DUNFERMLINE BUILDING SOCIETY (DBS) · 4.1. The basis for my “no support” assumption 22 4.2....

DUNFERMLINE

BUILDING SOCIETY

(DBS):

AMOUNTS RECOVERABLE BY THE

FINANCIAL SERVICES COMPENSATION

SCHEME (FSCS) -

REQUEST BY HM TREASURY (HMT) AND

FSCS FOR RECONSIDERATION OF

DETERMINATION –

RECONSIDERATION AND REPORT

Independent Valuer – Ian Burns BA FCA CF

30 April 2013

DBS – REQUEST FOR RECONSIDERATION OF

DETERMINATION, HMT/FSCS:

Contents

1. INTRODUCTION 1

1.1. Purpose of report 1

1.2. Structure of report 1

2. REQUESTS FOR RECONSIDERATION 2

2.1. FSCS 2

2.2. HMT 15

3. RECONSIDERATION OF ISSUES RAISED BY BOTH FSCS AND HMT 18

3.1. Introduction 18

3.2. Loan losses 18

3.3. Interest income 20

3.4. Conclusion 21

4. RECONSIDERATION OF ISSUES RAISED BY FSCS 22

4.1. The basis for my “no support” assumption 22

4.2. Inadequate information regarding calculations and assumptions 24

4.3. Use of hindsight 24

4.4. Other areas of calculation used to develop estimates 25

5. RECONSIDERATION OF ISSUES RAISED BY HMT 26

5.1. More prompt realisation of the loan book 26

5.2. Timing of distributions to FSCS 27

5.3. Implication of application of set-off 27

5.4. Unwinding of derivative contracts 28

5.5. Irrecoverable VAT of Administration costs 28

5.6. Legal fees too low 29

5.7. Impact of Corporation Tax 29

6. IMPACT OF RECONSIDERATION ON DETERMINATION 30

APPENDIX A – ESTIMATES OF LOAN BOOK IMPAIRMENTS: EVIDENCE USED 31

APPENDIX B – LETTER TO FSCS, 23 OCTOBER 2012 32

APPENDIX C – COMMERCIAL LOAN BOOK, SOCIAL HOUSING IMPAIRMENTS 35

APPENDIX D – ALTERNATIVE SCENARIOS: BUILDING SOCIETY INSOLVENCY,

BSSA 38

DUNFERMLINE BUILDING SOCIETY (DBS):

1

1. INTRODUCTION

1.1. Purpose of report

On 31 July 2012, I gave notice of the determination (“my Determination” or “my Report”) I was

required to make pursuant to Regulation 13 of the Financial Services and Markets Act 2000

(Contribution To Costs Of Special Resolution Regime) Regulations 2010 (SI 2010/2220) in relation to

DBS. My Determination set out the amounts that would have been likely to be recovered by the

Financial Services Compensation Scheme (“FSCS”) in a counterfactual insolvency of DBS (“the

Counterfactual Regime” or “Counterfactual”), and the times at which those amounts would have been

likely to be recovered. My Report of 31 July 2012 contained the assumptions and calculations relevant

to my Determination.

On 30 October 2012, the FSCS wrote to me to request that I reconsider my Determination, (“the FSCS

Request”) citing a number of detailed examples in support. The FSCS Request, suggests that, in my

Determination, I significantly under-estimated the likely returns to the FSCS in the Counterfactual.

On 31 October 2012, I received a similar request from HM Treasury (“HMT”) (“the HMT Request”

and, together with the FSCS Request, “the Reconsideration Requests”), requesting me to reconsider my

Determination, on the grounds that I had significantly over-estimated likely FSCS returns.

1.2. Structure of report

This report sets out my reconsideration of my Determination in response to the comments of both the

FSCS and HMT, dealing with all issues raised.

• In Section 2 I have included copies of the FSCS Request and the HMT Request.

• In Section 3 I respond to those issues raised by both the FSCS and HMT.

• In Section 4 I discuss the other issues raised by the FSCS.

• In Section 5 I deal with the other issues raised by HMT.

• In Section 6 I set out the results of my reconsideration of my Determination, and conclude that it is

not appropriate to amend my Determination in respect of any of the issues raised in the requests of

the FSCS and HMT.


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2. REQUESTS FOR RECONSIDERATION

2.1. FSCS

A copy of the FSCS Request is provided overleaf.


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2.2. HMT

A copy of the HMT Request is provided overleaf.


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3. RECONSIDERATION OF ISSUES RAISED BY BOTH FSCS AND HMT

3.1. Introduction

A number of issues in the Reconsideration Requests were raised by both FSCS and HMT. These issues

asserted diametrically opposing views. In the light of the implications of these issues to the quantum

and timing of the amounts incorporated in my Determination, I comment on them together, as opposed

to separately, as my responses substantially apply to both.

General comment

Before dealing with individual issues raised below, I believe it is appropriate to make a general remark.

As the Determination that I am required to make must of necessity involve judgement, the issues raised

below illustrate the task of the Independent Valuer, who has to assess the merits of conflicting facts and

arguments, and synthesise them appropriately in order to arrive at a justifiable solution. In my

experience, in reports such as my Determination, whose impact can be characterised as part of a zero-

sum game, it is not unusual to attract criticism from both interested parties, each of whom will have

obligations to their own stakeholders.

It is also relevant to note that the issues raised below by both HMT and the FSCS, which relate to the

quantum of loan losses and interest income assumed in my Determination, in my opinion represent

potentially the biggest quantitative disagreement between us.

Individual issues

3.2. Loan losses

3.2.1. FSCS/HMT views

In the Annex to their Request, the FSCS raise a number of concerns on my estimate of loan losses,

which they suggest are materially overstated.

As a general comment, in Paragraph 1.1 of the Annex, they assert:

“Total loan losses have been determined at £441m. This is significantly higher (perhaps as much as

£260 million higher) than the levels derived from more contemporaneous assessments provided by

those responsible for managing the assets following the exercise of stabilisation powers.”

The FSCS have also raised specific questions over my estimate of loan losses on the commercial loan

book (“CLB”) and the Social Housing portfolio. On the subject of the CLB, at Paragraphs 1.2.1 to

1.2.4 of the Annex, they argue:

“Our advisers have considered…[the £242m provision against the CLB] by comparison to the range

forecast by KPMG in February 2010 (£100m - £200m)…we note that… £242m is far higher than the

upper end of the KPMG forecast in February 2010 and some £92m above the mid-point of their

range…Bearing these points in mind, we would expect that the losses that could reasonably have been

considered likely, as at 30 March 2009, would be significantly lower than £242m.”


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The FSCS also question my estimate of loan losses on the Social Housing portfolio at Paragraph 1.3 of

the Annex, where they assert:

“Nationwide took a fair value adjustment of £62m (similar to the £60m losses attributed to this book in

the determination notice); however they did so on the basis that the book was likely to yield interest

income at a rate below that sufficient to generate an economic return. This low level of interest

income should (and we believe has) been recognised in the Report within the £649m interest income

determined over the 10 year administration period. It is not apparent that any allowance has been

made for this in any calculation of a forced sale discount at the end of the administration period - as a

result we are concerned that there is an element of double counting here…Indicative modelling

suggests that even if it continued to be reasonable to assume that the funding markets for potential

acquirers remained difficult in 2019 it would only be appropriate to expect a discount of around 50% of

the fair value adjustment seen in 2009.”

By contrast, the HMT view is confined to a statement at Item 1 of their Request, viz:

“HM Treasury considers that the loan book impairments provision are too low, particularly in view of

the nature of the loan book, the economic circumstances prevailing at 30 March 2009 and the heavy

discounts being suffered on block sales of loans at that time, reflecting the market’s valuation of

mortgage securities.”

3.2.2. My response

As regards the general issues raised by the FSCS, and the opinion of HMT, Appendix E of my Report

summarises the approach I have used in determining loan arrears. On 23 October I wrote to the FSCS

setting out further details of anticipated losses by loan book category. For the sake of completeness, I

have included a copy of this letter as Appendix B.

Appendix A sets out further details of the information I have gathered to determine these amounts. I

continue to believe that my estimates derived from such an approach and such evidence are robust, and

accordingly do not amend my Determination in this regard.

In coming to this conclusion, I have considered the detailed issues relating to impairments in the CLB

and the Social Housing portfolio raised above, and the consequential assertion that my assessment of

overall losses is perhaps as much as £260m higher than those derived from the relevant post-

Administration managers. I set out the detailed reasons why I do not agree with the assertions made by

the FSCS in this regard, in Appendix C. In summary, however:

• as regards the assertion by the FSCS that my estimated CLB provisions lie outside the range of

estimates provided by KPMG in February 2010, in fact they lie comfortably within the range of

provisions which KPMG now consider relevant; and

• as regards the FSCS’s view that my calculation of the expected loss on the sale of the rump of the

Social Housing portfolio at the end of the Administration (£60m) is around double what it should

be, I agree with the logic behind their calculations but point out that they take no account of the

offsetting impact of the higher future margins already being charged in the marketplace to similar

Housing Associations to those in the DBS portfolios.


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3.3. Interest income

3.3.1. FSCS, HMT views

In the Annex to the FSCS Request, at Paragraph 2.2, the FSCS state:

“Evidently were those losses lower it could be anticipated that the average value of the performing

book would be higher over the course of the administration thereby generating greater interest income

than has been assessed.”

Further, at Paragraph 2.3, it is asserted:

“In respect of [the anticipated timing of impairments], information from KPMG LLP indicates that, in

spite of worse economic performance than was generally anticipated as at 30th March 2009, the

commercial book alone has generated on average over £35m interest income per annum…this does call

into question the amount of interest that has been determined overall…we can only assume from the

low level of interest income assessed that it must have been assumed that materially all impairments

happened in 2009/2010…If that assumption has not been made then we remain at a loss as to why the

interest income that has been determined is so low.”

Finally, at 2.4, the FSCS state:

“… to the extent that historic amortisation rates have been relied upon [to calculate the rate of attrition

on the mortgage books, and thus the level of interest-bearing assets], we believe these should have been

adapted to take account of that feature.”

By contrast, HMT state in Item 3 of the HMT Request:

“…the pricing policy which drives the interest income…results in income figures that appear to be

unreasonably high ...”

3.3.2. My response

The approach I have taken in comparing interest receivable can be summarised as follows.

Value of assets

In response to the assertion that, were losses lower, interest income would be greater, I repeat my

response made in Paragraph 3.2.2. on the subject of loan losses, viz: I continue to believe that my

estimates derived from the approach I have taken and the evidence I have seen are robust, and

accordingly I do not consider any need to revisit the interest income estimates I have made to take

account of this view.

Interest rates used

I can confirm that:

• interest income has been calculated using actual product rates for each mortgage book contained in

the data tapes provided by Citibank, advisers to HMT;

• fixed interest rate mortgages have been assumed to pay interest at these rates until their move to

variable rates;

• in the case of variable rate mortgages, future rates have been estimated with reference to the GBP 3

Month LIBOR future swap curve as at 29 March 2009, which I view as a suitable benchmark for


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the market’s view on future interest rates at that time. (N.B: were base rates throughout the

Administration period assumed to have remained at March 2009 levels, indicative modelling

suggests that total interest income would have reduced by approximately £90m. I do not however

consider this to be a reasonable assumption to have made at 30 March 2009); and

• margins have been assumed to remain at March 2009 levels, which I consider a rational policy for

the Administrator to adopt.

Interest received on commercial loan book

I am unsure of the source of the FSCS’s assertion that information from KPMG indicates that the CLB

has generated over £35m interest per annum.

Progress reports produced in the BSSA for the periods 30 March 2009 to 29 September 2009 and 30

September 2009 to 30 March 2010 show interest receipts on the CLB of £10.8m and £9.5m

respectively. A linear apportionment of these amounts leads me to estimate that actual receipts in the

years to December 2010 and 2011 would have approximated £16m and £19m respectively. This

compares with estimates of £17m and £18m in my Determination, which were derived on an estimated/

calculated formula, as opposed to actual amounts received.

Quantum of interest bearing assets: attrition

In answer to the FSCS query as to my treatment of attrition rates, I confirm that I have taken account of

the fact that the attrition rates experienced in the market prior to the date of the Administration were at a

historic low by basing estimated future attrition rates on forecasts made at that date by knowledgeable

market participants, which assume a lower rate of mortgage prepayments in the early years, but a rising

rate of mortgage prepayments towards the end of the Administration period.

3.4. Conclusion

For the reasons given above, I consider that, as regards the key issues of loan losses and interest

income, the estimates contained in my Determination are robust.


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4. RECONSIDERATION OF ISSUES RAISED BY FSCS

I set out below the issues in my Determination which the FSCS have requested me to reconsider, other

than those discussed in Section 3.

4.1. The basis for my “no support” assumption

4.1.1. FSCS view

In the FSCS Request, the FSCS makes several assertions relating to the assumptions in my

Determination that there would have been no financial assistance provided to DBS by either or both of

the Bank of England (“BoE”) and HMT. The FSCS has further stated that, as a result, in the

Counterfactual, DBS would have entered Administration under Part II of the Insolvency Act 1986 and

the relevant Scottish Insolvency Rules.

In particular, in Paragraph 2.5, they state:

“…we do not agree that you were required to assume, that…it would not have been possible for any

support to have been given by HMT or the Bank of England (BoE). Nor have we seen any evidence to

indicate that HMT specified that you must make that assumption.”

In Paragraph 2.6, the FSCS note:

“…the building society insolvency procedure would have remained available, and we consider it

possible that this (or building society administration) would have been used…”

In Paragraph 2.7, it is noted:

“We also note that in the actual circumstances which applied to DBS, support was indeed considered

appropriate and was provided both to DBS in special administration and to the DBS Bridge Bank.

Such support was permissible under State Aid rules, and was authorised in the actual DBS

circumstances.”

As a result of the above assertions it is concluded, at Paragraph 2.8:

“Therefore, in so far as your determinations rely on an assumption that you were required to assume

that no support would have been given, and/or that no support was possible…it appears to us that you

have not given proper consideration to this possibility and any potential consequences for your

determinations.”

4.1.2. My response

Paragraph 2.5

I was originally appointed under the Dunfermline Building Society Compensation Scheme, Resolution

Fund and Third Party Compensation Order 2009 (“the Compensation Order”) to carry out inter alia

functions set out in Regulation 8 of the Financial Services and Markets Act 2000 (Contribution to Costs

of the Special Resolution Regime) Regulations 2009 ("the 2009 Regulations"). The 2009 Regulations

required me to calculate the amount that would have been recovered by the FSCS if DBS was in


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default, had entered into insolvency and the FSCS had paid the amount of compensation that qualifying

claimants would have been entitled to receive (under regulation 8 of the 2009 Regulations).

The 2009 Regulations were revoked and replaced with the Financial Services and Markets Act 2000

(Contribution to Costs of the Special Resolution Regime) Regulations 2010 (the "2010 Regulations").

The 2010 Regulations required me to determine the amounts that would have been recoverable in the

circumstances set out in Section 214C(3)(a) of the Financial Services and Markets Act 2000 ("the

FSMA").

The legislation setting out my function for the purposes of making the Determination, namely Section

214D(3) of the FSMA, does not set out any express assumptions which I must make. However

Regulation 18(6)(B) of the 2010 Regulations does provide that HMT shall promptly specify any

principles, methods or matters to be applied, used or taken into account by the Independent Valuer

when making the Determination.

At a meeting with HMT on 17 March 2011, HMT confirmed to me that in relation to my function under

Section 214D(3) of FSMA I was to assume that DBS was insolvent, that no stabilisation power had

been exercised and that there would be no HMT or BoE financial assistance.

Paragraph 2.6

I remain of the view that Administration is the appropriate choice for the Counterfactual. Where there

is the possibility of continuation of at least part of the business of an inherently complex entity such as

DBS, any insolvency office holder appointed would prefer to work within a regime with the benefit of a

moratorium and to have the powers and flexibility which Administration provides.

In Section 2.1 of my Report, I discuss the reasons I consider that neither the Building Society

Insolvency procedure nor Building Society Special Administration under the Banking Act 2009 was a

competent choice for the Counterfactual. Further background to my decision can be found in Appendix

D.

Paragraph 2.7

In determining the nature of the Counterfactual, I am required to assume no financial assistance was

provided, as noted in my response to Paragraph 2.5 above.

I must carry out the functions dealing with assessment of recoveries of the FSCS under the FSMA and

associated secondary legislation. I am required to carry out my functions in terms of such legislation.

Paragraph 2.8

My response to Paragraph 2.5 above sets out the reasons for my assumption, in determining the nature

of the Counterfactual, that no financial assistance from BoE or the Treasury would have been given.

In any event, the assumption that no financial assistance from BoE or HMT would have been provided

was not the only factor in the choice of the Counterfactual. Although this assumption precluded BSSA

as the Counterfactual (as discussed further in Appendix D), it did not preclude BSI, liquidation or

Administration. As set out in my response to Paragraph 2.6 above and Section 2.1 of my Report, due

consideration was given to BSI and liquidation, where I concluded that they were not appropriate

choices for the Counterfactual Regime.


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4.2. Inadequate information regarding calculations and assumptions

In Paragraph 3.1 of their request, the FSCS state:

“We do not consider that the Report provides sufficient information regarding the assumptions and

calculations relevant to your determinations as required by Regulation 13(6)(C) of the 2010

Regulations and/or the public law duty to give reasons.”

The FSCS have also requested that I provide them with specific and detailed information, including a

copy of the financial model I have used, in order that they can decide whether or not to challenge the

model or the conclusions derived from it.

This issue does not relate to my Determination, rather the information I give in respect of reaching the

Determination. However, I consider that it is appropriate to respond to this statement.

The FSCS also referred me to the cases of Stefan v GMC [1999] 1 WLR 1293 and R (on the application

of Savva) v Royal Borough of Kensington and Chelsea [2010] EWCA Civ 1209 in relation to the

common law duty on decision makers to give proper reasons for their decisions. I do not consider it

appropriate to respond in detail to the claim by the FSCS that I have a common law duty to give reasons,

although I note that on the facts of both of these cases, there was no statutory obligation for the relevant

decision maker to give reasons (which is not the case in respect of my obligations, as the 2010

Regulations set out the requirements to give information relevant to my Determination).

The court held in Stefan (which was followed in Savva) that any reasons given do not need to be

elaborate or lengthy, but need to be such as to tell the parties in broad terms why the decision was

reached. If such a common law duty is applicable to me, I consider that I have met this limited

requirement.

The FSCS are correct in stating that I am required to give assumptions and calculations relevant to my

Determination. This is provided in regulation 13(6)(c) of the 2010 Regulations.

The 2010 Regulations do not, however, require me to provide all information I have considered in

reaching my Determination nor do they require me to provide underlying financial data.

I consider that my Report set out the assumptions and calculations relevant to my Determination and

therefore that it complied with the requirements of the 2010 Regulations. Specifically, I do not

consider that the 2010 Regulations require me to disclose in full any financial models used in

connection with my Determination, as asserted by the FSCS.

4.3. Use of hindsight

In Paragraph 5.3 of their request, the FSCS state:

“In our view the independent valuer is required to make an assessment of the level and timing of

potential recoveries based on information…available at the date at which the stabilisation powers were

exercised. We do not consider that this precludes looking at how things have turned out in the general

economy and/or the actual DBS administration. We believe it would be legitimate to do so for the

purposes of reviewing the validity of the reasoning applied, confirming and/or amending

calculations…”

I am not entirely clear as to the exact meaning of this statement, or its detailed practical effect on my

Determination. I have accordingly set out my own approach to the use of hindsight below.

I agree with the validity of using the review of subsequent events as a diagnostic tool, to assess whether

they can provide additional evidence or support for a condition which existed at the measurement date

(my italics), or a judgement as to the future which could have been made at that date. I do not however


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believe that, merely because an event happened subsequent to the measurement date, this must of

necessity influence the position at that date.

I have applied the above principle throughout my work, and throughout my Determination.

4.4. Other areas of calculation used to develop estimates

In Section 5.4 of their request, dealing with my estimate of the costs of the Administration, the FSCS

state:

“We note that you have used the actual KPMG administration costs as a source of comparative data

for part of your costs calculations and for “other bases of calculations”…please provide information…

about the approach you have taken. In so far as your current determinations rely on what has

happened in practice rather than based on an assessment of what was likely as at 30 March 2009 we

also request that you re-consider your determinations …”

I have developed my estimation of Administration costs using a zero-based approach, although where

appropriate I have had regard to details of certain estimates and records of actual expenditure provided

by KPMG, and used their actual costs as guidance in specific areas.

In assessing the likely costs of the Administrator in the Counterfactual, I undertook analyses of the

areas of activity that I anticipated an Administrator would need to undertake, broadly following the

category headings set out in Statement of Insolvency Practice 9 (SIP9 (Scot)), adapted for the specific

circumstances of my Determination.

In the case of the loan books I have adopted a mixed costs approach with a fixed core annual cost of

managing the loan books (to encompass portfolio supervision, accounting and compliance) plus a

percentage of recoveries to recognise the diminishing size of the actual book. This reflects the costs of

dealing with volume based aspects of the portfolio. The percentages applied are higher for the more

complex or potentially harder to realise books (such as the CLB).

Where I have chosen to make the calculations on an hours expended basis I have looked at the average/

compound rate actually incurred by KPMG in their reporting as a guide to the rate that might be

incurred in the Counterfactual. I consider that early reported data from the BSSA provides a good

guide as to the compound rate that might have been expected at the date of the exercise of the

stabilisation power and have rounded this to £350 per hour inclusive of VAT.

Certain areas of the costs would have been highly uncertain and, in respect of these aspects, I have

made what I consider realistic judgements of the amount of costs that would be incurred.

I also consider as a less subjective model the possibility that the Administrator in the Counterfactual

might seek to base his remuneration on a percentage of realisations. Were this approach to have been

taken, then I estimate that the equivalent fees would have been higher than my direct assessment. In

practice however, I do not think this approach would have appealed to an Administrator, as he would

have been appointed in circumstances where he had limited knowledge of DBS’s affairs, recoverability

of assets and the risks involved. Similarly it is not clear whether such an approach would have

appealed to the major stakeholders, as they would be paying a premium for the costs of the process

compared to an expectation on a time costs basis.


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5. RECONSIDERATION OF ISSUES RAISED BY HMT

I set out below the issues in my Determination which HMT have asked me to reconsider, other than

those dealt with in Section 3.

5.1. More prompt realisation of the loan book

In Item 2 of their request, HMT state:

“The Determination does not take full account of the likely need and desire of the creditors for a more

prompt realisation of the loan book than envisaged in the counterfactual insolvency. HM Treasury

believes that an administrator would have been likely to attempt to sell blocks of loans early on in the

administration…”

I do not agree with this contention for the following reasons.

• In the Counterfactual, the major creditor would have been the FSCS. An Administrator would

have taken soundings from the FSCS on their general strategy. I consider that the FSCS would not

have been driven by a fire-sale low quantum, high speed return but by a longer term run-off of the

book with a greater return; and

• aside from the view of major creditors, I believe that the risk profile of the Administrator would

tend to lead him to a run-off strategy, especially where market conditions for sales of loan books

were poor (see below). He would have no real cost of capital, and would not bear losses in the

same way as a trading entity. Purchasers would price for that risk and further discount

substantially in any offers for those parts of the book.

I believe that this view is supported by the fact that both Bradford & Bingley and Heritable are being

administered/ run-off on a long-term basis.

In addition:

• discussions with KPMG indicated exceptionally low offers for parts of the book, which they did

not accept;

• the market for loan portfolio sales was particularly poor in 2009. There are no direct publically

available pricing comparables for sales of UK residential mortgage portfolios around March 2009.

However, knowledge gained by my consortium partners from their involvement in a number of

transactions considered at that time confirms my view that completed transactions in the UK were

infrequent and subject to significant discounts to book value; and

• my review of the pre-transfer attempts to sell DBS’s assets piecemeal reveal that significant parts

of the mortgage book were functionally unsaleable.

Accordingly, I am not persuaded to amend my approach, or my Determination.


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5.2. Timing of distributions to FSCS

In Item 4 of HMT’s letter, it is stated:

“We see no reason why distributions would have been made more quickly in the counterfactual

insolvency…[and] request that you amend your assumption on the dates of the distributions in the early

years of the counterfactual insolvency to the 1st subordinated creditors in a reconsidered valuation.”

KPMG paid a dividend relating to the first liability (£0.5bn) in the period between March and July

2010, i.e. within 12-15 months of the Transfer date. The next dividend - £150m – was paid between

August 2011 and January 2012, i.e. 2.4 -2.8 years after the Administration date.

In my Determination, I have assumed (Sections 6.3, 6.4) that distributions would commence 9 months

after Administration inception and be paid in 6 monthly intervals thereafter until all the

ordinary/unsecured creditors had been paid off, together with all related statutory interest. A first

distribution to the FSCS in its capacity as a deferred/subordinated creditor was therefore deferred until

the end of Year 2. As noted in my Report, I consider that the Administrator’s distribution policy would

have been actuated by the imperative to return money to creditors as quickly as possible consistent with

maintaining an adequate contingency reserve, which I have estimated at between 7.5% and 20% of

funds available. The distributions I have assumed follow from these assumptions.

In my opinion, two factors in particular would have enabled distributions to have been made more

quickly in the Counterfactual than in the actual, viz:

• the Administrator in the Counterfactual would have had access to all receipts from the £1.05bn

own-originated residential portfolio, which could have been expected significantly to enhance

funds available to distribute at an early stage; and

• one of the reasons for the Administration delaying the second (£150m) distribution was the need

first to settle the issues relating to priority and statutory interest, which were not formally resolved

until the decision of the Court of Sessions referred to in Section 2.5.3 of my Report. A significant

portion of the delay in reaching this decision arose from the need for the Administrator to liaise

with the Independent Valuer as to the need for, content and drafting of the relating court

application, which I consider would have been effected significantly more quickly by the

Administrator acting alone, thereby accelerating the process.

I accordingly consider that my assumptions as to distribution are robust.

I would also point out that, were HMT to be correct in their assertion, this would have no impact on the

amounts received by the FSCS, but would only, on my assumptions, delay the receipt of £94m by up to

one year, which would only affect the amount payable by the FSCS to HMT by the related interest cost,

at 4.5% per annum.

5.3. Implication of application of set-off

In Item 5 of HMT’s letter, they state:

“…we consider it likely that the application of set off may have had a significant effect on the cash

flows and outcome of the counterfactual insolvency. We therefore request that you state how you have

dealt with set off…”


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Whilst set-off is mandatory in English insolvencies under the Insolvency Act 1986, the position is

different under Scots law. In Scotland set-off arises under common law and there are no statutory rules

governing this.

In Scotland set-off must be invoked if it is to apply. Both obligations must exist pre-insolvency and the

debtor and creditor must owe the cross obligations in the same capacity.

The most likely potential area of set-off in the Counterfactual arises from individual customers of DBS

who held a mortgage from DBS and also had sums on deposit, and who would not have been

compensated by FSCS for the balance on deposit. Those who would have been compensated would

have assigned all rights as creditors to the FSCS, and would thus not have been creditors of DBS.

The number and value of such accounts was assessed in a report prepared by Deloitte for the FSCS

which calculated the sum payable by the FSCS to depositors. I was given a draft copy dated March

2010 by the FSCS.

This report identified that the value of customer deposits, which were not compensated by FSCS and

were off-set against mortgages, was £8.7m. This comparatively small sum was excluded from the FSCS

total of customer deposits eligible for compensation.

To the extent that these depositors are successful in off-setting this sum against their mortgage

repayments, it is reflected in my estimate of loan book losses.

5.4. Unwinding of derivative contracts

In Item 6 of their request, HMT state:

“The determination refers to the unwinding of derivative contracts. This is a complex area and has

been subject to extensive litigation in other insolvency cases involving financial institutions. We

consider it likely that the estimated losses on unwinding the derivative contacts are understated and we

therefore request that you amend your estimates to a more realistic estimate of losses in a reconsidered

valuation.”

The DBS derivatives portfolio was almost entirely comprised of straightforward interest rate swaps,

which in my view would have been relatively easy to unwind.

In my calculations, I have assumed a 20% cost to unwind the contracts. This has been tested for

reasonableness through enquiry of other market experts, including the Administrators for DBS, who

have unwound some of the derivative contracts concerned.

I accordingly consider that I do not need to amend my Determination in this regard.

5.5. Irrecoverable VAT of Administration costs

Item 7 of the HMT Request states:

“The determination does not state whether the costs and expenses of £133m include irrecoverable VAT.

To the extent that this is not included, we request that you include irrecoverable VAT in a reconsidered

valuation.”

I confirm that, where my estimated Administration costs included invoices where VAT would have

been charged, and VAT would not have been recoverable, the gross amount of such invoices was

included in my estimates.


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5.6. Legal fees too low

The HMT Request states in Item 8:

“…the costs and expenses of £133m include legal fees of £6m. HM Treasury considers that this

estimate is unrealistically low…”

My estimate of legal fees was made in consultation with my legal and insolvency advisers, and was

developed in the light of a range of possible outcomes. In the light of the materiality of this sum, I

consider both this range, and the final assessed amount, to be reasonable.

The KPMG BSSA report to July 2012 shows actual legal costs incurred of £3.8m over a 3.3 year

period. Many of the legal costs would be incurred in the early part of the process, and I consider that

my own estimate is reasonable.

5.7. Impact of Corporation Tax

In Item 9 of their request, HMT states:

“The Determination contains an assumption that no corporation tax would arise in the counterfactual

insolvency. We consider that corporation tax may arise…”

Table 3.4 of my Report sets out a table of adjusted net assets, which is very similar in form to what

would constitute a profit and loss account of the Administration for tax purposes.

This results in a pro-forma loss of £2.14 billion, largely the result of the charging of statutory interest of

£2.17 billion in this calculation.

As statutory interest would be an allowable expense for tax purposes in these circumstances, I consider

my assumption that no Corporation Tax would arise in the Counterfactual is robust.


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6. IMPACT OF RECONSIDERATION ON DETERMINATION

6.1. I have considered all the major issues raised by HMT and the FSCS, set out in Section 2, in Sections 3-

5. I have concluded that, in the case of each issue raised, my assessments and resulting estimates are

robust, and do not require amendment.

6.2. Additionally, I do not consider that the overall, as opposed to individual, impact of the issues raised in

Section 2 should give rise to any adjustment in my estimates.

6.3. Accordingly, I am not minded to amend my Determination.


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APPENDIX A – ESTIMATES OF LOAN BOOK IMPAIRMENTS: EVIDENCE

USED

Mortgage type Information received External evidence used

Residential Mortgages

(own originated)

BTL

Non-BTL

- Mortgage data tape (incl. LTV, arrears

figures, credit quality)

- "Whole Book Summary " sheets

- Historical arrears data

- Mortgage data tape (incl. LTV, arrears

figures, credit quality)

- "Whole Book Summary " sheets

- Historical arrears data

- Analyst forecasts for UK retail

operations of publicly quoted

companies

- Private company projections to

which my advisors have had

access

- Analyst forecasts for UK retail

operations of publicly quoted

companies

- Private company projections to

which my advisors have had

access

Social Housing - "Project Forth" Data Tape provided by

Citibank

- Discussions with the Housing

Association Group of my firm

- Enquiry of pre-transfer advisers to

HMT

Commercial - S.166 report on Commercial

mortgages

- Detailed, on site review of selected

large loans

- Enquiry of KPMG (Administrators)

Third Party Acquired - Data tapes provided by KPMG - My advisors’ experience of working with companies with similar portfolios


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APPENDIX B – LETTER TO FSCS, 23 OCTOBER 2012


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Schedule:

Mortgage Book – Summary of approach adopted, results

Category of Mortgage

Book Value (29 March

2009)

Impairments During

Administration Period

Loss on Sale of "Rump"

Estimated to Realise Comments

£'m £'m £'m £'m

Own originated mortgages

1,069 (44) (2) 1,023

Impairments assumptions were made having regard to historical experience of DBS, knowledge gained from working with peers with similar mortgage portfolios and the sale to Nationwide in March 2009. Assumptions relating to the sale of the "rump" were made having regard to comparable situations to which we have had access.

Social housing

482 - (60) 422

Impairments assumptions were made having regard to historical experience of DBS, the nature of the borrower (low credit risk) and knowledge gained from working with peers with similar mortgage portfolios. Assumptions relating to the sale of the "rump" were made having regard to the actual sale to Nationwide in July 2009, comparable situations to which we have had access and reflect the low yield nature of the book.

Commercial loans

674 (209) (33) 432

Impairments assumptions were made following a review of the underlying credit risk in relation to a substantial and risk-focused sample of individual loans in DBS's commercial portfolio by reference to internal management documentation, and in discussions with the BSS Administrators. Assumptions relating to the sale of the "rump" were made having regard to comparable M&A situations to which we have had access.

Third party acquired mortgages

191 (71) (23) 98

Impairments assumptions were made having regard to historical experience of DBS, the nature of the portfolios and knowlege gained from working with peers with similar mortgage portfolios (including portfolios acquired from the same sellers). Assumptions relating to the sale of the "rump" were made having regard to comparable M&A situations to which we have had access.

Provisions included in opening balance sheet

(36) 36 - - Impairments during the Administration period that were already provided for in the opening balance sheet.

Total

2,380 (287) (117) 1,975


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APPENDIX C – COMMERCIAL LOAN BOOK, SOCIAL HOUSING

IMPAIRMENTS

C.1 Introduction

In this Appendix, I give my response to the detailed queries of the FSCS in relation to CLB impairments,

and receipts from the sale of the Social Housing portfolio at the end of the Administration, as set out in

Section 3.2.1, together with my assessment on the impact of these issues on the FSCS’s overall case.

C.2 CLB impairments

C.2.1 FSCS view

As noted in Section 3.2.1, at Paragraph 1.2.1 of the Annex of their request, the FSCS state that my

estimate of provisions against the CLB - £242m - should be compared with estimated provisions made by

the Administrators (KPMG) of between £100m and £200m, submitted in February 2010. This, inter alia

leads them to conclude (at Paragraph 1.2.4) that the losses that could reasonably have been considered

likely, as at 30 March 2009, would be significantly lower than £242m.

C.2.2 My response

As noted in Appendix B of this report and Appendix E of my Determination, my computation of CLB

provisions does not rely on KPMG calculations, although I have had regard to the information provided

by and discussions with the Administrators. In particular, although my estimates have been refined

through the prism of what could have been known at March 2009, the timing of my work (N.B: my

appointment was less than one month prior to the date of the KPMG communication referred to by the

FSCS) has enabled me to consider a number of factors which were relevant at the Administration date,

but which would not have been known to or fully considered by the Administrators on 4 February 2010.

Turning to the FSCS’s numerical analysis, I am not sure as to the source of the FSCS assertion that

KPMG’s estimated provisions against the CLB lie in the region of £100-200m. As acknowledged in a

subsequent email, copied to HMT, the FSCS noted that the KPMG estimates, set out in an

Administrator’s Estimated Outcome Statement dated 4 February 2010 (“EOS”) do not include a

breakdown between expected provisions with a cash effect and a net present value (“NPV”) adjustment.

They have accordingly undertaken indicative modelling to arrive at their assessment of the above

estimates. I have not been able to validate these workings or their results.

I have contacted KPMG to discuss the possibility of obtaining the relevant breakdowns of “cash” and

“NPV” elements of their estimated recoveries, and therefore provisions. These estimates are set out in a

range, between “high case” recoveries – i.e. lower provisions – and “low case”, i.e. higher provisions.

KPMG have informed me that they now do not consider their February 2010 EOS as a relevant indicator

of what they believe would have represented a reasonable estimate of likely provisions which could have

been made at March 2009, in the light of the impact on their estimate of many facts which were not

known at that date but which provide competent evidence as to the then true position. They believe that

the only robust assessment of these potential provisions at March 2009 is contained in their latest EOS,


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dated 25 June 2012, copies of which have been sent to the FSCS and HMT, and which assume

impairments in the “high case” scenario of £233m, and £324m in the “low case” scenario.

This document is in similar format to the February 2010 EOS, although all provision estimates are stated

without any NPV adjustments, i.e. on the same basis as that used in my Determination. Review of this

provision range reveals that, as regards the combined Commercial and Bought-In loan books, my

estimate of the additional provisions required - £300m– lies approximately at the mid point between the

mean and bottom of KPMG’s recovery range, i.e. between the mean and high end of their provision

estimates.

It should be noted here that the KPMG estimates were produced using two assumptions in particular

which could be expected to give rise to a difference between their estimates and mine, viz:

• KPMG have, in estimating their high case recoveries, used unchanged interest rates across the

period, as opposed to my calculations, which have assumed a rising interest rate, based on the

LIBOR Future Swap Curve at March 2009. They note that, should interest rates rise, this would

“probably [result in] an increase in defaults, arrears and necessary enforcement action. The lower

case estimates are an attempt to reflect this, albeit in a rather unsophisticated way”; and

• KPMG assume an end of Administration in 2014/15, as opposed to my 10 year Administration span.

At the point of a 5/6 year sale, a larger percentage of the portfolio would need to be sold than I have

assumed. I believe that any discount to par on a Year 5/6 sale would be likely to be lower than at 10

years, when the resulting portfolio could be expected to contain a higher proportion of problem

loans.

I believe that the effect of adjusting for these items is to increase both KPMG’s estimated high and low

case provisions, which I consider might move my estimate of £300m of required additional provisions

against the Commercial and Bought-In loan books towards the mid-point of KPMG’s expected range.

I have also discussed with KPMG the basis for their view that the changes between estimates disclosed in

their EOS’s between February 2010 and June 2012 are predominantly the result of evidence which

emerged during that period to further illuminate the position at March 2009, as opposed to changes in the

condition of the loan book after that date. In this assessment, they have confirmed what my own analysis

has revealed in terms of systemic problems within the CLB in particular, viz:

• imperfections in the loan documentation evident throughout the portfolio, which could materially

inhibit the ability of DBS to enforce those normal legal rights on which lenders would rely to

maximise their recoveries; and

• major problems in the financial position and potential solvency of a significant percentage of

borrowers.

These factors were not fully appreciated at the Administration date, and only emerged over time.

In the light of the above, I consider that the estimates of loan impairment provisions provided from time

to time by KPMG serve to support my estimates of the additional provisions required on the Commercial

and Bought-In loan books.


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C.3 Losses on the Social Housing portfolio

C.3.1 FSCS view

As noted in Section 3.2.1 of this report, the FSCS advance a technical argument to suggest that my

assessment of the estimated loss on the sale of the remaining Social Housing loan book at the end of the

Administration period - £60m - is overstated, perhaps by as much as 50%. I repeat this below:

“Nationwide took a fair value adjustment of £62m (similar to the £60m losses attributed to this book in

the determination notice); however they did so on the basis that the book was likely to yield interest

income at a rate below that sufficient to generate an economic return. This low level of interest income

should (and we believe has) been recognised in the Report within the £649m interest income determined

over the 10 year administration period. It is not apparent that any allowance has been made for this in

any calculation of a forced sale discount at the end of the administration period - as a result we are

concerned that there is an element of double counting here…Indicative modelling suggests that even if it

continued to be reasonable to assume that the funding markets for potential acquirers remained difficult

in 2019 it would only be appropriate to expect a discount of around 50% of the fair value adjustment

seen in 2009.”

C.3.2 My response

I should first note that my estimate of the discount on the sale of the rump of the Social Housing portfolio

is equivalent to 25%, a similar figure to that actually realised on the sale of the Bridge Bank in 2010.

As to the merits of the FSCS argument above, I agree with their contention that, where a loan at inception

was valued at a discount to par by virtue of a sub-market rate of interest, that percentage discount could

be expected to narrow as the loan nears maturity, and the implied “interest penalty” decreases. Indicative

yield to maturity modelling conducted by my advisers prior to the issue of my Determination indicates a

similar result to that noted in the FSCS letter.

This trend must however be considered in the light of the likely future market rates of interest on Social

Housing loans relevant to the DBS portfolio. In this connection, the Social Housing Team of Smith &

Williamson has reviewed the composition of the Social Housing loan book at March 2009, and noted the

preponderance of small Scottish HAs in the book. They have also advised that, unlike in the mid-2000’s,

such credits by March 2009 were becoming increasingly unattractive to lenders, who were looking to

concentrate their HA lending on larger Associations, to whom they could sell a range of more

sophisticated (and profitable) financial products. By March 2009 this was pushing up required yields in

the smaller HA sector, despite their good credit risk, as lenders sought to decrease their exposure to such

balances, with good credit prospects but high servicing costs. This trend, which is still in evidence, is

typically being effected by encouraging such HAs to re-finance, by increasing interest rates across the

smaller HA sector. Overall, I calculate that the impact of this would have fully offset the yield to

maturity diminution effect noted above, and fully restore the expected discount to par in 2019 to that

actually realised on the sale of the Bridge Bank in 2010.

C.4 Impact on overall FSCS view

In the light of the above, I consider that my original estimates of loan losses on the CLB and Social

Housing book remain reasonable. This response addresses the bulk of the issues raised by the FSCS in

this area and I believe that the FSCS assertion set out in Section 3.2.1 of this Report that my estimated

loan losses are perhaps as much as £260m in excess of KPMG estimates does not require me to alter my

Determination.


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APPENDIX D – ALTERNATIVE SCENARIOS: BUILDING SOCIETY

INSOLVENCY, BSSA

Introduction

In this Appendix, I set out in more detail why I consider that neither the Building Society Insolvency (“BSI”)

procedure under Part 2 of the Banking Act 2009 nor Building Society Special Administration (“BSSA”) under

Part 3 of the Banking Act represented a competent choice of insolvency regime for the Counterfactual.

Building Society Insolvency

Although BSI provides a specific framework for banks and building societies, once Objective 1 of BSI (to work

with the FSCS so as to ensure that as soon as is reasonably practicable each eligible depositor has the relevant

account transferred to another financial institution or receives payment from or on behalf of the FSCS) has been

met, the BSI procedure broadly follows that of liquidation in terms of the Insolvency Act 1986.

The nature and consequences of liquidation, both BSI and liquidation under the Insolvency Act 1986, mean that

it is the appropriate insolvency regime to use where there is both no prospective or likely purchaser for the

entity's business and the entity's “active” trading life is to be brought to an end.

DBS did enter BSSA (with parts of its business being transferred to a bridge bank and some parts to a private

sector purchaser) which I consider supports the view that some parts of DBS’s business were deemed

commercially viable and could either be sold or traded for a more beneficial realisations of DBS’s assets. As a

result, liquidation in any form would not in my opinion have been an appropriate regime for DBS to have

entered.

In my Report I concluded that the insolvency practitioner in the Counterfactual Regime would have pursued a

strategy of continuing to trade DBS to the extent that parts of the DBS operation would continue to run-off the

loan books over an extended period. The provisions of the Insolvency Act 1986 relating to the powers of

liquidators are applied to BSI and a liquidator in BSI could only carry on the business of DBS so far as may be

necessary for its beneficial winding up.1 The Banking Act does not confer any additional powers on a BSI

liquidator which would allow him to carry on the business of DBS other than would be necessary for its

beneficial winding up. The main functions of a liquidator under BSI or the Insolvency Act 1986 are to secure

that the assets of the company are identified, realised and distributed to the company's creditors and, if there is a

surplus, to the persons entitled to it.2

The powers responsibilities and objectives of a liquidator, whether in BSI or under the Insolvency Act 1986 are

therefore not compatible with an insolvency scenario requiring a sustained period of trading under an office

holder's control.

Liquidation, in any form, does not provide the protection of a statutory moratorium from creditor action. The

inherently complex nature of a formally insolvent building society means that any office holder appointed would

require to work within a regime with the benefit of a moratorium.

I have also taken into account the statutory objective of the Special Resolution Regime under the Banking Act, in

particular the importance of protection of depositors and funds and public perception and confidence in the

1 Schedule 4 of Insolvency Act 1986 as applied to BSI by Section 103 of the Banking Act 2009

2 Section 143 Insolvency Act 1986 as applied to BSI by Section 103 of the Banking Act


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banking sector. I have concluded that the nature and consequences of liquidation in any form preclude

liquidation and BSI from being appropriate regimes for the Counterfactual.

I therefore remain of the view that a form of Administration rather than liquidation would be appropriate for the

Counterfactual.

BSSA

Building Society Special Administration under the Banking Act ("BSSA") was not a competent choice for the

Counterfactual Regime.

Section 136 of the Banking Act provides that BSSA is used where part of the business is sold to a commercial

purchaser or transferred to a Bridge Bank. Section 143 of the Banking Act requires that that the BoE has made or

intends to make a Property Transfer Instrument (“PTI”) before it can apply for a BSSA order.

As set out in Section 4.1.2 of this report the Independent Valuer must assume that no stabilisation power (i.e.

share transfer powers and PTIs) has been exercised. Since I must assume that no PTI has been or would have

been made, BSSA cannot be the Counterfactual, as the key requirement for BSSA is the making of a PTI or the

intention to make a PTI.

DUNFERMLINE BUILDING SOCIETY (DBS) · 4.1. The basis for my “no support” assumption 22 4.2....

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