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First of all, I thought it would be interesting to have a look at how the bank is actually structured at the moment. Sadly I can find no information about Northern Rock's current balance sheet but what I have been able to find is some information from the first half of last year showing how the bank is actually funded:
http://companyinfo.n...ockEx070725.asp
crock1.PNG (17.08K)
Number of downloads: 63
Now as we can see Northern Rock had just under £25bn of retail deposits (bank accounts basically), £26 billion in non-retail deposits (basically money from short and medium term loans from other financial institutions and bond issues), £45 billion in securitisations and around £8 billion in covered bonds (these are basically mortgage backed securities which are kept on the bank's balance sheet).
The £45 billion, nearly half of the bank's total funding comes through bond issues through its Granite subsiduary. Unsurprisingly information on this operation is not particularly forthcoming but I have been able to find out a couple of things:
http://ftalphaville....-northern-rock/
http://www.taxresear...eeding-answers/
Basically Granite is set up as a charitable trust fund to raise money for a small Down's syndrome charity called Downs Syndrome North East. Despite having somewhere between £45 and £50 billion in assets, Granite has never actually made a profit or donated a penny to Downs Syndrome North East. Its very existance came as a bit of a surprise to the charity which issued a press release saying it had never heard of Granite and confirmed that it had never received a penny in funding. Granite itself is owned by a holding company called the Law Debenture Society which is in turn controled by Northern Rock.
Granite has a prospectus which can be downloaded from Northern Rock's website here
The kind of securities issued by Granite are shown on the first page of its prospectus:
Crock2.PNG (25.51K)
Number of downloads: 36
Basically they are long term bonds and appear to be backed by the choicier bits of Northern Rock's mortgage book. As far as I can see the majority of these have been bought by large US institutions such as Merril Lynch.
Now there is a particularly tasty problem to deal with in relation to Granite in that the average length of time somebody has a Northern Rock mortgage for is three years after which many people choose to remortgage. Some of the bonds issued by Granite have a 50 year term, not maturing until 2054. Northern Rock has a contractual obligation in that it has to make sure that should some of the mortgages be repaid or should one of the moregagees go bankrupt then it has to replace that mortgage with another from its book. In other words Northern Rock, a soon to be nationally owned company has a legal obligation to keep feeding an offshore holding company with new mortgages for up to 50 years from now. If it doesn't then investors are contractually entitled to call in their entire £45 billion worth of loans (http://www.telegraph...m....xml&page=1). It was partly this relationship which allowed Northern Rock to obtain large amounts of funding in the first place. In essence, in exchange for £45 billion in funding it has allowed Wall Street to cherry pick its assets for the next 50 years.
Dodgy though all this undoubtedly is, this was not, as far as I can see, the source of all Northern Rock's troubles to begin with. If we go back to the balance sheet we can see that about a quarter of Northern Rock's funding, some £26 billion or so comes from "non-retail deposits". Again the structure of these is about as clear as mud, but one or two tidbits of information can be gleaned from the Crock's own website.
The "investor relations" page from 2004 gives a little more detail:
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Non-Retail Funding
Total net non-retail funding for the year amounted to £3,317 million with balances at 31 December 2003 amounting to £17.0 billion (2002 - £13.7 billion). Our non-retail funding provides a balanced mixture of short and medium term funding with increasing diversification of our global investor base. In July 2003 Moody's confirmed an upgrade to our long-term credit rating from A2 to A1, which will further benefit diversification and the cost of funding.
During 2003 several notable transactions were successfully concluded, contributing to the £3.6 billion of medium term funds raised during the year. We completed the first benchmark senior fixed rate Euro transaction for a single A rated UK financial institution raising €750 million. In October 2003 we raised US$600 million of Floating Rate Notes achieving 40% placement with Asian investors. In May 2003 we signed a £750 million syndicated revolving loan facility which at the time was the largest plain vanilla term facility ever established by a UK financial institution. Already in 2004 we have raised £1.5 billion through our US and Euro Medium Term Note programmes.
We intend, subject to market conditions and regulatory approval, to strengthen our funding this year with the introduction of a covered bond programme.
Total net non-retail funding for the year amounted to £3,317 million with balances at 31 December 2003 amounting to £17.0 billion (2002 - £13.7 billion). Our non-retail funding provides a balanced mixture of short and medium term funding with increasing diversification of our global investor base. In July 2003 Moody's confirmed an upgrade to our long-term credit rating from A2 to A1, which will further benefit diversification and the cost of funding.
During 2003 several notable transactions were successfully concluded, contributing to the £3.6 billion of medium term funds raised during the year. We completed the first benchmark senior fixed rate Euro transaction for a single A rated UK financial institution raising €750 million. In October 2003 we raised US$600 million of Floating Rate Notes achieving 40% placement with Asian investors. In May 2003 we signed a £750 million syndicated revolving loan facility which at the time was the largest plain vanilla term facility ever established by a UK financial institution. Already in 2004 we have raised £1.5 billion through our US and Euro Medium Term Note programmes.
We intend, subject to market conditions and regulatory approval, to strengthen our funding this year with the introduction of a covered bond programme.
So the plan was to raise money by whatever dodgy bond issues, loans and securitisations the market would bear. Another more recent page tells the story of what went wrong:
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Funding
Global investor appetite in the medium and long term markets, for either senior unsecured or asset backed securities, is currently greatly reduced. Whilst we expect conditions will improve over the medium term, potential volumes and pricing levels for the remainder of 2007 are likely to remain less favourable than those which have been achieved during the last two years. While Northern Rock has continued to raise new funds, these have been mainly in the short term wholesale debt markets and the amounts raised have not allowed Northern Rock to refinance maturing liabilities as well as to write new business at previous levels. In view of the difficulties Northern Rock has had in accessing longer term funding and the mortgage securitisation markets, the Company has been using its cash and other liquid reserves to support the funding of its business. Northern Rock expects current market conditions to continue for some time.
In light of the above, Northern Rock has concluded that it is important to ensure that additional standby liquidity arrangements are available. Accordingly, Northern Rock has agreed with the Bank of England that it can raise such amounts of liquidity as may be necessary by either borrowing on a secured basis from the Bank of England or entering into repurchase facilities with the Bank of England. Such repurchase facilities would include securities that have prime residential mortgage assets as underlying collateral. The collateral that can be used under this "Repo" facility is similar in nature to the collateral currently utilised by many Eurozone banks with the ECB. This additional source of funding will enable Northern Rock to adapt its business model in line with the developing market conditions.
Global investor appetite in the medium and long term markets, for either senior unsecured or asset backed securities, is currently greatly reduced. Whilst we expect conditions will improve over the medium term, potential volumes and pricing levels for the remainder of 2007 are likely to remain less favourable than those which have been achieved during the last two years. While Northern Rock has continued to raise new funds, these have been mainly in the short term wholesale debt markets and the amounts raised have not allowed Northern Rock to refinance maturing liabilities as well as to write new business at previous levels. In view of the difficulties Northern Rock has had in accessing longer term funding and the mortgage securitisation markets, the Company has been using its cash and other liquid reserves to support the funding of its business. Northern Rock expects current market conditions to continue for some time.
In light of the above, Northern Rock has concluded that it is important to ensure that additional standby liquidity arrangements are available. Accordingly, Northern Rock has agreed with the Bank of England that it can raise such amounts of liquidity as may be necessary by either borrowing on a secured basis from the Bank of England or entering into repurchase facilities with the Bank of England. Such repurchase facilities would include securities that have prime residential mortgage assets as underlying collateral. The collateral that can be used under this "Repo" facility is similar in nature to the collateral currently utilised by many Eurozone banks with the ECB. This additional source of funding will enable Northern Rock to adapt its business model in line with the developing market conditions.
So basically the bank was unable to sell long or medium term bonds to cover its funding needs, perhaps because the market didn't expect a chunk of its customers to be actually paying their mortgages in 5 years. It was forced to turn to shorter and shorter term funding and when this dried up it had to start eating into its cash reserves and shareholder capital. Since these were of the traditional "waffer thin" Basle II variety it was forced to seek emergency funding from the Bank of England which in turn triggered a bank run which required the government to step in and guarantee its deposits with taxpayers' money.
The government itself is now in quite a bind. It has at this moment something like £28 billion in direct exposure to Northern Rock in the form of emergency loans from the Bank of England. Presumably there is still a large chunk of Northern Rock bonds and securitisations out there which will need to be redeemed at some point, and if it can't do this via the money markets, which seems likely, or from whatever is left of the Crock's deposit base then that will have to be met by further loans from the Bank of England. What the government would presmuably like to do is gradually wind up the bank and use money from interest payments on its mortgages to gradually pay back the Bank of England loan. Whatever is left of the bank at this point would then be on a relatively sound business model. The gigantic problem for them however is what to do about Granite, the offshore charitable foundation with billions of assets which has never actually raised a penny for Down's syndrome. The government has to keep feeding the monster with new mortgages and so can't simply wind down the Crock's mortgage book - it has to keep getting new business. The problem of course is that the Crock doesn't actually have any money to lend. Furthermore the sheeple are basically maxed out on debt now and physically finding people to take out new mortgages may be difficult. Of course the government could use powers given to it in the forthcoming banking bill to nationalise Granite as well but then it has to find another £45-50 billion to do this. Unlike the Crock's shareholders, whose assets are effectively worthless, Merril Lynch and the like are currently sitting on hard assets with a real value providing (currently) a decent yield and are going to want hard currency for those bonds, presumably at face value as well. The government could try and raise this money through a bond issue, but guess who buys the bonds? Probably the same cartel of Wall Street banks that set up the Granite deal in the first place.
Looked at this way one of the reasons the US banks wanted the Granite deal structures this way in the first place become clear - they've got the government right where they want them. They get 50 years worth of guarenteed payments from Granite because the alternative is basically the government defaulting on the debt. Whilst Granite was owned by the Crock then defaulting on the debt was a real possibility but now the Crock has been nationalised the banks are sitting on top of £50 billion of sovereign backed debt yielding not the measly 4.5% or so of UK treasury bonds but rather US$ LIBOR plus a premium of anything up to half a percent. I don't know what LIBOR currently is but I'm guessing the yield on these will be somewhere around 6-7%.
So let's all take a moment to look at this picture of Gordon Brown and marvel at what a good job he's done of running the economy, shall we?
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