In 2009, worrying signals were already apparent. The accounts in the 100-plus page annual report showed all was far from rosy in Britannia's garden. The membership reward – the dividend repaid at the end of the year – had shrunk from £45.9m in 2007 to £18.4m in 2008 as a result of a near-80pc decline in operating profit over the same period.
Part of that decline related to the operations of Britannia Capital Investment Group – or BCIG, as it was known internally. BCIG was the society's specialist lending subsidiary, which dealt with making commercial property loans and specialist retail mortgages to individuals or companies who were not members of the society. In the 12 months to 2008, impairment losses from BCIG stood at £56.8m, set against just £1m in the society's bread-and-butter membership business.
The society's cessation accounts – the last published for Britannia on a stand-alone basis – show that in the seven months to the end of July 2009, the situation with BCIG's property book appeared to be worsening. In those seven months, another £44.5m of impairment losses were booked.
The BCIG book had also begun to dwarf its member business. At the point of the merger, member mortgages stood at £10.7bn, while BCIG loans stood at £13.03bn, made up of £3.69bn of commercial property, and £9.35bn of BCIG residential mortgages.
What is more, in those loans which had not been impaired, some 33.9pc of the £9.35bn of BCIG residential mortgages were classed as higher risk. In terms of profitability of default, on July 31, 2009 the society's auditors, PwC, had increased the likelihood to 8.61pc from 6.66pc seven months earlier.
Despite these worrying signs, on August 1, 2009, the two mutuals merged to form the Co-op Bank, bringing together 9m customers, 12,000 employees and 300 branches.
But it was not enough. Peter Marks, chief executive of the Co-operative Group, the Co-op Bank's parent, wanted to make more of financial services.
Within two years, Marks was bidding for Lloyds' 632 branches, known as Project Verde. By December 2011, the Co-op was chosen as the preferred bidder for the Verde branches, and despite reports of questions over governance and capital levels, all appeared to be proceeding as normal until April 24, when the Co-op announced it was pulling out of the £750m deal because of what Marks said was the "current economic environment".
It has since emerged that despite what Marks and the Co-op were saying outwardly, inwardly the story was somewhat different. In the summer of 2011, when the Verde deal was first mooted, Andrew Bailey, then deputy head of the Financial Services Authority's prudential business unit, told the bank's board that on the basis of a high-level examination, he felt it needed more capital to succeed on Verde.
Later, he wrote to the board, saying it needed to strengthen five key areas – capital, liquidity risk management, integration, governance and management – and that the regulator needed to see a plan. In terms of raising additional capital, the bank said it would sell its two insurance subsidies, and also pointed to the capital it would receive from buying the Verde branches, as Lloyds was putting in capital.
By the end of 2012, as part of the stress-testing work being undertaken by the Bank of England, Bailey, now head of the Prudential Regulatory Authority, said that even with proceeds from the sales and the Lloyds capital, it still would not be enough. The Co-op abandoned the deal.
It is now clear that Britannia's loan book is at the heart of what has gone wrong for the Co-op's balance sheet.
Sources who worked on the Britannia deal point to the amount of due diligence that was done at the time. "This wasn't a rushed deal," said one. "It took a long time to come to fruition, and the suggestion Britannia somehow pulled the wool over the Co-op's eyes just isn't the case."
Another source said that the suggestion that Britannia's loan book at the time of the merger is to blame is "not an accurate reflection" of the situation.
Regulatory sources, however, insist that it is Britannia's BCIG loans which have caused the majority of the shortfall. "The situation worsened," said one, pointing back to Britannia's BCIG impaired losses at the time of the merger.
The ins and outs of the shortfall – and why it took so long for it to be made public – will now be the subject of an inquiry by Sir Christopher Kelly, the former chairman of the Committee on Standards in Public Life, which is due to report by next spring's AGM.
The shortfall is also likely to be the subject of Treasury Select Committee hearings.
"None of us quite knows what happened. It was a quite bizarre position that [Verde] negotiations went on for more than a year when this capital shortfall existed," said Vince Cable, the Secretary of State at the business department. " I am sure the Treasury Select Committee will be wanting to have a careful trawl through what has gone on."
The first public confirmation of a capital problem came a few weeks after the Co-op pulled out of the Verde deal, when, in mid-May, ratings agency Moody's downgraded the bank's credit rating to junk, raising the need for external support.
It swiftly emerged the PRA was poring over the Co-op Bank's books to estimate the size of the capital shortfall, and so Euan Sutherland – Marks's replacement as group chief executive – drafted in Niall Booker, HSBC's former US head, to run the bank. UK Asset
Resolution chairman, Richard Pym, was named chairman. Suther-land also took on former Wm Morrison finance director, Richard Pennycook, as chief financial officer.
On June 17, after enlisting the aid of bankers UBS and Allen & Overy, all became clear. The capital hole stood at £1.5bn, and would be filled by a three-prong approach; £500m from the sale of the Co-op Group's insurance subsidiaries; £500m from the Co-op Bank's £1.3bn of junior bondholders and £500m from a bond issued by the Co-op Group.
Although the exact terms of the conversion will not be known until a circular is published in October, it is the one which is not proving popular with several bondholders. The value of the new instruments is not known. However, the PRA on Friday deferred the coupon payments on one tranche of the bonds. For the Co-op's plan to succeed, 77pc of the value of the holders of the subordinated debt and preference shares must back the plan. For retired investors reliant on the bonds for income, the scheme is far from popular.
"I am a retired nurse and the PIBs [corporate bonds issued by the Co-op] made up 50pc of my income. I bank with the Co-op. I shop at the Co-op. I can't believe this is happening and I don't know what I am going to do now," wrote one holder to Mark Taber, who is leading an acting group on behalf of 1,300 retail bondholders who account for approximately £65m of debt.
Of greater concern for the Co-op, however, is a group of hedge funds, co-ordinated by US outfit, Aurelius, which is thought to have enlisted lawyers Bingham McCutchen. The group hopes to strong-arm the Co-op into agreeing better terms, in order to turn a profit.
If bondholders accounting for just 23pc of the £1.3bn of sub-debt reject the deal, the crisis deepens. The Co-op has warned bondholders they face "more severe adverse consequences", claiming the PRA would intervene and put the Co-op into "resolution" – a form of administration that could wipe them out.
Regulatory sources are less convinced that politicians would let the Co-op take the nuclear option. Resolution would inevitably involve taxpayer money, as emergency liquidity and funding would be required. The complicated process could even force the state to inject capital, much as it did with the Royal Bank of Scotland and Lloyds.
To make matters worse, the Co-op has few options. Its banking syndicate – eight banks including RBS, Lloyds, HSBC and Barclays – has extended loans totalling £2.25bn to the group. The bulk of the debt has to be repaid by July 2017, but a £200m portion is due this December.
In July last year, the Co-op raised £1bn as part of a debt refinancing. By then, it was clear the Co-op was in difficulties and the syndicate exacted punitive terms to protect its investment. Those included the right to a large prepayment if any major group asset was sold, as well as a share of sale proceeds and rights to similar terms to any new debt issue.
All that came on top of the standard covenants, such as repayment if the group's credit rating fell below a predetermined level. Those are now close to being breached. After the rescue deal was struck for Co-op Bank last month, Standard & Poor's cut the group's credit rating two notches to a lowly BB-, and warned of "pressure on its financial covenants".
In other words, the group's management cannot simply sell another asset – such as the funerals or pharmacy business – to fill the capital hole in the bank. Doing so would require the syndicate to waive its rights, risking greater losses.
What happens next remains to be seen, but if Sutherland and his new lieutenants are not able to convince bondholders of the merits of the plan, there is a real risk that the vision of a "super mutual" just four years ago could end up in tatters.
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