Put Northern Rock into run-off

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: SContreras@Euromoney.com

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The UK government’s actions and intentions remain confused. It is time to end the uncertainty.

Do Gordon Brown and Alistair Darling share a fantasy: do they imagine themselves triumphantly working the same kind of turnaround on Northern Rock that Christopher Flowers, the billionaire private equity investor, managed in Japan. Flowers himself clearly saw the chance with the failed UK mortgage lender to repeat his career-defining success in reviving the bust LTCB and re-floating it as the born-again Shinsei Bank at a huge profit.

The Japanese government, advised 10 years ago by Goldman Sachs just as the UK government is today, nationalized LTCB in 1998, sold it to Flowers for a small sum in 2000, yet retained liability to clear its worst bad debts, so enabling Flowers to restructure the bank and reap a huge financial gain. In some ways, it was a notable success, mainly for Flowers, but also in showing how temporary public ownership prevented the worst from engulfing Japan’s financial system.

Japanese taxpayers weren’t so pleased, however, by the huge subsidy they paid to a foreign investor and the fact that his resuscitation of the failed bank entailed foreclosure on troubled Japanese borrowers that went bust.

No wonder, then, that Brown and Darling chose to cut out the middleman and exclude, at least for now, any private equity buyer from profiting from a taxpayer guarantee of Northern Rock liabilities. Similarly, their decision to hang out the hedge funds that bought up equity stakes in the broken bank, hoping to profit from its government guarantee, is entirely justified. Shed no tears for them.

Northern Rock was effectively nationalized on September 12 2007. It could not have survived another week without the support of public money. The decision announced by the UK government in February merely formalized the reality. Politically, having taxpayers take all the risk on liabilities and leaving a private equity investor to profit from the upside was unacceptable. However, it remains to be seen under what circumstances Northern Rock might be returned to private ownership in future.

The question for now is whether a bank can achieve under government ownership the same kind of successful transformation Shinsei did under private equity ownership. It’s not at all clear that it can or that it should even be allowed to try.

The UK government has suggested that Northern Rock will operate as a commercial organization at arm’s length from government and continue to operate as a going concern. The prospect of looking like heroes for turning a profit on the deal clearly tantalizes. And on the day it was nationalized, Northern Rock was advertising for retail deposits with a savings bond paying 6.35% to existing and new customers for cash that can be redeemed instantly at no charge.

The EU authorities on state aid are due to make their judgment in mid-March. Let’s be clear: Northern Rock failed because management and shareholders pursued an unsustainable business model that flourished briefly on low-cost wholesale funding that disappeared in an instant. The limit of national ownership should be to put Northern Rock through an orderly run-off, at the lowest possible cost to taxpayers consistent with protecting depositors and preserving confidence in the financial system. The alternative is to punish those who were more prudent.

In the aftermath of the announcement of the temporary nationalization, confusion reigned. S&P upgraded the credit rating of Northern Rock: Moody’s downgraded it, looking beyond temporary public ownership to the uncertainties surrounding eventual return to the private sector.

Well-meaning actions can have unfortunate unintended consequences. The worry is that nationalization of Northern Rock will involve a bank going into run-off, but that instead of Northern Rock itself, it will be one or more of the private sector lenders that was less dependent on wholesale funding and more conservative on underwriting standards.

On the day Northern Rock’s nationalization was announced, Alliance & Leicester gave a worrying update for its prospects in 2008. Having secured medium-term funding at high cost, it now sees both volumes and margins shrinking. Earnings must fall, leaving less capacity to replenish capital already threatened by write-downs. That’s not a good position from which to compete against a state-owned and subsidized rival.

Perhaps that’s why, as Euromoney has learnt, Darling promised the heads of the six largest UK high street banks at a meeting in early February that Northern Rock would be reduced to no more than one-third of its present size.

The predators recently circling Northern Rock might soon have a new victim in their sights. Let’s hope Brown and Darling aren’t pursuing a leveraged build-up and hoping to add to their portfolio.