With all the turmoil in the banking world, the disgrace of Iceland and a host of British savers getting a narrow escape*, I thought I would write a post about our often ignored building societies. After all, none of them have gone bust whilst all of the ones that the carpet baggers got their grubby hands have sunk like a stone. Just look at the casualty list of demutualised societies:

Halifax, Northern Rock, Bradford & Bingley, Alliance & Leicester, Birmingham Midshires… perhaps they should have remained mutual societies.

So why might building societies be safer than banks?

You have to look at why they demutualised in the first place. Northern Rock’s rapid expansion was only possible because it got a large portion of its funding from the money markets. This reliance on wholesale funding was ultimately the cause of it’s demise. Had it remained a building society it would not have been able to access this external capital, would not have been able to grow so aggressively and, I suggest, would not have gone belly up.

There are limits on how building societies can raise funds other than from individuals and on lending other than fully secured on residential property. At least 50% of the funds of a building society (or of the society’s group) must be raised in the form of shares held by individual members of the society. These rules leave no room for highly leveraged high risk growth strategies.

As at August 2008 there were 59 building societies in the UK with assets of £360bn, including mortgage assets of £250bn. Savings balances were £235bn. That seems pretty prudent to me.

The hunger for growth and expansion led Northern Rock to famously offer it’s 125% loan-to-value mortgages. This kind of irresponsible lending is not something you find in building societies. Building societies are primarily for the provision of (sensible) mortgage lending to members. They are not investment banks like Lehmans, JP Morgan, Goldman Sachs or any of the other irresponsible institutions that built their vast empires on massive leverage.

Now I hate to suggest that greedy executives drove societies to demutualise but… a study conducted in 2005 by Kent Business School showed that between 1993 and 2000 executive remuneration at demutualised societies increased by 293% compared to 65% at building societies.

Building societies also serve the wider interests of society in a way that banks just don’t. Not everything a building society does is driven by turning a profit – unlike banks. For example, if you struggle to get on the housing ladder and need a shared ownership mortgage where are you going to get one? Leeds building society, Kent & Reliance, Nationwide, (and Halifax but of course that’s a hangover from their mutual days). These are not the sort of institutions to take excessive risks for a bit of extra profit. They are cautious and, dare I say it, more caring than banks with a genuine concern for customers.

Having said all that, most of my personal money is not in building societies. I think that given the actions taken over the Northern Rock, Icesave, Bradford & Bingley episodes that if you are a UK resident with your money deposited in a UK bank then your savings are probably safe. I took my savings out of Icesave because I didn’t trust the Icelandic compensation scheme (phew!) but I have every confidence that my savings are safe where they are in Egg, Abbey, Northern Rock and Nationwide (the only building society on my list). Not only are they all covered by the UK Financial Services Compensation Scheme but the UK government has made it clear that they will not allow savers to lose their money.

* Readers from the Isle of Man have commented that there were no guarantees for them and another reader who had savings in the Guernsey branch but was not resident there says that he’s not sure if he is covered. Bank guarantees are not international.

UPDATE 11 October 2008: although I stand by the majority of this article, my conclusion has changed. Given recent actions by the UK government it is my opinion that savings are as safe in Egg (if you are a UK resident) as any other UK bank.

Egg Savings caused a stir back in the 90s with their internet only savings account that paid (if memory serves) 6% when others were all nearer 5%.  It was new, modern and friendly and all of us young internet friendly types flocked to them with our savings.  That, of course, was a classic customer acquisition strategy.  Just like MBNA entering the UK market with credit cards that were much cheaper than the competition.  Go in with a killer product then expand your range and cross-sell other products to your new customers to recoup your money.

Now it’s a different story.  Now it seems that those offering the highest interest rates may well be the ones that are most desperate for our money.  The ones that can’t buy at a decent price on the money markets which, to be fair, is not uncommon.

I mentioned previously that Egg was sold off by Prudential to Citibank in 2007.  It wasn’t a fire sale but it certainly was going cheap.  I know sometimes we don’t like to think of companies earning huge profits because it feels like we must be paying too much for their products or services but actually if they don’t make a profit then they won’t be around long!  Making a profit is good for the company and the consumer as long as its not an outrageous amount (leaving aside the obscene amounts some banks have been pocketing).

So, not doing that well and eventually sold off to Citibank.  Now Citibank has lost a fair amount in the recent troubles and is looking far less solid than it did.  They were very active in the rather dodgy credit default swaps (CDS) market.  Credit-default swaps are contracts issued to cover potential losses on corporate debt, bonds and mortgage securities. AIG suffered an $11 billion writedown on its CDS holdings. The CDS market is in a real mess – these insurance contracts can go through multiple trades so that when a default occurs the insured party doesn’t know whether or not the holder has the resources to cover the default.  I saw this on Bloomberg:

The $62 trillion market for credit- default swaps, created to protect banks from loan losses, helped fuel a near-meltdown in the financial system and now may be regulated for the first time.

A few points: not regulated!; $62 trillion!; and an ailing $700 billion rescue package.  The credit default swaps issue could be much bigger than the sub-prime mortgage market trouble.  Essentially what is happening is that the banks are over-leveraged (they’ve borrowed too much) and need to get rid of some of their debts.  They will be frantically trying to attract our cash deposits over the next couple of years.

So back to Egg.  It’s covered by the Financial Services Compensation Scheme (see earlier posts) so your money is safe up to £35,000 per person.  The parent company?  Well, I don’t have confidence in any american bank.  People have been talking about the risk of Kaupthing Edge and IceSave going bust but if you look at CDS prices you would think the same of many US banks right now.