DBRS Comments on Britannia’s 2008 Preliminary Results; Long-Term Debt Ratings Unaffected at “A”

DBRS has today commented that its ratings of Britannia Building Society (Britannia or the Society) are unaffected by the Society’s preliminary results announcement for the year ended 31 December 2008. DBRS rates Britannia’s Long-Term Senior Debt and Deposits at “A” and Commercial Paper at R-1 (middle). The trend on all ratings remains Negative.

This comment follows Britannia’s 26 February 2009 preliminary results announcement of a net profit of GBP5.2 million for the full year 2008 compared with a net profit of GBP49.3 million in 2007. These results were negatively impacted by an increase in impairment charges on loans and advances and non-reoccurring items, such as impairment charges on balances with counterparties and a GBP 19.8 million provision for the Financial Services Compensation Scheme (FSCS) levy. Specialist lending undertaken in 2006 and 2007, mainly to high LTV loans for first time home buyers and new-build city centre flats, were largely accountable for the GBP57.8 million impairment charge on Britannia’s residential mortgage loan book. Britannia’s treasury asset exposures to Lehman Brothers Inc. and Kaupthing, both of which collapsed in the fall of 2008, resulted in an impairment charge of GBP57.4 million.

Before loan impairments, the FSCS levy and the exceptional counterparty impairment charges, Britannia reported an operating profit of GBP158.2 million, an impressive 23% increase over 2007. Accordingly, DBRS considers Britannia’s underlying performance as solid, given the unprecedented market turmoil. Moreover, DBRS sees the solid operating profit before impairments and FSCS levy as an illustration of the Society’s underlying earnings generation power, which remains a key factor underpinning the rating. DBRS recognizes Britannia’s solid cost control efforts, which drove a 10% year-on-year decline in total costs.

Liquidity is well managed with liquid assets at GBP10 billion or 33.5% of shares and other borrowings. Britannia’s sizeable member deposit book continues to provide the foundation for the well-managed funding profile. Britannia benefited from the turmoil within the U.K. banking industry, with the total amount invested in Britannia’s savings accounts increasing by GBP1.0 billion from 2007 to GBP18.6 billion at 31 December 2008. DBRS views this solid increase in saving accounts and the increase in membership as illustrations of the strength of Britannia’s franchise, which remains a key rating consideration. Currently, retail funds cover 97% of unsecuritised mortgages. Further underpinning the rating are the Society’s strong position as the second-largest U.K. building society, its commitment to mutuality and its tangible reward scheme which promotes high levels of customer loyalty.

The Society’s asset quality is deteriorating but remains within DBRS’s expectations. Not unlike other mortgage lenders in the U.K., the rapid deterioration in the U.K. economy and continuing home price deflation have led to increasing arrears in the Society’s loan book. At 31 December 2008, 1.7% of originated residential mortgages have arrears greater than 2.5% of the loan balance, compared with a sector average of 1.6%. However, it is noted that Britannia’s standard book, (GBP11.2 billon or 60% of the residential lending) continues to exhibit minimal losses and arrears in this book remain a low 0.41%. Importantly, four out of every five Britannia mortgages are prime loans and 98% of Britannia borrowers are paying their mortgages in line with agreements.

The Negative trend reflects DBRS’s concerns that the continuing housing correction in the U.K. and the rapid deterioration in the U.K. economy will result in Britannia’s earnings remaining under pressure in the near term. Continued house price deflation and rising unemployment are likely to result in credit costs remaining elevated, adding pressure to earnings. Nonetheless, DBRS anticipates that the solid franchise and strong member loyalty will assist Britannia to manage through the current difficult operating environment with limited impact to the franchise. DBRS continues to closely watch the Society’s underlying profit and its earnings generation ability, which give Britannia the ability to manage the impact of the weaker credit cycle. Accordingly, a weakening in underlying earnings ability could negatively pressure ratings, especially if it impaired the Society’s ability to protect its franchise.

Britannia’s previously announced merger with Co-operative Financial Services (CFS) will be brought to a member vote at the Society’s Annual General Meeting on 29 April 2009. The proposed combination of Britannia and CFS will create a business with GBP70 billion of assets, GBP28.8 billion of customer deposits, nine million customers and over 300 branches and 20 corporate banking centres across the U.K. In DBRS’s opinion, the proposed merger is a long-term positive for Britannia as it enlarges the Society’s member and deposit base, reduces wholesale funding, and increases efficiencies through size and scale. Furthermore, DBRS expects that the strong personal and corporate banking, insurance and investment advisory business of CFS will provide additional revenue diversification.

Although the combination may have a negative impact on Britannia’s Tier 1 capital ratio, the impact is expected to be negligible. Offsetting the benefits of the merger is an increased share of the U.K. mortgage market at a time of rapid deterioration in the U.K. economy and, more specifically, the U.K. housing market. Further, as with any merger, integration risks pose a short-term challenge. Although DBRS has not yet fully concluded on the impact of the potential merger with CFS, one outcome of a successful merger, with the subsequent realization of the anticipated benefits, may be a positive rating action.

Note:
All figures are in GBP unless otherwise noted.

The applicable methodology is Analytical Background and Methodology for European Bank Ratings, Second Edition, which can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.