HBOS’s Denial

Cognitive Dissonance describes the uncomfortable feeling experienced when a person begins to understand that a belief the person holds as true is in fact false.

For example, believing that you can write mortgages to minimum wage-earning illegal aliens and expect them to pay it off. Or let’s take another example: believing the stockmarket will go up forever and house prices will never come down. Cognitive Dissonance is believing the good times will go on forever. It is believing that the Emperor really is wearing new clothes and the credit crisis will not seriously affect you.

Cognitive dissonance is a way of denying reality, to disassociates what you are cognizant of from what you want to believe. It requires a trigger to snap out of it. For HBOS, the implosion over the weekend of Lehman Brothers detonated an explosive break from cognitive dissonance. Witness:

HBOS Plc, the U.K.’s biggest mortgage lender, fell the most since it began trading seven years ago after Lehman Brothers Holdings Inc.’s bankruptcy stoked concerns about writedowns and foreclosures.

“There is the fear that there could be a lot more writedowns to come” at HBOS, said Colin Morton, who helps manage $3 billion including HBOS stock at Rensburg Fund Management in Leeds, England. “It’s almost guilty until proven innocent.”

There is fear now, but until the Lehman implosion there had just been denial:

HBOS holds 6.6 billion pounds of so-called Alt-A loans, which didn’t require income verification and are riskier than prime mortgages. Led by Chief Executive Officer Andy Hornby, HBOS was Britain’s biggest lender to landlords last year and provided loans to subprime borrowers through its Birmingham Midshires unit. About 2 percent of its 235 billion pounds of mortgage loans were in arrears as of June 30, the company said in July.

Investors and management alike have been aware of the £6.6B of Alt-A loans and concerns about write-downs and foreclosures should have been prevalent since those products were issued. Instead, junk was bundled with prime goods and offloaded to someone else’s balance sheet in the belief that it would not come back to hurt them.

But there is no such disbelief in the credit markets, there they get paid only if they’re right. The the spreads on credit default swaps are swelling:

The cost of credit default protection on U.K. mortgage backed bonds surged. Credit-default swaps sold through Permanent Master Issuer by HBOS jumped to a record 295 basis points from about 160 on Sept. 12, said David Hoffman, a securities trader at Commerzbank AG in London.

But when the CEO of the Halifax bank said he feared that the credit crisis would last another 18 months, he was not practicing cognitive dissonance. He was outright lying. The truth is, he wishes it would only last that long. So do we. But it doesn’t change a thing for the Halifax bank, which will likely render no semblance of its present self by then.

“It’s going to take 18 months before U.S. house prices have started to rise again — which is what’s required for banks to have the confidence to start lending again. It will take a long time to play out.

Actually that’s only a necessary condition. The banks also need to have confidence in the borrowers and in each other. Investors must have confidence in HBOS as well. That’s quite a bit more than a stone’s throw from here.

Aside from that, the bank got its rear handed to it when 92 percent shrugged off the bank’s rights issue last week.

HBOS PLC said Monday that only about 8 percent of its shareholders opted to buy into its 4 billion-pound ($8 billion) rights issue.

Even though the bank got its $8B, the underwriters had to come up with the other 92 percent for the junk they had expected to dump on the public.

So, in the tumultuous aftermath of the Lehman Brothers collapse, with losses and credit-related write-downs increasing and options running out, investor denial exploded. The shock wave drove HBOS stock down 62 percent in a single trading session on September 16.

Shares in HBOS PLC, Britain’s biggest mortgage lender, plunged as much as 60 percent on the London Stock Exchange on Tuesday as financial shares fell sharply in the wake of Lehman Brothers Holding Inc.’s bankruptcy. The shares later rebounded but still lost over a third of their value.

With meat hanging from the bone, the rating agencies S&P and Fitch joined the party and the bank’s ability to raise capital was further diminished. Now with the writing on the wall, management’s denial was blasted away at last and they served themselves up.

It all comes down to confidence. Northern Rock collapsed when retail customers lost faith, pulling out their savings. For Bear Stearns and Lehman Brothers, it was market participants who gave up on the banks.

Now its HBOS, Britain’s biggest mortgage lending and savings institution, that has lost the confidence of the markets. Without confidence, the latest events have made abundantly clear, a bank is nothing.

Oddly, with no confidence to spare loyalty overflowed to a bank that served only itself:

There was a sense of astonishment in Edinburgh yesterday that one of the city’s most revered institutions, and the oldest commercial bank in Britain, could have been brought to its knees in the space of 48 hours.

North of the border, HBOS is still known to most people simply as the Bank of Scotland.

And shareholders balked at the buyout by Lloyd’s of London. Where loyalty and anger mix, there is usually a fight, so we can not consider the Halifax Bank imploded yet, but the sense is that it’s now just a matter of when and how.