Directors' report

Business review - Our 2007 performance

Items excluded from underlying profits

In order to enable stakeholders to obtain a clear view of the ongoing performance of the Group, the Board excludes certain items that are the result of long-term strategic decisions and/or the impacts of unusual and extreme external events and accounting volatility that can have a distorting effect on financial performance in single reporting periods. Profit excluding such items is defined as underlying profit. The items not included in underlying profit are the net loss on sale of commercial and housing association loans, the impairment of wholesale assets, fair value movements and hedge ineffectiveness.

Loss on sale

During 2007, the Board resolved to sell our commercial property and housing association loans. This decision reflects the Group’s strategy of focusing on areas of the lending market that offer superior returns and growth, specifically the UK specialist mortgage market. Under two separate transactions announced in November, a total of £4.0bn of assets were sold for a net consideration of £44.7m below book value. In addition, £13.3m of transactional and restructuring costs were incurred. These assets contributed c. £45m profit to the Group in 2007 and following the sale, the Group retains £1,022m of commercial property and housing association loans.

Asset impairment

At the time of our pre-close trading statement, the Group held £125m in structured investment vehicles (SIVs) and a further £140m in collateralised debt obligations (CDOs) of asset backed securities with some exposure to the US sub-prime market.

At the time of the pre-close announcement, at the end of November, one of our CDO investments of £20m had been further downgraded by rating agents. Since then, further information has become available and we have undertaken analysis on all our wholesale assets, including SIVs and CDOs, in order to identify any that we believe may be impaired. To arrive at this conclusion we have considered actions from rating agents, the pricing on bonds in the market (where available) and reports on the underlying security of bonds prepared by their investment managers. There is a very restricted market for these securities with few, if any, recent trades taking place, therefore pricing information cannot be used as the only guide to value. Consequently, we have also modelled the expected out-turn of some of the investments that have been downgraded or suffered a material reduction in pricing to estimate the likely level of recovery. This modelling uses assumptions based on the performance of the security of the collateral of each investment, the reports from the investment managers and the general liquidity conditions in the market. As a result of this analysis, we have concluded that £64.2m of our SIVs and £30.2m of CDOs are impaired, and accordingly we have made charges to the income statement to reflect these amounts.

Fair value of financial instruments

The volatility of interest rates and asset prices has brought changes to accounting for financial instruments, implemented under the transition to International Financial Reporting Standards. Where in previous periods these movements have been immaterial, in 2007, the Group’s Income Statement contains a number of fair value movements that are more significant. These fair value movements introduce volatility to reported profits, and are therefore not included in the underlying profit of the Group.

Hedge ineffectiveness represents how we account for fair value differences in future cash flows of hedged items. The majority of these items are fixed rate mortgage and savings related swaps and from an economic perspective are matched to customer balances. The movement in the fair value of these items in 2007 was £23.5m.

The Group has a number of investments in synthetic CDOs. The treatment of these financial instruments differs from that of our other CDOs, as they contain an embedded derivative. This means they are subject to fair value accounting, with any movement in current value being recorded in the Income Statement. In the current environment, their market price has fallen significantly which has adversely affected their current value by £49.7m. This movement in value has been recorded in the Income Statement. However, it is important to note that our review of these CDOs shows that they continue to perform and are meeting their coupon payments. We will continue to review these assets on a regular basis and any change in their value will be recorded in the Income Statement.

Other fair value movements

All of the Group’s remaining wholesale assets are held as available-for-sale with any movements in value being recorded in the balance sheet via the available-for-sale reserve. In addition to the amounts recorded in the Income Statement and explained in the preceding paragraphs the Group has recorded a debit to the balance sheet of £60.4m after tax in respect of the fair value movement on these items.