Dancing with the Untouchables

With NatWest now in the fold RBS continued to grow. Five years post NatWest and with a raft of further acquisitions we find RBS still unstoppable, ranked according to some measures among the top five biggest banks globally. The insatiable appetite for growth and expansion still hadn’t been satisfied and much like the early pioneers RBS was to take the advice to “Go, west young man!”The USA was now in their sights.

With their US arm Citizen giving them a bridge-head in America it was time to advance further into what they hoped would be the road to further fortune. Mellon Financial became the first target of the Scots giant and was duly captured, but this was only a prelude to what was to follow.  The main battle plan was actioned with a massive $10.5 billion takeover of Charter One. RBS had now extended its’ reach into the lucrative Chicago market and had gone from a regional UK entity to the 7^th largest bank in the USA.  What could possibly go wrong? Was the sun ever going to set on this doyen of the banking industry?

This massive 30 billion shopping spree by RBS had taken its toll and all was not well, perhaps the sun was beginning to at least dim. There were dissenting voices in the city and those that felt that RBS had overpaid for Charter One. The doubters contributed to a drop in the share price. The RBS lion was on the defensive and would have to fight back.

RBS looked to Greenwich Capital which they had inherited with NatWest to provide a path to recovery. They acquired huge bundles of mortgages and loans from banks and other lenders across the USA. The bundles were then packaged up, sliced and diced and sold on to investors. The state of the US housing market must have given hope at this stage, with real estate experiencing a boom and realising extensive profits. There was an in-built weakness with this strategy as there was a negative relationship between time and the number of people the bank could lend to. This weakness forced the bank to foray into what now appears as the high risk world of sub-prime lending which involved lending to those who in more cautious times would be termed financial untouchables, borrowers with issues, Gorton (2009) characterises them as those with:

“(1) insufficient funds for a down payment on the house; (2) credit issues, either no credit history or prior problems repaying debts;(3) an inability to document income; (4) a lack of information or erroneous information.”

 This dance with the untouchables was viewed as incurring a high level of risk but as long as the mortgages were paid the investors would reap the rewards. This risk initially appeared to pay off as the City recovered its belief in RBS and resulted in a share price increase.  Sir Fred Goodwin appeared either to be ignorant of this strategy or else wholly embarrassed by it. In the Annual Report for 2006, Sir Fred referred to RBS’s “longstanding aversion to sub-prime lending, wherever we do business.”  Was this a case of hear no evil, so no evil, or did this knight of the realm allow himself to be blinded by profits despite massive risk? It would not be long before this house of cards would fall.