The Business: Hitting Rock Bottom

by Matthew Lynn

Whatever other epitaphs are eventually delivered on the Premiership of Gordon Brown, and on the Chancellorship of Alistair Darling, “decisive” is not likely to be among them. We are now into the third month since the crisis at Northern Rock erupted, causing the first run on a bank in a developed country in living memory and the greatest financial crisis in Britain since the fringe banking collapse of the early 1970s. Yet how much closer are we to a solution? Hardly so much as a step.

Between them, Brown and Darling have failed to provide the leadership the situation demands. They have not come up with a plan. They have failed to protect the reputation of the City, on which the prosperity of the whole economy crucially depends. Instead, they have fluffed around, while the failed bank sinks ever further into a financial swamp.

It was on 13 September that Northern Rock decided to seek emergency funding from the Bank of England; Lloyds TSB had been ready to take on the bank but talks with the Treasury broke down. Northern Rock had adopted what at the time was thought to be a clever business model: rather than relying on deposits to fund its loans and mortgages, it borrowed the funds on the money markets, regularly rolling the loans over as they expired.

As the global credit crunch intensified, the Rock found itself no longer able to roll over its loans, even though its collateral – its mortgage book – was robust. Northern Rock was forced to ask the authorities for help. As the news broke, savers started rushing to withdraw their money, worsening the crisis.

In a panic move, the government rushed to guarantee deposits above the current limit (at present, the first £2,000 ($4,127, E2,791) worth of deposits are entirely guaranteed, and then 90% of the next £32,000, a very low sum). It also agreed to lend what amounts to limitless funds to the Rock to make sure it could pay off its loans. Brown had decided to bail out Northern Rock, putting it on life support.

More than two months later, the situation has barely moved on. Bids for the bank were finally received this week; but the potential costs are surging. Northern Rock has been lent £24bn from the Bank of England. Add in the guarantees to £20bn or so of accountholders’ money and the total exposure for the taxpayer could be well over £44bn. The Rock’s share price plummeted this week; but it remains greater than zero, buoyed by hedge funds hoping the bank will be rescued and that existing shareholders will eventually make money.

There was a decent case to be made for rescuing the bank: the impact on financial confidence and, potentially, on the housing market, had it gone bust, would have been horrendous. But there was an equally good case for letting the bank shut: it would certainly have been a useful reminder to bankers that lending money you don’t have is a risky business. Some savers could have lost a lot of money.

There is no case, however, for the confusion and indecision surrounding Northern Rock since the rescue in September. On Monday, the government took a bad situation and made it a lot worse. The Treasury announced that the £24bn loan was finite and wouldn’t necessarily stay in place beyond next February.

What it was hoping to achieve with that statement, other than to hammer the Rock’s share price, is hard to fathom; the excuse is that Darling still has to figure out whether he can give any aid to Northern Rock without falling foul of European Union rules. The sale documents sent out to possible buyers of Northern Rock contained financial projections in which it borrowed billions of pounds from the Bank of England until 2010.

This is clearly state aid: the rate of interest paid by the Rock to the Bank may be high but it is still lower than what it would have to pay in the marketplace, assuming it could find anybody to lend it the funds, which is another reason why this is state aid, of the kind supposedly banned by Brussels: right now, Northern Rock has zero chance of raising money in the money markets in the usual way. It can’t stage a rights issue: there is no business plan and, as of last Friday, no chief executive either. So, if the government loan was to be withdrawn, it would collapse.

In reality it doesn’t matter whether the government’s assistance falls foul of EU rules or not. Any case will take years to go to the courts; if it thinks it is doing the right thing today, a fine in five or even 10 years’ time should be seen as a price worth paying.

There are many potential buyers for Northern Rock. Richard Branson’s Virgin Group has put together one consortium; another is led by the American buyout firm J.C. Flowers; a third is headed by the former boss of Abbey National, Luqman Arnold. Ten expressions of interest have been received, not all of them serious; one of the potential bidders, Cerberus, a private equity firm, pulled out this week.

Darling has set out the principle that the costs of a rescue should be borne “to the greatest extent possible” by the buyers and the bank itself. That is a shift from the previous position, which was that there should be no cost to the taxpayer. Northern Rock is being charged a crippling rate of interest and has been forced to pledge a chunk of its mortgage book as collateral. But this might be worth less than face value, even though few of its mortgages are thought to be bad; if the Bank of England begins to auction off the loan book, it would have to sell them at a discount.

A new analysis from Mike Denham, an accountant for the TaxPayers’ Alliance, explains why taxpayers are right to worry. If Northern Rock goes into liquidation, taxpayers will be waiting in line with other creditors, at least for part of their liabilities, hoping liquidators can raise enough from selling assets.

At the top of the Rock’s claims tree are the secured creditors. They lent money specifically secured against mortgage loans. Darling tried hard this week to give the impression that all his exposure is of this kind. But that’s not really the case, Denham argues cogently.

Because of the way the Rock funded itself in the wholesale money markets, a large chunk of its mortgage loans have already been pledged as security. Those mortgages have been ring-fenced, most via an offshore financing vehicle called Granite, for the benefit of investors in medium-term notes. Others have been assigned to a presciently constructed “bankruptcy remote special purpose vehicle” as security for its covered bond programme.

In its mid-year report, Northern Rock said that around £54bn of its loan book has been pledged to wholesale creditors. Another £24bn or so will since have been pledged to the Bank of England (if not, taxpayers really are in trouble). The total size of the balance sheet was £113bn mid-year. This must be much lower today, which means that there won’t be that many unpledged assets left.

Next in line come senior unsecured creditors. They get first dibs on any fire sale proceeds left over after the pledged assets have been stripped away. Taxpayers have exposure to this unsecured senior debt via the guarantee to depositors, including all wholesale deposits. As at mid-year, such deposits were somewhere between £33bn and £48bn (including £24bn of retail deposits). This is significantly lower today, which is lucky for taxpayers given how little unpledged collateral there remains.

Subordinated creditors come last; this debt is getting riskier by the day. It is thought that the penal element of the interest charged by the Bank of England on loans to Northern Rock is being rolled up as subordinated debt, not to be repaid for five years. The penal element has been defined as not merely the 0.5 percentage point excess over the normal market interbank rate, but as the one percentage point excess over the Bank rate. This could amount to £500m; Darling denied it is as much as that, but not its existence.

As Denham of the TaxPayers’ Alliance puts it: “It’s increasingly obvious that taxpayers are exposed to all layers of Northern Rock’s 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.”

Both Brown are Darling are now paying the price for their earlier indecisiveness. As soon as Northern Rock ran into trouble there were three realistic options; they haven’t changed since then.

One, let it go into administration. It would have been a rough solution, but so long as depositors were protected it might have avoided the worst damage. Shareholders would have lost everything; but such must regrettably be the fate of anybody who invests in a failed company. It would certainly have served as a warning to the markets that the government doesn’t bail-out companies that make a mess of their finances.

Two, Northern Rock could have been nationalised. Again, that has the virtue of honesty, though it would have meant buying out the shareholders and handing over to them more than they really deserved. A combination of the first solution – administration – and the second – nationalisation – could have avoided this. A hard-headed banker could then be appointed gradually to wind up the bank in an orderly fashion.

Three, the board could have been told to auction the bank off as a going concern to the highest bidder. To do that, the government would have had to spell out exactly how long the Bank of England loan would remain in place, and terms and conditions. This solution might have amounted to giving the bank away for a symbolic £1, or even for the government to pay somebody to buy it. This would have been the best solution; a version of it is still what the government hopes to achieve.

Any of those options could have been chosen at the end of September. All have different costs and benefits, but each of them would have been better than drifting aimlessly. Instead, it is close to the end of November and the government doesn’t appear to be any closer to making a decision.

That is ridiculous. It is not doing anything for the reputation of the London Stock Exchange that what is still – bizarrely – a FTSE 100 Index company has been turned into little more than a casino chip for the hedge funds. There can no meaningful market in the shares of a company with a future this uncertain.

The best we can now hope for is that the bill for taxpayers will not turn out to be too high, and that one of the financial institutions currently bidding will come up with a workable plan, recapitalise the business, line up new borrowing facilities and pay back the borrowing to the Bank.

Two months ago, the Northern Rock disaster could have still been described as an accident: an unfortunate combination of reckless management and a credit crunch in the markets conspiring to bring the bank down. Now, it can only be described as a fiasco, one entirely of the British government’s own making.