Credit quality and exposure to assets affected by current capital market uncertainties

Overall credit quality remains satisfactory

Impairment losses increased by 15 per cent to £1,796 million. Our impairment charge on loans and advances expressed as a percentage of average lending was 0.82 per cent, excluding the impact of market dislocation and the 2007 Finance Act, compared to 0.83 per cent in 2006. Impaired assets increased by 8 per cent to £5,311 million, less than the rate of lending growth, and now represent 2.5 per cent of total lending, down from 2.6 per cent at 31 December 2006.

In UK Retail Banking, impairment losses decreased by £14 million, or 1 per cent, to £1,224 million. During 2007, we have seen a reduction in the level of customer insolvencies, improvements in the Group’s collections procedures and better than assumed recoveries. The quality of new unsecured lending has continued to be strong and our arrears and delinquency trends have improved during the year. In addition, the asset quality of our mortgage portfolio has remained excellent. Whilst the uncertain UK macroeconomic environment and customer insolvency trends remain key factors in the outlook for retail impairment, our current lead indicators are good, we are continuing to enhance our underwriting and collections procedures and the quality of new business remains strong. As a result, based on current trends, we do not expect a significant change in the retail impairment charge in the first half of 2008, compared to the first half of 2007.

The Wholesale and International Banking charge for impairment losses increased by £264 million to £572 million, including a £92 million impairment charge relating to the impact of market dislocation in the second half of 2007, and a one-off charge of £28 million relating to the impact of the 2007 Finance Act on the Group’s leasing business. The increase in the impairment charge also reflects a lower level of releases and recoveries in Corporate Markets and the impact of recent double-digit growth rates in Corporate lending.

“We do not expect a significant change in the retail impairment charge in the first half of
2008, compared to the first half of 2007.”

Limited exposure to assets affected by current capital market uncertainties

Whilst no bank has been immune to the impact of the turbulence in global financial markets in the second half of 2007, Lloyds TSB’s high quality business model means that the Group has relatively limited exposure to assets affected by current capital markets uncertainties.

US sub-prime Asset Backed Securities (ABS) and ABS Collateralised Debt Obligations (CDOs)

Lloyds TSB has no direct exposure to US sub-prime ABS and limited indirect exposure through ABS CDOs. During the second half of 2007, the market value of our holdings in ABS CDOs reduced and, as a result, the Group has taken an income statement charge of £114 million, leaving a residual investment of £130 million, net of hedges. The write-down largely reflects junior tranches of CDOs which have been written down to the expected interest payments to be received within the next 12 months. The Group has no exposure to mezzanine ABS CDOs. The Group’s residual investment of £130 million is stated net of credit default swap (CDS) protection totalling £470 million purchased from a ‘triple A’ rated monoline Financial Guarantor. At 31 December 2007, the underlying assets supported by this protection had fallen in value, leaving a reliance on the CDS protection totalling £155 million. In addition, we have £1,861 million of ABS CDOs which are fully cash collateralised by major global financial institutions.

Structured Investment Vehicle (SIV) Capital Notes

At 30 June 2007 the Group’s exposure to SIV Capital Notes totalled £100 million. During the second half of 2007 the Group wrote down the value of these assets by £22 million, leaving a residual exposure at 31 December 2007 of £78 million. Additionally, at 31 December 2007 the Group had commercial paper back up liquidity facilities totalling £370 million, of which £98 million had been drawn. All of these liquidity lines are senior facilities. Since the year end, these facilities have been reduced to £208 million, of which £115 million has been drawn. The Group has no SIV-Lite exposure.

Trading portfolio

In the second half of 2007, Corporate Markets also saw a reduction in profit before tax of approximately £144 million as a result of the impact of mark-to-market adjustments in the Group’s trading portfolio, to reflect the marketwide repricing of liquidity and credit. At 31 December 2007 the trading portfolio contained £181 million of indirect exposure to US sub-prime mortgages and ABS CDOs. This super senior exposure is protected by note subordination.

Available-for-sale assets

At 31 December 2007, the Group’s portfolio of available-for-sale assets totalled £20,196 million (31 December 2006: £19,178 million). A significant proportion of these assets (£8.3 billion) related to the ABS in Cancara. The residual assets included £3.2 billion Student Loan ABS, predominantly guaranteed by the US Government, £4.6 billion Government bond and short-dated bank commercial paper and certificates of deposit and £4.1 billion major bank senior paper and high quality ABS. These available-for-sale assets are intended to be held to maturity however, under IFRS, they are marked-to-market through reserves. During 2007, a net £413 million reserves adjustment, which has no impact on the Group’s capital ratios, has been made to reflect a reduction in the value of these assets. These assets are not impaired and we expect to obtain full value for them upon maturity.

The Group’s investment in Cancara, our hybrid Asset Backed Commercial Paper conduit, was £12.0 billion at 31 December 2007, comprising £8.3 billion ABS and £3.7 billion client receivables transactions. Cancara, which is fully consolidated in the Group’s accounts, is managed in a very conservative manner, which is demonstrated by the quality and ratings stability of its underlying asset portfolio. At 31 December 2007, the ABS bonds in Cancara were 100 per cent Aaa/AAA rated by Moody’s and Standard & Poor’s respectively, and there was no exposure either directly or indirectly to sub-prime US mortgages within the ABS portfolio. Since the year end, ABS totalling £67 million have been downgraded. At 31 December 2007 the client receivables portfolio included £115 million of US sub-prime mortgage exposure.

Scottish Widows has no exposure to US sub-prime ABS either directly or indirectly through CDOs. The Group holds £25 million of short-dated SIV commercial paper through Scottish Widows.