Rock Crashes Onto Our Heads

November 16, 2007 5:04 PM




As offers to buy Northern Rock come in, a key question for taxpayers is how to minimise our losses from the debacle.


This is a lengthy blog, but in summary we conclude:


  • Total taxpayer exposure is already £35-40bn (loans plus deposit guarantees)

  • Underlying security is questionable

  • NR shareholders are seeking to profit at taxpayer expense

  • Taxpayer losses will be minimised by setting a short deadline for full repayment

There was a school of thought that reckoned Northern Rock needn't cost taxpayers a bean. Because it was a liquidity problem rather than a solvency problem, we could even be making money. After all, we were lending at a penal interest rate against the security of a very high quality mortgage book. Once the Rock was sold, we'd walk away quids in (eg see here).

We were never convinced by that rosy scenario (eg see this first blog). In particular, NR suffers from a couple of major problems:


  • Questionable asset values- NR has been just about the most aggressive High Street lender, both in mortgages and unsecured loans. True, its mid-year report estimated the overall Loan-To-Value ratio on its outstanding mortgages was only around 60% (ie on average it could afford to see a 40% house price fall before its loans went underwater). But the LTV on its recent mortgages has averaged a rather less comfortable 80%. Moreover, NR has been offering packages of mortgage plus unsecured loan up to a combined maximum of 125% of property value. They might stay lucky in a house price crash. But then again, they might not.

  • Funding collapse- At mid-year, its assets totalled £113.5bn. But only £24.3bn (21%) of that was funded by traditional retail deposits, normally by far the cheapest source of money. The bulk came from the wholesale markets, including a whopping £46bn from securitising bundles of its mortgages via various special purpose financing instruments. They are part of what the FT described as a mind-bogglingly complex offshore financing vehicle by the name of Granite Finance Holdings (investigated in detail by the excellent Richard Murphy). The key point here is that in Credit Crunch World nobody wants to buy such murky beasts. Plus, billions of those retail deposits have also fled through the door, despite that "cast iron" HMG guarantee. Which means that NR's "business model" is irretrievably bust.

And that's precisely why after months of faffing round, it's been unable to secure any of those widely mooted white knight buyers. If it hadn't been for Mr Darling opening our wallet, NR would already be lying in the gutter, belly up.


So far, depending on who you ask, we taxpayers have lent NR about £25bn, secured against some part of those supposedly high quality assets. And it's reportedly earning us a penal interest rate of 6.75-7%, compared to a market rate of 6.3% (three month interbank). So that's a premium of about £100-150m pa over what we could earn by just putting the Bank of England's money into the normal market- not a great reward for that £25bn exposure.


But are we ever going to get that extra interest anyway? At present, the whole lot is effectively rolling up, as our loan grows week by week. To state the obvious, we only get the cash if a buyer comes along and agrees to pay it all back.


And just to be clear, we are currently exposed not only through the c£25bn of loans we've made, but also the unconditional guarantee given on all NR's retail deposits (see this blog). We don't know exactly how much of the £24bn mid-year retail deposits are still left, but we'd guess £10- 15bn.


So our total exposure is already £35-40bn.


And the portents are not good. For sure, the whole shebang has now been put up for sale via a formal bid process. And we hear there are at least eight bidders.


But we must remember this key fact- the sale is being managed by Northern Rock itself to maximise shareholder value- not to safeguard taxpayers from loss.


We can see how things are shaping up in the sale memorandum leaked and published by an FT blogsite earlier in the week. After FT publication, the memo was partially suppressed by NR's investment bankers' lawyers getting a court injunction. But not before we discovered the following key inducements for would-be buyers:


  • The Bank of England's loan facility will remain in place at least up until 2010- the memo assumes £6bn will still be outstanding at that point, via what it calls a "replacement facility"- still provided by the BoE

  • The BoE will reduce the penalty interest rate after sale, allowing NR's profits to rebound to £643m by 2010- which is more than it earned in its record 2006

  • A partial sale of NR is possible, with the buyer taking only the more attractive assets, leaving the less attractive rump to run off over time, with proceeds (if any) used to repay the BoE.

Taxpayers should be alarmed and angry. Northern Rock management is offering our continued support to buyers, so that they can find a buyer for their devalued shares (see also this excellent article by Anatole Kaletsky).


The memo's propositions are outrageous. To start with, there's no way taxpayers should get stuffed with rump assets that nobody else wants. The official line has always been that NR's assets are all high quality, give no reason to question the bank's solvency, and have been checked over thoroughly by the FSA. We've always suspected that's optimistic (see above), but any private buyer must be made to take the whole shooting match. Even if it means the price they pay to NR shareholders is zero (or the traditional £1).

Second, we don't want to be funding their bank. It means we have to borrow more ourselves (for a given money supply), and we don't want our bungling government to be a financial intermediary, with all its attendant risks. And dropping the penal rate is out of the question- our instinct should be to increase it (see above).


The Guardian has run an even more worrying story. They reckon that potential NR bidders are pressing the BoE to waive the entire £2bn penal interest bill that will have been clocked up since the bail out commenced. It's such a jaw-dropping idea, you have to think it's true.


But surely you say, surely the government knows all this and will hang tough with these buyers.


Hmm.


Even setting aside the fact that the government isn't actually the seller, Labour may do whatever it costs us to safeguard those precious thousands of jobs up on Tyneside. Plus, they are so scared of the alternatives (ie nationalisation or receivership), they'll bend over backwards to achieve a sale.


Worse, the shareholders now include a number of high rolling hedge fund players attracted by the smell of taxpayers' blood (one now owns 6.2% of the company). They've bought in because they can recognise a politico on a skewer, and they know that spells easy profit (cf G Soros 1992). Worse, they play something called HARD BALL- much much harder than anything our wibbly politicos are used to. It's simply not a fair fight.


The prospects for taxpayers look bleak. We're already in the can for £35-40bn, which may or may not be redeemable against NR's assets, depending on what they're really worth. And now we face the prospect of new owners who will demand further subsidies out as far as anyone can see.


So what can be done?


Nobody would start from here, but Anatole Kaletsky's plan is the least unattractive option: to concentrate minds, the government should give notice that all loans must be repaid in full by end-February (including the rolled up interest); if not, Northern Rock will be nationalised for £1, the depositors paid out, the assets sold off over a period of time, and the operation closed down.


Taxpayers look most unlikely to escape unharmed. But before we shell out a bean, shareholders must lose the lot.


No argument.




As offers to buy Northern Rock come in, a key question for taxpayers is how to minimise our losses from the debacle.


This is a lengthy blog, but in summary we conclude:


  • Total taxpayer exposure is already £35-40bn (loans plus deposit guarantees)

  • Underlying security is questionable

  • NR shareholders are seeking to profit at taxpayer expense

  • Taxpayer losses will be minimised by setting a short deadline for full repayment

There was a school of thought that reckoned Northern Rock needn't cost taxpayers a bean. Because it was a liquidity problem rather than a solvency problem, we could even be making money. After all, we were lending at a penal interest rate against the security of a very high quality mortgage book. Once the Rock was sold, we'd walk away quids in (eg see here).

We were never convinced by that rosy scenario (eg see this first blog). In particular, NR suffers from a couple of major problems:


  • Questionable asset values- NR has been just about the most aggressive High Street lender, both in mortgages and unsecured loans. True, its mid-year report estimated the overall Loan-To-Value ratio on its outstanding mortgages was only around 60% (ie on average it could afford to see a 40% house price fall before its loans went underwater). But the LTV on its recent mortgages has averaged a rather less comfortable 80%. Moreover, NR has been offering packages of mortgage plus unsecured loan up to a combined maximum of 125% of property value. They might stay lucky in a house price crash. But then again, they might not.

  • Funding collapse- At mid-year, its assets totalled £113.5bn. But only £24.3bn (21%) of that was funded by traditional retail deposits, normally by far the cheapest source of money. The bulk came from the wholesale markets, including a whopping £46bn from securitising bundles of its mortgages via various special purpose financing instruments. They are part of what the FT described as a mind-bogglingly complex offshore financing vehicle by the name of Granite Finance Holdings (investigated in detail by the excellent Richard Murphy). The key point here is that in Credit Crunch World nobody wants to buy such murky beasts. Plus, billions of those retail deposits have also fled through the door, despite that "cast iron" HMG guarantee. Which means that NR's "business model" is irretrievably bust.

And that's precisely why after months of faffing round, it's been unable to secure any of those widely mooted white knight buyers. If it hadn't been for Mr Darling opening our wallet, NR would already be lying in the gutter, belly up.


So far, depending on who you ask, we taxpayers have lent NR about £25bn, secured against some part of those supposedly high quality assets. And it's reportedly earning us a penal interest rate of 6.75-7%, compared to a market rate of 6.3% (three month interbank). So that's a premium of about £100-150m pa over what we could earn by just putting the Bank of England's money into the normal market- not a great reward for that £25bn exposure.


But are we ever going to get that extra interest anyway? At present, the whole lot is effectively rolling up, as our loan grows week by week. To state the obvious, we only get the cash if a buyer comes along and agrees to pay it all back.


And just to be clear, we are currently exposed not only through the c£25bn of loans we've made, but also the unconditional guarantee given on all NR's retail deposits (see this blog). We don't know exactly how much of the £24bn mid-year retail deposits are still left, but we'd guess £10- 15bn.


So our total exposure is already £35-40bn.


And the portents are not good. For sure, the whole shebang has now been put up for sale via a formal bid process. And we hear there are at least eight bidders.


But we must remember this key fact- the sale is being managed by Northern Rock itself to maximise shareholder value- not to safeguard taxpayers from loss.


We can see how things are shaping up in the sale memorandum leaked and published by an FT blogsite earlier in the week. After FT publication, the memo was partially suppressed by NR's investment bankers' lawyers getting a court injunction. But not before we discovered the following key inducements for would-be buyers:


  • The Bank of England's loan facility will remain in place at least up until 2010- the memo assumes £6bn will still be outstanding at that point, via what it calls a "replacement facility"- still provided by the BoE

  • The BoE will reduce the penalty interest rate after sale, allowing NR's profits to rebound to £643m by 2010- which is more than it earned in its record 2006

  • A partial sale of NR is possible, with the buyer taking only the more attractive assets, leaving the less attractive rump to run off over time, with proceeds (if any) used to repay the BoE.

Taxpayers should be alarmed and angry. Northern Rock management is offering our continued support to buyers, so that they can find a buyer for their devalued shares (see also this excellent article by Anatole Kaletsky).


The memo's propositions are outrageous. To start with, there's no way taxpayers should get stuffed with rump assets that nobody else wants. The official line has always been that NR's assets are all high quality, give no reason to question the bank's solvency, and have been checked over thoroughly by the FSA. We've always suspected that's optimistic (see above), but any private buyer must be made to take the whole shooting match. Even if it means the price they pay to NR shareholders is zero (or the traditional £1).

Second, we don't want to be funding their bank. It means we have to borrow more ourselves (for a given money supply), and we don't want our bungling government to be a financial intermediary, with all its attendant risks. And dropping the penal rate is out of the question- our instinct should be to increase it (see above).


The Guardian has run an even more worrying story. They reckon that potential NR bidders are pressing the BoE to waive the entire £2bn penal interest bill that will have been clocked up since the bail out commenced. It's such a jaw-dropping idea, you have to think it's true.


But surely you say, surely the government knows all this and will hang tough with these buyers.


Hmm.


Even setting aside the fact that the government isn't actually the seller, Labour may do whatever it costs us to safeguard those precious thousands of jobs up on Tyneside. Plus, they are so scared of the alternatives (ie nationalisation or receivership), they'll bend over backwards to achieve a sale.


Worse, the shareholders now include a number of high rolling hedge fund players attracted by the smell of taxpayers' blood (one now owns 6.2% of the company). They've bought in because they can recognise a politico on a skewer, and they know that spells easy profit (cf G Soros 1992). Worse, they play something called HARD BALL- much much harder than anything our wibbly politicos are used to. It's simply not a fair fight.


The prospects for taxpayers look bleak. We're already in the can for £35-40bn, which may or may not be redeemable against NR's assets, depending on what they're really worth. And now we face the prospect of new owners who will demand further subsidies out as far as anyone can see.


So what can be done?


Nobody would start from here, but Anatole Kaletsky's plan is the least unattractive option: to concentrate minds, the government should give notice that all loans must be repaid in full by end-February (including the rolled up interest); if not, Northern Rock will be nationalised for £1, the depositors paid out, the assets sold off over a period of time, and the operation closed down.


Taxpayers look most unlikely to escape unharmed. But before we shell out a bean, shareholders must lose the lot.


No argument.

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