Subordinated Taxpayers


Junk bonds at least give you a nice certificate to hang on the wall


So following Darling's statement on Northern Rock this afternoon, are we any the wiser?

Not really- "it would be quite wrong to dismiss any option now without proper consideration as some suggest," doesn't really tell us anything.

More to the point, are we all up to speed on subordinated debt?

Because as taxpayers, it looks like we need to be.

In the event Northern Rock goes into liquidation, we will be waiting in line with all the other creditors. Hoping the liquidators can raise enough from selling NR's assets to pay us all out. Our problem is that not all creditors are equal. Some have claims that rank a long way ahead of ours.

At the top of NR's claims tree are the secured creditors. They are people who've lent money specifically secured against a chunk of those high quality mortgage loans we've heard so much about.

Now, Darling tried hard this afternoon to leave us with the impression that all of our exposure is of this kind- debt secured against "quality assets". But that's not true.

First, we need to note that because of the way NR funded itself in the wholesale money markets, a large chunk of its mortgage loans have already been pledged as security against market borrowing. Those mortgages have been ringfenced, most via NR's complex offshore financing vehicle Granite, for the benefit of investors in its Medium Term Notes. Others have been assigned to a presciently constructed "bankruptcy remote special purpose vehicle" as security for NR's Covered Bond programme.

How much of NR's mortgages are so pledged? In its mid-year report, NR said it had £54bn of such secured borrowing, implying that over 60% of its £87bn mortgage loan book was pledged.

Of course, we don't know what's happened since then because we taxpayers have been kept in the dark. But those who've seen the leaked sales memorandum (see this blog) tell us that £74bn of the mortgage loan book is now "encumbered"- ie pledged as security. A chunk is (presumably) pledged to the Bank of England against our £25bn loan , but it sounds like at least £50bn is still pledged to wholesale creditors.

After the secured creditors, next in line come the so called senior unsecured creditors. They get first dibs on any fire sale proceeds left over after the pledged assets have been stripped away. In NR's case, this ought to encompass all the other creditors with the exception of subordinated debtors. That includes the depositors, and the holders of senior debt issues.

Taxpayers have exposure to this unsecured senior debt via our guarantee to depositors, including all wholesale deposits (see HMT statement here). As at mid-year, such deposits were somewhere between £33bn and £48bn (depending on what exactly comprised "deposits" as opposed to other forms of borrowing.

Subordinated creditors come last, ranking just above the equity investors, who of course get nothing in a liquidation.

And for obvious reasons, NR subordinated (or sub) debt is getting riskier by the day. Moodys just cut its credit rating today, while S&P already assigned it a junk rating two months ago.

Now in theory, we taxpayers shouldn't have any subordinated debt exposure at all. But according to the BBC's Robert Peston, the penal element of the interest charged by the Bank of England on our loans to NR is being rolled up as subordinated debt, apparently not to be repaid for five years. Worse, the penal element has been defined as not merely the c 0.5% excess over the normal market interbank rate, but as the c 1% excess over Bank Rate.

According to Peston, it is being held by the Treasury rather than the Bank. More important, it could amount to £500m.

This afternoon, Darling denied it was as much that, but he did not deny its existence. So that's a tranche of unsecured sub debt we knew nothing about until today.

What else don't we know? As Mr Rumsfeld pointed out, we don't know what we don't know.


But it's increasingly obvious that taxpayers are exposed to all layers of Northern Rock's stressed out financial structure. We can take no comfort at all in all those official assurances that our lending is all fully secured. We are at risk all the way down to junk rated subordinated debt.
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