Thursday, February 21, 2008
Half-baked Rock 2
Are we all up to speed with Northern Rock's offshore financing vehicle Granite? It has featured heavily in the debate this week as it finally dawned on everyone that a socking great chunk of NR's mortgage assets has already been pledged to Granite as security for its wholesale borrowings, and they are therefore excluded from the assets being nationalised.
We've blogged Granite many times before (eg see here). Last November we explained its significance thus:
"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... 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."
Now for taxpayers, there are two key problems with this.
First, the mortgages that have been pledged to Granite are almost certainly the best quality ones NR has. Which means the stuff we're left with- the "unencumbered" rump- contains a concentration of dodgy loans, including all NR's unsecured lending.
Second, the value of the mortgages pledged to Granite exceeds the value of the loans raised through Granite. In other words, Granite is "overcollateralised". That's standard practice with these vehicles, and largely explains why the Crock was able to borrow more cheaply through Granite than directly on the market: Granite's investors know they have a safety cushion of overcollateralisation in the event of mortgages defaulting and are therefore willing to lend at a lower average rate.
But of course the converse is also true: lenders to NR directly have less security, because the assets backing their loans and deposits are reduced by the amount of Granite's overcollateralisation*.
Thus Granite hits taxpayers two ways, greatly increasing our exposure to default on the Crock's mortgages and other loans.
But there's more. As we've blogged before, Granite imposes other obligations on NR: it isn't "fire and forget" funding. In particular, NR is obliged to maintain Granite's pool of mortgages as they get repaid. It has to replace redeemed mortgages with new ones of comparable quality and characteristics.
If it doesn't do that, "the trustees of the fund could call for a “rapid amortisation” of Granite, which would require bondholders to be paid back in full." In other words, there'd be a fire sale of assets, in which Granite's trustees would act purely in the interests of bondholders. They'd probably be fine because they could afford to use that overcollaterisation to cut prices. But for taxpayers itw would be very costly: they'd certainly lose as the mortgages were sold off cheap.
Which of course is why Ron Sandler may find it difficult to stop NR extending new mortgages- he has to keep the pipeline going or risk Granite going into "rapid amortisation".
What a mess.
So what's the scale of the problem? What's the likely damage?
As usual it's difficult to tell because we've had no proper accounts from the Crock for months, and Darling won't tell us anything (after all, we're only the taxpayers). But the number that's been bandied about is £49bn.
Of that, a wedge will be the overcollateralisation. Last November, the Economist reckoned it was £7bn; the current estimate is around £6bn. Either way, that's a big chunk of taxpayer value at risk.
And that's without considering the fact that Granite forces us taxpayers to hold the lower quality assets. For example, as at end-June last year, £8bn 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.
There's so little hard information about NR's true financial position, we can't really put a figure on our prospective losses. But as we said the other day, given the prospects for the housing market and NR's mounting problems with bad debts, a £10-20bn loss is by no means inconceivable.
*Footnote: Granite is an excellent example of financial sleight of hand. By bundling its highest quality most secure mortgages off its main balance sheet, and adding in a fat collateral cushion, Crock was able to borrow at lower rates in the international wholesale market. But its existing onshore lenders and depositors (in particular Mr and Mrs Joe Public) were left lending to an entity that was correspondingly much less secure. Of course, they had no idea what was going on and imagined NR was just the same old safe-as-houses High St presence it had always been. What a shame we didn't have a financial regulator full of bright savvy people, poring over the books and blowing the whistle before things got out of hand. But all we had was Brown's hopeless FSA.
PS For excellent further analysis of the Crock and Granite, see Richard Murphy's Tax Research UK. Tyler has manifold issues with Murphy's philisophical adherence to Big Government, but on the grisly details of this disaster he's definitive.