HSBC fires US executives as it works to get Household in order

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"Embarrassing", "catastrophic" and "disastrous" as not words one usually associates with HSBC. But they were being thrown around with wild abandon yesterday as the market woke up to the first profits warning in the 167-year history of Britain's biggest and most prestigious banking group.

The first came from the mouth of an HSBC spokesman; the latter two were used by analysts to describe a truly horrific trading statement in which the company was forced to admit it had got its figures on non-performing loans - bad debts - badly wrong.

While the market had expected provisions of about $8.8bn (£4.5bn) to cover these, the bank was forced to admit it will need to set aside nearer $10.6bn. The reason? The US sub-prime lender, Household.

Everyone knew there was a problem with the business, which offers mortgages and other loans to people whose poor credit histories mean they are shunned by mainstream lenders.

The company was forced to admit in December that it was grappling with difficulties at the operation, bought for $15bn in 2003. Some clients were defaulting on second mortgages within just six months of taking them out.

However, it appears that the bank underestimated the scale of the difficulties faced by Household. The biggest problem lies with mortgage books bought from other banks. There is a plethora of small banks in the US and their financing costs are much higher than HSBC's. So, the reasoning went, if HSBC were to buy up these books it would produce a good return because it could finance the acquisitions relatively cheaply.

What it didn't take into account was a fundamental problem with the US housing market. There has been an unprecedented construction boom in the US over the past 15 years. So much so that the Goldman Sachs economist, Jan Hatzius, estimates there are about 1.5 million excess homes in the US.

Combined with that is the impact of 17 successive interest rate rises in two and a half years, taking them up from 1 per cent to 5.25 per cent. Aside from a few "bubble" areas (central Manhattan, for example) these two factors have caused house prices to fall.

Typically, sub-prime borrowers tend to refinance their sub-prime Household mortgages after a couple of years, having established a credit history. However, they have been finding this increasingly difficult as the equity built up in their homes from rising house prices has been wiped out and interest rates have risen. Just meeting repayments has proved a serious struggle, and many of them have ended up defaulting on their loans.

Unfortunately, for HSBC, it has not been able to recover much when this happens.. Flling house prices means the resale value of a repossessed house is lower. What's more, the lack of equity in these houses means that where people have two mortgages on them, there tends to be little left for the provider of the second mortgage after the sale, and Household has an awful lot of second mortgages on its books.

HSBC's combative chief executive Michael Geoghegan was talking tough yesterday. "Are we on top of it [Household]? Yes we are and we are resolving it," he said. "We have put in people in the risk-profile side and we are bringing in a more consistent HSBC quality. We are bringing this business under the HSBC model."

Asked under what circumstance the bank would simply have done with the affair and sell Household, he said: "We are not considering selling so that is not a question it is worth responding to. We are feeling the house price impact in certain areas but 90 per cent of our customers are still paying us."

Getting "on top of it" has meant shaking up the management at Household. Yesterday the bank said Brendan McDonagh, previously chief operating officer of the company's New York retail bank and a well-respected HSBC lifer, was hurried in as chief operating officer and vice-chairman at the beginning of the week.

Those blamed for the debacle in the Household mortgage business have been fired but Bobby Mehta, chief executive of the US operations, has so far clung on to his job.

Mr Geoghegan also said the bank would be wary of buying up books of second mortgages or self-certification mortgages (sold to the self-employed and others unable to prove their income) in future.

The focus of Household - or HSBC Financial Corporation as it is now known - will change. HSBC wants to focus on the US's rapidly growing immigrant community who know its brand from their countries of origin and can be relied upon to work hard at establishing themselves and drag themselves up the social and income ladders.

Yesterday a spokesman sought to defend Household's history saying: "We still don't think this was a bad acquisition at all. Over three years we have made $9bn in profits and a 16 per cent return on our investment."

But with bad debts also rising in the UK, thanks to record levels of personal insolvency, is it not simply true that HSBC is not very good at lending money? "This is not the case. Our Asian businesses are doing well and this is a specific issue. Our UK bad debts are small by comparison."

To be fair, Household was bought under when Sir John Bond was executive chairman although Stephen Green (who now occupies that position) was chief executive. And they can hardly blame Sir John for what has happened since his departure.

Dissident investors are growing increasingly restive over this once rock-solid bank's performance. The bank's shares were the worst performers in the UK banking sector last year and some of the worst in Europe. If improvements do not start to happen fast it will not just be managers at Household who start to lose their jobs.

Those at the top of the heap may be looking for new opportunities as well. Yesterday's trading statement (profits warning) was a first for the bank. Many are now asking how long before it will be followed by a defenestration at the top.