If, as expected, UK authorities and their financial advisors for Northern Rock fail to attract fresh finance and capital to aid the ailing mortgage lender, nationalisation is highly probable by the end of January 2008. Indeed, as significant time has passed since the bank first reported problems, the chances of Northern Rock finding a viable solution to its predicament are low.
Exacerbated by the squeeze on the credit markets and drying up of wholesale liquidity and funding for banks, the avenues for re-financing have all but dried up. Goldman Sachs, the UK Government’s advisor on the sale and or restructuring of Northern Rock, finally approached Gulf sovereign wealth funds in an attempt to rescue a private deal. Reflecting the weakening position of Northern Rock’s banking franchise and a deteriorating asset yielding balance sheet from the UK’s fifth largest mortgage lender, as well an increased risk profile due to the higher costs in the interbank funding market, Middle East investors were very circumspect about investing. It may have been a different story if Gulf investors were approached earlier in the process.
The UK’s Chancellor, Alistair Darling, has conceded huge difficulty in securing private sector finance to cover the £26 billion (Dh188bn) lent by the government to support Northern Rock. The search for a private solution faced many difficulties as many financial institutions cannot borrow or lend at the sums required.
In a precursor to probable official confirmation, the UK Treasury and the chancellor have made it clear that nationalisation is a very live option. The treasury recruited the former boss of Lloyd’s insurance market, Ron Sandler, to lead Northern Rock in the event of nationalisation. The treasury has a fully developed plan to own and manage the bank, should a commercial solution be impossible. Sandler restored confidence in Lloyd’s after its years in financial disarray and massive losses.
The next few days will be crucial. Shareholders sought to restrict the ability of the company’s board to sell assets without seeking their permission. This is largely driven by two hedge funds, RAB Capital and SRM Global. Both have built considerable stakes in Northern Rock over the months following Northern Rock’s problems.
The value of their investment has been hit very hard and both companies’ investment strategies in special situations appears to have missed the mark this time. In order to try to improve their investment position, they have been vocal in calling for a private solution, and mainly supporting the Olivant Group’s bid and proposal.
Shareholders’ action and, inter alia their objectives, are in effect hostile to the interests of taxpayers. This is important as UK taxpayers are exposed to Northern Rock to the tune of £55bn through direct loans made by the Bank of England and guarantees to other lenders made by the treasury.
It is all very well shareholders trying to put in place stricter conditions regarding the sale of the bank’s assets but the fact is that the government, and specifically taxpayers’ money, is supporting the bank to a substantial level.
The treasury’s priority is to secure repayment of taxpayers’ money. If this does not occur, then it will be a huge burden for Gordon Brown’s Labour Government with criticism dragging on up to the next election. Nevertheless, nationalisation will also be seen as a failure of government regulation and supervision and specifically reflect poorly on the British Prime Minister and Chancellor. It is thought that nationalisation was seen as the best option some months ago but delay has been in part caused by the government’s wish to find a private sector solution. Semi-nationalisation has also been mooted with the government taking a stake. However, this was considered too messy.
The Bank of England, and therefore the treasury and taxpayers, have already incurred a notional loss on one element of its exposure to Northern Rock. The so-called premium on the interest payable on the Rock’s loans from the Bank of England is being rolled up into subordinated debt rather than being paid in cash. This subordinated debt now has a market price of 65 pence in the pound, implying that the government is incurring a 35p loss on every pound of subordinated debt it receives from the Rock.
In a further signal nationalisation is close, Rock agreed to sell £2.2bn, or two per cent, of its mortgage assets to JP Morgan. The lender said it will use the funds to reduce the £25bn of emergency loans it has been given by the Bank of England. The price JP Morgan is paying represented a 2.25 per cent premium over the value of the assets. While the premium is positive, the bank has begun to sell some of its best assets. The assets sold was a portfolio of equity-release mortgages. The equity-release mortgages are normally sold to older people who agree to sell some or all of their home in return for a small income.
The facilities have a low loan to value ratio and are therefore considered higher quality than other Northern Rock mortgages, where some mortgages have loan to value ratios of 125 per cent. Together with current restrictive international financial markets for raising cash, a further obstacle for potential suitors is Northern Rock’s pension fund. The bank’s pension fund now has a £100m deficit, which has just been disclosed. This would have to be taken on by any buyer.
Goldman Sachs aimed to structure and convert up to £15bn of the taxpayer loan into bonds, for sale to international investors. Gulf sovereign funds and other large Middle East investors were approached by Goldmans. However, the proposal proved difficult to complete and this undermined attempts to organise a commercial rescue of the Rock by either a consortium led by Virgin Group or by the Olivant Group.
To have made the bonds attractive and sellable, the new Northern Rock bonds would need to have carried a AAA credit rating, and hence would need to have been guaranteed by the treasury and be the equivalent of gilt-edged stock. Alternatively, to gain the AAA rating, the large global commercial reinsurers could have insured them. This would be costly. Moreover, a number of reinsurers have also come under pressure and their own credit ratings are under review.
However, completion of the bond issue is still considered a remote possibility. Due to the government’s involvement, it required the approval from Brussels and this is believed to have been forthcoming. The prime minister will also need to approve the financing. The bond proposal, which will allow Northern Rock to repay some of the £26bn in emergency loans, gives a credible financing package to any of the private-sector solutions.
A distant third solution involves an internal rescue bid. The board of Northern Rock would appoint well-regarded ex-Resolution plc chief executive and former investment banker Paul Thompson as chief executive. This would be accompanied by a £1bn cash call and a promise to aggressively shrink the business to a £60bn loan book.
The UK Government holds the trump card in making the final decision. They are propping up the ailing bank. Without the £26bn funding, the bank would collapse.
If nationalisation does occur, management and the government’s aim will be to protect the existing franchise as much as possible, restoring the overall financial profile and performance of the bank, and strengthening the funding position. The government will look to actively sell chunks of the bank’s assets in order to repay the borrowings. The defence of the bank’s franchise will not be easy. Already, much of it has eroded and realistically there is not a lot of value in the Northern Rock name. Going forward, if the bank is finally sold following nationalisation, it will be a slimmed down version.