.6%
3.95%
2.95%
5.15%
3.6%
3.95%
Assumptions
Price inflation Salary inflation Mortality
PA00(YoB) PA92(YoB) MC, 1% MC, rated up underpin 2 years
z
The ongoing funding position at 30 September 2008 on consistent Burgundy assumptions shows a deficit of £67 million. The worsening in the funding position is a result of poor asset returns over the period to 30 September 2008
z
Moving to funding assumptions consistent with those used for Claret’s main DB scheme shows a deficit of £148 million. This is largely as a result of: −
stronger salary inflation assumption; which increase the level of the assessed liability by around £61 million
−
stronger pre-retirement discount rate assumption; increase of £42 million
−
stronger price inflation assumption; increase of £23 million
−
these are offset by a weaker post-retirement discount rate (reducing the liabilities by around £15 million) and weaker mortality assumptions (reducing the liabilities by around £30 million)
z
If full allowance is made for the increase in real (corporate) bond yields but the mortality assumption is not updated to reflect the Burgundy funding valuation assumptions, then the IAS19 accounting position at 30 September 2008 on consistent Burgundy accounting assumptions shows a surplus of £71 million
z
Moving to IAS19 accounting assumptions consistent with those used for Claret’s main DB scheme shows a surplus of £19 million. This is largely as a result of a more prudent discount rate, more prudent price inflation assumption, both of which are offset slightly by a weaker mortality assumption
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PA92(YoB) PA92(YoB) MC, rated up MC 2 years
Sources: KPMG estimates
PwC have estimated the net asset position as at 30 June to be £41 million
It should be noted that the surplus and deficit figures quoted below are very sensitive to small movements in interest rates and asset movements because they represent the difference between two large and volatile figures
Claret IAS19
367
5.1% 4.6% PA92(YoB) MC
In order to illustrate the current level of the funding and accounting deficit, we set out below the estimated funding and IAS19 accounting position as at 30 September 2008 using financial assumptions consistent (relative to market conditions) with those used by Burgundy as at 5 April 2008 and 31 December 2007 respectively. We have then shown the effect of moving to the funding and accounting assumptions adopted in respect of the Claret DB scheme
Burgundy IAS19
(434)
Liabilities
Updated position z
Claret AVR
£m
Sources: Burgundy Annual Report as at 31 December 2007
z
Burgundy AVR
Basis
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Contents
Executive summary Overview of business and key financials Key issues z Residential mortgage lending z Commercial lending z Available for sale assets z Funding and liquidity z Securitisation z Accounting policies z Taxation z Adjusted earnings z Pensions z Capital
Appendices
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Capital
Capital adequacy forecasts and sensitivities (1) There is currently significant uncertainty over the projected level of capital headroom in 2008 and 2009 The potential risks to
Overview of Burgundy stand alone position
z The final capital requirement as a result of the FSA letter has increased by £30 million This section of the report covers the Burgundy stand alone position Combined Claret and Burgundy position under their ICAAP submitted earlier in 2005. Further work is being completed on Burgundy’s forecast stand alone position and the forecast z Claret and Burgundy have been working together to develop a combined combined capital position which is subject to a separate report by KPMG capital base case and stress scenario which is subject to a separate due diligence report z In May 2008 the surplus capital under Basel II was £319 million with a solvency ratio of 14.2% z As work continues on the capital forecasting, it is likely that the opening z
z
capital could be in the region of £98 million to £130 million. When viewed in the context of
z
Burgundy’s ‘adverse’ scenario, this would leave
There have been adjustments made which mitigate this, the principal one being an adjustment for the double counting of HPI falls when considering the full peak to trough scenarios
z
We understand that the reason for the current burn rate is the worsening PDs and LTVs seen on the loan portfolios as apposed to an increasing balance sheet
z
We have received the FSA’s final ICG letter which highlights a number of key areas they wish management to address as follows:
the business with insufficient capital
Under the forecasts submitted to the Board (via ALCO in July) the forecast outturn for FY08 was a capital surplus position of £230 million; however, it noted that given the current monthly capital burn rate of £15 million a month, this would result in a capital surplus just above the lower Board limit of £150 million by December 2008
There are a number of areas of discussion still to be agreed for the combined Claret and Burgundy capital
−
a more conservative approach should be taken in the stress testing and capital planning
−
revising the methodology used in calculating the operational risk capital requirement
−
revisiting the contingency funding plan to make it consistent with their stress scenarios
−
reassessing their interest rate risk capital requirement
projections z
Further work is being carried out on the capital projections to the end of FY08 and into FY09 in response to the SREP letter from the FSA 29 August 2008 and further requests from the FSA for stress test in the week commencing 13 October 2008, the latter of which is not yet complete
z
The latest formal projection of capital headroom at 31 December 2008 (performed in July) was £188 million. This project also includes ‘adverse’ and ‘severe’ stress scenarios. Management has informed us that this forecast was only high level and its expectation is that the outturn will be higher (in excess of £200 million). A more rigorous process is underway with a view to updating the capital forecasts for 2008 and 2009 for submission to the FSA by the end of October 2008
position of FY09 capital will change
Burgundy capital surplus Actual 31 Dec 07
Actual 30 Jun 08
Capital requirement
1,193
1,304
1,482
Capital resources Surplus
1,656 463
1,646 342
1,681 199
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Forecast 31 Dec 08
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Contents
Executive summary Overview of business and key financials Key issues Appendices z Scope of work z Key residential lending exposures z Further arrears analysis z MBS / ABS with MTM losses of 30% or more z Granite MBS z Granite issues and Burgundy holdings z Aire Valley MBS z Other MBS / ABS with BBB or A rating
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 1
Scope of work (1) Scope Scope area
Com ment
Customers and products Set out the key products offered by Burgundy Set out customer groups of Burgundy and comment on key products targeted to respective customer groups Comment on the level of customer numbers by loan portfolio over the period from 1 January 2007 to 30 June 2008 (the ‘historical period’)
To be covered at phase 2 with full access
Static loan portfolio data Comment on the composition of the static loan portfolio as at 30 June 2007, 31 December 2007 and 30 June 2008 (e.g. Society, Platform, Commercial etc) Comment on the key risks to each loan portfolio (where applicable) covering:
Leek 18/19 completed, to update at Phase 2
- loan type
Leek 18/19 completed, to update at Phase 2
- LTV
Leek 18/19 completed, to update at Phase 2
- reversionary date (on fixed and discounted products)
Leek 18/19 completed, to update at Phase 2
- nature of security held
Leek 18/19 completed, to update at Phase 2
- geographic spread
Leek 18/19 completed, to update at Phase 3
- broker / introducer relationship
Leek 18/19 completed, to update at Phase 4
Comment on changes in the profile of the static loan portfolio over the historical period
Leek 18/19 completed, to update at Phase 5
Comment on concentration risk within the Commercial loan portfolio, including a summary of significant advances in excess of materiality (defined as £2 million), covering: - principal contractual terms
To be covered at phase 2 with full access
- details of security
To be covered at phase 2 with full access
- current credit grading, including details of arrears
To be covered at phase 2 with full access
To be covered at phase 2 with full access
New lending and redemptions Where key risks have been identified through the course of our work in loan portfolios through the static loan portfolio data, comment on trends in monthly new lending over the historical period
To be covered at phase 2 with full access
Comment on changes in the lending criteria by loan portfolio over the historical period Comment on new business advances in the historical period by source (ie broker; internally generated; other) Comment on trends in redemptions by loan portfolio over the historical period Arrears and loss analysis Comment on the procedures for monitoring existing accounts and identifying and managing arrears, and how arrears are calculated and accounts are classified as being in arrears Set out the provisioning policy and consider whether it has been consistently applied over the historical period, including the policy of capitalisation of arrears
To be covered at phase 2 with full access
Comment on any changes to basis of impairment provisioning in the last 12 months and estimate impact Comment on the arrears and bad debts experience by loan portfolio for the historical period
To be covered at phase 2 with full access
Comment on arrears and loss experience as compared with peer organisations (to the extent that information is available) Comment on trends in arrears and post-default repayments by month of initial advance (i.e. as a percentage of total advances in that month)
To be covered at phase 2 with full access
Comment on issues raised by management, credit committee, internal and external auditors on the current credit grading and security rating policy
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Appendix 1
Scope of work (2) Scope S cope area
Comme nt
Broker relationships (w here data is available) Comment on the le vel of reliance on top 10 brokers, and summarise:
To be covered at phase 2 with full access
- value of advances in the historical period;
To be covered at phase 2 with full access
- whether a contract is in place;
To be covered at phase 2 with full access
- key contra ctual commi tments (start and end date an d details of volume commitments);
To be covered at phase 2 with full access
- commission arrangements; and
To be covered at phase 2 with full access
- override arrangements
To be covered at phase 2 with full access
Comment on trends in commission rates and levels as a percentage of new advances over the historical period
To be covered at phase 2 with full access
Liquidity, funding & securitisation Comment on the current funding (both wholesale/retail) structure (excluding securitisation structures covered below), including a summary of associated off bal ance sheet treasu ry and trading po sitions, split by: - product typ e - value - maturity and re-pricing profile S ummarise Burgundy’s current and forecast position in connection with the Bank of England’s Special Liquidity Scheme (“SLS”) and potential implications for B urgundy’s stress testing of liquidity S ummarise details of significant tranches of deposits or other funding, in particular pricing and maturity Comment on average funding costs by fundin g type Compare average e xternal funding costs to internal rech arges by division and/or key product typ e
To be covered at phase 2 with full access
Comment on liquidity stress testing undertaken by management (retail run, closure of wholesale markets, credit rating downgrade) S ecuritisation structure S ummarise securitisation structures in place, covering leve l and maturity profile of funding raised as at 30 June 2008, rating agency grades, and waterfall arrange ments Comment on residual income paid from securitisation vehi cles to Burgundy over th e historical period Comment on servicing fee arrangements p ayable to WMS, and on servicer ratings of WMS For each vehicle consider first loss reserve re quirement, covering the potential impact of further securitisation of first loss reserves through the Doved ale structures Comment on excess spread versus losses and provisioning in the period from 1 July 2007 to 30 Ju ne 2008 S ummarise the key triggers contained in the securitisation structures, covering drawdowns on the first loss reserve, minimum selle r share, swap collateral requi rements, asset replacement (if any), and early amortisation Comment upon monitoring performed by B urgundy over the performance of each securitisa tion vehicle including key triggers n oted above Comment upon losses reported by each vehicle and compare with peer data (to the extent that information is available) Comment on the po tential impact on securitisations from liquidity and capital stress testing undertaken by Burgundy
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 1
Scope of work (3) Scope Scope area
Com ment
Capital structure Comment on the current structure of Burgundy split by: - capital type (including tier) - value - maturity and re-pricing profile Comment on the interim capital assessment prepared by Burgundy Comment on the regulatory capital position of Burgundy over the historical period (including the excess held over the regulatory thresholds) covering; - Gross Capital - Free Capital - Liquid Assets - Lending Limits - Funding limits Comment on the factors which determine the regulatory capital requirement and on stress testing undertaken by management Comment on the ICAAP and IRB waiver applications submitted to the FSA, and correspondence with the FSA in respect of these Treasury assets - Treasury procedures and controls Comment on treasury operations, covering resources, strategy and responsibilities of the Society’s Treasury function, Burgundy Treasury Services and the asset and liability committee
To be covered at phase 2 with full access
Comment on dealing policies, including limits
To be covered at phase 2 with full access
Set out breaches of dealing policies or limits noted by internal or external auditors Treasury assets - Current treasury positions Comment on maximum and current trading assets in the ‘liquidity portfolio’ Comment on treasury assets held within the Society by product type and by client rating Comment on valuation services used by Burgundy, covering details of assets which have been valued using internal pricing models Detail which Treasury assets were subject to or were considered by management for write down as at 31 December 2007 and 30 June 2008 Summarise Treasury assets which have been subject to credit rating down-grades or watch lists in the market that have not been impaired by Burgundy Comment on Burgundy’s hedging policies during the historical period covering:
To be covered at phase 2 with full access
- Fair value hedging (including income statement impact)
To be covered at phase 2 with full access
- Cash flow hedging (including SORIE impact)
To be covered at phase 2 with full access
- Other derivative portfolios
To be covered at phase 2 with full access
Detail fair value volatility and hedge effectiveness reported by Burgundy in the historical period
To be covered at phase 2 with full access
Current trading and earnings Compare’s Burgundy’s accounting policies with those of Claret and highlight major differences and comment on potential implications for adjusted earnings of Burgundy Comment on trading results for the historical period
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 1
Scope of work (4) Scope S cope area
Comme nt
Income drivers Comment on the key trends in net interest margin, non-interest income and profitability, by preparing bridges as applicable Comment on revenue seasonality over the historical period Comment on income recognition policies adopted by Burgundy during the historical period Comment on trends in the key drivers of performance by revenue stream (inte re st receivabl e, redemption income, PP P commission and arrangement fe es) over the historical period Comment on the yield earned on loans over the h istorical period and commen t on trends noted Administration cost drivers Comment on trends in business overhead costs by category over the historical period
To be covered at phase 2 with full access
Comment on the le vel of fixed and variable costs for the historical period
To be covered at phase 2 with full access
Comment on the employee profile and costs by function/location/busin ess
To be covered at phase 2 with full access
Comment upon one-off and potentially non-recurring i tems (defined by Claret as income/costs exceedin g £0.5 million which impacts a single financial year) and comment on the movement in adjusted earnings for the historical period Balance sheet overview Comment on the ba lance sheets at each year-end for the historical period and 30 June 2008, including commentary on principal components and significant movements Comment on material investments held split between category (e.g. available for sale, held to maturity) including the methodology employed to value material investments P roperty, plant and equipment and intangible asse ts Comment on the components of property, plant and equipment and intangibl e assets and set out the depreciation/amortisation policies employed in the historical peri od Comment on significant operating and finance lease contracts held during the historical period
To be covered at phase 2 with full access
Comment on significant capital commitments identified by Burgundy
To be covered at phase 2 with full access
Comment on capitalised development costs
To be covered at phase 2 with full access
Comment on goodwill and reported impairment of goodwill per the statutory accounts
To be covered at phase 2 with full access
To be covered at phase 2 with full access
Other material assets and liabilities Comment on other assets and liabilities in the historical period Comment on conti ngent assets and li abilities
To be covered at phase 2 with full access
Comment on assets held in trust for clients
To be covered at phase 2 with full access
Comment on other de btors as at 31 December 2007 a nd 30 June 2008, highlighting key components
To be covered at phase 2 with full access
Comment on other creditors as at 31 December 200 7 and 30 June 2008, highlighting key components
To be covered at phase 2 with full access
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 1
Scope of work (5) Scope Scope area
Comm ent
Taxation Summarise the status of the Burgundy’s tax returns and comment on the potential impact of open enquiries and the potential outcome of material HMRC investigations Comment on the historical tax treatment of the Membership Reward Scheme for both Burgundy and the members, including details of agreements reached with HMRC or correspondence on the Scheme Comment on the cancellation of shares in 2007 in respect of one of the off-shore entities
To be covered at phase 2 with full access
Comment on the collective impairment provision as disclosed in statutory accounts for 31 December 2007
To be covered at phase 2 with full access
To be covered at phase 2 with full access To be covered at phase 2 with full access
Comment on the VAT partial exemption methodology adopted by the Group
To be covered at phase 2 with full access
Comment on the tax attributes (including losses) and their potential availability following a change in ownership
To be covered at phase 2 with full access
Comment on the presence of overseas companies (including captive insurance company in Channel Islands and offshore deposit taker in the Isle of Man), transfer To be covered at phase 2 with full access pricing policy and Controlled Foreign Company risk Pensions Analyse the funding basis and results of the recent Burgundy actuarial valuation, commenting on the assumptions used relative to market practice and, specifically, to Group's assumptions Consider the impact of the proposed deal on the cash funding of pensions (including an indication of updated figures) Comment on the accounting and capital adequacy requirements of pensions
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Appendix 2
Key residential lending exposures – total book as at the end of September 2008 Stock position at end September 2008
Total Lending £bn 24.46 Provision £m 105.91
c -1.97% >90 Day Arrears £m No. % 664 4835 2.14% Possessions £m No. % 136 1195 3.53% LPA Receiver Cases £m No. % 35 8 1.77%
Member Prime £bn 10.9 Provision £m 0.56 Intermediary Prime £bn 1 Provision £m 9.51
Specialist £bn 8.81 Provision £m 90.14
Commercial £bn 3.75 Provision £m 5.7 Source:
d -0.33% >90 Day Arrears £m No. % 28 461 0.32% Possessions £m No. % 3 34 0.02%
£m 44 £m 16
£m 564 £m 117
c -2.96% >90 Day Arrears No. % 290 3.52% Possessions No. % 92 1.02% c -5.06% >90 Day Arrears No. % 4080 5.61% Possessions No. % 1069 1.47%
f -0.88% >90 Day Arrears £m No. % 28 4 0.88% LPA Receiver Cases £m No. % 35 8 1.77%
Arrears and Losses MI pack July 2008
Self Cert £bn 2.72 Provision £m 13.68
BTL Cert £bn 2.61 Provision £m 12.86
Non Conf £bn 3.48 Provision £m 63
£m 108 £m 32
£m 80 £m 30
£m 376 £m 115
c -2.98% >90 Day Arrears No. % 594 3.49% Possessions No. % 160 0.90%
c -2.12% >90 Day Arrears No. % 560 2.46% Possessions No. % 181 0.78%
c -8.35% >90 Day Arrears No. % 2926 8.78% Possessions No. % 728 2.29%
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 2
Key residential lending exposures – Platform as at the end of September 2008 Non conf
Platform Lending £bn
8.26%
BTL £bn
Provisions £m > 90 Day arrears 1.6 No. Of Possessions
4.1 2.24% 39
Self Cert £bn
Provisions £m > 90 Day arrears 1.2 No. Of Possessions
3.3 3.10%
Provisions £m > 90 Day arrears 0.2 No. Of Possessions
0.8 2.69%
NB Flats £bn
Provisions £m > 90 Day arrears 0.1 No. Of Possessions
15.1 16.77% 148
FTB £bn
Provisions £m > 90 Day arrears 0.7 No. Of Possessions
17.9 7.41% 164
Non Conf £bn
Provisions £m > 90 Day arrears 0.5 No. Of Possessions
18.0 14.45% 182
BTL £bn
Provisions £m > 90 Day arrears 0.2 No. Of Possessions
3.8 3.85% 52
Self Cert £bn
Provisions £m > 90 Day arrears 0.4 No. Of Possessions
4.0 3.99% 34
Int Prime £bn
Provisions £m > 90 Day arrears 0.1 No. Of Possessions
1.6 3.93% 15
£bn 6.2
< 85% LTV (indexed) £bn
Provision £m
Provisions £m > 90 Day arrears 4.2 No. Of Possessions
76.0
>90 Day Arrears £m 408
No. 2935
% 5.66%
No. 838
% 1.62%
15.5 4.39% 230
Possessions £m 142
z
More detailed breakdown of < and > 85% LTV categories added in July 2008
Int Prime £bn
> 85% LTV (indexed) £bn
Provisions £m > 90 Day arrears 2.0 No. Of Possessions
56.1 7.39% 550
Burgundy known issue area No change since last month Arrears higher than last month Arrears lower than last month Source:
Arrears and Losses MI pack July 2008
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7.4
Provisions £m > 90 Day arrears 1.3 No. Of Possessions
153
47
4
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Appendix 2
Key residential lending exposures – BTS as at the end of September 2008 BTS Lending £bn
< 85% LTV (indexed) Provisions £m > 90 Day arrears £bn
Provision 3.6 £m 23.6
2.1 No. Of Possessions
3.6 3.20% 85
>90 Day Arrears £m 3.55
No. 1435
% 4.79%
No. 323
% 1.08%
Non conf £bn
Provisions £m > 90 Day arrears 0.6 No. Of Possessions
1.4 6.11% 29
BTL £bn
Provisions £m > 90 Day arrears 0.5 No. Of Possessions
0.6 1.42% 20
Provisions £m > 90 Day arrears 0.7 No. Of Possessions
1.3 2.86% 27
Self Cert £bn
Possessions £m 51
z
More detailed breakdown of < and > 85% LTV categories added in July 2008
> 85% LTV (indexed) Provisions £m > 90 Day arrears £bn
1.4 No. Of Possessions
20.0 8.12% 238
Int Prime £bn
Provisions £m > 90 Day arrears 0.3 No. Of Possessions
0.3 1.47% 9
NB Flats £bn
Provisions £m > 90 Day arrears 0.0 No. Of Possessions
0.0 5.66% 3
FTB £bn
Provisions £m > 90 Day arrears 0.2 No. Of Possessions
0.2 5.66% 1
Non Conf £bn
Provisions £m > 90 Day arrears 0.5 No. Of Possessions
12.0 12.51% 133
BTL £bn
Provisions £m > 90 Day arrears 0.2 No. Of Possessions
2.0 3.88% 37
Self Cert £bn
Provisions £m > 90 Day arrears 0.3 No. Of Possessions
2.8 5.21% 36
Burgundy known issue area No change since last month Arrears higher than last month Arrears lower than last month Source:
Int Prime £bn
Provisions £m > 90 Day arrears 0.2 No. Of Possessions
Arrears and Losses MI pack July 2008
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 2
Key commercial lending exposures as at the end of September 2008
Commercial £bn 3.75
£m 28.43
% 0.88%
£bn 0.83
£m 35.28
LPA Receiver Cases No. 8
% 1.77%
£m 0
Provision £m 5.70
Housing Association
> 90 Day Arrears No. 4
£m 0
> 90 Day Arrears No 0
%
£m 0
LPA Receiver Cases No 0
%
Provision
Commercial Investment £bn 2.21
> 90 Day Arrears £m 18.39
Provision £m 0.45
No
0
0
Provision
No. 1
5.26
35.28
£m
Arrears higher than last month
0
No.
%
8
10.81%
> 90 Day Arrears £m 0.11
Provision
No change since last month
% 1.35%
LPA Receiver Cases £m
Owner Occupied
Issue area
%
> 90 Day Arrears £m 9.93
£m
£bn 0
% 0.38
LPA Receiver Cases £m
Residential Investment £bn 0.70
No 1
No. 2
% 3.45%
LPA Receiver Cases £m
No.
0
0
% -
Arrears lower than last month Source:
Arrears and Losses MI pack July 2008
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Private & confidential
Appendix 3
Further arrears analysis Balances outstanding split by LTV and arrears status – Leek 18 Mar 08
Balances outstanding split by LTV and arrears status – Leek 19 Mar 08
100%
100%
90%
90%
80%
80%
70%
70%
60%
60%
50%
50%
40%
40%
30%
30%
20%
20%
10%
10%
0%
0%
0-30 UTD
Source:
30-50 >0-3 mo nths
50-75 LT V % 75-90 3-6 mo nths
6-12 mo nths
12-24 mo nths
90-100
100+
0-30
Leek 18 data tape
30-50 UTD
24+ mo nths
Source:
>0-3 mo nths
50-75 LT V % 75-90 3-6 mo nths
6-12 mo nths
90-100
Leek 19 data tape
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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100+
12-24 mo nths
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Private & confidential
Appendix 4 MBS / ABS with MTM losses of 30% or more ISIN number
Note type
Originator
Origination date
XS0307511591
RMAC SECURITIES NO.1 PLC - Series 2007-NS1 M2c
GMAC RFC
Jun-07
XS0300475083
RESLOC UK 2007-1 PLC - Class C1b
Morgan Stanley
Book Value (£) 6,327,080 6,600,000
MTM movement
MTM %
Rate on issuance Most recent Rating > 3months (S&P/Moody/Fitch) Fitch grading movement arrears
(4,942,715)
(78.1%)
A/A1/A
(3,630,000)
(55.0%)
A
A (Fitch)
A
stable stable
7.3% 4.1%
Inception (£)
Inception (%)
5,775,000
1.1%
no data
6.5%
Credit enhancement Latest (£) Latest (%) 4,951,468 no data
1.1% 7.4%
Date of update
Required (£)
Required (%)
5,775,000
no data
Sep 08 update-Jun figures
no data
no data
Sep-08
XS0307496264
RMAC SECURITIES NO.1 PLC - Series 2007-NS1 M1a
GMAC RFC
Jun-07
7,000,000
(3,648,400)
(52.1%)
AA/Aa3/AA
AA
stable
7.3%
5,775,000
1.1%
4,951,468
1.1%
5,775,000
no data
Sep 08 update-Jun figures
XS0289327826
BRUNEL RESIDENTIAL MORTGAGE SECURITISATION NO.1 PLC D4B Reg S notes D4A reg S notes
Bank of Ireland
Mar-07
2,000,000
(1,040,400)
(52.0%)
no data
BBB
stable
1.0%
77,053,308
1.5%
77,053,308
2.3%
77,053,308
no data
Sep-08
3,001,500
(1,561,380)
(52.0%)
BBB
stable
1.0%
no data
no data
no data
no data
no data
no data
no data
XS0289327826 XS0289327313 XS0289327313
1,583,194
(823,419)
(52.0%)
BBB
stable
1.0%
3,957,984
(2,058,547)
(52.0%)
BBB
stable
1.0%
XS0248222225
NEWGATE FUNDING PLC - Mortgages Backed Securities Mortgages PLC (subsid of no data Programme Merrill Lynch) Series 2006-1 Class Cc Mortage backed floating rate notes due Dec 2050
4,296,719
(2,183,592)
(50.8%)
no data
no data
no data
no data
XS0149246711
1st Flexible no 5 plc. Class B due 01/06/34
Jun-02
1,000,000
(500,000)
(50.0%)
BBB/Baa2/Not rated
BBB+/watch possible (S&PJun 06)
no data
0.0%
7,000,000
no data
8,500,000
7.1%
8,500,000
no data
01-Oct-08
XS0213178709
RESIDENTIAL MORTGAGES SECURITIES 20 PLC Class Kensington M2a mortgage backed floating rate notes due 2038
no data
1,551,600
(698,220)
(45.0%)
A (Fitch)
A
stable
23.1%
no data
6.5%
no data
10.1%
no data
no data
Sep-08
XS0213178709
RESIDENTIAL MORTGAGES SECURITIES 20 PLC Class Kensington M2a mortgage backed floating rate notes due 2038
no data
2,413,117
(1,085,903)
(45.0%)
A (Fitch)
A
stable
23.1%
no data
6.5%
no data
10.1%
no data
no data
Sep-08
XS0300474607
RESLOC UK 2007-1 PLC - Class C1a Mortgage Backed Morgan Stanley Floating Rate Notes due 2043 Paragon No.7 plc CLASS B1A MORTGAGE BACKED Paragon FLOATING RATE NOTES DUE 15/05/2043 1st Flexible no.5 PLC CLASS M MORTGAGE BACKED Paragon FLOATING RATE NOTES DUE 01/06/2034; 1st Flexible no.5 PLC CLASS M MORTGAGE BACKED Paragon FLOATING RATE NOTES DUE 01/06/2034; 1st Flexible no.5 PLC CLASS M MORTGAGE BACKED Paragon FLOATING RATE NOTES DUE 01/06/2034; RESLOC UK 2007-1 PLC Class B1a Mortgage Backed Floa Morgan Stanley
no data
9,375,000
(4,218,750)
(45.0%)
A
A
stable
4.1%
no data
6.5%
no data
7.4%
Sep-08
May-04
3,931,123
(1,729,694)
(44.0%)
A/A2/A
A
positive
0.2%
no data
no data
19,815,000
Jun-02
1,004,000
(366,058)
(36.5%)
A/A1/not rated
no data
no data
0.0%
7,000,000
no data
8,500,000
6,000,000
(2,100,000)
Arkle 2006-1 SERIES 5 CLASS C2 FLOATING RATE NOTES DUE 17/02/2052 Paragon No.8 PLC CLASS B1A MORTGAGE BACKED FLOATING RATE NOTES DUE 15/04/2044
Lloyds TSB
Nov-06
5,000,000
(1,535,500)
Paragon
Oct-04
9,000,000
(2,733,300)
(30.4%)
XS0193406435 XS0149246554 XS0149246554 XS0149246554 XS0300473542 XS0273286368 XS0203411730
Paragon
7.1%
no data
no data
19,815,000
no data
Jul-08
8,500,000
no data
01-Oct-08
Jun-02
2,000,000
(729,200)
(36.5%)
A/A1/not rated
no data
no data
0.0%
7,000,000
no data
8,500,001
7.1%
8,500,001
no data
01-Oct-08
Jun-02
3,004,320
(1,095,375)
(36.5%)
A/A1/not rated
no data
no data
0.0%
7,000,000
no data
8,500,002
7.1%
8,500,002
no data
01-Oct-08
(35.0%)
AA (Fitch)
AA
stable
4.1%
no data
9.8%
no data
11.0%
no data
no data
Sep-08
(30.7%)
BBB/Baa2/BBB
BBB
stable
0.6%
no data
no data
493,300,000
1.3%
493,300,000
1.3%
Sep-08
A/A2/A
A
positive
0.2%
no data
no data
19,000,000
no data
19,000,000
no data
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
Page 157
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Appendix 5 Granite MBS ISIN number XS0298980813 XS0240607480 XS0252427009 XS0210926571 XS0240603653 XS0267968658 XS0220174972 XS0276823167 XS0298980060 XS0220172257 XS0220175862 XS0210925847 XS0210929161 XS0176410776 XS0176410693 XS0184563541 XS0184563541 XS0184566569 XS0184565249 XS0193219754
Origination date
Note type CLASS 3B3 FLOATING RATE NOTES DUE 17/12/2054 07-2 CLASS M3 FLOATING RATE NOTES DUE 25/12/2054 06-1 CLASS A6 FLOATING RATE NOTES DUE 24/12/2054 06-2 CLASS C3 NOTES DUE 20/12/2054 05-1 CLASS A8 FLOATING RATE NOTES DUE 25/12/2054 06-1 CLASS A6 FLOATING RATE NOTES DUE 19/12/2054 06-3 CLASS M3 FLOATING RATE NOTES DUE 20/12/2054 05-2 CLASS A8 FLOATING RATE NOTES DUE 20/12/2054 06-4 CLASS 4A2 FLOATING RATE NOTES DUE 17/12/2054 07-2 CLASS A7 FLOATING RATE NOTES DUE 20/12/2054 05-2 CLASS B3 FLOATING RATE NOTES DUE 20/12/2054 05-2 CLASS A6 NOTES DUE 20/12/2054 05-1 CLASS A5 NOTES DUE 20/12/2054 05-1 SERIES 3 CLASS B FLOATING RATE NOTES DUE 20/01/2044 03-3 SERIES 3 CLASS A FLOATING RATE NOTES DUE 20/01/2044 03-3 SERIES 2 CLASS M FLOATING RATE NOTES DUE 20/03/2044 04-1 SERIES 2 CLASS M FLOATING RATE NOTES DUE 20/03/2044 04-1 SERIES 3 CLASS M FLOATING RATE NOTES DUE 20/03/2044 04-1 SERIES 3 CLASS A FLOATING RATE NOTES DUE 20/03/2044 04-1 SERIES 3 CLASS M FLOATING RATE NOTES DUE 20/06/2044 04-2
Credit enhancement (%) Latest Required
Book Value (£)
MTM movement
23-May-07
14,000,000
(3,715,600)
(26.5%)
AA/Aa3/AA
AA
stable
1.65
2.22
Sep-08
25-Jan-06
3,500,000
(756,700)
(21.6%)
A/A2/A
A
stable
1.65
2.22
Sep-08
24-May-06
47,500,000
(10,065,250)
(21.2%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
26-Jan-05
4,976,000
(995,200)
(20.0%)
BBB/Baa2/BBB
BBB
stable
1.65
2.22
Sep-08
MTM %
Rate on issuance (S&P/Moody/Fitch)
Most recent Fitch grading
Rating movement
Date of update
25-Jan-06
32,000,000
(6,300,800)
(19.7%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
19-Sep-06
50,000,000
(6,750,000)
(13.5%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
25-May-05
8,000,000
(1,020,000)
(12.8%)
A/A2/A
A
stable
1.65
2.22
Sep-08
29-Nov-06
25,000,000
(2,630,000)
(10.5%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
23-May-07
28,050,000
(2,790,000)
(9.9%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
25-May-05
28,000,000
(2,702,000)
(9.7%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08
25-May-05
10,000,000
(953,000)
(9.5%)
AA/Aa3/AA
AA
stable
1.65
2.22
Sep-08
26-Jan-05
4,411,500
(246,750)
(5.6%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
Sep-08 Sep-08
26-Jan-05
5,051,667
(258,140)
(5.1%)
AAA/Aaa/AAA
AAA
stable
1.65
2.22
24-Sep-03
684,024
(13,475)
(2.0%)
AA/Aa3/AA
AAA
stable
4.40
4.40
Sep-08
24-Sep-03
17,563,000
(250,097)
(1.4%)
AAA/Aaa/AAA
AAA
stable
4.40
4.40
Sep-08
28-Jan-04
399,001
(16,930)
(4.2%)
A/A2/A
AA
Positive
4.71
4.71
Sep-08
28-Jan-04
1,581,770
(67,115)
(4.2%)
A/A2/A
AA
Positive
4.71
4.71
Sep-08
28-Jan-04
1,000,000
(41,710)
(4.2%)
A/A2/A
AA
Positive
4.71
4.71
Sep-08
28-Jan-04
2,856,555
(61,387)
(2.1%)
AAA/Aaa/AAA
AAA
stable
4.71
4.71
Sep-08
26-May-04
2,500,000
(593,500)
(23.7%)
A/A2/A
AA
Positive
3.23
3.23
Sep-08
XS0193216578
SERIES 2 CLASS M FLOATING RATE NOTES DUE 20/06/2044; FULLY PAID 04-2
26-May-04
1,260,943
(136,308)
(10.8%)
A/A2/A
AA
Positive
3.23
3.23
Sep-08
XS0193216578
SERIES 2 CLASS M FLOATING RATE NOTES DUE 20/06/2044; FULLY PAID 04-2
26-May-04
1,577,124
(170,487)
(10.8%)
A/A2/A
AA
Positive
3.23
3.23
Sep-08
XS0193218350
SERIES 3 CLASS A FLOATING RATE NOTES DUE 20/06/2044; FULLY PAID 04-2
26-May-04
20,000,000
(1,948,000)
(9.7%)
AAA/Aaa/AAA
AAA
stable
3.23
3.23
Sep-08
XS0193218350
SERIES 3 CLASS A FLOATING RATE NOTES DUE 20/06/2044; FULLY PAID 04-2
26-May-04
40,000,000
(3,896,000)
(9.7%)
AAA/Aaa/AAA
AAA
stable
3.23
3.23
Sep-08
22-Sep-03
1,035,221
(37,786)
(3.7%)
AA/Aa3/AA
AAA
stable
2.93
2.93
Sep-08
May-07
5,000,000
(3,273,500)
(65.5%)
BBB/Baa2/BBB
BBB
stable
1.65
2.22
Sep-08
May-07
3,954,425
(2,587,776)
(65.4%)
BBB/Baa2/BBB
BBB
stable
1.65
2.22
Jan-07
3,200,000
(1,600,000)
(50.0%)
BBB/Baa2/BBB
BBB
stable
1.65
2.22
May-07
2,372,655
(968,043)
(40.8%)
BBB/Baa2/BBB
BBB
stable 1.65
2.22
1.65
2.22
1.65
2.22
XS0201483657 XS0298984641 XS0298978320 XS0284075560 XS0298977512
XS0284074167 XS0240608371
SERIES 2 CLASS B FLOATING RATE NOTES DUE 20/09/2044 04-3 Granite Master Issuer plc - Class 3c3 floating rate notes due 17/12/2054 07-02 Granite Master Issuer plc Class 3c2 Granite Master Issuer plc - Class 3c2 floating rate notes due 24/12/54 07-1 CLASS 2C2 FLOATING RATE NOTES DUE 17/12/2054 07-2 CLASS 3M2 FLOATING RATE NOTES DUE 24/12/2054 07-1 CLASS C3 FLOATING RATE NOTES DUE 25/12/2054 06-1
Jan-07
10,000,000
(4,000,000)
(40.0%)
A/A2/A
A
stable
Jan-06
4,000,000
(1,300,000)
(32.5%)
BBB/Baa2/BBB
BBB
stable
Sep-08 Sep-08
Sep-08 Sep-08
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 6 Granite issues and Burgundy holdings Amounts issued by Granite (value) Issue A notes B notes M Notes C Notes Total
2003-3 846,169,600 46,690,470 17,431,675 50,998,950 961,290,695
2004-1 1,311,801,000 94,970,990 45,590,050 67,453,400 1,519,815,440
2004-2 2,055,892,600 111,661,880 68,812,615 118,889,210 2,355,256,305
2004-3 1,401,949,660 113,192,216 88,042,531 209,423,255 1,812,607,662
2005-1 4,411,995,000 152,247,395 154,774,550 169,933,710 4,888,950,655
2005-2 3,833,709,150 134,678,280 136,813,350 154,703,313 4,259,904,093
2005-3 1,000,000,000 1,000,000,000
2005-4 1,304,517,411 62,336,490 56,720,590 70,198,750 1,493,773,241
2006-1 1,550,000,000 198,185,832 33,500,000 220,579,326 2,002,265,158
2006-2 3,053,792,550 66,161,725 65,760,650 97,618,200 3,283,333,125
2006-3 5,461,875,700 165,247,380 153,873,930 142,047,330 5,923,044,340
2006-4 3,100,996,187 83,462,979 99,211,018 76,399,576 3,360,069,760
2007-1 16,231,395,500 249,179,390 235,707,350 339,286,664 17,055,568,904
2007-2 4,198,183,400 219,135,450 213,268,620 196,035,985 4,826,623,455
Total 49,762,277,758 1,697,150,477 1,369,506,929 1,913,567,669 54,742,502,833
2004-1 2,856,555 2,980,771 5,837,326
2004-2 60,000,000 5,338,067 65,338,067
2004-3 1,035,221
2005-1 9,463,167 4,976,000 14,439,167
2005-2 28,000,000 10,000,000 8,000,000 46,000,000
2005-3 -
2005-4 -
2006-1 32,000,000 3,500,000 4,000,000 39,500,000
2006-2 47,500,000 47,500,000
2006-3 50,000,000 50,000,000
2006-4 25,000,000 25,000,000
2007-1 10,000,000 32,000,000 42,000,000
2007-2 28,050,000 14,000,000 11,327,080 53,377,080
Total 300,432,722 25,719,245 29,818,838 52,303,080 408,273,885
2004-1 86.3% 6.2% 3.0% 4.4% 100.0%
2004-2 87.3% 4.7% 2.9% 5.0% 100.0%
2004-3 77.3% 6.2% 4.9% 11.6% 100.0%
2005-1 90.2% 3.1% 3.2% 3.5% 100.0%
2005-2 90.0% 3.2% 3.2% 3.6% 100.0%
2005-3 100.0% 100.0%
2005-4 87.3% 4.2% 3.8% 4.7% 100.0%
2006-1 77.4% 9.9% 1.7% 11.0% 100.0%
2006-2 93.0% 2.0% 2.0% 3.0% 100.0%
2006-3 92.2% 2.8% 2.6% 2.4% 100.0%
2006-4 92.3% 2.5% 3.0% 2.3% 100.0%
2007-1 95.2% 1.5% 1.4% 2.0% 100.0%
2007-2 87.0% 4.5% 4.4% 4.1% 100.0%
Total 90.9% 3.1% 2.5% 3.5% 100.0%
2004-2 91.8% 8.2% 100.0%
2004-3 100.0% 100.0%
2005-1 65.5% 34.5% 100.0%
2005-2 60.9% 21.7% 17.4% 100.0%
2005-3 0.0% 0.0% 0.0% 0.0% 0.0%
2005-4 0.0% 0.0% 0.0% 0.0% 0.0%
2006-1 81.0% 8.9% 10.1% 100.0%
2006-2 100.0% 100.0%
2006-3 100.0% 100.0%
2006-4 100.0% 100.0%
2007-1 23.8% 76.2% 100.0%
2007-2 52.6% 26.2% 21.2% 100.0%
Total 73.6% 6.3% 7.3% 12.8% 100.0%
Amounts purchased by Burgundy (value) Issue A notes B notes M Notes C Notes Total
2003-3 17,563,000 684,024 18,247,024
1,035,221
Amounts issued by Granite (%) Issue A notes B notes M Notes C Notes Total
2003-3 88.0% 4.9% 1.8% 5.3% 100.0%
Amounts purchased by Burgundy (%) Issue A notes B notes M Notes C Notes Total
2003-3 96.3% 3.7% 100.0%
2004-1 48.9% 51.1% 100.0%
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 7 Aire Valley MBS ISIN number
Note type
Originator
XS0264192716
SERIES 1 CLASS C2 ASSET BACKED FLOATING RATE NOTES DUE Bradford and Bingley 20/09/2066
Origination date
Book Value (£)
MTM movement
MTM %
Rate on issuance (S&P/Moody/Fitch)
Most recent Fitch grading
Rating movement
> 3months arrears
Latest (£)
Latest (%)
Required (£)
Aug-06
1,585,250
(243,019)
(15.3%)
BBB/Baa2/BBB
BBB
stable
2.64%
380,000,000
2.96%
380,000,000
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Date of Required (%) update 2.96%
Oct-08
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Appendix 8 Other MBS / ABS with BBB or A rating ISIN number XS0114780421 XS0188150527 XS0292759635 XS0305306598 XS0305306598 XS0312955304 XS0163980476 XS0179403257 XS0187602403 US71419QAK40 XS0270511115 XS0277530274 XS0256211318
Note type Series 4 Class C floating asset backed due 15/7/2040 Series 4 Class C floating asset backed due 15/7/2040 Series 3 Class C3 mortgage backed floating Series 2 Class C3 mortgage backed floating Series 2 Class C3 mortgage backed floating Series 2007-1 Class 4D3 mortgage backed floating Series 5 Class C Floating due 30/6/2042 Series 5 Class C Floating due 30/6/2042 Series 5 Class C Floating due 30/6/2042 Series 3 Class C floating due 30/6/2042 Series 4 Class C asset backed floating SERIES 3 CLASS C3 FLOATING RATE NOTES DUE 17/02/2052 CLASS DC ASSET BACKED FLOATING RATE NOTES DUE 12/04/2056
Origination date
Book value (£)
MTM
required
current
0.76
BBB
stable
1.68
1.68
15-Jul-04
4,000,000
(111,600)
(2.8%)
BBB/Baa2/BAbbey/Holmes Fin No 8
0.76
BBB
stable
1.68
1.68
28-Mar-07
1,000,000
(169,100)
(16.9%)
BBB/Baa2/BAbbey Holmes Fin Master Issuer 07-1
0.76
BBB
stable
1.68
1.68
20-Jun-07
2,000,000
(265,400)
(13.3%)
BBB/Baa2/BAbbey/Holmes Fin Master Issuer 07-2
0.76
BBB
stable
1.68
1.68
20-Jun-07
2,981,400
(395,632)
(13.3%)
BBB/Baa2/BAbbey/Holmes Fin Master Issuer 07-2
0.76
BBB
stable
1.68
1.68
06-Aug-07
5,000,000
(1,350,500)
(27.0%)
BBB/Baa2/BClydesdale Bank
no data
BBB
stable
1.5
no data
06-Mar-03
4,044,800
(67,346)
(1.7%)
BBB/Baa2/BHBOS
1.07
BBB
stable
2.26
2.26
25-Nov-03
1,581,770
(309,394)
(19.6%)
BBB/Baa2/BHBOS
1.07
BBB
stable
2.26
2.26
Jun-04
2,513,250
(572,518)
(22.8%)
BBB/Baa2/BHBOS
1.07
BBB
stable
2.26
2.26
Jun-04
2,807,945
(149,383)
(5.3%)
BBB/Baa2/BHBOS
1.07
BBB
stable
2.26
2.26
17-Oct-06
2,372,655
(689,968)
(29.1%)
BBB/Baa2/BPermanent Master Issuer
1.07
BBB
stable
1.86
1.86
14-Dec-06
3,000,000
(480,000)
(16.0%)
BBB/Baa2/BLloyds TSB
0.63
BBB
stable
1.65 (1.77combined)
1.65 (1.77combined)
4.78
BBB
stable
100
100
1,977,213
(388,918)
(19.7%)
ARRAN RESIDENTIAL MORTGAGES BBB/Baa1/B FUNDING NO.1 PLC
1,250,000
(376,250)
(30.1%)
BBB/Baa2/BAlliance & Leicester/Fosse Master Issuer
0.22
BBB
stable
1.7
1.81
19,600,000
(4,192,440)
(21.4%)
A/A2/A
Lloyds TSB
0.63
A
stable
4.45
1.77
(12.1%)
A/A2/A
ARRAN RESIDENTIAL MORTGAGES FUNDING NO.1 PLC
4.78
A
stable
100
100
(1,787,500)
(16.3%)
A/A2/A
Royal Bank of Scotland plc (Arran 2)
4.05
A
stable
100
100
17,000,000
(4,178,600)
(24.6%)
A/A2/A
Bank of Ireland
no data
A
stable
no data
no data
25-Jan-07
8,840,223
(839,821)
(9.5%)
AAA/none/A Paragon Mortgages Ltd
7.13
A
stable
no data
no data
28-Nov-06
4,000,000
(944,400)
(23.6%)
A/A2/A
Alliance & Leicester
0.22
A
stable
3.4
3.63
28-Nov-06
16,000,000
(1,344,000)
(8.4%)
AAA/Aaa/AAAlliance & Leicester
0.22
A
stable
9.25
9.21
20-Jun-07
5,000,000
(487,500)
(9.8%)
A/A2/A
Abbey National plc
0.76
A
stable
4.55
4.57
28-Mar-07
11,800,000
(859,040)
(7.3%)
A/A2/A
Abbey National plc
0.76
A
stable
4.55
4.57
SERIES 2007-1 CLASS 4C2 MORTGAGE BACKED FLOATING 06-Aug-07 RATE NOTES DUE 22/12/2054
8,000,000
(1,380,800)
(17.3%)
A/A2/A
Clydesdale Bank
no data
A
stable
4.8
no data
Jun-04
3,000,000
(472,800)
(15.8%)
A/A2/A
HBOS PLC (Perm Fin 4)
1.07
A
stable
no data
5.09
Jun-04
3,014,400
(475,069)
(15.8%)
A/A2/A
HBOS PLC (Perm Fin 4)
1.07
A
stable
no data
5.09
Jun-04
1,581,770
(136,032)
(8.6%)
A/A2/A
HBOS PLC (Perm Fin 4)
1.07
A
stable
no data
5.09
Jun-04
1,123,178
(34,369)
(3.1%)
A/A2/A
HBOS PLC (Perm Fin 4)
1.07
A
stable
no data
5.09
12-Oct-06
XS0267352200
20-Dec-06
11,000,000
XS0289326935
Class C4c Mortgage Backed Floating Rate Notes due January 2039
13-Jul-07
XS0282470797
CLASS A MORTGAGE BACKED FLOATING RATE NOTES DUE 15/09/2033
XS0274294759
CLASS M4 ASSET BACKED FLOATING RATE NOTES DUE 18/10/2054
XS0274293785
CLASS A4 ASSET BACKED FLOATING RATE NOTES DUE 18/10/2054
XS0305305863
SERIES 2 CLASS M3 RESIDENTIAL MORTGAGEBACKED FLOATING RATE NOTES DUE 15/07/2040
XS0292755138
SERIES 3 CLASS M3 RESIDENTIAL MORTGAGEBACKED FLOATING RATE NOTES DUE 28/07/2040
XS0312955056
XS0187602155 XS0187596910 US71419QAL23
Credit enhancement (%)
stability
BBB/Baa2/BAbbey/Holmes Fin No 1
(482,800)
XS0187602155
Grading
(12.6%)
4,000,000
XS0256206235
Most recent arrears losses (%) Fitch grading
(298,531)
CLASS CA ASSET BACKED FLOATING RATE NOTES DUE 20/09/2056
XS0273285048
Ratings (S&P/Mo Originator ody/Fitch
2,376,840
CLASS C4 ASSET BACKED FLOATING RATE NOTES DUE 28-Nov-06 18/10/2054 SERIES 5 CLASS M2 FLOATING 06-Nov-06 RATE NOTES DUE 17/02/2052 CLASS CA ASSET BACKED FLOATING RATE NOTES DUE 12-Oct-06 12/04/2056; FULLY PAID
XS0274294916
MTM %
Oct-00
movement
SERIES 5 CLASS M FLOATING RATE NOTES DUE 30/06/2042 SERIES 5 CLASS M FLOATING RATE NOTES DUE 30/06/2043 SERIES 4 CLASS M FLOATING RATE NOTES DUE 30/06/2042 SERIES 3 CLASS M FLOATING RATE NOTES DUE 30/06/2042
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TRANSACTION SERVICES
Project Vintage Capital projections report 23 December 2008 ADVISORY
Page 162
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KPMG LLP Transaction Services 1 The Embankment Neville Street LEEDS LS1 4DW
Tel +44 (0) 113 231 3000 Fax +44 (0) 113 231 3186
Private & Confidential The Directors Cooperative Financial Services 4th Floor Miller Street Manchester M60 0AL
We draw your attention to the Important notice included on the following page Within the draft findings below we have identified where work is still incomplete
22 December 2008
We shall be pleased to receive your observations on our draft report
Dear Ladies and Gentlemen Project Vintage As requested, we enclose a copy of our draft report on Project Vintage Capital Projections dated 22 December 2008. We understand that your purpose in requesting a draft report at this stage is to enable you to give preliminary consideration to the findings available to date with regard to the key issues identified by you in relation to the transaction. You will note that we have not received sufficient information to address all areas of our scope and as such this report represents a status update of our findings to date. In accordance with our engagement letter dated 18 September and the variation letter dated 23 October 2008, you have agreed that our final written report shall take precedence over this draft, and that no reliance will be placed by you on any draft report other than at your own risk This draft status update has been prepared on the basis of fieldwork carried out up to 22 December 2008. You will be aware that we have not yet completed the work required to enable us to report in accordance with the terms of reference set out in our Engagement Letter. You should, therefore, bear in mind when considering the draft report that the information contained within it and our preliminary conclusions based thereon may alter or be refined as our work progresses
KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative
Registered in England No OC301540 Registered office: 8 Salisbury Square, London EC4Y 8BB
Page 163
Our draft report is confidential and is released to you on the basis that it is not to be copied, referred to or disclosed, in whole or in part, without our prior written consent, save as permitted in our Engagement Letter. In accordance with that letter, you may disclose our draft report to your legal and other professional advisers in order to seek advice in relation to our work for you, provided that when doing so you inform them that, to the fullest extent permitted by law, we accept no responsibility or liability to them in connection with our draft report and our work for you Yours faithfully
KPMG LLP
Treasury Select Committee - Project Verde
Private & confidential
Important notice z
Our work commenced on 4 August 2008 and this report reflects our fieldwork up to 22 December 2008. You will be aware that we have not yet completed the work required to enable us to report in accordance with the terms of reference set out in our engagement letter dated 18 September 2008 and variation letter dated 23 October and 17 November 2008. You should, therefore, bear in mind when considering the draft report that the information contained within it and our preliminary conclusions based thereon may alter or be refined as our work progresses
z
This engagement is not an assurance engagement conducted in accordance with any generally accepted assurance standards and consequently no assurance opinion is expressed
z
Our report makes reference to ‘KPMG Analysis’; this indicates only that we have (where specified) undertaken certain analytical activities on the underlying data to arrive at the information presented; we do not accept responsibility for the underlying data
z
The numerical data presented in our report has been imported from Excel spreadsheets and may include minor rounding differences as a consequence
z
The contents of our report have not been reviewed in detail by the directors of Burgundy to confirm the factual accuracy of the report
z
We accept no responsibility or liability for the findings or reports of legal and other professional advisers even though we have referred to their findings and/or reports in our report
z
The prospective financial information set out within our report has been prepared by Burgundy; we do not accept responsibility for such information. We must emphasise that the realisation of the prospective financial information is dependent on the continuing validity of the assumptions on which it is based. The assumptions will need to be reviewed and revised to reflect any changes in trading patterns, cost structures or the direction of the business as they emerge. We accept no responsibility for the realisation of the prospective financial information. Actual results are likely to be different from those shown in the prospective financial information because events and circumstances frequently do not occur as expected, and the differences may be material
z
The analysis of ‘adjusted’ earnings is for indicative purposes only. We have sought to illustrate the effect on earnings of adjusting for those items identified in the course of our work that may be considered to be 'non-recurring' or 'exceptional' or otherwise unrepresentative of the trend in earnings using criteria established by Claret. However the selection and quantification of such adjustments is necessarily judgmental. Because there is no authoritative literature or common standard with respect to the calculation of ‘adjusted’ earnings, there is no basis to state whether all appropriate and comparable adjustments have been made. In addition, while the adjustments may indeed relate to items which are 'non-recurring' or 'exceptional' or otherwise unrepresentative of the trend, it is possible that earnings for future periods may be affected by such items, which may be different from the historical items
Limitations of scope z
We draw your attention to the significant limitations in the scope of our work. We have had limited access to the premises of Burgundy. Access to the audit files has not been granted at this stage, although a meeting with the auditors of Burgundy has taken place. Management information available has been restricted to specified documents in a data room and supporting work papers have not be available in all instances. These restrictions have had a corresponding impact on the nature of comments we have been able to make on the financial information available
z
We do not accept responsibility for such information which remains the responsibility of management. We have satisfied ourselves, so far as possible, that the information presented in our report is consistent with other information which was made available to us in the course of our work in accordance with the terms of our engagement letter. We have not, however, sought to establish the reliability of the sources by reference to other evidence
z
In preparing this update, our only source of information has been the information contained in the Burgundy data room, various meetings with Burgundy management between 12 August and 19 November 2008 and the JPM model.
z
Information provided in the Burgundy data room has not been sufficient to address all areas of our scope. This report focuses on a number of key issues identified in discussion with you and reflects the information with which we have been provided and discussions we have held as noted above. We have also highlighted within this report recommendations for subsequent phases of work should further information be made available
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Glossary of terms ABS
Asset Backed Security
HY1
Period from 1 January to 30 June
AFS
Available For Sale
HY2
Period from 1 July to 31 December
CDS
Credit Default SWAP
HPI
House price index
EIR
Effective Interest Rate
ICAAP
Internal Capital Adequacy Assessment Process
EL
Expected loss
ICG
Interim capital guidance
Forecast period
1 January 2009 to 31 December 2012
LGD
Loss given default
FSA
Financial Services Authority
LT2
Lower tier 2
LTV
Loan to Value
FST
Financial Stability Testing MBS
Mortgage backed security
FSD
Forced Sale Discount
PA
Per annum
FRN
Floating Rate Notes
PD
Probability of default
FY08, FY09, FY10, Financial year ended 31 December 2008 to 2012 FY11, FY12
PIBS
Permanent interest bearing shares
FVA
Fair Value Adjustments
SVR
Standard Variable Rate
GCC
Group Credit Committee
TOMS
Tax scheme in relation to Foreign Exchange Translation
GEB
Guaranteed Equity Bond
YTD
Year to date
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Contents The contacts at KPMG in connection with this report are: Andrew Walker Financial Sector Group Partner, KPMG LLP Leeds Tel: +44 113 231 3913 Fax: +44 113 231 3139
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’
[email protected]
Synergies Jonathan Holt Financial Sector Group Partner, KPMG LLP Manchester Tel: +44 113 231 3913 Fax: +44 113 231 3139
[email protected]
Fair value adjustments Burgundy stand alone capital Due diligence findings
Kieran Cooper Financial Sector Group Senior Manager, KPMG LLP Leeds Tel: +44 113 231 3972 Fax: +44 113 231 3139
[email protected]
Katie Clinton Financial Sector Group Senior Manager, KPMG LLP Manchester, Tel: +44 161 246 4480 Fax: +44 161 838 4040
[email protected]
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Introduction
Scope of work Overview z
The purpose of this report is to comment on the capital projections of Burgundy, under different scenarios, covering the period between 2009 and 2012 (“the forecast period”). The combined capital projections of both Burgundy and Claret are being developed as part of the JPM modelling and will be subject to separate reporting to the Risk Management Committee (‘RMC’). At this stage we have not been requested to comment on any of the other components of the business case.
z
This report summarises the key findings from our work on the combined capital projections, which has comprised the following principal components: −
identifying the key assumptions which have been used by Burgundy in preparing its stand alone financial forecasts and stand-alone capital projections;
−
where appropriate, comparing key assumptions used by Burgundy and by Claret and identifying any significant discrepancies;
−
reviewing the fair value of Burgundy’s assets and liabilities, the consistency of key assumptions adopted by Burgundy in its stand alone financial forecasts with those used in the fair value exercise and the unwind profile of the fair value adjustments ;
−
identifying the capital impact of fair value and other combination adjustments;
−
understanding, at a high level, the key drivers of synergies and dis-synergies and integration costs;
−
identifying the impact on capital projections of our due diligence findings from Phase I
z
We have also identified key areas where follow up work is, in our view, still necessary as part of Phase II due diligence
z
This report brings together the findings from a number of KPMG work streams on Project Vintage. As such, the work included within the report has been completed under a number of different KPMG engagement letters as detailed below;
z
−
Due diligence: Engagement letter agreed and signed on 18 September 2008 along with the variation of terms signed on 23 October. These engagement terms are reproduced in Appendix 1 of the Phase I due diligence report dated 21 November 2008;
−
Synergies and integration costs engagement letter; and
−
Fair value accounting and capital treatments engagement letter
Each of the areas of this report should be considered in conjunction with the engagement terms set out above
Scope of work z
Our work has been based on the outputs of the JPM model. Whilst we have completed work on the inputs in relation to the Burgundy Strategic Plan Light and stand alone capital modelling, we have not completed any additional due diligence work on the JPM model itself or the Claret inputs
z
We would emphasise that the Burgundy Strategic Plan Light and the subsequent capital modelling are high level only and are not the result of an extensive modelling exercise
z
Our work on these models has been limited to understanding and challenge of the key assumptions adopted by Burgundy and that the Burgundy model outputs have been correctly input in the JPM model
z
Burgundy is completing a fuller projections exercise to be completed in January 2009. We would be happy to perform further follow up work on the outputs of that exercise
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Contents
Introduction Executive summary z Headlines z Overview of financials z Next steps
Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings
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Executive summary
Headlines
Strategic plan light – balance sheet
z
The base case projections have been based on the forecast income statement and balance sheets from the ‘Strategic Plan Light’ prepared by Burgundy for the purposes of their current capital planning (FSA FST). This was completed as a top down exercise
£ million
FY09
FY10
FY11
FY12
CAG R
z
At this stage subject to the due diligence findings outlined below, and explained in more detail later in this report, the Strategic Plan Light is considered adequate for this exercise. However, given the level of uncertainty in the market partially due to the low base rate environment and the change that will occur between now and any potential acquisition date, we would recommend that any announcement and any pre-completion agreements are drawn up accordingly
Income E xpenses B ad debt P BT (pre capital) Capital cost P BT (post capital)
387.0 (225.7) (75.0) 86.3 86.3
391.7 (218.3) (65.1) 108.2 108.2
406.8 (215.6) (38.4) 152.8 152.8
432.0 (218.3) (23.2) 190.6 190.6
z
We would further recommend that Burgundy complete a full Strategic Planning exercise including full capital planning which we understand they will be completing in January 2009
B MR P BT (post BMR) Tax P AT Cost/income ratio Cost/asset ratio
(20.0) 66.3 (19.2) 47.1 (58.3%) (0.63%)
(30.0) 78.2 (22.7) 55.6 (55.7%) (0.64%)
(40.0) 112.8 (32.7) 80.1 (53.0% ) (0.64% )
(50.0) 140.6 (40.8) 99.8 (50.5%) (0.63%)
3.7% (1.1%) (32.3%) 30.2% n/a 30.2% 35.7%
Burgundy income statement - Base case scenario
z
Management has assumed an increasing interest margin over both the base case and the moderate stress. No detailed margin analysis by product has been completed in coming to these margin assumptions. Burgundy’s margins have been falling since FY05; however, they did show a recovery in H1 FY08 to 0.94%. This is above the projected start point of 0.92% in the base case and moderate stress scenarios
z
As discussed in our due diligence findings, we believe Burgundy’s impairment assumptions are challenging and may not be achievable in the short term. The impact of the government scheme to support customers in arrears has not yet been modelled
z
The residential and commercial lending numbers are the only numbers in the Strategic Plan Light that have been based on a ‘bottom up’ approach
z
Overall, the base case shows an assumption of the balance sheet reduction in the early years with a slight recovery of growth in FY11 and FY12. This is consistent with the overall assumption that the market hits the bottom of the cycle in late FY09 or early FY10
30,000
z
In the moderate stress, management has assumed that the balance sheet retraction continues throughout the projection period
20,000
z
The mix of assets moves towards more prime assets as the impact of the changes in lending criteria take effect. The gradual change is effected through the slow redemption of certain portfolios and limited new advances in prime assets. In the moderate stress, no new lending is assumed after FY09
z
The key assumption on the liabilities side of the balance sheet is that surrounding the level of retail funding which is assumed to grow over the projection period at a CAGR of 6.1% in both the base case and moderate stress. Of the £4.9 billion of growth, circa £2.4 billion could be achieved through accrued interest if Burgundy are able to retain current depositors
z
We would, however, recommend that further, more detailed projections are prepared which take account of a low base rate environment
Mortgage asset projections – base case
25,000
15,000 10,000 5,000 FY08
Prime
FY09
Buy-t o-let
FY10
Self cert
FY11
Sub-prime
FY12
Com mercial
Source: JPM financials model v 9
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28.5% 28.5% 28.5%
Source: JPM financials model v 9
£ million
Strategic plan light – profitability
7
Treasury Select Committee - Project Verde
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Executive summary
Headlines (continued) FVA
z
z
z
z
z
z
Summary of Burgundy FV adjustments as at 31 October 2008
For accounting purposes, the proposed FVAs post assumed tax will reduce total assets by £1,122m whilst reducing liabilities by £980m. The net debit to the balance sheet is highly dependent on the use of mark to market principles on the debt securities in issue (£1.2bn). A change in market prices or an inactive market may result in a markedly different net result.
FVAs: Statutory basis
For MBS, ABS, FRNs and debt securities in issue, the FVAs have been calculated based on mark to market prices. However, for sensitivity purposes, the FVAs for certain asset and liability classes have also been calculated by reference to mark to model assumptions. This is based upon Burgundy’s view that markets may be inactive. The use of Burgundy’s mark to model prices results in a fundamentally different FVA (ie over £500m increase in net liability). It should be noted that we have a number of observations in respect of the assumptions applied by Burgundy in generating their mark to model FVAs. Going forward certain asset and liability classes (ABS/MBS and Leek Notes) might be expected to move, to some degree, in a correlated manner. However, if there is significant change on both mortgage backed assets and liabilities (eg significant improvement in the mortgage backed securities market) this may result in a sizeable increase in liabilities resulting in an overall material net credit to the balance sheet. By their very nature, the FVAs will change at the point of transfer and such changes may be significant.
tax £m
Net £m
£m
£m
Assets Loans & advances to customers Interest rate & EIR FV adjts Credit risk Other change in hedging adjts
(164)
46
(366)
102
(264)
-
(264)
(311)
87
(224)
(118)
-
(224)
-
(118)
Invt securities L&R (formerly in AFS) Existing valuation
203
(57)
146
-
146
Revision to DCF basis
(580)
162
(418)
-
(418)
AFS Reserve
(137)
-
(137)
-
(137)
-
(44)
Counterparty risk AFS investments Goodw ill Intangibles Core deposit intangible PP&E Cashflow hedging
(61) 20
17
(44)
-
14
(195)
37
(6)
(158)
14
158
0
-
-
-
-
125
(35)
90
(90)
-
10
(3)
7
-
7
-
(18)
-
(18)
-
(18)
(1,474)
352
(1,122)
68
(1,054)
Liabilities Non-core retail deposits
(84)
24
Deposits from banks
11
(3)
8
-
8
Other deposits
(19)
5
(14)
-
(14)
897
-
897
Debt securities Contingent liabilities Subordinated liabilities Subscribed capital
1,246
(349)
(60)
-
(60)
-
-
-
-
-
162
(45)
117
-
117
45
(13)
32
-
32
1,361
(381)
980
-
980
Scope We have performed a high level accounting review of the fair value adjustments (FVAs) proposed by Burgundy based on the Burgundy balance sheet as at 31 October 2008. We have commented on the appropriateness of the accounting treatment and approach adopted. Note that: z
we have not performed an audit or verified Burgundy’s numbers, nor have we undertaken any independent valuation
z
the proposed FVAs at 31 October 2008 are only indicative and can be expected to change substantially by the transaction date
z
we have not had access to underlying data
z
Burgundy’s approach to the FVA exercise has necessarily been high level; for simplification, certain key assumptions (including averaging) have been applied
z
to the extent that Claret’s view of the proposed adjustments differs to that of Burgundy, the accounting and capital impacts are disclosed in KPMG’s updated Due Diligence report.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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FVAs: Regulatory capital
Deferred Gross £m
The net impact will be different for regulatory capital purposes (on Day 1 and beyond) because of the inconsistencies between the accounting and capital treatments that are set out in the detailed FVA paper. In conjunction with the Claret team, we have sought confirmation from the FSA regarding the Day 1 regulatory capital treatment of FVAs (and their component parts). Following clarification by the FSA, it has been confirmed that the regulatory capital treatment will be consistent with the treatment for accounting purposes other than to the extent that prudential filters are applied. In summary, Burgundy's proposed FVAs result in a Day 1 capital hit of £1,054m in respect of asset write downs that will be offset by a reduction in liabilities (and therefore benefit to Day 1 capital) of £980m. Prudential filters apply in respect of goodwill, intangibles and pensions. The FSA confirmed, however, that they may increase capital add ons subject to the size and nature of the reduction in liabilities – particularly where they relate to credit. The FSA previously stated that a capital shelter may be available for the element of any credit fair value adjustment in respect of loans and receivables that are already impaired. Burgundy has updated the August FVAs as at 31 October to provide an indication of the quantum and direction of FVAs arising in current market conditions whilst revisions to the valuation basis applied have sought to introduce more granularity and a greater level of precision to the calculations. We note, however, that the increase in fair value for a commercial lending book in the current environment seems counterintuitive.
FVAs: Disregarded for capital purposes
8
Treasury Select Committee - Project Verde
Private & confidential
Executive summary
Headlines (continued) Burgundy stand alone capital
z
The new risk weights, prepared by Burgundy and agreed with Claret, but not the FSA, have a significant impact on the capital requirement in FY09 in both the base and moderate stress case
z
In the base case, the continued improvement in retained earnings builds the capital buffer to £1,056.8 million by the end of FY11
z
In the moderate stress case, the initial improvement is countered in FY10 with an assumption that the economic climate continues to decline, leading to a reduction in headroom, which recovers to £769.0 million by FY11
z
z
z
z
z
Originally, Burgundy management had assumed that as HPI deflation increased, the level of FSD experienced fell. This assumption, whilst not contravening any requirement from the FSA, was felt to be imprudent and therefore, the FSD was increased to 25% across all years and stresses. The 25% rate is in line with that already being experienced by Burgundy (preIllius) and is also consistent with the FSD used by Claret The combination of the HPI falls and FSD in the Burgundy base case lead to an overall peak to trough of 44.0% and 47.5% in the moderate case. These are considered materially consistent by Claret management who use 47.5% in both the base case and moderate stress Minimal impact from Illius has been factored into the capital projections to date, with the exception of reduced time to sale. If Illius were to proceed as projected by management, this could have a significant positive impact on the capital required. Management have not calculated this impact to date A number of model changes have also been assumed in the Burgundy stand alone capital model and risk weights. Where applicable, the relevant data has been collated by management to justify the changes; however, we note that these have not, as yet, been approved by the FSA (a process which is currently underway) A number of differences have been noted as part of the KPMG due diligence process, a number of which have been reflected in the capital planning with the following remaining outstanding;
Base case capital buffer FY09 to FY11 1,200 1,000 800 600 400 200 0 FY08
FY09
B efo re DD adjustments
FY10
FY11
A fter DD adjustments
Source: JPM financials model v 9
Moderate stress capital buffer FY09 to FY11
900 800 700 600 500 400 300 200 100 0
-
Additional tax provisions of £10.3 million (one off adjustment);
-
FSCS costs (recurring cost estimated at £35 million FY08 and £20 million FY09); and
-
SLS interest costs (recurring cost estimated at £2.5 million FY08 and £30 million FY09)
z
No account has been taken of further, potentially material FSCS costs
FY08
FY09
B efo re DD adjustments
FY10
FY11
A fter DD adjustments
Source: JPM financials model v 9
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Executive summary
Overview of financials The current capital projections include a capital injection to mitigate
Combined capital buffer – base case
Combined capital buffer – moderate stress
1,200
900 800
1,000
the additional capital required of £74.4 million in the form of the fair value
700
800
600 500
600
400
adjustment at acquisition 400
300
This capital injection is designed to offer sufficient capital headroom in the
200
200
100
0
0
moderate stress scenario over the projection period
Source: JPM financials model v 9 Source: JPM financials model v 9
Key capital performance indicators FY08 Base case Risk weighted assets Equity Tier 1 ratio (%) Tier 1 ratio (%) Total capital ratio (%) Return on combined capital Moderate stress Risk weighted assets Equity Tier 1 ratio (%) Tier 1 ratio (%) Total capital ratio (%) Return on combined capital
Burgundy FY09 FY10
FY11
FY08
Claret FY09
FY10
FY11
FY08
Combined FY09 FY10
FY11
11,768 6.7% 9.4% 13.3%
9,994 9.2% 12.3% 17.1%
9,962 9.8% 13.0% 17.9%
9,880 10.7% 13.9% 18.9%
8,459 7.7% 8.4% 11.4%
9,164 7.4% 8.1% 10.9%
9,550 7.6% 8.2% 10.9%
10,102 7.7% 8.3% 10.8%
20,227 7.6% 9.5% 13.0% 12.2%
19,232 8.9% 10.8% 14.7% 12.8%
19,894 9.5% 11.4% 15.1% 19.5%
20,704 9.4% 11.2% 14.8% n/a
12,791 6.2% 8.6% 15.1%
11,614 7.6% 10.3% 19.9%
10,764 8.3% 11.2% 19.3%
10,061 9.4% 12.6% 20.1%
8,687 7.5% 8.2% 12.5%
10,513 6.2% 6.8% 11.9%
11,113 6.1% 6.6% 11.5%
10,713 6.6% 7.2% 12.3%
20,227 7.6% 9.5% 12.7% 7.4%
22,249 7.5% 9.1% 13.2% 7.9%
22,744 7.9% 9.6% 12.2% 17.1%
22,467 8.2% 9.9% 12.7% n/a
Source: JPM financials model
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Treasury Select Committee - Project Verde
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Executive summary
Next steps FSA discussions
z
Now the combined capital projections have been agreed, negotiations need to be completed with the FSA to ensure all the mitigant and assumptions used in the projections will be acceptable
Burgundy forecasting
z
Burgundy is to undergo a more rigorous, bottom up forecasting exercise
z
Once this process is completed (early to mid January), the updated forecasts should be input to the JPM model to ensure that the capital buffer currently being shown is not eroded
Burgundy ICAAP
z
We understand that Burgundy management is currently in the process of completing another ICAAP
z
We would recommend that this process is completed based on a full bottom up process and includes getting approval from the FSA for the management actions, model and assumption changes incorporated into these capital projections
z
Following approval of the ICAAP process, the new approved risk weights should be updated in the JPM model to ensure that the capital buffer currently being shown is not eroded
z
Work on a joint ICAAP position should be started following any announcement to ensure that the capital requirements day one are in line with the high level capital modelling done as part of this exercise
Joint ICAAP
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Treasury Select Committee - Project Verde
Private & confidential
Contents
Introduction Executive summary Basis of preparation z Capital and financial modeling z Sources of data and key assumptions
Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Basis of preparation
Capital and financial modelling Inputs Inputs
The diagram opposite
Transaction adjustments adjustments Transaction
Outputs Outputs
Vintage business business case case Vintage
gives an overview of the process used to complete
Fair Fair valuation valuation •• Burgundy Burgundy balance balance sheet sheet
the combined financial and capital model for Vintage The areas with a page number are areas KPMG has covered as a part of the various work streams
Burgundy Burgundy standalone standalone • Strategic Plan ‘Light’ • Strategic Plan ‘Light’ Base Base Moderate Moderate stress stress
• • • •
P15 P29
•• ‘Temporary’ ‘Temporary’ vs vs ‘permanent’ ‘permanent’ adjustments adjustments •• Unwind P24 Unwind profile profile
each of these areas and
Burgundy Burgundy adjustments adjustments •• Solo / Lehman Solo / Lehman // Pension Pension // TOMS TOMS
their impact on capital in
•• PIBS PIBS
on Project Vintage, and comment is included on
Operational Operational Risks Risks
Governance Governance Risks Risks
Proforma Proforma bank bank model model
Financial Financial Risks Risks
this report
Reputational Reputational Risks Risks
For the purpose of this
Synergies Synergies Cost // Revenue Revenue •• Cost
paper, we have ignored the deemed purchase
Integration costs costs •• Integration
consideration, as the
P22
difference between consideration and the aggregate of assets and liabilities at fair value represented by goodwill, as this is neutral for capital purposes
KPMG KPMG DD DD findings findings Claret Claret standalone standalone • Strategic Plan • Strategic Plan • • • •
P36
Base Base Moderate Moderate stress stress
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Basis of preparation
Sources of data and key assumptions Strategic Plan Light
Capital planning (continued)
z
The base case projections have been based on the forecast income statement and balance sheets from the ‘Strategic Plan Light’ prepared by Burgundy for the purposes of their current capital planning (FSA FST)
z
Burgundy considers that the resultant ICAAP risk weights were overly prudent, a view with which Claret management agree and current experience within Burgundy’s loan portfolios confirms this
z
This was completed as a top down exercise whereby management agreed the following key principles;
z
-
the split of prime to non-prime lending should move towards prime;
-
more retail borrowing would be sought with rates being increased to achieve this where necessary;
-
the liquidity currently held would remain static over the projection period, thereby leading to an overall reduction in wholesale funding as the retail funding increased;
Burgundy’s FSA FST submission has been fully modelled (i.e. a complete bottom up process was used rather than top down and high level); however, it included assumptions surrounding model and assumption changes that have not yet been agreed with the FSA. It also included FSD and HPI assumptions below the minimum set by the FSA in their recent communiqué on capital modelling
z
-
balance sheet shrinkage would be tolerated in the earlier years of the plan if necessary;
-
interest margin should improve over the projection period, which would imply an increase in the margin on new prime mortgage lending; and
As the ICAAP numbers are felt to be too prudent, and the FSA FST now out of line with the requirements of the FSA, Burgundy and Claret management have agreed a set of assumptions that will be used to give a ‘most realistic’ outcome in a base case and moderate stress environment for Burgundy. It is this version of assumptions that has been analysed as part of this report
uncertainty in the market
z
-
the cost income ratio should improve over the projection period
and the change that will
z
Management of the three main lending areas (Member Business, Platform and BTS) provided redemption and origination plans for each area based on the high level principles noted above. These were then used as a basis for the balance sheet and income statements
We understand that the Strategic Plan Light and the capital planning exercise, whilst they have not be formally adopted by the Board of Burgundy, have been agreed by each executive director of Burgundy
z
More detailed assumptions underpinning the Strategic Plan Light are commented on in the next section of this report; however, we note that in view of the timing of the exercise, certain key circumstances have not been considered as yet;
Burgundy’s financial and capital planning has been necessarily top down in nature and high level. We would recommend that Burgundy complete a full Strategic Planning exercise including full capital planning which we understand they are completing throughout January. At this stage, given the level of
occur between now and any potential acquisition date, the Strategic plan light is considered adequate for this exercise -
the impact on the plans of a low base rate environment;
Key fair value
-
the Government Guarantee Scheme to customers in mortgage arrears; and
assumptions are the
-
the recent consultation paper on bank liquidity requirements
subject of a separate
Capital planning
KPMG report and are
z
The FSA, as part of the Government Guarantee Scheme, insisted that banks and building societies submit their capital projections for 2009 based on their current agreed risk weights (i.e. their ICAAP numbers)
z
Burgundy’s ICAAP was agreed by the FSA following a period of ‘overnight’ requests from the FSA to show differing stress scenarios which, given the notice given to complete them, were necessarily top down and high level. At the time, Burgundy management was not aware that the FSA was considering these stress scenarios as part of Burgundy's official ICAAP submission
summarised in the Fair Value section of this report
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Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ z Overview of financials z Key balance sheet assumptions z Key income statement assumptions z Impairment assumptions
Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings
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Burgundy strategic plan ‘light’
Overview of financials – base case The base case assumes a
Income statement - Base case scenario
slight reduction in overall
£ million
balance sheet throughout FY09 and FY10 before returning to balance sheet growth in FY11 Income increases over the period due to overall balance sheet growth and increasing margins. This could be difficult to
FY09
FY10
FY11
FY12
CAGR
Income E xpenses B ad debt P BT (pre capital) Capital cost P BT (post capital)
387.0 (225.7) (75.0) 86.3 86.3
391.7 (218.3) (65.1) 108.2 108.2
406 .8 (215 .6) (38 .4) 152 .8 152 .8
432.0 (218.3) (23.2) 190.6 190.6
B MR P BT (post BMR) Tax P AT Cost/income ratio Cost/asset ratio
(20.0) 66.3 (19.2) 47.1 (58.3%) (0.63%)
(30.0) 78.2 (22.7) 55.6 (5 5.7%) (0 .64%)
(40 .0) 112 .8 (32 .7) 80 .1 (53.0%) (0.64%)
(50.0) 140.6 (40.8) 99.8 (50.5%) (0.63%)
3.7% (1.1%) (32.3%) 30.2% n/a 30.2% 35.7%
FY08
FY09
FY10
FY11
FY12
CAGR
85 236
85 236
85 236
85 236
85 236
120 20,372 3,793 2,058 8,310 639 35,613
406 19,219 3,776 1,852 7,810 639 34,023
646 19,438 3,728 1,789 7,310 639 33,870
888 20,415 3,680 1,575 7,310 639 34,829
1,104 21,859 3,632 1,540 7,310 639 36,405
74.3% 1.8% (1.1%) (7.0%) (3.2%) 0.6%
Retail Funds Whole sale Noteholder funds O ther Liabilities S ubordinated Liabilities
18,250 11,337 3,570 506 546
19,198 9,814 2,507 506 546
20,317 8,971 2,023 506 546
21,637 9,064 1,490 506 546
23,159 9,434 1,073 506 546
6.1% (4.5%) (26.0%) -
S ubscribed Capital G eneral Reserve
296 1,109 35,613
296 1,156 34,023
296 1,211 33,870
296 1,291 34,829
296 1,391 36,405
5.8% 0.6%
28.5% 28.5% 28.5%
Increased income is achieved through both balance growth over the projection period (CAGR of 1.8%) and through improving margins
Bad debt expenses are assumed to fall in the base case from a peak of £75 million in FY09. As previously report, we believe that this is challenging and losses are likely to be closer to those shown in the moderate stress
achieve in a low rate environment As discussed in our due diligence findings, we believe Burgundy’s impairment assumptions are challenging and may not be achievable in the short term. The impact of the government scheme to support customers in arrears has not yet been modelled Additionally, the impact of the FSCS is not yet included
Balance sheet - Base case scenario £ million Assets Fixed assets Intangible assets Investme nt properties Residential mortgages Commercial loans MBS / ABS Li quid assets O ther assets Liabilitie s
Investment properties are assumed to grow significantly as Illius takes on more possessed properties
Mortgage growth is kept minimal, even showing slight shrinkage in the early years, as the effects of moving to more prime borrowers slows the pace of lending
Liquid assets fall slightly over the projection period; however, the main falls in Treasury assets are the higher risk ABS / MBS portfolios No new securitisation is assumed in the projections and the note holder funds diminish accordingly. Additional retail funding is assumed with the balance reducing the wholesale borrowing
Source: JPM financials model v 9
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Burgundy strategic plan ‘light’
Overview of financials – moderate stress The key differences in the stress scenario are the increases in bad debt, a reduction in redemptions and no new lending at all Management also assumes that more drastic cost cutting is achieved including the reduction of the BMR paid to customers The impact on the balance sheet is reflected through a larger reduction in wholesale borrowing with liquidity levels and retail levels being assumed to remain as per the base case
Income statement - Moderate stress scenario £ million Income
FY09 384.1
FY10 372.3
FY11 361 .0
FY12 357.8
E xpenses B ad debt P BT (pre capital) Capital cost P BT (post capital) B MR
(223.8) (131.8) 28.4 28.4 (10.0)
(203.4) (130.9) 38.0 38.0 (10.0)
(182 .3) (82 .2) 96 .5 96 .5 (25 .0)
(171.3) (39.6) 146.9 146.9 (35.0)
P BT (post BMR) Tax P AT Cost/income ratio Cost/asset ratio
18.4 (5.3) 13.1 (58.3%) (0.63%)
28.0 (8.1) 19.9 (5 4.6%) (0 .61%)
71 .5 (20 .7) 50 .8 (50.5%) (0.58%)
111.9 (32.4) 79.4 (47.9%) (0.57%)
FY08
FY09
FY10
FY11
FY12
85 236 124
85 236 395
85 236 616
85 236 880
85 236 1,081
20,333 3,775 2,058 8,310 639 35,561
18,741 3,715 1,852 7,810 639 33,474
16,877 3,655 1,789 7,310 639 31,208
15,542 3,585 1,575 7,310 639 29,853
14,664 3,515 1,540 7,310 639 29,070
Retail Funds Whole sale Noteholder funds O ther Liabilities S ubordinated Liabilities S ubscribed Capital
18,250 11,285 3,570 506 546 296
19,198 8,979 2,827 506 546 296
20,317 6,051 2,350 506 546 296
21,637 3,863 1,813 506 546 296
23,159 2,047 1,245 506 546 296
G eneral Reserve
1,109 35,561
1,122 33,474
1,142 31,208
1,192 29,853
1,272 29,070
CAGR (2.3%) (8.5%) (33.0%) 72.8% n/a 72.8% 51.8% 82.4% 82.4% 82.4%
Balance sheet - Moderate stress scenario £ million Assets Fixed assets Intangible assets Investme nt properties Residential mortgages Commercial loans MBS / ABS Li quid assets O ther assets
CAGR 71.7% (7.8%) (1.8%) (7.0%) (3.2%) (4.9%)
Liabilitie s
Source: JPM financials model v 9
6.1% (34.7%) (23.2%) 3.5% (4.9%)
Income in the moderate stress reduces due to the shrinkage in the residential lending over the projection period (CAGR (7.8%)). This is offset by increasing margins The bad debt expense in the moderate stress is more in line with our view of the actual bad debt that could be experienced in the portfolios. These assume a significant recession in FY09 and FY10 with a recovery from FY11 onwards Investment properties again increase significantly in the moderate stress; however, at a slightly slower rate to that in the base case. This is due to value of repossessed properties falling over the period leading to a lower overall balance sheet amount A significant fall in residential mortgage lending is assumed in the moderate stress. This is achieved by stopping new lending and allowing the book to run-off Similar assumptions are made on the reduction of MBS / ABS as is seen in the base case. This appears counter-intuitive as we would expect the underlying assets in the MBS / ABS to perform worse in a stress scenario leading to increased losses and reduced valuation; however, management believe they are prudent enough in the base case. Any additional reduction would not be considered material As with the base case, the retail liabilities are assumed to grow at a CAGR of 6.1%. The note holder funds reduce at a slower rate than in the base case as mortgage assets take longer to run-off and the balancing figure is taken through a reduction in wholesale funding
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Treasury Select Committee - Project Verde
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Burgundy strategic plan ‘light’
Key asset assumptions The residential and
Key mortgage asset assumptions
Mortgage asset projections – base case
commercial lending 30,000
numbers in the Strategic
25,000
Plan Light that have been
20,000
based on a ‘bottom up’ approach
£ million
numbers are the only
z
Overall, the base case shows an assumption of the balance sheet reduction in the early years with a slight recovery of growth in FY11 an FY12. This is consistent with the overall assumption that the market hits the bottom of the cycle in late FY09 or early FY10
z
In the moderate stress, management has assumed that the balance sheet retraction continues throughout the projection period
z
Burgundy has assumed that the mix between prime and non-conforming would improve with the mix of prime versus other lending assets moving from 49.0% in FY08 to 65.9% in FY12 in the base case. This ratio movement is less marked in the moderate stress (49.1% to 59.5%) due to the lower ration of new lending to redemptions assumed in this case
z
As noted as part of our financial die diligence, management has tightened the criteria under which they will lend (now more closely aligned to that shown in Claret) and this will enable the gradual move from sub-prime to prime to be achieved
z
In both cases, the commercial book is assumed to remain relatively constant as management continue with the strategy to only lend small amounts to current clients in the base case and complete no new lending in the moderate stress
10,000
-
towards more prime
As noted earlier, the residential and commercial lending numbers are the only numbers in the Strategic Plan Light that have been based on a ‘bottom up’ approach, with each of the three separate areas of the business providing the central finance function with their plans over the forecast period
15,000
5,000
The mix of assets moves
z
FY08
assets as the impact of the
FY09
FY10
FY11
FY12
changes in lending criteria Prime
take effect. The gradual
Buy-t o-let
Self cert
Sub-prime
Com mercial
change is effected through the slow redemption of certain portfolios and limited new advances in
Source: JPM financials model
Mortgage asset projections – moderate stress
prime assets 30,000
new lending is assumed
25,000
after FY09
20,000
£ million
In the moderate stress, no
Redemption rates B ase Case Moderate stress
15,000 10,000 5,000
Prime
FY09
Buy-t o-let
FY10
Self cert
FY11
Sub-prime
FY09
FY10
FY11
FY12
12.2% 16.9% 8.2% 12.8%
14.4% 13.7% 12.1% 12.9%
14.4% 12.4% 10.1% 13.0%
11.9% 17.2% 22.7% 10.8%
The reason BCIG has relatively stable redemptions is that circa £1.3 billion of mortgages are due come off their teaser rate in the second half of FY09 and management believes that a number of these will re-mortgage with other lenders as they will be prime or near-prime borrowers
z
New advances are assumed to be minimal in the base case (up to £349 million) and no new advances are assumed in the moderate stress following FY09. The balance between advances and redemptions have been addressed following earlier discussions with management to a level which is felt more reasonable
z
Detail of the advances and redemptions assumptions can be seen in appendix 1
FY12
Com mercial
FY08 11.3% 23.6% 11.3% 23.6%
z
FY08
Platform BTS Platform BTS
Source: JPM financials model
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Burgundy strategic plan ‘light’
Key liability assumptions The key assumption on the
Key liability assumptions
Liability projections – base case
liabilities side of the balance sheet is that surrounding the level of retail funding This is assumed to grow over the projection period at a CAGR of 6.1% in both the base case and
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY08
moderate stress Of the £4.9 billion of
Retail
FY09 Wholesale
FY10 Not e holder
FY11 Other
FY12
The most significant assumption on the liabilities side of the balance sheet is the growth of retail funding of Burgundy. The resultant retail funds are then used to wholesale funding
z
In the base case, the retail funds are assumed to grow over the period by 26.9% (CAGR of 6.1%). The leads to an increase in the level of retail funding from 51.2% to 63.6%. This increase was agreed by management as an inspirational target behind which, detailed plans are not currently in place
z
In the moderate stress, this assumption remains constant; however, as the level of wholesale funds is significantly reduced (as the balance sheet is smaller) it leads to an increase in the retail funding ratio from 51.3% to 79.7%
z
The level of retail funds increases being assumed are not significant given the fact that of the £4.9 billion assumed over the whole period, using the average interest rate of 3% (FY07 average 4.3%), £2.4 billion would be achieved through accrued interest alone as long as depositors were retained
z
Management has stated that, if it were needed, they are prepared to increase rates in order to attract the correct levels of retail funds to meet this target. If rates were raised to attract new retail funding, this would impact on the interest margin and could act as a barrier to achieving the margin improvement noted below
z
The note holder funds reduce at a CAGR of (26.0%) in the base case and (23.2%) in the moderate stress. This reflects the repayment of mortgage backed securities as the securitisation vehicles run off. No new securitisation is assumed. The reduced run off of note holders in the moderate stress reflects the slower redemptions experienced in this scenario
z
The liquidity levels remain relatively stable throughout the projection period. Management has decided that they wish to maintain their liquidity positions at this constant level and the cost of funding this level of liquidity has been factored into the interest margin assumptions
z
Based on the retail funding assumption, and the decision that management wishes to maintain its liquidity position over the projection period, the balancing number becomes a reduction to the wholesale funding
Reserves
growth, circa £2.4 billion could be achieved through
z
Source: JPM financials model
accrued interest if Burgundy is able to retain
Liabilities projections – moderate stress
current depositors 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY08 Retail
FY09 Wholesale
FY10 Note holder
FY11 Other
FY12 Reserves
Source: JPM financials model
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Burgundy strategic plan ‘light’ Income statement assumptions Management has assumed
Key interest margin assumptions
Net interest margin projections
z
Management have assumed an increasing interest margin over both the base case and the moderate stress. No detailed margin analysis by product has been completed in coming to these margin assumptions
z
Since FY05, Burgundy’s margin per its published financial data has been falling (1.05% in FY05; 0.98% in FY06 and 0.88% in FY07). This trend, however, was reversed in the first half of FY08 with the interim statements showing margin increasing to 0.94%
z
Both scenarios start with a margin of 0.97% (i.e. above the rate currently being experienced) and gradually increase to 1.02% in both scenarios. These increases do not appear to be aggressive given the current experience of Burgundy; however, when coupled with the planned significant growth in retail funding, this could be more difficult to achieve
z
Burgundy management has reviewed the lower margin products and believe that the 2006/07 lower margin products should have rolled onto improved margin products by the end of 2009 / early 2010
z
Dependent on the levels of Government capital, or any increases in funding costs due to the recent down-grading, the funding costs of Burgundy could increase and squeeze this margin increase
z
Overall, the levels assumed are not inconsistent with the movements seen in the market; however, we would recommend a detailed margin review be completed as part of a more detailed strategic planning process
400
margin over both the base case and the moderate analysis by product has been completed in coming
300 £ millions
stress. No detailed margin
1.03% 1.02% 1.01% 1.00% 0.99% 0.98% 0.97% 0.96% 0.95% 0.94% 0.93%
350 250 200 150 100
to these margin
50
assumptions
FY09
Burgundy’s margins have been falling since FY05;
FY10
FY11
% margin
an increasing interest
FY12
Base case
M oderate st ress
Base case
M oderate st ress
however, they did show a recovery in H1 FY08 to below the projected start point of 0.97% in the base
Source: JPM financials model v 9
Cost base projections
case and moderate stress
Key cost assumptions 70.0%
250
scenarios
the worst performers in the top ten building societies in terms of cost : income ratios and cost : asset ratios. This
50.0% £ millions
Burgundy has been one of
z
The assumption has been to improve the cost / asset ratio over the projections period. This has been done at a holistic level as apposed to detailed bottom review of costs. Overall, the costs / asset ratio improves from 0. 66% to 0. 60% over the forecast period
z
This has been justified on the basis that significant savings have been made in FY08 and whilst savings of this level are not assumed to continue going forward, management believe significant further savings can be made
z
Comparing Burgundy's cost ratios to is peer group in the Building Society sector, they have been the least efficient of the top five Building Societies in terms of cost : income ratio (67.6% in FY07) and second worst in terms of cost : assets ratio (0.74% in FY07). This suggests that further cost savings could be achieved
z
Additionally, management inform us that other large cost savings could be achieved if more radical action were to be taken such as;
60.0%
200 150
40.0%
100
30.0% 20.0%
50
Cost:Income ratio
0.94%. This is slightly
10.0%
-
FY09
FY10
FY11
FY12
suggests that the cost reductions assumed by management could be
Base case
M oderate stress
-
Move Platform from London to a lower cost area
Base case
M oderate stress
-
Reduction in overall number of sites (i.e. combine Bristol site into Head Office)
-
Close Platform to new lending and reduce cost base to a minimum level which would still allow them to re-enter the market at a later date
z
We have checked with Claret management to ensure that there are no duplication of cost assumptions between the Strategic Plan Light and the synergies work stream
achievable Source: JPM financials model v 9
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Burgundy strategic plan ‘light’ Impairment assumptions KPMG impairment projections
The loan impairment numbers remain at a level
18.0
predicted by Burgundy
16.0 14.0
the due diligence process
12.0
8.0
Base Source:
Dec-12
Oct-12
Nov-12
Sep-12
Jul-12
Aug-12
Jun-12
Apr-12
May-12
Mar-12
Jan-12
Feb-12
Dec-11
Oct-11
Nov-11
Sep-11
Jul-11
Aug-11
Jun-11
Apr-11
M ay-11
Mar-11
Jan-11
Feb-11
Dec-10
Oct-10
Nov-10
Sep-10
Jul-10
Aug-10
Jun-10
Apr-10
M ay-10
Mar-10
Jan-10
Feb-10
Dec-09
Oct-09
Nov-09
Sep-09
Jul-09
Aug-09
Jun-09
Apr-09
May-09
M ar-09
Jan-09
0.0 Feb-09
2.0
2009, are low
Sep-08
4.0
projections, at least for
Dec-08
6.0
believe that these
Oct-08
diligence report, we
10.0
Nov-08
As discussed in the due
£ million
and discussed as part of
Stress
KPMG analysis
Key impairment assumptions
Key impairment assumptions
z
The loan impairment numbers remain at a level predicted by Burgundy and discussed as part of the due diligence process as detailed opposite
z
z
As discussed in the due diligence report, we believe that these projections, at least for 2009, are challenging. Accordingly, we have extrapolated forward the level of possessions experienced in the BTS and Platform books for the 12 month period to August FY08. For our purposes, we assume losses will peak in June 2009 in the base case and in October 2009 in the moderate stress scenario
Burgundy’s current projections are based on a significant expansion of the Illius scheme (to just over £1 billion of assets by FY12) which has a significant impact on losses via the reduction in FSD experienced
z
Currently Burgundy are behind plan on the numbers of properties entering the scheme and were this to continue, less benefit would be felt. Additionally, the impact of the Government Guarantee Scheme to those in arrears could significantly impact the number of properties going into possession in the next couple of years
z
The FVA’s will take into account an element of the these losses (via the credit adjustment) as will the severity of the losses in the moderate stress case
z
Projecting these levels of possessions forwards and assuming a CAGR in the level of loss experienced by case, the loss levels shown in the diagram above were calculated. This equates to the numbers shown in the table opposite. These are considered on the prudent side as;
-
Each of these scenarios have been run based on extrapolating FY08 experience, and hence do not take into account the projected growth of Illius (see below); and
£ million B ase case Moderate stress
-
Equally, no impacts of any of the management actions have been taken into account (i.e. Illius on FSD’s, the Loss Recovery Group etc) other than the fact that this would have impacted the loss rates in the last four months (albeit only to a minimal degree)
£ million
No commercial loan losses have been included although we note that the Woolworths and MFI losses will feed through via the opening reserves
B ase case Moderate stress
z
Burgundy impairment projections FY09 75 .0 131 .8
FY10 65.1 130.9
FY11 38.4 82.2
FY12 23.2 39.6
FY09
FY10
FY11
FY12
104 .7 132 .3
119.5 189.3
91.3 152.5
54.1 119.7
KPMG impairment projections
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Source: KPMG analysis
21
Treasury Select Committee - Project Verde
Private & confidential
Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Private & confidential
Synergies Overview of synergy savings Synergy value £m
This page shows the
Updated KPMG Assessment
Rationale for Assessment
10.9
Achievable
Synergies reduced from £11.9 million for all years to reflect 5 months delay to the level three FTE savings and £1 million reduction pa
6.0
6.0
Achievable
Synergies reduced to 5% in years 1-3 and 15% in years 4-5
6.8
6.8
6.8
Uncertain
Further work needs to be performed to validate the in-scope cost base, but we are comfortable with the 10% assumption
1.4
1.4
3.8
3.8
Challenging
No adjustment to V1 base case. 40% reduction appear challenging as this does not reflect reductions in channels
-
3.5
3.5
3.5
3.5
Achievable
No adjustment to V1 base case. Assumed savings in line with reduced governance structures
Training (staff and suppliers)
2.5
2.5
2.5
2.5
2.5
Undemanding
No adjustment to V1 base case
HR (staff)
0.8
1.7
3.3
5.0
5.0
Undemanding
No adjustment to V1 base case
Branch (staff and occupancy)
-
0.2
0.2
1.8
3.6
Undemanding
Already undemanding synergies reduced further in early years. Separate analysis suggests £10m+ p.a. may be achievable
Mortgages (staff and systems)
-
2.3
2.6
2.6
2.6
Achievable
No adjustment to V1 base case
0.8
1.6
2.4
2.4
2.4
Achievable
No adjustment to V1 base case. See comments in respect of synergy number 6
-
-
-
2.4
2.4
Undemanding
Slight adjustment to V1 base case (year 3 synergy deleted to align to EP). Achievable through attrition along given current market conditions
Finance (staff)
0.5
0.9
1.4
1.9
1.9
Challenging
No adjustments to V1 base case but £2.2 million of costs found to be potentially out of scope, and c.27% saving now assumed
IS savings
0.8
2.9
7.2
10.0
10.0
Achievable
Added in V2. Appears reasonable
Cost avoidance
2.5
2.5
2.4
2.4
2.4
Achievable
Not reviewed but includes Burgundy internet development in years 1,2 and Claret third site costs for years 3-5
-
5.2
5.0
6.0
6.0
Mix
Includes all other synergies plus adjusting staff costs to half year savings in year 1. Note that this includes many ‘undemanding’ Customer functions
24
45
52
68
70
Description
1
2
3
4
5
Leadership (top three tiers: staff)
6.8
10.9
10.9
10.9
Marketing (suppliers)
2.0
2.0
2.0
Service Contracts (suppliers)
6.8
6.8
Sales Support (staff and suppliers)
-
Governance and Fees (suppliers)
overview of the synergy savings calculated as part of the synergy work stream and reported on by KPMG on 3 November 2008. This version has been used to populate the JPM combined capital model The V2 low case for synergies incorporated much of the feedback received on V1 and seeks to de-risk synergies in years 1 and 2 All areas of the synergy assessment V2 are now
Marketing (staff)
either achievable or undemanding with the
Contact centre (staff)
exception of sales support staff and finance staff reductions which are challenging
Others (sub £1 million pa opportunities) V2 Low case totals
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Private & confidential
Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments z Overview of fair value adjustments z Comparison of key assumptions to capital
Burgundy stand alone capital Due diligence findings
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Project Vintage
Burgundy summary balance sheet as at 31 October 2008 Summary Burgundy
Summary of Burgundy FV adjustments as at 31 October 2008 FVAs: Statutory basis
proposed FVAs and capital treatment
FVAs: Disregarded for capital purposes
FVAs: Regulatory capital
£m
£m
Deferred Gross £m
tax £m
Net £m
Assets Loans & advances to customers Interest rate & EIR FV adjts
(164)
46
(118)
-
(118)
Credit risk
(366)
102
(264)
-
(264)
(311)
87
(224)
-
(224)
Other change in hedging adjts Invt securities L&R (formerly in AFS) Existing valuation
203
(57)
146
-
146
Revision to DCF basis
(580)
162
(418)
-
(418)
AFS Reserve
(137)
-
(137)
-
(137)
(61)
17
(44)
-
(44)
20
(6)
14
-
14 0
Counterparty risk AFS investments Goodw ill
(195)
37
(158)
158
-
-
-
-
-
125
(35)
90
(90)
-
PP&E
10
(3)
7
-
7
Cashflow hedging
(18)
-
(18)
-
(18)
(1,474)
352
(1,122)
68
(1,054)
Non-core retail deposits
(84)
24
(60)
-
(60)
Deposits from banks
11
(3)
8
-
8
Other deposits
(19)
5
(14)
-
(14) 897
Intangibles Core deposit intangible
Liabilities
Debt securities
1,246
(349)
897
-
-
-
-
-
-
162
(45)
117
-
117
45
(13)
32
-
32
1,361
(381)
980
-
980
Contingent liabilities Subordinated liabilities Subscribed capital
Source: Burgundy Management
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Private & confidential
Fair value adjustments Comparison of key assumptions with capital FVA and capital modelling assumptions Whilst the capital modeling exercise for the combined entity is ongoing, to a certain extent the assumptions underpinning the FVAs may be consistent with or overlap those assumptions applied in the capital modeling exercise. We have considered below the extent to which assumptions are applied consistently for each of the FVA adjustments below BS caption
Loans & Receivables
Assumptions: FVAs vs capital modelling August 2008 FVA exercise
October 2008 FVA exercise
For the August exercise, Burgundy has:
Relationship between FVA and capital modelling assumptions consistent with August exercise
z
Taken Lifetime EL to be a proxy for determining the element of the FVA required to reflect the fact that credit spreads have moved; and
z
Modelled portfolio run off profiles by reference to EIR models that are retrospective and based on Burgundy experience to the date of calculation
FVA (£612m)
Assumptions are consistent for FVA and capital modelling in respect of EL. We understand that the 12 month EL start point for the Lifetime EL extrapolation is between Burgundy’s Base and Moderate case for capital modelling purposes on a standalone basis Assumptions are inconsistent for FVA and capital modelling purposes in respect of redemption profiles. Whilst application of EIR for FVA purposes is retrospective, capital modelling requires application of redemption profiles that are prospective in nature, respond to changing market conditions and are applicable to both new lending and assets on balance sheet at date of transaction Loans and receivables (formerly AFS)
Based on the FVA methodology applied at August 2008, FVA and capital modelling assumptions are consistent; current market values are applied to determine revised balance sheet carrying amounts
Relationship between FVA and capital modelling assumptions consistent with August exercise
Based on the FVA methodology applied at August 2008, FVA and capital modelling assumptions are consistent; current market values are applied to determine revised balance sheet carrying amounts
Relationship between FVA and capital modelling assumptions consistent with August exercise
FVA (£438m) Investment securities – AFS / AFS Reserve FVA £20m
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Fair value adjustments Comparison of key assumptions with capital (continued) BS caption
Goodwill and intangible assets
Assumptions: FVAs vs capital modelling August 2008 FVA exercise
October 2008 FVA exercise
Goodwill and intangible assets are irrelevant for capital modelling purposes
Relationship between FVA and capital modelling assumptions consistent with August exercise
Consistent assumptions apply for both FVA and capital modelling purposes
Relationship between FVA and capital modelling assumptions consistent with August exercise
In accordance with IFRS 3, a full actuarial valuation is required to determine the actual FVA at transaction date. The proposed FVA of £26.0m adjusts the retirement benefit asset of £45.0m as at 31 December 2007 to an asset of £19.0m reflecting Claret Group’s assumption basis in accordance with IAS 19
Relationship between FVA and capital modelling assumptions consistent with August exercise
FVA (£195m) and £125m PPE FVA £10m Retirement benefits FVA (£26m)
The retirement benefit funding deficit drives the capital requirement that is driven by:
Shares FVA (£84m)
Deposits from banks FVA (£11m)
1.
Burgundy’s funding obligation in excess of normal contribution levels for the next five years (Pillar 1); plus
2.
Any amount set aside for volatility associated with the pension obligation (Pillar 2)
FVA determined by reference to a DCF exercise based on the balance sheet carrying amount as at 31 August; no future growth assumptions applied. The capital model assumes that retail deposit balances will grow into the future. The result is disconnect between assumptions applying for FVA and capital purposes
Relationship between FVA and capital modelling assumptions consistent with August exercise
No FVA proposed though we note that in the event of an interest rate change close to the date of transfer, the FVA could be material even though the maturity period is short. Consistent FVA and capital modelling assumptions therefore apply
Relationship between FVA and capital modelling assumptions consistent with August exercise
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Fair value adjustments Comparison of key assumptions with capital (continued) BS caption
Other deposits FVA £19m
Debt securities in issue – Member business
Assumptions: FVAs vs capital modelling August 2008 FVA exercise
October 2008 FVA exercise
The £19m FVA increase to liabilities reflects the adjustment to retail deposits in Britannia International. The FVA is calculated in accordance with adjustment to Shares set out above.
Relationship between FVA and capital modelling assumptions consistent with August exercise
Based on the FVA methodology applied at August 2008, FVA and capital modelling assumptions are consistent; current market values are applied to determine revised balance sheet carrying amounts.
Relationship between FVA and capital modelling assumptions consistent with August exercise
Based on the FVA methodology applied at August 2008, FVA and capital modelling assumptions are consistent; current market values are applied to determine revised balance sheet carrying amounts.
Relationship between FVA and capital modelling assumptions consistent with August exercise
Consistent treatment for FVA and capital modelling purposes
Relationship between FVA and capital modelling assumptions consistent with August exercise
Based on the FVA methodology applied at August 2008, FVA and capital modelling assumptions are consistent; current market values are applied to determine revised balance sheet carrying amounts
Relationship between FVA and capital modelling assumptions consistent with August exercise
FVA (£57m) Debt securities in issue – Leen Notes FVA (£1,189m) Contingent liabilities FVA £nil Subordinated liabilities and subscribed capital FVA (£207m)
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Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital z Summary capital calculations z Base case and moderate stress capital bridges z Key capital assumptions z Resultant risk weights
Due diligence findings
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Burgundy stand alone capital Summary capital calculations The tables opposite show
Summary capital position - base case
the aggregation of Burgundy and Claret capital positions and the transaction adjustments to get to the closing FY08 capital position
Equity Tier 1 Tier 1 Regulatory capital available Total capital required Capital buffer (£m)
Claret 648.2 708.2 964.2 838.0 126.2
Burgundy 793.2 1,107.2 1,563.5 1,392.6 170.8
Combined 1,441.4 1,815.4 2,527.7 2,230.6 297.1
RWAs (£m) Equity Tier 1 ratio (%) Tier 1 ratio (%) Total capital ratio (%)
8,459 7.7% 8.4% 11.4%
11,768 6.7% 9.4% 13.3%
20,227 7.1% 9.0% 12.5%
FVA Non-credit 94.1 94.1 94.1 94.1
Transaction adjustments FVA Ineligible Credit Mitigants capital (168.5) 175.0 (168.5) 175.0 (168.5) 175.0 (185.0) (168.5) 360.0 -
FY08
FY09
FY10
FY11
1,541.9 1,915.9 2,628.2 2,045.6 582.6
1,707.7 2,081.7 2,820.8 1,872.6 948.1
1,885.6 2,259.6 3,005.4 1,933.7 1,071.7
1,938.3 2,312.3 3,064.8 2,007.9 1,056.8
20,227 7.6% 9.5% 13.0%
19,232 8.9% 10.8% 14.7%
19,894 9.5% 11.4% 15.1%
20,704 9.4% 11.2% 14.8%
Using these, the strategic plans, agreed risk weights and the FVA unwind profile, the capital position is then forecast over the projection period The realisation of the Burgundy mitigants against capital
Source: JPM financials model
The first step in the process has been to take the two stand alone capital calculations and adjust these for agreed synergy savings, additional stand alone capital etc. These are then combined to get pre-transaction adjustment capital
The transaction adjustments are then applied based on the work completed by the FVA work stream. These are split between the credit and non-credit FVAs,
The mitigants relating to Burgundy include the sale of Britsafe (£35 million); dividends from BINT (£18 million); £42 million in model changes due to Illius and removal of the Op Risk and IRB add on totalling £60 million. There is also an injection of capital from Claret group of £175 million assumed
This then gives a closing FY08 position and the forecasts are projected using the underlying strategic plans, risk weights and FVA unwind profiles
requirements of £155 million is not certain and subject to agreement by
Summary capital position - moderate stress
the FSA Equity Tier 1 Tier 1 Regulatory capital available Total capital required Capital buffer (£m)
Claret 648.2 708.2 964.2 838.0 126.2
Burgundy 793.2 1,107.2 1,563.5 1,392.6 170.8
Combined 1,441.4 1,815.4 2,527.7 2,230.6 297.1
RWAs (£m) Equity Tier 1 ratio (%) Tier 1 ratio (%) Total capital ratio (%)
8,459 7.7% 8.4% 11.4%
11,768 6.7% 9.4% 13.3%
20,227 7.1% 9.0% 12.5%
FVA Non-credit 94.1 94.1 94.1 94.1
Transaction adjustments FVA Ineligible Credit Mitigants capital (168.5) 175.0 (168.5) 175.0 (168.5) 175.0 (185.0) (168.5) 360.0 -
FY08
FY09
FY10
FY11
1,541.9 1,915.9 2,628.2 2,045.6 582.6
1,659.8 2,033.8 2,738.3 2,171.4 566.9
1,802.3 2,176.3 2,881.8 2,207.5 674.3
1,851.4 2,225.4 2,942.7 2,173.7 769.0
20,227 7.6% 9.5% 13.0%
22,249 7.5% 9.1% 12.3%
22,744 7.9% 9.6% 12.7%
22,467 8.2% 9.9% 13.1%
Source: JPM financials model
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Burgundy stand alone capital Base case and moderate stress capital bridges The new risk weights have
Moderate stress case capital buffer bridge 2008 to 2011
Base case capital buffer bridge 2008 to 2011
700
a significant impact on the
800
capital requirement in
700
600
FY09 in both the base and
600
500
500
moderate stress case
400
400
300
In the base case, the
300
continued improvement in
200
retained earnings builds
100
100
0
0
the Burgundy stand alone
200
capital buffer to £730.1 million by the end of FY11 In the moderate stress case, the initial improvement is countered
Source: JPM financials model
Source: JPM financials model
in FY10 with an
Burgundy stand alone base case
Burgundy’s moderate stress case
assumption that the
z
The bridge chart above shows the movement from Burgundy’s stand alone base case headroom as at FY08 of £170.8 million to that in FY11 of £730.1 million
z
Once again, the main impact on the capital headroom in the moderate stress case is the move from the current ICAAP risk weights to the new risk weights agreed with Claret
z
The base case shows continuing growth in the retained earnings over the period from FY08 outturn, predominantly driven by projected margin improvement, cost reduction and the falling bad debt charges as discussed in the Strategic Plan Light section of the report
z
z
The main changes in the capital requirement is the large decrease in credit risk (along with the ICG add uplift) in FY08 as management move to the revised risk weights agreed with Claret
This has a significant impact between FY08 and FY09, as in the base case scenario; however, the moderate stress case then shows an increasing requirement in FY10 as the economic climate is assumed to continue to fall. The forecast economic recovery in FY11 then leads to an improvement in credit risk in that year
z
Once again, the risk weights are predominantly driven by the HPI and FSD assumptions and these are discussed in more detail in the key assumptions pages of this section of the report
economic climate continues to decline, leading to a reduction in headroom, which recovers to £588.1 million by FY11 on a stand alone basis
z
The opening adjustment relates to £35 million improvement for the sale of Britsafe and £18 million for release of £18 million of dividends from Burgundy International. We note that the Britsafe sale would require significant work to actually come to fruition and that the FSA have not currently agreed to allowing the inclusion of the Burgundy International dividends
z
The risk weights are predominantly driven by the HPI and FSD assumptions and these are discussed in more detail in the key assumptions pages of this section of the report This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Burgundy stand alone capital Key capital assumptions Key assumptions KPMG comment Area HPI
FSD
Base
Moderate
z
FY09: 22%
z
FY09: 27%
z
FY10: 22%
z
FY10: 30%
z
FY11: 22%
z
FY11: 30%
z
FY09: 25%
z
FY09: 25%
z
FY10: 25%
z
FY10: 25%
z
FY11: 25%
z
FY11: 25%
z
The HPI assumptions used by Burgundy, which exclude FSD, have been set at a constant rate for the base case (peak to trough of 22%) and a deteriorating HPI in the moderate stress (peak to trough of 27% reducing to 30%)
z
Claret use a constant 30% HPI reduction peak to trough throughout all of their base case and moderate stress scenarios; however, this is felt by Claret management to be prudent
z
The current environment continues to be volatile, with the two main mortgage lenders in the country being at odds in their latest HPI deflation statistics for November (Halifax 2.6% deflation and Nationwide just 0.4% deflation for the month). This makes it very difficult to comment sensibly on the ‘correct’ level of HPI deflation to use; however, we note that the FSA have said that a floor combined HPI / FSD assumption of 40% should be used therefore suggesting both Burgundy and Claret are within their expectations
z
Originally, Burgundy management had assumed that as the HPI deflation increased, the level of FSD experienced fell. This assumption, whilst not contravening any requirement from the FSA, was felt to be imprudent and therefore, the FSD was increased to 25% across all years and stresses
z
The 25% rate is in line with that already being experienced by Burgundy (pre-Illius) and is also consistent with the FSD used by Claret
z
The combination of the HPI falls and FSD in Claret base case lead to an overall peak to trough of 47.5% compared to Burgundy’s 44.0%. These are considered materially consistent by Claret management and are both consistent at 47.5% in the moderate stress
z
Both Claret and Burgundy are using the same FSD in both the base case and moderate stress cases as these are considered prudent FSDs given the level of HPI deflation and the management mitigants in place at Burgundy such as Illius. We concur this assumption
Model changes from ICAAP Area Probability of possession
Key assumptions
KPMG comment
z
Original ICAAP had a probability given default (‘PGD’) of 60% across all books
z
Burgundy management has been monitoring the probability of a property going into possession following a default across all portfolios
z
Following modelling change PGD reduced to 50% (BTS) and 45% (Platform)
z
The data available at the time of the ICAAP showed an average PGD of 60% across the whole BTS / Platform portfolio; however, now management believes they have sufficient data across the segmented book to use the lower PGD values. These have been submitted to the FSA for approval
z
As the data has been collated over the required period of time to the correct level of segmentation, Burgundy management is confident that the assumption change will be accepted and it is therefore appropriate to use these assumptions. There remains a risk that the assumptions are not accepted by the FSA
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Burgundy stand alone capital Key capital assumptions Model changes from ICAAP Area Exposure at default payments
Exposure at default – further advances
Time from default to sale
Key assumptions
KPMG comment
z
The assumptions around the exposure at default (EAD) have been changed in the latest model from those used in the ICAAP due to changes in payments made prior to default
z
The ICAAP model would recognise a default indicator and then assume the account would go into default three months later (the average time to default). Over this period, the model was not assuming any further payment when in fact, three months of payment should have been received before actual default happened z
z
The EAD is partially driven by the impact of future further advances, prior to an account going into default. The ICAAP used estimates of this number based on data from August FY05 to July FY06.
z
This data has been updated following a further 12 months monitoring which shows that the ICAAP model was slightly overestimating this impact
z
The previous time from default to sale was 20.5 months and this has been reduced to 10 months (BTS) and 12.25 months (Platform) due to the improving time to sale on the properties going into Illius (averaging 2 months)
z
The model has been amended to assume that three months of payments are made which has the following impacts;
-
On interest only accounts, the exposure at default remains the same, as accrued interest is the only amount paid off each month; On repayment mortgages, the interest is paid and an element of capital, therefore the exposure at default is reduced; and On part-and-part the same will apply as above only to a lesser degree This would be considered a correction to the original model which was incorrect and overestimating the EAD and is therefore appropriate
z
Given the more recent data will given a better picture of current customer behaviour, it would be considered appropriate to use the most recent data in the modelling
z
As the economy tightens, people have less appetite for excess spending and therefore, it would be expected that lower levels of further advances would be applied for. Additionally, as Burgundy management has reduced the maximum LTVs allowed on their products, there would naturally be less opportunity for these to be advanced
z
The time to sale would, in a downturn, be assumed to increase as less people are in the market to purchase repossessed houses
z
In this case, the opposite is happening due to the impact of the introduction of Illius, which allows for the time to sale to be vastly shortened.
z
There is currently evidence that the time to sale is averaging two months for Illius; however, this is based on a minimal sample and has not yet been tested under the significantly increased volumes that are assumed in the business model. This would therefore be considered an unproven benefit by us at this stage
z
This leads to an overall reduction in exposure and as it is a contractual arrangement, should be included in the revised modelling
Sales costs
z
Burgundy has re-negotiated its contracts in connection with the sale process and has managed to reduce its costs from 3.88% per case to 1.76%
Illius
z
Illius will also have further impacts on the capital modelling going forward as the volume of possessions purchased by the company increases. These impacts are not included in the current projections (subject to the point above) but would include;
-
Burgundy estimate an overall fall in loss on sale of 30% through reduced forced sale discounts;
-
Reductions in sales costs;
-
Reduced exposures at sale through the shorter time to sale; and
-
Reduced capital requirements overall due to the quicker move from being assets in default with high risk weightings to investment properties with lower100% risk weighting This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Burgundy stand alone capital Resultant risk weights – base case The result of the changes
Base case risk weights
in the modelling
% Credit risk weights Member business Platform BTS Housing association Member pipeline Platform pipeline Other risk weights OTC derivatives Treasury counterparty Treasury assets Commitments - on balance sheet Commitments - off balance sheet Commercial investments Residential investments MBS / ABS FV adj for hedged risk Tangible fixed assets Deferred tax assets Other assets Illius invesment properties Total
assumptions is changes in the overall risk weights that are applied to the balance sheet in determining the capital requirement The overall reduction in risk weights between FY08 and FY09 is due to the changes in modelling with the overall risk weights being assumed to remain relatively constant throughout FY09 and FY10 before improvements being seen in FY11 as a result of improved residential mortgage credit
FY08
FY09
FY10
FY11
6.0% 97.7% 76.8% 36.0% 6.0% 46.1%
7.2% 69.6% 60.4% 36.0% 7.2% 15.1%
7.6% 54.8% 57.7% 36.0% 7.6% 15.6%
7.5% 40.5% 51.2% 36.0% 7.5% 15.7%
26.8% 10.5% 11.7% 13.0% 11.7% 91.2% 95.6% 12.7% 100.0% 100.0% 100.0% 100.0% 100.0% 30.8%
26.8% 10.5% 11.8% 13.0% 8.3% 90.8% 91.5% 12.7% 100.0% 100.0% 100.0% 100.0% 100.0% 28.5%
26.8% 10.5% 11.9% 13.0% 9.3% 90.8% 88.4% 12.7% 100.0% 100.0% 100.0% 100.0% 100.0% 28.4%
26.8% 10.5% 11.9% 13.0% 9.8% 90.8% 87.4% 12.7% 100.0% 100.0% 100.0% 100.0% 100.0% 27.3%
The Member Business risk weights look counterintuitive as they are increasing under the new model. Burgundy management has not been able to find a reason for this anomaly; however, a 0.5% movement in risk weight only leads to a £4.4 million increase in capital required
Whilst the Member Business risk weights remain relatively stable throughout the projection period, the Platform and BTS risk weights improve in FY09 due to model development and then after due to assumed improvement in both the macro economic environment and the quality of the underlying assets as old assets move off the book to be replaced by new, higher quality assets
The movement of commercial risk weights is not excessive and this is due to these still being rated on the standardised approach. This leads to the changes in risk weightings between risk bandings being low – this is similar to the position seen in Claret
Source: Spreadsheet of risk weights supplied by Burgundy
In the base case, the overall risk weights are assumed to remain relatively constant throughout FY09 and FY10 before improvements being seen in FY11 through improved residential mortgage credit risk
risk
The overall reduction in risk weights between FY08 and FY09 is due to the changes in modelling discussed on the previous two pages (FSDs, EAD etc)
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Burgundy stand alone capital Resultant risk weights – moderate stress Most areas of the moderate stress show deterioration over that of the base case as we would expect
Moderate stress risk weights % Credit risk weights Member business Platform BTS Housing association Member pipeline Platform pipeline Other risk weights OTC derivatives Treasury counterparty Treasury assets Commitments - on balance sheet Commitments - off balance sheet Commercial investments Residential investments MBS / ABS FV adj for hedged risk Tangible fixed assets Deferred tax assets Other assets Illius invesment properties Total
FY08
FY09
FY10
FY11
9.0% 90.1% 83.1% 41.3% 9.0% 18.3%
9.0% 90.1% 83.1% 41.3% 9.0% 18.3%
9.0% 90.1% 83.1% 41.3% 9.0% 18.3%
9.0% 90.1% 83.1% 41.3% 9.0% 18.3%
26.8% 12.8% 14.0% 13.0% 7.1% 89.6% 101.3% 13.7% 100.0% 100.0% 100.0% 100.0% 100.0% 33.8%
26.8% 12.8% 14.0% 13.0% 7.1% 89.6% 101.3% 13.7% 100.0% 100.0% 100.0% 100.0% 100.0% 34.1%
26.8% 12.8% 14.0% 13.0% 7.1% 89.6% 101.3% 13.7% 100.0% 100.0% 100.0% 100.0% 100.0% 33.8%
26.8% 12.8% 14.0% 13.0% 7.1% 89.6% 101.3% 13.7% 100.0% 100.0% 100.0% 100.0% 100.0% 32.9%
As would be expected, the risk weights in the moderate stress for the residential mortgage lending are worse than that seen in the base case
Slight deterioration is assumed in the treasury portfolio as a result of the moderate stress
Whilst the risk weights remain constant on the Illius properties throughout the base case and moderate stress, Burgundy management have not assumed any profit and loss impact of investment property prices in the moderate stress scenario
Source: Spreadsheet of risk weights supplied by Burgundy
Platform and BTS risk weights – base versus moderate 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% FY08 P latfo rm (base)
FY09
P latfo rm (mo derate)
FY10 B TS (base)
Unlike in the base case, no recovery is assumed in the moderate stress and risk weights continue to deteriorate throughout the projection period
FY11 B TS (mo derate)
Source: Spreadsheet of risk weights supplied by Burgundy This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings
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Due diligence findings Key due diligence findings impacting capital A number of differences
Unadjusted due diligence findings
have been noted as part of the KPMG due diligence process. Those that have
£ million Opening balance
FY08
FY09
Closing reserves 1,109.0
PBT 47.1
Base case 948.1
Capital headroom (FY09) Moderate stress 566.9
Note 1
Tax provisions
(10.3)
-
(7.4)
(7.4)
not been reflected in the
FSCS costs
(35.0)
(20.0)
(39.6)
(39.6)
3
capital planning total £47.8
SLS interest costs
(2.5)
(30.0)
(23.4)
(23.4)
4
million of additional
Total adjustments
(47.8)
(50.0)
(70.4)
(70.4)
Closing balance
1,061.2
(2.9)
877.7
496.5
expense with a resultant impact on capital
Source:
2
This is the total FY08 and FY09 differences then adjusted for tax
KPMG analysis
Previous issues now adjusted for z
We understand that the suggested provisions relating to the Lehman's and Icelandic Bank exposures have now been fully reflected in the combined capital planning along with the de-recognition of the pension asset in the available capital
z
The impairment numbers included in the due diligence report for the loan impairment and ABS/MBS impairment have been included within the FVAs to ensure the correct level of adjustment is achieved
Adjustments following due diligence findings z
Differences in the treatment and quantum of certain assets and liabilities have come about as part of the due diligence process. These have been captured here to show what impact they would have on the FY09 income statement and capital position (both base case and moderate stress) of Burgundy
1. The FY09 income statements and capital projections prepared by Burgundy have been used. The opening reserves and capital headroom figures address the
due diligence findings from our full due diligence report, with the exception of those described in items 2 to 4 below. 2. Following the receipt of additional information on taxation, we have reduced our estimate of the additional tax provisions we believe are needed to £10.3
million. This consists of increasing the TOMS provision to 100% (from 95%) and including an element of fines and late payment interest – this would be a one off adjustment 3. Following the nationalisation of Bradford & Bingley and the collapse of Icelandic banks and London & Scottish Bank, all UK deposit takers are required to pay
an element of the interest and capital on loans of circa £20 billion to the Financial Services Compensation Scheme (‘FSCS’). The FSCS are using the level of retail deposits to determine how much each entity must pay. Based on current expectations in the market, we believe that Burgundy’s element of this could be as high as £35.0 million in FY08 and at least £20 million per annum for FY09 to FY11. There is also the potential risk for Burgundy’s share of the capital on these loans 4. In the projections, it is assumed that a further £1.5 billion of SLS funding is received. No additional interest cost has been accounted for on this funding.
Claret management believes this would be in the region of £30.0 million per annum
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Due diligence findings Key due diligence findings impacting capital (continued) Base case capital buffer FY09 to FY11
The diagrams opposite
Moderate stress case capital buffer FY09 to FY11
show the capital buffers in 1,200
both the base case and
900 1,000
moderate stress scenarios following adjustment for
800
the due diligence findings
600
800 700 600 500 400
400
300 200
200
100 0
0 FY08
FY09
B efo re DD adjustments
FY10
FY11
FY08
A fter DD adjustments
FY09
B efo re DD adjustments
Source: JPM financials model and KPMG analysis
FY10
FY11
A fter DD adjustments
Source: JPM financials model and KPMG analysis
Other areas of consideration z
In addition to the due diligence findings contained on the previous page, there are three additional areas that have not been considered as part of the transaction to date, due to their timing, which will need to be considered in the strategic plans going forward;
-
The impact of a low base rate environment has not been considered within the Strategic Plan Light. This could have a material impact on the margin assumed within the plan and leave the current plan looking optimistic
-
The impact of government schemes of mortgage assistance to those in difficulties has also not been considered to date. This would be likely to impact the level of possessions going forward and would impact on income and losses
-
Finally, the FSA consultation paper on liquidity has not yet been considered which would significantly impact the funding basis of the combined entity going forward if the plans were to be approved
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Contents
Introduction Executive summary Basis of preparation Burgundy strategic plan ‘light’ Synergies Fair value adjustments Burgundy stand alone capital Due diligence findings Appendices
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Appendix 1 Redemptions and advances Burgundy base case redemptions and advances 2009
P HL P HL P HL P HL
- Prime Old - Thinc Prime - BTL - SC
P HL - NC Total Platform B TS - Pri me Old B TS - Pri me New B TS - BTL B TS - SC B TS - NC Total BTS Source:
Opening balance 361 593 1,053
Adv 500 97 37
2010 Reds & Repay (81) (4) (42) (158)
Closing balance 280 496 648 931
Adv 1,017 161 61
Reds & Repay (75) (14) (66) (201)
2011 Closing balance 205 1,498 743 791
Adv 1,556 214 81
Reds & Repay (72) (80) (91) (2 35)
2012 Closing balance 133 2,974 867 637
Adv 1,994 268 101
Reds & Repay (49) (224) (108) (190)
Closing balance 84 4,745 1,027 548
1,228 3,236
67 700
(152) (437)
1,144 3,499
112 1,350
(244) (600)
1,012 4,249
149 2,000
(2 77) (7 54)
884 5,495
186 2,550
(237) (807)
833 7,237
573 722
150 -
(101) (1) (122)
472 149 600
150 -
(59) (17) (84)
412 282 516
150 -
(48) (20) (69)
364 412 446
150 -
(76) (40) (100)
289 522 346
995 1,211 3,500
100 250
(162) (226) (612)
833 1,085 3,139
199 349
(116) (178) (454)
717 1,106 3,034
199 349
(1 10) (1 49) (3 97)
607 1,157 2,986
199 349
(164) (165) (545)
443 1,191 2,791
Burgundy redemption and advances analysis
Burgundy moderate stress redemptions and advances 2009
P HL P HL P HL P HL
- Prime Old - Thinc Prime - BTL - SC
P HL - NC Total Platform B TS - Pri me Old B TS - Pri me New B TS - BTL B TS - SC B TS - NC Total BTS Source:
Opening balance 356 594 1,048
Adv 42 5 2
2010 Reds & Repay (58) (21) (64)
Closing balance 298 42 578 985
Adv -
Reds & Repay (65) (0) (39) (105)
2011 Closing balance 234 41 538 880
Adv -
Reds & Repay (65) (2) (37) (57)
2012 Closing balance 169 40 501 824
Adv -
Reds & Repay (62) (5) (40) (205)
Closing balance 107 34 462 619
1,213 3,211
3 52
(121) (265)
1,095 2,998
-
(154) (363)
941 2,635
-
(1 05) (2 66)
836 2,369
-
(227) (538)
609 1,831
573 722
60 -
(75) (1) (91)
498 59 631
-
(66) (3) (75)
433 56 556
-
(56) (5) (62)
377 51 494
-
(45) (8) (46)
332 43 448
995 1,211 3,500
40 100
(123) (165) (454)
872 1,086 3,147
-
(104) (158) (406)
768 928 2,741
-
(98) (1 35) (3 55)
671 794 2,386
-
(76) (83) (259)
595 710 2,127
Burgundy redemption and advances analysis
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Appendix 1 Redemptions and advances (continued) Base case redemption and advances
Moderate stress redemption and advances
12,000
12,000
10,000
10,000
8,000
6,000 £m
£m
8,000
6,000
4,000 4,000 2,000 2,000
Source:
Burgundy redemption and advances analysis
Closing buffer FY12
Source:
Closing buffer FY12
Burgundy redemption and advances analysis
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Redemptions
Closing buffer FY11
Redemptions
Closing buffer FY10
Redemptions
Closing balance FY09
Redemptions
Advances
0 Closing balance FY08
Redemptions
Advances
Closing buffer FY11
Redemptions
Advances
Closing buffer FY10
Redemptions
Advances
Closing balance FY09
Redemptions
Advances
Closing balance FY08
0
41
Treasury Select Committee - Project Verde
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FINANCIAL SERVICES
Project Vintage Fair Value adjustments: accounting, tax and capital implications UPDATE 23 December 2008 Advisory
© 2008 KPMG LLP, the UK member firm of KPMG International, a Swiss cooperative. All rights reserved. The KPMG logo and name are trademarks of KPMG International.
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Contents The contacts at KPMG in connection with this report are:
Page
Contents:
Jonathan Holt Financial Sector Group Partner, KPMG LLP Manchester,
Burgundy balance sheet as at 31 October 2008
3
Executive summary
5
Fair value adjustments
Tel: +44 161 246 4046 Fax: +44 161 838 4040
7
[email protected]
Katie Clinton Financial Sector Group Senior Manager, KPMG LLP Manchester,
Other issues for consideration: accounting
17
Tax considerations
18
Tel: +44 161 246 4480 Fax: +44 161 838 4040
[email protected]
Richard Little Tax Partner KPMG LLP Manchester, Tel: +44 161 246 4391 Fax: +44 161 838 4602
[email protected]
Andrew Hughes M&A Tax Manager KPMG LLP Liverpool, Tel: +44 151 473 5147 Fax: +44 161 473 5200
[email protected]
z
To a certain extent the content of this memorandum comprises general information that has been provided by, or is based on discussions with, senior management and directors of Burgundy
z
We do not accept responsibility for such information which remains the responsibility of management. We have satisfied ourselves, so far as possible, that the information presented in our report is consistent with other information which was made available to us in the course of our work in accordance with the terms of our engagement letter. We have not, however, sought to establish the reliability of the sources by reference to other evidence. The scope of our work was different from that for an audit and, consequently, no assurance is expressed.
z
This memorandum is provided on the basis that it is for the information of the directors and management of Claret; that it will not be quoted or referred to, in whole or in part, without our prior written consent; and that we accept no responsibility to any third party in relation to it.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Project Vintage
Burgundy summary balance sheet as at 31 October 2008 Summary Burgundy
Summary of Burgundy FV adjustments as at 31 October 2008 FVAs: Statutory basis
proposed FVAs and capital treatment
FVAs: Disregarded for capital purposes
FVAs: Regulatory capital
£m
£m
Deferred Gross £m
tax £m
Net £m
Assets Loans & advances to customers Interest rate & EIR FV adjts
(164)
46
(118)
-
(118)
Credit risk
(366)
102
(264)
-
(264)
(311)
87
(224)
-
(224)
Other change in hedging adjts Invt securities L&R (formerly in AFS) Existing valuation
203
(57)
146
-
146
Revision to DCF basis
(580)
162
(418)
-
(418)
AFS Reserve
(137)
-
(137)
-
(137)
(61)
17
(44)
-
(44)
20
(6)
14
-
14 0
Counterparty risk AFS investments Goodw ill
(195)
37
(158)
158
-
-
-
-
-
125
(35)
90
(90)
-
PP&E
10
(3)
7
-
7
Cashflow hedging
(18)
-
(18)
-
(18)
(1,474)
352
(1,122)
68
(1,054)
Non-core retail deposits
(84)
24
(60)
-
(60)
Deposits from banks
11
(3)
8
-
8
Other deposits
(19)
5
(14)
-
(14) 897
Intangibles Core deposit intangible
Liabilities
Debt securities
1,246
(349)
897
-
-
-
-
-
-
162
(45)
117
-
117
45
(13)
32
-
32
1,361
(381)
980
-
980
Contingent liabilities Subordinated liabilities Subscribed capital
Source: Burgundy Management
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Burgundy balance sheet as at 31 October 2008 Summary of Burgundy FV adjustments as at 31 October 2008
Burgundy’s detailed balance sheet as at 31 October 2008 has been adjusted by Burgundy’s proposed fair value adjustments. Burgundy have also updated the balance sheet for the November change in Bank Base Rate (1.5%) and assumed an equal and
£m Assets Cash & balances with BoE Loans & advances to banks Loans & advances to customers MB Commercial Lending BCIG Residential FV adjustments for hedged risk Other FV adjts for hedging L&R (formerly AFS) AFS investments Derivatives FV hedges CF hedges FX hedges
11,722 2,839 9,842
148 11 444
Investments in joint ventures Goodwill Intangible assets Property, plant & equipment Other assets Prepayments and accrued income Retirement benefit asset
opposite offset to increases or decreases
Deferred tax assets/(liabilities) Total assets
in derivative values. The Day 1 capital impact of the restated fair value balance sheet is provided in the final column
Liabilities Shares Deposits from banks Other deposits Derivatives FV hedges CF hedges FX hedges Derivatives Debt securities in issue Member Business Leek notes Currency hedging adjts Other liabilities Provns for liabilities & charges Contingent liabilities Accruals and deferred income Current taxes Subordinated liabilities Subscribed capital Total liabilities General reserve Available-for-sale reserve Cashflow hedging reserve
Source: Burgundy Management
BS carrying amount £m
Roll forward for BBR change £m
183 1,898
-
24,403 (82) 5,744 2,221
-
Rolled fwd BS carrying amount £m £m -
183 1,898
11,722 2,839 9,842 24,403 (82) 311 5,744 2,221
Interest rates £m
Analysis of FV adjustments Release Core Credit Change FV adjts deposits risk to EIR £m £m £m £m
-
-
-
-
(174) 104 (177)
-
-
(25) (67) (274)
(377) 20
82 (311) -
-
-
-
Acqn accg £m
Total FV chnge Adjustment £m -
Revised FV BS £m 183 1,898
Day 1 capital impact £m
-
-
-
1 (6) 6
-
(198) 31 (445)
11,524 2,870 9,397
(182) 30 (292)
(61) -
-
-
82 (311) (438) 20
5,306 2,241
82 (311) (377) 20
-
-
-
-
-
-
(195) ? 10 -
(195) 125 10 -
1,287 2 164 127 103 168 42
10 -
1 (0)
(185) 34
(1,319) (29)
35,312 (17)
(1,020) (17)
1
(151)
311 -
-
271 (7) 420
419 4 864
-
-
1,287 2 195 39 117 103 168 42
-
-
125 -
-
35,636 8
995 4
-
36,631 12
(604) (213)
(229) 66
125 (35)
(427) 120
35,644
999
36,643
(817)
(163)
90
(308)
(1,348)
35,295
(1,037)
18,471 6,445 2,116
-
-
18,471 6,445 2,116
91 19
(7) (11) -
-
-
-
-
84 (11) 19
18,555 6,434 2,135
(84) 11 (19)
582 7 (57)
673 13 -
686
-
-
-
-
-
-
-
2,740 3,402
(57) (1,189)
-
-
-
-
-
8 15
-
-
-
-
(1,366) 549 -
5 (323) 137 18
90 -
(308) -
1 -
(817)
(163)
90
(308)
1
603 2 195 39 117 103 168 42
91 6 57
154
2,740 3,402
6,142 79 5 208 14 547 298
477 -
-
6,142 477 79 5 208 14 547 298
34,479 1,306 (137) (4)
1,009 4 (14)
-
35,488 1,310 (137) (18)
35,644
999
-
36,643
686
-
(57) (1,189)
2,683 2,213
57 1,189
(162) (45)
477 79 5 208 14 385 253
162 45
(151) -
(1,361) (142) 137 18
34,127 1,168 -
1,361
(151)
(1,348)
35,295
169
-
(170) (60)
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Executive summary (1) Background
We were originally engaged by Claret to perform a high level accounting review of the fair value adjustments (FVAs) proposed by Burgundy based on the Burgundy balance sheet as at 31 August 2008. We have reported our findings in respect of those proposed adjustments to previous RMC, ARCC and Board meetings. Further to discussions on 19 November, Burgundy agreed to re-perform a revaluation as at 31 October 2008 in order to: z Reflect the impact of continued economic turmoil, recent changes in accounting treatments and more recent market developments (including the bank base rate change
in early November); z Determine the FVA for certain key adjustments by reference to alternative methodologies in order to ‘sense check’ the August result; and z Achieve greater precision in the FVA calculation – especially for loans and receivables
In addition to refinements in the methodology for calculating the FVA in respect of Loans & Receivables, Burgundy has applied alternative valuation bases to the bases applied in the 31 August 2008 modeling exercise to assess the sensitivity of certain adjustments (including Asset and Mortgage Backed Securities (ABS/MBS), Fixed Rate Notes (FRNs), and securitisation loan notes) . For sensitivity purposes, Burgundy has estimated the impact of a move from a mark to market to a mark to model basis of valuation due to their view that current markets may be ‘inactive’ and therefore market prices may not be reliable. We note, however, that the FVAs presented on pages 3 and 4 still reflect mark to market based FVAs for ABS, MBS, FRNs and debt securities in issue. Whilst the 31 October 2008 balance sheet forms the basis of this revised exercise, the impact of the 150bps reduction in base rate in early November has been modelled at a high level as at that date in order to determine the impact of prevailing market conditions in mid November. To the extent that market values moved in response to the base rate reduction (eg derivative valuations), these have been ‘rolled forward’ in the October balance sheet to ensure consistent presentation. In order to facilitate completion of the October exercise, we worked alongside the Claret and Burgundy teams challenging valuation principles and underlying accounting assumptions as the exercise was in progress. Scope
We have performed a high level accounting review of the fair value adjustments (FVAs) proposed by Burgundy based on the Burgundy balance sheet as at 31 October 2008. We have commented on the appropriateness of the accounting treatment and approach adopted in accordance with IFRS 3 Business Combinations and considered the associated capital and tax treatments. In forming our views, we have also been cognisant of the accounting, capital and tax treatments proposed in respect of other ongoing deals. Note that: z
we have not performed an audit or verified Burgundy’s numbers, nor have we undertaken any independent valuation
z
the proposed FVAs at 31 October 2008 are only indicative and can be expected to change substantially by the transaction date; market conditions have further changed considerably since the exercise was undertaken
z
we have not had access to underlying data, including data tapes (loan books (except Leek Finance 18 and 19) and deposit books in particular), in order to analyse and form an independent view of the scale of potential adjustments from first principles or perform any re-projections
z
Burgundy’s approach to the FVA exercise has necessarily been high level; for simplification, certain key assumptions (including averaging) have been applied to quantify the adjustments and in certain key areas (eg mortgage adjustment), proxies have been used
z
the FVAs presented on pages 3 and 4 reflect Burgundy’s proposed adjustments. To the extent that Claret’s view of the proposed adjustments differs to that of Burgundy, the accounting and capital impacts are disclosed on page 11 of KPMG’s updated Due Diligence report. Those FVAs where the views of Claret and Burgundy differ include: −
Loans & receivables (formerly AFS assets) – credit risk adjustment
−
Inconsistent accounting treatment for Guaranteed Equity Bonds
−
Recoverability of deferred tax asset © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Executive summary (2) Scope
This report should be read in conjunction with our previous reporting to RMC, ARCC and Board and KPMG’s Updated Due Diligence Report. We do not seek to repeat detailed explanations here; instead we focus on the revisions to valuation methodology applied in the October exercise and the resulting accounting, capital and tax implications.
Fair value adjustments and regulatory capital impacts
For accounting purposes, the proposed FVAs post assumed tax will reduce total assets by £1,122m whilst reducing liabilities by £980m. The net debit to the balance sheet is highly dependent on the use of mark to market principles on the debt securities in issue (£1.2bn). A change in market prices or an inactive market may result in a markedly different net result. The net impact will be different for regulatory capital purposes (on Day 1 and beyond) because of the inconsistencies between the accounting and capital treatments that are set out below and in the pages that follow. In conjunction with the Claret team, we have sought confirmation from the FSA regarding the Day 1 regulatory capital treatment of FVAs (and their component parts). Following clarification by the FSA, it has been confirmed that the regulatory capital treatment will be consistent with the treatment for accounting purposes other than to the extent that prudential filters are applied. In summary, Burgundy’s proposed FVAs result in a Day 1 capital hit of £1,054m in respect of asset write downs that will be offset by a reduction in liabilities (and therefore benefit to Day 1 capital) of £980m. Prudential filters apply in respect of goodwill, intangibles and pensions. The FSA confirmed, however, that they may increase capital add ons subject to the size and nature of the reduction in liabilities – particularly where they relate to credit. The FSA previously stated that a capital shelter may be available for the element of any credit fair value adjustment in respect of loans and receivables that are already impaired. Burgundy’s October exercise provides an indication of the quantum and direction of FVAs arising in current market conditions whilst revisions to the valuation basis applied have sought to introduce more granularity and a greater level of precision to the calculations. We note, however, that the increase in fair value for a commercial lending book in the current environment seems counterintuitive. For MBS, ABS, FRNs and debt securities in issue, the FVAs have been calculated based on mark to market prices. However, for sensitivity purposes, the FVAs for certain asset and liability classes have also been calculated by reference to mark to model assumptions. This is based upon Burgundy’s view that markets may be inactive. The use of Burgundy’s mark to model prices results in a fundamentally different FVA (ie over £500m increase in net liability). It should be noted that we have a number of observations in respect of the assumptions applied by Burgundy in generating their mark to model FVAs. Going forward certain asset and liability classes (ABS/MBS and Leek Notes) might be expected to move, to some degree, in a correlated manner. However, if there is significant change on both mortgage backed assets and liabilities (eg significant improvement in the mortgage backed securities market) this may result in a sizeable increase in liabilities resulting in an overall material net credit to the balance sheet. By their very nature, the FVAs will change at the point of transfer and such changes may be significant.
Taxation
There is no specific tax legislation relating to the transfer of financial assets and liabilities and existing HMRC guidance is unclear. However, we understand that HMRC may seek to deny relief for any fair value debit arising on the transfer of financial assets and liabilities from Burgundy. Burgundy's deferred tax calculations currently assume that all adjustments will be tax effected but there is a risk that £114 million of the asset in relation to the Society assets and liabilities may be invalid (being 28% of the adjustment in relation to financial assets and liabilities). The split of adjustments between Society and subsidiaries includes a number of broad assumptions and remains subject to change. Further comment is provided on page 18.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (1) BS caption
Accounting
Regulatory capital
Loans & Receivables
The fair value adjustment for Loans and Receivables could be arrived at by reference to pricing in the mortgage-backed securities secondary market or pricing for the origination of new loans. The first is an exit price whereas the second is an entry price, albeit a proxy. If an exit price methodology were used, a liquidity discount would need to be applied. For a nonprime mortgage book this could be very significant in the current environment and for this reason Burgundy has chosen to apply an entry pricing methodology (IAS 39 AG 77). Burgundy’s logic for determining this adjustment is appropriate and not out of line with emerging industry practice.
The FVA is a Day 1 hit to capital.
Adjustment of (£612m)
Burgundy’s DCF model compares all the cash flows on existing loan books with the rate inherent in a new deal as at November 2008 (‘current price’). SVR is already considered to be at fair value and therefore excluded from the model. Current prices across all loan books are adjusted to strip out the credit risk component (Burgundy has taken Lifetime Expected Losses (EL) as a proxy for determining the element of the FVA required to reflect the fact that credit spreads have moved) and the fair value of the credit risk adjustment is calculated separately. Certain simplifying assumptions are applied in the calculation (eg redemption profiles, LTVs, current pricing for instances of ‘risk retreat’) and since we do not have access to underlying loan books, it has not been possible for us to perform a high level challenge the appropriateness of these assumptions or perform an exercise to determine the FVA independently of the Burgundy calculation. For the purposes of the October exercise, Burgundy has re-run the original FVA model based on 31 October loan balances with current prices updated to November 2008 and the impact of 150bps base rate reduction reflected. Burgundy has confirmed: z
Appropriateness of methodology applied in respect of all product types
z
Accuracy of product classification and reversionary rates across all lending divisions and product types
z
Appropriateness of Lifetime Expected Loss calculation by division
z
EIR modelling based on up to date assumptions
The FVA may unwind over time. To the extent that the FVA write down is creditrelated, the future P&L will be ‘protected’ against future credit losses. To the extent the FVA write down is interestrelated, this element may reverse. On transfer of the assets to the combined entity, the newly calculated EIR will unwind over time; the benefit that accretes to P&L will be recorded in Retained Earnings and thus treated as Core Tier 1 capital. Gross of tax, the Day 1 regulatory capital impact of the FVA is therefore a reduction of £444m.
To the extent possible, the October exercise has applied more granularity to current prices applied in the model by reference to LTV bandings by division and product type. Application of more granular pricing results in an answer that is more appropriate for the underlying risk of past and current pricing. Following completion of the October exercise, Burgundy management has further revisited current pricing applied in the model to ensure appropriateness. Following review of the revised adjustments, management concluded that current pricing across all three divisions should be further refined. The FVA proposed in respect of the Commercial Lending division was impacted most significantly as a result of this refinement; the original non credit-related FVA that increased the asset value by £104m was reduced to an increase of circa £67m. We note that any increase in fair value for a commercial lending book in the current environmental seems counterintuitive. This reduction was offset by corresponding adjustments across the Member Business and BCIG portfolios where current prices were also adjusted. Given that the net impact of these revisions to current prices was £nil in respect of the non credit-related FVAs, no amendment has been made to Burgundy's proposed adjustments recorded on page 4. We have not seen these revisions reflected in the underlying model, nor have we received any high level detail in respect of the underlying assumptions.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (2) BS caption
Accounting
Regulatory capital
Cash and balances with BOE
Burgundy does not propose a FVA on the basis that cash and balances with BOE are highly liquid and any adjustment would be minimal. Whilst we concur with Burgundy’s logic, we have not had access to high level information in order to corroborate this view.
N/A
Adjustment of £nil
In the event that interest rates change in the months prior to transfer, the FVA could be material even though the maturity period is short.
Loans and advances to Banks
Burgundy does not propose a FVA on the basis that 99% of Loans and advances to banks are at variable rate and short term. Burgundy concludes that any adjustment would therefore be minimal. Whilst we concur with Burgundy’s logic, we have not had access to high level information in order to corroborate this view.
Adjustment of £nil
In the event that interest rates change in the months prior to transfer, the FVA could be material even though the maturity period is short.
Fair value adjustments for hedged risk
Burgundy has rolled forward the 31 October balance sheet to incorporate the 150 bps base rate movement in early November by marking to market the derivative portfolio as at 25 November 2008. Burgundy has assumed that all derivatives are 100% effective and has therefore booked an equal and opposite fair value adjustment for hedged risk to the appropriate asset categories. We have not been provided with any details of Burgundy’s hedging strategy and are therefore unable to comment on the appropriateness of Burgundy’s accounting assumption that interest rate risk is perfectly hedged. The assumption is therefore accepted at face value for the purposes of rolling forward the fair value adjustments for hedged risk though in the event that this assumption is not appropriate, the financial impact could be material.
Adjustment of £229m
N/A
Treatment consistent for accounting and capital purposes.
Given that the fair value exercise is being calculated on a gross basis (ie before taking into account adjustments for hedged risk), the fair value adjustments for hedged risk have been reversed out to avoid double count.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (3) BS caption
Accounting
Regulatory capital
Loans and receivables (formerly AFS)
Consistent with the approach taken in respect of the August exercise, Burgundy has calculated the FVA by applying current market values to the ABS, MBS and FRN portfolios that constitute the Loans & receivables (formerly AFS) category of asset. The £377m reduction in asset value reflects an increase in asset value of £203m (being to reinstate the asset value to original book value) and subsequent reductions of £500m and £80m (both rounded) in respect of ABS/MBS and FRN portfolios respectively to represent the difference between book value and market value as at 30 November. (The actual reductions in book value calculated by reference to the underlying asset breakdowns are £510m and £82m respectively). In addition, Burgundy has booked an additional credit adjustment of £61m in respect of Lehman’s and Kaupthing. Given that a market value basis of valuation is being applied, this additional reduction in the asset value is considered prudent.
The proposed FVA reduces the asset value by £438m and is a Day 1 hit to capital.
Adjustment of (£438m)
Market value is considered to be an appropriate basis of valuation to the extent that markets are active and market values are considered to be reliable. However, in Burgundy’s view, the current markets for Asset Backed Securities (ABS), Mortgage Backed Securities (MBS) and Fixed Rate Notes (FRNs) are inactive. Consequently, Burgundy has reclassified all such assets to Loans & Receivables as of 1 July 2008 in accordance with the recent amendment to IAS 39 on the basis that the reclassification criteria set out under the amendment have been met (reclassification remains subject to audit by PWC). Burgundy’s decision to reclassify certain asset classes is largely irrelevant for the purposes of determining the asset’s closing fair value though it will impact the quantum of the adjustment itself depending on whether an opening asset at fair value or amortised cost is being adjusted. To the extent that markets are deemed inactive, mark to model techniques may be applied. There is an obvious inconsistency, therefore, between the mark to market value applied for the purposes of the FVAs and the mark to model methodology which Burgundy believe should be applied given an inactive market. The difference between the two may be significant. To summarise the key principles of IAS 39: z
A financial instrument is regarded as being in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency, and those processes represent actual and regularly occurring market transactions on an arm’s length basis.
z
Fair value is defined in terms of a price agreed by a willing buyer and a willing seller in an arm’s length transaction. The existence of published price quotations in an active market is the best evidence of fair value and when they exist they are used to measure the financial asset or financial liability.
z
When a financial instrument is not traded in an active market, its fair value should be determined using a valuation technique. The entity should use a valuation technique that is commonly used by market participants to price the financial instrument concerned, when that technique has, in the past, provided reliable estimates of prices obtained in actual market transactions. Examples of valuation techniques include using recent market transactions in similar financial instruments, adjusted for factors unique to the instrument being valued, discounted cash flow analysis or option pricing models.
z
The objective when choosing and developing an appropriate valuation technique is to establish what a transaction price would have been on the measurement date in an arm's length exchange motivated by normal business conditions.
The FVA may unwind over time. To the extent that the FVA write down is credit-related (£61m reduction in asset value), the future P&L will be ‘protected’ against future credit losses. To the extent the FVA is interestrelated (£212m increase in asset value), this element may reverse. On transfer of the assets to the combined entity, the newly calculated EIR will unwind over time; the charge to P&L will be recorded in Retained Earnings and thus treated as Core Tier 1 capital. Gross of tax, the Day 1 regulatory capital impact of the FVA is therefore an increase of £151m.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (4) BS caption
Accounting
Regulatory capital
Loans and receivables (formerly AFS)
z
The chosen valuation technique should make use of observable market data about the market conditions and other factors that are likely to affect the instrument's fair value. The technique should be consistent with accepted economic methodologies, and its inputs should include factors that market participants usually would take into account when pricing an instrument, relying as little as possible on entityspecific factors. Also, it is necessary for the validity of the results of the technique to be tested regularly so that the technique can be recalibrated as required. In the case of complex financial instruments where no relevant observable market data is available, sophisticated valuation models are required.
See above.
z
IAS 39 does not prescribe whether the discount rate or the cash flows should be adjusted to reflect risk. For assets with specified cash flows, such as debt securities, an approach of adjusting the discount rate for risks inherent in the asset often is the best method. For other assets it may be more appropriate to adjust the expected cash flows and discount these at a risk-free interest rate.
Adjustment of (£438m)
Burgundy mark to model approach Burgundy believe that a market value basis may not be the most suitable valuation basis (because elements of the market are considered to be inactive), and therefore a mark to model approach provides an alternative FVA within the range of potential outcomes. Burgundy has therefore proposed a high level modelling methodology as an alternative to market value that applies a discount rate equal to the interest rate curves relating to bank debt plus a ‘margin’ to reflect the increased level of risk inherent within ABS/MBS that is in excess of the level of risk attributable to bank debt. Key valuation principles adopted by Burgundy are as follows: z
Base interest rate curve: Burgundy obtained interest rate curves for bank debt with AAA, AA, A and BBB credit ratings. A single weighted average interest rate curve has then been calculated for the whole book by weighting each of the curves in accordance with the percentage of the book at each credit grading.
z
Additional risk margin: Burgundy applied an additional risk margin of 85bps to the discount rate to reflect the additional risk inherent within ABS/MBS assets. This additional margin was not applied in the case of FRNs.
We understand from Burgundy that on this alternative mark to model basis, the total FVA would result in an increase to the asset value of £151m (rather than a £580m reduction using mark to market prices) though we have not have sufficient information in order to re-perform the mark to model valuation. KPMG view We have three principal observations in respect of the mark to model methodology set out above: z
Granularity of the model: We would have expected a greater level of granularity to have been used within the calculation, rather than the weighted average approach that has been adopted. This would involve subdividing the portfolio by credit rating and by asset class (prime RMBS, non-conforming, BTL etc) and applying a different discount rate to each element.
z
Discount rate: In our view the 85bps additional element is insufficient in the current market. IAS39 requires that, when using a mark to model methodology, an institution uses as much market information as possible within its model. Although we recognise that the market may not be operating effectively at present, it is not necessarily the case that there is no useful information to be extracted from it. Consequently, we would have expected the additional element to be more in line with those currently published by organisations such as JP Morgan (suggesting that margin should be 200bps+ depending on the on the specific characteristics of each security in the portfolio, including repayment profiles and information on the position of Burgundy’s notes within the payment waterfall). © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (5) BS caption
Accounting
Loans and receivables (formerly AFS)
z
Regulatory capital
Incidence of loss: Burgundy has assumed that there is no loss within the portfolio of asset backed securities with the exception of a £61m credit risk adjustment booked in respect of Lehmans and Kaupthing. Consequently, the fair value model has included all contractual cash flows, with no adjustment for future impairment. Given the current concerns surrounding ABS/MBS and the UK housing market, we are of the opinion that this assumption is potentially aggressive.
Adjustment of (£438m) Loans and receivables (formerly AFS) Adjustment of (£438m)
Investment securities – AFS / AFS Reserve
In our view and where reliable market information and inputs are available, this should form the basis of any mark to model valuation and there should be a direct relationship between the mark to market inputs and any mark to model valuation. Whilst the proposed FVA using current market prices represents a Day 1 hit to capital, consistent treatment on the liability side of the balance sheet results in a significant reduction in liabilities and therefore a Day 1 benefit to capital that more than offsets the reduction in asset values. See pages 14 and 15 for further comment. Whether a mark to market or mark to model methodology is most appropriate depends on a line by line detailed analysis of the underlying assets. It should be noted, however, that the approach taken on the asset side should be consistent with the approach to the mortgage backed liabilities and this may have a significant impact on the overall adjustment. We have not verified the extent to which, line by line, markets are active or inactive though we note that broker quotes can be obtained for individual assets. For investment securities that remain in the AFS category (CDs and Gilts), these are already stated at market price. The FVA on the AFS book at 31October 2008 of £20m reflects the increase in market values arising from the base rate reduction for fixed rate investments.
Negative AFS reserve, previously disregarded for capital purposes, crystallises as a fair value adjustment, and as a result reduces capital. FVA of £20m is a Day 1 benefit to capital. The FVA may unwind over time to the extent the FVA is liquidity related.
Existing goodwill (arising from the acquisitions of Platform and the B&W savings business) is written down to £nil in accordance with IFRS 3; we concur with this treatment. However, IFRS 3 also requires that Claret calculates goodwill arising on the deal by imputing the fair value of consideration. To the extent that positive or negative goodwill arises on the merger, the quantum is still to be confirmed.
Creation or write off of goodwill is neutral for regulatory capital purposes on Day 1 and beyond.
Adjustment of £20m
Goodwill Adjustment of (£195m)
See above.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (6) BS caption
Accounting
Regulatory capital
Intangible assets
An intangible asset of £125m arises on the core deposit book due to the positive interest rate margin, reflecting the inertia benefit of the deposit book. The core deposit book will give rise to an intangible asset where the rate payable on Burgundy's deposits is below Claret’s current cost of funding. Burgundy's calculation reflects management’s view of future attrition rates.
Nil capital impact on Day 1 and beyond.
Adjustment of £125m
An element of the Burgundy intangible relates to software development that will be transferred to the combined entity at transaction date (£40.1m at 31 Dec 07). Burgundy has assumed that these existing intangibles (mainly computer software) are fairly stated and no adjustment is therefore proposed. We are unable to conclude on this point until management’s plans for the combined entity become known. Additional intangibles that may be recognised on the transaction date have not yet been considered including brand, cross sales and customer lists. Valuations are to be determined in due course. PPE Adjustment of £10m
Burgundy holds land and buildings with a net book value of £37.8m (as at 31 December 2007) and carries these at historical cost less depreciation. Burgundy has assumed that commercial property market values would have increased by £15m since acquisition though £10m has been applied as the FVA owing to falls in the commercial property market in 2007/08. This FVA is not supported by a a professional valuation and is instead based on the view of Burgundy's Estate Manager. A professional valuation will be required at transaction date to determine actual FVA.
Owing to the mismatch between treatments for accounting and capital purposes, a form of shadow accounting will be required to convert the statutory to the regulatory balance sheet.
Day 1 benefit to capital, assuming uplift to asset carrying amount following professional valuation.
Whilst the impact of the Illius scheme is considered not material for the purposes of the October FVA exercise, the extent of Burgundy’s planned expansion of the scheme will result in significant investment properties being recorded on balance sheet by transaction date. The fair value implications associated with such assets will be an increasingly material adjustment within subsequent FVA exercises. Retirement benefits Adjustment of (£26m)
In accordance with IFRS 3, a full actuarial valuation is required to determine the actual FVA at transaction date. On an IAS 19 basis, Burgundy carried a surplus of £45m at 31 Dec 07. On a funding basis, at 5 Apr 08 Burgundy had a deficit of £28m which is to be paid off as a lump sum. A further £8.5m per annum will also be paid. The funding basis is the measure applied for regulatory capital purposes.
From a regulatory capital perspective, the funding deficit drives the required capital requirement. The IAS 19 surplus / deficit is disregarded for capital purposes and replaced by:
Analysis by KPMG shows that the deficit on the funding basis at 30 Sept 08 could be £67m using the Burgundy assumptions and £148m if the Claret assumptions were applied. At the same date, on an IAS 19 basis the scheme surplus would have grown to £71m using Burgundy’s assumptions but would reduce to £19m using those of Claret. The funding and IAS 19 bases diverge because of differences between the discount rates applied to determine pension liabilities in the case of each. AA Corporate Bond rates are applied to discount the liabilities on an IAS 19 basis whilst government gilt rates are applied to determine liabilities on the funding basis. The higher discount rate applied on the IAS 19 basis results in total liabilities that, when compared to the valuation of total assets, drives an accounting surplus.
1. Burgundy’s funding obligation in excess of normal
contribution levels for the next five years (Pillar 1); plus 2. Any amount set aside for volatility associated with the
pension obligation (Pillar 2)
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Accounting
Regulatory capital
Retirement benefits
The proposed FVA of £26.0m (for statutory reporting purposes) adjusts the retirement benefit asset of £45.0m as at 31 December 2007 to an asset of £19.0m reflecting Claret Group’s assumption basis. Burgundy's proposed FVA table on pages 3 and 4 has not been updated to reflect this.
On a standalone basis, Burgundy has reflected an amount of £44m in respect of volatility associated with the pension liability though the £41.0m pre-tax IAS 19 surplus as at 30 June 08 has not been reversed from its capital assessment. The Day 1 capital impact for the combined entity will therefore be a reduction of £41.0m reflecting the reversal of IAS 19 surplus – we understand this is reflected in the latest capital model.
Burgundy has calculated the fair value of the deposit portfolio to be an increase in liabilities of £84m as at 31 October 2008.
As confirmed by the FSA, the FVA results in a Day 1 hit to regulatory capital. The FVA may unwind over time. To the extent that the FVA write down is creditrelated, the adjustment will not reverse. To the extent the FVA write down is interest-related, this element may reverse.
Adjustment of (£26m)
Shares Adjustment of (£84m)
On demand accounts are assumed to be at a market rate (where fair value equals book value) so fair value analysis is performed only in respect of those accounts which do not provide instant demand access. The key assumptions within the calculation are the attrition rates and the discount rate. Burgundy’s calculation assumes current pricing for retail deposits to be the discount rate thereby generating a FVA that increases the liability by £84m. The reduction in current pricing for retail deposits following the interest rate cut on 6 November 2008 has reduced the discount factor applied in the FVA calculation thereby resulting in a lower NPV. In addition to the FVA in respect of Shares, Burgundy's accounting policy for Guaranteed Equity Bonds (GEBs) needs to be aligned to that of Claret. In FY08, Burgundy’s accounting policy for GEBs was changed. Previously, payments received on entering into the swaps were incorporated into the effective yield on the GEB and spread over the life of the GEB. From FY08 payments received are recognised immediately on entering into the swap. The justification is that the embedded derivative element of the swap was previously not recognised and that the receipt on the swap provides evidence of the fair value of this element of the GEB. Claret use an accounting policy more consistent with Burgundy prior to its change of policy. The adjustment required to restate the liability on Claret's basis of accounting is intended to be recognised as a FVA at transaction date. The before tax impact is to increase the liability by c£11m (based on H1 08 quantification).
On transfer of the liabilities to the combined entity, the EIR will be recalculated in accordance with IAS 39. To the extent that the newly calculated EIR will unwind over time, the corresponding charge to P&L will be recorded in Retained Earnings and treated as Core Tier 1 capital.
Burgundy’s summary of proposed adjustments on pages 3 and 4 has not been updated to reflect this realignment; instead the required adjustment is reflected on page 87 of KPMG’s updated Due Diligence report.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (8) BS caption
Accounting
Regulatory capital
Deposits from banks
Burgundy states that 99% of the book is repayable in less that 3 months and no FVA is therefore proposed other than to release the FV adjustment for hedged risk resulting in a debit adjustment of £11m. In our view, the release of the FV adjustment for hedged risk is not necessary since a gross adjustment to this caption has not been computed on the basis that it is considered minimal.
Treatment consistent for accounting and capital purposes.
Adjustment of (£11m)
Due to immateriality, the FVA reported on pages 3 and 4 is unchanged. In the event that interest rates change in the month prior to transfer, the FVA could be material even though the maturity period is short. Other deposits
The £19m FVA increase to liabilities reflects the adjustment to retail deposits in Britannia International. The FVA is calculated in accordance with adjustment to Shares set out on page 13.
Adjustment of £19m
No other FVA is proposed by Burgundy in respect of other deposits on the basis that:
See comment on page 13 in respect of adjustment to Shares
1. Circa 50% of the funding is priced close to LIBOR so any FV adjustment would be minimal; and 2. Of the remaining book, 85% expired within 3 months of the 2007 year end (being the most recent date
at which we have a complete list of underlying assets). We do not have ISIN numbers so are unable to independently value the assets at that date. Whilst we agree with Burgundy’s logic, we have not received the underlying data in order to corroborate. In the event that interest rates change in the month prior to transfer, the FVA could be material even though the maturity period is short. Debt securities in issue – Member business Adjustment of (£57m)
Burgundy has calculated the fair value adjustment on member business debt securities by reference to available market values. The corresponding reduction in liabilities of £57m therefore represents a Day 1 benefit to capital. Assuming inactive markets and therefore unreliable market prices, Burgundy’s alternative basis of calculation would be to model the FVA by comparing the weighted average interest rate on the portfolio to one year LIBOR to calculate the additional margin being paid on the securities compared to current market rates. Applying this additional margin to the book value of the portfolio to derive the additional interest due, the FVA would be a £73m increase to liabilities. See Loans & Receivables (formerly AFS) for a more detailed analysis of the basis of calculation under IAS 39 (pages 9-11).
As confirmed by the FSA, Burgundy’s proposed FVA results in a Day 1 benefit to regulatory capital. The FVA may unwind over time. To the extent that the FVA write down is credit-related, the adjustment will not reverse. To the extent the FVA write down is interestrelated, this element may reverse. On transfer of the liabilities to the combined entity, the EIR will be recalculated in accordance with IAS 39. To the extent that the newly calculated EIR will unwind over time, the corresponding charge to P&L will be recorded in Retained Earnings and treated as Core Tier 1 capital.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (9) BS caption
Accounting
Regulatory capital
Debt securities in issue – Leek Notes
Consistent with the approach taken in respect of the August exercise, Burgundy has calculated the FVA by applying 30 November market values to the Leek notes; a £1,189m reduction in liabilities therefore results. This adjustment represents a Day 1 benefit to capital that would more than offset the Day 1 hit to capital arising on the ABS/MBS portfolio when consistent valuation principles are applied. See pages 9-11 for further comment.
Adjustment of (£1,189m)
Market value should be considered to be an appropriate basis of valuation to the extent that markets are active and market values are considered to be reliable.
As confirmed by the FSA, the FVA results in a Day 1 benefit to regulatory capital. The FVA may unwind over time. To the extent that the FVA write down is credit-related, the adjustment will not reverse. To the extent the FVA write down is interest-related, this element may reverse.
To the extent that markets are deemed inactive and market prices are therefore deemed unreliable, Burgundy believes markets for mortgage backed securities are currently inactive and for the purposes of sensitivity analysis has proposed an alternative mark to model approach that is consistent with the mark to model approach proposed in respect of the ABS/MBS portfolios. Burgundy has applied the same modelling principles to Leek securitisation notes in issue. Our observations in respect of the mark to model methodology and assumptions that would be applied in respect of the Leek notes are consistent with our comments on pages 9-11 in respect of the ABS/MBS and FRN portfolios. Whilst application of mark to model techniques to determine the fair value adjustment is an acceptable approach insofar as the principles set out in IAS 39 are followed, we have two principal concerns with the model approach proposed by Burgundy set out below: z
Granularity of the model: We would have expected a greater level of granularity to have been used within the calculation, rather than the weighted average approach that has been adopted. This would involve subdividing the portfolio by credit rating and by liability and applying a different discount rate to each element.
z
Discount rate: In our view the 85bps additional element is insufficient in the current market. IAS39 requires that, when using a mark to model methodology, an institution uses as much market information as possible within its model. Although we recognise that the market may not be operating effectively at present, it is not necessarily the case that there is no useful information to be extracted from it. Consequently, we would have expected the additional element to be more in line with those currently published by organisations such as JP Morgan (suggesting that margin should be 200bps+ depending on the on the specific characteristics of each security in the portfolio)
On transfer of the liabilities to the combined entity, the EIR will be recalculated in accordance with IAS 39. To the extent that the newly calculated EIR will unwind over time, the corresponding charge to P&L will be recorded in Retained Earnings and treated as Core Tier 1 capital.
With regard to credit risk, Burgundy has no reason to believe that the Leek Note liabilities will not be repaid in full and contractual cash flows have therefore been modelled. However a review of current market prices of the Leek Notes would however indicate that this is not in line with the market’s perception of the securities. The mark to model and mark to market valuations provide alternative FVAs within the range of potential outcomes. We understand from Burgundy that on this alternative mark to model basis, the total FVA would result in an increase to the liability of £48m. It should be noted that using Burgundy’s alternative model approach would result in a hit to capital on Day 1 in excess of £1bn. © 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Fair value adjustments (10) BS caption
Accounting
Regulatory capital
Contingent liabilities
In conjunction with the other Big Four firms, current KPMG thinking on the treatment of the FSCS levy is as follows:
N/A
Adjustment of £nil
z
An entity makes a provision for its best estimate of its annual levy when it is assessed for its share of the deposit market (31 December each year)
z
The entity does not need to create a contingent liability for other future payments as the obligation point is being a member of the deposit market on the assessment date each year (it therefore has no possible or present obligation for future costs)
z
This accounting is analogous to accounting for Waste Electrical Equipment (WEE Directive) addressed in IFRIC 6
No contingent liability adjustment is therefore proposed in respect of the FSCS levy though the impact is quantified on page 11 of KPMG’s Updated Due Diligence report. Based on discussions with Burgundy management, we are not aware of any other contingent liabilities that require an accounting adjustment, however this will require reassessment at the point of transfer. Subordinated liabilities and subscribed capital
The net negative FV adjustment has been calculated by applying the October market values to the notional amount – this treatment assumes an active market for these securities. The reductions in liabilities for subordinated liabilities and subscribed capital are £162m and £45m respectively. Burgundy has not calculated an alternative mark to model based adjustment in respect of this liability.
Adjustment of (£207m)
As confirmed by the FSA, the FVA results in a Day 1 benefit to regulatory capital. The FVA may unwind over time. To the extent that the FVA write down is creditrelated, the adjustment will not reverse. To the extent the FVA write down is interest-related, this element may reverse. On transfer of the liabilities to the combined entity, the EIR will be recalculated in accordance with IAS 39. To the extent that the newly calculated EIR will unwind over time, the corresponding charge to P&L will be recorded in Retained Earnings and treated as Core Tier 1 capital. It should be noted that any fair value benefit due to a reduction in the PIBs liability is expected to be offset by an equal and opposite reduction in available capital, being the PIBs value itself – we understand this is reflected in the capital model.
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Other issues for consideration - accounting A number of other
Accounting z
Fair value of consideration: Claret should consider how to determine fair value of consideration (being the valuation of Burgundy) for the purposes of the goodwill calculation in accordance with IFRS 3. An exercise to determine the value of the Burgundy business is currently ongoing by Claret and the NPV that is central to this valuation may, depending on its mechanics, be a suitable basis for determining the fair value of Burgundy.
z
Date of acquisition: Per IFRS 3, the date of acquisition is the date that control passes to the acquirer. This will depend on the facts and circumstances of each case and the decision is based on the substance of transaction rather than its legal form. In determining the date of acquisition, it should be noted that the definition of control has two elements – the power to govern the financial and operating policies so as to obtain benefits and both elements must be achieved at the date of acquisition. When making decisions about when control of the Burgundy business (or divisions thereof) will change going forward, Claret should be mindful of the IFRS 3 requirements to ensure that the transaction date for consolidation purposes is not unintentionally triggered (eg by bringing operational and financial management of the Burgundy liquidity books under combined control).
z
Practicalities of consolidation: Consolidation of the combined group on Day 1 and beyond is made more difficult owing to different cut off dates applying to the reporting frameworks of Claret and Burgundy (for MI, statutory and regulatory reporting purposes). Cut off dates are ‘hard coded’ into the finance systems of both entities and cannot be easily changed. Under IFRSs it is not possible to designate an effective date of acquisition other than the actual date that control is transferred. However, in some cases it may be acceptable for an acquirer to consolidate a subsidiary from a period-end date close to the date of acquisition for convenience, as long as the effect is immaterial. For Day 1 consolidation purposes, a workaround solution (assuming immateriality) may be acceptable; however, for MI, statutory and regulatory reporting purposes beyond Day 1 (and until such time that the two reporting frameworks become one), this mismatch may not be practicable and an interim solution may be required in the medium term.
z
Financials for inclusion in Burgundy Circular: Burgundy is required to prepare a Circular for distribution to members and certain financial information in respect of the Claret Group, Claret Financial Services and Claret Bank may be required for inclusion in this document. Whilst the precise content of the Circular is yet to be determined by reference to the Butterfill legislation and FSA agreement, certain practical implications associated with the early preparation of Claret financials are currently being considered by Finance.
accounting issues are being considered in conjunction with the FVA exercise
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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Tax treatment of fair value adjustments There is no specific tax legislation relating to the transfer of financial assets and liabilities and existing HMRC guidance is unclear However, we understand that HMRC may seek to deny relief for any fair value debit arising on the transfer of financial assets and liabilities from Burgundy The calculations currently assume that all adjustments will be tax effected but there is a risk that £114 million of the asset in relation to the Society assets and liabilities may be invalid (being 28% of the adjustment in relation to financial assets and liabilities) The split of adjustments between Society and subsidiaries includes a number of broad assumptions and remains
Summary of estimated fair value adjustments as at 31 October 2008 £'m
Society
Assets Loans & advances to customers MB Commercial Lending BCIG Residential FV adjustments for hedged risk Other FV adjts for hedging L&R (formerly AFS) AFS investments Goodwill Intangible assets Property, plant & equipment
1
1
1 1 1
Total assets Liabilities Shares Deposits from banks Other deposits Debt securities in issue M ember Business Leek notes Subordinated liabilities Subscribed capital
(198)
1
1
90 (207) (292) 20 (158) 125 10 (610)
1
1
1
Impact on net assets
(37)
(198) 31 (445) 82 (311) (438) 20 (195) 125 10 (1,319)
11 (19)
(84) 11 (19)
1,189 162 45 (430)
Total
(709)
57
1 1
31 (445) (8) (104) (146)
(84)
1
1
Subs
472
57 1,189 162 45 42
Summary breakdow n £'m Financial assets and liabilities Other assets Total
1
Society (407) (23) (430)
Subs 509 (37) 472
Total 102 (60) 42
Non-financial assets z The expected legal form of this transaction is likely to be a transfer under the Building Societies (Funding) and Mutual Societies (Transfers) Act 2007 following, as a guiding principle, the provisions of s97 of the Building Societies Act 1986. At present, s97 covers building society demutualisations and there are some existing tax provisions z In relation to the adjustments to goodwill, intangible assets, property plant and equipment, the existing provisions provide for tax neutrality on transfer (i.e. assets transfer at their tax written down value). Accordingly, as the tax base of these assets should be unaffected by the fair value exercise, it will be necessary to provide a deferred tax asset / liability Financial assets and liabilities z Under the current fair value analysis, the key tax consideration is whether a deferred tax asset can be recognised in relation to the net adjustments to financial assets and liabilities transferring from the society itself (£407 million gross). Assuming an asset is recognised at 28%, the enlarged business’s capital base would be enhanced by £114 million z The recognition of a deferred tax liability is not in question for the adjustments arising in subsidiary companies since the tax base of the assets remains unaffected by the transaction (the fair value adjustments are only reflected on consolidation, whereas the tax treatment is driven by the individual accounts) z In relation to the society adjustments, the deferred tax treatment will ultimately be driven by the basis on which future taxable profits will be determined z There is no specific legislation in this area and the key HMRC guidance is somewhat ambiguous z We are aware of building society mergers where HMRC has been unable to confirm that a net debit arising on fair value adjustments is tax deductible z Accordingly, there is a risk that no deduction will be available for the fair value adjustments to financial assets and liabilities. As a result, the tax base of these assets and liabilities would be the same as their accounts base (fair value) meaning that no temporary difference arises and no deferred tax asset should be recognised z Consequently, there is a risk that the overall deferred tax liability recognised on fair value adjustments is understated by £114 million z It should further be noted that the allocation of adjustments between the society and subsidiaries remains subject to change and accordingly the figure of £114 million is just an estimate at this stage
subject to change
© 2008 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved. This document is confidential and its circulation and use are restricted. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative.
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FINANCIAL SERVICES
Project Vintage phase II Fair value adjustments & Accounting policy alignment review July 2009
ADVISORY
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Section I: Fair value adjustments Scope of work
Work in relation to the fair value adjustments to the balance sheet of the merged group on day 1 has been undertaken each month by Finance since the initial due diligence exercise and management is currently working to complete the final fair value adjustments as at 31 July 2009. We have performed an in-depth review of the methodology for each of the adjustments and have worked with management on updating the unwind profile of these where relevant. This document provides a summary of the nature and quantum of the fair value adjustments, their impact on capital, and the forecast unwind profile of these following initial recognition on day 1. At the date of drafting this report, the calculation of the fair value adjustments as at 31 July 2009 is still being completed by management. However, in order to set the adjustments into numerical context we have referred to the preliminary July 2009 calculations in this report. Where possible, we will provide a verbal update on the final fair value adjustments at the audit committee. Our final audit of the final fair value adjustments at 31 July is expected to be completed in September / October 2009.
Summary of fair value adjustments
The fair value adjustments as at July 2009 are summarised as follows:
Preliminary 31 July balance sheet adjustments
Cash and advances to banks Loans and advances to customers: Member mortgages Commercial lending BCIG mortgages Hedging adjustments Debt securities (AFS assets and loans and receivables) Derivatives Goodwill Intangible assets Investment properties Property, plant and equipment Other assets (tax adjustment) Total assets Shares Deposits from banks and other deposits Derivatives Debt securities in issue (Member business and Leek notes) Provisions for liabilities Other liabilities Subordinated debt and PIBS Total liabilities
July balance sheet1 £m 1,543
Fair value adjustment £m -
Revised fair value balance sheet £m 1,543
Capital impact of adjustments £m -
10,697 3,689 9,400 419 6,639 727 195 37 131 73 200 33,750
(178) (183) (467) (419) (563) (195) 46 (1) 10 91 (1,859)
10,519 3,506 8,933 6,076 727 83 130 83 291 31,891
(171) 55 (183) (419) (563) (1) 10 11 (1,261)
18,104 7,861 568 4,901 14 329 872 32,649
(9) (4) (1,296) 72 (328) (1,565)
18,095 7,857 568 3,605 86 329 544 31,084
(9) (4) (1,296) 72 (1,237)
Reserves General reserve 1,225 (418) 807 Non P&L reserves (124) 124 Total reserve impact 1,101 (294) 807 1 The preliminary July numbers have been used; these are in the process of being updated for the final month end and cessation accounts adjustments and may not reflect the final position
These are the preliminary 31 July fair value adjustments. These are not fully finalised and have not been subject to audit. Certain adjustments may therefore be updated.
(24) (124) (148)
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Section I: Fair value adjustments Income
Accounting guidance
The accounting in relation to the fair value adjustments is set out in IFRS 3 Business Combinations. A revised version of this standard has been issued, butstatement this revised version will onlysheetbe Balance applicable for accounting periods beginning on or after 1 July 2009. In contrast with the existing standard, the revised standard is explicit on how to account for combinations of mutual entities in which no consideration is paid. To that extent, CFS is taking account of only the relevant parts of the revised standard which deals with the issue, but is not adopting the revised standard in full. In summary, the revised standard requires acquisition accounting, i.e. consideration to be ‘imputed’ for Britannia, all the assets and liabilities of the Society and Group to be measured at fair value on the balance sheet at merger, and the difference to be recorded as goodwill. We are comfortable that this approach is being applied appropriately in the fair values work.
Impact of tax regulations
Draft regulations have been issued by HMRC in connection with the tax position of fair value adjustments and accounting policy alignment adjustments. In short, the draft regulations are currently favourable for CFS and are intended to be backdated, thereby being effective for the Britannia merger. A consultation process on the regulations is scheduled to occur over the next 2-3 months, and they are expected to be enacted in November 2009. The regulations provide that there will be tax relief on fair value adjustments for Society 'loan relationships' over a period of six years starting in 2010 and the ability for Society losses to be relieved against future profits of the Bank. On the basis that there is a reasonable expectation that the regulations will be enacted without significant change, the fair value adjustments have therefore been 'deferred tax effected' where appropriate.
Capital treatment
During the preparation of the fair value adjustments, CFS has been in regular consultation with the FSA on the capital impact of fair value adjustments. Specifically, the FSA has agreed that there is a double count of the Life Time Expected Loss capital requirement for the negative fair value adjustment on loans and advances and the Regulatory expected loss. The methodology for making this adjustment has been discussed with the FSA, who are reviewing a number of technical documents supplied by the Bank. Secondly, all fair value adjustments can be tax effected, as discussed above. The fair value adjustments, as currently presented, have been drawn up in line with the agreed individual treatments, although we would note that the full fair value adjustments and methodology, together with specific enquiries, are still subject to review and clearance by the FSA.
Summary of findings
Overall Phase II of Project Vintage has resulted in refinements to the calculations providing the day 1 fair value adjustments and the forecast unwind of these to the profit and loss account over future years. The capital implications of these adjustments have been considered and discussed with the FSA. This shows that the capital position of the merged group should not be compromised either at day 1 of the merger, or going forward as the adjustments unwind. In addition, management now has clarity over the different accounting policies used, and the information set needed to ensure appropriate alignment of these going forward.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Draft for discussion
Section I: Fair value adjustments Summary of findings (continued)
Mortgages - negative adjustment of £645m The adjustment to mortgages comprises an element for interest rate movements and a credit risk adjustment; each adjustment has been calculated separately. The fair value adjustment per the July calculations for both the member and BCIG portfolios is negative; the adjustment for the member business is -£178m (interest rate: -£171m and credit risk -£7m) and the BCIG adjustment is -£467m (interest rate: -£183m and credit risk: -£284m). The interest rate adjustment for the member business is negative because it is impacted by the omission of any floors being written into the tracker and discounted products. The existence of floor rates would have potentially reduced the gap between the contractual rate of interest being applied compared to the current required rate of return in the market. Similarly, the BCIG book is impacted by the low “revert to” rates written into all the different products. The credit risk element of the adjustments has been calculated by estimating the lifetime expected losses (‘LEL’) for each portfolio; the impact of the credit risk adjustment is more significant in the BCIG portfolio, as anticipated. We have performed a high level discounted cash flow calculation to ‘sense check’ the credit risk adjustments; this analysis suggests that the margin built into the pricing of a new product to cover credit losses over the expected life of the products (i.e. to cover the lifetime expected losses in the fair value adjustments) would be approximately 6 bps for the member business and 200 bps for BCIG. Commercial loans portfolio - negative adjustment of £183m The interest rate adjustment for the commercial loans portfolio of +£55m is calculated on a similar basis to that of the residential portfolios with the average rate implicit in the lending compared to current market prices. The credit risk adjustment of -£238m is again based on the lifetime expected losses which are forecast to arise in the portfolio. Management has reviewed the portfolio and identified those accounts which are currently in default or expected to enter default and an assessment has been made of the potential loss which may emerge on each of these accounts in the event of foreclosure. This assessment has considered the indexed value and nature of the underlying security and the knowledge and insight of the relationship managers responsible for the accounts. In addition, an LEL has been calculated for those accounts not in, or expected to, default in the near future to ensure that there is adequate cover for any unforeseen circumstances which may arise within the performing portfolio. We are working with management to finalise our review in relation to this adjustment, but note that it has been increased significantly in the latest July position. Wholesale assets – negative adjustment of £563m The portfolio of wholesale assets has been fair valued using market prices as at 31 July 2009 and will unwind through profit over the remaining expected life of the securities held up to their expected maturity value. Management is considering the existence of an inactive market for the wholesale assets portfolio at 31 July 2009 and subject to confirmation is expected to classify the ABS/MBS assets as loans and receivables. This classification means that the unwind of the fair value adjustment will be on an amortised cost basis for the ABS/MBS portfolio going forward. Should the market for these products become active once again, then IAS 39 requires that they be reclassified as available for sale assets and held at fair value. Furthermore, an impairment review over the assets is required to ensure that credit risk has been captured within the day 1 adjustment to fair value, and in the unwind profile back to the expected proceeds at maturity. Debt securities in issue – positive adjustment of £1,296m The debt securities are based on market prices and generate the largest fair value adjustment £1,296m which is due to the low price of the Leek notes in the current market. This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a cooperative. All rights reserved. Included within the fair value adjustment is an element of foreignSwissexchange movement which is fully hedged and therefore has a corresponding balance in the derivatives line on the balance sheet. The unwind of this adjustment should be on an effective yield basis over the expected life of the notes. This is currently anticipated to be the full Page 225
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Section I: Fair value adjustments Summary of findings (continued)
Subordinated debt / Wholesale funding – positive adjustment of £328m
Income statement
Balance sheet
The fair values of these liabilities have been calculated using current market prices. The foreign exchange element, as with the Leek notes, is fully hedged. The wholesale funding adjustment has a positive fair value due to several long term contracts being at a significantly reduced rate to current market prices. Shares and savings – positive adjustment of £9m The fair value adjustment to shares has been calculated based on the fixed rate products. The fixed rate portfolio generates a positive £32m adjustment due to lower current market rates. This is offset partially by the recognition of a deferred income balance on the Guaranteed Equity Bond swaps. Please refer to page 7 for further details. Intangible assets and goodwill – negative adjustment of £149m An impairment review of £37m of capitalised software intangibles is to be performed by management to determine whether the software has any value in the market and a fair value adjustment will be posted to reflect any impairment identified. A fair value of £44m has been calculated for the core deposit intangible as the variable rate savings portfolio is at favourable rates compared to the current LIBOR funding rate. Existing goodwill of £195m on the Britannia balance sheet (which principally arose on its acquisition of the Bristol & West savings business) is fully written off as part of the fair value exercise. A value of £2m has been ascribed to the Britannia brand. Property, plant and equipment / Investment property – positive adjustment of £9m A commercial property pricing index has been applied to the most recent market valuation of each of the properties in the fixed asset portfolio to estimate the current market value. In addition, external market valuations are being obtained for 10 properties (including the head office) and these valuations will be used to sense check the accuracy of the indexed valuations. A model has been developed to calculate the fair value of the investment properties held in the Illius portfolio based on future rental yields. Other The remaining FSCS levy of £15.1m for the periods 2010/11 and 2011/12 has been included in the fair value adjustment. This adjustment is subject to further consideration. Technically no liability has yet arisen in respect of these levy years (as the liability arises on 31 December prior to each levy year); however, it is possible to make a fair value adjustment for an estimate of any potential ‘exit’ levy which has already been incurred at 31 July 2009. This estimate should be consistent with the treatment adopted in the CFS half year statements. The inclusion of the levy does not include any potential capital repayment that may be required. An adjustment of £44m is proposed for the BMR (Members Reward scheme) representing an annual expected liability of £11m for 4 years. Small adjustments will also arise for other liabilities including the BBS members joining fee to the Co-op, and payments to the Charitable Foundation. The treatment of tax provisions (£10m) to cover the potential tax exposure in relation to TOMS and transfer pricing is still being discussed, as to whether these will be reflected in the cessation accounts or as a fair value adjustment. (Adjustments are pre tax and what will be accounted for, rather than the capital impact thereof)
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Section I: Fair value adjustments Changes in the fair values since the original business case
As a result of movements in market prices and rates, and refinements made to models produced to compute the fair value adjustments, the day 1 adjustments have altered since the original Income business case. The original business case Balance sheet adjustment to reserves resulted in a £75m negative impact to capital. The preliminary July 2009 adjustments show that this has increased to £148m. The key factors behind this increase include:statement
• • • •
An increased negative adjustment to mortgage assets due to decreases in base rates impacting the current market rates expected on assets, and the lengthening of the expected lives on all products An increased adjustment for credit risk in the impairment provisions as the view on expected losses has increased Market prices on wholesale assets have fallen Offsetting the above negative falls, the value of the Leek notes in issue has fallen.
Unwind profile Forecast unwind of the fair value adjustments
Cash and advances to banks Loans and advances to customers: Member mortgages Commercial lending BCIG mortgages Hedging adjustments Debt securities (AFS assets and loans and receivables) Derivatives Goodwill Intangible assets Investment properties Property, plant and equipment Other assets Total assets Shares Deposits from banks and other deposits Derivatives Debt securities in issue (Member businesss and Leek notes) Provisions for liabilities Other liabilities Subordinated debt and PIBS Total liabilities
Fair value adjustment £m -
2009 £m -
2010 £m -
2011 £m -
2012 £m -
2013 £m -
2014 £m -
2015+ £m -
21 58 89 79 (4) 1
43 4 64 119 134 (14) 350
35 2 28 54 97 (10) 206
23 20 21 59 (4) 119
8 1 20 5 22 (3) 53
167 147 (58) (10) 246
(178) (183) (467) (419) (563) (195) 46 (1) 10 91 (1,859)
244
48 9 130 189 172 (11) 537
(9) (4) (1,296) 72 (328) (1,565)
3 80 (12) 9 80
5 1 206 (17) 22 217
1 1 226 (11) 25 242
1 237 (11) 29 256
1 223 (11) 33 246
68 39 107
256 171 427
164
320
108
(50)
(127)
(54)
(181)
Total P&L impact: credit/(charge)
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Section II: Accounting policy alignments Scope of work In addition to the review of fair value adjustment, we have also reviewed the accounting policy and methodology alignment between Britannia Building Society (‘BBS’) and Co-operative Financial Services (‘CFS’). Areas of potential differences inIncome key accounting policies have been identified, statement with commentary provided on unwind considerations, recommended management actions and the impact of policy alignment. The potential impact of the alignment has been estimated, where possible. Overall findings There are eight key areas where there are policy or methodology differences which are summarised below and considered in more detail in Appendix 2. In general, CFS’ accounting policies are slightly more prudent than those adopted by Britannia; however, Britannia’s practices and methodologies are more sophisticated in certain areas such as impairment and EIR.
Policy area
Level of inconsistency
Key areas to note
Key management actions
Impact going forward Income statement
Consistent
Effective interest rate (‘EIR’)
Early repayment charges (‘ERCs’) are spread on an
EIR basis in the BBS model, whereas CFS recognises these on a receipts basis. BBS uses the fixed term as the expected life. In
contrast, CFS uses the fixed term plus 2 years. The EIR methodology used by BBS is a combination
of a straight line and sum of digits method. CFS spreads on a straight line basis only.
Impairment provisioning
Balance sheet
Inconsistent
The CFS mortgage provision covers accounts greater
than 3 months in arrears, whereas BBS goes further and applies a provision to up to date accounts and those less than 3 months in arrears. As well as applying a forced sale discount (‘FSD’),
BBS also applies loss propensities, and subtracts sale and legal costs and discounts the expected recovery amount. The commercial provisioning methodologies are
broadly the same apart from the application of FSDs which differ slightly.
Inclusion of ERCs in the EIR calculations is in line
with IAS 39. The policy going forward will be to spread ERCs on
an EIR basis at both CFS and BBS. The adjustment is expected to not be material in the short term as expected lives continue to lengthen. Therefore, an EIR asset may not be carried for this at the 2009 year end.
An adjustment to reinstate ERCs would increase the balance sheet EIR asset, and bring forward future income. The BBS ERC adjustment is not recognised within the fair value adjustments.
Align the BBS and CFS policies to give consistency
going forward. We recommend that the BBS member book model
is applied to the CFS portfolio as the loan qualities are broadly aligned. Management may wish to consider applying a credit
score to the CFS book to establish an IBNR (impaired but not reported) provision. Oversight of the impairment reviews should be
Any adjustment to align impairment provisioning policies could lead to an adjustment either way to the balance sheet provision. However, such an adjustment is not expected to be material.
aligned to ensure consistency in approach and prudence.
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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Section II: Accounting policy alignments Policy area
Level of inconsistency Consistent
Wholesale (AFS) assets reclassification
Key areas to note
Key management actions
Inconsistent
BBS chose to reclassify the majority of its FRNs,
whereas CFS did not reclassify any on the basis that an active market was considered to still exist. The fair value calculated by BBS includes accrued
interest, which may lead to a small adjustment as prices are usually quoted clean.
BBS and CFS use different hedging policies (fair
value vs cash flow hedging strategies). The cash flow hedge relationships in BBS will need
to be redesignated from merger date. This may lead to ineffectiveness in these hedging relationships going forward.
active market (at 31 July and going forward) for FRNs and MBSs in order to make a decision on their classification going forward, between loans and receivables and available for sale. Managements expects to conclude that an inactive
ensure the least volatility to the combined income statement. Update hedge documentation. Prospective testing to prove effectiveness for
redesignated cash flow hedges. amortisation.
BBS currently uses the cost model to value
properties. CFS has no investment property but the Co-op Group uses the fair value model.
Guaranteed Equity Bonds
BBS receives an upfront payment on the equity
derivative, which is taken to the P&L reflecting a day 1 gain on initial recognition. CFS receives no such payment.
The impact to the balance sheet and income statement going forward will depend on future market price movements.
Align hedging process going forward in order to
Any newly unhedged swaps considered for
Investment properties
Balance sheet
Management is considering the existence of an
market only exists for the ABS/MBS portfolio.
Hedging
Impact going forward Income statement
Ineffectiveness arising from hedging will lead to income statement volatility.
Management has concluded that the fair value
methodology will be used going forward. This may incur some additional income statement volatility going forward, particularly in relation to Illius. The two accounting policies being applied in BBS
and CFS are different due to the different criteria within the swap against these products.
On day 1 of changing the policy to spread upfront fees, an adjustment will be amended to spread the day 1 commission, would be made to recognised a than thisof independent up front. This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP rather and a member firm ofrecognise the KPMG network member firms affiliated with KPMG International, a deferred income balance. Swiss cooperative. All rights reserved.
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Management has determined that the BBS policy
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Section II: Accounting policy alignments Policy area
Level of inconsistency Consistent
Dormant accounts
Key areas to note
Key management actions
Inconsistent
CFS wrote back dormant account balances
previously written off under UK GAAP on transition to IFRS. BBS did make such a write back, but only for income which had been taken in the period from January 2004 to IFRS transition date. This treatment was, nonetheless, in line with the accounting treatment. Securitisations
Impact going forward Income statement
Whilst CFS does not have any securitisation
vehicles, parallels can be drawn between the CFS Covered Bond and the Leek vehicles.
The magnitude of a BBS write back has been
calculated as £9m. Management is likely to align the approach with
Balance sheet
Nil – day one fair value adjustment that would provide future income statement protection
that adopted by CFS, by adjusting for this liability in the fair value adjustments.
Ensure operational accounting and statutory
TBD
TBD
reporting for the securitisation vehicles remains appropriate under IAS 39.
Discussions are ongoing in relation to the valuation
and accounting for the intercompany swap and the deemed loan relationships. Impact going forward The direction of the arrows depicts whether there would be an increase/decrease or potentially an adjustment either way going forward to the income statement and balance sheet
The length of the arrows depicts the expected quantum of the impact of the adjustment going forward
This document is CONFIDENTIAL and its circulation and use are RESTRICTED. © 2009 KPMG LLP, a UK limited liability partnership, is a subsidiary of KPMG Europe LLP and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. All rights reserved.
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12 NOVEMBER 2008
S TRI CTLY
PRI VATE
AND
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PROJECT VINTAGE: APPROACH TO VALUATION AND TERMS
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PROJ E CT
VI NTAGE :
APPROACH
TO
VALU ATI O N
AND
TE RM S
English_General
This presentation was prepared exclusively for the benefit and internal use of the JPMorgan Cazenove client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan Cazenove. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan Cazenove. The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. JPMorgan Cazenove’s opinions and estimates constitute JPMorgan Cazenove’s judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan Cazenove makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects. JPMorgan Cazenove’s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan Cazenove also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan Cazenove is a marketing name for JPMorgan Cazenove Limited. This presentation does not constitute a commitment by JPMorgan Cazenove or its affiliates to underwrite, subscribe for or place any securities or to extend or arrange credit or to provide any other services.
PROJECT VINTAGE
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Terms—transaction approach Transaction concept
Issues for Burgundy
Combination is a merger of mutual organisations
Similarities between Claret and Burgundy constitutional
TE RM S AND
One-off transaction payment is inconsistent with overall
Dividend payments
Claret and Burgundy have long term commitment to mutuality.
Reinforced by Burgundy’s charitable assignment
Capital deployed for benefit of customers Democratic representation
ethos
Significant difference: rights on dissolution Concern for Burgundy arises on sale Sale of Burgundy: proceeds go to members
approach to a merger This principle has now been acknowledged by Burgundy
Sale of Claret FS: discretionary use of proceeds Burgundy has raised possibilities of cash payment, shares in
Concept of merger should be reinforced by:
Claret FS or contingent value right
Retention of brands and key locations
Agreed that cash payment will not be made
Management structure
Contingent value issue is unresolved
Most tangible ownership benefit: loyalty payment scheme
Considered impractical to change Claret constitution or grant
Burgundy members become entitled to Claret scheme: amount
and growth prospects are critical
legacy rights to Burgundy members Burgundy position undermined by charitable assignment scheme
(five years) Pragmatic approach involving some form of strategic
VI NTAGE :
APPROACH
TO
Payment of windfall benefits appears at odds with culture and
VALU ATI O N
positions
Ownership interests are retained
commitment from Claret to financial services and continuing ownership of Burgundy may provide compromise Need to assess impact for Burgundy members under reward
PROJ E CT
scheme
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Value proposition to Burgundy members Components of value
Sidebyside analysis
Will account for at least 42% of enlarged
Bur gundy
Membership rights
Empowered to influence strategy of Claret Group
process and dividend benefits
VALU ATI O N
1.5
Voting members: Burgundy / Claret
2.1
42:58
115
PBT: Burgundy / Claret 2007A
267
30:70
PBT: Burgundy / Claret 2008E
94
334
22:78
PBT: Burgundy / Claret 2009E
87
278
24:76
NAV: Burgundy / Claret 2007A
1,255
3,797
25:75
45.9
99.7
32:68
Participation in Claret reward scheme Expected uplift to dividend versus standalone
Income benefits
prospects Diversification and synergy benefits flow through
dividend
TO APPROACH VI NTAGE : PROJ E CT
Clar et Gr oup
On-going ownership rights through democratic
AND
TE RM S
membership
Dividend: Burgundy / Claret1 2007A
0%
50%
100%
Economic interest in Group’s capital value Significant enhancement of attributable NAV and
Capital benefits
Group distribution includes payments to corporates, employees and community
PBT per member Capital position supports profit growth, dividend,
strategy, business development and product provision
Per member statistics2
Creation of a larger, more profitable and financially
stronger group with a sustainable business model Enhanced financial security and prospects
1 Claret
Mutuality maintained Customer offering enhanced, including product
range, servicing, distribution reach and pricing
Burgundy
Claret Group
PBT 2007A
£ per member
77
127
PBT 2008E
63
159
PBT 2009E
58
133
NAV 2007A
837
1,808
2 Burgundy
figures are based on voting members only
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Value proposition for Claret members Components of value The impact of the transaction should increase
The value of the acquired business comprises the
Earnings and dividend enhancement
VALU ATI O N
Enhancement of dividends for members over the
Value creation
longer-term
Less any capital requirements, integration costs and
the dividend strain of the acquisition Key metrics: NPV and ROI
dividend per point
The chart below represents an illustrative valuation framework focused on the NPV
Illustrative components of value1 Burgundy Profit
Synergies
Terminal value
ILLUSTRATIVE NUMBERS ONLY
TO APPROACH VI NTAGE : PROJ E CT
capital and cashflows attributable to Burgundy’s business, including synergies
Key metrics: Bank KPIs, Claret Group KPIs and
AND
TE RM S
earnings and improve growth prospects
52
61
63
63
63
63
41 10 35
29 47
81
89
94
97
100
102
103
2009
2010
2011
2012
2013
2014
2015
2016
2017
(43) (40)
(36) (40)
(11) (40)
(42)
(45)
(47)
(48)
(48)
(49)
Integration costs
n.a.
Terminal value
Dividend
NPV of combination to Claret Group at 9% cost of capital is c. £402m (with no terminal value). At 12% cost of capital, NPV is £339m Source: Burgundy base case, with Claret due diligence assumptions on impairment. Figures displayed are post-tax 1 No capital injection assumed. Cost and revenue synergy figures as per v2 base case. Phasing assumes 30 June 2009 completion. Due diligence work assumes restructuring charge total of £125m (pre-tax). Dividend in 2012 and onwards reflects fixed payout ratio as a percentage of Burgundy PAT (c. 32%)
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Value benchmarking using the branch network Investment cost of building a national branch network
Economic value of a national branch network to Claret
APPROACH VI NTAGE : PROJ E CT
One-off costs associated with new branch acquisition were estimated at £600k per location. For 188 branches this would translate to £113m over 5 years
337
The main costs associated with new branch openings have been estimated as follows (per branch):
Removal of overlapping branches
(60)
Refit of new premises
Final combined branch network
277
Marketing
Increase in Claret branch network
188
Recruitment and training
Combined branch network under Vintage:
Current Claret branches
89
Current Burgundy branches (257 less 9 announced closures)
248
Combined branch network
In 2005, LEK carried out some analysis quantifying the cost and benefit of investing in increasing the Claret branch network by an additional 133 branches over a 5 year period
LEK’s assessment gave an NPV of £221m resulting from 133 new branches (using a 25 year NPV timeline plus a terminal value)
Before accounting for inflation or any changes in the economic environment, this NPV would equate to £312m for 188 branches (assuming 1st branch acquired in 2010)
Due to the high level of up-front one-off costs, the payback period for a phased investment in new branches over 5 years would be 10 years
TO
VALU ATI O N
AND
TE RM S
£544k £50k £4k
Whilst the one-off costs have been quantified above, there are also potential operational constraints which would need to managed to progress a branch opening programme over this timescale
Property & Facilities capacity for finding locations and project management of all activity
IS capacity for installing new technology in new branches
HR and Network capacity for all recruitment and training to support the rollout
There is also a major constraint of related to the availability of suitable properties in target locations
Alternative approaches to value Date
Member
Pay-out /
pay-out
reserves
branches
Nationwide
Portman
Sep-06
500
65%
3.5x
Newcastle
Universal
May-06
19
60%
2.1x
Portman
Lambeth
Mar-06
55
67%
6.1x
Leeds
Mercantile
Jan-06
7
39%
0.6x
Portman
Staffordshire
Jun-03
65
49%
1.5x
60%
2.1x
471
528
Median Claret
Burgundy
Note: Santander / A&L multiples were 111% and 5.0x respectively
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Next steps Refine valuation analysis of the Burgundy business, including an assessment of the possible value attribution
of the two businesses (BCIG and member business) Incorporation of value items arising from due diligence Reflect of transaction adjustments, including:
— — — —
capital synergies integration costs accounting adjustments
Presentation of a proforma business plan, including assessment of: projected profits, balance sheet and capital position Develop dividend analysis and proposal for Group
PROJ E CT
VI NTAGE :
APPROACH
TO
VALU ATI O N
AND
TE RM S
Update for latest Burgundy financial projections
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PROJECT VINTAGE: IMPLICATIONS FOR DIVIDEND
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PROJ E CT
VI NTAGE :
I M PLI CATI ON S
F OR
D I VI D E N D
English_General
This presentation was prepared exclusively for the benefit and internal use of the JPMorgan Cazenove client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan Cazenove. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan Cazenove. The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. JPMorgan Cazenove’s opinions and estimates constitute JPMorgan Cazenove’s judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan Cazenove makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects. JPMorgan Cazenove’s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan Cazenove also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan Cazenove is a marketing name for JPMorgan Cazenove Limited. This presentation does not constitute a commitment by JPMorgan Cazenove or its affiliates to underwrite, subscribe for or place any securities or to extend or arrange credit or to provide any other services.
PROJECT VINTAGE
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Principal assumptions Current assumption underlying analysis is that the existing Claret scheme structure does not change for Vintage This may need to change in light of the assessed impact of the transaction Assumed that only Burgundy’s voting members (c.1.5m) and those additional nonvoting members receiving
payments under BMR (c.200,000) become members of Claret’s reward scheme. Claret will pay £1 per member
PROJ E CT
VI NTAGE :
I M PLI CATI ON S
F OR
D I VI D E N D
Note that other Burgundy members may either already be Claret members or could post-transaction join as
new members, thus becoming entitled to dividend on their financial products and other trade with Claret Group Assumes that Burgundy members receive a full payment in 2009, although merger is likely to complete mid-year Assumed that Claret reward payments are not made on Burgundy members’ third party products This would serve to encourage Burgundy members to switch to Claret financial products rather than remaining
with third party providers Current Burgundy members pay tax on dividends received on savings products Assumption is that this continues For consistency, Claret would no longer pay tax on behalf of CFS members Analysis assumes dividend payments continue to retail PIB holders (c. 4,000 holders¹) Analysis is based on the latest Claret financial plan (version 3) and the current set of Burgundy projections, which
are subject to review and are likely to change No assumption has been made for one-off implementation costs of changing the Claret scheme. The on-going
maintenance costs of the Burgundy scheme are included in Burgundy profits and assumed to cover the additional annual cost of servicing Burgundy members within the Claret scheme Source: Company information ¹ See Dataroom, Burgundy, Customer Journey, 5.14
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Comparison of the schemes—cost implications The material differences between the schemes are:
Burgundy
Claret
Quantum impact
PROJ E CT
VI NTAGE :
I M PLI CATI ON S
F OR
D I VI D E N D
Actual 2007 BMR
£45.9m
Pay-out per £1,000 of balance is 90p for mortgages and 180p for savings
Pay-out per £1,000 of balance is 132p for mortgages and 263p for savings
£11.8m
Caps on mortgage (>£110,000) and savings (>£22,000) balances
No caps on mortgage or savings balances
£15.4m
Maximum pay-out capped at £500
No cap on maximum pay-out
Tenure bonus for members with society for more than 5 years (150%) and 10 years (200%)
No tenure bonus
Earn points on third party products
Only earn points on Claret financial products
£(15.8)m
Claret equivalent1 1
De minimis
£(4.4)m £53.0m
Based on Claret dividend of 2.63p per point in 2007
Impact on Claret dividend
Pro forma impact on 2007 Claret dividend (£m)
The dividend analysis above is based on Claret’s 2007 dividend of 2.63p per point
Given Burgundy produced £83m of post-tax distributable profits in 2007, under the current Claret scheme this would support an incremental contribution to the dividend of £16.6m on a 40% pay-out and 50% allocation to individual members
Total Claret points awarded under the scheme would increase as Burgundy members become members of Claret reducing the dividend per point from 2.63p to 1.76p
At 1.76p per point, the equivalent total dividend for Burgundy members would have been approximately £36m
82.9 60.4
/
3,419m
=
1.76p
43.8 33.2 16.6
Burgundy
Total div
pr ofits after
(40% pay-
Div. to ind. Claret div. to member s
tax
out)
(50% of total)
Pro forma
ind. members div. to ind.
Enlarged
Clar et div.
Clar et points
per point
members
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Membership—who participates and benefits
The impact for Claret depends on which Burgundy members become members of Claret’s scheme
Current assumption is that all members receiving BMR or with a vote will automatically become Claret members and entitled to dividends under the Claret scheme (c. 1.7m members)
Equivalent Claret dividend (£m)1
Burgundy dividend 2007 (£m)
D I VI D E N D
Members Mortgages
Total
Mortgages
Savings
Total
1.47m
Members receiving BMR
1.24m
12.4
29.0
4.4
45.9
12.2
40.8
53.0
In qualifying period (5 years) with large balances
Long-time savings and mortgage members (>10 years), where outstanding balance is small
All members joining the Society within the last two years (if included by Claret)
Long-time mortgage members (between 5 and 10 years) with large balances
Members with third party products
PROJ E CT
VI NTAGE :
Savings
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Dividend pay-out—sustainability
Burgundy distributes significantly more of its post-tax earnings than Claret and only half of Claret’s total payment goes to individual members, with the rest split between corporate members, employees and community
Annual dividend to individual members (£m) Burgundy
Pay-out ratios (%)
Claret Group
Burgundy
D I VI D E N D
69
39
FY07
56%
65
48
40%
41
38
32
F OR I M PLI CATI ON S VI NTAGE : PROJ E CT
48
46
FY 08
Claret Group
20%
Corporates, community & employees
20%
Members
32
FY09
FY 10
Pay-out ratio after tax
FY11
Potential headwinds on Burgundy profits will impact dividend affordability
Indicative Burgundy base case pre-tax profits (£m)
Indicative Burgundy downside case pre-tax profits (£m)
173 115 95
120
115 94
69
87
38 2
FY07
FY 08
FY09
FY 10
FY11
FY07
FY 08
FY09
FY 10
FY11
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Further considerations—status quo Claret dividend needs to be considered in the context of: Potential removal of IFRS pension income, which contributed £89m to distributable profits before tax in 2007 (would have c.£25m
impact on the dividend assuming a 40% pay-out) Somerfield, with interest expense exceeding operating profit in the first two years (c.£30m impact in 2009) Assuming the current pay-out policy is unchanged (40%), on current forecasts, the standalone dividend per point would fall from 2.63p
to 2.27p in 2008 and 1.60p in 2009
PROJ E CT
VI NTAGE :
The removal of IFRS pension income reduces the dividend by c. 0.50p (see green bars) The impact of the Somerfield deal reduces the dividend by 0.70p in 2009 as a result of the debt servicing expense and enlarged
membership as Somerfield customers become Group members (see yellow bars) In light of this, it is our current understanding that Claret Group may consider smoothing the dividend in 2008 and subsequent years, by
flexing the pay-out ratio (subject to any restrictions such as covenants on the Somerfield debt), until the full benefits of Somerfield are captured and debt is paid down allowing the pay-out ratio to revert to more normal levels
2007A
2009E
2010E
2011E
2007A
2008E
2009E
2.20
2.85
2010E
2.41
2.45
1.96
2.93 1.60
2.30
2.82
2.27
2.38
2.94
2.63
2.63
2.63
365
319
371 279
300
352
Dividend per point (p)
197
315
2008E
264
249
239
300
249
249
Distributable profits after tax (£m)
249
I M PLI CATI ON S
F OR
D I VI D E N D
The blue bars in the graphs below illustrate the position before the above adjustments are made
2011E
Including pension income, before Somerfield and Vintage Excluding pension income, before Somerfield and Vintage Excluding pension income, after Somerfield and before Vintage
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Further considerations—Vintage Without amending the current structure of the Claret scheme, some dilution to existing members would result from Project Vintage in
the first couple of years This is a function of: Significantly expanded membership and dividend strain Timing of synergies which are expected only to be fully delivered by 2012
Assuming no changes to the current Claret scheme (maintained pay-out, points system and allocation of dividend between stakeholder
groups), the impact of Vintage on the dividend is a further reduction of 0.54p in 2009, although this reduces over time as the synergy benefits of the merger flow through (see purple bars) Assumes 40% pay-out (from distributable profits) Allocation of the dividend: 50% individual members, 20% corporate members, 20% employees and 10% to the community
PROJ E CT
2008E
2009E
2010E
2011E
2007A
2008E
2009E
2010E
1.80
2.20 1.47
1.96 1.06
1.60
2.27
2.27
2.63
365
392
279
260
239
239
249
249
2007A
2.63
Dividend per point (p)
527
Distributable profits after tax (£m)
197
VI NTAGE :
I M PLI CATI ON S
F OR
D I VI D E N D
The yellow bars represent the profits and dividend before Vintage, but after adjustments for Somerfield and pension income
2011E
Excluding pension income, after Somerfield and before Vintage Excluding pension income, after Somerfield and Vintage
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Relative profit contribution and dividend allocation The graphs below show the relative contribution to profit and the allocation of the dividend among stakeholder groups on the
assumption of no change to the current Claret scheme structure Post-Vintage Claret Group PBT (£m) Trading Group
CFS
D I VI D E N D
60%
Bur gundy
Synergies 7%
Trading Group
43%
24%
1
80%
70%
70%
38%
Other
90%
22% 49%
Burgundy
100%
24%
80%
CFS
7%
26%
55%
50%
50%
50%
50%
23%
22%
21%
6%
5%
5%
22%
23%
24%
FY 09
FY 10
FY 11
60%
22%
50%
50%
40%
40%
10%
30% 51%
45%
20%
48% 20%
38%
10%
10%
0%
0%
FY07
FY 08
8%
30%
57%
FY09
FY 10
Note: using base case profits
37%
FY 07
FY11 1
PROJ E CT
VI NTAGE :
I M PLI CATI ON S
90%
F OR
100%
Post-Vintage Claret Group dividend splits (%)
40%
FY 08
Comprises corporate members (20%), employees (20%) and community (10%)
PROJECT VINTAGE
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Considerations for the future structure of the dividend scheme The impact on the dividend from Somerfield and Vintage can be mitigated in a variety of ways: Temporary smoothing of the dividend through an increase in the pay-out ratio over a transition period
— However, this is likely to be unsustainable from a cashflow and capital perspective if used on its own — For example, the corporate members and the community are maintained to ensure they are no worse off than before the transaction, but the benefits of Vintage are used to off-set the dilution in payment to the individual members and employees Adjusting the points awarded for trade
— For example, reducing the points earned on CFS financial products, thereby reducing the dividend strain of the Burgundy members joining Aligning the points awarded for trade more closely with the profitability of business segments (or
hypothecation) It is possible that the optimal approach may incorporate some or all of these alternatives Consideration of the funding of the dividend has not yet been assessed In particular, the ability of CFS to fund a growing Group dividend in the early years post-Vintage Also the ability of Claret Group to fund the dividend whilst servicing Somerfield debt within its financial
covenants
PROJ E CT
VI NTAGE :
I M PLI CATI ON S
F OR
D I VI D E N D
Adjusting the allocation of dividend between stakeholder groups
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20 JANUARY 2009
S T R I C TL Y
P R I V A T E
AN D
C O N F I D E N T I A L
PROJECT VINTAGE BOARD PAPER
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s or valuation
P R OJ E C T
VINT A G E
B O AR D
P AP E R
G:\Corporate Finance Advice\Clients\Co-operative Group\Project Vintage\Presentations\JPMC board paper final.ppt
This presentation was prepared exclusively for the benefit and internal use of the JPMorgan Cazenove client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan Cazenove. Neither this presentation nor any of its contents may be disclosed or used for any other purpose without the prior written consent of JPMorgan Cazenove. The information in this presentation is based upon any management forecasts supplied to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. JPMorgan Cazenove’s opinions and estimates constitute JPMorgan Cazenove’s judgment and should be regarded as indicative, preliminary and for illustrative purposes only. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan Cazenove makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Unless expressly contemplated hereby, the information in this presentation does not take into account the effects of a possible transaction or transactions involving an actual or potential change of control, which may have significant valuation and other effects. JPMorgan Cazenove’s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan Cazenove also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan Cazenove is a marketing name for JPMorgan Cazenove Limited.
CLARET FINANCIAL SERVICES
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Agenda Strategic rationale
1
Merger terms
7
Dividend
13
Valuation
18
Appendix
29
P R OJ E C T
VINT A G E
B O AR D
P AP E R
Page
CLARET FINANCIAL SERVICES
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Merger transforms Claret’s banking business UK UK mortgage mortgage stock stock (2007, (2007, £bn) £bn) LTSB/HBOS 153.3 (12.9%)
Nationwide
CFS 31%
CFS 50%
101.9 (8.6%)
Northern Rock
90.8 (7.6%)
Barclays
69.8 (5.9%)
RBS
67.3 (5.7%)
HSBC
PBT (pre Vintage) = £462m4
39.4 (3.3%)
Claret
23.4 10.6
Deposits (2007, £bn)
Burgundy²
23.4 (2.0%)
Customers (m) Branches
R AT I O N ALE
2.8
90
254 20%
Market position (ranking)
Claret³
Mortgages
3.3 (0.3%)
17.6
0.56
0%
S T RA T E G I C
36.8
3.3
26.7 (2.2%) 23.7 (2.0%)
Burgundy
13.1
Assets (2007, £bn)
39.1 (3.3%)
Bristol & West¹
PBT (post Vintage)= £636m5
Market Market position position
Mtg stock(2007, £bn)
Claret/Burgundy
Trading Group 50%
Trading Group 69%
337.0 (28.4%)
Abbey/A&L
B&B
Stronger Stronger and and more more profitable profitable financial financial services services group group (2009E) (2009E)
Branches
40%
60%
80%
100%
Claret
Burgundy
n.m.
10
Total 9
10
8
7
Source: Company reports, Datamonitor, Bank of England 1 Subsidiary of Bank of Ireland 2 Loans and advances secured on residential dwellings, as reported in Burgundy 2007 annual report 3 Claret Education Session pack 4 PBT is before group central and finance costs, before tax 5 PBT is before group central and finance costs, before tax and one-off merger costs. Synergies assumed are run-rate of £88m 6 Claret FS
CLARET FINANCIAL SERVICES
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Combination of complementary businesses will benefit customers Introduction Introduction
Complementary Complementary financial financial services services businesses businesses
Vintage represents a one-off transformational opportunity for Claret
Key benefits to customers include improved product offering,
Shared strategic vision, purpose and values between two groups Becomes No.2 mutual in banking sector Total loans and advances of £34.5bn1
Enhanced financial services offering to customers
distribution and servicing, and reinforced mutual ethos
Culture Burgundy’s core member
Significant cost and revenue synergies
Creation of a sustainable business model
business similar to Claret’s core retail banking relationship approach Similar mutual culture and
shared values
Product Product offering offering of of the the combined combined group group Burgundy
Strength and depth of
Membership rewards Similar approach to rewarding
members Reward members based on
trade undertaken with institution Reward scheme will be
enhanced by a transaction
management talent from both organisations
Claret
Current account inc. overdraft and sweeping Distribution
Savings and GEBs per savings strategy
Complementary strengths
S T RA T E G I C
R AT I O N ALE
Credit cards and personal loans
transforms Claret network of 90 branches
Mortgages
Claret has telephone and web
Protection and general insurance Life and investments
254 Burgundy branches
TBC
Life, investments and pensions
capability which Burgundy are looking to develop Burgundy are also looking to
develop their direct sales proposition
Product offering Complementary product
offering Potential to rationalise savings
and mortgage offerings Burgundy strong in
mortgages and savings products
Claret can provide life and
pensions, GI products, loans and credit cards
¹ 2007 reported. Includes Burgundy commercial lending and other Claret loans
CLARET FINANCIAL SERVICES
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Anticipated synergies are meaningful Phasing Phasing of of anticipated anticipated transaction transaction synergies synergies (£m) (£m) Cost syn.
Revenue syn.
Dissynergies
Overview Overview Imp'tation cost
Meaningful synergies, largely based on cost savings initiatives, are anticipated Cost synergies—£70m by year 5, including customer facing costs (£5.3m),
head office (£37.1m), processing (£21.2m) and property (£3.4m)
80
Revenue synergies—£18m by year 5, comprising incremental current account,
16.0
loan, cards and motor penetration to Burgundy base (£8m), and mortgages (£6m) and Notice/Term savings into Claret base (£4m)
11.7
Dissynergies—attrition from merger and brand confusion/poor integration
60
Implementation costs—£139m including membership costs, core integration
7.9
costs, redundancy, IT, communications and branch rationalisation costs
40
5.1 60.0
Implementation costs at two times benefits are towards the top end of the range
48.5
20 2.0 12.0 0
Overall, the level of synergies are in-line with precedent in-market transactions
69.0
(4.0)
(20)
of precedents
34.5
(6.5)
(30.0)
(3.5)
(1.0) (9.0)
Cost synergies synergies (% (% smaller smaller party party cost cost base) base)11 Cost Burgundy/Claret
(30.0)
28.0%
HBOS/Lloyds TSB
(40)
(70.0)
A&L/Abbey
S T RA T E G I C
R AT I O N ALE
BoS/Halifax
(60)
Woolwich/Barclays
28.4% 23.3% 25.7% 35.7% 57.6%
NatWest/RBS
(80) 2009
2010
2011
2012
2013
TSB Group/Lloyds
30.9% Median 29.7%
Source: JPMorgan Cazenove, Claret, Burgundy ¹ Run rate cost synergies (most recently disclosed) as a percentage of smaller party cost base (underlying, excluding goodwill or intangible amortisation). Vintage run rate synergies of £70m
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Pro forma earnings are enhanced by the merger Base Base case case
Moderate Moderate stress stress case case
£m
2009E
2010E
2011E
2012E
£m
2009E
2010E
2011E
Income¹
917.5
945.0
989.3
1,051.9
Income¹
889.6
899.4
917.3
951.4
Expenses
(554.1)
(538.3)
(540.1)
(517.1)
Expenses
(536.0)
(506.3)
(489.0)
(453.1)
Impairment
Impairment
(260.9)
(263.6)
(196.6)
(141.4)
92.7
129.4
231.7
356.8
(184.1)
(177.8)
(142.8)
(120.0)
Underlying PBT
179.3
228.9
306.4
414.7
Underlying PBT
FVA unwind
118.1
88.8
(193.8)
(46.2)
FVA unwind
118.1
88.8
(193.8)
(46.2)
Claret significant items
(23.1)
(12.4)
(8.7)
(6.2)
Claret significant items
(23.1)
(12.4)
(8.7)
(6.2)
Implementation costs
(70.0)
(30.0)
(30.0)
(9.0)
Implementation costs
(70.0)
(30.0)
(30.0)
(9.0)
Profit before tax
204.3
275.3
73.9
353.2
Profit before tax
117.7
175.8
(0.9)
295.4
Net interest margin (%)
1.44%
1.47%
1.46%
1.47%
Net interest margin (%)
1.38%
1.43%
1.48%
1.54%
Cost: income (%)
60.4%
57.0%
54.6%
49.2%
Cost: income (%)
60.3%
56.3%
53.3%
47.6%
Return on assets (%)
0.34%
0.49%
0.51%
0.62%
Return on assets (%)
0.21%
0.35%
0.45%
0.64%
(75.0)
(65.1)
(38.4)
(23.2)
(131.8)
(130.9)
(82.2)
(39.6)
(74.1)
(63.7)
(37.2)
(22.5)
(131.0)
(129.6)
(81.0)
(38.8)
49.0
95.0
44.0
30.2
49.0
95.0
44.0
30.2
(26.0)
29.9
5.6
7.0
(82.8)
(35.9)
(38.2)
(9.4)
Claret
(109.1)
(112.7)
(104.4)
(96.8)
Claret
(129.1)
(132.7)
(114.4)
(101.8)
Net total
(135.0)
(82.8)
(98.7)
(89.9)
Net total
(211.9)
(168.7)
(152.6)
(111.2)
Ratios
Ratios
Impairment Burgundy o/w BCIG FVA credit unwind Net Burgundy
Impairment Burgundy o/w BCIG FVA credit unwind Net Burgundy
¹ Includes return on Claret equity capital injected
S T RA T E G I C
R AT I O N ALE
2012E
CLARET FINANCIAL SERVICES
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Alternative opportunities are limited Claret Claret Financial Financial Services Services strategy strategy
UK banking banking landscape landscape UK
Scale increasingly important in current environment
Bank / Society
Strategic priority is to achieve scale through expanding
RBS
customer base Key to this ambition is building out the Claret bank branch
network
Barclays
1,365.7
HSBC
1,279.6
HBOS
681.4
Lloyds TSB
367.8 207.4
Standard Chartered
199.3
Alternative Alternative strategies strategies
Nationwide¹
179.0
Organic development of branch network
NAB
40.7
Burgundy
36.8
Yorkshire
20.5
No synergies or broader transaction benefits available Acquisition of a branch network
Current opportunities limited in present environment
No synergies or broader transaction benefits available Bolt-on acquisitions of smaller mutuals or banks
R AT I O N ALE
1,948.7
Abbey
Expected to take c. 5 years and £100m of investment
S T RA T E G I C
Assets (£bn)
Some smaller societies and banks potentially looking for
stronger partners
Transaction benefits likely to be significantly less than
Vintage and execution of a series of acquisitions has challenges Major acquisition of another bank or building society
No other institution of a comparable size to Burgundy
Coventry
14.9
Claret Bank
13.5
Chelsea
13.1
Skipton
12.5
Paragon
11.5
West Bromwich
9.6
Leeds
9.2
Derbyshire¹
7.1
Principality
5.9
Cheshire¹
5.0
Newcastle
4.8
Cattles
3.4
Source: Building Societies Association, Company Reports Notes: 1 Nationwide merged with Derbyshire and Cheshire on 1 Dec and 15 Dec 2008
available
CLARET FINANCIAL SERVICES
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Agenda Strategic rationale
1
Merger terms
7
Dividend
13
Valuation
18
Appendix
29
P R OJ E C T
VINT A G E
B O AR D
P AP E R
Page
CLARET FINANCIAL SERVICES
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Overview of the Merger Principles and and terms terms of of the the Merger Merger Principles
Mutuality is preserved Acquisition of 100% of the business of the Burgundy Building Society (“Burgundy”) under the Mutual Societies (Transfers) Order 2009
Claret Members Membership rights & CVR
Eligible Burgundy members (i.e. active members) become members of the Claret Group
Claret Group
Opportunity for substantial democratic empowerment over time
Dividend rights
Certain temporary protections (referred to as the “Contingent Value Right”) for Burgundy members including
Claret FS
Entrenched CFS board positions for 4 Burgundy nonexec directors for up to 3 years Claret commitment to compensate former Burgundy members on a sale of the Burgundy member business or a demutualisation of the Claret Group within 5 years
Entitlement to future Claret dividends under a revised scheme, which are equivalent to a c. 48% share of CFS earnings distributed to stakeholders over next 4 years
M E R G E R
T E R M S
Burgundy Members
No upfront consideration or windfall payment to Burgundy members
Structure Structure of of the the Merger Merger
Burgundy
Transfer of business
Claret Bank
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Transaction terms Further Further detail detail on on the the terms terms of of the the Merger Merger
Approach to senior management teams, board representation, brands, strategy and key locations are all synonymous with a merger
The members of Burgundy, as the current owners of the business, will continue to participate as members of the Claret Group
Over time, Burgundy members will enjoy increasing influence through Claret’s governance structure, reflecting the accountability of the local area committees, regional and Group boards towards a significantly expanded membership
Since the Burgundy member business is core to the CFS banking strategy and the Claret Group has no present intention of demutualisation, these protections amount to an anti-embarrassment provision for the Burgundy Board
On-going economic participation is achieved through the redesigned Claret dividend scheme, which aims to provide Burgundy members with a fair share of the benefits resulting from the combination The absence of any upfront consideration or windfall payment provides meaningful protection to Claret on entering into the merger
It is acquiring 100% control of Burgundy’s businesses for nil upfront consideration Although value will transfer from Claret to Burgundy members, via the dividend scheme, this will only occur should profits flow from the combined CFS business Nevertheless, some dilution would result in the event of a substantial deterioration in the trading performance and financial position of Burgundy, particularly if total dividends from CFS have to be cut or additional capital support is required from the centre
In summary, the transaction is structured as a true merger of equals
M E R G E R
T E R M S
A further 1 million Burgundy members, who are less active members, will have the option to become members of Claret if they choose – should all these members choose to join, former Burgundy members would then account for up to 60%
In the meantime, Burgundy members will benefit from certain protections, including entrenched non-exec positions on the CFS board for 3 years and a compensation payment should Claret sell the Burgundy member business or demutualise with 5 years
On current estimates, it is anticipated that up to 2 million Burgundy members will automatically become eligible for membership of the Claret Group, representing c. 50% of the enlarged membership base
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Value proposition to Burgundy members Components Components of of value value
Sideúbyúside Sideúbyúside analysis analysis
Could account for up to 60% of enlarged membership
Membership Membership rights rights
Empowered to influence strategy of Claret Group On-going ownership rights through democratic process and
dividend benefits
Expected uplift to dividend versus standalone prospects Diversification and synergy benefits flow through dividend
115
per member
57:43
267
30:70
88
334
21:79
PBT: Burgundy/Claret 2009E
87
278
24:76
NAV: Burgundy/Claret 2007A
1,255
3,797
25:75
Dividend: Burgundy/Claret¹ 2007A
45.9
0%
Significant enhancement of attributable NAV and PBT
2.1
PBT: Burgundy/Claret 2008E
Economic interest in Claret Group’s capital value
Capital Capital benefits benefits
Claret Group
2.8
Voting members: Burgundy/Claret PBT: Burgundy/Claret 2007A
Participation in Claret reward scheme
Income Income benefits benefits
Burgundy
99.7 50%
32:68
100%
¹ Claret Group distribution includes payments to corporates, employees and community
Capital position supports profit growth, dividend,
strategy, business development and product provision
Enhanced Enhanced financial financial security security and and prospects prospects
stronger group with a sustainable business model Mutuality maintained Customer offering enhanced, including product range,
servicing, distribution reach and pricing
Burgundy
Claret Group
PBT 2007A
£ per member
41
127
PBT 2008E
31
159
PBT 2009E
31
133
NAV 2007A
448
1,808
² Burgundy figures are based on all members
M E R G E R
T E R M S
Creation of a larger, more profitable and financially
2 Per Per member member statistics statistics2
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Contingent value right Principles Principles
Board responsibilities responsibilities and and advice advice Board
Four Burgundy non-executive directors will join the board of
The sale of all, or a substantial part, of the former Burgundy
CFS Their position will be entrenched for three years and they will
be able to veto any sale of the former Burgundy member business over that period A share of the proceeds realised on any sale would be paid to
Burgundy members on fair and reasonable terms In the event of a demutualisation of Claret Group, a fair share
of the proceeds would also be paid to Burgundy members The payment provisions will last for five years from completion Eligible members will be former Burgundy members who
are continuous members of the Claret Group and customers of Claret Bank until the time of sale or demutualisation The board veto will not apply where Claret is ordered by a
member business or the demutualisation of Claret would require the approval of the relevant Claret board The directors would be required to take account of the
interests of the former Burgundy members as well as their other fiduciary duties as directors of Claret, CFS or Claret Bank The directors must take independent advice on the fairness and
reasonableness of the terms of the transaction for the former Burgundy members, as well as Claret members as a whole Any payment and terms may take account of the value of the
Burgundy businesses as a whole, where appropriate It would also confirm the arm's length nature of the transaction
with the counterparty These provisions would last five years
M E R G E R
T E R M S
regulatory authority to make the disposal
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Transaction risks Pre-announcement risks Pre-announcement risks
Post-announcement Post-announcement risks risks
Definitive confirmation from FSA and Treasury on capital and
Burgundy member vote—75% of savers and 50% of mortgage
Government Guarantee—obtained
borrowers voting
Credit rating—potential for downgrade
Rating evaluation process undertaken pre-announcement with
Moody’s to confirm rating position
Fitch and S&P also presented to prior to announcement to
solicit their views
A downgrade would have significant implication for
standalone and combined funding and Claret continues to review implications Rating confirmation obtained Significant movement on FVAs—valuations could change up to
announcement and afterwards
FSA have indicated flexible approach would be taken
Final agreement of key terms including dividend, CVR and MAC
clause
Material adverse change in the financial position or trading
performance of Burgundy’s business—termination rights may be difficult to enforce Regulatory capital MAC given
Formal FSA approval process
In principle agreement before announcement mitigates risk
Intervention risk from interloper—currently viewed as low
probability in current environment, but cannot be entirely discounted Unforeseen delay to timetable—significant planning exercise to
ensure timetable met given tight schedule to achieve EGM and other regulatory steps OFT clearance—not expected to be an issue Change of control approvals—reviewed as part of due diligence
Agreed in the Framework Agreement
Post completion integration will be complex and require
M E R G E R
T E R M S
significant management time and resources
CLARET FINANCIAL SERVICES
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Agenda Strategic rationale
1
Merger terms
7
Dividend
13
Valuation
18
Appendix
29
P R OJ E C T
VINT A G E
B O AR D
P AP E R
Page
CLARET FINANCIAL SERVICES
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Claret reward scheme—before Vintage Current Current reward reward scheme scheme
Comments Comments
The existing Claret reward scheme pays out a dividend
Dividend policy has been reviewed in light of past transactions
according to an agreed policy
and Vintage
Dividend is fixed at 40% pay-out of distributable profits1
It is recognised that the policy needs to be adapted to the new
Total dividend is allocated across following stakeholder groups: Individual members: 50% (less costs for member relations) Corporate members: 20% Employees: 20%
shape of the group, regardless as to whether Vintage happens or not Group Audit & Risk Committee have reviewed the policy and
approved the basis for a new policy
Community: 10% Dividend is funded by Trading Group earnings and dividend
from CFS CFS dividend is determined at 50% of Group dividend and
central costs (both adjusted for tax shield)
D I V I D EN D
¹ Distributable profits = trading profit, less central costs, finance costs, IFRS pension items, taxation and minorities, but excluding significant items
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Hypothecated Claret reward scheme—after Vintage Overview of revised reward scheme scheme Overview of revised reward
Key financials financials Key
Dividends to Trading Group and CFS individual members
Pro forma
determined separately as proportion of segmental distributable profits¹ Each segmental dividend payable allocated to stakeholder
Annual pay-out ratio (%) Annual distribution
groups in 2010 and 2011 as follows:
Individual members: 55%/57.5% (less member relation costs) Corporate members: 15%/12.5% Employees:
Community:
Trading—profit available for distrib.
177.8
267.6
40.0%
40.0%
40.0%
39.0
71.1
107.0
12.0
—
—
71.1
107.0
10%/10%
Annual distribution One-off distribution Total distribution/funding
89.2
200.4
254.0
40.0%
40.0%
40.0%
35.7
80.1
101.6
—
—
—
35.7
80.1
101.6
Dividend allocations (£m)
CFS/Burgundy: savings, mortgages, loans and insurance
CFS members
halved versus current scheme
Trading: CLS/Travel halved versus current scheme and no
points for petrol Claret’s Audit & Risk Committee have approved the revised
policy The analysis on this page and the next page is before taking
account of the dividend top-up
14.1
8.3
11.7
—
31.8
42.5
Trading members
27.8
35.1
57.3
Membership costs
7.4
8.0
8.5
Corporate members
14.9
22.7
26.1
Employees
14.9
30.3
41.7
Community
7.5
15.1
20.9
86.7
151.3
208.6
314
524
723
Burgundy members
Total distribution Pay-out per employee (£)
D I V I D EN D
97.6
51.0
Annual pay-out ratio (%)
Level of points awarded across group adjusted from 2009
2011E
Total distribution/funding CFS—profit available for distrib²
Trading Group individual members in 2009
2010E
One-off distribution
20%/20%
Unused dividends of £12m are used to supplement dividend to
2009E
Note: Additional £20m payment to Burgundy members in 2009E not included in table ¹ Distributable profits = trading profit, less central costs, finance costs, IFRS pension items, taxation and minorities, but excluding significant items ² Excludes Burgundy profits in 2009E Makes allowance for certain Burgundy members who do not currently qualify for BMR ( ,6##$ ? &
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