A RESCUE operation to save one of Britain’s biggest building societies is under way in the first of a new series of expected bailouts in the sector.

West Bromwich building society, which celebrated its 160th anniversary this year, has a loan book worth almost £10 billion. It is being secretly offered to potential white-knight bidders by the Financial Services Authority (FSA), the City regulator.

Coventry and Yorkshire building societies are both in talks with the regulator on a possible takeover of their struggling rival. If no deal can be agreed the worst parts of its loan book are likely to be nationalised, with its 47 branches and 530,000 customers passed to another society. The move follows stringent new stress tests being imposed on the sector by the FSA.

An early draft of West Brom’s full-year results that has been passed to the FSA revealed it made sizeable losses last year due to bad debts on commercial property.

A handful of other societies are also under intense scrutiny and could be forced into finding a suitor, according to insiders. Although none of the societies involved is considered to be in imminent danger, the regulator is concerned about the impact of falling house prices.

The FSA is said to have particular concerns about societies which bought sub-prime mortgage-backed securities from institutions such as Lehman Brothers and GMAC.

Dunfermline building society, which was part-nationalised in March, had £900m of these assets, and huge exposures to commercial property and buy-to-let home loans.

West Brom also owns about £240m of sub-prime mortgage securities bought from GMAC, according to its most recent annual report.

An analysis drawn up by Royal Bank of Scotland into building societies identified West Brom as one of its biggest concerns.

“It has an alarmingly high BTL [buy-to-let] and commercial-loan portfolio, combining to represent nearly two-thirds of the whole loan book,” it said. “The full-year numbers are due within the next few weeks and we expect deterioration to have fed through to arrears and charge-off figures quite materially compared with the half-year.” Robert Sharpe, chief executive of West Brom, insisted he had “no knowledge of any attempt by the FSA to find a buyer for the society” and said the stress-test operations had only recently begun.

Previous rescue auctions for Dunfermline and Bradford & Bingley were conducted by the FSA without the prior consent of the company.

Credit downgrades by rating agency Moody’s on nine building societies have worsened a funding crisis in the sector. The rating cut has forced a number of local authorities to withdraw deposits from building societies, prompting a small-scale run on some.

Local councils have been under increasing pressure from the National Audit Office over how they invest their money since the collapse of Iceland’s banking sector, which ensnared 123 local authorities.

Emergency-funding measures with the Bank of England have had to be renegotiated by some societies as a result of the downgrade. Chelsea, Skipton, Newcastle, Norwich & Peterborough and Principality were among those hit by the rating agency’s actions. Coventry and Yorkshire were also affected but have since resolved the funding issues.

The Bank of England is working on new funding measures tailor-made for the sector to handle these particular issues.

The FSA’s new stress tests have covered more than just funding concerns. The societies were previously forced to model how they would handle a one-in-25-year recession, and are now being asked to test their books to destruction.

There are 52 building societies in Britain with more than 30m customers. The sector holds more than £200 billion in savings and has lent about £400 billion, mostly into the collapsing housing market.

Nationwide, Britain’s biggest building society, has already bailed out three struggling societies and is said to have a limited appetite to do more deals. The new super-mutual being created through the merger of Britannia and the Coop is among other parties being sounded out by the regulator on their appetite for possible deals.

The RBS report into the sector also raised concerns about the Cardiff-based Principality building society, which has more than 20% of its total loan book exposed to commercial lending and 15% in second-charge mortgages.

The RBS analysts also said falling commercial property values could have a severe impact on Newcastle, Britannia and Nationwide – although technical issues made Nationwide’s book less of a concern.

Moody’s report on the sector warned that building societies have limited capital to absorb the extraordinary losses being suffered across the financial sector as a consequence of the global recession.

With no share listing, the societies have limited means to raise more capital. The savage cuts in interest rates by the Bank of England have also discouraged savers from leaving money on deposit. Building societies are more reliant on customer savings than any other source of funding.

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