Chairman's Statement

“On February 22 2007 HSBC fires its head of its US mortgage lending business as losses reach $10.5bn”

This was the headline that signalled the fact that there were problems in the sub prime market in the US. The news warranted a few lines in the financial press but certainly didn’t give any clues to the degree of turmoil that was about to beset worldwide financial markets.

As the weeks passed the story started to unfold and it wasn’t too long before people realised that the problem was not isolated to the US – it was a worldwide problem - but no one knew exactly the extent to which individual financial institutions were at risk and global stock markets reacted accordingly.

Of course this story is still playing out and to this day there is no one who is able to forecast when the financial markets will return to what we would class as normal. For a problem that started over there, its impact is now well and truly being felt over here.

The credit crunch, as it has been labelled, has fundamentally changed the dynamic of the financial markets in the UK and we are seeing banks, building societies and other financial institutions having to adapt their operations to accommodate the demands of the current market. As we all know it’s the banks not wanting to lend to each other that’s making the problem worse and as a result there’s a shortage in what is termed - wholesale funds.

We’ve seen mortgage applications reduce significantly; mortgage lenders realign their lending criteria and reduce their portfolio of mortgage products. Of more interest is the fact that in many instances the historic relationship between mortgage rates and Bank Base rates has been temporarily severed. Whichever way you look at it, it’s not a good time for borrowers.

By contrast the impact on savers is positive as financial institutions offer highly competitive savings rates in order to maintain high levels of liquidity.

It’s a financial backdrop that’s not been experienced by many in the market and it’s one that changes every day. We’re all in uncharted waters and we need to navigate through them very carefully.

So what impact have all these issues had on the Stroud & Swindon.

Well the first thing to stress is that we’re a mutual building society and our prime focus is on providing competitive savings and mortgage products for customers.

We’ve never lost sight of this and that’s why to this day, our mortgages are in the main, funded by savings from our members - typically only around 25% of our funds are sourced from the wholesale market which is below the building society sector average of 30%. Just to put that into context the Northern Rock was operating with wholesale funding levels in excess of 70%.   

At the same time the Society has increased its level of liquidity in order to protect depositors and ensure that they can access their savings should they wish to do so. Indeed we’ve taken a prudent approach and increased the society’s level of liquidity and we now consistently operate at a level well over 20%. Again to put this into context, historically we would operate at around 16%.

We’ve spoken about the effects of the sub prime collapse in the US but we should just spend a few minutes looking at why this part of the market imploded and whether the same thing could happen in the UK. The analysis of what happened in the US is simple – Reckless lending on the part of organisations chasing growth in a low interest environment. Some of the stories you hear, about what was going on in the US, are quite unbelievable.

In the UK we’ve seen mortgage lenders reassess their lending criteria and withdraw completely from certain sectors of the market. There will inevitably be a few people out there who find themselves in a negative equity position and it will certainly be more difficult for certain groups of individuals to obtain a mortgage. Although there are signs that the economy is slowing down and house prices are declining, employment levels remain high and we don’t appear to have quite the same mix of factors at play that resulted in the collapse of the housing market in the US.

So how will the Stroud & Swindon fare in this environment. Well the first thing to say, is that we don’t have any direct exposure to the US market - we don’t write any mortgages in the US and we don’t hold any US mortgage backed securities.

In terms of our mortgage book we have what can only be described as a high quality low risk portfolio. We do have some non-prime mortgages but at the year-end these only represented around 5% of our mortgage assets. In recent years we’ve reduced our activity in the non-prime market when competition eroded profit margins to unacceptable levels, and we no longer felt that the profit adequately covered the risks involved.

With the recent readjustments in the market the risk reward balance is moving back into a more favourable position and there may be opportunities to re-enter this market in the future.

As far as our prime mortgage portfolio is concerned our cautious lending policy has resulted in assets of extremely high quality, which is reflected in the low levels of arrears experienced in 2007. With the recent concerns over house price deflation and negative equity it is of some comfort to know that the average loan to value ratio is only 49% for all mortgage assets held by the Society.    
  
In summary, we’re not overly exposed to the vagaries of the wholesale markets and we maintain a high level of liquidity within the business. We’ve not experienced any difficulties raising funds when we’ve needed them and our prudent business model and sound financial base offers protection against the volatility that exists in the financial markets. Our mortgage asset is high quality and through our own cautious approach to lending we’re not particularly exposed by the recent declines in house prices.

The credit crunch has had an effect on our business and it will continue to do so until the markets return to some form of normality but we’re very clear what we have to do to is ride out the storm and remain in good shape for our onward journey.

But enough about the big picture how did the Society perform during 2007?

The headlines are as follows:

With the market being so competitive it’s essential that the Society not only invests in its core business but it must ensure that it explores ways in which it can continue to maximise the value it provides for members. One of the ways this can be done is to identify and pursue opportunities for diversified sources of revenue in activities that are closely related to our core business as a building society.

With this in mind, during 2007 we established a new subsidiary called Five Valleys Property Company Limited. The company has been set up to invest in new build homes - in and around our heartland, which are then rented out on the open market or leased back to the developer. Over the long term there will be a planned rotation of properties with a view to making a capital gain over a period of time.

At the end of the 2007 we had purchased 23 properties with a book value of £3.7m. In the short time that we’ve been involved with this initiative we’ve found that rental incomes are strong and despite the current market conditions we’d be able to show that a significant capital gain had been made.

Looking ahead we believe there are still many opportunities to acquire further properties at a discount and achieve good levels of rental performance.  Although the housing market may deteriorate this will potentially strengthen the rental market as prospective purchasers’ wait until house prices stabilize or they have to continue to rent because they simply can’t secure a mortgage in the current climate.

We’re pleased with the performance of the subsidiary so far and we believe it’s a diversification, which will generate an important financial contribution to the society over the long term.

I’d now like to move away from the financial performance and initiatives for one moment to focus on a number of Corporate Governance issues that I believe are both topical and particularly relevant to the Society for 2007.

I should point out that the Society continues to meet all the key requirements of the Combined Code and has done so since its introduction.  Last year Mike Bramall, our previous Chairman explained at some length the role and responsibilities of Non Executive Directors and the need for them to be independent of the day to day running of the Society so as to act in the best interests of members and of the Society as a whole.

The society has a policy statement setting out the length of service of Non executive directors that is in line with the Combined Code and recommendations of the Building Societies Association. At the end of this month there will be two Non Executive Directors that will be retiring in line with this policy and good governance practice. During 2007 Stella Pirie another non-executive director also retired from the Board due to other commitments and therefore there were three Board positions that we had to fill.

To ensure a smooth transition we recruited these Non executives last summer and they were phased onto the Board during the autumn. I’m delighted to report that the process was very successful and we were able to appoint three outstanding individuals. Rather than take you through their background and experience now I have asked them to say a few words a little later to introduce themselves.

We were particularly pleased with the recruitment process as it was well structured, transparent and merit based.  Gone are the days when appointments are made on the basis of an individual being a friend of an existing board member.

You may recall that we sent out an invitation for members to apply for the non-executive positions with the Summary Report and Accounts last year and the response was tremendous. We had 124 expressions of interest and from these we received 61 formal applications. In addition to these applications we also drew up a list of external candidates using a specialist recruitment firm. By taking this approach we could be satisfied that we had cast our search as widely as possible and in doing so attract the very best candidates.

In the end 15 candidates were interviewed at length by a panel of four people using structured interview techniques and merit based criteria.   

There will be some members that are disappointed by the fact that we have not appointed more women. When we developed our selection process we were very aware that, as I mentioned earlier, we would have to deliberately cast our net as wide as possible to make certain that we attracted a diverse group of candidates from which we could draw up a short list. Despite adopting this approach the number of female candidates was disappointingly low and unfortunately this was reflected in the number that were invited for interview. 

Once on the shortlist all candidates were subject to the same interview process where the same selection criteria were used irrespective of gender.

What we cannot lose sight of is the fact that as a Board we have a responsibility to members to make certain that we appoint Directors who have the appropriate knowledge and experience to oversee the affairs of the Society.

Whilst we make every effort to appoint individuals from as diverse a group as possible our assessment of any candidate can only be merit based. We don’t employ a positive discrimination policy as we don’t believe it’s in the best interest of the Society or its members.

Finally I would now like to turn to the pay of the Executive Directors.  We have heard much today about the difficulties being faced by firms in the financial services sector. The market is highly competitive and to remain successful businesses must be able to attract, maintain and motivate high calibre Senior Executives.  At the Stroud and Swindon we are absolutely convinced that this is the right approach and this is why we have a well-established process in place to monitor and recommend executive directors’ salaries.
 
Every year the Governance and Remuneration Committee – which is only, comprised of Non Executive Directors, carries out a detailed benchmarking of Executive salaries against published statistics for other UK financial services firms as well as the building society movement. Using these figures as a base, we then take into account the individual experience of Executive Directors their capability and performance in the role, to arrive at a remuneration package that is tailored to each individual.

It’s a thorough and robust process and one that gives me – as chair of the Governance & Remuneration confidence in the Society’s remuneration policies and the salaries awarded as a result of applying those policies.

You’ve heard from David Hill and myself about the performance of the Stroud & Swindon for 2007 together with some of the plans that we have for the future. You will have seen that despite the significant problems being experienced in the financial market the Stroud and Swindon remains financially sound with a balance sheet that has a high level of liquidity and a relatively low dependence on wholesale funds.

We’ve seen that the strength of the traditional building society model has enabled the Stroud & Swindon to respond positively to the disruption being experienced in the market and it reinforces the fact that our focus on traditional lending and savings activities definitely has its advantages.

I hope that above all we have illustrated to you, that you are dealing with a safe and secure provider.