Analysis: As the UK and Scottish governments ponder the first state rescue of a building society holed by a risky commercial property loan book, they may also want to examine why Dunfermline Solutions was set up as a subsidiary of the society to "provide software solutions and back-office services to deposit takers and mortgage lenders".
As the UK and Scottish governments ponder the first state rescue of a building society holed by a risky commercial property loan book, they may also want to examine why Dunfermline Solutions was set up as a subsidiary of the society to "provide software solutions and back-office services to deposit takers and mortgage lenders".
The society's last annual report published 13 months ago revealed a £9.5m write-down on its IT development but not its ambitious business development plans.
The statutory accounts of the subsidiary, published only five months ago, show that it wrote down £6.9m against "the value of assets in the course of construction", but continues: "The directors are committed to the completion of the development of these systems."
Resources would be made available "through the on-going support" of the society, they went on, concluding: "The directors believe there is a market opportunity for the provision of an operating system that can be offered both in the UK and overseas."
Dunfermline Solutions made a £5m loss (£7.9m before a tax credit) and was left with assets of £20.7m and a deficit of £10.7m - after swallowing up £31.4m to date from the Dunfermline Building Society.
The subsidiary company records that it had one employee, an executive who was paid £76,000.
The accounts were published late last October, several weeks after a boardroom and management shake-up saw the departure of two executives and the arrival as chief operating officer of Jim Willens. In December, Willens was installed as chief executive to replace Graeme Dalziel, 52.
The last report shows Dalziel was paid a salary of £190,000, received further bonuses and pension of £126,000, and was eligible for a further bonus "based on achievement of corporate objectives".
It then goes on: "The corporate bonus in 2007 was zero."
Jim Faulds, however, the former advertising entrepreneur who chairs the building society, gave Dalziel a glowing testimonial, noting he had left the society stronger than when he became chief executive (eight years earlier), although not repeating a tribute he had paid earlier in 2008, when he called Dalziel's leadership "sensational".
The society's 340,000 mem- bers, most of them savers, went to the Dunfermline not for sensation but for safety, yet according to industry experts the society was operating a highly unusual business model for its size in the sector.
They underline that the Dunfermline made operating profits of £11.5m in 2007, but the £9.5m write-off reduced that to £2m, leaving it financially weakened just as the credit crunch arrived. The annual report explained that there had been "changes in the IT market" and the society had decided to "focus on areas of more member benefit".
Asked yesterday whether the project to develop the new business had now been aborted, the Dunfermline declined to respond.
One expert, who has been involved in advising build- ing societies on their accounts for the past 15 years, told The Herald this week: "The Dunfermline was never a particularly profitable organisation. The IT loss was pretty huge compared with the size of their profits - so their buffer against further losses is not as good as it could be."
He went on: "They have a good brand, healthy margins on their residential lending, but venturing into anything beyond housing association finance risks losses on property development type loans. It is easy to grow your balance sheet by lending to property developers, but it is quite unusual for that size of institution. If you are anything less than a £10bn society, the solution is not to get involved in anything other than simple basic commercial loans."
The Dunfermline's expected £26m loss is more than twice the £10m loss which forced a takeover by the Nationwide of the £7bn Cheshire, the only other building society to have cited a major commercial loan default.
The last annual report is packed with glowing testimony to the society's careful management, its rigorous corporate governance, and the mutual benefits' to members.
"There are a number of critical ways in which our situation differs from that of Northern Rock," Faulds wrote.
But the two organisations do share the same supplier of balance sheet management software. It enables the financial institution to receive regu-lar reports on balance sheet risk, interest margins, interest rate risks, and liquidity.
The supplier Strategic Risk International promises "expert support, globally, round the clock" from its base in Chatswood, NSW, Aus- tralia. It does not have a UK base and could not be contacted yesterday. The Dunfermline said its suppliers were confidential.
In its last report, the Dunfermline assured: "Building societies are subject to more stringent regulatory controls than banks and DBS adheres strictly to these requirements."
But there was nothing to stop the society embarking on an HBOS-style foray into commercial property lending, much of it south of the border. Assets had been grown in five years from zero to £260m, according to Dalziel in his last review, making up around 15% of total lending, and rising.
Among smaller building societies, that is said to be unheard of.
Asked about its commercial exposure, the similar-sized Nottingham Building Society (assets £3bn) said it was "very low, a few percentage points". The Norwich & Peterborough (£4.3bn) said its commercial book was very small: "We have been a very cautious lender, and that applies to our residential as well as our commercial lending."
Even in residential lending, the Fife-based society seemed determined to punch above its weight when it came to keeping the balance sheet growing. A year ago, it was still offering 100% mortgages - way above the 80% loan to value regarded as conservative in the sector.
Yet its free capital ratio, according to its report in February 2008, had already been eroded from 5.1% the previous year to 4.4%, and its markets were surely already deteriorating.
The Yorkshire Building Society, now the second- largest society after the Nationwide with £23bn of assets, commented: "Our commercial lending is zero."
At the £35bn Britannia, which is merging with the Co-op, a spokesman said: "We do have a commercial investment arm but it is a very modest part of our overall port- folio - nothing like that (15%)."
At the Skipton, fifth-largest society with £13bn of assets and a £22.5m profit in 2008, retail general manager Gordon Jolly said: "We have been in and out of commercial lend- ing over the years, our commercial book is about £550m out of our £7.5bn book (7%)."
He went on: "We took the decision last November to pull out of commercial lending - and there are certain things we haven't done for many years like building development and lending to the leisure industry."
The Skipton, which reported last month, has made virtually no write-downs on its commercial portfolio. "I think we have made a provision against one pub," Jolly said. "You have to be selective."
All three of these bigger societies have developed their own mortgage systems, with both the Yorkshire and particularly the Skipton successfully selling it on to other users in the financial sector.
But most smaller societies have opted to buy an off-the-shelf IT system such as two readily available in the market, from suppliers Lynx and MTV. The Nottingham society a year ago completed a major IT project which saw it replace completel;y its hardware and software systems - at a total cost of £10m.
An industry source commented: "Most small societies use one of these systems, as it is lower cost and lower risk. It is a specialist game, and I don't think it is an easy market to make money in."
On the commercial loans, he added: "I suspect it (Dunfermline) will be lending to developers at money market rates, where if it goes well the developer makes a fortune, and if it doesn't the building society loses money. The bigger societies have the departments and the expertise for commercial lending, the Dunfermline got into it quite quickly with no background."
It now appears that Scotland's only sizeable building society had caught the banking self-destruct virus which originated in Edinburgh.
