Friday, November 23, 2007

How Much Will We Lose On Northern Crock?


The Crock- "rotten as a carrot"

Having glanced under the bonnet, none of the prospective buyers thinks the Crock is even worth a fiver. And they're only prepared to tow it away for scrap if we taxpayers provide them with fully comp insurance for free.

So how much are we going to lose? [NB this post has got longer and longer- you may need the towel wrapped especially tight round your head to get through it- alternatively, cut to the conclusion].

It remains very difficult to estimate because the whole grisly business is shrouded in mystery. But we do have some further small chinks of light this morning.

In his Commons statement on Monday, Darling tried to give the impression our loan is all secured against "quality assets". We were sceptical, and today the Guardian reports that only half of it is secured:

"The first tranche of the Bank's emergency lending to Northern Rock in September has been secured against specific assets. But the second tranche is secured only by a more general floating charge, which would mean the Bank would be vying with other creditors for repayment if Northern Rock failed. It is not clear how much money was loaned in each tranche, but the emergency loans are thought to have been for about £11bn each."

When we looked at taxpayers' exposure, we pointed out that at mid-year £54bn of NR's £87bn mortgage portfolio was already pledged against wholesale market borrowings (our analysis has since been picked up in an interesting piece in The Business).

We also noted that NR's leaked sales memorandum (now suppressed by court injunction) reportedly shows that £74bn of mortgage loans are currently "encumbered". We hoped and presumed that the £20bn growth from £54bn to £74bn represented the security given against the BoE loan.

It now seems we were too optimistic. One reason may be because we ignored the fact that the offshore financing vehicles (including Granite) through which that £54bn of secured wholesale borrowing was done, contain more than £54bn of NR mortgages. In other words they are "over-collateralised", so as to provide a safety margin for NR's wholesale funders. Leaving, of course, fewer mortgage loans on NR's core balance sheet to pay off other lenders in the event of liquidation, at least in the near term.

And according to this week's Economist, the amount of this over-collateralisation is £7bn. The implication is that of the £74bn pledged mortgage assets, £61bn or so is ringfenced inside the offshore companies. On that basis, the assets pledged to us only amount to around £13bn, or less.

The truth seems to be we taxpayers have £11bn or £12bn of unsecured loans to the Crock. And that's on top of our unsecured exposure via the guarantee to depositors: at mid-year such deposits amounted to £30bn, but we estimate they've since halved to around £15bn (see previous blog).

So out of our total loans of £35-40bn, our total unsecured exposure is now ballpark £25-30bn. Including several hundred million of subordinated debt (again, see previous blog).

Of course, if NR's assets are all top notch- as Darling originally asserted- it needn't be too much of a problem, at least in the long-term. But we've always feared the loans are not all top notch, and here the Guardian has more bad news:
  • Mortgage loans of over 90% of the purchase price of a house have soared to £16bn, from £2.7bn, in the space of three years

  • Loans have exceeded the value of the property on nearly 2,500 mortgages, with a value of £263m. Three years ago, the figure was just £13m on 158 properties

  • 10,000 Northern Rock customers are a month or more in arrears on their mortgages, on loans worth nearly £1.2bn. At the end of 2003, there were only 2,500 in the same difficulties, with mortgages worth £168.8m

  • In 2003 Northern Rock repossessed 80 properties. Last year more than 1,000 properties were repossessed. By the end of September this year 912 properties had already been repossessed.

And note this analysis is of the mortgages that have been pledged to NR's offshore financing vehicles. They may well be the best of NR's overall mortgage book, in order that NR could ensure the credit rating agencies gave their offshore funding issues high ratings. The mortgages left back home on NR's residual "rump" book may well be the ones the international wholesale market wouldn't have liked.

So to summarise, the Crock has £87bn of mortgages (mid-year), some £61bn of which are ringfenced inside the offshore companies. Leaving around £12-13bn pledged against the Bank of England loans, and a mere £13bn to repay all unsecured lenders, including depositors. And since we know virtually nothing about those mortgages, they could be quite badly exposed to a housing market... umm... "correction".

Of course, NR also has around £25bn of other assets (mid-year), but again, the quality may not be the highest. For example, £8bn of that was unsecured personal loans, including NR's "Together" top-up loans for mortgagees, which could take their combined loan up to 125% of their house value (note- the secured mortgages seem to have been shunted off into the offshore companies, with the unsecured top-up loans left on the main NR balance sheet). And for all we know, some of those non-mortgage assets may well have been pledged against specific loans from other wholesale lenders: we just don't know.

And understand this: because NR's offshore company borrowing is overcollateralised by £7bn, in the event of a liquidation, that's £7bn less to pay out its other creditors, at least in the short-term (say, the next 5-10 years). Now, if the Crock does get liquidated, shareholders will lose all their funds, which at mid-year, amounted to £3.3bn (including so-called reserve and subordinated capital debt). But even netting that off the £7bn, there's still a shortfall of around £4bn. So not all onshore creditors will get paid out any time soon.

OK, so what could it all mean for taxpayer losses?

Let's assume house prices fall by 10% from the values currently assumed by NR- by no means an extreme assumption given current market conditions. The Guardian's analysis suggests up to £16bn of the £61bn offshore pledged mortgages would then be underwater- ie one quarter. On that basis, we should assume that at least a quarter of the £26bn probably lower quality mortgages in its rump book would also sink beneath the waves: call it £6-8bn.

Of course, just because borrowers have negative equity doesn't mean they will default. But we now know that at least 10,000 customers are already in arrears, and many are facing considerable hikes on fixed rate deals resetting over the next twelve months. There will be many more arrears on properties that no longer cover the outstanding loan. Yes, repayments can be deferred and mortgages extended, but defaults would definitely increase.

And if borrowers do default in a falling market, then we're looking at a fire sale. The kind of knock-down repossession property auctions we saw back in the early-90s, when the discount on fair market price was often 20-40% (see here for recent 20-30% repossession discounts in a strong market).

A large-scale fire sale would mean Big Discounts. A quite plausible one-third discount on £6-8bn nominal value would mean a loss of £2-3bn.

So for a 10% house price fall, is £2-3bn our prospective loss? In theory, it should be less. Apart from the fact that not everyone would default, our £11bn of secured lending should incorporate a collateral margin, just like with NR's offshore funding programme. But can we be sure the BoE insisted on that? We don't know.

Also, NR's other unsecured creditors should take a share of the pain. Judging from the mid-year report, they hold about £18bn of senior unsecured NR debt, and should rank pari passu with our £25-30bn unsecured exposure in a liquidation.

Drawing this together, our best guess is that a 10% fall in house prices could leave taxpayers with £1-2bn loss on repossessions.

But in addition, because of the £7bn "excess" collateral tied up in those offshore companies, we would also have to wait a number of years to get the rest of our money out. At 7% pa the interest cost on that would be around £0.5bn pa, of which £0.3bn pa would fall to us. Call it 5 years delay, equals £1.5bn.
And we also have to consider prospective losses on the £25bn of non-mortgage loans and investments. It's anyone's guess, but the £8bn of unsecured personal loans are particularly concerning, especially those "Together" top-up loans. It would be surprising if we got away with less than another £1bn loss there.

Plus of course, there will be all the usual costs of a bankruptcy. In the case of MG Rover, taxpayers took a hit of £250m on redundancies and other incidentals.

Totting it all up, we get to around £4bn.

And if- heaven forbid but it's certainly on the cards- the housing market went for a real walk, say 20% down, our costs would be considerably higher. Many more mortgages would default, and we could easily be looking at a doubled bill- let's call it £8bn.
As Darling contemplates these risks and the huge political hole he's in, the temptation to do a sweetheart deal with one of these prospective scrap bank dealers is likely to be overwhelming.

But taxpayers should understand we won't avoid the costs. Any buyer will insist on that fully comp insurance.

If things work out, the car doesn't crash, and the buyer manages to sell the bits on, he will take all the upside. But if the bottom drops out of the engine compartment on the way to the yard, and it causes a pile-up, guess who'll be paying.
PS Tyler's first car failed its first MOT. On returning to the garage to pick it up, he was told it was "as rotten as a carrot", and he'd be well advised not to drive it home. Even so, he still sold it- to a somewhat dodgy looking geezer- no questions asked, for 30 notes, cash in the hand (the equivalent of at least £300 today). He's trying deperately to track down the geezer to see if he'd be interested in an MOT failure bank.

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