Could action be taken in the US courts over the acquisition of HBOS?
"Go for a business that any idiot can run -- because sooner or later, any idiot probably is going to run it" -- Peter Lynch
Towards the end of 2008 at the height of the banking crisis, Lloyds TSB bank agreed to buy HBOS to create Lloyds Banking Group (LSE: LLOY). At the time management hailed it as "a fantastic deal", but it has turned out to be a complete disaster for their shareholders, as the share price has fallen by almost 90% since the deal was proposed.
Most Lloyds shareholders will have been cheered by the recent news that a group of American investors are planning to sue its former Chairman and Chief Executive for having engaged in a "reckless disregard for the truth" when they recommended the purchase of HBOS.
Some British shareholders are already suing the same directors, having organised themselves into an action group called Lloyds Action Now. But we could well see fireworks on the other side of the Atlantic before anything happens in the English courts.
The smoking gun
Lloyds TSB's former directors have been on a very sticky wicket ever since the then CEO Eric Daniels admitted to a House of Commons select committee that they didn't perform the due diligence that they would have normally done before deciding to buy HBOS.
The official Parliamentary report into the banking crisis can be found at this link (it's a 2MB PDF file). The HBOS and Lloyds TSB deal is covered in paragraphs 120 to 128, while the lack of due diligence is noted in paragraph 123 on page 53, which says that Daniels "…admitted that had Lloyds had more time, they "probably would have put in somewhere around three to five times as much time" on due diligence work."
That's a very surprising admission, particularly given the bullish statements made by senior directors at the time of the merger such as "the strategic rationale for the acquisition of HBOS is compelling."
And there's also a second smoking gun, one which has the American and British governments' fingerprints all over it. The affair of the secret loans!
Loans, what loans? Oh, those loans!
In a few years time, officials at the Bank of England, America's Federal Reserve and even former government ministers might well find themselves appearing in court to testify under oath about HBOS' true financial position in late 2008.
That's because when the merger with HBOS was recommended to Lloyds TSB's shareholders, HBOS was being supported by the authorities using secret loans worth £25.4 billion and $11 billion which were not disclosed to Lloyds TSB's shareholders.
So, when these shareholders approved the purchase of HBOS, they did so having been misled by the authorities as to its true level of indebtedness.
Jim Rai, head of litigation at Winckworth Sherwood, who is acting for Lloyds Action Now, went straight to the heart of the matter last year when he said that: "There can be no doubt that the fact of the £25.4bn loan was not only being kept secret for the possible advantage of the UK banking system, but was deliberately kept secret so that Lloyds TSB shareholders were not put off the proposed acquisition of HBOS."
Banking by idiots
Banks have the ability to very quickly leverage their assets by using other people's money. So if Peter Lynch's proverbial idiots are running a bank, there's a good chance that they will do this and wreck it in the process.
One way to ruin a bank is to link senior managements' bonuses to the amount of money that is lent, rather than the quality of the loans. This will cause them to seek out bad risks and lend at ridiculously low interest rates.
We saw a lot of this in the 1990s and 2000s with the spread of "liar loans" where people were encouraged by some lenders to lie about their income so that they could take out an even bigger mortgage.
For many years, I've held the view that banking shares are very speculative, high-risk investments. Despite that, I believe that Lloyds Banking Group's shares are probably oversold, so I have a few, but I'm not putting much money behind this idea.
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> Tony owns shares in Lloyds Banking Group.
